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Gross Income: Inclusions and Exclusions
Solutions to Problem Materials DISCUSSION QUESTIONS
6-1 a. False. Receipts are included in gross income unless specifically listed as excludable. [See p. 6-2 and 61(a).] It is the taxpayer's responsibility to prove that a particular type of income is excluded and to cite the specific authority providing the exclusions. False. Tax returns show that (1) gross receipts except those that are entirely excludable (nontaxable) (2) less excludable portion (3) equals gross income. (See p. 6-2.) Many receipts, such as refunds for state taxes not previously deducted, will not appear on the tax return. True. As long as the municipal bond carries tax-exempt status, (i.e., it is issued by a state, a territory, a U.S. possession or any of their political subdivisions and is not an industrial development or arbitrage bond) the interest income is excludable (nontaxable) by individuals and corporations. [See Example 4, p. 6-7 and 103(a)(1).] b. c. 6-2 For C to evaluate which investment would produce a greater after-tax return, she must have knowledge of the interest rate of the state bond, estimate the expected rate of return of anticipated dividends from H, Inc., know her marginal tax rate, estimate future proceeds from the sale of the investments, and select a discount rate to determine the present value of the expected future cash flows. (See Example 4 and p. 6-7.) a. The after-tax return will be higher if the taxpayer invests in the State of Kentucky bonds. (See Exhibit 6-2 and Example 4 and pp. 6-7 and 6-8.) Corporate Bonds 7% $ 70.00) (24.50) $ 45.50) 4.55%) State Bonds 3% $ 30) (0) $ 30) 3.0%) 6-3 Annual interest income Federal income tax--35% After-tax income After-tax rate of return 11- 6-1 6-2 Chapter 6 Gross Income: Inclusions and Exclusions b. The after-tax return will be higher if the taxpayer invests in the corporate bonds. Corporate Bonds 7% $ 70.00) (10.50) $ 59.50) 5.95%) State Bonds 3% $ 30) (0) $ 30) 3.0%) Annual interest income Federal income tax--15% After-tax income After-tax rate of return 6-4 11- A dividend is a distribution paid by a domestic corporation from its current or accumulated earnings and profits. A corporate distribution that is not from current or accumulated earnings and profits generally qualifies as a return of capital. These distributions are treated as a return of investment with the shareholder's basis in the stock being reduced. Any distributions in excess of basis are capital gains. Other distributions treated as a return of capital include those from mutual insurance companies on unmatured life insurance policies and patronage dividends to cooperative members. Distributions from regulated investment companies representing gains on investment sales are included as capital gains. [See Example 1, p. 6-1, and 301(c)(3) and 316.] When a stock dividend is distributed with the potential to change the stockholders' proportionate ownership interest, it is taxable. Thus, if a choice exists between receiving cash or stock, the dividend is ordinary income. At certain times, a corporation will issue stock dividends to shareholders without giving them an option to receive cash. If the dividend is common or nonconvertible preferred stock distributed to common shareholders, it is nontaxable. The basis of the original common stock is allocated between the preferred received and the common previously owned based on their relative fair market values, or equally among the old and new common if the dividend is in common stock. A stock dividend to preferred shareholders usually is treated as a cash dividend, and is therefore taxable. (See Examples 2 and 3, p. 6-6, and 305 and 307.) In some instances, earnings on deposits with banks, credit unions, and savings and loan associations are referred to as dividends when they actually possess all the characteristics of interest.
