Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al.

Taxation of Individuals 2018

Edition 9th Edition Spilker
Solutions Manual
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Chapter 4
Individual Income Tax Overview, Exemptions, and Filing Status

SOLUTIONS MANUAL

Discussion Questions

1. [LO 1] How are realized income, gross income, and taxable income similar, and
how are they different?

Realized income is more broadly defined than gross income which is more broadly
defined than taxable income.

Gross income includes all realized income that taxpayers are not allowed to
exclude from gross income or are not permitted to defer to a later year.
Consequently, gross income is the income that taxpayers actually report on their
tax returns and pay taxes on. In the tax formula, taxable income is gross income
minus allowable deductions for and from AGI. Taxable income is the base used to
compute the tax due before applicable credits. However, any income included in
gross income can be considered “taxable” income because gross income is income
that is taxable and causes an increase in the taxes that a taxpayer is required to
pay (gross income increases taxable income).

2. [LO 1] Are taxpayers required to include all realized income in gross income?
Explain.

No. Taxpayers are allowed to permanently exclude certain types of income from
gross income or defer certain types of income from taxation (gross income) until a

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 Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al.

subsequent tax year. Consequently, taxpayers are not required to include all
realized income in gross income.

3. [LO 1] All else being equal, should taxpayers prefer to exclude income or defer it?
Why?

Taxpayers should prefer to exclude income rather than defer income. When they
exclude income they are never taxed on the income. When they defer income, they
are still taxed on the income, but they are taxed in a subsequent tax year.

4. [LO 1] Why should a taxpayer be interested in the character of income received?

A taxpayer should be interested in the character of income received because the

character of the income determines how the income is treated for tax purposes
(including the rate at which the income is taxed). For example, ordinary income is
taxed at the rates provided in the tax rate schedule. Qualified dividend income and
long-term capital gains (after a netting process) are generally taxed at a maximum
15% rate (20% in the case of high income taxpayers and 0% in the case of low
income taxpayers).

5. [LO 1] Is it easier to describe what a capital asset is or what it is not? Explain.

It is easier to describe what a capital asset is not. In general, a capital asset is any
asset other than:
• Accounts receivable from the sale of goods or services.
• Inventory and other assets held for sale in the ordinary course of business.
• Assets used in a trade or business, including supplies.
Thus, any asset used for investment or personal purposes is considered to be a
capital asset.

6. [LO 1] Are all capital gains (gains on the sale or disposition of capital assets) taxed
at the same rate? Explain.

No. If a taxpayer holds a capital asset for a year or less the gain is taxed at
ordinary tax rates. If the taxpayer holds the asset for more than a year before
selling, the gain is generally taxed at a maximum 15% rate but could be taxed as
high as 20% for high income taxpayers, or as low as 0% for low income taxpayers.
If the taxpayer sells more than one capital asset during the year and recognizes
both capital gains and capital losses, the gains and losses are netted together
before determining the applicable tax rate.

7. [LO 1] Are taxpayers allowed to deduct net capital losses (capital losses in excess
of capital gains)? Explain.

In general, a taxpayer is allowed to deduct, as a “for AGI deduction,” up to $3,000

of net capital loss against ordinary income. If the net capital loss exceeds $3,000,

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 Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al.

the taxpayer is allowed to carry the loss over indefinitely to deduct in subsequent
years (subject to the $3,000 annual deduction limitation). If however, a capital loss
arises from the sale of a personal use asset (such as a personal automobile or a
personal residence), the loss is not deductible.

8. [LO 1] Compare and contrast for and from AGI deductions. Why are for AGI
deductions likely more valuable to taxpayers than from AGI deductions?

All deductions are classified as either “for AGI” or “from AGI” deductions. Gross
income minus “for AGI deductions” equals AGI. AGI minus “from AGI
deductions” equals taxable income. “For AGI deductions” are often referred to as
deductions above the line, while deductions from AGI are referred to as deductions
below the line. The line is AGI (the last line on the front page of the individual tax
return).

Though both types of deductions may reduce a taxpayer’s taxable income, “for
AGI” deductions are generally more valuable to taxpayers because they reduce
AGI which may allow taxpayers to deduct more of their from AGI deductions (and
other tax benefits) that are subject to AGI limitations. “From AGI deductions”
don’t affect AGI.

9. [LO 1] What is the difference between gross income and adjusted gross income,
and what is the difference between adjusted gross income and taxable income?

Gross income is more inclusive than is adjusted gross income (AGI). Gross income
is all income from whatever source derived that is not excluded or deferred from
income. AGI is gross income minus “for AGI” deductions. So the primary
difference between gross income and AGI is the amount of “for AGI deductions.”
Adjusted gross income is more inclusive than taxable income. AGI is gross income
minus “for AGI” deductions. Taxable income is AGI minus “from AGI”
deductions. Consequently, the difference between AGI and taxable income is the
amount of “from AGI” deductions.

10. [LO 1] How do taxpayers determine whether they should deduct their itemized
deductions or utilize the standard deduction?

