Solutions | Gross Income | Dividend

CHAPTER 4 Gross Income: Concepts and Inclusions DISCUSSION QUESTIONS 1.

The Supreme Court has recognized the different objectives for measuring financial accounting income and taxable income. The conservatism principle is biased towards the understatement of income. This bias is appropriate when issuing financial statements because it protects investors and other interested parties (e.g., creditors and management). However, a bias towards a low measure of income is not consistent with the goal of the income tax system; that is, the equitable collection of revenue. p. 4-5 a. According to the economic concept of income, the taxpayer’s income in the current year is $1,000 (the value at the time of the sale of $8,000 less the value at the beginning of the year of $7,000). Gross income for tax purposes is the difference between the selling price of $8,000 and the taxpayer’s cost of $5,000 = $3,000. Economic income is $8,000, the increase in value during the current year. Gross income for tax purposes is $0 because no income was realized; that is, the taxpayer was providing services to his property. Under both economic income and gross income for tax purposes, the shareholder’s income is $5,000. The gross income would be treated as a dividend to the shareholder. Economic income and gross income for tax purposes both are $25,000.

4-5

2.

b.

c.

d.

pp. 4-3 to 4-5 3. Charley received something of value from the casino. Under the broad concept of income, the airfare and hotel accommodations would be considered income. However, Charley could argue that the income should be matched with his $15,000 in gambling losses on the trip, and when the income and losses are combined, the net effect is an economic loss. As will be discussed later in the text, the net loss is not deductible, but at least the gambling losses can be used to offset the income from his gambling activities. pp. 4-3 to 4-5 The tax laws encourage do-it-yourself activities. If Tom paints his house, the $90 he saved is not included in gross income. He foregoes only $72 [(1-.28)($100)] in after-tax income from not working and earnings $100. This reasoning assumes that Tom can paint as fast as and as well as someone he would hire (i.e., the time consumed and the quality are the same). pp. 4-3 and 4-4 Because Cecil does not know how much he will receive from the sale of automobile parts, and it is impractical to determine the cost of individual automobile parts, he could reason that all sales proceeds are a recovery of capital until he has received his cost of $250, and all subsequent proceeds are included in gross income. The IRS may argue that Cecil should allocate his cost of the car among the various parts, which may be impractical. p. 4-6 The employer is required to include the $3,000 in gross income in 2005, when the employer’s agent receives the payment from the customer. pp. 4-7 to 4-10 and 4-16 a. The income should be reported in 2006. In 2005, Jared has not received anything of value.

4.

5.

6. 7.

4-6 b.

2006 Comprehensive Volume/Solutions The significance of when the income is recognized by Jared relates to (1) the time value of money—if the tax is deferred, the present value of the tax decreases; and (2) the marginal tax rates—the taxpayer may be subject to different rates between years because of changes in the tax law, changes in his or her taxable income, changes in the taxpayer’s filing status, and changes in the entity status.

pp. 4-7 to 4-9 8. a. The issue is when does Albert recognize gross income from the dinosaur bones: when he discovers the bones, or when he sells the property. The situation is analogous to an owner discovering oil on his or her property. In 2005, Albert did not receive anything he did not already own. Therefore, no income is realized until the bones are sold in 2006. This treatment is consistent with the wherewithal to pay doctrine. Albert probably will not be allowed to allocate any basis in the land to the bones. Therefore, his gross income from the sale of the bones in 2006 is $26,000.

b.

pp. 4-2 to 4-5 9. a. b. Allyson must report income under the original issue discount (OID) rules in each of the four years, 2005, 2006, 2007, and 2008. Clearly, the original issue discount rules were not enacted to relieve the taxpayer’s compliance burden as no such burden existed. In fact, the OID rules add significant complexity to a relatively simple fact pattern. Without the OID rules, the income would all be reported in one year (i.e., when the investment matures), and the problems of allocating the income among the four years would be obviated. Apparently then, equitable considerations probably were the motivation for the OID rules. Without the OID rules, cash basis taxpayers could easily defer their tax obligations by selecting investments issued at a discount. Accelerated and timely revenue recognition also likely was a contributory factor.

pp. 4-10 to 4-12 10. The bank certificate of deposit is subject to the original issue discount (OID) rules. Therefore, the taxpayer will recognize accrued interest income for each year until the certificate matures. The Series EE governmental savings bonds are exempt from the OID rules. Therefore, no interest will be included in gross income until the EE bonds’ maturity date. p. 4-11 a. b. p. 4-12 12. If Rex sells the car, he must pay the tax on the gain of $3,800 ($9,000 – $5,200). If Rex gives the automobile to his daughter and she sells it, she will be taxed on the gain of $3,800. Thus, the increase in value that is economically attributable to Rex will become his daughter’s income. If Rex is in a higher marginal tax bracket (probably the case), the Coal sold the goods in 2005 and should report the gross income of $100 ($500 – $400) in that year. The refund is accounted for in 2006. Coal will take a deduction of $100 and increase inventory by $400.

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Gross Income: Concepts and Inclusions

