Solution Manual For Pearson's Federal Taxation 2025 Individuals, 38th Edition by Mitchell Franklin L

Solutions Manual Pearson’s Federal Taxation 2025 Individuals

Mitchell Franklin Luke E. Richardson Thomas R. Pope Timothy J. Rupert David S. Hulse N. Allen Ford LeAnn Luna Charlene Henderson William D. Brink Susan Albring

TABLE OF CONTENTS

Chapter No. Chapter Title Preface

Page No. iii

I:1

An Introduction to Taxation

I:1-1

I:2

Determination of Tax

I:2-1

I:3

Gross Income: Inclusions

I:3-1

I:4

Gross Income: Exclusions

I:4-1

I:5

Property Transactions: Capital Gains and Losses

I:5-1

I:6

Deductions and Losses

I:6-1

I:7

Business Expenses and Deferred Compensation

I:7-1

I:8

Itemized Deductions

I:8-1

I:9

Losses and Bad Debts

I:9-1

I:10

Depreciation, Cost Recovery, Amortization, and Depletion

I:10-1

I:11

Accounting Periods and Methods

I:11-1

I:12

Property Transactions: Nontaxable Exchanges

I:12-1

I:13

Property Transactions: Section 1231 and Recapture

I:13-1

I:14

Special Tax Computation Methods, Tax Credits, and Payment of Tax

I:14-1

I:15

Tax Research

I:15-1

I:16

Corporations

I:16-1

I:17

Partnerships and S Corporations

I:17-1

I:18

Taxes and Investment Planning

I:18-1

Summary of Question and Problem Revisions

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I:SQR-1

PREFACE This manual includes solutions to the discussion questions, problems, comprehensive problems, tax strategy problems, case study problems, and tax research problems to the Pearson’s Federal Taxation 2025: Individuals text. To restrict student access to the tax form/return preparation problems, these problem solutions are included in the Instructor’s Resource Manual.

The Instructor’s Resource Manual, including lecture outlines, is available on the Instructor’s Resource Center (IRC) online at: www.pearsonhighered.com/pearsontax Registration/login is required on the IRC online. For assistance, you may contact your Pearson representative. If you do not know your Pearson representative, you may visit: www.pearsonhighered.com/replocator Every effort was made to minimize technical and typographical errors in the preparation of the Solutions Manual for the 2025 Edition. The solutions to each chapter were prepared by the individual who authored the text material for the chapter. In addition, a review of the materials for the 2025 Edition was conducted by an accuracy reviewer and by the editors.

We would appreciate receiving any corrections for subsequent revisions from those instructors who have adopted the text. In addition, we would appreciate receiving any suggestions for adding new problems or questions to the current problem materials for the next edition of this volume or enhancing the coverage of existing problem materials included in the 2025 Edition. Our thanks go out to those individuals who have alerted us to errors in the Solutions Manual for previous editions. These errata items have been corrected in this Solutions Manual. If you locate what you believe to be an error, please notify Professor Mitchell Franklin at franklma@lemoyne.edu. A prompt reply will be provided concerning all possible errors. In addition, corrections to errors will be posted online at www.pearsonhighered.com/pearsontax. See “Textbook Errata.”

Sincerely, Mitchell Franklin Luke E. Richardson

Copyright © 2025 Pearson Education, Inc. iii

Chapter I:1 An Introduction to Taxation Discussion Questions I:1-1 The Supreme Court held the income tax to be unconstitutional in 1895 because the income tax was considered to be a direct tax. At that time, the U.S. Constitution required that an income tax be apportioned among the states in proportion to their populations. This type of tax system would be extremely difficult to administer because different rates of tax would apply to individual taxpayers depending on their states of residence. p. I:1-2.

I:1-2 The pay-as-you-go withholding was needed in 1943 to avoid significant tax collection problems as the tax base broadened from 6% of the population in 1939 to 74% in 1945.

Pay-as-you-go permitted the federal government to deduct taxes directly out of an employee's wages. p. I:1-3.

I:1-3 Under a progressive tax rate structure, the tax rate increases as the taxpayer's income increases. Currently, for 2024, tax rates of 10%, 12%, 22%, 24%, 32%, 35% or 37% apply depending upon the taxpayer's filing status and taxable income levels. Under a proportional tax rate or "flat tax" structure, the same tax rate applies to all taxpayers regardless of their income levels.

Under a regressive tax rate structure, the tax rate decreases with an increase in income level. The concept of vertical equity holds that taxpayers with higher income levels should pay a higher proportion of tax and that the tax should be borne by those who have the "ability to pay." Thus, Congressman Patrick's opposition to the flat tax is philosophically correct; under a flat tax system, all taxpayers pay taxes at the same rate, regardless of the ability to pay. pp. I:1-4 and I:1-5.

I:1-4 It is possible for the government to raise taxes without raising tax rates. Because there are two components in computing a taxpayer's tax, the tax base and the tax rate, taxes can be raised by increasing either the rate or the base. Thus, even though the Governor proclaimed that tax rates have remained at the same level, adjustments to the tax base, such as the elimination of deductions, result in tax increases which can be as much, or more, as increases in tax rates. p.

I:1-4.

I:1-5 The marginal tax rate is of greater significance in measuring the tax effect for Carmen's decision. The marginal tax rate is the percentage that is applied to an incremental amount of taxable income that is added to or subtracted from the tax base. Through the marginal tax rate, the taxpayer may measure the tax effect of the charitable contribution to her church. If her marginal tax rate is 24%, she will save 24¢ for each $1 contributed to her church. The average tax rate is simply the total tax liability divided by taxable income. pp. I:1-5 and I:1-6.

I:1-6 Gift and estate taxes are levied when a transfer of wealth (property) takes place and are both part of the unified transfer tax system. The tax base for computing the gift tax is the fair market value of all gifts made in the current year minus an annual donee exclusion of $18,000 (2024) per donee, minus a marital deduction for gifts to spouse and a charitable contributions Copyright © 2025 Pearson Education, Inc.

I:1-1

deduction if applicable, plus the value of all taxable gifts in prior years. The tax base for the estate tax is the decedent's gross estate, minus deductions for expenses, and a marital or charitable deduction if applicable, plus taxable gifts made after 1976. pp. I:1-7 through I:1-10.

I:1-7 a.

Cathy, the donor, is primarily liable for the gift tax on the two gifts. The children are contingently liable for payment of the gift tax in the event the donor fails to pay. b.

Before considering the unified tax credit equivalent of $13.61 million for 2024, a gift tax results on the two gifts for the current year 2024 computed as follows: Total gifts $100,000 Minus: Annual gift tax exclusion ($18,000 x 2 donees) ( 36,000) Gift tax base $ 64,000 Since Cathy has never made gifts in prior years, no gift tax will be due because of the substantial unified tax credit that is available. pp. I:1-8 and I:1-9.

I:1-8 Carlos would report a taxable gain of $2,000 ($27,000 - $25,000). His tax basis in the stock that he inherited is the fair market value on the date of his father’s death. pp. I:1-9 and I:1-10.

I:1-9 a.

Most estates are not subject to the federal estate tax because of generous credit and deduction provisions, such as the unified tax credit and the unlimited marital deduction. The unified tax credit equivalent for 2024 is $13.61 million. This means that, at a minimum, for decedents dying in 2024, no estate of $13.61 million or less will be subject to the federal estate tax. b.

This is a controversial question that has proponents on both sides of the issue.

Those that believe the estate tax should be reduced or eliminated basically argue that the estate tax is a double tax, that is, the property of the decedent has already been subject to income taxation during his or her lifetime and should not be subjected to further taxation at death. On the other hand, proponents of retaining or increasing the estate tax believe in the ability to pay principle. p. I:1-10.

I:1-10 a.

Progressive. b.

Progressive. c.

Proportional. d.

Proportional. e.

Proportional. (However, state and local sales taxes are considered regressive when measured against income). pp. I:1-4 and I:1-5 and I:1-12.

I:1-11 Decrease. When Carolyn operates her business as a sole proprietor, she is considered to be self-employed. A self-employment tax is imposed at the rate of 15.3% for 2024 (12.4% OASDI + 2.9% Medicare) on all of her business income with a ceiling on the non-hospital insurance (OASDI) portion of the tax base of $168,600 in 2024. Carolyn is also entitled to an income tax deduction equal to 50% of the self-employment tax payments if she is self-employed.

If she works as an employee, however, the OASDI and Medicare taxes are imposed at the employee level at a rate of 7.65% for 2024. The OASDI is imposed on earned income up to a maximum of $168,600 in 2024 while Medicare taxes have no ceiling. Her employer would have to match Carolyn’s OASDI and Medicare taxes. Thus, Social Security taxes are levied at the Copyright © 2025 Pearson Education, Inc.

I:1-2

same rate of 15.3% (7.65% on the employee and 7.65% on the employer). If the corporation does not pay Carolyn a salary equal to its earnings, the Social Security taxes will be slightly less than under the sole proprietorship. The hospital insurance portion of the FICA premium continues to apply with no ceiling amount for employees, employers, and self-employed individuals. The rate is 2.9% for self-employed individuals and 1.45% each for employees and employers. p. I:1-11.

I:1-12 a.

Property taxes are primarily used by local governments and include both real property taxes (real estate) and personal property taxes (tangible and intangible property). b.

Excise taxes are primarily used by the federal government and are imposed on items such as alcohol, tobacco, telephone usage, and many other goods. While not as extensive as the federal government, many state and local governments impose similar types of taxes. c.

Sales taxes are primarily used by state governments and constitute a major revenue source for many states. Local governments are increasingly using sales taxes as well as states. The local governments frequently tack-on 1¢ or 2¢ to the existing state sales tax rather than imposing a separate sales tax. d.

Income taxes are the primary domain of the federal government and constitutes its major source of revenue. However, many state and local governments now use the income tax in their revenue structures. e.

Employment taxes are primarily used by the federal government. Social security (FICA) taxes are a major source of federal revenue. Unemployment taxes are used by states as a compliment to the federal unemployment compensation tax. pp. I:1-10 and I:1-11.

I:1-13 a.

The five characteristics of a “good” tax are equity, certainty, convenience, economy, and simplicity. Equity refers to the fairness of the tax to the taxpayers. A certain tax is one that ensures a stable source of government revenue and provides taxpayers with some degree of certainty concerning the amount of their annual tax liability. Convenience refers to the case of assessment, collectability, and administration for the government and reasonable compliance requirements for taxpayers. An economical tax requires minimal compliance costs for taxpayers and minimal administration costs for the government. Simplicity means the tax system is simple to understand and to comply. b.

1.

The federal income tax meets the first four criteria reasonably well, even though many critics would suggest otherwise. The tax is reasonably fair in that the high-income taxpayers pay the most tax, the low-income taxpayers the least tax. While tax laws are constantly changing, most taxpayers have a pretty good idea of what their taxes are going to be for the tax year and the federal income tax does provide the government with a stable source of revenue.

The tax is convenient to pay although compliance requirements for taxpayers have risen steadily over the years. The tax is economical for the government to collect; however, the cost of compliance for taxpayers is much too high as approximately 56% of all taxpayers pay a tax preparer to prepare their tax returns. However, virtually no one would suggest that the federal income tax law is simple. In fact, complexity is one of the law’s major flaws.

2.

The state sales tax meets the criteria of certainty, convenience, economy and simplicity quite well. However, the sales tax is criticized as not being equitable as it tends to fall more heavily on lower and middle-income taxpayers.

3.

Property taxes do not fare well according to the characteristics of a “good” tax. From equity standpoint, the property tax is imposed on property owners without regard to their income situation. Thus, a farmer may have substantial property but little income to pay the Copyright © 2025 Pearson Education, Inc.

I:1-3

property tax. Property taxes are certain but clearly not convenient in the sense that they are normally assessed in a lump-sum amount once a year. Property taxes do not meet the economy criteria. Property taxes are rather simple although differences in judgments as to valuation of property are a problem. pp. I:1-12 through I:1-14.

I:1-14 a.

Horizontal equity refers to the concept that similarly situated taxpayers should pay approximately the same amount of tax. Vertical equity, on the other hand, refers to the concept that higher income taxpayers should not only pay a higher amount of tax but should pay a higher percentage of tax. Vertical equity is based on the notion that taxpayers who have the “ability to pay” (e.g., higher income taxpayers) should pay more tax than lower income taxpayers. b.

Fairness is an elusive term. Because of widely divergent opinions as to what constitutes fairness, it logically follows that there are also many different and divergent opinions as to what constitutes a “fair” tax structure. p. I:1-13.

I:1-15 Secondary objectives include the following: a.

Economic objectives such as stimulating private investment, reducing unemployment, and mitigating the effects of inflation. b.

Encouraging certain activities such as research and development and small business investment. c.

Social and public policy objectives, (e.g. encouraging charitable contributions and discouraging illegal bribes). pp. I:1-14 and I:1-15.

I:1-16 Probably not. It would be difficult to achieve a simplified tax system and also provide incentives to certain industries as well as achieve social objectives. To achieve a simplified tax system would require the elimination of special purpose provisions, such as with the several consumption tax proposals being forwarded. But consumption taxes generally are considered unfair as they fall disproportionately on the low and middle class. pp. I:1-14 through I:1-16.

I:l-17 Taxpaying entities generally are required to pay income taxes on their taxable income.

The major taxpaying entities are individuals and C corporations. Flow-through entities generally do not directly pay income taxes on their taxable income but merely pass the income on to a taxpaying entity. The major flow-through entities are sole proprietorships, partnerships, S corporations, limited liability companies (LLC), limited liability partnerships (LLP), and certain trusts. Some entities do not neatly fall within each category and are actually hybrid entities. S corporations, for example, are subject to income taxes in certain situations, such as taxes on built-in gains, the LIFO recapture tax, etc. Not many S corporations incur these taxes. pp. I:1-16 through I:1-24.

I:1-18 Sally and Tom’s taxable income for 2024 would be $110,800, computed as follows: AGI $ 140,000 Larger of itemized deductions ($22,000) or standard deduction ($29,200) (29,200) Taxable income $ 110,800

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I:1-4

If Sally and Tom had itemized deductions of $32,000 rather than of $22,000, their taxable income would be $108,000, computed as follows: AGI $ 140,000 Larger of itemized deductions ($32,000) or standard deduction ($29,200) (32,000) Taxable income $ 108,000 As can be seen previously, the standard deduction of $29,200 is larger than $22,000 of their itemized deductions, so they obviously would claim the standard deduction. Alternatively, if the itemized deductions were $32,000, their taxable income would be 108,000 ($140,000 - $32,000) as the itemized deductions exceed the standard deduction of $29,200. Taxpayers are allowed to deduct the greater of itemized deductions or the standard deduction. pp. I:1-6, I:1-7, and I:1-17.

I:1-19 To properly respond to Bruin, tax calculations for both Bruin Corporation and John Bean must be made for the year. $400,000 dividend. If the $400,000 is distributed to John as a dividend, Bruin Corporation would get no deduction for the dividend and would have corporate taxes of $105,000 ($500,000 x 0.21) based on taxable income of $500,000. John would then pay a maximum rate of 20% on the dividend because his taxable income is greater than $518,900 given the tax bracket he is in the 37% bracket starts at taxable income over $609,350 for single taxpayers, so the income taxes due by John on the $400,000 dividend would be $80,000. Thus, the total income taxes would be $185,000 ($105,000 + $80,000). $400,000 salary. If the $400,000 is distributed to John as a salary, Bruin Corporation would be allowed a deduction and the corporation’s taxable income now would be $100,000. The corporate tax on $100,000 is $21,000. John would be required to pay income taxes on the $400,000 at 37%, so the tax would be $148,000. The total income taxes for the year would be $169,000.

As can be seen from the analysis above, the $400,000 salary would result in smaller taxes. This results even though John is in the top 37% tax bracket. The tax savings would be even higher if John were in a lower tax bracket. (Note that this solution ignores the incremental 3.8% tax on net investment income for high income taxpayers, which is discussed in later chapters). pp. I:1-19 and I:1-20.

I:1-20 The term “double taxation” refers to the taxing of the same income twice. This type of taxation typically results from a C corporation paying tax on its taxable income and shareholders paying income tax on any dividends received from the C corporation. The impact of double taxation of C corporations has been substantially reduced by the fact that dividends generally are taxed at a 15% rate with a maximum rate of 20%. An example of double taxation can be seen in Example I:1-15 of the textbook. pp. I:1-19 and I:1-20.

I:1-21 Limited liability companies (LLCs) generally are taxed as partnerships. Therefore, the LLC is not subject to income tax on its taxable income but such income is allocated to the members (owners) of the LLC. Thus, only a single-level of taxation is imposed. The same Copyright © 2025 Pearson Education, Inc.

I:1-5

allocation rules that pertain to partnerships also apply to LLCs. Another principle feature of LLCs is limited liability for owners (members) of the LLC. pp. I:1-22 and I:1-23.

I:1-22 To prevent double taxation, the tax law allows partners to increase their basis in the partnership for any income that is allocated to the partner. Since partnership distributions are not subject to taxation if such distributions are less than the partner’s basis, double taxation is prevented. Similarly, to prevent double deductions, the tax law requires partners to decrease their basis for any loss or deduction that is allocated to the partner. pp. I:1-21 and I:1-22.

I:1-23 Schedule K-1 is an integral part of both the annual partnership tax return and the S corporation tax return. Partnerships and S corporations use the same allocation system. The K-1 reports a partner’s allocable share of partnership ordinary income and separately-stated items, such as dividends, long-term capital gains, etc. A K-1 is prepared for each partner in the partnership and is filed with Form 1065. So, if a partnership has ten partners, there will be ten K-1s that allocate the total partnership income to each partner. A copy of each partner’s K-1 is provided to the partners so that they can report the information on their own tax returns. pp. I:1-21 and I:1-22.

I:1-24 Quint’s taxable income for 2024 is computed as follows: Allocable share of PDQ Partnership income ($150,000 x .3333) Other income Adjusted gross income (AGI) Standard deduction Taxable income

$50,000 15,000 $ 65,000 $(14,600) $50,450

The $30,000 distribution from the partnership is considered a return of capital and is not taxable to Quint. Since he reports his allocable share of partnership income, if the distribution were taxed again, the result would be double taxation. If the partnership is eligible for the 20% qualified business income (QBI) deduction, Quint would also be allowed a deduction of $10,000 ($50,000 x 0.20) for his share of partnership income. pp. I:1-17 and I:1-21.

I:1-25 Because of the vast volume of tax law sources, it is nearly impossible for any person to have recall knowledge of the entire tax law. Thus, the ability to understand what the relevant sources of tax law are, their relative weight (importance), and where to find the sources are vital to a person working in the tax area. p. I:1-24.

I:1-26 Even though the Code is the highest authority of tax law sources, the Code contains general language and does not address the many specific situations and transactions that occur.

To resolve tax questions concerning specific situations, administrative rulings and court decisions are an integral part of the income tax law. p. I:1-24.

I:1-27 a.

Ways and Means Committee (House of Representatives), Senate Finance Committee (U.S. Senate) and the Joint Conference Committee. b.

Committee reports are helpful for two major purposes: (1) to explain the new law before the Treasury Department drafts regulations on the tax law changes, and (2) to explain the intent of Congress for passing the new law. pp. I:1-24 through I:1-26.

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I:1-6

I:1-28 The National Office of the IRS issues revenue rulings to provide guidance to taxpayers on specific factual situations, processes ruling requests from taxpayers (private letter rulings), and prepares Revenue Procedures that assist taxpayers with compliance matters. Of course, the National Office also provides administrative and human resources functions at the top level of the organization. p. I:1-26.

I:1-29 Individuals most likely to be audited include those that may be involved in any of the following situations: • Individuals who are sole proprietors and incur significant expenses in connection with the trade or business.

• Itemized deductions in excess of an average amount for the person's income level.

• Filing of a refund claim by a taxpayer who has been previously audited and the audit resulted in a substantial tax deficiency.

• Individuals who are self-employed with substantial business income or income from a profession such as a medical doctor. p. I:1-27.

I:1-30 a.

Rarely will the IRS review each line of Anya’s return. Audits of individual taxpayers generally focus on selected items on the return. Note: In prior years, the IRS had a Taxpayer Compliance Measurement Program (TCMP) where a small number of taxpayers were selected by a random sample and their returns were audited on a line-by-line basis. These audits were primarily for statistical purposes. Currently, this program has been abandoned. However, the IRS now uses the National Research Program (NRP) to select returns for audit. The NRP will update data compiled in the old TCMP audits and develop new statistical models for identifying returns most likely to contain errors. b.

Generally not all items on a return will be audited. All tax returns are initially checked for mathematical accuracy and items that may be considered clearly erroneous. If differences are noted the IRS sends the taxpayer a bill for the corrected amount. Upon an audit of Anya's return, the IRS generally only examines selected items on the return. These items are those that the IRS believes there is a possibility of error. p. I:1-27.

I:1-31 a.

The term "hazards of litigation" refers to the probability of winning or losing a case if it goes to court. b.

Because of the possibility that a case may be lost and the cost of litigation, both the IRS and taxpayers frequently settle a case to avoid such possibilities. The IRS may also decide to settle a case because it does not want to establish an unfavorable precedent of cases in a specific area. A taxpayer may settle a case to avoid substantial legal and professional fees. p. I:129.

I:1-32 No, just because the taxpayer has filed a return and received a refund, the IRS may still audit a taxpayer. Tax returns that are selected for audit generally are audited a year or two after the return is received by the IRS. p. I:1-28.

I:1-33 a.

The statute of limitations remains open indefinitely if a fraudulent return is filed or if no return is filed at all.

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I:1-7

b.

The general rule for the disallowance of tax deduction items is that an assessment may be made against the taxpayer within three years from the later of the date the tax return was filed or its due date. c.

A six-year statute of limitations applies if the taxpayer omits an item of gross income that is in excess of 25 percent of the gross income that is reported on the return. p. I:1-28.

I:1-34 The best possible defensibly correct solution is one that is advantageous to the client but is based upon substantial authoritative support (e.g., favorable court cases) even though the position may be challenged upon audit by the IRS. p. I:1-30.

I:1-35 The four principal areas of activity for the profession of tax practice are: tax compliance and procedure, tax research, tax planning and financial planning. Tax compliance and procedure essentially consists of tax return preparation and assisting the taxpayer in dealing with the IRS. Tax research is the process of developing the most defensibly correct solution to a tax problem.

Tax planning involves the process of reducing taxes so as to maximize a taxpayer's after-tax return. Financial planning, while not exclusively related to tax, is an area for tax professionals to assist clients with planning for their entire financial affairs. pp. I:1-29 through I:1-31.

I:1-36 a.

Because income taxes may exceed 50% of a taxpayer's income (including federal, state, and local income taxes and Social Security taxes), taxes are an extremely important part of the financial planning process. Any financial plan that does not carefully consider taxes is a flawed plan. b.

Because tax professionals see their clients at least once a year at a minimum (preparation of their income tax returns) and are familiar with the client’s financial information, this represents a perfect opportunity to perform financial planning. p. I:1-31.

I:1-37 No, the principal goal of tax planning is to maximize a taxpayer's after-tax cash flow, not just the minimization of taxes due. For example, if a taxable investment generates a better return after taxes are paid than a nontaxable investment, the taxable investment is superior even though taxes must be paid. p. I:1-30.

I:1-38 Tax planning involves the evaluation of alternative courses of action. The evaluation of alternative courses of action can be very time-consuming because of the numerous and complex tax calculations necessary to arrive at an optimal solution. Using tax software has become an essential tool in this process because of the speed and accuracy in which tax calculations can be made as well as data analytic methods to analyze large amounts of tax data. pp. I:1-30 and I:131. Tax planning and complex tax calculations, as well as tax research are increasingly performed, or at least assisted, by artificial intelligence (AI).

Problems I:1-39 a.

Income: Salary Business income

$100,000 25,000

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I:1-8

Interest income

10,000 $135,000

Deductions: Business expenses Itemized deductions Taxable Income Tax

$9,500 20,000

29,500 $105,500 $18,363

Note: Tax-exempt bond interest is not taxable and itemized deductions are greater than the standard deduction amount.

b.

Marginal rate = 24% Average rate = 17.41% Effective rate = 14.41%

(From tax rate schedule) ($18,363/$105,500) ($18,363/($135,000 + $5,000 - $9,500))

c.

From a tax planning point of view, the marginal rate is the most important rate because it measures the tax saving from each additional $1 of deduction (or additional tax from each additional $1 of taxable income). pp. I:1-4 through I:1-7 and I:1-17 and I:1-18.

I:1-40. The income tax payable, average tax rate, and marginal tax rate for each amount for 2024 for married couples filing joint income tax returns is as follows: a.

$2,320 + .12($30,000 - $23,200) = $3,136 Average tax rate: $3,136/$30,000. = 10.45% Marginal tax rate: 12%

b.

$10,852 + .22($100,000 - $94,300) = $12,106 Average tax rate: $12,106/$100,000. = 12.11% Marginal tax rate: 22%

c.

$78,221 + .32($425,000 - $383,900) = $91,373 Average tax rate: $91,373/$425,000. = 21.50% Marginal tax rate: 32%

d.

$196,669.50 + .37($800,000 - $731,200) = $222,125.50 Average tax rate: $222,125.50/$800,000 = 27.77% Marginal tax rate: 37%

Note: This problem clearly demonstrates the progressive nature of the federal income tax. The average tax rate rises from 10.45% to 27.77% in this problem.

I:1-41 a.

Their marginal tax rate with $500,000 of taxable income is 35%. However, with an additional $40,000 of deductions, their taxable income drops to $460,000, which would reduce their marginal tax rate to 32% (for 2024, the 35% rate begins when taxable income exceeds $487,450).

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I:1-9

b.

Their tax savings using the 2024 Tax Rate Schedules and married filing jointly would be computed as follows: Tax on $500,000 $ 115,750 Tax on $460,000 (102,573) Tax savings $ 13,177 pp. I:1-4 through I:1-7.

I:1-42 Betty’s taxable gift for the current year (2024) is $82,000 computed as follows: Gift to daughter $100,000 Gift to husband 40,000 Total gifts during year $140,000 Annual exclusion ($18,000 x 2) $36,000 Marital deduction ($40,000 - $18,000) 22,000 (58,000) Taxable gifts $82,000 Note: Charitable contributions are not subject to the gift tax. Thus, the contribution to her church is not subject to the gift tax. pp. I:1-8 and I:1-9.

I:1-43 a. follows:

The amount of Clay's taxable estate is $8,225,000. This amount is computed as Gross estate Minus: Funeral and Admin. Expenses Debts Taxable Estate

$8,500,000 (125,000) (150,000) $8,225,000

b.

The tax base for computing Clay's estate tax is $ 8,225,000, computed as follows: Taxable estate $8,225,000 Gifts after 1976 0 Estate tax base $8,225,000

c.

If the tentative estate tax is $3,235,800, no estate tax is due, computed as follows: Estate tax from rate schedule Minus: Unified tax credit (2024) based on an equivalent of $13,610,000 Estate tax due

$3,235,800* (5,389,800) $0

*[$345,800 + .40 (8,225,000 – 1,000,000)] d.

Yes, because the aggregate value of the estate decreased during the six-month period following the date of death, the alternate valuation date may be selected by the administrator. The important factors in deciding whether to use the alternate valuation date are (1) the amount of estate taxes to be saved, and (2) the impact on the beneficiaries’ income tax Copyright © 2025 Pearson Education, Inc.

I:1-10

situation. However, in this case, the alternate valuation date would not be necessary because the estate tax using date-of-death value is zero.

Note: There can never be a tax refund even if the unified credit is greater than the tax liability. e.

If the gross estate was $18,500,000, the taxable estate and tax base would be $18,225,000 ($18,500,000 - $125,000 - $150,000). The estate tax would be as follows: Estate tax from rate schedule $7,235,800 Minus: Unified tax credit (2024) based on an equivalent of $13,610,000 (5,389,800) Estate tax due $1,846,000 pp. I:1-9 and I:1-10.

I:1-44 a. The corporate tax liability of KT, Inc. for 2024 would be computed as follows: Gross income Expenses: Operating expenses Taxable income

$2,000,000 (800,000) $ 1,200,000

Corporation tax ($1,200,000 x 0.21)

$ 252,000

The tax liability of Keith and his wife on their individual return for 2024 is as follows: Dividend from KT, Inc. Other taxable income Adjusted Gross Income (AGI) Itemized deductions Taxable income

$350,000 130,000 480,000 (40,000) $440,000

Income tax (joint return rate schedule): Taxable income (above)

$440,000

Minus: dividends Taxable income without dividends Tax from rate schedule on $90,000 Tax on dividends ($350,000 x 15%*)

( 350,000) $ 90,000 $ 10,336 52,500 $ 62,836

Thus, the total tax liability for both the corporation (Keith’s share of 50%) and Keith and his wife is $188,836 ($126,000 + $62,836). b. follows:

If the consulting business was organized as an LLC, the income taxes would be as

KT, LLC Gross income

$2,000,000 Copyright © 2025 Pearson Education, Inc.

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Operating expenses Taxable income

( 800,000) $1,200,000

Income tax

$

0

LLCs are flow-through entities and are not subject to income taxes on the entity.

The tax liability of Keith and his wife on their individual return for 2024 is as follows: Pass-through income from ($1,200,000/2) Other taxable income Adjusted gross income (AGI) Itemized deductions Taxable income Income tax rounded)*

(joint

return

KT,

LLC

$600,000 130,000 730,000 (40,000) $690,000

rate

schedule,

$ 182,250

*Keith would also be subject to self-employment taxes on the $600,000 from KT, LLC. This amount is not shown in this problem. Self-employment taxes are covered later in this textbook.

In this case, as seen from the tax calculations above, when the consulting business is organized as an LLC, income taxes are decreased by $6,586, calculated as the difference between their tax as an LLC of $182,250 minus their tax as a C Corporation of $188,836. This results even though the dividends are taxed at a rate of 15%. Also, the $700,000 of LLC distributions ($350,000 each) are not subject to income taxation. pp. I:1-19 through I:1-23.

Note: This extremely simplified problem is intended to illustrate the effect of double taxation of C corporations and shareholders. Prior to 2018, the tax effect was much more significant. The reduction of C corporation tax rates to 21% (from 35%) has substantially reduced the tax advantage of flow-through entities. However, the 20% deduction for flow-through entities would further enhance the viability of flow-through entities.

I:1-45 Howard and Dawn’s taxable income and income tax liability for 2024 is computed as follows: Dawn’s salary Allocable share of partnership income ($180,000 x 0.40) Qualified dividends ($4,000 + $3,000) Net long-term capital gain [($28,000 - $12,000) x 0.40] Adjusted gross income (AGI) Larger of itemized deductions or standard deduction: Standard deduction, or Itemized deductions: Mortgage interest $13,000 Copyright © 2025 Pearson Education, Inc.

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$ 80,000 72,000 7,000 6,400 $165,400 $29,200

Real estate taxes State and local income taxes Charitable contributions ($1,600 + $3,000) Taxable income

6,000 3,300 4,600

26,600

( 29,200) $136,200

Income tax liability (from tax rate schedules, see calculations below) Income tax payments made during the year: Tax withheld from salary $12,500 Estimated tax payments 10,000 Refund *$136,200 – (7,000 + 6,400) = 122,800; tax $17,122 Dividends and LTCG: ($13,400 x 0.15) 2,010 Total tax liability $19,132

$ 19,132*

22,000 $ 2,868

Note: The cash distributions of $150,000 are not subject to income taxation for the partners.

Also, Howard would likely be subject to self-employment taxes which are substantial. Selfemployment taxes are covered in Chapter I:14 of this textbook. pp. I:1-17 through I:1-19.

I:1-46 Since Paul's return is filed late and the final balance due on the return is paid late (both due on or before April 15, 2025), Paul is subject to further interest and penalties on his 2024 income tax return. Both interest and penalties are computed on the net tax due or, in this case, $8,000 (the difference between the tax liability and the withholdings). The interest and penalties are computed as follows (assuming a 7% interest rate on underpayments on tax and the return is 232 days late): Interest:

$8,000 x 7% x 232/365 = $355.95.

There are two penalties to which Paul would be subject, a failure to file (timely) penalty and a failure to pay the tax (timely) penalty. The late payment penalty is .5% per month to a maximum of 25%; the late filing penalty is 5% per month to a maximum of 25%. However, both penalties are not assessed together. If both penalties apply, the failure to file penalty is reduced by .5%.

Failure-to-pay penalty (0.5% per month to a maximum 25%): Based on filing the return 9 months late: Tax due $8,000.00 Lesser of (a) 0.5% × 9 or (b) 25% × 4.5% Failure-to-pay penalty $ 360.00 Failure-to-file penalty (5% per month to a maximum 25%, reduced by the failure-to-pay penalty for each month both penalties apply): Tax due Lesser of (a) 5% × 9 or (b) 25% Failure-to-file penalty before reduction

$8,000.00 × 25% $2,000.00

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Failure-to-pay penalty for 5 months* ( 200.00) Failure-to-file penalty $1,800.00 *0.5% × 5 months × $8,000 = $200.00. Because the 5% per month penalty has a 25% maximum, it applied for only 5 months. See IRM Sec. 8.17.7.3.

Thus, Paul must pay an additional $355.95 of interest plus $2,160.00 ($360.00 + $1,800.00) of penalties for filing the return late, for a total cost of $2,515.95 for filing late. Obviously, Paul would be prudent to file his return in a timely manner. pp. I:1-28 and I:1-29.

I:1-47 a.

Of the three individuals, Connie would most likely be audited. Individuals who have unincorporated businesses that produce significant tax losses are likely to get audited by the IRS. b.

Craig is not likely to be audited. c.

Dale is not likely to be audited. However, it is likely that the Form 1099 will be checked against the reported amount and the IRS Center will send Dale a bill for the corrected amount of tax. p. I:1-27.

I:1-48 The statute of limitations will not prevent the IRS from issuing a deficiency assessment for all three years of 2015, 2020, or 2022. Dan's taxes from 2015 can be assessed because the statute of limitations remains open indefinitely if no return is filed.

The $40,000 of unreported gross income from 2020 is taxable. A six-year statute of limitations applies if the taxpayer omits an item of gross income that is in excess of 25% of the reported gross income. In this case reported gross income was $60,000. $40,000 is greater than $15,000 (0.25 x $60,000).

The $600 unsubstantiated business travel deduction is disallowed in 2022 and gross income will be increased in 2022 because an assessment may be made against the taxpayer within three years from the later of the due date or the date the tax return was filed. In this case the omission occurred in 2022. p. I:1-28.

Tax Strategy and Critical Thinking Problem I:1-49 Pedro is in a good position to begin a gifting program to his children. Since he has such a significant portfolio of stocks and bonds, he could make annual gifts of $18,000 of stocks and bonds in 2024 and future years to each of his children. The effect of these gifts is to shift the dividends and interest from Pedro (at his high rate) to the children (at their low rates) as well as removing these assets from Pedro’s estate upon his death. Since the children have no income, the dividends and interest would be taxed to the older two children at the lowest marginal income tax rates.

As will be discussed in Chapter I:2 of this text, the children will be taxed at special rates for much of the income shifted to them per the so-called “kiddie tax.” Thus, the shifting of investment income is not effective for children under the age of 18 (or 24 and in college). Also, Pedro and his wife can actually gift $36,000 ($18,000 x 2) per year for each child and over a few years, a sizeable amount of assets can be transferred to the children. To protect the assets, the gifts can be made to trusts rather than directly to the children to ensure that the children do not Copyright © 2025 Pearson Education, Inc.

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make bad decisions during their youthful years.

There are many other aspects of this type of tax strategy, but this problem is intended to demonstrate both the income and estate tax savings that can be accomplished through the making of annual gifts.

Case Study Problem I:1-50  The apartment buildings constitute a rental activity and are subject to the passive activity rules of Section 469 of the Internal Revenue Code. Since Rick’s adjusted gross income (AGI) is greater than $150,000 before the loss, he would be unable to currently deduct the losses on his personal income tax return. Therefore, the $100,000 of losses in each of the first three years would not be deductible. However, the losses would be considered as suspended passive losses and would be available as a deduction against the rental income in future years.  The blueberry farm, while requiring a substantial cash outlay, would not result in as much a loss as Rick believes. The reason is that most of the cash outlays must be capitalized and, if allowed, depreciated over several years rather than deducted currently. The land would not be depreciated at all. Both the equipment and blueberry plants must be capitalized and depreciated. So, while he may not get as much of a current deduction, he still would be able to claim the deductions in future years when the farm begins generating revenue.  Rick is correct about using appreciated stock as a charitable contribution. If he gave his entire amount of stock to charitable organizations, he would receive a $200,000 charitable deduction in the year of the contribution. He would not be required to recognize any of the appreciation as income on his tax return. See Section 170 of the Internal Revenue Code for details.

Tax Research Problem I:1-51 In CIR v. Court Holding Co. the main issue was whether the petitioner should have been taxed on the gain realized on the sales of all its assets, or whether the sale was made by its stockholders individually after distribution of the assets to them in complete liquidation. The sole asset in the corporation was an apartment house. All of the outstanding stock was owned by a husband and wife. Negotiations took place between the corporation, a sister and brother-in-law, and lessees of the building to sell the property. Just prior to putting the sale in writing, the corporation's attorney advised the husband and wife that this sale would cause a large tax to the corporation. The next day the corporation declared a "liquidating dividend" which deeded the property to the husband and wife, who in turn surrendered all of their stock. A sales contract was then drawn between the husband and wife and the lessees of the building for sale of the property.

The $1,000 that was previously paid to the corporation was given to the husband and wife as a down payment. The property was then conveyed to the lessees.

The Tax Court found that the corporation had not abandoned the sales negotiations. "A sale by one person cannot be transferred for tax purposes into a sale by another by using the latter as a conduit through which to pass title." The Supreme Court upheld the Tax Court's Copyright © 2025 Pearson Education, Inc.

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findings that the sale was actually a sale by the corporation and the necessary taxes were imposed. The Supreme Court held that the incidence of the transaction depends upon the "substance" of the transaction and that the separate steps previously described should be viewed as a whole transaction.

In U.S. v. Cumberland Public Service Co. the issue was essentially the same. Who actually made the sale, the corporation or the shareholders? The Cumberland Public Service Company was in the business of generating and distributing electric power. A local cooperative began to distribute power in the area serviced by Cumberland. The competing company had more efficient means of generating electricity. Cumberland offered to sell all of its stock to the competing company. The company refused the offer but countered with an offer to buy the transmission and distribution equipment of Cumberland. Cumberland refused because under such a deal it would have been subject to a heavy capital gains tax. Shareholders of Cumberland offered to buy the corporate property and then sell the property to the competing corporation.

The Court of Claims found that the shareholders did actually make the sale and that at no time was the corporation ever planning to make such a sale. In addition, the court held that the liquidation and dissolution genuinely ended the corporation's activities and existence. The Supreme Court upheld the Court of Claims findings.

While the Court Holding Co. and Cumberland Public Service Co. cases appear to revolve around very similar facts, the courts have ruled that the steps of such transactions must be explored as well as the end result. The Cumberland Public Service Company was able to show that the liquidation and dissolution genuinely ended the corporation's activities and existence so that the shareholders acted on their own behalf when they executed the previously contemplated sale to the cooperative.

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Chapter I:2 Determination of Tax Discussion Questions I:2-1 a.

Gross income is income from taxable sources. Form 1040 combines the results of computations made on several separate schedules. For example, income from a sole proprietorship is reported on Schedule C, where gross income from the business is reduced by related expenses. Only the net income or loss computed on Schedule C is carried to Schedule 1 (and from there to Form 1040). This is procedurally convenient but means gross income is not shown on Form 1040. b.

Gross income is relevant to certain tax determinations. For example, whether an individual is required to file a tax return is based on his or her gross income. As the amount does not necessarily appear on any tax return, it may be necessary to separately make the computation in order to determine whether a dependent is a qualifying relative. pp. I:2-3, I:2-15, and I:2-35.

I:2-2 The term “income” includes all income from whatever source derived, based on principles of economics and/or accounting. Gross income refers only to income from taxable sources; it does not include tax-exempt income. p. I:2-3.

I:2-3 a.

A deduction is an amount that is subtracted from gross income (or adjusted gross income), while a credit is an amount that is subtracted from the tax itself. b.

In general, a $200 credit is worth more than a $200 deduction because the credit results in a $200 tax savings. The savings from a deduction is less than 100% of $200, depending on the tax bracket that applies to the taxpayer. c.

If a refundable credit exceeds the taxpayer’s tax liability, the taxpayer will receive a refund equal to the excess. In the case of nonrefundable credits, the taxpayer will not receive a refund, but may be entitled to a carryover or carryback. pp. I:2-4 through I:2-6.

I:2-4 A dependent must be a qualifying child or a qualifying relative. ● A qualifying child must: • Be the taxpayer’s (a) child, (b) sibling, or (c) descendent of (a) or (b) • Be under 19, a full-time student under 24, or disabled • Live with the taxpayer for more than half the year, and • Not provide more than half of his or her own support. ● A qualifying relative must: • Be related to the taxpayer (or reside in the taxpayer’s home for the entire year) • Have gross income less than $5,050 (2024), • Receive more than half of his or her support from the taxpayer, and • Not be a qualifying child.

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Additional requirements must be met for a taxpayer to claim a qualifying child or qualifying relative as a dependent: • The qualifying child or qualifying relative meets a citizenship test • The qualifying child or qualifying relative generally cannot file a joint return, and • The taxpayer is not a dependent of someone else. pp. I:2-13 through I:2-17.

I:2-5 a.

Support includes amounts spent for food, clothing, shelter, medical and dental care, education, and the like. Support does not include the value of services rendered by the taxpayer for the dependent nor does it include a scholarship received by a son or daughter of the taxpayer. b.

Yes, it is possible. There are several situations where a taxpayer provides 50% or less of another person’s support and can claim that person as a dependent: • If the other person does not provide more than half of his or her own support, that person is the taxpayer’s qualifying child (if the other tests for a qualifying child are met).

• When several individuals contribute to the support of another, it is possible for members of the group to sign a multiple support agreement that enables one member of the group to claim the supported person as a qualifying relative.

• In the case of divorced couples, the parent with custody for over half of the year may claim their child as a dependent. Similarly, in the case of a written agreement, the noncustodial parent may claim their child as a dependent. c.

The value of an automobile given to an individual may represent support for that individual. The automobile must be given to the individual and must be used exclusively by the individual. pp. I:2-14 through I:2-16.

I:2-6 A taxpayer will use a tax rate schedule instead of a tax table if taxable income exceeds the maximum in the tax table (currently $100,000) or if the taxpayer is using a special tax computation method such as short-year computation. p. I:2-20.

I:2-7 a.

In general, it is an individual’s gross income that determines whether he or she must file a return. The specific dollar amounts are listed in the text. Certain individuals must file even if they have less than the specified gross income amounts: (1) dependent individuals whose unearned income exceeds $1,300 or whose total gross income exceeds the standard deduction, (2) taxpayers who owe the 0.9% Additional Medicare Tax or the 3.8% Net Investment Income Tax, and (3) taxpayers with $400 or more of net self-employment income. b.

Individuals who owe no tax because of deductions or other reasons must still file a return if they have gross income in excess of the filing requirement amounts. p. I:2-35.

I:2-8 Home mortgage interest and real property taxes are itemized deductions. As a result, a homeowner’s itemized deductions often exceed the standard deduction, making it beneficial to itemize. Renters typically do not have these deductions, so the standard deduction often is greater than itemized deductions. p. I:2-12.

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I:2-2

I:2-9 If the support test for a qualifying relative were “50% or more” and two individuals each provided exactly 50% of another person’s support, that person would be a qualifying relative of both individuals (assuming the other requirements for a qualifying relative were met). By specifying that the individual provides “more than 50%” of the person’s support, that person cannot be a qualifying relative of more than one individual. If two individuals each provide exactly 50% of another person’s support, that person would not be a qualifying relative of anyone because no one provided more than half of his or her support, but the two individuals may be able to use a multiple support agreement to allow one of them to claim that other person as a dependent.

In practice, it is unlikely that an individual provides exactly 50% of another person’s support. The distinction between “50% or more” and “more than 50%” is important, however, in other areas of the tax law. For example, consider an individual who owns exactly 50% of a corporation’s stock, and that individual sells all of his or her stock to the person who owns the other 50% of the corporation’s stock. As Chapter C:7 discusses, the deductibility of a corporation’s net operating loss is limited if the corporation’s ownership changes by more than 50 percentage points. In this case, that limitation would not be triggered because the corporation’s ownership changes by exactly 50 percentage points, not more than 50 percentage points. p. I:2-16.

I:2-10 The normal due date for calendar year individuals and C corporations is April 15. The normal due date for calendar year partnerships and S corporations is March 15. If the normal due date is a Saturday, Sunday, or holiday, the due date is delayed to the next day that is not a Saturday, Sunday or holiday. p. I:2-35.

I:2-11 Automatic extensions of six months generally are available. For a C corporation, the extension is six or seven months, depending on the fiscal year-end. Any tax that may be owed must be paid with the application for an extension. pp. I:2-35 and I:2-36.

I:2-12 Yes. In general, the source of income is not important. It is the use that is important. An exception does exist for a child’s scholarship. Parents do not have to consider a child’s scholarship when determining whether they provide over half of the child’s support (or whether the child provided more than half of his or her own support). p. I:2-16.

I:2-13 Scholarships generally do qualify as support, but an exception exists for a scholarship received by the taxpayer’s child. Parents may ignore a child’s scholarship in determining whether they provide over half of the child’s support (or whether the child provided more than half of his or her own support). p. I:2-16.

I:2-14 The purpose of the multiple support agreement is to allow one member of a group to claim a supported person as a qualifying relative when the members together contribute more than 50% of the support of that person and each member of the group contributes over 10% (the group includes only those individuals contributing over 10% of the supported person’s support and who meet the relationship test for a qualifying relative with respect to the supported person).

The multiple support agreement results in an exception to the requirement that the taxpayer alone must provide over one-half of the qualifying relative’s support. pp. I:2-17 and I:2-18.

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I:2-15 In general, the parent with custody for the greater part of the year may claim the children as dependents. The noncustodial parent may claim them as dependents only if required documentation provides for it. p. I:2-19.

I:2-16 In general, a couple must be married on the last day of the tax year in order to file a joint return. In addition, the spouses must have the same tax year. Also, if one spouse is a nonresident alien, then that spouse must agree to include all of his or her gross income on the return. p. I:2-21.

I:2-17 The phrase “maintain a household” means to pay over one-half of the costs of the household. These costs include property taxes, mortgage interest, rent, utility charges, upkeep and repairs, property insurance, and food consumed on the premises. Such costs do not include clothing, education, medical treatment, vacations, life insurance and transportation. p. I:2-24.

I:2-18 A married person, if otherwise qualified, can claim head of household status if he or she is married to a nonresident alien or if he or she qualifies as an abandoned spouse. To be an abandoned spouse, the taxpayer must have lived apart from his or her spouse for the last six months of the year and maintain a household for a qualifying child in which they both live. pp. I:2-24 and I:2-25.

I:2-19 a.

A C corporation is taxed on its income. In other words, it is taxed as a separate entity. An S corporation is normally not taxed on its income. Instead, its shareholders report the S corporation’s income on their own income tax returns. That is, the shareholders (not the corporation) are taxed on the corporation’s income. This flow-through treatment occurs even if the income is not actually distributed. b.

Some corporations are ineligible for making an S corporation election. Others may choose the C corporation because the 21% corporate tax rate is less than the rate for the higher individual tax brackets (e.g., 32%, 35%, and 37%). Other considerations that were not discussed in Chapter I:2 include fringe benefits, the need to retain earnings in the business, and dividend policy. pp. I:2-28 and I:2-29.

I:2-20 The 21% tax rate that applies for C corporations. If an individual with a significant amount of other income operates a new business as a sole proprietorship, that income is taxed at the owner’s marginal tax rate, which may be as high as 37%. Thus, the current tax can be reduced if the corporate form is used and income is retained in the corporation. This advantage will be reduced (and possibly reversed) if the corporation distributes the income. New businesses often need to retain income for expansion. p. I:2-29.

I:2-21 a.

The major categories of property excluded from capital asset status are: • Inventory • Trade receivables, such as accounts receivable • Certain properties created by the efforts of the taxpayer • Depreciable business property and business land • Certain government publications.

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b.

Yes. An individual’s net long-term capital gain generally is taxed at 0%, 15%, or 20%, depending on the taxable income and filing status. These tax rates are less than the rates that otherwise would apply. Short-term capital gains are taxed much like other income. c.

The availability of favorable tax rates for net long-term gains is one implication of capital asset classification. Another is the limitation on the amount of capital loss that can be deducted from other income. At the present time, only $3,000 of net capital loss can be deducted from other income by an individual taxpayer in any year. d.

Individual taxpayers first deduct (or offset) capital losses from capital gains. If a net capital loss results, only $3,000 of the net capital loss can be deducted from other income.

Net capital losses in excess of $3,000 are carried over to future years. pp. I:2-31 and I:2-32.

I:2-22 Yes. By waiting, the taxpayer can convert the short-term capital gain to a long-term capital gain that is potentially taxed at a lower rate. The lower rate will not be available if the taxpayer holds the property for 12 months or less. The taxpayer should, however, take into consideration other nontax factors, such as whether the value of the asset may decline during the extended holding period. pp. I:2-31 and I:2-32.

I:2-23 a.

Shifting income means moving income from one tax return to another. Splitting income means creating additional taxable entities (such as C corporations) so as to spread income between more taxpayers. b.

Different taxpayers are in different tax brackets. Thus, taxes can be saved by shifting income from a taxpayer who is in a high tax bracket to a taxpayer who is in a lower tax bracket. c.

The tax on the unearned income of children (i.e., the kiddie tax) was created to reduce the opportunity to reduce taxes by shifting income from parents who are in high tax brackets to children who have little or no other income and would, therefore, normally be in a low tax bracket. pp. I:2-32 and I:2-33.

I:2-24 a.

Both spouses are liable for additional taxes on a joint return. An exception exists for a so-called innocent spouse. To utilize the innocent spouse provision, the tax must be attributable to erroneous items of the other spouse. In addition, the innocent spouse cannot have known or had reason to know of the error, and must elect relief within two years after the IRS begins collection activities. Further, it must be inequitable to hold the innocent spouse liable for the understatement. b.

In the event of underpayment of taxes on a joint return, the IRS can collect the unpaid tax from either spouse. pp. I:2-33 and I:2-34.

I:2-25 Couples may change from joint returns to separate returns only prior to the due date for the return. Couples may change from separate returns to a joint return within three years of the due date including extensions. p. I:2-34.

Issue Identification Questions I:2-26 Sam must be a qualifying child or a qualifying relative to be claimed as a dependent, each of which have several requirements. Additional requirements also apply for both types of dependents.

Many issues thus need to be considered: Copyright © 2025 Pearson Education, Inc.

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•

Is Sam a citizen, resident, or national of the U.S.? If not, is he a resident of Canada or Mexico?

•

Is Sam married? If so, does he file a joint return with his spouse? If so, do they file the joint return solely to claim a refund of tax withheld?

•

Is Sam’s mother, grandmother, or grandfather a dependent of someone else?

•

Does the way in which Sam is related to his mother, grandmother, or grandfather meet the relationship test for a qualifying child? For the relationship test for a qualifying relative?

•

How old is Sam? Is he considered a full-time student for the year?

•

For what fraction of the year is Sam’s principal place of abode with his mother? grandmother? His grandfather?

•

What is Sam’s gross income for the year?

•

Does Sam provide more than half of his own support for the year? grandmother, or grandfather? Is a multiple support agreement feasible?

His

Does his mother,

Both types of dependents must meet several requirements: •

Citizenship: A dependent must be a citizen, resident, or national of the U.S. (or a resident of Canada or Mexico).

•

Joint return: A dependent cannot file a joint return with his or her spouse (except if doing so is solely to claim a refund of tax withheld).

•

Not a dependent: A taxpayer who is a dependent of someone else cannot claim any dependents.

For example, if Sam’s mother is a dependent of Sam’s grandmother, Sam’s mother cannot claim Sam as a dependent.

The facts do not indicate whether these requirements are met. Additional information is needed to determine if all three of them are met.

To be a qualifying child of another taxpayer, Sam must meet four tests: •

Relationship test: The qualifying child is the taxpayer’s child, sibling, or descendent of these.

Sam is the child of his mother, and he is a descendant of his grandmother’s and grandfather’s child. He meets the relationship test for qualifying child.

•

Age test: The qualifying child is under age 19, a full-time student (for at least five months of the year) under age 24, or permanently and totally disabled. Sam is age 18 at the end of the year, so he is under age 19. Although Sam is a full-time student for at least five months of the year, such status is irrelevant because he is under age 19 (status as a full-time student, however, may be important for determining whether he is a dependent next year). Sam’s disability status is irrelevant because he meets the age test for another reason.

•

Abode test: The qualifying child has the same principal place of abode as the taxpayer for more than one-half of the year. Sam lived with his mother for four months during the year (i.e., not more than one-half of the year), his grandmother for three months, and his grandfather for zero months. Sam does not meet the abode test.

•

Support test: The qualifying child does not provide more than one-half of his or her own support during the year. Sam’s mother (not Sam) provided more than one-half of his support for January 1 to May 1, his grandmother did so from May 1 to August 1, and his grandfather did so Copyright © 2025 Pearson Education, Inc.

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from August 1 to December 31. Sam meets the support test for a qualifying child.

Sam does not meet all four tests to be a qualifying child because he does not meet the abode test. He thus is not a qualifying child.

To be a qualifying relative, Sam must meet four tests: •

Relationship test: The qualifying relative is the taxpayer’s child, child’s descendant, sibling, sibling’s child, parent, parent’s ancestor or sibling, or a specified step-relative or in-law (or the qualifying relative lives with the taxpayer for the entire year). Sam is the child of his mother, and he is a descendant of his grandmother’s and grandfather’s child. He meets the relationship test for a qualifying relative.

•

Gross income test: The qualifying relative’s gross income is less than $5,050 (for 2024). The facts do not indicate what Sam’s gross income is for the year, so additional information is needed to determine if he meets the gross income test.

•

Support test: The taxpayer provides more than one-half of the qualifying relative’s support. If Sam’s monthly support is the same throughout the year, his mother would provide 33.33% of his support (100% x 4/12), his grandmother 15% (60% x 3/12), and his grandfather 29.17% (70% x 5/12). If Sam’s support is not the same each month, it is possible (though unlikely) that his mother, grandmother, or grandfather provides more than one-half of Sam’s support for the year.

Sam’s mother, grandmother, and grandfather collectively provide over one-half of Sam’s support, so a multiple support agreement would allow one of them to claim Sam as a qualifying relative (if Sam meets the other tests for a qualifying relative, such as the gross income test). His mother, grandmother, and grandfather likely each provide more than 10% of Sam’s support for the year, so the two of these three individuals who do not claim Sam as a dependent would have to agree in writing to allow the third one to do so.

•

Not a qualifying child: Sam meets this test (see the discussion above).

Sam may or may not meet all four tests to be a qualifying relative. Additional information is needed to determine whether he meets the gross income and support tests. If he meets the gross income test (and meets the citizenship, joint return, and not a dependent requirements) but no one provided more than one-half of his support for the year, he nonetheless is a qualifying relative of his mother, grandmother, or grandfather if they have a multiple support agreement; Sam is a qualifying relative of the individual that the agreement specifies. pp. I:2-13 through I:2-18.

I:2-27 The primary tax issue is whether they should file a joint return. Filing jointly could produce a tax savings because more income will be taxed at a 10% rather than 12% rate.

Carmen, however, should carefully consider whether Carlos is disclosing all of his income. If not, she may be liable for additional taxes, interest, and penalties resulting from the unreported income. The innocent spouse rules may not protect her. She is not required to know with certainty Carlos’ income in order to be liable. The fact that Carmen is “surprised” that Carlos’ income is so low suggests that she has reason to know that there is unreported income. pp. I:2-33 and I:2-34.

I:2-28 The primary tax issue is the filing status for both Bill and Jane. Both can file as unmarried taxpayers because they were divorced prior to the end of the tax year, assuming neither one has remarried. To file as a head of household, a taxpayer must pay more than onehalf of the costs of maintaining a household (as one’s home) in which a dependent relative lives Copyright © 2025 Pearson Education, Inc.

I:2-7

for more than one-half of the year. In the case of divorce, the child need not be a dependent of the custodial spouse. The facts in this question are similar to W.E. Grace v. CIR, 25 AFTR 2d 70-328, 70-1 USTC ¶ 9149 (5th Cir., 1970) and Levon P. Biolchin v. CIR, 26 AFTR 2d 70-5727, 70-2 USTC ¶ 9674 (7th Cir., 1970) where the courts disregarded the fact that the taxpayer owned the house and denied head of household status. Jane should also fail to qualify for head of household status because she did not pay more than one-half of the costs of maintaining the household. Secondary issues concern the treatment of alimony and child support payments. p. I:2-23.

Problems I:2-29 $350 tax due for the Smiths and $1,384 refund for the Millers, determined as follows: Smiths Millers Wages and salaries $ 50,000 $115,000 Taxable interest income 0 1,000 Gross income $ 50,000 $116,000 Deductions for AGI (IRA contributions) 0 (14,000) Adjusted gross income (AGI) $ 50,000 $102,000 Standard deduction or itemized deductions (greater) (29,200) (33,000) Taxable income $ 20,800 $ 69,000 Gross tax* Tax credits (child tax credit) Net tax Prepayments (withholdings) Tax due (refund)

$ 2,080 0 $ 2,080 (1,730) $ 350

$ 7,816 (4,000) $ 3,816 (5,200) ($ 1,384)

* These amounts are based on the 2024 tax rate schedule because the 2024 tax table was unavailable when this solution was prepared. The amounts using the tax table would be very close to these amounts. pp. I:2-6, I:2-7, and I:2-12.

I:2-30 Wages Dividends Adjusted gross income Standard deduction Taxable income

Part a $10,000 540 $10,540 (14,600) $ 0

Part b $10,000 540 $10,540 (10,450)* $ 90

*$14,600 standard deduction is limited to the greater of $10,450 ($10,000 earned income plus $450) or $1,300. p. I:2-13.

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I:2-8

I:2-31

Adjusted gross income (salaries) Itemized deductions* Taxable income**

Part a Part b Carl Carol Carl & Carol $75,000 $95,000 $170,000 (13,500) (17,100) (30,600) $61,500 $77,900 $139,400

*In part a, Carl cannot claim the standard deduction because his spouse (Carol) claims itemized deductions. Their total itemized deductions are $30,600 ($13,500 + $17,100). Each could have claimed a $14,600 standard deduction ($29,200 total), so their deductions are $1,400 ($30,600 - $29,200) greater by itemizing. In part b, Carl and Carol claim their $30,600 of itemized deductions because it is greater than the $29,200 standard deduction they are allowed. **Note that the sum of their $61,500 and $77,900 taxable incomes if they file separately equals their $139,400 taxable income if they file jointly. p. I:2-13.

I:2-32 The person is not Wes and Tina’s dependent in parts a, b, and d but is their dependent in parts c and e. a.

Brian is not a qualifying child because he fails the age test (he is over age 23).

Brian is not a qualifying relative because he fails the gross income test (his gross income of $8,000 is not less than $5,050 for 2024). b.

No effect. Brian’s student status is irrelevant because he is over age 23. Thus, Brian is not a qualifying child or a qualifying relative. c.

Sherry meets the four requirements to be a qualifying child: (1) she meets the relationship test because she is Wes and Tina’s child, (2) she meets the age test because she is under age 24 and a full-time student, (3) she meets the abode test because her principal place of abode is with her parents for more than half the year; her temporary presence in the dormitory for her college education is treated as time living with her parents, and (4) she does not provide more than half of her own support because her parents provide more than half of it. Sherry’s gross income is relevant for determining if she is her parent’s qualifying relative, but she meets the criteria to be a qualifying child. d.

Sherry is not a qualifying child because she fails the age test (she is not under 24 and a full-time student, and she is not under 19). Sherry is not a qualifying relative because she fails the gross income test (her gross income of $7,500 is not less than $5,050 for 2024).

Although the parents meet the relationship test and support test with respect to Sherry, they must meet all of the tests for her to be their qualifying relative. e.

Granny is not a qualifying child because she fails the age test (she also fails the relationship test for a qualifying child). However, Granny meets all the requirements to be a qualifying relative of Wes and Tina: (1) she meets the relationship test because she is an ancestor of Tina, (2) she meets the gross income test because her gross income is zero (her only income, the Social Security, is wholly tax-exempt), (3) she meets the support test because Wes and Tina provide more than 50% of her support, i.e., 60%, and (4) she is not a qualifying child. pp. I:2-13 through I:2-17.

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I:2-9

I:2-33 a.

Carole and John can claim David and Kristen as dependents this year (David and Kristen are their qualifying children). Jack is not a qualifying child (over age 18 and not a fulltime student) and is not a qualifying relative because his gross income is not less than $5,050.

David meets the requirements to be a qualifying child: (1) he meets the relationship test because he is Carole and John’s child, (2) he meets the age test because he is under age 24 and a full-time student, (3) he meets the abode test because he lives with Carole and John for more than half the year, and (4) he meets the support test because he does not provide more than half of his own support. The fact that David’s $6,400 gross income is not less than $5,050 is irrelevant; it is relevant for determining whether he is a qualifying relative. Kristen also meets the requirements to be a qualifying child. b.

Jack is Carole and John’s qualifying child because he meets the age test (Jack is under age 24 and a full-time student for at least five months this year). Carole and John can claim Jack, David, and Kristen as dependents. Note that Jack will not be Carole and John’s qualifying child next year because he will be age 24, not under age 24 (although Jack may be their qualifying relative next year). c.

As in part a, Jack is not a qualifying child because he fails the age test. However, he meets the requirements to be Carole and David’s qualifying relative: (1) he meets the relationship test because he is their child, (2) he meets the gross income test because his $3,000 gross income is less than $5,050, (3) he meets the support test because John and Carole provide more than half of Jack’s support, and (4) he is not a qualifying child. d.

David would not be a qualifying child because he would fail the age test (he is not under age 24 and a full-time student). David also would not be a qualifying relative because he fails the gross income test (his $6,400 gross income is not less than $5,050). e.

David would not be a qualifying child because he would fail the support test for a qualifying child (he would provide more than half of his own support). David also would not be a qualifying relative because he would fail the support test for a qualifying relative (John and Carole would not provide more than half of David’s support). pp. I:2-13 through I:2-17.

I:2-34 a.

No. Jane is not a qualifying child because she fails the age test (she is not under age 19 and is not a full-time student under age 24). Jane also fails the abode test because she does not live with Robert for more than half the year. Jane is not a qualifying relative because her $20,000 gross income is not less than $5,050. b.

Yes. The children meet the requirements to be Jane’s qualifying children: (1) they meet the relationship test because they are Jane’s children, (2) they meet the age test because they are under age 19, (3) they meet the abode test because they live with Jane for more than half the year, and (4) they each meet the support test because Robert, not themselves, provides more than half of their support. The children are not Robert’s qualifying relatives because they are Jane’s qualifying children. c.

Jane is entitled to the $2,000 child tax credit for each of her two children because they are her qualifying children and are under age 17. Jane does not qualify as a head of household because she does not pay over half of the costs of maintaining her household (Robert does), so her filing status is single. Assuming Jane claims the standard deduction, her taxable income is $5,400 ($20,000 - $14,600) and her tax before credits is $540 ($5,400 x 0.10). The refundability of Jane’s child tax credit is limited to the lesser of $2,625 ((0.15 x ($20,000 $2,500)) or $3,400 ($1,700 x 2), so she can use $540 of the $4,000 ($2,000 x 2) credit to offset Copyright © 2025 Pearson Education, Inc.

I:2-10

her $540 tax before credits and another $2,625 as a refundable credit. Jane will be unable to use the last $835 ($4,000 - $540 - $2,625) of the credit. pp. I:2-13 through I:2-24.

I:2-35 Based on the facts given, Juan cannot claim either Maria or Norma as dependents. He can claim Jose as a dependent only if written documentation exists.

Maria provides $12,000 of her own support, and Juan provides $9,000 ($5,000 + $4,000) of it. Juan thus does not provide more than half of Maria’s support, so the support test for a qualifying relative is failed. The support test for a qualifying child is also failed, as well as the age test for a qualifying child.

Jose generally would be Linda’s qualifying child because she is Jose’s custodial parent. If Linda signs a completed Form 8332, Juan can claim Jose as a dependent.

Norma is not a qualifying child because she fails the age test (she is not under age 24 and a full-time student). Norma also fails the abode test with respect to Juan because she does not live with him for more than half the year (she also fails the abode test with respect to her father).

Norma is not a qualifying relative because her $6,000 gross income is not less than $5,050. pp. I:2-13 through I:2-16 and I:2-19.

I:2-36 a.

Mario and Elaine. To be eligible to claim Anna as a qualifying relative under a multiple support agreement, an individual must: • Provide more than 10% of the supported person’s support. In Anna’s case, Mario, Caroline, and Elaine provide more than $700 (0.10 x $7,000) of Anna’s support.

• Meet all requirements, other than the support requirement, for claiming Anna as a qualifying relative. Anna meets the relationship test for a qualifying relative with respect to Mario, Doug, and Elaine, and she meets the gross income test because her zero gross income is less than $5,050.

Only Mario and Elaine meet both criteria, so only they are eligible to claim Anna as a qualifying relative under a multiple support agreement. b.

Elaine. That is, all other individuals who are eligible to claim Anna as a qualifying relative under a multiple support agreement. c. $14,600. Mario is not married and presumably is not a surviving spouse. Head of household status cannot be based on dependency obtained as the result of a multiple support agreement. Mario is not eligible for an additional standard deduction due to age. Although his dependent mother is age 65 or older, Mario is not. pp. I:2-13 through I:2-18.

I:2-37 a.

Joan, the custodial spouse, claims the children as dependents and claims the child tax credit for them. b.

No. p. I:2-19.

I:2-38 a.

Schedule 3 because of the child care credit Abby and Bert claim. b.

None. Form 1040 reports all of the information Celeste needs to report. c.

None. Donna and Ernie report on Form 1040 the salary, pension benefits, qualified dividends, net capital gain, and federal income taxes withheld (the long-term capital gain carries to Form 1040 from Schedule D, and it may carry to Schedule D from Form 8949).

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I:2-11

They also file Schedule A to claim their itemized deductions. Donna and Ernie can file Form 1040-SR instead of Form 1040 because Ernie is age 65 or older, but they are not required to do so. d.

None. Fiona also files Schedule B to report the taxable interest income and Form 8615 for her kiddie tax. p. I:2-36.

I:2-39 a.

Zero dependents and zero credit. A cousin does not meet the relationship test for a qualifying child and meets the relationship test for a qualifying relative only if the cousin lives with the taxpayer for the entire year. b.

One dependent and $500 credit. Bob’s father is a qualifying relative. The gross income test is met because the father’s gross income of $800 is less than $5,050. The abode test must be met for a qualifying child but not for a qualifying relative. Bob and Ann are allowed a $500 credit for the father because he is their dependent but is not a qualifying child under age 17. c.

One dependent and $500 credit. The daughter is a qualifying child. Although the gross income test must be met for a qualifying relative, it does not have to be met for a qualifying child. Clay is allowed a $500 credit; although the daughter is a qualifying child, she is not under age 17. d.

Zero dependents and zero credit. The multiple support agreement is irrelevant because the mother provided over half of her own support. e.

Two dependents and $2,500 credit. The daughter is a qualifying child; the gross income test need not be met. The son is also a qualifying child. Zoe and Walt are allowed a $2,000 child tax credit for their son because he is a qualifying child under age 17, but they are allowed only a $500 credit for their daughter because she is not under age 17. pp. I:2-13 through I:2-20.

I:2-40 a.

Juan’s AGI exceeds $200,000, but Maria’s AGI does not. The child tax credit thus would be reduced if Juan claims it, but there would be no reduction if Maria claims it. Overall, the tax savings are larger if Maria claims the child tax credit, so it would be better not to have a written agreement allowing Juan to claim the children as dependents. However, Juan may not be willing to pay as much child support if he foregoes any child tax credit. b.

As the custodial parent, Maria is entitled to file as a head of household. This is true even if she does not claim the children as dependents. Juan will file as a single taxpayer. pp. I:2-19 and I:2-20.

I:2-41 a.

b.

Adjusted gross income ($132,000 + $107,000) Minus: Itemized deductions ($25,400 + $13,200) Taxable income

$239,000 ( 38,600) $200,400

Gross tax

$ 34,194

Mary’s tax filing as a single taxpayer: Adjusted gross income Minus: Standard deduction Taxable income

$107,000 ( 14,600) $ 92,400

Gross tax

$ 15,381* Copyright © 2025 Pearson Education, Inc.

I:2-12

Bill’s tax filing as a single taxpayer: Adjusted gross income Minus: Itemized deductions Taxable income

$132,000 (25,400) $106,600

Gross tax

$ 18,627

Their income taxes total $34,008 ($15,381 + $18,627). *This amount is based on the 2024 tax rate schedule because the 2024 tax table was unavailable when the solution was prepared. c.

Their tax will be $186 ($34,194 - $34,008) higher if they marry before year-end.

This is attributable to the fact that their $38,600 of itemized deductions is $1,400 less than the $40,000 ($14,600 + $25,400) of total deductions they would claim if they were not married. The increased taxes due to this is partially offset by the fact that $6,075 ($106,600 - $100,525) of Bill’s taxable income is taxed at 22% if they are married rather than 24% if they are not. pp. I:2-21 and I:2-22.

I:2-42 a.

Amy need not file because her gross income is less than the threshold of $14,600 and her self-employment income is less than $400. b.

Betty need not file, as her gross income ($9,100) is less than $16,550 ($14,600 + $1,950). c.

Chris must file, as his gross income of $4,500 ($3,800 + $700) exceeds his standard deduction of $4,250 ($3,800 + $450). Chris’ standard deduction is limited to the amount of earned income plus $450 (or $1,300, if greater). d.

Dawn must file because her unearned income is over $1,300 and her total gross income exceeds her standard deduction. e.

Doug must file because his gross income is over $5 and he is married and not living with his spouse. p. I:2-35.

I:2-43 a.

Yes. b.

No. The aunt does not live with the taxpayer for more than half the year. c.

No. Cindy qualifies as a surviving spouse, so she does not qualify as a head of household. This is beneficial for Cindy because, as a surviving spouse, she is allowed a larger standard deduction than as a head of household, and the tax rate schedule is also more favorable. d.

Yes. Because Dick qualifies as an abandoned spouse, he can file as a head of household. pp. I:2-23 and I:2-24.

I:2-44 a. 2022: Celia files a joint return even though Wayne died in October.

2023: Celia must file as a single taxpayer. As a part-time student, Wally is not a qualifying child. Celia thus does not qualify as a head of household because she does not maintain a household in which a dependent lives for more than half the year.

2024: Same as 2023.

2025: Same as 2023.

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I:2-13

b.

Single. Juanita does not qualify for head of household status because Josh is not a qualifying child. He is over 18 and is not a full-time student. c.

Gertrude may use the head of household filing status. Even though she is still legally married, she meets the tests for an abandoned spouse. She lived apart from her spouse for the last six months of the taxable year and paid over one-half the cost of maintaining a household for her dependent son. pp. I:2-21 through I:2-24.

Note: A good exercise is to ask the class how the solution for part a would change if Wally were a full-time student rather than part-time. Celia would qualify as a surviving spouse in 2023 and 2024 and a single taxpayer in 2025. Wally would not be Celia’s qualifying child in 2025 because he would no longer be under age 24, and he would not be her qualifying relative because he would fail the gross income test (assuming that test’s threshold for 2025 is less than $9,800).

I:2-45 Jim’s salary Revenues for Pat’s sole proprietorship Gross income Minus: Expenses for Pat’s sole proprietorship IRA contributions (2 x $7,000) Adjusted gross income Minus: Standard deduction Qualified business income deduction Taxable income

$ 92,000 98,000 $190,000 (48,000) (14,000) $128,000 (29,200) (10,000)a $ 88,800 $ 10,192b (2,000) $ 8,192 (6,800) (3,000) $ (1,608)

Gross tax Minus: Child tax credit Net tax Minus: Withholdings Estimated tax payments Additional tax due (refund) a

0.20 x ($98,000 - $48,000). $2,320 + [0.12 x ($88,800 – $23,200)]. This is based on the 2024 tax rate schedule because the 2024 tax table was unavailable when the solution was prepared. pp. I:2-2 through I:2-7 and I:2-19. b

I:2-46 Jan should take the standard deduction. Jan cannot deduct any medical expenses as they are less than 7.5% of AGI. She is left with $5,000 of itemized deductions (mortgage interest of $3,000 and property taxes of $2,000) which are less than the $14,600 standard deduction. p. I:2-12.

I:2-47 Wages Interest Adjusted gross income Standard deduction Taxable income

$ 9,000 10,400 $19,400 (9,450)* $ 9,950

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I:2-14

*Because she is a dependent, Lucy’s $14,600 standard deduction is limited to the greater of $9,450 ($9,000 earned income plus $450) or $1,300.

Lucy is under age 18, so she is subject to the kiddie tax. Her net unearned income is $7,800 ($10,400 - $1,300 - $1,300), and it is taxed at 24% because her parents’ $240,000 taxable income is in the 24% tax bracket. Lucy’s tax is calculated as follows: Tax on net unearned income ($7,800 x 24%) Tax on taxable income exceeding net unearned income (($9,950 - $7,800) x 10%) Total income tax

$1,872 215 $2,087

pp. I:2-25 through I:2-27.

I:2-48

Salaries Allowable capital loss Adjusted gross income Standard deduction Taxable income

$130,000 (3,000) $127,000 (29,200)a $ 97,800

Gross tax Child tax credit and credit for other dependents ((2 x $2,000) + (1 x $500)) Net tax Withholdings Additional tax due (refund)

$11,622b (4,500) $ 7,122 (11,000) $(3,878)

a

John and Georgia claim the standard deduction because it is greater than their itemized deductions of $21,800 ($10,000 + $4,000 + $2,800 + $5,000). None of the medical expenses are deductible because they are less than $9,525 (0.075 x $127,000). b $10,852 + [0.22 x ($97,800 - $94,300)]. This amount is based on the 2024 tax rate schedule because the 2024 tax table was unavailable when this solution was prepared.

I:2-49 The kiddie tax applies to Morgan in parts a, b, d but not in parts c and e. a. The kiddie tax applies to Morgan because she is under age 18 and her $4,000 of unearned income exceeds $2,600. b. The kiddie tax applies to Morgan because she is age 18, her earned income ($0) is less than or equal to one-half of her total support, and her $4,000 of unearned income exceeds $2,600. c. The kiddie tax does not apply to Morgan. As someone who is a full-time student and age 19-23, her earned income is not less than or equal to one-half of her total support. d. The kiddie tax applies to Morgan. She is age 19-23, a full-time student, has earned income that is less than or equal to one-half of her total support, and her $4,000 of unearned income exceeds $2,600.

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I:2-15

e. The kiddie tax does not apply to Morgan. As someone who is age 19-23, she is not a fulltime student. p. I:2-26.

I:2-50 $1,666 for part a, $1,751 for part b, and $960 for part c. Eli is subject to the kiddie tax in all three parts because he is under age 18 and his $9,000 of unearned income exceeds $2,600.

Adjusted gross income Standard deduction a Taxable income

Part a $9,000 (1,300) $7,700

Part b $16,700 (8,150) $ 8,550

Part c $9,000 (1,300) $7,700

Tax on net unearned income b Tax on rest of Eli’s taxable income c Eli’s total tax

$1,536 130 $1,666

$ 1,536 215 $ 1,751

$ 960 -0$ 960

a

As a dependent, Eli’s $14,600 standard deduction is limited to the greater of earned income plus $450 or $1,300. In parts a and c, Eli has no earned income, so his standard deduction is limited to $1,300. In part b, Eli’s earned income is $7,700, so his standard deduction is limited to $8,150. b Eli’s net unearned income is $6,400 ($9,000 - $1,300 - $1,300), which is taxed at his parents’ marginal tax rate. Their taxable income is $350,000, so their marginal tax rate is 24% for ordinary income and 15% for qualified dividends. c The rest of Eli’s taxable income is $1,300 ($7,700 - $6,400) for parts a and c, and $2,150 ($8,550 - $6,400) for part b. These amounts fall entirely within the 10% tax bracket for a single individual, so Eli’s marginal tax rate is 10% for ordinary income and 0% for qualified dividends. The $130 and $215 are based on the 2024 tax rate schedule because the 2024 tax table was unavailable when this solution was prepared. pp. I:2-25 through I:2-28.

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I:2-16

I:2-51 a.

Salaries ($70,000 + $90,000) S corporation income Adjusted gross income Itemized deductions Qualified business income deduction Taxable income Gross tax

$160,000 30,000 $190,000 ( 31,000) ( 6,000)* $153,000 $ 23,766

*0.20 x $30,000. b.

Peach Corporation: Taxable income Gross tax (0.21 x $30,000)

$ 30,000 $ 6,300

Individuals: Salaries ($70,000 + $90,000) Dividend ($30,000 - $6,300) Adjusted gross income Itemized deductions Qualified business income deduction Taxable income Gross tax

$160,000 23,700 $183,700 ( 31,000) -0$152,700 $ 22,041*

Total tax ($6,300 + $22,041)

$ 28,341

*The gross tax is the total of the tax on the dividend income and the tax on the remaining income. The tax on the dividend income of $23,700 is $3,555 (0.15 x $23,700). The tax on the remaining income of $129,000 ($152,700 - $23,700) is $18,486, computed using the rate schedule for married couples filing jointly. c.

The answer to part a is unchanged as the shareholder (Georgia) is taxed on the S corporation’s income regardless of whether it is distributed. In part b, the corporation’s tax is the same, $6,300, but the shareholder is only taxed on the salary of $70,000: Salaries (also adjusted gross income) Itemized deductions Qualified business income deduction Taxable income Gross tax Total tax ($6,300 + $18,486)

$160,000 ( 31,000) -0$129,000 $ 18,486 $ 24,786

The shareholder will be taxed on the corporation’s undistributed income if it is paid out as a dividend in a future year. pp. I:2-28 through I:2-31.

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I:2-17

I:2-52 Before considering any reduction due to her AGI, Lana’s child tax credit is $6,000 (3 x $2,000). For unmarried individuals, the threshold for reducing the credit is $200,000. Lana’s AGI is $204,400, so there are five $50 reductions in her credit (($204,400 - $200,000) / $1,000 = 4.4, which is four $1,000s of AGI exceeding $200,000 plus a fraction thereof). Lana’s child tax credit is $5,750 [$6,000 - ($50 x 5)]. pp. I:2-19 and I:2-20.

I:2-53 a.

b. c.

They will save $1,110 ($3,000 x 0.37). Only $3,000 of loss can be offset against other income. The remaining $12,000 of loss carries over and can offset future income.

The additional tax is $2,000 ($10,000 x 0.20).

They will save $1,110 as in part a. The net loss is $5,000 but as in part a, only $3,000 can be offset against other income. The carryover, however, is only $2,000 ($15,000 - $10,000 - $3,000). They also will not have to pay any tax in the future on the $10,000 gain because they reported the gain in the current year. pp. I:2-31 and I:2-32.

I:2-54

a.

b.

c.

2024

2025

Salary Minus: Itemized or standard deduction Taxable income

$90,000 (14,600) $75,400

$90,000 ( 18,200) $71,800

Gross Tax

$11,641

$10,849

Salary Minus: Itemized or standard deduction Taxable income

$90,000 (14,600) $75,400

$90,000 ( 14,600) $75,400

Gross tax

$11,641

$11,641

Salary Minus: Itemized or standard deduction Taxable income

$90,000 ( 14,600) $75,400

$90,000 (22,200) $67,800

Gross tax

$11,641

$ 9,969

d.

By contributing the $8,000 in 2025, Virginia is able to deduct the entire amount.

If $4,000 is contributed in each year, only the $4,000 contributed in 2025 is deductible. No tax benefit is received in 2024 because Virginia does not itemize deductions that year. If $8,000 is contributed in 2024, then no tax benefit is received. p. I:2-33.

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I:2-18

I:2-55 a. Maria’s adjusted gross income is $48,000.

Salary Capital loss allowable Adjusted gross income

$51,000 ( 3,000) $48,000

b. Maria’s taxable income is $33,400.

Adjusted gross income Standard deduction Taxable income

$48,000 ( 14,600) $33,400

c. Maria’s tax liability is $3,776 [$1,160 + (0.12 x ($33,400 - $11,600))].

I:2-56 a. $780 tax savings. As a dependent, Pam’s standard deduction is limited to the greater of $450 ($0 earned income plus $450) or $1,300. Her standard deduction thus is $1,300, and her taxable income is $12,700 ($14,000 AGI minus $1,300). Pam is under age 18 and her unearned income exceeds $2,600, so the kiddie tax applies to her. Pam’s tax is calculated as follows: Net unearned income = $14,000 - $1,300 - $1,300 = $11,400 Ralph and Tina’s $500,000 taxable income is in the 35% tax bracket, so this net unearned income is taxed at 35%. Pam’s tax is: Tax on net unearned income ($11,400 x 0.35) $3,990 Tax on taxable income exceeding net unearned income (($12,700 - $11,400) x 0.10) 130 Total income tax $4,120 The $130 is based on the 2024 tax rate schedule because the 2024 tax table was unavailable when this solution was prepared. Pam’s tax liabilities in Part b are also based on the 2024 tax rate schedule.

If Ralph and Tina had not transferred the bonds to Pam, they would have received the interest and incurred $4,900 (0.35 x $14,000) of tax on it. By transferring the bonds to Pam, the family saves $780 ($4,900 - $4,120) of tax in the current year. b. $3,220 tax savings. The kiddie tax does not apply because Pam is not under age 24. Pam’s tax on the $14,000 of interest can be determined by calculating her tax with and without the $14,000: With $14,000:

Taxable income = $35,000 + $14,000 - $14,600 = $34,400 Tax = $3,896

Without $14,000:

Taxable income = $35,000 - $14,600 = $20,400 Tax = $2,216

Pam’s tax increases by $1,680 ($3,896 - $2,216) when she receives the interest in addition to her wages. Because her last dollar of taxable income is in the 12% tax bracket with and without the Copyright © 2025 Pearson Education, Inc.

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$14,000, the $1,680 increased tax can also be calculated by multiplying $14,000 by 12%. If Ralph and Tina had not transferred the bonds to Pam, the tax on the $14,000 of interest would have been $4,900 (see part a). By transferring the bonds to Pam, the family saves $3,220 ($4,900 - $1,680) of tax in the current year. This tax savings can also be calculated by multiplying $14,000 by 23% (0.35 – 0.12).

I:2-57 a.

Gail’s 2024 filing status is married filing jointly because she and her husband were married when he died (assuming Gail does not choose to file separately from her deceased husband). Gail qualifies as a surviving spouse for 2025 and 2026 and as a head of household for 2027 and 2028. Gail’s son attains age 17 in 2028, so she can claim a $2,000 child tax credit for him for 2024 through 2027 and a $500 credit for other dependents for him for 2028. Gail’s tax each year is calculated as follows:

Adjusted gross income Greater of standard deduction or itemized deductions Taxable income Gross tax Credit for child or other dependent Net tax

2024 $150,000

2025 $150,000

2026 $150,000

2027 $150,000

2028 $150,000

(29,200)a $120,800

(29,200)a $120,800

(29,200)a $120,800

(24,000)b $126,000

(24,000)b $126,000

$16,682

$16,682

$16,682

$21,589

$21,589

(2,000) $14,682

(2,000) $14,682

(2,000) $14,682

(2,000) $19,589

(500) $21,089

a

Greater of $24,000 itemized deductions or $29,200 standard deduction allowed for a married couple filing jointly and for a surviving spouse. b Greater of $24,000 itemized deductions or $21,900 standard deduction allowed for a head of household. b.

As in part a, Gail’s 2024 filing status is married filing jointly. Gail does not qualify as a surviving spouse or head of household in any of the subsequent years because the son who lives with her is not her dependent. Her filing status those years is single, and she is not allowed any credit for a child or other dependent. Gail’s tax each year is calculated as follows: 2024: Gross tax is $16,682 (see part a). Net tax also is $16,682.

2025: Gail claims itemized deductions because their $24,000 amount exceeds the $14,600 standard deduction she is allowed. Her taxable income is $126,000 ($150,000 $24,000), and her gross tax is $23,283. Her net tax also is $23,283.

2026: $23,283 (see 2025).

2027: $23,283 (see 2025).

2028: $23,283 (see 2025).

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Tax Strategy and Critical Thinking Problems I:2-58 The tax liability under the three alternatives is computed as below: Business income: Income before Jack’s compensation Salary paid to Jack Net Corporate income tax (21%) Jack’s income: Business income Salary Dividends Other income Adjusted gross income Itemized deductions Qualified business income deduction Taxable income Individual income tax Total tax

Proprietorship $190,000 _______ $190,000

S Corporation $190,000 ( 100,000) $ 90,000

$190,000

$ 90,000 100,000

C Corporation $190,000 ( 100,000) $ 90,000 $ 18,900

22,000 $212,000 ( 20,000) ( 38,000)a $154,000

22,000 $212,000 (20,000) (18,000)b $174,000

$100,000 7,500 22,000 $129,500 (20,000) -0$109,500

$ 30,003 $ 30,003

$ 34,803 $ 34,803

$ 18,648 $ 37,548

a

20% x $190,000 = $38,000.

20% x $90,000 = $18,000.

b

The total tax paid when Jack operates the business as a sole proprietorship is less than when he operates it as an S corporation because the qualified business income (QBI) deduction is greater with a sole proprietorship than with an S corporation. This difference occurs because the QBI deduction is allowed for flow-through income but not salary income. Jack could increase his QBI deduction with the S corporation organizational form by decreasing the salary, but the IRS might challenge this reduced amount as being unreasonably low.

In this case, the total tax for the current year is highest with the C corporation organizational form, and the analysis does not consider the potential future individual income tax on the remaining $63,600 ($90,000 - $18,900 - $7,500) of corporate income when the corporation distributes that income. An important reason the tax is higher is that Jack obtains no QBI deduction with the C corporation. This detriment, however, could be mitigated or reversed if the business becomes more profitable. With a C corporation, the additional profits would be taxed at 21% (plus a 15% or 20% tax when distributed to Jack as a dividend, depending on the extent to which it is more profitable). With a sole proprietorship or S corporation, the additional profits could be taxed to Jack in the 24% or a higher tax bracket.

I:2-59 a.

Andrea will save $740 (37% x $2,000) of tax if she makes the contribution. b.

Andrea’s taxes will not change. She does not deduct the contribution if she does not claim itemized deductions. c.

Andrea will save $222 (37% x $600) if she makes the gift. Given the amount of her income, the daughter will owe no tax because the $600 will be offset by a $1,300 standard deduction.

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d.

Andrea will save $222 (37% x $600) of tax, assuming there is no gain or loss on the sale. She however will not be as well off because the tax-exempt interest of $300 is less than the after-tax interest of $378 ($600 - $222) from the taxable bonds.

I:2-60 The tax law does not limit the amount of income Nell and Nick can shift to Toni, but the tax savings the family can realize is limited because of the kiddie tax. Some of Toni’s interest would be offset by her standard deduction and thus be tax-free. The interest exceeding her standard deduction would be taxed, and the portion of this excess that is net unearned income would be taxed to Toni at Nell and Nick’s 35% marginal tax rate. To the extent Toni is taxed on the interest at a rate of less than 35%, the family’s total taxes will be reduced. However, if Nell and Nick transfer too many corporate bonds to Toni, the kiddie tax will cause some of the interest to be taxed at 35%, resulting in no tax savings.

The maximum amount of the corporate bonds Nell and Nick can transfer to Toni so the interest from them is taxed to Toni at less than a 35% rate can be determined algebraically. Let z be the amount of bonds transferred: Interest generated by z bonds = 0.048z (all of this is unearned income) To avoid the kiddie tax, Nell and Nick need to ensure that the transferred bonds do not generate more than $2,600 of interest. This will be the case if: 0.048z ≤ 2,600 z ≤ 54,167 If Nell and Nick transfer $54,167 (or less) of the corporate bonds to Toni, all the interest on those bonds will be taxed to Toni at less than a 35% rate.

The $54,167 is larger than the $18,000 annual exclusion for the gift tax for 2024 (Chapter I:1), although Nell and Nick can each use the $18,000 amount. To avoid gift tax implications, Nell and Nick could transfer the bonds to Toni over two years, limiting the amount transferred each year to double the annual exclusion. Nell and Nick should also consider nontax implications of these transfers. For example, upon reaching the age of majority (e.g., 18 or 21), Toni would be free to sell the bonds and use the proceeds for whatever purposes she desires, regardless of Nell and Nick’s approval or disapproval.

An alternative way of determining the $54,167 is to use an Excel worksheet. Set a cell to an arbitrary value for z (the cell is A1 for this explanation). Another cell (A2 here) contains the formula for Toni’s net unearned income [=(0.048*a1)-2600]. Excel’s Goal Seek feature can then be used, setting cell A2 to zero by changing cell A1.

Tax Form/Return Preparation Problems I:2-61 (See Instructor’s Resource Manual) I:2-62 (See Instructor’s Resource Manual) I:2-63 (See Instructor’s Resource Manual) Copyright © 2025 Pearson Education, Inc.

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Case Study Problems I:2-64 This question has some interesting implications. One problem relates to the sale of the loss property. Bala and Ann can only deduct $3,000 of the capital loss from ordinary income each year. As a result, it would take ten years to use up the loss unless they realize a capital gain against which to offset the loss. Although a $3,000 capital loss offsets income that would otherwise be taxed at 37%, it takes a long time to use up the loss. If Bala and Ann sell both of their parcels, they will realize an $8,000 net capital loss, which they will use in the current and next two years even if they realize no additional gains. Further, the $8,000 net capital loss will offset income that would otherwise be taxed at 37%.

Kim is a dependent of her parents and has no other income, so her taxable income if the land were sold would be $17,700 ($19,000 - $1,300 standard deduction). Because she is under age 18, Kim is subject to the kiddie tax, under which her net unearned income would be $16,400 ($19,000 - $1,300 - $1,300). Her $17,700 taxable income is comprised entirely of long-term capital gain, so $16,400 would be taxed at 20% (Bala and Ann’s tax rate for net capital gain) and the remainder would be tax-free (Kim’s 0% tax rate for net capital gain). Kim’s tax would be $3,280 ($16,400 x 0.20). By waiting to sell her land when she is no longer subject to the kiddie tax, more of the gain may be taxed at 0% or 15%, depending on her income at that time. pp. I:2-13, I:2-25 through I:2-28, and I:2-32.

I:2-65 As Larry and Sue were married at the end of the year, they can file either a joint income tax return or two separate returns. On the surface, there is not much difference between the tax liability on a joint return versus separate returns. The important issue here is the fact that Sue believes that Larry may be under-reporting tip income. If they file a joint return, Sue may be liable for the joint tax liability, including penalties that may result from under-reporting. There is an innocent spouse provision, but one condition for claiming innocent spouse status is that the taxpayer did not know and had no reason to know that there was under-reporting. As Sue is suspicious of her husband, she should file a separate return to protect herself from possible tax liability associated with unreported income. pp. I:2-33 and I:2-34.

Tax Research Problems I:2-66 None of the three individuals qualify as Ed’s qualifying children; they do not live with him and thus fail the abode test. A child meets the relationship test for a qualifying relative (Sec. 152(d)(2)(A)), and a child for this purpose includes a stepchild (Sec. 152(f)(1)(A)(i)). Further, Reg. Sec. 1.152-2(d) states that a relationship “once existing will not terminate by divorce or death of a spouse.”

On the other hand, Ed is not related to the stepdaughter’s husband. Stepson-in-laws are not listed in Sec. 152(d)(2). The Tax Court in Desio Barbetti [9 T.C. 1097 (1947)] held that grandchildren do not include step-grandchildren, and that neither stepchildren nor children-inlaw covers stepchildren-in-law. Current law refers to children and their descendants, which suggests that the step-grandchild meets the relationship test for a qualifying relative (as noted above, a child for this purpose includes a stepchild).

Ed’s stepdaughter and her child meet all the tests for a qualifying relative, so Ed can claim them as dependents (the problem’s facts are such that they meet the gross income and support tests). Ed cannot claim his stepdaughter’s husband as a dependent.

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I:2-67 The baby can be claimed as a dependent even though he or she lived for only a day. In Rev. Rul. 73-156, 1973-1 C.B. 58, the IRS ruled that dependency may be claimed if state or local law treats the child as having been born alive, and this is evidenced by an official document such as a birth or death certificate. If the child had no Social Security number, the IRS instructs taxpayers to enter “Died” in place of the Social Security number on Form 1040.

I:2-68 Although Larry may not meet the technical definition of “blind” when he wears the new contact lens, the fact that he can only wear the lens for brief times means that he cannot depend on having the advantage of improved sight. Therefore, the Tax Court in Emanuel Hollman, 38 T.C. 251 (1963) granted an extra personal exemption for blindness permitted under prior law. It seems likely that the same rule would be available to taxpayers today claiming the additional standard deduction amount available to blind taxpayers under current law.

“What Would You Do In This Situation?” Solution Ch. I:2, p. I:2-25.

A married person has the option of filing a joint return or as a married person filing separately. Whether a person is married depends on the laws of the state of residence. The abandoned spouse rules provide an exception, but the rules only apply if the taxpayer maintains a household for a dependent child. This case does not indicate that Jane has a child.

State laws establish conditions that must be met for a missing person to be declared legally dead. Typically, a missing person cannot be declared legally dead for seven years. During the interim, a guardian can be appointed to handle the affairs of the missing person. This all taken together indicates that Jane is still classified as a married person for tax purposes.

The IRS has ruled that a spouse who is appointed guardian may elect to file a joint return with his or her missing spouse (Rev. Rul. 55-387, 1955-1 CB 131). The joint return would enable Jane to take advantage of the lower rate schedule and utilize a larger standard deduction. Before she could file a joint return, Jane would have to be appointed as Jim’s guardian.

Choosing to file a joint return does have some risks. Jane does not know how much income Jim has or whether he is even alive. Should she file a joint return, the innocent spouse provision probably would protect Jane from tax on any income that Jim may be earning.

One unusual aspect of the situation is that the IRS may know of her husband’s status.

This is because the IRS would have any return that Jim is filing and have information on any income that is being reported under his Social Security number on 1099s and W-2s. The IRS is prohibited from giving out information on taxpayers including where they live. As a result, it is unclear what the IRS would do with the information should Jane file a joint return.

Jane could file for a divorce. If the divorce were granted before year end, Jane would file as a single taxpayer. Also, if Jim is declared legally dead Jane will file as a single taxpayer.

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Chapter I:3 Gross Income: Inclusions Discussion Questions I:3-1 The phrase "income from whatever source derived" appears in both the 16th Amendment to the Constitution and in Sec. 61(a). This overlapping terminology was adopted to assure the constitutionality of the income tax. p. I:3-2.

I:3-2 Economists define income as the amount that an individual could consume during a period and remain as well off at the end of the period as he or she was at the beginning of the period. In accounting, income is measured by a transactions approach. Accountants measure income when it is realized in a completed transaction. pp. I:3-2 and I:3-3.

I:3-3 It is much easier to administer the tax law based on the accounting concept of income instead of the economic concept. Also, wherewithal-to-pay is greater when income is taxed as it is realized. pp. I:3-3 and I:3-4.

I:3-4 The concept of wherewithal-to-pay means that a tax should be imposed when the taxpayer can most easily pay. A taxpayer who owns property that has increased in value does not necessarily have the funds needed to pay any tax. Taxing the gain when it is realized often means that the tax becomes due at the same time the taxpayer collects the sales price. pp. I:3-4 and I:3-5.

I:3-5 A loan repayment is not consistent with the normal meaning given to the word income.

A taxpayer is no better off because a loan is repaid. There has been no economic benefit. As a result the repayment of a loan is not taxable simply because it is not income. p. I:3-3.

I:3-6 Congress taxes prepaid rental income because of concern that taxpayers who spend the money will be unable to pay the tax when it comes due. Taxing such amounts is to tax income when taxpayers have the greatest wherewithal to pay. The problem created for taxpayers is that they are taxed before they incur related expenses. Repairs, insurance, depreciation, interest and other expenses are incurred as the income is earned. Therefore, there is a mismatching of revenue and expense. pp. I:3-4 and I:3-11 through I:3-12.

I:3-7 Such arrangements might cause the IRS to question whether the improvements are being made in lieu of rent. If such was the case then the owner of the property may be required to include the value of the improvements in gross income. pp. I:3-15 and I:3-16.

I:3-8 No. The form of payment (cash, property, or services) is usually unimportant. The important question is whether the taxpayer receives economic benefit. pp. I:3-4 and I:3-5.

I:3-9 In the 1930 case of Lucas v. Earl, the Supreme Court held that earnings from labor are taxed to the person who performs the services rather than the person who receives the income.

In the 1940 case of Helvering v. Horst, the Supreme Court held that income from property is Copyright © 2025 Pearson Education, Inc.

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taxed to the person who owns the property rather than the person who receives the income. One cannot assign income by arranging to have payment made to another person. p. I:3-6.

I:3-10 Under community property law, community income is divided equally between the spouses. The question of who performed services that produce the income is ignored. In one sense this is contrary to Lucas v. Earl. In another sense the services of both spouses contribute to income production. A spouse who works at home frees the other spouse to work outside the home. pp. I:3-6 and I:3-7.

I:3-11 Jane is taxed even if her father is the employer. Jane is taxed even if her wages are paid to one of her parents. If a child under age 18 (and under age 24 in some cases) has unearned income over $2,600, that income is, however, taxed at higher rates (per the kiddie tax rules).

Since Jane has earned income, the $3,000 of wages are not subject to the kiddie tax rules. This is true even though Jane is under age 18. p. I:3-8.

I:3-12 a.

Under the concept of constructive receipt, income is taxed when it becomes available to the taxpayer. The taxpayer cannot defer the tax by refusing to accept payment. b.

Income is not constructively received if (1) the receipt is subject to substantial limitations or restrictions, (2) the payor does not have the funds necessary to make payment, or (3) the amount is unavailable to the taxpayer. pp. I:3-9 and I:3-10.

I:3-13 A territorial system has been adopted, effective 2018. In general, dividends received by U. S. corporations from a 10% or greater foreign subsidiary are eligible for a dividend received deduction. The dividend received deduction is 100% if all of the subsidiary’s accumulated earnings are from foreign sources, effectively exempting the income from the U. S. corporate income tax. The deduction is prorated if a portion of the subsidiary’s earnings are from domestic sources. This recognizes that host countries tax locally earned income. p. I:3-16.

I:3-14 Income is considered to be earned by an accrual basis taxpayer when all the events have occurred which fix the right to receive the income and the amount of income can be determined with reasonable accuracy. p. I:3-11.

I:3-15 a.

Prepaid income is usually taxable when it is received. This is unlike financial accounting where income is reported as it accrues. b.

The concept of wherewithal-to-pay and the desire by the Federal Government to raise tax revenues are the reasons that the tax law does not conform with financial accounting. c.

One problem with this system is that taxpayers must often report income before expenses related to the income are incurred. The result is a mismatching of revenue and expenses. pp. I:3-11 and I:3-12.

I:3-16 The three conditions that must be met by an accrual basis taxpayer who wishes to defer reporting amounts received in connection with the sale of goods are (1) the goods are not on hand, (2) the amount received is less than the cost of the item, and (3) the income is deferred for financial accounting purposes. pp. I:3-11 and I:3-12.

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I:3-17 An accrual basis taxpayer may defer reporting prepaid service income if the services are to be rendered before the end of the tax year following receipt. p. I:3-12.

I:3-18 a.

Interest on U.S. government obligations (issued after February 29, 1942) and foreign government obligations are taxable. A limited exclusion is available for Series EE savings bonds if the bond proceeds are used for educational purposes. Interest on obligations of states, territories, U.S. possessions and their political subdivisions is tax exempt. There are exceptions for federally insured, arbitrage, and private activity bonds. b.

In general, tax exempt bonds pay a lower interest rate than taxable bonds because investors are willing to accept a lower before-tax return on tax exempt investments. c.

No. In general, investors in lower tax brackets are better off investing in taxable bonds because their after tax return is generally higher. pp. I:3-13, I:3-14, and I:3-29.

I:3-19 Qualified dividends received by individuals are taxed at lower rates than other income (0% to 20% instead of 10% to 37%). In addition, eligible corporations can elect to be treated much like partnerships. The income of these so-called “S corporations” is reported by shareholders and is not taxed to the corporations. In addition, corporations receiving dividends from other corporations are eligible to claim a dividend-received deduction that varies between 50% and 100% of the dividends received depending on the percentage of stock owned. pp.

I:3-16 and I:3-17.

I:3-20 Distributions are taxable to shareholders as dividends only to the extent they are made from either current or accumulated earnings and profits. Distributions in excess of earnings and profits are treated as a nontaxable recovery of capital. Distributions in excess of the basis of the stock are treated as capital gain. p. I:3-17.

I:3-21 The Supreme Court concluded that stock dividends are not taxable because they are not income. No income is realized from stock dividends because there is no real change in the taxpayer's interest or the risks faced by the taxpayer. p. I:3-18.

I:3-22 A constructive dividend is a dividend that is given some other label by the parties. For example, a dividend may be called compensation. Such amounts are reclassified as dividends for tax purposes. Thus, the deduction for compensation would be disallowed if a payment were reclassified as a dividend. p. I:3-18.

I:3-23 Prior law applies to divorces and separations executed on or before December 31, 2018.

Alimony payments covered by prior law are deductible for AGI by the payor and are included in the gross income of the recipient. Alimony payments covered by the Tax Cuts and Jobs Act are neither taxable to the recipient nor deductible by the payor. pp. I:3-19 and I:3-20.

I:3-24 a.

Although Sec. 61 lists several different types of taxable income, it also says any item of income not listed is taxable unless it is specifically excluded. Therefore, a taxpayer must be able to identify a specific exclusion in order to avoid being taxed on an item of income. b.

The Supreme Court has held that unrealized amounts are not income, and therefore are not taxable under the sixteenth amendment to the Constitution.

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c.

Yes. It makes no difference whether the taxpayer receives cash or some other form of payment. The important question is whether the taxpayer received economic benefit.

Otherwise, taxpayers could easily avoid taxes by choosing to receive stock or some other form of payment. d.

The basic question is whether the note has a market value. The receipt of a readily marketable note represents realization. pp. I:3-4 through I:3-6.

I:3-25 a.

A taxpayer who recovers an amount deducted in a previous year must report as gross income the recovered amount. The recovered amount need not be included in gross income if the taxpayer received no tax benefit from the previous deduction. There is a tax benefit only if the deduction reduced the tax in the previous year. b.

The reimbursement of a medical expense by insurance would be taxable only if the taxpayer had previously deducted the expense and it resulted in a tax savings. There would have been no tax benefit if either the taxpayer had claimed the standard deduction, or if the floor for the medical deduction exceeded the medical expenses. pp. I:3-26 and I:3-27.

I:3-26 The chapter outlines requirements found in Sec. 451 that, when met, allow taxpayers to defer the recognition of prepayments for goods and services. Further, taxpayers can control the terms of contracts to identify payments as deposits rather than prepaid income. This, of course, assumes that such payments are properly so classified. Moreover, cash basis taxpayers can prepay certain expenses in order to offset prepaid income. p. I:3-28.

I:3-27 No. Such taxpayers do not receive relief under the tax benefit rule. Therefore, if a taxpayer is in a higher tax bracket when the recovery occurs, the taxpayer will pay more tax as a result of the recovery than was saved from the original deduction. p. I:3-27.

I:3-28 The main tax factor is whether the difference in interest rates is offset by the amount of tax that must be paid on the taxable interest income. Thus, George should look at the after-tax cash flow from each investment as the principal tax factor to consider. Other nontax factors, of course, influence the decision. These include the term of the two alternative investments, liquidity, marketability and other quality factors influencing risk. p. I:3-29.

I:3-29 The statement is incorrect. The forgiveness of debt does result in an economic benefit as the debtor is relieved of the obligation to make future payments. pp. I:3-4 and I:3-5.

I:3-30 One point that they should realize is that if they accept the offer for the automobile that a portion of their social security benefits will be taxable because their provisional income would be greater than the base amount of $32,000 (married filing jointly).

Also, there is some question as to the type of income to be reported from the sale of the automobile. Ordinarily, gains on the sale of investment and personal use assets are capital gains.

The fact that the gain is attributable to the work they did themselves could cause the gain to be treated as ordinary. However, if this is the only automobile they have restored, they probably are not considered to be in the automobile restoration business. Should they be in the automobile restoration business, they would also owe self-employment tax.

The automobile probably is not covered by Sec. 1221 which classifies "artistic compositions" and similar property as ordinary assets. Reg. Sec. 1.1221-1(c) defines "similar Copyright © 2025 Pearson Education, Inc.

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property" to include theatrical productions, radio programs, newspaper cartoon strips, and other property eligible for copyright protection. pp. I:3-24 through I:3-26.

Issue Identification Questions I:3-31 The primary issue is whether Andy has constructively received the delayed payment.

Andy apparently earned the salary and was entitled to it. The company had the money to pay him on a timely basis. He agreed to delay payment for what may be a valid business reason.

