Solution Manual for Taxation for Decision Makers 2017th Edition by Shirley Dennis- Escoffier, Karen

Solution Manual for Taxation for Decision Makers 2017th Edition by Shirley DennisEscoffier, Karen A. Fortin Chapter 1-12

Solutions to Chapter 1 Problem Assignments Check Your Understanding 1. [LO 1.1] What is a tax? Solution: A tax is a required payment to a governmental unit to support its operations that is not related to the value of goods or services the person or business receives. A fine is levied as a result of an unlawful act. 2. [LO 1.1] Constitutional Authority Solution: The federal income tax system as we know it today did not begin until 1913 when the 16th Amendment to the U.S. Constitution was ratified. The 16th Amendment gave Congress the power to lay and collect taxes ―on income, from whatever source derived,‖ without the previous requirement that all direct taxes be imposed based on population. 3. [LO 1.1] Current Tax Code Solution: The Tax Reform Act of 1986 was so extensive, the Code was renamed the Internal Revenue Code of 1986. Any current changes to the tax laws are now amendments to the Internal Revenue Code of 1986. 4. [LO 1.1] Tax Expenditures Solution: Tax expenditures can take the form of special exclusions, deductions, credits or preferential rates for specific activities. These tax expenditures result in a reduction in the revenue that would be collected under a more comprehensive income tax. 5. [LO 1.1] SALT Solution: The practice of state and local taxation is commonly referred to as a SALT practice. 6. [LO 1.1] Nexus Solution: Nexus is the necessary type and degree of connection between a business and the state in which it is located for the state to impose a tax on its sales or activities 7. [LO 1.1] State Income Tax Solution: Without physical presence within Arizona, the state cannot assess state income tax on Suntan Corporation’s sales made to persons or businesses located within Arizona.

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8. [LO 1.1] Franchise Tax Solution: A franchise tax is an excise tax based on the right to do business or own property in a state. It is usually determined based on corporate income, however, so would, in effect, simply be another name for an income tax. 9. [LO 1.1] State Income Allocation Solution: The three-factor allocation formula uses a percentage of corporate sales, payroll costs, and tangible property allocated to the state. 10. [LO 1.1] Employment Taxes Solution: An employee pays the Social Security and Medicare (FICA) tax; the employer also pays an equivalent Social Security and Medicare (FICA) tax, but the employer also may have to pay an unemployment tax. 11. [LO 1.1] Wealth Taxes Solution: The most common wealth tax is the real property tax based on the fair market value of property owned by an individual or a business. 12. [LO 1.1] Intangible Tax Solution: The intangible tax is levied on intangible property such as receivables, stocks, bonds, and other forms of investment instruments owned by businesses and individuals. 13. [LO 1.1] Estate and Gift Tax Solution: Property that is given away during a lifetime that exceeds an annual allowance per donee is subject to a gift tax; however, the lifetime exemption prevents most gifts from being subject to this tax. Once, however, taxable gifts exceed the lifetime exemption, gifts are subject to the gift tax. When the person passes away, the remaining property owned at death (not previously given away) is now subject to the estate tax. Any gift tax exemption not used previously by the decedent is then available as an exemption from the estate tax. Thus, a decedent’s estate escapes taxation unless his or her total lifetime taxable gifts plus taxable transfers at death exceed the lifetime exemption. 14. [LO 1.1] Consumption vs Income Tax Solution: A consumption tax is levied on purchases of goods or services that are going to be used or consumed. The most common consumption tax is the sales tax, but the value-added tax is another form used in many countries outside the United States. The income tax is based on the value of money or goods that are received, whether it is spent or saved. An income tax will tax money that is going to be saved rather than spent while the consumption tax only taxes money that is spent. The consumption tax is thought to encourage savings. 15. [LO 1.1] Wealth Taxes Solution: A wealth tax is based on the value of wealth that a person has at a particular point

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in time. The real or personal property taxes are wealth taxes. The wealth transfer tax is based on the value of money or property that is passed on to another person. The estate, gift, and inheritance taxes are wealth transfer taxes. 16. [LO 1.1] Use Taxes Solution: A use tax is a companion tax to a sales tax that is imposed on property to be used in one state but which was purchased in another state to which no sales tax was paid on the purchase. 17. [LO 1.1] Income Taxes Solution: Two single persons with taxable income of $76,550 each will pay the same total tax as a married couple with taxable income of $153,100. Above $153,100 the married couple’s rate increases to 28% but each of the single persons does not reach that rate until taxable income is over $91,900. 18. [LO 1.2] Types of Taxes Solution: The income tax system in the United States is a progressive system; that is, as income increases, the tax rate increases and the person pays a greater percentage of income as a tax. A person who has $9,000 of taxable income will pay $900 in taxes (10%). A person who makes $18,000 will pay $2,233.75 ($932.50 + .15 ($18,000 $9,325). $2,233.75/$18,000 = 12.41%. A regressive tax system imposes a lower tax rate as income increases; that is, a person pays a decreasing percentage of their income in taxes as income increases. The Social Security portion of the FICA tax is a regressive tax; as the taxpayer’s income on which the tax is based exceeds a maximum, the tax is no longer collected and the rate declines. A proportional tax would collect the same percentage of tax on the tax base, regardless of the size of the base. The sales tax is a proportional tax as the same percent tax is collected regardless of the amount spent. 19. [LO 1.2] Income Tax Rates Solution: Individuals have basic tax rates of 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% that apply to their ordinary income and their interest income. The basic tax rates for their dividend income are 0%, 15%, and 20%. Corporations have no tax-favored incomes so they pay tax on all income at rates of 15%, 25%, 34%, and 35%, excluding surtaxes on certain portions of income that ultimately produce a flat tax of 35% on income above $18,333,333. 20. [LO 1.2] Income Tax Rates Solution: Individual’s short-term capital gains tax rates are the same as the tax rates on ordinary income. A single individual’s long-term capital gains rates are 0% on long-term capital gains (LTCG) from 0 to $37,950; 15% on LTCG from $37,951 to $418,400, and 20% on LTCG exceeding $418,400. 21. [LO 1.3] Canons of Taxation Solution: The basic idea of equity is that persons with similar incomes will face similar taxes. Thus, individuals each with $200,000 in taxable income will pay the same amount

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of tax. A tax meets the criterion of economy when the amount of revenue it raises is at an optimum level after the costs of administration and compliance are considered. The canon of certainty would dictate that a taxpayer know with reasonable accuracy the tax consequences of a transaction at the time the transaction takes place. The last canon of convenience states that a convenient tax is one that would be readily determined and paid with little effort. 22. [LO 1.3] Equity Concepts Solution: Horizontal equity would require persons with equal incomes pay equal amounts of taxes. Vertical equity would require persons with higher incomes to pay a higher percentage of their income than persons with lower incomes. This is the basis of the U.S. tax system. 23. [LO 1.4] Taxable Persons Solution: Only individuals, regular (or C) corporations, and fiduciaries (estates and trusts) pay income taxes. 24. [LO 1.4] Gross Income Solution: The term gross income is an all-inclusive term that includes income from all sources that are not specifically excluded. 25. [LO 1.4] Basic Tax Model Solution: The basic elements of the tax model are gross income, less deductions, that equal taxable income or loss. The applicable tax rate is applied to this to determine the gross tax liability. From this tax credits and prepayments are deducted to determine the tax liability owed or the refund due. 26. [LO 1.4] Capital Losses Solution: An individual may deduct up to $3,000 of capital losses in excess of capital gains annually; the excess may be carried forward indefinitely to succeeding years. A corporation can only offset capital losses against capital gains; losses are not deductible against other income. Instead the corporation first carries the losses back to the three previous years and then forward for 5 years. 27. [LO 1.4] Basic Income Tax Rates Solution: Individuals have basic tax rates of 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% that are applied to their ordinary income. A corporation’s basic tax rates are 15%, 25%, 34%, and 35%, excluding surtaxes. 28. [LO 1.4] Fiduciaries Solution: Trusts and estates are two fiduciary entities; a trust is established by a grantor who appoints a trustee to manage the assets for the benefit of the trust’s beneficiaries. An estate is an entity that is created on the death of a person that provides management for the assets in the decedent’s estate until they can be distributed to the beneficiaries. A grantor is the person who creates the trust when assets are placed in the trust for the benefit of the beneficiaries. The trustee is the person

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selected by the grantor to oversee the assets and ensure the trust functions as specified by the grantor. The beneficiary of the trust is the person for whom the trust was established and who is to benefit from the income from the trust (an income beneficiary) or receive the assets when the trust is closed (the remainderman). 29. [LO 1.5] Sole Proprietorships Solution: Only one taxable person, who must be an individual, can own a sole proprietorship. The sole proprietor is personally liable for all debts of the business. The sole proprietor cannot be an employee of the business and must pay self-employment tax. The results of operations of the sole proprietorship are reported on the Schedule C and these are then included in the owner’s personal tax return. A partnership must have more than one owner. A general partner is liable for partnership debts but limited partners are only liable for their investment in the partnership. Like sole proprietors, partners cannot be employees of the partnership and general partners are required to pay self-employment tax. Although partnerships do not pay taxes directly, they must file information tax returns. The income/loss from the partnership flows through to the partners and is reported on their own tax returns. Partners pay any taxes owing on the income items but loss is deductible only if a partner has sufficient basis. A partner’s basis begins with his or her investment in the partnership and is increased for the partner’s share of partnership liabilities. Partnerships and limited liability companies differ in a number of ways. Owners of partnerships are partners while owners of limited liability companies are called members. There are no legal requirements to set up a partnership but a limited liability company must be established according to the laws of the state of domicile. Limited liability companies can elect to be taxed as corporations while partnerships do not have that option. In some states, a limited liability company may have only one owner but a partnership must have two or more owners. Only the managing members of a limited liability company may be subject to selfemployment taxes. 30. [LO 1.5] Corporations Solution: The principal difference between a C corporation and an S corporation is in the method of taxation. A C corporation pays a tax directly on its income. Any net after-tax income that is distributed to its shareholders as dividends is subject to a second level of tax. Thus, these corporate earnings are said to be subject to double taxation. An S corporation’s income flows directly through to its shareholders (whether there is an actual distribution of this income in cash or not) undiminished by taxes at the corporate level. The income is then taxed once only at the shareholder level. The corporation can then make actual distributions of this previously-taxed income to the S corporation shareholders without any additional taxes due. There are a number of other differences in that the number and type of S corporation shareholders is limited; it can only have one class of stock outstanding, and its choice of tax year is restricted. None of these restrictions apply to a C corporation. Other items of comparison could be drawn from the table in the text

