Solutions

CHAPTER 4 Gross Income: Concepts and Inclusions 4-5

DISCUSSION QUESTIONS

1. The Supreme Court has recognized the different objectives for measuring financialaccounting income and taxable income. The conservatism principle is biased towards theunderstatement of income. This bias is appropriate when issuing financial statementsbecause it protects investors and other interested parties (e.g., creditors andmanagement). However, a bias towards a low measure of income is not consistent withthe goal of the income tax system; that is, the equitable collection of revenue. p. 4-5

2. a. According to the economic concept of income, the taxpayer’s income in thecurrent year is $1,000 (the value at the time of the sale of $8,000 less the value atthe beginning of the year of $7,000). Gross income for tax purposes is thedifference between the selling price of $8,000 and the taxpayer’s cost of $5,000 =$3,000.

b. Economic income is $8,000, the increase in value during the current year. Grossincome for tax purposes is $0 because no income was realized; that is, thetaxpayer was providing services to his property.

c. Under both economic income and gross income for tax purposes, theshareholder’s income is $5,000. The gross income would be treated as a dividendto the shareholder.

d. Economic income and gross income for tax purposes both are $25,000.

pp. 4-3 to 4-5

3. Charley received something of value from the casino. Under the broad concept ofincome, the airfare and hotel accommodations would be considered income. However,Charley could argue that the income should be matched with his $15,000 in gamblinglosses on the trip, and when the income and losses are combined, the net effect is aneconomic loss. As will be discussed later in the text, the net loss is not deductible, but atleast the gambling losses can be used to offset the income from his gambling activities.pp. 4-3 to 4-5

4. The tax laws encourage do-it-yourself activities. If Tom paints his house, the $90 hesaved is not included in gross income. He foregoes only $72 [(1-.28)($100)] in after-taxincome from not working and earnings $100. This reasoning assumes that Tom can paintas fast as and as well as someone he would hire (i.e., the time consumed and the qualityare the same). pp. 4-3 and 4-4

5. Because Cecil does not know how much he will receive from the sale of automobileparts, and it is impractical to determine the cost of individual automobile parts, he couldreason that all sales proceeds are a recovery of capital until he has received his cost of$250, and all subsequent proceeds are included in gross income. The IRS may argue thatCecil should allocate his cost of the car among the various parts, which may beimpractical. p. 4-6

6. The employer is required to include the $3,000 in gross income in 2005, when theemployer’s agent receives the payment from the customer. pp. 4-7 to 4-10 and 4-16

7. a. The income should be reported in 2006. In 2005, Jared has not received anythingof value.

4-6 2006 Comprehensive Volume/Solutions

b. The significance of when the income is recognized by Jared relates to (1) the timevalue of money—if the tax is deferred, the present value of the tax decreases; and(2) the marginal tax rates—the taxpayer may be subject to different rates betweenyears because of changes in the tax law, changes in his or her taxable income,changes in the taxpayer’s filing status, and changes in the entity status.

pp. 4-7 to 4-9

8. a. The issue is when does Albert recognize gross income from the dinosaur bones:when he discovers the bones, or when he sells the property. The situation isanalogous to an owner discovering oil on his or her property. In 2005, Albert didnot receive anything he did not already own. Therefore, no income is realizeduntil the bones are sold in 2006. This treatment is consistent with thewherewithal to pay doctrine.

b. Albert probably will not be allowed to allocate any basis in the land to the bones.Therefore, his gross income from the sale of the bones in 2006 is $26,000.

pp. 4-2 to 4-5

9. a. Allyson must report income under the original issue discount (OID) rules in eachof the four years, 2005, 2006, 2007, and 2008.

b. Clearly, the original issue discount rules were not enacted to relieve thetaxpayer’s compliance burden as no such burden existed. In fact, the OID rulesadd significant complexity to a relatively simple fact pattern. Without the OIDrules, the income would all be reported in one year (i.e., when the investmentmatures), and the problems of allocating the income among the four years wouldbe obviated. Apparently then, equitable considerations probably were themotivation for the OID rules. Without the OID rules, cash basis taxpayers couldeasily defer their tax obligations by selecting investments issued at a discount.Accelerated and timely revenue recognition also likely was a contributory factor.

pp. 4-10 to 4-12

10. The bank certificate of deposit is subject to the original issue discount (OID) rules.Therefore, the taxpayer will recognize accrued interest income for each year until thecertificate matures. The Series EE governmental savings bonds are exempt from the OIDrules. Therefore, no interest will be included in gross income until the EE bonds’maturity date. p. 4-11

11. a. Coal sold the goods in 2005 and should report the gross income of $100 ($500 –$400) in that year.

b. The refund is accounted for in 2006. Coal will take a deduction of $100 andincrease inventory by $400.

p. 4-12

12. If Rex sells the car, he must pay the tax on the gain of $3,800 ($9,000 – $5,200). If Rexgives the automobile to his daughter and she sells it, she will be taxed on the gain of$3,800. Thus, the increase in value that is economically attributable to Rex will becomehis daughter’s income. If Rex is in a higher marginal tax bracket (probably the case), the

Gross Income: Concepts and Inclusions 4-7

family unit will generate tax savings by Rex’s daughter selling the car. Thus, gifts ofappreciated property can be a useful tax planning concept. pp. 4-15 and 4-16

13. The recipient of alimony payments reports income and the payer qualifies for adeduction. By allowing a $50,000 deduction to Sarah and requiring Fred to include the$50,000 in his gross income, the fruit (service income) is shifted away from the tree(Sarah as the provider of the service). pp. 4-14 and 4-15

14. The S corporation shareholders and the partners pay the tax on the income earned by theS corporation and the partnership, regardless of whether the income is actuallydistributed to the owners. pp. 4-17 and 4-18

