5. Wages, Salaries, and Other Earnings
Table of Contents
* What's New
* Reminder
* Introduction
* Useful Items - You may want to see:
* Employee Compensation
o Baby-sitting.
o Miscellaneous Compensation
o Fringe Benefits
o Retirement Plan Contributions
o Stock Options
o Restricted Property
* Special Rules for Certain Employees
o Clergy
o Members of Religious Orders
o Foreign Employer
o Military
o Volunteers
* Sickness and Injury Benefits
o Disability Pensions
o Long-Term Care Insurance Contracts
o Workers' Compensation
o Other Sickness and Injury Benefits
What's New
Elective deferrals. The limit on the amount of your wages you can elect to
defer into certain retirement plans (such as section 401(k) plans)
increases each year through 2006. If you are age 50 or older, you may be
able to make additional catch-up elective deferrals. See Elective deferrals
in Retirement Plan Contributions under Employee Compensation.
Katrina Emergency Tax Relief Act of 2005. This Act provides tax relief for
persons affected by Hurricane Katrina. Under this Act, you may be able to
exclude from income amounts you receive as mileage reimbursements from a
qualified charitable organization. See Publication 4492.
Reminder
Foreign income. If you are a U.S. citizen or resident alien, you must
report income from sources outside the United States (foreign income) on
your tax return unless it is exempt by U.S. law. This is true whether you
reside inside or outside the United States and whether or not you receive a
Form W-2, Wage and Tax Statement, or Form 1099 from the foreign payer. This
applies to earned income (such as wages and tips) as well as unearned
income (such as interest, dividends, capital gains, pensions, rents, and
royalties). If you reside outside the United States, you may be able to
exclude part or all of your foreign source earned income. For details, see
Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
Introduction
This chapter discusses compensation received for services as an employee,
such as wages, salaries, and fringe benefits. The topics include:
*
Bonuses and awards,
*
Special rules for certain employees, and
*
Sickness and injury benefits.
The chapter explains what income is included in the employee's gross income
and what is not included.
Useful Items - You may want to see:
Publication
*
463 Travel, Entertainment, Gift, and Car Expenses
*
503 Child and Dependent Care Expenses
*
505 Tax Withholding and Estimated Tax
*
525 Taxable and Nontaxable Income
Employee Compensation
This section discusses various types of employee compensation including
fringe benefits, retirement plan contributions, stock options, and
restricted property.
Form W-2. If you are an employee, you should receive Form W-2 from your
employer showing the pay you received for your services. Include your pay
on line 7 of Form 1040 or Form 1040A, or on line 1 of Form 1040EZ, even if
you do not receive a Form W-2.
Child care providers. If you provide childcare, either in the child's
home or in your home or other place of business, the pay you receive must
be included in your income. If you are not an employee, you are probably
self-employed and must include payments for your services on Schedule C
(Form 1040), Profit or Loss From Business, or Schedule C-EZ (Form 1040),
Net Profit From Business. You generally are not an employee unless you are
subject to the will and control of the person who employs you as to what
you are to do and how you are to do it.
Baby-sitting. If you baby-sit for relatives or neighborhood children,
whether on a regular basis or only periodically, the rules for childcare
providers apply to you.
Miscellaneous Compensation
This section discusses different types of employee compensation.
Advance commissions and other earnings. If you receive advance
commissions or other amounts for services to be performed in the future and
you are a cash-method taxpayer, you must include these amounts in your
income in the year you receive them.
If you repay unearned commissions or other amounts in the same year you
receive them, reduce the amount included in your income by the repayment.
If you repay them in a later tax year, you can deduct the repayment as an
itemized deduction on your Schedule A (Form 1040), or you may be able to
take a credit for that year. See Repayments in chapter 12.
Allowances and reimbursements. If you receive travel, transportation, or
other business expense allowances or reimbursements from your employer, see
Publication 463. If you are reimbursed for moving expenses, see Publication
521, Moving Expenses.
Back pay awards. Include in income amounts you are awarded in a
settlement or judgment for back pay. These include payments made to you for
damages, unpaid life insurance premiums, and unpaid health insurance
premiums. They should be reported to you by your employer on Form W-2.
Bonuses and awards. Bonuses or awards you receive for outstanding work
are included in your income and should be shown on your Form W-2. These
include prizes such as vacation trips for meeting sales goals. If the prize
or award you receive is goods or services, you must include the fair market
value of the goods or services in your income. However, if your employer
merely promises to pay you a bonus or award at some future time, it is not
taxable until you receive it or it is made available to you.
Employee achievement award. If you receive tangible personal property
(other than cash, a gift certificate, or an equivalent item) as an award
for length of service or safety achievement, you generally can exclude its
value from your income. However, the amount you can exclude is limited to
your employer's cost and cannot be more than $1,600 ($400 for awards that
are not qualified plan awards) for all such awards you receive during the
year. Your employer can tell you whether your award is a qualified plan
award. Your employer must make the award as part of a meaningful
presentation, under conditions and circumstances that do not create a
significant likelihood of it being disguised pay.
However, the exclusion does not apply to the following awards.
*
A length-of-service award if you received it for less than 5 years of
service or if you received another length-of-service award during the year
or the previous 4 years.
*
A safety achievement award if you are a manager, administrator,
clerical employee, or other professional employee or if more than 10% of
eligible employees previously received safety achievement awards during the
year.
Example.
Ben Green received three employee achievement awards during the year: a
nonqualified plan award of a watch valued at $250, and two qualified plan
awards of a stereo valued at $1,000 and a set of golf clubs valued at $500.
