ACC 430 Chapter 16

Chapter 15

Chapter 16 - Investment and Personal Financial Planning

Chapter 16Questions and Problems for Discussion1.a.Interest on U. S. Treasury bonds is taxable income for federal purposes but tax-exempt for state purposes.

b.Interest on a State bond is tax-exempt for federal purposes but may be taxable income or tax-exempt for state purposes, depending on the taxpayers state of residence.

c.The stated interest paid on a corporate bond is taxable income for both federal and state purposes.

d.The stated interest paid on a corporate bond and the amortization of the original issue discount (OID) is taxable income for both federal and state purposes.

e.Dividends on preferred stock are taxable income for both federal and state purposes. Qualified dividend income is taxed at a preferential federal rate.

f.Ordinary dividends paid by mutual funds can consist of ordinary taxable income, qualified dividend income, and capital gain distributions. Qualified dividend income and capital gain distributions are taxed at a preferential federal rate.

2.The lapse of a term life insurance policy has no income tax consequences.

3.Mrs. SD probably should not move her savings into a tax-deferred annuity. The value of the tax deferral offered by the annuity is a function of the investors marginal rate: the higher the rate, the greater the value of the deferral. Because Mrs. SD is in the lowest tax bracket, the value of deferral may be too small to offset any implicit tax or transaction costs associated with the annuity. The value of tax deferral also depends on the length of time the investor can postpone receiving taxable income. If Mrs. SD must liquidate her annuity in just a few years to fund her move to a retirement home, the value of the brief deferral period is minimal. Moreover, she may be required to pay a monetary penalty to the annuity company for a premature liquidation (as the term is defined in the contract). This additional transaction cost would almost certainly negate the benefit of tax deferral.

4.Ms. B would recognize capital gain on the sale of GG stock even though she immediately repurchases the shares; the wash sale rule applies only to realized losses. However, she can maximize the value of her $12,000 net capital loss by deducting $3,000 this year and each of the next three years. These deductions reduce AGI and result in an annual tax savings of $1,050 ($3,000 ( 35%). At a 6 percent discount rate, NPV of this stream of savings is $3,857. In contrast, if Ms. B implements her strategy to sell GG stock, the $12,000 capital loss offsets a $12,000 capital gain that would be taxed at 15 percent three years hence. At a 6 percent discount rate, NPV of this $1,800 tax savings is only $1,512. Consequently, Ms. B should not sell any GG stock.

5.Under state law, limited partners are prohibited from active involvement in the partnership business. Consequently, they cannot materially participate in that business, and their interest in the partnership is a passive activity.

6.If Mrs. K materially participates in TKs business, she should be employed by the corporation and receiving a salary reflecting the value of her services.

7.Investors with passive activity losses should be willing to pay a premium for profitable rental real estate (as compared to other investments with the same risk and before-tax rate of return) because they can use the losses to shelter the real estate income from tax. Consequently, the market value of the real estate should increase.

8.All three limitations permit taxpayers to claim a current deduction to the extent of a certain type of income. Investment interest expense is deductible to the extent of net investment income. Capital losses are deductible to the extent of capital gains. Passive activity losses are deductible to the extent of passive activity income.

9.a.Mr. and Mrs. FBs 60 percent equity interest represents legal control of FB Inc. Because the owner of this equity can control corporate policy (including dividend payments), the value of Mr. and Mrs. FBs gift to their son is more than $6 million (i.e., the value should reflect a control premium).

b.The owner of a 10 percent minority interest can do little to influence corporate policy. Consequently, the value of the investors gift to her son is less than $1 million (i.e., the value should reflect a minority discount).

10.This strategy wastes one spouses lifetime transfer tax exclusion. Mr. and Mrs. T should each bequeath property with a value equal to the current year exclusion to their offspring and only the remainder of his or her property to the surviving spouse. This strategy eliminates any estate tax when the first spouse dies and allows each spouse to use his or her lifetime transfer tax exclusion to transfer property to younger-generation family members.

11.Mr. and Mrs. B can spend their after-tax income or save (invest) it. They can spend their wealth (accumulated income), give it away during their life, or hold it until death, at which point it will pass to another owner.

Application Problems1.a.Ms. Ss tax is $2,937 ($19,580 15% preferential rate on qualified dividend income).

b.The tax is $2,937. Ms. S is in constructive receipt of the dividend income even though it was automatically reinvested in additional BenBow shares.