6-5 a. Taxable. There are two potential exclusions for lodging. The first is Section 119 that provides an exclusion for the value of meals and lodging if (1) it is provided for the employer's convenience (substantial noncompensatory business purpose exists); (2) it is provided on the employer's business premises and (3) in the case of lodging, the employee is required to occupy the quarters in order to properly perform his or her employment duties. Section 119 would not apply in this instance because the employer does not appear to have a good business purpose for providing the lodging. (See p. 6-26.) The lodging could possibly be excluded under 132 as a no-additional cost fringe benefit. In this case, there is no substantial additional cost as a result of the employee's usage so it would appear to qualify. However, the exclusion is limited to services sold in the normal course of business in which the employee works. The value of the lodging is taxable because R works for another line of business, the real estate agency, not the hotel business. (See p. 6-31.) However, it may be nontaxable under a rather obscure exception. If Z, Inc., provided substantially all employees these benefits on 1/1/84, regardless of the employees' line of business and elects to continue this benefit, it must pay a nondeductible 30 percent excise tax levied on the following [(total value of the exclusion of these services employee discounts) 1% total compensation]. (see Reg 1.132-4(g) and reference to 4977 and footnote 68 on p. 6-31.) Nontaxable. R would have the value of the lodging excluded as a no-additional-cost service. The exclusion would apply to the value of the lodging for himself, his spouse, and his dependent children because he works in his employer's hotel business. (See p. 6-31.) Nontaxable. The value of the lodging may be excluded as a no-additional-cost service. Employees identified with more than one line of business may exclude the benefits received from all of them. (The exclusion extends to benefits provided under a written reciprocal agreement by another employer that is in the same line of business.) [See p. 6-30 and Reg. 1.132-4T(a)(1)(iv)(A).] 1. 2. Parking provided by the employer is a deductible business expense for the employer and nontaxable income (i.e., up to $230 per month for 2011) for the employee. (See p. 6-32.) When the employee pays the fee, it is a nondeductible personal expense. b. c. 6-6 a. Solutions to Problem Materials 6-3 b. c. Health insurance premiums are a deductible employee-related expense for the employer. The employee does not have taxable income except when reimbursement of medical expenses exceeds expenses incurred or the employee receives a tax benefit from a prior year's deduction. [See Example 22, p. 6-24, and 105(b), 106, and 213.] 2. The premiums are deductible as an itemized deduction when the employee pays for them. Reimbursement in a subsequent year is taxable income only to the extent the taxpayer received a tax benefit from the deduction. Excess reimbursements are not taxable when the employee pays the premiums. 1. Disability income premiums represent nontaxable income for the employee, but proceeds received from an employer-provided plan are taxable, except in the case of total and permanent disability under the age of 65. Limitations are imposed on the amount excludable in this circumstance. The cost of the premiums is deductible by the employer. (See pp. 6-25 and 6-26 and 105.) 2. Employee-paid premiums are a nondeductible personal expense but any income from the plan is fully excluded. [See Example 25, p. 6-26, and 104(a)(3).] 1. Meals provided by an employer when the employee must remain on the premises are nontaxable income to the employee and a deductible expense for the employer. (See pp. 6-26 through 6-27.) 2. Employee-paid meals are a nondeductible personal expense even if eaten on the premises at the convenience of the employer. 1. Employer-provided meals and lodging are nontaxable income to the employee if three conditions are met. They must be provided for the employer's convenience, they must be supplied on the employer's business premises and, in the case of lodging, the employee is required to occupy the quarters in order to perform employment duties. (See Example 26 and pp. 6-26 through 6-27, and 119.) 1. Camp Counselor--on call 24 hours a day to supervise campers 2. Ski Resort Doctor--on call 24 hours a day for medical emergencies 3. Construction Worker--employed at remote job site 4. Cruise Ship Captain--responsible for ship's safety 5. Sorority Housemother--presence required to perform duties 6. Bodyguard--presence necessary for employer's protection 7. State Governor--residence in governor's mansion part of position 8. Cemetery Caretaker--on premises for security measures 9. Zoo Veterinarian--on call 24 hours a day for animal care 10. Flight attendant--working on flights during meals 11. Gas Station attendant--one person on duty to wait on customers 12. Food-server--required to work during normal meal periods d. 6-7 a. b. 6-8 Employee benefits that would serve either employers or society at large should be considered. Some possibilities are discussed below. 