I:3 Chapter Gross Income-Inclusions True-False
I:3-1. Except as otherwise provided, gross income means all income from whatever source derived. T, p. I:3-2. I:3-2. Under the economists definition, unrealized gains, as well as gifts and inheritances, are income. T, p. I:3-2. I:3-3. The definition of income for income tax purposes is closer to the accountant's concept of income than to the economist's concept and generally relies on objectivity. T, p. I:3-3. I:3-4. The wherewithal-to-pay concept provides that a tax should be collected when the taxpayer is most easily able to pay the tax. T, p. I:3-4. I:3-5. Internal Revenue Code Section 61 provides an inclusive list of all possible items taxed under the Code. F, p. I:3-4. I:3-6. Gross income is limited to amounts received in the form of cash. F, p. I:3-4. I:3-7. Gross income may be realized when a taxpayer receives economic benefit even if no cash is received. T, p. I:3-4. I:3-8. Gregory receives 100 shares of stock from his employer as a year-end bonus. The fair market value of the stock is included in Gregorys income for the year. T, p. I:3-5. Solution: Example I:3-3. I:3-9. Ellen, a CPA, prepares a tax return for Frank, a farmer, in exchange for twenty bushels of rice. Since no cash changed hands, neither taxpayer reports income. F, p. I:3-5. Solution: Example I:3-4. I:3-10. AAA Corporation distributes an automobile to Alexandria, a shareholder, in lieu of a cash dividend. Alexandria must report the value of the automobile as dividend income. T, p. I:35. Solution: Example I:3-5. I:3-11. The portion of a taxpayers wages that are garnished by court order and forwarded to pay a
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delinquent bank loan are not taxable income to the taxpayer. F, p. I:3-5. Solution: Example I:3-6. I:3-12. A taxpayer may not avoid responsibility for payment of income taxes by assigning the income to a third party. T, p. I:3-6. I:3-13. For federal income tax purposes, income is allocated between a husband and wife depending on the state of residence. T, p. I:3-6. I:3-14. In community property states, income from separate property owned before marriage is always considered separate income after marriage. F, p. I:3-7. Solution: In Idaho, Louisiana, and Texas, such income is community income. I:3-15. Earnings of a minor child are taxed to the child regardless of the states property law system. T, p. I:3-8. I:3-16. If a taxpayer's method of accounting does not clearly reflect income, the IRS may specify a different accounting method which must be used by the taxpayer. T, p. I:3-8. I:3-17. The cash receipts and disbursements method of accounting is used by most individual taxpayers and most noncorporate businesses that do not have inventories. T, p. I:3-8. I:3-18. Under the cash method of accounting, income is reported in the year the taxpayer actually or constructively receives the income. T, p. I:3-8. I:3-19. A cash-basis taxpayer can defer income recognition by refusing to accept payment. F, p. I:3-9. I:3-20. A check received after banking hours is considered constructively received by the payee even though the check can not be converted to cash. T, p. I:3-10. I:3-21. Interest credited to a bank savings account is taxed regardless of whether or not it is withdrawn. T, p. I:3-10. I:3-22. Interest on Series E and Series EE U.S. savings bonds may be reported when the bonds mature. T, p. I:3-10.
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I:3-23. Under the accrual method of accounting, income is considered earned when all the events have occurred which fix the right to receive the income and when the amount of income can be determined with reasonable accuracy. T, p. I:3-11. I:3-24. An accrual basis taxpayer may defer advance payments for services if the payments are for services to be performed before the end of the tax year following the year of receipt. T, p. I:3-12. I:3-25. Gains realized from property transactions are included in gross income unless a nonrecognition rule applies. T, p. I:3-13. I:3-26. Interest on the obligations of the U.S. government, states, territories, and U.S. possessions and their political subdivisions are tax-exempt. F, p. I:3-14. Solution: Interest on U.S. government obligations is taxable. I:3-27. An amount received by a lessor to cancel, amend, or modify a lease is taxable. T, p. I:3-15. I:3-28. Improvements to leased property made by a lessee are includable in the lessors gross income only if made in lieu of rent or if rent is reduced because of the improvements. T, p. I:3-15. I:3-29. In 2007, qualified dividends received by individuals are taxed at either 5% or 15% depending on the taxpayers marginal tax rate. T, p. I:3-16. I:3-30. Distributions in excess of a corporation's current and accumulated earnings and profits are treated as a nontaxable recovery of capital unless they exceed the basis of the stock. T, p. I:3-17. I:3-31. The recipient of a taxable stock dividend includes the value of the stock received in gross income and that amount becomes the basis for the stock received. T, p. I:3-17. I:3-32. Alimony received is taxable to the payee while child support payments are not. T, p. I:3-18. I:3-33. In order to be treated as alimony for tax purposes, payments must be made in cash. T, p. I:319. I:3-34. Property settlements made incident to a divorce have no immediate tax consequences; that is, the transfer from one spouse to another is not taxable. T, p. I:3-19. I:3-35. With some exceptions, amounts withdrawn from a pension prior to the normal starting date are subject to a ten percent nondeductible penalty. T, p. I:3-22.
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I:3-36. An S corporation shareholder is not taxed on his or her share of the corporation's income unless the income is actually distributed in the form of cash. F, p. I:3-23. I:3-37. Income from illegal activities is taxable. T, p. I:3-24. I:3-38. Unemployment compensation is exempt from federal income tax. F, p. I:3-24.