Nevertheless, he decided to delay payment, and that is likely to be construed as constructive payment.

Although not discussed in the text until Chapter 6, there is an issue as to how much State can deduct for Andy's salary. As Andy is not a related party, Sec. 267 will not delay the deduction for his salary until it is included in his income. This assumes that the salary is reasonable. pp. I:3-9 and I:3-10.

I:3-32 The salary levels raise questions relating to the assignment of income and constructive dividends. The reduction in Lisa's salary and the high level of Jane's salary suggest that there is an effort to remove income from Lisa's return (and estate) and transfer the amounts to Jane without a gift tax. Although students are not expected to be familiar with gift and estate taxes at this point, they should question why the salaries are at the level indicated in the question. In Lucas v. Earl, 8 AFTR 10287, 2 USTC ¶ 496 (USSC, 1930), a husband tried unsuccessfully to assign income from his law practice to his wife. The efforts by Lisa could be compared to the action in Lucas v. Earl. Also the issue of constructive dividends can be raised. The high salary paid to Jane may be viewed as a constructive dividend paid to her. pp. I:3-6 and I:3-18.

I:3-33 The question in this case is when should Larry report the payments as income. The facts indicate that the amounts may qualify as deposits because customers receive refunds and make additional payments when orders are filled. Also, payments are sometimes refunded as Larry is unable to find items that meet customer’s needs. Rev. Rul. 72-519, 1972-2 C. B. 32 explains the difference between deposits and advance payments. In Rev. Rul. 72-519, however, the examples involve situations where the payments are not ordinarily credited toward the price of gasoline, utilities and other items illustrated. As a result, the treatment of payments in this case is not entirely clear. At this level, students should be able to recognize that the issue is when the payments are taxable and question the application of Sec. 451. pp. I:3-8 through I:3-10.

Problems I:3-34 a.

Paid holidays are taxable. b.

The value of the stock, $1,000, is taxable. c.

The issuance of the old computers does appear to be intended as compensation.

Nevertheless, there is a question of what value, if any, they might have. pp. I:3-4 and I:3-5.

I:3-35 Amounts (a) and (b) have been constructively received. Amount (d) and (e) were unavailable to the taxpayer. Amount (c) was not constructively received because there were no funds available. pp. I:3-9 and I:3-10.

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I:3-36 a. and b. Business income is computed below under the accrual and cash methods. Note that there is a significant difference in the amount of income Carmen reports under the two accounting methods.

Sales Purchases Inventory Cost of sales Gross profit Expenses Net income

Accrual $ 600,000 $400,000 50,000

Cash $570,000 $380,000 30,000*

350,000 250,000

350,000 220,000

160,000 $ 90,000

145,000 $ 75,000

*Not deductible because not sold by year-end. The treatment of ending inventory is consistent with Rev. Proc. 2001-10. c.

Paying the $15,000 will not change the net amount of business income Carmen reports if she elects the accrual method. Under the accrual method, the question is whether she incurred the expenses not whether she paid the expenses. However, under the cash method, she would be able to deduct the $15,000 reducing her business income from $75,000 to $60,000.

The amount of income Carmen reports varies from $90,000 to $60,000 depending on the accounting method she chooses and whether she prepays the $15,000. This, in turn, will dramatically impact the amount of tax she will have to pay. Carmen might not, however, have the cash to pay the $15,000. The comparison indicates the importance of the choice of accounting methods. p. I:3-11.

I:3-37 a.

Since the proceeds were used to pay qualified college expenses for their dependent daughter and all the other requirements are met, all $500 of interest is excludable. b.

The exclusion is limited to $300 ($500 interest x $1,200 net tuition and fees / $2,000 principal and interest). c.

The excess modified AGI is $6,000 ($150,700 other income + $500 interest $145,200 threshold). The exclusion is reduced by $60 ($300 otherwise available exclusion x $6,000 excess AGI / $30,000). Therefore, the available exclusion is $240 ($300 - $60). pp. I:3-14 and I:3-15.

I:3-38 a.

If the divorce were covered by prior law (i.e., the divorce was complete prior to December 31, 2018) Fred can deduct the $20,000 payments as alimony. Tammy must include the payments in gross income. b.

If covered by new law, alimony payments are not deductible by the payer nor are they taxable to the recipient. c.

The basis of the residence is $100,000. d.

Representatives of individuals involved in a divorce must make sure that the participants understand the after tax implications of alimony payments.

I:3-39 a.

A substantial portion, perhaps $165,000, would likely be classified as unreasonable and be reclassified as a dividend.

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I:3-6

b.

The rent is identified as being about the same amount as that paid for similar buildings. It should not be a constructive dividend. c.

Although payments to minor children are often examined closely, it is likely that most, if not all, of the salary is deductible. d.

No reason is given to indicate that the corporation is entitled to deduct the alimony payment. Since the compensation paid to Brad already exceeds the normal limitations, it is likely that this amount is a constructive dividend to Brad. Brad would probably be entitled to a deduction for alimony paid if the divorce occurred under prior law. p. I:3-18.

I:3-40 In absence of any alternative explanation, (a), (b), (d), and (e) would likely be classified as constructive dividends. Probably (c) would not be since the sale is at the property's fair market value. p. I:3-18.

I:3-41 Stan would report the first and last month's rent, or $6,000, in 2023. In 2024 Stan would report $14,300 of gross income. This consists of February, March, April, and May rent collected from Clay or $12,000; one-half month's rent withheld from the deposit or $1,500; and the amount withheld for damage or $800. Stan can deduct the cost of repairs. pp. I:3-9 and I:3-15.

I:3-42 In addition to the regular rental income from the apartment and health club Ed must include $2,600 in gross income. This consists of the lease cancellation payment of $1,000, the first month's rent of $800, and the last month's rent of $800. The security deposit is not taxable.

Since there is no reduction in rent, Ed need not include the value of the swimming pool in gross income. pp. I:3-9, I:3-15, and I:3-16.

I:3-43 Susan’s salary of $44,000, her dividends of $600, her share of the partnership’s income of $4,000, and the lottery winnings of $2,000 are all taxable. Susan is not taxed on the partnership distributions as she has already paid tax on the partnership’s income. To tax the partnership distributions would create double taxation. Although not discussed until a later chapter, she can deduct the cost of lottery tickets up to the amount of her winnings if she itemizes.

I:3-44 Holly must report $1,300 of gross income determined as follows: Capital Gain from sale of City of Atlanta Bonds Interest on Series EE Bonds Interest on City of Quebec Bonds Gross income pp. I:3-13 and I:3-14.

I:3-45 a.

The exclusion ratio is 25.74 percent computed as follows: $40,000 = 25.74% 25.9 x $500 x 12

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$ 200 800 300 $1,300

The annual exclusion is then determined by multiplying the annual payments times the exclusion ratio.

0.2574 x 12 x $500 = $1,544.40 b.

The amount of income that Tim reports will change if he outlives his life expectancy of 25.9 years. Thus, he will be taxed on the entire amount he collects after his total exclusion reaches $40,000. pp. I:3-20 through I:3-22.

I:3-46 a.

The simplified method is used because the annuity is related to her employment.

b.

Employee contribution Divided by the number of anticipated payments Monthly exclusion

$13,000 ÷ 260 $ 50

c.

Total pension Exclusion for 12 months Taxable pension

$ 3,600 (600) $ 3,000

pp. I:3-20 through I:3-22.

I:3-47 a.

Dan and Diana will be taxed on $750 of the social security benefits.

Adjusted gross income (excluding social security) Plus: 50% of social security Provisional income

$31,000 2,500 $33,500

The taxable portion is the lesser of $2,500 (0.50 x $5,000 of social security benefits) or $750 [0.50 x ($33,500 of provisional income - $32,000)]. b.

Dan and Diana will be taxed on $4,250 of the social security benefits.

Adjusted gross income (excluding social security) Plus: 50% of social security Provisional income

$46,000 2,500 $48,500

The taxable portion is the lesser of $4,250 (0.85 x $5,000 of social security benefits) or $6,325 [the lesser of $6,000 or 0.50 x $5,000 of social security benefits + 0.85 x ($48,500 of provisional income - $44,000)]. pp. I:3-24 through I:3-26.

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I:3-48 a.

Assuming she sells all of the stock this year and that she collects the dividends before the sale, one half of the social security benefits are taxable.

Pension Social Security (50%) Dividends Gain on the sale of stock Provisional income

$10,000 3,500 1,000 20,000 $34,500

The taxable portion is the lesser of $5,950 (0.85 x $7,000 of social security benefits) or $3,925 [the lesser of $4,500 or 0.50 x $7,000 of social security benefits + 0.85 x ($34,500 of provisional income - $34,000)]. Thus, her AGI of $34,925 is computed as follows: Pension Social security benefits Dividends Gain AGI

$10,000 3,925 1,000 20,000 $34,925

b.

On the other hand, if she only sells half of the stock this year, none of the social security benefits are taxable. That is because the provisional (income computed) below is less than the $25,000 threshold for single social security recipients.

Pension Social security benefits (50%) Dividends Gain Provisional income

$10,000 3,500 1,000 10,000 $24,500

The result is that her AGI (computed below) is $13,925 lower than in part (a) because the capital gain is only $10,000 and none of the social security benefits are taxable. Of course, the other half of the gain will be taxable next year. She, however, has avoided paying tax on any of her social security benefits by selling half of the stock this year and half next year.

Pension Dividends Gain AGI

$10,000 1,000 10,000 $21,000

pp. I:3-24 through I:3-26.

I:3-49 a.

Provisional income is $28,500 which is computed as follows: Salary Plus: 50% of social security (0.50 x $3,000) Provisional income Copyright © 2025 Pearson Education, Inc.

I:3-9

$27,000 1,500 $28,500

The taxable portion of the social security benefits is equal to $1,500, which is equal to the lesser of 1. 50% of social security benefits, $1,500 (50% x $3,000), or 2. 50% of provisional income in excess of $25,000, $1,750 [50% ($28,500 $25,000)]. b.

The answer would not change. Bob’s provisional income would increase to $29,500 if he also had $1,000 of tax exempt interest income as 50% of the excess provisional income is $2,250. Nevertheless, the taxable portion of the Social Security benefits remains at 50% or $1,500.

c.

In this instance, having tax exempt interest income will result in $2,550 of Bob’s Social Security benefits being taxed. Bob’s provisional income increases to $38,500. As his provisional income exceeds $34,000, Bob is subject to an alternative computation. The taxable portion of the social security benefits is equal to $2,550, which is equal to the lesser of 1. 85% of the Social Security benefit, $2,550 (0.85 x $3,000), or 2. 85% of provisional income over $34,000, plus the lesser of (1) $4,500 or (2) 0.50 x Social Security benefits {$5,325 = [0.85 x ($38,500 - $34,000) + 0.50 x $3,000]}.

pp. I:3-24 through I:3-26.

I:3-50

Salary Dividends Pension Rent Social Security Adjusted gross income

$25,000 2,700 2,400 ( 5,000) 1,200 $26,300

The taxable portion of the pension is $2,400 (4 x $1,000 x 0.60). The rental activity results in a net loss of $5,000 which is subtracted in computing adjusted gross income. One-half of the social security benefits of $1,200 (0.50 x $600 x 4) is taxable. The formula amount is $2,150 (see below) but since that is over one-half of the benefit, the formula is not applicable.

Adjusted gross income (excluding social security benefits) Plus: 50% of social security benefits Tax exempt interest Provisional income Minus: Base amount Total Formula amount pp. I:3-24 through I:3-26.

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I:3-10

$25,100 1,200 3,000 $29,300 (25,000) $ 4,300 x 0.50 $ 2,150

I:3-51 a.

None. The amount received is a recovery of capital. b.

None. The repayment of a loan is nontaxable. The fact that the taxpayer had to initiate a lawsuit is irrelevant. c.

Accounting fees are taxable. The fact that she had to sue is not relevant. A cash basis taxpayer would report the fee when it is collected. An accrual basis taxpayer would report the fee when the services are rendered. An accrual basis taxpayer would not have to report the fee a second time when collected unless it had been written off as a bad debt. d.

None of the amounts represent income. There is a possibility that forgiveness of debt could become an issue, but that does not yet appear to be the case. p. I:3-26.

I:3-52 a.

Yes. The payment is taxable as there are no restrictions on Jesse's use of the money. As Jesse is in the 24% tax bracket his additional tax from including the $8,000 in gross income is $1,920 (0.24 x $8,000). b.

Jesse can simply deduct the $8,000, which will reduce his tax by $960 (0.12 x $8,000). Alternatively, he can compute the tax that he would otherwise pay and then reduce that tax by the additional $1,920 tax he paid the previous year when he reported the lump-sum payment. Obviously, the second alternative is preferred. c.

As the amount is less than $3,000, Jesse has only the option of deducting the repayment. pp. I:3-26 and I:3-27.

I:3-53 a.

They would save $148 (0.37 x $400) per year. The daughter would not be subject to tax on any of the interest. ($400 interest - $1,300 standard deduction). b.

They would save $148 of taxes per year, but forego $100 [$400 - (0.06 x $5,000)] of interest. Thus, they would be better off to acquire the tax-exempt bonds. c.

They would save $370 (0.37 x $1,000). This assumes no phase-out of itemized deductions. d.

If the salary is reasonable, the full $10,000 should be deductible as a business expense. Otherwise, the amount deemed unreasonable would be treated as a gift. If other gifts were made during the year it could result in a gift tax. The salary would be taxable to the daughter as income assuming it is not a gift. The parents will save $3,700 in income taxes. pp.

I:3-13 and I:3-29.

I:3-54 a.

Even though an 11 year old is subject to the kiddie tax, there will be no tax liability as long as the son's income is less than $1,300 per year. b.

The son should file a return and elect to report interest annually. If interest is reported annually there will be little if any tax. If all interest is reported when the bonds mature there will be a large income reported in a single year and a significant tax liability. c.

Each gift potentially increases the child's income. If a dependent child's unearned income increases above $1,300, there is a potential tax and the tax on income over $2,600 will be at higher rates as long as the child is under age 18 (24 in some instances). Therefore, it may be desirable to either elect out of the annual reporting of Series EE interest or choose to make gifts of other types of assets. Growth stocks might be desirable as they produce little current income.

Also, dividend income is taxed at lower rates. pp. I:3-13 through I:3-15 and I:3-27 through I:328.

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I:3-11

Comprehensive Problems I:3-55 a.

No. She would be protected by the innocent spouse provision of Sec. 66. b.

Head-of-household (see Chapter I:2). c. $1,500. One half of her husband's earnings prior to the time he left home. d.

No. The amount of income is less than her standard deduction (see Chapter I:2). pp. I:3-17 through I:3-19.

I:3-56 Salary Interest on money market account Interest on loan to brother Fee for jury duty State income tax refund Dividend on Ace stock Dividend on Tray stock Adjusted gross income Minus: Itemized deductions Taxable income

$97,000 200 2,100 50 140 1,000 1,400 $101,890 ( 19,700) $82,190

Gross tax Minus: Credit for dependent Minus: Withholding Net refund due

$ 12,967* ( 500) ( 14,000) $ 1,533

*The dividend income of $2,400 is taxed at 15% ($2,400 x 0.15 = $360). The tax on the remaining income of $79,790 ($82,190 - $2,400) is computed using the rate schedule for single taxpayers and amounts to $12,607. The total tax is $12,967 ($360 + $12,607).

Tax Strategy and Critical Thinking Problems I:3-57 a. If the divorce settlement is reached after 2018, payments would not be deductible by Kamal or taxable to Padma. Tax advisors should inform their clients of the tax implications of divorce settlements so the clients can weigh tax payments when agreeing to a specific arrangement. b. Transferring the stock to Padma means she would become a co-owner in the restaurant.

As a co- owner she would be taxed on her 30% share of restaurant profits and Kamal would be taxed on his salary and on his 70% share of the profits. This would produce a net tax savings if Padma is in a lower tax bracket than Kamal. In some ways, the plan produces a tax result that is similar to alimony under old law. Obviously, there are other issues that would determine whether Kamal and Padma would choose this option. For example, Padma’s future income is tied to future profits of the restaurant. She could choose to sell her interest in the business bringing in an unfamiliar investor. pp. I:3-18 through I:3-20.

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I:3-12

I:3-58 The $1,000 deduction on this year’s return will save taxes of $370 (0.37 x $1,000) compared to $240 (0.24 x $1,000) on next year’s return. Also, making the contribution today (December 31) instead of tomorrow (January 1) enables Jake to benefit from the deduction on this year’s tax return instead of next year’s return. Delaying the contribution one day results in a one year delay in the tax savings from the deduction and a reduction in the benefit of $130.

Tax Form/Return Preparation Problems I:3-59 (See Instructor’s Resource Manual) I:3-60 (See Instructor’s Resource Manual)

Case Study Problems I:3-61 The memo for the file should include the following points: 1.

Child support payments are not included in gross income. As the cash payments were designated as child support by Jim, this characterization is likely to be followed. The transfer of the automobile probably is not taxable as alimony income as the alimony rules require that such payments be made in the form of cash.

2.

It follows that Jim is not entitled to deduct any of the payments. If Linda agrees in writing he could receive a dependency exemption and child credit. The fact, however, that he was unemployed much of the year may mean that he owes little if any tax, and that he would not benefit from additional deductions or credits. pp. I:3-18 and I:3-19.

I:3-62 The following points should be discussed in your memo: 1.

The main advantage of purchasing Series EE bonds in the parents' names is that they may be able to exclude the interest income they eventually receive. They must meet the requirements that the funds be used for educational purposes and meet the income limitation. As the limitation is indexed for inflation and their future income is unknown, the parents cannot be certain whether they will be entitled to the exclusion.

2.

If the bonds are purchased in the names of the children and they are under 24 years of age, the interest may be subject to the "kiddie" tax. Nevertheless, if the annual interest is less than $2,600 per child and the children elect to report it each year there will be little tax even if the children are under age 24 and no tax if the income is under $1,300.

3.

The fact that the parents expect high income means that purchasing the bonds in the names of the children may be more desirable. This is true if either the annual income is under $2,600 per child or the children are over 23 years of age.

4.

The fact that the children may have other income in the future means that the children may face significant future taxes if the bonds are purchased in their names. This is particularly a problem if the children are under age 24 because the parents’ tax rate may apply to all of the interest income. If that is the case the children would probably benefit from waiting to report the interest when the bonds are redeemed. pp. I:3-14, I:3-16, I:3-30, and I:3-31.

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I:3-13

I:3-63 The primary ethical issue relates to how you can adequately advise both clients when their interests may conflict. For example, if they have a child, only one spouse may claim the child as a dependent. It may well be possible to inform both Lee and Jane as to the relevant tax rules. Nevertheless, one may find it difficult to recommend arrangements that both will find satisfactory. For example, Jane may not want you to advise Lee that there is a rule that enables him to claim children as dependents if she has custody of any children. On the other hand, Lee may not want you to tell Jane that receiving low basis assets could increase the tax she will have to pay when she sells those assets. As a result the information you provide and the advice you give may alienate you from one or both persons. Depending on the situation, it may be desirable to recommend that either Lee or Jane seek advice from another professional tax consultant about relevant tax issues.

Tax Research Problem I:3-64 Under Reg. Sec. 1.109-1 the value of improvements to real estate must be included in gross income if the lessee makes the improvements in lieu of rent. In this case, it is given that the taxpayer did forego one month's rent (which amounted to $1,000) and that the improvements cost $4,000. In CIR v. G. H. Cunningham [2 AFTR 2d 5511, 58-2 USTC ¶ 9771 (9th Cir., 1958)], the court concluded that there was no income to the lessor because the improvements did not increase the value of the property. Though the wiring in this instance cost $4,000, its specialized use did not increase the value of the property.

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I:3-14

Chapter I:4 Gross Income: Exclusions Discussion Questions I:4-1 The IRS and the courts must interpret the tax law passed by Congress. The efforts of the IRS and the courts may result in broad definitions of certain exclusions. Such broad definitions may reasonably be termed administrative or judicial exclusions. Administrative exclusions are those that are developed by the Treasury Department and IRS through Regulation, rulings, etc.

Judicial exclusions are the result of court decisions. p. I:4-2.

I:4-2 The tax law specifically excludes gifts from the definition of gross income. It is the position of the IRS that welfare benefits are gifts. Hence, such benefits are not taxable. p. I:4-2.

I:4-3 In Eisner v. Macomber, the issue was whether a stock dividend was taxable. The Supreme Court sought to define income and concluded that realization must occur before income is recognized. pp. I:4-2 and I:4-3.

I:4-4 Most exclusions exist for either reasons of benevolence (social generosity or sympathy) or incentive (the desire to encourage or reward a particular type of behavior). Exclusions for employee death benefits, life insurance benefits, and public assistance exist because of reasons of benevolence, while the foreign earned income exclusion and the exclusions for certain employee benefits are intended to be economic incentives. p. I:4-4.

I:4-5 a.

Income earned prior to the gift is taxable to the donor while income earned after the gift is taxable to the donee. b.

The total tax liability can be reduced if the donee is in a lower income tax bracket than the donor. pp. I:4-4 and I:4-5.

I:4-6 a.

Motive plays an important role. For a transfer to be a gift, it must be made for reasons such as love, affection, kindness, sympathy, generosity, or admiration. b.

Tips are considered to be compensation for services. This is true even though generosity or other motives may be present. pp. I:4-4 and I:4-5.

I:4-7 The face amount of life insurance generally is excluded from the gross income of a beneficiary if the amount is paid upon the death of the insured. If the amount paid exceeds the face of the policy, then the excess is taxable. p. I:4-5.

I:4-8 For an award to be excluded under Sec. 74, it must be made for religious, charitable, scientific, educational, artistic, literary, or civic achievement. The recipient must be selected without action on his or her part, and the recipient may not be required to perform any substantial future services. In addition, the recipient must designate that the payor is to pay the award to either a charity or governmental unit. p. I:4-7.

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I:4-1

I:4-9 The requirement that the recipient must designate that the payor is to pay the award to a charity or governmental unit severely limits the use of Sec. 74. The rule does benefit taxpayers who have such awards that exceed the ceiling limitation on the charitable contributions deduction (e.g., 60% of AGI). Also, the exclusion favors taxpayers who claim the standard deduction as such taxpayers do not deduct charitable contributions. p. I:4-7.

I:4-10 a.

A scholarship is an amount paid or allowed to, or for the benefit of, a degree candidate to aid the individual in pursuing his or her studies. b.

The exclusion is limited to amounts awarded for tuition, books, fees, supplies, and equipment. As a result, if a scholarship either exceeds the total amount of qualifying expenses or, alternatively, the scholarship is specified as being for nonqualifying expenses, the scholarship will be at least partially taxable. c.

It is likely that such a scholarship will be viewed as compensation for future services, and will, therefore, be taxable. The employee may be allowed to deduct the education expenses or claim a credit for them. d.

No. The amounts will normally be taxable compensation. p. I:4-7.

I:4-11 Nondegree candidates may not exclude scholarships from gross income. p. I:4-7.

I:4-12 Section 104 limits the exclusion to personal physical injury. pp. I:4-8 and I:4-9.

I:4-13 a.

Employers may generally deduct the cost of premiums paid on medical, health, disability, and life insurance coverage for employees. b.

Employees need not include in gross income premiums paid by an employer on medical and health and disability policies. Except for a limited exclusion for group term life insurance, an employee must include life insurance premiums paid on his or her behalf in gross income. c.

Medical and health insurance benefits are excluded except when the benefits exceed the actual costs. Disability benefits are taxable unless the premiums were paid by the employee. Life insurance benefits are generally excluded from gross income. pp. I:4-8 through I:4-10.

I:4-14 Employees must include in gross income amounts determined by IRS tables in instances where coverage exceeds $50,000. Key employees are taxed the same as other employees as long as coverage is nondiscriminatory. If coverage is discriminatory, key employees must include in gross income the greater of the actual premiums or the amount determined by reference to IRS tables. pp. I:4-11 and I:4-12.

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I:4-2

I:4-15 a.

The seven major types of fringe benefits covered by Sec. 132 are: 1.

No additional cost benefits, 2.

Qualified employee discounts, 3.

Working condition benefits, 4.

De minimis benefits, 5.

Qualified transportation and parking fringes, and 6.

Athletic facilities.

7.

Educational assistance

b.

If the requirements of Sec. 132 are met, employees are not required to include the value of the benefits in gross income. c.

Working condition, qualified transportation and parking, and de minimis benefits must be offered only to employees. Educational assistance can be offered to employees and former employees. The remaining benefits may be offered to employees, spouses, dependents, and retirees. d.

Discrimination is prohibited relative to most Sec. 132 benefits. Discrimination is permitted relative to working condition benefits, parking and transportation and de minimis benefits other than eating facilities. e.

Employees who receive prohibited discriminatory benefits must include the value of the discriminatory benefits in gross income. The exception is discriminatory right to use recreation and athletic facilities. In the case of such discrimination, the employer loses the right to deduct the related expense. pp. I:4-13 through I:4-15.

I:4-16 For meals to be excluded from an employee’s gross income, they must be furnished on the premises of the employer and for the convenience of the employer. For lodging to be excluded from an employee’s gross income it must meet the same tests as meals and the employee must be required to accept the lodging as a condition of employment. p. I:4-15.

I:4-17 As there is no exclusion for premiums paid on a whole life policy, the officers must include the amount of the premiums in gross income. Because of the discriminatory practices relative to discounts on products, the officers must include the discounts in gross income.

Whether the payment of social club expenses is taxable depends on the use of the club. The officers may exclude payments from gross income to the extent they are business related. The payment of any personal portion of social club expenses is taxable income to the officers. The free parking provided by the employer is not taxable even if it is only provided to the officers.

This is true even if the benefit is provided to the officer on a discriminatory basis. pp. I:4-10 through I:4-14.

I:4-18 Most of the fringe benefits that are tax-favored for employees are not tax-favored for selfemployed individuals. Retirement plans are available to self-employed individuals. Selfemployed individuals may also deduct health insurance premiums. Further, self-employed persons may deduct certain business related expenses, such as travel. Otherwise, self-employed individuals do not benefit from most tax-favored items, such as group term life insurance. pp. I:4-18 through I:4-19.

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I:4-3

I:4-19 For 2018–2025, employees cannot deduct any portion of the cost of meals and entertainment. pp. I:4-15 and I:4-16.

I:4-20 Only to the extent the income distributions exceed qualified education expenses. pp. I:4-7 and I:4-8.

I:4-21 The exclusion is applicable to earnings from personal services rendered in foreign countries. To qualify for the foreign earned income exclusion, a taxpayer must either be a bona fide resident of one or more foreign countries for the entire taxable year or be present in one or more foreign countries for a minimum of 330 days during a period of 12 consecutive months. pp. I:4-19 and I:4-20.

I:4-22 Employees can no longer deduct expenses incurred in producing that income. p. I:4-20.

I:4-23 a.

In general, debt cancellation results in gross income, while gifts, bequests, and renegotiations of purchase price are not taxable. b.

In most cases, the taxpayer must reduce the basis of the property by the amount of the debt reduction. pp. I:4-20 and I:4-21.

I:4-24 a.

The discharge of indebtedness is not taxable if it occurs during bankruptcy, when the taxpayer is insolvent, and in the case of certain student loans. Table I:4-2 also notes a limited exclusion for debt cancellation related to real property used in a business by taxpayers other than C corporations. A temporary limited exclusion for home mortgage forgiveness is now scheduled to expire at the end of 2025, but Congress has consistently chosen to extend the date when the provision nears expiration. b.

A father’s forgiveness of a daughter’s debt may be motivated by reasons such as love and affection. As a result, the forgiveness may be a gift and excluded from gross income. pp. I:4-20 and I:4-21.

I:4-25 Although the financially troubled taxpayer does not have to recognize gross income, tax attributes such as a Net Operating Loss must be reduced. As a result, the taxpayer does not benefit from both an exclusion for the debt forgiveness and the tax attributes. p. I:4-21.

I:4-26 Yes. Partners and proprietors are ineligible for the favorable tax treatment for many fringe benefits such as group term life insurance. Although they can deduct medical insurance premiums and retirement plan contributions paid on their behalf for AGI, the amounts remain subject to self-employment tax. pp. I:4-18 and I:4-19.

I:4-27 Many employees are not interested in certain tax favored benefits. For example, single employees are often not interested in life insurance coverage. As employers must provide benefits on a nondiscriminatory basis, it is difficult to offer benefits only to interested employees and at the same time meet the nondiscrimination requirement. This can lead to employers providing benefits that are of little benefit to certain employees. Under a cafeteria plan, employees may select which benefits they wish to receive. As a result, employees select items that they feel are most beneficial. p. I:4-23.

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I:4-4

I:4-28 a.

High-income employees are more likely to select nontaxable fringe benefits.

Higher income employees tend to be in higher tax brackets, and they must pay a greater additional tax if they select cash instead of exempt fringe benefits. b.

One result of options to receive cash is that some lower-income employee may choose cash over health insurance, leading to more uninsured individuals. The number of uninsured individuals, especially those employed by large companies, has received much attention recently. As the cost of medical insurance increases more employees choose cash over health insurance. p. I:4-23.

Issue Identification Questions I:4-29 The basic question is whether the reduction in rent represents taxable compensation to Luke. The Sec. 119 exclusion states that Luke must be an employee who is required to live in the unit, and that this requirement is for the benefit of Julie. Julie obviously is trying to help Luke with his financial issues. Julie should specify that Luke is required to live in the apartment so that he is available to do repairs as needed. Sec. 119 is only available if Luke is an employee. If he works independently (works without supervision, sets his own hours, provides his own tools, etc.), Luke is an independent contractor and not an employee. If that is the case, he is ineligible for the exclusion. Specifying the terms of their arrangement can help assure that Luke is eligible for the exclusion.

If the exclusion is available, Julie reports the $300 monthly as rental income, while Luke reports no income. If the exclusion is unavailable, Luke is taxed on the $350 monthly discount.

Julie reports $650 of monthly income and deducts $350 monthly.

Other tax issues, such as self-employment taxes, withholding, and payroll taxes, are also contingent on the employee versus independent contractor classification. These topics are introduced in Chapter I:14. p. I:4-15.

I:4-30 The primary issue Mildred faces is determining whether the $25,000 payment represents taxable compensation for her years of service or a gift. If the amount is a gift, Mildred has no income tax liability. If the payment is a gift, Larry and Kay would have to report the payment on gift tax returns. The information provided does not make it clear whether the payment is compensation or a gift. It does, however, indicate that the payment is made in appreciation of years of service, suggesting that the payment is compensation. If the payment represents compensation, Larry and Kay need to consider FICA and other payroll tax requirements. pp. I:4-4 and I:4-5.

I:4-31 The tax issue is whether the arrangement represents discrimination. The discrimination rules are intended to be sure that Sec. 132 benefits are not offered to some employees on a favorable basis. Reg. Sec. 1.132-8(c)(1) specifically indicates that basing discounts on seniority does not constitute making discounts available to employees on the same terms. Therefore, the practice described here is likely to be viewed as discriminatory. A secondary issue (assuming that the arrangement is not discriminatory) is that the exclusion is limited to the employer’s gross profit percentage. Amounts deemed to be not eligible for the exclusion should, nevertheless, be deductible by Troy as a business expense. pp. I:4-13 and I:4-14.

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I:4-32 The primary tax issue is whether some of the reimbursements represent taxable income to Jerry. The meals with prospective employees likely are business related. Meals with fellow employees may or may not be business related depending on the reason for the luncheons. Onehalf of the cost of meals is deductible by Jerry’s employer if employment related matters are discussed. It is important that Jerry document the business purpose of meals. If there is inadequate documentation, reimbursements may be considered taxable compensation to Jerry. pp. I:4-15 and I:4-16.

Problems I:4-33 a.

Self-help income is not taxable. b.

Exchanges of services are taxable. Hence, each taxpayer would have to report $200 of gross income. This does assume that the services are reciprocal. The fact that neighbors do, on occasion, help one another without obligation, would seem to be inapplicable. Where there is an agreement, the exchange would be taxable. c.

Such help would likely be a nontaxable gift. pp. I:4-3 through I:4-5 and I:4-24.

I:4-34 a.

The amount is a taxable prize. The payment is not a gift as donative intent is not present. b.

The payment is taxable compensation. c.

The $500 is a nontaxable gift. The forgiveness was based on the family relationship and was given as a graduation present. pp. I:4-4 and I:4-5.

I:4-35 a.

Anna must include in income $4,000 ($20,000 - $16,000). b.

None of the $50,000 is taxable. c.

Don must report $2,500 ($15,000 - $50,000/4) per year for four years as income. pp. I:4-5 and I:4-6.

I:4-36 a. $5,000 ($20,000 - $6,000 - $9,000). Amy purchased the policy from her brother.

Because she purchased the policy, she is not entitled to the usual life insurance exclusion. b.

No. No income has to be recognized upon the collection of the face of a life insurance policy if the policy was transferred from the original owner as a gift. pp. I:4-5 and I:4-6.

I:4-37 a.

Although Sue has a very serious health problem, she is not terminally ill. As a result, no special exclusion is available for the lump sum payment received. If she accepts the lump sum settlement, she would be required to include in gross income the amount she receives in excess of the premiums she has paid $145,000 ($225,000 - $80,000). b.

Sue does not have to report any gross income from the annuity, as the benefits are less than the cost of her long-term health care. c.

She may exclude the full amount, as the benefits are less than $410 (for 2024) per day. pp. I:4-8 through I:4-10.

I:4-38 a.

Only the interest of $600 is taxable. It is taxable even though Hank left the amount with the insurance company.

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b.

Yes. Hank would be taxed on the dividends in excess of premiums $1,000 ($9,000 - $8,000) along with the interest. Although called dividends, the amounts do not qualify for the lower tax rates available to recipients of corporate dividend distributions. pp. I:4-5 and I:4-6.

I:4-39 a.

The winnings are taxable. b.

The prize is taxable. c.

The award is nontaxable only if Linda designates that the $2,000 is to be paid to a charity or governmental unit. p. I:4-7.

I:4-40 a.

The scholarship is not taxable as long as tuition, books, supplies, equipment, and fees exceed the $1,500, but the salary earned working in the bookstore is taxable. b.

Although one might argue that the full amount awarded was a salary paid for playing football, it seems to be the practice of the IRS to exclude such awards as scholarships. If the student were required to play in order to receive the award, the full amount would be taxable.

Nevertheless, Marty must include in income $4,000 of the scholarship that covers room, board and laundry. c.

Even though all students must work in the hospital to graduate, the salary is taxable. p. I:4-7.

I:4-41 Otto must include his salary of $50,000 and the grant of $2,000. Although not specifically asked, it is noted that the expenses related to the grant are deductible. Because the expenses are reimbursed, the deduction is for AGI. p. I:4-7.

I:4-42 a. b. c. d. e.

I:4-10.

Neither amount is taxable.

The $4,000 is taxable.

The $1,800 is not taxable.

The entire $1,600 is taxable as it is derived from an employer-financed policy.

The $1,700 is taxable as it is derived from Ted’s employer. pp. I:4-8 through

I:4-43 a. $4,100 ($3,600 + $300 + $200). The full amount of premiums paid on Ursula’s behalf is deductible. b.

None of the premiums need be included in Ursula’s gross income. c.

The disability income of $5,000 is taxable. Ursula may possibly qualify for the credit for the elderly and disabled (see Chapter I:14). Because the medical insurance benefit represents a reimbursement for medical expenses, it is not taxable. d.

None of the life insurance benefit is taxable. pp. I:4-5 and I:4-10 through I:4-12.

I:4-44 a. $5,600 ($4,000 + $700 + $600 + $300). Data Corp. can deduct the premiums paid on the group term policy. b.

Neither Bob nor Damitria is required to report any premiums as gross income as the group coverage is less than $50,000. Andy must report $1,188 of gross income which is computed as follows: $.66 per thousand x 12 months x $150,000 of excess coverage/$1,000.

Cindy must report $28.80 computed as follows: $.08 per thousand x 12 months x $30,000 of excess coverage/$1,000. pp. I:4-9 through I:4-12.

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I:4-45 a. b. c.

None of the amount is taxable.

Based on Table I:3-1, Joe’s life expectancy is 20 years.

Face amount of the policy $100,000 Life expectancy ÷ 20 Annual exclusion $ 5,000 d.

Annual benefit $ 12,000 Less: Annual exclusion (5,000) Taxable amount $ 7,000 pp. I:4-5 and I:4-6.

I:4-46 All of the benefits (except the one week vacation) are covered by Sec. 132 and, therefore, are nontaxable. Although the vacation was awarded because of Al’s safety record, it is compensation for services he rendered as an employee. Therefore, the $2,300 value of the vacation is taxable. The award does not qualify as a Sec. 274 award as such awards must be presented in the form of tangible personal property. Also, the amount of the award exceeds the $1,600 limit specified in the law. pp. I:4-13 through I:4-16.

I:4-47 The corporation can deduct all the expenses except entertainment. In the case of the rental units occupied by the managers, Jet Corporation is entitled to deduct the actual expenses associated with the units (repairs, depreciation, taxes, insurance, etc.) rather than the rental values. Probably none of the amounts listed would have to be included in the employee’s gross income. The rental value of the apartments is covered by Sec. 119. The corporation cannot deduct the cost of the entertainment by the president. The supper money is excluded under Sec. 132. The vice president’s expenses are covered by the travel while away from home. The IRS would typically disallow a portion of the vice president’s costs as meals. The portion of the cost that is associated with meals is subject to a 50% disallowance to the Jet Corporation (assuming that the expenses are reimbursed). pp. I:4-13 through I:4-16.

I:4-48 a.

The letter indicates the amount is awarded for past services. In absence of any contradictory information, and assuming the amount is reasonable, it is deductible. b.

The payment would be taxable. There is little indication that the amounts represent gifts. Although there is no legal obligation to pay the additional amount, it is paid in recognition of services provided. p. I:4-16.

I:4-49 a.

None. Federal employees are not eligible for the exclusion. b. $30,000. 30% of the income is eligible for the exclusion as capital is a material income producing factor. c.

None. Ken meets neither the residence nor the time requirement necessary to claim an exclusion. pp. I:4-19 and I:4-20.

I:4-50 a. $126,500. It is not necessary to prorate the exclusion even though Rita was not present in Germany for the entire year. She was present for over 330 days and that is all that is necessary. b.

None of the expenses are deductible. pp. I:4-19 and I:4-20.

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I:4-51 a. b.

No. Debt reduction during bankruptcy does not result in income.

USA must reduce its NOL by $380,000 ($780,000 - $400,000). pp. I:4-20 and I:4-21.

I:4-52 a.

The debt reduction is $250,000 (0.50 x $500,000). As the reduction is not one that takes place in bankruptcy, it is subject to limitations. There is a $120,000 debt reduction associated with insolvency ($500,000 - $380,000). That reduction in debt reduces the net operating loss carryover to $30,000 ($150,000 - $120,000). b.

The balance of the debt reduction is $130,000 ($250,000 - $120,000).

The corporation must recognize $130,000 of income. pp. I:4-20 and I:4-21.

I:4-53 a.

Under Sec. 104, taxpayer will have to include the entire $40,000 award in gross income as there is no indication of physical injury nor are there any medical expenses. b.

Libel has been held to be personal injury. However, as it is not a physical injury, no exclusion is available under Sec. 104. c.

The $10,000 she received from the employer sponsored disability policy is taxable. If her injury was deemed permanent, she may possibly qualify for the disability credit.

As the $15,000 is a reimbursement for medical expenses, she does not have to include the reimbursement in gross income. pp. I:4-8 through I:4-10.

I:4-54 a.

By participation in the plan, Jangyoun would save $2,880 (0.32 x $9,000). b.

Probably not. Although there would still be a tax savings, that is not sufficient reason to spend $9,000 on duplicate medical insurance coverage. One possible reason for carrying the additional coverage would be if the wife’s employer’s insurance plan did not provide adequate benefits. c.

Yes. Participation in the employer plan would result in a tax savings of $832 (0.32 x $2,600). That is greater than the savings from the credit of $480. The scale-down of the benefits from the tax credit are discussed in Chapter I:14. p. I:4-23.

I:4-55 $0 for part a, $8.4 million for part b, yes for part c, and $300,000 for part d. a.

Charlie realizes a gain of $8.4 million ($11,200,000 - $2,800,000). He has held the qualified small business stock for more than five years, so the sale qualifies for the qualified small business stock exclusion. His exclusion is limited to $28 million (greater of $10 million or ten times his $2.8 million basis), so he excludes all $8.4 million of the realized gain. Charlie thus includes none of the gain in his 2024 gross income. b.

Charlie has not held the stock for more than five years, so its sale does not qualify for the exclusion. He thus includes all $8.4 million of the realized gain in his 2024 gross income. c.

Charlie has held the qualified small business stock for more than six months, so he excludes all of the gain if he acquires at least $11.2 million of replacement stock within 60 days of the sale of the Venice stock. d.

Charlie realizes a gain of $10.3 million ($11,200,000 - $900,000). His exclusion is limited to $10 million (greater of $10 million or ten times his $900,000 basis), so he excludes $10 million of the gain. Charlie thus includes $300,000 ($10,300,000 - $10,000,000) of gain in his 2024 gross income. p. I:4-22.

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Comprehensive Problem I:4-56

Salary $32,000 Alimony 18,000 Dividends 4,600 Adjusted gross income $54,600 Minus: Standard deduction ( 21,900) Taxable income $32,700 The alimony is taxable, as the divorce was finalized before 2019. All of the fringe benefits are excludable along with the interest on the State of California bonds. The dividends are taxed at a lower rate applicable to dividends.

Tax Strategy and Critical Thinking Problems I:4-57 Many employers require employees to pay part or all of the cost of health insurance coverage, especially family coverage. Sally may wish to consider establishing a cafeteria plan, which permits employees to elect family coverage in exchange for reduced compensation. Under such a plan, Sally could elect to reduce her salary in exchange for family coverage under the company policy. Sally’s personal income tax would be reduced because her family coverage would be provided out of pre-tax dollars. Sally’s employee who is seeking family coverage would have the opportunity to receive the benefit but would have to accept reduced compensation. Certainly, the employee seeking family coverage would prefer that the company pay the full cost, but Sally could point out that the company is paying more for employee coverage because of the increased premiums and that she plans to participate in the family coverage arrangement herself. She could also point out the income tax and FICA savings that will accrue to the employee who participates. The tax benefits associated with the arrangement do not eliminate the entire financial burden of health insurance coverage but do reduce the outof-pocket cost. The plan also results in a FICA tax benefit to the company because amounts paid for health insurance premiums are not subject to employer portions of that tax.

I:4-58 She will net $408 [$600 – (0.32 x $600)] after the federal income tax from working overtime, and her take home pay will be further reduced by FICA, state, and other taxes. Her after tax earnings would be less than the cost of paying the professional painter $500. This suggests she should turn down the overtime and do the painting herself.

There are a variety of factors that she should consider beyond taxes. For example, would turning down the overtime jeopardize her employment? What is her personal preference regarding working overtime versus doing the painting herself? Also, could she choose to work overtime and do the painting herself later on? Tax considerations may affect the financial aspects of a decision, but there are also important non-tax considerations as well.

I:4-59 This decision would be based in part on whether the higher compensation offered by Glenmark is sufficient to offset lower fringe benefits.

Glenmark’s salary offer is $7,000 more than Mahindra’s. However, she would pay $1,540 ($7,000 × 0.22) of federal income taxes on that $7,000, as well as $536 ($7,000 × 0.0765) of FICA taxes. The after-tax additional salary thus is $4,924 ($7,000 - $1,540 - $536). If Ellen Copyright © 2025 Pearson Education, Inc.

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resides in a state with an individual income tax, this amount would be further reduced. The advantage of Glenmark’s higher salary offer is further reduced by the $2,430 ($8,100 x 0.30) Ellen must pay for health insurance. If Glenmark offers a wage reduction option, the net of tax cost of Ellen’s health insurance coverage is $1,710 (($2,430 x (1 - 0.22 – 0.0765)) because she will not have to pay tax on the $2,430 she contributes toward her health insurance premiums.

Considering salary and health insurance differences, the Glenmark offer is $3,214 ($4,924 $1,710) higher than Mahindra’s in the first year. The difference is $2,494 ($4,924 - $2,430) if Glenmark does not have a wage reduction option.

The amount of Glenmark’s educational assistance offer is $4,500 less than Mahindra’s. Does this mean the offer from Glenmark is less attractive than the offer from Mahindra? Education assistance is a one-time benefit, not an annual benefit. Glenmark’s higher first year salary may well translate into higher future wages, suggesting the Glenmark offer is financially more lucrative. It is also noted that an individual working full-time in public accounting may take several years to complete a graduate degree. So, Ellen will likely receive only part of the $4,500 of additional assistance her first year of employment.

The final decision as to which position is preferable should be made in light of other factors, including the potential for advancement, the relative stability of the two firms, and personality fit.

(The $5,250 statutory annual limitation for educational assistance may be irrelevant to Ellen’s decision if her annual tuition costs are a fraction of the $9,500 (e.g., she pays the $9,500 over several years because she is a part-time student). Further, a degree completed in one academic year would straddle two calendar years, doubling the limitation. Students familiar with the American Opportunity and Lifetime Learning credits may suggest that these credits are relevant to Ellen’s decision. Ellen’s salary income is below the phase-out for the Lifetime Learning Credit, so she is likely eligible for the credit if she doesn’t have other significant sources of income. Ellen probably used up her four years of American Opportunity credit eligibility as an undergraduate. The discussion of education credits is found in Chapter I:14. A credit would reduce the after-tax cost of Ellen’s out-of-pocket education expenses.)

Tax Form/Return Preparation Problems I:4-60 (See Instructor’s Resource Manual) I:4-61 (See Instructor’s Resource Manual)

Case Study Problems I:4-62 The following points should be made in the client memo: 1.

The economics from the receipt of a nontaxable fringe benefit compared with the receipt of an equivalent amount of taxable compensation should be stressed. For example, an employee who is unable to deduct medical expenses because he or she does not claim itemized Copyright © 2025 Pearson Education, Inc.

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deductions (or, if itemizing, does not have medical expenses exceeding 7.5% of AGI) would be economically better off if his employer paid his medical and health insurance premiums instead of receiving the same amount as a salary increase.

2.

As a minimum, the company should consider providing medical and health insurance and group-term life insurance coverage up to $50,000 per employee because the premium payments are deductible by the employer and are not taxable to employees. The health insurance plan could help the company avoid penalties imposed by the Affordable Care Act. 3.

Free parking might be provided on a discriminatory basis to executives or to all employees if the vacant building can be easily converted. This fringe benefit is nontaxable.

4.

Employee discounts on automotive parts can be provided (limited to the employer’s gross profit percent) on a tax-free basis.

5.

The company should consider establishing a dependent care assistance program because it can then provide an exclusion up to $5,000 of dependent care assistance for each employee, provided that the benefits are offered under a plan that does not discriminate in favor of highly compensated employees. It should be noted, however, that the employee’s child care credit may be reduced to the extent that dependent care assistance payments are received.

6.

Explain that the benefit program should be integrated with the process of determining annual salary adjustments. Otherwise, a significant program may be prohibitive in terms of its cost to the company.

I:4-63 The corporation is obligated to both report the value of the vacations on the W-2s and withhold. The withholding would, of course, have to be from the other compensation paid to the recipients. Failure to withhold can subject both the corporation and the responsible party, in this case the president, to major penalties. Assuming the behavior is not deemed criminal, which could result in imprisonment, the president will be held liable for the 100% penalty under Sec. 6672. That is, the president would be personally liable for a penalty equal to the taxes not withheld. In addition, the corporation could be penalized for filing an incorrect W-2 (Sec. 6721), furnishing the employee with an incorrect W-2 (Sec. 6674), and failure to collect and remit taxes (Sec. 6672).

Tax Research Problems I:4-64 Under Sec. 117(b), Ann may exclude only $500 of her $2,000 scholarship as the only qualified expenses she incurs is $500 for books and supplies. The compensation of $14,000 is also taxable as it represents compensation for services. Sec. 117(c) specifically states no exclusion is available for amounts that represent payment for teaching. Although the tuition waiver is compensation for services, Sec. 117(d)(2) states that “qualified tuition reductions” may be excluded from gross income even if the reductions represent compensation for services rendered to the educational institution. Sec. 117(d)(5) states specifically that the exclusion is available to graduate students who receive tuition reductions for teaching. Prop. Reg. Sec. 1.117-6(d)(5) includes examples describing compensation and tuition reductions awarded teaching and research assistants. The examples indicate that the compensation is taxable, but that the tuition waiver is nontaxable as long as the compensation is comparable to that paid to others who are not receiving the scholarship.

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I:4-65 In both Boston Fish Market Corp., 57 T.C. 884 (1972) and Sirbo Holdings, Inc., 61 T.C. 723 (1974) on rem’d from 31 AFTR2d 73-1005, 73-1 USTC ¶9312 (2nd Cir., 1973), the courts held that the payments had to be included in the gross income of the property owner. According to the courts, cash payments are not covered by the Sec. 109 exclusion for improvements by lessees.

I:4-66 Sec. 123 contains an exclusion for insurance reimbursements of additional living expenses incurred because a taxpayer is denied access to his or her residence. As a result, the Taylors are entitled to exclude all but $300 of the reimbursement they receive. The $300 represents the amount they would normally pay for meals. As a result, this is not an additional cost.

I:4-67 Each of the authorities cited in the problem addresses the tax treatment of gifts of tangible personal property to employees.

Sec. 74 excludes from employee gross income achievement awards, but only if the awards are presented in the form of tangible personal property. Reg. Sec. 1.132-6(e)(1) provides for the exclusion of small holiday gifts of property, but specifically states that the exclusion does not apply to cash payments.

Rev. Rul. 59-58 states that Sec. 132 excludes from gross income the value of holiday gifts of turkeys, hams, and similar items of merchandise of nominal value. The ruling specifically states that the exclusion does not apply to gifts of cash. The Hallmark Cards case, cited in the problem, did permit the exclusion of gift certificates, but the certificates were redeemable only in company merchandise. The certificates could not be converted into cash.

Sec. 274(b) states that no business deduction is permitted for gifts of merchandise with a value in excess of $25. Obviously, the payments do not exceed the $25 limitation. Because the payments are made in cash, Sec. 274 (b) would not apply even if the amounts exceeded $25. As a result, the amounts are deductible employee compensation, not gifts.

“What Would You Do In This Situation?” Solution Ch. I:4, p. I:4-17.

Ordinarily, expenses incurred by a company when testing its products are deductible.

Further, Sec. 132 and Reg. Sec. 1.132-5(n) exclude from an employee’s gross income the value of consumer goods that are provided to the employee for product testing outside the workplace.

Here, however, there seems to be a real question as to whether the boat is being provided for product testing and demonstration. The regulations note that the product cannot be made available longer than necessary to test and evaluate its performance, and they require that the employee submit detailed reports on the testing. Further, there is no indication that there is any real use of the product as a demonstrator.

If the use of testing and demonstration cannot be supported, the value of the boat’s use may constitute compensation income to the president. As compensation, the costs associated with the boat are deductible by the company, assuming that the total compensation paid to the Copyright © 2025 Pearson Education, Inc.

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president is reasonable. Alternatively, if the president is a major shareholder the value of the boat’s use may constitute a constructive dividend. A constructive dividend would not be deductible by the company.

The president should be asked to document the use of the boat as a demonstrator and provide written reports detailing test results. Most likely, some portion of the use may qualify as testing and demonstration that may be excluded from the president’s gross income. That, of course, would depend on the reported use. Any balance would be taxable.

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Chapter I:5 Property Transactions: Capital Gains and Losses Discussion Questions I:5-1 It may be difficult to determine the fair market value (FMV) of the used building received by the investor. The problem is likely to be resolved by using the FMV of the property given (the publicly-traded stock) to measure the amount realized. p. I:5-3.

I:5-2 Cost of the house Cost of the room added to the house Cost of built-in bookshelves Basis for the house p. I:5-4.

$150,000 20,000 1,200 $171,200

I:5-3 Yes, sales tax paid or accrued in connection with the acquisition of property is included as part of the property's cost. p. I:5-5.

I:5-4 Amount realized Minus: basis (50 shares x $90)* LTCG *FIFO method is used. p. I:5-6.

$8,000 (4,500) $3,500

I:5-5 a.

David's holding period starts on October 22 of the current year (the day after the date of the gift) if David uses the FMV at the date of the gift to determine his basis. b.

His holding period starts on January 21, 1995 if he uses his grandfather's basis. pp. I:5-28 and I:5-29.

I:5-6 a.

The value of the taxable estate would be $400,000 less, and the estate tax is reduced by electing to use the alternate valuation date. b.

Jim's basis for the property would be $400,000 higher, and he might have a smaller gain or larger loss for income taxes when he sells or exchanges the land. c.

The potential savings in estate tax is $160,000 (40% x $400,000). If the property is subsequently sold at a gain, the tax savings will be $60,000* (15% x $400,000); thus the alternate valuation date should be elected. The holding period for an inherited asset is long-term, so the gain is LTCG eligible for a preferential rate (here 15% because Jim’s marginal tax rate is 24% which means his taxable income is associated with a 15% preferential rate). Another factor to consider is whether Jim plans to sell the property in the near future since the income tax savings would not occur until Jim sells or exchanges the property, while the estate tax savings are realized currently. *The income tax savings may be more than $60,000 because the $400,000 gain may cause the tax rate on ANCG to be increased to 20%. Also, the 3.8% Medicare tax on net investment income must be considered, so the savings due to having a higher basis could be as much as $95,500 (23.8% x $400,000), but still less than $160,000. p. I:5-8.

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I:5-7 $150 ($82,500/550 shares). pp. I:5-10 and I:5-11.

I:5-8 Basis of stock owned before stock dividend



Total number of shares owned after stock dividend

=

Basis for each share owned after dividend

$38,880 divided by x = $18 x = 2,160 shares Total number of shares after stock dividend Total number of shares before stock dividend Increase in shares due to stock dividend Percentage dividend distributed (160 divided by 2,000) = pp. I:5-10 and I:5-11.

2,160 2,000 160 8%

I:5-9 The interest must be capitalized. p. I:5-5.

I:5-10 For Andy, the refrigerator is inventory and not a capital asset. Roger's refrigerator is a capital asset since it is not included in the list of properties that are not capital assets. pp. I:5-12 and I:5-13.

I:5-11 The purchase and sale of future contracts was an integral part of the company's business. p. I:5-13.

I:5-12 The dealer must clearly identify that the security is held for investment. This act of identification must occur before the close of the day on which the security is acquired and the security must not be held primarily for sale to customers in the ordinary course of the dealer's trade or business at any time after the day of purchase. p. I:5-14.

I:5-13 a.

The gain is LTCG since the requirements of Sec. 1237 are satisfied. b.

The cost of the 30 acres would be allocated among the lots on the basis of their relative FMVs. p. I:5-15.

I:5-14 The NSTCL is first offset against LTCG that is taxed at 28%, the highest rate for LTCG, then against LTCG taxed at 25%, and finally against the LTCG that is ANCG taxed at 15% (or 20%). The NSTCL is used first to reduce gains taxed at the higher rates. p. I:5-19.

I:5-15 The debt is a nonbusiness bad debt. The loss is treated as a STCL. p. I:5-15.

I:5-16 The motive for purchasing the stock is not relevant in determining whether or not the stock is a capital asset. The stock is not within one of the classes of property excluded from capital-asset status. p. I:5-14.

I:5-17 Agree; Because half of the gain is excluded and the remaining half is taxed at a maximum rate of 28%, the effective tax rate is normally 14%. A taxpayer whose tax rate is less than 28% Copyright © 2025 Pearson Education, Inc.

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might have a lower effective tax rate. Furthermore, the effective tax rate could be zero if the Sec. 1202 stock was purchased after September 27, 2010. p. I:5-17.

I:5-18 Nancy held the bonds of the East Corporation as an investment. For Minor Corporation, the securities of the East Corporation are securities of an affiliated corporation. Thus, Minor's loss due to the worthless securities is an ordinary loss. p. I:5-22.

I:5-19 There is no original issue discount since the discount of $20,000 is less than $25,000 (.0025 x $500,000 x 20). p. I:5-22.

I:5-20 Juanita purchased a market discount bond (i.e., her purchase price was less than the maturity value) and the accrued market discount must be recognized as ordinary income when she has a disposition of the bond unless the de minimus rule applies (i.e., market discount is zero if the discount is less than 1/4 of 1% of the stated redemption price of the bond at maturity multiplied by the number of years to maturity). If the bonds are sold after two years, up to 2/11 of the market discount may be treated as ordinary income if the realized gain is equal to or greater than this amount. pp. I:5-23 and I:5-24.

I:5-21 She should transfer all substantial rights to the patent. p. I:5-26.

I:5-22 The transferor of a franchise may not treat the transfer as a sale or an exchange of a capital asset if the transferor retains any significant power, right or continuing interest with respect to the subject matter of the franchise. pp. I:5-26 and I:5-27.

I:5-23 The lessor treats the payments as ordinary income. p. I:5-27.

I:5-24 April 1, 2025. p. I:5-28.

I:5-25 The gain on the sale of A is a LTCG of $12,000; the loss on the sale of B is a STCL of $3,000; and the gain on the sale of C is a LTCG of $7,400. Phil's NLTCG is $19,400 and his NSTCL is $3,000. The net capital gain is $16,400 ($19,400 - $3,000). Because there is no collectibles gain, Sec. 1202 gain or unrecaptured Sec. 1250 gain, the NCG is ANCG. p. I:5-28.

I:5-26 If the individual taxpayer does not have capital gains, only $3,000 of capital losses may be deducted annually. It may take many years before an investor with a large capital loss is allowed to deduct all of the losses. Possibly, a taxpayer could die with unused capital losses.

The unfavorable treatment of capital losses may cause the investor to be less willing to take the risks associated with purchasing stock of a high-risk, start-up company. The instructor may want to refer to Sec. 1244 which is mentioned in Chapter I:5 and discussed in Chapter I:9. p. I:5-18.

I:5-27 The taxpayer may not care if the loss is an ordinary loss or a STCL if the taxpayer has STCGs or has NLTCG that is 28% - rate gain but his marginal tax rate is 28% or less. The STCL could be used to offset STCG or NLTCG. p. I:5-18.

I:5-28 The amount realized is increased by the amount of the liability assumed by Fred. Fred's basis is increased by the amount of the assumed liability. p. I:5-3.

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I:5-3

Issue Identification Questions I:5-29 a.

Do the Pickens have gross income?

b.

If the Pickens do have gross income should the gross income be reported in Y1 with an amended return or in Y8? c. expired? d.

If the income should have been reported in Y1, has the statute of limitations

If the Pickens have gross income, does it qualify as capital gain income?

Based on Cesarini v. U.S [428 F.2d 812 (CA-6, 1970)], a case with very similar facts, the Pickens do have gross income in Y8 based on Sec 61 and Revenue Ruling 61 [1953-1 C.B. 17] which states that “The finder of treasure trove is in receipt of taxable income ... for the taxable year in which it is reduced to undisputed possession.”

Yes, the statute of limitations would have expired.

The income is not capital gain because there was no sale or exchange.

I:5-30 1. Are the breeding beavers capital assets for Lisa and John? No, they are depreciable property used in a trade or business.

2. What is the basis of the beavers? The contract is unusual in that the taxpayers may pay the debt with beavers instead of cash. There may be an issue of whether or not the $30,000 paid for the beavers is an inflated cost, which could be used to increase depreciation deductions.

Is this an arm's length transaction? If the cash price for a pair of breeding beavers is significantly less than $30,000, the basis should not be $30,000.

In Bryant v. Comm [86-1 USTC 9456 (9th Cir., 1986)] beavers were sold under similar contracts as above to investors for $1,750 when others could purchase beavers for $250. There were tax related reasons for inflating the cost, and the court reduced the basis to FMV. 3. When John and Lisa pay the debt with the beavers, will a gain or loss be recognized?

Yes, the gain or loss is ordinary. The payment of the debt by delivering the beavers is equal to a sale of the beavers. The sales price is the amount of the debt, which is satisfied. Gain or loss is measured by the difference between the sales price and the adjusted basis (cost). pp. I:5-12 and I:5-13.

I:5-31 The primary tax issue is whether the gain or loss on the sale of the farm is capital or ordinary. To determine the amount of gain or loss, the basis rules for inherited property need to be addressed. If the gain or loss is capital, the holding period rules for inherited property need to be applied. The basis of the property is $500,000 and the $20,000 gain should be LTCG because Mike is holding the property for investment (assuming that he keeps the inherited property separate from his real estate business). pp. I:5-8, I:5-9, I:5-12, and I:5-29.

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I:5-4

I:5-32 The primary tax issue is whether the $175,000 gain on the sale of the house is capital or ordinary. A secondary issue is whether the gain (if capital) is LTCG or STCG. It appears that the gain is capital because Sylvia is not in the business of home construction. Since she started construction of the house more than one year ago, she may be deemed to have a split holding period whereby the portion of the gain attributable to construction on or before July 29, 2023, would be LTCG (portion of house constructed more than one year before the date of sale). pp. I:5-12 and I:5-13.

Problems I:5-33 Amount realized Minus: Adjusted basis LTCL

$219,000* (250,000) ($ 31,000)

*($94,000 + $50,000 + $75,000) p. I:5-3.

I:5-34 a. b. c.

$30,000 [($40,000/$120,000) x $90,000] $60,000 [($80,000/$120,000) x $90,000] Yes, because the FMV on the date of the gift is greater than the donor's basis.

p. I:5-6.

I:5-35 a.

Amount realized Minus: Basis* Gain Realized

$784,000 ( 118,000) ($666,000)

($800,000 - $16,000)

*$110,000 + ($200,000/$300,000 x $12,000) b.

Amount realized Minus: Basis Gain realized

$784,000 ( 110,000) $ 674,000

pp. I:5-6 and I:5-7.

I:5-36 Adjusted gross income: a. $62,500 b. $42,500 c. $56,500. a.

Selling price Minus: Basis LTCG Increase in AGI

$48,000 ( 30,500) [$30,000 + ($15,000/$45,000 x $1,500)] $17,500 $17,500

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b.

Selling price Minus: Basis LTCL Reduction in AGI

$28,000 ( 30,500) $( 2,500) $( 2,500)

c.

Selling price Minus: Basis LTCG Increase in AGI

$42,000 ( 30,500) $11,500 $11,500

Holding period starts on April 13, 2007 for a, b, c. pp. I:5-6 and I:5-7.

I:5-37 a. b.

$9,600 $600 realized loss [$5,000 - ($9,600 - $4,000)].

pp. I:5-9 and I:5-10.

I:5-38 Gain or Loss on Sale of A & M

Gain or Loss on Sale of Longhorn

a.

$62,600 -44,790 $42,000 + [($18,000/$60,000)($9,300)] $17,810 LTCG

$30,750 -30,000 ** $ 750 LTCG

b.

$58,200 -44,790 $13,410 LTCG

$28,650 -30,000 ** $ 1,350 LTCL

c.

No gain or loss*

$30,750 -30,000 ** $ 750 LTCG

*Because the FMV of the stock was less than the donor’s basis on the date of the gift, no gift tax may be added to the donee’s basis in the stock. FMV at time of gift is used to determine a loss and donor’s basis is used to determine a gain. **Basis for the property inherited is FMV. I:5-39 a.

$160,000 ($200,000 - $40,000 allocated to land)

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b.

$ 27,000 and $3,000

Amount Realized Adjusted Basis Realized Gain c. d.

House $208,000 (80% x $260,000) -181,000 [($245,000 x 80% - $15,000)] $ 27,000

Land $52,000 -49,000 ($245,000 x 20%) $ 3,000

$15,000 See note below. $196,000 (80% x $245,000)

Note: The character of the gain on the sale of the building is Sec. 1231 gain and $15,000 of the gain is unrecaptured Sec. 1250 gain taxed at a maximum rate of 25%. The remaining gain on the sale of the building is Sec. 1231 gain and may be taxed at 15% or 20%.

I:5-40 a. b. c. d.

0 $16 ($10,000/$60,000)($48,000) = $8,000; $8,000/500 = $16 $2,600 LTCG [$10,600 - ($16 x 500)] = $2,600 $55,500 [$8,000 + 500 ($95)]; November 10

I:5-41 a.

The basis allocated to the rights is $500 [($1,000/$8,000) x $4,000].

b.

Amount realized Minus: Basis LTCG

$1,080 ( 500) $ 580

The holding period for the stock rights starts on July 26, 2001. c.

The basis of the 100 shares purchased by exercising the stock rights is $7,300 ($6,800 + $500). The holding period starts on May 14 of the current year. d.

$1,080 LTCG. p. I:5-11.

I:5-42 Since Sec. 1237 applies and less than five lots have been sold, none of the gain recognized last year will be ordinary income. A LTCG of $7,520 is recognized.

Selling price Minus: Selling expenses Amount realized Minus: Basis Gain (LTCG)

$12,000 ( 480) $11,520 ( 4,000) $ 7,520

This year, ordinary income of $3,000 (0.05 x $60,000) is recognized, and a deduction for selling expenses of $1,900 is allowed. A LTCG of $37,000 is recognized.

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I:5-7

Amount realized Minus: Basis Gain

$58,100 ($60,000 - $1,900) ($20,000) $38,100

Ordinary income LTCG

$ 1,100 ([0.05 x $60,000] - $1,900) $37,000

p. I:5-15.

I:5-43 CASE A - 24% - gain is STCG and taxed at the same rates as ordinary income CASE B - 24% - collectibles gain. Because the Dunbars’ marginal tax rate is 24%, there is no advantage to having the gain on the sale of the clock which is a collectible classified as LTCG, so marginal tax rate is 24%.

CASE C - 15% - gain is ANCG and taxable income is more than $94,050 and less than $583,750 so the preferential rate is 15%. p. I:5-17.

I:5-44 a. b. c. d.

$2,850 $4,250 $3,760 $3,800

(15% x $19,000) NCG and ANCG amount is $19,000 [($7,000 x 35%) + ($12,000 x 15%)] [($7,000 x 28%) + ($12,000 x 15%)] (20% x $19,000)

pp. I:5-16 through I:5-18.

I:5-45 a. b.

$16,159 [Tax on $90,000 + 15% ($20,000)] ($13,159 + $3,000) $17,749 [$15,469 + 24% ($110,000 - $100,500)].

pp. I:5-16 through I:5-18.

I:5-46 a. b. c.

$2,560 $9,750 $8,518

I:5-47 a.

$132,353

b.

$136,207

(32% x $8,000) (28% x $30,000) + (15% x $9,000) (28% x $25,600) + (15% x $9,000) SP – [.15 x (SP - $50,000)] = $120,000 SP - .15 SP + $7,500 = $120,000 .85 SP = $112,500 SP = $132,353 SP – [.188 x (SP - $50,000)] = $120,000 SP - .188 SP + $9,400 = $120,000 .812 SP = $110,600 SP = $136,207

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I:5-8

I:5-48

AGI after considering capital gains and losses NSTCG (NSTCL) NLTCG (NLTCL)

Situation 1

Situation 2

Situation 3

Situation 4

$45,000 4,000 1,000

$58,000 ( 3,000) 11,000

$59,000 1,000 ( 2,000)

$67,000* (9,000) 5,000

2021

2022

2023

2024

$37,000 1,000 --

$47,000 -7,000

$57,000

$67,000

800

3,300

*$1,000 STCL is a carryforward. pp. I:5-16 through I:5-18.

I:5-49

AGI STCL to be carried forward LTCL to be carried forward pp. I:5-18 and I:5-19.

I:5-50 The loss due to Wolverine stock at one time would have been an ordinary loss since the security probably would not have been a capital asset due to the Corn Products doctrine.

However, the Supreme Court's decision in 1988 in the Arkansas Best Corporation case severely limits the use of the ordinary loss exception in the case of stock or other assets that fall within the definition of a capital asset. As a result, the loss on the Wolverine stock is probably a capital loss. The loss due to the Spartan stock is a LTCL. The loss due to the Huron stock is ordinary since the stock is that of an affiliated corporation. p. I:5-22.

I:5-51 a. b.

$3,432 ($20,000 - $16,568) $94 Cash Received

12-31-23 06-30-24 12-31-24 06-30-25 12-31-25 06-30-26

$900 900 900 900 900

Amortization of Discount

Interest Income

Basis of Bond

$ 994 1,000 1,006 1,012 1,019

$16,568 16,662 16,762 16,868 16,980 17,099

$ 94 100 106 112 119

For the first semiannual period, Phil must recognize $94 of original issue discount as ordinary income.

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I:5-9

c. d.

$1,994 ($994 + $1,000) $16,762 ($16,568 + $94 + $100). p. I:5-23.

I:5-52

Amount Realized Adjusted Basis Realized and Recognized Gain or (Loss) Ordinary Gain Capital Gain or (Loss)

(a.)

(b.)

(c.)

$191,000 (184,000)

$185,750 (184,000)

$183,000 (184,000)

$

$

($

$

7,000 2,000* 5,000

$

1,750 1,750 0

1,000) 0 ($ 1,000)

*The market discount of $16,000 accrued for the two years that Swen held the bond is $2,000 ($16,000 x 2 years/16 years). pp. I:5-23 and I:5-24.

I:5-53 $99,700. The $13,500 loss on the sale of the automobile is not deductible. Gary has an $11,700 STCG that is offset by $2,000 ($5,000 - $3,000 deduction in 2023) STCL carried forward from 2023. Thus, Gary has a $9,700 NSTCG. Gary's AGI is $99,700 ($90,000 + $9,700). pp. I:5-18 and I:5-19.

I:5-54 a.

Amount realized Minus: Basis STCG

b.

$5,000 (20 X $250) STCL

c.

$11,000 LTCG Amount realized Minus: Basis LTCG

$ 6,200 ( 5,000) $ 1,200

(20 x $310)

$100,000 ( 89,000) $ 11,000

(2,000 x $50) [(2,000 x $42) + $5,000]

pp. I:5-24 and I:5-25.

I:5-55 a.

b.

$23,550 LTCG Amount realized Minus: Basis LTCG

$38,550 (15,000) $23,550

($37,500 + $1,050) (500 x $30)

$1,050 STCG is recognized in 2025. pp. I:5-24 and I:5-25.

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I:5-10

I:5-56 Case A Case B Corporate Taxable Income $184,000 $115,000 *Net corporate capital losses are not deductible.

Case C $80,000*

Case D $90,000*

pp. I:5-18 through I:5-21.

I:5-57 a. b. c.

$9,259 ($4,614 + $4,645) $4,677 $1,736 [$95,949 - ($92,277 + $614 + $645 + $677)]. p. I:5-23.

I:5-58 a.

$40,000 ( 3,000) 14,000 $51,000

AGI without considering the gains and losses Capital loss Ordinary gain AGI

b.

$40,000 4,000 $44,000

AGI without considering the gains and losses Net capital gain ($14,000 - $10,000) AGI

c.

The answer in part (a) is the same. The AGI in part (b) is reduced by $2,500 to $41,500 since the net capital gain is $1,500 ($14,000 - $12,500). pp. I:5-16 through I:5-18.

I:5-59 a.

Taxable income is $705,000 ($660,000 + $10,000 + $15,000 + $20,000) Tax liability increases by $12,300 [37% ($10,000) + 20% (15,000) + 28% ($20,000)]

The stock held for nine months is a STCG and taxed at Charlene’s ordinary income rate of 37%. The stock held for three years is a LTCG and taxed at 20%. The collectible asset is taxed at 28%. b.

Taxable income is $691,000 Tax liability increases by $7,480 [20% ($15,000) + 28% ($16,000)]

The $14,000 STCL first reduces the $10,000 STCG and the remaining $4,000 NSTCL reduces the $20,000 collectible gain. The rate on ANCG is 20%. c.

Taxable income is $678,000 Tax liability increases by $5,300 [37% ($10,000) + 20% ($8,000)] p. I:5-19.

d.

$1,710 [3.8% ($45,000)]

I:5-60 a.

NSTCG is $13,000 because the capital loss incurred in 2019 is carried forward as a $40,000 STCL. b.

$263,000 ($250,000 + $13,000).

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I:5-11

c. $303,000 ($250,000 + $53,000). The $40,000 capital loss may not be carried forward to 2024 because the carryforward period is only five years. pp. I:5-20 and I:5-21.

Comprehensive Problem I:5-61 The painting is not a capital asset. She has ordinary income of $1,950. The basis for the stock is $30,000; thus a LTCL of $1,500 ($28,500 - $30,000) is recognized. The holding period for inherited property is always considered to be more than one year (i.e., long-term).

Because the land is sold at a loss, her basis is $30,000. Her basis is the property's FMV on the date of the gift, and the holding period starts on the day after the gift, April 9, 2024. She has a STCL of $5,000. a.

NSTCL of $5,000 b.

NLTCL of $1,500 c.

Betty's AGI is $90,950 ($92,000 + $1,950 - $3,000). d.

Betty has a STCL carryforward of $2,000 ($5,000 - $3,000) and a LTCL carryforward of $1,500. pp. I:5-6 through I:5-8, I:5-16, and I:5-19.

Tax Strategy and Critical Thinking Problems I:5-62 a.

Dale should give the stock to Tammy and have her sell the stock. b.

If Dale sells the stock, his LTCG is $5,500 and the tax is $825 ($5,500 x 0.15).

He will have $5,675 ($6,500 - $825) to give to Tammy.

If Dale gives the stock to Tammy and she sells it, her LTCG is $5,500 because her basis for the stock is $1,000. Assuming she is a full-time student, Tammy’s taxable income is $4,200 ($5,500 - $1,300 (standard deduction)) and she will be subject to the kiddie tax. Her net unearned income of $2,900 is taxed at Dale’s tax rate of 15%. He should still make the gift because $1,300 of her gain is not taxed due to the standard deduction of $1,300 and $1,300 of her taxable income is taxed at a rate of zero. Dale should save $390 (15% x $2,600) by making the transfer to Tammy, so she could sell the stock.

I:5-63 When Calvin collects the first $10,000 interest payment on December 31, 20Y1, he must pay taxes of $3,500 and will have $6,500 to reinvest at a 6.5% after-tax rate of interest for four years. The after-tax payment received on December 31, 20Y2, will be reinvested at a 6.5% after-tax rate for three years, etc. At the end of the five years, he will have cash of $137,008 as shown below: $ 6,500 x 6,500 x 6,500 x 6,500 x 6,500 100,000 Total Cash Available

1.2864 = 1.2079 = 1.1342 = 1.065 = = =

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I:5-12

$

8,362 7,851 7,372 6,923 6,500 100,000 $137,008

The value of the stock increases as follows: End of year one End of year two End of year three End of year four End of year five

$108,000 116,640 125,971 136,049 146,933

Amount realized on sale Less taxes (15% x $46,933) Cash Available

$146,933 7,040 $139,893

Despite the different before-tax returns (10% and 8%), Calvin should purchase the stock since $139,893 exceeds $137,008 by $2,885.

Note: This problem illustrates the value of deferring the tax and the implications of preferential tax treatment for net capital gains.

To further illustrate the value of the deferral, ask the students what alternative should be selected if the time period was six years instead of five years. Without computing the numbers, students should be able to respond that the stock would be the better investment by a larger margin.

With the bond, Calvin would have another $8,905 ($6,500 x 1.3700), thus increasing the total to $145,913. The value of the stock at the end of the sixth year would be $158,688 (1.08 x $146,933). After paying taxes of $8,803, he would have cash of $149,885 ($158,688 - $8,803).

The advantage of purchasing the stock is now $3,972 instead of $2,885.

I:5-64 Winneld should select the third alternative. a. $23,900 increase in her taxes this year [($50,000 NSTCG @ 37%) + ($27,000 @ 20%)]. b. $5,400 increase in her taxes this year ($27,000 @ 20%) and $18,500 increase in her taxes next year ($50,000 @ 37%). However, if she holds the Viking, Inc. stock for five more months, the gain would be LTCG with only a $10,000 increase in her taxes ($50,000 x 20%). c.

Her taxes decrease by $1,110 ($3,000 @ 37%) this year and increase by $16,000 ($80,000 @ 20%) next year. The LTCL may be used to offset the STCG and $3,000 of ordinary income this year. The remaining $2,000 of unused LTCL is carried forward to next year and reduces the $82,000 LTCG. Her NCG next year is $80,000 which is ANCG taxed at 20%. d. $2,926. [3.8%($77,000)] I:5-65 $910. If he does not sell the chair, the STCL will offset the LTCG and the excess $800 is a deduction for AGI. His tax will be reduced by $280.

If he sells the antique chair, he will have a $5,000 LTCG due to the sale of a collectible and a $10,200 LTCG due to the sale of stock. The STCL is used to offset the $5,000 collectible gain and $6,000 of the LTCG due to the sale of stock. His ANCG is $4,200 taxed at 15%, which is $630.

His tax will increase by $910 if he makes the sale. Instead of having a decline in taxes of $280 due to the sale, he must pay $630 in taxes after considering the sale of the chair.

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I:5-13

I:5-66 It may not make any difference, but he should almost always sell Dublin and recognize a STCL of $2,813 ($10,000 - $15 - $12,798) instead of the LTCL of $2,815 if he sells Wendys.

Consider the following sales of capital assets that might occur during the remainder of the year: For cases A and B, it would not make any difference because the capital loss will reduce the gain, but it could make a big difference in case C. A. He sells another capital asset and has a LTCG of $4,000.

B. He sells another capital asset and has a STCG of $4,000.

C. He sells two other capital assets and has a LTCG of $4,000 and a STCG of $3,500.

If he had recognized the LTCL in August, the loss would reduce the gain taxed at preferential rates. If he had recognized the STCL, the loss would reduce the STCG and all $4,000 of the LTCG is taxed at preferential rates.

Tax Form/Return Preparation Problems I:5-67 (See Instructor’s Resource Manual) I:5-68 (See Instructor’s Resource Manual)

Case Study Problems I:5-69 a.

Taxpayers who own appreciated capital assets often have the ability to determine when or if the asset will be sold (i.e., the taxpayer has control over determining when the tax will be paid). Proponents of preferential treatment for capital gains often argue that tax revenue will substantially increase in the year the law is changed to allow for preferential treatment. They maintain that many taxpayers with appreciated assets hold appreciated capital assets waiting for more favorable tax treatment. Most revenue estimates do show an expected increase in tax revenue during the year of change.

For older taxpayers, the voluntary nature of the tax is affected by the basis rules.

Taxpayers may avoid the tax on the capital gain by passing the property to an heir, since the heir is allowed a basis equal to the property's FMV at the date of decedent's death. b.

Since high-income taxpayers are more likely to have capital gain income and be subject to higher tax rates on non-capital gain income, high-income taxpayers are likely to receive greater benefit from preferential treatment on capital gain income than low-income taxpayers. Based on the Internal Revenue Service's 2009 data, over one-third of all NLTCGs are earned by those who earn more than $1 million annually which is less than .5% of all taxpayers. Clearly, taxpayers with income of $1 million or more benefit much more from the lower rates on capital gains. This is true even though lower income taxpayers pay zero taxes on capital gains. Single taxpayers with taxable income of less than $47,026 have a zero tax rate for ANCG. Copyright © 2025 Pearson Education, Inc.

I:5-14

Proponents of preferential treatment of capital gain income maintain that preferential treatment stimulates economic growth thus benefiting low-income taxpayers and small businesses. They also maintain that numbers such as the above often include moderate-income taxpayers with large, one-time gains. pp. I:5-34 and I:5-35.

I:5-70 It is well established that in tax practice a CPA may resolve doubt in favor of his client if there is reasonable support for the position (see Rule of Conduct 102 of the Code of Professional Ethics). The tax practitioner has the obligation to be an advocate for his client (unlike the umpire role that is assumed in an audit of financial statements by a CPA). In this situation it is clear that the weight of authority is strongly on the side of the IRS and the client's position does not have a realistic possibility of being sustained on its merits if challenged. STRP No. 1, now Statement on Standards for Tax Services No. 1, indicates that in such cases a CPA should not prepare or sign a return for the client unless the position is adequately disclosed and not frivolous. The client should be informed as to the possible tax consequences if ordinary loss treatment is reported on the tax return (e.g., penalties and interest).

Tax Research Problems I:5-71 Sec. 1235 may apply to half of the proceeds. While "a partnership cannot be a holder, each member of a partnership who is an individual may qualify as a holder as to his share of a patent owned by the partnership. For example, if an inventor who is a member of a partnership composed solely of individuals uses partnership property in the development of his invention with the understanding that the patent when issued will become partnership property, each of the inventor's partners during this period would qualify as a holder." Reg. 1.1235-2(d)(2).

Reg. 1.1235-2(d)(2) is supported in George N. Soffron v. Comm. 35 T.C. 787 (1961). "... each member of a partnership who is an individual may qualify as a holder as to his share of a patent owned by the partnership."

All substantial rights to the patent have been transferred. Reg. 1.1235-2(b)(2)(ii) states that the following right is not considered to be substantial: "The retention by the transferor of rights in the property which are not inconsistent with the passage of ownership, such as the retention of a security interest (such as a vendor's lien), or a reservation in the nature of a condition subsequent (such as a provision for forfeiture on account of nonperformance)." Thus, the forfeiture provision should not be a substantial right.

While the Kansas Corporation may not qualify as a holder [Reg. 1.1235-1(b) and Rev. Rul. 76414], Tom Williams qualifies as a holder for half of the proceeds, thus his half of the proceeds should qualify as LTCG. The fact that the patent was held only eight months is not relevant.

I:5-72 Lynette must recognize ordinary income. In Rev. Rul. 65-261 [1965-2 C.B. 281], the taxpayer "transferred the exclusive and perpetual right to use and exploit his name, nickname, facsimile signature, portrait, and likeness in connection with the manufacture, sale, and advertising of any merchandise or services the purchaser chose to associate with them". The "transaction is not a sale of property which is a capital asset within the meaning of section 1221 of the Code, and any income realized therefrom is taxable to the individual as ordinary income".

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I:5-15

I:5-73 The $200,000 is ordinary income for Jack. In Estelle Goldman, [TC Memo 1975 – 138] the taxpayer had a contract to provide services for a corporation. He agreed to terminate the contract in return for a payment of $20,000 from the corporation. The Tax Court ruled that "the payment he received for the release is taxable in the same manner as would be the payment he would have received under the contract had the contract not been terminated."

In Harry M. Flower, [5th circuit affirmed TC (61 TC 140) in an unpublished opinion] the taxpayer received a payment for the termination of an agreement to provide personal services on a commission basis. The Tax Court ruled that consideration received for the transfer of a contract right to provide personal services is taxable as ordinary income.

In Merrill J. Foote [81 T.C. 930(1983)] a professor at SMU had ordinary income when he accepted a payment to relinquish his tenured position.

In North Dakota State University [255 F3d 599 (CA-8, 2001); 2001-2 USTC 50,485] North Dakota State University (NDSU) had an early retirement program whereby tenured faculty members or administrators could mutually agree with the university to retire and receive a payment. To be eligible, a prospective retiree’s age plus years of service at NDSU must be at least 70 years. The payment might be 100% or less of final year’s salary. Factors considered in determining the payment were past performance, current salary, curriculum needs of NDSU, and the available budget. The retiree must give up tenure rights and/or any other notice rights.

The issue of whether or not the payment was LTCG was not discussed, but the court did conclude that payments were not wages for FICA purposes because the payments are for property rights rather than a mere employment right.

The University of Pittsburgh had a plan similar to North Dakota State University, and the District Court ruled that the income was not wages, but the Third Circuit Court of Appeals reversed. [The University of Pittsburgh v. U.S. 507 F 3rd 165 (CA-3, 2007)] I:5-74 Berry Corporation must treat the loss as a capital loss. The house is a capital asset since it is not listed as one of the statutory exceptions in Sec. 1221. The house was not acquired to be used in Berry’s trade or business. Rev. Rul. 82-204, 1982-2 C.B. 192, states that homes purchased under a home-buying plan to assist in relocating employees are capital assets. The facts in this case are similar to those in the Azar Nut case where the Tax Court, relying on Arkansas Best, found that the home was a capital asset. The Fifth Circuit affirmed the Tax Court, 67 AFTR 2d 91-987, 91-1 USTC ¶ 50,257 (5th Cir., 1991).

Some companies have used relocation companies to purchase the employees’ houses to avoid the capital loss treatment, but without much success. The company is often considered to be the actual owner and the loss is capital, however, the taxpayer was successful in Amdahl [108 TC 507 (1997)]. In this case, the court ruled that neither the relocation company nor Amdahl was the owner; Amdahl was allowed to deduct the fee paid to the relocation company as an ordinary expense.

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I:5-16

Chapter I:6 Deductions and Losses Discussion Questions I:6-1 Deductions for AGI (before AGI) reduce the taxpayer’s taxable income by the full amount of the deduction even if the standard deduction is used. Deductions from AGI are not beneficial unless their sum exceeds the standard deduction, in which case these deductions will be included as itemized deductions. Also, some deductions from AGI are decreased by a percentage of AGI (e.g., 7.5% x AGI for medical expenses). pp. I:6-3 and I:6-4.

I:6-2 Expenses incurred in producing rental income are deductions for AGI. p. I:6-3.

I:6-3 A deduction for a loss incurred on the sale of a capital asset held for investment is a deduction for AGI. p. I:6-3.

I:6-4 Joe’s AGI is computed as follows: Gross Income from Business Business Deductions Alimony paid Self-employed health insurance premiums AGI

$200,000 ( 60,000)

$ 140,000 ( 30,000) ( 6,000) $ 104,000

The $4,000 mortgage interest on his personal home and the $2,000 for medicine and doctors that Joe paid during the year are deductions from AGI. pp. I:6-3 and I:6-4.

I:6-5 a.

If the expenses are deductions for AGI, Mario’s taxable income is as follows.

Income Deductions for AGI AGI Standard deduction Taxable income

b.

$55,000 ( 9,000) $46,000 (14,600) $31,400

If the expenses are deductions from AGI, Mario’s taxable income is as follows.

Income Deductions for AGI AGI Standard deduction Taxable income

$55,000 ( 0) $55,000 (14,600) $40,400

p. I:6-4.

I:6-6 a.

Factors used to determine whether an activity is profit- motivated include: Copyright © 2025 Pearson Education, Inc.

I:6-1

1.

2.

3.

4.

5.

6.

7.

8.

9.

Whether the activity is conducted in a business-like manner, The expertise of the taxpayer or his advisor, The time and effort expended by the taxpayer in carrying on the activity, Whether the assets used are expected to appreciate in value, The taxpayer’s success in carrying on other similar activities, The history of income or losses with respect to the activity, The amount of occasional profits, The financial status of the taxpayer, and Any elements of personal pleasure or recreation, which the activity might involve.

b.

Whether an activity is profit-motivated depends upon the intent of the taxpayer.

These factors provide an objective way of determining a taxpayer’s intent. Expenses incurred in a profit-motivated activity are deductible, whereas expenses incurred in a personal activity generally are not deductible (with certain exceptions). Thus, external indications of a taxpayer’s motive or intent are extremely important in determining the deductibility of an expenditure. pp.

I:6-29 and I:6-30.

I:6-7 No, it is not automatically deemed a hobby. The other factors mentioned in the Regulations can be relied upon to assess whether the activity is a business. The burden to prove it is not a hobby is generally on the taxpayer. However, meeting the 3 out of 5 year test (presumptive test) shifts the burden of proof to the IRS. pp I:6-29 and I:6-30.

I:6-8 It is important to determine whether the activity is a business or an investment because different tax consequences may result depending on the type of activity. For example, deductions incurred in a business are generally for AGI whereas investment expenses may be deductible for AGI (rental property) but are otherwise not deductible. Losses incurred on business property are ordinary, whereas losses on investment property generally are capital losses and are subject to limitation. pp. I:6-5 and I:6-6.

I:6-9 An ordinary expense is an expense that bears a reasonable and close (or direct) relationship to the income-producing activity or property. It must be customary or usual to the particular activity. Also, ordinary expenses are currently deductible as opposed to expenditures that must be capitalized.

Necessary is defined as appropriate or helpful. However, an expense does not need to be indispensable in order to be necessary. The test here is whether a reasonable business person would have incurred the same expenditure.

A reasonable expense is one that is reasonable in amount. It must not be excessive or unusual when compared to similar expenses made by similar businesses. pp. I:6-7 through I:6-9.

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I:6-2

I:6-10 Capital expenditures: Under the tangible property regulations, capital expenditures are amounts paid for: 1.

2.

3.

New buildings Permanent improvement or betterments that increase the value of any property, or Restoring property to its normal usage.

A currently deductible expenditure generally keeps a business asset in a normal operating condition and does not improve the asset. p. I:6-10.

I:6-11 The disallowance for expenses related to tax-exempt income prevents the taxpayer from enjoying a double tax benefit. If expenses related to tax-exempt income were deductible, the taxpayer would benefit by not paying tax on the income and at the same time would be able to deduct the expenses related to that income. p. I:6-12.

I:6-12 A bribe or kickback that is illegal under state law may be deducted by the taxpayer if the state law is not generally enforced. pp. I:6-12 and I:6-13.

I:6-13 a.

None of the $400 is deductible. Prior to 2018, such an expense was deductible from AGI as a miscellaneous itemized deduction. Under the Tax Cuts and Jobs Act, Sec. 67(g) repeals miscellaneous itemized deductions subject to the 2% floor from 2018-2025. b.

Because $250 of the fee is attributable to Michelle’s business, this amount is deductible under Sec. 162(a) as a for AGI deduction. The remaining $150 is not deductible (see above for part a). pp. I:6-6 and I:6-7.

I:6-14 a.

Although Otter Corporation’s lobbying expenses relate to its business, they are not deductible. The de minimis exception in Sec.162(e)(4)(B) is not helpful because the expenses incurred by Otter exceed $2,000 for the year. b.

No. The Tax Cuts and Jobs Act (2017) repealed the exception allowing deductions for the cost of lobbying local legislation. c.

Yes. These are in-house expenditures that do not exceed $2,000 for the year.

Thus, under the de minimis exception (Sec. 162(e)(4)(B)), they are deductible. pp. I:6-14 and I:6-15.

I:6-15 a.

Tommy’s Inc. has incurred these $6,800 in expenses in the regular course of its existing restaurant business. Tommy’s Inc. can deduct the expenses in the year incurred (last year). b.

Because Tommy’s Inc. is not in the restaurant business when these expenses are incurred, they are not deductible as business expenses. However, they do qualify as start-up costs, deductible beginning in the month Tommy’s begins its restaurant business. If Tommy’s makes a Sec. 195 election, it can take a current deduction for $5,000 of the expenses, and amortize the remaining $1,800 over a 180-month period. This year, Tommy’s may deduct $5,110 [$5,000 + ($6,800 - $5,000)/180 months x 11 months].

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I:6-3

c.

Because Tommy’s is not in the restaurant business when these expenses are incurred, they are not deductible as business expenses. Furthermore, since it did not enter the restaurant business, they also cannot be amortized and deducted under Sec. 195. pp. I:6-15 and I:6-16.

I:6-16 For travel or entertainment expenses to be deductible, documentation such as account books, logs, receipts, statements of witnesses, etc., must exist. The documentation must substantiate the amount, the time and place, the business purpose, and the business relationship with the person entertained. pp. I:6-17 and I:6-18.

I:6-17 Generally, under the cash method of accounting the prepayment of expenses will be deductible in the year paid. However, if in the year paid, the expenditure creates an asset with a useful life which extends substantially beyond the close of the taxable year, the expenditure must be amortized as it is used (typically over time) to determine the deduction allowed in the year of payment and subsequent years. An exception allows a deduction in the year of payment if the prepaid asset does not extend more than one year and taxpayer is obligated to make the prepayment. pp. I:6-19 and I:6-20.

I:6-18 Except for certain taxpayers who meet a small business exception (prior 3 year average gross receipts $30 million or less), inventories must be accounted for using the accrual method.

As a result, a cash method taxpayer meeting this exception who has inventory may use both methods of accounting. This constitutes a hybrid method. p. I:6-18.

I:6-19 a.

Economic performance occurs as the taxpayer provides the property or services. b.

Economic performance occurs as the property or services are provided to the taxpayer. c.

For recurring liabilities, economic performance can be treated as having occurred in the year of accrual if all of the following tests are met: 1.

The all-events test is met during the year, 2.

Economic performance occurs within the shorter of (a) 8 ½ months after the close of the tax year, or (b) a reasonable period after the close of the tax year, 3.

The expense is recurring and the taxpayer consistently treats the item as incurred in the tax year, and 4.

Either the item is not material or the accrual of the item in the tax year results in a more proper matching against income than accruing the item in the tax year in which economic performance occurs.

The recurring liability exception applies only to the following transactions: 1.

Another person provides the taxpayer with property or services.

2.

The taxpayer uses property.

3.

The taxpayer provides property or services to another person.

4.

The taxpayer makes payments to another for rebates, refunds, awards or prizes, insurance or service contracts, or taxes. pp. I:6-21 through I:6-23.

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I:6-4

I:6-20 Congress enacted the "wash sale" provisions to prevent taxpayers from generating artificial tax losses in situations where taxpayers do not intend to reduce their holdings in the securities that are sold. pp. I:6-23 and I:6-24.

I:6-21 Judicial and administrative rulings have held that preferred stock of a corporation is not considered substantially identical to common stock of the same corporation. However, bonds of the same corporation that have maturity dates within a few months of each other have been held to be substantially identical. pp. I:6-24 and I:6-25.

I:6-22 a.

An individual’s spouse, brothers and sisters, ancestors, and lineal descendants are considered members of the taxpayer’s family for purposes of Sec. 267. b.

"Related parties" under Sec. 267(b) includes (1) an individual and a corporation in which the individual owns more than 50% of the value of the outstanding stock, (2) a corporation and a partnership if the same persons own more than 50% in value of the stock of the corporation and more than 50% of the partnership, and (3) two corporations if the same persons own more than 50% in value of both corporations and at least one of the corporations is an S corporation. These relationships are included because the taxpayer may be able to exert control or influence which may keep transactions between the parties from being completely at arm’s length. pp. I:6-26 and I:6-27.

I:6-23 Congress has imposed the concept of constructive ownership to prevent taxpayers from attempting to circumvent the related party rules by dispersing ownership of a corporation among family members or related entities while at the same time retaining economic control. p. I:6-26.

I:6-24 Though the loss on a sale to a related party is disallowed for the seller, on a subsequent sale of the property, the related purchaser may reduce a gain the purchaser realized on a subsequent sale by the amount of the disallowed loss. However, the disallowed loss is allowable only to the extent of the gain recognized on the subsequent sale by the related purchaser. p.

I:6-28.

I:6-25 The $1,000 income from the hobby is included in Jill’s gross income. None of the expenses are deductible (2018–2025), due to the elimination of itemized deductions subject to the 2% floor (Sec. 67(g)). pp. I:6-29 and I:6-30.

I:6-26 Under Section 280A, a day of personal use of the vacation home includes any day that the property is used (1) by the taxpayer or his/her family, (2) by any individual under a reciprocal-use arrangement, and (3) by an individual not paying a fair rental for the property. p. I:6-31.

I:6-27 According to Sec. 280A(e)(1) and the IRS, expenses are allocated to the rental use of a vacation home by the following formula: Rental use Number of rental days Total expense = x expenses Total number of days used for year However, the Tax Court and the 9th and 10th Circuit Courts of Appeal have held that the allocation of interest and taxes to the rental use may be based on a fraction in which the Copyright © 2025 Pearson Education, Inc.

I:6-5

denominator takes into account all the days in the year. The denominator in the allocation fraction for interest and taxes would be 365 if this approach is used.

The expenses allocated to rental use are deducted in the following order: 1.

2.

3.

Expenses that the taxpayer may deduct even if not incurred in a trade or business or investment activity, Other expenses that could be deducted if incurred in a business or investment activity but which do not reduce the tax basis of the vacation home, Expenses of the vacation home that could have been deducted if incurred in a trade or business or investment activity that reduce the tax basis in the asset. pp. I:6-31 and I:6-32.

I:6-28 Pursuant to Sec. 280A(g), if the vacation home has been rented for less than 15 days during the tax year, the revenue from any rentals are excluded from the taxpayer’s gross income.

Property tax expense related to the vacation home is deductible from AGI as an itemized deduction. If the taxpayer used the vacation home as a personal residence (owner used residence for more than the larger of 14 days or 10% of days rented, Sec. 280A(d)), the related mortgage interest expense may be deducted from AGI as an itemized deduction. If the vacation home does not qualify as a personal residence, none of the related mortgage interest expense is deductible.

In this case, the taxpayer has rented the property for only 12 days during the year, so the rental income is excluded from the taxpayer’s gross income.. The property tax paid is allowed as an itemized deduction. If the taxpayer did not occupy the home for 15 days or more, the vacation home does not qualify as personal residence, meaning the mortgage interest expense is not allowed as an itemized deduction. pp. I:6-32 and I:6-33.

Issue Identification Questions I:6-29 The primary tax issue is whether the exercise equipment qualifies as a trade or business expense, an unreimbursed employee expense, or is a nondeductible personal expense. The facts in this question are similar to those in David A. Kelly, 1991 PH T.C. Memo ¶ 91,605, 62 TCM 1406 where the taxpayer, an employee of Arthur Young & Co., before the purchase of the equipment belonged to two health clubs. Because of his long hours of work; the facilities were often closed by the time he got off work. The court held that, despite his need to maintain a rigorous work schedule, the health benefits were inherently personal in nature. The Tax Court compared the equipment with eye-glasses and business suits, stating that these too are necessary for business, but due to their personal nature, are not deductible (Sec. 262). p. I:6-2.

I:6-30 The settlement payment and legal fees paid by CTTC will not be allowed as a tax deduction. Sec. 162(q) denies a deduction for settlement payments and related legal fees based on sexual abuse claims if the settlement is subject to a nondisclosure agreement. pp. I:6-7 and I:6-8.

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I:6-6

I:6-31 The primary tax issue is whether the payment of the mortgage interest by Kathleen is deductible as an itemized deduction. The facts in this question are similar to Kathleen M. Emmons, 20 TCM 1513 (1961) where the Tax Court did not allow Kathleen Emmons a mortgage interest expense deduction because the indebtedness was not hers. pp. I:6-9 and I:6-10.

I:6-32 The primary tax issue is whether the activity is a business or a hobby. If the activity is treated as a business, the income will be included in gross income and the allocated expenses will be deductible. If the activity is treated as a hobby, the income will be included in gross income, but the expenses will not be deductible. The facts in this situation appear similar to Mark A. Stephens, 62 TCM 430 (1991) where the Tax Court ruled that the activity was a business.

However, this situation is different from the Stephens case in a few respects. Most importantly, there is no evidence that Katie and Alan conduct the activity like a business, that they maintain an accounting system, or that they promote the activity. However, Katie and Alan might still be found to have a business because Alan acquired training and advice from professionals and they take patrons out during the times of demand. pp. I:6-5, I:6-29, I:6-30, and I:6-37.

Problems I:6-33 All of the expenses qualify as for AGI deductions because Roberta incurred them in her own business. Thus, Roberta will report them as deductible business expenses on her Schedule C. For the year 2024, Roberta can only report $1,225 ($1,425 - $200) as deductions because she can deduct only 50% of the client meals. pp. I:6-3 and I:6-4.

I:6-34 Kent’s taxable income is $126,600, calculated as follows.

Income: Salary Dividends Interest Rental income Minus: For AGI deductions Maintenance Property taxes Utilities Depreciation Insurance Loss on sale of stock Alimony paid AGI Minus: Itemized deductions: Medical Minus: 7.5% x $141,900 Taxes Contributions Mortgage interest on principal residence

$150,000 800 1,500 $8,000 $ 500 1,000 2,400 1,700 800

$6,000 (10,643)

(6,400)

1,600 ( 2,000) ( 10,000) $141,900

-04,300 4,000 7,000

Itemized deductions

( 15,300)

Taxable income

$126,600 Copyright © 2025 Pearson Education, Inc.

I:6-7

pp. I:6-3 and I:6-4.

I:6-35 1. Replacement of roof: capitalize and depreciate. Permanently improves the asset.

2. Repainting of interior: deduct as repair expense. Merely keeps the asset in good condition.

3. Repair of door handles and installation of locks: deduct as repair expense. Merely keeps the asset in good condition.

4. Replacement of broken windowpanes: deduct as repair expense. Merely keeps the asset in good condition.

5. Replacement of crumbling sidewalks and stairs: capitalize and depreciate.

Permanently improves the asset.

Note that the Treasury has issued regulations with detailed instructions and examples regarding how to determine whether an expenditure is to be capitalized or deducted. pp. I:6-10 and I:6-11.

I:6-36 a.

Eljay, LLP incurred in-house expenditures of $650 ($500 + $150), below the ceiling of $2,000 for the de minimis exception. Eljay may deduct $650. b.

Eljay may deduct all $150 of the in-house expenditures because the total does not exceed $2,000. pp. I:6-14 and I:6-15.

I:6-37 a.

Not deductible. This cost should be capitalized as part of the cost of the property. b.

Deduction for AGI. This is an ordinary and necessary business expense. c. $400 is a deduction for AGI and $100 is a personal nondeductible expense. d.

Not deductible. This represents a personal expenditure. e.

Deduction for AGI. This is an ordinary and necessary business expense. pp. I:6-6 and I:6-7.

I:6-38 Damian Corp.’s taxable income from this illegal business activity is $355,500, computed as follows: a.

Sales $750,000 Minus: Cost of goods sold (270,000) Gross income $480,000 Minus: Salaries $75,000 Freight 22,500 Lease Payments 15,000 Interest 12,000 Total (124,500) Taxable income $355,500 The bribes of $30,000 are not deductible. A deduction is not allowed for bribes paid to domestic or foreign government employees. p. I:6-12. b.

Taxable income is $480,000 ($750,000 - $270,000). Under Sec. 280E, expenses incurred in the illegal trafficking of a controlled substance are not deductible. Cost of goods sold is not a deduction but is used to compute gross income. pp. I:6-12 through I:6-14.

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I:6-8

I:6-39 a.

The payment is not deductible because it is an illegal bribe paid to a government employee. The Department of Veterans Affairs is an agency of the federal government. b. Not deductible if the payment is unlawful under the Foreign Corrupt Practices Act of 1977. c. Not deductible if the payment is unlawful under state law and state law is generally enforced. pp. I:6-12 through I:6-14.

I:6-40 a. The expenses are currently deductible as trade or business expenses because Big Bang, LLP is already in the business of operating entertainment galleries. b. The expenses are start-up expenses because Big Bang, LLP incurred the costs to investigate a new line of business, and prior to deciding whether to proceed with the new store.

Typically, these costs are capitalized. However, in the first year (business starts), up to $5,000 in start-up costs may be deducted immediately, with the excess over $5,000 capitalized and amortized over the next 180 months (Sec. 195).* If the new store opens in May, first year amortization equals $5,356. $5,000 + [($13,000-$5,000)/(180 months) x (8 months)] = $5,356 * Assumes total start-up expenses do not exceed $50,000. pp. I:6-15 and I:6-16.

I:6-41 a.

The expenses are not deductible because Big Bang, LLP is not engaged in the entertainment business and it did not enter the new business. b. $6,089 current year deduction.

For Big Bang, the immediate deduction and first year amortization are determined below. [$5,000 - ($51,000 - $50,000)] + ($51,000 - $4,000)/(180 months) x (8 months)] $4,000 + $2,089 = $6,089 pp. I:6-15 and I:6-16.

I:6-42 Timing of Expense Recognition. a.

1. Solutions may deduct only $4,000 in the current year. The all-events test requires that (1) the existence of liability is established, and (2) the amount of the liability is determined with reasonable accuracy. Although a liability to the contractor is established, the amount of the liability is uncertain. The amount of the liability can be accurately established only with respect to $4,000. The economic performance test is met because the contractor performed the remodeling service before the year-end of December 31.

2. Solutions Corporation may deduct $11,500 on its current-year tax return for the amounts actually paid to service the warranties during the current year. It cannot take a deduction for its estimated liability for next year because it fails both the all-events test and the economic performance test. First, the liability is not certain in existence or amount. Second, the corporation did not perform work related to the estimated liability.

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I:6-9

2. As of December 31, Solutions reports the following related to the trade seminars: Expenses paid in current year: Rent Seminar Teacher Compensation Printer Total

$1,250 1,800 700 $3,750

Expenses to be paid in the following year: Rent $2,500 Seminar Teacher Compensation 3,600 Printer 1,400 Total $7,500

Solutions can deduct the $3,750 paid in the current year. These expenses meet both the all-events test and the economic performance test.

The expenses to be paid in the following year meet the all-events test because they are certain in existence and amount. However, the expenses do not meet the general economic performance test because the services to which they relate are not performed in the current year.

Solutions Corporation cannot use the exception to economic performance for recurring liabilities to deduct the following year expenses of $7,500 in the current year. The scenario fails to meet the “better matching” condition (iv below).

Though the revenue from the seminars was received in full in the current year, only the revenue for the two seminars completed in the current year has been recognized as earned in the current year. i. The all-events test is met in the current year, ii. Economic performance will occur before August 15 of next year, which is within 8 ½ months of the close of next year, iii. The expense is recurring and the taxpayer (we assume) consistently treats the item as incurred in the tax year; and iv. The accrual of the item in the tax year results in a more proper matching against income than accruing the item in the tax year in which economic performance occurs. b.

1.

Solutions Corporation cannot not deduct any amount of the disputed liability in the current year. It can deduct the remodeling expense in the period in which it pays the bill, which will likely be the following year.