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family unit will generate tax savings by Rex’s daughter selling the car. Thus, gifts of appreciated property can be a useful tax planning concept. pp. 4-15 and 4-16 13. The recipient of alimony payments reports income and the payer qualifies for a deduction. By allowing a $50,000 deduction to Sarah and requiring Fred to include the $50,000 in his gross income, the fruit (service income) is shifted away from the tree (Sarah as the provider of the service). pp. 4-14 and 4-15 The S corporation shareholders and the partners pay the tax on the income earned by the S corporation and the partnership, regardless of whether the income is actually distributed to the owners. pp. 4-17 and 4-18 A joint return cannot be filed by Mike and Debbie, unless Debbie can be located and she consents to filing a joint return. Mike cannot qualify as an abandoned spouse because he has no dependent children. On separate income tax returns for 2005, Mike and Debbie each must include one-half of the community’s income. This results because they live together for part of the year. Thus, Mike must include in his gross income his share of Debbie’s earnings for the year, including a share of Debbie’s post-separation earnings. pp. 4-18 to 4-20 One purpose of the alimony rules is to distinguish a nondeductible property division from payments for support as alimony (which are deductible by the payor). Large cash payments in the early years are tantamount to a property division, or even a purchase of a property interest, as distinguished from payments for support of the former spouse. To the extent of alimony recapture, what has been classified as alimony is reclassified as a property settlement. pp. 4-20 to 4-22 Considering only taxes, Jean should accept the securities. The high basis in the stock will provide Jean with a tax benefit. She will have a carryover basis of $115,000 in the securities. If she sells the securities for $100,000, she will recognize a $15,000 loss. She will be allowed to offset this loss against other capital gains. If she has no capital gains, she can offset $3,000 of the loss against ordinary income each year, as discussed in Chapter 3. Thus, the loss would offset other income on Jean’s income tax return. pp. 4-20 and 4-21 The following issues are suggested from the facts presented: • • • • • Will gains and losses from the sale of property pursuant to the divorce be subject to tax? Are the child care payments deductible? Would payments with respect to William’s contribution toward her education be taxable to her? What is their filing status until the divorce has been completed? Should the payments be arranged so that they are deductible by William and taxable to Abigail? If the payments are taxable to her, what additional amounts should she request in exchange for agreeing to terms that are tax favorable to William? Is the daycare that is being provided by the grandparents taxable to either William or Abigail?

14.

15.

16.

17.

18.

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2006 Comprehensive Volume/Solutions Who will be able to claim April as a dependent?

pp. 4-19 to 4-22 19. Mary should consider the following tax considerations. The receipt of the $12,000 each year for ten years would be taxable to her as alimony, provided the payments cease upon her death within the 10-year period. Otherwise, the $12,000 payments are not alimony. The receipt of the common stock would be a property settlement rather than being alimony. However, to evaluate this option, she needs to know Bob’s basis in the stock because his basis will become her basis. Thus, if she decided to sell the stock, she could have a taxable gain or loss. The installment payments have significant nontax issues such as the risk that Bob will be unable to make the payments. In addition, Mary should compare the present value of the installment payments (on an after-tax basis) with the value ($100,000) of the stock. For example, assuming a 15% marginal tax rate, the aftertax amount received each year is $10,200, and with an after-tax rate of return of 6%, the present value of future payments is only $80,200. pp. 4-20 to 4-23 Income is imputed to the lender so as to prevent the lender from shifting income to the borrower who may be taxed at a lower tax rate. The rules presume that the lender would have earned some income from the funds in the absence of making the loan to the relative. By not requiring the relative to pay any interest, the lender has effectively made a gift back to the relative for the amount of interest not charged. pp. 4-23 to 4-27 The corporation will have imputed interest income and an offsetting amount for compensation expense. In addition, the corporation may have additional Social Security and Medicare tax and withholding obligations on the additional compensation. If, however, the employee is also a shareholder, the IRS may determine that the loan is instead a corporation-shareholder loan. This would still result in an increase in the corporation’s gross income in the form of imputed interest income. However, the corporation would not be able to deduct the related deemed dividend paid (as opposed to compensation expense being deductible). pp. 4-23 to 4-27 and Concept Summary 4-2 The following issues are suggested from the facts presented: • • • • • Is the corporation required to impute interest income on the loan to Brad? Is Brad required to recognize income from the loan proceeds? Is Brad required to recognize income in respect to the favorable interest rate? Is the loan made to Brad in his capacity as a shareholder or as an employee? Is the loan subject to the original issue discount rules?

20.

21.

22.

pp. 4-11 and 4-22 to 4-27 23. Betty’s life expectancy used in calculating the annuity exclusion percentage was 10.6 years. Therefore, all of the payments received after the end of 10.6 years must be included in Betty’s gross income since she has recovered her investment of $75,600. So in the twelfth year, all of the $8,900 received must be included in Betty’s gross income. pp. 4-28 to 4-30 Under the broad concept of gross income contained in the Code, premiums on group term life insurance purchased by employers for employees would be included in the

24.

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employee’s gross income. Therefore, § 79 creates an exclusion of premiums on up to $50,000 of insurance coverage for employees. pp. 4-32 and 4-33 25. The additional income will be, in effect, taxed at a 31.5% rate. That is, each dollar of additional income from other sources will increase the taxable portion of Social Security benefits by 50%. Thus, for each additional dollar of income, the marginal tax rate is 31.5% [1.5 X (15% + 6%)]. Her after-tax earnings on the $3,000 would be $2,055 [1-.315) X $3,000]. pp. 4-33 and 4-34

PROBLEMS 26. a. The taxpayer has a $1,000 economic gain on the sale because the taxpayer’s economic income would be the selling price less the value of the asset as of the beginning of the year. Gross income for tax purposes is $4,000 ($10,000 – $6,000). The $15,000 is economic income and gross income for tax purposes. The use of the automobile does not result in economic income because the taxpayer owns the corporation and thus owns the automobile. For tax purposes, the taxpayer is deemed to have received an $800 dividend from the corporation. The taxpayer has economic income of $800 from the production in her garden. However, for tax purposes no income is realized. The realization requirement is not satisfied because the vegetables are consumed by her and her neighbors, rather than sold to others. The increase in value of $10,000 is economic income but is not gross income for tax purposes because the realization requirement has not been satisfied. The taxpayer realized $1,000 economic income and gross income from discharge of the indebtedness.

b. c.

d.

e. f.

pp. 4-3 to 4-5 27. Amos should use the cash method of accounting so that the income from services billed to the insurance company can be deferred until the income is collected. Under the cash method, the amounts billed to the insurance companies will be continuously deferred until the year following his final year of practice. That is, with the cash method of accounting as compared to the accrual method, Amos will enjoy a deferral of two months of billings to insurance companies. Amos’s marginal tax rate may be lower in the first year of practice than in subsequent years. Thus, accelerating income through the use of the accrual method would have some benefit. But the benefit of the lower rates probably would not equal the benefit of deferral. pp. 4-7 to 4-9 Alternative (a) is superior to alternative (b) or alternative (c). Alternative (a) yields the greater after-tax value. Alternative a: Land. Value in 5 years, $10,000 X 1.34 Less tax .15($13,400 – $10,000) After-tax value $13,400 (510) $12,890

28.

