Solutions to Develop Research Skills Problems Taxation for Decision Makers 2017th Edition by Shirley

Solutions to Develop Research Skills Problems Taxation for Decision Makers 2017th Edition by Shirley Dennis-Escoffier, Karen A. Fortin| Chapter 2 to 12 Chapter 2-12

Chapter 2 The Tax Practice Environment Solutions to Develop Research Skills Note to Instructor: Many of the research problems can be solved using sources that are available on the Internet at no charge. URLs for these free sources are shown in Figure 2.1 of Chapter 2 in the text. The solution for each problem indicates if it can be solved using free Internet sources or if it requires access to Checkpoint® or a similar service.

76. [LO 2.4] Deducting Cosmetic Surgery (can be solved using free Internet sources) Your client, Ms. I.M. Gorgeous, is an aspiring actress. She has managed to earn a living doing television commercials but was unable to get the acting parts she really wanted. She decided to have botox injections in her forehead and collagen enhancements to her lips. After these procedures, her career improved dramatically and she received several movie offers. Ms. Gorgeous is sure that she should be able to deduct the cost of the cosmetic enhancements because she read about another actress having a face-lift in 1988 and deducting the cost on her tax return as a medical expense. Can Ms. Gorgeous deduct the cost of these procedures?

Research Aid: Section 213(d)(9).

Issue: Can Ms. Gorgeous deduction the cost of the botox injections and collagen enhancements as medical expenses?

Conclusion: Ms. Gorgeous will not be allowed to deduct the cost of botox injections and collagen enhancements.

Discussion of Reasoning and Authorities: Code Section 213 allows a deduction for expenses paid for medical care of the taxpayer. Section 213(d)(1)(A) defines medical care as amounts paid ―for the diagnosis, cure, mitigation, treatment, or prevention of disease or for the purpose of affecting any structure or function of the body.‖ Rev. Rul. 76-332, 1976-2 C.B. 81 allowed a deduction for cosmetic surgery for a face-lift under Section 213. However, the Code was subsequently amended by the Revenue Reconciliation Act of 1990.

Under §213(d)(9)(A), no deduction is allowed for cosmetic surgery or other similar procedures, unless the surgery or procedure is necessary to ameliorate a deformity arising from, or directly related to, a congenital abnormality, a personal injury resulting from an accident or trauma, or disfiguring disease. Section 213(d)(9)(B) defines cosmetic surgery as any procedure which is directed at improving personal appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease. Thus, no deduction will be allowed.

77. [LO 2.4] Deducting Bad Debt Loss (can be solved using free Internet sources) Last year your client, Barney Bumluck, worked part-time for Timely Tax Return Preparation Service.

Barney was promised an hourly wage plus a commission. He worked under this arrangement from early February until April 15. His accrued pay amounted to $900 plus $120 of commissions. When he

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went to collect his pay, however, he found only a vacant office with a sign on the door reading ―Nothing is sure but death and taxes.‖ Can Barney take a bad debt deduction for the wages and commission he was unable to collect?

Research Aid: Reg. Section 1.166-1(e) Issue: Can Barney take a bad debt deduction for the wages and commission he was unable to collect? Conclusion: Barney will not be permitted a deduction since the wages and commission were not previously included in his return as income.

Discussion of Reasoning and Authorities: Under Reg. §1.166-1(e), worthless debts arising from unpaid wages, salaries, fees, rents, and similar items of taxable income shall not be allowed as a deduction unless the income has been included in the return of income for the year for which the deduction as bad debt is claimed or for a prior taxable year. Because Barney did not previously include the wages or commission in income, he is not entitled to a deduction for his inability to collect these items.

78. [LO 2.4] Deducting Charitable Contributions (can be solved using Checkpoint® or a similar service) Your clients, Sonny and his wife Honey, believe in worshiping Ta-Ra, the Sun God. To practice their religious beliefs, they take a weeklong trip to Hawaii to worship Ta-Ra. The cost of this pilgrimage (including airfare, hotel, and meals) is $2,800. Sonny wants to know if he can deduct the cost of this trip as a charitable contribution to his religion.

Note to Instructor: No research aid is provided in the textbook for this problem. This allows you to choose whether or not to provide any hints to your students.

Research Aids: Kessler, 87 T.C. 1285 (1986) Issue: Can Sonny and Honey deduct their trip to Hawaii as a charitable contribution made in the practice of their religion?

Conclusion: No deduction will be allowed because no donation was made directly to a qualified charitable organization.

Discussion of Reasoning and Authorities: In Kessler, 87 T.C. 1285 (1986), the Tax Court disallowed a charitable deduction for the expenses incurred for a trip to Puerto Rico. The Court denied the deduction because there was no donation made to a religious organization as defined

by Code §170(c)(2)(B). The Court based its decision on precedent and Congressional intent stating that the purpose of the charitable contribution can only be furthered if the government can be assured that the funds are appropriately expended. This can be done only if contributions are made to a qualified organization that can be audited and examined. Since Sonny and Honey‘s expenses were not contributions or gifts to an organized entity, the expenses do not qualify under §170 as a charitable contribution.

79. [LO 2.4] Trade or Business versus Hobby (can be solved using Checkpoint® or a similar service) Fred Fisher is a licensed scuba diver who lives in Key Largo. He is employed full-time as an engineer. Five years ago he had been employed as a professional diver for a salvage company. While working for the salvage company he became interested in marine archaeology and treasure hunting.

Until last year he gave diving lessons on weekends and trained individuals in the sport of treasure hunting under the name of ―Fred‘s Diving School.‖ Three of the diving students he taught subsequently found shipwrecks. Fred generally did not engage in recreational diving.

Last year, Fred began a treasure hunting business named ―Treasure Seekers Company.‖ He bought a boat specifically designed for treasure hunting and did extensive research on potential locations of shipwrecks. Fred located several shipwrecks, but none were of substantial value. He did retrieve several artifacts but has not sold any yet. Although these artifacts may have some historical significance, they have a limited marketability. Thus, Fred has not yet had any gross income from his treasure hunting activities.

Other than retaining check stubs and receipts for his expenses and an encoded log, Fred did not maintain formal records for Treasure Seekers Company. Fred maintains as few written records as

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possible because he fears for his safety. He took steps to keep his boat and equipment from public view and took precautionary measures to maintain the secrecy of his search areas. Fred incurred $5,000 of expenses relating to his treasure-hunting activities last year. Can Fred deduct the expenses of his treasure hunting business or will the IRS claim it is a hobby and disallow the expenses?

Note to Instructor: No research aid is provided in the textbook for this problem. This allows you to choose whether or not to provide any hints to your students.

Research Aids: Randy R. Reed, III, T.C. Memo 1988-470, 56 TCM. 363, PH T.C. Memo ¶88470 and Reg. §1.183-2(b)(1)-(9) Issue: Can Fred deduct the expenses of his treasure hunting as business expenses?

Conclusion: Yes, Fred should be able to deduct his expenses as trade or business expenses.

Discussion of Reasoning and Authorities: Section 162 allows a deduction for business expenses that are ordinary, necessary, and reasonable in amount. Reg. §1.183-2(b)(1)-(9) lists a number of factors that should be considered in determining whether an activity is a trade or business, or should be classified as a hobby. These include: (1) Manner in which the taxpayer carries on the activity.

(2) The expertise of the taxpayer or his advisors.

(3) The time and effort expended by the taxpayer in carrying on the activity.

(4) Expectation that assets used in the activity may appreciate in value.

(5) The success of the taxpayer in carrying on other similar or dissimilar activities.

(6) The taxpayer‘s history of income or losses with respect to the activity.

(7) The amount of occasional profits, if any, which are earned.

(8) The financial status of the taxpayer.

(9) Elements of personal pleasure or recreation.

The Tax Court‘s decision in Randy Reed III, T.C. Memo 1988-470, 56 CCH T.C.M. 363, PH T.C. Memo ¶88,470 (1988) examines a situation very similar to that of Fred Fisher. In this case, a treasure hunter was an experienced diver and had personally trained other divers in the field of treasure hunting. His diving did not appear motivated by recreational intentions. He kept a checkbook separate from his personal account, maintained receipts and check stubs for his expenditures and kept a partial log book of his activities until his maps were stolen. Reed said that he kept limited records for security reasons. While not extensive, these records were held to be adequate for a sole practitioner in this type of business with a low volume of transactions, and Reed was allowed to deduct his expenses as those of a trade or business. In that the facts pertaining to Fisher‘s situation are nearly identical to Reed‘s, Fisher should be able to deduct the expenses of his treasure hunting business as valid business expenses.

80. [LO 2.4] Locate and Read Court Case (can be solved using free Internet sources) Locate and read Greg McIntosh, TC Memo 2001-144, 81 TCM 1772, RIA TC Memo ¶2001-144 (6/19/2001). Answer the following questions. a. What requirements must be met for a taxpayer to recover litigation costs from the IRS? b. Was the taxpayer in this case able to recover his attorney fees from the IRS? Why or why not?

Solution: a. Under Code Section 7430(a), a judgment for litigation costs incurred in connection with a court proceeding may be awarded only if a taxpayer: (1) is the ―prevailing party‖; (2) has exhausted his or her administrative remedies within the IRS; and (3) did not unreasonably protract the court proceeding. To be a prevailing party, the taxpayer must substantially prevail with respect to either the amount in controversy or the most significant issue or set of issues presented and satisfy the applicable net worth requirement. b. The taxpayer was not able to recover his attorney fees from the IRS because he was not found to be the ―prevailing‖ party. In this case, the court found that the IRS‘s positions on the disputed issues were reasonable positions sufficiently supported by the facts and

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circumstances in the taxpayer‘s case and the existing legal precedent. Since the IRS‘s positions were found to have been reasonable, the court could not find the taxpayer to be the ―prevailing‖ party.

This decision was affirmed in 91 AFTR 2d 2003-1275, 2003-1 USTC¶50,334 (CA9, 3/7/2003) 81. [LO 2.4] Locate and Analyze Court Cases (can be solved using free Internet sources) Locate and read the following two cases: J.B.S. Enterprises, Inc., T.C. Memo 1991-254, 61 TCM. 2829, 1991 PH T.C. Memo ¶91,254 Summit Publishing Company, Inc., T.C. Memo 1990-288, 59 TCM. 833, 1990 PH T.C. Memo ¶90,288 List those facts that you feel most influenced the judges to reach different conclusions in these two cases.

Solution: Facts J.B.S. Enterprises Summit Publishing Person who received salary Former spouse of sole Spouse of sole shareholder shareholder Services performed for None Extensive valuable services salary Dividend history Not mentioned Substantial dividends paid The court allowed a deduction for expenses in Summit Publishing for a portion of the payments that the IRS argued were unreasonable compensation. The Court noted how valuable the shareholder‘s spouse‘s services were to the firm and that dividends had been paid to the shareholder. In J.B.S. Enterprises, the sole shareholder seemed to be attempting to disguise support payments made to his former wife as salary expense. However, she performed no services for which compensation would normally be paid.

Chapter 3 Determining Gross Income Solutions to Develop Research Skills Note to Instructor: Beginning with this chapter, no research aids or ―hints‖ are provided in the textbook.

Before the solution to each problem, however, suggested research aids are provided. This allows you to choose whether or not to provide any hints to your students for a particular problem. For problems that can be solved using free Internet sources, you must provide students with the citations in these hints and refer students to Figure 2.1 of Chapter 2 in the text for the URLs to enable them to solve these problems using free Internet sources. Some of the problems require access to Checkpoint® or a similar service.