2.a.Mr. Lays tax is $7,711 ($22,030 35%).

b.Mr. Lays tax is $6,813 ($6,139 [$17,540 35%] + $674 [$4,490 15% preferential rate]).

c.Mr. Lays tax is $4,689 ($2,422 [$6,920 35%] + $2,267 [$15,110 15% preferential rate]).

3.Mr. Ss basis in his 620 Carmel shares is $9,160 ($9,300 cost basis $140 return of capital).

4.a.$753 ($2,690 interest 28%).

b.$753 ($2,690 interest 28%).

c.$753 ($2,690 interest 28%).

d.$753 ($2,690 interest 28%).

e.Mrs. Nunns federal tax is -0- (municipal bond interest is tax-exempt).

5.a.$188 ($2,690 interest 7%)

b.Mrs. Nunns state tax is -0- (federal bond interest is tax-exempt).

c.$188 ($2,690 interest 7%)

6.Mrs. Zs before-tax income from the Pennsylvania bond$3,400

Virginia income tax at 6%(204)

Federal tax savings from deduction of Virginia tax

($204 35%) 71

After-tax income$3,267

$3,267 $50,000 investment = 6.534% after-tax rate of return

7.a.$74,800 before-tax cash flow - $24,684 tax cost ($74,800 interest income 33%) = $50,116 after-tax cash flow.

b.-0- before-tax cash flow - $24,684 tax cost ($74,800 interest income 33%) = ($24,684) after-tax cash flow.

c.-0- before-tax cash flow - $24,684 tax cost ($74,800 interest income 33%) = ($24,684) after-tax cash flow.

8.a.$100,000 redemption proceeds - $93,100 cost basis = $6,900 interest income.

b.$100,000 redemption proceeds - $100,000 adjusted basis ($72,900 cost + $27,100 amortized OID) = -0- interest income.

9.a.Mrs. Ulm must recognize $1,512 OID interest income in 2005 and $1,480 OID interest income in 2006. Her long-term capital gain on the sale of the bond is computed as follows.

Amount realized on sale

$84,180

Adjusted basis ($80,000 + amortized OID)(82,992)

Long-term capital gain

$1,188

b.Mrs. Ulm does not recognize the accrued market discount as income. However, when she sells the bond, she must recognize the $2,992 accrued market discount (based on the bonds yield to maturity) as ordinary income and the $1,188 remaining gain as long-term capital gain.

Amount realized on sale$84,180

Adjusted basis(80,000)

Realized gain $4,180

Ordinary income (accrued discount)(2,992)

Long-term capital gain $1,18810.a.Amount realized (4,052 shares ( $18)$72,936

Adjusted basis (cost + reinvested dividends)(58,393)

Mr. Dales recognized gain$14,543

b.Amount realized (800 shares ( $18)$14,400

Adjusted basis ($14 cost of 800 original shares)(11,200)

Mr. Dales recognized gain$3,200

c.Amount realized (800 shares ( $18)$14,400

Adjusted basis ($58,393 ( [800 shares ( 4,052 shares])(11,529)

Mr. Dales recognized gain$2,87111.a.Mrs. Cole recognizes $7,220 ($38,500 cash surrender value $31,280 investment in the policy) as ordinary income.

b.Mrs. Coles $400,000 accelerated death benefit is excludable from her taxable income.

12.Mr. F is entitled to a tax-free return of his $50,000 investment in the annuity contract. The taxable portion of each $1,300 monthly payment is computed as follows.

$50,000 investment ( $312,000 expected return = .16026 exclusion ratio

Monthly payment $1,300

Exclusion ratio.16026

Tax-free return of investment$208

Taxable annuity payment ($1,300 ( $208)$1,09213.a.Mr. Fs total annuity payments for the year$15,600

Unrecovered investment(1,875)

Taxable payments$13,725

b.Unrecovered investment at beginning of year$1,875

Tax-free recovery from January payment (208)

Unrecovered investment at date of death$1,667

The $1,092 taxable portion of the January payment is included in gross income, and the $1,667 unrecovered investment is reported as an itemized deduction on Mr. Fs final Form 1040.

14.Mr. L is treated as selling his Drago stock on the last day of the year for an amount realized of zero. Therefore, he recognizes a $14,400 long-term capital loss (unrecovered basis in the worthless stock).

