Chapters 15 &amp; 16 Assigned Problems Solutions 52. Ferris and Jody are married and file a joint return. During the current year, Ferris had a salary of $40,000. Neither Ferris nor Jody is covered by an employer-sponsored pension plan. Determine the maximum IRA contribution and deduction amounts in each of the following cases: Because neither Ferris nor Jody are covered by a pension plan, any amounts that they are eligible to contribute to an IRA are deductible for <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> . a. Jody earns $28,000, and their <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> is $114,000. Both taxpayers have earned income. They are both allowed to contribute and deduct $5,000 of their earned income to their IRA's. Thus, they may contribute and deduct a total of $10,000 for <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> . b. Jody does not work outside the home and their <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> is $65,000. A married couple s total IRA contribution and deduction is based on the couple s joint earned income. Because their joint earned income is greater than $10,000, Jody is also allowed to contribute and deduct $5,000 even though she has no earned income. Thus, they may contribute and deduct a total of $10,000 for <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> . c. Assume the same facts as in part a, except that Ferris is covered by an employer-sponsored pension plan. Because only Ferris is covered by an employer sponsored pension plan, the amount that Jody can contribute and deduct is not phased out until their <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> exceeds $159,000. Therefore, she can contribute and deduct $5,000 to her IRA. However, because Ferris is covered by an employersponsored pension plan and their <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> exceeds $105,000, his contribution is not deductible. They can contribute a total of $10,000 to their IRA s ($5,000 each), but they can only deduct $5,000 of their contribution. d. Assume the same facts as in part a, except that Ferris and Jody are covered by an employer-sponsored pension plan. Because both spouses are covered by an employer sponsored pension plan, the amount of the IRA deduction is reduced when a married couple's <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> exceeds $85,000 and is fully phased out when <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> exceeds $105,000. Because their <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> is $114,000, they can each contribute $5,000 but cannot take any deduction for their contributions. 63. Juan and Angel, ages 56 and 54, respectively, decide to establish Roth IRAs. Juan and Angel are married, and both are covered by pension plans where they work. Their <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> is $125,000. They want to make the maximum contribution to the Roth IRAs. a. What is the maximum amount they may contribute to a Roth IRA? Juan and Angel may make a maximum contribution of $10,000 ($5,000 each) to a Roth IRA. The contributions are not deductible and the earnings will accumulate tax-deferred until withdrawn. If they make a qualified distribution from the Roth IRA, the tax-deferred earnings are not subject to tax. A distribution is qualified if at the time of the distribution, the taxpayer is age 59 1/2 and the contributions were in the Roth IRA for at least five years. b. Assume that Juan and Angel's <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> for the year is $165,000. What is the maximum contribution they may make? Contributions to a Roth IRA are limited to certain <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> limitations and are phased-out for married couples filing jointly when AGI reaches $159,000. Because Juan and Angel's AGI is greater than $159,000, their maximum contribution is phased-out ratably over a $10,000 range until the amount they can contribute is fully phased-out when their <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> exceeds $169,000. Juan and Angel must reduce the amount of their contribution by 60% [($165,000 - $159,000) $10,000]. They each can contribute $2,000 [$5,000 - ($5,000 x 60%)] to their Roth IRA. c. Assume that Juan and Angel are now ages 62 and 60, respectively, and want to withdraw $10,000 to purchase a new car. What are the tax implications of the withdrawal from the Roth IRA? Because Juan and Angel are over age 59 1/2 and contributions from the Roth IRA have been held in the account for more than five years, the distribution, including the untaxed earnings, is tax-free. d. Assume the same facts in part c, except Juan is 60 and Angel is 58? Because Angel has not reached age 59 1/2 prior to the distribution date, the amount associated with her withdrawal is not a qualified distribution. However, there is no income tax due on the amount distributed to the extent the distribution represents prior year contributions and not earnings on the contributions. The ordering rules require that amounts distributed from a Roth IRA first come from contributions and then from the earnings on the contributions. However, the early withdrawal penalty would apply to the entire amount attributable to Angel's share of the withdrawal. e. Assume the same facts in part a, except that Juan and Angel have a regular IRA they want to rollover to a Roth IRA. The balance