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comparing business entity attributes. Crunch the Numbers 31. [LO 1.1] Property Taxes Solution: He will pay $750. $20,000,000 / $4,000,000,000 = .005 or 5 mills per $1 of valuation. $150,000 x .005 = $750 in tax 32. [LO 1.1] FICA Tax Solution: $40,000 x 7.65% = $3,060 33. [LO 1.1] FICA Taxes Solution: 9,377 is withheld for FICA taxes in 2017. $127,200 x 6.2% = $7,886 $140,000 x 1.45% = 2,030 Total $9,916 34. [LO 1.4] Taxable Income Solution: Taxable income = $29,600 $40,000 Salary Less 6,350 Standard deduction Less 4,050 Personal exemption $29,600

35. [LO 1.4] Taxable Income Solution: Taxable income = $49,400 $71,000 Salary Plus 1,500 Interest income Less 15,000 Itemized deductions Less 8,100 Personal and dependency deductions $49,400 36. [LO 1.4] Taxable Income Solution: Taxable income = $49,000 $450,000 Gross receipts minus 145,000 Cost of goods sold equals $305,000 Gross income plus 20,000 Gain on sale minus 276,000 Expenses equals $49,000 Taxable income The $500 interest on State of New York bonds is tax-exempt. 37. [LO 1.4] Taxable Income Solution: Taxable income = $237,500

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plus minus equals

$560,000 2,500 325,000 $237,500

Gross income Interest income Expenses Taxable income

The $20,000 capital loss is not deductible currently. 38. [LO 1.4] Taxable Income Solution: Taxable income = $77,900 George's salary plus Mary's salary equals Gross income minus Itemized deductions minus Personal exemptions equals

$65,000 45,000 $110,000 24,000 8,100 $ 77,900

39. [LO 1.4] Determining Tax Liability Solution: Taxable income = $29,600; income tax = $3,973.75. Income Tax: ($9,325 x 10%) + ($20,275 x 15%) = $3,973.75. 40. [LO 1.4] Determining Tax Liability Solution: Taxable income = $49,400; income tax = 6,742.50. Income Tax: [($49,400 - $13,350) x 15%] + $1,335 = $6,742.50 41. [LO 1.4] Determining Tax Liability Solution: Taxable income = $49,000; income tax = $7,350. Income Tax: $49,000 x 15% = $7,350. 42. [LO 1.4] Determining Tax Liability Solution: Taxable income = $237,500; Income tax = $75,875 [($237,500 - $100,000) x 39%] + $22,250 = $75,875 (The $20,000 capital loss is not deductible currently.) 43. [LO 1.4] Marriage Penalty Solution: They have a marriage penalty of $207 ($31,684.50 - $31, 477.50). MFJ: [($160,000 - $153,100) x 28%] + $29,752.50 = $31,684.50 Single: [($80,000 - $37,950) x 25%] + $5,226.25 = $15,738.75 x 2 = $31,477.50 44. [LO 1.4] Joint vs. Single Filing Solution: a. It will be to their advantage to marry in 2017. b. By marrying before the end of 2017 and filing jointly, they save $6,097.25 ($43,381.75 - $37,284.50) in taxes.

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MFJ: [($180,000 - $153,100) x 28%] + $29,752.50 = $37,284.50 Single: [($180,000 - $91,900) x 28%] + $18,713.75 = $43,381.75 c. If they each have $90,000 of income, they would each pay $18,238.75 in taxes and they would then have a marriage penalty of $807 ($37,284.50 - $36,477.50). In this case, they would be slightly better off by postponing their wedding until 2018. Tax on $90,000 (Single): [($90,000 - $37,950) x 25%] + $5,226.25 = $18,238.75 $18,238.75 x 2 = $36,477.50 45. [LO 1.4] Income Tax Liability Solution: Taxable income = $48,850 and the net tax liability = $6,155. $76,000 salary and wages - $15,000 of itemized deductions and $12,150 in personal exemptions = $48,850 taxable income. Income tax liability is: $1,865 + .15 x [$48,850 - $18,650] = $6,395 $6,395 - $240 credit = $6,155 46. [LO 1.4] Tax Liability Solution: The estate will pay $6,215.60. $2,550 x 15% = $382.50 $3,450 x 25% = 862.50 $3,150 x 28% = 882.00 $3,350 x 33% = 1,105.50 $7,500 x 39.6 = 2,970.00 Total tax $6,202.50 47. [LO 1.4] Tax Rates Solution: .05 x ($335,000 - $100,000) = $11,750 $50,000 (.34 - .15) = $9,500 ($75,000 - $50,000)(.34 - .25) = $2,250. $9,500 + $2,250 = $11,750 48. [LO 1.4] Tax Rates Solution: .03 x ($18,333,333 - $15,000,000) = $100,000 (.35 - .34)($10,000,000) = $100,000 49. [LO 1.5] Tax Liability Solution: William’s income is twice John’s, but his taxes are 2.67 ($10,771.25/$4,036.25) times John’s. This illustrates the progressive nature of the tax system as well as vertical equity. [($30,000 - $9,325) x 15%] + $932.50 = $4,033.75 [($60,000 - $37,950) x 25%] + $5,226.25 = $10,738.75 50. [LO 1.5] Net Operating Loss

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Solution: Lilikoi paid $6,000 tax for 2015 and $30,050 tax for 2016. Lilikoi will have a refund of $9,900 from carrying back $40,000 of the 2017 loss to 2015 and $10,000 of the loss to 2016. (Note that Lilikoi cannot carry the loss back to only 2016 without first carrying it back to 2015.) Tax paid for 2015 on $40,000 was $40,000 x 15% = $6,000 Tax paid for 2016 on $120,000 was [($20,000 x 39%) + $22,250] = $30,050. The $10,000 loss that is carried back to 2016 reduces the taxable income for that year from $120,000 to $110,000 saving tax at the 39% rate that applies to income between $110,000 and $120,000. Tax refund from 2017 loss is ($40,000 x 15%) + ($10,000 x 39%) = $9,900 51. [LO 1.5] Determining Tax Liability Solution: The net tax liability is $20,000. $250,000 gross income - $125,000 expenses = $125,000 taxable income. The income tax liability is: [($25,000 x 39%) + $22,250] = $32,000 gross tax $32,000 - $12,000 tax credit = $20,000 net tax 52. [LO 1.5] Determining Tax Liability Solution: Taxable income = $28,650 and the tax liability is $3,833.75 $46,000 Salary minus 7,000 Partnership loss (50% x $14,000) equals $39,000 Gross income minus 10,400 Deduction equals $28,600 Taxable income Tax: [($28,600 - $9,325) x 15%] + $932.50 = $3,823.75 53. [LO 1.4 & 1.5] Tax Liability Comparisons Solution: Partnership: Pays no tax. June and John are each taxed on the $32,000 passed through to them at their marginal tax rates. To determine their marginal tax rates, find the tax bracket in which their other taxable income falls. (Note that the ―other ordinary taxable income‖ is provided; either the standard or their itemized deductions and the personal exemptions have already been subtracted.) June’s $475,000 of other ordinary taxable income puts her in the 39.6% marginal tax bracket because she is a head of household with taxable income over $444,550. John’s $32,000 falls within the 25% marginal tax bracket ($110,000 of taxable income plus the additional $32,000 does not exceed $153,100 – the 25% tax bracket). His $32,000 is taxed at 25% for a married taxpayer filing a joint return. June’s tax = $32,000 x 39.6% = $12,672. John’s tax = $32,000 x 25% = $8,000. Together they pay a total of $20,672 in taxes. S Corporation: Pays no tax. June and John are each taxed on the $32,000 passed

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through to them at their marginal tax rates as shown above for the partnership and together they pay $20, 672 in taxes. C Corporation: The corporation pays a tax of $11,000 [$7,500 + ($64,000 - $50,000) x 25%] = $11,000 Neither June nor John pay any taxes as they received no distributions from the corporation. Note the problem specified only income taxes; employment taxes are not included in the solution to this problem. 54. [LO 1.4 & 1.5] Tax Liability Comparisons Solution: Partnership: The answer does not change because June and John are taxed fully on their shares of income whether they are distributed or not and the partnership pays no tax. Thus, June’s tax is still $12,672 and John’s tax is $8,000 for a total of $20,672 in taxes. They pay no additional tax on the $28,000 distribution. S Corporation: The answer does not change because June and John are taxed fully on their shares of income whether they are distributed or not and the S corporation pays no tax. Thus, June’s tax is still $12,672 and John’s tax is $8, 000 for a total of $20,672 in taxes. They pay no additional tax on the $28,000 distribution. C Corporation: The corporation pays the same tax of $11,000 [($50,000 x 15%) + ($14,000 x 25%)]. June and John, however, will now have to recognize $28,000 of dividend income; John will be taxed at the 15% dividend rate but June will be taxed at 20% (the dividend rate for taxpayers in the 39.6% marginal tax bracket). June’s tax = $28,000 x 20% = $5,600. John’s tax = $28,000 x 15% = $4,200. The total tax for the corporation, June, and John is $20,800 ($11,000 + $5,600 + $4,200). Note the problem specified only income taxes; Medicare surtaxes and employment taxes are not included in the solution to this problem. 55. [LO 1.4 & 1.5] Tax Liability Comparisons Solution: Partnership: The partnership does not benefit from the loss. June and John are each allocated $22,000 of loss and can deduct the loss against their other income because they have sufficient basis in the partnership [$20,000 invested + ($30,000 bank loan x 50%) = $35,000 basis before loss - $22,000 loss = $8,000 ending basis]. June’s and John’s incomes are high enough for them to remain fully in their respective marginal tax rates of 39.6% and 25%. June benefits from a reduction in taxes of $8,712 ($22,000 x 39.6%) and John saves $5,500 ($22,000 x 25%) in taxes at his marginal tax rate. The total tax savings for both are $14,212 ($8,712 + $5,500). S Corporation: The S corporation does not benefit from the loss. June and John are each allocated $22,000 of the loss but they can only deduct $20,000 of this loss against their other income because their deduction is limited to their basis in their S corporation stock (which does not include any of the corporation’s liabilities).