2. Solutions Corporation may deduct the $11,500 paid to service the warranties.

3. Solutions Corporation may deduct only the amount of expenses paid in the current year, $3,750. pp. I:6-18 through I:6-23.

I:6-43 a.

All of the $12,000 rent payment is deductible in the current year. Though $10,000 (10 months x $1,000/month) is prepaid expense, the prepayment period does not exceed one year and its prepayment is required by the lease. The $5,000 refundable deposit is not deductible. b. $500 ($18,000 x 1 month/36 months) c. $5,000 d.

The $700 worth of stationery and office supplies is not currently deductible because Pamello did not pay for the supplies during the current year. e. $1,000 pp. I:6-18 through I:6-20.

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I:6-10

I:6-44 a.

Total deductions in the current year are $16,200 ($12,000 mortgage interest + $4,200 in points which represent interest). The points of $4,200 are computed as follows: $280,000 loan amount x .015. b.

The other closing costs (appraisal fee and the title search) are added to the cost basis of the home. pp. I:6-19 and I:6-20.

I:6-45 a.

Although John has a realized loss of ($5,500) (selling price of $5,000 – basis of $10,500) on the December 8 sale of the Silver Fox common stock, because of the wash sale provisions, he can recognize only $3,667 of the total realized loss. The wash sale provisions apply in this case because John purchased 250 shares of Silver Fox common stock within 30 days after the sale of the stock. Thus, $1,833 (250/750 x $5,500) of the realized loss is disallowed. The wash sale rules do not apply to John’s purchase of the Silver Fox preferred stock because the Silver Fox preferred stock is not considered substantially equivalent to the Silver Fox common stock. b.

John’s basis in the 250 shares of Silver Fox common stock is $3,583 ($1,750 purchase price plus the $1,833* disallowed loss).

His basis in the remaining 750 common shares acquired in 2011 is $10,500. The holding period for the newly purchased 250 shares begins on April 17, 2011. Basis in the preferred stock is its cost of $1,000, and its holding period begins on January 2, 2024. pp. I:6-23 through I:6-25.

I:6-46 Date March 8, 2011 October 3, 2024 October 12, 2024 November 1, 2024

Transactions in Western Common Stock Purchases 1,000 shares Purchases 300 shares Sells original 1,000 shares Purchases 500 shares

Amount $12,000 3,000 8,500 4,000

a.

Mr. Cougar realizes a total loss of $3,500 ($8,500 - $12,000). However, Mr. Cougar cannot recognize $2,800 ($3,500 * (300 shares + 500 shares)/1000 shares) of the total loss. His recognized loss is $700 ($3,500 - $2,800). Under the wash sale rules, $2,800 of the realized loss is disallowed because Mr. Cougar repurchased 80% of the common stock sold within the 61 day period beginning 30 days before the date of sale and ending 30 days after the date sale. b.

The basis in the 300 shares purchased October 3, 2022 is $4,050. [$3,000 purchase price + $1,050 (300 shares/(300 shares + 500 shares) x $2,800 disallowed loss)]. The basis in the 500 shares purchased November 1, 2022 is $5,750. [($4,000 purchase price + $1,750 (500 shares/(300 shares + 500 shares)) x $2,800 disallowed loss)].

The holding period for both of these blocks of stock starts on March 8, 2011. c.

The recognized loss would be $3,500. Nonvoting, nonconvertible preferred stock is not substantially identical to common stock in the same corporation. Thus, the wash sale rules Copyright © 2025 Pearson Education, Inc.

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do not apply to the purchase of the preferred stock. Mr. Cougar’s basis in the preferred stock would be the cost of the stock ($3,000 for the October 3 purchase and $4,000 for the November 1 purchase) and the holding periods would begin on the respective dates of purchase. pp. I:6-23 through I:6-25.

I:6-47 Constructive Ownership a.

Troy is deemed to own 30% in Berry Corporation (see diagram) because he is treated as owning the stock owned by his family, which under Sec. 267 includes his wife, Angie, and his son, Tom. Note that Troy is not deemed to own the stock owned by Jimmy (Troy’s cousin) or Jimmy’s father (Troy’s uncle), because cousins and uncles are not considered family under Sec. 267. Also note that Troy and Jimmy are partners in TJ partnership. In general, under Sec. 267 a partner is considered as owning the stock that his/her partner owns. However, this attribution from a partner does not apply if the only stock the individual is treated as owning is stock owned by his/her family. Because the only stock Troy is treated as owning is the stock owned by his wife, Angie, and his son, Tom, he does not own the stock owned by his partner, Jimmy.

Troy’s constructive ownership 20% 0% 0% 10% 0% 30%

Percentage ownership 20% 15% 30% 10% 25% 100%

Owner Tom (Troy’s son) Jimmy (Troy’s cousin) Jimmy’s Father (Troy’s uncle) Angie (Troy’s wife) Nicole (Angie’s sister) T J Pship

Troy

Tom

Jimmy

Angie 50%

Jimmy’s

50%

Father

Nicole

TJ 15% 20%

10%

30%

Berry Corporation

25%

b.

Troy may recognize the entire $5,000 loss because he and Berry Corporation are not related parties under Sec. 267. Because this loss is a capital loss, Troy can only deduct the Copyright © 2025 Pearson Education, Inc.

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recognized capital loss against his capital gains for the year, plus an additional $3,000 of capital losses in excess of his capital gains. c.

Troy cannot recognize the $5,000 loss. Troy is deemed to own 70% in Berry Corporation. Thus, he and the corporation are related parties and he cannot recognize the $5,000 loss. He is attributed 10%, from Angie, his wife, and 20% from Tom, his son, because they are family members under Section 267. He is attributed 12.5% from the partnership, because partners own their proportionate share of what the partnership owns. Thus, because of this constructive ownership from the partnership, Troy is treated as owning stock in Berry Corporation in a way other than just from his family (Angie and Tom). He is also attributed the 15% that Jimmy (his partner) directly owns and the 12.5% that Jimmy is deemed to own through the partnership, because a taxpayer is attributed everything his partner owns except stock that is attributed to the partner through family attribution (the 30% owned by Jimmy’s father).

Owner Tom (Troy’s son) Jimmy (Troy’s cousin) Jimmy’s Father (Troy’s uncle) Angie (Troy’s wife) TJ Partnership

Percentage Ownership 20% 15% 30% 10% 25%

Troy’s constructive ownership 20% 15% 0% 10% 25%

100%

70%

Troy is attributed stock from TJ Partnership, Jimmy, Angie, and Tom.

Troy 50%

50%

Tom

Jimmy TJ Jimmy’s Father

15%

20% 25%

30%

10% Berry Corporation

pp. I:6-26 through I:6-29.

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Angie

I:6-48 a.

Ralph may recognize the loss of $10,000 on the sale of the land to Burnham, Inc. Of course, this loss is a capital loss and is first offset against his other capital gains. Any capital loss in excess of his other capital gains is only deductible up to $3,000 per year. Any excess must be carried over to subsequent years. In order to determine if the loss disallowance rules of Sec. 267 apply, we must determine Ralph’s direct and constructive ownership in Burnham, Inc. This ownership is determined as follows: Direct ownership Through Thann (Ralph’s brother) Thann’s actual ownership Thann’s ownership through PIB (.4 x .7) Total

10% 10 28

38% 48%

Because under Sec. 267, Ralph doesn’t own over 50% in Burnham, Inc., he may recognize the loss. b.

Thann’s entire loss is disallowed. Under Sec. 267, Thann is treated as owning 100% of Burnham, Inc., computed as follows: Direct ownership Through Ralph (Thann’s brother) Through PIB to himself (.7 x .4) Through PIB to his partners (.7 x .6) Through Sara, his partner Total

10% 10% 28% 42%

70% 10% 100%

Note that since Thann owns stock in Burnham, Inc. other than through a family member, he is treated as owning the stock actually and constructively owned by his partners.

Thus, the loss is disallowed. However, when Burnham, Inc. subsequently sells the land for a gain, it may offset up to $10,000 of the gain it recognizes. If it subsequently sells the land at a loss, Thann’s disallowed $10,000 loss is completely lost. c.

Thann can recognize the loss and offset it against his other capital gains. Any capital loss in excess of his other capital gains is deductible up to $3,000 in the current year. The remainder is carried over to subsequent years. Thann is treated as owning only the 40% that Ralph owns. Because the only stock he is considered as owning is attributed to him from a family member, he is not treated as owning the stock in Burnham, Inc. that his partner, Sara owns.

pp. I:6-26 through I:6-29.

I:6-49 Because Sally is considered a related party to Sage Corporation (she constructively owns 60% of the corporation through her brother and grandmother), the corporation may only deduct the payment of consulting fees in the year that Sally reports the fees as income. Thus, each alternative situation is taxed as follows: a.

1.

Sally must report the income in 2024.

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2. b.

c.

1.

2.

1.

2. pp. I:6-28 and I:6-29.

Sage Corporation must deduct the expense in its tax year ending January 31, 2025.

Sally must report the income in the year 2025.

Sage Corporation must deduct the expense in its tax year ending January 31, 2025.

Sally must report the income in the year 2025.

Sage must deduct the expense in its tax year ending January 31, 2026.

I:6-50 a.

CVI Realized loss = $75,000-$98,000 purchase price = ($23,000) CVI Recognized loss = $0 The realized loss is disallowed because CVI Corporation and Sandi are related parties (Sec. 267). b.

1. Sandy realized gain = $85,000 - $75,000 purchase price = $10,000 Sandy recognized gain = $10,000 – [lesser of CVI disallowed loss $23,000 or realized gain $10,000] = $0 2. CVI Corporation is unaffected by Sandi’s subsequent sale c.

Sandy realized loss = $70,000 - $75,000 purchase price = ($5,000) Sandy recognized loss = ($5,000) d.

Sandy realized gain = $105,000 - $75,000 purchase price = $30,000 Sandy recognized gain = $30,000 – [lesser of CVI disallowed loss $23,000 or realized gain $30,000] = $7,000 pp. I:6-25 through I:6-28.

I:6-51 Rachel may make an election to keep tax year 2023 open for possible audit with respect to her bath product sales until after 2026. At that point, with five years of history, the presumptive test may be applied. If she has profit from her sales in 2024, 2025, and 2026, the burden of proof will shift to the IRS. The IRS will have to prove that her bath product business is a hobby in order to disallow the loss from 2023. pp. I:6-29 and I:6-30.

I:6-52 Emily cannot make the election to keep the year open. The election allows the year in question to remain open with respect to the activity until sufficient years have passed so that the presumptive test may be applied. The election must be made within 3 years after the due date for the year in which the taxpayer first engages in the activity. In this situation, Emily has reported losses four out of six years (four of the most recent five years), and the profits test is not met during those years. pp. I:6-29 and I:6-30.

I:6-53 a.

Because this activity is a hobby, Chuck must report all $1,100 of income as part of gross income, but he cannot deduct any of the expenses related to the hobby activity. The exception is for otherwise deductible expenses. Chuck can deduct $200 in property taxes as an itemized deduction. b.

The only deductible expense is the $200 of property taxes. This deduction will be from AGI as an itemized deduction. c.

-0-. None of the depreciation is deductible so the basis of the hutches is not reduced. pp. I:6-29 through I:6-31.

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I:6-54 Kim’s vacation home’s tax treatment is considered mixed personal and rental (category 2) because the home was rented for more than 14 days and the amount of her personal use days (20) exceeds the greater of 14 days or 10% of rented days (6). All $9,100 of rent income is included in gross income. The total deductions of the rental portion of the condo expenses will be limited to rental income of $9,100. a.

Expense by tier Tier 1 Interest on mortgage Property taxes Tier 2 Repairs Insurance Utilities Tier 3 Depreciation

Total $3,000 1,000

Allocated to rental use (60/(60 + 20)) $2,250 750

Allocated to personal use (20/(60 + 20)) $ 750 (deduction from) 250 (deduction from)

700 500 800

525 175 (nondeductible) 375 125 (nondeductible) 600 200 (nondeductible) * 8,000 $4,600 2,000 (nondeductible) $9,100 *Subtotal of rental expenses for Tier 1 and Tier 2: $4,500 Deduction for Tier 3 expenses limited to $4,600 ($9,100 rental income - $4,500) Deductions from AGI (allocated to personal use and qualify as itemized deductions): (750 + 250 = $1,000). The vacation home qualifies as Kim’s qualified residence because its personal use (20 days) exceeds the larger of 14 days or 10% of rented days (6 days). b. The condominium’s basis is reduced only for the deductible portion of depreciation expense, $4,600. pp. I:6-30 and I:6-31.

I:6-55 Because the condominium was rented for fewer than 15 days, it falls into category 1, primarily personal. Thus, Kim will report no income or deductions from the property. Because Kim did not use the condo for more than the greater of 14 days or 10% of rented days, it is not a personal residence, and the interest on the mortgage is not allowed as an itemized deduction.

However, Kim may deduct the property taxes from AGI. pp. I:6-31 through I:6-34.

Comprehensive Problems I:6-56 1.

Bryce’s taxable income is computed as follows.

Salary Net capital gain (3,000 + 5,000 - 2,000) Hobby income AGI Itemized deductions: Property taxes

$100,000 6,000 2,500 $108,500 $125

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State income taxes Charitable contributions Total (less than standard deduction) Standard deduction Taxable income

4,800 5,000 $9,925 (14,600) $93,900

a. Assuming Bryce’s fly-tying activities are a hobby, the expenses are not deductible. b. Because the building lot was sold to Bryce’s brother, the $7,000 realized loss is a related party loss and not currently deductible. c. Bryce realized  a $3,000 gain ($8,000 - $5,000) on the sale of Gold Corporation stock,  a $4,000 loss ($5,400 - $9,400) on the sale of the Silver stock, and  a $5,000 gain ($12,000 - $7,000) on the sale of the United stock.

All $8,000 of the gain from sales of Gold and United stock is recognized ($3,000 + $5,000).

However, because Bryce purchased 100 shares of Silver Corporation stock within 30 days before the sale of the 200 shares of Silver Corporation stock, one-half of the loss is disallowed. Thus, only $2,000 (100/200 x $4,000) of the loss is recognized. Note, however, that if Bryce’s intention in the April 15 sale was to reduce his holdings of Silver Corporation, none of the $4,000 loss will be disallowed.

2.

Bryce’s basis in the 100 remaining shares of Silver stock is $4,800 ($2,800 purchase price + $2,000 disallowed loss). pp. I:6-29 through I:6-31.

I:6-57 1.

Jaron qualifies as a surviving spouse because his wife died just two years ago, he has not remarried by the end of 2024, and he maintained his household as the home of his three dependent children (ages 14, 17, and 19).

2.

Jaron is not allowed a home office deduction for the expenses allocable to his home office. His use of the office in his home does not meet any of the following requirements: (1) the home office is not his principal place of business, (2) Jaron does not meet with clients in the home office, and (3) Jaron has another office where he conducts the administrative and managerial activities of the business. The property taxes (all $5,100) on Jaron’s home are deductible as a “from” AGI deduction.

3.

Laura and Chad’s 24 days of use of the rental apartment is considered personal use of the apartment. However, Jaron’s personal use of the rental apartment is less than the greater of 14 days or 10% of the number of days the apartment was rented out (270 x .1 or 27 days), so the condominium is treated as primarily rental. The net income from the rental is determined below.

Rental income Mort. interest Taxes Other expenses Depreciation Total

(3,150) x (270/294) = (1,700) x (270/294) = (6,000) x (270/294) = (7,090) x (270/294) =

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$18,000 ( 2,893) ( 1,561) ( 5,510) ( 6,511) $ 1,525

Note that the allocation formula used for interest and taxes is based on the total number of days used (294) rather than the modified allocation formula allowed by the courts (which would have allocated the interest and taxes using a ratio of 270/366 in a leap year). Use of this ratio allocates more interest and taxes to the rental use of the condominium, which allows Jaron to claim more overall deductions. Because the condo does not qualify as Jaron’s residence, the interest allocated to the personal use is not deductible. The taxes of $139 allocated to the personal use ($1,700 - $1,561) generally would be deductible as a “from” AGI deduction.

4.

5.

Jaron’s land sale has the following tax consequence: LTCG on land: ($75,000 - $70,000) Brother’s disallowed loss (earlier related party transaction) Jaron’s stock transaction has the following tax consequence: STCL on Genomics: (8,000 - $10,000)

$ 5,000 (4,000) $1,000

($2,000)

With the $1,000 LTCG on the land and the $2,000 STCL on the Genomics stock, Jaron will have a net STCL of $1,000, all of which is deductible (up to $3,000).

6.

Jaron reports $98,500 net income from his consulting business on Schedule C. Consulting fees received $185,000 Wages expense ( 47,400) Rent expense ( 20,000) Depreciation ( 2,100) Other expenses ( 17,000) Net income $ 98,500

Self-employment tax of $13,918 (0.9235 x $98,500 x 0.153) will be imposed on this income. One half of this tax ($6,959) is allowed as a deduction for AGI. Jaron’s taxable income is determined below.

Income: Net Business income (Sch. C) Capital gain or (loss) (Sch. D)

$98,500 $1,000 (2,000)

Net rental income (from Sch. E) Gross Income - One-half self-employment tax AGI: Qualified Business Income Deduction Standard deduction Taxable Income

( 1,000) 1,525 $99,025 ( $6,959) $92,066 (13,233)* ( 25,900) $52,933

* Lesser of: (1) 20% of qualified business income = 20% ($98,500 - $6,959) or (2) 20% of taxable income before the QBI deduction = 20% ($92,066 – 25,900) Copyright © 2025 Pearson Education, Inc.

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pp. I:6-30 through I:6-34.

Tax Strategy and Critical Thinking Problems I:6-58 The business is currently facing a loss for 2024 ($9,000 - $9,200 – 50%($150)). If the loss is reported on Danielle’s Schedule C, it will be the third loss reported in the past five years.

Therefore, the activity will not meet the safe-harbor rule (i.e., if a business activity generates a profit in three out of five consecutive years, the burden of proof shifts to the IRS, and the activity will not likely be subject to hobby loss rules).

If the business can generate a profit for 2024, it will meet the safe-harbor rule. To do so, Danielle should act to accelerate income recognition and defer payment of expenses.

First, Danielle should not wait until the end of the month to bill the Springville Orchestra, but instead, should deliver a bill immediately. The orchestra will likely pay the bill within ten days, before December 31, 2024. By including this item of income, the business reports a profit of $725.

If Danielle continues her practice of paying bills right away, she will incur $1,000 in additional expenses. She should delay paying her bills until January 1, 2025 even if the delay requires her to deliver payments. She should still take the meal deductions, as that expense will be lost if she does not claim it on her 2024 return. The final result is as follows: Schedule C Income received before 12/12/2024: Payment from Springville Orchestra: GROSS INCOME General Expenses Meals (150 x 50%) Total Expenses Net Income Reported on Schedule C Deductions in next year when paid: Refurbishing repair/maintenance expense Newspaper advertisement expense Printer advertisement expense

$9,000 1,000 $10,000 9,200 75 $

9,275 725

300 200 500 $1,000

The tax practitioner should strongly advise the client to distinguish her performing activities from personal activities by maintaining a separate bank account, account books and records, and perhaps dedicating an area of her home to performing managerial and administrative duties relating to the business. pp. I:6-29 through I:6-31.

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I:6-59 TO: FROM: DATE: SUBJECT:

Peter Baumann Student, CPA October 12, 2022 Sale of printing press

I have looked over your transaction, and it appears that—beyond the realized loss of $40,000—selling your printing press to Chamberlain Corporation will produce some unfavorable tax consequences.

Taxpayers may not deduct any loss on a sale of property to a related party. Under the definition of related parties in Sec. 267 of the Internal Revenue Code, you are considered owning 75% of Chamberlain Corporation. (12.5% through the Coxmann Partnership, 30% through Emily Cox (Emily is considered as owning 12.5% through Coxmann Partnership and 17.5% through Chloe, International, Inc.) 7.5% through your sister, Susan, and 25% through your brother, Brian.) This means that you are considered related to Chamberlain Corporation, and you will not be able to deduct the $40,000 realized loss if you sell the press to Chamberlain. Chamberlain will have a basis of $50,000 in the press. If Chamberlain sells the press at a gain later, it will be able to offset the gain to the extent of your disallowed loss.

I recommend that you sell the printing press to an unrelated third party. That way, you will be able to deduct your $40,000 loss. Chamberlain Corporation may then buy a comparable press from an unrelated party.

If you have any questions, please give me a call. Thank you.

Sincerely,

Student, CPA pp. I:6-26 through I:6-28.

Tax Form/Return Preparation Problems I:6-60 (See Instructor’s Resource Manual) I:6-61 (See Instructor’s Resource Manual) I:6-62 (See Instructor’s Resource Manual)

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Case Study Problem I:6-63 FACTS: 1.

2.

3.

4.

5.

John left his employment in 2018 and in 2019, he created a fishing charter service.

John was an avid fisherman and Kathy, a CPA, assisted John in creating a business plan. They also opened a bank account for the charter service, developed a bookkeeping system, and acquired insurance to cover the boat and passengers.

John completed the requirements to acquire the necessary licenses. He advertised the charter service in local newspaper and magazines.

The activity was unprofitable in 2 of 4 years from 2019 through 2020.

In 2021, John started full-time employment with an insurance company and continued to take paying and non-paying parties each weekend throughout the fishing season. John’s costs increased unexpectedly and the activity lost $8,000 in 2023.

ISSUES: Are the Browns engaged in the activity for profit, which would allow all expenses related to the activity to be deducted under Sec. 162? Or, is the activity a hobby with expenses not deductible (Sec. 67(g))?

DISCUSSION: Reg. Sec. 1.183-2(b) provides a list of factors to assist in determining whether an activity is engaged in for profit. The list is as follows: 1.

2.

3.

4.

5.

6.

7.

8.

9.

Whether the taxpayer conducts the activity in a businesslike manner.

The expertise of the taxpayer or his advisors.

The time and effort expended by the taxpayer in carrying on the activity.

Whether the assets in the business are expected to appreciate.

The taxpayer’s success in carrying on other similar activities.

The taxpayer’s history of income or losses with respect to the activity.

The amount of occasional profits, if any, that are earned.

The taxpayer’s financial status.

Any elements of personal pleasure or recreation that the activity might involve.

For the following reasons the charter activity may be considered engaged in for profit: 1.

2.

3.

The activity was carried on in a businesslike manner. This is evidenced by the business plan, an established bookkeeping system, insurance, licenses, advertising, and the restructuring.

The Browns’ expertise. John is an avid fisherman with many years of experience.

Kathy is a practicing CPA and she assisted John in the business portion of the activity.

The time and effort expended in the activity. Even though John was employed full-time, he devoted substantial amounts of time to the activity.

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4.

The element of pleasure that is involved. Although John enjoys fishing, almost all of his trips were either with paying parties or promotional non-paying parties. The fact that Kathy would rarely accompany John is an additional indicator that the activity was an attempt to produce income and not done for recreation.

The activity may be classified as a hobby for the following reasons: 1.

2.

3.

4.

The assets John uses are not expected to appreciate.

John’s history of income and profits indicate the activity was a hobby. He incurred a loss in three of the five years of operation.

When a profit was made, the amount of profit was relatively small.

John’s financial status also might indicate the activity was a hobby. He was employed in a full-time job during 2023.

The factor dealing with the taxpayer’s success in carrying on other similar activities does not apply to the Brown’s situation. They had never tried a similar venture.

Using the regulation as a research source, a student may be able to establish a strong argument for both sides in this case. However, the weight of the evidence probably leans towards a determination that John is engaged in a business. See John R. Zwicky, 1984 PH T.C. Memo ¶84,471, 48 TCM 1026. pp. I:6-35 and I:6-36.

Tax Research Problems I:6-64 FACTS: 1.

2.

3.

4.

5.

Richard Penn is the president and part owner of an architecture consulting firm.

He also owns 25% of a corporation that is now bankrupt.

Many unsecured creditors of the corporation were unable to collect on the debts.

Some of the bankrupt corporation’s creditors are also clients of Richard’s firm.

Richard was not obligated to pay off the corporation’s debts. However, he did pay the debts because he felt that it was necessary to improve his business reputation with the customers of his architecture firm.

ISSUES: 1.

Can Richard deduct the amount he paid on behalf of the bankrupt corporation?

CONCLUSIONS: 1.

Richard may deduct, under Sec. 162, the amount paid to those who are also customers of his consulting firm.

2.

Richard may not deduct the amount paid to the other creditors of the corporation.

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DISCUSSION: Sec. 162 allows a deduction for business expenses that are incurred for a business motive, and are ordinary and necessary.

Many times the determination of whether a payment is ordinary and necessary is extremely difficult. A landmark case in this area is Welch v. Helvering, 12 AFTR 1456, 3 USTC 1164 (USSC, 1953). In the case, the Supreme Court decided that when a taxpayer paid the debts of his former corporation because he dealt with many of the same customers in his new job, the payments were not deductible. The Court stated that the payments were made to build goodwill in his new employment, instead of preserving his existing business reputation. See also Earl E. Cloud, 1976 PH T.C. Memo ¶76,027, 35 TCM 95. and Justice Steel, Inc., 1980 PH T.C. Memo 80,466, 41 TCM 209.

The determination of whether a necessary business motive is present can also be difficult.

In Paul L. Dunmire, 1981 T.C. Memo ¶81,372, 42 TCM 438 the taxpayer owned 99% of a furniture corporation; however, he did not actively participate in the operations of the corporation. The taxpayer pledged stock owned in another corporation to obtain the furniture corporation’s loans. When the furniture corporation wasn’t able to pay its creditors, he made direct payments to the corporation’s creditors so that he would not lose his stock and maintain his business reputation. The court decided that a business motive did not exist.

The courts have decided that payments made to maintain a present professional reputation are deductible. In William A. Thompson, 46 TCM 1109 (1983), the taxpayer owned 51% of a coal mine, which eventually liquidated. The taxpayer stated he felt morally bound to repay the corporation’s creditors and later repaid all the debts of the liquidated mine. The court allowed a deduction for the payments made to creditors who were also clients of Thompson’s engineering firm. See also Warren Young v. US, 85-2 USTC 9643 (D.C. No. Dist. of Okla.) and Harold L. Jenkins, 47 TCM 238 (1983).

From the court cases cited, Richard can make a strong argument for deducting the payments he made to the creditors who were also clients of his architecture firm.

I:6-65 FACTS: 1.

Paul Wilde owns a large portfolio of stocks and securities which he manages himself.

2.

His investing philosophy is to purchase and hold stocks for the dividends and long-term growth.

3.

Although he buys and sells stock regularly during the year, most of the stocks he sells have been held over one year.

4.

This year he has rented a suite of offices and has hired two investment assistants and four secretaries. He has also purchased some new computer equipment and office furniture for the offices.

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ISSUES: 1.

Do Paul’s activities constitute a trade or business, or are they an investment activity?

2.

What is the tax treatment of his expenses? Specifically, are they deductions “for” or are they not deductible?

CONCLUSIONS: 1.

Paul’s activities are not considered a business. Instead, Paul is involved in an investment activity.

2.

After 2017, the expenses are not deductible.

3.

Paul cannot deduct the purchase of the computers and office furniture.

DISCUSSION: In Higgins v. CIR, 41-1 USTC §9233 (USSC, 1941), the Supreme Court held that a taxpayer who merely kept records and collected interest and dividends from his securities was not involved in a trade or business. This was the case, despite the size of the taxpayer’s holding. Subsequent cases also indicate that a taxpayer who buys and sells stocks and securities for the dividends and long-term growth and who is not involved in short-term trading is not engaged in a trade or business. See also Estate of Louis Yaeger, Deceased, Judith Winters, Ralph Meisels, Abraham J. Weber and the Bank of New York, 89-2 USTC ¶9633 (CA-2), Frederick R. Mayer and Jan Perry Mayer, 67 TCM 2949 (1994), and Rudolph W. and Abbie A Steffler, 69 TCM 2940 (1995). In each of these cases, the taxpayer was more interested in the long-term investing potential rather than merely trading based upon short term market fluctuations. Furthermore, the taxpayers were not involved in selling stocks and securities to others in the capacity of a broker.

Since Paul is deemed to be engaged in an investment activity rather than in a business, the expenses are treated as miscellaneous itemized deductions and nondeductible. Sec. 67(g) disallows a deduction for miscellaneous itemized deductions in tax years 2018– 2025.

Since Paul is not considered engaged in a trade or business, the cost of the computers and office equipment is not deductible.

“What Would You Do In This Situation?” Solution Ch. I:6, p. I:6-34 The determination of whether an activity is truly a business or merely a hobby is always a hot topic for the IRS because so many taxpayers try to deduct the expenses associated with the activity even though their intent and purpose of engaging in the activity is really for personal pleasure rather an attempt to make money. Because you have a long term relationship with Mr. Gerbeuses, you should feel comfortable initiating a serious and detailed discussion with him.

In this discussion you should address the factors that the IRS uses to determine whether an activity is a business or a hobby. A partial list of these factors include: Copyright © 2025 Pearson Education, Inc.

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1.

2.

3.

4.

5.

Whether the taxpayer conducts the activity in a businesslike manner The taxpayer’s expertise as well as advice he/she receives from advisors The time and effort expended by the taxpayer in the activity Whether the assets used in the activity are expected to appreciate in value The taxpayer’s financial status.

In this discussion, you should also help him identify how to establish the facts that will demonstrate these factors, including making sure he can document a strong business plan and he develops proper strategic planning, management and bookkeeping processes. In order to do so he should document marketing studies, etc.

You should also help him understand the differences in the tax consequences if the activity is a hobby instead of a business. In this discussion, using actual analytical data could help him understand the importance of making the right decision and then properly following and documenting the plan.

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Chapter I:7 Business Expenses and Deferred Compensation Discussion Questions I:7-1 It is important to distinguish whether an individual is an employee or an independent contractor (self-employed) because some expenses are only partially deductible by employees or not deductible at all. A self-employed individual who incurs a business-related expenditure may deduct, under Section 162, the expense for determining AGI on Schedule C, Form 1040. In addition, employers pay certain payroll taxes on behalf of their employees. On the other hand, an individual's employment-related activities, such as travel and transportation, are no longer deductible in tax years 2018–2025. Individuals may prefer to be classified as employees rather than independent contractors because the employee portion of the social security tax rate in 2024 of 7.65% is less than the self-employment tax rate of 15.3%. This difference is mitigated somewhat because self-employed individuals receive an income tax deduction equal to 50% of their self-employment tax. Consideration should also be given to the hospital insurance portion of the FICA tax, which continues to apply without limit at a 1.45% rate for both employees and employers and at a 2.90% rate for self-employed individuals. p. I:7-3.

I:7-2 For reporting purposes, deductions for AGI can be classified into two categories: (1) expenses that are netted against income from the activity, such as expenses connected with a trade or business (Schedule C), rental real estate (Schedule E), or a farm (Schedule F); and (2) various other types of for AGI deductions that are reported as Adjustments to Income on Schedule 1 of Form 1040. From AGI deductions are itemized deductions reported on Schedule A. p. I:7-2.

I:7-3 Expenses of a self-employed individual are netted against the income from his business activity and the net amount is reported on Schedule C. The net amount of income from Schedule C is then reported on Line 3 of Schedule 1 of Form 1040. A similar reporting procedure is also followed for Schedule E for rental real estate and Schedule F for a farm. Other types of for AGI deductions are merely listed as Adjustments to Income on Schedule 1 of Form 1040. p. I:7-2.

I:7-4 a.

Marilyn may deduct the travel expenses for 2024 including airfare, lodging, and meals for AGI assuming that the trips are necessary and not personal in nature. (Note: The business meal portion of this expense is reduced by 50% for 2024 and future years.) b.

For 2024, reimbursed travel expenses of employees are no longer deductible.

However, since the reimbursements are made pursuant to an accountable plan, Marc will not report the reimbursement as income or the travel expenses as deductions on his return. This socalled “wash” treatment of reimbursements and business expenses is because the employer maintained an accountable plan. c.

Marc may not deduct unreimbursed expenses as a miscellaneous itemized deduction in 2024. Miscellaneous itemized deductions are not deductible for tax years 20182025. d.

Kay may deduct travel expenses for AGI for 2024. pp. I:7-2 through I:7-8.

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I:7-5 Kelly may deduct $850 as a for AGI deduction in 2024. The deduction is computed as follows: Total business meal expenses Minus: lavish and extravagant expenses Balance of meal expenses Reduction of 50% for meals Deductible amount

$2,200 ( 500) $1,700 ( 850) $ 850

For meals to be considered lavish or extravagant is a rare occurrence. It possibly could happen in large cities at very expensive restaurants. This lavish or extravagance rule is more of a weapon of the IRS rather than being self-reported by taxpayers. pp. I:7-4 and I:7-7.

I:7-6 a.

All expenses except personal clothing (e.g., transportation, meals and lodging) are classified as travel expenses and are deductible for AGI in 2024. The meal costs of $1,000 are deductible in 2024, subject to the 50% reduction. Thus, the total deductible amount is $8,500 ($1,000 + 7,000 + 500). The expenses are deductible because her assignment is temporary in nature, i.e., less than one year in duration. b.

Same as a. Latoya could deduct the expenses for the nine-month assignment, as that employment would be considered temporary under Rev. Rul. 93-86. None of her expenses incurred in Ohio after the nine-month assignment would be deductible, as the assignments would be indefinite in nature, per Rev. Rul. 93-86. pp. I:7-4 through I:7-8.

I:7-7 For 2024, the travel expenses related to attending the seminars are not deductible since they are related to the production of income under Sec. 212 rather than a trade or business. Also, the registration fees of $1,000 are not deductible as miscellaneous itemized deductions are no longer deductible. pp. I:7-8 and I:7-9.

I:7-8 For 2024, a self-employed individual can only deduct travel expenses that are incurred while away from home overnight. Her expenses incurred in the city where she lives and works are treated as transportation expenses and are limited in nature. When she is away from home overnight, she can deduct her travel expenses. p. I:7-5.

I:7-9 For 2024, the actual expense method may be used in subsequent years for self-employed individuals. However, MACRS under the regular method may not be used for computing depreciation (straight-line method is required) and the basis of the automobile must be reduced by 30 cents in 2024, 28 cents in 2023, 26 cents in 2022 and 2021, 27 cents in 2020, and 26 cents in 2019. p. I:7-11.

I:7-10 The taxpayer may not switch to the standard mileage rate method. If a taxpayer depreciates an automobile under MACRS or expenses all or part of the automobile under Sec. 179, a change to the standard mileage rate method is not permitted. p. I:7-11.

I:7-11 When a taxpayer mixes business and pleasure on a trip, the tax law requires that the trip be deemed as either primarily business or primarily personal. If the trip is primarily business Copyright © 2025 Pearson Education, Inc.

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(more days spent on business than pleasure), the entire cost of the transportation to and from the destination is deductible. Other expenses, such as hotel and meals, are deductible only on the business days. If the trip is primarily personal, no expenses incurred in traveling to and from the destination are deductible. The other costs (hotel, meals, etc.) are deductible only for the business days. pp. I:7-7 and I:7-8.

I:7-12 Robert may deduct the automobile expenses other than commuting expenses of $2,470 and the business lunches with his customers of $580 (subject to 50% reduction for meals in 2024). He is not allowed any deduction for commuting expenses and lunch by himself. The lunch is not deductible because it is not a travel expense, as he is not away from home overnight.

The lunch is a personal expense. pp. I:7-9 and I:7-10.

I:7-13 Moving expenses are no longer deductible for most taxpayers. The only taxpayers allowed to deduct moving expenses are members of the U.S. Armed Forces on active duty who move pursuant to a military order and incident to a permanent change of station. p. I:7-14.

I:7-14 Self-employed individuals can deduct business automobile expenses under either of two methods: the actual expense method or the mileage method. The actual expense method includes gasoline, oil, repairs, and depreciation for the business-use portion of the automobile. The mileage method allows taxpayers to deduct 67 cents (2024) per business mile. Parking and tolls can be deducted in addition to the amounts computed under both methods. Taxpayers generally must be consistent over the years. pp. I:7-10 through I:7-12.

I:7-15 For tax years 2018-2025, entertainment expenses are not deductible. p. I:7-12.

I:7-16 For tax years 2018-2025, entertainment expenses are not deductible. Expenses related to country club dues are considered entertainment expenses and, therefore, are not deductible.

However, if a self-employed individual pays for a business meal with a customer at a country club, the meal would be deductible. p. I:7-12.

I:7-17 For tax years 2018-2025, entertainment expenses are not deductible. Therefore, the cost of the tickets to the Super Bowl are not deductible. However, since the cost of food and beverages at the event are separately-stated, they will be deductible as a business meal. In this case, Bass may deduct $2,500 (10 tickets times $500 less 50% disallowance). As mentioned above, the cost of the tickets of $20,000 are not deductible. p. I:7-12.

I:7-18 The $2,500 expense incurred for the CPA review course is nondeductible because these expenses were incurred to meet the minimum standards for entry into the profession of accounting. The continuing education expenses are deductible for AGI in the amount of $500 ($1,000 less 50% of meals). The law school expenses of $9,000 are nondeductible because these expenses qualify the taxpayer for a new trade or business. pp. I:7-15 and I:7-16.

I:7-19 a.

Yes, Maggie is entitled to an office-in-home deduction because the office is used exclusively on a regular basis as the principal place of business for a trade or business, and it is used as a place for meeting or dealing with patients, clients, or customers in the normal course of Copyright © 2025 Pearson Education, Inc.

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business. Additionally, her office is the most significant place for the conduct of her business activities. She is self-employed. b.

An office in home qualifies as a taxpayer’s principal place of business if (1) the office is used by the taxpayer for administrative or management activities of the taxpayer’s trade or business, and (2) there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business. Since Bobby does not have an office at another location and he conducts substantially all of his administrative and management activities from his office in his home, he will be able to deduct office in home expenses as a for AGI deduction on Schedule C. pp. I:7-18 through I:7-20.

I:7-20 Employer contributions to a qualified plan are immediately deductible (subject to specific limitations upon annual contribution amounts) and such amounts are not taxable to an employee until the pension payments are received. If an employee contributes to the qualified plan, such amounts may be made on either a pre-tax or after-tax basis. Currently, most employees contribute to qualified plans on a pre-tax basis. Thus, when pension payments are received upon retirement, the amounts received are fully taxable. Under a nonqualified deferred compensation plan (such as a restricted property plan), the employee is taxed upon the FMV of the property contributed at the earliest date when the property is no longer subject to risk of forfeiture or when the property is transferable. The employer receives a corresponding compensation deduction at that time. Clearly, substantial tax benefits are available in qualified plans over nonqualified plans. However, qualified plans must meet highly restrictive rules and, in some situations, may not be permitted. pp. I:7-20 through I:7-26.

I:7-21 In a defined contribution plan, fixed amounts (for example, 5% of each participant's salary) are contributed for each participant to a separate account. The retirement benefits for that participant are based on the value of the participant's account at the time of retirement. Defined benefit plans establish in advance the value of the retirement benefits and a contribution amount is established based on actuarial tables to fund this amount (e.g., 40% of an employee's average salary for the five years prior to retirement). A distinguishing feature of a defined benefit plan is that forfeitures of nonvested amounts (e.g., due to employee resignations) must be used to reduce the employer contributions that would otherwise be made under the plan. In a defined contribution plan, however, the forfeitures may either be reallocated to the other participants in a nondiscriminatory manner or used to reduce future employer contributions. p. I:7-21.

I:7-22 The plan is discriminatory because it favors highly-compensated employees. For 2024, employees who earn more than $155,000 per year are considered highly compensated employees for tax purposes. As a result, the plan should be considered to be a nonqualified plan by the IRS. The employer should not be able to receive the immediate tax deduction for pension contributions. Under a nonqualified plan the employer's deduction is generally deferred until the employee recognizes income from the plan. p. I:7-22.

I:7-23 No, generally employer-provided benefits must be 100% vested after five years of service. Taxpayers are permitted to use an alternative vesting plan that begins vesting after three years and full vesting occurs after seven years. p. I:7-22.

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I:7-24 a. Fully taxable to the employee when the payment is received. b. The taxability of payments received out of a qualified plan depends on whether the employee contributions were made on a pre-tax or after-tax basis. If the employee contributions were made on a pre-tax basis, all amounts received are fully taxable. If the employee contributions were made on an after-tax basis, amounts received are taxed under the Sec. 72 annuity rules. The employee’s contributions are considered the employee’s investment in the contract. Employer contributions are fully taxable when retirement distributions are made to employees. pp. I:7-23 and I:7-24.

I:7-25 Limitations for the year 2024 include: •

Defined contribution plan contributions are limited to the smaller of $69,000 (in 2024) or 100% of the employee's compensation.

Defined benefit plans are restricted to an annual benefit to an employee equal to the greater of $275,000 (2024) or 100% of the participant's average compensation for the highest three years.

An overall maximum annual employer deduction of 25% of compensation paid or accrued to plan participants is placed upon profit sharing and stock bonus plans.

• • p. I:7-24.

I:7-26 Nonqualified deferred compensation plans are particularly well-suited for use in executive compensation arrangements because they are not subject to the same restrictions which are imposed upon qualified plans such as the nondiscrimination and vesting rules. pp. I:7-25 and I:7-26.

I:7-27 Yes, he should consider the Sec. 83(b) election because he will pay a higher tax when the restrictions lapse due to the substantial appreciation. If the employee does not make the Sec. 83(b) election the tax consequences from the stock transfer are deferred for both the employee and the corporation until the lapse of the nontransferability or forfeiture restrictions.

If the election is made, the employee will be taxed on the fair market value of the stock today and the corporation will receive a deduction for the same amount immediately. The maximum 20% capital gain rate may increase the attractiveness of this option because capital gain treatment is accorded upon the eventual sale of the stock, and the adjusted net capital gain tax rate for high-income taxpayers is 20% when taxable income is in excess of $518,900 for 2024 for single taxpayers and $583,750 for married taxpayers filing a joint return. p. I:7-26.

I:7-28 ISO requirements include: • • • •

The option price must be equal to or greater than the FMV of the stock on the option's grant date.

The option must be granted within 10 years of the date the plan is adopted and the employee must exercise the option within 10 years from the grant date.

The option must be exercisable only by the employee and is nontransferable except in the event of death.

The employee cannot own more than 10% of the voting power of the employer corporation's stock immediately prior to the option's grant date.

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•

•

The total FMV of the stock options that become exercisable in any one year to an employee may not exceed $100,000 (e.g., an employee can be granted ISOs to acquire $200,000 of stock in one year provided that no more than $100,000 is exercisable in any one year).

Other procedural requirements must be met (e.g., shareholder approval of the plan, etc.).

If an employee meets the requirements of an ISO, no tax consequences occur on the grant date (except that the excess of the stock’s FMV over the option price is a tax preference item) and LTCG or loss is recognized when the stock is sold. Under a nonqualified stock option arrangement, ordinary income is recognized either on the grant date or on the exercise date (depending upon whether the option has a readily ascertainable FMV). LTCG treatment should favor the ISO for the employee's tax consequences because of the spread between the maximum 20% capital gain rate and the highest rate on ordinary income (i.e., 37%). However, the employer is more favorably treated under the nonqualified stock option rules because the employer receives a tax deduction for the amount of compensation that is recognized by the employee. pp.

I:7-27 through I:7-29.

I:7-29 If a nonqualified stock option has a readily ascertainable FMV on the grant date, the employee recognizes ordinary income on the grant date equal to the difference between FMV and the option price. The employer receives a compensation deduction on the grant date equal to the same amount that is recognized by the employee. In such case, no tax consequences occur on the date the option is exercised and the employee recognizes capital gain or loss upon the sale or disposition of the stock. If a nonqualified stock option has no readily ascertainable FMV, no tax consequences occur on the grant date. On the exercise date, the employee recognizes ordinary income equal to the spread between the FMV and the option price and the employer receives a corresponding compensation deduction. pp. I:7-28 and I:7-29.

I:7-30 Yes, a self-employed individual who is covered by an employer's qualified pension plan is eligible to establish an H.R. 10 or an SEP plan relative to his or her self-employment income. p. I:7-30.

I:7-31 For a defined contribution H.R. 10 plan, a self-employed individual may contribute the lesser of $69,000 or 25% of earned income for 2024 (before the H.R. 10 plan contribution but after the deduction for one-half of self-employment taxes paid) from the self-employment activity. The full-time employees must be covered, as required in the rules for qualified plans. p.

I:7-30.

I:7-32 The essential differences between a traditional IRA and a Roth IRA are, first, amounts contributed to a traditional IRA are tax-deductible in the current year whereas amounts contributed to a Roth IRA are not tax-deductible. However, upon withdrawal of amounts from the IRA at retirement, the withdrawn amounts are fully taxable from a traditional IRA but not taxable from a Roth IRA. Second, Roth IRAs are available to many more taxpayers as the AGI limits are higher for Roth IRAs than for traditional IRAs. pp. I:7-31 through I:7-35.

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I:7-33 Most tax advisors would advise a 30-year old individual to establish a Roth IRA rather than a traditional deductible IRA. The major reason is that even though the contributions to the Roth IRA are nondeductible, the contributions and earnings grow tax-free. And, since the 30year old has nearly 30 years before distributions are eligible to be made, the Roth IRA should experience significant growth and all future distributions are not subject to tax. For an individual who is 55-years old, the answer is not so straightforward because the individual is close to retirement and does not have a long investment horizon. For both individuals, should an emergency occur and the money in the Roth IRA is needed before age 59 ½, contributions (not earnings) generally are permitted to be withdrawn without being subjected to taxation. pp. I:7-31 through I:7-35.

I:7-34 If Charley rolls his traditional IRA into a Roth IRA, he must include the rollover in his gross income and pay income taxes on such amount. The principal benefit of doing the rollover is that when Charley withdraws amounts from his Roth IRA at retirement, no further taxes will be due. While a precise analysis should be performed, since Charley’s marginal tax rate at retirement will be no higher than his present rate and he has the funds outside of his IRA to pay the tax, most analysts conclude that Charley will be better off to do the rollover and pay the tax now. The principal economic benefit is that the rollover funds in the Roth IRA are able to grow tax-free and be ultimately withdrawn tax-free. Thus, in Charley’s case, because he has sufficient outside funds to pay the tax, he should be advised to rollover his traditional IRA into a Roth IRA. Charley is permitted to rollover amounts from his traditional IRA to a Roth IRA. pp. I:7-37 and I:7-38.

I:7-35 While Sally’s AGI of $100,000 is still too high to deduct contributions to a deductible traditional IRA (maximum AGI of $87,000 for 2024 for single taxpayers who are active participants in an employer-sponsored plan), she certainly is eligible to contribute up to $7,000 to a Roth IRA as the Roth IRA AGI limit for 2024 is $146,000 before the phase-out begins. She also is eligible to contribute to a nondeductible IRA, but the Roth IRA is much superior to the nondeductible IRA. pp. I:7-31 through I:7-35.

I:7-36 The Coverdale Education Savings Account (CESA) has several important features, including: (1) the annual contribution into such plans is $2,000, (2) CESAs may be used for elementary and secondary education expenses, and (3) a distribution from a CESA may be excluded even if the Hope credit or lifetime learning credit was claimed in the same year. Of course, the same expenses cannot be used for both the CESA exclusion and one of the two credits. pp. I:7-35 and I:7-36.

I:7-37 a.

A SEP offers small business owners the opportunity to provide retirement benefits for its employees that are comparable with qualified pension and profit sharing plans with reduced administrative compliance costs (i.e., reduced paperwork and need for actuaries and CPA tax specialists in the pension area to assure that the plan qualification requirements are met). b.

A sole proprietor of a small business may establish an SEP for himself rather than using an H.R. 10 plan. p. I:7-31.

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Issue Identification Questions I:7-38 For 2024, the principal issue is whether Georgia is entitled to deduct travel expenses for the 11-month away-from-home time period. To be deductible, she must be away from her tax home. The IRS's position in Rev. Rul. 93-86 is that the initial realistic expectation of a 15-month assignment controls despite the fact that the assignment lasts only 11 months. Therefore, the assignment was for an indefinite period (more than one year) and the expenses are not deductible because her tax home shifts to the new location. pp. I:7-6 and I:7-7.

I:7-39 The primary tax issue is whether the office-in-home qualifies as a deduction under the tax law. To make this determination, the office must meet several tests. First of all, the office must be used exclusively and on a regular basis as the principal place of business for a trade or business. Juan does not meet with patients, so the office must be the principal place of business.

Second, the exclusive use of the office must be for the convenience of the employer. Since Juan is self-employed, he meets this test. Third, an office meets the definition of “principal place of business” if (1) the office is used by the taxpayer for administrative or management activities of the taxpayer’s trade or business, and (2) there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business. pp. I:7-17 through I:7-18.

I:7-40 The major issues that David must address are as follows: 1.

2.

Does the education qualify David for a new trade or business? If so, the education expense would be nondeductible. However, the courts have generally ruled favorably on the deductibility of education expenses incurred to obtain an MBA degree.

Is the education directly connected with David's employment or trade or business?

Since David is not employed, the IRS may attempt to assert that the education expenses are not deductible because the taxpayer does not have a current trade or business. However, some courts have held that education expenses are deductible if the education is deemed to be only a temporary cessation of a business activity.

For 2024, if David’s education expenses are deductible, they would be treated as a deduction for AGI. pp. I:7-15 through I:7-17.

Problems I:7-41 a.

Mike's deduction in 2024 for business-related expenses is computed as follows: Automobile expenses $2,500 Moving expenses—not deductible 0 Entertainment expenses—not deductible 0 Travel (excluding meals) 2,000 Meals ($500 x 50%) 250 Professional dues 500 Total $5,250 Copyright © 2025 Pearson Education, Inc.

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Mike’s AGI and taxable income for 2024 are computed as follows: Interest and dividends $ 12,000 Business income: Gross income $130,000 Deductions for AGI, above 5,250 124,750 AGI 136,750 Qualified Business Income Deduction* (21,510) Standard deduction (greater than itemized deductions) (29,200) Taxable income $86,040 * QBID is lesser of: (1) 20% of QBI = 20% ($130,000 - $5,250) = $24,950; or (2) 20% of TI before QBID = 20% ($136,750 - $29,200) = $21,510. pp. I:7-4 through I:7-14. b.

I:7-42 a.

2024: Travel Business meals ($1,000 x 50%) Transportation Total deductible expenses

$4,000 500 2,000 $6,500

Commuting expenses and entertainment expenses are not deductible. For the local transportation expenses, Monique can compute her deductible expense under either the actual or standard mileage rate method. These methods are covered in this chapter. b.

Each of these items for 2024 is classified as a for AGI deduction because she is self-employed and the expenses are connected with a trade or business. c.

If Monique is an employee, then these employment-related expenses are not deductible because employee business expenses after 2017 are disallowed. pp. I:7-4 and I:7-5, I:7-9 and I:7-10, I:7-13 and I:7-14, I:7-19 and I:7-20.

I:7-43 a.

The total amount of Mary's deductible expenses for 2024 is $2,700.

The deduction is computed as follows: Airfare Taxi (transportation) Meals while traveling ($300 x 50%) Laundry Lodging Business meals ($500 x 50%) Total deductible expenses

$1,500 100 150 50 650 250 $2,700

Entertainment expenses are not allowed, and investment counseling fees and tax return preparation fees were miscellaneous itemized deductions that are no longer allowed after December 31, 2017.

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b.

The deductible expenses in 2024 are classified as deductions for AGI as Mary is self-employed. pp. I:7-4 through I:7-16.

I:7-44 a.

In 2024, since Marilyn is on a temporary assignment of less than one year, her tax home is still considered to be Cleveland and she is “away from home” while in Atlanta. Thus, all of her expenses are considered travel expenses and she can deduct the following expenses: Airfare ($800 + 8,000) Apartment rent Meals ($8,500 x 50%) Total

$ 8,800 10,000 4,250 $23,050

Entertainment expenses are not deductible after 2017. b.

Expenses for 2024 are classified as for AGI as Marilyn is self-employed. c.

The airfare for weekend trips, apartment rent and meals would be personal nondeductible expenses. d.

Only the expenses associated with the first ten months would be deductible in 2024 if the position of the IRS is upheld by the courts. The apartment rent, airfare and meal expenses for the last seven months are not deductible because the move lasts more than one year and is considered indefinite for the extended period. The entertainment is not a travel expense and is still deductible. pp. I:7-4 through I:7-16.

I:7-45 a.

In 2024, Mike may only deduct his expenses that are related to business. The business-related expenses are $825 ($450 + $75 + $300). The airfare of $450 is not prorated because Mike’s trip was primarily for business. The meals for 3 days of $150 are deductible subject to the 50% reduction, and entertainment expenses are not deductible after 2017. The personal expenses of meals (2 days x $50 = $100) and hotel (2 days x $100 = $200) are not deductible. b.

If Mike spent two days on business and three personal days in 2024, the trip generally is considered primarily personal in nature. As a result, none of the airfare is deductible.

Below is a summary of the trip expenses for 2024: Airfare $ 0 Meals ($100 x 50%) 50 Hotel 200 Total $250 pp. I:7-4 through I:7-13.

I:7-46 a. follows:

$16,480 of the business expenses are deductible for 2024 for AGI, computed as 24,000 miles unreimbursed x $0.67 per mile in 2024 Plus: parking and tolls Deductible for AGI Copyright © 2025 Pearson Education, Inc.

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$16,080 + 400 $16,480

b. as follows:

Under the actual cost method, $13,660 is deductible for AGI for 2024, computed Expenses (excluding parking and tolls) Business use

$22,100 x 0.60 $13,260 Parking and tolls 400 Total deduction $13,660 c.

Although taxpayers are permitted to change from one method to another, there are specific requirements that must be met. A change from the mileage method to the actual method must reduce the basis of the automobile by a mileage rate and the straight-line method must be used in subsequent years. A change from the actual method to the mileage method is only permitted if the taxpayer used the straight-line method of depreciation. pp. I:7-9 through I:7-12.

I:7-47 a. $13,232. Under the actual cost method, her deductible expenses for 2023 are computed as follows: Total expenses Business-use percentage (22,400/28,000 miles) Deduction

$16,540 x .80 13,232

b. $15,008. Under the standard mileage method, her deductible expenses for 2024 are computed as follows: Total business-use mileage Business mileage rate (2024) Deduction c.

22,400 x$0.67 $15,008

$22,108 for 2024, computed as follows: Fully-Deductible Expenses $15,008 4,600 1,860

Automobile expenses Airfare Hotel Meals ($720 x 50%) Taxi fees and tips Deduction d.

Meals

360 280 21,748

The deduction would be for AGI.

pp. I:7-12 and I:7-14.

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360

I:7-48 The business meals are deductible in the amount of $2,000 ($4,000 x 50%). None of the other expenses are deductible because they are entertainment expenses and disallowed for years after 2017. pp. I:7-12 through I:7-14.

I:7-49 a.

The tickets and the skybox rental are considered entertainment expenses and not deductible. Since the food and beverages are separately-stated, they would be deductible in the amount of $2,500 ($5,000 x .50). b.

If the food and beverages were not separately-stated, they are considered entertainment expenses and not deductible. Therefore, the entire cost of the tickets and skybox would not be deductible. p. I:7-12.

I:7-50 For 2024, any qualified education expense connected with a trade or business under Reg. Sec. 1.162-5 is deductible as a for AGI deduction. a.

Not deductible, the education qualifies the taxpayer for a new trade or business of law. b.

Yes, deductible as a for AGI deduction. The taxpayer is self-employed and continuing professional education expenses are qualified expenses and tax-deductible. The $200 of meals are subject to the 50% reduction. c.

Yes, deductible as a for AGI deduction. An MBA degree is not considered as qualifying an individual for a new trade or business. d.

Not deductible. Bar review course expenses, like CPA review course expenses, are treated as incurred to meet the minimum educational requirements for qualification in the taxpayer’s trade or business. pp. I:7-15 through I:7-17.

I:7-51 2024: a.

Office-in home expenses must be classified as either direct or indirect expenses.

Calculation of the for AGI deduction is as follows: Direct expenses – painting and window blinds

$1,400

Indirect expenses: Real estate taxes and mortgage interest Real estate taxes Mortgage interest Total Percent of home used for business*

$2,000 5,000 7,000 10% x $700

Other office expenses Insurance Repairs and utilities Depreciation Total Percent of home used for business*

$ 500 1,000 3,500 5,000 10% x $500

$1,200 $2,600 *Only an office used exclusively for business qualifies for the office-in-home deduction. The den is not allowed because it is not used exclusively as the principal place of business.

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Nancy's home office deduction is limited to gross income less regular business expenses and home office expenses. Since her net income before home office expenses was $40,000, no limitation applies in this case. Thus, the full amount of $2,600 is deductible as a for AGI deduction. In addition, $1,800 of real estate taxes ($2,000 - $200) and $4,500 of mortgage interest ($5,000 - $500) are deductible as itemized deductions. The real estate taxes are subject to the overall limitation of $10,000 for taxes as itemized deductions. b.

Yes, because Nancy’s home office expenses exceed the gross income from the business, her deductions are limited. Using the ordering rules under Reg. Sec. 1.280A-2, Nancy’s deductions for 2024 are computed as follows: Gross Income 1. Mortgage interest and real estate taxes

$2,500 ( 700)

2. Home office expenses other than depreciation - $1,400 + [($500 + $1,000) x 10%]

(1,550)

3. Depreciation $350, limited to

( 250) -0-

Thus, Nancy will be allowed $700 of mortgage interest and real estate taxes and $1,800 of the office in home expenses. $100 of depreciation is disallowed because of the income limitation. However, the disallowed expenses may be carried over to next year subject to the income limitation in the later year. pp. I:7-17 through I:7-20.

I:7-52 a. b. c. d. e.

qualified profit sharing plan qualified pension plan qualified pension plan (defined benefit plan) nonqualified plan employee stock ownership plan. pp. I:7-20 through I:7-29.

I:7-53 a.

The entire $12,000 would be taxable to Pat in 2024 because she made the pension contributions on a pre-tax (deferred) basis. A pre-tax or deferred basis means that Pat received a deduction (or a reduction of salary) for the pension contributions over the years. Most employees make their pension contributions on a pre-tax basis. b.

Since the pension contributions were made on an after-tax basis and relates to a qualified retirement plan, the $12,000 pension payments will be taxed under the simplified method for qualified retirement plan annuities. (For a discussion of the simplified method, see Chapter I:3.) An after-tax basis means that Pat did not deduct any pension contributions over the years. The taxation of the $12,000 is determined as follows: Investment in contract: $30,000 Number of anticipated payments: 260 Exclusion amount per month: $30,000/260 months = $115.38 per month Exclusion amount for the year: $115.38 x 12 months = $1,384.56 Includible amount for the year: Amount received $12,000.00 Excluded amount ( 1,384.56) Copyright © 2025 Pearson Education, Inc.

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Includible amount

$10,615.44

c.

Pat’s final return in 2025 will include $10,615.44 of income from the pension payments and an itemized deduction for the unrecovered investment in the contract of $27,230.88 [$30,000 – (24 months x $115.38)]. pp. I:7-23 and I:7-24.

I:7-54 a.

The tax consequences from the stock transfer are deferred for both employee Patrick and Bear Corporation until the lapse of the nontransferability and forfeiture restrictions in year 2029. Thus, Patrick recognizes no compensation income on the receipt of the stock in 2024, and Bear receives no deduction. b.

Patrick would recognize $1,000 (100 shares x $10) of ordinary income subject to tax in 2024. Bear Corporation receives a $1,000 deduction in 2024. c.

1. No effect to Patrick despite the fact that he was previously taxed. Bear must include $1,000 in gross income because it received tax benefit due to the prior deduction.

2. No tax effect if no Sec. 83(b) election was made. d.

1. There is no tax effect if a Sec. 83(b) election was made.

2. Patrick reports income of $10,000 and Bear receives a $10,000 deduction (100 shares x $100). e.

1. $120/share x 100 shares = $12,000 - $1,000 basis = $11,000 LTCG for Patrick.

No effect to Bear.

2. $120/share x 100 shares = $12,000 - $10,000 basis = $2,000 LTCG for Patrick.

No effect to Bear. pp. I:7-27 through I:7-29.

I:7-55 a.

Jamal may deduct $2,800 of the contribution for tax year 2024, as the contribution was made by the due date for the 2024 income tax return (April 15, 2025). The $77,000 ceiling is exceeded by $6,000 so 60% ($6,000/$10,000) of the contribution is not deductible. Alternatively, Jamal could elect to treat the IRA contribution as made for 2025. Since Jamal’s AGI is only $70,000 in 2025 and the income for 2025 is less than the 2024 limit, he would be eligible to deduct the full $7,000 in 2025. (2025 limitation almost certainly will not decrease.) b.

The deduction is for AGI. c.

Jamal is allowed to deduct $7,000 in either year because the special income limitations in part (a) do not apply if taxpayer is not an active participant in a qualified plan. d. $7,000 would then be deductible since their AGI does not exceed the $123,000 (2024) married joint return limit. Since Jamal has at least $14,000 of earned income, Jamal is eligible to put $7,000 into his IRA and his spouse is eligible to put $7,000 into a spousal IRA. Thus, Jamal and his spouse can contribute and deduct a total of $14,000 into IRAs during 2024. pp. I:7-31 through I:7-33.

I:7-56 a.

The full $14,000, $7,000 each. Phil’s spouse can put $7,000 into a traditional IRA as a spousal IRA even though her earned income is only $4,000. The rule is the earned income of the couple. The special income limitations do not apply because Phil is not an active participant of an employer-sponsored retirement plan. b.

2024 because the contribution is made on or before the due date of the 2024 return, i.e., April 15, 2025. c.

For AGI d.

No change since their joint AGI does not exceed $123,000 (2024).

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e.

Yes, nondeductible contributions to an IRA are permitted to the extent that an individual is ineligible to make deductible contributions. However, total IRA deductions (to all types of IRAs, traditional deductible and nondeductible, and both IRAs) may not exceed $7,000. f.

Phil’s spouse is eligible to make a $7,000 contribution to an IRA for the tax year 2024. Even though Phil is covered under an employer-sponsored plan, since their AGI is less than $230,000, Phil’s spouse may contribute and deduct $7,000 to a traditional IRA. Phil is not eligible to contribute and deduct any amount to an IRA because he is an active participant in a qualified plan and their AGI is greater than $143,000. pp. I:7-31 through I:7-33.

I:7-57 a.

Chatham Mae is eligible to contribute $5,133 into a Roth IRA. She is not eligible to contribute and deduct amounts to a traditional IRA because her income exceeds $87,000. Since her AGI exceeds $146,000 (2024), she is limited as to how much she can put into a Roth IRA, as follows: Limitation reduction: $7,000 x ($150,000 - $146,000)/$15,000 = $1,867 Contribution ceiling amount: $7,000 ceiling - $1,867 = $5,133 If Chatham Mae elects to not put any money into a Roth IRA, she can contribute $7,000 to a nondeductible traditional IRA. Finally, if she contributes $5,133 to a Roth IRA, she also is permitted to put $1,867 into a nondeductible traditional IRA. Taxpayers are allowed to put a combined maximum of $7,000 into all IRAs. b.

The $25,000 distribution to pay off her car loan is not a qualified distribution because Chatham Mae is not yet age 59½ and does not meet any of the other requirements.

However, under the special ordering rules for nonqualified distributions, Chatham Mae may first withdraw $20,000 tax-free, to the extent of her contribution to the Roth IRA. The additional $5,000 is includible in her gross income and also subject to the 10% withdrawal penalty ($5,000 x 10% = $500). Alternatively, if the $25,000 was used for first-time homebuyer expenses, the first $10,000 is treated as a qualified distribution and, therefore, not taxable. The remaining $15,000 is treated as being made from contributions, first and therefore, nontaxable. c.

Chatham Mae is eligible to rollover her traditional IRA to a Roth IRA. She must include the entire rollover amount of $50,000 in her gross income in the year of the rollover. pp.

I:7-33 through I:7-35.

I:7-58 a.

Since Jack and Katie’s AGI exceeds $190,000, the annual $2,000 amount that can be contributed to the CEA accounts must be reduced as follows: $2,000 x ($196,000 - $190,000)/$30,000 = $400 Thus, the maximum that can be contributed to each of the grandchildren ages 10, 12, 15, and 16 is ($2,000 - $400) = $1,600. No contribution may be made for the 19-year old, as she is over 17 years old.

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b.

The granddaughter may exclude $5,500 of the $7,000 distribution, as these are qualified education expenses. However, the excess $1,500 is includible in the granddaughter’s income in 2024 and she is also subject to a 10% penalty, or $150. pp. I:7-35 and I:7-36.

I:7-59 a.

Paula must provide comparable coverage for her nurse who is an eligible full-time employee. For example, if she contributes 25% of her earned income, a comparable benefit rate must be contributed based upon the salary payments to the nurse. b.

For AGI. The maximum deductible amount is the lesser of 25% of compensation or $69,000 for 2024. However, if Paula elects the maximum 25% rate, she must reduce the percentage for her contribution. Paula’s rate would be 20% (0.25/1.0 + 0.25). Thus, her maximum contribution in 2024 would be $40,000 ($200,000 x 0.20). c.

Yes, because she is a full-time employee. In addition, she must contribute 25% of the nurse’s earned income. d.

If the contributions were deductible then they are taxable when the funds are withdrawn and a nondeductible 10% penalty tax is imposed upon the amounts withdrawn unless one of the exceptions provided in Sec. 72(t) applies such as death, or disability of the taxpayer. p. I:7-30.

I:7-60 a.

January 1, 2024: No effect since no tax consequences occur on the grant of an incentive stock option.

April 1, 2026: No effect except for a $200 [($100 - $80) x 10 shares] tax preference item for purposes of the alternative minimum tax.

May 1, 2028: $400 long term capital gain is recognized by Peggy, computed as follows: Sale price Minus: Basis LTCG

$ 1,200 ($120 x 10 shares) ( 800) ($80 x 10 shares) $ 400

Peggy is entitled to long-term capital gain treatment, since both of the requirements for incentive stock options were met. Bell Corporation does not receive a corresponding compensation deduction. b.

Since Peggy did not hold the stock the required holding period, she would recognize $200 ordinary income on the sale date equal to the spread between the option price and the exercise price [($100 - $80) x 10 shares = $200] ordinary income on May 1, 2026. Bell Corporation is permitted a $200 deduction for compensation on May 1, 2026, because the option is treated as a nonqualified stock option. On the sale date Peggy also recognizes a STCG of $300 [$1,300 - ($100 x 10 shares)]. pp. I:7-27 and I:7-28.

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I:7-61 a.

January 1, 2024: Penny recognizes ordinary income of $20,000 [($100 - $80) x 1,000 shares] on the grant date equal to the difference between FMV and option price as the stock options have a readily ascertainable fair market value. Bender Corporation receives a compensation deduction of $20,000.

January 1, 2025: There is no tax effect on the exercise date.

January 1, 2027: Penny recognizes long-term capital gain of $100,000 computed as follows: Selling price ($200 x 1,000 shares) Minus: Basis ($100 x 1,000 shares) LTCG recognized by Penny

$200,000 (100,000) $100,000

No tax effect to Bender Corporation. b.

January 1, 2024: There are no tax consequences on the grant date.

January 1, 2025: Penny recognizes ordinary income of $70,000 [($150 - $80) x 1,000 shares]. Bender Corporation receives a compensation deduction of $70,000.

January 1, 2027: Penny recognizes long-term capital gain of $50,000 computed as follows: Selling price ($200 x 1,000 shares) Minus: Basis ($80 x 1,000 shares) + $70,000 ordinary income reported LTCG recognized by Penny

$200,000 (150,000) $ 50,000

pp. I:7-28 and I:7-29.

Comprehensive Problem I:7-62 Dan and Cheryl’s taxable income tax liability for 2024 is determined below.

Wages and salaries – Cheryl Interest Dividends, qualified Dan’s business income: Commissions earned Deductions: Auto mileage (32,000 miles x $0.67) Parking and tolls Tax preparation fees allocation Travel expenses Office-in-home expense Net short-term capital loss

$ 65,400 1,450 5,950 $125,000 21,440 280 250 4,860 (1) 900 (2)

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(27,730)

97,270 (3,000) (3)

Self-employed health insurance Self-employment tax deduction ($13,812 x 50%) Adjusted gross income (AGI) Itemized deductions: Medical expenses Minus: 7.5% of AGI

(4,400) (6,872) (4) $155,798

$ 470 (11,685)

Taxes: Real estate taxes Personal property taxes State income taxes ($1,800 + 2,200)

6,800 1,400 4,000 12,200

Mortgage interest Charitable contributions

-0-

10,000 (5) 7,400 17,000

Total itemized deductions

(34,400)

Qualified business income deductions (6)

(17,200)

Taxable income

104,198

Income tax liability Income taxes paid: withheld estimated income tax payments Overpayment – refund to Dan and Cheryl

26,358 (7) 9,000 20,000

(29,000) (2,642)

Notes: (1) Travel expenses: $4,200 + 410 + 100 + 150 = $4,860 (meals reduced by 50%) (2) Office-in-home expense: 180 sq. ft. x $5 = $900 (simplified method) (3) $6,100 net STCL; deduction limited to $3,000 per year. Excess is carried over.

(4) Self-employment tax deduction: $13,744 x 50% = $6,872 (5) Limited to $10,000 (6) QBI deduction: ($97,270 – 6,872 – 4,400) x 20% = $17,200 (7) Taxable income $104,198 Less: qualified dividends ( 5,950) $ 98,248 Tax per 2024 rate schedule on $98,248 $11,721 Tax on dividends ($5,950 x 0.15) 893 Self-employment tax ($97,270 x .9235 x .153) 13,744 Total tax liability for 2024 $26,358 (8) Cheryl’s nursing expenses and the personal portion of the tax preparation fee would be miscellaneous itemized deductions that are not deductible for tax years 2018–2025.

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Tax Strategy and Critical Thinking Problem I:7-63 a.

Yes, assuming that Laura is a bona fide employee of Lightmore Communications, her travel expenses would be deductible. Since the facts state that Laura’s presence would be helpful to Paul and the corporation, it would appear that making Laura an employee would be accepted by the IRS. To establish her employment status, she would probably need to be assigned other duties with the business other than just traveling. b.

If Laura is an employee of the business, she would be entitled to all of the benefits that are available to other employees, including retirement plan, group life insurance, health insurance, etc. Thus, there are certainly more benefits than just travel expenses in having Laura be an employee of the business. c.

The major detriment is that Laura’s salary with the business would be subject to income taxes (stacked on top of her husband’s income) and payroll taxes (Social Security and Medicare). The benefits above would certainly need to be greater than the additional taxes to make this a viable planning option. p. I:7-8.

Tax Form/Return Preparation Problem I:7-64 (See Instructor’s Resource Manual)

Case Study Problems I:7-65 The following points should be stressed in the client memo: 1.

2.

3.

4.

5.

6.

Ajax needs to expand its equity base because of its high debt/equity ratio and needs for growth.

Management philosophy favors employee stock ownership for employees and executives.

Conditions are favorable to offer compensation arrangements involving qualified and nonqualified plan arrangements because the company's stock is publicly traded.

A Sec. 401(k) and or an ESOP plan should be considered for employees as a supplement to the existing qualified pension plan because current pension benefits are minimal. An ESOP offers attractive cash flow advantages to the company.

A nonqualified plan such as a restricted property arrangement involving Ajax stock is needed to attract, motivate, and retain key executives. A nonqualified plan may discriminate in favor of key executives.

An incentive stock option plan should be considered for employees and/or executives as a means to raising additional equity capital. An ISO results in deferral of immediate taxation to employees and eventual capital gain treatment although Ajax receives no direct tax benefit unless a nonqualified stock option plan is adopted.

I:7-66 Contained in the new standards of the AICPA's Statements on Standards for Tax Services (SSTS) is Statement No. 4, which explains that a CPA can use taxpayers' estimates if it is Copyright © 2025 Pearson Education, Inc.

I:7-19

impractical to obtain exact data and the estimated amounts are reasonable under the facts and circumstances known to the CPA. However, certain expenses must be evidenced by proper documentation. Travel and entertainment expenses must, under Sec. 274(d), be substantiated by adequate documentation by the taxpayer as prescribed in that section. The CPA cannot use estimates for these amounts.

The client letter should explain to the taxpayer that a deduction cannot be allowed for the travel and entertainment expenses incurred unless proper documentation has been made under the requirements of Sec. 274(d) of the Internal Revenue Code. Documentation should include an expense book or diary containing the time, place, business purpose, and proof of the amount.

Tax Research Problem I:7-67 The primary issue in this case is whether Charley is “away from home”. If Charley is considered away from home, his travel expenses would be deductible. The IRS and the courts have struggled with this type of situation in several previous cases. In Williams v. Patterson, 286 F.2d 333 (CA-5, 1961), the court established the “sleep or rest” rule which suggests that a trip long enough to require interruption for rest was equivalent to being away overnight.

Due to the discrepancies in applying the “sleep or rest” rule, the Supreme Court granted certiorari in U.S. vs. Correll, 389 U.S. 299 (1967), where the Court ruled unfavorably for the taxpayer in a situation where a traveling salesman pulled his car over to the side of the road and slept for several hours during trips. Soon after the Correll decision, the Treasury Department issued Rev. Rul. 75-168, 1974 C.B. 58, which addressed trips of less than 24 hours. According to the ruling, travel expenses may be deductible for trips of less than 24 hours if it was reasonable for the taxpayer to require sleep or rest.

In this case, the result is not absolutely clear. It appears that Charley Long used his judgment to determine whether he needed sleep or rest. It seems fairly clear that he should be able to deduct his food and lodging on the nights he stayed in a motel. However, on the nights he slept in his cab, the Correll case may be unfavorable to Charley’s position.

“What Would You Do In This Situation?” Solution Ch. I:7, p. I:7-13.

Joe Windsack is clearly committing an act of tax fraud by claiming fictitious deductions.

You as a CPA have the ethical responsibility to inform Windsack that the excess deductions are not allowable and must not be claimed on his return. Under the Statement on Standards for Tax Services #6, you cannot associate yourself with a tax return (by signing the return as tax preparer) if you know that an error exists on the return. If he objects to this treatment, you must withdraw from this client engagement and not prepare his return for the taxable year.

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Chapter I:8 Itemized Deductions Discussion Questions I:8-1 a.

A taxpayer may deduct medical expenses incurred on behalf of the taxpayer, the taxpayer's spouse, the taxpayer's dependents, and the taxpayer’s children. The taxpayer may also deduct medical expenses paid for an individual who would otherwise qualify as a dependent except for the fact that the gross income test is not met, even though the taxpayer may not take an exemption for the individual. b.

No. Medical expenses incurred by the divorced parents of a child are deductible by whichever parent incurs the expenses, even though the parent incurring the expenses is not entitled to the dependency exemption for the child. p. I:8-2. c.

The taxpayer who is the subject of a multiple support agreement is treated as the dependent of the taxpayer who is entitled to take the dependency exemption. Since a taxpayer may deduct medical expenses (subject to the 7.5% of AGI limit) incurred for a dependent, the taxpayer entitled to the dependency exemption under the multiple support agreement should be the one who pays the medical expenses.

I:8-2 Medical care is defined as amounts paid for: 1.

2.

3.

4.

5.

The diagnosis, cure, mitigation, treatment, or prevention of disease.

The purpose of affecting any structure or function of the body. (Medical expenses incurred for cosmetic surgery are not deductible).

Transportation primarily for and essential to the first two items listed above.

Long-term care services for the chronically ill. Chronically ill generally is defined as the loss of certain daily living activities such as eating, toileting, bathing, dressing, and continence.

Insurance covering all of the items above. However, the deductibility of longterm care insurance premiums is subject to a dollar ceiling based on age. pp. I:8-2 through I:8-6.

I:8-3 a.

The Internal Revenue Code defines cosmetic surgery as any procedure that is directed at improving the patient's appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease. b.

In general, the cost of cosmetic surgery is not deductible unless it is necessary to ameliorate a deformity arising from or directly related to, a congenital abnormality, a personal injury resulting from an accident or trauma, or a disfiguring disease. p. I:8-4.

I:8-4 a.

In 2024, the IRS allows a deduction of 22 cents for each mile driven for medical reasons in addition to the cost of tolls and parking. Taxpayers may also deduct 50% of the cost of meals and $50 per night for lodging while en route to a medical facility as part of deductible Copyright © 2025 Pearson Education, Inc.

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travel costs incurred for medical purposes. If a person is unable to travel alone, the taxpayer may deduct an additional $50 per night for the lodging cost of a nurse, parent or spouse. b.

If the trip for medical purposes is long enough to warrant the deductibility of meals, the meals are still subject to the 50% limit. Additionally, the lodging costs are limited to $50 per person, per night. However, the cost of meals on trips too short to warrant a stop for meals is not deductible. pp. I:8-4 and I:8-5.

I:8-5 Generally the cost of meals is not deductible for an individual receiving treatment as an outpatient while away from home. The cost of lodging for an outpatient is deductible if (1) the travel is undertaken primarily for medical care, (2) the medical care is provided by a physician in a licensed hospital (or a facility that is related or equivalent to a licensed hospital), and (3) there is no significant element of personal pleasure or recreation. Furthermore, the deduction for lodging is limited to $50 per night, per person. These rules also apply to a nurse, parent, or spouse if the sick or injured individual is unable to be alone. The cost of lodging subject to the $50 limit and 50% of the cost of meals received by an individual as an inpatient are considered part of the treatment received and are, therefore, deductible as medical expenses. p. I:8-4.

I:8-6 a.

Capital expenditures qualify for a current deduction if incurred as a medical necessity for primary use by the taxpayer, taxpayer's spouse, or dependents in need of medical treatment. There are three types of capital expenditures that qualify for a deduction.

1.

2.

3.

Expenditures that relate only to the sick person and not to the permanent improvement of the taxpayer's property. These include expenditures for items such as wheelchairs, eyeglasses, etc.

Expenditures that permanently improve the taxpayer's property as well as provide medical care.

Expenditures incurred in removing physical barriers in the home of a physically handicapped individual.

b.

Capital expenditures in the first and third categories are fully deductible.

However, capital expenditures in the second category are deductible only to the extent the expenditure exceeds the increase in fair market value of the residence. p. I:8-5.

I:8-7 The cost of the trip most likely would not be deductible because of the personal enjoyment factor. Because Bill's doctor recommended the trip specifically as treatment for his ulcer, an argument could be made to deduct the cost of the trip as treatment for a specific ailment. Before taking such a position, however, the taxpayer and his/her tax return preparer should evaluate whether or not the position has a “reasonable” or “more likely than not” chance of winning upon audit. pp. I:8-3 and I:8-4.

I:8-8 If the premiums cover more than just health care or long-term care for the chronically ill, (i.e. coverage for loss of income or life) and the cost of the separate items are not identified as a component of the total premium, then none of the premiums are deductible. p. I:8-6.

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I:8-9 Medical expenses that exceed 7.5% are deductible from AGI, if the sum of this excess and all other deductions from AGI exceeds the standard deduction. A deduction can be taken in the year that the care is paid for; although, if the care is prepaid, the amount is deductible only after the services are performed unless the prepayment is required by the provider of the services or there is a legal obligation to pay. Furthermore, under certain conditions, the prepayment of certain long-term care treatments may also be deductible when paid. pp. I:8-6 and I:8-7.

I:8-10 a.

The following taxes are specifically identified as deductible under Sec. 164: • • • • • • •

State, local, and foreign real property taxes State and local personal property taxes if the tax is ad valorem State, local, and foreign income, war profits, and excess profits tax State and local sales taxes if the taxpayer makes an election to deduct them instead of state and local income taxes.

The federal generation-skipping transfer tax on income distributions Other state, local, and foreign taxes, which are paid or incurred in either a trade or business or an income-producing activity.

One-half of the self-employment taxes imposed on a self-employed individual.

The aggregate amount of taxes to be deducted cannot exceed $10,000 ($5,000 for married filing separately). b.

Certain taxes not specifically listed in Sec. 164 are still deductible as ordinary and necessary expenses if incurred in the taxpayer's business or income-producing activity. Taxes paid in connection with the acquisition of property (such as a sales tax) are treated as part of the cost of the property and are capitalized accordingly. pp. I:8-9 and I:8-10.

I:8-11 Cash method taxpayers deduct all state taxes in the year paid or withheld. A refund of state taxes must be included in gross income in the year of the refund to the extent a tax benefit was received in the year the deduction was taken. p. I:8-10.

I:8-12 An ad valorem tax is a tax determined by the value of the property being taxed. A personal property tax that is not an ad valorem tax is still deductible as an ordinary business expense if the property is used in a trade or business. If the tax is not an ad valorem tax and the property is not used in a trade or business or income-producing activity, the tax imposed is on personal property and is not deductible. p. I:8-10.

I:8-13 When real estate is sold during a year, the real estate taxes on the property must be apportioned between the buyer and seller in order to properly determine the amount of gain or loss to the seller and the basis of the property in the hands of the buyer as well as the amount of deduction for the property tax that the seller and buyer each may deduct. The seller of real estate is treated as having paid the proportionate share of the real estate taxes up to the date of the sale and the allocation of the taxes is generally properly accounted for at the closing, regardless of who actually pays the tax. If the closing agreement does not allocate and account for the real estate taxes and the seller does not actually pay his or her share of the taxes, the selling price of Copyright © 2025 Pearson Education, Inc.

I:8-3

the property will increase by the amount of the tax and the buyer's basis will increase by the same amount. If the closing agreement does not allocate and account for the real estate taxes and the buyer does not actually pay his or her share of the taxes, the selling price will be decreased by the amount of the tax and the buyer's basis will decrease by the same amount. p. I:8-11.

I:8-14 a.

For tax purposes, interest expense of an individual is divided into the following categories: personal interest, active trade or business interest, passive activity interest, investment interest, qualified residence interest, and student loan interest. In general, the classification of interest is determined by the use of the borrowed money, not the nature of the property used to secure the loan. b.

Personal interest is not deductible. Active trade or business interest is deductible as a for AGI deduction on Schedule C. Passive activity interest is deductible against passive income and is deductible either for or from AGI, depending on the activity in which the interest is incurred. For example, interest incurred in a passive rental activity is a deduction for AGI. Investment interest is deductible as a from AGI deduction, up to the amount of the taxpayer’s net investment income for the year. Qualified residence interest is deductible as a from AGI deduction on Schedule A. Student loan interest is a for AGI deduction. pp. I:8-12 through I:820.

I:8-15 A point is equal to one percent of the loan amount. Points may represent an additional interest expense, or a service charge. If the points represent additional interest, they are deductible as interest. Points that represent a service fee are amortized and deducted only if incurred in a business or for investment. pp. I:8-17 and I:8-18.

I:8-16 Points representing prepaid interest on a loan are deductible in the year that they are paid if the loan is obtained to purchase or improve the taxpayer's principal residence. If not, the points must be capitalized and amortized over the period to which the interest relates. pp. I:8-17 and I:8-18.

I:8-17 Section 267 requires related cash-method lenders and accrual-method borrowers to report the results of the transactions in the same year. The restrictions imposed by Sec. 267 serve to prevent a related accrual-method taxpayer from taking a deduction in a year earlier than the year in which the related cash-method taxpayer reports the income. p. I:8-20.

I:8-18 a.

The deduction for investment interest expense is limited to the taxpayer's net investment income for the year. b.

Net investment income is the excess of investment income over deductible investment expenses (excluding the investment interest expense) that are directly connected with the production of investment income. Beginning in 2018, the deduction for investment expenses was disallowed for individuals. Investment income is gross income from property held for investment including items such as dividends, interest, annuities, and royalties (if not earned in a trade or business). Investment income also includes net gain (all gains minus all losses) on the sale of investment property, but only to the extent the net gain exceeds the net capital gain (net long-term gains in excess of net short-term losses) on such property. Thus, a net short-term capital gain is included. If the taxpayer elects to subject them to the regular tax rates, net capital gains (net long-term gains in excess of short-term losses) are included in the definition to the Copyright © 2025 Pearson Education, Inc.

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extent the taxpayer elects to subject them to the regular tax rates. Gains on business or personaluse property are not included in the calculation of investment income. c.

Disallowed investment interest expense may be carried over and deducted in a subsequent year. The carryover amount is treated as paid or accrued in the subsequent year and is subject to the disallowance rules that pertain to the subsequent year. pp. I:8-15 and I:8-16.

I:8-19 Acquisition indebtedness is debt that is secured by the taxpayer's residence and is incurred in acquiring, constructing, or substantially improving the qualified residence of the taxpayer. For debt incurred on December 15, 2017 or later, acquisition indebtedness is limited to $750,000. Acquisition debt incurred prior to that date is limited to $1,000,000. Home equity indebtedness is any debt (other than acquisition indebtedness) that is secured by the taxpayer's qualified residence. Beginning in 2018, the interest on home equity indebtedness is not deductible unless the proceeds are used for home improvements, in which case it is treated as part of the acquisition debt. pp. I:8-17 and I:8-18.

I:8-20 For any taxable year, a taxpayer may have two qualified residences: (1) the taxpayer's principal residence, and (2) one other residence selected by the taxpayer which the taxpayer personally uses more than the greater of (1) 14 days or (2) 10% of the rental days during the year. If the residence has not been rented by the taxpayer during the year, it may be selected by the taxpayer as the second residence with respect to which qualified residence interest may be deducted even though the taxpayer does not meet the 14-day or 10% test. p. I:8-18.

I:8-21 The interest is disallowed as a deduction because the taxpayer would realize a double tax benefit if allowed to have the proceeds from the tax-exempt securities not taxed and also deduct the interest for the debt to purchase or hold the tax-exempt securities. If the interest was allowed to be deducted, a taxpayer could, under certain circumstances borrow money at a higher rate of interest than the rate at which it is invested, while still generating a positive net cash flow. p. I:814.

I:8-22 The cash method taxpayer normally deducts the interest expense in the year paid.

Prepaid interest relating to a period that extends beyond the end of the tax year must be capitalized and amortized over the life of the loan. If points paid on a loan incurred to purchase or substantially improve the taxpayer's principal residence represent prepaid interest, the deduction can be taken in the year paid.

If a new loan with a third party is entered into to pay an existing loan, the amount of the payment which represents interest is deductible in the year paid. If the funds used to pay the first loan are borrowed from the same party and the purpose of the second loan is to pay the interest on the first loan, no interest deduction is available.

A cash-method taxpayer may deduct interest on a discounted note when the note is repaid. Personal interest, however, is not deductible. pp. I:8-19 and I:8-20.

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I:8-5

I:8-23 a.

Capital gain property is property held over one year upon which a long-term capital gain would be recognized if it were sold at its FMV on the date of contribution. If a capital loss or a short-term capital gain would be recognized, the property is considered ordinary income property for purposes of the charitable contribution deduction. Ordinary income property also includes property that would result in the recognition of ordinary income if the property were sold. b.

It is important to make the distinction between capital gain property and ordinary income property because of the different rules that apply in determining the amount of the charitable contribution deduction. If capital gain property is donated to a public charity, generally the amount of the contribution is its FMV except for special rules relating to tangible personal property. Ordinary income property contributed to a public charity generally results in a contribution amount equal to the FMV less the gain that would have been recognized if the property had been sold. pp. I:8-22 and I:8-23.

I:8-24 In general, the amount of the charitable contribution of capital gain property donated to a private nonoperating foundation is equal to the FMV of the property reduced by the gain that would be recognized if the property were sold at its FMV. In the case of capital gain property donated to a public charity, the charitable contribution is equal to the FMV of the property. In this case, the limit on the charitable deduction is 30% of AGI. An individual may, however, elect to have the amount of the contribution become the property's FMV reduced by the gain that would be recognized. In this case, the limit is increased to 50% of AGI. If tangible personal property (not realty) is donated to a public charity and is used by the charity for purposes unrelated to the charity’s purposes, or if the property consists of certain intangibles, the amount of the contribution equals the property’s FMV reduced by the gain which would have been realized if the property had been sold. Special rules apply to certain types of inventory donated by a corporation. pp. I:8-22 and I:8-23.

I:8-25 The taxpayer cannot take the charitable contribution as an itemized deduction. In 2024, a married taxpayer filing a joint return is allowed the greater of the standard deduction of $29,200 or itemized deductions. In this situation, the itemized deductions total only $7,000 and the taxpayer would use the standard deduction. p. I:8-2.

I:8-26 The overall deduction limitation on charitable contributions for individuals is 60% of the taxpayer's AGI for the year (50% of AGI for property). The limitation for corporations is 10% of taxable income computed without regard to the dividends received deduction, the charitable contribution deduction, or any NOL or capital loss carrybacks. pp. I:8-24 and I:8-25.

I:8-27 Charitable contributions that exceed the deduction limitation may be carried over and deducted in the subsequent five years. The carryovers are still subject to the limitations that apply in the subsequent years. pp. I:8-25 and I:8-26.

I:8-28 Charitable contribution deductions are reported on Schedule A of the individual's tax return. If contributions of property exceed $500, Form 8283 must also be submitted. This form requires information about the type, location, holding period, basis, and FMV of the property.

Additionally, if contributions of $250 are made, no deduction is allowed unless the taxpayer obtains and retains a contemporaneous, written acknowledgment by the donee organization.

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I:8-6

This acknowledgement must include whether or not the organization provided any goods or services in consideration for the cash or property received, including a description and good faith estimate of the value of any goods or services provided by the organization.

Separate payments generally are treated as separate contributions for purposes of applying the $250 threshold. Charitable contributions made in cash after August 17, 2006 are not deductible unless the donor can show a cancelled check or credit card statement or has a written statement from a charity verifying the contribution. pp. I:8-32 through I:8-34.

I:8-29 The purpose of the qualified business income deduction was to decrease the differences in tax rates paid by sole proprietorships and pass-through entities when the tax rate for corporations was decreased to a flat 21% tax rate beginning in 2018. The top individual tax rate is currently 37%, which if a full qualified business income deduction is allowed would reduce the tax rate to [0.37 – (0.37 x 0.2)] = 29.6% which is higher than the 21% tax rate imposed on corporations. It is important to consider, however that the income distributed from a corporation is also taxed when distributed.

Issue Identification Questions I:8-30 The primary tax issue is how Wayne and Maria can maximize their medical expense deductions by engaging in tax planning. A secondary issue is whether the proposed medical services (e.g., the orthodontic work) may be deducted despite the fact that the services may be performed, in part, in a subsequent year. Because of the 7.5% of AGI limitation, it is preferable to "bunch" the medical expenses into one year. pp. I:8-29 and I:8-30.

I:8-31 The primary tax issue is whether Chuck can use the current interest expense incurred on his investment property to offset current year ordinary income. Chuck will not have income from his investment in the land for at least five years and when Chuck recognizes the capital gain it will be taxed at either 15% or 20%, depending upon Chuck’s taxable income in that year.

Without any restriction or limitation, he can currently deduct the interest against his ordinary income, which is taxed in the current year at his marginal tax rate (likely 24%). Thus, Chuck should take into consideration the amount of his current year net investment income in order to determine the amount of the current investment interest expense he can deduct. p. I:8-14.

I:8-32 The primary tax issue is whether the contribution is made to a qualified charitable organization. The payments to a political candidate indicate that the organization may not qualify. If the contribution is qualified, George needs to consider contribution limits and the character of the contribution (i.e., LTCG or ordinary income property). p. I:8-22.

I:8-33 The primary tax issue is whether the charitable contribution limits (i.e., 30% of AGI for contributions of LTCG property) will apply and whether an election should be made to reduce the amount of the contribution to the property's basis so that the 50% limit is applied. A secondary issue is the application of the contribution carryover rules and their effect upon the deductibility of contributions in the current year. pp. I:8-24 and I:8-25.

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I:8-7

Problems I:8-34 Angela’s 2024 taxable income is $42,900, computed as follows: AGI Less itemized deductions: Medical*: Doctor bills $11,700 Hospital bills 10,400 Health premiums 600 Total $22,700 Less: Reimbursement ( 10,000) Less: 7.5% AGI ( 4,350) Deductible medical expenses $ 8,350 Mortgage interest** 6,750 Total itemized deductions $15,100 Compare to standard deduction 14,600 Deduction (itemized deduction > standard deduction) Taxable income

$58,000

(15,100) $42,900

*The legal fees do not meet the definition of medical expenses in Sec. 213 of the IRC. **The car loan interest is considered to be personal interest and not deductible. pp. I:8-3 through I:8-6.

I:8-35 Angela must include $500 in her 2025 income because of the reimbursement. In the calculation, Angela must compute the amount of tax benefit from the medical expense deduction for the prior year. She must compare the actual taxable income for 2024 with what the 2024 taxable income would have been if the $4,000 additional reimbursement for her medical expenses had been received in 2024.

AGI Less itemized deductions: Medical: Doctor bills Hospital bills Health premiums Total Less: Reimbursement ($10,000 + $4,000) Less: 7.5% AGI Deductible medical expenses Mortgage interest Total itemized deductions Compare to standard deduction Deduction Taxable income Actual 2024 taxable income

$58,000 $11,700 9,400 600 $21,700 ( 14,000) ( 4,350) $ 3,350 6,750 $10,100 14,600 (14,600) $43,400 $43,900

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I:8-8

Tax benefit $ 500 Thus, Angela must include $500 in her gross income in 2025 because of the reimbursement. The reimbursement for the legal fees is not income to Angela because she did not originally deduct the legal fees when they were expended in 2022. p. I:8-7.

I:8-36 Dan can deduct $1,418 as medical expenses.

Mileage (12 trips x 400 miles x 0. 22 per mile) Lodging (12 trips x $85 per night limited to $50 per night) Meals ($100 en route x 0.50) Dan's qualified medical expense for the year

$1,056 600 50* $1,706

* Note that the IRS's position is that the meals en route are not deductible but the Tax Court and the Sixth Circuit Court of Appeals have ruled that the meals are deductible. p. I:8-4.

I:8-37 Chad’s deductible medical expenses are $3,400.

Orthodontic work for Sara Broken leg for Brett Health insurance premium for Chad, Brett, Sara (not deductible) Prescription drugs for Chad Doctor bills for Chad Minus: 7.5% of $40,000 AGI Medical expense deduction

$3,000 2,000 0* 400 1,000 $6,400 (3,000) $3,400

* Health insurance premiums paid on a pre-tax basis have already been deducted for tax purposes from Chad’s salary. pp. I:8-3 through I:8-6.

I:8-38 a. Charla’s 2024 taxable income is $19,420, computed as follows: AGI Less itemized deductions: Medical: Hospital bills $14,000 Excess cost of pool over increased value of home ($25,000 - $22,000) 3,000 Maintenance of pool 930 Medical premiums 1,200 Wheelchair 2,300 Total expenses $21,430 Less: 7.5% AGI ( 2,850) $18,580 Compare to standard deduction 14,600 Total deduction Net taxable income Copyright © 2025 Pearson Education, Inc.

I:8-9

$38,000

( 18,580) $19,420

b. In 2025, Charla must include the $5,630 reimbursement in her taxable income to the extent that it provided tax benefit in 2024.

Total AGI Less itemized deductions: Medical expenses Less: Reimbursement Less: 7.5% of AGI Total medical Compare to standard deduction Total deductions Net Taxable income

Amount Reported In 2024 $38,000

Amount if Reimbursement Were Received in 2024 $38,000

$21,430 --( 2,850) $18,580 13,850

$21,430 ( 9,000) ( 2,850) $ 9,580 14,600 (18,580) $19,420

(14,600) $23,400

Increase in taxable income from reimbursement ($23,400 – 19,420) = $3,980 (included in income in 2025).

In 2025, Charla’s AGI is $46,980 ($43,000 + $3,980) and her medical expense deduction is $6,536, computed as follows: Fees paid to physical therapist Hospital bed Medical premiums Pool maintenance Total Expenses Minus: 7.5% AGI Qualified medical expense deduction in 2025:

$ 4,000 3,800 1,200 1,060 $10,060 ( 3,524) $ 6,536

Because the medical expenses are her only itemized deduction, Charla would take the standard deduction instead. pp. I:8-3 through I:8-6.

I:8-39 a.

In 2023, Joyce may deduct $1,720 in state income tax, the $120 she paid with her 2022 state tax return and the $1,600 withheld from her paychecks during 2023. b.

In 2024, Joyce may deduct $2,300 in state income tax, the $200 she paid with her 2023 state tax return and the $2,100 withheld from her paychecks during 2024. c.

Joyce’s taxable income for 2024 is $35,200, computed as follows: AGI Less itemized deductions: State tax deduction Mortgage interest Total itemized deductions Compare to standard deduction Deduction for 2023 Taxable income

$51,000 $2,300 13,500 15,800 14,600 ( 15,800) $35,200

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I:8-10

pp. I:8-9 through I:8-12.

I:8-40 a.

Dawn’s available deduction for her taxes is $2,927, computed as follows: State income taxes $2,000 Ad valorem property tax on the car ($20,000 x 0.02) 400 Dawn’s portion of the house property taxes (104/365 x $1,850) 527 Total $2,927 However, if Dawn does not have additional itemized deductions, she will take the standard deduction of $14,600. b.

Dawn will report this deduction on Form 1040 Schedule A, if she itemizes her deductions. pp. I:8-9 through I:8-11.

I:8-41 July 1 of the prior year through April 30 of the current year equals 304 days. Thus, $4,997 ($6,000 x 304/365) of the taxes are apportioned to Tara, even though Janet (the buyer) pays the full $6,000 in property taxes on September 1. The remainder of the taxes of $1,003 ($6,000 - $4,997) are apportioned to Janet. a.

Janet may deduct $1,003 in the current year. b.

Tara may deduct $4,997 in the current year. c.

The total selling price of the building and the cost basis to Janet (the buyer) is $504,997 ($500,000 + $4,997). This increase in the selling price occurs because (1) no apportionment of the real property taxes is made in the sales agreement in order to withhold the $4,997 in property taxes that are apportioned to Tara, and (2) Janet is the one who pays all $6,000 of the property taxes (including the $4,997 that is apportioned to Tara). Thus, in essence, Janet is actually paying $4,997 more for the building. p. I:8-10.

I:8-42 Scott's interest expense for the year is classified as follows: Jan. 1 - Mar. 31

100%

investment interest

Apr. 1 - Jun. 30

93.75% 6.25%

passive interest ($75,000/$80,000) investment interest ($5,000/$80,000)

Jul. 1 - Nov. 30

93.75% 6.25%

passive interest personal interest

Dec. 1 - Dec. 31

100%

passive interest

pp. I:8-12 through I:8-14.

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I:8-11

I:8-43 Travis’ taxable income for the current year is $139,400, computed as follows: AGI before investments Long-term capital gains Short-term capital gains Dividends Interest Income AGI

$130,000 8,600 7,300 10,000 2,100 $158,000

Less itemized deductions: Qualified Residence Interest

$7,800

Investment Interest expense: ($30,000/40,000 x $3,200) Possible limitation: Net Investment Inc. ($7,300 + 2,100) Invest. Interest exp. Deduction (lesser amount)

$2,400

9,400

State Income Taxes Total Itemized deductions

2,400 8,400 (18,600)

Taxable Income

$139,400

*Because the long-term capital gains and the dividends are subject to the 15% preferential tax rate, Travis should not make the election to include them as investment income in calculating the deduction limit for investment interest expense. Thus, Travis has $9,400 of investment income ($7,300 short-term capital gains and $2,100 of interest income). As the investment expenses of $8,000 are not deductible in 2024, they are not considered when calculating net investment income. Travis’ net investment income is greater than his investment interest expense of $2,400, so the deduction for the investment interest expense is not limited. pp. I:8-14 and I:8-15.

I:8-44 Tina may deduct interest on a total indebtedness of $750,000, based on the following: Tina is limited to interest expense deductions on a total of $750,000 acquisition indebtedness incurred on December 15, 2017, or thereafter. Thus, Tina may deduct interest paid on the $700,000 acquisition debt secured by the principal residence, and $50,000 of the acquisition debt secured by the condominium. pp. I:8-16 through I:8-18.

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I:8-12

I:8-45 Susie

Jeremy

Brett 45%

55%

40%

Crown

60% BJ

a.

Crown can deduct the entire interest accrued because it and BJ Partnership are not related parties. The same person does not own over 50% of both the partnership and corporation. b.

Crown cannot deduct any of the interest in the current year. If Jeremy were Brett’s brother, Brett would constructively own 100% of BJ Partnership. Thus, Brett would own over 50% of both Crown Corp. and BJ Partnership. Crown Corp. could only deduct the interest in the period in which BJ Partnership would recognize the interest income, which would be the next year. p. I:8-20.

I:8-46 a.

Henry can deduct $900 of interest in the current year. Since Henry is a cash method taxpayer, he must deduct the interest expense as the loan is repaid. Thus, the total amount of the interest expense of $1,800 ($12,000 - $10,200) is deductible as the loan is repaid.

Four payments are to be made. Henry makes two payments in the current year (on July 1 and October 1). Thus, $900 (0.50 x $1,800) of the interest expense is deductible in the current year. b.

Henry can’t deduct any of the interest in the current year. Since none of the loan is repaid during the current year, none of the interest is deductible during the current year. It will all be deductible by Henry when the loan is paid off in subsequent years. c.

Henry can deduct $1,350 of interest in the current year. Since Henry is an accrual method taxpayer, he may deduct the interest as it accrues. The loan is to be outstanding for one year. Three-fourths of the loan period occurs during the current year. Thus, $1,350 (0.75 x $1,800) of the interest expense is deductible during the current year. p. I:8-19.

I:8-47 Doug’s 2024 taxable income is $20,400, computed as follows: AGI Itemized Deductions: Medical expenses Minus: 7.5% of AGI State income taxes Local property taxes Charitable contributions Total itemized deductions Minus: Greater of itemized deductions ($7,300) or standard deduction ($14,600) Taxable income

$35,000 $ 800 (2,625)

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I:8-13

$

-02,300 3,000 2,000 $7,300 (14,600) $20,400

I:8-48 a.

James’ 2024 taxable income is $43,375, computed as follows:

Income: Salary Interest Net capital gain ($23,000 - $15,000) AGI

$70,000 7,000 8,000 $85,000

Deductions: Medical Minus: ($85,000 x 0.075) Taxes: Lesser of: a. $7,000 + $4,000 b. $10,000 Qualified residence interest Investment interest (limited to net investment income of $15,000*) Charitable contributions

$ 8,000 ( 6,375)

$ 1,625

10,000 12,000 15,000 3,000

Total itemized deductions

($41,625)

Taxable income

$43,375

*$7,000 interest + $8,000 net capital gain. b.

James can carry over $1,000 of excess investment interest expense. James’ excess investment interest expense of $1,000 ($16,000 - $15,000) is carried over to the next year. pp. I:8-2 through I:8-30.

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I:8-14

I:8-49 James’ 2024 taxable income is $113,000, computed as follows: Income: Salary Interest Net capital gain ($23,000 - $15,000) AGI

$130,000 7,000 8,000 $145,000

Deductions: Medical Minus: 7.5% AGI ($145,000 x 0.075) Taxes: Lesser of: a. ($7,000 + $4,000) b. $10,000 Qualified residence Investment interest (limited to net investment income of $7,000 Charitable contributions

$ 8,000 ( 10,875)

$

-0-

10,000 12,000 7,000* 3,000

Total itemized deductions

(32,000)

Taxable income

$ 113,000

*The net LTCG is not included in investment income.

The excess investment interest of $9,000 ($16,000 - $7,000) is carried over to next year. pp. I:82 through I:8-34.

I:8-50 Donna’s charitable contribution deduction for the year is $800. When services are rendered to a qualified charitable organization only the unreimbursed expenses incurred while performing the services are deductible. p. I:8-24.

I:8-51 a.

The charitable contribution is $40,000, subject to a limitation of 30% of AGI. b.

The charitable contribution is $10,000, subject to a limitation of 50% of AGI. c.

The charitable contribution is $100,000, subject to a limitation of 30% of AGI. d.

The charitable contribution is $50,000, subject to a limitation of 50% of AGI. e.

The charitable contribution is $500, subject to a limitation of 50% of AGI. pp. I:8-24 and I:8-25.

I:8-52 a.

The charitable contribution is $10,000 limited to the lesser of (1) 20% of the taxpayer's AGI or (2) 30% of AGI, reduced by any contributions of capital gain property donated to a public charity. b.

The charitable contribution is still $10,000 subject to a limitation of 30% of AGI. c.

The charitable contribution is $50,000 limited to the lesser of (1) 20% of AGI or (2) 30% of AGI, reduced by capital gain property donated to a public charity.

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I:8-15

d.

Same as (c) above. e.

The charitable contribution is $500 limited to 30% of AGI. pp. I:8-22 through I:8-25.

I:8-53 The maximum charitable contribution deduction Helen can take for this year is $40,000.

Under the regular rules, the charitable contribution is $50,000, subject to an overall 30% of AGI limit. Therefore, the charitable contribution would be $30,000 (0.30 x $100,000 AGI). Helen would have a $20,000 carryover of excess contributions under the general rule. If she elects to reduce the amount of the contribution by the long-term capital gain, the charitable contribution is $40,000 [$50,000 - ($50,000 - $40,000)] subject to an overall 50% of AGI limit. The amount of the charitable contribution deduction would be $40,000 for this year (50% of AGI limit is $50,000). If the election is made, there will be no carryover of unused contributions since all of the contribution is deductible in the current year. pp. I:8-24 and I:8-25.