1. Allow employees to take up to 40 hours a year in time off paid by the employer for the explicit purpose of donating that time to qualified charities. This would be nontaxable income. The charitable organization would verify to the employer that the employee did volunteer services. This would increase charity by the private sector, reducing part of the burden carried by the government. 2. Many employees incur large clothing expenses to present themselves in a manner preferred by their employers yet cannot deduct any of these expenses unless the clothing qualifies as uniforms. The issuance of a stipulated clothing allowance, deductible by the employer and excludable by the employee, would help alleviate this condition. 3. Provisions could be made where an employee could exclude from income the receipt of a sizeable cash benefit to quit smoking. The employer would benefit by an improved atmosphere on the premises, the probably increased longevity and health of the employee, and a tax-deductible expense. Other incentives for health improvements such as weight loss for obese persons could also be included. 4. An excludable employee benefit that would serve to reduce urban traffic congestion and corresponding air pollution would be to encourage the use of public transportation for commuting to work. Although businesses currently may provide transportation in a commuter highway vehicle, this would carry the idea further and utilize existing facilities. Employees would have nontaxable income equal to the employer's reimbursement of documented expenditures for traveling to and from work on city buses, subways, and commuter trains. Some employers would benefit by reduced costs involved in providing employee parking. 6-4 Chapter 6 Gross Income: Inclusions and Exclusions 6-9 Gifts of income-producing property to family members who are at least 19 years old (or 24 if a full-time student) and have lower marginal tax rates will produce a reduction of the family's total income tax liability. Although the transferor has no deduction and the transferee has no taxable income on the amount of the gift, the savings of taxes on the property's income could be substantial. [See p. 6-35, 102(a), and Reg. 1.102-1.] a. Payments that represent alimony are deductible for A.G.I. by the payor and taxable income to the payee. Child support payments are nondeductible personal expenses and nontaxable income to the recipient. [See Example 33, pp. 6-35 through 6-40, and 71(a) and 215(a).] For payments to qualify as child support, they must be a specific fixed amount, paid solely for the support of minor children (under age 21), and payable by decree, instrument, or agreement. If all three requirements are not met, the payments are treated as alimony with no part considered to be child support. In the current arrangement, the entire amount would be deductible by the husband and taxable income for the wife. (See Example 38, and p. 6-39.) Many divorce agreements require that (1) periodic cash payments be made by one party to the other and (2) title to specified assets be transferred from one party to the other. Tax implications of cash payments are given in b above. When title to assets is transferred, (1) the recipient has no taxable income and the bases in the assets (or portion of an asset) not previously owned transfers with the property, and (2) neither party recognizes any gain or loss. These varying tax results allow for considerable tax-planning when negotiation is possible. For discussion purposes, it is assumed the husband's marginal tax rate is 28 percent and the wife's is 15 percent after changes to the agreement made below. (See Example 62 and p. 6-56.) 1. One possible option is to increase the amount of the periodic payment and allocate most or all of it to alimony rather than child support. All of it is treated as alimony if no specific dollar amount is assigned to child care. This benefits both the husband and wife because every $100 of alimony has an after-tax cost to the husband of $72 and an after-tax benefit to the wife of $85. In contrast, his after-tax cost of $85 of child care is $85 and her benefit is $85. Thus, her situation remains the same and he saves $13 with the change. 2. Another available option is to transfer title of more income-producing property to the wife and decrease periodic payments. In this situation, the taxable income from the property is taxed at the wife's lower marginal rate. This achieves the same tax effect as alternative (1) above. Of course, the property transferred should have taxable income and not be tax-exempt or tax-deferred. 