15. A joint return cannot be filed by Mike and Debbie, unless Debbie can be located and sheconsents to filing a joint return. Mike cannot qualify as an abandoned spouse because hehas no dependent children. On separate income tax returns for 2005, Mike and Debbieeach must include one-half of the community’s income. This results because they livetogether for part of the year. Thus, Mike must include in his gross income his share ofDebbie’s earnings for the year, including a share of Debbie’s post-separation earnings.pp. 4-18 to 4-20

16. One purpose of the alimony rules is to distinguish a nondeductible property division frompayments for support as alimony (which are deductible by the payor). Large cashpayments in the early years are tantamount to a property division, or even a purchase of aproperty interest, as distinguished from payments for support of the former spouse. Tothe extent of alimony recapture, what has been classified as alimony is reclassified as aproperty settlement. pp. 4-20 to 4-22

17. Considering only taxes, Jean should accept the securities. The high basis in the stockwill provide Jean with a tax benefit. She will have a carryover basis of $115,000 in thesecurities. If she sells the securities for $100,000, she will recognize a $15,000 loss. Shewill be allowed to offset this loss against other capital gains. If she has no capital gains,she can offset $3,000 of the loss against ordinary income each year, as discussed inChapter 3. Thus, the loss would offset other income on Jean’s income tax return.pp. 4-20 and 4-21

18. The following issues are suggested from the facts presented:

• Will gains and losses from the sale of property pursuant to the divorce be subject totax?

• Are the child care payments deductible?

• Would payments with respect to William’s contribution toward her education betaxable to her?

• What is their filing status until the divorce has been completed?

• Should the payments be arranged so that they are deductible by William and taxableto Abigail? If the payments are taxable to her, what additional amounts should sherequest in exchange for agreeing to terms that are tax favorable to William?

• Is the daycare that is being provided by the grandparents taxable to either William orAbigail?


• Who will be able to claim April as a dependent?

pp. 4-19 to 4-22

19. Mary should consider the following tax considerations. The receipt of the $12,000 eachyear for ten years would be taxable to her as alimony, provided the payments cease uponher death within the 10-year period. Otherwise, the $12,000 payments are not alimony.The receipt of the common stock would be a property settlement rather than beingalimony. However, to evaluate this option, she needs to know Bob’s basis in the stockbecause his basis will become her basis. Thus, if she decided to sell the stock, she couldhave a taxable gain or loss. The installment payments have significant nontax issuessuch as the risk that Bob will be unable to make the payments. In addition, Mary shouldcompare the present value of the installment payments (on an after-tax basis) with thevalue ($100,000) of the stock. For example, assuming a 15% marginal tax rate, the after-tax amount received each year is $10,200, and with an after-tax rate of return of 6%, thepresent value of future payments is only $80,200. pp. 4-20 to 4-23

20. Income is imputed to the lender so as to prevent the lender from shifting income to theborrower who may be taxed at a lower tax rate. The rules presume that the lender wouldhave earned some income from the funds in the absence of making the loan to therelative. By not requiring the relative to pay any interest, the lender has effectively madea gift back to the relative for the amount of interest not charged. pp. 4-23 to 4-27

21. The corporation will have imputed interest income and an offsetting amount forcompensation expense. In addition, the corporation may have additional Social Securityand Medicare tax and withholding obligations on the additional compensation. If,however, the employee is also a shareholder, the IRS may determine that the loan isinstead a corporation-shareholder loan. This would still result in an increase in thecorporation’s gross income in the form of imputed interest income. However, thecorporation would not be able to deduct the related deemed dividend paid (as opposed tocompensation expense being deductible). pp. 4-23 to 4-27 and Concept Summary 4-2

22. The following issues are suggested from the facts presented:

• Is the corporation required to impute interest income on the loan to Brad?

• Is Brad required to recognize income from the loan proceeds?

• Is Brad required to recognize income in respect to the favorable interest rate?

• Is the loan made to Brad in his capacity as a shareholder or as an employee?

• Is the loan subject to the original issue discount rules?

pp. 4-11 and 4-22 to 4-27

23. Betty’s life expectancy used in calculating the annuity exclusion percentage was 10.6years. Therefore, all of the payments received after the end of 10.6 years must beincluded in Betty’s gross income since she has recovered her investment of $75,600. Soin the twelfth year, all of the $8,900 received must be included in Betty’s gross income.pp. 4-28 to 4-30

24. Under the broad concept of gross income contained in the Code, premiums on group termlife insurance purchased by employers for employees would be included in the


employee’s gross income. Therefore, § 79 creates an exclusion of premiums on up to$50,000 of insurance coverage for employees. pp. 4-32 and 4-33

25. The additional income will be, in effect, taxed at a 31.5% rate. That is, each dollar ofadditional income from other sources will increase the taxable portion of Social Securitybenefits by 50%. Thus, for each additional dollar of income, the marginal tax rate is31.5% [1.5 X (15% + 6%)]. Her after-tax earnings on the $3,000 would be $2,055[1-.315) X $3,000]. pp. 4-33 and 4-34

PROBLEMS

26. a. The taxpayer has a $1,000 economic gain on the sale because the taxpayer’seconomic income would be the selling price less the value of the asset as of thebeginning of the year. Gross income for tax purposes is $4,000 ($10,000 –$6,000).

b. The $15,000 is economic income and gross income for tax purposes.

c. The use of the automobile does not result in economic income because thetaxpayer owns the corporation and thus owns the automobile. For tax purposes,the taxpayer is deemed to have received an $800 dividend from the corporation.

d. The taxpayer has economic income of $800 from the production in her garden.However, for tax purposes no income is realized. The realization requirement isnot satisfied because the vegetables are consumed by her and her neighbors,rather than sold to others.

e. The increase in value of $10,000 is economic income but is not gross income fortax purposes because the realization requirement has not been satisfied.

f. The taxpayer realized $1,000 economic income and gross income from dischargeof the indebtedness.

pp. 4-3 to 4-5

27. Amos should use the cash method of accounting so that the income from services billedto the insurance company can be deferred until the income is collected. Under the cashmethod, the amounts billed to the insurance companies will be continuously deferreduntil the year following his final year of practice. That is, with the cash method ofaccounting as compared to the accrual method, Amos will enjoy a deferral of two monthsof billings to insurance companies. Amos’s marginal tax rate may be lower in the firstyear of practice than in subsequent years. Thus, accelerating income through the use ofthe accrual method would have some benefit. But the benefit of the lower rates probablywould not equal the benefit of deferral. pp. 4-7 to 4-9

28. Alternative (a) is superior to alternative (b) or alternative (c). Alternative (a) yields thegreater after-tax value.

