The following pages are from the solutions manual for Acct 421 (Income Tax Accounting I).  They are out of order.  The individual files can be found on Moses.

 

 

 

 

CHAPTER 4

 

INCOME EXCLUSIONS

 

DISCUSSION QUESTIONS

 

1. What are the two reasons most commonly advanced for excluding items from income? Give examples of each and explain how they accomplish the purpose of the exclusion.

The two reasons commonly advanced for the exclusion of income items are 1) to alleviate the effects of double taxation, and 2) to encourage taxpayers to engage in transactions for which relief is provided.

Exclusions that avoid double taxation include the foreign earned income exclusion (credit), which prevents income earned in foreign countries from being taxed in the foreign country and in the United States. The exclusion for property received by gift or inheritance prevents double taxation by the income tax and the gift and estate tax on the same transaction.

Most other exclusions encourage taxpayers to engage in specific transactions. For example, the exclusion of all payments received from medical insurance policies purchased by individuals encourages individuals to purchase medical insurance. The exclusion for interest received on municipal bonds encourages taxpayers to invest in such securities versus taxable investments.

 

2. What is the difference between an exclusion of income and a deferral of income?

An income item that is excluded is never subject to tax - either in the current period or a future period. Deferred income items are not subject to tax in the current period, but will be taxed in some future period. Most items are deferred until the taxpayer has the wherewithal-to-pay the tax.

 

3. How can gifts be used to lower the overall tax paid by a family?

Because gifts are not subject to income tax, a high bracket taxpayer can make a gift of income producing property to a low bracket member of his/her family (father to son, grandmother to granddaughter, etc.). By using the annual gift tax exclusion and the lifetime gift and estate tax exclusion, payment of the gift tax on the gift property can also be avoided. When the property produces income, it will be taxed at a lower marginal tax rate, thus reducing the overall tax paid by the family.

 

 

4. Why are life insurance proceeds excluded from the gross income of the beneficiary of the policy?

Because, in most instances, life insurance proceeds are counted as part of a decedent's estate, they resemble inherited property, which is excluded from tax. Thus, to provide equity with other forms of inherited property, they are excluded from tax.

 

5. Explain the circumstances under which a scholarship would not be excluded from gross income.

Most scholarships are excluded from tax. However, the amount of the exclusion is limited to the direct costs of education - tuition, fees, books, lab equipment, etc. Therefore, if the scholarship exceeds the student's direct costs, the excess is taxable. In addition, any scholarship that is specifically for room and board cannot be excluded even if it does not exceed the direct costs.

 

6. What tax relief is provided to U.S. citizens who earn income in a foreign country and pay taxes in that country?

To prevent double taxation of income, foreign earned income may either be excluded from gross income (up to $85,700 in 2007) or the income may be included in gross income and a tax credit taken for the taxes paid to the foreign country. However, the tax credit cannot exceed the amount of U.S. taxes the taxpayer would have paid on the income.

7. How do employees benefit from payments made into a qualified pension plan on their behalf?

From a tax perspective, an employee receives two benefits from the payments made by an employer into a qualified pension plan. First, the payment constitutes compensation income to the employee. However, payment of tax on the income is deferred until the employee withdraws the money from the plan. This feature provides the time-value savings common to deferrals of income. In addition, if the employee's marginal tax rate is lower when the money is withdrawn, the employee pays less tax than if it is not deferred (note that the opposite result could occur if tax rates went up or the employee has higher income when the money is withdrawn).

The second tax advantage is that the earnings on the pension plan assets are not subject to tax until they are withdrawn. This gives a higher rate of return each year the assets are left in the plan, resulting in a larger amount in the plan at retirement than if the income had been taxed as it was earned.

 

8. Distinguish group term life insurance from whole life insurance.

Group-term life insurance is insurance provided for a group of employees for a limited term. The policy will only pay the beneficiaries if the employee dies during the term of the policy. Term insurance is only insurance, there is no savings component.

A whole-life insurance policy is a policy on a single individual for the life of the individual. That is, in contrast to term insurance, once the policy is paid for, the proceeds are always paid at death. Whole life insurance includes an insurance component and a savings component (i.e., it has a cash surrender value)

 

9. What is the difference in the tax treatment of a medical insurance plan that is purchased from a third-party insurer and a self-insured medical reimbursement plan?

There is no difference in treatment between the two types of plans. Premiums paid on purchased medical insurance and payments for medical expenses from the plan are excluded from the employees' income. Payments made from a self-insured medical plan are also excluded from gross income as long as the plan does not discriminate in favor of "highly compensated" employees. If a self-insured plan does discriminate, the "highly compensated" employees must include the payments made from the plan in their gross income (those who are not considered to be "highly compensated" still receive the exclusion).

 

10. What is a Health savings account?

An HSA is a savings account used to pay medical expenses with pre-tax income. Earnings on an HSA are not taxed. Distributions from an HSA that are used to pay medical expenses are excluded from gross income. To be eligible to establish an HSA, an individual must be covered by a high-deductible health insurance plan. Contributions to an HSA can be made by an employer or the individual establishing the account. Contributions by an employer are excluded from the employee’s gross income. Contributions by an individual are deductible for adjusted gross income. In addition, unlike a flexible benefits plan, the unused balance in the HSA can be carried forward to future tax years.

 

11. What is the difference between a qualified employee discount and a bargain purchase by an employee?

Both a qualified employee discount and a bargain purchase allow employees to purchase goods or services from an employer at a price below the normal selling price. As such, they are a form of compensation. The difference between the two is that a qualified employee discount must be offered to all employees in order for the employee to exclude the discount from income. If all employees are not eligible for the discount, then any discounts received become bargain purchases and are included in the employee's gross income as compensation.

 

12. What is the difference between a cafeteria plan and a flexible benefits (salary reduction) plan?

In a cafeteria plan, the employer allows each employee a pre-determined dollar amount of benefits. The employee chooses the benefits provided by the plan up to the pre-determined amount or takes cash instead. Any benefits chosen are excluded from gross income while any cash received is included in gross income.

A flexible benefit plan (also called a salary reduction plan) differs in that the employee directs the employer to reduce his/her salary by the amount he/she wishes to put into the plan. The amounts in the plan can then be used to pay unreimbursed medical expenses, dental costs, eye-care, child-care, etc. Any amounts paid into the plan that are not spent by the employee during the plan year revert to the plan and the employee effectively loses that amount.

 

13. Why are workers' compensation payments treated differently from unemployment compensation payments for tax purposes?

Worker's compensation payments are paid when a worker is injured on the job. As such, they are intended to make the taxpayer whole (restore the human capital lost by the injury) and thus, are not taxed. Unemployment compensation is a substitute for earned income lost due to unemployment. Because it is a payment for loss of income, it is taxed according to the general rule that taxes all payments that are for loss of income.

 

14. What is a personal physical injury for purposes of excluding damage payments received?

Beginning August 21, 1996, only: 1) compensatory payments received for personal physical injuries or personal physical sickness and 2) medical payments for emotional distress can be excluded from income. Under this provision, if the action creating the payment has as its origin a physical injury or physical sickeness then all compensatory payments received are excluded.

In addition, courts often award loss-of-income damages and punitive damages. Loss-of-income payments can be excluded only if the payment is due to physical injury or physical sickness. All punitive damage payments received are taxable.

 

15. Are punitive damages taxable? Explain.

Punitive damages are always taxable.

 

16. Are payments for loss of income taxable? Explain.

Payments for loss of income are generally included in gross income. However, if the payment is related to a physical injury or a personal physical sickness, the loss-of-income payment is excluded from gross income. In addition, payments for loss of income from an insurance policy purchased by the taxpayer are excluded from income.

 

17. Discuss the difference in the tax treatment of payments received from an employer-provided health and accident insurance policy and a health and accident insurance policy purchased by the taxpayer.

The exclusion for payments received from an employer provided medical insurance plan are limited to those payments for medical costs (up to the amount of the actual medical expenses), loss of body parts or disfigurement, and payments made for specific types of injuries. Payments received from an employer provided plan for loss of income (sick pay) must be included in the gross income of the employee.

All payments received from a medical insurance policy purchased by the taxpayer are excluded from tax. Thus, loss of income payments from such a plan are not taxable as they are when received by an employer provided plan.

 

 

18. What is the purpose of excluding municipal bond interest from gross income?

The purpose of excluding interest on municipal bonds is to allow state and local governments to obtain financing easier and at lower rates than for comparable taxable bonds. By excluding the interest on municipal bonds from tax, municipalities do not have to pay as high an interest rate as a comparable taxable bond to achieve the same after-tax return.

 

19. Are all stock dividends received excluded from gross income?

The general rule is that a dividend received in the form of stock is not taxable because it does not represent an increase in the wealth of the taxpayer. However, when the stockholder has the option of taking cash in lieu of the stock, the dividend is taxable (even if the stock is taken). In this case, the stock is deemed to have a cash-equivalent that represents an increase in wealth and therefore, is subject to tax.

 

 

PROBLEMS

 

20. Throughout the textbook, it has been stated that tax relief can come in several forms. Assuming that the taxpayer in question is in a 28% marginal tax rate bracket and the time-value of money is 6%, determine the tax value of the following forms of relief:

a. A $2,000 item of income that is excluded from income

Because there is no tax paid on the $2,000 of excluded income, there is an implicit savings of the tax that would have been paid if the income been taxable, in this case $560 ($2,000 x 28%).

 

b. A $2,000 expenditure that is deductible in computing taxable income

A tax deduction results in a reduction of tax 560 tax saving for a 28% marginal tax rate payer.

 

c. A $2,000 expenditure that is eligible for a 10% tax credit

The value of a tax credit is equal to the amount of the tax credit because it is a direct reduction in the tax liability. The value of the tax credit is $200.

 

d. A $2,000 item of income that is deferred for five years (Assume no change in the marginal tax rate.)

The value of a deferral is equal to the time value of money tax savings on the item. In this case, the payment of the $560 tax is deferred for 5 years. The tax savings then is equal to the difference between the $560 of tax that would have been paid currently without the deferral minus the present value of the $560 tax payment 5 years from now. The present value factor for 6% for 5 years is .747, giving a present value of $418. Thus, the tax savings on the time value of money is $142 ($560 - $418).

 

21. A fire extensively damaged a small Alaska town where Intech Company had its primary plant. Intech decided to give $200 to each household that lost its residence. About 12% of the payments were made to Intech employees. Is the receipt of $200 by some Intech employees taxable as compensation or excludable as a gift?

The question to be resolved is whether the payments made to Intech employees are gifts (excluded) or are a form of compensation. In order to be a gift, the payment must be made with a "detached and disinterested generosity" that is out of "affection, respect, admiration, charity, or like impulses." In making this determination, the courts have held that it is the intention of the transferor that is the controlling factor in determining whether a payment is a gift. The facts would indicate that the payments to Intech employees do constitute gifts. Because Intech gave $200 to all households that suffered damage, the payments show detachment (payments to individuals that are not its employees) and charitable intent (helping out the community), with no specific intent to compensate its employees.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

22. On May 1, Raisa received a $10,000, 9% bond of Altomba Corporation as a graduation present from her Aunt Lenia. The bond pays interest on June 30 and December 31. What are the tax effects of this transfer for Raisa and Lenia for the current year?

The value of a gift is excluded from income. Under the assignment of income doctrine, Lenia is taxed on the $300 [$10,000 x 9% x (4 ÷ 12)] of interest earned up to the date of the gift. Because Raisa receives the entire $450 semi-annual interest payment, the $300 of interest earned by Lenia is part of the excludable gift. However, the exclusion is limited to the value of the gift. Any subsequent earnings on the bonds are taxable. Raisa must recognize $150 of interest from the June 30 payment and the entire $450 December 31 payment, a total of $600 of interest income for the year.

23. During the current year Alexis gives her daughter Tabatha stocks worth $80,000 on the condition that she pay her son Rory the first $7,000 in dividends on the stock each year. Discuss the taxability of this arrangement in each of the following cases.

The value of a gift is excluded from income. The receipt of the stock would not be taxable. Any subsequent earnings on the stock would be taxable. The question to be resolved is whether the transfer of the dividends from Tabatha to Rory is an assignment of income that will be taxed to Tabatha. In this case, Alexis is making a gift of up to $7,000 of the income from the stock to Rory. The gift of income is not excludable; it is taxed to Rory. Tabatha will only have income from any dividends she retains.

a. The stocks pay total dividends of $8,000. Tabatha pays Rory $7,000 under the agreement.

Rory includes the $7,000 in his gross income. Tabatha is taxed on the $1,000 of dividends that she retains.

b. The stocks pay total dividends of $5,500. Tabatha pays Rory $5,500 under the agreement.

Rory is taxed on the entire $5,500. Tabatha receives no dividends and has no income from the dividends.

Instructor's Note: If the terms of the gift required Tabatha to always pay Rory $7,000 regardless of the amount of dividends, then Tabatha would have to sell some of the stock in part b to make the required payment. In this case, the additional $1,500 payment would have been from principal and therefore, not subject to tax under the capital recovery concept.

24. Herman inherits stock with a fair market value of $100,000 from his grandfather on March 1. On May 1, Herman sells half of the stock at a gain of $10,000 and invests the $60,000 proceeds in Jordan County school bonds. The bonds' annual interest rate is 6%, which is paid on July 31 and January 31. On October 15, Herman receives a $2,200 dividend on the remaining shares of stock. How much gross income does Herman have from these transactions?

Herman must include the $10,000 capital gain from the sale of half of the stock and the $2,200 of dividend income in his gross income. The receipt of the inherited stock is excluded from income. However, any subsequent earnings on the stock is not part of the inheritance and must be included in gross income. The interest Herman receives from the Jordan County school bonds is excludable municipal bond interest.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

25. Fatima inherits a rental property with a fair market value of $90,000 from her aunt on April 30. On May 15, the executor of the estate sends her a check for $7,000. A letter accompanying the check states that the $7,000 comes from the rent received on the property since her aunt's death. Fatima receives $6,600 in rent on the property during the remainder of the year and pays allowable expenses of $4,200 on the property. How much gross income does Fatima have from these transactions?

Fatima has $2,400 ($6,600 - $4,200) of rental income from the property. The receipt of the inherited rental property is excluded. The $7,000 received from the estate is also an excludable inheritance. Although the $7,000 represents rent on the property, the estate held ownership during the period covered by the rental payments. Under the assignment of income doctrine, the owner of property is taxed on the income from the property, regardless of who actually receives the property. Therefore, the estate must include the $7,000 of rental income on its income tax return.

 

 

 

26. Allison dies during the current year. She is covered by a $1,000,000 life insurance policy payable to her husband Bob. Bob elects to receive the policy proceeds in 10 annual installments of $120,000. Write a letter to Bob explaining the tax consequences of the receipt of each installment.

Life insurance proceeds are excluded from tax. Therefore, the $1,000,000 face value of the policy is excluded as it is received. However, the earnings on the policy during the time it is held by the insurance company are not excludable. The total interest earned is $200,000 [($120,000 x 10) - $1,000,000]. As each payment on the policy is received, Bob will exclude $100,000 ($1,000,000 ÷ 10) and include $20,000 ($200,000 ÷ 10) in gross income.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

27. Earl is a student at Aggie Tech. He receives a $5,000 general scholarship for his outstanding grades in previous years. Earl is also a residence hall assistant, for which he receives a $1,000 tuition reduction and free room and board worth $6,000 per year. Earl's annual costs for tuition, books, and supplies are $8,000. Does Earl have any taxable income from the scholarship or the free room and board?

Earl has $7,000 ($6,000 + $1,000) of income from the receipt of the free room and board. Even if the room and board were considered to be a scholarship, it could not be excluded because it is designated for payment of costs that are not direct education costs. The $5,000 general scholarship is excluded because it is less than the actual direct costs.

NOTE: Earl may be able to exclude the value of the room and board and the $1,000 tuition reduction if it meets the requirements for meals and lodging provided by an employer. To exclude the value of meals, the meals must be provided on the employer's premises and be for the convenience of the employer. The same requirements are applicable to lodging with the extra provision that the lodging be required in order to accept employment. In determining whether this exclusion applies, one would first have to determine whether Earl is an employee of the residence hall. Assuming that he is, it does not seem that the meals would meet the convenience of employer test (there is no advantage to the employer in having Earl eat in the residence hall cafeteria) and would not be excludable. The lodging would meet the convenience test and would be excludable.

 

28. Assume the same facts as in problem 27, except that Earl is not a residence hall assistant and his general scholarship is for $10,000.

Scholarships can be excluded up to the amount of the direct education costs. In case a, the scholarship is less than the $8,000 of direct costs and fully excludable. In case b, the scholarship exceeds Earl's direct costs and he is taxed on the $2,000 excess.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

29. Fawn receives a $2,500 scholarship to State University. Discuss the taxability of the scholarship under each of the following assumptions:

a. The scholarship is paid from a general scholarship fund and is awarded to students with high academic potential. Recipients are not required to perform any services to receive the scholarship.

The scholarship is excluded from income to the extent of Fawn's direct education costs (tuition, fees, books, supplies, special equipment). The scholarship is excluded because it was awarded based on academic potential (i.e., all students were eligible for the scholarship) and there are no future services to be performed as a result of receiving the scholarship.

 

 

b. The scholarship is paid by the finance department. Recipients are required to work 10 hours per week for a professor designated by the department.

This is not a scholarship that is eligible for exclusion. To be excluded from income, a scholarship must be gratuitous in nature and not be a form of compensation for past, present, or future services. In this case, the recipient is required to provide future services as a condition of the award, making it a form of compensation; it is not a gratuitous transfer.

30. Determine whether the taxpayers in each of the following situations have realized taxable income:

a. Alexander inherited a tract of land from his uncle who died during the current year. A friend of Alexander's who is a petroleum engineer told him he thought there might be oil on the land. Alexander had the land surveyed, and an oil deposit worth an estimated $5,000,000 was discovered on the property.

The value of the land is excluded because it is received through inheritance. The discovery of the oil deposit does not constitute a realization. Although the form of the property may be altered by the discovery, the value of the discovery has not been realized through an arm's-length transaction.

 

b. Mickey was given 2 tickets to the World Series by a friend. Mickey sold the tickets for $500 apiece.

Mickey has realized income of $1,000 less his basis in the tickets. The receipt of the tickets is excluded as a gift. However, the subsequent sale of the tickets is not excludable. Note: The tickets have a basis equal to Mickey's friend's basis, which reduces the gain on the sale. Basis rules for gifts are covered in Chapter 10.

 

c. Hannah is the purchasing agent for Slim Diet Centers. Harold, a salesman who does considerable business with Hannah, gave her a set of golf clubs worth $750. Harold told Hannah that he was giving her the clubs to show his appreciation for being such a good friend throughout their business dealings.

The question to be answered is whether the golf clubs are a valid gift or a payment for past, present or future services. In this case, the business relationship is so strong that is likely that the golf clubs would not meet the criteria for a gift. It appears that Harold is attempting to compensate Hannah for their past relationship in hopes of continuing the relationship.

 

d. Melanie's father died during the current year. She was the beneficiary of a $200,000 insurance policy on her father's life. She received the proceeds on August 1 and immediately invested them in a bank certificate of deposit with a 9% annual earnings rate.

The receipt of the $200,000 face value of the life insurance policy is excluded from tax. However, any subsequent earnings on the $200,000 would be taxable.

 

31. Armando, a manager for Petros Pizza Pies (PPP), dies in an accident on July 12. PPP pays his wife, Penelope, $600 in salary that had accrued before Armando died. Armando was covered by a $90,000 group term life insurance policy, which is also paid to Penelope. In addition, the board of directors of PPP authorizes payment of $6,000 to Penelope and $4,000 to their child in recognition of Armando's years of loyal service and contributions to the success of the company. What are the tax consequences of the payments to Penelope and her child?

Penelope has $6,600 ($600 + $6,000) of gross income. Death benefit payments received after August 19, 1996 are fully taxable. Penelope must include in income the $6,000 she receives from PPP due to Armando’s loyal service and the $600 salary Armando earned prior to his death. The receipt of the $90,000 life insurance proceeds is excluded. Her daughter must include in income the $4,000 she receives from PPP.

 

 

32. Lucinda, a welder for Big Auto Inc. dies in an automobile accident on March 14 of this year. Big Auto has a company policy of paying $5,000 to the spouse of any employee who dies. In addition to the $5,000 payment, Big Auto pays Harvey, Lucinda's husband, $1,600 in salary and $1,100 in vacation pay Lucinda had earned before her death. Harvey also collects $120,000 from a group-term life insurance policy Big Auto provided as part of Lucinda's compensation package. Lucinda had contributed to a qualified employer sponsored pension plan. Big Auto had matched Lucinda's contributions to the plan. The plan lets the beneficiary of an employee who dies before payments begin take the plan balance as an annuity or in a lump-sum. Harvey elects to take the $250,000 plan balance in a lump-sum. Write a letter to Harvey explaining the tax consequences of each payment he receives.

Salary and vacation pay - the $1,600 salary and $1,100 of vacation pay were earned prior to Lucinda's death and must be included in gross income.

Payment due to death - the $5,000 payment to Lucinda’s spouse is included in gross income. Death benefits received after August 19, 1996 are fully taxable.

Life insurance proceeds - the $120,000 life insurance proceeds are excludable.

Pension plan payment - because the $250,000 is from a qualified plan, none of the amounts contributed to the plan or the earnings on the contributions have been subject to tax. Therefore, the entire $250,000 payment is taxable.

33. Joan is a single individual who works for Big Petroleum, Inc. During all of 2007, she is stationed in West Africa. She pays West African taxes of $17,000 on her Big Petroleum salary of $83,000. Her taxable income without considering her salary from Big is $37,000. How should Joan treat the salary she receives from Big Petroleum on her 2007 U.S. tax return?

Because Joan has worked in West Africa for the entire year, she has the option of excluding the $83,000 salary from her income (less than $85,700) or including the entire salary in her income and taking a foreign tax credit for the West African taxes she paid (the foreign tax credit cannot exceed the U.S. tax that would have been paid on her West African income). If Joan elects the exclusion option, her taxable income will be $37,000 ($83,000 - $83,000 + $37,000). The exclusion cannot exceed her salary. The tax on the $37,000 is the difference between the tax on the taxable income without the exclusion ($120,000) and the tax on the excluded amount ($83,000). Under the foreign tax credit option, her taxable income will be $120,000 ($83,000 + $37,000). Joan's net tax payable will be $351 ($10,360 versus $10,711) lower with the exclusion option:

Options:

1. Exclude $83,000 from taxable income:

Income tax on $120,000:

$15,698.75 + [28% x ($120,000 - $77,100)] $ 27,711

Less: Tax on $83,000

$15,698.75 + [28% x ($83,000 - $77,100)] 17,351

Equals: Tax on $42,000 $ 10,360

2. Foreign Tax Credit Alternative:

Income tax on $120,000:

$15,698.75 + [28% x ($120,000 - $77,100)] $ 27,711

Tax credit for West African taxes paid* (17,000)

Net tax due $ 10,711

Tax savings using exclusion option $ 351

* The foreign tax credit cannot exceed the amount of U.S. tax that would have been paid on the West African income. In this case, the U.S. tax on her West African income is $19,167 and Joan is allowed a foreign tax credit for the $17,000 of actual taxes paid:

$27,711 x ($83,000 ¸ $120,000) = $19,167

34. Boris is an unmarried systems specialist with a public accounting firm. During all of 2007, he is on temporary assignment in London. He pays $19,000 in British income tax on his $80,000 salary. Boris knows little about taxes and seeks your advice on the taxability of the salary he earns while in London. Write Boris a memorandum explaining the tax treatment of his London salary. Assume that Boris has no other income sources and that he does not itemize deductions.

Because Boris has worked in London for the entire year, he has the option of excluding his $80,000 British income (less than $85,700) from his U.S. income or including his British income in his U.S. income and taking a foreign tax credit for the $19,000 of British income tax he paid (the foreign tax credit cannot exceed the U.S. tax he would have paid on his British income). Boris should elect the option that provides the lowest U.S. tax. Without the exclusion, his taxable income is $71,250. If Boris elects to exclude $80,000 of his British income, his taxable income will be zero. Using the foreign tax credit, his net tax is also zero. He cannot get a refund of foreign taxes paid.

Calculation of taxable income without exclusion:

Gross income = adjusted gross income $ 80,000

Deductions from adjusted gross income:

Standard deduction (5,350)

Personal exemption (3,400)

Taxable income $ 71,250

Options:

1. Exclude $80,000 - Taxable Income = $0

 

2. Include $80,000 salary income

Tax on $71,250:

$4,386.25 + [25% x ($71,250 - $31,850)] $ 14,236

Tax credit for British taxes paid* (14,236)

Net tax $ -0-

 

* Because Boris entire U.S. tax is due to British income, his maximum tax credit is the $14,236 of U.S. taxes.

 

35. Zoie has worked for Humple Manufacturing for 16 years. Humple has a pension plan that matches employee contributions by up to 4% of an employee’s salary. Zoie, age 60, is ready to retire. She has contributed $20,000 to the plan. Under Humple’s pension plan, Zoie will receive $1,000 per month until she dies. Assume that Zoie is expected to live 25 more years. She wants to know the tax consequences of each pension payment that she would receive.

a. Assume Humple’s plan is a qualified pension plan.

Because no tax was paid on any amounts paid into the plan or the earnings from the plan, all payments received are included in Zoie’s gross income. As payments were made into the plan and income was earned, the income was deferred. When Zoie begins receiving payments from the plan, she must recognize all of the income that was deferred. Thus, Zoie will have $1,000 per month of gross income from each payment.

 

 

 

 

b. Assume Humple’s pension plan is not a qualified plan. Zoie has paid tax on all contributions into and earned by the plan.

Because Zoie has paid tax on all the contributions and earnings of the pension plan, the $1,000 she receives each month from the pension plan is not taxable.

 

 

 

36. Erwin works for Close Corporation for 24 years. Close has a qualified, noncontributory pension plan that pays employees with more than 5 years of service $100 per month per year of service when they reach age 65. Erwin turns 65 in February of this year and retires in June. Payments from Close's plan begin in July. In preparing for his retirement, Erwin had purchased an annuity 15 years ago for $26,000. The annuity pays $775 per month for life beginning at age 65. Erwin begins receiving the annuity payments in March. How much gross income does Erwin have from the receipt of the payments from Close and the annuity in the current year?

The payments from Close Corporation's qualified pension plan are fully taxable. In a qualified plan, contributions to the plan and earnings on assets in the plan are not subject to tax as they are made or earned. Therefore, all payments become taxable when they are paid out at retirement. Erwin will have $14,400 ($100 x 24 = $2,400 per month x 6 months in the current year) of income from the pension plan.

Erwin is not taxed on the portion of each annuity payment that is considered to be a return of his $20,000 investment. Under the simplified method, the recipient uses the IRS annuity table -- which represents the individual’s life expectancy in months-- to determine the number of months the individual is expected to receive the annuity. To determine the monthly amount that can be excluded, the recipient divides their investment in the annuity by the number of months the annuity is expected to be received (i.e., the table number). Using the table, Erwin is expected to receive 260 monthly payments from the annuity. As a result, $100 of each payment ($26,000 ÷ 260) is excluded from income

Erwin must include $675 ($775 - $100) of each payment in gross income. During the current year, he receives 10 payments, resulting in gross income of $6,750 ($675 x 10). Erwin’s gross income for the year is $21,150 ($14,400 + $6,750).

37. Bear Company provides all its employees with a $10,000 group term life insurance policy. Elk Company does not provide any life insurance but pays $10,000 to survivors of employees who die. Jackie, an employee of Bear Company, and her sister-in-law, Rosetta, an employee of Elk Company, both die during the current year. Their husbands, Bo and Carl, do not understand the tax effects of the $10,000 payments they receive. Write a letter to Bo and Carl explaining the tax effects of the $10,000 payments each receives.

Payments received from life insurance policies are excluded from the gross income of the recipient. Death benefit payments received after August 19, 1996 are fully taxable. In this case, the $10,000 insurance payments received by Bo is excluded from gross income. The $10,000 death benefit payment received by Carl is included in gross income. Even though both employers are attempting to provide for employees' families upon the death of an employee, the tax law favors the use of life insurance through its exclusion from gross income.

38. Horace is an employee of Ace Electric Co. Ace provides all employees with group term life insurance equal to twice their annual salary. How much gross income does Horace have under each of the following assumptions?

The first $50,000 of premiums paid on group-term life insurance are excluded from gross income. The premiums paid on coverage in excess of $50,000 must be included in gross income using the IRS premium table - Table 4-1, which gives the cost of life insurance premiums per $1,000 by age of the taxpayer.

 

a. Horace is 26 and earns $16,000 per year.

Horace's coverage is $32,000 (2 x $16,000) and all premiums paid are excluded from gross income under the $50,000 exclusion rule.

 

b. Horace is 26 and earns $42,000 per year.

The coverage is $84,000 and the premiums on $34,000 ($84,000 - $50,000) must be included in gross income. For a 26 year old, the amount of gross income is $24.48 (34 x $.72).

 

c. Horace is 63 and earns $42,000 per year.

The coverage is $84,000 and the premiums on $34,000 ($84,000 - $50,000) must be included in gross income. For a 63 year old, the amount of gross income is $269.28 (34 x $7.92).

 

d. Horace is 46 and earns $90,000 per year.

The coverage is $180,000 and the premiums on $130,000 ($180,000 - $50,000) must be included in gross income. For a 46 year old, the amount of gross income is $234 (130 x $1.80).

39. Abe is an employee of Haddock, Inc. Haddock provides basic health and accident insurance to all its employees through a contract with Minor Accident Insurance Company. Because the Minor policy does not cover 100% of medical costs, Haddock provides all executive officers with a self-insured plan to pay any medical costs not covered by Minor's policy. Abe is eligible for both plans. During the current year, premiums on the Minor policy for Abe were $1,450. Abe is reimbursed for $1,900 of his medical costs from the self-insured plan.

a. What are the tax consequences to Abe of the payments made by Haddock?

Because all employee's are covered by the policy, the premiums paid on the Minor policy are excludible. Self-insured medical reimbursement plans are also excludible if they do not discriminate in favor of highly compensated employees. In this case, it would appear that only highly compensated employees (executive officers) receive benefits from the plan and Abe would, therefore, be taxed on the $1,900 of reimbursements received from the plan.

 

b. What difference would it make if all employees were covered under both plans?

 

Because all employees are covered by both plans, the premiums paid on the Minor policy and the reimbursements from the self-insured plan are excludible from Abe's gross income.

 

 

 

40. Faldo, Inc., provides medical coverage to employees through a self-insured plan. Nick, the president of Faldo, receives $3,400 in medical expense reimbursements from the plan during the current year. Discuss the tax consequences to Nick under the following circumstances:

a. All employees are fully covered by the plan.

Payments made to employees from self-insured medical reimbursement plans are excluded from the employee's income if the plan does not discriminate in favor of highly compensated employees. Because all employees are covered by the plan, it is non-discriminatory and Nick excludes the $3,400 in payments from his gross income.

 

b. All employees are covered by the plan. However, only Faldo's executive officers are fully reimbursed for all expenses. All other employees are limited to a maximum reimbursement of $1,000 per year.

Even though all employees are covered by the plan, the limitation on medical expense reimbursements of employees who are not executive officers is discriminatory. Because all employees are entitled to a $1,000 reimbursement, only payments made to executive officers in excess of $1,000 are discriminatory and therefore, not eligible for exclusion. Nick must include the $2,400 ($3,400 - $1,000) excess reimbursement in his gross income. Note: Employees who are not executive officers can exclude the reimbursements they receive.

 

 

41. Hamid’s employer provides a high-deductible health plan ($1,100 deductible) and contributes $500 to each employee’s Health Savings Account. Hamid makes the maximum allowable contribution to his HSA. During the year, he spends $300 on qualified medical expenses and the HSA earns $18. What is the effect of Hamid’s participation in the HSA on his adjusted gross income?

Hamid’s adjusted gross income is reduced by $2,350 ($2,850 - $500). Hamid is not taxed on either the $500 contribution his employer makes to the HSA, the $18 in earnings on the account, or the $300 he receives from the account for qualified medical expenses. The maximum aggregate contribution to an HSA for a single taxpayer is $2,850 (2007 maximum). Because his employer contributes $500 to the account, Hamid’s maximum contribution is $2,350 ($2,850 maximum - $500 employer contribution). Hamid deducts his $2,350 HSA contribution for adjusted gross income.

42. Tia is married and is employed by Carrera Auto Parts. In 2007, Carrera established high-deductible health insurance for all its employees. The plan has a $2,200 deductible for married taxpayers. Carrera also contributes 5% of each employee's salary to a Health Savings Account. Tia's salary was $25,000 in 2007 and $27,000 in 2008. Tia makes the maximum allowable contribution to her HSA in 2007 and 2008. She received $600 from the HSA for her 2007 medical expenses. In 2008, she spends $1,400 on medical expenses from her HSA. The MSA earns $28 in 2007 and $46 in 2008. What is the effect of the HSA transactions on Tia's adjusted gross income? How much does Tia have in her HSA account at the end of 2008?

Contributions made to an HSA by an employer and earnings on amounts in an HSA are not taxable to the employee. Reimbursements for medical expenses are also excluded from income. Employees can deduct contributions to their HSA for adjusted gross income. The maximum aggregate contribution to an HAS for a married couple is $5,650 (2007). Carrera contributes $1,250 in 2007 and $1,350 in 2008. Tia can contribute $4,400 ($5,650 maximum contribution - $1,250 employer contribution) in 2007 and $4,300 ($5,650 maximum - $1,350 employer contribution) in 2008. Therefore, her adjusted gross income is reduced by $4,400 in 2007 and $4,300 in 2008. Unused amounts paid into an HSA are carried over for use in succeeding years.

At the end of 2008, Tia has $9,374 in her HSA account:

2007 employer contribution - $25,000 x 5% $ 1,250

2007 employee contribution 4,400

2007 medical expenses paid (600)

2007 earnings 28

Balance at end of 2007 $ 5,078

2008 employer contribution - $27,000 x 5% 1,350

2008 employee contribution 4,300

2008 medical expenses (1,400)

2008 earnings 46

Balance at end of 2008 $ 9,374

 

 

 

 

43. Adam works during the summer as a fire watcher for the Oregon forest service. As such he spends 3 weeks in the woods in a forest service watchtower and then gets a week off. Because of the remoteness of the location, groceries are flown in by helicopter to Adam each week. Does Adam have any taxable income from this arrangement? Explain.

Because the lodging is provided on the employer's premises, is for the convenience of the employer, and is required as a condition of employment, the value of the free lodging is excluded. However, the value of the groceries is not excludable. Only "meals" provided on the employer's premises can be excluded. Groceries have been held to not constitute "meals" and therefore, are taxable. Instructors Note: This is an example of the strict interpretation that is applied to exclusions. That is, the statute specifically allows the exclusion of meals. Therefore, only meals in the ordinary sense of the word are excluded from gross income.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

44. Don is the production manager for Corporate Manufacturing Facilities (CMF). CMF works three production shifts per day. Because Don is so integral to operations, the company requires him to live in housing that CMF owns so he can be available for any emergencies that arise throughout the day. The housing is located four blocks from the CMF plant. Is Don taxed on the value of the housing? Explain.

Yes, Don is taxed on the fair market value of the rental housing. In similar circumstances, the courts have held that the lodging is not eligible for exclusion because it is not provided on the employer's business premises. This is an example of the strict interpretation that is applied to exclusions. That is, the statute specifically allows an exclusion for lodging provided "on the employer's premises". Because the housing in this case is four blocks from the plant, it is not on CMF's business premises and therefore, not eligible for exclusion. See Dole v. Comm., 43 T.C. 697 aff'd., 351 F.2d 308 (1st Cir. 1965)

45. Determine whether the taxpayer has received taxable income in each of the following situations. Explain why any amount(s) may be excluded:

 

a. Jim is an employee of Fast Tax Prep, Inc. All employees of Fast Tax Prep are eligible for a 50% discount on the preparation of their income tax return. Jim's tax return preparation would normally have cost $300, but he paid only $150 because of the discount.

Because the discount is available to all employees, it qualifies for exclusion. However, the exclusion for discounts on services is limited to 20%. Thus, only $60 ($300 x 20%) of the $150 discount is excluded from gross income. The additional $90 discount is included in Jim's gross income.

 

b. Mabel is a lawyer for a large law firm, Winken, Blinken, and Nod. Winken pays Mabel's annual license renewal fee of $400 and her $300 annual dues to the American Lawyers' Association. Mabel also takes advantage of Winken's educational assistance plan and receives payment of the $6,000 cost of taking two night school courses in consumer law.

The payment of Mabel's licensing fees and association membership by Winken is excluded as a working condition fringe. That is, Mabel would have been able to deduct these costs as an employee business expense had she paid for them herself. Employees can exclude up to $5,250 of reimbursements from qualified educational assistance plans that reimburse an employee for the cost of coursework. Mabel must include $750 ($6,000 - $5,250) in gross income. However, depending on her adjusted gross income she can deduct the cost either as a deduction for adjusted gross income or as a miscellaneous itemized deduction (see Chapter 6). Alternatively, she might be able take a Lifetime Learning Tax credit on the $750 she reported as income (see Chapter 8).

 

c. Lori Company runs a nursery near its offices. Employees are allowed to leave their children at the nursery free of charge during working hours. Nonemployees may also use the facility at a cost of $300 per month per child. Dolph is an employee of Lori with 2 children who stay at Lori's facility while Dolph is at work.

The value of employer-provided day care is excluded up to a maximum of $5,000. In this case, the value received is $7,200 ($300 x 2 x 12) and Dolph is taxed on the $2,200 ($7,200 - $5,000) excess.

 

d. At the sporting goods store where Melissa works, her employer lets all employees to buy goods at a 40% discount. Melissa purchases for $300 camping and fishing supplies that retail for $500. The goods had cost her employer $250.

This is a qualified employee discount and is not taxable to Melissa. The discount is less than the employer's gross profit percentage (50%) and therefore, is not included in Melissa's gross income.

46. Courtney is an employee of Freemont Company. An average of three times a week, she works out during her lunch hour at a health club provided by Freemont. Discuss the taxability of Freemont’s provision of the health club in the following situations.

a. The health club is owned by Freemont and is located on its business premises. All employees and their dependents are allowed to use the facility. The cost of joining a comparable facility is $60 per month.

Employees can exclude the value of using an employer's athletic facility if the facility is on the employer's premises and substantially all of the use of the facility is by employees and their families. These conditions are met and Courtney does not have any income from the use of health club.

 

b. The health club is located in Freemont’s office building, but is owned by Manzer Fitness World. Freemont pays the $60 per month health club dues.

Because the health club is not owned by Freemont Co., Courtney cannot exclude the value of the health club dues. Courtney must include the $720 ($60 x 12) of health club dues paid by Freemont in her gross income.

 

c. Freemont is in the health club business. The health club is used primarily by customers, although several employees, including Courtney, use it, too.

Courtney cannot exclude the value of the health club dues under the provision for use of an employer's athletic facility because the primary use of the facility is by customers, not employees. However, if free use of the health club is available to all of Freemont's employees, it is excluded as a no-additional cost service. If all employees are not allowed to use the health club, then Courtney must include the $720 ($60 x 12) of health club dues in her gross income.

 

 

47. Dow, 42, is a manager for Winter Company. In addition to his $90,000 salary, he receives the following benefits from Winter during the current year:

Winter pays all its employees' health and accident insurance. Premiums paid by Winter for Dow's health insurance are $1,800.

Winter provides all employees with group term life insurance coverage equal to their annual salary. Premiums on Dow's $90,000 in coverage are $900.

Winter has a flexible benefits plan in which employees may participate to pay any costs not reimbursed by their health insurance. Dow has $3,000 withheld from his salary under the plan. His actual unreimbursed medical costs are $3,430. Winter pays Dow the $3,000 paid into the plan during the year.

All management-level Winter employees are entitled to employer-provided parking. The cost of Dow's parking in a downtown garage is $3,200 for the year.

Winter pays Dow's $150 monthly membership fee in a health club located in the building in which Dow works. Dow uses the club during his lunch time and on weekends.

Compute Dow's gross income for the current year.

Dow's gross income is $89,468:

 

Winter's company salary $ 90,000

Health and accident insurance premiums - excluded -0-

Group term life - premiums on $50,000 of coverage excluded

Excess premiums - $40,000 (40 x $1.20 from Table 4-1) 48

Payments into flexible benefits plan (3,000)

Free parking - $3,200 - (12 x $215)* 620

Health club membership fee - $150 x 12 1,800

Total gross income $ 89,468

* Employer-provided parking of up to $215 per month is excluded as a working condition fringe.

 

 

48. Becky, 45, is a senior vice president for South Publishing Co. During the current year, her salary is $125,000 and she receives a $25,000 bonus. South matches employee contributions to its qualified pension plan up to 10% of an employee's annual salary before bonuses. Becky contributes the maximum to the plan. She also receives the following benefits from South during the year:

• South has a cafeteria plan that allows all employees to select tax-free benefits or the cash equivalent on 5% of their annual salary before any bonus or pension plan payments. Becky uses the plan to purchase health and accident insurance for her daughter at a cost of $1,600, group term life insurance coverage of $200,000 at a cost of $1,300, and child care at a cost of $2,800. She takes the remaining $550 in cash.

• All executive officers' medical expenses are covered by a self-insured medical reimbursement plan. Becky is fully reimbursed for her $600 in medical expenses.

• South pays the employee's share of Social Security taxes on all executive employees' regular salaries.

• Executive officers are provided with covered parking at company headquarters. All other employees must pay for their own parking. Becky's free parking is worth $4,500 this year.

• Becky belongs to several professional organizations. South pays Becky's dues of $850. In addition, South pays the dues for all executive officers at one social club. South also pays Becky's $3,600 country club membership.

• The executive officers eat lunch in a private dining room at company headquarters. The purpose of the dining room is to encourage the officers to interact in an informal setting. They often discuss business but are not required to follow an agenda. The value of the meals Becky ate in the dining room this year is estimated at $1,900.

Compute Becky's gross income from South Publishing for the current year.

Becky's gross income is $154,198:

Salary $125,000

Less: Pension plan payments ($125,000 x 10%) (12,500)

Add: Bonus 25,000

Cash from cafeteria plan 550

Medical reimbursements 600

Group term insurance {($200,000 - $50,000) x $1.80] 270

Social Security paid by employer

[($97,500 x 6.2%) + ($125,000 x 1.45%)] 7,858

Employer provided parking [$4,500 - ($215 x 12)] 1,920

Dues to professional organizations -0-

Country club membership paid by employer 3,600

Meals in company dining room 1,900

Gross Income $154,198

49. Janet, 43, is an employee of Primus University. Her annual salary is $44,000. Primus provides all employees with health and accident insurance (Janet's policy cost $1,800) and group term life insurance at twice their annual salary rounded up to the nearest $10,000 ($90,000 of coverage for Janet). In addition, Primus pays the first $1,000 of each employee's Social Security contribution. The university has a qualified pension and a flexible benefits plan. Janet had $4,000 of her salary withheld and paid (and Primus matches the payment) into the pension plan. She also elects to have $1,300 of her salary paid into the flexible benefits plan. Because her medical costs were lower than expected, Janet gets back only $1,250 of the $1,300 she paid into the plan. What is Janet's gross income for the current year?

Janet's gross income is $39,748:

Salary $ 44,000

Health and accident insurance - excluded -0-

Group term life insurance - premiums on $50,000 excluded

Excess premiums $40,000 (40 x $1.20 from Table 4-1) 48

Payment of Social Security tax by employer 1,000

Payments made to qualified pension plan (4,000)

Payments into flexible benefits plan (1,300)

Gross income $ 39,748

The payment of $1,000 of Janet's Social Security tax is a payment of an expense by another that is intended to be compensation. Therefore, it is included in Janet's gross income as compensation.

Payments made by an employee into a qualified pension plan are not subject to tax (they are deferred until withdrawn from the plan) and reduce the employee's gross salary. Similarly, payments made by an employer into an employee's qualified pension plan are deferred until they are withdrawn.

Payments into a flexible benefits plan are treated as reductions of salary. The full amount paid into the plan is a reduction of Janet's gross income. The $50 ($1,300 paid-in - $1,250 expenses paid from the plan) becomes the property of the plan and Janet no longer can benefit from the $50. Therefore, she does not adjust the reduction in her salary for the $50.

 

 

50. Theresa is an employee of Hubbard Corporation with an annual salary of $60,000. Hubbard has a cafeteria plan that lets all employees select a total of 10% of their annual salary from a menu of nontaxable fringe benefits. Theresa selects medical insurance that costs the company $4,200, and $50,000 worth of group-term life insurance that costs the company $1,000, and takes the remainder in cash. What is the effect of Hubbard's cafeteria plan on Theresa's gross income?

Theresa is not taxed on the value of the nontaxable fringe benefits she takes using the cafeteria plan. However, she is taxed on the $800 [($60,000 x 10%) - $4,200 - $1,000] cash she takes in lieu of nontaxable fringe benefits.

 

51. Determine the taxability of the damages received in each of the following situations:

 

a. Helio Corporation sues Wrongo Corporation, charging that Wrongo made false statements about one of Helio's products. Helio claims that the statements injured its business reputation with its customers. The court awards Helio $2,000,000 in damages.

Helio must include the $2,000,000 in damages in gross income. The exclusion for damages is based on personal physical injuries to the taxpayer. Because a corporation is an artificial entity, it cannot suffer a personal injury and must include any damages it receives in gross income.

 

b. Lien is injured when a chair on a ski lift she is riding on comes loose and crashes to the ground. Lien sues the ski resort and receives $12,000 in full payment of her medical expenses, $4,000 for pain and suffering, and $6,500 for income lost while she recovers from the accident. The company that manufactured the ski lift also pays Lien $50,000 in punitive damages.

Lien has gross income of $50,000. Payments received for personal physical injury or sickness are excluded from income. Loss of income payments are included in income unless they are paid as a result of a personal physical injury. Because the $6,500 loss of income payment is made on account of personal injury, it qualifies for exclusion. Punitive damages are included in gross income. Therefore, the $50,000 payment to Lien is included in her gross income. The $12,000 she receives for medical expenses and the $4,000 of pain and suffering payments are payments for a personal physical injury, and are excludable.

 

c. A major broadcasting company reports that Dr. Henry Mueller was engaged in Medicare fraud. The doctor is incensed and sues the company for libel. The court rules that the report was made with reckless disregard for the truth and awards Mueller $20,000 for the humiliation he suffered because of the allegation, $200,000 for loss of his business reputation, and $150,000 in punitive damages.

Dr. Mueller has gross income of $370,000. The $20,000 payment for humiliation is not a personal physical injury and is included in gross income. The $150,000 punitive damage payment and $200,000 for loss of business reputation are also included in gross income.

 

52. May was injured when a forklift tipped over on her while she was moving stock in the company warehouse. Because of her injuries, she could not work for three weeks. Her employer paid her $400, which was half her normal wages for the three-week period. She also received $600 in workers' compensation for the injury. May is required to include the $400 she received from her employer in her gross income but excludes the $600 workers compensation payment. Discuss why the payments are taxed differently.

The payments received from her employer are substitutes for her income and must be included in gross income. Workers' compensation payments are payments to make the person whole again after the injury (a recovery of capital) and are excluded from gross income.

 

 

 

 

 

 

 

 

 

53. Bill was severely injured when he was hit by a car while jogging. He spent one month in the hospital and missed three months of work because of the injuries. Total medical costs were $60,000. Bill received the following payments as a result of the accident:

His employer-provided accident insurance reimbursed him for $48,000 of the medical costs and provided him with $3,800 in sick pay while he was out of work.

A private medical insurance policy purchased by Bill paid him $12,000 for medical costs.

His employer gave Bill $6,000 to help him get through his rehabilitation period.

A separate disability policy that Bill had purchased paid him $4,000.

How much gross income does Bill have as a result of the payments received for the accident?

Bill has gross income of $9,800 from the $3,800 of sick pay from his employer and the $6,000 the employer gave him to get through his rehabilitation period.

The medical reimbursement payments received are not taxable. The payments from the employer's policy are less than the actual medical costs and therefore, excluded from gross income. The payments received from the plan Bill purchased are always excluded from gross income.

The disability policy payment is also excluded from gross income because the policy was purchased by Bill.

 

 

54. Determine the tax treatment of the payments received in each of the following cases:

a. Anastasia is covered by her employer's medical insurance policy. During the current year, the policy reimburses her for $960 of the $1,200 in medical costs she incurred.

Payments received for medical expenses from an employer-provided insurance policy are excluded from income. The exclusion is limited to the actual medical costs incurred. Because the reimbursement is less than actual costs, Anastasia excludes the $960 reimbursement.

 

b. Alfredo, who is self-employed, is injured in a snowmobile accident. The insurance he purchased covers $3,200 of the $3,900 in medical costs related to the accident. It also pays him $2,000 to cover the income he loses during his recuperation.

All payments received from medical insurance policies purchased by the taxpayer are excluded from income. Because Alfredo purchased the policy, he excludes all amounts received from the policy (even the $2,000 loss of income payment).

 

c. Libby is injured when a company truck backs over her at a warehouse. The company pays her $2,200 in medical expenses from its self-insured medical reimbursement plan. (All employees are covered by the plan.) During her recuperation, the company pays her normal $1,300 salary. In addition, she receives $600 from an insurance policy the company purchased to cover its liability to injured employees.

Libby has gross income of $1,900 ($1,300 + $600). Payments received from a non-discriminatory self-insured medical reimbursement plan are excluded from income. The $1,300 in salary she receives is not a payment related to the personal physical injury (she would have received it without the injury). Payments for medical expenses, loss of limbs, disfigurement, etc. received from employer-provided medical policies are excluded. The payment from the employer's liability policy does not meet these criteria and cannot be excluded from gross income.

 

d. Shortly after beginning work for El Dorado Corporation, Manny is injured when a lathe he is operating breaks his leg. Because he has not worked for the company long enough to qualify for employee medical insurance coverage, the company pays his $800 medical bill.

Manny has $800 of gross income. The payment is not made from an employer-provided insurance policy or from a non-discriminatory medical reimbursement plan.

 

 

55. Determine Rona's gross income from the following items she receives during the current year:

Interest on savings account $ 300

Dividends on Microsoft stock 200

Interest on Guam development bonds 2,000

Dividend on life insurance policy

(The company is a mutual life insurance

company, and the dividend is a return of

part of the premiums she paid on the policy.) 200

In addition, Rona owns 1,000 shares of Cochran Corporation common stock. Cochran has a dividend reinvestment plan through which stockholders can receive a stock dividend equal to 4% of their holdings in lieu of a cash dividend of equal value. Rona takes the 40 shares of stock, which are worth $3 per share.

Rona has gross income of $620 [$300 + $200 + $120 (40 x $3)]. The interest on the Guam development bonds is excluded because Guam is a possession of the United States. The $200 received from the life insurance policy is a return of capital investment (the premium paid) and is not taxable. Because the dividend reinvestment plan has a cash option, Rona must include the fair market value of the 40 dividend shares in her gross income.

Note: The $200 in dividends from the Microsoft stock is taxed as a net long-term capital gain at a tax rate of 15% (the rate would be 5% if her marginal tax rate is either 10% or 15%).

 

 

 

 

 

 

 

 

 

56. Horatio owns Utah general purpose bonds with a face value of $50,000 that he purchased last year for $52,000. During the current year, Horatio receives $2,400 in interest on the bonds. In December, Horatio sells the bonds for $48,000. What is the effect of the bond transactions on Horatio’s gross income for the current year?

Interest received on debt obligations of U.S. state and local governments and U. S. possessions is excluded from gross income. Thus, Horatio does not have to include the $2,400 in interest he received on the bonds in gross income. However, any gains or losses from dealing in the bonds are subject to taxation. In this case, Horatio has a loss of $4,000 ($48,000 - $52,000) from the sale of the bonds. The $4,000 loss is a capital loss that Horatio will net against other capital gains and losses occurring during the year. If Horatio has no other capital gains and losses, he can deduct $3,000 of the loss for adjusted gross income. The remaining $1,000 is carried forward to the following year.

 

57. Determine the amount of gross income Elbert must recognize in each of the following situations:

a. In October, Elbert sells city of Norfolk bonds with a face value of $6,000 for $5,800. Elbert had purchased the bonds 2 years ago for $5,200, and had received $450 in interest on the bonds before he sold them.

Interest received on municipal bonds is excluded from income. Elbert is not taxed on the $450 in interest he receives on the bonds. However, the exclusion is for interest received on such bonds, not for gains (or losses) in buying and selling the bonds. Elbert must include the $600 ($5,800 - $5,200) gain on the sale of the sale of the bonds in his gross income as a long-term capital gain.

 

b. Elbert owns 1,000 shares of Tortoise, Inc., common stock for which he had paid $8,000 several years ago. Tortoise declares and distributes a 20% stock dividend during the current year. On December 31, Tortoise common stock is selling for $10 per share.

Elbert is not in receipt of income from the receipt of a stock dividend. His wealth has not increased as a result of the receipt and it has not been realized through an arms-length transaction. Stock dividends are specifically excluded from gross income unless a cash option exists.

 

c. In December, Elbert sells city of Quebec bonds with a face value of $7,600 for $7,200. Elbert had purchased the bonds in January for $7,700, and received $950 in interest on the bonds before he sold them.

Elbert must include the $950 bond interest received in his gross income. Only interest on obligations of state and local governments of the United States and its possessions are excluded from income. Elbert will also include the $500 ($7,200 - $7,700) loss on the sale of the bonds in his income calculation as a short-term capital loss.

 

 

58. Maysa is considering making an investment in municipal bonds yielding 4%. What would the yield on a taxable bond have to be to provide a higher after-tax return than the municipal bond if Maysa is in a 35% marginal tax rate bracket?

The taxable bond will have to have a yield greater than 6.15% to provide a higher after-tax yield. This is determined by setting the tax-free rate equal to the after-tax rate, x, and solving for x:

.04 = x - .35x

.04 = .65x

.04 = .65x

.65 .65

.0615 = x

 

 

 

 

 

59. Return to the facts of problem 58. Assume that Maysa bought $5,000 par value of Rondo Corporation bonds for $4,500. The bonds pay 8% interest annually. Three years later, the price of the bonds has increased to $6,200. Maysa can purchase municipal bonds yielding 5.5%. Should she sell the Rondo Corporation bonds and buy the municipal bonds?

Maysa receives $400 ($5,000 x 8%) of taxable interest on the bonds. Her tax on the bond interest is $140 ($400 x 35%), leaving her $260 after-tax. This is a 5.78% after-tax return (on original cost) which is greater than the 5.5% after-tax return on the municipal bond.

However, If she sells the bonds Maysa will have the $6,200 proceeds less the capital gains tax to invest. Selling the bonds results in a long-term capital gain of $1,700 and she will pay a tax of $255 ($1,700 x 15%) on the gain. This will leave her $5,945 ($6,200 - $255) to reinvest. If she purchases the municipal bonds, she will receive $327 ($5,945 x 5.5%) in after-tax interest. Therefore, selling the Rondo Corporation bonds will allow her to invest the unrealized gain she has made on the bonds and result in her having $67 ($327 - $260) more after-tax income than she currently receives.

 

60. Vito is having financial difficulties. Among other debts, he owes More Bank $300,000. Rather than lend Vito more money to help him out, More Bank agrees to reduce his debt to $200,000.

Discharges of debt generally constitute taxable income. However, if the taxpayer is insolvent (liabilities exceed assets) before the discharge, no income is recognized if the taxpayer remains insolvent after the discharge. However, if the discharge makes the taxpayer solvent, income must be recognized to the extent of the taxpayer's solvency (a measure of wherewithal-to-pay) after the discharge.

a. How much gross income must Vito recognize if his assets total $600,000 and his liabilities are $400,000 before the forgiveness of debt?

Because Vito is solvent before the forgiveness of debt, the full $100,000 (300,000 - $200,000) debt reduction is included in his gross income.

 

b. Assume the same facts as in part a, except that Vito's liabilities are $800,000 before the forgiveness of debt.

In this case, Vito is insolvent before ($600,000 - $800,000) and after [$600,000 - ($800,000 - $100,000) = ($100,000)] the discharge. Therefore, he is not taxed on the $100,000 forgiveness of debt.

 

c. Assume the same facts as in part a, except that Vito's total liabilities are $625,000 before the forgiveness of debt.

Vito is insolvent before the forgiveness ($600,000 - $625,000) and solvent [$600,000 - ($625,000 - $100,000) = $75,000] after the forgiveness. He must recognize $75,000 of the forgiveness as gross income, the extent to which he is solvent after the discharge.

 

61. Orts Block and Tackle Shop is experiencing cash flow problems. Among other debts, Orts owes Cowdrey State Bank $80,000. After negotiations, Cowdrey agrees to reduce Orts's debt to $50,000 with a 1% increase in the interest rate on the $50,000 debt. How much income does Orts have from the debt reduction under the following circumstances?

Income from discharges of debt generally constitute taxable income. Orts has obtained a claim of right to the $30,000 ($80,000 - $50,000) reduction in debt and is taxed under the general income recognition principles. However, if Orts is insolvent (liabilities exceed assets) before the discharge, no income is recognized if he remains insolvent after the discharge. In cases where the discharge makes Orts solvent, income must be recognized to the extent of his solvency (a measure of wherewithal-to-pay) after the discharge.

a. Orts is a sole proprietorship owned by A.J. A.J.'s total assets are $180,000 and his total liabilities are $200,000 before the debt reduction.

A.J. is insolvent before the forgiveness ($180,000 - $200,000) and solvent [$180,000 - ($200,000 - $30,000) = $10,000] after the forgiveness. He must recognize $10,000 of the forgiveness as gross income, the extent to which he is solvent after the discharge.

 

b. Assume the same facts as in part a. The Cowdrey debt was incurred to buy a storage building with a current fair market value of $40,000. The building cost $120,000 when it was purchased in 1991 and has an adjusted basis of $90,000.

As in part a, A.J. could exclude $20,000 of the debt reduction under the general insolvency rule. However, because the debt relates to real property used in a trade or business of an individual, A.J. has the option of using the exception for qualified real property business indebtedness. Under this option, A.J. can exclude the lesser of:

1. $90,000, his adjusted basis

OR

2. $40,000 ($80,000 indebtedness before the discharge minus $40,000 market value of the property).

This provision will allow A.J. to exclude the entire $30,000 debt discharge. He must reduce the basis of the property by the amount of the exclusion to $60,000 ($90,000 - $30,000).

 

c. Assume the same facts as in part b, except that Orts is organized as a corporation.

Orts can exclude $20,000 of the $30,000 debt discharge. Although the general insolvency exception applies to corporations, the qualified real property business indebtedness exception does not apply to corporations.

 

 

62. Helena has assets of $130,000 and liabilities of $160,000. One of her debts is for $120,000. Discuss the tax consequences of the reduction of this debt in each of the following circumstances:

a. The debt was incurred by Helena for medical school expenses. She borrowed $120,000 from her grandfather, who agreed to reduce the debt to $80,000, because Helena had done so well in school.

The reduction in the debt by her grandfather would be considered a gift. As such, Helena would not be taxed on the forgiveness.

 

b. The debt was incurred to buy property used in Helena's business. To help Helena get back on her feet, the bank that loaned her the money agreed to reduce the debt to $80,000.

Because Helena is insolvent before the debt reduction ($130,000 - $160,000) and solvent after the debt reduction $130,000 - [$160,000 - ($120,000 - $80,000)] = $10,000, Helena must recognize the forgiveness of debt to the extent that she is solvent after the debt reduction, $10,000.

 

c. The debt was incurred to buy equipment used in Helena's business. Because the equipment did not perform as advertised by the manufacturer, the manufacturer, who had financed the purchase, agreed to reduce the debt to $80,000.

This would not be a forgiveness of debt because the reduction of the debt was due to nonperformance of the equipment. Therefore, the reduction of the debt is an adjustment of the selling price of the equipment. Helena will have to reduce her basis in the equipment by the $40,000 reduction in the selling price. This is an application of the substance over form doctrine that taxes transactions according to their economic substance (a reduction in selling price), rather than their form (a reduction of debt).

 

63. Determine the amount of income that must be recognized in each discharge of indebtedness situation that follows. Assume in all cases that the related debt was incurred before 1993.

Discharges of debt on qualified real property business indebtedness can be excluded from income by taxpayers other than corporations. The amount of the exclusion is limited to the lesser of: 1) the property's adjusted basis, or 2) the excess of the debt before the discharge over the fair market value of the property. Note that this exclusion is only effective when the fair market value of the property is less than the amount of the debt before the discharge.

a. Noreen owns a building with a fair market value of $90,000 that she uses in her construction business. The building is secured by a debt of $120,000 and has an adjusted basis of $25,000. The lender reduces the debt to $75,000.

The debt qualifies for the exclusion because it is used in Noreen's trade or business and the debt was incurred before 1993. The total debt discharge is $45,000 ($120,000 - $75,000). However, only $25,000 of the debt can be excluded:

Maximum exclusion is the lesser of:

1. the adjusted basis of the building = $25,000.

OR

2. the excess of the debt before the discharge over the fair market value of the property = $120,000 - $90,000 = $30,000.

Noreen must include $20,000 ($45,000 - $25,000) of the debt reduction in gross income. The basis of the building must be reduced by the $25,000 exclusion, leaving an adjusted basis of $0.

 

b. Armando owns a building with a fair market value of $400,000 that he uses in his business. The building is secured by a debt of $520,000 and has an adjusted basis of $300,000. The lender reduces the debt to $300,000.

The debt is qualified real property business debt. The total debt discharge is $220,000 ($520,000 - $300,000). Armando can exclude $120,000 of the $220,000 debt reduction.

Maximum exclusion is the lesser of:

1. the adjusted basis of the building = $300,000.

OR

2. the excess of the debt before the discharge over the fair market value of the property = $520,000 - $400,000 = $120,000.

The remaining $100,000 of the debt reduction must be recognized in gross income. In addition, he must reduce the basis of the building by the amount of the exclusion to $180,000 ($300,000 - $120,000).

 

c. Newton purchased a warehouse to use in his wholesaling business in 1988 at a cost of $260,000. The warehouse is currently worth $240,000 and has an adjusted basis of $220,000. Newton's business has been experiencing financial difficulties and his bank agrees to reduce the $180,000 debt on the warehouse to $150,000 to help him out.

The debt is qualified real property business debt. The total debt discharge is $30,000 ($180,000 - $150,000). Newton cannot exclude any of the $30,000 debt reduction because the fair market value of the property exceeds the amount of debt before the discharge:

Maximum exclusion is the lesser of:

1. the adjusted basis of the warehouse = $220,000.

OR

2. the excess of the debt before the discharge over the fair market value of the warehouse = $180,000 - $240,000 < $0.

Newton will include the $30,000 debt reduction in gross income. No adjustment is made to the basis of the warehouse.

 

 

64. Paulsons Partnership owns a building that it has rented out to Corner Grocery Store for the last 10 years. Corner went out of business and returns the property to Paulsons. Corner had made improvements to the store costing $30,000 during the 10-year lease period. The partnership had paid $60,000 for the building, which is now worth $200,000. Does Paulsons have any gross income from the ending of the lease? Discuss when Paulsons will recognize any income from the building.

Paulsons Partnership does not have any income from the return of the property. The value of improvements made to property by a lessee are specifically excluded from gross income until they are realized through an arm's-length transaction. Similarly, the increase in the value of the building has not been realized and would not be included in gross income when the property is returned. Any income from the improvements made by the lessee and the increase in the value of the property will be recognized when a realization of the value occurs (i.e., it is sold or otherwise disposed of in a taxable transaction). It will be realized in the form of a gain (i.e., the difference between the amount realized on the sale and the adjusted basis of the property).

 

 

 

 

 

 

 

 

 

 

 

 

65. Jonas owns a building that he leases to Dipper, Inc., for $5,000 per month. The owner of Dipper has been complaining about the condition of the restrooms and has proposed making improvements that will cost $24,000. Dipper's owner is willing to pay to have the improvements made if Jonas will reduce the monthly rent on the building to $4,000 for one year. Write a letter to Jonas explaining the tax effects for Jonas of the proposal by Dipper's owner.

Improvements made by a lessee to property are not income to the lessor until the lessor realizes the value of the improvements (i.e., the property is sold or otherwise disposed of in a taxable transaction). However, if the improvements are made in lieu of rental payments, the improvements must be included in the gross income of the lessor as rental income.

In this case, the improvements attributable to the $1,000 ($5,000 lease agreement - $4,000 proposed rent for one year) monthly rent reduction will have to be included in Jonas gross income because they are made in lieu of the normal rental payment. Jonas will have $12,000 (12 x $1,000) of rental income under the proposal. The remaining cost of the improvements to the property will not be recognized until Jonas realizes the value of the improvements through sale or other taxable disposition of the property. The $12,000 rental reduction improvements are capitalized and included in Jonas’ basis in the building.

ISSUE IDENTIFICATION PROBLEMS

In each of the following problems, identify the tax issue(s) posed by the facts presented. Determine the possible tax consequences of each issue that you identify.

66. A tornado extensively damaged the community in which Bodine Company had its primary manufacturing facilities. Bodine gives $1,000 to each household that suffered damage from the tornado to help residents while repairs are being made. Some (but not all) of the payments are made to Bodine employees.

The issue to be resolved is whether the payments made to Bodine employees are gifts (excluded) or are a form of compensation. To be a gift, the payment must be made with a "detached and disinterested generosity" that is out of "affection, respect, admiration, charity, or like impulses." In making this determination, the courts have held that it is the intention of the transferor that is the controlling factor in determining whether or not a payment is a gift. The facts would indicate that the payments to Bodine employees do constitute gifts. Because Bodine gave $1,000 to all households that suffered damage, the payments show detachment (payments to individuals that are not its employees) and charitable intent (helping out the community).

 

 

 

 

 

 

 

 

 

 

67. Kermit receives a $1,000, 6% bond of General Foods, Inc., from his uncle Ed as a graduation present. The bond pays interest on June 30 and December 31. Kermit receives the bond on May 1.

The issue is to determine who is taxed on the interest payments. The receipt of the bond is not taxable because gifts are excluded from gross income. However, any subsequent earnings on gift property are not part of the gift and are subject to taxation. Even though Kermit owns the bond on June 30 and receives the interest payment, he only recognizes the interest that was earned during the time he held the bond. Under the assignment of income doctrine, the owner of property is taxed on the income from the property. Ed owned the bond until May 1 and must recognize the $20 [($1,000 x 6% x (4 ¸ 12)] of interest earned during this period. Kermit recognizes the remaining $40 of interest on the June 30 payment and the $60 December 31 payment in his gross income.

 

 

68. Hersh inherits $50,000 from his grandfather. He receives the money on January 1 and immediately invests $25,000 in General Motors bonds that pay 8% annual interest and $25,000 in Lane County highway improvement bonds with a 6% annual interest rate.

The issue to be resolved is the taxation of the amounts invested in the bonds. The receipt of the $50,000 inheritance is excluded from gross income. However, any subsequent earnings on the inherited property are not part of the inheritance and thus, not excluded from tax. The interest on the General Motors Bonds is taxable and Hersh must include the $2,000 ($25,000 x 8%) of interest in his gross income in the year he receives the interest. The Lane County bonds are municipal bonds, the interest on which is excluded from tax. Therefore, the $1,500 ($25,000 x 6%) of interest Hersh receives on the bonds is excluded from gross income.

 

 

 

 

 

 

 

 

 

 

 

 

 

69. Than's grandmother dies and leaves him jewelry worth $40,000. In addition, he is the beneficiary of a $100,000 life insurance policy that his grandmother had bought before she retired.

The issue is whether Than is taxed on the amounts received from his grandmother. The receipt of the jewelry is not taxable because inherited property is excluded from income. Similarly, the $100,000 life insurance proceeds are not taxed because life insurance proceeds are excluded from income.

 

70. Binh met Anika 10 years ago at a cocktail party. Anika was a wealthy investor with extensive holdings in the oil and gas industry. Binh was a real estate agent earning about $35,000 a year. Several months later, Binh proposed marriage and Anika accepted. Just before the wedding, Anika told Binh that she had a "mental hangup" about marriage, and Binh agreed to live with her without being married. In return, Anika promised to leave Binh her entire estate. In the ensuing years, they had an intimate, marriage-like relationship, attending social, business, and family functions together. Anika died in 2004. No will was found immediately. A few months after Anika's death, her sister found a one-page paper signed by Anika. The paper left Anika's entire estate to her brothers and sisters and named her sister as executor of the estate. Binh sued Anika's estate and won a judgment of $2 million for services rendered to Anika during their relationship. The estate appealed the decision, which was affirmed as to liability but reversed and remanded for a new trial on the amount of the judgment. Binh and the estate subsequently worked out an agreement in which the estate paid Binh $1.2 million to settle his claim.

The issue to be resolved is whether the $1.2 million is an excludible inheritance or is taxable compensation. The substance over form doctrine requires that transactions be taxed according to their true intention. Thus, a key to resolving this problem is whether Anika intended to leave Binh any part of her estate. Because Binh was specifically left out of Anika's will, on form there is no indication of any intention to bequest part of her estate to Binh. Because Binh sued to receive the claim on Anika's estate, the taxability of the $1.2 million depends on the nature of the claim Binh asserted and the actual basis of the recovery. If the settlement award is a substitute for income, then the payment is taxable. Although not clear from the facts, it appears that the basis of the settlement award was for services rendered to Anika and therefore, compensatory in nature. However, if the basis for the settlement was that Binh had provided "husbandly services" for Anika, then the payment is not compensatory in nature, and can be excluded.

Instructor's Note: This problem is based on the facts of Green v. Comm., 846 F.2d 870 (2nd Cir. 1988). It is an excellent demonstration of how the legal interpretation or theory can affect the tax treatment of a transaction.

 

71. Ariel has worked for Sander Corporation for 30 years. Sander has a pension plan in which it matches employee contributions by up to 5% of the employee's salary. Ariel retires during the current year when she is 66 years old. Her pension plan contains payments and earnings of $300,000, half of which are attributable to payments made by Ariel and half attributable to payments made by Sander. Under the plan, Ariel is to receive $2,000 per month until she dies.

The issue is the amount of each $2,000 payment that is included in gross income. If Sander’s pension plan is a qualified plan, no tax has been paid on any of the amounts paid into the plan or the earnings on the plan. As payments were made into the plan and income was earned by the plan, the income was deferred. Therefore, all payments received are included in Ariel's gross income if the plan is a qualified plan. When Ariel begins receiving the amounts from the plan, she must recognize all of the income that has been deferred.

If the plan is not qualified, Ariel has paid tax on the amounts paid into and earned by the plan. Therefore, the receipts should not be taxed again. The payments are in the form of an annuity and only amounts received which have not been previously included in her gross income are subject to tax. The simplified method is used to determine how much of each annuity payment is excluded from tax:

$300,000 ¸ 210 (Table 3-1) = $1,429 Excluded

$2,000 - $1,429 = $ 571 Taxable

Instructor’s Note: The solution assumes that Ariel is single.

 

 

 

 

 

 

 

72. Ikleberry is a self-employed fisherman. He buys a health insurance policy by donating 1,000 salmon filets to the Nordisk Insurance Companyís annual Christmas party. During the year, Ikleberry receives $321 in reimbursements from the plan.

The issue is whether Ikleberry should recognize $321 as disguised compensation for his services or exclude the money as a reimbursement on his health insurance policy. If Nordisk Insurance Company was Ikleberry’s employer in this transaction, Ikleberry could exclude the health insurance reimbursement. Thus, the best answer is to exclude the reimbursement on the health insurance. Ikleberry should recognize income from the salmon equal to the cost of the insurance policy.

 

73. Salina is an apartment manager and is paid $6,000 per year. The owner of the apartments offered her the option of a $300-per-month living allowance or the use of an apartment rent-free. Salina chose to live in the apartment, which normally rents for $400 per month.

The issue is whether Salina is taxed on the receipt of the rent-free apartment and if so, how much income would she recognize. The use of the apartment rent-free is compensation. Employer provided lodging is excludible if it is on the employer’s premises, for the convenience of the employer, and is required as a condition of employment. Because the use of the apartment is not a job requirement, Salina is taxed on her free use of it. Under the cash-equivalent approach, Salina must include the $400 per month fair rental value of the apartment in her gross income.

 

 

 

 

 

 

 

 

 

 

74. Taki was injured in an airplane crash. He sues the airline and receives $4,400 for his pain and suffering, $3,300 for lost wages while he recuperated from his injuries, and $7,000 in punitive damages. He also uses $1,000 from his Medical Savings Account to pay for medical expenses related to the crash. Taki had deposited $1,400 in the account during the year.

 

The issues to be resolved are the taxability of each of the payments Taki receives. Payments received for personal physical injury or sickness are excluded from gross income. Loss of income payments are included in gross income unless they are paid as a result of personal physical injury. Punitive damages are always included in gross income. Takiís reimbursement from his medical savings account is not included in gross income. In this case, all the payments except the $7,000 punitive damages are excluded from Taki’s income. Taki has $7,000 of gross income.