in the IRA is $20,000. Write a memo describing the tax factors that Juan and Angel should consider before deciding to roll over the IRA to a Roth IRA. Several tax factors need to be considered when deciding whether to rollover an IRA into a Roth IRA. In general, a rollover or conversion of an existing IRA to a Roth IRA is a taxable event requiring the taxpayer to pay tax on the distribution. It is treated as any other distribution. However, the rollover distribution is not subject to the 10% early withdrawal penalty. As a practical matter, the rollover is a good idea if the present value of taxes paid on the rollover are less than the tax savings on the distributions taken in later years. Because Juan and Angel are close to retirement, it is questionable whether they will have enough time to build up the Roth IRA with tax-free earnings to replace the taxes paid on the rollover. Again, this will depend on when they plan on retiring and their marginal tax rate at retirement. In addition, they must also consider the rate of return on the investment and the state tax effects of the rollover. Finally, the question of whether to make nondeductible contributions to any type of IRA must be evaluated in light of the lower capital gains rates that might be applicable for similar investments. 55. In October 2008, the Clark Corporation decides to establish a SIMPLE-401(k) retirement plan for its employees. Clark meets all requirements for establishing a SIMPLE. The company has notified its employees that in 2008, it will fund the SIMPLE-401(k) by contributing 2% of each employee's salary to the plan. Determine the maximum employee and employer contribution for Lei, an employee, in each of the following cases: a. Lei's salary is $62,000. Lei does not have to contribute to the plan, but she can elect to contribute up to $10,500 to the plan. The employer's contribution of 2 percent of an employee's compensation is mandatory, even if the employee does not contribute. However, the maximum amount of compensation that Clark can consider in determining its contribution under a SIMPLE-401(k) is $230,000. Clark must contribute $1,240 ($62,000 x 2%) to the SIMPLE-401(k) on Lei's behalf. b. Lei's salary is $240,000. As in part a, Lei does not have to contribute to the plan, but she can elect to contribute up to $10,500 to the plan. Because her salary exceeds $230,000, the maximum amount that Clark can contribute is $4,600 ($230,000 x 2%). It should be noted that because Clark elected to use this funding option, it must contribute $4,600, regardless of the amount Lei contributes to the SIMPLE 401(k). c. Assume the same facts as in part b, except that Clark funds the plan by matching employees' contributions up to a maximum of 3% of each employee's compensation. Lei contributes the maximum. As in parts a and b, Lei does not have to contribute to the plan, but she can elect to contribute up to $10,500 to the plan. Because her salary exceeds $230,000, the maximum amount that Clark can contribute is $6,900 ($230,000 x 3%). d. Assume the same facts as in part b, except that Clark establishes a SIMPLE-IRA and Lei contributes the maximum. Lei is not required to make a contribution to the SIMPLE-IRA. However, she can elect to contribute up to $10,500 to the plan and Clark is required to contribute 2% of Lei s salary to the plan. However, unlike with a SIMPLE 401(k), the maximum amount Clark can contribute on Lei s behalf is $10,500. Because Clark elected to use this funding option, it must contribute $4,600 ($230,000 x 2%) regardless of the amount Lei contributes to the SIMPLE 401(k). e. Assume the same facts as in part d, except that Clark funds the plan by matching an employee's contributions up to a maximum of 3% of each employee's compensation. Lei contributes the maximum. Lei is not required to make a contribution to the SIMPLE-IRA. However, she can elect to contribute up to $10,500 to the plan and Clark is required to contribute 3% of Lei s salary to the plan. The maximum amount Clark is required to contribute on Lei s behalf is $6,900 ($230,000 x 3%). However, unlike in part d, Clark is only required to match the amount Lei contributes to the SIMPLE-IRA. Therefore, if Lei only contributes $4,000 to the plan, Clark is only required to match the $4,000 Lei contributes. 66. On May 10, 2008, Somerton Inc., grants Louise a nonqualified stock option to acquire 700 shares of the company s stock for $11 per share. The <a href="/keyword/fair-market-value/" >fair market value</a> of the stock on the date of grant is $13. The option does not have a readily ascertainable <a href="/keyword/fair-market-value/" >fair market value</a> . On June 1, 2008, when the <a href="/keyword/fair-market-value/" >fair market value</a> of the stock is $15, Louise exercises the stock option. Determine the tax consequences for Louise and Somerton on the grant date of the option and the exercise date. An employee who receives an option that does not have a readily ascertainable <a href="/keyword/fair-market-value/" >fair market value</a> will not recognize income at the date of grant but rather at the date of exercise. The amount of income the employee must recognize is the difference between the option price and the <a href="/keyword/fair-market-value/" >fair market value</a> of the stock at the date of exercise. Her basis is equal to the amount of income recognized at the date of the exercise plus the cash paid to exercise the option. The holding period for the stock begins at the exercise date. Because the employee does not recognize income at the date of grant, the employer is not entitled to a corresponding deduction. At the date of the grant Louise does not recognize any income and the Somerton Corporation is not entitled to a deduction. Louise has compensation income of $2,800 [($15 - $11) x 700)] and her basis in the stock is $10,500 [($4 + $11) x 700]. This represents the $2,800 ($4 x 700) in ordinary income she recognized on the date of exercise, plus the $7,700 ($11 x 700) she paid to exercise the option. Because Louise recognized ordinary income at the date of exercise, the Somerton Corporation is entitled to a compensation deduction of $2,800. 