Alternative a: Land.Value in 5 years, $10,000 X 1.34 $13,400Less tax .15($13,400 – $10,000) (510)After-tax value $12,890


Alternative b: Bond.Principal $10,000Annual interest (after tax) [(1 – .35)($600)] $390Reinvested for 5 years, at 3.90%, after-tax

annuity factor X 5.39 2,102After-tax value $12,102

Alternative c: Stock.Principal $10,000Annual dividend (after tax) [(1 – .15)($500)] $425Reinvested for 5 years, at 4.25%, after-tax

annuity factor X 5.44 2,312After-tax value $12,312

Speech for Tax Class

Assume a taxpayer has the following alternative investment opportunities:

• Investment in land for $10,000 that will increase in value by 6% each year.

• Investment in a taxable bond for $10,000 yielding 6% before tax, and the interest canbe reinvested at 6% before tax.

• Investment in stock for $10,000 yielding 5% before tax, and the dividends can bereinvested at 5% before tax.

The taxpayer is in the 35% tax bracket for ordinary income and 15% for qualifyingcapital gains and qualified dividends in all years and the investment will be liquidated atthe end of five years.

The purpose of my presentation is to demonstrate that taxes do affect investmentdecisions. If neither investment were subject to taxation, the land and bond alternativeinvestments would yield identical earnings (rounding produces a small difference).

LandValue in 5 years ($10,000 X 1.34) $13,400

BondPrincipal $10,000Annual interest $600Reinvested for 5 years at 6%: annuity factor X 5.64 3,384Value in 5 years $13,384

Both of these alternative investments are subject to taxation. However, the interest on thetaxable bond is taxed annually, whereas the gain on the land is not taxed until the land issold. In addition, the land is taxed at capital gain rates. Thus, the after-tax results are asfollows:

LandValue in 5 years $13,400Less tax: .15($13,400 – $10,000) (510)After-tax value $12,890


BondPrincipal $10,000Annual interest (after tax) $390Reinvested for 5 years at 6%: after-tax annuity factor X 5.39 2,102Value in 5 years $12,102

Therefore, the investment in the land will produce a greater after-tax value by an amountof $788 ($12,890 – $12,102).

The future value of the land will exceed the future value of the bond because the intereston the bond is taxed each year while the appreciation in the land value is not taxed untilthe end of the five years and the appreciation on the land is taxed at a lower tax rate.Thus, with the bond, the investor has less of an investment that is growing at acompounded rate.

The investment in stock is superior to the investment in the bond in terms of after-taxyield because of the lower tax rate (15%) applied to the qualified dividends.

pp. 4-3 to 4-5, 4-35, and 4-36

29. a. Olga has $200 of interest income and a recognized gain of $300 ($10,500 – $200– $10,000).

b. Olga does not recognize income from using the stock as collateral for the debt.Her assets (cash) and liabilities increased by the same amount, and she continuedto own the stock. Thus, there is no realized gain.

c. Mere increases in the value of an asset are not included in gross income. Note theattorney’s fee should be added to Olga’s cost of the property in calculating herbasis for the vacant lot.

pp. 4-3 to 4-6

30. a. The $1,500 is a dividend from the corporation to Amos. The corporation wasentitled to the rebate. The rebate was a reduction in the cost of the corporation’sautomobile. The assignment of the $1,500 to Amos was an economic benefitrealized solely because he was the controlling shareholder and thus is a dividendto him.

b. The $50,000 payment received under the covenant is included in Amos’s grossincome because the payment is an increase in wealth realized.

c. The neighbor’s actions that increased the value of Amos’s property by $1,500 donot result in the realization of income by him. Amos’s wealth has increased, butthe realization requirement is not satisfied, since he did not receive any additionalproperty nor were any improvements made to his property. Amos will not realizethis increase in wealth for tax purposes until he sells the property. pp. 4-7 and 4-8

31. a. Gross income using cash method:Cash collections from customers $150,000

Under the cash method, income is recognized when cash or its equivalent isactually or constructively received, regardless of when it was actually earned.Neither gross income nor taxable income is affected by the uncollectible


accounts. Income was not recognized when the income was earned. The depositis not Al’s money. Rather, Al is the agent holding the money on behalf of theclient.

b. Gross income using accrual method:Cash collections $150,000Less: Beginning accounts receivable (25,000)Plus: Ending accounts receivable 45,000

$170,000

c. Al should use the cash method so that he will not have to pay income taxes onuncollected accounts receivable.

pp. 4-7 to 4-9

32. Selma must use the accrual method of accounting for her farm implements businessbecause inventories are a material income-producing factor to the business.

