Entities; 3
Taxable Tax Formula; Introduction to Property Transactions
Solutions to Problem Materials
DISCUSSION QUESTIONS
3-1 The three classes of taxable entities under the Federal income tax system are: 1. Individuals; 2. Regular corporations; and 3. Fiduciaries (estates and trusts). In addition to the taxable entities, the partnership files an information return showing its income, deductions, gains, and losses, and how they are allocated among the partners. An S corporation, or electing small business corporation, usually pays no Federal income tax and is treated similar to a partnership. (See Exhibit 3.1 and p. 3-2.) 3-2 The net taxable income of a corporation is subject to Federal income taxation. Any portion of the net profit remaining that is distributed to its shareholders as dividends is taxed at the shareholder level. The corporation is not entitled to a deduction for this dividend paid. This is thought by some to be double taxation because they believe the same income is taxed twice. (See Example 3 and pp. 3-6 and 3-7.) A fiduciary that makes no current distributions is taxable on its entire net taxable income. When a fiduciary makes distributions, they are generally taxable to the beneficiaries to the extent of the trust's or estate's taxable income. Any distributions in excess of the entity's income are considered distributions of capital, known as corpus, and are tax free. It is important to note that the trust or estate is entitled to a deduction for the amount of distributions that are taxable to the beneficiary(ies). Therefore, the income is not taxed twice. (See Example 4 and 5 p. 3-8.) The annual return of a partnership (Form 1065) merely provides information about the income, deductions, gains, losses, and credits of the partnership, and information about how they are allocated among the partners. Since the partnership is never subject to tax on its income, the return can properly be referred to as an information return. The same is generally true of the S corporation tax return (Form 1120S), but in some instances penalty taxes must be paid. (See Example 7 and p. 3-9.)
3-3
3-4
3-1
3-2
Chapter 3
Taxable Entities; Tax Formula; Introduction to Property Transactions
3-5
The question is not specific as to whether the income of the partnership is derived from a trade or business or not. a. b. The guaranteed compensation paid to Y is subject to income tax and self-employment taxes. Y's share of net income of $22,000 is subject to income tax. It is also subject to self-employment tax if it was earned in a trade or business. If it was not trade or business income (e.g., rents), the income would not be subject to self-employment tax.
(See p. 3-10.) 3-6 a. b. K's salary, assuming it is reasonable in amount, is treated as a salary for income tax and payroll tax purposes. It is therefore subject to both income tax withholding and F.I.C.A. The $50,000 of income that passes through to K is subject to income tax, but it is not subject to either F.I.C.A. (since it is not payroll) or self-employment tax (since the S corporation's income is not subject to self-employment tax). Employment taxes are discussed in detail in Chapter 1. The $3,600 of medical coverage premium is treated as compensation to a 2 percent or more shareholder/employee. It is therefore subject to income tax.
c.
(See p. 3-11.) 3-7 Refer to Exhibit 3.3, p. 3-6. Gross income is income, as most broadly conceived, reduced by any items specifically excluded from gross income. Exhibits 3.4 and 3.5 (pp. 3-15 and 3-16) contain lists of selected items that are included in and excluded from gross income, respectively. Adjusted gross income (A.G.I.) for an individual is a somewhat arbitrary concept. It is calculated by subtracting specified deductions from gross income. The deductions for A.G.I. are listed in Exhibit 3.6 (p. 3-19). Taxable income for an individual is calculated by subtracting the larger of the taxpayer's allowable itemized deductions or standard deduction and his or her allowable personal and dependency exemption deductions from adjusted gross income. Exhibit 3.7 (p. 3-21) contains a partial list of itemized deductions. The gross tax is calculated based on taxable income and is reduced by any allowable credits and prepayments. Exhibit 3.8 (p. 3-23) contains a partial list of credits. The primary difference between the tax formula for individuals and the one for corporations is the fact that the corporation does not calculate A.G.I., and therefore, there is no distinction between deductions for A.G.I. and deductions from A.G.I. Other differences also exist within the various categories of the formula. (See Exhibits 3.2 and 3.3, p. 3-6.) Gross income is defined in the Code as consisting of all income, from whatever source derived, minus those items specifically excluded from gross income. (See Exhibits 3.4 and 3.5 and pp. 3-15 through 3-16.) A partial list of income items is provided in 61(a) and Exhibit 3.4 (See p. 3-15.). Specific Code provisions dealing with inclusions in gross income are found in 71 through 86. Exhibit 3.5 Partial List of Exclusions from Gross Income reveals some of the exclusions from gross income that are included in 101 through 130. (See Exhibit 3.5 and p. 3-16.) Deductions for adjusted gross income are those deductions specified in 62 of the Code that are allowed in arriving at A.G.I. (See Exhibit 3.6 and pp. 3-18 and 3-19.) All other allowable deductions for an individual taxpayer are deductions from A.G.I., which are usually referred to as itemized deductions. Since a taxpayer deducts the larger of the standard deduction or total itemized deductions, he or she benefits from itemized deductions only if they exceed the standard