15.Mrs. B can treat the nonbusiness bad debt as a $10,000 short-term capital loss. Note that the debt is not a business debt because she did not incur the debt for her business purposes. Her loan was an investment in Mr. Js business.

16.a.The exchange of common stock for common stock in the same corporation is nontaxable. Thus, CVF does not recognize its $162,000 realized gain.

b.The exchange of Jarvis common stock for U. S. bonds is taxable. Thus, CVF must recognize its $92,500 realized gain.

c. The exchange of Jarvis common stock for Newton common stock is taxable because it was not pursuant to a corporate reorganization. Thus, CVF must recognize its $55,000 realized gain.

d. The exchange of Jarvis common stock for Newton common stock is nontaxable because it was pursuant to a corporate reorganization. Thus, CVF does not recognize its $55,000 realized gain.

17.a.CVFs basis in the 1,300 shares of Jarvis voting common stock is $225,000, which is the substituted basis of the 2,000 shares surrendered in the exchange.

b.CVFs basis in its U.S. bonds is $317,500, which is the cost of the bonds.

c.CVFs basis in its 900 shares of Newton stock is $280,000, which is the cost of the stock.

d.CVFs basis in its 900 shares of Newton stock is $225,000, which is the substituted basis of the 2,000 shares of Jarvis stock surrendered in the exchange.

18.a.Mrs. Beard can deduct $3,000 of the capital loss.

b.Mrs. Beard can deduct $6,780 of the capital loss ($3,780 capital gain + $3,000).

c.Mrs. Beard can deduct the entire $12,290 capital loss against her $15,610 capital gain.

19.a.Mr. Alms AGI is $58,850 ($61,850 salary - $3,000 net capital loss).

b.Mr. Alms AGI is $68,500 ($61,850 salary + $6,650 net capital gain ($12,250 capital gain - $5,600 capital loss).

c.Mr. Alms AGI is $60,350 ($61,850 salary - $1,500 net capital loss ($8,000 capital gain distribution - $5,600 capital loss - $3,900 capital loss carryforward).

20.a.Mr. and Mrs. Revel recognized a $6,100 net long-term capital loss of which they can deduct $3,000 against other sources of income. Therefore, their AGI is $203,200.

b.Mr. and Mrs. Revel recognized a $380 net long-term capital gain. Their AGI is $206,580.

c.Mr. and Mrs. Revel recognized a $9,800 net capital loss of which they can deduct $3,000 against other sources of income. Their AGI is $203,200.

d.Mr. and Mrs. Revel recognized a $4,100 net short-term capital loss of which they can deduct $3,000 against other sources of income. Their AGI is $203,200.

21.a.Mr. and Mrs. Revel have a $3,100 long-term capital loss carryforward.

b.No carryforward.

c.Mr. and Mrs. Revel have an $1,800 short-term capital loss carryforward and a $5,000 long-term capital loss carryforward.

d.Mr. and Mrs. Revel have a $1,100 short-term capital loss carryforward.

22.Ordinary taxable income$421,000

Capital transactions:

Net short-term capital gain14,300

Long-term capital gain$64,000

Long-term capital loss(12,900)

Net long-term capital gain

51,100

Taxable income$486,400

Tax on $435,300 ordinary income (single)$131,429

Tax on $51,100 long-term capital gain at 15%7,665

Mr. Js tax$139,09423.a.$4,395 ($29,300 long-term capital gain 15%)

b.$5,695 ($2,895 [$19,300 LTCG 15%] + $2,800 [$10,000 collectibles gain 28%])

c.$5,945 ($2,070 [$13,800 LTCG 15%] + $3,875 [$15,500 unrecaptured Section 1250 gain 25%])

d.$6,816 ($840 [$5,600 LTCG 15%] + $476 [$1,700 collectibles gain 28%] + $5,500 [$22,000 unrecaptured Section 1250 gain 25%])

24.Amount realized $685,000

Adjusted basis (544,700)

Gain realized $140,300

Tax on unrecaptured Section 1250 gain

($51,900 25%) $12,975

Tax on Section 1231 gain treated as LTCG

($88,400 15%) 13,260

Tax on gain realized$26,23525.a.Ordinary taxable income$191,000


Long-term capital gain on Seta stock sale$67,400

Excluded gain (50 percent)(33,700)

Gain on qualified small business stock sale33,700

Other long-term capital gain 8,600


Tax on $191,000 ordinary income (HH) $45,985

Tax on $33,700 capital gain at 28%9,436

Tax on $8,600 capital gain at 15% 1,290

Ms. EJs tax$56,711

b.In this case, Ms. EJ did not hold the Seta stock for more than five years, and her long-term capital gain on sale is not eligible for the 50 percent exclusion.