67. Return to the facts of problem 66. If the stock is subject to substantial restrictions, what are the tax consequences for both Louise and Somerton on the date Louise is granted the stock option and the date she exercises the stock assuming she does not make a Section 83(b) election? How would your answer change if she makes a Section 83(b) election and the <a href="/keyword/fair-market-value/" >fair market value</a> of the stock when the restrictions lapse on March 31, 2009 is $22? An employee who receives a stock option that is subject to substantial risk of forfeiture is not taxed until the restriction on the option has lapsed. The employee is not considered to have a claim of right to the stock option until the restrictions lapse at that time the employee will recognize income. Because the employee does not recognize income at the date of grant or the date of exercise, the employer is not entitled to a corresponding deduction at either date. At the date of the grant, Louise does not recognize any income and the Somerton Corporation is not entitled to a deduction. Louise does not recognize any income at the date of exercise. Her basis in the stock is the $7,700 ($11 x 700), she paid to exercise the option. When the restrictions lapse on March 31, 2009, Louise must recognize income of $7,700 [($22 - $11) x 700]. Her basis in the stock $15,400 ($7,700 + $7,700). The Somerton Corporation is entitled to a compensation deduction of $7,700, the amount Louise recognizes as income, on the date the restrictions lapse. By making a Section 83(b) election at the date of exercise, Louise will treat as ordinary income the difference between the exercise price and the <a href="/keyword/fair-market-value/" >fair market value</a> of the stock at the date of exercise. Her basis is equal to the amount of income recognized at the date of the exercise plus the cash paid to exercise the option. The holding period for the stock begins at the exercise date. Louise has compensation income of $2,800 [($15 - $11) x 700)] and her basis in the stock is $10,500 [($4 + $11) x 700]. This represents the $2,800 ($4 x 700) in ordinary income she recognized on the date of exercise, plus the $7,700 ($11 x 700) she paid to exercise the option. Because Louise recognized ordinary income at the date of exercise, the Somerton Corporation is entitled to a compensation deduction of $2,800. Instructors Note: By making a Section 83(b) election Louise will recognize a lower amount of ordinary income as long as the stock price continues to increase. This is especially important if the stock is held for more than one year. 69. On July 1, 2008, Howard is granted the right to acquire 500 shares of the Matoney Corporation for $15 per share. The option qualifies under the company s incentive stock option plan. The current <a href="/keyword/fair-market-value/" >fair market value</a> of the stock is $12. On August 18, 2009 when the stock is selling for $18 per share, Howard exercises his option to purchase the stock. He sells the shares on September 15, 2010, for $29 per share. Determine the tax consequences for Howard and the Matoney Corporation on the An incentive stock option is not taxable when the option is granted or when it is exercised. Rather, the taxpayer is allowed capital gain treatment on the difference between the sales price of the stock and the price paid for the option (i.e., exercise price). However, this difference is a tax preference item in computing an individual s alternative minimum tax liability. Because the employee receives special tax treatment, the employer is not entitled to a compensation deduction for the difference between the option price and the <a href="/keyword/fair-market-value/" >fair market value</a> of the stock. a. Date of grant At the date of grant Howard does not recognize any income. Because he does not recognize any ordinary income, Matoney is not entitled to a compensation deduction. b. Date of exercise Howard does not recognize any income on the date of exercise, and Matoney is not entitled to a compensation deduction. However, the difference between the <a href="/keyword/fair-market-value/" >fair market value</a> of the shares at the date of exercise ($18) and the exercise price ($15) is a tax preference in computing his alternative minimum tax liability. Howard s tax preference is $1,500 [($18 - $15) x 500]. Howard s basis in the stock is $7,500 ($15 x 500). His holding period begins on the date of exercise. His basis for AMT purposes is $9,000 ($7,500 + $1,500) or $18 per share ($9,000 500). c. Date of sale Howard will recognize a long-term capital gain of $7,000 [($29 $15) x 500] on the sale of the stock. The gain is long-term