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Thus, June benefits from a reduction in taxes of $7,920 ($20,000 x 39.6%) at her marginal tax rate. John reduces his taxes by $5,000 ($20,000 x 25%) at his marginal tax rate. They will each carry their excess $2,000 loss forward; these losses can be deducted in a future year when they have sufficient basis. The total tax savings for the current year is $12,920 ($7,920 + $5,000). C Corporation: Neither June nor John have any current tax savings from the $44,000 loss. As a new corporation, it can only carry its loss forward to offset income (and realize tax savings) in a future year. Losses of a C corporation do not pass through to shareholders. Note the problem specified only income taxes; Medicare surtaxes and employment taxes were not included in the solution. 56. [LO 1.4 & 1.5 Choice of Business Entity] Solution: a. (1) The partnership does not pay any tax in years 1 or 2. (2) The S corporation does not pay any tax in years 1 or 2. (3) The C corporation pays no tax in year 1 but its year-1 loss can be carried forward to year 2 to offset $54,000 of its year-2 $60,000 income; it will pay a tax of $900 ($6,000 x 15%) on this remaining $6,000 income in year 2. b. (1) Tax savings for first year of partnership: Clara and Charles are each allocated $27,000 of loss and each can deduct $25,000 of the loss (the extent of basis [$15,000 investment + (50% x $20,000 loan)]. Clara’s tax savings will be $7,000 ($25,000 deductible loss x 28%) and Charles’s tax savings will be $6,250 ($25,000 deductible loss x 25%). The excess loss is carried forward to the next year. Partner’s basis computations: $15,000 Partner’s original investment +10,000 Partner’s share of liabilities ($20,000 loan x 50%) $25,000 Basis before deducting loss - 25,000 Deductible loss ($54,000 loss x 50% = $27,000 but limited to basis and $2,000 excess loss carried forward) 0 Basis at end of first year (2) Tax savings for first year of S corporation: Clara and Charles are each allocated $27,000 of loss and can deduct loss to the extent of the basis in the S corporation stock. Clara’s tax savings will be $4,200 ($15,000 deductible loss x 28%) and Charles’s savings will be $3,750 ($15,000 deductible loss x 25%). S corporation shareholder’s stock basis computations: $15,000 Shareholder’s original investment -15,000 Deductible loss ($54,000 loss x 50% = $27,000 but limited to basis and $12,000 excess loss carried forward) 0 Basis at end of first year Note that an S corporation shareholder does not increase stock basis for any corporate liabilities.

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(3) First year of C corporation: No effect on Clara or Charles. Their basis in stock remains $15,000 each. c. (1) Income tax for second year of partnership: Clara pays $7,840 income tax [($30,000 profit - $2,000 loss carried forward) x 28%] and Charles pays $7,000 income tax [($30,000 profit - $2,000 loss carried forward) x 25%]. The cash distribution is not taxed but is a reduction of basis. Partner’s basis computations: 0 $30,000 - 5,000 $25,000 - 2,000 $23,000

Basis at end of first year Year 2 profit ($60,000 x 50%) Cash distribution Subtotal Deduct loss carried forward from previous year Basis at end of second year

(2) Income tax for second year of S corporation: Clara pays $5,040 in tax [($30,000 profit - $12,000 loss carried forward) x 28%] and Charles pays $4,500 tax [($30,000 profit $12,000 loss carried forward) x 25%]. The cash distribution is not taxed but is a reduction of basis. S corporation shareholder’s stock basis computations: 0 Basis at end of first year $30,000 Year 2 profit ($60,000 x 50%) - 5,000 Cash distribution $25,000 Subtotal - 12,000 Deduct loss carried forward from previous year $13,000 Basis at end of second year (3) Income tax for second year of C corporation: Clara and Charles each pay $750 tax on their dividend income ($5,000 dividend income x 15% dividend rate = $750 tax). Their basis in the corporate stock remains $15,000. 57. [LO 1.5] Partnership Basis Solution: His basis is $5,200. $4,000 beginning basis + (30% x $7,000 partnership income) – (30% x $3,000 distribution) = $4,000 + $2,100 - $900 = $5,200 Develop Planning Skills 58. [LO 1.4] Single vs. Married Filing Status Solution: Married Filing Separately: [($89,700 - $75,950) x 28%] + $14,758.75 = $18,608.75 $18,608.75 x 2 = $37,217.50 Married Filing Jointly: [($179,400 - $151,900) x 28%] + $29,517.50 = $37,217.50

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Single: [($89,700 - $37,650) x 25%] + $5,183.75 = $18,196.25 x 2 = $36,392.50 It makes no difference if they marry this year and file either as married filing jointly or separately. If they postpone the wedding until next year, they will save $825 ($37,217.50 - $36,392.50) in taxes filing as single individuals this year. 59. [LO 1.4 & 1.5] Total Tax Comparison Solution: Sole Proprietorship: Jeremy will be taxed on the entire net income from the sole proprietorship of $68,000 ($80,000 – $12,000) regardless of the ―salary.‖ $68,000 $10,350 allowable deduction = $57,650 taxable income; [25% x ($57,650 $37,650)] + $5,183.75 = $10,183.75 income tax. Corporation: $80,000 - $12,000 - $30,000 = $38,000 taxable income; $38,000 x 15% = $5,700 corporate income tax. Income tax on Jeremy’s $30,000 salary: Jeremy’s taxable income = $30,000 - $10,350 allowable deduction = $19,650. Tax on $19,650 = $927.50 + [($19,650 - $9,275) x 15%] = $2,438.75. Total taxes as a corporation = $5,700 + $2,438.75 = $8,183.75 Based solely on income taxes, Jeremy should incorporate because his taxes will be $2,000 ($10,183.75 - $8,183.75) less than operating as a sole proprietorship. 60. [LO 1.1, 1.4 & 1.5] Form of Business Operations: C Corporation vs. S Corporation Solution: Regular C Corporation: FICA tax on Carol’s $60,000 salary is $4,590 ($60,000 x 7.65%). FUTA = $420 ($7,000 x 6%) Corporate taxable income = $200,000 - $75,000 - $60,000 salary - $4,590 FICA -$420 FUTA= $59,990. Income tax on $59,990 = [($59,990 - $50,000) x 25%] + $7,500 = $9,997.50. Total corporate taxes = $4,590 + $420 + $9,997.50 = $15,007.50. Carol’s taxes: Carol also pays $4,590 ($60,000 x 7.65%) in FICA taxes on her salary but she cannot deduct these taxes. Carol’s taxable income = $60,000 - $6,350 standard deduction and $4,050 personal exemption= $49,600. Income tax: ($49,600 - $37,950) x 25%] + $5,226.25 = $8,138.75. Carol’s total taxes = $8,138.75 + $4,590 = $12,728.75. Total taxes = $15,007.50 + $12,728.75 = $27,736.25 S Corporation: FICA tax on Carol’s $60,000 salary is $4,590 ($60,000 x 7.65%). FUTA = $420 ($7,000 x 6%). The net S corporation income of $59,990 (same as the regular corporation) is passed through to Carol for taxation along with her salary income. Carol’s taxable income = $60,000 salary + $59,990 corporation income - $6,350 standard deduction and $4,050 personal exemption = $109,590. Tax on Carol’s $109,640 taxable income = [($109,590 - $91,900) x 28%] + $18,713.75 = $23,666.95 Carol’s total tax = $23,666.95 + $4,590 = $28,256.95

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Total taxes = $28,256.95 + $4,590 +$420 = $33,266.95 Based on 2017 total taxes only, Carol should not make the S corporation election because the total taxes will be $5,530.70 ($33,266.95 - $27,736.25) less operating as a regular C corporation. Think Outside the Text

These questions require answers that are beyond the material that is covered in this chapter. 61. [LO 1.2] Tax Rates Solution: Income Tax Rate on salary 15% 28% 28%

33%

Employment Tax Rate 7.65% 6.2% up to $127,200 and 1.45% on $132,000 6.2% up to $127,200 and 1.45% on $176,000 salary 6.2% up to $127,200; 1.45% on $285,000*

Capital Gains Tax Rate 0% 15% 15% on $139,000*

15% on the first $133,400 (up to AGI of $418,400) and 20% on remaining $114,650* *excluding Medicare surtaxes

62. [LO 1.2] Tax Fairness Solution: No answer is suggested here as the purpose of this question is to require the student to select an alternative and construct an argument to support that position. 63. [LO 1.2] Property Tax Solution: As an ad valorem tax, a property tax is proportional. If you use another tax base except the value of the property, the tax may be progressive for some group of citizens and regressive for others. For example, senior citizens generally have lower incomes than working persons. They may have lived in their home a long time and paid off the mortgage. If it had significantly appreciated (with property tax increases), based on a percentage of their income, the property tax would be regressive. Alternatively, a lower income person may spend only 25 percent of his or her income on housing because of other necessities. A high-income person may be able to spend 40 percent of his or her income on housing. The latter’s property taxes will be much higher as a percent of income than the former. In this situation, the tax is progressive when based on income. Thus, for a wealth tax such as a property tax, wealth is the only base on which it is practical to evaluate it. It is generally proportional, although a certain base amount may be excluded from the tax (for example, a $25,000 homestead exemption for persons who

Chapter 1: An Introduction to Taxation 15

own their own home would make it somewhat progressive). 64. [LO 1.2] Flat Tax Solution: Most students will agree that there will have to be some basic exclusions or deductions to enact a viable flat tax. Comparisons can be drawn, however, to the FICA taxes, which have been flat over incomes up to the Social Security base amount ($127,200 for 2017), but only the Medicare portion applies above this base amount; an income flat tax, on the contrary, could be structured to exempt a certain base amount from tax with the tax applying on all income above that minimum excluded base. Discussions of a flat tax can often lead to discussions of higher minimum wages, guaranteed annual incomes, and negative income taxes in order to keep the flat tax relatively simple. 65. [LO 1.3] Tax Evaluation Using the Canons of Taxation Solution: The four canons of taxation are equity, economy, certainty, and convenience. In general, with the exception of an evaluation based on equity, many persons believe the sales tax that most states levy is superior to the income tax. The costs to collect and comply with the sales tax are relatively small compared to the amounts collected (although internet sales are a significant problem now); most persons know that when they purchase certain items they are required to pay sales taxes; and they pay at the point of sale without having to file end-of-year returns. Sales taxes are considered regressive, however, and therefore not considered equitable. As a percentage of income, lower income persons pay more sales tax than higher income persons do because they are obliged to spend more of their income. As an absolute amount, however, most wealthy persons spend more overall than poor persons, and, as a result pay more sales taxes (vertical equity). Two persons with equal incomes can pay different amounts of sales taxes, however, if one party chooses to save money while the other spends; this would violate horizontal equity. The income tax has far higher costs of collections and administration but its tax rates are progressive and it contains provisions that exempt lowincome taxpayers from paying any taxes. Thus, it is generally seen as more equitable than a sales tax. It fails, however, on convenience and certainty because of the annual filing requirements and constant changing of the laws. 66. [LO 1.4] Marriage Penalty Solution: An evaluation of this proposal at this point usually focuses on the cost to the taxpayer in time and money to determine the tax under the dual system. Other problems arise in the dividing up of dependency exemptions, itemized deductions, and tax credits. If taxpayers are allowed to choose the method that allows them to pay the lower tax, there will also be a decline in total tax revenues. To some degree taxpayers have a choice now – but the difference in tax rates from single to married filing separately and the requirement that both must either choose the standard deduction or itemize deductions limits their ―gaming the system.‖ 67. [LO 1.4] After-Tax Interest Rate Solution: The interest rate = 4.34%.