Ordinary taxable income$191,000


Long-term capital gain on Seta stock sale$67,400

Other long-term capital gain 8,600

76,000


Tax on $191,000 ordinary income (HH)$45,985

Tax on $76,000 capital gain at 15%11,400

Ms. EJs tax$57,38526.Mr. EF recognized the following losses on sale of his LLG stock.

Sale of Section 1244 stock issued to Mr. EF:

Amount realized (500 shares ( $16)$8,000

Adjusted basis (cost)(45,000)

Ordinary loss$(37,000)

Sale of stock purchased by Mr. EF:

Amount realized (1,000 shares ( $16)$16,000

Adjusted basis (cost)(40,000)

Capital loss$(24,000)

a.Salary $80,000

Ordinary loss on LLP stock sale(37,000)

Limited net capital loss deduction (3,000)

Mr. EFs AGI$40,000

b.Salary $80,000

Ordinary loss on LLP stock sale(37,000)

Capital gain on sale of marketable securities$20,000

Capital loss on LLP stock sale(24,000)

Net capital loss(4,000)

Limited net capital loss deduction (3,000)

Mr. EFs AGI$40,00027.a.Ms. Reids deduction for her $3,900 investment interest expense is limited to $1,100. (If Mrs. Reid treats her $1,100 qualified dividend income as investment income, the dividend will not be taxed at the 15% preferential rate.)

b.Ms. Reids deduction for her $3,900 investment interest expense is limited to $690.

c.Ms. Reid can deduct her entire $3,900 investment interest expense.

28.a.If Mr. and Mrs. MS do not elect to treat any long-term capital gain as investment income, their tax is $10,103.

Salaries$84,000

Interest income (investment income)*963

Short-term capital gain (investment income)*600

Long-term capital gain 7,200

AGI$92,763

Itemized deductions:Investment interest*$1,563

Other12,500

(14,063)

Exemption amount ($3,400 ( 2) (6,800)

Taxable income

$71,900

Tax on $64,700 ordinary income (MFJ)$9,023

Tax on $7,200 long-term capital gain at 15%1,080

Mr. and Mrs. MSs tax$10,103

b.If Mr. and Mrs. Poe elect to treat $2,837 of their long-term capital gain as investment income, their tax is $9,677.

Salaries$84,000

Interest income (investment income)*963

Short-term capital gain (investment income)*600

Long-term capital gain ($2,837 investment income)* 7,200

AGI$92,763

Itemized deductions:Investment interest*$4,400

Other12,500

(16,900)

Exemption amount ($3,400 ( 2) (6,800)

Taxable income

$69,063

Tax on $64,700 ordinary income (MFJ)$9,023

Tax on $4,363 long-term capital gain at 15%654

Mr. and Mrs. MSs tax$9,677

Mr. and Mrs. Poe minimize their current year tax by electing to treat $2,837 of their long-term capital gain as investment income. However, a comparison of current year tax liabilities ignores the present value of any future tax savings generated by the carryforward of nondeductible investment interest expense that results if Mr. and Mrs. Poe do not make the election.

29.a.Mr. Ds tax savings from the loss was $5,250 ($15,000 short-term capital gain offset by $15,000 capital loss ( 35%).

b.Mr. Ds tax savings from the loss was $2,250 ($15,000 long-term capital gain offset by $15,000 capital loss ( 15%).

c.Mr. Ds tax savings from the loss was $4,200 ($15,000 28 percent rate gain offset by $15,000 capital loss ( 28%).

d.Mr. Ds NPV of the tax savings from the loss was $4,773.