deduction amount. Accordingly, we say that a taxpayer itemizes his or her deductions only if they exceed the standard deduction. A taxpayer whose itemized deductions are less than the standard deduction does not itemize. (See Exhibit 3.7 for a partial list of itemized deductions and pp. 3-21 through 3-22.) Because deductions are allowed for expenditures such as state and local income taxes, property taxes, and charitable contributions, any taxpayer would report these deductions, regardless of how small they are in total. To prevent taxpayers with small amounts of itemized deductions from having to report them and to prevent the IRS from having to audit them, Congress allows any taxpayer a base amount of deductions-- called the standard deduction--in lieu of itemizing. The amounts of the standard deductions are provided in the text on page 3-20. Since the applicable standard deduction is $5,800 in 2011, a single taxpayer with itemized deductions of $1,500 would subtract the standard deduction of $5,800 plus any allowable exemption deductions from adjusted gross income in arriving at his or her taxable income. However, another taxpayer with itemized deductions of $5,850 would subtract that $5,850 plus any allowable exemption deductions in arriving at taxable income. (See pp. 3-19 through 3-21.)
3-8
3-9
3-10
Solutions to Problem Materials
3-3
For 2011 the standard deduction is the sum of two components: the basic deduction and the increases for being blind or 65. A taxpayer who has attained the age of 65 or who is legally blind at the end of the year may claim an additional standard deduction amount. For unmarried taxpayers, each of these results in an additional amount of $1,450 (for 2011); for married taxpayers, $1,150 (for 2011). A single taxpayer who is 67 years of age, with good sight, will be entitled to a standard deduction of $7,250 ($5,800 standard deduction for single $1,450 additional standard deduction) for 2011. (See p. 3-20.) 3-11 Seven categories of itemized deductions that might be listed are as follows: Medical expenses (to the extent they exceed 7.5% of A.G.I.); Investment interest (to the extent of investment income with the excess carried over); Casualty and theft losses (to the extent they exceed 10% of A.G.I.); Certain income, real property, and personal property taxes; Charitable contributions (maximum deduction generally is 50% of A.G.I. with the excess carried over); Residence interest (maximum indebtedness for which the related interest is deductible generally is $1,100,000); and 7. Miscellaneous itemized deductions (to the extent they exceed 2% of A.G.I.). 1. 2. 3. 4. 5. 6. Prior to 2011, itemized deductions other than medical, casualty and theft, investment interest and gambling losses were subject to a phaseout for high income earners. The phase-out expired in 2009 and does not apply for 2011. However, some believe that it will be resurrected. (See Exhibit 3.7, and pp. 3-21 through 3-22.) 3-12 True. The performance of services for compensation as an employee is a trade or business activity. An individual who is employed is in the business of providing services for compensation. Therefore any expenses incurred in order to generate salaries and wages are trade or business expenses. This is true even though they are itemized deductions if they are not reimbursed and they may be subject to specific limits and rules. (See p. 3-17.) H and W are entitled to their basic standard deduction of $11,600 (2011) and two extra deduction amounts of $1,150 (2011) each for being at least 65 years of age. As a result, their standard deduction for 2011 is $13,900. In addition, they are entitled to two exemption deductions or $7,400 ($3,700 in 2011 2). As a result, their taxable income would be $18,700 ($40,000 $13,900 $7,400). (See Example 12 and p. 3-21.) Personal exemptions are allowed for the taxpayer on his or her return. On a joint return filed by husband and wife there are two taxpayers, and therefore, at least two exemptions. Dependency exemptions are allowed for family members and certain other individuals who are supported by the taxpayer. A taxpayer who is claimed as a dependent on any other taxpayer's return may not claim a personal exemption (technically the exemption deduction is zero) on his or her own return. (See p. 3-22.) Likely credits to be listed: foreign tax credit, child tax credit, child and dependent care credit, earned income credit, and the HOPE scholarship credit and lifetime learning credit. (For additional credits, see Exhibit 3.8 on p. 3-23.) Credits reduce one's tax directly, and credits of equal amounts are of equal value to all taxpayers. Deductions of a given amount are typically more valuable to taxpayers in higher tax brackets than to those in lower tax brackets. For example, an interest deduction of $100 saves a 25 percent bracket taxpayer $25 in Federal income taxes, whereas an equal deduction saves a 15 percent bracket taxpayer only $15. If a credit of $20 were allowed rather than the $100 deduction, the taxpayer in the 15 percent bracket would be better off and the one in the 25 percent bracket would be worse off than they would with the deduction. (See p. 3-24.) "Wherewithal to pay" (or pay-as-you-go) refers to the proposition that the government should collect the tax due from a taxpayer while he or she has the assets with which to pay the tax. This is not a rule of taxation, but a concept that is the logical support for many of the provisions of the Internal Revenue Code. Quarterly prepayments and withholding of income taxes from salaries and wages are applications of this concept, in that the government gets the money while (or perhaps before) the taxpayer has it. (See p. 3-24.)