Calculation of sales:Cash receipts (excluding $50,000 investment and $5,000 customer deposit) $445,000Accounts receivable: end of the year 15,000

Total sales $460,000Cost of goods sold:

Cash payments for merchandise $350,000 Accounts payable: end of the year 40,000 Cost of goods available for sale $390,000 Less: ending inventory (75,000)Cost of goods sold (315,000)

Gross profit $145,000

Note that the $5,000 customer deposit on inventory must be excluded from incomereported in financial statements presented to the creditors and investors. Otherwise, thedeposit cannot be deferred for tax purposes. pp. 4-7 to 4-9

33. Willis, Hoffman, Maloney, and Raabe, CPAs5191 Natorp Boulevard

Mason, OH 45040

October 1, 2005

Ms. Amanda SimsManaging PartnerAspen Associates100 James TowerDenver, CO 80208

Dear Ms. Sims:

I am responding to your suggestion that Aspen Associates should change to the accrualmethod of accounting for tax purposes as a means of reducing accounting fees. Underthe accrual method of accounting, receivables must be recognized as income as the


services are performed. This is to be contrasted with the cash method of accountingwhere no income is recognized until payment is received.Each year, under the accrual method, accelerated tax payments would occur so long asthe billing and collection pattern remains the same. Therefore, the partners will pay taxon an additional $75,000 in the first year’s income, and those payments will not berecovered until the company ceases its operations. Assuming the partners are in the 35%(combined State and Federal) marginal tax bracket, the deferred taxes under the cashmethod are $26,250 (.35 X $75,000). If the partners earn a 2.29% ($600 ÷ $26,250)return, or greater, on the deferred taxes, the additional accounting fees will be recovered.Therefore, I recommend that you continue to use the cash method.

Sincerely,

Tara Kelly, CPATax Partner

pp. 4-7 to 4-9

34. TO: Susan AppleFROM: Bill SwanSUBJECT: Dispute Over Recording of Income by Color Paint Shop, Inc.DATE: October 1, 2006

I am responding to the questions you raised regarding the timing of the reporting ofincome by Color Paint Shop, Inc. with respect to the dispute concerning the painting ofSamuel Customer’s car. The key issue is whether Color (1) should accrue the $1,000 ofincome in 2005 and take a $200 loss deduction in 2006 (the IRS view), (2) report the$800 in 2005 or (3) delay recording the $800 income until 2006 (Color’s preferredapproach).

An accrual basis taxpayer is required to recognize income when (1) all the events haveoccurred to establish the taxpayer’s right to receive the income, and (2) the amount of theincome can be determined with reasonable accuracy. In Color’s case, it does not appearthat all the events to fix the rights to the income had occurred in 2005. The insurancecompany had not approved the work by the end of the year. One could reason thatSamuel’s approval of the work is the critical event that fixes Color’s right to receive theincome, because the insurance company is merely the paying agent of the customer.However, even with this conclusion that the all-events test had been satisfied by the endof 2005, the amount of the income cannot be determined with reasonable accuracybecause the insurance company may renegotiate the price. Thus, the transaction shouldbe held open and no income should be reported until 2006. The amount of income Colorshould report in 2006 is $800. pp. 4-8 and 4-9

35. a. The taxpayer would report the income actually received in 2005. If the salary ispaid according to the agreement, the taxpayer will have received 11 payments of$10,000 each, or $110,000 in 2005. The fact that the employer was willing tonegotiate a different payment schedule does not affect the timing of the taxpayer’sincome.

b. The cash basis taxpayer must report the $8,000 of income in 2004 when it wasactually received.

c. The fact that the employer violated the agreement and paid the taxpayer in 2005may cause the taxpayer to have a grievance against the employer, but it does not


alter the fact that he received the income in 2005. Therefore, the $10,000 isincluded in his gross income in 2005.

pp. 4-9 and 4-10

36. a. Morris must recognize $3,861 ($10,000 – $6,139) of interest income from theretirement of the Series EE bonds. His basis was the original cost of $6,139 sinceSeries EE bonds are not subject to the original issue discount rules.

b. The two-year certificate is subject to the original issue discount rules. Thefollowing amount of interest income is recognized each year by Morris.

2003 $9,244 X 4% X 3/12 = $ 922004 $9,336 X 4% X 12/12 = 3732005 $9,709 X 4% X 9/12 = 291

$756

Thus, Morris’s basis for the CD at redemption is $10,000 ($9,244 + $756).Because his basis of $10,000 equals the maturity value of $10,000, no gain or lossis realized.

The one-year CD he purchased in 2005 has $500 ($10,500 – $10,000) originalissue discount, but amortization of that discount is not required because it matureswithin one-year from the date of purchase. Morris will report this $500 of interestwhen it is collected in 2006.

pp. 4-10 and 4-11

37. a. The $1,200 advance payment can be deferred until 2005 because the property wasnot delivered until 2005 and the revenue was not recognized for financialaccounting purposes until 2005.

b. Gross income of $140 ($20 per month X 7 months) from the 12-month contractmust be reported in 2005. The prepaid income qualifies for deferral under IRSRevenue Procedure 2004-34. The portion of the advance payment that relates toservices performed in the tax year of receipt is included in gross income in the taxyear of receipt. The portion of the advance payment that relates to services to beperformed after the tax year of receipt ($240 – $140 = $100) is included in grossincome in the tax year following the tax year of receipt of the advance payments.For the 24-month contract, the amount included in gross income in 2005 is $20($20 per month X 1 month) and in 2006 is $460 ($480 – $20).

c. The company must include $1,200 in gross receipts and can deduct the cost of theappliance, $750, in arriving at gross income of $450. The fair market value of thenote is not relevant for purposes of determining the accrual method taxpayer’sgross income.

pp. 4-8, 4-9, 4-13, and 4-14

38. a. Freda actually received only $180,000 in 2006. She did not constructivelyreceive the remaining $60,000 in 2006, since under the terms of the actualcontract she did not have the right to receive that amount in 2006.

b. Freda may be bargaining for the deferred payments because she expects to be in alower marginal tax bracket in 2007. However, the lower tax rate must be


sufficient to compensate for her loss of the use of the income for the periodOctober through December 2006.

pp. 4-7 to 4-11

39. a. • The damage deposit is not taxable at the time it is collected, but the $400prepaid rent is taxed in the year of receipt.

• The $800 prepaid rent is taxed in the year of receipt.