Assuming that the requirements for qualified plan awards are otherwise
satisfied, each award by itself would be excluded from income. However,
because the $1,750 total value of the awards is more than $1,600, Ben must
include $150 ($1,750 - $1,600) in his income.
Government cost-of-living allowances. Cost-of-living allowances generally
are included in your income. However, they are not included in your income
if you are a federal civilian employee or a federal court employee who is
stationed in Alaska, Hawaii, or outside the United States.
Allowances and differentials that increase your basic pay as an incentive
for taking a less desirable post of duty are part of your compensation and
must be included in income. For example, your compensation includes Foreign
Post, Foreign Service, and Overseas Tropical differentials. For more
information, see Publication 516, U.S. Government Civilian Employees
Stationed Abroad.
Nonqualified deferred compensation plans. Your employer will report to
you the total amount of deferrals for the year under a nonqualified
deferred compensation plan. This amount is shown on Form W-2, box 12, using
code Y. This amount is not included in your income.
However, if at any time during the tax year, the plan fails to meet
certain requirements, or is not operated under those requirements, all
amounts deferred under the plan for the tax year and all preceding tax
years are included in your income for the current year. This amount is
included in your wages shown on Form W-2, box 1. It is also shown on Form
W-2, box 12, using code Z.
For information on the requirements and the amount to include in income,
see Internal Revenue Code section 409A and Notice 2005-1. The notice is on
page 274 of Internal Revenue Bulletin 2005-2 at
www.irs.gov/pub/irs-irbs/irb05-02.pdf.
Note received for services. If your employer gives you a secured note as
payment for your services, you must include the fair market value (usually
the discount value) of the note in your income for the year you receive it.
When you later receive payments on the note, a proportionate part of each
payment is the recovery of the fair market value that you previously
included in your income. Do not include that part again in your income.
Include the rest of the payment in your income in the year of payment.
If your employer gives you a nonnegotiable unsecured note as payment for
your services, payments on the note that are credited toward the principal
amount of the note are compensation income when you receive them.
Severance pay. Amounts you receive as severance pay are taxable. A
lump-sum payment for cancellation of your employment contract must be
included in your income in the tax year you receive it.
Accrued leave payment. If you are a federal employee and receive a
lump-sum payment for accrued annual leave when you retire or resign, this
amount will be included as wages on your Form W-2.
If you resign from one agency and are reemployed by another agency, you
may have to repay part of your lump-sum annual leave payment to the second
agency. You can reduce gross wages by the amount you repaid in the same tax
year in which you received it. Attach to your tax return a copy of the
receipt or statement given to you by the agency you repaid to explain the
difference between the wages on the return and the wages on your Forms W-2.
Outplacement services. If you choose to accept a reduced amount of
severance pay so that you can receive outplacement services (such as
training in résumé writing and interview techniques), you must include the
unreduced amount of the severance pay in income.
However, you can deduct the value of these outplacement services (up to
the difference between the severance pay included in income and the amount
actually received) as a miscellaneous deduction (subject to the 2% of
adjusted gross income (AGI) limit) on Schedule A (Form 1040).
Sick pay. Pay you receive from your employer while you are sick or
injured is part of your salary or wages. In addition, you must include in
your income sick pay benefits received from any of the following payers.
*
A welfare fund.
*
A state sickness or disability fund.
*
An association of employers or employees.
*
An insurance company, if your employer paid for the plan.
However, if you paid the premiums on an accident or health insurance
policy, the benefits you receive under the policy are not taxable. For more
information, see Publication 525.
Social security and Medicare taxes paid by employer. If you and your
employer have an agreement that your employer pays your social security and
Medicare taxes without deducting them from your gross wages, you must
report the amount of tax paid for you as taxable wages on your tax return.
The payment is also treated as wages for figuring your social security and
Medicare taxes and your social security and Medicare benefits. However,
these payments are not treated as social security and Medicare wages if you
are a household worker or a farm worker.
Stock appreciation rights. Do not include a stock appreciation right
granted by your employer in income until you exercise (use) the right. When
you use the right, you are entitled to a cash payment equal to the fair
market value of the corporation's stock on the date of use minus the fair
market value on the date the right was granted. You include the cash
payment in your income in the year you use the right.
Fringe Benefits
Fringe benefits received in connection with the performance of your
services are included in your income as compensation unless you pay fair
market value for them or they are specifically excluded by law. Abstaining
from the performance of services (for example, under a covenant not to
compete) is treated as the performance of services for purposes of these rules.
Accounting period. You must use the same accounting period your employer
uses to report your taxable noncash fringe benefits. Your employer has the
option to report taxable noncash fringe benefits by using either of the
following rules.
*
The general rule: benefits are reported for a full calendar year
(January 1- December 31).
*
The special accounting period rule: benefits provided during the last
2 months of the calendar year (or any shorter period) are treated as paid
during the following calendar year. For example, each year your employer
reports the value of benefits provided during the last 2 months of the
prior year and the first 10 months of the current year.
Your employer does not have to use the same accounting period for each
fringe benefit, but must use the same period for all employees who receive
a particular benefit.
You must use the same accounting period that you use to report the
benefit to claim an employee business deduction (for use of a car, for
example).
Form W-2. Your employer reports your taxable fringe benefits in box 1
(Wages, tips, other compensation) of Form W-2. The total value of your
fringe benefits may also be noted in box 14. The value of your fringe
benefits may be added to your other compensation on one Form W-2, or you
may receive a separate Form W-2 showing just the value of your fringe
benefits in box 1 with a notation in box 14.
Accident or Health Plan
Generally, the value of accident or health plan coverage provided to you by
your employer is not included in your income. Benefits you receive from the
plan may be taxable, as explained later under Sickness and Injury Benefits.
