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

Taxation of Individuals and Business

Entities 2017 8th Edition Spilker
Solutions Manual
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Chapter 5
Gross Income and Exclusions

SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] Based on the definition of gross income in §61 and related regulations, what is the
general presumption regarding the taxability of income realized?

§61(a) defines gross income as all income from whatever source derived. Reg. §1.61-(a)
provides further insight into the definition of gross income as follows: Gross income means
all income from whatever source derived, unless excluded by law. Gross income includes
income realized in any form, whether in money, property, or services. Thus, the general
presumption regarding any income realized is that it is taxable, unless otherwise excluded
by law.

2. [LO 1] Based on the definition of gross income in §61, related regulations, and judicial
rulings, what are the three criteria for recognizing taxable income?

Based on §61(a), Reg. §1.61-(a), and various judicial rulings, taxpayers recognize gross
income when (1) they receive an economic benefit, (2) they realize the income, and (3) no
tax provision allows them to exclude or defer the income from gross income for that year.

3. [LO 1] Describe the concept of realization for tax purposes.

As indicated in Reg. §1.61-(a), the tax definition of income adopts the realization principle.
Under this principle, income is realized when (1) a taxpayer engages in a transaction with

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

another party, and (2) the transaction results in a measurable change in property rights. In
other words, assets or services are exchanged for cash, claims to cash, or other assets with
determinable value. The concept of realization for tax purposes closely parallels the concept
of realization for financial accounting purposes. Requiring a transaction to trigger
realization reduces the uncertainty associated with determining the amount of income
because a change in rights can typically be traced to a specific moment in time and is
generally accompanied by legal documentation.

4. [LO 1] Compare and contrast realization of income with recognition of income.

Realization is a judicial concept that determines the period in which income is generated,
whereas, recognition is a statutory concept that determines whether realized income is
going to be included in gross income during the period. Realization is a prerequisite to
recognition, and absent an exclusion or deferral provision, recognition is automatic.

5. [LO 1] Tim is a plumber who joined a barter club. This year Tim exchanges plumbing
services for a new roof. The roof is properly valued at $2,500, but Tim would have only
billed $2,200 for the plumbing services. What amount of income should Tim recognize on
the exchange of his services for a roof? Would your answer change if Tim would have
normally billed $3,000 for his services?

Assuming the roof is properly valued, the taxpayer should recognize the value of the
property received or $2,500 regardless of the amount he would have billed. The value of the
plumbing services, however, would help determine the value of the roof.

6. [LO 1] Andre constructs and installs cabinets in homes. Blair sells and installs carpet in
apartments. Andre and Blair worked out an arrangement whereby Andre installed cabinets in
Blair’s home and Blair installed carpet in Andre’s home. Neither Andre nor Blair believes
they are required to recognize any gross income on this exchange because neither received
cash. Do you agree with them? Explain.

Both Andre and Blair are required to recognize gross income equal to the value of the
goods and services they received. Reg. §1.61-(a) indicates that taxpayers realize income
whether they receive money, property, or services in a transaction. That is, the form of the
receipt does not matter. In this case, Andre should report gross income equal to the carpet
he received and Blair should report gross income equal to the value of the cabinets he
received.

7. [LO 1] What issue precipitated the return of capital principle? Explain.

The issue was the amount of income taxpayers must realize when they sell property.
Initially, the IRS was convinced that Congress’s all-inclusive definition of income required

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

taxpayers to include all sale proceeds in gross income. Taxpayers, on the other hand,
argued that a portion of proceeds from a sale represented a return of the cost or capital
investment in the underlying property (called tax basis). The courts determined that when
receiving a payment for property, taxpayers are allowed to recover the cost of the property
tax free. Consequently, when taxpayers sell property, they are allowed to reduce the sale
proceeds by their unrecovered investment in the property to determine the realized gain
from the sale. When the tax basis exceeds the sale proceeds, the return of capital principle
generally applies to the extent of the sale proceeds. The excess of basis over sale proceeds is
generally not considered to be a return of capital, but rather a loss that is deductible only if
specifically authorized by the tax code.

8. [LO 1] Compare how the return of capital principle applies when (1) a taxpayer sells an asset
and collects the sale proceeds all immediately and (2) a taxpayer sells an asset and collects
the sale proceeds over several periods (installment sales). If Congress wanted to maximize
revenue from installment sales, how would they have applied the return of capital principle
for installment sales?