3. Any property to be sold should be transferred to the party with the lower marginal tax rate (and possibly to one of the children). The DRA, as amended by the TRA of 1986, included a provision to discourage excessive amounts from being treated as alimony in the early years. Accordingly, under the front loading rules, alimony must be recaptured in the third year if alimony payments decreased by more than $15,000 during the three-year period. The recapture for the second year is $10,000 ($25,000 paid in the second year $0 paid in the third year $15,000). The recapture for the first year is $2,500 [$25,000 paid in the first year ($25,000 paid in the second year $10,000 excess from the first calculation $15,000 $0 paid in the third year $15,000/2 $7,500 average for the two years) $15,000]. H's deduction for A.G.I. and W's taxable income are $25,000 for the first year and $25,000 for the second year. In the third year, the recaptures exceed payments; thus, H's taxable income and W's deduction for A.G.I. is $12,500 ($10,000 $2,500). The payment schedule could be restructured so that the $50,000 payments could be paid equally over the three years. W could minimize her taxable income by requiring the $50,000 to be paid in the first year. 6-10 b. c. 6-11 a. b. c. (See Examples 36 and 37 and pp. 6-37 through 6-39.) 6-12 a. The value of the prizes may be less than their selling price if the property won has no resale market or is nontransferable. The Tax Court has estimated the value of such prizes to be what the particular winner could and would pay for similar goods. Even if the prize can be sold, an argument could be made against the IRS's assigned retail selling price. Many items have a list selling price but are readily attainable at show-room stores or discount marts at reduced prices. The value designated should not exceed what a prudent shopper would pay for the prizes. (See p. 6-42.) Solutions to Problem Materials 6-5 b. Prizes and awards that are made in recognition of the recipients' achievement in religious, charitable, scientific, educational, artistic, literary, or civic work are excluded if (1) the recipients were selected without any direct action on their part to enter the contest, (2) they are not required to perform substantial future services as a condition of receiving the prize or award, and (3) they designate the payor to give the award to a governmental unit or tax-exempt organization. [See Example 43 and p. 6-45 and 74(b).] 6-13 Prior to the TRA of 1986, recipients may have qualified for a limited exclusion. However, amounts received after 1986 generally will be included in taxable income unless the recipient designates that the payor give the award to a governmental unit or to a tax-exempt organization. [See Example 43 and p. 6-45 and 117 and 74(b).] The amounts withdrawn from a 529 plan are nontaxable if they are used for qualified education expenses as defined in 529(e)(3). Qualified education expenses include tuition, fees, books, supplies, equipment, and room and board for students who are at least half-time that are "required for the enrollment or attendance of a designated beneficiary." (In addition, expenses for special needs services for a special needs beneficiary also qualify.) The amounts paid for tuition, fees and books clearly qualify since they meet the letter of the statute. The costs of the appliances, furniture and bedding do not qualify since they are not "required" for enrollment. The major issue is whether the computer can be considered equipment and whether it is "required" for enrollment. Under a special rule contained in 529(e)(3)(A)(iii), purchases of computers for 2009 and 2010 were considered qualified higher education expenses. However, this rule was not extended. Consequently, for 2011 and future years, the issue, once again, is whether the computer is required for enrollment. This issue was addressed in James M. Gorski, et ux. v. Commissioner, TC Summary Opinion 2005-112, a case involving application of the 10% early withdrawal penalty to use of distributions that are not used for qualified education expenses. In Gorski, the taxpayer had withdrawn amounts used for purchase of a computer for the taxpayer's daughter who was attending Miami of Ohio. The court acknowledged that "neither the Internal Revenue Code nor the applicable regulations provide specific guidance on whether a computer is a qualified higher education expense." It said the real issue was whether it was "necessary" for their daughter's attendance at the university. According to the court, "[N]otwithstanding the absence of documentation from Miami University stating that it requires students to purchase a computer, it cannot be said from this record that a computer was required for Kathleen's enrollment in classes." The court explained that the school did not require students to have a computer; in fact, it provided a limited number of computers for