I:8-54 If the current year is 2024, the $30,000 contribution is cash, and Melissa elects to have the 100% limit apply for her qualified cash contributions, her charitable contributions deduction is determined as follows: a.

b.

Contribution to private nonoperating foundation Contribution to Middle State University [limited to (100% x $200,000) - $60,000] Charitable contributions deduction

$60,000*

Contribution to private nonoperating foundation Contribution to Middle State University [limited to (100% x $200,000) - $60,000] Charitable contributions deduction

$60,000*

$30,000 $90,000

$45,000 $105,000

*The deduction for the $65,000 contribution to the private nonoperating foundation is limited to the lesser of: (a) $60,000 (30% x $200,000 AGI) (b) $100,000 (50% x $200,000 AGI minus $0 of contributions subject to 50% limit) See IRS Publication 526 (2020, pp. 16–17) for a detailed discussion of the charitable contribution deduction’s determination when multiple percentage limitations apply. pp. I:8-24 and I:8-25.

I:8-55 Circle’s total charitable contribution deduction is $575,000.

Because Circle (1) manufactured the computer and the computer is included in Circle’s inventory, (2) the computer is donated to a higher education institution that will use the computer for research, and (3) City College certifies that it will use the computer in its research, Circle can deduct the computer’s basis plus ½ of the gain it would have recognized if it had sold the computer (not to exceed twice the computer’s basis). Thus, a.

Circle's contribution for the current year is as follows: Copyright © 2025 Pearson Education, Inc.

I:8-16

Donation of main-frame Donation of stock Total charitable contribution

$475,000 ($650,000 - [$350,000 x 0.50]) 100,000 $575,000

b.

Circle may deduct $400,000 ($4,000,000 x 0.10) and $175,000 may be carried forward for five years. p. I:8-24.

I:8-56

Amount of deduction Amount of carryover from 2024 from 2025

2024

2025

2026

2027

$30,000

$36,000

$34,800

$13,200

10,000

10,000 3,000

200 3,000

-0-0-

pp. I:8-25 and I:8-26.

I:8-57 Liam’s taxable income is calculated as follows (ignoring the deduction for one-half of self-employment tax): Share of partnership ordinary income $200,000 Share of partnership long-term capital gain $7,500 Minus short-term capital loss (6,000) Net capital gain 1,500 Minus: Standard deduction (29,200) QBI Deduction (34,160) Taxable Income $138,140 QBI deduction lesser of: 200,000 x 0.2 = $40,000 OR (200,000 – 29,200) x 0.2 = 34,160 1:8-58 I. Deduction for the general limit ($2,800,000 x 50% ownership x 20%) = $280,000 II. Deduction limitation limited to greater of: (a) $900,000 x 50% interest x 50% = $225,000 (b) ($1,600,000 x 50% x 2.5%) + ($900,000 x 50% x 25%) = $132,500 Greater of (a) or (b) = $225,000 Allowable Section 199A deduction (lesser of I or II) =

$225,000

1:8-59 a. Marilyn’s consulting income $115,000 * Qualified business income deduction percentage 20% = Qualified business income deduction $23,000.

Earned income, $115,000 + Capital gain, $20,000 – Standard deduction, $14,600 = Taxable income $120,400.

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I:8-17

Taxable income $120,400** - Capital gain, $20,000 = Excess of taxable income over net capital gain, $100,400.

Limit: $100,400 * 20% = 20% of excess taxable income over net capital gain, $20,000. b. Their joint income will be greater than the income limit of $383,900 and as her business income is from consulting, she will not be allowed any QBI deduction.

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I:8-18

Comprehensive Problem I:8-60 The Nelsons’ taxable income for 2024 is $96,577, computed as follows: Wages ($150,000 + 3,888) $153,888 Capital Gains/Losses: Cabinets, Inc. The Outdoor Corporation

( 2,700) 3,900 1,200 $155,088

Total AGI Less itemized deductions: Medical expenses Reduced by 7.5% AGI

$ 4,900 ( 11,632)

State income taxes Withheld from Tim Withheld from Monica Paid with 2021 return

8,500 85 250

-0-

$ 8,835 Charitable contribution FMV donated asset Limited to 30% AGI Allowed deduction

$ 96,000 $ 46,526 $46,526

Mortgage interest Paid on original loan Paid on loan to improve home

$2,300 $ 850

$3,150

($58,511) Net taxable income

$ 96,577

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I:8-19

Tax Strategy and Critical Thinking Problems I:8-61 If the stock is donated directly, the contribution deduction would be the $30,000 FMV of the stock. The tax benefit would be $10,500 (0.35 x $30,000), for a net positive cash flow of $10,500. If the stock is sold and the $30,000 proceeds are donated, the following would result: Selling price Minus: Basis Gain Times: rate Increase in taxes

$30,000 10,000 $20,000 x 0.15 $ 3,000

Contribution deduction Times: rate Tax savings

$ 30,000 x 0.35 $ 10,500

Net tax benefit $10,500 - $3,000 = $7,500 The direct contribution would result in positive cash flow of $10,500. If the stock is sold and the proceeds are donated to the college, the positive cash flow is only $7,500. This is due to the fact that Dean must report the gain on the sale of the stock in his income tax return. pp. I:831 and I:8-32.

I:8-62 Rebecca should donate part of the Sycamore stock to charity. If she donates the Redwood stock, she would only be allowed to deduct the adjusted basis, $4,900, in the stock because she held the stock for less than one year. She should not donate the Oak stock because she would permanently lose the tax benefit of a capital loss.

Corporation Sycamore Oak Redwood

FMV on Dec. 1 9,600 2,900 5,400

Adjusted Basis 7,800 3,800 4,900

Date Purchased 5/22/16 9/10/17 6/15/21

Unrealized Gain/Loss 1,800 ( 900) 500

Character LTCG LTCL STCG

Rebecca should also consider bunching her donations into one year. Her present habit of making an annual $5,000 donation provides no tax benefit in the form of a deduction because the standard deduction for a single individual is greater than $5,000. If she combines three donations in one year, the $15,000 total would exceed the standard deduction for the year of donation and provide tax savings. p. I:8-32.

Tax Form/Return Preparation Problems I:8-63 (See Instructor’s Resource Manual) I:8-64 (See Instructor’s Resource Manual)

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Case Study Problems I:8-65 Mr. Brian Brown 100 East Rosebrook Mesa, Arizona 85203 Dear Mr. Brown: Pursuant to your request, we have determined the tax consequences of your donation of land to the Rosepark Community College. As we understand them, the facts are as follows: 1.

Your estimated adjusted gross income for the current year is $100,000. Since you plan on retiring next year, you anticipate that your adjusted gross income will be $35,000 for all future years.

2.

For federal income tax purposes, you file a joint return with your wife.

3.

You purchased the land 14 months ago for $50,000. The land's current appraised value is $58,000.

4.

Selling the land and donating the cash is not an alternative.

5.

You do not anticipate making any additional large charitable contributions in the future.

6.

You feel that an appropriate discount rate is 10%.

Because the results of our analysis are based upon these facts as we understand them, if the facts are not as stated, please notify us immediately.

In general, the amount of a contribution of long-term capital property is the fair market value of the property. Thus, under the general rule, the amount of your contribution is $58,000. However, such deductions are subject to an annual limitation of 30% of your adjusted gross income. Any excess is carried over and deducted in subsequent years.

If you choose this general rule, your discounted tax savings are as follows (assuming the current year is 2024): Year

Deduction Limited: 30% AGI

2024 2025 2026 2027 Total

$30,000 10,500 10,500 7,000 $58,000

x

Marginal Tax Rate 0.22 0.12* 0.12* 0.12*

x

Discount 1.00 0.91 0.83 0.75

=

Savings $ 6,600 1,147 1,046 630 $ 9,423

*Depending on other itemized deductions, this rate could be 10%. You may receive no benefit if your itemized deductions do not exceed the $29,200 standard deduction.

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Alternatively, you may make an election to reduce the amount of the contribution from the property's fair market value to your cost in the property. If you make the election, the amount of your contribution would be reduced from $58,000 to $50,000. However, if this election is made, the annual limitation increases to 50% of your adjusted gross income.

If you choose this alternative, your discounted tax savings are as follows (assuming the current year is 2024):

Year

Deduction Limited: 50% AGI x

2024

$50,000

Marginal Tax Rate x .22

Discount = Savings 1.00

$11,000

By making the election, your discounted tax savings are $1,577 higher than if you were to use the general rule. Thus, our recommendation is that you make the election.

We will be happy to help you make this election, as well as help you in any other tax matter or question you may have. If you have any questions, please feel free to call.

Sincerely, pp. I:8-32 and I:8-33.

I:8-66 You know that an accrual-method corporation can take a charitable contribution in the year the contribution is pledged as long as the amount is actually paid within two and one-half months from the end of the tax year.

The circumstances, however, indicate that the pledge probably was not actually authorized until after the year's end, thus, requiring the deduction to be taken in the subsequent year. Statement on Standards for Tax Services (SSTS) No. 3, states: In preparing or signing a return, a member may in good faith rely, without verification, on information furnished by the taxpayer or by third parties.

However, a member should not ignore the implications of information furnished and should make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to a member. (Emphasis added.)

This is a difficult situation. You don't want to offend or possibly lose a valuable client. At the same time, however, you recognize your ethical obligations and responsibilities. One possible action you could take is to request a conference with Bill in order to explain your position. In this conference, you could outline the risks (penalties) to both him and you that taking such a position would create. You might also do some forecasting of next year's income in order to demonstrate that the difference between taking the deduction this year or next is merely the Copyright © 2025 Pearson Education, Inc.

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difference in the present values of the tax savings (next year's being discounted only one year).

At a constant 0.35 tax rate and a discount rate of 10%, the present value of next year's tax savings is $6,365 ($20,000 x 0.35 x 0.909) while trying to rationalize taking the deduction this year would result in present value savings of $7,000 ($20,000 x 0.35). Thus, the difference amounts to only $637 ($7,000 - $6,363).

If Bill continues to insist on taking the deduction this year, and if you know that the authorization for the pledge was backdated, you should resign from the engagement. p. I:8-26.

Tax Research Problems I:8-67 A taxpayer can deduct ordinary business expenditures, but cannot deduct personal interest (§162,163(h)(1)). Personal interest includes interest paid on “underpayments of individual Federal, State, or local income taxes” (Reg. §1.163-9T(b)(2)(i)(A)). Such an underpayment does not constitute a business expense, even when the “income underlying the deficiency originates from the taxpayer’s business” (Kikalos v. Comm., 84 AFTR 2d 99-5933).

Thus, Mr. Hancock’s $18,000 interest payment is non-deductible personal interest, even though the interest related to his business as a lawyer.

I:8-68 The total amount of medical expenses that Smith may claim in the current year is 0 ([$1,800 + $500] - [$60,000 X 0.075]). The $500 spent for pool maintenance and the $1,800 of other medical expenses qualify as medical expenses, but they do not exceed the 7.5% of AGI floor. The $8,000 (the increase in the value of the home due to the pool) does not qualify as a medical expense.

The Regulations under Sec. 213 state that a capital expenditure for a permanent improvement or betterment of property may "qualify as a medical expense to the extent that the expenditure exceeds the increase in the value of the related property, if the particular expenditure is related directly to medical care" [Reg. Sec. 1.213-1(e)(1)(iii)]. In other words, a deduction is allowed for capital expenditures only if the taxpayer pays more than the increase in FMV. In the case at hand, it must be determined if Smith paid more than the FMV of the property.

In P.A. Lerew [1982 PH T.C. Memo ¶82,483, 44 TCM 918] and J.H. Robbins [1982 PH T.C. Memo ¶82,565, 44 TCM 1254], the taxpayers were denied medical deductions for existing pools in homes they had purchased. The courts held that the actual price paid for the home and pool (assuming an arm's length transaction) should be exactly equal to its FMV. Based on these and other discussions and the income tax regulations, it appears that Mr. Smith may deduct the $12,000 ($20,000 - $8,000) only if he can show that he paid $12,000 more than the increase in the FMV of the property.

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“What Would You Do In This Situation?” Solution Ch. I:8, p. I:8-35.

According to the AICPA SSTS and Treasury Department Circular 230, you should only take a position on the return, which has a reasonable possibility of being sustained on its merits if it is challenged administratively or judicially. This is particularly true on so-called "hot-button" issues like charitable donations of goods, which are subject to intense scrutiny by the IRS because of widespread valuation abuses in the past. Furthermore, under current law, a taxpayer can only take a deduction for clothing and household items that are in “good” condition.

Assuming these items are considered in good condition, several valuation and compliance procedures must be met in order for you to qualify Mr. and Mrs. Nice's donations to Goodwill as a charitable deduction on their tax return. First you must show that the donee is a qualified organization.

Second, you must identify the type of property donated and how it is to be used by the qualified organization. Here the reasonable assumption is that Goodwill will resell the goods in one of its thrift stores in the U.S. Your clients’ records already indicate the listing of goods contributed, original purchase prices, and condition of the goods at the time of contribution made in the current tax year. Because the total original cost basis in the goods was approximately $15,000, you will most likely use Form 8283 in conjunction with Mr. and Mrs. Nice's Schedule A on their joint 1040 return.

The real issue, which remains, is valuation. Most accountants use a rule of thumb, which says to claim ten percent of the original value of the items being donated. But does this rule best serve your client's interest? And would it be ethical to claim a higher value? According to the IRS publication 561 Determining the Value of Donated Property, certain guidelines may be used. First, if the total value of the donation claim is over $5,000, an independent outside appraisal will be required to be submitted with the return. In addition, comparable sales may be used to find out what the donated goods will sell for in the Goodwill Thrift Shops. For example, the average price of jeans sold is $7 while bridal gowns sell for $25. In addition, you might consult valuation guides such as Cash for Your Used Clothing, by William R. Lewis or other valuation texts.

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Chapter I:9 Losses and Bad Debts Discussion Questions I:9-1 The closed transaction doctrine states that a realized loss must be evidenced by a completed transaction or identifiable event. This doctrine exists to prevent taxpayers from recognizing a loss as a result of fluctuating prices prior to the disposition of the property. This is, of course, different from the economic concept for realized loss. p. I:9-2.

I:9-2 The amount of the deductible loss when property is disposed depends on (1) the type of property, (2) the manner in which the taxpayer uses the property, (3) the basis in the property, (4) the amount realized upon disposition, and (5) the way the property is disposed. pp. I:9-2 and I:93.

I:9-3 In order to deduct a loss on worthless securities, the taxpayer must first establish when the security actually became worthless. The deduction is only available in the year the security becomes worthless. Once this is determined, Sec. 165(g) provides that the loss incurred is treated as a loss from the sale of a capital asset on the last day of the taxable year. Because of the limitations imposed on the deductibility of capital losses, this may severely restrict the current tax benefit to the taxpayer. Under certain circumstances, if a domestic corporation holds worthless securities in an affiliated corporation, the loss to the domestic corporation is treated as having arisen from a sale of a noncapital asset. This makes the loss an ordinary loss. In order for this exception to apply, two requirements must be met: (1) the domestic corporation must own at least 80% of the voting power of all classes of the affiliated corporation's stock and 80% of the total value of the stock, and (2) more than 90% of the affiliated corporation's gross receipts for all its taxable years must be from nonpassive income. pp. I:9-3 and I:9-4.

I:9-4 If the worthless securities consist of securities of an affiliated corporation held by a domestic corporation, the loss is treated as an ordinary loss rather than a capital loss. For this exception to apply the domestic corporation must own at least 80% of the voting power of all classes of the affiliated corporation's stock and 80% of the total value of the stock. Additionally, more than 90% of the affiliated corporation's gross receipts for all its taxable years must be from nonpassive income. (i.e., sources other than dividends, interest royalties, rents, annuities, and gains from the sale or exchange of stock and securities.) pp. I:9-3 and I:9-4.

I:9-5 To have a capital loss, (1) there must be a sale or exchange and (2) the transaction must involve a capital asset. For example, the loss from the destruction of a capital asset is an ordinary loss and not a capital loss because there has not been a sale or exchange. Furthermore, a loss on the sale of inventory is ordinary because inventory is not a capital asset. pp. I:9-4 and I:9-5.

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I:9-6 In order for stock to be considered Sec. 1244 stock, the following requirements must be met: 1.

2.

3.

4.

5.

6.

The stock must be owned by an individual or a partnership.

The stock must have been originally issued to the individual or to a partnership in which the individual is a partner.

The stock must be stock in a domestic corporation.

The stock must have been issued in exchange for cash or property other than stock or securities.

The corporation may not have derived over 50% of its gross receipts from passive income sources (i.e., sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges of stock and securities) during the immediately preceding five taxable years.

At the time the stock is issued, the amount of money and property contributed to both capital and paid-in surplus may not exceed $1 million. p. I:9-5.

I:9-7 Losses on the sale or worthlessness of Sec. 1244 stock are deductible as ordinary losses up to a maximum of $50,000 per taxable year ($100,000 for married taxpayers filing a joint return). Any excess loss for the year is a capital loss. Gains on the sale of Sec. 1244 stock are capital gains. p. I:9-5.

I:9-8 Under Sec. 267, a loss on the sale of investment property between an individual and a controlled partnership or corporation (the individual owns more than 50% of the partnership or corporation) is disallowed. The individual and the controlled entity are deemed to be related parties, and therefore, the loss is disallowed. If the loss were not disallowed, the individual would be able to create a tax loss and still retain economic control of the property. The same reasoning applies to the wash sale provisions under Sec. 1091, where losses on the sale of stock or securities are disallowed if the taxpayer purchases substantially identical stock or securities within 30 days before or 30 days after the sale. Furthermore, under Sec. 351, a loss realized on property transferred to a controlled corporation in exchange for stock or securities of the corporation is deferred. Pursuant to the like-kind exchange rules of Sec. 1031, losses realized on exchanges of like-kind property are also deferred. p. I:9-6.

I:9-9 a.

A passive activity is any trade or business in which the taxpayer does not materially participate. A passive activity also includes any rental activity that is not a trade or business. b.

Individuals, estates, trusts, closely held C corporations, personal service corporations, and certain publicly traded partnerships, are subject to the passive loss limitation rules. The purpose of the passive loss rules is to prevent certain taxpayers from offsetting their portfolio and active income with losses generated in passive activities. pp. I:9-10 through I:9-12.

I:9-10 a.

A closely held C corporation is a C corporation where more than 50% of the stock is owned by five or fewer individuals at any time during the last half of the corporation's taxable year. b.

A closely held C corporation may offset its passive losses against its active business income but not its portfolio income. Individuals and personal service corporations may not offset either their active or portfolio income with passive losses. pp. I:9-12 through I:9-14.

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I:9-11 A taxpayer's material participation in an activity is determined separately for each activity. Furthermore, suspended losses are deductible only upon the complete disposition of the passive activity. Also, the rental losses allowed under the special real estate exceptions must not be mixed in with losses from other types of passive activities. For these reasons, it is critical to identify exactly what constitutes an activity. pp. I:9-10 and I:9-11.

I:9-12 a.

Under the Regulations, different business operations may constitute one or more activities, depending upon all the pertinent facts and circumstances. The facts that are given more weight in this determination include: • • • • •

Similarities and differences in the types of business The extent of common control The extent of common ownership The geographical location, and Any interdependencies between the operations (i.e., the extent to which they purchase or sell goods between themselves, have the same customers, are accounted for with a single set of books, etc.).

Generally, taxpayers have a good deal of flexibility in identifying how operations are to be combined into activities based on these facts. However, once this determination is made, taxpayers must be consistent from year to year. b.

In general, a business operation and a rental operation cannot be combined into the same activity for purposes of the passive activity loss rules. However, if the business operation and the rental operation are situated at the same location and the business operation is insubstantial in comparison to the rental operation, or vice versa, the two may be combined into one activity. The Regulations do not define what constitutes insubstantial. p. I:9-10.

I:9-13 a.

No. The rental unit qualifies as a real property trade or business with respect to Laura. This is the case because she meets the following requirements: 1.

The rental unit is Laura's only business and she spends over 750 hours during the year managing and caring for the rental unit.

2.

Because Laura is the sole manager of the unit, she meets the material participation requirement.

3.

More than 50% of Laura's personal services for the year is spent in this real estate business. b.

Yes. The lab is a passive activity with respect to Kami. A business activity is passive with respect to a taxpayer if the taxpayer does not materially participate in the activity.

In order to materially participate, the taxpayer must meet one of several tests: 1.

The individual participates in the activity for more than 500 hours during the year.

2.

The individual's participation in the activity for the year constitutes substantially all of the participation in the activity by all individuals, including individuals who do not own any interest in the activity.

3.

The individual participates in the activity for more than 100 hours during the year, and that participation is more than any other individual's participation for the year.

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4.

Under the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.

The only test Kami possibly could meet is the fourth one. However, her participation is probably not continuous and substantial. Since Kami does not meet any of these tests, she does not materially participate, and the activity is passive. c.

There is a possibility that under the Regulations, the three operations (the lab, the medical supply company, and the medical services partnership) could be combined into one activity. If this is the case, Kami will have materially participated (over 500 hours) in the activity and the activity would not be passive with respect to her. If the three operations are treated as separate activities, she probably does not materially participate in any of them, based upon the tests mentioned in part b above. However, since she has participated over 100 hours in each of them, they are considered "significant participation" activities. Taxpayers can aggregate participation in these significant participation activities for purposes of determining material participation. This aggregation causes her participation to exceed the 500 hour test. Thus, none of the activities is passive with respect to Kami. pp. I:9-11 through I:9-14.

I:9-14 A taxpayer materially participates in an activity if he or she meets one of the following tests.

1.

The individual participates in the activity for more than 500 hours during the year.

2.

The individual's participation in the activity for the year constitutes substantially all of the participation in the activity by all individuals, including individuals who do not own any interest in the activity.

3.

The individual participates in the activity for more than 100 hours during the year, and that participation is not less than any other individual's participation for the year (including participation by individuals who do not own any interest in the activity).

4.

The individual participates in "significant participation activities" for an aggregate of more than 500 hours during the year. A significant participation activity is one in which the taxpayer participates for more than 100 hours during the year but which does not meet the material participation test alone. An individual who spends over 100 hours each in several separate significant participation activities may aggregate the time spent in these activities in order to meet the 500 hour test.

5.

The individual has materially participated in the activity in any five years during the immediately preceding ten taxable years. These five years need not be consecutive.

6.

The individual materially participated in the activity for any three years preceding the year in question, and the activity is a personal service activity.

7.

Taking into account all the relevant facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.

Active participation, on the other hand, is a less strict test. The taxpayer does not need to be involved on a regular or continuous basis. However, he or she still must be involved in management decisions or in the arranging for others to provide services. The active participation test is used in the case of rental real estate activities. pp. I:9-11 and I:9-14.

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I:9-15 a.

Individual taxpayers who have actively participated in the rental of real estate may deduct losses from that passive activity of up to $25,000 against their active and portfolio income. However, this deduction is reduced by 50% of the taxpayer's AGI in excess of $100,000. Thus, the requirements are (1) the taxpayer must be an individual, (2) the taxpayer must have actively participated in the management of the rental activity, (3) the activity generating the loss must be a real estate rental activity, and (4) the taxpayer must not have AGI in excess of $150,000 (the loss is phased out at a 50% rate for AGI between $100,000 and $150,000). b.

To be exempted from the passive activity loss rules, an individual's rental activity must qualify as a real property trade or business. For individuals, more than one-half of the personal services performed in trades or businesses by the taxpayer during the year must be performed in real property trades or businesses in which the taxpayer materially participates.

Additionally, the taxpayer must perform more than 750 hours of service during the taxable year in real property trades or businesses in which the taxpayer materially participates. pp. I:9-14 through I:9-16.

I:9-16 Losses suspended under the passive loss rules are not lost forever. The suspended losses are carried forward indefinitely and are treated as losses allowable to the activity in the following taxable years. Any suspended losses that still exist when the taxpayer disposes of the property or activity may be deducted in the year of disposal. These losses are subject to the $305,000 ($ 610,000 for joint returns) limitation on excess business losses. pp. I:9-7 and I:9-8.

I:9-17 A deductible casualty loss is a loss that (1) occurs in an identifiable event and (2) is sudden, unexpected, or unusual. For a loss to be a deductible casualty loss, the taxpayer must be able to determine or identify the event that caused or resulted in the loss. For example, a taxpayer will have a deductible casualty loss if she can show that a storm caused damage to her property. A sudden event is one that is swift, not gradual or progressive. An unexpected event is one that is ordinarily unanticipated and which the taxpayer did not intend. An unusual event is one that is not a day-to-day occurrence and that is not typical of the activity in which the taxpayer is engaged. For example, damage to property as a result of years of stormy weather will not qualify as a casualty loss. To deduct a personal casualty loss, the unexpected event must be a federally declared disaster. pp. I:9-17 through I:9-19.

I:9-18 A casualty gain is realized when the insurance proceeds the taxpayer receives exceed the taxpayer’s adjusted basis in the property. For personal-use property, all the casualty gains and losses realized during the year are netted together. If the losses exceed the gains, the excess is reduced by 10% of the taxpayer's AGI and the remainder is deductible as a from AGI deduction if the loss is due to a federally declared disaster. However, if the casualty gains exceed the casualty losses for the year, the gain is treated as a long-term capital gain. p. I:9-20.

I:9-19 Under Sec. 165(h)(5)(E), no casualty loss deduction may be taken on personal-use property to the extent it is covered by insurance but a timely insurance claim is not filed. Since Rulon’s insurance will only cover half the damage, he may argue that the uncovered portion is eligible for a casualty loss deduction. However, $4,400 (half of the $9,000 damage minus $100 floor reduction) will not exceed the 10% of AGI limitation (10% x $50,000 = $5,000). Thus, Rulon probably won’t be able to deduct any of the casualty loss. p. I:9-20.

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I:9-20 The casualty loss deduction on personal-use property is limited to the lesser of (1) the taxpayer’s basis in the property or (2) the reduction in fair market value. This is the case whether the property is totally or partially destroyed.

The casualty loss deduction on partially destroyed business or investment property is limited to the lesser of (1) basis or (2) reduction in FMV. The amount of the casualty loss deduction for the total destruction of business or investment property is equal to the basis of the property. Casualty losses on personal-use property are reduced by $100 per casualty and then are further reduced by 10% of AGI. Casualty losses on business property are not subject to these limits and floors. Casualty losses on business property and investment property that produce rents or royalties are for AGI deductions. pp. I:9-18 through I:9-20.

I:9-21 Theft losses are deducted in the tax year in which the theft is discovered, not when the theft actually occurs. Thus, if the theft is discovered in a year subsequent to the year of the theft, the deduction is taken in the later year. Also, if the insurance reimbursement is less than anticipated, the unrecovered portion can be deducted in the subsequent year. Another situation in which the casualty loss can be deducted other than in the year in which the loss occurred, is if the taxpayer sustains a loss in a location that the President of the United States declares a disaster area. In this case, the taxpayer can make an election to deduct the loss in the year just prior to the year in which the loss occurred. pp. I:9-22 and I:9-23.

I:9-22 Casualty losses are first reported on Form 4684 (Casualties and Thefts). Casualty losses on personal-use property then flow to Schedule A where they are reported as itemized deductions. Casualty losses on business property flow from Schedule 4684 to Form 4797 and then to line 4 on Form 1040, Schedule 1. p. I:9-21.

I:9-23 The reduction on personal-use casualty losses is $100 per casualty. The $100 reduction is not imposed upon each individual item if more than one item is destroyed in a single casualty.

The $100 floor decreases the amount of the casualty loss before the loss is netted against the casualty gains. pp. I:9-20 and I:9-21.

I:9-24 Excess business loss is the amount of cumulative net business losses for the year over the cumulative net business income plus $305,000 ($610,000 for joint returns). This limit of deducting net $305,000 in business losses is applied to both passive and nonpassive businesses.

I:9-25 Sarah must treat the loan as a nonbusiness bad debt (assuming the loan is bona fide and is not a gift) even though John used the money in a business. Thus, the $15,000 bad debt is treated as a short-term capital loss. If Sarah has no capital gains for the year, she may take a capital loss deduction of $3,000, carrying the remainder over to subsequent years. On the other hand, if Sarah were in the business of lending money, then she could treat the loan as a business bad debt and deduct the entire loss as an ordinary loss in the current year. p. I:9-25.

I:9-26 Dana may not take any deduction with respect to this bad debt. Although it is a bad debt that had been incurred in her business, she has no basis in the debt because she is a cash method taxpayer and did not report the receivable in as income. pp. I:9-25 and I:9-26.

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I:9-27 A third party guarantor of a loan who is required to repay the debt is entitled to a bad debt deduction under certain circumstances. To obtain the bad debt deduction, the guarantee must not be considered a gift. pp. I:9-24 and I:9-25.

I:9-28 A nonbusiness bad debt is defined as any debt other than: (a) a debt created or acquired in connection with a trade or business of the taxpayer or (b) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. Nonbusiness bad debts are deductible as short-term capital losses. pp. I:9-26 and I:9-27.

I:9-29 In deducting a loss on a deposit in a qualified financial institution a taxpayer may elect to treat the loss as a personal casualty loss in the year in which the loss can be reasonably estimated. By treating the loss as a personal casualty loss, the total loss is reduced by 10% of the taxpayer's AGI. p. I:9-28.

I:9-30 When a taxpayer collects a bad debt that was previously written off and deducted, the recovery must be reported in income to the extent the taxpayer received a tax benefit from the deduction in the prior year. p. I:9-28.

I:9-31 An NOL deduction is a deduction taxpayers take against their income for a year following the year in which they incur the NOL. The NOL arises when the taxpayer's business deductions (and personal casualty loss deductions) exceed the taxpayer’s business and other income. The deduction can be carried forward indefinitely but the deduction is limited to 80% of taxable income before the NOL deduction. The statute allows the deduction in an attempt to equalize the federal income tax burden imposed on taxpayers with business income that fluctuates from year to year, with the tax burden imposed on taxpayers with business income that is relatively stable from year to year. p. I:9-29.

I:9-32 An individual taxpayer's net tax loss is adjusted by the following items in computing an NOL: (1) any NOL deduction, (2) any capital loss deduction, (3) the excess of nonbusiness deductions over nonbusiness income. These adjustments are made either in an attempt to measure only the economic loss that occurs when business expenses exceed business income or to prevent a possible double benefit from the deduction. Since capital losses have their own carryover provisions, allowing them to create or increase a net operating loss would create a double benefit for the same loss. pp. I:9-30 and I:9-31.

I:9-33 Yes. For purposes of the NOL computation, casualty losses on personal-use assets are treated as business losses. Therefore, casualty losses on personal-use assets are excluded in making the adjustment for excess nonbusiness deductions over nonbusiness income and can create or increase an NOL. p. I:9-31.

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I:9-34 The carry back provision of the prior rules meant that taxpayers could get a refund currently on previous taxes paid. Under the new rules, the fact that the NOL is carried forward indefinitely means that the taxpayer will eventually get to use the NOL (which under the previous rules would expire after 20 years); however, it will only have future tax benefits and does not allow for a current refund of taxes like the previous rules. Finally, the new rules also limit the amount of tax benefit that the taxpayer can claim for the NOL in a given year. The NOL cannot exceed 80% of the taxable income computed before any NOL deduction taken. p.

I:9-32.

Issue Identification Questions I:9-35 The primary tax issues Sheryl must consider are (1) whether the stock is worthless, (2) when it became worthless, and (3) the character of the loss. Since stock held for investment is a capital asset, the loss, if allowed, should receive capital loss treatment. Under Sec. 165(g), a security that becomes worthless during the taxable year is treated as having been sold on the last day of the taxable year. In this case, Sheryl must determine exactly when the stock became worthless. Although bankruptcy is one indication of worthlessness, the stock may, in fact, have become worthless in a prior year. Thus, if Sheryl can demonstrate that the stock became worthless in the prior year, she can report a short-term capital loss in that year. If it is determined that the stock became worthless in the current year, Sheryl will report a long-term capital loss in the current year. pp. I:9-3 and I:9-4.

I:9-36 The primary tax issue is the character of the $75,000 loss (i.e., ordinary or capital). If, for the last five years, more than 50% of Gold, Inc.’s aggregate gross receipts were from sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges of stocks or securities, then the Gold stock should qualify as Sec. 1244 stock because (1) Cora (an individual) received the stock in exchange for cash or property that she contributed directly to the corporation, (2) at the time the stock was issued, Gold, Inc.'s capital was less than $1,000,000, and (3) for the last five years, more than 50% of its aggregate gross receipts were from sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges of stocks or securities. Thus, of the total $75,000 loss, Cora will report $50,000 as ordinary loss and $25,000 as a long-term capital loss. The capital loss, of course, is first netted against any capital gains.

The current year deduction for any excess capital loss is limited to $3,000. pp. I:9-5 and I:9-6.

I:9-37 This qualifies as a personal-use casualty loss from a federal declared disaster. Evan must apply the $100 and 10% of AGI limits to the personal-use casualty loss. A corollary issue is whether the failure to file an insurance claim will invalidate the deduction. Although automobile accidents in general have been held to qualify for casualty loss treatment, an exception is made if the accident is caused by the taxpayer's willful negligence or willful act. Even if this accident qualifies as a casualty, no deduction is available if the taxpayer doesn't file an insurance claim to the extent that the loss is covered by insurance. Thus, if Evan does not file a claim, the casualty loss should be limited to the amount of the loss that is not covered by insurance. pp. I:9-17 through I:9-20.

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I:9-8

I:9-38 The principal tax issue is the character of the bad debt (i.e., business or nonbusiness).

Since a nonbusiness bad debt is treated as a short-term capital loss, whereas a business bad debt is an ordinary loss, the determination of what kind of loan Dan has made to Beta, Inc. becomes critical. In order to show that this loss is a business bad debt, Dan must demonstrate that his motivation in making the loan was to protect his job rather than to protect his stock ownership.

In cases where the loan was made to protect the taxpayer's job, the courts have held that the loss is a business bad debt. On the other hand, if the loan was made to protect the taxpayer's investment, the loss is a nonbusiness bad debt. pp. I:9-25 through I:9-27.

Problems I:9-39 a.

Amount realized Minus: Basis Loss recognized

$ 22,000 ( 89,000) $(67,000)

Because the stock qualifies as Sec. 1244 stock, the first $50,000 of the loss is ordinary loss. The remainder is a long-term capital loss. b.

A $67,000 ordinary loss is recognized. The yearly limit on the ordinary loss deduction for Sec. 1244 stock by a taxpayer who is married and filing a joint return is $100,000. c.

To qualify the loss as ordinary under Sec. 1244, the stock must have been originally issued to the individual or to a partnership in which an individual is a partner.

Therefore, under this revised fact pattern the sale of the stock would result in a $67,000 longterm capital loss. Sec. 1244 does not apply. d.

By selling a portion of the stock in one year and the remaining stock in another year the taxpayer could convert all $67,000 to an ordinary loss. The $50,000 maximum is per taxable year. This would also avoid the annual $3,000 limit on the deductibility of capital losses. p. I:9-5.

I:9-40 a.

Because Fox, Inc. is insolvent, all of its assets will go toward its debts, leaving nothing for Randall. Randall will not recover any of his basis in the stock. Because the stock was not acquired from the corporation on original issuance, the stock does not qualify as Sec. 1244 stock. Thus, Randall suffers a $250,000 long-term capital loss. b.

The stock is qualified Sec. 1244 stock since it is original issue stock. Since Randall is single, the loss will consist of $50,000 ordinary loss and $200,000 long-term capital loss. c.

Since at least 80% of the voting power of Fox’s stock is owned by Randall Corporation, and more than 90% of Fox’s gross receipts are from its business operation, the $250,000 loss is all ordinary. d.

Same as part (c). pp. I:9-5 and I:9-6.

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I:9-9

I:9-41 Short-Term Gain or Item Loss Tidal Radio $ 20,000 Wavetable ( 6,000)

Long-Term Gain or Item Loss IBM $ 5,000 Microsoft (20,000)

Non( 14,000) business bad debt Net STCG $ -0-

BTR

( 92,000)

Net LTCL

$ (107,000)

a. b.

Ordinary Gain or Item Loss Salary $114,000 Stewart ( 15,000) (Sec. 1244)

Ordinary

$ 99,000

Brian’s Net Long-Term Capital Loss is $107,000 ($107,000 - $0).

Brian’s AGI for the year is $96,000.

AGI Ordinary Net LTCL AGI

$99,000 ( 3,000) $96,000

pp. I:9-5 and I:9-6.

I:9-42 Alice can deduct a total of $20,000 of the passive losses against the $20,000 of passive income she reports from Activity X, ($14,000 of the loss is allocated from Activity Y and $6,000 is allocated from Activity Z).

Activity X Activity Y Activity Z Net passive loss carryover Activity Y:

$30,000 x

$ 20,000 ( 35,000) ( 15,000) ($30,000) $35,000 = $21,000 $50,000

$15,000 = $9,000 $50,000 These losses carry over to subsequent years and may be used to offset any income from passive activities. Additionally, any remaining loss attributable to an activity that is disposed of may be deducted in the year of disposal. This is why it is important to allocate the portion of the total net passive loss carryover to each individual activity. pp. I:9-7 through I:9-12.

Activity Z:

$30,000 x

I:9-43 a.

When a passive activity is disposed of, the suspended losses of that activity may offset other than passive income. Because Clay sold Activity Z this year, he can deduct all of the passive losses from Activity Z, including the suspended losses, in the current year. Additionally, because passive Activity X generates $28,000 of income this year, all of the ($10,000) loss from Activity Y can be deducted against Activity X’s passive income. Thus, there is no passive loss that must be carried over.

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I:9-10

Loss from Z for the year Suspended losses from Z Gain from the sale of Z

($20,000) ( 40,000) 30,000

Income from X Loss from Y

$28,000 ( 10,000)

($30,000)

Loss deductible against active business and portfolio income

18,000 ($12,000)

b.

Clay’s AGI for the current year will be $88,000 ($100,000 - $12,000). pp. I:9-7 through I:9-9.

I:9-44 Irene’s AGI for the year is $120,000, computed as follows: a.

Salary Income Minus: maximum rental real estate loss $25,000 Reduced by phase out: ($130,000 - $100,000) x 0.50 (15,000) Deductible amount (not to exceed actual loss of $50,000) AGI b.

$130,000

( 10,000) $120,000

$40,000 - $10,000 = $30,000 suspended loss attributed to: Activity Y: $30,000 x

$30,000 = $18,000 $50,000

Activity Z: $30,000 x

$20,000 = $12,000 $50,000

Note: The total passive loss for the year is $50,000. $10,000 of this loss is offset against the passive income of $10,000 from Activity X and $10,000 is deductible because Irene actively participates in the rental real estate activities (Activity Y and Activity Z). Thus, there is a total of $30,000 suspended loss ($50,000 – [$10,000 + $10,000]). This suspended loss must be allocated between the two loss activities, based on their relative proportion of the total loss incurred by each rental activity. pp. I:9-15 and I:9-16.

I:9-45 Although in 2024, activity A is not a passive activity, it is treated as a former passive activity. Thus, the suspended losses of $24,000 for activity A are first offset against the current income of activity A, leaving a remainder of $14,000 ($24,000 - $10,000). This $14,000 excess is still treated as a passive activity suspended loss and is only deductible against passive income.

Passive activity B has income of $20,000 in 2024. This income is first reduced by the $8,000 suspended loss from activity B, leaving a remainder of $12,000 of passive income. Thus, $12,000 of the remaining suspended loss from activity A is used to offset this income. $2,000 of the suspended loss from activity A is carried over to 2025. pp. I:9-7 through I:9-9.

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I:9-11

I:9-46 Juan must carry forward $1,320 in tax credits. Since Juan is in the 24% tax bracket, the credits equal $12,500 ($3,000 ÷ 0.24) in deduction equivalents. This amount, plus the $6,000 in losses, equals a total of $18,500 in deductions and deduction equivalents. Since this amount is less than the $25,000 real estate deduction amount, Juan normally would be able to use all of the loss deductions and credits against his active business income. However, because Juan has AGI in excess of $100,000, the real estate deduction is reduced to $13,000 {$25,000 - [($124,000 $100,000) x 0.50)]}, and the maximum that Juan may use is $13,000 in deductions and deduction equivalents. The deductions are taken first. Thus, Juan deducts the total of the $6,000 losses, leaving $7,000 in deduction equivalents available to be used in the current year. This translates to $1,680 ($7,000 x 0.24) in credits. Therefore, the suspended losses and credits carried over to next year are: Losses: $6,000 - $6,000 = $0 Credits: $3,000 - $1,680 = $1,320 pp. I:9-15 and I:9-16.

I:9-47 Julie’s 2024 taxable income is $146,000, computed as follows: The first step is to compute AGI. This step consists of a two-step process. First the limit on the deduction of the $25,000 real estate exemption for passive losses is computed as follows: Salary Interest income Net capital gains ($22,000 - 17,000) Tentative AGI (for passive loss)

$166,000 14,000 5,000 $185,000

Thus, the passive loss exemption for real estate is reduced to $0 [$25,000 - ($185,000 $100,000) x 0.50]. AGI is $185,000.

The next step is to compute the deductions from AGI. AGI Itemized Deductions Property taxes on residence Interest: Qualified Residence Investment Interest ($21,000), Limited to Investment Income ($14,000)

$185,000 5,000 12,000 14,000

26,000

Charitable Contributions

8,000

Total Itemized Deduction

39,000

Taxable Income

( 39,000) $146,000

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I:9-12

Note: Because Julie did not use net LTCG in computing net investment income for 2024, she may use the 15% rate for LTCG when computing her tax. The miscellaneous itemized deductions (tax preparation fees and unreimbursed employee expenses) are not deductible. pp.

I:9-7 through I:9-16.

I:9-48 Tony can take a for AGI deduction of ($8,500) for the losses on the business assets, and $0 from AGI deduction for the casualty loss on his personal automobile, computed as follows: Casualty Item Gain/(Loss) Equipment A. The decrease in FMV is $8,300, which is less than Tony’s adjusted basis in the property. Because the decrease in FMV is available, the cost to repair the equipment should not be used. The deductible loss is the amount of the loss not compensated for by insurance, which is $4,600 ($8,300 - $3,700). ($ 4,600) Equipment B. The decrease in FMV is $8,100, but the deductible loss is limited to Tony’s $3,000 adjusted basis in the property. Thus, Tony realizes a gain of $4,800 ($7,800 - $3,000). Because the machine is a depreciable Sec. 1245 asset, all of the gain is probably attributable to the prior depreciation taken on the property, and all of the gain will be recaptured as ordinary income. Even though Tony realized the gain because of a casualty, this ordinary gain is not included in the casualty gain/loss netting process. $ 4,800 Equipment C. Because the decrease in FMV is not available, the taxpayer can use the cost of repairing the asset, as long as the repairs bring the property back to its condition immediately before the casualty, do not cost an excessive amount, do no more than repair the damage caused by the casualty, and do not increase the value of the property over its value immediately before the casualty. Assuming Tony’s repairs on Equipment C meet these requirements, the deductible loss is $2,400: the $13,800 cost of repairs less $11,400 of insurance proceeds. ($ 2,400) Delivery Truck. The deductible loss is $1,500 – Tony’s adjusted basis in the truck, $17,500, less $16,000 of insurance proceeds. ($- 1,500) Net Business Casualty Loss Deduction ($ 8,500) Automobile. A personal casualty loss is limited to the lesser of the property’s fair market value before the casualty or the taxpayer’s adjusted basis in the property, less any insurance proceeds. The automobile’s fair market before the theft was $15,000, which is less than Tony’s $28,000 basis in the property. Therefore, the loss is $3,000: the 15,000 fair market value before the casualty less the $12,000 insurance reimbursement. This $3,000 loss is reduced by the $100 floor, and is further limited by the 10% *See AGI limitation on personal casualty deductions. calculation

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I:9-13

*AGI before casualty losses Less: Business casualty loss deduction AGI Personal casualty loss Less $100 floor Less: 10% AGI Deductible Personal casualty loss

$80,000 ( 8,500) $71,500 $ 3,000 ( 100) $ 2,900 ( 7,150) $ 0

pp. I:9-17 through I:9-24.

I:9-49 a.

The $3,000 cash is a business asset and is deductible without reduction or netting with other items. The ring and necklace are both personal-use items. Thus, the loss on the ring must be netted against the gain on the necklace.

Necklace ($6,000 insurance - $2,300 basis) Minus: Ring ($3,000 - 100) Net gain

$3,700 (2,900) $ 800

Since Kelly has a $800 net personal casualty gain, the $3,700 gain on the necklace is reported as a long-term capital gain and the $2,900 loss on the ring is reported as a short-term capital loss. Since a net gain was reported, there is no reduction for the 10% of AGI floor. b. $0. Theft losses are deductible in the year of discovery. pp. I:9-17 through I:924.

I:9-50 a.

The loss and reimbursement should not be reported in 2024 or 2025 since Jerry has a reasonable expectation of full recovery. b.

Assuming Jerry didn’t know until after he filed his 2024 return: He should report the loss in 2024, computed as follows: Amount of loss ($15,000 - $1,500)

$13,500

c.

If Jerry deducted the loss on his 2024 return, he doesn’t file an amended return for 2024. Rather, Jerry should include as income on his 2025 tax return an amount equal to the tax benefit he received for the deduction in the previous year. pp. I:9-22 through I:9-23.

I:9-51 Since the losses on the business property exceed the gains, they are all ordinary losses for AGI. Thus Pam's AGI is $65,000 ($80,000 - $15,000). Pam's net loss on the personal-use property is $11,000. This is first reduced by $100 because the losses were all suffered in the same casualty. The net $10,500 is then reduced by 10% of AGI for a deductible personal casualty loss of $4,000 ($10,500 - [0.10 x $65,000]).

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I:9-14

Asset Business 1 Business 2 Business 3

Loss

Insurance

($15,000) ( 8,000) ( 18,000)

$ 4,000 3,000 19,000

Net loss on business property Personal 1 Personal 2 Personal 3

Net ($11,000) ( 5,000) 1,000 ($15,000)

($12,000) ( 3,000) ( 6,000)

$ 2,000 -08,000

Net loss on personal use property Less: nondeductible floor Net loss on nonbusiness property

($10,000) ( 3,000) 2,000 ($11,000) ( 100) ($10,900)

Business income Business casualty AGI

$80,000 (15,000)

Residential interest Property taxes Charitable Contributions Casualty losses [$10,900 - (0.10 x $65,000)]

$ 6,000 2,000 4,000 4,400

$65,000

(16,400) $48,600

Taxable income pp. I:9-20 through I:9-24.

I:9-52 The bad debt deduction is $0. Since Elaine is a cash-method taxpayer, she does not have any basis in the receivable. pp. I:9-25 and I:9-26.

I:9-53 2024: $0. No bad debt deduction is allowed since no bona-fide debtor-creditor relationship exists.

2025: $0. No bad debt deduction is allowed since a bona-fide debtor-creditor relationship does not exist. pp. I:9-26 and I:9-27.

I:9-54 2024: $0. No deduction is allowed for partial worthlessness of a nonbusiness bad debt.

2025: $4,500. Since the debt is a nonbusiness bad debt, no deduction was available in 2024 because the debt was not totally worthless. pp. I:9-26 and I:9-27.

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I:9-15

I:9-55 a.

Michelle and Mark’s taxable income is a loss of ($40,100), computed as follows: Taxable Income Dental Practice Items: Revenues $65,000 Payroll and Salary Expense ( 49,000) Supplies ( 17,000) Rent ( 16,400) Advertising ( 4,600) Depreciation ( 8,100) Net Business Loss ($30,100) Mark’s Salary 18,000 Interest earned on savings account 1,200 Total AGI ($10,900) Itemized Deductions: Interest paid on personal residence Itemized deductions for state and local taxes or Standard Deduction Taxable Income

12,700 9,400 22,100 29,200

( 29,200) ($40,100)

b.

Michelle and Mark’s NOL for the year is ($12,100), computed as follows: NOL Taxable Income ($40,100) Non-business Deductions $29,200 Non-business Income ( 1,200) Plus: Excess of Non-business Deductions over Non-business Income 28,000 Net Operating Loss ($12,100) pp. I:9-29 through I:9-32.

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I:9-16

I:9-56 a.

Michelle and Mark’s taxable income is a loss of ($41,500), computed as follows: Taxable Income Dental Practice Items: Revenues $65,000 Payroll and Salary Expense ( 49,000) Supplies ( 17,000) Rent ( 16,400) Advertising ( 4,600) Depreciation ( 8,100) Net Business Loss ($30,100) Mark’s Salary 18,000 Interest earned on savings account 1,200 Total AGI ($10,900) Itemized Deductions: Interest paid on personal residence Itemized deductions for state and local taxes Casualty Loss or Standard Deduction Taxable Income

12,700 9,400 8,500 30,600 29,200

( 30,600) ($41,500)

b.

Michelle and Mark’s NOL for the year is ($16,600), computed as follows: NOL Taxable Income ($41,500) Non-business Deductions Itemized Deductions $30,600 Minus: Casualty Loss Deduction ( 8,500) $22,100 Minus: Non-business Income ( 1,200) Plus: Excess of Non-business Deductions 20,900 over Non-business Income Net Operating Loss ($16,600) pp. I:9-29 through I:9-32.

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I:9-17

I:9-57 a.

Michelle and Mark’s taxable income is a loss of ($40,100), computed as follows: Taxable Income Dental Practice Items: Revenues Payroll and Salary Expense Supplies Rent Advertising Depreciation Net Business Loss Mark’s Salary Interest earned on savings account Total AGI Itemized Deductions: Interest paid on personal residence State and local taxes Personal casualty loss

$65,000 ( 49,000) ( 17,000) ( 16,400) ( 4,600) ( 8,100) ($30,100) 18,000 1,200 ($10,900)

15,300 9,400 8,500 33,200

or Standard Deduction

( 33,200) 29,200

Taxable Income

($40,100)

b.

Michelle and Mark’s NOL for the year is ($16,600), computed as follows: NOL Taxable Income ($40,100) Non-business Deductions Itemized Deductions $33,200 Minus: Casualty Loss Deduction ( 8,500) 24,700 Minus: Non-business Income ( 1,200) Plus: Excess of Non-business Deductions 23,500 over Non-business Income Net Operating Loss ($16,600) pp. I:9-29 through I:9-32.

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I:9-18

I:9-58 a.

Karen’s taxable income is a loss of ($36,500), computed as follows: Taxable Income Interior Design Business Revenues $52,000 Cost of Goods Sold ( 41,000) Advertising ( 3,300) Office Supplies ( 1,700) Rent ( 13,800) Contract Labor ( 28,000) Net-Business Loss ($35,800) Salary 13,500 Net Long-Term Capital Gain 400 ($4,200 - $3,800) Total AGI ($21,900) Itemized Deductions: or Standard Deduction Taxable Income

5,200 14,600

( 14,600) ($36,500)

b.

Karen’s NOL for the year is ($22,300), computed as follows: NOL Taxable Income ($36,500) Non-business Deductions $ 14,600 Non-business Income ( 400) Plus: Excess of Non-business Deductions over Non-business Income 14,200 Net Operating Loss ($22,300) pp. I:9-29 through I:9-32.

I:9-59 Business deductions ($7,775,000 + $1,300,000) Business income plus $610.000 ($7,850,000 + $120,000 + 610,000) Excess Business Loss

$9,075,000 $8,580,000 ($495,000)

The excess business loss is added to the NOL carryforward generated for the current year.

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I:9-19

Tax Strategy and Critical Thinking Problems I:9-60 TO: FROM: DATE: SUBJECT:

Treehouse Rentals Your CPA March 15, 2024 Suspended Passive Activity Losses

Treehouse can deduct the suspended activity losses related to the properties you sold during 2024.

In 1996, citing Sec. 1371(b), the IRS disallowed a former C corporation’s suspended passive activity losses (PALs) related to property it sold after it had obtained S corporation status, (T.A.M. 9628002). In 2000, however, the Tenth Circuit Court of Appeals ruled that the deduction of such losses was allowed under Sec. 469(b) (St. Charles Investment Co. v.

Commissioner, 86 AFTR 2d 2000-6882). Because you live in Denver, you are under the jurisdiction of the Tenth Circuit Court of Appeals. Therefore, you can deduct the $63,000 and $112,000 previously suspended PALs related to property you sold in 2024.

I:9-61 TO: FROM: DATE: SUBJECT:

Seaton & Associates, LLC Your CPA February 14, 2024 Losses Generated in 2024

Each member of your company can deduct his or her full portion of the $530,000 loss generated in 2024.

A taxpayer may fully deduct a flow-through loss if the taxpayer materially participated in the business during the year. If the taxpayer did not materially participate in the business, the loss is subject to passive activity loss limitations. In general, a limited partner is not considered to materially participate in an activity (Reg. 1.469-5T(e)(1)). The limited partner does materially participate, however, if the partner meets one of three material participation tests (Reg. 1.4695T(e)(2)).

Maria and Jamal both meet the first test, which is that the individual participate in the activity for more than 500 hours during the year. Therefore, they can both deduct their full portion of the loss, $53,000 each.

Jace, however, does not meet the first test because he worked only 300 hours during the year.

The two final tests are qualitative tests. One requires that the taxpayer materially participated in the activity for any five of the previous ten taxable years. The activity has not been in existence long enough for Jace to meet this test.

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I:9-20

Fortunately, Jace meets the final test. This requires that the activity be a personal service activity and the individual materially participated in the activity for any three taxable years preceding the taxable years. The regulations specifically state that architectural services are a personal service activity. Further, Jace worked as the CEO of an architectural firm for six years, thereby meeting the three-year requirement.

Finally, this conclusion is supported by an Oregon U.S. District Court decision involving an LLC involved in health services (Gregg v. U.S., 87 AFTR 2d 2001-337). Thus, Jace can deduct his full portion of the loss, which is $424,000. This loss, however, is subject to the excess business loss limitation of $305,000. His net business income of $100,000 guaranteed payment plus his $305,000 exceeds his net business deduction of $424,000 by $19,000. The disallowed loss of $19,000 increases his NOL carryforward.

I:9-62 If the Kents stay in the rental home for more than the greater of 14 days or 10% of the total rental days, they must recognize income and expenses relating to the home using the vacation home rules of Sec. 280A. Additionally, they must allocate the expenses of the rental property between the rental activity and their personal use. If they do not stay in the home, the entire activity is treated as a passive activity entered into for profit, and the passive activity rules of Sec. 469 apply.

Assuming the Kents personally use the property starting December 10 through December 31, they have personally used the property for a total of 22 days during the year. Their personal use of the property exceeds the greater of (1) 14 days or (2) 21 days [10% of the 210 rental days].

Thus, the vacation home rules of Sec. 280A apply. In this case, the tax consequences are as follows: Vacation Home Treatment Rental income Mortgage interest* Property taxes* HOA fees* Depreciation* Net loss

Total $16,000 ( 12,400) ( 4,300) ( 3,500) ( 18,000) ($22,200)

Personal ( 1,176) ( 408) ( 332) ( 1,707) ($3,623)

Rental Activity $16,000 ( 11,224) ( 3,892) ( 3,168) ( 16,293) ($18,577)**

*Based on total use days (22/232) **The loss is limited to the gross income from the property pursuant to Sec. 280(A).

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I:9-21

Taxable Income Ordinary Income Deanna’s salary Alex’s salary Passive income Rental income Rental expenses AGI

$75,000 65,000 1,000 16,000 (16,000) $141,000

Less itemized deductions: Medical expenses Reduced by 7.5% AGI Taxes State income taxes Property taxes (home) Property taxes (vacation home)

8,100 ( 10,575) 9,700 2,900 408 13,800

Limited to: Mortgage interest Personal residence Vacation home

10,000

7,800 1,176 8,976 14,200

Charitable contribution Total itemized deductions

($33,176)

NET TAXABLE INCOME

$107,824

Assuming they do not stay in the rental property, the tax consequences are as follows: Passive Activity Treatment Rental income Mortgage interest Property taxes HOA fees Depreciation Net loss

Total $16,000 ( 12,400) ( 4,300) ( 3,500) ( 18,000) ($22,200)

Personal

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I:9-22

Passive Activity $16,000 ( 12,400) ( 4,300) ( 3,500) ( 18,000) ($22,200)

Taxable Income Ordinary Income Deanna’s salary Alex’s salary Passive income Less: Deductible passive loss

$75,000 65,000 1,000 ( 1,000) _______ $140,000

AGI before rental real estate deduction Rental real estate deduction: $25,000 Decreased by 50% of AGI over $100,000 [$25,000 – (50% x $140,000 - $100,000)]

( 5,000)

AGI

$135,000

Less itemized deductions: Medical expenses Reduced by 7.5% AGI Taxes State income taxes Property taxes (home)

8,100 ( 10,125) 9,700 2,900 $12,600

Limited to Mortgage interest Paid on personal residence Charitable contribution Total itemized deductions

$ 10,000 7,800 14,200 ($32,000)

NET TAXABLE INCOME

$103,000

Note: The nondeductible passive loss of $16,200 [$22,200 – ($1,000 + $5,000)] may be carried forward and deducted against passive activity income of a subsequent year.

Passive Loss Carryforward Less: Total allowed loss Carryforward to future years

Loss

($22,200) 6,000 ($16,200)

By staying in the home, their taxable income is increased by $4,824 ($107,824 - $103,000) because they would be unable to deduct any of the loss attributable to the rental portion against the other passive income ($1,000). Furthermore, they could not deduct the additional $5,000 because of the rental real estate active participation rule under the passive loss rules. They can, however, deduct an additional $1,176 in interest allocated to the personal use of the unit.

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I:9-23

I:9-63 Jim can treat the loss in one of two ways. The first requires an election.

1. Casualty Loss.

The loss would be reduced by the $100 floor, then by 10% AGI ($110,000 x .10 = $11,000). Thus, he would be allowed an itemized deduction of $88,900 ($100,000 - $100 - $11,000). Casualty and theft losses are disallowed from 2018-2025 so this election would not be made during those years.

2. Nonbusiness bad debt. The loss would be treated as a short-term capital loss limited to an ordinary deduction of $3,000 because he has no other capital gains or losses in the current year. The remaining $97,000 can be carried forward to future years.

In this case, Jim should elect to treat the loss as a casualty loss. In other situations, where Jim reports large short-term capital gains, the third option may be more beneficial because the loss is treated as a short-term capital loss, which can offset (without reduction) the other short-term capital gains.

I:9-64 a.

Chelsea should consider selling the Apple Stock. It will offset her short-term capital gain which would be taxed at her marginal tax rate of 32% while the long-term capital gain will be taxed at the preferential 20% tax rate. b.

Chelsea would prefer the short-term capital loss. She currently has a $6,000 short-term capital loss. The additional $13,000 short-term loss will result in a net $19,000 shortterm capital loss. She can recognize $3,000 of it and the remaining $16,000 loss will be carried forward as a short-term capital loss. c.

Chelsea would be indifferent between the long or short-term losses. If she realizes a long-term capital loss of $13,000, it will offset the long-term capital gain and Chelsea will recognize a net $1,000 capital loss on her tax return (individuals can recognize capital losses to the extent of capital gains plus an additional $3,000 in losses). If she realizes a short-term capital loss of $13,000, it will be netted against her $12,000 long-term gain resulting in a $1,000 net short-term loss which she will recognize on her tax return.

Tax Form/Return Preparation Problems I:9-65 (See Instructor’s Resource Manual) I:9-66 (See Instructor’s Resource Manual) I:9-67 (See Instructor’s Resource Manual)

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Case Study Problems I:9-68 November 10, Current Year Dr. John Brown 444 Physician's Drive, Suite 100 Anytown, USA 88888 Dear Dr. Brown: I thank you for the opportunity of helping you with your tax work this year.

I understand that for the current year you estimate you will earn $150,000 of taxable income from your medical practice as well as $10,000 in dividends and interest income.

You also anticipate that your share of Limited's loss this year will be $10,000 in addition to last year's $15,000 loss. Finally, you estimate $30,000 in taxable income from the new lab that you established this year. The lab is staffed by two full-time qualified technicians and a part-time bookkeeper keeps the accounts. You have managed the lab to date, spending 320 hours during the year.

As you will recall, you were unable to deduct the $15,000 loss from Limited last year because of what are known as the passive loss limitations on passive activities. This loss is deferred or suspended into subsequent years and is only deductible against your income from passive activities. Among other things, a business or investment is considered passive if you work less than 500 hours in that activity during the year.

Through the end of this year, you will have a total of $25,000 in suspended passive losses from Limited. In general, if you limit your involvement in the lab to less than 500 hours for the year, the lab will also be treated as a passive activity this year. That means that the cumulative losses of $25,000 from Limited can be deducted against the $30,000 income from the lab. On the other hand, if you work in the lab over 500 hours this year you will not be able to deduct the cumulative losses of $25,000 from Limited. Thus, I recommend that you limit your involvement in the lab for the rest of the year.

Furthermore, each year we should analyze your involvement in the lab because circumstances may change from year to year.

I must mention that the IRS can, under certain circumstances treat a taxpayer's involvement in an activity as active even if the taxpayer's involvement is less than 500 hours. I believe, however, that the facts in your situation do not warrant this treatment since the lab should be self-sustaining without any of your efforts.

As always, my recommendations are based upon the facts as I have stated them above. If I have not identified the facts correctly, please contact me immediately since a change in the facts may cause a change in the recommendation.

Again, I thank you for the opportunity of serving you.

Sincerely,

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I:9-69 Pursuant to Statement on Standards for Tax Services (SSTS) No. 1, a CPA should not recommend that a tax return position be taken with respect to any item unless he or she "... has a good-faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged." [SSTS No. 1 .02(a)]. If a position does not meet the realistic possibility standard, a CPA may still recommend a position as long as it is not frivolous and the position is adequately disclosed on the return. Furthermore, paragraph .04 states that a CPA. "... has both the right and responsibility to be an advocate for the taxpayer with respect to any position satisfying the aforementioned standards.”

According to SSTS Interpretation No. 1-1, the realistic possibility standard is less stringent than both the "substantial authority" and the "more likely than not" standards that are established by the Internal Revenue Code with regard to substantial understatements of liability.

Furthermore, in addition to the authorities used in establishing "substantial authority," a CPA can rely on "... well-reasoned treatises, articles in recognized professional tax publications, and other reference tools and sources of tax analyses commonly used by tax advisers and preparers of returns" in meeting the realistic possibility standard.

Although your client's position is a grey one, it appears that there is sufficient authority to meet the realistic possibility standard, allowing you to sign the return taking the deduction.

However, you should advise Jack that if there is not "substantial authority," he may be subject to a penalty unless he discloses the position. [SSTS No. 1 ¶.02(d)].

In any event, you should not take a position that exploits the audit selection process or serves as a mere arguing position [SSTS No. 1 ¶.03].

Tax Research Problem I:9-70 Keith will be allowed to deduct the $30,000 loan as a theft loss in the year of discovery.

The loan is not treated as a nonbusiness bad debt since the loan was made based upon the false representations of Dan. In R.S. Gerstell [46 T.C. 161 (1966)] and M. Monteleone [34 T.C. 688 (1960)], the taxpayers were allowed to deduct as theft losses the amount of money or property taken from them under false pretenses. In both cases, the court stated that "for tax purposes, whether a theft loss has been sustained depends upon the law of the jurisdiction wherein the particular loss occurred" [Monteleone, p. 692]. For example, theft is defined in the California penal code as "the taking of money from another under false representations or false pretenses" [Monteleone, p. 692]. Assuming a similar law in the state where Keith resides, the $30,000 would be treated as a theft loss also. Of course, it will be subject to the $100 and 10% of AGI limitations. In addition, personal casualty and theft losses are only deductible to the extent of personal casualty and theft gains, if not the result of a federal-declared disaster.

The distinction must be made between a bona fide loan and a loan made based upon false pretenses. In Monteleone, the IRS contended that the loan was a nonbusiness bad debt and therefore should be treated as a short-term capital loss. If the loan is a bona-fide loan made without deceit and it subsequently becomes worthless due to bankruptcy or some other reason, the loan is treated as a bad debt. In the instant case, fraud was involved and, as a result, the loan, by definition, constitutes theft.

See also: Code Sec. 165, the Regulations under Sec. 165 and Paul C.F. Vietzke 37 T.C. 504 (1961).

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“What Would You Do In This Situation?” Solution Ch. I:9, p. I:9-35 This is an interesting situation. If this is truly a loan that the taxpayer made to his child, it would generally be considered a non-business bad debt unless the client is in the business of making loans. The client has produced a document that appears to be a properly executed note with a stated interest and payment dates. However, under these circumstances, several of the facts that you know indicate that this is probably a gift to the child. These facts include: (1) Over the entire two-year period that the “loan” has been outstanding, the child hasn’t made any payments of interest or principal, and (2) the child who has filed for bankruptcy appears to either (a) have enough cash to spend a long and expensive vacation in Europe, or (b) is receiving substantial gifts from the taxpayer because the child’s vacation in Europe is with other family members.

Under these circumstances, you should question if the intent of the taxpayer was a gift instead of a loan. If it was a gift, then, of course, the taxpayer can’t take a deduction.

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Chapter I:10 Depreciation, Cost Recovery, Amortization, and Depletion Note to Instructors about Chapter I:10 For some editions prior to the current edition, the IRS did not release the ceiling amounts for luxury automobiles and the lease inclusion amounts until after the editions had gone to press.

The IRS released these amounts for 2024 in time for the current edition (2025) to reflect them, and they are also reflected in the following solutions.

Discussion Questions I:10-1 a. An asset held for personal use is not eligible for amortization, depreciation, or cost recovery. b. Goodwill acquired in an acquisition of a trade or business is a Sec. 197 intangible, so its cost is amortized on a ratable basis over a 15-year period beginning with the month of acquisition. c. A customer list acquired in an acquisition of a trade or business is a Sec. 197 intangible, so its cost is amortized on a ratable basis over a 15-year period beginning with the month of acquisition. d. The patent’s cost is amortized over 17 years since the patent has a definite and limited life. The patent is not a Sec. 197 intangible because it was not acquired in connection with a transaction that involves the acquisition of a trade or business or a substantial portion of a trade or business. e. Land is not eligible for amortization, depreciation, or cost recovery. f. A covenant not to compete acquired in an acquisition of a trade or business is a Sec. 197 intangible, so its cost is amortized on a ratable basis over a 15-year period beginning with the month of acquisition. This treatment applies even if the covenant is for a shorter period of time (e.g., five years). In such case, no loss is recognized, and the basis of retained Sec. 197 intangibles is increased by the unrecognized loss. pp. I:10-2 through I:10-4, I:10-17, and I:10-18.

I:10-2 Depreciation deductions are not discretionary. The adjusted basis of property must be reduced by the amount of depreciation that the taxpayer is entitled to deduct (allowable depreciation) even if no depreciation was claimed. The adjusted basis of the property must be reduced on a consistent basis by depreciation computed using one of several accounting methods provided under the tax law. If no method had previously been used, allowable depreciation is determined under the straight-line method. So, Rick could wind up recognizing a gain to the extent the asset is sold for more than its adjusted basis. p. I:10-3.

I:10-3 The depreciable basis of property converted from personal use to business or investment use is the lesser of the property’s adjusted basis or its fair market value (FMV) at the conversion Copyright © 2025 Pearson Education, Inc.

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date. Furthermore, a portion of such lesser amount is attributable to the land on which the house is located, and this portion is not depreciable. The depreciable basis of Rita’s house thus is the lesser of (a) Rita’s $250,000 purchase cost minus the portion of it attributable to the land or (b) the $200,000 FMV minus the portion of it attributable to the land. This lower of cost or market rule is intended to prevent Rita from deducting the decline in the house’s value while she used it for personal purposes. pp. I:10-3 and I:10-4.

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Furniture Plumbing fixtures Land Goodwill Trademark Automobile Heavy truck Machinery Building

Part a – Eligible for MACRS Sec. 197 Depreciation?

Amortization?

Yes No Yes No No No No Yes No Yes Yes No Yes No Yes No Yes No

Part b Recovery Period 7 years 7 years N/A 15 years 15 years 5 years 5 years 7 years 39 years

pp. I:10-5 and I:10-17 through I:10-18.

I:10-5 a. $214,350 for 2024 and $367,350 for 2025. Andes does not elect Sec. 179 expensing and elects out of bonus depreciation, so it deducts MACRS depreciation for the entire $1.5 million cost of the machinery. Using the MACRS percentages from Table 1 in Appendix C: 2024 (Year 1): $1,500,000 x 0.1429 = $214,350 2025 (Year 2): $1,500,000 x 0.2449 = $367,350 b. $1,404,005 for 2024 and $27,429 for 2025. Andes places into service more than $1.22 million (but less than $3.05 million) of Sec. 179 property during the year, so it deducts $1.22 million of the machinery’s cost under Sec. 179. The remaining $280,000 ($1,500,000 $1,220,000) of the machinery’s cost is eligible for bonus depreciation, which does not have a dollar limitation and which Andes does not elect out of. Bonus depreciation is 60% for 2024, so Andes deducts $168,000 (0.60 x $280,000) of the cost as bonus depreciation. Andes can also deduct MACRS depreciation for the $112,000 ($1,500,000 - $1,220,000 - $168,000) of the machinery’s cost that is not claimed as Sec. 179 expensing or bonus depreciation, and this MACRS depreciation is $16,005 (0.1429 x $112,000) for 2024 and $27,429 (0.2449 x $112,000) for 2025. Andes’ total depreciation deduction is $1,404,005 ($1,220,000 + $168,000 + $16,005) for 2024 and $27,429 for 2025. c. $1,260,012 for 2024 and $68,572 for 2025. As in part b, Andes deducts $1.22 million of the machinery’s cost under Sec. 179. Because Andes elects out of bonus depreciation, $280,000 ($1,500,000 - $1,220,000) of the machinery’s cost is eligible for MACRS depreciation, which is $40,012 (0.1429 x $280,000) for 2024 and $68,572 (0.2449 x $280,000) Copyright © 2025 Pearson Education, Inc.

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for 2025. Andes’ total depreciation deduction is $1,260,012 ($1,220,000 + $40,012) for 2024 and $68,572 for 2025.

Note: It typically would not be beneficial for a taxpayer to elect Sec. 179 expensing and also elect out of bonus depreciation, but many states’ income tax rules do not allow bonus depreciation. Andes would need to make calculations like those in part c if it operates in such states. States also may allow Sec. 179 expensing to a different extent than the federal income tax. pp. I:10-5 through I:10-8.

I:10-6 a. $215,755 for 2024 and $360,655 for 2025. Goodrich does not place into service either asset in the fourth quarter, so the half-year convention applies. It uses the percentages from Appendix C, Table 1 to compute its MACRS depreciation deductions: 2024: Asset #1: $950,000 × 0.1429 Asset #2: $400,000 × 0.2000 Total MACRS depreciation

$135,755 80,000 $215,755

2025: Asset #1: $950,000 × 0.2449 Asset #2: $400,000 × 0.3200 Total MACRS depreciation

$232,655 128,000 $360,655

b. $1,308,400 for 2024 and $16,640 for 2025. Goodrich places into service $1,350,000 ($950,000 + $400,000) of Sec. 179 property during the year. This amount is greater than $1.22 million but not greater than $3.05 million, so it deducts $1.22 million of the assets’ cost under Sec. 179. To maximize its 2024 depreciation deduction, Goodrich should use Sec. 179 first for Asset #1’s cost because its 7-year recovery period is longer than Asset #2’s 5-year recovery period. Goodrich thus should use Sec. 179 for all $950,000 of Asset #1’s cost and $270,000 ($1,220,000 - $950,000) of Asset #2’s cost.

Goodrich can claim 60% bonus depreciation for 2024 for the portion of the assets’ cost for which it does not claim Sec. 179 expensing, which is $130,000 ($400,000 - $270,000) of Asset #2’s cost. Bonus depreciation is $78,000 (0.60 x $130,000).

Goodrich uses MACRS to depreciate the remaining $52,000 ($400,000 - $270,000 $78,000) of Asset #2’s cost, using the same percentages as in part a. MACRS depreciation is $10,400 (0.20 x $52,000) for 2024 and $16,640 (0.32 x $52,000) for 2025. The depreciation deductions for 2024 and 2025 are: Depreciation for 2024 Depreciation for 2025 Asset #1 Asset #2 Asset #1 Asset #2 Sec. 179 expensing $950,000 $270,000 $ -0$ -0Bonus depreciation -078,000 -0-0MACRS depreciation -010,400 -016,640 Total for asset $950,000 $358,400 $ -0$16,640 Total for year $1,308,400 $16,640 pp. I:10-5 through I:10-8.

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I:10-7 Yes. Depreciation for depreciable real estate is computed using tables that follow the mid-month convention, so depreciation is allowed in the year of sale. The amount of depreciation is computed by taking one-half month for the month the asset is sold plus the number of full months held prior to the month of sale, divided by 12 months. Thus, one-half of a month’s depreciation is allowed for the month of disposal regardless of the day of the month the disposal occurred. For example, if a calendar-year taxpayer sells property on October 30 (in a year before the last year of its recovery period), the table percentage must be multiplied by the fraction 9.5/12 (nine full months plus one-half month for October). p. I:10-10.

I:10-8 a. No. The salesman is incorrect. If the taxpayer elects out of bonus depreciation, the maximum amount of depreciation (Sec. 179 and regular MACRS) is limited to $12,400 for 2024 due to the Section 280F luxury auto limits. If Sec. 179 is not elected, the depreciation deduction of $16,900 still would be greater than $12,400. Thus, the depreciation deduction in the initial year is less than claimed by the salesperson. As one may observe, Sec. 179 is not recommended for luxury automobiles. If Jose did not elect out of bonus depreciation, the limit would be $20,400. b. The maximum depreciation deduction under Sec. 280F in the first year would be $7,440 ($12,400 limit x 0.60 business). c. Jose could deduct the lease payments. However, he must reduce the deduction by a lease inclusion amount from tables published by the IRS. See Table 12 of Appendix C. Jose is not eligible for the Sec. 179 deduction. d. The salesman’s claims are more accurate in this case. Because the SUV has a GVWR of greater than 6,000 pounds, the ceiling limitations do not apply. However, the Sec. 179 deduction is limited to $30,500 (for 2024). In this case, Jose may claim a Sec. 179 deduction of $30,500 and a regular MACRS deduction of $10,800 [($84,500 - $30,500) x 0.20], for a total of $41,300. This illustrates how a taxpayer may claim a depreciation deduction in the year an SUV is acquired that exceeds that for a passenger automobile. pp. I:10-13 through I:10-16.

I:10-9 Rhonda expects her marginal tax rate to be higher after the current year, so a depreciation deduction saves her more taxes in the future than in the current year. The alternative depreciation system (ADS) uses the straight-line method of depreciation, while MACRS uses the 200%-declining balance method for 5-year and 7-year property. By electing the ADS, Rhonda deducts less of the property’s cost in the current year (which would otherwise save taxes at a 24% rate) and more of the cost in the future (expected to save taxes at a 37% rate). Also, the ADS often uses a depreciable life that is longer than that under MACRS, which further reduces the portion of the property’s cost Rhonda deducts in the first year. Although Rhonda’s use of the ADS is expected to result in greater tax savings, she should consider the time value of money because the tax savings are deferred. p. I:10-11.

I:10-10 Section 179 allows for an ordinary deduction in the year placed in service of up to $1.22 million (for 2024) of the cost of tangible personal business property. Its primary advantage is the time value of the tax benefits that result from a larger depreciation deduction in the first year and the corresponding deferral of tax. pp. I:10-6 and I:10-7.

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I:10-11 The improvements Luby made are qualified improvement property (QIP). Under MACRS, the cost of QIP is depreciable over 15 years using the straight-line method.

Alternatively, Luby may be able to deduct some or all of the QIP’s cost as Sec. 179 expensing (depending on Luby’s taxable income limitation for Sec. 179 and the phase-out of Sec. 179 expensing). Another alternative for Luby is to claim bonus depreciation for the QIP’s cost. pp. I:10-10 and I:10-11.

I:10-12 a. The automobile is 5-year property under MACRS, so the 200%-declining balance method and a 5-year recovery period are used. Because your client will use the automobile 80% of the time for business, only $72,000 ($90,000 x 0.80) of its cost is depreciable. However, your client’s 2024 deduction for this vehicle is limited to $9,920 ($12,400 x 0.80) under the so-called luxury automobile rules, if she elects out of bonus depreciation ($16,320 ($20,400 x 0.80) if she does not elect out of bonus depreciation). b. If your client’s business use of the automobile decreases to 50% or less in a subsequent year, the property is subject to recapture of excess cost recovery deductions, and the depreciation deductions for all subsequent years are computed using the ADS. When the business use first falls to 50% or below, such excess deductions are recaptured to the extent that cumulative MACRS depreciation exceeds cumulative ADS depreciation. pp. I:10-5 and I:10-12 through I:10-14.

I:10-13 a. Qualified property for bonus depreciation includes (1) MACRS property with a recovery period of 20 years or less and (2) computer software (other than computer software that must be amortized under Sec. 197). Prior to 2018, the original use of the property must have begun with the taxpayer (i.e., it could not have been used property). b. Sec. 179 depreciation is taken before any bonus depreciation. p. I:10-8.

I:10-14 $8,381. Sarah must reduce her deduction by a lease inclusion amount: Lease payments ($850/month x 10 months) Minus: Lease inclusion amount ($142 x 306/366) Deduction for 2024 lease payments

$8,500 (119) $8,381

p. I:10-16.

I:10-15 Intangible assets acquired in connection with the purchase of a trade or business are Sec. 197 intangibles, amortizable ratably over a 15-year period. Gain on disposition will be given Sec. 1231 treatment (discussed in Chapter I:13), but a loss on disposition is not deductible if other intangibles acquired in the same asset purchase are retained. Internally created intangibles and intangibles acquired by the purchase of an individual asset are subject to amortization only if they have both a definite and limited life (e.g., an internally created patent with a 17-year useful life). pp. I:10-17 and I:10-18.

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I:10-16 a. The internally created patent should be amortized over the useful life of 17 years, $2,000 ($34,000 ÷ 17 years) in the current year. Goodwill and going concern value, the covenant not to compete, licenses, and customer lists are Sec. 197 intangibles and are amortizable on a straight-line basis over 15 years, $20,000 in the current year ($300,000 ÷ 15 years). b. The purchaser should attempt to allocate as much of the total purchase price as possible to inventory, because gross profit is reduced when inventory is sold. Next, allocate as much of the remaining purchase price as possible to the assets with the shortest recovery periods (e.g., the equipment and the Sec. 197 intangibles). The smallest amount possible should be allocated to the land because land is not depreciable. pp. I:10-17, I:10-18, and I:10-24.

I:10-17 a. For 2022 and later years, taxpayers must capitalize R&E expenditures and amortize them ratably over the five-year period beginning with the middle of the year in which they are paid or incurred. b. Most taxpayers would prefer the pre-2022 treatment of R&E expenditures because the deductions’ tax savings are realized immediately rather than over five years, increasing their present value. Pre-2022 tax law allowed two alternatives to the immediate deductibility of R&E expenditures, which may have been beneficial if the taxpayer were in a low tax bracket. The flexibility that pre-2022 tax law provided is not available in 2022 and later years. pp. I:10-19 and I:10-20.

I:10-18 Buyers generally prefer a liberal allocation of the purchase price to ordinary assets such as inventory because gross profit is reduced when the inventory is sold. Allocations to shortlived depreciable assets and Sec. 197 intangibles are preferred over allocations to land and other nondepreciable assets due to the acceleration of tax benefits obtained from the depreciation and amortization. p. I:10-24.

I:10-19 Cost depletion is the systematic allocation of the cost of a natural resource property over the property’s expected recoverable life. Cost depletion is similar to the units-ofproduction method of depreciation and is calculated by dividing the asset’s adjusted basis by the estimated recoverable units to arrive at a per-unit depletion amount. This per-unit amount is then multiplied by the number of units sold to determine the cost depletion deduction.

Percentage depletion, on the other hand is computed by multiplying the percentage depletion rate times the gross income from the property. While there are limitations on percentage depletion based upon a taxpayer’s taxable income, percentage depletion may be taken in excess of the taxpayer’s basis in the property. Percentage depletion will generally provide larger deductions than cost depletion, especially when measured over the life of the property. pp. I:10-22 and I:10-23.

I:10-20 a. Assuming Simon wants to maximize his deductions in the initial year, he would elect expensing of the IDCs, because the total deduction is $25,000 ($15,000 percentage depletion + $10,000 IDC) if the IDC is expensed, but only $20,000 if the IDC is capitalized.

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b. Intangible drilling costs (IDCs) are generally expensed because of the greater current tax benefit over capitalizing and deducting the costs in future periods. If percentage depletion is expected to be greater than cost depletion, it is more beneficial to deduct the IDCs. The capitalization and amortization of IDC merely increases the cost depletion amount and produces limited or no tax benefit. Expensing IDCs reduces gross income, thereby lowering taxable income. pp. I:10-23 and I:10-24.

Issue Identification Questions I:10-21 The principal tax issue is whether depreciation starts in the year of acquisition or in the year the automobile is placed into service. Other issues are the use of MACRS, Sec. 179, and bonus depreciation, as well as the luxury auto limits. pp. I:10-2, I:10-3, I:10-13, and I:10-14.

I:10-22 The following tax issues need to be addressed: • The regular MACRS depreciation amounts each year, as well as Sec. 179 and bonus depreciation.

• The luxury auto limitations on depreciation each year.

• The lease inclusion amount under tables published by the IRS for the initial year and subsequent years if the automobile is leased.

• The effect of recapture of excess cost recovery deductions and the required use of the ADS when the business use of the auto falls to 50% or less.

• Paula’s increased marginal tax rate and the impact of her changed tax situation on the decision. pp. I:10-13 through I:10-16.

I:10-23 The principal tax issue is whether Sec. 197 amortization applies to the intangible assets and to what extent the purchase agreement will establish tax basis for the acquired properties.

Generally, under Sec. 1060, an agreement between the purchasing and selling parties is binding unless the IRS determines the allocations are not appropriate. p. I:10-24.

I:10-24 The principal issue to consider is the applicability of the mid-quarter convention. While Woburn did not place more than 40% of the property into service in the fourth quarter ($800,000 is 35% of the $2.3 million total cost), the 40% test is computed after subtracting the cost of property deducted under Sec. 179 for the year. Assuming Woburn elects the maximum $1.22 million allowed under Sec. 179 for 2024, the denominator for the 40% test is $1.08 million ($2,300,000 - $1,220,000). If Woburn elects this $1.22 million for the January 20 and August 2 properties, 74% ($800,000/$1,080,000) of property is placed into service in the fourth quarter, so the mid-quarter convention applies. If Woburn elects $800,000 for the November 15 property (and $420,000 for the other property), 0% of property is placed into service in the fourth quarter, and the mid-year convention applies.

Woburn’s ability to also claim $648,000 [0.60 x ($2,300,000 - $1,220,000)] of bonus depreciation mitigates the depreciation convention’s effect. If Woburn claims bonus Copyright © 2025 Pearson Education, Inc.

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depreciation in addition to Sec. 179 expensing, only $432,000 ($2,300,000 - $1,220,000 $648,000) of the properties’ cost would remain for MACRS depreciation. This $432,000 is only 19% of their $2,300,000 cost.

Many states’ income tax rules do not allow bonus depreciation. If Woburn operates in such a state, it deducts a larger fraction of the properties’ $2.3 million cost under MACRS (how much larger depends on the state’s rules for Sec. 179). Even though a state might decouple from the federal rules for Sec. 179 and/or bonus depreciation, it typically does not do so for MACRS. Note: This issue identification question could be extended by having students determine the smallest amount of Sec. 179 expensing that Woburn could elect for the November 15 property without triggering the mid-quarter convention. Because the denominator for the 40% test is $1.08 million, Woburn will not trigger the mid-quarter convention if no more than $432,000 ($1,080,000 x 0.40) of the fourth-quarter property’s cost remains after subtracting out Sec. 179 expensing. Woburn thus needs to elect at least $368,000 ($800,000 - $432,000) of Sec. 179 expensing for the November 15 property. pp. I:10-8 and I:10-9.

Problems I:10-25 a. Even though Sandy did not claim any depreciation in 2022 through 2024, she is required to reduce her basis for the amount of allowable depreciation. The adjusted basis of the machine is computed as follows: 2021: ($10,000 x 0.1429) 2022: ($10,000 x 0.2449) 2023: ($10,000 x 0.1749) 2024: ($10,000 x 0.1249 x 0.50) Total allowable depreciation

$ 1,429 2,449 1,749 625 $ 6,252

Acquisition cost Minus: Allowable depreciation Adjusted basis

$10,000 ( 6,252) $ 3,748

Sandy may file amended returns for 2022 and 2023 to claim depreciation for those years. Her 2024 return should be corrected before she files it to claim depreciation for 2024.

Note: If any of Sandy’s prior years are closed by the statute of limitations, she could get relief by requesting a change of accounting method under Rev. Proc.

2007-16. With this change, all prior allowable depreciation deductions missed (even for closed years) can be taken in the year of change as a Sec. 481 adjustment (see Chapter I:11 for changes in accounting methods).

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b.

Sandy recognizes a $2,252 gain upon the sale of the asset, computed as follows: Sales price $ 6,000 Minus: Adjusted basis ( 3,748) Recognized gain $ 2,252

pp. I:10-3, I:10-5, and I:10-6.

I:10-26 a. The automobile’s basis for depreciation is $18,000. When personal-use property is converted to business use, its basis for depreciation is the lesser of its adjusted basis or fair market value (FMV) on the conversion date. The automobile’s adjusted basis for depreciation thus is $18,000 (lesser of $30,000 or $18,000). b. Depreciation for 2024 is $3,600 ($18,000 x 0.20) (Table 1, Appendix C). pp. I:10-2 through I:10-4.

I:10-27 a. For 2024, Silver cannot deduct depreciation for the land (because it is not depreciable) or for the equipment (because it is not placed in service until 2025). Silver cannot claim any Sec. 179 expensing because the $7 million ($2,000,000 + $5,000,000) cost of Sec. 179 property placed in service in 2024 is $4.27 million or more.

For 2024, Silver can claim 60% bonus depreciation for the cost of the trucks and machinery, and it can claim MACRS depreciation for the other 40% of those properties’ cost (as well as the building’s cost). Because the building is real property, its cost is not considered for the 40% test. None of the trucks or machinery is placed in service in the fourth quarter, so the half-year convention applies for both of them (0% is not more than 40%). MACRS depreciation is calculated using the percentages from Table 1 (for the trucks and machinery) and Table 8 (for the building) in Appendix C. Depreciation for 2024 for the three properties is calculated as follows: Trucks Machinery Building

Bonus depreciation $ 1,200,000 a 3,000,000 c -0$ 4,200,000

MACRS depreciation $ 160,000 b 285,800 d 10,700 e $ 456,500

Total $ 1,360,000 3,285,800 10,700 $ 4,656,500

a

0.60 x $2,000,000 0.20 x ($2,000,000 - $1,200,000) c 0.60 x $5,000,000 d 0.1429 x ($5,000,000 - $3,000,000) e 0.00107 x $10,000,000 b

b. For 2025, Silver cannot claim any Sec. 179 expensing because the $5.5 million cost of Sec. 179 property placed in service in 2025 is $4.27 million or more. It can claim 40% bonus depreciation for the equipment, but it cannot again claim bonus depreciation for the trucks or machinery. Silver can claim second-year MACRS depreciation (using the half-year convention) for the trucks, machinery, and building. It can also claim first-year MACRS depreciation for the portion of the equipment’s cost that is not claimed as bonus depreciation, and the half-year convention applies for MACRS because none of the cost of depreciable personal property is placed in service in the fourth quarter of 2025. MACRS depreciation is calculated using the Copyright © 2025 Pearson Education, Inc.

I:10-9

percentages from Table 1 (for the trucks, machinery, and equipment) and Table 8 (for the building) in Appendix C. Depreciation for 2025 for the four properties is calculated as follows: Trucks Machinery Building Equipment

Bonus depreciation $ -0-0-02,200,000 d $ 2,200,000

MACRS depreciation $ 256,000 a 489,800 b 256,400 c 660,000 e $ 1,662,200

Total 256,000 489,800 256,400 2,860,000 $ 3,862,200 $

a

0.32 x ($2,000,000 - $1,200,000) 0.2449 x ($5,000,000 - $3,000,000) c 0.02564 x $10,000,000 d 0.40 x $5,500,000 e 0.20 x ($5,500,000 - $2,200,000) b

pp. I:10-4 through I:10-10.

I:10-28 a. Large Corporation can depreciate only the truck, machinery, and building. The 40% test was used to determine which convention (half-year or mid-quarter) applied for MACRS depreciation of the truck and the machinery. The 40% test showed that both assets use midquarter depreciation, because more than 40% of all tangible personal property placed in service in 2024 was placed in service in the last three months ($85,000 ÷ $121,000 = 70.2%). Total depreciation for 2024 is $15,935, computed as follows: Truck [$36,000 x 0.35 (Table 2, Year 1)] Machinery [$85,000 x 0.0357 (Table 5, Year 1)] Building [$280,000 x 0.00107 (Table 8, Year 1, 12th month)] Total depreciation

$12,600 3,035 300 $15,935

b. Because the MACRS table percentages for the machinery and building are full-year percentages, Large must adjust depreciation in the year of disposition. Adjusted bases for the machinery and the building are computed as follows:

Original cost Accumulated depreciation: 2024 (from above) 2025 2026 Adjusted Basis

Machinery $85,000 $ 3,035 23,418a 2,091b ( 28,544) $56,456

Building $280,000 $

300 7,179c 5,085d (12,564) $267,436

a

$85,000 x 0.2755 (Table 5, Year 2) $85,000 x 0.1968 x 0.5/4 (Table 5, Year 3) c $280,000 x 0.02564 (Table 8, Year 2, 12th month) d $280,000 x 0.02564 x 8.5/12 (Table 8, Year 3, 12th month) b

pp. I:10-4 through I:10-10.

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I:10-10

I:10-29 a. $232,146. The apartment building is 27.5-year property, so Turner uses the midmonth convention for it. For the office furniture and office machinery, Turner applies the 40% test to determine whether it uses the half-year or mid-quarter convention for them. Of these two properties’ cost, 39.1% ($500,000 ÷ ($780,000 + $500,000)) is for property placed into service in the fourth quarter, so the half-year convention applies to them because 39.1% is less than or equal to 40%. The apartment building is real property (not personal property), so its cost is ignored for the 40% test. Using MACRS, Turner calculates its total depreciation deduction for 2024 as follows: Apartment building [$910,000 × 0.02273 (Table 7, Year 1, 5th month)]* $ 20,684 Office furniture [$780,000 × 0.1429 (Table 1, Year 1)] 111,462 Office machinery [$500,000 × 0.2000 (Table 1, Year 1)] 100,000 Total depreciation deduction $232,146 *The $80,000 cost of the land is not depreciable. b. $1,243,684. Turner applies the 40% test after subtracting the cost of property expensed under Sec. 179, so it applies this test using none of the office furniture’s cost and $60,000 ($500,000 - $440,000) of the office machinery’s cost. Thus, 100% of this $60,000 pertains to property placed into service in the fourth quarter, which triggers the mid-quarter convention because it is more than 40%. Turner calculates its total depreciation deduction for 2024 as follows: Sec. 179 expensing ($780,000 + $440,000) $1,220,000 MACRS depreciation: Apartment building [$910,000 × 0.02273 (Table 7, Year 1, 5th month)]* 20,684 Office furniture -0Office machinery [$60,000 × 0.0500 (Table 5, Year 1)] 3,000 Total depreciation deduction $1,243,684 *The $80,000 cost of the land is not depreciable.

Note: Many states’ income tax rules do not allow bonus depreciation, so Turner would need to make calculations like those above and in part c if it operates in those states, even if it deducts bonus depreciation for federal income tax purposes. Those states may vary in the extent to which the Sec. 179 expensing they allow differs from that for federal income tax purposes. c. $1,249,258. As in part b, Turner applies the 40% test after subtracting the cost of property expensed under Sec. 179. Turner claims all of the fourth-quarter property’s cost under Sec. 179, so 0% of tangible personal property is treated as placed into service in the fourth quarter. The half-year convention thus applies to the tangible personal property. Turner claims Sec. 179 expensing for all of the office machinery’s cost, so none of it is depreciated under MACRS. Turner calculates its total depreciation deduction as follows:

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I:10-11

Sec. 179 expensing ($720,000 + $500,000) $1,220,000 MACRS depreciation: Apartment building [$910,000 × 0.02273 (Table 7, Year 1, 5th month)]* 20,684 Office furniture [($780,000 - $720,000) × 0.1429 (Table 1, Year 1)] 8,574 Office machinery -0Total depreciation deduction $1,249,258 *The $80,000 cost of the land is not depreciable. pp. I:10-4 through I:10-10.

I:10-30 a. Tish can deduct $160,000 for 2024 under Sec. 179. The maximum amount she can elect under Sec. 179 ($1.22 million for 2024) is more than the properties’ $205,000 total cost, so Tish can elect Sec. 179 expensing for all of it. The deduction for the amount elected under Sec. 179 is limited to business taxable income before the Sec. 179 and 50% of self-employment tax deductions, which is $160,000 for Tish. Her $45,000 ($205,000 – $160,000) unused Sec. 179 expense carries over to 2025. b. $160,000. Tish cannot claim bonus depreciation or MACRS depreciation for the properties because she elected Sec. 179 for all of their cost. If Tish had elected Sec. 179 for only $160,000 of the properties’ cost, she could deduct $27,000 [0.60 × ($205,000 - $160,000)] as 2024 bonus depreciation, as well as MACRS depreciation on the remaining $18,000 of the properties’ cost. (The amount of MACRS depreciation would depend on the extent to which she claims the $160,000 of Sec. 179 expensing for each of the two properties and the convention that applies.) However, her total depreciation ($160,000 + $27,000 + MACRS) would more than offset her $160,000 of taxable income (before deducting Sec. 179 depreciation and 50% of her self-employment tax), likely resulting in a net operating loss that she would carry forward indefinitely. c. To use the $45,000 carryover in 2025, Tish must have sufficient business taxable income and also not have the dollar limitation next year be reduced below $45,000 (plus the cost of 2025 property for which she elects Sec. 179 treatment). d. In part a, Tish could deduct all $205,000 for 2024 under Sec. 179 because it is less than the $300,000 taxable limitation. She would have $0 to carry over to 2025. In part b, her total 2024 depreciation deduction would be $205,000. In part c, she would have no Sec. 179 carryover to 2025. pp. I:10-6 through I:10-7.

I:10-31 a. Depreciation for 2024 is computed as follows: Automobile [$9,000 x 0.1152 x 1/2 (Table 1, Year 4)]* Equipment [$20,000 x 0.1249 x 1/2 (Table 1, Year 4)] Building [$100,000 x 0.02564 x 11.5/12 (Table 8, Year 11, 4th month)] Total depreciation

$ 518 1,249 2,457 $4,224

*Note that this $518 is less than the $5,860 limitation for the fourth year for passenger automobiles placed into service in 2021 (see Table 6 in Appendix C).

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I:10-12

b. Gain or loss on each asset sold is computed as follows: Automobile:

Sales price Cost Accum. depr.

$ $ 2021 2022 2023 2024

$1,800 2,880 1,728 518

9,000

(6,926)

Loss on sale Equipment:

Building:

Sales price Cost Accum. depr.

1,200

(2,074) $ (874) $

9,500

Gain on sale

$

(7,497) 2,003

Sales price Cost Accum. depr.

$240,000

$ 20,000 2021 2022 2023 2024

2,858 4,898 3,498 1,249

(12,503)

$100,000 2014 2015-23 2024

$ 1,819 23,076 2,457

Gain on sale

(27,352)

(72,648) $167,352

pp. I:10-4 through I:10-10.

I:10-32 a. $1,248,580 for 2024, $48,980 for 2025, $34,980 for 2026, $24,980 for 2027, $17,860 for 2028, $17,840 for 2029, $17,860 for 2030, and $8,920 for 2031.

Richmond can deduct for 2024 the $1.22 million it elects under Sec. 179. In addition, Richmond can claim MACRS depreciation deductions for 2024-2031 for the remaining $200,000 ($1,420,000 – $1,220,000) of the machine’s cost. Richmond calculates its total depreciation deductions as follows (MACRS depreciation percentages are from Table 1):

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I:10-13

2024:

Sec. 179 expensing

$1,220,000

MACRS depreciation ($200,000 × 0.1429)

28,580

Total depreciation deduction for machine for 2024

$1,248,580

2025:

MACRS depreciation ($200,000 × 0.2449)

$

48,980

2026:

MACRS depreciation ($200,000 × 0.1749)

$

34,980

2027:

MACRS depreciation ($200,000 × 0.1249)

$

24,980

2028:

MACRS depreciation ($200,000 × 0.0893)

$

17,860

2029:

MACRS depreciation ($200,000 × 0.0892)

$

17,840

2030:

MACRS depreciation ($200,000 × 0.0893)

$

17,860

2031: MACRS depreciation ($200,000 × 0.0446) $ 8,920 Note: It generally would not be beneficial for a taxpayer to elect Sec. 179 expensing and also elect out of bonus depreciation, but many states’ income tax systems do not allow bonus depreciation. b. $1,351,432 for 2024, $19,592 for 2025, $13,992 for 2026, $9,992 for 2027, $7,144 for 2028, $7,136 for 2029, $7,144 for 2030, and $3,568 for 2031.

Richmond can deduct for 2024 the $1.22 million it elects under Sec. 179 and bonus depreciation of $120,000 [0.60 × ($1,420,000 - $1,220,000)]. In addition, Richmond can deduct MACRS depreciation for 2024 through 2031 for the $80,000 ($1,420,000 - $1,220,000 - $120,000) of the machine’s cost it does not deduct as Sec. 179 expensing or bonus depreciation. Richmond calculates its total depreciation deductions as follows (MACRS depreciation percentages are from Table 1): 2024:

2025: 2026: 2027: 2028: 2029: 2030: 2031:

Sec. 179 expensing Bonus depreciation (0.60 × $200,000) MACRS depreciation ($80,000 × 0.1429) Total depreciation deduction for machine for 2024 MACRS depreciation ($80,000 × 0.2449) MACRS depreciation ($80,000 × 0.1749) MACRS depreciation ($80,000 × 0.1249) MACRS depreciation ($80,000 × 0.0893) MACRS depreciation ($80,000 × 0.0892) MACRS depreciation ($80,000 × 0.0893) MACRS depreciation ($80,000 × 0.0446)

$1,220,000 120,000 11,432 $1,351,432 $19,592 $13,992 $ 9,992 $ 7,144 $ 7,136 $ 7,144 $ 3,568

c. 2024 and 2025 depreciation deductions do not change for parts a and b; 2026 depreciation deduction is $17,490 for part a and $6,996 for part b; and 2027-2031 depreciation deductions are zero for both parts. Gain is $325,050 for part a and $388,020 for part b.

For the year it sells the machine (2026), Richmond can deduct MACRS depreciation only for Copyright © 2025 Pearson Education, Inc.

I:10-14

the first half of the year because the half-year convention applies. Its 2026 depreciation deduction thus is $17,490 ($200,000 × 0.1749 × ½) for part a and $6,996 ($80,000 × 0.1749 × ½) for part b. In addition, it cannot claim depreciation deductions for the machine after that year because it no longer owns the machine. Richmond calculates the machine’s adjusted basis and the gain or loss on its sale as follows: Part a Part b Original cost $ 1,420,000 $ 1,420,000 2024 depreciation (see parts a & b) (1,248,580) (1,351,432) 2025 depreciation (see parts a & b) (48,980) (19,592) 2026 depreciation (see above) (17,490) (6,996) Adjusted basis when sold $ 104,950 $ 41,980 Amount realized

$

430,000

$

430,000

Adjusted basis Gain (loss) realized

$

(104,950) 325,050

$

(41,980) 388,020

Note that the machine declines in value by $990,000 ($1,420,000 - $430,000) while Richmond owns it. This decline is $325,050 less than the $1,315,050 of depreciation deductions Richmond claims for it in part a ($388,020 less than the $1,378,020 of depreciation deductions for part b). pp. I:10-4 through I:10-10.

I:10-33 a. $1,345,693 total depreciation for 2024. Wabash applies the 40% test to determine whether it uses the half-year or mid-quarter convention for the assets, and it does so after subtracting the cost it elects under Sec. 179. The denominator for the 40% test is $1.78 million ($1,510,000 + $1,490,000 - $1,220,000). If Wabash elects the $1.22 million for Asset #1, it places into service 84% ($1,490,000/$1,780,000) of the assets in the fourth quarter. Because this is greater than 40%, Wabash uses the mid-quarter convention for both assets. Wabash’s total depreciation deduction for 2024 is: Asset #1: Sec. 179 expensing $1,220,000 MACRS depreciation [($1,510,000 – $1,220,000) × 0.2500]* 72,500 Asset #2: MACRS depreciation [$1,490,000 × 0.0357]** 53,193 Total depreciation deduction $1,345,693 *Table 2, Year 1 **Table 5, Year 1 Note: It generally would not be beneficial for a taxpayer to elect Sec. 179 expensing and also elect out of bonus depreciation, but many states’ income tax systems do not allow bonus depreciation. b. $1,474,362 total depreciation for 2024. As in part a, the denominator for the 40% test is $1.78 million, but Wabash now places into service 15% (($1,490,000 – $1,220,000) ÷ $1,780,000) of the assets in the fourth quarter. Because this is less than or equal to 40%, Copyright © 2025 Pearson Education, Inc.

I:10-15

Wabash uses the half-year convention for both assets. Wabash’s total depreciation deduction for 2024 is: Asset #1: MACRS depreciation [$1,510,000 × 0.1429]* $ 215,779 Asset #2: Sec. 179 expensing 1,220,000 MACRS depreciation [($1,490,000 – $1,220,000) × 0.1429]* 38,583 Total depreciation deduction $1,474,362 *Table 1, Year 1 pp. I:10-4 through I:10-10.

I:10-34 a. All of Bobby’s assets are depreciated under the alternative depreciation system (ADS) using straight-line and the half-year convention. Depreciation for 2024 is computed as follows: Equipment [$40,000 x 0.0714 (Table 10, Year 1)] Truck [$30,000 x 0.20 x 1/2 (Table 10, Year 5)] Furniture [$10,000 x 0.1429 (Table 10, Year 5)] Automobile [$12,000 x 0.20 x 1/2 (Table 10, Year 4)] Total depreciation

$2,856 3,000 1,429 1,200 $8,485

*Note that the $1,200 for the automobile is less than the $5,860 limitation for the fourth year for passenger automobiles placed in service in 2021 (see Table 6 in Appendix C). b. Gain on each asset sold is computed as follows: Truck:

Sales price Cost Accum. depr.

$ 8,000 $30,000 2020 2021 2022 2023 2024

$3,000 6,000 6,000 6,000 3,000

(24,000)

Gain on sale Automobile:

Sales price Cost Accum. depr.

(6,000) $ 2,000 $10,000

$12,000 2021 2022 2023 2024

$1,200 2,400 2,400 1,200

Gain on sale p. I:10-11.

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I:10-16

(7,200)

(4,800) $ 5,200

I:10-35 a. The automobile is 5-year MACRS property; see p. I:10-5. (Some instructors may want to specify this information for their students, while other instructors may want students to determine it on their own.) It also is “listed property” and is subject to the special rules contained in Sec. 280F. When the property’s business use is greater than 50% of its total use, the taxpayer may use regular MACRS depreciation for the business-use portion of the asset’s cost. Trish’s MACRS depreciation deduction is computed as follows: Cost Times: Business-use percentage Business portion of cost Times: MACRS rate (Table 1, Year 1, 5-year recovery period) 2024 depreciation before the luxury auto ceiling limitation

$72,000 × 0.60 $43,200 × 0.20 $ 8,640

The limitation for the first year for passenger automobiles placed into service in 2024 if bonus depreciation does not apply is $12,400 (Table 6 in Appendix C). Because Trish’s business-use percentage is 60%, her limitation is $7,440 ($12,400 x 0.60). Trish’s 2024 depreciation deduction for the automobile is $7,440 (lesser of $8,640 or $7,440). b. Because Trish’s business use of the automobile is 50% or less of its total use, she must use the alternative depreciation system (ADS) for it. The ADS uses straight-line depreciation over the ADS recovery period (five years for automobiles). Trish’s depreciation deduction is computed as follows: Cost Times: Business-use percentage Business portion of cost Times: ADS rate from Table 10, Appendix C 2024 depreciation

$72,000 x 0.40 $28,800 x 0.10 $ 2,880

Trish’s 2024 depreciation deduction is limited to $4,960 ($12,400 x 0.40), so her deduction is $2,880 (lesser of $2,880 or $4,960). pp. I:10-12 through I:10-14.

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I:10-17

I:10-36 a. Tammy’s depreciation deductions are $2,800 for 2021, $4,480 for 2022, $1,600 for 2023, and $1,400 for 2024, computed as follows (note that the luxury limits for 2021 apply, the year Tammy placed into service the automobile): 2021:

2022:

2023:

2024:

Regular MACRS depreciation (100% business use): $20,000 x 0.20 = $4,000 Luxury limit (100% business use) = $10,200 Depreciation: 70% of the lesser of $4,000 or $10,200; $4,000 x 0.70 = $2,800 Regular MACRS depreciation (100% business use): $20,000 x 0.32 = $6,400 Luxury limit (100% business use): $16,400 Depreciation: 70% of the lesser of $6,400 or $16,400; $6,400 x 0.70 = $4,480 ADS depreciation (100% business use): $20,000 x 0.20 = $4,000. Business use fell to 50% or below, so ADS is required.