75. Sonya purchases a house for $65,000. The seller had listed the house for sale at $80,000 but got into financial trouble and had to accept Sonya's $65,000 offer to avoid bankruptcy.

The issue is whether Sonya has any income from the purchase of the house below its listed price. A bargain purchase is taxable if the seller is trying to compensate the buyer through a reduced purchase price. In this case, there is no business relationship between Sonya and the seller. Therefore, the reduction in the sales price is not compensatory in nature and Sonya does not have any income from the purchase of the house.

 

 

 

 

 

 

 

 

76. Bud borrows $20,000 from a friend. Before he can repay any of the loan, the friend dies. His friend's will provides that any amounts owed to him are to be forgiven upon his death.

The issued to be resolved is whether this is a discharge of indebtedness that is taxable, or an inheritance that would be excluded from income. Because the claim on the debt is included in the friend's estate and subject to estate tax, the relief from the claim would, in effect, be a distribution of the claim to Bud. Thus, it would be excluded as an inheritance, not a taxable discharge of debt.

 

 

 

 

 

 

 

 

77. Perry Corporation leases a building to Jimison Corporation for $10,000 per month. The terms of the lease provide that any improvements to the building will revert to Perry upon termination of the lease. During the current year, Jimison adds a wing to the building at a cost of $50,000.

The issue is whether Perry Corporation must recognize the $50,000 improvement to its building as income when the improvement is made. Improvements made by a lessee to property are not income to the lessor until the lessor realizes the value of the improvements (i.e., the property is sold or otherwise disposed of in a taxable transaction). Therefore, Perry does not recognize the $50,000 as income when the improvement is made.

78. TAX SIMULATION CASE. In April, a tornado damages the house owned by Delbert and Debbie. The damaged residence required extensive repairs, making it necessary for Delbert and Debbie to move into a motel and eat their meals in restaurants. During the repair period they incur $1,200 for lodging at a motel, $800 for meals (their normal grocery costs would have been $220), and $150 for laundry services (Delbert usually does the laundry, but the $150 includes $40 in dry cleaning costs they would have incurred if they hadn’t moved out of their residence). Included in the cost of the meals is $250 for lunches they normally would have incurred. They continue to make the $785 mortgage payment on their residence but their home utility expenses are only $80 (they normally would have paid $240 for utilities if they had occupied the residence). Their insurance company reimburses them $2,150 for the living expenses they incur while their residence is being repaired.

Required: Determine the income tax treatment of the receipt of the $2,150 from the insurance company. Search a tax research database and find the relevant authority (ies) that forms the basis for your answer. Your answer should include the exact text of the authority (ies) and an explanation of the application of the authority to Delbert and Debbie’s facts. If there is any uncertainty about the validity of your answer, indicate the cause for the uncertainty.

Sec. 123(a) allows the exclusion of amounts received from insurance that are paid for living expenses of an individual (and members of the individual’s household) that result from the loss of use or occupancy of a principal residence due to damage caused by fire, storm, or other casualty.

Sec 123(a) General Rule.—In the case of an individual whose principal residence is damaged or destroyed by fire, storm, or other casualty, or who is denied access to his principal residence by governmental authorities because of the occurrence or threat of occurrence of such a casualty, gross income does not include amounts received by such individual under an insurance contract which are paid to compensate or reimburse such individual for living expenses incurred for himself and members of his household resulting from the loss of use or occupancy of such residence.

Although Delbert and Debbie qualify for this exclusion, Sec. 123(b) limits the exclusion to the excess of actual living expenses over the normal living expenses that would have been incurred during the period of time the principal residence is not occupied.

Sec. 123(b) Limitation.—Subsection (a) shall apply to amounts received by the taxpayer for living expenses incurred during any period only to the extent the amounts received do not exceed the amount by which—


123(b)(1) the actual living expenses incurred during such period for himself and members of his household resulting from the loss of use or occupancy of their residence, exceed


123(b)(2) the normal living expenses which would have been incurred for himself and members of his household during such period.

Reg. Sec. 1.123-1(a)(2) expands on Sec. 123(b) by stating that the exclusion is limited to the reimbursement of "reasonable" and "necessary" expenses that maintain their normal standard of living during the loss period.

(2) This exclusion applies to amounts received as reimbursement or compensation for the reasonable and necessary increase in living expenses incurred by the insured and members of his household to maintain their customary standard of living during the loss period.

Reg. Sec. 1.123-1(b)(1) states that, in general, the excludable is for excess expenses actually incurred due to the casualty for rent, transportation, food, utilities, and miscellaneous services.

Generally, the excludable amount represents such excess expenses actually incurred by reason of a casualty, or threat thereof, for renting suitable housing and for extraordinary expenses for transportation, food, utilities, and miscellaneous services during the period of repair or replacement of the damaged principal residence or denial of access by governmental authority.

Reg. Sec. 1.123-1(b)(2) states that for expenses (eg., food and transportation) that are normally incurred, only the increase in the expense is considered to be an actual living expense.

To the extent that the loss of use or occupancy of the principal residence results merely in an increase in the amount expended for items of living expenses normally incurred, such as food and transportation, only the increase in such costs shall be considered as actual living expenses in computing the limitation.

In determining normal living expenses, Reg. Sec. 1.123-1(b)(3) requires normal living expenses that are not incurred (or are reduced) due to casualty to be counted at the decreased amount.

(3) Normal living expenses not incurred.—Normal living expenses consist of the same categories of expenses comprising actual living expenses which would have been incurred but are not incurred as a result of the casualty or threat thereof. If the loss of use of the residence results in a decrease in the amount normally expended for a living expense item during the loss period, the item of normal living expense is considered not to have been incurred to the extent of the decrease for purposes of computing the limitation.

Reg. Sec. 1.123-1(b)(4) provides an example and method of computing the excludable amount by comparing actual costs incurred to normal costs that are not incurred. Based on this calculation format, Delbert and Debbie can exclude $1,480 of the $2,150 and must include the remaining $670 in their gross income.

Normal not Increase

Actual Incurred (decrease)

Lodging $1,200 $ -0- $1,200

Meals 800 220 580

Lunches 250 (250) -0-

Laundry 150 40 110

Utilities 80 240 (160)

Total $2,480 $ 750 $1,730

Note that the mortgage payment is not considered in the calculation. Although not evident from reading the code or the regulation, Example 1 in Reg. Sec. 1.123-1(b)(4) indicates that a mortgage payment results from a contractual obligation that has no causal relationship to the casualty and therefore, is not considered to be an actual living expense that results from the loss of use of the residence.

An alternative way to calculate the exclusion is to compare the excess of each payment over the normal living expenses not incurred as a result of the casualty. The excess lodging cost is $1,040 ($1,200 - $240 + $80), excess meals total $580 ($800 - $220), and excess laundry costs are $110 ($150 - $40). The sum of the excess costs gives the $1,730 ($1,040 + $580 + $110) exclusion amount.

79. INTERNET ASSIGNMENT The Small Business Job Protection Act of 1996 limited the exclusion for damages received to nonpunitive damages received on account of a personal physical injury or physical sickness. The new law specifically disqualifies emotional distress as a physical injury or physical sickness. Accompanying each new tax law is a committee report that provides an explanation of the new law. Use the Internet to find the joint conference committee report that discusses this law change and determine what Congress includes in its definition of emotional distress.

A good place to start the research is to visit a page with "cool" tax links. For example, see the page created by Professor Dennis Schmidt at www.taxsites.com. From there you will click on a succession of links to Federal Tax Law. Then, under Congressional Information click on Thomas Legislative Information. At this point you are at the webpage for the U.S. Congress. Click on Committee Reports and then click on 104th Congress (1995-1996). Using the search engine provided type in "physical injury". Your search should provide you with the Small Business Job Protection Act. At this point, you need to scroll down until you reach Code Section 104 which discusses the new law and how it specifically disqualifies emotional distress as a physical injury or physical sickness.

 

INSTRUCTOR'S NOTE: Information on the Internet is developing at a rapid pace. Therefore, this solution may become outdated. We suggest that you do the assignment prior to assigning it to your students. This will allow you to provide students with any additional information they may need to complete the assignment.

80. Internet Assignment In the U.S. tax system, employers can provide a wide array of nontaxable fringe benefits to employees. Excluding fringe benefits from taxation is one method of encouraging employers to provide such benefits to their employees. Australia takes a different approach to the tax treatment of fringe benefits. Go to the Australian government web site (http://www.ato.gov.au) and locate the government publication that deals with fringe benefits. Explain the Australian tax treatment of fringe benefits. Choose two of the fringe benefits listed in the publication and compare their treatment with the U.S. tax system treatment.

Australia imposes a fringe benefits tax on employers for fringe benefits provided by employers to employees. The publication describing the tax can be found at: http://www.ato.gov.au/business

The menu on the left-hand side contains links to tax topics one of which is fringe benefits. The publication indicates that "The term benefit is broadly defined and includes any right (including any property right), privilege, service, or facility. The publication goes on to state that:

"As a rule of thumb, the following question may be of assistance in deciding if the benefit is provided in respect of employment. Would the benefit have been provided if the recipient had not been an employee?"

Thirteen specific benefits are discussed in the publication:

1. Car fringe benefits

2. Loan fringe benefits

3. Debt waiver fringe benefits

4. Expense payment fringe benefits

5. Housing fringe benefits

6. Board (meal) fringe benefits

7. Airline transportation fringe benefits

8. Living away from home allowance fringe benefits

9. Entertainment provided by a tax-exempt organization

10. Meal entertainment fringe benefits

11. Car parking fringe benefits

12. Property fringe benefits

13. Residual fringe benefits

 

INSTRUCTOR’S NOTE: Information on the Internet is developing at a rapid pace. Therefore, this solution may become outdated. We suggest that you do the assignment prior to assigning it to your students. This will allow you to provide students with any additional information they may need to complete the assignment.

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CHAPTER 5

 

INTRODUCTION TO BUSINESS EXPENSES

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DISCUSSION QUESTIONS

 

1. All allowable deductions of individual taxpayers are classified as either for adjusted gross income or from adjusted gross income. Why are deductions for adjusted gross income usually more advantageous than deductions from adjusted gross income?

Although both types of deductions reduce taxable income, deductions for adjusted gross income are always deductible. Taxpayers who incur allowable deductions from adjusted gross income may not receive the full advantage of the deduction. First, even though an allowable expense may be incurred, if the taxpayer's total itemized deductions do not exceed the standard deduction amount, then the taxpayer will deduct the standard deduction and receive no benefit from the allowable expenses. Second, many of the deductions are subject to limitations based on the taxpayer's adjusted gross income. For example, the deduction for medical expenses is reduced by 7 1/2% of the taxpayer's adjusted gross income. Thus, many of the allowable deductions from adjusted gross income are not deductible in full. In addition, total itemized deductions are subject to a reduction rule when the taxpayer's adjusted gross income exceeds a specified amount, further lowering the value of such deductions. Lastly, given the reductions based on adjusted gross income, any deductions for adjusted gross income have the effect of making the allowable deductions from adjusted gross income larger.

 

2. Why does the computation of adjusted gross income apply only to individual taxpayers and not to other tax entities such as corporations?

Individuals are allowed to deduct certain personal expenditures in computing their taxable income (e.g., medical expenses, home mortgage interest) that are not deductible under the general rules for deductions. In allowing these deductions, Congress separated them from individual deductions that have a business purpose and provided a minimum deduction that all taxpayers can deduct for personal expenditures (the standard deduction). Therefore, the personal nature of the deductions causes the split nature of individual deductions, requiring the intermediate computation of adjusted gross income. In contrast, corporations are separate legal entities formed for a business purpose. Therefore, all of their expenditures qualify for deduction under the general rules. Corporations make no personal expenditures, so there is no need to segregate their deductions.

 

3. What is the fundamental requirement that must be satisfied to deduct a business expense?

The dominant motive for incurring the expense must be to earn an economic benefit that is independent of any tax savings. Thus, the business purpose of the transaction must be a profit motive other than tax avoidance.

 

4. What are the two primary categories of business expense? Why is it necessary to classify business expenses in these two categories?

The two categories of business expense are:

• Trade or business expenses, and

• Expenses for the production of income (investment expenses).

All expenses must be classified into one of the categories to determine the proper reporting and limitations on the deduction of the expenses. A trade or business expense is fully deductible in calculating adjusted gross income of an individual. An expense for the production of income is usually subtracted from adjusted gross income as an itemized deduction. As an itemized deduction, the expense may be limited based on the taxpayer's adjusted gross income. Also, the taxpayer will only receive a benefit from a production of income expense if the taxpayer itemizes his/her deductions.

 

5. Why must a conduit entity report certain deductions separately?

Unlike a corporation, a conduit entity (partnership or S corporation) is not a separate taxable entity. The income and deductions from the conduit entity flow through to each owner. Separately reporting certain deductions preserves the tax treatment for the expenditure and assures that the expenditure receives the same tax treatment as if it was actually incurred by the taxpayer. For example, investment expenses are classified as miscellaneous itemized deductions and must be reduced by 2% of adjusted gross income. If investment expenses are included in determining the entity’s ordinary taxable income, an individual would receive a greater deduction (the full amount) from the expenditure. The following deductions must be separately stated: charitable contributions, investment interest expense, investment expenses, Section 179 expense, and nondeductible expenses.

 

6. What is the effect on a partner's individual tax return if a partnership does not report separately the partner's pro rata share of investment expenses and instead includes these expenses in determining the partnership's ordinary taxable income?

The effect of not separately reporting investment expenses is to understate the individual's taxable income. For example, assume that Helen is a 50% partner in a partnership that has income net of deductions of $10,000 ($40,000 income - $30,000 deductions), $2,000 of which is for investment expenses. By including the investment expenses in computing ordinary taxable income, Helen's share of the partnership's ordinary taxable income is $5,000 ($10,000 x 50%). However, if the investment expenses is separately stated, the ordinary taxable income is $12,000 [$40,000 - (30,000 - $2,000)] and Helen's share is $6,000 ($12,000 x 50%). As a 50% partner, Helen's share of the investment expense is $1,000. If Helen's other itemized deductions are only $2,000 then she would not receive any benefit from the investment expenses because her standard deduction would exceed her itemized deductions [$5,000 > ($2,000 + $1,000)]. Therefore, Helen's taxable income increases by $1,000 ($6,000 versus $5,000) because the investment expenses are reported separately. Instructor’s Note: The purpose of the question is to illustrate the impact separately reporting items can have on a taxpayer’s taxable income. At this stage of the course students do not know that investment expenses are reduced by 2% of adjusted gross income (see Chapter 8).

 

 

7. The rules for deducting business expenses assure that virtually all expenses related to a trade or business or a production of income activity are deductible at some time during the life of the activity. However, few personal expenditures are deductible. Why is there such a difference in treatment of the expenses?

Allowing individuals to deduct most of their individual living expenses would be an administrative nightmare. Individuals would have to document their expenses and the government would have to spend more time and effort ensuring that the expenses were valid. In addition, individuals with expensive life styles would receive proportionately more deductions than those who tend to save.

The tax law takes into account the fact that not all of the income earned by an individual is available for the payment of taxes by allowing certain personal expenditures as deductions from adjusted gross income. For those taxpayers that incur minimum amounts of the allowable expenditures, a minimum deduction for personal expenditures, called the standard deduction, is allowed. In addition, taxpayers are allowed to deduct exemption amounts for themselves and for other individuals that are dependent on them for support. These deductions are discussed in Chapter 8.

 

8. Discuss how well the rules for deducting expenses implement the ability-to-pay concept.

The deduction of expenses implements the ability-to-pay concept by allowing taxpayers with differing levels of expenses to pay a tax based on their net income. However, the rules for deducting expenses do create a bias toward a trade or business, which is allowed to deduct all ordinary, necessary, and reasonable expenses. The ordinary, necessary, and reasonable expenses related to the production of income are also deductible. However, such expenses (other than those related to rentals and royalties) are deductible from adjusted gross income for individuals. Therefore, individuals must itemize their deductions to be able to deduct their investment related expenses. Further, the expenses are generally deductible as miscellaneous itemized deductions which are subject to a 2% of adjusted gross income limitation. This reduces the deduction for such expenses and may cause individuals to pay more tax on their investment income than would be paid on comparable trade or business income. Only certain personal expenditures may be deducted. These expenses are allowed only as deductions from adjusted gross income and therefore, are deductible only if they exceed the standard deduction. In addition, many of the allowable deductions are subject to a limit based on the taxpayer's adjusted gross income. This has the effect of allowing more deductions for lower income taxpayers than for higher income taxpayers, thus enhancing the ability-to-pay concept. However, the restrictiveness of the allowable personal deductions puts them at a disadvantage relative to trade or business and production of income deductions.

 

9. How are mixed-use expenditures and expenses related to mixed-use assets treated for tax reporting?

A mixed-use expense must be analyzed to determine the portion of the expense that is allowed as a deduction. Only that portion of the expense that has a business purpose (or is an allowable personal expense) is deductible. This requires determination of the deductible business expense using a reasonable allocation method. The expense allocated to personal use is not deductible unless it qualifies as a specifically allowed itemized deduction.

 

10. What is the difference between a trade a trade or business and a production of income activity and why is it important to distinguish a trade or business activity from a production of income activity?

The term trade or business has not been adequately defined in the Internal Revenue Code or the Treasury regulations. Whether an activity is a trade or business is determined on a case by case basis by examining the facts related to the activity.

The Supreme Court has indicated that the following factors are important in classifying an activity as a trade or business:

1. The primary purpose of the activity must be to earn a profit,

2. There must be regularity and continuity in the taxpayer's involvement in the activity, and

3. The activity must be engaged in to earn a livelihood and not as a hobby or for amusement.

As a practical matter, selling goods and services will be viewed as a trade or business. In addition, an employee will normally be considered engaged in a trade or business. Generally, an investor in securities is not deemed to be in a trade or business regardless of the level of investment activity.

An activity will be considered to be for the production of income if it is profit motivated (i.e., it has a business purpose) but fails to satisfy the more rigorous trade or business tests. Thus, lack of regularity and continuity by the taxpayer in the activity can result in classification of an activity as being for the production of income. Also, involvement in an activity for profit but not to provide the taxpayer's livelihood can result in production of income classification.

All of the ordinary, necessary, and reasonable expenses of a trade or business and a production of income activity are deductible. However, trade or business expenses of individuals are deductible for adjusted gross income, while production of income expenses are deductible from adjusted gross income usually as miscellaneous itemized deductions. To deduct production of income expenses, an individual must itemize deductions, while trade or business expenses are always deductible in full. Trade or business expenses are not subject to any income limitation, while the deductible portion of production of income expenses is limited to the amount in excess of 2% of adjusted gross income. Because trade or business expenses reduce adjusted gross income, any itemized deductions that are subject to a limit based on adjusted gross income are increased as a result of deducting the business expenses, while production of income expense deductions have no effect on the amount of other allowable deductions.

 

 

11. What requirements must be met to deduct a trade or business expense? an expense related to the production of income?

In addition to having a profit motivated business purpose, several tests must be satisfied for an expenditure to be currently deductible as a trade or business expense or as an expense related to the production of income. The expense must be:

1. Ordinary,

2. Necessary,

3. Reasonable in amount,

4. Related to earning income and not a personal expense, and

5. For the taxpayer's benefit.

The expense may not be:

1. A personal expense,

2. Capital in nature,

3. A violation of public policy, or

4. Related to earning tax-free income.

 

12. When are capital expenditures deductible?

A capital expenditure is any expenditure in which the usefulness of the expenditure extends substantially beyond the end of the current tax year. As such, a capital expenditure must be capitalized and allocated to the periods benefited by the expenditure using an acceptable accounting method (i.e., amortization or depreciation). Depreciation is discussed in Chapter 10.

 

13. How do you distinguish a currently deductible expenditure from a capital expenditure? Give examples of each type of expenditure.

Determining whether an expenditure is a current expense versus a capital expenditure requires an analysis of the period benefited from the expenditure. If the expenditure benefits only the current period, it is deducted as a current period expense. Capital expenditures have a benefit that extends substantially beyond the end of the year in which the expenditure is made. Examples of current period expenses include salaries, utilities, taxes, interest, supplies, repairs, and maintenance costs. Capital expenditures include all long-lived asset purchases such as buildings, cars, machinery, equipment, furniture, land, and prepaid expenses.

 

 

14. Why are start-up costs related to the investigation of a business opportunity treated differently depending on the current trade or business of the taxpayer?

The difference in treatment stems from the business purpose of the expenditure and whether the expenditure is considered ordinary, necessary, and reasonable. When investigating the purchase of a business that is in the same trade or business that the taxpayer is currently engaged, the purpose is directly related to the taxpayer's trade or business. In addition, such investigation is considered ordinary, necessary, and reasonable (i.e., all businesses look toward expansion). Therefore, the costs associated with the investigation are currently deductible expenses.

When a taxpayer investigates the purchase of a business that is unrelated to their current trade or business, the business purpose of the expenditure is not related to their current trade or business. In addition, the courts have held that such expansion is not ordinary. Therefore, the costs are capital in nature. If the investigation does not result in the purchase of the business, the costs are considered to be personal (no business purpose has ever been established) and nondeductible. If the investigation results in the purchase of the business, a taxpayer who incurs less than $50,000 of start-up costs can deduct up to $5,000 of the start-up costs in the year the new business is started. Any amount in excess of $5,000 must be amortized over 180 months. For taxpayers, with start-up costs in excess of $50,000, the $5,000 amount is phased-out on a dollar-by-dollar basis. Therefore, the deduction for start-up costs can be viewed as consisting of two parts. The first is a $5,000 current deduction and a second part that amortizes the remaining start-up costs over 180 months.

 

15. Explain the rationale for not allowing a deduction for political and lobbying expenditures.

The conceptual reason for denying deductions for political contributions and lobbying expenses is that such expenses are not ordinary and necessary to a taxpayer's trade or business. In upholding the denial of a deduction for political contributions, the courts have maintained that the money had an "insidious influence" on politics and that the tax system should not promote expenditures that encourage the frustration of public policy. The rationale for disallowing lobbying expenses is to remove the tax incentive associated with a taxpayer's attempt to influence legislation. Note: A taxpayer who incurs a de minimus amount of lobbying expenses (up to $2,000) is permitted to deduct the lobbying expenses.

 

16. Explain why the income tax concepts support a deduction for some of the expenses of an illegal business.

Under the all-inclusive income concept, all income received is taxable unless otherwise excluded. Thus, income from illegal activities is subject to tax. The ability-to-pay concept requires the tax to be an amount that the taxpayer can afford to pay. Therefore, unless Congress legislatively disallows a deduction for an expenditure(s) associated with an illegal activity, as they have for expenses incurred in the trade or business of illegal drugs, the expenditure is deductible.

17. Why are expenses related to the production of tax-exempt income not deductible?

Because the income is not subject to tax, no deduction is necessary to insure that the taxpayer has the ability-to-pay the tax. To allow a deduction for expenses related to tax-exempt income would create a situation in which an investment in tax-exempt income producing activities would lower the tax paid on taxable forms of income. This would create a double tax break for investments that produce tax-exempt income.

18. Explain the rationale for the treatment of deductions related to hobbies, vacation homes, and home offices.

Hobbies, vacation homes, and home offices all produce income that is taxable under the all-inclusive income concept. The ability-to-pay concept specifies that the cost of producing the income should be deductible. However, because hobbies, home offices, and vacation homes all involve a significant personal element, the amount of the allowable deductions is limited to the income generated.

 

19. What is/are the requirement(s) for determining whether a residence used for personal purposes is a vacation home or a true rental property?

A mechanical test based on the number of days of personal use of the property is used to determine whether the property is a vacation home or a true rental property. In order to qualify as a true rental property, the taxpayer's personal use of the property cannot exceed the greater of 1) 14 days, or 2) 10% of rental days. If personal use exceeds this amount, the property is a vacation home.

 

20. Under what circumstances can a taxpayer deduct the costs of a home office?

To deduct the cost of a home office, the office must be used regularly and exclusively as either the taxpayer's principal place of business or as a place for meeting customers or clients. Employees can only deduct home office expenses if the use of the office is "for the convenience of the employer." In most cases, employee use of a home office is for the employee's convenience, not the employer’s. Therefore, situations in which an employee can deduct home office costs are relatively rare.

In addition, a taxpayer that uses a home office to conduct substantial administrative or management activities and has no other fixed location to conduct these activities is allowed to deduct the cost of a home office. The taxpayer still must use the home office exclusively and on a regular basis in carrying on a trade or business.

 

21. What is/are the criterion (criteria) for the deduction of an expense by a cash basis taxpayer?

Cash basis taxpayers are allowed to take a deduction in the year in which the expense is paid. However, even cash basis taxpayers cannot take current deductions for the full amount of current period capital expenditures.

 

22. What constitutes the payment of an expense by a cash basis taxpayer?

An expense can be paid with any cash-equivalent. Therefore, the strict payment of cash is not necessary to fix the year of deduction. If an expense is paid with property, the payment is made when title to the property passes. Expenses paid with services are deductible when the service is performed.

 

 

23. What are the criteria for the current deduction of a prepaid expense by a cash basis taxpayer?

To deduct a prepaid expense, the benefit of the payment must not extend substantially beyond the end of the tax year. This is interpreted to mean that the pre-payment was required and the benefit of the expense must be used or consumed before the end of the tax year following the year of payment (the one-year rule). There are exceptions to this rule - for example, prepaid taxes are always deductible in the year of payment, while prepaid interest (other than points paid to acquire a home mortgage) is never deductible under the one-year rule. The deduction for home mortgage points is discussed in Chapter 8.

 

24. What tests must be met for an accrual basis taxpayer to deduct an expense?

An accrual basis taxpayer deducts expenses when the all-events test and the economic performance tests are satisfied. The all-events test requires that all events have occurred that determine the fact that a liability exists and the amount of the liability must be known with reasonable accuracy. This last requirement generally requires that the payee of the expense be known in addition to the amount of the liability.

The economic performance test requires that economic performance with regard to the liability must have occurred. This generally means that services or property related to the liability have either been received or used by the taxpayer.

 

25. What is the general purpose of the economic performance test?

The purpose of the test is to disallow current deductions for costs that will not be paid in the near future. Thus, estimates of future contingent liabilities (e.g., estimated warranty costs) cannot be deducted until economic performance on the liability occurs.

 

 

PROBLEMS

 

26. Alexandra is a veterinarian employed by Fast Vet Services. Susan is a self-employed veterinarian. During the current year, Alexandra and Susan have the same amounts of income and deductions. Why might a deductible expense paid by Susan affect her taxable income differently from the payment of the same expense by Alexandra?

Because Susan is self-employed, her vet practice constitutes a trade or business. Therefore, all of her veterinary expenses are deductible for adjusted gross income. As an employee, Alexandra is also considered to be in a trade or business. However, the unreimbursed expenses of an employee are deducted as miscellaneous itemized deductions. Thus, Susan always gets the full benefit of the deduction, while Alexandra only benefits if she itemizes her deductions and then only to the extent that her unreimbursed business expenses exceed 2% of her adjusted gross income.

 

 

 

 

 

 

 

 

 

 

 

 

27. Discuss how an individual would deduct each of the following expenditures. If more than one treatment is possible, discuss the circumstances under which each type of deduction would be obtained:

a. Amos purchased 500 shares of Lietzke stock for $50 per share. He also paid $1,200 in commissions on the purchase.

Commissions paid are part of the cost of acquiring the stock and must be added to the basis of the stock. Because stock does not have a definite life, capital recovery does not occur until Amos disposes of the stock.

b. Dandy owns an optical store. She paid $2,000 in medical insurance premiums on her employees and $1,400 on a medical policy covering herself and her family.

The $2,000 of premiums paid on employees’ insurance is deductible as an ordinary and necessary business expense (for adjusted gross income). If Dandy owns the store as a sole proprietor, she is not an employee of the store and cannot deduct the $1,400 as a business expense (just as an employee could not deduct the cost of personal medical insurance as a business expense). As a self-employed individual, Dandy can deduct all of the cost of her policy for adjusted gross income (see Chapter 6).

c. Oscar is a finance professor at State University. He purchased professional journals costing $400 which he uses to keep current on the latest developments in finance.

Oscar is considered to be in a trade or business and the journals are related to his trade or business. However, employees are only allowed to deduct expenses related to their employment as miscellaneous itemized deductions, which are subject to a 2% of adjusted gross income limitation (see Chapter 8).

d. Gerry is a nurse. He paid $350 for nursing uniforms.

Gerry is considered to be in a trade or business and special clothing required in a trade or business is deductible. If he is an employee of a hospital or doctor, he will only be allowed to deduct the cost of the uniforms as a miscellaneous itemized deduction (which is subject to a 2% of adjusted gross income limitation). However, if he is self-employed, the cost of the nursing uniforms would be deducted for adjusted gross income.

e. Edgar owns a rental property. His rental income for the year was $13,000, and his allowable expenses were $9,000.

Rental expenses are always deductible for adjusted gross income without regard to whether the rental activity is a trade or business or a production of income activity. As a practical matter, the expenses are netted against the income from the rental and the net amount is reported on the tax return. In this case, $4,000 ($13,000 - $9,000) would be included in gross income.

28. Determine how each of the following expenses would be deducted for tax purposes. If the expense is not deductible, explain why not.

a. Chander paid $500 in interest on a loan he used to purchase equipment for his retail business.

The interest is related to a trade or business and is fully deductible. If the business is a sole proprietorship, it will be a deduction for adjusted gross income.

b. Peter paid $500 in interest on a loan he used to purchase 1,000 shares of Pickled Pepper stock.

The interest is related to an investment. Investment interest expense is deductible as an itemized deduction. It is limited to the amount of the taxpayer's net investment income (see Chapter 8).

c. Portia paid $500 in interest on a loan she used to purchase her personal automobile.

The interest is related to a personal use asset and is not deductible.

d. Jordan's primary source of income is his wholesale warehousing business. During the current year, he paid $8,000 in state income taxes.

State income taxes are a personal expense that is allowed as an itemized deduction.

e. Alphonse is a professional golfer who likes to race cars in his spare time. He spent $60,000 on expenses related to racing cars during the current year.

The expenses are not related to his trade or business as a golfer. To determine the proper treatment of the expense, it would have to be determined whether Alphonse's involvement in the race car business meets the criteria for a trade or business. Based on the facts as given, it would appear that the activity has a significant pleasure element that would disqualify the activity as a trade or business. If so, it would most likely be a hobby. Hobby deductions are limited to hobby income and are only deductible as miscellaneous itemized deductions.

f. Barry is an insurance agent. He bought a golf cart and had his insurance company logo put on the golf cart to attract customers while he played golf.

The cost of the golf cart would not be a deductible business expense since it is not used in Barry's trade or business. The cost of the logo is a form of advertising that is deductible as a business expense.

29. Andy, Azim, and Ashwin operate the Triple-A Steak House, a popular restaurant and bar. The three, who have been friends since childhood, are equal partners in the establishment. For the year, Triple-A reports the following:

Sales revenues $ 800,000

Short-term capital gains 24,000

Short-term capital losses (12,000)

Business expenses (560,000)

Investment expenses ( 6,000)

Taxable income $ 246,000

How must the Triple-A Steak House report its results to each partner for tax purposes?

Because capital gains and losses and investment expenses are subject to special rules, these items cannot be used to calculate the partnership’s ordinary taxable income. Instead, these items must be reported separately by the partnership. The short-term capital gains and losses are reported separately and netted with the partners’ other capital gains and losses. The investment expenses are treated as miscellaneous itemized deductions and must be reduced by 2% of adjusted gross income on the partner’s returns.

The ordinary taxable income of the partnership is $240,000 ($800,000 sales - $560,000 trade and business expenses). Since Andy, Azim, and Ashwin are equal partners, the Triple-A partnership would report the following amounts to each partner:

 

Taxable ordinary income ($ 240,000 ¸ 3) $ 80,000

Short-term capital gain ($24,000 ¸ 3) 8,000

Short-term capital loss ($12,000 ¸ 3) (4,000)

Investment expenses ($ 6,000 ¸ 3) (2,000)

 

 

 

30. Manuel and Fernando own and operate an electronics store, Electronica, as an S corporation. Manuel owns 70%, and Fernando owns 30%. For the current year, the store reports the following:

Sales revenue $1,000,000

Long-term capital gains 8,000

Business expenses (840,000)

Charitable contributions (9,000)

Non-deductible expenses (4,000)

Short-term capital losses (15,000)

Operating income $ 140,000

a. How must Electronica report its results to Manuel and Fernando for tax purposes?

Because capital gains and losses and charitable contributions are subject to special rules, these items cannot be used to calculate the corporation’s ordinary taxable income. Instead, these items must be reported separately by the S corporation. Also, as their name suggests, non-deductible expenses cannot be used to determine taxable income. However, the expenses must be disclosed because these expenses affect the shareholders basis in the entity. The long-term capital gains and the short-term capital losses are reported separately and netted with the shareholder’s other capital gains and losses. The charitable contributions are separately reported because these expenses deductible as itemized deductions.

The ordinary taxable income of the S corporation is $160,000 ($1,000,000 sales - $840,000 trade and business expenses). The taxable ordinary income and the separately reported information are allocated to Manuel and Fernando based on their percentage of ownership. Electronica would report the following amounts to Manuel and Fernando:

100% 70% 30%

Total Manuel Fernando

Taxable ordinary income $ 160,000 $112,000 $ 48,000

Long-term capital gain 8,000 5,600 2,400

Short-term capital loss (15,000) (10,500) (4,500)

Charitable contributions (9,000) (6,300) (2,700)

Non-deductible expenses (4,000) (2,800) (1,200)

 

b. In addition to the income and deductions from Electronica, Manuel has interest and dividend income of $3,500, long-term capital gains of $1,500, and other itemized deductions of $14,500. He is married and has two children. What is his taxable income?

Because Electronica is an S corporation, Manuel must report his pro rata share of its ordinary taxable income. In addition, he must include the items separately reported to him. Manual’s adjusted gross income is $112,500 ($112,000 + $3,500 - $3,000). He has a net short-term capital loss of $3,400 (see below). However, only $3,000 of the loss can be deducted in the current year. The remaining $400 ($3,400 - $3,000) is carried forward to the following year. His adjusted gross income is reduced by his itemized deductions of $20,800. The charitable contribution of $6,300 from Electronica is added to his other itemized deductions of $14,500. His personal and dependency exemptions of $13,600 ($3,400 x 4) reduce his taxable income to $78,100.

Income from Electronica $ 112,000

Interest and dividends 3,500

Capital loss (3,000)

Adjusted gross income $ 112,500

Itemized deductions:

Charitable contributions $ 6,300

Other deductions 14,500 (20,800)

Exemptions (4 x $3,400) (13,600)

Taxable income $ 78,100

 

Capital Gain and Loss Netting:

Short-term capital loss $ (10,500)

Long-term capital gain (Electronica) $5,600

Long-term capital gain 1,500

Total long-term capital gain $ 7,100

Net short-term capital loss $ (3,400)

Capital loss deduction 3,000

Short-term capital loss carryforward $ 400

 

31. Fernando is a retired auto mechanic. Since retiring four years ago, he has made stained glass windows. Because he has only occasional sales, Fernando treats this activity as a hobby. A friend of Fernando's recommends him to a local merchant who is renovating her office and needs someone to make and install 15 new windows. The job takes Fernando a month to complete, and he is paid $3,000. In preparing his tax return, Fernando is unsure whether the $3,000 is subject to self-employment tax. The instructions accompanying his federal income tax return indicate that a payment is subject to self-employment tax only if an individual is engaged in a trade or business. Write a letter to Fernando explaining whether he is engaged in a trade or business.

Whether a taxpayer is engaged in a trade or business is determined on a case by case basis by examining the facts related to the activity. The Supreme Court has indicated that the following factors are important in classifying an activity as a trade or business:

1. The primary purpose of the activity must be to earn a profit,

2. There must be regularity and continuity in the taxpayer's involvement in the activity, and

3. The activity must be engaged in to earn a livelihood and not as a hobby or for amusement.

Applying the criteria established by the Supreme Court to this situation, one could reasonably assume that Fernando's primary purpose in taking the job is to make a profit (i.e., earn additional income). However, the facts also indicate that Fernando does not engage in this activity on a regular or continuous basis and therefore, he does not meet the second factor. In addition, because Fernando is retired and his primary activity is making stained glass windows (which he considers a hobby), it also is difficult to assert that this one-time project is necessary for him to earn a livelihood. Overall, it appears that Fernando fails to meet the factors necessary for him to be considered engaged in a trade or business. Therefore, the $3,000 payment he received for installing the windows would not be subject to self-employment tax.

INSTRUCTORS NOTE: This problem was adopted from Batok, TCM 1992-727, where, on similar facts, the court concluded that the taxpayer’s one-time job did not rise to the level of a trade or business.

 

32. Max owns an office building that he rents for $750 a month. Under the terms of the lease, the tenant is responsible for paying all property taxes and costs related to the building's operation and maintenance. The only cost to Max in relation to the lease is an annual legal fee for renewing the lease. Is Max engaged in the trade or business of renting real estate? How would you classify his deduction for the attorney's fee?

The IRS historically viewed the rental of a single piece of improved real estate as a trade or business. If the IRS continues this position, the attorney fees are a deductible business expense.

However, the IRS has indicated that rental property must produce active income to be considered a trade or business. In determining whether rents are active business income, the scope of the lessor's ownership and management activities are important considerations. If the IRS continues this position, the attorney fees are expenses related to the production of income because Sam is not actively involved the operation of the rental activity.

Regardless of classification, expenses related to earning rental income are deductible for adjusted gross income.

 

 

33. Don was a senior vice president of a bank until its officials found he had embezzled more than $1,000,000. Don had set up fictitious checking accounts and deposited the funds into the accounts. He then created fictitious loans to himself. The embezzled money was used for personal purposes and to keep the fictitious loan payments current. Thus, he created fictitious loans to make payments on prior fictitious loans. Don worked hard to keep the loans current so he would not be detected. Because of a tax audit, he is seeking your advice. If his embezzlement activity is a trade or business, he claims he should be able to deduct as an ordinary and necessary expense the payments on the loans to keep his actions secret. What advice would you give Don concerning his business and deductions? Explain.

The Courts have consistently held that embezzlement is not a trade or business because of public policy concerns (See D.P. Flynn, TC Memo 1981- 491). Employers have a right to expect integrity and honor from the people they hire.

The payments Don made on the loans are not deductible as a business expense based on the following:

1. The loan payments are not normal, customary, or usual in the banking business. The payments fail the ordinary and necessary tests.

2. The loan repayments are on valid bank loans and were not restitution payments to the victim of embezzlement.

3. Because the embezzled funds were not reported as income by a cash basis taxpayer, a deduction for repayment is not allowed.

 

 

34. Hamid owns and lives in a duplex. He rents the other unit to an unrelated married couple for $850 per month. During the current year, he incurs the following expenses related to the duplex:

Mortgage interest $ 7,500

Property taxes 1,100

Utilities 1,450

Repairs

Paint exterior of duplex $2,200

Fix plumbing in rental unit 320

Shampoo carpet in both units 290

Fix dishwasher in Hamid’s unit 120 2,930

Homeowner's association fee 480

Insurance 800

Special property tax assessment to pave sidewalks 3,100

Depreciation (both units) 4,200

How should Hamid treat the expenditures related to the duplex? Explain.

Because the duplex is used for both a business purpose and a personal purpose, the costs must be allocated between the two units. Assuming that the two units are of equal size, 1/2 of each of the common costs are allocated to each unit. The repair to the dishwasher is not deductible because it involved Hamid's unit. The amounts expended for personal purposes are generally not deductible. However, Hamid can deduct the personal portion of the mortgage interest and property taxes as an itemized deduction. Painting the exterior of the duplex is a maintenance expense because it does not extend the useful life of the duplex. As with the other joint expenses. only the portion attributable to the duplex is deductible. The special property tax assessment is not a deductible tax and must be added to the basis of the land.

Rent income ($850 x 12) $ 10,200

Deductions for adjusted gross income:

Mortgage interest ($7,500 x 1/2) $ 3,750

Property taxes ($1,100 x 1/2) 550

Utilities ($1,450 x 1/2) 725

Shampoo carpeting ($290 x 1/2) 145

Repair plumbing 320

Homeowner's association fee ($480 x 1/2) 240

Insurance ($800 x 1/2) 400

Painting exterior ($2,200 x 1/2) 1,100

Depreciation ($4,200 x 1/2) 2,100 (9,330)

Net rental income $ 870

 

Itemized Deductions:

Mortgage interest $ 3,750

Property tax 550

35. In 2007, RayeAnn acquires a car for $14,000. She uses the car in her advertising business and for personal purposes. Her records indicate the car is used 70% for business and that the total operating expenses, including depreciation, are $3,800.

a. How should RayeAnn treat the operating costs of the car for tax purposes?

The car is considered a mixed-use asset. The expenses associated with a mixed-use asset must be allocated between the business portion and the personal portion. In this case, 70% of RayeAnn's expenses are treated as a business expense. She can deduct $2,660 ($3,800 x 70%) of the cost of operating the car. The remaining $1,140 is a personal expense and is not deductible.

 

b. In 2010, RayeAnn sells the car for $6,500. Her business use for 2008 through 2010 remains at 70%, and she properly deducted $5,880 in depreciation. What is her taxable gain or loss from the sale of the car?

RayeAnn must treat the sale of the car as the sale of two assets - a business asset and a personal asset. The $6,500 sales price and the $14,000 purchase price is allocated between her business and personal use:

Business Personal

Selling price - $6,500 x 70% $ 4,550

- $6,500 x 30% $ 1,950

Less: Adjusted basis

Original cost - $14,000 x 70% $ 9,800

- $14,000 x 30% $ 4,200

Less: Depreciation (5,880) (3,920)

Gain (loss) on sale $ 630 $(2,250)

The gain on the sale of the business portion of the asset is considered a Section 1231 gain (discussed in Chapter 11). The loss on the personal portion of the asset is a nondeductible personal use loss.

36. Big Star Auto regularly advertises on local television. Carla, the owner of Big Star pays her 6-year-old grandson $250 for each commercial in which he appears for Big Star. During the current year, the grandson appeared in 100 commercials. Big Star wants to deduct the full $25,000 as a business expense. The grandson will report the $25,000 as income. Write a letter to Carla explaining whether Big Star can deduct the advertising fee paid to her grandson.

Advertising expense qualifies as an ordinary and necessary business expense of a car dealer. However, the transactions between Big Star and the grandson are subject to special scrutiny because they are related parties.

Was the transaction between Big Star and the owner's grandson negotiated at arm's-length and in fact, a payment for grandson's services? If the fee was not actually paid for the grandson's services, the expense is not deductible.

Was the payment reasonable in amount? If the payment was not reasonable in amount, it will also fail the ordinary and necessary tests. As a result, only the part of the fee that is determined to be reasonable will be allowed as a deduction. The reasonableness of the payments is determined by comparing the fees paid to other actors appearing in similar commercials.

 

37. Discuss whether the following expenditures meet the ordinary, necessary, and reasonable requirements.

a. Sadie owns 5 shares of Megaconglomerate stock. She spent $4,000 to attend the annual shareholders' meeting.

The expenditure of $4,000 to attend the shareholders' meeting would not be considered ordinary, nor would it be reasonable. It would not be ordinary because a prudent business person in the same situation would not make such a large expenditure on such a small investment. In addition, it is likely that the $4,000 cost is greater than the amount invested, making it an unreasonable amount.

 

b. Sam runs a successful medical practice. Because he has a substantial investment portfolio, he spent $3,000 to attend a seminar on investing strategies.

The expenditure meets the ordinary, necessary, and reasonable test if Sam's investment portfolio is large in relation to the expenditure. However, the costs of attending seminars are deductible only if they are related to the trade or business of the taxpayer (discussed in Chapter 6).

 

c. Alana is a self-employed tax attorney. She spent $3,000 to attend the American Institute of Certified Public Accountants' annual conference on income tax developments.

The cost of attending the seminar would meet the ordinary, necessary, and reasonable tests. The purpose of the expenditure is directly related to Alana's trade or business as a tax attorney and would be a deductible education expense.

 

d. Kevin owns a large ranching operation. He is deeply religious and feels it is important that his employees have access to religious counseling. He hired an ordained minister to live on the ranch and be available to counsel his employees on any religious problems they might have.

The expenditure would not be considered ordinary because it is not a common business practice in the ranching business. The necessity of the expenditure is also questionable because it does not directly benefit Kevin's business. The primary benefit is personal - Kevin gets the satisfaction of having a minister available for himself and his employees.

 

38. Discuss whether the following expenditures meet the ordinary, necessary, and reasonable requirements:

a. The Brisbane Corporation is being sued in connection with allegations that it produced a faulty product. Brisbane has hired an expert witness to testify that the product was not faulty. The expert's standard fee is $200 per day plus expenses. Brisbane has agreed to pay her standard fee plus expenses and a bonus of $5,000 if the company wins the lawsuit.

Assuming the expenses are not lavish, the standard fee and the expenses paid to the expert witness are deductible business expenses because the expenses are considered ordinary, necessary and reasonable expenses in conducting a business. Business product liability suits are filed against corporation’s everyday. However, the bonus paid to the expert witness is not deductible because the expense is not considered ordinary. The expense is not a common and accepted means of defense in litigation.

b. Shannon is a professor who teaches film study at Burwood College. Her annual salary is $45,000. She maintains an extensive library of films and books at her home. During the year, she spends $15,000 on new material for her library. Most of the material is available at the university library.

Although the expenditure of $15,000 for new material for her library is an employment related expense and might be considered a necessary or reasonable business expense the amount she spent is not reasonable. The expense would fail the reasonable requirement because the amount of the expenditure is excessive relative to her salary as a professor.

c. Francis operates a video store and rents the building from his aunt Shirley who acquired it last year. He paid the previous owner $600 a month in rent. When Francis's lease expires, his aunt increases the rent to $750. Rent for a comparable building in the area is $850.

The rent expense meets the ordinary, necessary, and reasonable requirements. The purpose of the expenditure is directly related to Francis' trade or business and would be a deductible business expense. Instructor’s Note: The lower than fair market rent charged by Francis’ aunt does not create a tax problem because Francis and his aunt are not considered related parties.

d. Max owns a dairy farm in Wisconsin. During the year, he makes 10 phone calls to his sister Ruby, who is an accountant. The calls, which total $150, are for financial and business advice. Ruby prepares Max's business and personal tax returns.

As long as the cost of the phone calls is reasonable, the $150 phone expense would be considered an ordinary and necessary business expense directly related to Max's trade or business as a dairy farmer. Note: This is based on Lewis ¶89,078 PH Memo TC (aff’d by unpublished opinion, 6th Cir. 3-14-91), where, on similar facts, the court found in favor of the taxpayer. It should be mentioned that the IRS will always scrutinize related party transactions, especially those expenses that appear to be personal in nature.

39. For each of the following situations, discuss whether the expense is currently deductible or must be capitalized:

a. The Mickleham Hotel installs a $125,000 sprinkler system to comply with recently enacted fire regulations.

The cost of installing the sprinkler system is a capital expenditure. The sprinkler system has a useful life that extends substantially beyond the end of the tax year. The expense also increases the value of the building by reducing the chances of it being destroyed by fire and by making it safer for the occupants. The fact that the expenditure is required to conform the building to the new fire regulations does not make the expense immediately deductible.

b. The Healesville Corporation pays a real estate commission of $35,000 in acquiring its new office building.

The $35,000 real estate commission is a capital expenditure that must be added to the cost of the building. The fee is considered a cost of acquiring the building.

c. The Doverson Company pays $25,000 to repave its parking lot.

The cost of repaving the parking lot is deductible in the current year as a repair expense. The repaving does not extend the useful life of the parking lot, but returns the lot to its original condition. Note: If the expenditure is to convert a dirt parking into an asphalt parking lot, the cost is considered a capital expenditure, because Doverson has more than maintained the parking lot ¾ it has substantially improved and increased the value of the parking lot.

d. The Watsonia Company pays $56,000 to add an air-conditioning system to its warehouse. The company had agreed to air condition the warehouse as part of a three-year labor agreement with its employees.

The cost of installing the air-conditioning system is a capital expenditure. The air conditioning system has a useful life that extends substantially beyond the end of the tax year and increases the value of the warehouse. The fact that the expenditure is required under the current labor agreement does not change the treatment of the expense.

e. Hua pays $600 to repair the walls and ceiling of his rental property after his tenant moves out.

The $600 cost of repairing the walls and ceiling are a current period expense. The expense is a repair expense because it does not extend the useful life of the rental property, but rather restores the property to its original condition.

 

 

40. Rebecca is the head chef at a local restaurant and is exploring the possibility of leaving her current job and opening her own restaurant in a nearby town. She has spent $15,000 investigating potential locations for the restaurant and $14,000 on an analysis of the demand for a restaurant specializing in Asian cuisine. Write a letter to Rebecca explaining the proper tax treatment of the investigation expenses.

A taxpayer who incurs less than $50,000 of start-up costs can deduct up to $5,000 of the start-up costs in the year the new business. Any amount in excess of $5,000 must be amortized over 180 months. For taxpayers, with start-up costs in excess of $50,000, the $5,000 amount is phased-out on a dollar-by-dollar basis. Therefore, the deduction for start-up costs can be viewed as consisting of two parts. The first is a $5,000 current deduction and a second part that amortizes the remaining start-up costs over 180 months.

Because Rebecca does not currently operate a restaurant, the expenses are not ordinary and necessary business expenses. If Rebecca opens the restaurant, she can deduct $5,000 and amortizes the remaining $24,000 ($29,000 - $5,000) over 180 months [i.e., ($24, 000 ÷ 180 = $133.33) per month]. Therefore, assuming the restaurant is open for 6 months, her deduction in the current year would be $5,800 [$5,000 + (6 x $133.33)].

If Rebecca does not open the restaurant, the investigation expenses are nondeductible personal expenditures. That is, she has no trade or business to write the expenses against and there is no personal deduction allowed for such expenses.

 

 

41. Neal and Ned spend $25,000 on travel, surveys, and financial forecasts to investigate the possibility of opening a bagel shop in the city. Because their suburban bagel shop has been so successful, they would like to expand their operations. What is the proper treatment of their expenditures if

They open a bagel shop in the city?

Because they are investigating the expansion of an existing business, they may deduct the $25,000 as a current expense. The investigation is considered to be an ordinary and necessary business expense.

 

They decide not to open a bagel shop in the city?

The $25,000 is deductible even if they don’t open a business in the new location. The expenses are related to expanding the existing active business, which is an ordinary and necessary business activity.

 

Answer a and b assuming they are investigating opening a computer store in the city and they operate a bagel shop in the suburbs.

A taxpayer who incurs less than $50,000 of start-up costs can deduct up to $5,000 of the start-up costs in the year the new business. Any amount in excess of $5,000 must be amortized over 180 months. For taxpayers, with start-up costs in excess of $50,000, the $5,000 amount is phased-out on a dollar-by-dollar basis. Therefore, the deduction for start-up costs can be viewed as consisting of two parts. The first is a $5,000 current deduction and a second part that amortizes the remaining start-up costs over 180 months.

Because they are investigating a "new" business, the $25,000 is a capital expenditure and is not currently deductible. If they open the computer store, they can deduct $5,000 and amortize the remaining $20,000 ($25,000 - $5,000) over 180 months [i.e., ($20,000 ÷ 180 = $111.11) per month]. Therefore, assuming the restaurant is open for 6 months, her deduction in the current year would be $5,667 [$5,000 + (6 x $111.11)].

If they do not open the computer store, the investigation expenses are nondeductible personal expenditures. That is, they have no trade or business to write the expenses against and there is no personal deduction allowed for such expenses.

 

 

42. What is the proper tax treatment for each of the following expenses?

a. All apartment house construction in Sandy Beach must comply with local and state building codes. To ensure that these codes are observed, Rex, a city building inspector, regularly visits construction sites. Shoddy Construction deposits $20,000 in a fund to provide a scholarship for Rex's son to attend college. The payment is in appreciation for Rex's help in getting around a building code violation.

Because the payment to the scholarship fund results from the relationship between Rex and Shoddy, the payment will probably be viewed as an indirect payment to Rex.

Shoddy's payment to Rex very likely violates city and/or state ordinances prohibiting such payments to public officials. Shoddy's payment would be viewed as a bribe or other illegal payment which is not deductible.

 

b. Rachel operates a pharmacy. She pays a 10% commission on all Medicare and Medicaid business and a 5% commission on all other business sent her way by the Last Stop Nursing Home.

Rachel's payment to Last Stop violates the prohibition against the payment of bribes, kickbacks, or rebates by a provider of services or a supplier under Medicaid or Medicare. Thus, Rachel's payment is not deductible.

 

c. Kelly is a registered nurse. She receives a $1,750-per-month salary working for a local clinic. Because Kelly is five minutes late to work two days in a row, the clinic fines her $25. Thus, her salary for the current month is $1,725.

Kelly is being penalized for breaking her employer's rules. She has not violated a public law or a clearly defined public policy which is enforced. Kelly would have to report her salary of $1,725, (as reduced by the $25 fine) as gross income.

 

 

43. What is the proper tax treatment for each of the following expenses?

a. Bernilyn, a commercial real estate broker, is late for a meeting with her boss when she is stopped and ticketed $150 for speeding. She is using a company car when she receives the ticket.

The $150 speeding ticket is a fine. Fines are not deductible business expenses because it is neither ordinary nor necessary to violate the law.

 

b. Russell is an employee of the Dinsmore Corporation, a small plumbing repair business. He learns that his boss Simon, the sole owner of the business, was arrested twenty years ago for burglary. Because Simon needs access to homes and businesses to do his work, he pays Russell $100 per month for his silence.

The $1,200 ($100 x 12) Simon paid Russell is not deductible. The payment to Russell is probably illegal under local or state law. The tax law explicitly states that illegal bribes are not deductible.

 

c. Anastasia owns a travel agency. The daughter of the president of her largest corporate client is getting married, and Anastasia insists on paying for her bridal shower at a local restaurant.

The payment of the cost of a bridal shower for her largest client’s daughter is not an ordinary or necessary business expense. The function is primarily personal in nature.

 

d. The San Martin Construction Company pays local union officers $20,000 to ensure that San Martin continues to receive construction contracts. The payments are standard practice in the area.

The payment of $20,000 as a kickback is not considered a valid business expense because it violates public policy. This is true even though the payments are considered standard practice in the area. Instructors Note: If the payments are not illegal under state law (i.e., it is standard practice), the payment may be an ordinary and necessary business expense.

 

 

44. Are the following payments deductible?

a. A contribution to a fund to finance Honest Abe's campaign for mayor.

Contributions to a political campaign are never deductible.

b. A contribution to the Hardcore Gamblers' Association to fund efforts to persuade the public to vote for parimutuel betting on licensed turtle races.

A contribution to a fund to influence public opinion about how to vote is not deductible.

c. Joyce, who is in the import-export business, sends an employee to Washington, D.C., to monitor current legislation. The expenses for the one-week trip are $1,500.

Expenses incurred to monitor the impact of legislation on a business are deductible. The expenses associated with monitoring legislation are considered to be ordinary and necessary expenses incurred in a trade or business.

 

d. Ruth, a small business owner, incurs $3,000 in travel, lodging and meal expenses to testify in Washington, D.C., on the effect on small business of new environmental regulations.

The expenditures incurred by Ruth are considered lobbying expenses and as a general rule are not deductible.

 

 

45. During the current year, the Fremantle Corporation, a real estate development firm, incurs $2,200 of expenses lobbying and testifying before the city council to change the zoning rules. The firm also spends $3,500 testifying before the state legislature and lobbying to modify the existing law that restricts commercial building in areas that are classified as a wetlands. Can Fremantle deduct the cost of these lobbying efforts?`

Freemantle can deduct the $2,200 incurred to lobby and testify before the city council. The rules restricting the deductibility of lobbying expenses do not apply to expenses incurred to influence a local legislative body.

Freemantle cannot deduct the expense of testifying and lobbying before the state legislature. The expenses incurred to testify before the state legislature and lobby for the law change are considered lobbying expenses. However, any expenses incurred to monitor legislation are ordinary and necessary business expenses and are deductible.

 

46. During the current year, Maureen pays Universal Bank and Trust $1,600 for investment advice. The fee is not directly related to any particular investment owned by Maureen. The company provides her with the following summary of her investments:

Fair Market Value

Type of Security of Securities Income Earned

Taxable $72,000 $7,300

Tax-exempt $48,000 $2,700

Write a letter to Maureen explaining the proper tax treatment of the $1,600 she paid for investment advice.

Maureen should allocate the deductible and nondeductible portion of the investment fees based on the fair market value of the securities. The important point is that Maureen must allocate the investment fee using a reasonable method and that she applies that method on a consistent basis. If Maureen allocates the investment fees based on the fair market value of the securities, the allocation between the nondeductible portion of the fee and the deductible portion is:

$ 640 = [$1,600 x ($48,000 ÷ $120,000)] is not deductible.

$ 960 = [$1,600 x ($72,000 ÷ $120,000)] is deductible.

Instructors Note: Unlike investment interest, investment expenses can be allocated based on investment income. However, she must use the method on a consistent basis.

$ 432 = [$1,600 x ($2,700 ÷ $10,000)] is not deductible.

$1,168 = [$1,600 x ($7,300 ÷ $10,000)] is deductible.

 

 

 

47. Ying pays an adviser $300 to help manage her investments and provide investment advice. The adviser's fee is not directly related to any particular investment owned by Ying. She owns $40,000 worth of municipal bonds that pay her $2,400 in interest and $20,000 worth of bonds that pay her taxable interest of $2,000. What is the proper tax treatment of the $300 fee for investment advice?

 

Ying should allocate the deductible and nondeductible portion of the investment fees based on the fair market value of the securities. The important point is that Ying must allocate the investment fee using a reasonable method and that she applies that method on a consistent basis. If Ying allocates the investment fees based on the fair market value of the securities, the allocation between the nondeductible portion of the fee and the deductible portion is:

$ 200 = [$300 x ($40,000 ÷ $60,000)] is not deductible.

$ 100 = [$300 x ($20,000 ÷ $60,000)] is deductible.

Instructors Note: Unlike investment interest, investment expenses can be allocated based on investment income. However, she must use the method on a consistent basis.

$ 164 = [$300 x ($2,400 ÷ $4,400)] is not deductible.

$ 136 = [$300 x ($2,000 ÷ $4,400)] is deductible.

 

 

48. Tracy and Brenda are equal partners in Crescent Home Furniture, which is organized as an S corporation. For the year, the company reports sales revenue of $330,000 and business expenses of $195,000. Crescent also earns $15,000 in taxable interest and dividend income and $3,700 in tax-exempt interest on its investments. The investment portfolio consists of $35,000 in tax-exempt securities and $100,000 in taxable securities. Not included in the business expenses is a $3,400 fee Crescent paid for investment advice. As the staff accountant in charge of taxes for Crescent Home Furniture, write a memo to Judy, the accounting manager, explaining how the company must report its results to Tracy and Brenda.

Crescent Home is organized as an S corporation and therefore, must report certain items separately. These items include the taxable interest and dividends of $15,000, the tax-exempt interest of $3,700, the investment expenses of $3,400 and the nondeductible expenses. Because the investment expenses relate to both taxable and nontaxable investments, Crescent must allocate the investment expenses between the deductible and nondeductible amount. Only $2,727 {[$15,000 ¸ $18,700 ($15,000 + $3,700) x $3,400]} of the $3,400 investment expense is a deductible investment expense. The remaining $673 ($3,400 - $2,727) of investment expenses are classified as a nondeductible expense. The ordinary taxable income for the S corporation is $135,000 ($330,000 - $195,000). As equal partners, Crescent Home Furniture would report to Tracy and Brenda the following:

Ordinary income ($135,000 x 50%) $ 67,500

Taxable interest and dividends ($15,000 x 50%) 7,500

Tax-exempt interest ($3,700 x 50%) 1,850

Investment expenses ($2,727 x 50%) 1,364

Nondeductible expenses ($673 x 50%) 336

 

Instructors Note: Crescent could also allocate the deductible and nondeductible portion of the investment fees based on the fair market value of the securities. The important point is that Crescent must allocate the investment fee using a reasonable method and that she applies that method on a consistent basis. If Crescent allocates the investment fees based on the fair market value of the securities, the allocation between the nondeductible portion of the fee and the deductible portion is:

$ 881 = [$3,400 x ($35,000 ÷ $135,000)] is not deductible.

$ 2,519 = [$3,400 x ($100,000 ÷ $135,000)] is deductible.

49. Determine the current tax deduction allowed in each of the following situations:

a. Doug, John's son, buys a new car that is titled in Doug's name. John pays for Doug's auto license tag. The tag costs $220: $40 for registration plus $180 in property taxes based on the value of the auto. Doug qualifies as John's dependent for tax purposes. Doug uses the auto for personal transportation.

Because the $220 tag cost relates to personal use of the auto, it is not a business expense. Although the $180 ad valorem property tax is an allowable itemized deduction, neither John nor Doug may claim the deduction. Unless John can demonstrate he benefited from Doug having the car, John is not entitled to the deduction because it is not an expense incurred for his benefit. Doug may not claim the deduction because he did not pay the expense. If John had made a gift of cash to Doug and Doug used the cash to pay the tax, Doug would be entitled to an itemized deduction.

 

b. Elvis owns Ace Auto Repair. His head mechanic is arrested for drunken driving. Because Elvis needs the mechanic back at work as soon as possible, he pays the $500 bail to get the mechanic out of jail. To keep him out of jail, he pays $450 in attorney's fees and the $500 fine the court imposes on the mechanic.

A deduction is generally not allowed for the payment of another's expense. However, in this case, a business purpose exists for the expenditures Elvis made on behalf of his mechanic. If the mechanic is required to repay the expenses, it would constitute a loan and not be deductible. However, if Elvis does not require the mechanic to repay the amounts paid on the mechanics behalf, the payments would constitute compensation to the mechanic. The mechanic would have income and Elvis would get a deduction for compensation paid.

50. Determine the current tax deduction allowed in each of the following situations:

a. Sam owns and operates SoftPro, a software programming business. In June, the firm files for bankruptcy. Eighteen months earlier, Karl, had recommended SoftPro as a good investment to his clients. Three of Karl’s clients each loaned SoftPro $40,000 at 12% interest. To avoid losing his three clients, Karl repaid the $40,000 each client had loaned to SoftPro.

Karl is not allowed a deduction for the amount he paid to each of his clients. Although the expense might be necessary for Karl to maintain his business reputation, the expense would not be considered ordinary. For the expense to be considered ordinary, the expense must be commonly incurred in the taxpayer’s business. In addition, the expense must be customary or usual in the taxpayer’s business. Karl’s payment to the clients does not meet either of these requirements.

 

 

 

During the year, Susan’s mother is hospitalized for 3 weeks and incurs $36,000 of medical costs. Her mother’s insurance company pays only $22,000 of the medical expenses. Because her mother could pay only $4,000 of the remaining medical costs, Susan pays the remaining $10,000. Susan’s mother does not qualify as her dependent.

To be deductible, an expenditure must be for the taxpayer’s benefit or be the payment of a taxpayer’s obligation. A payment of another person’s obligation does not result in a tax deduction for either person. An exception to this is for medical expenses paid on behalf of a taxpayer’s dependent. However, since Susan’s mother does not qualify as a dependent this exception does not apply. Therefore, Susan cannot deduct the $10,000 she pays for her mother’s medical costs.

Instructor’s Note: As discussed in Chapter 8, if Susan’s mother did not qualify as a dependent because she fails to meet either the gross income or the joint return test (i.e., she meets the support test), then her mother is considered a dependent for purposes of deducting the $10,000 in medical expenses.

 

51. As a hobby, Jane creates and sells oil paintings. During the current year, her sales total $8,000. How is the tax treatment of her hobby different from the treatment of a trade or business, if

a. Her business expenses total $5,600?

Because Jane's activity is a hobby, her sales must be reported as gross income and her expenses are allowed as a miscellaneous itemized deduction. Her deductions will be subject to the general limitation (2% of adjusted gross income) on miscellaneous itemized deductions. Jane should report:

Gross Income $ 8,000

Miscellaneous Itemized Deductions $ 5,600

Instructor’s Note: The solution in part a, b and c assumes that the expenses related to Jane’s hobby are not for interest and taxes that could otherwise be deducted as itemized deductions.

 

b. Her business expenses total $10,000?

Because Jane's expenses exceed her gross income, her hobby expenses are limited to the $8,000 of income from the hobby. She should report:

Gross Income $ 8,000

Miscellaneous Itemized Deductions $ 8,000

Nondeductible Personal Expense $ 2,000

 

c. Assume that Jane itemizes her deductions and that she has an adjusted gross income of $42,000 before considering the effect of the hobby. Discuss the actual amount of the deduction Jane would receive in parts a and b.

Hobby expenses are deductible as miscellaneous itemized deductions, which are subject to a 2% of adjusted gross income limitation. The $8,000 of hobby income will increase her adjusted gross income to $50,000. Assuming that Jane has no other miscellaneous itemized deductions, the allowable hobby deductions must be reduced by $1,000 ($50,000 x 2%). This will leave her with an actual deduction of $4,600 ($5,600 - $1,000) in part a and $7,000 ($8,000 - $1,000) in part b.

Part a Part b

Gross Income $ 8,000 $ 8,000

Hobby expenses $ 5,600 $ 8,000

Less: 2% of AGI ($50,000 x .02) (1,000) (4,600) (1,000) (7,000)

Net income effect $ 3,400 $ 1,000

 

 

52. Sharon is single and a data-processing manager for the phone company. She also owns and operates a sports memorabilia store. Sharon goes to shows, subscribes to numerous magazines on sports memorabilia, and maintains a Web page on the Internet. She has been engaged in the activity for the last 5 years. During that time, she reported a net loss in two of the years and net income in the other three. Overall, her sports memorabilia activity has shown a slight loss, but the value of her collection over the 5 years has increased by 20%. Sharon rents a 600-square-foot storefront for $500 a month. Although the store is open only on Saturdays, she is usually in her office at the store 2 or 3 nights a week buying and selling sports memorabilia over the Internet. For the current year, she has an adjusted gross income of $42,000 before considering the following income and expenses related to her sports memorabilia activity:

Sale of memorabilia $11,500

Cost of items sold 3,725

Cost of new memorabilia acquired 1,500

Registration and booth fees 750

Transportation to memorabilia shows 600

Meals attending shows 250

Cost of magazines 280

Cost of Internet connection 240

Office utilities 800

Phone 400

Depreciation on computer 200

a. What is the proper tax treatment of these items if Sharon is engaged in a trade or business?

If Sharon is engaged in a trade or business, she is allowed to deduct all ordinary, necessary and reasonable expenses in determining her business income. Without considering whether Sharon can deduct any home office expenses, her loss from the card collecting activity is $1,620:

Sales of cards $ 11,500

Cost of cards sold $ 3,725

Rent ($500 x 12) 6,000

Registration and booth fees 750

Transportation to card shows 600

Meals attending shows ($250 x 50%) 125

Cost of magazines 280

Cost of Internet connection 240

Office utilities 800

Phone 400

Depreciation on computer 200 (13,120)

Net income from business $ (1,620)

The $1,500 of memorabilia Sharon acquires is inventory and has been included in the calculation of cost of goods sold.

 

 

b. What is the proper tax treatment of these items if she is engaged in a hobby?

Sharon must include the $11,500 in gross income. She is allowed to deduct up to $11,500 of expenses. The expenses must be taken in a specified order: with interest and taxes first, expenses other than depreciation second, and depreciation last. The deductions are from adjusted gross income and not deductions for adjusted gross income. In addition, for Sharon to receive any benefit for the expenses, she will have to be able to itemize her deductions. A further restriction is that the expenses are considered miscellaneous itemized deductions and are reduced by 2% of Sharon’s adjusted gross income. Sharon is allowed to deduct only $10,430 of the expenses.

Adjusted gross income before hobby $ 42,000

Hobby income 11,500

New adjusted gross income $ 53,500

Hobby expenses $ 11,500

Less: 2% of AGI ($53,500 x .02) (1,070)

Miscellaneous itemized deduction $ 10,430

 

c. What factors (e.g., facts, aspects) of Sharon's sports memorabilia activity indicate that it is a hobby? a trade or business?

In determining whether Sharon's memorabilia activity is a trade business or a hobby, the IRS will examine the following nine factors:

• Whether the taxpayer carries on the activity in a business-like manner

• The expertise of the taxpayer or her reliance on expertise

• The history of income and profits

• The time and effort spent on the activity

• The taxpayer's success in similar activities

• Whether the activity is engaged in for personal pleasure or recreation

• The taxpayer's financial condition

• The expectation that the assets used in the business will appreciate

• The amount, if any, of occasional profits

 

53. Lee and Sally own a winter retreat in Harlingen, Texas, that qualifies as their second home. This year they spent 40 days in their cabin. Because of its ideal location, it is easy to rent at $120 a day and was rented for 80 days this year. The total upkeep costs of the cabin for the year were as follows:

Mortgage interest $ 9,000

Real and personal property taxes 1,200

Insurance 750

Utilities 600

Repairs and maintenance 1,000

Depreciation 2,500

What is the proper treatment of this information on Lee and Sally's tax return?

Because the personal use of the home exceeds 14 days, the home is a vacation home and deductions are limited to rental income. Deductions must be taken in a specified order: interest and taxes first, expenses other than depreciation second, and depreciation last. The expenses are allocated based on actual days the vacation home is rented to total days used for either rental or personal use. Thus, 66.7% [80 ÷ 120 (40 + 80)] of the expenses are related to the rental activity.

Rent (80 days x $120) $ 9,600

Interest and taxes ($10,200 x 2/3) (6,800)

Balance of income $ 2,800

Operating expenses ($2,350 x 2/3) (1,567)

Balance of Income $ 1,233

Depreciation ($2,500 x 2/3 = 1,668) 1,233*

Balance of income $ -0-

* Limited to balance of income

The adjusted gross income from rents would be reported as zero. The $438 ($1,668 - $1,230) of depreciation not allowed because of the income limit can be carried forward and deducted in a year when income is large enough to absorb the deductions.

The interest and taxes $3,400 ($10,200 - $6,800) allocated to the personal use of the dwelling are allowed as an itemized deduction. Thus, if Lee and Sally can itemize their deductions, the rental will decrease their taxable income by the $3,400 of itemized deductions.

 

 

 

54. Mel and Helen own a beachfront home in Myrtle Beach, S.C. During the year, they rented the house for 5 weeks (35 days) at $800 per week and used the house for personal purposes 65 days. The costs of maintaining the house for the year were

Mortgage interest $ 5,500

Real property taxes 4,500

Insurance 650

Utilities 1,000

Repairs and maintenance 480

Depreciation (unallocated) 3,500

a. What is the proper tax treatment of this information on their tax return?

Because the personal use of the home exceeds 14 days, the home is a vacation home and deductions are limited to rental income. Deductions must be taken in a specified order: interest and taxes first, expenses other than depreciation second, and depreciation last. The expenses are allocated based on actual days the vacation home is rented to total days used for either rental or personal use. Thus, 35% [35 ÷ 100 (35 + 65)] of the expenses are related to the rental activity.

Rent ($800 x 5 weeks) $ 4,000

Interest and taxes ($10,000 x 35%) (3,500)

Balance of income $ 500

Operating expenses ($2,130 x 35% = $746) ( 500)*

Balance of income $ -0-

Depreciation ($3,500 x 35% = $1,225) -0- **

Income from rental $ -0-

* Limited to the balance of income, remaining amount is carried forward.

** Allocated amount is carried forward

The adjusted gross income from rents would be reported as zero. The remaining $246 ($746 - $500) of expenses and the allocated depreciation of $1,225 that is not allowed because of the income limit can be carried forward and deducted in a year when income is large enough to absorb the deductions.

The interest and taxes $6,500 ($10,000 - $3,500) allocated to the personal use of the dwelling are allowed as an itemized deduction. Thus, if Mel and Helen itemize their deductions, the rental will decrease their taxable income by the $6,500 of itemized deductions.

 

b. What is the proper tax treatment if Helen and Mel rented the house for only 2 weeks (14 days)?

If the dwelling is rented 14 days or less, the $1,600 of rental income ($800 x 2 weeks) is not reported and expenses related to rental use are not deducted. The interest and taxes ($10,000) are allowed as an itemized deduction.

 

 

55. Matilda owns a condominium on the beach in Rebooth, Delaware. During the current year, she incurs the following expenses related to the property:

Mortgage interest $ 8,000

Property taxes 1,750

Utilities 1,050

Maintenance fees 600

Repairs 350

Depreciation (unallocated) 3,200

Determine the amount of Matilda's deductions in each of the following cases:

Rental Rental Personal

Case Income Days Use Days

A $ 12,000 365 0

B $ 3,800 80 20

C $ 600 14 86

D $ 9,050 275 25

In each case, you must first determine whether the property is a true rental (all allocable deductions allowed) or a vacation home (allocable deductions allowed to the extent of rental income with ordering of deductions).

