4 CHAPTER GROSS INCOME: CONCEPTS AND INCLUSIONS
Instructor: The test items in both the print Test Bank and ExamView test-creation software are numbered by question type within each chapter. Thus, users of ExamView can more easily preview their selections using the printed Test Bank in the same numbering system. Status: Present Topic TRUE OR FALSE 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 Realization Realization Realization Economic income and realization Economic income versus tax gross income Tax accounting versus financial accounting Tax accounting versus financial accounting Original issue discount Original issue discount: Series EE bonds Savings bonds and certificates Easement and recovery of capital Cash basis and prepayments Accrual basis and prepayments Prepaid income Prepaid income Prepaid income Constructive receipt Constructive receipt: cash versus accrual method Who is the taxpayer? Who is the taxpayer? Constructive receipt Accrued interest Dividends: whose income Income received by an agent S corporation Partnership income S corporation income Partnership income Partnership income Partnership income S corporation income Dividends: whose income Community property income Alimony 4-1 New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged New Unchanged Unchanged 2 3 4 5 6 7 9 10 11 12 13 14 15 16 17 19 20 21 22 24 25 26 27 29 30 31 33 34 Edition Q/P in Prior Edition
Question/ Problem
4-2 35 Question/ Problem 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 Alimony
2009 Annual Edition/Test Bank Unchanged Status: Present Topic Alimony and child support Divorce: property transfers Divorce: property transfers Alimony recapture Alimony recapture Below-market loans Below-market loans Below-market loans Annuities Annuities Prizes Group term life insurance Social Security Social Security Social Security MULTIPLE CHOICE 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 Realization Realization Claim of right doctrine and an easement Claim of right doctrine Damages Constructive receipt: cash surrender value Constructive receipt: contract negotiation Constructive receipt: deferred compensation Cash surrender value of insurance Original issue discount Original issue discount Original issue discount Prepaid income Prepaid income Prepaid income Prepaid income Prepaid income Prepaid income Prepaid income Who is the taxpayer? Who is the taxpayer? Who is the taxpayer? Accrued interest on a gift Accrued interest Accrued interest Dividends: who is the taxpayer? Income from partnerships Community property income New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged 2 3 4 5 6 7 8 9 11 12 14 15 16 17 18 19 21 22 23 24 25 26 28 Edition Unchanged Unchanged Unchanged New New Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged 35 Q/P in Prior Edition 36 37 38 41 43 44 45 46 47 48 49 50
Gross Income: Concepts and Inclusions 29 30 Question/ Problem 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 Topic Divorce: property transfers and alimony Alimony Divorce: property transfers and alimony Divorce: property transfers Alimony recapture Alimony recapture Alimony and alimony recapture Alimony and child support Alimony and child support Below-market loans Below-market loans Below-market loans Below-market loans Below-market loans Annuities Annuities Annuities Annuities Group term life insurance Group term life insurance Group term life insurance Social Security Social Security Social Security Realization and planning Realization and planning PROBLEMS 1 2 3 4 5 6 7 8 9 10 11 Realization Prepaid income Dividends and interest Partnership income Alimony, property settlements, and child support Below-market loans Below-market loans, prizes, and unemployment compensation Annuities and OID Social Security benefits Alternative investments Alternative investments Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Community property income Alimony Unchanged Unchanged Status: Present Edition Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged
4-3 29 30 Q/P in Prior Edition 31 33 34 35 36 37 38 39 40 41 42 43 44 45 47 48 49 51 52 53 54 55 56
1 2 3 4 6 7 8 9 10 11
4-4
2009 Annual Edition/Test Bank
Question/ Problem Topic ESSAY 1 2 3 4 5 6 7 8 Gross income concept Gross income concept Original issue discount Alimony Prepaid income Annuities Below-market loans Social Security benefits
Status: Present Edition
Q/P in Prior Edition
Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged
1 2 3 4 5 6 7 8
Gross Income: Concepts and Inclusions
TRUE/FALSE
4-5
1. The realization requirement provides an incentive to sell assets that have increased in value and a disincentive for selling assets that have decreased in value. ANS: F According to the realization requirement, gain or loss is not recognized until it is realized, generally from a sale or exchange. If the asset has increased in value, the after-tax proceeds will be less than the value of the asset sold, decreasing the taxpayers net worth computed at market values. The sale at a loss, assuming the loss is deductible, will result in after-tax proceeds greater than the value of the asset sold. PTS: 1 REF: p. 4-4
2. The realization requirement applies to taxable income but not to the economists concept of income. ANS: T The economic concept of income treats changes in the values of assets as income regardless of whether gain or loss has been realized. PTS: 1 REF: p. 4-4
3. Judy is a cash basis attorney. In 2008, she performed services in connection with the formation of a corporation and received stock with a value of $3,000 for her services. By the end of the year, the value of the stock had decreased to $1,000. She continued to hold the stock. Judy must recognize $1,000 of gross income from the stock for 2008. ANS: F Judy must recognize the income that relates to the services she rendered in 2008. Therefore, Judy must recognize gross income of $3,000 in 2008. The decline in value of the stock is not deductible because the loss has not been realized. PTS: 1 REF: p. 4-5 to 4-8
4. Fred painted his house which saved him $2,000. According to the realization requirement, the taxpayer must recognize $2,000 of income. ANS: F Fred did not realize income because he did not engage in a transaction with another party. PTS: 1 REF: p. 4-3 to 4-5
5. Jeff owned stock that decreased in value by $15,000 during the year, but he did not sell the stock. He earned $40,000 salary, but received only $29,000 because $11,000 in taxes were withheld. Jeff saved $5,000 of his salary and used the remainder for personal living expenses. Jeffs economic income exceeded his gross income for tax purposes for the year. ANS: F Jeffs economic income would be reduced by the unrealized losses on his stock. However, these unrealized losses are not recognized for tax purposes until the securities are sold. PTS: 1 REF: p. 4-3 to 4-5
4-6
2009 Annual Edition/Test Bank
6. Because financial accounting and tax accounting both employ the realization principle, taxable income will always equal accounting income as computed under generally accepted accounting principles. ANS: F Both the financial accounting system and the tax accounting system employ the realization principle, but there are other differences between the two systems which have different objectives. PTS: 1 REF: p. 4-5
7. The financial accounting principle of conservatism is well-suited to the task of measuring taxable income. ANS: F As the Supreme Court reasoned in Thor Power Tool Co., the conservatism principle would not serve the governments goal of raising revenues. PTS: 1 REF: p. 4-4 | p. 4-5
8. A cash basis taxpayer who purchases a certificate of deposit for $750 that will pay $1,000 when it matures in 5 years must recognize income each year the certificate is held. ANS: T The difference between the issue price and the amount due at maturity is original issue discount that must be amortized and the amortized amount is added to income for each year the certificate is held. PTS: 1 REF: p. 4-11
9. Ralph purchased his first Series EE bond during the year. He paid $709 for a 10-year bond with a $1,000 maturity value. The yield to maturity on the bonds was 3.5%. Ralph is not required to recognize the $291 ($1,000 $709) original issue discount until the bond matures. ANS: T Series EE bonds are not subject to the original issue discount rules. Note, however, that an election can be made to amortize the discount. PTS: 1 REF: p. 4-12
10. At the beginning of 2008, Mary purchased a 3-year certificate of deposit (CD) for $8,760. The maturity value of the certificate was $10,000 and it was to yield 4.5%. She also purchased a Series EE bond for $6,400 with a maturity value in 10 years of $10,000. Mary must recognize income from the certificate of deposit each year, 2008-2010, and $3,600 from the Series EE bonds in 2017. ANS: T The income from the certificate of deposit must be amortized over the three-year period as original issue discount. The Series EE bonds are also original issue discount instruments, but the law permits the taxpayer to defer the income until maturity. PTS: 1 REF: p. 4-10 to 4-12
Gross Income: Concepts and Inclusions
4-7
11. In 2001, Terry purchased land for $150,000. In 2008, Terry received $5,000 from a local cable television company in exchange for Terry allowing the company to run an underground cable across Terrys property. Terry is not required to recognize income from receiving the $5,000 because it was a return of his capital invested in the land. ANS: T Terry does not recognize income, but he must reduce his basis for the land by $5,000. PTS: 1 REF: p. 4-6
12. In December 2008, Mary collected the December 2008 and January 2009 rent from a tenant. Mary is a cash basis taxpayer. The amount collected in December 2008 for the 2009 rent should be included in her 2009 gross income. ANS: F The cash basis taxpayer must report the rent income in gross income for the year it is received, 2008, rather than the year in which it is earned. PTS: 1 REF: p. 4-13
13. Abby, an accrual basis taxpayer, collects the rent for December 2008 and January 2009 on December 1, 2008. Abby must include the December 2008 rent and the January 2009 rent in her 2008 gross income because she received the cash in 2008. ANS: T Both payments must be included in Abbys 2008 gross income. PTS: 1 REF: p. 4-13
14. On January 1, 2008, an accrual basis taxpayer entered into a contract to provide termite inspection service each month for 36 months. The amount received for the contract was $1,800. The taxpayer should report $600 of income each year in 2008, 2009, and 2010. ANS: F The prepaid income cannot be deferred beyond the tax year following the year of receipt. Therefore, the taxpayer should report $600 of income in 2008 and $1,200 in 2009. PTS: 1 REF: p. 4-13
15. An accrual basis taxpayer can defer all advance payments for services until the services are performed if the method of accounting for the services is the same for tax and financial reporting purposes. ANS: F The income from advance payments for services received by an accrual basis taxpayer cannot be deferred beyond the tax year following the year of receipt. The scenario described in the question relates to advance payments for goods received by an accrual basis taxpayer. PTS: 1 REF: p. 4-13
4-8
2009 Annual Edition/Test Bank
16. An accrual basis taxpayer who owns and operates a professional basketball team cannot allocate income from season ticket sales on the basis of the number of games played during the year. ANS: F The Seventh Circuit Court of Appeals has permitted the taxpayer to defer income recognition until the games were played because definite dates could be established as to the time the income would be earned. PTS: 1 REF: p. 4-13
17. In 2008, Jimmy, a cash basis taxpayer, was offered $3,000,000 for signing a professional baseball contract. He rejected the offer in favor of $900,000 per year for 4 years beginning in 2009. Jimmy must recognize $3,000,000 income in 2008 because it was constructively received by him. ANS: F The income was not constructively received in 2008 by Jimmy because he did not have the right to receive the income in that year. The $3,000,000 offer was merely part of Jimmys contract negotiations. PTS: 1 REF: Example 12