3-13
3-14
3-15
3-16
3-17
3-4
Chapter 3
Taxable Entities; Tax Formula; Introduction to Property Transactions
3-18
The alternative minimum tax (AMT) is a broad based tax on alternative minimum taxable income, as defined to include certain adjustments and preference items that Congress deemed were subject to preferential tax treatment. Congress chose to assess this alternative tax, rather than simply disallowing the favorable treatment of the various items. (See p. 3-24.) The amount realized in a sale or other disposition is a measure of the economic benefit derived from the transaction. It is calculated as follows: Amount of money received (net of money paid) Fair market value of other property received Liabilities discharged (net of liabilities assumed) Less: Selling cost Amount realized (See Exhibit 3.10 and pp. 3-28 and 3-29.) $xxx xxx xxx xxx $xxx
3-19
3-20
Adjusted basis is the "tax cost" or "tax book value" of an asset. Accordingly, it is the maximum amount of money or other property that can be received on the sale or other disposition of a property without the realization of gain. Any amount realized in excess of adjusted basis results in gain realized. Any amount of basis in excess of the amount realized results in loss realized. The basis of purchased property generally is its cost. It is adjusted to reflect improvements to the asset, depreciation allowed or allowable, and other capital recoveries. (See Exhibit 3.11 and p. 3-29.) The gain or loss realized on the sale or other disposition of property is calculated as follows: Amount realized (see Problem 3-28) Adjusted basis (see Problem 3-29) Gain or loss realized (See Exhibit 3.12, Examples 16 and 17, and pp. 3-28 through 3-30.) $xxx xxx $ xx
3-21
3-22
The determination of the gain or loss realized is a calculation based on the provisions of the Code. Gains and losses are realized in any sale or other disposition, but are not necessarily recognized. If realized gains and losses are taken into account in determining a taxpayer's tax liability for a given year, they are said to be recognized. (See p. 3-30.) Three classes of losses deductible by individual taxpayers are: 1. 2. 3. Losses incurred in a trade or business; Losses incurred in a transaction entered into for profit; and Casualty and theft losses (subject to limitations).
3-23
Note that personal losses, other than those from casualty or theft, are not deductible. [See p. 3-31.] In addition, capital losses in excess of capital gains are deductible up to $3,000. [See p. 3-34 and 165(c) and 1211.] 3-24 Capital assets are defined by exception. All assets are considered to be capital assets except the five classes specified in 1221. Those five classes are: 1. 2. 3. 4. 5. Inventory or other property held primarily for sale to customers in the ordinary course of a trade or business; Depreciable property or land used in a trade or business of the taxpayer; Trade accounts or notes receivable; Certain copyrights, literary, or artistic compositions, and letters or memoranda held by the person whose personal efforts created such property and certain other holders; and U.S. Government publications acquired other than by purchase at a price at which they are sold to the general public.
Several general types of assets are not excluded in this definition and are therefore capital assets. For example, most investments and personal use assets are capital assets. (See p. 3-31 and 1221.)