73. [LO 3.2] Year Gift Card Revenue is Included in Income (can be solved using free Internet sources if citations are provided to students) Gamma Corporation, a calendar-year accrual-basis taxpayer, operates department stores. Alpha Corporation and Beta Corporation are wholly-owned domestic subsidiaries of Gamma Corporation and file a consolidated federal tax return under Gamma Corporation‘s consolidated group. Gamma,

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Alpha, and Beta enter into a gift card service agreement under which Gamma is primarily liable for the value of the gift cards until redemption while Alpha and Beta are obligated to accept the gift cards as payment for goods and services. Gamma issues the gift cards and reimburses Alpha and Beta for the sale price of the goods and services purchased with the gift cards. The group recognizes revenue in its applicable financial statement when the gift cards are redeemed. In year 1, Gamma Corporation makes $2 million in gift card sales. Gamma tracks redemptions of gift cards electronically and determined that $1,800,000 was redeemed in year 1. How much revenue does Gamma Corporation recognize from the gift card sales for tax purposes and in which year(s)?

Hint: Reg. Sec. 451-5 and Rev. Proc. 2004-34, 2004-22 C.B. 991 Issue: How much revenue does Gamma Corporation recognize from the gift card sales for tax purposes and in which year(s)?

Conclusion: Gamma Corporation will recognize $1,800,000 in year 1 and the remaining $200,000 in year 2 (unless it chooses to report the entire $2 million in year 1).

Discussion of Reasoning and Authorities: Code Section 451(a) states that income is normally recognized when received unless the method of accounting allows for the income to be recognized in a different period. Reg. Section 1.451-5 states that payments received for gift cards redeemable for goods can be deferred to the earlier of the year the sale is reported for financial accounting or the second tax year after the year of receipt. Rev. Proc. 2004-34, 2004-20 I.R.B. 991 states that a taxpayer with an applicable financial statement may account for advanced payments from gift cards by either the full inclusion method or the deferral method. Under the full-inclusion method, the advance payment is reported as income in the year of receipt regardless of whether the payment is earned or recognized for financial reporting purposes. Under the deferral method, a taxpayer is allowed to defer recognition of advance payments to the tax year following the year of receipt to the extent the taxpayer establishes that the advance payments are not recognized as revenue in their financial statement. Any portion not included in gross income in the year of receipt must be included in gross income in the next tax year. Rev. Proc. 2011-18, 2011-5 I.R.B. 443 clarifies that the definition of an eligible advance payment includes gift cards that are redeemable by the taxpayer or by other entities that are legally obligation to accept the card from a customer as payment for goods or services. Rev. Proc. 2013-29, 2013-33 I.R.B. 141 further clarified that a taxpayer is not precluded from using the deferral method just because the taxpayer never earns payment from eligible gift card sales.

74. [LO 3.4] Personal Use of Political Campaign Funds (can be solved using Checkpoint® or a similar service) Thomas ran for Congress, raising $2 million for his campaign. Six months after losing the election, auditors discovered that Thomas kept $160,000 of the campaign funds using the money to purchase a vacation home. What are the tax consequences of this use of campaign funds?

Hint: Rev. Rul. 71-449, 1971-2 C.B. 77 (clarified by Rev. Rul. 74-22, 1974-1 C.B. 16) Issue: Does Thomas have income as a result of using the campaign funds to purchase a vacation home?

Conclusion: Yes, Thomas must recognize $160,000 income in the year the campaign funds were used to pay for his vacation home.

Discussion of Reasoning and Authorities: Code Section 61 states that gross income includes income from all sources unless specifically excluded. Rev. Rul. 71-449, 1971-2 C.B.77 concluded that political contributions used for personal purposes by a political candidate are included in gross income in the year the funds are diverted to personal use. A candidate is not taxed on campaign funds to the extent they are used for expenses of a political campaign or a similar purpose. Therefore, Thomas must recognize $160,000 income in the year the campaign funds were used to pay for his vacation home.

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75. [LO 3.4] Income from Donation of Blood (can be solved using Checkpoint® or a similar service) Samantha has been unemployed for some time and is very short of money. She learned that the local blood bank has a severe shortage of her type of blood and, therefore, is willing to pay $120 for each blood donation. Samantha gives blood twice a week for 12 weeks, receiving $120 for each donation.

Are these funds includable in Samantha's gross income?

Hint: Green v. Comm. 74 T.C. 1229 (1980) Issue: Does Samantha have income as a result of the funds she received for donating her blood?

Conclusion: Yes, Samantha must recognize as income the payments she received for selling her blood.

Discussion of Reasoning and Authorities: Code Section 61 states that gross income includes income from all sources unless specifically excluded. In Green v. Comm, 74 T.C. 1229 (1980), the Court concluded that payments received for ―donations‖ of blood plasma were income received in the trade or business of selling the product of blood plasma.

Note to instructor: This case also addresses the deductibility of expenses for transportation to give blood, expenses for special food and drugs, health insurance, and a depletion allowance.

Although some expenses were deductible, the taxpayer was not permitted an allowance for depletion.

76. [LO 3.4] Payment of Life Insurance Premiums as Alimony (can be solved using free Internet sources if citations are provided to students) Alice and Manny agree to divorce. Alice proposes that Manny purchase and assign to her a life insurance policy on his life as part of the divorce agreement. She wants Manny to continue paying the premiums on this policy for the next 10 years. Manny wants to know if the premium payments will be treated as alimony.

Hints: Reg. Section 1.71-1T(b), Q&A 6 and Rev. Rul. 70-218, 1970-1 C.B. 19.

Issue: Will Manny‘s payments of the life insurance premiums qualify as alimony?

Conclusion: Yes, the premium payments will qualify as alimony providing that Alice is the irrevocable beneficiary of the life insurance policy assigned to her.

Discussion of Reasoning and Authorities: Reg. Section 1.71-1T(b), Q&A 6 states that premiums paid by the payor spouse for term or whole life insurance on the payor‘s life under the terms of the divorce or separation instrument will qualify as payments on behalf of the payee spouse to the extent that the payee spouse is the owner of the policy. Rev. Rul.70-218, 1970-1 C.B. determined that when a life insurance policy on the life of the husband is assigned to the wife and she is the irrevocable beneficiary, the premiums are deductible as alimony by the husband and taxable to the wife.

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77. [LO 3.4 & 3.5] Income vs. Gift (can be solved using free Internet sources if citations are provided to students) A minister receives an annual salary of $16,000 in addition to the use of a church parsonage with an annual rental value of $6,000. The minister accepted this minimal salary because he felt that was all the church could afford to pay. He plans to report these amounts on his income tax return but he is uncertain how to treat the cash gifts he receives from the members of his congregation. These gifts are made out of love and admiration for him. During the year the congregation developed a regular procedure for making gifts on special occasions. Approximately two weeks before each special occasion when the minister was not present, the associate pastor announced before the service that those who wished to contribute to the special occasion gifts could do so by placing cash in envelopes and giving them to the associate who would give them to the minister. Only cash was accepted to preserve anonymity. The church did not keep a record of the amounts given nor the contributors, but the minister estimates that these gifts amount to about $10,000 in the current year. How should he treat these gifts?

Hint: Goodwin, Lloyd L., Reverend v. U.S., 76 AFTR 2d 95-6716, 67 F3rd 149, 95-2 USTC ¶50534 (1995, CA8); affirming 74 AFTR 2d 94-6987 (DC IA).

Issue: How should the minister treat the $10,000 in cash gifts?

Conclusion: The minister should include the $10,000 in his gross income as compensation.

Discussion of Reasoning and Authorities: Code Section 61(a) provides that gross income includes all income from whatever source derived unless excluded by a specific provision of the Code. According to Section 61(a)(1), compensation for services, in whatever form received, is includable in gross income. Section 102(a) excludes from gross income the value of property acquired by gift. Whether a payment is a gift under Section 102(a) or gross income under section 61(a) is a factual question.

In Goodwin v. U.S., a minister received gifts from members of his congregation who believed he was a good minister and wanted to reward him. The payments were made on a regular basis, were systematically organized and collected by church personnel, were substantial compared to the minister‘s salary, and were made to retain the minister‘s services. The court held that these factors showed that the intent was to increase the minister‘s compensation. The fact that the payments were anonymous and were not coerced did not change the result. Therefore the socalled gifts were part of the minister‘s taxable compensation.

Chapter 4 Employee Compensation Solutions to Develop Research Skills Note to Instructor: No research aids or ―hints‖ are provided in the textbook for problems in this chapter.

Before the solution to each problem, however, suggested research aids are provided. This allows you to choose whether or not to provide any hints to your students for a particular problem. For problems that can be solved using free Internet sources, you must provide students with the citations in these hints and refer students to Figure 2.1 of Chapter 2 in the text for the URLs to enable them to solve these problems using free Internet sources. Some of the problems require access to Checkpoint® or a similar service.

67. [LO 4.1] Reasonable Compensation and Timing Issues (can be solved using Checkpoint® or a similar service) Martin Martindale, the 40-year-old founder and President of Martindale Corporation (an accrual-basis calendar-year C corporation), owns 60 percent of the stock and receives a salary of $600,000. Four unrelated shareholders own the rest of the stock equally. The corporation has paid dividends regularly to the shareholders and plans to continue to do so in the future. Martin plans to recommend that the

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board of directors authorize the payment of a bonus to himself and two other employees (all cash-basis calendar-year individuals). The first employee is the vice president, who owns 10 percent of the corporation and receives a salary of $400,000. The other employee is the controller, who is not currently a shareholder in the corporation and receives a salary of $200,000. Martin would like the bonus to equal 75 percent of each recipient's current salary. Martin believes that the total compensation is probably a little high when compared to the corporation's competitors but Martindale is much more profitable. Martindale‘s profits have increased by more than 20 percent in the last two years due to the efforts of the individuals who will receive the bonuses, while other businesses in the same industry showed an increase in profits of less than 10 percent. Martin asks you, as the corporation's tax advisor, to recommend what the corporation needs to do so that it gets a deduction for the planned bonuses. Martin would prefer to pay the bonuses next year but have the business deduct them this year. a. Locate and read Mayson Manufacturing Co., 178 F.2d 115, 38 AFTR 1028, 49-2 USTC ¶9467 (CA6, 1949) and Elliotts Inc. 716 F.2d 1241, 52 AFTR 2d 83-5976, 83-2 USTC ¶9610 (CA9, 1985).

Summarize the important points of these cases as it relates to Martindale. b. Prepare a summary of the relevant Code and regulation sections as they apply to Martindale. c. Prepare a one-paragraph summary for Martin on what the corporation needs to do to qualify for a deduction for the planned bonuses. a. In the case of Mayson Manufacturing, the IRS disallowed a portion of the compensation paid to three officers as being unreasonable in amount. The facts state that the Petitioner felt that the company would prosper more if a bonus system was established for Mayson Manufacturing Co. In this case, the board agreed to bonuses based on a percentage of the net profits and a percentage of gross sales. The Tax Court ruled in favor of the IRS. The Tax Court‘s ruling was based in part upon its finding that the compensation, including the basic salary and bonus, paid to Mayson‘s officers did not result from an arm‘s length transaction.

