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

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

Solutions to Chapter 1 Problem Assignments Check Your Understanding 1. [LO 1.1] What is a tax?

Solution: A tax is a required payment to a governmental unit to support its operations that is not related to the value of goods or services the person or business receives. A fine is levied as a result of an unlawful act.

2. [LO 1.1] Constitutional Authority Solution: The federal income tax system as we know it today did not begin until 1913 when the 16th Amendment to the U.S. Constitution was ratified. The 16th Amendment gave Congress the power to lay and collect taxes ―on income, from whatever source derived,‖ without the previous requirement that all direct taxes be imposed based on population.

3. [LO 1.1] Current Tax Code Solution: The Tax Reform Act of 1986 was so extensive, the Code was renamed the Internal Revenue Code of 1986. Any current changes to the tax laws are now amendments to the Internal Revenue Code of 1986.

4. [LO 1.1] Tax Expenditures Solution: Tax expenditures can take the form of special exclusions, deductions, credits or preferential rates for specific activities. These tax expenditures result in a reduction in the revenue that would be collected under a more comprehensive income tax.

5. [LO 1.1] SALT Solution: The practice of state and local taxation is commonly referred to as a SALT practice.

6. [LO 1.1] Nexus Solution: Nexus is the necessary type and degree of connection between a business and the state in which it is located for the state to impose a tax on its sales or activities 7. [LO 1.1] State Income Tax Solution: Without physical presence within Arizona, the state cannot assess state income tax on Suntan Corporation’s sales made to persons or businesses located within Arizona.

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8. [LO 1.1] Franchise Tax Solution: A franchise tax is an excise tax based on the right to do business or own property in a state. It is usually determined based on corporate income, however, so would, in effect, simply be another name for an income tax.

9. [LO 1.1] State Income Allocation Solution: The three-factor allocation formula uses a percentage of corporate sales, payroll costs, and tangible property allocated to the state.

10. [LO 1.1] Employment Taxes Solution: An employee pays the Social Security and Medicare (FICA) tax; the employer also pays an equivalent Social Security and Medicare (FICA) tax, but the employer also may have to pay an unemployment tax.

11. [LO 1.1] Wealth Taxes Solution: The most common wealth tax is the real property tax based on the fair market value of property owned by an individual or a business.

12. [LO 1.1] Intangible Tax Solution: The intangible tax is levied on intangible property such as receivables, stocks, bonds, and other forms of investment instruments owned by businesses and individuals.

13. [LO 1.1] Estate and Gift Tax Solution: Property that is given away during a lifetime that exceeds an annual allowance per donee is subject to a gift tax; however, the lifetime exemption prevents most gifts from being subject to this tax. Once, however, taxable gifts exceed the lifetime exemption, gifts are subject to the gift tax. When the person passes away, the remaining property owned at death (not previously given away) is now subject to the estate tax. Any gift tax exemption not used previously by the decedent is then available as an exemption from the estate tax. Thus, a decedent’s estate escapes taxation unless his or her total lifetime taxable gifts plus taxable transfers at death exceed the lifetime exemption.

14. [LO 1.1] Consumption vs Income Tax Solution: A consumption tax is levied on purchases of goods or services that are going to be used or consumed. The most common consumption tax is the sales tax, but the value-added tax is another form used in many countries outside the United States.

The income tax is based on the value of money or goods that are received, whether it is spent or saved. An income tax will tax money that is going to be saved rather than spent while the consumption tax only taxes money that is spent. The consumption tax is thought to encourage savings.

15. [LO 1.1] Wealth Taxes Solution: A wealth tax is based on the value of wealth that a person has at a particular point

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in time. The real or personal property taxes are wealth taxes. The wealth transfer tax is based on the value of money or property that is passed on to another person.

The estate, gift, and inheritance taxes are wealth transfer taxes.

16. [LO 1.1] Use Taxes Solution: A use tax is a companion tax to a sales tax that is imposed on property to be used in one state but which was purchased in another state to which no sales tax was paid on the purchase.

17. [LO 1.1] Income Taxes Solution: Two single persons with taxable income of $76,550 each will pay the same total tax as a married couple with taxable income of $153,100. Above $153,100 the married couple’s rate increases to 28% but each of the single persons does not reach that rate until taxable income is over $91,900.

18. [LO 1.2] Types of Taxes Solution: The income tax system in the United States is a progressive system; that is, as income increases, the tax rate increases and the person pays a greater percentage of income as a tax. A person who has $9,000 of taxable income will pay $900 in taxes (10%). A person who makes $18,000 will pay $2,233.75 ($932.50 + .15 ($18,000 $9,325). $2,233.75/$18,000 = 12.41%. A regressive tax system imposes a lower tax rate as income increases; that is, a person pays a decreasing percentage of their income in taxes as income increases. The Social Security portion of the FICA tax is a regressive tax; as the taxpayer’s income on which the tax is based exceeds a maximum, the tax is no longer collected and the rate declines. A proportional tax would collect the same percentage of tax on the tax base, regardless of the size of the base. The sales tax is a proportional tax as the same percent tax is collected regardless of the amount spent.

19. [LO 1.2] Income Tax Rates Solution: Individuals have basic tax rates of 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% that apply to their ordinary income and their interest income. The basic tax rates for their dividend income are 0%, 15%, and 20%. Corporations have no tax-favored incomes so they pay tax on all income at rates of 15%, 25%, 34%, and 35%, excluding surtaxes on certain portions of income that ultimately produce a flat tax of 35% on income above $18,333,333.

20. [LO 1.2] Income Tax Rates Solution: Individual’s short-term capital gains tax rates are the same as the tax rates on ordinary income. A single individual’s long-term capital gains rates are 0% on long-term capital gains (LTCG) from 0 to $37,950; 15% on LTCG from $37,951 to $418,400, and 20% on LTCG exceeding $418,400.

21. [LO 1.3] Canons of Taxation Solution: The basic idea of equity is that persons with similar incomes will face similar taxes.

Thus, individuals each with $200,000 in taxable income will pay the same amount

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of tax. A tax meets the criterion of economy when the amount of revenue it raises is at an optimum level after the costs of administration and compliance are considered. The canon of certainty would dictate that a taxpayer know with reasonable accuracy the tax consequences of a transaction at the time the transaction takes place. The last canon of convenience states that a convenient tax is one that would be readily determined and paid with little effort.

22. [LO 1.3] Equity Concepts Solution: Horizontal equity would require persons with equal incomes pay equal amounts of taxes. Vertical equity would require persons with higher incomes to pay a higher percentage of their income than persons with lower incomes. This is the basis of the U.S. tax system.

23. [LO 1.4] Taxable Persons Solution: Only individuals, regular (or C) corporations, and fiduciaries (estates and trusts) pay income taxes.

24. [LO 1.4] Gross Income Solution: The term gross income is an all-inclusive term that includes income from all sources that are not specifically excluded.

25. [LO 1.4] Basic Tax Model Solution: The basic elements of the tax model are gross income, less deductions, that equal taxable income or loss. The applicable tax rate is applied to this to determine the gross tax liability. From this tax credits and prepayments are deducted to determine the tax liability owed or the refund due.

26. [LO 1.4] Capital Losses Solution: An individual may deduct up to $3,000 of capital losses in excess of capital gains annually; the excess may be carried forward indefinitely to succeeding years. A corporation can only offset capital losses against capital gains; losses are not deductible against other income. Instead the corporation first carries the losses back to the three previous years and then forward for 5 years.

27. [LO 1.4] Basic Income Tax Rates Solution: Individuals have basic tax rates of 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% that are applied to their ordinary income. A corporation’s basic tax rates are 15%, 25%, 34%, and 35%, excluding surtaxes.

28. [LO 1.4] Fiduciaries Solution: Trusts and estates are two fiduciary entities; a trust is established by a grantor who appoints a trustee to manage the assets for the benefit of the trust’s beneficiaries.

An estate is an entity that is created on the death of a person that provides management for the assets in the decedent’s estate until they can be distributed to the beneficiaries. A grantor is the person who creates the trust when assets are placed in the trust for the benefit of the beneficiaries. The trustee is the person

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selected by the grantor to oversee the assets and ensure the trust functions as specified by the grantor. The beneficiary of the trust is the person for whom the trust was established and who is to benefit from the income from the trust (an income beneficiary) or receive the assets when the trust is closed (the remainderman).

29. [LO 1.5] Sole Proprietorships Solution: Only one taxable person, who must be an individual, can own a sole proprietorship.

The sole proprietor is personally liable for all debts of the business. The sole proprietor cannot be an employee of the business and must pay self-employment tax. The results of operations of the sole proprietorship are reported on the Schedule C and these are then included in the owner’s personal tax return.

A partnership must have more than one owner. A general partner is liable for partnership debts but limited partners are only liable for their investment in the partnership. Like sole proprietors, partners cannot be employees of the partnership and general partners are required to pay self-employment tax. Although partnerships do not pay taxes directly, they must file information tax returns. The income/loss from the partnership flows through to the partners and is reported on their own tax returns. Partners pay any taxes owing on the income items but loss is deductible only if a partner has sufficient basis. A partner’s basis begins with his or her investment in the partnership and is increased for the partner’s share of partnership liabilities.

Partnerships and limited liability companies differ in a number of ways. Owners of partnerships are partners while owners of limited liability companies are called members. There are no legal requirements to set up a partnership but a limited liability company must be established according to the laws of the state of domicile. Limited liability companies can elect to be taxed as corporations while partnerships do not have that option. In some states, a limited liability company may have only one owner but a partnership must have two or more owners. Only the managing members of a limited liability company may be subject to selfemployment taxes.

30. [LO 1.5] Corporations Solution: The principal difference between a C corporation and an S corporation is in the method of taxation. A C corporation pays a tax directly on its income. Any net after-tax income that is distributed to its shareholders as dividends is subject to a second level of tax. Thus, these corporate earnings are said to be subject to double taxation. An S corporation’s income flows directly through to its shareholders (whether there is an actual distribution of this income in cash or not) undiminished by taxes at the corporate level. The income is then taxed once only at the shareholder level. The corporation can then make actual distributions of this previously-taxed income to the S corporation shareholders without any additional taxes due. There are a number of other differences in that the number and type of S corporation shareholders is limited; it can only have one class of stock outstanding, and its choice of tax year is restricted. None of these restrictions apply to a C corporation. Other items of comparison could be drawn from the table in the text

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comparing business entity attributes.

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

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

37. [LO 1.4] Taxable Income Solution: Taxable income = $237,500

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plus minus equals

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

Gross income Interest income Expenses Taxable income

The $20,000 capital loss is not deductible currently.

38. [LO 1.4] Taxable Income Solution: Taxable income = $77,900 George's salary plus Mary's salary equals Gross income minus Itemized deductions minus Personal exemptions equals

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

39. [LO 1.4] Determining Tax Liability Solution: Taxable income = $29,600; income tax = $3,973.75.

Income Tax: ($9,325 x 10%) + ($20,275 x 15%) = $3,973.75.

40. [LO 1.4] Determining Tax Liability Solution: Taxable income = $49,400; income tax = 6,742.50.

Income Tax: [($49,400 - $13,350) x 15%] + $1,335 = $6,742.50 41. [LO 1.4] Determining Tax Liability Solution: Taxable income = $49,000; income tax = $7,350.

Income Tax: $49,000 x 15% = $7,350.

42. [LO 1.4] Determining Tax Liability Solution: Taxable income = $237,500; Income tax = $75,875 [($237,500 - $100,000) x 39%] + $22,250 = $75,875 (The $20,000 capital loss is not deductible currently.)

43. [LO 1.4] Marriage Penalty Solution: They have a marriage penalty of $207 ($31,684.50 - $31, 477.50).

MFJ: [($160,000 - $153,100) x 28%] + $29,752.50 = $31,684.50 Single: [($80,000 - $37,950) x 25%] + $5,226.25 = $15,738.75 x 2 = $31,477.50 44. [LO 1.4] Joint vs. Single Filing Solution: a. It will be to their advantage to marry in 2017. b. By marrying before the end of 2017 and filing jointly, they save $6,097.25 ($43,381.75 - $37,284.50) in taxes.

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MFJ: [($180,000 - $153,100) x 28%] + $29,752.50 = $37,284.50 Single: [($180,000 - $91,900) x 28%] + $18,713.75 = $43,381.75 c. If they each have $90,000 of income, they would each pay $18,238.75 in taxes and they would then have a marriage penalty of $807 ($37,284.50 - $36,477.50). In this case, they would be slightly better off by postponing their wedding until 2018.

Tax on $90,000 (Single): [($90,000 - $37,950) x 25%] + $5,226.25 = $18,238.75 $18,238.75 x 2 = $36,477.50 45. [LO 1.4] Income Tax Liability Solution: Taxable income = $48,850 and the net tax liability = $6,155. $76,000 salary and wages - $15,000 of itemized deductions and $12,150 in personal exemptions = $48,850 taxable income.

Income tax liability is: $1,865 + .15 x [$48,850 - $18,650] = $6,395 $6,395 - $240 credit = $6,155 46. [LO 1.4] Tax Liability Solution: The estate will pay $6,215.60. $2,550 x 15% = $382.50 $3,450 x 25% = 862.50 $3,150 x 28% = 882.00 $3,350 x 33% = 1,105.50 $7,500 x 39.6 = 2,970.00 Total tax $6,202.50 47. [LO 1.4] Tax Rates Solution: .05 x ($335,000 - $100,000) = $11,750 $50,000 (.34 - .15) = $9,500 ($75,000 - $50,000)(.34 - .25) = $2,250. $9,500 + $2,250 = $11,750 48. [LO 1.4] Tax Rates Solution: .03 x ($18,333,333 - $15,000,000) = $100,000 (.35 - .34)($10,000,000) = $100,000 49. [LO 1.5] Tax Liability Solution: William’s income is twice John’s, but his taxes are 2.67 ($10,771.25/$4,036.25) times John’s. This illustrates the progressive nature of the tax system as well as vertical equity. [($30,000 - $9,325) x 15%] + $932.50 = $4,033.75 [($60,000 - $37,950) x 25%] + $5,226.25 = $10,738.75 50. [LO 1.5] Net Operating Loss

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Solution: Lilikoi paid $6,000 tax for 2015 and $30,050 tax for 2016. Lilikoi will have a refund of $9,900 from carrying back $40,000 of the 2017 loss to 2015 and $10,000 of the loss to 2016. (Note that Lilikoi cannot carry the loss back to only 2016 without first carrying it back to 2015.)

Tax paid for 2015 on $40,000 was $40,000 x 15% = $6,000 Tax paid for 2016 on $120,000 was [($20,000 x 39%) + $22,250] = $30,050.

The $10,000 loss that is carried back to 2016 reduces the taxable income for that year from $120,000 to $110,000 saving tax at the 39% rate that applies to income between $110,000 and $120,000.

Tax refund from 2017 loss is ($40,000 x 15%) + ($10,000 x 39%) = $9,900 51. [LO 1.5] Determining Tax Liability Solution: The net tax liability is $20,000. $250,000 gross income - $125,000 expenses = $125,000 taxable income.

The income tax liability is: [($25,000 x 39%) + $22,250] = $32,000 gross tax $32,000 - $12,000 tax credit = $20,000 net tax 52. [LO 1.5] Determining Tax Liability Solution: Taxable income = $28,650 and the tax liability is $3,833.75 $46,000 Salary minus 7,000 Partnership loss (50% x $14,000) equals $39,000 Gross income minus 10,400 Deduction equals $28,600 Taxable income Tax: [($28,600 - $9,325) x 15%] + $932.50 = $3,823.75 53. [LO 1.4 & 1.5] Tax Liability Comparisons Solution: Partnership: Pays no tax. June and John are each taxed on the $32,000 passed through to them at their marginal tax rates.

To determine their marginal tax rates, find the tax bracket in which their other taxable income falls. (Note that the ―other ordinary taxable income‖ is provided; either the standard or their itemized deductions and the personal exemptions have already been subtracted.) June’s $475,000 of other ordinary taxable income puts her in the 39.6% marginal tax bracket because she is a head of household with taxable income over $444,550. John’s $32,000 falls within the 25% marginal tax bracket ($110,000 of taxable income plus the additional $32,000 does not exceed $153,100 – the 25% tax bracket). His $32,000 is taxed at 25% for a married taxpayer filing a joint return.

June’s tax = $32,000 x 39.6% = $12,672.

John’s tax = $32,000 x 25% = $8,000.

Together they pay a total of $20,672 in taxes.

S Corporation: Pays no tax. June and John are each taxed on the $32,000 passed

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through to them at their marginal tax rates as shown above for the partnership and together they pay $20, 672 in taxes.

C Corporation: The corporation pays a tax of $11,000 [$7,500 + ($64,000 - $50,000) x 25%] = $11,000 Neither June nor John pay any taxes as they received no distributions from the corporation.

Note the problem specified only income taxes; employment taxes are not included in the solution to this problem.

54. [LO 1.4 & 1.5] Tax Liability Comparisons Solution: Partnership: The answer does not change because June and John are taxed fully on their shares of income whether they are distributed or not and the partnership pays no tax. Thus, June’s tax is still $12,672 and John’s tax is $8,000 for a total of $20,672 in taxes. They pay no additional tax on the $28,000 distribution.

S Corporation: The answer does not change because June and John are taxed fully on their shares of income whether they are distributed or not and the S corporation pays no tax. Thus, June’s tax is still $12,672 and John’s tax is $8, 000 for a total of $20,672 in taxes. They pay no additional tax on the $28,000 distribution.

C Corporation: The corporation pays the same tax of $11,000 [($50,000 x 15%) + ($14,000 x 25%)]. June and John, however, will now have to recognize $28,000 of dividend income; John will be taxed at the 15% dividend rate but June will be taxed at 20% (the dividend rate for taxpayers in the 39.6% marginal tax bracket).

June’s tax = $28,000 x 20% = $5,600.

John’s tax = $28,000 x 15% = $4,200.

The total tax for the corporation, June, and John is $20,800 ($11,000 + $5,600 + $4,200).

Note the problem specified only income taxes; Medicare surtaxes and employment taxes are not included in the solution to this problem.

55. [LO 1.4 & 1.5] Tax Liability Comparisons Solution: Partnership: The partnership does not benefit from the loss. June and John are each allocated $22,000 of loss and can deduct the loss against their other income because they have sufficient basis in the partnership [$20,000 invested + ($30,000 bank loan x 50%) = $35,000 basis before loss - $22,000 loss = $8,000 ending basis]. June’s and John’s incomes are high enough for them to remain fully in their respective marginal tax rates of 39.6% and 25%. June benefits from a reduction in taxes of $8,712 ($22,000 x 39.6%) and John saves $5,500 ($22,000 x 25%) in taxes at his marginal tax rate. The total tax savings for both are $14,212 ($8,712 + $5,500).

S Corporation: The S corporation does not benefit from the loss. June and John are each allocated $22,000 of the loss but they can only deduct $20,000 of this loss against their other income because their deduction is limited to their basis in their S corporation stock (which does not include any of the corporation’s liabilities).

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Thus, June benefits from a reduction in taxes of $7,920 ($20,000 x 39.6%) at her marginal tax rate. John reduces his taxes by $5,000 ($20,000 x 25%) at his marginal tax rate. They will each carry their excess $2,000 loss forward; these losses can be deducted in a future year when they have sufficient basis. The total tax savings for the current year is $12,920 ($7,920 + $5,000).

C Corporation: Neither June nor John have any current tax savings from the $44,000 loss. As a new corporation, it can only carry its loss forward to offset income (and realize tax savings) in a future year. Losses of a C corporation do not pass through to shareholders.

Note the problem specified only income taxes; Medicare surtaxes and employment taxes were not included in the solution.

56. [LO 1.4 & 1.5 Choice of Business Entity] Solution: a. (1) The partnership does not pay any tax in years 1 or 2.

(2) The S corporation does not pay any tax in years 1 or 2.

(3) The C corporation pays no tax in year 1 but its year-1 loss can be carried forward to year 2 to offset $54,000 of its year-2 $60,000 income; it will pay a tax of $900 ($6,000 x 15%) on this remaining $6,000 income in year 2. b. (1) Tax savings for first year of partnership: Clara and Charles are each allocated $27,000 of loss and each can deduct $25,000 of the loss (the extent of basis [$15,000 investment + (50% x $20,000 loan)]. Clara’s tax savings will be $7,000 ($25,000 deductible loss x 28%) and Charles’s tax savings will be $6,250 ($25,000 deductible loss x 25%). The excess loss is carried forward to the next year.

Partner’s basis computations: $15,000 Partner’s original investment +10,000 Partner’s share of liabilities ($20,000 loan x 50%) $25,000 Basis before deducting loss - 25,000 Deductible loss ($54,000 loss x 50% = $27,000 but limited to basis and $2,000 excess loss carried forward) 0 Basis at end of first year (2) Tax savings for first year of S corporation: Clara and Charles are each allocated $27,000 of loss and can deduct loss to the extent of the basis in the S corporation stock.

Clara’s tax savings will be $4,200 ($15,000 deductible loss x 28%) and Charles’s savings will be $3,750 ($15,000 deductible loss x 25%).

S corporation shareholder’s stock basis computations: $15,000 Shareholder’s original investment -15,000 Deductible loss ($54,000 loss x 50% = $27,000 but limited to basis and $12,000 excess loss carried forward) 0 Basis at end of first year Note that an S corporation shareholder does not increase stock basis for any corporate liabilities.

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

Partner’s basis computations: 0 $30,000 - 5,000 $25,000 - 2,000 $23,000

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

(2) Income tax for second year of S corporation: Clara pays $5,040 in tax [($30,000 profit - $12,000 loss carried forward) x 28%] and Charles pays $4,500 tax [($30,000 profit $12,000 loss carried forward) x 25%]. The cash distribution is not taxed but is a reduction of basis.

S corporation shareholder’s stock basis computations: 0 Basis at end of first year $30,000 Year 2 profit ($60,000 x 50%) - 5,000 Cash distribution $25,000 Subtotal - 12,000 Deduct loss carried forward from previous year $13,000 Basis at end of second year (3) Income tax for second year of C corporation: Clara and Charles each pay $750 tax on their dividend income ($5,000 dividend income x 15% dividend rate = $750 tax). Their basis in the corporate stock remains $15,000.

57. [LO 1.5] Partnership Basis Solution: His basis is $5,200. $4,000 beginning basis + (30% x $7,000 partnership income) – (30% x $3,000 distribution) = $4,000 + $2,100 - $900 = $5,200 Develop Planning Skills 58. [LO 1.4] Single vs. Married Filing Status Solution: Married Filing Separately: [($89,700 - $75,950) x 28%] + $14,758.75 = $18,608.75 $18,608.75 x 2 = $37,217.50 Married Filing Jointly: [($179,400 - $151,900) x 28%] + $29,517.50 = $37,217.50

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Single: [($89,700 - $37,650) x 25%] + $5,183.75 = $18,196.25 x 2 = $36,392.50 It makes no difference if they marry this year and file either as married filing jointly or separately. If they postpone the wedding until next year, they will save $825 ($37,217.50 - $36,392.50) in taxes filing as single individuals this year.

59. [LO 1.4 & 1.5] Total Tax Comparison Solution: Sole Proprietorship: Jeremy will be taxed on the entire net income from the sole proprietorship of $68,000 ($80,000 – $12,000) regardless of the ―salary.‖ $68,000 $10,350 allowable deduction = $57,650 taxable income; [25% x ($57,650 $37,650)] + $5,183.75 = $10,183.75 income tax.

Corporation: $80,000 - $12,000 - $30,000 = $38,000 taxable income; $38,000 x 15% = $5,700 corporate income tax. Income tax on Jeremy’s $30,000 salary: Jeremy’s taxable income = $30,000 - $10,350 allowable deduction = $19,650. Tax on $19,650 = $927.50 + [($19,650 - $9,275) x 15%] = $2,438.75. Total taxes as a corporation = $5,700 + $2,438.75 = $8,183.75 Based solely on income taxes, Jeremy should incorporate because his taxes will be $2,000 ($10,183.75 - $8,183.75) less than operating as a sole proprietorship.

60. [LO 1.1, 1.4 & 1.5] Form of Business Operations: C Corporation vs. S Corporation Solution: Regular C Corporation: FICA tax on Carol’s $60,000 salary is $4,590 ($60,000 x 7.65%). FUTA = $420 ($7,000 x 6%) Corporate taxable income = $200,000 - $75,000 - $60,000 salary - $4,590 FICA -$420 FUTA= $59,990.

Income tax on $59,990 = [($59,990 - $50,000) x 25%] + $7,500 = $9,997.50.

Total corporate taxes = $4,590 + $420 + $9,997.50 = $15,007.50.

Carol’s taxes: Carol also pays $4,590 ($60,000 x 7.65%) in FICA taxes on her salary but she cannot deduct these taxes.

Carol’s taxable income = $60,000 - $6,350 standard deduction and $4,050 personal exemption= $49,600.

Income tax: ($49,600 - $37,950) x 25%] + $5,226.25 = $8,138.75.

Carol’s total taxes = $8,138.75 + $4,590 = $12,728.75.

Total taxes = $15,007.50 + $12,728.75 = $27,736.25 S Corporation: FICA tax on Carol’s $60,000 salary is $4,590 ($60,000 x 7.65%). FUTA = $420 ($7,000 x 6%).

The net S corporation income of $59,990 (same as the regular corporation) is passed through to Carol for taxation along with her salary income.

Carol’s taxable income = $60,000 salary + $59,990 corporation income - $6,350 standard deduction and $4,050 personal exemption = $109,590.

Tax on Carol’s $109,640 taxable income = [($109,590 - $91,900) x 28%] + $18,713.75 = $23,666.95 Carol’s total tax = $23,666.95 + $4,590 = $28,256.95

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

Think Outside the Text

These questions require answers that are beyond the material that is covered in this chapter.

61. [LO 1.2] Tax Rates Solution: Income Tax Rate on salary 15% 28% 28%

33%

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

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

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

62. [LO 1.2] Tax Fairness Solution: No answer is suggested here as the purpose of this question is to require the student to select an alternative and construct an argument to support that position.

63. [LO 1.2] Property Tax Solution: As an ad valorem tax, a property tax is proportional. If you use another tax base except the value of the property, the tax may be progressive for some group of citizens and regressive for others. For example, senior citizens generally have lower incomes than working persons. They may have lived in their home a long time and paid off the mortgage. If it had significantly appreciated (with property tax increases), based on a percentage of their income, the property tax would be regressive. Alternatively, a lower income person may spend only 25 percent of his or her income on housing because of other necessities. A high-income person may be able to spend 40 percent of his or her income on housing. The latter’s property taxes will be much higher as a percent of income than the former. In this situation, the tax is progressive when based on income.

Thus, for a wealth tax such as a property tax, wealth is the only base on which it is practical to evaluate it. It is generally proportional, although a certain base amount may be excluded from the tax (for example, a $25,000 homestead exemption for persons who

Chapter 1: An Introduction to Taxation 15

own their own home would make it somewhat progressive).

64. [LO 1.2] Flat Tax Solution: Most students will agree that there will have to be some basic exclusions or deductions to enact a viable flat tax. Comparisons can be drawn, however, to the FICA taxes, which have been flat over incomes up to the Social Security base amount ($127,200 for 2017), but only the Medicare portion applies above this base amount; an income flat tax, on the contrary, could be structured to exempt a certain base amount from tax with the tax applying on all income above that minimum excluded base.

Discussions of a flat tax can often lead to discussions of higher minimum wages, guaranteed annual incomes, and negative income taxes in order to keep the flat tax relatively simple.

65. [LO 1.3] Tax Evaluation Using the Canons of Taxation Solution: The four canons of taxation are equity, economy, certainty, and convenience. In general, with the exception of an evaluation based on equity, many persons believe the sales tax that most states levy is superior to the income tax. The costs to collect and comply with the sales tax are relatively small compared to the amounts collected (although internet sales are a significant problem now); most persons know that when they purchase certain items they are required to pay sales taxes; and they pay at the point of sale without having to file end-of-year returns. Sales taxes are considered regressive, however, and therefore not considered equitable. As a percentage of income, lower income persons pay more sales tax than higher income persons do because they are obliged to spend more of their income. As an absolute amount, however, most wealthy persons spend more overall than poor persons, and, as a result pay more sales taxes (vertical equity). Two persons with equal incomes can pay different amounts of sales taxes, however, if one party chooses to save money while the other spends; this would violate horizontal equity. The income tax has far higher costs of collections and administration but its tax rates are progressive and it contains provisions that exempt lowincome taxpayers from paying any taxes. Thus, it is generally seen as more equitable than a sales tax. It fails, however, on convenience and certainty because of the annual filing requirements and constant changing of the laws.

66. [LO 1.4] Marriage Penalty Solution: An evaluation of this proposal at this point usually focuses on the cost to the taxpayer in time and money to determine the tax under the dual system. Other problems arise in the dividing up of dependency exemptions, itemized deductions, and tax credits.

If taxpayers are allowed to choose the method that allows them to pay the lower tax, there will also be a decline in total tax revenues. To some degree taxpayers have a choice now – but the difference in tax rates from single to married filing separately and the requirement that both must either choose the standard deduction or itemize deductions limits their ―gaming the system.‖ 67. [LO 1.4] After-Tax Interest Rate Solution: The interest rate = 4.34%.

16

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

Taxable income = $200,000; marginal tax bracket = 33%. Tax savings from the $4,000 deduction = $1,320 (33% x $4,000).

A $4,000 tax credit reduces each taxpayer’s tax by $4,000. The tax savings from a tax credit is independent of the taxpayer’s marginal tax rate.

Search the Internet

For the following four problems, consult the IRS Web site (www.irs.gov).

Check solutions 69. [LO 1.1] Statistical Information Solution: On the IRS.gov home page search for tax statistics or click on Tax Stats, Facts and Figures at the bottom of the page to access www.irs.gov/uac/Tax-Stats-2. There are links to a wide range of tables, articles, and data that describe and measure elements of the U.S. tax system. These include statistics and other information about returns filed with the IRS. Headings under this section include: Business Tax Statistics; Individual Tax Statistics; IRS Operations & Budget; Statistics of Income (SOI); Charitable & Exempt Org. Statistics; Products, Publications, & Papers; Statistics by Form; Other IRS Data and Research, Additional Information; and What’s New. 70. [LO 1.1] Asking Questions or Making Comments to the IRS Solution: On www.irs.gov/uac/TaxStats-2 page under ―Additional Information,‖ there is a direct link under Questions on Tax Statistics? that accesses a page on which you can send an email to the IRS with general questions or comments regarding these statistics. Links are also provided for accessing other information.

71. [LO 1.1] Statistics of Income Solution: About SOI, Dissemination Policy, SOI Products and Services, SOI Data Releases, Statistical Methodology, and All Topics 72. [LO 1.1] Information about the IRS Solution: At the bottom of the IRS home page, click on "About Us." A list of topics pop up including ―The Commissioner’s Section,‖ ―The Agency, Its Mission and Statutory Authority‖ and ―Brief History of IRS‖ along with other links including Today’s IRS Organization, Equity, Diversity and Inclusion of IRS, Strategic Plan and Other References, Open Government Initiative, Contracting Opportunities, and Contact Us.

Chapter 1: An Introduction to Taxation 17

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

Identify the Issues

Identify the issues or problems suggested by the following situations. State each issue as a question.

74. [LO 1.4] Filing Status Solution: What is John and Mary’s filing status for the current year?

75. [LO 1.5] S Corporation Requirements Solution: Is the S corporate restriction of no more than 100 shareholders violated when John gives half of his shares to his wife? Will its S election terminate?

76. [LO 1.5] Disguised Dividend Solution: Will all of Clifford’s salary be deductible by the corporation as salary or is it possible that a portion of it will be declared a disguised dividend?

18

Solutions to Chapter 2 Problem Assignments Check Your Understanding 1. [LO 2.1] DIF Formula Solution: The DIF formula is designed to identify those taxpayers for which an audit will be cost effective; that is, that the audit will yield additional taxes sufficient to warrant the expenditure of resources necessary to conduct the audit.

When the DIF score is high, indicating a high probability of adjustment to the return, the return will be examined manually to confirm the audit potential. If confirmed, an audit will commence.

2. [LO 2.1] Types of Audits Solution: Correspondence audit is the simplest audit that is conducted when only one or two relatively straightforward items on a return are questioned. The audit and the taxpayer’s response can be handled entirely by mail.

An office audit involves one or more issues that are too complex for a correspondence audit. The taxpayer is asked to come to a district office for an interview and should bring any records or documents to support the items in question.

Field audits are more comprehensive than office audits and are usually limited to an examination of business returns. Field audits are usually conducted on the taxpayer’s premises and generally involve a complete review of the entire financial operations of the business. This type of audit is usually used for corporations.

3. [LO 2.1] Appeal Options Solution: If the taxpayer does not agree with the proposed deficiency specified in the 30-day letter, he or she may request a conference with an agent of the IRS Appeals Division within 30 days of receiving the letter.

4. [LO 2.1] Appeal Options Solution: (1) File a petition with the U.S. Tax Court within 90 days of receiving the notice.

(2) Pay the tax; the taxpayer may then go to a U.S. District Court or the U.S. Court of Federal Claims to sue for refund.

(3) Take no action and be subject to IRS-enforced collection procedures.

5. [LO 2.1] Hazards of Litigation Solution: Hazards of litigation refers to factors that may affect the outcome of a case that is litigated such as ambiguous facts, uncertain application of the law to known facts, credibility of witnesses, and the ability to meet the required burden of proof.

6. [LO 2.1] Trial Courts and Appeals Solution: The taxpayer can initiate litigation in the U. S. Tax Court, the U. S. District Court, or the U. S. Court of Federal Claims. All of the decisions from these courts can be appealed to a higher court except those cases that are tried in the small tax case

Chapter 1: An Introduction to Taxation 19

division of the Tax Court.

7. [LO 2.1] Appeals Process Solution: The taxpayer should be advised to ask for a meeting with an agent from the IRS Appeals Division as the only cost effective course of action to get the additional tax assessment abated. The costs of litigating would generally far exceed the $1,050 additional tax that has been assessed and litigation should be discouraged.

If she wishes to pursue this in court, she should go to the small case division of the Tax Court.

8. [LO 2.1] Taxpayer Penalties Solution: If a taxpayer is convicted of criminal fraud (tax evasion), a prison sentence can be imposed in addition to monetary fines.

9. [LO 2.1] Statute of Limitations Solution: The statute of limitations is the time period beyond which neither the taxpayer nor the IRS can take legal action nor make changes to a tax return.

The statute of limitations brings closure to a tax return for the taxpayer and the IRS. The IRS cannot audit a tax return after the statute of limitations has passed nor can the taxpayer make changes to the return or file a claim for refund beyond that date.

10. [LO 2.2] Avoidance vs. Evasion Solution: Tax avoidance is the minimization of taxes by using legal alternatives to determine the tax owed. Tax evasion is the avoidance of taxes through illegal means.

11. [LO 2.2] Preparer Penalties Solution: Yes. Code Section 6694 imposes a penalty of $1,000 or 50 percent of the fee for the work, if greater, on preparers whose clients’ tax deficiencies result from an ―unreasonable position‖ on the return that the preparer knew or should have known was a departure from the rules or regulations and the position was not disclosed. (Disclosure is typically accomplished by using Form 8275; however, filing the form would probably raise a red flag with the IRS.) A reasonable position requires the preparer to have ―substantial authority‖ upholding a ―realistic possibility of success‖ for nonabusive, undisclosed tax return positions.

Substantial authority exists if the weight of authorities (including the Internal Revenue Code, regulations, court cases, committee reports, revenue rulings, revenue procedures, and similar documents) supporting the reported tax treatment is substantial in relation to the weight of those authorities taking a contrary position. If the position taken on the tax return involves a tax shelter (or similar abusive transaction called a ―listed transaction‖), however, a higher ―more-likelythan-not‖ (greater than 50 percent) standard applies.

If a preparer takes an unreasonable position in a ―willful‖ attempt to understate the taxpayer’s liability or if the preparer is guilty of ―reckless or intentional disregard‖ of rules or regulations, the penalty increases to the greater of $5,000 or 50 percent of the preparer’s fees. If a preparer is convicted of criminal tax evasion, the penalty can consist of a fine of up to $100,000 ($500,000 in the case of a

20

corporation) and imprisonment. Severe monetary penalties also apply to promoters of and advisors to tax shelters for the failure to provide required information returns, maintain required investor lists, and to provide these lists when requested.

12. [LO 2.2] Sources of Guidance Solution: Treasury Circular 230: Regulations Governing the Practice before the Internal Revenue Service, the AICPA’s Code of Professional Conduct and the AICPA’s Statements on Standards for Tax Services all contain guidelines for tax professionals.

13. [LO 2.2] SSTS Solution: The Statements on Standards for Tax Services are a series of statements that delineate the extent of a tax practitioner’s responsibility to his or her client, the public, the government, and his or her profession. They are issued by the Federal Taxation Executive Committee of the AICPA. 14. [LO 2.2] SSTS Solution: In general, a CPA may rely on information furnished by a client and other third parties unless the information appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known by the CPA. If there is such evidence, the CPA must make further inquiry to determine the accuracy of the information provided.

15. [LO 2.2] SSTS Solution: Estimates are appropriate when records are missing (for example, a flood or fire destroying records) or precise information is not available at the time of filing the tax return.

16. [LO 2.3] Tax Planning vs. Compliance Solution: Tax compliance involves the gathering of relevant information, evaluating and classifying that information, filing tax returns, and representing clients at Internal Revenue Service audits. Tax planning is the process of evaluating the tax consequences associated with a transaction and making recommendations to achieve the desired objective at minimal tax cost. It generally involves extensive tax research.

17. [LO 2.3] Tax vs. Nontax Factors Solution: a. This is primarily a nontax factor situation. The taxpayer has specified that she is risk averse, a personal choice, due to having experienced prior losses. b. The taxpayer’s dislike of paying taxes is really a nontax factor; this dislike, however, leads him to seek income tax advice to reduce taxes and he is willing to pay significant amounts of money to find ways to avoid taxes. Thus, this really has significant elements of both. c. This situation involves tax factors in tax planning. There are numerous ways in which a taxpayer can arrange transactions to take advantage of loss carryovers before they lose significant value due to the time value of these losses.

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

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

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

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

22. [LO 2.4] Primary vs. Secondary Authority Solution: Primary authority comes directly from statutory, administrative or judicial sources.

Secondary authority consists of tax services, books, journals, and newsletters that assist the taxpayer in locating and interpreting primary authorities.

23. [LO 2.4] Steps in Tax Research

Solution: The basic steps include: (1) gather the facts and identify the issues, (2) locate the sources of authority, (3) evaluate the relevant authorities, and (4) communicate the recommendations.

24. [LO 2.4] Tax Service Solution: A tax service or reference service is a comprehensive publication providing reference information related to the tax laws that can be used to assist in the tax research process. Most tax services contain the Code, regulations, rulings, and cases as well as an index to aid the researcher in locating the relevant discussions of tax problems and are usually available only through paid subscriptions.

25. [LO 2.4] Committee Reports Solution: The House Ways and Means Committee, the Senate Finance Committee, and the Joint Conference Committee may generate committee reports in the process of a bill

22

becoming law.

26. [LO 2.4] Committee Reports Solution: Committee reports contain a general and technical discussion of a bill’s provisions.

The reports contain important information about the legislative intent of a bill that may be used to resolve disputes between taxpayers and the Internal Revenue Service. These reports provide the only guidance about a new law until the Treasury provides regulations.

27. [LO 2.4] Sections of Internal Revenue Code Solution: The Code is cited by a section number. The sections of the Code are consecutively numbered and each section has a unique number.

28. [LO 2.4] Regulation Citations Solution: The 1 is a prefix that refers to an income tax regulation; the 247 is a root number that designates the Code section to which the regulation is related.

29. [LO 2.4] Types of Regulations Solution: A legislative regulation is one that has been specifically authorized by the Code to provide the details of the meaning and rules for a Code section. It carries weight similar to that of a Code section.

An interpretive regulation is one that provides a detailed explanation of and examples for a particular Code section. It does not carry the same weight of authority as a legislative regulation.

30. [LO 2.4] Proposed vs. Temporary Regulations Solution: A proposed regulation provides an advance indication of what position the IRS intends to take on a particular issue. Positions taken in proposed regulations cannot be relied on, as they are simply proposals.

Temporary regulations provide operating rules for a particular Code section until final regulations can be issued. These regulations can be followed until final regulations are issued, so they carry significantly more weight than proposed regulations.

31. [LO 2.4] Letter Ruling vs. Revenue Ruling Solution: A letter ruling is issued to a specific taxpayer to provide guidance on how a planned transaction will be taxed. It generally applies only to the taxpayer to which it was issued and may not necessarily apply to another taxpayer in a similar situation.

A revenue ruling is issued as general guidance on the tax consequences of a particular transaction. It is usually issued for ambiguous tax situations. Although these rulings are generally fact specific, taxpayers with similar fact situations can rely on them for guidance.

32. [LO 2.4] Nonacquiescence Solution: To signal disagreement with a court decision, the IRS will publicly

Chapter 1: An Introduction to Taxation 23

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

33. [LO 2.4] Golsen Rule Solution: The Golsen rule requires the Tax Court to follow a decision of the Court of Appeals that has direct jurisdiction over the taxpayer in question. If there has been no appellate decision on an issue in a specific circuit, the Tax Court is free to decide the issue on its own merits.

34. [LO 2.4] Citator Solution: A citator contains an alphabetical listing of virtually all tax cases. The citator permits a researcher to determine the case’s history and what other courts may have said about this decision. Each case is followed by a record of other decisions that have cited or referred to this case. The validity of a decision may be assessed by examining how the subsequent cases viewed the cited decision and whether the IRS or other courts agree or disagree with the decision in this case.

35. [LO 2.4] Rule 155

Solution: A decision entered under Rule 155 means that the court has reached a decision regarding the facts and issues of the case but leaves the computational aspects for the opposing parties to determine.

36. [LO 2.4] Communicating Tax Research Results

Solution: Practitioners communicate the results through a memorandum to the client file and letter to the client.

37. [LO 2.4] Memo to File

Solution: The four sections of a memo to file are: (1) Facts—a statement of all facts necessary to answer the issues raised, in chronological order. (2) Issues—the tax questions involved, numbered separately and presented in logical order. (3) Conclusions—short answers to each numbered issue. (4) Discussion—presentation of the reasoning and authorities on which the conclusions are based.

Crunch the Numbers 38. [LO 2.1] Penalties Solution: $45. Adam’s tax payment is 1 partial and 2 full months late. He will be assessed a late-payment penalty equal to one-half of one percent for each partial and full month or $45 ($3,000 x 0.5% x 3).

39. [LO 2.1] Penalties Solution: $800. Robert’s return and tax payment is 1 partial and 3 full months late. He will be assessed a late filing penalty of 18 percent (4.5% x 4 x $4,000 = $720, which is

24

greater than the minimum $210 penalty) and a late payment penalty of 2 percent (0.5% x 4 x $4,000 = $80) for a total of 20 percent of the $4,000 balance due. He will be charged a total of $800 (20% x $4,000).

40. [LO 2.1] Statute of Limitations Solution: April 15, 2021. The three-year statute of limitations begins to run from the later of the due date or date of filing.

41. [LO 2.1] Statute of Limitations Solution: The deliberate omission of $40,000 of gross income will generally constitute fraud (tax evasion) and in those circumstances there is no statute of limitations. The IRS can assess additional taxes, interest, and penalties at any time although it must prove fraud.

If the IRS cannot prove fraud on Kevin’s part, then the statute of limitations would expire April 15, 2021, three years from the later of the due date or date of filing.

Once an assessment of tax is made, the IRS has 10 years within which to collect the taxes.

42. [LO 2.1] Statute of Limitations Solution: October 15, 2023. The $40,000 of gross income inadvertently omitted is in excess of 25 percent of the gross income reported ($40,000/$150,000 = 27%), so the statute of limitations is extended to 6 years from the later of the due date or date of filing.

Once an assessment of tax is made, the IRS has 10 years within which to collect the taxes.

43. [LO 2.1] Statute of Limitations Solution: a. April 15, 2024. If the income proves taxable, Thomas would have omitted gross income in excess of 25 percent of the gross income reported ($30,000/$50,000 = 60%) so the statute of limitations is extended to 6 years from the later of the due date or date of filing. b. If the IRS can prove fraud, there is no time limit (no statute of limitations) on when it can assess additional taxes, penalties, and interest.

44. [LO 2.3] Income Shifting Solution: $1,620.

Tax on $100,000 for a married couple filing joint return [($100,000 - $75,900) x 25%] + $10,452.50

$16,477.50

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

(14,477.50)

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

2,000.00

(380.00) $1,620.00

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

45. [LO 2.3] Changing Character of Income

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

46. [LO 2.3] Timing Issues

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

26

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

47. [LO 2.3] Timing Issues

Solution: a. Kimo should pay the expense in this year. Because Kimo’s marginal tax rate is expected to be the same, the only consideration is the time value of money. If Kimo chooses to pay the expense this year, it will have an after-tax savings of $3,750 ($15,000 x 25%). If Kimo defers payment of the expense, its net present value of the after-tax savings will be $3,506 ($15,000 x 25% x .935 PV factor). Therefore, Kimo should pay the expense this year since it will result in a $244 greater after-tax savings ($3,750 - $3,506). b. Kimo should pay the expense this year. If Kimo’s marginal tax rate is expected to decrease to 15%, Kimo will have a lower after-tax savings next year. The net present value of Kimo’s after-tax savings would be $2,104 ($15,000 x 15% x .935 PV factor). Kimo should pay the expense this year since it will result in a $1,646 greater after-tax savings ($3,750 - $2,104). c. Kimo should wait and pay the expense next year. If Kimo’s marginal tax rate is expected to increase to 34%, Kimo will have a greater after-tax savings next year. The net present value of Kimo’s after-tax savings would be $4,769 ($15,000 x 34% x .935 PV factor). Kimo should wait and pay the expense next year since it will result in a $1,019 greater after-tax savings ($4,769 $3,750).

Develop Planning Skills 48. [LO 2.3] Sole Proprietorship vs. C Corporation Solution: a. The sole proprietorship will generate $18,000 ($150,000 x 12%) in before-tax cash flow. It will pay no taxes directly; Jessica will pay all taxes. Jessica will pay income taxes of $4,500 ($18,000 x 25%) reducing the net cash flow to $13,500 ($18,000 - $4,500).

(Note that although this problem said to ignore employment taxes, you should be aware that self-employment taxes will reduce the net cash flow.) b. The corporation will pay income tax of $2,700 ($18,000 x 15%) on its income.

Jessica will pay income tax of $1,350 [(50% x $18,000) x 15% dividend rate]. The net cash flow as a corporation is $18,000 - $2,700 - $1,350 = $13,950.

Chapter 1: An Introduction to Taxation 27

c. There are a number of nontax factors to consider such as her personal liability, the ease of raising additional capital, the ease of sale of ownership interests, and participation in fringe benefits. d. With significant income from other sources, the corporate form would protect the assets generating this income. In addition, by paying taxes at the corporate rate and leaving a significant portion of the income in the corporation, the business has more capital with which to grow. At a later date, if Jessica needs to take money from the corporation, she could do so as salary and avoid the double tax on this income (although as salary, the corporation and Jessica would have to pay employment taxes) or withdraw more dividends. Based on the tax rates of both the corporation and Jessica, paying dividends would result in a lower tax liability.

Either way, the corporate form appears to be a better fit for Jessica’s situation.

49. [LO 2.3] Partnership vs. C Corporation Solution: a. The partnership has income of $20,000 ($200,000 x 10%) but will pay no taxes; thus, it will have cash remaining in the partnership of $12,000 ($20,000 - $8,000 distributed to Richard and Jack). Richard and Jack will each pay taxes on their onehalf share of the partnership’s $20,000 income. Richard will pay income tax of $2,500 ($10,000 x 25%); Jack will pay income tax of $2,800 ($10,000 x 28%).

Richard will have an after-tax cash inflow of $1,500 ($4,000 – $2,500) and Jack will have an after-tax cash inflow of $1,200 ($4,000 - $2,800). Total taxes paid are $5,300 ($2,500 + $2,800). b. The corporation will have to pay $3,000 ($20,000 x 15%) tax on its income.

After the $8,000 dividend distribution to Richard and Jack, its remaining cash is $9,000 ($20,000 – $3,000 - $8,000). Richard and Jack will each have to pay $600 ($4,000 dividend x 15% dividend rate) in income taxes. Richard and Jack each have an after-tax cash inflow of $3,400 ($4,000 - $600). Total tax is $4,200 ($3,000 + $600 + $600). c. Some of the nontax factors that Richard and Jack should consider include their exposure to liability as partners in the partnership, their ability to raise additional capital, the ease of selling their ownership interests, and their participation in fringe benefits. d. As presented, it appears that the corporation offers the best alternative form of business. They are able to benefit from the corporation’s lower tax rates and this form provides the best overall cash flow considering both the business and the owners at this time. Richard and Jack are paying very high taxes on income that flows through to them from the partnership. With the limited distributions made, they have little positive cash flow. If they intend to leave most of the income in the business, they can avoid the taxes at their level through the corporate form. If at a later date, they need income, they can make additional dividend distributions.

Note that when employment taxes are considered (discussed in Chapter 4), the corporate form is even more attractive.

28

50. [LO 2.3] Capital Gain vs. Ordinary Income Solution: Robin would have a gain or income totaling $22,800 ($28,800 - $6,000 basis) on the sale of land. If interest of only 4 percent is designated, Robin will have less interest income to recognize and more gain on the sale of the property than if an interest rate of 8 percent were designated. A lower interest rate benefits Robin because the interest income is taxed at his ordinary income rates, while the gain on the property sale generally will be taxed at the lower long-term capital gain rate.

If Norman is purchasing this property as an investment or to build a personal residence, the 8 percent interest rate would be better for him because it would result in a higher interest expense deduction for the debt. Although this results in a lower property basis, the higher current interest rate is preferable because it gives him a higher current deduction against ordinary income. Although gain realized on a subsequent sale will be higher, the tax on that gain will be postponed until it is sold and the gain will be capital gain normally taxed at favorable rates. If Norman builds a principal residence on the property, any future realized gain may escape taxation completely (due to the Section 121 exclusion discussed in Chapter 8).

51. [LO 2.3] Loan vs. Sale of Property Solution: (1) If Debbie sells the land, she will have a gain of $34,000 [$40,000 – (50% x $12,000)] on the sale. If she is not in the top tax bracket, she will most likely have to pay a capital gains tax of $5,100 (15% x $34,000) on the sale leaving her with a net cash inflow of $34,900 ($40,000 - $5,100). If she is in the top tax bracket, her capital gains tax rate would be 20% resulting in a tax of $6,800 (20% x 34,000). If she needs a total of $40,000, she will need to make up the $5,100 (or $6,800) shortfall from her other funds or borrow that amount. She would have a much smaller debt than if she borrowed the entire $40,000. If she does not expect the property to continue to increase in value or to possibly decrease in value in the future, then selling when its value is at a high point would be best.

(2) If Debbie borrows the entire $40,000, she can avoid any current taxes. She will, however, be required to make interest and principal payments over a number of years to retire the debt. Her ability to do this is dependent on her other income.

Whether undertaking debt and holding the property will prove the better financial alternative depends on the after-tax interest rate that she will have to pay on the loan (as this is to purchase additional investment property she may be able to deduct the interest) and the present value of the after-tax net profit that she could receive on a future sale. For example, if in three years she anticipates selling the entire property to a developer for $120,000, her profit on the half of the land will have increased by $20,000 [(50% x $120,000) - $40,000]. After taxes, she will have an additional $17,000 [$20,000 x (1-.15)] or $16,000 [$20,000 x (1-.20)] if in the top tax bracket and even when present value is considered, this may more than compensate for the interest payments over the three years.

In recommending a final decision, selling would be the better alternative if appreciation potential is only moderate and she has little income to service the debt for the borrowing alternative. If she has other income and expects the property to

Chapter 1: An Introduction to Taxation 29

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

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

Ken

Lisa

Estimated pretax cash inflow

$6,000

$5,600

Probability of success

x 80%

x 75%

Expected pretax cash inflow

$4,800

$4,200

Tax on expected return (39%)

(1,872)

0

Expected after-tax cash inflow

$2,928

$4,200

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

$(5,600)

$(6,000)

2,184

2,340

After-tax cost (outflow)

(3,416)

(3,660)

Net after-tax cash flow

$(488)

$540

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

Job 1

Job 2

Revenues

$360,000

$220,000

Expenses

(200,000)

(120,000)

Before-tax cash flow

$160,000

$100,000

(45,650)

(22,250)

$114,350

$77,750

First year:

Income tax After-tax cash flow Second year:

30 Revenues

$80,000

$220,000

Expenses

(40,000)

(120,000)

Before-tax cash flow

40,000

100,000

Income tax

(6,000)

(22,250)

After-tax cash flow

34,000

77,750

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

31,790

72,696

$146,140

$150,446

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter.

54. [LO 2.1] Statute of Limitations Solution: After the statute of limitations has passed, the taxpayer knows that he or she can no longer be audited and additional taxes, interest, and penalties assessed. This allows the taxpayer to move on with certainty for a closed year. In many instances, this allows the taxpayer to dispose of certain records that have no bearing on future years. The closure of years through the statute of limitations also allows the IRS to move on to current years for their audit potential. Unless the IRS suspects fraud, this also limits the IRS’s ability to go back through prior years when discrepancies are determined in a year currently under audit. This provides a practical limit to the workload of the Service.

55. [LO 2.1] Improving Compliance Solution: This question requires the student to develop a position and state whether that position is viable. For example, a penalty such as lifetime in prison may improve compliance but it is unlikely that such a provision would be passed.

56. [LO 2.3] Advantages of Debt vs. Equity Solution: The corporation can pay interest on the debt and deduct the interest expense from its gross income. If the corporation pays dividends on the stock, the dividends are not deductible by the corporation. Whether the payment is for interest or dividends, the shareholder recognizes income for the amount received; however, dividend income is taxed at a lower rate. Another consideration is that the corporation can repay debt with no tax consequences to the shareholders. If the corporation retires a shareholder’s stock, it is possible that the amount received could also be treated as a dividend unless specific redemption requirements are met.

57. [LO 2.1, 2.3 & 2.4] Effect of Law Changes on Tax Planning Solution: Because of changes in tax laws, successful plans devised in previous years may no longer be available for replication in the current year. When researching a tax plan,

Chapter 1: An Introduction to Taxation 31

the tax professional must be certain that a plan follows the laws in effect at the time the plan is to be put into effect. For example, the regulations often are not changed immediately when a section of the Code is amended. If a section of the regulations is affected by a law change, then the regulations cannot be relied on as guidance under the new law for a current plan. Similarly, rulings and case law can be superseded by law changes.

58. [LO 2.4] Origination of Tax Bills Solution: The Senate can initiate a tax bill by attaching the bill to another House-passed revenue bill already under consideration in the Senate. This happened in 1982 when Senator Robert Dole, Chairman of the Senate Finance Committee, put together a package of miscellaneous revenue-raisers and ―loophole closings‖ in his Finance Committee. He then tacked it onto a minor House-passed tax bill that had been stripped of all its original provisions, passed it through the Senate, and sent it to the House. It eventually became the 1982 tax reform act.

59. [LO 2.4] Benefit of Rulings Solution: The rulings issued by the IRS provide a blueprint for the taxpayer on how to structure a transaction so that the tax consequences are known when the transaction is consummated. Having certainty about the outcome of a transaction is highly beneficial to the taxpayer. This also reduces the number of disagreements between the taxpayer and IRS when the taxpayer follows a sanctioned form of a transaction. This allows the IRS to better allocate its scarce resources.