Taxpayers generally deduct the greater of (1) the applicable standard deduction or
(2) their total itemized deductions, after limitations. However, taxpayers that do not
want to bother with tracking itemized deductions may choose to deduct the
standard deduction, even when itemized deductions may exceed the standard
deduction.

11. [LO 1]. Why are some deductions called “above the line” deductions and others
called “below the line” deductions? What is the “line”?

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 Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al.

The line is adjusted gross income (AGI). AGI is considered the line because of the
significance it plays in the amount of deductions allowed from AGI. “For AGI”
deductions are called above-the-line deductions because they are deducted in
determining AGI. “From AGI” deductions are called below-the-line deductions
because they are deducted after AGI has been determined. They are deducted from
AGI to arrive at taxable income. Below the line deductions may be subject to
limitations based on the taxpayer’s AGI.

12. [LO 1] What is the difference between a tax deduction and a tax credit? Is one more
beneficial than the other? Explain.

A deduction generally reduces taxable income dollar for dollar (although from AGI
deductions may not reduce taxable income dollar for dollar). This translates into a
tax savings in the amount of the deduction times the marginal tax rate. In contrast,
credits reduce a taxpayer’s taxes payable dollar for dollar. Thus, generally
speaking, credits are more valuable than deductions.

13. [LO 1] What types of federal income-based taxes, other than the regular income
tax, might taxpayers be required to pay? In general terms, what is the tax base for
each of these other taxes on income?

In addition to the individual income tax, individuals may also be required to pay
other income based taxes such as the alternative minimum tax (AMT) or self-
employment taxes. These taxes are imposed on a tax base other than the
individual’s taxable income. The AMT tax base is alternative minimum taxable
income, which is the taxpayer’s taxable income adjusted for certain items to more
closely reflect the taxpayer’s economic income than does taxable income. The tax
base for self-employment taxes is the net earnings derived from self-employment
activities.

14. [LO 1] Identify three ways taxpayers can pay their income taxes to the government.

Taxpayers can pay taxes through (1) income taxes withheld from the taxpayer’s
salary or wages by her employer, (2) estimated tax payments directly to the
government, and (3) taxes the taxpayer overpaid in the previous year that the
taxpayer elects to apply as an estimated payment for the current year.

15. [LO 1] If a person is considered to be a qualifying child or qualifying relative of a

taxpayer, is the taxpayer automatically entitled to claim a dependency exemption
for the person?

No, taxpayers may claim a dependency exemption for a qualifying child and/or a
qualifying relative only if the qualifying child or relative is a citizen of the United
States or a resident of the United States, Canada, or Mexico. Further, the
qualifying child or qualifying relative must meet the joint tax return test if the
person is married (no joint return with spouse unless there is no tax liability

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Education.
 Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al.

(positive taxable income) on the joint return and there would have been no tax
liability on either separate tax return if the spouses had filed separately).

16. [LO 2] Emily and Tony are recently married college students. Can Emily qualify as
her parents’ dependent? Explain.

Depending on the circumstances, Emily may qualify as a dependent of her parents.

A taxpayer who files a joint return with his or her spouse may not qualify as a
dependent of another, unless there is no tax liability on the couple's joint return
and there would not have been any tax liability on either spouse’s tax return if they
had filed separately. As long as Emily and Tony meet these criteria, then Emily will
qualify as a dependent of her parents assuming she also meets tests to be her
parents’ qualifying child or qualifying relative.

17. [LO 2] Compare and contrast the relationship test requirements for a qualifying
child with the relationship requirements for a qualifying relative.

The relationship test for a qualifying child includes the taxpayer’s child or
descendant of a child (child or grandchild) while the relationship test for qualifying
relatives includes both descendants and ancestors of the taxpayer (child,
grandchild, parents, or grandparent). The relationship test for the qualifying
relative includes a descendant or ancestor of the taxpayer (child, grandchild,
parent, or grandparent). The relationship test for qualifying child includes siblings
of the taxpayer or descendants of siblings of the taxpayer while the qualifying
relative test also includes siblings of the taxpayer and sons or daughters of the
taxpayer’s siblings. The relationship test for qualifying relative also includes the
taxpayer’s in laws, aunt, uncle, and any person (even if there is no qualifying
family relationship as described above) who has the same principal place of abode
as the taxpayer for the entire year. Thus, the relationship test for qualifying relative
is much more broad in scope than the relationship test for qualifying child.

18. [LO 2] In general terms, what are the differences in the rules for determining who
is a qualifying child and who qualifies as a dependent as a qualifying relative? Is it
possible for someone to be a qualifying child and a qualifying relative of the same
taxpayer? Why or why not?

The rules for determining who qualifies as a dependent as a qualifying child and
who qualifies as a dependent as a qualifying relative overlap to some extent. The
primary differences between the two are:
(1) the relationship requirement is more inclusive for qualifying relatives
than qualifying children,
(2) qualifying children are subject to age restrictions while qualifying
relatives are not,
(3) qualifying relatives are subject to a gross income restriction while
qualifying children are not, and

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