18. The constructive receipt doctrine may prevent a cash basis taxpayer from deferring income, but it is not generally relevant to accrual basis taxpayers. ANS: T Cash basis taxpayers must recognize income when it is actually or constructively received. Accrual basis taxpayers generally report income when they have earned the right to receive it. PTS: 1 REF: p. 4-10 | p. 4-11
19. Mabel is age 65 and lives on her Social Security benefits and gifts from her son, Fred. Fred is a full-time teacher. He has written a book and receives royalties from it. This year Fred directed the publisher to make the royalty check payable to Mabel because she needs the money for support. Mabel must include the amount of the royalty check in her gross income. ANS: F The royalties must be included in the gross income of Fred, the taxpayer who earned it. PTS: 1 REF: p. 4-14
20. When Jessica failed to repay a loan, the bank garnished her salary. Each week $40 was withheld from Jessicas salary and paid to the bank. Jessica is taxed on the $40 that is taken from her salary. ANS: T Income is generally taxed to the person who earns the income, regardless of what the person does with the income. PTS: 1 REF: p. 4-14
Gross Income: Concepts and Inclusions
4-9
21. ABC Corporation mails out its annual Christmas bonuses to employees on December 23rd. Ed, a cash basis taxpayer, is an employee who is on a ski trip until January 3rd of the new year, but is aware that his annual Christmas bonus arrives on the 28th of December. Ed can delay reporting the income from the bonus until the new year. ANS: F The income was set aside and made available to Ed in December. PTS: 1 REF: p. 4-10
22. Tom purchased a bond on March 31 for $10,000, plus $150 accrued interest. In December, Tom collected $600 interest from the bond. Toms interest income from the bond for the year is $450. ANS: T The accrued interest of $150 is included in the gross income of the seller rather than in Toms gross income. PTS: 1 REF: p. 4-15
23. When stock is sold after the dividend is declared but prior to the record date, the buyer treats the dividend as a recovery of his or her investment because the right to the dividend increased the price paid for the stock. ANS: F Dividends are included in the gross income of the person who receives them. The price of the stock may in fact include the value of the dividend, but the tax law does not include this refinement. PTS: 1 REF: p. 4-16
24. Linda delivers pizzas for a pizza shop. On Wednesday, December 31, 2008, Linda made several deliveries and collected $350 from customers. However, Linda forgot to turn in the proceeds for the day to her employer until the following Friday, January 2, 2009. The pizza shop owner recognizes the income of $350 when he receives it from Linda in 2009. ANS: F Linda is her employers agent. Therefore, the employer must include the $350 in gross income in 2008, the tax year in which the income was received by the employers agent. PTS: 1 REF: p. 4-17
25. Tom is the sole shareholder of an S corporation that earned $80,000 in 2008, but did not distribute anything to him because the corporation needed cash for the business. Tom is not required to recognize any income from the S corporation because he does not have the ability to pay. ANS: F Tom is taxed on his share of the income earned by the S corporation of $80,000 ($80,000 100%) regardless of whether the corporation makes a distribution to him. PTS: 1 REF: p. 4-17
4-10
2009 Annual Edition/Test Bank
26. A partner must include in gross income his or her share of the partnerships income for the year whether or not the partner withdraws anything from the partnership. ANS: T The income from the partnership flows to the partner whether or not the partner receives any assets from the partnership during the year. PTS: 1 REF: p. 4-17
27. An advantage to operating a business as an S corporation is that the shareholder has no gross income from the S corporation unless the shareholder makes a withdrawal during the tax year. ANS: F A shareholder is required to recognize his or her share of S corporation income even if it is not distributed to the shareholder. PTS: 1 REF: p. 4-17
28. Als share of the partnerships profits for 2008 is $90,000, but the partnership distributed only $30,000 to him because the partnership needed the cash for its operation in 2008. The other $60,000 was distributed to Al in 2009. Als gross income from the partnership for 2008 is $90,000. ANS: T Each partner in a partnership must report his or her distributive share of the partnerships income and deductions for the partnerships tax year ending within or with the partners tax year even if such income is not actually distributed. PTS: 1 REF: p. 4-17
29. Rhonda has a 30% interest in the capital and profits of the ABC Partnership. Her share of the profits for 2008 was $60,000. She withdrew $40,000 from the partnership in 2008. In January 2009, after her share of the profits for 2008 had been computed, she withdrew her remaining $20,000 share of 2008 profits. As a result, Rhonda must recognize $40,000 of gross income in 2008 and $20,000 in 2009. ANS: F Rhonda must recognize in 2008 her 30% of the partnerships income ($60,000) regardless of whether it is distributed to her. PTS: 1 REF: p. 4-17
30. April is a 50% partner in Pale Partnership. During the year, she withdraws $100,000 and her share of the partnership profits is $125,000. April must include $125,000 in her gross income. ANS: T April is taxed on her share of the profits ($125,000). The withdrawals of $100,000 are a distribution of her capital investment, a nontaxable recovery of her capital. PTS: 1 REF: p. 4-17
Gross Income: Concepts and Inclusions
4-11
31. Amos is the sole shareholder of an S corporation that earned $100,000 in 2008 and distributed $25,000 to Amos. Amos must recognize $25,000 as income from the S corporation in 2008. ANS: F Amos must recognize $100,000 as income. PTS: 1 REF: p. 4-17
32. If Aeriel gives her son, Fred, the right to collect dividends on stock that she owns, Aeriel is taxed on the dividends. But if Aeriel gives the stock to Fred and then he receives dividends, he is taxed on the dividends. ANS: T If Aeriel gives away the tree, the owner (Fred) is taxed on the fruit (the dividends). PTS: 1 REF: p. 4-36 | p. 4-37
33. In all community property states, the income from property that was inherited by a spouse after the marriage is treated as if one-half is earned by each spouse. ANS: F This result occurs only in certain community property states. PTS: 1 REF: p. 4-18 | p. 4-19
34. Ted earned $100,000 during the current year. He paid April, his former wife, $40,000 in alimony. The $40,000 payment reduces Teds AGI and increases Aprils AGI. ANS: T The alimony rules tax the person who benefits from the $40,000. PTS: 1 REF: p. 4-20
35. George and Erin are divorced, and George is required to pay Erin $20,000 of alimony each year. George earns $75,000 a year. Erin is not required to include the alimony payments in gross income because George earned the income and therefore he should pay the tax on the income. ANS: F George is allowed to deduct the alimony of $20,000 from his gross income and Erin includes the alimony of $20,000 in her gross income. Thus, the alimony rules tax the person who benefits from the income rather than the person who earned the income. PTS: 1 REF: p. 4-20
4-12
2009 Annual Edition/Test Bank
36. After the divorce, Jeff was required to pay $18,000 per year to his former spouse, Darlene, who had custody of their child. Jeffs payments will be reduced to $12,000 per year in the event the child dies or reaches age 21. During the year, Jeff paid the $18,000 required under the divorce agreement. Darlene must include the $12,000 in gross income. ANS: T The alimony taxable to Darlene is only $12,000. Because of the contingency related to the child, the additional $6,000 is child support (nondeductible to Jeff and not included in Darlenes gross income). PTS: 1 REF: p. 4-23
37. Paula transfers stock to her former spouse, Fred. The transfer is pursuant to a divorce agreement. Paulas cost of the stock was $50,000 and its fair market value on the date of the transfer is $75,000. Fred later sells the stock for $78,000. Freds recognized gain from the sale of the stock is $3,000. ANS: F Freds basis is $50,000, the same as Paulas basis. So Freds recognized gain is $28,000 ($78,000 $50,000). PTS: 1 REF: p. 4-20 | p. 4-21 | Example 33
38. Hank and Marilyn were co-owners of a personal residence. As part of their divorce agreement, Marilyn received sole ownership of their personal residence. This property transfer is classified as alimony if both spouses make the proper election. ANS: F Property transfers incident to a divorce are classified as a property settlement rather than as alimony. In addition, alimony payments must be in cash. PTS: 1 REF: p. 4-20 | p. 4-21
39. Alimony recapture may occur if there is a substantial decrease in the amount of the alimony payments in the second year. ANS: T Alimony recapture occurs if there is a substantial decrease in the amount of the alimony payments during the first three years. PTS: 1 REF: p. 4-20 to 4-22
40. If the alimony recapture rules apply, the recipient of the alimony decreases his or her AGI by a portion of the amount included in gross income as alimony in a prior year or years. ANS: T The net effect is that the excessive payment is treated as a nondeductible and nonincludible property settlement. So the payors AGI increases and the payees AGI decreases. PTS: 1 REF: p. 4-21
Gross Income: Concepts and Inclusions
4-13
41. Father made an interest-free loan of $15,000 to Son who used the money to buy a certificate of deposit. If Sons investment income for the year is less than $1,000, Father is not required to impute interest income. ANS: T Assuming the principal purpose of the loan is not tax avoidance, no interest is imputed because the loan amount is $100,000 or less and the sons investment income is less than $1,000. PTS: 1 REF: p. 4-25
42. In the case of a below-market gift loan for which there is no exception to the imputed interest rules, the borrower is deemed to have received a gift of the imputed interest. ANS: T The borrower is treated as though he or she owed interest but was forgiven from the debt by the creditor (i.e., a gift). PTS: 1 REF: p. 4-24 | Concept Summary 4-2
43. In the case of a gift loan of less than $100,000, the imputed interest rules apply if the donee has net investment income of over $1,000. ANS: T The imputed interest rules apply to gift loans. However, if the amount of the loan is for $100,000 or less, the imputed interest cannot exceed the borrowers net investment income for the tax year. If net investment is $1,000 or less, it is considered to be $0. PTS: 1 REF: p. 4-26
44. Susan purchased an annuity for $120,000. She is to receive $15,000 each year and her life expectancy is 12 years. If Susan collects under the annuity for 13 years, the entire $15,000 received in the 13th year must be included in her gross income. ANS: T At the end of the 12th year, Susans basis for the annuity is $0. PTS: 1 REF: p. 4-28 to 4-30
45. Terri purchased an annuity for $100,000. She was to receive $8,000 per year and her life expectancy was 20 years. She died after receiving 15 payments. Terris final return should reflect a loss of $40,000 (5 payments not made $8,000). ANS: F Terri should report a loss of $25,000 [5 ($100,000/20 years)], which is her cost of the annuity that was not deducted during her life. PTS: 1 REF: p. 4-28 to 4-30
4-14
2009 Annual Edition/Test Bank
46. If a Nobel peace prize winner transfers the prize to a qualified government unit or nonprofit organization, then the prize is excluded from the winners gross income if the amount of the prize does not exceed 50% of the winners AGI. ANS: F By transferring the prize to one of the qualified groups, it is not included in the gross income of the winner. However, there is no relationship between the amount of the exclusion and the taxpayers AGI. PTS: 1 REF: p. 4-31
47. If the employer provides all employees with group term life insurance equal to twice the employees annual salary, an employee with a salary of $40,000 has no gross income from the life insurance protection provided by the employer. ANS: F The premiums paid by the employer on the first $50,000 of coverage are excludible by the employee. However, premiums calculated using the IRS table on the additional $30,000 [($40,000 2) $50,000] of coverage must be included in the employees gross income. PTS: 1 REF: p. 4-32