because he has held the stock more than 12 months from the date of exercise. Matoney is not entitled to a compensation deduction. His gain for AMT purposes is $5,500 [($29 - $18) x 500] Assume that Howard sells the stock on August 15, 2010 for $27 per share. What are the tax consequences to Howard and the Matoney Corporation. Because Howard did not hold the stock for one year after the date of exercise (August 18, 2009, until August 15, 2010), the stock does not receive the favorable tax treatment of an ISO. For tax purposes the stock is treated as a nonqualified stock option. Howard must recognize $1,500 [($18 - $15) x 500] in ordinary income. Because he recognizes $1,500 as income, his basis in the stock is $9,000 ($1,500 + $7,500). When Howard sells the stock on August 15, 2010 for $13,500 ($27 x 500 shares) he recognizes a short-term capital gain of $4,500 ($13,500 - $9,000). The gain is short term because he did not hold the stock more than 12 months from the date of exercise. Because Howard recognizes ordinary income on the stock option, Matoney is entitled to a compensation deduction of $1,500. For regular tax purposes, Howard will get a tax credit to the extent the $1,500 caused Howard to pay an AMT tax in the year of exercise. 79. Alice and Frank had the following items on their current-year tax return: <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> 90,000 Less: Deductions from <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> Medical expenses $ 7,200 Less: 7.5% x $90,000 (6,750) Home mortgage interest Home equity loan interest State income taxes Property taxes <a href="/keyword/charitable-contributions/" >charitable contributions</a> (cash) Miscellaneous itemized deductions $ 2,200 Less: 2% x $90,000 (1,800) (11,200) Less: Exemptions (2 x $3,500) (7,000) $ $ 450 5,300 1,200 2,325 950 575 400 Determine the amount of the adjustments that Alice and Frank will have to make in computing their alternative minimum tax. The primary adjustments that are required of individual taxpayers are for deductions from <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> that are either modified or not allowed for AMT purposes. The only itemized deductions allowed from AGI for AMT purposes are 1. 2. 3. 4. 5. 6. Medical expenses in excess of 10% of AGI (i.e., not 7.5%) <a href="/keyword/charitable-contributions/" >charitable contributions</a> Casualty and theft losses Qualified housing interest Investment interest Miscellaneous itemized deductions not subject to the 2 percent of AGI reduction (gambling losses, premature cessation of annuities) Personal and dependency exemption amounts are not deducted in arriving at AMTI. Home equity loan interest is deductible only if the proceeds of the loan were used to improve the residence. Alice and Frank will not be able to deduct the following expenses that are deductible for regular taxable income: (1) Medical expenses are not deductible because the actual amount, $7,200, is less than the threshold amount of $9,000 (10% x $90,000). Therefore, the $450 of medical expenses deducted for regular tax purposes is not deductible for AMT purposes. (2) State taxes ($2,325) and property taxes ($950) are not deductible for AMTI. (3) Assuming that the home equity loan is not used to improve the house, the home equity interest ($1,200) is not deductible. (4) The miscellaneous itemized deductions ($400) are not deductible because only miscellaneous itemized deductions that are not required to be reduced by 2% of <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> are permitted. (5) The exemptions of $7,000 are not deductible for AMT purposes. Regular taxable income: <a href="/keyword/adjusted-gross-income/" >adjusted gross income</a> (AGI) 90,000 Less: Total deductions from AGI (11,200) Less: Exemptions (7,000) Taxable income 71,800 AMT adjustments for itemized deductions and exemptions: Add: Medical expenses $ 450 Home equity loan interest 1,200 State income taxes 2,325 Property taxes 950 Miscellaneous itemized deductions 400 Exemptions 7,000 12,325 84,125 Less: AMT exemption (married filing jointly) (66,250) Equals: AMTI 17,875 Tax Rate 26% Tax 4,648 $ $ $ $ x $ A married couple filing a joint return on $71,800 of taxable income would have a regular tax liability of $10,638: $8,962.50 + [25% x ($71,800 - $65,100)] = $10,638 Because their regular tax ($10,638) is greater than their alternative minimum tax ($4,648), they are not subject to the alternative minimum tax and their total tax liability is $10,638. 38. Use any print or CATR or the Internet to find a Code section(s) on the following deduction topics. For each item, indicate the Code section number(s) and full title of the relevant Code section(s). a. <a href="/keyword/charitable-contributions/" >charitable contributions</a> The Code Section that discusses <a href="/keyword/charitable-contributions/" >charitable contributions</a> is Sec. 170 and is entitled: <a href="/keyword/charitable-contributions/" >charitable contributions</a> etc., and gifts. Instructors Note: The charitable contribution deduction for estate and gift taxes is at Sec. 2522. b. Dividends-received deduction for corporations The Code Section that discusses the dividends received deduction for corporations is Sec. 243 and is entitled: Dividends received by corporations c. Medical expenses The Code Section that discusses medical expenses is Sec. 213 and is entitled: Medical, dental expenses etc.