CASE A

This is a true rental. Because there is no personal use, all expenses are deducted against rental income.

Rental income $ 12,000

Interest and taxes ($8,000 + $1,750) (9,750)

Other rental expenses ($1,050 + $600 + $350) (2,000)

Depreciation (3,200)

Net rental loss $ (2,950)

 

CASE B

This is a vacation home because the personal use of the home (20 days) exceeds the greater of 14 days or 8 days (10% of rental days). Therefore, the deductions are limited to rental income and must be taken in a specified order: interest and taxes first, expenses other than depreciation second, and depreciation last. The expenses are allocated based on actual days the vacation home is rented to total days used for either rental or personal use. Thus, 80% [80 ÷ 100 (80 + 20)] of the expenses are related to the rental activity.

Rental income $ 3,800

Interest and taxes [$9,750 x 80% = 7,800] (3,800)*

Balance of income $ -0-

Other rental expenses ($2,000 x 80% = $1,600) -0- **

Balance of income $ -0-

Depreciation ($3,200 x 80% = $2,560) -0- **

Income from rental $ -0-

* Limited to the balance of income, remaining amount is carried forward.

** Allocated amount is carried forward

The adjusted gross income from rents would be reported as zero. The remaining $4,000 ($7,800 - $3,800) of interest and taxes, the $1,600 of allocated expenses and the allocated depreciation of $2,560 that are not allowed because of the income limit can be carried forward and deducted in a year when income is large enough to absorb the deductions.

The interest and taxes $1,950 ($9,750 - $7,800) allocated to the personal use of the dwelling are allowed as an itemized deduction. Thus, if Matilda itemizes her deductions, the rental will decrease her taxable income by the $1,950 of itemized deductions.

 

CASE C

Because the property is rented 14 days or less, no income is reported and the $9,750 of interest and taxes are allowed as an itemized deduction.

 

CASE D

This is a true rental because the 25 personal use days are less than the greater of 14 days or 28 days (10% of rental days). Therefore, all allocable deductions are allowed for adjusted gross income.

Rental income $ 9,050

Interest and taxes [$9,750 x (275 ÷ 300)] (8,938)

Other rental expenses [$2,000 x (275 ÷ 300)] (1,833)

Depreciation [$3,200 x (275 ÷ 300)] (2,933)

Net rental loss $ (4,654)

 

 

56. Haysad owns a house on Lake Tahoe. He uses a real estate firm to screen prospective renters, but he makes the final decision on all rentals. He also is responsible for setting the weekly rental price of the house. During the current year, the house rents for $1,500 per week. Haysad pays a commission of $150 and a cleaning fee of $75 for each week the property is rented. During the current year, he incurs the following additional expenses related to the property:

Mortgage interest $ 12,000

Property taxes 2,700

Utilities 1,400

Landscaping fees 900

Repairs 450

Depreciation (unallocated) 7,500

a. What is the proper tax treatment if Haysad rents the house for only 1 week (7 days) and uses it 50 days for personal purposes?

If Haysad rents the dwelling for 14 days or less, the $1,500 of rental income is not reported and expenses related to rental use are not deducted. The interest and taxes are deductible as itemized deductions.

 

b. What is the proper tax treatment if Haysad rents the house for 8 weeks (56 days) and uses it 44 days for personal purposes?

Because Haysad’s personal use of the home exceeds 14 days (and 10% of the rental days), the property is a vacation home and deductions are limited to rental income. Deductions must be taken in a specified order: interest and taxes first, expenses other than depreciation second, and depreciation last. The expenses (other than the commission and cleaning expenses) are allocated based on actual days the vacation home is rented to total days used for either rental or personal use. Thus, 56% [56 ÷ (56 + 44)] of the expenses are related to the rental activity.

Rent ($1,500 x 8 weeks) $ 12,000

Interest and taxes ($14,700 x 56%) (8,232)

Balance of income $ 3,768

Non-allocated operating expenses ($225 X 8 x 100%) (1,800)

Alocated operating expenses ($2,750 x 56%) (1,540)

Balance of income $ 428

Depreciation ($7,500 x 56% = $4,200) (428)*

Income from rental $ -0-

* The depreciation is limited to $428. The remaining $3,772 ($4,200 - $428) can be carried forward.

In addition, the $6,468 ($14,700 - $8,232) of interest and taxes are deductible as itemized deductions. If Haysad can itemize his deductions, the rental property reduces his taxable income by $6,468.

c. What is the proper tax treatment if Haysad rents the house for 25 weeks (175 days) and uses it 15 days for personal purposes?

Because Haysad’s personal use is less than 10% of the days rented [15 < (175 x 10%)], the property is considered a true rental. However, only those expenses attributable to the rental are deductible against rental income. The expenses (other than the commission and cleaning expenses) are allocated based on actual days the vacation home is rented to total days used for either rental or personal use. As a result 92%* [175 ÷ (15 + 175)] of the other expenses are deducted for rental use. Due to the definition of qualifying home mortgage interest, the interest allocated to personal use is not deductible (see Chapter 8). However, the personal portion $135 ($2,700 - $2,565) of the taxes is deductible as an itemized deduction.

Rent ($1,500 x 25 weeks) $ 37,500

Interest ($12,000 x 92%) (11,040)

Taxes ($2,700 x 92%) (2,484)

Non-allocated operating expenses ($5,625 x 100%) (5,625)

Allocated operating expenses ($2,750 x 92%) (2,530)

Depreciation ($7,500 x 92%) (6,900)

Income from rental $ 8,921

* The 92% is rounded

Note: The non-allocated operating expenses consist of the cleaning fee of $75 and the commission of $150 for each week the house is rented. Thus the total non-allocated operating costs are $5,675 [($75 + $150) x 25 weeks].

57. Ray, 83, is a used car dealer. He lives in a rural community and operates the business out of his home. One room in his 6-room house is used exclusively for his business office. He parks the cars in his front yard, and when customers come along, they sit on the front porch and negotiate a sale price. The income statement for Ray's auto business is as follows:

Sales $110,000

Cost of cars sold 78,000

Gross profit $ 32,000

Interest expense on cars $ 4,200

Property tax on cars 700

Gas, oil, repairs 1,200

Loan fees 3,200

Depreciation on equipment 1,800 (11,100)

Net profit $ 20,900

If Ray's home were rental property, the annual depreciation would be $2,900. The utilities and upkeep on the home cost Ray $6,400 for the year. Ray's mortgage interest for the year is $2,400. When asked about the loan fees, Ray bitterly responds that Jim, the bank loan officer, charges him 10% of his gross profit on cars financed through the bank. Ray says, "The money is under the table, and if I don't shell out the cash, Jim won't loan the money to my customers to buy my cars. Everybody goes to Jim -- he's got the cash."

Write a letter to Ray explaining the proper tax treatment of this information on his tax return.

The loan fees ($3,200) are not deductible as an ordinary expense related to selling used cars. They are an illegal kickback. Since 1/6 of the home is used for business the following expenses are allowed as a home office deduction: *

Utilities $ 6,400 x 1/6 = $ 1,067

Interest $ 2,400 x 1/6 = 400

Depreciation $ 2,900 x 1/6 = 483

Total $ 1,950

The interest expense related to personal use of the home is an itemized deduction [$2,400 x (5 ÷ 6) = $2,000].

Sales $110,000

Cost of cars sold 78,000

Gross profit $ 32,000

Interest expense on cars $ 4,200

Property tax on cars 700

Gas, oil, repairs 1,200

Loan fees -0-

Depreciation on equipment 1,800

Business use of home 1,950 (9,850)

Net profit $ 22,150

* Some may question whether Ray qualifies for a home office deduction. However, because the home is his principal place of business, the office should qualify for deduction. Ray should report $22,150 of adjusted gross income from his used car business.

58. Hromas uses a separate room in his home as an office. The room is 500 square feet of the total 2,000 square feet of the house. During the current year, Hromas incurs the following household expenses:

Mortgage interest $ 12,000

Property taxes 1,400

Insurance 450

Utilities

Gas and electric $ 2,100

Cable television 280

Phone ($15 per month for a separate phone number

for the office) 450 2,830

House cleaning 1,820

Long-distance phone calls (business-related) 670

Depreciation (unallocated) 5,600

How much of a deduction is Hromas allowed for the cost of the home office in each of the following situations?

a. Hromas is an independent salesperson who uses the room exclusively to call customers who buy goods from him. During the current year, his sales total $83,000, cost of goods sold is $33,000 and he incurs other valid business expenses unrelated to the office of $25,000.

Because Hromas uses the office exclusively and on a regular basis as a principal place of business, he is allowed to deduct the costs associated with the home office. However, the home office deduction cannot exceed his income from the trade or business less the costs unrelated to the office. In addition, to the $25,000 of expenses unrelated to his office, he can deduct $180 for the extra phone line and the long distance phone calls of $670 as business expenses. Therefore, he is limited to a maximum home office deduction of $24,150 ($83,000 - $33,000 - $25,000 - $180 - $670).

The costs of the home office must be allocated on some reasonable basis. The square footage of the office is 25% (500 ÷ 2,000) of the total square footage and provides a reasonable basis to allocate expenses that are related to the house. The cost of the cable TV is not deductible. In addition, only the $15 per month cost of the office phone number is deductible. The long-distance business calls do not have to be allocated.

Interest ($12,000 x 25%) $ 3,000

Property taxes ($1,400 x 25%) 350

Insurance ($450 x 25%) 113

Gas & electric ($2,100 x 25%) 525

Cable TV -0-

House cleaning ($1,820 x 25%) 455

Depreciation ($5,600 x 25%) 1,400

Total home office costs $ 5,843

b. Hromas is an employee of Ace Computer Company. He uses the office primarily when he brings work home at nights and on weekends. He occasionally uses the office to pay personal bills and to study the stock market so he can make personal investments. His salary at Ace is $80,000 per year. He is not paid extra for the time he spends working at home.

For an employee to deduct the cost of a home office, the exclusive and regular use tests must be met. In addition, the office must be for the convenience of the employer and required as a condition of employment. In this case, Hromas does not meet the exclusive use test (office work and personal work done in the office). In addition, the office is clearly for his convenience, not the employers, and there is no indication that Hromas must maintain the office in order to retain his job. Therefore, no deduction is allowed for the home office. He would be able to deduct all of the mortgage interest and property taxes as itemized deductions.

 

 

59. Charlotte owns a custom publishing business. She uses 500 square feet of her home (2,000 square feet) as an office and for storage. All her business has come from telemarketing (telephone sales), direct mailings, or referrals. In her first year of operation, she has revenues of $37,000, cost of goods sold of $25,900, and other business expenses of $8,100. The total expenses related to her home are:

Home mortgage interest $6,400

Real property taxes 2,100

Insurance 560

Utilities 800

Repairs and maintenance 600

House cleaning 960

Depreciation (unallocated) 5,000

What amount can Charlotte deduct for her home office?

Because Charlotte uses the office exclusively and on a regular basis as a principal place of business, she is allowed to deduct the costs associated with the home office. However, the home office deduction cannot exceed her income from the trade or business less the costs unrelated to the office. In this case, she is limited to a maximum home office deduction of $3,000 ($37,000 - $25,900 - $8,100).

The costs of the home office must be allocated on some reasonable basis. The square footage of the office is 25% (500 ÷ 2,000) of the total square footage and provides a reasonable basis to allocate expenses that are related to the house.

Total home office costs are limited to $ 3,000

Home mortgage interest ($6,400 x 25%) (1,600)

Real property taxes ($2,100 x 25%) (525)

Balance of income $ 875

Insurance ($560 x 25%) (140)

Utilities ($800 x 25%) (200)

Repairs and maintenance ($600 x 25%) (150)

House cleaning ($960 x 25%) (240)

Balance of income $ 145

Depreciation ($5,000 x 25% = 1,250) (145)

Total home office costs $ -0-

 

Charlotte has no income from her custom publishing business. She can deduct only $3,000 of the $4,105 of home office expenses because home office expenses cannot create a business loss. She must deduct the expenses related to interest and taxes first, then deduct her other business expenses, then depreciation. She may carry forward the $1,105 ($145 limit - $1,250 current depreciation) not used in the current year to a future year when her business income can absorb the deduction.

 

 

60. The Adelaide Advertising Agency, a cash basis taxpayer, bills its clients for services it renders and any out-of-pocket expenses it pays to third parties on behalf of its clients. For example, in creating a television commercial for a client, Adelaide charges the client for its staff time in creating the commercial and the third-party costs of filming and editing the commercial. During the year, Adelaide bills its clients $2,800,000. Of this amount, $600,000 is for expenses it pays to third parties. On December 31, the accounts receivable ledger shows a balance due to Adelaide of $400,000, $35,000 of which is for third-party expenses. How much of the third-party expenses can Adelaide deduct during the current year?

Adelaide can only deduct the portion of the expenses $565,000 ($600,000 - $35,000) that it has been reimbursed. The $35,000 of unreimbursed expenses are incurred on behalf of another taxpayer - - its clients, and cannot be deducted because it is not an expense incurred for Adelaide’s benefit.

Instructor’s Note: The facts of this problem are adopted from Private Letter Ruling 9432003. It should be noted that if Adelaide cannot collect the expenses or it decides not to collect the expenses, then it can deduct the expenses in the year the expenses are not collected.

 

61. On July 1, 2007, Andaria borrows $30,000 from the First Financial Bank. The loan is for 1-year at an annual interest rate of 10%. How much interest can Andaria deduct under each of the following situations?

a. The bank deducts the interest from her the loan proceeds.

Prepaid interest is not generally deductible under the one-year rule. The only exception to this rule is for the payment of "points" on a loan to purchase a principal residence. Andaria is required to allocate the interest expense deduction of $3,000 ($30,000 x 10%) to the time periods the loan is outstanding. She can deduct $1,500 [(6 ÷ 12) x $3,000] as interest expense in 2007 and the remaining $1,500 in 2008.

 

b. The $30,000 loan proceeds are due at the end of the loan, but Andaria pays interest on the loan each month.

Assuming the interest on the loan is not compounded, (i.e., simple interest method) Andaria will pay $250 [($30,000 x 10%) ÷ 12] of interest each month. Because Andaria pays interest on the loan each month, she can deduct $1,500 ($250 x 6 months) as interest expense in 2007 and $1,500 of interest in 2008.

 

c. The interest and loan proceeds are due June 30, 2008.

If Andaria is a cash basis taxpayer, the interest is not deductible until it is paid in 2008. In 2008, she would deduct $3,000 ($30,000 x 10%) of interest. If she is an accrual basis taxpayer, $250 [($30,000 x 10%) ÷ 12] of interest will accrue each month. Andaria can deduct $1,500 ($250 x 6) in 2007 and $1,500 ($250 x 6) in 2008.

 

 

62. The Kane Corporation is an accrual basis taxpayer. State law requires that Kane acquire workers’ compensation insurance from a third-party carrier or maintain a self-funded insurance plan. Kane has decided to create a self-fund workers’ compensation plan and pays $6 per month (the state minimum) for each of its 800 employees. During the year, the corporation pays $52,500 in workers’ compensation benefits to its employees. How much can Kane deduct as workers’ compensation expense for the year? Discuss.

Under the economic performance requirement, Kane cannot deduct the workman compensation expense until the benefits have been paid to the employees. The $57,600 (800 workers x $6 x 12 months) payment into the fund is an estimate of a future liability and is not deductible until performance on the liability occurs. The $52,500 of actual expenses can be deducted because economic performance has occurred.

 

 

 

 

 

 

 

 

 

 

 

 

63. Appliance Sales Corporation sells all types of appliances. In addition, it offers purchasers of its appliances the option of purchasing repair contracts. During the current year, Appliance estimates that repairs totaling $13,100 will be made under the contracts sold during the current year. Actual repair costs are $7,500 related to last year's contracts and $2,450 on contracts sold during the current contract year. How much repair cost can Appliance deduct during the year?

If Appliance is a cash basis taxpayer (hybrid method for sales and purchases), it will deduct the $9,950 ($7,500 + $2,450) of actual repair costs it pays during the year.

If Appliance is an accrual basis taxpayer it will only be allowed to deduct the $9,950 of actual repair costs. Reserve accounting (i.e., the allowance method) is not allowed for warranties because the all-events test is not met with respect to the $13,100 estimate. That is, although Appliance has a reasonable estimate of its expense, the all-events test requires that the actual payee be known. In addition, the economic performance test is not met until the repairs under the warranty contract are actually performed.

 

 

 

 

 

 

 

 

 

 

64. Gonzo Company is an accrual basis taxpayer. It provides medical insurance for its employees through a self-insured reimbursement plan. Gonzo pays $150 per month per employee into the plan fund. The fund is then used to reimburse employees' medical expenses. During the current year, Gonzo pays $90,000 into the fund and pays medical reimbursement claims totaling $78,300. How much can Gonzo deduct for the provision of employee medical coverage? Discuss.

Under the economic performance requirement, Gonzo cannot deduct the medical insurance expense until the services have been rendered. The $90,000 payment into the fund is an estimate of a future liability and is not deductible until performance on the liability occurs. The $78,300 of actual expenses can be deducted because economic performance has occurred.

 

 

 

 

 

 

 

 

65. Damon's Lawn and Garden Supply, an accrual basis taxpayer, is the exclusive dealer for Tru-Cut lawn mowers. In 2007, Damon's agrees to pay the Dash Corporation, the manufacturer of Tru-Cut, an additional $15 per lawn mower. In exchange, the Dash Corporation will provide advertising and promotion to Damon's over for a 2-year period. Damon's purchases and pays for 200 lawn mowers in 2007 and 350 lawn mowers in 2008. The Dash corporation paid $2,750 for advertising and promotion in 2007 and $5,500 in 2008. How much of the amount pays to the Dash Corporation for advertising and promotional services can Damon's deduct in 2007? in 2008?

For Damon’s to deduct the promotion expenses, both the all-events test and the economic performance test must be met. The all-events test requires that the liability exists and the amount of the liability can be determined with reasonable accuracy. Economic performance occurs when services or property are provided to the taxpayer or when the taxpayer uses the property. Although Dash corporation receives $3,000 ($200 x $15) for advertising and promotion from Damon's in 2007, only $2,750 is spent by Dash. Therefore, Damon’s can only deduct $2,750, because economic performance for services occurs when the services are provided to the taxpayer.

In 2008, Damon's can deduct $5,500 for promotion expenses. This includes the $5,250 (350 x $15) paid in 2008 and the $250 from 2007 that met the all-events test, but not the economic performance test because the services were not provided by Dash. The $5,500 in services is provided in 2008 and the economic performance test is met.

 

 

66. Joy incurs the following expenses in her business. When can she deduct the expenses if she uses the accrual method of accounting? the cash method?

a. Joy rents an office building for $750 a month. Because of a cash-flow problem, she is unable to pay the rent for November and December 2007. On January 5, 2008, Joy pays the $2,250 rent due for November, December, and January.

If Joy uses the accrual method, she can deduct $1,500 of accrued rent expense for November and December 2007. Both the all-events test and the economic performance tests are satisfied. Economic performance occurred as Joy used the office building in November and December. The January rent is deducted in 2008.

As a cash basis taxpayer, Joy can deduct the $2,250 when paid in cash (or its equivalent) on January 5, 2008.

 

b. Joy borrows $60,000 on a 1-year note on October 1, 2007. To get the loan, she has to prepay $6,200 in interest.

Under the accrual method, Joy is required to allocate the interest expense deduction to the time periods the loan is outstanding. Joy deducts $1,550 of interest expense for 2007 [(3 ÷ 12) x $6,200)]. The remaining $4,650 is deducted in 2008.

Cash basis taxpayers can deduct prepaid expenses in the year paid if the payment does not create an asset that extends substantially beyond the end of the year. Under the one-year rule for prepaid expenses, the prepaid expense is deductible in the year of payment if the prepayment if the prepayment will be used up before the end of the tax year following the year of prepayment.

Prepaid interest is not generally deductible under the one-year rule. The only exception to this rule is for the payment of "points" on a loan to purchase a principal residence. Joy is required to allocate the interest expense deduction to the time periods the loan is outstanding. Joy deducts $1,550 of interest expense for 2007 [(3 ÷ 12) x $6,200). Thus, Joy is effectively treated as an accrual basis taxpayer for purposes of deducting prepaid interest expense. Joy deducts the remaining $4,650 in 2008.

 

c. Joy owes employees accrued wages totaling $20,000 as of December 31, 2007. The accrued wages are paid in the regular payroll on January 5, 2008.

If Joy uses the accrual method, Joy can deduct $20,000 of accrued wages on December 31, 2007. The all-events and economic performance tests have been met. Economic performance occurred as the employees rendered services to Joy.

As a cash basis taxpayer, Joy can deduct the wages when paid on January 5, 2008.

d. Joy purchases $2,400-worth of supplies from a local vender. The supplies are delivered on January 29, 2007. They are fully used up on December 30, 2007. Because of unusual circumstances, a bill for the supplies arrives from the vendor on January 10, 2008, and is promptly paid.

If Joy uses the accrual method, Joy can deduct the supplies expense when they are delivered on January 29, 2007. The all-events test and economic performance tests are met when the supplies are delivered to Joy.

As a cash basis taxpayer, Joy can deduct the supplies expense when she pays the invoice in cash (or its equivalent) in January 2008.

 

e. While at a trade convention, Joy purchases some pens and paperweights to send out as holiday gifts to her clients. She charges the $700 cost to her credit card in December 2007. She pays the credit card bill in January 2008.

The $700 cost is a deductible advertising cost. As an accrual basis taxpayer, both the all-events test and the economic performance test have been met. Economic performance occurs when Joy gives the pens and paperweights. Joy will be able to deduct the cost in 2007 when she charged the cost to her credit card.

As a cash basis taxpayer, Joy would be allowed the deduction in 2007. Joy will be able to deduct the cost in 2007 when she charged the cost to her credit card. Payment is considered made when money is borrowed from a third party - the credit card company.

 

 

67. The Parr Corporation incurs the following expenses. When can it deduct the expenses if it uses the accrual method of accounting? the cash method?

a. Parr Corporation mails a check for $5,000 to the United Way on December 26, 2007. The company's canceled check shows that the United Way did not deposit the check until January 16, 2008.

If Parr is an accrual basis taxpayer, Parr can deduct the $5,000 in 2007 because both the all-events test and the economic performance tests are met. Economic performance occurs when Parr provides (mails) the check to the United Way.

If Parr is a cash basis taxpayer, the $5,000 is deductible in 2007 as long as the check is honored when it is deposited by the United Way. The fact that it took the United Way 3 weeks to deposit the check does not have an impact on Parr's deduction.

 

b. For 2007, Parr Corporation estimates its warranty expense to be 1.5% of sales. The company's sales for 2007 were $2,100,000. The actual warranty costs paid in 2007 were $40,000.

Although for financial purposes Parr will accrue $31,500 ($2,100,000 x 1.5%) in warranty expenses, Parr's deduction for tax purposes is $40,000. The all-events test (the liability exists and the amount of the liability can be determined) and the economic performance test have been met only with respect to the $40,000 of actual warranty costs.

A cash basis taxpayer can deduct expenses as the expenses are paid. As a cash basis taxpayer, Parr can deduct $40,000.

 

c. On August 1, 2007, Parr Corporation borrows $225,000 on a 1-year note. Since the company is experiencing a cash flow problem, the bank agrees to let Parr pay the interest when the note matures. In exchange, the interest rate on the note is 10% - - 3% above the current market rate.

Interest relates to the use of money over-time. The accrual method requires Parr to allocate the interest deduction of $22,500 ($225,000 x 10%) over the life of the loan. Therefore, Parr's interest deduction for 2007 is $9,375 [(5 ¸ 12) x $22,500]. The remaining $13,125 is deductible in 2008.

If Parr is a cash basis taxpayer, none of the interest is deductible in 2007 since the interest is not paid until 2008. When the interest is paid in 2008, Parr deducts $22,500 ($225,000 x 10%).

 

d. Parr Corporation advertises on radio and in the newspaper. During the year, the company is billed $16,500 for advertising. The beginning balance in the advertising payable account on January 1, 2007, is $2,500 and the ending balance on December 31, 2007 is $3,300.

As an accrual basis taxpayer, Parr's advertising deduction for 2007 is $16,500. The amount charged to the advertising payable account is deductible because both the all-events test and economic performance test have been met. Economic performance occurred as the advertising services were provided.

As a cash basis taxpayer, Parr only can deduct the amount paid for advertising in 2007. Parr's advertising deduction for 2007 is $15,700. Because the advertising payable account increased by $800 ($2,500 - $3,300), one can assume that Parr only paid $15,700 ($16,500 - $800), the $16,500 billed in 2007 minus the $800 liability incurred but not paid during the year.

 

e. On August 1, 2007, Parr Corporation pays $3,200 for a 1-year fire insurance policy for the period August 1, 2007, through July 31, 2008. Parr's insurance company requires the 1-year prepayment, which the company makes every year.

As an accrual basis taxpayer, Parr would be able to deduct the $3,200 in the current year only if the expense meets the recurring item exception to the economic performance test. Congress intended this exception to apply primarily to accrued expenses - - those expenses that have not yet been paid but that meet the all-events test and will be paid within a reasonable time after the close of the year. To meet this exception the expense must be immaterial for both financial accounting and tax purposes and the relationship between the cost of insurance and Parr’s other items of income and expenses must be immaterial. If Parr cannot meet this exception then it can only deduct $1,333 [(5 ¸ 12) x $3,200] in 2007. The remaining $1,867 ($3,200 - $1,333) is deducted in 2008.

If Parr is a cash basis taxpayer, the corporation is allowed to deduct the entire amount ($3,200) in 2007. Under the one-year rule for prepaid expenses, a cash basis taxpayer can deduct the entire amount of an expense, if the taxpayer can show that the prepayment is required and the benefit will be consumed or used up before the end of the tax year following the year of payment.

 

 

68. Kai, a cash basis taxpayer, is a 75% owner and president of Finnigan Fish Market. Finnigan, an S corporation, uses the accrual method of accounting. On December 28, 2007, Finnigan accrues a bonus of $40,000 to Kai. The bonus is payable on February 1, 2008. When is the bonus deductible? How would your answer change if Finnigan is a cash basis taxpayer?

Generally, an accrual basis corporation can deduct an expense in the tax year in which the payment is made to a cash basis taxpayer. However, because Kai and Finnigan are related parties, Finnigan must wait to deduct the expense until 2008, the tax year Kai reports the bonus as income. Finnigan can deduct the expense on its tax return for the year ended December 31, 2008 and Kai will report the bonus as income on his 2008 tax return. Note that the effect of the related party rule is to always have the income and the corresponding deduction reported in the same year.

If both Kai and Finnigan are cash basis taxpayers, then Finnigan will deduct the bonus when it is paid in 2008 and Kai will report the bonus as income in 2008.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

69. Lonnie owns 100% of Quality Company's common stock. Lonnie, the president of Quality, is a cash basis taxpayer. Quality is short of cash as of December 31, 2007, the close of its tax year. As a result, it is necessary to accrue a $50,000 bonus payable to Lonnie. As soon as the cash becomes available on January 15, 2008, Quality pays Lonnie the bonus in cash. When is the bonus deductible for the accrual basis corporation? How would your answer change if Lonnie is an accrual basis taxpayer?

Generally, an accrual basis corporation can deduct an expense in the tax year in which the payment is made to a cash basis taxpayer. However, because Lonnie and Quality are related parties, Quality must wait to deduct the expense until 2008, the tax year Lonnie reports the bonus as income. Quality will deduct the expense on its tax return for the year ended December 31, 2008 and Lonnie will report the bonus as income on his 2008 tax return. Note that the effect of the related party rule is to always have the income and the corresponding deduction reported in the same year.

If both Lonnie and Quality are accrual basis taxpayers, then Quality will accrue and deduct the bonus as an expense in 2007 and Lonnie will accrue the bonus as income in 2007.

 

70. During the current year, Covino Construction makes $5,000 in political contributions to ten political candidates. What amount can Covino deduct for financial accounting purposes? for tax purposes?

For financial accounting purposes, Covino can deduct the $50,000 ($5,000 x 10) in political contributions as a business expense. However, for tax purposes the political contributions are not deductible. The expense is not ordinary and necessary to the taxpayer's trade or business. In upholding the denial of a deduction for political contributions, the courts have maintained that the money has an "insidious influence" on politics and that the tax system should not promote expenditures that encourage the frustration of public policy. The $50,000 difference between the amount deducted for financial purposes and tax purposes is treated as a permanent difference.

 

 

 

 

 

 

 

 

 

 

 

71. Martin Corporation is an accrual basis taxpayer that manufactures cellular phones. The company provides a 5-year limited warranty on its phones and estimates that warranty expenses will be 1.5% of sales. During the current year, Martin has sales of $12,000,000 and incurs $149,000 of warranty expenses. What amount can Martin deduct for financial accounting purposes? for tax purposes?

For financial accounting purposes, Martin Corporation can deduct $180,000 ($12,000,000 x 1.5%) in warranty expenses. Under generally accepted accounting principles (GAAP), a corporation can deduct an estimate of its future obligations under a warranty contract. However, for tax purposes, Martin is only allowed to deduct the $149,000 of warranty costs it actually incurs. Reserve accounting (i.e., the allowance method) is not allowed for warranties because the all-events test is not met with respect to the $180,000 estimate. That is, although Martin has a reasonable estimate of its expense, the all-events test requires that the actual payee be known. In addition, the economic performance test is not met until the repairs under the warranty contract are actually performed.

The $31,000 difference between the amount deducted for financial purposes ($180,000) and tax purposes ($149,000) is treated as a temporary difference.

ISSUE IDENTIFICATION PROBLEMS

In each of the following problems, identify the tax issue(s) posed by the facts presented. Determine the possible tax consequences of each issue you identify.

 

72. Shuana works as a lawyer for a large law firm where professional dress is expected. Her friend, Carissa, is a nurse at a local hospital. Shuana spends $1,500 a year on clothing, shoes, and accessories that she wears to work. Carissa spends $500 on uniforms and shoes for her job.

The issue is whether clothes used by Carissa and Shuana in their jobs can be deducted as a business expense. Carissa is allowed to deduct the cost of her uniform and shoes. The cost of these items are deductible because Carissa acquired and used these items exclusively in her job as a nurse. It is not common for a nurse to wear these items outside of the hospital (i.e., for personal use). The $500 is an unreimbursed employee expense and is deducted as a miscellaneous itemized deduction (see Chapter 8).

Shuana cannot deduct the cost of the clothes, shoes and accessories that she wears to work. Unlike Carissa, the clothes Shauna wears to her job are not used exclusively in her job as a lawyer. It is common for a taxpayer to also use these items for personal purposes.

Instructors Note: It could be argued that the clothes are a mixed use asset. However, the government, under the administrative convenience concept, feels that is easier to disallow the deduction than to determine whether the taxpayer properly allocated the cost of the clothes between business and personal use.

 

 

 

73. Angela owns a duplex. She rents out one unit and lives in the other. During the current year, she pays $4,500 in interest on the loan she used to buy the duplex, $900 in property taxes on the duplex, and $1,200 in dues to the duplex association which maintains the grounds and the swimming pool.

The two issues that should be considered are which expenses can Angela deduct and the deductible amount of each expense. The duplex is a mixed-use asset and the expenses related to the duplex are mixed-use expenditures. Angela will be able to deduct all expenses related to the rental unit against her rental income as a deduction for adjusted gross income. Assuming that the two units are equivalent (for example, based on square footage of each unit), half of the interest, taxes and association dues are deducted as rental expenses. The remainder of each expense is a personal expense. Home mortgage interest and property taxes are deductible as itemized deductions. The personal portion of the association dues would not be deductible.

Rent Expense Personal

Interest $2,250 $2,250

Property taxes 450 450

Dues 600 600

74. Harry and Sydney each inherited 50% of the stock in their father's corporation when he died. Harry had been working for their father and wanted to retain control of the business. Sydney was not really interested in the family business and wanted to sell her stock to outsiders. To retain control of the corporation, Harry made Sydney a vice president of the corporation with an annual salary of $200,000. The only requirements of the position were that Sydney not sell her stock and that she let Harry run the business.

The issue is whether the corporation will be allowed to deduct the $200,000 it paid to Sydney. The corporation will not be entitled to a deduction because the amount paid is not reasonable considering her responsibilities and duties to the corporation. The substance of the transaction is that it is a guaranteed dividend payment. Thus, Sydney will be taxed on the $200,000, but the corporation is not allowed a deduction for the dividend payment.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

75. Leonard owns an apartment complex. During the current year, he pays $14,000 to have all the apartments painted and recarpeted. Gena purchases an apartment complex during the current year. Before she can rent out the apartments, she pays $14,000 to have them painted and recarpeted.

The issue is whether the expenses are currently deductible or should be capitalized. Painting and recarpeting apartments is generally considered to be an ongoing maintenance expense. Because Leonard has owned the apartment in prior years, he would be allowed to deduct the $14,000 as a current period expense. Because Gena purchased her apartments in the current year and the work was necessary to rent them out, they are capital expenditures. That is, they are part of the cost of getting the apartments ready to rent and must be added (i.e., capitalized) to the cost of the building and deducted through depreciation.

76. In auditing the Philbin Corporation's repair expense account, Sara finds a $28,000 entry. Since the amount is so large, she obtains supporting documentation. The invoice lists the Fradin Roofing Company as providing the service, but no description of the work the company performed is attached to the invoice. However, a notation on the check says "office roof."

The issue is whether the roof repair is currently deductible or should be capitalized. Sara must determine whether the repair either increases the useful life of the building or increases the value of the building. If so, the $28,000 expense must be capitalized and Philbin Corporation will recover the cost of the roof over the tax life of the building (depreciation is discussed in Chapter 10). If the expense for the roof is incurred only to maintain the building in its normal operating condition, then the $28,000 is deductible in the current period.

For example, if a new roof would cost the Philbin Corporation $600,000, then the $28,000 expenditure should be considered a repair expense. The amount spent on the roof does not extend the useful life of the building, rather, the expense maintains the building in its normal operating condition. However, if the cost of a new roof would cost $35,000, then the $28,000 expenditure should be treated as a capital expenditure, since the amount spent on the roof extends the useful life of the building.

 

 

 

 

 

 

 

 

77. Gary and Wes operate a wholesale meat company. The company sells to restaurants, golf clubs and other dining establishments. Recently they spent $20,000 for market and demographic surveys, financial projections and real estate appraisals to help them decide whether to open a retail store.

The issue is whether opening the retail store is related to their current trade or business. If so, the $20,000 in costs are considered ordinary and necessary business expenses and are deductible regardless of whether they open the new store.

If the retail store is not related to their current trade or business, the costs are start-up costs. A taxpayer who incurs less than $50,000 of start-up costs can deduct up to $5,000 of the start-up costs in the year the new business begins. Any amount in excess of $5,000 must be amortized over 180 months. For taxpayers, with start-up costs in excess of $50,000, the $5,000 amount is phased-out on a dollar-by-dollar basis. Therefore, the deduction for start-up costs can be viewed as consisting of two parts. The first is a $5,000 current deduction and a second part that amortizes the remaining start-up costs over 180 months. If they do not open the store, then the expenses are considered a personal capital expenditure and are not deductible.

78. Marcus is the vice president of human resources for Griffin Industries. He spent one week testifying before Congress on the impact health care legislation will have on small business. His trip cost $2,750.

The issue is whether Marcus's trip is a business expense or a lobbying expense. The trip is not deductible because it is considered a lobbying expense. Only the cost of monitoring legislation is a deductible business expense.

 

 

 

 

 

 

 

 

 

 

79. Russell is employed as a prosecutor for the town of Swansee. He also works 15-20 hours a week raising purebred Labradors. Over the last 7 years, he has reported an average net income from this activity of $7,000 per year. However, in two of those years, he has had losses of $3,000 and $4,000. He believes he could make more money from the activity if he kept better records, was less stubborn, and listened more to the advice of his cousin who has won national awards in dog breeding.

The issue is whether Russell is engaged in the trade or business of raising Labradors or whether the activity is a hobby. In determining whether Russell is engaged in a trade or business or a hobby, the IRS will examine the following nine factors:

• Whether the taxpayer carries on the activity in a business-like manner

• The expertise of the taxpayer or her reliance on expertise

• The history of income and profits

• The time and effort spent on the activity

• The taxpayer's success in similar activities

• Whether the activity is engaged in for personal pleasure or recreation

• The taxpayer's financial condition

• The expectation that the assets used in the business will appreciate

• The amount, if any, of occasional profits

The fact that Russell has made money in most years is beneficial in proving that he is engaged in a trade or business. However, the fact that he does not conduct the activity in a business-like manner (i.e., his poor records) and does not rely on the expertise of a professional (i.e., his cousin) will work against him.

 

 

 

80. Chin, a cash basis taxpayer, borrows $25,000 on a 2-year loan from State Bank to purchase business equipment. Under the terms of the loan, State Bank deducts $4,500 in interest on the loan and gives Chin the $20,500 net proceeds. Chin will repay State Bank $25,000 in 2 years.

The issue is when can Chin deduct the $4,500 in interest on the loan. Can basis taxpayers can only deduct expenses as they are paid. In this case Chin will deduct the $4,500 of interest in 2 years when the loan is repaid.

 

 

 

 

 

 

 

 

 

 

 

81. The Showgate Hotel Casino is an accrual basis taxpayer and maintains its records on a calendar year. It has 3,000 slot machines, one of them a progressive machine whose jackpot increases based on the amount wagered. The casino guarantees that a person who hits the jackpot will receive the lesser of 5% of the amount wagered to date or $250,000. On December 1, 2007, the progressive slot machine reaches the $250,000 maximum payoff. The following January, a hotel guest wins the $250,000 jackpot.

The issue is whether Showgate can deduct the $250,000 payment in 2007. Accrual basis taxpayers can only deduct expenses when the all-events and economic performance tests have been met. Although the liability for the jackpot exists, and the amount is known, since Showgate does not know the payee, it does not meet the all-events test. The economic performance test requires that economic performance with regard to the liability must have occurred. This generally means that property (in this case cash) related to the liability must have been received by the winner. Because the actual payment to the winner is not made until 2008, the economic performance test is not met and the casino cannot take a deduction for jackpot until 2008. Instructors Note: This is a modification of an example in the regulations [Reg. Sec. 1.461-4(g)(8)].

82. RIA RESEARCH EXERCISE Use the RIA Checkpoint database to answer the following questions. Cut and paste the relevant Internal Revenue Code and Regulation section(s) into your solution and explain how the authority answers the tax issue in question. Give the most specific citation applicable [e.g., Section 168 (a) (1)] to the question. Note: If the answer can be found in both the code and regulations you must provide both authorities.

1. Sally is a teacher. In her spare time, she enjoys painting watercolors. Occasionally she sells one of her paintings. Last year, Sally spent $800 on paint supplies, and received $1,000 from the sale of her paintings. What code section and/or regulation allows Sally to deduct some of the expenses from her hobby?

Sec. 183 (b) sets forth the type of expenses that can be deducted if the taxpayer is engaged in a hobby (activity not engaged in for a profit). Although not obvious, the Code in (b)(1) is referring to interest and taxes, where in (b((2) it is referring to other business expenses (e.g., supplies, utilities and depreciation). These distinctions become clearer upon reading Reg § 1.183-1 (b) (1).

Sec. 183 Activities not engaged in for profit.

(b) Deductions allowable. In the case of an activity not engaged in for profit to which subsection (a) applies, there shall be allowed—

(1) the deductions which would be allowable under this chapter for the taxable year without regard to whether or not such activity is engaged in for profit, and

(2) a deduction equal to the amount of the deductions which would be allowable under this chapter for the taxable year only if such activity were engaged in for profit, but only to the extent that the gross income derived from such activity for the taxable year exceeds the deductions allowable by reason of paragraph (1).

Reg § 1.183-1. Activities not engaged in for profit.

(b) Deductions allowable.

(1) Manner and extent. If an activity is not engaged in for profit, deductions are allowable under section 183(b) in the following order and only to the following extent:

(i) Amounts allowable as deductions during the taxable year under chapter 1 of the Code without regard to whether the activity giving rise to such amounts was engaged in for profit are allowable to the full extent allowed by the relevant sections of the Code, determined after taking into account any limitations or exceptions with respect to the allowability of such amounts. For example, the allowability-of-interest expenses incurred with respect to activities not engaged in for profit is limited by the rules contained in section 163(d).

(ii) Amounts otherwise allowable as deductions during the taxable year under chapter 1 of the Code, but only if such allowance does not result in an adjustment to the basis of property, determined as if the activity giving rise to such amounts was engaged in for profit, are allowed only to the extent the gross income attributable to such activity exceeds the deductions allowed or allowable under subdivision (i) of this subparagraph.

 

(iii) Amounts otherwise allowable as deductions for the taxable year under chapter 1 of the Code which result in (or if otherwise allowed would have resulted in) an adjustment to the basis of property, determined as if the activity giving rise to such deductions was engaged in for profit, are allowed only to the extent the gross income attributable to such activity exceeds the deductions allowed or allowable under subdivisions (i) and (ii) of this subparagraph. Deductions falling within this subdivision include such items as depreciation, partial losses with respect to property, partially worthless debts, amortization, and amortizable bond premium.

2. Jerry, a salesman, sends his five best clients gift baskets on their birthdays. The gift baskets cost Jerry $50 each. What code section and/or regulation allows Jerry to deduct $25 of the price of each gift?

Sec. 162 (b) specifically disallows a deduction for business gifts. However, relief is found in Sec. 274 and the regulations of that code section.

Sec. 162 Trade or Business Expenses

(a) In general.

There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business

(b) Charitable contributions and gifts excepted.

No deduction shall be allowed under subsection (a) for any contribution or gift which would be allowable as a deduction under section 170 were it not for the percentage limitations, the dollar limitations, or the requirements as to the time of payment, set forth in such section.

Both Sec. 274 (b)(1) and Reg. Sec. 1-274-3(a) limit the amount of a deduction for a gift to $25. Both authorities also make it clear that the $25 limit is not a per gift limit, but a yearly deduction limit per individual.

Sec. 274 Disallowance of certain entertainment, etc., expenses.

(b) Gifts.

(1) Limitation. No deduction shall be allowed under section 162 or section 212 for any expense for gifts made directly or indirectly to any individual to the extent that such expense, when added to prior expenses of the taxpayer for gifts made to such individual during the same taxable year, exceeds $25. For purposes of this section , the term "gift" means any item excludable from gross income of the recipient under section 102 which is not excludable from his gross income under any other provision of this chapter, but such term does not include—

Reg § 1.274-3. Disallowance of deduction for gifts.

(a) In general. No deduction shall be allowed under section 162 or 212 for any expense for a gift made directly or indirectly by a taxpayer to any individual to the extent that such expense, when added to prior expenses of the taxpayer for gifts made to such individual during the taxpayer's taxable year, exceeds $25.

 

 

 

3. Marvin’s house is damaged by a tornado. What code section and/or regulation allows him to deduct any loss he suffers due to the tornado?

Sec. 165(a) allows an individual to deduct losses not compensated by insurance, if the loss arises from a casualty. Sec. 165(c)(3) and Reg. 1.165-7(a)(1) all list the types of casualties that qualify as a casualty but this is not to be interpreted as an exhaustive list. A tornado is considered a storm.

§ 165 Losses.

(a) General rule. There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.

(b) Amount of deduction. For purposes of subsection (a), the basis for determining the amount of the deduction for any loss shall be the adjusted basis provided in section 1011 for determining the loss from the sale or other disposition of property.

Sec. 165(c)(3) and Reg. Sec. 1.165-7(a)(1) limits personal losses of individuals to those from fire, storm, shipwreck or other casualty.

(c) Limitation on losses of individuals. In the case of an individual, the deduction under subsection (a) shall be limited to

(1) losses incurred in a trade or business;

(2) losses incurred in any transaction entered into for profit, though not connected with a trade or business; and

(3) except as provided in subsection (h) , losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft.

Reg § 1.165-7. Casualty losses.

(a) In general. (1) Allowance of deduction. Except as otherwise provided in paragraphs (b)(4) and (c) of this section, any loss arising from fire, storm, shipwreck, or other casualty is allowable as a deduction under section 165(a) for the taxable year in which the loss is sustained. However, see §1.165-6, relating to farming losses, and

§1.165-11, relating to an election by a taxpayer to deduct disaster losses in the taxable year immediately preceding the taxable year in which the disaster occurred. The manner of determining the amount of a casualty loss allowable as a deduction in computing taxable income under section 63 is the same whether the loss has been incurred in a trade or business or in any transaction entered into for profit, or whether it has been a loss of property not connected with a trade or business and not incurred in any transaction entered into for profit. The amount of a casualty loss shall be determined in accordance with paragraph (b) of this section. For other rules relating to the treatment of deductible casualty losses, see §1.1231-1, relating to the involuntary conversion of property.

 

 

4. Peter undergoes a medical procedure to prevent him from snoring. His insurance company will not reimburse him for the $2,000 procedure since he does not suffer from sleep apnea and contends that the procedure is cosmetic surgery. What code section and/or regulation does not allow him to deduct the cost of the procedure if the medical procedure is considered cosmetic surgery?

Sec. 213 (a) provides that a taxpayer can deduct unreimbursed medical care incurred on behalf of the taxpayer, their spouse or their dependent.

§ 213 Medical, dental, etc., expenses

(a) Allowance of deduction. There shall be allowed as a deduction the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, his spouse, or a dependent (as defined in section 152 , determined without regard to subsections (b)(1) , (b)(2) , and (d)(1)(B) thereof), to the extent that such expenses exceed 7.5 percent of adjusted gross income.

Sec. 213(d)(1)(A) defines medical care as amounts paid "for the purpose of affecting any structure or function of the body" This would allow Peter a deduction for the cosmetic surgery.

§ 213 Medical, dental, etc., expenses.

(d) Definitions. For purposes of this section —

(1) The term "medical care" means amounts paid—

(A) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body,

(B) for transportation primarily for and essential to medical care referred to in subparagraph (A) ,

(C) for qualified long-term care services (as defined in section 7702B(c) ), or

(D) for insurance (including amounts paid as premiums under part B of title XVIII of the Social Security Act, relating to supplementary medical insurance for the aged) covering medical care referred to in subparagraphs (A) and (B) or for any qualified long-term care insurance contract (as defined in section 7720B(b).

However, Sec. 213(d)(9)(A) specifically states that medical care does not include cosmetic surgery. The definition of cosmetic surgery is found in Sec. 213(d)(9)(B).

§ 213 Medical, dental, etc., expenses.

(9) Cosmetic surgery.

(A) In general. The term "medical care" does not include cosmetic surgery or other similar procedures, unless the surgery or procedure is necessary to ameliorate a deformity arising from, or directly related to, a congenital abnormality, a personal injury resulting from an accident or trauma, or disfiguring disease.

(B) Cosmetic surgery defined. For purposes of this paragraph , the term "cosmetic surgery" means any procedure which is directed at improving the patient's appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease.

83. TAX RESEARCH EXERCISE Carmela is single, 52 years old, and has an adjusted gross income of $52,000. Carmela is covered by a qualified employee pension plan and she contributes the maximum amount to her Individual Retirement Account (IRA).

a. What code section and/or regulation allows a deduction for contributions to an IRA?

Sec. 219(a) allows a deduction for a contribution to a qualified retirement plan.

Sec. 219 Retirement savings.

(a) Allowance of deduction. In the case of an individual, there shall be allowed as a deduction an amount equal to the qualified retirement contributions of the individual for the taxable year.

Reg. Sec. 1.219-1(a) provides that the taxpayer is allowed a deduction for adjusted gross income up to the maximum amount provided in Sec 219 (b)(1).

Reg § 1.219-1(a)

(a) In general. Subject to the limitations and restrictions of paragraph (b) and the special rules of paragraph (c)(3) of this section, there shall be allowed a deduction under section 62 from gross income of amounts paid for the taxable year of an individual on behalf of such individual to an individual retirement account described in section 408(a), for an individual retirement annuity described in section 408(b), or for a retirement bond described in section 409. The deduction described in the preceding sentence shall be allowed only to the individual on whose behalf such individual retirement account, individual retirement annuity, or retirement bond is maintained. The first sentence of this paragraph shall apply only in the case of a contribution of cash. A contribution of property other than cash is not allowable as a deduction under this section. In the case of a retirement bond, a deduction will not be allowed if the bond is redeemed within 12 months of its issue date.

b. What code section and/or regulation limits the amount that can be contributed to an IRA?

Sec. 219(b)(1) limits the amount that can be deducted to the lesser of earned income or the deductible amount. Sec. 219(b)(5)(A) provides the maximum deductible amount. For 2007, the maximum amount is $4,000.

Sec. 219 Retirement savings.

(b) Maximum amount of deduction.

(1) In general. The amount allowable as a deduction under subsection (a) to any individual for any taxable year shall not exceed the lesser of—

(A) the deductible amount, or

(B) an amount equal to the compensation includible in the individual's gross income for such taxable year.

(5) Deductible amount. For purposes of paragraph (1)(A)—

(A) In general. The deductible amount shall be determined in accordance with the following table:

For taxable years beginning in: The deductible amount is:

2003 through 2005 $3,000

2006 through 2008 $4,000

2009 and thereafter $5,000.

Proposed Reg § 1.219(a)-2(b)(1) also discusses the limits. However, the regulations have not been updated since 1981.

Prop Reg § 1.219(a)-2

b) Limitations and restrictions.

(1) Maximum deduction. The amount allowable as a deduction for contributions to an individual retirement plan to an individual for any taxable year cannot exceed the lesser of—

(i) $2,000, or

(ii) An amount equal to the compensation includible in the individual's gross income for the taxable year, reduced by the amount of the individual's qualified voluntary employee contributions for the taxable year.

c. What code section and/or regulation allows an increased IRA contribution due to age?

For 2007, Sec. 219(b)(5)(B)(ii) allows taxpayers age 50 and over to contribute and deduct an additional $1,000 to their IRA accounts.

Sec. 219 Retirement savings.

(5) Deductible amount.

(B) Catch-up contributions for individuals 50 or older.

(i) In general. In the case of an individual who has attained the age of 50 before the close of the taxable year, the deductible amount for such taxable year shall be increased by the applicable amount.

(ii) Applicable amount. For purposes of clause (i) , the applicable amount shall be the amount determined in accordance with the following table:

Year Amount

2002 through 2005 $ 500

2006 and thereafter $1,000.

d. What code section and/or regulation limits the amount of the IRA deduction for members of a qualified employee pension plan?

Sec. 219(g)(1) specifies that if an individual or the individual’s spouse is a active participant in a pension plan, the amount of the taxpayer’s contribution that can be deducted is reduced as specified in Sec. 219 (g)(2). The reduction is phased out over a $10,000 range as specified in Sec. 219(g)(2)(A)(ii).

Sec. 219 Retirement savings.

(g) Limitation on deduction for active participants in certain pension plans.

(1) In general. If (for any part of any plan year ending with or within a taxable year) an individual or the individual's spouse is an active participant, each of the dollar limitations contained in subsections (b)(1)(A) and (c)(1)(A) for such taxable year shall be reduced (but not below zero) by the amount determined under paragraph (2).

(2) Amount of reduction.

(A) In general. The amount determined under this paragraph with respect to any dollar limitation shall be the amount which bears the same ratio to such limitation as—

(i) the excess of —

(I) the taxpayer's adjusted gross income for such taxable year, over

(II) the applicable dollar amount, bears to

(ii) $10,000 ($20,000 in the case of a joint return for a taxable year beginning after December 31, 2007).

(B) No reduction below $200 until complete phaseout. No dollar limitation shall be reduced below $200 under paragraph (1) unless (without regard to this subparagraph) such limitation is reduced to zero.

(C) Rounding. Any amount determined under this paragraph which is not a multiple of $10 shall be rounded to the next lowest $10.

(3) Adjusted gross income; applicable dollar amount

(B) Applicable dollar amount. The term "applicable dollar amount" means the following:

(i) In the case of a taxpayer filing a joint return: The applicable dollar amount is:

Year Amount

1999 $50,000

2000 $51,000

2001 $52,000

2002 $53,000

2003 $54,000

2004 $60,000

2005 $65,000

2006 $70,000

2007 $75,000

2008 and thereafter $80,000.

(ii) In the case of any other taxpayer (other than a married individual filing a separate return): The applicable dollar amount is:

Year Amount

1999 $30,000

2000 $31,000

2001 $32,000

2002 $33,000

2003 $34,000

2004 $40,000

2005 $45,000

2006 and thereafter $50,000.

84. TAX SIMULATION. In April of the current year, the Mojena Corporation, a computer power supply manufacturer, was found guilty of price fixing under the Sherman Anti-Trust Act and fined $50,000. In addition, The United States sued Mojena under Section 4A of the Clayton Act for $140,000, of which $100,000 represents the actual damages (compensatory damages) resulting from the price fixing and $40,000 represents court costs. In July, Mojena Corp. pays the United States $190,000 ($50,000 + $100,000 + $40,000) in full settlement of the charges.

Required: Determine the amount Mojena can deduct on its tax return. Search a tax research database and find the relevant authority (ies) that form the basis for your answer. Your answer should include the exact text of the authority (ies) and an explanation of the application of the authority to Mojena’s facts. If there is any uncertainty about the validity of your answer, indicate the cause for the uncertainty.

Sec. 162(a) allows a deduction all ordinary and necessary expenses incurred in carrying on a trade or business.

Sec. 162(a) There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business

However, Sec. 162(f) prohibits a deduction for any fine paid to the government.

Sec. 162 (f) Fines and penalties. No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.

While it is clear from the above Code Section that the $50,000 fine is not deductible, it is not clear whether the $100,000 of actual damages and the $40,000 of court costs are considered a fine or a penalty under Sec. 162(f). Reg. Sec. 1.162-21(b)(2) provides clarification of what is considered a fine or penalty by stating that amounts paid as compensatory damages and for court costs are not considered to be fines or penalties.

The amount of a fine or penalty does not include legal fees and related expenses paid or incurred in the defense of a prosecution or civil action arising from a violation of the law imposing the fine or civil penalty, nor court costs assessed against the taxpayer, or stenographic and printing charges. Compensatory damages (including damages under section 4A of the Clayton Act (15 U.S.C. 15a), as amended) paid to a government do not constitute a fine or penalty.

Based on the above, it would appear that Mojena would be able to deduct the $100,000 of compensatory damages and the $40,000 of court costs. However, Sec. 162 (g) states:

Sec. 162 Treble damage payments under the antitrust laws.
If in a criminal proceeding a taxpayer is convicted of a violation of the antitrust laws, or his plea of guilty or nolo contendere to an indictment or information charging such a violation is entered or accepted in such a proceeding, no deduction shall be allowed under subsection (a) for two-thirds of any amount paid or incurred—

(1) on any judgment for damages entered against the taxpayer under section 4 of the Act entitled "An Act to supplement existing laws against unlawful restraints and monopolies, and for other purposes", approved October 15, 1914 (commonly known as the Clayton Act), on account of such violation or any related violation of the antitrust laws which occurred prior to the date of the final judgment of such conviction, or

(2) in settlement of any action brought under such section 4 on account of such violation or related violation. The preceding sentence shall not apply with respect to any conviction or plea before January 1, 1970, or to any conviction or plea on or after such date in a new trial following an appeal of a conviction before such date.

Therefore, it appears as if based solely on the Code and Regulations there is uncertainty as to whether an entity would lose 2/3 of its deduction for payments made under the Clayton Act or only those payments in which the payment is not specified as a compensatory payment.

85. INTERNET ASSIGNMENT Many legislative, administrative, and judicial resources are available on the Internet. Court cases can be located using a search engine provided by your browser or a tax directory site on the Internet. Using a search engine or one of the tax directory sites provided in Exhibit 16-6 (Chapter 16), find the 1987 Supreme Court decision that provides the current criteria for determining what constitutes a trade or business. Trace the process you used to find this case (search engine or tax directory used and key words). Describe the facts that led to this decision.

The Tax and Accounting Sites Directory http://www.taxsites.com/ is a good tax directory to start your search. Clicking on Federal Tax Law will take the student to a page that lists Court Decisions. From there, clicking on U.S. Supreme Court Decisions will take the student to Findlaw (http://www.findlaw.com/casecode/supreme.html). Using the search term "tax and trade and business" a list of all cases with this search term and the standard cite for the case will appear. The first 1987 case that appears on the list is Commissioner v Groetzinger, 480 U.S. 23 (1987).

Case Background:

For most of 1978, respondent devoted 60 to 80 hours per week to pari-mutuel wagering on dog races with a view to earning a living from such activity, had no other employment, and gambled solely for his own account. His efforts generated gross winnings of $70,000 on bets of $72,032, for a net gambling loss for the year of $2,032. Although he reported this loss on his 1978 tax return, he did not utilize it in computing his adjusted gross income or claim it as a deduction. Upon audit, the Commissioner of Internal Revenue determined that, under the Internal Revenue Code of 1954 (Code) as it existed in 1978, respondent was subject to a minimum tax because part of the gambling loss deduction to which he was entitled was an "item of tax preference." Under the Code, such items could be lessened by certain deductions that were "attributable to a trade or business carried on by the taxpayer." The Supreme Court held that a full-time gambler who makes wagers solely for his own account is engaged in a "trade or business" within the meaning of Code 162(a) and 62(1).

INSTRUCTOR’S NOTE: Information on the Internet is constantly changing, so this solution may become outdated. We suggest that you do the assignment prior to assigning it to your students. This will allow you to provide students with any additional information they may need to complete the assignment. In addition, a hint to the students to help in the search process is that the case deals with a gambler.

86. INTERNET ASSIGNMENT Articles on tax topics are often useful in understanding the income tax law. One journal that is free and accessible through the Internet is the CPA Journal. Go to the CPA Journal web page (http://www.cpajournal.com/) and find an article discussing the tax deductibility of environmental cleanup costs. Summarize the information in the article.

Using the search terms "environmental and cleanup" the student will find 6 documents. The fifth article listed is entitled "New Ruling on treatment of Environmental Clean-up Costs" by Charles E. Price and Leonard G. Weld. The article discusses the Revenue Ruling 2005-18, which now requires that previously deductible environmental clean-up costs must be capitalized as indirect costs of inventory.

INSTRUCTOR’S NOTE: Information on the Internet is constantly changing, so this solution may become outdated. We suggest that you do the assignment prior to assigning it to your students. This will allow you to provide students with any additional information they may need to complete the assignment.

__________________________________________________________________

CHAPTER 6

 

BUSINESS EXPENSES

___________________________________________________________________

DISCUSSION QUESTIONS

 

1. Most expenditures that have a business purpose and meet the ordinary, necessary, and reasonable requirements are deductible. However, specific rules must be adhered to in determining the deductibility of many expenses that meet this test. Why are these specific rules necessary?

There are many business expenses that have a personal element to them. As such, they are subject to abuse by taxpayers. For example, meals and entertainment can be valid business expenses. However, due to the potential for taxpayers to attempt to deduct personal meal and entertainment expenses, specific rules on the deductibility of such expenses have been created. In addition to the qualifying requirements, most expenses that are usually considered to be personal in nature (e.g., car expenses) must be adequately substantiated.

 

2. What requirements must be met for meal and entertainment expenses to be deductible?

To qualify as deductible business expenses, meal and entertainment expenses must:

1. Have a business purpose,

2. Qualify as an ordinary and necessary expense of the business and not be lavish or extravagant (i.e., reasonable in amount),

3. Be directly related to or associated with the active conduct of the taxpayer's business activity, and

4. Be adequately documented.

 

3. How does an entertainment expense directly related to business differ from an entertainment expense associated with business?

The two entertainment expense classifications are similar in that both:

1. Require that the expense be incurred for a business purpose that is related to the active conduct of the taxpayer's business.

2. Both must qualify as an ordinary and necessary expense of the business and not be lavish or extravagant (i.e., reasonable in amount).

3. Both must satisfy substantiation requirements.

The two entertainment expense classifications are different in that:

1. A bona fide business activity must take place to qualify as a directly related entertainment expense. To qualify as an associated with expense, the entertainment must directly precede or follow substantial business discussions.

2. Directly related expenses are amounts spent to provide entertainment for the taxpayer and the person(s) involved in the conduct of the business activity. Associated with expenses may include expenses related to persons whose presence is appropriate for business reasons but not necessary for the actual conduct of business. The tax law refers to this requirement as expenses of persons closely connected with the individual who conducted business with the taxpayer. For example, the costs related to the presence of a business associate's spouse at a dinner following a substantial business meeting would qualify as an associated with expense.

The associated with test may be easier to satisfy than the directly related test. In addition, the persons whose expenses qualify for deduction is broader under the associated with test.

 

4. What problems does the taxpayer who uses an automobile for both business and personal purposes encounter? What option(s) does the taxpayer have regarding the automobile expense deduction?

When an asset is used for more than one purpose, the cost of the asset and any expenditures associated with the asset must be allocated between the two purposes in some reasonable manner. Because the business use of the automobile is deductible and the personal use is not, the automobile is treated as two separate assets for tax purposes. In addition, the expenses of operating the automobile must be allocated between business use and personal use.

The taxpayer may elect to use either the actual cost method or the standard mileage rate method to determine the allowable deductions on the automobile. Both methods require the taxpayer to substantiate the business miles driven. The actual cost method also requires the substantiation of the expenses related to the automobile. The standard mileage rate is 48.5 cents per mile in 2007.

 

5. What records are necessary to properly document travel, entertainment, and gift expenses?

A deduction is allowed for substantiated (proven) travel, entertainment, and gift expenses. To properly substantiate an expense, the taxpayer must make a written record as near to the time an expense is incurred as possible to show:

1. The amount of each separate expense,

2. The date of the entertainment or gift, or the time period the taxpayer traveled,

3. Where the entertainment took place, or the travel destination,

4. The description of a gift,

5. The business purpose of the expense, and

6. The business relationship between the taxpayer and persons entertained or given a gift.

 

 

6. Under what circumstances are business gifts deductible?

A taxpayer can deduct up to $25 in gifts to business customers. The taxpayer is required to maintain documentation describing the taxpayer's relationship with the recipient, the date of the gift, the description of the gift, and the business purpose of the gift. The gift is not subject to the 50% limitation on entertainment and meals expenses.

 

7. Explain the criteria used to determine whether an educational expense is deductible or nondeductible and how education expenses are deducted on a taxpayer's return.

Individuals are allowed to deduct education expenses if the education expense meets either of the following requirements: (1) the education is required by law or by the employer for the taxpayer to retain the taxpayer's job or (2) the expense maintains or improves the skills required in the taxpayer's trade or business.

Because education is viewed as a personal capital expenditure, education expenses are not deductible if the expense is incurred to (1) meet the minimum educational requirements required for the taxpayer's job or (2) if the education qualifies the taxpayer for a new trade or business.

A taxpayer is allowed a deduction from adjusted gross income for education expenses if the expenses are incurred as a requirement for the taxpayer to continue employment or are incurred to maintain or improve the skills required in their job. In 2007, a taxpayer with adjusted gross income less than $65,000 ($130,000 for a married couple filing a joint return) is allowed to deduct for adjusted gross income a maximum of $4,000 of qualified higher education expenses. If a taxpayer’s adjusted gross income exceeds $65,000 ($130,000 for a married couple filing a joint return) but does not exceed $80,000 ($160,000 for a married couple filing a joint return), the taxpayer can deduct a maximum of $2,000 of qualified higher education expenses. If the taxpayer’s adjusted gross income exceeds these amounts $80,000 ($160,000 for a married taxpayer filing jointly), then the taxpayer is not allowed a deduction for adjusted gross income. Therefore, in 2007, some taxpayers can deduct qualified higher education expenses even if the expenses are not incurred as a requirement for the taxpayer to continue employment or do not maintain or improve the skills required in their job. Qualified higher education expenses are limited to tuition and fees paid to attend the institution. A taxpayer who claims the deduction cannot claim a HOPE or Lifetime Learning Credit (discussed in Chapter 8) for the same individual. However, a taxpayer may claim the deduction and receive a distribution from an Education IRA as long as the distribution is not used for the same educational expenses for which the deduction is claimed.

 

8. Can education expense incurred by one taxpayer be deductible whereas the same expense incurred by another taxpayer is not deductible? Explain.

An education expense is deductible when the expense is either (1) required by law or by the employer for the taxpayer to maintain her/his job, or (2) the expense maintains or improves the skills required in the taxpayer's trade or business. However, an education expense that (1) meets the minimum educational requirements required for the taxpayer's job, or (2) qualifies the taxpayer for a new trade or business might not be deductible. Therefore, an education expense that is deductible for one taxpayer could be treated as a nondeductible expense for another taxpayer.

For example, if two individuals are enrolled in the same advanced database management course, the tax treatment can vary based on the background of each individual. Assume that Judy has a B.S. in computer science and works full-time for Hazelnut Corporation as a computer programmer. She enrolls in the course to refresh her skills in database management. On the other hand, Sam is a full-time student who works part-time as a computer programmer for Pine Corporation and is taking the course to meet his undergraduate requirements for a degree. For Judy, the course is considered a deductible education expense because the course maintains or improves her skills. For Sam, the course generally would not be deductible.

A taxpayer is allowed a deduction from adjusted gross income for education expenses if the expenses are incurred as a requirement for the taxpayer to continue employment or are incurred to maintain or improve the skills required in their job. In 2007, a taxpayer with adjusted gross income less than $65,000 ($130,000 for a married couple filing a joint return) is allowed to deduct for adjusted gross income a maximum of $4,000 of qualified higher education expenses. If a taxpayer’s adjusted gross income exceeds $65,000 ($130,000 for a married couple filing a joint return) but does not exceed $80,000 ($160,000 for a married couple filing a joint return), the taxpayer can deduct a maximum of $2,000 of qualified higher education expenses. If the taxpayer’s adjusted gross income exceeds these amounts $80,000 ($160,000 for a married taxpayer filing jointly), then the taxpayer is not allowed a deduction for adjusted gross income. Therefore, in 2007, some taxpayers can deduct qualified higher education expenses even if the expenses are not incurred as a requirement for the taxpayer to continue employment or do not maintain or improve the skills required in their job. Qualified higher education expenses are limited to tuition and fees paid to attend the institution.

9. Is all compensation paid to an employee deductible? Discuss the circumstances in which employee compensation cannot be deducted.

Payments for compensation paid to an employee are deductible to the extent that they are ordinary, necessary, and reasonable in amount. Compensation paid that is unreasonable in amount may not be deducted as a business expense. Unreasonable compensation situations generally arise when the payment is being made to a related party. In such cases, taxpayers often try to transfer income from one party to another to lower the total tax paid. However, if the payment made is unreasonable for the duties and responsibilities of the payee, it will not be considered compensation and will not be deductible.

For publicly traded corporations, deductible compensation paid to the CEO and the four highest compensated officers other than the CEO cannot exceed $1,000,000 for each person.

 

10. Explain the difference in the tax treatment of business and nonbusiness bad debts.

A business bad debt is deductible in the period in which the fact of the bad debt becomes known. That is, estimates of the amount of the debt may be made at the time the debt is known to be uncollectible. Adjustments for the actual amount of the bad debt are made in subsequent periods. Business bad debt deductions are deductible in full as a trade or business expense.

A nonbusiness bad debt is not deductible until the period in which the actual amount of the debt that will not be collected is known. Thus, estimates of nonbusiness bad debts are not allowed. In addition, nonbusiness bad debts are treated as short-term capital losses. This could result in the debt not being fully deductible in the period in which the amount of the bad debt is determined due to the capital loss deduction limitations (i.e., $3,000 per year).

 

11. What accounting method must be used to account for bad debts that result from the sale of merchandise or the provision of services?

Only accrual basis taxpayers are allowed deductions for bad debts. Cash basis taxpayers have not recognized any income related to receivables and therefore, have no basis in the debt to deduct.

With a few limited exceptions, taxpayers must use the specific charge-off method to deduct bad debts. This method allows bad debt deductions only in the period in which an account is determined to be worthless. The tax law generally disallows the use of the allowance method of accounting for bad debts.

12. Explain how the tax benefit rule may apply to bad debt deductions.

Business bad debts are deductible in the period in which it is determined that the debt will not be collected. The amount of the deduction is based on an estimate of how much of the debt will not be collected. When the actual amount of the bad debt becomes known in a future period, adjustments to the estimate are made. Therefore, if the estimated bad debt turns out to be more than the actual bad debt, the taxpayer will receive amounts that were deducted in a prior period. The tax benefit rule requires any amounts received that were deducted in a prior period to be included in current period income to the extent that a tax benefit was received from the prior period deduction.

13. What activities qualify for the qualified production activities deduction?

The following activities qualify for the production activities deduction: (1) the manufacture, production, growth or extraction of qualifying production property by the taxpayer in whole or in significant part within the U.S; (2) the production of any qualified film by the taxpayer; (3) the production of electricity, natural gas, or potable water by the taxpayer in the U.S.; (4) the performance of construction activities in the U.S. by the taxpayer; and (5) the performance of engineering or architectural services in the U.S. in connection with construction projects in the U.S.

 

14. Explain how a taxpayer determines qualified production activities income and how a taxpayer calculates their qualified production activities deduction.

A taxpayer’s qualified production activities income is the excess of domestic production gross receipts minus the cost of goods sold allocable to such receipts and deductions, expenses, or losses directly allocable to such receipts; and a ratable portion of deductions, expenses, and losses not directly allocable to such receipts. A taxpayer’s qualified production deduction is equal to 3% of the lesser of the taxpayer's qualified production activities income or taxable income before the qualified production activities deduction. However, the amount of the QPAD cannot exceed 50 percent of the W-2 wages paid by the taxpayer as an employer during the year. An individual calculates the deduction using adjusted gross income in lieu of taxable income.

15. What requirements must be met to deduct life insurance premiums paid on an employee's policy?

Premiums paid on group-term life insurance policies are deductible. For other employee life insurance premiums to be deductible, the payment of the premium must constitute income to the employee. For the policy to be considered gross income for the employee, the employer cannot be the beneficiary of the policy.

16. Are sales taxes deductible? Explain.

Sales taxes paid on the purchase of business assets that are expensed in the current period (e.g., supplies) are deductible. However, sales taxes paid on the purchase of long-lived assets are capitalized as part of the cost of the asset. Therefore, the sales tax is deducted as the cost of the asset is recovered through time via amortization or depreciation or when the asset is sold. Sales taxes paid on personal use items are not deductible.

17. Are all legal fees paid by a taxpayer deductible? Explain.

To be deductible, legal fees must have a business purpose. The origin of the legal fee determines the purpose of the expenditure. If the legal fee originates in a profit motivated activity, then it is deductible. However, if the legal fee is generated for personal reasons, it is not deductible. For example, legal fees related to a divorce originate from a personal action. Therefore, even though the fee may be related in some way to a taxpayer's trade or business or investment assets, the fee is a nondeductible personal expenditure. If part of the fee in a divorce is specified as being for tax advice, that portion of the fee is deductible.

Legal fees that have a business purpose must be capitalized if they relate to the acquisition of, or the protection of title to a long-lived asset.

 

18. Why are deductions for adjusted gross income "better" than deductions from adjusted gross income?

Deductions FOR AGI are better because they provide more tax savings than deductions FROM AGI. That is, once the amount of a for AGI deduction is determined, it is not subject to any limits based on the taxpayer's income as are many of the FOR AGI deductions. Second, there is no minimum amount of FOR AGI deductions - whatever the taxpayer incurs is allowed as a deduction. In contrast, taxpayers with small amounts of from AGI deductions will use the applicable standard deduction in lieu of itemizing their actual deductions. Third, deductions FOR AGI reduce the taxpayer's AGI, making the FROM AGI deductions that are subject to an AGI limitation larger.

19. What is an accountable employee expense reimbursement plan? What is the significance of such a plan?

An accountable reimbursement plan is one in which employees are required to make an adequate accounting of their allowable expenses with the employer and return any excess reimbursements to the employer.

The significance of an accountable plan is that all reimbursements from the plan are deductible for AGI. Only unreimbursed expenses are deducted as miscellaneous itemized deductions, subject to the 2% of AGI limitation. In addition, the 50% meals and entertainment limitation does not apply to reimbursed expenses. If a reimbursement plan is not accountable, all deductions must be taken as miscellaneous itemized deductions, subject to the 2% and 50% limitations.

20. Why are self-employed taxpayers allowed to deduct their medical insurance premiums and self-employment tax for adjusted gross income?

The reason for allowing for AGI deductions for these two items is to attempt to equalize the treatment of self-employed taxpayers with employees. That is, employees receive the benefits of employer provided health insurance tax-free because the cost of the premiums is excluded from income. By allowing self-employed taxpayers to deduct the cost of their health insurance for AGI, an element of equality is provided between the two types of taxpayers. Similarly, employers match the Social Security payments of employees, which is not included in the employee's income. Because the self-employment tax is twice the Social Security tax, the deduction of 1/2 of the self-employment tax somewhat equalizes the tax treatment for employees and self-employed taxpayers.