Luxury limit (100% business use) = $9,800 Depreciation: 40% of the lesser of $4,000 or $9,800; $4,000 x 0.40 = $1,600 ADS depreciation (100% business use): $20,000 x 0.20 = $4,000 Luxury limit (100% business use): $5,860 Depreciation: 35% of the lesser of $4,000 or $5,860; $4,000 x 0.35 = $1,400

b. When the business-use percentage for listed property decreases to 50% or below, as it did in 2023, the property becomes subject to recapture of excess recovery deductions. The alternative depreciation system (ADS) must be used to recompute all prior year depreciation deductions. The excess depreciation is included in the taxpayer’s gross income in the year in which the percentage falls to 50% or below. ADS depreciation for the prior years 2021 and 2022 is computed as follows: Year

ADS Depreciation (Table 10)

2021

$1,400 ($20,000 cost x 0.10 x 0.70 business-use), which is less than the luxury limit of $7,140 ($10,200 x 0.70)

2022

$2,800 ($20,000 cost x 0.20 x 0.70 business-use), which is less than the luxury limit of $11,480 ($16,400 x 0.70)

Total recapture in 2023 is $3,080 [($2,800 + $4,480) – ($1,400 + $2,800)]. The $3,080 must be included in Tammy’s gross income. pp. I:10-5, I:10-12 through I:10-14.

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I:10-18

I:10-37 Depreciation deductions are computed as follows:

Year 2024 2025 2026 2027 2028 2029 2030 2031

MACRS Deduction (Table 1; 5-year recovery period) $77,000 × 0.20 = $15,400 $77,000 × 0.32 = $24,640 $77,000 × 0.192 = $14,784 $77,000 × 0.1152 = $8,870 $77,000 × 0.1152 = $8,870 $77,000 × 0.0576 = $4,436**

Ceiling Limit (Table 6) $ 12,400 19,800 11,900 7,160 7,160 7,160

Allowed Deduction* $ 12,400 19,800 11,900 7,160 7,160 4,436 7,160 6,984 $ 77,000

*For 2024-2029, the allowed deduction is the lesser of (1) the regular MACRS deduction or (2) the ceiling amount. For subsequent years, a $7,160 ceiling limitation applies until the automobile is fully depreciated. **Differs from 5.76% of $77,000 due to rounding.

I:10-38 a. Depreciation deductions are computed as follows:

Year 2024 2025 2026 2027 2028 2029 2030 2031 2032

MACRS Deduction (Table 1) (5-year recovery) $80,000 × 0.20 = $16,000 $80,000 × 0.32 = $25,600 $80,000 × 0.192 = $15,360 $80,000 × 0.1152 = $9,216 $80,000 × 0.1152 = $9,216 $80,000 × 0.0576 = $4,608

Ceiling Limit (Table 6) $ 12,400 19,800 11,900 7,160 7,160 7,160

Allowed Deduction* $ 12,400 19,800 11,900 7,160 7,160 4,608 7,160 7,160 2,652 $ 80,000

*For 2024-2029, the allowed deduction is the lesser of (1) the regular MACRS deduction or (2) the ceiling amount. For subsequent years, a $7,160 ceiling limitation applies until the automobile is fully depreciated.

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I:10-19

b. Depreciation deductions are computed as follows:

Year 2024 2025 2026 2027 2028 2029

Ceiling Limit (Table 6) $ 12,400 19,800 11,900 7,160 7,160 7,160

MACRS Deduction (Table 1) (5-year recovery) $48,000 × 0.20 = $9,600 $48,000 × 0.32 = $15,360 $48,000 × 0.192 = $9,216 $48,000 × 0.1152 = $5,530 $48,000 × 0.1152 = $5,530 $48,000 × 0.0576 = $2,764**

Allowed Deduction* $ 9,600 15,360 9,216 5,530 5,530 2,764 $ 48,000

*Lesser of (1) the regular MACRS deduction or (2) the ceiling amount. **Differs from 5.76% of $48,000 due to rounding.

In this case, the luxury automobile limitations do not restrict Luby’s depreciation deductions.

By the end of 2029, the property is fully depreciated, so Luby does not deduct any depreciation for 2030 and subsequent years. pp. I:10-13 through I:10-15.

I:10-39 a. Depreciation for each year is computed as follows: 100% Business-Use MACRS Ceiling Deduction Limit $15,200 $12,400

Deduction Allowed 70% of lesser $8,680

Unrecovered Basis at end of year $63,600 ($76,000 - $12,400)

2024:

MACRS depreciation: $76,000 × 0.20 = $15,200

2025:

MACRS depreciation: $76,000 × 0.32 = $24,320

$24,320

$19,800

$13,860

$43,800 ($63,600 - $19,800)

2026:

MACRS depreciation: $76,000 × 0.192 = $14,592

$14,592

$11,900

$8,330

$31,900 ($43,800 - $11,900)

2027:

MACRS depreciation: $76,000 × 0.1152 = $8,755

$8,755

$7,160

$5,012

$24,740 ($31,900 - $7,160)

2028:

MACRS depreciation: $76,000 × 0.1152 = $8,755

$8,755

$7,160

$5,012

$17,580 ($24,740 - $7,160)

2029:

MACRS depreciation: $76,000 × 0.0576 = $4,378

$4,378

$7,160

$3,065

$13,202 ($17,580 - $4,378)

$7,160

$5,012*

Reduce by $7,160 each year

Each year after 2029 *

Tracy can deduct $5,012 of depreciation each year until the unrecovered basis is zero.

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I:10-20

b.

If the SUV’s GVWR is over 6,000 pounds, the luxury auto depreciation rules do not apply to it, and the taxpayer can deduct up to $30,500 under Sec. 179 for it (for 2024).

However, only $53,200 ($76,000 x 0.70) of the SUV’s cost can be depreciated because personal-use assets are not depreciable. Therefore, MACRS depreciation is allowed for $22,700 ($53,200 - $30,500) of the SUV’s cost. Depreciation for 2024 and each subsequent year is: 2024: Sec. 179 expensing MACRS depreciation (0.20 × $22,700) Total depreciation 2025: MACRS depreciation (0.32 × $22,700) 2026: MACRS depreciation (0.192 × $22,700) 2027: MACRS depreciation (0.1152 × $22,700) 2028: MACRS depreciation (0.1152 × $22,700) 2029: MACRS depreciation (0.0576 × $22,700)

$30,500 4,540 $35,040 $ 7,264 $ 4,358 $ 2,615 $ 2,615 $ 1,308

pp. I:10-13 through I:10-15.

I:10-40 a. $11,184 ($1,165 x 12 x 0.80) of the lease payments is deductible as a business expense in each of the two years. b. Troy reduces each year’s lease payment deduction by 80% of the lease inclusion amount for a $79,000 automobile for that year (using Table 12, Appendix C): 1st year (2024): $118 x 0.80 = $94 2nd year (2025): $259 × 0.80 = $207 3rd year (2026): $385 x 0.80 = $308 c. Lease payments of $7,536 ($785 x 12 months x 80%) are deductible. No reduction is required because the FMV is below the minimum amount designated as a luxury auto. p. I:10-16.

I:10-41 a. Vicki’s assets would be recorded by Palm Corporation as follows: Tangible assets: Intangible assets: Covenant not to compete Goodwill Patents Customer list Total:

$400,000 50,000 70,000 30,000 50,000 $600,000

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I:10-21

b. All except the tangible assets are Sec. 197 intangible assets and are amortized as follows: • Covenant: $3,333 ($50,000 ÷ 15 years) even though the covenant is for a period of 5 years.

• Goodwill: $4,667 ($70,000 ÷ 15 years).

• Patent: $2,000 ($30,000 ÷ 15 years) even though the remaining useful life is only 12 years.

• Customer list: $3,333 ($50,000 ÷ 15 years).

The tangible assets would be depreciated under the MACRS rules to the extent Palm does not deduct their cost through Sec. 179 expensing or bonus depreciation. pp. I:10-17 through I:10-19.

I:10-42 The only expenditures that are deductible as research and experimental costs under Sec. 174 are materials and supplies for research laboratory, utilities and depreciation on research laboratory and equipment, and research costs subcontracted to a local university. Costs of acquiring another entity’s patent, market research surveys, and labor and supplies for quality control tests do not qualify. pp. I:10-19 and I:10-20.

I:10-43 $17,000 for 2024 and $34,000 for 2025. Tempe’s 2024 R&E expenditures are $170,000 [$40,000 + $80,000 + $30,000 + ($100,000 × 20%)]. Tempe’s 2024 deduction for these expenditures is $17,000 [($170,000 ÷ 5 years) × ½], and its 2025 deduction is $34,000 ($170,000 ÷ 5 years). pp. I:10-19 and I:10-20.

I:10-44 Phillips Corporation can deduct the cost of computer software as follows: •

•

•

The cost of software included in the cost of the computer hardware may be depreciated with the hardware as long as the taxpayer consistently follows this treatment. Therefore, the total computer system would be considered 5-year property and the depreciation deduction would be ($15,000 x 0.20) = $3,000.

The portion of the depreciation deduction attributable to the software would be $600 ($3,000 x 0.20), although it would not be separately stated.

The bookkeeping software was acquired separately and would be depreciated over 36 months on a straight-line basis. Since the software was purchased on September 1, 2024, the deduction would be $640 ($5,760/36 months x 4 months).

The computer software acquired in connection with a purchase of assets of an existing trade or business is a Sec. 197 intangible and amortized over 15 years.

Therefore, the amortization deduction for 2024 is $1,944 [($50,000/15 years) x 7/12].

pp. I:10-20 and I:10-21.

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I:10-22

I:10-45 a.

If the IDCs are expensed, the cost depletion amount is $40,000, computed as follows: Basis (acquisition cost) Divided by: Estimated recoverable units Cost depletion per unit Times: Units sold Depletion amount

b.

$200,000  20,000 $ 10 4,000 $ 40,000

If the IDCs are capitalized, the cost depletion amount is $44,000, computed as follows: Basis ($200,000 + $20,000 IDCs) Divided by: Estimated recoverable units Cost depletion per unit Times: Units sold Depletion amount

$220,000  20,000 $

11 4,000 $ 44,000

c.

The greater of cost depletion or percentage depletion, not to exceed 100% of taxable income before depletion. Therefore, cost depletion of $44,000 is deducted if the IDCs are capitalized, and $40,000 if the IDCs are expensed, because percentage depletion is only $25,000.

d.

Assuming Tina has substantial gross income, the immediate expense method is preferable because $20,000 of IDCs may be expensed in the initial year while also deducting $40,000 of cost depletion. Under the capitalization method, only $44,000 can be deducted. pp. I:10-21 through I:10-24.

I:10-46 a.

If the IDCs are expensed the percentage depletion amount is $75,000 ($500,000 x 0.15). The limitation is $200,000 (taxable income before depletion) and, therefore, is not applicable.

If the IDCs are capitalized, the percentage depletion amount is still $75,000.

Taxable income before depletion is $300,000 ($500,000 - $200,000) so, again, the limitation does not apply.

If the IDCs are expensed, the depletion deduction is $75,000 (the greater of $75,000 percentage depletion or $20,000 of cost depletion).

The percentage depletion method should be used because the taxpayer may deduct the $75,000 plus the $100,000 of IDCs in the current year.

b.

c. d.

pp. I:10-21 through I:10-24.

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I:10-23

Comprehensive Problem I:10-47 Note: This problem pertains to 2023 rather than 2024 because its facts are used by one of the Tax Form/Return Preparation Problems (I:10-51), and IRS forms for 2024 were not available when this textbook edition was published.

Wages

$ 42,000

Business income: Sales revenues (8,000 u. @ $15/u.)

Service revenues Cost of goods sold Gross profit

$120,000 94,000

$214,000 45,000(1) 169,000

Expenses: Auto, gas, oil, etc.

Depreciation Interest on business loans Lease expense Taxes and licenses Salaries Utilities

4,800 51,240(2) 6,000 5,996(3) 3,300 36,000 2,800 110,136

Gain on sale of 7-year equipment Total income One-half SE tax [($58,864 x 0.9235 x 0.153) = $8,317 x 0.50] Adjusted gross income Standard deduction Qualified business income deduction [0.20 × ($58,864 + $6,645 - $4,159)] Taxable income Income tax (from 2023 Tax Table) Self-employment tax ($58,864 x .9235 x .153) Total tax Withholdings and estimated tax payments [$4,000 + (4 × $3,100)] Overpayment (refund) Detailed Computations

$

7,165 8,317 $ 15,482 ( 16,400) $ (918)

(1)

Cost of goods sold:

(2)

Depreciation for 2023: Equipment (7-year recovery) Table 1, Year 6: ($30,000 x 0.0892 x ½ year) Old store building ($100,000 x .02564) Table 8, Year 16 New store building ($115,000 x .02033) Table 8, Year 1 Equipment (5-year recovery) expensed under Sec. 179

(3)

Beginning Inventory (4,000 u. @ $5/u.)

Purchase #1 (3,000 u. @ $6/u.)

Purchase #2 (4,000 u. @ $7/u.)

Ending Inventory (3,000 u. @ $7/u.)

COGS

Lease expense deduction: ($860 × 7) – ($41 × 7/12) = $5,996 Copyright © 2025 Pearson Education, Inc.

I:10-24

58,864 6,645(4) $107,509 (4,159) $103,350 (27,700) (12,270) $ 63,380

$20,000 18,000 28,000 ( 21,000) $45,000

$ 1,338 2,564 2,338 45,000 $51,240

(4)

Gain on sale of 7-year equipment: Amount realized Adjusted basis: Cost Accumulated depreciation: 2018 ($30,000 × 0.1429) 2019 ($30,000 × 0.2449) 2020 ($30,000 × 0.1749) 2021 ($30,000 × 0.1249) 2022 ($30,000 × 0.0893) 2023 ($30,000 × 0.0892 × ½) Gain realized (ordinary)

$12,000 $30,000 $4,287 7,347 5,247 3,747 2,679 1,338

24,645

5,355 $ 6,645

Note: Some instructors may want to make this problem more comprehensive by specifying itemized deductions that exceed the standard deduction. Doing so would affect the taxpayers’ taxable income, income tax, total tax, and refund.

Tax Strategy and Critical Thinking Problems I:10-48 Based on present value analysis, Stan would be better off leasing the car. The analysis is presented below.

Purchase the car: MACRS depreciation (using the percentages from Appendix C, Table 1) and the ceiling limits for luxury automobile depreciation deductions are as follows: 2024 2025 2026 2027 2028

MACRS depreciation $75,000 x 0.2000 = $15,000 $75,000 x 0.3200 = $24,000 $75,000 x 0.1920 = $14,400 $75,000 x 0.1152 = $ 8,640 $75,000 x 0.1152 = $ 8,640

Ceiling limit $12,400 $19,800 $11,900 $ 7,160 $ 7,160

Each year’s depreciation deduction is the lesser of MACRS depreciation or the ceiling limit, which is the ceiling limit in this case. Stan can also deduct the interest on the car loan. The present value of these deductions is determined as follows, using the 24% marginal tax rate and 6.2% discount rate specified in the problem: Present value Depreciation Interest Total Tax savings of tax savings 2024 $12,400 $ 4,140 $16,540 $ 3,970 $ 3,738 2025 19,800 3,321 23,121 5,549 4,920 2026 11,900 2,453 14,353 3,445 2,876 2027 7,160 1,532 8,692 2,086 1,640 2028 7,160 554 7,714 1,851 1,370 $58,420 $12,000 $70,420 $16,901 $14,544

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I:10-25

When Stan sells the car at the end of five years for $23,000, he will realize a gain of $6,420 [$23,000 - ($75,000 - $58,420)]. At a 24% tax rate, this gain would generate an additional $1,541 ($6,420 x 0.24) of tax, which has a present value of $1,141 ($1,541/1.0625). Finally, the $23,000 received from the sale of the car has a present value of $17,026 ($23,000/1.0625). The net present value of purchasing the car would be (all amounts are present values): Loan payments over 60 months Tax savings from deductions Tax paid on gain on sale Cash received from sale of car Net present value of purchasing the car

($75,000) 14,544 (1,141) 17,026 $(44,571)

Lease the car: Stan can deduct the lease payments, net of the lease inclusion amounts: Present value of $1,120 monthly lease payment for 60 months at 0.5% per month: Present value of tax benefits: Lease payment per month $1,120 Lease inclusion amount per month ($268/12) (22) Lease deduction per month $1,098 Marginal tax rate x 0.24 Monthly tax savings $ 264 PV of $264 @ 0.5% per month for 60 months Net present value of leasing the car

($57,933)

13,656 $(44,277)

Conclusion: The after-tax cost (net present value) of obtaining the car’s use is lower if Stan leases it ($44,277) rather than purchasing it ($44,571).

I:10-49 a. $239,517 if the allocation is $1 million to the equipment and $400,000 to the goodwill, and $220,636 if the allocation is $750,000 to the equipment and $650,000 to the goodwill.

Blaze deducts for Year 1 60% of the amount allocated to the equipment as bonus depreciation, and it also deducts for Years 1 through 8 MACRS depreciation for the other 40% of its cost. The goodwill is a Sec. 197 intangible for Blaze, so it deducts the amount allocated to goodwill over 15 years. The total present value of Blaze’s 21% tax savings under each alternative can be determined as follows:

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I:10-26

Present value of tax savings from depreciation deductions for equipment:

Bonus depr.

MACRS:b Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Total

(i) $1,000,000 allocated to equipment Deduction Tax savings a Present value $ 600,000 $126,000 $126,000

(ii) $750,000 allocated to equipment Deduction Tax savings a Present value $450,000 $ 94,500 $ 94,500

57,160 97,960 69,960 49,960 35,720 35,680 35,720 17,840 $1,000,000

42,870 73,470 52,470 37,470 26,790 26,760 26,790 13,380 $750,000

12,004 20,572 14,692 10,492 7,501 7,493 7,501 3,746 $210,001

12,004 18,702 12,142 7,883 5,123 4,653 4,234 1,922 $192,663

9,003 15,429 11,019 7,869 5,626 5,620 5,626 2,810 $157,502

9,003 14,026 9,107 5,912 3,843 3,490 3,176 1,442 $144,499

a

21% of deduction.

Amount allocated to equipment minus bonus depreciation, multiplied by MACRS percentage from Appendix C, Table 1 (14.29% for Year 1, 24.49% for Year 2, etc.). b

Present value of tax savings from amortization deductions for goodwill: (i) $400,000 allocated to goodwill: Annual deduction = $400,000 ÷ 15 years = $26,667 Annual tax savings = $26,667 × 0.21 = $5,600 Present value of tax savings = $5,600 × 8.3667 = $46,854 (ii) $650,000 allocated to goodwill: Annual deduction = $650,000 ÷ 15 years = $43,333 Annual tax savings = $43,333 × 0.21 = $9,100 Present value of tax savings = $9,100 × 8.3667 = $76,137 Note: The 8.3667 present value factor is for an annuity due (n = 15, and R = 10%).

(1 + R) × {[1 - (1 + R)-n] ÷ R} = 1.10 × {[1 – 1.10-15] ÷ 0.10} = 8.3667 Present value of tax savings from both deductions: (i) $1 million allocated to equipment and $400,000 allocated to goodwill: $192,663 + $46,854 = $239,517 (ii) $750,000 allocated to equipment and $650,000 allocated to goodwill: $144,499 + $76,137 = $220,636 Blaze realizes present value of tax savings that are $18,881 ($239,517 – $220,636) greater with allocation (i) versus allocation (ii). Blaze saves the same amount of taxes with either allocation (21% of the $1.4 million allocated to the equipment and goodwill), but it realizes those tax savings more quickly with the first allocation. b. $394,500 if the allocation is $1 million to the equipment and $400,000 to the goodwill, and $352,000 if the allocation is $750,000 to the equipment and $650,000 to the goodwill.

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I:10-27

Helen realizes total gains of $1.25 million ($1,400,000 – $150,000 – $0), assuming the amount allocated to the equipment exceeds its $150,000 adjusted basis. The allocation of the $1.4 million between the equipment and goodwill, however, affects the gain Helen realizes on each asset. This in turn affects her taxes on the sale because the tax rate for the equipment’s ordinary gain is 37%, while the tax rate for the goodwill’s long-term capital gain is 20%: (i) $1 million allocated to equipment and $400,000 allocated to goodwill: Equipment:

Ordinary gain = $1,000,000 – $150,000 = $850,000 Tax = $850,000 × 0.37 = $314,500

Goodwill: Long-term capital gain = $400,000 – $0 = $400,000 Tax = $400,000 × 0.20 = $80,000 Total tax = $314,500 + $80,000 = $394,500 (ii) $750,000 allocated to equipment and $650,000 allocated to goodwill: Equipment:

Ordinary gain = $750,000 – $150,000 = $600,000 Tax = $600,000 × 0.37 = $222,000

Goodwill: Long-term capital gain = $650,000 – $0 = $650,000 Tax = $650,000 × 0.20 = $130,000 Total tax = $222,000 + $130,000 = $352,000 Helen’s tax liability is $42,500 ($394,500 – $352,000) greater with allocation (i) versus allocation (ii). This occurs because a greater portion of the total gains of $1.25 million is taxed at 37% rather than 20% when more of the $1.4 million is allocated to the equipment. c. Blaze is better off with allocation (i) because it realizes a greater present value of tax savings, but Helen is better off with allocation (ii). Blaze prefers that more of the $1.4 million be allocated to the equipment because it deducts the equipment’s cost more quickly than the goodwill’s cost. Helen prefers that less of the $1.4 million be allocated to the equipment because gain on the equipment is taxed to her at a higher rate than gain on the goodwill. The two parties’ preferences thus conflict, making it unclear which allocation is better.

Considering the two parties’ preferences jointly, allocation (ii) results in more favorable combined tax consequences. Although Blaze realizes present value of tax savings that are $18,881 less, Helen’s tax liability is $42,500 less. The parties might resolve their conflicting preferences by negotiating a total price for the equipment and goodwill that is less than $1.4 million and allocating that smaller amount more heavily to the goodwill.

The allocation of the $1.4 million (or less, if so negotiated) should be consistent with the two assets’ fair market values (FMVs), but there can be uncertainty about the FMV of assets like specialized equipment and goodwill. Taken to an extreme, the entire $1.4 million could be allocated to the goodwill and zero allocated to the equipment. However, the IRS might challenge an arrangement that allocates more to the goodwill (and less to the equipment) than is reasonable.

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I:10-28

Tax Form/Return Preparation Problems I:10-50 (See Instructor’s Resource Manual) I:10-51 (See Instructor’s Resource Manual)

Case Study Problems I:10-52 The following points should be mentioned in the client memo.

1. The tangible assets should be recorded at their FMV of $400,000. Appraisals should be obtained to establish credibility for the individual asset allocations. It is preferable for your client (Able) to allocate cost liberally to the inventory and depreciable assets. The sale of inventory results in an immediate tax benefit in the form of an increase in cost of goods sold, whereas allocations of cost to land affect only gain or loss upon a future sale.

2. It makes no difference for tax purposes whether the $600,000 excess amount is allocated to a covenant not to compete or to goodwill, because both types of assets are Sec. 197 intangibles and are amortizable over a 15-year period. Section 197 applies to intangible assets acquired in connection with a transaction that involves the acquisition of a trade or business.

I:10-53 For 2022 and 2023, Margate should have reported the value of the officer’s personaluse benefit to the IRS by including such amounts on the officer’s Form W-2. Statement on Standards for Tax Services No. 1 says that a CPA should promptly inform a taxpayer of an error in a previously filed return. The CPA should advise the taxpayer of the error’s potential consequences and corrective measures to be taken, and the CPA should advise the taxpayer to seek legal counsel if the CPA believes that the taxpayer may face exposure to allegations of criminal misconduct. The CPA generally should not inform the IRS of an error without the taxpayer’s permission. If the taxpayer does not take appropriate action to correct the error, the CPA should consider whether to withdraw from preparing the taxpayer’s current tax return and continuing a professional relationship with the taxpayer. Although Margate’s taxable income is not affected (only the officer’s personal return), Margate may be liable for penalties. You thus should ascertain whether Margate is taking appropriate measures to correct the error and consider whether it is appropriate for you to continue your professional relationship with Margate.

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I:10-29

Tax Research Problem I:10-54 Depreciation of works of art has been controversial. The IRS takes the position in Rev. Rul. 68-232, 1968-1 C.B. 79, that assets that automatically increase in value with age are not depreciable. In Associated Obstetricians and Gynecologists v. Comr., 46 TCM 613 (1983), affd.

762 F.2d. 38 (6th Cir. 1985), the court agreed with the IRS that pieces of artwork for their office had no useful life and were not subject to depreciation. Likewise, in Shauna C. Clinger, 60 TCM 598 (1990), the Tax Court held that artwork was not depreciable because it did not have a useful life. However, in two later cases, the requirement of a useful life has been diminished to some degree. In Simon v. Comr., 103 T.C. 247 (1994), affd. 95-2 USTC 50,552 (2d Cir. 1995) and Liddle v. Comr., 103 TC 285 (1994), affd. 95-2 USTC 50,488 (3d Cir. 1995), the taxpayers were allowed to depreciate violins because the taxpayer played the instruments as opposed to using them as passive objects displayed for admiration of their aesthetic qualities. In Timothy Couch’s situation, it appears that the artworks will not be eligible for depreciation.

“What Would You Do In This Situation?” Solution Ch. I:10, p. I:10-25.

Ruth Less’ solicitation of your client, Widgets R Us, Inc., is clearly unethical under the AICPA’s Code of Professional Conduct. Rule 302 prohibits contingent fees by stating that professional services shall not be offered or rendered under an arrangement whereby no fee will be charged unless a specified finding or result is attained, or where the fee is otherwise contingent upon the findings or results of such services. Thus, Ruth Less’ fees being based solely on the amount of savings resulting from the R&E expenditures deductions would constitute a contingent fee under the Code of Professional Conduct. Further, the solicitation by Ruth Less of your client may be a violation of Rule 502, which deals with false, misleading, or deceptive acts in advertising or solicitation.

While the arrangement as proposed by Ruth Less is clearly unethical, a slightly different approach would probably be acceptable and is done routinely in business today. Many CPA firms provide consulting services for clients who have another CPA do audit and general tax work. Thus, if Ruth Less was proposing an R&E study and not an attempt to take the client away from your firm, the R&E study would not be unethical. However, the fee structure would have to be modified to avoid contingent fee status.

Finally, if the claims of Ruth Less are valid (or even somewhat valid), your CPA firm should improve its update of tax laws because at present, you are not providing the necessary advice for your client to pay the minimum income tax allowable under the law.

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I:10-30

Chapter I:11 Accounting Periods and Methods Discussion Questions I:11-1 In the long run, the amount of income reported by a taxpayer will generally be the same regardless of the accounting methods used by the taxpayer. In a given year, the amount of income reported by a taxpayer can vary significantly depending on the accounting method used by the taxpayer. p. I:11-2.

I:11-2 The accounting methods used by a taxpayer can accelerate or defer the recognition of income, and, thereby, change when the tax must be paid. Also, because of the progressive tax rate structure, taxes for an individual can be saved by spreading income over several years, rather than having income bunched into one year, pushing the taxpayer into higher brackets. p. I:11-2.

I:11-3 The tax year must coincide with the year used to keep books and records. Taxpayers who do not have books must use the calendar year. Most individuals who are wage earners do not keep books and, therefore, must file using a calendar year. p. I:11-2.

I:11-4 Once a tax year is elected, it normally cannot be changed without IRS approval. The appropriate tax year can make record keeping easier. If the year ends during the slow season, inventories may be lower and employees are available to take inventory and perform other accounting duties associated with the year end. pp. I:11-4 through I:11-5.

I:11-5 A partnership must use the same tax year of the partners who own the majority of the partnership income and capital. If the majority does not have the same tax year, the partnership must use a taxable year which is the same as the taxable year of all its principal partners (or the same taxable year of all its principal partners who do not have such taxable year concurrently change). If the principal partners do not have the same tax year, a taxable year that results in the least aggregate deferral of income to the partners must be used. Partnerships may also elect a natural business year even if it differs from the tax year of its partners. Also, a partnership may elect a fiscal year involving a deferral period of three months or less if the partnership makes a required tax payment. pp. I:11-2 through I:11-5.

I:11-6 Yes. S corporations are generally required to adopt a calendar year unless either the corporation has a natural business year or elects to make required tax payments. Rules similar to those imposed upon partnerships (see the answer to Question I:11-5 above) are applied to S corporations. pp. I:11-2 through I:11-5.

I:11-7 The 52- to 53- week year is especially useful to businesses with inventories. For example, a manufacturer might choose a 52- to 53- week year that ends on the last Friday in December so as to permit the inventory to be taken over the weekend without interfering with the company’s manufacturing process. pp. I:11-3 through I:11-5.

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I:11-1

I:11-8 A newly married person may change his or her tax year to conform to that of the other spouse so that a joint return may be filed. Also, a 52- to 53- week year can be adopted if the year ends on a day that refers to the same month in which the taxpayer’s prior year ended. p. I:11-5.

I:11-9 A subsidiary corporation filing a consolidated return with its parent is required to change its accounting period to conform with its parent. p. I:11-5.

I:11-10 a.

When a taxpayer files his or her first or final return or when the taxpayer changes accounting periods. b.

Annualization is required when a change in the accounting period occurs. c.

Due to progressive tax rates, annualization generally increases an individual’s tax liability. pp. I:11-5 through I:11-6.

I:11-11 The due date of the tax return does not change because of the taxpayer’s death. Final returns are filed, and taxes are paid, as if they were returns for a 12-month period ending on the last day of the short period. p. I:11-5 and I:11-6.

I:11-12 a.

Taxpayers may use the cash method as long as average annual gross receipts do not exceed $30 million (for 2024) for the prior three years. If this average exceeds the threshold, taxpayers with inventories are required to use the accrual method for sales and cost of sales. This is not a requirement that they use the accrual method for other items on their returns. b.

In general, other taxpayers may choose any accounting method they want. This, of course, assumes that the method chosen clearly reflects income. c.

The cash method is preferred to the accrual method because it is simpler to use. It frees the taxpayer from having to make the year-end accruals associated with the accrual method.

Also, it enables taxpayers to accelerate deductions by prepaying expenses. Similarly, income that has been earned but not yet received is not taxable until it is collected. Thus, the cash-method taxpayer does not have to report uncollected receivables. pp. I:11-7 through I:11-10.

I:11-13 a.

The term “method of accounting” refers not only to overall methods of accounting but also the accounting treatment of any item. Examples of accounting methods for specific items include Sec. 174 relating to research and experimentation expenditures, Sec. 451 relating to long-term contracts, and Sec. 453 relating to installment sales. b.

Accounting methods generally affect when income is reported not whether it is reported. Thus, the total amount of income reported over time is not affected by a taxpayer’s accounting method. c.

Because an accounting method determines when income is reported, it can change the total amount of tax paid because tax brackets differ over time. p. I:11-7.

I:11-14 a.

A cash-method taxpayer deducts expenses when they are paid. A cash-method taxpayer is, however, required to capitalize fixed assets and recover the cost through depreciation or amortization. Section 179 does, however, permit many taxpayers to currently deduct up to $1,220,000 (for 2024) of equipment. Prepaid expenses must also be capitalized and deducted over the term of the prepayment if that term extends substantially beyond the end of the tax year.

Typically, capitalization is required only if the term of the prepayment extends beyond the close of the tax year following the year of payment.

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I:11-2

b.

No. Prepaid interest is not deductible. An exception permits a cash-method taxpayer to deduct points paid on a home mortgage if the property is the taxpayer’s principal residence and the mortgage was for the purchase or improvement of the residence. c.

Yes. Cash-method taxpayers are subject to the same rules as other taxpayers. pp. I:11-7 and I:11-8.

I:11-15 Companies whose average annual gross receipts for the three preceding years were $30 million or less (for 2024) may use the completed contract method for construction contracts that are expected to take two years or less to complete. In addition, the completed contract method may be used for home construction contracts. pp. I:11-15 through I:11-17.

I:11-16 A taxpayer cannot deduct a deposit as long as he has a right to receive a refund. p. I:11-8.

I:11-17 Payment can be either by check that is honored in due course or by use of a credit card.

Payment by credit card is considered to be the equivalent of borrowing funds and using the borrowed funds to pay the expense. A taxpayer’s note is not considered to be the equivalent of cash. p. I:11-9.

I:11-18 Economic performance of services or property to be provided to a taxpayer occurs when the property or the services is actually provided by the other party. If a taxpayer is obligated to provide property or services, economic performance occurs in the year the taxpayer provides the property or service. p. I:11-9.

I:11-19 Five conditions must be met. They are: 1.

The all events test, without regard to economic performance, must be satisfied.

2.

Economic performance must occur within a reasonable period (but in no event more than 8½ months) after the close of the taxable year.

3.

The item is recurring and is treated consistently by the taxpayer.

4.

Either the amount is not material or the earlier accrual of the item results in a better matching of income and expense.

5.

The taxpayer is not a tax shelter. p. I:11-9.

I:11-20 No. The all events and economic performance tests prevent the deduction of estimated expenses. The expense becomes deductible once the actual cost is known. Prepaid expenses are deductible as long as the exception to the economic performance test is met. p. I:11-10.

I:11-21 The Regulations state that inventory methods used by a taxpayer must conform to the best accounting practice in the trade or business and it must clearly reflect income. In Thor Power Tool Co., the Supreme Court held that the clear reflection of income standard shall prevail in cases where the two standards conflict. Regulation Sec. 1.471- 4(b) states that obsolete and other slow moving inventory cannot be written down unless the selling price is also reduced. Thor Power Tool Co. wrote-off the cost of obsolete inventory. The Supreme Court held this practice was not acceptable as it conflicted with the clear reflection of income requirement. p. I:11-11.

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I:11-22 a.

Manufacturing overhead (such as factory repairs and maintenance, utilities, rent and other costs relating to the manufacturing process) must be included in inventory.

Nonmanufacturing costs (such as advertising and selling expenses) are not required to be included in inventory. Other overhead costs (such as employee benefits, and factory administration) must also be included in inventory unless they relate to the nonmanufacturing areas such as selling or advertising. b.

Retailers whose average annual gross receipts for the three preceding years exceeds $30 million (for 2024) must include in inventory a portion of purchasing, warehousing, packaging, and related administrative costs. c.

No. Financial accounting does not require retailers to include purchasing, warehousing, packaging, and related administrative costs in inventory. Financial accounting rules have not required manufacturers to inventory employee benefits and certain administration costs that must now be included in inventory for tax purposes. Similarly, financial accounting rules do not require that interest be added to the cost of inventory with long-term production periods. For example, financial accounting does not require that interest be added to the cost of whiskey that is being aged while such interest must be included in inventory cost for tax purposes. pp. I:11-11 and I:11-12.

I:11-23 Long-term contracts include building, installation, construction, or manufacturing contracts that are not completed in the same taxable year in which they are entered into. A long-term manufacturing contract involves the manufacture of either a unique item not normally carried in finished inventory or items that normally require more than 12 calendar months to complete. Contracts for services do not qualify for long-term contract treatment. pp. I:11-15 through I:11-17.

I:11-24 a.

The installment sales method is applicable only to transactions involving gains where at least one payment is to be received after the close of the taxable year in which the disposition occurs. It may not be used in connection with the sale of publicly traded property or inventory. b.

One reason to elect out of the installment method could relate to the application of lower tax rates in the current year where higher tax rates are anticipated during the installment period. Also, a taxpayer with current operating and/or capital losses or expiring loss carryovers may prefer to offset a gain against the losses in the current year. pp. I:11-17 through I:11-19.

I:11-25 In effect, the installment sale method is not available because the entire amount of ordinary income must be reported in the year of the sale. pp. I:11-18 and I:11-19.

I:11-26 The gifting of an installment obligation is a taxable event. The donor must recognize gain equal to the difference between the face of the obligation and its adjusted basis. p. I:11-20.

I:11-27 Installment sales to related persons are subject to the same rules as other installment sales except when the property is resold by the related purchaser. In the case of a resale, the first seller is required to treat amounts received by the related person as having been received personally. The acceleration provision is applicable only if the resale takes place within two years after the initial sale to the related party. p. I:11-21.

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I:11-28 The imputed interest rules may reallocate the amount received from an installment sale between selling price and interest if the stated interest rate is below the applicable federal rate.

The result is to increase the amount of interest (versus principal reported) in early years under an installment sale. All of the interest is taxable versus only a portion of the principal. As a result, the amount of income reported in the early years is greater. Less income is reported in later years.

Also, the imputed interest rules may convert a favorably taxed long-term capital gain into interest, which is taxed at ordinary rates. pp. I:11-22 and I:11-23.

I:11-29 Taxpayers may elect to change to the LIFO inventory method without IRS approval. p. I:11-26.

I:11-30 The IRS can require a taxpayer to change accounting methods if the method that has been used does not clearly reflect income. If the accounting method used by a taxpayer clearly reflects income, the IRS cannot require a change to another method that would also clearly reflect income. p. I:11-26.

I:11-31 The purpose is to spread the amount of the change over four years in order to reduce the immediate impact on taxes. The additional tax (or tax reduction) is spread over the current year and the subsequent three years. The three year rule is generally simpler. p. I:11-27.

I:11-32 Although the answer is not clear, it would seem to be no. Book and tax accounting methods must be the same, but the term “books” seems to include a supplemental reconciliation of income. Hence, if the two methods are reconciled, a taxpayer is presumably complying with the requirement. p. I:11-27.

Issue Identification Questions I:11-33 There are two obvious questions. One question is how she should value the automobiles she receives as trade-ins. The second question is how Judy should value the automobiles that she has had on hand for two years or longer. Reg. Sec. 1.471-2(c) states that second-hand goods taken in exchange should be valued at bona fide selling pricing less direct cost of disposition. This suggests that Judy should estimate how much she expects to receive when she sells a trade, and subtract from that amount the estimated costs of disposition (e.g., commissions to salesperson).

Reg. Sec. 1.471-2(c) also applies to the vehicles that have been on hand for two years or longer. That is, they may not be valued at less than a bona fide selling price less the direct cost of disposition. The regulation further specifies that a bona fide selling price means an actual offering of goods during a period ending not later than 30 days after the inventory date. As selling prices are negotiated by Judy and individual customers, she must somehow demonstrate that she has reduced the price of individual vehicles. The regulation states that she should maintain records of dispositions of goods so as to enable verification of the inventory valuation. pp. I:11-11 and I:11-12.

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I:11-34 The principal issue is whether surveying constitutes a new and separate trade or business, or alternatively, is an extension of the existing trade or business. If it is judged to be a new trade or business, Lana has the opportunity to elect different accounting methods than she currently uses for the appraisal activity. p. I:11-7.

I:11-35 Accepting the second offer will result in a transaction where the installment sales rules apply. Thus, an obvious question is how do they apply when the amount John will receive is unknown? It is necessary to decide how to value the future payments. Also, as no interest is stated, the imputed interest rules must be considered. pp. I:11-17 through I:11-23.

I:11-36 Because winter is the slow season, it is unlikely that Lee will be able to meet the 25% test normally used by the IRS in deciding whether the business is sufficiently seasonal to warrant a fiscal year. That is, it is unlikely that 25% of Lee’s revenues occur in January and February. Lee may, however, meet the test for a fiscal year ending on July 31 or August 31 as much of his revenue may be generated during summer months. Alternatively, Lee could request a fiscal year ending on September 30, October 31, or November 30. Such a year-end would result in required payments equal to 38% (37% + 1%) of the deferred income. The amount of the required payment is determined by multiplying the maximum individual tax rate (37%) plus 1% times the previous year’s taxable income times a deferral ratio.

As Lee is likely to be in a lower tax bracket, such payments will probably be viewed as too burdensome. Even if the corporation obtains a fiscal year, Lee’s personal taxable period will still be the calendar year. Therefore, Lee’s individual return will still be due April 15. pp. I:11-2 through I:11-5.

Problems I:11-37 a.

Not acceptable. Year would have to end on the last day of the month (January 31 or December 31). b.

Acceptable. c.

Acceptable. d.

Not acceptable, based on the least aggregate deferral of income to the partners, a March 31 year-end would be required. The calculation is as follows:

Year-End

A (3/31)

B (4/30)

C (6/30)

Least Aggregate Deferral

3/31 4/30 6/30

-03.67 3.00

.33 -03.33

1.00 .67 -0-

1.33 4.34 6.33

The numbers in the table represent the percent of the partnership owned by the partner multiplied by the number of months between the end of the partnership’s year and the end of the partner’s year. Since the March 31 year-end results in the least aggregate deferral, that year-end must be used. e.

Acceptable. pp. I:11-2 and I:11-3.

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I:11-38 Approval is not required in any of the situations. Iowa Corporation is required to change its accounting period to conform with its parent if a consolidated return is filed. pp. I:11-4 and I:11-5.

I:11-39 Only situation (c) involves a change in accounting year. Hence, annualization is required only for situation (c). Annualization is required even though the change itself does not require IRS approval. p. I:11-5.

I:11-40 1.

Modified taxable income: Practice income Interest Itemized deductions Modified taxable income

$38,500 3,000 ( 6,500) $35,000

2.

Annualized modified taxable income 12/7 x $35,000

$60,000

3.

Tax on annualized modified taxable income

$8,253

4.

Gross tax (7/12 x $8,253)

$ 4,814

pp. I:11-5 and I:11-6.

I:11-41 Items (b) and (d) are not deductible. Prepaid interest is not deductible. A note does not constitute payment. Payment by credit card and payment with borrowed funds constitute cash payment. Further, a check mailed (and postmarked) before year-end constitutes payment. pp. I:11-7 and I:11-8.

I:11-42 a.

Only warranty work actually performed this year is deductible. Hence, Camp can deduct $74,000. b.

As all work has been completed, $20,000 is deductible. c.

As the $5,000 is refundable, no amount is deductible. d.

The $18,000 of rent is deductible. The security deposit of $1,000 is not deductible. pp. I:11-9 and I:11-10.

I:11-43 a, c, e, f, g, and h must be included. pp. I:11-11 and I:11-12.

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I:11-44 2025 year-end inventory: 2025 year-end inventory at 2024 prices: (130% ÷ 134%) x $134,000 = $130,000 Base inventory (2024) Plus: 2025 layer: (134% ÷ 130%) x ($130,000 - $110,000) 2025 year-end inventory

$110,000 20,615 $130,615

2026 year-end inventory: 2026 year-end inventory at 2024 prices: (130% ÷ 140%) x $125,000 = $116,071 Base inventory (2024) Plus: 2025 layer: (134% ÷ 130%) x ($116,071 - $110,000) 2026 year-end inventory

$110,000 6,258 $116,258

As there was a reduction in inventory from 2025 to 2026, there is no 2026 layer. Further, the 2025 layer has been reduced. pp. I:11-13 and I:11-14.

I:11-45

a. Selling price Cost Accumulated depreciation Adjusted basis Sec. 1245 gain

$80,000 $900,000 900,000 -0 $80,000

b. All $80,000. c. Only the interest. pp. I:11-18 and I:11-19.

I:11-46 LIFO is undesirable because it will lock-in older, higher costing inventory layers. If the company is not doing so now, it might consider electing the “lower of cost or market” in conjunction with FIFO. This would enable the company to write down inventory on hand as prices are lowered. p. I:11-14.

I:11-47 a.

First Company cannot use the installment method because the stock being sold is publicly held. As a result, First Company must report the entire gain of $25,000 this year. The interest is reported as it accrues. b.

Because the transaction results in a loss, the installment method is unavailable. The loss of $30,000 is reported currently. Interest is reported as it accrues. c.

The installment method cannot be used to report sales of merchandise. As a result, the company must report sales of $4,500,000 this year. It can deduct the cost of goods sold.

Although the allowance method for reporting bad debts is not permitted for tax purposes, the company can deduct the amount of any specific receivables it writes off. pp. I:11-17 and I:11-18.

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I:11-48 a.

b.

Gross profit ($20,000 - $14,000) Gross profit percentage ($6,000 / $20,000) Gain recognized in year of sale (0.30 x $5,000) Selling price Basis [$15,000 - (0.30 x $15,000)] Gain

$ 6,000 30% $ 1,500 $13,800 ( 10,500) $ 3,300

pp. I:11-17 and I:11-18.

I:11-49 a.

Gross profit percent is 73.333% [($45,000 - $12,000)/$45,000]. The gain reported in the year of sale is $11,000 ($15,000 x 73.333%). b.

The gain reported is $21,500 {$30,000 - $500 – [$30,000 – ($30,000 x 73.333%)]}. c.

The rug’s basis is $30,000. pp. I:11-17 through I:11-20.

I:11-50 a.

Joe reports a loss of $20,000 ($42,000 - $2,000 - $60,000). The loss is a capital loss, which means he can deduct only $3,000 from ordinary income if he has no capital gains and no other capital losses. However, if he has sufficient capital gains from other transactions, he can offset the full loss against the gains. b.

Joe reports the interest income as it accrues if he is an accrual basis taxpayer and when he collects it if he is a cash basis taxpayer. c.

No. All of the loss is available in the year of the sale. Should Joe be unable to deduct the full capital loss in the year of the sale because he has insufficient capital gains, he would have a capital loss carryforward. The amount of the carryforward that can be used depends on the amount of capital gains and losses reported in the carryforward year. The collection of the installment payments does not affect the amount of loss available in carryforward years. pp. I:11-7 through I:11-10, I:11-17, and I:11-18.

I:11-51 a. $32,288 [$200,000 - ($200,000 x 0.83856)]. b.

2026. As the stated sales price is less than $250,000, no accrual of interest is required. c. $37,712 ($200,000 - $32,288 - $130,000). d.

2026. Assuming Amy does not elect out of the installment sales method, the gain is reported in the year the sales price is collected. e. $167,712 ($200,000 - $32,288). pp. I:11-22 through I:11-24.

I:11-52 a.

The amount of the adjustment is $800 ($16,000 - $15,200). The $16,000 of receivables were not included in income in prior years, so they must be added to income. The $15,200 of payables were not deducted in prior years, although they would have been deductible under accrual accounting. b.

As the amount of this adjustment is less than $3,000, the full amount of $800 must be added to current year income. pp. I:11-26 and I:11-27.

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I:11-53 a.

The addition to the deposit is $14,000 [($400,000 x 38% x 9/12) - $100,000]. b.

The payment must be made by May 15, 2026. c.

No. The amount cannot be subtracted from the partner’s personal tax liability. The amount of the deposit is adjusted up or down each year to reflect changes in the partnership’s income. In the event of a decline in the partnership's income a portion of the deposit will be refunded to the partnership. pp. I:11-3 and I:11-4.

I:11-54 Yes. Changing to the LIFO inventory valuation method does not require IRS approval.

Taxpayers may make the change by attaching Form 970 to the return for the year the change takes place. Changes to LIFO from FIFO usually result in a reduced inventory value. Taxpayers, in general, are expected to spread the amount of any adjustment resulting from changes in accounting methods over four years. Typically, adjustments of $25,000 or less can be made in the year a change in accounting methods takes place. The IRS has not specifically said whether this option is available in connection with adjustments that result from changes to LIFO. Form 970 does ask whether taxpayers plan to report the amount of the adjustment over three years. One reason for not spreading the amount of the adjustment over multiple years might be because the amount is relatively small. The IRS states that any change in accounting method is subject to its approval.

In fact, the IRS notes that even automatic changes may be disallowed. This means the taxpayer can make the change without IRS approval, but that the IRS can require the taxpayer to change again. pp. I:11-25 through I:11-27.

I:11-55 a.

For income tax purposes, it is not necessary to impute interest on this gift loan because the amount of the loan is under the $100,000 threshold and John’s net investment interest income is $1,000 or less. b.

Assuming an applicable federal rate of 8%, imputed interest equals $10,000 (.08 x $125,000) per year. c.

The interest appears to be qualified residential interest and as such is deductible if John itemizes. d.

Jane is treated as having received the $10,000 as interest income for the year.

Further, she is treated as having made a gift to John of an equal amount. Unless there are other gifts, however, the annual gift tax exclusion means there is no requirement that Jane file a gift tax return. pp. I:11-22 through I:11-25.

I:11-56 a.

King reports $360,000 of income during year one computed as follows: Expected profit ($11,200,000 - $10,000,000) Percentage complete ($3,000,000 / $10,000,000) Income—year one

b.

$1,200,000 x 0.30 $ 360,000

The reported income for the second year is $600,000 computed as follows: Expected profit Percentage complete ($8,000,000 / $10,000,000) Income—year one and two Minus: Previously reported income Income—year two Copyright © 2025 Pearson Education, Inc.

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$1,200,000 x 0.80 $ 960,000 ( 360,000) $ 600,000

c.

The reported loss for year three is $260,000 computed as follows: Contract amount Minus: Actual costs Income from contract Minus: Previously reported income Loss—year three

$11,200,000 (10,500,000) $ 700,000 ( 960,000) ($ 260,000)

d.

King overestimated its income from the contract, and as a result, overpaid its tax.

Under the look-back interest rule, King is entitled to receive interest on the additional tax it paid because it overreported income in years one and two. pp. I:11-15 through I:11-17.

Comprehensive Problem I:11-57 a.

Depreciation is $7,200 ($100,000 x 0.1440 x 0.50).

Appendix C, Table 1, 10-year property, 3rd year. b.

The 0.1440 is from

The gain on the sale of the tugboat ($25,200) is less than the accumulated depreciation ($35,200 = $10,000 + $18,000 + $7,200). As a result, the full gain must be reported currently: Selling price Adjusted Basis: Cost Accumulated depreciation Gain

$90,000 $100,000 ( 35,200)

64,800 $25,200

c.

Under the cash method of reporting income, interest income is reported as it is collected. As Dan has not yet received any interest, none is taxable. d.

Business income Depreciation Other expenses Net business income

$72,000 ( 7,200) (30,000) $34,800

e.

Net business income Gain on sale of tugboat IRA distribution Social security benefits (85%) Adjusted gross income

$34,800 25,200 20,000 1,700 $81,700

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f.

Contributions Real property taxes State income taxes ($200 + $800) Mortgage interest Total

$ 5,000 2,000 1,000 6,500 $14,500

g.

Adjusted gross income Qualified Bus. Inc. Ded. Itemized deductions Taxable income

$81,700 (12,000)* (14,500) $55,200

* 20% ($34,800 + $25,200)

Tax Strategy and Critical Thinking Problems I:11-58 The transactions are “gift loans,” resulting in Leon reporting imputed interest income of $13,000 (6.5% x $200,000). The tax is $3,120 (0.24 x $13,000). The son includes $14,000 of bond interest he receives in gross income and deducts the $13,000 of imputed interest as an itemized deduction (if he itemizes). The son’s tax is $100 (0.10 x $1,000). The total tax for the family is $3,220 ($3,120 + $100). The “kiddie tax” does not apply to the son because he is not under age 24 (see Chapter I:2).

Had Leon invested the funds himself, the tax on the bond interest would have been $3,360 (0.24 x $14,000). The transactions produce a $140 tax savings for the family. First, the son’s tax bracket is lower than the father’s, and second; the interest rate on the investment is slightly higher than the applicable federal rate. The imputed interest rules prevent much larger tax savings. The relatively small savings associated with the transaction and its complexity is the reason such transactions are uncommon. In fact, a major objective of the imputed interest rules is to reduce the tax advantage of “gift loans.”

This answer does ignore some other possible tax implications. Leon would not be able to claim his son as a dependent if the son becomes self-supporting. The question is whether the tuition represents more than one half of the son’s support.

Students familiar with the American Opportunity and Lifetime Learning credits may raise the question as to how these credits might impact this decision. A given dollar amount of credit produces the same tax saving for either taxpayer. Nevertheless, the father may not be eligible to claim any credit because he has too much income (See Chapter I:14). If the son paid the tuition, he would be eligible for the credit.

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I:11-12

I:11-59 If Linda chooses to receive cash she will owe an immediate income tax of $18,000 [0.15 x ($200,000 - $80,000)]. She would receive $182,000 after taxes.

If she chooses to receive installments, she will receive the same amount of principal and pay the same tax on the gain, but both will be spread over two years. The question is whether the interest is sufficiently large to compensate Linda for the delayed receipt of the principal.

Principal Tax on gain Net

Current year $100,000 ( 9,000) $ 91,000

Interest (8% x $100,000) Tax on interest (0.24 x $8,000) Net

Next year $100,000 ( 9,000) $ 91,000

( $

8,000 1,920) 6,080

If Linda accepts the installment option, she will have to wait one year to receive the installment payment and will receive interest as compensation. In after-tax dollars, she will receive interest of $6,080 in exchange for waiting a year for the after-tax installment of $91,000. Thus, the return is 6.68% ($6,080/$91,000). This is less than the minimum 10% return specified in the problem.

Students familiar with present value computations may present the computation differently. They might discount the payments associated with the installment option.

Installment net of tax Interest net of tax Total Present value

$91,000 ______ $91,000 $91,000

$91,000 6,080 $97,080 $88,246*

Total ($91,000 + $88,246) = $179,246. *$97,080 x .909 The present value of the installment payments of $179,246 is less than the $182,000 realized after taxes from the cash sale indicating that the installment payments are worth less than the payments associated with the cash sale.

Tax Form/Return Preparation Problem I:11-60 (See Instructor’s Resource Manual)

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Case Study Problems I:11-61 It is important for Lavonne to make the correct election on the first corporate return, as the election cannot be changed without IRS approval. Approval is usually granted only if a sound business reason can be given for the change.

Lavonne can elect either the cash or accrual method of reporting income from her medical practice. One aspect of many professional practices is that collections often lag. Doctors must file claims with insurance companies, Medicare, and others. Payments may be delayed many months.

Doctors also experience bad debts. Under the accrual method, these amounts must be included in gross income when the services are provided without any allowance for uncollectible accounts.

This can result in the doctor having to pay taxes on income that has not been collected and, in fact, may never be collected. As a result, the cash method has a distinct advantage because Lavonne can wait to report income from her practice if and when it is received.

Income from a medical practice is not ordinarily seasonal. Therefore, Lavonne’s corporation will likely not have a natural business year. Also, the corporation will almost surely be classified as a personal service corporation. As a personal service corporation, it is subject to several limitations including one on the choice of taxable years. Assuming Lavonne reports on the calendar year, the corporation will have to either report on a calendar year, or a fiscal year ending September 30, October 31, or November 30. If the corporation elects one of the available fiscal years, the corporation will have to make required distributions to Lavonne. These distributions will reduce or eliminate any tax deferral that might be obtained from the fiscal year. (Some knowledgeable students may mention an S election). An S corporation will have the same available years, but the S corporation will make required payments to the government instead of required distributions to Lavonne. In either case, there is no real advantage of a fiscal year to Lavonne. pp. I:11-3 and I:11-7.

I:11-62 Don is faced with a significant tax on the sale, especially in the first year even if he applies the installment method. The proceeds from the sale total $600,000, and the basis of the property is $290,000 ($400,000 - $110,000). Thus, Don will have to report $310,000 of income from the sale.

This consists of a combination of depreciation recapture, Sec. 1231 gain (which is subject to special rules; discussed in Chapter I:13), and interest income which must be imputed. The amount of imputed interest depends upon the applicable federal rate at the time of the sale. Although the sale can be reported under the installment method, depreciation recapture of $110,000 has to be reported in the year of the sale and is taxed at ordinary rates. The tax, assuming a 24% rate, would be $26,400. In addition, Don will have to report a portion of the Sec. 1231 gain in the year of the sale. As Don will pay $90,000 to retire the mortgage, he will have to find some other source of funds in order to pay the tax on the depreciation recapture and Sec. 1231 gain.

There are some things that Don can do to improve his situation. First, he could probably request that the contract specify interest at a rate not less than the applicable federal rate so as to avoid the need to impute interest. The selling price would normally be reduced to reflect the interest charge. Second, the contract should be written so as to avoid the problem of the negative cash flow in the current year. This could be done by requiring a larger down payment or by obtaining outside financing. The buyer, however, may object to a larger down payment, and outside financing may mean that Don has to report all of the income currently. (Knowledgeable students may suggest wrap around or subject to financing, but most students will not propose these solutions as they are not discussed in the text.) Alternatively, a rental agreement with an option to buy might enable the taxpayer to defer gain recognition until after retirement when Don may be in a lower tax bracket. pp. I:11-17 through I:11-21.

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I:11-14

I:11-63 The uniform capitalization rules clearly require that indirect manufacturing costs be included in inventory, and the taxpayer must comply with the rules. This leaves the taxpayer with two problems. How can the corporation comply with the rule without spending excessive amounts to determine how much to include in inventory? What procedures must be followed in bringing the company into compliance? It is an acceptable professional practice to use estimates if actual amounts are unavailable or too difficult to determine (see SSTS No. 4). In this situation, it might be acceptable to change how inventories are valued by increasing the overhead application rate or making similar adjustments. Such an effort could produce a reasonable estimate of the additional costs that should be included in inventory under the uniform capitalization rules. It is not entirely clear whether this change in the overhead application rate represents a change in accounting methods requiring IRS approval. Changing cost patterns cause businesses to change the application rate, sometimes annually or more often. In this case, adding to the list of costs may be a change of methods. The safest approach would be to request IRS approval. The company could ask that the amount of the change be spread over four years. pp. I:11-11 and I:11-12.

Tax Research Problems I:11-64 All three cited authorities indicate that amounts placed in escrow constitute constructive receipt by the seller. As a result, the entire sales price is considered to have been received by Eagle in the year of the sale. In the absence of any contrary authority, the entire gain is taxable in the year of the sale. In the situation described, financial security and tax security are inversely related. Since the seller faces little financial risk, the gain is taxable in the year of sale.

I:11-65 Reg. Sec. 1.471-2 refers to “trade customs” and “best accounting practice in the particular trade or business.” Reg. Sec. 1.471-3 states if, “the usual rules for computation of cost of production are inapplicable, costs may be approximated upon such basis as may be reasonable and in conformity with established trade practice in the particular industry.” In Justice & Parker Co., the court placed great weight on the judgment and experience of the taxpayer’s personnel, and in Morris Chaitlen, the court accepted a practice similar to the one described in the case, but questioned the experience and judgment of the taxpayer’s personnel. As a result, the acceptability of the Texas Corporation’s inventory value depends on the judgment and experience of the taxpayer’s personnel.

I:11-66 According to Reg. Sec. 1.446-(1)(e)(3)(i), consent must be secured from the Commissioner to change from the cost method in valuing inventory to the lower cost or market method. Apple Corporation must file an application Form 3115 with the Commissioner. Apple Corporation must also furnish all necessary information, including all items that would be treated differently. American Liberty Pipe Line Co. v. CIR [32 AFTR 1099, 44-2 USTC ¶9408 (5th Cir., 1944)] exemplified this point. The company was unable to value its inventory at lower of cost or market method without obtaining permission from the Commissioner.

Thor Power Tool Co. v. CIR [43 AFTR 2d 79-362, 79-1 USTC ¶9139 (USSC, 1979)] states that inventory is valued at cost unless market value is lower. Market value will be lower than cost when the taxpayer has offered to sell merchandise at a price lower than replacement cost and where the merchandise is defective. Thor Power Tool attempted to write down excess inventory to its own estimate of the net realizable value, although the parts were kept on hand and the asking price was not reduced. According to Reg. Sec. 1.471-4(b), the selling price must be Copyright © 2025 Pearson Education, Inc.

I:11-15

reduced for inventories to be written down. The Supreme Court ruled that the reflection of income test was paramount.

“What Would You Do In This Situation?” Solution Ch. I:11, p. I:11-14.

There are hints that Jack wants to use the year-end inventory value to control his tax liability. The lower the reported year-end inventory value, the lower the reported taxable income.

AICPA ethical guidelines (SSTS No. 3) indicate that CPAs may rely without verification upon information furnished by a client. The guidelines, however, further state that the CPA “should not ignore the implications of information furnished and should make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to the [CPA].” The client reports that he could not get along with his previous accountant. This could well mean that the problem is not new.

You should review prior returns and ask permission to contact the previous accountant. If not satisfied with information obtained from these steps, you could visit the client’s place of business and observe the inventory. Further, you could examine invoices and other documentation to ascertain the reasonableness of an inventory figure presented by the client. In the event the inventory value provided by the client is judged to be understated, you should discuss the matter with the client. You can point out that the IRS could also conduct a similar examination. You should not use an inventory value simply because the client wants to pay a lower tax.

Your discussion with the client may be productive if you offer tax planning ideas that permit the client to minimize his tax liability while still complying with the tax law. For example, you could review the records to determine whether lower of cost or market or LIFO inventory valuation is being employed.

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I:11-16

Chapter I:12 Property Transactions: Nontaxable Exchanges Discussion Questions I:12-1 The statement is not correct. For nontaxable exchanges, taxpayers maintain a continuing investment in comparable property. p. I:12-2.

I:12-2 A taxpayer may want to recognize a loss on the exchange. The taxpayer's particular tax situation may make it advantageous to recognize a gain. For example, the taxpayer may be in a low tax bracket or have losses, which may be used to offset the gain. If the exchange is taxable, the basis of the property received may be higher. pp. I:12-2 and I:12-21.

I:12-3 a.

Debbie's basis for the building received in the exchange is $300,000, and the holding period starts on May 10, 2012. b.

The exchange is not a like-kind exchange if either Debbie or Doug disposes of the property within two years following the date of the exchange. pp. I:12-6 through I:12-8.

I:12-4 a.

No. The maximum gain recognized is the realized gain which is the sum of the FMV of the real property received and the FMV of the marketable securities less the adjusted basis of Kay's real property. b.

No. If the FMV of the marketable securities exceeds the realized gain, the recognized gain is equal to the realized gain. c.

The basis of the marketable securities is their FMV. d.

The holding period for the marketable securities begins on the day following the date of the exchange. pp. I:12-6, I:12-8, and I:12-10.

I:12-5 The two separate transactions could be viewed as an exchange if the two transactions are interdependent. If Jerri sells real property to Bill for cash with a commitment to purchase real property from Bill, the two transactions could be viewed as one, an exchange. p. I:12-4.

I:12-6 No. The quality or grade of the property is not considered. p. I:12-3.

I:12-7 The property must be identified within 45 days after the date on which the taxpayer transfers the property relinquished in the exchange and received within 180 days after the date on which the taxpayer transfers the property relinquished in the exchange (but not later than the due date for filing a return for the year in which the transfer of the relinquished property occurs). p. I:12-4.

I:12-8 They might do a nonsimultaneous exchange. Burke may transfer the $800,000 to an escrow account and Kim should locate like-kind property that she wishes to own. p. I:12-4.

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I:12-1

I:12-9 If Jane identifies like-kind property that she would like to own, Lanny could purchase the property and then exchange the property for Jane’s farm. The exchange is a like-kind exchange for Jane and she does not recognize gain. p. I:12-4.

I:12-10 No. The receipt of boot will not cause a realized loss to be recognized. p. I:12-5.

I:12-11 A taxpayer who gives boot will recognize a gain if the FMV of the boot is greater than the basis of the boot. A loss is recognized if the FMV of the boot (assuming the boot is not personal-use property) is less than the basis of the boot. p. I:12-8.

I:12-12 An involuntary conversion is beyond the control of the taxpayer. Since the property is replaced, the taxpayer maintains a continuing investment and may lack the wherewithal to pay a tax on the gain. Section 1033 applies only to the nonrecognition of gain. p. I:12-9.

I:12-13 No. The threat or eminence of requisition or condemnation of property may cause an involuntary conversion. p. I:12-10.

I:12-14 If a portion of the taxpayer's property is condemned, the value of retained property may decline. Severance damages are amounts received because of the decline in value. Amounts received as severance damages reduce the basis of the retained property and any amount received in excess of basis is treated as gain. pp. I:12-12 and I:12-13.

I:12-15 The replacement property must be functionally the same as the converted property. For example, a typewriter and a FAX machine do not perform the same functions and are not functionally related. p. I:12-12.

I:12-16 If the real property is held for productive use in a trade or business or for investment and is condemned, a proper replacement may be made by acquiring like-kind property. p. I:12-12.

I:12-17 With the current law, gain is always excluded, not deferred. The amount that may be excluded ($250,000 or $500,000) is higher. The exclusion may be used by a taxpayer more than once during his lifetime and regardless of age. To use the exclusion today, the property must be used and owned as a principal residence for at least two years, not three, of the five-year period before the sale. Instructors may want to mention problems associated with taxpayers losing their eligibility to use the $125,000 exclusion if they marry a person who has already used the exclusion. Today, the exclusion is determined on an individual basis. pp. I:12-15 and I:12-16.

I:12-18 Maintaining an accurate adjusted basis is important if: 1. the gain realized exceeds $250,000 ($500,000 if married couple is eligible).

2. the taxpayer does not qualify for the exclusion when residence is sold.

3. property is later used for rental and/or business and depreciation is allowable. p. I:12-15.

I:12-19 Because Steve’s house is his personal residence, he would want to capitalize the cost of wallpapering. There is no tax benefit to the homeowner of a personal residence if the cost of wallpapering is expensed.

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I:12-2

Martha's house is rental property and she wants to expense the cost of wallpapering against the rental income. p. I:12-16 and Chapter I:6, p. I:6-10.

I:12-20 $373,200 ($300,000 + $1,000 + $79,200 - $7,000). p. I:12-16.

I:12-21 The property must be owned and used as a principal residence for at least two years during the five-year period ending on the date of sale. The exclusion applies to only one sale or exchange every two years. p. I:12-17.

Issue Identification Questions I:12-22 The principal tax issue is whether the exchange is taxable or qualifies as a tax-free exchange. If the exchange is taxable, John and Jane both need to consider the character (i.e., capital or ordinary) of the gain and determine the amount of the gain. Although not discussed in the text, it should be noted that Reg. Sec. 1.1031(a)-1 provides that partnership interests are not like-kind property and the exchange should, therefore, be taxable. p. I:12-3.

I:12-23 What will be the realized gain on the exchange and how much of the gain is recognized?

The realized gain is $2,800,000 [$7,000,000 - ($3,000,000 + $1,200,000)]. The FMV of the old houseboat must be $5,800,000.

The amount of recognized gain depends on whether or not the exchange qualifies as a like-kind exchange, and there are at least two possible reasons why the exchange will not be a like-kind exchange.

A. An exchange of real property located in the U.S. for real property outside the U.S. is not a like-kind exchange. If the houseboat is to be used in Finland, the houseboat may be considered to be real property outside the U.S., and the exchange is not a like-kind exchange.

B. The houseboat must be real property for the exchange to be a qualified likekind exchange. The determination may vary from state to state. If the houseboat is continually being moved, the case for the houseboat being personal property is stronger. The case for the houseboat being real property is better when the houseboat is more permanently moored.

Reg. 1.121-1(b)(1) states that “the taxpayer’s residence may include a houseboat,” which should provide some support for real property status. An important fact may be whether or not Chauvin is paying real property taxes or personal property taxes.

Taxpayers are often confronted with proposed transactions where the tax treatment is not clear and may want to seek a private letter ruling.

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I:12-3

I:12-24 Has Jaharta made a property replacement that will allow the corporation to elect to defer the gain resulting from the condemnation. In John L. Stevenson, [250 F. Supp. 647, 64-2 USTC 9821] the court ruled in favor of the taxpayer on facts identical to those in this case. The proceeds were reinvested “in property similar or related in service or use to the property condemned.” pp. I:12-12 and I:12-13.

Problems I:12-25 The exchanges in b, c and f qualify as like-kind exchanges under Sec. 1031. pp. I:12-2 through I:12-4.

I:12-26 Only the exchange in part d qualifies as a like-kind exchange. pp. I:12-2 through I:12-4.

I:12-27 Realized Gain or (Loss) a. b. c. d. e.

Recognized Gain or (Loss)

Basis of Land Received

-014,000 25,000 28,000 -0-

$20,000 $45,000 $60,000 $60,000 $68,000

$65,000 $39,000 $30,000 $28,000 ($13,000)

pp. I:12-5 through I:12-7.

I:12-28

a. b. c.

Realized Gain or (Loss)

Recognized Gain or (Loss)

$52,000 ($ 9,000) $27,000

$52,000 ($ 9,000) $27,000

*Prior to 2018, exchanges in parts a and b qualified as like-kind exchanges. Only $16,000 of gain was recognized in part a, and the loss in part b was not recognized. pp. I:12-5 and I:12-6.

I:12-29 a.

Amount realized ($750,000 + $200,000) Minus: Basis of land exchanged Debt assumed by Paul Gain realized

$950,000 $340,000 200,000

540,000 $410,000

b.

No gain is recognized. c.

Paul's basis for the building is $540,000 [($950,000 - $410,000) or ($340,000 + $200,000)]. When Paul assumes the debt, it is equivalent to the transfer of cash to Kelley. pp. I:12-5 through I:12-7.

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I:12-4

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I:12-5

I:12-30 Value of farm received Plus: Liability that apartment complex is subject to Total consideration received Minus: Basis of apartment complex Liability to which farm is subject Gain realized

$770,000 180,000 $950,000 $600,000 $100,000

(700,000) $250,000

The amount of boot received by Helmut is $80,000 ($180,000 - $100,000). If each party assumes a liability of the other party, Reg. Sec. 1.1031(d)-2 holds that only the net liability given or received is treated as boot. Since the amount of the boot received is less than the gain realized, Helmut recognizes a gain of $80,000. The basis of the farm is determined as follows: Basis of apartment complex Minus: Boot received ($180,000 - $100,000) Plus: Gain recognized Basis of farm received

$600,000 ( 80,000) 80,000 $600,000

pp. I:12-5 through I:12-7.

I:12-31 Gain Recognized = $20,000 and Basis of new land = $50,000 Value of land received $ 90,000 Plus: Liability that warehouse is subject to 20,000 Total consideration received $110,000 Minus: Basis of warehouse (50,000) Gain realized $ 60,000 The amount of boot received by Jeff is $20,000 (the liability that Carol assumes). Since the amount of the boot received is less than the gain realized, Jeff recognizes gain of $20,000. The basis of the land is determined as follows: Basis of the warehouse Minus: Boot received Plus: Gain recognized Basis of new land received

$50,000 ( 20,000) 20,000 $50,000

I:12-32

Amount realized Minus: Basis of land and marketable securities Gain realized Gain recognized

Total

Securities

Land

$150,000 ( 60,000) $ 90,000 $ 15,000

$25,000 ( 10,000) $15,000 $15,000

$125,000 ( 50,000) $ 75,000 $ -0-

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I:12-6

Gain recognized is $15,000. The FMV of the marketable securities exceeds the basis by $15,000 ($25,000 - $10,000). The basis for the apartment building is $75,000 ($50,000 + $10,000 + $15,000 recognized gain). pp. I:12-5 through I:12-7.

I:12-33 a.

Bob's realized and recognized gain is $214,000 ($300,000 - $86,000). The exchange is not a like-kind exchange since it was made with a related party who disposed of the property within two years after the exchange. b.

Cindy's realized and recognized gain on the sale is $12,000 ($312,000 -$300,000).

She must also recognize $21,000 ($300,000 - $279,000) gain on the exchange since it does not qualify as like kind. Therefore, the basis of the property sold is $300,000. pp. I:12-7 and I:12-8.

I:12-34 a.

Amount realized Minus: Adjusted basis Gain realized

$300,000 86,000 $214,000

None of the gain is recognized since neither related party transferred the property within two years of the exchange. b.

Amount realized Minus: Adjusted basis Gain realized

$300,000 ( 279,000) $ 21,000

None of the gain is recognized since neither related party transferred the property within two years of the exchange. c.

Amount realized Minus: Adjusted basis Gain realized

$312,000 ( 279,000) $ 33,000

The $33,000 gain is recognized. pp. I:12-7 and I:12-8.

I:12-35 Amount realized Minus: Basis of office building Gain realized

$750,000 ( 400,000) $350,000

Amount realized Minus: Cost of new office building Gain recognized

$750,000 ( 682,000) $ 68,000

Cost of new office building Minus: Gain deferred Basis of new office building

$682,000 ( 282,000)* $400,000

* $350,000 - $68,000 = $282,000.

Basis of machinery acquired

$ 90,000

pp. I:12-9 through I:12-11.

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I:12-7

I:12-36 Amount realized Minus: Basis Gain realized

a. b. c.

$25,000 ( 3,000) $22,000

Recognized Gain

Basis of Land Purchased

$ 2,500 -0$ 1,400

$3,000 $6,500 $3,000

Replacement period ends three years after the close of the first taxable year in which any part of the gain is realized due to condemnation of real property held for productive use in a trade or business or for investment. p. I:12-14.

I:12-37 a. $ 840,000. b.

December 31, 2026 c.

Zero. None of the gain may be deferred as an office building and an underground storage tank are not functionally related. Therefore, Ava James must recognize a gain of $240,000 ($840,000 - $600,000). d.

If real property used in a trade or business is condemned, the replacement period is three years from the end of the tax year in which the gain is realized, so Ava James has until December 31, 2027, to replace the office building. Furthermore, like-kind property may be used as the replacement property. There could be an issue of whether or not a 900,000-gallon storage tank is real property, and the answer may vary among states, but such a large storage tank will most likely qualify as real property especially if it is underground.

Because the replacement property cost $810,000 and the amount realized is $840,000, only $30,000 of the gain is recognized. The remaining gain of $210,000 ($240,000 - $30,000) is deferred. pp. I:12-11 through I:12-14.

I:12-38 a. $30,000 of the gain must be recognized. b.

Zero. All of the gain may be deferred. c.

This is not a replacement of property, which is similar or related in service to the converted property. Therefore, the recognized gain is $300,000. d.

The replacement period ends on December 31, 2026. Therefore, the recognized gain is $300,000. pp. I:12-12 through I:12-14.

I:12-39 a.

The gain of $30,000 is recognized. Section 1033 does not apply since she does not plan to replace the property. b.

She does not have to recognize a gain because of the severance damages.

Severance damages reduce her basis, and a gain is recognized only if the severance damages received exceed the basis. c. $2,500 ($10,000 - $7,500). pp. I:12-11 and I:12-12.

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I:12-8

I:12-40

Selling price Minus: Selling expenses Amount realized Minus: Basis ($55,000 + $6,000) Gain realized

$180,000 ( 8,000) $172,000 ( 61,000) $111,000

The realized gain is $111,000 and none of the gain is recognized. The basis of the new residence is its cost, $162,000. pp. I:12-15 and I:12-16.

I:12-41 The realized gain is $89,000 [($300,000 - $11,000) - $200,000] The recognized gain is zero because they own and use the house for at least two years of the five-year period before the sale. pp. I:12-15 and I:12-16.

I:12-42 a. $250,000. If Joe lives in the house for two years, they could exclude up to $500,000 of gain. b. $250,000. pp. I:12-16 and I:12-17.

I:12-43 a.

Yes, they may exclude the gain under Sec. 121. The basis of the residence is $480,000. b.

Yes, they may defer the gain under Sec. 1033 as an involuntary conversion. The basis of the residence is $370,000 ($480,000 - $110,000). The Snells should exclude the gain under Sec. 121. p. I:12-20.

I:12-44 Zero. Because the sale was due to a change in employment, a portion of the gain is excluded even if the two-year requirement is not satisfied. Because the $25,000 realized gain is less than $69,178 (101/730 of $500,000), all of the gain is excluded. p. I:12-18.

I:12-45 a. $1,480,000 ($1,500,000 - $220,000 + $200,000). The painting of the house and the repairs are not capital expenditures. b.

No, she may not claim a depreciation deduction. Mrs. Self may not deduct any home office expenses, because the home office is not used regularly and exclusively as her principal place of business. Furthermore, an employee must prove that the exclusive use is for the convenience of the employer. (See chapter I:9 for a discussion of home office expenses.) c. $820,000 LTCG ($2,800,000 - $1,480,000 - $500,000 exclusion) d. $820,000 LTCG ($2,800,000 - $1,480,000 - $500,000 exclusion) The Selfs may use the $500,000 exclusion because they are filing a joint return and only one spouse is required to own the house if both use the house as a principal residence and the other requirements of Sec. 121 are met. e.

No. The house is not included in his gross estate. If they own the house jointly when Mr. Self dies, Mrs. Self will inherit his half of the house with a basis of $1.4 million (half of the $2.8 million FMV). f.

Recognized gain of $820,000 ($2,800,000 - $1,480,000 - $500,000), the transaction is not a like-kind exchange.

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I:12-9

g.

For tax purposes, the Selfs do not have a casualty loss. Instead, they have a $620,000 recognized gain ($2,600,000 - $1,480,000 - $500,000). Even though the Selfs are receiving insurance proceeds of $200,000 less than the FMV, they will not recognize a casualty loss since the insurance proceeds are greater than the basis of the house. h. $2,100,000 ($2,600,000 - $500,000) I:12-46 a.

$360,000 [$500,000 – ($300,000 - $160,000)]

b. $360,000 The house is not used as a principal residence for two of the last five years. c. $189,286 The property has been used as a principal residence for at least two of the last five years, but some of the gain must be recognized because of a period of unqualified use. Sherron has owned the property for a total of 208 months, and there are 173 months of unqualified use, period rented after 2008. The first $160,000 of gain due to depreciation is recognized. Because of the unqualified use, $166,346 [(173/208)($200,000)] of the gain is also recognized. p. I:12-17.

I:12-47 a. $204,000 ($300,000 - $96,000) b. $4,000 of the gain is recognized because it is attributable to depreciation after May 6, 1997. The gain is Sec. 1231 gain and is taxed at a maximum rate of 25% because it is unrecaptured Sec. 1250 gain.

I:12-48 a. b. c. d. apply.

$24,000. [($80,000 - $6,000) - $50,000] Zero. Sec. 121 applies. $51,000. [($148,000 - $7,000) - $90,000). $51,000. The two-year use and ownership tests are not met and no exceptions

pp. I:12-15 through I:12-18.

I:12-49 a.

Realized gain is $122,000. [($200,000 - $8,000) - $70,000]. b.

Recognized gain is zero. c.

Realized gain is $240,000. [($520,000 - $30,000) - $250,000]. d.

Recognized gain is $26,301. They may exclude up to $213,699 (312/730 x $500,000) although the two-year use and ownership tests are not satisfied. An exception applies when the move is due to a change in employment. A portion of the gain is excluded based on a ratio with a denominator of 730 days and the numerator being the shorter of: (1) the period which the ownership and use tests were met during the five-year period ending on the date of sale (312 days), or (2) the period of time after the date of the most recent sale or exchange for which the exclusion applied until the date of the current sale of exchange (497 days). pp. I:12-16 through I:12-18.

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I:12-10

Comprehensive Problem I:12-50 1. $125,000 ($72,000 + $44,000 + $9,000) 2. $15,000 [($329,000 - $14,000) - $50,000 = $265,000 - $250,000 exclusion] 3. $15,000 The loss on the sale of Dell stock is a wash sale.

4. $140,000 5. $ 5,120 Interest on acquisition indebtedness of Iowa residence ($3,120 + $2,000).

4,756 Real property taxes in Texas (212/365 x $8,200) 8,000 Charitable contributions 3,020 Taxes ($2,465 + 555) $20,896 6. $119,104 ($140,000 - $20,896) 7. $250,933 [$250,000 + liability for property taxes assumed of $933 (227/365)($1,500)] 8. No, his AGI would now be $240,000, but none of his expenses are affected by AGI, so taxable income is $219,104.

Education expenses are not deductible because they qualify him for a new trade or business. The loss on the sale of Dell stock is a wash sale. Medical expenses are not deductible as they are less than 7.5% of AGI. The prorated real property taxes on the Iowa residence are deductible when paid.

The property taxes and state income taxes total less than $10,000 and are deductible.

For tax years after 2017, Paden is not able to deduct the following expenses that were deductible prior to 2018: Moving expenses 2% miscellaneous expenses [the employee business expenses of 50% of entertainment and supplies)] If the education expenses did qualify for a deduction, they would have been classified as nondeductible 2% miscellaneous itemized deduction Interest on home equity debt (Interest on home equity is deductible only if the borrowed funds were used to buy or build a home or make improvements to the home.)

Tax Strategy and Critical Thinking Problem I:12-51 a.

It should not make a difference. If they sell their houses before marriage at FMV, Ray and Ellie each exclude the gain because the gain on each house is less than $250,000. If they sell their houses after marriage, they may still exclude the gain on each house. The exclusion is determined on an individual basis. b.

There is probably no change if they sell before or after the marriage. If they sell the houses before marriage at FMV, Ray will not recognize a gain, but Ellie will recognize a gain because the realized gain is greater than $250,000. If they sell after the marriage, Ellie will still have to recognize gain. Taxes might be lower or higher depending on their tax rate filing a joint return compared to filing as single.

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I:12-11

c.

Ray could sell his house and exclude the gain, then live in Ellie’s house for two years before they sell that house and exclude up to $500,000. p. I:12-16.

Tax Form/Return Preparation Problems I:12-52 (See Instructor’s Resource Manual) I:12-53 (See Instructor’s Resource Manual) I:12-54 (See Instructor’s Resource Manual)

Case Study Problem I:12-55 Electric Corporation will recognize a taxable gain of $1,000,000 since the corporation receives boot as part of a like-kind exchange. The realized gain is $3,400,000 ($5,000,000 $1,600,000), which is more than the $1,000,000 of boot received. The tax basis of the land received is $1,600,000 and the tax basis of the marketable securities is $1,000,000.

For financial accounting, it is important to determine if the transaction is an exchange of nonmonetary assets with commercial substance. If so, the gain or loss is recognized, and Electric would report a gain of $3,400,000. An exchange has commercial substance if future cash flows change as a result of the exchange, and it is likely that most exchanges will have commercial substance.

If the exchange is of nonmonetary assets without commercial substance, any loss is recognized but not gain. However, gain is recognized if cash is received. Because the exchange is land for land, it may be an exchange of nonmonetary assets without commercial substance with the monetary asset treated as equivalent to cash. If so, the exchange is viewed as a combination of an exchange and a sale with the basis of the land exchanged allocated based on relative FMV as shown below:

FMV of Land Received Basis of Land Exchanged Gain Realized

$4,000,000 ( 1,280,000) $2,720,000

FMV of Securities Received Basis of Land Sold Gain Realized

$1,000,000 ( 320,000) $ 680,000

Gain realized on sale of the securities is $680,000. The financial accounting basis of the land received in the exchange is $1,280,000 and the basis of the marketable securities is $1,000,000.

Since taxable income ($1,000,000) is greater than financial accounting income ($680,000), the deferred tax account will be debited by $67,200 ($320,000 x 21%).

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I:12-12

Tax Research Problems I:12-56 The Orchards should be able to exclude the entire gain realized from both sales.

The sale or exchange of vacant land is a sale or exchange of a taxpayer’s principal residence if the vacant land is owned and used as part of the taxpayer’s principal residence and is adjacent to land containing the dwelling unit of the taxpayer’s principal residence. The sale or exchange of the dwelling unit must meet the requirements of Sec. 121 and the sale must be within two years before or two years after the date of sale or exchange of the vacant land. The requirements of Sec. 121 must be met with respect to the vacant land. For purposes of the maximum amount that may be excluded, the dwelling unit and the land are treated as one sale or exchange [Reg. 1.121-1(b)(3) Reg. 1.121-1(b)(4) Examples 3 and 4].

I:12-57 a.

The exchange is not a like-kind exchange because George did not intend to hold the property received for productive use in a trade or business or for investment. He exchanged the property with the intent to make gifts of the property received [D.H. Click, 78 T.C. 225 (1982)]. b.

After the exchange, George should rent the houses to the sons at a fair rental value. If he uses the property as rental property, the exchange is a like-kind exchange. George may later make gifts of the houses to the sons [F.S. Wagensen, 74 T.C. 653 (1980)].

I:12-58 $165,000. Occupancy is required, and a one-year sabbatical is not a temporary absence.

[Reg. 1.121-1(c)(4) Example 4].

I:12-59 She should be able to exclude the entire gain if she sells the residence this year or next year. The basis on half of the house is increased to $400,000 because the basis is FMV at time of death, thus the basis for the house is $450,000 ($400,000 for his half and $50,000 for her half).

If she sells the house for $825,000 this year, the realized gain is $375,000, which may be excluded on their joint return. If she sells the house next year for $830,000, the realized gain is $380,000 and all of the gain may be excluded. Prior to 2007, it was advantageous for her to sell the house during the year her spouse died to be eligible for the $500,000 exclusion. However, Congress changed the law to allow an unmarried individual whose spouse is deceased on the date of the sale or exchange to use the $500,000 exclusion. The sale or exchange must occur within two years after the date of the spouse’s death. Furthermore, the couple must have been eligible for use of the $500,000 exclusion immediately before such date of death.

I:12-60 a.

Yes. [Reg. 1.121-3(c)(1) & (4) Example 1] b.

Yes. [Reg. 1.121-3(d)(1) & (3) Example 4]; the son is a qualified individual [Reg. 1.121-3(f)]. c.

Probably No. The safe harbor test of (e)(2) is not satisfied. [Reg. 1.121-3(e)(1) & (4) Example 5].

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I:12-13

Chapter I:13 Property Transactions: Section 1231 and Recapture Discussion Questions I:13-1 Gain on the sale or exchange of land held as inventory is ordinary while the gain is a Sec. 1231 gain if the land is used in a trade or business and held more than one year. If the land is used in a trade or business and held for one year or less, the gain is ordinary. If the land is held as an investment or for personal use, the gain is LTCG if held more than one year. pp. I:13-5 and I:13-6.

I:13-2 The gain was classified as ordinary income. In 1942, Congress created the predecessor of Sec. 1231, which allowed taxpayers to treat net gains from the sale of business property as capital gains and net losses as ordinary losses. p. I:13-2.

I:13-3 Yes, $140,000 of the gain may be treated as Sec. 1231 gain if Alice elects to treat the cutting of timber as a sale or exchange. The gain is determined by comparing the timber's adjusted basis for depletion with its FMV on the first day of the taxable year in which it is cut.

The remaining gain of $10,000 is ordinary. pp. I:13-5 and I:13-6.

I:13-4 Gains and losses due to the condemnation of business assets held more than one year are classified as Sec. 1231 gains and losses. Gains and losses due to casualties or thefts of business assets held more than one year are combined with gains and losses due to casualties or thefts of nonpersonal use capital assets held more than one year. If the result is a net gain, the gains and losses are treated as Sec. 1231 gains and losses. If the result is a net loss, the gains and losses are ordinary. pp. I:13-6 through I:13-8.

I:13-5 Livestock held by the taxpayer for draft, breeding, dairy, or sporting purposes for more than one year is considered to be Sec. 1231 property. Cattle and horses must be held for 24 months or more. p. I:13-6.

I:13-6 Net Sec. 1231 gain is treated as ordinary income to the extent of any nonrecaptured net Sec. 1231 losses for the five most recent preceding years. p. I:13-3.

I:13-7 a.

Because the Sec. 1231 gains exceed the Sec. 1231 losses, the $10,000 is characterized as LTCG. If her taxable income is more than $47,025 and less than or equal to $518,900, the gain will be taxed at 15% if the ANCG is $10,000. b. Her regular tax rate is 37% and she has at least $10,000 of unrecaptured Sec. 1231 losses, which means that the gain is taxed as ordinary income. c. The gain is from the sale of a building and she has $10,000 Sec. 1231 gain and all of the gain is unrecaptured Sec. 1250 gain. Depreciation was at least $10,000. d. Same as (a.) and her taxable income is more than $518,900. e. Same as (a.) except her taxable income is $47,025 or less. p. I:13-4.

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I:13-8 Equipment is Sec. 1245 property and gain to the extent of total depreciation is ordinary income but limited to the amount of realized gain. Generally, the amount of depreciation is greater than the gain realized. Taxpayers must sell the equipment for more than the original basis to have any of the gain treated as Sec. 1231 gain. p. I:13-8.

I:13-9 If the holding period is one year or less, the $500 loss is ordinary. If the holding period is more than one year, the loss is a Sec. 1231 loss that may offset other Sec. 1231 gains which would otherwise be granted LTCG treatment (i.e., if Sec. 1231 gains exceed Sec. 1231 losses). p. I:13-3.

I:13-10 If the straight-line method is used, the amount of the gain will be smaller than if an accelerated method is used. It may be advantageous for Jackie to have smaller deductions in years one and two with a smaller gain in year three than have higher deductions in years one and two, when her tax rate is lower, with a higher gain in year three, when her tax rate is higher.

Consideration should also be given to the time value of money. pp. I:13-8 and I:13-9.

I:13-11 The entire realized gain of $3,721 ($3,721 - $0) is Sec. 1245 ordinary income. pp. I:13-9 and I:13-20.

I:13-12 The motel must have been placed in service after 1980 and before 1987 and the ACRS statutory rates were used. p. I:13-10.

I:13-13 No. An individual taxpayer will not have to recognize Sec. 1250 ordinary income if the building was placed in service after 1986 because the straight-line method of depreciation must be used and there is no excess depreciation (i.e., depreciation in excess of straight-line depreciation) to be recaptured as ordinary income. A corporate taxpayer may have to recognize Sec. 1250 but not more than 20% of depreciation allowed.

I:13-14 None of the gain is recaptured as ordinary income due to Sec. 1250 since there is no excess depreciation. If Marty is a corporate taxpayer and, therefore, Sec. 291(a) applies, some of the gain, but not more than 20% of depreciation, is ordinary income. p. I:13-11.

I:13-15 The inventory and marketable securities do not qualify as Sec. 1231 property. pp. I:13-5 and I:13-6.

I:13-16 An office building is subject to the depreciation recapture rules of Sec. 1245 if the building is placed in service after 1980 and before 1987 and the ACRS statutory rates are used to determine the cost recovery deductions. p. I:13-10.

I:13-17 No. The building is not residential rental property. For a building to qualify as residential rental property, 80% or more of the gross rental income from the building must be rental income from dwelling units. p. I:13-13.

I:13-18 Zero. Roger’s estate will not recognize any gain because the estate's basis for the apartment complex will be $2 million. p. I:13-18.

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I:13-19 Rashad would never have to recognize any Sec. 1245 ordinary income as a result of selling residential rental property even if the property is placed in service after 1980 and before 1987. p. I:13-13.

I:13-20 Less. John will pay $7,500 (15% x $50,000) which is less than what Karen will pay because some or all of her Sec. 1231 gain is unrecaptured Sec. 1250 gain taxed at 25%. If all of the gain is unrecaptured Sec. 1250 gain, she pays $12,500 (25% x $50,000). If depreciation amounted to $40,000, Karen pays $11,500 [(25% x $40,000) + (15% x $10,000)]. pp. I:13-4 and I:13-12.

I:13-21 A corporate taxpayer must apply the recapture rules of Sec. 291(a). If a corporate taxpayer disposes of Sec. 1250 property, 20% of the excess of the amount that would be recaptured if the property was Sec. 1245 property over the amount recaptured as ordinary income under Sec. 1250 is ordinary income. p. I:13-16.

I:13-22 No. Given the same sale, the corporate taxpayer and the individual taxpayer should have the same amount of Sec. 1245 ordinary income. Sec. 291 does not cause any additional recapture for the corporation because Sec. 1250 does not apply to equipment. pp. I:13-16 and I:13-17.

I:13-23 a.

There is no recapture for the donor. The recapture potential carries over to the donee. b.

There is no recapture for the donor. However, the donor's charitable contribution deduction is reduced by the amount of ordinary income that would have been recognized if the property were sold. c.

Dale must recognize $40,000 of ordinary income if he disposes of the equipment in an installment sale despite the fact that Dale only receives $10,000. pp. I:13-18 through I:13-20.

I:13-24 $270,000. Without considering any limitations due to his AGI, his charitable contribution deduction is $270,000 the FMV ($500,000) less the amount of gain that would be ordinary income if he sells the property ($230,000). p. I:13-18.

I:13-25 Ted may elect to defer $500,000 of the realized gain of $580,000 ($580,000 - $0). He must recognize $80,000 of Sec. 1245 ordinary income. The $500,000 cost of the replacement property is $80,000 less than the amount received due to the involuntary conversion. If Ted does not make the election to defer, the $580,000 gain is ordinary under Sec. 1245. p. I:13-19.

I:13-26 The amounts subject to recapture include both the amounts deducted as IDC and for depletion. The amount of ordinary income due to the recapture of IDC and depletion is not more than the realized gain. p. I:13-21.

I:13-27 Yes, gain resulting from the sale of the building is ordinary income under Sec. 1239 because the building is depreciable property, and William owns more than 50% of the corporation. The land is not subject to recapture under Sec. 1239 because it is not depreciable. p. I:13-22.

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Issue Identification Questions I:13-28 What is the character of the gain or loss resulting from the sale of the 11 chinchillas from her breeding stock? Sec. 1231 should apply. Sec. 1231 does apply to livestock held for breeding if the holding period is 12 months or more (24 for cattle and horses), and Revenue Ruling 57-588 [1957-2 CB 305] include chinchillas as livestock.

In Cedarburg Fox Farms, Inc. [60-2 USTC 9760, 283 F2d 711] the 7th Circuit stated that culled breeding stock qualified as Sec. 1231 property.

All of the sales from the market group would result in ordinary income or loss. pp. I:13-5 and I:13-6.

I:13-29 The primary tax issue for Green Acres is whether the $130,000 represents amounts received from the sale or exchange of property used in a trade or business under Sec. 1231. The facts in this question are similar to those in R.T. Watts v. U.S., 10 AFTR 2d 5832, 62-2 USTC ¶ 9778 (D.C. Ore., 1962) which held that the proceeds came under Sec. 1231. The principal issue for Stanley is whether the payments are deductible as an ordinary and necessary business expense which should be the case. p. I:13-5.

I:13-30 The primary tax issue for Sarah is the character of the gain that would be recognized if she sells her business (i.e., what type of property is structure X and structure Y)? The facts in this question are similar to those in Rev. Rul. 80-151, 1980-1 C.B. 7 which held that both types of properties are Sec. 1231 properties since they both represent depreciable property used in a trade of business. Structure X is Sec. 1245 property and structure Y is Sec. 1250 property because it is a permanent structure.

Key issues considered when determining if property is tangible personal property or inherently permanent structures: 1.

2.

3.

4.

5.

6.

Is property capable of being moved and has it been moved?

Is property designed or constructed to remain permanently in place?

Do circumstances suggest that property will have to be moved?

How difficult is it to remove the property?

How much damage will the property sustain upon its removal?

What is the manner of affixation of the property to the land?

pp. I:13-5, I:13-9, and I:13-11.

I:13-31 The key issue is whether the transfer of the automobile from business use to personal use constitutes a disposition resulting in Sec. 1245 ordinary income of $2,900 to Sylvester. The facts in this question are similar to those in Rev. Rul. 69-487, 1969-2 C.B. 165 which held that the conversion is not a disposition for purposes of Sec. 1245 because there is no gain recognized

by Sylvester when the property is converted to personal use. Sec. 1245 may apply to a subsequent disposition of the automobile. p. I:13-9.

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Problems I:13-32 Sec. 1231

Sec. 1245

Sec. 1250

yes yes --yes --yes

--yes --yes -----

----------yes

Land on which factory is located Equipment Inventory Patent Land held primarily for sale* Factory building

*Gain or loss is ordinary because the land is held for sale. pp. I:13-5, I:13-9, and I:13-11.

I:13-33 a. b. c. d.

AGI $54,000 ($40,000 + $14,000 NLTCG) $28,000 ($40,000 - $ 12,000 ordinary loss) $37,300 ($40,000 + $ 6,300 NLTCG - $9,000 ordinary loss) $30,000 ($40,000 - $ 3,000 LTCL - $7,000 ordinary loss)

p. I:13-3.

I:13-34 a. $450 ($3,000 x 15%). The net Sec. 1231 gain of $3,000 is taxed at 15%. b.

Decrease by $1,080 ($4,080 - $3,000). The net Sec. 1231 gain of $20,000 is taxed at 15%, resulting in tax of $3,000. The $17,000 loss is ordinary and her tax is reduced by $4,080 (24% x $17,000). c. $600. The net Sec. 1231 gain of $3,000 is taxed at 20%, because her tax rate for ANCG is 20%. pp. I:13-3 and I:13-4.

I:13-35 a. b. c. d.

Sec. 1231 does not apply to personal use assets Sec. 1231 gain Sec. 1231 loss All of the $4,000 gain is Sec. 1245 ordinary income.

pp. I:13-5, I:13-6, and I:13-8.

I:13-36 a. b.

$67,000 ($70,000 - $3,000) $58,000 ($70,000 - $12,000)

If the $12,000 realized loss ($23,000 - $35,000) is a capital loss, only $3,000 of the loss may be deducted in the current year, and $9,000 of the loss is carried forward for an indefinite period. If the $12,000 realized loss is a Sec. 1231 loss and there are no Sec. 1231 gains, the $12,000 loss is an ordinary loss and is deductible. Vicki is assumed to be in an active trade or business and the passive loss limitations do not apply. p. I:13-3.

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I:13-37 a. $80,000. The gain is a Sec. 1231 gain that is classified as a LTCG since the corporation does not have any Sec. 1231 losses. b.

Zero. The capital loss carryforward may be used only to offset capital gain income. pp. I:13-3, I:13-7, and I:13-8.

I:13-38 a. $110,000. Because the $50,000 gain due to the casualty exceeds casualty losses (zero), the $50,000 gain is combined with the $60,000 Sec. 1231 gain and Sean has net capital gain of $110,000. b.

Zero. As in case a, the $50,000 gain is combined with other Sec. 1231 gains and losses. Because the $60,000 Sec. 1231 loss exceeds the Sec. 1231 gain of $50,000, Sean does not have net capital gain. He may deduct $10,000 as ordinary loss. c.

Zero. The $50,000 casualty gain is combined with the $200,000 casualty loss.

Because the net amount is a loss, the gain and loss are not treated as Sec. 1231. Sean has net capital gain of zero. He has an ordinary loss of $150,000 ($200,000 - $50,000). pp. I:13-6 and I:13-7.

I:13-39 2019 $2,000 NLTCG 2020 Zero - $4,000 ordinary loss 2021 Zero - $7,000 ordinary loss 2022 Zero - The $5,000 net Sec. 1231 gain is ordinary income since there is $11,000 of nonrecaptured net Sec. 1231 losses at the beginning of the year. The nonrecaptured net Sec. 1231 losses at the end of the year are $6,000.

2023 $5,800 NLTCG and $6,000 of ordinary income 2024 Zero - $7,000 ordinary loss. pp. I:13-3, I:13-7, and I:13-8.

I:13-40 $15,950 ($14,000 + $1,950). $40,000 of the gain from the sale is ordinary income due to the five-year look back rule; thus $40,000 is taxed at 35%. The remaining gain of $13,000 is taxed at 15%. pp. I:13-3, I:13-7, and I:13-8.

I:13-41 Case

Gain (Loss)

Ordinary

Sec. 1231

A B C

$107,000 452,000 ( 55,000)

$107,000 350,000 ---

--$ 102,000 ( 55,000)

pp. I:13-8 and I:13-9.

I:13-42 a. $230,000. The maximum selling price that Elizabeth could sell the equipment for without having to recognize Sec. 1245 ordinary income is $230,000, the adjusted basis. Any gain due to depreciation is Sec. 1245 ordinary income. b. $291,000. The first $270,000 of gain resulting from the sale of the equipment is Sec. 1245 ordinary income. If she sells the property and has a $61,000 gain, the gain is Sec. 1245 ordinary income. If SP - $230,000 = $61,000, then the selling price is $291,000. pp. I:13-8 and I:13-9.

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I:13-43 a.

Depreciation of $403 ($4,200 x 0.1920 x 0.5) is allowed in 2024. The 50% results from the half-year convention. b.

Amount realized Minus: Adjusted basis Realized gain (loss)

Business Portion of Truck

Personal Use Portion

$2,100* (1,613)** $ 487

$ 900 ( 1,800) ($ 900)

* (0.70 x $3,000) ** ($4,200 - $2,587) The $487 gain is ordinary income under Sec. 1245. The $900 loss is a capital loss, but is not deductible since that portion of the truck is a personal use asset. pp. I:13-8 and I:13-9.

I:13-44 a. b. c. d. e. f.

Realized gain is $38,000 ($82,000 - $44,000).

Recognized gain is $38,000. $26,000 of the gain is Sec. 1245 ordinary income. $12,000 of the gain is Sec. 1231.

Basis of the marketable securities Basis of equipment received is $52,000.

is

$30,000.

p. I:13-19.

I:13-45 a. $6,000. ($40,000 - $34,000). b.

Zero. The exchange was a like-kind exchange before 2018. c. $34,000. d. $20,000. ($41,000 - $21,000) of Sec. 1245 ordinary income. e.

The gain is $31,000. ($52,000 - $21,000). $29,000 of Sec. 1245 ordinary income and $2,000 of Sec. 1231 gain. f. $6,000 recognized gain and basis of new truck is $40,000. The exchange of the truck (personal property) is no longer a like-kind exchange after 2017. p. I:13-19.

I:13-46 a. $58,000 ($110,000 - $52,000) b. $58,000 Sec. 1245 does not affect the amount of gain. Sec. 1245 affects the character of the gain. c. $11,600 ($20,300 - $8,700) (35% times the Sec. 1245 ordinary income of $58,000) – (15% times the $58,000 LTCG due to Sec. 1231 if Sec. 1245 does not exist) p. I:13-9.

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I:13-47 a. $610,000 ($720,000 - $110,000) b. $130,000 ($690,000 - $560,000) is Sec. 1250 ordinary income and $480,000 is Sec. 1231 gain. The $480,000 gain is unrecaptured Sec. 1250 gain taxed at the rate of 25%. c. $80,000 ($180,000 - $100,000) Sec. 1231 gain I:13-48 a. $610,000 b. $226,000 of Sec. 1250 ordinary income and $384,000 of Sec. 1231 gain.

More ordinary income must be recognized in (b) since Sec. 291(a) must be considered. Total Sec. 1250 ordinary income is $130,000; Sec. 291 ordinary income is $96,000 [0.20 x ($610,000 $130,000)] and Sec. 1231 gain is $384,000. For corporations, none of the gain is unrecaptured Sec. 1250 gain. c. $80,000 Sec. 1231 gain pp. I:13-12 through I:13-14, I:13-16, and I:13-17.

I:13-49 a. $3,840 increase. $12,000 ($40,000 - $28,000) Sec. 1245 ordinary income is taxed at his 32% marginal tax rate. b. $4,550 increase. $19,000 ($80,000 - $61,000) Sec. 1231 gain but $10,000 is ordinary because of the nonrecaptured net Sec. 1231 losses ($10,000 x 32%) + ($9,000 x 15%). c. $6,450 increase. $10,000 of the Sec. 1231 gain of $23,000 ($163,000 - $140,000) is ordinary taxed at 32% and $13,000 is unrecaptured Sec. 1250 gain taxed at 25% ($13,000 x 25%). d. $4,160 decrease ($13,000 x 32%). Sec. 1231 loss of $13,000 ($127,000 $140,000).

I:13-50 a.

Sec. 179. b. c.

$14,290 (14.29% x $100,000) of depreciation plus $250,000 expensed under $12,245 (24.49% x $100,000 x 1/2) $76,535 Sec. 1245 ordinary income. ($150,000 - $73,465)

I:13-51 a. $62,730 (3.485% x $1,800,000) Property is residential rental property. b. $51,813 (3.636% x $1,800,000 x 9.5/12) c.

No, because no depreciation recapture is required for property that is depreciated using the straight-line method if the taxpayer is a noncorporate taxpayer. d. $629,991 Sec. 1231 gain ($2,250,000 - $1,620,009 = $629,991). The basis of $1,620,009 is computed as follows: Cost $1,800,000 Depreciation: 2022 $62,730 2023 $65,448 2024 $51,813 ( 179,991) $1,620,009 e. $50,000 Sec. 1231 gain ($250,000 - $200,000) f.

Yes, $179,991, the gain due to depreciation allowed for the building, which is unrecaptured Sec. 1250 gain.

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I:13-52 a.

Amount realized Minus: Adjusted basis Realized gain Ordinary income Sec. 1231 gain

Building-90%

Land-10%

$112,500 ( -0-)* $112,500 -0-** $112,500

$12,500 (10,000) $ 2,500 2,500

* $90,000 - $90,000. ** $90,000 - $90,000. b.

Jesse must recognize $90,000 of Sec. 1245 ordinary income and $22,500 of Sec. 1231 gain due to the sale of the building. The $2,500 gain on the sale of land is Sec. 1231 gain. pp. I:13-11 through I:13-14 and I:13-19.

I:13-53 a. $227,000. The maximum selling price that Rosemary could sell the building for without having to recognize Sec. 1250 ordinary income is $227,000, the adjusted basis. b. $278,000. The first $73,000 (i.e., the additional depreciation) of gain resulting from the sale of the building would be Sec. 1250 ordinary income. If SP - $227,000 = $51,000, then the selling price is $278,000. pp. I:13-13 and I:13-14.

I:13-54 1. T. Gain to the extent of excess depreciation, the excess of accelerated over straightline depreciation, is Sec. 1250 ordinary income. The statement would be false if the building is fully depreciated because there is no additional depreciation and none of the gain is ordinary.