Long-term care coverage. Contributions by your employer to provide
coverage for long-term care services generally are not included in your
income. However, contributions made through a flexible spending or similar
arrangement (such as a cafeteria plan) must be included in your income.
This amount will be reported as wages in box 1 of your Form W-2.
Contributions you make to the plan are discussed in Publication 502,
Medical and Dental Expenses.
Archer MSA contributions. Contributions by your employer to your Archer
MSA generally are not included in your income. Their total will be reported
in box 12 of Form W-2 with code R. You must report this amount on Form
8853, Archer MSAs and Long-Term Care Insurance Contracts. File the form
with your return.
If your employer does not make contributions to your MSA, you can make
your own contributions to your MSA. These contributions are discussed in
Publication 969, Health Savings Accounts and Other Tax-Favored Health
Plans. Also, see Form 8853.
Health flexible spending arrangement (health FSA). If your employer
provides a health FSA that qualifies as an accident or health plan, the
amount of your salary reduction, and reimbursements of your medical care
expenses and those of your spouse and dependents, generally are not
included in your income.
Health reimbursement arrangement (HRA). If your employer provides an HRA
that qualifies as an accident or health plan, coverage and reimbursements
of your medical care expenses and those of your spouse and dependents
generally are not included in your income.
See also Reimbursement for medical care under Other Sickness and Injury
Benefits, later.
Health savings accounts (HSA). If you are an eligible individual, you and
any other person, including your employer or a family member, can make
contributions to your HSA. Contributions, other than employer
contributions, are deductible on your return whether or not you itemize
deductions. Contributions made by your employer are not included in your
income. Distributions from your HSA that are used to pay qualified medical
expenses are not included in your income. Distributions not used for
qualified medical expenses are included in your income. See Publication
969, Health Savings Accounts and Other Tax-Favored Health Plans, for more
information.
Contributions by a partnership to a bona fide partner's HSA are not
contributions by an employer. The contributions are treated as a
distribution of money and are not included in the partner's gross income.
Contributions by a partnership to a partner's HSA for services rendered are
treated as guaranteed payments that are includible in the partner's gross
income. In both situations, the partner can deduct the contribution made to
the partner's HSA.
Contributions by an S corporation to a 2% shareholder-employee's HSA for
services rendered are treated as guaranteed payments and are includible in
the shareholder-employee's gross income. The shareholder-employee can
deduct the contribution made to the shareholder-employee's HSA.
Adoption Assistance
You may be able to exclude from your income amounts paid or expenses
incurred by your employer for qualified adoption expenses in connection
with your adoption of an eligible child. See the Instructions for Form
8839, for more information.
Adoption benefits are reported by your employer in box 12 of Form W-2 with
code T. They are also included as social security and Medicare wages in
boxes 3 and 5. However, they are not included as wages in box 1. To
determine the taxable and nontaxable amounts, you must complete Part III of
Form 8839, Qualified Adoption Expenses. File the form with your return.
De Minimis (Minimal) Benefits
If your employer provides you with a product or service and the cost of it
is so small that it would be unreasonable for the employer to account for
it, the value is not included in your income. Generally, the value of
benefits such as discounts at company cafeterias, cab fares home when
working overtime, and company picnics are not included in your income.
Holiday gifts. If your employer gives you a turkey, ham, or other item of
nominal value at Christmas or other holidays, do not include the value of
the gift in your income. However, if your employer gives you cash, a gift
certificate, or a similar item that you can easily exchange for cash, you
include the value of that gift as extra salary or wages regardless of the
amount involved.
Educational Assistance
You can exclude from your income up to $5,250 of qualified
employer-provided educational assistance. For more information, see
Publication 970, Tax Benefits for Education.
Employer-Provided Vehicles
If your employer provides a car (or other highway motor vehicle) to you,
your personal use of the car is usually a taxable noncash fringe benefit.
Your employer must determine the actual value of this fringe benefit to
include in your income. For more information, see Publication 525.
Tip
Certain employer-provided transportation can be excluded from gross income.
See the discussion on Transportation, later.
Group-Term Life Insurance
Generally, the cost of up to $50,000 of group-term life insurance coverage
provided to you by your employer (or former employer) is not included in
your income. However, you must include in income the cost of
employer-provided insurance that is more than the cost of $50,000 of
coverage reduced by any amount you pay toward the purchase of the insurance.
For exceptions, see Entire cost excluded, and Entire cost taxed, later.
If your employer provided more than $50,000 of coverage, the amount
included in your income is reported as part of your wages in box 1 of your
Form W-2. It is also shown separately in box 12 with code C.
Group-term life insurance. This insurance is term life insurance
protection (insurance for a fixed period of time) that:
*
Provides a general death benefit,
*
Is provided to a group of employees,
*
Is provided under a policy carried by the employer, and
*
Provides an amount of insurance to each employee based on a formula
that prevents individual selection.
Permanent benefits. If your group-term life insurance policy includes
permanent benefits, such as a paid-up or cash surrender value, you must
include in your income, as wages, the cost of the permanent benefits minus
the amount you pay for them. Your employer should be able to tell you the
amount to include in your income.
Accidental death benefits. Insurance that provides accidental or other
death benefits but does not provide general death benefits (travel
insurance, for example) is not group-term life insurance.
Former employer. If your former employer provided more than $50,000 of
group-term life insurance coverage during the year, the amount included in
your income is reported as wages in box 1 of Form W-2. Also, it is shown
separately in box 12 with code C. Box 12 also will show the amount of
uncollected social security and Medicare taxes on the excess coverage, with
codes M and N. You must pay these taxes with your income tax return.