 

21. Are all taxpayers allowed a deduction for contributions to a conventional individual retirement account? Explain.

All taxpayers are allowed to contribute $4,000 to an individual retirement account. A taxpayer who is at least 50 years old is allowed to make an additional contribution of $1,000. However, a deduction for the contribution is allowed only to those taxpayers who are not covered by an employer provided retirement plan. If an unmarried taxpayer is covered by an employer-provided retirement plan, the allowable deduction is phased-out ratably over a $10,000 range beginning at an adjusted gross income of $52,000. For married taxpayers if both the husband and wife are covered by an employer-sponsored plan, the deduction is phased-out ratably over a $20,000 range beginning at an adjusted gross income of $83,000. If only one spouse is covered by an employer provided retirement plan the allowable deduction for the spouse not covered by a plan is phased-out ratably over a $10,000 range beginning at an adjusted gross income of $156,000.

INSTRUCTORS NOTE: With the passage of the Pension Protection Act of 2006 and effective for tax years beginning in 2007, the income limits for income limits for deductible contributions to an Individual Retirement Account for active participants who are covered by an employer-sponsored plan begins at $52,000 for single taxpayers, begins at $83,000 for married taxpayers (both are active participants) and begins at $156,000 for married taxpayers when only one taxpayer is an active participant. These new phase out levels are not incorporated into the text but are set forth in a supplement along with additional problems that incorporate these new limits and can be found on the textbooks website http://murphy.swlearning.com.

 

22. How does the tax treatment of a conventional IRA differ from a Roth IRA?

All taxpayers are allowed to contribute to an individual retirement account. However, a deduction for the contribution is allowed only to those taxpayers who are not covered by an employer provided retirement plan. If an unmarried taxpayer is covered by an employer-provided retirement plan the allowable deduction is phased-out ratably over a $10,000 range beginning at an adjusted gross income of $52,000. For married taxpayers if both the husband and wife are covered by an employer-sponsored plan, the deduction is phased-out ratably over a $20,000 range beginning at an adjusted gross income of $83,000. If only one spouse is covered by an employer provided retirement plan the allowable deduction for the spouse not covered by a plan is phased-out ratably over a $10,000 range beginning at an adjusted gross income of $156,000.

The contribution to a Roth IRA is not deductible. The major benefit of a Roth IRA is that qualified distributions from it, including the income earned on the IRA assets, are not included in the taxpayer's gross income. Unmarried taxpayers with an adjusted gross income of less than $95,000 may contribute $4,000 to a Roth IRA. As with an IRA, a taxpayer who is at least 50 years old is allowed to make an additional contribution of $1,000. However, the amount contributed to a Roth IRA must be reduced by any contributions made to other IRA accounts. When an unmarried taxpayer's adjusted gross income exceeds $95,000, the amount that can be contributed is reduced ratably over a $15,000 range until no contribution is allowed when adjusted gross income exceeds $110,000. For married taxpayers with an adjusted gross income of less than $150,000, each spouse can contribute $4,000 to a Roth IRA. The amount that can be contributed is reduced ratably over a $10,000 range when adjusted gross income exceeds $150,000 and is fully phased-out when adjusted gross income exceeds $160,000.

INSTRUCTORS NOTE: With the passage of the Pension Protection Act of 2006 and effective for tax years beginning in 2007, the income limits for income limits for deductible contributions to an Individual Retirement Account for active participants who are covered by an employer-sponsored plan begins at $52,000 for single taxpayers, begins at $83,000 for married taxpayers (both are active participants) and begins at $156,000 for married taxpayers when only one taxpayer is an active participant. In addition, the income limits for Roth contributions will be indexed for inflation. As a result, the income limits for Roth IRA contributions at $99,000 for single taxpayers, and at $156,000 for married taxpayers. These new phase out levels are not incorporated into the text but are set forth in a supplement along with additional problems that incorporate these new limits and can be found on the textbooks website http://murphy.swlearning.com.

 

23. Who is eligible to make and receive contributions to a Coverdell Education Savings Account?

All taxpayers can make a nondeductible contribution of up to $2,000 to a Coverdell Education Savings Account for the benefit of an individual who is not 18 years of age. However, the total amount contributed to a Coverdell Education Savings Account is limited to $2,000. For unmarried taxpayers, the amount of the contribution is phased out ratably over a $15,000 range beginning when adjusted gross income exceeds $95,000 and is fully phased-out when adjusted gross income exceeds $110,000. For married taxpayers this amount is phased out ratably over a $30,000 range beginning when adjusted gross income exceeds $190,000, and is fully phased-out when adjusted gross income exceeds $220,000.

24. Is the interest on education loans always deductible? Explain

A qualified education loan is one that is used to pay for tuition, fees, room and board, and other necessary education expenses. The maximum amount of interest that can be deducted is $2,500. Any amount in excess of the maximum is considered personal interest and is not deductible. The interest deduction is phased out ratably for single taxpayers over a $15,000 range beginning when adjusted gross exceeds $55,000 and is fully phased-out at $70,000. For married taxpayers, the $30,000 phase-out begins when adjusted gross income exceeds $110,000 and is fully phased out when adjusted gross income exceeds $140,000.

 

25. Explain the general requirements that must be met to obtain a deduction for moving expenses and the type of moving expenses that are deductible.

The two general requirements are the distance and time requirements. The taxpayer's commuting distance from the old residence to the new job must be more than 50 miles than the distance would have been from the old job. The time test requires the taxpayer be employed for 39 weeks in the 12-month period following the move (78 weeks in 2 years for self-employed taxpayers).

Only direct moving expenses are deductible for adjusted gross income. Direct moving expenses are limited to:

• the cost of moving household goods and personal effects to the new residence.

• the transportation and lodging costs of moving the taxpayer and the taxpayer's family from the old residence to the new residence. Mileage is at 20 cents per mile.

The taxpayer cannot deduct the cost of meals incurred in moving from the old residence to the new residence.

PROBLEMS

 

26. A.J. is the vice president for Keane Products, a marketing consulting firm. On a business trip to New York City, he meets with three executives from Keane’s top account. After the meeting, A.J. takes them to dinner and then to the theater. The theater tickets cost $350. The cost of the meal is $190, including sales tax of $17 and a tip of $34. Throughout the evening, A.J. pays $42 in cab fares. How much can A. J. deduct as an entertainment expense?

A.J. can deduct $175 (50% x $350) for the theater tickets and $95 (50% x $190) for the meal. The entertainment qualifies as an expense associated with the conduct of the taxpayer's trade or business because it follows a substantial business discussion. The $42 cab fare is fully deductible as transportation and is not subject to the 50% rule because it is not considered to be an entertainment expense. Thus, A.J’s total deduction for the evening is $312 ($175 + $95 + $42). Instructor’s Note: Even if A.J. and the clients did not have a business meeting before the theater, the entertainment is deductible if they had a business discussion at dinner.

 

 

 

 

 

 

 

 

 

 

 

27. Karl is the vice president of finance for Wyatt Industries. Last month, he took a client to an afternoon baseball game. The box-seat tickets cost $30 each. Because the client had a plane flight after the game, Karl was unable to take her to dinner. During the game, Karl spent $15 on sodas and snacks. What amount can Karl deduct as an entertainment expense? Assume that Karl and the client went to dinner and that the meal cost $88. How much can Karl deduct as an entertainment expense?

For the entertainment to qualify under the associated with test, two requirements must be met. First, there must exist a clear business purpose, other than goodwill, for the entertainment. Karl probably could establish that this test is met. However, the second test requires that the entertainment occur either preceding or following a substantial business discussion. Given the facts of this example, this did not occur. Therefore, the $37.50 [($60 tickets + $15 food) x 50%] of entertainment expense are considered a nondeductible personal expense. Instructor’s Note: The facts of the problem imply that Karl met the client at the game and that no business discussions preceded the game.

If Karl went to dinner with the client and business was discussed, Karl can deduct $44 ($88 x 50%) as a business meal expense. In addition, because a business discussion took place following the baseball game, the $37.50 in entertainment expenses are deductible. Karl’s total meal and entertainment expense is $81.50 ($44 + $37.50).

28. Marcel is the former chief executive officer and chairman of the board of Donovan Technology. He is a member of the board of directors and has the title of chairman emeritus. Marcel and his wife enjoy having parties and entertaining clients of Donovan. During the current year, Marcel spends $15,000 entertaining clients of Donovan and other business associates. The entertainment is not expected of Marcel in his current role. Company policy limits reimbursement for entertainment expenses to the chief executive officer and the chief financial officer. What amount of the entertainment expenses can Marcel deduct on his individual tax return?

Marcel may not deduct the $15,000 of entertainment expenses. The entertainment is not an ordinary and necessary expense of Marcel’s business. The entertainment is not required or expected in Marcel in his current role with the company. This is evident by the fact that the company does not reimburse Marcel for his entertainment expenses. Although the entertainment might serve a business purpose, to be deductible, the business purpose must create more than client goodwill. The entertainment appears to be more personally motivated (Marcel and his wife enjoy it), and thus, does not meet the business purpose test.

 

 

 

 

 

 

 

 

 

29. For each of the following situations, explain whether a deduction should be allowed for entertainment expenses:

a. Neil owns a real estate agency and has an annual Christmas party at his house. The party is only for employees of his firm and costs $2,600.

The cost of the Christmas party is fully deductible. Employee recreational expenses, such as a Christmas party, are not subject to the 50% limitation on meals and entertainment.

 

b. Carol is a personal financial planner. Over the years, she has made it a practice to invite her best clients to lunch on the client’s birthday. At the lunch, she always makes it a point to ask about any major changes in the client's financial status that she should be aware of. However, most of the conversation relates to personal matters. During the year, Carol spent $850 on these lunches.

The key test that Carol must meet for the meal to be deductible under the directly related test is that the principal reason for providing the meal must be to conduct business. For the meal to be deductible under the associated with test, there must be a clear business purpose, other than goodwill, for the meal and it either precedes or follows a substantial business discussion. Because Carol entertains the client on their birthday and the majority of the conversion is not business related, it appears that she does not meet either of these tests. Therefore, the $850 spent for the lunches is not deductible.

 

c. Vijay is a doctor at a local hospital. Every month, he buys lunch at the hospital for the six residents and interns who assist him in surgery and caring for his patients. The lunches cost $420 for the year.

Vijay may not deduct the $420. Because Vijay is not required as part of his job to pay for these lunches and the lunches are not directly related to or associated with his job as a doctor, the lunches are not considered ordinary and necessary expenses of his job. The expenses related to these meals are nondeductible personal expenses

 

d. Tom, Hillary, and George are friends from college who live and work in the Dallas metropolitan area. They are all stockbrokers for different firms and get together twice a month for lunch to exchange rumors concerning the stock market. In addition, they catch up on personal news and make plans to get together with their spouses and other friends. Last year, George made $50,000 for a client based on a tip he received from Hillary at one of their meetings. Each stockbroker pays for his or her own lunch, and during the year, George paid $320.

George may not deduct any of the expense for the meals. The expense is allowed as a deduction only if George can show a business purpose for the expense and it qualifies as directly related to or associated with his job as a stockbroker. In George's case, the meals appear to be primarily based on personal motives and not directly related to or associated with the active conduct of her business.

30. For each of the following situations, explain whether a deduction should be allowed for entertainment expenses:

a. Gayle, a dentist, invites 50 of her best patients to her daughter's wedding reception. The cost of the reception related to the presence of her patients is $5,000.

Gayle cannot deduct the $5,000 of entertainment expenses. The wedding reception is not an ordinary and necessary expense of Gayle's business. The reception is a personally motivated event which lacks a business purpose.

b. Stan is one of 5 shift supervisors responsible for 100 employees at Label House, Inc. He regularly meets with the other shift supervisors at the plant. In addition, Stan makes it a practice to go to lunch at least once a week with each of the other 4 shift supervisors in order to network. During the current year, Stan pays $1,500 for his and the other supervisors' lunches. Stan's job description does not require him to entertain the other supervisors.

Stan may not deduct the $1,500. The expenses related to Stan's meals are personal living expenses. Because Stan's supervisory position is not affected by the entertainment (i.e., not required as part of his job), the lunches are not an ordinary and necessary expense of his job.

c. Jan is a real estate broker who holds an open house for a different client each Sunday afternoon. During the open house, she provides cookies and soft drinks for whoever visits the house. Jan pays $2,000 for open house entertainment.

The $2,000 Jan paid for refreshments at the open house is deductible. The expenses are in the nature of advertising or promoting goodwill and are an ordinary and necessary expense of a real estate broker. These expenses are not subject to the 50% limitation, under the exception for food and entertainment provided to the general public.

d. Felicia is vice-president of sales for Drivitt, Inc. She invited the company's major clients and some of her coworkers from Drivitt to her annual Super Bowl party. Most guests attend with their spouses. The party is held in a separate room at a local sports bar and costs her $1,500.

The expense of the party does not qualify as an entertainment expense because it fails both the directly related and associated with tests. The directly related test requires that the entertainment expense meet four test, one of which is that a bonafide business activity take place during the entertainment. This is probably not the case, because the setting for the entertainment is a bar.

For the entertainment to qualify under the associated with test, two requirements must be met. First, there must exist a clear business purpose, other than goodwill, for the entertainment. Felicia probably could establish that this test is met. However, the second test requires that the entertainment occur either preceding or following a substantial business discussion. Given the facts of this example, this did not occur. Therefore, the $1,500 entertainment expense is considered a nondeductible personal expense.

31. You have just been hired as a tax accountant by a local public accounting firm. One partner is impressed by your writing skills and asks you to write a one-page memo to a client describing the general rules on the deductibility of meals and entertainment. The client also needs to know under what circumstances the cost of its skybox (with 10 tickets) at Optus Park is deductible.

Instructor’s Note: The memo that each student will prepare will be different. The following answer highlights the points that each student should include in his/her memo.

Under the general rules for meals or entertainment expenses to qualify as a deductible business expense the expense must:

1. Have a business purpose,

2. Qualify as an ordinary and necessary expense of the business and not be lavish or extravagant (i.e., reasonable in amount),

3. Be directly related to or associated with the active conduct of the taxpayer's business activity, and

4. Be adequately documented.

It is extremely difficult for an entertainment expense to qualify under the directly related test because the expense must meet all of the following requirements:

There is a general expectation of deriving income or a business benefit from the meals or entertainment,

A bonafide business activity takes place during the meal or entertainment,

The principal reason for providing the meal or entertainment is to conduct business, and

The expenses are related to the taxpayer and people involved in the business.

For entertainment to qualify as an associated with expense, only two requirements must be met. First, there must be a clear business purpose, other than goodwill, for the entertainment. Second, the entertainment must directly precede or follow substantial business discussions.

No portion of the skybox fee is deductible. However, the client can deduct the cost of the ten tickets. The deduction for each ticket is limited to the price of the most expensive non-luxury box seat. Finally, the student should mention that only 50% of meal and entertainment expenses are deductible.

32. Pablo is a computer sales representative and spends only 4 days a month in the office. His office is 18 miles from home. Pablo spends 3 nights a month traveling to his out-of-town clients.

a. What portion of Pablo's travel is considered business?

Pablo can deduct the cost of traveling from home to his business clients and back. If applicable, he can also deduct the cost of traveling from his office to his clients and back to his office. Finally, any out-of-town traveling he incurs is fully deductible. The cost of traveling to his office and then home, as he does 4 days a month, is considered commuting and is a nondeductible personal expense.

 

During the year, Pablo keeps the following record of his travel:

Miles

Home to office 864

Office to home 864

Home to local clients to home 10,630

Home to out of town clients to home 2,650

The company reimburses Pablo for all of his lodging, meals, and entertainment while he is on the road. If he uses the standard mileage rate, what amount can he deduct as a business expense?

Pablo's deductible business expense is $6,441 (13,280 miles x 48.5 cents). The standard mileage rate for 2007 is 48.5 cents per mile. In computing his deduction, Pablo may deduct the mileage from home to his clients and back home (10,630), and the miles (2,650) to and from his out of town clients. The miles from home to his office and back are considered commuting and cannot be used to determined his allowable business expense.

 

 

33. Julianita is a sales representative for a food distributor and spends only 1 day of the week in the office. Her office is 12 miles from home. She also has a part-time job as a bartender. Typically, she works 2 nights during the week and 1 night on the weekend. The restaurant where she works is 5 miles from her office and 10 miles from her home.

a. What portion(s) of Julianita's travel is considered business?

Julianita can deduct the cost of traveling from home to her business clients and back. She can also deduct the cost of traveling from her office to her clients and back to her office. The cost of traveling to her office and then home, as she does 1 day a week, is considered commuting and is nondeductible. However, the cost of traveling from either her office or clients to her second job as a bartender is deductible. The cost of traveling home from her bartending job is not deductible because the travel is considered commuting. Finally, any out-of-town traveling Julianita incurs is fully deductible.

 

During the year, Julianita keeps the following record of her travel:

Miles

Home to office 588

Office to home 353

Office to restaurant 150

Restaurant to home 1,500

Home to restaurant 500

Home to clients to home 8,850

Clients to restaurant 2,100

If she uses the standard mileage rate, what amount can she deduct as a business expense?

Julianita's deductible business expense is $5,384 (11,100 x 48.5 cents). The standard mileage rate for 2007 is 48.5 cents per mile. In computing her deduction, Julianita may deduct the mileage from home to her clients and back home (8,850), the miles from her clients to the restaurant (2,100) and the mileage from her office to the restaurant (150). The miles from home to her office and back are considered commuting, as are the miles from her home to the restaurant and from the restaurant to her home.

 

 

34. Cassandra owns her own business and drives her van 15,000 miles a year for business and 5,000 miles a year for commuting and personal use. She purchases a new van in 2007 and wants to claim the largest tax deduction possible for business use. Cassandra's total auto expenses for 2007 are as follows:

Gas, oil, and maintenance $ 3,840

Insurance 775

Interest on car loan 1,200

Depreciation 2,960

License 180

Parking fees and tolls (all business) 240

Determine Cassandra's 2007 deduction for business use of the van.

Because this is the first year Cassandra uses the van, she must select an accounting method to determine the costs associated with the van. She has the option of using either the standard mileage rate method or the actual cost method to determine her deduction on the van. Based on the calculation of the deduction under each method, the standard mileage method results in a $1,459 ($7,515 - $6,056) larger deduction. Parking and tolls are added separately, because these expenses are all business related. Interest expense is not considered a cost incurred to operate or maintain the vehicle and is deductible under either method if the taxpayer is self-employed. Because Cassandra is self-employed, she can deduct the business portion (75%) of the interest expense under both methods.

Standard Mileage Deduction:

15,000 miles x 48.5 cents $ 7,275

Add: Parking and tolls 240

Total deduction $ 8,515

Interest expense ($1,200 x 75%) 900

Actual Cost Deduction:

Total actual expenses (other than parking, tolls and interest) $ 7,755

Business usage percentage (15,000 mi. ÷ 20,000 mi.) x 75%

Allocated actual cost $ 5,816

Add: Parking and tolls 240

Total deduction $ 6,056

Interest expense ($1,200 x 75%) 900

 

Instructor's Note: For reporting purposes Interest expense is separately stated on Schedule C.

 

35. Mario owns his own business and drives his car 15,000 miles a year for business and 7,500 miles a year for commuting and personal use. He wants to claim the largest tax deduction possible for business use of his car. His total auto expenses for 2007 are as follows:

Gas, oil, and maintenance $ 6,700

Insurance 500

Interest on car loan 480

Depreciation 2,960

License 180

Parking fees and tolls (all business) 290

a. What is Mario's 2007 deduction using the standard mileage rate?

Under the standard mileage rate method Mario can deduct $7,565. He can deduct 48.5 cents for each mile he uses his car for business. Parking and tolls are added separately because these expenses are all business related. Interest expense is not considered a cost incurred to operate or maintain the vehicle and is deductible under either method if the taxpayer is self-employed. Because Mario is self-employed, he can deduct the business portion (66.7%) of the interest expense.

Standard Mileage Deduction:

15,000 miles x 48.5 cents $ 7,275

Add: Parking and tolls 290

Total deduction $ 7,565

Interest expense ($480 x 66.7%) 320

 

b. What is Mario's 2007 deduction using the actual cost method?

Under the actual cost method, Mario can deduct $7,187. Based on the business use of his car he can deduct 66.7% (15,000 mi. ÷ 22,500 mi.) of the cost (other than parking, tolls) of operating the vehicle. Parking and tolls are added separately because these expenses are all business related. Interest expense is not considered a cost incurred to operate or maintain the vehicle and is deductible under either method if the taxpayer is self-employed. Because Mario is self-employed, he can deduct the business portion (66.7%) of the interest expense.

Actual Cost Deduction:

Total actual expenses (other than parking, tolls and interest) $10,340

Business usage percentage (15,000 mi. ÷ 22,500 mi.) x 66.7%

Allocated actual cost $ 6,897

Add: parking and tolls 290

Total deduction $ 7,187

Interest expense ($480 x 66.7%) 320

 

Instructor's Note: For reporting purposes Interest expense is separately stated on Schedule C.

 

36. Prudy is a recent college graduate who has taken a position with a real estate brokerage firm. Initially, Prudy will be selling both residential and commercial property. She is thinking about buying a new car at a cost of $14,500. However, the salesperson is trying to sell her a car that costs $18,000. He has assured her that because she is now self-employed, the entire cost of the car is tax-deductible. Prudy comes to you, her tax accountant, for advice about the purchase of the car. She tells you she expects that 65% of her driving will be for business purposes. She asks you to write her a letter specifying whether she can deduct the entire cost of the car, which expenses she needs to keep track of, and how these expenses are used in computing the business deduction for her car.

The information provided to Prudy by the car dealer is not correct. Because Prudy will be using her car for more than one purpose, the cost of the car and any expenditures associated with it must be allocated between the business and personal use in some reasonable manner. Therefore, only 65%, not 100%, of the cost of operating the automobile is deductible. The 35% personal portion is a personal expense and not deductible. In essence, the automobile is treated as two separate assets for tax purposes.

Prudy may elect to use either the actual cost method or the standard mileage rate method to determine the allowable deductions on the automobile. Both methods require her to substantiate the business miles driven. The actual cost method also requires the substantiation of the expenses related to the automobile. The standard mileage rate is 48.5 cents per mile in 2007. If she uses the actual cost method, she will need to keep track of the following expenses gasoline, oil, repairs, insurance, and licensing fees. She can also depreciate the cost of the car. Depreciation of automobiles is subject to special rules discussed in Chapter 10.

Because she is self-employed, she can deduct the business portion of any ad valorum property taxes and interest she pays on her car loan. Any unreimbursed business parking and tolls are fully deductible.

 

 

37. Juanita travels to San Francisco for 7 days. The following facts are related to the trip:

Round trip airfare $ 475

Hotel daily rate for single or double occupancy 175

Meals -- $40 per day 40

Incidentals -- $25 per day 25

a. If she spends 4 days on business and 3 days sightseeing, what amount may she deduct as travel expense?

Based on time spent on business and personal activities, the trip was primarily for business. As a result, transportation is fully deductible. Other expenses are deducted as follows:

Airfare $ 475

Hotel ($175 x 4) 700

Meals ($40 x 4 x 50%) 80

Incidentals ($25 x 4) 100

Total deduction $ 1,355

Only expenses related to the 4 days devoted to business can be deducted. Meals are further limited to 50% of the deductible amount.

 

b. If she spends 2 days on business and 5 days sightseeing, what amount may she deduct as travel expense?

Based on the time spent on business and personal activities, the trip was primarily for personal reasons (i.e., fewer days spent on business than on personal). As a result, none of the transportation is deductible. Other expenses are allowed for business days as follows:

Airfare $ -0-

Hotel ($175 x 2) 350

Meals ($40 x 2 x 50%) 40

Incidentals ($25 x 2) 50

Total deduction $ 440

Only expenses related to the 2 days devoted to business can be deducted. Meals are further limited to 50% of the deductible amount.

c. Assume the same facts as in part a, except that Juanita’s husband Jorge accompanied her on the trip and the hotel’s single occupancy rate is $150. Jorge went sightseeing every day and attended business receptions with Juanita at night. Assume that Jorge's expenses are identical to Juanita's. What amount may Juanita and Jorge deduct as travel expense?

None of Jorge's expenses are allowed as a business deduction unless there is a substantial business purpose for his presence and he is an employee of Juanita's business. Because Jorge fails both of these requirements, none of his expenses are deductible. Because the hotel rate is the greater for a double occupancy than for a single, Juanita can only deduct $150 per night for lodging. The $25 difference is considered a personal expense and allocated to Jorge. Juanita can deduct the following amount:

Airfare $ 475

Hotel ($150 x 4) 600

Meals ($40 x 4 x 50%) 80

Incidentals ($25 x 4) 100

Total deduction $ 1,255

 

38. Chai is self-employed and travels to New Orleans for a business conference. The following facts are related to the trip:

Round trip airfare $375

Hotel daily rate for single 120

Conference registration fee 190

Meals---$54 per day 54

Incidentals---$27 per day 27

 

a. If Chai spends 4 days at the conference and 2 days sightseeing, what amount may he deduct as travel expense?

Based on time spent on business and personal activities, the trip is primarily for business. As a result, transportation is fully deductible. The conference registration fee is also fully deductible. The other expenses are deducted as follows:

Airfare $ 375

Hotel ($120 x 4) 480

Conference registration 190

Meals ($54 x 4 x 50%) 108

Incidentals ($27 x 4) 108

Total deduction $ 1,261

Only expenses related to the 4 days devoted to business can be deducted. Meals are further limited to 50% of the deductible amount.

 

b. If he spends 2 days at the conference and 4 days sightseeing, what amount may he deduct as travel expense?

Based on time spent on business and personal activities, the trip is primarily for pleasure. As a result, the transportation is not deductible. However, the conference registration fee is fully deductible. The other expenses are deducted as follows:

Airfare $ -0-

Hotel ($120 x 2) 240

Conference registration 190

Meals ($54 x 2 x 50%) 54

Incidentals ($27 x 2) 54

Total deduction $ 538

Only expenses relating to the 2 day devoted to business can be deducted. Meals are further limited to 50% of the deductible amount.

 

 

c. Next year, Chai would like his wife, Li, who does not work outside their home, to go with him to the conference. Li's expenses would be similar to Chai's, except that the room rate for double occupancy is $150. Li would probably attend one or two sessions and the receptions at night. What portion of her expenses can they deduct?

If the primary purpose of his trip is business (as in part a above) then Chai’s airfare is fully deductible. Chai will be able to deduct the business portion of his other expenses. The conference registration fee does not have to be allocated because the fee is business related. No portion of his wife’s expenses is deductible. Further, if the double occupancy rate is greater than the single occupancy rate (as the facts indicate) Chai’s deductible portion for the hotel room is limited to the single occupancy rate ($120 per business night).

 

 

39. Olga has to travel to Philadelphia for 2 days on business. She enjoys history and is planning to visit the Liberty Bell and other historic sights in the city. If time permits, she would like to make a side-trip to nearby Gettysburg. A friend of Olga's tells her, "The best part of traveling on business is that once the business is over, you can sightsee all you want and the cost is tax-deductible." Olga, who is self-employed, has scheduled her trip over the Labor Day weekend so that she can spend 3 days sightseeing. Write a letter to Olga in which you explain whether her friend‘s advice is correct.

Olga's friend has provided her with poor advice. Only the business portion of a combined business and personal trip is deductible. In determining whether the travel cost of a combined business and personal trip is deductible, the taxpayer must determine whether the primary purpose of the trip is business or pleasure. This is determined based on whether more days were spent on business than for pleasure. In Olga's case, because only 2 days are spent on business while 3 days are for pleasure, the primary purpose of the trip is considered pleasure. Therefore, Olga will not able to deduct the cost of her travel to Philadelphia. However, she can deduct her lodging, meals (limited to 50%) and the cost of incidental expenses (laundry, tips etc.) for the two business days. The costs of the remaining three days are considered nondeductible personal expenditures.

40. Marisa is an obstetrician. Every February, she attends a 3-day conference on financial planning with Ester, her college roommate. Ester is Marisa’s accountant and is a certified financial planner. This year, the seminar was in San Diego, and each had a separate hotel room. The costs of attending the conference for Marisa and Ester are as follows:

Marisa Ester

Airfare $425 $375

Hotel daily rate 120 120

Meals - $35 per day 35 35

Incidentals - $20 per day 20 20

Registration 170 170

Rental car* 90 90

* Marisa and Ester split the cost of the rental car.

How much of the trip costs can Marisa and Ester deduct?

Marisa’s expenses are considered nondeductible investment expenses. Travel expenses to attend the investment seminar are only deductible if she is engaged in the trade or business of making investments. Given the facts of this problem, Marisa is in the trade or business of being an obstetrician.

Because Ester is a certified financial planner and the seminar deals with financial planning, the conference qualifies as a deductible business expense. As a result, transportation is fully deductible. The conference registration fee is also fully deductible. The other expenses are deducted as follows:

Airfare $ 375

Hotel ($120 x 3) 360

Conference registration 170

Meals ($35 x 3 x 50%) 53

Car rental 90

Incidentals ($20 x 3) 60

Total deduction $ 1,108

 

41. Floyd owns an antique shop. During the year, he and his wife, Amanda, who works as a real estate broker, attend a 3-day antique show in Boston. The expenses related to the antique show are as follows:

Train per person $ 110

Hotel daily rate - double occupancy* 115

Meals - $37 per day per person 37

Incidentals - $14 per day per person 14

*The hotel rate for double occupancy is $20 more than the single

occupancy rate.

What amount can Floyd deduct as travel expense? Explain.

Only Floyd's expenses are deductible because he is the only one engaged in the antique business. Amanda's expenses are deductible only if there is a bonafide business purpose for her presence and she is an employee of the antique business. Amanda fails both of these tests. Because Amanda's expenses are not deductible, the hotel deduction is limited to $95, the single occupancy rate. Floyd can deduct the following expenses relating to his trip.

Train $ 110

Hotel ($95 x 3 days) 285

Meals ($37 x 3 days x 50%) 56

Incidentals ($14 x 3 days) 42

Total $ 493

 

42. Jan owns the Mews Bar and Grill. Every year at Christmas, he has a party for his 20 employees and their families. This year’s party cost $1,600. At the party, Jan presented each employee with a $50 gift certificate redeemable for merchandise at a local department store. How much can Jan deduct for entertainment and gift expenses?

Jan may deduct the full $1,600 cost of the Christmas party. Employee recreational expenses, such as a Christmas party are not subject to the 50% limitation on meals and entertainment. Unless the $50 gift certificate is considered a de minimus fringe, the gift certificate will be compensation to the employee. It cannot be considered an employee award because it is given to all employees and is not based on length of service or safety. Whether it is a de minimus fringe or compensation Jan can deduct $1,000 ($50 x 20 employees) and his total deduction is $2,600 ($1,600 entertainment + $1,000 business gift). Instructor's Note: The employees would like the gift certificate to be treated as a de minimus fringe benefit since it would not be subject to tax.

 

a. Assume that the party is attended by 10 employees and 10 of the Mews major suppliers. At the party each receives a holiday cheese basket that costs $30. How much can Jan deduct?

As in the first part, Jan can deduct the $1,600 cost of the party. The holiday cheese baskets given to the suppliers are considered a gift and the deduction is limited to $25 for each basket. The baskets given to the employees are a de minimus fringe benefit and are fully deductible. Jan’s total deduction is $2,150 [$1,600 + ($25 x 10) + ($30 x 10)].

 

 

 

 

 

 

43. For each of the following situations determine whether the expenses are deductible as an education expense.

a. Dorothy owns a real estate business. She is enrolled in a one-year weekend MBA program that meets in a city three-hours away. She takes a train to and from the city. A one-year weekend pass for the train is $800. The fee for the MBA program including lodging, meals, books and tuition is $25,000.

The education costs do not qualify Dorothy for a new trade or business because she owns her own real estate business. As the owner of the business, the education expenses are deductible because the expenses maintain or improve her skills as a manager. The entire cost of her education expenses $25,800 ($25,000 + $800), is deductible. If the business is a sole-proprietorship, Dorothy deducts the education expenses as a business expense.

b. Forest is employed as a production manager for a printing company. He is enrolled in a night course costing $350 at the local college. The course is not required by his employer, but does improve his job skills.

Although the course is not required by his employer, the cost of the night course is deductible because it improves his job skills. Forest can deduct the $350 as an unreimbursed employee business expense, which is a miscellaneous itemized deduction and is reduced by 2% of adjusted gross income (see Chapter 8). A taxpayer is allowed a deduction from adjusted gross income for education expenses if the expenses are incurred as a requirement for the taxpayer to continue employment or are incurred to maintain or improve the skills required in their job.

In 2007 a taxpayer with adjusted gross income less than $65,000 ($130,000 for a married couple filing a joint return) is allowed to deduct for adjusted gross income a maximum of $4,000 of qualified higher education expenses. If a taxpayer’s adjusted gross income exceeds $65,000 ($130,000 for a married couple filing a joint return) but does not exceed $80,000 ($160,000 for a married couple filing a joint return), the taxpayer can deduct a maximum of $2,000 of qualified higher education expenses. If the taxpayer’s adjusted gross income exceeds these amounts $80,000 ($160,000 for a married taxpayer filing jointly), then the taxpayer is not allowed a deduction for adjusted gross income. Therefore, in 2007, some taxpayers can deduct qualified higher education expenses even if the expenses are not incurred as a requirement for the taxpayer to continue employment or do not maintain or improve the skills required in their job. Qualified higher education expenses are limited to tuition and fees paid to attend the institution.

Note: If the expense is considered an itemized deduction due to AGI limitations, then the expense would only qualify as an itemized deduction if the course is not part of a program of study that qualifies Forest for a new trade or business.

 

c. Elise is a recent graduate of law school and has been hired by a local firm. The firm expects her to pass the bar exam on her initial attempt. To prepare for the bar exam, she is taking a law review course that costs $1,500.

Even though Elise is a graduate of law school and is working in a local law firm, she is not considered a lawyer until she passes the bar exam. The law review course she takes to pass the bar exam is not deductible because it is an education expense that qualifies her for a new trade or business (e.g., a lawyer).

In 2007, a taxpayer with adjusted gross income less than $65,000 ($130,000 for a married couple filing a joint return) is allowed to deduct for adjusted gross income a maximum of $4,000 of qualified higher education expenses. If a taxpayer’s adjusted gross income exceeds $65,000 ($130,000 for a married couple filing a joint return) but does not exceed $80,000 ($160,000 for a married couple filing a joint return), the taxpayer can deduct a maximum of $2,000 of qualified higher education expenses. If the taxpayer’s adjusted gross income exceeds these amounts $80,000 ($160,000 for a married taxpayer filing jointly), then the taxpayer is not allowed a deduction for adjusted gross income. Therefore, in 2007, some taxpayers can deduct qualified higher education expenses even if the expenses are not incurred as a requirement for the taxpayer to continue employment or do not maintain or improve the skills required in their job. Qualified higher education expenses are limited to tuition and fees paid to attend the institution.

 

d. Simon is the managing partner of a CPA firm and is required to attend 30 hours of continuing education every year. State law requires that 5 hours be in ethics training. The 5-hour ethics course costs $400; the remaining 25 hours of continuing education cost $1,800.

The cost of the ethics seminar is deductible because it is required by law. The cost of the 25 hours of continuing education is deductible for two reasons. First, the 25 hours are required by law so that Simon can maintain his license to practice. Second, the courses either maintain or improve his skills as an accountant.

 

44. Paula is single and works as a high school science teacher. Each summer, she travels to a national conference on high school science curriculum. She also spends one week during the summer traveling to areas in the United States to further her science knowledge. This year, she spent one week exploring the caves and rock formations around Carlsbad, New Mexico. She plans on using the knowledge and information from this trip in her earth science class. The costs of each trip are as follows:

Science Conference Carlsbad Trip

Airfare $350 $450

Hotel 200 375

Meals 120 250

Incidentals 40 110

Rental car 75 190

Registration 100 -

Tours - 90

Paula has asked for your advice on the deductibility of these costs as a business expense? Write her a letter explaining her allowable deduction for these costs. If any of the costs are not deductible, explain why she cannot deduct them.

Because Paula is a high school science teacher and attends the annual science conference to improve her skills as a science teacher, the cost of the conference qualifies as a deductible business expense. The amount she can deduct as an unreimbursed business expense is:

Airfare $ 350

Hotel 200

Meals ($120 x 50%) 60

Incidentals 40

Car rental 75

Conference registration 100

Total deduction $ 825

Unreimbursed business expenses are treated as a miscellaneous itemized deduction which are reduced by 2% of adjusted gross income. In addition, the expense would not qualify as an education expense deductible for AGI because the expense was not paid to a qualified educational institution.

None of the costs that Paula incurrs on her trip to Carlsbad are deductible travel expenses. Travel as a form of education is not deductible. In this case, the travel is intended to improve her job skills (a form of education) and is not deductible.

45. Cory is the fourth-highest-paid officer of the Mast Corporation, a publicly traded corporation. The company pays Cory a salary of $1,100,000. What amount can it deduct as salary expense? Would your answer change if Mast is a closely held corporation and the payments are typical of other companies of similar size in the industry?

Cory's salary is subject to the $1,000,000 limitation on compensation expense because he is one of the top four paid officers of the corporation. The corporation can deduct only $1,000,000 of the $1,100,000 paid to Cory as compensation expense.

There is no limit on the amount of compensation paid to any employee of a closely held corporation. The only requirements that must be meet for the compensation to be deductible is that the payment is ordinary, necessary, and reasonable in amount. Compensation paid that is unreasonable in amount may not be deducted as a business expense. Unreasonable compensation situations generally arise when the payment is being made to a related party (i.e., a significant owner of a closely held corporation). If the payment made is unreasonable for the duties and responsibilities of the payee, it will not be considered reasonable compensation and the unreasonable portion is not deductible.

 

 

 

 

 

 

46. Chet is an officer of the Branson Corporation a publicly traded corporation. His salary for the year is $1,320,000, which is the sixth-highest salary at Branson. What amount can the corporation deduct as salary expense? How would your answer change if Chet’s salary is the third-highest at Branson?

Chet's salary is not subject to the $1,000,000 limitation on compensation expense because Chet is not the CEO or one of the top four paid officers of the corporation. The corporation can deduct the $1,320,000 paid to Chet as compensation expense.

If Chet has the third highest salary at Branson, then Chet’s salary is subject to the $1,000,000 limitation. Therefore, Branson can deduct only $1,000,000 of the $1,320,000 paid to Chet.

 

47. Howard loaned $8,000 to Bud two years ago. The terms of the loan call for Bud to pay annual interest at 8%, with the principal amount due in three years. Until this year, Bud had been making the required interest payments. When Howard didn't receive this year's payment, he called Bud and found out that Bud had filed for bankruptcy. Bud's accountant estimated that only 40% of his debts would be paid after the bankruptcy proceeding. No payments were received. In the next year, Howard received $2,700 in full satisfaction of the debt under the bankruptcy proceeding. What deductions are allowed to Howard, assuming that the debt was

a. Related to Howard's business?

Because the debt is related to Howard's trade or business, he will be allowed a deduction in the current year for an estimate of the worthlessness of the debt. Since 40% is estimated to be received, a bad debt deduction for $4,800 ($8,000 x 60%) will be allowed in the current year as an ordinary deduction.

Upon receipt of the $2,700 in the next year, Howard will be allowed an additional bad debt deduction for the amount of the debt not previously deducted.

Total debt $ 8,000

Amount of bad debt previously deducted (4,800)

Amount received in payment of bad debt (2,700)

Current year bad debt $ 500

b. Unrelated to Howard's business?

If the debt is unrelated to Howard's business, it is a nonbusiness bad debt. Nonbusiness bad debts are deductible as short-term capital losses in the year in which the actual amount of loss is known. No deduction is allowed for the estimated amount of the loss. Howard will have a $5,300 ($8,000 - $2,700) short-term capital loss in the year in which he receives the payment. Howard can only utilize $3,000 of the loss in the current year. The remaining $2,300 is carried forward and deducted in subsequent years. Note: If Howard has capital gains in the current year, he can offset part or all of the $5,300 loss against his capital gains.

c. How would your answers to parts a and b change if Howard received $3,300 in satisfaction of the debt in the next year?

If Howard receives $3,300 on a business bad debt, he will have to include the tax benefit he received from the overstatement of the deduction in the previous year.

Total debt $ 8,000

Amount of bad debt previously deducted (4,800)

Amount received in payment of bad debt (3,300)

Current year gross income $ (100)

Because the calculation results in a negative $100, under the tax benefit rule, the deduction that was taken in the previous year will be income in the year of receipt. If the receipt is for a nonbusiness bad debt, Howard's short-term capital loss deduction in the year of receipt is $4,700 ($8,000 - $3,300).

48. During the year, Grace Inc. has total sales of $800,000. Based on total sales, the corporation estimates that its bad debts for the year are 2% of sales. As a result, the corporation deducts $16,000 in bad debts for financial accounting purposes. At the end of the year, the controller reviews the accounts receivable ledger to identify uncollectible accounts. She determines that $3,900 in accounts receivable cannot be collected. In addition, the accountant's analysis shows that the corporation has recovered $1,400 in accounts receivable written off as a bad debt for tax purposes in the previous year. How should this information be reported for tax purposes?

Although financial accounting permits Grace to deduct the $16,000 estimate, for tax purposes business bad debts are allowed as a deduction when they become fully or partially uncollectible using the specific charge-off method. Using the specific charge-off method results in a $3,900 business bad debt deduction in the current year. The recovery of the $1,400 of bad debts deducted in the previous year must be reported as income in the current year under the tax benefit rule.

 

 

49. The following information is from the financial records of the Adham Corporation at the end of the year:

Accounts receivable $ 450,000

Allowance for bad debts account (34,000)

Net accounts receivable $ 416,000

The allowance for bad debts account is based on an aging of the corporation’s accounts receivable. At the end of the year, the allowance for bad debts account was increased from $7,000 to $34,000. During the year, $8,000 of the accounts receivable were specifically identified by the company as uncollectible and written off.

a. If Adham’s bad debts arise from the sale of merchandise, how should the adjustments to the allowance for bad debt accounts be reported for tax purposes?

Financial accounting practices require Adham to use the allowance method for reporting bad debts expense. However, because tax accounting does not generally allow the use of the allowance method for deducting bad debts, Adham must use the specific charge-off method to deduct bad debts for tax reporting. As a result:

1. For tax purposes, the $8,000 of accounts receivable specifically identified at year end as uncollectible is deducted as the bad debt expense in the current year.

2. The $27,000 ($34,000 - $7,000) of estimated bad debts expense added to the allowance for bad debts account for financial accounting during the year cannot be deducted for tax reporting.

 

b. If Adham uses the cash method of accounting and the bad debts expense arise from providing counsulting advice, how should the adjustments to the allowance for bad debt accounts be reported for tax purposes?

Because Adham uses the cash method of accounting, the company has not reported the taxable income related to its accounts receivable. As a result, Adham does not have a tax basis in its accounts receivable. Since Adham does not have a tax basis in its accounts receivable, Adham cannot take a bad debt deduction. Adham cannot deduct either the $8,000 of specifically identified bad debts or the $27,000 amount shown as an addition to the allowance for bad debts account.

50. In addition to being an employee of Rock Hard Roofing Material, Lou owns 10% of the company's common stock. Rock Hard falls on hard times in 2006. To forestall bankruptcy, Rock Hard's employees and shareholders loan the company $1,000,000. Lou's share of the total loan is $50,000 - $25,000 related to her position as an employee and $25,000 related to her ownership of stock. In early 2007, creditors force Rock Hard into bankruptcy. Lou loses her entire $50,000.

a. Is Lou's loss related to a trade or business or an investment?

Lou's loan to the company to protect her job is considered a business debt. The loss on the loan is a bad debt expense that is directly related to Lou's earning a livelihood by working for an employer. Lou's bad debt deduction is a trade or business expense of an employee.

The loan related to protecting Lou's stock ownership interest is considered an investment. As a result, the loss on the investment loan is considered to be a nonbusiness bad debt (i.e., short-term capital loss).

 

b. Can Lou deduct her loss as a bad debt expense?

Lou can deduct both the business and nonbusiness bad debt. The business bad debt is deducted as an employee's business expense and the nonbusiness bad debt is deducted as a capital loss. As a capital loss, the investment deduction is limited to $3,000 per year until the loss is fully deducted.

51. The Cavanaugh Corporation owns the licensing rights to the Mississippi Marauders hockey apparel. For 2007, Cavanaugh has gross receipts from qualified production activities of $6,000,000. The cost of goods sold related to these receipts is $2,000,000 and the direct costs related to these receipts is $225,000. Cavanaugh estimates that 15% of its $500,000 of indirect costs are attributable to its qualified production activities. Cavanaugh’s taxable income before the qualified production activities deduction is $3,200,000.

a. What is Cavanaugh’s qualified production activities income?

Cavanaugh Corporation’s qualified production activities income is $3,700,000 [$6,000,000 - $2,000,000 - $225,000 - $75,0000 ($500,000 x 15%)] Cavanaugh’s qualified production activities gross receipts of $6,000,000 are reduced by its $2,000,000 cost of goods sold, the $225,000 direct costs attributable to the qualified production activities and $75,000 ($500,000 x 15%) of indirect costs attributable to the qualified production activities income.

b. What is Cavanaugh’s qualified production activities deduction?

Cavanaugh's qualified production activities deduction for 2007 is $192,000 ($3,200,000 x 6%). The deduction is based on the lesser of Cavanaugh's $3,700,000 of qualified production activities income or its taxable income before the QPAD of $3,200,000.

c. Assume that Cavanaugh’s W-2 wages allocable to its domestic production gross receipt points (DPGR) are $190,000. How does this impact Cavanaugh’s qualified production activities deduction?

Cavanaugh’s qualified production activities deduction cannot exceed 50 percent of the W-2 wages allocable to the taxpayer’s domestic production gross receipts. Because 50% of Cavanaugh’s DPGR wages are $95,000 ($190,000 x 50%), its qualified production activities deduction is limited to $95,000.

52. The Rollins Group produces training corporate training videos. It operates as a sole proprietorship and is 100% owned by Scott Rollins. For 2007, Rollins has gross receipts from qualified production activities of $1,500,000. The cost of goods sold related to these receipts is $1,200,000 and the direct costs related to these receipts is $100,000. Rollins estimates that 30% of its indirect costs of $50,000 are attributable to its qualified production activities. Scott’s adjusted gross income is $200,000.

a. What is Rollins’ qualified production activities income?

Rollins qualified production activities income is $185,000 [$1,500,000 - $1,200,000 - $100,000 - $15,0000 ($50,000 x 30%)] Rollins’ qualified production activities gross receipts of $1,500,000 are reduced by $1,200,000 cost of goods sold , the $100,000 direct costs attributable to the qualified production activities, and $15,000 ($50,000 x 15%) of indirect costs attributable to the qualified production activities income.

b. What is Rollins’ qualified production activities deduction?

Rollins qualified production activities deduction for 2007 is $11,100 ($185,000 x 6%). The deduction is based on the lesser of Rollins’ $185,000 of qualified production activities income or Scott’s $200,000 adjusted gross income.

c. Assume that Rollins’ W-2 wages allocable to its domestic production gross receipts (DPGR) are $150,000. How does this impact Rollin’s qualified production activities deduction?

Scott’s qualified production activities deduction cannot exceed 50 percent of the domestic production gross receipts wages paid during the year. Because 50% of the Rollins Group’s DPGR wages is $75,000 ($150,000 x 50%), the W-2 wages limitation does not affect its qualified production activities deduction. Scott’s qualified production activities deduction is $11,100.

 

53. KOM pays the following insurance premiums during 2007:

Auto accident and liability insurance:

Paid 1/1/07 Coverage period 1/1/07 - 12/31/07 $3,500

Fire, storm, and other casualty insurance:

Paid 4/1/07 Coverage period 4/1/07 - 3/31/09 $5,000

Business liability insurance:

Paid 5/1/07 Coverage period 5/1/07 - 4/30/08 $3,000

a. If KOM uses the accrual method of accounting, what is the insurance expense deduction for 2007?

Using the accrual method of accounting, KOM's 2007 insurance expense deduction is $7,375 ($3,500 + $1,875 + $2,000). Note: The deduction is only $7,375 if the business liability insurance is a material expense. The auto accident and liability insurance premium is fully deductible because it relates to the 2007 tax year. The 2007 deduction is $3,500.

The fire, storm, and other casualty insurance premium must be deducted ratably over the term of the policy. Because the prepaid premium relates to two tax years, the recurring item exception to the economic performance test does not apply. The 2007 deduction is $1,875 [$5,000 x (9 months ¸ 24 months)].

As an accrual basis taxpayer, KOM is able to deduct the $3,000 business liability insurance premium in the current year only if the expense meets the recurring item exception to the economic performance test. Congress intended this exception to apply primarily to accrued expenses --- those expenses that have not yet been paid but that meet the all-events test and will be paid within a reasonable time after the close of the year. To meet this exception the expense must be immaterial for both financial accounting and tax purposes and the relationship between the cost of insurance and KOM’s other items of income and expenses must be immaterial. If KOM cannot meet this exception then it can only deduct $2,000 [$3,000 x (8 months ¸ 12)] months in 2007. The remaining $1,000 ($3,000 - $2,000) is deducted in 2008.

 

b. If KOM uses the cash method of accounting, what is the insurance expense deduction for 2007?

KOM's 2007 insurance expense deduction is $8,375 ($3,500 + $1,875 + $3,000). The auto accident and liability Insurance premium is fully deductible because it relates to the 2007 tax year. The 2007 deduction is $3,500.

The fire, storm, and other casualty insurance premium must be allocated to the tax years covered by the policy. Because the prepaid premium relates to two tax years, the prepayment creates an asset that extends substantially beyond the end of 2008 and the one year rule does not apply. The 2007 deduction is $1,875 [$5,000 x (9 months ¸ 24 months)].

The business liability Insurance premium is fully deductible because the prepaid premium does not create an asset that extends substantially beyond the end of 2007 (one-year rule for prepaid expenses). The 2007 deduction is $3,000.

54. For each of the following situations, state whether the expense related to the transaction can be deducted as an insurance expense:

a. Baker Company pays the insurance premium to provide each of its employees with a $50,000 whole life insurance policy. Baker and the insurance company consider the employee the owner of the policy. As owner of the policy, the covered employee designates the beneficiary of the life insurance proceeds in the event of the employee's death. Each employee's policy costs $2,000 per year.

The $2,000 premium paid for each employee is not a deductible insurance expense. Only premiums on group-term life insurance qualify for deduction as life insurance expense. Because Baker does not benefit directly or indirectly from the policy, the insurance premiums are deducted as additional compensation paid to the employee (the employee must include the $2,000 in gross income). When the employee dies, the beneficiary of the policy excludes the insurance proceeds from gross income.

 

b. Baker Company has a nondiscriminatory self-insured medical reimbursement plan for the benefit of its employees. Once a month, Baker transfers $1,000 in cash from its general bank account to a special medical reimbursement checking account. The transfer is based on the premium an insurance company would demand to provide the same benefits to the employees.

The $1,000 per month deposited into the medical reimbursement checking account is not deductible as an insurance expense. The company still controls the money while it is in the checking account and can withdraw it for general business use at any time. In addition, the amount deposited represents an estimated expense that is not permitted as a tax deduction. The amount actually reimbursed to employees from the medical reimbursement account can be deducted as a medical insurance expense and excluded from the employee's gross income.

 

c. The employees' of Baker Company receive large sums of cash in the mail. To protect against loss, Baker pays a $500 annual insurance premium for an employees fidelity bond.

The $500 premium paid for the employees fidelity bond is deductible as an insurance expense. The purpose of the fidelity bond is to protect Baker from losses due to an employee's dishonesty.

 

d. Baker Company is owned by Ross. Baker pays a $1,500 annual premium for a sickness and disability income continuation insurance policy on Ross. The purpose of the policy is to give Ross $3,500 per month if he is unable to work for Baker because he is sick or disabled.

The $1,500 premium paid on the income continuation policy is not deductible as an insurance expense but as compensation expense. If Ross collects the $3,500 per month benefit because he becomes ill or disabled, the payments are excluded from his gross income. The income is excluded because when the company made the payments, the premium amount was included in Ross's income.

55. State whether the following taxes are allowed as a current deduction for taxes paid by a business:

a. Sales tax on the purchase of a desk

The sales tax paid on the purchase of an asset is not currently deductible. The sales tax must be added to the basis of the asset and can be recovered through a depreciation deduction. However, a sales tax imposed on a business for items benefiting only the current tax year can be deducted (i.e., supplies, small tools, other consumable items).

 

b. State and local income, real estate, and personal property taxes

State and local income, real estate, and ad valorem personal property taxes are allowed as a deduction when paid or accrued based on the taxpayer's accounting method.

 

c. Federal income, estate, and gift taxes

Federal income, estate, and gift taxes cannot be deducted.

 

d. An employer's payment to the IRS of federal income and Social Security taxes withheld from an employee's wages

Payment to the IRS of taxes withheld from an employee's wages is not deductible by the employer. The payment to the IRS represents a transfer of a payment from the employee to the IRS. The employer is just a middleman who facilitates the payment. The employer does deduct the gross wages paid to the employee. In addition, the employer can deduct the employer's share of the Social Security tax when it is paid to the IRS.

 

 

56. Martin receives the following tax bills, related to a rental dwelling, from the county treasurer.

Special assessment for installing sidewalks and streets $ 12,000

Real property tax on dwelling for the 1/1/07 -- 12/31/07

property tax year, due on 10/1/07 $ 1,500

On May 1, 2007, Martin sells the dwelling for $70,000. His basis in the dwelling at the date of sale is $40,000. Martin's basis in the dwelling does not reflect the property tax bills. As part of the sale contract, the buyer agrees to pay the real property taxes when they come due on October 1, 2007, but Martin has to pay the special assessment before the sale closes. What is the proper tax treatment of the tax payments?

When Martin pays the $12,000 special assessment for sidewalks and streets, the expenditure is added to his basis in the dwelling. As a result, the basis in the dwelling is increased to $52,000 ($40,000 + $12,000). The special assessment is not a current deduction because it is not an ad valorem property tax. However, it does reduce the gain on the sale of the dwelling through the addition to basis.

When the rental dwelling is sold, the annual real estate tax must be allocated between the buyer and the seller of the property. Because Martin owned the property from January 1, through April 30, he can deduct 4/12 of the property taxes. As a result, Martin's real estate tax deduction is $500 [$1,500 x (4 ÷ 12)]. The buyer can deduct the remaining $1,000 of real estate taxes.

Because the buyer pays the real estate tax and Martin is allowed a deduction for taxes he did not directly pay, the sales price of the dwelling is adjusted. The sale price is increased by the amount of Martin's share of the real estate tax liability assumed by the buyer of the dwelling. The sale price of the residence, after adjustment for the real estate tax is $70,500 ($70,000 + $500). As a result of the above adjustments, Martin's income is increased by $500 (by increasing the gain on the sale of the building) and his deductions are increased by $500, resulting in a zero net effect on taxable income.

Martin has a gain of $18,500 on the sale of the building:

Amount realized ($70,000 + $500) $ 70,500

Adjusted basis ($40,000 + $12,000) (52,000)

Gain on sale $ 18,500

Instructors Note: Some students might realize that while the net effect on Martin's taxable income is zero, Martin could benefit because the tax rate for the income portion (i.e., the gain if held more than 12 months) is 15% (5% if Martin’s marginal tax rate is 10% or 15%) while his real estate taxes might be deducted at a higher marginal tax rate depending on Martin's income.

57. The Kimpton Corporation pays the following taxes during 2007:

Federal taxes withheld from employees $26,000

State taxes withheld from employees 9,000

Social Security withheld from employees 4,850

Kimpton's share of Social Security taxes 4,850

Federal income tax paid in 2007 with 2006 tax return 1,790

Federal income tax paid in 2007 12,340

Real estate taxes 6,750

State income taxes paid in 2007 5,720

State income taxes paid in 2007 with 2006 return 690

Sales tax on capital acquisitions 2,700

Sales tax on supplies 3,250

Also, the county treasurer notifies Kimpton that it is being assessed a special real estate tax of $64,000 for upgrading the sidewalks and sewer connections in the area. The special tax is payable in 4 yearly installments of $16,000. What amount can Kimpton deduct for taxes paid in 2007?

The Kimpton Corporation can only deduct the taxes that it actually paid in 2007. As an employer, Kimpton is required by the federal government to withhold federal income taxes and Social Security taxes from its employees and remit them to the government. The state government also requires Kimpton to withhold state income taxes. The federal and state taxes withheld from its employees are not deductible by Kimpton. The company can deduct the following taxes:

Kimpton's share of Social Security taxes $ 4,850

Real estate taxes 6,750

State income taxes paid in 2007 5,720

State income taxes paid in 2007 with 2006 return 690

Sales tax on supplies 3,250

Total tax deduction $ 21,260

The sales tax paid on the capital acquisitions must be added to the basis of the asset and is deducted through depreciation. The special assessment is not deductible because it is not an ad valorum tax; it is added to the basis of Kimpton’s property as it is paid. For 2007, Kimpton increases the basis of its property by $16,000.

58. Kuerten Manufacturers sue the Rafter Corporation for patent infringement. The court upholds Kuerten’s claim and requires Rafter to pay Kuerten $2,000,000 in damages. However, the court does not allow Kuerten to recover its $100,000 in legal expenses from Rafter. Can Kuerten deduct the $100,000 in legal expenses? Would your answer change if Kuerten were allowed to collect the legal fees from Rafter?

Kuerten can deduct the cost of its legal fees in suing Rafter Corporation for patent infringement. The legal fees are considered an ordinary and necessary business expense. The fact that the court did not allow the company to collect the fees from Rafter does not impact Kuerten’s ability to deduct the legal expenses.

If Kuerten is reimbursed for the legal fees, the legal fees are still deductible. However, Kuerten will have to include the $100,000 in income.

59. Can Joe Corporation deduct the following expenses related to its business?

a. Legal fee paid ($40,000) to acquire a competing chain of stores

The corporation must capitalize the $40,000 legal fee. The legal fee relates to acquiring the assets of a competing chain of stores and is not deductible. The benefit Joe Corporation derives from acquiring the stores extends substantially beyond the end of the tax year. Therefore, the legal fee must be capitalized.

 

b. Legal fee paid ($12,000) to determine whether it should become an S corporation

The legal fee paid to investigate whether Joe’s should become an S corporation is deductible because it is an ordinary business expense.

 

c. Legal fee paid ($5,000) to defend the company's president in a lawsuit filed by a disgruntled customer

The $5,000 legal fee paid to defend the company’s president is a valid business expense. The origin of the expense is business related and the expense is an ordinary and necessary expense of doing business. Many lawsuits that are filed against a business include one or all of the company’s officers as defendants.

 

d. Legal fee paid ($500) to defend title to a vacant lot Joe is holding for construction of a storage building for use in its business.

The legal fees related to establishing or defending title to property are not deductible. The corporation should capitalize the $500 legal fee as part of its basis in the vacant lot.

 

e. Legal fee paid ($2,500) to defend against damages suffered by a customer who was injured when he fell in the company's store.

The legal fee originated from a claim against the business. Because the fee is related to protecting the business and its assets, there is a business purpose for the expense. Thus, the corporation can deduct the $2,500 legal fee as a business expense.

 

 

60. Diane and Peter were divorced in 2005. The divorce agreement states that Peter is to have custody of their son, Stewart, and that Peter will be entitled to the dependency exemption. In addition, Diane is required to pay Peter $12,000 per year until Stewart turns 18 years of age, when the yearly amount will be reduced to $8,000. What is Diane’s allowable deduction, and how should it be deducted on her return?

Diane is allowed a deduction for adjusted gross income (alimony) for only $8,000 of $12,000 she pays to Peter (who includes the $8,000 in his gross income). Because the payment will be reduced from $12,000 to $8,000 when Stewart turns 18, only $8,000 is considered alimony and $4,000 is child-support. The child support payment is not deductible by Diane nor is it taxable to Peter.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

61. During the current year, Carson pays $1,500 in child support and $2,000 in alimony to his ex-wife. What is Carson's allowable deduction, and how should it be deducted on his tax return?

Carson is allowed a deduction for adjusted gross income for the $2,000 of alimony he paid to his ex-wife (who includes the alimony in her gross income). The child-support payment is not deductible by Carson nor is it taxable to his ex-wife.

 

62. Mona works for Leonardo Corporation as a sales representative. Leonardo gives her a travel allowance of $350 per month. During the current year, she spends the following amounts on valid travel expenses:

Transportation $ 2,700

Meals 1,200

Lodging 1,800

Entertainment 300

How should Mona treat the $350 per month travel allowance and the travel costs she incurs if

a. Leonardo's reimbursement plan is an accountable plan?

Mona receives $4,200 ($350 x 12) of reimbursement for $6,000 of expenses, putting her in a net deduction situation. Mona must include the $4,200 in her gross income.

With an accountable plan, Mona is allowed a deduction for adjusted gross income for the $4,200 of reimbursed expenses. The $1,800 of unreimbursed expenses are deductible as miscellaneous itemized deductions. The unreimbursed portion of each expense is 30% ($1,800 ÷ $6,000). Mona is subject to the 50% limit on meals and entertainment for her itemized deductions, leaving her a deduction of $1,575:

 

Transportation ($2,700 x 30%) $ 810

Meals ($1,200 x 30% x 50%) 180

Lodging ($1,800 x 30%) 540

Entertainment ($300 x 30% x 50%) 45

Total miscellaneous itemized deduction $ 1,575

The $1,575 employee business expense is added to any other allowable miscellaneous itemized deductions and the total is deductible to the extent it exceeds 2% of Mona's adjusted gross income.

 

b. Leonardo's reimbursement plan is a nonaccountable plan?

With a nonaccountable reimbursement plan, the $4,200 reimbursement must be included in Mona's gross income. Mona is not allowed to deduct any of her expenses for adjusted gross income. Mona can only deduct the costs as miscellaneous itemized deductions, subject to the 2% of adjusted gross income limitation. The meals and entertainment expenses are subject to the 50% limit, resulting in an itemized deduction of $5,250:

 

Transportation $ 2,700

Meals ($1,200 x 50%) 600

Lodging 1,800

Entertainment ($300 x 50%) 150

Total itemized deduction $ 5,250

The $5,250 employee business expense is added to any other allowable miscellaneous itemized deductions and the total is deductible to the extent it exceeds 2% of Mona's adjusted gross income.

63. Alvin is an employee of York Company. During the year, he incurs the following employment-related expenses:

Travel $ 4,000

Meals 2,400

Lodging 2,500

Entertainment 1,100

a. How should Alvin treat these expenses if York Company has an accountable employee business expense reimbursement plan and Alvin is reimbursed

1. $ 9,000?

Alvin is in a net deduction situation. The $9,000 is included in gross income and Alvin is allowed a deduction for adjusted gross income (AGI) for the $9,000 of reimbursed expenses. The remaining $1,000 of expenses are deductible as itemized deductions, subject to the 50% meals and entertainment limitation and the overall 2% of AGI limit for all miscellaneous itemized deductions. The from AGI deduction before the 2% limit is $825, calculated as follows:

Reimbursement ratio = $9,000 ÷ $10,000 = 90%

Unreimbursed percentage = 10%

Travel ($4,000 x 10%) $ 400

Meals ($2,400 x 10% = $240 x 50%) 120

Lodging ($2,500 x 10%) 250

Entertainment ($1,100 x 10% = $110 x 50%) 55

Total itemized deduction $ 825

 

2. $ 10,000?

Because the plan is accountable and the reimbursement equals actual expenses, no gross income is reported and no deductions are taken.

 

3. $ 11,000?

Because this is an accountable plan, the $1,000 excess reimbursement is included in Alvin's gross income and no deductions are allowed.

 

b. How would your answer to part a change if York's reimbursement plan were nonaccountable?

With a nonaccountable plan, any reimbursement is included in gross income. None of the expenses are deductible for adjusted gross income. The expenses are deducted as miscellaneous itemized deductions, subject to the 50% meals and entertainment limitation and the 2% of AGI limit. In each case, the from AGI deduction before the 2% limit is $8,250, calculated as follows:

Travel $ 4,000

Meals ($2,400 x 50%) 1,200

Lodging 2,500

Entertainment ($1,100 x 50%) 550

Total itemized deduction $ 8,250

 

c. How would your answer to part a change if Alvin were self-employed (i.e., receiving no reimbursements)?

If Alvin is self-employed, the expenses are considered to be trade or business expenses and therefore, deductible FOR AGI. However, the meals and entertainment limitations still apply and Alvin's deduction will be $8,250 as calculated in part (b) above. However, as FOR AGI deductions they are not subject to any further limitation; that is, the 2% AGI limit is only for unreimbursed employee business expenses.

 

 

64. The Ballaraat Corporation is cutting costs. The vice president of finance has asked the tax department to justify the company's continued use of an accountable employee expense reimbursement plan. You are the manager of the tax department. Prepare a letter to the vice president of finance explaining the tax consequences of not using an accountable employee expense reimbursement plan. Also discuss any nontax benefits of maintaining the plan.

An accountable reimbursement plan is one in which employees are required to make an adequate accounting of their allowable expenses with the employer and return any excess reimbursements to the employer. The significance of an accountable plan is that all reimbursements from the plan are deductible for AGI. In addition, the 50% meals and entertainment limitation does not apply to reimbursed expenses. Only unreimbursed expenses are deducted as miscellaneous itemized deductions, subject to the 2% of AGI limitation. If a reimbursement plan is not accountable, all deductions must be taken as miscellaneous itemized deductions, subject to the 2% and 50% limitations. Therefore, by not using an accountable plan, the employer is shifting part of the business costs to the employee. Because the expenses are considered deductions from AGI instead of for AGI, the employee, not the employer, must reduce any meal and entertainment expenses by 50% and the expenses must be reduced by 2% of adjusted gross income. Therefore, even if the employee’s reimbursement for the year equaled their expenses, there is a tax cost to the employee. If the employee cannot itemize, the tax cost is even greater.

Some of the nontax benefits the vice president of finance should consider are that by having an accountable plan, the company has greater internal control over their business expenses. If the company only provides a monthly stipend for business expenses, the company has no record of how or if the stipend is being spent on attracting new business and/or maintaining old business relationships. In fact, due to the tax disadvantages, employees could be cutting back on entertaining clients and "pocketing" part of the monthly stipend. Another problem the company might face is attracting and retaining quality employees. Because, of the negative tax consequences associated with a nonaccountable plan, the company will have to pay its employees either higher salaries or higher monthly stipends. By paying higher salaries, the company also indirectly increases the cost of its fringe benefits (e.g., pension contribution, Social Security tax).

 

65. Evelyn is single and a self-employed engineer. During 2007, Evelyn's income from her engineering business is $55,000. Evelyn pays $3,100 for her medical insurance policy.

a. How should the medical insurance policy payment be reflected on Evelyn's 2007 tax return?

Evelyn is allowed a deduction for adjusted gross income for the cost of the policy.

 

b. What is Evelyn's 2007 self-employment tax deduction?

Evelyn is allowed to deduct 1/2 of the self-employment tax paid as a deduction for adjusted gross income. Because this deduction reduces her self-employment income, the amount of self-employment income subject to the tax is 92.35% of self-employment income. Her self-employment income subject to the tax is $50,793. Because she is under the self-employment tax ceiling of $97,500 in 2007, she will pay a tax of 15.3% on the entire $50,793. Her tax is $7,771 and her deduction for adjusted gross income is $3,886.

Net Self-employment income ($55,000 x 92.35%) $ 50,793

Self-employment tax ($50,793 x 15.3%) $ 7,771

Deduction for one-half of self-employment tax ($7,771 x 50%) $ 3,886

 

 

 

66. Thomas is single and a self-employed architect. During 2007, Thomas’s income from his business is $128,000. He also pays $2,200 for a medical insurance policy.

a. How should the medical insurance policy payment be reflected on his 2006 tax return?

Thomas is allowed a deduction for adjusted gross income for the cost of the policy.

 

b. What is his 2007 self-employment tax deduction?

Thomas is allowed to deduct 1/2 of the self-employment tax paid as a deduction for adjusted gross income. Because this deduction reduces his self-employment income, the amount of self-employment income subject to the tax is 92.35% of self-employment income. His self-employment income subject to the tax is $118,208 ($128,000 x 92.35%). Because he is over the self-employment tax ceiling of $97,500 in 2007, he will pay a tax of 12.4% (6.2% x 2) on $97,500, plus 2.9% (1.45% x 2) on $118,208. His self-employment tax is $15,518 and his deduction for adjusted gross income is $7,759.

Net Self-employment income ($110,000 x 92.35%) $101,585

OASDI on $97,500 x 12.4% $ 12,090

MHI on $118,208 x 2.9% 3,428

Total self-employment tax $ 15,518

Deduction for one-half of self-employment tax ($15,518 x 50%) $ 7,759

 

 

c. Assume the same facts as in part a, except that Thomas is married, his wife’s salary is $30,000, and they are covered by a medical policy from her employer.

If his wife's employer provides her with medical coverage, no deduction is allowed for adjusted gross income for his policy. The $2,200 policy cost is an itemized medical expense deduction (see Chapter 8).

 

67. Carlos and Angela are married, file a joint return, and both are 42 years old. During the current year, Carlos’s salary is $70,000. Neither Carlos nor Angela is covered by an employer-sponsored pension plan. Determine the maximum IRA contribution and deduction amounts in each of the following cases:

a. Angela earns $18,000, and their adjusted gross income is $91,000.

Both taxpayers have earned income. Because neither Carlos nor Angela is covered by a pension plan, they each can contribute and deduct up to $4,000. Thus, they may contribute and deduct a total of $8,000 for adjusted gross income.

b. Angela does not work outside the home, and their adjusted gross income is $75,000.

Even though Angela does not have earned income, they are allowed to contribute and deduct a maximum of $8,000 for adjusted gross income because their total earned income exceeds $8,000. However, they must establish separate IRA accounts and the total amount contributed to each account cannot exceed $4,000.

c. Assume the same facts as in part a, except that Carlos is 52, Angela is 48 and both are covered by an employer-sponsored pension plan.

Angela is allowed to contribute $4,000 to her IRA. Because Carlos is at least 50 years of age, he is allowed to contribute $5,000 to an IRA account. Because both are covered by an employer-sponsored pension plan, the amount of the IRA deduction is reduced when their adjusted gross income reaches $83,000. The deduction is fully phased out when adjusted gross income exceeds $103,000. The maximum contribution amount is not affected by this limitation, only the deductible amount of the contribution. Angela's $4,000 deduction must be reduced by 40% [($91,000 - $83,000) ÷ $20,000] and leaves her with an allowable deduction for adjusted gross income of $2,400 [$4,000 - ($4,000 x 40%)]. Carlos's $5,000 deduction is also reduced by 40% [($91,000 - $83,000) ÷ $20,000] and leaves him with an allowable deduction for adjusted gross income of $3,000 [$5,000 - ($5,000 x 40%)]. Their total deduction for AGI is $5,400 ($2,400 + $3,000).

 

d. Assume the same facts as in part a, except that Carlos is covered by an employer-sponsored pension plan.

Because Carlos is covered by an employer-sponsored pension plan, the amount of his IRA deduction is reduced because their adjusted gross income exceeds the $80,000 phase-out level. Therefore, he may contribute $4,000 but the amount he can deduct must be reduced by 40% [($91,000 - $83,000) ÷ $20,000]. This leaves an allowable deduction for adjusted gross income of $2,400 [$4,000 - ($4,000 x 40%)].

Because Angela is not covered by an employer-sponsored pension plan, and their total adjusted gross income does not exceed $156,000, she may contribute $4,000 and deduct the entire contribution for adjusted gross income. Therefore, their maximum contribution is $8,000 and their maximum deduction is $6,400.

Instructor’s Note: Carlos’s deductible contribution will be fully phased-out when their AGI exceeds $103,000. When their AGI exceeds $156,000, Angela’s deductible contribution would begin to be phased-out and would be fully phased-out when AGI exceeds $166,000.

INSTRUCTORS NOTE: With the passage of the Pension Protection Act of 2006 and effective for tax years beginning in 2007, the income limits for income limits for deductible contributions to an Individual Retirement Account for active participants who are covered by an employer-sponsored plan begins at $52,000 for single taxpayers, begins at $83,000 for married taxpayers (both are active participants) and begins at $156,000 for married taxpayers when only one taxpayer is an active participant . These new phase out levels are not incorporated into the text but are set forth in a supplement along with additional problems that incorporate these new limits and can be found on the textbooks website http://murphy.swlearning.com.

 

68. Lois and Kam are married and file a joint return. Lois earns $63,500 and Kam earns $30,000. Their adjusted gross income is $96,000. Determine the maximum IRA contribution and deduction in each of the following cases:

a. Neither Lois nor Kam is covered by an employee-sponsored pension plan.

Both taxpayers have earned income. Because neither Lois nor Kam are covered by a pension plan, they each can contribute and deduct up to $4,000. Thus, they may contribute and deduct a total of $8,000 for adjusted gross income.