2. T. Gain due to depreciation, but not excess depreciation, is unrecaptured Sec. 1250 income taxed at 25%.

3. T. If accelerated cost recovery is used, building #2 is Sec. 1245 property.

4. T. If straight-line method is used, building #2 is Sec. 1231 property.

5. T. If accelerated cost recovery is used and the building is sold for more than its original basis, gain due to depreciation is Sec. 1245 ordinary income and the remaining gain is Sec. 1231 gain.

6. T. Gain due to depreciation, but not excess depreciation, is unrecaptured Sec. 1250 income taxed at 25%. Because the straight-line method of depreciation was used, all of the gain due to depreciation is taxed at 25%.

7. F. A building is Sec. 1245 property only if placed in service during the period from January 1, 1981 to December 31, 1986 and accelerated cost recovery is allowed.

8. T. Gain due to depreciation, but not excess depreciation, is unrecaptured Sec. 1250 income taxed at 25%. Because the building was placed in service after 1986, the straight-line method of depreciation must be used, and there is no excess depreciation for building #3.

9. F. Because the straight-line method of depreciation must be used, there is no excess depreciation and thus no Sec. 1250 ordinary income.

10. F. $30,000 might be ordinary income due to the five-year-lookback rule, but not $40,000.

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I:13-55 1. T. Gain to the extent of excess depreciation, the excess of accelerated over straightline depreciation is Sec. 1250 ordinary income.

2. F. Corporate taxpayers do not have unrecaptured Sec. 1250 gain taxed at 25%.

3. T. If accelerated cost recovery is used, building #2 is Sec. 1245 property.

4. T. If straight-line method is used, building #2 is Sec. 1231 property. Some of the gain is Sec. 1250 gain, not more than 20% of depreciation, but most of the gain is Sec. 1231 gain.

5. T. If accelerated cost recovery is used and the building is sold for more than its original basis, gain due to depreciation is Sec. 1245 ordinary income and the remaining gain is Sec. 1231 gain.

6. F. Corporate taxpayers do not have unrecaptured Sec. 1250 gain taxed at 25%.

7. F. A building is Sec. 1245 property only if placed in service during the period from January 1, 1981, to December 31, 1986, and accelerated cost recovery is allowed.

8. F. Corporate taxpayers do not have unrecaptured Sec. 1250 gain taxed at 25%.

9. T. 20% (gain that would be ordinary income if building was Sec. 1245 less gain that is Sec. 1250 ordinary income) is additional Sec. 1250 ordinary income for corporate taxpayers.

10. F. $30,000 might be ordinary income due to the five-year-lookback rule and $8,000 is Sec. 1250 ordinary income [20% ($40,000 – 0)] but all $40,000 would not be ordinary income.

I:13-56 a.

Building $4,050,000

SP Original cost Accumulated deprec.

Sec. 1231 Gain AB

$ 2,700,000 1,000,000

1,700,000 $2,350,000

b.

Land $450,000 300,000 $150,000

SP AB Sec. 1231 Gain c. d.

$1,000,000. All of the gain to the extent of depreciation taken.

Reduce gain taxed at 25%, capital losses reduce gains at the highest tax rates first.

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I:13-57 a.

SP AB Gain Ordinary – Sec. 1250 Sec. 1231 G

$ 4,050,000 1,700,000 $2,350,000 200,000 $2,150,000

b.

SP AB Sec. 1231 G

$ 450,000 - 300,000 $ 150,000

c.

Zero. The 25% rate does not apply to corporations.

I:13-58 a. b.

$12,800 $40,000 ( 4,500) (35,500) 11,360

20% ($1,000,000 – 0)

($40,000 x 32%) cash received due to the sale cash needed for taxes on $30,000 Sec. 1231 gain at 15% cash contributed to the university tax savings due to the contribution (32% x $35,500)

Raquel would be $1,440 better off as a result of donating the land instead of selling the land and donating the cash. Further, the university would only receive $35,500 as compared to $40,000 in Part a. Bottom line: taxes play a significant role in structuring transactions.

Note: By reducing Raquel’s AGI, the difference in the two alternatives could be reduced. With an AGI of $100,000, she could deduct only $30,000 with a $10,000 carryforward. If she donates cash, she could deduct the entire $35,500.

I:13-59 Sec. 1231 Gain (Loss) Building purchased in 2008 for $220,000 with adjusted basis of $165,000

Ordinary Income

Taxed at 32%

$35,000

Equipment purchased in 2020 for $300,000 with adjusted basis of $144,000

$170,000

Building purchased in 2007 for $150,000 with adjusted basis of $112,000

$88,000

Equipment purchased in 2021 for $180,000 with adjusted basis of $140,000

$20,000

Taxed at 20%

Taxed at 15%

$35,000

$56,000

Land purchased in 2001 for $30,000 to use as a building site

Taxed at 25%

$56,000

$170,000

$38,000

$40,000

$40,000

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I:13-11

$50,000

$20,000

I:13-60 a.

The recognized gain is $225,000 ($825,000 - $600,000), and $40,000 (0.40 x $100,000) is ordinary income. The remaining $185,000 is Sec. 1231 gain. b.

The recognized gain is $15,000 and all of the gain is ordinary income since it is less than the amount of soil and water conservation expenditures recaptured. pp. I:13-20 and I:13-21.

I:13-61 $100,000 ordinary. The recognized gain is $100,000 ($900,000 - $800,000) and all of the gain is ordinary income since the gain is less than the amount of IDC ($300,000) subject to recapture. p. I:13-21.

I:13-62 a. $250,000 ordinary. The realized gain is $250,000 ($950,000 - $700,000) and all the gain is ordinary income under Sec. 1254. All gain to the extent of depletion ($200,000) and IDC that was expensed ($170,000) is recaptured as ordinary income. b. $1,070,000. Jack must sell the property for more than $1,070,000 ($700,000 + $370,000) before he has a Sec. 1231 gain since the first $370,000 ($200,000 depletion + $170,000 IDC that was expensed) is ordinary income. p. I:13-21.

I:13-63 a. $330,000 ordinary. The $330,000 gain ($500,000 - $170,000) due to the sale of the building is ordinary income since Ed and the Crane Corporation are related parties and the building is depreciable property. b. $135,000 Sec 1231 gain. The $135,000 gain ($200,000 - $65,000) due to the sale of the land is a Sec 1231 gain. p. I:13-22.

Comprehensive Problem I:13-64 a. b. c. d.

$160,000. Sale of the racehorse results in Sec. 1245 ordinary income.

Zero.

No. The pony is a personal-use asset. $565,000. The net Sec. 1231 gain exists because of four transactions:

$200,000 casualty gain - building 35,000 condemnation of land 350,000 sale of racehorse for more than original cost (20,000) loss on exchange of equipment e.

Yes. The casualty gain is netted against casualty losses of Sec. 1231 property and non-personal use capital assets held more than one year. Since there are no such losses, the $200,000 gain is combined with Sec. 1231 gains and losses. After all Sec. 1231 gains and losses are netted, a net Sec. 1231 gain of $565,000 ($585,000 - $20,000) exists, thus all Sec. 1231 gains and losses are treated as LTCG and LTCL. f. $130,000. The unrecaptured Sec. 1250 gain is taxed at 25%. If Sec. 1250 provided for the recapture of all depreciation instead of just additional depreciation, $130,000 of the gain resulting from the involuntary conversion would have been ordinary income. pp. I:13-6 through I:13-12.

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Tax Strategy and Critical Thinking Problems I:13-65 a.

The $20,000 Sec. 1231 loss in 2024 is an ordinary loss in 2024, and the $20,000 Sec. 1231 gain in 2025 is ordinary income. The Sec. 1231 gain is ordinary income because of the nonrecaptured net Sec. 1231 losses at the beginning of 2025, so there is no difference in total taxes paid for the two years. b.

The Sec. 1231 gain recognized in 2024 is a LTCG, and the $20,000 Sec. 1231 loss recognized in 2025 is an ordinary loss. This alternative may be preferable because the NLTCG is taxed at a lower rate than the ordinary income. The net capital gain of $20,000 in 2024 is taxed at a maximum rate of 15% (for a taxpayer who expects to have a marginal tax rate of 32%) or 25% if the 1231 gain is unrecaptured Sec. 1250 gain, although the time value of money should be considered. p. I:13-3.

I:13-66 Holly's 2024 taxes do not increase if she recognizes the $5,000 Sec. 1231 gain in 2024.

The Sec. 1231 gain is a LTCG that is offset by her $9,000 STCL. $3,000 of the STCL reduces gross income, and she has a $1,000 STCL carryforward. If she does not recognize the $5,000 Sec. 1231 gain in 2024, $3,000 of the STCL reduces gross income, and she has a $6,000 STCL carryforward. p. I:13-3.

Tax Form/Return Preparation Problems I:13-67 (See Instructor’s Resource Manual) I:13-68 (See Instructor’s Resource Manual)

Case Study Problems I:13-69 a.

Kent prefers Sec. 1231 gain instead of ordinary income. The first $450,000 of gain due to the sale of the equipment is ordinary income, but gain on the sale of land is Sec. 1231 gain possibly taxed at 15%. He wants to allocate more of the sales price to land instead of equipment. All gain due to sale of inventory is ordinary income. The gain due to the sale of the building is Sec. 1231 gain. The first $406,000 of Sec. 1231 gain resulting from sale of the building is unrecaptured Sec. 1250 gain taxed at a maximum rate of 25%. Any Sec. 1231 gain in excess of $406,000 may be taxed at 15%. b.

Although the presence of capital losses usually makes taxpayers want to recognize capital gain instead of ordinary income, the presence of the preferential tax rates as described above already creates a strong preference for Sec. 1231 gains. The presence of capital losses may make his preference for Sec. 1231 gains even stronger because he will be able to use the capital losses to offset capital gain. The use of capital losses to offset ordinary income is restricted to $3,000 per year.

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To illustrate the different results, assume the following two allocations:

Equipment Building Land Inventory

Equipment Building Land Inventory

Allocation of Sales Price

Ordinary Income

Sec. 1231 Gain

$ 250,000 500,000 140,000 110,000 $1,000,000

$100,000 0 0 60,000 $160,000

0 $ 6,000 40,000 0 $46,000

Allocation of Sales Price

Ordinary Income

Sec. 1231 Gain

$ 225,000 525,000 151,000 99,000 $1,000,00

$ 75,000 0 0 49,000 $124,000

0 $31,000 51,000 0 $82,000

Note, in the second allocation, 10% of the amount allocated to equipment was allocated to the building and 10% of the amount allocated to inventory was allocated to the land.

With the first allocation, Kent has $160,000 of ordinary income and $46,000 of Sec. 1231 gain with $6,000 taxed at 25% and $40,000 taxed at 15%. With the second allocation, he has $36,000 less ordinary income and more Sec. 1231 gain taxed at 15%. c.

Tom will prefer to have greater amounts of the purchase price allocated to depreciable property as opposed to allocating to the land which is not depreciable. The building will have a longer recovery period than the equipment, thus he will prefer to allocate more of the purchase price to the equipment than to the building. Since the inventory is likely to be sold soon and deducted as cost of goods sold, he will prefer to have a large amount allocated to the inventory. d.

There is probably a good business reason for having Kent sign a covenant not to compete, since Tom does not want Kent to build a new bowling alley and compete with him.

Amounts allocated to a covenant not to compete may be amortized by Tom. Amounts received as payment for a covenant not to compete constitute ordinary income for Kent. If the FMV of the tangible assets is less than $1 million, an allocation to intangible assets must be considered.

There is some indication that the business does have goodwill (i.e., loyal group of customers).

Prior to the Revenue Reconciliation Act of 1993, amortization of goodwill was not allowed for taxes. If goodwill was not amortizable, Tom would prefer to allocate amounts to amortizable intangibles such as a covenant not to compete. For Kent, amounts received for goodwill Copyright © 2025 Pearson Education, Inc.

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represent capital gain thus he prefers an allocation to goodwill. Since the transaction occurs after August 10, 1993, both goodwill and the covenant not to compete are Section 197 intangibles and are amortizable over 15 years. e.

Since the taxpayers may have conflicting positions, especially in the case where Kent has a preference for Sec. 1231 gain instead of ordinary income, it may be difficult to advise both individuals at the same time. At a minimum, you should make Kent and Tom aware of the potentially conflicting objectives.

For allocation rules for certain asset acquisitions, see Secs. 1060 and 338(b)(5).

I:13-70 The allocation of the purchase price should be the same for the buyer and the seller.

Sec. 1060 specifies that any written agreement as to the allocation or the FMV of the assets is binding on both parties unless the Secretary determines that such allocation or FMV is not appropriate.

Mr. Earl’s tax liability will probably increase by $8,000 ($14,000 - $6,000) because the ordinary income is taxed at 35% while the $40,000 gain on the sale of the land is probably taxed at 15%. However, he may be willing to agree to the reallocation to make the sale.

Before complying with Mr. Quick's request to make the reallocation, the accountant should have substantive evidence to indicate that the appraisal is not correct and the FMV of the inventory and the land are $150,000 and $100,000, respectively. If the accountant complies without the existence of such evidence, Mr. Quick may request additional reallocations.

The accountant should review Sec. 6662 pertaining to accuracy-related penalties, although it would not appear that the reallocation as Tom requests is a substantial valuation misstatement.

The accountant should recall that buyers and sellers of businesses must file Form 8594 with their tax return to summarize the purchase price allocation if the seller enters into an employment contract, covenant not to compete, royalty or lease arrangement or other such agreement with the buyer. [Sec. 1060(e)] Since the seller does not appear to be entering any such arrangement, Form 8594 would not have to be filed.

Tax Research Problem I:13-71 The automobiles provided by the Berkeley Corporation for the use of the head basketball coach for short periods of time are not likely to qualify as Sec. 1231 property. The automobiles are held primarily for sale to customers in Berkeley's trade or business. Rev. Rul. 75-538 [1975-2 C.B. 34] states: "A taxpayer engaged in the trade or business of selling motor vehicles is presumed to hold all such vehicles primarily for sale to customers in the ordinary course of the taxpayer's trade or business. To overcome this presumption, it must be clearly shown that the motor vehicle was actually devoted to use in the business of the dealer and that the dealer looks to consumption through use of the vehicle in the ordinary course of business operation to recover the dealer's cost. A vehicle is not property used in the business if it is merely used for demonstration purposes, or temporarily withdrawn from stock-in-trade or inventory for business use." Rev. Rul. 89-25, 1989-1 C.B. 79 refers to Rev. Rul. 75-538 in ruling that a builder's new houses temporarily used as models and/or sales offices are not subject Copyright © 2025 Pearson Education, Inc.

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to depreciation. The new houses temporarily used as models or sales offices are not Sec. 1231 properties.

“What Would You Do In This Situation?” Solution Ch. I:13, p. I:13-21.

By following the manager's instructions, you will be filing a correct return, so there are no legal issues. The issue is more in the nature of "the right action to take" and one's answer may depend on one's own value system.

Some students may react very strongly that the manager's suggestion is wrong. They may want to contact the client and explain the mistake, although it is probably best to try to work within the CPA firm. Work first with the manager and give him time to rethink his proposal and hope that he will decide that the client needs to be informed. Try to avoid strong statements such as we must disclose, or I will go to the partner, although it may eventually be necessary to go to the partner. A question to the manager such as "I am uncomfortable about not disclosing the mistake, so could we take more time to think about what we should do - possibly sleep on the decision?" might be appropriate.

The more difficult issue is what does one do if the partner agrees with the manager not to disclose. The eventual answer may be to find another employer.

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Chapter I:14 Special Tax Computation Methods, Tax Credits, and Payment of Tax Discussion Questions I:14-1 Most individual taxpayers are not subject to the alternative minimum tax (AMT) because they do not have substantial tax preferences and AMT adjustments and because there is a generous exemption amount to reduce the tax base on which the AMT is calculated. p. I:14-2.

I:14-2 No, the alternative minimum tax does not apply if an individual's tentative minimum tax is less than his regular tax liability. It applies only if the tentative minimum tax exceeds the regular tax liability. p. I:14-2.

I:14-3 b only. Only excess depreciation for real property placed in service before 1987 is a tax preference item. For tax years prior to 1987, net long-term capital gains were a tax preference item (i.e., the 60% long-term capital gain deduction) and for taxable years prior to 1993 the appreciated portion of the fair market value of capital gain real property contributed to charity was a tax preference item. p. I:14-4.

I:14-4 a, b, c only. Itemized deductions that are not allowed in computing AMTI, excess depreciation on real property placed in service after 1986, and excess MACRS depreciation for personal property placed in service between 1987 and 1998, are all AMT adjustments. Taxexempt interest is not an AMT adjustment but may be a tax preference item if the bonds are private activity bonds. pp. I:14-4 through I:14-6.

I:14-5 a, b, e only. Charitable contributions and mortgage interest related to the purchase of a personal residence are deductible when computing AMT. Medical expenses in excess of the 7.5% floor are deductible for AMT. Investment interest is deductible up to the amount of qualified net investment income. Because the individual has no investment income, the investment interest expense is not deductible. pp. I:14-4 and I:14-5.

I:14-6 Most people are not subject to the self-employment tax because they are classified as employees for tax purposes. Employees pay employment taxes through withholding and in amounts that must be matched by their employers. p. I:14-8.

I:14-7 Tony will be required to pay FICA taxes on wages and net self-employment (SE) earnings (92.35%*SE earnings). The Social Security portion of FICA taxes (6.2% on wages and 12.4% on net SE earnings) applies up to $168,600 ceiling (2024). The Medicare portion of FICA taxes (1.45% on wages and 2.9% on net SE earnings) applies to all earnings without a ceiling.

Tony’s net SE earnings equal $55,410 (92.35%*$60,000).

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If Tony continues as an employee, the Social Security portion of FICA will be imposed on his salary of $90,000 and on $78,600 ($168,600 ceiling - $90,000 salary) of his net SE earnings.

The Medicare portion will be imposed on both his employee earnings and his net SE earnings.

If Tony retires and no longer earns a salary, the Social Security portion of FICA will be imposed on his net SE earnings ($55,410) and the Medicare portion will be imposed on his net SE earnings ($55,410).

As shown below, because the Social Security portion of FICA will apply to all of his net SE earnings, Tony’s consulting earnings after payroll taxes will increase by $1,834 after he retires.

While an employee and consultant: Net employee earnings = $90,000 – (7.65% x $90,000) = $83,115 Net consulting earnings = $60,000 – [12.4% x ($168,600 – $90,000 salary)] – (2.9% x $55,410) = $48,647 Total earnings after FICA taxes = $83,115 + $48,647 = $131,762 While a consultant only: Net consulting earnings = $60,000 – (12.4% x $55,410) – (2.9% x $55,410) = $51,522 Total earnings after FICA taxes = $51,522 Difference (after retirement) in consulting earnings: $51,522 - $48,647= 2,876 pp. I:14-8 and I:14-9.

I:14-8 If the engagement is set up as a consulting arrangement rather than an employment contract, then the consulting firm will be able to avoid making matching FICA contributions for Theresa’s earnings and will not be required to withhold the employee's share of FICA tax. If the compensation paid to Theresa would be the same whether she was an employee or independent consultant, the cost of Theresa’s services would be less if she were a consultant rather than an employee. Theresa, if paid as a consultant, will be subject to the self-employment tax. If her income as an employee (e.g., college professor) is in excess of the ceiling amount for the Social Security portion of self-employment income, she will not be subject to the 12.4% Social Security portion of the tax. She will however, be subject to the 2.9% Medicare portion on her selfemployment income. Thus, receiving compensation as a consultant is more expensive to Theresa because she bears both the employer and employee sides of the FICA tax. p. I:14-8.

I:14-9 a.

The couple’s AMT exemption equals $133,300 (2024). Their alternative minimum taxable income is below the threshold for the phaseout ($900,000 < $1,218,700 [2024]). b.

If the couple’s AMTI increases by $400,000, their AMT exemption will be $112,975. $133,300 – [25% x ($1,300,000 - $1,218,700)] = $112,975 pp. I:14-3 and I:14-4.

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I:14-10 a.

Foreign tax credits are provided to reduce the effect of double taxation on foreign source income. b.

The research credit is given to encourage (reduce the after tax cost of) research and development activities. c.

Business energy credits are incentives to encourage energy conservation measures and the use of fuel other than petroleum. d.

The premium tax credit is designed to make the cost of health insurance more affordable for taxpayers with modest household incomes. e.

The child and dependent care credit was enacted to reduce the cost of child care for parents and other individuals who must incur expenses for household and dependent care services while they are away from home at work. f.

The earned income credit is designed to encourage low-income individuals to become gainfully employed or to continue to work despite low earnings. g.

The purpose of the American Opportunity tax credit is to reduce the cost of postsecondary education for low and middle income taxpayers. h.

The adoption credit is designed to reduce the financial burdens associated with adopting children. Topic Review I:14-2 on p. I:14-26.

I:14-11 To a taxpayer in the 12% marginal tax bracket, a $200 deduction is worth $24 in tax savings and is therefore worth less than a $40 credit. To a taxpayer in the 22% marginal tax bracket, the deduction is worth $44 in tax savings, more than a $40 credit. Thus, for all taxpayers with a marginal tax rate of 22% or more, the deduction is more advantageous than the credit. p. I:14-10.

I:14-12 The general business credit includes the work opportunity credit, the rehabilitation expenditures credit, research credit, business energy credits, and the disabled access credit. pp. I:14-19 through I:14-23.

I:14-13 a.

The general business credit may not exceed the smaller of: (1) net income tax minus the tentative AMT or (2) net income tax minus 25% of the ―net regular tax‖ in excess of $25,000. The first limit prevents the credit from reducing the tax liability to less than AMT. The second limit prevents the credit from entirely eliminating the tax liability of high-income taxpayers. b.

The general business credit is a nonrefundable credit and has a lower priority than personal tax credits. An individual must use personal tax credits as well as the foreign tax credit to offset tax liability before the general business credit is used. Since the credit is nonrefundable, if the tax liability is eliminated by credits with a higher priority than the general business credit, the taxpayer will only be able to carryback or carryforward the unused general business credit. c.

The general business tax credit may be carried back 1 year and any remaining credit may be carried forward 20 years. Credits carried forward from prior years (commencing with the earliest carryover years) are used before credits arising from the current year. p. I:1423.

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I:14-14 a.

The foreign tax credit equals the income tax paid or accrued to a foreign country, but it is limited to the taxpayer’s U.S. tax liability on foreign earnings (the U.S. income tax liability multiplied by the ratio of foreign source taxable income to worldwide taxable income).

This limitation restricts the use of foreign tax credits when the effective foreign tax rate exceeds the effective U.S. tax rate. In this case, the effective foreign tax rate is lower than the effective U.S. tax rate, and the foreign tax credit would be $25,600 ($128,000 x 0.20), the foreign tax paid. b.

In this case Sarah would be better off choosing the earned income exclusion because $126,500 (2024) of her income could be excluded from U.S. taxation.

1.

If Sarah elects the foreign-earned income exclusion, U.S. taxable income after exclusion ($128,000 – 126,500) U.S. tax rate U.S. tax Foreign tax credit ($1,500 x 0.20) Net U.S. tax liability Plus: Foreign tax paid Total taxes paid

$1,500 x 24% $ 360 ( 300) $ 60 25,600 $ 25,660

Sarah is eligible for a foreign tax credit only on the $1,500 of foreign earned income subject to U.S. tax.

2.

If Sarah elects the foreign tax credit, U.S. tax on worldwide taxable income ($128,000 x 24%) Foreign tax credit ($128,000 x 0.20) Net U.S. tax liability Plus: Foreign tax paid Total taxes paid

$30,720 ( 25,600) $ 5,120 25,600 $ 30,720

Ultimately, Sarah pays the higher tax rate (24%) on the $128,000 income: 20% to the foreign country and 4% (after FTC) to the U.S. pp. I:14-17, I:14-18, and I:14-32.

I:14-15 Queen Corporation is eligible for the disabled access credit as an eligible small business.

Though the company exceeded $1 million or less of gross receipts requirement in the preceding year, it meets the alternate test because it had fewer than 30 employees (25). The credit is $5,000 (0.50 x $10,000). Only $10,000 of the $15,000 expenditure qualifies for the credit (expenditures over $250 but not exceeding $10,250, or $10,000 maximum). The depreciable basis of the property is reduced by the $5,000 allowable credit. p. I:14-21.

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I:14-16 a.

The credit applies to expenditures for the rehabilitation of older industrial and commercial buildings and certified historic structures. Expenditures must be for depreciable business or investment property. Residential real estate does not qualify unless the structure is a certified historic structure. b.

A rate of 10% applies to expenditures on structures placed in service before 1936 and a rate of 20% applies to expenditures on certified historic structures. c.

For the purpose of depreciation, the basis of the property must be reduced by the full amount of the credit taken. d.

Depreciation of qualifying expenditures must be computed using the straight-line depreciation method. e.

The rehabilitation credit must be recaptured proportionately in the event of an early disposition of the property (within 5 years). Excluded from this recapture provision are dispositions by reason of death. p. I:14-19.

I:14-17 Solar energy property (both electric generating and light generating). p. I:14-20.

I:14-18 Many personal tax credits are motivated by both economic and social policy objectives.

For example, the dependent care credit makes it profitable for more parents to work and provide adequate child care. p. I:14-10.

I:14-19 A refundable tax credit resembles a direct subsidy. Because it can fully offset an income tax liability and generate a tax refund, it is a type of negative income tax.

A nonrefundable tax credit may be used only to offset the taxpayer’s tax liability. If the credit exceeds the tax liability, the taxpayer receives no refund and, at best, can only carryback or carryforward the excess credit. The earned income credit is a refundable tax credit. Dependent care credits are nonrefundable credits. pp. I:14-11 and I:14-23.

I:14-20 If an individual is unemployed and has no earned income, it is generally not possible to receive a child and dependent care credit because eligible expenses are limited to earned income.

One exception to this rule applies to married taxpayers. A spouse who is either a full-time student or incapacitated is deemed to have earned income of $250 per month (one qualifying dependent) or $500 per month (two or more qualifying dependents). pp. I:14-11 and I:14-12.

I:14-21 There are several significant differences between the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC). First, the AOTC only applies during a student’s first four years of post-secondary education, whereas the LLC applies to undergraduate, graduate, and professional education. Second, the AOTC applies per student (maximum $2,500 per student) whereas the LLC applies per taxpayer (maximum $2,000). pp. I:14-14 through I:14-16.

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I:14-22 The maximum amount of child and dependent care expenses that qualify for the credit for a taxpayer with two or more qualifying individuals is $6,000. A taxpayer who has $8,000 of eligible expenses may claim a maximum credit of $2,100 ($6,000 x 35%). The credit rate decreases to a minimum of 20% as the taxpayer’s AGI increases from $15,000 to $43,000. If the taxpayer’s AGI exceeds $43,000, the maximum credit is $1,200 ($6,000 x 20%). pp. I:14-11 and I:14-12.

I:14-23 Vivian’s child and dependent care expenses are limited first by the $6,000 ceiling amount, and second, the $6,000 is reduced to $2,000 by the $4,000 employer reimbursement.

Her credit rate is 30% because her AGI of $24,500 exceeds the base AGI of $15,000 by $9,500.

Thus, the basic 35% credit is reduced by 5% to 30% ($9,500/$2,000 = 4.75, rounded to 5%).

The allowable credit equals $600 (30% credit rate x $2,000 allowed expenses). pp. I:14-11 and I:14-12.

I:14-24 a.

The adoption credit allowed is the amount of qualified adoption expenses incurred up to a maximum of $16,810 (2024). The credit must be used in the year adoption is finalized for qualified expenses paid both in the finalized year and in prior years. The credit must be used in the year qualified expenses are paid if paid in years after the finalized year. This rule is intended to prevent taking a credit for adoption expenses where the adoption is not finalized.

Finally, there is a phase-out of the credit based on the taxpayer’s AGI. b.

As with other phase-outs in the tax law, Congress did not intend this credit for higher-income taxpayers. Whether adoption is affordable may not influence adoption decisions for high income households. p. I:14-14.

I:14-25 Alice is eligible for the earned income credit (EIC) both because 1) she has qualifying children (2), 2) she has earned income ($25,000), 3) she does not have excessive investment income ($0), and 4) her modified adjusted gross income (AGI) ($25,000) is modest enough to avoid full phaseout of the credit.

Tentative EIC = 40% (lesser of earned income [$25,000] or maximum eligible earned income [$17,400 2024]) = 40% ($17,400) = $6,960 Phaseout = 21.06% [(greater of earned income or AGI) - $21,560] = 21.06% ($25,000 - $22,720) = $480 Allowed EIC = $6,960 - $480 = $6,480 pp. I:14-23 and I:14-24.

I:14-26 Most elderly people are unable to qualify for the credit because they receive Social Security benefits which exceed the ceiling limitation, or they have AGI in excess of the limitation, or both. p. I:14-13.

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I:14-27 Penalties are imposed if an employer fails to withhold federal payroll tax and income tax and pay them to the IRS. Corporate officers, directors, and other officials may be held personally liable for payment of the tax. p. I:14-27.

I:14-28 a.

Given the budget constraints of lower and middle income households, Congress wanted to enact this credit to further encourage saving for retirement. b.

The credit is computed by multiplying qualifying contributions (maximum $2,000 per taxpayer per year) by an applicable percentage between 50% and 10%, depending on the taxpayer’s adjusted gross income and filing status. Therefore, the maximum annual credit equals $1,000 ($2,000 x 0.50). p. I:14-17.

I:14-29 a.

The two components of the credit for employer-provided childcare are (1) qualified childcare expenses (expenses paid to acquire, construct, rehabilitate, expand, and operate a qualified childcare facility), and (2) qualified child care resource and referral expenditures (expenses paid to provide child care resource and referral services for employees). b.

The credit equals 25% of qualified childcare expenses plus 10% of qualified childcare resources and referral expenditures. The total credit for an employer is limited to $150,000 for any given tax year. Finally, if an employer ceases its childcare operations within the first three years, 100% of the credit is recaptured. pp. I:14-20 and I:14-21.

I:14-30 The research credit is allowed for increasing research expenditures. The credit is 20% of the excess of qualified research expenses for the taxable year over an established base amount.

The policy objective of increasing research activity is met by the incremental nature of the credit. pp. I:14-23 and I:14-24.

I:14-31 a.

Yes, a person may request greater withholdings on Form W-4. b.

An individual might request an increase in the amount of tax withheld, if she anticipates that taxes will be owed at the end of the year and she does not wish to make quarterly estimated tax payments. For example, this situation occurs for taxpayers earning both wage and nonwage income. c.

Virginia can request lower withholding in a tax year if she has larger than average deductible expenses (for example, mortgage interest expenses on a newly-financed house) relative to the average for a family of Virginia’s income amount. p. I:14-28.

I:14-32 a.

Mario should file exempt status on a Form W-4 to avoid having amounts withheld. b.

Mario would receive a smaller paycheck each period due to withholding. Since he owes no taxes, on filing a federal income tax return, he would be entitled to a refund of all withholding amounts. In effect, Mario would be loaning the government the withholding amount interest-free. p. I:14-28.

I:14-33 Backup withholding was implemented to prevent abusive noncompliance with tax provisions (e.g., where the taxpayer fails to provide the payor with his tax identification number, or fails to report this type of income on his return). Backup withholding provides for withholding of taxes at 28% from pension income, interest income, dividends, and royalty income under certain circumstances. p. I:14-28.

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I:14-34 a.

For the current year, Vincent was not required to make estimated tax payments to avoid an underpayment penalty. His prior year AGI was less than $150,000. Vincent met a safe harbor because in the current year, he had more income tax withheld ($9,000) than 100% of his previous year tax liability ($8,000). He will not be subject to an underpayment penalty. b.

Because his prior year AGI was more than $150,000, to avoid the underpayment penalty for the current year, Vincent’s federal income tax prepayments (withholdings plus estimated payments) must total at least $8,800 (110% x $8,000). His current year withheld federal income tax of $9,000 exceeds the $8,800 safe harbor minimum, so no penalty is imposed. pp. I:14-29 and I:14-30.

I:14-35 To avoid the estimated tax underpayment penalty, the taxpayer should make certain that his combined estimated payments and withholdings equal or exceed the required percentage of the preceding year’s tax liability. A taxpayer must prepay 100% of the preceding year’s tax liability if his AGI was $150,000 or less in the previous year. If the taxpayer’s previous year AGI exceeded $150,000, to avoid the penalty, for the current year, the taxpayer would need to prepay 110% of his previous year tax liability. p. I:14-31.

I:14-36 It is preferable to have an underpayment of the tax liability because the IRS does not pay interest on overpayments if it refunds the overpayment within 45 days from the later of the due date of the return or its filing date. Overpaying is similar to making an interest free loan to the U.S. Treasury. p. I:14-32.

I:14-37 Many people over pay their taxes to avoid the risk of having to pay a lump-sum balance due at the filing date. Others use the system as a "forced savings" program. As mentioned previously, the disadvantage with this forced savings is that no interest is earned on such savings. p. I:14-32.

Issue Identification Questions I:14-38 The primary issue is the impact of paying self-employment taxes directly on consulting income versus continuing to pay FICA taxes via withholding from salary. In addition, Daryl should consider the effect of the change on his marginal tax rate and the tax treatment of his pension benefits. He should also consider the loss of tax-free employee fringe benefits, such as employer contributions to accident and health insurance, and the need to acquire essential health insurance to avoid the tax penalty imposed on taxpayers who fail to obtain health insurance coverage. pp. I:14-29 and I:14-30.

I:14-39 For divorces finalized after 2018, alimony is no longer a deduction to payer ex-spouse and no longer taxable income to the payee ex-spouse. Therefore, Jennifer needs to be aware that she does not receive this deduction and should make sure that her tax prepayments are sufficient to pay the tax on her taxable income, which includes the alimony paid to her former husband. p.

I:14-29.

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I:14-8

Problems I:14-40 a.

b.

Taxable income Plus: Tax preference items Plus: AMT Adjustments Adjustment related to itemized deductions AMTI Minus: Exemption (no phaseout) Alternative minimum tax base Tentative minimum tax ($26,700 x 0.26) Minus: Regular tax Alternative minimum tax

$100,000 20,000

Taxable income Plus: Tax preference items Plus: AMT Adjustments Adjustment related to itemized deductions AMTI Minus: Exemption (no phaseout) Alternative minimum tax base Tentative minimum tax ($74,300 x 0.26) Minus: Regular tax Alternative minimum tax

$100,000 20,000

40,000 $160,000 (133,300) $ 26,700 $ 6,942 ( 12,615) $ 0

40,000 $160,000 (85,700) $ 74,300 $ 19,318 ( 17,043) $ 2,275

pp. I:14-2 through I:14-7.

I:14-41

Regular taxable income AMT preferences AMT adjustments Adjustments related to itemized deductions AMTI Minus: Exemption ($85,700 - 0.25($670,000 - $609,350)) AMT tax base Tentative minimum tax ($232,600 x 0.26) + [($599,462- $232,600) x 0.28] Minus: Regular tax Alternative minimum tax

pp. I:14-3 and I:14-4.

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I:14-9

$550,000 70,000 50,000 $670,000 ( 70,538) $599,462 $163,197 (161,688) $ 1,509

I:14-42 a.

Dylan can incur approximately $118,545 of AMT preferences and positive adjustments before incurring AMT. The calculation is below. The formula can be put into excel for easier analysis.

Alternative Minimum Tax: Taxable income (above) Plus: AMT Adjustments AMTI Minus exemption ($85,700 - (25% x (718,545 – 609,350))) AMT base Tentative minimum tax ($232,600 x 0.26) + ((660,144 – 232,600) x 0.28) Net regular tax Alternative minimum tax

$600,000 118,545 $718,545 (58,401) $660,144 $180,188, ($180,188) $ 0

b.

There are multiple marginal tax rate brackets above the 28% maximum AMT rate.

Therefore, the tax base has to be higher since it is being subject to a lower tax rate to incur AMT. pp. I:14-3 through I:14-7.

I:14-43 a.

State and local taxes are limited to a maximum $10,000 itemized deduction for regular tax purposes. This includes both the real estate taxes and state income taxes. The state and local tax deduction is not allowed for AMT, therefore the total adjustments related to itemized deductions is $10,000. b.

Taxable income $150,000 Plus: Tax preferences 40,000 Plus/Minus: AMT Adjustments Related to itemized deductions 10,000 AMTI $200,000 Minus: Exemption (no phaseout) ( 85,700) Alternative minimum tax base $ 114,300 Tentative minimum tax ($114,300 x 0.26) $ 29,718 Minus: Regular tax liability ( 28,053) Alternative minimum tax $ 1,665 pp. I:14-3 through I:14-7.

I:14-44 a.

SE tax = Social security tax + Medicare tax = $8,016 + $1,875 = $9,891 Social security tax = 12.4% x lesser of 1) or 2) below = 12.4% x 64,645 = $8,016 1) $64,645 net SE income [$70,000 * .9235] or 2) $123,600 Social Security base ceiling reduced by wages [$168,600 -

$45,000] Medicare tax = 2.9% x net SE income = 2.9% x $64,645 = $1,875 Deduction for SE tax = 50% x $9,891 = $4,946 Copyright © 2025 Pearson Education, Inc.

I:14-10

b.

SE tax = Social security tax + Medicare tax = $0 + $1,875 = $1,875 Social security tax = 12.4% x lesser of 1) or 2) below = 12.4% x $0 = $0 1) $64,645 net SE income [$70,000 * .9235] or 2) $0 Social Security base ceiling reduced by wages [$168,600 -

$180,000] Medicare tax = 2.9% x net SE income = 2.9% x $64,645 = $1,875 Deduction for SE tax = 50% x $1,875 = $938 pp. I:14-8 through I:14-10.

I:14-45 Arnie: A partner’s income from a partnership is considered self-employment income.

Arnie’s self-employment tax is computed as follows: Net SE income: ($75,000 x 0.9235) = $69,263 Social Security tax: $69,263 x 0.124 Medicare tax $69,263 x 0.029 Total SE tax

$ 8,589 2,009 $10,598

Note: Angela’s earnings as an employee are not considered in evaluating Arnie’s SE income relative to the Social Security ceiling. Though Arnie and Angela are married, their selfemployment taxes are computed separately.

Angela is not self-employed and is therefore, not subject to the SE tax. She pays the employee share of FICA (Social Security and Medicare) via wage withholding. pp. I:14-8 and I:14-9.

I:14-46 a.

Director Fees Consulting loss ($9,000 - $15,000) Gross SE income Net SE income Social Security tax: Medicare tax: SE tax

$11,000 (6,000) $ 5,000  .9235 $ 4,618

$4,618 x 0.124 = 573 4,618 x 0.029 = 134 $707

Taxpayers may deduct losses from self-employment activities against self-employment income.

Anita incurred a $6,000 loss from her consulting practice, and this amount offset her $11,000 of director’s fees.

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I:14-11

b.

Anita will not pay Social Security tax because her salary is greater than the maximum OASDI amount of $168,600. The Medicare portion of her SE tax equals $134 ($4,618 x 0.029).

SE tax = Social Security tax + Medicare tax = $0 + $134 = $134 pp. I:14-8 and I:14-9.

I:14-47 a. b.

Allowable personal tax credits total $3,200 ($2,000 + $1,200).

Total business tax credits are $1,500 ($900 + $600).

The allowable business tax credit is $800.

The overall limit on business tax credits is $800, the lesser of these two items: 1) Net income tax – tentative AMT = [($4,000 - $3,200) – $0] = $800 2) Net income tax – 25% x (Regular tax - $25,000) = [($4,000 - $3,200) – $0 =

$800 c.

Unused business tax credits of $700 ($1,500 - $800) may be carried back one year and carried forward 20 years. pp. I:14-10 through I:14-24.

I:14-48 a.

The credit equals $1,200 ($6,000 x 20%). Qualifying expenses of $9,000 are limited to $6,000 (2 qualifying dependents × $3,000 each). Since AGI is greater than $43,000, the credit rate is 20%. b.

The credit equals $1,200. Payments to relatives are qualified expenses as long as the relative is not a dependent or child (under age 19) of the taxpayer. c.

The credit is $500 [(25% x ($3,000 - $1,000)]. Qualifying expenses are limited to $3,000 for the one child under age 13. The $1,000 excluded from Bruce's gross income under Sec. 129 must reduce qualified expenses. AGI exceeds $15,000 by $20,000, so the credit rate is 25%. d.

The credit is $800 (20% x $4,000). Qualifying expenses are limited to $4,000.

(The lower earned income of Candice). The credit rate is 20% because AGI exceeds $43,000. e.

The credit is $1,000 ($5,000 x 20%). The amount of qualifying expenses is generally limited to the earned income of the spouse earning less. Ben has no earned income during the year, but because he is a full-time student, with two qualifying children, he is treated as earning $500 per month, or $5,000 (10 months x $500). The credit rate is 20% because AGI exceeds $43,000. pp. I:14-11 and I:14-12.

I:14-49 a. Valerie and Brad's qualified adoption expenses include: 2023 2024 Agency fees $ 5,000 $ 4,000 Travel expenses 1,500 400 Publications 300 0 Legal fees 1,000 1,000 Court costs 0 1,500 TOTAL $ 7,800 $ 6,900 Copyright © 2025 Pearson Education, Inc.

I:14-12

Total

$14,700

The publications qualify if they are directly related to, and have the principal purpose of the legal adoption of an eligible child. [Sec. 23(d)]. The kennel fees for the dog and the cost of nursery furniture are not qualified expenses. The qualified adoption expenses paid in 2023 are not eligible for the credit until the year the adoption is finalized, 2024. So, no credit is allowable in 2023. b.

The maximum credit is $16,810 which may be taken in 2024, the year the adoption is final. They incurred $14,700 of qualified expenses, so the credit amount is limited to $14,700. The phaseout of the credit does not apply because their AGI is less than the phaseout threshold. c.

The credit would equal $16,810. This amount is the maximum even for a child with special needs. The law also provides that an adoption credit of $16,810 is allowed for a child with special needs regardless of how much (or little) the taxpayer has paid in qualified adoption expenses. pp. I:14-13 and I:14-14.

I:14-50 a.

AOTC = 100% of first $2,000 qualified education expenses + 25% of up to next $2,000 of qualified education expenses Because the Norths’ 2024 AGI does not exceed $160,000, the allowed AOTC will not be reduced by phaseout.

Phil: 2024 Qualified education expenses = $17,350 = ($7,500 + $8,000 + $500 + $500 + $400 + $450) Tentative & Allowed AOTC = 100%($2,000) + 25%($2,000) = $2,500 Jaci: 2024 Qualified education expenses = $3,900 = ($1,600 + $1,750 + $250 + $300) Tentative & Allowed AOTC = 100% ($2,000) + 25% ($1,900) = $2,475 Note 1: For Phil and Jaci to qualify as eligible students, each must 1) not have used the AOTC for 4 prior tax years, 2) not have completed the first 4 years of postsecondary education (evaluated at beginning of 2024), 3) have been enrolled at least half-time in a degree program (or other credential), AND 4) not have been convicted of a felony drug offense (evaluated at end of tax year) Jaci appears to meet all 4 conditions.

Phil appears to meet conditions 2), 3), and 4).

The solution above assumes he meets condition 1) for 2024 (AOTC has not been used for Phil’s expenses in 4 prior tax years), meaning for Spring 2024 and Fall 2024, he qualifies as an eligible student for AOTC. Note 2: If instead, the AOTC has already been used for Phil’s expenses in 4 tax years before 2024, his Copyright © 2025 Pearson Education, Inc.

I:14-13

qualified education expenses do not qualify for the AOTC. Instead, the Lifetime Learning Credit (LLC) should be used for Phil’s 2024 qualified education expenses.

LLC = 20% (qualified education expenses up to $10,000 per year) Phil: Qualified education expenses = ($7,500 + $8,000 + $500 + $500) = $16,500 Tentative LLC = 20% ($10,000) = $2,000 Because the Norths’ 2024 AGI does not exceed $160,000, the allowed LLC will not be reduced by phaseout. b.

Phil’s qualified education expenses must be reduced by the scholarship ($17,350 2($3,000) = $11,350). His expenses remain high enough to yield the maximum tentative AOTC. Tentative AOTC = 100%($2,000) + 25%( $2,000) = $2,500 c.

With AGI of $175,000, phaseout will reduce the AOTC allowed for the Greens.

Combined tentative AOTC = $2,500 + $2,475 = $4,975 Allowed AOTC = $4,975 - $4,975[($175,000 - $160,000)/$20,000] = $1,244 d.

The answer would have been the same. Phil’s status as a qualified student for AOTC is based on his progress as a student at the beginning of each tax year. In both scenarios—with Phil as a junior and as a senior—Phil has not completed the first four years of postsecondary education. Note: With an AGI of $175,000 Lou and Stella would be completely phased out of the LLC. pp. I:14-14 through I:14-16.

I:14-51 a.

Initial ceiling amount Minus: Nontaxable social security benefits Minus: One-half of AGI in excess of $7,500 (0.50 x [$8,500 - $7,500]) Credit base Times: Rate Total tentative credit

$5,000 $3,000 500

(3,500) $1,500 x 0.15 $ 225

b.

Caroline’s $225 tentative tax credit is allowed because it does not exceed her $540 pre-credit tax liability. pp. I:14-12 through I:14-13.

I:14-52 a.

Regular tax before credits

Net Income Tax $37,500

Alternative minimum tax Foreign tax credit

0 (4,500)

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I:14-14

Net Regular Tax $ 37,500 n/a (4,500)

Other nonrefundable credits

(6,100)

(6,100)

Net income tax (NIT): $26,900 $ 26,900 Net regular tax (NRT): The general business credit cannot exceed the smaller of 1. (NIT - tentative minimum tax) = $26,900 - $20,200 = $6,700 2. [NIT – 0.25 x (NRT - $25,000)] = $26,900 - 0.25 x (26,900 - 25,000) = $26,425 The current year allowable general business credit is $6,700. b.

Mark’s current year credit will be $33,000, including $3,000 from the carryforward credit and $30,000 from the credit earned in the current year. Its use is limited to $6,700. The $6,700 consists first of the $3,000 carryforward and then $3,700 from the current year credit earned of $30,000. c.

Mark will carry forward to next year the $26,300 ($33,000 – $6,700) of unused credits. pp. I:14-22 through I:14-23.

I:14-53 Laser's foreign tax credit of $74,000 is limited to $38,850 [($185,000/($185,000 + $320,000)) x $106,050], because the effective foreign tax rate (40%) exceeds the effective U.S. tax rate (21%). The $35,150 ($74,000 - $38,850) unused foreign tax credit can be carried back one year and forward for ten years. pp. I:14-18 and I:14-19.

I:14-54 For their family size (2) and income ($47,200), their household income equals 239% of the federal poverty guidelines (FPG) HHI/FPG = $47,200/$19,720 = 239% 239% falls into the ―over 200% up to 250% FPG‖ category.

The precise rate equals 4.32% determined as follows.

Range of rates within the 200% - 250% category: 4.00% - 2.00% = 2.00% Range of FPG category: 250% - 200% = 50% Prorated rate = 2.00% + [2.00% x (239% - 200%)/50%] = 3.56% The deemed affordable premium equals 3.56% x $47,200 household income = $1,680 The benchmark plan costs $5,616.

Premium tax credit = benchmark plan cost – affordable premiums = $3,936 = ($5,616 - $1,680) a.

Under a Gold plan, the Walls’ personal share of their health insurance premiums equals $3,084 ($7,020 – $1,680). b.

Under the Silver plan, the Walls’ personal share of their health insurance premiums equals $1,680 ($5,616 – $1,680). c.

Under a Bronze plan, the Walls’ personal share of health insurance premiums Copyright © 2025 Pearson Education, Inc.

I:14-15

equals $744 ($4,680 - $1,680). pp. I:14-24 through I:14-26.

I:14-55 a.

The $40,000 expenditures qualify for the credit because they renovate a historic structure; they exceed the larger of the property’s basis ($20,000) or $5,000; and the structure is used in Bob’s business. The rehabilitation tax credit is $8,000 (20% x $40,000). b.

The building’s basis is $52,000 [$20,000 building costs + ($40,000 renovation costs - $8,000 tax credit)]. c.

Straight-line depreciation must be used for the $32,000 in basis from the renovation costs. Though regular MACRS depreciation rules apply to the $20,000 basis that is not eligible for the credit, nonresidential real estate must be depreciated using straight-line over 39 years.

(20,000  32,000) / 39 yrs 

4.5months  $500 12months

pp. I:14-19 and I:14-20.

I:14-56 Pharm, Inc. may claim a credit for research activities in the current year as follows: Regular Research Credit: Salaries Supplies and materials Depreciation Total qualified research expenses Base amount: greater of 1) 3% ($5,000,000) = $150,000 2) 50% ($372,000) = $186,000 Excess over base Credit percentage Regular research credit

$180,000 162,000 30,000 $372,000 ( 186,000) $186,000 x 20% $ 37,200

Pharm, Inc. also is entitled to a research and experimentation deduction of $334,800 (Sec. 174).

Research expenses for the regular research credit $372,000 Less research credit ( 37,200) Deduction allowed for current year $334,800 pp. I:14-21 and I:14-22.

I:14-57 a.

Carolyn’s tentative earned income credit (EIC) is $4,213 (34% x $12,390).

b.

Carolyn’s earned income credit is reduced because her AGI of $24,000 exceeds the threshold.

Phaseout = 15.98% x ($24,000 - $22,720) = $205 Allowable EIC = $4,213 - $205 = $4,008 Copyright © 2025 Pearson Education, Inc.

I:14-16

c.

Yes. The EIC is refundable.

d.

If Carolyn is married filing a joint return, the tentative EIC of $3,995 is allowed in full. The phaseout is $0 because AGI ($24,000) does not exceed the phaseout floor of $29,640 for married filing joint taxpayers. pp. I:14-25 and I:14-26.

I:14-58 a.

Tentative EIC = 7.65% x $8,260 = $632

b.

Phaseout = 7.65% x ($13,200 - $10,330) = $220 Allowable EIC = $632 - $220 = $412

c.

Yes, because the earned income credit is refundable.

d.

Yes. Jose would not be entitled to the earned income credit because his investment income exceeds $11,600. pp. I:14-23 and I:14-24.

I:14-59 1.

2.

Taxable income = $24,700 - $21,900 = $2,800 Regular tax before credits = $280 Tentative EIC = 40% x $17,400 = $6,960 Phaseout = 21.06% x ($24,700 - $22,720) = $417 Allowable EIC = $6,960 - $417 = $6,543

3.

Regular tax before credits $ 280 Regular child tax credit (280) Additional child tax credit (2,715)* Earned income credit (6,543) Tax due (refund) $(9,258) *Note: The child tax credit = $4,000 (2 x $2,000).

The refundable portion equals the lesser of (1) (4,000 – 280) or (2) 15% x (20,600 – 2,500) or (3) $1,700 per qualifying child (1,700 x 2). pp. I:14-23 and I:14-24.

I:14-60 a.

It is vital that the corporation forward FICA and federal income tax withholding to the IRS. Penalties must be imposed if Lake fails to pay these amounts to the IRS. b.

The liability for payment can extend beyond the corporation. Responsible individuals such as the treasurer, in this case, can be held personally liable for payment of the tax. p. I:14-27 (see Footnote 53).

I:14-61 Wages for household employees (a), independent contractors (not employees) (b), and tips under $20 per month (g) are exempt from withholding. Only newspaper carriers (c) under age 18 are exempt. p. I:14-27.

I:14-62 a.

Barry may not claim exempt status. Although he meets the condition of expecting no current year federal income tax, he was required to pay taxes last year.

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I:14-17

b.

Barry may not claim more than one exemption. Additional withholding allowances are allowed if an individual has an unusually large amount of deductions from adjusted gross income or tax credits. p. I:14-27.

I:14-63 The important pieces of tax information reported on Form W-4 include the taxpayer’s filing status, the number of jobs the taxpayer has, the employment status of the taxpayer’s spouse (if applicable), and the number of dependents qualifying for the child tax credit. In addition to these items the taxpayer can report estimated additional income and deductions that will impact the taxpayer’s tax liability. Lastly, the taxpayer can request an employer withhold additional amounts. The taxpayer’s employer will utilize the information on Form W-4 to calculate the tax withholdings per pay period for the taxpayer. p. I:14-30.

I:14-64 a.

No. Anna is not subject to the underpayment penalty because her current year withholdings ($18,200) exceed 100% of her tax liability for the previous year ($18,000). The 100% of prior year tax exception applies because her AGI for the prior year was not more than $150,000. b.

Yes. Anna is subject to the underpayment penalty because her current year withholdings ($15,000) are less than 100% of last year's tax liability ($18,000), and also less than $27,000 (90% of the current year's $30,000 tax liability). c.

No. Though the underpayment penalty is based on the federal short-term interest rate plus 3%, the penalty is not deductible as interest. p. I:14-31.

I:14-65 Jane is subject to the underpayment penalty because her $26,000 in current year prepayments (withholding of $12,000 plus $14,000 estimated tax payments) are less than 110% of last year's tax liability (110% x $25,000 = $27,500) and less than 90% of this year's tax liability (90% x $30,000 = $27,000). She must meet the 110% exception instead of the 100% exception because her prior year AGI was more than $150,000. p. I:14-31.

Comprehensive Problem I:14-66 a.

Salary Consulting practice net income Novelty business net loss Interest income Qualified dividend income Long-term capital gain Short-term capital loss ½ of self-employment tax AGI

$175,000 $53,000 (18,000)

35,000 3,000 9,000

24,000 ( 4,000) 20,000 (469)a $ 241,531

Less: Qualified business income deduction ($35,000 x 20%) Itemized deductions: State and local taxes and real estate taxes

( 7,000) 10,000

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I:14-18

Home mortgage interest Charitable contributions = Taxable income

9,000 8,000

Tax on preferred income ($29,000 x 0.15) Tax on balance of taxable income ($178,531) Total regular tax before credits Less nonrefundable credits: Child tax credit $4,000b Child and dependent care credit 600c Self-employment tax Total regular tax

(27,000) $207,531

$ 4,350 $29,383 $33,733

(4,600) $29,642 937a $30,070

a

SE Tax: $35,000 x 0.9235 = $32,323 net earnings from self-employment.

Medicare tax = 32,323 x 0.029 = 937 Social Security tax = 0 because Mike’s salary exceeds the $168,600 ceiling.

Deduction for AGI = ½ ($937) = $469.

b

Tentative child tax credit = $4,000 = 2 × $2,000

c

The child and dependent care credit is 20% x $3,000 = $600. Only one child qualifies, and Nancy is deemed to have earned $250 per month, or $3,000 for the year. b.

Yes. They owe $4,436 in AMT. AMT Taxable Income AMT Preferences AMT Adjustments Itemized deductions AMT Income Less: AMT Exemption AMT Base Tentative AMT# Less: Regular tax AMT

$ 207,531 70,000 + 10,000 $ 287,531 ( 133,300) $ 154,231 $ 36,910 ( 33,733) $ 3,177

# Tentative AMT: 15% (29,000) + 26% (161,031 - 29,000) = $4,350 + $34,328 = $38,678 c.

Total tax liability Regular tax SE tax AMT Less: Credits Less: Prepayments

$ 37,847 33,733 937 3,177 (4,600) (35,000)

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I:14-19

Withholding Estimated payments Balance due / (refund)

21,000 12,000

________ $ 247

d.

The Webbs avoid the under-payment penalty by having prepayments ($33,000) that exceed at least one of the two safe harbors.

Safe harbor 1) 110% x prior year tax $29,000 = $31,900 Safe harbor 2) 90% x current year tax $39,615 = $35,654

Tax Strategy and Critical Thinking Problem I:14-67 This situation involves two issues: (1) whether F&L should rent or buy, and (2) if it is better to buy, which building is the optimal choice.

Rent or Buy? Given the facts, F&L’s cash flows would be better if they decided to buy rather than rent. The net out-of-pocket cost of owning equals $27,000 ($117,000 mortgage payment $90,000 rent income) and is significantly less than the rent of $72,000 they are currently paying.

Given the expected appreciation of the buildings, the buy decision is clearly superior.

Building #1 or Building #2? Building #2 is the superior choice. F&L would be eligible for a 20% credit on the $600,000 of rehabilitation expenditures since the building is a certified historic structure. No credit would be available if F&L buys Building #1.

It should be pointed out that much planning needs to be done with respect to Building #2 to ensure that the tax credit is allowable. Several technical requirements must be met to take the credit, such as at least 75% of the external walls and at least 75% of the building’s internal structure must remain in place.

Tax Form/Return Preparation Problems I:14-68 (See Instructor’s Resource Manual) I:14-69 (See Instructor’s Resource Manual) I:14-70 (See Instructor’s Resource Manual) I:14-71 (See Instructor’s Resource Manual)

Case Study Problems I:14-72 The following issues should be included in the client memo: 1.

The IRC contains no specific penalty for failure to file quarterly estimated tax payments. There is an underpayment penalty for not paying income taxes on a Copyright © 2025 Pearson Education, Inc.

I:14-20

timely basis, but this penalty may be avoided by paying taxes either through withholding or quarterly estimated payments.

2.

An underpayment penalty will be imposed in 2023 because Barbara's withholdings of $1,500 are not equal to at least 100% of the prior year's tax liability of $1,900. To avoid the penalty, Barbara should make quarterly estimated payments of at least $100 per quarter so that her total tax prepayments ($1,500 withheld + $400 estimated payments) equal at least $1,900. The 100% of prior year tax liability (rather than 110%) applies because Barbara's AGI for the prior year was not in excess of $150,000.

3.

From an efficiency perspective, Barbara’s quarterly estimated payments should not be more than $100 per quarter even though she will owe a considerable amount of tax when she files her 2023 return. She can invest any excess cash, earn investment income, then pay the taxes due in April 2024. No interest or penalties will be imposed if she prepays $1,900, meeting the safe harbor of 100% of prior year tax.

4.

From a cash-flow planning perspective, emphasize to Barbara that in 2024, the settlement year, there will be no payment due on the $20,000 back alimony or $18,000 of current year alimony. Knowing that the alimony will not trigger tax should help her plan moving forward.

I:14-73 The IRS considers several factors when determining whether an individual will be classified as an employee. Revenue Ruling 87-41 provides guidance and specifies 20 factors to be considered in making this determination. The overall decision usually centers around who has the right to control the individual’s activities and time. The ruling gives examples, one of which is similar to the case at hand. The IRS would most likely rule that Simone was an employee of the corporation primarily because the corporation had control over what services she performed and had to ensure that the services were performed satisfactorily.

The corporation will be responsible for withholding and remitting payroll taxes for Simone.

Simone will be required to file a Form W-4 with the corporation to help calculate withholdings.

The corporation's failure to pay the employment taxes may make certain officers of the corporation liable for the payment of these taxes. Those liable are persons responsible for the accounting, collection and payment of the tax who willfully fail to do so. A corporation should uphold its ethical responsibilities in the collection and payment of employment taxes. The employer has a legal and ethical responsibility to file a W-4 for each employee and remit the appropriate taxes to the government willingly.

Tax Research Problem I:14-74 Section 6672 states that "Those persons charged with the responsibility of collecting, accounting for, and paying over the tax to the government are subject to a penalty for willful failure to collect or account for the tax." "Responsible person" has been determined by the courts by considering such factors as: 1) Did the person have day to day management Copyright © 2025 Pearson Education, Inc.

I:14-21

responsibilities? 2) Is he an officer, director, or major stockholder? 3) Was he involved and knowledgeable concerning the affairs of the corporation? 4) Did he sign checks, approve disbursements? 5) Was he or she a founder of the corporation? "Willful conduct" has been defined as the voluntary, conscious, or intentional act to prefer other creditors over the United States.

The facts in this tax research problem are based on the cited case (Ernest W. Carlson v.

U.S.). In the tax research problem Carl Jones (1) was not the one who had final word on which bills should or should not be paid; (2) did not have significant or exclusive control over the company; (3) did not have a significant role in corporate decision making; (4) did not have management responsibilities; (5) was not knowledgeable concerning the affairs of the corporation except those which he was assigned; and (6) was not a founder of the corporation. In addition, he was not willfully failing to pay the taxes. Thus, Carl Jones is not subject to the penalty provisions of Sec. 6672.

However, Bruce Smith (1) was one the incorporators; (2) was authorized to sign bank checks; (3) had authority to make management decisions, and (4) was a key officer and member of the board of directors, and (5) was responsible for insuring that payroll taxes were paid. Thus, he does meet the definition of "responsible person." Furthermore, he did willfully fail to pay the taxes as evidenced by the decision to prefer other creditors to the IRS. Thus, he is liable for the penalties under Sec. 6672.

In Schiff v. U.S., the court held that Jones and Schiff were responsible for collecting and paying taxes for employees because they both were responsible persons with significant control over the corporation's finances even though they did not hold official corporate titles. The court explains that the actual mechanics of decision making instead of the absence of official title will help determine one who is a responsible person and those with significant control can be liable for willful avoidance of payment of taxes.

In Tsouprake v. U.S., the sole shareholder and chairman of the corporation did not partake in daily management of the corporation. However, he was held liable for the penalty for failure to pay employment taxes because he was a responsible person and willfully avoided the tax payments. The court looked at his stock ownership, check-signing authority, and corporate financing ability.

In Guito, Jr. v. U.S., an officer of the corporation was a responsible party for payment of employment taxes. He willfully did not pay the taxes and was held partly liable because he participated in major decision making, was chief policymaker, corporate boss, and held sufficient power to insure timely payments of the corporate tax liability.

“What Would You Do In This Situation?” Solution Ch. I:14, p. I:14-29.

Mr. Princeton is probably liable for payroll taxes on the amounts paid to the domestic workers. The issue is whether the domestic workers were employees or independent contractors.

The distinction generally depends on the amount of control the employer has over the worker.

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The IRS has published a list of 20 factors that taxpayers should use to determine the degree of control over the workers. Since Mr. Princeton specifically provides the tasks to be performed, the workers will likely be classified as employees. The fact that a contract was signed declaring that they were to be classified as independent contractors is irrelevant in making the determination.

Statement No. 1.2 'Knowledge of Errors' of the Statements on Standards for Tax Services sets forth the responsibilities of CPAs in situations where the CPA is aware of an error. In this case, no payroll taxes were paid and no returns were filed. Therefore, the CPA should advise Mr. Princeton of the measures that should be taken to correct this situation. Returns should be filed to report the amounts paid as wages and appropriate payroll taxes should be paid. If Mr. Princeton refuses to file such returns, the CPA must consider whether to continue the professional relationship with Mr. Princeton.

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Chapter I:15 Tax Research Note: To complete the online research problems for this chapter, textbook users must have access to an Internet-based tax service at their institution. Solutions are provided using CHECKPOINT, when applicable. In some cases, solutions using other tax services may differ.

Discussion Questions I:15-1 In a closed-fact situation, the facts have occurred, and the tax advisor’s task is to analyze them to determine the appropriate tax treatment. In an open-fact situation, by contrast, the facts have not yet occurred, and the tax advisor’s task is to plan for them or shape them so as to produce a favorable tax result. p. I:15-2.

I:15-2 According to the AICPA’s Statement on Standards for Tax Services No. 1, the tax advisor must promptly inform the taxpayer of the error and advise on corrective measures that should be taken. If the taxpayer refuses to take such recommended actions, the advisor should consider resigning from the engagement. pp. I:15-31 through I:15-33.

I:15-3 When tax advisors speak about “tax law,” they refer to the IRC as elaborated by Treasury Regulations and administrative pronouncements and as interpreted by federal courts. The term also includes the meaning conveyed by committee reports. p. I:15-7.

I:15-4 Committee reports concerning tax legislation explain the purpose behind Congress’ proposing the legislation. Transcripts of hearings reproduce the testimonies of the persons who spoke for or against the proposed legislation before the Congressional committees. Committee reports are sometimes used to interpret the statute. p. I:15-7.

I:15-5 Committee reports can help resolve ambiguities in statutory language by revealing Congressional intent. They are indicative of this intent. pp. I:15-7 and I:15-8.

I:15-6 The Internal Revenue Code of 1986 is updated for every statutory change to Title 26 subsequent to 1986. Therefore, it includes the post-1986 tax law changes enacted by Congress and today reflects the current state of the law. p. I:15-8.

I:15-7 No. Title 26 deals with all taxation matters, not just income taxation. It covers estate tax, gift tax, employment tax, alcohol and tobacco tax, and excise tax matters. p. I:15-8.

I:15-8 a.

Subsection (c). It discusses the tax treatment of property distributions in general (e.g., amount taxable, amount applied against basis, and amount exceeding basis).

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b.

Because Sec. 301 applies to the entire chapter, one should look throughout that entire chapter (Chapter 1 of the IRC – which covers Sec. 1 through Sec. 1400U-3) for any exceptions. One special rule – Sec. 301(e) – is found in Sec. 301. This special rule explains the tax treatment of dividends received by a 20% corporate taxpayer. Section 301(f) indicates some of the important special rules found in other IRC sections. c.

Legislative. Section 301(e)(4) authorizes the issuance of Treasury Regulations as may be necessary to carry out the purposes of the subsection. pp. I:15-9 through I:15-10.

I:15-9 Researchers should note the date on which a Treasury Regulation was adopted because the IRC may have been revised subsequent to that date. That is, the regulation may not interpret the current version of the IRC. Discrepancies between the IRC and the regulation occur when the Treasury Department has not updated the regulation to reflect the statute as amended. p. I:15-9.

I:15-10 a.

Proposed regulations are not authoritative, but they do provide guidance concerning how the Treasury Department interprets the IRC. Temporary regulations, which are binding on the taxpayer, often are issued after recent revisions to the IRC so that taxpayers and tax advisors will have guidance concerning procedural and/or computational matters. Final regulations, which are issued after the public has had time to comment on proposed regulations, are considered to be somewhat more authoritative than temporary regulations. pp. I:15-9 and I:15-10. b.

Interpretative regulations make the IRC’s statutory language easier to understand and apply. They also often provide computational illustrations. In the case of legislative regulations, Congress has delegated the rulemaking on a specific topic (either narrow or broad) to the Treasury Department. However, after the Mayo Foundation case, both types of regulations will have the same authoritative weight. p. I:15-10.

I:15-11 Prior to 2011, courts gave more authority to legislative regulations than to interpretive regulations. However, after the Supreme Court decision in Mayo Foundation, courts will hold both interpretive and legislative regulations to the same standard and will overturn them only in very limited cases. p. I:15-10.

I:15-12 Under the legislative reenactment doctrine, a Treasury Regulation is deemed to have been endorsed by Congress if the regulation was finalized before a related IRC provision was amended by Congress and in the interim, Congress did not amend the statutory provision to which the regulation relates. p. I:15-10.

I:15-13 a.

Revenue rulings are not as authoritative as court opinions, Treasury Regulations, or the IRC. They represent interpretations by an interested party, the IRS. p. I:15-12. b.

If the IRS audits the taxpayer’s return, the IRS likely will contend that the taxpayer should have followed the ruling and, therefore, owes a deficiency. p. I:15-12.

I:15-14 a.

The Tax Court, the U.S. Court of Federal Claims, or the U.S. district court for the taxpayer’s jurisdiction. p. I:15-14.

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b.

The taxpayer might consider the precedent, if any, existing within each jurisdiction. The taxpayer might prefer to avoid expending cash to pay the proposed deficiency.

If so, the taxpayer would want to litigate in the Tax Court. If the taxpayer would like to have a jury trial address questions of fact, he or she should opt for the U.S. district court. pp. I:15-14 through I:15-19, p. I:15-21, and p. I:15-23. c.

Appeals from Tax Court and U.S. district court decisions are made to the circuit court of appeals for the taxpayer’s geographical jurisdiction. U.S. Court of Federal Claims decisions are appealable to the Court of Appeals for the Federal Circuit. Appeals from any of the circuit courts of appeals may be brought to the U. S. Supreme Court. pp. I:15-20 through I:15-21.

I:15-15 No. A taxpayer may not appeal a case litigated under the Tax Court’s Small Cases Procedure. p. I:15-17.

I:15-16 Tax Court regular and memo decisions have about the same precedential value.

Decisions issued under the Small Cases Procedure of the Tax Court have little or no precedential value. pp. I:15-15 and I:15-17.

I:15-17 Yes. The IRS can acquiesce (or nonacquiesce) in any federal court decision that is adverse to the IRS if the IRS decides to do so. In many cases the IRS does not acquiesce or nonacquiesce. p. I:15-17.

I:15-18 In both the AFTR and USTC: decisions of U.S. district courts, U.S. bankruptcy courts, U.S. Court of Federal Claims, circuit courts of appeal, and the U.S. Supreme Court. Tax Court decisions are reported in neither of the two reporters. pp. I:15-16 and I:15-17 through I:15-22.

I:15-19 Prior to 2009, revenue rulings appeared in the weekly Internal Revenue Bulletin (I.R.B.), and twice each year the decisions published in the I.R.B. were bound together and published in the Cumulative Bulletin (C.B.). For pre-2009 rulings, the I.R.B citation was temporary and was replaced by a citation to the C.B. After 2008, the IRS no longer publishes the Cumulative Bulletin. Therefore for current rulings, the initial I.R.B. citation is final. p. I:15-12.

I:15-20 According to the Golsen Rule, the Tax Court will not follow a decision it made earlier, but rather will follow a decision of the circuit court of appeals to which the case under consideration is appealable. As an example, assume that the Tax Court, in a case involving a First Circuit taxpayer, ruled for the taxpayer. The issue had not been litigated earlier. Then, a U.S. district court in Georgia decided a case involving the same issue in favor of another taxpayer. The Eleventh Circuit, however, reversed the decision. Now a taxpayer from the Eleventh Circuit litigates the same issue in the Tax Court. Under the Golsen Rule, the Tax Court will follow the Eleventh Circuit’s decision favoring the government. The Tax Court need not follow an appeals court decision if a case was litigated by a taxpayer whose appeal would have been made to any circuit other than the Eleventh. p. I:15-21.

I:15-21 a.

The precedent binding upon a California taxpayer would be the Tax Court case.

The Tax Court has national jurisdiction. pp. I:15-21 and I:15-23. b.

Under the Golsen Rule, the Tax Court will depart from its earlier decision and follow the Fifth Circuit’s decision favoring the government. p. I:15-21.

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I:15-22 a.

Congressional Record b.

Internal Revenue Bulletin c.

Tax Court of the United States Reports d.

Federal Register, Internal Revenue Bulletin, and/or Cumulative Bulletin e.

Federal Supplement, American Federal Tax Reports (only tax-related), United States Tax Cases (only tax-related). f.

Not found in an “official” publication; published by tax services pp. I:15-7, I:15-12 through I:15-14, and I:15-17 through I:15-19.

I:15-23 A tax advisor might find the provisions of a tax treaty useful where a U.S. taxpayer engages in transactions in a foreign country. The United States has tax treaties with many countries. p. I:15-24.

I:15-24 Citators (1) trace the history of the case in question and (2) list other authorities that have cited such case. p. I:15-30.

I:15-25 Revenue rulings, revenue procedures, and judicial decisions. p. I:15-29.

I:15-26 Keyword, index, or citation are the three ways to search in tax service databases. p. I:15-26.

I:15-27 a.

• • • • • • • b.

• • •

The principal primary sources found in CHECKPOINT are as follows: IRC Treasury Regulations Court opinions Revenue rulings and procedures Letter rulings Committee reports Tax treaties The principal secondary sources found in CHECKPOINT are as follows: Federal Tax Coordinator United States Tax Reporter Warren, Gorham & Lamont journals and treatises

Secondary sources will differ among the tax services. pp. I:15-26 through I:15-29.

I:15-28 The features (i.e., icons, templates, and command buttons) will vary depending upon the particular tax service/Internet site accessed. Just about all commercial tax databases can be searched by keyword and citation. Some can be searched by table of contents and topic. Most noncommercial tax databases can be searched by keyword. Some can be searched by citation and table of contents.

The advantages of using a commercial tax service (as opposed to a noncommercial service) are broader database scope, greater historical coverage, and more efficient search engines. The principal disadvantage is cost.

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Because of their relative disadvantages, the noncommercial sites should not be regarded as a substitute for a commercial tax service. Access is non-uniform. The scope and breadth of their databases are limited. pp. I:15-26 through I:15-28.

I:15-29 The member should have a good faith belief that his or her position has a realistic possibility of being sustained administratively or judicially on its merits if challenged. p. I:15-31.

I:15-30 Under the AICPA’s Statements on Standards for Tax Services (SSTSs), a tax preparer is not obligated to (1) verify client provided information if the information is not suspicious on its face, or (2) update professional advice based on developments following its original conveyance. p. I:15-31.

I:15-31 This answer lists six requirements. Under Circular 230, the practitioner is expected to: (1) base the advice on reasonable assumptions, (2) consider relevant facts and circumstances, (3) identify the facts relevant to the advice, (4) be properly skeptical of representations by the taxpayer and others, (5) relate applicable law and authority to the facts, and (6) not base an opinion on the chances that a transaction will be identified by IRS and subject to audit. p. I:1530.

I:15-32 Circular 230 is a government issued document that dictates rules for practicing before the IRS. The AICPA's Statements on Standards for Tax Services (SSTSs) are ethical standards issued by the AICPA aimed at tax practitioners. Circular 230 applies only to federal tax issues, and the SSTSs apply to both federal and state issues. Circular 230 only applies to income taxes, and the SSTSs apply to all types of taxes. Finally, Circular 230 does not provide the same depth of ethical guidance found in the SSTSs. p. I:15-30.

Problems I:15-33 a.

Yes. According to Secs. 71(a) and (b), the wife includes $25,000 per year. Also, the divorce agreement must explicitly state that the husband has no liability to make payments after the wife’s death. See Sec. 71(b)(1)(D) and Temp. Reg. Sec. 1.71-1T(b), Q-11. b.

Yes. The husband deducts $25,000 per year according to Secs. 215(a) and (b).

According to Sec. 62(a)(10), the alimony is deductible for AGI. c.

For alimony agreements after December 31, 2018, Secs. 71 and 215 are repealed. pp. I:15-8 and I:15-26 through I:15-29.

I:15-34 a.

Legislative. According to Sec. 385(a), “The Secretary is authorized to prescribe such regulations as may be necessary or appropriate. . . .” b.

Yes. Section 385(a) states that the regulations will be applicable “for purposes of this title.” “This title” is Title 26 of the federal statutes. Because Title 26 encompasses all tax statutes, the regulations would be relevant for estate tax purposes. pp. I:15-8 through I:15-10 and I:15-26 through I:15-29.

I:15-35 a.

Both rulings hold that contributions to a fund formed to acquire a portrait of a former judge and donated to a governmental agency are deductible under Sec. 170. pp. I:15-12 and I:15-13. b.

Private letter rulings cannot be cited as precedence and apply only to the taxpayer for whom the IRS issued the ruling. pp. I:15-12 and I:15-13.

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c.

Revenue rulings can be cited as precedence, and they are relied on by both taxpayers and the IRS for guidance in particular factual situations. pp. I:15-12 and I:15-13.

I:15-36 Sections 355 and 856. The official IRS publication is the Internal Revenue Bulletin, which eventually is incorporated into the Cumulative Bulletin. pp. I:15-12 and I:15-29.

I:15-37 Results might vary as the online service adds or deletes documents, but as of this writing: a.

443. b.

203. c.

87.

I:15-38 The following results were obtained using CHECKPOINT. Results using other tax services may vary. a.

14. b.

8 using ‘home office’ without quotations, 4 with quotes around the term. c.

The results after refining for “home office” are more relevant primarily because 280A also covers issues related to rental and vacation homes and refining the results omits these references. The search within results output produced revenue rulings related to home office issues, and the first result is to a revenue ruling explaining how the IRS would interpret an important Supreme Court case addressing home office deductions. pp. I:15-26 through I:15-28.

I:15-39 a.

Acquiescence. See AOD 1986-030, 1986-1 C.B. 1. b.

No. The acquiescence was only with respect to whether a transfer to the taxpayer’s spouse is a taxable disposition. pp. I:15-17 and I:15-29.

I:15-40 a.

Acquiescence. See AOD 2016-02. b.

The AOD addressed whether the limitation on home mortgage deductions applied on a per property or per taxpayer business. pp. I:15-17 and I:15-29.

I:15-41 a.

Nonacquiescence. See AOD 1988-014, 1988-2 C.B.1. b.

Yes. In 2003, the Commissioner withdrew the 1988 AOD and acquiesced. See AOD 2003-001, 2003-2 I.R.B. pp. I:15-17 and I:15-29.

I:15-42 a.

Yes. The case was reviewed by the court. No. It was not a unanimous decision.

Judges Korner, Swift, and Gerber did not participate. Judge Simpson dissented. pp. I:15-26 through I:15-29. b.

Yes. The decision was entered under Rule 155. p. I:15-17. c.

Yes. The case was reviewed by the Sixth Circuit Court of Appeals. pp. I:15-26 through I:15-29.

I:15-43 a.

Yes. The case was reviewed by the court. The decision was not unanimous.

Judge Quealy dissented. Judge Tannenwald issued a concurring opinion with which five judges agreed. Judge Chabot issued a dissenting opinion with which three judges agreed, and Judge Nims issued a dissenting opinion with which three judges agreed. pp. I:15-26 through I:15-29. b.

No. The decision was not entered under Rule 155. p. I:15-17.

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c.

Yes. The case was reviewed by the Sixth Circuit Court of Appeals in 1982. pp.

I:15-26 through I:15-29.

I:15-44 a.

National Cash Register Co. v. U.S., 400 F.2d 820, 22 AFTR 2d 5562, 68-2 USTC ¶9576 (6th Cir., 1968). b.

Thomas M. Dragoun, 1984 RIA T.C. Memo ¶84,094 (T.C. Memo 1984-94), 47 TCM 1176. c.

U.S. v. John M. Grabinski, 558 F. Supp. 1324, 52 AFTR 2d 83-5169, 83-2 USTC ¶9460 (DC MN, 1983). d.

U.S. v. John M. Grabinski, 727 F.2d 681, 53 AFTR 2d 84-710, 84-1 USTC ¶9201 (8th Cir., 1984). e.

Rebekah Harkness v. U.S., 469 F.2d 310, 30 AFTR 2d 72-5754, 72-2 USTC ¶9740 (Ct. Cl., 1972). Note that during this period, Court of Claims decisions were published in the Federal Reporter, Second Series. Alternatively, you could give the citation 199 Ct. Cls. 721, which references the Court of Claims Reporter. In the CHECKPOINT citator the name of the case is simply Harkness. f.

Hillsboro National Bank v. CIR, 460 U.S. 370, 51 AFTR 2d 83-874, 83-1 USTC ¶9229 (USSC, 1983). g.

Rev. Rul. 78-129, 1978-1 C.B. 67. pp. I:15-17 through I:15-22.

I:15-45 a.

Rev. Rul. 99-7, 1999-1 C.B. 361. b.

Frank H. Sullivan, 1 B.T.A. 93 (1924). c.

Tate & Lyle, Inc., 103 T.C. 656 (1994). d.

Ralph L. Rogers v. U.S., 539 F. Supp. 104, 49 AFTR 2d 82-1160, 82-1 USTC ¶9246 (DC OH, 1982). e.

Norman Rodman v. CIR, 542 F.2d 845, 38 AFTR 2d 76-5840, 76-2 USTC ¶9710 (2nd Cir., 1976). pp. I:15-17 through I:15-22.

I:15-46 a.

Circuit Court of Appeals for the Ninth Circuit; page 1198 of Volume 648 of the Federal Reporter, Second Series and page 81-5353 of Volume 48 of the American Federal Tax Reports, Second Series. b.

U. S. Court of Federal Claims; page 455 of Volume 14 of the Claims Court Reporter and paragraph (not page) 9231 of Volume 1 of the 1988 U. S. Tax Cases. c.

Supreme Court; page 13 of Volume 309 of the United States Supreme Court Reports and page 816 of Volume 23 of the American Federal Tax Reports. d.

A U.S. District Court in Texas; page 76 of Volume 441 of the Federal Supplement and page 78-335 of Volume 41 of the American Federal Tax Reports, Second Series. e.

Not a court decision; page 72 of Volume 1 of the 1983 Cumulative Bulletin. f.

Circuit Court of Appeals for Sixth Circuit; page 474 of Volume 568 of the Federal Reporter, Second Series and paragraph (not page) 9199 of Volume 1 of the 1978 U.S. Tax Cases. pp. I:15-16 and I:15-22.

I:15-47 a.

A facelift as a deductible medical expense is discussed in ¶K-2109 of the Federal Tax Coordinator. Solutions using other tax services will differ. b.

Section 213.

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c.

Generally no. Section 213(d)(9) (effective for tax years beginning after 1990) provides that the cost of cosmetic surgery is not deductible except in certain narrow circumstances. pp. I:15-28 and I:15-29.

I:15-48 No. The regulation does not reflect the amendments to Sec. 302 made by P.L. 96-589, P.L. 97-248, P.L. 98-369, and P.L. 111-325. A caution to this effect appears at the beginning of the regulation. pp. I:15-26 through I:15-29.

I:15-49 a.

Casualty losses from termite damage are discussed in ¶M-1743 (Federal Tax Coordinator) and Ann ¶1655.3020 (U.S. Tax Reporter). b.

Authorities include: Rev. Rul. 63-232, 1963-2 C.B. 97; Henry L. Sutherland, 1966 PH T.C. Memo ¶66,155, 25 TCM 822; and Martin A. Rosenberg v. CIR, 42 AFTR 2d 303, 52-2 USTC ¶9377 (8th Cir., 1952). The first two authorities denied a deduction and the third allowed a deduction. Textbook users may find additional authority. pp. I:15-28 and I:15-29.

I:15-50 a.

More than 35% of the excess of the value of the decedent’s gross estate over the sum of allowable Sec. 2053 and 2054 deductions. b.

No. The regulation indicates the test is more than (1) 35% of the gross estate or (2) 50% of the taxable estate. It does not reflect the P.L. 94-455 or P.L. 97-34 amendments to the IRC. A caution to this effect appears before the beginning of the reprint of the regulations. pp. I:1526 through I:15-29.

I:15-51 a. b. c. d. e. p. I:15-25.

645.

572-3rd - Accounting Methods – Adoptions and Changes.

570- 2nd - Accounting Methods – General Principles.

568-4th.

367.

523-2nd.

I:15-52 “Fireman, Allowed; uniform” is discussed at ¶L-3806. Note: The CHECKPOINT source document does not use the gender neutral phrase “firefighter.” The revenue ruling dealing with this topic is Rev. Rul. 70-474, 1970-2 C.B. 34. pp. I:15-27 and I:15-28.

I:15-53 a. b. c.

13.

12 issues are listed in the findings of fact.

Yes. The Fourth Circuit reviewed the case. pp. I:15-28 and I:15-29.

I:15-54 a. b. deductions. c.

27.

No. According to the headnote to the opinion, the decision dealt with one issue,

I:15-55 a. b. c.

1972.

The deductibility of the cost of a customer list under Sec. 162.

The government. The cost was not currently deductible.

No. The decision has not been cited unfavorably. pp. I:15-28 and I:15-29.

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d.

No. The decision was not reviewed at the trial level. e.

Yes. The decision was appealed to the Sixth Circuit Court of Appeals. f.

Yes. The CHECKPOINT citator lists nine citations to the Tax Court Memorandum decision and 13 citations to the CA6 decision. pp. I:15-26 through I:15-29.

I:15-56 a.

To file a tax return electronically, one must (1) purchase the requisite software from a commercial vendor or download it from a designated Internet site; (2) obtain a Personal Identification Number (PIN) from the IRS; (3) either prepare a tax return offline and upload, or prepare the return online; and (4) transmit the return to the IRS. b.

The taxpayer can transmit funds electronically in one of three ways: (1) by authorizing an electronic funds withdrawal from a checking or savings account; (2) by authorizing payment by credit card; or (3) by mailing to the IRS a check or money order using a payment voucher. c.

Electronic filing (1) allows the taxpayer to file a return from any personal computer; (2) is more accurate than manual filing; (3) offers the safety and security of direct deposit; (4) offers the convenience of filing a tax return early and delaying payment up to the due date, and (5) allows one to file federal and state tax returns simultaneously. p. I:15-28.

I:15-57 a. b. c. p. I:15-28.

“Request for Copy of Tax Return.”

“Corporation Claim for Deduction for Consent Dividends.”

“Excise Tax on Greenmail.”

I:15-58 a. b. c. p. I:15-28.

“Request for Copy of Individual Tax Return.”

“Corporation Income and Franchise Tax Return.”

“Partnership Income Tax Return.”

I:15-59 The latest data as of this writing was for tax year 2022 (as of January 1, 2023) a.

8 (Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, Wyoming). b.

1 (New Hampshire). c.

9.9%. d.

North Dakota, 2.9%. p. I:15-28.

Comprehensive Problem I:15-60 STEP ONE: In performing a keyword (intuitive) search in CHECKPOINT, type “depreciate garbage dump” and select the Federal Tax Coordinator Analysis. You will find the annotation ¶L-7922 Air space and pits used as dumps as depreciable property. This source cites John Sexton 42 TC 1094 (1964), where a taxpayer purchased an open-pit mine to be used as a dump. The Tax Court held for the taxpayer and allowed the depreciation.

The Tax Court reasoned that “rights in space have been recognized as property subject to transfer separately from the land” and concluded that these rights should be depreciable in the Copyright © 2025 Pearson Education, Inc.

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taxpayer’s business. The Tax Court also held that the difference between the property’s cost and salvage value was a reasonable measure of the amount to be depreciated and that a depreciation method based on the depreciable cost divided by quantity dumped was reasonable. The facts in Sexton are analogous to our client’s case.

STEP TWO: Check the status of the case by checking the citator. The reasoning is followed in Kendrick & Barbara Sanders, 75 TC 157 (1980) and distinguished from A, Duda & Sons v. U.S., 40 AFTR 2d 77-5911 (CA, 1977).

STEP THREE: Consult the AOD database to see if the IRS issued an Action on Decision for Sexton. In A.O.D. 1969 WL 21099, the IRS acquiesced in the result but disagreed with the Tax Court’s reasoning. The IRS believed the depreciation should be premised on the land’s having a determinable useful life rather than on the concept of air space separate from the land itself. The IRS, however, acquiesced without qualification to the taxpayer’s units-of-production method of calculating depreciation.

STEP FOUR: Conclude that Mr. Stench can depreciate the difference between the dump’s site’s cost and salvage value at the end of its useful life ($20,000), and he should elect the units of production method to calculate the annual amount deductible. pp. I:15-26 through I:15-29.

Tax Strategy and Critical Thinking Problem I:15-61 Choose Alternative 2; file the lawsuit in the Tax Court. HPU is likely to lose a lawsuit filed in the U. S. district court (Alternative 1) because that court is bound by district court precedent adverse to the taxpayer. Likewise, HPU is likely to lose a lawsuit filed in the Court of Federal Claims (Alternative 3) because that court is bound by circuit court precedent adverse to the taxpayer. On the other hand, in the Tax Court (Alternative 2) the tax return position taken by HPU has a realistic possibility of being sustained on its merits. In a case involving HPU, the Tax Court would not be bound by the other circuit court’s precedent, which is adverse to the taxpayer because of the Golsen Rule. Rather, the Tax Court would be bound by HPU’s own circuit court precedent, which, based on the specific facts of the problem, is nonexistent because HPU’s circuit court has merely offered dictum, which is not binding. However, if the Tax Court issues a ruling consistent with the circuit court’s second proposition, namely, that by opening the home improvement center, HPU is merely “improving customer access to its existing products,” HPU will win the lawsuit, and its deduction will be sustained. pp. I:15-21 and I:15-23.

Case Study Problem I:15-62 Statement on Standards for Tax Services (SSTS) No. 2 states that “a member may, in good faith, rely on information furnished, without verification, by the taxpayer or by third parties” (Par. 2.3.2). Thus, you may accept Mal’s information at face value. His increase in AGI of over $30,000 may explain his increase in charitable contributions of approximately $10,000.

In the second scenario the provision from SSTS No. 2 that a member “should make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to a member” would be pertinent. Recently, the Copyright © 2025 Pearson Education, Inc.

I:15-10

IRS audited Mal’s return, and Mal lacked substantiation for about 75 percent of the charitable contributions he had claimed. (He may have made the contributions, but he could not prove that he did.) Further, the round amount ($25,000) reported by Mal suggests that Mal may be estimating what he contributed. You probably should request to see substantiation (canceled checks, etc.) for the contribution(s) claimed. For charitable contributions of $250 or greater, no deduction is allowed unless the donee organization substantiates the contribution with a contemporaneous, written acknowledgement. Mal needs to be made aware of this rule for his current year’s return. All cash contributions, regardless of amount, must be documented with a bank record or written communication from the charity. The communication must include the name of the charity, date, and amount. p. I:15-32.

Tax Research Problems I:15-63 a.

The primary issue is whether the amounts Thomas A. Curtis, M.D. Inc. paid to Ellen Curtis as compensation during fiscal years 1988 and 1989 were reasonable. b.

Neither party was totally victorious. In fiscal year 1988, Ellen Curtis was paid $410,500. The amount held to be reasonable compensation by the Tax Court for 1988 was $227,000. In fiscal year 1989, Ellen Curtis was paid $510,500. The amount held to be reasonable compensation by the Tax Court for 1989 was $239,000. The amount held to be compensation, however, is more than the $100,000 and $105,000 the IRS asserted was reasonable compensation. c.

The plaintiff is the corporation because it is the party that claimed a deduction for the compensation. The IRS is attempting to disallow the corporation’s deduction for part of the compensation paid. The disallowance of the deduction will have little effect on the two individuals since the amounts received will be either salary or dividends depending on the outcome of the case. d.

Ellen Barnert married Dr. Thomas Curtis in 1984. e.

Ms. Curtis worked approximately 60 to 70 hours supervising all departments set up within the corporation and the independent contractors, including scheduling and staffing of all the corporation’s offices. Ms. Curtis was a registered nurse. She had a bachelor’s degree in science and took worker’s compensation courses at the University of Southern California Law School. She had worked as a nurse for a number of years and managed an ambulatory hospital system. f.

In fiscal year 1989, Ellen Curtis was paid $510,500. The Tax Court held $239,000 to be reasonable compensation in 1989. g.

The corporation paid no dividends in either fiscal year. h.

The case is appealable to the Ninth Circuit. i.

The five factors mentioned in determining reasonable compensation according to Elliott’s are: (1) the employee’s role in the company, (2) external comparison of the employee’s salary with those paid by similar companies for similar services, (3) character and condition of the company, (4) conflict of interest in the employee’s relationship to the corporation, and (5) the internal consistency in the company’s treatment of payments to employees.

I:15-64 Judicial authority exists to exclude the Medicare payments from the amount the mother is treated as having provided for her own support. The IRS agrees with this authority; therefore, if the IRS audits the client’s return, the IRS will not argue that Josh’s mother provided the majority of her own support. (This information should be included in the client letter.)

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The work papers should include a discussion of the authorities summarized below.

Section 152(a) provides that one of the tests for claiming another as a dependent is to provide over one-half of such person’s support. (Note: Josh’s mother’s gross income of $2,000 is not too high in the current year for her to be claimed his dependent assuming all other requirements are met.) If he provides over one-half of her support, he also may deduct any medical expenses he pays on her behalf. Section 152 does not define “support.” Regulation Sec. 1.152-1(a)(2) states that support includes “food, shelter, clothing, medical and dental care, education, and the like.”

It also provides that in determining the amount an individual contributes to his own support, one must count the cost of support items paid for from “income, which is ordinarily excludable from gross income, such as benefits received under the Social Security Act.” In Alfred H. Turecamo v. CIR, 39 AFTR 2d 77-1487, 77-1 USTC ¶9415 (2nd Cir., 1977), the court held that hospital costs paid by Basic Medicare do not constitute support the ill person furnishes for himself or herself. After studying the legislative history of the Medicare statute, the court could find no valid basis “for distinguishing between hospital benefits received under Part A of Medicare [Basic Medicare] and either private insurance proceeds or supplemental benefits received under Part B [of Medicare].”

In Rev. Rul. 70-341, 1970-2 C.B. 31, the IRS ruled that Basic Medicare payments on a person’s behalf must be treated as contributions by such person toward his own support. Such treatment was in contrast to that of Supplemental Medicare, which the IRS viewed as in the nature of insurance proceeds, and not self-support. Revenue Ruling 64-223, 1964-2 C.B. 50, held that amounts paid by an insurance company for medical costs are disregarded in the support test.

In Rev. Rul. 79-173, 1979-1 C.B. 86, however, the IRS revoked Rev. Rul. 70-341. Thus, the IRS currently treats Basic Medicare payments consistently with Supplemental Medicare and ignores amounts received from either source for purposes of the support test. In Archer v. Comm.

73 T.C. 963 (1980), the court held that both Medicare and Medicaid are disregarded in the support test.

I:15-65 In determining whether the property is used “too much” for personal purposes so that Sec. 280A applies, use of the residence by Amy or by family members constitutes personal use, as does use by persons who pay less than fair rental value (Sec. 280A(d)(2)). Use by Amy when performing repairs and maintenance full-time is totally disregarded (Sec. 280A(d)(2)). For purposes of allocating the expenses attributable to rental use, however, all the days on which the property is rented for fair rental value are considered, even if the property is rented to family members on some of these days (Prop. Reg. Sec. 1.280A-3(c)).

The total number of days rented at fair rental value – the numerator of the fraction used in the allocation – is determined as follows: Days rented to sister Days rented to cousin Days rented to three families Total

8 4 120 132

The denominator for allocating interest and taxes is in dispute. Per Prop. Reg. Sec. 1.280A-3(d)(3), the denominator is the total number of days of actual use (exclusive of use by Copyright © 2025 Pearson Education, Inc.

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the owner for performing repairs). Thus, the denominator would be 146 (12 + 8 + 4 + 2 + 120).

Case law supports using as the denominator the number of days in the year, or 365 days in this case for allocating interest and taxes. Dorrance D. Bolton v. CIR 51 AFTR 2d 83-305, 82-2 USTC ¶9,699, (9th Cir., 1982), affirming 77 T.C. 104 (1981), and Edith G. McKinney v. CIR 52 AFTR 2d 83-6281, 83-2 USTC ¶9,665 (10th Cir., 1983).

For allocating repairs, insurance, and depreciation, this ratio is the number of days rented at fair rental value divided by the total number of days of actual use, or 132/148. However, there is a conflict between Sec. 280A(e) and Prop. Reg. §1.280A-3(d)(3). The proposed regulation excludes repair days from the denominator, but the IRC is silent. Excluding the repair days results in a denominator of 146.

I:15-66 a.

The principal issue in both cases was whether the corporation could deduct amounts paid as compensation to the spouse (ex-spouse) of a sole shareholder. This issue, in turn, depended on whether such compensation was “reasonable” under the circumstances. b.

The Tax Court considered a number of factors, including (1) the employee’s qualifications and training, (2) the nature, extent, and scope of her duties, (3) responsibilities and hours involved, (4) the size and complexity of the business, (5) the results of the employee’s efforts, (6) the prevailing rates for comparable employees in comparable businesses, (7) the scarcity of other qualified employees, (8) the ratio of compensation to the gross and net income of the business, (9) the salary policy of the employer to other employees, and (10) the amount of compensation paid to the employee in prior years. c.

The facts of these cases are similar in the following respect: in both cases, the taxpayers were corporations that claimed a deduction for payments made to the spouse or exspouse of a sole shareholder. The facts are different in these respects: (1) In Summit the IRS contended that only a portion of the salary payments were nondeductible; in J.B.S., it argued that none of the salary payments were deductible. (2) In Summit, the spouse performed extensive services for the firm; in J.B.S., the ex-spouse appears to have performed no services. (3) In Summit, the court took into consideration the corporation’s rising profits; in J.B.S., the court did not. (In fact, the latter opinion does not mention the firm’s profits or loss position). (4) In Summit, the payments did not appear to be motivated by tax avoidance. (Because the corporation paid substantial dividends to its sole shareholder, the payments to the spouse did not appear to be “disguised dividends”). In J.B.S., the payments did appear to be motivated by tax avoidance.

(Testimony indicated that some tax positions had been taken to minimize the corporation’s tax liability.)

I:15-67 The memorandum should supply the following answers: a.

Revenue Proc. 2024-1, 2024-1 I.R.B. 1 and Rev. Proc. 2024-4, 2024-1 I.R.B. 162 govern requests for determination letters. b.

Form 5300, “Application for Determination for Employee Benefit Plan,” must be filed with the request. c.

The following information must be provided in the request: 1.

Complete statement of facts and other information 2.

Copies of all contracts, wills, deeds, agreements, instruments, other documents pertinent to the transaction, and foreign laws 3.

Analysis of material facts Copyright © 2025 Pearson Education, Inc.

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4.

Statement regarding whether same issue is in an earlier return and additional information required for §301.9100 requests 5.

Statement regarding whether same or similar issue was previously ruled on or whether a request involving it was submitted or is currently pending 6.

Statement regarding interpretation of a substantive provision of an income or estate tax treaty 7.

Statement regarding involvement of a transactional party located in a foreign country 8.

Letter from Bureau of Indian Affairs relating to a letter ruling request for recognition of Indian tribal government status or status as a political subdivision of an Indian tribal government.

9.

Statement of supporting authorities 10.

Statement of contrary authorities 11.

Statement identifying pending legislation 12.

Statement identifying information to be deleted from the public inspection copy of letter ruling or determination letter 13.

Signature by taxpayer or authorized representative 14.

Authorized representatives 15.

Power of attorney and declaration of representative 16.

Penalties of perjury statement 17.

Number of copies of request to be submitted 18.

Sample format for a letter ruling request 19.

Checklist for letter ruling requests d.

Actions that must accompany the filing include payment of appropriate user fee and notification of interested parties.

“What Would You Do In This Situation?” Solution Ch. I:15, p. I:15-34.

In this context, you have two professional duties: first, a duty of confidentiality to each client, and second, a duty to verify information that appears to be incorrect on its face. According to Statement No. 2 of the Statements on Standards for Tax Services, a member who is required to sign a tax return should consider information actually known to the CPA from the tax return of another client if (1) that information is relevant to the former return, (2) its consideration is necessary to properly prepare that return, and (3) the use of such information does not violate any rule of confidentiality. Here, (1) the information relating to each return is relevant to the other; (2) its consideration is necessary to properly prepare the other return; and (3) the use of such information does not violate any rule of confidentiality, so long as the information is not disclosed to the other client. Your considering the tax return information should lead you to believe that it is incorrect on its face; therefore, you have a duty to verify it.

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Accordingly, without revealing the basis for your belief, you should request from each client documentary evidence of its respective claim. Such evidence should consist of a paid invoice, a canceled check, a signed or certified receipt, a bill of lading, or any other document that indicates the essential terms of the contract of sale.

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Chapter I:16 Corporations Discussion Questions I:16-1 a.

Corporation. Under the check-the-box regulations Sales, Inc. must be classified as a corporation. b.

Elective treatment is not available to Sales, Inc. under the check-the-box regulations. However, a corporation’s owner(s) can make an S corporation election under IRC Sec. 1361 to be taxed as an S corporation. The S corporation rules permit Sales, Inc. to be exempt from the federal corporate income tax and to be treated as a conduit entity. c.

No change. Sales is a corporation, so it cannot elect to be treated as a disregarded entity. If Sales were an unincorporated entity, such as an LLC, it could elect to be treated as a disregarded entity because it has only one owner. pp. I:16-2 and I:16-3.

I:16-2 There are several reasons an entrepreneur might choose to organize a business as a C corporation instead of a flow-through entity, despite the double taxation of a C corporation’s income: •

The first part of the double tax occurs at a 21% rate, which may be lower than the entrepreneur’s tax rate for ordinary income (e.g., 37%). The second part of the double tax occurs when the corporation pays a dividend to its shareholders or when a shareholder realizes a capital gain from selling his or her stock, and it may be taxed at a preferential rate (e.g., 0%, 15%, or 20%). The burden of two smaller taxes may be less than the burden of one larger tax. See Chapter I:18 for an analysis of this situation.

•

S corporation status is more restrictive than C corporation status. For example, S corporations cannot have more than 100 shareholders and cannot have more than one class of stock (for further discussion of the requirements for S corporation status, see Chapter C:11 of this text’s companion volume titled Pearson’s Federal Taxation: Corporations, Partnerships, Estates & Trusts).

•

Owners of a C corporation can more easily transfer their ownership interests to others than is the case with the various types of flow-through entities due to the legalities related to the transfer of partnership or limited liability company ownership interests and due to the restrictions on S corporation status.

•

It may be easier to conduct multistate and international business activities through a C corporation (or group of C corporations) than through a flow-through entity. For example, a particular state’s or country’s tax system may make it better to conduct the entrepreneur’s business there through a C corporation than through a flow-through entity.

•

Mergers and acquisitions may be easier to accomplish with a C corporation than with the other entity forms, such as for the reasons mentioned in the third and fourth points.

p. I:16-2.

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I:16-3 Through various transactions. Tax analysts argue that besides being able to shift the tax burden to consumers in the form of higher prices, some corporations are able to shift the burden to (a) employees in the form of lower salaries and wages, (b) tenants in the form of higher rents, and/or (c) shareholders in the form of lower dividends and stock values. p. I:16-2.

I:16-4 Where the investor has also realized long-term capital losses. In this situation, the investor can offset the losses against the gains, thereby reducing his or her overall tax liability. pp. I:16-4 and I:16-5.

I:16-5 a.

Yes, resulting in a $4,000 net capital loss for the current year. b.

No, the net capital loss is not deductible in the current year. Instead, it carries back three years and over five years, thus being available for use against capital gain net income in those years. c.

The corporate carryback and carryforward loss rules. All $4,000 of the net capital loss for the current year carries back to the prior year. $3,000 of the loss offsets the $3,000 capital gain net income for that year. The other $1,000 of the current year’s net capital loss carries forward as a short-term capital loss to the next five tax years and is deductible to the extent of Acorn’s capital gain net incomes for those years. pp. I:16-4 and I:16-5.

I:16-6 a.

To mitigate the possible triple taxation of income earned by a corporation. For example, without the dividends-received deduction (DRD), corporate income would be taxed once when earned, again when distributed to a corporate shareholder, and a third time when distributed to the shareholders of the second corporation. The DRD reduces the taxation to the second corporation, but not the taxation to the corporation earning the income or its shareholders. b.

The 50% and 65% dividends-received deductions (DRDs) are limited to the product of (1) the DRD percentage and (2) taxable income computed without regard to the DRD, the net operating loss deduction, and any deduction for capital loss carrybacks. This limitation, however, does not apply if there would be a net operating loss if the full DRD (i.e., DRD percentage x dividends received) were deducted. A corporation thus deducts the full DRD when its taxable income is large enough to make its DRD limitation greater than its full DRD and when the full DRD creates or increases a net operating loss. However, for a certain range of taxable income, the limitation reduces the DRD that the corporation may claim. c.

Different tax liabilities, depending on percentage ownership. A C corporation that receives $10,000 of dividend income from a 10%-owned corporation can claim a $5,000 (50% × $10,000) DRD, resulting in an additional tax liability of $1,050 (0.21 × ($10,000 $5,000)). If the C corporation instead owns 25%, the DRD would be $6,500 (65% × $10,000), and the additional tax liability would be $735 (0.21 × ($10,000 - $6,500)). If the C corporation instead owns 100% (and a consolidated tax return is not filed), then a 100% DRD can be claimed, effectively making tax-free the $10,000 dividend received. d.

Different effective tax rates, depending on different percentage ownerships: 10.50% if the dividend is received from a 10%-owned corporation ($1,050 ÷ $10,000), 7.35% if it is received from a 25%-owned corporation ($735 ÷ $10,000), and 0% if it is received from a 100%-owned corporation. pp. I:16-5 and I:16-6.

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I:16-7 The charitable contribution must be (1) authorized by the board of directors during the tax year for which it will be deducted and (2) paid within 3½ months following the end of that year. This election for accrued charitable contributions is not available to an S corporation. p. I:16-7.

I:16-8 a.

The $200,000 increase in Carl’s salary is not deductible, even though it is fully taxable to Carl, because it exceeds the $1 million deduction ceiling for certain key executives in publicly-held corporations (IRC Sec. 162(m)). The $1 million ceiling is a fixed amount and is not adjusted annually for inflation. b.

Instead of increasing Carl’s fixed salary above $1 million, Acorn should consider increasing (subject to limits) deductible payments to retirement plans and tax-free fringe benefits that do not trigger current taxation. p. I:16-8.

I:16-9 Agnew is unlikely to incur the book minimum tax if it goes public. A corporation is subject to this tax if its average annual adjusted financial statement income (AFSI) for any prior three-taxable-year period ending after December 31, 2021, exceeds $1 billion, and Agnew’s AFSI is likely much less than $1 billion. It is irrelevant whether Agnew’s stock is publicly traded. Agnew’s average annual AFSI for a three-taxable-year period may eventually exceed $1 billion, but its profits would have to be more than about ten times what they currently are. pp. I:16-10 and I:16-11.

I:16-10 The book minimum tax is 15% of adjusted financial statement income (AFSI) exceeding the regular tax, and the regular tax is 21% of taxable income. In order for 15% of AFSI to exceed 21% of taxable income, AFSI needs to be greater than 140% of taxable income (AFSI ÷ TI > 0.21 ÷ 0.15). Blazic’s AFSI is only about 120% of taxable income, so its book minimum tax for the current year is zero. pp. I:16-10 and I:16-11.

I:16-11 a.