Search the Internet 60. [LO 2.1] Locate employment information for Internal Revenue Agent positions Solution: a. At least 30 hours of accounting courses. b. GS-7 requires one full year of graduate level education. GS-9 requires a master’s or equivalent graduate degree or two full years of progressively higher level graduate education leading to such a degree or LL.B. or J.D. 61. [LO 2.1] Locate IRS Publication Solution: Form 8857 62. [LO 2.1] Locate IRS Notice

Solution: a. $5,000 b. Positions that are the same as or similar to the following are frivolous: (1) Compliance with the internal revenue laws is voluntary or optional and not required by law. (This statement is followed by 9 examples.)

(2) The Internal Revenue Code is not law (or ―positive law‖) or its provision are ineffective or inoperative, including the sections imposing an income tax or requiring the filing of tax returns, because the provision have not been implemented by regulations even though the provisions in question either (a) do not expressly require the Secretary to issue implementing regulations to become

32

effective or (b) expressly require implementing regulations which have been issued.

(3) A taxpayer’s income is excluded from taxation when the taxpayer rejects or renounces United States citizenship because the taxpayer is a citizen exclusively of a State (sometimes characterized as a ―natural-born citizen‖ of a sovereign state‖), that is claimed to be a separate country or otherwise not subject to the laws of the United States. This position includes the argument that the United States does not include all or a part of the physical territory of the 50 States and instead consists of only places such as the District of Columbia, Commonwealths and Territories (e.g.

Puerto Rico), and Federal enclaves (e.g., Native American reservations and military installations), or similar arguments described as frivolous in Rev. Rul. 2004-28, 2004-1 CB 624 or Rev. Rul. 2007-22, 2007-14 IRB 866.

63. [LO 2.2] Locate Circular 230

Solution: a. (1) Communicating clearly with the client regarding the terms of the engagement. (2) Establishing the facts, determining which facts are relevant, evaluating the reasonableness of any assumptions or representations, relating the applicable law (including potentially applicable judicial doctrines) to the relevant facts, and arriving at a conclusion supported by the law and the facts.

(3) Advising the client regarding the import of the conclusions reached, including, for example, whether a taxpayer may avoid accuracy-related penalties under the Internal Revenue Code if a taxpayer acts in reliance on the advice.

(4) Acting fairly and with integrity in practice before the Internal Revenue Service. b. Under §10.37, practitioners must: (1) base the written advice on reasonable factual and legal assumptions (including assumptions as to future events); (2) reasonably consider all relevant facts and circumstances that the practitioner knows or reasonably should know; (3) use reasonable efforts to identify and ascertain the facts relevant to written advice on each Federal tax matter; (4) not rely upon representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) of the taxpayer or any other person if reliance on them would be unreasonable; (5) relate applicable law and authorities to facts; and (6) not, in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit

64. [LO 2.2] Locate SSTS

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

Chapter 1: An Introduction to Taxation 33

65. [LO 2.4] Locate Definitions of Terms in Internal Revenue Bulletins Solution: Amplified describes a situation where no change is being made in a prior published position, but the prior position is being extended to apply to a variation of the fact situation set forth therein. Thus, if an earlier ruling held that a principle applied to A, and the new ruling holds that the same principle also applies to B, the earlier ruling is amplified. Modified is used where the substance of a previously published position is being changed. Thus, if a prior ruling held that a principle applied to A but not to B, and the new ruling holds that it applies to both A and B, the prior ruling is modified because it corrects a published position. Clarified is used in those instances where the language in a prior ruling is being made clear because the language has caused, or may cause, some confusion. It is not used where a position in a prior ruling is being changed. Distinguished describes a situation where a ruling mentions a previously published ruling and points out an essential difference between them.

66. [LO 2.4] Locate Tax Court Filing Fees Solution: The petition filing fee is $60.00.

Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

67. [LO 2.4] Medical Expense Deduction Solution: Can Barry deduct any portion of the cost of the hot tub or its operating expenses as a medical expense deduction?

68. [LO 2.4] Penalties Solution: Will Simon be assessed late filing penalties? What are his remedies if any penalties are assessed?

69. [LO 2.4] Statute of Limitations Solution: Will Jennifer be required to pay the $500 deficiency? Does the statute of limitations apply when no tax return is filed?

70. [LO 2.4] Statute of Limitations Solution: Does the statute of limitations prohibit the assessment of the additional tax?

71. [LO 2.4] Evaluating Authority Solution: Does the case or revenue rulings have more authority for the client? Can Georgia recommend the tax plan to her client without possible adverse consequences? Does the plan meet the requirement of having substantial authority upholding a realistic possibility of success?

72. [LO 2.4] Realistic Possibility of Success Solution: Does a 25 percent chance constitute a realistic possibility that the tax transaction will be sustained on its merits?

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73. [LO 2.4] Use of Estimates Solution: Can Verne use estimates supplied by the client? Does the use of cents as well as dollars imply greater accuracy than implied by the estimates?

74. [LO 2.4] Error on Prior Year Return Solution: What course of action should Jim take as a result of discovering the error? Is Jim required to notify the IRS of the error? Can Jim continue to prepare the current year’s return if the client does not want to correct the error?

75. [LO 2.4] Deduction Disallowed in Prior Year Solution: Can the tax preparer take the deduction on the current year’s return even though it was disallowed on a prior year’s return?

Develop Research Skills Solutions to research problems 76 – 81 are in Instructor’s Manual.

Solutions to Chapter 3 Problem Assignments Check Your Understanding 1. [LO 3.1] Realization Principle Solution: Income is not recognized (included in gross income) until the taxpayer has realization. Realization usually takes place when an arm’s-length transaction occurs, such as the sale of goods or the rendering of services. Fluctuations in value are not income unless that change is realized through some transaction.

2. [LO 3.1] GAAP vs. Tax Solution: (1) The goals of financial accounting and tax reporting are very different. The purpose of financial accounting is to provide information decision makers, such as shareholders and creditors, find useful, while the goal of tax accounting is to collect revenue equitably.

(2) Financial accounting often relies on the principle of conservatism, which tends to understate income when uncertainty exists. In contrast, the income tax system would be greatly hampered in its collection of revenue if taxpayers were allowed the freedom of reporting income conservatively.

(3) Financial accounting often relies on estimates and probabilities. The tax system would not function very efficiently or equitably if taxpayers were allowed to estimate income or base their reported income on probabilities.

3. [LO 3.1] Book/Tax Differences Solution: The two major categories are temporary (or timing) differences and permanent differences. For temporary differences, income is taxed in a different period than it is accrued for accounting purposes. Income that is not taxed but is included in financial accounting income would be a permanent difference.

Chapter 1: An Introduction to Taxation 35

4. [LO 3.1] Tax-favored Investments Solution: Tax law favors investments that yield appreciation rather than annual income. The tax on appreciation (gain) is deferred until gain is recognized and then it is frequently taxed at lower long-term capital gains rates. Congress wants to encourage taxpayers to invest for the long-term as it helps the economy.

5. [LO 3.2] Choice of Tax Year Solution: The sole proprietorship’s operating results will all be reported on Michelle’s tax return. As a result, it will have to be on a calendar-year basis unless Michelle applies for and receives permission to change her tax-year end to October 31.

6. [LO 3.2] Accounting Methods Solution: Jabba must recognize the fair market value of the computer (assumed to be approximately $2,000) as income in payment of the bill. Cash-basis taxpayers must recognize income when cash or cash equivalents are received as payment. The computer constitutes a cash equivalent.

7. [LO 3.2] Accounting Methods Solution: Murphy should recognize the income in year 1. The check was readily available several days before the end of the year and, as a cash-basis taxpayer, Murphy cannot turn its back on the income by failing to pick up the check.

8. [LO 3.2] Accounting Methods Solution: There are several restrictions on the use of the cash method. If inventory is a material factor in the determination of income, an otherwise cash-basis taxpayer must use the accrual method for determining sales and purchases. They may use the cash method for all other income and expense items, however. Businesses with average annual gross receipts of no more than $10 million may use a variation of the cash method under which they account for the cost of merchandise inventory as an asset, but account for their sales on the cash basis. Finally, a C corporation with average annual gross receipts of more than $5 million (except personal service corporations) is prohibited from using the cash method.

9. [LO 3.2] Tax vs. Financial Accounting Solution: The government is concerned with collecting its tax revenue when the taxpayer has the ―wherewithal‖ to pay the tax. Thus, the government usually does not permit an accrual taxpayer to postpone the recognition of income not yet earned but for which the taxpayer has received payment. GAAP, however, requires the use of accrual accounting even for prepaid items to properly match income to the periods over which it is earned. This helps to maintain the comparability of financial statements over time that would otherwise be distorted if prepaid items were recognized as income when payment was received.

10. [LO 3.2] Long-Term Construction Contracts Solution: A long-term contract is a contract for the manufacture, building, installation or construction of property that will not be completed in the year the contract is entered

36

into. There are two permissible tax treatments: the completed contract method and the percentage-of-completion method. The first allows the contractor to postpone the recognition of income and expenses related to the contract until the year the contract is completed. The percentage-of-completion method allows the taxpayer to recognize income based on the ratio of actual expenses incurred to date to total anticipated expenses for the contract as a whole. The latter method spreads income recognition across the period of time over which the income is earned.

11. [LO 3.3] Assignment of Income Solution: Ryan’s gross income is $120,000. He earned the income and he is responsible for including it in his taxable income. He will be treated as making a gift of the $20,000 to his grandmother.

12. [LO 3.3] Community Property Laws Solution: For tax purposes, community income is split evenly between spouses who file separate returns in community property states. In common law states, income is usually taxed to the individual who earns the income.

13. [LO 3.4] Income Tax Effects of Gifts Solution: Tommy will recognize the $100 dividend income because he is the legitimate owner of the stock at the time the dividend is paid. Virginia has no income.

14. [LO 3.4] Tax-Exempt Bonds Solution: The interest exclusion for most state and local bond issues permits state and local governments to finance their governmental activities at much lower interest rates than they would be required to pay if they were competing with corporate bonds.

15. [LO 3.4] Original Issue Discount Solution: Martha must include the $840 of accrued interest in her income. The bonds were issued with original issue discount, so this accrued interest must be included in income even by a cash-basis taxpayer.

16. [LO 3.4] Gross Income/Treasure Find Solution: Jane should include the $100 in her gross income. Treasure finds also constitute gross income.

17. [LO 3.4] Gross Income/Unemployment Compensation Solution: Unemployment compensation is a substitute for the taxable wages a person would receive from his or her employment. A substitute for a form of income that is subject to tax will also be included in gross income and taxed. (The American Reinvestment and Recovery Act allowed the first $2,400 of unemployment compensation received in 2009 to escape taxation, but that provision was never extended beyond the 2009 filing year.)

18. [LO 3.5] Gross Income/Gifts and Inheritances Solution: No. The recipients of gifts and inheritances do not include the items received in

Chapter 1: An Introduction to Taxation 37

their gross income. Instead, the giver (donor or decedent) may be subject to a transfer tax (gift or estate tax). Some people consider this transfer tax a second tax because the donor may have been subject to income tax when he or she earned the amounts that were later given as gifts or inheritances.

19. [LO 3.5] Life Insurance/Buy-Sell Agreement Solution: A buy-sell agreement is an agreement between co-owners of a business that provides for the purchase of one owner’s interest by the other (and the other heir’s obligation to sell) should the owner die. Life insurance on the deceased payable to the surviving owner(s) provides the funds necessary for the purchase of the deceased owner’s interest.

20. [LO 3.6] Taxes for a U.S. Citizen vs. Nonresident Alien Solution: United States citizens are subject to U.S. tax on their worldwide income. Income earned by nonresident aliens is divided into three categories: U.S. business income (called effectively connected income), non-U.S. business income, and U.S. investment income. Nonresident aliens are taxed similar to U.S. citizens on their effectively connected business income. Business income that is not effectively connected with the United States is usually not subject to U.S. tax. U.S. investment income includes interest, dividends, and royalties and is usually taxed at a flat 30 percent rate (or treaty rate if lower).

21. [LO 3.6] Tax Treaty Solution: The objective of a tax treaty with a foreign country is to minimize double taxation of the same income by the United States and the foreign country.

22. [LO 3.6] Foreign Tax Credit Solution: The purpose of the foreign tax credit is to minimize double taxation of the same income by two countries. Under the source principle, a country can claim the right to tax income earned within its boundaries. To minimize the double tax, the resident country then allows its citizens and corporations to offset the domestic tax on their foreign income with a foreign tax credit up to the amount of tax paid to the source country. The net tax paid will usually be the greater of the taxes imposed by the two countries claiming jurisdiction over the income.

Crunch the Numbers 23. [LO 3.2] Short Tax Years Solution: $26,273.

Annualized income = $96,000 x 12/8 = $144,000.

Corporate tax on $144,000 of income is $39,410 [($50,000 x 15% = $ 7,500) + ($25,000 x 25% = $6,250) + ($25,000 x 34% = $8,500) + ($44,000 x 39% = $17,160)] The tax for 8 months is $39,410 x 8/12 = $26,273.

24. [LO 3.2] Refunds of Prior Income

38

Solution: a. Because the refund exceeds $3,000, Specialty Training has two choices: it can deduct the $5,000 in the current year or it can reduce the current year’s tax by the amount of tax paid in the prior year on the $5,000. b. At 39 percent marginal tax rate in the year of repayment, Specialty would be better off taking a deduction for the amount repaid at that time. It will reduce its taxes by $250 [(39% - 34%) x $5,000] more than taking the deduction for prior year’s taxes paid. c. With a marginal tax rate of 25 percent, Specialty should reduce the current year’s tax for the $1,700 ($5,000 x 34%) of taxes paid in the prior year. It will be $450 [(34% - 25%) x $5,000] better off.

25. [LO 3.2] Prepaid Rental Revenue Solution: a. For tax purposes Realty will recognize $6,000 ($3,000 x 2 months’ rent) income in year 1 because prepaid income is taxed when received for both cash and accrual basis taxpayers. For financial accounting no income will be recognized in year 1. b. For tax purposes, Realty will recognize $8,500 ($3,000 March rent + $3,000 April rent + $2,500 kept from deposit) income in year 2. For financial accounting, Realty will recognize all $14,500 as income in year 2. (Note that a deduction would be allowed for the costs to repair the damages.)

26. [LO 3.2] Prepaid Service Revenue Solution: a. $1,000 (1/24 of $24,000) for both tax and financial accounting. b. $23,000 for tax accounting and $12,000 for financial accounting. Deferral for tax is not permitted beyond the year following the prepayment. c. $0 for tax accounting and $11,000 ($24,000 - $1,000 - $12,000) for financial accounting.

27. [LO 3.2] Long-Term Construction Contract Solution: (1) Under the completed contract method, Highrise will recognize all $250,000 of gross income and $226,000 of costs in year 2. It will recognize no income or expenses in year 1.

(2) Under the percentage-of-completion method, Highrise will recognize $137,500 of gross income ($121,000/$220,000 x $250,000) and $121,000 of expenses in year 1 for net taxable income of $16,500. In year 2, it will recognize the balance of the revenue of $112,500 ($250,000 - $137,500) and expenses of $105,000 for net taxable income of $7,500.

28. [LO 3.3] Shifting Income to Children Solution: a. Alana has $10,970 gross income and Mac has none. Mac includes nothing in his gross income because he gave the stock to Alana and is no longer the owner.

Alana is taxed on the dividend income ($170) because she was the owner when the dividend was declared and paid. Alana also includes the $10,800 [600 x ($38 $20)] gain on the sale of the stock in her gross income. She will use Mac’s purchase price (carryover basis) of the stock to determine her gain on the sale. b. $1,969.50. Because the gain on the sale of the stock is short-term capital gain, it

Chapter 1: An Introduction to Taxation 39

will be taxed at ordinary income rates. Mac’s 33% marginal tax rate would apply to the short-term capital gain and his rate for dividend income would be 15%.

Alana’s 15% marginal tax rate applies to the short-term capital gain and her rate for dividend income is zero. The difference in the tax rates on the STCG between Mac and Alana is 18% (33% - 15%) resulting in a $1,944 ($10,800 x 18%) tax savings. The difference in the tax rates on the dividend income is 15% (15% for Mac – zero for Alana) resulting in a $25.50 ($170 x 15%) tax savings. By having the $10,970 total income taxed to Alana rather than Mac, the family has a total tax savings of $1,969.50 ($1,944 + $25.50).

Note that this solution specifies that Alana is age 24. As discussed in Chapter 12, the kiddie tax provision can cause some unearned income of children under age 24 to be taxed at their parent’s marginal tax rate.

29. [LO 3.4] Municipal Bonds Solution: Carl recognizes gain of $3,000 ($43,000 - $40,000) on the sale of the stock. The interest is nontaxable because these are tax-exempt municipal bonds.

30. [LO 3.4] Taxable vs. Nontaxable Bonds Solution: a. Jessica’s after-tax cash flow from the municipal bonds is $550 (5.5% x $10,000) because this interest income is tax exempt. For the corporate bonds, Jessica will receive $700 ($10,000 x 7%) in interest income but will pay $105 ($700 x 15%) in tax on that income resulting in an after-tax cash flow of $595 ($700 - $105). b. Jessica will now pay $196 ($700 x 28%) in tax on the corporate bond interest income resulting in after-tax cash flow of only $504 ($700 - $196) while her aftertax cash flow from the municipal bonds is still $550.

31. [LO 3.4] Gift Loan Solution: a. There are no tax consequences to Joshua or Seth because the loan is not in excess of $100,000 and the proceeds are used for personal expenses (rather than investment); the transaction is not subject to the imputed interest rules. b. The imputed interest rules treat the transaction as if Seth paid $4,000 in interest ($100,000 x 4%) to Joshua each year with Joshua recognizing $4,000 of interest income; Joshua would then be assumed to make a gift of $4,000 annually to Seth.

Thus, Joshua must recognize $4,000 in interest income (from the interest imputed at the federal rate) annually and Seth recognizes $8,000 of interest income (from his investment in corporate bonds). If Seth’s net investment income is less than $4,000, the imputed interest will be limited to the lower net investment income.

32. [LO 3.4] Employee/Shareholder Loans Solution: Lynn is assumed to pay Sheldon Corporation $3,200 in interest (4% x $80,000) on the loan. Sheldon has $3,200 in interest income. If Lynn is an employee, Sheldon is assumed to then return the $3,200 to Lynn as taxable compensation, deductible by the corporation. If Lynn is a shareholder, the return of the $3,200 is assumed to be taxable dividend income to Lynn but nondeductible by the corporation.

33. [LO 3.4] Gross Income from Investments

40

Solution: $11,800. George must include in gross income all except the $1,000 distributed by ABC as a nontaxable distribution. Thus, his gross income must include the $4,000 taxable distribution from ABC and both the $6,500 dividend and the $1,300 capital gain distribution from Brightstar for a total of $11,800.

34. [LO 3.4] Stock Dividend Solution: Cheryl recognizes no income from the receipt of the stock dividend. She will spread the basis of the original 100 shares over the new total of 300 shares. Each of the 300 shares will now have a basis of $3.33 [(100 x $10)/300].

35. [LO 3.4] Annuities Solution: a. $3,000. If Charles lives for 15 years, he will receive a total of $165,000 (15 x $11,000). $120,000 of this represents a return of his investment; the remaining $45,000 represents income earned on this investment and is taxable. Of each $11,000 payment, $3,000 [($45,000/$165,000) x $11,000] must be included in income. The remaining $8,000 is a tax-free return of his investment. b. If Charles dies after receiving only $77,000 (7 years at $11,000 per year), he will have recovered only $56,000 (7 x $8,000) of his total $120,000 investment.

The remaining $64,000 ($120,000 - $56,000) can be deducted on his final tax return.

36. [LO 3.4] Annuities Solution: $13,750. All of the contributions to Barney’s retirement plan except for the $20,000 from after-tax employee contributions will be taxable when received along with the excess received over the total investment. Thus, of the $240,000 in expected payments, $220,000 is taxable. Of each $15,000 payment, $13,750 [$15,000 x ($220,000/$240,000)] must be included in Barney’s gross income.

37. [LO 3.4] Income from Lottery Winnings Solution: Julie must include all $500,000 of each payment received in years 1 through 4 in income when received. When she sells her rights to the remaining 26 payments for $8,900,000, the $8,900,000 must be included in income when received.

38. [LO 3.4] Social Security Benefits Solution: $31,600. Vera’s modified adjusted gross income is $64,000 [$18,000 + $38,000 + ($16,000 x 50%)]. Because her MAGI exceeds $34,000, she will have to include up to 85 percent of her Social Security benefits in her income determined as the lesser of (1) $13,600 (85% x $16,000) or $30,000 [85% ($64,000 - $34,000) + $4,500] . The inclusion of the tax-exempt interest in MAGI is sufficient to put her in the position of having to include $13,600 of her Social Security benefits in income. Thus, her gross income is $31,600 ($18,000 dividend income + $13,600 Social Security benefit). Although the tax-exempt bond interest must be included in determining modified adjusted gross income, it is not included in determining gross income for tax purposes.

39. [LO 3.4] Social Security Benefits Solution: $5,000. Jeff’s modified adjusted gross income does not exceed $25,000 so none of

Chapter 1: An Introduction to Taxation 41

his $18,000 social security benefits are included in his gross income. His gross income consists of only the $5,000 interest income.

40. [LO 3.4] Damage Payments for Injuries Solution: $5,000. Mike must include the $2,000 for emotional distress and $3,000 for lost wages in his income. The $12,000 for the physical injuries is excluded from income as a return of his human capital. His gross income is $5,000.

41. [LO 3.4] Tax Consequences of Divorce Solution: a. Harriet must recognize the $1,300 monthly alimony payment as income ($15,600 annually). She has no income on the transfer of the home as part of the divorce settlement or for the child support payments. b. Stu is permitted to deduct the monthly alimony payments of $1,300 ($15,600 annually) in determining his adjusted gross income.

42. [LO 3.4] Cancellation of Debt Solution: Markum must recognize a $15,000 ($60,000 - $45,000) taxable gain on the transfer of the property as if it had sold the property for $60,000 and used the proceeds to pay the debt.

43. [LO 3.4] Recovery of Bad Debt Solution: a. Sandle would recognize $15,000 of income in year 1. In year 2 it would write off (deduct) the $15,000 as a bad debt as a result of Jim’s bankruptcy. In year 3, it would recognize $12,000 of income on the recovery of that portion of the debt that had been written off in the prior year. b. If Sandle is a cash-basis taxpayer, it would recognize no income in year 1, would have no deduction in year 2, but would recognize $12,000 of income in year 3.

44. [LO 3.4] Taxable vs. Nontaxable Bonds Solution: a. Krystyna’s after-tax cash flow from the municipal bonds is $950 (4.75% x $20,000) because this interest income is tax exempt. For the corporate bonds, Krystyna will receive $1,000 ($20,000 x 5%) in interest income but will pay $150 ($1,000 x 15%) in tax on that income resulting in an after-tax cash flow of $850 ($1,000 - $150). b. Krystyna will now pay $330 ($1,000 x 33%) in tax on the corporate bond interest income resulting in after-tax cash flow of only $670 ($1,000 - $330) while her after-tax cash flow from the municipal bonds is still $950.

45. [LO 3.3 & 3.4] Shifting Income to Children Solution: a. Carlos has $9,200 gross income and Justin has none. Justin includes nothing in his gross income because he gave the stock to Carlos and is no longer the owner.

Carlos is taxed on the dividend income ($200) because he was the owner when the dividend was declared and paid. Carlos also includes the $9,000 [450 x ($38 $18)] gain on the sale of the stock in his gross income. He will use Justin’s purchase price (carryover basis) of the stock to determine his gain on the sale. b. $2,254. Because the gain on the sale of the stock is short-term capital gain, it

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will be taxed at ordinary income rates. Justin’s tax rate is 39.6% for the short-term capital gain and 20% for dividend income. The difference in the tax rates between Justin and Carlos on the short-term capital gain is 24.6% (39.6% - 15%) resulting in a $2,214 ($9,000 x 24.6%) tax savings. The difference in the tax rates on the dividend income is 20% (20% for Justin – zero for Carlos) resulting in a $40 ($200 x 20%) tax savings. By having Carlos taxed on the $9,200 total income rather than Justin, the family has a total tax savings of $2,254 ($2,214 + $40). c. $1,840. The gain on the sale of the stock is now long-term capital gain (8 months + 5 months = 13 months holding period) because Justin’s holding period tacks on to the period the gift is held by Carlos. Justin’s tax rate is 20% for the long-term capital gain and dividend income while Carlos has a zero rate for the long-term capital gain and dividend income. The difference in the tax rates between Justin and Carlos is 20% (20% for Justin – zero for Carlos) resulting in a $1,840 ($9,200 x 20%) tax savings.

This solution does not include the 3.8% net investment income (NII) Medicare surtax discussed in Chapter 5. Also note that this solution specifies that Carlos is age 24. As discussed in Chapter 12, the kiddie tax provision can cause some unearned income of children under age 24 to be taxed at their parent’s marginal tax rate.

46. [LO 3.5] Property from Gift or Inheritance Solution: Myra must include only the $7,000 interest from the bonds in her income. The receipt of a gift or inheritance is not subject to income tax.

47. [LO 3.5] Life Insurance Proceeds Solution: a. Zero. If Linda takes the lump-sum $500,000 payment, she recognizes no gross income, as life insurance proceeds are usually are not taxable. b. $8,000 each year. If she elects to take the insurance proceeds in annual installments, $80,000 of the total $580,000 (10 x $58,000) expected to be received will represent taxable interest. Of each annual $58,000 payment, $8,000 ($80,000/$580,000 x $58,000) will be income and $50,000 ($500,000/$580,000 x $58,000) will be tax free.

48. [LO 3.5] Disability Insurance Solution: $16,500. A portion of each payment that represents the premium paid by Mark’s employer is taxable income to Mark. Thus, if Mark collects $30,000 under the disability policy, $16,500 (55% x $30,000) must be included in gross income and the remaining $13,500 (45% x $30,000) is tax free.

49. [LO 3.5] Scholarships Solution: $4,000 is included in income. Sara must include the $1,000 that was spent for room and board and the $3,000 from her part-time job on campus in her income.

Only the money spent for tuition and required textbooks qualifies as the nontaxable portion of the scholarship.

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50. [LO 3.5] Scholarships Solution: $400 in year 2. Larry spent only $6,600 ($3,200 + $3,400) on qualified expenses from the scholarship money. Thus, he must include the $400 ($7,000 - $6,600) not spent on qualified expenses in income. He does not have to include this amount until year 2, however.

51. [LO 3.6] Income Recognition from Foreign Subsidiaries Solution: Zero. Because Small Corporation does not make any dividend distributions, Small’s $1.5 million is not subject to U.S. taxes. When the earnings are repatriated, Giant Corporation will be able to claim a foreign tax credit for the taxes Small paid to the foreign country on the income it recognizes.

Develop Planning Skills 52. [LO 3.2] Accounting Methods Solution: The cash method of recognizing income and expenses, if available, usually provides the higher net present value for the company’s cash flow. Income is not recognized until payment is received. This is usually later than when income would be recognized under the accrual method. By delaying the recognition of income, the payment of taxes on this income can be delayed. In addition, cashbasis taxpayers may have the ability to make early payments for expenses at yearend, accelerating their deductions. A deduction in the current year may be worth more than the same deduction in the next year due to the time value of money 53. [LO 3.2] Prepaid Rent Solution: If $4,000 is designated as the last two months’ rent, $4,000 must be included in income when received. If only $2,000 is designated as rent, then only $2,000 must be included in income when received. Thus, the designation of $4,000 as security deposit is better for Palace Company from a tax standpoint (although they might lose prospective tenants with a high security deposit).

54. [LO 3.4] Investment Alternatives Solution: With a marginal tax rate of 39.6 percent, her after-tax return on the corporate bonds is only 5.436 percent [9% x (1-.396)]. She would be better off investing in the tax exempt bonds that pay 6 percent. With a marginal tax rate of only 28 percent, her after-tax return on the corporate bonds improves to 6.48 percent [9% x (1- .28)], and she would be better off investing in the corporate bonds.

55. [LO 3.4] Tax Effects of Divorce Solution: a. To receive $15,000 after tax at a 15 percent marginal tax rate, Elizabeth would have to receive $17,647. If Kevin pays Elizabeth $17,647 as alimony, she will have a net after-tax cash flow of $15,000 after she pays the tax of $2,647 ($17,647 x .15). [The $15,000 after-tax is ―grossed-up‖ to the $17,647 before-tax amount by dividing $15,000 by .85 (100% - 15%)] b. If Kevin can deduct the $18,500 as alimony, he can reduce his taxes by $6,105 ($18,500 x 33%). His net after-tax cash outflow is $12,395 ($18,500 - $6,105). His cash flow improves by $2,605 ($15,000 nondeductible payment - $12,395 net

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after-tax alimony payment) over the $15,000 alternative. Elizabeth must pay $2,775 ($18,500 x 15%) tax on the alimony resulting in a net after-tax cash inflow of $15,725 ($18,500 - $2,775). Elizabeth’s cash position improves by $725 ($15,725 - $15,000).

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter.

56. [LO 3.2] Doctrine of Constructive Receipt Solution: Based on the doctrine of constructive receipt, the tax court judge would rule in favor of the IRS. The doctrine of constructive receipt requires Walter to recognize the income when the funds were made available to him. The $77,000 should be included as income in the year the original check was received. The fact that a tear slip exists, indicates that the check was received. If the check was detached and not received with the tear slip, Walter should have contacted the customer and requested another check to be sent immediately. This was the decision of the court in Walter v. U.S., 92 AFTR 2d. 98-5115, 148 F. 3d 1027, 98-2 USTC ¶50546.

57. [LO 3.4] Social Security Benefits Solution: The student should present a logical argument for or against the 100 percent tax rate on Social Security benefits of high-income individuals so answers will vary.

They may consider the following points.

The Social Security Act states that every individual who meets program eligibility requirements is entitled to benefits so it is referred to as an entitlement program.

Social Security was originally designed as social insurance meant to ensure that, regardless of which might happen with their personal finances and retirement savings over the course of their lifetime, elderly Americans would be protected by a government-based safety net that would prevent destitution in old age. The concept of Social Security as an earned right has helped ensure its high level of public support.

Public attention has recently focused on Social Security’s long-range financial problems with policy reformers suggesting that Social Security should be subject to some form of means testing. People in favor of means testing argue that this would save a large amount of money by reclaiming benefits from wealthy Americans who can get along fine without them while still allowing Social Security to serve its basic purpose of providing a safety net to the elderly. Higherincome individuals would be guaranteed that if their income level declined, they would be able to keep a greater share of their benefits.

People against means testing argue that Social Security would be fundamentally changed from social insurance to a redistributive welfare program. They argue that means testing would create a disincentive for people to save, buy other insurance, or work part-time in retirement. They also argue that such a system would create pressure for younger workers to be able to opt out of Social Security, threatening to undermine its political viability in the long term.

58. [LO 3.4] Retroactive Changes Solution: The student should try to present logical arguments why the retroactive inclusion

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of certain items in income should or should not be permitted by laws passed late in the year. For a long time it has been understood that interest on tax-exempt bonds has been excluded from income because Congress has continued the exclusion; it could change the law whenever it votes to do so. For a number of years now, Congress has retroactively reinstated deductions so there is significant precedence for Congress to be allowed to act at any time during the year and have those actions apply retroactively to the beginning of the tax year. The primary argument against allowing this type of retroactive law is that it does not allow taxpayers to plan adequately. However, it is hard to argue that the law that states Congress can tax income from whatever source would not apply to income earned during the year the law is passed. It would be a different matter if Congress were to act retroactively to tax items received in prior tax years as there has always been the concept of tax years to provide closure for the taxpayer for prior years.

59. [LO 3.4] Alimony Recapture Solution: Part of any payments structured as alimony payments that decrease by more than $15,000 per year from year 1 to year 2 and then again from year 2 to year 3 can be recharacterized as property settlements. The portion so recharacterized must be recaptured (taken into income) by the payor and can be deducted by the recipient in the third year. To prevent this reclassification as nondeductible property settlement, alimony payments during the first three years should not decrease by more than $15,000 between years.

60. [LO 3.5] Insurance Transfer Solution: Joe will have income for the $800 ($5,000 - $4,200) portion of the debt that Willy forgives as part of accepting the cash surrender value of the policy to cancel the debt. When Joe is killed, Willy’s basis in the insurance policy is $5,050 ($5,000 debt + $50 premium payment). He will have income of $19,950 on the collection of the $25,000 from the insurance policy. When a policy is transferred to a third party for money or money’s worth, the receipt of the face value of the policy is no longer tax free. Income must be recognized based on the proceeds received and the purchaser’s investment in the policy at the time of the decedent’s death.

61. [LO 3.2, 3.4 & 3.5] Doctrine of Constructive Receipt Solution: This question is based on an Oprah Winfrey show. The only significant difference is that Oprah gave more than 300 audience members debit cards for only $1,000 each.

1. Does the receipt of the debit card (―prize‖) result in $15,000 taxable income to the recipient even if the recipient does nothing further with the card? Even though the prize is not supposed to be used for one’s own use, would the recipient’s control over the disbursement of the proceeds from the debit card be sufficient to cause the recipient to have taxable income under Section 61? Do constructive receipt principles apply? Reg. Sec. 1.451-2 states ―...income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.‖ Will the stipulation that the use of the card be for a charitable cause amount to a ―substantial limitation or restriction‖? There does not appear to be a way for the show to effectively enforce this so it is doubtful that this

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stipulation will qualify as a substantial restriction but there is no authority directly on point.

2. If the receipt of the card is not itself a taxable event, what about the actual usage of the card? What are the ramifications for the audience participants who transfer the $15,000 to their selected person or cause? The drawing down of cash (regardless of the intent for so doing) is actual (not merely constructive) receipt of the money. This will substantially increase the risk that the recipient of the debit card has gross income under Section 61 at the moment of cash withdrawal. Again, there is no authority directly on point.

3. If the audience members give the money to a qualified charitable organization, the individuals can claim a charitable contribution deduction only if they itemize their deductions. If they have no other itemized deductions, their tax benefit from the contribution will be limited to the amount it exceeds their standard deduction (thus, not completely offsetting their $15,000 gross income).

4. If the audience members donate the money to a needy person instead of a qualifying charitable organization, they would have $15,000 of gross income and would have made a taxable gift of $1,000 ($15,000 gift less $14,000 annual exclusion) assuming they had not given other amounts that year to the same donee.

5. Will the Bank of America be able to deduct the payouts on the debit cards as a business expense (possibly as marketing)? Most likely it will get some deduction.

The bank would not, however, qualify for any charitable contribution deductions because it has no control over which donees are selected by the audience members.

6. Must the value of the DVD recorders be included as taxable income as a prize?

Alternatively were the DVD recorders merely ―loaned‖ to the audience members, to be returned when the future show is taped? Will only those audience members who return for the future show (with a recorded story for use on the show) be permitted to keep the recorder? Will they have taxable compensation income from providing their video recording services in exchange for being permitted to keep the DVD recorders? It certainly seems likely they would have taxable income.

Search the Internet 62. [LO 3.4] Locate IRS Publication and Calculate Income Solution: $2,500. Add one-half of $10,000 social security benefits to the $20,000 dividend income and the $5,000 of tax-exempt bond interest, resulting in a total of $30,000.

Subtract the $25,000 base amount for a single individual from the $30,000 total yielding $5,000 in excess of the base amount. Because the excess beyond the base amount ($5,000 excess) is less than $9,000, no more than half the benefits will be taxed. Compare $2,500 (half of the $5,000 excess beyond the base amount) to $5,000 (half of the Social Security benefits of $10,000). The smaller of these two ($2,500) is included in the taxpayer’s gross income. Thus, the taxpayer’s gross income is $22,500 ($20,000 dividend income + $2,500 taxable Social Security income).

63. [LO 3.4] Locate IRS Publication and Determine Countries Where Exempt

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Solution: U.S. citizens who are residents of the following countries are exempt from U.S. tax on their benefits: Canada, Egypt, Germany, Ireland, Israel, Romania, and the United Kingdom. A resident of Italy is exempt but only if also a citizen of Italy.

64. [LO 3.4] Dividend Income from Foreign Corporations Solution: Dividend income received from foreign corporations located in China or Jamaica will be treated as qualified dividends eligible for the reduced tax rate. However, dividend income from Bermuda and the Netherland Antilles is not eligible for the reduced dividend tax rate.

65. [LO 3.5] Consequences of Frequent Flyer Miles Solution: The IRS policy for now is that it will not assert that a taxpayer has understated his or her federal tax liability because of the receipt or personal use of frequent flyer miles attributable to business or official travel. Any future guidance on the taxability of these benefits will be applied prospectively only.

Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

66. [LO 3.2] Barter Transactions Solution: Will Jason or Bob’s Auto Repairs be required to recognize any income as a result of this barter arrangement? Will they be entitled to a deduction for repair expenses?

67. [LO 3.2] Prepaid Rent Solution: How should the landlord treat the prepayment of 3 months’ rent that is characterized as part rent and part security deposit? In which year(s) is income recognized and does the answer change if the landlord is an accrual basis taxpayer rather than cash basis?

68. [LO 3.2] Timing and Amount of Income Solution: When should Sid’s Body Shop recognize the income for the repair work? How should it handle the reduction in expected payment from $2,000 to $1,700?

69. [LO 3.4] Treasure Find Solution: Does Gillian have any taxable income as a result of her treasure find? If yes, how would the amount of income be determined?

70. [LO 3.4] Tax Effects of Divorce Solution: How will the $1,000 payment be treated for tax purposes, as alimony, child support, or a combination of the two?

71. [LO 3.4] Cancellation of Debt Solution: Does Sharp Corporation have income or other tax consequences as a result of the creditor writing off $20,000 of its debt?

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72. [LO 3.6] Bond Interest Solution: Is interest income on bonds issued by a foreign governmental entity taxable or taxexempt?

Develop Research Skills Solutions to research problems 73 – 77 are included in the Instructor’s Manual.

Fill-in the Forms The solution to tax form problem 78 is included in the Instructor’s Manual.

Solutions to Chapter 4 Problem Assignments Check Your Understanding 1. [LO 4.1] Excessive Compensation Solution: No. Jenny's excess $8,000 [($15 - $7) x 1,000 hours] salary over what other employees would earn is considered excessive compensation. The $8,000 would probably be reclassified as a dividend, treated as dividend income to Barbara (Jenny’s mother) but no longer deductible by the corporation.

2. [LO 4.2] Employee Fringe Benefits Solution: No. Anne has no income from these benefits because they are within the limits for exclusion. Under an educational assistance plan, up to $5,250 can be excluded; if the education qualifies as a working condition fringe benefit, there is no dollar limit on the exclusion. Parking valued at up to $255 per month can be excluded and up to $5,000 per year as a dependent care benefit can also be excluded.

3. [LO 4.2] Employee Discount vs. Bargain Purchase Solution: A qualified employee discount is a discount within allowable limits provided on a nondiscriminatory basis and is excluded from the employee's income. The excludable discount on merchandise is limited to the gross profit percentage times the price charged to customers. The excludable discount for services cannot exceed 20 percent of the price normally charged to customers. Discounts in excess of the allowable limits are taxed to the employee as compensation. A bargain purchase is a discount that is made available only to select employees and is taxable as additional compensation income to the employee.

4. [LO 4.2] De Minimis Benefits Solution: Only the $50 check in part d must be included in income. Items a, b, and c are excluded de minimis fringe benefits.

5. [LO 4.2] Moving Expenses

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Solution: She can either (1) deduct the moving expenses on her year 1 tax return or (2) wait until the time requirement is satisfied and file an amended return for year 1. If the expenses are deducted in year 1 and the time requirement is not met, the employee must either include the amount previously deducted for moving expense as other income in the current year or file an amended return excluding the previously deducted moving expenses.

6. [LO 4.3] Stock Options Solution: ISOs receive favorable tax treatment from the perspective of the employee because they do not trigger income recognition at either the grant date or at exercise. Instead, the employee recognizes income when the stock is sold and the employee recognizes long-term capital gain rather than ordinary income. A negative feature of ISOs is that the employer receives no compensation deduction at any time for the option. An ISO has certain restrictions imposed on the option price, transferability, and exercise.

A NQSO is more flexible, but the tax treatment is not as favorable for the employee.

No income is generally recognized at the grant date unless the strike price is below the fair market value and the option is exercisable. If so, the employee has income equal to that difference between the option and strike price and the corporation has a corresponding deduction at that time. The employee, however, recognizes ordinary income on a NQSO when he or she exercises the option. The amount of ordinary income recognized is the difference (called the bargain element) between the strike price (or the higher fair market value at grant) and the fair market value of the stock on the exercise date. The employer claims a matching compensation deduction when the employee recognizes income.

7. [LO 4.3] Phantom Stock and SARs Solution: A phantom stock plan and a stock appreciation right (SAR) plan provide the advantages of stock options without employees owning stock.

8. [LO 4.3] Phantom Stock and SARs Solution: Both phantom stock plans and stock appreciation right (SAR) plans capture the appreciation of company stock without requiring employees to buy the stock.

Alternatively, employers could offer NQSOs that employees can exercise under a cashless program. In a cashless program, the employee immediately sells some or all of the shares at the market rate and receives the proceeds from the sale less the strike price, withholding taxes, and brokerage commissions.

9. [LO 4.4] Qualified Retirement Plan Solution: The employer gets an immediate tax deduction as contributions are paid into a plan while the earnings accumulate tax free and the employee’s tax is deferred until the benefits are received in a future year. Employees can make contributions to the retirement plan with before-tax earnings, postponing the tax on both the contributions and the earnings until the funds are withdrawn from the plan.

10. [LO 4.4] Qualified vs. Nonqualified Retirement Plans

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Solution: Qualified plans have more advantages (such as an immediate tax deduction as contributions are paid into a plan while earnings accumulate tax free), but they have contribution limits and must be offered on a nondiscriminatory basis generally to all employees. Under a nonqualified plan, an unlimited amount of compensation for highly compensated executives can be deferred without extending the plan benefits to other employees.

11. [LO 4.4] Deferred Compensation Solution: (1) Ricardo includes the entire $3,900,000 ($325,000 x 12 months) in taxable income this year and his employer deducts the same.

(2) If the contract provides for $900,000 in deferred compensation, Ricardo includes only $3,000,000 ($250,000 x 12 months) in income this year and is taxed on the $900,000 in the year he receives it. His employer is allowed a deduction of $3,000,000 in the current year and will deduct the $900,000 deferred compensation when it is paid.

12. [LO 4.4] Individual Retirement Accounts.

Solution: No. Under a traditional IRA, the taxpayer may qualify for a deduction but all contributions and earnings are taxed when withdrawn. If an individual is not covered by another employer retirement plan, then he or she can contribute and deduct up to $5,500 (plus an additional $1,000 if age 50 or older) to a traditional IRA. If the individual is covered by an employer-sponsored plan, then the contribution deduction may be limited based on the employee's adjusted gross income. In either case, the earnings on the amounts contributed are not taxable until they are withdrawn from the IRA. Under a Roth IRA, the earnings (as well as all contributions) can be withdrawn tax free, but contributions to a Roth IRA are not deductible.

13. [LO 4.4] Individual Retirement Accounts Solution: a. Sharon should use a Roth IRA because the earnings are tax-free when withdrawn. She avoids tax in the later higher-tax years when the contributions will be withdrawn. b. Ken should use a traditional IRA because he will get a deduction now for the contribution and he defers taxation on the earnings until he withdraws the funds in retirement when his tax rate will be the same or lower. c. Susan should use a Roth IRA because there is no minimum distribution requirement during the owner's lifetime. The funds can be left in the account to grow tax free and then passed on to beneficiaries.

14. [LO 4.2 & 4.5] Fringe Benefits for Self-Employed vs. Employees Solution: Owners who are employees of a C corporation are eligible for all the employee fringe benefits discussed in this chapter. Partners are considered self-employed individuals and cannot participate in many of the fringe benefits provided on a taxfree basis to employees. They must use after-tax dollars for these benefits that employees obtain with before-tax dollars. Some of the benefits that self-employed individuals cannot receive on a tax-free basis include health and accident

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insurance, group term life insurance, on-premises lodging, employee achievement awards, moving expenses, transit passes, and parking benefits. To mitigate the difference in this treatment, self-employed individuals may deduct the cost of health insurance premiums for AGI. Although S corporation shareholders can be paid a salary as an employee, if they own more than 2 percent of the S corporation's outstanding stock, they are ineligible for most tax-free fringe benefits and are treated the same as partners for fringe benefit purposes.

15. [LO 4.6] Foreign Earned Income Exclusion Solution: John can elect to exclude up to $102,100 in 2017 under the foreign earned income exclusion. He may also be eligible for the exclusion for excess housing costs.

16. [LO 4.6] Tax Reimbursement Plans Solution: A tax protection plan reimburses an individual for any U.S. or foreign taxes paid in excess of the liability he or she would have incurred in U.S. tax if the individual had remained in the United States. If actual taxes are lower than the assumed tax liability, the employee benefits from the foreign assignment because only the actual U.S. and foreign taxes are paid; the employee keeps any tax savings. Thus, under a tax protection plan, an employee may realize significant tax savings in a move to a low-tax country. From an employer’s perspective, however, employees may be reluctant to accept assignments in high-tax countries in which actual taxes exceed the assumed U. S. tax.

Under a tax equalization plan, an employee working in a foreign country has the same net tax liability he or she would have paid had the employee remained in the United States. To achieve this balance, the employee’s salary is reduced by the hypothetical U.S. tax, but the employee is then reimbursed for the actual U.S. and foreign taxes on the covered income. Under this plan, the employer pays any excess tax but keeps any tax benefit from having employees in low-tax countries.

This helps offset the tax costs of having employees in high-tax countries and also prevents employees from preferring one foreign assignment over another merely due to tax differences. Although the objectives of tax protection and equalization plans are similar, a tax equalization plan is usually considered less costly for the employer. Any amounts excluded under foreign earned income or housing cost exclusions reduce the cost of protection or equalization plans to employers because the company does not have to reimburse the employee for U.S. tax on those amounts.

Crunch the Numbers 17. [LO 4.1] Employee Payroll Taxes Solution: Both Largo Corporation and Melissa will pay $9,757 in taxes; the corporation can deduct all of the taxes it pays. $127,200 ceiling limit x 6.2% = $7,886.40 Social Security tax ($105,000 + $24,000) x 1.45% = $1,870.50 Medicare tax $7,886.40 + $1,870.50 = $9,756.90 tax paid and deductible by Grand Corporation Melissa will also pay $9,756.90.

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18. [LO 4.1] Employee Payroll Taxes Solution: Both Grand Corporation and Rebecca will pay $11,294 in taxes; the corporation can deduct all of the taxes it pays. $127,200 ceiling limit x 6.2% = $7,886.40 Social Security tax ($190,000 + $45,000) x 1.45% = $3,407.50 Medicare tax $7886.40 + $3,407.50 = $11,293.90 tax paid and deductible by Grand Corporation Rebecca will also pay $11,293.90.

19. [LO 4.1] Excessive Compensation Solution: There will be an overall increase in taxes of $23,986. $200,000 will not be deductible by Charlie Corporation increasing its tax liability by $68,000 ($200,000 x 34%). Charlie Corporation will save $2,900 ($200,000 x 1.45%) in Medicare taxes but lose the $986 ($2,900 x 34%) tax savings from deducting the Medicare taxes resulting in a net tax increase of $66,086 ($68,000 + $986 - $2,900). There is no change in Social Security taxes because the compensation is above the $127,200 limit.

Charlie will be taxed on the $200,000 at the 20% dividend income rate so he will save $39,200 [(39.6% - 20%) x $200,000] in income taxes in addition to the $2,900 savings in Medicare taxes for a total of $42,100.

The net effect will be an increase in overall taxes of $23,986 ($66,086 - $42,100).

As discussed in Chapter 5, Charlie’s actual savings will be $5,800 less when the Medicare surtaxes are considered. Charlie's $200,000 of salary income would have been subject to the 0.9% Medicare surtax on salaries; that is now replaced by the 3.8% NII Medicare surtax. He will pay a higher NII Medicare surtax of $5,800 [(3.8% NII surtax – 0.9% surtax) x $200,000] resulting in a net tax savings to him of only $36,300 ($39,200 + $2,900 - $5,800) and a total increase in overall taxes of $29,786 ($66,086 - $36,300).

20. [LO 4.1] Timing of Compensation Solution: Because Amy is a cash-basis taxpayer she includes the salary and bonus in income in the year she receives it.

Year a. Amy b. Vargus Corporation 1 $100,000 $100,000 2 $130,000 $162,000 3 $132,000 $100,000 Vargus Corporation must pay the accrued bonus within 2½ months after year-end to deduct it in the year accrued. If paid later than 2½ months after year-end, it is deducted in the year paid.

21. [LO 4.2] Group Term Life Insurance Solution: a. Tom must include $914 in income. $110,000 - $50,000 excluded = $60,000 taxable coverage. (60 increments x $1.27 table rate x 12 months = $914.40)

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b. $914. c. $914. d. $3,000. Tom is a key employee and the plan is discriminatory so he must include in income the greater of the actual premiums ($3,000) or the $1,676.40 computed from the table without excluding the first $50,000 (110 increments x $1.27 table rate x 12 months = $1,676.40).

22. [LO 4.2] Fringe Benefits under Cafeteria Plan Solution: Priscilla includes $72,700 in income ($70,000 salary + $2,700 cash benefits). The group term life insurance and health insurance are tax-free benefits.

23. [LO 4.2] Flexible Spending Arrangement Solution: a. Zero. It is all excluded. b. Zero. It is all excluded. c. It is forfeited. There is no adjustment to Jennifer's income or taxes for the unused amount placed in the FSA. 24. [LO 4.2] Lodging vs. Cash Allowance Solution: Clark must include $34,800 in income [$30,000 salary + ($400 x 12 months)].

Lodging must be required as a condition of employment to be excluded.

25. [LO 4.2] Employee Discount Solution: Yes, $100 is taxable. The excludable discount for services cannot exceed 20 percent (20% x $500 = $100 maximum tax-free discount). Kevin's discount was $200 - $100 maximum tax-free discount = $100 excess discount that is taxable.

26. LO 4.2] Tax-Free Fringe Benefits Solution: Zero. All of the fringe benefits are tax free. An employer can provide up to $50,000 in group term life insurance and an unlimited amount of medical insurance tax free. Up to $5,000 of dependent care benefits can be provided tax free. Employee discounts for merchandise are tax free as long as the employee pays at least the employer's cost.

27. [LO 4.2] Moving Expense Qualification Solution: a. The important distances are the 15 miles from the old home to the old employer and the 70-mile distance the commute would be if she did not move. b. She exceeds the minimum by 5 miles. (70 miles - 15 miles = 55 miles - 50 mile minimum = 5 miles) 28. [LO 4.2] Moving Expense Deduction and Reimbursement Solution: a. Susan can deduct $2,500 ($2,300 transportation for household goods + $200 airfare). b. Susan will have $1,100 in taxable income ($3,600 reimbursement - $2,500 qualified expenses = $1,100).

29. [LO 4.3] Restricted Stock Solution: a. (1) zero; (2) $75,000; (3) $25,000. Luis will not recognize any income until the

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stock vests. Upon vesting, Luis will have $75,000 ordinary income equal to the fair market value at that time. When he sells the stock, Luis will recognize a capital gain of $25,000 ($100,000 - $75,000 basis). b. (1) $20,000; (2) zero; (3) $80,000. If Luis makes an election to accelerate the recognition of income, he will recognize the $20,000 fair market value of the stock as ordinary income in the year the stock is issued. There is no recognition of income or gain when the stock vests. Upon sale of the stock, Luis will recognize a long-term capital gain of $80,000 ($100,000 - $20,000 basis). c. No. If Luis leaves the company before the stock vests, he will not be allowed a refund or deduction for any taxes paid as a result of the prior income recognition.

30. [LO 4.3] Nonqualified Stock Options Solution: a. Zero. No income is recognized when the option is granted because the option price exceeds the fair market value of the stock. b. $120,000 bargain element is ordinary income. [($50 FMV - $10 strike price) x 3,000 shares = $120,000] c. There are no tax consequences in the year of grant but Cargo deducts the $120,000 bargain element as compensation paid in the year Mark exercises the options.

31. [LO 4.3] Incentive Stock Options Solution: a. Zero. No income is recognized when the option is granted. b. Zero. No taxable income when the option is exercised (however, the bargain element is subject to the alternative minimum tax). c. Zero. No deduction for Netcom in the year of grant or exercise. d. Karen has an $88,000 capital gain [($50 selling price - $6 cost) x 2,000 shares].

Netcom receives no tax deduction and thus no tax benefit.

32. [LO 4.3] Stock Appreciation Rights Solution: a. Zero. There is no income when the SARs are granted. b. $12,000 ordinary income recognized when she exercises the SARs. [($60 - $20) x 300 SARs] c. $8,640. Maria will pay a tax of $3,360 ($12,000 x 28%) on the exercised SARs. Maria’s after-tax cash flow from the exercise of the SARs is $8,640 ($12,000 $3,360 tax). d. Yes. Handcock deducts $12,000 as compensation expense the same year that Maria exercises the SARs and is taxed on the income.

33. [LO 4.2 & 4.4] Employee Benefits Solution: Larry recognizes $55,829 in income and Horizon deducts $66,620. Larry’s income includes his net salary of $55,800; this is the $60,000 salary reduced for the $4,200 (7% x $60,000) contributed to the retirement plan. He also must include $29 in income for the life insurance (80 - 50 = 30 increments x .08 x 12 months = $28.80).

Horizon deducts $60,000 salary + $120 life insurance + $3,900 medical insurance

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+ $2,500 pension contributions + $100 watch = $66,620.

34. [LO 4.4] Individual Retirement Account Solution: a. $5,000. No phase-out when he is not covered by an employer-sponsored plan. b. $3,900 is deductible. ($66,000 - $62,000)/$10,000 = 40% phased out. $6,500 maximum – ($6,500 x 40%) = $3,900 maximum deductible amount he can deduct.

35. [LO 4.4] Roth IRA Solution: a. Zero. Her adjusted gross income exceeds $133,000. b. $5,500. Her income is below $118,000 where the phase-out of contributions begins. c. $3,500. She must reduce her maximum allowable Roth contribution deduction of $5,500 by the $2,000 she contributes to her traditional IRA. 36. [LO 4.5] Self-Employment Tax Solution: a. $3,532 ($25,000 x 92.35% x 15.3%). b. $1,766, the employer’s half of the tax, is deductible for AGI. c. Zero. No self-employment tax is owed when there is a loss.

37. [LO 4.5] Self-Employment Tax Solution: George pays $5,554 and deducts $2,777. George first multiplies his $43,000 selfemployment income by 92.35% = $39,710.50. George then reduces the $118,500 ceiling by the $83,000 of employee earnings on which social security tax has already been paid. Only $35,500 ($127,200 - $91,700) of his self-employment earnings is subject to the social security tax; however, his entire $39,710.50 of self-employment earnings is subject to the Medicare tax (because there is no limit on Medicare taxes). George’s self-employment taxes are $5,553.60 [$35,500 x 12.4% = $4,402) + ($39,710.50 x 2.9% = $1,151.60)] George deducts one-half of his self-employment taxes of $2,776.80 [($35,500 x 6.2% = $2,201) + ($39,710.50 x 1.45% = $575.80)] as a deduction for AGI. 38. [LO 4.5] Self-Employment Tax Solution: Melissa pays $5,652 and deducts $2,826.

Melissa first multiplies her $40,000 self-employment income by 92.35% = $36,940. Melissa then reduces the $127,200 ceiling by the $90,000 of employee earnings on which social security tax has already been paid leaving up to $37,200 still subject to Social Security tax. Because her $36,940 of self-employment income is less than $37,200, the $36,940 is subject to Social Security as well as Medicare tax, so a combined rate of 15.3% (12.4% + 2.9%) can be used. Melissa’s self-employment taxes are $5,651.82 ($36,940 x 15.3%).