The return of capital principle states that the proceeds from a sale are not income to the
extent of the taxpayer’s cost or investment in the asset. When the proceeds are collected
over several periods, the return of capital principle is usually modified by the law to provide
that the return of capital occurs evenly (pro rata) over the collection period. To maximize
revenues, the government might require for the return of capital to occur at the end of the
collection; whereas, taxpayers normally prefer for the return of capital to occur at the
beginning of the collection period to allow them to defer recognizing income from the
transaction.

9. [LO 1] This year Jorge received a refund of property taxes that he deducted on his tax return
last year. Jorge is not sure whether he should include the refund in his gross income. What
would you tell him?

If the refund is made for an expenditure deducted in a previous year, then under the tax
benefit rule the refund is included in gross income to the extent that the prior deduction
produced a tax benefit. In this case, if Jorge deducted the property taxes (and received a tax
benefit or tax savings from the deduction) on his prior year tax return, he must include the
refund in his gross income this year to the extent the property taxes resulted in a tax benefit.
If he did not deduct property taxes on his tax return last year, he is not required to include
the refund in his gross income.

10. [LO 1] Describe in general how the cash method of accounting differs from the accrual
method.

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

Under the cash method taxpayers recognize income in the period they receive it. Under the
accrual method, they recognize income when they earn it rather than when they receive it.
Likewise, cash basis taxpayers are entitled to claim deductions when they make expenditures.
Under the accrual method, taxpayers deduct expenses when they incur or accrue the
associated expenditure.

11. [LO 1] Janet is a cash-basis calendar-year taxpayer. She received a check for services
provided in the mail during the last week of December. However, rather than cash the check,
Janet decided to wait until the following January because she believes that her delay will
cause the income to be realized and recognized next year. What would you tell her? Would it
matter if she didn’t open the envelope? Would it matter if she refused to check her mail
during the last week of December? Explain.

The constructive receipt doctrine states that a taxpayer realizes and recognizes income
when it is actually or constructively received. Constructive receipt is deemed to occur when
the income has been credited to the taxpayer’s account or when the income is
unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability,
and there are no restrictions on the taxpayer’s control over the income. This doctrine
prevents Janet, a cash basis taxpayer, from arbitrarily shifting income to a later period by
postponing the delivery or acceptance of a payment. It does not matter if she refuses to open
the envelope or check her mail, because the income is unconditionally available to her, she
is aware of the income’s availability, and there are no restrictions on her control over the
income.

12. [LO 1] The cash method of accounting means that taxpayers don’t recognize income unless
they receive cash or cash equivalents. True or false? Explain.
False—under the cash method, taxpayers recognize income in the period they receive it (in
the form of cash, property, or services).

13. [LO 1] Contrast the constructive receipt doctrine with the claim of right doctrine.

The constructive receipt doctrine states that a taxpayer realizes and recognizes income
when it is actually or constructively received. Constructive receipt is deemed to occur when
the income has been credited to the taxpayer’s account or when the income is
unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability,
and there are no restrictions on the taxpayer’s control over the income. In contrast, the
claim of right doctrine states that income has been realized if a taxpayer receives income
and there are no restrictions on the taxpayer’s use of the income (for example, the taxpayer
does not have an obligation to repay the amount). Thus, the constructive receipt applies
where the taxpayer has not yet actually received income (but it has been credited to the
taxpayer’s account or is unconditionally available), whereas the claim of right doctrine

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

applies when the taxpayer has received an item of income and the question is whether the
taxpayer has an unrestricted right to the income.

14. [LO 1] Dewey is a lawyer who uses the cash method of accounting. Last year Dewey
provided a client with legal services worth $55,000, but the client could not pay the fee. This
year Dewey requested that in lieu of paying Dewey $55,000 for the services, the client could
make a $45,000 gift to Dewey’s daughter. Dewey’s daughter received the check for $45,000
and deposited it in her bank account. How much of this income is taxed, if any, to Dewey?
Explain.

A cash method taxpayer recognizes income on the value of property received, so $45,000 of
income will be recognized in this year. The assignment of income doctrine holds that earned
income is taxed to the taxpayer providing the goods or services. Hence, Dewey, and not his
daughter, is taxed on the entire amount of service income. Because the money went to
Dewey’s daughter, his daughter will be treated as though she received a gift from Dewey.

15. [LO 2] Clyde and Bonnie were married this year. Clyde has a steady job that will pay him
about $37,000 while Bonnie does odd jobs that will produce about $28,000 of income. They
also have a joint savings account that will pay about $400 of interest. If Clyde and Bonnie
reside in a community property state and file married-separate tax returns, how much gross
income will Clyde and Bonnie each report? Any difference if they reside in a common law
state? Explain.