48. The amount of an individuals salary withheld and paid into the Social Security program reduces the amount of benefits received that must be included in gross income after the individual reaches retirement age. ANS: F The gross income from Social Security benefits is based on a formula that is not related to the amount an individual has paid into the Social Security program. PTS: 1 REF: p. 4-33
49. Normas income for 2008 is $27,000 from part-time work and $9,000 of Social Security benefits. Norma is not married. A portion of her Social Security benefits must be included in her gross income. ANS: T Normas earned income of $27,000 plus 50% of her Social Security benefits of $4,500 ($9,000 50%) exceed the threshold amount of $25,000. PTS: 1 REF: p. 4-33
50. Lois, who is single, received $9,000 of Social Security benefits. She also received $30,000 from dividends, interest, and her employers pension plan. If Lois sells a capital asset that produces a $1,000 recognized loss, Loiss taxable income will decrease by less than $1,000. ANS: F The $1,000 loss will reduce her MAGI and thus reduce her taxable Social Security benefits. PTS: 1 REF: p. 4-33
Gross Income: Concepts and Inclusions
MULTIPLE CHOICE
4-15
1. On a particular Saturday, Tom had planned to paint a room in his house, but his employer gave him the opportunity to work that day. If Tom works, he must hire a painter for $100. For Tom to have a positive cash flow from working and hiring the painter: a. Tom must earn at least $125 if Tom is in the 25% marginal tax bracket. b. Tom must earn at least $150 if Tom is in the 33% marginal tax bracket. c. Tom must earn at least $150 if he is in the 25% marginal tax bracket. d. Tom must earn at least $115 if he is in the 15% marginal tax bracket. e. None of the above. ANS: B Tom will have after-tax pay of $100.50 [(1 .33)($150)], which is more than the $100 he pays the painter. PTS: 1 REF: p. 4-3 | p. 4-4
2. The tax concept and economic concept of income are in agreement on which of the following: a. The fair rental value of an owner-occupied home should be included in income. b. The increase in value of assets held for the entire year should be included in income for the year. c. The decrease in value of assets held for the entire year should reduce income for the year. d. All of the above. e. None of the above. ANS: E The realization requirement applies to the taxable income, but does not apply to economic income. PTS: 1 REF: p. 4-3 | p. 4-4
3. The Blue Utilities Company paid Sue $1,500 for the right to lay an underground electric cable across her property anytime in the future. a. Sue must recognize $1,500 gross income in the current year if the company did not install the cable during the year. b. Sue must recognize $1,500 gross income in the current year regardless of whether the company installed the cable during the year. c. Sue must recognize $1,500 gross income in the current year, and when the cable is installed she must reduce her cost basis in the land by $1,500. d. Sue is not required to recognize gross income from the receipt of the funds, but she must reduce her cost basis in the land by $1,500. e. None of the above. ANS: D PTS: 1 REF: p. 4-6
4-16
2009 Annual Edition/Test Bank
4. For purposes of determining gross income, which of the following is true? a. A taxpayer who finds a wallet full of money is not required to recognize income because someone will eventually ask for the return of the money. b. A mechanic completed repairs on an automobile during the year and collects money from the customer. The customer was not satisfied with the repairs and sued the mechanic for a refund. The mechanic cannot defer recognition of the income until the suit has been settled. c. Embezzlement proceeds are not included in the embezzlers gross income because the embezzler has an obligation to repay the owner. d. All of the above are true. e. None of the above is true. ANS: B Under the claim of right doctrine, the mechanic must include the money received in gross income in the tax year of receipt. PTS: 1 REF: p. 4-8
5. Able Corporation sued Baker Corporation for intentional damage to Ables goodwill. Able had created its goodwill through providing high-quality services to its customers. Thus, no basis for the goodwill appeared on Ables balance sheet. The suit was settled and Able received $2,000,000, the estimated profits lost because of Bakers damage infliction. a. The $2,000,000 is not taxable because it replaces the goodwill destroyed. b. The $2,000,000 is not taxable because Able did nothing to earn the money. c. The $2,000,000 is not taxable because it represents a recovery of capital. d. The $2,000,000 is not taxable because Able settled the case. e. None of the above. ANS: E Able Corporation must include the $2,000,000 in gross income. PTS: 1 REF: p. 4-8 | p. 4-9
6. The annual increase in the cash surrender value of a life insurance policy: a. Is taxed when the individual dies and the heirs collect the insurance proceeds. b. Must be included in gross income each year under the original issue discount rules. c. Reduces the deduction for life insurance expense. d. Is not included in gross income each year because of the substantial restrictions on gaining access to the policys value. e. None of the above. ANS: D The income has not been actually received and, because of the restrictions, is not constructively received. PTS: 1 REF: p. 4-10
Gross Income: Concepts and Inclusions
4-17
7. Turner, a successful executive, is negotiating a compensation plan with his potential employer. The employer has offered to pay Turner a $720,000 annual salary, payable at the rate of $60,000 per month. Turner counteroffers to receive a monthly salary of $50,000 ($600,000 annually) and a $180,000 bonus in 5 years when Turner will be age 65. a. If the employer accepts Turners counteroffer, Turner will recognize $65,000 ($780,000 12) each month. b. If the employer accepts Turners counteroffer, Turner will be in constructive receipt of $60,000 per month. c. If the employer accepts Turners counteroffer, Turner will be in constructive receipt of $60,000 per month and the $180,000 bonus. d. If the employer accepts Turners counteroffer, Turner will recognize as gross income $50,000 per month and $180,000 in year 5. e. None of the above. ANS: D The constructive receipt doctrine does not apply to the negotiations. Therefore, Turner will include the salary and bonus in his gross income in the tax year received in accordance with the negotiated contract. PTS: 1 REF: p. 4-10
8. Taupe Corporation is considering deferred compensation plans for its executive employees over age 55. One plan is to allow the employee to make an election at the end of the year to collect his or her bonus when the employee retires, at which time the executive would receive the deferred pay plus 6% interest. a. The interest is original issue discount and must be included in gross income before retirement. b. The employee cannot defer the income (both the bonus and the interest) for tax purposes because it is constructively received each year. c. The employee must recognize the bonus each year, but can defer the interest. d. The bonus and the related interest can be deferred from inclusion in gross income until they are received. e. None of the above. ANS: C The bonus is due at the end of the year and therefore an employee who elects the deferral has turned his or her back on the income. PTS: 1 REF: p. 4-8 to 4-11
9. The annual increase in the cash surrender value of a life insurance policy: a. Is taxed according to the original issue discount rules. b. Is not included in gross income because the policy must be surrendered to receive the cash surrender value. c. Reduces the deduction for life insurance expense. d. Is exempt because it is life insurance proceeds. e. None of the above. ANS: B The substantial restrictions on gaining access to the policy, the fact the taxpayer must cancel the policy means that the increase in value is not actually or constructively received. PTS: 1 REF: p. 4-10 | p. 4-11
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2009 Annual Edition/Test Bank
10. Under the original issue discount (OID) rules as applied to a three-year certificate of deposit: a. All of the income must be recognized in the year of purchase. b. The OID will not be included in gross income until the end of the third year. c. The interest income for the first year will be greater than the interest income for the second year. d. The original issue discount must be amortized using the effective interest method. e. None of the above is correct. ANS: D The OID is amortized using the effective interest rate method. Because the principal amount is increased each year by the amount of the OID which is amortized, the total interest income increases each year. Thus, answers a., b., and c. are incorrect. PTS: 1 REF: p. 4-11 | Example 14
11. Dorothy purchased a certificate of deposit for $10,000 on January 1, 2008. The certificates maturity value in two years (December 31, 2009) is $10,816, yielding 4% before-tax interest. a. Dorothy must recognize $400 (.04 $10,000) gross income in 2008. b. Dorothy must recognize $816 gross income in 2009. c. Dorothy must recognize $816 gross income in 2008. d. Dorothy must recognize $408 ($816/2) gross income in 2008 and 2009. e. None of the above. ANS: A The 4% interest rate is applied to the $10,000 original investment in the first year ($10,000 4% = $400). Answers b., c., and d. are incorrect because these answers assume a method of allocating the income that differs from the effective interest method. PTS: 1 REF: p. 4-11
12. Jerry purchased a U.S. Series EE savings bond for $279. The bond has a maturity value in 10 years of $500 and yields 6% interest. This is the first Series EE bond that Jerry has ever owned. a. Jerry must report the interest income each year using the original issue discount rules. b. Jerry can report all of the $221 interest income in the year the bond matures. c. The interest on the bonds is exempt from Federal income tax. d. Jerry must report ($500 $279)/10 = $22.10 interest income each year he owns the bond. e. None of the above. ANS: B The original issue discount (OID) on the Series EE bonds is not subject to the OID rules. PTS: 1 REF: p. 4-12
Gross Income: Concepts and Inclusions
4-19
13. Home Office, Inc., leased a copying machine to a new customer on December 27, 2008. The machine was to rent for $500 per month for a period of 36 months beginning January 1, 2009. The customer was required to pay the first and last months rent at the time the lease was signed. The customer also was required to pay an $800 damage deposit. Home Office must recognize as income for the lease: a. $1,000 in 2008, if Home Office is an accrual basis taxpayer. b. $1,000 in 2009, if Home Office is a cash basis taxpayer. c. $1,800 in 2008, if Home Office is a cash basis taxpayer. d. $0 in 2008, if Home Office is an accrual basis taxpayer. e. None of the above. ANS: A The company is required to recognize the $1,000 (January 2009 and December 2011 rent) in 2008 because prepaid income from rents is ineligible for deferral. The damage deposit of $800 is not income. PTS: 1 REF: p. 4-12 | p. 4-13 | Example 17
14. Kathy operates a gym. She sells memberships that entitle the member to use the facilities at any time. A one-year membership costs $360 ($360/12 = $30 per month); a two-year membership costs $600 ($600/24 = $25 per month). Cash payment is required at the beginning of the membership period. On July 1, 2008, Kathy sold a one-year membership and a two-year membership. I. If Kathy is a cash basis taxpayer, her 2008 gross income from the contracts is $960 ($360 + $600). II. If Kathy is an accrual basis taxpayer, her 2008 gross income from the contracts is $330 [(6/12 $360) + (6/24 $600)]. III If Kathy is an accrual basis taxpayer, her 2009 gross income from the contracts is $630 . [(6/12)($360) + $450]. a. b. c. d. e. Only I is true. Only I and II are true. Only II and III are true. I, II, and III are true. None of the above.