To discourage a corporation from retaining excess earnings for purposes unrelated to its business. Because income tax rates can be higher for an individual than for a C corporation (e.g., 37% versus 21%), there can be an incentive to shelter earnings within a C corporation. The accumulated earnings tax rate is 20%, the same rate that high income shareholders are taxed on dividend income if the corporation distributes its accumulated earnings. The accumulated earnings tax decreases the attractiveness of retaining excess earnings for tax avoidance purposes.

The penalized earnings could be subject to triple taxation: once when earned by the corporation, a second time when penalized under the accumulated earnings tax, and a third time when the earnings ultimately are distributed to the shareholder. b.

Because this type of accumulation does not circumvent Congress’s purpose for enacting the penalty tax. Thus, the corporation is allowed to reduce accumulated taxable income by amounts retained for its reasonable business needs. In many cases, this adjustment either reduces or eliminates entirely the accumulated earnings tax. pp. I:16-12 and I:16-13.

I:16-12 Not necessarily. To avoid an attack by the IRS, the corporation must use the $1 million of retained earnings for reasonable needs of the business and not for unrelated business needs. Dividend payments are not required if the earnings are reinvested in operating assets or the funds are retained to meet the reasonable needs of the business. Reasonable business needs include business expansion, plant replacement, acquiring assets or stock of another business, Copyright © 2025 Pearson Education, Inc.

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retiring debt, and making investments in or loans to suppliers or customers. To avoid the accumulated earnings tax, all business and expansion plans must be definite as opposed to being vague. The business and expansion plans need to be documented by the corporation and made available to the IRS should a question about the need to reinvest earnings ever arise. Because the E&P has been reinvested in operating assets for expansion purposes, Acme Corporation is not likely subject to the accumulated earnings tax. pp. I:16-12 and I:16-13.

I:16-13 a.

To discourage individuals from using a corporation to shelter earnings generated by passive- or investment-type assets. Because income tax rates can be higher for an individual than for a C corporation (e.g., 37% versus 21%), there can be an incentive to shelter earnings within a C corporation. Usually, such corporations are closely held. The PHC tax rate is 20%, the same rate that high income individuals are taxed on dividend income if the corporation distributes its earnings. b.

The 50% stock ownership test and the 60% of adjusted ordinary gross income test. Closely held corporations with high levels of passive or investment income are the target of the PHC tax. The 50% stock ownership test identifies closely held corporations, and the 60% of adjusted ordinary gross income test identifies corporations with substantial passive or investment income. pp. I:16-14 and I:16-15.

I:16-14 The difference is this: a corporation’s incurring liability for the personal holding company tax does not require a tax avoidance motive. Rather, it requires mechanical application of two objective tests. By contrast, a corporation’s incurring liability for the accumulated earnings tax does require such a motive; specifically, an intent to avoid the tax on dividends. pp. I:16-12 through I:16-15.

I:16-15 Because a tax advantage could be derived from operating a single business as two or more separate corporations controlled by the same shareholders. This advantage results, in part, from the possibility of duplicating the benefits from certain tax attributes across multiple corporations. For example, a single business operating through two corporations could get the benefit of multiple Sec. 179 expense limitations, effectively doubling the business’ immediate deduction for qualified asset acquisitions to $2,440,000 (vs. the $1,220,000 limitation for 2024; ignoring the phase-down for Sec. 179 property acquired in excess of $3,050,000). pp. I:16-15 through I:16-17.

I:16-16 The underlying rationale is this: Section 351 allows shareholders to defer recognition of gain or loss on the transfer of assets to a controlled corporation. Without Sec. 351, a sole proprietorship would have difficulty adopting the corporate form of organization because the transfer of appreciated property would constitute a taxable transaction resulting in gain (but perhaps not a loss due to the Sec. 267 related party rules) being recognized by the transferors.

Under a Sec. 351 transfer, only the form of business changes (e.g., a sole proprietorship or partnership becomes a corporation) while the assets remain under the control of the transferors.

In addition, shareholders that receive only stock, as opposed to cash and liquid assets on the transfer, would not have the wherewithal to pay tax on the gains that otherwise would be recognized. pp. I:16-18 and I:16-19.

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I:16-17 a.

Disadvantages: Gator’s basis for the building is its $30,000 basis in Brett Nelson’s hands. This basis difference causes Gator to deduct approximately $1,500 less depreciation per tax year (based on an assumed 30-year remaining recovery period for nonresidential real property and straight-line depreciation) than would be available if the building had been purchased for cash. If the building is later sold in a taxable transaction, using the carryover basis for the building may cause part or all of the $45,000 difference between the building’s FMV and its tax basis that existed on Gator’s acquisition date to be recognized as an increased gain by Gator. b.

Disadvantages: The building transfer is tax-free to Brett Nelson under Sec. 351.

His $45,000 ($30,000 FMV of stock received - $75,000 adjusted basis of building) realized loss is not recognized for tax purposes. Brett Nelson must defer his $45,000 realized loss until he sells his stock in a taxable transaction. Nelson may have been better off to sell the building for cash so he could immediately recognize his tax loss. Such a sale may be subject to the limitations found in the Sec. 267(a) related party loss rules. The building’s basis in Gator’s hands generally is $30,000, i.e., its FMV (Sec. 362(e)(2)). c.

The basis of property that is contributed to a corporation in a Sec. 351 transaction is not increased to the property’s FMV because recognition of the gain on the transaction is deferred until the property is sold or exchanged by the transferee corporation. A step-up in the property’s basis occurs if the transferor recognizes part or all of the gain realized on the asset transfer. A step-down in basis occurs if the property’s FMV is less than its adjusted basis. d.

Gator would still recognize no gain on the transfer of the building from Brett Nelson to Gator in exchange for Gator stock. The building’s adjusted basis in the hands of Gator is $30,000. Brett Nelson’s basis in the Gator stock is reduced from $30,000 to $5,000 by the $25,000 amount of his liabilities that are acquired by Gator (IRC Sec. 358(a)). pp. I:16-18 through I:16-22.

I:16-18 a.

The likely tax consequences are as follows: Because Carmen mortgaged the property immediately prior to the Sec. 351 exchange and transferred the property and the liability to the corporation, the transaction probably lacks a bona fide business purpose because the mortgaged funds were used for a personal purpose (remodeling her home). Under Sec. 357(b), the $50,000 liability is reported as boot received by Carmen. Carmen’s $40,000 recognized gain is the lesser of her realized gain of $40,000 ($100,000 - $60,000) or the boot of $50,000 received. b.

Rationale: If the shareholder borrows money just before the incorporation and has the corporation assume the loan, the shareholder in effect gets money out of the corporation without incurring an income tax liability as would happen if the shareholder had received the $40,000 cash directly from the corporation as boot. Without the special rule for tax avoidance or failure to have a bona fide business purpose, the shareholder could engage in this maneuver without boot being triggered because of the general rule that the assumption of a liability does not constitute boot. pp. I:16-20 through I:16-22.

I:16-19 a.

For the corporation, the principal advantage of capitalizing with debt as opposed to equity is that interest on debt is deductible, whereas dividends on equity are nondeductible.

For the shareholders, the principal advantage is that debt retirement is not a taxable event, whereas stock (i.e., equity) redemption is a taxable event.

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b.

The property transfer is tax-free, so Sato, Jose, and Satish do not recognize the gains they realize. c.

The following tax consequences would result: (i) interest on the debt would be nondeductible by the corporation and taxed to Jose and Satish as a dividend; (ii) future debt retirement would be taxed to Jose and Satish as a stock redemption; (iii) the contribution of cash would likely be tax-free under Sec. 351. pp. I:16-18 through I:16-22.

I:16-20 (1) The S corporation, and (2) the limited liability company. With respect to both forms, taxable items reported at the entity level flow through to the separate returns of the entity’s owners. In this specific case, the start-up losses generated at the entity level during the first two years of operation would flow through to Chang and George’s separate returns. There, each owner could offset a pro rata share of the losses against his or her income. In addition, both an S corporation and a limited liability company afford all of their owners limited liability (unlike the case of a limited partnership, in which at least one general partner incurs unlimited liability). Given the extraordinary risks associated with an explosives business, such a feature would be advantageous. p. I:16-2.

I:16-21 A bias of a corporation’s capital structure in favor of debt over equity. Such a bias would be economically inefficient if the debt-to-equity ratio differs from that which would occur without the tax influence. This bias may cause a corporation to be excessively leveraged and to be capitalized too thinly, thereby increasing the corporation’s interest rate, creating potential financial difficulties or incurring IRS challenges to the interest deduction. This bias is mitigated by the preferential tax rate on qualified dividends (i.e., 0%, 15%, or 20%), which may cause the shareholder/creditor to prefer to receive payments as dividends rather than interest.

Nevertheless, since interest is deductible (subject to limitations) to the corporation and dividends are not, the disincentive to pay dividends instead of interest remains for the paying corporation.

Students should form their own opinions as to whether the tax law should be changed. p. I:16-22.

I:16-22 Because the meaning of “not essentially equivalent to a dividend” is somewhat unclear.

The Supreme Court decided in the Maclin P. Davis case that a redemption is “not essentially equivalent to a dividend” if it results in a meaningful reduction in the shareholder’s interest in the corporation’s assets at liquidation, interest in the corporation’s current and accumulated earnings, and right to vote his or her stock. The IRS has generally held that a meaningful reduction has occurred when the shareholder goes from a majority stock position to a minority stock position or from one minority stock position to a smaller minority stock position. Due to the uncertainty regarding the application of Sec. 302(b)(1), a safer course to follow is the mechanical tests in Secs. 302(b)(2) [substantially disproportionate] and 302(b)(3) [complete termination of a stock interest]. pp. I:16-26 through I:16-28.

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I:16-23 Substantially disproportionate a. Often permissible, even where stock ownership does not decrease by more than 20% b. Constructive ownership rules may be waived

Not permissible

Not waivable

Not essentially equivalent to a dividend Permissible, so long as there is a “meaningful reduction” in shareholder interest Not waivable

Complete termination of shareholder interest Not permissible

c. Treated as an exchange taxed as capital gain or loss d. Stock not surrendered in exchange for corporate distribution

Yes

Yes

Waivable, if shareholder agrees not to acquire corporate interest for 10 years Yes

Not the case

Not the case

Not the case

pp. I:16-26 through I:16-28.

I:16-24 Not necessarily. The major difference between the complete termination of a shareholder’s interest under Sec. 302(b)(3) and the substantially disproportionate test under Sec. 302(b)(2) is that the family constructive ownership rules can be waived only when Sec. 302(b)(3) is used. For the family constructive ownership rules not to apply, the former shareholder must file an agreement with the IRS stating that he or she will have no interest in the corporation, other than that of a creditor, for a 10-year period. pp. I:16-26 through I:16-28.

I:16-25 In terms of taxability. Liquidation of a controlled subsidiary corporation is a tax-free transaction under Code Sec. 332(a) assuming that there are no minority shareholders. Neither the parent corporation nor the subsidiary corporation recognizes gain or loss on the liquidation.

The bases of the subsidiary’s assets carry over to the parent along with other tax attributes (IRC Sec. 381(a)). [If there are minority shareholders, their tax treatment is the same as for a regular liquidation.] The parent’s basis in the subsidiary’s stock disappears.

The liquidation of a corporation that does not qualify as a controlled subsidiary (for example, a less than 80%-owned subsidiary), on the other hand, is a taxable event. The liquidated corporation recognizes gains and losses on the distribution or sale of its noncash assets, and the shareholders recognize gain or loss on the receipt of cash or noncash property in exchange for their stock interest. The shareholders’ gains and losses equal the difference between the FMV of the assets distributed (minus the amount of any liabilities distributed) and Copyright © 2025 Pearson Education, Inc.

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the basis of their stock. The shareholders take a FMV basis in the noncash assets distributed.

Corporate tax attributes disappear in a taxable liquidation.

When a controlled subsidiary is liquidated, the business stays within the corporate form, and the tax law generally deems such transactions as nontaxable (IRC 332(a)). When an individual liquidates his or her corporation, however, the corporate form disappears. Moreover, the individual receiving the liquidating distribution may decide not to continue the trade or business in a noncorporate form. pp. I:16-29 through I:16-31.

I:16-26 For the following reasons: The cost of a corporate formation transaction usually is quite low because Sec. 351 permits appreciated property to be transferred to a corporation with no gain being recognized except to the extent that excess liabilities are transferred to the corporation that are taxable under IRC Sec. 357(c) or the shareholder receives boot property. The shareholders generally recognize no loss on a corporate formation transaction even if they receive boot property.

On the other hand, a liquidating corporation recognizes gain or loss on its noncash property distributions unless certain exceptions apply. The shareholders also recognize gain or loss upon receiving liquidating distributions in exchange for their stock. One common exception to the gain recognition requirement occurs when a corporation forms a controlled subsidiary corporation and then subsequently liquidates the corporation. IRC Secs. 332 and 337 permit both the liquidating corporation and its parent corporation to avoid recognizing gain or loss on the liquidation. pp. I:16-29 through I:16-31.

I:16-27 To facilitate investments in small corporations. If an individual invests in a sole proprietorship or a partnership, the invested amounts, if used for operations, are deductible against the individual’s ordinary income even if the business fails. However, if the individual invests in a C corporation and the corporation fails, the losses would not be deductible because the corporation has no income against which to offset the losses. Moreover, without Sec. 1244, an individual shareholder could not deduct the investment in the worthless stock against ordinary income. Such losses would be a capital loss deductible only against capital gains or deductible annually up to $3,000 against ordinary income. This disparate treatment could raise an impediment to incorporating businesses. To reduce this disparity, Sec. 1244 allows ordinary loss treatment within specified dollar limits, thereby removing potential roadblocks to business incorporations. Section 1244 stock is often called a “no cost” advantage for shareholders of a small business corporation. There is no downside risk and only a small extra cost to make a Sec. 1244 election. The difference between capital loss and ordinary loss treatment, however, can be substantial. pp. I:16-31 and I:16-32.

I:16-28 For reasons of corporate deductibility. Dividends are fully taxable to the shareholders if the corporation has sufficient E&P, but dividends are not deductible by the corporation.

Payment of additional salary, interest, or rent, while taxable to the shareholders, is deductible by the corporation as long as the amounts are reasonable. The additional salary is subject to a FICA tax levy unless the employee has already earned the maximum amount of FICA wages for the year. p. I:16-32.

I:16-29 One advantage of having a corporation treated as a C corporation is that the corporate entity is not limited by the number of shareholders. An S corporation, on the other hand, is limited to 100 shareholders (with all family members being treated as a single shareholder). For Copyright © 2025 Pearson Education, Inc.

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a newly-formed business this may not be an issue until a number of years after its creation. Once the corporation goes beyond the S corporation shareholder limit the S corporation election is lost and a corporation is taxed as a C corporation.

A second advantage is that the S corporation’s profits are taxed ratably to each shareholder and taxed at his or her marginal individual income tax rate with no second level of taxation occurring when a “dividend” distribution is paid by the corporation to its shareholders.

In the case of both a C corporation and an S corporation, a tax is imposed at capital gains rates on the profit reported on the sale or other disposition of part or all of a shareholder’s stock investment.

A third advantage is that the ordinary income (profits) and capital gains reported by the S corporation are allocated to each shareholder and increases the shareholder’s basis in his or her S corporation’s stock investment. Ordinary losses and capital losses of the S corporation are allocated to each shareholder and decrease the shareholder’s basis (but not below zero) in his or her S corporation stock investment.

I:16-30 Because the IRS will find these differences useful in determining whether and what items to audit. Schedule M-3 reconciles a C corporation’s financial accounting net income and taxable income (before the net operating loss and dividends-received deductions). Generally, corporations with total assets of $10 million or more are required to file Schedule M-3 with their Form 1120. p. I:16-35.

I:16-31 Besides M-1 and M-2, the following schedules, with their respective reporting functions, are incorporated in Form 1120: Schedule Reporting Function C Reports dividends received by the corporation and calculates the dividends-received deduction for them J Reports computation of corporate tax, as well as prepayments (e.g., estimated tax payments) the corporation made K Reports “other information,” such as accounting method, business activity, corporate affiliates L Reports balance sheet, per the corporation’s books

Issue Identification Questions I:16-32 The following tax issues: In the short-run, the primary issue is the imposition of penalty taxes (i.e., the accumulated earnings tax or the personal holding tax) if future earnings are reinvested in nonoperating assets. A secondary issue in the long run involves the tax consequences arising from the acquisition of investment securities (e.g., the availability of the dividends-received deduction). Rather than reinvesting the monies in the business, Helen might consider increasing her salary and fringe benefits. Helen also needs to consider the tax consequences arising from the eventual liquidation of the corporation, a sale of the business assets followed by a liquidation of the corporation, or a sale of the corporate stock when she retires. pp. I:16-12 through I:16-15.

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I:16-33 The primary tax issue is the tax consequences arising from the formation of the corporation. If Sec. 351 is applicable, will gain or loss be recognized by Helga and Hugo? Does the transfer of liabilities in excess of the basis of the assets trigger the recognition of gain by Hugo?

If so, what is the character of the gain? What is Hugo’s basis in his stock? Does Hugo’s stock qualify as Sec. 1244 stock? What is the corporation’s basis in the assets it receives from Hugo?

Should Helga attempt to avoid the operation of Sec. 351 so as to recognize losses on the transfer of her assets? Should Helga attempt to sell her assets to an unrelated third party so as to recognize the loss and invest the proceeds in the corporation? Do the related party loss rules of Sec. 267(b) apply to a sale of Helga’s assets to the corporation? If Helga recognizes a loss, what is its character?

What is Helga’s basis for her stock? Does Helga’s stock qualify as Sec. 1244 stock? What is the corporation’s basis in the assets it receives from Helga? Should Hugo and Helga make an S corporation election for their new entity? What accounting period and other tax elections should be made in the initial year? pp. I:16-18 through I:16-22, I:16-31, and I:16-32.

I:16-34 The primary tax issue is whether Sec. 385 debt-equity rules will apply to recharacterize the debt as equity under the first alternative. What impact will the loss of the interest deduction have on the corporation’s tax position? If the interest deduction creates a loss, then would an S corporation election or an alternative business form (for example, partnership or limited liability company) be desirable? A secondary consideration is the effect of the issuance of debt upon the need for recognition of gain by John and Joy on the asset transfer under Sec. 351(b). A third consideration is the ability of the stock (and debt?) to qualify as Sec. 1244 stock. pp. I:16-22, I:16-31, and I:16-32.

Problems I:16-35 a. $60,000. First has a net long-term capital gain of $12,000 ($20,000 - $8,000), a net short-term capital loss of $14,000 ($16,000 - $30,000), and a net capital loss of $2,000 ($12,000 - $14,000). As a C corporation, First cannot deduct a net capital loss in the year incurred, so its taxable income is $60,000. b.

The $2,000 net capital loss carries back three years and forward five years. pp. I:16-4 and I:16-5.

I:16-36 a.

Federal’s 2024 net capital loss of $200,000 ($80,000 + $120,000) carries back three years and forward five years as a short-term capital loss. Federal uses $19,000 of the carryback to offset its 2021 capital gain net income (CGNI), $20,000 to offset its 2022 CGNI, and $60,000 to offset its 2023 CGNI. b.

Federal used $99,000 ($19,000 + $20,000 + $60,000) of the 2024 net capital loss during the three-year carryback period, so it carries forward for five years the unused amount of $101,000 ($200,000 - $99,000). c.

The character of unused capital loss carryforwards also is short-term. pp. I:16-4 and I:16-5.

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I:16-37 a. $130,000. The dividends-received deduction (DRD) before considering its limitation is $130,000 (0.65 x $200,000); the DRD percentage is 65% because Florida owns at least 20% (but less than 80%) of the distributing corporation’s stock. The DRD limitation of $195,000 (0.65 x ($100,000 + $200,000)) exceeds $130,000, so Florida’s DRD is $130,000. b. $117,000 DRD. As in part a, the DRD before considering its limitation is $130,000. The DRD limitation of $117,000 (0.65 x (-$20,000 + $200,000)) is less than $130,000, so Florida’s DRD is $117,000. This limitation applies because Florida would not have a net operating loss if it were to claim the full $130,000 as its DRD (-$20,000 + $200,000 $130,000 = $50,000, which is not negative). c. $100,000 DRD for Part a, and $100,000 DRD for Part b. The DRD before considering the limitation is $100,000 (0.50 x $200,000); the DRD percentage is 50% because Florida owns less than 20% of the distributing corporation’s stock. For Part a, the DRD limitation of $150,000 (0.50 x ($100,000 + $200,000)) exceeds $100,000, so Florida’s DRD is $100,000. For Part b, the DRD limitation does not apply because Florida would have a net operating loss if it were to claim the full $100,000 as its DRD (-$130,000 + $200,000 - $100,000 = -$30,000). Florida thus claims the full $100,000 as its DRD. pp. I:16-5 and I:16-6.

I:16-38 Gross income from operations Allowable business deductions Dividends received Taxable income before DRD Dividends-received deduction (DRD) Taxable income

Part a $260,000 (170,000) 200,000 $290,000 (130,000)a $160,000

Part b $160,000 (180,000) 220,000 $200,000 (100,000)b $100,000

a

The DRD before considering its limitation is $130,000 (0.65 x $200,000); the DRD percentage is 65% because Purple owns at least 20% (but less than 80%) of Blue’s stock. The DRD limitation of $188,500 (0.65 x $290,000) exceeds $130,000, so Purple’s DRD is $130,000. b

The DRD before considering its limitation is $110,000 (50% x $220,000); the DRD percentage is 50% because Yellow owns less than 20% of Green’s stock. The DRD limitation of $100,000 (0.50 x $200,000) is less than $110,000, so Yellow’s DRD is $100,000. This limitation applies because Yellow would not have a net operating loss if it were to claim the full $110,000 as its DRD ($200,000 - $110,000 = $90,000, which is not negative). pp. I:16-5 and I:16-6.

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I:16-39 Negative $72,500, calculated as follows: Gross income from business operations Business deductions Dividends received Taxable income before DRD Dividends-received deduction (DRD) Taxable income

$500,000 ( 625,000) 150,000 $ 25,000 (97,500)* $ (72,500)

*

The DRD before considering its limitation is $97,500 (0.65 x $150,000). The DRD limitation does not apply because Alpha would have a net operating loss if it were to claim the full $97,500 as its DRD ($25,000 - $97,500 = -$72,500). Alpha thus claims the full $97,500 as its DRD. pp. I:16-5 and I:16-6.

I:16-40 a. $25,000. Georgia’s charitable contributions deduction is limited to 10% of taxable income, computed without regard to the charitable contributions deduction, capital loss carrybacks, or the dividends-received deduction. The limitation of $25,000 (0.10 x ($900,000 $650,000)) is less than Georgia’s $40,000 of charitable contributions, so it deducts $25,000. b. $15,000 ($40,000 - $25,000) carries forward for up to five years. pp. I:16-7 and I:16-8.

I:16-41 $68,460, determined as follows: Gross profit Deductible expenses Long-term capital gain Short-term capital gain Dividends received Taxable income before DRD Dividends-received deduction (DRD) Taxable income Tax rate Tax liability

$800,000 (490,000) 10,000 2,000 8,000 $330,000 (4,000)a $326,000 × 0.21b $ 68,460

a

The DRD before considering its limitation is $4,000 (0.50 x $8,000); the DRD percentage is 50% because Colorado owns less than 20% of the payor’s stock. The DRD limitation of $165,000 (0.50 x $330,000) exceeds $4,000, so Colorado’s DRD is $4,000. b

The 21% tax rate applies to all of Colorado’s taxable income, including the portion that is net capital gain and qualified dividends. pp. I:16-9 and I:16-10.

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I:16-12

I:16-42

$15,750,000 book minimum tax, determined as follows: Net income $2,500,000,000 Federal income tax expense 450,000,000 Book depreciation 330,000,000 Tax depreciation (375,000,000) Adjusted financial statement income $2,905,000,000 × 0.15 $ 435,750,000 Regular tax ($2,000,000,000 × 0.21) (420,000,000) Book minimum tax (not less than zero) $ 15,750,000

Yellow’s total tax for the current year is $435,750,000 ($420,000,000 + $15,750,000). pp. I:16-10 and I:16-11.

I:16-43 $130 million adjusted financial statement income (AFSI) for Year 4. The $1 billion net loss for Year 3 carries forward indefinitely, but its use to reduce a year’s AFSI is limited to 80% of AFSI before this reduction. For Year 4, Euclid’s use of the Year 3 loss is limited to $520 million ($650,000,000 × 0.80). Euclid thus uses $520 million of the Year 3 loss and carries forward to Year 5 the remaining $480 million ($1,000,000,000 - $520,000,000) of it. Year 4 AFSI is $130 million ($650,000,000 - $520,000,000). pp. I:16-10 and I:16-11.

I:16-44 a.

b.

$33 million, determined as follows: 15% of adjusted financial statement income Regular tax (21% of taxable income) Book minimum tax (not less than zero)

$600,000,000 (567,000,000) $ 33,000,000

Zero, determined as follows: 15% of adjusted financial statement income Regular tax (21% of taxable income) Book minimum tax (not less than zero)

$615,000,000 (630,000,000) $ 0

c. $15 million. The $33 million book minimum tax for Year 1 is available as a minimum tax credit for Year 2. However, its use in Year 2 is limited to $15 million ($630 million regular tax exceeding $615 million (15% of AFSI)). Badger thus may claim a $15 million minimum tax credit for Year 2. d.

$18 million = $33,000,000 - $15,000,000.

pp. I:16-10 and I:16-11.

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I:16-45 a.

$103,500, computed as follows: Taxable income Adjustments: Plus: Dividends-received deduction Minus: Federal income taxes paid Dividends paid Accumulated earnings credit Accumulated taxable income

$150,000 85,000 ( 31,500) ( 20,000) ( 80,000)* $ 103,500

* The greater of: 1.

Remaining statutory exemption: $70,000 ($250,000 - $180,000) E&P at beginning of year, or

2.

Current earnings retained for business needs: $80,000 (reasonable needs of $260,000 at end of year - $180,000 accumulated E&P at the beginning of the year retained for reasonable needs).

b. $20,700. The accumulated earnings tax rate is 20%. Crane’s accumulated earnings tax liability is $20,700 ($103,500 x 0.20). c.

One option for Crane is to distribute cash to the shareholders, thus increasing the dividends-paid deduction. A second option is to identify additional reasonable business needs, thus increasing the accumulated earnings credit by justifying the retention of further current earnings. One needs to remember that payment of the accumulated earnings tax in one tax year does not provide protection against being cited for having an unreasonable earnings accumulation in a later year. pp. I:16-12 and I:16-13.

I:16-46 a.

Incorrect. Delta meets both tests to qualify as a personal holding company (PHC). It meets the stock ownership test because five or fewer individuals own more than 50% of its stock (i.e., three individuals own 100% of its stock). Delta meets the second test because more than 60% (i.e., 75%) of its adjusted ordinary gross income is PHC income. Although the payment of dividends reduces the PHC tax base, the 50% and 60% tests determine whether a corporation qualifies as PHC and thus is liable for the PHC tax. b.

$22,700, computed as follows:

Taxable income Adjustments: Plus: Dividends-received deduction Minus: Federal income tax liability ($50,000 x 0.21) Dividends-paid deduction Undistributed PHC income Times: PHC tax rate PHC tax Copyright © 2025 Pearson Education, Inc.

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$ 50,000 80,000 ( 10,500) ( 6,000) $113,500 x 0.20 $ 22,700

c.

Through (1) the payment of additional dividends to reduce or eliminate the $113,500 tax base, (2) failing to meet the stock ownership test by making changes in shareholder ownership amounts (for example, by selling stock to people unrelated to the three current shareholders), or (3) failing to meet the 60% of adjusted ordinary gross income test by reducing the amount of PHC income (e.g., dividends and interest), or by (4) reinvesting its earnings in operating assets producing nonpassive income. pp. I:16-14 and I:16-15.

I:16-47 First and Third Corporations. If all three corporations are tested together, they fail to be a brother-sister controlled group under the 80%-50% test because Cathy owns stock in only two of the corporations and the 80% common ownership requirement is failed.

Individuals

First

Second

Third

Identical Interest

Alfred Barbara Total

40% 30 70%

40% 60 100%

40% 30 70%

40% 30 70%

Although, the shareholders meet the 50% test, they fail the 80% test because together they do not own at least 80% of each and every one of the three corporations. As illustrated below, if First and Third Corporations are tested without Second Corporation, Cathy's ownership is included and First and Third are brother-sister corporations. Second Corporation, however, is not a member of the controlled group.

Individuals Alfred Barbara Cathy Total

First

Third

Identical Interest

40% 30 30 100%

40% 30 30 100%

40% 30 30 100%

p. I:16-16.

I:16-48 The transaction qualifies for Sec. 351 treatment because the property transferors own at least 80% of Giant’s stock immediately after the transaction (Jack, Karen, Latoya, and Marc own 100%). a.

Jack recognizes $20,000 of Sec. 1231 gain (the lesser of Jack’s realized gain of $40,000 [$100,000 FMV - $60,000 adjusted basis] or $20,000 FMV of boot securities received).

Jack’s basis in the Giant stock is $60,000 ($60,000 adjusted basis + $20,000 gain recognized - $20,000 of marketable securities). Jack’s basis in the marketable securities is $20,000, their FMV. Giant’s basis in the building is $80,000 (Jack’s $60,000 adjusted basis in the property + $20,000 gain recognized by Jack).

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b.

Karen recognizes none of her $20,000 realized loss [($80,000 FMV of stock + $20,000 FMV of note) - $120,000 basis of equipment] even though the 20-year note is treated as nonqualifying property (boot). Karen’s basis in the stock is $100,000 ($120,000 adjusted basis for equipment - $20,000 note received), and her basis in the note is $20,000. Giant’s basis in the equipment is its FMV of $100,000 (Sec. 362(e)(2)). c.

Latoya recognizes $20,000 of ordinary income [the lesser of her $30,000 realized gain ($100,000 FMV - $70,000 adjusted basis) or $20,000 boot received]. Latoya’s basis in the stock is $70,000 ($70,000 adjusted basis + $20,000 gain recognized - $20,000 boot received).

Latoya’s basis in the boot property is $20,000. Giant’s basis in the inventory is $90,000 (Latoya’s $70,000 adjusted basis in the property + $20,000 gain recognized by Latoya). d.

Marc recognizes no gain or loss due to Sec. 351. However, Sec. 357 triggers gain recognition since the assumption of a debt, the amount of which is in excess of his basis in the land is treated as boot property under Sec. 357(c)(3). Marc’s gain is $10,000 ($40,000 mortgage - $30,000 basis in the land). Marc’s basis in the stock is $0 ($30,000 adjusted basis - $40,000 mortgage assumed by the corporation + $10,000 gain recognized). Giant’s basis in the land is its $30,000 carryover basis plus the $10,000 recognized gain, or $40,000. e.

Giant Corporation recognizes a $5,000 ($20,000 - $15,000) gain under Secs.

311(b) and 351(f) from the distribution of appreciated marketable securities (boot property) to Jack. pp. I:16-18 through I:16-22.

I:16-49 a.

Basis = $35,000; gain recognized = $0 Because the transfer qualifies under Sec 351, the shareholders generally will not recognize gain or loss on the transaction. With the corporation assuming the liability, Linda’s basis is $35,000 ($45,000 adjusted basis - $10,000 liability assumed by the corporation). Because the liability is less than her basis, she does not need to recognize any gain on the transfer. b.

Basis = $32,000; gain recognized = $0 Because the transfer qualifies under Sec. 351, Cynthia will not need to recognize any gain or loss on the transaction, and her basis will $32,000 (the same as her basis in the land). pp. I:16-18 through I:16-22.

I:16-50 a.

A $200,000 gain ($800,000 liability assumed - $600,000 adjusted basis) under Sec. 357(c)(3). The character of the gain is determined by the nature of the asset and how it was used by the transferor. The gain is Sec. 1231 gain because the asset transferred was land used in Matt’s business. The gain would have been capital gain if the land was held by Matt as an investment. b.

Zero ($600,000 + $200,000 gain recognized - $800,000 liabilities transferred).

The liabilities assumed by the corporation exceeded the adjusted basis of the property transferred. c. $800,000 ($600,000 adjusted basis in transferor’s hands + $200,000 gain recognized). pp. I:16-18 through I:16-22.

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I:16-51 a.

$104,700, computed as follows:

Taxable income Difference between depreciation for regular taxable income and for E&P Dividends-received deduction Federal income tax liability Charitable contributions exceeding 10% limitation Current E&P

$ 30,000 30,000* 60,000 ( 6,300) ( 9,000) $104,700

*

$94,000 - $64,000. The $30,000 difference is added because depreciation for regular taxable income exceeds depreciation for E&P. b. $100,000. The distribution is deemed to be made first out of current E&P, and the $104,700 of current E&P is sufficient to cover all $100,000. The entire distribution thus is treated as a dividend. c. $295,300 deficit. The $4,700 ($104,700 – $100,000) of undistributed current E&P increases accumulated E&P at the end of the current year (i.e., from a $300,000 deficit to a $295,300 deficit). pp. I:16-22 through I:16-25.

I:16-52 a. $69,000 ($100,000 + $10,000 + $7,000 - $21,000 - $27,000). b. $269,000 ($69,000 current E&P + $200,000 accumulated E&P) is taxable as a dividend. $31,000 ($300,000 - $269,000) is a tax-free return of capital that reduces the shareholder’s stock basis. The top tax rate for qualifying dividend income is 20%. c. $0 ($200,000 accumulated E&P at the beginning of the current year minus $200,000 of the distribution that is deemed to be from accumulated E&P). pp. I:16-22 through I:16-25.

I:16-53 a. $15,200. The accumulated E&P of $40,000 and $24,800 of year-to-date current E&P deficit (124 days x $200/day E&P deficit) are netted on the distribution date. The $73,000 E&P deficit is allocated on a daily basis as $200 per day ($73,000 ÷ 365). The 124 days (from January 1 through May 4 in a non-leap year) are used to determine the $15,200 ($40,000 - $24,800) E&P available at the distribution date. b. $44,800 ($60,000 - $15,200) is a tax-free return of capital, reducing the stock basis to $280,200 ($325,000 - $44,800). c.

The accumulated E&P deficit is $48,200 ($40,000 – $15,200 – $73,000). pp. I:16-22 through I:16-25.

I:16-54 a. $50,000 for each. For Nancy, the amount distributed equals $50,000 [0.50 (percentage share of the property) x $100,000 (the FMV of the property)]. This amount is treated as a taxable dividend because the corporation has more than $100,000 of E&P. For Palm Corporation, the tax consequences are the same as for Nancy. Palm also is eligible for a dividends-received deduction of $32,500 (0.65 x $50,000) because Palm owns at least 20% (but less than 80%) of Old’s stock. b.

For each: $50,000 FMV of each shareholder’s interest in the land. c.

Old must recognize any realized gain because the appreciated property is treated as if the corporation sold the property to the shareholders immediately before its distribution Copyright © 2025 Pearson Education, Inc.

I:16-17

for its FMV (Sec. 311(b)). Thus, Old recognizes a $70,000 gain ($100,000 FMV - $30,000 adjusted basis). pp. I:16-25 and I:16-26.

I:16-55 a.

A $10,000 gain ($80,000 FMV - $70,000 adjusted basis) that increases taxable income and E&P. E&P is reduced by the federal income taxes imposed on the gain. b. $55,000 ($80,000 FMV - $25,000 liability). c.

The $80,000 FMV. pp. I:16-25 and I:16-26.

I:16-56 Galadriel Corporation’s pre-tax earnings are $500,000. The $100,000 salary is deductible by the corporation when calculating the corporation’s income tax liability. The salary is taxable as ordinary income to Galadriel. In a real-life situation for 2024, both the corporation and Galadriel would pay FICA taxes in the amount of 7.65% on the first $168,600 of earned income. The employer will also owe state employment taxes on a similar dollar amount. The employee would not be able to deduct the amount of the FICA taxes that she pays.

The corporation would be able to deduct the amount of the FICA taxes and state employment taxes that it pays as a business expense.

After considering the salary (but ignoring FICA and state unemployment taxes), Galadriel Corporation has taxable income calculated as follows: Pre-salary income $500,000 Less: Salary 100,000 Taxable income $400,000 Galadriel corporate income taxes due are $84,000. After-tax earnings, for the corporation are $316,000 ($400,000 taxable income minus $84,000 taxes). Using the assumption stated in the problem that this income is all taxed at the highest marginal tax rate for individuals, Gabby’s income tax on the salary is $37,000 ($100,000 x 37%) for a total income tax bill for Gabby and the corporation of $121,000.

Note that the real world addition of FICA and unemployment taxes on the salary option would add over $15,000 in taxes to this total tax bill.

If the $100,000 payment to Gabby is a dividend, Galadriel would be denied a deduction for the payment amount. No employment taxes would be owed on the dividend payment. With a dividend payment to Gabby, Federal corporate income taxes on the $500,000 taxable income are $105,000 ($500,000 x 21%). Galadriel’s after-tax earnings are $395,000 ($500,000 $105,000). Because the dividend is a qualifying dividend, Gabby pays taxes of $20,000 ($100,000 x 20%). Total income tax bill for Gabby and the corporation is $125,000. The reduction in tax rate on dividends has made the two alternatives much closer in total tax due.

Note that if Gabby is subject to the 3.8% net investment income tax, this total tax bill could be higher by up to $3,800. p. I:16-32.

I:16-57 a.

The $600,000 is treated as a dividend under Sec. 301 because the redemption does not qualify as a complete termination under Sec. 302(b)(3) nor a substantially disproportionate reduction of Jane’s interest under Sec. 302(b)(2). Before the redemption Jane owns 90 of the 100 shares (50 directly and 40 indirectly) or 90%. After the redemption Jane owns 50 of the 60 shares outstanding (10 directly and 40 indirectly) or 83.3%. To meet the substantially disproportionate test, Jane’s ownership interest needs to be reduced below 50% of the total combined voting power entitled to vote to meet the 50% test. Under the 80% test, the Copyright © 2025 Pearson Education, Inc.

I:16-18

ownership percentage must be reduced below 72% (0.80 x 90%). Jane meets neither the 50% nor 80% test needed to qualify for Sec. 302(b)(2) treatment. Jane’s redemption is not eligible for “not essentially equivalent to a dividend” treatment under Sec. 302(b)(1) since she is still the controlling shareholder in Private Corporation after the redemption. b. $250,000 ($50,000 + $200,000 basis of the redeemed stock). c.

The redemption would qualify for capital gain treatment under Sec. 302(b)(2).

Jane owned 50% (50 out of 100 shares) of the Private stock prior to the redemption. Jane owns 16.67% (10 out of 60 shares) of the Private stock following the redemption. Jane satisfies the Sec. 302(b)(2) substantially disproportionate redemption exception to the dividend income treatment since she owns less than 50% of Private’s stock following the redemption. In addition, her ownership interest after the redemption (16.67%) is less than 80% of her ownership interest prior to the redemption (50% x 80% = 40%). As a result, Jane recognizes a $400,000 ($600,000 distribution - $200,000 adjusted basis) long-term capital gain on the redemption. The basis of Jane’s remaining 10 shares is $50,000. pp. I:16-26 through I:16-28.

I:16-58 a.

Sam (Son) recognizes a capital gain of $70,000 ($100,000 - $30,000) because his interest is completely terminated under Sec. 302(b)(3) if a waiver agreement is filed with the IRS. Frank (Father) recognizes dividend income of $50,000 because his redemption fails the substantially disproportionate test. To qualify, the shareholder must own less than 80% of the former percentage interest in the voting stock. Before the distribution, Frank owned 70% (50% directly + 20% from Sam) of the common stock. After the distribution, Frank must own less than 56% (0.80 x 70%) to meet the 80% test and less than 50% to meet the 50% test. However, after the distribution, Frank owns 57.1% (40/70 remaining shares). He fails both the 50% and 80% tests. Frank’s redemption is not eligible for “not essentially equivalent to a dividend” treatment under Sec. 302(b)(1) since he still owns more than 50% of Prime’s stock following the redemption. b.

If Sam does not file an agreement with the IRS to waive the family attribution rules or if he violates the agreement during the 10-year post-redemption period, the distribution will be taxed as a $100,000 dividend. The $30,000 basis for Sam’s stock would be reallocated to Frank. pp. I:16-26 through I:16-28.

I:16-59 a.

Liquidating corporations must recognize gains and losses on sales or distributions of property. Queen Corporation recognizes $1 million ($3 million proceeds - $2 million basis) of gain from the sale of the fixed assets. Of the $1 million gain on the sale of fixed assets, $800,000 is ordinary income due to Sec. 1245 recapture, and the remaining $200,000 is Sec. 1231 gain. Queen also recognizes $1 million ($5 million proceeds - $4 million basis) of capital gain from the sale of the land. Queen must report the $400,000 ($1,000,000 proceeds - $600,000 basis) gross profit from the sale of the inventory to customers as ordinary income. All of the gain is taxed at a 21% rate. b.

Ahmed recognizes $800,000 ($1,200,000 - $400,000) of capital gain. The shareholder is deemed to have sold his stock to the corporation in exchange for money or other property. c.

Since all three assets have appreciated in value, the tax consequences of distributing the assets in liquidation to Ahmed would be no different than having Queen Corporation sell the assets directly to third parties. In each case, Sec. 336 requires Queen to recognize the gain realized on distributing the assets to Ahmed. Queen recognizes $400,000 of Copyright © 2025 Pearson Education, Inc.

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ordinary income when the inventory is distributed, $1 million of gain ($800,000 of Sec. 1245 gain and $200,000 of Sec. 1231 gain) when the depreciable fixed assets are distributed, and $1 million of capital gain when the land is distributed. Because of the loss disallowance rules found in Sec. 336, the results might be different to Queen if one or more properties had an unrealized loss at the time of the distribution to Ahmed. pp. I:16-29 through I:16-31.

I:16-60 a.

Zero. Union Corporation recognizes none of the $1.8 million ($2,500,000 FMV of assets -$700,000 basis) realized gain as a result of the liquidation per Sec. 332. b. $700,000. The basis of the subsidiary’s assets carries over to the corporation, and the adjusted basis of the parent’s interest in the subsidiary’s stock disappears. Tampa also assumes the $100,000 in liabilities. c.

Tampa Corporation inherits Union’s $125,000 E&P balance. In addition, Union’s depreciation recapture potential under Secs. 1245 and 1250 carries over to Tampa along with the assets. pp. I:16-29 through I:16-31.

Tax Strategy and Critical Thinking Problems I:16-61 Several strategies. The first issue you should explain to the couple is that there are various business forms that will limit the couple’s risk—these include limited liability companies (LLCs), limited partnerships, C corporations, and S corporations. The nontax advantages and disadvantages of each entity form should be discussed with the couple. After covering these items in detail, the couple should be told how the various entity forms are taxed—the flowthrough method for limited liability companies, limited partnerships, and S corporations. The two levels of taxation required with a C corporation should also be discussed. The tax rates should be discussed including the possibility that the corporate tax rate could be lower than the top individual tax rate that applies to LLCs, limited partnerships, and S corporations. Penny and Rick, however, may be taxed at a marginal personal tax rate that is less than the marginal corporate tax rate. The fact that there is a second layer of taxation for a C corporation will need to be considered in addition to the marginal corporate tax rate.

Second, you should cover the tax consequences of the business incurring losses, and that the LLC, limited partnership, and S corporation forms of doing business permit the losses to be passed through to the owners of the business. A C corporation, on the other hand, only can use the losses to offset profits earned by the corporate entity in subsequent years.

Third, you should discuss with the clients that the transaction cost of creating any of these entity alternatives to a proprietorship is not large. Because an LLC and limited partnership are taxed under the partnership taxation rules, the creation of an LLC and a limited partnership are tax-free under the Sec. 721 partnership taxation rules. Similarly, creation of a C or an S corporation is tax-free under the Sec. 351 corporate taxation rules.

Fourth, you should mention that liquidation of the two entity forms will be different.

Liquidation of a C corporation or an S corporation requires gains and losses to be recognized by the entity on the distribution of the entity’s assets to the shareholders. A second tax will be imposed on the gain realized by the shareholder(s) on receiving the assets. Generally, liquidation of a partnership is a tax-free event. The shareholders will take a carryover basis in the assets from the books of the partnership.

There is no one right answer in terms of selection of a business entity form. For example, if the owners want to use a flow-through business entity form, there are a series of alternatives— Copyright © 2025 Pearson Education, Inc.

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partnership, limited partnership, LLC, or S corporation—all with different advantages and disadvantages.

I:16-62 The following advice: Peter Martin appears to have set himself up pretty well for his retirement years in Florida. He is apparently worried about whether his pension plan from Martin Corporation will provide sufficient income for he and his wife to live comfortably. Peter would like to keep the Martin stock in the family because he is thinking about having Martin Corporation redeem their shares at some future date. Unfortunately, 75% of the Martin shares are owned by family members. The Sec. 318 attribution rules will pose a problem for making a stock redemption under Secs. 302(b)(1) or (2) that permits the couple’s basis in the stock to be recovered tax-free when less than 100% of their stock holdings are redeemed. Redemption of 100% of their stock holdings will not qualify for capital gains treatment under the Sec. 302(b)(3) complete termination rules; the family attribution rules cannot be waived because Peter will continue to serve on Martin’s board of directors. The Martins may want to consider selling their stock to other family members to produce capital gain treatment, or living off other assets that have been accumulated over the years and keep their entire Martin Corporation stock holdings.

Alternatively, Peter could no longer serve on the board of directors. This would allow the family attribution rules to be waived, thus qualifying the redemption as a complete termination of interest.

Depending on the age and health condition of the family members, Sec. 303 (redemption of stock to pay death taxes) may prove to be a valuable tax-planning device. Sec. 303 permits part or all of the Martin stock to be redeemed at capital gains rates following the death of either the husband or wife. Coupled with the step-up in basis that occurs at death, the capital gains tax incurred when a Sec. 303 stock redemption takes place may be small or nonexistent.

I:16-63 Alternative One: Sell the land to ABC. If Gertrude sells the land, she will recognize long-term capital gain of $1,490,000 and will pay income tax on the gain of $298,000 ($1,490,000 x 20% capital gains tax). ABC will then have a purchase price basis in the land of $1,500,000. ABC can expect the following income from the lot sales: Sales proceeds $ 3,000,000 Purchase price for land (1,500,000) Development costs (300,000) Sales commissions (5% of proceeds) (150,000) Taxable income $ 1,050,000 Tax (21%) $ 220,500 Total of Gertrude’s and ABC’s tax related to sales of this land: $518,500 ($298,000 + $220,500). Note that Gertrude’s tax will be due in the tax year in which the sale to ABC takes place, while the corporate income tax will come due over the time period when the lots are sold.

Alternative Two: Transfer the land to ABC in exchange for stock.

The transfer of land to Gertrude’s wholly owned corporation would qualify as tax free to both Gertrude and ABC Corporation under Sec. 351. The corporation takes a carryover basis in Copyright © 2025 Pearson Education, Inc.

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the land ($10,000) and Gertrude has a $10,000 basis in her new shares of ABC stock. Under this alternative, ABC would have the following income and tax expenses: Sales proceeds $3,000,000 Carryover basis for land (10,000) Development costs (300,000) Sales commissions (5% of proceeds) (150,000) Taxable income $2,540,000 Tax (21%) $ 533,400 This tax will be due over the time period when the lots are sold. It is possible that this tax bill could be spread over several years.

Note that under this alternative, Gertrude still has no cash from this transfer. If Gertrude wants cash, she would need to sell some of her ABC shares (and pay the 20% capital gains tax on her gain on the sale of shares) or take a dividend from ABC (with a 20% tax rate on qualifying dividends). Either of these alternatives makes the tax cost of this transaction even larger.

Tax Form/Return Preparation Problems I:16-64 (See Instructor’s Resource Manual) I:16-65 (See Instructor’s Resource Manual)

Case Study Problems I:16-66 The following points should be made in the memo for the clients: 1.

The transaction should qualify under Sec. 351 although the boot rules should result in some gain recognition by Paul, and the services rendered by Sam do not constitute Sec. 351 property. Sam will be treated as having received compensation (ordinary income) for his legal services. Although some stock is issued to Sam in exchange for services, and some property is received from Paul in exchange for boot property, the total amount of stock issued by the corporation for property is sufficient to permit the remainder of the transaction to be taxfree under Sec. 351.

2.

The recharacterization of debt to equity under Sec. 385 does not appear to be a problem because the total debt of $50,000 is small relative to the total capital of $300,000, and the debt will not be owned proportionately by the shareholders.

3.

Frank recognizes no gain or loss because he receives only FPS stock. His basis in the stock is $50,000, and FPS’s basis in the land and building is $50,000. His holding period in the stock carries over from the assets transferred. Frank’s holding period for the building and land carries over to the corporation.

4.

Paul’s realized and recognized gain on the transfer of inventory is $40,000 (the smaller of the $40,000 realized gain or the $50,000 boot) because FPS debt is not qualifying Copyright © 2025 Pearson Education, Inc.

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property and constitutes boot received. Paul’s basis in the FPS stock is $50,000 ($60,000 basis for the property + $40,000 recognized gain - $50,000 boot received) and is $50,000 for the notes.

FPS’s basis in the inventory is $100,000 ($60,000 carryover basis + $40,000 gain recognized by Paul).

5.

Sam does not recognize the $20,000 loss ($60,000 FMV stock - $80,000 basis) on the transfer of equipment due to the operation of Sec. 351. However, he must report $40,000 of compensation income for rendering services. Section 351 continues to apply to Sam’s asset transfer because the transfer of equipment for FPS stock is significant relative to the FMV of the services. Sam’s basis in the stock is $120,000 ($80,000 basis of equipment transferred + $40,000 FMV of compensatory stock) even though its FMV is only $100,000. FPS’s basis in the equipment is $60,000 (Sec. 362(e)(2)). FPS’s treatment of the $40,000 legal fees depends on the nature of the legal services (e.g., organizational expenditures, ordinary and necessary business expenses, part of an asset’s cost that is capitalized).

6.

The corporation recognizes no gain when issuing the stock for cash or noncash property. (Sec. 1032). pp. I:16-18 through I:16-22.

I:16-67 The memo to Beth should include the following points. The points contain references to IRC sections for reference purposes, but the memo to Beth should minimize such citations.

1.

The contribution of cash in exchange for stock will be a nontaxable transaction under Sec. 351. Also, the cash is not appreciated property, so it would not trigger gain in any case. The basis of the new stock will be $50,000. Finally, the corporation recognizes no gain or loss under Sec. 1032 when it issues stock for cash.

2.

The loan to the corporation is a nontaxable event for both Beth and the corporation, and Beth has a $50,000 basis in the debt instrument.

3.

A key issue is whether the loan will be reclassified as equity. To be treated as debt, the instrument must have the proper legal form, specifically, a stated reasonable interest rate, currently paid interest, a definite maturity date, and repayment when due. In addition, the debt-equity ratio must not be excessive, the debt should not be proportional to stock ownership, and the debt should not be convertible into stock.

4.

In this case, the debt cannot escape proportionality since Beth is the sole shareholder, which endangers its status as debt. However, the courts have deemed proportionality irrelevant for sole shareholders. See J.S. Biritz Construction Co. v. CIR, 20 AFTR 2d 68-5891, 68-1 USTC ¶ 9118 (8th Cir., 1968).

5.

Although debt is beneficial because interest payments are deductible (subject to limitations) while dividends are not, debt may not be the best choice in Beth's situation. To qualify as debt, the corporation must make regular interest payments, which may put a cash drain on the corporation. Thus, if the corporation needs its cash for expansion and operations, it may Copyright © 2025 Pearson Education, Inc.

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prefer equity because it can retain its earnings for business needs. The corporation does not have to pay dividends to avoid possible imposition of the accumulated earnings tax if it can show that it is not doing so for the purpose of avoiding income tax with respect to Beth (Sec. 532), such as by showing that it is retaining earnings for the reasonable needs of the business. On the other hand, if Beth wants the contribution returned to her in the near future, debt would be the better option because repayment would be a tax-free return of capital rather than a potential dividend involving the redemption of some of her stock holdings.

Tax Research Problems I:16-68 a.

b.

c. d.

The State of Florida permits four types of business forms to operate in Florida.

The business forms are: sole proprietorships, corporations, partnerships, and limited liability companies (LLCs).

Corporations, partnerships, and LLCs created or organized in Florida must register with the State of Florida. The appropriate state agency is the Florida Division of Corporations.

Corporations, partnerships, and LLCs that are created or organized outside of Florida, and operate inside of Florida, also must register with the State of Florida.

The State of Florida imposes a corporate income tax.

1. Corporations and other entities, including those located in other states that are partners in a partnership or members of a joint venture doing business in Florida must file Florida Form F-1120 (Corporate Income/Franchise and Emergency Excise Tax Return).

2. The Florida corporate income tax is calculated using the federal taxable income modified by certain Florida adjustments, to determine adjusted federal income.

I:16-69 Prior to the acquisition, Charlie and Delta Corporations filed separate income tax returns, on which each corporation reported its own income, deductions, and tax liability. After the acquisition, Charlie’s 100% ownership of Delta’s allows them to elect to file a consolidated tax return; the 80% minimum ownership requirement is satisfied.

Delta is a major supplier of raw materials and components used in Charlie’s production of plastic toys. Prior to the acquisition, Delta recognized in its separate tax return its profits from these sales to Charlie when they took place. After the acquisition (if a consolidated tax return is filed), recognition of Delta’s profits on these sales are deferred until Charlie sells the plastic toys containing those raw materials and components (i.e., until Charlie sells them to third parties that are not members of the affiliated group). Before electing to file a consolidated tax return, one should look at the value of the tax deferral on the intercompany profits and compare it with the increased cost of filing a consolidated tax return instead of separate tax returns. The CEO should be informed that, once a consolidated tax return election is made, the corporations generally cannot later switch back to filing separate tax returns (e.g., if the cost of complying with the consolidated return rules is greater than expected). In addition, a similar comparison needs to be made with respect to the state corporation rules for each state in which the company operates or plans to operate.

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I:16-70 Arguably yes. Section 302(b)(3) grants exchange treatment to a shareholder of a corporation when he has a complete termination of his interest. Section 302(c)(2) states that the attribution rules of Sec. 318(a)(1) shall not apply if, after the distribution, the distributee has no interest in the corporation “including an interest as an officer, director, or employee.” The only interest the distributee may have is that of a creditor. In William M. Lynch [83 T.C. 597 (1984)], the Tax Court held that the redemption of the shareholder’s stock constitutes a complete redemption of his interest under Section 302(b)(3). The specific facts of the Lynch case closely parallel the facts in the research problem.

In the Lynch case, the taxpayer originally was a sole shareholder of a corporation.

Later, he transferred some of his stock to his son, and thereafter the corporation redeemed the balance of his stock. After the redemption, the shareholder, Lynch, performed some services for the corporation pursuant to a consulting agreement. The shareholder was compensated under the consulting agreement.

In the Lynch case, the Tax Court concluded that tax avoidance was not a principal purpose for the transfer of the stock to his son within the meaning of Sec. 302(c)(2)(B). The Court held that the petitioner did not hold a financial stake in the corporation after the redemption. “The payments which the petitioner received pursuant to the consulting agreement were in no sense contingent on the profitability or the future operations of the corporation.”

However, the Lynch case was reversed upon appeal by the U.S. Court of Appeals. See William M. Lynch v. CIR, 58 AFTR2d 86-5970, 86-2 USTC ¶ 9731 (CA-9, 1986). The Court of Appeals found that the taxpayer had failed to sever all noncreditor interests in the corporation.

He had an office in the corporation and was covered by medical insurance in addition to acting as an independent contractor for the corporation. By providing these services, he held a prohibited interest, and the family attribution rules of Sec. 318 were held to apply. The taxpayer was disqualified for a complete termination under IRC Sec. 302(b)(3), and the redemption was treated as a dividend.

Ted cannot hope to avoid the tax problem by claiming that the three-year limitations period has expired. Sec. 302(c)(2) extends the limitations period to ten years starting with the date of the redemption distribution.

The consulting agreement in the case study is different from the one used in Lynch.

The consulting agreement found in this research question specifies a $175 hourly rate and reimbursement for expenses. No guaranteed number of hours of work is mentioned in the agreement. In addition, unlike the Lynch case, office space is not being made available to Ted during time periods when consulting services are not being provided.

Ted’s scenario appears to be different from the Lynch case in a number of ways. These differences should permit a tax practitioner to develop a stronger case for qualifying under Sec. 302(b)(3). Ted’s situation is more like the facts in the Estate of Milton S. Lennard v. CIR case (61 T.C. 554 [1974]). In Lennard, the taxpayer’s interest was completely terminated following the redemption of all of his stock under Sec. 302(b)(3). Similar to Lynch, Ted performed services for his former employer following his retirement. Unlike Lynch, Ted is serving in the Copyright © 2025 Pearson Education, Inc.

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traditional role of an independent contractor. Being an independent contractor leaves Ted with only a creditor interest in the corporation. In addition, no mention is made of Ted receiving a pension from his former employer. The lack of a pension being paid to Ted is a positive factor towards Ted terminating his interest.

The facts in our scenario appear to be more closely aligned to the Lennard case than the Lynch case. These differences should make it easier to show that Ted should be taxed on his profit at capital gains rates under the Sec. 302(b)(3) “safe haven” and not be required to recognize dividend income under Sec. 301.

One thing that is not mentioned in the facts of the case is the number of hours that Ted will be working for his former employer. If Ted performed substantial duties that required fulltime (or close to full-time) employment as a consultant by his former employer, then the IRS would have the possibility of saying that the original relationship between employer and employee-shareholder Ted had not in fact changed.

If your client is entertaining the possibility of engaging in a similar type of transaction, he or she should examine the cases that have been decided in the taxpayer’s favor in similar types of Sec. 302(b)(3) transactions to see what makes them different from the Lynch case.

I:16-71 Yes. A contribution to capital qualifies for nontaxable treatment under IRC Sec. 351 even though the corporation does not issue additional stock. Sol Lessinger v. CIR, 63 AFTR 2d 89-1055, 89-1 USTC ¶9254 (2nd Cir., 1989) held that additional stock issued to a sole shareholder would be a “meaningless gesture.” If Beth made a contribution to capital, the basis of her existing stock would increase by $50,000. In addition, the corporation would recognize no gain or income from the contribution under Sec. 118.

However, various authorities [See Sec. 1244(d)(1)(B), Reg. Secs. 1.1244(c)-1(b) and 1.1244(d)-2(a), and James D. Pierce, 1989 PH T.C. Memo ¶89,647, 58 TCM 865] hold that an increase in basis resulting from a contribution to capital will not be treated as part of the basis when determining the amount of the Sec. 1244 stock loss. Section 1244 treatment is important because Beth would be allowed an ordinary loss if the stock became worthless. Without Sec. 1244 treatment for the capital contribution, upon worthlessness she would incur a $40,000 ordinary loss (her original basis) and a $50,000 capital loss. The capital loss would be deductible only to the extent of capital gains recognized in a tax year plus $3,000. On the other hand, if the corporation issues stock to Beth in exchange for the $50,000, the stock will qualify as Sec. 1244 stock, thereby allowing her a $90,000 ordinary loss if the stock becomes worthless. The limitation on ordinary loss treatment is $100,000 for a married taxpayer filing a joint tax return.

Thus, to maximize her Sec. 1244 stock benefits, Beth should have the corporation issue additional shares in exchange for the $50,000.

I:16-72 The following advice: Under the general rules of Sec. 1001(a), Peter will realize and recognize a gain equal to the difference between his sales proceeds and the basis of the shares that he sells. If he sells all of his shares, $300,000 of gain will be recognized. In general, this gain is taxed as a long-term capital gain under Sec. 1201(a). Such capital gain ordinarily will be taxed at a maximum rate of 20% (Sec. 1(h)). There are three exceptions to this general rule.

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• IRC Sec. 1202(a) permits 100% of the gain realized from the sale or exchange of qualified small business stock held for more than five years to be excluded from taxation (if such stock was acquired after September 27, 2010). Peter does not meet the requirement of having held the stock for more than five years. Able Corporation satisfies the requirements of being a C corporation, and maintaining an active business. Peter’s profit will not exceed the $10 million ceiling on excludable gain.

• IRC Sec. 1045 permits a rollover of gain realized from a qualified small business stock sale to another qualified small business stock investment. A qualified small business stock is defined in Sec. 1202(a). The stock that is sold must have been held for more than six months, and the stock that is purchased must have been acquired within 60 days of the sale date. The realized gain that goes unrecognized reduces the basis of the newly purchased stock.

The three alternatives give Peter an opportunity to exempt from current taxation part or all of the currently realized gain. Two of the three alternatives (Secs. 1044 and 1045) require reinvestment of the sales proceeds. The third alternative (Sec. 1202) exempts the gain from current taxation even though no reinvestment takes place. The choice of which alternative to use is up to the investor, and the decision-making should involve the investor’s need for current cash as well as an examination of the remainder of Peter’s stock portfolio. If Peter is to use the first alternative, he must hold the stock longer.

I:16-73 As a sale of capital asset, because the transaction qualifies as a complete termination of Erin’s interest. The easy part of this problem is the analysis of the sale to Evan and the two employees. The gain on the sale of this 10% of her stock is $245,000 ($250,000 - $5,000 basis in 10% of the stock).

The more difficult analysis is the determination of the tax result on the redemption of 90% of her shares. This transaction cannot qualify as a substantially disproportionate redemption of stock under Sec. 302(b)(2) since she still owns 60% indirectly through her son Evan. To qualify as a sale, she needs to meet the requirements of Sec. 302(b)(3) minus a complete termination of her interest. She qualifies for a complete termination only if the constructive ownership rules can be waived under Sec. 302(c). According to that IRC section, the constructive ownership rules can be waived if, among other things, the distributee (Erin) has no interest in the corporation other than an interest as a creditor. (Section 302(c)(2)(A)(i)). Reg. Sec. 1.302-4(d) outlines relationships that are not acceptable for a creditor such as having the interest rate dependent on earnings. None of these appear to be a problem for this debt.

The only remaining issue appears to be whether the status as landlord will be a problem.

In Rev. Rul. 77-467, the service held that an arm’s length lease between a corporation and the redeemed shareholder does not prevent the transaction being treated as a redemption.

In spite of the straightforward look of this research problem, a Tax Court decision suggests that the IRS was trying to cloud this issue (thankfully, with no success). In the Hurst case, the IRS maintained that having several relationships with the firm – each relationship one that has been found to be acceptable – could be found to be too much together. In this case decided by the Tax Court, the taxpayer received notes for his redeemed shares, was the landlord for the corporation, and had a spouse who continued to work for the corporation as an employee.

The IRS contended that the totality of the circumstances gave the taxpayer a financial stake in the corporation. The Tax Court rejected this argument and held that the redemption qualified as a complete termination.

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What Would You Do In This Situation? Solution Ch. I:16, p. I:16-13. a.

The accumulated earnings tax is not a self-assessed tax. (See Pearson’s Federal Taxation: Corporation, Partnerships, Estates & Trusts, 2025 Edition, Chapter C:5.) The IRS has the responsibility to audit the taxpayer’s return and to allege that the company is subject to the accumulated earnings tax if warranted by the facts. In this case, although the making of loans to the shareholders is not a reasonable business need for the retention of earnings and the nonpayment of dividends to the shareholders is a potential indicator that an accumulated earnings problem exists, the fact that the corporation has reinvested its earnings in operating assets (with the possible exception of the marketable securities) is a very positive indicator that the earnings have been reinvested in reasonable business needs. In this situation, the failure to inform the IRS of the potential problem or to pay the tax is not an error, and the CPA has no responsibility to inform the IRS or to instruct the client to do so. (See AICPA Statement on Standards for Tax Services No. 1.)

The CPA should inform the client of the potential problem and offer advice so as to prevent the problem from occurring in the future. Some thought should be given to annually documenting the firm’s business needs for the retention of earnings.

Scott, Steve, and Sean should be advised to consider making an S corporation election.

There may be an income tax savings to have the corporation’s income divided up among the three individuals and taxed on their personal income tax returns. We do not have enough information to compare the corporation’s tax liability when operating as a C corporation versus its tax liability as an S corporation. In addition, the three individuals might obtain a second tax savings by avoiding the double taxation that is encountered when a C corporation’s earnings are distributed to the shareholders as a dividend. Operating as an S corporation can eliminate exposure to accumulated earnings tax problems that the firm may be facing in the future. The S corporation election cannot eliminate possible problems that the firm may encounter when the IRS examines the firm’s pre-S corporation election tax years. b.

The personal holding company (PHC) tax status is based on a mechanical formula. Once the PHC tests are met, the tax is self-assessed, and a Schedule PH should be filed with Form 1120 in the year the determination is made. Any penalty tax due should be paid upon the filing of the corporate income tax return. Interest and penalties on the PHC tax will be owed from the due date of the income tax return until the tax is paid. Failure to file the Schedule PH will extend the statute of limitations for a PHC from the normal three-year period to six years even if the corporation owes no additional taxes [Reg. Sec. 301. 6501(f)-1]. The three owners may want to determine whether the PHC penalty tax problem is a short-run (oneyear) phenomenon or represents a long-term multi-year problem. If it is a long-term problem, the owners may want to consider making an S corporation election. Again, like with the accumulated earnings tax, earnings from S corporation tax years are passed through to the owners and no PHC tax can be imposed.

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Chapter I:17 Partnerships and S Corporations Discussion Questions I:17-1 a.

A partnership is not a taxable entity because income, deductions, losses, and credits pass through to the individual partners who, in turn, report these amounts on their tax returns. In other words, the partnership files only an information return on Form 1065, which summarizes certain financial information such as partnership ordinary income or loss and separately stated income, deduction, loss, and credit items that pass through to the partners. An S corporation may be subject to the built-in gains tax and a tax on excess net passive income.

Otherwise, an S corporation is treated similar to a partnership and is not subject to tax, although it must file a tax return. A C corporation pays a separate tax at the corporate level on its taxable income. Corporate income is taxed again at the shareholder level when the corporation distributes earnings to shareholders as dividends, when the shareholders sell or redeem their stock, or when the corporation liquidates. Partners and S corporation shareholders may qualify for the business income deduction while C corporation shareholders are not eligible for this deduction. b.

In a partnership and an S corporation, distributions to the owners generally are not taxable because owners are taxed as the partnership or the S corporation earns the income.

Distributions reduce the owner’s basis for their S corporation stock or partnership interest. In a C corporation, income is taxed first at the corporate level and, if distributed to the shareholders as a dividend, is taxed a second time at the shareholder level. c.

A partnership and an S corporation generally are not treated as a separate tax entity. Instead, they are conduits through which income, deductions, losses, and credits pass to the owners’ tax returns. A C corporation is treated as a separate taxable entity and not as a conduit for its shareholders. d.

The tax law imposes no limits to the number or types of entities that can own interests in a partnership or stock in a C corporation. However, S corporation shareholders only can be individuals who are U.S. citizens or residents, certain trusts, estates, and qualifying tax exempt organizations, and the number of shareholders is limited to 100. This rule is much less restrictive than in the past because members of a family are now counted as a single shareholder for purposes of the 100 shareholder limit. pp. I:17-2 through I:17-4, I:17-12, and I:17-13.

I:17-2 a.

The default classification for a corporation is taxation as a C corporation. The corporation can elect (and its shareholders can consent) to an S election and be treated as a passthrough entity. b.

General and limited partnerships are treated as partnerships under the default classification in the check-the-box regulations. A partnership files an information return (Form 1065) annually showing the results of the partnership’s operations for the tax year. The income on the Form 1065 is allocated to the partners via Schedule K-1 and reported on their federal income tax returns. A partnership can elect to be taxed as a C corporation or an S corporation under the check-the-box regulations.

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c.

The default classification for a limited liability company (LLC) is treatment as a partnership if it has two or more owners. If the LLC has only one owner, it is a disregarded entity treated as a sole proprietorship. The LLC can elect to be taxed as a C corporation or an S corporation. d.

The default classification for a limited liability partnership (LLP) is treatment as a partnership. The LLP can elect to be taxed as a C corporation or an S corporation. pp. I:17-2 through I:17-4.

I:17-3 If the partnership elects to be taxed as a C corporation, Anya cannot use the NOLs created in the first five years of operation because losses do not pass through from a C corporation to its owners as they do in a partnership or S corporation. Instead, the corporate NOLs carry over to offset any future corporate profits. The decision to be taxed as a C corporation may not be a good idea if the owners want the losses to pass through to their individual tax returns. However, treating the entity as a partnership or S corporation still may cause loss deductions for the owners to be restricted by the at-risk, passive activity loss rules (see Chapter I:8), and/or the limitation on excess business losses. Once the partnership becomes profitable, it can incorporate tax-free under Sec. 351 and take advantage of sheltering its income by retaining C corporation status. If an S corporation, it can revoke the S election once it becomes profitable. However, in doing so, Anya would no longer be eligible for the qualified business income deduction. pp. I:17-2 through I:17-4 and I:17-12 through I:17-16.

I:17-4 a.

Paula recognizes no gain. According to Sec. 721, no gain or loss is recognized on the transfer of property in exchange for a partnership interest. b.

Paula recognizes a $10,000 loss. The transaction is treated as a sale of property because she did not receive a partnership interest. Instead, she received a partnership note and retains the status of a partnership creditor. The loss may be disallowed under the Sec. 707(b)(1) related party rules if Paula owns (directly or indirectly) more than a 50% interest in the partnership. pp. I:17-4 and I:17-5, I:17-15, and I:17-16.

I:17-5 Penny’s beginning basis in her partnership interest is $50,000, and the partnership’s basis in the machine is $50,000.

Penny’s holding period for the partnership interest and the partnership’s holding period for the machine includes Penny’s holding period for the machine.

Section 722 holds that, if no gain is recognized under Sec. 721, the basis of a partnership interest is equal to the adjusted basis of the property transferred to the partnership. This rule, which eliminates paying taxes on a realized gain, enables taxpayers to contribute appreciated property for partnership interests without having to experience liquidity problems. Without this rule, taxpayers might have difficulty forming a partnership because the partners would be forced to pay taxes on contributions of appreciated property. Also, the transaction represents a mere change in the form of doing business. The nontaxable treatment under the partnership formation rules parallel the corporate formation rules. Section 723 provides that the partnership’s basis in contributed property is the same as the transferor partner’s basis before the transfer. pp. I:17-4 through I:17-7.

I:17-6 The two sets of rules are similar. The corporate formation rules of Sec. 351 and the partnership formation rules of Sec. 721 both provide for nontaxable transfers of property to the entity in exchange for an ownership interest. All partnership formation transactions receive Copyright © 2025 Pearson Education, Inc.

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nontaxable treatment under Secs. 721-723. The Sec. 351 corporate formation rules apply to the initial formation of the corporation as well as the entry of new shareholders. The new shareholder(s), however, must hold an 80% interest in the corporation to qualify for nontaxable treatment. No percentage ownership requirement is required for the nontaxable creation of a new partnership, or the addition of a new partner to a partnership. In both cases, the formation transactions are nontaxable and the entity takes a carryover basis in the assets. The receipt of boot property (for example, cash) by a shareholder of a new corporation generally is taxable. A similar situation involving a new partner generally does not trigger taxation for the new partner unless the cash received exceeds the partner’s basis in the partnership interest. pp. I:16-17 through I:16-21 and I:17-4 through I:17-7.

I:17-7 a. $45,000 net increase. Under Sec. 752, the excess of the decrease in a contributing partner’s liabilities assumed by the partnership over the partner’s share of partnership liabilities is treated as a distribution of money by the partnership to the contributing partner. As a result, the contributing partner’s (Mario’s) basis decreases by $25,000 [$50,000 decrease in individual liabilities - (0.50 x $50,000) Mario’s share of the $50,000 in partnership’s liabilities]. Mario’s basis also increases by the $70,000 basis of the property he contributed. The $100,000 FMV of the building does not affect the partner’s or partnership’s basis calculation. b. $25,000 increase. Mario’s share of increased partnership liabilities is treated as a contribution of money. Therefore, Mario’s basis increases by his 50% interest in the partnership multiplied by the $50,000 increase in accounts payable, or $25,000. c. $20,000 decrease. Mario’s share of decreased partnership liabilities is treated as a distribution of money. Therefore, Mario’s basis decreases by his 50% interest in the partnership multiplied by the $40,000 decrease in notes payable, or $20,000. d. $10,000 decrease. The $10,000 distribution is not taxable to Mario. The distribution reduces Mario’s basis in his partnership by $10,000. Assuming Mario’s partner has made similar transactions involving the partnership during the years, the distribution also reduces by $10,000 that partner’s basis in the partnership interest. pp. I:17-4 through I:17-7.

I:17-8 No gain or loss recognized; partnership’s basis = $125,000; Sally’s basis = $160,000.

Neither Sally nor the partnership recognize gain or loss on the transfer of the farm machinery to the partnership. The partnership’s basis in the farm machinery is $125,000. The partnership’s holding period for the farm machinery includes Sally’s holding period for the property. Sally’s basis in her partnership interest is $160,000 ($125,000 basis of machinery - $37,500 deemed cash distribution for liabilities (note) transferred by Sally and allocated to the other partners + $72,500 Sally’s 25% share of partnership liabilities other than the note she transferred to the partnership).

A taxable transaction. If Sally made an asset contribution to an existing corporation, the transaction would be taxable because Sally did not own sufficient stock (80% or more) to qualify for a nontaxable transaction under Sec. 351. Sally would recognize the appreciation as gain at the time she contributed the property to the corporation. Recognition of gain could be avoided if part or all of the other shareholders made additional capital contributions at the same time as Sally’s contribution. Section 351 requires that capital contributions be made by Sally and other shareholders who in total own 80% or more of the voting power of the corporation to avoid gain recognition on the asset transfer(s). pp. I:16-17 through I:16-21 and I:17-4 through I:17-7.

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I:17-9 No gain or loss recognized; Sally’s stock basis = $ 75,000. The owners recognize no gain or loss on the contribution of the property to the new S corporation because the rules of Sec. 351 and related IRC sections apply. Sally’s basis in her S corporation stock is $75,000 ($125,000 property contribution minus the $50,000 liability assumed by the corporation). Note that Sally’s basis in S corporation stock does not include any share of the corporation’s liabilities. pp. I:1717 through I:17-21.

I:17-10 Potentially taxable in both partnership and C corporation situations. If the deemed distribution from the liability assumption by the partnership exceeds the partner’s basis in the partnership interest, the partner recognizes gain for the excess amount as if the partnership distributed actual money to the partner. The deemed distribution is the amount of the partner’s liability assumed by the partnership reduced by the partner’s share of all partnership liabilities.

Further, the partner recognizes gain only to the extent that this deemed distribution exceeds the partner’s entire basis in the partnership interest immediately before the distribution. If the contribution instead is made to a corporation, the nonrecognition of gain or loss rules of Sec. 351 generally permits any realized gain to be deferred. However, a shareholder in a C corporation recognizes gain under Sec. 357(c) equal to the excess of the liabilities assumed or acquired by the corporation over the contributed property’s adjusted basis. pp. I:16-19 through I:16-21, I:175, and I:17-6.

I:17-11 Misallocation of future gains and losses. If the partners were not required to make special allocations for precontribution gains and losses attributable to noncash properties contributed to the partnership, inequities would result when the partnership later sells the property. For example, the contributing partner would shift part of the tax burden to other partners for any gain on the property that accrued to him or her prior to transferring the property to the partnership. Because the partner recognized no gain on the initial transfer, the contributing partner must report gain on appreciation that accrued while the asset was in his or her hands prior to transferring it to the partnership. The gain or loss recognized due to the property’s appreciation while in the hands of the partnership is allocated to the partners according to their profit and loss ratios. pp. I:17-8 through I:17-10.

I:17-12 Item

a. b. c. d. e. f. g. h.

Basis Increases

Ordinary income Ordinary loss Tax-exempt income Capital loss Capital gains Charitable contribution Distribution of cash to the partners Distribution of noncash property to the partners

X X X X X

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Basis Decreases

X X X

Basis Not Affected

i.

Guaranteed payments

X*

*Technically, the partner’s basis increases by the income recognized from the guaranteed payment and decreases by the payment of the same amount. Thus, the net effect on the partner’s basis is zero. p. I:17-11.

I:17-13 a. $20,000. In the current year, Phyllis may deduct only $20,000 of the loss per Sec. 704(d). Phyllis’s share of the loss is $30,000 (0.30 x $100,000). However, Phyllis’s deductible loss in the current year is limited to her $20,000 basis in the partnership interest.

Phyllis would not be subject to the limitation on excess businesses losses because the loss is below the $259,000 threshold (assuming she is single). b.

Zero. Phyllis’s basis in her partnership interest is zero at the end of the current year. c.

It carries over. Unused losses and deductions carry over indefinitely and are allowed in subsequent years when the partner again has a positive basis in her partnership interest. Thus, $10,000 carries over to subsequent years. d.

Increase her basis in the partnership interest. Phyllis could make an additional capital contribution of $10,000 to the partnership before the end of the tax year. Alternatively, Phyllis could cause the PQR Partnership to borrow additional amounts from a bank or a thirdparty lender such that her share of the additional borrowing would be at least $10,000. If the additional borrowing increases the basis of her partnership interest to $30,000 or more, the basis increase permits the entire loss to be used in the current year. Phyllis needs to be certain that her tax loss will be more valuable in the current year than in a future year (or vice versa) by examining her marginal tax rates in current and future years. p. I:17-14.

I:17-14 a.

Loss recognized. Ralph recognizes the loss because he owns (directly or indirectly) a 50% or smaller interest in the partnership. Under Sec. 267(b), Ralph is deemed to own his 20% interest plus his son’s 20% interest, for a total of 40%. b.

Loss not recognized. Ralph may not recognize the loss because he owns 70% (his 35% interest plus his daughter’s 35% interest) after applying the constructive ownership rules of Sec. 267(b). c.

Loss not recognized. Ralph may not recognize the loss because he owns 70% (his 35% interest plus his corporation’s 35% interest) after applying the constructive ownership rules of Sec. 267(b). pp. I:17-15 and I:17-16.

I:17-15 a. $2,000 LTCG. Jose recognizes a $2,000 ($3,000 FMV - $1,000 basis) long-term capital gain because he held the stock as an investment for more than one year. The gain is not treated as ordinary income because the partnership held the stock as a capital asset. b. $15,000 ordinary income. Jose recognizes $15,000 ($25,000 FMV - $10,000 basis) of ordinary income because Jose owns more than a 50% interest in the partnership and because the partnership uses the land in its trade or business (a Sec. 1231 asset). If instead the partnership holds the land as an investment, Jose’s gain is capital because the asset is a capital asset in the hands of the transferee.

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c.

Loss not recognized. The partnership does not recognize the $40,000 ($100,000 $60,000) loss because Jose owns more than a 50% interest in the partnership. pp. I:17-15 and I:1716.

I:17-16 $37,000 to Marsha and $31,500 each to Niles and Oprah. Partnership ordinary income after deducting the guaranteed payment is $90,000 ($100,000 - $10,000). Marsha’s share of partnership ordinary income is $27,000 ($90,000 x 30%). This amount plus her $10,000 guaranteed payment totals $37,000. Niles and Oprah each report a $31,500 ($90,000 x 35%) share of partnership ordinary income. In addition, the partners would be eligible for the 20% qualified business income deduction on their ordinary business income. For Marsha, the basis for the deduction would be $27,000, exclusive of her guaranteed payment. p. I:17-16.

I:17-17 As separately stated pass-through items. The partnership is not a taxable entity. Thus, as a pass-through entity, partnership income and losses are divided by to the two partners according to the partnership agreement. The partnership will report the income to the two partners but will not be taxed on the income it earns. Sandy and Jack each will include one-half the $125,000 profit from operations, and one-half the $25,000 interest from the corporate bonds in his or her gross income. In addition, they can claim the 20% qualified business income deduction for their shares of operational profits. The municipal bond interest is exempt from taxation and will not be reported by either partner. In addition, each partner reports one-half the $20,000 long-term capital loss from the stock sale. The loss can be used to the extent each partner reports capital gains from the partnership or other activities. Any loss that exceeds an individual partner’s capital gains can be deducted by the partner on his or her personal tax return up to a $3,000 maximum. pp. I:17-8, I:17-9, I:17-12, and I:17-13.

I:17-18 Generally, neither the partner nor the partnership recognize gain or loss if the partnership distributes money or other property to the partner. The distribution is treated as a nontaxable return of capital or, in other words, as a reduction in the partner’s basis in his or her partnership interest. However, an exception applies if the amount of money or a partner’s release from a liability, which is treated as a money distribution, plus the adjusted fair market value of marketable securities exceeds the partner’s basis for his or her partnership interest. In this case, the partner recognizes gain to the extent the money distribution exceeds the partner’s basis in his or her partnership interest. If the partnership distributes to the partner property other than money, the basis of the partnership interest is reduced by the adjusted basis of the distributed property. If the partnership distributes both money and property, the money distribution applies initially as a reduction in the basis of the partnership interest before any basis adjustment for the property distribution. Also, partners recognize no losses on nonliquidating distributions. pp.

I:17-16 and I:17-17.

I:17-19 Liability relief is treated as money received. Section 741 provides that gain or loss is measured by the difference between the amount realized and the selling partner’s adjusted basis in the partnership interest. The amount realized includes the selling partner’s share of partnership liabilities from which he or she is released as a result of the sale. The selling partner no longer is responsible for repaying any partnership liabilities. Thus, the release from his or her share of partnership liabilities is a benefit to the selling partner and is included in the amount realized. pp. I:17-17 through I:17-19.

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I:17-20 Ordinary income. If a partnership has unrealized receivables or inventory items at the time partner sells a partnership interest, the selling partner recognizes ordinary income to the extent the gain is attributable to that partner’s share of the Sec. 751 assets. This rule prevents a partner from converting ordinary income into a capital gain through the sale of a partnership interest. The partner is treated as though he or she sold the underlying assets. pp. I:17-17 through I:17-19.

I:17-21 Congress enacted the qualified business income deduction to give pass-through entity owners a tax rate somewhat comparable to the 21% corporate tax rate. Thus, Congress did not want to give a tax break to C corporations while not giving a tax break to businesses operating in a pass-through form. pp. I:17-12 and I:17-13.

I:17-22 To be subject to the limitation on excess business losses, the losses would have to exceed the threshold amounts ($305,000 for single taxpayers or $610,000 for married taxpayers filing jointly). A small business likely would not generate losses that exceed these thresholds. pp. I:17-14 and I:17-15.

I:17-23 One level of taxation. The primary advantage of using an S corporation is its single level of taxation. The S corporation’s earnings are taxed to its shareholders based on the number of shares of stock they own. In addition, the shareholders might be eligible for the 20% qualified business income deduction. Similarly, losses incurred by the S corporation pass through to its shareholders. However, if large enough, these losses might be subject to the limitation on excess business losses. A shareholder’s stock basis increases for his or her share of earnings retained in the business and decreases by losses and distributions passed through to the shareholder.

The single level of taxation can be compared with a C corporation where earnings are taxed to the corporation when earned and to the shareholders when the corporation distributes them as a dividend or when shareholders sell their stock. However, the corporate tax rate is fairly low at 21%, and dividends are taxed at the preferential tax rate for long-term capital gains.

Therefore, the C corporation form is not as onerous as it was when the corporate tax rate was much higher (34% or 35%). Losses incurred by an S corporation are deductible by the S corporation’s shareholders to the extent they have basis in their stock. Distributions made by an S corporation are nontaxable to the shareholders and reduce the shareholders basis in their stock.

A business also could consider operating as a limited liability company (LLC). This form of business offers the pass-through and limited liability advantages of an S corporation while adding the flexibility of being treated as a partnership under the tax law. pp. I:17-3, I:1712, and I:17-13.

I:17-24 Termination of election. If one requirement is not met for a small business corporation at some point in a tax year, the election may terminate on the day preceding the date of the disqualifying event and for subsequent tax years. The IRS may waive the disqualification if the corporation can show that it was an inadvertent termination. The S corporation can reapply for a new S election if its election terminates. However, a five-year waiting period is usually required.

The waiting period also can be waived with IRS permission. pp. I:17-24 and I:17-25.

I:17-25 Yes, if not qualifying as straight debt. The S corporation rules contain a “safe harbor” rule, which provides that straight debt will not be treated as a second class of stock. To qualify Copyright © 2025 Pearson Education, Inc.

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as straight debt, the interest rate cannot be contingent on profits, the debt cannot be convertible into stock, and the creditor must be a person otherwise eligible to be an S corporation shareholder or a person actively and regularly engaged in the business of lending money. Debt that does not satisfy the safe harbor requirements might be reclassified as stock. “Interest” paid with respect to such debt would not be deductible by the S corporation. p. I:17-23.

I:17-26 All shareholders must consent. Both Andrew and Angela, as well as all other shareholders, must consent to the S corporation election on Form 2553. Persons who were shareholders during any part of the tax year in which the corporation makes the election must consent to the election even though they are not shareholders on the election date. All shareholders during the year are affected by the election. For example, a ratable share of items relating to the early part of the year will pass through to Andrew even though he sells his Ajax shares before the corporation makes the S election. Thus, fairness dictates that all shareholders consent to making the S election. The March 15 S election is valid and is retroactive to the beginning of the tax year (January 1 in the case of a calendar year taxpayer). Andrew receives an allocation of Ajax Corporation income from January 1 through March 1 (the shareholder who disposes of S corporation stock is the shareholder of record for the day of disposition). Angela receives an allocation of Ajax income from March 2 through December 31. p. I:17-23.

I:17-27 More than 50%. Voluntary revocation is permitted if shareholders who own more than 50% of the corporation’s stock consent to the revocation. A revocation is effective for the entire tax year if the corporation files a statement on or before the fifteenth day of the third month of the tax year. If the corporation files the revocation after this date, the effective date is the first day of the next tax year. An exception applies if the corporation specifies a prospective revocation date. In this case, the revocation results in a short tax year for the S corporation tax return and a short tax year for the initial C corporation tax return. p. I:17-24.

I:17-28 Failing to meet S corporation requirements. An S corporation will involuntarily lose its S election and revert to being a C corporation if it fails to meet the small business requirements (such as, it has more than 100 shareholders) or if it has accumulated E&P and has excess passive income for each year in a three-year period. If the IRS deems the termination to be inadvertent and the S corporation or its shareholders take the necessary steps within a reasonable time period to correct the defect, the S corporation status is considered to be continuously in effect. For example, an S corporation that has excess passive income can distribute its accumulated E&P to avoid having its S election terminated. pp. I:17-24 and I:17-25.

I:17-29 Item a. b. c. d. e. f.

Repairs Long-term capital gains Short-term capital losses Section 1231 gains Tax-exempt interest income Tax credits

Part of Ordinary Income (or loss) X

Separately Stated Item X X X X X

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g. h.

Tax preference items Salary paid to an S corporation shareholder

X X

pp. I:17-25 through I:17-27.

I:17-30 To prevent double taxation or double deductions. S corporation profits and losses pass through and are taxed to the shareholders on an annual basis regardless of whether the S corporation distributes such net profits. If the basis adjustments were not allowed to reflect corporate profits and losses, S corporation shareholders eventually would be subject to double taxation (or be permitted to take a double deduction) in the form of a capital gain (or capital loss) upon the sale of the S corporation stock. pp. I:17-2, I:17-27, and I:17-28.

I:17-31 Timing and tax rates are important to the decision. Anne may consider making additional capital contributions (or loans) next year, when she expects her marginal tax rate to increase from 12% to 32% and the S corporation expects to have substantial profits. In the current year, Anne first may deduct $10,000 of the $28,000 loss to the extent of her $10,000 stock basis. She then may deduct losses up to the $8,000 debt basis of loans she made to the corporation. This situation leaves Anne with a $10,000 loss carryover to next year. Subsequent net increases reported by the S corporation next year and in future years first apply to restore the $8,000 basis reduction in the loan. Excess positive adjustments then apply to increase the basis of the shareholder’s stock. To fully use the $10,000 loss carryover, Anne must increase stock and/or debt basis by $10,000. For example, she could make an additional $10,000 contribution or loan to the corporation. However, Anne probably should not make additional capital contributions or loans in either year if her share of S corporation income next year is expected to be sufficient to use the $10,000 loss carryover. She should allow her share of next year’s income to restore her basis in the debt and the stock and then offset the income earned with the $10,000 of loss carryovers when her marginal rate is 32%. For example, if her share of S corporation income next year is $15,000, her net increase is $5,000 ($15,000 - $10,000 loss). Thus, she increases debt basis by $5,000 and stock basis by $10,000. The $10,000 of stock basis gives her sufficient basis to allow the loss. After the loss, her stock basis is zero and her debt basis is $5,000. pp. I:17-27 through I:17-30.

I:17-32 S corporation gain on distribution passes through to the shareholder. The S corporation recognizes a $100,000 Sec. 1231 gain under Sec. 311(b) if it distributes the appreciated property to its sole shareholder. This gain passes through and is taxed to the shareholder. The basis of the property to the shareholder will be $130,000. The shareholder’s basis in his Allied stock increases by the $100,000 gain recognized by the corporation and decreases by the $130,000 FMV of the land distributed. The corporation pays no taxes on the $100,000 gain recognized. pp. I:17-30 and I:17-31.

I:17-33 Pass-through entities have restrictions on their tax years. Assuming Barry and Bart are calendar year taxpayers, an S corporation, limited liability company, or partnership must use a calendar year unless the entity can establish a business purpose for electing a fiscal year.

A C corporation is free to choose any year-end. Thus, Barry and Bart generally cannot achieve the desired tax deferral with a pass-through entity. A shorter deferral period (up to three months) Copyright © 2025 Pearson Education, Inc.

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is permitted, however, if the limited liability company, S corporation, or partnership makes a special fiscal year election under Sec. 444, which also entails a required amount of tax payments/deposits annually by the entity. p. I:17-31.

I:17-34 Use of fringe benefits is restricted. In a partnership, partners are not employees and are not eligible for corporate fringe benefits. In an S corporation, shareholders owning more than 2% of the stock are not eligible for corporate fringe benefits. The special fringe benefit rules apply only to statutory fringe benefits. They do not apply to benefits such as stock options, qualified retirement plans, and nonqualified deferred compensation. The fringe benefits limited by the more-than-2%-shareholder rule include (but are not limited to) group term life insurance premiums (Sec. 79), accident and health benefit plan insurance premiums and payments (Secs.

105 and 106), cafeteria plan benefits (Sec. 125), and employer-provided parking (Sec. 132).

Fringe benefits that may be excluded by a more-than-2% shareholder include those excluded as compensation for injuries and sickness (Sec. 104), educational assistance program benefits (Sec. 127), dependent care assistance program benefits (Sec. 129), and fringe benefits provided under Sec. 132 other than employer-provided parking. In a C corporation, fringe benefits are available as exclusions for employees and are deductible by the corporation. The IRS has ruled, however, that amounts paid on behalf of partners and more-than-2% shareholder-employees for accident and health insurance premiums are treated like guaranteed payments. Thus, such amounts are deductible by both a partnership and S corporation and are includible in the partner’s or shareholder-employee’s gross income. p. I:17-31.

I:17-35 Net built-in gains, passive investment income, and LIFO situations. S corporations are not subject to the regular corporate income tax. For S corporations making an election after December 31, 1986, a tax on net built-in gains may be imposed under Sec. 1374, but not if the corporation always has been an S corporation. S corporations that have an accumulated E&P balance from prior C corporation tax years also may be subject to a tax on excess net passive investment income under Sec. 1375 if certain requirements are met. Upon making an S election, the corporation also may be taxed on the difference between its LIFO and FIFO inventory balances of the corporation had elected LIFO. The tax on this difference applies to the final C corporation year. p. I:17-32.

Issue Identification Questions I:17-36 The primary tax issue is whether the Sec. 721 nonrecognition of gain or loss rules apply to the proposed asset transfer. To Bert, the key issue involves the potential recognition of gain because of the excess liabilities. José, on the other hand, needs to be concerned with the tax treatment associated with the transfer of services (for example, if and when he must recognize gross income and how the value of the services contributed enters into the basis of the partnership interest). If José continues to provide services to the partnership after it becomes operational, Bert and José need to address whether José should receive a guaranteed payment annually from the partnership for the services provided. In considering the guaranteed payment issue, José needs to be aware that guaranteed payments do not qualify for the business income deduction. Thus, any guaranteed payment would reduce his qualified business income and hence the deduction. Other issues concern the basis and holding period of the transferred assets for the partnership and the basis and holding period of the partnership interests for each of the two Copyright © 2025 Pearson Education, Inc.

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partners. Are the organizational expenditures for the partnership deductible up to $5,000 with the remainder being amortizable? What tax year and accounting methods should the partnership elect? Two alternatives to using a partnership also should be considered: a limited liability company (LLC) and an S corporation. Under the check-the-box regulations, an LLC is treated as a partnership for federal taxation purposes. Being treated as a partnership means that the same basic issues discussed above for partnerships apply to the LLC. The LLC, however, provides limited liability protection for partners that is not available with a general partnership. An S corporation also provides limited liability protection for its shareholders. The entity is subject to the S corporation rules found in Secs. 1361-1378 instead of the partnership taxation rules. The tax rules for an S corporation typically are less flexible than the rules for a partnership. Therefore, assuming all other things being equal, the investors likely would prefer using an LLC to an S corporation. The scope of this entity choice decision, however, goes far beyond the tax factors.

(Note: The IRS is in the process of revising its rules concerning service partnerships. See Notice 2005-43, 2005-24 I.R.B. 1221.) Multiple pages throughout the chapter.

I:17-37 The two important tax issues are the taxation of the guaranteed payment to Helga and whether it is deductible by the partnership. Because the guaranteed payment will result in a $40,000 loss from operations and the partners’ bases in their partnership interests are negligible, a secondary issue is the application of the loss limitation rules under Sec. 704(d). Another issue that applies to the guaranteed payment is the need to pay self-employment taxes on the $40,000 guaranteed payment amount. In considering the guaranteed payment issue, Helga also needs to be aware that guaranteed payments do not qualify for the business income deduction. Thus, any guaranteed payment would reduce her qualified business income and hence the deduction once the partnership becomes profitable. pp. I:17-12 through I:17-14 and I:17-16.

I:17-38 The C corporation apparently is attempting to reduce the tax liability associated with selling its assets and possibly liquidating by electing to be treated under Subchapter S instead of Subchapter C. The primary S corporation issues include (1) the application of the built-in-gains tax under Sec. 1374 to a former C corporation, (2) the tax treatment accorded the cash distribution under Sec. 1368, and (3) the income pass-through to the shareholders arising from the sale of the appreciated assets. If the built-in gains tax applies, it will result in double taxation at the entity level and the shareholder level thus defeating one of the major reasons for using an S election. p. I:17-30.

Problems I:17-39 a. $0 for Andrea and Robert; $20,000 ordinary income for Agatha. Andrea recognizes no gain under Sec. 721 because she contributed property in exchange for an interest in a partnership. Likewise Robert recognizes no gain. Even though much of the realized but unrecognized gain on the equipment is Sec. 1245 recapture, Sec. 1245(b)(3) provides that a contributing partner recognizes no Sec. 1245 gain on the Sec. 721 contribution to a partnership unless some other provision requires that gain be recognized on the transaction. Agatha also recognizes no gain on the contribution of the accounts receivable and cash. However, the contribution of services to the partnership by Agatha is not covered by Sec. 721 and is a taxable transaction. Accordingly, Agatha recognizes $20,000 of ordinary income. (Note: The IRS is in Copyright © 2025 Pearson Education, Inc.

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the process of revising its rules concerning service partnerships. See Notice 2005-43, 2005-24 I.R.B. 1221.) b.

The partnership recognizes no gain or loss on the formation. Assuming no other organizational expenditures, the partnership can deduct $5,000 of the $20,000 value of partnership interest paid to Agatha for setting up the accounting system. The remaining $15,000 will be capitalized and amortized over 180 months beginning with the month in which the business begins. c.

The partnership’s bases in its assets are as follows: Cash $185,000 ($60,000 + $35,000 + $90,000 loan) A/R $0 Equipment $50,000 Land $20,000 Org. expend. $15,000 d.

The partners’ bases in their partnership interests are computed as follows: Andrea Robert Agatha Basis of noncash property contributed $ 20,000 $50,000 $ -0Cash contributed 60,000 35,000 Income recognized 20,000 Share of liabilities 30,000 30,000 30,000 Basis in partnership interest $110,000 $80,000 $85,000 pp. I:17-4 through I:17-7.

I:17-40 a. $16,667. The partners have equal economic risk of loss so they share the recourse liabilities equally. Bonnie recognizes a $16,667 gain due to the treatment of the partnership’s liabilities, computed as follows: Adjusted basis of the land and building transferred Plus: Bonnie’s share of mortgage assumed by the partnership ($100,000 x 1/3) Minus: Decrease in Bonnie’s individual liabilities treated as a cash distribution Bonnie’s basis in the partnership interest (cannot be negative) Excess of deemed cash distribution over partnership basis ($100,000 - $83,333)

$ 50,000 33,333 (100,000) $ -0$ 16,667

b.

Zero. Bonnie’s basis in her partnership interest is zero (see calculation in Part (a)). In addition, no increase to the partnership’s basis of the land and building occurs because the gain recognized is due to the release from the liabilities. c.

Carlos’s basis in his partnership interest is $133,333, computed as follows: Cash contributed $100,000 Plus: Carlos’s share of $100,000 mortgage assumed by the partnership 33,333 Carlos’s basis in the partnership interest $133,333

d.

Dale recognizes no gain or loss.

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I:17-12

e.

Dale’s basis in the partnership interest is $233,333, computed as follows: Land contributed (adjusted basis) $200,000 Plus: Dale’s share of $100,000 mortgage assumed by the partnership 33,333 Dale’s basis in his partnership interest $233,333

f.

The partnership’s bases in the assets are as follows: Cash $100,000 Building ($180,000 - $150,000) 30,000 Land from Bonnie 20,000 Land from Dale 200,000

pp. I:17-4 through I:17-7.

I:17-41a. b.

c.

Dana recognizes a $10,000 capital gain, computed as follows: Basis in partnership interest before “money distribution” (equal to basis of property contributed) Deemed money distribution ($35,000 share of mortgage transferred - $70,000 liability assumed by partnership) Excess money distribution treated as capital gain

( 35,000) $ 10,000

Adjusted basis of land ($20,000) and building ($5,000) contributed Plus: Dana’s share of mortgage transferred Minus: Decrease in Dana’s individual liabilities Dana’s basis in the partnership interest (cannot be negative)

$ 25,000 35,000 ( 70,000) $ -0-

$ 25,000

The day after Dana purchased the property in 1990.

d.

Land basis is $20,000 and building basis is $5,000 ($85,000 - $80,000 depreciation). No increase to the basis of the land and building occurs because the gain recognized is due to the release from the liabilities and not the property contribution. pp. I:17-4 through I:17-7.

I:17-42 a. follows:

Dan may deduct a $35,500 ordinary loss in his individual tax return, computed as

Cash contribution to DEF Partnership $ 10,000 Plus: Share of partnership bank loan ($75,000 x 0.10) 7,500 Share of accounts payable ($180,000 x 0.10) 18,000 Dan’s basis in his partnership interest after contribution $ 35,500 Minus: Deductible share of the loss ( 35,500)a Dan’s basis in his partnership interest at the end of the year $ -0a $40,000 ($400,000 x 0.10) share of loss is limited by the partner’s $35,500 basis in his interest. b.

Zero (see calculation in Part (a)).

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I:17-13

c. $4,500 ($40,000 - $35,500). Dan may deduct the loss in the following year if sufficient basis ($4,500 or more) is available at year-end. The needed basis can come from additional capital contributed by Dan, the share of partnership profits allocated to Dan, or additional partnership liabilities allocable to Dan. Dan would not be subject to the limitation on excess business losses because the loss does not exceed the threshold amounts ($305,000 single; $610,000 married filing jointly). pp. I:17-4 through I:17-7 and I:17-14.

I:17-43 a.

Up to $5,000 of legal fees and accounting fees incident to the organization of the partnership can be deducted in the current year as organizational expenditures under Sec. 709.

The remaining $4,000 ($6,000 legal + $3,000 accounting - $5,000 deduction) must be capitalized and amortized over the 180-month period beginning with July of the current year. Printing costs and brokerage fees are nondeductible syndication fees. Legal fees associated with the asset transfers are capitalized as part of the cost of the individual assets. b.

For the current year, $133.33 of amortization of organizational expenditures plus the $5,000 amount (above) should be deducted. The amortization expense is computed as follows: $ 22.22 per month ($4,000/180 months) x 6 months $133.33 p. I:17-7.

I:17-44 a.

The following items should be separately stated on Damien’s individual return: Long-term capital gains ($40,000 x 0.50) Research and experimentation credit ($4,000 x 0.50) AMT tax preference items ($6,000 x 0.50)

$20,000 2,000 3,000

In addition, Damien should report an ordinary loss of $5,000 ($10,000 x 0.50). The $12,500 distribution to Damien does not trigger gain recognition because his basis for the partnership exceeds the amount distributed. b.

After adjustments for the Schedule K items, Damien’s basis in his partnership interest is $92,500, computed as follows: Basis at the beginning of the year Plus: Share of increased partnership liabilities ($20,000 x 0.50) Share of long-term capital gains Minus: Share of partnership losses ($10,000 x 0.50) Partnership distribution Basis in partnership interest at end of the year

$ 80,000 10,000 20,000 ( 5,000) ( 12,500) $ 92,500

The research and experimentation credits and AMT tax preferences pass-through items do not affect Damien’s basis for the partnership interest.

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I:17-14

pp. I:17-8 through I:17-11.

I:17-45 The partnership recognizes a $50,000 long-term capital again, allocated $45,000 to Ed and $5,000 to Gail.

The $45,000 gain attributed to Ed is calculated as follows: FMV on date of contribution Minus: Adjusted basis Precontribution gain allocable to Ed

$100,000 ( 60,000) $ 40,000

Selling price Minus: FMV on date of contribution Postcontribution gain Times: Ed’s interest in partnership Postcontribution gain allocable to Ed Plus: Precontribution gain allocable to Ed Total gain allocable to Ed

$110,000 (100,000) $ 10,000 0.50 $ 5,000 40,000 $ 45,000

The $5,000 gain allocable to Gail is calculated as follows: Selling price Minus: FMV on date of contribution Postcontribution gain Times: Gail’s interest in partnership Postcontribution gain allocable to Gail

$110,000 (100,000) $ 10,000 0.50 $ 5,000

The result is equitable to Gail because she is taxed only on her share of the appreciation that occurred while the partnership owned the land. Ed, on the other hand, is taxed on the full amount of the precontribution gain plus one-half of the postcontribution gain. pp. I:17-9 and I:17-10.

I:17-46 $51,750 each to Alice and Bruce; $6,000 to Carl. Alice and Bruce each report a $51,750 loss as his or her allocable share of the $109,500 ordinary loss for the current tax year, computed as follows: Annual partnership loss $109,500 Times: Partnership interest for Alice and Bruce 1/2 Share of annual loss each to Alice and Bruce $ 54,750 Times: Allocation for 1/1–11/1 305/365 Share of loss each to Alice and Bruce $ 45,750 Plus: 11/2–12/31 loss split into three parts ($109,500 x 60/365 x 1/3) 6,000 Total 12-month loss for each Alice and Bruce $ 51,750

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I:17-15

Carl reports a $6,000 loss. Using the calendar day proration method, this amount is computed as follows: Annual partnership loss Times: Share of annual loss each to Alice, Bruce, and Carl Partnership loss allocable to each partner for full year Times: Allocation for 11/2–12/31 Carl’s share of 11/2–12/31

$109,500 1/3 $ 36,500 60/365 $ 6,000

p. I:17-10.

I:17-47 a.

None. Anita recognizes no gain on the transfer of the land to the partnership. Her basis in her partnership interest will increase by $20,000 as the result of her contribution. The partnership will take a $20,000 basis in the land, and the $80,000 precontribution gain ($100,000 FMV at contribution - $20,000 basis) will be allocated to Anita when the partnership sells the land. b.

Anita’s basis in her partnership interest at the end of the current year is $128,500, computed as follows: Anita’s basis in partnership interest at beginning of current year Plus: Share of increased partnership liabilities ($50,000 x 0.50) Share of partnership ordinary income ($60,000 x 0.50) Share of tax-exempt interest income ($10,000 x 0.50) Contribution of land (adjusted basis) Minus: Distribution to Anita Share of capital losses ($20,000 x 0.50) Nondeductible expenses ($3,000 x 0.50) Anita’s basis in partnership interest at end of current year

$ 75,000 25,000 30,000 5,000 20,000 ( 15,000) ( 10,000) ( 1,500) $128,500

p. I:17-11.

I:17-48 a. $40,000. Keith deducts $40,000 of the ordinary loss in the current year, and $140,000 ($180,000 - $40,000) of the loss carries over to the next year. Keith would not be subject to the limitation on excess business losses because the loss does not exceed the threshold amounts ($262,000 single; $524,000 married filing jointly). b.

Zero. Keith’s basis for his partnership interest at the end of the current year is zero. c. $50,000 ordinary income; $110,000 deduction. Keith deducts $110,000 of the $140,000 ordinary loss carryover in the next year, which offsets the $60,000 additional capital contribution and his $50,000 share of ordinary income. (See Part d for basis calculation.) d.