Multiple-Choice
I:3-39. In the current year, Marlena earned a salary of $50,000. She consumed $25,000 of food, clothing, housing and medical care. Assets owned by Marlena at the beginning of the year had a value of $110,000 (including $10,000 of saved salary); at the end of the year the value was $125,000. What is the amount of Marlenas economic income and her accounting income? Economic income Accounting income a. $15,000 $50,000 b. $15,000 $40,000 c. $40,000 $50,000 d. $40,000 $40,000 c, pp. I:3-2 and I:3-3; Examples I:3-1 and I:3-2. Solution: Economic income is [$25,000 + ($125,000 - $110,000)] = $40,000. The accounting income includes the salary only. I:3-40. Which one of the following items is not considered gross income for tax purposes? a. gambling winnings b. illegal income c. life insurance proceeds d. forgiveness of loan c, pp. I:3-4 and I:3-5; Example I:3-7. Solution: Forgiveness of debt is taxable. I:3-41. Frasier and Marcella, husband and wife, file separate returns. Frasier and Marcella live in a community property state that considers separate property income to be separate. Frasier's salary is $32,000 and Marcella's salary is $35,000. Marcella receives dividend income of $4,000 from stock inherited from her parents. Frasier receives interest income of $5,000 from bonds purchased with his salary after marriage. Frasier and Marcella receive $10,000 dividend income from stock they purchased jointly. Marcella's income would be a. $45,000. b. $44,000. c. $42,500. d. $41,500. a, p. I:3-7; Example I:3-8. Solution: ($16,000 + $17,500 + $4,000 + $2,500 + $5,000 = $45,000.)
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I:3-42. Bill and Hillary, husband and wife, file separate returns. Bill and Hillary live in a community property state that considers separate property income to be community income. Bill's salary is $32,000 and Hillary's salary is $36,000. Hillary receives dividend income of $4,000 from stock inherited from her parents. Bill receives interest income of $5,000 from bonds purchased with his salary after marriage. Bill and Hillary receive $10,000 dividend income from stock they purchased jointly. Hillary's income would be a. $42,500. b. $43,500. c. $45,000. d. $45,500. b, p. I:3-7; Example I:3-8. Solution: ($16,000 + $18,000 + $2,000 + $2,500 + $5,000 = $43,500.) I:3-43. All of the following statements are true except a. Under the cash method, prepaid income such as rent is usually taxed when received rather than when earned. b. The annual increase in the cash surrender value of life insurance is taxable. c. Interest on Series EE savings bonds is not taxable until maturity. d. All of the above statements are true. b, pp. I:3-8 and I:3-10; Examples I:3-9, I:3-10, I:3-13. I:3-44. Examples of income which are constructively received include all of the following except a. interest credited to a savings account. b. a check received after banking hours. c. a paycheck received from employer, when employer does not have funds in the bank to cover the check. d. dividends available on December 31; unclaimed dividends will be mailed out. c, p. I:3-10; Example I:3-11. Solution: Since the funds are not available to the employee, they are not considered constructively received. I:3-45. Farmers may report crop insurance proceeds in the year following receipt if the crop would have ordinarily been sold in the a. earlier year. b. following year c. same year as the receipt. d. none of the above. b, p. I:3-10. Solution: The Code provides that farmers may report crop insurance proceeds in the year following receipt if the crop would have ordinarily been sold in the following year. I:3-46. Ms. Marples books and records reflect the following information: Salary earned this year $65,000
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Interest on savings account (credited to her account this year, withdrawn next year) Interest on county bonds earned and collected this year Interest on savings account (credited to her account last year, withdrawn this year) What is the amount Ms. Marple should include in her gross income this year? a. $66,800 b. $67,000 c. $67,200 d. $69,000 a, p. I:3-10. Solution: $65,000 + $1,800 = $66,800.
1,800 2,000 200
I:3-47. One of the requirements that must be met in order to defer recognition of income for advance payments for goods is a. the taxpayer's method of accounting for the sale for tax purposes is the same as the method used for financial reporting purposes. b. the goods are on the taxpayer's premises on the last day of the tax year. c. the goods are produced in the United States. d. the amount received is more than the taxpayer's cost of the goods. a, p. I:3-11. Solution: The tax reporting method must match the financial reporting method. I:3-48. Which of the following advance payments cannot qualify for income tax deferral? a. advance collection for services b. advance collection for merchandise c. advance collection of rent with out associated services d. advance collection of rent with associated services c, p. I:3-12. Solution: Rent received in advance is immediately taxable assuming no services are associated with the rent.
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I:3-49. CT Computer Corporation, an accrual basis taxpayer, sells service contracts on the computers it sells. At the beginning of January of this year, CT Corporation sold contracts with service to begin immediately: One for three months $150 One for 20 months costing 600 One for 36 months costing 900 The amount of income CT Corporation must report for this year is a. $810. b. $1,360. c. $1,410. d. $1,650. c, p. I:3-12; Example I:3-15. Solution: ($150 + $360 + $900 = $1,410) Collections for services that do not extend beyond the next tax year may be accrued. $600 / 20 months = $30 per month. $30 x 12 months this year = $360 of the $600 accrued this year. I:3-50. Alex is a calendar year sole proprietor. He began business on December 1, this year. He uses the accrual method of accounting. Alex had the following collections in December. Collected $7,000 in December, from clients who paid cash for services to be performed next year. Collected $5,000 in December, for services performed during December; deposited in an operating account on December 31, this year. Collected $9,000 in December; on accounts receivable for services performed in December; deposited in operating account on January 2, next year. What is the amount Alex must include in his income for December? a. $7,000 b. $12,000 c. $14,000 d. $21,000 c, p. I:3-12. Solution: $5,000 + $9,000 = $14,000. I:3-51. Mickey, who gives music lessons, is a calendar year taxpayer using the accrual method of accounting. On October 1 of this year, he received $25,000 for a one-year contract beginning on that date to provide 10 lessons. He gave 6 lessons this year. How much should Mickey include in income this year? a. $0 b. $10,000 c. $15,000 d. $25,000 c, p. I:3-12. Solution: $25,000/10 lessons = $2,500 per lesson. 6 lessons in this year times $2,500 = $15,000. I:3-52. All of the following are excluded from taxable income as a fringe benefit except
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a. b. c. d.