students to use in the library. Second, the Gorskis admitted that Kathleen was not enrolled in any classes that required her to have her own computer. Thus, having a personal computer was more of a convenience than a requirement. It should also be noted that the court said that the $400 the Gorskis spent on books for their daughter was disallowed in part because they did not have all of the receipts to prove they had spent this money. In addition, none of the books were required her enrollment or for any specific class. Thus a dictionary might be a handy thing to have, but if it is not a requirement of admission, it is not a "qualified higher education expense." (See. pp. 6-15 and 6-16.) a. When no amount is specifically assigned to a non-competition agreement, the entire amount is for goodwill. Thus, the allocation as stated would result in $40,000 capital gain to the seller and a deductible business expense (amortized ratably over a period of 15 years) to the purchaser. (See Example 50 and p. 6-48.) Because amounts assigned to a non-competition clause are included in ordinary income, the seller may be reducing his tax liability with the current arrangement (where all of the $40,000 is considered to be goodwill). Effective for acquisitions after August 10, 1993 all "Section 197 intangibles" must be amortized over 15 years. The taxpayer must use the 15-year period even if the useful life is actually more or less than 15 years. Section 197 intangibles include, among others, goodwill and covenants not to compete. Consequently, the buyer would be indifferent. (See p. 6-48.) V will have taxable income of $530,000 if the court awards the amounts and specifications as requested. The $500,000 award for personal injury due to slander is not for physical injury or sickness and therefore, represents taxable income. The award for psychiatric care will reduce any itemized medical deductions but could be taxable as a reimbursement if V received a tax benefit for them in a prior year. The award for lost wages is considered to be for back pay and thus is included in gross income. (See p. 6-42.) Unfortunately, V no longer has much leeway. After the 1996 legislation, amounts received for nonphysical injuries (except for amounts paid for medical care) are taxable. 6-14 6-15 b. c. 6-16 a. b. 6-6 Chapter 6 Gross Income: Inclusions and Exclusions PROBLEMS
6-17 a. $22,200. Gross income for proprietorships, partnerships, and corporations is total revenues plus net sales less cost of goods sold. (See p. 6-48.) $21,000 $3,000 $1,800 $22,200 b. c. $6,000. Total rents received are included in gross income. Expenses incurred for rental property are deductions allowed to arrive at A.G.I. (See pp. 3-18 and 3-19 and Example 8 in Chapter 4 and p. 4-8.) $15,000. A taxpayer is denied deductions for amounts withheld for social security or federal income taxes. Health insurance premiums are only deductible as itemized deductions. The employer's share of social security taxes is considered nontaxable income to the employee. Z will have taxable dividend income on his joint return of $330. Basis remains unchanged at $6,000. (See pp. 6-4 and 6-5.) Because it is a return of capital, the full $330 is excluded from gross income. Basis is reduced to $5,670 ($6,000 $330) and the basis of each share is $113.40 ($5,670=50). [See Example 1, pp. 6-4 and 6-5, and 301(c)(3) and 316(a).] Assuming A did not have the right to receive cash or other assets in lieu of the stock, she has no taxable income. Her $12,000 basis is allocated among the total 110 shares of common stock for a $109.09 per-share basis ($12,000=110 shares). [See Example 2, p. 6-6, and 305(a) and 307(a).] The stock dividend does not result in any taxable income. The original basis of the common stock is allocated over both the preferred stock and the common stock based on their relative fair market values. The preferred stock will have a total basis of $779.22, or a $77.92 per-share basis. [($1,000 fair market value preferred/the total fair market value $1,000 $14,400) $12,000 basis $779.22 preferred basis.] The common stock will have a total basis of $11,220.78 ($12,000 $779.22) or a $112.21 per-share basis ($11,220.78=100 shares). This is again assuming A did not have the right to receive cash or other assets in lieu of the stock. [See Example 3, p. 6-6, and 305(a) and 305(b)(5).] Distribution Dividend (taxable): Current E&P Accumulated E&P Return of investment (nontaxable) Total 11- b. Sales price Original cost of stock Less return of investment Long-term capital gain $40,000 6-18 a. b. 6-19 a. b. 6-20 a. $10,000 20,000 10,000 $40,000 $ 36,000 $ 25,000 (10,000) (15,000) $ 21,000 11- [See Example 1, pp. 6-4 through 6-5, and 316(a).] Interest: Corporate bonds Bank savings account Personal loan Life insurance Taxable interest 6-21 $1,100 ,200 ,500 2,500* $4,300 11- *The interest portion of the $7,500 received from the insurance company is computed as follows: Solutions to Problem Materials 6-7 Amount received currently Less: return of capital ($50,000=10 years) Taxable interest $ 7,500 (5,000) $ 2,500 11- Interest received from state or municipal bonds, except industrial development or arbitrage bonds, is fully excluded from gross income. [See Example 4, pp. 6-7 and 6-8, and 103(a)(1). Note that interest paid on federal securities such U.S. Treasury Bonds are fully taxable for federal income tax purposes. In addition, special rules apply to Series EE savings bonds issued by the Federal government. (See p. 6-9 and Chapter 5.) 