ANS: D A cash basis taxpayer recognizes the income when it is actually or constructively received. The accrual basis taxpayer who receives prepaid income for services can prorate the income in the year of receipt but must include the balance of the income in the second year. This limited deferral is provided under Revenue Procedure 2004-34. PTS: 1 REF: p. 4-13
4-20
2009 Annual Edition/Test Bank
15. Orange Cable TV Company, an accrual basis taxpayer, allows its customers to pay by the year in advance ($350 per year), or two years in advance ($680). In September 2008, the company collected the following amounts applicable to future services: October 2008-September 2010 services (two-year contracts) October 2008-September 2009 services (one-year contracts) Total As a result of the above, Orange Cable should report as gross income: a. $136,000 in 2008. b. $64,000 in 2008. c. $84,000 in 2009. d. $111,000 in 2009. e. None of the above. ANS: D One-eighth (3/24) of the payments on the two-year contracts were earned (1/8 $72,000 = $9,000) and one-fourth (1/4 $64,000 = $16,000) of the payments on the one-year contracts were earned in 2008 and is included in 2008 gross income. The balance of the payments of $111,000 ($136,000 $9,000 $16,000) must be included in 2009 gross income. PTS: 1 REF: p. 14-13 $ 72,000 64,000 $136,000
16. With respect to the prepaid income from services, which of the following is true? a. The treatment of prepaid income is the same for tax and financial accounting. b. A cash basis taxpayer can spread the income over the period services are to be provided if all of the services will be completed by the end of the tax year following the year of receipt. c. An accrual basis taxpayer can spread the income over the period services are to be provided if all of the services will be completed by the end of the tax year following the year of receipt. d. An accrual basis taxpayer can spread the income over the period services are to be provided on a contract for three years or less. e. None of the above. ANS: C Answer a. is incorrect because the tax treatment is based on the income tax provisions, whereas the financial accounting treatment is based on generally accepted accounting principles. Answer b. is incorrect because the cash basis taxpayer recognizes the income in the year of receipt. Answer c. is correct because under Revenue Procedure 2004-34 any unearned income at the end of the first tax year must be included in the gross income of the second tax year. Answer d. is incorrect because there is no three-year provision. The deferral possibilities for services to be provided exist only in the case of accrual basis taxpayers who satisfy the requirements of Revenue Procedure 2004-34. PTS: 1 REF: p. 4-13
Gross Income: Concepts and Inclusions
4-21
17. With respect to income from services, which of the following is true? a. The income is always amortized over the period the services will be rendered by an accrual basis taxpayer. b. A cash basis taxpayer can spread the income from a 12-month service contract over the contract period. c. If an accrual basis taxpayer sells a 24-month service contract on July 1, 2008, for $2,400, the taxpayers 2009 gross income from the contract is $1,800. d. If the accrual basis taxpayer sells a 12-month service contract on July 1, 2008, all of the income is recognized in 2008. e. None of the above. ANS: C Answer b. is incorrect because Revenue Procedure 2004-34 does not apply to cash basis taxpayers. Answers a. and d. are incorrect because they are not in accordance with Revenue Procedure 2004-34. PTS: 1 REF: p. 4-13
18. The Green Company, an accrual basis taxpayer, provides business-consulting services. Clients generally pay a retainer at the beginning of a 12-month period. This entitles the client to no more than 40 hours of services. Once the client has received 40 hours of services, Green charges $400 per hour. Green Company allocates the retainer to income based on the number of hours worked on the contract. At the end of the tax year, the company had $40,000 of unearned revenues from these contracts. The company also had $10,000 in unearned rent income received from excess office space leased to other companies. Based on the above, Green must include in gross income for the current year: a. $0. b. $10,000. c. $40,000. d. $50,000. e. None of the above. ANS: B The prepaid income from services that will be earned in the following year by Green can be deferred under Revenue Procedure 2004-34. However, the prepaid income from rents is not eligible for deferral. PTS: 1 REF: p. 4-13
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2009 Annual Edition/Test Bank
19. Teal company is an accrual basis taxpayer. On December 1, 2008, a customer paid for an item that was on hand, but the customer wanted the item delivered in early January 2009. Teal delivered the item on January 4, 2009. Teal included the sale in its 2008 income for financial accounting purposes. a. Teal must recognize the income in 2008. b. Teal must recognize the income in the year title to the goods passed to the customer, as determined under the state laws in which the store is located. c. Teal can elect to recognize the income in either 2008 or 2009. d. Teal must recognize the income in 2009. e. None of the above. ANS: A Teal received the income before the goods were delivered to the customer. Therefore, when Teal recognizes the income for tax purposes depends upon Teals financial accounting method. PTS: 1 REF: p. 4-8 to 4-11
20. On January 2, 2008, Jill purchased a bond for $25,000 and on September 1, 2008, she gave the bond to Tina. The bond pays $3,000 interest each December 31st. Jill and Tina are cash basis taxpayers. When Tina collects the interest in December 2008: a. Jill must include all of the interest in her gross income. b. Tina must include all of the interest in her gross income. c. Jill must report $2,250 interest income in 2008, and Tina must report $750 interest income in 2008. d. Jill must recognize $2,000 interest income in 2008, and Tina must report $1,000 interest income in 2008. e. None of the above are correct. ANS: D The cash basis taxpayer does not recognize the interest income until it is collected. When it is collected in December 2008, it must be allocated between Jill and Tina on the basis of the amount of time each owned the bond (Jill for 8 months, and Tina for 4 months). PTS: 1 REF: p. 4-15 | Example 21
21. Hubert contracted with Silver Company, Huberts controlled corporation. Hubert was a medical doctor and the contract provided that he would work exclusively for the corporation. No other doctor worked for the corporation. The corporation contracted to perform an operation for Paula for $1,800. The corporation paid Hubert $1,200 to perform the operation under the terms of his employment contract. a. Hubert must recognize $1,800 gross income since the patient obviously wanted him to perform the operation. b. Hubert must recognize the $1,800 income because he provided the service. c. Huberts gross income is $1,200. d. The corporations gross income is $600. e. None of the above. ANS: C Hubert is an employee of Silver Company. Thus, Silver is taxed on the $1,800 income from the services provided by Hubert to the patient. Hubert is taxed on the $1,200 of compensation received from Silver. PTS: 1 REF: p. 4-14
Gross Income: Concepts and Inclusions
22. As a general rule: I. Income from property is taxed to the person who owns the property. II. Income from services is taxed to the person who earns the income. III. The assignee of income from property must pay tax on the income. IV. The person who receives the benefit of the income must pay the tax on the income. a. b. c. d. e. Only I and II are true. Only III and IV are true. I, II, and III are true, but IV is false. I, II, III, and IV are true. None of the above is true.