Christmas bonus check. group term life insurance. employee discount. contribution to retirement plans.
a, p. I:3-13. Solution: There is no provision in the Code to exclude bonuses from income. I:3-53. Which of the following bonds do not generate tax-exempt Federal income? a. U.S. Treasury bonds b. bonds issued by fire districts c. school district bonds d. bonds issued by port authorities a, p. I:3-14. Solution: There is no provision in the Code to exclude from interest income from U.S. Treasury bonds. I:3-54. Carla redeemed EE bonds which qualify for the educational exclusion. The redemption consisted of $14,000 principal and $6,000 interest. The net qualifying educational expenses are $8,000. No reduction of the exclusion is required. The taxable interest is a. $0. b. $2,400. c. $3,600. d. $6,000. c, p. I:3-14; Example I:3-16. Solution: [$6,000 x ($8,000 / $20,000)] = $2,400 exclusion. $6,000 - $2,400 = $3,600 taxable. I:3-55. In December of this year, Jake and Stockard, a married couple, cashed qualified Series EE U.S. Savings Bonds which they had purchased in January 1993. The proceeds were used to help pay for their daughter's college tuition. Jake and Stockard received proceeds of $5,000 representing principal of $2,500 and interest of $2,500. The qualified higher educational expenses they paid this year totaled $2,000. What is the amount of interest income Jake and Stockard can exclude from their income this year? a. $1,000 b. $1,500 c. $2,000 d. $2,500 a, p. I:3-14; Example I:3-16. Solution: [$2,500 x ($2,000 / $5,000)] = $1,000 exclusion.
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I:3-56. Jacob, who is single, paid educational expenses of $16,000 in 2007. He redeemed Series EE bonds and received principal of $8,000 and interest of $3,000. Jacob has other adjusted gross income of $66,100. The $3,000 exclusion must be reduced by a. $0. b. $1,200. c. $1,800. d. $3,000. b, p. I:3-15; Example I:3-17. Solution: $3,000 x [($66,100 + $3,000 - $63,100)/$15,000] = $1,200. I:3-57. In December 2007, Max, a cash basis taxpayer, rents an apartment to Charlie. Max receives both the first and last months rent totaling $1,000 plus a security deposit of $400. The amount of income reported as taxable in 2007 is a. $500. b. $900. c. $1,000. d. $1,400. c, p. I:3-15; Example I:3-18. Solution: A security deposit is not taxable until final disposition. That is, it is not taxable unless nonrefundable or until the tenant moves out and all or part of the deposit is not returned to the tenant. Rent is taxable when received. I:3-58. Hoyt rented office space two years ago, to Harris, receiving the first and last months' rent plus a security deposit of $800. In early January of this year, Harris moves and Hoyt refunds $350 of the deposit and keeps the remainder to cover $250 which is spent for repairs to the office space and one week of unpaid rent that amounts to $200. How would this information be reflected on Hoyt' tax return this year? a. $450 income and $250 deduction b. $450 income and no deduction c. $200 income and $250 deduction d. $800 income and $250 deduction a, p. I:3-15; Example I:3-18. Solution: The $450 deposit not returned to the tenant is income. However, the $250 repairs may be deducted.
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I:3-59. Rocky, an accrual-basis taxpayer, leases out an office building at $1,000 per month, starting in October. Rocky receives rent for October and November. He also charges a refundable security deposit of $800 which he also received in October. Rocky's tenant does not pay the December rent until January 2, of next year. This year, Rocky must report rental income of a. $2,000. b. $2,800. c. $3,000. d. $3,800. c, p. I:3-15. Solution: Three months rent for the accrual basis taxpayer at $1,000 per month = $3,000. I:3-60. Which of the following is not included in gross income when received? a. prepaid rent b. mineral rights c. amounts received to cancel or modify a lease d. refundable security deposit d, p. I:3-15. Solution: A security deposit is not taxable until final disposition. That is, it is not taxable unless nonrefundable or until the tenant moves out and all or part of the deposit is not returned to the tenant. I:3-61. Professor Jones rents property and does not provide any services associated with the rentals. He is also a cash basis taxpayer. If Professor Jones collects advanced rent of $3,600 on October 1 of this year for a one-year lease, how much is reported as income on this years tax return? a. $-0b. $300 c. $900 d. $3,600 d, p. I:3-15. Solution: Rent collected in advance is income in the year received. I:3-62. Professor Jones rents property and does not provide any services associated with the rentals. He is also an accrual basis taxpayer. If Professor Jones collects advanced rent of $3,600 on October 1 of this year for a one-year lease, how much is reported as income on this years tax return? a. $-0b. $300 c. $900 d. $3,600 d, p. I:3-15. Solution: Rent collected in advanced is income in the year received even by an accrual basis taxpayer. I:3-63. Professor Jones rents property and does not provide any services associated with the
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rentals. He is also a cash basis taxpayer. If Professor Jones collects a damage deposit of $3,600 on October 1 of this year for a one-year lease, how much of the deposit is reported as income on this years tax return? a. $-0b. $300 c. $600 d. $3,600 a, p. I:3-15. Solution: Damage deposits are not income unless kept at the end of the lease to pay for damages. I:3-64. Ricky has rented a house from Sarah since last year. The rent is usually $800 per month, but Sarah reduced the monthly rent down to $600 for all twelve months this year in exchange for Ricky constructing an addition to the house. The addition has a fair market value of $3,500. How much total rental income must Sarah report this year? a. $7,200 b. $9,600 c. $10,700 d. $14,200 c, p. I:3-16; Example I:3-19. Rent collected of $7,200 (12 X $600) plus FMV of improvement $3,500 = $10,700. I:3-65. Distributions from corporations to the shareholders in a non-liquidating distribution will usually be classified as a dividend up to the amount of the corporations a. earnings and profits. b. retained earnings. c. taxable income for the year. d. stock basis. a, p. I:3-17. Solution: A distribution is considered a dividend to the extent of current and accumulated earnings and profits.
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I:3-66. Mrs. Richard purchased stock in Emma Corporation two years ago for $2,500. Last year, she received a distribution of $1,000, when Emma had no current or accumulated earnings and profits. This year, Mrs. Richard received a $200 dividend, when Emma had earnings and profits in excess of its distribution. There has been no other activity related to this stock. What is Mrs. Richard's taxable dividend income for last year and this year, and what is her basis in the Emma Corporation stock as of December 31, this year? This Year's Last Year's This Year's Basis Income Income 12-31 a. $1,000 $200 $2,500 b. $1,000 $200 $1,500 c. $0 $200 $1,500 d. $0 $200 $2,500 c, p. I:3-17; Example I:3-22. Solution: Last years distribution of $1,000 is considered return of capital since there were no current or accumulated earnings and profits. The $200 is a taxable dividend this year because there are sufficient earnings and profits. The stock basis was $2,500 original cost less $1,000 nontaxable distribution from last year or $1,500. I:3-67. Erin is the sole shareholder of Hazelwood Corporation. The basis of her stock is $75,000. Accumulated earnings and profits at the beginning of this year are $35,000, and current earnings and profits are $5,000. This year Hazelwood makes a cash distribution to Erin of $60,000. This year, Erin will report Taxable Non-Taxable Dividend Return of Income Capital a. $ 5,000 $55,000 b. $ 35,000 $25,000 c. $ 40,000 $20,000 d. $ 60,000 $-0c, p. I:3-17; Example I:3-22. Solution: The dividend is taxable to the extent of current and accumulated earnings and profits of $40,000. The remainder or $20,000 ($60,000 - $40,000) is nontaxable return of capital.