Melissa deducts one-half of her self-employment taxes ($5,651.92 x 50%) = $2,825.91)] as a deduction for AGI. 39. [LO 4.5] Self-Employed Health Insurance Solution: Yes, $9,200 ($2,300 x 4 employees) for employee insurance premiums is deductible from the business income of the sole proprietorship on Luis's Schedule

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C. $2,300 for Luis's own insurance is deductible for AGI on the first page of his Form 1040.

40. [LO 4.5] IRA Eligibility for Self-Employed Solution: $45,000 earned income. The rental and interest income do not count and the salary is not reduced for the business loss in determining the earned income for his IRA contribution.

41. [LO 4.6] Foreign Earned Income Exclusion Solution: The exclusion saves $11,582. If Wendy claims the foreign earned income exclusion, she excludes the $95,000 salary, leaving only $10,000 of taxable income on which she will pay a U.S. tax of $2,800 (using the 28% rate that applies to income from $95,000 to $105,000). If she does not claim the foreign earned income exclusion, Wendy's taxable income is $105,000 ($95,000 foreign salary plus $10,000 other taxable income). The U.S. tax on $105,000 is $22,381.75 [$18,713.75 + 28% ($105,000 - $91,900)]. Wendy can claim a tax credit for the $8,000 in foreign tax paid, reducing her U.S. tax to $14,382 ($22,382 - $8,000).

The income exclusion results in a tax savings of $11,582 ($14,382 - $2,800).

42. [LO 4.6] Foreign Tax Credit Solution: $2,685. If Mark claims the $102,100 foreign earned income exclusion, the amount ineligible for the credit is $15,315 [$18,000 x ($102,100/$120,000)], leaving $2,685 ($18,000 - $15,315) in creditable taxes.

Develop Planning Skills 43. [LO 4.1] Net Present Value of After-Tax Compensation Solution: a. The net present value of the after-tax cash flows for Melinda are $87,250 from Argus and $89,394 from Dynamic computed as follows: After-tax cash flow from Argus salary: Year 1: $75,000 – ($75,000 x 25%) – ($75,000 x 7.65%) = $50,513 Year 2: $75,000 – ($75,000 x 33%) – ($75,000 x 7.65%) = $44,513 NPV of Argus salary: ($50,513 x .943) + ($44,513 x .890) = $87,250 After-tax cash from Dynamic salary: Year 1: $100,000 – ($100,000 x 25%) – ($100,000 x 7.65%) = $67,350 Year 2: $49,000 – ($49,000 x 33%) – ($49,000 x 7.65%) = $29,082 NPV of Dynamic salary: ($67,350 x .943) + ($29,082 x .890) = $89,394 The NPV of the after-tax cost for the corporations are $98,183 for Argus and $98,491 for Dynamic computed as follows: After-tax cost for Argus: FICA tax = $5,738 ($75,000 x 7.65%) FUTA = $420 ($7,000 x 6%)

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Year 1: [$75,000 + $5,738 + $420] x (1-.34) = $53,564 Year 2: [$75,000 + $5,738 + $420] x (1-.34) = $53,564 NPV of the cost of Melinda’s salary: ($53,564 x .943) + ($53,564 x .890) = $98,183 After-tax cost for Dynamic: Year 1: [$100,000 + ($100,000 x 7.65) + $420] x (1-.34) = $71,326 Year 2: [$49,000 + ($49,000 x 7.65%) + $420] x (1-.34) = $35,091 NPV of the cost of Melinda’s salary: ($71,326 x .943) + ($35,091 x .890) = $98,491 b. (1) The best alternative for Melinda would be Dynamic because it results in $2,144 ($89,394 - $87,250) higher net present value of after-tax cash flows than offered by Argus.

(2) From the corporations’ perspective, Argus’s offer provides a slightly lower after-tax cost but the difference is only $308 ($98,491 - $98,183).

44. [LO 4.1] Maximizing After-Tax Compensation Income and Deduction Solution: The bonus option is better for both Miguel and the corporation, assuming Miguel is willing to accept the risk.

After-tax cash flow to Miguel from $2,000,000 salary: $2,000,000 – ($2,000,000 x 39.6%) – ($2,000,000 x 1.45% Medicare) = $1,179,000 After-tax cash flow to Miguel from $1 million salary + $1.25 million bonus: $2,250,000 – ($2,250,000 x 39.6%) – ($2,250,000 x 1.45%) = $1,326,375 After-tax cash outflow for corporation from $2,000,000 salary: $2,000,000 + ($2,000,000 x 1.45% Medicare = $29,000) – ($1,029,000 x 35% tax savings) = $2,029,000 - $360,150 tax savings = $1,668,850 After-tax cash outflow for corporation from salary + bonus: $2,250,000 + ($2,250,000 x 1.45% Medicare = $32,625) – ($2,282,625 x 35% $798,918.75 tax savings) = $2,282,625 - $798,918.75 tax savings = $1,483,706.25 The bonus option provides Miguel with a $147,375 ($1,326,375 - $1,179,000) higher after-tax cash inflow and the bonus option also provides the corporation with a $185,144 ($1,668,850 - $1,483,706) lower after-tax cash outflow. The catch is the Miguel bears the risk of the contingent compensation so he must consider this before he accepts the offer. (Note: Using incremental analysis, the 6.2% Social Security tax and FUTA are omitted as they are the same for both options. Also omitted is the Medicare surtax discussed in Chapter 5.)

45. [LO 4.2 & 4.4] Planning for Salary Increase Solution: Some possible opportunities include:  Taking some of the salary in the form of additional tax-exempt fringe benefits

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 Having some of the salary put into qualified and nonqualified deferred compensation plans  Investing the money saved in tax-exempt securities.

46. [LO 4.4] Lump Sum Distribution vs. Rollover Solution: If Maria takes the funds from her retirement plan, the plan trustee is required to withhold 20 percent for income taxes, so she will only receive the remaining $30,400 [$38,000 x ($38,000 x 20%)] in cash. The 20 percent withheld for taxes will not pay all of the taxes she will owe on this premature distribution. She will have to pay income taxes at her regular 28 percent marginal tax rate along with a 10 percent premature withdrawal penalty, resulting in an effective tax rate of 38 percent or $14,440 ($38,000 x 38%). Her after-tax funds available will be only $23,560 ($38,000 - $14,440 tax). With the auto dealer offering a very low interest rate, she would be better off rolling over the funds in her retirement plan into an IRA, saving the $14,440 in taxes, and paying for the car from her current income.

47. [LO 4.4] 401(k) vs. Municipal Bond Investment Solution: By investing $12,000 in a 401(k) plan, William avoids current income taxes of $3,360 ($12,000 x 28% marginal tax rate). His after-tax cost for this investment is only $8,640 ($12,000 - $3,360) while he has $12,000 invested in the 401(k) plan than can earn income until he withdraws it at retirement. In the meantime, he pays no taxes on all of the investment income, allowing this income to be fully reinvested in the 401(k) plan.

If William invests only $6,000 in the 401(k), his taxes are reduced by only $1,680 ($6,000 x 28%). He will have to pay income taxes on the $6,000 he receives to invest in municipal bonds and he will have only $4,320 ($6,000 - $1,680 tax) remaining to invest. His net after-tax cost of this investment is $10,320 ($6,000 + $4,320). He will then earn annual tax-exempt interest income on this investment of $259 ($4,320 x 6%). Because he has less invested in total, his overall return will be less and the amount available at retirement will be significantly reduced. In addition, he must be able to reinvest the municipal bond interest that is paid annually to continue to earn income on this interest as only the portion invested in the 401(k) provides for automatic reinvestment. Thus, he is better off in the current year investing the entire $12,000 in a 401(k) plan.

48. [LO 4.4] Traditional vs. Roth IRA Solution: Contributions to a traditional IRA are made with pre-tax dollars because the contribution is tax deductible. Thus the entire $3,000 can be contributed to a traditional IRA. After 10 years, Robert will have accumulated $41,460 ($3,000 annuity x 13.82) in the account. When these funds and their earnings are withdrawn in retirement, the tax on the withdrawn funds will be levied at Robert's then current 15 percent tax rate. If he wants to take $3,000 per year after taxes from this account, he will have to withdraw $3,529 ($3,000/.85) annually.

Assuming the same 7 percent interest rate during the withdrawal years, it will take approximately 25 years before the account is depleted ($41,460/$3,529 = 11.748).

This coincides with the present value of an annuity of $1 that is slightly in excess

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of 25 years.

Contributions to a Roth IRA are not tax deductible so Robert will be required to pay taxes on the $3,000 before contributing the funds to a Roth IRA. The $840 ($3,000 x 28% marginal tax rate) in taxes will reduce the amount available to contribute to only $2,160 ($3,000 - $840 taxes). After 10 years, Robert will have accumulated $29,851 ($2,160 x 13.82). When Robert withdraws the funds in retirement, he will pay no taxes on it. It will be almost 18 years before the funds in the Roth IRA are depleted ($29,851/$3,000 = 9.95). This coincides with the present value of an annuity of $1 that is slightly less than 18 years.

(Note that present value tables are included in the Appendix at the end of the textbook.)

49. [LO 4.6] Foreign Earned Income Solution: If Jorge stays only six months in Saudi Arabia, he must include the entire $68,400 [(12 months x $5,000 salary) + (6 months x $1,400 additional compensation)] in income.

If Jorge extends his assignment for an additional six months, he will be eligible to exclude up to $102,100 by using the foreign earned income exclusion. Using this provision, he could exclude his entire $76,800 [12 months x ($5,000 salary + $1,400 additional compensation)] compensation. From a tax standpoint, Jorge is better off extending his stay at least long enough to meet the 330-day physical presence test.

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter.

50. [LO 4.1] Reasonable Compensation Solution: As the tax adviser, you will want to establish that Cindy’s compensation is reasonable so the IRS will not reclassify a portion as a constructive dividend. Some possible questions include:  What is the extent and scope of Cindy's duties for the corporation?  What do other executives in comparable positions in comparable companies earn annually?  Have other executives been as successful in expanding their business as Cindy has been?  How does Cindy's salary compare to the corporation's gross and net income?  Was her salary kept unusually low in the beginning with the expectation that it would be increase significantly if she proved to be successful in expanding the company?  Does the corporation plan to pay dividends?

51. [LO 4.3] Exercising Incentive Stock Options Solution: Although the taxpayer pays no regular income tax when an ISO is exercised, the taxpayer must include the bargain element (the difference between the strike price and the fair market value when exercised) in alternative minimum taxable income

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(AMTI) for the year exercised. The alternative minimum tax (AMT) is assessed at a 26 – 28% rate (refer to Chapter 5 for details). The taxpayer must include the bargain element in AMTI even if the value of the stock declines after exercising the ISO, so tax planning should be done to minimize the AMT. The following four strategies should be considered when exercising ISOs: 1. Exercise sooner rather than later If the value of the stock is expected to rise steadily, exercising the ISOs soon after they vest will minimize the amount of bargain element that is subject to the AMT. 2. Spread the exercise over several years If the ISO does not expire before the end of the year, and the stock has already increased substantially in value, a partial exercise in one year, with the balance exercised in a future year or years, will minimize the amount of bargain element subject to the AMT in any one year.

3. Minimize the other elements of AMTI If a large bargain element cannot be avoided, then try to minimize other elements that increase AMTI. For example, it may be possible to defer a year-end bonus into the next year.

4. Avoid AMT through a disqualifying disposition The AMT can be completely avoided if the shares acquired with the ISO are sold in the same year as the ISO is exercised. This will be considered a disqualifying disposition (because the stock is not held for more than one year from exercise date) and any gain will be taxed at ordinary income tax rates (instead of favorable long-term capital gains rates). If the stock starts to decline in value, a disqualifying disposition may result in lower tax and increased cash flow compared to holding the stock while it continues to decline.

52. [LO 4.3] Stock Option Taxation Solution: Under one scenario, an employee receives a significant number of nonqualified stock options (NQSO) at a price slightly above the current market price. After the stock's price increases dramatically, the employee exercises the options and would be required to recognize the bargain element (the difference between the strike price and the fair market value when exercised) as taxable ordinary income. Soon after the exercise, the stock's price drops dramatically. The employee must pay income taxes on the exercise of the option but due to the significant decline in market value cannot sell the stock for enough money to cover the taxes owed.

(This happened to many employees in the technology sector.)

53. [LO 4.4] Stock Option Terminology

Solution: a. Backdating is claiming an option was granted earlier than it actually was, to take advantage of a more favorable exercise price, to enhance its potential value. b. Repricing involves setting a new, lower exercise price for existing options, because of a decline in the market price of the stock subsequent to the original award. c. Reloading is automatically granting new options, at current market prices, to replace some or all of the options that are being exercised. d. Spring-loading is awarding options just before the release of positive news that

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is likely to increase the stock price. e. Bullet-dodging involves postponing the award of options until after bad news has driven down the stock price.

See Maremont and Forelle, ―Bosses’ Pay: How Stock Options Became Part of the Problem,‖ The Wall Street Journal, December 27, 2006, page A1, for a discussion of these terms and additional information on the stock option backdating problem.

54. [LO 4.4] Defined Benefit vs. Defined Contribution Plan Solution: An older employee would usually prefer a defined benefit plan because it is based on current earnings. With a shorter period of time over which to make contributions, the defined benefit plan usually permits greater current contributions; the limits on contributions are usually more liberal allowing a faster build-up within the plan. Defined contribution plans are advantageous for younger employees because of the longer time the contributions in the plan earn income.

55. [LO 4.4] Retirement Contribution Taxation Solution: If Congress changed the law so that contributions to retirement plans could no longer be made with before-tax dollars, the short-term effect would be a reduction in the funds available for retirement savings due to the taxes that would have to be paid. There would be a reduction in the incentive to save for retirement, which would result in even less money being saved. This could result in more people depending on the government during their retirement years. Also, the effect on the economy of decreased saving (these funds will no longer be available for investment by the pension trustees) could also be significant.

56. [LO 4.1 & 4.5] Business Formation Solution: a. (1) If Evan chooses to be a sole proprietorship, his total tax cost will be $31,620 ($14,836 + $16,784) Self-employment tax: ($130,000 - $25,000) x 92.35% = $96,967.50 x 15.3% = $14,836.

Adjusted gross income: $105,000 income – ($105,000 x .9235 x 7.65%) - $3,000 insurance premiums = $94,582 AGI. $94,582 - $10,400 deductions = $84,182 taxable income. Income tax on $84,182 = $16,784.25 [$5,226.25+ 25% ($84,182$37,950)].

(2) If Evan chooses to be an S corporation, his total tax cost will be $23,640 ($2,678 + $420 + $17,864 + $2,678).

The S corporation deducts FICA taxes paid of $2,678 ($35,000 x 7.65%) and FUTA taxes of $420 ($7,000 x 6%). The total amount of income that will pass through to Evan’s K-1 will be $63,902 ($130,000 - $25,000 - $35,000 - $2,678 $420 - $3,000) plus $3,000 for health insurance. Because Evan owns more than 2% of the S corporation stock, he is taxed on the health insurance and then can deduct the $3,000 for AGI. Evan’s gross income is $101,902 [$35,000 wages + $63,902 S corporation income + $3,000 health insurance]. Evan’s adjusted gross income is $98,902 ($101,902 $3,000 insurance premiums). Evan’s taxable income is: $88,502 ($98,902 AGI -

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$10,400 deductions). His income tax is $17,864.25 [$5,226.25 + 25% ($88,502$37,950)]. Evan also pays his employee share of FICA tax of $2,678 ($35,000 x 7.65%).

(3) If Evan chooses a C corporation, his total tax cost will be $19,976 ($10,976 corporation income taxes + $2,678 employer FICA taxes + $420 FUTA taxes + $3,224 personal income taxes + $2,678 employee FICA taxes). The C corporation will pay $2,678 ($35,000 x 7.65%) for FICA taxes and $420 ($7,000 x 6%) FUTA taxes. The C corporation will have taxable income of $63,902 ($130,000 $25,000 - $35,000 - $2,678 - $420 - $3,000). The tax liability for the C corporation will be $10,976 [$7,500 + 25% ($63,902-$50,000)].

Evan has taxable income of $24,600 ($35,000 AGI - $10,400 deductions). His personal income tax liability is $3,223.75 [$932.50 + 15% ($24,600-$9,325)]. He also pays employee FICA taxes of $2,678. b. C corporation. Setting up as a C corporation would result in the lowest amount of taxes for the first year. c. Some factors to consider when deciding between a C corporation and an S corporation are:  Shareholders of both C and S corporations can be employees of a corporation, but greater than 2% shareholder-employees of S corporations are not eligible for most tax-free fringe benefits and therefore will have to use after-tax dollars for fringe benefits (except health insurance which is deductible for AGI).  If $35,000 is considered to be an unreasonably low salary, the IRS might reclassify some of the S corporation’s distribution as salary, requiring the payment of additional employment taxes (and possibly penalties).  An S corporation’s income is taxed to the shareholders when earned, even if not distributed.  What will the expected profits (losses) be in future years? Based on the expectations, the overall marginal tax cost may be higher for a C corporation in future years. If there are losses, the losses flow through to and S corporation owner and are immediately deductible. Losses of a C corporation can only offset profits from other C corporation years.  When a C corporation pays dividends, the income is effectively subject to double taxation (once at the corporate level and then to the shareholders when distributed at their dividend rate) because dividends are not deductible by the corporation.

Search the Internet 57. [LO 4.2] Excess Mileage Allowance Solution: The amount that exceeds the standard mileage allowance [number of miles x (60 cents – 53.5 cents in 2017)] is treated as taxable compensation to the employee.

No later than the first payroll period following the payroll period in which the

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business miles of travel are substantiated, the employer must withhold and pay employment taxes on the amount that exceeds the standard mileage allowance.

58. [LO 4.2] Flexible Spending Arrangement Solution: Medicine and drugs include only items that are legally procured. Toiletries (e.g., toothpaste), cosmetics (e.g., face creams) and sundry items are not medicines or drugs so amounts expended for these items are not eligible for reimbursement through a FSA. Beginning in 2011, the definition of medical expenses eligible for payment through an FSA no longer includes over-the-counter medicines. Note that Revenue Ruling 2010-23 made Rev. Rul. 2003-102 obsolete.

59. Conversion to Roth IRA Solution: The articles and URLs will vary but here are a few of the main points regarding conversion.

When converting from a traditional to a Roth IRA, income tax (but not the 10% early withdrawal penalty) must be paid on deductible contributions and taxdeferred earnings for the year they are moved from the traditional to Roth IRA. The entire IRA does not need to be converted at one time. A partial conversion is a way to minimize the tax cost for that year. Generally, it is preferable to contribute to a Roth IRA if the contributions to your traditional IRA are nondeductible. Prior to 2010, an individual whose AGI was in excess of $100,000 was not eligible to convert a traditional IRA to a Roth IRA. In 2010, the $100,000 AGI limit was eliminated, allowing high-income taxpayers to convert a traditional IRA to a Roth IRA. The elimination of the AGI limit provides high-income individuals a ―back door‖ to a Roth IRA by making nondeductible contributions to a traditional IRA and then converting it to a Roth IRA. Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

60. [LO 4.1] Reasonable Compensation Solution: Is Susan's compensation reasonable for her position and responsibilities? How will Sanibel Corporation treat Susan's compensation for tax purposes? Will the deduction be limited to $1,000,000 or is a portion of the payment incentive based?

61. [LO 4.1] Reasonable Compensation Solution: Is Virginia now receiving compensation that is unreasonable for her position and responsibilities? Is the reasonable compensation issue mitigated by her having taken no salary from the business for two years?

62. [LO 4.2] Employer-Provided Lodging Solution: What are the tax consequences of George accepting the rent-free use of the apartment as part of his employment? What could be done to ensure a favorable tax outcome?

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63. [LO 4.2] Personal-Use of Company-Owned Vehicle Solution: How will Victor treat the additional compensation for the lease value of the Jaguar and is he entitled to a deduction for his business use of the vehicle? How will the company treat the Jaguar for depreciation purposes? What amount can the company deduct for compensation expenses?

64. [LO 4.2] Moving Expenses Solution: Does Margaret have any income as a result of the reimbursement? Can Margaret’s employer deduct the entire reimbursement as a business expense?

65. [LO 4.4] Traditional vs. Roth IRA Solution: Is Sarah eligible to make a deductible contribution to a traditional IRA or a nondeductible contribution to a Roth IRA? What are the other personal, family, and business factors that Sarah should consider in deciding whether to invest in a traditional IRA, a Roth IRA, or the preferred stock?

66. [LO 4.4] Pension Contribution Solution: Will Ken's interest and dividend income be considered along with his salary in determining the maximum amount he can contribute to his company's qualified pension plan? What is the maximum amount that Ken can contribute and how much can his company match?

Develop Research Skills Solutions to research problems 67-70 are included in the Instructor’s Manual.

Fill-in the Forms The solution to tax form problem 71 is included in the Instructor’s Manual.

Solutions to Chapter 5 Problem Assignments Check Your Understanding 1. [LO 5.1] Deductions for AGI Solution: Student loan interest: Taxpayers can deduct up to $2,500 of qualified student loan interest; the deduction is phased out proportionately as AGI increases from $65,000 to $80,000 (single filers) or $135,000 to $165,000 (married filing jointly).

Tuition and fees: A $4,000 deduction is allowed for higher-education expenses for taxpayers whose AGI does not exceed $65,000 (single filers) or $130,000 (married filing jointly). Single taxpayers with incomes between $65,000 and $80,000 (between $130,000 and $160,000 for joint filers) are allowed to deduct $2,000 of qualifying expenses.

Educator expenses: Kindergarten through 12th grade teachers are permitted to deduct up to $250 of unreimbursed expenses for books, supplies, computer

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equipment, software, and other supplementary materials used in the classroom.

Health savings accounts: Taxpayers with high-deductible medical insurance plans (at least $1,300 for individual coverage or $2,600 for family coverage) can take a deduction for contributions to an HSA for up to $3,400 for individual coverage and $6,750 for family coverage in 2017.

Penalty on early withdrawals of savings: Taxpayers assessed a penalty for premature withdrawals from certificates of deposits or other savings accounts can deduct this penalty for AGI to ensure that only the net interest income is included in taxable income. Other deductions for AGI include deductions for certain business expenses of reservists, performing artists, and government officials, moving expenses, the employer’s portion of self-employment tax, self-employed health insurance, IRA and certain other pension plan contributions, alimony paid, and the domestic production activities deduction.

2. [LO 5.1] Adjusted Gross Income Solution: Adjusted gross income (AGI) is a subtotal unique to individuals. It is used to limit the amount that is deductible for some items and as a threshold that must be exceeded before any deduction is allowed for other items. For example, charitable contributions are limited to 50 percent of AGI but medical expenses are deductible only to the extent they exceed 10 percent of AGI. It is also the determining factor in the phaseout of a number of otherwise deductible items.

3. [LO 5.2] Deductions for AGI for penalty Solution: When a taxpayer makes a premature withdrawal, the bank reports the entire amount of interest earned to the IRS but reduces that amount by the early withdrawal penalty, paying the taxpayer only the net amount. This penalty differs from prior nondeductible penalties in that it is a reduction of interest income; without this special provision, the penalty could only be deducted as a miscellaneous itemized deduction. This provision ensures that only the net interest income received is included in taxable income.

4. [LO 5.3] Filing Status Solution: An unmarried taxpayer can file as head of household if he or she maintains a home for a qualifying relative; otherwise an unmarried individual files as single.

Married taxpayers can file joint returns or file separate returns. A surviving spouse (qualifying widow or widower who has not remarried) can claim the standard deduction for married filing jointly and may use the joint tax rate schedule for up to two years after a spouse’s death if there is a qualifying dependent child in the household. After that, the widow or widower would file as head of household (with a qualifying child) or single. Usually, a taxpayer must be unmarried to file as head of household but a qualifying abandoned spouse may also use this filing status.

5. [LO 5.3] Head of Household Solution: There are two requirements to qualify as head of household: (1) the individual must be single at the end of the year, unless qualifying as an abandoned spouse and (2) the taxpayer must pay more than half the cost of maintaining a home in which a

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qualifying child (regardless of dependency status) or other relative claimed as a dependent lives for more than half the tax year. A dependent parent does not have to live with the taxpayer.

6. [LO 5.3] Abandoned Spouse Solution: This provision provides relief by permitting a qualifying taxpayer to file as head of household instead of married filing separately, the filing status with the harshest tax rate schedule. A qualifying taxpayer is one who is married at year-end but who has not lived with his or her spouse at any time during the last six months of the tax year, and has one or more dependent children living with him or her.

7. [LO 5.3] Abandoned Spouse vs. Surviving Spouse Solution: An abandoned spouse is a person who is married at year-end but has lived apart from his or her spouse during the last 6 months of the tax year and paid more than one-half the cost of maintaining a home in which he or she lived with a dependent child for more than half the tax year. An abandoned spouse may claim the head of household standard deduction and use the head of household tax rate schedule for as long as he or she qualifies as an abandoned spouse.

A surviving spouse is a widow or widower who has not remarried and has at least one dependent child in the home for the entire year (for whom he or she pays more than one-half the cost of maintaining the home). For two tax years after the spouse’s death, the surviving spouse may claim the standard deduction for married filing jointly and may use the joint tax rate schedule. After two years, a surviving spouse with a dependent child may use the head of household standard deduction and tax rate schedule.

8. [LO 5.4] Standard Deduction vs. Itemizing Solution: A taxpayer would claim the standard deduction when it is equal to or greater than the total of deductible itemized deductions. Unlike itemized deductions, the standard deduction is not phased-out for high-income taxpayers. If spouses file separate returns and one spouse itemizes deductions, however, the other spouse must also itemize.

9. [LO 5.4] Itemized Deductions Subject to Floor Solution: The following deduction must exceed a floor which is a percentage of adjusted gross income:  Medical expenses must exceed 10 percent of AGI  Casualty and theft losses must exceed 10 percent of AGI  Miscellaneous itemized deductions must exceed 2 percent of AGI. 10. [LO 5.4] Ceiling and Floor Limitations Solution: A ceiling is the maximum deduction that can be claimed in any one year; for example, only charitable contributions that do not exceed 50% (30% or 20% for contributions to certain types of charitable organizations) of AGI are deductible.

(There are carryover provisions for the excess, however.) A floor, or threshold, is the minimum expense a taxpayer must incur before the excess can be deducted: for

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example, only medical expenses in excess of 10% of AGI are usually deductible.

(There are no carryover provisions these floor amounts.) Table 5.4 lists the expenses subject to ceiling and floors and describes their limits.

11. [LO 5.4] Deductible Taxes Solution: Deductible taxes include the following:  State, local and foreign income taxes.  State, local and foreign real property taxes.  State and local personal property taxes.  Other state, local, and foreign taxes that are incurred in the context of a trade or business or other income-producing activity.

Additionally, state and local sales taxes can be deducted instead of state and local income taxes.

12. [LO 5.4] Investment Interest Expense Solution: Without this limitation, taxpayers could deduct interest paid to carry investments that produce little or no current income and whose income could be deferred at the discretion of the taxpayer.

13. [LO 5.4] Investment Interest Expense Solution: Investment income does not include net long-term capital gains from the sale of investment property or dividend income unless the taxpayer elects to forego the favorable tax rate that may apply to this income. Before electing to forgo the favorable rates for long-term capital gains and dividend income, taxpayer should calculate the tax savings from the investment interest expense deduction to ensure that this provides a greater after-tax benefit than the reduced tax rate on the dividend income and capital gains. In making this comparison, individuals should take into account the time value of money and the marginal tax brackets for the current year and any future year to which the investment interest would be carried forward and deducted.

14. [LO 5.4] Qualified Residence Interest Solution: Qualified residence interest is debt secured by the taxpayer’s residence to acquire, construct, or substantially improve such residence (acquisition indebtedness).

Interest on debt principal up to $1 million is deductible as an itemized deduction.

A taxpayer may combine acquisition indebtedness on no more than two homes to reach the $1 million debt principal limit. If the second residence is rented out for part of the year, then the taxpayer’s personal use of it must exceed the greater of 14 days or 10 percent of the rental days for any of the interest expense to qualify as acquisition debt. Any interest paid on debt principal in excess of $1 million is not deductible and cannot be carried forward.

Qualified residence interest also includes interest on a home equity loan of up to $100,000 and is deductible regardless of the use to which the loan proceeds are put (and can include the interest on additional acquisition debt of up to $100,000 on a home in which the borrower has at least the loan amount as equity). The equity in an individuals’ qualified residence is the difference between its fair market value

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and the amount of mortgage debt associated with the residence.

15. [LO 5.4] Interest Deduction for Points Solution: Points, also called loan origination fees, are fees that mortgage companies charge to borrowers for finding, placing, or processing their loans. The payment of points is treated as the equivalent of prepaying interest to the extent these fees do not represent service charges for real estate appraisals, title searches, or other legal work. When points are paid in connection with loans to purchase or improve a taxpayer’s primary personal residence, they are deductible as itemized deductions in the year paid. If incurred to refinance an existing home mortgage, points and other prepaid interest must be capitalized and amortized over the duration of the loan.

16. [LO 5.4] Charitable Contribution Limit Solution: The overall ceiling limit on charitable contributions is 50 percent of adjusted gross income. Excess contributions can be carried forward for up to five years. (There are other limitations of 30% and 20% of AGI depending on the type of property donated or donation recipient.)

17. [LO 5.4] Charitable Contributions Solution: Collin should sell the stock and recognize the $7,500 loss [($40 - $100) x 125 shares]. He can then contribute the $5,000 proceeds from the sale to the charity.

This way he preserves the tax benefit of the loss. If he contributes the stock, he will get a contribution deduction of $5,000 but no tax benefit from the stock’s decline in value.

18. [LO 5.4] Miscellaneous Itemized Deductions Solution: Miscellaneous itemized deductions include most unreimbursed employee business expenses, investment expenses, hobby expenses, and tax preparation fees.

Employee business expenses include costs for professional dues, union dues, uniforms, subscriptions to employment-related publications and business travel.

Expenses incurred in looking for a new job in the same field are deductible but the costs incurred while looking for a first job or a job in a new field are generally not deductible. Examples of investment expenses include safety deposit box rental to store stock certificates, investment advisor fees, subscriptions to investment publications, software to track investment portfolios, and depreciation on a computer used to monitor personal investments. Other deductible expenses include hobby expenses (to the extent of income) and expenses related to the determination, collection, or refund of any tax, including tax return preparation, appraisal fees to document the value of property donated to a charity, accounting and legal fees for representation in a tax audit, and accounting fees for tax planning advice. Miscellaneous itemized expenses are deductible to the extent the total exceeds 2% of AGI (except for gambling losses). Gambling losses are not subject to the 2% of AGI floor but cannot exceed gambling winnings included in gross income.

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19. [LO 5.5] Itemized Deduction Phaseout Solution: High-income taxpayers reduce certain itemized deductions if their AGI exceeds a specific threshold. The threshold is presented in Table 5.5. The affected itemized deductions are reduced by 3% of AGI over the threshold up to a maximum of 80% of affected itemized deductions. For most taxpayers, only their charitable contributions, home mortgage interest, and taxes are subject to this phaseout.

Medical expenses, casualty losses, investment interest, and gambling losses (deductible to the extent of gambling winnings) are not affected by this phaseout.

A taxpayer cannot lose more than 80% of the affected deductions.

20. [LO 5.5] Exemptions Solution: Each self-supporting taxpayer is allowed to claim a personal exemption for him or herself. Dependents are not allowed to claim personal exemptions. Instead, the taxpayer providing the requisite support for the dependent is allowed to claim a dependency exemption. The deductible amount for each exemption is $4,050 in 2016 and 2017.

21. [LO 5.5] Dependents Solution: Qualifying relatives include:  Parents, grandparents, and other direct ancestors  Children, grandchildren, and other lineal descendants  Sisters and brothers  Aunts and uncles (sisters and brothers of the taxpayer’s parents)  Nieces and nephews (children of brothers and sisters)  In-laws including brothers and sisters-in-law, sons-in-law, daughters-in-law, brothers-in-law, and fathers-in-law.

Only nieces, nephews, aunts, and uncles by blood are qualifying relatives. Cousins are not qualifying relatives.

22. [LO 5.5] Dependency Requirements Solution: Table 5.6 compares the requirements. A qualifying child must satisfy four tests: (1) residency (live with the taxpayer for more than one-half of the year), (2) relationship (the child must be the taxpayer’s son, daughter, brother, sister or descendant of any of these individuals); (3) age (the child must be under age 19 or under age 24 if a full-time student); and (4) support (the child must not provide more than one-half of his or her own support).

A qualifying relative must meet three tests; there is no residency test or age test but instead there is an income test. The income test requires that the dependent’s taxable gross income must be less than the exemption amount ($4,050 for 2016 and 2017). The relationship test includes a much broader group such parents, grandparent, in-laws, nieces, nephews, aunts, uncles and a resident in the taxpayer’s household for the entire year. The support test requires that the taxpayer provide more than half of the support.

23. [LO 5.5] Multiple Support Agreement Solution: A multiple support agreement prevents a dependency exemption from being lost by

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allowing one of the group of support providers to claim the dependency exemption for a qualifying relative as long as that person provides more than 10 percent of the support of the dependent, the group as a whole provides more than 50 percent of the dependent’s support, and the other members of the group who provide more than 10 percent of the support agree to grant the exemption to that person.

24. [LO 5.5] Gross Income Test Solution: To qualify as a dependent, the dependent’s gross income that is subject to taxation must be less than the exemption amount for the year ($4,050 for 2016 and 2017).

The gross income test is waived for the qualifying child of a taxpayer. A qualifying child must satisfy four tests: (1) be the taxpayer’s son, daughter, brother, sister, or descendant of any of these individuals; (2) be under age 19 (or under age 24 if a full-time student) or be totally and permanently disabled; (3) have the same principal place of abode as the taxpayer for more than one-half of the year; and (4) not provide more than one-half of his or her own support.

25. [LO 5.5] Exemption Phaseout Solution: High-income taxpayers with AGIs exceeding a threshold are required to phase out their personal and dependency exemption. These thresholds are the same as those presented in Table 5.5 for phasing out of itemized deductions and are based on filing status. The excess AGI beyond the threshold is divided by $2,500 ($1,250 if married filing separately) to yield a phaseout factor that is rounded up to the next whole number. This phaseout factor is multiplied by 2 (because the phaseout applies in increments of 2%) to get a phaseout percentage (up to 100%). The phaseout percentage is multiplied by the otherwise deductible exemption amount to get the reduction which is subtracted from the exemption amount to get the allowable exemption deduction. If the phaseout percentage is 100% or more, then the entire benefits of all exemptions is lost.

26. [LO 5.6] Credit vs. Deduction Solution: A credit is a direct dollar-for-dollar reduction in the tax liability and generates a tax reduction that is independent of the taxpayer’s marginal tax rate. The value of a deduction is dependent upon the taxpayer’s marginal tax rate. For example, a $100 credit saves $100 in tax dollars. A $100 deduction saves a taxpayer in the 28 percent marginal tax bracket $28 ($100 x 28%) in taxes and saves a taxpayer in the 15 percent marginal tax bracket only $15 ($100 x 15%) in taxes.

27. [LO 5.6] Refundable vs. Nonrefundable Credit Solution: A refundable credit will result in a refund to the taxpayer if the credit is greater than the taxpayer’s income tax liability. A nonrefundable credit can only offset the current tax liability, reducing it to zero; any credit in excess of the tax liability is lost. Most tax credits are nonrefundable. The earned income credit is one of the few refundable credits and all or part of the child tax credit may be refundable based on the taxpayer’s earned income or social security taxes paid.

Nonrefundable credits include the education credits, the child and dependent care credit, and credits to encourage energy efficiency.

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28. [LO 5.6] Education Credits Solution: Both credits are available for the taxpayer, the taxpayer’s spouse, and the taxpayer’s dependents. Both are phased out for higher-income taxpayers.

Table 5.7 provides a comparison of these credits. The American opportunity credit provides a tax credit equal to 100% of the first $2,000 and 25% of the next $2,000 for qualifying expenses for up to 4 years for each student. The lifetime learning credit equals 20% of a maximum of $10,000 of qualifying expenses for part-time or full-time undergraduate, graduate, or professional degree programs and is available for an unlimited number of years.

Qualifying expenses for the American opportunity credits include tuition and fees, as well as required books, supplies and equipment. The lifetime learning credit applies to tuition and fees but excludes books and other materials.

The American opportunity credit phases out over a higher AGI range than the lifetime learning credit. The lifetime learning credit is a nonrefundable credit, but 40% of the American opportunity credit is refundable.

29. [LO 5.7] AMT Solution: As originally drafted, the AMT was designed to ensure that all high-income taxpayers would pay some tax by reducing their deductions and increasing their incomes for certain items not included in regular taxable income. The lower AMT rate was then applied to this broadened concept of taxable income. An AMT exemption amount (indexed for inflation) somewhat shelters taxpayers who are not necessarily considered high income from being subject to the tax, but who have a large number of dependents or other deductions disallowed when computing the AMT. 30. [LO 5.7] Alternative Minimum Tax Rates Solution: The alternative minimum tax (AMT) rates are usually lower than the ordinary rates but they apply to a broader base of income, alternative minimum taxable income (AMTI). The AMT rates are 26% on the first $187,800 of AMTI and 28% on the excess.

31. [LO 5.7] AMT Itemized Deductions Solution: Table 5.12 compares itemized deductions allowed for AMT with regular itemized deductions. For AMT, no deduction is allowed for taxes, home equity loan interest expense, or miscellaneous itemized deductions.

32. [LO 5.8] Net Operating Loss Solution: If an individual’s deductions exceed his or her income, the negative taxable income does not necessarily mean that the individual has a net operating loss (NOL). Individuals must make several adjustments to arrive at a potential NOL because an NOL can only result from business losses, such as losses from a sole proprietorship, partnership, or an S corporation. Additionally, employee wages and salary are considered business income and will effectively reduce any other business losses in determining the NOL. In computing an NOL, individuals cannot deduct any personal or dependency exemptions, nonbusiness capital losses can

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only offset nonbusiness capital gains (excess nonbusiness capital losses cannot increase an NOL), and nonbusiness deductions (most itemized deductions) can only offset nonbusiness income (such as interest and dividends).

33. [LO 5.8] Filing Requirements Solution: A taxpayer with gross income exceeding the sum of the basic standard deduction (plus the addition for age only, not for blindness) and personal exemption, must file a tax return. The taxpayer cannot consider exemptions for dependents in determining the gross income threshold for filing. However, self-employed individuals must file, regardless of their gross income, if their net earnings from self-employment are $400 or more, dependents must file if their gross income is greater than their standard deduction, and married persons filing separate returns must file if their gross income equals or exceeds their personal exemption.

34. [LO 5.8] Kiddie Tax Solution: The kiddie tax is intended to limit the tax savings from asset transfers to children by taxing unearned income (such as dividends, interest, and net capital gains) of children under age 19 and full-time students under age 24 at their parents’ marginal tax rate. This special tax calculation applies only to the child’s net unearned income that exceeds $2,100; it does not apply to earned income (such as salaries and wages) or to children whose net unearned income is $2,100 or less.

35. [LO 5.8] Medicare Surtaxes Solution: There are two types of Medicare surtaxes and both apply only if certain income thresholds are exceeded. The thresholds are $200,000 for single individuals (and heads of household), $250,000 for married taxpayers filing a joint return, and $125,000 for married taxpayers filing separately. The Medicare surtax rate is 0.9% on taxable compensation income of employees and self-employed individuals in excess of the threshold. The Medicare surtax on net investment income (NII) is assessed at a rate of 3.8% on the lesser of (a) net investment income or (b) modified adjusted gross income in excess of the threshold. To determine net investment income subject to the NII tax, gross investment income (such as taxable interest income, dividends, capital gains, and royalties) is reduced by related investment expenses.

Crunch the Numbers 36. [LO 5.2] Student Loan Interest Solution: Her deduction is $2,083.25 $140,000 AGI - $130,000 threshold = $5,000 excess $5,000 excess/$30,000 phase out range = 16.67% phase out $2,500 maximum – ($2,500 x 16.67% phase out) = $2,083.25.

37. [LO 5.2] Health Savings Accounts Solution: $3,400 and $6,000. The maximum Ashley can contribute to an HSA for 2017 is $3,400 ($4,400 if age 55 or older).

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She can deduct the $3,400 for AGI if contributed to an HSA. She can also deduct the $2,600 medical insurance premium for AGI as she is self-employed as a sole proprietor; $3,400 + $2,600 = $6,000 deductible.

38. [LO 5.3] Standard Deduction Solution: $17,700. $12,700 basic standard deduction + $5,000 (4 x $1,250) additional for age and blindness.

39. [LO 5.3] Standard Deduction Solution: $10,900. $9,350 basic for head of household + $1,550 additional for age.

40. [LO 5.4] Medical Expense Deduction Solution: $2,000 and claim the standard deduction. $14,000 - $3,000 reimbursement – (10% x $90,000) floor = $2,000.

If this is Daniel’s only itemized deduction, he would be better off simply taking the $6,350 standard deduction.

41. [LO 5.1 & 5.4] Tax Benefit Rule Solution: $300 ($13,000 - $12,700 standard deduction) of the $900 refund is included in income in 2018. If their itemized deductions had been $13,600 or more, then the entire $900 refund would be included in income in 2018.

42. [LO 5.4] Investment Interest Expense Solution: a. $240 [$100 + $300 + $1,200 – ($68,000 x 2%)] b. He can deduct $5,960 ($6,200 - $240) if he elects to forgo the maximum 15 percent rate for his capital gain and dividend income; otherwise, he can only deduct $4,960 ($6,200 - $1,000 - $240).

Edward’s deduction for investment interest expense is limited to his net investment income, which is the excess of gross investment income over deductible investment expenses (excluding interest). His deductible investment expense is the lesser of the actual $400 ($100 + $300) of investment expenses or the allowable $240 miscellaneous expense deduction (as computed above). Edward’s investment income can include long-term capital gains and dividend income only if he elects to forgo the maximum 15 percent tax rate that applies to that type of income. If he makes this election, his taxable income will increase by $1,000 but his tax will only increase by $100 [$1,000 x (25% - 15%)]; he will, however, be able to deduct $1,000 more in investment interest, which will save $250 ($1,000 x 25%) in taxes.

His net tax savings is $150 ($250 - $100), so he should make the election. He will report net investment income of $5,960 ($6,200 - $240) and investment interest expense of $5,960. If he does not make the election, he can only deduct $4,960 ($5,200 - $240) of investment interest expense. c. The remaining $4,040 ($10,000 - $5,960) is carried forward (indefinitely) until he has sufficient net investment income in a future year.

43. [LO 5.4] Interest Expense Solution: $10,000. ($3,000 points + $7,000 home mortgage interest). The interest on the car

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loan is not deductible.

44. [LO 5.4] Charitable Contributions Solution: $23,900 is Arnold’s total deduction as follows: $4,000 to State University ($5,000 x 80%). Note that the 80% limit applies regardless of the value of the preferred ticket rights. $19,500 for stock ($22,000 fair market value limited to 30% of his $65,000 AGI) $400 fair market value of clothing He can carry $2,500 ($22,000 - $19,500) from the stock contribution forward (up to 5 years) but deductibility in future years will be limited to 30% of AGI in the year deductible.

45. [LO 5.4] Itemized Deduction Phaseout Solution: a. $20,300. $9,800 + $3,000 + $5,000 + $2,500 = $20,300; there is no phase out. b. $19,329.50. ($320,000 - $287,650) x 3% = $970.50 reduction $20,300 - $970.50 = $19,329.50 deductible c. $16,179.50. ($425,000 - $287,650) x 3% = $4,120.50 reduction $20,300 - $4,120.50 = $16,179.50 deductible 46. [LO 5.4] Itemized Deductions Solution: $58,224.

Medical expenses are not deductible because they do not exceed the AGI floor. $30,000 of home mortgage interest is deductible due to the $1 million limit [$36,000 x $1,000,000/$1,200,000] $3,360 of home equity loan interest is deductible due to the $100,000 limit [$4,200 x $100,000/$125,000] $17,900 taxes are deductible ($4,900 + $13,000) $4,400 charitable contributions are deductible due to the 80% limit on contributions to booster clubs [($3,000 x 80%) + $2,000] $1,200 is deductible as miscellaneous itemized deductions [$1,800 + $6,600 + $500 – (2% x AGI)] $3,500 is deductible for investment interest expense because this is limited to net investment income (NII). Investment income = $4,700 ($3,000 + $1,700.

Investment income is reduced by the lesser of $1,800 other investment expenses or the $1,200 portion deductible as a miscellaneous itemized deduction (after applying the 2% of AGI floor). NII = $4,700 - $1,200 = $3,500.

Total itemized deductions before the phaseout are: $30,000 + $3,360 + $17,900 + $4,400 + $1,200 + $3,500 = $60,360.

Phaseout: ($385,000 AGI - $313,800 threshold) x 3% = $2,136 Itemized deductions after phaseout are $58,224 ($60,360 - $2,136).

47. [LO 5.5] Dependency Exemptions Solution: One. Miriam’s taxable income ($4,200) is above the allowable $4,050 limit so she does not pass the gross income test. Mike is a qualifying child so he qualifies as a dependent.

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48. [LO 5.5] Phaseout of Personal and Dependency Exemptions Solution: a. $14,175. Their exemptions before phaseout are $20,250 ($4,050 x 5). ($350,500 - $313,800)/$2,500 = 14.68 (round up to next whole number) = 15 15 x 2 = 30% phaseout percentage 30% x $20,250 = $6,075 reduction $20,250 - $6,075 = $14,175 deductible b. $1,134. His exemption before phaseout is $4,050 for one personal exemption. ($350,500 - $261,500)/$2,500 = 35.6 (round up to next whole number) = 36 36 x 2 = 72% phaseout percentage 72% x $4,050 = $2,916 reduction $4,050 - $2,916 = $1,134 deductible Note that the phaseout factor is always rounded up to the next whole number because the phaseout applies to each increment of $2,500 ―or fraction thereof.‖ 49. [LO 5.5] Exemption Phaseout Solution: a. $24,300. Their exemptions are $24,300 ($4,050 x 6); they are not phased out. b. $12,150. Their exemptions before phaseout are $24,300. ($375,000 - $313,800)/$2,500 = 24.48 (round up to next whole number) = 25 25 x 2 = 50% phaseout percentage 50% x $24,300 = $12,150 reduction $24,300 - $12,150 = $12,150 deductible c. zero. Their exemptions before phaseout are $24,300. ($475,000 - $313,800)/$2,500 = 64.48 (round up to next whole number) = 65 65 x 2 = 130% phaseout percentage, but up to a maximum of 100% All of their exemptions are phased out so they have no deduction.

Note that the phaseout factor is always rounded up to the next whole number because the phaseout applies to each increment of $2,500 ―or fraction thereof.‖ 50. [LO 5.3 & 5.5] Taxable Income Solution: $79,600. $90,000 AGI - $6,350 standard deduction - $4,050 personal exemption.

51. [LO 5.3 & 5.5] Dependent’s Taxable Income Solution: $450. $2,500 wages + $800 dividend income = $3,300 AGI - $2,850 ($2,500 + $350) standard deduction = $450 taxable income.

A dependent’s standard deduction is the greater of $1,050 or earned income ($2,500) plus $350. No personal exemption is allowed.

52. [LO 5.3 & 5.5] Dependency Support Test Solution: a. $9,900. $5,500 + ($5,200 x 50%) + $1,800 = $9,900. b. Yes. c. Head of household.

53. [LO 5.4 & 5.5] Computing Taxable Income with Phaseout of Exemptions and Itemized Deductions Solution: $307,323 taxable income.

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Itemized deductions: [($380,500 AGI - $313,800 threshold) x 3%] = $2,001 phaseout (which is less than all of their deductions subject to the phaseout) $64,000 - $2,001 = $61,999 allowable itemized deductions.

6 exemptions x $4,050 = $24,300 exemptions before phaseout ($380,500 AGI - $313,800)/$2,500 = 26.68 (round up to 27) 27 x 2 = 54% phaseout percentage 54% x $24,300 = $13,122 reduction $24,300 - $13,122 = $11,178 deductible exemptions $380,500 AGI - $61,999 itemized deductions - $11,178 exemptions = $307,323 taxable income.

Note that the phaseout factor for exemptions is always rounded up to the next whole number because the phaseout applies to each increment of $2,500 ―or fraction thereof.‖ 54. [LO 5.6] Child Tax Credit Solution: $2,750 ($3,000 - $250) $1,000 x 3 children = $3,000 before phaseout [($80,000 AGI - $75,000)/$1,000 x $50] = $250 reduction 55. [LO 5.6] Education Credits Solution: $6,200 in total credits. 2 x [(100% x $2,000) + (25% x $2,000)] = $5,000 as both sons are eligible for the full $2,500 American Opportunity Credit in 2017. The daughter is eligible for a $1,200 (20% x $6,000) lifetime learning credit.

56. [LO 5.6] Lifetime Learning Credit Solution: $1,800 allowed credit 20% x $10,000 maximum = $2,000 credit before phaseout $57,000 - $56,000 = $1,000 excess AGI $1,000 excess/$10,000 phaseout range = 10% reduction $2,000 - ($2,000 x 10% reduction) = $1,800 57. [LO 5.6] Dependent Care Credit Solution: a. $600 (20% x $3,000 one-child maximum) b. $400 (20% x $2,000) 58. [LO 5.6] Excess Payroll Tax Withheld Solution: $422.

Payroll tax withheld ($3,060 + $7,191) Total wages ($40,000 + $94,000 = $134,000) $134,000 x 1.45% Medicare tax $127,200 Social Security ceiling x 6.2% Credit for excess withholding

$10,251 $1,943 7,886

9,829 $ 422

59. [LO 5.7] Tax Liability Solution: a. Tax liability = $15,638.75. $90,000 - $6,350 standard deduction - $4,050 exemption = $79,600 taxable

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income. [($79,600 - $37,950) x 25%] + $5,226.25 = $15,638.75. b. Tax liability = $9,447.50. $90,000 - $12,700 standard deduction - $8,100 exemptions = $69,200 taxable income. [($69,200 - $18,650) x 15%] + $1,865 = $9,447.50. c. Tax liability = $15,730.25. $90,000 - $6,350 standard deduction - $4,050 exemption = $79,600 taxable income. [($79,600 - $76,550) x 28%] + $14,876.25 = $15,730.25.

60. [LO 5.7] Medicare Surtax Solution: $679. His Medicare surtax of 0.9% is assessed on $75,410 consisting of $20,000 salary in excess of the threshold ($220,000 - $200,000 threshold) plus $55,410 ($60,000 x 92.35%) self-employment income. His additional Medicare tax is $678.69 ($75,410 x 0.9%).

61. [LO 5.7] Medicare Surtax Solution: $949. The Medicare surtax of 0.9% is assessed on $105,465 consisting of $180,000 salary plus $175,465 ($190,000 x 92.35%) self-employment income less $250,000 threshold. They must pay $949.19 (0.9% x $105,465) additional Medicare tax.

62. [LO 5.7] NII Medicare Surtax Solution: $2,812. The NII tax is 3.8% times the lesser of NII or modified AGI in excess of the threshold. NII is $74,000 ($60,000 long-term capital gain + $8,000 dividend + $6,000 interest). Modified AGI in excess of the threshold is $484,000 ($660,000 salaries + $74,000 NII - $250,000 threshold). Note that tax-exempt income is excluded. $74,000 NII x 3.8% = $2,812.

63. [LO 5.7] NII Medicare Surtax Solution: $1,824. The NII tax is 3.8% times the lesser of NII or modified AGI in excess of the threshold. NII is $52,000 ($40,000 short-term capital gain + $7,000 dividend + $5,000 interest). Modified AGI in excess of the threshold is $48,000 ($196,000 salary + $52,000 NII - $200,000 threshold). Note that tax-exempt income is excluded. $48,000 NII x 3.8% = $1,824.

64. [LO 5.7] AMT Solution: a. Tentative minimum tax = $94,244 [($350,000 AMTI - $187,800) x 28% + ($187,800 x 26%)] b. AMT = $38,245. Regular tax = $55,999.25 [($220,000 - $191,650) x 33% + $46,643.75]. AMT = $38,245 ($94,244 tentative minimum tax - $55,999 regular tax).

65. [LO 5.7] Compare Regular and AMT Itemized Deductions Solution: a. $58,645. Total itemized expenses = [$14,000 – ($280,000 x 10%) = 0 medical expenses] + $25,000 home acquisition loan interest + $6,000 home equity loan

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interest + $18,000 taxes + $7,000 charitable contributions + [$8,800 – ($280,000 x 2%) = $3,200 misc. itemized deductions] = $59,200 total before phase out. ($280,000 - $261,500) x 3% = $555 phase out. $59,200 total before phase out $555 phased out = $58,645 total itemized deductions. b. $32,000 ($25,000 home acquisition loan interest + $7,000 charitable contributions). Medical expenses must exceed 10% of AGI so none are deductible for AMT. Interest on home equity loans, taxes, and miscellaneous itemized deductions are not deductible when computing AMT. AMT itemized deductions are not subject to a phase out.

66. [LO 5.8] Computing an NOL Solution: $9,000. $11,000 salary + $2,000 interest income - $20,000 S corporation loss = ($7,000) AGI - $7,300 itemized deductions - $4,050 personal exemption = ($18,350) taxable income.

To compute her NOL the personal exemption and excess of itemized deductions over the $2,000 nonbusiness income must be added back. ($18,350) taxable income + $4,050 personal exemption + $5,300 excess of itemized deductions over interest income = ($9,000) NOL. The NOL could also be computed as $11,000 salary - $20,000 S corporation loss = ($9,000) NOL. 67. [LO 5.8] Compute Tax Due Solution: $100. $8,000 - $6,900 - $1,000 = $100 68. [LO 5.8] Filing Requirements Solution: a. Carolyn is not required to file. $6,350 standard deduction + $1,550 extra for age + $4,050 personal exemption = $11,950 which is more than her gross income subject to tax of $5,000 ($2,000 + $3,000). b. Tim is required to file. $2,000 earned income + $400 interest income = $2,400 gross income. No personal exemption is allowed for a dependent. He is required to file because his $2,400 income exceeds his allowable standard deduction of $2,350 ($2,000 earned income + $350). c. Justin is not required to file. $6,350 standard deduction + $4,050 personal exemption = $10,400 which is more than his gross income of $8,750. He would have to file, however, to receive a refund of any income tax that was withheld from his pay.

69. Comprehensive Problem.

Solution: Taxable income = $46,900; $1,232.50 refund is expected.

Salary Cash dividends Interest income on U.S. Treasury bills Alimony Net rental income Short-term capital gain ($18,000 - $12,000) Long-term capital loss ($14,000 - $30,000)

$60,000 3,000 4,000 2,500 3,500 $6,000 (16,000)

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Net long-term capital loss (10,000) Limit on current capital loss deductions (3,000) Adjusted gross income (AGI) 70,000 Less itemized deductions: Home mortgage interest $6,000 Property taxes 2,000 Charitable contributions 7,000 Less total itemized deductions (15,000) Less personal and dependency exemptions (2 x $4,050) (8,100) Taxable income 46,900 Tax on ordinary income (head of household): $1,335 + [15% x ($46,900 - $13,350] $6,367.50 Plus tax on $3,000 dividend income ($3,000 x 0%) 0 $6,367.50 Less child tax credit (1,000) Less dependent care credit ($3,000 maximum x 20%) (600) Less income tax withholdings (6,000) Tax refund ($1,232.50) Nontaxable income includes: interest income on City of New York bonds, child support, and life insurance proceeds.

She has a $7,000 capital loss carryforward ($10,000 net long-term capital loss $3,000 limit on current capital loss deduction).

70. Comprehensive Problem.

Solution: a. AGI = $359,132 and taxable income = $242,448. $120,000 salary + $148,000 income from sole proprietorship + $12,000 interest income on corporate bonds + $19,000 cash dividends + $70,000 long-term capital gain = $369,000 total income - $9,868 deductible half of self-employment tax = $359,132 AGI - $106,640 itemized deductions - $10,044 exemptions = $242,448 taxable income.