• The $800 damage deposit is not taxed in the year of receipt.

b. The Bonhaus Apartments should use the third option. By doing so, it maximizesdeferrals without affecting the cash flows.

pp. 4-12 and 4-13

40. a. No. Gus should include the entire $125,000 in his gross income because heprovided the services that produced the income. The fact that his creditors are thebeneficiaries of the income is not relevant.

b. Yes. The corporation owns the property and therefore is taxed on the net rentalincome from the property. The corporation will be taxed on this amount at thecorporate tax rates. However, because Gus retained the corporation’s cash, hewill be required to include the $18,000 in his gross income as a dividend from thecorporation (assuming the corporation has earnings and profits of at least thatamount).

c. Yes. If the corporation is an S corporation, the income will flow through to Gus,the sole shareholder.

pp. 14-17 and 4-18

41. a. The cash basis corporation must recognize the income of $3,000 in 2005 when itsagent, Tracy, received the check, which is a cash equivalent. Tracy will notrecognize any bonus until it is actually or constructively received. The fact thatthe employer received the fees in 2006 does not affect the time Tracy recognizesthe bonus.

b. The corporation must recognize the income in 2005, when the agent, Tracy,performed the services. Tracy will recognize the 10% bonus in 2006, becauseneither actual nor constructive receipt of the bonus occurs in 2005.

c. The fact that the customer admits the check will not be honored if presented at theend of the year means the check is not a “cash equivalent.” Furthermore, therestriction on when the check can be presented for payment is “substantial.”Thus, the income is not realized in 2005.

pp. 4-7 to 4-10 and 4-17

42. Each partner’s gross income from the partnership for the year is $80,000 [($360,000 –$120,000)/3 = $80,000]. The partner’s gross income is his or her share of the profitsunder the profit and loss agreement, and generally is not affected by the partner’scontributions or withdrawals for the year. pp. 4-17 and 4-18


43. a. Amur dividends (Note 1) $55,000Blaze dividends (Note 2) 25,000Grape dividends 12,000Total dividend income $92,000

Note 1: Even though Amur is a foreign corporation, the dividend is a qualifieddividend because its stock is traded on an established U.S. securitiesmarket.

Note 2: The dividend paid by Blaze is not a qualified dividend because theholding period requirement is not satisfied (i.e., must be held more than60 days during the 120-day period beginning 60 days before the ex-dividend date).

Qualified dividendsAmur dividend $55,000Grape dividend 12,000

$67,000Applicable rate X 15%Tax on qualified dividends $10,050

Non-qualifying dividendsBlaze dividend $25,000Applicable rate X 35%Tax on non-qualified dividends $ 8,750

b. The daughter is in the 10% marginal tax bracket. She has $1,000 of qualifieddividends which are eligible for the alternative tax rate of 5% (rather than theusual 15%). So the daughter’s tax liability on the dividends is $50 ($1,000 X5%).

pp. 4-15 and 4-16

44. a. b. California Texas Doug Liz Doug Liz

Salary $48,000 $48,000 $48,000 $48,000Rent 6,000 3,000 3,000Dividends 1,900 950 950Interest 900 900 900 900

$50,800 $54,900 $52,850 $52,850

Under Texas law, the rents and dividends belong to the community even though thisincome is derived from separate property. Under California law, the income iscommunity or separate depending on the state law classification of the underlying assets.In this case, the interest is community income because the savings account was fundedwith community property. pp. 4-18 to 4-20 and Example 29

45. a. The use of the house is not alimony because it is not a cash payment. Thus, Nelldoes not recognize income and Kirby is not entitled to a deduction.

b. The $1,000 per month payments are in cash and satisfy all of the otherrequirements to be labeled as alimony. Thus, the payments are deductible to


Kirby and are includible in Nell’s gross income. The securities transfer isincident to a divorce and therefore produces no recognized gain to Nell. Kirby’sbasis is a carryover basis of $100,000.

c. The $600 per month payments are nondeductible child support, since the paymentscease upon the happening of a contingency related to the child’s age or death.

pp. 4-20 to 4-22

46. a. The $30,000 per year received by Al is alimony—ordinary income to Al anddeductible as a deduction for AGI by Karen. Al’s basis of $40,000 ($80,000 X50%) carries over to him.

b. The $50,000 per year for years 1, 2, and 3 and the $30,000 per year forsubsequent years are alimony—ordinary income to Al and deductible as adeduction for AGI by Karen. The payments in the first three years are not “front-loaded” because they are the same for each of those years. So there is no alimonyrecapture. Economically, though, Al has given up a one-half interest in the stock,which if he had received would have a cost basis to him of $40,000 ($80,000 X50%) and a fair market value of $60,000. Therefore, with the higher cashpayments of $60,000 ($20,000 X 3), Al will lose the ability to take a recovery ofcapital deduction for $40,000, as compared to receiving less cash but alsoreceiving his share of the stock. In addition, any recognized gain on the futurestock sale is eligible for the beneficial capital gain rates.

c. Al will report $80,000 of alimony in year 1 and Karen can deduct this amount.The $80,000 cash payment in year 1 with the decrease to $30,000 thereafter willcause alimony recapture of $35,000 which is reported in year 3.

$80,000 – [($30,000 year 2 payment + $30,000 year 3 payment)/2) +$15,000] = $80,000 – $45,000 = $35,000

Al will receive a $35,000 deduction for AGI in year 3, and Karen will have$35,000 to include in gross income. The $35,000 deduction will partiallycompensate for the $40,000 basis (and $60,000 fair market value) of the stock hesurrendered.

pp. 4-20 to 4-22

47. The receipt of the common stock is not taxable to Sandra because it is a non-cash transferof property under the terms of a divorce. The $300 per month actual child supportpayments are not included in Sandra’s gross income. The $1,000 monthly paymentincludes $250 of implicit child support. That is, because the payments would be reducedas a result of a contingency related to the child (i.e., attaining age 21), the amount of thecontingent reduction is considered child support. Therefore, Sandra must include only$4,500 ($750 X 6) from alimony in gross income in the current year. pp. 4-21 to 4-23

48. Under the guarantee arrangement, the family would receive before tax interest of $9,000($150,000 X 6%) on Hal’s certificates of deposit and would pay $10,500 ($150,000 X7%) interest on Roy’s loan. Furthermore, the interest received will be taxed at 35%(Hal’s marginal tax rate) while the interest paid will be deductible at only 15% (Roy’smarginal tax rate). The transactions will produce a negative cash flow of $3,075[($9,000) (1 – .35) – ($10,500) (1 – .15) = –$3,075] for the family.