Solutions to Problem Materials
3-5
3-25
Assets with a short-term holding period have been held one year or less by the taxpayer. Those with holding periods longer than one year have a long-term holding period. (See p. 3-32 and 1222 and 1223.) Each year, the taxpayer combines long-term gains and losses separately from short-term gains and losses to arrive at a net result. Then, these results are combined to arrive at either an overall capital gain or an overall capital loss. An overall capital gain, whether short-term or long-term, is fully includible in taxable income. If there is a net short-term capital gain or a short-term capital gain in excess of a long-term capital loss, the amount is treated just like ordinary income. If there is a net long-term capital gain or a long-term capital gain in excess of a short-term capital loss (i.e., a net capital gain), the amount is taxed at a rate not exceeding 28 percent (sometimes 5 percent or 15 percent). If part or all of the gain would otherwise be taxed at 35 percent, the 15 or 28 percent rate applies. (See Example 19, and pp. 3-31 through 3-33.) An individual is entitled to a deduction for capital losses in excess of capital gains for a given year. This deduction is limited to $3,000 ($1,500 for married persons filing separately). If a taxpayer has both shortterm and long-term capital losses, the short-term losses are deducted first. Losses in excess of the limit may be carried forward to subsequent tax years. (See Example 24 and pp. 3-36 and 3-37.) A corporation is not allowed a current deduction for any capital losses in excess of capital gains. (See p. 3-37.) Excess capital losses of individuals are carried forward to subsequent years and treated as if they occurred in the carryover year. There is no time limit on the carryover period. Both long-term and short-term losses retain their character in the carryover periods. (See Example 21 and p. 3-34.) Corporate taxpayers are allowed a limited carryback and/or carryover for excess losses--three-year carryback and five-year carryforward. (See p. 3-34.)
THE
3-26
3-27
3-28 3-29
YOU MAKE
3-30
CALL
Dewey, Cheatham, and Howe has an obligation to inform the client of the error and advise them that they should amend their tax return to correct the error. Murray has notified his supervisor, Norm, and is now caught in a dilemma. Has he done all that he needs to by notifying Norm? Should Murray notify the client? Should he notify Norm's supervisor? Should he quit? Clearly, Norm is in error. Has Murray satisfied his obligation by informing Norm? Probably so! However, Murray should make some note in the records to the effect that Norm was notified. Murray should also consider his relationship to the other supervisors and managers of the firm. If he also reports directly to the other members of the firm, he might consider reporting the error to them. He should consult firm policy, if any. It is unlikely that Murray should contact the client directly over Norm's objection. In no instance should Murray contact the IRS.
PROBLEMS
3-31 a. Alpha Partnership is not subject to tax on its net income. The partners, however, must include their share of income in their respective A.G.I. as follows: William includes $7,200 ($12,000 60%) and Patricia includes $4,800 ($12,000 40% ). Note that in determining the taxable income of the partners, the distributions are ignored since all of the partnership taxable income flows through. (See Example 7 and pp. 3-9 and 3-10.) A trust only pays tax on its net income to the extent the income exceeds its current distributions. Because the distributions by Beta Trust exceeded the net income, all of the income passes through and is taxed to the beneficiary, Gregory. Specifically, Gregory's A.G.I. is increased by $5,500. (See Examples 4 and 5 and pp. 3-7 and 3-8.) The taxable net income of $24,000 is taxable to Gamma Corporation at the regular corporate income tax rates. (See the inside cover for the corporate tax rates.) The corporation is not entitled to a deduction for the dividends it pays; but, Heather and Kristie must include dividends of $1,350 each in their gross income. This is a clear example of the fact that a regular corporation's earnings are subject to double taxation. (See Example 3 and pp. 3-5 through 3-7.)
b.
c.
3-6
Chapter 3
Taxable Entities; Tax Formula; Introduction to Property Transactions
3-32
These determinations are not easily made based on partial information. But, based solely on the information that is presented, the following recommendations and reasons for their selection are made. a. Edmund and Gloria should strongly consider using either the partnership (or LLC) or the S corporation form. These are advantageous, because the operating losses pass through to the owners to be offset against their other taxable incomes, unless they are disallowed or limited under some provision of the Code. Robin can avoid the double tax (i.e., avoid tax on the distribution of profits) by electing to have her corporation treated as an S corporation. The profits are taxed directly to the shareholder(s) and can be distributed tax-free. If the election were not made, the profits would be taxed to a regular corporation at corporate rates and the distributions would be taxed to the shareholder(s) as dividends when made.
b.