16

The $7,000 interest ($100,000 x 7%) would reduce taxes by $2,660 ($7,000 x 38%). Thus the net interest paid is $4,340 ($7,000 - $2,660). The after-tax interest rate is 4.34% ($4,340/$100,000). Alternatively, this can be calculated directly as 7% (1 - .38) = 4.34% 68. [LO 1.4] Deductions vs. Credits Solution: Taxable income = $50,000; marginal tax bracket = 25%. Tax savings from the $4,000 deduction = $1,000 (25% x $4,000). Taxable income = $200,000; marginal tax bracket = 33%. Tax savings from the $4,000 deduction = $1,320 (33% x $4,000). A $4,000 tax credit reduces each taxpayer’s tax by $4,000. The tax savings from a tax credit is independent of the taxpayer’s marginal tax rate. Search the Internet

For the following four problems, consult the IRS Web site (www.irs.gov). Check solutions 69. [LO 1.1] Statistical Information Solution: On the IRS.gov home page search for tax statistics or click on Tax Stats, Facts and Figures at the bottom of the page to access www.irs.gov/uac/Tax-Stats-2. There are links to a wide range of tables, articles, and data that describe and measure elements of the U.S. tax system. These include statistics and other information about returns filed with the IRS. Headings under this section include: Business Tax Statistics; Individual Tax Statistics; IRS Operations & Budget; Statistics of Income (SOI); Charitable & Exempt Org. Statistics; Products, Publications, & Papers; Statistics by Form; Other IRS Data and Research, Additional Information; and What’s New. 70. [LO 1.1] Asking Questions or Making Comments to the IRS Solution: On www.irs.gov/uac/TaxStats-2 page under ―Additional Information,‖ there is a direct link under Questions on Tax Statistics? that accesses a page on which you can send an email to the IRS with general questions or comments regarding these statistics. Links are also provided for accessing other information. 71. [LO 1.1] Statistics of Income Solution: About SOI, Dissemination Policy, SOI Products and Services, SOI Data Releases, Statistical Methodology, and All Topics 72. [LO 1.1] Information about the IRS Solution: At the bottom of the IRS home page, click on "About Us." A list of topics pop up including ―The Commissioner’s Section,‖ ―The Agency, Its Mission and Statutory Authority‖ and ―Brief History of IRS‖ along with other links including Today’s IRS Organization, Equity, Diversity and Inclusion of IRS, Strategic Plan and Other References, Open Government Initiative, Contracting Opportunities, and Contact Us.

Chapter 1: An Introduction to Taxation 17

73. [LO 1.1] Tax Freedom Day Solution: (a) Tax Freedom Day is the specific day in the year that, on average, Americans stop working to pay the government; that is, income to that date all goes to pay taxes; income for the rest of the year belongs to the taxpayer to do with as he or she chooses. (b) Tax Freedom Day was April 24 in both 2015 and 2016. Thus, 111 days in each year were worked to pay taxes. This date varies greatly when done on a state-by-state basis. Identify the Issues

Identify the issues or problems suggested by the following situations. State each issue as a question. 74. [LO 1.4] Filing Status Solution: What is John and Mary’s filing status for the current year? 75. [LO 1.5] S Corporation Requirements Solution: Is the S corporate restriction of no more than 100 shareholders violated when John gives half of his shares to his wife? Will its S election terminate? 76. [LO 1.5] Disguised Dividend Solution: Will all of Clifford’s salary be deductible by the corporation as salary or is it possible that a portion of it will be declared a disguised dividend?

18

Solutions to Chapter 2 Problem Assignments Check Your Understanding 1. [LO 2.1] DIF Formula Solution: The DIF formula is designed to identify those taxpayers for which an audit will be cost effective; that is, that the audit will yield additional taxes sufficient to warrant the expenditure of resources necessary to conduct the audit. When the DIF score is high, indicating a high probability of adjustment to the return, the return will be examined manually to confirm the audit potential. If confirmed, an audit will commence. 2. [LO 2.1] Types of Audits Solution: Correspondence audit is the simplest audit that is conducted when only one or two relatively straightforward items on a return are questioned. The audit and the taxpayer’s response can be handled entirely by mail. An office audit involves one or more issues that are too complex for a correspondence audit. The taxpayer is asked to come to a district office for an interview and should bring any records or documents to support the items in question. Field audits are more comprehensive than office audits and are usually limited to an examination of business returns. Field audits are usually conducted on the taxpayer’s premises and generally involve a complete review of the entire financial operations of the business. This type of audit is usually used for corporations. 3. [LO 2.1] Appeal Options Solution: If the taxpayer does not agree with the proposed deficiency specified in the 30-day letter, he or she may request a conference with an agent of the IRS Appeals Division within 30 days of receiving the letter. 4. [LO 2.1] Appeal Options Solution: (1) File a petition with the U.S. Tax Court within 90 days of receiving the notice. (2) Pay the tax; the taxpayer may then go to a U.S. District Court or the U.S. Court of Federal Claims to sue for refund. (3) Take no action and be subject to IRS-enforced collection procedures. 5. [LO 2.1] Hazards of Litigation Solution: Hazards of litigation refers to factors that may affect the outcome of a case that is litigated such as ambiguous facts, uncertain application of the law to known facts, credibility of witnesses, and the ability to meet the required burden of proof. 6. [LO 2.1] Trial Courts and Appeals Solution: The taxpayer can initiate litigation in the U. S. Tax Court, the U. S. District Court, or the U. S. Court of Federal Claims. All of the decisions from these courts can be appealed to a higher court except those cases that are tried in the small tax case

Chapter 1: An Introduction to Taxation 19

division of the Tax Court. 7. [LO 2.1] Appeals Process Solution: The taxpayer should be advised to ask for a meeting with an agent from the IRS Appeals Division as the only cost effective course of action to get the additional tax assessment abated. The costs of litigating would generally far exceed the $1,050 additional tax that has been assessed and litigation should be discouraged. If she wishes to pursue this in court, she should go to the small case division of the Tax Court. 8. [LO 2.1] Taxpayer Penalties Solution: If a taxpayer is convicted of criminal fraud (tax evasion), a prison sentence can be imposed in addition to monetary fines. 9. [LO 2.1] Statute of Limitations Solution: The statute of limitations is the time period beyond which neither the taxpayer nor the IRS can take legal action nor make changes to a tax return. The statute of limitations brings closure to a tax return for the taxpayer and the IRS. The IRS cannot audit a tax return after the statute of limitations has passed nor can the taxpayer make changes to the return or file a claim for refund beyond that date. 10. [LO 2.2] Avoidance vs. Evasion Solution: Tax avoidance is the minimization of taxes by using legal alternatives to determine the tax owed. Tax evasion is the avoidance of taxes through illegal means. 11. [LO 2.2] Preparer Penalties Solution: Yes. Code Section 6694 imposes a penalty of $1,000 or 50 percent of the fee for the work, if greater, on preparers whose clients’ tax deficiencies result from an ―unreasonable position‖ on the return that the preparer knew or should have known was a departure from the rules or regulations and the position was not disclosed. (Disclosure is typically accomplished by using Form 8275; however, filing the form would probably raise a red flag with the IRS.) A reasonable position requires the preparer to have ―substantial authority‖ upholding a ―realistic possibility of success‖ for nonabusive, undisclosed tax return positions. Substantial authority exists if the weight of authorities (including the Internal Revenue Code, regulations, court cases, committee reports, revenue rulings, revenue procedures, and similar documents) supporting the reported tax treatment is substantial in relation to the weight of those authorities taking a contrary position. If the position taken on the tax return involves a tax shelter (or similar abusive transaction called a ―listed transaction‖), however, a higher ―more-likelythan-not‖ (greater than 50 percent) standard applies. If a preparer takes an unreasonable position in a ―willful‖ attempt to understate the taxpayer’s liability or if the preparer is guilty of ―reckless or intentional disregard‖ of rules or regulations, the penalty increases to the greater of $5,000 or 50 percent of the preparer’s fees. If a preparer is convicted of criminal tax evasion, the penalty can consist of a fine of up to $100,000 ($500,000 in the case of a

20

corporation) and imprisonment. Severe monetary penalties also apply to promoters of and advisors to tax shelters for the failure to provide required information returns, maintain required investor lists, and to provide these lists when requested. 12. [LO 2.2] Sources of Guidance Solution: Treasury Circular 230: Regulations Governing the Practice before the Internal Revenue Service, the AICPA’s Code of Professional Conduct and the AICPA’s Statements on Standards for Tax Services all contain guidelines for tax professionals. 13. [LO 2.2] SSTS Solution: The Statements on Standards for Tax Services are a series of statements that delineate the extent of a tax practitioner’s responsibility to his or her client, the public, the government, and his or her profession. They are issued by the Federal Taxation Executive Committee of the AICPA. 14. [LO 2.2] SSTS Solution: In general, a CPA may rely on information furnished by a client and other third parties unless the information appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known by the CPA. If there is such evidence, the CPA must make further inquiry to determine the accuracy of the information provided. 15. [LO 2.2] SSTS Solution: Estimates are appropriate when records are missing (for example, a flood or fire destroying records) or precise information is not available at the time of filing the tax return. 16. [LO 2.3] Tax Planning vs. Compliance Solution: Tax compliance involves the gathering of relevant information, evaluating and classifying that information, filing tax returns, and representing clients at Internal Revenue Service audits. Tax planning is the process of evaluating the tax consequences associated with a transaction and making recommendations to achieve the desired objective at minimal tax cost. It generally involves extensive tax research. 17. [LO 2.3] Tax vs. Nontax Factors Solution: a. This is primarily a nontax factor situation. The taxpayer has specified that she is risk averse, a personal choice, due to having experienced prior losses. b. The taxpayer’s dislike of paying taxes is really a nontax factor; this dislike, however, leads him to seek income tax advice to reduce taxes and he is willing to pay significant amounts of money to find ways to avoid taxes. Thus, this really has significant elements of both. c. This situation involves tax factors in tax planning. There are numerous ways in which a taxpayer can arrange transactions to take advantage of loss carryovers before they lose significant value due to the time value of these losses.

Chapter 1: An Introduction to Taxation 21 18. [LO 2.3] Marginal Tax Rates Solution: Currently, Beta Corporation’s marginal tax rate is 34%. Beta’s income would need to exceed $10,000,000 to step-up to the next tax bracket. Therefore, Beta Corporation should use a 34% marginal tax rate in evaluating a project that would generate an additional $200,000 in income.

19. [LO 2.3] Marginal Tax Rates Solution: Maria should use a 25% tax rate because her income is between $37,950 and $91,900. Her tax savings will be $500 ($2,000 deduction x 25%).