The 6% loan from Hal to Roy would reduce the family’s negative cash flow by $1,275($3,075 – $1,800) compared to the guarantee. This results because Hal will receive$9,000 interest and Roy will pay the same amount. On an after-tax basis, the $9,000received by Hal is taxed at 35%, the same as with the certificates of deposit, and theinterest is deductible by Roy at a 15% tax rate.

[($9,000) (1 – .35) – ($9,000) (1 – .15) = – $1,800]

A zero interest rate loan would have been the best alternative if the total loans betweenRoy and Hal had been less than $100,000. The zero interest rate loan would be eligiblefor the $100,000 exception for gift loans. Therefore, interest would not be imputed, sinceRoy has no investment income. Roy would not receive any interest income, and Halwould not pay any interest. Since this option is not available, the better option appears tobe the 6% loan from Hal to Roy.

[($0) (1 – .35) – ($0) (1 – .15) = $0]

pp. 4-23 to 4-28

49. IncomeLoan from employer

Compensation ($62,000)(.07)(6/12) = $2,170* Loans to others

To controlled corporation ($31,000)(.07)(6/12) = 1,085**To Tab (exempt under $100,000 exception) -0-

Certificates of depositOne year certificate (not subject to OID rules) -0- Two year certificate ($6,000)(.0625)(6/12) [subject to OID rules] 188

*Ridge also has $2,170 of interest expense which may be deductible as investmentinterest (to the extent the loan proceeds were used for investment purposes).

**Treated as an additional investment by Ridge and added to his cost of the stock.

pp. 4-10, 4-11, and 4-23 to 4-28

50. a. This loan is a gift loan between individuals that is eligible for the $100,000exception. Although the sister has $900 of investment income, interest is notimputed, under this exception, if the borrower’s investment income is not greaterthan $1,000.

b. This loan is an employer-employee loan for not greater than $10,000. Sam didnot use the funds to buy investments and there appears to be no tax avoidancemotive. Thus, no interest is imputed.

c. Interest is imputed on this loan. The $100,000 exception is not available oncorporation-shareholder loans. The imputed interest would be calculated asfollows:

$15,000 X (5.5% – 4%) X 1/2 = $112$15,112 X (5.5% – 4%) X 1/2= 113

$225


pp. 4-26 to 4-28

51. a. The employer-employee loan would be eligible for the $10,000 exemptionthrough June 30, 2005. However, in July 2006, the total outstanding loans exceed$10,000. The $100,000 exemption does not apply to these loans. Therefore,interest is imputed on the $12,000 amount of the loans for the period July throughDecember 2006. Vito, Inc. has interest income and Vito has compensationincome of $480 [.08($12,000 X 6/12)]. Vito also has interest expense of $480and Vito, Inc. has compensation expense of the same amount. Note thatemployer-employee loans are not eligible for the $100,000 exception.

b. A corporation-shareholder loan is not eligible for the $100,000 exemption andusually does not qualify for the $10,000 exemption (i.e., cannot satisfy therequirement that tax avoidance not be a principal purpose of the loan). Therefore,for 2005 and 2006, the corporation has interest income and dividends paid (notdeductible) as follows:

2005 ($8,000 X 8% X 6/12) $320

2006 ($8,320 X 8% X 6/12) $333($8,320 + $333 + $4,000)(.08)(6/12) 506 $839

Vito has dividend income and interest expense of equal amounts.

pp. 4-22 to 4-28

52. a. Cost (her investment) $120,000

Employee’s investment $120,000Number of anticipated payments = 260 = $461.54 exclusion

[Table 4-2]

Collections in 2005 (6 payments X $2,000) $12,000Exclusion for capital recovery ($461.54 X 6 payments) [rounded] (2,769)Include in gross income $ 9,231

The simplified method is used to calculate the annuity exclusion percentage sincethis is a qualified retirement plan distribution.

b. Thelma will have recovered her investment as a return of capital prior to thetwenty-ninth year. Thus, all annuity payments received in the twenty-ninth yearare includible in her gross income.

$2,000 X 12 payments = $24,000

c. Investment in the contract $120,000Total amount collected 180 X $2,000 = $360,000Less: capital recovered $360,000 X .23077* (83,077)Unrecovered cost (loss in the final year return) ($ 36,923)

Income from collections in final year: $12,000(1 – .23077*) $ 9,231


* $120,000$260 X 2,000 = 23.077% exclusion percentage.

pp. 4-27 to 4-30

53. a. Joe is required to include $210,000 ($60,000 + $150,000) in gross incomeassociated with the award he received. The award does not satisfy the right typeof achievement requirement to qualify for exclusion from gross income. Inaddition, the provision which requires the recipient to contribute the award to aqualified governmental unit or nonprofit organization is not satisfied.

b. Wanda is required to include the $100,000 of prizes received in her gross income.She is required to render substantial future services. In addition, the provisionwhich requires the recipient to contribute the award to a qualified governmentalunit or nonprofit organization is not satisfied.

c. George can exclude the $900,000 prize received from his gross income. All ofthe requirements for exclusion are satisfied.

pp. 4-31 and 4-32

54. a. Alice’s gross income from the excess coverage is computed as follows:

Uniform premiums for $1,000 of protection for 1 month $ .09Coverage for 12 months X 12

$ 1.08

$85,000 – $50,000 X 35Excess coverage: 1,000

Includible amount for Alice $37.80

Kay is a partner (not an employee) and therefore the exclusion for group term lifeinsurance premiums is not applicable for her. The partnership will deduct theactual premiums paid. The premiums attributable to the partners (based on theuniform table) are included in the partner’s gross income. Therefore, Kayincludes $414 in her gross income.