Include them in your total tax on line 63, Form 1040, and enter “UT” and
the amount of the taxes on the dotted line next to line 63.
Two or more employers. Your exclusion for employer-provided group-term
life insurance coverage cannot exceed the cost of $50,000 of coverage,
whether the insurance is provided by a single employer or multiple
employers. If two or more employers provide insurance coverage that totals
more than $50,000, the amounts reported as wages on your Forms W-2 will not
be correct. You must figure how much to include in your income. Reduce the
amount you figure by any amount reported with code C in box 12 of your
Forms W-2, add the result to the wages reported in box 1, and report the
total on your return.
Figuring the taxable cost. Use the following worksheet to figure the
amount to include in your income.
Worksheet 5-1. Figuring the Cost of Group-Term Life Insurance To Include in
Income
1. Enter the total amount of your insurance coverage from your
employer(s) 1.
2. Limit on exclusion for employer-provided group-term life insurance
coverage 2. 50,000
3. Subtract line 2 from line 1 3.
4. Divide line 3 by $1,000. Figure to the nearest tenth 4.
5. Go to Table 5-1. Using your age on the last day of the tax year, find
your age group in the left column, and enter the cost from the column on
the right for your age group 5.
6. Multiply line 4 by line 5 6.
7. Enter the number of full months of coverage at this cost. 7.
8. Multiply line 6 by line 7 8.
9. Enter the premiums you paid per month 9.
10. Enter the number of months you paid the premiums 10.
11. Multiply line 9 by line 10. 11.
12. Subtract line 11 from line 8. Include this amount in your income as
wages 12.
Age Cost
Under 25 $.05
25 through 29 .06
30 through 34 .08
35 through 39 .09
40 through 44 .10
45 through 49 .15
50 through 54 .23
55 through 59 .43
60 through 64 .66
65 through 69 1.27
70 and older 2.06
Example.
You are 51 years old and work for employers A and B. Both employers provide
group-term life insurance coverage for you for the entire year. Your
coverage is $35,000 with employer A and $45,000 with employer B. You pay
premiums of $4.15 a month under the employer B group plan. You figure the
amount to include in your income as follows.
Worksheet 5-1. Figuring the Cost of Group-Term Life Insurance to Include in
Income—Illustrated
1. Enter the total amount of your insurance coverage from your
employer(s) 1. 80,000
2. Limit on exclusion for employer-provided group-term life insurance
coverage 2. 50,000
3. Subtract line 2 from line 1 3. 30,000
4. Divide line 3 by $1,000. Figure to the nearest tenth 4. 30.0
5. Go to Table 5-1. Using your age on the last day of the tax year, find
your age group in the left column, and enter the cost from the column on
the right for your age group 5. .23
6. Multiply line 4 by line 5 6. 6.90
7. Enter the number of full months of coverage at this cost. 7. 12
8. Multiply line 6 by line 7 8. 82.80
9. Enter the premiums you paid per month 9. 4.15
10. Enter the number of months you paid the premiums 10. 12
11. Multiply line 9 by line 10. 11. 49.80
12. Subtract line 11 from line 8. Include this amount in your income as
wages 12. 33.00
Entire cost excluded. You are not taxed on the cost of group-term life
insurance if any of the following circumstances apply.
1.
You are permanently and totally disabled and have ended your employment.
2.
Your employer is the beneficiary of the policy for the entire period
the insurance is in force during the tax year.
3.
A charitable organization (defined in chapter 24) to which
contributions are deductible is the only beneficiary of the policy for the
entire period the insurance is in force during the tax year. (You are not
entitled to a deduction for a charitable contribution for naming a
charitable organization as the beneficiary of your policy.)
4.
The plan existed on January 1, 1984, and:
1.
You retired before January 2, 1984, and were covered by the
plan when you retired, or
2.
You reached age 55 before January 2, 1984, and were employed by
the employer or its predecessor in 1983.
Entire cost taxed. You are taxed on the entire cost of group-term life
insurance if either of the following circumstances apply.
*
The insurance is provided by your employer through a qualified
employees' trust, such as a pension trust or a qualified annuity plan.
*
You are a key employee and your employer's plan discriminates in
favor of key employees.
Retirement Planning Services
If your employer has a qualified retirement plan, qualified retirement
planning services provided to you (and your spouse) by your employer are
not included in your income. Qualified services include retirement planning
advice, information about your employer's retirement plan, and information
about how the plan may fit into your overall individual retirement income
plan. You cannot exclude the value of any tax preparation, accounting,
legal, or brokerage services provided by your employer.
Transportation
If your employer provides you with a qualified transportation fringe
benefit, it can be excluded from your income, up to certain limits. A
qualified transportation fringe benefit is:
*
Transportation in a commuter highway vehicle (such as a van) between
your home and work place,
*
A transit pass, or
*
Qualified parking.
Cash reimbursement by your employer for these expenses under a bona fide
reimbursement arrangement is also excludable. However, cash reimbursement
for a transit pass is excludable only if a voucher or similar item that can
be exchanged only for a transit pass is not readily available for direct
distribution to you.
Exclusion limit. The exclusion for commuter highway vehicle
transportation and transit pass fringe benefits cannot be more than a total
of $105 a month.
The exclusion for the qualified parking fringe benefit cannot be more
than $200 a month.
If the benefits have a value that is more than these limits, the excess
must be included in your income.
Commuter highway vehicle. This is a highway vehicle that seats at least
six adults (not including the driver). At least 80% of the vehicle's
mileage must reasonably be expected to be:
*
For transporting employees between their homes and work place, and
*
On trips during which employees occupy at least half of the vehicle's
adult seating capacity (not including the driver).