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2006 Comprehensive Volume/Solutions Alternative b: Bond. Principal Annual interest (after tax) [(1 – .35)($600)] Reinvested for 5 years, at 3.90%, after-tax annuity factor After-tax value Alternative c: Stock. Principal Annual dividend (after tax) [(1 – .15)($500)] Reinvested for 5 years, at 4.25%, after-tax annuity factor After-tax value Speech for Tax Class Assume a taxpayer has the following alternative investment opportunities: • • • Investment in land for $10,000 that will increase in value by 6% each year. Investment in a taxable bond for $10,000 yielding 6% before tax, and the interest can be reinvested at 6% before tax. Investment in stock for $10,000 yielding 5% before tax, and the dividends can be reinvested at 5% before tax.

$390 X 5.39

$10,000 2,102 $12,102 $10,000 2,312 $12,312

$425 X 5.44

The taxpayer is in the 35% tax bracket for ordinary income and 15% for qualifying capital gains and qualified dividends in all years and the investment will be liquidated at the end of five years. The purpose of my presentation is to demonstrate that taxes do affect investment decisions. If neither investment were subject to taxation, the land and bond alternative investments would yield identical earnings (rounding produces a small difference). Land Bond Value in 5 years ($10,000 X 1.34) Principal Annual interest Reinvested for 5 years at 6%: annuity factor Value in 5 years $13,400 $10,000 3,384 $13,384

$600 X 5.64

Both of these alternative investments are subject to taxation. However, the interest on the taxable bond is taxed annually, whereas the gain on the land is not taxed until the land is sold. In addition, the land is taxed at capital gain rates. Thus, the after-tax results are as follows: Land Value in 5 years Less tax: .15($13,400 – $10,000) After-tax value $13,400 (510) $12,890

Gross Income: Concepts and Inclusions Bond

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Principal Annual interest (after tax) Reinvested for 5 years at 6%: after-tax annuity factor Value in 5 years

$390 X 5.39

$10,000 2,102 $12,102

Therefore, the investment in the land will produce a greater after-tax value by an amount of $788 ($12,890 – $12,102). The future value of the land will exceed the future value of the bond because the interest on the bond is taxed each year while the appreciation in the land value is not taxed until the end of the five years and the appreciation on the land is taxed at a lower tax rate. Thus, with the bond, the investor has less of an investment that is growing at a compounded rate. The investment in stock is superior to the investment in the bond in terms of after-tax yield because of the lower tax rate (15%) applied to the qualified dividends. pp. 4-3 to 4-5, 4-35, and 4-36 29. a. b. Olga has $200 of interest income and a recognized gain of $300 ($10,500 – $200 – $10,000). Olga does not recognize income from using the stock as collateral for the debt. Her assets (cash) and liabilities increased by the same amount, and she continued to own the stock. Thus, there is no realized gain. Mere increases in the value of an asset are not included in gross income. Note the attorney’s fee should be added to Olga’s cost of the property in calculating her basis for the vacant lot.

c.

pp. 4-3 to 4-6 30. a. The $1,500 is a dividend from the corporation to Amos. The corporation was entitled to the rebate. The rebate was a reduction in the cost of the corporation’s automobile. The assignment of the $1,500 to Amos was an economic benefit realized solely because he was the controlling shareholder and thus is a dividend to him. The $50,000 payment received under the covenant is included in Amos’s gross income because the payment is an increase in wealth realized. The neighbor’s actions that increased the value of Amos’s property by $1,500 do not result in the realization of income by him. Amos’s wealth has increased, but the realization requirement is not satisfied, since he did not receive any additional property nor were any improvements made to his property. Amos will not realize this increase in wealth for tax purposes until he sells the property. pp. 4-7 and 4-8 Gross income using cash method: Cash collections from customers $150,000

b. c.

31.

a.

Under the cash method, income is recognized when cash or its equivalent is actually or constructively received, regardless of when it was actually earned. Neither gross income nor taxable income is affected by the uncollectible

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2006 Comprehensive Volume/Solutions accounts. Income was not recognized when the income was earned. The deposit is not Al’s money. Rather, Al is the agent holding the money on behalf of the client. b. Gross income using accrual method: Cash collections Less: Beginning accounts receivable Plus: Ending accounts receivable $150,000 (25,000) 45,000 $170,000

c.

Al should use the cash method so that he will not have to pay income taxes on uncollected accounts receivable.

pp. 4-7 to 4-9 32. Selma must use the accrual method of accounting for her farm implements business because inventories are a material income-producing factor to the business. Calculation of sales: Cash receipts (excluding $50,000 investment and $5,000 customer deposit) Accounts receivable: end of the year Total sales Cost of goods sold: Cash payments for merchandise $350,000 Accounts payable: end of the year 40,000 Cost of goods available for sale $390,000 Less: ending inventory (75,000) Cost of goods sold Gross profit

$445,000 15,000 $460,000

(315,000) $145,000

Note that the $5,000 customer deposit on inventory must be excluded from income reported in financial statements presented to the creditors and investors. Otherwise, the deposit cannot be deferred for tax purposes. pp. 4-7 to 4-9 33. Willis, Hoffman, Maloney, and Raabe, CPAs 5191 Natorp Boulevard Mason, OH 45040 October 1, 2005 Ms. Amanda Sims Managing Partner Aspen Associates 100 James Tower Denver, CO 80208 Dear Ms. Sims: I am responding to your suggestion that Aspen Associates should change to the accrual method of accounting for tax purposes as a means of reducing accounting fees. Under the accrual method of accounting, receivables must be recognized as income as the