Interest on state bonds is not subject to income tax.

Self-employment tax: $148,000 x 92.35% = $136,678 x 2.9% = $3,963.66 Medicare + $15,772.80 ($127,200 x 12.4%) Social Security = $19,736 total selfemployment tax x 50% = $9,868 deduction for AGI. Itemized deductions: $48,000 mortgage interest + $11,000 taxes + $49,000 charitable contributions = $108,000 before phase out. ($359,132 - $313,800) x 3% = $1,359.96 phase out. $108,000 - $1,360 = $106,640 itemized deductions.

Exemptions: $4,050 x 4 = $16,200 before phaseout. ($359,132 - $313,800)/$2,500 = 18.13 rounded up to 19 x 2% = 38% x $16,200 = $6,156 phase out. $16,200 $6,156 phaseout = $10,044 exemptions. b. $1,124 tax due. $43,568 income tax + $19,736 self-employment tax + $60 Medicare surtax on self-employment income + $3,838 NII tax = $66,124 total tax $65,000 tax prepaid through withholding and estimated payment = $1,124.

Income tax: $242,448 – ($19,000 dividends + $70,000 LTCG) = $153,448. Tax = $153,448 - $153,100) x 28% + $29,752.50 = $29,849.94 + ($89,000 x 15%) = $43,199.94.

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Medicare surtax: $120,000 salary + $136,678 self-employment income - $250,000 threshold = $6,678 x 0.9% = $60.

NII tax: $12,000 taxable interest + $19,000 dividends + $70,000 capital gain = $101,000 x 3.8% = $3,838 NII tax. ($101,000 is less than $359,132 AGI $250,000 threshold = $109,132). c. 18.61% effective tax rate as a percentage of AGI ($66,834 total tax/$359,132) Develop Planning Skills 71. [LO 5.3] Timing Charitable Contributions Solution: a. Tax liability is $9,651.25 for each year. [$68,000 – ($5,800 + $2,500) - $4,050 exemption = $55,650 taxable income. [($55,650 - $37,950) x 25%] + $5,226.25 = $9,651.25 each year x 2 = $19,302.50 for two years. b. $9,026.25 for 2017 and $10,138.75 for 2018.

2017: [$68,000 – ($5,800 + $5,000) - $4,050 exemption = $53,150 taxable income. [($53,150 - $37,950) x 25%] + $5,226.25 = $9,026.25 for 2017.

2018: [$68,000 – $6,350 standard deduction - $4,050 exemption = $57,600 taxable income. [($57,600 - $37,950) x 25%] + $5,226.75 = $10,138.75 for 2018.

The total for the two years is $19,165 ($9,026.25 + $10,138.75). c. She should contribute $5,000 in 2017.

72. [LO 5.4] After-Tax Interest Rate Solution: Larry should finance the car through a home equity loan because the after-tax interest rate is only 3.35 percent [5% x (1-.33 tax rate)] for the home equity loan compared with 3.5 percent for the loan through the dealer. The home equity loan interest expense is deductible while the car loan interest is not.

73. [LO 5.4] Charitable Contributions Solution: d. Manuel should contribute the cash to get a $10,000 deduction.

The stock acquired five years ago should be sold so Manuel can deduct the $3,000 loss; then he could contribute the proceeds from the sale.

The stock acquired six months ago would only generate a contribution deduction of $4,000 because it has not been held for more than one year.

The inventory would only generate a contribution deduction of $10,000, so it should be sold and the loss recognized.

74. [LO 5.4] Charitable Contributions Solution: Martin should elect to deduct the $50,000 basis this year because it allows him to deduct up to 50 percent of AGI in the current year. There will be no carryover to future years, however. Martin would have taxable income of $43,950 [$100,000 $4,050 personal exemption – ($50,000 + $2,000 real estate taxes). His tax on $43,950 is $6,726.75 ([($43,950 - $37,950) x 25%] + $5,226.25).

If Martin instead chooses to use the $60,000 fair market value, his current deduction will be limited to $30,000 (30% of AGI) with the $30,000 balance

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carried forward a maximum of five years, and he will be subject to the same 30 percent of AGI limitation. His taxable income with the $30,000 deduction is $63,950 [$100,000 - $4,050 – ($30,000 + $2,000)]. His tax on $63,950 is $11,726.25 ([($63,950 - $37,950) x 25%] + $5,226.25), an increase of $5,000 ($11,726.25 - $ 6,758.75) over the first alternative.

As his expected AGI in the coming years is only $15,000, he will have a maximum charitable contribution of only $4,500 ($15,000 x 30%) in each year. Over the five-year carry over period, he would be able to deduct a maximum of only $22,500 (5 x $4,500) and he would lose the remaining $7,500. In addition, assuming his other itemized deductions remain at $2,000 and he is not yet 65, he will benefit by no more than $150 ($4,500 + $2,000 - $6,350 standard deduction) in any of the future years depending on the standard deduction inflation adjustment. This would amount of an annual tax savings of $15 ($150 x 10% tax rate) or a savings of $75 ($15 x 5) over the 5-year carry over period. At 6 percent, the present value of an annual tax savings of $15 is only $63.18 ($15 x 4.212).

This is $4,936.82 ($5,000 - $63.18) less than the tax savings achieved by deducting the $50,000 this year. If Martin reaches age 65 during this period, his standard deduction will increase by at least $1,550, further eroding the benefit of itemizing his deductions to a negative $1,400 ($4,500 + $2,000 - $6,350 - $1,550 extra standard deduction for age) for any year he is 65 and increasing the tax savings of the $50,000 deduction.

75. [LO 5.2 & 5.6] Education Tax Credit and Deduction Solution: The tuition and fees they pay are eligible for the American Opportunity credit (maximum $2,500 on annual tuition, fees, and course materials of $4,000 or more) for up to four years of post-secondary education. Lillian would then be eligible for the lifetime learning credit (up to 20 percent of $10,000 tuition and fees) for the remaining years of her education. The American Opportunity credit phases out proportionately over modified AGIs of $160,000 - $180,000 for married taxpayers.

The lifetime learning credit phases out proportionately over modified AGIs of $112,000 - $132,000 for married taxpayers.

If the credits are not claimed, a $4,000 deduction may be allowed for highereducation expenses for taxpayers whose AGI does not exceed $130,000 (married filing jointly) if this provision is extended by Congress (it expired at the end of 2016). Under this provision, married taxpayers with income between $130,000 and $160,000 are allowed to deduct $2,000 of qualifying expenses.

76. [LO 5.6] Fringe Benefit vs. Additional Pay Solution: The $19,000 job with Mahalo that provides free child care provides the greater after-tax cash flow.

Their current $76,000 taxable income (after all deductions) will increase to $95,000 ($19,000 + $76,000) if Sharon accepts the job with Mahalo; their taxable income will increase to $102,000 ($26,000 + $76,000) if she accepts the job with Ohana. The 15% tax bracket ends at $75,900 so all of the additional income from either job will be taxed at a 25% tax rate.

If Sharon takes the job that pays $7,000 more ($26,000 - $19,000), she will have to

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use $6,300 ($525 x 12 months) in after-tax dollars to pay for her childcare.

She will be subject to additional FICA tax of $535.50 ($7,000 x 7.65%). She will have $1,750 [($7,000 x 25%)] in income taxes for the additional $7,000 in income from this job for a net increase in income taxes of $550 [$1,750 - $1,200 (20% x $6,000) dependent care credit].

The additional $1,085.50 ($535.50 FICA + $550 income tax) in total tax leaves her with only $5,914.50 ($7,000 - $1,085.50 tax) in after-tax cash flow to pay the $6,300 in child care expenses.

She will be better off by $385.50 ($6,300 - $5,914.50) to take the job with Mahalo for $19,000 that provides free child care facilities. She should, however, carefully consider whether there would be other reasons to take the higher paying job that outweigh the tax advantages of the one providing child care.

77. [LO 5.6] Dependent Care Credit versus FSA Solution: Using an FSA results in $1,032.50 more in total tax savings compared to claiming a dependent care credit. Eileen’s taxable income before considering the FSA deduction is $57,550 ($75,000 – $8,100 exemptions and $9,350 standard deduction) and this places her in the 25% tax bracket. Using an FSA effectively allows a deduction of $5,000 at the 25% tax rate (saving $1,250) compared to the dependent care credit that allows a deduction equivalent of $3,000 at a 20% rate (saving only $600 in taxes) for an income tax savings of $650. Additionally, using an FSA saves $382.50 ($5,000 x 7.65%) in FICA taxes.

The total tax liability using an FSA would be $11,745 computed as follows: $75,000 salary - $5,000 to FSA = $70,000 net salary - $9,350 standard deduction $4,050 personal exemption - $4,050 dependency exemption = $52,550 taxable income. The income tax is {$6,952.50 + [($52,550 - $50,800) x 25%]} = $7,390 $1,000 child tax credit = $6,390. The FICA tax is $5,355 ($70,000 net salary x 7.65%). The total tax liability is $11,745 ($6,390 income tax + $5,355 FICA tax).

The total tax liability if claiming the dependent care credit is $12,777.50 computed as follows: $75,000 salary - $9,350 standard deduction - $4,050 personal exemption - $4,050 dependency exemption = $57,550 taxable income. The income tax is $6,952.50 + [($57,550 - $50,800) x 25%] = $8,040 - $1,000 child tax credit $600 ($3,000 x 20%) dependent care credit = $7,040 income tax. The FICA tax is $5,737.50 ($75,000 salary x 7.65%). The total tax liability is $12,777.50 ($7,040 income tax + $5,737.50 FICA tax). $12,777.50 - $11,745 = $1,032.50 tax savings with an FSA 78. [LO 5.7] Stock Options and AMT Solution: Alisa recognizes no income regardless of when she exercises the options. She will however, recognize the appreciation on the stock for regular tax purposes in the year she sells the stock acquired with the ISO. At the time of sale, she will have a long-term capital gain of $1.7 million [($100 selling price - $15 basis) x 20,000 shares] for regular tax purposes.

For AMT purposes, however, Alisa’s current year income tax return will show an AMT adjustment of $500,000 [($40 fair market value at exercise date – $15

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exercise price) x 20,000 shares] if the options are exercised now and an AMT adjustment of $800,000 [($55 fair market value at exercise date – $15 exercise price) x 20,000 shares] if the options are exercised later in the year.

When the stock is sold, the basis for AMT purposes will be the fair market value at the time the option was exercised. If she exercises the option when the fair market value is $40, she will have a $1.2 million [($100 - $40) x 20,000 shares] long-term capital gain upon sale for AMT purposes. If she exercises the option when the fair market value is $55, she will have a $900,000 [($100 - $55) x 20,000 shares] longterm capital gain upon sale for AMT purposes.

Alisa’s AMTI and AMT are significantly lower when she exercises her ISOs at the lower fair market value. Her lower stock value results in a decrease in the AMT adjustment and a corresponding decrease in the AMT due. She trades AMT ordinary income, which is taxed at 26 to 28 percent, for AMT long-term capital gain income, which is generally taxed at a maximum 20 percent (excluding any applicable surtax). She also defers payment of the tax because AMT ordinary income is a current year tax liability while the AMT long-term capital gain tax from the sale is deferred until the year of sale.

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter.

79. [LO 5.2] Deductions for vs. from AGI Solution: Answers will vary with student.

80. [LO 5.4] Deductions for vs. from AGI Solution: Answers will vary with student.

81. [LO 5.4] Interest Expense Solution: Congress needed to eliminate some deductions in 1986 to pay for other tax cuts in the tax bill. It wanted to encourage savings and did not want to encourage increased personal debt. One way to discourage debt is to eliminate the tax deduction for interest. Note that the interest deduction for residence mortgage was retained because Congress wants to encourage home ownership. For many taxpayers, their homes become their most significant long-term investment.

82. [LO 5.5] Proposed New Deduction Suggested Solution: Some may argue that people with no children view their pets as children. This provision could encourage better care of animals particularly if more funds are spent on medical care. Moreover, a significant amount of research has shown that older persons who have pets are healthier and live longer than those who are alone. This could encourage those persons to acquire a pet and could have the effect of lowering health care costs for older persons. Others may argue that the cost of this proposal would be too expensive and that these funds could be better spent on something else. They could also argue that acquisition of a pet is a purely personal decision and should not be subsidized. The cost for personal

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assistance animals is already deductible.

83. [LO 5.6] Dependent Care Fringe Benefit vs. Credit Solution: Factors to be considered include the number of qualifying dependents, the anticipated cost of the childcare and the income level of the taxpayer. The dependent care assistance benefit has a $5,000 limit regardless of the number of children. The maximum dependent care credit is more for two or more children than for one child and the percentage rate for the credit is higher for lower income taxpayers. Thus, the interaction of the number of dependents, the qualifying expenses and the rate determines which is the most advantageous.

Search the Internet 84. [LO 5.3] Additional Standard Deduction for Blindness.

Solution: If the taxpayer has impaired vision, he or she must get a certified statement from an eye doctor or registered optometrist that the taxpayer: 1. Cannot see better than 20/200 in the better eye with glasses or contact lenses, or 2. The field of vision is not more than 20 degrees.

If the eye condition will never improve beyond these limits, the statement should include this fact and be kept with the taxpayer’s records.

If the taxpayer’s vision can be corrected beyond these limits only by contact lenses that can be worn only briefly because of pain, infection, or ulcers, the taxpayer can take the additional standard deduction for blindness.

85. [LO 5.4] Impairment-Related Work Expenses Solution: Impairment-related work expenses are the necessary expenses that a taxpayer who is disabled incurs to be able to work. Impairment-related expenses are deductible as business expenses if they are: 1. Necessary for the taxpayer to do his or her work satisfactorily 2. For goods and services not required or used, other than incidentally, in the taxpayer’s personal activities, and 3. Not specifically covered under other income tax laws.

Employees report their expenses on Form 2106 (or 2106-EZ). This amount is then entered on Schedule A: Itemized Deductions under Other Miscellaneous Deductions. The impairment-related work expenses are not subject to the 2 percent of AGI floor.

Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

86. [LO 5.3] Abandoned Spouse Solution: Will Holly qualify as an abandoned spouse?

87. [LO 5.4] Medical Expense Deduction Solution: Does liposuction qualify as a deductible medical expense?

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88. [LO 5.4] Medical Expense Deduction Solution: Does the pool qualify as a medical expense deduction? If yes, how much of the cost can be deducted?

89. [LO 5.4] Medical Expenses Solution: Can they deduct their daughter’s tuition as a medical expense?

90. [LO 5.4] Interest Expense Deduction Solution: How much can Helen deduct for interest expense for the current year?

91. [LO 5.5] Dependents Solution: Will Carla’s mother pass the gross income test and qualify as a dependent of Carla? Can Carla qualify as head of household?

92. [LO 5.5] Dependents Solution: If Jose’s parents move to Mexico, will they pass the residency test to qualify as dependents of Jose?

93. LO 5.5] Dependents Solution: Can the student qualify as Jessica’s dependent?

94. [LO 5.4 & 5.5] Dependent’s Medical Expenses Solution: Can Sabrina claim her Aunt Betty as a dependent? Can she deduct Aunt Betty’s medical expenses whether she is or is not a dependent?

95. [LO 5.2 & 5.6] Education Credit or Deduction Solution: How much can they claim for an education tax credit? Are there any alternatives to the education credit? Do the income limitation phaseouts affect their options?

Develop Research Skills Solutions to research problems 96 - 99 are included in the Instructor’s Manual.

Fill-in the Forms Solutions to tax forms problems 100 – 104 are included in the Instructor’s Manual.

Solutions to Chapter 6 Problem Assignments Check Your Understanding 1. [LO 6.1] Trade or Business Solution: To be a qualified trade or business, an activity must have a profit motive (to make money) and the taxpayer must spend a sufficient amount of time in the business so that it is not considered simply an investment activity or a hobby. The motivation for the activity cannot be primarily personal pleasure; it must be profit.

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2. [LO 6.1] Investment Expenses Solution: An investment activity is one in which the owner intends to make a profit but does not spend sufficient time to elevate it to a trade or business. Typically, the income from an investment activity comes from owning income-producing assets or from long-term appreciation in assets.

Investment expenses are deductible but the deduction may be limited. Individuals are only permitted to deduct their investment expenses as miscellaneous itemized deductions subject to the 2 percent of AGI limitation.

3. [LO 6.1] Substantiation Solution: Substantiation may be provided in the form of receipts, canceled checks, and paid bills. If the expense is for travel, entertainment, gifts or automobile expenses, the substantiation could include diaries, trip sheets, travel logs, paid bills, receipts, account books, and expense reports. These should document the amount of the expense, the time and place of the expense, the business purpose for the expense, the date and description of a gift and the business relationship to the person receiving a gift.

4. [LO 6.2] Timing of Expense Deduction Solution: a. Marvil can deduct the expense in year 1. b. Because Marvin’s daughters own Marvil Corporation, it is a related entity, so Marvil cannot deduct the payment for the legal expense until year 2, the year Marvin recognizes the income.

5. [LO 6.2] Timing of Expense Deduction Solution: Businesses are not permitted to use reserves for expenses for tax purposes. Aloha can only deduct the repair expenses in the year the repairs are performed, if it is an accrual-basis taxpayer, or when they are paid, if it is a cash-basis taxpayer.

6. [LO 6.3] Business Investigation Expenses Solution: Diane can deduct the $1,900 ($1,600 + $300) in the current year as business investigation expenses. Diane can deduct this amount because she is already in the clothing business and expenses for potential expansion are ordinary business expenses whether or not a new store is opened. Her brother, however, is not permitted any deduction for the $1,900 that he expended. Cameron could only deduct the $1,900 (along with start-up expenses not exceeding $5,000 in total) if the new store was opened.

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7. [LO 6.3] Organization Costs vs. Business Expenses Solution: $5,000 of the $6,000 organizational costs are deducted in the first tax year and the remaining $1,000 are capitalized and amortized over 180 months starting with the month the corporation begins business. The $700 legal fee is fully deductible in the second year as a business expense.

8. [LO 6.4] Business Gifts Solution: The deduction for business gifts is limited to $25 per donee annually.

9. [LO 6.4] Domestic vs. Foreign Travel Solution: Domestic travel—Actual transportation expenses (plane, train, etc.) as part of travel are fully deductible if the trip is primarily business (more business than nonbusiness days). If the trip is primarily personal, no transportation expenses are deductible.

Meals and lodging are deductible only for business days.

Foreign travel—If the travel is purely for business, all transportation costs are deductible. If the travel combines business with some personal days, the transportations costs must be allocated between business and personal time unless the travel time does not exceed one week or less than 25 percent of the time is spent on personal pursuits. In these latter cases, all transportation expenses are deductible.

If the travel is primarily personal (personal days exceed business days), no transportation expenses may be deducted. Costs of meals and lodging must be allocated between business and personal days with a deduction only allowed for business days.

10. [LO 6.5] Vacation Rental Solution: If a vacation home is used by the owner and rented out, the limit on the expense deduction depends upon the relative use by each. If the home is rented for less than 15 days, only those normal expenses of a second home such as mortgage interest and taxes, are deductible as itemized deductions.

If the home is rented for more than 14 days and is used no more than the greater of 14 days or 10 percent of the rental days by the owner, the home is treated as rental property and all rental expenses are deductible against the rental income (subject to the passive loss limitation exception). Mortgage interest for the personal-use days is not deductible because the dwelling does not qualify as a ―home‖ due to the limited personal use. Real estate taxes, however, are still deductible as itemized deductions.

For rental of more than 14 days, with owner-use more than the greater of 14 days or 10 percent of rental days, the deduction for rental expenses is limited to the rental income. Both mortgage interest and taxes for the personal-use portion, and any portion of these expenses that are disallowed due to the rental income limitations, are deductible as itemized deductions.

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11. [LO 6.5] Passive Loss Limits for Rental Property Solution: The passive activity rules separate income or loss into one of three categories: active (salaries, wages, and profit or loss from a business in which the taxpayer materially participates), portfolio (interest, dividends and capital gains), and passive (rental activities and limited partnerships). Losses from passive activities can only offset profits from another passive activity (not income from the other two categories). Disallowed passive rental losses are carried forward to offset profits in a future year from another rental or passive activity.

A limited exception allows a deduction for up to $25,000 of losses from rental real estate. To be eligible for this relief, the taxpayer must own at least 10 percent of the rental activity, must not be a limited partner, and must ―actively‖ participate in the activity. Active participation requires the taxpayer to participate in the management of the property, such as setting rents, qualifying renters, and approving repairs. To deduct the full $25,000, taxpayer’s adjusted gross income (AGI) must not exceed $100,000. For every dollar the taxpayer’s AGI exceeds $100,000, the taxpayer loses 50 cents of the deduction. The entire deduction is lost when the taxpayer’s AGI reaches $150,000.

12. [LO 6.5] Home Office Deduction Solution: For a self-employed person to claim a deduction for a home office, the space must be used exclusively and on a regular basis for the business, and it must be one of the following: the principal place of business for the taxpayer, a place where clients or customers are met regularly in the normal course of business, or located in a structure separate from the home. In addition to the above requirements, an employee’s home office must be for the convenience of the employer (for example, relieving the employer from providing the employee with an office).

13. [LO 6.5] Hobby vs. Business Solution: Factors that differentiate a hobby from a business include:       

The manner in which the taxpayer carries on the activity; The expertise of the taxpayer and of the taxpayer’s consultants; The time and effort spent by the taxpayer in the activity; The taxpayer’s history of profits or losses for this activity; The success of the taxpayer in similar activities; The overall financial status of the taxpayer; and The elements of pleasure or recreation that are part of the activity.

14. [LO 6.6] Tax vs. Financial Accounting Solution: A permanent difference between tax and financial accounting is one that results from a treatment that does not reverse over time (the difference remains imbedded

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in their respective net incomes permanently). A temporary or timing difference is one that does reverse in a later period. (Over two or more periods, the income or deductions for financial accounting will equal the income or deductions for tax accounting.) Examples of timing differences include differences in depreciation schedules, bad debt deductions vs. allowances for bad debt, and prepaid expenses.

Examples of permanent differences include tax-exempt interest income on municipal bonds, life insurance proceeds, and nondeductible fines.

15. [LO 6.6] Schedule M-3 Solution: Large corporations with assets of $10 million or more must file a Schedule M-3.

This schedule requires large corporations to separately report temporary and permanent differences. The IRS has mandated this disclosure of permanent differences to assist in preventing the use of abusive tax shelters that are structured either to reduce the amount of taxes paid without reporting any corresponding decrease in book income or to increase book income without a corresponding increase in tax liability.

16. [LO 6.6] Uncertain Tax Positions Solution: Step 1: The business must evaluate each tax position to assess whether it is more likely than not (greater than 50 percent) that the position would be sustained upon examination (including the administrative appeals and litigation process). The business must base its assessment on an analysis of the relevant tax authorities (such as the Code, regulations, rulings, and court cases) and it must assume that the tax authorities have full knowledge of all relevant information (including access to work papers and legal opinions from outside tax advisors). This requirement must be met even if the business believes the possibility of audit or discovery of the matter is remote. Additionally, each tax position must stand on its own technical merits so that a business may not consider one position as a bargaining chip against another tax position.

Step 2: If a tax position satisfies the first step, the business can then proceed to measure the tax benefit that can be recognized in the financial statements from its uncertain position. If no single amount is more likely than not to be realized, then a cumulative probability analysis of the possible outcomes is required. The business records the largest tax benefit that meets a greater than 50 percent cumulative probability of realization upon ultimate settlement.

17. [LO 6.6] UNICAP Rules Solution: The uniform capitalization rules require a business to include as part of the cost of inventory all the direct costs of manufacturing, purchasing, and storing inventory along with an extensive list of items that are part of overhead, such as factory administration, taxes, pension costs, and service support functions. Businesses whose average annual gross receipts in the three preceding years exceed $10

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million are subject to the UNICAP rules for determining the costs of inventory.

18. [LO 6.6] UNICAP Rules Solution: a. Factory insurance - Included b. Advertising – Not included c. Payroll taxes for factory employees - Included d. Research and experimentation costs – Not included e. Repairs to factory equipment – Included 19. [LO 6.6] LIFO Inventory Solution: In an economy with rising prices, the LIFO inventory method for tax purposes matches the latest and highest costs for goods sold with the selling price of the goods. This reduces the business’s taxable income and its taxes payable. The disadvantage is that LIFO must then be used for financial reporting. Thus, financial accounting income reported will also be lower. The business can, however, report an alternative inventory valuation in supplementary material to the financial statements.

Crunch the Numbers 20. [LO 6.1] Expenses Related to Tax-Exempt Income Solution: Mary is allowed no interest deduction because the loan proceeds were used to invest in tax-exempt securities.

21. [LO 6.1] Interest Deduction Solution: a. Mike cannot deduct anything because it is not his loan. b. Kelley can only deduct the $5,850 interest expense for the nine monthly payments that she made. c. Mike should have given (or loaned) the money to Kelley and let Kelley make the loan payments. That way, Kelley could take a deduction for the $7,800 interest paid that year.

22. [LO 6.2] Prepaid Rent Solution: a. Bender can only deduct $1,800 (3 x $600) rent for the three months remaining in the current year, because the rent payment is for a period extending beyond the end of the succeeding year. b. Bender can deduct the $7,200 in each year that it is paid. The contract calls for the advance payments and each payment does not extend beyond the end of the year following the year it is paid.

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23. [LO 6.2] Prepaid Expenses Solution: Simon can only deduct the $5,000 paid for supplies. The insurance payment must be capitalized and written off one-third in each of the years it covers as if Simon was an accrual-basis taxpayer.

24. [LO 6.2] Interest Deduction Solution: $200 for year 1 and $10,200 for year 2. Foster must amortize the loan discount ($100,000 - $98,000 = $2,000 discount) over the 10-year life of the loan at a rate of $200 per year. Foster can only deduct the $200 amortized discount in year 1; it can deduct $10,200 in year 2, consisting of the $10,000 interest paid on January 1 and the $200 amortization.

25. [LO 6.3] Start-up and Organizational Costs Solution: $10,170 is deductible in the first year ($5,000 + $120 + $5,000 + $50). The $2,800 investigation expenses are combined with the $4,600 of start-up expenses for a total of $7,400. Marco can expense $5,000 of these expenses; the remaining $2,400 is amortized at a rate of $13.33 per month ($2,400/180), beginning with the first month of operations ($13.33 x 9 months = $120 for the first year). $5,000 of the organization costs can be expensed in the first year; the remaining $1,000 is amortized at a rate of $5.56 per month ($1,000/180), beginning with the first month of operations ($5.56 x 9 months = $50).

26. [LO 6.4] Business Meals and Club Dues Solution: Elisa can deduct $500 (50% x $1,000) of the business lunches only. She has no deduction for any portion of the club dues.

27. [LO 6.4] Entertainment Expenses Solution: $70. Entertainment tickets are not only subject to the 50% limit, but the 50% limit applies to the face value of the tickets. Thus, Jim is allowed a deduction for only one-half of the face value of the tickets or $70 (50% x $140).

28. [LO 6.4] Travel Expenses Solution: Martha cannot deduct any travel expenses. Her tax home is in San Diego. Her travel to Los Angeles is purely personal and her expenses are nondeductible.

29. [LO 6.4] Travel Expenses Solution: $1,100 deductible travel expenses. The airfare of $420, $500 for the hotel, $100

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(50% x $200) for meals for the 4 business days, and $80 ($20 x 4) for the cost of 4 days for the rental car = $1,100 deductible travel expenses. He may also deduct $25 of the cost of the gift for the customer in Phoenix, but that is not a travel expense.

30. [LO 6.4] Temporary Assignments Solution: $8,500. The $7,000 for lodging and transportation and $1,500 ($3,000 x 50%) for meals during the first seven months are deductible as travel expenses. At that point, the assignment is no longer temporary because the 10-month extension will extend it beyond the one-year limit; the expenses from that point on no longer qualify as travel expenses.

31. [LO 6.4] Temporary Assignments Solution: Dan cannot deduct any of his expenses incurred for the apartment rent or meals during the 18 months in New York. Because the assignment exceeded one year, it is not temporary and his tax home shifted to New York.

32. [LO 6.4] Transportation Expense Solution: $7,222.50 (90 days x 150 miles x 53.5¢); John is allowed to deduct his mileage only. He has no deduction for meals as he is not ―traveling away from home.‖ 33. [LO 6.4] Foreign Travel Solution: $2,730. Luis can deduct $980 (7/10 x $1,400) transportation costs, $1,400 (7 x $200) for his hotel, and $350 (7 x $100 x 50%) for his meals, for a total of $2,730.

34. [LO 6.4] Uncollectible Accounts Solution: a. Maria must recognize $50,000 of income during the current year. She will deduct the $2,000 as a bad debt in the year she determines it is uncollectible. b. Maria will recognize only $48,000 of income in the current year. She has no deduction for the $2,000 that she cannot collect because it was never recognized as income.

35. [LO 6.4] Insurance Solution: Melbourne can deduct $36,000 ($16,000 + $20,000) in insurance expense. The $2,000 premium for the president’s life insurance policy is not deductible because the insurance proceeds would be tax exempt.

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36. [LO 6.4] Legal Expenses Solution: Jim may deduct the $15,000 in legal fees only. The fines for the parking tickets are nondeductible.

37. [LO 6.5] Home Office Expenses Solution: a. Maureen’s deductible expenses for her home office are limited to the business income ($3,400) and she must account for expenses in the following order: $1,600 Mortgage interest and property taxes [($5,000 + $1,400) x 400/1600] 450 Utilities and repairs [($1,200 + $600) x 400/1600] 1,350 Depreciation ($6,000 x 400/1600 = $1,500) limited to $1,350 ($3,400 $1,600 - $450 = $1,350 remaining).

Her business income would be zero and she would owe no self-employment taxes. b. Maureen could elect the simplified option that allows her to deduct $5 per square foot up to 300 square feet = $1,500 for her home office expenses without requiring an allocation of mortgage interest and taxes. Her business income would then be $1,900 ($3,400 - $1,500) instead of zero so she would have to pay income tax and self-employment tax on that income. However, she would be allowed to deduct the full $6,400 for mortgage interest and property taxes as itemized deductions. c. If she uses the actual method (in part a), the nondeductible portion of the depreciation ($150) will be carried forward to future years and will be deductible subject to similar limitations. If she uses the simplified method (in part b), she would have no carryover of any expenses to future years.

38. [LO 6.5] Business vs. Hobby Solution: a. If the activity is a business, Teresa may deduct all of the expenses from the revenue; she will report a loss of $3,000 ($24,000 - $10,000 - $3,000 - $8,000 $2,000 - $4,000). b. If the activity is a hobby, Teresa will be able to deduct expenses only to the extent of her income from the activity. So she can deduct only $24,000 of the expenses. c. Some of the factors that should be considered are:       

The manner in which the taxpayer carries on the activity; The expertise of the taxpayer and of the taxpayer’s consultants; The time and effort spent by the taxpayer in the activity; The taxpayer’s history of profits or losses for this activity; The success of the taxpayer in similar activities; The overall financial status of the taxpayer; and The elements of pleasure or recreation that are part of the activity.

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39. [LO 6.5] Vacation Home Rental Solution: a. Neil does not include the $1,500 ($150 x 10) rent in income. He deducts the mortgage interest and property taxes in full as itemized deductions. He is allowed no deduction for the other expenses. b. Neil must recognize $15,000 ($150 x 100) rent as income. He deducts 100/110 of each expense against this income. Thus, the expense deductions are $21,818 ($24,000 x 100/110) for mortgage interest; $10,909 ($12,000 x 100/110) for property taxes; $10,909 ($12,000 x 100/110) for depreciation; and $4,545 ($5,000 x 100/110) for the other expenses resulting in a rental loss of $33,181 ($15,000 $48,181). The current deductibility of this loss may be limited by the passive activity loss rules. He is not allowed to deduct the balance of the mortgage interest because his personal-use did not meet the threshold to qualify as a ―home‖ but he can deduct the $1,091 ($12,000 - $10,909) personal portion of the property taxes as an itemized deduction. c. His deductions are now limited to his rental income of $9,000 ($150 x 60 days).

He must first deduct the rental portion of mortgage interest and property taxes of $19,636 ($36,000 x 60/110); this deduction is limited to $9,000, however. The $27,000 ($36,000 - $9,000) remaining interest and taxes are deductible as itemized deductions. None of the other expenses are deductible.

40. [LO 6.6] Book/Tax Differences Solution: a. $406,500. ($400,000 - $8,000 tax-exempt interest income + $11,000 (50% x $22,000) meals and entertainment expense + $3,300 life insurance premium + $200 fines). b. $138,210 ($406,500 x 34%). Tax expense on the financial statement and taxes payable will be the same because all of the adjustments are for permanent differences between tax and financial accounting income.

41. [LO 6.6] Book/Tax Differences Solution: a. $3,400 [($80,000 - $70,000) x 34%] b. The $3,400 is a deferred tax asset as taxes payable are more than book tax expense, resulting in a prepayment of the tax. c. It will credit the $3,400 deferred tax asset created in the prior year for the difference.

42. [LO 6.6] Book/Tax Differences Solution: a. All except two of the items are permanent differences. The $2,100 ($3,000 $900) excess of the addition to the allowance for bad debts over the direct writeoff is a temporary difference and the $4,000 ($11,000 - $7,000) excess of MACRS depreciation over straight-line financial depreciation is also a temporary

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difference. b. Taxable income is $452,600 and the income tax payable is $153,884. $500,000 book income - $3,000 exempt interest income + $200 nondeductible interest expense + $2,100 excess of addition to allowance for bad debts over the direct write-off + $2,000 ($4,000 x 50%) nondeductible portion of meals and entertainment - $4,000 excess of MACRS depreciation over straight-line financial depreciation + $2,800 nondeductible premiums on officer’s life insurance $50,000 tax-exempt life insurance proceeds + $2,500 nondeductible fines = $452,600 taxable income. $452,600 x 34% = $153,884 income tax payable.

43. [LO 6.6] Accounting for Deferred Tax Assets and Deferred Tax Liabilities Solution: a. The $2,100 ($3,000 - $900) excess of the addition to the allowance for bad debts over the direct write-off results in a deferred tax asset of $714 ($2,100 x 34%). The $4,000 ($11,000 - $7,000) excess of MACRS depreciation over straight-line financial depreciation results in a deferred tax liability of $1,360 ($4,000 x 34%). b. The journal entry is as follows: Income tax expense Deferred tax asset

154,530 714

Deferred tax liability

1,360

Income tax payable

153,884

44. [LO 6.6] Accounting for Uncertainty in Income Taxes Solution: $600. Makai will recognize a $600 deduction in its financial statements because it is the largest amount of benefit that is more than 50% likely to be sustained based on the outcome’s cumulative probability.

45. [LO 6.6] UNICAP Rules Solution: 70% (14 factory employees / 20 factory & sales staff) of the office costs are allocated to inventory.

46. [LO 6.6] FIFO vs. LIFO Solution: a. No. Inventory costing methods do not have to match the actual flow of inventory. b. $102,000 [($375,000 - $75,000) x 34%] could have been saved by using the LIFO inventory method. c. If Barley uses LIFO for tax reporting, it will be required to use LIFO in its financial statements; it will, however, be able to supply supplementary data on alternate inventory methods outside the financial statements.

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47. Comprehensive Problem for Chapters 4 and 5 on Sole Proprietorship Solution: a. Net income from the business is $31,767. The expenses deductible from the $45,000 of gross income are: $ 500 for advertising 2,900 for supplies 500 for taxes and licenses 600 for travel (other than meals) 200 for meals (50% x $400) 4,494 for auto expense (53.5¢ x 8,400 miles) 100 parking and tolls 3,939 for home office expenses* $13,233 total expenses *Home office expense: 500/2,000 x $10,300 total expense other than depreciation = $2,575 + $1,364 depreciation for office = $3,939 Net income from the business is $31,767 ($45,000 - $13,233). b. Self-employment income = $31,767 x 92.35% = $29,336.82 x 15.3% = $4,488.53 self-employment tax. c. Martin may claim the following additional deductions for AGI: $2,244 ($4,488 x .5) for self-employment taxes; $1,400 health insurance premium; and $2,500 contribution to his IRA. He would have itemized deductions of $5,775 (1500/2000 x $7,700 interest and taxes). The $120 for speeding tickets is not deductible. d. The simplified option that allows him to deduct $5 per square foot up to 300 square feet = $1,500 for his home office expenses without requiring an allocation of mortgage interest and taxes. The net income from his business would then be $34,206 ($45,000 - $10,794).

Self-employment income = $34,206 x 92.35% = $31,589.24 x 15.3% = $4,833.15 self-employment tax.

Martin may claim the following additional deductions for AGI: $2,416.58 ($4,833.15 x .5) for self-employment taxes; $1,400 health insurance premium; and $2,500 contribution to his IRA. He would have itemized deductions of $6,000 mortgage interest and $1,700 property taxes. The $120 for speeding tickets is not deductible.

Develop Planning Skills 48. [LO 6.2] Timing of Payments Solution: Kondex should pay the expenses next year.

Pay in current year: $50,000 x 25% = $12,500 tax reduction from expense.

Pay next year: $50,000 x 34% x .935 = $15,895 present value of tax reduction in the following year.

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49. [LO 6.4] Combined Business and Pleasure Travel Solution: Bob should arrange business meetings on Friday and Monday. His third business day could be either Thursday or Tuesday. By arranging the meetings on both sides of the weekend, he may be able to deduct all of his travel expenses as business expenses even though he spends Saturday and Sunday on personal pleasure. If it is less expensive for him to stay over for the weekend rather than return home after the meeting on Friday and return for the meeting on Monday, then he will be able to stay over and consider the weekend hotel and meals costs as business expenses.

50. [LO 6.4] Temporary Business Assignments Solution: Yes. If Ken sends two employees, both will be on temporary assignments of less than one year. Kendrick will be able to deduct all of the expenses for lodging (and 50 percent of meals) for the two employees, but they will have no income from the reimbursement. If he sends only one employee for 18 months, that employee’s tax home will change to the new location. Kendrick will be able to deduct the reimbursements for meals and lodging as employee compensation (subject to payroll taxes) and it will be taxable income to the transferred employee, who will have no deduction for any of these expenses.

51. [LO 6.5] Vacation Rental Solution: If John does not extend the rental, none of the tenant’s $3,500 (14 x $250) rent payment is income and John simply deducts the $6,000 taxes and interest that he pays on the vacation condo as itemized deductions.

If he extends the rental, John will have to include $5,250 (21 x $250) in income; he will allocate one-half (3/6 weeks) of all the expenses to the rental income in the following order: taxes and interest, repairs and insurance, then depreciation. Thus, he can deduct $3,000 (50% x $6,000) of the taxes and interest and $1,550 (50% x $3,100) of the allocated repairs and insurance. He takes a depreciation deduction of $500 (50% x $1,000) and reduces the basis of the property accordingly. His total deduction for rental expenses is $5,050 resulting in $200 ($5,250 - $5,050) net rental income. The remaining $3,000 of his interest and taxes may be deducted as itemized deductions.

If he extends the rental he will receive an additional $1,750 (7 x $250) in cash for the rental, but will be taxed on $3,200 more income ($3,000 difference in itemized deductions + $200 net rental income). John would incur $1,056 ($3,200 x 33%) additional taxes to generate $1,750 additional cash from rent. Therefore, he should extend the rental because he will have a positive after-tax cash flow of $694 ($1,750 - $1,056).

Think Outside the Text

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These questions require answers that are beyond the material that is covered in this chapter.

52. [LO 6.5] Vacation Rental Solution: Yes, but there will be limitations on his deductible expenses similar to other vacation homes. The time-share property meets the definition of a dwelling unit.

Prop. Reg. 1-280A-3(f) states that the allocation for the rental expense on a time share shall be applied on the basis of the taxpayer’s expenses for the unit, the number of days during the taxable year that the unit is rented at a fair rental, and the number of days during the taxable year that the unit is used for any purpose.

53. [LO 6.5] Presumption Activity Not a Hobby Solution: By filing Form 5213 within three years of starting the business, Michael keeps the IRS from questioning the profit motive behind his business for 5 years after he starts it. Filing this form, however, puts the IRS on notice that Michael has a business with anticipated losses and may actually invite the IRS to audit him. In addition, if the activity is still losing money after the first 5 years, the form authorizes the IRS to disallow all 5 years of loss deductions; otherwise it generally can go back only 3 years. A better strategy would be to operate the business with a real profit motive and carry on the business in a professional manner, thus eliminating any need to file Form 5213.

54. [LO 6.6] Book/Tax Differences Solution: (1) Prepaid rent expense: deductible under certain circumstances for tax purposes but not deductible for financial purposes until the rental term has passed.

(2) Allowances for repairs: deductible for financial purposes when accrued but not deductible in computing taxable income until the expense is incurred.

(3) Allowances for bad debts: deductible for financial purposes when accrued but not deductible for tax purposes until the debt is determined uncollectible.

There are three reasons why financial accounting treatment differs from tax treatment. First, the goals of financial accounting and tax reporting are very different. The former seeks to provide information that decision makers (such as shareholders and creditors) find useful. The latter seeks to collect revenue equitably. Second, financial accounting often relies on the principle of conservatism, which tends to understate income when uncertainty exists. In contrast, the income tax system would be greatly hampered in its collection of revenue if taxpayers were allowed the freedom of reporting income conservatively.

Third, financial accounting often relies on estimates and probabilities. The tax system would not function very efficiently or equitably if taxpayers were allowed to estimate expenses that may never actually be incurred.

55. [LO 6.6] Book/Tax Differences Solution: The provisions that determine taxable income and financial accounting income

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have many differences. There are two types of differences, permanent and temporary. The permanent differences do not cause any differences in the tax reported for financial purposes than that actually paid. The timing differences, however, result in deferred tax liabilities or deferred tax assets because the differences will reverse in a later period. If there is a deferred tax liability created, the tax expense reported on the financial statement matches financial accounting income; but the taxable income is lower along with the taxes paid; the liability will have to be paid at a later date, however. The deferred tax liability account on the financial statement puts the financial statement users on notice that this tax will have to be paid sometime in the future. The opposite is true for a deferred tax asset; that is, taxes will be lower in the future because of the tax prepayment. In general, the matching of the tax expense to the financial accounting income is believed to provide better evaluative information for the users of financial statements.

56. [LO 6.6] Deferred Tax Assets and Liabilities Solution: If corporate income tax rates are reduced, corporations will benefit on their deferred tax liabilities. The amount of tax paid in the future will be lower than if paid today. The opposite is true for deferred tax assets. Deferred tax assets will provide lower future tax savings for the corporation.

57. [LO 6.6] Tax vs. Financial Accounting for Travel Vouchers Solution: Similar to warranty expenses, a travel voucher expense would be estimated and accrued for book purposes, but it would not be deductible for tax purposes until the vouchers are used. This will result in temporary differences until the vouchers are used or expire.

Search the Internet 58. [LO 6.4] Business Travel Solution: Yes. According to Publication 463, Costa Rica qualifies as part of North America.

59. [LO 6.6] Locate Annual Report Solution: All of the information needed for this problem can be found under ―Note 12.

Income Taxes‖ of Gap’s 2015 annual report. a. Gap’s effective tax rate for the fiscal year 2015 was 37.5% and its effective tax rate for fiscal 2014 was 37.3%. b. Gap’s valuation allowance was $101 million for the year ended January 30, 2016 and $94 million for the year ended January 31, 2015. c. At January 30, 2016, Gap had approximately $65 million state and $180 million foreign loss carryovers in multiple taxing jurisdictions that could be used to reduce the tax liabilities of future years. The tax-effected loss carryovers were

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approximately $4 million for state and $43 million for foreign as of January 30, 2016. Gap provided a valuation allowance of approximately $33 million against the deferred tax assets related to the foreign loss carryovers. Gap also provided a valuation allowance of approximately $68 million related to other federal, state, and foreign deferred tax assets. The state losses expire between fiscal 2019 and fiscal 2034, approximately $57 million of the foreign losses expire between fiscal 2016 and fiscal 2035, and $123 million of the foreign losses do not expire

Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

60. [LO 6.1] Penalties Solution: Can Ace deduct the $3,000 penalty?

61. [LO 6.1 & 6.4] Travel Expenses Solution: Are the expenses incurred to testify deductible as business travel or lobbying expenses?

62. [LO 6.4] Travel Expense Solution: How much of Ken’s expenses for the four-day conference and the week exploring Gettysburg can he deduct as unreimbursed travel expenses for business purposes?

63. [LO 6.4] Bad Debt Deductions Solution: Does Christina have a bad debt deduction for the amount she is unable to collect?

How much and when is any allowable amount deducted?

64. [LO 6.5] Vacation Home Solution: What are the tax effects of exchanging the use of vacation homes? Does this exchange result in any taxable income and are any rental expenses deductible?

65. [LO 6.5] Office in Home Solution: What, if any, of the expenses related to the office at the vacation home are deductible by Scott?

66. [LO 6.5] Business vs. Hobby Solution: Will Anne’s business be considered a hobby or a legitimate business given the lack of profits and the manner in which the business has been conducted?

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Develop Research Skills Solutions to research problems 67 – 70 are included in the Instructor’s Manual.

Fill-in the Forms Solutions to tax forms problems 71 – 75 are included in the Instructor’s Manual.

Solutions to Chapter 7 Problem Assignments Check Your Understanding 1. [LO 7.1] Basis Solution: Linda’s basis is $30,000, the fair market value at the date of death.

2. [LO 7.1] Depreciation Solution: No, depreciation must be taken in the year to which it is allocated; if not taken, basis is still reduced for the allowable depreciation.

3. [LO 7.2] Averaging Conventions Solution: There are two averaging conventions, the half-year and the mid-quarter, which are used for personalty (5-year and 7-year property). A mid-month convention is used for all realty (27½-year and 39-year property).

The half-year convention is used for personalty unless more than 40 percent of the investment in qualifying property is made in the last quarter of the year; then the mid-quarter convention must be used for all personalty placed in service that year based on the quarter the items are placed into service. When calculating if the over40 percent test is met, any personalty expensed under Section 179 and all realty are excluded from the computation.

4. [LO 7.2] Depreciation in Year of Disposition Solution: Yes. Taxpayers must use the same averaging convention that applied at acquisition in the year of disposal if the asset is not fully depreciation. For realty, the month in which a building is disposed of determines the percentage of the annual depreciation rate. Thus, depreciation is taken from the beginning of the year to the midpoint of the month in which the disposition takes place.

5. [LO 7.2] ADS Depreciation Solution: There are several reasons to elect ADS depreciation. If the taxpayer has a net operating loss in the current year, no benefit will be derived from the increased deduction for regular tax depreciation. If the taxpayer is in a low tax bracket this year but expects to be in a higher bracket in future years, postponing part of the depreciation deduction may be beneficial. Finally, if the taxpayer is nearing the point at which the alternative minimum tax would apply, the depreciation

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adjustment for AMT may be avoided by using ADS depreciation.

6. [LO 7.3] Section 179 Expensing Solution: Only tangible business personalty is eligible for Section 179 expensing and there is an annual limit on expensing of $510,000 for 2017 ($500,000 for 2016). This limit had to be reduced dollar-for-dollar for qualifying investments that exceed $2,030,000 for 2017 ($2,010,000 for 2016). The amount expensed is also limited to taxable income for the year.

7. [LO 7.3] Section 179 Expensing Solution: The corporation should expense $510,000 of the furniture’s cost because it is used property ineligible for bonus depreciation and is also 7-year property; the remaining $90,000 can be depreciated using the regular MACRS depreciation rates. The amount of depreciation expensed under Section 179 for automobiles is subject to the ceiling limitations. The warehouse is not eligible for Section 179 expensing because it is not personalty.

8. [LO 7.3] Section 179 Expensing Solution: For 2017, the $510,000 allowable expensing amount must be reduced on a dollarfor-dollar basis when total eligible investments exceed $2,010,000. A business is not eligible to expense any of its assets when it acquires more than $2,540,000 ($2,030,000 + $510,000) of eligible assets for the year. Under these rules, almost all relatively small businesses can expense all of their eligible asset acquisitions.

Only fairly large businesses exceed this investment limit.

9. [LO 7.4] Employee-owned Property Solution: Employee-owned property must meet two additional tests: (1) the use of the employee’s property must be for the convenience of the employer; and (2) the use of the property must be required as a condition of employment.

10. [LO 7.4] Limitations on Automobile Depreciation Solution: Carl’s depreciation deductions are subject to ceiling limits that restrict maximum annual depreciation deductions to an amount set by the government. His depreciation for the first year is limited to $3,160 ($11,160 if bonus depreciation extended), the second to $5,100, the third to $3,050, and the fourth and all succeeding years to $1,875.

He cannot completely circumvent these limits by leasing the auto because the deductions for lease expenses are partially offset by a lease inclusion amount (from IRS tables) that is based on the fair market value of the auto at lease inception; this is designed to prevent taxpayers from taking advantage of leasing to avoid the depreciation limits. Taxpayers can compare the after-tax cost of leasing versus buying using present value concepts.

11. [LO 7.4] Limitations on Automobile Depreciation Solution: No. The automobile ceiling limits prevent more than $11,160 (including $8,000 for bonus depreciation for new vehicles) from being claimed for depreciation in the

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first year for cars that weigh no more than 6,000 pounds. Electing Section 179 will not circumvent this limit. There is an exception, however, for heavy sport utility vehicles (SUVs) that weight more than 6,000 pounds that would allow up to $25,000 of Section 179 expensing and regular depreciation on the balance.

12. [LO 7.4] Mixed Use of Auto Solution: As long as the employer includes the value of the personal use of the auto in the employee’s income, the employer may treat the auto as used 100 percent for business and is not required to allocate depreciation to the business-use portion.

The answer will not change if business use decreases to 35 percent as long as the value of personal use is included in the employee’s income.

An exception applies, however, to personal use of a company car by a more-than-5 percent owner of a business or someone related to the owner; this personal use is never qualified business use for MACRS depreciation.

13. [LO 7.5] Depletion Solution: Cost depletion is determined in a manner similar to the units of production method of depreciation; that is, the depletion deduction is based on the cost of the property, an estimate of the total product that will be recovered, and the amount of product sold each year. Percentage depletion is based on fixed percentages that are multiplied by the gross income from the property. It is unrelated to cost and allows the taxpayer to recover more than the cost of the property.

14. [LO 7.5] Intangible Drilling and Development Costs Solution: Intangible drilling and development costs (IDCs) are the costs associated with the development of oil and gas properties such as the cost of labor to clear the property, erect derricks, and drill the well. At the taxpayer’s option, the IDCs can be deducted fully as an expense in the year incurred, or capitalized and deducted through depletion.

15. [LO 7.1, 7.4 & 7.6] Depreciation/Amortization Solution: a. No. Land is not eligible for cost recovery as it is not a wasting asset. b. No. Using the standard mileage rate prevents the taxpayer from taking depreciation deductions. c. Yes. These are intangible assets subject to amortization.

15. [LO 7.6] Amortization Solution: If RCL acquires only the patent, it will be able to amortize its costs over the nine years of its remaining life. If it acquires the patent as part of the purchase of all of the assets of Royal Corporation, it will be required to amortize the patent over 15 years.

17. [LO 7.6] Research and Experimentation Expenses Solution: Research and experimentation expenditures are those costs incident to obtaining a patent, development of an experimental or pilot model, formula, invention, or similar property, but exclude costs for ordinary testing or inspections of products

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for quality control. These costs are usually expensed in full in the year paid or incurred, or alternatively, they can be amortized over a period of not less than 60 months or capitalized and deducted only when the project becomes worthless or is abandoned.

Crunch the Numbers 18. [LO 7.1] Basis for Depreciation Solution: $900. Warren uses the lower of his basis or fair market value at the date the asset is converted from personal to business use.

19. [LO 7.1] Basis for Depreciation Solution: $125,000. Anne uses the lower of her basis or fair market value at the date the condo is converted from personal to rental property.

20. [LO 7.1] Basis for Depreciation Solution: $300,000. Sharon must use the lower of basis or fair market value less the value of land, which cannot be depreciated. Thus, her basis for depreciation is $300,000 ($400,000 - $100,000).

21. [LO 7.1] Gift Basis Solution: $18,500. David uses Ted’s basis increased by a portion of the gift tax related to the appreciation on the gift determined as follows:

$2,000 gift tax x [($24,000 - $18,000)/$24,000] = $500 gift tax related to appreciation. $18,000 carryover basis from donor + $500 gift tax = $18,500.

22. [LO 7.1] Gift Basis Solution: a. $60,000. The donor’s basis is always used to determine a gain. b. $50,000. Fair market value (when it is lower than the donor’s basis) is used to determine loss. c. $55,000. When the selling price is between the donor’s basis and the lower fair market value, there is no gain or loss. Effectively, basis equals the selling price.

23. [LO 7.2] MACRS Depreciation/Averaging Conventions Solution: $396,563. Depreciation for the manufacturing equipment (7-year property) is $314,380 ($2,200,000 x 14.29%). Depreciation for the computer equipment (5year property) is $80,000 ($400,000 x 20%). Depreciation for the office building (39-year realty) is $2,183 ($680,000 x 0.321%).

Blanco would not be eligible to claim any Section 179 expensing because it placed too much property in service this year.

24. [LO 7.1 & 7.2] Adjusted Basis When Depreciation Not Claimed Solution: $7,497. The basis of the asset is reduced by the allowable depreciation (the depreciation the taxpayer was entitled to deduct) if the taxpayer fails to claim a depreciation deduction. For 2014, he claimed $2,858 ($20,000 x 14.29%) for

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depreciation. He was entitled to claim $4,898 ($20,000 x 24.49%) for 2015 and $3,498 ($20,000 x 17.49% for 2016. Depreciation for 2017 is $1,249 ($20,000 x 12.49% x ½). The adjusted basis for determining gain is $7,496 ($20,000 - $2,858 - $4,898 - $3,498 - $1,249).

25. [LO 7.1 & 7.2] Basket Purchase/Computing MACRS Depreciation Solution: $12,940. The original basis for each asset is determined under the relative fair market value method as follows: $500,000 x $220,000/$550,000 = $200,000 basis for the land; $500,000 x $264,000/$550,000 = $240,000 basis for the warehouse; and $500,000 x $66,000/$550,000 = $60,000 basis for the equipment. Depreciation for the equipment (7-year property) is $8,574 ($60,000 x 14.29%). Depreciation for the warehouse (39-year realty) is $4,366 ($240,000 x 1.819%).

26. [LO 7.2] MACRS Depreciation/Averaging Conventions Solution: a. Azona’s first-year depreciation is $371,540 ($2,600,000 x 14.29%) regular MACRS depreciation. (Note that Azona is not eligible to claim Section 179 expensing because it placed too much property in service this year.) b. Azona’s first-year depreciation is $92,820 ($2,600,000 x 3.57% mid-quarter rate for a 4th quarter acquisition).

27. [LO 7.2] Depreciation/Averaging Conventions for Fiscal-year Corporation Solution: a. $385,830. If placed in service in June, the half-year convention is used ($2,700,000 x 14.29% = $385,830). The property is not eligible for the Section 179 expensing because Kensington has placed too much property in service this year. b. $96,390. The mid-quarter convention applies: $2,700,000 x 3.57% = $96,390. c. To maximize the first-year deduction the property should be placed in service sometime prior to August 1 to avoid the mid-quarter convention.

28. [LO 7.2] Depreciation of Realty Solution: a. $3,338 ($240,000 x 1.391%). This is 39-year property placed in service in month 6. b. $4,728 ($240,000 x 1.97%). This is 27½-year property placed in service in month 6.