6-22 a. H and W may exclude $1,200 [60% the interest ($4,000 $1,000)=$5,000 $2,000]. The interest exclusion applies only to the extent that the proceeds of the bond redemption are used to pay for qualified education expenses. These include tuition but not room and board. In addition, any qualifying expenses must be reduced by any scholarship received or employer assistance. (See Example 6 and p. 6-9.) It would appear that D should not have withdrawn. A technical reading of the Code implies that the exclusion is only available to the extent the bond proceeds are actually used for education expenses in the year of the redemption. Because no qualified educational expenses were paid, no exclusion is allowed. (See pp. 6-9 through 6-10.) The exclusion would not be available because S is not a dependent at the time the bonds are redeemed. He is not a qualifying child since he fails the age test (not less than 19 or less than 24 and a full-time student). Similarly, he does not qualify as a dependent under the qualifying relative test because his gross income exceeds the amount of personal exemption and he is at least 24 years old. (See p. 6-10.) The exclusion is phased out once a married couple's A.G.I. in the year of the redemption exceeds certain thresholds. For 2011, the phase-out begins at $106,650 and is complete when A.G.I. exceeds $136,650. In effect, the taxpayer loses about 3.33% for each $1,000 over the threshold. Therefore, the exclusion equals $1,680 (i.e. $110,000 $106,650 $3,350/$30,000 11.2% $2,000 $224) ($2,000 $224 $1,776.) (See 135(b)(2) and Form 8815 Example 7 and p. 6-9.) Note that the phaseout percentage is rounded to at least three decimals. No exclusion. The exclusion is available only if the bonds were issued to someone who was 24 years of age at the time they were issued. Note that without this rule, the income limitation could be circumvented by gifting the bonds to a low-income child or gifting cash and having the child purchase the bonds. (See p. 6-10.) Part of the annuity is a nontaxable return of capital, and the remainder is interest income. To calculate the portion that is a return of capital on a lifetime annuity, a multiple corresponding to the annuitant's age is derived from Table V, Reg 1.72-9. (See partial reproduction, p. 6-14.) Since P was 65 when the annuity payments began, his return of capital on the annuity is $2,000, calculated as follows: b. c. d. e. 6-23 a. $40,000 investment $5,000 annual receipt $2,000 return of capital ($5,000 20.0 multiple $100,000 expected return)
The interest on the annuity is the remaining $3,000. [See Example 12 pp. 6-12 through 6-13, and 72(b).] The exclusion ratio as determined at age 65 remains constant and is applied to P's annuity payments as long as he continues to receive them, until payments are made for the expected 20.0 years. Therefore, of the $5,000 P will receive in year five, $2,000 will be a return of the capital and $3,000 will continue to be taxable. [See Example 12, p. 6-13, and 72(b).] P's taxable income from the annuity will be the entire $5,000 received. After 20 years, the entire $40,000 investment will have been recovered ($2,000 20 $40,000). [See Example 12, p. 6-13, and 72(b).] If P lives only 15 years, the total amount he excludes is $30,000 ($2,000 15 $30,000), and the unrecovered amount of $10,000 ($40,000 $30,000) is allowed as a deduction on P's final tax return. [See Example 12, p. 6-13, and 72(b).] b. c. d. 6-8 Chapter 6 Gross Income: Inclusions and Exclusions e. Investments that are not from after-tax funds are ignored in determining P's basis in the investment. Therefore, P's basis is limited to $12,000. $12,000 investment $5,000 annual payment $600 return of capital ($5,000 20.0 multiple)
Thus, P has taxable income of $4,400 ($5,000 $600 $4,400). 6-24 a. The nontaxable portion of each $1,500 monthly payment to A is computed as follows: $39,000 investment $150 return of capital 260 monthly payments Therefore, of the first 260 payments A receives, $1,350 ($1,500 $150) will be included in gross income each month. After 260 annuity payments have been made, any additional payments will be fully taxable. This is true because A will have recovered his investment of $39,000 in full (i.e., 260 months $150 $39,000). (See Example 13, pp. 6-13 and 6-14.)