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services are performed. This is to be contrasted with the cash method of accounting where no income is recognized until payment is received. Each year, under the accrual method, accelerated tax payments would occur so long as the billing and collection pattern remains the same. Therefore, the partners will pay tax on an additional $75,000 in the first year’s income, and those payments will not be recovered until the company ceases its operations. Assuming the partners are in the 35% (combined State and Federal) marginal tax bracket, the deferred taxes under the cash method are $26,250 (.35 X $75,000). If the partners earn a 2.29% ($600 ÷ $26,250) return, or greater, on the deferred taxes, the additional accounting fees will be recovered. Therefore, I recommend that you continue to use the cash method. Sincerely, Tara Kelly, CPA Tax Partner pp. 4-7 to 4-9 34. TO: FROM: SUBJECT: DATE: Susan Apple Bill Swan Dispute Over Recording of Income by Color Paint Shop, Inc. October 1, 2006

I am responding to the questions you raised regarding the timing of the reporting of income by Color Paint Shop, Inc. with respect to the dispute concerning the painting of Samuel Customer’s car. The key issue is whether Color (1) should accrue the $1,000 of income in 2005 and take a $200 loss deduction in 2006 (the IRS view), (2) report the $800 in 2005 or (3) delay recording the $800 income until 2006 (Color’s preferred approach). An accrual basis taxpayer is required to recognize income when (1) all the events have occurred to establish the taxpayer’s right to receive the income, and (2) the amount of the income can be determined with reasonable accuracy. In Color’s case, it does not appear that all the events to fix the rights to the income had occurred in 2005. The insurance company had not approved the work by the end of the year. One could reason that Samuel’s approval of the work is the critical event that fixes Color’s right to receive the income, because the insurance company is merely the paying agent of the customer. However, even with this conclusion that the all-events test had been satisfied by the end of 2005, the amount of the income cannot be determined with reasonable accuracy because the insurance company may renegotiate the price. Thus, the transaction should be held open and no income should be reported until 2006. The amount of income Color should report in 2006 is $800. pp. 4-8 and 4-9 35. a. The taxpayer would report the income actually received in 2005. If the salary is paid according to the agreement, the taxpayer will have received 11 payments of $10,000 each, or $110,000 in 2005. The fact that the employer was willing to negotiate a different payment schedule does not affect the timing of the taxpayer’s income. The cash basis taxpayer must report the $8,000 of income in 2004 when it was actually received. The fact that the employer violated the agreement and paid the taxpayer in 2005 may cause the taxpayer to have a grievance against the employer, but it does not

b. c.

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2006 Comprehensive Volume/Solutions alter the fact that he received the income in 2005. Therefore, the $10,000 is included in his gross income in 2005. pp. 4-9 and 4-10

36.

a.

Morris must recognize $3,861 ($10,000 – $6,139) of interest income from the retirement of the Series EE bonds. His basis was the original cost of $6,139 since Series EE bonds are not subject to the original issue discount rules. The two-year certificate is subject to the original issue discount rules. following amount of interest income is recognized each year by Morris. 2003 $9,244 X 4% X 3/12 = 2004 $9,336 X 4% X 12/12 = 2005 $9,709 X 4% X 9/12 = $ 92 373 291 $756 The

b.

Thus, Morris’s basis for the CD at redemption is $10,000 ($9,244 + $756). Because his basis of $10,000 equals the maturity value of $10,000, no gain or loss is realized. The one-year CD he purchased in 2005 has $500 ($10,500 – $10,000) original issue discount, but amortization of that discount is not required because it matures within one-year from the date of purchase. Morris will report this $500 of interest when it is collected in 2006. pp. 4-10 and 4-11 37. a. The $1,200 advance payment can be deferred until 2005 because the property was not delivered until 2005 and the revenue was not recognized for financial accounting purposes until 2005. Gross income of $140 ($20 per month X 7 months) from the 12-month contract must be reported in 2005. The prepaid income qualifies for deferral under IRS Revenue Procedure 2004-34. The portion of the advance payment that relates to services performed in the tax year of receipt is included in gross income in the tax year of receipt. The portion of the advance payment that relates to services to be performed after the tax year of receipt ($240 – $140 = $100) is included in gross income in the tax year following the tax year of receipt of the advance payments. For the 24-month contract, the amount included in gross income in 2005 is $20 ($20 per month X 1 month) and in 2006 is $460 ($480 – $20). The company must include $1,200 in gross receipts and can deduct the cost of the appliance, $750, in arriving at gross income of $450. The fair market value of the note is not relevant for purposes of determining the accrual method taxpayer’s gross income.

b.

c.

pp. 4-8, 4-9, 4-13, and 4-14 38. a. Freda actually received only $180,000 in 2006. She did not constructively receive the remaining $60,000 in 2006, since under the terms of the actual contract she did not have the right to receive that amount in 2006. Freda may be bargaining for the deferred payments because she expects to be in a lower marginal tax bracket in 2007. However, the lower tax rate must be

b.

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sufficient to compensate for her loss of the use of the income for the period October through December 2006. pp. 4-7 to 4-11 39. a. • • • b. The damage deposit is not taxable at the time it is collected, but the $400 prepaid rent is taxed in the year of receipt. The $800 prepaid rent is taxed in the year of receipt. The $800 damage deposit is not taxed in the year of receipt.