29. [LO 7.2] Depreciation in Disposal Year Solution: Office Furniture: $352 ($20,000 x 14.06% x 1.5/12) Computer Equipment: $576 ($10,000 x 11.52% x ½) 30. [LO 7.2] ADS vs. MACRS Solution: $616,500 less depreciation over the first three years using ADS vs. MACRS MACRS accelerated depreciation Year 1 $ 428,700 ($3,000,000 x .1429) Year 2 734,700 ($3,000,000 x .2449) Year 3 524,700 ($3,000,000 x .1749) Total $1,688,100

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ADS depreciation Year 1 $ 214,200 ($3,000,000 x .0714) Year 2 428,700 ($3,000,000 x .1429) Year 3 428,700 ($3,000,000 x .1429) Total $1,071,600 $1,688,100 - $1,071,600 = $616,500 less depreciation using ADS. 31. [LO 7.2 & 7.3] Depreciation/Section 179 Expensing Solution: a. $78,595 ($550,000 x 14.29%) for 2017 and $134,695 ($550,000 x 24.49%) for 2018. b. $507,145 [$510,000 Sec. 179 + ($40,000 x 14.29% = $5,716)] for 2017 and $9,796 ($40,000 x 24.49%) for 2018 32. [LO 7.3] Depreciation/Section 179 Expensing Solution: The total depreciation deduction for 2017 is $648,646. Lenux is limited to $400,000 [$510,000 - ($2,140,000 - $2,030,000)] of Section 179 expensing because its acquisitions exceeded $2,030,000 and the maximum $510,000 Section 179 expense deduction must be reduced for each dollar the investment exceeds that amount. Regular MACRS depreciation = $248,646 [($2,140,000 - $400,000) x 14.29%]. Office furniture is 7-year property.

The depreciation deduction for 2018 is $426,126 [($2,140,000 - $400,000) x 24.49%].

33. [LO 7.3] Depreciation/Section 179 Expensing Solution: a. $450,000 ($510,000 less the excess of $2,090,000 over $2,030,000). b. $1,640,000 ($2,090,000 - $450,000). c. $684,356 [($1,640,000 x 14.29%) + $450,000]. The machinery is 7-year property. (Note that used property is not eligible for bonus depreciation.) d. $401,636 ($1,640,000 x 24.49%) depreciation for 2018.

34. [LO 7.3] Depreciation/Section 179 Expensing Solution: $558,586 for 2017. $510,000 of Section 179 expensing. Regular MACRS depreciation of $48,586 [($850,000 - $510,000) x 14.29%)]. Used equipment was not eligible for bonus depreciation. $83,266 for 2018 [($850,000 - $510,000) x 24.49%)].

35. [LO 7.3] Section 179 Expensing Solution: a. $510,000 Section 179 expensing. b. $510,000 Section 179 expensing. (The total eligible assets placed in service this year is less than $2,030,000.) c. $100,000 [$510,000 - ($550,000 + $1,890,000 - $2,030,000)] Section 179 expensing.

36. [LO 7.3] Depreciation/Section 179 Expensing Limitation Solution: $17,000. David’s current-year Section 179 expense deduction is limited to his $17,000 of net income before the deduction. He will have a Section 179 carryover of $3,000 that he can use in the following year subject to similar net income

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limitations.

37. [LO 7.3] Impact of Section 179 on After-Tax Cost of a Depreciable Asset Solution: $456,553. After electing to expense $510,000 under Section 179, the basis remaining for MACRS depreciation = $155,000 ($665,000 - $510,000) which is multiplied by 20% for the first year resulting in $31,000 depreciation. (Note that bonus depreciation cannot be claimed for used equipment.) The total first-year depreciation is $541,000 ($510,000 + $31,000). Depreciation for the remaining years is computed by multiplying $155,000 by 32% for year 2, 19.20% for year 3, 11.52% for year 4, 11.52% for year 5, and 5.76% for year 6. Present value of the after-tax cost of the computers is $456,552.79.

Year 0 1 2 3 4 5 6

Cash Purchase $(665,000)

Depreciation Deduction $541,000 49,600 29,760 17,856 17,856 8,928

Tax Rate 34% 34% 34% 34% 34% 34%

Cash flow $(665,000) 183,940.00 16,864.00 10,118.40 6,071.04 6,071.04 3,035.52

PV Factor .943 .890 .840 .792 .747 .705 Total

38. [LO 7.3] Adjusted Basis at Disposition with Bonus Depreciation Solution: $3,748 determined as follows: Year Depreciation 2014 (50% x $20,000) + ($10,000 x 14.29%) = $11,429 2015 $10,000 x 24.49% = $2,449 2016 $10,000 x 17.49% = $1,749 2017 $10,000 x 12.49% x ½ = $625

PV Cash Flow $(665,000) 173,455.22 15,008.96 8,499.46 4,808.26 4,535.07 2,140.04 $(456,552.79)

Adjusted Basis $8,571 $6,122 $4,373 $3,748

39. [LO 7.3 & 7.4] Section 179 Expensing/Bonus Depreciation/Auto Limits Solution: 2017 2018 Auto $11,160 $5,100 Furniture $300,000 0 Warehouse $1,862 $14,871 Automobile depreciation is limited to the vehicle ceiling limits including bonus depreciation. The depreciation for the furniture is $300,000 all expensed under Section 179 in 2017 so no depreciation in future years. The depreciation for the warehouse is $1,861.80 ($580,000 x .00321) for 2017 and is $14,871.20 ($580,000 x .02564) for 2018. (The warehouse is not eligible for Section 179 expensing.)

40. [LO 7.4] Mixed Use of Auto with Bonus Depreciation Solution: a. The 2017 depreciation is $11,160 with bonus depreciation per the limitation ($3,160 + $8,000 bonus). The 2018 deduction is $5,100 per the second year ceiling

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limit. The 2019 deduction is $3,050 per the third year ceiling limit. In 2020 and beyond the deduction is $1,875 per the ceiling limit. b. The answer would not change. As long as the company includes the value of Karen’s personal use of the auto in her income, it treats it as used 100 percent for business (assuming that Karen is not a more-than-5 percent owner of the business or related to the owner). It is, however, subject to the depreciation limits for automobiles.

41. [LO 7.4] Mixed Asset Use with Recapture Solution: a. $720 is the 2017 depreciation deduction; cost recovery recapture is $1,408 ($3,328 - $1,920).

2015 depreciation claimed = $8,000 x 20% MACRS rate x 80% business use = $1,280. 2016 depreciation claimed = $8,000 x 32% MACRS rate x 80% business use = $2,048. Total depreciation claimed for first two years = $3,328.

ADS 2015 depreciation = $8,000 x 10% ADS rate x 80% business use = $640.

ADS 2016 depreciation = $8,000 x 20% ADS rate x 80% business use = $1,280.

Total ADS depreciation for first two years = $1,920.

ADS 2017 depreciation = $8,000 x 20% ADS rate x 45% business use = $720. Her cost recovery recapture in 2017 is $1,408 ($3,328 - $1,920) b. $3,760. 2015 = $8,000 x 80% = $6,400 expensed under Section 179.

ADS 2015 depreciation = $8,000 x 10% ADS rate x 80% business use = $640.

ADS 2016 depreciation = $8,000 x 20% ADS rate x 80% business use = $1,280.

Elaine would claim $720 of ADS depreciation in 2016 ($8,000 x 20% ADS rate x 45% business use). She would have to recapture $4,480 ($6,400 - $640 - $1,280) for the excess of the Section 179 deduction over the ADS depreciation in 2015 and 2016. Her net increase in income in 2017 = $3,760 ($4,480 - $720).

42. [LO 7.4] Mixed Use of Auto Solution: The 2017 depreciation is $11,160 per the ceiling limitation. The 2018 deduction is $5,100 per the second year ceiling limit.

43. [LO 7.4] Auto lease Solution: a. $650 x 12 x 90% = $7,020. b. $61 x 90% = $54.90.

44. [LO 7.4] Auto Lease Solution: a. $660 x 10 x 80% = $5,280 for year 1. $660 x 12 x 90% = $7,128 for year 2. b. $80 x (306 days leased/365 days in year) x 80% = $53.65 for year 1. $174 x 90% = $156.60 for year 2.

45. [LO 7.5] Cost Depletion Solution: Year 1 = $6,300; year 2 = $3,748 $90,000/100,000 tons = $.90 depletion rate; Year 1 cost depletion = $.90 x 7,000 units sold = $6,300

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($90,000 - $6,300)/167,500* = $.4997 adjusted depletion rate; Year 2 cost depletion = $.4997 x 7,500 tons = $3,748 *The $7,500 sold during the year must be added to the ending estimate of ore remaining to determine the depletion rate.

46. [LO 7.5] Cost Depletion Solution: $100,000/100,000 = $1 depletion rate; Year-1 cost depletion = 8,000 tons sold x $1 = $8,000 ($100,000 - $8,000)/158,000* = $.5823 adjusted depletion rate; Year-2 cost depletion = 8,000 tons sold x $.5823 = $4,658. *The $8,000 sold during the year must be added to the ending estimate of ore remaining to determine the depletion rate.

47. [LO 7.5] Percentage depletion Solution: $40,000 x 15% depletion rate = $6,000; this is less than the net income of $27,000 ($40,000 - $13,000).

His adjusted basis is $119,000 ($125,000 - $6,000)

48. [LO 7.6] Intangible Asset Amortization Solution: $2,000,000/15 = $133,333 per year 49. [LO 7.6] Research and Development Expenses Solution: a. year 1 = 0; year 2 = 0; year 3 = [($8,000 + $11,000) / 60] x 11 = $3,483 b. year 1 = $8,000; year 2 = $11,000; year 3 = $0 50. Comprehensive Problem for Chapters 4, 6, and 7 Solution: a. Robert’s net income from his business is $74,212 Gross Income $600,000 Less: Advertising $ 2,500 Employee Salaries 150,000 Office Rent 24,000 Supplies 18,000 Taxes and licenses 17,000 Travel (other than meals) 3,800 Meals and Entertainment (limited to 50% of 1,200 $2,400) Utilities 3,800 Employee Health Insurance Premiums 6,600 226,900 Subtotal 373,100 Depreciation Expense: New automobile (limited to $11,160 x 80%) $ 8,928 Used Fixtures (7-year property): $238,000 all expensed under Section 179 238,000 New equipment (5-year property):

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$50,000 all expensed under Section 179

50,000 296,928 76,172

Subtotal Automobile Expense: Gas and Oil ($1,200 x 80%) Insurance ($1,000 x 80%) Parking and Tolls Net Income

960 800 200

1,960 $74,212

b. Robert must pay $10,486 in self-employment tax. $74,212 x 92.35% = $68,534.78 $68,534.78 x 15.3% = $10,485.82 c. Robert’s adjusted gross income is $66,769.

Net income from business $74,212 Less: Self-employment taxes ($10,486 x 50%) (5,243) Self-employed health insurance premiums (2,200) Adjusted Gross Income $66,769 Robert is allowed a deduction for the employer’s portion of the self-employment tax.

Develop Planning Skills 51. [LO 7.1 & 7.2] Lease vs. Purchase Decision Solution: Cost to purchase is $83,073 - $88,790 cost to lease = $5,717 savings by buying.

Year 1 1 2 3 4 5 6 7 8

PV PV Factor Cash flow .35 .943 19803 .35 .943 2,830 .35 .890 4,577 .35 .840 3,085 .35 .792 2,077 .35 .747 1,401 .35 .705 1,320 .35 .665 1,247 .35 .627 587 Savings = $36,927 *$60,000 first-year bonus depreciation reduces the basis for regular MACRS depreciation Basis* 120,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000

Recovery % 50% 14.29% 24,49% 17.49% 12.49% 8.93% 8.92% 8.93% 4.46%

Tax Rate

Depreciation 60,000 8,574 14,694 10,494 7,494 5,358 5,352 5,358 2,676

Cash Flow 21,000 3,001 5,143 3,673 2,623 1,875 1,873 1,875 937

Net cost to purchase = $83,073 ($120,000 - $36,927 tax savings).

Year 1 2 3 4 5

Lease Expense $22,000 22,000 22,000 22,000 22,000

1 – Tax rate = 1-.35 = .65 .65 .65 .65 .65 .65

After-tax Lease Cost $14,300 14,300 14,300 14,300 14,300

PV factor .943 .890 .840 .792 .747

PV of After-tax Lease Cost $13,485 12,727 12,012 11,326 10,682

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22,000 22,000 22,000

.65 .65 .65

14,300 14,300 14,300

.705 .665 .627 Total

10,082 9,510 8,966 $88,790

Net cost to lease = $88,790 Arco should buy the equipment as that has a lower after-tax cost.

52. [LO 7.2, 7.3 & 7.4] Depreciation/Section 179 Expensing/Auto Limits Solution: a. To maximize its depreciation deduction, Roman should expense $510,000 of the office furniture to avoid the application of the mid-quarter convention [($800,000 $510,000)/($30,000 + $700,000 + $800,000 - $510,000) = 28.43%]. The warehouse is not eligible for Section 179 expensing because it is not personalty.

The automobile is subject to the ceiling limitations for depreciation of automobiles. (Used assets are not eligible for bonus depreciation.) b. $655,273 total depreciation Automobile $3,160 ceiling limit = Equipment $700,000 x 14.29% = Office furniture $510,000 Sec. 179 expensing + [($800,000 - $510,000) x 14.29%] = Warehouse $200,000 x 0.321% = Total

$3,160 100,030 551,441 642 $655,273

53. [LO 7.2 & 7.3] Depreciation Averaging Conventions/Section 179 Expensing Solution: If the proposed furniture purchase is made in December, Herald Corporation's depreciation will be $299,055 less than if it postpones the purchase until January.

Therefore, the proposed purchase should be made in January.

If the proposed furniture purchase is postponed until January, the total depreciation deduction is $694,353 computed as follows: Used computer equipment

$50,000 x 20%

$10,000

Used office furniture

$940,000 x 14.29% =

134,326

Used office fixtures

[($1,090,000 - $460,000 Sec. 179 expense) x 14.29%] = $90,027 + $460,000 Section 179 =

Total depreciation

550,027 $694,353

$460,000 ($510,000 - $50,000 excess over $2,030,000) can be expensed under Section 179 because Herald placed in service $2,080,000 of eligible property. By electing to expense $460,000 of the used office fixtures under Section 179, the mid-quarter convention can be avoided [($1,090,000- $460,000) / ($2,080,000 $460,000) = 38.89%].

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Total depreciation will decrease if the new office furniture is placed in service in December. Herald will not be eligible for any Section 179 expensing because its asset purchases now total $2,540,000. The mid-quarter convention will be required because more than 40 percent of personalty will be placed in service in the last quarter of the year [($1,090,000 + $460,000) / ($2,080,000 + $460,000) = 61.02%].

If the proposed new purchase is made in December, the depreciation for the assets using the mid-quarter convention would be as follows: Used computer equipment

$50,000 x 35% =

$17,500

Used office furniture

$940,000 x 10.71% =

100,674

Used office fixtures

$1,090,000 x 3.57% =

38,913

Subtotal for existing purchases Proposed additional office furniture

$157,087

($460,000 x 50% bonus) + [($460,000 - $230,000) x 3.57%] =

Total depreciation with proposed office furniture

238,211 $395,298

The $395,298 total depreciation is $299,055 less than the amount ($694,353) that would be allowed if Herald Corporation postponed the purchase of new office furniture until January. Therefore, Herald should wait until January to make the acquisition.

54. [LO 7.3] Lease vs. Purchase Decision Solution: Bing Corporation should lease the car because it has a lower after-tax cost.

The net after-tax cost to purchase the automobile is $17,920 (-$40,000 purchase price + $6,169 tax savings from depreciation deductions + $15,120 proceeds from sale + $791 tax savings from loss deduction) Year 1 2 3

Depreciation $11,160 5,100 3,050 $19,310

Tax rate .35 .35 .35

Cash Flow PV factor $3,906 .943 1,785 .890 1,068 .840

After-tax Cash Flow $3,683 1,589 897 Total $6,169

Present value of proceeds from sale = $18,000 x .840 = $15,120 Loss on sale = $18,000 – [$40,000 - $19,310] = -$2,690 Tax savings from loss deduction = (35% x $2,690 = $941.50) x .840 = $791 The net after-tax cost to lease the car is $10,912.

Chapter 1: An Introduction to Taxation 113 Lease Inclusion $(43) (95) (140)

Net Tax Deduction $6,057 6,005 5,960

Tax Rate 35% 35% 35%

*($450 x 12) + (1/3 x $2,100) Tax Year Payments Savings 0 $(2,100) 1 (5,400) $2,120 2 (5,400) 2,102 3 (5,400) 2,086

Cash Flow $(2,100) (3,280) (3,298) (3,314)

Discount Factor

Year 1 2 3

Deduction for Payments $6,100* 6,100* 6,100*

.943 .890 .840

Tax Savings 2,120 2,102 2,086 $6,308 Present Value $(2,100) (3,093) (2,935) (2,784) $(10,912)

Bing Corporation should lease the car because the after-tax cost to lease is $7,008 less than the cost to purchase ($17,920 - $10,912).

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter.

55. [LO 7.1] Depreciation Solution: Cost recovery is used to allocate costs of long-lived assets. If the asset is purchased and disposed of in the same year, no depreciation would be claimed.

56. [LO 7.1] Lease Acquisitions Costs Solution: These costs would be capitalized and amortized over the length of the lease.

57. [LO 7.4] Leasing vs. Purchase of Auto Solution: The necessary information includes total purchase price of the car; the up-front lease costs plus the monthly lease payments; the allowable depreciation per year if purchased; any lease inclusion amount, if leased; the number of years the car would be used before disposing of it; if purchased, the estimated value when disposed of; the tax rate for the years the car is to be used; the discount rate for evaluation purposes; any differences in insurance or maintenance costs between leasing and buying.

58. [LO 7.6] Web Site Development Costs Solution: To operate a Web site, a business must acquire the appropriate computer hardware by either purchasing a Web server or renting space on a Web server from a hosting service or Internet service provider. If a business chooses to purchase the hardware, the company can depreciate the cost of the hardware as five-year recovery property. If a business chooses to outsource its hardware needs, then the lease payments are ordinary and necessary business expenses and are currently deductible.

Determining the proper treatment of software costs is a little more complex.

Software costs can be divided into three broad categories: leased software, developed software, and purchased software. The cost of leasing or licensing software for a specific period of time may be deducted over the lease term.

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Developed software is software that is custom designed by a business for its own internal use. Purchased software may be a generic publicly available product or a software package designed by an outside consultant under circumstances where the consultant, rather than the company, bears the risk of failure. However, if the consultant provides services but the company bears the risk with regard to successful implementation, the expenses incurred should be regarded as the company’s software development costs. The costs of developing software are similar to research and experimental expenditures so the business can choose to either immediately expense (which is usually preferred) or amortize over 60 months.

If the software was purchased as part of a package or bundled with new hardware and not priced separately from the hardware, the business must recover the software costs over the useful life of the hardware which usually means five years.

Therefore, buying software unbundled, meaning it is either not purchased with hardware or it is but its price is separately stated, generally results in a faster write off. Off-the-shelf software is eligible to be expensed under Section 179 and qualifies for bonus depreciation (if available). Software acquired as part of a business purchase is usually considered a Section 197 intangible and must be amortized over fifteen years.

Many taxpayers use a combination of purchased and developed software, making it challenging to segregate the costs and apply the correct tax treatment. This can be even further complicated when an outside consultant provides services. It is important that expenses be carefully analyzed to determine whether the costs relate to the modification of purchased computer software or are simply installation costs. Costs incurred to modify purchased software are deductible, while installation costs must be capitalized.

59. [LO 7.6] Goodwill Solution: The treatment of goodwill for tax and GAAP differs. For tax purposes, goodwill is amortized over a period of 15 years.

For financial accounting, the income statement is not charged unless goodwill has been impaired. To test for impairment, the fair value of the reporting unit is compared to the carrying amount of its net assets including goodwill. If the fair value of the reporting unit is greater, goodwill is considered not to be impaired and the company does nothing. If, however, the fair value is less than the carrying amount of the net assets, then the ―implied value‖ of goodwill must be determined and compared to the recorded goodwill to determine if a charge is necessary.

Search the Internet 60. [LO 7.2] Depreciation Solution: a. Sidewalks are 15-year property; MACRS depreciation = 5% x $6,000 = $300. b. The barn is 20-year property; MACRS depreciation = 3.75% x $120,000 = $4,500. c. The tugboat is 10-year property; MACRS depreciation is 10% x $85,000 = $8,500.

61. [LO 7.2] ADS

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Solution: The bus is 9 year property for ADS; ADS depreciation is $60,000 x .0556 = $3,336 62. [LO 7.2] Amortization Solution: Amortization is reported Form 4562. If you then refer to the instructions for Form 4562, it states that line 42 must be completed when the amortization period begins in the current tax year. This is reported in the last section of Form 4562.

Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

63. [LO 7.1] Unclaimed Depreciation Solution: Can James Corporation deduct the unclaimed depreciation in a later year? What must James do to deduct the depreciation for 2017?

64. [LO 7.1] Placed in Service Date Solution: In what year is the machine considered placed in service so that Denmark Corporation can begin depreciating it?

65. [LO 7.1] Cost Recovery for Art Objects Solution: What is the useful life of the marble statutes? Can Marble Corporation claim any form of cost recovery deduction for the statues?

66. [LO 7.3] Depreciation/Section 179 Expense Solution: How does the restatement of Monicon income by the IRS affect the Section 179 deduction because it now exceeds the restated income? Can Monicon still claim the $24,000 Section 179 deduction on its 2014 return? Does this affect returns for subsequent tax years?

Develop Research Skills Solutions to the research problems 67 - 69 are in the Instructor’s Manual.

Fill-in the Forms Solutions to the tax forms problems 70 - 71 are in the Instructor’s Manual.

Solutions to Chapter 8 Problem Assignments Check Your Understanding 1. 1. [LO 8.1] Asset Classification Solution: Assets are first classified as business, personal-use, or investment assets; then they are classified as capital assets, Section 1231 assets, and ordinary income assets to determine their tax treatment. Assets may also be classified as realty or personalty and tangible or intangible.

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2. [LO 8.1] Asset Dispositions Solution: Property dispositions take several forms including sales, exchanges, involuntary conversions, and abandonments.

3. [LO 8.1] Amount Realized Solution: The amount realized on a sale or exchange is the sum of the cash received, the fair market value of property received, and the liabilities assumed by the buyer reduced by the sum of the seller’s selling expenses and the liabilities of the buyer assumed by the seller.

4. [LO 8.1] Realized vs. Recognized Gain Solution: A realized gain is the excess of the amount realized on a sale or exchange over the adjusted basis of the property sold or exchanged. The recognized gain is the amount of this realized gain that will be treated as income and subject to tax on the seller’s income tax return.

5. [LO 8.1] Asset Classification Solution: The most common Section 1231 assets are depreciable realty and personalty used in a trade or business held for more than one year and nondepreciable trade or business realty, also held for more than one year. These Section 1231 assets include machinery and equipment, office furniture and fixtures, rental real estate, factory buildings and land held for future expansion of a business. In addition, long-term capital gain property held for the production of income that is involuntarily converted is also Section 1231 property. To qualify, all of these assets must have been held for more than one year.

Capital assets include most investment properties and personal-use assets. They exclude inventory, real and depreciable property used in a trade or business, and accounts and notes receivable from the sale of inventory in the ordinary course of business. Capital assets include investment stocks and bonds and other investment property, personal residences, and personal property items such as furs, jewelry, autos, and clothing.

Ordinary assets include inventory, stock in trade, and accounts and notes receivable from inventory sales in the ordinary course of business. In addition, any asset that cannot be classified as a capital or Section 1231 asset must be an ordinary asset.

Section1231-type assets that fail to meet the more-than-one-year holding period are generally ordinary income assets.

6. [LO 8.1] Sale of Receivables

Solution: The sale of receivables at 80 percent of their face value results in an ordinary loss.

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7. [LO 8.1] Loss on Business Property

Solution: The machine was used less than one year so Core has an ordinary loss of $20,000 on the disposition or abandonment of the machine. If they used the machine for 18 months, it would no longer be ordinary income property (and depreciable) and the loss would then be a Section 1231 loss.

8. [LO 8.2] Capital Assets Solution: A long-term capital asset is one that is held for more than one year. A short-term capital asset is one that does not meet the holding period for a long-term capital asset (that is, is held for one year or less).

Long-term capital gains and losses are first separated from short-term capital gains and losses. The long-term gains and losses are netted against each other and the short-term gains and losses are netted against each other separately. If the result is a short-term gain (loss) and a long-term loss (gain), these are then netted against each other with the resulting number taking the character of the largest element. The netting process continues subtracting losses from gains until there are only gains or only losses remaining. The net gain(s) or net loss(es) are then taxed according to the type of taxpayer.

9. [LO 8.2] Capital Gains Solution: The net short-term capital gains of both individuals and corporations are included in income and taxed at ordinary income rates.

10. [LO 8.2] Capital Losses Solution: An individual may deduct a maximum of $3,000 of capital losses annually against ordinary income. Short-term capital losses are deducted before long-term losses up to the $3,000 maximum. The remaining losses must be carried forward (and they retain their character as short-term or long-term) indefinitely until fully deducted.

The losses that are carried forward enter the capital asset netting process in the carryover year and, thus, may also offset capital gains realized in that year. In future years in which the capital losses exceed capital gains, the excess losses continue to offset ordinary income at the rate of $3,000 per year.

The net capital losses of corporations can only be carried back three years and then forward up to five years to offset capital gains in the carryover years. They are not permitted to deduct the net losses against the current year ordinary income. The losses carried over are all assumed to be short-term capital losses and they enter the capital asset netting process in the carryover year. Any unused losses remaining at the end of the five-year carryforward period are lost.

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11. [LO 8.2] Capital Gains and Losses Solution: a. $10,000 – $8,000 = $2,000 short-term capital gain (held only one year). b. $7,000 - $8,000 = $1,000 long-term capital loss. c. $17,000 - $15,000 = $2,000 long-term capital gain.

12. [LO 8.2] Sale of Capital Assets

Solution: $44,000 long-term capital gain on the investment land; $4,000 long-term capital loss on the stock; $700 short-term capital loss on the ring; and$1,100 short-term capital gain on the auto. The ring and the auto are personal capital assets and they do not enter the netting process.

The $44,000 gain ($105,000 - $61,000) on the land and the $4,000 loss ($14,000 - $18,000) on the stock are netted and there is a net $40,000 long-term capital gain. Serena includes this net $40,000 LTCG and the $1,100 STCG on the auto in her income. The STCG is taxed at her marginal tax rate and the LTCG is taxed at a maximum rate of 20%.The $700 ($1,800 - $2,500) loss on the engagement ring is a short-term capital loss and is a nondeductible personal loss. Although the auto was also a personal asset, she is not allowed to offset the nondeductible personal loss on the ring against the gain on the auto.

13. [LO 8.2] Determining Adjusted Gross Income

Solution: $65,000. Netting the $15,000 STCG with the $24,000 LTCL results in a $9,000 LTCL. Sharon can deduct only $3,000 of this capital loss in the current year; thus, her adjusted gross income is $65,000 ($68,000 - $3,000). She can carry the remaining $6,000 LTCL forward and deduct it at a rate of $3,000 per year unless she the losses with capital gains realized in future years.

14. [LO 8.2] Taxable Capital Gain and Carryover

Solution: In year 1, Chester has a $3,100 net LTCL ($3,500 - $400) and a $2,400 STCL. He first deducts the $2,400 STCL and then deducts $600 of the net LTCL (for a total deduction of $3,000) from ordinary income. He has a $2,500 LTCL ($3,100 $600) carryover to year 2.

In year 2, he has a $1,200 net STCL ($500 gain - $1,700 loss); he also has a net $2,600 LTCL ($900 gain - $1,000 loss - $2,500 loss carryover) for total capital losses of $3,800 ($1,200 + $2,600), of which he can deduct $3,000 in year 2 from ordinary income and carry $800 of the LTCL over to year 3.

Chapter 1: An Introduction to Taxation 119 In year 3, he has a $1,600 net STCG ($2,000 gain - $400 loss); he also has a $1,000 LTCL ($300 gain - $500 loss - $800 loss carryover) for a net short-term gain of $600 ($1,600 STCG - $1,000 LTCL). He includes the $600 STCG in ordinary income in year 3 and has no loss carryover to year 4.

15. [LO 8.3] Recapture Solution: Taxpayers deduct depreciation expenses against ordinary income resulting in a tax savings equal to the depreciation expense times the ordinary income marginal tax rate. Without recapture, all the gain that is realized and recognized on the disposition of a depreciable asset would be Section 1231 gain and could receive favorable tax treatment as long-term capital gain. To ensure that all or part of the gain that results from the basis reduction for depreciation is taxed at ordinary income rates, depreciation recapture was instituted.

Section 1245 full recapture and Section 1250 partial recapture apply to depreciable property (including property on which Section 179 expensing was claimed) that has been disposed of at a gain. (It does not apply to property on which there are losses from dispositions.) Section 1245 property includes all depreciable personalty and Section 1250 applies to most depreciable realty.

16. [LO 8.3] Section 1231 Look-Back Solution: The Section 1231 look-back procedure, which requires all or a portion of Section 1231 gain to be taxed as ordinary income, applies to the gain on Section 1231 assets to the extent the taxpayer deducted Section 1231 losses against ordinary income during the five preceding tax years (referred to as unrecaptured Section 1231 losses).

The Section 1231 netting procedure requires the offsetting of gains and losses that occur in the same tax years. Taxpayers became adept at realizing Section 1231 losses in some years, deducting them from ordinary income and then realizing their Section 1231 gains in other years, benefiting from taxation at capital gains rates.

The look-back procedure was designed to prevent this ―game.‖ 17. [LO 8.3] Section 291 Recapture Solution: Section 291, applicable only to corporations, requires corporations to recapture (tax as ordinary income) an additional amount of Section 1231 gain beyond the normal recapture amount required on property subject to the Section 1250 recapture rules.

This "additional" recapture applies even if there is no otherwise required Section 1250 recapture on the realty sold. It simply converts part of the Section 1231 gain realized to ordinary income as Section 291 recapture. The amount of Section 291 recapture is 20% of the excess of Section 1245 recapture (as if Section 1245 recapture applied) over the Section 1250 recapture, if any. This corporate recapture rule eliminates some of the capital gains that would otherwise be available to offset capital losses as corporations can only offset capital losses with capital gains; the

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recapture amount is taxed as it if were ordinary income.

The term unrecaptured Section 1250 gains apply to individual taxpayers. This provision applies a maximum 25% tax rate to gains on the sale of realty that would be a Section 1250 gain if all prior depreciation were recaptured (similar to the rules for Section 1245 recapture). These capital gains would usually be taxed at a maximum 20% capital gains tax rate otherwise.

18. [LO 8.3] Section 1231 Netting Solution: Net Section 1231 losses that are the result of the Section 1231 netting process are deductible from ordinary income of both corporations and individuals. When there is a net Section 1231 gain, the taxpayer must first recapture as ordinary income any unrecaptured Section 1231 losses from the previous five years. The remaining net Section 1231 gain enters the capital asset netting process and can offset capital losses. If the taxpayer has no capital gains or losses, the net Section 1231 gain is included with the taxpayer’s other income for taxation, based on the type of taxpayer. In the case of a corporate taxpayer, the net Section 1231 gains are included in and taxed as ordinary income. The net Section 1231 gains of individuals are generally taxed as long-term capital gains subject to a maximum 20% capital gains tax rate, except for certain long-term capital gains on specified asset types, which may be subject to a 25% or 28% tax rate.

19. [LO 8.4] Mixed Use Property Solution: Business Use: .80 ($20,000 - $16,000) = $3,200 basis for business use when sold. (.80 x $6,000) - $3,200 = $1,600 Section 1245 depreciation recapture included in ordinary income.

Personal Use: .20 ($6,000 - $20,000) = $2,800 personal, nondeductible loss.

20. [LO 8.5] Section 1244 Stock Solution: Up to $50,000 of the loss ($100,000 if married filing jointly) on the sale of Section 1244 stock in any year may be treated as an ordinary loss rather than as a capital loss. Any loss in excess of this limit is capital loss. This provision only applies to individuals or partnerships that are the original owners of the stock.

21. [LO 8.5] Qualified Small Business Corporation Solution: A noncorporate taxpayer that realizes a gain on the sale of stock in a qualified small business corporation may exclude a specified percentage of the gain from income based on the year of acquisition. These excluded amounts are 50% of the gain from taxation on stock acquired before February 18, 2009 and after December 31, 2014; 75% of the gain on stock acquired after February 17, 2009 and before September 28, 2010; and 100% on stock acquired after September 27, 2010.

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22. [LO 8.6] Gain on Personal Residence Solution: The personal residence must be the primary residence of the taxpayer; the taxpayer or the taxpayer’s spouse must have owned the residence for at least two of the five previous tax years; and the taxpayer (and the taxpayer’s spouse, if married) must have occupied the home for at least two of the last five years. If both spouses qualify, up to $500,000 of gain is excluded. If only one spouse meets the use test, then the qualifying spouse can exclude up to $250,000 gain.

Normally, this exclusion can be claimed only once every two years. If, however, the taxpayer(s) does not meet the ownership or use tests at the time of the sale and the sale of the residence is due to a change in health, employment, or other circumstance beyond the taxpayer’s control, a portion of the gain may be excluded. Other circumstances include death of a spouse or co-owner, divorce, unemployment, disasters, and involuntary conversion of the residence.

The Housing Assistance Tax Act of 2008 now requires a reduction in the gain exclusion for any time after December 31, 2008, that a second home was owned but was not used as a principal residence, even if it meets the ownership and occupancy criteria for a personal residence at the time of sale.

23. [LO 8.7] Maximum Tax Rates Solution:

15%

25%

33%

39.6%

a. 0%.

15%

18.8%

23.8%

b. 15%

28%

31.8%

31.8%

c. 15%

25%

28.8%

28.8%

Note that the rates for the 33% and 39.6% brackets include the 3.8% Medicare surtax.

Crunch the Numbers 24. [LO 8.1] Realized Gain or Loss Solution: a. ($40,000 + $19,000 - $2,000) - $47,000 = $10,000 realized gain. b. ($40,000 + $19,000 - $2,000) - $67,000 = $10,000 realized loss.

25. [LO 8.1] Recognized Gain and Loss Solution: a. $5,000 + $15,000 + $13,000 = $33,000 amount realized. b. $33,000 - $34,000 = $1,000 loss. c. Long-term capital loss. d. If the property had been used in a business, it would be Section 1231 property

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and Allan would have a Section 1231 loss.

26. [LO 8.1] Determination and Character of Gain and Loss Solution: a. $50,000 + $100,000 + $150,000 - $15,000 - $2,000 - $234,000 = $49,000 Section 1231 gain recognized. b. As an investment, the gain would be long-term capital gain.

27. [LO 8.1] Sale of Real Property Solution: a. $40,000 + $180,000 - $2,300 - $7,000 = $210,700 amount realized. b. $210,700 - $138,000 = $72,700 gain. c. Long-term capital gain. If she owned and used the house as her principal residence for at least two of the previous five years, she could qualify to exclude the gain. d. If used in a sole proprietorship, the gain on the building’s sale would be Section 1231 gain reduced for the depreciation allowed or allowable on the building. The portion of gain attributable to this depreciation would be taxed as unrecaptured Section 1250 gain (subject to the 25% capital gains tax rate).

28. [LO 8.1] Determination and Character of Gains and Losses Solution: $325,000 x (1 - .80) = $65,000 ordinary loss on the factoring of the receivables. $45,000 - $38,000 = $7,000 ordinary loss as the autos had not been held more than one year. Both losses are a direct reduction from ordinary income.

29. [LO 8.3] Determination and Character of Gains and Losses Solution: a. DDF has $507,000 ($575,000 - $68,000) Section 1231 gain on the land sale. It has a $635,000 ($125,000 - $760,000) Section 1231 loss on the sale of the equipment. b. The $635,000 loss is netted against the $507,000 gain. The result is a $128,000 net Section 1231 loss that is deducted against DDF Corporation’s ordinary income.

30. [LO 8.3] Determination and Character of Gain Solution: $27,000 - $17,000 = $10,000 total gain. $7,000 ($24,000 - $17,000) of the gain is taxed as ordinary income due to Section 1245 recapture; the remaining $3,000 gain is Section 1231 gain.

31. [LO 8.3] Sale of Business Property Solution: a. Machine 8: $12,000 – $14,000 = $2,000 loss realized. Machine 6: $24,000 -

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$19,000 = $5,000 gain realized. b. The machines are Section 1231 property. The loss on Machine 8 is a Section 1231 loss; the gain on Machine 6 is ordinary income due to Section 1245 recapture because the gain is less than the prior depreciation deductions ($45,000 - $19,000 = $26,000 accumulated depreciation). c. The $2,000 loss is deducted directly from ordinary income; the $5,000 Section 1245 recapture is included directly in ordinary income.

32. [LO 8.3] Sale of Business Property Solution: a. $680,000 - $500,000 = $180,000 Section 1231 gain; $150,000 ($650,000 $500,000) of this gain would be unrecaptured Section 1250 gain subject to the 25% capital gains tax rate. b. $680,000 - $500,000 = $180,000 Section 1231 gain; $150,000 ($650,000 $500,000) of this gain would be unrecaptured Section 1250 gain subject to the 25% capital gains tax rate. c. $30,000 Section 291 recapture ($150,000 x 20%); the remaining $150,000 ($180,000 - $30,000) of gain is Section 1231 gain.

33. [LO 8.3] Section 1231 Recapture Solution: a. Only $10,000 of the $25,000 of Section 1231 gain must be recaptured as ordinary income; Barbara deducted a $45,000 Section 1231 loss in year 2, and $35,000 ($20,000 + $15,000) was recaptured in years 3 and 4. The remaining $15,000 ($25,000 - $10,000 recaptured) of the gain is simply Section 1231 gain. b. There is no unrecaptured loss remaining after year 5.

34. [LO 8.3] Sale of Business Property Solution: a. $700,000 – ($600,000 - $80,000) = $180,000 total gain. Only $80,000 of this gain is subject to Section 291 recapture, however, as that is the limit of Section 1245 recapture as if that provision applied. Thus, the Section 291 recapture = 20% x $80,000 = $16,000. The corporation recognizes $16,000 of ordinary income due to Section 291 and the remaining $164,000 ($180,000 – $16,000) is Section 1231 gain. b. If Angel were a sole proprietorship, there would be no Section 291 recapture.

The entire $180,000 gain would be Section 1231 gain; however, the $80,000 unrecaptured Section 1250 gain could be subject to the 25% capital gains tax rate (excluding any surtax) when included in the sole proprietor’s tax return. c. If Angel Corporation has $43,000 of Section 1231 losses in the prior year, $43,000 of the $164,000 Section 1231 gain would be recaptured (under the lookback rules) and included in ordinary income (along with the $16,000 Section 291 recapture). Only the remaining $121,000 ($180,000 - $16,000 - $43,000) is Section 1231 gain (treated as long-term capital gain).

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35. [LO 8.2 & 8.3] Capital Gains and Losses Solution: Taxable income is reduced by $2,000.

Step 1. Net the $10,000 Section 1231 gain with the $6,000 Section 1231 loss; the result is a net Section 1231 gain of $4,000.

Step 2. Net the $4,000 Section 1231 gain with the long-term capital gains and losses; the result is a net $1,000 long-term capital gain ($4,000 + $4,000 - $7,000).

Step 3. The $3,000 short-term capital gain is netted with the $6,000 short-term capital loss; the result is a net $3,000 short-term capital loss.

Step 4. The $3,000 STCL and $1,000 LTCG are netted; the result is a $2,000 STCL. This loss is deducted from the taxpayer’s other income, reducing taxable income by $2,000.

36. [LO 8.2 & 8.3] Taxable Income and Multiple Property Transactions Solution: a. Juno’s taxable income is $224,000.

The $8,000 of short-term capital gain and $14,000 of long-term capital loss are given.

The machines and building are Section 1231 properties.

Machines: $30,000 – ($80,000 – $35,000) = $15,000 Section 1231 loss.

Building: $400,000 – ($390,000 - $108,000) = $118,000 total gain.

Because Juno is a corporation, Section 291 recapture must be determined: $108,000 x 20% = $21,600 Section 291 recapture income. Total gain of $118,000 - $21,600 Section 291 recapture = $96,400 Section 1231 gain. (Section 291 applies to only $108,000 of the gain, the amount of prior depreciation deductions.) This Section 1231 gain is netted with the $15,000 Section 1231 loss on the machines for a net Section 1231 gain of $81,400 ($96,400 – $15,000) and is treated as a long-term capital gain.

Capital gains: The $81,400 Section 1231 gain is netted with the $14,000 long-term capital loss for a net $67,400 LTCG. Juno’s taxable income: $127,000 ordinary income + $21,600 ordinary income due to Section 291 recapture + $67,400 long-term capital gain + $8,000 short-term capital gain = $224,000. b. $209,950 taxable income if Juno is an individual. $118,000 building gain - $15,000 Section 1231 loss = $103,000 LTCG - $14,000 LTCL = $89,000 gain subject to the 25% rate for unrecaptured Section 1250 gain. $127,000 other taxable income + $8,000 STCG + $89,000 LTCG = $224,000 AGI - $10,000 itemized deductions - $4,050 personal exemption = $209,950 taxable income.

Juno will use his regular income tax rates for $120,950 and the 25% rate for $89,000 of income. He will also be subject to the 3.8% NII surtax on $24,000 of

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capital gains that exceed the $200,000 AGI threshold. c. $515,800 taxable income. $118,000 building gain - $15,000 Section 1231 loss = $103,000 LTCG - $14,000 LTCL = $89,000 gain subject to the 25% rate for unrecaptured Section 1250 gain. $425,000 other taxable income + $8,000 STCG + $89,000 LTCG = $522,000 AGI - $6,350 standard deduction = $515,650 taxable income. Because Juno’s AGI now exceeds the $384,000 limit for the phaseout of itemized deductions and exemptions, he cannot take them but he is still allowed to take a standard deduction (details of these phaseouts are included in Chapter 5).

Juno will use his regular income tax rates for $426,650 and the 25% rate for $89,000 of income. He will also be subject to the 3.8% NII surtax on his $97,000 ($89,000 + $8,000) of capital gains because his AGI exceeds the $200,000 threshold. He may also be subject to a Medicare surtax on some of his other ordinary income depending on the source of that income.

37. [LO 8.4] Mixed-Use Asset Solution: $410 Section 1231 loss plus $290 nondeductible personal loss. This is a mixed-use asset and the business and personal portions must be separated.

Business-use portion: 2,250 / (2,250 + 250) = 90% business use. Purchase price = 90% x $4,000 = $3,600. Adjusted basis at sale = $3,600 - $2,200 depreciation = $1,400. (90% x $1,100) - $1,400 = $410 Section 1231 loss on sale of business portion.

Personal-use portion: 10% personal use: (10% x $1,100) – (10% x $4,000) = $290 nondeductible personal loss on this portion of the computer.

38. [LO 8.5] Qualified Small Business Stock Solution: $5,500,000 long-term capital gain. Daniel acquired the stock before February 2009 and when he sells the stock for $13,000,000, he has a gain of $11,000,000. Gain eligible for the exclusion cannot exceed $20,000,000 which is the greater of 10 times the stock basis (10 x $2,000,000) or $10,000,000. Thus, he can exclude onehalf of $11,000,000, or $5,500,000. He will have only a long-term capital gain of $5,500,000 taxed at 28 percent. $10,000,000 long-term capital gain. If Daniel sells the stock for $25,000,000, he has a gain of $23,000,000, but the maximum that is eligible for the exclusion is $20,000,000 (10 times stock basis) as this is greater than $10,000,000. He can exclude one-half of the $20,000,000 gain or $10,000,000. The remaining $13,000,000 will be taxed at 28 percent.

39. [LO 85] Section 1244 Stock Solution: Vanessa has a total loss on the Section 1244 stock of $104,000 ($3,000 – $107,000). She can treat $50,000 of the loss as an ordinary loss, deductible from ordinary income. The remaining $54,000 loss is a long-term capital loss. She can deduct $3,000 this year as a capital loss giving her a total deduction of $53,000 in the current year. The remaining

126 $51,000 of the long-term capital loss can only be carried forward and deducted at a rate of $3,000 per year after offsetting other net capital gains in future years.

40. [LO 8.5] Section 1202 Stock Solution: a. In 2017, Taylor has a long-term capital gain of $400,000 ($500,000 - $100,000) on start-up company A that must be fully recognized because she did not hold the stock for more than 5 years. On start-up company B, she has a $220,000 ($300,000 $80,000) long-term capital gain but is only required to recognize $110,000 ($150,000/$300,000 x $220,000) of the gain because she held the stock for more than six months and reinvested one-half of the proceeds in another qualifying Section 1202 stock. b. If Taylor had purchased the stock of start-up company A in year 2007, she would have held the stock for more than five years when she sold the shares in years 2017.

She could exclude $200,000 of her $400,000 gain and the remaining gain would have been taxed at 28% as Section 1202 stock.

41. [LO 8.5] Section 1244 Stock

Solution: a. George has a loss on the Section 1244 stock of $115,000 ($160,000 - $45,000).

As a single person, he can deduct only $50,000 of this loss as an ordinary loss plus $3,000 of the remaining loss as a capital loss from his other income. The remaining $62,000 ($115,000 - $53,000) of the loss will have to be carried forward as a capital loss and deducted against future capital gains and/or deducted at a rate of $3,000 per year if he has no capital gains. b. If George is married and files a joint return, he can deduct $100,000 of the loss as ordinary income on the Section 1244 stock. He can still deduct an additional $3,000 as a capital loss. The remaining $12,000 loss ($115,000 - $103,000) must be carried forward as a capital loss.

42. [LO 8.6] Sale of Personal Residence Solution: $301,000 realized and $0 recognized gain. Their realized gain = $301,000 [$387,000 – ($56,000 + $30,000)]. Under Section 121 they can exclude up to $500,000 of gain from taxation; thus, they have no recognized gain as they both meet the ownership and use tests.

43. [LO 8.6] Sale of Personal Residence Solution: Carlotta’s realized and recognized gain is $25,000 ($235,000 - $210,000). She is

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permitted to elect Section 121 only once every two years except in special circumstances that do not apply if she is only moving for her convenience.

If Carlotta moves into a nursing home because of her health and that is the reason she sells the home, she may exclude a portion of the gain based on the time lived in the second home. She would be able to exclude up to 10/24 x $250,000 or $104,167 of gain. Thus, she would not have to recognize any of her $25,000 realized gain.

44. [LO 8.1, 8.2, & 8.7] Property transactions Solution: (a) $19,000 - $16,000 = $3,000 LTCG (property held>1 year); taxed at 15% (b) $30,000 - $31,000 = ($1,000) STCL (held < 1 year) would otherwise be deductible from ordinary income but is netted against the LTCG reducing it to $2,000 taxed at 15% (c) $28,000 - $20,000 = $8,000 gain on qualified small business stock; Only $4,000 is taxed due to its purchase date but the $4,000 gain is subject to the 28 percent capital gains tax rate.

45. [LO 8.4 & 8.7] Income Tax Liability Solution: Clarice’s taxable income is $43,752 and her total tax liability for 2017 is $5,959.80.

Clarice has a long-term capital gain of $18,000 ($34,000 - $16,000) on the sale of her BBC stock and a $25,000 ($55,000 - $30,000) long-term capital gain on the sale of the coin collection. She must pay self-employment tax on the $12,000 of income from her sole proprietorship of $1,696 ($12,000 x 92.35% x 15.3%). She is allowed to deduct $848 ($12,000 x 92.35% x 7.65%) as a deduction for adjusted gross income. Clarice is also entitled to a standard deduction of $6,350 and a personal exemption deduction of $4,050. Her total taxable income is $12,000 + $18,000 + $25,000 - $848 - $6,350 - $4,050 = $43,752 including her capital gains The gain on the stock can be taxed at a maximum 15%/20% rate and the gain on the coin collection at a maximum 28% rate; her taxable income, excluding these gains, however, falls into the 10% bracket; thus all or part of these gains will be taxed at less than their maximum rates (to the extent they do not exceed the 15% bracket), with the gain on the coin collection (a 28% asset) considered prior to the gain on the stock (a 15%/20% asset).

Her taxable income before the capital gain is included is as follows: ($12,000 - $6,350 - $4,050 - $848) = $752 x 10% regular tax rate = $72.20 tax Tax on coin collection: $25,000 + $852 = $25,852 taxable income with the gain on the coins only; as this is less than the $37,650 end of the 15% bracket, part of the $25,000 gain on the coins will be taxed at 10% and the remainder at 15% as follows:

128 ($9,325 - $752) = $8573 x 10% tax rate = $857.30 ($25,000 - $8,573) = $16,427 x 15% tax rate = $2,464 Tax on stock: $37,950 - $25,752 = $12,198 remaining in the 15% bracket; thus, part of the gain on the stock will be taxed at 0% and the remainder at 15% as follows: ($12,198) x 0% = $0 ($18,000 - $12,198) x 15% = $870.30 The total income tax is $72.20 + $857.30 + $2,464 + $0 + $870.30 = $4,263.80 Her total tax liability is $4,263.80 +$1,696 self-employment tax = $5,959.80

46. [LO 8.7] Income Tax Liability Solution: His taxable income is $22, 600 and his tax liability is $2,923.75.

1. Al must include the $13,000 Section 1245 recapture in ordinary income.

2. Net $3,000 Sec. 1231 gain (d) with $6,000 Section 1231 loss (f); the result is a net Section 1231 loss which is deductible from ordinary income.

3. Net $26,000 Section 1202 gain (a) with $24,000 long-term capital loss (c), $8,000 longterm loss (e) and $20,000 long-term gain (g); the result is a $14,000 net long-term capital gain.

4. Net this $14,000 long-term gain (3) with the $5,000 short-term loss (b); the result is a $9,000 long-term gain.

5. Because there is a net long-term gain and items included are subject to various tax rates (along with a short-term loss), further analysis is required.

6. 28% rate assets: net $26,000 Section 1202 gain with $8,000 loss on coin collection resulting in $18,000 gain tentatively taxed at 28%.

7. Maximum 15%/20% rate assets: Net $24,000 LTCL with $20,000 LTCG on stocks resulting in a $4,000 loss.

8. Apply the $4,000 loss (7) and the $5,000 short-term capital loss against the $18,000 net gain on the 28% assets resulting in a final taxed amount of $9,000 of 28% assets.

9. Determine tax: Al’s income before the capital gain:

Chapter 1: An Introduction to Taxation 129 $14,000 salary + $13,000 Section 1245 recapture (1) - $3,000 Section 1231 loss (2) $6,350 standard deduction - $4,050 personal exemption = $13,600.

Tax on $13,600 = $9,325 x .10 + ($13,600 - $9,325) x .15 = $1,573.75 The $9,000 capital gain (on a 28% capital asset) all falls within the 15% bracket so total taxable income is $22,600 ($13,600 + $9,000 which is less than the 15% bracket cut-off of $37,950). Thus, this gain is taxed at the 15% rate and is $9,000 x .15 = $1,350.

Total tax = $1,573.75 + $1,350 = $2,923.75.

47. [LO 8.7] Capital Gain Tax Rates Solution: Net all the capital gains with the capital losses (all long term): $10,200 - $5,000 2,500 (all collectibles) + $15,000 - $11,300 (stock) + $5,000 (Unrecaptured Sec. 1250 gain) = $11,400 net capital gain. As there is a net gain, each of the asset types must be netted separately. Thus there is a $2,700 gain ($10,200 - $5,000 - $2,500) for collectibles taxed at a 28% rate; a $3,700 gain ($15,000 - $11,300) on the stock taxed at the 15% rate (ordinary tax rate is 28%); and the Section 1250 gain taxed at the 15% rate.

48. [LO 8.7] Capital Gains Tax Rates Solution: The general maximum tax rate for long-term capital gains for individuals is 15% except for higher income taxpayers who are subject to a 20% rate. The maximum tax rate for gains on antiques and collectibles is 28% and the maximum tax rate for unrecaptured Section 1250 gains is 25%. These tax rates may be modified if the individual’s marginal tax rate on ordinary income is less than these rates. To the extent the taxpayer’s taxable income (including capital gains) does not exceed the 15% tax bracket, the 25% and 28% assets are taxed at the 15% rate and the 15% assets are taxed at zero percent. Taxpayers may also be subject to the 3.8% Medicare surtax if modified adjusted gross income exceeds $200,000 or more based on filing status. The rates applicable to the capital gains shown for a single individual are: a. 0% b. 15% + 3.8% Medicare surtax = 18.8% c. 20% + 3.8% Medicare surtax = 23.8% d. (a) 15%; (b) 28%; (c) 28% + 3.8% = 31.8% e. (a) 15%; (b) 25%; (c) 25% + 3.8% = 28.8% 49. [LO 8.7] Income Tax Liability Solution: a. Tax liability = $7,783.25. Total taxable income including all capital gains is $59,000. Tax is first determined on the $15,000 of ordinary income: $9,325 x 10% + ($15,000 - $9,325) x 15% = $1,783.75. The $10,000 unrecaptured Section 1250 gain is taxed next at 15% since the taxable income thus far does not exceed

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$37,950. $10,000 taxed at 15% = $1,500. The $9,000 gain on the painting (collectible) is included next and is also taxed at 15% as the total now is $34,000 still below the $37,950 threshold. $9,000 taxed at 15% = $1,350. The remaining $25,000 gain is taxed as follows: ($37,950 - $34,000) x 0% + [$25,000 – ($37,950 - $34,000)] x 15% = $3,157.50. Total tax is $1,783.75 + $1,500 + $1,350 + $0 +$3,157.50 = $7,793.25 b. Tax liability = $68,090.25. If ordinary taxable income is $225,000; tax on this amount again would be determined first and would be $46,643.75 + ($225,000 $191,650) x .33 = $57,648.25. The unrecaptured Section 1250 gain is taxed at 25% + 3.8% NII surtax: $10,000 x 28.8% = $2,880. The $9,000 collectible gain is taxed at 28% + 3.8% surtax: $9,000 x 31.8% = $2,862. The $25,000 gain on the stock is taxed at 15% + 3.8 surtax: $25,000 x 18.8% = $4,700. Total tax is $57,648.25 + $2,880 + $2,862 + $4,700 = $68,090.25 c. Tax liability = $135,811.35. Ordinary taxable income is $425,000; tax on this amount is determined first and would be $121,505.75 + ($425,000 - $418,400) x .396 = $124,119.35. The taxes on the $10,000 unrecaptured Section 1250 gain and the $9,000 collectible gain are the same as in (b). The $25,000 stock gain is now taxed at 20% + 3.8% Medicare surtax = 23.8% or $5,950. The total tax is now $124,119.35 + $2,880 + $2,862 + $5,950 = $135,811.35.

50. [LO 8.7] Capital Asset Netting and Tax Total Computation

Solution: (a) $800 net LTCG. Net the LTCGs and LTCLs to see if the result is a gain or loss. $2,300 LTCG -$1,900 LTCL + $1,200 LTCG = $1,600 LTCG. Netting the $500 STCG on the stock against the $1,300 STCL on the land = $800 net STCL. This $800 net STCL then offsets $800 of the $1,600 net LTCG for a final $800 LTCG. (b) $500 gain on stock is STCG (ordinary rate); $2,300 gain on land is LTCG (15%/20% applicable rate based on Bill’s AGI); $1,900 loss on gold coins is LTCL (loss on an asset in the 28% collectibles rate); $1,200 gain on toys is LTCG (applicable rate for collectibles = 28%); $1,300 loss on land is STCL (ordinary rate).

Net the LTCGs and LTCLs to see if the result is a gain or loss. $2,300 LTCG $1,900 LTCL + $1,200 LTCG = $1,600 LTCG; thus, the gain/loss on the 28% class assets must be considered separately.