 

b. Both Kam and Lois are covered by an employee-sponsored pension plan.

They both can contribute $4,000 to an IRA account. Because both are covered by an employer-sponsored pension plan, the amount of the IRA deduction is reduced when their adjusted gross income reaches $80,000. The deduction is fully phased out when adjusted gross income exceeds $100,000. The maximum contribution amount is not affected by this limitation, only the deductible amount of the contribution. Each $4,000 deduction must be reduced by 65% [($96,000 - $83,000) ÷ $20,000]. This leaves both Kam and Lois with an allowable deduction for adjusted gross income of $1,400 [$4,000 - ($4,000 x 65%)]. Their total deduction for AGI is $2,800 ($1,400 x 2).

 

c. Assume that only Kam is covered by an employer-sponsored pension plan and that their adjusted gross income is $154,000.

Both Kam and Lois are allowed to contribute $4,000 to their IRA accounts. Because Kam is covered by an employer-sponsored pension plan and their adjusted gross income exceeds $103,000, he is not eligible to deduct his contribution. However, because Lois is not covered by an employer-sponsored pension plan, her contribution is fully deductible if their adjusted gross income is less than $156,000. Since their adjusted gross income is less than $156,000, Lois can take deduct the entire contribution.

INSTRUCTORS NOTE: With the passage of the Pension Protection Act of 2006 and effective for tax years beginning in 2007, the income limits for income limits for deductible contributions to an Individual Retirement Account for active participants who are covered by an employer-sponsored plan begins at $52,000 for single taxpayers, begins at $83,000 for married taxpayers (both are active participants) and begins at $156,000 for married taxpayers when only one taxpayer is an active participant . These new phase out levels are not incorporated into the text but are set forth in a supplement along with additional problems that incorporate these new limits and can be found on the textbooks website http://murphy.swlearning.com.

 

69. Kathy, who is single and 25, inherited $4,500 from her grandmother. A coworker has suggested that Kathy open an Individual Retirement Account with the $4,500. Her friend says that an IRA is a great way to save because you don't have to pay tax on the income from the investment and you get a tax deduction for your contribution. Write a letter to Kathy explaining whether her friend's advice is correct. To the extent her friend's information is inaccurate, provide Kathy with the correct tax treatment and explain how different facts may lead to different tax treatments.

Part of the information Kathy’s co-worker has provided is accurate. An IRA is an excellent vehicle to save and the income does accumulate tax-free. The information concerning the amount she can contribute and whether she can receive a tax deduction needs to be clarified. Kathy is only allowed to contribute up to $4,000 per year, not $4,500, into an individual retirement account. Assuming Kathy is not covered by an employer provided retirement plan, she is allowed to deduct the entire $4,000. If she is covered by an employer-provided retirement plan, her allowable deduction is phased-out over a $10,000 range beginning when her adjusted gross income exceeds $52,0000. Therefore, when her adjusted gross income exceeds $62,000 she receives no tax benefit for her contribution.

Alternatively, if she is covered by a qualified employer-sponsored pension plan and her adjusted gross income exceeds $62,000, she could make a $4,000 nondeductible contribution to a Roth IRA. Kathy is allowed to make a contribution to a Roth IRA if her adjusted gross income does not exceed $99,000. If her adjusted gross income exceeds this amount, the amount she can contribute is phased out ratably until no contribution is allowed when her adjusted gross income equals $114,000.

INSTRUCTORS NOTE: With the passage of the Pension Protection Act of 2006 and effective for tax years beginning in 2007, the income limits for income limits for deductible contributions to an Individual Retirement Account for active participants who are covered by an employer-sponsored plan begins at $52,000 for single taxpayers, begins at $83,000 for married taxpayers (both are active participants) and begins at $156,000 for married taxpayers when only one taxpayer is an active participant. In addition, the income limits for Roth contributions will be indexed for inflation. As a result, the income limits for Roth IRA contributions at $99,000 for single taxpayers, and at $156,000 for married taxpayers. These new phase out levels are not incorporated into the text but are set forth in a supplement along with additional problems that incorporate these new limits and can be found on the textbooks website http://murphy.swlearning.com.

 

 

70. Chanda is 36, single, and an active participant in a qualified employee pension plan. Determine the maximum Roth IRA contribution that she can make in each of the following cases:

a. Her adjusted gross income for the year is $66,000.

A single taxpayer with an adjusted gross income of less than $99,000 is allowed to make a $4,000 nondeductible contribution to a Roth IRA. Therefore, the maximum Chandra is allowed to contribute to her Roth IRA is $4,000. This assumes that she did not make any contributions to other IRA accounts during the year.

 

b. Her adjusted gross income for the year is $102,000.

When a taxpayer's adjusted gross income exceeds $99,000, the amount that can be contributed to a Roth IRA is phased out ratably until no contribution is allowed when adjusted gross income equals $114,000. The amount of Chandra’s Roth IRA deduction must be reduced because her adjusted gross income exceeds the $99,000 phase-out level. Therefore, she must reduce the amount she contributes by 20% [($102,000 - $99,000) ÷ $15,000] and can contribute only $3,200 [$4,000 - ($4,000 x 20%)] to her Roth IRA.

 

c. Her adjusted gross income for the year is $126,000.

Because Chandra’s adjusted gross income exceeds $114,000, she is not allowed to make a contribution to a Roth IRA.

 

Her adjusted gross income for the year is $54,000, and she makes a $2,400 contribution to a deductible IRA account.

The maximum amount that a taxpayer can contribute to all of his or her IRA accounts is $4,000. Because Chandra made an $2,400 contribution to another IRA account, the maximum amount that she can contribute to her Roth IRA is $1,600 ($4,000 - $2,400).

INSTRUCTORS NOTE: With the passage of the Pension Protection Act of 2006 and effective for tax years beginning in 2007, the income limits for income limits for deductible contributions to an Individual Retirement Account for active participants who are covered by an employer-sponsored plan begins at $52,000 for single taxpayers, begins at $83,000 for married taxpayers (both are active participants) and begins at $156,000 for married taxpayers when only one taxpayer is an active participant. In addition, the income limits for Roth contributions will be indexed for inflation. As a result, the income limits for Roth IRA contributions at $99,000 for single taxpayers, and at $156,000 for married taxpayers. These new phase out levels are not incorporated into the text but are set forth in a supplement along with additional problems that incorporate these new limits and can be found on the textbooks website http://murphy.swlearning.com.

 

 

71 Kevin and Jill are married and file a joint return. Kevin is 52, and is not an active participant in a qualified employee pension plan, while Jill is 48 and is an active participant in a qualified employee pension plan. Determine the maximum Roth IRA contribution that can be made in each of the following cases:

a. Their adjusted gross income for the year is $122,000.

Generally, married taxpayers with an adjusted gross income of less than $156,000 may each contribute $4,000 to a Roth IRA. When a married couple's adjusted gross income exceeds $156,000, the amount that can be contributed is phased out ratably until no contribution is allowed when adjusted gross income equals $166,000. However, a taxpayer who is at least 50 years of age can make an additional contribution of $1,000. Therefore, the maximum Roth IRA contribution Kevin can make is $5,000. Jill's maximum contribution to her Roth IRA’s is $4,000 (total of $9,000). This assumes that they did not make any contributions to other IRA accounts during the year.

b. Their adjusted gross income for the year is $157,000.

When a married taxpayer's adjusted gross income exceeds $156,000, the amount that each can contribute to a Roth IRA is phased out ratably until no contribution is allowed when adjusted gross income equals $166,000. The amount of their Roth IRA deduction must be reduced because their adjusted gross income exceeds the $156,000 phase-out level. Therefore, they must reduce the total amount they contribute by 10% [($157,000 - $156,000) ÷ $10,000]. Kevin can contribute $4,500 [$5,000 - ($5,000 x 10%)] and Jill can contribute $3,600 [$4,000 - ($4,000 x 10%)] to her Roth IRA.

c. Their adjusted gross income for the year is $164,000.

When a married taxpayer's adjusted gross income exceeds $156,000, the amount that each can contribute to a Roth IRA is phased out ratably until no contribution is allowed when adjusted gross income equals $166,000. The amount of their Roth IRA deduction must be reduced because their adjusted gross income exceeds the $156,000 phase-out level. Therefore, they must reduce the total amount they contribute by 80% [($164,000 - $156,000) ÷ $10,000]. Kevin can contribute $1,000 [$5,000 - ($5,000 x 80%)] and Jill can contribute $800 [$4,000 - ($4,000 x 80%)] to her Roth IRA.

How would your answers to parts a and b change if Kevin made the maximum allowable contribution to his deductible IRA.

In part a, because Kevin is at least 50 years of age, is not covered by an employer-sponsored pension plan, and their total adjusted gross income does not exceed $156,000, he may contribute $5,000 to an IRA and deduct the entire contribution for adjusted gross income. Because the maximum amount that Kevin can contribute to all of his IRA accounts is $5,000, he cannot make a contribution to a Roth IRA in part a. Assuming Kevin limited his contribution in part b to his maximum deduction ($4,500), he would also be entitled to contribute $500 (the phase-out calculation is the same as in part b) to a Roth IRA.

Jill cannot make a deductible contribution to an IRA because she is covered by an employer-sponsored plan. Therefore, in part a, Jill can make a $4,000 contribution to her Roth IRA. In part b, Jill’s contribution to a Roth IRA is $3,600. Instructor’s Note: Because the tax treatment of a Roth IRA is better (qualified distributions are tax-free) than a nondeductible IRA, Jill should always contribute (assuming she can) to a Roth IRA instead of a nondeductible IRA.

INSTRUCTORS NOTE: With the passage of the Pension Protection Act of 2006 and effective for tax years beginning in 2007, the income limits for income limits for deductible contributions to an Individual Retirement Account for active participants who are covered by an employer-sponsored plan begins at $52,000 for single taxpayers, begins at $83,000 for married taxpayers (both are active participants) and begins at $156,000 for married taxpayers when only one taxpayer is an active participant. In addition, the income limits for Roth contributions will be indexed for inflation. As a result, the income limits for Roth IRA contributions at $99,000 for single taxpayers, and at $156,000 for married taxpayers. These new phase out levels are not incorporated into the text but are set forth in a supplement along with additional problems that incorporate these new limits and can be found on the textbooks website http://murphy.swlearning.com.

 

72. Alex and Carmin are married and have two children, ages 6 and 3. Their adjusted gross income for the year is $123,000. What is maximum amount they can contribute to each child’s Coverdell Education Savings Account for the year?

All taxpayers can make a nondeductible contribution of up to $2,000 to an Education IRA for the benefit of an individual who is not 18 years of age. However, the total amount contributed to an individual’s Coverdell Education Savings Account is limited to $2,000. For married taxpayers, this amount is phased out ratably when their adjusted gross income exceeds $190,000 and is fully phased-out when adjusted gross income exceeds $220,000. Because Alex and Carmin’s adjusted gross income is less than $190,000, they can contribute $2,000 to each child’s education savings account.

 

If their adjusted gross income is $208,000, what is the maximum contribution that can be made to each child’s education savings account?

Because their adjusted gross income exceeds $190,000 the amount that they can contribute to each education savings account is phased out ratably until no contribution is allowed when adjusted gross income equals $220,000. Therefore, they must reduce the total amount they contribute to each education savings account by 60% [($208,000 - $190,000) ÷ $30,000] and they can contribute $800 [$2,000 - ($2,000 x 60%)] to each education savings account.

 

 

 

 

 

 

 

 

73. Gary and Patricia are divorced and have three children, ages 9, 6, and 2. Patricia has custody of the children and is entitled to the dependency exemption for each child. Their adjusted gross incomes are $48,000 and $61,000 respectively. During the current year, Gary contributes $1,500 to each child's Coverdell Education Savings Account. What is the maximum amount that Patricia can contribute to her children's education savings account?

All taxpayers can make a nondeductible contribution of up to $2,000 to education savings account education IRA for the benefit of an individual who is not 18 years of age. However, the total amount contributed to an individual’s Coverdell Education Savings Account is limited to $2,000. Because Gary has already contributed $1,500 to each child’s account, the maximum amount that Patricia can contribute to each child’s education savings account is $500.

74. Lleyton is single and has adjusted gross income for the year of $58,000. He works as a marketing manager for a national clothing store. During the year he enrolls in two business courses at Heath University. Even though the courses improve his job skills, his company does not reimburse him for the $1,500 in tuition.

a. How should Lleyton account for the education expense on his tax return?

Individuals are allowed to deduct education expenses if the education expense meets either of the following requirements: (1) the education is required by law or by the employer for the taxpayer to retain the taxpayer's job or (2) the expense maintains or improves the skills required in the taxpayer's trade or business. Because the courses improve his job skills and Lleyton is not reimbursed for the tuition he can deduct the expense on his tax return.

In 2007 a taxpayer with adjusted gross income less than $65,000 ($130,000 for a married couple filing a joint return) is allowed to deduct for adjusted gross income a maximum of $4,000 of qualified higher education expenses. If a taxpayer’s adjusted gross income exceeds $65,000 ($130,000 for a married couple filing a joint return) but does not exceed $80,000 ($160,000 for a married couple filing a joint return), the taxpayer can deduct a maximum of $2,000 of qualified higher education expenses. If the taxpayer’s adjusted gross income exceeds these amounts $80,000 ($160,000 for a married taxpayer filing jointly), then the taxpayer is not allowed a deduction for adjusted gross income. Therefore, some taxpayers can deduct qualified higher education expenses even if the expenses are not incurred as a requirement for the taxpayer to continue employment or do not maintain or improve the skills required in their job. Because Leyton’s AGI is less than $65,000, he has a deduction for adjusted gross income of $1,500.

 

b. Assume same the same facts as in part a, except that his tuition is $4,200.

Because the education expense exceeds $4,000, Lleyton can only deduct $4,000 for adjusted gross income. The remaining $200 ($4,200 - $4,000) is deductible as a miscellaneous itemized deduction that must be reduced by 2% of adjusted gross income, $1,160 (2% x $58,000), so no portion of the expense is deductible..

 

c. Assume the same facts as in part a, except that his adjusted gross income is $82,000.

ecause Lleyton's adjusted gross income is greater then $80,000 he cannot deduct any portion of the education expense as a deduction for adjusted gross income. The $1,500 is deductible as a miscellaneous itemized deduction that must be reduced by 2% of adjusted gross income $1,640 (2% x $82,000), so no portion of the expense is deductible.

 

 

d. Assume the same facts as in part a, except that his adjusted gross income is $73,000 and his tuition is $3,200.

Because Lleyton's adjusted gross income is greater then $65,000 and less than $80,000,he can only deduct $2,000 of the education expense as a deduction for adjusted gross income. The remaining $1,200 ($3,200 - $2,000) is deductible as a miscellaneous itemized deduction that must be reduced by 2% of adjusted gross income, $1,460 (2% x $73,000), so no portion of the expense is deductible.

 

 

75. Martha graduated from Tassle Tech and immediately started working as an accountant for Creedon Industries. To finance her college education, she borrowed $23,000 from a local bank pays $1,800 of interest expense during the year. Her adjusted gross income for the year is $39,000.

 

a. What amount can Martha deduct as student loan interest?

Martha can deduct the $1,800 of student loan interest for adjusted gross income. Interest paid on a qualified education loan during the first 60 months that is required to be repaid is deductible for adjusted gross income. A qualified education loan is one that is used to pay for tuition, fees, room and board, and other necessary education expenses. The maximum amount of interest that can be deducted is the lesser of $2,500 or the amount of interest paid. Any amount in excess of the maximum is considered personal interest and is not deductible. The interest deduction is phased out ratably for unmarried taxpayers with adjusted gross income between $55,000 and $70,000.

 

b. Assume that Martha borrowed $32,000 to finance her education and paid interest during the year of $2,700. What amount can she deduct as student loan interest?

Martha can only deduct $2,500 of the interest for adjusted gross income. The remaining $200 ($2,700 - $2,500) is considered personal interest and is not deductible.

 

Assume the same facts as in part a, except that Martha’s adjusted gross income is $60,000. What amount can she deduct as student loan interest?

When a taxpayer's adjusted gross income exceeds $55,000, the maximum amount of student loan interest that can be deducted is phased-out ratably over a $15,000 range. Since Martha's adjusted gross income is greater than $55,000, the maximum interest deduction of $2,500 must be reduced by 33.33% [($60,000 - $55,000) ÷ $15,000]. Therefore, the maximum amount of student loan interest she can deduct is $1,200 [$1,800 - $600 ($1,800 x 33.33 )]. The remaining $600 ($1,800 - $1,200) of interest is treated as nondeductible personal interest.

 

 

76. Simon graduated from Lessard University last year. He financed his education by working part-time and borrowing $16,000. During the current year, he pays $1,400 of interest on his student loan.

 

a. What amount can Simon deduct as student loan interest if his adjusted gross income is $33,000?

Simon can deduct the $1,400 of student loan interest for adjusted gross income. A qualified education loan is one that is used to pay for tuition, fees, room and board, and other necessary expenses. The maximum amount of interest that can be deducted is the lesser of $2,500 or the interest paid. Any amount in excess of the maximum is considered personal interest (discussed in Chapter 8) and is not deductible. The interest deduction is phased out ratably for single taxpayers with adjusted gross income between $55,000 and $70,000.

 

b. What amount can Simon deduct as student loan interest if his adjusted gross income is $67,000?

The maximum amount of student loan interest that can be deducted is phased-out ratably when adjusted gross income exceeds $55,000. Since his adjusted gross income is greater than $55,000, the amount that he can deduct must be reduced by 80% [($67,000 - $55,000) ÷ $15,000]. This leaves him with an allowable deduction for adjusted gross income of $280 [$1,400 - $1,120 ($1,400 x 80%)]. The remaining $1,120 (1,400 - $280) of interest is personal and is not deductible.

The amount of the student loan interest that is subject to the phase-out is the lesser of the interest paid or $2,500. In this example, the amount of interest paid, $1,400 is less than $2,500, so $1,400 is used in the calculation.

 

 

77. Myron graduates from college this year and lands a job with the Collingwood Corporation in Dallas. After accepting the job, he flys to Dallas to find an apartment. Myron uses $2,000 his grandmother gave him as a graduation gift to pay a moving company to transport his household goods from Atlanta. He doesn’t drive directly to Dallas but goes via Panama City to vacation with friends. In going to Dallas via Panama City, he incurs the following expenses:

Transportation of household goods $2,000

Lodging 675

Meals 330

Mileage (1,560 miles)

House-hunting trip:

Airfare 325

Lodging 165

Meals 110

The expenses listed include $375 for lodging and $230 for meals in Panama City. The direct mileage between Atlanta and Dallas is 1,340 miles. When Myron arrives in Dallas, he is informed that the moving van has mechanical problems and will not arrive for two days. Instead of sleeping on the apartment floor, he stays in a local hotel, paying $55 per night; he also spends $60 for meals. What is Myron’s allowable moving deduction?

Myron can deduct $2,541 of moving expenses for adjusted gross income.

Transportation of household goods $ 2,000

Lodging during move ($675 - $375) 300

Transportation (1,340 x $.20) 268

Total $ 2,568

Myron can only deduct his direct moving expenses. Direct moving expenses include the cost of moving household goods and personal effects to the new residence, and the transportation and lodging costs of Myron moving from his old residence to his new residence. His mileage is deductible at $.20 per mile. However, Myron can only deduct the direct mileage from Atlanta to Dallas. The additional mileage via Panama City is personal. The housing hunting expenses, the hotel costs upon arriving in Dallas, and all his meal expenses are considered personal in nature and are not deductible. The $2,000 gift from his grandmother is not taxable and does not affect the amount of his deductible moving expenses.

78. During the current year, the Coetzer Corporation hires Marcelo, and agrees to reimburse him for all his moving costs. Marcelo submits the following expenses to Coetzer for reimbursement:

Transportation of household goods $2,700

Airfare 340

Temporary living

Lodging 430

Meals 120

House-hunting trip:

Transportation 330

Lodging 280

Meals 110

What amount can Marcelo deduct as moving costs?

Marcelo can deduct $3,040 of moving expenses for adjusted gross income.

Transportation of household goods $ 2,700

Airfare 340

Total $ 3,040

Marcelo can only deduct his direct moving expenses. Direct moving expenses include the cost of moving household goods and personal effects to the new residence, and Marcelo’s airfare to his new residence. The housing hunting expenses and temporary living expenses are considered personal in nature and are not deductible.

 

If Marcelo is in the 28% marginal tax bracket, what is the effect of the reimbursement on his taxable income and his total tax liability?

Because Marcelo is reimbursed for all of his moving costs, he will have to include the $4,310 he is reimbursed in income but is only allowed to deduct $3,040 of these expense. Therefore, the net effect is that he will report $1,270 of income. Since he is in the 28% marginal tax bracket, he will pay an additional $356 in taxes.

Total moving expenses reimbursed $ 4,310

Deductible moving expenses (3,040)

Net increase in income $ 1,270

Marginal tax rate x 28%

Increase in Marcelo’s tax liability $ 356

 

ISSUE IDENTIFICATION PROBLEMS

In each of the following problems, identify the tax issue(s) posed by the facts presented. Determine the possible tax consequences of each issue you identify.

79. Marjorie is an accountant and Alana is an attorney. They have been business acquaintances for about 10 years. They meet every Friday at 6 P.M. at a local tavern to socialize. As always happens with attorneys and accountants, they discuss what is happening in their offices. They take turns paying the bar tab, which averages $30 for each meeting. Because Marjorie has kept the receipts for the nights she paid, she would like to claim a deduction for her $600 of expenses.

The issue is whether Marjorie can deduct the cost of the Friday night meetings as an entertainment expense. Marjorie may not deduct any of the expense for reciprocal entertainment. The expense is allowed as a deduction only if Marjorie can show a business purpose for the expense and it qualifies as directly related to or associated with her accounting practice. In Marjorie's case, the entertainment appears to be primarily based on personal motives and not directly related to or associated with the active conduct of her business.

 

80. Salvador is an insurance representative for the Hendricken Insurance Company. Recently, he heard that the controller of his largest account, Gore Plastics, was asking other insurance representatives to submit quotes on the cost of providing workers’ compensation insurance for the company. Hendricken’s contract with Gore is due to expire in two months. Knowing that the controller of Gore is an avid golfer, Salvador sends him the new Big Whomper Driver. The golf club costs $350. Salvador submits the bill for the golf club to the company, and the expense is approved for reimbursement by the vice president of finance.

The issue is whether the Hendricken Company can deduct the cost of the golf club as an ordinary and necessary business expense. The deduction for business gifts is limited to $25. Therefore, the Hendricken Company will only be allowed a deduction of $25 for the golf club. Because Salvadore's intent in making the gift has a business purpose -- retaining Gore as a client -- the controller of Gore must include the value of the golf club in gross income. It does not qualify as an excludable gift.

 

81. Jennifer is self-employed. At Christmas, she gives the elevator operator in the building where her office is located a pair of gloves. She makes similar gifts to the two parking lot attendants who park her car.

The issue is whether Jennifer can deduct the cost of the gloves given to the elevator operator and parking attendants as a business expense. Because the gloves are a gift, the maximum Jennifer could deduct is $25 for each pair of gloves. Her total deduction would be $75 ($25 x 3). However, she can only deduct the expense as a gift if it is made to business customers or she can show a direct connection between the expenditure and her business. Given the facts, she cannot take a deduction for the gloves. Instructor’s Note: The problem is based on Richard Sutter 21 TC 170 (1953).

82. Carla has a B.S. degree in history and is employed as an administrative assistant for a public accounting firm. After work, she attends Wittman College where she is enrolled in an accounting course. Her goal is to take the necessary courses to sit for the CPA exam. Her firm does not reimburse her for the cost of the course.

The issue is whether the accounting course can be deducted as an education expense. Generally, an individual is allowed to deduct an education expense if the education expense is either: (1) required by law or by the employer for the taxpayer to retain the taxpayer’s job or (2) maintains or improves the skills required in the taxpayer’s trade or business. An education expense is not deductible if the course (1) meets the minimum educational requirements required for the taxpayer’s job or (2) qualifies the taxpayer for a new trade or business. Carla might be able to argue that the introductory accounting course(s) help improve her skills.

In 2007, a taxpayer with adjusted gross income less than $65,000 ($130,000 for a married couple filing a joint return) is allowed to deduct for adjusted gross income a maximum of $4,000 of qualified higher education expenses. If a taxpayer’s adjusted gross income exceeds $65,000 ($130,000 for a married couple filing a joint return) but does not exceed $80,000 ($160,000 for a married couple filing a joint return), the taxpayer can deduct a maximum of $2,000 of qualified higher education expenses. If the taxpayer’s adjusted gross income exceeds these amounts, $80,000 ($160,000 for a married taxpayer filing jointly), then the taxpayer is not allowed a deduction for adjusted gross income.

Therefore, in 2007, some taxpayers can deduct qualified higher education expenses even if the expenses are not incurred as a requirement for the taxpayer to continue employment or do not maintain or improve the skills required in their job. This is true regardless of whether the course she takes would qualify her for a new trade or business (i.e., being a CPA). If the provision is not extend and Carla is able to deduct the expense for taking the course it would be a miscellaneous itemized deduction. As discussed in Chapter 8, miscellaneous itemized deductions are reduced by 2% of AGI.

83. Vince is the third highest paid executive for Sensor Corporation, a publicly traded-corporation. His salary is $1,250,000.

The issue is how much of Vince’s salary is deductible. Because Vince is one of the top four officers of the corporation, his salary is subject to the $1,000,000 limitation on compensation expense. The corporation can deduct only $1,000,000 of the $1,250,000 paid to him as compensation expense.

84. Jake loaned his cousin, Arnold, $10,000 in March 2005 to open a cybercafe in Santa Barbara. Arnold signed a loan agreement to pay Jake 7% interest annually, with the principal due in 2010. Jake received his 2005 interest payment but did not receive any interest payment in 2006. In March 2007, Jake's father informs him that his cousin has filed for bankruptcy.

There are three potential issues. The first is whether the loan is a valid bad debt. Assuming it is a valid bad debt, the second issue is whether the debt is a business or nonbusiness bad debt. The third issue is when (i.e., what year) the bad debt is deductible. It appears that the loan is a valid debt since it contains a written promise to pay, a stated interest rate, and a date for repayment. Because the loan is not related to Jake’s business, the loan is considered a nonbusiness bad debt and is deductible as a short-term capital loss in the year in which the actual amount of the loss is known. Therefore, Jake will be entitled to a bad debt deduction (i.e., short-term capital loss) when the bankruptcy proceedings are concluded.

 

 

85. Susan loaned $2,000 to her minister a year ago. The loan is not evidenced by a note and does not bear interest. The minister has moved out of town without paying her back. She doesn't want to embarrass him by asking him to repay the loan.

There are three potential issues. The first is whether the loan is a valid bad debt. Assuming it is a valid bad debt, the second issue is whether the debt is a business or nonbusiness bad debt. The third issue is when (i.e., what year) the bad debt is deductible. There is little indication that a valid debt exists. The loan does not contain the common elements of a valid loan - written promise to pay, stated interest rate, period and terms of repayment, collateral, etc. In addition, the loan appears to be motivated by reasons other than the opportunity to earn interest income. As such, the lack of repayment would not be viewed as a deductible nonbusiness bad debt. Susan has, in effect, made a gift to the minister as a result of forgiving the loan. If she is able to claim it as a nonbusiness bad debt, should could deduct it as a short-term capital loss in the current year.

 

 

86. The Copeland Corporation acquires a machine for $5,000 and pays $250 in state sales tax. The machine has a tax life of 7 years.

There are two issues in this problem. The first is whether the cost of the machine can be deducted in the current year. The second issue is whether the sales tax on the machine can be deducted in the current year. Because the tax life of the machine is longer than one year, the cost of the machine must be capitalized and deducted through depreciation over its useful life (i.e., 7 years – discussed in Chapter 10). In addition, all costs associated with acquiring a capital asset, including sales tax, must be added to the basis of the asset and depreciated over the tax life of the machine.

 

 

87. The town of Dinsmore passed a bill requiring that all homes be connected to the town sewer system. Baskin Ridge is the only section of town that does not have town sewers. Dinsmore will finance the project by assessing each homeowner in Baskin Ridge $10,000, payable over a 10-year period.

The issue is whether the sewer assessment can be deducted in the current period. The special assessment is not deductible because it is not an ad valorum tax; the tax is added to the basis of each homeowner’s property as it is paid. Assuming each homeowner pays $1,000 ($10,000 ¸ 10) per year, the basis in their home will increase by $1,000 each year.

 

 

 

 

 

 

88. Scott is single and wants to maximize his retirement income. He contributes the maximum allowable to his company's qualified pension plan. His adjusted gross income for the year is $73,000.

The issue is what type of retirement vehicle Scott can use to maximize his retirement income. Scott cannot make a deductible contribution to an IRA account because he is an active participant in a qualified retirement plan and his adjusted gross income exceeds $62,000. He could make a $4,000 nondeductible contribution to a nondeductible IRA account. However, upon retiring, a portion of the distribution (i.e., the income earned on the IRA assets) will be included in his gross income.

A better choice is to make a $4,000 nondeductible contribution to a Roth IRA. Although the contribution to a Roth IRA is not deductible, upon retiring, the entire amount of the qualified distribution from the Roth IRA, including the income earned on the IRA assets, is excluded from his gross income.

INSTRUCTORS NOTE: With the passage of the Pension Protection Act of 2006 and effective for tax years beginning in 2007, the income limits for income limits for deductible contributions to an Individual Retirement Account for active participants who are covered by an employer-sponsored plan begins at $52,000 for single taxpayers, begins at $83,000 for married taxpayers (both are active participants) and begins at $156,000 for married taxpayers when only one taxpayer is an active participant. In addition, the income limits for Roth contributions will be indexed for inflation. As a result, the income limits for Roth IRA contributions at $99,000 for single taxpayers, and at $156,000 for married taxpayers. These new phase out levels are not incorporated into the text but are set forth in a supplement along with additional problems that incorporate these new limits and can be found on the textbooks website http://murphy.swlearning.com.

 

89. TAX SIMULATION. Sam, the owner of The Perfect Cut, a wholesale meat distributor, unexpectedly dies during the current year. In an effort to provide equally for his two children, Sam’s will provides that the entire business less 40% of its accounts receivables be left to his daughter Helen. Sam’s son, Phil, is to receive the other 40% of the businesses receivables and the majority of Sam’s other assets. The following year, after extensive legal action, Phil is unable to collect a $5,000 receivable from his father’s business and the receivable is deemed worthless.

Required: Determine how Phil should treat the worthless receivable on his tax return. Search a tax research database and find the relevant authority (ies) that form the basis for your answer. Your answer should include the exact text of the authority (ies) and an explanation of the application of the authority to Phil’s facts. If there is any uncertainty about the validity of your answer, indicate the cause for the uncertainty.

Sec. 166(a) allows a deduction for any debt which becomes worthless during the year.

Sec. 166 (a) General Rule.Wholly worthless debts. There shall be allowed as a deduction any debt which becomes worthless within the taxable year.

However, the general rule does not apply if the debt that becomes worthless is considered a nonbusiness bad debt. Sec. 166(d)(2) defines a nonbusiness bad debt as any debt not created in the taxpayers trade or business.

Nonbusiness debt defined. For purposes of paragraph (1), the term "nonbusiness debt" means a debt other than—

(A) a debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer; or

(B) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.

The question that needs to be resolved is whether the bad debt that Phil inherited, which was incurred in his father’s trade or business, is treated as a business bad debt. Reg. Sec 1.166-5(b)(1) expands the definition set forth in the Code, by defining a nonbusiness bad debt in the negative. That is, it defines a nonbusiness bad debt as any debt other than a debt created or acquired in the taxpayers trade or business and without regard to the relationship of the debt to the taxpayers trade or business at the time the debt becomes worthless.

Nonbusiness debt defined. For purposes of section 166 and this section, a nonbusiness debt is any debt other than— A debt which is created, or acquired, in the course of a trade or business of the taxpayer, determined without regard to the relationship of the debt to a trade or business of the taxpayer at the time when the debt becomes worthless; or

Although this might appear to indicate that Phil can treat the debt as a business bad debt, Reg. Sec 1.166-5(b)(2) states that whether a debt is considered a nonbusiness debt will be determined on a case by case basis.

A debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. The question whether a debt is a nonbusiness debt is a question of fact in each particular case. The determination of whether the loss on a debt's becoming worthless has been incurred in a trade or business of the taxpayer shall, for this purpose, be made in substantially the same manner for determining whether a loss has been incurred in a trade or business for purposes of section 165(c)(1). For purposes of subparagraph (2) of this paragraph, the character of the debt is to be determined by the relation which the loss resulting from the debt's becoming worthless bears to the trade or business of the taxpayer. If that relation is a proximate one in the conduct of the trade or business in which the taxpayer is engaged at the time the debt becomes worthless, the debt comes within the exception provided by that subparagraph. The use to which the borrowed funds are put by the debtor is of no consequence in making a determination under this paragraph. For purposes of section 166 and this section, a nonbusiness debt does not include a debt described in section 165(g)(2)(C). See §1.165-5, relating to losses on worthless securities.

In an effort to provide guidance to taxpayers, Reg. Sec 1.166-5(d) provides six examples of what constitute a nonbusiness bad debt. Example 4 is very similar to Phil’s situation. Specifically, the example explains that because Phil is not in the trade or business of running a wholesale meat business, the debt is considered a nonbusiness bad debt.

The application of this section may be illustrated by the following examples involving a case where A, an individual who is engaged in the grocery business and who makes his return on the basis of the calendar year, extends credit to B in 1955 on an open account: In 1956 A dies, leaving the business to his son, C, but leaving the claim against B to his son, D, the taxpayer. The claim against B becomes worthless in D's hands in 1957. During 1956 and 1957, D is not engaged in any trade or business. D's loss is controlled by the nonbusiness debt provisions even though the original consideration has been advanced by A in his trade or business, since the debt has not been created or acquired in connection with a trade or business of D and since in 1957 D is not engaged in a trade or business incident to the conduct of which a loss from the worthlessness of such claim is a proximate result.

Once it has been determined that the bad debt is a nonbusiness bad debt, two things need to be determined. The first is the amount Phil can deduct and the second is the tax treatment (i.e., ordinary loss, capital loss). The amount that Phil can deduct is determined by Sec. 166 (b) and is limited to his basis in the receivable.

Sec 166 (b) Amount of deduction. For purposes of subsection (a), the basis for determining the amount of the deduction for any bad debt shall be the adjusted basis provided in section 1011 for determining the loss from the sale or other disposition of property.

The tax treatment of the nonbusiness bad debt is determined by Sec. 166(d)(1)(A) and (B). This section provides that a nonbusiness bad debt of an individual taxpayer is treated as a short-term capital loss.

Nonbusiness debts. General rule. In the case of a taxpayer other than a corporation—

(A) subsection (a) shall not apply to any nonbusiness debt; and

(B) where any nonbusiness debt becomes worthless within the taxable year, the loss resulting therefrom shall be considered a loss from the sale or exchange, during the taxable year, of a capital asset held for not more than 1 year.

Finally, according to Reg. Sec 1.166-5(b)(2), the taxpayer cannot deduct a nonbusiness bad debt until the tax year in which the debt becomes totally worthless.

A loss on a nonbusiness debt shall be treated as sustained only if and when the debt has become totally worthless, and no deduction shall be allowed for a nonbusiness debt which is recoverable in part during the taxable year.

NOTE: The student should indicate that the amount of the deduction cannot be determined since the problem does not specify Phil’s basis in the inherited receivable.

 

90. INTERNET ASSIGNMENT The use of a "flat tax" to replace the current income tax system has received a considerable amount of interest in recent years. Various flat-tax proposals have been made, but the gist of a flat tax is the use of a single tax rate with very few deductions. Using a search engine or one of the tax directory sites provided in Exhibit 16-6 (Chapter 16), find a flat-tax proposal and explain how it would affect the deductions currently allowed by the income tax system.

One possible starting point is the Yahoo search engine (http://www.yahoo.com). Starting at the Yahoo homepage, the student should further specify the search heading to Government. Under the Government heading, the search can be further specified to the topic Taxes. Within Taxes search using the term "flat tax", which will provide numerous websites. Two websites the student can go to find information on the flat tax are:

The National Center For Policy Analysis: Flat Tax

http://www.ncpa.org/pi/taxes/tax7.html

Flat Tax -Citizens for Tax Justice

http://www.ctj.org/html/flattx.htm

 

INSTRUCTOR’S NOTE: Information on the Internet is developing at a rapid pace. Therefore, this solution may become outdated. We suggest that you do the assignment prior to assigning it to your students. This will allow you to provide students with any additional information they may need to complete the assignment.

 

91. INTERNET ASSIGNMENT The Internet is a useful resource for gathering tax information. An important aspect of taxes discussed in this chapter is how deductible IRA’s and Roth IRA’s can be used to save for retirement. One site that provides a comparison of these two retirement vehicles is found at http://retireplan.about.com/. Go to that site and click on the retirement planning calculators on the right side of the page. Then click on the IRA comparison calculator. Fill out the worksheet with your personal information. Provide the information you used in filling out the IRA comparison calculator and the results of the calculation.

 

The following information was used to determine whether a taxpayer should invest in a deductible IRA or a Roth IRA.

1.

For which year will this IRA be effective?

2006

     

2.

Your current federal tax rate

25%

     

3.

Your expected tax rate in retirement

25%

     

4.

Rate of return you expect to earn on your IRA investments

8%

     

5.

Amount you expect to invest annually in an IRA. For 2006, you can enter any sum between $200 and $4,000 ($4,500 if age 50+). Please use the eligibility calculator to see how much you'll actually be allowed to contribute based on your income, retirement plan participation, and tax-filing status.

$4,000

     

6.

Your current age

22

     

7.

Your anticipated age at retirement, or age at which you expect to take withdrawals from your IRA

22

Note: Withdrawals from an IRA before age 59½ are generally subject to a 10% early penalty. Also, withdrawals from a Roth IRA that has been open for fewer than five years may be subject to tax and penalties.

 

 

Roth

Deductible

Non-deductible

Annual IRA contribution

$4,000

$4,000

$4,000

Annual tax savings

$0

$1,000

$0

Effect on annual net income

($4,000)

($3,000)

($4,000)

IRA total at retirement(after federal income taxes)

$1,423,801

$1,067,851

$1,110,851

Future value of tax savings

$0

$187,508

$0

Net at retirement(after federal income taxes)

$1,423,801

$1,255,358

$1,110,851

Your results are based on:

Contribution period:

43 years

Current federal tax rate:

25%

Projected tax rate in retirement:

25%

Average projected rate of return until withdrawal:

8%

Taxes for classic IRAs are paid at distribution (calculation does not factor state and local taxes, if any). Qualified distributions from a Roth IRA are taken tax-free if over age 59½ and contribution period is greater than five years.

 

INSTRUCTOR’S NOTE: Information on the Internet is developing at a rapid pace. Therefore, this solution may become outdated. We suggest that you do the assignment prior to assigning it to your students. This will allow you to provide students with any additional information they may need to complete the assignment.

___________________________________________________________________

CHAPTER 7

LOSSES - DEDUCTIONS AND LIMITATIONS

___________________________________________________________________

 

DISCUSSION QUESTIONS

1. How are deductions and losses different? How are they similar? Explain.

Differences - The main difference is that most deductions are for current expenditures and amortization of capital expenditures, whereas losses result from either an excess of deductions over income (annual loss) or an excess of basis over the amount realized on the disposition of an asset (transaction loss).

Similarities - Both deductions and losses represent amounts invested to produce income and are reductions in taxable income under the ability-to-pay concept. In addition, the general approach to the deductibility of losses is similar to the approach taken for deductions. That is, tax relief is the result of legislative grace and any deductions allowed must be specified in the tax law. The categorization of losses by those incurred in a trade or business, production of income losses, and personal use losses is identical to the approach for deductions. The limitation on losses is similar to the limitations placed on deductions within each category.

 

2. Discuss the basic differences between annual losses and transaction losses.

Annual losses result from an excess of deductions over income for a single accounting period. Thus, they represent the effect of all the transactions affecting an entity during the accounting period.

Transaction losses result when the amount realized from a sale or other disposition of property is less than the basis of the property. That is, a transaction loss represents an incomplete capital recovery on a single transaction by an entity.

 

3. What are the net operating loss carryback and carryforward periods? Does a taxpayer have a choice of the years to which a net operating loss can be carried? Explain.

A net operating loss can be carried back 2 years to obtain a refund of taxes paid. The loss must be carried to the earliest year in the carryback period first. If the loss is not entirely used up in the earliest year, the previous year is then used. If the entire loss is not used up during the 2-year carryback, any remaining loss can be carried forward for 20 years. A taxpayer may elect not to carryback any of the loss and only use the carryforward period.

4. What are the characteristics of a tax shelter as the term is commonly used by tax practitioners?

A tax shelter is an activity that is designed to produce losses through the use of allowable deductions. These losses are then passed through to the owners of the activity who use the losses to reduce their tax on other income sources. The owners of the shelter may pay a tax when they sell their investment. However, such a sale (if it does occur) will take place in the future, thus providing the tax shelter owner with a time value of money tax savings.

 

5. How is a taxpayer's amount at risk in an activity different from the taxpayer's basis in the same activity? What purpose does the amount at risk serve in regard to losses?

The amount at risk is the amount that the taxpayer stands to lose if the activity should fail. Therefore, it represents any amounts invested in the activity that have not yet been recovered, as well as any liabilities the taxpayer has to pay should the activity be unable to pay the liabilities.

The amount at risk in an activity is very similar to the basis in the activity. That is, the at-risk amount is adjusted in the same manner as basis for additional capital investments, the share of income (loss) from the activity and any withdrawals or other capital recoveries which the taxpayer receives from the activity. The primary difference between the at risk amount and basis is the treatment of nonrecourse debt used to finance real estate in the activity. Because the taxpayer is not liable for nonrecourse debt, it is not added to basis. However, the tax law allows nonrecourse debt used to finance real estate to increase the amount at risk in an activity if the borrowing is made on reasonable commercial terms.

The purpose of the at risk rules is to limit loss deductions to an amount that the taxpayer actually stands to lose should the activity fail. Therefore, the taxpayer can only deduct losses from an activity to the extent she or he is at risk.

 

6. What is a nonrecourse debt? How is financing using nonrecourse debt different from financing using recourse debt?

A nonrecourse debt is a liability that is only secured by the underlying property related to the debt; the other assets of the entity borrowing the money cannot be used to pay the debt if the entity defaults on the loan. A recourse debt is one that is secured by the property underlying the debt and the other assets of the entity borrowing the money.

The main difference between the two financing methods is that nonrecourse debt is generally not added to basis in the activity and can only increase the at-risk amount in the activity if the financing relates to the holding of real estate. A recourse debt is always added to basis in the activity and always increases the amount at risk in the activity.

 

7. What is the purpose of the passive loss rules?

The basic intention of the passive loss rules is to disallow the deduction of losses from passive activities against other forms of income. That is, a passive loss cannot be deducted against earned income or portfolio income of the taxpayer.

 

8. Are the passive loss rules disallowance-of-loss provisions or are they loss deferral provisions? Explain.

The passive loss rules are deferral of loss provisions. Any net passive loss not deductible in the year it is incurred is suspended and carried forward to future years and used to offset passive income. In addition, any suspended loss on an activity is deductible in the year in which the taxpayer's entire interest in the activity is disposed of in a taxable transaction.

 

9. For purposes of the passive loss rules, what is a closely held corporation? How is the tax treatment of passive losses incurred by a closely held corporation different from the tax treatment of passive losses incurred by

A closely held corporation has five or fewer shareholders who own less than 50% of the stock of the corporation during the last half of the tax year. Closely held corporations are allowed to deduct passive losses against active business income but not against portfolio income.

 

a. Individuals?

Individuals are only allowed to deduct passive losses against passive income under the general passive loss rules. However, for rental real estate two major exceptions exist. First, if a taxpayer passes the real estate professional exception, the activity is not passive and all losses are deductible. To qualify under this exception, a taxpayer must spend more than 50% of her/his personal service time in a real property trade or business, the amount of time spent in the real property trade or business must be greater than 750 hours and the taxpayer must materially participate in the rental activity. To be a material participant, the taxpayer must either spend greater than 500 hours managing the rental activity or must spend more than 100 hours a year in the activity, and the 100 hours must be more hours than any other owner or non-owner spends on the activity (known as the 100-hour test). The second exception is for taxpayers who meet the active participant test. To meet the active participant test, the taxpayer must own at least a 10% interest in the property and have a significant and bonafide involvement in the activity. Under this exception, an individual can deduct up to $25,000 of losses from the rental activity each year against active and portfolio income. However, the maximum allowable deduction is reduced when an individual's adjusted gross income exceeds $100,000. The $25,000 maximum deduction is reduced $.50 for every dollar of adjusted gross income in excess of $100,000. The $25,000 is completely phased out when the taxpayer's adjusted gross income exceeds $150,000.

 

b. Corporations?

Corporations are not subject to the passive loss rules. Therefore, they may deduct all passive losses against any form of income.

 

 

10. When a business sustains a loss from a casualty, one of two measurement rules is used to determine the amount of the loss. Why is the use of two measurement rules necessary for determining a business casualty loss?

Two measurement rules are necessary to insure that the amount of the capital recovery from the loss does not exceed the amount invested in the asset. That is, the amount of the loss from a casualty is generally the decline in the value of the asset. However, when business property is partially destroyed, the measurement rule is the lesser of the decline in value of the property or the property's basis. This insures that the amount of loss can never exceed the amount invested in the property (basis). For business property fully destroyed or stolen, the measurement of loss is the property's basis. This also insures that the full amount of the taxpayer's unrecovered investment in the property is allowed as a loss. If the first measurement rule were always used, assets whose values have declined below their basis would not get a full capital recovery when they were destroyed.

 

11. What are the limitations on the deductibility of capital losses by individuals? How do the limitations compare with those for corporations?

Capital losses of individuals are netted against other capital gains that the individual has during the year. If the result of the netting is a loss, the individual can deduct the net capital loss up to a maximum of $3,000. Any excess loss is carried forward and used in the next year's capital gain and loss netting.

Corporations also net together capital losses and capital gains. However, if the result of the netting is a net capital loss, the loss is not deductible in the period in which it is incurred. The net capital loss can be carried back 3 years and netted against any net capital gains on which the corporation paid tax to obtain a refund of the taxes paid. If the carryback period is not sufficient to fully absorb the loss, any remaining loss can be carried forward for 5 years and used to offset capital gains.

 

12. Most sales of securities at a loss result in capital losses. Under what circumstances would a loss on the sale of a security be treated as an ordinary loss? Explain the rationale for allowing this treatment.

Ordinary loss treatment is accorded to sales of securities in which the security does not meet the definition of a capital asset. For example, a sale of a security by a dealer in securities receives ordinary loss treatment because the securities represent inventory for the dealer.

A second exception is provided for losses on the sale of qualified small business stock. This exception allows an individual to deduct up to $50,000 ($100,000 for a married couple) of losses on the sale of small business stock as an ordinary loss each year. Any loss in excess of the limit is a capital loss.

The rules were adopted to encourage individuals to invest in small businesses. Recent statistics suggest that 85% of the new jobs created in the U.S. are by small businesses. This provides protection (and incentive to invest in small businesses) to investors who otherwise would be able to deduct only $3,000 in losses each year.

 

13. What is the purpose of the related party rules as they apply to sales of property?

The related party rules are designed to stop individuals from creating losses through the sale of securities (or other property) to related parties at prices that are not bargained at arms-length. This is accomplished by disallowing all losses on the sale of property to a related party. Any disallowed loss can be used to reduce any gain on the subsequent sale of the property to an unrelated party.

 

14. Losses incurred on the sale of business assets are generally deductible in full in the year the loss is realized. Describe a situation in which a realized loss on the sale of a business asset is not deductible in the current year, and explain why it would not be deductible.

If a business sells business assets at a loss to a related party, the realized loss is not deductible by the business. The purpose of the related party provisions is to stop businesses from creating losses by selling assets to related parties at prices that are not made at arms-length.

 

15. What is a wash sale? How is the treatment of a wash sale different from the treatment of other sales of securities?

A wash sale occurs when securities are sold at a loss and the securities are replaced with substantially identical securities within 30 days (before or after) of the loss sale.

Losses on shares that are replaced within the 30 day wash sale period are disallowed. The disallowed loss is added to the basis of the replacement shares. This treatment effectively views the replacement shares as a continuation of the investment in the shares sold at a loss.

 

16. How are the rules for deducting personal casualty and theft losses different from the rules for business casualty and theft losses? Explain the difference in treatments and the rationale for the difference.

The differences in the rules involve the measurement of the loss and limitations on the deductions. The measurement of the loss is different for property fully destroyed – the loss on business property fully destroyed (stolen) is the adjusted basis; personal property losses are measured as the lesser of 1) the adjusted basis, or 2) the decline in fair market value resulting from the casualty or theft. This measurement rule prevents individuals from deducting any loss in value that occurred prior to the casualty (a personal use loss).

Personal casualty losses are only deductible as itemized deductions. Each loss occurring during the year is reduced by the $100 statutory limit. The sum of all casualty losses for the year is further reduced by 10% of the taxpayer’s adjusted gross income. This treatment is based on administrative convenience. A business casualty loss is fully deductible.

 

PROBLEMS

17. The Graves Corporation was incorporated in 2006 and incurred a net operating loss of $35,000. The company’s operating income in 2007 was $47,000. Because of a downturn in the local economy, the company suffers a net operating loss of $21,000 in 2008. What is the treatment of the 2008 loss?

A corporation is a taxable entity that is responsible for the payment of tax on its income. Therefore, it is allowed a deduction for a net operating loss. The 2006 NOL is carried forward and used to reduce the 2007 operating income to $12,000 ($47,000 - $35,000). Graves pays a tax of $1,800 (15% x $12,000) on the income in 2007. The 2008 loss is carried back to 2007 and $12,000 of the $21,000 loss is used to reduce the 2007 income to zero. This results in a refund of the $1,800 of tax paid in 2007. The remaining $9,000 of loss is carried forward to 2009 and used to reduce income.

2006 2007 2008_

Operating income $ (35,000) $ 47,000 $ (21,000)

Carryforward of 2006 loss (35,000)

2007 Taxable Income $ 12,000

Carryback of 2008 loss to 2007 (12,000) 12,000

Carryforward of 2008 loss to 2009 $ (9,000)

2007 Taxable income $ 12,000

Tax rate on $12,000 of income x 15%

2007 Tax paid (refund of carryback) $ 1,800

 

Instructor's Note: Graves has the option of electing not to carry the 2008 loss back to 2007 and carrying the $21,000 loss forward to 2009. Graves should make the election if it feels that its marginal tax rate will increase and the net present value of the tax savings of carrying the loss forward exceed carrying back the current year's loss.

 

How would your answer change if Graves were an S corporation?

An S corporation is a conduit entity that does not pay tax on its income. The shareholders of Graves are taxed on any income and also receive their proportionate share of any losses generated by Graves. For 2008, the $21,000 operating loss is distributed to each shareholder. The shareholder then takes the appropriate allowable deduction on his/her return. Because the income and loss is passed through to the individual shareholders each year, S corporations do not have net operating loss carryforwards or carrybacks.

 

 

18. Habiby, Inc., has the following income and expenses for 2005 through 2008. What is the amount of tax that Habiby should pay each year? Use the corporate tax rate schedules in Appendix A to compute the tax liability.

2005 2006 2007 2008

Income $ 280,000 $ 300,000 $ 290,000 $ 320,000

Expenses (180,000) (200,000) (600,000) (220,000)

Taxable Income $ 100,000 $ 100,000 $ (310,000) $ 100,000

Using the corporate tax rate schedules, Habiby would have paid a tax of $22,250 each year on its 2005 and 2006 taxable income of $100,000. The $310,000 NOL in 2007 could be carried back and used to offset the $200,000 of taxable income for 2005 and 2006, resulting in a refund of all tax paid ($22,250) each year. For 2008, $100,000 of the remaining $110,000 of the 2007 NOL is carried forward and deducted against 2008 income reducing 2008 taxable income to $0. The remaining $10,000 ($110,000 - $100,000) can be carried forward to offset income in future years.

2005 2006 2007 2008

Operating income $ 100,000 $ 100,000 $ (310,000) $100,000

Carryback of 2007 loss (100,000) (100,000) 200,000

Taxable Income $ -0- $ -0-

Tax refund $ 22,250 $ 22,250

Remaining carryforward $ (110,000)

Carryforward of 2007 loss (100,000)

Taxable Income $ -0-

Remaining carryforward $ 10,000

 

 

19. Post Haste, incorporated in 2005, suffers a net operating loss of $80,000 in 2007. Post Haste had a net operating loss of $30,000 in 2005 and taxable income of $65,000 in 2006. Allison, the financial vice president of Post Haste, expects 2008 to be a banner year, with operating income of approximately $200,000. Write a memo to Allison advising her how to treat the $80,000 loss in 2007. Post Haste normally earns 9% on its investments.

Post Haste has the option of carrying back the $80,000 loss to 2006 and the unused loss forward or carrying the entire loss forward for 20 years. To determine the optimal choice, the present value of the tax savings of each option must be calculated. A carryback to 2006 will result in a refund of $5,250 ($35,000 x 15%). Only $35,000 of the loss is used up in the carryback because the $30,000 loss carryforward from 2005 reduced 2006 taxable income to $35,000 ($65,000 - $30,000). The remaining $45,000 ($80,000 - $35,000) of loss will be carried forward to 2008 and reduces taxable income to $155,000 ($200,000 - $45,000) resulting in a tax savings of $17,550.

Corporate tax on $200,000 =

{$22,250 + [($200,000 - $100,000) x 39%]} = $ 61,250

Corporate tax on $155,000 =

{$22,250 + [($155,000 - $100,000) x 39%]} = (43,700)

Tax savings from carrying forward $45,000 $ 17,550

Present value factor x .917

Present value of tax savings of the carryforward $ 16,093

Present value of tax savings of carryback 5,250

Total present value of tax savings $ 21,343

Because the savings is one year in the future, it is discounted at 9% to obtain a present value tax savings of $16,093 ($17,550 x .917). The present value of the tax savings using the carryback is $21,343 ($5,250 + $16,093).

If the loss carryforward option is elected, the tax savings on the carryforward to 2008 is $31,200 (see below) and the present value of the tax savings is $28,610 ($31,200 x .917). Therefore, by foregoing the carryback, and carrying the entire loss forward, Poste Haste realizes a present value tax savings of $7,267 ($28,610 - $21,343).

Corporate tax on $200,000 =

{$22,250 + [($200,000 - $100,000) x 39%]} = $ 61,250

Corporate tax on $120,000 =

{$22,250 + [($120,000 - $100,000) x 39%]} = (30,050)

Tax savings from carrying forward of $80,000 $ 31,200

Present value factor x .917

Total present value of tax savings $ 28,610

 

 

20. Marlene opens an outdoor sports complex that features batting cages, minature golf, and a driving range. She invests $100,000 of her own money and borrows $750,000 from her bank. She uses $475,000 of the loan proceeds to acquire land and construct the office building for the sports complex. The remaining loan proceeds are used to acquire equipment and furnishings. The loan is secured by the land, building, and equipment. What is Marlene's amount at risk in the business if the $750,000 debt was obtained on reasonably commercial terms and is secured by

a. The business assets purchased, and Marlene is personally liable if the business assets are insufficient to satisfy the debt?

Marlene is at risk for $850,000. She is at risk for the $100,000 of personal funds she invested and for the $750,000 she borrowed because she is personally liable for the debt.

 

b. The business assets purchased, and Marlene is not personally liable if the business assets are insufficient to satisfy the debt?

Marlene is at risk for $100,000. She is only at risk for the $100,000 of personal funds she invested in the business. She is not considered at-risk for the nonrecourse loan because she is not personally liable on any of the debt and the loan is not used in the trade or business of holding real property.

c. Assume the same facts as in part b, except that Marlene uses the $750,000 loan to purchase an apartment complex.

Marlene is at risk for $575,000. She is at risk for the $100,000 of personal funds invested and the $475,000 of the loan proceeds used to acquire the land and building. Although she is not personally liable on any of the debt, a nonrecourse loan that is used in the trade or business of holding real property that is secured by the real property used in the business is considered at risk. Therefore the $475,000 debt on the land and building us at risk, but the remaining $275,000 ($750,000 - $475,000) that is used for equipment and furnishings is not at risk.

21. Carlos opens a dry cleaning store during the year. He invests $30,000 of his own money and borrows $60,000 from a local bank. He uses $40,000 of the loan to buy a building and the remaining $20,000 for equipment. During the first year, the store has a loss of $24,000. How much of the loss can Carlos deduct if the loan from the bank is nonrecourse? How much does Carlos have at risk at the end of the first year?

Carlos is at risk for $30,000. He is only at risk for the $30,000 of personal funds he invested in the business. He is not considered at-risk for the nonrecourse loan because he is not personally liable on any of the debt and the loan is not used in the trade or business of holding real property. Because he is considered at risk for $30,000, he can deduct the entire $24,000 loss. The $24,000 loss reduces Carlos’ amount at-risk to $6,000 ($30,000 - $24,000).

 

 

 

 

 

 

 

22. Return to the facts of problem 21. In the next year, Carlos has a loss from the dry cleaning store of $18,000. How much of the loss can Carlos deduct? Explain.

Because his at-risk amount in the dry cleaning store is only $6,000, Carlos can deduct only $6,000 of the $18,000 loss. The remaining $12,000 ($18,000 - $6,000) of the loss is suspended due to the at-risk rules. He will be able to deduct the loss when his at-risk amount is increased either through additional investment in the business or when the business generates taxable income.

 

23. Wayne owns 30% of Label Maker Corporation. Label Maker is organized as an S corporation. During 2007, Label Maker has a loss of $160,000. At the beginning of 2007, Wayne's at risk amount in Label Maker is $30,000.

a. Assuming that Wayne's investment in Label Maker is not a passive activity, what is his deductible loss in 2007?

As an S corporation, the income and losses are passed through to its shareholders for taxation. In 2007, Wayne's share of the loss is $48,000 ($160,000 x 30%). Wayne cannot deduct any loss in excess of his at-risk amount in Label Maker. Therefore, Wayne's 2007 loss deduction is limited to $30,000 (reducing his at-risk amount to zero). The remaining $18,000 of his loss is suspended until his at-risk amount increases.

 

b. In 2008, Label Maker has a taxable income of $50,000. What is the effect on Wayne's 2008 income?

The net effect on Wayne's income is zero. Wayne's share of the income is $15,000 ($50,000 x 30%), which is included in his 2008 gross income. However, the $15,000 of income from Label Maker increases his amount at-risk by $15,000 and he is allowed to deduct $15,000 of the $18,000 suspended loss from 2007. After deducting the loss, Wayne's at risk amount is reduced to zero. His suspended loss in the activity due to the at-risk rules is $3,000 ($18,000 - $15,000).

 

24. A taxpayer has the following income (losses) for the current year:

Active Income Portfolio Income Passive Income

$18,000 $31,000 $(35,000)

What is the taxpayers taxable income (loss) if

a. The taxpayer is a publicly held corporation?

Publicly held corporations are not subject to the passive activity loss rules. The taxpayer reports income of $14,000 ($18,000 + $31,000 - $35,000).

 

b. The taxpayer is a closely held corporation?

A closely held corporation is allowed to deduct passive losses against active income of the corporation, but not against portfolio income. In this case, $18,000 of the passive loss is deducted against the $18,000 of active income, leaving the corporation with a taxable income of $31,000 (i.e., the portfolio income).

 

c. The taxpayer is a single individual and the passive income is not from a rental activity?

An individual cannot deduct passive losses against active or portfolio income. The taxpayer has taxable income of $49,000 ($18,000 + $31,000) and a suspended loss of $35,000.

 

d. The taxpayer is a single individual and the passive income is the result of a rental activity for which the taxpayer is a qualified real estate professional?

An individual who qualifies as real estate professional can deduct all losses from the activity against active and portfolio income. The taxable income is $14,000 ($18,000 + $31,000 - $35,000).

 

e. The taxpayer is a single individual and the passive income is the result of a rental activity for which the taxpayer fails to qualify as a real estate professional but does meet the active participation test?

An individual who is an active participant in a rental real estate activity is allowed to deduct up to $25,000 of losses from rental activities against active and portfolio income. The taxable income is $24,000 ($18,000 + $31,000 - $25,000).

 

25. A taxpayer has the following income (losses) for the current year:

Active Income Portfolio Income Passive Income

$43,000 $29,000 $(27,000)

What is the taxpayers taxable income (loss) if

The taxpayer is a single individual and the passive income is not from a rental activity?

An individual cannot deduct passive losses against active or portfolio income. The individual taxpayer has taxable income of $72,000 ($43,000 + $29,000) and a suspended loss of $27,000.

 

The taxpayer is a single individual and the passive income results from a rental activity for which the taxpayer qualifies as a real estate professional?

An individual who qualifies as real estate professional can deduct all losses from the activity against active and portfolio income. The taxable income is $45,000 ($43,000 + $29,000 - $27,000).

 

The taxpayer is a single individual and the passive income results from a rental activity for which the taxpayer fails to qualify as a real estate professional but does meet the active participation test?

An individual who is an active participant in a rental real estate activity is allowed to deduct up to $25,000 of losses from rental activities against active and portfolio income. The taxable income is $47,000 ($43,000 + $29,000 - $25,000).

 

 

26. Which of the following would be a passive activity? Explain.

a. Kevin is a limited partner in Marlin Bay Resort and owns a 15% interest in the partnership.

A limited partnership interest is always considered to be a passive activity. As a limited partner, Kevin has no involvement in managing the partnership’s assets, so he does not meet the material participation test.

 

b. Tom owns a 15% interest in a real estate development firm. He materially participates in the management and operation of the business.

The real estate development firm qualifies as a trade or business. Because Tom materially participates in the management of the firm, it is not considered a passive activity.

 

c. Jasmine owns and operates a bed-and-breakfast.

The activity is not a rental activity under the passive activity loss rules because Jasmine provides significant personal services in operating the bed-and-breakfast. In addition, she is a material participant in the business. The activity is not passive for Jasmine.

 

d. Howard owns an apartment complex that meets federal guidelines qualifying it as low-income housing.

Investments in low-income housing are generally not considered to be passive activities. Howard's investment is not a passive activity.

 

e. Felicia owns a 25% working interest in an oil and gas deposit.

A working interest in an oil and gas deposit is specified as not being a passive activity.

 

f. Assume the same facts as in part e, except that Felicia owns a 25% interest in a partnership that owns a working interest in an oil and gas deposit. She does not materially participate in the management and operation of the partnership.

Generally, a working interest in an oil and gas deposit is specified as not being a passive activity. However, because the deposit is owned by a partnership, each individual partner must be evaluated for material participation in the partnership to determine whether the investment in the partnership is passive. In this case, because Felicia does not materially participate in the management and operation of the partnership, the activity is passive for her.

27. Which of the following are passive activities?

a. Marvin is a limited partner in the Jayhawk Beach Club and owns a 20% interest in the partnership. The partnership's sole asset is a resort hotel.

A limited partnership interest is always considered to be a passive activity. Although a hotel is listed as an exception to the passive activity rules because the activity provides significant services, Marvin can only meet this exception if he materially participates in the hotel's operations. As a limited partner, Marvin has no involvement in managing the resort and does not meet the material participation test.

 

b. Marcie owns a royalty interest in an oil and gas operation.

A royalty interest in an oil and gas operation is considered portfolio income.

 

c. Neil owns an 18-hole semiprivate golf course. He is a certified professional golfer and serves as the club pro. He provides lessons and is involved in the daily management of the business.

A golf course is not considered a rental activity under the passive activity rules because managing a golf course requires the individual to provide significant services. Neil qualifies for this exception if he materially participates in the golf courses operations. Based on the facts, Neil is a material participant in the business and the activity is not passive.

 

d. Assume the same facts as in part c, except that Neil plays on the professional tour. When on break from the tour, he mingles with the members and conducts golf clinics. The club is managed by his brother and sister.

A golf course is not classified as a rental activity under the passive activity rules, because it entails significant services. However, to qualify for this exception the individual must materially participate in the activity. Neil does not qualify for this exception, because he does not materially participate in the management of the golf course. The work Neil performs is more "promotional" than management. Because his brother and sister manage the golf course, the activity is passive for Neil.

 

e. Laura owns a commercial office building. She spends more than 500 hours a year managing the building. She also spends 1,700 hours working in her own real estate development firm.

Laura qualifies as a real estate professional. She spends more than 50% of her personal service time in a real property trade or business, the amount of time spent in the real property trade or business is greater than 750 hours, and she materially participates in the rental activity (i.e., spends greater than 500 hours managing the rental activity). Because she qualifies as a real estate professional, the office building is not a passive activity.

 

f. Assume the same facts as in part e, except that Laura hires a full-time manager for the commercial office building. She spends 75 hours meeting with the manager and reviewing the operations.

The office building is a passive activity. Because Laura does not spend more than 500 hours managing the rental property, she does not qualify as a real estate professional.

28. Sidney and Gertrude Pearson own 40% of Bearcave Bookstore, an S corporation. The remaining 60% is owned by their son Boris. Sidney and Gertrude do not participate in operating or managing the store and they invested $19,000 in the business when it opened in 2004. The bookstore reported the following net income (loss) for the years 2004 through 2007:

2004 2005 2006 2007

$ (24,000) $ (14,000) $ (12,000) $ 5,000

a. How much do Sidney and Gertrude have at-risk in Bearcave at the end of each year (2004-2007)?

The amount at-risk is the amount that Sidney and Gertrude stand to lose if the activity should fail. Therefore, it represents the amount they have invested in the activity that has not yet been recovered. At the beginning of 2004, the amount they have at-risk is their investment of $19,000. The amount at-risk is increased by the income from the activity and is reduced by any losses incurred by the activity. Therefore, at the end of 2004, the amount at-risk is reduced by their share, $9,600 ($24,000 x 40%), of the loss to $9,400. In 2005, their share of the loss, $5,600 ($14,000 x 40%), reduces the amount they are at risk to $4,000 ($9,600 - $5,600). In 2006, their share of the loss, $4,800 ($12,000 x 40%), exceeds the amount that they have at-risk. Therefore, $1,000 of the loss is suspended due to the at-risk rules. In 2007, when their share of the bookstore income is $2,000 ($5,000 x 40%), the amount of the loss suspended due to the at-risk rules is eliminated and their at-risk amount is $1,000.

2004 2005 2006 2007_

Investment/Beginning at-risk $ 19,000 $ 9,400 $ 3,800 $ -0-

Share of income (loss) (9,600) (5,600) (4,800) 2,000

Ending at risk $ 9,400 $ 3,800 $ -0- $ 1,000

Suspended at-risk $ (1,000)

 

 

b. What amount can they recognize as income or loss from Bearcave for each year (2004-2007)?

Because Sidney and Gertrude do not materially participate in the bookstore, it is a passive activity and their share of the losses can only offset income from other passive activities. In 2004, when Sidney and Gertrude are at-risk for the amount of the loss incurred, the loss is suspended due to the passive activity rules. In 2005, the $5,600 loss is also suspended due to the passive activity rules. In 2006, when the loss exceeds the amount they have at-risk, $3,800 is suspended due to both the at-risk rules and the passive activity rules and $1,000 is suspended due to the at-risk rules. In 2007, when the bookstore produces income of $2,000, the amount suspended due to the at-risk rules is eliminated. In addition, they are allowed to offset the $2,000 of income with $2,000 of the loss suspended under the passive activity rules.

2004 2005 2006 2007

Investment/Beginning at-risk $ 19,000 $ 9,400 $ 3,800 $ -0-

Share of income (loss) (9,600) (5,600) (4,800) 2,000

Ending at risk $ 9,400 $ 3,800 $ -0- $ 1,000

Amount of income/loss $ (9,600) $ (5,600) $ (4,800) $ 2,000

Allowable loss -0- -0- -0- (2,000)

Suspended passive loss $ (9,600) $ (5,600) $ (4,800) N/A

Total suspended passive loss $ 9,600 $ 15,200 $ 20,000* $18,000

Total suspended at-risk $ 1,000

* In a particular year, a loss can be suspended under both the at-risk and passive activity rules. In 2006, $1,000 is suspended under both sets of rules.

 

c. Assume that Sidney and Gertrude materially participate in Bearcave for each year (2004-2007). What amount can they recognize as income or loss from Bearcave for each year (2004-2007)?

2004 2005 2006 2007

Investment/Beginning at-risk $ 19,000 $ 9,400 $ 3,800 $ -0-

Share of income (loss) (9,600) (5,600) (4,800) 2,000

Ending at risk $ 9,400 $ 3,800 $ -0- $ 1,000

Amount of income/loss $ (9,600) $ (5,600) $ (4,800) $ 2,000

Allowable loss (at-risk) $ (9,600) $ (5,600) $ (3,800) $ (1,000)

Suspended at-risk $ 1,000

Because Sidney and Gertrude materially participate in the bookstore, they can deduct losses from the activity up to the amount they are at-risk in the activity. In 2004, Sidney and Gertrude are at-risk for the entire amount of the loss, so they can deduct their $9,600 loss. In 2005, they can deduct their $5,600 loss. In 2006, Sidney and Gertrude only can deduct $3,800 of the loss because of the at-risk limitation. In 2007, when the bookstore produces income of $2,000, their amount at-risk increases by their share of the income ($2,000). The amount that they will report as income on their tax return is $1,000. The $2,000 of 2007 income is reduced by the $1,000 of loss they could not deduct in 2006 due to the at-risk limitations.

 

29. Aretha and Betina own a 10-unit apartment complex. Aretha owns a 60% interest in the apartment complex, and Betina has a 40% interest. Aretha is an investment banker and spends 120 hours helping to manage the apartment complex. Betina is the co-owner of a real estate agency where she works 1,600 hours a year. She also spends 520 hours managing the apartment complex. During the current year, the apartment complex generates a loss of $24,000. Aretha’s adjusted gross income before considering the loss from the apartment complex is $175,000, and Betina’s is $162,000. How much of the loss can Aretha deduct? How much of the loss can Betina deduct?

To qualify under the real estate professional exception, an individual must spend more than 50% of their personal service time in a real property trade or business, the amount of time spent in the real property trade or business must be greater than 750 hours, and the taxpayer must materially participate in the rental activity. To materially participate in the activity the taxpayer must either spend greater than 500 hours managing the rental real estate activity, or spend more than 100 hours in the activity and that must be more time than any owner or non-owner spends on the activity. Only Betina qualifies under the real estate professional exception. She spends more than one-half of her time in a real property trade or business, the amount of time spent on the activities is greater than 750 hours and she spends more than 500 hours managing the rental activity. Accordingly, the rental activity is not passive and she can deduct her $9,600 ($24,000 x 40%) share of the loss against her other income. Betina's adjusted gross income after the loss is $152,400 ($162,000 - $9,600).

Aretha fails to qualify as a real estate professional. However, she is an active participant in the activity. As an active participant, Aretha can deduct up to $25,000 in losses from the rental activity. However, because her adjusted gross income exceeds the $150,000 phase-out limit, she cannot deduct any portion of her $14,400 ($24,000 - $9,600) share of the loss. The loss is suspended as a passive loss and can be deducted in the following year either against passive income or under next year's $25,000 limit. Aretha’s adjusted gross income remains at $175,000.

a. Assume the same facts except that Aretha’s adjusted gross income before the rental loss is $145,000 and Betina’s is $140,000. How much of the loss can Aretha deduct? How much of the loss can Betina deduct?

Betina can still deduct the full amount of her share of the loss. Betina’s adjusted gross income is $130,400 ($140,000 - $9,600).

Because Aretha’s adjusted gross income is less than $150,000, she can deduct some of her loss from the rental activity. However, because her adjusted gross income exceeds $100,000, she must reduce the $25,000 maximum by $.50 for each dollar of adjusted gross income in excess of $100,000. As a result, Aretha must reduce the $25,000 maximum by $22,500 [($145,000 - $100,000) x $.50] to $2,500. Because Aretha’s loss from the passive activity ($14,400) exceeds the $2,500 limit, her adjusted gross income can only be reduced by $2,500. Her adjusted gross income is $142,500 ($145,000 - $2,500). The remaining loss of $11,900 ($14,400 - $2,500) is suspended as a passive loss and can be deducted in the following year either against passive income or under next year's $25,000 limit.

 

b. Assume the same facts as in part a, except that the apartment complex qualifies under federal guidelines as low-income housing. How much of the loss can Aretha deduct? How much of the loss can Betina deduct?

Investments in low-income housing are not generally considered to be passive activities. Therefore, both Aretha and Betina can deduct the full amount of the their share of the loss from the rental activity. Aretha’s adjusted gross income is $160,600 ($175,000 - $14,400). Betina's adjusted gross income after the loss deduction is $152,400 ($162,000 - $9,600).

Instructor's Note: The solution to this problem assumes that Betina and Aretha have enough at-risk to deduct the losses.

