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The most common active income is wages (W2), sole proprietorship business income (SchC) and farming income (SchF). Since retirement income and Social Security benefits were generated from active earned income, they are also included in the active income category. S corporation (1120S) and partnership (1065) income where the taxpayer materially participates in the business operation would also be considered active income. Following is a discussion of other active income and the tax treatment.
Scholarships, Fellowships and Grants are awarded based on the student's financial need or scholastic achievement and merit. For federal income tax purposes (and Maryland) these awards are nontaxable as long as:
1. The recipient is a degree candidate.
2. A condition of the award is that the money must be used for "qualified tuition and related expense" (tuition and enrollment fees, books, supplies and equipment required for courses, but not room and board).
3. The recipient establishes that the money was actually used for the intended purposes.
To meet the third requirement the student need not trace the actual uses of awards. The funds are automatically assumed to be used for qualified tuition and related expense up to the net amount of such expense paid by the student. Awards in excess of the student's net qualified tuition and related expenses count as taxable income. To ensure tax-free treatment, students should keep records of their outlays for qualified expenses.
Work-Study Programs are a form of financial aid in which students are given jobs to help pay for their college education. Students typically work for the school they're attending. However, they could work for another employer under the auspices of a work-study program, such as under an intern or coop program. Generally, wages paid under a work-study program are also subject to Social Security and Medicare taxes. When students are employed directly by the school they attend, Social Security and Medicare taxes normally do not apply. All wages are taxable for both federal and state income taxes.
Disability Benefits - Payments by an employer for employee disability insurance coverage are nontaxable to the employee. However, if the premium cost is excluded from the employee's income, subsequent disability benefits would be taxable to the employee. In contrast, if the premium is paid with after tax dollars by the employee or the premium cost is added to compensation this will allow payments made in the event of disability to be nontaxable.
Special Rule: In the case of a permanent loss (or loss of the use) of a member or function of the body, or a permanent disfigurement, employer disability payments are not taxed as long as they are not computed on the amount of time lost from work. Social Security disability benefits may be taxed under the rules that govern taxability of retirement Social Security benefits.
Workmen's Compensation Benefits - If an employee is injured on the job, he or she may be eligible to receive worker's compensation benefits. These benefits are not taxable if they are paid under a state or federal worker's compensation statute. No exclusion is available if the payments are for nonwork connected disabilities or if the amount of the payment is based on age or service. Interest received on back award is taxable.
Pointer: Often employers, like the State Police, put the workmen's compensation payments on the W-2 as ordinary income. This is often the case when the benefits are self-insured. If you get into this situation your tax advisor will have to contact the state agency for a statement that clearly shows what part of the income is self-insured workmen's compensation benefits, normal salary paid while the employee was out on work-related illness or injury leave which is workmen's compensation, and what part was normal salary when on the job or on paid vacation.
Court Awards and Damages - Generally, a judgement award or settlement ending a dispute is taxable if it replaces taxable income. The law permits individuals to exclude from gross income only those damages that are received on account of a personal physical injury or physical sickness. Thus, under IRC 104 as amended by the Small Business Job Protection Act of 1996 provides that:
Punitive Damages - Taxable except when awarded in a wrongful death action brought under state law that classifies all damages awarded in wrongful death as punitive damages.
Physical Injury - Compensatory damages paid on account of physical injury or sickness are tax free.
Other Personal Injury - Damages paid on account of personal injuries which are not physical injuries are fully taxable. IRC 104 now provides specifically that emotional distress is not a physical injury. Damages not in excess of medical expenses for treatment of emotional distress can be excluded from tax. These claims include discrimination, breach of promise, invasion of privacy, libel, slander and defamation.
Any awards for back pay and liquidated damages are considered compensation and must be included in taxable income.
Gambling and Lottery Winnings - Taxable income includes any winnings from gambling or lottery drawings. If you itemize your deductions, losses can be deducted as miscellaneous deductions to the extent of winnings. If you are a professional gambler involved in gambling activities on a regular basis, your gambling losses are still deductible only to the extent of winnings. However, the income and losses for a professional gambler are reported on Schedule C, and if the winnings exceed the losses, the profit is subject to self-employment tax.
Pointer: Hold on to all losing lottery tickets, losing horse tickets and other verifications of losses to offset gambling income. The IRS looks for suspicious tickets. An example of a suspicious ticket is a losing horse ticket with heel prints on it.
Unemployment Compensation is fully taxable for both federal and Maryland income tax. Therefore, if you are receiving unemployment benefits, you need to either have withholding taken out of the benefits or make sure that your withholdings from your job or estimated tax payments are adequate to cover the tax obligation.
Prizes - Employees can exclude certain length of service and safety awards from their income. But all other prizes and awards received will be fully taxable to you. The IRS takes the position that the value of prizes must be measured by the fair market value at the time that you won them. However, the Tax Court has been liberal in determining what constitutes the value of a prize. If you were to win a car on the Wheel of Fortune Game show, you will be given a Form 1099 with the retail value. It would be advisable to obtain an affidavit from your local dealer and hold onto it for use in the likely event of an audit. Report the value of the car at what you could have reasonably acquired it for. It would be advisable to explain any difference between the Form 1099 value and the value reported as income on the tax return. Note also in 1995 the Tax Court determined that prizes from a television quiz show are not gambling winnings and, consequently, the expenses incurred in winning the prizes are not gambling losses. Therefore, any expenses such as travel could only be deducted as a miscellaneous expense subject to 2% of AGI.
Life Insurance Contracts - Life insurance is an investment that continues to receive favorable tax treatment although it produces no write-offs or tax credits. Investing in whole life or universal life insurance allows you to obtain both life insurance protection and a savings vehicle. The savings vehicle, the cash surrender value, accumulates tax-free until the policy is surrendered. If the policy is never surrendered but the insurance company pays the death benefits to the beneficiary, the payout will generate tax-free income.
Tax Trap: If your life insurance is owned by you or you are the beneficiary and you die, your heirs will still pay estate tax on the proceeds. See more on this in the Estate Tax Section of this document.
Annuities - Annuity contracts also enjoy tax-favored treatment. The contracts are purchased either in a lump sum or over a period of time. The contract will provide you with a fixed payment at a specific age. The earnings on the annuity accumulate tax-free until the annuitant begins receiving distributions from the contract. Early withdrawals are subject to a 10% penalty on the taxable portion. Withdrawals subject to the penalty would be drawn prior to the age of 59 ½ unless the payment is on account of disability or is one of a series to be paid over the life expectancy of the recipient. If you borrow from the annuity contract, the loan amount will be considered a taxable cash withdrawal and subject to the 10% penalty. If the loan exceeds the interest buildup, then the excess is a tax-free recovery of your original investment. Once you begin receiving the annuity a portion of each payment will be tax-free to allow you to recover your investment in the contract.