(See pp. 3-3 through 3-12.) 3-33 a. MN, Inc.'s taxable income is determined as follow: Net income before salaries Minus: Salaries to M Taxable income Tax on $23,000 (at 15%) b. M's adjusted gross income is determined as follows: Salaries Dividends Interest Adjusted gross income c. $102,000 30,000 12,500 $144,500 $ 125,000 102,000 $ 23,000 $ 3,450
If M believes MN's income is his income, he believes his income is subject to a double tax. A $30,000 amount was taxed at the corporate level (only $23,000 was taxed this year) and again when distributed. However, not all people agree that this is a double tax since they view the corporation as totally separate from its 100 percent owner. Congress has mitigated this double tax by providing that most dividends are taxed at capital gains rates. (See Example 3 and pp. 3-5 and 3-7.) JKLM's taxable income is determined as follows: Net income before salaries ($880,000 $540,000 $145,000) Minus: Guaranteed salaries to partners Taxable income The partnership pays no tax.
3-34
a.
$195,000 90,000 $105,000
b.
J's income from the partnership is determined as follows: Partner's guaranteed salary Distributive shares of JKLM income (.25 $105,000) Taxable income This income is included with J's other income. $ 45,000 26,250 $ 71,250
c.
All $71,250 is self-employment income (since the income is from sales, it is definitely self-employment income).
(See pp. 3-9 and 3-10.)
Solutions to Problem Materials
3-7
3-35
a.
The Trust's taxable income is determined as follows: Net income before distributions ($45,000 $1,900) Minus: Distributions deduction Taxable income $ 43,100 12,500 $ 30,600
b.
B's adjusted gross income is determined as follows: Income from trust Interest income Adjusted gross income $12,500 22,300 $34,800
(See Examples 4 and 5, and p. 3-8.) 3-36 a. A sole proprietorship does not deduct any salaries or other distributions paid (i.e., withdrawals) to the proprietor. As such, the net income of the business is $35,500 ($95,000 $43,000 $16,500). This $35,500 is included in T's adjusted gross income and is reported on Schedule C of the Form 1040. It is subject to income tax and self-employment tax. Assuming the salary is to be paid (i.e., allocated) to S before profits are allocated, the taxable income to be allocated between R and S is $15,500 ($95,000 $43,000 $16,500 $20,000). Accordingly, R's share of the partnership income is $7,750 ($15,500 50%), and S's share is $27,750 ($20,000 guaranteed salary $7,750). All amounts are taxed to the partners as partnership income, and the partnership pays no income tax. The corporation's taxable income is $15,500 because the $20,000 salary is a deductible business expense and the dividends are not deductible. K must include the salary of $20,000, and U and K must each include dividends of $2,500 in gross income. The corporation pays tax (at 15 percent) on the taxable income of $15,500, but it is not entitled to a deduction for the dividends paid to U and K. Pay roll taxes are also paid on K's salary.
b.
c.
(See pp. 3-3 through 3-10.) 3-37 The examples of includible and excludable income used in this problem were selected as good items to begin to master material that is covered in detail in Chapters 5 and 6. a. b. Fully includible. Alimony is taxable to the recipient. Other payments related to divorce, such as property settlements and child support, are not taxable. Fully excludable. Municipal bond interest is generally exempt from Federal income tax. However, if the proceeds were used for some private activity, the interest is taxed. Furthermore, any gain or loss on the sale or other disposition of the municipal bond is recognized. Fully excludable. Gifts and inheritances are not subject to Federal income tax. Any earnings (such as interest, dividends, and rents) from the property after the transfer are taxable under normal rules. Partially excludable and partially includible. For low-income Social Security annuitants, the benefit is fully excludable, but for higher-income annuitants, up to 85 percent of the benefit may be taxed. Exhibit 3.4 merely indicates that there is a limitation on the excludible amount. Fully includible. Tips and gratuities are income for services rendered. Fully excludable. Life insurance proceeds paid on account of death are not subject to Federal income taxation.
c. d.
e. f.