The Bonhaus Apartments should use the third option. By doing so, it maximizes deferrals without affecting the cash flows.

pp. 4-12 and 4-13 40. a. No. Gus should include the entire $125,000 in his gross income because he provided the services that produced the income. The fact that his creditors are the beneficiaries of the income is not relevant. Yes. The corporation owns the property and therefore is taxed on the net rental income from the property. The corporation will be taxed on this amount at the corporate tax rates. However, because Gus retained the corporation’s cash, he will be required to include the $18,000 in his gross income as a dividend from the corporation (assuming the corporation has earnings and profits of at least that amount). Yes. If the corporation is an S corporation, the income will flow through to Gus, the sole shareholder.

b.

c.

pp. 14-17 and 4-18 41. a. The cash basis corporation must recognize the income of $3,000 in 2005 when its agent, Tracy, received the check, which is a cash equivalent. Tracy will not recognize any bonus until it is actually or constructively received. The fact that the employer received the fees in 2006 does not affect the time Tracy recognizes the bonus. The corporation must recognize the income in 2005, when the agent, Tracy, performed the services. Tracy will recognize the 10% bonus in 2006, because neither actual nor constructive receipt of the bonus occurs in 2005. The fact that the customer admits the check will not be honored if presented at the end of the year means the check is not a “cash equivalent.” Furthermore, the restriction on when the check can be presented for payment is “substantial.” Thus, the income is not realized in 2005.

b.

c.

pp. 4-7 to 4-10 and 4-17 42. Each partner’s gross income from the partnership for the year is $80,000 [($360,000 – $120,000)/3 = $80,000]. The partner’s gross income is his or her share of the profits under the profit and loss agreement, and generally is not affected by the partner’s contributions or withdrawals for the year. pp. 4-17 and 4-18

4-16 43. a.

2006 Comprehensive Volume/Solutions Amur dividends (Note 1) Blaze dividends (Note 2) Grape dividends Total dividend income Note 1: $55,000 25,000 12,000 $92,000

Even though Amur is a foreign corporation, the dividend is a qualified dividend because its stock is traded on an established U.S. securities market. The dividend paid by Blaze is not a qualified dividend because the holding period requirement is not satisfied (i.e., must be held more than 60 days during the 120-day period beginning 60 days before the exdividend date). $55,000 12,000 $67,000 X 15% $10,050 $25,000 X 35% $ 8,750

Note 2:

Qualified dividends Amur dividend Grape dividend Applicable rate Tax on qualified dividends Non-qualifying dividends Blaze dividend Applicable rate Tax on non-qualified dividends b.

The daughter is in the 10% marginal tax bracket. She has $1,000 of qualified dividends which are eligible for the alternative tax rate of 5% (rather than the usual 15%). So the daughter’s tax liability on the dividends is $50 ($1,000 X 5%).

pp. 4-15 and 4-16 44. Doug Salary Rent Dividends Interest $48,000 1,900 900 $50,800 a. California b. Texas

Liz

Doug $48,000 3,000 950 900 $52,850

Liz

$48,000 6,000 900 $54,900

$48,000 3,000 950 900 $52,850

Under Texas law, the rents and dividends belong to the community even though this income is derived from separate property. Under California law, the income is community or separate depending on the state law classification of the underlying assets. In this case, the interest is community income because the savings account was funded with community property. pp. 4-18 to 4-20 and Example 29 45. a. b. The use of the house is not alimony because it is not a cash payment. Thus, Nell does not recognize income and Kirby is not entitled to a deduction. The $1,000 per month payments are in cash and satisfy all of the other requirements to be labeled as alimony. Thus, the payments are deductible to

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Kirby and are includible in Nell’s gross income. The securities transfer is incident to a divorce and therefore produces no recognized gain to Nell. Kirby’s basis is a carryover basis of $100,000. c. The $600 per month payments are nondeductible child support, since the payments cease upon the happening of a contingency related to the child’s age or death.

pp. 4-20 to 4-22 46. a. The $30,000 per year received by Al is alimony—ordinary income to Al and deductible as a deduction for AGI by Karen. Al’s basis of $40,000 ($80,000 X 50%) carries over to him. The $50,000 per year for years 1, 2, and 3 and the $30,000 per year for subsequent years are alimony—ordinary income to Al and deductible as a deduction for AGI by Karen. The payments in the first three years are not “frontloaded” because they are the same for each of those years. So there is no alimony recapture. Economically, though, Al has given up a one-half interest in the stock, which if he had received would have a cost basis to him of $40,000 ($80,000 X 50%) and a fair market value of $60,000. Therefore, with the higher cash payments of $60,000 ($20,000 X 3), Al will lose the ability to take a recovery of capital deduction for $40,000, as compared to receiving less cash but also receiving his share of the stock. In addition, any recognized gain on the future stock sale is eligible for the beneficial capital gain rates. Al will report $80,000 of alimony in year 1 and Karen can deduct this amount. The $80,000 cash payment in year 1 with the decrease to $30,000 thereafter will cause alimony recapture of $35,000 which is reported in year 3. $80,000 – [($30,000 year 2 payment + $30,000 year 3 payment)/2) + $15,000] = $80,000 – $45,000 = $35,000 Al will receive a $35,000 deduction for AGI in year 3, and Karen will have $35,000 to include in gross income. The $35,000 deduction will partially compensate for the $40,000 basis (and $60,000 fair market value) of the stock he surrendered. pp. 4-20 to 4-22 47. The receipt of the common stock is not taxable to Sandra because it is a non-cash transfer of property under the terms of a divorce. The $300 per month actual child support payments are not included in Sandra’s gross income. The $1,000 monthly payment includes $250 of implicit child support. That is, because the payments would be reduced as a result of a contingency related to the child (i.e., attaining age 21), the amount of the contingent reduction is considered child support. Therefore, Sandra must include only $4,500 ($750 X 6) from alimony in gross income in the current year. pp. 4-21 to 4-23 Under the guarantee arrangement, the family would receive before tax interest of $9,000 ($150,000 X 6%) on Hal’s certificates of deposit and would pay $10,500 ($150,000 X 7%) interest on Roy’s loan. Furthermore, the interest received will be taxed at 35% (Hal’s marginal tax rate) while the interest paid will be deductible at only 15% (Roy’s marginal tax rate). The transactions will produce a negative cash flow of $3,075 [($9,000) (1 – .35) – ($10,500) (1 – .15) = –$3,075] for the family.

b.

c.

48.