Tax savings in 2007 ($3,000 deduction ( 35%)$1,050

Present value of annual tax savings in 2008-2011

($1,050 ( 3.546 discount factor at 5%)3,723

NPV$4,77330.Grocery store net profit$44,000

Adjustment for one-half of SE tax(3,109)

Dividends and interest income1,080

Passive activities:Rental loss deductible up to $25,000)(6,470)

LP interest (nondeductible loss) -0-

Mr. and Mrs. Morriss AGI$35,50131.a.Salary$62,300

Business income from VP19,000

Passive activities:BL (nondeductible loss) -0-

Mr. Kellys AGI$81,300

b.Salary$62,300

Business loss from BL.(25,000)

Passive activities:VP19,000


c.Salary$62,300

Business income from VP 19,000

Business loss from BL.(25,000)


d.Salary$62,300

Passive activities:VP income$19,000

BL deductible loss(19,000)

-0-

Mr. Kellys AGI

$62,30032.a.Salary

$59,000

Interest and dividends 4,400

AGI before real estate rental loss$63,400

Real estate rental loss (deductible up to $25,000)(25,000)

Ms. TNs AGI

$38,400

b.Salary

$113,400


AGI before real estate rental loss$117,800

Real estate rental loss (deductible up to

$25,000 ( [50% $17,800 excess AGI]) (16,100)

Ms. TNs AGI

$101,700c.Salary

$168,250


Ms. TNs AGI

$172,65033.Net profit from sole proprietorship$75,000

Adjustment for one-half of SE tax(5,299)

Interest and dividends

1,500

Passive activities:Rent house$9,500

ABCD (deductible loss)(9,500)

-0-

Ms. Adamss AGI

$71,201

Because Ms. Adamss tax for the year is the same with or without the $9,500 rent income, the tax cost of the rent income is zero.

34.Salary

$85,000


Gain on sale of partnership interest$14,000

Loss on securities sale(12,000)

Net capital gain

2,000

Passive activities:Partnership income$2,100

S corporation loss*(13,900)

(11,800)

Mr. Ds AGI

$75,200Mr. D can deduct the entire S corporation loss because he has $16,100 passive activity income from other sources. The $14,000 gain on sale of the partnership interest is characterized as both capital gain and passive activity income, a dual characterization that allows Mr. D to deduct both his capital loss on the securities sale and his passive activity loss.

35.a.Mr. Zeplin can transfer $276,000 ($12,000 23 donees) without making a taxable gift.

b.Mr. and Mrs. Zeplin can transfer $552,000 ($24,000 23 donees) without making a taxable gift.

36.a.Because the $738,000 taxable gift ($750,000 FMV - $12,000 annual exclusion) is less than Mr. Itos $1 million lifetime exclusion, no amount is subject to gift tax.

b.The $438,000 excess of the $1,438,000 taxable gift ($1,450,000 FMV - $12,000 annual exclusion) over Mr. Itos $1 million lifetime exclusion is subject to gift tax.

c.The $207,500 excess of the $620,500 taxable gift ($632,500 FMV - $12,000 annual exclusion) over Mr. Itos $413,000 remaining lifetime exclusion ($1 million - $587,000 previous taxable gift) is subject to gift tax.

37.Callies investment income $5,831

Base amount (1,700)

Excess investment income $4,131

Tax rate (parents marginal rate) .28

Tax $1,157

Callies remaining taxable income $1,700

Standard deduction (850)

Taxable income

$850

Tax rate (single)

.10

Tax

$85

Callies total tax ($1,157 + $85) $1,24238.Gross estate

$10,000,000

Debts of the decedent

(789,000)

Funeral and administrative expenses(95,600)

Deductible bequests:First Lutheran Church$500,000

Western Wisconsin College1,000,000

Mrs. JS2,400,000

(3,900,000)

Mr. JSs taxable estate$5,215,40039.a.Mrs. WPs amount realized on sale$200,000

Basis

(138,000)

Gain recognized

$62,000

Mrs. WPs tax rate on capital gain .15

$9,300

Sale proceeds

$200,000

Tax cost

(9,300)

Mrs. WPs after-tax sale proceeds$190,700

b.Grandchildrens amount realized on sale$200,000

Basis (carryover from Mrs. WP)(138,000)

Gain recognized (one-fourth by each seller)$62,000

Grandchildrens tax rate on capital gain .05

$3,100

Sale proceeds

$200,000

Tax cost

(3,100)

Grandchildrens after-tax sale proceeds$196,900

c.Daughters amount realized on sale$200,000

Basis (FMV at date of death)(200,000)

Gain recognized

-0-

Sale proceeds

$200,000

Tax cost

-0-

Daughters after-tax sale proceeds$200,000

Issue Recognition Problems1.Is the election by a cash basis individual to accrue interest income on U.S. savings bonds an annual election, or is it a permanent election that must apply in all future taxable years?