In a community property state each spouse will report exactly half of the income earned by
the other. Hence, Bonnie and Clyde will each report $32,700 ($18,500+$14,000+$200). In
a common law state, Bonnie will report $28,200, which is her separate income ($28,000)
plus half of the joint income ($200). Likewise, Clyde will report $37,200.

16. [LO 2] Distinguish earned income from unearned income, and provide an example of each.

Earned income is income derived from services and includes compensation and other forms
of business income received by a taxpayer even if the taxpayer’s business is selling
inventory. In contrast, unearned income is income derived from property. Salary is a good
example of earned income whereas interest is an example of unearned income.

17. [LO 2] Jim purchased 100 shares of stock this year and elected to participate in a dividend
reinvestment program. This program automatically uses dividends to purchase additional
shares of stock. This year Jim’s shares paid $350 of dividends and he used these funds to
purchase shares of stock. These additional shares are worth $375 at year-end. What amount
of dividends, if any, should Jim declare as income this year? Explain.

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ARTIFICIAL FORMATION OF ADIPOCIRE.
On December 8th, 1853, a bullock’s heart weighing 1240 grammes,
without removing its fat, was buried in sand in an inverted tubulated
receiver held in a retort stand, and so placed against the glass that a
portion of it could be seen: a reservoir of water was placed above the
receiver, and this water was suffered to fall, drop by drop, upon the sand
by means of a syphon of lamp-wick. The water was removed when
necessary, and the changes appearing in the heart observed. These
changes were the same as in the case of the bottled experiments; it began
soon to deepen in colour, and on May 11th, 1854, was quite dark, while
the liquid falling from the receiver contained a black amorphous
precipitate, which is probably, from Liebig’s observation of a similar
case, sulphuret of iron. A deep zone of green vegetable parasitic matter
was visible around the inside of the receiver, commencing within half of
an inch above the position of the heart where it was deepest in colour,
and thence diminishing as it approached the surface of the sand. On June
7th, the heart was removed and dissected for the purpose of viewing the
extent of the decomposition: it maintained its original form, but was
larger; the separation of the chambers was apparent; the valves present
and the chordæ tendineæ in a perfect state; the greater part of the fleshy
walls of the heart was pinkish, soft, of the consistence of lard, of putrid
smell, and under the microscope (700 D,) presented an amorphous mass,
mingled with fragments of crossed muscular fibre. It was not in as
advanced a stage of decomposition as the bottled hearts of December
13th, 1854. The fat which was purposely left around the coronary
vessels, was hard, white, and of an appearance approaching that of
adipocire. The heart was returned to the vessel and the experiment
continued. On my return to the city, after an absence in the summer time,
I found that the water reservoir and lamp wick had fulfilled their duty,
for the sand was still moist. On December 9th, 1854, the experiment was
concluded, and the heart removed from the sand and washed. It was in
two pieces, and weighed, when still wet, 219 grammes: after drying in
the air for five days it weighed 107 grammes, or 8·6 per cent. of the
original weight, and was still moist. This was principally the fat from
around the coronary vessels, the impressions of which were on it; the
tendinous chords of the valves were perfect, and the valves themselves
were indicated. The smell was decidedly tallowish, with the strong smell
I have described as adipocire smell, and with the smell of earth worms;
all of these odours were plain, and suggested themselves at once to the
mind. The fat was hard, and resembled exactly adipocire; it presented a
different appearance in two different places: one portion was hard and
compact, in some parts denser, in others lighter than water, and appeared
granular under the microscope, like the specimens of adipocire already
described: the other portion was of a more buttery nature, and of about
the density 0·8365. Neither of these specimens gave any traces of fat
globules with the microscope, but contained aggregations of white
angular fatty matter, of nearly the same size, and about one fourth the
diameter of fat globules. With ether the fat disappeared, and left
shrunken membranous matter, which after the evaporation of the ether
and treatment with acetic acid, became, for the most part, transparent. A
comparative experiment with beef fat gave similar results, and I am
inclined to think that the most of this matter proceeds from the fat cells,
[9] and their accompanying cellular tissue.