4-18

2006 Comprehensive Volume/Solutions The 6% loan from Hal to Roy would reduce the family’s negative cash flow by $1,275 ($3,075 – $1,800) compared to the guarantee. This results because Hal will receive $9,000 interest and Roy will pay the same amount. On an after-tax basis, the $9,000 received by Hal is taxed at 35%, the same as with the certificates of deposit, and the interest is deductible by Roy at a 15% tax rate. [($9,000) (1 – .35) – ($9,000) (1 – .15) = – $1,800] A zero interest rate loan would have been the best alternative if the total loans between Roy and Hal had been less than $100,000. The zero interest rate loan would be eligible for the $100,000 exception for gift loans. Therefore, interest would not be imputed, since Roy has no investment income. Roy would not receive any interest income, and Hal would not pay any interest. Since this option is not available, the better option appears to be the 6% loan from Hal to Roy. [($0) (1 – .35) – ($0) (1 – .15) = $0] pp. 4-23 to 4-28

49.

Loan from employer Compensation ($62,000)(.07)(6/12) = Loans to others To controlled corporation ($31,000)(.07)(6/12) = To Tab (exempt under $100,000 exception) Certificates of deposit One year certificate (not subject to OID rules) Two year certificate ($6,000)(.0625)(6/12) [subject to OID rules]

Income $2,170* 1,085** -0-0188

*Ridge also has $2,170 of interest expense which may be deductible as investment interest (to the extent the loan proceeds were used for investment purposes). **Treated as an additional investment by Ridge and added to his cost of the stock. pp. 4-10, 4-11, and 4-23 to 4-28 50. a. This loan is a gift loan between individuals that is eligible for the $100,000 exception. Although the sister has $900 of investment income, interest is not imputed, under this exception, if the borrower’s investment income is not greater than $1,000. This loan is an employer-employee loan for not greater than $10,000. Sam did not use the funds to buy investments and there appears to be no tax avoidance motive. Thus, no interest is imputed. Interest is imputed on this loan. The $100,000 exception is not available on corporation-shareholder loans. The imputed interest would be calculated as follows: $15,000 X (5.5% – 4%) X 1/2 = $112 $15,112 X (5.5% – 4%) X 1/2= 113 $225

b.

c.

Gross Income: Concepts and Inclusions pp. 4-26 to 4-28 51. a.

4-19

The employer-employee loan would be eligible for the $10,000 exemption through June 30, 2005. However, in July 2006, the total outstanding loans exceed $10,000. The $100,000 exemption does not apply to these loans. Therefore, interest is imputed on the $12,000 amount of the loans for the period July through December 2006. Vito, Inc. has interest income and Vito has compensation income of $480 [.08($12,000 X 6/12)]. Vito also has interest expense of $480 and Vito, Inc. has compensation expense of the same amount. Note that employer-employee loans are not eligible for the $100,000 exception. A corporation-shareholder loan is not eligible for the $100,000 exemption and usually does not qualify for the $10,000 exemption (i.e., cannot satisfy the requirement that tax avoidance not be a principal purpose of the loan). Therefore, for 2005 and 2006, the corporation has interest income and dividends paid (not deductible) as follows: 2005 ($8,000 X 8% X 6/12) 2006 ($8,320 X 8% X 6/12) ($8,320 + $333 + $4,000)(.08)(6/12) $333 506 $320 $839

b.

Vito has dividend income and interest expense of equal amounts. pp. 4-22 to 4-28 52. a. Cost (her investment) Employee’s investment $120,000 = = $461.54 exclusion Number of anticipated payments 260 [Table 4-2] Collections in 2005 (6 payments X $2,000) Exclusion for capital recovery ($461.54 X 6 payments) [rounded] Include in gross income $12,000 (2,769) $ 9,231 $120,000

The simplified method is used to calculate the annuity exclusion percentage since this is a qualified retirement plan distribution. b. Thelma will have recovered her investment as a return of capital prior to the twenty-ninth year. Thus, all annuity payments received in the twenty-ninth year are includible in her gross income. $2,000 X 12 payments = $24,000 c. Investment in the contract Total amount collected 180 X $2,000 = $360,000 Less: capital recovered $360,000 X .23077* Unrecovered cost (loss in the final year return) Income from collections in final year: $12,000(1 – .23077*) $120,000 (83,077) ($ 36,923) $ 9,231

4-20

2006 Comprehensive Volume/Solutions * pp. 4-27 to 4-30 $120,000 = 23.077% exclusion percentage. $260 X 2,000

53.

a.

Joe is required to include $210,000 ($60,000 + $150,000) in gross income associated with the award he received. The award does not satisfy the right type of achievement requirement to qualify for exclusion from gross income. In addition, the provision which requires the recipient to contribute the award to a qualified governmental unit or nonprofit organization is not satisfied. Wanda is required to include the $100,000 of prizes received in her gross income. She is required to render substantial future services. In addition, the provision which requires the recipient to contribute the award to a qualified governmental unit or nonprofit organization is not satisfied. George can exclude the $900,000 prize received from his gross income. All of the requirements for exclusion are satisfied.

b.

c.

pp. 4-31 and 4-32 54. a. Alice’s gross income from the excess coverage is computed as follows: Uniform premiums for $1,000 of protection for 1 month Coverage for 12 months Excess coverage: Includible amount for Alice $85,000 – $50,000 1,000 .09 X 12 $ 1.08 X 35 $37.80 $

Kay is a partner (not an employee) and therefore the exclusion for group term life insurance premiums is not applicable for her. The partnership will deduct the actual premiums paid. The premiums attributable to the partners (based on the uniform table) are included in the partner’s gross income. Therefore, Kay includes $414 in her gross income. Uniform premiums for $1,000 of protection for 1 month Coverage for 12 months Excess coverage: Includible amount for Kay b. $150,000 – $0 1,000 .23 X 12 $ 2.76 X 150 $414.00 $

As an employee of the incorporated business, Kay is eligible for the group term life insurance exclusion. Uniform premiums for $1,000 of protection for 1 month Coverage for 12 months .23 X 12 $ 2.76 $