None of the $20,000 distribution is included in either Z's or the parent's gross income. (See Example 15 and pp. 6-15 and 6-16.) The earnings portion of the "nonqualified" withdrawal is subject to income tax and an additional 10 percent penalty tax. Thus, Z's parents must include $20,000 in their gross income (i.e., total proceeds received of $80,000 less total contributions of $60,000). (See p. 6-16.) Without an election, the taxable gift is $32,000 ($45,000 $13,000 annual exclusion in 2011). (See p. 6-16.) If the election is made, V is treated as making $9,000 in gifts ($45,000=5 $9,000) to W in 20112015. Assuming no other gifts are made by V to W in these five years, the $9,000 gifts are offset by the $13,000 annual exclusion and consequently no gift tax will be paid in 2011 through 2015. (See Example 16 and p. 6-17.) In 2011, 2012, 2013 and the year of death, V may exclude $9,000 annually or a total of $39,000. The remaining $9,000 will be included in V's gross estate. (See p. 6-17.) b. 6-25 a. b. 6-26 a. b. c. 6-27 As a general rule, life insurance proceeds received by a beneficiary on account of the insured's death are excluded. If the beneficiary takes the life insurance proceeds in installments, the portion representing the life insurance is nontaxable but any excess (e.g., investment earnings while the proceeds are left with the insurance company) are taxable. Each installment represents a prorata portion of the insurance. In this case, there are five installments of $5,200 so each installment represents $4,000 ($20,000 proceeds/5 installments) of nontaxable life insurance and the remaining $1,200 is taxable. Alternatively, the exclusion can be computed as follows: $20,000 investment $5,200 $4,000 return of capital $5,200 5 years (See Example 40 and p. 6-41.) Solutions to Problem Materials 6-9 6-28 As a general rule, social security benefits are nontaxable. However, if the taxpayer's modified A.G.I. (including half of the social security benefits received) exceeds certain thresholds, up to 85 percent of the benefits could be taxable. a. Taxable interest Dividend income A.G.I. Taxable social security benefits: A.G.I. Plus: Tax-exempt interest of social security benefits Modified AGI 11X's taxable social security is $3,600 computed as follows: Step 1 Amount Lesser of 50% social security of $7,200 Or 50% ($33,600 $25,000 $8,600) Step 1 amount Step 2 Amount Lesser of Step 1 amount ($3,600) not to exceed $4,500 85% ($33,600 $34,000 $0) Or $12,000 10,000 $22,000 $22,000 8,000 3,600 $33,600 $3,600 $4,300 $3,600 $3,600 ,000 $3,600 $6,120 $3,600 85% social security of $7,200 Step 2 amount and taxable social security benefits b. Modified AGI would be reduced by $2,000 to $31,600. Taxable social security benefits are computed as follows: Step 1 Amount Lesser of 50% social security of $7,200 Or 50% ($31,600 $25,000 $6,600) Step 1 amount and taxable social security benefits $3,600 $3,300 $3,300 (See Examples 19 and 20, pp. 6-20 through 6-22, and 86.) 6-29 Total insurance coverage Less: "tax-free" insurance Insurance coverage subject to tax Cost of coverage per $1,000 of protection for one-month period Cost per year per $1,000 coverage includible in E's gross income ($0.43 12 100) 11-(See Example 21 and pp. 6-23 and 6-24.) $150,000 (50,000) $100,000 $0.43 $516 6-10 Chapter 6 Gross Income: Inclusions and Exclusions 6-30 a. 1. 2. b. c. 1. 2. 1. 2. d. 1. 2. 1. 