(See Exhibits 3.4 and 3-5 and pp. 3-15 through 3-16.) 3-38 The examples of deductions for A.G.I. and from A.G.I. used in this problem were selected as good items to begin to master material that is covered in detail in Chapter 7 through 11. a. Deduction for A.G.I. Since the recipient spouse must fully include any alimony received, Congress deemed it appropriate that the paying spouse be allowed a deduction whether or not the taxpayer itemizes. Itemized deduction. Deduction for A.G.I. Because the business income of a self-employed person is fully included in income, Congress deemed it appropriate that the income-producing expenses be allowed as a deduction whether or not the taxpayer itemizes.
b. c.
3-8
Chapter 3
Taxable Entities; Tax Formula; Introduction to Property Transactions
d.
e. f. g.
Deduction for A.G.I. Because the rental income of a self-employed person is fully included in income, Congress deemed it appropriate that the income-producing expenses be allowed as a deduction whether or not the taxpayer itemizes. Itemized deduction. Deduction for A.G.I. Because the expense reimbursement is fully included in gross income, Congress deemed it appropriate that the employee be allowed a deduction whether or not he or she itemizes. Itemized deduction.
(See Exhibits 3.6 and 3-7 and pp. 3-17 through 3-19.) 3-39 Fred and Susan have A.G.I. of $56,000 ($57,200 $1,200) and taxable income of $29,600, determined as follows: Adjusted gross income Less the larger of Itemized deductions Standard deduction (2011) Less personal and dependency exemptions (4 $3,700) Taxable income (See Exhibit 3.3 and pp. 3-15 through 3-23.) 3-40 1. Gross income deductions for A.G.I. A.G.I. $67,400 deductions for A.G.I. $58,550. Deductions for A.G.I. $8,850. 2. A.G.I. itemized deductions (or $11,600 in 2011, if larger) personal and dependency exemptions taxable income. $58,550 itemized deductions [4 $3,700 in 2011 $14,800] $29,250. Itemized deductions $14,500. $ 56,000 $ 8,900 $11,600
(11,600) (14,800) $ 29,600
(See pp. 3-15 through 3-25.) 3-41 These answers in bold are for 2011. Note in part B the A.G.I. in the text should be $57,350. Gross income Deductions for A.G.I. A.G.I. Itemized deductions Standard deduction Exemptions Taxable income (See Exhibit 3.3 and pp. 3-15 through 3-25.) 3-42 a. b. c. The income is included in T's taxable income. T is able to reduce the U.S. tax by $2,000 in the form of a foreign tax credit for the tax paid to the foreign government. The foreign tax credit is limited to the U.S. tax on the foreign source income. As a result, T may only claim a credit of $1,800. Under the foreign earned income provisions, T may elect to exclude up to $92,900 (2011) from gross income the income from personal services performed while a resident of a foreign country. As a result, there is no U.S. tax and no foreign tax credit. A $ 50,000 (8,000) 42,000 (9,000) (5,800) (7,400) $25,600 B $ 86,000 (8,000) $ 78,000 (4,650) (5,800) (3,700) $ 68,500 C $ 82,700 (7,000) 75,700 (7,350) (5,800) (3,700) $ 64,650
(See Example 2 and p. 3-4.)
Solutions to Problem Materials
3-9
3-43
L's alternative minimum tax is computed below. Regular tax (single) Regular taxable income Tax on regular taxable income (2011 rates) Alternative minimum tax Regular taxable income Adjustments and preferences AMTI Exemption phaseout $48,450 (single) $7,975 [(25% (AMTI $144,400 threshold $112,500 $31,900)] Base Rate Tentative AMT Regular tax AMT See Example 15 and pp. 3-24 and 3-25.
$ 74,200 $ 14,675 $ 74,200 70,200 $144,400 (40,475) $103,925 26% $ 27,021 00,(14,675) $ 12,346
3-44
a. b. c. d. e. f. g. h.
C. However, this asset falls into a special class because it is also personal use property. The treatment of such properties will be developed in subsequent chapters. (See p. 3-31.) C. Passive investments are generally capital assets. (See p. 3-31.) C. See answer (a). O. Inventory does not qualify as a capital asset. (See No. 1 on p. 3-31). C. See answer (b). T. This is 1231 property. (See p. 3-34.) O. Trade accounts and notes receivable do not qualify as capital assets or 1231 assets. (See No. 3 on p. 3-31.) C. See answer (b).
3-45
The following calculations apply to W's sale: Amount realized Amount of money received Fair market value of other property received Liabilities discharged in the transaction Less adjusted basis Gain realized (See Exhibits 3.10 through 3-12 and pp. 3-28 through 3-39.)