Transit pass. This is any pass, token, farecard, voucher, or similar item
entitling a person to ride mass transit (whether public or private) free or
at a reduced rate or to ride in a commuter highway vehicle operated by a
person in the business of transporting persons for compensation.
Qualified parking. This is parking provided to an employee at or near the
employer's place of business. It also includes parking provided on or near
a location from which the employee commutes to work by mass transit, in a
commuter highway vehicle, or by carpool. It does not include parking at or
near the employee's home.
Retirement Plan Contributions
Your employer's contributions to a qualified retirement plan for you are
not included in income at the time contributed. (Your employer can tell you
whether your retirement plan is qualified.) However, the cost of life
insurance coverage included in the plan may have to be included. See
Group-Term Life Insurance, earlier, under Fringe Benefits.
If your employer pays into a nonqualified plan for you, you generally must
include the contributions in your income as wages for the tax year in which
the contributions are made. However, if your interest in the plan is not
transferable or is subject to a substantial risk of forfeiture (you have a
good chance of losing it) at the time of the contribution, you do not have
to include the value of your interest in your income until it is
transferable or is no longer subject to a substantial risk of forfeiture.
Elective deferrals. If you are covered by certain kinds of retirement
plans, you can choose to have part of your compensation contributed by your
employer to a retirement fund, rather than have it paid to you. The amount
you set aside (called an elective deferral) is treated as an employer
contribution to a qualified plan. It is not included in wages subject to
income tax at the time contributed. However, it is included in wages
subject to social security and Medicare taxes.
Elective deferrals include elective contributions to the following
retirement plans.
1.
Cash or deferred arrangements (section 401(k) plans).
2.
The Thrift Savings Plan for federal employees.
3.
Salary reduction simplified employee pension plans (SARSEP).
4.
Savings incentive match plans for employees (SIMPLE plans).
5.
Tax-sheltered annuity plans (403(b) plans).
6.
Section 501(c)(18)(D) plans.
7.
Section 457 plans.
Overall limit on deferrals. For 2005, you generally should not have
deferred more than a total of $14,000 of contributions to the plans listed
in (1) through (6) above. You should not have deferred more than the lesser
of your includible compensation or $14,000 of contributions to the plan
listed in (7) above (section 457 plan).
Excess deferrals. Your employer or plan administrator should apply the
proper annual limit when figuring your plan contributions. However, you are
responsible for monitoring the total you defer to ensure that the deferrals
are not more than the overall limit.
If you set aside more than the limit, the excess generally must be
included in your income for that year. See Publication 525 for a discussion
of the tax treatment of excess deferrals.
Catch-up contributions. You may be allowed catch-up contributions
(additional elective deferral) if you are age 50 or older by the end of
your tax year.
Stock Options
If you receive a nonstatutory option to buy or sell stock or other property
as payment for your services, you usually will have income when you receive
the option, when you exercise the option (use it to buy or sell the stock
or other property), or when you sell or otherwise dispose of the option.
However, if your option is a statutory stock option, you will not have any
income until you sell or exchange your stock. Your employer can tell you
which kind of option you hold. For more information, see Publication 525.
Restricted Property
Generally, if you receive property for your services, you must include its
fair market value in your income in the year you receive the property.
However, if you receive stock or other property that has certain
restrictions that affect its value, you do not include the value of the
property in your income until it has substantially vested. (You can choose
to include the value of the property in your income in the year it is
transferred to you.) For more information, see Restricted Property in
Publication 525.
Dividends received on restricted stock. Dividends you receive on
restricted stock are treated as compensation and not as dividend income.
Your employer should include these payments on your Form W-2.
Stock you chose to include in income. Dividends you receive on restricted
stock you chose to include in your income in the year transferred are
treated the same as any other dividends. Report them on your return as
dividends. For a discussion of dividends, see chapter 8.
For information on how to treat dividends reported on both your Form W-2
and Form 1099-DIV, see Dividends received on restricted stock in
Publication 525.
Special Rules for Certain Employees
This section deals with special rules for people in certain types of
employment: members of the clergy, members of religious orders, people
working for foreign employers, military personnel, and volunteers.
Clergy
If you are a member of the clergy, you must include in your income
offerings and fees you receive for marriages, baptisms, funerals, masses,
etc., in addition to your salary. If the offering is made to the religious
institution, it is not taxable to you.
If you are a member of a religious organization and you give your outside
earnings to the organization, you still must include the earnings in your
income. However, you may be entitled to a charitable contribution deduction
for the amount paid to the organization. See chapter 24.
Pension. A pension or retirement pay for a member of the clergy is
usually treated as any other pension or annuity. It must be reported on
lines 16a and 16b of Form 1040 or on lines 12a and 12b of Form 1040A.
Housing. Special rules for housing apply to members of the clergy. Under
these rules, you do not include in your income the rental value of a home
(including utilities) or a designated housing allowance provided to you as
part of your pay. However, the exclusion cannot be more than the reasonable
pay for your service. If you pay for the utilities, you can exclude any
allowance designated for utility cost, up to your actual cost. The home or
allowance must be provided as compensation for your services as an
ordained, licensed, or commissioned minister. However, you must include the
rental value of the home or the housing allowance as earnings from
self-employment on Schedule SE (Form 1040) if you are subject to the
self-employment tax. For more information, see Publication 517, Social
Security and Other Information for Members of the Clergy and Religious Workers.
Members of Religious Orders
If you are a member of a religious order who has taken a vow of poverty,
how you treat earnings that you renounce and turn over to the order depends
on whether your services are performed for the order.