Netting $1,900 loss on coins against $1,200 gain on toys = $700 net loss on 28% assets; this loss offsets $700 of the $2,300 gain on land yielding a $1,600 net LTCG (15/20% applicable CG rate). Netting the $500 STCG on the stock against the $1,300 STCL on the land = $800 net STCL. This $800 net STCL then offsets $800 of the $1,600 net LTCG for a final $800 LTCG. (c) Since Bill is in the 28% marginal tax bracket, the $800 LTCG will be taxed at 15%. (d) Taxable income is $220,000 and total income tax is $48,380.50. $240,000 salary + $800 LTCG - $12,700 standard deduction - $8,100 personal exemptions = $220,000 taxable income. Tax on regular income of $219, 200 is $48,380.50. [$219,200 - $153,100) x 28%] + $29,752.50 = $48,260.50. Tax on LTCG is $120

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($800 x 15%). Total income tax is $48,380.50 ($48,260.50 + $120).

51. Comprehensive Problem for Chapters 7and 8 Solution: a. Depreciation deductions for years 2014 through 2017:

Asset

Life

Basis 900

$

2015

2016

180

$ 288 352

211

127

9,796

6,996

4,996 3,205

Computer

5 yrs.

Tools

5 yrs.

1,100

220

Machine A

7 yrs.

24,000

24,000

Machine B

7 yrs.

40,000

5,716

Building

39 yrs.

125,000

3,076

3,205

Off. Furniture

7 yrs.

4,000

2,286

490

Machine C

7 yrs.

48,000

27,430

5,878

New Computer

5 yrs.

5,100

New Machine

7 yrs.

58,000

Total

$

2014

$

173

2017 $

52

1,020 ______

______

______

8,288

$30,116

$43,228

$16,953

$17,688

Depreciation for all personalty is calculated using the half-year averaging convention.

Machine A is the only asset on which Section 179 expensing was claimed. Bonus depreciation of 50% is claimed in 2015 on asset acquisitions along with regular MACRS depreciation on the balance in 2015. Only regular MACRS depreciation is taken on the two assets acquired in 2017 and they did not use Section 179 expensing or bonus depreciation. A half-year’s depreciation is taken in the year of disposition for the old computer. b. $6,000 Section 1245 ordinary income is realized and recognized on the disposal of Machine A. Machine A’s basis was reduced to zero by Section 179 expensing. Therefore, the entire $6,000 sales proceeds will be recaptured as ordinary income under Section 1245.

A $600 long-term capital gain is realized and recognized on the bonds ($10,400 $9,800 basis = $600 long-term capital gain).

No gain or loss is recognized on the disposition of the computer. The computer’s basis at disposition is $207 ($900 - $693 depreciation) for loss and

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$2,007 ($2,700 cost - $693 depreciation) for gain. Because it is sold for a price ($300) between basis for gain and basis for loss, the basis is set equal to the selling price resulting in no realized or recognized gain or loss.

Develop Planning Skills 52. [LO 8.1] Avoiding Ordinary Income Solution: As a real estate dealer, Betty’s sales of property would be sales of inventory and any gain taxed as ordinary income. She should give the piece of property to her son. She can avoid gift taxes by using her annual exclusion and part of her lifetime credit. The son can then either sell the property or he could borrow against the property. There would be the expense involved in the title transfers, but the tax savings to Betty would more than offset them. She could also gift partial (50%) interests in the property to her son over two years, avoiding gift taxes solely by using her annual exclusion for the interest gifted. If, however, the son needs the $25,000 immediately, the first alternative would be a good option.

53. [LO 8.2] Selling Decision Solution: If Natalie elects to hold on to her Dritco stock, she will only be able to deduct $3,000 of her $5,000 capital loss. This will reduce her taxes by $1,188 ($3,000 x 39.6%). Currently, she has a $12,000 unrealized gain on her Dritco stock, which is equal to a gain of $12.00 per share. She has three potential courses of action: a.

Sell all the stock now; b. Sell all the stock after June 15. c. Sell enough stock now to allow her to offset all $3,000 of her loss and sell the remaining stock next year. a. Sell all now: $27,000 - $15,000 = $12,000 short-term capital gain; the tax on the net gain of $7,000 net STCG ($12,000 STCG - $5,000 STCL) is $2,772 ($7,000 x 39.6%) + $266 ($7,000 x 3.8% NII). Her net cash flow is $23,962 ($27,000 $2,772 - $266). b. Sell all after June 15: $26,000 - $15,000 = $11,000 long-term capital gain; tax on the net gain of $6,000 ($11,000 LTCG - $5,000 STCL) is $1,428 ($6,000 x 23.8%). Her net cash flow is $24,572 ($26,000 - $1,428). c. Sell some stock now: Selling 167 shares now yields a gain of $2,004 [167 x ($27 - $15)]. She will have a net short-term capital loss of $2,996 ($5,000 STCL $2,004 STCG) that will reduce her taxes by $1,186 ($2,996 x 39.6%). If she sells the remaining shares next year, she will have a $9,163 gain [833 x ($26 - $15)] which will result in a tax of $2,181 ($9,163 x 23.8%). Her cash flow without considering the time value of the money would be $4,509 (167 x $27) + $1,186 + $21,658 (833 x $26) - $2,181 = $25,172. If, however, we use a 6 percent discount factor for the sale and taxes in the next year, the net cash flow is reduced to $24,062 [$4,509 + $1,186 + .943 ($21,658 - $2,181)].

Considering the time value of money, Natalie’s best decision would be to sell all of the stock sometime after June 15 to take advantage of the long-term capital gain rates. Alternatively, if her discount rate is much lower than 6 percent or her tax rate on her capital gains is significantly lower (her other income is reduced), the

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last alternative could be used, but any additional drop in the stock price could alter that and overall is the most ―iffy‖ of alternatives.

54. [LO 8.2] Timing of Sale Solution: Yes. If he sells the land now, he will have a long-term capital gain of $40,000.

This will offset all but $2,000 of the short-term capital loss. He will be able to deduct this remaining loss and reduce other taxes by $800 ($2,000 x 40%). His total cash flow is $60,800 ($60,000 + $800).

If he waits three more years, he will only be able to deduct $3,000 of his shortterm capital loss in the current and next two succeeding years. This will reduce his taxes in each of those years by $1,200 ($3,000 x 40%). In the 4th year, he will have a $46,000 ($66,000 - $20,000) long-term capital gain on the sale. His remaining short-term capital loss of $33,000 ($42,000 - $9,000) will offset all but $13,000 of this gain. He will pay a federal capital gains tax of $1,950 ($13,000 x 15%—assuming the 15% rate is applicable based on his other income) plus a state tax on this gain reducing his net proceeds to no more than $64,050 ($66,000 $1,950). The net present value of the proceeds over the current and the next three years is: $1,200 (current tax savings) + $1,200 (.943) + $1,200 (.89) + $64,050 (.84) = $1,200 + $1,132 + $1,068 + $53,802 = $57,202 less the present value of any state tax.

George should sell to his brother this year as this improves the present value of his cash flow by a minimum of $3,598 ($60,800 - $57,202).

(Note: This problem implicitly assumes that state and federal tax laws are similar.

When federal laws change, state laws may differ and this could change the analysis.)

55. [LO 8.2] Timing of Stock Sales Solution: If Wilma’s marginal tax rate is relatively static, Wilma should sell all of her stock (or enough of the stock to realize a $15,000 gain). The realized gain will offset all but $2,000 ($3,000) of the loss and allow her to deduct the remaining loss in the current year. She can then take the proceeds and repurchase some or all of this same stock to benefit from its expected appreciation. Although she may have some transaction costs, the present value of accelerating the tax benefit compared to spreading the loss deduction over 6 years should exceed these costs. (There is no provision that prevents Wilma from selling gain stock and repurchasing it as there is for loss stock with the wash sale rules.)

56. [LO 8.2 & 8.3] Timing Asset Sales Solution: As a sole proprietorship, the sales of both personal and business property flow through to her personal tax return.

134

Gains/Losses on Business Assets: Asset

Amt. Gain (Loss) Type

Truck

$

Office Bldg.

140,000 $125,000 unrecaptured Section 1250 gain and $15,000 Section 1231 gain

Machine 1

(15,000) Section 1231 loss

Machine 2

3,000 Section 1245 ordinary income

5,000 Section 1245 ordinary income

Monique should consider selling all of these business assets as the gains on them may be helpful in offsetting losses on sales of her personal investment assets. She has $8,000 ($3,000 + $5,000) of Section 1245 ordinary income that will be taxed at her 39.6% marginal tax rate on sales of the truck and machine 2; her $15,000 Section 1231 loss on Machine 1 offsets her $15,000 Section 1231 gain on the building; she has a $125,000 unrecaptured Section 1250 gain remaining on the building that is subject to the 25% tax rate (plus the 3.8% Medicare surtax), but which could potentially offset losses on other sales.

Potential Gains/Losses on Personal Assets: Asset

Amt. Gain (Loss)

Type

Proceeds of Sale

Sculpture

$140,000

LTCG @ 28% rate

$400,000

Painting

(125,000)

LTCL @ 28% rate

400,000

100,000 sh. ACC

(250,000)

LTCL @ 15/20% rate

800,000

10,000 sh. BBL

50,000

LTCG @ 15/20% rate

400,000

Monique needs $800,000 from the sale of personal assets for her expansion. Her choices are (a) sell ACC stock only, (b) sell the sculpture and painting, (c) sell the sculpture and BBL stock, or (d) sell the painting and BBL stock. (a) Sell ACC stock only: The $250,000 loss on ACC stock offsets her $125,000 unrecaptured Section 1250 gain on the building. She can only deduct $3,000 of the remaining loss this year; the remaining $122,000 loss is carried forward and is deductible subject to the $3,000 annual limit. She will pay no taxes on these sales. (b) Sell Sculpture and painting: Netting the $140,000 LTCG on the sculpture against the $125,000 LTCL on the painting and the $125,000 unrecaptured Section 1250 gain leaves Monique with $110,000 of unrecaptured Section 1250 gain to recognize that would be taxed at 25% plus the 3.8% Medicare surtax . (c) Sell Sculpture and BBL stock: Monique will have $315,000 ($140,000 + $50,000 + $125,000) of total gain to recognize ($50,000 at 20%, $125,000 at 25%, and $140,000 at 28%, all rates subject to the 3.8% Medicare surtax as well). (d) Sell painting and BBL stock: Monique will have a $50,000 LTCG - $125,000

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LTCL = $75,000 LTCL that offsets $75,000 of the $125,000 unrecaptured Section 1250 gain reducing the taxable gain to $50,000 taxed at 25% plus the 3.8% Medicare surtax.

Options (a) provides the best solution with (d) providing the next best alternative.

Option (a) has no current tax cost, but the value of the deductibility of the net loss could be greatly reduced unless Monique has the possibility of realizing additional capital gains in the near future. (Although not one of the choices given, if Monique sells her sculpture in addition to the ACC stock, she will have a LTCG of $140,000 to offset the $125,000 loss; the net $15,000 gain would be taxed at 28% (plus Medicare surtax), but she will have freed up an additional $400,000 to invest in the business.)

Option (d) does have a current tax cost, but it is the least costly of the three options providing the $800,000.

57. [LO 8.6] Sale of Personal Residence Solution: Joy should sell her Florida home as that is the only home that now qualifies as her primary residence for at least two-out-of-five previous years to qualify for the Section 121 exclusion. By the end of 2017 when she hopes to have a home sold, she will no longer meet the two-out-of-five year occupancy requirement for the Maine home as her principal residence because the Maine home became her second home when she changed her primary residence to Florida on October 1, 2014. All profit, therefore, on a sale of the Maine home at the end of 2017 would be subject to tax.

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter.

58. [LO 8.1] Personal Asset Converted to Business Use Solution: a. When personal property is converted to business use and then depreciated, dual depreciation schedules should be kept—one based on the asset’s original cost, the other on the fair market value, if lower because a different basis may be used to determine gain than for loss. Her adjusted basis for loss is $9,000 (the $12,000 fair market value at conversion less the $3,000 depreciation). When the auto is sold for $8,000, she has a $1,000 Section 1231 loss ($8,000 - $9,000 basis). b. Her adjusted basis for gain is $13,000 ($16,000 purchase price - $3,000 depreciation). If the auto is sold for $14,000, she would have $1,000 gain ($14,000 - $13,000 basis). The gain would be taxed as ordinary income due to Section 1245 recapture.

59. [LO 8.1] Gains and Losses on Stock Transactions Solution: a. If specific identification is not used, the first-in, first-out method is used to determine which shares are sold.

136

May 4, year 3 sale: $1,400 – [(150 x $5) + (50 x $6)] = $350 gain.

April 12, year 4 sale: $600 – (150 x $6) = $300 loss b. $600 – (150 x 6.50) = $375 loss.

60. [LO 8.3] Capital Asset Netting Suggested Solution: The most likely reason that the netting process remains for corporations is that at some time in the future Congress could reinstate some form of preferential treatment for corporate capital gains. Preferential treatment for corporations’ capital gains was dropped when corporate tax rates were reduced significantly; if these rates are increased in the future, preferential treatment for capital gains could easily be reintroduced. Another likely possibility is that these and many other provisions are just sitting unaddressed because Congress has chosen not to address these seemingly unnecessary provisions until a more complete revision of the tax laws is undertaken.

61. [LO 8.3] Capital Gains Solution: Under the current tax provisions, Gregory's gains on the Section 1202 stock and his art collections will be taxed at 28%: ($45,000 + $102,000) x 28% = $41,160. With the addition of these gains to his ordinary taxable income, his adjusted AGI will exceed $418,400 and the $55,000 gain on the stock will be subject to the 20% capital gains rate: $55,000 x 20% = $11,000. His AGI also far exceeds the threshold for adding the NII surtax so all gains above $418,400 will be subject to an additional tax of 3.8%: ($45,000 + $102,000 + $55,000 – ($418,400 - $375,000) x 3.8% = $158,600 x 3.8% = 6,027 ). Total tax on the gains would be $41,160 + $11,000 + $6.027 = $58,187. If all gains were taxed at 20%, the total be $202,000 x 20% = $40,400. This would result in a reduction in taxes of $11,760 ($147,000 x 8%) due to the difference between the 28% and 20% rates and an additional reduction of $6,927 if the Medicare surtax does not apply, for a total reduction of $18,687 in taxes.

62. [LO 8.6] Exclusion of Gain on Personal Residence Suggested Solution: Just as the interest rate deduction for mortgage interest encourages home ownership, the ability to invest in a personal residence and exclude gain on a future sale encourages persons to make this type of investment. In addition, most persons who do sell a home purchase another residence. Taxing gain on the sale of the first residence would reduce the taxpayer’s ability to purchase a comparable residence at the same price at which the old one was sold due to the tax payment.

The old Section 1034 gain deferral required the taxpayer to purchase a more expensive residence to exclude any gain. This encouraged taxpayers to ―move up.‖ Having to pay taxes defeats encouraging taxpayers to ―move up.‖ The exemption also allows older persons who wish or need to move out of their home and into a more comfortable environment to do so without tax penalty. Many older persons’ primary investment is in their home and their equity is looked at as their retirement nest egg. Homes in general are purchased with after-tax income (although

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mortgage interest on most homes is deductible); thus, this allows the gain to be exempt from tax similar to allowing an exemption for retirement funds set aside with after-tax income (for example, the Roth IRA). Congress has now, however, reduced the amount of the gain that can escape taxation on a second home that is converted to the primary residence at a later date.

Search the Internet 63. [LO 8.1] Capital Gains Rates Solution: Articles and citations will vary.

64. [LO 8.3] Capital Gain Schedules Solution: The Schedule D that accompanies an individual’s Form 1040 for 2016 is only 2 pages long. Form 8949, however, must generally be filed along with the Schedule D, except for certain transactions that can be combined and reported solely on the Schedule D without using Form 8949. If required, the Form 8949 is where all the necessary information for all of the basic short- and long-term capital gains are reported rather than on the Schedule D. The individual transactions are then aggregated for reporting on Schedule D. The instructions for Form 8949 are provided separately. The instructions for Schedule D are 16 pages long and contain a number of schedules related to determining tax rates and carryovers. The Schedule D that accompanies a corporation’s Form 1120 is also 2 pages long with individual items reported on Form 8949. The instructions for this Schedule D are only 5 pages long. This is a perfect illustration that the capital gains for individuals are far more complex than they are for corporations.

65. [LO 8.6] Sale of Personal Residence Solution: These instructions can be found in several places. The instructions for Schedule D for individuals and Form 8949 both contain basic instructions for completing these two forms for reporting the sale information, determining any recognized gain, and for filing instructions. Publication 523 provides much more detailed information on determining the tax results of selling a personal residence. If the taxpayer’s entire realized gain on the sale of a personal residence is excluded from taxation, then the taxpayer does not report any information regarding the sale on his or her tax return. If the taxpayer has gain that is not excluded or elects not to exclude the gain, the gain generally is reported first on Form 8949 and then transferred to Schedule D, unless it qualifies for an exception.

Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

66. [LO 8.1] Worthless Stock

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Solution: What is Kwan Lu’s loss on the stock and how and when will he be able to deduct it?

67. [LO 8.1] Character of Gain Solution: What will be Gallagher Farms amount and character of the gains realized on the sale of the dormitories and the land? How will these be taxed?

68. [LO 8.1 & 8.3] Asset Sales Solution: How will Martco be taxed on the sales of the various hearing aids: those sold to customers, the first lots sold to retail outlets, and the second bulk sale to a distributor?

69. [LO 8.6] Sale of Personal Residence Solution: What is the length of time Marco is considered to have occupied the smaller home? How will he treat the gain that he realizes on the sale of this home?

Develop Research Skills Solutions to research problems 70-72 are included in the Instructor’s Manual.

Fill-in the Forms Solutions to tax form problems 73-74 are in the Instructor’s Manual.

Solutions to Chapter 9 Problem Assignments Check Your Understanding 1. [LO 9.1] Gain/Loss Deferral Solution: Gain or loss on disposal of an asset is usually deferred by adjusting the basis of the asset acquired in the transaction, such as a like-kind exchange. If gain is deferred, basis of the acquired asset is reduced for the deferred gain; if loss is deferred, basis is increased for the deferred loss.

The holding period of the acquired asset whose basis is adjusted for deferred gain or loss normally includes the holding period of the asset that was disposed of that gave rise to the gain or loss.

2. [LO 9.2] Like-Kind Exchanges Solution: Business or investment realty, whether improved or unimproved, qualifies for like-

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kind exchange treatment, but personalty must be of the same kind or general business asset classification.

3. [LO 9.2] Boot Solution: Boot is cash or any other property received in a deferral transaction (e.g. a like-kind exchange) that is not qualifying property eligible for gain or loss deferral (e.g. nonlike-kind property). Any boot received in addition to qualifying deferral property causes realized gain to be recognized to the extent of the lesser of the fair market value of the boot received or the realized gain. If, however, there is realized loss, boot received does not affect loss recognition. Boot given along with deferral property does not affect gain or loss recognition on the deferral property.

4. [LO 9.2] Nonsimultaneous Exchange Solution: A nonsimultaneous exchange is one in which one part of the exchange takes place at one time, but the completion of the exchange takes place at a later date. This usually involves a third party who arranges a sale of property for the person desiring the exchange. The third party holds the sale proceeds and uses them to purchase a property that the exchanging party wants.

The key to success is the insulating of the sale proceeds from the seller and strict adherence to the 45 day time limit to identify the property or properties to be acquired and the completion of the transaction within 180 days. If the seller has access to any part of the money or property received on the sale of the first property or the time limits are exceeded, tax deferral is lost.

5. [LO 9.2] Indirect Exchanges Solution: An indirect exchange is one in which a sale by one party to another party does not involve a direct transfer of the property from the selling party to the purchasing party but involves one or more intermediaries. One common form of indirect exchange has the seller selling the property to a third party intermediary who then resells the property to the party who originally wanted to purchase the property. A second form involves a nonsimultaneous exchange in which the seller sells the property to be exchanged, but a third party intermediary holds all the proceeds, allowing the seller 45 days to locate like-kind property to for the exchanged; the seller is not permitted access to any proceeds.

6. [LO 9.3] Casualty Loss Solution: The loss on complete or partial destruction of personal-use property is the lesser of the property’s adjusted basis as of the date of destruction or the difference between its fair market value before and after the complete or partial destruction. In the case of complete destruction, the fair market value after destruction is generally zero, so fair market value before the loss can simply be compared to its adjusted basis.

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If the reduction in fair market value is not available, then the costs to restore the property may be substituted for the amount of loss if the repairs do not improve the property beyond its pre-loss condition.

7. [LO 9.3] Casualty Loss Solution: The loss on the complete destruction of business or investment property is always the property’s adjusted basis as of the date of the loss.

The loss on the partial destruction of business or investment property is the lesser of the property’s adjusted basis as of the date of the destruction or the difference between its fair market value before and after the loss.

8. [LO 9.3] Casualty Losses Solution: Casualty and theft losses of personal-use property are subject to two limits: (1) the deductible loss on each occurrence must exceed a base amount of $100; (2) the total loss for all occurrences (after the $100 reduction per loss) must exceed 10% of adjusted gross income to be deductible. The remaining loss after these limitations are applied is deductible as an itemized deduction.

9. [LO 9.3] Casualty Losses Solution: Theft losses are deducted in the year discovered; casualty losses are deducted in the year the casualty occurs.

A taxpayer has the choice of deducting the casualty loss that occurs in a presidentially declared disaster area in the year the casualty occurs or on the tax return for the year immediately preceding the casualty year.

10. [LO 9.3] Involuntary Conversions Solution: The functional-use test requires the taxpayer to replace property subject to an involuntary conversion with property that provides the same function as the property converted. This is a very restrictive provision that applies to property that is owned and used by the taxpayer.

The taxpayer-use test is less restrictive and allows the owner of converted property that is leased or rented to others to replace the converted property with property that can also be leased or rented.

11. [LO 9.3] Involuntary Conversion Solution: An individual whose home is subject to an involuntary conversion may use Section 121, which allows nonrecognition of gain on the sale of a residence, and/or Section 1033 for deferral of the gain from involuntary conversion. The involuntary conversion is treated as a sale of the residence and the owner can use Section 121 first to avoid recognition of $250,000 of gain ($500,000 married filing jointly) if

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ownership and occupancy requirements are met. Any qualifying gain remaining after the allowable Section 121 nonrecognition can be deferred under Section 1033.

12. [LO 9.4] Property Exchange Solution: Charlie transferred his land and the sports car for his interest in the partnership.

Charlie has a $125,000 gain realized on the exchange of the land and a $10,000 gain realized on the exchange of the sports car for the 40 percent interest in the partnership. Charlie does not recognize gain on either the land or the sports car and has a $365,000 ($325,000 + $40,000) basis in his partnership interest. The partnership recognizes no gain or loss on the exchange, taking carryover bases in the land and the sports car of $325,000 and $40,000, respectively.

13. [LO 9.4] Exchange of Insurance Policies Solution: This exchange is treated as a like-kind exchange of qualifying insurance policies by owners’ of a business and is not taxable.

14. [LO 9.4] Wash Sale Solution: The $4 ($18 - $22) per share loss ($2,000 total loss) on the 500 shares sold by the broker on April 18 (within 30 days of the purchase by Claire of the identical stock) cannot be recognized. Instead, the $2,000 unrecognized loss is added to the $10,000 basis of the identical ABCO stock purchased by Claire on May 10.

15. [LO 9.4] Installment Sale Solution: An installment sale is a sale in which the payments are received over a period of time rather than the entire payment being received at the time of sale. For tax purposes a sale of certain qualifying goods is an installment sale if one or more payments are received in a future tax year. In a qualifying installment sale, the taxpayer recognizes gain (income) and is taxed on this gain only as payments are received. A proportion of each payment is gain; the proportion is the ratio of total gain to the total proceeds on the sale. The taxpayer must elect out of installment sale treatment if he or she does not want it to apply to a qualifying sale simply by reporting the entire gain on the sale in the year the sale is closed.

16. [LO 9.5] Corporate Formation Solution: To be tax free to all transferors, the transferors together must own at least 80 percent or more of the stock of the corporation to which qualifying properties are transferred. Receipt of boot may cause taxation to a transferor but will not cause loss of tax deferral to the other qualifying transferors. A transfer of services in exchange for stock, however, will not be tax free.

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17. [LO 9.5] Corporate Formation Solution: Liabilities assumed by the corporation on a transfer of property to it in a qualifying Section 351 exchange do not affect the deferral of gain or loss under most conditions. If the liabilities assumed by the corporation exceed the basis of the property transferred, then gain will be recognized to the extent of any excess gain to avoid a negative stock basis. If the assumption of a liability by the corporation has the purpose of tax avoidance, then all liabilities assumed by the corporation for that taxpayer are converted to boot and gain would be recognized to the extent of the lesser of the gain realized or the boot received.

18. [LO 9.5] Partnership Formation Solution: In general, partners do not recognize gain or loss on the transfer of property to a partnership in exchange for a partnership interest. If the partner’s net liabilities exceed the partner’s basis in the property transferred, gain must be recognized to the extent of the excess net liability to avoid a negative basis in the partnership interest.

19. [LO 9.5] Partnership Formation Solution: A person who provides services to a partnership in exchange for a partnership interest must recognize income to the extent of the fair market value of the partnership interest received at the time the partner has unconditional control of the partnership interest received.

20. [LO 9.6] Corporate Reorganization Solution: A corporate reorganization is the transfer of all or part of one corporation’s assets or stock to a second corporation over which it has control in a transaction that qualifies as reorganization under Section 368. Reorganizations may be acquisitive, divisive, recapitalizations, or changes in name or form. There are seven types of reorganizations designated types A through G, each with its own requirements to qualify for tax deferral. Type A is a statutory merger or consolidation; Type B is a stock for voting stock acquisition; Type C is similar to a Type A consolidation or merger but very specific requirements must be met to qualify; Type D reorganizations can either be an acquisitive (stock for assets) or a divisive reorganization (spin-off, split-off, or split-up); Type E is a recapitalization; Type F is a change of name, place of incorporation, or status (profit vs. nonprofit).

Crunch the Numbers 21. [LO 9.1] Section 1231 Netting with Prior Section 1231 Loss Solution: a. Wilma has a $25,000 casualty loss on the bearer bonds (an investment asset) that is the only item in Step 1 of the Section 1231 netting process; as a result it is

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deductible immediately as an investment casualty loss. In Step 2 of the netting process, Wilma will net the $20,000 loss on the condemned land (an investment asset) with the $60,000 Section 1231 gain and the $15,000 Section 1231 loss from her sole proprietorship for a net Section 1231 gain of $25,000. This $25,000 net gain will enter the capital asset netting process and will be treated as if it is a longterm capital gain subject to a maximum 20% (excluding surtax) capital gains rate. b. If Wilma had a Section 1231 loss two years ago, she would be required to recapture $12,000 of her Section 1231 net gain from Step 2 of the netting process as ordinary income. Only the remaining $13,000 ($25,000 - $12,000) of the Section 1231 gain would enter the capital asset netting process to be treated as a long-term capital gain subject to a maximum 20% (excluding surtax) capital gains rate.

22. [LO 9.2] Like-Kind Exchange Solution: $400,000 received - $230,000 basis = $170,000 gain realized but deferred. $400,000 - $170,000 deferred gain = $230,000 basis in land received.

23. [LO 9.2] Like-Kind Exchange Solution: a. $320,000 received - $350,000 basis = $30,000 loss realized but deferred. $320,000 + $30,000 deferred loss = $350,000 basis of apartment building. b. Because Shawn must defer the loss, he would have been better off if he had sold the factory building and then purchased the apartment building with the proceeds. In that way, he could recognize the $30,000 loss and reduce his taxes.

24. [LO 9.2] Sale or Exchange

Solution: This is not a like-kind exchange but a sale. (a) Loss of $200,000; (b) Gain of $300,000; (c) Gain of $600,000.

25. [LO 9.2] Like-Kind Exchange Solution: a. No. This transaction qualifies as a like-kind exchange and Wilma recognizes neither gain nor loss. b. Wilma has a realized but deferred gain of $500 ($500 trade-in value – zero basis in computer). c. Wilma’s basis in the new computer is $2,500 ($2,500 cash + $500 trade-in $500 deferred gain).

26. [LO 9.2] Like-Kind Exchange Solution: a. $108,000 - $16,000 cash - $69,000 basis = $23,000 realized gain. None of the

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$23,000 gain is recognized. b. $23,000 gain is deferred. Taylor gave boot; only the receipt of boot triggers gain. c. The basis of the large machine is $85,000 ($108,000 - $23,000 deferred gain).

(Alternative basis calculation: $69,000 basis of machines surrendered + $16,000 boot given + 0 gain recognized – 0 boot received = $85,000.)

27. [LO 9.2] Like-Kind Exchange Solution: a. Whipple: ($2,500 + $400 boot) amount received - $1,250 basis = $1,650 realized gain; $400 gain recognized. (The tickets are boot.) Go-Along has a $500 loss [$2,900 amount received – ($3,000 basis of file cabinets + $400 tickets)] realized but none is recognized. b. Whipple defers $1,250 gain ($1,650 – $400); Go-along defers $500 loss. c. Whipple’s file cabinets: $2,500 - $1,250 gain deferred = $1,250 basis; tickets = $400 basis. (Alternative basis calculation: $1,250 basis of office furniture + $400 gain recognized - $400 boot received = $1,250.) Go-Along’s office furniture: $2,900 + $500 deferred loss = $3,400 basis. (Alternative basis calculation: $3,000 basis of file cabinets + $400 basis of tickets + 0 gain recognized – 0 boot received = $3,400.) d. The only way Whipple could avoid recognizing the $400 gain would be to get additional like-kind property for the office furniture instead of the tickets. GoAlong, however, has a realized and unrecognized loss; it would have been better off to sell its file cabinets rather than exchange them. Go-Along purchasing the office furniture from Whipple would cause recognition of the entire gain; thus, it appears that this exchange is a compromise where both parties ―gave‖ a little.

28. [LO 9.2] Like-Kind Exchange Solution: a. ($3,750,000 + $250,000) amount received - $2,250,000 = $1,750,000 realized gain; $250,000 gain recognized for the boot (cash) received. b. Delta defers $1,500,000 of the gain ($1,750,000 - $250,000). c. $3,750,000 - $1,500,000 deferred gain = $2,250,000 basis. (Alternative basis calculation: $2,250,000 basis of plane surrendered + $250,000 gain recognized $250,000 boot received = $2,250,000.) d. ($3,750,000 + $250,000) – $3,900,000 = $100,000 realized gain; $100,000 gain recognized (the lesser of the gain realized or the boot received); there would be no deferred gain and the basis of the plane would be $3,750,000 (fair market value – 0 deferred gain). (Alternative basis calculation: $3,900,000 basis of plane surrendered + $100,000 gain recognized - $250,000 boot received.) e. ($3,750,000 + $250,000) - $4,150,000 = $150,000 realized loss; no loss recognized; there would be $150,000 of deferred loss; the basis of the plane would be $3,900,000 ($3,750,000 FMV + $150,000 deferred loss). (Alternative basis calculation: $4,150,000 basis the plane surrendered + 0 gain recognized - $250,000

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boot received.)

29. [LO 9.2] Like-Kind Exchange Solution: a. Realized and recognized gain/loss calculations

Lab Kennels

Wolman Developers

$900,000

FMV of property received

$750,000

-350,000

Mtge assumed by Lab Kennel

+350,000

+200,000

Mtge assumed by Wolman

-200,000

$750,000

Amount received

$900,000

-300,000

Basis of property surrendered

-400,000

$450,000

Gain realized

$500,000

-0-

Gain recognized

$150,000 Excess mortgage assumed by Lab Kennels

b. Deferred gain: Lab Kennels = $450,000 (no gain recognized; all deferred).

Wolman = $500,000 gain realized - $150,000 gain recognized = $350,000 deferred. c. Basis in land: Lab Kennels = $900,000 FMV of land acquired - $450,000 deferred gain = $450,000. Wolman = $750,000 FMV of land acquired - $350,000 deferred gain = $400,000.

Alternate calculation: Lab Kennels

Wolman Developers

$300,000

Basis of property surrendered

$400,000

+350,000

+ Boot given

+200,000

+ Gain recognized

+150,000

-200,000

- Boot received

-350,000

$450,000

= Basis

$400,000

+0

30. [LO 9.2] Like-Kind Exchange Solution: a. Realized and recognized gain/loss calculation:

DDD Corporation

Jason Briggs

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$450,000

FMV of property received

$600,000

- 50,000

Cash received by Briggs

+ 50,000

+200,000

Mtge assumed by Briggs

-200,000

$600,000

Amount received

$450,000

-200,000

Basis of property surrendered

-125,000

$400,000

Gain realized

$325,000

$150,000 Excess of mortgage assumed by Briggs over cash given*

Gain recognized

$50,000 Cash (boot) received

*Cash given may offset an excess mortgage assumed; cash received cannot offset a mortgage assumed and must be recognized as boot. b. Deferred gain: DDD Corporation = $400,000 gain realized - $150,000 gain recognized = $250,000 deferred gain. Jason Briggs = $325,000 realized gain $50,000 gain recognized = $275,000 deferred gain. c. DDD basis in land = $450,000 FMV of building received - $250,000 deferred gain = $200,000 basis. Jason Briggs = $600,000 FMV of land received - $275,000 deferred gain = $325,000. Jason Briggs also has a $50,000 basis in the cash received.

Alternate calculation: DDD Corporation

Jason Briggs

$200,000

Basis of property surrendered

$125,000

+50,000

+ Boot given

+200,000

+150,000

+ Gain recognized

+50,000

-200,000

- Boot received

-50,000

$200,000

= Basis

$325,000

31. [LO 9.2] Direct or Indirect Exchange Solution: Clover should try to arrange a like-kind exchange. It can do this directly by finding a person willing to take the land in exchange for an office building Clover finds suitable. Alternatively, it can use a third party to sell the land and hold the proceeds purchasing a suitable office building within the time limits required for a nonsimultaneous exchange. In this way Clover can avoid recognizing its $400,000 ($1,200,000 - $800,000) realized gain.

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32. [LO 9.2] Sale or Exchange Solution: It should make the exchange.

Sale Option—If Bently sells the warehouse for $800,000, it will have a $500,000 gain ($800,000 - $300,000) on which it will pay taxes of $200,000 ($500,000 x 40%). It would have an $800,000 basis in the new property that would be depreciated at $20,000 ($800,000/40) per year for 40 years. The depreciation deductions would reduce its annual taxes (assuming no change in tax rate) by $8,000 ($20,000 x 40%). This is equivalent to an annuity of $8,000 for 40 years at 8 percent interest and would have a present value of $95,400 (11.925 x $8,000).

Exchange Option—If Bently exchanges the buildings, it will have a $300,000 carryover basis in the building acquired. It would have annual depreciation deductions of only $7,500 ($300,000/40); this would reduce its annual taxes by $3,000 ($7,500 x 40%). The present value of this annuity is $35,775 (11.925 x $3,000). The sale option provides an increased annuity value of $59,625 ($95,400 - $35,775) for the tax reduction; but, $200,000 must be paid in taxes initially, leaving a negative net present value of $140,375. Thus, the building should be exchanged to avoid the current tax effects.

The savings in taxes are sufficient to outweigh the fact that the other party to the exchange is asking more than the appraised value for the building. Unless Bently plans to dispose of the newly acquired building within a very short period, the difference in appraised value would not change the outcome.

33. [LO 9.3] Involuntary Conversion Solution: a. Heywood’s loss is $300,000, the lesser of the reduction in fair market value of the building ($500,000 - $200,000 = $300,000) and the building’s basis ($320,000). b. $20,000 ($320,000 - $300,000 loss). c. $50,000 loss ($300,000 loss - $250,000 insurance); basis after insurance recovery remains equals $20,000 ($320,000 - $250,000 insurance recovery $50,000 loss). d. $170,000 ($20,000 basis before repairs + $150,000 repairs).

34. [LO 9.3] Involuntary Conversion Solution: a. $135,000 loss ($160,000 - $25,000 land) b. $135,000 - $100 – ($40,000 x 10%) = $130,900. c. $190,000 - $135,000 = $55,000 realized gain. d. Zero, if she uses Section 121. This is the same as a sale and she does not have to recognize any remaining gain, assuming that she meets the ownership and occupancy requirements. If she elects not to use Section 121 (or does not qualify), she will have to recognize all $55,000 of her gain (the lesser of the $55,000

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realized gain and the $60,000 of the $190,000 proceeds that were not reinvested).

35. [LO 9.3] Casualty Loss Solution: $400 deductible loss.

Television: $1,500 loss ($4,600 - $1,100 = $3,500 loss - $2,000 insurance recovery).

Furniture: $200 gain ($3,200 insurance - $3,000 cost).

Net $1,500 loss against $200 gain = $1,300 loss before floor $1,300 loss - $100 floor for this occurrence = $1,200 loss Golf Cart: $2,900 loss ($6,500 - $2,000 = $4,500 loss - $1,500 insurance recovery = $3,000 loss before floor); $3,000 - $100 floor = $2,900 loss. ($1,200 + $2,900) – (.10 x $37,000) = $4,100 - $3,700 = $400 deductible loss.

36. [LO 9.3] Theft Solution: $32,700 deducted in 2017. Her loss before any limitations is $40,000, the lesser of the reduction in fair market value ($40,000 – 0) or basis ($54,000). Her deduction is $40,000 - $100 – ($72,000 x 10%) = $32,700. She must deduct the theft loss in 2017 when it was discovered.

37. [LO 9.3] Condemnation Solution: a. Clayton has a $165,000 ($400,000 – $235,000) realized and recognized gain. b. Recognized gain = $50,000 ($400,000 - $350,000); deferred gain = $115,000 ($165,000 - $50,000). c. $235,000 ($350,000 – $115,000 deferred gain). d. If $500,000 is spent on replacement property, Clayton has no recognized gain; all $165,000 is deferred. e. $335,000 ($500,000 - $165,000). f. June 30, year 5 (3 years from June 30, year 2).

38. [LO 9.3] Casualty Solution: a. $50,000 ($325,000 - $275,000) realized and recognized gain. b. $25,000 ($325,000 – $300,000) recognized gain; $25,000 deferred gain ($50,000 - $25,000 recognized). c. $275,000 ($300,000 - $25,000 deferred gain). d. If $350,000 is spent on replacement property, there is no recognized gain; $50,000 gain is deferred. e. $300,000 ($350,000 - $50,000 deferred gain).

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f. April 30, year 3 (2 years from April 30, year 1).

39. [LO 9.3] Sale of Section 1231 Assets with Depreciation Recapture

Solution: a. Machine #1: $19,000 – ($45,000 - $35,000) = $9,000 Section 1245 recapture.

Machine #2: $24,000 – ($105,000 – $90,000) = $9,000 Section 1245 recapture.

Machine #3: $66,000 – ($63,000 - $12,000) = $12,000 Section 1245 recapture; $3,000 Section 1231 gain.

Building: $425,000 - ($400,000 - $45,000) = $70,000 total gain; $9,000 (20% x $45,000) is Section 1250 gain (by operation of Section 291); the remaining $61,000 ($70,000 - $9,000) gain is Section 1231 gain. b. Performance Industries would have $39,000 in ordinary income [$30,000 Section 1245 recapture and $9,000 Section 1250 gain (by operation of Section 291)] and $64,000 in Section 1231 gains (treated as long-term capital gains), increasing net income by $103,000. c. If Performance had $6,000 of Section 1231 losses in year 3, it would be required to treat $6,000 of its Section 1231 gain as ordinary income, reducing its Section 1231 gain to $58,000 ($64,000 - $6,000) and subsequently reducing the amount treated as long-term capital gain to $58,000. Net income would still increase by $103,000.

(Note: Since this is a corporation, all gain items, in effect, are simply included in ordinary income.)

40. [LO 9.3] Section 1231 Netting Process

Solution: a. Ten year old machinery would be completely depreciated at the time of the tornado; as a result, all $75,000 gain would be Section 1245 gain included directly in income and would not enter the Section 1231 netting process. All $200,000 of the casualty loss on the building would be deductible as it would be the only item in Step 1 of the Section 1231 netting process. At Step 2 of the netting process, Bradley would net the $100,000 condemnation gain on the land with the $150,000 Section 1231 loss and $25,000 Section 1231 gain for a net Section 1231 loss of $25,000. This $25,000 loss would be deductible immediately and would not be included in the capital asset netting process. b. The result would be the same if Bradley was a sole proprietorship except the gains and losses would be included on Bradley’s personal income tax return.

41. [LO 9.1 & 9.4] Like-Kind Exchange Solution: It should sell its used auto and purchase the new one. If Xenon sells the used auto, it will recognize a $3,500 gain ($4,000 - $500) and will pay a tax of $875 ($3,500 x 25%). Its net cash outflow will be $16,875 [$20,000 - ($4,000 - $875)].

Its basis in the new auto will be $20,000. If it trades in the used auto, it will have cash outflow of $17,000; it will not recognize any gain but the auto will have a

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basis of $17,500 ($17,000 + $500). Depreciation deductions over the 3 years will be the same due to the depreciation limitations; Xenon’s cash outflow is lower by selling the car outright and paying $20,000 for the car.

42. [LO 9.4] Wash Sale Solution: $15,000 realized loss; $5,000 recognized loss; and $60,000 basis. The sale of the stock by the broker yields a $15,000 ($85,000 - $100,000) realized loss, but only $5,000 is recognized. Moore cannot recognize two-thirds of the loss due to his purchase of 2,000 shares in January within 30 days after the loss on the sale of 3,000 shares in December due to the wash sale rules. The disallowed loss of $10,000 [(2,000 shares purchased/3,000 shares sold) x $15,000 total loss] is added to the basis of the 2,000 shares purchased in January for a total basis for those shares of $60,000 ($50,000 + $10,000).

43. [LO 9.4] Wash Sale Solution: $2,000 loss recognized and basis of 1,000 shares increased to $10,000. One half ($2,000) of the $4,000 loss on the July 3 sale cannot be recognized due to the wash sale rules because he purchased the 1,000 shares within 30 days of the sale of identical shares sold at a loss. (1,000 shares purchased/2,000 shares sold) x $4,000 realized loss = $2,000 loss deferred. The $2,000 deferred loss increases the basis of the 1,000 shares purchased from $8,000 ($8 x 1,000 shares) to $10,000.

44. [LO 9.4] Related Party Sale Solution: Marilyn has a $3,000 ($7,000 - $10,000 basis) realized but unrecognized loss on the sale of the 200 shares of stock to her brother. Her $15,000 basis in the stock remaining is $15,000. Her brother has a cost of $7,000 as his basis in the stock; he will, however, reduce the $5,000 gain on the subsequent sale to $2,000 for Marilyn’s $3,000 unrecognized gain on the original sale.

45. [LO 9.4] Related Party Sale Solution: William has a realized but unrecognized loss of $20,000 ($80,000 sale price - $100,000 basis in stock) on the sale of the stock to his grandfather. The grandfather has a basis of $80,000 on the purchase of the shares from William. When he sells the stock to the neighbor, he has a $5,000 realized gain but he does not recognize this gain as it is offset by $5,000 of the original $20,000 unrecognized loss.

Chapter 1: An Introduction to Taxation 151 46. [LO 9.4] Stock Transactions/Wash Sales Solution: 11/01 sale of XYZ: $800 ($15 - $18) = $2,400 long-term capital loss realized; none recognized due to the purchase on 11/18 of identical shares of stock. The basis of the shares purchased on 11/18 is increased to $26,400 [(2000 x $12) + $2,400] for the deferred loss.

11/04 sale of DEF: 500 ($22 - $20) = $1,000 short-term capital gain realized and recognized.

11/20 sale of ABC: 500 ($22 - $25) = $1,500 short-term capital loss realized; none recognized due to the purchase of the ABC shares on 12/02.

The basis of the ABC shares purchased on 12/02 is increased for the deferred loss to $22,500 [(1,000 x $21) + $1,500]. The basis of the remaining 500 shares of ABC purchased on 10/15 is $12,500 (500 x $25).

Kelly also has 1,000 GHI shares purchased on 11/07 with a basis of $16,000 (1,000 x $16) and 500 DEF shares purchased on 11/22 with a basis of $9,000 (500 x $18).

47. [LO 9.4] Installment Sale Solution: Randy has a total gain of $11,500 [($6,000 + $7,000 + $7,000) - $8,500 basis] on the sale of the land. On an installment sale, Randy must recognize 57.5% ($11,500/$20,000) of each payment as gain. Thus, his gain in year 1 is $3,450 (57.5% x $6,000); in each of years 2 and 3, he will recognize $4,025 (57.5% x $7,000) along with interest on the unpaid balance of $1,120 (.08 x $14,000) in year 2 and $560 (.08 x $7,000) in year 3. If he elects out of the installment sale method, Randy must recognize the entire $11,500 of gain in year 1.

48. [LO 9.4] Installment Sale Solution: Conroy has a total gain of $81,000 [($70,000 + $60,000 + $60,000) – ($156,000 $47,000)] on the sale of the excess machinery. Conroy must recognize the $47,000 of depreciation recapture in the year of sale in addition to 17.88% [($81,000 $47,000)/$190,000 of each annual payment in the current and two following years.

Year of sale total gain is = $59,500 [$47,000 + .1788 (70,000)]. In each of two following years, it will recognize $10,750 (.1788 x $60,000). If Conroy elects out of the installment method for this sale, it will recognize the $47,000 of depreciation recapture and $34,000 of Section 1231 gain.

49. [LO 9.5] Corporate Formation Solution: Jim has a $10,000 ($50,000 - $40,000) realized gain and Cindy a $5,000 ($45,000 $50,000) realized loss on the transfer of their properties to the corporation, neither of which is recognized. Cindy, however, must recognize $5,000 of income for the

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services provided. Jim’s basis in his shares is $40,000 ($50,000 - $10,000 deferred gain). (Alternative calculation: $40,000 basis of property transferred + 0 gain recognized - 0 boot received.) Cindy’s basis in her shares is $55,000 ($45,000 + $5,000 deferred loss + $5,000 of income recognized). (Alternative calculation: $50,000 basis of property transferred + $5,000 service income = $55,000 basis.)

50. [LO 9.5] Corporate Formation Solution: Wilbur has a $30,000 ($100,000 - $70,000) realized gain on the transfer of property to the corporation; none of this gain is recognized. His basis in the stock received is $70,000 ($100,000 - $30,000 deferred gain). (Alternative calculation: $70,000 basis of property transferred + 0 gain recognized – 0 boot received.) The corporation’s basis in the property is $70,000; Wilbur’s basis carries over to the corporation.

51. [LO 9.5] Transfer to Corporation Solution: a. Arleta: $210,000 – $190,000 = $20,000 realized gain. Georgia: $85,000 $75,000 = $10,000 realized gain. Georgia also realizes $5,000 income for her accounting services. b. Neither Arleta nor Georgia recognizes their realized gains, but Georgia must recognize $5,000 of ordinary income for the services provided. c. Arleta’s basis = $190,000 ($210,000 - $20,000 deferred gain). (Alternative calculation: $190,000 basis of property transferred + 0 gain recognized – 0 boot received.) Georgia’s basis is $80,000 ($85,000 - $10,000 deferred gain + $5,000 service income). (Alternative calculation: $75,000 basis of property transferred + $5,000 service income = $80,000.) d. BCD’s basis in the property transferred by Arleta is $190,000; its basis in the property transferred by Georgia is $75,000; it will either capitalize (if organizational costs) or expense the $5,000 paid for Georgia’s services.

52. [LO 9.5] Transfer to Corporation Solution: a. $1,050,000 stock value ($1,250,000 value of building - $200,000 mortgage assumed. b. $100,000 realized loss ($1,050,000 value of stock + $200,000 mortgage assumed = $1,250,000 amount realized - $1,350,000 basis in building) No loss recognized. c. Carol’s basis in her stock will be $1,350,000 unless she elects to reduce her stock basis for the $100,000 excess of the building’s basis ($1,350,000) over its fair market value ($1,250,000). If she chooses to make this election, her stock’s basis will be reduced to $1,250,000. If Carol does not make the election, the corporation’s basis in the building

Chapter 1: An Introduction to Taxation 153 cannot exceed its fair market value of $1,250,000. With the election by Carol, the corporation would be able to take the carryover basis of $1,350,000 in the building.

53. [LO 9.5] Transfers to Corporation Solution: a. Cornelia has a $150 gain realized ($500 value of stock received - $350 basis of property) on the transfer and Ferdinand has a $190 gain realized ($400 value of stock received + $50 cash received - $260 basis of property) on the transfer of his property. b. Cornelia’s gain is not recognized, but Ferdinand must recognize $50 of his gain because he received other property (boot) in addition to stock on the transfer. c. Cornelia has a $350 ($350 basis of property transferred + 0 gain recognized – 0 boot received) basis in the stock. Ferdinand has a $260 ($260 basis of property transferred + $50 gain recognized - $50 FMV of boot received) basis in the stock and a $50 basis in the cash (boot). d. Wayside has a $350 basis in the property transferred by Cornelia and a $260 basis in the property transferred by Ferdinand. e. Wayside does not recognize any gain or loss.

54. [LO 9.5] Incorporating a Proprietorship Solution: a. $50,000 realized loss on the building ($750,000 - $800,000) and a $25,000 realized gain on the equipment ($400,000 - $375,000); he has neither realized gain nor loss on the inventory. b. Neither the gain nor the loss is recognized on the transfer; they are both deferred. c. Tinker’s basis in his stock will be $1,225,000 ($800,000 + $375,000 + $50,000) unless he makes an election to reduce his basis by the $25,000 excess of total transferred basis ($1,225,000) over the fair market values ($1,200,000) of the properties transferred. If Tinker does not make this election, the corporation’s basis in the assets acquired cannot exceed $1,200,000 ($750,000 + $400,000 + $50,000), the total fair market values of all the properties transferred. The carryover basis of the building would be reduced to $775,000, by the excess of the transferred basis ($1,225,000) over the fair market values of all properties ($1,200,000). The business will have a $375,000 basis in the equipment and a $50,000 basis in the inventory. If Tinker does make the election to reduce stock basis by the $25,000 excess basis, his stock will have a basis of $1,200,000 ($1,225,000 - $25,000) and the corporation will take the full $800,000 basis in the building.

55. [LO 9.5] Partnership Formation Solution: Zoe has a realized gain of $25,000 ($75,000 - $50,000) but neither Zoe nor the partnership recognizes any gain or loss on the transfer of the property. The

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partnership has a $50,000 basis in the property transferred by Zoe and has cash transferred from Jim and Angie with a $150,000 basis. Jim and Angie each have a $75,000 basis in their partnership interest. Zoe has a $50,000 basis in her partnership interest.

56. [LO 9.5] Partnership Formation Solution: Moe and Curly each have a basis of $90,000 [$50,000 + (1/3 x $120,000)] in their partnership interests. Larry’s basis in his partnership interest is $45,000 [$125,000 - $120,000 + (1/3 x $120,000)].

57. [LO 9.5] Partnership Formation Solution: X’s partnership interest basis = $40,000 + ($25,000 x 20%) = $45,000.

Y’s partnership interest basis = $50,000 + ($25,000 x 40%) = $60,000.

Z’s partnership interest basis = $70,000 - $25,000 + ($25,000 x 40%) + $5,000 services = $60,000.

The partnership has a basis of $40,000 in the cash, $50,000 in the property contributed by Y, and $70,000 basis in the property contributed by Z. It will either expense or capitalize the $5,000 for the services performed.

58. Comprehensive Problem for Chapters 6, 7, 8, and 9 Solution: a. Tax depreciation years 2014 – 2017: Asset/Year

2014

2015

2016

2017

Office Furniture

$ 1,143

$1,959

$1,399

$ 500

Computer

$

800

$1,280

$ 768

$ 230

Machine A

$ 2,144

$3,674

$2,624

$ 937

Machine B

$21,000

Machine C

$ 4,430

$7,592

$5,422

$ 3,872

Building

$ 5,083

$6,410

$6,410

$ 5,075

Machine D

$11,250

New Furniture

$

536

New Computer

$ 1,500

Chapter 1: An Introduction to Taxation 155 Machine E

$ 1,000

New Building

$ 1,402

Totals

$34,600

$20,915

$16,623

$25,302

Basis of Machine E: The adjusted basis of Machine B = $0. Machine E basis = $28,000 The mid-quarter convention must be used for 2016 because more than 40% ($43,000/$94,000 = 45.7%) of personalty is placed in service in the last quarter of the year. Depreciation for machine D is $11,250 ($45,000 x 25%), for the new furniture is $535.50 ($15,000 x 3.57%), for the new computer is $1,500 ($6,000 x 25%) and for machine E is $999.60 ($28,000 x 3.57%).

Basis of New Building: The adjusted basis of the building at the time of sale is $227,022 ($250,000 - $22,978). Columbo has a $47,978 ($275,000 - $227,022) gain on the condemnation. It recognizes no gain because it invests more than the proceeds in a new building. The basis of the new building is $262,022 ($310,000 $47,978 deferred gain). Depreciation for the new building is $1,401.82 ($262,022 x 0.535%). b. Machine A’s basis = $5,621; $7,000 - $5,621 = $1,379 Section 1245 recapture.

Basis is $2,999 for the furniture at the time of sale, but the loss is disallowed when sold to a related party (the sole shareholder). The shareholder will have dividend income in the amount of $1,900 ($2,000 fair market value - $100 paid). This is a bargain purchase.

There is a $47,978 Section 1231 gain realized on the building as determined above. None of the gain is recognized, however, due to the investment in a new building.

There is a $922 (equal to adjusted basis) Section 1231 loss on the computer that is both realized and recognized. c. The net effect of the property transactions is $1,379 of Section 1245 gain included in ordinary income and a deduction for the Section 1231 loss of $922 for a net increase in income of $457. d. (1) Financial Accounting Depreciation Asset/Year

2013

2014

2015

2016

Office Furniture

$800**

$800

$800

-0-*

Computer

$800**

$800

$800

-0-*

Machine A

$1,500**

$1,500

$1,500

-0-*

Machine B

$2,100**

$2,100

$2,100

-0-*

Machine C

$3,100**

$3,100

$3,100

$3,100

Building (40 yr.)

$6,250**

$6,250

$6,250

Machine D

$4,500**

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New Furniture

$1,500**

New Computer

$1,200**

Machine E

$4,270**

Building

______

______

______

$7,750**

Totals

$14,550

$14,550

$14,500

$22,320

*No depreciation in disposal year. **Full year’s depreciation in acquisition year.

The adjusted basis of Machine B is $14,700 ($21,000 - $6,300) when it is traded in on Machine E. The basis of Machine E is $42,700 ($28,000 + $14,700). There is no gain or loss on the exchange of Machine B for Machine E. (2) There is a $3,500 ($7,000 - $10,500 adjusted basis) loss on Machine A. There is a $3,600 ($1,900 - $5,600 adjusted basis + $100) loss on the sale of the furniture to the sole shareholder. There is a $1,600 (0 - $1,600 adjusted basis) loss on the computer that is destroyed. There is a gain of $43,750 [$275,000 – ($250,000 - $18,750)] on the condemned building.

(3) Comparison of Tax and Financial Accounting Results

Tax Dep.

2013

2014

2015

2016

$34,600

$20,915

$16,623

$25,302

Tax Gain (Loss) Fin. Dep.

$ 457 $14,550

$14,550

$14,550

Fin. Gain (Loss) Difference

$22,320 $35,050

Deferred tax Deferred tax liability liability

Deferred tax liability

Deferred tax liability

Develop Planning Skills 59. [LO 9.2] Sales Alternatives Solution: Glades needs to find a third party (an exchange accommodation party) who is interested in its property. The third party would then purchase the new property desired by Glades, allowing the owner to have cash for the property. The third party would then trade the purchased property for Glades property in a like-kind exchange. The third party could be a party that actually wants the Glade property, or, for a fee, acts as a broker and will then sell that property. The costs of using the third party must be weighed against the tax savings.

60. [LO 9.2] Sale Alternatives

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Solution: Timberlake could find a third party to whom the proceeds of the sale could be paid and held until Timberlake can identify and have the third party purchase the desired property within the time period required for like-kind exchanges. The third party can then exchange this new property for Timberlake’s property.

Alternatively, Carroll Corporation could purchase property that Timberlake will exchange for its property. Either of these exchanges is a qualifying like-kind exchange and will allow Timberlake to defer gain recognition and postpone paying $875,000 ($2.5 million x 35%) in tax.