$12,000 0 32,000
$ 44,000 (23,000) $ 21,000
3-46
M's basis would be calculated as follows: Original cost Improvements--garage and patio deck $8,000 $2,500 Repairs and maintenance on rental property--bremsp allowed as current deductions when paidbremsp or incurred (therefore, not capitalized) Subtotal Less depreciation allowed Adjusted basis (See Examples 16 and 17, Exhibit 3.11 and pp. 3-29 through 3-30.) $39,000 10,500
n/a $49,500 (7,500) $42,000
3-10
Chapter 3
Taxable Entities; Tax Formula; Introduction to Property Transactions
3-47
Each of the requested amounts for S is shown in the following computation: Amount realized Amount of money received Fair market value of other property received Liabilities discharged in the transaction Less adjusted basis ($52,000 $12,000) Gain realized (See Exhibit 3.10 and pp. 3-28 through 3-29.)
$ 6,000 30,000 36,000
$ 72,000 (40,000) $ 32,000
3-48
First segregate the gains and losses into the four groups as follows: Long-term capital gains ($1,000 $6,000) Long-term capital losses Short-term capital gains Short-term capital losses $ 7,000 (2,000) 0 0
The loss on the sale of jewelry is ignored since personal losses are not deductible. Netting the other transactions results in a net long-term capital gain of $5,000 ($7,000 $2,000) and a net short-term capital gain of $0. The net capital gain of $5,000 ($5,000 net long-term capital gain $0 net short-term capital loss) is included in taxable income and taxed at the capital gains rate. (See Examples 19 through 21 and, pp. 3-31 through 3-34.) 3-49 First segregate the gains and losses into the four groups as follows: Long-term capital gains Long-term capital losses Short-term capital gains Short-term capital losses $ 0 (9,000) 4,000 0
Netting these items results in a net long-term capital loss of $9,000 ($9,000 $0) and a net short-term capital gain of $4,000 ($4,000 $0). Further netting results in a net long-term capital loss of $5,000. The capital loss deduction for T for the year is the lesser of the following: The net capital loss The annual limit $5,000 $3,000
Because the limit applies, the excess loss of $2,000 is carried forward as a long-term capital loss to the succeeding year. (See Example 21 and p. 3-34.) 3-50 The following calculations detail each of the items required for this problem (as a technical matter, gross income ("a") is $35,970, but gross income is not calculated on the tax return). Salary Interest earned from savings accounts Gift from grandmother--excluded from income LTCG from sale of investment 3,000 (1,000) STCL (allowed to offset LTCG) a. Gross income Less deductions for adjusted gross b. Adjusted gross income Less the standard deduction (2011) Less personal and dependency exemptions (2011) c. Taxable income d. 11$ 32,670 1,300 n/a 2,000 $ 35,970 (0) $ 35,970 (5,800) (3,700) $ 26,470
Richard Hartman's income tax before credits or prepayments should be determined by use of the tax tables provided by the IRS. Because the 2011 tables were not available at the time this solution was being prepared, Schedule X (single) of the 2011 Tax Rate Schedules appearing on the inside cover of
Solutions to Problem Materials
3-11
e.
the text was used to calculate a tax liability before credits or prepayments of $3,246 [($850 $2,396 (15% ($26,470 $2,000 LTCG $8,500 $15,970)) ($2,000 LTCG 0% for 2011]. Mr. Hartman could deduct the $2,000 contribution even if he was covered by a qualified employer retirement plan (since his earnings are less than $50,000). Since the $2,000 is deductible, by making this payment, Mr. Hartman would save $300 ($2,000 .15) in taxes for the current year.
(See entire chapter, especially Exhibit 3.3.) 3-51 a. Mr. and Mrs. G report the following on their joint tax return:
Salary of $80,000 and dividends of $42,000 from X; Net income passing through of $36,000 from P; Loss pass-through of $7,000 from H; and No income from the trust.
b.
G, Jr. reports the following on his tax return:
Salary of $24,000 and dividends of $10,500 from X; Loss pass-through of $7,000 from H; and Income pass-through from G Trust of $4,500.
c.
d. e. f.