2.Is Ms. As receipt of 1,450 additional SBS shares a taxable event? Is a stock dividend taxable to the recipient? If the stock dividend is taxable, what is the dollar amount of the dividend? What is Ms. As basis in her new 1,450 shares of SBS stock?

3.Must Mr. L characterize his entire $24,000 loss realized on the worthless bond as capital loss? Can Mr. L characterize $6,000 of his worthless security loss as ordinary because it represents accrued ordinary interest income?

4.Can Mr. and Mrs. G amortize the $3,000 premium as deductible interest expense over the life of the bond? If Mr. and Mrs. G hold the bond to maturity, will they recognize a $3,000 capital loss or ordinary loss when they redeem the bond for $50,000?

5.Can Mrs. B claim a $12,000 ordinary abandonment loss because she surrendered her shares back to NN Corporation when the shares still had some minimal value?

6.Can Ms. X report a $3,500 nonbusiness bad debt as a capital loss on her tax return? Was the substance of the original transaction between Ms. X and her daughter a loan or a gift? Did Ms. X intend that her daughter repay the loan?

7.Does Mr. O have a $10,000 business bad debt (fully deductible) or a $10,000 nonbusiness bad debt (capital loss)? Did Mr. O make the loan to MNOP as part of his business or as an investment?

8.What happens to an individuals loss carryforwards when that individual dies? Are any of Ms. Ts loss carryforwards deductible on her final Form 1040? Can another taxpayer inherit Ms. Ts loss carryforwards, or do the carryforwards die with her?

9.When an individual sells an interest in a passive activity to a related party, can the individual deduct any suspended losses from the activity?

10.Does the abandonment of an interest in a passive activity qualify as a disposition that triggers a deduction for any suspended losses from the activity?

11.Does the transfer of Mr. OGs property into trust qualify for a marital deduction for federal estate tax purposes? Does Mrs. OGs income interest in the trust qualify for a marital deduction?

12.Is the $140,000 value of the IRA included in Mr. Ds taxable estate? When Mr. Ds son withdraws funds from the IRA inherited from his father, must the son recognize the withdrawals as taxable income? Is the sons tax basis in the inherited IRA stepped up to $140,000 (FMV at date of death) so that a withdrawal of the $140,000 fund balance is a tax-free return of basis to the son?

13.What is Mr. ASs tax basis in the real property after to his wifes death? Is the basis in one-half of the property or the basis in the entire property stepped up to FMV on the death of a co-owner?

Research Problems

1.This problem is based on the facts in Dorothy Dye v. United States, 121 F. 3d 1399 (CA-10, 1997). The IRS argued that Ms. Dye must claim the legal fees incurred in her suit against her stockbroker as miscellaneous itemized deductions (subject to the 2 percent AGI floor). The Tenth Circuit Court of Appeals applied the origin of claim doctrine to conclude that the portion of the legal fees relating to Mrs. Dyes procurement of capital gain income should be treated as a capital loss rather than an ordinary deduction. Based on this decision, Mrs. Baker can net her legal fees against the capital gain from her settlement.

2.The sequence of events suggests that Todd Zimler believed that he could convert $100,000 of the $125,000 unrealized capital loss on the investment land to ordinary loss. However, Section 1244(d)(1) prevents such a conversion. This paragraph applies if an individual made a tax-free exchange of property for Section 1244 stock, and the basis of the property exceeded its FMV. When the individual sells the stock, any Section 1244 ordinary loss must be reduced by such excess. Without this anti-conversion rule, Todds sale of his Section 1244 stock would result in a $100,000 Section 1244 loss and a $23,000 capital loss. However, because the basis of the investment land that Todd exchanged for the stock was $125,000 more than the lands FMV, Todds Section 1244 loss is reduced to zero, and he recognizes a $123,000 capital loss.