The Appellate Court stated that each case of this kind must be based on the individual company‘s facts and circumstances. Some of the factors to be considered include:  The employee‘s qualifications  The nature, extent and scope of the employee‘s work  The size and complexities of the business  A comparison of salaries paid with the gross and net income of the business  The prevailing general economic conditions  A comparison of salaries with distributions to stockholders  The prevailing rates of compensation for comparable positions  The amount of compensation paid to the employee in previous years  The salary policy of the corporation The Appellate Court found that the basic salary and bonus plan was, in fact, made in good faith. Furthermore, no evidence was introduced by either party in regard to what compensation other companies engaged in the same type of work paid for comparable services during the year in question. Such evidence, if available would have a bearing upon the issue.

The Appellate Court held that the facts in Mayson suggested the amounts paid as compensation were reasonable.

In Elliotts Inc., the Ninth Circuit applied a 5-factor test in determining reasonable compensation under Section 162(a)(1). These factors included: 1. The taxpayer‘s role in the company.

2. An external comparison of the employee‘s salary with those paid by similar companies for similar services.

3. The character and condition of the company (which takes into consideration the size and complexity of the business)

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4. Conflicts of interest (that is, does a relationship exist between the company and its employee that might permit the company to disguise nondeductible corporation distributions as salary or bonuses 5. Internal consistency in the company‘s treatment of payment to employees.

The Ninth Circuit‘s evaluation of the fourth conflict of interest item included the independent investor test. In making this determination, the Court stated that it is relevant whether an inactive, independent investor would be willing to compensate the employee to the extent of the actual compensation paid. The corporation‘s rate of return on equity would be particularly important to an independent investor in assessing the reasonableness of compensation in a small corporation where excessive compensation would noticeably decrease the rate of return.

The Court concluded that an average return on equity of 20% over the two years at issue would clearly satisfy an investor. b. Sec. 162(a)(1) allows a reasonable deduction for salaries or other compensation.

Sec. 267 states that a deduction is not allowed for compensation accrued to a "related party" until the payment is made. This section defines a "related" taxpayer to include a shareholder owning more than 50% of the corporation (Martin).

Reg. Sec. 1.404(a)-1(b) states that in determining what is considered reasonable compensation, personal services actually rendered in prior years as well as the current year and all compensation paid to the employee should be considered.

Reg. Sec. 1.404(b)-1T(b)(1) states that payment made after the fifteenth day of the third calendar month after the employer's taxable year in which the services are rendered will be considered deferred compensation. This means it will not be deductible until the year paid and included in the income of the employee. c. In order to qualify for a deduction for the planned bonuses, the bonus plan must be considered reasonable. The factors to consider as to reasonableness are those listed in the cited cases. The corporation will need to be able to justify the reasoning for salaries that exceed the norm in the industry. Rather than base the bonus plan on a percentage of the employee‘s salaries, it might be better to pay a bonus based on the percentage of income or sales of the company. In addition, Martindale Corporation must pay the bonus to Martin before December 31 if it wants to deduct his bonus in the current year. For the other two employees, the liability for their bonuses must be determined by December 31 and then paid

by March 15th next year if it wants to deduct these bonuses in the current year.

68. [LO 4.2] Income from Personal Use of Corporate Aircraft (can be solved using free Internet sources if citations provided to students) McGuire Corporation is planning to acquire a corporate jet to increase the efficiency and security of its executives who will use the jet for both business trips and personal vacations. McGuire Corporation wants to know how it should determine the amount that is taxed to its employees when they use the corporate jet for personal travel.

Hint: Regulation Section 1.61-21(b) and (g); Revenue Ruling 2017-10 2017-17 IRB 1108.

When corporations allow employees to use corporate aircraft for nonbusiness trips, there are several methods that can be used to value the personal use of employer-provided noncommercial aircraft. If the employee‘s flight is primarily personal, under Reg. Sec. 1.6121(b), the value of the flight is the amount that an individual would have to pay in an arm‘slength transaction to charter the same or a comparable piloted aircraft. The flight‘s charter cost must be allocated among all employees on board, unless one or more of the employees controlled the use of the aircraft. Control is defined as the ability of the employee to determine the route, departure time, and destination of the flights. When one or more employees control

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the use of the aircraft, the value of the flight is allocated among them only, unless a written agreement among all employees on the flight determines otherwise.

There are two other more favorable special valuation methods: (1) the seating capacity method and (2) the Standard Industry Fare Level (SIFL) formula. The seating capacity method, if applicable, will produce the best result from a tax viewpoint, because the employee may have no taxable income at all under that rule. The seating capacity method can be used if 50 percent or more of the regular passenger seating capacity of an aircraft is occupied by persons who are traveling primarily for the employer‘s business. If the 50 percent seat occupancy is met, the value of the flight for any employee who is traveling primarily for nonbusiness purposes is treated as zero. Under this rule, only employees are considered. As a result, independent contractors and directors of the employer are not counted toward the 50 percent of seats occupied for the employer‘s business.

To determine if this valuation rule is available, the 50 percent seating capacity requirement must be met when the individual whose flight is being valued both boards and deplanes the aircraft. The aircraft seating capacity is the maximum number of seats installed on the aircraft at any time prior to the date of the flight (when owned or leased by the employer), even if some seats have been removed for the flight in question. It does not, however, include seats that are not legally usable during takeoff (such as jump seats). If the employer permanently removes seats from the aircraft, the regular seating capacity will be deemed reduced, provided that such seats are not added within the following 24 months.

If the seating capacity method does not apply, then the value of the flight may be calculated using the SIFL formula. This method takes four factors into account: (1) miles flown, (2) aircraft size (weight), (3) passenger status (whether the passenger is a control employee), and (4) a terminal charge.

Control employees are defined in Regulation Section 1.61-21(g)(8) as:  Employees who are officers of the employer (the lesser of 10 employees or 1 percent of all employees),  Employees who are among the top 1 percent most highly compensated employees (up to 50 employees),  Employees who own 5 percent or greater equity, capital, or profits interest in the employer, or  Directors of the employer.

Under this method, a three-step calculation is used to determine the personal-use compensation: 1. On a per-individual basis, the number of miles flow is multiplied by the SIFL cents-per-mile charge in effect for the period during which the flight is taken.

2. This figure is then multiplied by the appropriate aircraft multiple, based on use by a control or noncontrol employee.

3. A terminal charge is added.

The SIFL cents-per-mile amount and the terminal charge are calculated by the Department of Transportation and revised semiannually. Revenue Ruling 2017-10 specifies the amounts to be used for this computation for the first half of 2017.

When a flight is taken for both personal and business reasons, the valuation is dependent on whether the flight was primarily for business purposes or primarily for personal purposes. If the trip is primarily for the employer‘s business, the employee includes in income only the excess of the value of all the flights over the value of the flights that would have been taken if there were no personal flights. If the trip is primarily personal, the full value of all flights is

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includible in the employee‘s income.

Income may also be imputed when a family member accompanies an employee. A family member of a control employee will be deemed a control employee for purposes of the valuation. A family member is any party covered by Section 267(c)(4), including brothers, sisters, spouses, ancestors, and lineal descendants. This also means that if the value of the flight to the employee is zero based on the seating capacity method, the value is also zero for a spouse or child.

This problem can easily be extended to ask about restrictions on the employer‘s deduction.

The American Jobs Creation Act of 2004 amended Section 274(e) partially overturning the holding in Sutherland Lumber (88 AFTR 2d 2001-5026) by limiting the corporate deduction to the amount taxed to certain individuals (such as officers, directors, and greater-than-10percent owners) as compensation for their personal flights. IRS provides detailed guidance on this in Regulation Section 1.274-10.

69. [LO 4.4] Premature Withdrawal from IRA (can be solved using free Internet sources if ciations are provided to students) Robert, age 35, has accumulated $36,000 in his traditional IRA. He recently married and would like to withdraw $25,000 from his IRA for a down payment on their first house. Write a letter to Robert stating the tax implications of his proposed withdrawal.

Hint: Section 72(t)(2)(F) Dear Robert: In our last meeting, we discussed your desire to withdraw $25,000 from your IRA account to purchase your first home. Under Internal Revenue Code Section 72(t)(2)(F), individuals under 59½ can avoid the 10 percent early withdrawal penalty if the withdrawal is for a first home purchase. However, the regular income tax on the distribution will still apply.

Section 72(t)(8) provides a lifetime limit of $10,000 on the amount of withdrawals that can be taken out without a penalty under the first-time homebuyer provision. If you withdraw $25,000 from your IRA, you will be subject to the 10 percent early withdrawal penalty on the excess $15,000. The penalty amount would be $1,500 ($15,000 x 10%). In addition, you will be required to pay income tax on the entire $25,000 withdrawal.

You have an alternative method to reduce the withdrawal penalty if your wife has sufficient funds in her IRA. If she does, she may also be able to withdraw up to $10,000 without incurring the 10 percent penalty. This alternative would reduce your penalty to $500, which is based on an excess $5,000 withdrawal.

If you have any questions or would like to discuss this matter further, please do not hesitate to call. I look forward to hearing from you.

70. [LO 4.4] Premature Withdrawal from IRA (can be solved using free Internet sources if citations are provided to students) Jennifer, age 40, has accumulated $40,000 in her traditional IRA. She would like to withdraw $22,000 from her IRA to pay for her daughter's college expenses. She plans to use $15,000 for tuition and $7,000 for room and board. Write a letter to Jennifer stating the tax implications of her proposed withdrawal.

Hint: Section 72(t)(2)(E) Dear Jennifer: In our last meeting, we discussed your desire to withdraw $22,000 from your IRA account to pay for your daughter‘s college expenses. Under Internal Revenue Code Section 72(t)(2)(E), individuals under 59½ can avoid the 10 percent early withdrawal penalty if the

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withdrawal does not exceed the qualified higher education expenses. These expenses must be incurred by yourself, your spouse or your child to be eligible for exclusion from the early withdrawal penalty. However, the regular income tax on the distribution will still apply.

Section 529(e)(3) of the Internal Revenue Code defines qualified higher education expenses to include tuition, fees, books, supplies and equipment. The amount treated as qualified higher education expenses for room and board is limited to the allowance included in the cost of attendance as determined by the eligible educational institution that your daughter attends. If the $7,000 exceeds the allowance amount, the actual invoice amount for room and board will be used providing the housing is owned or operated by the eligible educational institution. Thus, the $22,000 should be fully excludable from the early withdrawal penalty.

However, the full distribution amount will be taxed at your ordinary income tax rate.

If you have any questions or would like to discuss this matter further, please do not hesitate to call. I look forward to hearing from you.

Chapter 5 Deductions for Individuals and Tax Determination Solutions to Develop Research Skills Note to Instructor: No research aids or ―hints‖ are provided in the textbook for problems in this chapter.

Before the solution to each problem, however, suggested research aids are provided. This allows you to choose whether or not to provide any hints to your students for a particular problem. For problems that can be solved using free Internet sources, you must provide students with the citations in these hints and refer students to Figure 2.1 of Chapter 2 in the text for the URLs to enable them to solve these problems using free Internet sources. Some of the problems require access to Checkpoint® or a similar service.

96. [LO 5.4] Medical Expense Deduction (can be solved using free Internet sources if citations are provided to students) Don has a very painful terminal disease and has learned that marijuana may mitigate his pain. Don lives in a state in which it is legal to use the drug if its use is under the direction of a medical doctor.

Can Don deduct the cost of the marijuana as a medical expense?