On cutting through the thickest portion of this adipocire, the fat was of a
pure white colour, and could not be distinguished from adipocire; in
some portions it was nearly an inch in thickness, and at first sight
certainly gave the impression that the fleshy walls of the heart were
converted into fat; but on closer inspection, this seemed to me
improbable. The lumps of adipocire were thickest at the top of the heart,
and just where were the lumps of fat in which the coronary vessels were
imbedded; moreover, it was the most like adipocire in the centre of those
very portions of fat. I obtained the approximate density of the adipocire
of this part, by diluting alcohol with water, until the adipocire just swam
half way between the surface and the bottom of the liquid, and found it
to be 0·8902, which is by experiment lower than that of ox fat. Indeed, as
would a priori seem probable, the fat, by the gases evolved during the
putrefaction of the proteine bodies, is rendered more porous, and of a
lower specific gravity, which deceives the eye, and makes the mass of fat
to appear greater than it really is. An ash determination of this part of the
adipocire performed upon 1·471 grammes, yielded 0·0015, equal to
0·102 per cent. of a reddish ash, containing iron. No acroleine was
observed during this experiment, and no other than the characteristic
adipocire smell, which proves the absence of glycerine, and that the fatty
acids are uncombined. Ox fat (2·069) gave (0·001, or) a per centage of
0·048 white ash. The iron of the former proceeds probably from the
hæmatine in the heart. These ashes are too small in quantity, to arrive at
any satisfactory result in ascertaining the nature of their component
parts; they appeared by a few tests to contain principally lime, and soda
and potash were detected by Smith’s test. The melting point of the above
portion of adipocire was about 47°, but at 52° the fat still contained a
faint precipitate.
The adipocire, on February 3d, 1855, until which time it had been kept in
a loosely stoppered bottle, weighed 97 grammes, which is 7·8 per cent.
of the original heart. From 91 grammes the fat was separated by boiling
it with 317 alcohol, filtering hot, pressing powerfully, and weighing the
residue; the latter was bulky, and weighed 40·1, corresponding to 44 per
cent. of the adipocire, which contains, consequently, only 66 per cent. of
fat. If the per centage of fat be calculated from the original weight of the
heart, it amounts to only 4·4, which is undoubtedly less than was
originally in the heart, so that, so far from there being a gain of fat in the
formation of the adipocire, there was actually a loss, which accords with
the bottle experiments. The alcoholic solution deposited 16·2 grammes
of a rather dark fat, which was recrystallized from 368 grammes of
alcohol, and yielded 11 grammes of a lighter fat. I was desirous of
retaining a greater portion of this fat for future experiments, and without
proceeding to purify it further, obtained its equivalent. It melted between
69°-70°, did not crystallize plainly from alcohol, with which it behaved
like stearic acid: a neutral silver salt, deepened in colour considerably
when dried at 100°, and gave only 20·59 and 20·68 per cent. of silver. As
decomposition had evidently taken place in this salt, the baryta
compound was prepared by adding acetate of baryta to the alcoholic
solution. The baryta was determined both as carbonate and by converting
into sulphate; there was no difference in the two results; the baryta of the
carbonate was 0·1701, and that of the sulphate was 0·1700, which
corresponds to a per centage of 19·65—stearic acid (Heintz) requires
21·76 per cent., and palmitic acid 23·62 per cent. of baryta for the
neutral salts. I have no doubt that a further purification will show this to
be stearic acid, as might be expected from the original fat of the heart.
I am not desirous of claiming for these experiments a greater importance
than they deserve, nor any but that the experiments were carefully
performed: they were extended over the greater part of a year, during
which my attention has been particularly directed to this subject. When
the investigation was commenced, I was inclined to the belief that
adipocire was a result of the decomposition of the blood-forming
substances, and this, principally, from the experiments of Blondeau (see
first part of this article) which I have not seen refuted, and partly from
the testimony of those who have had opportunities of observing the
formation of adipocire, and who have stated that fleshy parts of the body
are wholly converted into it. The formation of the lower terms of the
series of fatty acids from proteine bodies forbids maintaining that this is
impossible; but from what I have seen, and on weighing the evidence of
what I have read, my impression is, that adipocire proceeds from the
original fat of the body.
It appears to follow from the foregoing experiments, that the higher
members of the series of fatty acids do not result from the putrefaction of
proteine compounds; at least from such putrefaction as is accompanied
by exclusion of air. Flesh fibrine with restriction of air does not putrefy
as rapidly as would be supposed, according to the experiment, where a
portion was sealed with water on a microscope slide; the air here was not
absolutely excluded, since a partial evaporation of the water took place.
It is true that the amount of water in this experiment was small, in
proportion to the fibrine, and it appears that much water is necessary to
such decomposition, and which supports Liebig’s theory of the motion of
the molecules. In the experiments of the bottles and of the sand, the