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I:3-68. Jill is the sole shareholder of Able Corporation. The basis of her stock is $70,000. Accumulated earnings and profits at the beginning of this year are $35,000, and current earnings and profits are $5,000. This year Able makes a cash distribution to Jill of $120,000. This year, Jill will report Taxable Non-Taxable Long-term Dividend Return of Capital Income Capital Gain a. $ 5,000 $70,000 $45,000 b. $ 35,000 $70,000 $15,000 c. $ 40,000 $70,000 $10,000 d. $ 120,000 $-0$-0c, p. I:3-17; Example I:3-22. Solution: The dividend is taxable to the extent of current and accumulated earnings and profits of $40,000. The remainder or $80,000 ($120,000 - $40,000) is nontaxable return of capital, but only to the extent of the adjusted basis of the stock, $70,000. Therefore, $10,000 ($80,000 - $70,000) is long-term capital gain. I:3-69. Donald bought stock in Kat Corporation for $3,500 in 1990. Donald received a distribution of $1,000 in a year when Kat Corporation had no current or accumulated earnings and profits. Donald sold his Kat Corporation stock this year for $4,500. What is the amount of long-term capital gain to be reported by Donald? a. $-0b. $1,000 c. $2,000 d. $4,500 c, p. I:3-17. Solution: $4,500 ($3,500 original basis - $1,000 return of capital) = $2,000. I:3-70. Keith purchased 2,000 shares of GSX Corporation for $13,200. This year, GSX declared a 10% stock dividend, and Keith received 200 shares. After the dividend Keith's per share basis will be a. $6.00. b. $6.57. c. $6.60. d. $7.26. a, p. I:3-18; Example I:3-23. Solution: $13,200 original basis divided by 2,200 new total number of shares = $6 per share.
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I:3-71. Which of the following is least likely to result in a constructive dividend? a. an unreasonable salary paid to a shareholder. b. a sale of a corporations asset to a shareholder at fair market value. c. a payment by a corporation of a shareholders debts. d. a payment by a corporation of a shareholders personal expenses. b, p. I:3-18. Solution: The sale of an asset at fair market value will not result in a constructive dividend. I:3-72. Alimony is a. deductible by both the payor and the payee. b. deductible by the payor, and included in income by the payee. c. included in income by the payor and deducted by the payee. d. an item which does not affect the payors and the payees tax reporting. b, p. I:3-18. Solution: The Code includes alimony in the definition of gross income of the payee and specifically allows a for AGI deduction for alimony paid by the payor. I:3-73. With respect to alimony and property settlements in a divorce or separation, all of the following are true with the exception of a. a property settlement does not result in income to either spouse. b. no tax deduction is allowed for payment of a property settlement. c. the spouse receiving a property settlement has a basis equal to the basis of that property to the paying spouse prior to payment. d. no deduction is allowed for alimony paid to the former spouse, if a property settlement is also paid. d, p. I:3-19. Solution: Alimony is taxable to the payee and deductible by the payor; a property settlement has no tax consequences. I:3-74. The requirements for a payment to be considered as alimony include all of the following except a. be made in cash or property. b. be made pursuant to a divorce, separation or a written agreement between the spouses. c. terminate at the death of the payee. d. not be designated as being other than alimony. a, p. I:3-19. Solution: Property may not be part of an alimony payment.
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I:3-75. Child support is a. deductible by both the payor and the payee. b. deductible by the payor, and included in income by the payee. c. included in income by the payor and deducted by the payee. d. an item which does not affect the payors and the payees tax reporting. d, p. I:3-18. Solution: The Code specifically excludes child support from taxable income and does not specifically allow a deduction for child support paid. I:3-76. Thomas and Sally were divorced last year. As a result, Thomas must pay Sally alimony of $100,000 per year starting this year and relinquish the house and car with a combined value of $170,000 and a combined cost basis of $155,000. The house and car are given as a property settlement. As a result of these transactions Thomas has a deduction of a. $100,000. b. $155,000. c. $170,000. d. $270,000. a, p. I:3-19. Solution: Only the $100,000 alimony is a for AGI deduction for Thomas. I:3-77. Carolyn, who earns $400,000, is required to pay John, her ex-husband, $200,000 as part of the property settlement as a result of their divorce. In turn, John transfers stock worth $50,000 to Carolyn. What is the amount of Carolyns adjusted gross income for the year? a. $200,000 b. $250,000 c. $400,000 d. $450,000 c, p. I:3-19; Examples I:3-25 and I:3-26. Solution: Neither the transfer of cash to John nor the transfer of stock to Carolyn are taxable events. Thus, only the $400,000 salary is included in Carolyns adjusted gross income.