$ 2.76

$150,000 – $0 X 150Excess coverage: 1,000

Includible amount for Kay $414.00

b. As an employee of the incorporated business, Kay is eligible for the group termlife insurance exclusion.


$ 2.76


$150,000 – $50,000 X 100Excess coverage: 1,000

Includible amount for Kay $276.00

The availability of the life insurance premiums and other benefits available toemployees that are discussed in Chapter 5 are considerations in deciding whetherto incorporate a business.

pp. 4-32 and 4-33

55. Salary $ 90,000Unemployment compensation 8,300*Interest income 90Dividend income 550Lottery winnings 1,500*Gross income $100,440

* Unemployment compensation is includible in gross income. The $5 cost of the lotteryticket is deductible as a miscellaneous itemized deduction, not subject to the 2%reduction. Neither the $12,000 loan nor the $2,000 savings account withdrawal areincluded in gross income.

p. 4-33

56. a. Taxable Social Security benefits =.5[$35,000 + .5($9,000) – $32,000] = .5($7,500) $ 3,750

Pension benefits, etc. 35,000AGI $38,750

b. Other income ($35,000 – $8,000) $27,000Taxable Social Security benefits =

.5[$27,000 + $6,000 + .5($9,000) – $32,000] 2,750$29,750

AGI in a. above (38,750)Decrease in AGI ($ 9,000)

Note: The taxpayers’ economic income decreased by $2,000 ($8,000 – $6,000),but taxable income decreased by $9,000. However, with a 15% marginal tax rate,their after-tax economic income will decrease by only $650.

Decrease in interest income $2,000Decrease in tax liability (15% X $9,000) (1,350)Decrease in economic income $ 650

c. Lesser of:(1) .85[$65,000 + .5($9,000) – $44,000] = .85($25,500) $21,675

Plus smaller of:Amount calculated by the first formula, which is the lesser of

.5($9,000) = $4,500 .5[$65,000 + .5($9,000) – $32,000] = $18,750 or $6,000 4,500

$26,175


or(2) .85($9,000) $ 7,650

Therefore, Linda and Don would be required to include 85% of the SocialSecurity benefits ($7,650) in their gross income.

Includible Social Security benefits $ 7,650Other income ($35,000 + $30,000) 65,000AGI $72,650AGI in a. above (38,750)Increase in AGI $33,900

Note: The increase in AGI exceeds the increase in earnings because more of theSocial Security benefits became taxable.

pp. 4-33 and 4-34

57. a. NotRetired Retired Change

Salary $80,000Retirement pay $60,000Interest and dividends 12,000 12,000Tentative AGI $72,000 $92,000Social Security ($15,000 X 85%) 12,750 AGI $84,750 $92,000Less deductions (18,000) (18,000)Taxable income $66,750 $74,000 ($7,250)

b. If Jim retires, the couple’s after-tax cash flow will decrease by $2,825.

Decrease in taxable income from retirement ($7,250)Plus non-taxable Social Security earned while retired 2,250Taxes saved by retiring ($7,250 X 30%) 2,175Total decrease in cash flow after retirement ($2,825)

pp. 4-33 to 4-35

58. Donna has substantial tax problems:

a. Donna’s share of the partnership income of $70,000 will be taxable to Donnaeven though the income was not distributed. Therefore, she will need to come upwith the cash required to pay the taxes. p. 4-17

b. A portion of the Social Security benefits will be taxable because Donna has otherincome. If Donna and her husband file separate returns, she must include $7,140($8,400 X 85%) of the Social Security benefits in her gross income (i.e., the baseamount is $0 in this case). Even with a joint return, Donna and her husbandwould include $7,140 of the Social Security benefits in their gross income (i.e., inthis case, the base amount would be $44,000). pp. 4-33 to 4-35

c. Donna must report the $1,200 of interest income even though the creditorreceived the money. She owned the property which earned the income. Also, shebenefited from the income in that the money was used to satisfy her liability.pp. 4-14 and 4-15


d. Donna will be required to include in gross income one-half of her husband’sincome because they are residents of a community property state. pp. 4-18 to4-20

CUMULATIVE PROBLEMS

59. Part 1—Tax Computation

Gross incomeSalary and commissions ($86,000 + $31,000) (Note 1) $117,000Interest income on certificate of deposit (Note 2) 433

Interest income on Second Bank savings account (Note 3) 1,300Dividends on CSX stock (Note 4) 2,600Income from partnership (Note 5) 11,000Deductions for adjusted gross income -0-Adjusted gross income $132,333Itemized deductions

State income tax (Note 6) $4,500Personal property tax 900Real estate tax 3,600Home mortgage interest 4,900Cash contributions 975 (14,875)

Personal and dependency exemptions (Note 7) (12,800)Taxable income $104,658

Tax on taxable income other than dividends $102,058 [$8,180 + 18,844.25($102,058 – $59,400)]

Tax on dividend income ($2,600 X 15%) 390Less: Tax withheld by employers (15,000)

Estimated tax payments (5,000)Net tax payable (or refund due) for 2005 ($ 766)

Notes

(1) Assuming that Dan and Freida are cash basis taxpayers, the $2,000 commissionwill not be included in gross income until it is received in 2006.

(2) The original interest discount rules apply. The OID for 2005 is $433.Maturity value $15,000

2003 OID ($13,868 X 4%) X 3/12 $1392004 OID ($14,007 X 4%) 560

Adjusted basis at beginning of 2005 ($14,007 + $560) (14,567)2005 OID $ 433

(3) The $2,900 of interest on the City of Corbin bonds is excluded from grossincome.