30. Carlos is a 25% owner of CEBJ Builders, a company that specializes in residential construction. The other 75% of CEBJ is owned by his three brothers. During the year, Carlos spends 1,800 hours managing the operations of CEBJ. He also is the 100% owner of four rental properties and spends 125 hours a year maintaining the properties, more than any other individual. During the current year, the four properties generate a loss of $18,500. His adjusted gross income before considering the rental loss is $118,000. What amount of the loss can Carlos deduct in the current year?

Carlos qualifies under the real estate professional exception because he spends more than 50% of his personal service time in real property trade or businesses, the amount of time spent in real property trade or businesses is greater than 750 hours, and he materially participates in the rental activity (i.e., he is the sole owner and spends more than 100 hours). The rental activity is not considered passive and he is allowed to offset the $18,500 loss against his active and portfolio income. Carlos's adjusted gross income after considering the loss is $99,500 ($118,000 - $18,500).

 

a. Assume that Carlos’s ownership interest in CEBJ is 4%. What amount of the loss can he deduct?

Because Carlos only owns 4% (he must own greater than 5%) of the construction business, the 1,800 hours he spends in the construction business is not considered as time spent in a real property trade or business. Thus, only 6.5% (125 hours ¸ 1,925 hours) of his time is in a real property trade or business and he fails to qualify as a real estate professional. However, Carlos does meet the active participant exception. Because Carlos's adjusted gross income exceeds $100,000, Carlos must reduce the $25,000 maximum allowance by $.50 for each dollar in excess of $100,000. Thus, Carlos must reduce the maximum allowance by $9,000 ($118,000 - $100,000 = $18,000 x .50 = $9,000) to $16,000 ($25,000 - $9,000). The maximum loss Carlos is entitled to deduct is $16,000. Carlos's adjusted gross income after considering the loss is $102,000 ($118,000 - $16,000). The remaining $2,000 ($18,000 - $16,000) is considered a suspended loss.

Instructor’s Note: Even though Carlos meets the active participant test, the rental property is still considered passive.

 

b. Assume that Carlos spends only 600 hours managing CEBJ Builders and 1,200 hours managing a microbrewery he acquired earlier in the year. What amount of the loss can he deduct?

To qualify as a real estate professional, Carlos must spend more than 50% of his time in real property trade or businesses. Because Carlos spends only 37.7% [(600 + 125 = 725 hours) ¸ (125 + 600 + 1,200 = 1,925 hours)] of his time in real property trade or businesses, he fails the material participant test. Therefore, he is considered an active participant and, as in part a above, he can only deduct $16,000 of his loss. His adjusted gross income is $102,000.

 

c. Assume that Carlos hires his brother-in-law to help him manage the properties. Carlos spends 125 hours and his brother-in-law spends 225 hours managing the rental properties. What amount of the loss can Carlos deduct?

Carlos meets the first two requirements of the real estate professional exception. Although Carlos spends more than 100 hours managing the rental properties, he fails the third requirement because the amount of time he spends on the activity is not more hours than any other owner or non-owner spends on the activity. Therefore, Carlos is considered an active participant and, as in part a above, he is only allowed to deduct $16,000 of the rental loss.

31. Mort is the sole owner of rental real estate that produces a net loss of $18,000 in 2006 and $20,000 in 2007 and income of $6,000 in 2008. His adjusted gross income, before considering the rental property for the years 2006 through 2008, is $120,000, $140,000, and $90,000, respectively.

a. What is Mort's adjusted gross income for 2006, 2007, and 2008 if he qualifies as a real estate professional?

As a real estate professional, the rental activity is not passive and Mort can deduct the 2006 and 2007 losses. In 2008, when the rental property has net income of $6,000, the amount is added to his adjusted gross income.

2006 2007 2008

Adjusted gross income before rental $ 120,000 $ 140,000 $ 90,000

Rental income (loss) (18,000) (20,000) 6,000

Adjusted gross income $ 102,000 $ 120,000 $ 96,000

 

b. What is Mort's adjusted gross income for 2006, 2007, and 2008 if he actively participates in the rental activity?

An active participant is allowed to deduct up to $25,000 per year against active and portfolio income. However, the $25,000 rental real estate deduction is reduced when an individual's adjusted gross income exceeds $100,000. The amount of the reduction is $.50 for every $1 of adjusted gross income in excess of $100,000.

In 2006, when Mort's adjusted gross income is $120,000, the $25,000 maximum loss is reduced to $15,000 {$25,000 - [($120,000 - $100,0000) x $.50]}. The remaining $3,000 of loss ($18,000 - $15,000) is suspended and carried forward to 2007. The loss can be used either against passive income or next year's $25,000 limit. His adjusted gross income for the year is $105,000 ($120,000 - $15,000).

In 2007, the $25,000 maximum loss is reduced to $5,000 {$25,000 - [($140,000 - $100,0000) x $.50]}. The remaining $15,000 of loss ($20,000 - $5,000) is suspended and carried forward with the $3,000 loss suspended in 2006. Mort’s total suspended loss is $18,000 ($3,000 + $15,000). His adjusted gross income for the year is $135,000 ($140,000 - $5,000).

In 2008, Mort's adjusted gross income is less than $100,000, so he is eligible to deduct up to $25,000 of losses from his rental activities. Although Mort has income for the current year from the rental real estate of $6,000, he can offset the income with the $18,000 of suspended losses. His adjusted gross income for the year is $78,000 [$90,000 - $12,000 ($6,000 - $18,000)].

2006 2007 2008

Adjusted gross income before rental $ 120,000 $ 140,000 $ 90,000

Rental income (loss) (15,000) (5,000) (12,000)

Adjusted gross income $ 105,000 $ 135,000 $ 78,000

 

32. Katrina is the sole owner of rental real estate that produces a net loss of $18,000 in 2006 and $22,000 in 2007 and income of $9,000 in 2008. Her adjusted gross income, before considering the rental property for the years 2006 through 2008, is $115,000, $137,000, and $88,000, respectively.

a. What is Katrina's adjusted gross income for 2006, 2007, and 2008 if she qualifies as a real estate professional?

As a real estate professional, the rental activity is not passive and Katrina can deduct the 2006 and 2007 losses. In 2008, when the rental property has net income of $9,000, the amount is added to her adjusted gross income.

2006 2007 2008

Adjusted gross income before rental $ 115,000 $ 137,000 $ 88,000

Rental income (loss) (18,000) (22,000) 9,000

Adjusted gross income $ 97,000 $ 115,000 $ 97,000

 

What is Katrina's adjusted gross income for 2006, 2007, and 2008 if she actively participates in the rental activity?

An active participant is allowed to deduct up to $25,000 per year against active and portfolio income. However, the $25,000 rental real estate deduction is reduced when an individual's adjusted gross income exceeds $100,000. The amount of the reduction is $.50 for every $1 of adjusted gross income in excess of $100,000.

In 2006, when Katrina’s adjusted gross income is $115,000, the $25,000 maximum loss is reduced to $17,500 {$25,000 - [($115,000 - $100,0000) x $.50]}. The remaining $500 of loss ($18,000 - $17,500) is suspended and carried forward to 2007. The loss can be used either against passive income or next year's $25,000 limit. Her adjusted gross income for the year is $97,500 ($115,000 - $17,500).

In 2007, the $25,000 maximum loss is reduced to $6,500 {$25,000 - [($137,000 - $100,0000) x $.50]}. The remaining $15,500 of loss ($22,000 - $6,500) is suspended and carried forward with the $500 loss suspended in 2006. Katrina’s total suspended loss is $16,000 ($500 + $15,500). Her adjusted gross income for the year is $130,500 ($137,000 - $6,500).

In 2008, Katrina’s adjusted gross income is less than $100,000, so she is eligible to deduct up to $25,000 of losses from her rental activities. Although Katrina has income for the current year from the rental real estate of $9,000, she can offset the income with the $16,000 of suspended losses. Her adjusted gross income for the year is $81,000 [$88,000 - $7,000 ($9,000 - $16,000)].

2006 2007 2008

Adjusted gross income before rental $ 115,000 $ 137,000 $ 88,000

Rental income (loss) (17,500) (6,500) ( 7,000)

Adjusted gross income $ 97,500 $ 130,500 $ 81,000

 

33. Ivan and Olga own a duplex. They collect the rents and make repairs to the property when necessary. That is, they are active participants in the rental activity. During the current year, the duplex has gross rents of $16,000 and total allowable deductions of $31,000. What is the effect of the duplex rental on their taxable income if their adjusted gross income is

a. $87,000?

Individuals who are active participants in rental property are allowed to deduct up to $25,000 of losses from rental real estate against active and portfolio income. In this case, Ivan and Olga are allowed to deduct the entire $15,000 ($16,000 - $31,000) rental real estate loss.

 

b. $155,000?

The $25,000 rental real estate deduction is reduced when an individual's adjusted gross income exceeds $100,000. The amount of the reduction is $.50 for every $1 of adjusted gross income in excess of $100,000. Thus, the special rental real estate deduction is not available to taxpayer's whose adjusted gross income exceeds $150,000. Because Ivan and Olga have $155,000 of adjusted gross income, they are not allowed to deduct any of the $15,000 rental loss. The $15,000 loss is suspended as a passive loss and can be deducted in the following year against either passive income or under next year's $25,000 limit.

 

c. $122,000?

The $25,000 rental real estate deduction is reduced when an individual's adjusted gross income exceeds $100,000. The amount of the reduction is $.50 for every $1 of adjusted gross income in excess of $100,000. In this case, the $25,000 allowable maximum is reduced by $11,000 [($122,000 - $100,000) x $.50] to $14,000. Because Ivan and Olga's loss of $15,000 is greater than the $14,000 maximum, only $14,000 of loss is deductible. The $1,000 loss that is not deducted is suspended as a passive loss and can be deducted in the following year either against passive income or under next year's $25,000 limit.

 

d. $139,000?

The $25,000 rental real estate deduction is reduced when an individual's adjusted gross income exceeds $100,000. The amount of the reduction is $.50 for every $1 of adjusted gross income in excess of $100,000. In this case, the $25,000 allowable maximum is reduced by $19,500 [($139,000 - $100,000) x $.50] to $5,500. Thus, Ivan and Olga are only allowed to deduct $5,500 of the $15,000 rental loss. The $9,500 that is not deducted is suspended as a passive loss and can be deducted in the following year either against passive income or under next year's $25,000 limit.

 

34. Jacqueline is a 60% owner of a rental property and has a significant role in the management of the property. During the current year, the property has a rental loss of $21,500. What is the effect of the rental property on her taxable income, if her adjusted gross income is

a. $ 71,000?

Individuals who are active participants in rental property are allowed to deduct up to $25,000 of losses from rental real estate against active and portfolio income. As a 60% owner, Jacqueline's share of the loss is $12,900 ($21,500 x .60). Because her adjusted gross income is less than $100,000 she can deduct the entire $12,900 rental real estate loss.

b. $129,000?

The $25,000 rental real estate deduction is reduced when an individual's adjusted gross income exceeds $100,000. The amount of the reduction is $.50 for every $1 of adjusted gross income in excess of $100,000. In this case, the $25,000 allowable maximum is reduced by $14,500 [($129,000 - $100,000) x $.50] to $10,500. Because Jacqueline's $12,900 loss is greater than the maximum allowable amount of $10,500, she can deduct only $10,500 of the loss. The remaining $2,400 ($12,900 - $10,500) of the rental loss is suspended as a passive loss and can be deducted in the following year against either passive income or under next year's $25,000 limit.

c. $187,000?

The $25,000 rental real estate deduction is reduced when an individual's adjusted gross income exceeds $100,000. The amount of the reduction is $.50 for every $1 of adjusted gross income in excess of $100,000. Thus, the special rental real estate deduction is not available to taxpayers whose adjusted gross income exceeds $150,000. Because Jacqueline has $187,000 of adjusted gross income, she cannot deduct any of the $12,900 rental loss. The $12,900 rental loss is suspended as a passive loss and can be deducted in the following year against either passive income or under next year's $25,000 limit.

d. $107,000?

The $25,000 rental real estate deduction is reduced when an individual's adjusted gross income exceeds $100,000. The amount of the reduction is $.50 for every $1 of adjusted gross income in excess of $100,000. In this case, the $25,000 allowable maximum is reduced by $3,500 [($107,000 - $100,000) x $.50] to $21,500. Thus, Jacqueline is allowed to deduct the entire $12,900 of rental real estate loss.

35. Janet has a taxable income of $54,000 from her salary and investment assets. She also owns 3 passive activities that have the following income (loss) for the year:

Passive Activity 1 $ 12,000

Passive Activity 2 $ (18,000)

Passive Activity 3 $ ( 9,000)

a. What is the effect of the passive activities on Janet's income? Explain.

Janet has a net passive loss of $15,000:

Passive Activity 1 $ 12,000

Passive Activity 2 (18,000)

Passive Activity 3 ( 9,000)

Net passive loss $ (15,000)

Individuals are not allowed to deduct passive losses against nonpassive income. Janet would include the $12,000 of income from PA1 in her gross income and is allowed to deduct $12,000 of the loss from PA2 and PA3 against this income. The net passive loss of $15,000 is suspended and carried forward to subsequent years for netting against passive income. The net result is a taxable income of $54,000 (i.e., the income from her salary and investment assets).

 

b. How much suspended loss does Janet have in each passive activity?

The $15,000 of suspended loss must be allocated between PA2 and PA3 based on their relative contribution to the loss:

PA2 - ($18,000 ¸ $27,000) x $15,000 = $10,000

PA3 - ($ 9,000 ¸ $27,000) x $15,000 = $ 5,000

 

 

 

36. Return to the facts of problem 35. In the next year, Janet has a taxable income from her salary and investment activities of $62,000. The results for her 3 passive activities are

Passive Activity 1 $ 15,000

Passive Activity 2 $ ( 8,000)

Passive Activity 3 $ ( 2,000)

a. What is the effect of the passive activities on Janet's income? Explain.

There would be no effect on Janet's $62,000 taxable income. The $15,000 of suspended loss from the previous year would be netted against the current year's passive income and losses resulting in a net passive loss of $10,000:

Passive activity 1 15,000

Suspended loss passive activity 2 (10,000)

Passive activity 2 (8,000)

Suspended loss passive activity 3 (5,000)

Passive Activity 3 (2,000)

Net Passive Loss $ (10,000)

The total loss from passive activity 2 of $18,000 ($10,000 + $8,000) and passive activity 3 of $7,000 ($5,000 + $2,000) reduce the net passive activity income for the year to zero. The total suspended loss from PA2 and PA3 is $10,000.

 

b. How much suspended loss does Janet have in each passive activity?

The suspended loss must be allocated based on the proportion of passive loss from each activity over the two years to the total passive loss from all the activities for the two years. Using this weighted average formula, the remaining suspend loss for passive activity 2 and passive activity 3 is $ 7,200 and $2,800 respectively.

Formula:

Total passive loss from activity X Remaining suspended loss

Total passive losses all activities

PA2 - ($10,000 + $ 8,000) x $10,000 = $7,200

($15,000 + $10,000)

PA3 - ($ 5,000 + $ 2,000) x $10,000 = $2,800

($15,000 + $10,000)

 

 

 

37. Mason owns a passive activity that generates a loss of $14,000 in 2006, $12,000 in 2007, and income of $4,000 in 2008. In 2007, Mason purchases a second passive activity that has passive income of $6,000 in 2007 and $10,000 in 2008. Discuss the effect of Mason's passive activity investments on his taxable income in 2006, 2007, and 2008. Assume that neither passive activity involves rental real estate.

Mason's $14,000 loss in 2006 is suspended and carried forward to 2007. This results in a net passive loss of $20,000, which is carried forward to 2008. The $20,000 passive loss carryforward is used to offset the $14,000 ($4,000 + $10,000) of passive income Mason receives in 2008. The $6,000 passive loss is carried forward to 2009. The passive activities have no effect on Mason's taxable income for any of the three years.

2006 2007 2008

Suspended loss from prior years $ (14,000) $ (20,000)

Current year loss $ (14,000) (12,000) -0-

Current year income 6,000 14,000

Net passive loss $ (14,000) $ (20,000) $ (6,000)

 

 

38. Return to the facts of problem 37. At the end of 2008, Mason sells the passive activity that generated the losses for $16,000. What is the effect on his taxable income if his basis in the activity sold is

a. $4,000?

Mason has a long-term capital gain of $12,000 ($16,000 - $4,000) on the sale of the passive activity. In addition, the $6,000 suspended loss in the activity is deductible for adjusted gross income. The total effect of the sale is to increase Mason's income by $6,000. Note: The $12,000 long-term capital gain must be netted with other capital gains and losses. Because net long-term capital gains are taxed at 15% (5% if the taxpayer’s marginal tax bracket is 10% or 15%), depending on Mason's other capital asset transactions, the increase in his tax may not correspond directly with the increase in taxable income from the sale.

 

b. $21,000?

Mason has a long-term capital loss of $5,000 ($16,000 - $21,000) from the sale of the passive activity. In addition, the $6,000 suspended loss in the activity is deductible for adjusted gross income. The capital loss must be netted with Mason's other capital gains and losses for the year. If Mason has no other capital gains in 2008, then only $3,000 of the loss is deductible. This would result in a $9,000 reduction in his taxable income. Note: If Mason does have other capital gains in 2008, then, to the extent that the loss on the sale of the passive activity cancels out the gains, Mason's taxable income is effectively decreased versus what it is without the sale.

 

 

39. Jeremy owns a passive activity that has a basis of $30,000 and a suspended loss of $16,000. His taxable income from active and portfolio income is $81,000.

a. What is the effect on Jeremy's taxable income if he sells the passive activity for $37,000?

Any suspended loss on a passive activity is deductible in full when the entire interest in the activity is disposed of through a sale of the activity. In this case, Jeremy has a capital gain of $7,000 ($37,000 - $30,000) on the sale of the activity and a deduction of $16,000 for the suspended loss on the activity. This results in a net deduction of $9,000. However, the $7,000 capital gain is netted with any other capital gains and losses that Jeremy has during the year. Also, the tax rate on a net long-term capital gain is 15% (5% if the taxpayer’s marginal tax rate is 10% or 15%), which further complicates the tax effect of Jeremy’s net deduction of $9,000.

 

b. What is the effect on Jeremy's taxable income if he sells the passive activity for $25,000?

In this case, Jeremy has a $5,000 capital loss ($25,000 - $30,000) on the sale of the passive activity and is allowed a deduction for the $16,000 suspended loss. The capital loss must be netted with any other capital gains and losses that Jeremy had during the year and therefore, may not be deductible in full. For example, if Jeremy has no other capital gains and losses during the year, only $3,000 of the capital loss may be deducted in the year of sale.

 

40. Return to the facts of problem 39. Assume that Jeremy dies when the passive activity has a fair market value of $37,000. What is the effect on Jeremy's taxable income for the year he dies?

A deduction is allowed for a suspended loss on a passive activity held at death, but only to the extent of the excess of any suspended loss over the unrealized gain on the passive activity. In this case, the unrealized gain is $7,000 ($37,000 - $30,000) and the suspended loss is $16,000, resulting in an excess of $9,000. Therefore, Jeremy is allowed a deduction of $9,000.

 

 

 

 

 

 

 

 

 

 

41. Return to the facts of problem 39. Assume that Jeremy dies when the passive activity has a fair market value of $25,000. What is the effect on Jeremy's taxable income for the year he dies?

A deduction is allowed for a suspended loss on a passive activity held at death, but only to the extent of the excess of any suspended loss over the unrealized gain on the passive activity. In this case, there is no unrealized gain ($25,000 - $30,000 = $5,000 loss) and Jeremy is not allowed any deduction for the suspended loss.

 

 

 

 

 

 

 

 

 

 

42. Return to the facts of problem 39. Assume that Jeremy gives the property to his son Felipe when the property has a fair market value of $37,000. What is the effect of the gift on Jeremy's taxable income? Felipe's taxable income?

No suspended loss deduction is allowed for a gift of a passive activity. The donee (Felipe) takes a basis in the activity equal to the sum of the donor's basis and the amount of the suspended loss. Felipe's basis in the activity is $46,000 ($30,000 + $16,000). Neither Jeremy nor Felipe receive a deduction for the $16,000 suspended loss. This treatment prevents Felipe from using the suspended loss deduction against passive income.

 

43. Masaya owns a passive activity that has a basis of $32,000 and a suspended loss of $13,000. Masaya's taxable income from active and portfolio income is $73,000.

 

a. What is the effect on Masaya's taxable income if he sells the passive activity for $46,000?

Any suspended loss on a passive activity is deductible in full when an entire interest in an activity is disposed of through a sale of the activity. In this case, Masaya has a capital gain of $14,000 ($46,000 - $32,000) on the sale of the activity and a deduction of $13,000 for the suspended loss on the activity. This results in a net increase in income of $1,000. However, the $14,000 capital gain is netted with any other capital gains and losses that Masaya has during the year. Also, the tax rate on a net long-term capital gain is 15% (5% if the taxpayer’s marginal tax rate is 10% or 15%), which further complicates the tax effect of the net increase in Masaya’s income of $1,000.

 

b. What is the effect on Masaya's taxable income if he sells the passive activity for $26,000?

In this case, Masaya has a $6,000 capital loss on the sale of the passive activity and is allowed a deduction for the $13,000 suspended loss. The capital loss must be netted with any other capital gains and losses that Masaya had during the year and therefore, may not be deductible in full. For example, if Masaya has no other capital gains and losses during the year, only $3,000 of the capital loss may be deducted in the year of sale.

 

c. What is the effect on Masaya's taxable income if he dies this year while the fair market value of the passive activity is $40,000?

A deduction is allowed for a suspended loss on a passive activity held at death, but only to the extent of the excess of any suspended loss over the unrealized gain on the passive activity. In this case, the unrealized gain is $8,000 ($40,000 - $32,000) and the suspended loss is $13,000, resulting in an excess of $5,000. Therefore, Masaya is allowed a deduction of $5,000.

 

d. What is the effect on Masaya's taxable income if he dies this year while the fair market value of the passive activity is $22,000?

A deduction is allowed for a suspended loss on a passive activity held at death, but only to the extent of the excess of any suspended loss over the unrealized gain on the passive activity. In this case, there is no unrealized gain ($22,000 - $32,000 = $10,000 loss) and Masaya is not allowed a suspended loss deduction of $10,000.

 

e. What is the effect on Masaya's taxable income if he gives the passive activity to his daughter Hideko when the fair market value of the passive activity is $40,000? What would the effect of this be on Hideko's taxable income?

A suspended loss deduction is not allowed for a gift of a passive activity. The donee has a basis in the activity equal to the sum of the donor's basis and the amount of the suspended loss. Hideko's basis in the activity is $45,000 ($32,000 + $13,000). Neither Masaya nor Hideko receive a deduction for the $13,000 suspended loss. This treatment prevents Hideko from using the suspended loss deduction against passive income.

 

44. Claudio owns a passive activity that has a basis of $28,000 and a fair market value of $38,000. The activity has suspended losses of $16,000. To reduce their estate, every year Claudio and his wife give their son Anthony and his wife a gift of approximately $40,000. During the year, Anthony sells stock that results in a $10,000 short-term capital loss. A friend of Claudio's suggests that he give his passive activity to Anthony. The friend says that this will allow Claudio to avoid tax on the $10,000 capital gain and let his son offset his short-term capital loss with the $10,000 ($38,000 - $28,000) gain from the sale of the passive activity. In addition, Claudio can use the suspended loss from the passive activity to offset his other ordinary income. Write a letter to Claudio explaining the tax consequences of making the passive activity a gift to his son.

The information Claudio’s friend gave him is not accurate. If Claudio gifts the passive activity to his son, Anthony’s basis in the passive activity is $44,000. Anthony’s basis in the passive activity is the sum of Claudio’s basis of $28,000 and Claudio’s suspended loss of $16,000. Although Anthony’s basis is increased by the $16,000 suspended loss, neither Claudio nor Anthony receives a deduction for the suspended loss. This treatment prevents Anthony from using the suspended loss deduction against other passive income. Further, unlike Claudio’s friend suggested, if Anthony quickly sells the passive activity he will not recognize a $10,000 gain, but rather a $6,000 ($38,000 - $44,000) long-term capital loss.

45. ABC Company owns a chain of furniture stores. How much loss can ABC Company deduct in each of the following cases? Explain.

a. ABC closes a store in a depressed part of the county. Rather than move furniture to other stores, ABC sells furniture that had cost $275,000 for $140,000.

The $135,000 ($140,000 - $275,000) loss on the sale of the inventory is an ordinary loss that is fully deductible. All losses incurred in a trade or business are deductible as ordinary losses.

 

b. A fire severely damages one store. The cost of repairing the damage is $127,000. ABC's basis in the store building is $320,000. ABC's insurance company reimburses ABC $100,000 for the fire damage.

The loss from the fire damage is measured as the lesser of the decline in the value of the property or the property's basis. The cost of repairing the damage may be used as the measure of the decline in value. The $127,000 of repairs is reduced by the $100,000 of insurance proceeds to determine the net casualty loss of $27,000.

 

c. ABC decides to begin replacing some of its older delivery vans. It sells for $4,200 one van that had a basis of $7,300.

The sale of a business asset results in an ordinary loss. The loss on the sale of the van is $3,100 ($4,200 - $7,300).

 

d. ABC discovers that one of its buildings is infested with termites. The building is old and has been fully depreciated for tax purposes. The cost of getting rid of the termites is $8,400, none of which is covered by insurance.

Termite infestation is not a casualty. However, any loss incurred in a trade or business is deductible. The question is whether the cost of fixing the termite damage can be deducted immediately as a loss or must be capitalized as a betterment that extends the life of the building.

 

e. Someone breaks into one store by destroying the security system. Cash of $9,000 is missing from a safe. In addition, televisions that had cost $17,500 and were marked to sell for $34,000 are gone. The security system has a basis of $10,800. Because the system is outdated, a security expert estimates it is worth only $2,700 at the time it is destroyed.

Thefts of business property are measured at their basis. The theft loss is $26,500 ($9,000 cash + $17,500 televisions). The loss on the security system is the $10,800 basis, for a total loss of $37,300 ($26,500 + $10,800).

 

46. The Goodson Company is a chain of retail electronics stores. How much of a loss can Goodson deduct in each of the following cases. Explain.

a. An employee drops a 42 inch Plasma television, cracking the plastic case on the back. The television normally sells for $3,300. The cost of the set is $2,400 and Goodson's sells the damaged set for $1,500.

The question is whether the damage by dropping the television is considered a casualty loss. A casualty must be sudden, unexpected and unusual in nature. In most cases, the damage to the television from dropping it would be treated as a casualty loss. The loss is measured as the lesser of the basis of the television, $2,400 or the reduction in the fair market value of the television $900 ($2,400 - $1,500). Goodson's is allowed a casualty loss of $900. Instructors Note: In practice, an "immaterial "casualty loss" similar to this would probably be netted in the cost of goods sold calculation of the business.

 

b. The company replaces its inventory system. The old system cost $45,000 and has a basis of $16,000. The company sells the old system for $ 7,500. The new system costs $75,000.

The sale of a business asset results in an ordinary loss. The loss on the sale of the computer system is $8,500 ($7,500 - $16,000).

 

c. A flood damages one of Goodson's retail stores. The building suffers extensive water damage. The basis of the building is $60,000 and the cost of repairing the damage is $72,000. The insurance company reimburses Goodson $50,000.

The loss from the flood damage is measured as the lesser of the decline in the value of the property or the property's basis. The cost of repairing the building ($72,000) can be used as an estimate of the decline in market value. The basis of the property is increased by the repair cost of $72,000 to $132,000. The $72,000 loss is reduced by the $50,000 of insurance proceeds to determine the net casualty loss of $22,000 ($72,000 - $50,000).

 

d. The owner of Goodson sells a complete home entertainment center (e.g., projection TV, VCR, stereo system) to his sister for $7,000. The normal sales price is $8,500. The system costs $6,300.

Although the $7,000 charged to his sister, a related party, for the entertainment center is less than the normal sales price ($8,500) the price is greater than the owner of Goodson's cost ($6,300). Therefore, Goodson would recognize $7,000 from the sale of the entertainment center and deduct its cost of $6,300 (a gain of $700 on sale).

 

e. Assume the same facts as in part d, except that the owner of sells the home entertainment center to his sister for $5,500.

Unlike in the previous example, the owner of Goodson sold the entertainment center to a related party, his sister, for an amount ($5,500) which is less than its cost. Because the transaction is with a related party, Goodson's deduction for the cost of the system is limited to the amount paid by his sister $5,500. The $800 difference between the amount received ($5,500) and the cost ($6,300) is considered a disallowed loss between a related party and is not deductible. Instructors Note: Goodson's sister has a basis in the entertainment system of $5,500. If she sold the system for more than $5,500 but less than $6,300, she would not have to recognize a gain.

 

f. The owner of Goodson finds that the controller has embezzled $10,000 from the company. Before the owner can confront the controller, the controller leaves town and cannot be found.

An embezzlement loss is considered a theft. The basis of the property (cash) stolen is used in measuring a theft. Goodson is allowed to deduct the $10,000 cash embezzled as a business casualty loss.

 

g. Upon arriving at the company headquarters, the vice-president of sales finds that someone has broken in and stolen 3 computers. The damage to the outside door is extensive. The cost of repairing the door is $1,500, and the cost of replacing the 3 computers is $9,500. The original cost of the computers totals $10,500. Goodson's basis in the computers is $5,000. The thieves also stole $350 from the petty cash fund. Goodson files a claim with its insurance company and receives $4,800.

Goodson has incurred both a theft loss and a casualty loss. The basis of business property is used to measure the amount of a theft. The theft loss is $5,350 ($350 petty cash + $5,000 computers) and the casualty loss is $1,500 (cost to repair the door). The casualty and theft loss must be reduced by the $4,800 it receives from its insurance company. Goodson’s casualty and theft loss is $2,050 [($5,350 + $1,500) - $4,800).

 

 

47. Gordon is the sole proprietor of Fashion Flowers & Florals (FFF). During the current year, one of FFF's delivery vans is involved in an automobile accident. The van has a basis of $6,000. What is FFF's allowable casualty loss deduction under each of the following situations?

a. A comparable van sells for $4,000. FFF's van was totally destroyed in the accident. FFF's insurance pays $2,200 on the casualty.

The loss on business property totally destroyed is the property's basis. The $6,000 basis is reduced by the $2,200 insurance reimbursement for a deductible loss of $3,800.

 

b. A comparable van sells for $8,400. FFF's van was totally destroyed in the accident. FFF's insurance pays $6,400 on the casualty.

The $6,000 basis is the measure of loss. Because the $6,400 of insurance proceeds exceeds the $6,000 basis, FFF has a gain of $400 on the casualty.

 

 

 

 

 

 

 

 

 

 

 

 

 

48. Assume the same facts as in problem 47. What is FFF's allowable casualty loss deduction under each of the following situations?

a. A comparable van sells for $4,000. After the accident, the insurance adjuster estimates the van was worth $1,500. The insurance company pays FFF $1,200 on the casualty.

The loss on partially destroyed business property is measured as the lesser of the decline in the value of the property, $2,500 ($4,000 - $1,500), or the property's basis, $6,000. FFF's loss is the $2,500 decline in value. This is reduced by the $1,200 insurance reimbursement for a net casualty loss deduction of $1,300 ($2,500 - $1,200).

 

b. A comparable van sells for $8,400. After the accident, the insurance adjuster estimates the value of the van at $1,500. The insurance company pays FFF $1,200 on the casualty.

The loss on partially destroyed business property is measured as the lesser of the decline in the value of the property, $6,900 ($8,400 - $1,500), or the property's basis, $6,000. The loss is limited to the $6,000 basis. This is reduced by the $1,200 insurance reimbursement for a net casualty loss deduction of $4,800 ($6,000 - $1,200).

49. Stella owns a taxicab company. During the year, two of her cabs are involved in accidents. One is totally destroyed; the other is heavily damaged. Stella is able to replace the destroyed cab with an identical model for $5,500. Her adjusted basis in the destroyed cab is $3,750, and the insurance company pays her $2,800. The adjusted basis of the damaged cab is $3,800. The insurance adjuster estimates that the damaged cab is worth $3,600. Although a comparable cab sells for $7,800, the insurance company gives Stella only $2,900. Write a letter to Stella explaining the amount of her deductible casualty loss.

The loss on business property totally destroyed is the property's basis. The loss on partially destroyed business property is measured as the lesser of the decline in the value of the property or the property's basis. Whether the property is totally destroyed or only partially destroyed, the measured loss is reduced by any insurance reimbursement.

Stella’s loss for the cab that is totally destroyed is its basis of $3,750. The $3,750 is reduced by the insurance reimbursement of $2,800 for a deductible loss of $950. The loss on partially destroyed business property is the lesser of the decline in the value of the property, $4,200 ($7,800 - $3,600) or the property's basis, $3,800. Stella’s loss is the cab’s basis, $3,800 and is reduced by the $2,900 insurance reimbursement for a net casualty loss deduction of $900. Stella’s total casualty loss on the two accidents is $1,850 ($950 + $900).

Destroyed Cab Damaged Cab

Lower of:

Adjusted basis $3,750 $3,800

or

Reduction in FMV 5,500 $ 3,750 4,200 $ 3,800

Insurance reimbursement (2,800) (2,900)

Casualty loss $ 950 $ 900

50. Rhoda owns an electronics store that is burglarized during the current year. The burglars destroy the point-of-sale terminal and steal $380 from the cash drawer. The point-of-sale terminal was purchased for $7,500, and its adjusted basis is $3,700. The insurance adjuster estimates that the fair market value of a similar point-of-sale terminal is $6,000. The burglars also steal stereo equipment costing $4,200 that has a retail value of $7,000. In breaking into the store, the burglars break a large glass door that costs Rhoda $540 to replace. What is Rhoda’s deductible loss if the insurance company reimburses her $5,000?

Rhoda's deductible casualty loss is $3,820:

Amount of Loss:

Cash $ 380

Point of sale terminal (basis) 3,700

Stereo equipment (basis) 4,200

Broken glass door 540

Total loss $ 8,820

Less: Insurance (5,000)

Deductible theft loss $ 3,820

The loss on business property that is stolen is the property's basis. The loss on the broken glass is the cost to replace it.

 

 

51. Wilbur owns a 25% interest in the Talking Horse Corporation, which is organized as an S corporation. His basis in the property is $15,000. For the year, Talking Horse reports an operating loss of $28,000 and a capital loss of $6,000. Wilbur's adjusted gross income is $72,000

a. What effect would these losses have on Wilbur's adjusted gross income if he does not materially participate in Talking Horse? Explain.

As a 25% owner of Talking Horse, Wilbur's share of the ordinary loss is $7,000 ($28,000 x 25%) and his share of the capital loss is $1,500 ($6,000 x 25%). If Wilbur is not a material participant in the activity, the $7,000 loss cannot be deducted because the loss is incurred in a passive activity. However, assuming Wilbur's $1,500 share of the capital loss is not from the sale of an asset used in a passive activity, but from the sale of an investment (i.e., stock) of the passive activity, he can reduce his adjusted gross income by $1,500. Therefore, if Wilbur has no other capital gains or losses for the year his adjusted gross income is $70,500 ($72,000 - $1,500).

 

b. What effect would these losses have on Wilbur's adjusted gross income if he materially participates in Talking Horse? Explain.

As a 25% owner of Talking Horse, Wilbur's share of the ordinary loss is $7,000 ($28,000 x 25%) and his share of the capital loss is $1,500 ($6,000 x 25%). At the beginning of the year, Wilbur’s basis and the amount he has at-risk in Talking Horse is $15,000. Therefore, he is allowed to deduct the $7,000 loss. Wilbur can also use the $1,500 of capital loss to reduce his adjusted gross income. As a material participant, Wilbur's adjusted gross income is $63,500 ($72,000 - $7,000 - $1,500). Wilbur’s basis and his at-risk amount in Talking Horse at the end of the year is $6,500 ($15,000 - $7,000 - $1,500).

 

 

52. During 2007, Yoko has total capital gains of $8,000 and total capital losses of $16,000. What is the effect of the capital gains and losses on Yoko's 2007 taxable income? Explain.

The capital gains and losses are netted together to determine the net capital gain/loss position for the year. Yoko has a net capital loss of $8,000:

Total capital gains $ 8,000

Total capital losses (16,000)

Net capital loss $ (8,000)

2007 Deduction $ 3,000

Loss carryforward to 2008 $ (5,000)

The deduction for capital losses is limited to $3,000 per year, with any excess capital loss carried forward for netting in subsequent years. Yoko has a $5,000 capital loss carryforward.

 

a. Assume that in 2008 Yoko has total capital gains of $10,000 and total capital losses of $7,500. What is the effect of the capital gains and losses on Yoko's taxable income in 2008? Explain.

The 2008 capital gains and losses are netted with the $5,000 capital loss carryforward. This results in a net capital loss of $2,500. Because it is under the $3,000 maximum deduction limit, the entire $2,500 net capital loss is deductible in 2008.

Total capital gains $ 10,000

Total capital losses (7,500)

2007 Loss carryforward (5,000)

Net capital loss $ (2,500)

2008 Deduction $ (2,500)

 

b. How would your answer change if Yoko's total capital losses are $14,000 in 2008?

The netting of the 2008 gains and losses with the $5,000 capital loss carryforward results in a net capital loss of $9,000. Only $3,000 of the loss is deductible in 2008, with a $6,000 loss carryforward to 2009.

Total capital gains $ 10,000

Total capital losses (14,000)

2007 Loss carryforward (5,000)

Net capital loss $ (9,000)

2008 Deduction $ 3,000

Loss carryforward to 2009 $ (6,000)

 

53. Goldie sells 600 shares of Bear Corporation stock for $9,000 on December 14, 2007. She paid $27,000 for the stock in February 2004. Assuming that Goldie has no other capital asset transactions in 2007, what is the effect of the sale on her 2007 income?

Goldie realizes a long-term capital loss of $18,000 ($9,000 - $27,000) on the sale. However, because she has no other capital asset transactions during 2007, she can only deduct $3,000 of the loss in 2007. The remaining $15,000 of loss is carried forward to 2008.

 

a. Assume that Goldie has no capital asset transactions in 2008. What is the effect of the Bear Corporation stock sale on her 2008 income?

Goldie can deduct $3,000 of the $15,000 of loss carried forward from 2007 in 2008. The remaining $12,000 of loss is carried forward to 2009.

 

b. On July 2, 2009, Goldie sells 100 shares of Panda common stock for $12,400. Goldie purchased the stock on September 4, 2007, for $7,500. What is the effect of the sale on Goldie's 2009 income?

The sale of the stock results in a long-term capital gain of $4,900 ($12,400 - $7,500) that is netted against the $12,000 capital loss carryforward from 2008, resulting in a net long-term capital loss of $7,100 for the year. Goldie can deduct $3,000 of the $7,100 loss in 2009. The remaining $4,100 of loss is carried forward to 2010.

2009 Capital gain $ 4,900

Loss carryforward (12,000)

Net long-term capital loss $ (7,100)

2009 Deduction $ 3,000

Loss carryforward to 2010 $ (4,100)

 

 

54. Labrador Corporation has total capital gains of $18,000 and total capital losses of $35,000 in 2007. Randy owns 25% of Labrador's outstanding stock. What is the effect on Labrador's and Randy's 2007 taxable incomes if

a. Labrador is a corporation? Explain how Labrador and Randy would treat the capital gains and losses.

A corporation is a taxable entity. It nets its capital losses against its capital gains. In this case, Labrador Corporation has a $17,000 ($18,000 - $35,000) net capital loss in 2007. Corporations can only deduct capital losses against capital gains. Labrador is allowed to carryback the $17,000 capital loss from 2007 to 2004, 2005, and 2006 and use it to offset any net capital gains it paid tax on in those years. If there is insufficient capital gain income in the three carryback years, Labrador may carryforward any remaining loss for five years and use it to offset future capital gains.

 

b. Labrador is an S corporation? Explain how Labrador and Randy would treat the capital gains and losses.

An S corporation is a conduit entity. Labrador is not taxed on any income it earns. The income flows to the shareholders for taxation. As a shareholder, Randy receives his share of the gains and losses and reports them on his individual tax return, subject to the limits imposed on individuals. Randy receives capital gains of $4,500 (25% x $18,000) and capital losses of $8,750 (25% x $35,000). These are combined with any other capital gains and losses Randy incurs during the year. If Randy has no other capital gains and losses, his net capital loss would be $4,250 ($4,500 - $8,750) and he is allowed to deduct $3,000 of the loss in the current year, with the remaining $1,250 carried forward to 2008.

 

 

55. Bongo Corporation is incorporated in 2005. It has no capital asset transactions in 2005. From 2006 through 2009, Bongo has the following capital gains and losses:

2006 2007 2008 2009

Capital Gains $ 14,000 $ 12,000 $ 9,000 $ 30,000

Capital Losses (8,000) (26,000) (22,000) (11,000)

Assuming that Bongo's marginal tax rate during each of these years is 34%, what is the effect of Bongo's capital gains and losses on the amount of tax due each year?

The gains and losses must be netted together. Net capital gains are subject to the corporate tax. Net capital losses cannot be deducted in the year of the loss. Losses are carried back three years and forward five years and used to offset net capital gains in the carryover period. Carrybacks result in a tax refund. Carryforwards reduce the tax paid in future periods on net capital gains. For Bongo:

 

2006 2007 2008 2009_

Net gain (loss) $ 6,000 $ (14,000) $ (13,000) $ 19,000

 

The 2007 loss is carried back to 2006 and a $2,040 ($6,000 x 34%) refund is obtained. The remaining 2007 loss of $8,000 ($6,000 - $14,000) is carried forward to 2009 and is used to reduce the $19,000 capital gain to $11,000 ($19,000 - $8,000). The 2008 loss of $13,000 is carried forward to offset the remaining $11,000 of net capital gain. The remaining $2,000 ($11,000 - $13,000) of net capital loss is carried forward and used to reduce capital gains for a maximum of four more years.

 

2006 2007 2008 2009

Capital gain (loss) $ 6,000 $ (14,000) $ (13,000) $ 19,000

Tax rate x 34%

Tax paid $ 2,040

Carryback loss to 2006 (6,000) 6,000

Tax refund $ 2,040

Carryforward loss to 2008 $ (8,000) (8,000)

Carryforward loss to 2009 $ (21,000) (21,000)

Carryforward loss to 2010 $ (2,000)

 

56. Newcastle Corporation was incorporated in 2006. For the years 2006 through 2008, Newcastle has the following net capital gain or loss.

2006 2007 2008_

Net capital gain (loss) 6,000 (27,000) 18,000

If Newcastle is in the 34% marginal tax bracket for each of these years, what effect do the net capital gains (losses) have on its tax liability for 2006, 2007, and 2008?

Net capital gains are subject to the corporate tax at regular tax rates. Net capital losses cannot be deducted in the year of the loss. Losses are carried back three years and forward five years and used to offset net capital gains in the carryover period. Carrybacks result in a tax refund. Carryforwards reduce the tax paid in future periods on net capital gains. Part of the 2007 loss is carried back to 2006 and a $2,040 ($6,000 x 34%) refund is obtained. The remaining 2007 loss of $21,000 ($27,000 - $6,000) is carried forward to 2008 to offset the entire capital gain in 2008 The remaining $3,000 ($21,000 - $18,000) of 2007 capital loss can be carried forward for 4 more years.

2006 2007 2008

Capital gain (loss) $ 6,000 $ (27,000) $ 18,000

Tax rate x 34%

Tax paid $ 2,040

Carryback 2007 capital loss to 2006 (6,000) 6,000

Tax refund $ 2,040

Carryforward 2007 capital loss to 2008 21,000 (21,000)

Remaining carryforward to 2009-2012 $ (3,000)

 

 

 

57. Sonya, who is single, owns 20,000 shares of Malthouse Corporation stock. She acquired the stock in 2004 for $75,000. On August 12, 2007, Sonya’s father tells her of a rumor that Malthouse will file for bankruptcy within the next week. The next day, Sonya sells all her shares of Malthouse for $20,000. How much of the loss can she deduct?

Stock is a capital asset and the $55,000 loss ($20,000 - $75,000) is subject to the $3,000 annual capital loss limitation. The remaining $52,000 of loss is carried forward for use in subsequent years.

 

a. Assume the same facts, except that the stock is qualifying small-business stock. How much of the loss can she deduct?

If the stock is qualifying small business stock, a single individual can deduct up to $50,000 of loss per year as an ordinary loss. In this case, Sonya has an ordinary loss of $50,000 with the remaining $5,000 being a capital loss. Only $3,000 of the capital loss is deductible. Thus, her total loss deduction is $53,000. The remaining $2,000 of capital loss is carried forward for use in subsequent years netting.

 

b. Assume the same facts as in part a, except that Sonya is married. How much of the loss can she deduct?

Married couples are allowed to deduct up to $100,000 of loss on qualifying small business stock. If Sonya is married, she is able to deduct the entire $55,000 loss as an ordinary loss.

Note: Sonya being married has no impact on the answer to the initial question. The stock is a capital asset and the $55,000 loss is subject to the $3,000 annual capital loss limitation. The remaining $52,000 of loss is carried forward for use in subsequent years.

 

 

58. Rick, a single taxpayer, owns 30,000 shares of qualifying small business stock that he had purchased for $300,000. During the current year, he sells 10,000 of the shares for $25,000. What are the tax effects for Rick from selling the shares?

Rick has realized a loss of $75,000 on the sale of the stock:

Amount realized $ 25,000

Basis ($300,000 ˜ 30,000 = $10 x 10,000) (100,000)

Realized loss $ (75,000)

Because the stock is qualifying small business stock, Rick is allowed to deduct $50,000 of the loss as an ordinary loss. The remaining $25,000 of loss is a capital loss. Rick can deduct $3,000 of the loss and carryforward the remaining $22,000 of loss.

 

a. Assume that Rick also sells other capital assets at a gain of $12,000. What are the tax effects of Rick's capital asset transactions?

The $50,000 ordinary loss deduction is not affected. The remaining $25,000 loss is netted against the $12,000 of capital gains resulting in a net capital loss of $13,000. Only $3,000 of the loss is deductible. The remaining $10,000 is carried forward to next year.

Remaining capital loss from small business stock $ (25,000)

Capital gain 12,000

Net capital loss $ (13,000)

Capital loss deduction 3,000

Loss carryforward $ (10,000)

 

b. Assume the same facts as in part a. In the year after selling the 10,000 shares of qualified small business stock, Rick has total capital gains of $16,000 and total capital losses of $12,000. What are the effects of Rick's capital asset transactions on his taxable income?

The current year capital gains and losses are netted with the $10,000 capital loss carryforward resulting in a net capital loss of $6,000.

Capital gains $ 16,000

Capital losses (12,000)

Capital loss carryforward (10,000)

Net capital loss $ (6,000)

Only $3,000 of the net capital loss is deductible with the remaining $3,000 loss carried forward to the next year.

 

 

59. Evita sells 2 pieces of land during the current year. She had used the first piece as a parking lot for her pet store. (She owns the store as a sole proprietor.) The land cost Evita $45,000, and she sells it for $28,000. The second piece is a building she had purchased as a speculative investment. Evita paid $45,000 for the lot and sells it for $28,000. Assume that Evita has no other dispositions during the year. Write a letter to Evita explaining the deductible loss from her two land transactions.

Evita has realized a loss of $17,000 ($28,000 - $45,000) on each piece of land. The type of activity the loss is incurred in determines the deductibility of the realized loss.

The loss on the sale of the first piece of land is a loss incurred in a trade or business and the $17,000 loss is fully deductible. The second piece of land is held as an investment and is a capital asset. Therefore, the loss on the second piece of land is a capital loss. Because Evita had no other capital gain and loss transactions during the year, the loss is subject to the $3,000 annual capital loss limitation.

Evita's loss deduction is $20,000 ($17,000 trade or business loss + $3,000 capital loss). The remaining $14,000 capital loss is carried forward to the next year.

 

 

60. Katelyn purchased 300 shares of Condine, Inc., stock in 2005 for $9,000. During 2007, she sells 200 shares of Condine to her brother, Jon, for $3,600 and the remaining 100 shares to an unrelated third party for $2,000. Assuming that these are her only stock sales during the year, what impact do these sales have on her 2007 taxable income?

Katelyn’s basis in the 200 shares she sells to her brother is $6,000 [$9,000 ¸ 300 shares = $30 x 200 shares] and her realized loss on the sale is $2,400 ($3,600 - $6,000). Because Katelyn and her brother are related parties, she is not allowed to deduct any of the $2,400 loss on the sale of the stock to her brother. Upon subsequent sale to an unrelated party, her brother can use the loss to reduce the gain on the sale (but not below zero). Katelyn can deduct the $1,000 [$2,000 - $3,000 ($30 x 100 shares)] loss she has on the sale to the unrelated party.

 

a. Assume that Jon sells the Condine stock in 2008 for $4,800. What impact does the sale have on his and Katelyn’s 2008 taxable incomes?

The realized gain on sale by her brother is $1,200, but he can reduce his realized gain by $1,200 of Katelyn's disallowed loss of $2,400. The remaining $1,200 ($2,400 - $1,200) of Katelyn’s loss is disallowed. Jon’s recognized gain is $0.

2007 2008

Katelyn Jon

Selling price $ 3,600 $ 4,800

Less: Basis (6,000) (3,600)

Realized gain (Loss on sale) $ (2,400) $ 1,200

Deductible loss - 0- (1,200)

Recognized gain $ -0-

b. Assume that Jon sells the shares in 2008 for $6,200. What impact does the sale have on his and Katelyn’s 2008 taxable incomes?

The realized gain on sale by Jon is $2,600, but he can reduce his realized gain by Katelyn's disallowed loss of $2,400. Jon’s recognized gain is $200.

2007 2008

Katelyn Jon

Selling price $ 3,600 $ 6,200

Less: Basis (6,000) (3,600)

Realized gain (loss) on sale $ (2,400) $ 2,600

Deductible loss - 0- (2,400)

Recognized gain $ 200

c. Assume that Jon sells the shares in 2008 for $3,100. What impact does the sale have on his and Katelyn’s 2008 taxable incomes?

In this case, the subsequent sale results in a loss of $500 ($3,100 - $3,600). Katelyn’s disallowed loss cannot be used to increase her brother’s loss on the subsequent sale. Jon has a realized and recognized loss of $500.

61. Elliot sells some stock to his sister, Nancy, for $4,000. His basis in the stock is $6,000. Several years later, Nancy sells the stock for $7,000. What is the effect of the sales on Elliot and Nancy?

Elliot and Nancy are related parties. Elliot is not allowed to deduct any of the $2,000 loss on the sale of the stock to his sister. Upon subsequent sale to an unrelated party, Nancy can use the loss to reduce gain on the sale but not below zero. The gain on sale by Nancy is $3,000, which is reduced by Elliot's disallowed loss of $2,000 and her recognized gain is $1,000.

Elliot Nancy

Selling price $ 4,000 $ 7,000

Less: Basis (6,000) (4,000)

Realized gain (Loss on sale) $ (2,000) $ 3,000

Deductible loss -0- (2,000)

Recognized gain $ 1,000

 

a. Assume that the subsequent sale by Nancy is for $5,000.

The gain on the subsequent sale is only $1,000. Nancy may only use $1,000 of Elliot’s disallowed loss to offset her gain. A loss cannot be created on the subsequent sale by use of the disallowed loss. The remaining $1,000 of the original loss is lost forever.

Elliot Nancy

Selling price $ 4,000 $ 5,000

Less: Basis (6,000) (4,000)

Realized gain (Loss on sale) $ (2,000) $ 1,000

Deductible loss -0- (1,000)

Recognized gain $ -0-

b. Assume that the subsequent sale by Nancy is for $2,000.

In this case, the subsequent sale results in a loss of $2,000 ($2,000 - $4,000). Elliot's disallowed loss cannot be used to increase Nancy’s loss on the subsequent sale. Nancy recognizes a $2,000 loss.

62. Howard Company is 100% owned by Rona. During the current year, Howard sells some land to Rona for $50,000 that had cost Howard $80,000 and that had a fair market value of $100,000. Write a letter to Rona explaining the tax effects of the sale.

The bargain purchase by the related party shareholder is considered to be a dividend to Rona of $50,000 ($100,000 - $50,000). The loss on the sale of the land by Howard Company is disallowed because it is sold to a related party. Rona's basis in the land is $100,000 ($50,000 cash paid + $50,000 income recognized).

 

 

 

 

 

63. Darlene owns 500 shares of Sandmayor, Inc., common stock that she purchased several years ago for $20,000. During the current year, the Sandmayor stock declines in value. Darlene decides to sell the stock to realize the tax loss. On December 17, she sells the 500 shares for $12,000. Her investment adviser tells her she thinks the Sandmayor stock probably will begin to increase in value next year. On this advice, Darlene purchases 600 shares of Sandmayor common stock on January 10 of the next year for $15,000. The adviser turns out to be right --- Darlene sells the 600 shares in May for $22,000. What are the effects of the sales on Darlene's taxable income in each year? Explain.

The December 17 sale results in a realized loss of $8,000. However, the loss cannot be recognized because it is a wash sale (the 500 shares sold are repurchased within 30 days). The disallowed loss on the wash sale is added to the basis of 500 of the shares purchased on January 10. The total basis of the January 10 shares is $23,000 ($20,500 + $2,500).

Amount realized $ 12,000

Less: Basis (20,000)

Realized loss $ (8,000)

Disallowed loss - wash sale 8,000

Deductible loss $ -0-

 

500 Wash 100 New

Basis in shares: Sale Shares Shares

January 10 purchase ($25 per share) $ 12,500 $ 2,500

Disallowed loss 8,000 -

Basis $ 20,500 $ 2,500

 

The sale of the 600 shares in May results in a $2,167 long-term loss (holding period began several years ago) on the 500 "wash sale" shares and a short-term gain $1,167 (holding period began on January 10) on the "new" shares.

Amount realized ($36.67 per share) $ 18,333 $ 3,667

Less: Basis ($15,000 + $8,000) (20,500) (2,500)

Realized and recognized gain (loss) $ (2,167) $ 1,167

 

64. Ed owns 500 shares of Northern Company for which he paid $15,000 several years ago. On November 24, he purchases an additional 350 shares for $6,300. Ed sells the original 500 shares for $10,000 on December 14. What are the effects of the December 14 sale? Explain.

The sale of the 500 shares results in a realized loss of $5,000. However, 350 of the 500 shares sold are replaced within the 30 day period that defines a wash sale. Therefore, the loss on the 350 shares replaced is disallowed and added to the basis of the 350 replacement shares purchased on November 24. The loss on the 150 shares that are not replaced is allowed as a capital loss. The disallowed loss is $3,500 and the allowable loss is $1,500:

Amount realized $ 10,000

Less: Basis (15,000)

Realized loss $ (5,000)

Disallowed loss on 350 shares

(350 ¸ 500) x $5,000 3,500

Allowable loss on 150 shares not replaced $ (1,500)

The basis of the 350 shares purchased on November 24 is $9,800 ($6,300 cost + $3,500 disallowed loss on wash sale).

 

 

65. Leona owns 300 shares of Ross Industries. She acquired the shares on February 17, 2005, for $6,500. On September 17, 2007, she acquires another 200 shares of Ross for $4,800. Two weeks later, a lawsuit is filed against Ross for patent infringement, and its stock price drops to $19 per share. Unsure of the outcome of the lawsuit, Leona sells 300 shares of the stock for $5,400 on October 12, 2007. What is her recognized gain or loss on the sale of the Ross stock?

Leona has a realized loss of $1,100 on the sale of the 300 shares of stock. Unless the taxpayer specifies differently, the first shares acquired are considered the first shares sold. Because she acquired 200 shares within the 30 day period that defines a wash sale, the loss on 200 shares of the stock sold cannot be recognized. Therefore, Leona has a disallowed loss of $733 ($1,100 x (200 shares ¸ 300 shares) on the sale of the stock and a recognized loss of $367 ($1,100 - $733). The disallowed loss of $733 is added to her basis in the 200 shares she acquired on September 17, 2007. Her basis in the September 17, 2007 stock is $5,533 ($4,800 + $733).

October 12 Sale:

Amount realized $ 5,400

Less: Basis ( 6,500)

Realized loss $ (1,100)

Disallowed loss $ 733

Recognized loss $ 367

 

66. Jorge and his wife own a beachfront vacation home in Savannah, Georgia. During the year, high winds from a tropical storm shatter a sliding glass door and rain from the storm causes extensive water damage to the kitchen. Fortunately, during a calm in the storm, Jorge is able to board up the door, which limits the water damage to the kitchen. The items damaged in the storm are:

Value Value Insurance

Cost Before After Proceeds

Kitchen Furniture $2,100 $1,400 $400 $650

TV $ 250 $ 200 $ -0- $125

Refrigerator $1,000 $ 950 $100 $800

Linoleum Flooring $1,600 $ 900 $ -0- $500

In addition, Jorge pays $625 to replace the sliding glass door. The insurance company will not reimburse him for the cost of the new door because the old sliding glass door did not meet the company’s standards for a hurricane area. What is the amount of Jorge’s casualty loss before considering any annual limitations that may apply?

The measure of a personal casualty loss is the lesser of the decline in market value or the property's basis. In the case of a theft, the decline in market value is the market value of the property prior to the theft. The measured loss must be reduced by any insurance reimbursements and the $100 statutory floor. Jorge's casualty loss is $1,400 before considering the annual personal casualty loss limitation (i.e., 10% of adjusted gross income):

 

Kitchen furniture (decline in value) $ 1,000

Television (decline in value) 200

Refrigerator (decline in value) 850

Linoleum Flooring (decline in value) 900

Window damage (cost to repair) 625

Total loss before insurance reimbursement $ 3,575

Less: Insurance reimbursement ($650 + $125 + $800 + $500) (2,075)

Loss net of insurance $ 1,500

Less: statutory floor (100)

Net casualty loss before annual limitation $ 1,400

 

 

67. Ghon and Li own a home on Lake Gibran. During a heavy rainstorm, the lake overflows and floods the basement, which is used as their family room. The entire contents of the basement (rug, furniture, stereo, and so on) are destroyed. The insurance adjuster estimates that the damage to the basement and its contents is $13,500. Ghon and Li do not have flood insurance, so the insurance company will reimburse them only $2,700 for the damage. If their adjusted gross income for the year is $58,000, what is their deductible casualty loss?

The measure of a personal casualty loss is the lesser of the decline in market value or the property's basis. The measured loss must be reduced by any insurance reimbursements and the $100 statutory floor. This amount is then further reduced by the annual personal casualty loss limitation of 10% of their adjusted gross income. Ghon and Li’s casualty loss of $13,500 must be reduced by the insurance reimbursement of $2,700 and the $100 statutory floor for a net casualty before the annual limitation of $10,700. The annual 10% of AGI limitation results in a casualty loss of $ 4,900 [$10,700 - ($58,000 x 10%)].

Loss per insurance adjuster (decline in value) $ 13,500

Less: insurance reimbursement (2,700)

Loss net of insurance $ 10,800

Less: statutory floor (100)

Net casualty loss before annual limitation $ 10,700

Annual limitation ($58,000 x 10%) (5,800)

Deductible casualty loss $ 4,900

Instructors Note: The adjuster’s estimate of the damage should provide an accurate value of the property’s decline in value and in virtually all cases will be less than the original basis of the property.

 

 

68. Kevin is the sole proprietor of Murph's Golf Shop. During the current year, a hurricane hits the beach near Kevin's shop. His business building, which has a basis of $60,000, is damaged. In addition, his personal automobile, for which he paid $22,000, is damaged. Fair market values (FMV) before and after the hurricane are

Case A FMV Before FMV After

Building $ 130,000 $ 85,000

Automobile 12,000 3,000

 

Case B FMV Before FMV After

Building $ 130,000 -0-

Automobile 12,000 -0-

 

a. What is Kevin's gross loss in each of the above cases?

The gross loss (i.e., the loss before any limitations) in case A is $45,000 for the building and $9,000 for the automobile. For business property that is partially destroyed, the gross loss is measured as the lesser of 1) the decrease in fair market value, $45,000 ($130,000 - $85,000) or 2) the basis of the property, $60,000. All personal casualty losses are measured using the same valuation rule - the lesser of $22,000 basis versus $9,000 ($12,000 - $3,000) decline in market value.

In case B, the gross loss is $60,000 on the building and $12,000 on the automobile. Business property fully destroyed is measured at the basis of the property. Personal casualty losses are always measured using the valuation rule of the lesser of basis or decline in market value.

 

b. Assume that in case A, Kevin receives $36,000 from his insurance company for the building and $5,000 for his automobile. What is his allowable loss?

The allowable loss on the building is $9,000 ($36,000 - $45,000). The loss on the automobile is $3,900 ($5,000 - $9,000 - $100). Personal casualty losses are reduced by the $100 statutory floor per occurrence and then reduced by 10% of Kevin’s adjusted gross income.

 

c. Assume that the insurance proceeds are $130,000 and $5,000 in case B. What is the tax effect of the casualty for Kevin?

The receipt of insurance proceeds of $130,000 results in a gain of $70,000 ($130,000 - $60,000). The loss on the automobile is $6,900 ($5,000 - $12,000 - $100). The $6,900 personal casualty loss is then reduced by 10% of Kevin’s adjusted gross income.

 

69. Marsha owns a two-family condominium in southern California that she paid $140,000 for in 1992. One unit has 2,400 square feet of space, and the other has 1,600 square feet. Marsha uses the 2,400-square-foot unit as a vacation home and rents the other unit to a retired couple. During the current year, an electrical fire destroys the condominium. Because part of it was used as rental property, Marsha’s insurance company reimburses her only $120,000. The fair market value of the condominium before the fire was $160,000, and her adjusted basis in the rental unit is $20,000. Assume that Marsha’s adjusted gross income before considering the casualty is $55,000. Write a letter to Marsha explaining the effect of the casualty on her taxable income.

Because the rental property is a mixed-purpose asset it must be accounted for as two assets - a business asset and a personal asset. The best method for allocating between the business and personal portion of the condominium is based on the total square footage of the two units. Based on the square footage 40% [1,600 ¸ (2,400 + 1,600)] of the casualty loss is business and the remaining 60% is personal. The gain or loss from the casualty must be computed separately and the appropriate rules for business and personal property applied to each portion:

40% 60%

Business Personal

Initial basis $ 56,000 $ 84,000

Less: depreciation (36,000) -0-

Adjusted basis $ 20,000 $ 84,000

Amount of loss:

Business portion - adjusted basis $ (20,000)

Personal portion - lesser of:

Adjusted basis $84,000

OR

Decline in value ($160,000 x 60% = $96,000) $ (84,000)

Less: Insurance proceeds 48,000 72,000

Net casualty gain (loss) $ 28,000 $ (12,000)

Marsha has a $28,000 casualty gain on the business portion of condominium and a $12,000 loss on the personal portion of the condominium. The $28,000 gain is added to her $55,000 adjusted gross income giving her an adjusted gross income of $83,000 ($28,000 + $55,000). Assuming that Marsha itemizes her deductions, her deductible casualty loss is $3,600:

Loss net of insurance $ 12,000

Less: statutory floor (100)

Net casualty loss before annual limitation $ 11,900

Annual limitation ($83,000 x 10%) (8,300)

Deductible personal casualty loss $ 3,600

70. Jamila is involved in an auto accident during the current year that totally destroyed her car. She purchased the car 2 years ago for $28,000. Jamila used the car in her business 75% of the time over the past 2 years. She had properly deducted $4,000 in depreciation for the business use of the car. The fair market value of the car before the accident is 16,000. The insurance company reimburses her $12,000. Assuming that Jamila has an adjusted gross income of $45,000 during the current year before considering the effect of the auto accident, what is the effect of the accident on her taxable income?

Because the automobile is a mixed-use asset it must be accounted for as two assets - the business portion and the personal portion. The gain or loss from the casualty must be computed separately and the appropriate rules for business and personal property applied to each portion:

 

75% 25%

Business Personal

Initial basis $ 21,000 $ 7,000

Less: depreciation (4,000) -0-

Adjusted basis $ 17,000 $ 7,000

Amount of loss:

Business portion - adjusted basis $ (17,000)

Personal portion - lesser of:

Adjusted basis $ 7,000

OR

Decline in value

($16,000 x 25% = $4,000) $ 4,000 (4,000)

Less: Insurance proceeds 9,000 3,000

Net loss $ (8,000) $ (1,000)

 

Jamila can deduct the $8,000 loss on the business portion of the automobile. Assuming Jamila has no other casualty losses during the year, she is not entitled to a casualty loss on the personal portion of the automobile. The $900 loss ($1,000 - $100 statutory floor) does not exceed 10% of her adjusted gross income [ $900 < $4,500 ($45,000 x 10%)].

 

71. Andy sells the following assets during the year.

Gain (Loss)

Personal automobile $ (2,000)

ABC stock 4,800

Personal furniture 1,200

BCCI bonds (9,600)

What is Andy's deductible loss? Explain.

The loss on the automobile is not an allowable capital loss because it is a personal use asset. The gain on the furniture is taxable under the all-inclusive income concept. The gain on the stock and the loss on the bonds are capital gains and losses. Andy's net capital loss for the year is $3,600:

Gain on sale of stock $ 4,800

Gain on sale of furniture 1,200

Loss on BCCI bonds (9,600)

Net capital loss $ (3,600)

Capital loss deduction 3,000

Capital loss carryforward $ (600)

Only $3,000 of the net capital loss is deductible. The remaining $600 is carried forward to subsequent years for use in those years.

 

 

72. Faith, who is single, sells the following assets during 2007:

20,000 shares of qualified small business stock at a loss of $62,000. Faith bought the stock in 2002.

1,200 shares of Geelong Industries at a gain of $4,500. Faith bought the stock in 2004.

An XZ10 sailboat at a loss of $3,500. Faith acquired the boat, which she used in her leisure hours, in 2003.

A 1973 Holden Deluxe automobile at a gain of $3,700. Faith never used the car for business.

50 shares of Fremantle, Inc., at a gain of $1,300. Faith bought the stock in 2007 and sells it to her brother.

75 shares of Fitzroy Corporation at a loss of $300. Faith bought the stock in 2003 and sells it to her sister.

Calculate Faith's net capital gain (loss) for 2007.

Faith can deduct $50,000 as an ordinary loss on the qualifying small business stock. The remaining $12,000 ($50,000 - $62,000) is a long-term capital loss. The loss on the XZ10 sailboat is not an allowable capital loss because it is a personal use asset. The $3,700 gain on the automobile is taxable under the all-inclusive income concept. The $1,300 gain on the sale of stock to her brother is taxable. Only sales at a loss to a related party are disallowed. The $300 loss on the sale to her sister is disallowed -- related party sale. Faith’s net capital loss for the year is $2,500:

Short-term gain on sale of Fremantle stock $ 1,300

Long-term loss on small business stock $ (12,000)

Long-term gain on sale of Geelong stock 4,500

Long-term gain on sale of automobile 3,700 $ (3,800)

Net long-term capital loss $ (2,500)

Capital loss deduction $ 2,500

Note: Faith also has an ordinary loss on the small business stock of $50,000.

ISSUE IDENTIFICATION PROBLEMS

In each of the following problems, identify the tax issue(s) posed by the facts presented. Determine the possible tax consequences of each issue you identify.

 

73. The Readyhough Corporation was incorporated in 1999. During 2006, the corporation had operating income of $80,000. Because of a strike at its major supplier, the corporation had an operating loss of $60,000 in 2007. The corporation expects to rebound in 2008, forecasting operating income of $140,000. The current interest rate is 6%.

The issue is whether Readyhough should elect not to carry the loss back and carry the loss forward. To determine the optimal choice, the present value of the tax savings of each option must be calculated. A carryback to 2006 will result in a refund of $10,000 [($50,000 x 15%) + ($10,000 x 25%)].

If the loss carryforward option is elected, the tax savings on the carryforward to 2008 is $22,850 (see below) and the present value of the tax savings is $21,548 ($22,850 x .943). Therefore, by foregoing the carryback, Readyhough realizes a present value tax savings of $11,548 ($21,548 - $10,000).

Corporate tax on $140,000 =

{$22,250 + [($140,000 - $100,000) x 39%]} = $ 37,850

Corporate tax on $80,000 =

{$7,500 + [($80,000 - $50,000) x 25%]} = (15,000)

Tax savings from carrying forward $60,000 loss $ 22,850

 

74. Celine opens a jewelry store during the current year. She invests $20,000 of her own money and receives a nonrecourse bank loan of $80,000. During the current year, the store has a loss of $24,000.

The issue is to determine the amount of Celine's deductible loss. The amount of her loss is limited to the amount she is at-risk. Celine is at risk for $20,000 - the amount she invested in the jewelry store. She is not at-risk for the nonrecourse debt, because she is not personally liable to repay the debt. Nonrecourse debt only is considered at-risk if it is used to finance the holding of real estate. The $4,000 loss that is not deductible is carried forward until Celine increases her at-risk amount.

 

75. Anton is single and a self-employed plumber. His net income from his business is $56,000. He has dividend income of $6,000 and an $8,000 loss from a rental property in which he actively participates.

The issue is whether Anton can deduct the $8,000 loss from his rental activity. Because Anton actively participates in the rental activity and his adjusted gross is less than $100,000 he can deduct the entire $8,000 loss against his active and portfolio income. His adjusted gross income is $54,000.

76. Rita is the sole owner of Video Plus, a local store that rents video games, software, and movies. She works 40 hours a week managing the store.

The issue is whether Video Plus is a passive activity. A rental activity that includes significant services is not considered a rental activity under the passive activity rules. In addition, Rita must be a material participant in the business. Therefore, because the rental activity involves significant personal services and Rita is a materially participates in operating the store (i.e., works 40 hours per week > 500 hours per year), the store is not a passive activity.

 

 

77. Margery owns a passive activity with a basis of $15,000. The activity has a $9,000 suspended loss. Margery sells the passive activity for $22,000.

There are two issues. The first is whether Margery has a gain or loss on the sale of the passive activity. The second issue is whether the suspended loss is deductible. Margery has a capital gain of $7,000 ($22,000 - $15,000) on the sale of the activity and is allowed a deduction of $9,000 for the suspended loss on the activity. Any suspended loss on a passive activity is deductible in full when the entire interest in the activity is disposed of through a sale of the activity. This results in a net deduction of $2,000. However, the $7,000 capital gain is netted with any other capital gains and losses that Margery has during the year. Also, the tax rate on a net long-term capital gain is 15% (5% if the taxpayer’s marginal tax rate is 10% or 15%), which further complicates the tax effect of Margery's net deduction of $2,000.

 

 

78. Orlando owns a passive activity with a basis of $13,000 and a $6,000 suspended loss. He dies when the passive activity has a fair market value of $17,000.

The issue is whether Orlando's suspended loss is deductible. A deduction is allowed for a suspended loss on a passive activity held at death, but only to the extent the suspended loss exceeds the unrealized gain on the passive activity. Orlando's suspended loss of $6,000 exceeds his unrealized gain of $4,000 ($17,000 - $13,000) by $2,000 ($6,000 - $4,000). Therefore, he can deduct $2,000 of his suspended loss.

 

79. Emma owns and operates Conway Camera. One night someone breaks into the store and steals cameras that cost $2,200. The retail price of the cameras is $3,500.

The issue is to determine the amount of Conway's theft loss. A theft of business property is measured at its basis, not its retail value. Conway's theft loss is the $2,200 basis reduced by any insurance proceeds she receives.

 

 

80. Mike's Pizza decides to replace one of its delivery vehicles. The vehicle has a basis of $2,700 and Mike's is able to sell it for $2,100.

There are two issues. The first is whether Mike's has a gain or loss on the sale of its delivery vehicle. The second is whether the gain or loss is capital or ordinary. Mike has a loss of $600 ($2,100 - $2,700) on the sale of the delivery vehicle. The sale of a business asset results in an ordinary loss. Therefore, Mike has an ordinary loss deduction of $600.

 

 

81. Zoriana sells stock that she acquired in 2003 for $7,500. Her basis in the stock is $14,000. She has a $2,000 long-term capital loss carryover from 2006.

The issue is what amount Zoriana can deduct as a capital loss. She has a long-term capital loss of $6,500 ($7,500 - $14,000) that is added to her $2,000 long-term capital loss carryover. However, only $3,000 of her $8,500 ($6,500 + $2,000) long-term capital loss can be deducted in the current year. The remaining $5,500 ($8,500 - $3,000) is carried forward to the following year.

 

82. Alphonse sells stock with a basis of $5,500 to his brother, Conner, for $4,000. His brother sells it later in the year for $5,100.

There are two issues. The first is whether Alphonse can deduct the $1,500 loss on the sale of the stock. The second is what is the amount of Conner's gain on his subsequent sale of the stock. Alphonse and Conner are related parties. Therefore, Alphonse is not allowed to deduct any of the $1,500 loss on the sale of the stock to his brother. However, upon the subsequent sale to an unrelated party, Conner can use $1,100 of the loss to reduce his $1,100 gain ($5,100 - $4,000) to zero. A loss cannot be created on the subsequent sale by use of the disallowed loss. The remaining $400 ($1,100 - $1,500) of the original loss is lost forever.