20. [LO 2.3] Tax Planning Solution: Timing, income shifting, and changing the character of income.

21. [LO 2.3] Business Purpose Doctrine Solution: The business purpose doctrine holds that a transaction will be recognized for tax purposes only if it is made for some business or economic purpose other than a tax avoidance motive.

22. [LO 2.4] Primary vs. Secondary Authority Solution: Primary authority comes directly from statutory, administrative or judicial sources. Secondary authority consists of tax services, books, journals, and newsletters that assist the taxpayer in locating and interpreting primary authorities. 23. [LO 2.4] Steps in Tax Research

Solution: The basic steps include: (1) gather the facts and identify the issues, (2) locate the sources of authority, (3) evaluate the relevant authorities, and (4) communicate the recommendations. 24. [LO 2.4] Tax Service Solution: A tax service or reference service is a comprehensive publication providing reference information related to the tax laws that can be used to assist in the tax research process. Most tax services contain the Code, regulations, rulings, and cases as well as an index to aid the researcher in locating the relevant discussions of tax problems and are usually available only through paid subscriptions. 25. [LO 2.4] Committee Reports Solution: The House Ways and Means Committee, the Senate Finance Committee, and the Joint Conference Committee may generate committee reports in the process of a bill

22

becoming law. 26. [LO 2.4] Committee Reports Solution: Committee reports contain a general and technical discussion of a bill’s provisions. The reports contain important information about the legislative intent of a bill that may be used to resolve disputes between taxpayers and the Internal Revenue Service. These reports provide the only guidance about a new law until the Treasury provides regulations. 27. [LO 2.4] Sections of Internal Revenue Code Solution: The Code is cited by a section number. The sections of the Code are consecutively numbered and each section has a unique number. 28. [LO 2.4] Regulation Citations Solution: The 1 is a prefix that refers to an income tax regulation; the 247 is a root number that designates the Code section to which the regulation is related. 29. [LO 2.4] Types of Regulations Solution: A legislative regulation is one that has been specifically authorized by the Code to provide the details of the meaning and rules for a Code section. It carries weight similar to that of a Code section. An interpretive regulation is one that provides a detailed explanation of and examples for a particular Code section. It does not carry the same weight of authority as a legislative regulation. 30. [LO 2.4] Proposed vs. Temporary Regulations Solution: A proposed regulation provides an advance indication of what position the IRS intends to take on a particular issue. Positions taken in proposed regulations cannot be relied on, as they are simply proposals. Temporary regulations provide operating rules for a particular Code section until final regulations can be issued. These regulations can be followed until final regulations are issued, so they carry significantly more weight than proposed regulations. 31. [LO 2.4] Letter Ruling vs. Revenue Ruling Solution: A letter ruling is issued to a specific taxpayer to provide guidance on how a planned transaction will be taxed. It generally applies only to the taxpayer to which it was issued and may not necessarily apply to another taxpayer in a similar situation. A revenue ruling is issued as general guidance on the tax consequences of a particular transaction. It is usually issued for ambiguous tax situations. Although these rulings are generally fact specific, taxpayers with similar fact situations can rely on them for guidance. 32. [LO 2.4] Nonacquiescence Solution: To signal disagreement with a court decision, the IRS will publicly

Chapter 1: An Introduction to Taxation 23

―nonacquiesce,‖ indicating it will not follow the decision.

33. [LO 2.4] Golsen Rule Solution: The Golsen rule requires the Tax Court to follow a decision of the Court of Appeals that has direct jurisdiction over the taxpayer in question. If there has been no appellate decision on an issue in a specific circuit, the Tax Court is free to decide the issue on its own merits. 34. [LO 2.4] Citator Solution: A citator contains an alphabetical listing of virtually all tax cases. The citator permits a researcher to determine the case’s history and what other courts may have said about this decision. Each case is followed by a record of other decisions that have cited or referred to this case. The validity of a decision may be assessed by examining how the subsequent cases viewed the cited decision and whether the IRS or other courts agree or disagree with the decision in this case. 35. [LO 2.4] Rule 155

Solution: A decision entered under Rule 155 means that the court has reached a decision regarding the facts and issues of the case but leaves the computational aspects for the opposing parties to determine. 36. [LO 2.4] Communicating Tax Research Results

Solution: Practitioners communicate the results through a memorandum to the client file and letter to the client. 37. [LO 2.4] Memo to File

Solution: The four sections of a memo to file are: (1) Facts—a statement of all facts necessary to answer the issues raised, in chronological order. (2) Issues—the tax questions involved, numbered separately and presented in logical order. (3) Conclusions—short answers to each numbered issue. (4) Discussion—presentation of the reasoning and authorities on which the conclusions are based. Crunch the Numbers 38. [LO 2.1] Penalties Solution: $45. Adam’s tax payment is 1 partial and 2 full months late. He will be assessed a late-payment penalty equal to one-half of one percent for each partial and full month or $45 ($3,000 x 0.5% x 3). 39. [LO 2.1] Penalties Solution: $800. Robert’s return and tax payment is 1 partial and 3 full months late. He will be assessed a late filing penalty of 18 percent (4.5% x 4 x $4,000 = $720, which is

24

greater than the minimum $210 penalty) and a late payment penalty of 2 percent (0.5% x 4 x $4,000 = $80) for a total of 20 percent of the $4,000 balance due. He will be charged a total of $800 (20% x $4,000). 40. [LO 2.1] Statute of Limitations Solution: April 15, 2021. The three-year statute of limitations begins to run from the later of the due date or date of filing. 41. [LO 2.1] Statute of Limitations Solution: The deliberate omission of $40,000 of gross income will generally constitute fraud (tax evasion) and in those circumstances there is no statute of limitations. The IRS can assess additional taxes, interest, and penalties at any time although it must prove fraud. If the IRS cannot prove fraud on Kevin’s part, then the statute of limitations would expire April 15, 2021, three years from the later of the due date or date of filing. Once an assessment of tax is made, the IRS has 10 years within which to collect the taxes. 42. [LO 2.1] Statute of Limitations Solution: October 15, 2023. The $40,000 of gross income inadvertently omitted is in excess of 25 percent of the gross income reported ($40,000/$150,000 = 27%), so the statute of limitations is extended to 6 years from the later of the due date or date of filing. Once an assessment of tax is made, the IRS has 10 years within which to collect the taxes. 43. [LO 2.1] Statute of Limitations Solution: a. April 15, 2024. If the income proves taxable, Thomas would have omitted gross income in excess of 25 percent of the gross income reported ($30,000/$50,000 = 60%) so the statute of limitations is extended to 6 years from the later of the due date or date of filing. b. If the IRS can prove fraud, there is no time limit (no statute of limitations) on when it can assess additional taxes, penalties, and interest. 44. [LO 2.3] Income Shifting Solution: $1,620. Tax on $100,000 for a married couple filing joint return [($100,000 - $75,900) x 25%] + $10,452.50

$16,477.50

Tax on $92,000 for a married couple filing joint return [($92,000 - $75,900) x 25%] + $10,452.50

(14,477.50)

Chapter 1: An Introduction to Taxation 25 Tax savings to parents ($8,000 x 25% marginal tax bracket) Tax paid by children [($2,000 - $1,050 standard deduction) x 10% marginal tax rate] x 4 children Net tax savings to family from income shifting

2,000.00

(380.00) $1,620.00

(Note: The tax rate schedules and the standard deduction amounts are included in the Appendix at the end of the textbook. The standard deduction for a dependent child is limited to $1,050 as discussed in Chapter 1.)

45. [LO 2.3] Changing Character of Income

Solution: a. $20,160. If Diana sells the stock now, she will recognize a short-term capital gain. She will be taxed at her 28% ordinary rate. Her tax liability will be $7,840 [4,000 x ($19 - $12) x 28%]. Her after-tax cash inflow will be $68,160 [(4,000 x $19) - $7,840]. Subtracting her $48,000 (4,000 shares x $12) cost results in a net cash inflow of $20,160. b. $23,800. If Diana holds on to the stock for more than 12 months, she will be entitled to use the special long-term capital gains rate. Therefore, her tax liability would be reduced to $4,200 [4,000 x ($19 - $12) x 15%]. Diana’s after-tax cash inflow would be $71,800 [(4,000 x $19) - $4,200]. Subtracting her $48,000 cost results in a net cash inflow of $23,800. c. Diana should wait and sell the stock in one month. This will afford Diana the ability to use the special long-term capital gains rate, which is less than Diana’s ordinary tax rate. Diana’s tax liability will be $3,640 ($7,840 $4,200) lower using the special rate resulting in higher net after-tax cash flow. 46. [LO 2.3] Timing Issues

Solution: a. Monico should wait to bill its customers until the end of December. If Monico’s marginal tax rate is 25%, taxes paid this year would cost $1,250 ($5,000 x 25%) resulting in an after-tax cash inflow of $3,750 ($5,000 – $1,250). When considering the time value of money, the cost of the taxes that are deferred until next year will have a present value (cost) of only $1,179 ($1,250 x .943 PV factor) or $71 less ($1,250 - $1,179). b. Monico should defer billing its customers. If Monico’s marginal tax rate is 15% next year, then its after-tax cash inflow would be $4,293 [$5,000 – ($5,000 x 15% x .943 PV factor)]. Monico should defer billing its customers because this will result in a $543 higher after-tax cash inflow ($4,293 -

26

$3,750). c. Monico should bill its customers in the beginning of December. If Monico’s marginal tax rate is 34% next year, then its after-tax cash inflow would be $3,397 [$5,000 – ($5,000 x 34% x .943 PV factor)]. Monico should bill its customers in the beginning of December because deferral would result in a $353 after-tax cost ($3,397 - $3,750). 47. [LO 2.3] Timing Issues

Solution: a. Kimo should pay the expense in this year. Because Kimo’s marginal tax rate is expected to be the same, the only consideration is the time value of money. If Kimo chooses to pay the expense this year, it will have an after-tax savings of $3,750 ($15,000 x 25%). If Kimo defers payment of the expense, its net present value of the after-tax savings will be $3,506 ($15,000 x 25% x .935 PV factor). Therefore, Kimo should pay the expense this year since it will result in a $244 greater after-tax savings ($3,750 - $3,506). b. Kimo should pay the expense this year. If Kimo’s marginal tax rate is expected to decrease to 15%, Kimo will have a lower after-tax savings next year. The net present value of Kimo’s after-tax savings would be $2,104 ($15,000 x 15% x .935 PV factor). Kimo should pay the expense this year since it will result in a $1,646 greater after-tax savings ($3,750 - $2,104). c. Kimo should wait and pay the expense next year. If Kimo’s marginal tax rate is expected to increase to 34%, Kimo will have a greater after-tax savings next year. The net present value of Kimo’s after-tax savings would be $4,769 ($15,000 x 34% x .935 PV factor). Kimo should wait and pay the expense next year since it will result in a $1,019 greater after-tax savings ($4,769 $3,750). Develop Planning Skills 48. [LO 2.3] Sole Proprietorship vs. C Corporation Solution: a. The sole proprietorship will generate $18,000 ($150,000 x 12%) in before-tax cash flow. It will pay no taxes directly; Jessica will pay all taxes. Jessica will pay income taxes of $4,500 ($18,000 x 25%) reducing the net cash flow to $13,500 ($18,000 - $4,500). (Note that although this problem said to ignore employment taxes, you should be aware that self-employment taxes will reduce the net cash flow.) b. The corporation will pay income tax of $2,700 ($18,000 x 15%) on its income. Jessica will pay income tax of $1,350 [(50% x $18,000) x 15% dividend rate]. The net cash flow as a corporation is $18,000 - $2,700 - $1,350 = $13,950.