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I:3-78. Under the terms of their divorce agreement executed in August of this year, Clint transferred Beta, Inc. stock to his former wife, Rose, as a property settlement. At the time of the transfer, the stock had a basis to Clint of $55,000 and a fair market value of $68,000. Rose subsequently sold the stock for $75,000. What is the tax consequence of first the stock transfer and then the stock sale to Rose? Rose's Income Rose's Income Stock From Transfer From Stock Sale a. $0 $20,000 capital gain b. $0 $7,000 capital gain c. $13,000 $7,000 capital gain d. $13,000 $20,000 capital gain a, p. I:3-19; Example I:3-26. Solution: The stock transfer has no tax consequences because it is a property settlement. Roses basis in the stock is $55,000, Clints carryover basis. Thus, her gain on the sale is $20,000 ($75,000 - $55,000). I:3-79. Under the terms of their divorce agreement, Humphrey transferred Corporation H stock to his former wife, Greta as a property settlement. At the time of the transfer, the stock had a basis to Humphrey of $40,000 and a fair market value of $55,000. What is the tax consequence of this transaction to Humphrey, and what is Greta's basis in the Corporation H stock? a. Humphrey has no gain or loss; Greta's basis is $55,000 b. Humphrey has no gain or loss; Greta's basis is $40,000 c. Humphrey has a gain of $15,000; Greta's basis is $55,000 d. Humphrey has a gain of $15,000; Greta's basis is $40,000 b, p. I:3-19; Example I:3-26. Solution: There are no tax consequences from the property settlement. Greta has a carryover basisthat is, she takes Humphreys basis of $40,000. I:3-80. As a result of a divorce, Michael pays Judy $75,000 in year one and $25,000 per year in subsequent years. How much is deductible by Michael in year one? a. $25,000 b. $35,000 c. $40,000 d. $75,000 d, p. I:3-20. Solution: Although $35,000 will be recaptured in year three, the entire payment is deductible in year one.
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I:3-81. As a result of a divorce, Michael pays Judy $75,000 in year one and $25,000 per year in subsequent years. How much of the $75,000 in year one is properly characterized as alimony, and will not be recaptured later? a. $25,000 b. $35,000 c. $40,000 d. $75,000 c, p. I:3-20; Example I:3-27. Solution: First year alimony Minus: $15,000 change limit Minus: Average 2nd and 3rd year alimony Minus: Amount to be recaptured Amount not subject to recapture $75,000 (15,000) (25,000) (35,000) $40,000
I:3-82. Thomas purchased an annuity for $20,000 that will pay him $500 per month for ten years. What amount should Thomas include in his income each year? a. $0 b. $2,000 c. $4,000 d. $6,000 c, p. I:3-21; Example I:3-29. Solution: ($500 x 12 x 10) = $60,000 Expected return. ($20,000 / $60,000) x $6,000 = $2,000 Exclusion. $6,000 - $2,000 = $4,000 amount included in income. I:3-83. Anne, age 58, purchases an annuity for $33,600. Anne will receive $400 per month for the rest of her life. The expected return multiple is 20.0. At age 65, the amount that Anne may exclude from income is a. $0. b. $1,680. c. $3,120. d. $4,800. b, p. I:3-21; Example I:3-29. Solution: ($33,600/$96,000) x $4,800 = $1,680.
I:TB3-17
I:3-84. Julia, age 57, purchases an annuity for $33,600. Julia will receive $400 per month for the rest of her life. The expected return multiple is 20.0. At age 88, the amount that Julia may exclude from income is a. $0. b. $1,680. c. $3,120. d. $4,800. a, p. I:3-22. Solution: Once life expectancy is reached, the annual exclusion is no longer available because the original investment has been recovered. I:3-85. Marvin, age 62, retires and receives $2,000 per month annuity from his employers qualified pension plan. Marvin contributed $130,000 to the plan prior to his retirement. Under the simplified method, Marvins number of anticipated payments is 260. What is the amount includible in income in the first year of withdrawals assuming 12 monthly payments? a. $0 b. $6,000 c. $18,000 d. $24,000 c. p. I:3-22; Example I:3-30. Solution: $130,000/($2,000 x 260) x $24,000 = $6,000 excludible; $24,000 - $6,000 = $18,000 includible. I:3-86. Jonathon, age 50 and in good health, withdrew $6,000 from his pension plan during the current year. The withdrawal was not eligible for any exception to the 10% penalty. Jonathan had made $40,000 of after-tax contributions to the plan while his employer had contributed $80,000. How much must Jonathon include in income? a. $0 b. $3,000 c. $4,000 d. $6,000 c, p. I:3-22; Example I:3-31. Solution: $80,000/$120,000 x 6,000 = $4,000.
I:TB3-18
I:3-87. Jan purchased an antique desk at auction. For two years, the desk sat in Jan's garage until she decided to restore it. This year, while cleaning and restoring the desk, Jan discovered $1,500 in a hidden compartment inside one drawer. With respect to the $1,500, Jan must a. report nothing. b. amend her previous tax return and report the $1,500. c. report only $750 due to the statute of limitations. d. report $1,500 on this year's tax return. d, p. I:3-24; Example I:3-32. Solution: All income is taxable unless specifically excluded by the Code. I:3-88. While using a metal detector at the beach during spring break, Toni uncovered some rare coins with a current fair market value of $9,000. What are her tax consequences regarding this find? a. Because it was a find she only reports half of the FMV as income. b. She reports the entire FMV as income. c. Since she found the coins, she does not have to report any amount of income until she sells the coins. d. Under the discovery rules in the tax law, she will never report any amount as taxable since the value is under $10,000. b, p. I:3-24. Solution: All income is taxed except that which is specifically excluded. There is no exclusion for this type of found income. I:3-89. A taxpayer had the following income and losses in the current year: Salary Sold AT&T stock at a loss Lottery prize Gambling winnings Gambling losses What is the taxpayer's adjusted gross income? a. $57,500 b. $59,500 c. $62,500 d. $64,500 $55,000 ( 5,000) 4,500 8,000 ( 5,000)
d, p. I:3-24. Solution: Gambling losses are deductible as itemized deductions, to the extent of gambling winnings and therefore do not affect AGI. The capital loss deduction is limited to $3,000. $55,000 - $3,000 + $4,500 + $8,000 = $ 64,500.
I:TB3-19
I:3-90. Lily had the following income and losses: Salary Prize from quiz show Unemployment compensation Embezzled funds Partnership Income What is Lily's adjusted gross income? a. $135,000 b. $143,000 c. $165,000 d. $173,000 d, p. I:3-24. Solution: $75,000 + $25,000 + $8,000 + $30,000 + $35,000 = $173,000. I:3-91. Lori had the following income and losses: Wages Share of partnership income Unemployment compensation Gambling winnings Gambling losses Prize won on a game show What is Loris adjusted gross income? a. $65,000 b. $79,000 c. $82,000 d. $84,000
$75,000 25,000 8,000 30,000 35,000
$20,000 20,000 12,000 2,000 ( 5,000) 30,000
d, p. I:3-24. Solution: Gambling losses, to the extent of gambling winnings, are deductible as itemized deductions and do not affect AGI. $20,000 + $20,000 + $12,000 + $2,000 + $30,000 = $84,000. I:3-92. The term "social security benefits" does not include a. supplementary Medicare benefits. b. tier-one railroad retirement benefits. c. disability benefits received under social security. d. retirement benefits received under social security. a, p. I:3-24. Solution: Medicare benefits are not included in the term.