Alphonse Conner

Selling price $ 4,000 $ 5,100

Less: Basis (5,500) (4,000)

Realized gain (Loss on sale) $ (1,500) $ 1,100

Deductible loss -0- (1,100)

Recognized gain $ -0-

 

 

83. On January 1, 2007, Brenda acquires 200 shares of Disney stock for $8,000. She sells 200 shares of the stock on September 2, 2007, for $30 per share. On September 23, 2007, Brenda acquires 400 shares of Disney stock for $10,400.

The issue is the amount of the loss Brenda can deduct on the sale of the Disney stock. The sale of the 200 shares on September 2 results in a realized loss of $2,000 [(200 x $30) - $8,000]. However, all 200 shares sold are replaced within the 30-day period that defines a wash sale. Therefore, the loss on the shares replaced is disallowed and added to the basis of 200 of the replacement shares purchased on September 23:

Amount realized $ 6,000

Less: Basis (8,000)

Realized loss $ (2,000)

Disallowed loss 2,000

Allowable loss $ -0-

The cost of the 400 shares acquired on September 23 is $26 per share ($10,400 ¸ 400). However, the basis of the shares must be split into two parts. The basis of 200 of the shares purchased on September 23 is $7,200 [(200 x $26) + $2,000 disallowed loss on wash sale). The basis of the other 200 shares acquired is $5,200 (200 x $26)

 

 

84. George is single and has adjusted gross income of $37,000. He discovers termites in the basement of his house and pays $6,200 to fix the damage. His insurance company will not reimburse him for the damage.

The issue is whether George can claim a casualty loss for the damage caused by the termites. A casualty must be sudden, unexpected and unusual in nature. Although the damage is unexpected and unusual in nature, termite damage is not sudden and occurs over a substantial period of time. Therefore, the termite infestation is not a casualty and George cannot deduct the $6,200 loss.

85. Tax Simulation. Alicia, Bob and Carol are equal partners in, Dunning Law Associates. In 2001, Alicia, in an attempt to maximize the firms return on its investment portfolio, encourages her partners to acquire $90,000 of stock in a local Internet provider. The stock was acquired by the partnership from the issuing corporation and the corporation that issued the stock meets all the tests for the stock to be treated as small business stock. In 2006, when the stock is worth $20,000, Bob and Carol, who are upset with Alicia’s investment choice, distribute all the shares of the small business stock to Alicia as part of her partnership distribution. The following year, Alicia sells the stock for $15,000.

Required: Determine the tax treatment of Alicia’s loss on the sale of the stock. Search a tax research database and find the relevant authority (ies) that forms the basis for your answer. Your answer should include the exact text of the authority (ies) and an explanation of the application of the authority to Alicia’s facts. If there is any uncertainty about the validity of your answer, indicate the cause for the uncertainty.

Sec. 1244 (a) allows an individual taxpayer or a partnership to deduct the loss on the sale of Sec. 1244 stock (i.e., small business stock) as an ordinary loss.

Sec. 1244 (a) General rule — In the case of an individual, a loss on section 1244 stock issued to such individual or to a partnership which would (but for this section) be treated as a loss from the sale or exchange of a capital asset shall, to the extent provided in this section, be treated as an ordinary loss.

Sec. 1244 (b) limits the amount an individual taxpayer can deduct on the sale of the stock to $50,000 if the taxpayer is a single individual and $100,000 if the taxpayer files a joint tax return

Sec. 1244 (b) Maximum amount for any taxable year. For any taxable year the aggregate amount treated by the taxpayer by reason of this section as an ordinary loss shall not exceed— (1) $50,000, or (2) $100,000, in the case of a husband and wife filing a joint return for such year under section 6013.

Although the stock is considered to be small business stock to the partnership, the question to be resolved is whether it is still considered to be small business stock when Alicia sells it. Reg. Sec. 1.1244(a)-1(b) provides that only two classes of taxpayers are allowed an ordinary loss deduction on the sale of small business stock. The first is an individual who originally was issued the stock and the second, is an individual who was a partner in a partnership at the time the partnership acquired the stock and whose share of the partnership distribution reflects the loss sustained by the partnership on its sale of the stock (emphasis added).

Reg. Sec. 1.1244(a)-1(b) Taxpayers entitled to ordinary loss. The allowance of an ordinary loss deduction for a loss of section 1244 stock is permitted only to the following two classes of taxpayers: (1) An individual sustaining the loss to whom the stock was issued by a small business corporation, or (2) An individual who is a partner in a partnership at the time the partnership acquired the stock in an issuance from a small business corporation and whose distributive share of partnership items reflects the loss sustained by the partnership.

Reg. Sec. 1.1244(a)-1(b) goes on to state that ordinary loss treatment is not available to a partner if the partner receives Sec. 1244 stock in a distribution from the partnership because the stock is not considered small business stock when the partner sells the stock. For a partner to receive the benefit from Sec. 1244, the partnership must sell the stock at a loss and have the loss flow-through to the partner.

(b) Taxpayers entitled to ordinary loss. The allowance of an ordinary loss deduction for a loss of section 1244 stock is permitted only to the following two classes of taxpayers:

An individual sustaining the loss to whom the stock was issued by a small business corporation, or

(2) An individual who is a partner in a partnership at the time the partnership acquired the stock in an issuance from a small business corporation and whose distributive share of partnership items reflects the loss sustained by the partnership. The ordinary loss deduction is limited to the lesser of the partner's distributive share at the time of the issuance of the stock or the partner's distributive share at the time the loss is sustained. In order to claim a deduction under section 1244 the individual, or the partnership, sustaining the loss must have continuously held the stock from the date of issuance. A corporation, trust, or estate is not entitled to ordinary loss treatment under section 1244 regardless of how the stock was acquired. An individual who acquires stock from a shareholder by purchase, gift, devise, or in any other manner is not entitled to an ordinary loss under section 1244 with respect to this stock.

Thus, ordinary loss treatment is not available to a partner to whom the stock is distributed by the partnership. Stock acquired through an investment banking firm, or other person, participating in the sale of an issue may qualify for ordinary loss treatment only if the stock is not first issued to the firm or person. Thus, for example, if the firm acts as a selling agent for the issuing corporation the stock may qualify. On the other hand, stock purchased by an investment firm and subsequently resold does not qualify as section 1244 stock in the hands of the person acquiring the stock from the firm.

 

Reg. Sec. 1.1244(a)-1(c) provides an example which illustrates this point.

Example 3 - A and B, both individuals, and C, a trust, are equal partners in a partnership to which a small business corporation issues section 1244 stock. The partnership distributes section 1244 stock to partner A and he subsequently sells the stock at a loss. Section 1244 is not applicable to the loss since A did not acquire the stock by issuance from the small business corporation.

In conclusion, the stock is not considered qualified small business stock to Alicia. Therefore, the loss on the sale of the stock is treated as a capital loss and her loss deduction is limited to $3,000. Note: The $3,000 loss assumes she has no other sales of capital assets during the year.

 

86. INTERNET ASSIGNMENT Articles on tax topics are often useful in understanding the income tax law. CPA firms and other organizations publish tax articles on the Internet. Using the "Guides-Tips-Help" section of the Tax and Accounting Sites Directory (http://www.taxsites.com/) find an article, tax tip, or other information discussing passive activities and write a summary of what you found.

Clicking on Guides-Tips-Help within Tax Sites, one possible selection is H & R Block: Taxes (http://www.hrblock.com/taxes/). At this page, use the site search engine and the words "passive activities" and you will find a discussion on tax planning for passive activities.

INSTRUCTOR’S NOTE: Information on the Internet is developing at a rapid pace. Therefore, this solution may become outdated. We suggest that you do the assignment prior to assigning it to your students. This will allow you to provide students with any additional information they may need to complete the assignment.

 

 

87. INTERNET ASSIGNMENT The Internal Revenue Service provides information on a variety of tax issues in its publication series. These publications can be found on the IRS world wide web site (http://www.irs.gov/). Go to the IRS World Wide Web site and find publications with information on casualty losses. Describe the process you used to obtain this information and provide the title(s) of the publication(s) with relevant information.

At the IRS homepage you should click on More Forms and Publications. Under "Download forms and publications by", click on "Publication Number". After highlighting that publication click on retrieve selected publication. At the following screen, click on the file and it will be loaded into the Adobe Acrobat reader. Note: You will need Adobe Acrobat to read the PDF file "Publication 547". If you do not have Adobe Acrobat, you can download it from the IRS website.

Alternatively, you can go to Search for a Form or Publication. By using the search terms casualty loss you will get Publication 584 "Casualty, Disaster, and Theft Loss Workbook - Personal Loss Property". However, you will not get Publication 547 because the term casualties is used instead of casualty in the title. By using the search word "theft" both publications will be retrieved.

INSTRUCTOR’S NOTE: Information on the Internet is developing at a rapid pace. Therefore, this solution may become outdated. We suggest that you do the assignment prior to assigning it to your students. This will allow you to provide students with any additional information they may need to complete the assignment.

 

 

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CHAPTER 8

TAXATION OF INDIVIDUALS

___________________________________________________________________

DISCUSSION QUESTIONS

 

1. What is the difference between a personal exemption and a dependency exemption? Are all taxpayers allowed a personal exemption?

Both types of exemptions are worth the same amount in terms of a deduction. Personal exemptions are allowed to the taxpayer(s) filing the return (this can never be greater than two), while dependency exemptions are allowed for those individuals who qualify as a taxpayer's dependent.

Not all taxpayers are entitled to a personal exemption. A taxpayer that is claimed as a dependent of another is not allowed a personal exemption deduction. The effect of this provision is to allow only 1 exemption deduction per individual. Note: If there is total tax compliance, then the total number of exemptions taken equals the total U.S. population. However, two factors, administrative convenience and tax evasion, prevent this from happening. For purposes of administrative convenience, the government does not require every taxpayer to file a return. Other taxpayers who are required to file a return choose not to file -- tax evasion.

 

2. What are the five tests that must met for an individual to be considered a dependent as a qualifying child? as a qualifying relative? Briefly explain each test.

The 5 qualifying child tests are:

1. Age Test. To meet the age test, the individual must be under the age of 19 at the end of the year, a full-time student under the age of 24 at the end of the year, or be permanently and totally disabled.

2. Non-Support Test. To meet the support test, the individual being claimed as a dependent must not have provided more than one-half of their support.

3. Relationship Test. Under the relationship test an individual must be the taxpayer’s son, daughter, stepson, stepdaughter, eligible foster child or decedent of such a child, or the taxpayer’s brother, sister, stepbrother, stepsister or any descendant of any such relative.

4. Principal Residence Test. To meet the principal residence test, the individual must live with the taxpayer for more than one-half of the year. Temporary absences due to illness, vacation, education, military service or other special circumstances are not considered as time living away from the principal residence.

5. Citizenship or Residency Test. Under the citizenship or residency test, the child must be a citizen or resident of the United States, or a resident of the United States, Canada or Mexico.

The 5 qualifying relative tests are:

1. Gross Income Test - the gross income of a dependent cannot exceed the amount of the exemption deduction.

2. Support Test - the taxpayer seeking the exemption must pay more than 1/2 of the amount spent on the dependents support. Only amounts spent on support are considered in this test, not the amounts the dependent may have earned but did not spend on support.

3. Relationship or Member of Household Test - the dependent must be either a relative or a member of the taxpayer's household for the entire year. A relative is defined as lineal descendants (ancestor, daughter) and blood relatives (aunt, nephew).

4. Citizen or Residency Test - a dependent must be either a U.S. citizen or a resident of the U.S., Canada, or Mexico for at least part of the year.

5. Joint Return Test - a dependent cannot file a joint return, unless the only purpose for filing the return is to obtain a refund of taxes paid-in. That is, they are not required to file under the filing requirements.

3. Which parent is entitled to claim the dependency exemption for a child when the parents are divorced? Can the other parent ever claim the dependency exemption?

The custodial parent is entitled to the deduction, regardless of the level of support the non-custodial parent may provide. There are 2 possible ways that the non-custodial parent can claim the exemption deduction. First, the divorce decree may specify that the non-custodial parent is entitled to the dependency exemption(s). Second, the custodial parent can give the deduction to the non-custodial parent by written agreement. The agreement must be attached to the non-custodial parent's tax return.

 

4. What is a multiple support agreement? When is a multiple support agreement necessary?

A multiple support agreement is an agreement among 2 or more individuals to allow one of the individuals to take a dependency deduction for an individual that meets all of the dependency tests except the support test.

A multiple support agreement is necessary when all of the dependency tests are met except the support test. That is, two or more people provide more than 1/2 of the support of another, but no one individual provides more than 1/2 of the support.

 

5. Why is a taxpayer's filing status important?

Filing status is important because it determines which tax rate schedule the taxpayer must use to calculate the tax, the amount of the standard deduction, and the income level at which the phase-out of the exemption deduction begins.

 

 

6. What is a surviving spouse? Explain the tax benefit available to a surviving spouse.

A surviving spouse is a single taxpayer whose spouse died within the last two years and who has a dependent child living in the home.

The tax benefit is that a surviving spouse files using the same tax benefits as a married couple filing jointly receives for two years following the year of death. In the year of the spouse’s death, a joint return is filed. This provides a surviving spouse with a larger standard deduction and lower average tax rates than the individual would have received under the head of household filing status.

 

7. Under what circumstances can a married person file as a head-of-household?

The tax law allows an abandoned spouse to file as a head of household. To qualify, the taxpayer must be married at the end of the year, have a dependent child living in the home for more than 1/2 the year, and the taxpayer's spouse has not lived in the home during the last 6 months of the year.

8. What is(are) the main difference(s) between deductions for AGI and deductions from AGI?

The primary difference between the two types of deductions is that FOR AGI deductions are closely related to the earning of income, while most deductions FROM AGI are specifically allowable personal expenditures. In addition, there is no minimum deduction amount allowed FOR AGI; only actual expenses are deductible. In contrast, a minimum amount of deduction FROM AGI is allowed through the standard deduction. Some FROM AGI deductions are limited to only the excess of deductible expenses minus a percentage of AGI. For example, medical deductions are limited to the excess of allowable expenses over 7.5% of AGI.

 

9. What is the standard deduction? Explain its relationship to a taxpayer's itemized deductions.

The standard deduction is the minimum amount of deduction allowed from adjusted gross income for a particular filing status. Therefore, taxpayers will only itemize their deductions when the amount of their allowable itemized deductions exceeds their standard deduction.

 

10. One general requirement for deduction is that the expense be the taxpayer's, not that of another. Is this always true? Explain.

The only exception to the requirement that a deductible expense must be the taxpayer’s is for medical expenses of a dependent. This allows a taxpayer to obtain a deduction for the payment of their dependent's medical expenses. To qualify as a dependent for medical expense purposes, the gross income and joint return tests do not have to be met.

 

 

11. Explain the limitations placed on deductions for medical expenses.

Medical expenses are limited to those costs that directly relate to the diagnosis, cure, mitigation, treatment, or prevention of diseases or which affect the structure or function of the body. Prescription drugs and insulin are the only allowable drugs that can be deducted for medical expenses. The total allowable unreimbursed medical costs are limited to the amount in excess of 7 1/2% of the taxpayer's adjusted gross income. Thus, no deduction is allowed until a taxpayer's total qualified unreimbursed expenses exceed the 7 1/2% AGI limit.

 

12. What is an ad valorem tax? What is the significance of an ad valorem tax?

An ad valorem tax is a tax based on the value of the property being taxed. The significance is that the itemized deduction for property taxes allows only ad valorem property taxes to be deducted.

 

13. Which types of interest are deductible as itemized deductions? What limitations (if any) are imposed on the deduction?

Itemized deductions for interest are limited to home mortgage interest and investment interest. Home mortgage interest is limited to the interest paid on up to $1,000,000 dollars in acquisition debt on up to two residences of the taxpayer. In addition, interest on up to $100,000 of home equity loan debt is deductible mortgage interest. Any interest paid on amounts in excess of the limits is considered to be personal nondeductible interest.

Investment interest is limited to the net investment income of the taxpayer. Any interest in excess of the limit may be carried forward and used in future years. Net investment income is defined as investment income minus investment expenses (other than interest). The amount of investment expense is the amount that is deductible after considering the 2% of AGI limit on miscellaneous itemized deductions.

 

14. In what year(s) are points paid to acquire a loan deductible? Explain.

Points are prepaid interest. As such, they must be allocated over the term of the loan. The only exception to this treatment is for points paid to acquire a home mortgage, which is deductible in the year the points are paid. However, points paid to refinance an existing mortgage must be amortized over the term of the new loan.

 

15. Why is interest paid on a loan used to purchase municipal bonds not deductible?

The interest earned on municipal bonds is excluded from gross income. Because the income is excluded, a deduction is not necessary for the interest expense on these investments to ensure that the taxpayer has the ability to pay the tax on the income. Allowing a deduction for the interest on municipal bounds would provide a double tax benefit to such investments.

 

16. What limits are placed on deductions for charitable contributions?

Charitable contributions are limited to a maximum of 50% of the taxpayer's adjusted gross income. In addition, long-term capital gain property that is valued at fair market value is limited to a maximum of 30% of adjusted gross income. Deductions to certain private non-operating foundations are limited to a maximum of 20% of adjusted gross income. Any amounts in excess of the limits are carried forward for five years and applied to the carryforward years’ limitation after the current years' contributions have been applied.

17. Explain how the deduction allowed for a charitable contribution of ordinary income property is different from the deduction for the donation of long-term capital gain property.

The contribution for ordinary income property is limited to the lesser of the property's fair market value at the date of the gift or the property's adjusted basis. Therefore, any appreciation in the value of ordinary income property is not allowed as a deduction. Long-term capital gain property may be valued at fair market value. Thus, appreciation in the value of a long-term capital gain property is allowed as a deduction (and is not subject to tax). However, any property valued at fair market value is limited to a maximum deduction of 30% of adjusted gross income. The taxpayer can elect to treat the long-term capital gain property as ordinary income property (i.e., value of the property at its adjusted basis) and be subject to the 50% limitation.

 

18. What limitations are placed on miscellaneous itemized deductions?

Miscellaneous itemized deductions, other than those allowed for gambling losses (limited to gambling winnings), impairment related work expenses of a handicapped person, and the unrecovered investment in an annuity contract, are limited to the amount in excess of 2% of the taxpayer's adjusted gross income.

 

19. The itemized deduction and exemption deduction phase-outs are an example of what concepts?

The purpose of the phase-out is to reduce the allowable itemized and exemption deductions for higher income taxpayers. The theory is that these taxpayers have a greater ability to pay tax and therefore, have less need for the itemized and exemption deductions than those taxpayers below the phase-out thresholds.

 

20. Explain the operation of the itemized deduction phase-out. What stops a taxpayer from losing all itemized deductions under the phase-out?

The itemized deduction phase-out reduces the total amount of a taxpayer's itemized deductions when adjusted gross income reaches a pre-specified level ($156,400 in 2007). Total itemized deductions are reduced by 3% of AGI in excess of the phase-out level. Three things stop a taxpayer from losing all of their itemized deductions. First, medical expenses, gambling losses, investment interest and casualty losses are exempt from the phase-out. Second, the remaining deductions can only be reduced a maximum of 80% (i.e., at least 20% of other itemized deductions are always allowed). Finally, for tax years beginning January 1, 2006, the phase-out for itemized deductions is gradually eliminated over a five-year period. For tax year 2007, the calculated amount of the itemized deduction phase-out is reduced by one-third. For tax years 2008 and 2009, the calculated amount of the itemized deduction phase-out is reduced by two-thirds. Beginning in 2010, the phase-out for itemized deductions is eliminated.

21. What is the standard deduction amount for a dependent? Under what conditions can a dependent claim the same standard deduction as a single individual who is not a dependent?

The standard deduction for a dependent in 2007 is the greater of 1) $850, or 2) the dependents earned income (up to the individual standard deduction amount) + $300. Under this formula, the standard deduction for a dependent will never be less than $850 or exceed $5,350 (the 2007 standard deduction).

 

22. Why did Congress enact the "kiddie tax"?

Congress enacted the kiddie tax to prevent high-income taxpayers (parents) from shifting unearned income to low income taxpayers (children). The law prevents this from occurring by taxing the net unearned income of children under 18 at the parents marginal tax rate. Net unearned income is defined as the child's unearned income minus $850 minus the greater of itemized deductions or the standard deduction on unearned income ($850). As a general rule, unearned income in excess of $1,700 is taxed at the parent's marginal tax rate.

Although not specifically stated by Congress, the kiddie tax rules are an extension of the assignment of income doctrine. These rules help to ensure that the progressive tax rate structure and the ability to pay concept are maintained. However, in making the tax system "more" progressive, the kiddie tax adds a level of complexity to the tax system that hinders administrative convenience.

 

23. Can all taxpayers who claim a child as a dependent receive a child tax credit for that child? Explain.

A taxpayer can claim a $1,000 tax credit for each qualifying child. The definition of a qualifying child is similar to the definition of a child for dependency purposes except that the child must be under age 17 at the end of the tax year and a citizen or resident of U.S.

The credit is phased-out at a rate of $50 for each $1,000 of income (or fraction thereof) that a married taxpayer's adjusted gross income exceeds $110,000. The phase-out for taxpayers filing as single or head of household begins at $75,000.

 

24. What are the general criteria for eligibility for the earned income credit?

The earned income tax credit (EIC) provides tax relief to low-income taxpayers. A married taxpayer with no children must have 2006 adjusted gross income less than $14,120 ($14,590 in 2007) to be eligible for the credit. Adjusted gross income cannot exceed $34,001 ($35,241 in 2007) for a taxpayer with 1 child, while a taxpayer with 2 or more children cannot have adjusted gross income greater than $38,348 ($39,783 in 2007) be eligible for the credit. To qualify for the credit the taxpayer must meet the following three tests:

1. The taxpayer's principal place of abode for more than one-half of the year must be in the United States.

2. The taxpayer or the taxpayer's spouse must be older than 25 but not older than 65.

The taxpayer or taxpayer's spouse cannot be a dependent of another taxpayer.

4. The taxpayer cannot have portfolio or passive income in excess of $2,800 ($2,900 in 2007).

25. Is the child credit refundable? Explain.

For all families, a portion of the child credit may be refundable. The amount of the child credit that is refundable depends on the number of qualifying children in the family. For families with 1 or 2 qualifying children, the refundable credit is calculated as follows:

Maximum refundable credit = 15% x (earned income - $11,750)

However, the amount refunded cannot exceed the amount of the credit remaining after reducing the tax liability to zero. For families with 3 or more qualifying children, the maximum credit is the greater of the amount calculated using the formula for 1 or 2 qualifying children or the following formula:

Maximum refundable credit = Social Security tax paid - earned income credit

Generally, a taxpayer with 3 or more qualifying children will only benefit from the second formula if the taxpayer is ineligible for the earned income credit due to excessive unearned income.

26. What are the general criteria for eligibility for the child- and dependent-care credit?

A taxpayer who pays someone to care for any dependent younger than 13 and/or other dependent that is physically or mentally incapacitated so that the taxpayer can work is eligible for a credit based on the amount of their expenses and their earned income level. In addition, a taxpayer can claim the child-and dependent-care credit for a dependent who lives with the taxpayer for more than one-half the year, even if the taxpayer does not provide more than one-half of the cost of maintaining the household. The maximum credit is 35% and is reduced by 1% for each $2,000 (or portion thereof) of AGI in excess of $15,000. The maximum reduction is limited to 15 percent, leaving a minimum allowable credit of 20 percent. The minimum credit limit is reached when the taxpayer's AGI exceeds $43,000. The maximum amount of qualifying expenses is $3,000 for one qualifying individual and $6,000 for 2 or more qualifying individuals. The expenditures qualifying for the credit cannot exceed the earned income of the taxpayer. For married taxpayers, the lower earned income is used for the purpose of the limit.

To qualify for the credit, two conditions must be met:

1. The taxpayer must incur employment-related expenses

2. The expenses must be for the care of qualified individuals

 

27. Does the child-care credit help promote a progressive tax rate structure? Explain.

A tax credit reduces the tax liability of a taxpayer dollar for dollar and is neutral with respect to the marginal tax rate of the taxpayer. That is, unlike tax deductions, a $200 tax credit reduces a taxpayer's liability by $200 regardless of their marginal tax rate bracket.

Unlike most credits, the child care credit attempts to foster a progressive tax rate structure by reducing the maximum child-care credit percentage from 35% to a minimum credit of 20%. The credit is multiplied by the taxpayer's child-care expenses to determine the allowable child care credit. The child-care credit reduces the maximum credit by 1% for every dollar of adjusted gross income in excess of $15,000. However, the credit is never reduced below 20%. Therefore, all taxpayers with adjusted gross income greater than $43,000 and who have the same amount of child-care expenses receive the same amount of credit.

The credit also fosters a progressive tax structure by increasing and capping the amount of qualified expenses depending upon the number of qualifying individuals. The maximum amount of qualifying expenses is $3,000 for one qualifying individual and $6,000 for 2 or more qualifying individuals.

Some might argue that the child-care credit system could go further by completely phasing out the credit as adjusted gross income increases. However, for social reasons, Congress has decided to maintain the current system.

 

28. Compare and contrast the Hope Scholarship Tax Credit with the Lifetime Learning Tax Credit.

The Hope Scholarship Tax Credit and the Lifetime Learning Tax Credit are similar in that:

The expenses must be incurred on behalf of the taxpayer, the taxpayer’s spouse, or a dependent of the taxpayer.

A taxpayer cannot claim the Hope Scholarship Tax Credit or the Lifetime Learning Tax Credit if the taxpayer claims a deduction for adjusted gross income for higher education expenses. However, the taxpayer can claim an education tax credit if the taxpayer receives a tax-free distribution from a Coverdell Education Savings Account. To prevent a taxpayer from receiving a double benefit, the educational expenses that are paid from the Coverdell Education Savings Account cannot be used in determining the total education expenses for purposes of the Hope Scholarship Tax Credit or the Lifetime Learning Tax Credit. Recall from Chapter 6 that a tax-free distribution from a Coverdell Education Savings Account can be used to pay for up to $2,500 of room and board expenses. Therefore, a taxpayer can claim an education tax credit for tuition and fees while using a distribution from a Coverdell Education Savings Account to pay for up to $2,500 of room and board expenses.

Both credits are phased-out ratably for married taxpayers with adjusted gross incomes between $94,000 and $114,000 and for all other taxpayers when adjusted gross income is between $47,000 and $57,000.

The credits differ in that:

The HOPE Scholarship Tax Credit provides for a 100% tax credit on the first $1,100 of expenses and a 50% tax credit on the next $1,100 of higher education expenses paid during the year for each qualifying student. This is effectively a maximum of $1,650 per individual. The Lifetime Learning Tax Credit provides a 20% credit for up to $10,000 of qualified higher education expenses per taxpayer (i.e., per family). This is effectively a maximum of $2,000 per family.

The Hope Scholarship Tax Credit can only be claimed for expenses incurred in the first two years of college. The Lifetime Learning Credit can be claimed for expenses in any year of college or graduate school. Part-time students also can use the credit, if the course(s) help the student acquire or improve their job skills.

29. What determines who must file a tax return?

Taxpayers must file tax returns based on their gross income level in relation to their allowable standard deduction (including the additional deduction for age, but not for blindness) and personal (but not dependency) exemption amounts. When the gross income exceeds this amount, the taxpayer is required to file a return. In addition, self-employed individuals must file when their net earnings from self-employment exceeds $400, a married individual filing separately must file when their gross income exceeds $3,400, and a dependent must file when unearned income is greater than $850. Of course, any taxpayer who has had amounts withheld from their earnings will want to file to obtain a refund, even if they are not required to file under the gross income requirements.

 

PROBLEMS

30. Determine whether each of the following individuals can be claimed as a dependent in the current year. Assume that any tests not mentioned have been satisfied.

a. Nico is 20 and a full-time college student who receives a scholarship for $11,000. Tuition, books, and fees total $15,000. His father gives him an additional $6,000 to pay for room and board and other living expenses.

Nico meets all the tests as a qualifying child. Even though he used the scholarship for his support, scholarships are not considered support. Therefore, the non-support test is met and Nico is a dependent.

b. Lawrence pays $7,800 of his mother's living expenses. His mother receives $3,500 in Social Security benefits and $4,100 from a qualified employer retirement program, all of which is spent on her support.

Lawrence's mother fails the gross income test. Her gross income for tax purposes is $4,100 (pension), which is greater than the $3,400 exemption amount. The Social Security benefits are not included in gross income because her AGI is less than $25,000.

c. Megan's father has no sources of income. During the year, Megan pays all of her father's support. He is a citizen and resident of Australia.

Megan's father is not a dependent. The citizen or residency requirement is met if the dependent is a citizen or resident of the United States, Canada, or Mexico for any part of the tax year. Therefore, Megan’s father does not meet the residency requirement.

d. Tawana and Ralph are married and full-time college students. They are both 22 years old. Tawana works as a model and earns $4,300 and Ralph earns $2,100 during the year. Tawana and Ralph are not required to file a joint return and do so only to receive a refund of the taxes withheld on their respective incomes. Tawana's parents give them an additional $8,000 to help them through college.

Because Tawana and Ralph are not required to file a joint return, Tawana can be claimed as dependent by her parents under the qualifying child rules. Ralph can also be claimed as a dependent under the qualifying relative rules since his gross income is less than $3,400. If his gross income exceeded $3,400, he would not have met the gross income test.

 

31. Determine whether each of the following individuals can be claimed as a dependent in the current year. Assume that any tests not mentioned have been satisfied.

a. Victor gives his mother, Maria, $10,000 a year to help pay for her food, rent, and other household costs. Her only income is $8,000 in Social Security benefits.

Victor's mother is his dependent. The Social Security is not taxable because Maria's adjusted gross income is less than $25,000. The support test is met because Victor pays more than 50% {10,000 > [50% x ($10,000 + $8,000)]} of his mother's support.

b. Manuel is 22 years old and a full-time student. He lives at home with his parents, who pay $7,000 in college expenses and other costs to support him. During the year, he earns $5,600 working as a sales clerk in a department store of which he saves $600 and spends the rest on his support.

Manuel is a dependent under the qualifying child rules. He is less than 24 years of age and a full-time student and his parent’s have met the non-support test since he fails to provide more than one-half of his support.

c. Assume the same facts as in part b, except that Manuel is 25 years old.

Manuel is a not dependent of his parents. Because he is over 23 years of age, Manuel fails the age test to be considered a qualifying child. Because his gross income of $5,600 exceeds the $3,400 personal exemption amount, he fails the gross income test and is not a qualifying relative.

d. Michael and Veronica are divorced in the current year. Michael is required to pay $400 per month in child support. Veronica has custody of their 4-year-old son and pays the other $200 per month it costs to support him.

Veronica receives the exemption. The custodial parent receives the dependency exemption unless the noncustodial parent in entitled to the exemption through a separation agreement or divorcee decree or Veronica agrees in writing that Michael can take the exemption deduction. The written agreement must be attached to Michael’s tax return.

 

e Bettina pays all of the support for her father, Salvador, who lives in Mexico City.

Bettina's father is a dependent. The citizen or residency requirement is met if the dependent is a citizen of the United States or a resident of Canada, or Mexico for any part of the tax year. Therefore, Bettina’s father meets the residency requirement.

32. Determine the filing status in each of the following situations:

a. Angela is single for most of the year. She marries Tim on December 30.

Filing status is determined on the last day of the tax year. Angela is married, and must either file jointly with Tim or as married, filing separately.

b. Earl is divorced during the current year. Their son lives with Earl's former spouse. Earl lives alone.

Earl is single. Given the facts, he qualifies as a head of household only if his son is either a qualifying child or qualifying relative and he provided more than 50% of the cost of maintaining the household. Note: This assumes that Earl’s son lives with him for more than six months during the year.

 

c. Rita is married to Bob, and they have 2 children, ages 2 and 4, at home. Bob and Rita have a fight in March; Bob leaves and never returns. Rita has no idea where Bob is.

Assuming that Rita provides more than half of the cost of maintaining the home, she can file as a head of household under the abandoned spouse rule. NOTE: If Bob had left the home after June 30, the last half of the year requirement would not be met and Rita would have to file as married, filing separately. She most likely could not file a joint return as both taxpayers must sign the return.

d. Joe is single. He provides all the support for his parents, who live in a nursing home. Joe's parents' only source of income is from Social Security.

Joe's parents qualify as his dependents. Parents who qualify as dependents do not have to live in the household for Joe to qualify as a head of household.

e. Sam's wife died in February of last year. Their children are all of legal age and none lives in the household. Sam has not remarried.

Sam must file as a single individual. He cannot qualify as either a head of household or a surviving spouse because none of his children live in the home.

f. Would your answer to part e change if Sam has a dependent child who still lives in the home?

Sam may file as a surviving spouse (i.e., at joint return rates, deductions, etc.) because he has a dependent child who still lives in the home. This is only allowed for two years after the year of death.

33. Determine the 2007 filing status in each of the following situations:

a. Michaela and Harrison decide to separate on October 12, 2007. Before filing their 2007 tax return on February 18, 2008, Michaela files for and is granted a formal separation agreement.

Marital status is determined on the last day of the tax year. Because Michaela and Harrison are not legally separated on December 31, they are considered to be married for 2007. If they cannot agree to file a joint return, each must file a return as married filing separately.

 

b. Simon is single and owns a condominium in Florida. His father lives in the condominium, and Simon receives $1,000 per year from his father as rent. The total expenses of maintaining the condominium are $15,000. His father receives a pension of $25,000 and Social Security benefits of $8,000.

Simon is single. To obtain head of household status for support of his father, he must qualify as Simon’s dependent. He cannot be treated as a qualifying relative because his gross income ($25,000) exceeds the $3,400 personal exemption amount, so he fails the gross income test.

c. Nick is 32 years old and lives with his mother. He earns $36,000 a year and pays $4,000 a year toward the cost of maintaining the household. His mother, who is single, earns $60,000 and pays $8,000 toward the cost of maintaining the household.

Nick’s mother must file as single because Nick cannot be claimed as a dependent under either the qualifying child or qualifying relative tests.

 

d. Jamal’s wife died in 2005. He maintains a household for his twin daughters who are seniors in high school.

Jamal may file as a surviving spouse (i.e., at joint return rates, deductions, etc.) because he has two dependent children who still live in his home. This filing status is only allowed for 2006 and 2007. Instructor’s Note: To be a surviving spouse for 2006 and 2007, at least one of his daughters must still live with him and is a qualifying child or qualifying relative. Beginning in 2008, Jamal’s filing status will be head of household.

e. Kathy and Sven are married with two children, ages 14 and 12. In June, Kathy leaves Sven and their children. Sven has not heard from Kathy, but a former coworker of Kathy’s tells Sven that Kathy wanted to move to Ireland.

Assuming that Sven provides more than half of the cost of maintaining the home, he can file as a head of household under the abandoned spouse rule. NOTE: If Kathy had left the home after June 30, the last half of the year requirement would not be met and Sven would have to file as married filing separately. He most likely could not file a joint tax return as both taxpayers must sign the return.

34. Determine the maximum deduction from AGI in 2007 for each of the following taxpayers:

a. Pedro is single and maintains a household for his father. His father is not a dependent of Pedro’s. Pedro’s itemized deductions are $6,400.

He will use his itemized deductions of $6,400 because it exceeds the standard deduction of $5,350 for a single taxpayer.

 

b. Jie and Ling are married. Jie is 66 years old, and Ling is 62. They have itemized deductions of $11,900.

They will use their itemized deductions of $11,900 because it exceeds their standard deduction of $11,750 ($10,700 regular standard deduction + $1,050 additional deduction for Jie being over age 65).

 

c. Myron and Samantha are married, and both are 38 years of age. Samantha is legally blind. They have itemized deductions of $10,500.

Their standard deduction is $11,750 ($10,700 regular standard deduction + $1,050 additional deduction for blindness). They will deduct the standard deduction because it is greater than their itemized deductions of $10,500.

 

d. Joelynn is divorced and maintains a home for her 21-year-old son, who is a part-time student at the local university. He pays less than one-half of his support and his earned income for the year is $3,000. Her itemized deductions are $7,200.

She will use the standard deduction for head of household of $7,850 because it exceeds her itemized deductions of $7,200. Joelynn qualifies as head of household because her son’s gross income is less than $3,400 (the personal exemption amount). Therefore, Joelynn would meet all the tests for her son to be considered a qualifying relative.

 

e. Frank is 66 years of age. During the year, his wife dies. His itemized deductions are $10,400.

For 2006, Frank is considered married. His standard deduction is $11,750 ($10,700 regular standard deduction + $1,050 additional deduction for being over age 65). He will deduct the standard deduction because it is greater than his itemized deductions of $10,400.

f. Assume the same facts as in part e, except that Frank’s wife dies in 2006.

For 2007, Frank is considered single (he doesn’t qualify for surviving spouse because he has no dependent children living in the home). His standard deduction is $6,650 ($5,350 regular standard deduction + $1,300 additional deduction for being over age 65). He will deduct his itemized deductions of $10,400 because it is greater than his standard deduction. Note: Frank does not receive any benefit (i.e., an increase in his itemized deductions) for being over 65. Being over 65 can only increase his standard deduction.

35. Determine the maximum deduction from AGI in 2007 for each of the following taxpayers:

a. Selen is single and has itemized deductions for the year of $5,800. In addition, Selen's mother lives with her, but she does not claim her mother as a dependent.

Selen is single. For Selen to file as head of household, her mother would have to be her dependent. She will use her itemized deductions of $5,800 because it is greater than her standard deduction of $5,350.

Amanda and Adam are married. Amanda is 67 years old and is legally blind. Adam is 64 years old. They have itemized deductions of $12,150.

Their standard deduction is $12,800 ($10,700 regular standard deduction + $1,050 additional deduction for blindness + $1,050 additional deduction for being over age 65). They will deduct the standard deduction because it is greater than their itemized deductions of $12,150.

Micah and Ilana are married and have two children. In April, they have an argument and Micah leaves Ilana. At year-end, Ilana is unaware of Micah’s whereabouts, and no formal divorce proceedings have been initiated. Ilana’s itemized deductions total $8,100.

Ilana cannot file married, filing joint because Micah must sign the tax return. The tax law does allow her to file as head of household since she meets the requirements of an abandoned spouse. She will use her itemized deductions of $8,100 because it exceeds her standard deduction of $7,850.

d. Constantino is divorced and maintains a home for his 25-year-old daughter who is a graduate student at a local university and earns $6,000 during the year. His itemized deductions are $5,800.

Constantino must file as single because his daughter does not qualify as his dependent (fails gross income test). He will use his itemized deductions of $5,800 since it exceeds his standard deduction of $5,350.

e. Helen is 69 and a widower. Her 20-year old grandson, who is a full-time student at the local university, lives with her for the entire year. Her husband, Sam, dies in 2006 at the age of 71. Her itemized deductions are $8,500.

For 2007, Helen is a head of household. A taxpayer qualifies as a surviving spouse if the dependent is her child, stepchild, foster child or adopted child. Because the dependent child is her grandson, she does not qualify as a surviving spouse. However, she does qualify as head of household and her standard deduction is $9,150 ($7,850 regular standard deduction + $1,300 additional deduction for being over age 65). She will deduct her standard deduction of $9,150 because it exceeds her itemized deductions of $8,500.

f. Assume the same facts as in part e, except that Sam dies in 2007.

For 2007, Helen is married. Her standard deduction is $12,800 ($10,700 regular standard deduction + $2,100 additional deduction for both being over age 65). She will deduct the standard deduction because it is greater than her itemized deductions of $8,500.

36. Hongtao is single and has a gross income of $89,000. His allowable deductions for adjusted gross income are $4,200 and his itemized deductions are $12,300.

a. What is Hongtao’s taxable income and tax liability for 2007?

Hongtao’s taxable income is $69,100:

Gross income $ 89,000

Deductions for AGI (4,200)

Adjusted gross income $ 84,800

Deductions from AGI

The greater of:

Standard deduction $ 5,350

or

Itemized deductions $12,300 (12,300)

Personal exemption (3,400)

Taxable income $ 69,100

Hongtao’s tax is $13,699. From the 2007 tax rate schedule, the tax on $69,100 is:

$4,386.25 + [25% x ($69,100 - $31,850)] = $13,699

b. If Hongtao has $13,900 withheld from his salary during 2007, is he entitled to a refund or does he owe additional taxes?

Hongtao has a refund of $201 ($13,699 - $13,900).

 

c. Assume the same facts as in parts a and b, except that Hongtao is married. His wife’s salary is $30,000, and she has $3,200 withheld from her paycheck. What is their taxable income and tax liability for 2007? Are they entitled to a refund, or do they owe additional taxes?

Their joint taxable income is $95,700:

Gross income ($89,000 + $30,000) $ 119,000

Deductions for AGI (4,200)

Adjusted gross income $ 114,800

Deductions from AGI

The greater of:

Standard deduction $10,700

or

Itemized deductions $12,300 (12,300)

Personal exemption (2 x $3,400) (6,800)

Taxable income $ 95,700

Their tax liability is $16,773. From the 2007 tax rate schedule, the tax on $95,700 is:

$8,772.50 + [25% x ($95,700 - $63,700)] = $16,773

They will receive a refund of $327 [$16,773 - ($13,900 + $3,200)].

37. Arthur and Cora are married and have 2 dependent children. For 2007, they have a gross income of $88,000. Their allowable deductions for adjusted gross income total $4,000, and they have total allowable itemized deductions of $14,250.

a. What is Arthur and Cora's 2007 taxable income?

Arthur and Cora have a taxable income of $56,150:

Gross income $ 88,000

Deductions for AGI (4,000)

Adjusted gross income $ 84,000

Deductions from AGI:

The greater of:

Itemized deductions $ 14,250

or

Standard deduction $ 10,700 (14,250)

Personal and dependency exemptions (4 x $3,400) (13,600)

Taxable income $ 56,150

 

b. What is Arthur and Cora's 2007 income tax?

The tax on a married couple filing jointly in 2007 is $7,640. Their net tax liability after the child tax credit is $5,728.

$1,565.00 + [15% x ($56,150 - $15,650)] = $ 7,640

Less: Child tax credit (2 x $1,000) (2,000)

Net tax liability $ 5,640

 

c. If Arthur has $2,900 and Cora has $3,000 withheld from their paychecks during 2007, are they entitled to a refund, or do they owe additional taxes?

They are entitled to a refund of $260 [$5,640 - ($2,900 + $3,000)].

 

38. Rebecca and Irving incur the following medical expenses during the current year:

Medical insurance premiums $4,100

Hospital 950

Doctors 1,225

Dentist 575

Veterinarian 170

Chiropractor 220

Cosmetic surgery 1,450

Over-the-counter drugs 165

Prescription drugs 195

Crutches 105

They receive $4,000 in reimbursements from their insurance company of which $300 is for the cosmetic surgery. What is their medical expense deduction if

a. Their adjusted gross income is $44,000?

Rebecca and Irving’s allowable medical costs before reimbursement are $7,370. The cosmetic surgery, veterinarian fees, and the over-the-counter drugs are not allowable medical expenses. Their unreimbursed medical costs are $3,670 [$7,370 - $3,700 ($4,000 - $300)]. The $4,000 reimbursement is reduced by the $300 reimbursement for the cosmetic surgery. The $3,670 of medical expenses is subject to the 7 1/2% AGI limitation.

Their allowable deduction is $370:

Medical insurance premiums $ 4,100

Hospital 950

Doctors 1,225

Dentist 575

Chiropractor 220

Prescription drugs 195

Crutches 105

Total Allowable medical expenses $ 7,370

Less: Insurance reimbursements (3,700)

Unreimbursed medical expenses $ 3,670

Less: AGI limitation ($44,000 x 7.5%) (3,300)

Medical expense deduction $ 370

 

b. Their adjusted gross income is $61,000?

No deduction is allowed. The AGI limit is $4,575 ($61,000 x 7.5%), which is greater than their $3,670 of unreimbursed costs.

 

 

39. Lian is injured in an automobile accident this year. She is hospitalized for 4 weeks and misses 3 months of work after getting out of the hospital. The costs related to her accident are

Hospitalization $ 16,100

Prescription drugs 2,050

Doctor's fees 12,225

Wheelchair rental 380

Visits by home nursing service 2,400

Lian's employer-provided insurance policy pays $23,220 of the costs. She also receives $4,800 in disability pay from her employer while she is absent from work. By the end of the year, Lian is able to pay $6,100 of the costs which aren't covered by her medical insurance. What is Lian's allowed itemized deduction for medical expenses if her adjusted gross income is $39,000 before considering any of the above information?

All of the costs incurred are qualified medical expenses. Lian's unreimbursed medical expenses are $9,935. However, as a cash basis taxpayer she can only deduct the $6,100 in unreimbursed costs she paid in the current year. In addition, she must include in her gross income the $4,800 of disability pay she received from her employer. This increases her adjusted gross income to $43,800 ($39,000 + $4,800) which gives her a medical expense deduction of $2,815:

Allowable medical expenses $ 33,155

Less: Insurance reimbursements (23,220)

Unreimbursed medical expenses $ 9,935

Unreimbursed medical expenses paid $ 6,100

Less: AGI limitation ($43,800 x 7.5%) (3,285)

Medical expense deduction $ 2,815

Note: The remainder of Lian’s unreimbursed medical expenses $3,835 ($9,935 - $6,100) are eligible for deduction when the expenses are paid.

40. Paula lives in Kansas which imposes a state income tax. During 2006, she pays the following taxes:

Federal tax withheld 5,125

State income tax withheld 1,900

State sales tax – actual receipts 370

Real estate tax 1,740

Property tax on car (ad valoreum) 215

Social Security tax 4,324

Gasoline taxes 124

Excise taxes 112

a. If Paula’s adjusted gross income is $35,000 what is her allowable deduction for taxes?

Paula is allowed an itemized deduction, the real estate tax and the property taxes she paid on the car during the year. In addition, she can elect to deduct the greater of the amount she paid in state income taxes or the amount of her sales tax deduction. In determining the amount of her sales tax deduction, Paula deducts the greater of the actual amount paid in sales tax or the IRS table amount. She can also add to the table amount any taxes she paid to acquire motor vehicles, boats, and other items specified by the IRS.

Because the table amount of $530 is greater than the actual amount of $370, her sales tax deduction is $530. Since the amount Paula paid in state income taxes ($1,900) is greater than her sales tax deduction, Paula would deduct her state income taxes. The Social Security, gasoline and excise taxes are not allowable taxes. The federal income tax withheld is not a deductible tax but is a prepayment of Paula's federal tax liability. Paula’s deduction for taxes is $3,855:

State income tax withheld $1,900

Real estate tax 1,740

Property tax on car (ad valorem) 215

Total tax deduction $3,855

b. Assume the same facts as in part a, except that Paula pays $1,600 in sales tax on a motor vehicle she purchased during the year. What is Paula’s allowable deduction for taxes?

As discussed above, Paula can elect to deduct the greater of the amount she paid in state income taxes or the amount of her sales tax deduction. In determining the allowable amount of her sales tax deduction, Paula would take the greater of the actual amount paid in sales tax $2,130 ($530 + $1,600) or the $1,900 she paid in state income taxes. Since the total sales tax amount of $2,130 exceeds the amount Paula paid in state income tax ($1,900) she would elect to deduct her state sales taxes. Paula is allowed to deduct $4,085:

State sales tax $2,130

Real estate tax 1,740

Property tax on car (ad valoreum) 215

Total tax deduction $4,085

41. Jesse is a resident of New Jersey who works in New York City. He also owns rental property in South Carolina. During 2007, he pays the following taxes:

New Jersey state estimated tax payments $ 850

New York City income tax withheld 440

New York State income tax withheld 1,375

Federal Income tax withheld 6,310

Property tax - New Jersey home 2,110

South Carolina income taxes paid when filing 2006 tax return 220

South Carolina estimated tax payments 400

Gasoline taxes 190

Excise taxes 160

During 2007, Jesse’s 2005 New York State and New York City tax returns are audited. Based on the audit, he pays an additional $250 in New York City taxes but receives a refund of $185 in New York State taxes. He also has to pay a $40 penalty and interest of $12 to New York City. However, he receives interest of $16 from New York State. What is Jesse’s allowable deduction for taxes in 2007?

Jesse is allowed to deduct, as an itemized deduction, all state and local income taxes and property taxes paid in 2007, regardless of which year they relate to. The gasoline and excise taxes, interest and penalties on the audited tax returns are not allowable taxes. He is allowed to deduct $5,645, as follows:

2007 New Jersey state estimated tax payments $ 850

2007 New York City income tax withheld 440

2007 New York State income tax withheld 1,375

2007 Property tax - New Jersey home 2,110

2007 South Carolina estimated tax payments 400

South Carolina income taxes paid when filing 2006 tax return 220

New York City income tax paid on audit of 2005 tax return 250

Total taxes paid in 2007 $5,645

The federal income tax withheld is not a deductible tax but it is a prepayment of Jesse's federal tax liability.

Note: The $185 refund of New York State taxes received in 2007 is included in 2007 gross income under the tax benefit rule. It is not used to offset the previous year’s taxes paid deduction. The interest received is also included as income in 2007.

 

 

42. Simon is single and a stockbroker for a large investment bank. During 2007, he has withheld from his paycheck $2,350 for state taxes and $400 for city taxes. In June 2008, Simon receives a state tax refund of $145. What is the proper tax treatment of the refund in 2008 if

a. Simon uses the standard deduction?

Because Simon uses the standard deduction ($5,350) in 2007, he does not have to include the income tax refund in his 2008 taxable income. He would only include the refund or a portion of it, if he had itemized his deductions and deducted more state and city taxes then he actually owed (he received a tax benefit).

 

b. Simon has itemized deductions other than state and city income taxes of $4,300?

Simon must include the $145 income tax refund in his 2008 taxable income. He has deducted $2,750 in state and city taxes in 2007 when his actual state and city taxes should have been $2,605 [$400 + ($2,350 - $145 refund)]. Therefore, his total itemized deductions were overstated by $145 [reported as $7,050 ($4,300 + $2,750) instead of $6,955 ($4,300 + $2,605)].

 

c. Simon has itemized deductions other than state and city income taxes of $2,650?

Simon must include $50 of the income tax refund in his 2008 taxable income. As in part b, Simon has deducted $2,750 in state and city taxes in 2007 when his actual state and city taxes should have been $2,605 [$400 + ($2,350 - $145 refund)]. However, even though Simon’s reported deductions of $5,400 ($2,650 + $2,750) exceed his actual deductions of $5,255 ($2,650 + $2,605) by $145, Simon has benefited only by the amount his reported deductions exceed the standard deduction of $5,350. Remember, at a minimum Simon is entitled to the standard deduction. Therefore, Simon only includes $50 ($5,400 - $5,350) of the tax refund in his income for 2008.

 

43. Frank and Liz are married. During 2007, Frank has $2,800 in state income taxes withheld from his paycheck, and Liz makes estimated tax payments totaling $2,200. In May 2008, they receive a state tax refund of $465. What is the proper tax treatment of the refund in 2008 if

They use the standard deduction?

Because they use the standard deduction ($10,700) in 2007, they do not have to include the income tax refund in their 2008 taxable income. They would only include the refund or a portion of it, if they had itemized their deductions and deducted more state taxes then they actually owed (i.e., received a tax benefit).

 

b. They have itemized deductions other than state income taxes of $7,400?

Frank and Liz must include the $465 income tax refund in their 2008 taxable income. They deducted $5,000 ($2,800 + $2,200) in state taxes in 2007 when their actual state taxes should have been $4,535 ($5,000 - $465 refund). Therefore, their total itemized deductions were overstated by $465 [reported as $12,400 ($7,400 + $5,000) instead of $11,935 ($7,400 + $4,535)].

 

They have itemized deductions other than state income taxes of $5,900?

Frank and Liz must include $200 of the income tax refund in their 2008 taxable income. As in part b, they have deducted $5,000 in state taxes in 2007 when their actual state should have been $4,535 ($5,000 - $465 refund). However, even though their reported deductions of $10,900 ($5,000 + $5,900) exceed their actual deductions of $10,435 ($4,535 + $5,900) by $465, Frank and Liz have benefited only by the amount their reported deductions exceed the standard deduction of $10,700. Remember, at a minimum they are entitled to the standard deduction. Therefore, they only include $200 ($10,900 - $10,700) of the tax refund in income on their 2008 tax return.

 

 

 

44. Rocco owns a piece of land as investment property. He acquired the land in 1984 for $18,000. On June 1, 2007, he sells the land for $80,000. As part of the sale, the buyer agrees to pay all of the property taxes ($3,600) for the year.

a. What is Rocco’s gain on the sale of the land?

Because the buyer paid the real estate tax, the sale price is increased by the amount of Rocco’s share of the real estate tax liability assumed by the buyer of the land. The allocation of the real estate taxes is based on the number of days Rocco owned the property during the year (151 days from January 1 to May 31), resulting in the buyer effectively paying Rocco an additional $1,489 [$3,600 x (151 ÷ 365)] for the land. The sales price of the land, after adjustment for the real estate tax, is $81,489 ($80,000 + $1,489).

Rocco has a gain of $63,489 on the sale of the land:

Amount realized ($80,000 + $1,489) $ 81,489

Adjusted basis (18,000)

Gain on sale $ 63,489

 

b. What amount of the property taxes can Rocco deduct? What amount can the buyer deduct?

Rocco is only allowed to deduct the taxes paid for the portion of the year he owned the land. This allocation is based on the number of days he owned the property during the year (151 days from January 1 to May 31), resulting in a deduction of $1,489 [$3,600 x (151 ÷ 365)].

Likewise, the buyer is only allowed to deduct the taxes for the portion of the year (June 1 to December 31) he owned the land. The buyer can deduct $2,111 ($3,600 - $1,489) of property taxes.

 

c. What is the buyer’s basis in the land?

The buyer is allowed to increase their basis in the land by the amount of real estate taxes paid on behalf of the seller. Therefore, their basis in the land is $81,489 ($80,000 + $1,489).

Instructor’s Note: Although technically, the allocation is based on the number of days, using 5 months results in approximately the same deduction $1,500 [$3,600 x (7 ÷ 12)]. The $11 difference ($1,500 - $1,489) is due to rounding.

 

 

 

45. Robin purchases a new home costing $80,000 in the current year. She pays $8,000 down and borrowed the remaining $72,000 by securing a mortgage on the home. She also pays $1,750 in closing costs, and $1,600 in points to obtain the mortgage. She pays $4,440 in interest on the mortgage during the year. What is Robin's allowable itemized deduction for interest paid?

Robin is allowed to deduct the interest paid on the acquisition debt, $4,440, and the points paid to obtain the initial mortgage $1,600, for a total allowable home mortgage interest deduction of $6,040. The closing costs are not deductible interest and are added to the basis of the home.

 

 

 

 

 

 

 

 

 

 

46. On March 1, Roxanne acquires a house for $160,000. She pays $20,000 down and borrows the remaining $140,000 by obtaining a 15-year mortgage. Roxanne pays $3,500 in closing costs and $2,500 in points in purchasing the house. During the year, she pays $10,300 of interest on her mortgage.

 

a. What is her allowable interest deduction for the year?

Roxanne is allowed to deduct the interest paid on the acquisition debt, $10,300, and the points paid to obtain the initial mortgage $2,500, for a total allowable home mortgage interest deduction of $12,800. The closing costs are not deductible interest and are added to the basis of the home.

 

b. How would your answer to part a change if Roxanne already owned her home and the points paid on March 1 were for a 15-year mortgage to refinance her existing mortgage?

Points are only deductible in full in the year paid if they are paid to obtain an initial mortgage. Points paid to refinance an existing mortgage must be amortized over the term of the new loan. In Roxanne's case, the $2,500 of points are deductible over the 15 year term of the new loan, $167 ($2,500 ÷ 15) per year. Because the refinancing occurs in March, she can only amortize 10 months of the points in the current year. Thus, only $139 [$167 x (10 ÷ 12)] is deductible. Her total allowable home mortgage interest deduction is $10,439 ($10,300 + $139).

 

47. Keith bought his home several years ago for $110,000. He paid $10,000 down on the purchase and borrowed the remaining $100,000. When the home is worth $230,000 and the balance on his mortgage is $40,000, Keith borrows $120,000 using a home equity loan. Keith uses the proceeds of the loan to pay off some gambling debts. During the year, Keith pays $3,200 in interest on the original home mortgage and $7,600 in interest on the home equity loan. What is Keith's allowable itemized deduction for interest paid?

A deduction is allowed for interest paid on acquisition debt of up to $1,000,000 and on home equity loans secured by the residence up to $100,000. In addition, the total acquisition debt and home equity debt cannot exceed the fair market value of the property. In this case, the total debt is $160,000 ($40,000 + $120,000), which is less than the fair market value. However, only interest on $100,000 of the home equity loan is deductible, $6,333 [$7,600 x ($100,000 ÷ $120,000)]. The remaining $1,267 of interest is considered personal interest and is not deductible. All of the interest on the original home mortgage, $3,200, qualifies for deduction. Keith's total interest deduction is $9,533 ($6,333 + $3,200).

Note: The proceeds of the home equity loan may be used for any purpose; the only requirement for deductibility of a home equity loan is for the loan to be secured by the residence.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

48. Astrid originally borrowed $600,000 to acquire her home. When the balance on the original mortgage is $540,000, she purchases a ski chalet by borrowing $500,000, which is secured by a mortgage on the chalet. Astrid pays $45,000 in interest on her home mortgage and $32,000 in interest on the chalet's mortgage. What is Astrid's allowable itemized deduction for interest paid?

Interest paid on up to $1,000,000 of acquisition debt on the taxpayer's principal residence and one other residence may be deducted. In this case, Astrid's total acquisition debt on the two properties is $1,040,000 ($540,000 + $500,000). However, because she has equity in the original home, Astrid's $500,000 loan on the ski chalet consists of two components $460,000 of acquisition indebtedness and a $40,000 home equity loan. Astrid's has an allowable mortgage interest deduction of $77,000 ($45,000 + 32,000). Instructor's Note: The solution assumes that the fair market of Astrid's original home is at least $580,000.

 

 

49. Mandy is interested in purchasing a new automobile for personal use. The dealer is offering a special 1.9% interest rate on new cars. Last fall, she opened a home equity line of credit with her bank. If she uses the line of credit to purchase the car, the interest rate will be 7.95%. Write a letter to Mandy explaining whether she should finance the purchase of her car through the dealer or use her home equity line of credit. Assume Mandy is in the 35% tax bracket.

Mandy should finance the purchase of her new automobile through the dealer instead of the bank. Even though the interest expense on the home equity loan is tax deductible, while the interest on the loan from the car dealer is nondeductible personal interest, the after-tax cost of the home equity loan is higher. The after-tax interest rate on the home equity loan is 5.17% [(1 - .35) x 7.95%) versus 1.9% [(1 - .00) x 1.90%) if she finances the purchase through the car dealer.

 

 

50. Marjorie is single and has the following investment income:

Interest on savings $2,900

Municipal bond interest 1,500

Dividends 7,600

She pays investment interest expense of $15,000. The interest expense relates to all of the assets in her portfolio.

a. What is Marjorie’s allowable deduction for investment interest?

Investment interest is limited to net investment income. Marjorie's net investment income is $2,900 (she has no investment expenses). The $1,500 of municipal bond interest is excluded from tax and is not investment income for purposes of the investment interest limitation. Dividends receive special tax treatment and are taxed at 15%. Because of the preferential tax treatment, unless Marjorie elects otherwise, the dividends are not included as part of investment income.

The $15,000 of interest is paid to produce $10,500 of taxable income and $1,500 of tax-exempt income. The portion of the interest related to the production of the tax-exempt income is not deductible. Therefore, $1,875 [$15,000 x ($1,500 ÷ $12,000)] of the interest is not deductible. Marjorie’s investment interest expense is $13,125 ($15,000 - $1,875). Because this amount exceeds her investment income, Marjorie’s investment interest deduction is limited to $2,900. The remaining $10,225 ($13,125 - $2,900) is carried forward to the following year.

 

b. Assume that Marjorie’s marginal tax rate is 28%. If she sells stock that produces a long-term capital gain of $3,000, how will the sale of stock affect her investment interest deduction?

Marjorie's net investment income remains $2,900. Long-term capital gain income cannot be counted as investment income if the taxpayer takes advantage of the 15% capital gain rate. Because Marjorie’s marginal tax rate is 28%, she will be taking advantage of the favorable 15% tax rate and therefore, cannot include the capital gain income in determining her net investment income.

The $3,000 of capital gain income requires that the amount of deductible interest be recalculated from part a. The $15,000 of interest now produces $13,500 ($3,000 + $10,500) of taxable income and $1,500 of tax-exempt income. The portion of the interest related to the production of the tax-exempt income is not deductible. Therefore, $1,500 [$15,000 x ($1,500 ÷ $15,000)] of the interest is not deductible. Marjorie’s investment interest expense is $13,500 ($15,000 - $1,500). Because this amount exceeds her investment income, Marjorie’s investment interest deduction is limited to $2,900. The remaining $10,600 ($13,500 - $2,900) is carried forward to the following year.

 

 

51. Stoycho and Selen are married and have the following investment income for 2006 and 2007:

2006_ 2007_

Interest on U.S. Treasury notes $ 1,200 $ 1,400

Cash dividends 3,000 2,200

Interest on savings 2,000 1,500

Interest on State of Montana bonds 800 800

Net long-term capital gain 1,000 500

Their adjusted gross income before considering the investment income is $84,000 in 2006 and $73,500 in 2007. Stoycho and Selen pay $9,000 in investment interest in 2006 and $5,000 in 2007. The investment interest is incurred to acquire all the investments in their portfolio. Write a letter to Stoycho and Selen explaining how much investment interest they can deduct in 2006 and 2007.

The investment interest deduction is limited to their net investment income. In 2006, their investment income is $3,200 ($1,200 + $2,000). The interest received on the municipal bonds is tax-exempt and therefore, not allowed for purposes of computing the allowable investment interest deduction. The net long-term capital gain cannot be used in the calculation of gross investment income because it will be taxed at 15%. Dividends receive special tax treatment and are taxed at a maximum rate of 15%. Because of the preferential tax treatment, unless Stoycho and Selen elect otherwise, the dividends are not included as part of investment income.

The $9,000 of interest is paid to produce $7,200 of taxable income and $800 of tax-exempt income. The portion of the interest related to the production of the tax-exempt income is not deductible. Therefore, $900 [$9,000 x ($800 ÷ $8,000)] of the interest is not deductible. Their investment interest expense is $8,100 ($9,000 - $900). Because this amount exceeds their investment income, their investment interest deduction is limited to $3,200. The remaining $4,900 ($8,100 - $3,200) is carried forward to the following year.

In 2007, Stoycho and Selen have investment income of $2,900 ($1,400 + $1,500). As in 2006, the interest received on the municipal bonds is tax-exempt and therefore, not allowed for purposes of computing the allowable investment interest deduction. In addition, the dividends and the net long-term capital gain cannot be used in the calculation of gross investment income because it will be taxed at 15%.

The $5,000 of interest is paid to produce $5,600 of taxable income and $800 of tax-exempt income. The portion of the interest related to the production of the tax-exempt income is not deductible. Therefore, $625 [$5,000 x ($800 ÷ $6,400)] of the interest is not deductible. Their investment interest expense is $4,375 ($5,000 - $625). Because $4,375 exceeds their investment income, their investment interest deduction is limited to $2,900. The remaining $1,475 ($4,375 - $2,900) along with the $4,900 from 2006 is carried forward to the following year. Their total carryforward to 2008 is $6,375 ($4,900 + $1,475).

52. Liang pays $12,000 in interest on debt which was used to purchase portfolio investments. He receives $6,000 in interest from a certificate of deposit, $4,200 in royalties, and $2,000 in interest on municipal bonds during the year. His investment-related expenses total $700. Liang's adjusted gross income is $75,000.

a. Assuming that Liang has no other qualifying miscellaneous itemized deductions during the year and that none of the debt is used to acquire the municipal bonds, how much of the $12,000 in interest paid can he deduct?

Liang's investment interest deduction is limited to his net investment income. Gross investment income is $10,200 ($6,000 + $4,200). The interest received on the municipal bonds is tax-exempt and therefore, not allowed for purposes of computing the allowable investment interest deduction. Because none of the debt is used to acquire the municipal bonds, none of the investment interest is allocated to the bonds. However, the portion of the investment expenses attributable to tax-exempt income is not deductible. As discussed in Chapter 5, the nondeductible portion of the investment expenses is calculated based on the proportion of tax-exempt income ($2,000) to total income, $12,200 ($2,000 + $4,200 + $6,000). Therefore, $115 [$700 x (2,000 ÷ $12,200)] of the investment expenses are nondeductible. The remaining $585 ($700 - $115) of investment expenses are used in the calculation of net investment income. Investment expenses are those allowable after application of the 2% miscellaneous itemized deduction limitation. In this case, the 2% limitation is $1,500 ($75,000 x 2%), leaving no deductible investment expenses. Liang's investment interest deduction is equal to the investment income of $10,200. The remaining $1,800 ($12,000 - $10,200) of investment interest is carried forward to the next year.

 

b. What would Liang's deduction be if he also had $1,000 in qualifying miscellaneous itemized deductions (employee business expenses)?

In determining the amount of investment expenses applied against the 2% AGI limit, all other miscellaneous deductions must be applied against the limit first. In this case, the $1,000 of other miscellaneous expenses is applied to the $1,500 limit first. This leaves only $500 of Liang's $585 deductible investment expenses (as discussed in a) to be used against the limit and an investment expense deduction of $85. His net investment income is $10,115 ($10,200 - $85), resulting in deductible investment interest of $10,115. The remaining $1,885 ($12,000 - $10,115) is carried forward to next year.

 

c. Assume that in part b, the qualifying expenses total $2,700.

In this case, none of Liang's investment expenses are applied against the limit (the $2,700 of other miscellaneous expenses totally uses up the $1,500 limit), leaving net investment income at $9,615 ($10,200 - $585) and deductible investment interest of $9,615. The remaining $2,385 ($12,000 - $9,615) of investment interest is carried forward to next year.

 

53. Jana gives property worth $54,000 to her alma mater during the current year. She purchased the property several years ago for $32,000.

a. What is Jana's maximum deduction if the property is ordinary income property?

The allowable amount of the deduction for ordinary income property is the lower of the adjusted basis or the fair market value of the property. In this case, the allowable deduction amount is $32,000, the adjusted basis.

 

b. What is Jana's maximum deduction if the property is long-term capital gain property?

Long-term capital gain property may be deducted at the fair market value of the property, Jana's maximum allowable deduction amount is the $54,000 fair market value.

 

c. How would your answer change if Jana's adjusted gross income were $60,000?

If Jana's AGI is $60,000, her charitable contribution in both (a) and (b) are limited. In case (a), her maximum charitable deduction is limited to 50% of her adjusted gross income. Because the basis of the property is greater than 50% of her AGI [$32,000 > $30,000 ($60,000 x 50%)], her charitable contribution deduction is limited to $30,000. The remaining $2,000 ($32,000 - $30,000) can be carried forward for deduction in the succeeding 5 years.

In case (b), the maximum charitable contribution deduction for property valued at fair market value is limited to 30% of adjusted gross income. Because the fair market value of the property is greater than 30% of her AGI [$54,000 > $18,000 ($60,000 x 30%)], her charitable contribution is limited to $18,000. The remaining $36,000 ($54,000 - $18,000) is carried forward for deduction in the succeeding 5 years.

Note Jana can elect to reduce the amount of her contribution to the basis of the property, $32,000 and avoid the 30% limitation. This would allow the same charitable contribution deduction as in case (a).

 

54. Determine the allowable charitable contribution in each of the following situations:

a. Karen attends a charity auction where she pays $250 for two tickets to a Broadway show. The tickets have a face value of $150.

Karen is only allowed to deduct the amount paid in excess of the fair market value of the two tickets, $100 ($250 - $150). She cannot receive a charitable contribution for the $150 value of the tickets because she received a benefit (i.e., seeing the show) for that portion of her contribution.

 

b. State University holds a raffle to benefit the football team. Each raffle ticket costs $100, and only 500 tickets are sold, with the winner receiving $10,000. Gary buys two raffle tickets but does not win the $10,000 prize.

The $100 paid to purchase the raffle tickets is not a charitable contribution.

 

c. Peter is a nurse at a local hospital and earns $150 per day. One Saturday a month, he volunteers 8 hours of his time at a medical clinic in a neighboring town. The round-trip distance from Peter’s home to the clinic is 25 miles.

No deduction is allowed for the value of a person's time donated to charitable work. However, Peter is allowed to deduct 14 cents a mile for travel to and from the hospital. Peter’s charitable contribution is $42

(14 cents x 25 miles x 12 months).

d. Jordan donates stock with a fair market value of $36,000 to Caulfield College. She acquired the stock in 1991 for $13,000. Her adjusted gross income is $60,000.

Jordan’s charitable contribution is $36,000. Property valued at fair market value is limited to a maximum deduction of 30% of adjusted gross income. Jordan can deduct $18,000 ($60,000 x 30%) in the current year. The remaining $18,000 ($36,000 - $18,000) is carried forward for 5 years.

 

55. Miguel is a successful businessman who has been approached by St. Kilda University to make a donation to its capital campaign. He agrees to contribute $75,000, but he is unsure which of the following assets he should contribute:

Fair Market

Asset Basis Value

Ordinary income property $ 41,000 $ 75,000

Long-term capital gain property 84,000 75,000

Long-term capital gain property 32,000 75,000

Write a letter to Miguel advising him which property he should contribute to St. Kilda's capital campaign.

The amount of the contribution for ordinary income property is limited to the lesser of the property's fair market value at the date of the gift or the property's adjusted basis. Therefore, any appreciation in the value of ordinary income property is not allowed as a deduction. Long-term capital gain property may be valued at fair market value. Thus, appreciation in the value of a long-term capital gain property is allowed as a deduction (and is not subject to tax). However, any property valued at fair market value is limited to a maximum deduction of 30% of adjusted gross income. The taxpayer can elect to treat the long-term capital gain property as ordinary income property (i.e., value of the property at it's adjusted basis) and be subject to the 50% limitation. Any amounts in excess of the limits are carried forward for five years and applied to the carryforward years limitations after the current years' contributions have been applied.

Miguel should contribute the long-term capital gain property that has a basis of $32,000. If Miguel contributes the ordinary income property his charitable contribution is limited to his basis in the property, $41,000. Contributing either long-term capital gain property results in a charitable contribution deduction of $75,000. However, if he contributes the property with a basis of $84,000, Miguel loses the benefit of being able to recognize the $9,000 ($75,000 - $84,000) loss. If he contributes the property with a basis of $32,000, he does not recognize the $44,000 ($75,000 - $32,000) gain on its appreciation, yet is allowed to increase his charitable contribution by the value of the appreciation.

Instructor’s Note: If for other reasons Miguel wants to contribute the long-term capital gain property with a basis of $84,000, he should sell the property and realize the $9,000 loss. Assuming he does not have any capital gains, he will recognize a $3,000 capital loss. The amount of his donation to St. Kilda is the same, $75,000. However, instead of receiving property, St. Kilda would receive cash.

 

 

56. Kweisi incurs the following employment-related expenses during the year:

Airfare $2,000

Lodging 1,500

Meals 1,200

Entertainment 800

Incidentals 500

His employer maintains an accountable reimbursement plan and reimburses him $4,500 for his expenses. He also has $1,600 of other allowable miscellaneous expenses. What is his allowable deduction if

a. His adjusted gross income is $52,000?

With an accountable plan and a reimbursement less than actual expenses ($6,000), Kweisi includes the $4,500 reimbursement in gross income. The $4,500 of reimbursed costs are a deduction for adjusted gross income. The $1,500 of unreimbursed expenses are deductible as miscellaneous itemized deductions. The unreimbursed portion of each expense is 25% ($1,500 ÷ $6,000). Kweisi is subject to the 50% limit on meals and entertainment for his itemized deductions, leaving him with allowable unreimbursed employee business expenses of $1,250:

Airfare ($2,000 x 25%) $ 500

Lodging ($1,500 x 25%) 375

Meals ($1,200 x 25% x 50%) 150

Entertainment ($800 x 25% x 50%) 100

Incidentals ($500 x 25%) 125

Total unreimbursed employee business expenses $ 1,250

The $1,250 of unreimbursed employee business expenses is added to the other allowable miscellaneous itemized deductions of $1,600 and the total is deductible to the extent it exceeds 2% of Kweisi’s adjusted gross income.

Unreimbursed employee business expenses $ 1,250

Other miscellaneous itemized deductions 1,600

Total allowable miscellaneous itemized deductions $ 2,850

Less: 2% x $52,000 (1,040)

Allowable itemized deduction $ 1,810

 

 

b. Assume the same facts as in part a, except that Kweisi’s employer has a nonaccountable reimbursement plan and Kweisi receives $4,500 from the plan to pay for his business expenses.