4-23
ANS: A III is false because a person who has the right to income (the assignor) but assigns the rights to another must pay the tax on the income. IV is false because, for example, the assignee of income receives the benefit, but the assignor has the right to the income and therefore must pay the tax on that income. PTS: 1 REF: p. 4-14 | p. 4-15
23. On June 30, 2008, Billy, a cash basis taxpayer, gave Dan a bond, $10,000 face amount, that pays $1,000 interest each December 31. When Dan collected the interest on December 31, 2008: a. Billy must include all of the interest in his gross income. b. Dan must include all of the interest in his gross income. c. Billy must report $500 interest income and Dan must report $500 interest income. d. Billy must recognize $500 of income at the time of the gift. e. Dan must recognize $10,000 of income at the time of the gift. ANS: C PTS: 1 REF: p. 4-15 | Example 21
24. Daniel purchased a bond on July 1, 2008, at par of $10,000 plus accrued interest of $400. On December 31, 2008, Daniel collected the $800 interest for the year. On January 1, 2009, Daniel sold the bond for $10,200. a. Daniel must recognize $400 interest income for 2008 and a $200 gain on the sale of the bond in 2009. b. Daniel must recognize $800 interest income for 2008 and a $200 gain on the sale of the bond in 2009. c. Daniel must recognize $800 interest income for 2008 and a $200 loss on the sale of the bond in 2009. d. Daniel must recognize $400 interest income for 2008 and a $200 loss on the sale of the bond in 2009. e. None of the above. ANS: A The $800 collected consists of $400 of gross income for the interest earned from July 1 through December 31 and $400 of accrued interest that was purchased. The cost of the bond was $10,000, thus Daniel has a $200 gain ($10,200 $10,000) on the sale. PTS: 1 REF: p. 4-15 | Example 22
4-24
2009 Annual Edition/Test Bank
25. a Theresa, cash basis taxpayer, purchased a bond on July 1, 2005, for $10,000, plus $400 of accrued interest. The bond paid $800 of interest each December 31. On March 31, 2008, she sold the bond for $10,150, which included $200 of accrued interest. a. Theresas 2008 interest income from the bond is $150. b. Theresas gain on the sale of the bond is $150. c. Theresa has a $250 loss from the sale of the bond. d. Theresa has $200 of interest income and a $50 loss from the bond in 2008. e. None of the above. ANS: D The cost of the bond was $10,000 and the proceeds from the sale were $9,950 ($10,150 $200 accrued interest). Therefore, Theresa had a $50 ($9,950 $10,000) loss from the sale, and $200 of interest income. PTS: 1 REF: p. 4-15 | Example 22
26. Darryl, a cash basis taxpayer, gave 1,000 shares of Copper Company common stock to his daughter on September 29, 2008. Copper Company is a publicly held company that has declared a $1.00 per share dividend on September 30th every year for the last 20 years. Just as Darryl had expected, Copper Company declared a $1.00 per share dividend on September 30th, payable on October 15th, to stockholders of record as of October 10th. The daughter received the $1,000 dividend on October 18, 2008. a. Darryl must recognize the $1,000 dividend as his income because he knew the dividend would be paid. b. Darryl must recognize $750 of the dividend because he owned the stock for three-fourths of the year. c. Darryl must recognize the income of $1,000 because he constructively received the $1,000. d. The daughter must recognize the income because she owned the stock when the dividend was declared and she received the $1,000. e. None of the above. ANS: D The gift of the stock is made prior to the declaration date. PTS: 1 REF: p. 4-16
27. Ward owns a 50% interest in the capital and profits of Teal Company (a calendar year partnership). For tax year 2008, the partnership earned revenue of $300,000 and had operating expenses of $120,000. During the year, Ward withdrew from the partnership a total of $72,000, and his partner withdrew $60,000. For 2008, Ward:: a. Must report $24,000 as his share of the partnerships profits. b. Must report $72,000 as his share of the partnerships profits. c. Must report $90,000 as his share of the partnerships profits. d. Must report $150,000 as his share of the partnerships profits. e. None of the above. ANS: C Wards share of the profits from the partnership is $90,000 [.50($300,000 $120,000)]. PTS: 1 REF: p. 4-17 | Example 27
Gross Income: Concepts and Inclusions
4-25
28. Harry and Wanda were married in Virginia, a common law state, but moved to Texas, a community property state. The calculation of their income on a joint return: a. Will increase as a result of changing their state of residence. b. Will decrease as a result of changing their state of residence. c. Will not change as a result of changing their state of residence. d. Will not be permitted. e. None of the above. ANS: C All of their income, regardless of whether they live in a common law state or community property state, must be included on their joint return. PTS: 1 REF: p. 4-18
29. Jim and Nora, residents of a community property state, were married in early 2006. Late in 2006 they separated, and in 2008 they were divorced. Each earned a salary, and they received income from community owned investments in all relevant years. They filed separate returns in 2006 and 2007. a. In 2007, Nora must report only her salary and one-half of the income from community property on her separate return. b. In 2007, Nora must report on her separate return one-half of the Jim and Nora salary and one-half of the community property income. c. In 2008, Nora must report on her separate return one-half of the Jim and Nora salary for the period they were married as well as one-half of the community property income and her income earned after the divorce. d. In 2008, Nora must report only her salary on her separate return. e. None of the above. ANS: A Because Jim and Nora lived apart for the entire year, she does not have to report one-half of Jims salary on her separate return. She is required to report her share of the income from the community owned investments. PTS: 1 REF: p. 4-18 to 4-20
30. The underlying rationale for the alimony rules is that: a. The income should be taxed to the person with a claim of right to the income. b. The income should be taxed to the person who enjoys the benefits of the income. c. The fruit and tree metaphor should be rigorously applied. d. Alimony is a payment for the taxpayers property and, therefore, it is taxed to the recipient. e. None of the above. ANS: B PTS: 1 REF: p. 4-20
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2009 Annual Edition/Test Bank
31. Joe and Bonnie were divorced. Their only marital property consisted of a personal residence (fair market value of $400,000, cost of $200,000), and publicly-traded stocks (fair market value of $800,000, cost basis of $500,000). Under the terms of the divorce agreement, Bonnie received the personal residence and Joe received the stocks. In addition, Bonnie was to receive $50,000 for eight years. I. If the $50,000 annual payments to Bonnie will continue after her death (paid to her estate), the payments will not qualify as alimony. II. Bonnie has a taxable gain from an exchange of her one-half interest in the stocks for Joes one-half interest in the house and cash. III. If Joe sells the stocks for $850,000, he must recognize a $350,000 gain. a. b. c. d. e. Only I is true. Only I and II are true. I and III are true. I, II, and III are true. None of the above are true.
ANS: C To qualify as alimony, the cash payments must cease upon the death of the payee; therefore, I is correct. The basis of the marital property received by a former spouse is the same as the former married couples basis. Therefore, Joes basis in the stock was $500,000, and when it was sold Joe realized a $350,000 gain (III). PTS: 1 REF: p. 4-20 to 4-23
32. Which of the following is not a requirement for an alimony deduction? a. The payments must be in cash. b. The payments must cease upon the death of the payee. c. The payments must be pursuant to a legal obligation to provide support. d. The payor and payee must not live in the same household at the time of the payments. e. All of the above are requirements for an alimony deduction. ANS: C Although the state alimony laws were based on a legal obligation for support, the Federal law for deducting alimony does not require that such an obligation exists. The Federal law contains its own requirements that are contained in answers a., b., and d., above. PTS: 1 REF: p. 4-21
Gross Income: Concepts and Inclusions
4-27
33. Tim and Janet were divorced. Their only marital property was a personal residence with a value of $100,000 and cost of $40,000. Under the terms of the divorce agreement, Janet would receive the house and Janet would pay Tim $10,000 each year for 5 years, or until Tims death, whichever should occur first. Tim and Janet lived apart when the payments were made to Tim. The divorce agreement did not contain the word alimony. a. Tim must recognize a $30,000 [$50,000 1/2($40,000)] gain on the sale of his interest in the house. b. Tim does not recognize any income from the above transactions. c. Janet is allowed to deduct $10,000 each year for alimony paid. d. Janet is not allowed any alimony deductions. e. None of the above. ANS: C The $10,000 cash meets all of the requirements for alimony treatment. Although the circumstances suggest that Janet is paying Tim for his share of the marital property, the agreement must specify that the payments are not alimony to avoid alimony treatment. PTS: 1 REF: p. 4-20 to 4-23
34. Tina and Mike were divorced. Their only marital property was a personal residence with a fair market value of $1 million and a cost of $475,000. Under the terms of the divorce agreement, Mike would receive the house and Mike would pay Tina $100,000 each year for 6 years, or until Tinas death, whichever should occur first. Tina and Mike lived apart when the payments were made by Mike. The divorce agreement did not contain the word alimony. Mike paid the $600,000 to Tina over the six-year period. Then, Mike sold the residence for $1,500,000. Mikes recognized gain from the sale is: a. $0. b. $425,000 ($1,500,000 $475,000 $600,000). c. $500,000 ($1,500,000 $1,000,000). d. $1,025,000 ($1,500,000 $475,000). e. None of the above. ANS: D Mikes basis for the house is $475,000. PTS: 1 REF: p. 4-20 | p. 4-21 | Example 33
35. The alimony recapture rules are intended to: a. Assist former spouses in collecting alimony when the other spouse moves to another state. b. Prevent tax deductions for property divisions. c. Protect former spouses from having a large tax liability after the payments have already been spent. d. Distinguish child support payments from alimony. e. None of the above. ANS: B PTS: 1 REF: p. 4-21 to 4-23
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2009 Annual Edition/Test Bank
36. The effect of alimony recapture is to: a. Prevent a spouse who has not paid alimony due from leaving the state. b. Require the payee to increase his or her taxable income and allow the payor to reduce his or her taxable income. c. Require the payor to increase his or her taxable income by the recapture amount and to allow the payee to reduce his or her taxable income by the same amount. d. Require the payee to recognize income collections in the current year for alimony that was due in a prior year. e. None of the above. ANS: C PTS: 1 REF: p. 4-21 to 4-23 | Example 34
37. Under the terms of a divorce agreement, Kim was to pay her husband Tom $4,000 per month in alimony and $1,500 per month in child support. For a twelve-month period, Kim can deduct from gross income (and Tom must include in gross income): a. $0. b. $18,000. c. $48,000. d. $66,000. e. None of the above. ANS: C The $1,500 per month ($18,000) for child support is not deductible by Kim. The alimony of $4,000 per month ($48,000) is deductible by Kim. PTS: 1 REF: p. 4-20 | p. 4-23 | Example 32 | Concept Summary 4-1
38. Under the terms of a divorce agreement, Lanny was to pay his wife Joyce $2,500 per month in alimony and $500 per month in child support. For a twelve-month period, Lanny can deduct from gross income (and Joyce must include in gross income): a. $0. b. $6,000. c. $30,000. d. $36,000. e. None of the above. ANS: C The $500 per month for child support is not deductible by Lanny. PTS: 1 REF: p. 4-20 | p. 4-23 | Example 32 | Concept Summary 4-1