decomposition was seen to take place gradually; the sarcous element of
the flesh fibrine separated into discs, and these were by degrees resolved
into their simpler compounds, which either remained as liquids or gases
in solution in the bottles, or were carried off by the droppings in the sand
experiment. The original fat of the body, according to circumstances,
either partakes of this decomposition, or else, losing its glycerine and
most of its oleic acid, becomes gradually converted into adipocire. In
some bodies in the grave yards the fat is totally gone, while in others
large quantities of adipocire are formed. It is suggestive that in all cases
where adipocire has been found, the corpse was of a large and fat person,
and this abundance of fat resists an ultimate decomposition. Analyses by
Beetz of candles which had remained for a hundred years in a mine,
prove that the only alteration undergone by fats when alone, is
destruction of their oleine and glycerine. In the bottles of my
experiments no adipocire was formed, although the fat of the coronary
vessels was only partially removed; this may be accounted for on the
ground that the fat, which was small in quantity, was here kept in close
contact with the decomposing fibrine, and suffered with it
decomposition, whereas in the sand experiment, this could only take
place to a less degree. In grave yards, if the proportion of flesh to fat be
large, and especially if the ground be of such a nature as to prevent the
decomposed matter being carried off, as by draining, adipocire cannot be
formed, but the fat undergoes full decomposition.
The fact that in adipocire from different animals, the same substances are
found accompanying the original fat of the animal, as the goat-like or
mutton smell in sheep, and the tallow smell of the fossil adipocire, is
suggestive, and should shift the burden of experimental proof upon those
who maintain the formation of this substance from fibrine. The
microscopic experiments militate against the transformation from fibrine.
Those that believe in this change think to have proof from the shape, as it
were, of certain muscles transformed into fat; but fibrine does not require
to lose much substance in the shape of ammonia, &c., for this
transformation, and there would not be, therefore, a great disturbance in
the shape of the fibres of muscle; at any rate, it would be reasonable to
expect, that with the microscope, traces of an arrangement of the fatty
particles into fibres or rows would here and there be seen, but this is not
the case, and the appearance is that of fat particles of equal size among
themselves, and of a diameter one-fourth that of the original fat globules,
and indeed presenting all the appearances to be expected from a mass of
fat undergoing alteration from the decomposition of its oleine and
glycerine; and finally in the experiment where adipocire was artificially
formed, no gain of fat was observed, but a loss of what was purposely
left upon the specimen under examination.
I shall delay an examination of the products in my hands, until the
separation of the fatty acids is improved. It would be easy enough with
the present methods to isolate the two principal constituents of the fatty
acids from the material in hand; but small quantities of new products
would inevitably escape observation.
The desiderata in working the fatty acids at present, are, First, separation
of the oleic acid, without too much loss of substance.
Second, a less circuitous method of separating the fatty acids than by
Heintz’s method, which renders difficult the isolation of small quantities
of a different acid, as shown by his mistake of anthropic acid.
It is probable that a crystallization of salts (especially with a base of a
high equivalent) would effect this purpose, for in crystallization, other
compounds and impurities are concentrated in the mother liquids, while
in fractional precipitation, in the present case, an infinite subdivision
seems to take place, requiring many steps to accomplish a sufficient
purification; and brilliant as Heintz’s results are, considerable labour was
required to arrive at them. Heintz’s process of partial precipitation was
founded upon the method of fractional distillation, proposed by Liebig
for the separation of the lower members of the series of fatty acids; in the
latter case presence of an alkaline carbonate, in quantity insufficient to
saturate the mixed acids, alters their volatility, while in the former,
presence of a salt in insufficient quantity for perfect decomposition
changes the relations of solubility of the salt formed, and it does not
necessarily follow that the chemical affinity, active in both cases, will
afford as expeditious a method in cases of solubility as in those of
volatility.

FOOTNOTES:
[1] Liebig thinks this probable. Ch. Briefe.
[2] The degrees of thermometer in this article are centigrade, and the weights
grammes.
[3] Lehmann, Lehrbuch.
[4] Lehrbuch, III. p. 187.
[5] Lehmann.
[6] The liquid from No. 3 was all absorbed by the pressing cloths, and not
collected.
[7] Since the above was written, I have received the Journal für Pract.
Chemic., Heft III. Band LXIII. in which some late results by Heintz on this
point are communicated. He artificially prepared chemically pure stearine
from the acid and glycerine, by Berthelot’s process, and found that it had two
melting points, first at 55°, then solidifying and melting again when the heat
reached 71.6°.
[8] Ann. de Ch. & de Ph., xvii. p. 390.
[9] See Kolliker, Mic. Anat., II. 1st Part, page 16.
 *** END OF THE PROJECT GUTENBERG EBOOK ON
ADIPOCIRE, AND ITS FORMATION ***

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