61. [LO 9.2] Exchange Solution: Timberlake would exchange its property valued at $4,500,000 plus $300,000 cash for the property that Carroll purchases for $4,800,000. Timberlake has a gain of $2,500,000 ($4,800,000 - $2,000,000 – $300,000) that it can defer in its entirety.

As Timberlake is giving boot, it does not recognize any of the gain. Timberlake’s basis in the new property will be $2,300,000 ($4,800,000 - $2,500,000). Carroll recognizes no gain or loss and the basis for its property will be $4,500,000.

62. [LO 9.5] Corporate Formation Solution: Wilma should sell her property rather than contributing it to the corporation.

Wilma would receive the $50,000 cash for the property and recognize her $20,000 loss ($70,000 - $50,000) and then contribute the $50,000 to the corporation along with William and Wally’s assets. If the corporation wants Wilma’s property, Wally and William could form the corporation and purchase Wilma’s property.

Wilma could then become a shareholder of the corporation at a later date.

Alternatively, Wilma could borrow against the land or obtain $50,000 from another source to form the corporation with William and Wally. As Wilma will only be a 20 percent shareholder, she could then sell the property to the corporation and recognize the loss.

Alternatively, William could buy the land from Wilma and contribute the land and $50,000 cash to the corporation. Wilma could contribute her sale proceeds to the corporation in exchange for stock. All of these alternatives allow Wally nonrecognition of his gain.

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter.

63. [LO 9.2] Like-Kind Properties Suggested Solution: It is far more difficult to find land and buildings that are similar as required for personalty. To impose such strict regulations for exchanges of these assets would essentially render the provision useless. In addition, there is far less turnover in land and buildings than there is for personalty used in a business. Too

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much revenue would be lost if they relaxed the strict rules for personalty exchanges; by requiring personalty to be of the same depreciation class (already in the regulations) to qualify for exchange benefits, a fairly precise standard is available to guide taxpayers.

64. [LO 9.3] Personal Losses Suggested Solution: The tax law allows a limited expensing of personal items through the standard deduction or itemized deductions. The nondeductibility of loss in value as we use personal property is simply the price we have to pay to enjoy their use. If these losses were deductible, the government would effectively be subsidizing our usage of them through tax reduction. This would be of the greatest benefit to persons who could afford to invest in the greatest amount of personal assets. This is basically against the general policy of giving tax breaks to those with higher incomes. If the loss on an involuntary conversion is excessive, however, relative to the individual’s income, some relief is offered through a limited deduction.

65. [LO 9.3] Replacement Time Limits Suggested Solution: Possibly because the condemnation is an action of a governmental unit, the additional year is allowed by the federal government for the loss of the right to own the property that was condemned.

66. [LO 9.3] Condemnation Suggested Solution: If there is a threat of condemnation, and a person has the opportunity to sell the property, he is avoiding the risk of whether the condemnation will actually occur and on the price that would be obtained in the condemnation. The person may have found a suitable new location that may not be available when condemnation proceedings are complete and money is received. (This can take a significant amount of time.) If the possible condemnation is truly the reason for selling when a buyer is available, the whole uncertainty surrounding these events would argue that deferral is a logical benefit.

67. [LO 9.5] Section 351 Transaction Solution: When property transfers to a corporation without gain recognition, the corporation takes a carryover basis in the property. If the corporation sells the property, it recognizes the gain at that time. Thus, between the transferor-shareholder and the corporation, which both owned the property, the gain is recognized only once. If, however, the transferor recognizes all or part of the gain because of boot received or liabilities in excess of basis, failure to increase the basis of the assets transferred for this gain recognition would subject the same gain to a second round of taxation if the corporation should then sell the asset. Thus, increasing the basis of transferred property in the hands of the corporation by gain recognized by the

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transferor-shareholder preserves the taxation of the gain only once.

68. [LO 9.5] Section 351 Multiple Assets Solution: The gain and loss must be determined separately on each machine and the boot ($50,000 cash) must be apportioned over the two assets based on their relative fair market values. The shareholder realizes a $30,000 gain ($330,000 - $300,000) on Machine A and a $30,000 loss ($220,000 - $250,000) on Machine B. Boot of $30,000 is apportioned to A ($330,000/$550,000 x $50,000), and $20,000 to B ($220,000/$550,000 x $50,000). Thus, the shareholder will have to recognize the $30,000 gain on Machine A because that is the amount of gain realized as well as the boot received. The $20,000 boot allocated to Machine B does not cause any recognition because there is a realized loss on that machine.

If only the total fair market value ($550,000) and the total bases ($550,000) were considered, it would appear that no gain should be recognized. This can be a trap for taxpayers transferring property in a Section 351 exchange if they do not realize that boot is apportioned across all assets and gain and loss must be determined separately—not on an aggregate basis.

Search the Internet For the following problems, consult the IRS Web site (www.irs.gov).

69. [LO 9.2] Like-Kind Sales Solution: The sale will first be reported on Form 8824; if there is any recognized gain because of money or unlike property received it is first reported on Form 8984 and then on Schedule D (Form 1040) or Form 4797 (if there is depreciation recapture).

70. [LO 9.3] Casualties Solution: A casualty loss of a personal-use asset is reported on Form 4684 and on Schedule A: Itemized Deductions (Form 1040).

A casualty gain on personal-use property is reported on Form 4684 and on Schedule D: Capital Gains and Losses (Form 1040).

71. [LO 9.4] Wash Sale Solution: Report all wash sales transactions in Part 1 and/or Part 2 for Form 8949 with the appropriate box(es) checked. Complete all the columns and enter W in column (f).

Enter as a positive number in column (g) the amount of the loss not allowed. Then this publication directs you to see the instructions for Form 8949 to continue.

These instructions direct you to include totals from Part 1 on line 1 of Schedule D and the totals from Part 2 on line 8 of Schedule D (Form 1040). Then complete Schedule D.

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Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

72. [LO 9.3] Casualties Solution: Will this current flood qualify as a sudden and unusual event to allow for a casualty loss deduction given the repeated flooding during the past 12 years?

73. [LO 9.3] Casualties Solution: Is Karen entitled to a casualty loss deduction for the loss on the car?

74. [LO 9.3] Condemnations Solution: How will Timmins treat the severance damages and how much must it reinvest in new property to avoid recognition of gain on the condemnation?

75. [LO 9.3] Indirect Exchange Solution: Will acquiring only a partial interest in a piece of property qualify the purchaser for the like-kind exchange provision?

76. [LO 9.3] Condemnation Solution: How does Barry’s move into the replacement rental unit for the five months affect the condemnation tax treatment of the rental unit? Does it affect the tax treatment of the home that was condemned and its replacement property?

77. [LO 9.3] Replacement Period Solution: Will Carlson Manufacturing be allowed to use the gain deferral provisions for condemnations when the delay in occupancy is the result of events beyond its or the construction company’s control?

Develop Research Skills Solutions to research problems 78, 79, and 80 are included in the Instructor’s Manual.

Fill-in the Forms

Chapter 1: An Introduction to Taxation 161

Solutions to tax forms problems 81 and 82 are included in the Instructor’s Manual.

Appendix—Check Your Understanding 1. [LO 9A.1] Reorganization Type Solution: Types A, C, and D acquisitive all involve the acquisition of assets.

2. [LO 9A.1] Reorganization Type Solution: Types A, B, and C. 3. [LO 9A.2] Tax Consequences Solution: The acquiring corporation would recognize gain if it used appreciated assets as part of the acquisition price.

4. [LO 9A.2] Tax Consequences Solution: The shareholder recognizes gain if gain is realized on the reorganization and the shareholder receives boot.

5. [LO 9A.1] Reorganization Type Solution: Type D divisive reorganization allows a corporation to divide into two or more corporations in a spin off, split off, or split up.

6. [LO 9A.2] Divisive Reorganizations Solution: Spin off: The acquiring corporation transfers part of its assets to a new corporation in exchange for its stock. The stock is distributed to the shareholders of the acquiring corporation.

Split off: The acquiring corporation transfers part of its assets to a new corporation in exchange for its stock. The stock is distributed to some of the acquiring corporation’s shareholders in exchange for their stock in the acquiring corporation.

Split up: The original corporation transfers all of its assets to two or more new corporations in exchange for their stock. The stock of these corporations is then distributed to the shareholders of the original corporation in exchange for their stock in that corporation. The stock of the new corporations may be distributed to all the shareholders in their proportionate ownership in the original, or only certain shareholders may receive stock in one or more new corporations and not in others so that the ownership groups are split.

162

7. [LO 9A.1] Reorganization Type Solution: Type F 8. [LO 9A.3] Reorganization Type Solution: A change of state of incorporation qualifies as a Type F reorganization.

9. [LO 9A.3] Reorganization Type Solution: Filing for reorganization under bankruptcy qualifies as a Type G reorganization.

10. [LO 9A.4] Continuity of Interest Solution: Continuity of interest in the context of a reorganization means that owners of a target corporation continue an equity interest in the reorganized corporation.

Solutions to Chapter 10 Problem Assignments Check Your Understanding 1. [LO10.1] Corporate Income Solution: Income earned by a corporation is taxed once at year-end as regular income; it is taxed a second time when the corporation distributes that income as dividends to its shareholders.

2. [LO 10.1] Corporate Characteristics Solution: 1. Limited liability for owners; 2. Ease of raising capital; 3. Ease of selling ownership interest (shares); 4. Ability of owner-shareholder to receive a salary deductible as an expense by the corporation; 5. Ability of owner-shareholder to participate in corporate fringe benefits. (There are benefits beyond these five.)

3. [LO 10.2] Dividend Received Deduction Solution: When a corporation receives a dividend from another corporation, the dividend is included in the recipient corporation’s income but then the corporation is allowed a deduction based on its ownership percentage in the paying corporation. The dividend received deduction is the amount (generally a percentage of the dividend received) that is allowed as a deduction from that corporation’s income and, as a result, is not subject to tax. (Only the portion of the dividend remaining in income is subject to tax.)

A corporation that owns less than 20 percent of another corporation is entitled to a 70 percent dividend received deduction (remaining 30% taxed). A corporation that

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owns at least 20 percent but less than 80 percent is entitled to an 80 percent dividend received deduction (remaining 20% taxed). An affiliated corporation (80 percent or more ownership) is entitled to a 100 percent dividend received deduction (none taxed).

A dividend received deduction is limited to 70/80% taxable income (determined after the dividend but before the dividend received and US production activities deductions) if that is less than the normal 70/80% dividend received deduction— unless taking the full dividend received deduction (rather than the smaller 70/80% of taxable income) creates or increases a net operating loss for the corporation— then the full dividend received deduction is allowed.

4. [LO10.2] Charitable Contribution Solution: The contribution deduction is limited to 10 percent of taxable income before the dividend received deduction and after any net operating or capital loss carryforwards.

5. [LO 10.2] NOL Carryovers Solution: The normal carryover periods for net operating losses allow these losses to be carried back 2 years and forward 20 years.

6. [LO 10.2] Book vs. Tax Income Solution: Life insurance proceeds, tax-exempt income, and financial accounting depreciation deductions that are lower than tax depreciation deductions are three items that cause book income to exceed tax income. The payment of fines and bribes, excess charitable contributions, and capital losses in excess of capital gains cause book income to be less than taxable income. (There are other items as well as these detailed in Table 10-2.)

7. [LO 10.2] AMT Solution: The alternative minimum tax is a parallel tax calculation whereby a person or business with substantial real income in excess of its taxable income will be required to pay some tax on that income by disallowing certain exclusions and deductions that significantly reduce the determination of taxable income. The alternative minimum tax rate for corporations is 20 percent.

8. [LO 10.2] Due Date Solution: May 15 is the corporation’s regular due date for its return; its extended due date is November 15. It must make estimated payments in June, August, November, and February.

9. [LO 10.3] Earnings and Profits Solution: Corporate earnings and profits is intended to be the measure of how much a corporation can distribute to its shareholders as dividends without impairing the corporation’s contributed capital. Taxable income is not used because the numerous deductions and exclusions allowed in determining taxable income result in taxable

164

income’s failure to accurately reflect the corporation’s current dividend paying ability.

10. [LO 10.3] Earnings and Profits Solution: Current earnings and profits is the amount that is determined from operations for the current year only. At the beginning of the next year – any amount that is not used to pay dividends during the previous year from these E&P rolls over to the next year and becomes part of accumulated earnings and profits. Accumulated earnings and profits is the sum of income from prior years less dividends paid out in those prior years.

11. [LO 10.3] Earnings and Profits Solution: A corporation whose earnings and profits calculations for both the prior year and for the current year is negative will have negative accumulated earnings and profits for the prior year and negative current earnings and profits for the current year. This could easily be the case for a start-up company that has yet to show any type of profit for its first two years of operation. Note, however, that only negative earnings and profits can result from operations; they can never be negative because of dividend distributions.

12. [LO 10.3] Earnings and Profits Solution: Items that are added to taxable income to determine earnings and profits: Federal income tax refunds, dividends received deduction, proceeds of life insurance policies, NOL carryovers, capital loss carryovers, charitable contribution carryovers, excess of current year’s installment gain over portion recognized, percentage depletion in excess of cost depletion, depreciation expense in excess of allowable E&P depreciation, and Section 179 expense in excess of allowable depreciation.

Items that are deducted from taxable income to determine earnings and profits: Federal income taxes paid, capital losses in excess of capital gains, disallowed losses on sales to related parties, nondeductible fines and bribes, charitable contributions in excess of the 10 percent deduction limit, premiums on life insurance policies on which the corporation is the beneficiary, installment sale gain from a prior year’s installment sale, and 20 percent of the cost of Section 179 items expensed in the four prior years. Table 10.3 lists additional adjustments.

13. [LO 10.4] Redemptions Solution: A corporate redemption is the repurchase of its own shares by a corporation from a shareholder. In a qualifying redemption, a shareholder receives sale treatment, recognizing either gain or loss based on the basis of the shares redeemed and the redemption price. If the redemption is not a qualifying sale, the amount received is taxed as a dividend distribution to the extent of corporate E&P. 14. [LO 10.4] Liquidations

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Solution: A corporate liquidation is the cessation of business by a corporation along with a sale of some or all of its assets followed by a distribution of its cash and remaining property to its shareholders in exchange for the shareholders’ shares of the liquidating corporation. On a corporate liquidation, the corporation generally recognizes both gains and losses on both the sale and the distribution of its property to the shareholders. The shareholders receive sale treatment on the surrender of their shares in exchange for the cash or property distributed by the corporation.

15. [LO 10.4] Liquidations Solution: In a partial liquidation, the liquidating corporation recognizes only gains, not losses, on the disposition of its assets. In a complete liquidation, the liquidating corporation recognizes both gains and losses on the disposition of its assets.

16. [LO 10.5] Personal Holding Company Solution: The personal holding company tax is designed to discourage a corporation from retaining its earnings rather than paying it out as dividends so that shareholders can benefit from share price appreciation. The tax rate that applies (in addition to the regular corporate tax rate) is an additional 20 percent. The personal holding company avoids the tax by paying out sufficient dividends.

17. [LO 10.5] Accumulated Earnings Tax Solution: The accumulated earnings tax is designed to discourage a corporation from retaining earnings beyond the reasonable needs of the business ―for the purpose of avoiding income tax with respect to its shareholders.‖ Excess accumulations are subject to an additional 20 percent tax. This tax is avoided by paying out sufficient dividends beyond amounts that can be justified to meet current and future business needs.

18. [LO 10.5] Controlled Groups Solution: The two types of controlled groups for corporations are parent-subsidiary controlled groups and brother-sister controlled groups. Only parent-subsidiary controlled groups are consolidated groups allowed to file consolidated tax returns.

19. [LO 10.6] Consolidated Returns Solution: When one corporation controls another corporation (80 percent or more ownership by vote and value), they are permitted to file consolidated returns because it is similar to one corporation with two divisions rather than two separate entities.

20. [LO 10.6] Consolidated Returns Solution: To file a consolidated return, one corporation (the parent) must own directly at least 80 percent (by voting rights and value) or more of another corporation (the subsidiary); additional corporations can be included in the group as long as one or more of the corporations in the group owns at least 80 percent (by voting rights and value) of these other corporations.

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P owns 80 percent of S1; S1 owns 80 percent of S2; S2 owns 40 percent of S3; P also owns 40 percent of S3; S1 owns 50 percent of S4; and S3 owns 30 percent of S4. P, S1, S2, S3, S4 all form a consolidated group of corporations as P owns directly 80 percent of S1 and all the other corporations are related through 80 percent or more ownership within the group.

Crunch the Numbers 21. [LO 10.1] Corporate Tax Solution: Corporate tax on $200.000 = $22,250 + .39 x ($100,000) = $61,250. Tax on dividend = .15 x $50,000 = $7,500. Total tax on $200,000 = $68,750 ($7,500 + $61,250). Effective tax rate = $68,750/$200,000 = 34.38% 22. [LO 10.1] Dividend Tax Solution: a. $20,000 – (.7 x $20,000) = $6,000; taxable income = $81,000 b. $20,000 – (.8 x $20,000) = $4,000; taxable income = $79,000 c. $20,000 x 100% = $20,000; taxable income = $75,000 23. [LO 10.1] Cost of Debt Solution: $73,125. 7.5% (1 - .35) = 4.875% effective after-tax interest rate. $1,500,000 x 4.875% = $73,125 effective annual after-tax interest expense.

24. [LO 10.2] Corporate Tax Solution: $658,500 total tax and 43.9% effective rate. $1,500,000 x 34% = $510,000 corporate income tax. After-tax income = $990,000 ($1,500,000 - $510,000). $990,000 x 15% = $148,500 shareholder tax. ($510,000 + $148,500)/$1,500,000 = 43.9% effective tax rate on the $1,500,000 income.

25. [LO 10.2] Financial and Taxable Incomes Solution: a. $289,000 - $98,000 - $20,000 - $122,000 + $21,000 = $70,000 taxable income. b. $70,000 + ($20,000 - $5,000) - ($21,000 - $14,000) = $78,000 pretax financial accounting income.

26. [LO 10.2] Dividend Received Deduction Solution: a. $459,000 + $68,000 - ($68,000 x .70) = $479,400 taxable income. b. $459,000 + $68,000 - ($68,000 x .80) = $472,600 taxable income.

27. [LO 10.2] Dividend Received Deduction Solution: $9,000. $340,000 - $350,000 + $40,000 = $30,000 of taxable income before the dividend received deduction. The dividend received deduction is 70 percent of the lesser of taxable income ($30,000 x 70% = $21,000) or the dividend income ($40,000 x 70% = $28,000]. Thus, taxable income = $9,000 ($30,000 – $21,000).

28. [LO 10.2] Income Tax Solution: a. $12,500 = ($50,000 x 15%) + ($20,000 x 25%).

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b. $92,450 = $22,250 + [($280,000 - $100,000) x 39%]. c. $306,000 = $900,000 x 34%. d. $765,000 = $2,250,000 x 34%. e. $4,800,000 = $3,400,000 + ($4,000,000 x 35%).

29. [LO 10.2] Income Tax Solution: a. $280,500 = $825,000 x 34% b. $288,750 = $825,000 x 35% flat tax for PSC. 30. [LO 10.2] Income Tax Solution: a. $36,800 taxable income. $150,000 – $60,000 + $4,000 - $15,000 Section 179 deduction – $25,000 - $10,000 NOL = $44,000 income before the dividend received and charitable contribution deductions. The charitable contribution deduction is limited to $4,400 ($44,000 x 10%). The DRD is $2,800 ($4,000 x 70%). $44,000 - $4,400 - $2,800 = $36,800 taxable income. (The $9,000 capital gain offsets $10,000 of the capital loss; the other $5,000 of the capital loss cannot be deducted this year, but may be carried back three and then forward five years to offset gains in those years.) b. $5,520 income tax ($36,800 x 15%). c. Schedule M-1: Net income per books = $150,000 gross profit – $60,000 operating expenses + $4,000 dividend income + $10,000 capital gain - $15,000 capital loss - $22,000 financial depreciation - $5,000 charitable contributions $5,520 income tax = $56,480 net income per books. $56,480 net income per books + $5,520 income tax + $5,000 ($15,000 capital loss - $10,000 capital gain) excess capital loss + $600 ($5,000 - $4,400) excess charitable contributions - $18,000 ($15,000 Section 179 expensing + $25,000 additional tax depreciation - $22,000 financial depreciation) excess tax depreciation = $49,600 taxable income before special deductions.

$36,800 taxable income + $10,000 NOL + $2,800 DRD = $49,600 taxable income before special deductions.

31. [LO 10.2] General Business Credit Solution: $27,750. $400,000 x 34% = $136,000 gross tax liability. $25,000 + [75%

($136,000 – $25,000)] = $25,000 + $83,250 = $108,250 general business credit allowed.

The net tax liability is $27,750 ($136,000 - $108,250).

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32. [LO 10.2] Book/Tax Differences Solution: a. $204,700. $980,000 + $4,000 (Div.) - $420,000 - $380,000 + $6,000 (Ins. Prem.) + $11,000 (½ M&E) + $30,000 (Ch. Cont.) = $231,000 tentative taxable income before the DRD and allowable charitable contribution; DRD = $3,200 (80% DRD); Charitable contribution is limited to $23,100 (10% of $231,000); $231,000 - $3,200 - $23,100 = $204,700. b. $63,083. $22,250 + (.39 x 104,700) = $63,083. c. $57,818. $980,000 + $4,000 - 420,000 - $380,000 - $15,000 (excess tax depreciation) + $6,000 (Ins. Prem.) + $11,000 (½ M&E) + $30,000 (Ch. Cont.) - = $216,000 tentative taxable income before the DRD and allowable charitable contribution; DRD = $3,200 (80%); Charitable contribution is limited to $21,600 (10% of $216,000). $216,000 $3,200 - $21,600 = $191,200 taxable income, $22,250 + (.39 x $91,200) = $57,818 tax.

33. [LO 10.2] Business Credits Solution: $76,750 allowable credit for the current year. $25,000 + .75($94,000 - $25,000) = $76,750. $7,250 credit carryover. $54,000 + $30,000 - $76,750 = $7,250.

34. [LO 10.2] AMT Solution: AMTI = $118,750; AMT = $11,750 Tax on $68,000 = ($50,000 x 15%) + ($18,000 x 25%) = $12,000 AMT income before exemption = $68,000 + $87,000 + 2,000 = $157,000; AMT Exemption = $40,000 – ([$157,000 - $150,000] x .25) = $38,250; AMTI = $68,000 + $87,000 + $2,000 - $38,250 exemption = $118,750; Gross AMT = $118,750 x 20% = $23,750; AMT = $23,750 gross AMT - $12,000 regular corporate tax = $11,750.

35. [LO 10.2] Estimated Payments Solution: $575,000 x 34%)/4 = $48,875 each quarter under normal circumstances. In 2017, corporations with assets of $1 billion or more had to increase their estimated tax payments due in July, August, or September to 100.25 percent of what otherwise would be due ($48,997). They then reduced their payment due in October, November, or December to 99.75 percent of the payment otherwise due ($48,753).

36. [LO 10.3 & 10.6] Consolidated Returns Solution: a. $900,000 - $685,000 = $215,000 separate taxable income. b. General’s capital loss, casualty loss and charitable contribution are all separately stated items; the total of each of these items must be determined on a consolidated basis.

37. [LO 10.3] Retained Earnings

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Solution: $102,000 + $87,000 - $45,000 = $144,000 ending retained earnings.

38. [LO 10.3] Earnings and Profits Solution: $613,000. $668,000 + ($45,000 x 80% = $36,000 DRD) + $40,000 - $68,000 $40,000 - $23,000 = $613,000 39. [LO 10.3] Earnings and Profits Solution: All $6,000 is taxable as a dividend distribution. Amble has no remaining CE&P as all the CE&P and $2,000 of AE&P were paid out as dividends. AE&P has a balance of $21,000 ($23,000 - $2,000) at the beginning of the next tax year.

40. [LO 10.3] Property Distribution Solution: The total value of the distribution is $92,000 (4 x $23,000). Vanguard must recognize gain of $24,000 ($92,000 - $68,000). Each of the shareholders recognizes $23,000 dividend income, the value of their distribution (assuming the corporation has sufficient E&P).

41. [LO 10.3] Stock Dividend Solution: $400 gain. Adjusted basis of the shares = $4,400/110 share = $40 per share. $800 – (10 x $40) = $400 gain on the sale.

42. [LO 10.3] Stock Rights Solution: $9.375. Each right has a value of $3 ($13 - $9). $30 value of ten rights/$130 value of the ten shares = 23%; thus, basis must be allocated to the rights. The basis in the ten rights is $30/$160 total x $50 = $9.375.

43. [LO 10.3] Earnings & Profits Solution: a. Adam $6,000 dividend; Eva $9,000 dividend (No corporate consequences) b. Adam $10,000 dividend; Eve $15,000 dividend (No corporate consequences c. Adam $12,000 dividend; $2,000 return of capital; Eve $18,000 dividend; $3,000 return of capital (No corporate consequences) d. Adam $12,000 dividend; Eve $18,000 dividend (No corporate consequences) e. For simplicity, July 1 is assumed to be one-half year so that a $2,500 deficit has accrued by July 1 (on a daily basis it would actually be 181/365). Thus, Adam has a dividend of $3,000 and Eve a dividend of $4,500. f. Adam $4,000 dividend; Eve $6,000 dividend (No corporate consequences) g. Clarington recognizes $4,000 gain on the distribution increasing CE&P to $8,000. Adam has a $3,200 dividend and Eve a $4,800 dividend. h. Clarington cannot recognize the $2,000 loss on the distribution of the stock, but it reduces its current E&P to $2,000 for the loss. The distribution reduces both CE&P and AE&P to zero, limiting the total dividend to $5,000. Adam has a $2,000 dividend and a $1,200 return of capital while Eve has a $3,000 dividend and a $1,800 return of capital on the $8,000 distribution.

44. [LO 10.4] Redemptions Solution: a. $15,000 dividend. 800/1500 = 53.3% before redemption ownership; 53.3% x

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80% = 42.67% after redemption ownership; 650/1350 = 48.15% which is not less than 80% of the original ownership. Thus, Sheri will have to treat the $15,000 received as dividend income. b. $24,000 capital gain. 500/1,200 = 41.67% which is less than 80% of her original ownership of 53.3% (800/1500). Thus, Sheri will receive sale treatment. Her $24,000 capital gain is the difference between the $30,000 received and her basis in the 300 shares of $6,000 (300 x $20). c. Sheri will have dividend income (equal to the full amount received) in both instances because her father’s shares are attributed to her so she owns 100% of the shares both before and after the sales, regardless of the number sold.

45. [LO 10.4] Partial Liquidation Solution: a. Beacon will have a gain of $600,000 ($1,500,000 - $900,000) on the sale of the assets on which it will pay a tax of $204,000 ($600,000 x 34%). The after-tax proceeds are $1,296,000 ($1,500,000 - $204,000). When it distributes the $648,000 ($1,296,000 x 50%) to the shareholders, they will be able to treat this as a sale because it qualifies as a partial liquidation. The total gain is $198,000 [$648,000 – ($45 x 10,000)]. Assuming the shareholders have all held their stock for more than one year, they could pay taxes at rates from 0% to 20% (excluding any surtax) based on their other income; however, most will likely pay the tax at the 15% rate for a tax of $29,700 ($198,000 x 15%). (Note: any corporate shareholders would receive dividend treatment for any proceeds that they receive and could qualify for the dividend received deduction.) b. The corporation would have a $300,000 Section 1231 loss ($600,000 $900,000). This would reduce corporation taxes by $102,000 ($300,000 x 34%).

Total proceeds available for distribution would be $702,000 ($600,000 + $102,000). The shareholders would receive only half of this or $351,000. They would then have capital losses on the partial liquidation of $99,000 ($351,000 $450,000). These capital losses may or may not be deductible depending upon whether the shareholders have other gains that can offset the losses (in excess of the allowable $3,000 capital loss deduction for which the individual taxpayers could be eligible).

46. [LO 10.4] Liquidation Solution: $2,000 net loss for Loser Corporation and $89,000 capital loss for Bummer. Loser recognizes $500 ordinary income on the distribution of the inventory, an $11,000 ($56,000 - $67,000) Section 1231 loss on the building, and an $8,500 ($38,000 – $29,500) Section 1231 and/or Section 1245 gain on the machines. As a result. its net loss from these distributions is $2,000 ($500 ordinary income - $11,000 Section 1231 loss + $8,500 Section 1231 and/or Section 1245 gain). Bummer received property valued at $98,000 ($4,000 + $56,000 + $38,000) and has a capital loss on the surrender of his stock of $89,000 ($98,000 - $187,000). Unless Bummer has capital gains with which to offset the $89,000 capital loss, he will only be able to deduct losses of $3,000 per year against his other income with the balance of the loss carried forward.

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47. [LO 10.5] Controlled Group Solution: B, C, and D are brother-sister corporations.

Total ownership: A = 75%; B = 100%; C = 95%; D = 80% Sum of minimum ownership = 15% + 10% + 20% + 10% = 55% but A does not meet the 80% ownership requirement; thus, A, B, C, and D are not brother-sister corporations. B, C, and D, however, are brother-sister corporations as the sum of their minimum ownership in these three corporations remains 55 percent (15% + 10% + 20% + 10%).

48. [LO 10.5] Personal Holding Company Solution: Yes. Four of the nine shareholders own 36 percent in total with the tenth shareholder owning 19 (100% - [9 x 9%]) percent, a total of 55 percent for 5 shareholders. Thus, they meet the shareholder requirement to be a personal holding company because 5 or fewer shareholders own over 50 percent of the stock.

49. [LO 10.5] Personal Holding Company Tax Solution: $92,000. The corporation meets the shareholder requirement because any time there are less than 9 shareholders, five or fewer will own over 50 percent. $390,000/$540,000 = 72%. Thus, the corporation also meets the income requirement to be a personal holding company. $460,000 x 20% = $92,000 personal holding company tax in addition to its regular tax.

50. [LO 10.5] Accumulated Earnings Tax Solution: $83,200. $178,000 x 20% = $35,600 accumulated earnings tax in addition to its regular tax of $47,600 [($165,000 - $100,000) x 39% + $22,250], for a total tax of $83,200.

51. [LO 10.6] Consolidated Groups Solution: P, S1, S2, and S3, form one consolidated group. S4 and S5 cannot be part of this group because S4 does not meet the ownership requirements (80%) by P, S1, S2 and S3. S4 and S5 can form their own consolidated group with S4 as the parent, however.

Develop Planning Skills 52. [LO 10.1] Financing Alternatives Solution: The preferred stock is the best alternative. a. Loan: $2,000,000 x [9% (1- .30)] = $126,000 net after-tax interest payments.

The cost of the loan, which is the present value of the interest payments (an annuity of 10 years at 6%), is $126,000 x 7.360 = $927,360. (In each of the alternatives, $2,000,000 will have to be paid out at the end of the 10 year period; thus, it is unnecessary to determine the present value for this $2,000,000 outflow at the end of the 10 year period for any of them under the principle of incremental analysis.) b. Bonds: $2,000,000 x [7.5% (1 - .30)] = $105,000 net after-tax interest payments.

The present value of the interest payments is $105,000 x 7.360 = $772,800. The

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cost of the loan, however, includes both the total present value of the interest payments and the $200,000 underwriting fee, a total of $972,800. c. Preferred stock: $2,000,000 x 5% = $100,000. The present value of the dividend payments is $100,000 x 7.360 = $736,000. The total cost of the preferred stock, however, must include the present value of the $40,000 ($2,000,000 x 2%) redemption premium of $22,320 ($40,000 x .558). Thus, the total present value cost of the preferred stock is $808,320 ($50,000 + $736,000 + $22,320). The preferred stock is the best alternative.

53. [LO 10.2] Foreign Income Solution: The corporation is better off with the credit.

Deduction: $250,000 - $75,000 = $175,000; tax is [$22,250 + (39% x $75,000)] = $51,500.

Credit: Tax on $250,000 = $22,250 + (39% x $150,000) = $80,750. The corporation can offset $75,000 of the tax with its foreign tax credit and pay only $5,750 in taxes. Thus, the corporation is better off with the credit. The corporation is permitted the entire $75,000 tax credit because the rate of tax on the foreign income of 25 percent ($75,000/$300,000) is less than the rate of tax on the U.S. income of 32.3% ($80,750/250,000).

54. [LO 10.4] Asset Sales Solution: It should sell the loss asset.

If it sells the gain asset: Taxable income = $2,000,000 + $2,000,000 Section 1231 gain + $1,750,000 asset gain = $5,750,000. Tax = $5,750,000 x 34% = $1,955,000.

Alternative minimum tax: $5,750,000 + $4,500,000 = $10,250,000 AMTI. TAMT = $10,250,000 x 20% = $2,050,000; AMT = $95,000 ($2,050,000 - $1,955,000) If it sells the loss asset: Taxable income = $2,000,000 + $2,000,000 - $300,000 loss = $3,700,000. Tax = $3,700,000 x 34% = $1,258,000.

Alternative minimum tax: $3,700,000 + $4,500,000 = $8,200,000 AMTI. TAMT = $8,200,000 x 20% = $1,640,000. AMT = $1,640,000 - $1,258,000 = $382,000 AMT With either sale, the corporation will have to pay some alternative minimum tax.

The AMT is less selling the gain asset, but from a total tax standpoint, selling the loss assets results in taxes that are $410,000 less than selling the gain asset. On the general principle that taxes should be postponed, the loss asset should be sold. In addition, if the gain asset is sold in the near future, the AMT credit (the AMT paid this year when the loss asset is sold) potentially can be used as a credit against the regular tax in the year the gain asset is sold.

55. [LO 10.4] Shareholder Alternatives Solution: The corporation should redeem approximately 11% of Gene’s stock.

If Gene could find a buyer for his stock, he would only have to recognize the gain on the sale and pay taxes on the gain. The stock appears to be closely held, however, and an outside buyer may not be available. He may also be prevented from obtaining a loan outside the company using his stock as collateral because it may not be acceptable collateral if closely held. He could approach his brother to

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buy the stock, but his brother may not have the funds to do so. His best alternative would be to have the corporation redeem at least 10 percent of the stock. His ownership (both direct and indirect) before a redemption is 35 percent and 80 percent of that is 28 percent. To receive sale treatment, his direct and indirect ownership must be less than 80 percent after the redemption. If the corporation redeems 10 percent, he would then own 25% of the 90% of the stock that remains outstanding; 25/90 = 27.78% and is less than 80 percent of his previous ownership.

Redeeming 10% also gives him the needed $100,000 cash. His basis in the stock is $40,000 (10/25 x $100,000); he will have a $60,000 capital gain. He will need to have more than 10% redeemed to offset the potential $9,000 ($60,000 x 15%) tax.

Approximately 11% of his stock redeemed will cover the $100,000 for medical expenses and the taxes on the gain.

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter.

56. [LO 10.2] Tax and Financial Accounting Differences Solution: When computing taxable income: 1. No deduction for federal taxes; 2. Section 179 expensing allowed; 3. Depreciation based on artificial lives; 4. Amortization of many intangible assets fixed; 5. Fines and bribes not deductible; 6. Capital losses in excess of gains nondeductible; 7. Taxpayers permitted carryovers of nondeductible capital losses; 7. Deduction for charitable contributions limited; 8.

Net operating loss carryovers are permitted; 9. Corporations receive a dividend received deduction; 10. Requirements to file a consolidated return require a greater ownership percentage than required for accounting consolidation. (There are other differences besides the 10 listed here.)

57. [LO 10.3] Earnings and Profits Solution: Walter will have a $10,000 dividend distribution; John will have a $5,000 dividend distribution and a $5,000 return of capital.

The CE&P is allocated proportionately to Walter and John based on their total dividend during the year; thus, each is allocated $2,500 of CE&P ($5,000 x $10,000/$20,000). The $10,000 of AE&P is allocated based on the time within the year the dividend was distributed with earlier dividends allocated AE&P first; thus, Walter is allocated $7,500 of the $10,000 of AE&P; John in then allocated the remaining $2,500. As a result, Walter’s entire $10,000 is taxed as a dividend distribution but John’s $10,000 distribution is classified as $5,000 dividend and $5,000 return of capital.

58. [LO 10.3] Earnings and Profits Solution: $41,700. The deficit in CE&P that has accrued up through the day before the distribution reduces the AE&P balance on that date. January 1 – April 29 = 119 days for the April 30 distribution and 333 days (January 1 – November 29) for the November 30 distribution.

April 30 distribution: 119/365 x $36,500 = $11,900 deficit in CE&P. $75,000

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AE&P - $11,900 deficit = $63,100 AE&P as of that date; thus all $40,000 of the distribution is dividend.

November 30 distribution: 333/365 x $36,500 = $33,300 deficit in CE&P. $75,000 - $33,300 deficit - $40,000 dividend on April 30 = $1,700 AE&P; thus, $1,700 of the $20,000 distribution is dividend. $41,700 ($40,000 + $1,700) of the total distribution is a taxable dividend.

59. [LO 10.4] Attribution Rules Solution: Zero directly and 500 indirectly. Bob owns none of the shares of stock directly.

Under Section 267 he is considered to own 200 shares through his one-half interest in the family partnership and he has the 100 shares that his grandfather owns attributed to him. He also owns through reattribution, the 200 shares that his sister owns through her ownership in the partnership. Thus, he owns 500 shares indirectly. (There are a number of attribution sections in the Code applicable to specific transactions but Section 267 is one of the most commonly encountered.)

60. [LO 10.3 & 10.4] Corporate Distributions Solution: Corporations are taxed fully on their gains. If they distributed loss property to shareholders and recognized the losses, they could ―manufacture‖ these losses when necessary by these distributions—but the property would still be in the shareholders hands and the shareholder could then just rent the property back to the corporation. When the corporation liquidates, it ends its business operations.

At that time, it can recognize both gains and losses as there is no more corporation for the shareholders to control.

61. [LO 10.5] Controlled Groups Solution: (Examples will vary.) In a parent-subsidiary controlled group, the parent must own directly at least 80 percent of the combined voting power of the subsidiary or 80 percent of the stock by value; other corporations that together meet these ownership requirements (voting or value) are included in the controlled group. In an affiliated group, the parent is the primary focus and must own directly at least 80 percent by vote and by value of one corporation with other corporations meeting these same 80 percent ownership requirements (voting and value) also included.

Search the Internet 62. [LO 10.2] Corporation Tax Forms Solution: If a corporation has less than $250,000 in total receipts and total assets at the end of the tax year, it is not required to complete Schedules L, M1 and M2 if the yes box on Schedule K, Question 13 is checked Additionally, Schedule UTP (Uncertain Tax Positions) does not need to be filed for corporations with less than $50 million in assets.

63. [LO 10.2] Change of Tax Year Solution: To elect a 52-53-week tax year, a corporation must attach a statement to its tax

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return that specifies the following: (1) The month in which the new 52-53-week tax year ends; (2) The day of the week on which the 52-53-week tax year always ends; and (3) The date on which the tax year ends. It can be either of the following dates on which the chosen day (a) last occurs in the month in (1) above or (b) occurs nearest the last day of the month in (1) above.

Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

64. [LO 10.4] Attribution Solution: How will the redemption of these shares be treated for tax purposes? Will the fact that the brothers are estranged and have no contact affect this decision?

65. [LO 10.4] Liquidation Solution: Will the contribution of loss assets 20 months prior to the formal adoption of a plan of liquidation affect the gains and losses realized and recognized by the corporation when it liquidates?

66. [LO 10.4] Redemption Solution: Will acting as a consultant have any effect on the waiver of attribution that Joe signed with the IRS? Does he have to notify the IRS of this relationship?

67. [LO 10.4] Partial Liquidation Solution: Will this qualify as a partial liquidation or will the new corporation be viewed as simply a continuation of the old corporation? What would be the difference in the tax consequences for each of these outcomes?

68. [LO 10.5] Constructive Dividend Solution: How much of the constructive dividend will be taxed to the owner given the small amount of earnings and profits? Will the use of these corporate funds in prior years to pay personal expenses affect the determination of earnings and profits when determining the amount of the constructive dividend?

Develop Research Skills Solutions to research problems 69, 70, 71 & 72 are included in the Instructor’s Manual.

Fill-in the Forms Solutions to tax forms problems 73 & 74 are included in the Instructor’s Manual.

Appendix—Check Your Understanding 1. [LO 10A.1] Exempt Status Solution: An exempt organization can lose its exempt status if it fails to meet the

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requirements as an exempt organization under Section 501(c) of the Code on a continuing basis. Among other things, this section requires the exempt organization to be operated for the general public as a whole and receive a majority of its funds from the public or governmental units.

2. [LO 10A.1] Prohibited Transactions Solution: The federal government can levy excises taxes on or end the exempt status of an exempt organization that engages in prohibited transactions.

3. [LO 10A.2] Unrelated Business Income Solution: If an exempt organization is not taxed on its unrelated business income, it would have an unfair advantage when competing with taxable organizations conducting a similar type of business.

4. [LO 10A.2] Unrelated Business Solution: An unrelated business is one that does not have a proximate relationship to the exempt purpose of the organization. A related business has this relationship and supports the exempt status of the organization. For example, hospitals have flower and gift shops and colleges have bookstores and dining facilities; these are related to their exempt purpose. A golf course owned by a college but open to the public or a clothing store owned by a hospital would be unrelated businesses.

5. [LO 10A.3] Prohibited Transactions Solution: 1. Paying the personal expenses of an employee or manager. 2. An employee or manager taking property donated to an organization’s thrift shop for his or her personal use without adequate payment.3. Providing free services to an employee or manager that would otherwise have a cost if provided to the public.

6. [LO 10A.4] Private Foundation Solution: A private foundation is one that is not supported or operated for the general public as a whole but has a more narrow focus. It must receive less than one-third of its annual support from the general public, governments, or other exempt organizations.

7. [LO 10A.4] Prohibited Transaction Solution: A private foundation reduces its excise tax on prohibited transactions by correcting the prohibited transaction.

Solutions to Chapter 11 Problem Assignments Check Your Understanding 1. [LO 11.1] Liability Insulation Solution: C corporations, S corporations and limited liability companies insulate their owners from the general liabilities of the entity; a limited partner is insulated from partnership liabilities beyond the actual or agreed upon invested capital.

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2. [LO 11.1] LLP vs. LLC Solution: The partners in an LLP can be held liable for the general partnership debts; the members of an LLC are insulated from the general liabilities of the business.

3. [LO 11.2] Health Insurance Premiums Solution: Gem will deduct the cost of the health insurance for the two employees from its business income ($4,800 for the year); it cannot deduct the cost for the owner.

Instead, the owner will deduct the $2,400 cost as a deduction for adjusted gross income on his or her personal tax return.

4. [LO 11.3] Partnership Liabilities Solution: Recourse debt undertaken by a partnership increases a general partner’s basis in his or her partnership interest for his or her share of the liability determined by the losssharing ratio. When the recourse debt is paid off, his or her basis is reduced for the share of the liability discharged. Recourse liabilities do not affect the bases of limited partners.

Nonrecourse debt undertaken by a partnership increases both the general and limited partners’ bases in their partnership interests in their profit-sharing ratio. When the nonrecourse debt is paid off, their bases are reduced for their share of the liability discharged.

5. [LO 11.3 & 11.4] S Corporation Liabilities Solution: Liabilities of an S corporation have no effect on a shareholder’s basis in his or her stock. This is unlike a partnership in which liabilities of a partnership increase one or more partner’s basis in the partnership interest, based on the type of debt (recourse or nonrecourse) and type of partner (general or limited).

6. [LO 11.3] Loss Deductions Solution: First, to fully deduct their share of partnership losses, partners must have basis in their partnership interest equal to or greater than their share of the loss; if the basis is less, only a loss amount up to this lesser basis may be deducted after considering the at-risk and passive loss limitations. Second, this potentially deductible loss is compared to the amount that the partner has at risk. If this potentially deductible amount is more than the partner’s at-risk basis, the potentially deductible amount is further limited to the amount the partner has at-risk. Finally the potentially deductible loss amount that has passed these first two hurdles may be further limited by the passive loss limitation rules. These rules normally limit the deductibility of passive losses to the extent the taxpayer has passive income. The nondeductible excess losses can be carried forward to future years.

7. [LO 11.3] Partnership Theories Solution: The entity theory views the partnership as separate from the partners and allows the partnership and partner to act independently. This permits a partner to sell an asset to the partnership and recognize gain or loss on the sale. The aggregate (conduit) theory views the

178 partnership as an extension of the partners and every transaction that occurs at the partnership level is deemed to occur at the partner level; thus, partners can be held liable for the debts of the partnership and share in its gains and losses at year end.

8. [LO 11.3] Partner’s Basis Accounts Solution: A partner’s outside basis is the value of the partner’s capital account (in the financial accounting records) based on the fair market value of the property contributed. The partner’s inside basis is based on the partner’s basis in assets contributed to the partnership; that is, the partner does not recognize gain or loss on the contribution and the partnership takes a carryover basis in the property.

9. [LO 11.3] Guaranteed Payments Solution: A guaranteed payment is one that the partnership is obligated to make to a partner for services or use of capital and which is included when determining operating results as if it is an expense before the apportioning of partners’ residual shares of income or loss. A partner cannot be an employee of a partnership; although he or she may have a “salary” designated, it would not be deducted from partnership income as would payments for services of nonpartners. Unless this “salary” is otherwise designated as a guaranteed payment, the “salary” would be the share of profit to which he or she is entitled.

10. [LO 11.2, 11.3 & 11.4] Entity Liabilities Solution: The owner of a sole proprietorship and the general partners in a general partnership are all fully liable for the obligations of the business. Only the general partner(s) in a limited partnership are personally liable for the obligations of the limited partnership; the limited partners are only liable for the amount of their partnership contribution. Partners in an LLP are liable for the general obligations of the partnership but not for the acts of the other partners. The members of an LLC and the S corporation shareholders are protected from the general liabilities of these businesses.

11. [LO 11.3 & 11.4] Flow-Through Income Reporting Solution: Partnerships and S corporations separately state certain items on the Schedule K because the owners must treat these items in specific ways such as applying limitations or being required to combine them with other like items to determine their final disposition and taxation. Capital gains and losses, dividends, investment interest, charitable contributions, and Section 179 expenses are examples of items that must be separately stated.

12. [LO 11.4] Income Allocation Solution: S corporation income and loss items are first allocated to each day of the corporation’s tax year; then they are allocated to the shareholders based on their

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percentage ownership on each day of the year.

Example: An S corporation has $36,500 of income and it has two shareholders, one owning 40 percent and the other 60 percent. The corporation’s income is first allocated to each day at $100 per day. The 40 percent owner is then allocated $40 of each day’s income and the 60 percent owner is allocated $60. The 40 percent is allocated a total of $14,600 ($40 x 365) of income and the 60 percent owner is allocated $21,900 ($60 x 365) of income.

13. [LO 11.4] S Corporation Restrictions Solution: The S corporation must be a domestic corporation; it can have only one class of stock outstanding and it can have no more than 100 shareholders (with certain related shareholders and spouses counted as only one shareholder). The shareholders must be individuals or certain trusts or estates. (No corporate or partnership shareholders are permitted.) The individuals must be either citizens or residents of the United States (no nonresident alien shareholders are permitted).

14. [LO 11.4] S Corporation Elections Solution: A retroactive election is an election that is made by the 15th day of the third month of the corporation’s tax year and is effective from the beginning of the tax year.

The prospective election is an election that is made at any time during the tax year but which will not be effective until the beginning of the next (or a later) tax year as specified in the election.

15. [LO 11.4] Terminating Event Solution: A terminating event is any event that violates the corporate or shareholder restrictions on an S corporation and which can cause the termination of the S corporation election.

16. [LO 11.4] Loss Limitations Solution: Because debt of an S corporation has no effect on a shareholder’s stock basis, a shareholder’s basis in his stock is normally equal to the amount he or she is at risk.

17. [LO 11.4] AAA Solution: If in a future year, the S election terminates, the amount in the accumulated adjustments account is the measure of the amount this ―now-C corporation‖ (that was previously an S corporation) can distribute in cash to its shareholders during its post-termination period without receiving dividend treatment for the distribution.

18. [LO 11.4] S Corporation Taxes Solution: S corporations are subject to the BIG (built-in gains) tax, excess net passive investment income tax, and the LIFO recapture tax. The BIG and LIFO recapture taxes are only levied on S corporations that were previously C corporations with appreciated assets and appreciated inventory, respectively. The excess passive investment income tax applies to S corporations that have earnings and profits from a prior C corporation year and whose passive income exceeds a threshold

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based on its total revenue.

19. [LO 11.5] Rental Exception

Solution: A taxpayer is permitted a deduction from gross income of up to $25,000 for losses on rental real estate in which the taxpayer meets the requirement for active participation if his or her income is less than $150,000. The $25,000 deduction phases out for income between $100,000 and $150,000.

20. [LO 11.5] Passive Losses

Solution: Business losses are classified as passive, portfolio, or active. Limited partnership interests are always considered passive.

Crunch the Numbers 21. [LO 11.2] Sole Proprietorship Income Solution: Schedule C net income = $125,000 - $40,000 - $3,000 -$7,000 – $3,000 - $1,000 = $71,000.The dividend and interest income will be reported on Mason’s Schedule B of his Form 1040; the charitable contribution will be included with his personal charitable contributions and reported as an itemized deduction if he itemizes; the political contribution is nondeductible.

22. [LO 11.3] Partnership Income Solution: The $71,000 ($125,000 - $40,000 - $3,000 -$7,000 – $3,000 - $1,000) of items that make up net income on Schedule C in the preceding problem will all be reported as net income on Form 1065. The dividends, interest and charitable contributions will be reported on Schedule K (Form 1065) as separately stated items and the political contribution will be reported as a nondeductible item. John and Mary will each receive a Schedule K-1 reporting their shares of the net income, separately stated items, and nondeductible item. These will then be included in their Form 1040, with dividends and interest income on Schedule B and the charitable contributions included with other charitable contributions and reported as an itemized deduction.

23. [LO 11.4] S Corporation Income Solution: The business’s $71,000 of net income ($125,000 - $40,000 - $3,000 -$7,000 – $3,000 - $1,000) will be reported as net income on Form 1120S. The dividends, interest and charitable contributions will be reported on Schedule K (Form 1120S) as separately stated items and the political contribution will be reported as a nondeductible item. John will receive a Schedule K-1 detailing these items for inclusion on his Form 1040. The dividends and interest income will be included on Schedule B and the charitable contribution included with other charitable contributions and reported as an itemized deduction.

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24. [LO 11.3] Partnership Operations Solution: a. There are no tax consequences to Zoe for the contribution of property to the partnership. Her partnership interest will have a $50,000 basis, the same basis she had in the property transferred. b. The partnership has no tax consequences; it simply takes a $50,000 basis in the property transferred from Zoe. c. Jim’s basis = $75,000; Angie’s basis = $75,000; Zoe’s basis = $50,000. d. The partnership has a $150,000 basis in the money contributed and a $50,000 basis in the property.

25. [LO 11.3] Partnership Operations Solution: a. Partnership net income is $21,000 ($150,000 - $95,000 - $15,000 - $15,000 – $4,000). Each partner reports $10,500 (50% x $21,000). b. Each partner’s share of the Section 1231 gain will be included with any other Section 1231 gains and losses in the Section 1231 gain and loss netting process.

Each partner’s share of the charitable contribution will be included with his or her other charitable contributions and reported as an itemized deduction. c. George’s basis at year end: $80,000 + (50% x $21,000) + (50% x $2,000) – (50% x $1,000) = $91,000.

Georgenne’s basis at year end: $60,000 + (50% x $21,000) + (50% x $2,000) – (50% x $1,000) = $71,000.

26. [LO 11.3] Partnership Year End Solution: The partnership’s partners are all principal partners with different tax year ends and none has a majority interest; as a result, the partnership must use a tax year that provides the least aggregate deferral of income unless it can satisfy the requirement that an alternate year has a legitimate business purpose or has no more than a three-month deferral of income.

A June 30 year end provides the least number of months of income deferral (B: .35 x 6 months deferral = 2.1 + C: .35 x 4 months deferral = 1.4, an aggregate deferral factor of 3.5).

27. [LO 11.3] Partnership Distributions Solution: a. John’s $10,000 cash distribution reduces his partnership basis to zero and he must recognize $2,000 income for the excess cash received. The inventory has a zero basis. b.

There would be no change in the answer for a liquidating distribution. c. In a nonliquidating distribution, the $10,000 cash reduces his basis to $5,000 and the inventory takes this $5,000 as its basis. The result would be the same for a liquidating distribution.

28. [LO 11.3] Partnership Distribution

182 Solution: a. Quenton recognizes no gain or loss but reduces his basis to $4,000 by the $20,000 ($8,000 + $5,000 + 7,000) bases of the assets distributed. They would each have a carryover basis in the partner’s hands. b. Quenton recognizes no gain or loss; he takes an $8,000 basis in the cash, a $5,000 basis in the inventory and a $3,000 basis in the Sec. 1231 asset. His basis is now zero. c. In a. Quenton would still recognize no gain or loss, the cash and inventory would still have bases of $8,000 and $5,000 respectively, but the Section 1231 asset would now have the remaining basis of $11,000 ($24,000 - $8,000 - $5,000). In b. the basis for the cash and inventory would not change, but the Section 1231 asset would take the remaining $3,000 basis, postponing gain until this asset is disposed of. .

29. [LO 11.3] Partnership Distribution Solution: The partner recognizes no gain or loss on the nonliquidating distribution. The assets take a pro rata basis based on their actual bases. Asset A has a basis of $20,000 [4/7 ($35,000)] and Asset B has a basis of $15,000 [3/7 ($35,000).

30. [LO 11.3] Partnership Distribution Solution: The partner recognizes no gain or loss on the nonliquidating distribution. The assets take ratable bases determined by their current bases and the partner’s interest. Asset X has a basis of $20,000 [2/3 ($30,000)] and Asset B has a basis of $10,000 (1/3 [$30,000) 31. [LO 11.3] Partnership Distribution Solution: The partner recognizes neither gain nor loss as it receives a Section 1231 asset. The partner has a basis of $5,000 in the cash, $6,000 in the inventory, and $14,000 basis in the land.

32. [LO 11.3] Partnership Liquidation Solution: Alexandra’s “as if” proportionate distribution would be $7,500 cash, unrealized receivables with zero basis ($15,000 fair market value), inventory with $5,000 basis ($10,000 fair market value) and land with a $2,500 basis ($7,500 fair market value).

Instead, Alexandra receives all cash: her $7,500 actual share, $15,000 for the receivables (zero basis) and recognizes $15,000 ordinary income on the exchange, $5,000 ordinary income on the exchange of inventory ($10,000 cash - $5,000 basis) but neither gain nor loss on the land as she receives $7,500 cash equal to its basis. If she sells the land (before it is converted to other than a Sec.1231 asset) for its $30,000 value, she will have $22,500 of Section 1231 gain at that time.

33. [LO 11.3] Sale of Partnership Interest

Chapter 1: An Introduction to Taxation 183 Solution: Walter appears to have a $20,000 gain on the sale of his partnership interest. The actual results, however, are based on the sale of the separate asset categories at the $60,000 sale price. His proportionate interests are as follows: $20,000 cash, $8,000 inventory, and $10,000 land. He has a $16,000 gain on the inventory, taxed as ordinary income, and a $4,000 gain on the land that is a Section 1231 asset gain as shown below.

Asset Cash Inventory Land

Adjusted Bases $20,000 8,000 12,000

FMV $20,000 24,000 16,000

Amount Received $20,000 24,000 16,000

Gain or Loss -016,000 4,000

34. [LO 11.3] Sale of Partnership Interest Solution: Kenneth realizes $550,000 ($450,000 cash and assumption of his $100,000 share of the mortgage) on the sale of his partnership interest. He has a $200,000 ($550,000 $350,000 outside basis) gain on the sale of his interest. Charlie has a basis in the interest that he acquires of $550,000 ($450,000 cash + $100,000 mortgage assumption).