Gross Income: Concepts and Inclusions
4-29
39. Under the terms of a divorce agreement, Jack is to pay his wife Jenny $5,000 per month. The payments are to be reduced to $3,000 per month when their 15 year-old child reaches age 18. During the current year, Jack paid $60,000 under the agreement. Assuming all of the other conditions for alimony are satisfied, Jack can deduct from gross income (and Jenny must include in gross income) as alimony: a. $36,000. b. $24,000. c. $12,000. d. $0. e. None of the above. ANS: A $3,000 12 = $36,000. The remaining $2,000 per month is child support because of the contingency relative to Jacks child. PTS: 1 REF: p. 4-23
40. In the case of a below-market loan between family members, if the imputed interest rules apply: I. II. III. IV . a. b. c. d. e. The borrower must recognize interest income. The lender has interest income. The lender is deemed to have made a gift. The borrower has interest expense. Only I is true. II, III, and IV are true but I is false. I and II are false but III and IV are true. All of the above are true. None of the above is true. PTS: 1 REF: p. 4-23 to 4-27
ANS: B
41. On January 1, Father (Dave) loaned Daughter (Debra) $100,000 to purchase a new car. There were no other loans outstanding between Dave and Debra. The relevant Federal rate on interest was 6 percent. The loan was outstanding for the entire year. a. If Debra has $15,000 of investment income, Dave must recognize $6,090 of imputed interest income. b. Dave must recognize $6,090 of imputed interest income regardless of the amount of Debras investment income. c. Debra must recognize $6,090 of imputed interest income. d. Debra must recognize $6,090 of imputed interest income if Dave has at least $6,090 of investment income. e. None of the above. ANS: A The calculated imputed interest is $6,090 [($100,000 6% .5) + ($103,000 6% .5)]. Under the $100,000 exemption for below-market loans, Dave must recognize $6,090 of imputed interest income because Debra has investment income in excess of the calculated imputed interest income. PTS: 1 REF: p. 4-23 to 4-27
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2009 Annual Edition/Test Bank
42. The effects of a below-market loan for $450,000 made by a corporation to its chief executive officer as an enticement to get him to remain with the company are: a. The corporation has imputed interest income and compensation expense. b. The employee has imputed interest income and interest expense. c. The employee has no income unless the funds are invested and produce investment income for the year. d. The corporation has imputed interest expense. e. None of the above. ANS: A The corporation made a compensation related loan. It has imputed interest income and compensation expense. The employee has imputed interest expense and compensation income. Since the loan is for $450,000, the $10,000 exception does not apply. PTS: 1 REF: p. 4-23 to 4-27
43. Sarah, a majority shareholder in Teal, Inc., received a $150,000 interest-free loan from the corporation. Sarah is not an employee of the corporation. a. Sarah must recognize imputed interest income and the corporation must recognize imputed interest expense. b. Sarah must recognize imputed interest expense and the corporation must recognize imputed interest income. c. Sarah must recognize imputed dividend income and the corporation may recognize imputed interest expense. d. Neither Sarahs nor the corporations gross income is affected by the loans because no interest was charged. e. None of the above. ANS: B Sarah, as the borrower, has imputed interest expense. The corporation, as the lender, has imputed interest income. PTS: 1 REF: p. 4-23 to 4-27
44. Marge made a $60,000 interest-free loan to her son, Steve, who used the money to start a new business. Steves only sources of income were $25,000 from the business and $250 of interest on his checking account. The relevant Federal interest rate was 5%. Based on the above information: a. Steves business net profit will be reduced by $3,000 (.05 $60,000) of interest expense. b. Marge must recognize $3,000 (.05 $60,000) of imputed interest income on the below market loan. c. Steves gross income must be increased by the $3,000 (.05 $60,000) imputed interest income on the below market loan. d. Steves interest income is $250 and his interest expense is zero. e. None of the above is correct. ANS: E The $100,000 exception would apply. Marge is not required to recognize imputed interest income because Steves investment income is less than $1,000. Steve does not recognize any imputed interest expense. PTS: 1 REF: p. 4-25 | p. 4-26
Gross Income: Concepts and Inclusions
4-31
45. Jay, a single taxpayer, retired from his job as a public school teacher in 2008. He is to receive a retirement annuity of $1,000 each month and his life expectancy is 150 months. He contributed $30,000 to the pension plan during his 35-year career; so his adjusted basis is $30,000. What is the correct method for reporting the pension income? a. Since Jay is no longer working, none of the pension must be included in his gross income. b. The first $30,000 received is a nontaxable recovery of capital, and all subsequent annuity payments are taxable. c. The first $120,000 he receives is taxable and the last $30,000 is a nontaxable recovery of capital. d. For the first 150 months, 20% ($30,000/$150,000) of the amount received is a nontaxable recovery of capital and the balance is included in gross income. e. None of the above. ANS: D Jay is collecting under an annuity contract and the cost must be allocated among the payments received on the basis of the cost/expected return, until the total cost has been recovered. Thus, for each annuity payment received for the 150-month period, $200 ($1,000 20%) is excluded from gross income and $800 ($1,000 80%) is included in gross income. Any payments received after the 150-month period is included in his gross income. PTS: 1 REF: p. 4-27 to 4-30
46. In 2008, Ted purchased an annuity for $120,000. The annuity is to pay him $1,500 per month for the rest of his life. His life expectancy is 120 months. Which of the following is correct? a. Ted is not required to recognize any income until he has collected 80 payments (80 $1,500 = $120,000). b. If Ted collects 36 payments and then dies in 2010, Teds estate should amend his tax returns for 2008 and 2009 and eliminate all of the reported income from the annuity for those years. c. If Ted lives and collects on the annuity for 130 months, the amounts received in the last 10 months are included in his gross income. d. For each $1,500 payment received in the first year, Ted must include $1,000 in gross income. e. None of the above. ANS: C The annuity exclusion formula is: investment/expected return = $120,000/($1,500 120) = $120,000/$180,000 = .667. Therefore, when Ted collects a $1,500 payment, he must recognize $500 gross income [$1,500 (1 .667)]. If Ted lives longer than his life expectancy, he has recovered all of his cost at the end of his expected life, and therefore all subsequent payments are included in his gross income. Answer b. is incorrect. Instead of amending prior returns, Ted will be allowed to deduct a loss on his final return for the cost of the annuity less the amount previously excluded from gross income as a return of capital. PTS: 1 REF: p. 4-27 to 4-30
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2009 Annual Edition/Test Bank
47. Seth, a calendar year taxpayer, purchased an annuity for $20,000 in 2006. The annuity was to pay him $2,000 on the first day of each year, beginning in 2006, for the remainder of his life. Seths life expectancy at the time he purchased the annuity was 15 years. In 2008, Seth developed a deadly disease, and doctors estimated that he would live for no more than 24 months. a. If Seth dies in 2009, a loss can be claimed on his final return for his unrecovered cost of the annuity. b. If Seth dies in 2009, his returns for the two previous years can be amended to allocate the entire cost of the annuity to the years in which he received payments and reported gross income. c. If Seth is still alive at the end of 2008, he is not required to recognize any gross income because of his terminal illness. d. If Seth is still alive in 2023, his recovery of capital for that year is $1,333. e. None of the above. ANS: A Seths final return can report a loss in 2009 because he did not recover all of his cost of the annuity prior to his death. Answer d. is incorrect because Seth would have recovered his entire cost of the contract in the first 15 years under the contract, 2006-2020. Answers b. and c. are also incorrect. PTS: 1 REF: p. 4-30 48. Betty purchased an annuity for $21,000 in 2008. Under the contract, Betty will receive $250 each month for the rest of her life. According to the actuarial estimates, Betty will live to receive 96 payments and will receive a 3% return on her original investment. a. If Betty collects $3,000 in 2008, her gross income is $630 (.03 $21,000). b. Betty has no gross income until she has collected $21,000. c. If Betty lives to collect more than 96 payments, she must amend her prior years returns to increase her taxable portion of each payment received in the past. d. If Betty lives to collects only 60 payments before her death, she will report a loss from the annuity on her final return. e. None of the above. ANS: D The options other than d. are simply contrary to the scheme provided in the Code for the taxation of annuities. If Betty dies after collecting only 60 payments, before she has recovered all of her investment, a loss can be claimed on her final return. Therefore, d. is correct. PTS: 1 REF: p. 4-30
Gross Income: Concepts and Inclusions
4-33
49. Gordon, an employee, is provided group term life insurance coverage equal to twice his annual salary of $100,000 per year. According to the IRS Uniform Premium Table (based on Gordons age), the amount is $12 per year for $1,000 of protection. The cost of an individual policy would be $15 per year for $1,000 of protection. Since Gordon paid nothing towards the cost of the $200,000 protection, Gordon must include in his 2008 gross income which of the following amounts. a. $3,000. b. $2,400. c. $2,250. d. $1,800. e. None of the above. ANS: D Gordon must include in gross income the Uniform Premium Table amount for $150,000 ($200,000 coverage less the $50,000 exclusion): 150 $12 = $1,800. PTS: 1 REF: p. 4-31 | p. 4-32
50. Red, Inc., provides group term life insurance for all of its employees. The coverage is for twice the employees annual salary. Susan, a vice-president, received $150,000 of coverage for the year at a cost to Red, Inc., of $2,800. The Uniform Premiums (based on Susans age) are $.23 per month for $1,000 protection. How much of this must Susan include in gross income this year? a. $0. b. $276. c. $414. d. $2,800. e. None of the above. ANS: B The plan is nondiscriminatory. Therefore, Susans gross income is $276 [$.23 (cost per month per $1,000) 12 months 100 (150 50)]. PTS: 1 REF: p. 4-31 | p. 4-32
51. Turner, Inc. provides group term life insurance to the officers of the corporation only. Janet, a vice-president, received $400,000 of coverage for the year at a cost to Turner, Inc. of $5,600. The Uniform Premiums (based on Janets age) are $15 a year for $1,000 protection. How much of this must Janet include in gross income this year? a. $0. b. $2,700. c. $5,600. d. $6,000. e. None of the above. ANS: D The plan is discriminatory. Therefore, the employees income is the greater of the amount from the IRS table ($15 400 = $6,000) or the employers cost ($5,600). PTS: 1 REF: p. 4-32
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2009 Annual Edition/Test Bank