I:TB3-20
I:3-93. In addition to social security benefits of $8,000, Mr. and Mrs. Wells have adjusted gross income of $32,000 and tax-exempt interest of $1,000 and will file a joint return. The taxable portion of their social security benefits will be a. $0. b. $2,500. c. $4,000. d. $8,000. b, p. I:3-25; Example I:3-33. Solution: ($32,000 + $1,000 + $4,000 [one-half of social security]) $32,000 = $5,000.00 x 0.50 = $2,500 subject to the ceiling limit of one half of social security benefits, which is $4,000. Eighty-five percent of a portion of the social security benefits are subject to tax only if provisional income exceeds $44,000 on a joint return, or $34,000 for a single taxpayer. I:3-94. Mr. & Mrs. Bronson are both over 65 years of age and are filing a joint return. Their income this year consisted of the following: Taxable interest $ 6,000 Taxable dividends 9,000 Social Security payments (combined) 20,000 Tax-exempt interest 5,000 Taxable pension 11,000 They did not have any adjustments to income. What amount of Mr. & Mrs. Bronson's social security benefits is taxable this year? a. $-0b. $4,500 c. $10,000 d. $20,000 b, p. I:3-25; Example I:3-33. Solution: ($6,000 + $9,000 + $10,000 + $5,000 + $11,000) - $32,000 = $9,000 x 0.50 = $4,500 subject to the ceiling limit of one half of social security benefits, which is $10,000. Eighty-five percent of a portion of the social security benefits are subject to tax only if provisional income exceeds $44,000 on a joint return, or $34,000 for a single taxpayer.
I:TB3-21
I:3-95. Reva is a single taxpayer with a taxable pension of $20,000, tax-exempt interest of $15,000, and Social Security benefits of $10,000. What is the amount of her taxable Social Security benefits? a. $5,000 b. $8,500 c. $9,600 d. $10,000 b, p. I:3-25; Example I:3-33. Solution: Her provisional income is $20,000 + 15,000 + $5,000(.50 x $10,000) =$40,000. The taxable Social Security benefits are equal to $8,500 which is the lesser of $8,500 (.85 x$10,000) or $9,600 computed as follows: [($40,000 - $34,000 threshold) x.85] + the lesser of $4,500 or $5,000. I:3-96. Insurance proceeds received because of the destruction of property are a. included in gross income in all cases. b. excluded from gross income completely. c. included in gross income to the extent the proceeds are less than the adjusted basis of the replacement property. d. included in gross income only to the extent the proceeds exceed the adjusted basis of the replacement property. d, p. I:3-26. Solution: basis. The proceeds are not taxable to the extent of return of capitaladjusted
I:3-97. Homer Corporations office building was destroyed by fire. Homer collected insurance of $250,000, which equaled the buildings basis, and $150,000 for profits lost during the time the company was rebuilding the office building. What is the amount taxable this year? a. $0 b. $150,000 c. $250,000 d. $400,000 b, p. I:3-26; Example I:3-34. Solution: Only the $150,000 to cover lost profits is taxable.
I:TB3-22
I:3-98. During 2007, Christianas employer withheld $1,500 from her wages for state income taxes. She claimed the $1,500 as an itemized deduction on her 2007 federal income tax return which included $7,000 of itemized deductions. Christiana is single. On her 2007 state income tax return, her state income tax was $900. As a result, Christiana received a $600 refund in 2008. What amount must Christiana include in income in 2008? a. $0 b. $600 c. $900 d. $1,500 b, p. I:3-26; Example I:3-35. Solution: She received the full tax benefit of her itemized deduction so the entire amount of the refund is taxable. I:3-99. During 2007, Marlas employer withheld $2,000 from her wages for state income tax. Marla claimed the $2,000 as an itemized deduction on her 2007 federal income tax return. Her total itemized deductions for 2007 were $6,000. Marlas taxable income for 2007 was a negative $20,000. Marla received the $2,000 as a refund from the state during 2008. What amount must Marla include in income in 2008? a. $0 b. $1,000 c. $2,000 d. $6,000 a, p. I:3-27; Example I:3-36. Solution: Since she would have owed no income tax even without the state tax deduction, the refund is not taxable. She received no tax benefit. I:3-100.During 2007, Christianas employer withheld $1,500 from her wages for state income taxes. She claimed the $1,500 as an itemized deduction on her 2007 federal income tax return which included a total of $5,700 of itemized deductions. Christiana is single. On her 2007 state income tax return, her state income tax was $900. As a result, Christiana received a $600 refund in 2008. What amount must Christiana include in income in 2008? a. $0 b. $350 c. $600 d. $900 b, p. I:3-27; Example I:3-37. Solution: According to the tax benefit rule, she received a $350 tax benefit. $5,700 itemized deductions less $5,350 standard deduction.
I:TB3-23
I:3-101.During 2007, Robert's employer withheld $2,600 from his salary for state income taxes. Robert files a joint return for 2007 with his wife, and together they claimed the $2,600 taxes withheld as an itemized deduction on their federal tax return. Their itemized deductions totaled $10,900 on their 2007 tax return. Robert's state income tax was only $1,000 and he received a refund of $1,600 when he filed his state income tax return in 2008. As a result, Robert must a. amend 2007's federal tax return. b. report income of $200 in 2008. c. report income of $1,600 in 2008. d. reduce his deduction for state income taxes for 2008 by $1,600. b, p. I:3-27; Example I:3-37. Solution: The total itemized deductions exceeded the standard deduction by only $200 which is the tax benefit that must be included in income. ($10,900 $10,700). I:3-102.Gwen's marginal tax bracket is 25%. Gwen pays alimony of $24,000 per year. Gwen's aftertax cost for the $24,000 payment is a. $-0-. b. $6,000. c. $18,000. d. $24,000. c, p. I:3-28. Solution: (100% - 25%) x $24,000 = $18,000.