Hint: Rev. Rul. 97-9, 1997-1 CB 77 Issue: Is Don permitted to deduct the cost of medically prescribed marijuana as a medical expense?

Conclusion: No, Don is not permitted to deduct the cost of marijuana as a medical expense.

Discussion of Reasoning and Authorities: Certain medical expenses, including prescription drugs, are deductible under Section 213. Section 213(a)(3) defines the term "prescribed drug" as a drug, which requires a prescription of a physician for its use by an individual. Reg. 1.2131(e)(2) provides that the deduction applies only to medicines and drugs that are legally procured.

Rev. Rul. 97-9, 1997-1 CB 77 states that even though a controlled substance may be purchased for medical purposes under state law, if it is in violation of federal law, it is not considered to be ―legally procured‖. Even if Don is legally prescribed marijuana by his doctor under state law, it will not be deductible as a medical expense.

97. [LO 5.4] Medical Expense Deduction (can be solved using Checkpoint® or a similar service) Charlene provides 100 percent of the support for her elderly handicapped mother, Amanda. Amanda

Solutions to Develop Research Skills Problems 13

insists on living alone in her own apartment even though she has a severe hearing impairment.

Amanda has always liked cats, so Charlene purchased a cat that is registered as a hearing assistance animal with the county animal control division. The cat is trained to respond to unusual sounds in an instantaneous and directional manner, alerting Amanda to possible dangers. Charlene paid $800 for the cat and an additional $1,000 for special training. The maintenance costs for the cat are $15 a week. Charlene would like to know if any of these costs qualify as deductible expenses.

Hint: Rev. Rul. 55-261, 1955-1 CB 307, Rev. Rul. 68-295, 1968-1 CB 92, and PLR 8033038.

Issue: What type of deduction, if any, does Charlene have for the costs of acquisition, training, and maintenance of the hearing assistance cat provided to her dependent mother?

Conclusion: Charlene will be permitted a medical expense deduction for the costs incurred for the acquisition, training, and maintenance of the hearing assistance cat provided to her dependent mother.

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Discussion of Reasoning and Authority: Rev. Rul. 55-261, 1955-1 CB 307 provides that an amount paid primarily for the purpose of affecting some structure or function of the body is allowable as a medical expense deduction. Such expenses include a ―seeing-eye‖ dog and its maintenance. Rev. Rul. 68-295, 1968-1 CB 92 states that amounts paid to acquire, train, and maintain a dog to assist a dependent who is deaf are deductible as medical expenses as provided under Section 213. Furthermore, Private Letter Ruling 8033038 specifically allows a deduction for amounts paid for the acquisition, training and maintenance of a cat whose purpose is to assist a taxpayer that has a severe hearing loss. As such, the costs incurred by Charlene for the acquisition, training, and maintenance of the hearing assistance cat will be deductible as medical expenses.

98. [LO 5.6] Dependent Care Credit (can be solved using Checkpoint® or a similar service) Howard is a single parent with an 11-year-old dependent son. The son currently attends sixth grade at public school. Howard accepts a temporary foreign assignment from his employer, which is expected to last from August through December. Because of the unstable political environment in the foreign country, Howard is uncomfortable taking his son with him. Therefore, Howard decides to send his son to a boarding school for the fall term at a cost of $5,000 ($3,000 for tuition and $2,000 for room and board). Will the $5,000 qualify for the dependent care credit?

Hint: Brown v. Comm. 73 TC 156 (1979) and Reg. Sec. 1.21-1(d)(12).

Issue: Will any of the costs associated with the boarding school for Howard‘s son qualify for the dependent care credit?

Conclusion: Only the $2,000 portion of expenses related to room, board, and care will qualify for the dependent care credit.

Discussion of Reasoning and Authorities: In Brown v. Comm. 73 TC 156 (1979), the taxpayer felt that she was prevented from working while her son attended public school. Her concern was that she had to be readily available to pick him up if problems arose at school. Section 1.214A1(c)(1)(i) states that expenses are considered to be employment-related expenses only if they are incurred to enable the taxpayer to be gainfully employed and are paid for the care of one or more qualifying individuals. Example 2 in the regulation provides a scenario wherein the taxpayer has a dependent child who has been attending public school. The taxpayer who has been working part time is offered a position involving full-time employment which can only be accepted if the child is placed in a boarding school. The taxpayer accepts the position, and the child is sent to boarding school. The expenses paid to the school must be allocated between that part of the expenses which represents care for the child and that part which represents tuition for education.

The part of the expense representing care of the child is considered to be incurred for the purpose of permitting the taxpayer to be gainfully employed. Following these guidelines, the court held that the taxpayer would be permitted a deduction for the portion of the expenses attributable to room, board and supervision. However, there were two dissenting opinions. Subsequent to 1975, Section 214 was repealed and replaced by a tax credit for dependent care expenses. In that Howard can only accept the foreign assignment if his son is placed in boarding school, his situation should meet the requirement of ―permitting the taxpayer to be gainfully employed.‖ Thus, the $2,000 portion that is for room, board, and care should qualify for the dependent care credit. The $3,000 tuition does not qualify for the credit.

99. [LO 5.6] Dependent Care Credit (can be solved using free Internet sources if citations are provided to students) Sarah pays $800 per month for her five-year-old daughter to attend a private kindergarten from 8:30 A.M. until 2:30 P.M. and after-school care until 5:30 P.M. The price of the kindergarten without the after-school care is $300 per month. Assuming Sarah pays the $800 each month of the year, how much will qualify for the dependent care credit?

Solutions to Develop Research Skills Problems 15

Hint: Regulation Section 1.21-1(d)(5) Issue: Does the cost of kindergarten and after-school care qualify for the dependent care credit?

Conclusion: The costs incurred for Sarah‘s daughter to attend kindergarten does not qualify but the cost of the after-school care does qualify for the dependent care credit.

Discussion of Reasoning and Authorities: Regulation §1.21-1(d)(5) states that the full amount paid to a nursery school, pre-school, or similar program below the level of kindergarten in which a qualifying child is enrolled is considered as expenses qualifying for the dependent care credit.

Educational expenses incurred for a child in the kindergarten or higher are not considered expenses incurred for the care of a qualifying child but expenses for before- or after-school care can qualify. Because Sarah‘s daughter is in kindergarten, the $300 per month cost of kindergarten does not qualify but the additional $500 per month cost of after-school care will qualify for the credit.

Chapter 6 Business Expenses Solutions to Develop Research Skills Note to Instructor: No research aids or ―hints‖ are provided in the textbook for problems in this chapter.

Before the solution to each problem, however, suggested research aids are provided. This allows you to choose whether or not to provide any hints to your students for a particular problem. For problems that can be solved using free Internet sources, you must provide students with the citations in these hints and refer students to Figure 2.1 of Chapter 2 in the text for the URLs to enable them to solve these problems using free Internet sources. Some of the problems require access to Checkpoint® or a similar service.

67. [LO 6.1 & 6.4] Repaying Creditors of Prior Business (can be solved using Checkpoint® or a similar service) Gary Sanders owns his own real estate business. He has a reputation within the community for honesty and integrity and believes that this is one of the reasons his firm has been so successful. Gary was a 30 percent shareholder in an unsuccessful fast-food restaurant, Escargot-to-Go. Although he personally thought the business had great food and was well run, escargot never appealed to the local community. Early this year the corporation filed for bankruptcy.

Many of the creditors of Escargot-to-Go were also clients of Gary‘s real estate business. After Escargot declared bankruptcy, Gary‘s real estate business began to suffer. Gary felt that the decline in his real estate business was related to the bankruptcy of Escargot, so Gary used income from his real estate business to repay all the creditors of Escargot-to-Go. Within a few months, Gary‘s real estate business began to pick up. Gary has asked you to determine if his real estate business can deduct the expenses of repaying Escargot-to-Go‘s creditors.

Hint: William A. Thompson TC Memo 1983-487, 46 TCM 1109, 1983 PH T.C. Memo ¶83,487 Issue: Can Gary deduct the amount he paid to the bankrupt corporation‘s creditors?

Conclusion: Gary should be permitted to deduct the amount paid to those creditors who are also customers of his real estate business. However, Gary may not deduct the amount paid to the other creditors who are not customers of his real estate business.

Discussion of Reasoning and Authorities: Business expenses are deductible under Section 162 if they are ordinary, necessary and reasonable in amount. The general payment of another‘s debts is not usually considered an ordinary and necessary business expense. The determination of whether a particular payment is ordinary and necessary, however, can be difficult.

16 Taxation for Decision Makers Research Solutions

In the landmark case of Welch v. Helvering, 3, USTC ¶1164, 12 AFTR 1456 (UCCS, 1953), the Supreme Court discussed the meaning of the term ―ordinary and necessary‖. The court stated that while the payments to the corporation‘s creditors were necessary (in that they were appropriate and helpful) for the development of Welch‘s business, they were not ordinary. The court held that no deduction was allowed when the payments were made to build goodwill in the taxpayer‘s new job instead of preserving his existing business reputation. However, expenditures incurred by a taxpayer to protect his business reputation or avoid unfavorable business or commercial publicity have been regarded as deductible. A payment made to merely protect personal reputation is not deductible.

In William A. Thompson 46 TCM 1109, 1983 PH T.C. Memo ¶83,487, the taxpayer was allowed a deduction for the payments made to creditors of a defunct corporation providing these creditors were also clients of his engineering firm. Other payments made by Thompson to creditors whom he felt morally obligated to repay were not deductible.

Based on these cases, Gary should be permitted to deduct the payments he made to the creditors who were also clients of his real estate business. These payments were made to preserve his current professional reputation and to maintain the business relationship with the clients of his real estate business. However, payments made to the creditors who were not also current real estate clients will probably not be deductible.

68. [LO 6.4] Travel Away from Home (can be solved using free Internet sources if citations are provided to students) Ben is the chief executive officer of a restaurant chain based in Maine. Ben began the business 15 years ago and it has grown into a multimillion-dollar company, franchising restaurants all over the country. Ben has a new interest, however, in horse breeding. He previously raised horses with some success over the years but has only recently decided to pursue this new business with the same intensity which with he originally pursued the restaurant business. Ben likes South Florida and sets up his new horse breeding business there. He purchased a fully operational breeding farm and leased a nearby condominium for six months so he can oversee the business. Ben plans to spend about six months each year in Florida for the next three years overseeing his horse business, which should provide about 30 percent of his total income. Ultimately, Ben wants to sell his interest in his restaurant business and retire to Florida to devote all of his time to his horses. Ben wants to know if he can deduct any of the costs associated with his travel to Florida.

Hints: Andrews, Edward v. Comm., 67 AFTR 2d 91-881, 931 F2d 132, 91-1 USTC ¶50,211; Markey v. Comm., 33 AFTR 2d 74-595, 490 F2d 1249, 74-1 USTC ¶9192; and Revenue Ruling 54-147, 1954-1 C.B. 51.

Issue: What expenses, if any, can Ben deduct relating to his travel between Maine and Florida?

Conclusion: Since Ben will be traveling away from home on business, he can deduct his travel expenses between Maine and Florida, his Florida condominium lease expenses, and the allowable portion of meal costs.

Discussion of Reasoning and Authorities: As a general rule, living expenses are nondeductible personal expenses under Section 262. However, Ben may be able to deduct these costs as travel expenses. Section 162(b) specifically allows the deductions for traveling expenses, including the costs of meals and lodging, while away from home in the pursuit of business. If this rule applies, Ben would be permitted to deduct his travel expenses to and from Florida, his lease payments and the allowable portion of meal costs.