35. [LO 11.3] Partnership Formation Solution: a. No gain or loss recognized by Alpha or Beta. Gamma recognizes $10,000 of income for services performed. b. Alpha’s basis is $25,000 ($10,000 + $15,000). Beta’s basis is $35,000.

Gamma’s basis is $30,000 ($20,000 + $10,000). c. Basis in cash = $30,000; machinery = $15,000; land = $35,000; the services will have a basis of $10,000 if capitalized; if they are expensed, there would be no basis remaining.

36. [LO 11.3] Sale of Contributed Property Solution: The sale of the land results in a loss of $8,000 ($27,000 - $35,000). The first $5,000 of loss is allocated to the contributing partner (Beta) as the loss had accrued prior to its transfer to the partnership. The remaining $3,000 loss is divided equally between the 3 partners, each being allocated $1,000 of the total loss. Thus, Alpha and Gamma each have a $1,000 loss and Beta a $6,000 ($5,000 + $1,000) loss passed through.

37. [LO 11.3] Liability Allocations Solution: Recourse liabilities increase the basis of general partners only based on their losssharing ratio. Nonrecourse liabilities increase the basis of both general and limited partners based on their profit-sharing ratio. The $100,000 of recourse liabilities will be allocated entirely to Matt as the only general partner and his basis will increase by the $100,000 allocated liability. The $60,000 of nonrecourse liabilities will be allocated as follows: $12,000 (20% x $60,000) to Matt, bringing his total allocated liabilities to $112,000; $24,000 (40% x $60,000) to each of the two limited partners.

38. [LO 11.3] Liability Allocations Solution: a. All $100,000 of the recourse note is allocated to Carol, the only general partner. b. The $50,000 nonrecourse note is allocated based on the profit-sharing ratio as

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follows: Carol $25,000 (50% x $50,000); Charles $12,500; Charlotte $12,500 (25% x $50,000). c. If the three were all general partners, the answer to a. would change as follows: Carol would be allocated $25,000 of the $100,000 recourse liability; Charles would be allocated $40,000; and Charlotte would be allocated $35,000 as the allocations would be based on their loss-sharing ratio. The answer to b. would not change.

39. [LO 11.3] Partnership Operations Solution: a. $110,000 - $75,000 - $18,000 - $20,000 - $3,000 = $6,000 net loss; each partner is allocated $3,000 of this loss. b. Each partner’s share of the charitable contribution is included with his or her own charitable contributions if itemizing and the Section 1231 gain is included with other Section 1231 gains and losses and becomes part of the Section 1231 netting process. The tax-exempt interest is reported on page 1 of Form 1040 but it would not be included in partners’ ordinary income. c. Each partner’s basis at year end would decrease by $1,750 [50% (-$6,000 + $2,000 + $1,000 - $500)]. Thus Luis’s basis would be $78,250 ($80,000 - $1,750) and Jennifer’s would be $58,250 ($60,000 – $1,750). d. The value of Luis’s property contributed ($80,000) was equal to the adjusted basis of the property at the time of the contribution; he takes this $80,000 basis as his basis in his partnership interest. Jennifer’s basis in the property contributed was $60,000—the amount of her adjusted basis--and that becomes her substituted basis in her partnership interest; the fair market value of the property was $80,000—the same as Luis’s, however.

40. [LO 11.3 & 11.5] Loss Deductions Solution: Year 1: Sally’s beginning basis in her interest is $55,000 [$45,000 + (10% x $100,000)]. She is at risk, however, for only her $45,000 initial investment. The $31,000 loss reduces her basis to $24,000 and her at-risk amount to $14,000, although she will not be allowed to deduct any of the loss. Because she is a limited partner, this is a passive investment and she must have passive income against which to deduct the loss. As a result, it is held in suspense until she has passive income in future years.

Year 2: First, Sally’s basis is increased to $45,000 ($24,000 + $21,000) by the $21,000 income in year 2 and her at-risk amount is increased to $35,000 ($14,000 + $21,000). She can now deduct $21,000 of the passive loss held in suspense against this $21,000 of income. This reduces her passive loss held in suspense to $10,000 ($31,000 - $21,000).The net effect on her taxable income is zero. (Her basis and at-risk amounts remain at $45,000 and $35,000, respectively, as they were reduced for the loss in the prior year.)

Year 3: Sally first increases her basis to $49,000 ($45,000 + $4,000) and her atrisk amount to $39,000 ($35,000 + $4,000) for the $4,000 of income. She then deducts $4,000 of her $10,000 remaining suspended passive loss against this income, reducing the suspended passive loss amount to $6,000. The net effect on her income again is zero.

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Year 4: Sally first includes the $8,000 in income; this increases her basis to $57,000 ($49,000 + $8,000) and her at-risk amount to $47,000 ($39,000 + $8,000). She deducts the remaining $6,000 of her suspended passive loss against this income, reducing her suspended passive losses to zero. The net effect is a $2,000 increase in her income.

Year 5: Sally reduces her basis to $35,000 for the $22,000 loss. Her at-risk amount is also reduced to $25,000. The 22,000 loss is suspended due to the passive loss limitations.

Year 6: When Sally sells her partnership interest for $50,000 ($40,000 sales proceeds and $10,000 debt relief), she has a gain on the sale of $15,000 because her basis in the partnership is $35,000. She can now deduct the $22,000 passive loss that was suspended in year 5 due to the passive loss limitations against this gain because this is a complete disposition of her interest.

41. [LO 11.3] Partnership Distributions Solution: a. There is no gain or loss recognized on the distribution of the land to Partner X. Instead, Partner X has a basis of $25,000 in the land and the distribution reduces his basis in his partnership interest to $20,000 ($45,000 - $25,000). Any gain on a subsequent sale will be recognized only by Partner X. b. The partnership will have a realized and recognized gain of $5,000 ($30,000 $25,000) on the sale of the land. The gain will be allocated one-third to each of the partners increasing Partner X’s basis by $1,667 ($5,000 x 1/3) to $46,667. Partner X receives $30,000 cash, which reduces his basis in his partnership interest to $16,667 ($46,667 – $30,000). c. If the gain on the land had accrued while all the partners had held their partnership interest, the partnership should sell the land and recognize the $5,000 gain, passing one-third through to each partner as a matter of equity. For the partners other than X, it would be better for the partnership to distribute the land to X as X would then have to recognize the entire $5,000 gain, relieving the other two partners’ of their share of the gain and the taxes thereon. If the property had been contributed by one of the partners with the $5,000 gain built-in, the partnership should sell the land rather than distribute it as that gain would have to be assigned to the contributing partner.

42. [LO 11.3] Partnership Distributions Solution: a. There is no gain or loss recognized on the distribution of the land to Maria. Maria will take a $50,000 basis in the land and her basis in the partnership interest is reduced to $5,000 ($55,000 - $50,000). She will realize the loss on the subsequent sale of the land assuming she does not convert the land to personal use (e.g., building a personal residence on the land). b. The partnership will have a realized and recognized loss on the sale of the land of $23,000, which will be allocated to the partners based on their loss-sharing ratios. Maria will be allocated a loss of $5,750, reducing her basis to $49,250 ($55,000 – $5,750). She will then receive $27,000 in cash, which will reduce her basis in her partnership interest to $22,250 ($49,250 - $27,000). c. Maria should definitely insist on the sale of the land and the distribution of the

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proceeds rather than accepting a distribution of the land. If she takes the land, which will most likely be a capital asset in her hands (as an investment), it will have a carryover basis of $50,000 and a value of only $27,000. If she sells it, the $23,000 loss will be a capital loss and she will be limited to deducting $3,000 a year against her other income (unless she has other capital gains). If the land does not qualify as an investment asset, but becomes a personal use asset, any loss on a future sale would not be deductible.

43. [LO 11.3 & LO 11.4] Self-Employment Taxes Solution: a. Bob will pay FICA of $12,717. $90,000 [(50% x $80,000 net income) + $50,000 salary (guaranteed payment)] is subject to self-employment taxes. The $20,000 withdrawal does not affect self-employment taxes. Bob will pay $12,717 ($90,000 x .9235 x .153) in FICA taxes on this income. b. $3,825 will be paid by Bob ($50,000 x .0765) and the corporation will also pay $3,825 ($50,000 x .0765) in FICA taxes on the $50,000 salary, a total of $7,650 ($3,825 + $3,825). Neither the $40,000 of income after the salary payment nor the $20,000 withdrawal is subject to FICA taxes.

44. [LO 11.4] S Corporation Operations Solution: a. S corporation net income is $21,000 ($150,000 - $95,000 - $15,000 - $15,000 – $4,000). George and Georgenne will each report $10,500 ($21,000 x 50%) of net income at the end of the year. b. George and Georgenne will include their individual shares of the Section 1231 gain with their other Section 1231 gains and losses for the Section 1231 netting process. Their share of the charitable contribution will be included with other charitable contributions and reported as an itemized deduction. c. George’s basis at year end: $80,000 + (50% x $21,000) + (50% x $2,000) – (50% x $1,000) = $91,000.

Georgenne’s basis at year end: $60,000 + (50% x $21,000) + (50% x $2,000) – (50% x $1,000) = $71,000 45. [LO 11.4] S Corporation Basis Solution: a. Charles’s share of the loss is $15,000 ($60,000 x 25%) and the basis in his stock is $1,000 ($16,000 - $15,000 share of the corporation’s loss). His basis in his debt remains $10,000. b. Charles’s share of the loss is $22,500 ($90,000 x 25%) and the basis in his stock is reduced to zero by $16,000 of the loss; his basis in his debt is reduced to $3,500 ($10,000 – $6,500). c. Charles’s share of the loss is $30,000 ($120,000 x 25%) and the bases of both his stock and debt are reduced to zero. He is able to deduct only $26,000 of the loss as a result. The remaining $4,000 loss is suspended and cannot be deducted until he again has either debt or stock basis.

46. [LO 11.4] Shareholder-Employee Considerations Solution: There is a tax advantage equal to $321 using the S corporation rather than a C

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corporation.

Employment taxes: Both an S and a C corporation pay FICA and unemployment taxes for the shareholder of $6,158 [($75,000 x 7.65%) + ($7,000 x 6%)]. The shareholder-employee will have $5,738 ($75,000 x 7.65%) in FICA taxes deducted from his salary.

S corporation: Net income = $100,000 - $75,000 - $6,158 = $18,842. This is passed through the shareholder-employee and taxed along with the $75,000 salary.

Shareholder-employee: Income = $75,000 + $18,842 = $93,842. Taxable income = $93,842 - $4,050 - $6,300 = $83,492. Tax on $83,492 = $5,183.75 + [($83,492$37,650) 25%] = $16,644.25.

Total taxes = $6,158 + $5,738 + $16,644 = $28,540 on the $100,000 of income (a total tax rate of 28.5%).

C corporation: Net income = $18,542; $18,542 x 15% = $2,781 tax.

Shareholder-employee income = $75,000 + $15,000 dividend = $90,000. Taxable income = $90,000 - $4,050 - $6,300 = $79,650. Tax on $15,000 dividend income = $2,250 ($15,000 x 15%). Tax on the remaining $64,650 ($79,650 - $15,000 dividend) = $5,183.75 + [($64,650- $37,650) 25%] = $11,933.75; $2,250 + $11,933.75 = $14,183.75.

Total taxes = $6,158 + $5,738 + $2,781 + $14,194 = $28,861 on the $100,000 of income with a $15,000 dividend distribution to the shareholder-employee (a total tax rate of 28.9%). There is a tax advantage of $321 ($28,540, - $28,861) using the S corporation rather than a C corporation.

47. [LO 11.4] S Corporation Allocations Solution: Daily allocation of $50,000 = $136.99 per day.

Lisa: (50% x 120 x $136.99) + (25% x 245 x $136.99) = $16,610.

Shelley (25% x 245 x $136.99) = $8,391.

Marie (50% x 220 x $136.99) = $15,069.

George (50% x 145 x $136.99) = $9,932.

48. [LO 10.4] S Corporation Operations Solution: Net income from operations is $100,000 ($280,000 - $130,000 - $30,000 – $18,000 – $2,000). The Section 1231 loss and the interest income from the bonds are passed through separately. The traffic fines are nondeductible.

49. [LO 11.4] Passive Investment Income Tax Solution: No. The corporation must have C corporate earnings and profits to be liable for this tax. As the corporation has been an S corporation from its beginning, it is unlikely it has any C corporation earnings and profits.

50. [LO 11.4] S Corporation Distributions Solution: The AAA is reduced to $11,000 and Shareholder A’s stock basis is $12,000 and B’s is $20,000.

The corporation must recognize the $5,000 gain ($10,000 FMV - $5,000 basis) on the distribution of the land to A but it cannot recognize the loss on the distribution

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of the equipment to B. In addition, a specific priority must be followed for the adjustments to the AAA: taxable net income and separately stated income items are added first; the fair market values of distributions reduce AAA next, followed by nondeductible and deductible expense and loss items. Thus, the $6,000 net income and the $5,000 gain on the land increase the AAA to $46,000. The $30,000 fair market value of the distributions ($10,000 cash + $10,000 land + $10,000 equipment) reduces the corporation’s AAA to $16,000; the $5,000 nondeductible loss further reduces the AAA to $11,000.

Shareholder basis adjustments follow the same priority order: Shareholder A’s basis: $24,000 + $3,000 (50% x $6,000 income) + $2,500 (50% x $5,000 gain) = $29,500 basis before reduction for the property distributions. The $15,000 fair market value of the land and cash distributed to her reduce her basis to $14,500. The $2,500 (50% x $5,000) of the nondeductible loss reduces her stock basis to $12,000.

Shareholder B’s basis: $32,000 + $3,000 (50% x $6,000 income) + $2,500 (50% x $5,000 gain) = $37,500 basis before reduction for the property distributions. The $15,000 fair market value of equipment and cash distributed to him reduces his basis to $22,500. $2,500 of the $5,000 unrecognized loss reduces his stock basis to $20,000.

51. [LO 11.4] Corporate Liquidation and Distributions Solution: PA Corporation: The corporation realizes and recognizes a loss of $4,000 ($6,000 $10,000) on Asset 1, a gain of $8,000 ($12,000 - $4,000) on Asset 2, and a gain of $1,000 ($10,000 - $9,000) on Asset 3 for a net gain of $5,000. It has a total gain on the liquidation, including its operating loss, of $2,500 ($5,000 - $2,500). The corporation has $28,000 ($6,000 + $12,000 + $10,000) cash to distribute to the shareholders and each will receive $14,000.

Shareholder P. Her $4,000 basis is increased to $5,250 by one-half of the corporation’s net gain [($5,000 - $2,500) x 50%] which the shareholder must recognize. The $14,000 distribution reduces basis to zero and the shareholder has an $8,750 ($14,000 - $5,250) gain on the liquidation.

Shareholder A. His $20,000 basis is increased to $21,250 for the net gain [($5,000 - $2,500) x 50%] the shareholder must recognize. The $14,000 distribution reduces the basis to $7,250. The shareholder will recognize a $7,250 loss on the liquidation of the corporation in addition to the gain passed through to him.

52. [LO 11.5] Passive Activities

Solution: In year 1, Alfred includes PA-1’s $3,000 gain in income and deducts a $3,000 loss ratably from the losses of PA-2 ($2,000 deducted) and PA-3 ($1,000 deducted).

PA-2 has an $8,000 carryover loss and PA-3 has a $4,000 carryover loss. In year 2, Alfred includes PA-1’s $12,000 gain in income and deducts $12,000 from the losses of PA-2 and 3 as follows: PA-2 now has a total loss of $9,000 ($8,000 + $1,000) and PA-2 has a total loss of $6,000 ($4,000 + $2,000). Alfred deducts $7,200 [3/5 ($12,000)] of PA-2’s loss and $4,800 [2/5 ($12,000) of PA-3’s loss.

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53. Comprehensive Problem Solution: Depreciation on assets must be determined first: Ford Truck: $12,500 x .1920 x .5 = $1,200 2015 Machines: $60,000 x .1749 = $10,494 2016 Machines: $65,000 x .2449 = $15,919 2017 Machines: $35,000 x .1785 = $6,248 (mid-quarter convention) New Truck: $24,000 x .05 = $1,200 (mid-quarter convention) Net Income: Rental Income Sales of Products Total Revenue

$ 20,000 288,000

Expenses: Cost of Sales $121,000 Truck Expense 14,000 Telephone 600 Rent Expense 2,400 Part-time Delivery Person 25,000 Machine Repairs 5,500 50% of Meals and Entertainment 2,000 Liability Insurance 12,000 Depreciation 35,061 Business Use of Home [(400/1800) x $24,600] 5,467 Total Deductible Expenses Net Income

$308,000

$223,028 $ 84,972

Items not included on Schedule C: Truck sale: Basis = $12,500 x (1 – [.2 + .32 + (.5 x .1920)]) = $4,800 $5,000 selling price - $4,800 basis = $200 Section 1245 gain reported on Form 1040 from Form 4797.

The charitable contribution of $10,000 is included with his other charitable contributions and is an itemized deduction on Schedule A. Self-employment tax: $84,972 x .9235 x .153 = $12,006; the employer’s portion of this tax ($84,972 x .9235 x .0765 = $6,003) is deductible for AGI on page 1 of Form 1040.

Note: The part-time delivery person's cost includes payroll taxes.

Develop Planning Skills 54. [LO 11.2, 11.3 & 11.4] Choice of Entity Suggested Solution: Due to the type of business (food preparation), the entity that they select should insulate them from liability. Thus, their choices would be a regular corporation, an S corporation or an LLC. Because they anticipate losses in the first three years and both women are married with husbands who are employed, the effect of the losses can be softened by using a pass-through entity that allows them to deduct the losses against this other income. As both women will be involved in the business, they both should have no problem meeting the material participation requirements of an active business. Thus, the LLC and S corporation are the two

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choices. If they elect partnership status for the LLC, there will be no selfemployment taxes for the first three years as the business will show losses. If they choose S status, they would have to take no salary to avoid FICA taxes—and this could be characterized as unreasonable, even though the corporation shows losses.

At a later date, they could incorporate the LLC and elect S status, if they still want the benefit of loss pass through, although they would have to carefully consider the tax consequences, if any, at that time. Thus, for the time being, the LLC would appear to be the best choice for this business.

Because the rent and buy options require very similar cash outlays, the decision on whether they should rent or buy the business would appear to rest more on their future plans than on current profit or loss factors. If they buy, they will be out an additional $100 per month for the principal, but they will be building up equity in the building. They need to consider whether they plan to stay in this new location for a long time or do they think they could outgrow it or prefer a new location in a few years. If they expect the building to appreciate in value, buying might prove a wise choice should they believe they will stay long enough to benefit from the appreciation. Renting, however, allows them more flexibility should they either grow faster than expected, or should the business fail. Given the nature of the business, an alternate option might be to rent the building for a year or more, with an option to buy that is exercisable within the next year or two depending on the fortunes of the business. (Additional discussion could also consider the potential of opening a small bakery, deli, or restaurant to more fully utilize the available space and the kitchen they want for their wedding cake business.)

55. [LO 11.2, 11.3 & 11.4] Choice of Entity Suggested Solution: a. The limited liability company (treated as a partnership for tax purposes) or the S corporation form of entity would most likely provide the best alternative initially. These forms give liability protection to the investors while allowing them to benefit from the pass through of the losses in the initial years. At a later date when the business is profitable, it could decide to maintain that business form or change to a regular corporation. What is not clear is what Cynthia is going to receive in return for her hard work in the corporation as she appears to have no ownership initially. The S corporation would offer a simple way to compensate her through grants of stock or options to purchase stock. Her ownership percentage (even without a contribution) could be set up initially in the LLC and the profit and loss sharing agreement initially adopted could be used as the mechanism for rewarding her hard work, although this is not as simple as the stock arrangement for an S corporation. b. How does Cynthia expect to be paid for the work that she is going to put into the business? Is she getting a salary and/or is she getting part of the ownership of the business? What kind of income must she have to live on? What degree of autonomy will she have in running the company? Do the persons investing in the company want to be isolated from the company liabilities? Will they be able to make that additional investment in the company that will be needed in the future?

Who are the current owners and do they want to be able to deduct the business losses currently? What do the owners expect to take from the business as

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repayment for their investment?

56. [LO 11.4] S Corporation Losses Solution: To deduct the losses in excess of his $10,000 basis currently, the shareholder has several options: he can make an additional investment in the capital of the corporation or he can lend the corporation sufficient money to establish debt basis against which to deduct the losses. His last option is to do nothing and leave the losses suspended until he again has basis against which to deduct them through income generated by the corporation.

Questions to ask would include: What is your current tax rate? What do you expect you tax rate to be in the next several years? Do you expect the corporation to continue with losses or are these loss years unusual and the corporation will revert to profitability in the near future? What is your financial status? Do you have money to invest or to make a loan to the S corporation so that losses could be deducted currently? Do you want to sell the corporation? As the sole shareholder, can you do things that will improve the company’s profitability?

57. [LO 11.4 & 11.5] S Corporation Losses Suggested Questions: What is his current tax bracket? What does he expect his income and tax bracket to be in the next several years? Does he have money to invest or loan to the S corporation? If he does not have the money, can he borrow money that could be invested or lent to the corporation? What does he believe the future of the company will be? If he loans it money, does he believe the corporation will be able to pay it back? Is he interested in disposing of his stock in the near term?

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter.

58. [LO 11.2] Sole Proprietorship Solution: From a legal standpoint, the sole proprietorship cannot be separated from the owner. The tax law follows this basic premise that they cannot be separated. The reporting of operations on a separate form rather than the schedule within the Form 1040 would imply a separation that does not exist.

59. [LO 11.3] Services Contributions Solution: There are numerous definitions of what constitutes property—realty and personalty; tangible and intangible; ordinary, capital, and Section 1231. None of these include services—actions carried out by individuals acting for themselves or as employees of a business. Although receiving an interest in a business for services is similar to being paid for those services and then contributing the money in exchange for the business interest, the two steps simply cannot be combined to include services as part of the property received. Additionally, individuals have no basis in the property received for those services until they are taxed on the services; for most other property interests, however, individuals do have basis in the property whether acquired by purchase or gift. This separate treatment of

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services prevents the rendering of services from escaping ordinary income taxation.

60. [LO 11.3 & 11.4] LLCs Solution: Because of the differences in the manner in which LLC characteristics were prescribed by different states, many disagreements arose over whether the LLC was a partnership or a corporation. To eliminate the uncertainty of treatment, members may elect the desired form.

61. [LO 11.3 & 11.4] Distributions Solution: A partnership recognizes neither gain nor loss on nonliquidating or liquidating distributions of appreciated or depreciated property to the partners (except a disproportionate distribution). S corporations recognize gain but not loss on nonliquidating distributions, but recognize both gain and loss on liquidating distributions.

62. [LO 11.4] Limitations on S Corporations Solution: Because the net income and separately stated items are passed through to the shareholders based on their ownership percentages on a per day, per share basis; the addition of a second class of stock would complicate the manner in which these items are allocated to the shareholders as the income would have to first be divided between the classes of stock—an allocation that could be arbitrarily made to the detriment of some shareholders and to the advantage of others. As is, a shareholder owning one percent gets exactly the same amount of income/loss items as every other shareholder owning one percent.

Search the Internet 63. [LO 11.3] LLC Filing Requirements Solution: Answers will vary by state.

64. [LO 11.3 & 11.4] State Tax Issues Solution: Answers will vary by state.

65. [LO 11.4] S Corporation Issues Solution: Form 2553 is the form used to elect S corporation status. Information required on this form includes: The corporation’s name, address, identification number, date incorporated, state of incorporation, tax year, the effective date of election, and the selected tax year. The name and title of an officer or legal representative who IRS can call for additional information and his or her telephone number must be provided. The corporation must supply the names of all of the shareholders with their signature of consent to the S election, the date, their number of shares, date(s) acquired, their Social Security numbers, and the date of each shareholder’s tax year end. It must be signed by a corporate officer.

The instructions for Form 1120S state that elections made after the due date will be accepted as timely filed if the corporation can show that the failure to file on time

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was due to reasonable cause. When filing Form 2553 for a late S corporation election, the corporation must write in the top margin of the first page of Form 2553 ―FILED PURSUANT TO REV. PROC. 2013-30.‖ Also, if the late election is made by attaching Form 2553 to Form 1120S, the corporation must write in the top margin of the first page of Form 1120S ―INCLUDES LATE ELECTION(S) FILED PURSUANT TO REV. PROC. 2013-30.‖ To request relief for a late election, a corporation that meets the following requirements can explain the reasonable cause in the designated space on page 1 of Form 2553.

1. The corporation fails to qualify as an S corporation on the effective date entered on line E of Form 2553 solely because Form 2553 was not filed by the due date and it meets the following requirements and can explain the reasonable cause in the designated space on page 1 of Form 2553.

2. The corporation intended to be classified as an S corporation as of the date entered on line E of Form 2553.

3. The corporation fails to qualify as an S corporation on the effective date entered on line E of Form 2553 solely because Form 2553 was not filed by the due date.

4. The corporation has reasonable cause for its failure to timely file Form 2553 and has acted diligently to correct the mistake upon discovery of its failure to timely file Form 2553.

5. Form 2553 will be filed within 3 years and 75 days of the date entered on line E of Form 2553; 6. A corporation that meets requirements (1) through (4) must also be able to provide statements from all shareholders who were shareholders during the period between the date entered on line E of Form 2553 and the date the completed Form 2553 is filed stating that they have reported their income on all affected returns consistent with the S corporation election for the year the election should have been made and all subsequent years. Completion of Form 2553, Part I, column K, Shareholder's Consent Statement (or similar document attached to Form 2553), will meet this requirement; or 7. A corporation that meets requirements (1) through (3) but not requirement (4) can still request relief for a late election on Form 2553 if the following statements are true: The corporation and all its shareholders reported their income consistent with S corporation status for the year the S corporation election should have been made, and for every subsequent tax year (if any); At least 6 months have elapsed since the date on which the corporation filed its tax return for the first year the corporation intended to be an S corporation; and Neither the corporation nor any of its shareholders was notified by the IRS of any problem regarding the S corporation status within 6 months of the date on which the Form 1120S for the first year was timely filed.

To request relief for a late election when the above requirements are not met, the corporation generally must request a private letter ruling and pay a user fee in accordance Rev. Proc. 2014-1, 2014-1 I.R.B. 1 (or its successor).

66. [LO 11.2 & 11.4] Sole Proprietorship Income

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Solution: Schedule C Income: Expenses:

Publication royalties Travel $40,000 Transportation 3,000 Office expense 7,000 Total expenses

Net Income

$125,000

50,000 $75,000

All other items are either reported first on a separate schedule or directly on Form 1040—but not on Schedule C. Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

67. [LO 11.3] Abandoning a Partnership Interest Solution: Does Shana recognize any gain or loss as a result of her abandonment of her partnership interest?

68. [LO 11.3] Purchase of Land from Partner Solution: What are the tax consequences that would result from a sale of the land by Carol to the partnership?

69. [LO 11.3] Sales of Partnership Interests Solution: Are there any tax problems created by these various sales of partnership interests within this relatively short period of time? What are the tax consequences of these sales?

70. [LO 11.4] Fringe Benefits Solution: What are the tax consequences of the corporation providing these fringe benefits for the family? Are they tax free to the family?

71. [LO 11.4] Acquisition by S Corporation Solution: What are the tax consequences to the S corporation of acquiring 85 percent of a C corporation?

Develop Research Skills Solutions to research problems 72-74 are included in the Instructor’s Manual.

Fill-in the Forms Solutions to tax forms problems 75-79 are in the Instructor’s Manual.

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Solutions to Chapter 12 Problem Assignments Check Your Understanding 1. [LO 12.1] Unified Credit Solution: The lifetime unified credit for 2017 is $2,141,800 [$345,800 + (.40 x $4,490,000)]; this is equal to a related exclusion equivalent of $5,490,000. The unified credit is the amount available to a donor and/or the donor’s estate to offset all or a portion of the donor’s gift tax and/or the donor’s (now deceased) estate tax liability. The unified credit was $2,125,800 for 2016 and the exclusion equivalent was $5,450,000.

2. [LO 12.1] Generation Skipping Transfers Solution: Making gifts of property to third- and fourth-generation descendants by-passes gift taxes that would be owed by passing the property to directly succeeding generations. For example, great grandfather gifts $10,000,000 to his great grandson, by-passing both the grandfather and the father. A gift tax is paid once only. If the gift is passed to the grandfather, a gift tax will be paid then; when the remaining amount is gifted to the father, another gift tax is paid. The remainder that is left to be gifted to the great grandson will be much less than $10,000,000 now due to these intervening gift taxes. The generation-skipping transfer tax is designed to penalize these ―skips.‖ If it did not exist, making these gift skips would preserve more wealth within a family.

3. [LO 12.2] Gift Determination Solution: No, it is simply an arms-length sale.

4. [LO 12.2] Gift Determination Solution: Sharon must relinquish her right to change beneficiaries for this to be a completed gift.

5. [LO 12.2] Gift Tax Exclusion Solution: The annual gift tax exclusion of $14,000 ($13,000 prior to 2013) was enacted for taxpayer and administrative convenience to eliminate small gifts (birthday, wedding, etc.) from gift taxes.

6. [LO 12.2] Present vs. Future Interest Solution: A present interest is an interest that is received at the time the gift is made and it allows the recipient to benefit from and enjoy the gift property immediately. A future interest does not take place until sometime in the future and the enjoyment of property is postponed until then.

7. [LO 12.2] Gift to Minor Solution: The requirements for gifts made into a Section 2503(c) minor’s trust are: (1) The trustee may pay the income and/or trust assets to the beneficiary before the beneficiary reaches age 21. (2) The income and the assets must be distributed to the beneficiary when he or she reaches age 21. If the beneficiary dies before age 21, the

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trust property must be distributed to the beneficiary’s heirs or estate.

A Crummey trust could also qualify for the annual exclusion. A Crummey trust does not require a distribution of assets when the beneficiary reaches age 21; however, it must have an annual demand provision.

8. [LO 12.3] Kiddie Tax Solution: The kiddie tax was enacted to discourage a child’s parents from transferring unearned income producing assets to children under the age of 19 (24 if full-time students) so that the family could then benefit from lower graduated income tax rates on this income now taxed to the child, since, presumably, the child would have little other income subject to income taxes. The solution to this was to impose the tax on the child’s unearned income in excess of $2,100 at the parents’ marginal tax rate.

9. [LO 12.3] Coverdale Savings Plan Solution: The income on contributions of up to $2,000 per year to a Coverdale Education Savings plan (subject to income limitations) are permitted to accumulate tax free.

When the beneficiary withdraws the funds from the plan, no taxes are owed as long as the funds are used for qualified education expenses.

10. [LO 12.4] Life Insurance Proceeds Solution: If the decedent’s estate is the beneficiary or the decedent retained any incidents of ownership (for example, the right to change beneficiaries or to borrow against the policy) in the policy, the proceeds will be included in the decedent’s estate.

11. [LO 12.4] Life Insurance Transfers Solution: a. Yes. Troy has made a gift at the time of the transfer but the value of the gift is only equal to the cost of an equivalent policy. b. No. The proceeds are not included in his estate because he retained no incidents of ownership at the time of his death and the gift was not made within 3 years of his death.

12. [LO 12.4] Estate Valuation Solution: Estate property (except IRD) is valued at fair market value at the date of the decedent’s death or, if elected, the alternate valuation date. The alternate valuation date is 6 months after the decedent’s death and can be used only if the executor makes an irrevocable election on the estate tax return and both the gross estate and estate tax are reduced by using the alternate date. If the alternate valuation date is elected, but the property is sold prior to that date, the sale value of the property is included in the estate.

13. [LO 12.5] Asset Bases Solution: A donor normally takes the donor’s adjusted basis in appreciated property as his or her basis. If the donor pays a gift tax on appreciated property, the donor increases the donor’s adjusted basis by a pro rata portion of gift tax for this appreciation. If the gift’s fair market value is less than the donor’s basis when

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gifted, its basis, if disposed of at a loss, is this lower fair market value.

Beneficiaries, however, take a fair market value at the date of death (or alternate valuation date) as their basis for inherited property.

14. LO 12.5] Estate Planning Solution: Sidney has transferred both income (the $35,000 annual rent) and a potentially appreciating asset (the building) to his daughter. This transfer shields the post-gift appreciation from estate tax and provides the family annual income tax savings from income shifting (assuming the daughter is in a lower marginal tax bracket than Sidney).

15. [LO 12.6] Income in Respect of a Decedent Solution: IRD is income earned by a cash-basis taxpayer but not yet received at death. IRD receives no basis step-up and is taxed as income to the beneficiaries (or the estate, if not distributed).

16. [LO 12.6] Estate Taxation Solution: The income tax rate for income earned by assets held within an estate is extremely high, reaching 39.6 percent at $12,500 in 2017 (39.6 percent at $12,400 in 2016).

Distributing the estate assets quickly transfers the income earned on the assets to beneficiaries who may be in lower marginal tax brackets.

17. [LO 12.7] Adjusted Taxable Gifts Solution: Adjusted taxable gifts is the term given to the sum of all taxable gifts made by the decedent after 1976. The total amount of a decedent’s adjusted taxable gifts is added to his or her taxable estate (gross estate less allowable deductions). The transfer tax rates are then applied to this total. The tentative tax is then reduced by a credit for gift taxes paid on the post-1976 gifts based on the current tax rates and credit amount. Including adjusted taxable gifts in the calculation of the estate tax subjects the taxable estate to higher marginal tax rates.

18 [LO 12.7] Trust Characteristics Solution: A simple trust must (1) distribute all of its accounting income annually to the beneficiaries and (2) cannot make charitable contributions. Complex trusts do not have to distribute all accounting income and they can make charitable contributions.

19. [LO 12.7] Distributable Net Income Solution: DNI determines the maximum distribution deduction by the estate or trust and the maximum taxable distribution for the beneficiaries (regardless of the amount actually distributed).

20. [LO 12.7] Trust taxation Solution: A trust can be subject to a 3.8 percent surtax on the lesser of net investment income or the excess of adjusted gross income over the $12,500 threshold—the

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highest trust tax rate. The tax can be avoided by paying out sufficient income to the beneficiaries to lower its income below this threshold.

Crunch the Numbers 21. [LO 12.1] Exclusions Solution: $2,161,800 ($345,800 + .40 ($4,540,000) 22. [LO 12.1 &12.2] Exclusions Solution: $7,780,000 ($5,490,000 - $450,000) + ($5,490,000 - $450,000 - $2,300,000) 23. [LO 12.2] Gift Determination and Valuation Solution: a. $60,000 ($90,000 fair market value - $30,000 selling price). b. There is no gift until the daughter withdraws money. c. There is no gift when the property is transferred because the trust is revocable. If any income is paid to the daughter, then the income would be a gift when paid from the trust.

24. [LO 12.2] Gift Determination and Valuation Solution: a. Cynthia makes a taxable gift of $4,000 ($18,000 - $14,000 annual exclusion) when the trustee distributes that amount to Eileen. b. Services are not subject to gift tax. c. $1,000 gift ($15,000 - $14,000 annual exclusion). The medical expenses must be paid directly to the provider to be excluded. d. There is no taxable gift because the money is paid directly to the university.

25. [LO 12.2] Gift Determination and Valuation Solution: a. Stephanie makes a $15,000 gift in July when Michael withdraws the funds. b. There is no gift as the money is paid directly to the hospital. c. There is no gift as the money is paid directly to the university. d. $85,000 gift. e. Miguel does not make a gift until the trustee makes the $20,000 distribution to Juan; at that time Miguel makes a $20,000 gift of the money to Juan.

26. [LO 12.2] Gift Valuation Solution: $570,000 = ($40 + $36)/2 = $38 x 15,000 shares.

27. [LO 12.2] Gift Splitting Solution: a. $160,000 = ($30,000 – $14,000) x 10. b. $10,000 = ($15,000 - $14,000) x 10. Lisa also has $10,000 in taxable gifts.

28. [LO 12.2] Gift Splitting Solution: a. $24,000 = ($20,000 - $14,000) + ($32,000 - $14,000). The gift to her husband is not taxable.

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b. $2,000 = ($16,000 - $14,000). The gift to the daughter is now less than their combined gift annual exclusions. Ginny’s husband also has $2,000 in taxable gifts.

29. [LO 12.2] Gift Splitting Solution: a. $244,000 combined taxable gifts. Marah: ($20,000 – $14,000) + ($60,000 $14,000) + ($100,000 - $14,000) = $138,000.

Bryan: $120,000 – $14,000 = $106,000. b. $196,000 combined taxable gifts. Marah and Bryan: ($30,000 - $14,000) + ($50,000 - $14,000) + ($60,000 - $14,000) = $98,000 each. The gift to Sam is less than their two annual exclusions when gift splitting is elected.

30. [LO 12.2] Gift Splitting Solution: $46,000 total gift exclusions = $28,000 (2 x $14,000) for $30,000 cash gift + $18,000 (2 x $9,000) for gift of marketable securities. The remainder interest is not eligible for the annual exclusion.

31. [LO 12.2] Present vs. Future Interest Solution: a. This is a future interest, but it is eligible for the annual gift exclusion as a Section 2503(c) minor’s trust. b. Present interest for the $10,000 transferred each year. c. Present interest equal to the cost of a comparable policy at that date.

32. [LO 12.2] Grantor Trust Solution: a. Zero. Mark has no income from these transfers; they are income to George because this is a grantor trust. The distribution is a gift to Mark. b. George has $30,000 of income because this is a grantor trust.

33. [LO 12.3] Gift Planning Solution: a. $4,365 tax savings. For 2017, a zero tax rate applies to dividend income and long-term capital gains for individuals in the 10% or 15% marginal tax brackets; for single individuals that would include taxpayers with taxable income of less than $37,950 for 2017. Eileen has $2,100 dividend income and a long-term capital gain of $27,000 ($39,000 - $12,000 basis) resulting in $29,100 gross income.

Eileen’s taxable income is $18,700 ($29,100 - $6,350 - $4,050), all subject to a 0% tax rate in 2017. Note that Eileen cannot be a dependent because she is age 24 and her income exceeds $4,050.

The Parent’s tax on transferred income would have been: $2,100 x 15% = $315.

Capital gains tax: $27,000 x 15% = $4,050. Total tax = $4,050 + $315 = $4,365. b. No. Assuming the parent’s gift split, neither parent will have made a taxable gift as their annual exclusion now reduces taxable gifts to zero [($28,000 x 50%) $14,000].

34. [LO 12.3] Kiddie Tax Solution: $680 [($1,050 x .10) + ($2,300) x .25)

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35. [LO 12.3] Kiddie Tax Solution: a. $595. Lenny’s taxable income: $3,500 - $1,050 standard deduction = $2,450; Lenny’s tax: ($1,050 x 10%) + ($1,450 x 33%) = $105 + $478.50 = $583.50. b. $250. If Lenny is 24, his tax is: ($3,500 - $1,050) x 10% = $245, assuming Lenny is a dependent. If Lenny were not a dependent, he would be entitled to claim a standard deduction of $6,350 and a personal exemption of $4,050 resulting in no taxable income and no tax liability.

36. [LO 12.3] Kiddie Tax Solution: a. $1,006.50. Cindy’s standard deduction is $6,350 (Earned income + $350--the maximum allowable standard deduction). Her taxable income is $3,050 ($9,400 $6.350). Her tax at 33 percent is $1,006.50 ($3,050 x .33) b. Cindy’s taxable income is still $3,050, but her tax is now $305 (.1 x $3,050) . c. $701.50 ($1,006.50 - $305) 37. [LO 12.4] Gross Estate Determination Solution: a. Nothing included; the life estate ends with the beneficiary’s death. b. $60,000 included. c. $50,000 included in gross estate.

38. [LO 12.4] Gross Estate Determination Solution: a. $400,000. b. $400,000. c. $100,000.

39. [LO 12.2 & 12.4] Gross Estate Determination Solution: $80,000. This is a gift that had strings and it was transferred within three years of death; thus, it must be brought back into the estate.

40. [LO 12.4] Gross Estate Determination Solution: a. $89,000. b. $102,000.

41. [LO 12.4] Taxable Estate Determination Solution: $1,000,000 - $16,000 fee - $15,000 funeral expenses -$110,000 charitable contribution - $700,000 marital deduction = $159,000 taxable estate. A promise to pay without a valid contract is not an enforceable debt.

42. [LO 12.3. 12.4 & 12.5] Basis of transferred Property Solution: a. $3,000,000; Jessica’s basis. b. Date of death value of at least $3,000,000 plus any pre-death appreciation. c. If the son plans to keep the land, then the basis will not be very important to him, so Jessica should consider giving the land to him now as the gift tax exclusion equivalent in 2017 is $5,490,000. If the son eventually decides to sell the

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land, the appreciation may be taxed to him at the capital gains rate (current maximum 20 percent in 2017 excluding surtax). If Jessica waits until she dies to transfer the property, there may be an estate tax due. The current estate tax exclusion equivalent is $5,490,000 but it is indexed for inflation.

43. [LO 12.2, 12.3, & 12.5] Gift tax determination Solution: a. $50,320. $200,000 gift - $14,000 annual exclusion = $186,000 taxable gift Gift tax on $186,000 = $38,800 + [.32 x ($186,000 - $150,000)] = $50,320 Cherry must use $50,320 of her unified credit to offset the gift tax. She pays no tax at this time. b. $4,791.25 saved. Nancy has $13,200 (12 x $1,100) in Social Security income and $18,000 (.09 x $200,000) interest income on the bonds. As her total income ($31,200) exceeds $25,000 but does not exceed $34,000, one-half of the amount that her social security income that exceeds $25,000 must be included in her taxable income or $3,100 [.5( $31,200 - $25,000)] Her taxable income is $10,700 ($18,000 + $3,100 - $4,050 exemption - $6,350 standard deduction) and her tax is $1,138.75 [$932.50 + .15 x ($10,700 - $9,325)] . Cherry’s tax on the $18,000 interest would have been $5,940 ($18,000 x .33). Thus they have saved the $4,801.25.

44. [LO 12.5 & 12.6] Trust Income Solution: a. $160,000. b. Barbara as beneficiary. c. The trust, per the trust document.

45. [LO 12.6] IRD Solution: $72,000 of IRD, assuming none of the distribution from the retirement plan represented income on which taxes had already been paid by the decedent prior to death.

46. [LO 12.6] Trust Income Solution: $70,000 is taxed to the children; $30,000 is taxed to Wayne, the income from the newly contributed assets, as he retained rights to that income.

47. [LO 12.6] Trust Income Solution: a. $12,000 from the trust in year 1. b. $18,000 from the estate in year 2.

48. [LO 12.7] Gift Tax Calculation Solution: $1,005,800 = $345,800 + [40% x ($2,650,000 - $1,000,000)].

49. [LO 12.7] Gift Tax Calculation

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Solution: $3,404,000. $345,800 + [40% x ($14,000,000 - $1,000,000)] = $5,545,800 $2,141,800 unified credit 50. [LO 12.7] Estate tax Determination Solution: $1,344,000. Tax on taxable estate of $8,850,000: $345,800 + [($8,850,000 $1,000,000) x 40%] = $3,485,800 gross estate tax - $2,141,800 unified credit = $1,344,000 estate tax. Note that unless a decedent has used all or part of the unified credit to offset taxable gifts, a taxable estate of $5,490,000 or less would not pay any estate tax in 2017.

51. [LO 12.7] Gift tax determination Solution: No gift taxes owed.

Sondra

Jason

$ 450,000 ½ house to Sondra’s mother

$ 450,000

450,000 ½ house to Sondra’s father

450,000

475,000 Condo to Jason’s mother

475,000

500,000 Local charity

500,000

250,000 Sondra’s sister

250,000

250,000 Jason’s brother

250,000

375,000 Best man

375,000

125,000 Church

125,000

$2,875,000 Total gifts

$2,875,000

-112,000 Less: Annual exclusions (8 x $14,000 each)

- 112,000

- 597,000 Less: Charitable deductions ($625,000 – $28,000)

- 597,000

$2,166,000 Taxable gifts for current period

$2,166,000

-0- Plus: Prior taxable gifts

200,000

$2,166,000 Total taxable gifts

Gift tax on cumulative gifts – Sondra

$2,366,000

Chapter 1: An Introduction to Taxation 203 $ 812,200 $345,800 + [($2,166,000 - $1,000,000) x 40%] - 812,200 Less: Available unified credit used 0

Gift taxes payable – Sondra Gift tax on cumulative gifts – Jason $345,800 + [($2,366,000 - $1,000,000) x 40%] Less: Available current period unified credit used

$ 892,200 892,200

Less: Credit for taxes paid on prior taxable gifts at current rates but prior unified credit Gift taxes payable – Jason

-0 0

Tuition paid directly to the university is not a taxable gift.

52. [LO 12.7] Estate Tax Determination Solution: $201,600. Taxable estate: $7,000,000 gross estate - $26,000 funeral expenses $30,000 administrative expenses - $350,000 charitable deduction - $600,000 marital deduction = $5,994,000.

Estate tax = $345,800 + [($5,994,000 - $1,000,000) x 40%] = $2,343,400 gross estate tax - $2,141,800 unified credit = $201,600 estate tax.

Develop Planning Skills 53. [LO 12.2 & 12.5] Gift Selection Solution: a. The cash can be invested in income producing assets but only $2,000 of income will be taxed to the daughter (less if she has any other unearned income) due to the imposition of the kiddie tax prior to her turning 19 years of age (24 if a full-time student). The basis of the cash is $14,000 when received.

The corporate stock has increased in value but the daughter will get the lower $6,000 basis for determining gain. The dividend income is minimal and should be tax-free due to her zero dividend tax rate as long as her other unearned income does not exceed $2,000.

The S corporation is making a significant amount of income; transferring ownership of 10 percent will transfer a maximum of $2,000 of income to the daughter (less if she has other unearned income) to be taxed at her lower marginal tax rate due to imposition of the kiddie tax prior to her turning 19 years of age (24 if a full-time student). As this is a family corporation, care must be taken to ensure that reasonable salaries are paid to family members who work in the business before the net income is determined.

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The limited partnership interest losses would be of little or no use to the daughter as they are passive losses and she must have passive income to offset it. If Ted has not been able to deduct the passive losses from the partnership in prior years, the question arises whether the transfer of this interest to his daughter would qualify as a disposal and allow him to deduct losses that have been suspended from prior years. b. In the short term, it would appear that the best asset to transfer would be either the $14,000 cash or the corporate stock. It is highly unlikely that investing the $14,000 cash or the dividends on the stock will result in any significant tax (if any) to the daughter as the income would have to exceed $1,050 to be taxed in 2017 (unless she had other unearned income). The daughter would then have cash available for use later (for example, for college expenses) or she could sell the corporate stock at capital gains rates which could be as low as 0% based on 2017 tax rates if she has little or no other income. The transfer of the S corporation stock would only allow up to $2,100 of income to be taxed at the daughter’s tax rate; however the remaining income ($5,900) would be taxed at the father’s highest marginal tax rate until she turns 19 (24 if a full-time student). The father could achieve some additional tax savings by employing his daughter in the S corporation if at all possible. If he waits until she turns 19 (24 if a full-time student) to gift this stock, he can avoid the imposition of the kiddie tax. If the father takes minimal distributions from the S corporation during this time, the stock basis will increase as income increases. Long-term planning, however, may suggest gifting the S corporation stock, even if only $2,100 is taxed at the daughter’s tax rate for several years. She would be building basis is her stock as she and her father are taxed on the income—with the father presumably paying the taxes. Later, she could take distributions from the S corporation without incurring any additional tax expense. As a family business, involving the daughter at this stage may also encourage her to continue the business and the current tax cost may be a small price to pay.

54. [LO 12.4] Estate Valuation Solution: $7,600,000. Using the alternate valuation date gives a total estate value of $7,600,000 ($2,200,000 + $4,620,000 + $780,000). The $2,200,000 date of sale valuation must be used for the stock rather than the $2,180,000 on the alternate valuation date. Because this total is $20,000 is less than the date of death valuation, estate taxes are reduced by $8,000 (40% x $20,000). This also reduces the gain on which the estate (or the beneficiary) will have to pay taxes due to the bond sale by up to $4,000 ($20,000 x 20%). Thus, using the alternate valuation date provides significant tax savings.

55. [LO 12.6 & 12.7] Trust Assets Solution: a. If an election is made to recognize the gain on the sale of the land, the $15,000 of capital gain would be allocated to corpus and would offset the $14,000 of net capital losses, leaving only a $1,000 gain taxed to the trust. The beneficiary will get a basis in the land of $55,000 rather than $40,000. b. If the election is not made, the trust recognizes no income on the distribution

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and the beneficiary gets a $40,000 basis in the land. When the beneficiary sells the land, he or she will have to recognize gain or loss based on the $40,000 basis. The capital loss in the trust cannot offset any of the resulting gain. The trust could only deduct $3,000 of capital loss in the current year against other income and the remaining portion would have to be carried forward. c. It would be to the trust and beneficiary’s advantage to elect to recognize the gain. This allows the losses to be deducted currently at a cost of a tax on only $1,000 of gain. This also provides a much higher basis to the beneficiary for the planned sale of the land.

56. [LO 12.3 & 12.7] Estate Tax and Planned Gift Giving Solution: a. $1,384,000 tax due. Gross estate = ($3,800,000 x 50%) + $4,700,000 + $1,400,000 + $900,000 + $800,000 + $1,000,000 = $10,700,000 Taxable estate: $10,700,000 - $1,900,000 marital deduction = $8,800,000 Gross tax = $ 345,800 + [40% ($8,800,000 - $1,000,000)] = $345,800 + $3,120,000 = $3,465,800 Tax due = $3,465,800 - $2,141,800 unified credit = $1,324,000 b. $1,328,000. {(12 grandchildren + 4 children) x [(1 years x $13,000) + (5 years x $14,000)]}.

Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter.

57. [LO 12.1] Estate and Gift Tax Reform Solution: One of the most plausible reasons for having kept the gift tax while eliminating the estate tax was that when property was passed during life, the giver may have been transferring the income from that property to lower income taxpayers, reducing future income taxes from that property. Thus, paying a gift tax could potentially make up for this lost revenue. For very wealthy persons, the ability to transfer income producing assets to lower taxed family members could have overridden the gift tax cost, particularly if the gifted property had appreciation potential. For others, however, the gift tax would prevent the transfers if they felt the tax too burdensome. Congress may have also retained the gift tax while repealing the estate tax to encourage people to wait until death to transfer assets possibly to ensure that assets are retained to care for themselves until death. It ended up that both the gift and estate taxes have been continued only with much higher amounts exempted from these taxes. Thus, new planning strategies will be developed to use these changes to taxpayer’s advantage.

58. [LO 12.1] Estate and Gift Tax Reform Solution: The easiest change for Congress to make in the future would be to increase the top rates or to abandon the inflation adjustments as a way of increasing the revenue from this source. The current administration appears to like the use of surtaxes, however, when income levels hit upper limits. A series of surtaxes could also be imposed when certain gift or estate levels are reached while keeping the rate schedules currently in effect. In this way the rates can be raised on the wealthier donors or the larger estates of decedent's estates without any overt increase in the

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rates applicable to most persons.

59. [LO 12.2] Loan or Gift Solution: This is a gift-loan—but the principle is not an outright gift unless it is never repaid.

There is an agreement for repayment—but there is no interest provision. Interest will be imputed on the loan. The father will have to recognize interest income; the imputed interest paid by the son will be deductible only to the extent of the income from the investment. When the father accepts the $280,000 in repayment of the loan after five years, the $20,000 ($300,000 - $280,000) that is not repaid is a gift at that time eligible for the annual and lifetime exclusions.

60. [LO 12.3] Kiddie Tax Solution: The kiddie tax as originally enacted was meant to discourage high income taxpayers from transferring income producing assets to young children who, in most cases, would not understand the issues involved in investing. Originally targeted at children under the age of 14, the age has been raised several times so that now it applies to children under the age of 19 (24 if a full-time student) and that age is quite arbitrary. By age 19, however, most young persons understand some aspects of money management and may begin to have some unearned income from investing money they themselves may have earned. The law most likely does achieve the goal of discouraging transfers of assets simply because it is so complex. One way to simplify the law would be to tax a child’s unearned income above a minimum amount at a higher tax rate without the necessity of relating that rate to the parents’ rate. This law also taxes income that a child below the target age may have earned from assets purchased with money that he or she also earned at the parents’ rate, discouraging savings by children and other young adults.

Search the Internet 61. [LO 12.4] Estates of Foreign Nationals Solution: a. A nonresident alien decedent is a decedent who is neither domiciled in nor a citizen of the United States at the time of death. For purposes of this form, a citizen of a U.S. possession is not a U.S. citizen. b. The executor must file Form 706-NA if the date of death value of the decedent’s gross estate located in the United States under the Internal Revenue Code rules defining property ―located within the U.S.‖ exceeds the filing limit. The filing limit is $60,000 reduced by the sum of (1) the gift tax specific exemption (Section 2521) allowed with respect to gifts made between 9/9/1976 and 12/31/1976, inclusive, and (2) the total taxable gifts made after December 1976 that are not included in the gross estate.

62. [LO 12.2 & 12.7] Gift Splitting Solution: Generally, a husband and wife may not file a joint gift tax return to elect split gifts.

Each spouse is responsible for filing his or her own gift tax return. If they elect gift splitting, they must file separate gift tax returns (unless one of the following

Chapter 1: An Introduction to Taxation 207

exceptions is met) but each must sign the other’s gift tax return signifying consent to the gift splitting.

Exception 1: During the calendar year, only one spouse made any gifts, the total value of these gifts to each third-party donee does not exceed $28,000, and all of the gifts were of present interests.

Exception 2: During the calendar year, only one spouse (the donor spouse) made gifts of more than $14,000 but not more than $28,000 to any third-party donee, the only gifts made by the other spouse (the consenting spouse) were gifts of not more than $14,000 to third-party donees other than those to whom the donor spouse made gifts, and all of the gifts by both spouses were of present interests.

If either of the above exceptions is met, only the donor spouse must file a return and the consenting spouse signifies consent on that return.

If they live in a community property state and the gift is of community property or if the gift is of property held jointly or as tenants by the entirety, they are required to each file a gift tax return.

Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question.

63. [LO 12.2] Gift Determination Solution: Does the gift of the auto constitute a gift subject to the gift tax or will it simply be considered as one part of her support for her son and not subject to any gift tax?

64. [LO 12.2 & 12.4] Estate Value Solution: How much of the value of the trust assets will be included in Carolyn’s estate or will the release of her right to revoke prevent inclusion?

65. [LO 12.2 & 12.4] Property Settlement of a Decedent Solution: What is the proper tax treatment for the $200,000 payment to Loren prior to Tim’s death and the $400,000 payment by the executor subsequent to his death?

66. [LO 12.2 & 12.6] Trusts Solution: What type of trust is this? Who will be taxed on its income?

67. [LO 12.4] Real Estate of Foreign Resident Solution: Are there any estate tax consequences for Jorge’s estate for the Miami Beach real estate owned at death as a noncitizen, nonresident of the Unites States?

68. [LO 12.4 & 12.7] Estate Deductions Solution: How is the $6,000 credit card bill treated for estate tax purposes? Are alternative treatments available?

69. [LO 12.6 & 12.7] Trusts Solution: How will the transfer affect the taxation of the trust income and distributions to beneficiaries? Are the tax rates to which the income from the corporate bonds is

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subject so high that the after-tax return for the beneficiaries from these will be less than the non-taxable interest from the investment in tax-exempt securities? Will the tax-exempt bonds be as marketable as the corporate bonds should a sale become necessary in the future?

70. [LO 12.4 & 12.7] Estate Income and IRD Solution: How much of the $6,000 dividend and $3,200 interest is IRD? How will the IRD be taxed on the decedent’s final income tax return and how much, if any, income will be included in the gross estate?

Develop Research Skills Solutions to research problems 71 and 72 are included in the Instructor’s Manual.