3.According to Section 469(h)(2), Rachels limited interest in HN Partnership is a passive activity (i.e. a business activity in which Rachel does not materially participate). Consequently, her $3,810 loss is deductible in 2007 only to the extent that she has passive activity income for the year. The classification of Rachels interest in Jams-n-Jellies LLC as either active or passive depends on whether her 592 hours of work represents material participation in the LLCs business. According to Reg. Sec. 1.469-5T(a)(1), an individual materially participates in an activity if the individual participates for more than 500 hours during the year. Based on this 500-hour rule, Rachel materially participated in the LLCs business for 2007, and her share of ordinary business income is active rather than passive. Her consulting income from the LLC and her salary as a librarian are not passive activity income according to Section 469(e)(3). Therefore, Rachel has no passive activity income for 2007 and cannot deduct any of her partnership loss.

Tax Planning Cases1.Ms. K should sell the 800 shares acquired on December 3, 2001, and 200 of the shares acquired on July 12, 1997. She held both blocks for more than 12 months; consequently, her recognized gain will be long-term capital gain taxed at 15 percent. The shares purchased in 2001 have a higher per share basis than those purchased in 1997, and their sale will generate less gain. Ms. K should not sell any qualified small business stock (the shares acquired on September 30, 2004) until after September 30, 2009. If she sells the stock before this date, she is not eligible for the 50 percent exclusion. If Ms. K sells the stock acquired on October 2, 2007, she would recognize short-term capital gain taxed at 35 percent.

2.If Ms. EH cashes in the policy, her after-tax cash flow would be $82,750.

Cash surrender value$95,000

Investment in policy(46,000)

Ordinary gain recognized on surrender$49,000

Tax rate .25

Tax$12,250

Cash proceeds on surrender$95,000

Tax cost(12,250)

After-tax cash flow$82,750

If she borrows against the policy and repays the debt from the death benefit, the NPV of her after-tax cash flows would be $93,553.

Loan proceeds in year 0$70,000

Present value of interest payments in years 1 through 9

($3,500 ( 6.802 discount factor at 6%)(23,807)

Present value of year 9 death benefit less repayment

($80,000 ( .592 discount factor at 6%)47,360

NPV

$93,553

Thus, Ms. EH should borrow against the policy to maximize NPV of cash flows.

3.a.If Mr. and Mrs. KQ can deduct the annual interest and tax payments required to carry the land for five years, the NPV of the cash flows is positive and they should make the investment.

InvestmentInterest andTax SavingsNet Cash

Yearin LandTaxesfrom DeductionFlowPresent Value

0$(40,000)

$(40,000)$(40,000)

1

$(6,000)$2,100(3,900)(3,576)

2

(6,000)2,100(3,900)(3,284)

3

(6,000)2,100(3,900)(3,011)

4

(6,000)2,100(3,900)(2,761)

5

(6,000)2,100(3,900) (2,535)

$(55,167)

Sales proceeds net of debt repayment$100,000

Tax cost of sale:

Amount realized$160,000

Basis in land

(100,000)

Gain recognized $60,000

Tax rate

.15

Tax

(9,000)

After-tax cash from sale$91,000

Present value ($91,000 ( .650 discount factor)

59,150

NPV

$3,983

b.If Mr. and Mrs. B cannot deduct the interest and tax payments and elect to capitalize them, the NPV of cash flows is negative and they should not make the investment.

InvestmentInterest andTax SavingsNet Cash

Yearin LandTaxesfrom DeductionFlowPresent Value

0$(40,000)

$(40,000)$(40,000)

1

(6,000)-0-(6,000)(5,502)

2

(6,000)-0-(6,000)(5,052)

3

(6,000)-0-(6,000)(4,632)

4

(6,000)-0-(6,000)(4,248)

5

(6,000)-0-(6,000)(3,900)

$(63,334)

Sales proceeds net of debt repayment$100,000

Tax cost of sale:

Amount realized$160,000

Basis in land(130,000)

Gain recognized $30,000

Tax rate

.15

Tax

(4,500)

After-tax cash from sale$95,500

Present value ($95,500 ( .650 discount factor)62,075

NPV

$(1,259)

4.Mr. and Mrs. U will pay AMT in the years in which Mr. U exercises his incentive stock options, and their total tax (regular tax and AMT) will be $85,736.


AMT adjustments and preferences 75,000

AMTI$335,000

Exemption ($62,550 $46,250) (16,300)

Taxable AMTI$318,700

Tentative minimum tax:

$175,000 ( 26%$45,500

$143,700 ( 28%40,236

$85,736

Regular tax on $260,000 (MFJ)(65,000)

AMT$20,736

If they purchase the corporate bond and earn an additional $5,000 taxable income, their total tax will be $87,486.