 

If the plan is nonaccountable, the $4,500 reimbursement is included in gross income, increasing it to $56,500 ($52,000 + $4,500). Kweisi is not allowed to deduct any of his expenses for adjusted gross income. Kweisi can only deduct the costs as miscellaneous itemized deductions, subject to the 2% of adjusted gross income limitation. The meals and entertainment expenses are subject to the 50% limit, resulting in a$5,000 of employee business expenses.

Airfare $ 2,000

Lodging 1,500

Meals ($1,200 x 50%) 600

Entertainment ($800 x 50%) 400

Incidentals 500

Total itemized deduction $ 5,000

The $5,000 of employee business expenses is added to the other allowable miscellaneous itemized deductions of $1,600 and the total is deductible to the extent it exceeds 2% of Kweisi’s adjusted gross income.

Unreimbursed employee business expenses $ 5,000

Other miscellaneous itemized deductions 1,600

Total allowable miscellaneous itemized deductions $ 6,600

Less: 2% x $56,500 (1,130)

Allowable itemized deduction $ 5,470

 

 

 

57. Trevor is an English professor at Clayton College. His adjusted gross income for the year is $58,000 including $5,000 he won at the racetrack. Trevor incurs the following during the year:

Investment advice $ 550

Subscriptions to academic journals 240

Dues to academic organizations 275

Attorney fee for tax advice relating to his divorce 325

Parking at the university 100

Safe-deposit box 75

Gambling losses 450

Sport coats worn exclusively at work 750

What is Trevor’s allowable miscellaneous itemized deduction?

Trevor is not allowed to deduct his parking at the university or his sports coats. Trevor’s personal decision not to wear the sport coats outside of work does not make the cost of the coats a deductible business expense. The amount of the legal fees paid for tax advice relating to his divorce is deductible assuming the bill specifies how much of the fee is for tax advise. The gambling losses (to the extent of winnings) are a miscellaneous itemized deduction but are not subject to the 2% of AGI limitation. Trevor's total allowable itemized deductions before the 2% AGI limitation are $1,465. This is reduced by the 2% of adjusted gross income limitation on miscellaneous itemized deductions and his allowable itemized deduction is $755.

Investment advice $ 550

Subscriptions to academic journals 240

Dues to academic organizations 275

Attorney fee for tax advice relating to his divorce 325

Safe-deposit box 75

Total allowable deductions $ 1,465

Less: $58,000 x 2% (1,160)

Miscellaneous itemized deduction subject to 2% of AGI $ 305

Gambling losses 455

Allowable miscellaneous itemized deductions $ 755

 

58. Edna works as a marketing consultant. In her spare time, she enjoys painting. Although she sells some of her work at local craft shows, she either displays most of her paintings at home or gives them to family and friends. During the year, she receives $750 from the sale of her paintings. The cost of producing the sold paintings and the cost of attending the crafts shows is $1,850. Edna has other allowable miscellaneous deductions of $1,400, and her adjusted gross income before considering her painting activity is $48,000. Write a letter to Edna explaining her allowable miscellaneous itemized deduction for the year.

Edna must include the $750 from the sale of the paintings in her gross income. Because the activity constitutes a hobby, deductions are limited to the $750 of income. The hobby expenses are deducted as a miscellaneous itemized deduction, subject to the 2% of AGI limitation.

Edna’s adjusted gross income after considering the income from her paintings is $48,750 ($48,000 + $750) and her total miscellaneous itemized deductions are $2,150 ($1,400 + $750). This is reduced by the 2% of adjusted gross income limitation on miscellaneous itemized deductions and her allowable itemized deduction is $1,175.

Total miscellaneous itemized deductions $2,150

Less: $48,750 x 2% (975)

Allowable miscellaneous itemized deduction $1,175

 

 

59. Lee is a college professor with an adjusted gross income of $32,000. Lee has a lot of bad luck this year. First, a tornado blows the roof off of his house, causing $4,900 in damage. His insurance company reimburses him only $1,200 for the roof damage. Later in the year, he is out at a local pub when his $625 car stereo is stolen. His insurance company does not pay for the stereo because it is worth only $400 at the time and Lee's policy does not cover losses of less than $500. What is Lee's allowable casualty and theft loss for the year?

Personal casualty and theft losses are measured as the lesser of the decline in value due to the casualty or theft or the adjusted basis of the property. Each loss occurring during the year is reduced by any insurance reimbursements and the $100 statutory floor. The total casualty and theft losses for the year are subject to a 10% of adjusted gross income annual limitation. Due to the two limitations (per occurrence and adjusted gross income), Lee’s casualty loss deduction is $700.

 

Amount of loss on roof (Damages) $ 4,900

Less: Insurance reimbursement (1,200)

Less: Statutory floor (100)

Allowable loss on roof $ 3,600

Amount of loss on stereo (FMV) $ 400

Less: Statutory floor (100)

Allowable loss on stereo 300

Total casualty and theft losses $ 3,900

Less: Annual loss limitation (10% x $32,000) (3,200)

Deductible casualty loss $ 700

 

 

60. Michael owns a hair salon. During the current year, a tornado severely damages the salon and destroys his personal automobile, which is parked outside. It costs Michael $12,000 to make the necessary repairs to the salon. He had paid $21,500 for the automobile, which was worth $17,100 before the tornado. Michael's business insurance reimburses him for $7,000 of the salon repair costs. His automobile insurance company pays only $12,000 for the automobile destruction. Michael’s adjusted gross income is $34,000 before considering the effects of the tornado. Write a letter to Michael explaining his deductible loss from the tornado.

The damage to the hair salon is a business casualty, which is deductible for adjusted gross income. The deductible loss is $5,000, the $12,000 cost of repairing the salon, less the $7,000 insurance reimbursement.

The loss on the automobile is a personal casualty loss, which is deductible as an itemized deduction. The amount of the loss is $17,100 (the lesser of the $21,500 basis or the $17,100 decline in value). The $5,100 unreimbursed personal casualty loss ($17,100 - $12,000 reimbursement) is reduced by the $100 statutory floor. The total casualty loss for the year is subject to a 10% of adjusted gross income annual limitation. Michael’s adjusted gross income is $29,000 ($34,000 - $5,000 business casualty loss). Therefore, the $5,000 allowable loss is reduced by $2,900 ($29,000 x 10%) and his casualty loss deduction is $2,100.

Amount of loss $ 17,100

Less: Insurance reimbursement (12,000)

Less: Statutory floor (100)

Allowable loss on automobile before 10% of AGI limitation $ 5,000

Less: Annual loss limitation (10% x $29,000) (2,900)

Deductible casualty loss $ 2,100

 

 

 

61. Orley is a single individual with no dependents who has an adjusted gross income of $173,900 in 2007. Orley's itemized deductions total $19,400, which includes $1,200 in deductible medical costs and $5,700 in investment interest.

a. What is Orley's 2006 taxable income?

Because Orley's AGI is in excess of $156,400, his itemized deductions are subject to the 3% phase-out rule. The $1,200 of medical costs and $5,700 of investment interest are not subject to the reduction rule, leaving $12,500 [$19,400 - $6,900 ($1,200 + $5,700)] which can be reduced. The reduction cannot exceed $10,000 (80% of $12,500).

For tax years beginning January 1, 2006, the phase-out for itemized deduction is gradually eliminated over a five-year period. For 2007, the calculated amount of the itemized deduction phase-out is reduced by one-third. For tax years 2008 and 2009, the calculated amount of the itemized deduction phase-out is reduced by two-thirds. Beginning in 2010, the phase-out for itemized deductions is eliminated.

His AGI in excess of $156,400 is $17,500 ($173,900 - $156,400). The reduction in his itemized deductions is $525 ($17,500 x 3%). Because the phase-out of itemized deductions is being eliminated over time, Orley’s calculated itemized deductions phase-out of $525 is reduced by $175 ($525 x 33.33%). Therefore, his itemized deductions are reduced by $350 ($525 - $175) and his deductible itemized deductions for the year are $19,050 ($19,400 - $350).

Orley's $3,400 exemption is subject to a phase-out because his AGI is over the $156,400 threshold for a single individual. As with the phase-out for itemized deduction, for tax years beginning January 1, 2006, the exemption deduction phase-out is gradually eliminated over a five-year period. For 2007, the calculated amount of the exemption deduction phase-out is reduced by one-third. For tax years 2008 and 2009, the calculated amount of the exemption deduction phase-out is reduced by two-thirds. Beginning in 2010, the phase-out for the exemption deduction is eliminated.

The $17,500 of excess AGI gives him 7 ($17,500 ÷ $2,500 = 7,) phase-out increments at 2% per increment, for a total loss of 14%. Because the phase-out of the exemption deduction is being eliminated over time, Ortley’s calculated exemption phase-out of $476 ($3,400 x 14%) is reduced by $159 ($476 x 33.33%). Therefore, his exemption is reduced by $317 ($476 - $159) and his personal exemption amount for the year is $3,083 ($3,400 - $317).

Orley's taxable income is $151,767 ($173,900 - $19,050 - $3,083).

 

 

b. Assume that Orley's adjusted gross income is $530,900. What is his 2007 taxable income?

Because Orley's AGI is in excess of $156,400, his itemized deductions are subject to the 3% phase-out rule. The $1,200 of medical costs and $5,700 of investment interest are not subject to the reduction rule, leaving $12,500 [$19,400 - $6,900 ($1,200 + $5,700)] which can be reduced. The reduction cannot exceed $10,000 (80% of $12,500). His AGI in excess of $156,400 is $374,500 ($530,900 - $156,400). The reduction in itemized deductions is $11,235 ($374,500 x 3%).

The calculated amount of $11,235 exceeds the maximum allowable reduction of $10,000. Because the phase-out of itemized deductions is being eliminated over time, Orley’s calculated itemized deductions phase-out of $10,000 is reduced by $3,333 ($10,000 x 33.33%). Therefore, his itemized deductions are reduced by $6,667 ($10,000 - $3,333) and his deductible itemized deductions for the year are $12,733 ($19,400 - $6,667).

In addition, Orley should lose his entire exemption deduction because his AGI exceeds $278,900, which is the AGI level at which all exemptions are lost for a single individual. Because the phase-out of the exemption deduction is being eliminated over time, Ortley’s calculated exemption phase-out of $3,400 is reduced by one-third $1,133 ($3,400 x 33.33%). Therefore, his exemption must be reduced by $2,267 ($3,400 - $1,133) and his personal exemption amount for the year is $1,133 ($3,400 - $2,267).

Orley's taxable income is $517,034 ($534,900 - $12,733 - $1,133).

 

62. Jeff and Marion are married with 3 dependents. Their adjusted gross income in 2007 is $180,900. Their itemized deductions total $34,600, including $4,900 in investment interest.

a. What is their 2007 taxable income?

Because Jeff and Marion’s AGI is in excess of $156,400, their itemized deductions are subject to the 3% phase-out rule. The $4,900 of investment interest is not subject to the reduction rule, leaving $29,700 ($34,600 - $4,900) which can be reduced. The reduction cannot exceed $23,760 (80% x $29,700). Their AGI in excess of $156,400 is $24,500 ($180,900 - $156,400).

For tax years beginning January 1, 2006, the phase-out for itemized deduction is gradually eliminated over a five-year period. For 2007, the calculated amount of the itemized deduction phase-out is reduced by one-third. For tax years 2008 and 2009, the calculated amount of the itemized deduction phase-out is reduced by two-thirds. Beginning in 2010, the phase-out for itemized deductions is eliminated.

The reduction in itemized deductions is $735 ($24,500 x 3%). Because the phase-out of itemized deductions is being eliminated over time, their calculated itemized deductions phase-out of $735 is reduced by $245 ($735 x 33.33%). Therefore, their itemized deductions are reduced by $490 ($735 - $245) and their deductible itemized deductions for the year are $34,110 ($34,600 - $490).

They are allowed two personal and three dependency exemptions for a total exemption deduction of $17,000 ($3,400 x 5). They are not subject to any phase-out because their AGI is less than the $234,600 starting threshold for phasing-out exemptions for a married couple.

Jeff and Marion's taxable income is $129,790 ($180,900 - $34,110 - $17,000).

 

b. Assume that their adjusted gross income is $239,900 and their itemized deductions remain the same. What is their 2006 taxable income?

Because Jeff and Marion’s AGI is in excess of $156,400, their itemized deductions are subject to the 3% phase-out rule. The $4,900 of investment interest is not subject to the reduction rule, leaving $29,700 ($34,600 - $4,900) which can be reduced. The reduction cannot exceed $23,760 (80% x $29,700). Their AGI in excess of $156,400 is $83,500 ($239,900 - $156,400). The reduction in itemized deductions is $2,505 ($83,500 x 3%).

Because the phase-out of itemized deductions is being eliminated over time, their calculated itemized deductions phase-out of $2,505 is reduced by $835 ($2,505 x 33.33%). Therefore, their itemized deductions are reduced by $1,670 ($2,505 - $835) and their deductible itemized deductions for the year are $32,930 ($34,600 - $1,670)

The phase-out threshold level for exemptions for a married couple filing jointly begins at $234,600. The entire $17,000 ($3,400 x 5) exemption amount is subject to the phase-out. The $5,300 ($239,900 - $234,600) of excess AGI gives them 3 ($5,300 ÷ $2,500 = 2.12, always round up) phase-out increments at 2% per increment, for a total loss of 6%. Because the phase-out of the exemption deduction is being eliminated over time, their calculated exemption phase-out of $1,020 ($17,000 x 6%) is reduced by $340 ($1,020 x 33.33%). Therefore, their exemptions are reduced by $680 ($1,020 - $340) and their personal exemption amount for the year is $16,320 ($17,000 - $680)).

Jeff and Marion's taxable income is $190,650 ($239,900 - $32,930 - $16,320).

 

 

63. Determine the taxable income of each of the following dependents in 2007:

a. Louis is 12 and receives $1,050 in interest income.

Because Louis is a dependent, his standard deduction is limited to $850 and he receives no personal exemption. His taxable income is $200 ($1,050 - $850).

 

b. Jackson is 16. He earns $2,000 from his newspaper route and receives $700 in dividends on GCM stock.

Jackson's standard deduction is $2,300 [(earned income + $300) > $850). This leaves him with a taxable income of $400 ($2,000 + $700 - $2,300).

 

c. Loretta is 18. She earns $5,000 as a lifeguard during the summer. In addition, Loretta wins a rescue contest and receives a municipal bond worth $550. During the year, the bond pays $20 in interest.

Loretta's gross income is $5,550 ($5,000 + $550). The $550 prize she received from the rescue contest is included in her gross income. The municipal bond interest is excluded from gross income. Her standard deduction is $5,150 (the greater of earned income + $300 or $850, but limited to the standard deduction for a single individual), leaving her with a taxable income of $400.

 

d. Eva is 15. Her income consists of municipal bond interest of $750, stock dividends of $1,300, and interest credited to her savings account of $650.

Eva's gross income is $1,950 ($1,300 + $650 -- all unearned) and her standard deduction is $850, leaving her a taxable income of $1,100.

 

e. Elaine is a college student. Her only income consists of $3,000 from her part-time job delivering pizzas. Her itemized deductions total $235.

Elaine's gross income is $3,000. Her standard deduction is $3,000 (earned income + $300 is greater than $850). The standard deduction is greater than her actual itemized deductions, leaving her with zero taxable income.

 

f. Greg is 2. He has certificates of deposit given to him by his grandparents that pay $2,250 in interest.

Greg's taxable income is $1,400 ($2,250 - $850 standard deduction).

 

 

64. For each of the dependents in problem 63, calculate the income tax on their taxable income. In each case, assume that their parents' taxable income is $128,000.

a. Even though Louis is a minor child, his unearned income is less than $1,700 and he is not subject to the tax rules on unearned income of a minor child. His $200 of taxable income is subject to the single taxpayer rates, and his tax liability is $20 ($200 x 10%).

b. Jackson is a minor child but his unearned income is less than $1,700, so he is not subject to the tax rules on unearned income of a minor child. Jackson pays a tax of $20 ($400 x 5%). Because Jackson is in the 10% tax bracket, his dividend income is taxed at 5%.

c. Loretta is not a minor child and pays a tax of $40 ($400 x 10%).

Eva is a minor child with unearned income greater than $1,700 and is subject to the tax rules on unearned income of a minor child. Her net unearned income is $250 ($1,950 - $850 - $850), which is taxed at her parent’s marginal tax rate. Her remaining taxable income of $850 ($1,100 - $250) is taxed per the single taxpayer schedule. At a taxable income of $128,000, the parent's marginal tax rate would be 25%.

Because Eva has dividend income which is taxed at a preferential rate, Eva has to calculate the percentage of her income that will receive the preferential rate. This percentage will also be used by Eva’s parent’s to determine the amount of Eva’s unearned income that will be taxed at their marginal tax rate and the amount that will be taxed at the 15% dividend tax rate. The amount that is taxed at the dividend rate is determined by dividing the amount of dividend income by total income. Therefore, 66.67% ($1,300 ¸ $1,950) of Eva’s taxable income will be taxed at the preferential rate and 33.33% (100% - 66.67%) will be taxed at the marginal tax rate.

Tax on dividend income at parent’s rate - ($250 x 66.67% x 15%) $ 25

Tax on other income at parent’s rate - ($250 x 33.33% x 25%) 21

Tax on remaining taxable income ($850 x 5%) 43*

Total tax on taxable income $ 89

NOTE: If the child’s pro rata share of the dividend income [($1,300 x 66.67% = $866) > $850] exceeds the child’s taxable income, the child’s entire share of taxable income is treated as dividend income and taxed at the favorable 5% tax rate. Without the "kiddie tax", Eva's tax would have been $55 ($1,100 x 5%).

e. Elaine is not a minor child and has no taxable income. Therefore, she is not liable for any tax.

 

f. Greg is a minor child with unearned income greater than $1,700 and is subject to the tax rules on unearned income of a minor child. His net unearned income is $550 ($2,250 - $850 - $850), which is taxed at his parent’s marginal tax rate. His remaining taxable income of $850 ($1,400 - $550) is taxed per the single taxpayer schedule. At a taxable income of $128,000, the parent's marginal tax rate is 25%.

Tax on net unearned income ($550 x 25%) $ 138

Tax on remaining taxable income ($850 x 10%) 85

Total tax on taxable income $ 223

NOTE: Without the "kiddie tax", Greg's tax would have been $140 ($1,400 x 10%).

65. Calculate the 2007 tax liability and the tax or refund due for each situation:

a. Mark is single with no dependents and has a taxable income of $50,000. He has $9,200 withheld from his salary for the year.

Mark's 2007 tax is $8,924 {$4,386.25 + [25% x ($50,000 - $31,850)]}. He will receive a refund of $276 ($8,924 - $9,200).

 

b. Harry and Linda are married and have taxable income of $50,000. Harry has $3,250 withheld from his salary. Linda makes estimated tax payments totaling $3,725.

Harry's and Linda's 2007 tax filing a joint return is $6,718 {$1,565.00 + [15% x ($50,000 - $15,650)]}. They receive a refund of $257 ($6,718 - $3,250 - $3,725).

 

c. Aspra is single. His 20 year old son, Calvin, lives with him throughout the year. Calvin pays for less than one-half of his support and his earned income for the year is $3,000. Aspra pays all costs of maintaining the household. His taxable income is $50,000. Aspra's withholdings total $7,600.

Aspra qualifies to file as head of household. Apara's 2007 tax is $7,675 {$5,837.50 + [25% x ($50,000 - $42,650)]}. Apara's has a tax due of $75 ($7,600 - $7,675). Note: Calvin qualifies as a dependent as a qualifying relative.

 

d. Randy and Raina are married. Because of marital discord, they are not living together at the end of the year, although they are not legally separated or divorced. Randy's taxable income is $20,000, and Raina's is $50,000. Randy makes estimated tax payments of $2,500, and Raina has $8,000 in tax withheld from her salary.

If Randy and Raina can get together and file a joint return, their tax on $70,000 in 2007 will be $10,348 {$8,772.50 + [25% x ($70,000 - $63,700)]}. If they each file separately, Randy's tax will be $2,609 {$782.50 + [($20,000 - $7,825) x 15%) and Raina's tax will be $8,924 [$4,386.25 + [25% x ($50,000 - $31,850)]}. Their total 2007 tax filing separately is $11,533 ($8,924 + $2,609), which is $1,185 ($10,348 - $11,533) more tax than they would pay on a joint return.

If Randy and Raina file jointly they will receive a $152 ($10,348 - $2,500 - $8,000) tax refund. If they file separately, Randy would owe additional tax of $109 ($2,609 - $2,500), and Raina would owe additional tax of $924 ($8,924 - $8,000).

 

 

 

66. Anika and Jespar are married and have two children ages 16 and 14. Their adjusted gross income for the year is $98,000. What amount can they claim for the child credit?

Anika and Jespar can claim a child credit of $2,000 ($1,000 x 2). A taxpayer can claim a $1,000 tax credit for each qualifying child. The definition of a qualifying child is similar to the definition of a qualifying child for dependency purposes except that the child must be under age 17 at the end of the tax year.

The credit is phased-out at a rate of $50 for each $1,000 of income (or fraction thereof) that a married taxpayer's adjusted gross income exceeds $110,000.

 

What amount can they claim for the child credit if their adjusted gross income is $117,600?

Anika and Jespar are allowed a child credit of $1,600 ($2,000 - $400). Because their adjusted gross income exceeds $110,000, the credit must be phased-out at a rate of $50 for each $1,000 of adjusted gross income (or fraction thereof) that exceeds $110,000. Anika and Jespar must reduce their child credit by $400.

$117,600 - $110,000 = $7,600 ¸ $1,000 = 7.6 (round to 8)

$50 x 8 = $400 reduction in credit.

 

b. What amount can they claim for the child credit if the children are ages 18 and 16 and their adjusted gross income is $96,000?

Anika and Jespar can claim a child tax credit only for the child that is 16 years old. Therefore, their child tax credit is $1,000.

67. Neville and Julie are married and have two children ages 19 and 14. Their adjusted gross income for the year is $85,000. What amount can they claim for the child credit?

Neville and Julie can claim a child credit of $1,000 ($1,000 x 1). A taxpayer can claim a $1,000 tax credit for each qualifying child. The definition of a qualifying child is similar to the definition of a qualifying child for dependency purposes except that the child must be under age 17 at the end of the tax year.

What amount can they claim for the child credit if their children are ages 16 and 13?

Because both children are under 17 years of age, Neville and Julie can claim a child credit of $2,000 ($1,000 x 2).

 

b. Assume the same facts as in part a, except that their adjusted gross income is $116,400?

Neville and Julie are allowed a child credit of $1,650 ($2,000 - $350). Because their adjusted gross income exceeds $110,000, the credit must be phased-out at a rate of $50 for each $1,000 of adjusted gross income (or fraction thereof) that exceeds $110,000. Neville and Julie must reduce their child credit by $350.

$116,400 - $110,000 = $6,400 ¸ $1,000 = 6.4 (round to 7)

$50 x 7 = $350 reduction in credit.

68. Miguel and Katrina have 2 children under age 17, have earned income of $24,000, and pay $1,836 in Social Security tax. Their tax liability is $1,050 before the child credit.

a. What amount can they claim as a child credit, and what portion of the credit is refundable?

For all families, a portion of the child credit may be refundable. The amount of the child credit that is refundable depends on the number of qualifying children in the family. For families with 1 or 2 qualifying children, the refundable credit is calculated as follows:

Maximum refundable credit = 15% x (earned income - $11,750)

However, the amount refunded cannot exceed the amount of the credit remaining after reducing the tax liability to zero. For families with 3 or more qualifying children, the maximum credit is the greater of the amount calculated using the formula for 1 or 2 qualifying children or the following formula:

Maximum refundable credit = Social Security tax paid - earned income credit

Miguel and Katrina's child credit is $2,000 ($1,000 x 2),which is greater than their income tax liability of $1,050. Although the maximum refundable credit is $1,838 [15% x ($24,000 - $11,750)], the calculated amount can never exceed the available credit of $2,000. The $2,000 child credit will reduce their $1,050 tax liability to zero and they will receive a refund of $950.

b. Assume the same facts as in part a, except that Miguel and Katrina have 3 children under age 17 and are not eligible for the earned income credit. Their tax liability is $800 before the child credit. What amount can they claim as a child credit, and what portion of the credit is refundable?

Miguel and Katrina's child credit is $3,000 ($1,000 x 3), which is greater than their income tax liability of $800. The maximum amount of the credit that can be refunded is the greater of:

$1,838 = 15% x ($24,000 - $11,750)]

or

$1,836 = $1,836 - $0

The child credit of $3,000 will reduce their $800 tax liability to zero and they will receive a refund of $1,838.

 

69. Determine the total allowable 2006 earned income credit in each of the following situations:

a. Judy is single and earns $5,500 in salary for the year. In addition, she receives $2,300 in unemployment compensation during the year.

The amount of the credit is dependent on the taxpayer's earned income and phases out after income reaches a predetermined level. To qualify for the earned income credit (EIC), a taxpayer must meet the following requirements:

1. The taxpayer's principal place of abode for more than one-half of the year must be in the United States.

2. The taxpayer or the taxpayer's spouse must be 25 years of age but not 65 years of age.

3. The taxpayer or taxpayer's spouse cannot be a dependent of another taxpayer.

In addition, the taxpayer cannot qualify for the earned income credit if their portfolio income (e.g., interest, dividends, and tax-exempt interest) exceeds $2,800 ($2,900 in 2007).

Note that the requirements do not require that the taxpayer have a child. However, the amount of the credit increases if you have one or more qualifying children. Therefore, even though Judy does not have a child, she will qualify for the earned income credit.

The $2,300 that Judy receives in unemployment compensation is taxable. Judy's earned income is $5,500. However, her adjusted gross income is $7,800 (greater than earned income) and must be used in the credit phase-out. Using the earned income credit table in the Appendix to Chapter 8, Judy’s EIC is $329.

 

b. Monica is a single parent with 1 dependent child. She earns $12,500 from her job as a taxicab driver. She also receives $4,700 in child support from her ex-husband.

The $4,700 Monica receives from her ex-husband is not taxable income. Therefore, both Monica's earned income and AGI are $12,500. Monica's earned income credit (EIC) is $ 2,747.

 

c. Paul and Yvonne are married and have 3 dependent children. Their earned income is $21,300, and they receive $3,000 in interest income from their savings account.

Paul and Yvonne do not qualify for the earned income credit because their portfolio income exceeds $2,800.

 

d. Hattie is married to Herbert, and they have 2 dependent children. During February, Herbert leaves and hasn't been seen or heard from since. Hattie earns $16,400 from her job. During January and February, Herbert earned $4,800, but Hattie has no idea how much he earned for the entire year.

Married taxpayers are required to file a joint return in order to take the EIC. In Hattie's situation, she may elect to file as a Head of Household to alleviate this requirement. An abandoned spouse may file as a Head of Household. An abandoned spouse is one who has a dependent child living in the taxpayer's home for more than half of the year and the taxpayer's spouse does not live in the home at any time during the last half of the year.

Hattie would not be responsible for paying taxes on the income Herbert earned for January and February. Therefore, Hattie's earned income and AGI is $16,400. Hattie has two qualifying children and her EIC is $4,196.

Instructor’s Note: Only a taxpayer who files as married filing separate is not entitled to the earned income credit.

70. Determine the total allowable 2006 earned income credit in each of the following situations:

a. Rina is single and earns $6,300 in salary for the year. In addition, she receives $1,450 in unemployment compensation during the year.

The amount of the credit is dependent on the taxpayer's earned income and phases out after income reaches a predetermined level. To qualify for the earned income credit (EIC) a taxpayer must meet the following requirements:

1. The taxpayer's principal place of abode for more than one-half of the year must be in the United States.

2. The taxpayer or the taxpayer's spouse must be 25 years of age but not 65 years of age.

3. The taxpayer or taxpayer's spouse cannot be a dependent of another taxpayer.

In addition, the taxpayer cannot qualify for the earned income credit if their portfolio income (e.g., interest, dividends, and tax-exempt interest) exceeds $2,800 ($2,900 in 2007).

Note that the requirements do not require that the taxpayer have a child. However, the amount of the credit increases if you have one or more qualifying children. Therefore, even though Rina does not have a child, she will qualify for the earned income credit.

The $1,450 that Rina receives in unemployment compensation is taxable. Rina's earned income is $6,300. However, her adjusted gross income is $7,750 (greater than earned income) and must be used in the credit phase-out. Using the earned income credit table in the Appendix to Chapter 8, her EIC is $332.

b. Lachlan is single with 1 dependent child. During the year, he earns $8,000 as a waiter and receives alimony of $10,000 and child support of $5,000.

The $5,000 Lachlan receives from his ex-wife in child support is not taxable income. However, the $10,000 of alimony is taxable. Therefore, his earned income (alimony is considered earned income) and AGI are both $18,000. Lachlan's earned income credit (EIC) is $2,233.

c. Zorica is a single parent with 2 dependent children. She earns $19,000 from her job as a mechanic. She also receives $3,000 in child support from her ex-husband.

Both Zorica’s earned income and adjusted gross income are $19,000. The $3,000 in child support is not considered taxable income. Zorica’s EIC is $3,648.

 

d. Elliot and Pam are married and have 3 dependent children. Elliot and Pam earn $12,000 and 9,000 from their jobs, respectively. They receive $800 in interest and $1,000 in dividend income.

Elliot and Pam’s earned income is $21,000 but their adjusted gross income is $22,800. Their EIC is $3,269.

 

 

 

 

 

71. Determine the amount of the child and dependent care credit to which each of the following taxpayers is entitled:

a. Michael and Gladys are married and have a 7-year-old child. Their adjusted gross income is $44,000, and they pay $3,300 in qualified child-care expenses during the year. Michael earns $12,000 and Gladys earns $30,000 from their jobs.

Because Michael and Gladys' adjusted gross income (AGI) is in excess of $15,000, they must reduce the 35% general credit by 1% for each $2,000 (or portion thereof) of AGI in excess of $15,000. The maximum reduction is limited to 15 percent, leaving a minimum allowable credit of 20 percent. The minimum credit limit is reached when the taxpayer's AGI exceeds $43,000, which Michael and Gladys meet. The maximum amount of qualifying expenses is $3,000 for one qualifying individual and $6,000 for 2 or more qualifying individuals. For purposes of this credit, a qualifying individual includes any dependent younger than 13 or a dependent or a spouse of the taxpayer who is physically or mentally incapacitated. A taxpayer can claim the child-and dependent-care credit for a spouse or a dependent, if the individual lives with the taxpayer for more than one-half the year, even if the taxpayer does not provide more than one-half of the cost of maintaining the household. The expenditures qualifying for the credit cannot exceed the earned income of the taxpayer. For married taxpayers, the lower earned income of the two is used for the purpose of the limit ($12,000 in this case, Michael's earnings).

Michael and Gladys' child and dependent care credit is $600 (20% x $3,000 maximum allowable amount of child care expenditures).

 

b. Jill is a single parent with an 11-year-old daughter. Her adjusted gross income is $24,500, and she pays $2,100 in qualified child-care expenses.

Because Jill's adjusted gross income (AGI) is in excess of $15,000, she must reduce the 35% general credit by 1% for each $2,000 (or portion thereof) of AGI in excess of $15,000. The maximum reduction is limited to 15 percent, leaving the minimum allowable credit of 20 percent. The minimum credit limit is reached when the taxpayer's AGI exceeds $43,000, which Jill does not meet. The maximum amount of expenses eligible for the credit is limited to $3,000 ($6,000 with two or more qualifying individuals). The general credit of 35% must be reduced by 5% [($24,500 - $15,000) ÷ $2,000 = 4.75% = 5%] to 30%. Therefore, Jill's child and dependent care credit is $630 (30% x $2,100).

 

c. Cory is a single parent who earns $9,000 and receives other nontaxable government assistance totaling $5,700 during the year. She pays $1,600 in qualified child-care expenses during the year.

Because the government assistance of $5,700 is nontaxable, Cory does not include the amount in adjusted gross income (AGI). Therefore, Cory's AGI is $9,000, which is below $15,000 base and she is allowed the full 35% credit. Cory's child and dependent care credit is $560 (35% x $1,600). Note: Since Cory’s taxable is zero [($9,000 - $7,850 - $6,800) < 0], she would not benefit from the child and dependent care credit because the credit is nonrefundable

 

d. Roosevelt and Myrtle are married and have 2 children. Roosevelt earns $94,000, and Myrtle has a part-time job from which she earns $4,400 during the year. They pay $4,700 in qualified child-care expenses during the year.

The expenditures qualifying for the credit cannot exceed the earned income of the taxpayer. For married taxpayers, the lower earned income of the two is used for the purpose of the limit. Therefore, Roosevelt and Myrtle's qualifying expenses are limited to $4,400 (Myrtle's earned income). Because their adjusted gross income is in excess of $43,000, they are allowed the minimum 20% credit. This results in a child and dependent care credit of $880 ($4,400 x 20%).

 

e. Randy is single and earns $80,000 per year. He maintains a home for his father, who has been confined to a wheelchair since he had a stroke several years ago. Randy's father receives $6,000 in Social Security but has no other income. Because his father requires constant attention, Randy hires a helper to take care of his father while he is at work. Randy pays the helper $13,000 during the current year.

To qualify for the credit, two conditions must be met: (1) the taxpayer must incur employment-related expenses, and (2) the expenses must be for the care of qualified individuals.

An employment expense is one that must be paid to enable the taxpayer to work and must be paid for either household services or for the care of a qualified individual. Generally, the expenses must be incurred within the taxpayer's home, although out-of-the-home expenses for dependents younger than 13 and for a disabled dependent or spouse also qualify. A taxpayer can claim the child-and dependent-care credit for a spouse or a dependent, if the individual lives with the taxpayer for more than one-half the year, even if the taxpayer does not provide more than one-half of the cost of maintaining the household.By hiring a helper, Randy is able to maintain employment. Because Randy's father is disabled and meets the dependency tests he is a qualified individual.

Randy's adjusted gross income (AGI) is greater than $43,000, so Randy receives the minimum credit of 20%. Therefore, Randy's child and dependent care credit is $600 [20% x $3,000 (the $13,000 is limited to the $3,000 maximum expense for 1 qualifying individual)].

 

 

72. Determine the amount of the child-and-dependent care credit to which each of the following taxpayers is entitled:

a. Caryle and Philip are married and have a 4-year-old daughter. Their adjusted gross income is $48,000, and they pay $2,100 in qualified child-care expenses during the year. Caryle earns $18,000, and Philip earns $30,000 in salary.

Because Philip and Caryle' s adjusted gross income (AGI) is in excess of $15,000, they must reduce the 35% general credit by 1% for each $2,000 (or portion thereof) of AGI in excess of $15,000. The maximum reduction is limited to 15 percent, leaving a minimum allowable credit of 20 percent. The minimum credit limit is reached when the taxpayer's AGI exceeds $43,000, which Philip and Caryle meet. The maximum amount of qualifying expenses is $3,000 for one qualifying individual and $6,000 for 2 or more qualifying individuals. A taxpayer can claim the child-and dependent-care credit for a spouse or a dependent, if the individual lives with the taxpayer for more than one-half the year, even if the taxpayer does not provide more than one-half of the cost of maintaining the household. For purposes of this credit, a qualifying individual includes any dependent younger than 13 or a dependent or a spouse of the taxpayer who is physically or mentally incapacitated. The expenditures qualifying for the credit cannot exceed the earned income of the taxpayer. For married taxpayers, the lower earned income of the two is used for the purpose of the limit ($18,000 in this case, Caryle's earnings).

Philip and Caryle’s child and dependent care credit is $420 (20% x $2,100 child care expenditures).

 

b. Natalie is a single parent with an 8-year-old son. Her adjusted gross income is $27,000, and she pays $3,100 in qualified child-care expenses.

Because Natalie's adjusted gross income (AGI) is in excess of $15,000, she must reduce the 35% general credit by 1% for each $2,000 (or portion thereof) of AGI in excess of $15,000. The maximum reduction is limited to 15 percent, leaving the minimum allowable credit of 20 percent. The minimum credit limit is reached when the taxpayer's AGI exceeds $43,000, which Natalie does not meet. The maximum amount of expenses eligible for the credit is limited to $3,000 ($6,000 with two or more qualifying individuals). The general credit of 35% must be reduced by 6% [($27,000 - $15,000) ÷ $2,000 = 6.00% = 6%] to 29%. Therefore, Natalie's child and dependent care credit is $870 (29% x $3,000 maximum allowable amount of child care expenses).

 

c. Leanne and Ross are married and have 3 children, ages 6, 4, and 1. Their adjusted gross income is $78,000, and they pay $6,500 in qualified child-care expenses during the year. Leanne earns $48,000, and Philip earns $30,000 in salary.

Because their adjusted gross income is in excess of $43,000, they are allowed the minimum 20% credit. For 2 or more qualifying individuals the maximum amount of expenses eligible for the credit is $6,000. This results in a child and dependent care credit of $1,200 ($6,000 x 20%).

 

d. Malcolm and Mirella are married and have 2 children. Mirella earns $55,000, and Malcolm has a part-time job from which he earns $4,000 during the year. They pay $4,800 in qualified child-care expenses during the year.

The expenditures qualifying for the credit cannot exceed the earned income of the taxpayer. For married taxpayers, the lower earned income of the two is used for the purpose of the limit. Therefore, Malcolm and Mirella's qualifying expenses are limited to $4,000 (Malcolm's earned income). Because their adjusted gross income is in excess of $43,000, they are allowed the minimum 20% credit. This results in a child and dependent care credit of $800 ($4,000 x 20%).

 

e. Andrew is a single parent with a 14-year-old son. Because he does not arrive home from work until 7 p.m., Andrew has hired someone to take care of his son after school and cook him supper. Andrew's adjusted gross income is $59,000, and he pays $3,400 in child-care expenses.

Andrew does not qualify for the child care credit because his son is not a qualifying individual. For purposes of this credit, a qualifying individual includes any dependent younger than 13 or a dependent or a spouse of the taxpayer who is physically or mentally incapacitated.

 

f. Assume the same facts as in part e, except that Andrew's son is 12 years old.

Because his son is a qualifying individual, Andrew is eligible for the child care credit. Because his adjusted gross income is in excess of $43,000, he is allowed the minimum 20% credit. For 1 qualifying individual, the maximum amount of expenses eligible for the credit is $3,000. This results in a child and dependent care credit of $600 ($3,000 x 20%).

 

73. Martina is single and has two children in college. Matthew is a sophomore, and Christine is a senior. Martina pays $3,600 in tuition and fees for Matthew and $2,000 for his room and board. Christine's tuition and fees are $4,800, and her room and board expenses are $1,800. Martina's adjusted gross income is $49,000.

Eligible taxpayers who incur expenses for higher education can elect to claim one of two tax credits, the HOPE Scholarship Tax Credit (HSTC) or the Lifetime Learning Tax Credit (LLTC). Only one credit can be claimed for each qualifying student. Qualified higher education expenses are limited to tuition and related fees. Both credits are phased-out ratably for single taxpayers when adjusted gross income is between $47,000 and $57,000.

The HOPE Scholarship Tax Credit provides for a 100% tax credit on the first $1,100 of qualified expenses and a 50% tax credit on the next $1,100 of higher education expenses paid during the year for each qualifying student. Therefore, the maximum credit a taxpayer may claim per year for each qualifying student is $1,650 [($1,000 x 100%) + ($1,000 x 50%)]. The HSTC can only be claimed for the first two years of undergraduate study.

The Lifetime Learning Tax Credit provides a 20% credit for up to $10,000 of qualified higher education expenses. The LLTC is limited to a maximum amount of $2,000 ($10,000 x 20%), regardless of the number of qualifying individuals incurring higher education expenses.

a. What amount can Martina claim as a tax credit for the higher education expenses she pays?

Martina can claim a Hope Scholarship Tax Credit (HSTC) for Matthew and the Lifetime Learning Tax Credit for Christine. Only the expenses incurred for tuition and fees are eligible for either credit. Because Matthew's tuition exceeds $2,200, she can claim an HSTC of $1,650 [($1,100 x 100%) + ($1,100 x 50%)].

Christine is not eligible for the HSTC because she is in her fourth year of study. Martina can claim a LLTC of $960 ($4,800 x 20%). Because Martina’s adjusted gross income exceeds $45,000, her total tax credit for higher education expenses of $2,610 ($1,650 + $960) must be reduced using the following formula:

Tax credit percentage = Adjusted gross income - $47,000

$10,000

Tax credit allowed = Calculated tax credit x (1 - tax credit percentage)

20% = $49,000 - $47,000

$10,000

$2,088 = $2,610 x (1 - 20%)

Martina's higher education tax credit is $2,088.

 

b. Assume that Martina's adjusted gross income is $60,000. What amount can she claim as a tax credit for the higher education expenses she pays?

Because Martina’s adjusted gross income exceeds $57,000, she is not eligible to claim either tax credit.

INSTRUCTORS NOTE: Since her AGI is less than $65,000, she can deduct (for AGI) $4,000 of the higher education expenses.

 

74. Brendan and Theresa are married and have three children in college. Their twin daughters, Christine and Katlyn, are freshmen and attend the same university. Their son, Kevin, is a junior in college. Brendan and Theresa pay $12,000 in tuition and fees ($6,000 each) for their daughters and $4,200 in tuition and fees for Kevin. The twins’ room and board is $2,600, while Kevin's room and board is $1,400. Brendan and Theresa have an adjusted gross income of $77,000.

Eligible taxpayers who incur expenses for higher education can elect to claim one of two tax credits, the HOPE Scholarship Tax Credit (HSTC) or the Lifetime Learning Tax Credit (LLTC). Only one credit can be claimed for each qualifying student. Qualified higher education expenses are limited to tuition and related fees. Both credits are phased-out ratably for married taxpayers with adjusted gross incomes between $94,000 and $114,000.

The HOPE Scholarship Tax Credit provides for a 100% tax credit on the first $1,100 of qualified expenses and a 50% tax credit on the next $1,100 of higher education expenses paid during the year for each qualifying student. Therefore, the maximum credit a taxpayer may claim per year for each qualifying student is $1,650 [($1,100 x 100%) + ($1,100 x 50%)]. The HSTC can only be claimed for the first two years of undergraduate study.

The Lifetime Learning Tax Credit provides a 20% credit for up to $10,000 of qualified higher education expenses. The LLTC is limited to a maximum amount of $2,000 ($10,000 x 20%), regardless of the number of qualifying individuals incurring higher education expenses.

a. What amount can they claim as a tax credit for the higher education expenses they pay?

Brendan and Theresa can claim a Hope Scholarship Tax Credit (HSTC) for each of their daughters and the Lifetime Learning Tax Credit for Kevin. Only the expenses incurred for tuition and fees are eligible for either credit. Because the tuition for each daughter exceeds $2,200, they can claim a HSTC of $1,650 [($1,100 x 100%) + ($1,100 x 50%)] for each daughter.

Kevin is not eligible for the HSTC because he is in his third year of study. Brendan and Theresa can claim a LLTC of $840 ($4,200 x 20%). Their total tax credit for higher education expenses is $4,140 ($1,650 + $1,650 + $840).

 

b. Assume that their adjusted gross income is $101,000. What amount can they claim as a tax credit for the higher education expenses they pay?

Brendan and Theresa can claim a total tax credit for higher education expenses of $2,691. Because Brendan and Theresa’s adjusted gross income exceeds $94,000, they must reduce the amount of their higher education tax credits using the following formula:

Tax credit percentage = Adjusted gross income - $94,000

$20,000

Tax credit allowed = Calculated tax credit x (1 - tax credit percentage)

35% = $101,000 - $94,000

$20,000

$2,691 = $4,140 x (1 - 35%)

 

c. Assume the same facts as in part a, except that Kevin is a freshman and the twins are juniors. What amount can Brendan and Theresa claim as a tax credit for the higher education expenses they pay?

If Kevin is a freshman, they would claim a HSTC of $1,650. Kevin’s tuition and fees exceed $2,200, so they will be able to claim the maximum allowable credit.

If the twins are juniors, then they would not be eligible for the HSTC but only the LLTC. In addition, the LLTC is not a per person tax credit but a per taxpayer (i.e., Brendan and Theresa) tax credit. Therefore, the maximum LLTC for the twins is $2,000 ($10,000 x 20%).

Brendan and Theresa can claim a total tax credit for higher education expenses of $3,650 ($1,650 + $2,000).

75. Daniel is 25, single, and operates his own landscaping business. He is a senior and enrolled full-time in the turf management program at Vorando University. The tuition for the semester is $8,000. Daniel receives a $4,000 scholarship, and he pays the remaining tuition by borrowing $4,000 from a local bank. His adjusted gross income for the year is $42,000 and he is the 25% marginal tax rate bracket. What is the most advantageous tax treatment for Daniel’s higher education expenses?

Eligible taxpayers who incur expenses for higher education can elect to claim one of two tax credits, the HOPE Scholarship Tax Credit (HSTC) or the Lifetime Learning Tax Credit (LLTC). Only one credit can be claimed for each qualifying student. Qualified higher education expenses are limited to tuition and related fees. The amount of the tuition is reduced by any scholarships the qualifying individual receives. Tuition and fees paid with loans are eligible for either credit. Both credits are phased-out ratably for single taxpayers when adjusted gross income is between $47,000 and $57,000.

The Lifetime Learning Tax Credit provides a 20% credit for up to $10,000 of qualified higher education expenses. The LLTC is limited to a maximum amount of $2,000 ($10,000 x 20%), regardless of the number of qualifying individuals incurring higher education expenses. Because Daniel’s qualifying higher education expenses of $4,000 ($8,000 - $4,000) are less than $10,000, he can claim a Lifetime Learning Tax Credit of $800 ($4,000 x 20%).

However, since Daniel’s AGI is less than $65,000, he can deduct (for AGI) $4,000 of the higher education expenses. Since he is in the 25% marginal tax bracket, this would yield a higher tax benefit because the $4,000 deduction would reduce his tax liability by $1,000 ($4,000 x 25%).

Therefore, the greatest tax savings ($1,000 > $800), assuming this provision continues Daniel should forgo the Lifetime Learning Tax Credit and takes the education expenses as a deduction for adjusted gross income.

 

76. Determine whether each of the following taxpayers must file a return in 2007:

a. Jamie is a dependent who has wages of $3,400.

Jamie's standard deduction is equal to her wages, so she does not have to file.

 

b. Joel is a dependent who has interest income of $1,200.

Joel's unearned income is greater than $850, so he has to file a return.

 

c. Martin is self-employed. His gross business receipts are $24,000, and business expenses are $24,300. His only other income is $2,600 in dividends from stock he owns.

Although Martin's net income from self-employment is less than $400, his total gross income is $26,600, which is greater than $8,750 ($5,350 + $3,400). He must file a return.

 

d. Valerie is 68 and unmarried. Her income consists of $6,500 in Social Security benefits and $9,900 from a qualified employer-provided pension plan.

Valerie's gross income is $9,900 which is less than $10,050 ($5,350 + $3,400 + $1,300 exemption for age) and she is not required to file a return.

 

e. Raul and Yvonne are married and have 2 dependent children. Their only income is Raul's $19,000 salary.

Raul and Yvonne's gross income of $19,000 is more than $17,500 [$10,700 + (2 x $3,400)], so they must file a tax return. Note: The dependency exemptions are not included in determining whether Raul and Yvonne have to file a return. Therefore, even though their taxable income will be zero [$19,000 - $17,500 - $6,800 ($3,400 x 2)], they still must file a tax return. In fact, they should receive a refund because of his tax withholdings, the child tax credit, and the earned income tax credit.

77. Determine whether each of the following taxpayers must file a return in 2007:

a. Felicia is a dependent who has wages of $5,200 and interest income of $225.

Because Felicia's gross income of $5,425 is more than her standard deduction of $5,350, she must file a return.

 

b. Jason is a dependent who has interest income of $600.

Jason's unearned income is less than $850, so he does not have to file a return.

 

c. Jerry is self-employed. His gross business receipts are $43,000, and business expenses are $40,300. His only other income is $1,200 in interest from municipal bonds.

Because Jerry's gross income of $43,000 is greater than $8,750 ($5,350 + $3,400), he must file a return. In addition, Jerry must file because his self-employment income is greater than $400.

 

d. Magnus is 69, unmarried and legally blind. His income consists of $10,500 in Social Security benefits and $10,000 from a qualified employer-provided pension plan.

Magnus's gross income is $10,000, which is less than $10,050 ($5,350 + $3,400 + $1,300 age exemption) and he is not required to file a return. I

 

e. Wayne and Florencia are married and have 1 dependent child. Wayne stays home and takes care of their child. Florencia's salary is $17,800.

Wayne and Florencia's gross income of $17,800 is more than $17,500 [$10,700 + (2 x $3,400)], so they must file a tax return. Note: The dependency exemptions are not included in determining whether they have to file a return. Therefore, even though their taxable income will be zero [$17,800 - $17,500 - $3,400 ($3,400 x 1)], they still must file a tax return. In fact, they should receive a refund because of her tax withholdings, the child tax credit, and the earned income tax credit.

ISSUE IDENTIFICATION PROBLEMS

In each of the following problems, identify the tax issue(s) posed by the facts presented. Determine the possible tax consequences of each issue that you identify.

78. Kahn is 21 years old and a full-time student. He lives at home with his parents and pays less than half of his support. During the year, he earns $5,900 working as a sales clerk in a department store.

The first issue is whether Kahn is a dependent of his parents. Kahn would be dependent under the qualifying child rules. He meets the age test (full-time student under 24 years of age), principal residence test, non-support test (he does not pay for than one-half of his support), relationship test and citizenship test. The second issue is whether Kahn has to file a tax return. Since his income is more than the standard deduction amount of $5,350, he must file a tax return.

 

79. Lois is single. She provides more than 50% of the support for her mother who lives in a nursing home. Her mother receives $4,000 from Social Security and $7,000 in dividends.

There are two issues. The first is whether Lois's mother qualifies as her dependent. The second is whether Lois can file as head of household. Lois’s mother can only qualify as a dependent under the qualifying relative rules. Under these rules, her mother will not qualify as a dependent because her gross income ($7,000) exceeds the personal exemption amount of $3,400. Since her mother does not qualify as her dependent, Lois cannot file as head of household.

80. Hector is 66 years of age. During the year, his wife dies.

The issue is to determine Hector's filing status for the current year. Hector is considered married for the current year and would file using the married filing joint tax rates. Based on the information provided, Hector would file as single in the subsequent year.

 

81. Myrth is 67, single, and has poor hearing. She pays $300 for special equipment attached to her phones to amplify a caller's voice.

The issue is whether the special equipment qualifies as a medical expense deduction. The cost of the special equipment is a deductible medical expense because it was purchased by the taxpayer primarily to mitigate his condition of deafness.

Instructor's Note: This issue identification problem is based on Rev. Rul. 71-48, 1971-1, CB 99.

 

 

 

82. Jacqueline is single. In June 2007, she receives a refund of $250 from her 2006 state tax return. Her 2006 itemized deductions were $8,000. In October 2007, her 2005 state tax return is audited, and she has to pay an additional $340 in state taxes. During 2007, Jacqueline has $2,450 withheld from her paycheck for state income taxes.

The issue is to determine the tax treatment for the various state income tax transactions during the year. Under the tax benefit rule, the $250 refund she receives is included as income on her 2007 tax return. The $250 does not reduce her 2007 itemized deduction for state taxes. Even though the audit relates to the 2005 tax year, the additional $340 in state tax is deductible as an itemized deduction on her 2007 tax return. Jacqueline can also deduct as an itemized deduction the $2,450 in state taxes she had withheld in 2007. She will report $250 as income and her total itemized deduction for state taxes is $2,790 ($2,450 + $340).

83 Troy’s 2005 tax return is audited. The auditor determines that Troy inadvertently understated his ending inventory in calculating his business income. The error creates an additional tax liability of $5,000. The IRS charges interest on the additional tax liability of $600.

The issue is whether the interest is personal interest or interest incurred in a trade or business. If the interest is considered personal it is not deductible. The facts of this case indicate that Troy is being assessed an additional tax liability and interest on that liability as a result of understating the ending inventory in his business. The general rule is that interest on a personal tax return is considered personal interest. Because the interest expense can be directly traced to a mistake made in computing his business income, an argument could be made that the interest is business interest and deductible.

Instructors Note: The problem is designed to point out to the student that the logical and conceptually intuitive answer is not always correct. The facts of the problem are based on Miller 65 F. 3d 687, (1995), [reversing the District Court Miller et ux. v. US 841 F. Supp. 305 ND, (1993). In this case, the 8th Circuit Court ruled that a taxpayer who incurs interest expense on an additional tax liability as a result of the IRS disallowing farm expenses is not allowed to deduct the interest paid on the additional tax liability as a business expense.

84. Dwight purchases a new home costing $100,000 in the current year. He pays $15,000 down and borrows the remaining $85,000 by securing a mortgage on the home. He also pays $2,000 in closing costs, and $1,700 in points to obtain the mortgage. He pays $7,500 in interest on the mortgage during the year.

The issue is to determine which of Dwight's expenses in acquiring his new home are deductible. Dwight is allowed to deduct the $7,500 of interest paid on the acquisition debt and the $1,700 of points paid to obtain the initial mortgage. His total allowable home mortgage interest deduction is $9,200. The closing costs of $2,000 are not deductible and are added to the basis of the home.

 

 

85. Donna bought her home several years ago for $200,000. She paid $20,000 down on the purchase and borrowed the remaining $180,000. When the home is worth $280,000 and the balance on the mortgage is $120,000, she borrows $110,000 using a home equity loan. She uses the proceeds of the loan to acquire a new car, pay off some credit card debt, and pay her children's tuition at a private school. She pays $12,600 in interest on the home equity loan.

The issue is to determine the deductible amount of interest. A deduction is allowed for interest paid on acquisition debt of up to $1,000,000 and on home equity loans secured by the residence up to $100,000. In addition, the total acquisition debt and home equity debt cannot exceed the fair market value of the property. In this case, the total debt is $230,000 ($110,000 + $120,000), which is less than the fair market value. However, only interest on $100,000 of the home equity loan is deductible, $11,455 [$12,600 x ($100,000 ÷ $110,000)]. The remaining $1,145 of interest is considered personal interest and is not deductible.

Note that the proceeds of the home equity loan may be used for any purpose; the only requirement for deductibility of a home equity loan is that the loan be secured by the residence.

 

86. Diedre is single and has dividend income of $7,500 and a $6,000 long-term capital gain. She pays $9,000 of investment interest. The interest expense relates to all of the assets in her portfolio. Diedre has no tax-exempt income and her marginal tax rate is 33%.

The issue is to determine Deidre's investment interest expense deduction. Investment interest is limited to net investment income. Dividends receive special tax treatment and are taxed at a maximum rate of 15%. Because of the preferential tax treatment, unless Marjorie elects otherwise, the dividends are not included as part of investment income. Long-term capital gain income cannot be counted as investment income if the taxpayer takes advantage of the 15% capital gain rate. Unless Deidre elects to forego the preferential rates for dividends and long-term capital gains gain her net investment income for purposes of determining the amount of deductible interest is zero.

 

Because Diedre's marginal tax rate is 33%, she saves $540 ($2,025 - $1,485) by electing to include the dividends and capital gain income in investment income and not taking advantage of the favorable 15% tax rate. Her investment interest deduction is $9,000.

Using Prefential Rates:

Tax on dividends and capital gains ($13,500 x 15%) $2,025

Less: Tax benefit from investment interest -0-

Net Tax Cost $2,025

Not Using Prefential Rates:

Tax on dividends and capital gains ($13,500 x 33%) $4,455

Less: Tax benefit from investment interest ($9,000 x 33%) (2,970)

Net Tax Cost $1,485

Instructors Note: It is not always in the best interest of the taxpayer to forego the preferential rates. It is dependent on the taxpayer’s marginal tax rate, time value of money (since investment interest can be carried forward) and the amount the taxpayer’s investment interest expense. For example, if the taxpayer only incurred $5,000 of investment interest expense, the $1,650 ($5,000 x 33%) of tax savings from the deduction would result in a net tax cost of $2,805 ($4,455 - $1,650) and the preferential rate treatment would be preferred..

 

 

 

 

87. Jose donates stock worth $20,000 to the United Way. He purchased the stock several years ago for $8,000. His adjusted gross income is $60,000.

The issue is what amount can Jose deduct as a charitable contribution. Although contributions of long-term capital gain property may be valued at the fair market value of the property ($20,000), the maximum allowable deduction cannot exceed 30% of the taxpayer's adjusted gross income. Therefore, unless he elects to value the contribution at its adjusted basis, the maximum amount he can deduct in the current year is $18,000. The remaining $2,000 ($20,000 - $2,000) can be carried forward and deducted in the following year, subject to the 30% limit.

 

88. Royce received an antique watch as a gift from his grandfather. The fair market value of the watch is $12,500. The watch has been missing all year and is not covered by insurance.

The issue is whether missing property qualifies as a casualty loss. For the property to qualify as a casualty loss, the property must be missing due to a robbery, larceny or embezzlement. Missing items do not constitute a theft. Therefore, Royce will not be able to deduct the missing watch as a casualty loss.

 

89. Casandra and Gene are married and have a daughter who is a junior at State University. Their adjusted gross income for the year is $78,000, and they are in the 25% marginal tax bracket. They paid their daughter's $3,500 tuition and $3,200 in room and board with $4,500 in savings and by withdrawing $2,200 from a Coverdell Education Savings Account.

The first issue is whether Casandra and Gene should elect to take an education tax credit or take a deduction for adjusted gross income for the tuition. A taxpayer cannot claim an education tax credit if the taxpayer claims a deduction for higher education expenses. However, the taxpayer can claim an education tax credit or can claim a deduction if the taxpayer receives a distribution from an Coverdell Education Savings Account. Because their daughter is a junior, Casandra and Gene cannot claim the Hope Scholarship Tax Credit but can only claim The Lifetime Learning Tax Credit (LLTC).

The Lifetime Learning Tax Credit provides a 20% credit for up to $10,000 of qualified higher education expenses. The LLTC is limited to a maximum amount of $2,000 ($10,000 x 20%), regardless of the number of qualifying individuals incurring higher education expenses.

The second issue is the tax treatment of the proceeds from the Coverdell Education Savings Account. The proceeds are tax-free and do not impact the amount of the deduction since the proceeds from the Coverdell Education Savings Account can be used to pay up to $2,500 of room and board expenses.

90. TAX SIMULATION. Ross and Jessica are married and have one child, Joy, who is two years old. Ross is a recent college graduate and works as a software engineer. Jessica is a full-time student at Hendrick College, and attends classes in the Fall and Spring semesters. Ross earns $32,000 during the year and the couple incurred $2,200 in child care expenses so that Jessica could attend class.

Required: Determine the income tax treatment of the child care expenses. Search a tax research database and find the relevant authority (ies) that forms the basis for your answer. Your answer should include the exact text of the authority (ies) and an explanation of the application of the authority to Ross and Jessica’s facts. If there is any uncertainty about the validity of your answer, indicate the cause for the uncertainty.

Sec. 21(a)(1) allows a taxpayer who maintains a household for a qualifying individual to take a tax credit for a percentage of employment related expenses incurred to take care of the child.

(a) Allowance of credit. (1) In general. In the case of an individual who maintains a household which includes as a member one or more qualifying individuals (as defined in subsection (b)(1) ), there shall be allowed as a credit against the tax imposed by this chapter for the taxable year an amount equal to the applicable percentage of the employment-related expenses (as defined in subsection (b)(2) ) paid by such individual during the taxable year

Sec. 21(b)(1)(A) defines a qualified individual as a dependent of the taxpayer who is under 13 years of age.

(b) Definitions of qualifying individual and employment-related expenses. For purposes of this section — (1) Qualifying individual. The term "qualifying individual" means— (A) a dependent of the taxpayer (as defined in section 152(a)(1) ), (B) a dependent of the taxpayer (as defined in section 152 , determined without regard to subsections (b)(1) , (b)(2) , and (d)(1)(B) ) who is physically or mentally incapable of caring for himself or herself and who has the same principal place of abode as the taxpayer for more than one-half of such taxable year, or (C) the spouse of the taxpayer, if the spouse is physically or mentally incapable of caring for himself or herself and who has the same principal place of abode as the taxpayer for more than one-half of such taxable year

Sec. 21(b)(2)(A)(ii) defines employment related expenses as those expenses incurred to care for a qualifying individual.

(2) Employment-related expenses. (A) In general. The term "employment-related expenses" means amounts paid for the following expenses, but only if such expenses are incurred to enable the taxpayer to be gainfully employed for any period for which there are 1 or more qualifying individuals with respect to the taxpayer: (i) expenses for household services, and (ii) expenses for the care of a qualifying individual

Sec. 21(c)(1) sets forth the maximum amount of employment related expenses that can be used in calculating the amount of the child care tax credit.

(c) Dollar limit on amount creditable. The amount of the employment-related expenses incurred during any taxable year which may be taken into account under subsection (a) shall not exceed— (1) $3,000 if there is 1 qualifying individual with respect to the taxpayer for such taxable year, or (2) $6,000 if there are 2 or more qualifying individuals with respect to the taxpayer for such taxable year The amount determined under paragraph (1) or (2) (whichever is applicable) shall be reduced by the aggregate amount excludable from gross income under section 129 for the taxable year.

However, Sec. 21(d)(1) limits the amount of employment related expenses that can be used to calculate the child care credit for a married taxpayer to the lesser of the two spouses earned income.

(d) Earned income limitation. (1) In general. Except as otherwise provided in this subsection, the amount of the employment-related expenses incurred during any taxable year which may be taken into account under subsection (a) shall not exceed— (A) in the case of an individual who is not married at the close of such year, such individual's earned income for such year, or (B) in the case of an individual who is married at the close of such year, the lesser of such individual's earned income or the earned income of his spouse for such year.

While this would appear to not allow Ross and Jessica a child tax credit, Sec. 21(d)(2)(A) allows a spouse who is a full-time student to have earned income for purposes of meeting this test of $250 for each month the spouse is a full-time student.

(2) Special rule for spouse who is a student or incapable of caring for himself. In the case of a spouse who is a student or a qualifying individual described in subsection (b)(1)(C) , for purposes of paragraph (1) , such spouse shall be deemed for each month during which such spouse is a full-time student at an educational institution, or is such a qualifying individual, to be gainfully employed and to have earned income of not less than— (A) $250 if subsection (c)(1) applies for the taxable year, or (B) $500 if subsection (c)(2) applies for the taxable year. In the case of any husband and wife, this paragraph shall apply with respect to only one spouse for any one month.

In conclusion, Jessica is assumed to have $2,250 [$250 x 9 months (September through May)] of earned income for purposes of determining the amount of employment related expenses that can be used in the calculation of their child care tax credit. Since their child care expenses ($2,200) are less than $2,250, they are limited to $2,200 of expenses.

Because their adjusted gross income (AGI) is in excess of $15,000, they must reduce the 35% general credit by 1% for each $2,000 (or portion thereof) of AGI in excess of $15,000. The maximum reduction is limited to 15 percent, leaving the minimum allowable credit of 20 percent. The general credit of 35% must be reduced by 9% [($32,000 - $15,000) ÷ $2,000 = 8.50 = 9%] to 26%. Therefore, their child and dependent care credit is $572 (26% x $2,200).

91. INTERNET ASSIGNMENT With the recent changes in the tax law definition of a dependent, it is interesting to compare how the United States definition of a dependent differs throughout the world. Go to the Australian Government Tax webpage at http://www.ato.gov.au/. At that site click on the link in the upper right hand corner entitled A-Z Index. Using the drop down menu, click on individuals. This will produce a keyword index page. Click on the letter D and then click on the word "dependent". Then click on the term "dependents and separate net income". Read through the information provide on this page and determine how the Australian definition of a dependent is similar to and different from that of a qualifying child or a qualifying relative.

Note: The Australian spelling of dependant is "ant" instead of the American spelling "ent"

The Australian definition of a dependent is similar to our definition in that it includes the taxpayer’s children and parents. It is different in that the age of children who are not students is under 16 years of age as opposed to our age limit of under 19 years of age. In addition, for children who are attending school, the Australian age limit is under 25 years of age as opposed to our limit of under 24 years of age. Unlike the US definition of a dependent that defines the amount of support required to be provided (i.e, more than 50%), the Australian definition does not specifically define the percentage (Note: The amount might be defined in their regulations). Finally, the taxpayer’s spouse is considered a dependent for Australian tax purposes while for U.S. tax purposes, the terminology is different and both spouses are treated as personal exemptions.

Who is a dependant?

A dependant can be:

your spouse—married or de facto

a student who is under 25 years and is a full-time student at school, college or university

a child—including your spouse's child, adopted child, step-child or ex-nuptial child who is under 16 years and is not a student

a child-housekeeper—your child of any age who works full-time keeping house for you

an invalid relative—your child, brother or sister who is 16 years or over, who

receives a disability support pension or a special needs disability support pension, or

has a certificate from a Commonwealth-approved doctor certifying a continuing inability to work

your parents or spouse's parents.

A dependant needs to be an Australian resident for tax purposes (see Residency). For a spouse, student or child only, they will be treated as a resident if you have always lived in Australia or you came to live in Australia permanently—unless they have set up a permanent home outside Australia.

Overseas dependants

Your spouse and dependent children who are waiting to migrate to Australia are considered to be your dependants for tax offset purposes but they must migrate within 5 years from when you came to live in Australia permanently. We may ask you to provide evidence.

 

What is maintaining a dependant?

This means:

You and the dependant resided together, or

You gave the dependant food, clothing and lodging, or

You helped them to pay for their living, medical and educational costs.

If you had a spouse for the whole year and your spouse worked for part of the year, you are still considered to have maintained your spouse—as a dependant—for the whole year.

You are considered to have maintained a dependant even if you were temporarily separated—for example, due to holidays. You are still considered to have maintained dependants who were overseas if they were away from Australia only for a short time.

If you maintained a dependant for only part of the year, you may need to adjust your claim.

INSTRUCTOR'S NOTE: Information on the Internet is developing at a rapid pace. Therefore, this solution may become outdated. We suggest that you do the assignment prior to assigning it to your students. This will allow you to provide students with any additional information they may need to complete the assignment.

92. INTERNET ASSIGNMENT The Internet is a useful resource for tax planning. One useful tax planning tool can be found at the Microsoft Money home page (http://moneycentral.msn.com/tax/home.asp). At this site, you can estimate your tax liability by clicking on the tax estimator button at the top of the web page. Launch the tax estimator and supply your personal information. Provide the information you used in filling out the tax estimator and the results it gave to you.

There is no set solution for this problem. The following information was submitted to the tax estimator:

Salary $39,000

Interest 500

Qualifying dividends 1,000

Short-term capital gains 1,000

Long-term capital gains 3,000

Individual retirement account 3,000

Student loan interest 1,500

State and local taxes 1,100

Property local taxes 300

Federal taxes withheld 4,500

INSTRUCTOR'S NOTE: Obviously, the solution will vary based on the information submitted. The instructor might consider providing the students with the above information. The purpose of the exercise is to expose the students to the vast resources available on the Internet. At the time the solution went to press the tax planner was computing 2006 tax liability. This will probably be changed to calculate a taxpayer's 2007 tax liability.

Information on the Internet is developing at a rapid pace. Therefore, this solution may become outdated. We suggest that you do the assignment prior to assigning it to your students. This will allow you to provide students with any additional information they may need to complete the assignment.

SOLUTION:

With a filing status of single it is estimated that you will owe $170.

Information Entered:

Filing Status

Single

Exemptions

Yourself

Total Number of Dependents

0

Number of Dependents under 17

0

Age 65 or Older

No

Blind

No

Wages & salaries

$39,000

Taxable interest

$500

Taxable qualifying dividends

$1,000

Tax-exempt interest

$0

State & local income tax refunds

$0

Business income or loss

$0

Investments held 0-12 months

$1,000

Investments held more than 12 months

$3,000

Pension/annuities

$0

Unemployment

$0

Social Security benefits

$0

Rental income or loss

$0

Partnership & S corporation income or loss

$0

Other taxable income

$0

Contribution to traditional IRA:

$4,000

Do you have a retirement plan at work?

Yes

Student Loan Interest

$1,500

Deductible Contributions to qualified retirement plans

$0

Contributions to medical savings accounts

$0

Alimony Payments

$0

Moving Expenses

$0

Other adjustments to gross income

$0

Medical & dental expenses

$0

Home mortgage interest

$0

Points

$0

Charitable contributions

$0

Casualty & theft losses

$0

Employment expenses

$0

Investment interest paid

$0

Income related expenses

$0

Other miscellaneous deductions

$0

State and local income taxes

$1,100

Real estate taxes

$0

Personal property taxes

$300

Other taxes

$0

Child and dependent care

$0

Hope Scholarship Credit

$0

Lifetime Learning Credit

$0

Excess Social Security

$0

Other tax credits

$0

Federal tax withheld from wages

$4,500

Federal estimated payments made

$0

Tax Calculation

Gross Income $44,500
Adjustments to Gross Income $ 3,600
Adjusted Gross Income $40,900
Itemized or Standard Deduction $ 5,150
Personal Exemptions $ 3,300
Taxable Income $32,450
Federal Income Tax $ 4,670
Other Taxes $0
Self Employment Tax $0
Credits $0
Total Federal Tax $ 4,670
Withholdings & Payments $ 4,500
Tax Due or (Refund) $ 170

The Federal Tax Code is incredibly complicated and has many provisions that only affect a small percentage of taxpayers. For simplicity, we've chosen not to include many of them in this calculator. This service is provided for informational purposes only. To determine the specifics of your financial situation, you should always consult a professional tax advisor.

 

 

_____________________________________________________________________________

Chapter 9

 

Acquisitions of Property

 

DISCUSSION QUESTIONS

 

1. What effect does a property's use have on the cost recovery allowable on the property?

A property's use determines what, if any, deductions can be taken on the property. Current period expenditures related to a property that is used in a trade or business or for the production of income can be deducted. In addition, if the property has a finite life, its cost can be recovered over the period of use through either depreciation, depletion, or amortization deductions. The only recovery allowed on personal use property is at the property's disposition. Even then, if the disposition results in a loss, the capital recovery is allowed only to the extent of the amount realized on the disposition (i.e., a loss on the disposition of a personal use property is not deductible).

 

2. What is the difference between a property's use and its type?

Type of property refers to whether property is real, personal, or intangible. Any type of property can have any of the three uses of property - in a trade or business, for the production of income, or personal use. For example, a computer is always personal property. The computer can be used in a taxpayer's trade or business, a production of income activity of the taxpayer, or it could be used as a personal asset. Thus, the type of property never changes, but its use may change.

 

3. Explain the difference between tangible property and intangible property.

Tangible property has a physical existence; it has shape, form and substance. Intangible property only exists due to some economic right conferred by the property. Intangible property is usually represented by a document (e.g., a patent, copyright, or covenant not to compete). However, the value is not in the paper, but in the economic rights conferred in the document.

 

4. How is personal property different from personal use property?

Personal property is a type of property. It is any tangible property that is not real property. Personal use property is a use of property. It is any property that is used for personal purposes by the taxpayer. Therefore, personal use property can be personal property (e.g., the family car) or real property (e.g., the family residence).

 

5. Explain the role an asset's initial basis plays in determining the income to be recognized upon disposal of the asset.

The initial basis of the asset establishes the amount of capital recovery allowed on the asset. The basis may be recovered over time through depreciation, depletion, or amortization deductions. Any basis not recovered when the asset is disposed of is used to offset any amount realized from the disposition. Thus, the initial basis determines the maximum amount of capital recovery on the asset.

 

6. Explain the difference between a property's initial basis and its adjusted basis.

A property's initial basis is the amount paid to obtain the property and place it into operating condition (unless one of the special basis rules applies). It establishes the amount of capital recovery to be allowed on the property. As the property is used, additional expenditures that extend substantially beyond the end of the period of the expenditure (capital expenditures) are added to the basis for recovery. The recovery of capital, (i.e., depreciation) is subtracted from the basis to avoid a double recovery. The adjusted basis of a property is the initial basis with adjustments for capital expenditures (i.e., improvements) and recoveries of capital.

 

7. Larry is interested in acquiring a business owned by Jane. If Jane's business is organized as a corporation, what options are available to Larry in acquiring the business? Explain to Larry the difference in the options.

Larry can either purchase the assets of the business directly or acquire the stock of the company. The difference between the two is what Larry has a basis in. If he purchases the assets, Larry’s basis is in the assets and is at the amount he paid for the assets. If he purchases the stock, his basis is in the stock at the amount he paid for the stock and the basis of the assets of the corporation remain unchanged.

 

8. What tax problems does a taxpayer encounter when purchasing more than one asset for a single price? Explain.

The main problem is allocating the purchase price between the assets purchased. Because the assets may have different tax characteristics (e.g., one depreciable, one not), each asset purchased must have a basis assigned to it. In addition, the assets may be disposed of at