Chapter 1: An Introduction to Taxation 27

c. There are a number of nontax factors to consider such as her personal liability, the ease of raising additional capital, the ease of sale of ownership interests, and participation in fringe benefits. d. With significant income from other sources, the corporate form would protect the assets generating this income. In addition, by paying taxes at the corporate rate and leaving a significant portion of the income in the corporation, the business has more capital with which to grow. At a later date, if Jessica needs to take money from the corporation, she could do so as salary and avoid the double tax on this income (although as salary, the corporation and Jessica would have to pay employment taxes) or withdraw more dividends. Based on the tax rates of both the corporation and Jessica, paying dividends would result in a lower tax liability. Either way, the corporate form appears to be a better fit for Jessica’s situation. 49. [LO 2.3] Partnership vs. C Corporation Solution: a. The partnership has income of $20,000 ($200,000 x 10%) but will pay no taxes; thus, it will have cash remaining in the partnership of $12,000 ($20,000 - $8,000 distributed to Richard and Jack). Richard and Jack will each pay taxes on their onehalf share of the partnership’s $20,000 income. Richard will pay income tax of $2,500 ($10,000 x 25%); Jack will pay income tax of $2,800 ($10,000 x 28%). Richard will have an after-tax cash inflow of $1,500 ($4,000 – $2,500) and Jack will have an after-tax cash inflow of $1,200 ($4,000 - $2,800). Total taxes paid are $5,300 ($2,500 + $2,800). b. The corporation will have to pay $3,000 ($20,000 x 15%) tax on its income. After the $8,000 dividend distribution to Richard and Jack, its remaining cash is $9,000 ($20,000 – $3,000 - $8,000). Richard and Jack will each have to pay $600 ($4,000 dividend x 15% dividend rate) in income taxes. Richard and Jack each have an after-tax cash inflow of $3,400 ($4,000 - $600). Total tax is $4,200 ($3,000 + $600 + $600). c. Some of the nontax factors that Richard and Jack should consider include their exposure to liability as partners in the partnership, their ability to raise additional capital, the ease of selling their ownership interests, and their participation in fringe benefits. d. As presented, it appears that the corporation offers the best alternative form of business. They are able to benefit from the corporation’s lower tax rates and this form provides the best overall cash flow considering both the business and the owners at this time. Richard and Jack are paying very high taxes on income that flows through to them from the partnership. With the limited distributions made, they have little positive cash flow. If they intend to leave most of the income in the business, they can avoid the taxes at their level through the corporate form. If at a later date, they need income, they can make additional dividend distributions. Note that when employment taxes are considered (discussed in Chapter 4), the corporate form is even more attractive.

28

50. [LO 2.3] Capital Gain vs. Ordinary Income Solution: Robin would have a gain or income totaling $22,800 ($28,800 - $6,000 basis) on the sale of land. If interest of only 4 percent is designated, Robin will have less interest income to recognize and more gain on the sale of the property than if an interest rate of 8 percent were designated. A lower interest rate benefits Robin because the interest income is taxed at his ordinary income rates, while the gain on the property sale generally will be taxed at the lower long-term capital gain rate. If Norman is purchasing this property as an investment or to build a personal residence, the 8 percent interest rate would be better for him because it would result in a higher interest expense deduction for the debt. Although this results in a lower property basis, the higher current interest rate is preferable because it gives him a higher current deduction against ordinary income. Although gain realized on a subsequent sale will be higher, the tax on that gain will be postponed until it is sold and the gain will be capital gain normally taxed at favorable rates. If Norman builds a principal residence on the property, any future realized gain may escape taxation completely (due to the Section 121 exclusion discussed in Chapter 8). 51. [LO 2.3] Loan vs. Sale of Property Solution: (1) If Debbie sells the land, she will have a gain of $34,000 [$40,000 – (50% x $12,000)] on the sale. If she is not in the top tax bracket, she will most likely have to pay a capital gains tax of $5,100 (15% x $34,000) on the sale leaving her with a net cash inflow of $34,900 ($40,000 - $5,100). If she is in the top tax bracket, her capital gains tax rate would be 20% resulting in a tax of $6,800 (20% x 34,000). If she needs a total of $40,000, she will need to make up the $5,100 (or $6,800) shortfall from her other funds or borrow that amount. She would have a much smaller debt than if she borrowed the entire $40,000. If she does not expect the property to continue to increase in value or to possibly decrease in value in the future, then selling when its value is at a high point would be best. (2) If Debbie borrows the entire $40,000, she can avoid any current taxes. She will, however, be required to make interest and principal payments over a number of years to retire the debt. Her ability to do this is dependent on her other income. Whether undertaking debt and holding the property will prove the better financial alternative depends on the after-tax interest rate that she will have to pay on the loan (as this is to purchase additional investment property she may be able to deduct the interest) and the present value of the after-tax net profit that she could receive on a future sale. For example, if in three years she anticipates selling the entire property to a developer for $120,000, her profit on the half of the land will have increased by $20,000 [(50% x $120,000) - $40,000]. After taxes, she will have an additional $17,000 [$20,000 x (1-.15)] or $16,000 [$20,000 x (1-.20)] if in the top tax bracket and even when present value is considered, this may more than compensate for the interest payments over the three years. In recommending a final decision, selling would be the better alternative if appreciation potential is only moderate and she has little income to service the debt for the borrowing alternative. If she has other income and expects the property to

Chapter 1: An Introduction to Taxation 29

continue appreciating substantially, she should hold on to the property and borrow against it to obtain the needed funds.

52. [LO 2.3] After-Tax Cash Flow Solution: The manager should hire Lisa because the expected after-tax cash inflow is greater. Ken

Lisa

Estimated pretax cash inflow

$6,000

$5,600

Probability of success

x 80%

x 75%

Expected pretax cash inflow

$4,800

$4,200

Tax on expected return (39%)

(1,872)

0

Expected after-tax cash inflow

$2,928

$4,200

Before-tax cost (outflow) Tax savings (39%)

$(5,600)

$(6,000)

2,184

2,340

After-tax cost (outflow)

(3,416)

(3,660)

Net after-tax cash flow

$(488)

$540

53. [LO 2.3] After-Tax Cash Flow Solution: Marlin should accept Job 2 because it will result in a higher net present value. Job 1

Job 2

Revenues

$360,000

$220,000

Expenses

(200,000)

(120,000)

Before-tax cash flow

$160,000

$100,000

(45,650)

(22,250)

$114,350

$77,750

First year:

Income tax After-tax cash flow Second year:

30 Revenues

$80,000

$220,000

Expenses

(40,000)

(120,000)

Before-tax cash flow

40,000

100,000

Income tax

(6,000)

(22,250)

After-tax cash flow

34,000

77,750

Present value (after-tax cash flow x 0.935) Net present value

31,790

72,696

$146,140

$150,446

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter. 54. [LO 2.1] Statute of Limitations Solution: After the statute of limitations has passed, the taxpayer knows that he or she can no longer be audited and additional taxes, interest, and penalties assessed. This allows the taxpayer to move on with certainty for a closed year. In many instances, this allows the taxpayer to dispose of certain records that have no bearing on future years. The closure of years through the statute of limitations also allows the IRS to move on to current years for their audit potential. Unless the IRS suspects fraud, this also limits the IRS’s ability to go back through prior years when discrepancies are determined in a year currently under audit. This provides a practical limit to the workload of the Service. 55. [LO 2.1] Improving Compliance Solution: This question requires the student to develop a position and state whether that position is viable. For example, a penalty such as lifetime in prison may improve compliance but it is unlikely that such a provision would be passed. 56. [LO 2.3] Advantages of Debt vs. Equity Solution: The corporation can pay interest on the debt and deduct the interest expense from its gross income. If the corporation pays dividends on the stock, the dividends are not deductible by the corporation. Whether the payment is for interest or dividends, the shareholder recognizes income for the amount received; however, dividend income is taxed at a lower rate. Another consideration is that the corporation can repay debt with no tax consequences to the shareholders. If the corporation retires a shareholder’s stock, it is possible that the amount received could also be treated as a dividend unless specific redemption requirements are met. 57. [LO 2.1, 2.3 & 2.4] Effect of Law Changes on Tax Planning Solution: Because of changes in tax laws, successful plans devised in previous years may no longer be available for replication in the current year. When researching a tax plan,

Chapter 1: An Introduction to Taxation 31

the tax professional must be certain that a plan follows the laws in effect at the time the plan is to be put into effect. For example, the regulations often are not changed immediately when a section of the Code is amended. If a section of the regulations is affected by a law change, then the regulations cannot be relied on as guidance under the new law for a current plan. Similarly, rulings and case law can be superseded by law changes. 58. [LO 2.4] Origination of Tax Bills Solution: The Senate can initiate a tax bill by attaching the bill to another House-passed revenue bill already under consideration in the Senate. This happened in 1982 when Senator Robert Dole, Chairman of the Senate Finance Committee, put together a package of miscellaneous revenue-raisers and ―loophole closings‖ in his Finance Committee. He then tacked it onto a minor House-passed tax bill that had been stripped of all its original provisions, passed it through the Senate, and sent it to the House. It eventually became the 1982 tax reform act. 59. [LO 2.4] Benefit of Rulings Solution: The rulings issued by the IRS provide a blueprint for the taxpayer on how to structure a transaction so that the tax consequences are known when the transaction is consummated. Having certainty about the outcome of a transaction is highly beneficial to the taxpayer. This also reduces the number of disagreements between the taxpayer and IRS when the taxpayer follows a sanctioned form of a transaction. This allows the IRS to better allocate its scarce resources. Search the Internet 60. [LO 2.1] Locate employment information for Internal Revenue Agent positions Solution: a. At least 30 hours of accounting courses. b. GS-7 requires one full year of graduate level education. GS-9 requires a master’s or equivalent graduate degree or two full years of progressively higher level graduate education leading to such a degree or LL.B. or J.D. 61. [LO 2.1] Locate IRS Publication Solution: Form 8857 62. [LO 2.1] Locate IRS Notice

Solution: a. $5,000 b. Positions that are the same as or similar to the following are frivolous: (1) Compliance with the internal revenue laws is voluntary or optional and not required by law. (This statement is followed by 9 examples.) (2) The Internal Revenue Code is not law (or ―positive law‖) or its provision are ineffective or inoperative, including the sections imposing an income tax or requiring the filing of tax returns, because the provision have not been implemented by regulations even though the provisions in question either (a) do not expressly require the Secretary to issue implementing regulations to become

32

effective or (b) expressly require implementing regulations which have been issued. (3) A taxpayer’s income is excluded from taxation when the taxpayer rejects or renounces United States citizenship because the taxpayer is a citizen exclusively of a State (sometimes characterized as a ―natural-born citizen‖ of a sovereign state‖), that is claimed to be a separate country or otherwise not subject to the laws of the United States. This position includes the argument that the United States does not include all or a part of the physical territory of the 50 States and instead consists of only places such as the District of Columbia, Commonwealths and Territories (e.g. Puerto Rico), and Federal enclaves (e.g., Native American reservations and military installations), or similar arguments described as frivolous in Rev. Rul. 2004-28, 2004-1 CB 624 or Rev. Rul. 2007-22, 2007-14 IRB 866.