In the Supreme Court case, Commissioner v. Flowers, 326 U.S. 465 (34 AFTER 301) 1946, the Court stated that travel expenses are deductible only if (1) reasonable and necessary; (2) incurred while away from home; and (3) incurred in the pursuit of business.

The case of Andrews, Edward v. Comm., 67 AFTR 2d 91-881, 931 F2d 132, 91-1 USTC ¶50,211

Solutions to Develop Research Skills Problems 17

(CA-1, 1991), vacg. TC Memo 1990-391, PH TCM ¶90,391, 60 CCH TCM 277 provides similar facts to the case at hand. In the lower court case of Andrews, the Tax Court found that Andrews had two tax homes. Its decision was based on an observation that Andrews‘ business in Florida for 6 months was recurrent each year, rather than temporary. However, the Appellate Court found that Andrews had only one tax home and that the duplicate living expenses while on business at the other house were a cost of producing income and therefore, deductible as travel expenses. The Appellate Court left it up to the Tax Court to determine which of the two homes would be considered the tax home.

In this case, Ben meets the travel expense requirements provided in the Flowers case. He has substantial business activity in both locations. Ben would be considered away from his tax home when in Florida or in Maine, depending on where his tax home is located. Consideration should be given to how the tax home is determined.

It may behoove Ben to take steps to ensure that the place yielding the greatest tax benefits is ultimately considered his tax home. For example, if living costs in Florida would be greater than the costs of living in Maine, steps might be taken to ensure that Maine is the tax home so that the taxpayer would be in a travel status while in Florida.

Rev. Rul. 54-147 addressed the situation in which a taxpayer has two or more geographically separated places of business. In this ruling, the IRS indicated that a taxpayer would be away from home while at the location of the minor or secondary business. To determine which business is the principal and which is secondary, the IRS considered the following factors: (1) total time spent working in each area; (2) degree of business activity in each area; and (3) the relative amount of income from each area. The Sixth Circuit also held in Markey v. Comm. (33 AFTR 2d 74-595, 490 F2d 1249, 74-1 USTC ¶9192, rev‘g TC Memo 1972-154) that when a taxpayer has two places of business at a considerable distance from one another, the tax home will generally be the one where the taxpayer: (1) spends more of his time, (2) engages in greater business activity, and (3) derives a greater proportion of his income. Based on the facts provided, it would appear that Maine will be considered Ben‘s tax home since 70% of his income is derived from his business there.

69. [LO 6.4] Deductibility of Skybox Rental (can be solved using free Internet sources if citations are provided to students) Marino Corporation pays $6,500 to rent a 10-seat skybox for three football games to use for business entertainment at each game. The price for a regular nonluxury box seat at each game is $45. How much can Marino Corporation deduct for this entertainment expense?

Hint: Sections 274(l)(2) and 274(n).

Issue: How much can Marino Corporation deduct for the skybox rental?

Conclusion: Marino will only be permitted to deduct $675 as an entertainment expense.

Discussion of Reasoning and Authorities: When a skybox or other private luxury box is leased for more than one event, Section 274(l)(2) limits the amount allowable as a deduction to the sum of the face value of non-luxury box seat tickets for the number of seats in the box. Section 274(n) further reduces this amount by 50 percent to determine the amount that can be deducted as an entertainment expense. Therefore, Marino can deduct $675 as an entertainment expense [($45 FMV of nonluxury seats x 10 seats in the skybox) x 3 games) = $1,350, then reduced by 50% = $675].

70. [LO 6.5] Allocation of Vacation Home Expenses (can be solved using Checkpoint® or a similar service) Suzanne owns a vacation home at the beach in which she lived for 30 days and rented out for 61 days

18 Taxation for Decision Makers Research Solutions

during the current year. Her gross rental income is $2,600. Her total expenses for the vacation home are as follows: Mortgage interest $1,500 Property taxes 900 Utilities 700 Maintenance 300 Depreciation for entire house 1,100 a. Compute Suzanne‘s net rental income using the IRS method for allocating expenses. b. Compute Suzanne‘s net rental income using the Tax Court method (also known as the Bolton method) for allocating expenses. c. Which method results in less taxable income? Explain.

Solutions to Develop Research Skills Problems 19

Hint: Prop. Reg. Section 1.280A-3(c) and Bolton, 77 TC 104, aff‘d 694 F2d 556 (1982). a. Net rental income under the IRS method is zero. Section 280A(e)(1) specifies that the rental allocation of each expense should use a fraction ―which bears the same relationship to such expenses as the number of days during each year that the unit (or portion thereof) is rental at a fair rental bears to the total number of days during such year that the unit (or portion thereof) is used.‖ However, Section 280A(e)(2) specifies that this provision does not apply to ―any deduction that would be allowable under this chapter for the taxable year whether such unit (or portion therefore) was rented‖ and is generally considered to mean deductions such as interest and taxes. Prop. Reg. Section 1.280A-3(c) states that the IRS applies the Section 280A(e)(1) allocation procedures to all expenses that are otherwise allowable. Thus, the IRS interprets this to mean that interest and taxes should be apportioned between rental and personal days based on a ratio of the rental days (as the numerator) to the total number of days the vacation rental home was actually used for rental and personal purposes during the year (as the denominator). Under this method, 61/91 would the fraction used to allocate all categories of expenses to rental use as follows: Type of expense Rental Expenses Itemized Deductions Interest ($1,500 x 61/91) $1,005 Interest – personal portion ($1,500 - $1,005) $495 Taxes ($900 x 61/91) 603 Taxes – personal portion ($900 - $603) 297 Utilities ($700 x 61/91) 469 Maintenance ($300 x 61/91) 201 ____ Subtotal before depreciation $2,278 $792 Depreciation ($1,100 x 61/91 = $737) but limited to remaining income of $322 ($2,600 - $2,278) 322 Net rental income ($2,600 - $2,278 - $322) -0b. Net rental income under the Tax Court method is $792. The Tax Court in Bolton, 77 TC 104 (affirmed by the 9th circuit in 694 F2d 556) stated that Section 280(e)(2) prohibits applying the Section 280(e)(1) limit to the otherwise deductible items of interest and taxes. The Court approved the taxpayer‘s allocation of interest and taxes based on the entire year (365 days) and not just the total number of day the vacation home was actually used during the year. The Court reasoned that the vacation homeowner paid interest and taxes based on 365 days a year and not the actual number of days the property was used. The IRS, however, refused to accept this allocation method. Thus, the Tax Court (or Bolton) method allocates interest and taxes based on the number of days in the year. Expenses other than interest and taxes are allocated in the same manner under both methods. Under the Tax Court method, expenses would be allocated as follows: Type of expense Rental Expenses Itemized Deductions Interest ($1,500 x 61/365) $251 Interest – personal portion ($1,500 - $251) $1,249 Taxes ($900 x 61/365) 150 Taxes – personal portion ($900 - $150) 750 Utilities ($700 x 61/91) 469 Maintenance ($300 x 61/91) 201 ____ Subtotal before depreciation $1,071 $1,999 Depreciation ($1,100 x 61/91) 737 Net rental income ($2,600 - $1,071 - $737) $792

20 Taxation for Decision Makers Research Solutions

c. The Tax Court method usually results in more deductions and less overall taxable income.

Under the Tax Court method, total deductions are $3,807 ($1,808 rental expenses + $1,999 itemized deductions) and gross rental income is $2,600, resulting in $1,207 ($3,807 - $2,600) expenses in excess of income. Under the IRS method, total deductions are $3,392 ($2,600 rental expenses + $792 itemized deductions) and gross rental income is $2,600, resulting in only $792 expenses in excess of income. Under the Tax Court method, $415 ($1,207 - $792) more in expenses are allowed than under the IRS method if the taxpayer has enough other itemized deductions to make itemizing worthwhile and if the itemized deductions are not phased out.

Chapter 7 Property Acquisitions and Cost Recovery Deductions Solutions to Develop Research Skills Note to Instructor: No research aids or ―hints‖ are provided in the textbook for problems in this chapter.

Before the solution to each problem, however, suggested research aids are provided. This allows you to choose whether or not to provide any hints to your students for a particular problem. For problems that can be solved using free Internet sources, you must provide students with the citations in these hints and refer students to Figure 2.1 of Chapter 2 in the text for the URLs to enable them to solve these problems using free Internet sources.

67. [LO 7.1] Basis for Inherited Property (can be solved using free Internet sources if citations are provided to students) Robert owns some investment land that has a basis of $1,000 and a fair market value of $22,000. He expects that it will continue to appreciate in value. Robert‘s uncle, Mike has a terminal illness and is expected to survive no more than six months. Robert would like to increase the basis of the land and has devised a scheme in which he gifts the land to Mike. When Mike dies, Robert will inherit the land. Mike has agreed to participate in the plan; however, Robert wants you to confirm what his basis will be when he inherits the land from Mike.

Hint: Section 1014(e) Issue: Will Robert received a stepped-up basis when he inherits the land from Mike?

Conclusion: No, unless Mike lives longer than one year after receiving the gift, Robert will not be able to receive a stepped-up basis for the land. Robert‘s basis in the inherited land will be $1,000. If Mike lives longer than one year, Robert will inherit the land with a new basis equal to the fair market value at the date of Mike‘s death.

Discussion of Reasoning and Authorities: In general, when someone inherits property, the new basis for such property is the fair market value at the date of death (or alternate valuation date, if elected). However, under Section 1014(e), if the appreciated property was acquired by the decedent by gift during the 1-year period before death and the person (or the spouse) who gave the property to the decedent inherits it, then the recipient‘s basis will not be the fair market value at the date of death. Rather, the recipient‘s basis of the appreciated property will be the decedent‘s adjusted basis in the property immediately before death. Therefore, Mike‘s basis in the investment land would be $1,000 when received as a gift from Robert. Upon Mike‘s death, Robert would inherit the property with a $1,000 basis. If, however, Mike survived for more than one year after receiving the land, then Robert‘s basis in the inherited land would be the fair market value at the date of Mike‘s death (or alternate valuation date, if elected).

Solutions to Develop Research Skills Problems 21

68. [LO 7.1] Depreciating an Antique Musical Instrument (can be solved using free Internet sources if citations are provided to students) Jessica, a professional violinist with the Lincoln Symphony Orchestra, purchased a 100-year-old antique violin at a cost of $180,000. She thinks that it is a good investment because she knows that it will continue to appreciate in value as a treasured work of art. She plays this violin in concerts and wants to know if she can depreciate it as a business-use asset.

Hint: Liddle, Brian v. Comm., 76 AFTR 2d 95-6255, 65 F3d 329, 95-2 USTC ¶50,488 affg. 103 TC 285, nonacq. AOD 1996-1009, 7/15/96.

Issue: Can Jessica depreciate the violin as a business-use asset?

Conclusion: Yes, Jessica should be permitted to claim depreciation for the violin.

Discussion of Reasoning and Authorities: Section 167 provides that a reasonable allowance may be claimed for depreciation if the asset is used it in a trade or business and the taxpayer can establish the cost, the salvage value and the useful life of the property. One of the cases decided while this was the controlling Code section was Browning v. Comm. (65 AFTR 2d 90-385, affg.

TC Memo 1988-293). The Court relied on Section 167 to disallow a depreciation deduction for an antique violin stating that taxpayer could not establish that the salvage value of the violin was less than the original cost because the violin would appreciate in value, so no deduction would be allowed.

