Income Tax Exclusions: Time to Look Again

The current political buzz and mantra of tax reformers is to expand the tax base. By expanding the tax base, the experts tell us will increase revenues and promote fairness in the tax system. For most liberals this means to eliminate deductions, credits and along with raising rates. However, all of this begs the question is exactly included in income? Where is the starting point to make all the calculations for gross income, to adjusted gross income to net income to taxable income to actual taxes paid?

It is no surprise that the tax code takes a very expansive view on what is income. Gross income in the foundation Section 61 of the Internal Revenue Code states that it includes "all income from whatever source derived”. How is that for legislative drafting!

Section 61 goes on to define income to include “(but not limited to) the following items:(1) Compensation for services, including fees, commissions, fringe benefits, and similar items; (2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest; (5) Rents;(6) Royalties; (7) Dividends; (8) Alimony and separate maintenance payments; (9) Annuities; (10) Income from life insurance and endowment contracts; (11) Pensions; (12) Income from discharge of indebtedness; (13) Distributive share of partnership gross income; (14) Income in respect of a decedent; and (15) Income from an interest in an estate or trust.

That is quite a list and courts have consistently given very broad meaning to the definition of income, interpreting it to include all income unless a specific exclusion applies.

So now this is the fun part and the part that does not get much attention.--” exclusions” from income. It seems that even though you have income, it is not really income because the government says it is not for whatever reason and purpose attached. The list is long and I think is worth examining in re-shaping the tax system. Some of the important exclusions include:

Gifts and Inheritances: A gift, bequest, or inheritance is excluded from gross income.

Life Insurance Proceeds: Life insurance proceeds received by the beneficiary are not included in gross income.

Sale of Residence: Sales of principal residences are eligible for a $500,000 capital gains exclusion.

Retirement Income: A portion of the Social Security benefits or railroad retirement benefits.

Interest on State Obligations: Interest received on state and local government bonds is generally excludable from gross income.

Fringe Benefits and other employee benefits: Non-taxable benefits include group health insurance, group life insurance for policies up to $50,000, and other certain fringe benefits, including those under a flexible spending or cafeteria plans.

Adoption Expenses: Taxpayers may exclude from gross income certain amount of adoption expenses received.

Compensation for Injuries and Sickness: Specifically excluded from gross income are amount others are payments under workers' compensation, damages received on account of personal injuries or sickness, payments under accident and health insurance for personal injuries or sickness

Meals and Lodging: Employee may exclude the value of meals furnished by the employer in certain circumstances

Educational Assistance Plans: Certain payments of up to received by an employee for tuition, fees, books, and supplies under an employer's assistance program may be excluded from gross income.

Tuition Reduction Plans: Qualified tuition reductions made available to employees (and their families) of qualified educational institutions are excludable from the employee's gross income.

Dependent Care Assistance Programs: Dependent care assistance benefits paid under an employer plan are excludable from the employee's gross income,

Military Benefits: Qualified military benefits are excluded from gross income.

Scholarships: Excluded from income.

Foreign earned income: Exclusion for U.S. citizens or residents for income earned outside the U.S.

The above list is for illustrative purposes and perhaps each one can be justified on some level. There are dozens more but each one has a cost to the fisk. Let’s look at the cost of some of them. These amounts are taken from a few years ago from published data from OMB and are in dollars per year.

Capital gains exclusion on personal residences: $35 billion
Exclusion of Interest on State and local bonds: $26 billion
Exclusion on Worker’s Compensation benefits: $6 billion
Exclusion of reimbursed employee parking benefits: $3 billion
Exclusion of income earned abroad: $ 3 billion
Employer child care exclusion: $1.4 billion
Exclusion of parsonage allowance: $600 million
Exclusion of employer transit passes: $500 million
Exclusion of Railroad retirement benefits: $400 million
Exclusion of Volunteer EMS and Firefighter benefits: $80 million

The point being is that reforming the tax laws is a complicated process. These exclusions have big revenue impact. Some of the exclusion benefits lower income taxpayers and some- like the State and local interest exclusion- benefit higher income taxpayers. Some are based on common sense and others special interests. They are often overlooked in the discussion on how to design a better and fairer tax system. Many have been embedded for years but they need re-examining. If the traditional and better known “tax expenditures” are to be served up in tax reform, the exclusions are should be first appetizer.