63. [LO 2.2] Locate Circular 230

Solution: a. (1) Communicating clearly with the client regarding the terms of the engagement. (2) Establishing the facts, determining which facts are relevant, evaluating the reasonableness of any assumptions or representations, relating the applicable law (including potentially applicable judicial doctrines) to the relevant facts, and arriving at a conclusion supported by the law and the facts. (3) Advising the client regarding the import of the conclusions reached, including, for example, whether a taxpayer may avoid accuracy-related penalties under the Internal Revenue Code if a taxpayer acts in reliance on the advice. (4) Acting fairly and with integrity in practice before the Internal Revenue Service. b. Under §10.37, practitioners must: (1) base the written advice on reasonable factual and legal assumptions (including assumptions as to future events); (2) reasonably consider all relevant facts and circumstances that the practitioner knows or reasonably should know; (3) use reasonable efforts to identify and ascertain the facts relevant to written advice on each Federal tax matter; (4) not rely upon representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) of the taxpayer or any other person if reliance on them would be unreasonable; (5) relate applicable law and authorities to facts; and (6) not, in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit

64. [LO 2.2] Locate SSTS

Solution: Since the issuance of the original SSTSs, members asked for clarification on certain matters, such as the duplication of the language in SSTS No. 6 and No. 7 Also, changes in federal and state tax laws raised concerns regarding the need to revise SSTS No. 1. As a result, the original SSTS Nos. 1-8 were updated, No. 6 and No. 7 were combined, and the original No. 8 was renumbered as SSTS No. 7.

Chapter 1: An Introduction to Taxation 33

65. [LO 2.4] Locate Definitions of Terms in Internal Revenue Bulletins Solution: Amplified describes a situation where no change is being made in a prior published position, but the prior position is being extended to apply to a variation of the fact situation set forth therein. Thus, if an earlier ruling held that a principle applied to A, and the new ruling holds that the same principle also applies to B, the earlier ruling is amplified. Modified is used where the substance of a previously published position is being changed. Thus, if a prior ruling held that a principle applied to A but not to B, and the new ruling holds that it applies to both A and B, the prior ruling is modified because it corrects a published position. Clarified is used in those instances where the language in a prior ruling is being made clear because the language has caused, or may cause, some confusion. It is not used where a position in a prior ruling is being changed. Distinguished describes a situation where a ruling mentions a previously published ruling and points out an essential difference between them. 66. [LO 2.4] Locate Tax Court Filing Fees Solution: The petition filing fee is $60.00. Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question. 67. [LO 2.4] Medical Expense Deduction Solution: Can Barry deduct any portion of the cost of the hot tub or its operating expenses as a medical expense deduction? 68. [LO 2.4] Penalties Solution: Will Simon be assessed late filing penalties? What are his remedies if any penalties are assessed? 69. [LO 2.4] Statute of Limitations Solution: Will Jennifer be required to pay the $500 deficiency? Does the statute of limitations apply when no tax return is filed? 70. [LO 2.4] Statute of Limitations Solution: Does the statute of limitations prohibit the assessment of the additional tax? 71. [LO 2.4] Evaluating Authority Solution: Does the case or revenue rulings have more authority for the client? Can Georgia recommend the tax plan to her client without possible adverse consequences? Does the plan meet the requirement of having substantial authority upholding a realistic possibility of success? 72. [LO 2.4] Realistic Possibility of Success Solution: Does a 25 percent chance constitute a realistic possibility that the tax transaction will be sustained on its merits?

34

73. [LO 2.4] Use of Estimates Solution: Can Verne use estimates supplied by the client? Does the use of cents as well as dollars imply greater accuracy than implied by the estimates? 74. [LO 2.4] Error on Prior Year Return Solution: What course of action should Jim take as a result of discovering the error? Is Jim required to notify the IRS of the error? Can Jim continue to prepare the current year’s return if the client does not want to correct the error? 75. [LO 2.4] Deduction Disallowed in Prior Year Solution: Can the tax preparer take the deduction on the current year’s return even though it was disallowed on a prior year’s return? Develop Research Skills Solutions to research problems 76 – 81 are in Instructor’s Manual.

Solutions to Chapter 3 Problem Assignments Check Your Understanding 1. [LO 3.1] Realization Principle Solution: Income is not recognized (included in gross income) until the taxpayer has realization. Realization usually takes place when an arm’s-length transaction occurs, such as the sale of goods or the rendering of services. Fluctuations in value are not income unless that change is realized through some transaction. 2. [LO 3.1] GAAP vs. Tax Solution: (1) The goals of financial accounting and tax reporting are very different. The purpose of financial accounting is to provide information decision makers, such as shareholders and creditors, find useful, while the goal of tax accounting is to collect revenue equitably. (2) Financial accounting often relies on the principle of conservatism, which tends to understate income when uncertainty exists. In contrast, the income tax system would be greatly hampered in its collection of revenue if taxpayers were allowed the freedom of reporting income conservatively. (3) Financial accounting often relies on estimates and probabilities. The tax system would not function very efficiently or equitably if taxpayers were allowed to estimate income or base their reported income on probabilities. 3. [LO 3.1] Book/Tax Differences Solution: The two major categories are temporary (or timing) differences and permanent differences. For temporary differences, income is taxed in a different period than it is accrued for accounting purposes. Income that is not taxed but is included in financial accounting income would be a permanent difference.

Chapter 1: An Introduction to Taxation 35

4. [LO 3.1] Tax-favored Investments Solution: Tax law favors investments that yield appreciation rather than annual income. The tax on appreciation (gain) is deferred until gain is recognized and then it is frequently taxed at lower long-term capital gains rates. Congress wants to encourage taxpayers to invest for the long-term as it helps the economy. 5. [LO 3.2] Choice of Tax Year Solution: The sole proprietorship’s operating results will all be reported on Michelle’s tax return. As a result, it will have to be on a calendar-year basis unless Michelle applies for and receives permission to change her tax-year end to October 31. 6. [LO 3.2] Accounting Methods Solution: Jabba must recognize the fair market value of the computer (assumed to be approximately $2,000) as income in payment of the bill. Cash-basis taxpayers must recognize income when cash or cash equivalents are received as payment. The computer constitutes a cash equivalent. 7. [LO 3.2] Accounting Methods Solution: Murphy should recognize the income in year 1. The check was readily available several days before the end of the year and, as a cash-basis taxpayer, Murphy cannot turn its back on the income by failing to pick up the check. 8. [LO 3.2] Accounting Methods Solution: There are several restrictions on the use of the cash method. If inventory is a material factor in the determination of income, an otherwise cash-basis taxpayer must use the accrual method for determining sales and purchases. They may use the cash method for all other income and expense items, however. Businesses with average annual gross receipts of no more than $10 million may use a variation of the cash method under which they account for the cost of merchandise inventory as an asset, but account for their sales on the cash basis. Finally, a C corporation with average annual gross receipts of more than $5 million (except personal service corporations) is prohibited from using the cash method. 9. [LO 3.2] Tax vs. Financial Accounting Solution: The government is concerned with collecting its tax revenue when the taxpayer has the ―wherewithal‖ to pay the tax. Thus, the government usually does not permit an accrual taxpayer to postpone the recognition of income not yet earned but for which the taxpayer has received payment. GAAP, however, requires the use of accrual accounting even for prepaid items to properly match income to the periods over which it is earned. This helps to maintain the comparability of financial statements over time that would otherwise be distorted if prepaid items were recognized as income when payment was received. 10. [LO 3.2] Long-Term Construction Contracts Solution: A long-term contract is a contract for the manufacture, building, installation or construction of property that will not be completed in the year the contract is entered

36

into. There are two permissible tax treatments: the completed contract method and the percentage-of-completion method. The first allows the contractor to postpone the recognition of income and expenses related to the contract until the year the contract is completed. The percentage-of-completion method allows the taxpayer to recognize income based on the ratio of actual expenses incurred to date to total anticipated expenses for the contract as a whole. The latter method spreads income recognition across the period of time over which the income is earned. 11. [LO 3.3] Assignment of Income Solution: Ryan’s gross income is $120,000. He earned the income and he is responsible for including it in his taxable income. He will be treated as making a gift of the $20,000 to his grandmother. 12. [LO 3.3] Community Property Laws Solution: For tax purposes, community income is split evenly between spouses who file separate returns in community property states. In common law states, income is usually taxed to the individual who earns the income. 13. [LO 3.4] Income Tax Effects of Gifts Solution: Tommy will recognize the $100 dividend income because he is the legitimate owner of the stock at the time the dividend is paid. Virginia has no income. 14. [LO 3.4] Tax-Exempt Bonds Solution: The interest exclusion for most state and local bond issues permits state and local governments to finance their governmental activities at much lower interest rates than they would be required to pay if they were competing with corporate bonds. 15. [LO 3.4] Original Issue Discount Solution: Martha must include the $840 of accrued interest in her income. The bonds were issued with original issue discount, so this accrued interest must be included in income even by a cash-basis taxpayer. 16. [LO 3.4] Gross Income/Treasure Find Solution: Jane should include the $100 in her gross income. Treasure finds also constitute gross income. 17. [LO 3.4] Gross Income/Unemployment Compensation Solution: Unemployment compensation is a substitute for the taxable wages a person would receive from his or her employment. A substitute for a form of income that is subject to tax will also be included in gross income and taxed. (The American Reinvestment and Recovery Act allowed the first $2,400 of unemployment compensation received in 2009 to escape taxation, but that provision was never extended beyond the 2009 filing year.) 18. [LO 3.5] Gross Income/Gifts and Inheritances Solution: No. The recipients of gifts and inheritances do not include the items received in

