Important Changes for 2002

Retirement planning services.   If your employer has a qualified retirement plan, qualified retirement planning services provided for you (or your spouse) by your employer are not included in your income. For more information, see Retirement Planning Services under Fringe Benefits.

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) will increase each year from 2002 through 2006. If you are age 50 or older, you will also be able to make additional catch-up elective deferrals. See Elective Deferrals in the discussion on retirement plan contributions under Employee Compensation.

Employer-provided educational assistance.   You can exclude from your income up to $5,250 of employer-provided educational assistance. This benefit now includes graduate-level as well as undergraduate-level courses. For more information, see chapter 9 in Publication 970, Tax Benefits for Education.

Adoption assistance.   The exclusion from income of certain amounts paid or reimbursed by your employer for qualifying adoption expenses under an adoption assistance program has been made permanent. The maximum amount you can exclude has been increased. For more information, see Publication 968, Tax Benefits for Adoption.

Qualified tuition program (QTP).   Beginning in 2002:

• Qualified state tuition programs (QSTPs) are renamed qualified tuition programs (QTPs).
• A distribution from a QTP established and maintained by a state (or an agency or instrumentality of the state) can be excluded from your income if the amount distributed is used for qualified higher education expenses.
• You can make contributions to a QTP established and maintained by one or more eligible educational institutions. However, earnings on the account will be taxable if withdrawn before January 1, 2004.

For more information on QTPs, see chapter 6 in Publication 970.

Payment for services.   Generally, you must include in income the part of any scholarship, fellowship, or tuition reduction that represents payment for past, present, or future teaching, research, or other services. This applies even if all candidates for a degree must perform the services to receive the degree.

However, beginning in 2002, do not include in income the part of any scholarship, fellowship, or tuition reduction representing payment for teaching, research, or other services if you receive the amount under the National Health Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program.

Important Reminders

Terrorist attacks.   You can exclude from income certain disaster assistance, disability, and death payments received as a result of a terrorist or military action outside or within the United States. You also can exclude certain debt cancellations made after September 10, 2001, and before January 1, 2002, because an individual died as a result of the September 11 attacks or anthrax attacks. For more information, see Publication 3920, Tax Relief for Victims of Terrorist Attacks.

Payments received by Holocaust victims.   You can exclude from income certain restitution payments received after December 31, 1999, as restitution to a Holocaust victim (or an heir of a Holocaust victim). For more information, see Holocaust victims restitution under Other Income, later.

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.

Photographs of missing children.   The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843-5678) if you recognize a child.

Introduction

You can receive income in the form of money, property, or services. This publication discusses many kinds of income and explains whether they are taxable or nontaxable. It includes discussions on employee wages and fringe benefits, and income from bartering, partnerships, S corporations, and royalties. It also includes information on disability pensions, life insurance proceeds, and welfare and other public assistance benefits. Check the index for the location of a specific subject.

Generally, income is taxable unless it is specifically exempted by law. Income that is taxable must be reported on your return and is subject to tax. Income that is nontaxable may have to be shown on your tax return but is not taxable.

Constructively received income.   You are generally taxed on income that is available to you, regardless of whether it is actually in your possession.

A valid check that you received or that was made available to you before the end of the tax year is considered income constructively received in that year, even if you do not cash the check or deposit it to your account until the next year. For example, if the postal service tries to deliver a check to you on the last day of the tax year but you are not at home to receive it, you must include the amount in your income for that tax year. If the check was mailed so that it could not possibly reach you until after the end of the tax year, and you could not otherwise get the funds before the end of the year, you include the amount in your income for the next tax year.

Income received by an agent for you is income you constructively received in the year the agent received it. If you agree by contract that a third party is to receive income for you, you must include the amount in income when the third party receives it.

Example.   You and your employer agree that part of your salary is to be paid directly to your former spouse. You must include that amount in income when your former spouse receives it.

Prepaid income.   Prepaid income, such as compensation for future services, is generally included in your income in the year you receive it. However, if you use an accrual method of accounting, you can defer prepaid income you receive for services to be performed before the end of the next tax year. In this case, you include the payment in your income as you earn it by performing the services.

Comments and suggestions.   We welcome your comments about this publication and your suggestions for future editions.

You can e-mail us while visiting our web site at www.irs.gov.

You can write to us at the following address:

Internal Revenue Service
Tax Forms and Publications
W:CAR:MP:FP
1111 Constitution Ave. NW
Washington, DC 20224

We respond to many letters by telephone. Therefore, it would be helpful if you would include your daytime phone number, including the area code, in your correspondence.

Useful Items You may want to see:

Publication

• 520   Scholarships and Fellowships
• 523   Selling Your Home
• 527   Residential Rental Property (Including Rental of Vacation Homes)
• 550   Investment Income and Expenses (Including Capital Gains and Losses)
• 559   Survivors, Executors, and Administrators
• 564   Mutual Fund Distributions
• 575   Pension and Annuity Income
• 915   Social Security and Equivalent Railroad Retirement Benefits

See How To Get Tax Help, near the end of this publication, for information about getting these publications.

Employee Compensation

Generally, you must include in gross income everything you receive in payment for personal services. In addition to wages, salaries, commissions, fees, and tips, this includes other forms of compensation such as fringe benefits and stock options.

You should receive a Form W-2, Wage and Tax Statement, 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 child care, 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 child-care providers apply to you.

Miscellaneous Compensation

This section discusses many types of employee compensation. The subjects are arranged in alphabetical order.

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, later.

Allowances and reimbursements.   If you receive travel, transportation, or other business expense allowances or reimbursements from your employer, get Publication 463, Travel, Entertainment, Gift, and Car Expenses. If you are reimbursed for moving expenses, get 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, get Publication 516, U.S. Government Civilian Employees Stationed Abroad.