Gross Income: Concepts and Inclusions Excess coverage: Includible amount for Kay $150,000 – $50,000 1,000

4-21 X 100 $276.00

The availability of the life insurance premiums and other benefits available to employees that are discussed in Chapter 5 are considerations in deciding whether to incorporate a business. pp. 4-32 and 4-33 55. Salary Unemployment compensation Interest income Dividend income Lottery winnings Gross income $ 90,000 8,300* 90 550 1,500* $100,440

* Unemployment compensation is includible in gross income. The $5 cost of the lottery ticket is deductible as a miscellaneous itemized deduction, not subject to the 2% reduction. Neither the $12,000 loan nor the $2,000 savings account withdrawal are included in gross income. p. 4-33 56. a. Taxable Social Security benefits = .5[$35,000 + .5($9,000) – $32,000] = .5($7,500) Pension benefits, etc. AGI Other income ($35,000 – $8,000) Taxable Social Security benefits = .5[$27,000 + $6,000 + .5($9,000) – $32,000] AGI in a. above Decrease in AGI $ 3,750 35,000 $38,750 $27,000 2,750 $29,750 (38,750) ($ 9,000)

b.

Note: The taxpayers’ economic income decreased by $2,000 ($8,000 – $6,000), but taxable income decreased by $9,000. However, with a 15% marginal tax rate, their after-tax economic income will decrease by only $650. Decrease in interest income Decrease in tax liability (15% X $9,000) Decrease in economic income c. $2,000 (1,350) $ 650

Lesser of: (1) .85[$65,000 + .5($9,000) – $44,000] = .85($25,500) $21,675 Plus smaller of: Amount calculated by the first formula, which is the lesser of .5($9,000) = $4,500 .5[$65,000 + .5($9,000) – $32,000] = $18,750 or $6,000 4,500 $26,175

4-22 or

2006 Comprehensive Volume/Solutions

(2) .85($9,000)

$ 7,650

Therefore, Linda and Don would be required to include 85% of the Social Security benefits ($7,650) in their gross income. Includible Social Security benefits Other income ($35,000 + $30,000) AGI AGI in a. above Increase in AGI $ 7,650 65,000 $72,650 (38,750) $33,900

Note: The increase in AGI exceeds the increase in earnings because more of the Social Security benefits became taxable. pp. 4-33 and 4-34 57. a. Salary Retirement pay Interest and dividends Tentative AGI Social Security ($15,000 X 85%) AGI Less deductions Taxable income b. Retired $60,000 12,000 $72,000 12,750 $84,750 (18,000) $66,750 Not Retired $80,000 12,000 $92,000 $92,000 (18,000) $74,000 Change

($7,250)

If Jim retires, the couple’s after-tax cash flow will decrease by $2,825. Decrease in taxable income from retirement Plus non-taxable Social Security earned while retired Taxes saved by retiring ($7,250 X 30%) Total decrease in cash flow after retirement ($7,250) 2,250 2,175 ($2,825)

pp. 4-33 to 4-35 58. Donna has substantial tax problems: a. Donna’s share of the partnership income of $70,000 will be taxable to Donna even though the income was not distributed. Therefore, she will need to come up with the cash required to pay the taxes. p. 4-17 A portion of the Social Security benefits will be taxable because Donna has other income. If Donna and her husband file separate returns, she must include $7,140 ($8,400 X 85%) of the Social Security benefits in her gross income (i.e., the base amount is $0 in this case). Even with a joint return, Donna and her husband would include $7,140 of the Social Security benefits in their gross income (i.e., in this case, the base amount would be $44,000). pp. 4-33 to 4-35 Donna must report the $1,200 of interest income even though the creditor received the money. She owned the property which earned the income. Also, she benefited from the income in that the money was used to satisfy her liability. pp. 4-14 and 4-15

b.

c.

Gross Income: Concepts and Inclusions d.

4-23

Donna will be required to include in gross income one-half of her husband’s income because they are residents of a community property state. pp. 4-18 to 4-20

CUMULATIVE PROBLEMS 59. Part 1—Tax Computation Gross income Salary and commissions ($86,000 + $31,000) (Note 1) Interest income on certificate of deposit (Note 2) Interest income on Second Bank savings account (Note 3) Dividends on CSX stock (Note 4) Income from partnership (Note 5) Deductions for adjusted gross income Adjusted gross income Itemized deductions State income tax (Note 6) Personal property tax Real estate tax Home mortgage interest Cash contributions Personal and dependency exemptions (Note 7) Taxable income Tax on taxable income other than dividends $102,058 [$8,180 + .25($102,058 – $59,400)] Tax on dividend income ($2,600 X 15%) Less: Tax withheld by employers Estimated tax payments Net tax payable (or refund due) for 2005 Notes (1) (2) Assuming that Dan and Freida are cash basis taxpayers, the $2,000 commission will not be included in gross income until it is received in 2006. The original interest discount rules apply. The OID for 2005 is $433. Maturity value 2003 OID ($13,868 X 4%) X 3/12 $139 2004 OID ($14,007 X 4%) 560 Adjusted basis at beginning of 2005 ($14,007 + $560) 2005 OID $15,000 (14,567) $ 433 $117,000 433 1,300 2,600 11,000 -0$132,333 $4,500 900 3,600 4,900 975

(14,875) (12,800) $104,658 18,844 390 (15,000) (5,000) ($ 766)

(3) (4) (5)

The $2,900 of interest on the City of Corbin bonds is excluded from gross income. The dividends of $2,600 on the CSX stock are included in Dan and Freida’s gross income. Then they are treated as having made a gift of $2,600 to Ben. Freida’s share of the partnership profits is $11,000 ($100,000 X 11%). Therefore, she must include this amount in her gross income.