Short Answer
I:3-103. Which of the following constitutes constructive receipt in 2007? a. A check received on December 29, 2007. The check was postdated January 5, 2008. b. A check received on January 4, 2008. It had been mailed on December 29, 2007. c. A rent check, received on December 31, 2007, by the manager of an apartment complex. The manager normally collects rent for the owner who is out of town. d. A salary check received at 5:30 p.m. on December 31, 2007, after all banks are closed. e. A paycheck received on December 26, 2006. The check was not honored by the bank because the employers account did not have sufficient funds. Solution: C and D are constructively received. A and E are not because funds are not available. B is probably not considered constructively received assuming the taxpayer could not have picked up the check from the payor on December 29, 2007. p. I:3-10.
I:TB3-24
I:3-104. Chuck Corporation began operating a new retail business in the current year and had $500,000 of sales, $70,000 of which had not been collected by year-end. Total purchases were $350,000 on which $30,000 is still owed. Ending inventory is $60,000; operating expenses are $170,000, $50,000 of which is still owed at year-end. a. b. c. Compute net income from the business under the accrual method. Compute net income from the business under the cash method. Would paying the $50,000 she owes for operating expenses before year-end change her net income under the accrual method? Under the cash method?
Solution: Sales Purchases Inventory Cost of sales Gross profit Expenses Net income Accrual $ 500,000 $350,000 60,000 290,000 210,000 170,000 $ 40,000a $320,000 30,000* 290,000 140,000 120,000 $ 20,000b Cash $430,000
* $60,000 - $30,000 = $30,000. c. Paying the $50,000 will not change the net amount of business income under the accrual method. Under cash method, payment of the $50,000 expense would result in a $30,000 net loss. p. I:3-11; Example I:3-14.
I:TB3-25
I:3-105. The Cable TV Company, an accrual basis taxpayer, allows its customers to pay by the month, by the year, or two years in advance. In December 2007, the company collected the following amounts applicable to future services: Jan 2008 services (monthly contracts) $10,000 Jan - Dec 2008 services (annual contracts) 50,000 Jan 2008 - December 2009 contracts (2-year contracts) 68,000 If Cable TV wants to report as little income as possible for 2007, what is the amount of gross income that must be reported for 2007? Solution: $68,000 must be reported in 2007. All of the services for the first two sets of prepayments will be performed by the end of the tax year following the year of receipt. Therefore, the accrual basis taxpayer may defer to the period of performance for those two prepayments. However, because the services on the last prepayment of $68,000 will not be completed by the end of the tax year following the year of receipt, all of the prepayment must be included in income in the period received. p. I:3-12; Example I:3-15. I:3-106. Gabe Corporation, an accrual-basis taxpayer that uses the calendar year as its tax year, sells CPE (continuing professional education) courses under contracts ranging from three months to two years. Assume that Gabe Corporation sold three contracts in July 2006; one for six months costing $300; one for one year costing $500; and one for two years costing $800. Required: What is the minimum amount of income that must be recognized in 2007? Solution: Length of contract 6 months 12 months 24 months Total p. I:3-12; Example I:3-15. 2007 $300 $250 $800 $1,350 2008 $250 ____ $250
I:TB3-26
I:3-107. Leigh inherited $65,000 of City of New York bonds in January 2007. In March 2007, she received $4,000 of interest on the bonds. In July 2007, she sold the bonds at a $10,000 gain. Leigh also redeemed Series E U.S. Savings bonds in October 2007 that she had purchased several years ago and received accumulated interest of $2,600. In December 2007, she received $800 of City of Paris, France, bonds. What amount, if any of gross income must Leigh report? Solution: Leigh must report $13,400 of gross income determined as follows: Gain of City of New York bonds Interest on Series E Bonds Interest on City of Paris bonds Gross income pp. I:3-13 and I:3-14. I:3-108. Rocky owns The Palms Apartments. During the year, Molly Ann, a tenant, moved to another state. Molly Ann paid Rocky $1,500 to cancel the two-year lease she had signed. Rocky then rented the apartment to Elvis who paid the first and last months rents of $500 each and a security deposit of $800. Rocky also owns a building used as a dance club. The owner of the club requested that Rocky add on another room to be used for private parties. Rocky refused but allowed the club owner to make the addition at a cost of $20,000. What amount should be included in Rockys income with regard to these items? Solution: $1,500 + $500 + $500 = $2,500. Since there is no reduction in rent, the fair market value of the addition is not included in Rockys income. pp. I:3-15 and I:3-16. $10,000 2,600 800 $13,400
I:TB3-27
I:3-109. Ellen is a single taxpayer with a salary of $40,000, qualified dividend income of $5,000, and itemized deductions of $10,000. Required: Solution: a. AGI ($40,000 + $5,000) Itemized deductions Personal exemption Taxable income $45,000 ( 10,000) ( 3,400) $31,600 a. b. What is the amount of Ellens taxable income for 2007? What is the amount of Ellens total tax?
b.
Tax on other income of $26,600 excluding dividends: $782.50 + [.15 ($26,600 - $7,825)] = $3,599 Tax on dividends: $5000 x .05 = 250 $3,849
p. I:3-17; Example I:3-21. I:3-110. Emma is the sole shareholder in Atlantic Corporation and has owned the stock for five years. The basis in her stock is $50,000. Atlantic distributes $35,000 to Emma. Accumulated earnings and profits at the beginning of the year equal $25,000 and current earnings and profits equal $5,000. Required: a. b. What are the tax consequences of this information? What are the tax consequences of this information if, instead of distributing $35,000 to Emma, Atlantic distributes $100,000 to Emma? Emma reports $30,000 of taxable dividend income and a nontaxable return of capital equal to $5,000. In addition, Emma must reduce her basis in the stock by $5,000. Emma reports $30,000 of taxable dividend income, a nontaxable return of capital of $50,000, and capital gain of $20,000.
Solution: a. b.
p. I:3-17; Example I:3-22.