Services performed for the order. If you are performing the services as
an agent of the order in the exercise of duties required by the order, do
not include in your income the amounts turned over to the order.
If your order directs you to perform services for another agency of the
supervising church or an associated institution, you are considered to be
performing the services as an agent of the order. Any wages you earn as an
agent of an order that you turn over to the order are not included in your
income.
Example.
You are a member of a church order and have taken a vow of poverty. You
renounce any claims to your earnings and turn over to the order any
salaries or wages you earn. You are a registered nurse, so your order
assigns you to work in a hospital that is an associated institution of the
church. However, you remain under the general direction and control of the
order. You are considered to be an agent of the order and any wages you
earn at the hospital that you turn over to your order are not included in
your income.
Services performed outside the order. If you are directed to work outside
the order, your services are not an exercise of duties required by the
order unless they meet both of the following requirements.
*
They are the kind of services that are ordinarily the duties of
members of the order.
*
They are part of the duties that you must exercise for, or on behalf
of, the religious order as its agent.
If you are an employee of a third party, the services you perform for the
third party will not be considered directed or required of you by the
order. Amounts you receive for these services are included in your income,
even if you have taken a vow of poverty.
Example.
Mark Brown is a member of a religious order and has taken a vow of poverty.
He renounces all claims to his earnings and turns over his earnings to the
order.
Mark is a schoolteacher. He was instructed by the superiors of the order to
get a job with a private tax-exempt school. Mark became an employee of the
school, and, at his request, the school made the salary payments directly
to the order.
Because Mark is an employee of the school, he is performing services for
the school rather than as an agent of the order. The wages Mark earns
working for the school are included in his income.
Foreign Employer
Special rules apply if you work for a foreign employer.
U.S. citizen. If you are a U.S. citizen who works in the United States
for a foreign government, an international organization, a foreign embassy,
or any foreign employer, you must include your salary in your income.
Social security and Medicare taxes. You are exempt from social security
and Medicare employee taxes if you are employed in the United States by an
international organization or a foreign government. However, you must pay
self-employment tax on your earnings from services performed in the United
States, even though you are not self-employed. This rule also applies if
you are an employee of a qualifying wholly owned instrumentality of a
foreign government.
Employees of international organizations or foreign governments. Your
compensation for official services to an international organization is
exempt from federal income tax if you are not a citizen of the United
States or you are a citizen of the Philippines (whether or not you are a
citizen of the United States).
Your compensation for official services to a foreign government is exempt
from federal income tax if all of the following are true.
*
You are not a citizen of the United States or you are a citizen of
the Philippines (whether or not you are a citizen of the United States).
*
Your work is like the work done by employees of the United States in
foreign countries.
*
The foreign government gives an equal exemption to employees of the
United States in its country.
Waiver of alien status. If you are an alien who works for a foreign
government or international organization and you file a waiver under
section 247(b) of the Immigration and Nationality Act to keep your
immigrant status, different rules may apply. See Foreign Employer in
Publication 525.
Employment abroad. For information on the tax treatment of income earned
abroad, see Publication 54.
Military
Payments you receive as a member of a military service generally are taxed
as wages except for retirement pay, which is taxed as a pension. Allowances
generally are not taxed. For more information on the tax treatment of
military allowances and benefits, see Publication 3, Armed Forces' Tax Guide.
Military retirement pay. If your retirement pay is based on age or length
of service, it is taxable and must be included in your income as a pension
on lines 16a and 16b of Form 1040 or on lines 12a and 12b of Form 1040A. Do
not include in your income the amount of any reduction in retirement or
retainer pay to provide a survivor annuity for your spouse or children
under the Retired Serviceman's Family Protection Plan or the Survivor
Benefit Plan.
For more detailed discussion of survivor annuities, see chapter 10.
Disability. If you are retired on disability, see Military and Government
Disability Pensions under Sickness and Injury Benefits, later.
Veterans' benefits. Do not include in your income any veterans' benefits
paid under any law, regulation, or administrative practice administered by
the Department of Veterans Affairs (VA). The following amounts paid to
veterans or their families are not taxable.
*
Education, training, and subsistence allowances.
*
Disability compensation and pension payments for disabilities paid
either to veterans or their families.
*
Grants for homes designed for wheelchair living.
*
Grants for motor vehicles for veterans who lost their sight or the
use of their limbs.
*
Veterans' insurance proceeds and dividends paid either to veterans or
their beneficiaries, including the proceeds of a veteran's endowment policy
paid before death.
*
Interest on insurance dividends you leave on deposit with the VA.
*
Benefits under a dependent-care assistance program.
*
The death gratuity paid to a survivor of a member of the Armed Forces
who died after September 10, 2001.
Rehabilitative program payments. VA payments to hospital patients and
resident veterans for their services under the VA's therapeutic or
rehabilitative programs are not treated as nontaxable veterans' benefits.
Report these payments as income on Form 1040, line 21.
Volunteers
The tax treatment of amounts you receive as a volunteer worker for the
Peace Corps or similar agency is covered in the following discussions.
Peace Corps. Living allowances you receive as a Peace Corps volunteer or
volunteer leader for housing, utilities, household supplies, food, and
clothing are exempt from tax.
Taxable allowances. The following allowances must be included in your
income and reported as wages.
*
Allowances paid to your spouse and minor children while you are a
volunteer leader training in the United States.
*
Living allowances designated by the Director of the Peace Corps as
basic compensation. These are allowances for personal items such as
domestic help, laundry and clothing maintenance, entertainment and
recreation, transportation, and other miscellaneous expenses.
*
Leave allowances.
