14.2 Gross Income Exclusions

14.2 Gross Income Exclusions

REG Area IV, Group A also asks you to calculate the amounts that should be excluded from an individual’s gross income as reported on Form 1040, including tax-exempt interest, gifts received, and life insurance proceeds. That parenthetical is exhaustive for the exclusion task. This section teaches those three completely, then the closely related individual exclusions that REG treats as routine: qualified scholarships, inheritances of the property itself (not income in respect of a decedent), and the classic employee-fringe exclusions. Punitive damages were income in 14.1; compensatory damages for physical injury are the matching exclusion here.

Start from §61. An amount is out of Form 1040 gross income only if a statute takes it out.

Tax-exempt interest — IRC §103

Interest on obligations of a state or political subdivision is generally excluded under §103. This is the municipal-bond exclusion. Report the amount from Form 1099-INT (tax-exempt interest box) for information and for other computations that use tax-exempt interest, but do not include it in Form 1040 gross income.

Not every bond labeled “muni” is tax-exempt. Some municipal issues are taxable municipal bonds; if Form 1099-INT reports ordinary interest, include it. U.S. Treasury interest is the opposite pattern: included for federal tax, often exempt from state tax. REG tests federal inclusion.

Private-activity-bond interest can be a preference item for alternative minimum tax. REG’s assumption is that you will not be tested on inflation-indexed AMT figures. Know that §103 is the exclusion, and that a taxable municipal issue is not §103 interest.

Series EE and I savings-bond interest used for qualified higher-education expenses can be excluded, subject to modified-AGI phaseouts that are inflation-indexed. Do not memorize this year’s MAGI numbers. Know the exclusion exists, that it is for qualified education spending, and that phaseout can take it away.

Gifts received — IRC §102

Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. The property itself is excluded. A $40,000 painting received as a birthday gift is not income. A house received under a will is not income.

Section 102 does not shelter:

• Income from the gifted or inherited property after the transfer — dividends, rent, and interest earned after the gift are the donee’s (or heir’s) income.
• Income in respect of a decedent (IRD) under §691 — unpaid wages, unpaid accrued interest, traditional IRA and qualified-plan balances, and installment-note IRD. The property-law inheritance is real; the income tax still follows the item. IRD is not a §102 exclusion and does not take a §1014 step-up. Basis of inherited non-IRD property is in /study-guides/cpa-reg/asset-basis/inherited-basis.
• Compensation disguised as a gift. Commissioner v. Duberstein requires detached and disinterested generosity. An employer’s “holiday gift” of $10,000 cash to an employee is wages. Tips labeled gifts are still wages. A bonus check with a sticky note that says “gift” is still §61 compensation. Family gifts, by contrast, are the core §102 case.

Gift basis is a different statute (§1015) and a different Blueprint group. Here the only question is inclusion: the receipt of the gift is not gross income. Holding-period classification when the donee later sells the asset is in /study-guides/cpa-reg/gross-income/capital-gains, and the basis arithmetic is in /study-guides/cpa-reg/asset-basis/gift-basis.

Life insurance proceeds — IRC §101

Amounts received under a life insurance contract paid by reason of the death of the insured are excluded under §101(a). The face amount paid at death is the exclusion.

Three overlays REG actually tests:

1. Interest on delayed payment. If the insurer pays the $500,000 face six months late and adds $12,000 of interest, the $500,000 remains excluded and the $12,000 is ordinary interest income. The interest is pay for waiting, not proceeds paid by reason of death.
2. Installment payouts. When the beneficiary elects to take the death benefit in installments, each payment is split between excluded principal (the face, prorated) and taxable interest.
3. Transfer-for-value trap — high level. If the policy was transferred for valuable consideration, §101(a)(2) generally limits the death-benefit exclusion to consideration paid plus subsequent premiums. The exclusion is largely restored if the transferee is the insured, a partner of the insured, a partnership in which the insured is a partner, a corporation in which the insured is a shareholder or officer, or a transferee whose basis is determined in whole or in part by the transferor’s basis (a gift). You do not need the full life-settlement planning overlay; you need to recognize that a purchased policy is not automatically §101-clean.

Cash value withdrawn during life as a policy loan is generally not income; a lifetime surrender with gain is income. REG’s listed task is the death proceeds.

Worked life insurance. Avery is the named beneficiary. The insured dies. In June the carrier pays $500,000 of face plus $12,000 of interest because settlement was delayed. Avery excludes $500,000 and includes $12,000 of interest. If the same $512,000 had been a taxable punitive-damage award, the entire amount would be income. If it had been a gift of cash from a parent, the entire amount would be excluded under §102.

Qualified scholarships — IRC §117

A qualified scholarship is excluded to the extent it is used for qualified tuition and related expenses at an eligible educational institution: tuition, required fees, and required books, supplies, and equipment. Room and board are not qualified tuition and related expenses; that slice is income. A stipend paid for required teaching, research, or other services is compensation, not a scholarship, even if the school calls it a scholarship.

Compensatory damages versus punitive — IRC §104

Section §104(a)(2) excludes damages other than punitive damages received on account of personal physical injuries or physical sickness, whether by suit or agreement, lump sum or periodic. Medical-expense reimbursements for those injuries are also out.

• Physical is the gate. A broken-leg settlement is the statute. Pure emotional-distress, discrimination, or defamation recoveries are income, except to the extent they reimburse medical care attributable to emotional distress.
• Lost wages on account of the physical injury ride along with the exclusion. They are not recharacterized as wages.
• Punitive damages remain income even when the complaint is a physical-injury case. That is the 14.1 inclusion meeting this exclusion. See /study-guides/cpa-reg/gross-income/inclusions.

Employee fringe exclusions at teaching depth

The default remains inclusion at FMV. These exclusions are the routine REG catalog. Do not memorize inflation-indexed dollar caps; AICPA will not test those amounts.

• Employer-paid health coverage (IRC §106). Premiums the employer pays for employee accident or health coverage are excluded. There is no dollar cap in §106.
• De minimis fringes (IRC §132(e)). Property or services so small that accounting for them is unreasonable. Occasional coffee, a low-value holiday turkey, or flowers for a hospitalization can qualify. Cash and cash equivalents, including gift cards, are never de minimis.
• Working-condition fringes (IRC §132(d)). Property or services the employee could have deducted as a business expense if the employee had paid for them: job-related professional dues, a company laptop used for work, business use of a company car.
• Group-term life insurance (IRC §79). Coverage up to the statutory $50,000 is excluded; the excess is income, computed from IRS Table I, not from the employer’s actual premium. $50,000 is a Code number, not an indexed cap.
• Qualified transportation fringes exist under §132, but the monthly dollar ceilings are inflation-indexed. Know the category; do not recite this year’s monthly figure.

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