However in 1981, Congress adopted the Accelerated Cost Recovery System (ACRS) and codified it in Section 168. This effectively modified the requirements of Section 167 by no longer requiring the taxpayer to establish the useful life (because class lives were established by ACRS) and ignoring salvage value. Thus, the logic behind the ruling in Browning no longer applied. In two subsequent cases, the taxpayers were allowed to claim depreciation deductions.

In Liddle, Brian v. Comm. (76 AFTR 2d 95-6255, 65 F3d 329, 95-2 USTC ¶50,488, affg. 103 TC 285), the Appellate Court had to determine whether a valuable 17th century bass violin could be depreciated when used as a tool of trade by a professional musician even though the instrument actually increased in value while the musician owned it. The critical question was whether or not the violin was ―property of a character subject to the allowance for depreciation‖ under Section 168. The Court ruled that the violin was, in fact, depreciable since it was subject to daily wear and tear as required by Section 168. The Court pointed out that musicians, unlike rare-instrument collectors, did use the instruments in their profession.

In a similar decision, the Second Circuit allowed Richard Simon (76 AFTR 2d 95-6911, 95 USTC ¶50,552, affg 103 TC 247) to depreciate 19th century violin bows used in his profession. In both of these cases, the IRS nonacquiesced (AOD 1996-009, 7/15/96) indicating that the instruments appreciated in value despite use. The IRS said that it would continue to contest the treatment of antique musical instruments without a determinable useful life in circuits other than the Second and Third Circuits. Therefore, the taxpayer should be advised that unless she is in the Second or Third Circuit, she may have to litigate to prevail on her position.

69. [LO 7.6] Amortization of a Covenant-Not-to-Compete (can be solved using free Internet sources if citations are provided to students) Juan owns 40 percent and Mario owns 60 percent of Crispy Donuts, Inc. (CDI). Juan wants to buy out Mario‘s interest in CDI, so he arranges a stock sale agreement under which CDI will redeem (purchase) all of Mario‘s shares for $900,000. This will then make Juan the sole shareholder of CDI. Juan wants to ensure that Mario does not open a competing donut business nearby so he also has a covenant-not-to-compete drawn up at the same time as the stock sale agreement. Under the terms of the covenant-not–to-compete, Mario cannot open another donut business within a 10-mile radius for a period of five years. During this 60-month period, CDI will pay Mario $9,000 per month in return for his agreement not to compete. CDI wants to know over what time period it should amortize the

22 Taxation for Decision Makers Research Solutions

covenant-not-to-compete.

Hint: Section 197.

Issue: Over what time period should CDI amortize the covenant-not-to-compete?

Conclusion: CDI should amortize the covenant-not-to-compete over 15 years.

Discussion of Reasoning and Authorities: As a general rule, Section 197(a) states that a taxpayer shall be entitled to an amortization deduction with respect to any amortizable section 197 intangible. The amount of such deduction shall be determined by amortizing the adjusted basis of such intangible ratably over the 15-year period beginning with the month in which such intangible was acquired. A covenant-not-to-compete is considered a ―section 197 intangible‖ pursuant to Section 197(d)(1)(E). Even though the covenant only covers a five-year time period, it still must be amortized over 15 years. The amount of CDI‘s yearly amortization is $36,000 [($9,000 x 60 months) / 15 years].

Chapter 8 Property Dispositions Solutions to Develop Research Skills Note to Instructor: No research aids or ―hints‖ are provided in the textbook for problems in this chapter.

Before the solution to each problem, however, suggested research aids are provided. This allows you to choose whether or not to provide any hints to your students for a particular problem. For problems that can be solved using free Internet sources, you must provide students with the citations in these hints and refer students to Figure 2.1 in Chapter 2 of the text for the URLs to enable them to solve these problems using free Internet sources. Some of the problems require access to Checkpoint® or a similar service.

70. [LO 8.1] Property Transactions (can be solved using free Internet sources if citations are provided to students) A number of specific transactions do not necessarily follow the general tax provisions applicable to property transactions. Following are a group of transactions that are subject to specific tax provisions.

For each of the situations, you are to answer the questions and cite the source for your answer. a. Martin, a securities dealer, bought 100 shares of Datacard stock on April 5 of year 5 for $10,500.

Before the end of that day he identified the stock as being held for investment purposes.

1. Never having held the stock for sale to customers, he sold the stock on May 22 of year 6 for $11,500. How much and what kind of gain or loss does he have?

2. Assume that later in year 5 he starts trying to sell the stock to customers and succeeds in selling it on May 1 of year 6 for $9,000. How much and what kind of gain or loss does he have? b. Ruth subdivided a piece of real estate she had owned for seven years into 12 lots. Each lot was apportioned a $10,000 basis. In year 2, she sold four lots for $15,000 apiece with selling expenses of $500 per lot.

1. How much and what kind of gain or loss does Ruth have?

2. If, in year 3, she sold two more lots for $20,000 apiece and incurred selling expenses of $500 per lot, how much and what kind of gain or loss does she have? c. For 60 years, Shakia owned 1,000 acres of land in Kentucky on which coal was being mined under a royalty arrangement. Shakia received $164,000 in the current tax year in royalties. The coal‘s adjusted basis for depletion was $37,000. Determine the amount and type of gain Shakia realizes on the income. d. Howard owned a large farm on which he raised a variety of farm animals. Determine the type of

Solutions to Develop Research Skills Problems 23

gain or loss he would realize on the following sales: 1. a six-month-old calf 2. a one-and-one-half-year-old foal 3. six-week-old chickens 4. a 6-year-old bull 5. a 12-year-old mare 6. six-month-old lambs 7. a 2-year-old ram Solution: Hint: The answers are found in the Internal Revenue Code Sections 1236, 1237, 631, and 1231. a. 1. Under 1236(a), a gain by a dealer may be treated as a capital asset providing the security was, before the close of the day on which it was acquired, clearly identified in the dealer‘s records as a security held for investment. In addition, the security may not, at any time after the close of such day, be held by the dealer primarily for sale to customers in the ordinary course of his trade or business. As such, Martin meets the requirements under Section 1236(a) and will be permitted to treat this as a sale of a capital asset rather than a sale of inventory. Thus, Martin‘s $1,000 gain ($12,500 – $11,500) is a long-term capital gain.

2. Under Section 1236(b), if at any time the security was clearly identified in the dealer‘s records as a security held for investment, an ordinary loss cannot be recognized. Therefore, Martin is required to treat the $1,500 loss ($9,000 – $10,500) as a capital loss. Even though it was placed back into inventory, ordinary loss treatment is not permitted. b. 1. Under Section 1237(a), a taxpayer is not considered to be a real estate dealer solely because the taxpayer subdivided the tract of real property for purposes of sale. Furthermore, the real property must be held by the taxpayer for a period of 5 years. Providing that no substantial improvement has been made to the land, Ruth will be entitled to treat the profit from the sale as a long-term capital gain. Her LTCG from the sale of the four lots is $18,000 [4 x ($15,000 $10,000 - $500)].

2. Section 1237(b) states that if more than 5 lots contained in the same tract of real property are sold, the gain from the sale of any lot shall be deemed to be gain from the sale of property held primarily for sale to customers in the ordinary course of business to the extent of 5 percent of the selling price. In year 3, Ruth sold the 6th lot. Pursuant to this section, Ruth may be required to recognize five percent of the selling price for the lots sold this year (and in any future years) as potential ordinary income. Expenses incurred will be used to reduce the ordinary income. From the sale of the two lots sold in year 3, Ruth will have $1,000 of ordinary income and $18,000 of long-term capital gain. This is calculated following the examples provided in Regulation 1.1237(e)(2): Selling Price ($20,000 x 2) $40,000 Basis ($10,000 x 2) (20,000) Excess over basis $20,000 5% of selling price ($40,000 x 5%) Less: Expenses of sale ($500 x 2) Amount of gain realized that is treated as ordinary income Excess over basis Less: 5% of selling price Less: Excess of expenses over 5% of selling price Amount of gain realized that is treated as long-term capital gain

$2,000 (1,000) $1,000 $20,000 (2,000) (0) $18,000

c. Pursuant to Section 631(c), the difference between the amount realized from the disposal of

24 Taxation for Decision Makers Research Solutions

coal and the adjusted depletion basis shall be considered as though it were a gain or loss, providing the property was held more than 1 year and the owner retains an economic interest in the coal. Based on the facts provided, Shakia appears to meet these requirements. Shakia has owned the property for 60 years and retains an economic interest in the coal, even though it is mined through a royalty arrangement by another party. Following the provisions of this section, she has a long-term capital gain of $127,000 ($164,000 – $37,000) on the sale of the coal. d. Pursuant to Section 1231(a)(3), a Section 1231 gain or loss is any recognized gain or loss on the sale or exchange of property used in the trade or business. Under Section 1231(b)(3), certain requirements must be met for livestock to be treated as a Section 1231 asset. Cattle and horses, regardless of age, must be held by the taxpayer for 24 months or more from the date of acquisition. Other livestock, regardless of age, must be held by the taxpayer for 12 months or more from the date of acquisition. Poultry is not included under the definition of livestock for purposes of Section 1231 treatment. If the animals do not meet these requirements, Howard will have ordinary income. Based on the facts provided and assuming that Howard owned the animals since birth, the following is Howard‘s treatment for the sale of each of the listed animals: 1. Ordinary; 2. Ordinary; 3. Ordinary; 4. Section 1231; 5. Section 1231; 6. Ordinary 7. Section 1231.

71. [LO 8.1] Sale of Incomplete Equipment (can be solved using free Internet sources if citations are provided to students) A subsidiary of Corporation A, an electrical utility located in Springfield, and a subsidiary of Corporation B, a diversified manufacturer also located in Springfield, formed a joint venture under the general partnership laws of their state. The partnership was formed to construct and ultimately operate another electrical generating plant. Sufficient excess space was provided at the plant site to accommodate substantial future additions to the initial generating equipment. Three years after construction of the generating equipment had been started and was 50 percent complete, the partnership on the advice of its financial counselors began negotiations with a consortium of businessmen for the possible sale and leaseback of the generating equipment. Thirteen months later, when the plant was complete, the deal was finally made with the consortium for the sale and leaseback of the generating equipment. The sale resulted in a gain of $500,000 that the partnership treated as $250,000 of Section 1231 gain and $250,000 as ordinary income. Was the partnership correct in its determination of the type of gain recognized?

Hint: Rev. Rul. 75-524, 1975-2 CB 342; PLR 9147004.

Issue: What is the proper treatment of the gain recognized from the sale and leaseback of the generating equipment?

Conclusion: The partnership should treat one-half of the gain as Section 1231 gain and the other half as ordinary income.

Discussion of Reasoning and Authorities: From the beginning, the joint venture‘s purpose was to build and operate the generating plant. The joint venture was not formed for the purpose of selling the generating plant. It was only after three years, on the advice of its financial advisors, that the partnership considered the sale and leaseback of the property. These facts are nearly identical to those in PLR 9147004. Under this private letter ruling, the issue regarding the sale/leaseback was whether the plant might be property held by the partnership for sale to customers in the ordinary course of its trade or business. Since the partnership‘s initial intention was not to sell the plant, but rather to construct, own and operate the plant, it was determined that the sale/leaseback met the requirements for Section 1231 treatment.