I:TB3-28
I:3-111. Under the terms of a divorce agreement dated January 1, 2007, Edmond was to pay his wife Donna $3,000 per month in alimony and $500 per month in child support. Payments began on 1/1/07. In addition, Donna received the family residence with a cost basis of $110,000 and a fair market value of $120,000. a. What is the amount that Donna must include in income for the twelve-month period ended December 31, 2007? b. What is the basis in the home which Donna received as a result of the divorce? Solution: a. b. Alimony, which is taxable to Donna and must be included in income, is $3,000 per month x 12 = $36,000. The basis in the home received in the property settlement (which is not taxable) is $110,000, the transfer basis.
pp. I:3-18 and I:3-19. I:3-112. Marisa and Kurt divorced in 2007. Under the terms of the divorce agreement, Marisa was to pay Kurt $110,000 in 2007 and $60,000 each year following until Kurts death or remarriage. What must Kurt report on his tax return for 2009 regarding these transactions? Solution: First, Kurt must report $60,000 in gross incomethe amount of alimony received in 2009. Then, Kurt will get a For AGI deduction for alimony recaptured of $35,000. First year alimony Minus: $15,000 change limit Minus: Average 2nd and 3rd year alimony Amount to be recaptured There is no recapture between years two and three. p. I:3-20. $110,000 ( 15,000) ( 60,000) $ 35,000
I:TB3-29
I:3-113. On January 1, 1995, Erika Greene, who is single and 62 years old, purchased a single premium annuity for $15,000 that will pay her $5,000 every year for life beginning on January 1, 2007. Based on actuarial tables published by the IRS, her life expectancy multiple is 10. a. What is the amount to be excluded Erika's income for 2007? b. What is the amount to be excluded in Erika's income for the year 2018? Solution: $15,000/ ($5,000 x 10) x $5,000 = $1,500 excluded from income. a. Once Erika has recovered her original investment of $15,000 (after 10 years), all of the $5,000 is taxable and included in income; none of it is excluded. p. I:3-21. I:3-114. Jeannie, a single taxpayer, retired during the year, to take over the management of some rental property. She had the following items of income and expense: Salary prior to retirement $44,000 Dividends from domestic corporation 8,000 City of Los Angeles bonds 3,000 Pension (60% exclusion ratio) 12,000 Share of partnership income 30,000 Partnership distribution 10,000 Rent income 7,000 Rent expenses 9,000 What is Jeannies Adjusted Gross Income for the year? Solution: $44,000 + $8,000 + $4,800 ($12,000 x .40) + $30,000 + $7,000 - $9,000 = $84,800. p. I:3-30 and comprehensive.
I:TB3-30
I:3-115. Kevin is a single person who earns $70,000 in salary for 2007 and also has income from a variety of investments, as follows: Bank savings account interest State of Missouri Bonds Dividends from XYZ Corp. $5,500 3,500 7,000
Kevin also had refunds when he filed the previous years tax returns. The Federal refund was $600 and the state refund was $300. Last years Federal itemized deductions totaled $11,000. This year his itemized deductions total only $3,700, and the amount of withholding for Federal income taxes is $16,900. Compute Kevins taxable income. Solution: Salary Bank interest Dividends State refund AGI Standard deduction Personal exemption Taxable income p. I:3-39 and comprehensive. I:3-116. Adanyas marginal tax rate is 35% and she is trying to decide whether to invest in taxexempt bonds which pay 5% interest or taxable bonds paying 7% interest. The bonds have equivalent risk. Which of the bonds would yield the highest amount of income after taxes? Solution: The taxable bonds yield 4.55% after-tax [.07 (1-.35)], so she should invest in the taxexempt bonds. $70,000 5,500 7,000 300 $82,800 ( 5,350) ( 3,400) $74,050
I:TB3-31
Essay
I:3-117. Discuss the differences in the economist's concept of income and the accountant's concept of income. Solution: An economist measures income in terms of amounts consumed by an individual as well as changes in worth of the individual. Unrealized gains and losses are considered in measuring income. Also, income is adjusted for inflation. An accountant measures income by a transaction approach, recognizing income when it is realized in a transaction. Historical costs are used to measure income rather than unrealized gains and losses. Income is generally not adjusted for inflation. p. I:3-2. I:3-118. Discuss the concept of "constructive receipt." Solution: A taxpayer is in constructive receipt of income when the income is available to the taxpayer, there are no restrictions or limitations on the income, and the payor has the funds necessary to make payment to the taxpayer. pp. I:3-9 and I:3-10. I:3-119. While certain income of a minor may now be taxed at the parent's tax rate, discuss how income shifting may still be accomplished and any constraints that may exist on income shifting. Solution: 1. Children may own stock in the family business. Dividends may be distributed to the children, but these may be taxed at the parents' rates. 2. A child may work in the family business. Income earned by the child would be taxed at the child's tax rate. Income earned by the child would be subject to reasonable compensation limits. 3. Series EE U.S. savings bonds may be purchased in the child's name to mature after the child reaches age 18. A gift of the bonds to the child may be subject to gift tax. p. I:3-28.
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Issue Identification
I:3-120. Marcia and Dave are separated and negotiating a divorce agreement. They live in a common law state and have two children who will remain with Marcia. Dave is willing to transfer the jointly owned home to Marcia. He wishes to keep the couples jointly owned boat. Dave will either transfer securities to Marcia ($100,000 adjusted basis, $150,000 fair market value) or will pay her $30,000 for 5 years with interest of 8%. What issues should Marcia and Dave consider when formulating their divorce agreement? Solution: Marcia and Dave should consider the taxability of the transfer of the home to Marcia and the boat to Dave. That is, what are the tax consequences of a property settlement? (No immediate tax consequences; a carryover basis). In considering whether to take the securities or the payments, Marcia needs to consider whether or not the $20,000 per year will be classified as alimony, which is taxable. (It would be deductible for AGI to Dave). Each should consider what determines whether or not a payment is alimonymust be made in cash, must not be specified to not be alimony, must end with Marcias death or remarriage, Marcia and Dave can not live together. While the transfer of securities would not trigger immediate tax consequences, if Marcia sold the securities, she would have capital gain which she could offset against any capital losses she might have for the year. pp. I:318 through I:3-20 and I:3-28.
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