52. The amount of Social Security benefits received by an individual that he or she must include in gross income: a. Is computed in the same manner as an annuity [exclusion = (cost/expected return) amount received]. b. May not exceed the portion contributed by the employer. c. May not exceed 50% of the Social Security benefits received. d. May be zero or as much as 85% of the Social Security benefits received, depending upon the taxpayers Social Security benefits and other income. e. None of the above. ANS: D The taxable Social Security benefits are based on a formula intended to assure that low income taxpayers are not taxed on the Social Security benefits, but higher income taxpayers are taxed under the theory that, on the average the taxpayer will collect more from the Social Security program than he or she paid into the program. PTS: 1 REF: p. 4-33 | p. 4-34
53. The taxable portion of Social Security benefits is dependent upon: a. How much the taxpayer has contributed to the Social Security program. b. The individuals age. c. The number of quarters the individual worked. d. The individuals adjusted gross income from other sources. e. None of the above. ANS: D The formula used to calculate the taxable portion of Social Security requires the taxpayer to aggregate the taxpayers Social Security benefits and other sources of income and after the total exceeds a base amount, as much as 85% of the benefits can be subject to Federal income tax. PTS: 1 REF: p. 4-33 | p. 4-34
54. Ted is age 67 and unmarried and his only sources of income are $230,000 in taxable interest and $15,000 of Social Security benefits. Teds adjusted gross income for the year is: a. $230,000. b. $237,500. c. $242,750. d. $245,000. e. None of the above. ANS: C Ted must include 85% of her Social Security benefits in gross income. Therefore, her gross income is $242,750. PTS: 1 REF: p. 4-33 | p. 4-34
Gross Income: Concepts and Inclusions
4-35
55. Our tax laws encourage taxpayers to ____ assets that have declined in value and ____ assets that have appreciated in value. a. sell, sell b. sell, keep c. keep, sell d. keep, keep e. None of the above. ANS: B Because gains and losses are not recognized until realization has occurred, the taxpayer should sell depreciated assets (i.e., basis exceeds fair market value) and deduct any loss. The taxpayer should hold the appreciated assets (i.e., basis is less than fair market value) and, thus, defer gain. PTS: 1 REF: p. 4-35
56. Margaret owns land that appreciates at the rate of 10% each year. Ralph owns a zero coupon (i.e., all of the interest is paid at maturity but is taxed annually) corporate bond with a yield to maturity of 10%. At the end of 10 years, the bond will mature and the land will be sold. At the end of the 10 years, a. Margaret and Ralph will have accumulated the same after-tax amounts. b. Ralph will have accumulated a greater after-tax amount because the interest on the bond is tax-exempt. c. Margaret will have accumulated the greater after-tax amount because the gain on the land is tax-exempt. d. Margaret will have accumulated the greater after-tax amount but only if her marginal tax rate never exceeds 27%. e. Margaret will accumulate the greater after-tax amount because she earns a return on the deferred taxes. ANS: E In addition, the gain on the land sale will be taxed at long-term capital gain rates, while the interest income on the bond is taxed as ordinary income. PTS: 1 REF: p. 4-35 | Example 52
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PROBLEM
2009 Annual Edition/Test Bank
1. Two days before Halloween, Gene was driving in his car and noticed that he was low on fuel. He stopped at a gas station which offered a free pumpkin with the purchase of a full tank of gas. The pumpkin has a fair market value of $2.00, and the price of the gasoline was the same as at another station located across the street. Gene knew that this deal was too good to be true and so he took advantage of the offer before the station owner realized what a giveaway this was. How much should Gene include in his gross income? ANS: One could reason that Gene realized $2.00 income from this bargain purchase. His net worth increased by $2.00 because of the value of the gasoline and the pumpkin is greater than the cash he paid. However, it seems unlikely that the IRS would attempt to collect tax on the $2.00 because such situations create tremendous valuation issues such as the following. Is the pumpkin actually worth $2.00 or $1.50 or some other amount? Is the gasoline identical to the gasoline sold at the same price at the station across the street? The cost of collection to the IRS would probably exceed the additional revenue. PTS: 1 REF: p. 4-3 to 4-5
2. Determine the proper tax year for gross income inclusion in each of the following cases. a. An automobile dealer has several new cars in inventory, but often does not have the right combination of body style, color, and accessories. In some cases the dealer makes an offer to sell a car at a certain price, accepts a deposit, and then orders the car from the manufacturer. When the car is received from the manufacturer, the sale is closed, and the dealer receives the balance of the sales price. At the end of the current year, the dealer has deposits totaling $8,200 for cars that have not been received from the manufacturer. When is the $8,200 subject to tax? b. Purple Corporation, an exterminating company, is a calendar year taxpayer. It contracts to provide service to homeowners once a month under a one-, two-, or three-year contract. On April 1 of the current year, the company sold a customer a one-year contract for $120. How much of the $120 is taxable in the current year if the company is an accrual basis taxpayer. If the $120 is payment on a two-year contract, how much is taxed in the year the contract is sold and in the following year? If the $120 is payment on a three-year contract, how much is taxed in the year the contract is sold and in the following year? Pink, Inc., an accrual basis taxpayer, owns an amusement park whose fiscal year ends September 30. To increase business during the fall and winter months, Pink sold passes that would allow the holder to ride free during the months of October through March. During the month of September, $6,000 was collected from the sale of passes for the upcoming fall and winter. When will the $6,000 be taxable to Pink? The taxpayer is in the office equipment rental business and uses the accrual basis of accounting. In December he collected $5,000 in rents for the following January. When is the $5,000 taxable?
c.
d.
Gross Income: Concepts and Inclusions
4-37
ANS: a. Reg. 1.451-5 specifies that accrual basis taxpayers may defer the recognition of income from advance payments for the future sale of inventories that are not on hand the last day of the year and the amount collected is less than the sellers cost of the goods. The $8,200 would not be includible in the gross income of the dealer for the current year and would be includible in gross income at the time the sale is consummated upon delivery of the car. b. Revenue Procedure 2004-34 permits the accrual basis taxpayer to amortize the prepaid income for the first year under the contract. However, the balance of the unearned income must be recognized in the tax year following the year of receipt. In the case of a contract sold on April 1 that was for services over the twelve-month period beginning on that date, the taxpayer would recognize 9/12 of the income in the year of sale, and the remaining balance (3/12) in the following year. In the case of a contract sold on April 1 that was for services over the 24-month period beginning on that date, the taxpayer would recognize 9/24 of the income in the year of sale and the remaining balance (15/24) in the following year. In the case of a contract sold on April 1 that was for services over the 36-month period beginning on that date, the taxpayer would recognize 9/36 of the income in the year of sale and the remaining balance (27/36) in the following year. Revenue Procedure 2004-34 would permit deferral of $6,000 from income until the following tax year since all services will be performed by the end of the tax year following the year of receipt. Prepaid rent is taxable in the year of receipt to both the accrual and cash basis taxpayers. Revenue Procedure 2004-34 is not applicable to prepaid rent income. REF: p. 4-13 | p. 4-14
c.
d.
PTS: 1
3. On January 1, 2008, Faye gave Todd, her son, a 36-month certificate of deposit she purchased December 31, 2006, for $4,319. Faye gave Todd 1,000 shares of ABC, Inc., on December 2, 2008. The certificate had a maturity value of $5,000 and the yield to maturity was 5%. On November 30, 2008, ABC, Inc., had declared a dividend of $1.00 payable to stockholders of record on December 5th. How much interest and dividends should Todd include in his gross income for 2008? ANS: Todd must report $216 of interest income and no dividends. The certificate of deposit is an original issue discount instrument. Therefore, Faye should have reported $216 (.05 x $4,319) of interest income in 2007, and thus the adjusted basis of the CD is $4,535 ($4,319 + $216). Todd must report interest income for 2008 calculated as follows: $227 (.05 $4,535). The dividends had been declared before Todd received the stock. According to the IRS in this case, the income belongs to Faye since she was the owner of the stock when the dividend was declared and she assigned to Todd the right to receive it. PTS: 1 REF: p. 4-15 | p. 4-16
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2009 Annual Edition/Test Bank
4. Jos, a cash method taxpayer, is a partner in J&T Accounting Services, a calendar year partnership. Under the partnership agreement, Jos is to receive 25% of the partnerships profits or losses. Each partner is allowed to withdraw $8,000 each month for his or her living expenses. Jos withdrew $96,000 during the year as his monthly draw in 2008. In February of each year, the partnership computes its net profit and decides how much should be retained in the business. The balance of the earnings is distributed to the partners in early March. In March 2008, Jos received $25,000 as a distribution of 2007 profits, and in March 2009, Jos received $30,000 as his share of distributed 2008 profits. The partnership earnings before partners withdrawals for 2008 totaled $484,000. Compute Joss gross income from the partnership from the above for 2008. ANS: Joss gross income is his share of the partnership profits of $121,000 (.25 $484,000). The amount of the distributions he receives generally does not affect the amount he includes in his gross income. A withdrawal of profits is analogous to withdrawing cash from a bank account created with after-tax earnings. PTS: 1 REF: p. 4-17
5. Ted and Alice were divorced in 2008. Under the terms of the divorce, Alice received custody of their 9 year-old son, Jed. Alice received certain stocks that Ted had purchased before their marriage. His cost of the stock was $15,000 and the fair market value on the date Alice received the stock was $28,000. Alice also was to receive $2,000 each month for 10 years, or until her death, whichever should occur first. The payments would be reduced to $1,500 per month if Jed should die. Alice sold the stock for $32,000 and collected $24,000 under the agreement for monthly payments. What is Alices gross income from the above for 2008? ANS: Alice must recognize a $17,000 gain ($32,000 amount realized $15,000 adjusted basis) on the sale of the stock, and $18,000 of gross income from the alimony. Only $1,500 per month ($18,000 per year) is taxable as alimony. The other $500 per month she receives is not alimony because it is based on a contingency related to the son and therefore is child support rather than alimony. PTS: 1 REF: p. 4-20 to 4-23
Gross Income: Concepts and Inclusions
4-39
6. Margaret made a $90,000 interest-free loan to her son, Adam, who used the money to retire a mortgage on his personal residence and to buy a certificate of deposit. Adams only income for the year is his salary of $35,000 and $1,400 interest income on the certificate of deposit. The relevant Federal interest rate is 8% compounded semiannually. The loan is outstanding for the entire year. a. b. Based on the above information, what is the effect of the loan on Margarets gross income for the year? The facts are the same as above, except you discovered that Margaret had made an additional loan of $15,000 to Adam in the previous year. Adam used the funds to pay his childs private school tuition. What are the effects of the loans on Margarets gross income?