In Rev. Rul. 75-524, the IRS provided that only the gain on that portion of the property actually completed prior to 6 months before the date of sale is considered as held for more than 6 months for purposes of Section 1231 treatment. The portion that was not completed before the 6 month

Solutions to Develop Research Skills Problems 25

period prior to sale will be treated as ordinary income. The law has since been revised to make the requisite holding period one year. The facts provide that at the time negotiations began, which was 13 months prior to the sale date, the equipment was 50 percent completed. Although the generating equipment was completed by the time of sale, only 50 percent of the construction was complete at least one year prior to the sale. Therefore, the portion of construction that was completed more than one year prior to the sale will be given Section 1231 treatment. As such, 50 percent of the gain would be Section 1231 gain. The remaining 50 percent of the gain would be ordinary income.

72. [LO 8.1] Sale of Property Held for Expansion (can be solved using Checkpoint® or a similar service) Sheralyn was in the wholesale distribution business for pecans and peanuts grown in Georgia. She and her brother owned and operated several warehouses. Seven years ago, they purchased property for another warehouse in the eastern part of Georgia because the nut crop had been getting progressively larger over the past several years. Early last year they had plans drawn up for the warehouse and had gotten several bids from contractors. Unfortunately, Sheralyn‘s brother was killed in an auto accident just days before they were to sign papers to begin the construction. Sheralyn knew that she would not be able to manage their existing warehouses and oversee the construction of this new facility. She abandoned plans to construct the warehouse and put the property up for sale. It was sold early this year at a $125,000 loss. How should Sheralyn treat the loss on the sale?

Hint: Carter-Colton Cigar Company, 9 T.C. 219 Issue: What is the character of the loss realized by Sheralyn‘s business as a result of the sale of the property?

Conclusion: Sheralyn‘s business will be able to recognize a Section 1231 loss on the sale of the property.

Discussion of Reasoning and Authority: In Carter-Colton Cigar Company vs. Comm. (9 T.C. 219), the petitioner purchased unimproved real estate with the intention of erecting a building to be used by the business. Plans and specifications were prepared, but the original purpose was later abandoned after one of the owners died. The property was then sold at a loss. The Court found that since the property was originally intended to be used in the business, but was later sold as a result of unforeseen circumstances, the loss would be treated as ordinary as opposed to capital. Similar to the Carter-Colton case, Sheralyn‘s abandonment of the original plans to develop the property should not cause the property to be treated as a capital asset. Given the intervening death of her brother, there was a reason for Sheralyn to abandon construction and sell the land. Therefore, the loss resulting from the sale is not a capital loss, but rather a Section 1231 loss.

Chapter 9 Tax-Deferred Exchanges Solutions to Develop Research Skills Note to Instructor: No research aids or ―hints‖ are provided in the textbook for problems in this chapter.

Before the solution to each problem, however, suggested research aids are provided. This allows you to choose whether or not to provide any hints to your students for a particular problem. For problems that can be solved using free Internet sources, you must provide students with the citations in these hints and refer students to Figure 2.1 of Chapter 2 in the text for the URLs to enable them to solve these problems using free Internet sources. Some of the problems require access to Checkpoint® or a similar service.

78. [LO 9.2] Exchange of Intangibles (can be solved using free Internet sources if citations are provided

26 Taxation for Decision Makers Research Solutions

to students) Barry is very dedicated to the arts and has made a career of purchasing copyrights to various art forms. Once purchased, he publicizes these works to capitalize on the copyrights and has been very successful. Last year, he acquired a book manuscript that he believes would be better suited to a mainstream publisher. He approaches a publisher about trading the book copyright for the copyright on the words and music for a new musical comedy that he heard the publisher had acquired. Will the exchange qualify as like-kind exchange?

Hint: Regulation Section 1.1031(a)-2(c)(3) Issue: Will the exchange qualify as a like-kind exchange?

Conclusion: No, the exchange will not qualify as like-kind.

Discussion of Reasoning and Authorities: According to Example 2 provided in Regulation §1.1031(a)-2(c)(3), exchanging a copyright on a novel for a copyright on a song will not constitute a like-kind exchange.

79. [LO 9.3] Disease as Casualty (can be solved using Checkpoint® or a similar service) Cheryl owned six horses that she and her family used for riding and occasionally showing in hunterjumper competitions. At the beginning of May, one of the horses showed signs of severe illness and was diagnosed with equine encephalitis. She was required to destroy all of her horses, none of which was insured. The horses had been purchased for $23,000 but had a current value of $45,000. What type of a loss does Cheryl have on these horses?

Hint: Rev. Rul. 61-216, 1961-2 C.B. 134 Issue: What type of loss does Cheryl have resulting from the destruction of the horses?

Conclusion: Cheryl has a Section 1231 loss, but she will not be permitted a deduction since the horses were for personal use and not related to a trade or business.

Discussion of Reasoning and Authorities: Because the illness and destruction did not meet the suddenness criteria, it could not be considered a casualty as described under §165(c)(3) and 1231(a). According to Rev. Rul. 61-216, when livestock is destroyed by or on account of disease, the destruction is treated as an involuntary conversion as described in §1033(e). Section 1231(a) governs the loss treatment for the involuntary conversion. The treatment provided by Section 1231(a) is applicable in appropriate cases to a loss caused by the death of livestock from disease, assuming such diseased livestock are property used in the trade or business or capital assets held for more than one year. Thus, the loss is considered a Section 1231 loss. However, Section 1231 only allows a deduction for capital assets used in a trade or business or held for the production of income. As the horses are for personal use, no deduction is permitted.

80. [LO 9.5] Corporate Formation (can be solved using Checkpoint® or a similar service) Joe, June, and Jim—co-workers—decide that they want to start their own business. Joe has $200,000 to contribute, June has equipment valued at $100,000 (basis = $90,000) and Jim has real estate suitable for the business valued at $200,000 (basis = $110,000). Joe and Jim are each to receive 40 percent of the corporate stock and June is to receive 20 percent. Joe and June transfer title to their property to the corporation immediately. When Jim tries to transfer title to the real estate to the corporation, several legal errors in the title are discovered and he is unable to transfer title until the errors are corrected. Correcting the errors takes over 14 months. In the meantime, the corporation begins operating, renting the building from Jim. In the 15th month, Jim is able to transfer title and receive his stock. Is Jim eligible to use the nonrecognition provisions of Section 351 on this transfer?

Hint: Regulation Section 1.351-1(a)(1) and Marsan Realty Corp, TC Memo 1963-297, PH TCM ¶63297, 22 TCM 1513 (1963) Issue: Will Jim‘s contribution of the property to the corporation in exchange for stock qualify for

Solutions to Develop Research Skills Problems 27

nonrecognition under Section 351?

Conclusion: The delay of the contribution should not prohibit Jim from qualifying for nonrecognition under Section 351.

Discussion of Reasoning and Authorities: Regulation §1.351-1(a)(1) states that in general, for the nonrecognition of gain or loss upon the transfer by one or more persons of property to a corporation solely in exchange for stock, such persons must be in control of the corporation to which the property was transferred immediately after the exchange. The regulation further provides that the phrase ‗immediately after the exchange‘ does not necessarily require simultaneous exchanges by two or more persons, but comprehends a situation where the rights of the parties have been previously defined and the execution of the agreement proceeds with an expedition consistent with orderly procedure. According to the facts of this case, the delay in transfer was not the result of any action on Jim‘s part, but due to the legal complications arising from the title transfer. In Marsan Realty Corp, TC Memo 1963-297, PH TCM ¶63297, 22 TCM 1513 (1963), it was held that a late transfer qualified where it was clear that the transferors were all obligated to make a transfer of property to a corporation, and the transferors as a group were in control immediately after the transfer even though one of the transferors, due to mere procrastination, did not make his transfer until eight months after the other transfers were made.

Jim transferred the title to the corporation as soon as the legal complications were rectified and in the interim, made the building available for use. The facts indicate that Jim had an obligation and intended to transfer the property pursuant to the defined agreement. Therefore, Jim should be eligible to qualify for nonrecognition under Section 351.

Chapter 10 Taxation of Corporations Solutions to Develop Research Skills Note to Instructor: No research aids or ―hints‖ are provided in the textbook for problems in this chapter.

Before the solution to each problem, however, suggested research aids are provided. This allows you to choose whether or not to provide any hints to your students for a particular problem. For problems that can be solved using free Internet sources, you must provide students with the citations in these hints and refer students to Figure 2.1 in Chapter 2 of the text for the URLs to enable them to solve these problems using free Internet sources. Some of the problems require access to Checkpoint® or a similar service.

69. [LO 10.1] Debt Characteristics (can be solved using free Internet sources) Locate and read Section 385 of the Internal Revenue Code and develop a comprehensive list of factors that indicate legitimate debt. What is the status of the regulations that are to expand on this Code section?

Solution: Factors to be considered in determining whether debt is legitimate as specified in Section 385 include: (1) Whether these is a written unconditional promise to pay on demand or on a specified date, a sum certain in money in return for an adequate consideration in money or money‘s worth, and to pay a fixed rate of interest; (2) whether there is subordination to or preference over any indebtedness of the corporation; (3) the ratio of debt to equity of the corporation; (4) whether there is convertibility into the stock of the corporation; and (5) the relationship between holdings of stock in the corporation and holdings of the interest in question.

When Section 385 was written, Congress authorized the Service to issue clarifying regulations.

However, there are no regulations that are applicable today. Regulations were issued at one time, but since then have been withdrawn.

28 Taxation for Decision Makers Research Solutions

70. [LO 10.4] Property Dividends (can be solved using Checkpoint® or a similar service) Several years ago, Congress repealed the General Utilities Doctrine. Locate and read General Utilities & Operating Co. v Helvering, 296 U.S. 200 (1935). Summarize this case. What was the General Utilities Doctrine, and how did its repeal affect current transactions?

Solution: In the General Utilities case, the corporation distributed appreciated stock of another corporation as a dividend. The Board of Tax Appeals ruled in favor of General Utilities finding that the declaration and payment of the dividend resulted in no taxable income. The Commissioner, Helvering, appealed the case to the Fourth Circuit Court of Appeals. The appellate court reversed the prior ruling in favor of the Commissioner. The Supreme Court granted a writ of certiorari and held that the distributing corporation had no taxable income because the distribution was not a sale and the stock was not used to discharge a debt. This landmark case became known as the General Utilities Doctrine which allowed corporations to distribute appreciated property to their shareholders as a dividend without the recognition of income to the corporation. The General Utilities Doctrine was repealed in 1986. Since then, corporations have been required to recognize gain on the distribution of appreciated property to their shareholders for all distributions, including dividend distributions, redemptions, and liquidating distributions.

Solutions to Develop Research Skills Problems 29

71. [LO 10.4] Attribution (can be solved using free Internet sources) Locate and read Internal Revenue Code Sections 267, 318, and 544. Compare the definition of family in each of these sections.

Solution: Section 267(c)(4) defines family as an individual‘s brothers and sisters (whether whole or half blood), spouse, ancestors, and lineal descendants.

Section 318(a)(1) defines family as an individual‘s spouse, children, grandchildren, and parents.

Section 544(a)(2) defines family as an individual‘s brothers and sisters (whether whole or half blood), spouse, ancestors, and lineal descendants.