Chapter 1: An Introduction to Taxation 37

their gross income. Instead, the giver (donor or decedent) may be subject to a transfer tax (gift or estate tax). Some people consider this transfer tax a second tax because the donor may have been subject to income tax when he or she earned the amounts that were later given as gifts or inheritances. 19. [LO 3.5] Life Insurance/Buy-Sell Agreement Solution: A buy-sell agreement is an agreement between co-owners of a business that provides for the purchase of one owner’s interest by the other (and the other heir’s obligation to sell) should the owner die. Life insurance on the deceased payable to the surviving owner(s) provides the funds necessary for the purchase of the deceased owner’s interest. 20. [LO 3.6] Taxes for a U.S. Citizen vs. Nonresident Alien Solution: United States citizens are subject to U.S. tax on their worldwide income. Income earned by nonresident aliens is divided into three categories: U.S. business income (called effectively connected income), non-U.S. business income, and U.S. investment income. Nonresident aliens are taxed similar to U.S. citizens on their effectively connected business income. Business income that is not effectively connected with the United States is usually not subject to U.S. tax. U.S. investment income includes interest, dividends, and royalties and is usually taxed at a flat 30 percent rate (or treaty rate if lower). 21. [LO 3.6] Tax Treaty Solution: The objective of a tax treaty with a foreign country is to minimize double taxation of the same income by the United States and the foreign country. 22. [LO 3.6] Foreign Tax Credit Solution: The purpose of the foreign tax credit is to minimize double taxation of the same income by two countries. Under the source principle, a country can claim the right to tax income earned within its boundaries. To minimize the double tax, the resident country then allows its citizens and corporations to offset the domestic tax on their foreign income with a foreign tax credit up to the amount of tax paid to the source country. The net tax paid will usually be the greater of the taxes imposed by the two countries claiming jurisdiction over the income.

Crunch the Numbers 23. [LO 3.2] Short Tax Years Solution: $26,273. Annualized income = $96,000 x 12/8 = $144,000. Corporate tax on $144,000 of income is $39,410 [($50,000 x 15% = $ 7,500) + ($25,000 x 25% = $6,250) + ($25,000 x 34% = $8,500) + ($44,000 x 39% = $17,160)] The tax for 8 months is $39,410 x 8/12 = $26,273. 24. [LO 3.2] Refunds of Prior Income

38

Solution: a. Because the refund exceeds $3,000, Specialty Training has two choices: it can deduct the $5,000 in the current year or it can reduce the current year’s tax by the amount of tax paid in the prior year on the $5,000. b. At 39 percent marginal tax rate in the year of repayment, Specialty would be better off taking a deduction for the amount repaid at that time. It will reduce its taxes by $250 [(39% - 34%) x $5,000] more than taking the deduction for prior year’s taxes paid. c. With a marginal tax rate of 25 percent, Specialty should reduce the current year’s tax for the $1,700 ($5,000 x 34%) of taxes paid in the prior year. It will be $450 [(34% - 25%) x $5,000] better off. 25. [LO 3.2] Prepaid Rental Revenue Solution: a. For tax purposes Realty will recognize $6,000 ($3,000 x 2 months’ rent) income in year 1 because prepaid income is taxed when received for both cash and accrual basis taxpayers. For financial accounting no income will be recognized in year 1. b. For tax purposes, Realty will recognize $8,500 ($3,000 March rent + $3,000 April rent + $2,500 kept from deposit) income in year 2. For financial accounting, Realty will recognize all $14,500 as income in year 2. (Note that a deduction would be allowed for the costs to repair the damages.) 26. [LO 3.2] Prepaid Service Revenue Solution: a. $1,000 (1/24 of $24,000) for both tax and financial accounting. b. $23,000 for tax accounting and $12,000 for financial accounting. Deferral for tax is not permitted beyond the year following the prepayment. c. $0 for tax accounting and $11,000 ($24,000 - $1,000 - $12,000) for financial accounting. 27. [LO 3.2] Long-Term Construction Contract Solution: (1) Under the completed contract method, Highrise will recognize all $250,000 of gross income and $226,000 of costs in year 2. It will recognize no income or expenses in year 1. (2) Under the percentage-of-completion method, Highrise will recognize $137,500 of gross income ($121,000/$220,000 x $250,000) and $121,000 of expenses in year 1 for net taxable income of $16,500. In year 2, it will recognize the balance of the revenue of $112,500 ($250,000 - $137,500) and expenses of $105,000 for net taxable income of $7,500. 28. [LO 3.3] Shifting Income to Children Solution: a. Alana has $10,970 gross income and Mac has none. Mac includes nothing in his gross income because he gave the stock to Alana and is no longer the owner. Alana is taxed on the dividend income ($170) because she was the owner when the dividend was declared and paid. Alana also includes the $10,800 [600 x ($38 $20)] gain on the sale of the stock in her gross income. She will use Mac’s purchase price (carryover basis) of the stock to determine her gain on the sale. b. $1,969.50. Because the gain on the sale of the stock is short-term capital gain, it

Chapter 1: An Introduction to Taxation 39

will be taxed at ordinary income rates. Mac’s 33% marginal tax rate would apply to the short-term capital gain and his rate for dividend income would be 15%. Alana’s 15% marginal tax rate applies to the short-term capital gain and her rate for dividend income is zero. The difference in the tax rates on the STCG between Mac and Alana is 18% (33% - 15%) resulting in a $1,944 ($10,800 x 18%) tax savings. The difference in the tax rates on the dividend income is 15% (15% for Mac – zero for Alana) resulting in a $25.50 ($170 x 15%) tax savings. By having the $10,970 total income taxed to Alana rather than Mac, the family has a total tax savings of $1,969.50 ($1,944 + $25.50). Note that this solution specifies that Alana is age 24. As discussed in Chapter 12, the kiddie tax provision can cause some unearned income of children under age 24 to be taxed at their parent’s marginal tax rate. 29. [LO 3.4] Municipal Bonds Solution: Carl recognizes gain of $3,000 ($43,000 - $40,000) on the sale of the stock. The interest is nontaxable because these are tax-exempt municipal bonds. 30. [LO 3.4] Taxable vs. Nontaxable Bonds Solution: a. Jessica’s after-tax cash flow from the municipal bonds is $550 (5.5% x $10,000) because this interest income is tax exempt. For the corporate bonds, Jessica will receive $700 ($10,000 x 7%) in interest income but will pay $105 ($700 x 15%) in tax on that income resulting in an after-tax cash flow of $595 ($700 - $105). b. Jessica will now pay $196 ($700 x 28%) in tax on the corporate bond interest income resulting in after-tax cash flow of only $504 ($700 - $196) while her aftertax cash flow from the municipal bonds is still $550. 31. [LO 3.4] Gift Loan Solution: a. There are no tax consequences to Joshua or Seth because the loan is not in excess of $100,000 and the proceeds are used for personal expenses (rather than investment); the transaction is not subject to the imputed interest rules. b. The imputed interest rules treat the transaction as if Seth paid $4,000 in interest ($100,000 x 4%) to Joshua each year with Joshua recognizing $4,000 of interest income; Joshua would then be assumed to make a gift of $4,000 annually to Seth. Thus, Joshua must recognize $4,000 in interest income (from the interest imputed at the federal rate) annually and Seth recognizes $8,000 of interest income (from his investment in corporate bonds). If Seth’s net investment income is less than $4,000, the imputed interest will be limited to the lower net investment income. 32. [LO 3.4] Employee/Shareholder Loans Solution: Lynn is assumed to pay Sheldon Corporation $3,200 in interest (4% x $80,000) on the loan. Sheldon has $3,200 in interest income. If Lynn is an employee, Sheldon is assumed to then return the $3,200 to Lynn as taxable compensation, deductible by the corporation. If Lynn is a shareholder, the return of the $3,200 is assumed to be taxable dividend income to Lynn but nondeductible by the corporation. 33. [LO 3.4] Gross Income from Investments

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Solution: $11,800. George must include in gross income all except the $1,000 distributed by ABC as a nontaxable distribution. Thus, his gross income must include the $4,000 taxable distribution from ABC and both the $6,500 dividend and the $1,300 capital gain distribution from Brightstar for a total of $11,800. 34. [LO 3.4] Stock Dividend Solution: Cheryl recognizes no income from the receipt of the stock dividend. She will spread the basis of the original 100 shares over the new total of 300 shares. Each of the 300 shares will now have a basis of $3.33 [(100 x $10)/300]. 35. [LO 3.4] Annuities Solution: a. $3,000. If Charles lives for 15 years, he will receive a total of $165,000 (15 x $11,000). $120,000 of this represents a return of his investment; the remaining $45,000 represents income earned on this investment and is taxable. Of each $11,000 payment, $3,000 [($45,000/$165,000) x $11,000] must be included in income. The remaining $8,000 is a tax-free return of his investment. b. If Charles dies after receiving only $77,000 (7 years at $11,000 per year), he will have recovered only $56,000 (7 x $8,000) of his total $120,000 investment. The remaining $64,000 ($120,000 - $56,000) can be deducted on his final tax return. 36. [LO 3.4] Annuities Solution: $13,750. All of the contributions to Barney’s retirement plan except for the $20,000 from after-tax employee contributions will be taxable when received along with the excess received over the total investment. Thus, of the $240,000 in expected payments, $220,000 is taxable. Of each $15,000 payment, $13,750 [$15,000 x ($220,000/$240,000)] must be included in Barney’s gross income. 37. [LO 3.4] Income from Lottery Winnings Solution: Julie must include all $500,000 of each payment received in years 1 through 4 in income when received. When she sells her rights to the remaining 26 payments for $8,900,000, the $8,900,000 must be included in income when received. 38. [LO 3.4] Social Security Benefits Solution: $31,600. Vera’s modified adjusted gross income is $64,000 [$18,000 + $38,000 + ($16,000 x 50%)]. Because her MAGI exceeds $34,000, she will have to include up to 85 percent of her Social Security benefits in her income determined as the lesser of (1) $13,600 (85% x $16,000) or $30,000 [85% ($64,000 - $34,000) + $4,500] . The inclusion of the tax-exempt interest in MAGI is sufficient to put her in the position of having to include $13,600 of her Social Security benefits in income. Thus, her gross income is $31,600 ($18,000 dividend income + $13,600 Social Security benefit). Although the tax-exempt bond interest must be included in determining modified adjusted gross income, it is not included in determining gross income for tax purposes. 39. [LO 3.4] Social Security Benefits Solution: $5,000. Jeff’s modified adjusted gross income does not exceed $25,000 so none of