ANS: a. Margarets interest income from the loan is $1,400, which is equal to Adams net investment income for the year. Thus, Margarets imputed interest income for the year is $1,400, which is the lesser of the imputed interest at the Federal rate of $7,344 [($90,000 8% 1/2) + ($93,600 8% 1/2)] or Adams net investment income of $1,400. b. Margarets loans to Adam exceed $100,000 ($90,000 + $15,000). Therefore, Margaret must recognize interest income equal to the Federal rate times the outstanding loans. (.08 $105,000 1/2) = $4,200; (.08 $109,200 1/2) = $4,368 Total = $8,568 PTS: 1 REF: p. 4-23 to 4-27
7. Arnold was employed during the first six months of the year and earned a $46,000 salary. During the next 6 months, he collected $4,800 of unemployment compensation, borrowed $6,000 (using his personal residence as collateral), and withdrew $1,000 from his savings account (including $60, interest). His luck was not all bad, for in December he won $800 in the lottery on a $5 ticket. Because of his dire circumstances, Arnolds parents loaned him $10,000 (interest-free) on July 1 of the current year, when the Federal rate was 8%. Arnold did not repay the loan during the year and used the money for living expenses. Calculate Arnolds adjusted gross income for the year. ANS: Salary Unemployment compensation Interest income Lottery winnings Adjusted gross income $46,000 4,800 60 800 $51,660
The interest-free loan does not result in gross income to Arnold because of the $10,000 exception. The cost of the lottery ticket of $5 is a miscellaneous itemized deduction. PTS: 1 REF: p. 4-3 to 4-6 | p. 4-25 | p. 4-32
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2009 Annual Edition/Test Bank
8. Ted paid $73,600 to receive $10,000 at the beginning of each year for ten years. This would repay the principal plus 6% interest. What difference does it make whether the contract is treated as an annuity as compared to an original issue discount instrument? ANS: As an annuity, Ted would treat $7,360 ($73,600/10) of each payment as a recovery of capital and the remainder, $2,640 ($10,000 $7,360) would be included in gross income. As an original issue discount instrument, the income would decrease over time. In the first year, the income would be $4,416 ($73,600 .06) and the balance would be a recovery of the original investment. In the second year, interest would accrue on $68,016 ($73,600 $10,000 + $4,416). PTS: 1 REF: p. 4-11 | p. 4-27 to 4-30
9. Sarah, a widow, is retired and receives $24,000 interest income and dividends and $8,000 in Social Security benefits. Sarah is considering selling a stock at a $6,000 gain. What will be the increase in Sarahs gross income as a result of the sale of the stock? ANS: The $6,000 gain will cause Sarahs taxable Social Security benefits to increase to $4,000, which is the lesser of the following: 50%($8,000) 50%[$30,000 + 50%($8,000) $25,000] $4,000 $4,500
Without the $6,000 recognized gain, Sarah would have included $1,500 {50%[$24,000 + (50% $8,000) $25,000]} of the Social Security benefits in her gross income. Therefore, the $6,000 gain will cause Sarahs gross income to increase by $8,500 ($6,000 + $2,500). PTS: 1 REF: p. 4-33
10. Roy is considering purchasing land for $10,000. He expects the land to appreciate in value 8% each year (compounded) and he will sell it at the end of 10 years. He also is considering purchasing a bond for $10,000. The bond does not pay any annual interest, but will pay $21,589 at maturity in 10 years. The before-tax rate of return on the bond is 8%. Roy is in the 40% (combined Federal and State) marginal tax bracket. Roy has other investments that earn a 8% before-tax rate of return. Given that the compound interest factor at 8% is 2.1589, and at 4.8% the factor is 1.5981, which alternative should Roy choose? ANS: Roy should select the investment in the land. The investment in the bond earns a 4.8% after-tax rate of return. The tax on the original issue discount must be paid each year; therefore, owning the bond is equivalent to owning an investment that appreciates at an after-tax rate of 4.8%. At the end of 10 years, Roy will have accumulated $15,981 (1.5981 $10,000). With the land, Roys investment will appreciate to $21,589 (2.1589 $10,000) which exceeds the $15,981 amount accumulated with the bond. PTS: 1 REF: p. 4-35
Gross Income: Concepts and Inclusions
4-41
11. In January 2008, Tammy purchased a bond due in 24 months. The cost of the bond is $857 and its maturity value is $1,000. No interest is paid each year, but the compound interest rate on the bond is 8%. Tammy also purchased a Series EE United States Government bond for $558, with a maturity value in 10 years of $1,000. This is the only Series EE bond she has ever owned. The Series EE bond is sold to yield 6% interest. Tammy is 13 years old and has no other source of income. She is claimed as a dependent by her parents. Compute Tammys gross income from the bond and Series EE bond for 2008. ANS: Tammys only recognized income is from the original issue discount of $69 ($857 8%) on the bond. The Series EE bonds are exempt from the original issue discount rules. However, Tammy could elect to include the original issue discount on the Series EE bond each year, and it appears that the election should be made. Because Tammy has no other sources of income, the effective tax rate on the accrued Series EE bond interest is zero because of the available standard deduction of $900. The interest reported will increase Tammys basis in the Series EE bond and, therefore, she will not have to recognize any income at maturity. The interest on the Series EE bond for 2008, if the election is made, is $33 ($558 6%). PTS: 1 ESSAY 1. In some foreign countries, the tax law specifically designates the types of income items that are includible in gross income. How does this approach compare with the U.S. Internal Revenue Code ( 61)? What is a major advantage to the approach used in the U.S. tax law? ANS: The Internal Revenue Code defines gross income as all income unless specifically excluded. The advantage of the U.S. system is that an all-inclusive list of types of income does not have to be developed. PTS: 1 REF: p. 4-2 REF: p. 4-36
2. Melissa is a compulsive coupon clipper. She often brags about the time she purchased a cart full of groceries for $5.00, when the cost without coupons would have been $50. Discuss whether Melissa realizes gross income from her coupon clipping. ANS: Under the all-inclusive concept of gross income, one could reason that Melissa realizes income from her coupon collecting activities. She clearly increases her wealth, as she acquires food at 1/10th of the amount paid by those who do not spend their time and effort saving coupons. In some cases, the coupons may have been obtained when other goods were purchased. One could reason that the price paid included a cost of the coupon; thus, the price paid would be allocated between the goods received and the cost of the coupon. Then, when the coupon was utilized, the difference between Melissas cost and the redemption value would be income. However, it seems unlikely that the IRS would attempt to tax the earnings from coupon clipping because of the time and effort required to collect small amounts of taxes. PTS: 1 REF: p. 4-2 | p. 4-4
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2009 Annual Edition/Test Bank
3. Katherine purchased a zero coupon corporate bond for $463. The bond does not pay annual interest but at the end of 10 years she will receive $1,000, for a before-tax yield of 8%. Carl placed $463 into an interest bearing savings account that also pays 8% interest each year, and he reinvests the after-tax interest at 8%. Assume that Katherine and Carl will be in the 35% marginal tax bracket for all ten years. Who will have accumulated the greater amount at the end of ten years? ANS: Katherine and Carl will have the same accumulated amount at the end of ten years. Katherine must use cash from other sources to pay the tax on the original issue discount on the corporate bond. Carl must also use other sources of cash to pay the same amount of tax as Katherine must pay. PTS: 1 REF: p. 4-11
4. Edward and Jane are divorced in 2007. At the time of the divorce, Edward had a lawsuit pending. He had filed suit against a former employer for overtime pay. As part of a divorce agreement, Edward agreed to pay Jane one-half of the proceeds from the lawsuit. In 2008, Edward collected $100,000 from the former employer and paid Jane $50,000. What are the tax consequences for Edward receiving the $100,000 and then paying Jane the $50,000? ANS: The $100,000 payment is additional gross income to Edward. In order for Edward to avoid tax on the $50,000 he transferred to Jane, the payment must qualify as alimony. This means the payment must be made only if she is alive at the time Edward receives the award. Moreover, even if the payment qualifies as alimony, the large payment received in 2008 will probably result in some alimony recapture. PTS: 1 REF: p. 4-20 | p. 4-21
5. Rachel owns rental properties. When Rachel rents to a new tenant, she usually requires the tenant to pay an amount in addition to the first months rent. The additional amount serves as security for damages to the property and the tenants failure to pay future rents. How should the payments be characterized (e.g., on lease documents) to minimize Rachels current tax liability? ANS: The payments should be characterized as damage deposits. This will ensure that the IRS will not tax the payments as prepaid income. A payment to secure future rents would probably be treated as prepaid rent income. PTS: 1 REF: p. 4-12
Gross Income: Concepts and Inclusions
4-43
6. Rachel, who is in the 35% marginal tax bracket, is considering purchasing an annuity that will pay her $10,000 per year for the remainder of her life. Her life expectancy is 15 years. The cost of the annuity is $97,120, and the cost is calculated to yield her an expected 6% return on her investment. As an alternative, Rachel could place the $97,120 in a savings account yielding 6% and she could withdraw $10,000 each year for 15 years (reducing the value of the account to zero at the end of 15 years). How might the tax laws applicable to annuities affect Rachels decision? ANS: The tax laws favor the purchase of the annuity. This results because the annuity rules allow the taxpayer to recover his or her investment more quickly than under the savings account plan. Each alternative yields the same taxable income over the 15 years. However, Rachels taxes are deferred with the annuity contract. Under the annuity rules, Rachel would treat as a recovery of capital $6,475 ($97,120/15) each year. With the savings account, Rachel has less recovery of capital in the early years than in the later years. For example, in the first year Rachel earns interest on the savings account of $5,827 ($97,120 .06) and has a recovery of capital of $4,173 ($10,000 $5,827). Thus, the present value of the taxes are greater with the savings account. PTS: 1 REF: p. 4-27 to 4-30
7. In the case of a corporations zero interest loan to a shareholder-employee, why would the shareholder prefer that the loan be classified as a corporation to shareholder loan rather than an employer-employee loan? ANS: The imputed interest on the corporation-shareholder loan will be taxed to the shareholder as a dividend, with a maximum rate of 15%. However, the imputed interest on an employer-employee loan is taxed to the shareholder as compensation income at the shareholders marginal rate, which may be as high is 35%. In addition, the taxpayer may have Social Security and Medicare taxes on the employment income. PTS: 1 REF: Concept Summary 4-2
8. Under the formula for taxing Social Security benefits, low income taxpayers are not required to include any of the Social Security benefits in gross income. But as income increases, 50% of the Social Security benefits may be included in gross income. Further increases in income will cause as much as 85% of the Social Security benefits being subject to tax. Does this mean that the taxation of Social Security benefits is more or less progressive than the taxation of other types of income? ANS: The formula for the taxation of Social Security benefits is more progressive than the taxation of other sources of income. Under a progressive system, as income increases the tax as a percent of income increases. This is accomplished by increasing the marginal tax rate as income increases. With the Social Security taxing formula, as income increases, and the taxpayer is subjected to higher marginal rates, the amount of taxable income increases as more of the Social Security benefits are subject to tax. PTS: 1 REF: p. 4-33 | p. 4-34