4-24 (6) (7)

2006 Comprehensive Volume/Solutions The state income tax paid of $4,500 exceeded the sales tax of $1,206 from the sales tax table. Gina qualifies as a dependent. Since she is their child and is a full-time student under age 24, she does not have to satisfy the gross income test (i.e., it is waived). In any event, this is not a problem since Gina has $0 gross income. Gina does not file a joint return with her husband. Therefore, since all of the requirements are satisfied, Dan and Freida can claim a dependency deduction for Gina. Ben, Freida’s brother, fails to qualify as a dependent because of the gross income test. (Although he is a full-time student, he is not a child of either taxpayer.) Sam, their son, does qualify as a dependent. It appears he has too much gross income ($6,300). However, the gross income test is waived in this case because he is a full-time student during five calendar months. Therefore, Dan and Freida’s personal exemption and dependency deductions are $12,800 ($3,200 X 4).

Part 2—Tax Planning Willis, Hoffman, Maloney, and Raabe, CPAs 5191 Natorp Boulevard Mason, OH 45040 December 29, 2005 Dan and Freida Butler 625 Oak Street Corbin, KY 27521 Dear Dan and Freida: You asked me to estimate your after-tax income under the assumption that Dan will work only half-time next year. The $43,000 reduction in Dan’s pay will be partially offset by a $29,000 estimated increase in the amount Freida will earn. While your before tax income will decrease by $14,000, the after-tax decrease in income will be only $10,500. That is, while your income received will decrease, your tax payments also will decrease. If you have any further questions, please call me. Sincerely, John Jones, CPA TAX FILE MEMORANDUM December 27, 2005 From: John Jones Subject: Dan and Freida Butler, Change in taxes for 2006 Dan plans to work only half-time in 2006, but Frieda anticipates a substantial increase in her income. Dan’s income will decrease by $43,000 and Frieda’s income is expected to

Gross Income: Concepts and Inclusions

4-25

increase by $29,000. With a $14,000 decrease in salary and commission income, their tax liability will decrease by $3,500. Therefore, their after-tax decrease in earnings is only $10,500 as computed below. Decrease in earnings Loss: Tax liability reduction $14,000 X 25% After-tax decrease in earnings My assumptions for the analysis were as follows: 1. 2. 3. 4. 60. The $2,000 commission received on January 10, 2006 is included in the $60,000 income to be earned by Freida in 2006. The $3,200 exemption amount is the same in 2005 and 2006. The 25% 2005 marginal tax rate remains the same in 2006. Interest income, dividend income, partnership income, and itemized deductions are the same for 2005 and 2006. $29,500 5,500 2,000 2,160 10,200 1,600 1,850 $52,810 -0$52,810 (3,100) (11,800) $37,910 $ 4,979 (5,500) ($ 521) $14,000 (3,500) $10,500

Gross income: Pension Interest income (Note 1) Dividend income Annuity income (Note 2) Social Security benefits (Note 3) Imputed interest on gift loan (Note 4) Net rent income (Note 5) Gross income Deductions for AGI AGI Less: Personal exemption deduction (Note 6) Less: Itemized deductions (Note 7) Taxable income Tax liability (Tax Table) (Note 8) Less: Estimated tax payments Net tax payable (or refund due) for 2004 See the tax return solution beginning on page 4-28 of the Solutions Manual. Notes (1) (2) The $2,700 of interest on the City of Alto bonds is excludible.

The exclusion percentage and the related annual exclusion on the annuity contract Cecil purchased is calculated as follows: $52,800 $400 X 240 payments = 55% X $4,800 = $2,640

Cecil received $4,800 of annuity payments from the insurance company this year.

4-26

2006 Comprehensive Volume/Solutions Thus, Cecil must include $2,160 ($4,800 – $2,640) in his gross income this year. (3) The amount of the Social Security benefits that Cecil must include in his gross income is the lesser of the two following amounts: a. b. 85%($12,000) = $10,200 Sum of: (1) (2) .85[$52,810 – $10,200 + $2,700 + 50%($12,000) – $34,000] = $14,713, and Lesser of: (a) 50%($12,000) = $6,000 50%[$52,810 – $10,200 + $2,700 + 50%($12,000) – $25,000] = $13,155 $4,500

(b)

Thus, $14,713 + $4,500 = $19,213. Since the amount calculated under a. of $10,200 is less than the amount calculated under b. of $19,213, the $10,200 is included in Cecil’s gross income. (4) Since Cecil made a below-market gift loan to Sarah, he needs to determine if any imputed interest should be included in his gross income. The loan qualifies under the $100,000 exception. Since Sarah’s net investment income is only $1,600, Cecil has to include only $1,600 in his gross income rather than $2,400 ($40,000 X 6%). The net rental income from the townhouse is as follows: Rent income Less: Expenses Utilities Maintenance Real estate taxes Insurance Depreciation Net rent income (6) (7) $7,600 $1,500 1,000 750 500 2,000

(5)

(5,750) $1,850

Since Sarah is self-supporting, Cecil does not qualify for a dependency deduction for her. Cecil’s itemized deductions are as follows: Personal property taxes State income taxes Charitable contributions $ 2,100 3,300 6,400 $11,800

Gross Income: Concepts and Inclusions

4-27

Cecil’s state income taxes paid of $3,300 exceeded the sales taxes he paid of $912. Cecil’s standard deduction would be $8,350 ($7,150 basic standard deduction + $1,200 additional standard deduction). Thus, Cecil will itemize deductions. (8) Cecil uses the Tax Table for a Head of Household. He maintains a home for his unmarried daughter Sarah. Since she is unmarried, Sarah does not have to be his dependent. Tax on $35,910 5% X $2,000 dividend income $4,879 100 $4,979

4-28

2006 Comprehensive Volume/Solutions

60.

Gross Income: Concepts and Inclusions 60. continued

4-29

4-30 60. continued

2006 Comprehensive Volume/Solutions

Gross Income: Concepts and Inclusions 60. continued

4-31

4-32 60. continued

2006 Comprehensive Volume/Solutions

Gross Income: Concepts and Inclusions 60. continued

4-33

4-34 60. continued

2006 Comprehensive Volume/Solutions

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