(4) The dividends of $2,600 on the CSX stock are included in Dan and Freida’s grossincome. Then they are treated as having made a gift of $2,600 to Ben.

(5) Freida’s share of the partnership profits is $11,000 ($100,000 X 11%). Therefore,she must include this amount in her gross income.


(6) The state income tax paid of $4,500 exceeded the sales tax of $1,206 from thesales tax table.

(7) Gina qualifies as a dependent. Since she is their child and is a full-time studentunder age 24, she does not have to satisfy the gross income test (i.e., it is waived).In any event, this is not a problem since Gina has $0 gross income. Gina does notfile a joint return with her husband. Therefore, since all of the requirements aresatisfied, Dan and Freida can claim a dependency deduction for Gina. Ben,Freida’s brother, fails to qualify as a dependent because of the gross income test.(Although he is a full-time student, he is not a child of either taxpayer.) Sam,their son, does qualify as a dependent. It appears he has too much gross income($6,300). However, the gross income test is waived in this case because he is afull-time student during five calendar months. Therefore, Dan and Freida’spersonal exemption and dependency deductions are $12,800 ($3,200 X 4).

Part 2—Tax Planning

Willis, Hoffman, Maloney, and Raabe, CPAs5191 Natorp Boulevard

Mason, OH 45040

December 29, 2005

Dan and Freida Butler625 Oak StreetCorbin, KY 27521

Dear Dan and Freida:

You asked me to estimate your after-tax income under the assumption that Dan will workonly half-time next year. The $43,000 reduction in Dan’s pay will be partially offset by a$29,000 estimated increase in the amount Freida will earn. While your before tax incomewill decrease by $14,000, the after-tax decrease in income will be only $10,500. That is,while your income received will decrease, your tax payments also will decrease.

If you have any further questions, please call me.

Sincerely,

John Jones, CPA

TAX FILE MEMORANDUM

December 27, 2005

From: John JonesSubject: Dan and Freida Butler, Change in taxes for 2006

Dan plans to work only half-time in 2006, but Frieda anticipates a substantial increase inher income. Dan’s income will decrease by $43,000 and Frieda’s income is expected to


increase by $29,000. With a $14,000 decrease in salary and commission income, theirtax liability will decrease by $3,500. Therefore, their after-tax decrease in earnings isonly $10,500 as computed below.

Decrease in earnings $14,000Loss: Tax liability reduction $14,000 X 25% (3,500)After-tax decrease in earnings $10,500

My assumptions for the analysis were as follows:

1. The $2,000 commission received on January 10, 2006 is included in the $60,000income to be earned by Freida in 2006.

2. The $3,200 exemption amount is the same in 2005 and 2006.

3. The 25% 2005 marginal tax rate remains the same in 2006.

4. Interest income, dividend income, partnership income, and itemized deductionsare the same for 2005 and 2006.

60. Gross income:Pension $29,500Interest income (Note 1) 5,500Dividend income 2,000Annuity income (Note 2) 2,160Social Security benefits (Note 3) 10,200Imputed interest on gift loan (Note 4) 1,600Net rent income (Note 5) 1,850Gross income $52,810Deductions for AGI -0-AGI $52,810Less: Personal exemption deduction (Note 6) (3,100)Less: Itemized deductions (Note 7) (11,800)Taxable income $37,910

Tax liability (Tax Table) (Note 8) $ 4,979Less: Estimated tax payments (5,500)Net tax payable (or refund due) for 2004 ($ 521)

See the tax return solution beginning on page 4-28 of the Solutions Manual.

Notes

(1) The $2,700 of interest on the City of Alto bonds is excludible.

(2) The exclusion percentage and the related annual exclusion on the annuity contractCecil purchased is calculated as follows:

$52,800$400 X 240 payments

= 55% X $4,800 =$2,640

Cecil received $4,800 of annuity payments from the insurance company this year.


Thus, Cecil must include $2,160 ($4,800 – $2,640) in his gross income this year.

(3) The amount of the Social Security benefits that Cecil must include in his grossincome is the lesser of the two following amounts:

a. 85%($12,000) = $10,200

b. Sum of:

(1) .85[$52,810 – $10,200 + $2,700 + 50%($12,000) – $34,000] =$14,713, and

(2) Lesser of:

(a) 50%($12,000) = $6,00050%[$52,810 – $10,200 + $2,700 + 50%($12,000) –$25,000] = $13,155

(b) $4,500

Thus, $14,713 + $4,500 = $19,213.

Since the amount calculated under a. of $10,200 is less than the amount calculatedunder b. of $19,213, the $10,200 is included in Cecil’s gross income.

(4) Since Cecil made a below-market gift loan to Sarah, he needs to determine if anyimputed interest should be included in his gross income. The loan qualifies underthe $100,000 exception. Since Sarah’s net investment income is only $1,600,Cecil has to include only $1,600 in his gross income rather than $2,400 ($40,000X 6%).

(5) The net rental income from the townhouse is as follows:

Rent income $7,600Less: Expenses

Utilities $1,500Maintenance 1,000Real estate taxes 750Insurance 500Depreciation 2,000 (5,750)

Net rent income $1,850

(6) Since Sarah is self-supporting, Cecil does not qualify for a dependency deductionfor her.

(7) Cecil’s itemized deductions are as follows:

Personal property taxes $ 2,100State income taxes 3,300Charitable contributions 6,400

$11,800


Cecil’s state income taxes paid of $3,300 exceeded the sales taxes he paid of$912. Cecil’s standard deduction would be $8,350 ($7,150 basic standarddeduction + $1,200 additional standard deduction). Thus, Cecil will itemizedeductions.

(8) Cecil uses the Tax Table for a Head of Household. He maintains a home for hisunmarried daughter Sarah. Since she is unmarried, Sarah does not have to be hisdependent.

Tax on $35,910 $4,8795% X $2,000 dividend income 100

$4,979


60.


60. continued

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