72. [LO 10.4] Formation of Second Corporation (can be solved using Checkpoint® or a similar service) June owned all the stock of Corporation A. Over the years, the corporation had been very successful but had never paid any dividends, although it had substantial earnings and profits. June wanted to expand into another line of business as a sole proprietor but did not have the cash to do so. June decided to form B, a new corporation. She contributed all the stock of A to B. B borrowed $100,000 from a bank using A stock as collateral. B then distributed all of its stock and the $100,000 to June.

How should June treat the distribution of the stock and the $100,000?

Hint: Rev. Rul. 80-239, 1980-2 C.B. 103 Issue: How are the distributions of the stock and $100,000 of money to June treated for tax purposes?

Conclusion: The distribution of the stock will be tax free, but the distribution of the $100,000 will treated as a dividend to the extent of the earnings and profits of Corporation A. Discussion of Reasoning and Authority: Rev. Rul. 80-239, 1980-2 C.B.1 03 provides identical facts to those provided in this case. The ruling points out that Section 351(a) provides for no gain or loss recognition on the transfer of property to a corporation by one or more persons in exchange for stock of such corporation if, immediately after the transfer, the transferors are in control of the corporation. Section 351(b) also provides that Section 351 will apply even if something other than stock is received, but that gain may be recognized to the extent of the fair market value of the other property received. As such, Section 351(a) will apply to the transfer of the A stock to B in exchange for B‘s stock since June is in control of B immediately after the exchange. However, the nonrecognition provisions of Section 351 will not apply to the cash received by June. In the ruling, it was determined that the $100,000 was in substance a disguised dividend from the old corporation to the individual. A distribution by the old corporation cannot be transformed for tax purposes into a distribution by the new company by using the latter as a conduit through which to pass the $100,000. Thus, the individual will be treated as having received a $100,000 dividend from the old corporation to the extent of the earnings and profits of Corporation A.

Chapter 11 Sole Proprietorships and Flow-Through Entities Solutions to Develop Research Skills Note to Instructor: No research aids or ―hints‖ are provided in the textbook for problems in this chapter.

Before the solution to each problem, however, suggested research aids are provided. This allows you to choose whether or not to provide any hints to your students for a particular problem. For problems that can be solved using free Internet sources, you must provide students with the citations in these hints and

30 Taxation for Decision Makers Research Solutions

refer students to Figure 2.1 of Chapter 2 in the text for the URLs to enable them to solve these problems using free Internet sources. Some of the problems require access to Checkpoint® or a similar service.

72. [LO 11.3] Sale of Partnership Interest (can be solved using free Internet sources if citations are provided to students) Roberta Wynn has been a partner in the Cato Partnership for a number of years. With the permission of the other partners, she sells her partnership interest to a third party. At the time of sale, her basis in her partnership is only $100. For the portion of the year to the date of sale, she is allocated a partnership loss of $2,100. If she receives $10,000 for her partnership interest, what are the tax consequences of the sale and the results of partnership operations in her final year?

Hint: Sections 704(d), 705(a), and 741.

Issue: Will Roberta be allowed to deduct the full amount of her loss in the year she disposes of her partnership interest?

Conclusion: Roberta will be permitted to recognize only $100 of the $2,100 partnership loss, reducing her basis to zero. Roberta will have a $10,000 long-term capital gain.

Discussion of Reasoning and Authorities: Section 704(d) limits a partner‘s distributive share of partnership loss to the extent of the partner‘s adjusted basis. The excess loss will be allowed as a deduction at the end of the partnership year in which such excess is repaid to the partnership. As such, the $2,100 loss is limited to $100,l reducing Roberta‘s basis to zero. The only way Roberta could recognize the additional $2,000 loss would be to increase her basis. Under Section 705(a)(1), a partner‘s basis is increased by the distributive share of taxable income.

Alternatively, the partner can make an additional contribution to the partnership. Unless Roberta contributes $2,000 to the partnership prior to the sale, the excess loss cannot be deducted. Unlike passive losses for which a specific provision allows the deduction of suspended losses when completely disposing of a passive investment, no such provision exists for partnership losses held in suspense due to lack of basis. Roberta will have a $10,000 long-term capital gain from the sale of the partnership pursuant to Section 741.

73. [LO 11.3 & 11.4] Tax Issues Locate a recent appellate court case that has reversed a Tax Court decision regarding a partnership or S corporation tax issue. a. Summarize the facts, issues, and conclusions of the case. b. Explain why the appellate court reversed the Tax Court. c. Explain the impact this decision has on tax planning for clients.

Solution: Cases will differ among students.

74. [LO 11.3 & 11.4] Incorporating a Partnership (can be solved using free Internet sources if citations are provided to students) The partners of JPG Partnership want to change the form of entity from a partnership to a corporation.

The corporation can be formed in several ways: The partnership can distribute the assets to the partners who then contribute the assets to the corporation. The partnership can transfer the assets directly to the corporation. The partners can transfer their partnership interests to the corporation.

Write a memo outlining the tax effects of the various methods of forming the corporation.

Hint: PLR 8714042 and PLR 8107136 Solution: To: JPG Partnership Pursuant to Private Letter Ruling 8714042, a partnership meets the provisions of a Section 351 exchange by transferring all its assets and liabilities to the corporation, in exchange for common stock of the corporation. Under Section 351, no gain or loss is recognized by the

Solutions to Develop Research Skills Problems 31

partnership or the corporation as a result of the transfer. The partnership then distributes all of the common stock to the partners in complete termination of the partnership. This allows nonrecognition of gain or loss by the partnership on the liquidating distribution. The partners will recognize gain only if money is distributed that exceeds the basis of the partnership interests. The basis of the stock received by the partnership will be the same as the basis of the business assets surrendered in the exchange, decreased by the liabilities assumed in the exchange, and by the liabilities to which the transferred assets are subject. The corporation‘s bases in the business assets received in the exchange will be the same as the bases of such assets in the hands of the partnership immediately prior to the exchange.

Private Letter Ruling 8107136 provides that no gain or loss will be recognized by the partnership or partners in a Type A reorganization in which the partners transfer their partnership interests directly to the new corporation in exchange for stock and assumption of partnership liabilities. The partners will only recognize gain if money is distributed that exceeds the basis of the partnership interests. To the extent each partner is relieved of any partnership liabilities by reason of the assumption of such liabilities by the corporation, each partner is considered to have received a distribution of money. The basis of the stock received by the partner in complete liquidation of his interest is equal to the adjusted basis of such partner‘s interest in the partnership reduced by any money distributed in the same transaction.

If the partnership distributes the assets to the partners prior to the incorporation, the partners‘ bases in the distributed assets equal their bases in their partnership interest and generally recognize gain only if they receive money in excess of their bases. If the assets are distributed and immediately contributed to the corporation, the Service may simply disregard the intermediate step using the step transaction doctrine and treat this transaction as a contribution of assets directly to the corporation.

Chapter 12 Estates, Gifts, and Trusts Solutions to Develop Research Skills Note to Instructor: No research aids or ―hints‖ are provided in the textbook for problems in this chapter.

Before the solution to each problem, however, suggested research aids are provided. This allows you to choose whether or not to provide any hints to your students for a particular problem. For problems that can be solved using free Internet sources, you must provide students with the citations in these hints and refer students to Figure 2.1 of Chapter 2 in the text for the URLs to enable them to solve these problems using free Internet sources. Some of the problems require access to Checkpoint® or a similar service.

71. [LO 12.4] Transferee Liability (can be solved using free Internet sources if citations are provided to students) Two years ago, Herbert, a widower, made a gift of marketable securities to his 35-year-old daughter, Sabrina, on which he paid a federal gift tax of $3 million. When Herbert died in 2016, his estate had been greatly reduced in value due to his having given away most of his assets over his lifetime.

Herbert‘s executor filed an estate tax return showing an estate tax liability attributable to the gift to Sabrina. The estate tax was not paid because the estate had no liquid assets. The IRS assesses the portion of the estate tax related to this gift that Sabrina previously received against Sabrina under the rules relating to transferee liability. Is Sabrina liable for the estate tax?

Hint: Section 2035, 6324(a)(2), and Frank Armstrong III, 114 TC 94 (2000).

Issue: Is Sabrina liable for the estate tax?

32 Taxation for Decision Makers Research Solutions

Conclusion: Yes, Sabrina is personally liable for the unpaid estate taxes.

Discussion of Reasoning and Authorities: Section 2035(a) provides that if the decedent made a transfer of an interest in any property, or relinquished a power with respect to any property, during the three-year period ending on the date of the decedent‘s death, and the value of such property would have been included in the decedent‘s gross estate if such transferred interest had been retained by the decedent, then the value of the gross estate shall include the value of any property which would have been included. Under Section 2035(b), the donor-decedent‘s gross estate is increased by any gift tax that was paid on any gift made by the decedent during the threeyear period ending on the date of the decedent‘s death. This provision is known as the gross-up rule and applies to the gift tax triggered by a gift of any type of property during the three-year look-back period.

In the event a decedent‘s estate taxes are not paid when due, Section 6324(a)(2) imposes personal liability upon transferees of property included in the decedent‘s gross estate, and provides for the imposition of a lien on the transferee‘s separate property if the transferee transfers any of the property received from the decedent.

In a similar case, Frank Armstrong III, et al. v. Commissioner, 114 TC 94 (2000), the Tax Court agreed with IRS that the donees were personally liable for the unpaid estate taxes to the extent of the gift‘s value. The donees tried to argue that there was an insufficient nexus between the stock that they received as gifts and the estate taxes that IRS wanted to collect from them. The Tax Court said that Congress did not restrict transferee liability to those instances where there is an immediate link between an estate tax liability and property transferred to a transferee. As such, Sabrina will be liable for the estate tax.

Solutions to Develop Research Skills Problems 33

72. [LO 12.6] Trust Income Used to Pay for Child’s Education (can be solved using RIA Checkpoint® or a similar service) Samantha is a single parent providing the sole support for her six-year-old daughter, Hillary. They live in an area where the public school is known to have problems with drugs and other crimes.

Samantha wants to send Hillary to a private school to avoid these problems and provide a better environment for Hillary‘s educational development. Eight years ago, Samantha set up two trusts to manage the securities she inherited from her grandfather. Samantha is the sole beneficiary of Trust A from which she receives bimonthly distributions each made after approval by the trustee. Hillary is the sole beneficiary of Trust B and all distributions from this trust must be approved by its trustee. If Samantha convinces the trustee to pay for Hillary‘s tuition, writing a check out of Trust B funds to the school, are there any income tax consequences to Samantha?

Hint: Section 677 and Frederick C. Braun, Jr., TC Memo 1984-285, PH TCM ¶84,285, 48 TCM 210.

Issue: Will Samantha be taxed on the funds paid directly for Hillary‘s tuition?

Conclusion: Yes, Samantha probably will be taxed on the trust income used for the education of her dependent child.

Discussion of Reasoning and Authorities: Under Section 677(b), the income of a trust is taxable to the grantor to the extent that such income is applied or distributed for the support or maintenance of a beneficiary whom the grantor is legally obligated to support or maintain. In the case of Frederick C. Braun, Jr., (TC Memo 1984-285, PH TCM ¶84,285, 48 TCM 210), all of the income distributed from two trusts was used for the educational expenses of the children. The children were the beneficiaries of the two trusts. The Court ruled that the income from the two trusts was taxable to the petitioners. The Court stated that the income used for the education expenses of the children discharged the support obligation of the petitioner as described in Section 677(b). Therefore, Samantha will probably be taxed on the trust income used for the education of her child.