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 an 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 your 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 resumé 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% 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 Other Sickness and Injury Benefits under Sickness and Injury Benefits, later.

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 income in the year you use the right.

Work-training programs.   If you are enrolled in a state or local work-training program under the Economic Opportunity Act of 1964, payments you receive from the sponsor as compensation for services are taxable wages.

Fringe Benefits

Fringe benefits you receive 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.

See Valuation of Fringe Benefits, later in this discussion, for information on how to determine the amount to include in income.

Recipient of fringe benefit.   You are the recipient of a fringe benefit if you perform the services for which the fringe benefit is provided. You are considered to be the recipient even if it is given to another person, such as a member of your family. An example is a car your employer gives to your spouse for services you perform. The car is considered to have been provided to you and not to your spouse.

You do not have to be an employee of the provider to be a recipient of a fringe benefit. If you are a partner, director, or independent contractor, you can also be the recipient of a fringe benefit.

Provider of benefit.   Your employer or another person for whom you perform services is the provider of a fringe benefit regardless of whether that person actually provides the fringe benefit to you. The provider can be a client or customer of an independent contractor.

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 12. 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 12.

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 are generally 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.

Archer MSA contributions.   Contributions by your employer to your Archer MSA (previously called a medical savings account) 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. Attach the form to your return.

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 Publication 968, Tax Benefits for Adoption, for more information.

Adoption benefits are reported by your employer in box 12 of Form W-2 with code T. They also are 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. Attach the form to your return.

Athletic Facilities

If your employer provides you with the free or low-cost use of an employer-owned gym or other athletic club at your workplace, the value is not included in your compensation. The gym must be used primarily by employees, their spouses, and their dependent children.

If your employer pays for a fitness program provided to you at an off-site resort hotel or athletic club, the value of the program is included in your compensation.

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. Also see Employee Discounts, later.

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.

Dependent Care Benefits

If your employer provides dependent care benefits under a qualified plan, you may be able to exclude these benefits from your income. Dependent care benefits include:

• Amounts your employer pays directly to either you or your care provider for the care of your qualifying person while you work, and
• The fair market value of care in a day-care facility provided or sponsored by your employer.

The amount you can exclude is limited to the lesser of:

• The total amount of dependent care benefits you received during the year,
• The total amount of qualified expenses you incurred during the year,
• Your earned income,
• Your spouse's earned income, or
• $5,000 ($2,500 if married filing separately).

Your employer must show the total amount of dependent care benefits provided to you during the year under a qualified plan in box 10 of your Form W-2. Your employer also will include any dependent care benefits over $5,000 in your wages shown in box 1 of your Form W-2.

To claim the exclusion, you must complete either Part III of Form 2441, Child and Dependent Care Expenses, or Part III of Schedule 2 (Form 1040A), Child and Dependent Care Expenses for Form 1040A Filers. (You cannot use Form 1040EZ.)

See the instructions for Form 2441 or Schedule 2 (Form 1040A) for more information.

Educational Assistance

You can exclude from your income up to $5,250 of qualified employer-provided educational assistance. The exclusion applies to undergraduate and graduate-level courses. For more information, get Publication 508, Tax Benefits for Work-Related Education.

Employee Discounts

If your employer sells you property or services at a discount, you may be able to exclude the amount of the discount from your income. The exclusion applies to discounts on property or services offered to customers in the ordinary course of the line of business in which you work. However, it does not apply to discounts on real property or property commonly held for investment (such as stocks or bonds). The exclusion is limited to the price charged nonemployee customers multiplied by the following percentage.

• For a discount on property, your employer's gross profit percentage (gross profit divided by gross sales) on all property sold during the employer's previous tax year. (Ask your employer for this percentage.)
• For a discount on services, 20%.

Financial Counseling Fees

Financial counseling fees paid for you by your employer are included in your income and must be reported as part of wages. If the fees are for tax or investment counseling, they can be deducted on Schedule A (Form 1040) as a miscellaneous deduction (subject to the 2% limit).

Qualified retirement planning services paid for you by your employer under a qualified plan are not included in your income. For more information, see Retirement Planning Services, 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 to this rule, 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 provides 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 61, Form 1040, and enter UT and the amount of the taxes on the dotted line next to line 61.

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.   You figure the taxable cost for each month of coverage by multiplying the number of thousands of dollars of insurance coverage for the month (figured to the nearest tenth), less 50, by the cost from the following table. Use your age on the last day of the tax year. You must prorate the cost from the table if less than a full month of coverage is involved.

COST PER $1,000 OF PROTECTION FOR ONE MONTH

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

If you pay any part of the cost of the insurance, your entire payment reduces, dollar for dollar, the amount you would otherwise include in your income. However, you cannot reduce the amount to include in your income by:

• Payments for coverage in a different tax year,
• Payments for coverage through a cafeteria plan, unless the payments are after-tax contributions, or
• Payments for coverage not taxed to you because of the exceptions discussed later under Entire cost excluded.

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.

Employer A coverage (in thousands)	$ 35
Employer B coverage (in thousands)	+ 45
Total coverage (in thousands)	$ 80
Minus: Exclusion (in thousands)	- 50
Excess amount (in thousands)	$ 30
Multiply by cost per $1,000 per month, age 51 (from table)	× .23
Cost of excess insurance for 1 month	$ 6.90
Multiply by number of full months coverage at this cost	× 12
Cost of excess insurance for tax year	$82.80
Minus: Premiums you paid	- 49.80
Cost to include in income as wages	$33.00

The total amount to include in income for the cost of excess group-term life insurance is $33. Neither employer provided over $50,000 insurance coverage, so the wages shown on your Forms W-2 do not include any part of that $33. You must add it to the wages shown on your Forms W-2 and include the total on your return.

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