AMTI$340,000

Exemption ($62,550 $47,500) (15,050)



$175,000 ( 26%$45,500

$149,950 ( 28%41,986

$87,486


AMT$20,836

Therefore, the incremental tax cost of the additional income is $1,750 ($87,486 ( $85,736), and the annual after-tax cash flow from the investment is $3,250 ($5,000 ( $1,750).

If they purchase the private activity bond, the additional $3,750 income is not subject to regular tax but is a preference item that increases AMTI to $338,750. Their total tax will be $87,049.



AMTI$338,750

Exemption ($62,550 $47,188) (15,362)



$175,000 ( 26%$45,500

$152,938 ( 28%41,549

$87,049


AMT$22,049

The incremental tax cost of the additional income is $1,313 ($87,049 ( $85,736), and the annual after-tax cash flow from the investment is $2,437 ($3,750 ( $1,313). Therefore, the corporate bond is the superior investment for Mr. and Mrs. U.

5.a.The NPV of cash flows from Investment A is $15,028.

Annual before-tax cash flow$7,200

Tax cost ($7,200 taxable income ( 25%)(1,800)

$5,400

After-tax cash flow in years 0-2:

$5,400 ( 2.783 discount factor$15,028

Because Ms. ZH has no passive activity income, she cannot deduct the $50,000 of year 0 and 1 losses from Investment P until year 2, when the investment generates $73,000 passive activity income. Consequently, the NPV of cash flows from Investment P is only $14,783.

Taxable Income/(Tax Cost)/Net CashPresent

YearCash flow(Deductible Loss) Tax SavingsFlowValue

0-0--0--0--0--0-

1-0--0--0--0--0-

2$23,000$23,000(5,750)$17,250$14,783

Therefore, Investment A is the superior investment.

b.The NPV of cash flows from Investment A is $13,024.

Annual before-tax cash flow$7,200

Tax cost ($7,000 taxable income ( 35%)(2,520)

$4,680

After-tax cash flow in years 0-2:

$4,680 ( 2.783 discount factor$13,024

Because Ms. ZH has $40,000 passive activity income in years 0 and 1, she can deduct the losses generated by Investment P. Consequently, NPV of cash flows from Investment P is $14,668.

Taxable Income/(Tax Cost)/Net CashPresent

YearCash flow(Deductible Loss) Tax SavingsFlowValue

0-0-$(25,000)$8,750$8,750$8,750

1-0-(25,000)8,7508,7508,103

2$23,00073,000(25,550)(2,550)(2,185)

NPV

$14,668

Therefore, Investment P is the superior investment.

6.a.If Ms. BB invests in the TNB Limited Partnership, her $8,000 partnership income would be passive activity income. Therefore, she could deduct her $5,700 suspended passive activity loss in 2008. Her net taxable income would be $2,300, her tax cost at 25% would be $575, and her after-tax income would be $7,425 ($8,000 partnership income $575 tax cost), which represents a 7.425% return on her $100,000 investment.

If Ms. BB invests in the bond fund, her $10,000 interest income would be portfolio income. Because she has no passive activity income, she could not deduct her suspended passive activity loss in 2008. Her net taxable income would be $10,000, her tax cost at 25% preferential rate would be $2,500, and her after-tax income would be $7,500 ($10,000 interest $2,500 tax cost), which represents a 7.5% return on her annual investment. Thus, the mutual fund is the better investment.

b.If Ms. BB invests in the TNB Limited Partnership, her $8,000 partnership income would be passive activity income. Therefore, she could deduct her $5,700 suspended passive activity loss in 2008. Her net taxable income would be $2,300, her tax cost at 35% would be $805, and her after-tax income would be $7,195 ($8,000 partnership income $805 tax cost), which represents a 7.195% return on her $100,000 investment.

If Ms. BB invests in the bond fund, her $10,000 interest income would be portfolio income. Because she has no passive activity income, she could not deduct her suspended passive activity loss in 2008. Her net taxable income would be $10,000, her tax cost at 35% preferential rate would be $3,500, and her after-tax income would be $6,500 ($10,000 interest $3,500 tax cost), which represents a 6.5% return on her annual investment. Thus, the partnership interest is the better investment.

16-2

ACC 430 Chapter 16

Documents

Transcript of ACC 430 Chapter 16