*
Readjustment allowances or termination payments. These are considered
received by you when credited to your account.
Example.
Gary Carpenter, a Peace Corps volunteer, gets $175 a month as a
readjustment allowance during his period of service, to be paid to him in a
lump sum at the end of his tour of duty. Although the allowance is not
available to him until the end of his service, Gary must include it in his
income on a monthly basis as it is credited to his account.
Volunteers in Service to America (VISTA). If you are a VISTA volunteer,
you must include meal and lodging allowances paid to you in your income as
wages.
National Senior Services Corps programs. Do not include in your income
amounts you receive for supportive services or reimbursements for
out-of-pocket expenses from the following programs.
*
Retired Senior Volunteer Program (RSVP).
*
Foster Grandparent Program.
*
Senior Companion Program.
Service Corps of Retired Executives (SCORE). If you receive amounts for
supportive services or reimbursements for out-of-pocket expenses from
SCORE, do not include these amounts in income.
Volunteer tax counseling. Do not include in your income any
reimbursements you receive for transportation, meals, and other expenses
you have in training for, or actually providing, volunteer federal income
tax counseling for the elderly (TCE).
You can deduct as a charitable contribution your unreimbursed
out-of-pocket expenses in taking part in the volunteer income tax
assistance (VITA) program. See chapter 24.
Sickness and Injury Benefits
This section discusses sickness and injury benefits including disability
pensions, long-term care insurance contracts, workers' compensation, and
other benefits.
Disability Pensions
Generally, if you retire on disability, you must report your pension or
annuity as income.
Tip
You may be entitled to a tax credit if you were permanently and totally
disabled when you retired. For information on this credit and the
definition of permanent and total disability, see chapter 33.
For information on disability payments from a governmental program provided
as a substitute for unemployment compensation, see chapter 12.
Disability income. Generally, you must report as income any amount you
receive for personal injury or sickness through an accident or health plan
that is paid for by your employer. If both you and your employer pay for
the plan, only the amount you receive that is due to your employer's
payments is reported as income. However, certain payments may not be
taxable to you. Your employer should be able to give you specific details
about your pension plan and tell you the amount you paid for your
disability pension. In addition to disability pensions and annuities, you
may be receiving other payments for sickness and injury.
Tip
Do not report as income any amounts paid to reimburse you for medical
expenses you incurred after the plan was established.
Cost paid by you. If you pay the entire cost of a health or accident
insurance plan, do not include any amounts you receive from the plan for
personal injury or sickness as income on your tax return. If your plan
reimbursed you for medical expenses you deducted in an earlier year, you
may have to include some, or all, of the reimbursement in your income. See
Reimbursement in a later year in chapter 21.
Cafeteria plans. Generally, if you are covered by an accident or health
insurance plan through a cafeteria plan, and the amount of the insurance
premiums was not included in your income, you are not considered to have
paid the premiums and you must include any benefits you receive in your
income. If the amount of the premiums was included in your income, you are
considered to have paid the premiums, and any benefits you receive are not
taxable.
Retirement and profit-sharing plans. If you receive payments from a
retirement or profit-sharing plan that does not provide for disability
retirement, do not treat the payments as a disability pension. The payments
must be reported as a pension or annuity. For more information on pensions,
see chapter 10.
Accrued leave payment. If you retire on disability, any lump-sum payment
you receive for accrued annual leave is a salary payment. The payment is
not a disability payment. Include it in your income in the tax year you
receive it.
How to report. If you retired on disability, you must include in income
any disability pension you receive under a plan that is paid for by your
employer. You must report your taxable disability payments as wages on line
7 of Form 1040 or Form 1040A, until you reach minimum retirement age.
Minimum retirement age generally is the age at which you can first receive
a pension or annuity if you are not disabled.
Beginning on the day after you reach minimum retirement age, payments you
receive are taxable as a pension or annuity. Report the payments on lines
16a and 16b of Form 1040 or on lines 12a and 12b of Form 1040A. The rules
for reporting pensions are explained in How To Report in chapter 10.
Military and Government Disability Pensions
Certain military and government disability pensions are not taxable.
Service-connected disability. You may be able to exclude from income
amounts you receive as a pension, annuity, or similar allowance for
personal injury or sickness resulting from active service in one of the
following government services.
*
The armed forces of any country.
*
The National Oceanic and Atmospheric Administration.
*
The Public Health Service.
*
The Foreign Service.
Conditions for exclusion. Do not include the disability payments in your
income if any of the following conditions apply.
1.
You were entitled to receive a disability payment before September
25, 1975.
2.
You were a member of a listed government service or its reserve
component, or were under a binding written commitment to become a member,
on September 24, 1975.
3.
You receive the disability payments for a combat-related injury. This
is a personal injury or sickness that:
1.
Results directly from armed conflict,
2.
Takes place while you are engaged in extra-hazardous service,
3.
Takes place under conditions simulating war, including training
exercises such as maneuvers, or
4.
Is caused by an instrumentality of war.
4.
You would be entitled to receive disability compensation from the
Department of Veterans Affairs (VA) if you filed an application for it.
Your exclusion under this condition is equal to the amount you would be
entitled to receive from the VA.
Pension based on years of service. If you receive a disability pension
based on years of service, you generally must include it in your income.
However, if the pension qualifies for the exclusion for a service-connected
disability (discussed earlier), do not include in income the part of your
pension that you would have received if the pension had been based on a
percentage of disability. You must include the rest of your pension in your
income.