Zero basis, computed as follows: Basis in partnership interest at beginning of the year Additional capital contribution Copyright © 2025 Pearson Education, Inc.

I:17-16

$

-060,000

Plus: Share of partnership ordinary income ($100,000 x 0.50) Minus: Unused ordinary loss carried over Basis in partnership interest at end of the year

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I:17-17

50,000 (110,000) $ -0-

e. $30,000 of the partnership loss allocable to Keith remains unused. To use the loss one or more of the following three actions must occur: • The partnership must earn a profit in a future tax year, • The partnership must incur additional liabilities allocable to Keith, or • Keith must make an additional capital contribution to the partnership. pp. I:17-14 and I:17-15.

I:17-49 a. $15,000 long-term capital gain on stock; $0 on the land; $20,000 ordinary income on the machine. Gains are treated as ordinary income if a partner directly or indirectly owns a more-than-50% interest in the partnership and the asset sold is not a capital asset to the transferee. The constructive ownership rules of Sec. 267 apply when applying this requirement, so Kevin indirectly owns his son’s stock and, therefore, has a 60% interest in the partnership.

However, because the stock sold is a capital asset, Kevin recognizes the $15,000 gain as a capital gain.

Losses are disallowed on sales or exchanges between a partner and the partnership if the partner owns directly or indirectly a more-than-50% interest in the partnership. Consequently, Kevin may not recognize the $40,000 loss on the sale of land to the partnership. He probably would be better off selling the asset to an unrelated party for cash and then contributing the cash to the partnership.

Kevin recognizes $20,000 ($70,000 - $50,000) of ordinary income on the sale of the machine to the partnership because the asset is a Sec. 1231 asset (and not a capital asset) in the hands of the transferee partnership. Specifically, $10,000 of the recognized gain is ordinary income because of Sec. 1245 recapture. The remaining gain is reclassified from Sec. 1231 gain to ordinary income because of the partnership rules. b.

None. The partnership recognizes no gain or loss on the subsequent sale of the land, computed as follows: Selling price to outsider Minus: Basis in the land Gain realized by the partnership Minus: Previously disallowed loss on land sale to the partnership ($40,000 limited to the $30,000 realized gain) Gain recognized by the partnership

$ 90,000 ( 60,000) $ 30,000

( 30,000) $ -0-

pp. I:17-15 and I:17-16.

I:17-50 a. $85,000 gross; $75,000 taxable; $67,000 after-tax. Laura’s share of ordinary income for the current year is $50,000, computed as follows: Partnership ordinary income (after deducting guaranteed payment) Times: Laura’s share of partnership income Laura’s share of ordinary income

$100,000 0.50 $ 50,000

Laura includes her guaranteed payment and share of ordinary income in gross income for the current year as illustrated below.

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I:17-18

Guaranteed payment Plus: Share of ordinary income Gross income inclusion Minus: QBI deduction ($50,000 x 0.20) Taxable amount

$ 35,000 50,000 $ 85,000 ( 10,000) $ 75,000

After-tax income [$85,000 - ($75,000 x 0.24)]

$ 67,000

The $15,000 cash distribution is a nonliquidating distribution and is treated as a nontaxable return of capital assuming Laura has sufficient basis in her partnership interest. b.

$67,500 gross; $54,000 taxable.

Partnership ordinary income (with no guaranteed payment) Times: Laura’s share of partnership income Laura’s share of ordinary income (gross income) Minus: QBI deduction ($67,500 x 0.20) Taxable amount

$135,000 0.50 $ 67,500 (13,500) $ 54,000

After-tax income [$67,500 - ($54,000 x 0.24)]

$ 54,540

pp. I:17-12, I:17-13, and I:17-16.

I:17-51 a.

None. Unlike with a C corporation or an S corporation, the partnership recognizes neither gain nor loss when it distributes noncash property to a partner. b.

Zero. The distribution is a nontaxable return of capital, which reduces Lynn’s basis to zero. Lynn’s basis initially is reduced from $9,000 to $4,000 by the $5,000 cash distribution. The remaining $4,000 basis for the partnership interest is allocated to the land. Her outside basis is reduced to zero by the $4,000 basis in the distributed property. c. $4,000 (see Part b). d.

Zero (see Part b). pp. I:17-16 and I:17-17.

I:17-52 a.

b.

Allen realizes $45,000 on the sale, computed as follows: Selling price Plus: Share of partnership liabilities ($15,000 x 1/3) Amount realized Allen recognizes a $10,000 gain, computed as follows: Amount realized on sale of partnership interest Minus: Basis in partnership interest Gain recognized on sale

$40,000 5,000 $45,000 $45,000 (35,000) $10,000

Accordingly, $3,000 of the gain is ordinary income under Sec. 751 (one-third of $3,000 depreciation recapture plus one-third of the $6,000 inventory gain); $1,800 (one-third of $5,400) Copyright © 2025 Pearson Education, Inc.

I:17-19

is unrecaptured Sec. 1250 gain; and the remaining $5,200 ($10,000 - $4,800) is capital gain under Sec. 741. pp. I:17-17 through I:17-19.

I:17-53 a.

Rita reports $15,000 ($2,500 per month x 6 months) of salary on her 2024 individual tax return. b.

Rita reports $40,000 of ordinary income from the partnership on her 2025 individual tax return. Allocation of the ordinary income occurs on the last day of the partnership tax year (June 30, 2025). The drawings are distributions not included in Rita’s gross income. c. $15,000. The only income subject to Social Security taxes are the $15,000 salary payments made from January 1 through June 30, 2024. The remaining $40,000 partnership of ordinary income is subject to self-employment taxes in 2025. pp. I:17-10 and I:17-16.

I:17-54 follows:

Partnership ordinary income $2.5 million; taxable income $979,280, calculated as

Gross profit Minus: General business expenses Salaries (W-2 wages) Depreciation Interest expense* Partnership ordinary income

$ 9,000,000 (2,400,000) (1,600,000) (1,000,000) (1,500,000) $ 2,500,000

*Limited to 30% of adjusted taxable income: ($9,000,000 - $2,400,000 - $1,600,000) x 0.30.

The excess interest ($500,000) is treated as an NOL at the partner level and reduces the partner’s basis in the partnership, $250,000 to each partner.

Share of partnership ordinary income Minus: Standard deduction QBI deduction* Taxable income

$ 1,250,000 (29,200) (244,160) $ 976,640

*Combined QBI equals the lesser of 20% of qualified business income ($1,250,000 x 0.20) 50% of allocable W-2 wages ($800,000 x 0.50) QBI deduction equals the lesser of: Combined QBI 20% of excess taxable income ($1,220,800 x 0.20)

$250,000 or $400,000 $250,000 or $244,160

pp. I:17-12 through I:17-14.

I:17-55 a.

No termination. The 100-shareholder requirement has not been violated. Sam’s estate is a qualified shareholder, and the total number of shareholders remains at 100 as the estate replaces Sam as a shareholder under the family rule.

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I:17-20

b.

No termination. The S election remains in effect when the estate distributes the stock to the child because the child now substitutes for Sam and the estate under the family rule, so the S corporation still would have only 100 shareholders. c.

No termination. An S corporation may issue nonvoting common stock in addition to voting common stock without violating the one class of stock requirement. Also, the 100shareholder requirement remains satisfied because Susan and her children count as a single shareholder under the family rule. d.

Revocation occurs. Voluntary revocation is permitted if individuals owning more than 50% of the corporate stock consent to the revocation. The corporation is treated as a C corporation for the entire tax year if it files a statement on or before the fifteenth day of the third month of the tax year. In this case, however, the corporation makes the revocation as of October 1. The period from January 1 through September 30 is a short S corporation tax year, and the period from October 1 through December 31 is a short C corporation tax year if the corporation specifies a prospective revocation date. Otherwise, the S corporation status remains in effect until the beginning of the next tax year (January 1). pp. I:17-21 through I:17-25.

I:17-56 a.

Ordinary income for the year is $145,000, calculated as follows: Sales Minus: Cost of goods sold Repairs expense Depreciation expense Salary expense Ordinary income

b.

$260,000 ( 60,000) ( 5,000) ( 20,000) ( 30,000) $145,000

Separately stated items on Schedule K include: Long-term capital losses Charitable contributions Sec. 1231 losses

c.

$ 15,000 5,000 8,000

Carol’s adjusted stock basis is $133,500, calculated as follows: Basis of stock at beginning of year Plus: Ordinary income ($145,000 x 0.50) Minus: Long-term capital losses ($15,000 x 0.50) Charitable contributions ($5,000 x 0.50) Sec. 1231 losses ($8,000 x 0.50) Basis of stock at end of year

$ 75,000 72,500 ( 7,500) ( 2,500) ( 4,000) $133,500

d.

Carol should qualify for the qualified business income deduction because her taxable income is less than the $164,900 threshold amount. She can deduct the lesser of 20% of qualified business income of $13,700 ($72,500 ordinary income minus $4,000 Sec. 1231 loss) x 20% or 20% of taxable income net of capital gains of $11,190, calculated as follows: Ordinary Income from partnership $72,500 Sec. 1231 loss (4,000) Standard Deduction (12,950) Copyright © 2025 Pearson Education, Inc.

I:17-21

Taxable Income (net of capital gains) 20% of Taxable Income

55,550 $11,110

The QBI Deduction is $11,110. pp. I:17-12, I:17-13, and I:17-25 through I:17-28.

I:17-57 a.

Cathy’s stock basis at the end of the current year is $88,000, computed as follows: Original purchase price for stock Plus: Share of ordinary income Minus: Share of long-term capital loss Cash distributions Basis of stock at end of year

$80,000 30,000 ( 5,000) (17,000) $88,000

The salary payments to Cathy are included in her gross income and reduce the S corporation’s ordinary income. They are reported to Cathy on a Form W-2. Most of the other S corporation items are reported on Schedule K-1. b.

Long-term capital loss of $5,000, ordinary income of $30,000, and salary income of $40,000. The $5,000 capital loss is limited to $3,000 in her personal return unless she recognizes other capital gains to offset the capital loss. Cathy also will need to determine her qualified business income deduction. Note that the salary she pays herself reduces her ordinary business income and hence her QBI deduction. pp. I:17-12, I:17-13, and I:17-27 through I:17-29.

I:17-58 a. $55,000 loss and $15,000 ending basis to each partner. The allowed loss in the current year is limited to each partner’s basis in his or her partnership interest, which includes each partner’s share of partnership liabilities.

Harold Faye Contribution $ 50,000 $ 50,000 Share of partnership liabilities 20,000 20,000 Basis in partnership interest before loss $ 70,000 $ 70,000 Share of partnership loss allowed (55,000) (55,000) Basis in partnership interest at year end $ 15,000 $ 15,000 b. $50,000 loss and $0 ending basis to each shareholder. The allowed loss in the current year is limited to each shareholder’s basis in his or her stock, which does not include corporate level liabilities.

Basis in stock before loss (from contribution) Share of S corporation loss allowed Basis in stock at year end

Harold $ 50,000 (50,000) $ -0-

Faye $ 50,000 (50,000) $ -0-

Harold and Faye each carry over $5,000 of disallowed loss to the next year. pp. I:17-14, I:17-15, I:17-28, and I:17-29.

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I:17-22

I:17-59 a. $35,000. Chris’s share of the ordinary loss before limitations is $60,000 ($180,000 x 1/3). Chris deducts $35,000 ($25,000 stock basis + $10,000 debt basis) on his current year individual tax return, assuming the at-risk rules do not apply. b.

Zero basis for the stock and loan. c. $25,000.

The ordinary loss carryover to subsequent years is $25,000 ($60,000 - $35,000). d.

Stock basis, $0; debt basis, $5,000. Chris’s share of the $90,000 of income is $30,000, and his net increase is $5,000 ($30,000 - $25,000 loss carryover). The net increase restores the debt basis to $5,000, and the remaining $25,000 of income increases his stock basis.

Chris now has enough stock basis to claim the $25,000 loss that carried over (Part c). The $25,000 loss reduces his stock basis from $25,000 to zero; his debt basis remains at $5,000. pp. I:17-27 through I:17-30.

I:17-60 a.

Basis in loan on December 31: $7,000 (restoration from S corporation income) Basis in stock on December 31: $8,000 (additional shares acquired) b.

A $3,000 ($10,000 proceeds - $7,000 basis) capital gain will result when the corporation repays the loan on January 1 of the following year. Because the loan was in the form of a note, the repayment results in capital gain because the note constitutes a capital asset.

Ordinary income would result had the loan been an unsecured advance. pp. I:17-27 through I:17-30.

I:17-61 a. $1,000 ordinary income; $2,700 capital gains. Craig’s $1,000 share of ordinary income increases his stock basis to $9,000 ($8,000 + $1,000) before considering the distribution.

Because Control always has been an S corporation, the $11,000 distribution to Craig is treated as a return of capital up to his $9,000 stock basis. The $2,000 excess is a capital gain. The gain is long-term or short-term depending on Craig’s holding period for the stock. Control recognizes no gain or loss on the distribution of cash under Sec. 311(b). b.

Craig’s stock basis is zero. pp. I:17-30 and I:17-31.

I:17-62 a.

No gain or loss recognized by the partnership or partners. Ending basis in partnership interests: $170,000 to William; $140,000 to Mary. Each partner’s basis in his or her partnership interest after the distribution is calculated as follows: Basis in partnership interest before distribution Minus: Distribution of property (basis) Basis in partnership interest after distribution

William $200,000 (30,000) $ 170,000

Mary $200,000 (60,000) $ 140,000

On the distribution of property, neither the partnership nor the partners recognize gain or loss.

The partners take a carryover basis in the distributed property. b. $20,000 capital gain recognized by the S corporation. $10,000 pass-through gain recognized by each shareholder. Ending basis in S corporation stock: $160,000 to each shareholder, calculated as follows: William $200,000 10,000

Basis in stock before distribution Plus: Pass-through gain

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I:17-23

Mary $200,000 10,000

Minus: Distribution of property (FMV) Basis in stock after distribution

(50,000) $ 160,000

(50,000) $ 160,000

On the distribution of property, the S corporation recognizes gain but not loss. The corporation is not taxed on the gain, but the shareholders must recognize their share of pass-through gain in their personal tax returns. The shareholders take a FMV basis in the distributed property. c.

No. Distributing the loss property to Mary in the S corporation situation causes the loss to go unrecognized by anyone. The corporation does not recognize the loss on the distribution, and Mary would not recognize a loss upon selling the property because its basis and FMV are the same amount. pp. I:17-17, I:17-31, and I:17-32.

I:17-63 a.

Compact Corporation recognizes a $50,000 Sec. 1231 gain ($125,000 - $75,000) under Sec. 311(b), which passes through to Clay as a separately stated item and is reported on his individual tax return. The Sec. 1231 gain increases Clay’s stock basis by $50,000. Clay reports no income from the distribution. The distribution reduces his stock basis by $105,000 ($125,000 FMV of land - $20,000 liability). Thus, his ending stock basis is $115,000 ($170,000 + $50,000 - $105,000). b.

Clay’s basis in the land is $125,000, its FMV. c.

The corporation does not recognize the $25,000 ($75,000 FMV - $100,000 adjusted basis) loss (Sec. 311(a)). Clay reports no income from the distribution. The net distribution of $55,000 ($75,000 FMV - $20,000 liability) reduces his stock basis to $115,000 ($170,000 - $55,000), and Clay takes a $75,000 FMV basis in the land. Note that neither the corporation nor Clay will recognize the loss upon the distribution. Clay would be better off if the corporation sold the land, recognized the loss, and passed the loss through to Clay. The corporation then could distribute to Clay the sales proceeds (minus the liability the corporation must repay). pp. I:17-27 through I:17-31.

I:17-64 a.

The $2,000 in accident, health, and medical reimbursement insurance premiums for employees who are not shareholders and the $1,000 of group term life insurance premiums for employees who are not shareholders are deductible by Copper Corporation in the current year under Sec. 162. The group term life insurance premiums for shareholder-employees owning more than 2% of the stock are treated as guaranteed payments and also are deductible by Copper.

Similarly, the $5,000 in accident, health, and medical reimbursement insurance premiums for shareholder-employees owning more than 2% of the stock are treated as guaranteed payments and are deductible by Cooper. b.

Accident, health, and group term life premiums (up to $50,000) are nontaxable fringe benefits for the non-shareholder employees. The shareholder-employees are treated as partners and therefore must include the accident, health, and medical reimbursement insurance premiums and group term life insurance premiums in their gross income. Shareholderemployees can deduct under Secs. 162(l)(1) and (5) as a medical expense 100% of the premiums includable in their gross income. p. I:17-31.

I:17-65 a.

Yes. Delta Corporation is subject to the built-in gains tax under Sec. 1374 because it made an S election at the beginning of the current tax year. The corporation recognizes gain if the assets with a built-in gain are sold within the recognition period after the effective date of the S election. The FMV of the assets sold during the current year (measured Copyright © 2025 Pearson Education, Inc.

I:17-24

on the day the S election took effect) exceeds their $200,000 adjusted basis by $120,000. All $120,000 of this gain is taxed to the corporation under Sec. 1374. b. $25,200. To calculate the corporate tax on the built-in gains, one first must take the lesser of the corporation’s built-in gain ($120,000) or its taxable income as if it were a C corporation ($330,000) and then multiply this amount by the highest corporate tax rate. In this case, the built-in gain tax is $25,200 [($320,000 FMV - $200,000 basis) x 0.21 highest corporate rate in the current year]. c.

Delta Corporation would not be subject to the net built-in gains tax because the S corporation would have held the assets for a period longer than the recognition period. p. I:1732.

Comprehensive Problem I:17-66 Charles’ and Charlene’s 2024 tax return will report the following items: Adjusted gross income: Charlene’s salary Partnership ordinary income Partnership guaranteed payment Dividend income Interest income from corporate bonds Tax-exempt interest income Sec. 1231 loss Net capital gain or loss ($49,000 LTCG - $20,000 STCL) a. Adjusted gross income (AGI) Minus: Itemized deductions: Mortgage interest State income taxes $ 8,000 Property taxes 3,000 Total taxes $11,000 (limited to $10,000) Charitable contributions ($2,000 + $5,500) Total Minus: QBI deduction ($105,000 x 0.20) b. Taxable income Ordinary taxable income ($194,500 - $32,000)

$ 80,000 105,000 40,000 3,000 5,000 -0( 17,000) 29,000 $245,000

$12,000

10,000 7,500 ( 29,500) ( 21,000) $194,500 $162,500

Note: Cash distributions from the partnership are not included in gross income. c. Tax liability [$10,852 + 0.22 x ($162,500 - $94,300)] + [0.15 x ($29,000 LTCG + $3,000 dividends)] Minus: Withholding and estimated tax payments ($18,000 + $24,000) d. Refund

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$ 30,656 ( 42,000) $ (11,344)

Tax Strategy and Critical Thinking Problems I:17-67 The primary issue for Joann and Bob is to determine the type of business entity that should be used to conduct their temporary employment business. The company obviously has progressed past the start-up phase so the pass-through of start-up losses in the initial years of doing business is not a primary issue. Likewise, because Joann and Bob are presently co-owners of the business, the sole proprietorship form of doing business is not a viable alternative.

Now Joann and Bob must determine the best way to be taxed on the business earnings.

The partnership form means that Joann and Bob each face a top marginal tax rate of 24% on their $150,000 ($300,000 × 0.50) of partnership income, with their average tax rates being lower than 24%. With the qualified business income deduction, this rate effectively could be even less, for example, 19.2% [24% x (1 - 0.20)]. These individual marginal tax rates might be reduced if Joann and Bob elect to operate as a C corporation. With the corporate tax rate being 21%, the partnership form of doing business appears to be the better alternative.

The partnership form has the advantage of permitting business profits to be distributed to the two owners without incurring any additional tax cost, and it make the partners eligible for the qualified business income deduction. If a C corporation were used, the distribution of profits would trigger a second level of taxation, taxed at the 15% rate on dividends. The combination of the entity and shareholder taxes associated with a dividend may exceed those associated with the current partnership form of doing business. Some tax differences may be encountered between the corporate and partnership forms if Joann and Bob decide at a future date to sell their business.

Similarly, liquidation of a corporation is taxable to both the corporation and its shareholders.

Liquidation of a partnership generally triggers little or no tax because of the partners’ basis adjustments.

Some double taxation in a C corporation can be avoided by paying Joann and Bob salaries that reflect their contribution to the business. Salary payments are deductible by the corporation and taxable to each owner as ordinary income. For example, if the C corporation paid Bob and Joann each a deductible salary of $60,000 instead of dividends, the corporation would reduce its tax at the 21% tax rate, and Bob and Joann would be in the 12% to 22% tax bracket on the salary income. Fringe benefits are deductible by the corporation and may be taxexempt to the employee. The fringe benefits may provide an important income tax savings for the owners. The salary (and some fringe benefits) is subject to federal and state employment taxes that would not be encountered if the partnership’s earnings passed through to the owners.

Self-employment taxes apply, however, if Bob and Joann use the partnership.

The owners need to consider not only the tax factors, but also non-tax issues related with using the corporate or partnership forms of doing business. The general partnership form causes both owners to be at risk for all partnership liabilities. Alternatively, a limited liability company could be used whereby both owners have limited liability protection.

A corporate entity leaves the owners at risk only for the amount of their investment. Two corporate forms are available under the tax laws—C corporations and S corporations. The tax consequences for a C corporation were described above. An S corporation provides limited liability protection for all owners and permits the profits to be taxed to the shareholders without a corporate level tax.

How does one determine which business form is best for Joann and Bob? One way would be to employ the corporate and pass-through investment models found in Chapter I:18.

Using the techniques described in Chapter I:18, a tax advisor can compare the pass-through Copyright © 2025 Pearson Education, Inc.

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entity form with the C corporation form. Quantifying the economic differences between the two entity models may provide a valuable insight to the issues being faced by Joann and Bob. I:17-68 The primary issues with Peter, Paul, and Mary’s scenario is how to protect the wealth of the three owners of the business and at the same time reduce the tax cost of the business entity form that the trio agrees to employ in their new business. Some of the advantages and disadvantages of the various business forms are presented below.

C corporation: Pros: 1.

The C corporation permits income splitting between the business entity and its owners.

2.

Salary payments made by a C corporation are deductible by the entity resulting in only a single level of taxation. An extra cost may be encountered because such payments are subject to the federal and state employment taxes. The salary issue may be of particular importance in different ways to Peter, Paul, and Mary depending on the amount of time they devote to the business. Mary will be involved in the day-to-day business activities and may be the individual drawing the largest salary. The other two individuals may act in an investor capacity, and any salary considerations may be of minor importance.

3.

The corporate tax rate is relatively low at 21%.

4.

The corporate form permits owners to receive fringe benefits from the corporation. Many of the nontaxable fringe benefits (for example, group term life insurance) are not available when a pass-through entity provides the benefit to one of its owners.

5.

The corporate form provides its owners with limited liability protection. This feature may be the most important for the three owners because each individual has a net worth of at least $2 million.

6.

Worthless stock of a C corporation (or an S corporation) may be eligible for a limited ordinary loss deduction under Sec. 1244.

Cons: 1.

The C corporation triggers double taxation when it distributes earnings to the shareholders in the form of dividends.

2.

The C corporation form does not permit losses to pass through to its owners.

Losses carry over only at the entity level.

3.

The C corporation form generally is subject to the state corporation income tax.

4.

The C corporation and its owners are not eligible for the qualified business income deduction.

Partnership, S corporation, and limited liability company (LLC): Pros: 1.

The S corporation and LLC forms provide the owners with limited liability protection.

2.

The partnership, S corporation, and LLC forms involve only a single level of taxation.

3.

Distributions made by a partnership, S corporation, or LLC are generally Copyright © 2025 Pearson Education, Inc.

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4.

nontaxable to the owners.

Income allocations made by a partnership or LLC are determined by the partnership agreement and can be changed from year to year. Dividend payments

by S corporations and C corporations are allocated based on the number of shares of stock owned. Income and loss allocations to an S corporation’s shareholders are based on the shares owned.

The owners may be eligible for the qualified business income deduction.

5.

Cons: 1.

S corporations may be subject to the corporate income tax in some states. Other entity forms such as partnerships or LLCs may not subject to the corporate income tax.

2.

Nontaxable fringe benefits generally are not available to the owners of partnerships, S corporations, or LLCs to the same extent they are available to owners of a C corporation.

3.

Liability is not limited for general partners.

I:17-69 If the partners take the $40,000 distributions as draws, each partner will have $70,000 of pass-through business income and a $14,000 ($70,000 x 0.20) QBI deduction, resulting in a net taxable amount of $56,000 ($70,000 - $14,000) to each partner. On the other hand, if they take the distributions as guaranteed payments, partnership ordinary income will be $60,000 ($140,000 - $80,000), with each partner’s share being $30,000. Consequently, each partner’s QBI deduction will be only $6,000 ($30,000 x 0.20), resulting in a net taxable amount of $64,000 ($40,000 + $30,000 - $6,000), to each partner. Therefore, taking the distributions as draws is the better alternative.

I:17-70 If Abigail does not do anything to increase her basis, she will have to carryforward the $30,000 loss in excess of her basis. Comparison of her current marginal tax rate versus her future marginal tax rates is important to consider when analyzing the cost of carrying the loss forward. Another important factor to consider is that any additional investment in Crab Tree also increases her potential loss if the partnership does not become profitable. The after-tax cost from the loss of the additional investment is significantly larger than the potential tax savings from the current loss. Considering the large amount of losses that Crab Tree has incurred over the last five years. Abigail should assess her investment in Crab Tree to determine whether she believes she will make sufficient future returns on her investment. Finally, before Abigail decides to invest additional resources in Crab Tree (either through a cash investment or through additional debt in the partnership), Abigail should assess her investment options to determine if Crab Tree offers the highest after-tax rate of return.

Tax Form/Return Preparation Problems I:17-71 (See Instructor’s Resource Manual) I:17-72 (See Instructor’s Resource Manual)

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Case Study Problems I:17-73 The following points should be made in the client memo: 1.

The assets from the unincorporated accounting practices can be transferred to the pass-through entity (i.e., the partnership or S corporation) under Sec. 721 or 351 without gain recognition. A limited liability company (LLC) also can be used to avoid personal liability. The LLC discussion would parallel that for a partnership.

2.

The partnership form allows for special allocations of income, deductions, etc. as long as the special allocations have substantial economic effect. S corporation shareholders, on the other hand, must allocate these items based on their proportionate stock interests in the corporation. In addition, the partners may be eligible for the qualified business income deduction.

3.

With the partnership form, any precontribution gains or losses will be allocated to the contributing partners upon a subsequent sale. Similarly, any cash method partners contributing accounts receivable and payable will be allocated income on the accounts receivable when collected and the deduction on the accounts payable when paid. See Sec. 704(c). No such special allocation for contributed property exists for S corporations.

4.

Fringe benefit plans may be established for employees under either form of organization. Peggy, Phil, and Ralph will not be treated as employees under a partnership, and similar restrictions apply for more than 2% shareholders in an S corporation. Consequently, fringe benefits normally available to corporate employees are substantially restricted.

5.

Ordinary losses and separately stated deductions and losses pass through to Peggy, Phil, and Ralph with either a partnership or an S corporation. However, with a partnership, each partner’s basis in the partnership includes his or her share of the partnership liabilities. With an S corporation, only shareholder loans to the corporation may be included in basis for purposes of deducting losses. Thus, a larger dollar amount of losses may be deductible by the partners in a partnership.

6.

One alternative that might be suggested is a professional service corporation, which is taxed at 21%, which may be a lower tax rate than the individual tax rate. However, C corporations are subject to double taxation when they distribute profits as dividends. Such is not the case with an S corporation or a partnership, and also is not the case if the personal service corporation pays reasonable salaries rather than dividends.

7.

An alternate to a professional service corporation is a limited liability partnership (LLP). This business form is similar to an LLC, but is designed for professional service businesses. For small accounting firms, it may or may not be a viable alternative to an LLC or an S corporation.

8.

State law should be considered because in some states the S corporation is taxed as a corporation (for example, the S election is disregarded for state income tax purposes).

Further, in some states, professionals (such as CPAs) cannot form corporations.

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I:17-74 Under Sec. 1361(b)(1)(A), an involuntary termination of S corporation election occurs for the termination year and for succeeding years on the day preceding the termination event. No provision automatically allows for correcting the termination even if the defect is corrected prior to the end of the year. Section 1362(f), however, permits the S corporation election to continue if the IRS agrees that the termination was inadvertent and the taxpayer corrects the defect. In such case, the S corporation may be continued for the year in question. These corrective steps should be taken rather than assume the IRS will not discover the error.

SSTS No. 1 states that the CPA is not allowed to inform the IRS of an error without the taxpayer’s permission. Without such permission, the CPA should consider whether to withdraw from the preparation of the current year’s return if the error is not corrected. The client should be advised as to the potential penalty consequences.

The CPA is required to follow the AICPA’s Code of Professional Ethics, IRC statutes, Treasury Regulations, and rules governing practice before the IRS. In tax practice, a CPA may resolve doubt in favor of the client as long as reasonable support exists for the position. In the case study, an involuntary termination has occurred for the current year. SSTS No. 2 states that the preparer’s declaration is that the return is true, correct, and complete. Therefore, it would be unethical to ignore the terminating event. An extension of time to file the S corporation tax return may be helpful to have time to decide whether to request that the termination be classified as inadvertent. A substantial body of private letter rulings provides guidance in this area.

Further, the provision that allows an election to treat members of a family as a single shareholder might be helpful. Required timing for filing the election must be explored.

Tax Research Problems I:17-75 Section 721 states that no gain or loss is recognized on the contribution of property in exchange for an interest in a partnership. Treasury Regulations under this section further explain that, when a partner contributes services instead of property, the receipt of a capital interest does not fall under Sec. 721 and becomes taxable income under Sec. 61 equal to the fair market value (FMV) of the interest in capital transferred. Treasury Regulations do not provide authority for a partner who contributes services in exchange for a profits interest instead of a capital interest. In Rev. Proc. 93-27, 1993-2 C.B. 343, the IRS held that the receipt of a profits interest for services will not be treated as a taxable event unless the profits interest is in the form of a substantially certain and predictable stream of income, the partner disposes of the profits interest within two years, or the profits interest is a limited partnership interest in a publicly traded partnership.

In Sol Diamond v. CIR, 33 AFTR 2d 74-852, 74-1 USTC ¶9306 (7th Cir., 1974), the appellate court found that the taxpayer’s receipt of a profits interest would be taxable. It interpreted Treasury Regulations as treating a capital and profits interest in the same way. The taxpayer sold his interest shortly after receiving it, which placed a FMV on the profits interest that was to be included in the taxpayer’s income.

William G. Campbell v. CIR, 59 AFTR 2d 28-917, 91-2 USTC ¶50,420 (8th Cir., 1991), cites the Diamond case to explain important differences in the taxpayer’s situation. In the Campbell case, the taxpayer also received a profits only interest in exchange for services. The court attempted to distinguish between a capital interest and profits interest explaining that, because the regulations only mention treatment of the receipt of a capital interest in exchange for services, it does not necessarily mean the same is true of a profits interest because profits Copyright © 2025 Pearson Education, Inc.

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interests are not mentioned. More importantly, the court decided that the receipt of the profits interest by the taxpayer in exchange for services had no determinable FMV. The value of the interest was only speculative because the right to transfer the interest was limited, management participation was lacking, and the value of tax benefits and success of operations were speculative. In the Diamond case, the FMV could be determined because the partnership interest was sold shortly after its receipt and the taxpayer did not intend to remain a partner. The court held in the Campbell case that the profits interest was not a taxable event mainly because its FMV was not determinable.

Based upon the IRS’s position in Rev. Proc. 93-27 and existing judicial decisions in this area, it is reasonable to conclude that Sandra’s profits interest in the Deco Partnership should not be taxed upon receipt in exchange for the services she provided.

In May 2005, the Treasury Department proposed new regulations in this area that would significantly change some of the tax impacts of Sandra’s receipt of a profits interest in the Deco Partnership. (The biggest difference would be in gains or losses recognized by the partnership and the nonservice partners when the profits interest was granted.) Under these proposed regulations, the receipt of a profits interest in a partnership would be explicitly taxed under Sec. 83. An unrestricted receipt of a profits interest would be a taxable event at the time of receipt. However, the proposed regulations allow the FMV of the profits interest to be approximately by the liquidation value of the interest at the time of its receipt. Given that this interest would receive nothing on a liquidation immediately after Sandra receives the interest, it appears that the value of the profits interest in Deco Partnership would be zero. The taxpayer may not rely on the proposed rules until they are finalized and may continue to rely on existing rules and procedures. See Notice 2005-43, 2005-24 I.R.B. 1221.

I:17-76 Section 1366(d)(1) provides that pass-through losses and deductions to the shareholders cannot exceed the shareholder’s basis in his stock and debt. The important issue is whether the personal guarantee by the shareholders increases their stock basis (i.e., does the guarantee constitute an equity contribution and thus increases basis). In the Estate of Daniel Leavitt v.

CIR, 63 AFTR 2d 89-1437, 89-1 USTC ¶9332 (4th Cir., 1989), the appellate court determined that the shareholders’ guarantee of a loan to an S corporation did not increase their stock basis.

The court determined that a guarantee is not a contribution of cash or property. In this case, the court disagreed with Edward M. Selfe v. U.S., 57 AFTR 2d 86-464, 86-1 USTC ¶9115 (11th Cir., 1986). Selfe held that if the shareholder was the primary obligor of the loan, the guarantee could be treated as an equity investment and thereby increase the stock’s basis.

Based on the findings in the Leavitt case, Chuck, Cindy, and Clay may deduct only $10,000 (their cash contribution for the stock) in the current year because the guarantee is not added to their stock basis. A more aggressive position would be to rely on the Selfe case and increase their stock basis by the amount of the guarantee. This position appears to be questionable in view of the more recent Leavitt decision. Also, the guarantees would not give the shareholders debt basis because they did not lend money to the corporation.

The three shareholders, however, could structure debt to obtain basis for deducting losses.

The individual shareholders could personally borrow the needed funds ($30,000 each) from a bank or other lending institution and then lend Able Corporation the $30,000 they had borrowed. By making a $30,000 personal loan to Able, each shareholder would have a $30,000 debt basis that would provide the basis needed to deduct the loss pass-through. The basis in each loan would be reduced from $30,000 to zero by the loss pass-through. When Able repays the loan to each Copyright © 2025 Pearson Education, Inc.

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shareholder; the shareholder in turn could repay the bank. If the shareholder loans were repaid out of corporate profits, the corporate profit pass-through would restore the $30,000 basis in the loan made to Able, and the shareholders would recognize no gain or loss on Able’s repayment of the loan to the bank.

I:17-77 Section 721 makes the contributions nontaxable to Joey, Rachel and the Green Partnership. Under Sec. 705, Joey takes a $10,000 basis in his partnership interest, and Rachel takes a $5,000 basis. The partnership’s basis in the land is $10,000. Joey and Rachel share 2023 ordinary income equally, which results in each increasing basis by $5,000. On January 1, 2024, Joey has a basis in his partnership interest of $15,000 ($10,000 original basis plus $5,000 addition from his share of 2023 ordinary income) when he sells his interest to Phoebe. On the sale, Joey recognizes long-term capital loss of $4,000 ($11,000 amount realized - $15,000 basis).

So far nothing is out of the ordinary in these transactions.

In April 2024, Green sells the land that Joey contributed. The loss realized is $4,600 ($5,400 amount realized - $10,000 adjusted basis). However, Sec. 704(c) applies. This section mandates that this basis be used only for calculating partnership loss to be allocated to the original contributing partner (Joey) who is no longer a partner in Green. Section 704(c)(1)(C) states, “in determining the amount of items allocated to other partners, the basis of the contributed property in the hands of the partnership shall be treated as being equal to its fair market value at the time of contribution.” The loss recognized by the partnership and reported by Rachel and Phoebe is $600 ($5,400 amount realized - $6,000 FMV at the time of Joey’s contribution). This provision means the $4,000 loss occurring before Joey contributed the property will effectively be recognized only once – when the partnership sells the land with Joey still a partner, or the precontribution loss will be reflected in the loss Joey recognizes on the sale of his partnership interest (while the partnership still holds the land).

“What Would You Do In This Situation?” Solution Ch. I:17, p. I:17-10.

Although this issue is covered in Treasury Regulations dealing with substantial economic effect and special allocations, students should be able to address the problem without knowledge of these regulations. That is, they should be able to recognize that the proposed allocation has tax avoidance and sham aspects about it. In short, it does not pass the “smell test.”

Without the special allocation, the annual interest for the current year would be allocated as follows: Alex Alicia Total Marginal tax rate 12% 32% Taxable interest Tax-exempt interest Total interest

$1,250 1,250 $2,500

$1,250 1,250 $2,500

$2,500 2,500 $5,000

Allocable interest Minus: Taxes paid by partners

$2,500

$2,500

$5,000

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(Marginal tax rate x taxable interest) After-tax interest

( 150) $2,350

(

400) $2,100

( 550) $4,450

With the special allocation, the annual interest would be allocated as follows: Alex Alicia Marginal tax rate 12% 32%

Total

Taxable interest Tax-exempt interest Total Interest

$2,500 150 $2,650

$

-02,350 $ 2,350

$2,500 2,500 $5,000

Allocable interest Minus: Taxes paid by partners (Marginal tax rate x taxable interest) After-tax interest

$2,650

$ 2,350

$5,000

( 300) $2,350

( -0-) $2,350

( 300) $4,700

On an after-tax basis, with the special allocation, Alex is no worse off and Alicia is better off than they would be without the special allocation. Thus, the IRS would not respect this special allocation because it lacks substantial economic effect. This transaction is specifically described in Reg. Secs. 1.704-1(b)(2)(iii)(a) and 1.704-1(b)(5) Example 5.

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Chapter I:18 Taxes and Investment Planning Discussion Questions I:18-1 The primary distinguishing feature that causes the Current, Deferred, and Pension Models to differ is the timing of taxation. With the Current Model, after-tax dollars are invested, and the investment earnings are taxed currently. With the Deferred Model, after-tax dollars are invested, but the investment earnings are taxed at the end of the investment horizon. With the Pension Model, before-tax dollars are invested, and both the contributed dollars and the investment earnings are taxed at the end of the investment horizon. Thus, the Current Model provides no deferred taxation, the Deferred Model provides one level of deferred taxation (on earnings), and the Pension Model provides two levels of deferred taxation (on contributed- dollars and earnings). pp. I:18-2, I:18-5, and I:18-10 (page numbers where discussion of each model begins).

I:18-2 The annualized ATROR is the rate of return that would cause an investment conforming to the Current Model to yield the same accumulation per after-tax dollar invested as the investment under consideration. It is similar to the internal rate of return of the investment. The annualized ATROR is useful because it allows the planner to compare various kinds of investments without knowing the exact amount that he or she will invest. That is, it allows comparison of rates of returns rather than accumulated dollars. pp. I:18-7 and I:18-8.

I:18-3 First, the BTROR of the capital asset may be lower than the BTROR on a fully-taxable investment because the capital asset’s return may reflect implicit taxes. Nevertheless, the capital asset may be preferable because the benefit of deferred taxation will outweigh the reduced rate of return if the investment horizon is long enough. pp. I:18-8, I:18-24, and I:18-25.

I:18-4 A taxpayer trying to decide between saving outside an IRA or through an IRA should not necessarily avoid the IRA even if the withdrawal from the IRA would trigger the 10% early withdrawal penalty. The benefit of deferred taxation of the IRA will outweigh the penalty if the investment horizon is long enough. On the other hand, a taxpayer who plans to make an early withdrawal may want to consider the Roth IRA because withdrawals from a Roth IRA are deemed first from contributions (Chapter I:7). Thus, Roth IRA withdrawals that do not exceed prior contributions are exempt from taxation and are not subject to the 10% early withdrawal penalty even though the withdrawals are not qualified distributions. pp. I:18-8 through I:18-14.

I:18-5 It increases over time. Unlike the Current Model, which has a constant annualized ATROR regardless of the investment horizon, the Deferred Model’s annualized ATROR increases as the investment horizon increases. That is, rann increases as n increases, assuming a constant BTROR. This result occurs because the tax deferral benefit increases as the investment horizon increases. pp. I:18-7 and I:18-8.

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I:18-6 Equivalent if to = tn; not equivalent if to ≠ tn. That is, the Exempt and Pension Models are equivalent if the tax rate in the contribution year equals the tax rate in the withdrawal year and the contribution to each (in BT$) is the same. The equivalence breaks down, however, when to and tn are not equal. Assuming constant BTRORs, the Exempt Model is better than the Pension Model if tax rates are increasing (i.e., to < tn). Conversely, the Pension Model is better than the Exempt Model if tax rates are decreasing (i.e., to > tn). The $7,000 limitation (for 2024) affects the comparison of a traditional deductible IRA (Pension Model) and a Roth IRA (Exempt Model) because the $7,000 maximum contribution to a deductible IRA is deductible (BT$) while the $7,000 maximum contribution to a Roth is not deductible (AT$). To properly compare these two vehicles, the analyst must determine the after-tax accumulation resulting from investing the tax savings from the deductible contribution. This amount must be added to the deductible IRA accumulation so that the total accumulation can be compared with the accumulation from the Roth IRA. pp. I:18-12 through I:18-14.

I:18-7 Deferral of shareholder tax. The C corporation entails two levels of taxation, one at the corporate level and another at the shareholder level. Assuming no current distributions (i.e., dividends), the shareholder’s tax is deferred until the shareholder sells the stock or until the corporation liquidates. This deferred taxation is captured in the Deferred Model. pp. I:18-21 and I:18-22.

I:18-8 The key factor in the Roth conversion decision is the tax rate structure. A low tax rate at the time of conversion compared to a high tax rate at the time of withdrawal would bias the decision toward converting to the Roth. In this case, the conversion tax would be at a relatively low tax rate while distributions from the Roth IRA would avoid being taxed at a high tax rate.

Other factors also come into play, such as rates of return and the source of paying the conversion tax, but the tax rate structure is the key component of the decision. p. I:18-19.

I:18-9 The tax rates facing individual entity owners versus the 21% C corporation tax rate are key factors. Also important is the qualified business income (QBI) deduction available to pass-through entity owners. The QBI deduction effectively reduces the owner’s tax rate by a factor of 20%. The 100% Sec. 1202 exclusion, if applicable, plays an important role as well because it reduces the C corporation shareholder’s tax rate to zero upon the sale of the corporate stock. pp. I:18-22 through I:18-24.

I:18-10 Implicit taxes. An investment conforming to the Exempt Model may have a lower BTROR than does a risk-equivalent investment conforming to the Current Model because of implicit taxes. See the solution for Discussion Question I:18-11 for a discussion of the process that leads to implicit taxes. pp. I:18-24 through I:18-27.

I:18-11 An implicit tax is the reduced BTROR on a tax-favored investment compared to the BTROR on a risk-equivalent fully taxable benchmark investment. The implicit tax is defined as IT = Rb - Re, where Rb is the BTROR on the benchmark investment, and R e is the BTROR on the tax-favored investment. Investor demand for the tax-favored investment will drive up its price and drive down its BTROR until ATRORs are equal for the marginal investors. This reduced BTROR is an implicit tax. pp. I:18-24 through I:18-27.

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I:18-12 Market forces. Marginal investors are indifferent between fully taxable and tax-favored investments. As mentioned in Discussion Question I:18-11, investor demand for the tax-favored investment will drive up its price and drive down its BTROR until ATRORs are equal for the marginal investors. Thus, BTRORs adjust in the market to cause ATRORs to be equal for the marginal investors. If the ATRORs are equal, the marginal investors are at their point of indifference. pp. I:18-24 through I:18-27.

I:18-13 Although marginal investors are indifferent between risk-equivalent fully-taxable investments and tax-favored investments, investors whose tax rate exceeds or is less than that of the marginal investors are not indifferent. Generally, high-bracket investors prefer tax-favored investments because they can convert the investor’s high statutory (explicit) tax rate into a lower implicit tax rate. Low-bracket investors, on the other hand, prefer fully-taxable investments to avoid converting their low statutory (explicit) tax rate into a higher implicit tax rate. This phenomenon is called the clientele effect because certain investors form natural clienteles for certain investments. For a clientele opportunity to exist, the tax rate structure must be progressive (i.e., contain more than one rate), and at least one type of investment must be tax favored. pp. I:18-25 and I:18-26.

I:18-14 The quoted statement focuses on explicit taxes and ignores implicit taxes. If both implicit and explicit taxes are considered, the total tax rates will be higher than quoted for the tax-favored capital assets and the state and local bonds. In fact, for marginal investors, the total tax rate will be the same for all three type investments. This quotation highlights the danger of ignoring implicit taxes in policy discussions. pp. I:18-24 and I:18-25.

I:18-15 As mentioned in the solution for Discussion Question I:18-13, the clientele effect requires the existence of progressive tax rates. In a flat-rate tax system, all investors would be marginal investors. pp. I:18-25 and I:18-26.

I:18-16 Risk premium. The BTROR on a tax-favored investment may exceed that on fullytaxable investment if the tax-favored investment’s BTROR includes a risk premium. The implicit tax, however, still exists, but it is masked by the risk premium. To properly measure the implicit tax, the benchmark and tax-favored investments must be adjusted to the same level of risk. Usually, the tax-favored investment is risk adjusted to be compatible to the risk-free benchmark investment for purposes of measuring the implicit tax. p. I:18-26.

I:18-17 Two other examples where implicit taxes may arise are deductible mortgage interest and depreciable assets. Tax deductibility of mortgage interest increases the demand for housing and mortgage loans, which can drive up housing prices and/or interest rates. These increased prices and rates are implicit taxes on the home buyer and borrower. The home seller and/or mortgage lender “receives” the implicit subsidy in the form of higher selling prices and/or higher interest rates. If assets can be depreciated more rapidly than economic depreciation (e.g., through Sec. 179 expensing or bonus depreciation), the assets are tax-favored, which can increase demand and prices for assets subject to accelerated depreciation. The buyer “pays” the implicit tax in the form of increased prices, and the seller “receives” the implicit subsidy. Both of the examples illustrate that the tax benefit of specific provisions may not go to the expected party. pp. I:18-24 through I:18-27.

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I:18-3

Problems I:18-18 Greater than 10.77%. The ATROR on the taxable bond must be 7% to make it comparable to the tax-exempt bond. Thus: r = R (1 - t) R = r/(1 - t) R = 0.07/(1 - 0.35) R = 0.1077 Therefore, the taxable bond must yield over 10.77% before taxes to make it preferable to the taxexempt bond. p. I:18-4.

I:18-19 rb = 4.32% for Part a and 4.512% for Part b. This problem incorporates state taxation into the ATROR formula. The answers for Parts a and b below also incorporate the information requested in Part c. a. rb

= Rb - Rbtfed - Rbtst = Rb (1 - tfed - tst) = 8% (1 - 0.40 - 0.06) = 8% (0.54) = 4.32%

b. rb

= Rb - Rbtst - (Rb - Rbtst) tfed = Rb - Rbtst - Rbtfed + Rbtsttfed = Rb (1 - tst - tfed + tsttfed) = 8% [1 - 0.06 - 0.40 + (0.06)(0.40)] = 8% (0.564) = 4.512%

p. I:18-4.

I:18-20 a.

David should choose the Pension Model. accumulation (ATA) and largest annualized ATROR (rann).

Model Current Deferred Pension

It yields the largest after-tax

Formula [1 + 0.1 (1 - 0.15)]7 or (1.085)7 7

(1.1) (1 - 0.15) + 0.15 7

7

[1/(1 - 0.15)](1.1) (1 - 0.15) or (1.1)

b.

David should choose the Current Model. accumulation (ATA) and largest annualized ATROR (rann).

rann

1.7701

0.0850

1.8064

0.0881

1.9487

0.1000

It yields the largest after-tax

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I:18-4

ATA

Model

Formula

ATA

rann

Current

(1.085)6 (1.075)1

1.7538

0.0836

Deferred

(1.1)7 (1 - 0.25) + 0.25

1.7115

0.0798

Pension

[1/(1 - 0.15)] (1.1)7 (1 - 0.25)

1.7195

0.0805

In this case, the Current Model outperforms the others because the investment horizon is not long enough for the deferral of the Deferred and Pension Models to overcome the tax increase. pp. I:18-2 through I:18-12.

I:18-21 a.

Mark should choose the nondeductible IRA (Deferred Model), based on the following analysis:

Investment

Formula

ATA

rann

Tax-exempt bond

(1.07)15

2.7590

0.0700

Nondeductible IRA

(1.1)15 (1 - 0.35) + 0.35

3.0652

0.0775

b.

Mark’s tax rate must exceed 44.64% to make the tax-exempt bond more attractive than the nondeductible IRA, based on the following analysis: (1 + Rd)n (1 - tn) + tn < (1 + Re)n (1 + Rd)n - [(1 + Rd)n -1] tn < (1 + Re)n - [(1 + Rd)n -1] tn < (1 + Re)n - (1 + Rd)n [(1 + Rd)n -1] tn > (1 + Rd)n - (1 + Re)n

Set Deferred Model less than Exempt Model Multiply through by (1 + Rd)n; factor out (-tn) Subtract (1 + Rd)n from each side Multiply through by -1

tn >

(1 + Rd)n - (1 + Re)n [(1 + Rd)n - 1]

Divide both sides by [(1 + Rd)n -1]

tn >

(1.1)15 - (1.07)15 [(1.1)15 - 1]

Substitute in values

tn >

.4464

Solve for tn

pp. I:18-5 through I:18-10.

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I:18-5

I:18-22 a.

8 years. Based on the following analysis, Brenda must wait eight years until a deductible IRA (Pension Model) with penalty is better than direct investment in a bond outside the IRA (Current Model).

Bond outside IRA (current model): $5,250 [1 + 0.08 (1 - 0.25)]n = $5,250 (1.06)n Deductible IRA (pension model): $7,000 (1.08)n (1 - 0.35)

n 1 2 3 4 5 6 7 8 9

After-Tax Accumulation (ATA) Bond Ded. IRA $5,565 $4,914 5,899 5,307 6,253 5,732 6,628 6,190 7,026 6,685 7,447 7,220 7,894 7,798 8,368 8,422 8,870 9,095

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(switch over year)

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b.

15 years. Based on the following analysis, Brenda must wait 15 years until a Roth IRA functioning as a traditional nondeductible IRA (Deferred Model) with penalty is better than direct investment in a bond outside the IRA (Current Model). $5,250 [1 + 0.08 (1 - 0.25)]n = $5,250

Bond outside IRA (current model): (1.06)

Formatted: Space Before: 6 pt

n

$5,250 [(1.08)n (1 - 0.35) + 0.35]

Nondeductible IRA (deferred model):

n 1 2 3 4 5 6 7 8 9 10 11 12 13

After-Tax Accumulation (ATA) Bond Nonded. IRA $ 5,565 $ 5,523 5,899 5,818 6,253 6,136 6,628 6,480 7,026 6,852 7,447 7,253 7,894 7,686 8,368 8,154 8,870 8,659 9,402 9,205 9,966 9,794 10,564 10,431 11,198 11,118 Copyright © 2025 Pearson Education, Inc.

I:18-6

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14 15 16

11,870 12,582 13,337

11,861 12,663 13,529

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(switch over year)

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pp. I:18-2 through I:18-12.

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I:18-7

I:18-23 Martha should choose Alternative 2. That is, have the H.R. 10 plan invest in the bond, and Martha will invest in the stock outside the H.R. 10 plan. The analysis follows: Before-tax income Minus: Deduction for H.R. 10 investment Taxable income Times: Tax rate Tax Taxable income after tax (available for investment outside the H.R. 10 plan)

$40,000 ( 20,000) $20,000 0.35 $ 7,000 $13,000

Alternative 1: Stock in (Pension Model): Bond out (Current Model): Total ATA

$20,000 (1.1)10 (1 - 0.35) $13,000 (1.065)10

$33,719 24,403 $58,122

$20,000 (1.1)10 (1 - 0.35) $13,000 [(1.1)10 (1 - 0.15) + 0.15]

$33,719 30,611 $64,330

Alternative 2: Bond in (Pension Model): Stock out (Deferred Model): Total ATA

In this situation, the H.R. 10 plan yields the same result whether it contains the bond or the stock.

In effect, the H.R. 10 plan converts the stock into an ordinary income investment. However, the stock does better outside the H.R. 10 plan because it conforms to the Deferred Model while the bond outside the H.R. 10 plan conforms to the Current Model. In addition, the stock outside the H.R. 10 plan is taxed at 15% rather than 35%. pp. I:18-2 through I:18-12.

I:18-24 The decision models for Harry’s decision are as follows: Roth IRA

$7,000 (1 + R)n

Versus Deductible IRA

$7,000 (1 + R)n (1 - tn)

Plus Outside Investment

$7,000 (to) [(1 + R)n (1 - tn) + tn]

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I:18-8

Formatted: Left, Widow/Orphan control, Adjust space between Latin and Asian text, Adjust space between Asian text and numbers, Tab stops: Not at -72 pt + 39.6 pt

a.

In this case, Harry should choose the Roth IRA. If Harry’s tax rates remain the same, the two alternatives yield the following after-tax accumulations: Roth IRA [$7,000 (1.12)25]

$119,000

Deductible IRA [$7,000 (1.12)25 (1 - 0.30)] Plus: Outside investment {$7,000 (0.30) [(1.12)25 (1 - 0.15) + 0.15]} Total

$ 83,300 30,660 $113,960

b.

In this case, Harry should choose the deductible IRA plus the outside investment.

If Harry’s tax rates decrease, the two alternatives yield the following after-tax accumulations: Roth IRA [$7,000 (1.12)25]

$119,000

Deductible IRA [$7,000 (1.12)25] (1 - 0.15)] Plus: Outside investment [$7,000 (0.30) (1.12)25] Total

$101,150 35,700 $136,850

pp. I:18-13 and I:18-14.

I:18-25 The Roth IRA. The before-tax dollars comparable to $6,300 of after-tax dollars are $8,400 [$6,300/(1 - 0.25)]. Because this amount exceeds the $7,000 limitation on deductible IRA contributions, Beth can contribute only $7,000 to a deductible IRA, leaving a $1,400 excess.

From this $1,400 amount, Beth must pay taxes of $350 (0.25 x $1,400), leaving $1,050 ($1,400 $350) available for investment outside the deductible IRA. Accordingly, Beth’s choices are as follows: Roth IRA [$6,37,000 (1.1)30]

$109,931

Deductible IRA [$7,000 (1.1)30(1 - 0.25)] Plus: Outside investment {$1,050 [1 + 0.1 (1 - 0.25)] 30} Total

$ 91,609 9,193 $100,802

Thus, the Roth IRA will give Beth the greater after-tax accumulation. pp I:18-12 through I:18-14.

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I:18-9

I:18-26 Karen’s best strategy can be determined with the following table, which gives the aftertax accumulation per after-tax dollar invested. n 9 8 7 6 5 4 3 2 1 0

Year 1 2 3 4 5 6 7 8 9 10

IRAa 1.6895 1.5938 1.5036 1.4185 1.3382 1.2625 1.1910 1.1236 1.0600 1.0000

M.M.b 1.4861 1.4221 1.3609 1.3023 1.2462 1.1925 1.1412 1.0920 1.0450 1.0000

C.A.c 1.4926 1.4261 1.3629 1.3028 1.2457 1.1915 1.1399 1.0909 1.0443 1.0000

a

Pension Model: [1/(1 - 0.25)] (1.06)n (1 - 0.25) = (1.06)n (second form) b Current Model: [1 + 0.06 (1 - 0.25)]n = (1.045)n c Deferred Model: (1.0521)n (1 - 0.15) + 0.15 Strategy: 1.

2.

3.

4.

Invest the maximum $7,000 in the IRA for Years 1 - 9 because the IRA dominates the other vehicles for all years.

Invest the remaining savings in capital assets (C.A.) for Years 1 - 4 because capital assets dominate the money market fund (M.M.) for these years.

Invest the remaining savings in the money market fund for Years 5 - 9 because the money market fund dominates capital assets for these years.

Salary for Year 10 is not invested.

The following table shows the after-tax accumulation from this strategy.

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I:18-10

n Year 9 1 8 2 7 3 6 4 5 5 4 6 3 7 2 8 1 9 0 10 Totals

Total ----Allocated Savings---- ---------After-Tax Accumulations--------Income Taxesa Savings IRA M.M. C.A. IRAb M.M.c C.A.d Total $50,500 $10,875 $39,625 $7,000 $ 0 $32,625 $ 8,870 $ 0 $ 48,695 $ 57,565 50,500 10,875 39,625 7,000 0 32,625 8,368 0 46,526 54,894 50,500 10,875 39,625 7,000 0 32,625 7,894 0 44,464 52,358 50,500 10,875 39,625 7,000 0 32,625 7,447 0 42,504 49,951 50,500 10,875 39,625 7,000 32,625 0 7,026 40,657 0 47,683 50,500 10,875 39,625 7,000 32,625 0 6,628 38,906 0 45,534 50,500 10,875 39,625 7,000 32,625 0 6,253 37,231 0 43,484 50,500 10,875 39,625 7,000 32,625 0 5,899 35,627 0 41,526 50,500 10,875 39,625 7,000 32,625 0 5,565 34,093 0 39,658 50,500 12,625 37,875 0 0 0 0 0 0 37,875 $63,950 $186,514 $182,189 $470,528

Note: Spreadsheet may contain $1 rounding errors. a For Years 1 - 9: ($50,500 - $7,000) x 0.25: For Year 10: $50,500 x 0.25 b Pension Model: $7,000 (1.06)n (1 - 0.25) (first form) c Current Model: $32,625(1.045)n d Deferred Model: $32,625 [(1.0521)n (1 - 0.15) + 0.15] Thus, the optimal strategy yields Karen a total after-tax accumulation of $470,5287.

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pp. I:18-14 and I:18-15.

I:18-27 Ken should retain his existing traditional IRA because his after-tax accumulation will be $253,107 if he does so but only $244,453 (net of the conversion tax’s future value) if he converts it to a Roth IRA. Because Ken deducted all his contributions to the traditional IRA, the entire $75,000 balance will be taxable if he converts it to a Roth IRA, and the entire balance will be taxable at the end of the 16-year period if he retains it. The 10% penalty for early withdrawal does not apply to amounts converted from a traditional IRA to a Roth IRA, and this penalty will not apply at the end of the 16-year period because Ken will be age 63 at that time (47 + 16, which is older than age 59½). The after-tax accumulations are calculated as follows: Retain existing traditional IRA: Value of traditional IRA at end of 16-year period = $75,000 × 1.0916 = $297,773 Tax on withdrawal from traditional IRA = 0.15 × $297,773 = $44,666 After-tax accumulation = $297,773 – $44,666 = $253,107 Convert to Roth IRA: Conversion tax = 0.25 × $75,000 = $18,750 Value of Roth IRA at end of 16-year period = $75,000 × 1.0916 = $297,773 Future value (opportunity cost) of conversion tax = $18,750 × 1.067516 = $53,320 Copyright © 2025 Pearson Education, Inc.

I:18-11

After-tax accumulation = $297,773 – $53,320 = $244,453 pp. I:18-16 through I:18-19.

I:18-28 Conceptually, the comparison should start with the idea that the decision to convert occurs when the retention model produces an ATA that is less than the conversion ATA, that is when Formatted: Space Before: 6 pt

Retain traditional IRA ATA < Roth conversion ATA Because the IRA has no basis, the analysis can proceed as follows: Vk (1 + R)n - tn [Vk (1 + R)n] < Vk (1 + R)n - tk (Vk) (1 + r)n

where Bk = 0

(1 + R)n - tn (1 + R)n < (1 + R)n - tk (1 + r)n

Divide through by Vk

- tn (1 + R)n < - tk (1 + r)n

Subtract (1 + R)n from both sides

tn (1 + R)n > tk (1 + r)n

Multiply through by -1

tn >

tk (1 + r) (1 + R)n

n

Divide both sides by (1 + R)n

Thus, the client now has a formula into which to insert various values. Note that the critical value of tn is a function of the conversion date tax rate, the before- and after-tax rates of return, and the investment horizon. pp I:18-16 through I:18-19.

I:18-29 $473,473 for Part a, $500,191 for Part b, and $450,530 for Part c. a.

Value of S corporation’s stock at end of 10-year period = $200,000 × [1 + .12(1 – .25)]10 = $473,473 Amber’s basis for S corporation’s stock at end of 10-year period = $200,000 × [1 + .12(1 – .25)]10 = $473,473 After-tax accumulation = $473,473 – [0.15 × ($473,473 – $473,473)] = $473,473

b.

Value of S corporation’s stock at end of 10-year period = $200,000 × {1 + .12[1 – .25(1 – .20)]}10 = $500,191 = $200,000 × {1 + .12[1 – .25(1 – .20)]}10 = $500,191 Note: Amber’s qualified business income deduction affects her basis because the corporation distributes cash to her equal to the taxes she must pay on the corporation’s earnings.

After-tax accumulation = $500,191 – [0.15 × ($500,191 – $500,191)] = $500,191

c.

Value of C corporation’s stock at end of 10-year period = $200,000 × [1 + .12(1 – .21)]10 = $494,741 Copyright © 2025 Pearson Education, Inc.

I:18-12

Amber’s basis for C corporation’s stock at end of 10-year period = $200,000 After-tax accumulation = $494,741 – [0.15 × ($494,741 – $200,000)] = $450,530 pp. I:18-19 through I:18-24.

I:18-30 Myron should form a C corporation rather than operate as a sole proprietor. With the C corporation, Myron will accumulate $46,220 rather than $37,319 or $44,089 with the proprietorship, as shown below. Note that the Current Model portion of each model has to be partitioned into two parts because of the change in the BTROR after Year 5.

Proprietorship (Pass-Through Model without QBI deduction): ATA = $10,000 {[1 + 0.1 (1 - 0.4)]5 [1 + 0.18 (1 - 0.4)]10} = $10,000 [(1.06)5 (1.108)10] = $10,000 (3.731874) = $37,319 The annualized ATROR is as follows: rann = (3.731874)1/15 - 1 = 0.091763 Proprietorship (Pass-Through Model with QBI deduction): ATA = $10,000 {[1 + 0.1 (1 - 0.32)]5 [1 + 0.18 (1 - 0.32)]10} = $10,000 [(1.068)5 (1.1224)10] = $10,000 (4.408926) = $44,089 The annualized ATROR is as follows: rann = (4.408926)1/15 - 1 = 0.103966 C Corporation Model: ATA = $10,000 {[1 + 0.1 (1 - 0.21)]5 [1 + 0.18 (1 - 0.21)]10 (1 - 0.20) + 0.20} = $10,000 {[(1.079)5 (1.1422)10] (0.80) + 0.20} = $10,000 (4.6220) = $46,220 The annualized ATROR is as follows: rann = (4.6220)1/15 - 1 = 0.107445 The C corporation outperforms the proprietorship, with or without the QBI deduction, despite the two levels of taxation because of the low current corporate tax rate (21%) and the lengthy deferral of the shareholder’s tax at 20%. However, with the QBI deduction, the proprietorship’s ATA is much closer to that of the C corporation than without the QBI deduction.

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I:18-13

pp. I:18-19 through I:18-24.

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I:18-14

I:18-31

The following table summarizes the four alternative models: Years (n) 6 15 S corporation (tp = 37%, no QBI ded.): ATA = $10,000 [1 + 0.18 (1 - 0.37)]n $19,051 $50,092

$2,150,606

C corporation (no Sec. 1202 exclusion): ATA = $10,000 {[1 + 0.18 (1 - 0.21)]n (1 - 0.20) + 0.20}

$19,764

$60,779

$6,170,759

S corporation (tp = 29.6%, with QBI ded.): ATA = $10,000 [1 + 0.18 (1 - 0.296)]n

$20,460

$59,874

$3,897,626

C corporation (100% Sec. 1202 exclusion): ATA = $10,000 [1 + 0.18 (1 - 0.21)]n

$22,205

$73,474

$7,710,948

50

The C corporation with no Sec. 1202 exclusion compared to the S corporation with no QBI deduction (tp = 37%), shows that the C corporation outperforms the S corporation for each investment horizon. When tp drops to 29.6%, however, the S corporation outperforms the C corporation for the six-year horizon, but the C corporation is better for the 15-year and 50-year horizons. If the 100% Sec. 1202 exclusion applies, however, the C corporation beats the S corporation for all investment horizons. The shareholder incurs no capital gains tax, and the corporate tax rate (21%) is lower than the tax rate (either 37% or 29.6%) applicable to the S corporation shareholder. pp. I:18-19 through I:18-24.

I:18-32 The implicit tax rate on the tax-exempt bond is 20%, computed as follows: tI = (Rb - Re)/Rb = (7.5% - 6%)/7.5% = 0.2 or 20% a.

Tax-exempt bond. Terry should invest in the tax-exempt bond and thereby convert his 30% explicit tax rate into a 20% implicit tax rate. Viewed another way, Terry’s ATROR will be higher with the tax-exempt bond than with the taxable bond. The ATROR on the taxable bond is 5.25%, which is r = 7.5% (1 - 0.3). Thus, the 6% return on the tax-exempt bond beats the 5.25% return on the taxable bond. b.

Taxable bond. Terry should invest in the taxable bond to avoid converting his 15% explicit tax rate into a 20% implicit tax rate. Viewed another way, Terry’s ATROR will be higher with the taxable bond than with the tax-exempt bond. The ATROR on the taxable bond in 6.375% which is r = 7.5% (1 - 0.15). Thus, the 6.375% return on the taxable bond beats the 6% return on the tax-exempt bond. pp. I:18-25 and I:18-26.

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I:18-15

I:18-33 a.

In equilibrium, Re = re = rb = Rb (1 - t). Thus, if Alice is the marginal investor, Re = 10% (1 - 0.25) = 7.5%. The implicit tax rate is 25%, calculated as follows: tI = (Rb - Re)/Rb = (10% - 7.5%)/10% = 0.25 or 25% b.

If Brad is the marginal investor, Re = 10% (1 - 0.35) = 6.5%. The implicit tax rate is 35%, calculated as follows: tI = (Rb - Re)/Rb = (10% - 6.5%)/10% = 0.35 or 35% c.

If Camille is the marginal investor, Re = 10% (1 - 0.4) = 6%. The implicit tax rate is 40%, calculated as follows: tI = (Rb - Re)/Rb = (10% - 6%)/10% = 0.4 or 40% d.

Camille would like to see Alice be the marginal investor. If Alice is the marginal investor, the tax-exempt bond will yield 7.5% in equilibrium. Thus, Camille can get a 7.5% return on the tax-exempt bond rather than a 6% ATROR on the taxable bond. In other words, Camille can take advantage of the clientele effect and convert a 40% explicit tax rate into a 25% implicit tax rate. pp. I:18-25 and I:18-26.

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I:18-16

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D"

2024 Edition Modification "M"

Chapter I:1 Discussion Questions: I:1-1 I:1-2 I:1-3 I:1-4 I:1-5 I:1-6 I:1-7 I:1-8 I:1-9 I:1-10 I:1-11 I:1-12 I:1-13 I:1-14 I:1-15 I:1-16 I:1-17 I:1-18 I:1-19 I:1-20 I:1-21 I:1-22 I:1-23 I:1-24 I:1-25 I:1-26 I:1-27 I:1-28 I:1-29 I:1-30 I:1-31

I:1-1 I:1-2 I:1-3 I:1-4 I:1-5 I:1-6 I:1-7 I:1-8 I:1-9 I:1-10 I:1-11 I:1-12 I:1-13 I:1-14 I:1-15 I:1-16 I:1-17 I:1-18 I:1-19 I:1-20 I:1-21 I:1-22 I:1-23 I:1-24 I:1-25 I:1-26 I:1-27 I:1-28 I:1-29 I:1-30 I:1-31 Copyright © 2025 Pearson Education, Inc.

I:SQR-1

M

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:1-32 I:1-32 I:1-33 I:1-33 I:1-34 I:1-34 I:1-35 I:1-35 I:1-36 I:1-36 I:1-37 I:1-37 I:1-38 I:1-38 Problems: I:1-39 I:1-40 I:1-41 I:1-42 I:1-43 I:1-44 I:1-45 I:1-46 I:1-47 I:1-48

I:1-39 I:1-40 I:1-41 I:1-42 I:1-43 I:1-44 I:1-45 I:1-46 I:1-47 I:1-48

Tax Strategy and Critical Thinking Problem: I:1-49 I:1-49 Case Study Problem: I:1-50

I:1-50

Tax Research Problem: I:1-51

I:1-51

Chapter I:2 Discussion Questions: I:2-1 I:2-2 I:2-3 I:2-4 I:2-5 I:2-6

I:2-1 I:2-2 I:2-3 I:2-4 I:2-5 I:2-6 Copyright © 2025 Pearson Education, Inc.

I:SQR-2

2024 Edition Modification "M"

M M

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:2-7 I:2-7 I:2-8 I:2-8 I:2-9 I:2-9 I:2-10 I:2-10 I:2-11 I:2-11 I:2-12 I:2-12 I:2-13 I:2-13 I:2-14 I:2-14 I:2-15 I:2-15 I:2-16 I:2-16 I:2-17 I:2-17 I:2-18 I:2-18 I:2-19 I:2-19 I:2-20 I:2-20 I:2-21 I:2-21 I:2-22 I:2-22 I:2-23 I:2-23 I:2-24 I:2-24 I:2-25 I:2-25 Issue Identification Questions: I:2-26 N I:2-27 I:2-28

I:2-26 I:2-27 I:2-28

Problems: I:2-29 I:2-30 I:2-31 I:2-32 I:2-33 I:2-34 I:2-35 I:2-36 I:2-37 I:2-38

I:2-29 I:2-30 I:2-31 I:2-32 I:2-33 I:2-34 I:2-35 I:2-36 I:2-37 I:2-38

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:2-39 I:2-39 I:2-40 I:2-40 I:2-41 I:2-41 I:2-42 I:2-42 I:2-43 I:2-43 I:2-44 I:2-44 I:2-45 I:2-45 I:2-46 I:2-46 I:2-47 I:2-47 I:2-48 I:2-48 I:2-49 I:2-49 I:2-50 I:2-50 I:2-51 I:2-51 I:2-52 I:2-52 I:2-53 I:2-53 I:2-54 I:2-54 I:2-55 I:2-55 I:2-56 I:2-56 I:2-57 I:2-57

2024 Edition Modification "M"

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Tax Strategy and Critical Thinking Problems: I:2-58 I:2-58 I:2-59 I:2-59 I:2-60 I:2-60 Tax Form/Return Preparation Problems: I:2-61 I:2-61 I:2-62 I:2-62 I:2-63 I:2-63 Case Study Problems: I:2-64 I:2-65

I:2-64 I:2-65

Tax Research Problems: I:2-66

I:2-66 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:2-67 I:2-67 I:2-68 I:2-68 Chapter I:3 Discussion Questions: I:3-1 I:3-2 I:3-3 I:3-4 I:3-5 I:3-6 I:3-7 I:3-8 I:3-9 I:3-10 I:3-11 I:3-12 I:3-13 I:3-14 I:3-15 I:3-16 I:3-17 I:3-18 I:3-19 I:3-20 I:3-21 I:3-22 I:3-23 I:3-24 I:3-25 I:3-26 I:3-27 I:3-28 I:3-29 I:3-30

I:3-1 I:3-2 I:3-3 I:3-4 I:3-5 I:3-6 I:3-7 I:3-8 I:3-9 I:3-10 I:3-11 I:3-12 I:3-13 I:3-14 I:3-15 I:3-16 I:3-17 I:3-18 I:3-19 I:3-20 I:3-21 I:3-22 I:3-23 I:3-24 I:3-25 I:3-26 I:3-27 I:3-28 I:3-29 I:3-30 Copyright © 2025 Pearson Education, Inc.

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2024 Edition Modification "M"

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" Issue Identification Questions: I:3-31 I:3-32 I:3-33

I:3-31 I:3-32 I:3-33

Problems: I:3-34 I:3-35 I:3-36 I:3-37 I:3-38 I:3-39 I:3-40 I:3-41 I:3-42 I:3-43 I:3-44 I:3-45 I:3-46 I:3-47 I:3-48 I:3-49 I:3-50 I:3-51 I:3-52 I:3-53 I:3-54

I:3-34 I:3-35 I:3-36 I:3-37 I:3-38 I:3-39 I:3-40 I:3-41 I:3-42 I:3-43 I:3-44 I:3-45 I:3-46 I:3-47 I:3-48 I:3-49 I:3-50 I:3-51 I:3-52 I:3-53 I:3-54

Comprehensive Problems: I:3-55 I:3-56

I:3-55 I:3-56

Tax Strategy and Critical Thinking Problems: I:3-57 I:3-57 I:3-58 I:3-58 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" Tax Form/Return Preparation Problems: I:3-59 I:3-59 I:3-60 I:3-60 Case Study Problems: I:3-61 I:3-62 I:3-63

I:3-61 I:3-62 I:3-63

Tax Research Problem: I:3-64

I:3-64

Chapter I:4 Discussion Questions: I:4-1 I:4-2 I:4-3 I:4-4 I:4-5 I:4-6 I:4-7 I:4-8 I:4-9 I:4-10 I:4-11 I:4-12 I:4-13 I:4-14 I:4-15 I:4-16 I:4-17 I:4-18 I:4-19 I:4-20 I:4-21

I:4-1 I:4-2 I:4-3 I:4-4 I:4-5 I:4-6 I:4-7 I:4-8 I:4-9 I:4-10 I:4-11 I:4-12 I:4-13 I:4-14 I:4-15 I:4-16 I:4-17 I:4-18 I:4-19 I:4-20 I:4-21 Copyright © 2025 Pearson Education, Inc.

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2024 Edition Modification "M"

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:4-22 I:4-22 I:4-23 I:4-23 I:4-24 I:4-24 I:4-25 I:4-25 I:4-26 I:4-26 I:4-27 I:4-27 I:4-28 I:4-28 Issue Identification Questions: I:4-29 I:4-30 I:4-31 I:4-32

I:4-29 I:4-30 I:4-31 I:4-32

Problems: I:4-33 I:4-34 I:4-35 I:4-36 I:4-37 I:4-38 I:4-39 I:4-40 I:4-41 I:4-42 I:4-43 I:4-44 I:4-45 I:4-46 I:4-47 I:4-48 I:4-49 I:4-50 I:4-51 I:4-52 I:4-53

I:4-33 I:4-34 I:4-35 I:4-36 I:4-37 I:4-38 I:4-39 I:4-40 I:4-41 I:4-42 I:4-43 I:4-44 I:4-45 I:4-46 I:4-47 I:4-48 I:4-49 I:4-50 I:4-51 I:4-52 I:4-53 Copyright © 2025 Pearson Education, Inc.

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2024 Edition Modification "M"

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:4-54 I:4-54 I:4-55 I:4-55 Comprehensive Problem: I:4-56

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Tax Strategy and Critical Thinking Problems: I:4-57 I:4-57 I:4-58 I:4-58 I:4-59 I:4-59 Tax Form/Return Preparation Problems: I:4-60 I:4-60 I:4-61 I:4-61 Case Study Problems: I:4-62 I:4-63

I:4-62 I:4-63

Tax Research Problems: I:4-64 I:4-65 I:4-66 I:4-67

I:4-64 I:4-65 I:4-66 I:4-67

Chapter I:5 Discussion Questions: I:5-1 I:5-2 I:5-3 I:5-4 I:5-5 I:5-6 I:5-7 I:5-8 I:5-9 I:5-10

2024 Edition Modification "M"

I:5-1 I:5-2 I:5-3 I:5-4 I:5-5 I:5-6 I:5-7 I:5-8 I:5-9 I:5-10 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:5-11 I:5-11 I:5-12 I:5-12 I:5-13 I:5-13 I:5-14 I:5-14 I:5-15 I:5-15 I:5-16 I:5-16 I:5-17 I:5-17 I:5-18 I:5-18 I:5-19 I:5-19 I:5-20 I:5-20 I:5-21 I:5-21 I:5-22 I:5-22 I:5-23 I:5-23 I:5-24 I:5-24 I:5-25 I:5-25 I:5-26 I:5-26 I:5-27 I:5-27 I:5-28 I:5-28 Issue Identification Questions: I:5-29 I:5-30 I:5-31 I:5-32

I:5-29 I:5-30 I:5-31 I:5-32

Problems: I:5-33 I:5-34 I:5-35 I:5-36 I:5-37 I:5-38 I:5-39 I:5-40 I:5-41 I:5-42

I:5-33 I:5-34 I:5-35 I:5-36 I:5-37 I:5-38 I:5-39 I:5-40 I:5-41 I:5-42 Copyright © 2025 Pearson Education, Inc.

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2024 Edition Modification "M"

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:5-43 I:5-43 I:5-44 I:5-44 I:5-45 I:5-45 I:5-46 I:5-46 I:5-47 I:5-47 I:5-48 I:5-48 I:5-49 I:5-49 I:5-50 I:5-50 I:5-51 I:5-51 I:5-52 I:5-52 I:5-53 I:5-53 I:5-54 I:5-54 I:5-55 I:5-55 I:5-56 I:5-56 I:5-57 I:5-57 I:5-58 I:5-58 I:5-59 I:5-59 I:5-60 I:5-60 Comprehensive Problem: I:5-61

I:5-61

Tax Strategy and Critical Thinking Problems: I:5-62 I:5-62 I:5-63 I:5-63 I:5-64 I:5-64 I:5-65 I:5-65 I:5-66 I:5-66 Tax Form/Return Preparation Problems: I:5-67 I:5-67 I:5-68 I:5-68 Case Study Problems: I:5-69 I:5-70

I:5-69 I:5-70 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" Tax Research Problems: I:5-71 I:5-72 I:5-73 I:5-74

2024 Edition Modification "M"

I:5-71 I:5-72 I:5-73 I:5-74

Chapter I:6 Discussion Questions: I:6-1 I:6-2 I:6-3 I:6-4 I:6-5 I:6-6 I:6-7 I:6-8 I:6-9 I:6-10 I:6-11 I:6-12 I:6-13 I:6-14 I:6-15 I:6-16 I:6-17 I:6-18 I:6-19 I:6-20 I:6-21 I:6-22 I:6-23 I:6-24 I:6-25 I:6-26

I:6-1 I:6-2 I:6-3 I:6-4 I:6-5 I:6-6 I:6-7 I:6-8 I:6-9 I:6-10 I:6-11 I:6-12 I:6-13 I:6-14 I:6-15 I:6-16 I:6-17 I:6-18 I:6-19 I:6-20 I:6-21 I:6-22 I:6-23 I:6-24 I:6-25 I:6-26 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:6-27 I:6-27 I:6-28 I:6-28 Issue Identification Questions: I:6-29 I:6-30 I:6-31 I:6-32

I:6-29 I:6-30 I:6-31 I:6-32

Problems: I:6-33 I:6-34 I:6-35 I:6-36 I:6-37 I:6-38 I:6-39 I:6-40 I:6-41 I:6-42 I:6-43 I:6-44 I:6-45 I:6-46 I:6-47 I:6-48 I:6-49 I:6-50 I:6-51 I:6-52 I:6-53 I:6-54 I:6-55

I:6-33 I:6-34 I:6-35 I:6-36 I:6-37 I:6-38 I:6-39 I:6-40 I:6-41 I:6-42 I:6-43 I:6-44 I:6-45 I:6-46 I:6-47 I:6-48 I:6-49 I:6-50 I:6-51 I:6-52 I:6-53 I:6-54 I:6-55

Comprehensive Problems: I:6-56 I:6-57

I:6-56 I:6-57 Copyright © 2025 Pearson Education, Inc.

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2024 Edition Modification "M"

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" Tax Strategy and Critical Thinking Problems: I:6-58 I:6-58 I:6-59 I:6-59 Tax Form/Return Preparation Problems: I:6-60 I:6-60 I:6-61 I:6-61 I:6-62 I:6-62 Case Study Problem: I:6-63

I:6-63

Tax Research Problems: I:6-64 I:6-65

I:6-64 I:6-65

Chapter I:7 Discussion Questions: I:7-1 I:7-2 I:7-3 I:7-4 I:7-5 I:7-6 I:7-7 I:7-8 I:7-9 I:7-10 I:7-11 I:7-12 I:7-13 I:7-14 I:7-15 I:7-16 I:7-17 I:7-18 I:7-19

I:7-1 I:7-2 I:7-3 I:7-4 I:7-5 I:7-6 I:7-7 I:7-8 I:7-9 I:7-10 I:7-11 I:7-12 I:7-13 I:7-14 I:7-15 I:7-16 I:7-17 I:7-18 I:7-19 Copyright © 2025 Pearson Education, Inc.

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2024 Edition Modification "M"

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:7-20 I:7-20 I:7-21 I:7-21 I:7-22 I:7-22 I:7-23 I:7-23 I:7-24 I:7-24 I:7-25 I:7-25 I:7-26 I:7-26 I:7-27 I:7-27 I:7-28 I:7-28 I:7-29 I:7-29 I:7-30 I:7-30 I:7-31 I:7-31 I:7-32 I:7-32 I:7-33 I:7-33 I:7-34 I:7-34 I:7-35 I:7-35 I:7-36 I:7-36 I:7-37 I:7-37 Issue Identification Questions: I:7-38 I:7-39 I:7-40

I:7-38 I:7-39 I:7-40

Problems: I:7-41 I:7-42 I:7-43 I:7-44 I:7-45 I:7-46 I:7-47 I:7-48 I:7-49 I:7-50 I:7-51

I:7-41 I:7-42 I:7-43 I:7-44 I:7-45 I:7-46 I:7-47 I:7-48 I:7-49 I:7-50 I:7-51 Copyright © 2025 Pearson Education, Inc.

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2024 Edition Modification "M"

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:7-52 I:7-52 I:7-53 I:7-53 I:7-54 I:7-54 I:7-55 I:7-55 I:7-56 I:7-56 I:7-57 I:7-57 I:7-58 I:7-58 I:7-59 I:7-59 I:7-60 I:7-60 I:7-61 I:7-61 Comprehensive Problems: I:7-62

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Tax Strategy and Critical Thinking Problems: I:7-63 I:7-63 Tax Form/Return Preparation Problems: I:7-64 I:7-64 Case Study Problem: I:7-65 I:7-66

I:7-65 I:7-66

Tax Research Problems: I:7-67

I:7-67

Chapter I:8 Discussion Questions: I:8-1 I:8-2 I:8-3 I:8-4 I:8-5 I:8-6 I:8-7 I:8-8 I:8-9 I:8-10

I:8-1 I:8-2 I:8-3 I:8-4 I:8-5 I:8-6 I:8-7 I:8-8 I:8-9 I:8-10 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:8-11 I:8-11 I:8-12 I:8-12 I:8-13 I:8-13 I:8-14 I:8-14 I:8-15 I:8-15 I:8-16 I:8-16 I:8-17 I:8-17 I:8-18 I:8-18 I:8-19 I:8-19 I:8-20 I:8-20 I:8-21 I:8-21 I:8-22 I:8-22 I:8-23 I:8-23 I:8-24 I:8-24 I:8-25 I:8-25 I:8-26 I:8-26 I:8-27 I:8-27 I:8-28 I:8-28 I:8-29 I:8-29 Issue Identification Questions: I:8-30 I:8-31 I:8-32 I:8-33

I:8-30 I:8-31 I:8-32 I:8-33

Problems: I:8-34 I:8-35 I:8-36 I:8-37 I:8-38 I:8-39 I:8-40 I:8-41 I:8-42

I:8-34 I:8-35 I:8-36 I:8-37 I:8-38 I:8-39 I:8-40 I:8-41 I:8-42 Copyright © 2025 Pearson Education, Inc.

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2024 Edition Modification "M"

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:8-43 I:8-43 I:8-44 I:8-44 I:8-45 I:8-45 I:8-46 I:8-46 I:8-47 I:8-47 I:8-48 I:8-48 I:8-49 I:8-49 I:8-50 I:8-50 I:8-51 I:8-51 I:8-52 I:8-52 I:8-53 I:8-53 I:8-54 I:8-54 I:8-55 I:8-55 I:8-56 I:8-56 I:8-57 I:8-57 I:8-58 I:8-58 I:8-59 I:8-59 Comprehensive Problem: I:8-60

I:8-60

Tax Strategy and Critical Thinking Problems: I:8-61 I:8-61 I:8-62 I:8-62 Tax Form/Return Preparation Problems: I:8-63 I:8-63 I:8-64 I:8-64 Case Study Problems: I:8-65 I:8-66

I:8-65 I:8-66

Tax Research Problems: I:8-67 I:8-68

I:8-67 I:8-68

Chapter I:9 Discussion Questions: Copyright © 2025 Pearson Education, Inc.

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2024 Edition Modification "M"

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:9-1 I:9-1 I:9-2 I:9-2 I:9-3 I:9-3 I:9-4 I:9-4 I:9-5 I:9-5 I:9-6 I:9-6 I:9-7 I:9-7 I:9-8 I:9-8 I:9-9 I:9-9 I:9-10 I:9-10 I:9-11 I:9-11 I:9-12 I:9-12 I:9-13 I:9-13 I:9-14 I:9-14 I:9-15 I:9-15 I:9-16 I:9-16 I:9-17 I:9-17 I:9-18 I:9-18 I:9-19 I:9-19 I:9-20 I:9-20 I:9-21 I:9-21 I:9-22 I:9-22 I:9-23 I:9-23 I:9-24 I:9-24 I:9-25 I:9-25 I:9-26 I:9-26 I:9-27 I:9-27 I:9-28 I:9-28 I:9-29 I:9-29 I:9-30 I:9-30 I:9-31 I:9-31 I:9-32 I:9-32 I:9-33 I:9-33 I:9-34 I:9-34 Copyright © 2025 Pearson Education, Inc.

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2024 Edition Modification "M"

Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" Issue Identification Questions: I:9-35 I:9-36 I:9-37 I:9-38

I:9-35 I:9-36 I:9-37 I:9-38

Problems: I:9-39

I:9-39

I:9-40 I:9-41 I:9-42 I:9-43 I:9-44 I:9-45 I:9-46 I:9-47 I:9-48 I:9-49 I:9-50 I:9-51 I:9-52 I:9-53 I:9-54 I:9-55 I:9-56 I:9-57 I:9-58 I:9-59

I:9-40 I:9-41 I:9-42 I:9-43 I:9-44 I:9-45 I:9-46 I:9-47 I:9-48 I:9-49 I:9-50 I:9-51 I:9-52 I:9-53 I:9-54 I:9-55 I:9-56 I:9-57 I:9-58 I:9-59

Tax Strategy and Critical Thinking Problems: I:9-60

I:9-60

I:9-61

I:9-61

I:9-62

I:9-62

I:9-63 I:9-64

I:9-63 I:9-64 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D"

2024 Edition Modification "M"

Tax Form/Return Preparation Problems: I:9-65 I:9-65 I:9-66 I:9-66 I:9-67 I:9-67 Case Study Problems: I:9-68 I:9-69

I:9-68 I:9-69

Tax Research Problem: I:9-70

I:9-70

Chapter I:10 Discussion Questions: I:10-1 I:10-2 I:10-3 I:10-4 I:10-5 I:10-6 I:10-7 I:10-8 I:10-9 I:10-10 I:10-11 I:10-12 I:10-13 I:10-14 I:10-15 I:10-16 I:10-17 I:10-18 I:10-19 I:10-20

I:10-1 I:10-2 I:10-3 I:10-4 I:10-5 I:10-6 I:10-7 I:10-8 I:10-9 I:10-10 I:10-11 I:10-12 I:10-13 I:10-14 I:10-15 I:10-16 I:10-17 I:10-18 I:10-19 I:10-20

Issue Identification Questions: I:10-21 I:10-22

I:10-21 I:10-22

Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:10-23 I:10-23 I:10-24 I:10-24 Problems: I:10-25 I:10-26 I:10-27 I:10-28 I:10-29 I:10-30 I:10-31 I:10-32 I:10-33 I:10-34 I:10-35 I:10-36 I:10-37 I:10-38 I:10-39 I:10-40 I:10-41 I:10-42 I:10-43 I:10-44 I:10-45 I:10-46

I:10-25 I:10-26 I:10-27 I:10-28 I:10-29 I:10-30 I:10-31 I:10-32 I:10-33 I:10-34 I:10-35 I:10-36 I:10-37 I:10-38 I:10-39 I:10-40 I:10-41 I:10-42 I:10-43 I:10-44 I:10-45 I:10-46

Comprehensive Problem: I:10-47

I:10-47

Tax Strategy and Critical Thinking Problems: I:10-48 I:10-48 I:10-49 I:10-49 Tax Form/Return Preparation Problems: I:10-50 I:10-50 I:10-51 I:10-51 Case Study Problems: Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:10-52 I:10-52 I:10-53 I:10-53 Tax Research Problem: I:10-54

I:10-54

Chapter I:11 Discussion Questions: I:11-1 I:11-2 I:11-3 I:11-4 I:11-5 I:11-6 I:11-7 I:11-8 I:11-9 I:11-10 I:11-11 I:11-12 I:11-13 I:11-14 I:11-15 I:11-16 I:11-17 I:11-18 I:11-19 I:11-20 I:11-21 I:11-22 I:11-23 I:11-24 I:11-25 I:11-26 I:11-27 I:11-28

I:11-1 I:11-2 I:11-3 I:11-4 I:11-5 I:11-6 I:11-7 I:11-8 I:11-9 I:11-10 I:11-11 I:11-12 I:11-13 I:11-14 I:11-15 I:11-16 I:11-17 I:11-18 I:11-19 I:11-20 I:11-21 I:11-22 I:11-23 I:11-24 I:11-25 I:11-26 I:11-27 I:11-28 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:11-29 I:11-29 I:11-30 I:11-30 I:11-31 I:11-31 I:11-32 I:11-32 Issue Identification Questions: I:11-33 I:11-34 I:11-35 I:11-36

I:11-33 I:11-34 I:11-35 I:11-36

Problems: I:11-37 I:11-38 I:11-39 I:11-40 I:11-41 I:11-42 I:11-43 I:11-44 I:11-45 I:11-46 I:11-47 I:11-48 I:11-49 I:11-50 I:11-51 I:11-52 I:11-53 I:11-54 I:11-55 I:11-56

I:11-37 I:11-38 I:11-39 I:11-40 I:11-41 I:11-42 I:11-43 I:11-44 I:11-45 I:11-46 I:11-47 I:11-48 I:11-49 I:11-50 I:11-51 I:11-52 I:11-53 I:11-54 I:11-55 I:11-56

Comprehensive Problem: I:11-57

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Tax Strategy and Critical Thinking Problems: I:11-58 I:11-58 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:11-59 I:11-59 Tax Form/Return Preparation Problem: I:11-60 I:11-60 Case Study Problems: I:11-61 I:11-62 I:11-63

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Tax Research Problems: I:11-64 I:11-65 I:11-66

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Chapter I:12 Discussion Questions: I:12-1 I:12-2 I:12-3 I:12-4 I:12-5 I:12-6 I:12-7 I:12-8 I:12-9 I:12-10 I:12-11 I:12-12 I:12-13 I:12-14 I:12-15 I:12-16 I:12-17 I:12-18 I:12-19 I:12-20 I:12-21

I:12-1 I:12-2 I:12-3 I:12-4 I:12-5 I:12-6 I:12-7 I:12-8 I:12-9 I:12-10 I:12-11 I:12-12 I:12-13 I:12-14 I:12-15 I:12-16 I:12-17 I:12-18 I:12-19 I:12-20 I:12-21 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" Issue Identification Questions: I:12-22 I:12-23 I:12-24

I:12-22 I:12-23 I:12-24

Problems: I:12-25 I:12-26 I:12-27 I:12-28 I:12-29 I:12-30 I:12-31 I:12-32 I:12-33 I:12-34 I:12-35 I:12-36 I:12-37 I:12-38 I:12-39 I:12-40 I:12-41 I:12-42 I:12-43 I:12-44 I:12-45 I:12-46 I:12-47 I:12-48 I:12-49

I:12-25 I:12-26 I:12-27 I:12-28 I:12-29 I:12-30 I:12-31 I:12-32 I:12-33 I:12-34 I:12-35 I:12-36 I:12-37 I:12-38 I:12-39 I:12-40 I:12-41 I:12-42 I:12-43 I:12-44 I:12-45 I:12-46 I:12-47 I:12-48 I:12-49

Comprehensive Problem: I:12-50

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Tax Strategy and Critical Thinking Problem: I:12-51 I:12-51 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" Tax Form/Return Preparation Problems: I:12-52 I:12-52 I:12-53 I:12-53 I:12-54 I:12-54 Case Study Problem: I:12-55

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Tax Research Problems: I:12-56 I:12-57 I:12-58 I:12-59 I:12-60

I:12-56 I:12-57 I:12-58 I:12-59 I:12-60

Chapter I:13 Discussion Questions: I:13-1 I:13-2 I:13-3 I:13-4 I:13-5 I:13-6 I:13-7 I:13-8 I:13-9 I:13-10 I:13-11 I:13-12 I:13-13 I:13-14 I:13-15 I:13-16 I:13-17 I:13-18 I:13-19 I:13-20

I:13-1 I:13-2 I:13-3 I:13-4 I:13-5 I:13-6 I:13-7 I:13-8 I:13-9 I:13-10 I:13-11 I:13-12 I:13-13 I:13-14 I:13-15 I:13-16 I:13-17 I:13-18 I:13-19 I:13-20 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:13-21 I:13-21 I:13-22 I:13-22 I:13-23 I:13-23 I:13-24 I:13-24 I:13-25 I:13-25 I:13-26 I:13-26 I:13-27 I:13-27 Issue Identification Questions: I:13-28 I:13-29 I:13-30 I:13-31

I:13-28 I:13-29 I:13-30 I:13-31

Problems: I:13-32 I:13-33 I:13-34 I:13-35 I:13-36 I:13-37 I:13-38 I:13-39 I:13-40 I:13-41 I:13-42 I:13-43 I:13-44 I:13-45 I:13-46 I:13-47 I:13-48 I:13-49 I:13-50 I:13-51 I:13-52

I:13-32 I:13-33 I:13-34 I:13-35 I:13-36 I:13-37 I:13-38 I:13-39 I:13-40 I:13-41 I:13-42 I:13-43 I:13-44 I:13-45 I:13-46 I:13-47 I:13-48 I:13-49 I:13-50 I:13-51 I:13-52 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:13-53 I:13-53 I:13-54 I:13-54 I:13-55 I:13-55 I:13-56 I:13-56 I:13-57 I:13-57 I:13-58 I:13-58 I:13-59 I:13-59 I:13-60 I:13-60 I:13-61 I:13-61 I:13-62 I:13-62 I:13-63 I:13-63 Comprehensive Problem: I:13-64

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Tax Strategy and Critical Thinking Problems: I:13-65 I:13-65 I:13-66 I:13-66 Tax Form/Return Preparation Problems: I:13-67 I:13-67 I:13-68 I:13-68 Case Study Problems: I:13-69 I:13-70

I:13-69 I:13-70

Tax Research Problem: I:13-71

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Chapter I:14 Discussion Questions: I:14-1 I:14-2 I:14-3 I:14-4 I:14-5 I:14-6 I:14-7

I:14-1 I:14-2 I:14-3 I:14-4 I:14-5 I:14-6 I:14-7 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:14-8 I:14-8 I:14-9 I:14-9 I:14-10 I:14-10 I:14-11 I:14-11 I:14-12 I:14-12 I:14-13 I:14-13 I:14-14 I:14-14 I:14-15 I:14-15 I:14-16 I:14-16 I:14-17 I:14-17 I:14-18 I:14-18 I:14-19 I:14-19 I:14-20 I:14-20 I:14-21 I:14-21 I:14-22 I:14-22 I:14-23 I:14-23 I:14-24 I:14-24 I:14-25 I:14-25 I:14-26 I:14-26 I:14-27 I:14-27 I:14-28 I:14-28 I:14-29 I:14-29 I:14-30 I:14-30 I:14-31 I:14-31 I:14-32 I:14-32 I:14-33 I:14-33 I:14-34 I:14-34 I:14-35 I:14-35 I:14-36 I:14-36 I:14-37 I:14-37 Issue Identification Questions: I:14-38 I:14-39

I:14-38 I:14-39

Problems: Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:14-40 I:14-40 I:14-41 I:14-41 I:14-42 I:14-42 I:14-43 I:14-43 I:14-44 I:14-44 I:14-45 I:14-45 I:14-46 I:14-46 I:14-47 I:14-47 I:14-48 I:14-48 I:14-49 I:14-49 I:14-50 I:14-50 I:14-51 I:14-51 I:14-52 I:14-52 I:14-53 I:14-53 I:14-54 I:14-54 I:14-55 I:14-55 I:14-56 I:14-56 I:14-57 I:14-57 I:14-58 I:14-58 I:14-59 I:14-59 I:14-60 I:14-60 I:14-61 I:14-61 I:14-62 I:14-62 I:14-63 I:14-63 I:14-64 I:14-64 I:14-65 I:14-65 Comprehensive Problem: I:14-66

I:14-66

Tax Strategy and Critical Thinking Problem: I:14-67 I:14-67 Tax Form/Return Preparation Problems: I:14-68 I:14-68 I:14-69 I:14-69 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:14-70 I:14-70 I:14-71 I:14-71 Case Study Problems: I:14-72 I:14-73

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Tax Research Problem: I:14-74

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Chapter I:15 Discussion Questions: I:15-1 I:15-2 I:15-3 I:15-4 I:15-5 I:15-6 I:15-7 I:15-8 I:15-9 I:15-10 I:15-11 I:15-12 I:15-13 I:15-14 I:15-15 I:15-16 I:15-17 I:15-18 I:15-19 I:15-20 I:15-21 I:15-22 I:15-23 I:15-24 I:15-25

I:15-1 I:15-2 I:15-3 I:15-4 I:15-5 I:15-6 I:15-7 I:15-8 I:15-9 I:15-10 I:15-11 I:15-12 I:15-13 I:15-14 I:15-15 I:15-16 I:15-17 I:15-18 I:15-19 I:15-20 I:15-21 I:15-22 I:15-23 I:15-24 I:15-25 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:15-26 I:15-26 I:15-27 I:15-27 I:15-28 I:15-28 I:15-29 I:15-29 I:15-30 I:15-30 I:15-31 I:15-31 I:15-32 I:15-32 Problems: I:15-33 I:15-33 I:15-34 I:15-34 I:15-35 I:15-35 I:15-36 I:15-36 I:15-37 I:15-37 I:15-38 I:15-38 I:15-39 I:15-39 I:15-40 I:15-40 I:15-41 I:15-41 I:15-42 I:15-42 I:15-43 I:15-43 I:15-44 I:15-44 I:15-45 I:15-45 I:15-46 I:15-46 I:15-47 I:15-47 I:15-48 I:15-48 I:15-49 I:15-49 I:15-50 I:15-50 I:15-51 I:15-51 I:15-52 I:15-52 I:15-53 I:15-53 I:15-54 I:15-54 I:15-55 I:15-55 I:15-56 I:15-56 I:15-57 I:15-57 I:15-58 I:15-58 I:15-59 I:15-59 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" Comprehensive Problem: I:15-60 I:15-60 Tax Strategy and Critical Thinking Problem: I:15-61 I:15-61 Case Study Problem: I:15-62 I:15-62 Tax Research Problems: I:15-63 I:15-63 I:15-64 I:15-64 I:15-65 I:15-65 I:15-66 I:15-66 I:15-67 I:15-67

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Chapter I:16 Discussion Questions: I:16-1 I:16-2 I:16-3 I:16-4 I:16-5 I:16-6 I:16-7 I:16-8 I:16-9 I:16-10 I:16-11 I:16-12 I:16-13 I:16-14 I:16-15 I:16-16 I:16-17 I:16-18 I:16-19 I:16-20

I:16-1 I:16-2 I:16-3 I:16-4 I:16-5 I:16-6 I:16-7 I:16-8 I:16-9 I:16-10 I:16-11 I:16-12 I:16-13 I:16-14 I:16-15 I:16-16 I:16-17 I:16-18 I:16-19 I:16-20 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:16-21 I:16-21 I:16-22 I:16-22 I:16-23 I:16-23 I:16-24 I:16-24 I:16-25 I:16-25 I:16-26 I:16-26 I:16-27 I:16-27 I:16-28 I:16-28 I:16-29 I:16-29 I:16-30 I:16-30 I:16-31 I:16-31

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Issue Identification Questions: I:16-32

I:16-32

I:16-33 I:16-34

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Problems: I:16-35 I:16-36 I:16-37 I:16-38 I:16-39 I:16-40 I:16-41 I:16-42 I:16-43 I:16-44 I:16-45 I:16-46 I:16-47 I:16-48 I:16-49 I:16-50 I:16-51 I:16-52

I:16-35 I:16-36 I:16-37 I:16-38 I:16-39 I:16-40 I:16-41 I:16-42 I:16-43 I:16-44 I:16-45 I:16-46 I:16-47 I:16-48 I:16-49 I:16-50 I:16-51 I:16-52

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:16-53 I:16-53 I:16-54 I:16-54 I:16-55 I:16-55 I:16-56 I:16-56 I:16-57 I:16-57 I:16-58 I:16-58 I:16-59 I:16-59 I:16-60 I:16-60 Tax Strategy and Critical Thinking Problems: I:16-61 I:16-61 I:16-62 I:16-62 I:16-63 I:16-63 Tax Form/Return Preparation Problems: I:16-64 I:16-64 I:16-65 I:16-65 Case Study Problems: I:16-66 I:16-67

I:16-66 I:16-67

Tax Research Problems: I:16-68 I:16-69 I:16-70 I:16-71 I:16-72

I:16-68 I:16-69 I:16-70 I:16-71 I:16-72

I:16-73

I:16-73

Chapter I:17 Discussion Questions: I:17-1 I:17-2 I:17-3 I:17-4 I:17-5

I:17-1 I:17-2 I:17-3 I:17-4 I:17-5 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:17-6 I:17-6 I:17-7 I:17-7 I:17-8 I:17-8 I:17-9 I:17-9 I:17-10 I:17-10 I:17-11 I:17-11 I:17-12 I:17-12 I:17-13 I:17-13 I:17-14 I:17-14 I:17-15 I:17-15 I:17-16 I:17-16 I:17-17 I:17-17 I:17-18 I:17-18 I:17-19 I:17-19 I:17-20 I:17-20 I:17-21 I:17-21 I:17-22 I:17-22 I:17-23 I:17-23 I:17-24 I:17-24 I:17-25 I:17-25 I:17-26 I:17-26 I:17-27 I:17-27 I:17-28 I:17-28 I:17-29 I:17-29 I:17-30 I:17-30 I:17-31 I:17-31 I:17-32 I:17-32 I:17-33 I:17-33 I:17-34 I:17-34 I:17-35 I:17-35 Issue Identification Questions: I:17-36 I:17-37 I:17-38

I:17-36 I:17-37 I:17-38

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" Problems: I:17-39 I:17-40 I:17-41 I:17-42 I:17-43 I:17-44 I:17-45 I:17-46 I:17-47 I:17-48 I:17-49 I:17-50 I:17-51 I:17-52 I:17-53 I:17-54 I:17-55 I:17-56 I:17-57 I:17-58 I:17-59 I:17-60 I:17-61 I:17-62 I:17-63 I:17-64 I:17-65

I:17-39 I:17-40 I:17-41 I:17-42 I:17-43 I:17-44 I:17-45 I:17-46 I:17-47 I:17-48 I:17-49 I:17-50 I:17-51 I:17-52 I:17-53 I:17-54 I:17-55 I:17-56 I:17-57 I:17-58 I:17-59 I:17-60 I:17-61 I:17-62 I:17-63 I:17-64 I:17-65

Comprehensive Problem: I:17-66

I:17-66

Tax Strategy and Critical Thinking Problems: I:17-67 I:17-67 I:17-68 I:17-68 I:17-69 I:17-69 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:17-70 I:17-70 Tax Form/Return Preparation Problems: I:17-71 I:17-71 I:17-72 I:17-72 Case Study Problems: I:17-73 I:17-74

I:17-73 I:17-74

Tax Research Problems: I:17-75 I:17-76 I:17-77

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Chapter I:18 Discussion Questions: I:18-1 I:18-2 I:18-3 I:18-4 I:18-5 I:18-6 I:18-7 I:18-8 I:18-9 I:18-10 I:18-11 I:18-12 I:18-13 I:18-14 I:18-15 I:18-16 I:18-17

I:18-1 I:18-2 I:18-3 I:18-4 I:18-5 I:18-6 I:18-7 I:18-8 I:18-9 I:18-10 I:18-11 I:18-12 I:18-13 I:18-14 I:18-15 I:18-16 I:18-17

Problems: I:18-18 I:18-19 I:18-20

I:18-18 I:18-19 I:18-20 Copyright © 2025 Pearson Education, Inc.

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Summary of Question and Problem Revisions 2024 2025 Edition 2025 Edition 2024 Edition Edition Questions New Problems Questions and Deletions and Problems "N" Problems "D" I:18-21 I:18-21 I:18-22 I:18-22 I:18-23 I:18-23 I:18-24 I:18-24 I:18-25 I:18-25 I:18-26 I:18-26 I:18-27 N --I:18-28 I:18-27 I:18-29 N --I:18-30 I:18-28 --I:18-29 D --I:18-30 D I:18-31 I:18-31 I:18-32 I:18-32 I:18-33 I:18-33

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