X Corporation is taxed on its net taxable income of $75,000. In arriving at that amount, it deducted the salaries to Mr. G and G, Jr., which are presumed to be reasonable; but no deduction is allowable for the dividends. P Partnership pays no tax. Its income of $60,000 passes through to the partners. The $72,000 of distributions are tax-free, so long as they do not exceed the partner's basis in the partnership interest. H Corporation pays no tax. Its income or loss passes through to its shareholders. See answers (a) and (b) above. G Trust may deduct distributions to the extent includible by G, Jr. Therefore, its taxable income is $11,500 ($16,000 $4,500).
(See pp. 3-3 through 3-10.) 3-52 Salary Part-time consulting (Schedule C) Less consulting related travel expenses (Schedule C) Dividend income Employee expense reimbursement Less: Portion deductible for A.G.I. A.G.I. Itemized deductions: Residence interest Miscellaneous itemized deductions: Tax preparation fee $ , 500 Safe deposit box rental 50 Unreimbursed employee travel ($450 $200) 250 Total $ 800 Less 2% of A.G.I. , (1,470) Exemption deductions (2 $3,700 in 2011) Taxable income* $68,250 $ 5,000 (1,000) 4,000 1,250 $ ,200 ( ,200) ,00000..0 $73,500
$ 9,800
,00 0
(9,800) (7,400) $56,300
*Because the problem did not ask to calculate Indy's self-employment tax, no deduction for one-half the SE tax has been taken in arriving at taxable income of $56,300. The self-employment tax for 2011 is computed with a reduced rate of 10.4% (not discussed in the text) but reverts to 12.4% in 2012. The tax using the 12.4% rate would be $565 [Social Security of $458.05 ($4,000 self-employment income 92.35% 12.4%) plus MHI of $107.13 ($4,000 net income from self-employment 92.35% 2.9%)]. Therefore, the deduction for 1/2 of the self-employment tax would be $282.50 and it is a deduction for A.G.I. The ceiling OASDI (i.e., Social Security tax wages) is $106,800 in 2011, so the maximum amount Indy Smith can pay OASDI on is $38,550 ($106,800 $68,250 Social Security wages). (See entire chapter.)
3-12
Chapter 3
Taxable Entities; Tax Formula; Introduction to Property Transactions
3-53
Eli's salary Interestcorporate bonds Interest on State of Illinois bonds (tax-exempt) Rental income from duplex Expenses related to rental income Moving expenses* Adjusted gross income Itemized deductions: Medical expenses Less 7.5% of A.G.I. Residence interest Property taxes Charitable contributions Miscellaneous itemized Less 2% of A.G.I. Total itemized deductions Allowable itemized deductions Personal exemptions (2 $3,700) Taxable income
$ 95,000 5,600 n/a $10,000 (6,000) 4,000 (2,000) $102,600
$ 7,400 (7,695)
$
0 11,300 3,000 4,000
$ ,100 (2,052)
0 $18,300 (18,300) (7,400) $ 76,900
*Since the problem states that the moving expenses are deductible, the move must have met the mileage test (50 miles) and time test (39 weeks). 3-54 Assuming H and W have no other income, their regular and alternative minimum tax for 2011 are calculated as follows (see Example 18 and pp. 3-27 and 3-28): Salary Minus: Itemized deductions State and local property and income taxes Miscellaneous itemized deductions (after 2% limitation) Exemptions (7 $3,700 in 2011) Taxable income Tax on taxable income of $94,100 (2011 rates) Calculation of AMT: Regular taxable income Adjustments: State and local taxes Miscellaneous itemized deductions Exemption deductions AMTI Exemption $74,450 $3,750 [25% (AMTI $165,000 $150,000 $15,000)] AMT base Tentative AMT (26% $94,300) Minus: Regular tax Equals: AMT 3-55 $ 165,000 $40,000 5,000 25,900 (70,900) $ 94,100 $ 15,775
$ 94,100 40,000 5,000 25,900 $ 165,000 (70,700) $ 94,300 $ 24,518 (15,775) $ 8,743
The losses flow through to B and J. They both contributed cash and it appears that they can deduct the losses. However, the losses may be suspended under the passive activity rules (see Chapter 12). B should be able to claim the deduction for 30% since B materially participated. Based on the description, J did not materially participate. As a result, J can only deduct 70% to the extent J has passive activity income from other sources. (See p. 18 and Chapter 12.)
TAX RESEARCH PROBLEMS
Solutions to the Tax Research Problems (3-56) are contained in the Instructor's Resource Guide and Test Bank for 2012.