Questions & Answers Series

Federal Income Tax Topics: Exclusions from Gross Income; Gross Income

Exclusions from Gross Income

Question:

Two years ago, Sam was involved in an automobile accident in which he suffered significant injuries to his neck and back. He was out of work for six weeks and incurred medical and rehabilitation expenses. This year, Sam entered into a settlement with the driver of the other car under which Sam received $15,000 for medical expenses, $6,250 for lost income, and $10,000 for pain and suffering.

How much, if any, of the damages that Sam received is includable in gross income?

(A) None of the damages is includable in gross income

(B) $6,250 in lost income is includable in gross income

(C) $16,250 in lost income and damages for pain and suffering is includable in gross income

(D) The entire damage award of $31,250 is includable in gross income

Answer:
Answer (A) is correct. In general IRC § 104(a)(2) excludes amounts received as compensation for personal physical injuries or for physical sickness from gross income, except to the extent that the recipient has taken a deduction in any prior taxable year for medical expenses under IRC § 213 for which he is now being compensated.  Assuming that Sam did not deduct the medical costs that he incurred in prior years, the portion of the damage award that Sam received to reimburse him for medical expenses is excludable from his gross income.  Section 104(a)(2) also applies to damages received to compensate an injured person for lost wages and pain and suffering.  The fact that his income would have been taxable had Sam not been injured and had been able to continue work does not prevent § 104(a)(2) from applying because such damages are "received on account of" the personal physical injury. See, e.g., Commissioner v. Schleier, 515 U.S. 323 (1995).  Answers (B), (C), and (D) are incorrect for the reasons previously discussed.

Gross Income

Question:

Margaret is employed as a software engineer. Margaret received a salary of $75,000 last year. Because of the labor shortage for engineers like Margaret, she is allowed to live in an employer-provided apartment free of charge. Assume that the fair market value of renting the apartment for one year is $18,000. In addition, Margaret received a car from her employer with a fair market value of $20,000 but that was worth only $12,000 to Margaret.

How much must Margaret include in gross income this year? 

(A) $75,000

(B) $92,000

(C) $105,000

(D) $113,000

Answer:
Answer (D) is correct because it includes the value of all cash, property, and services that Margaret received from her employer. IRC § 61 requires that gross income include compensation for services regardless of whether the compensation is received in the form of cash, services, or property. Answer (A) is incorrect because $75,000 represents only Margaret's salary and not the additional benefits received from her employer. Answer (B) is incorrect. Answer (B) represents Margaret's salary plus the value of the employer-provided apartment but does not include the value of the car. Importantly, the Regulations provide that the value of any compensation paid other than in cash must be the fair market value of the services or property received. Treas. Reg. § 1.61-2(d)(1). Answer (C) is incorrect because the value of the car is included in gross income at Margaret's subjective valuation and not its objective fair market value.