Retroactive VA determination. If you retire from the armed services based
on years of service and are later given a retroactive service-connected
disability rating by the VA, your retirement pay for the retroactive period
is excluded from income up to the amount of VA disability benefits you
would have been entitled to receive. You can claim a refund of any tax paid
on the excludable amount (subject to the statute of limitations) by filing
an amended return on Form 1040X for each previous year during the
retroactive period.
If you receive a lump-sum disability severance payment and are later
awarded VA disability benefits, exclude 100% of the severance benefit from
your income. However, you must include in your income any lump-sum
readjustment or other nondisability severance payment you received on
release from active duty, even if you are later given a retroactive
disability rating by the VA.
Terrorist attack or military action. Do not include in your income
disability payments you receive for injuries resulting directly from a
terrorist or military action.
Long-Term Care Insurance Contracts
Long-term care insurance contracts generally are treated as accident and
health insurance contracts. Amounts you receive from them (other than
policyholder dividends or premium refunds) generally are excludable from
income as amounts received for personal injury or sickness. To claim an
exclusion for payments made on a per diem or other periodic basis under a
long-term care insurance contract, you must file Form 8853 with your return.
A long-term care insurance contract is an insurance contract that only
provides coverage for qualified long-term care services. The contract must:
*
Be guaranteed renewable,
*
Not provide for a cash surrender value or other money that can be
paid, assigned, pledged, or borrowed,
*
Provide that refunds, other than refunds on the death of the insured
or complete surrender or cancellation of the contract, and dividends under
the contract may be used only to reduce future premiums or increase future
benefits, and
*
Generally not pay or reimburse expenses incurred for services or
items that would be reimbursed under Medicare, except where Medicare is a
secondary payer or the contract makes per diem or other periodic payments
without regard to expenses.
Qualified long-term care services. Qualified long-term care services are:
*
Necessary diagnostic, preventive, therapeutic, curing, treating,
mitigating, and rehabilitative services, and maintenance and personal care
services, and
*
Required by a chronically ill individual and provided pursuant to a
plan of care as prescribed by a licensed health care practitioner.
Chronically ill individual. A chronically ill individual is one who has
been certified by a licensed health care practitioner within the previous
12 months as one of the following.
*
An individual who, for at least 90 days, is unable to perform at
least two activities of daily living without substantial assistance due to
loss of functional capacity. Activities of daily living are eating,
toileting, transferring, bathing, dressing, and continence.
*
An individual who requires substantial supervision to be protected
from threats to health and safety due to severe cognitive impairment.
Limit on exclusion. You can generally exclude from gross income up to
$240 a day for 2005. See Limit on exclusion, under Long-Term Care Insurance
Contracts, under Sickness and Injury Benefits in Publication 525 for more
information.
Workers' Compensation
Amounts you receive as workers' compensation for an occupational sickness
or injury are fully exempt from tax if they are paid under a workers'
compensation act or a statute in the nature of a workers' compensation act.
The exemption also applies to your survivors. The exemption, however, does
not apply to retirement plan benefits you receive based on your age, length
of service, or prior contributions to the plan, even if you retired because
of an occupational sickness or injury.
Caution
If part of your workers' compensation reduces your social security or
equivalent railroad retirement benefits received, that part is considered
social security (or equivalent railroad retirement) benefits and may be
taxable. For more information, see Publication 915, Social Security and
Equivalent Railroad Retirement Benefits.
Return to work. If you return to work after qualifying for workers'
compensation, salary payments you receive for performing light duties are
taxable as wages.
Other Sickness and Injury Benefits
In addition to disability pensions and annuities, you may receive other
payments for sickness or injury.
Railroad sick pay. Payments you receive as sick pay under the Railroad
Unemployment Insurance Act are taxable and you must include them in your
income. However, do not include them in your income if they are for an
on-the-job injury.
If you received income because of a disability, see Disability Pensions,
earlier.
Federal Employees' Compensation Act (FECA). Payments received under this
Act for personal injury or sickness, including payments to beneficiaries in
case of death, are not taxable. However, you are taxed on amounts you
receive under this Act as continuation of pay for up to 45 days while a
claim is being decided. Report this income on line 7 of Form 1040 or Form
1040A or on line 1 of Form 1040EZ. Also, pay for sick leave while a claim
is being processed is taxable and must be included in your income as wages.
Caution
If part of the payments you receive under FECA reduces your social security
or equivalent railroad retirement benefits received, that part is
considered social security (or equivalent railroad retirement) benefits and
may be taxable. For a discussion of the taxability of these benefits, see
Social security and equivalent railroad retirement benefits under Other
Income, in Publication 525.
You can deduct the amount you spend to buy back sick leave for an
earlier year to be eligible for nontaxable FECA benefits for that period.
It is a miscellaneous deduction subject to the 2% of AGI limit on Schedule
A (Form 1040). If you buy back sick leave in the same year you used it, the
amount reduces your taxable sick leave pay. Do not deduct it separately.
Other compensation. Many other amounts you receive as compensation for
sickness or injury are not taxable. These include the following amounts.
*
Compensatory damages you receive for physical injury or physical
sickness, whether paid in a lump sum or in periodic payments.
*
Benefits you receive under an accident or health insurance policy on
which either you paid the premiums or your employer paid the premiums but
you had to include them in your income.
*
Disability benefits you receive for loss of income or earning
capacity as a result of injuries under a no-fault car insurance policy.
*
Compensation you receive for permanent loss or loss of use of a part
or function of your body, or for your permanent disfigurement. This
compensation must be based only on the injury and not on the period of your
absence from work. These benefits are not taxable even if your employer
pays for the accident and health plan that provides these benefits.
Reimbursement for medical care. A reimbursement for medical care is
generally not taxable. However, it may reduce your medical expense
deduction. For more information, see chapter 21.
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