2. e. $100 ($200 50%). Entertainment expenses are deductible business expenses subject to a 50 percent limitation. $200. The reimbursement represents taxable income, but may be offset by an employee's business expense. (See p. 6-19.) $300. The bonus is deductible as employee compensation. $300. Bonuses are included in gross income. (See p. 6-17.) $18 each. Amounts transferred from an employer to an employee in the form of cash or other property are treated as compensation (never treated as a gift). $18 each. Treated as compensation and therefore not excludable as a gift. However, the value of the watch may be a nontaxable benefit if considered a de minimis fringe benefit or an employee achievement award. (See p. 6-19 and 6-32.) Parking provided for employees is deductible by the employer. $270 per month. ($500 $230 exclusion in 2011) Free parking (up to $230 per month for 2011) is not included in income. (See p. 6-32.) $150. Supper money is a deductible employee-related expense. (See pp. 6-28 through 6-29 and 6-34.) $0. It is nontaxable de minimis fringe benefit to the employee. (See Example 27 and pp. 6-27 and 6-32.) 6-31 a. b. 1. $700. Life insurance premiums are a deductible expense. 2. $55.20. Premiums paid for group term life insurance are nontaxable only for the first $50,000 of protection. Income for any excess coverage is determined by the Regulations rather than actual premiums paid. At age 52, the $20,000 additional coverage is valued at $55.20 ($2.76 annual income from Exhibit 6-6 on p. 6-23 20). [See Example 21, p. 6-23, and 79(a).] 1. $0. Employer reported sales net of discount, so no further deduction is allowed. (See p. 6-31.) 2. $0. Purchase discounts do not represent taxable income unless they discriminate in favor of highly compensated employees or when they exceed the normal profit. (See p. 6-31.) $0. F does not have any taxable income in the current year. Since F does not itemize medical expenses, he did not receive any prior year tax benefit on $220 reimbursement. The $650 also is not taxable but would serve to reduce any current-year medical deduction. The $400 premium is nontaxable income when provided by the employer. $220. Because F received a tax benefit from last year's medical expense, he must include the $220 in this year's gross income. The $650 reimbursement reduces the current year's itemized medical deduction to $250 ($900 $650). The premium remains nontaxable. [See Example 22; p. 6-24, and 105(b), 106, 111, and 213.] 6-32 a. b. 6-33 None of the $2,500 reimbursement is included in K's gross income in 2011. K's itemized deductions in 2010 would be computed as follows: State income taxes paid Property taxes on residence Charitable contributions Interest paid on residence Medical expenses [$2,500 (7.5% $30,000)] Total $2,000 ,600 ,400 1,200 ,250 $4,450 Because the standard deduction for filing as head of household was $8,400 in 2010, K would have elected to take the standard deduction and not itemized her deductions. Consequently, no tax benefit was obtained from the medical expenses incurred in 2010. (See Example 22 and p. 6-24.) Solutions to Problem Materials 6-11 6-34 a. Total insurance coverage Less: "Tax-free" insurance Insurance coverage subject to tax Cost of coverage per $1,000 of protection for one-month period for 46-year-old person Cost per year per $1,000 coverage includible in Professor P's gross income (0.15 12 25) Cost to Professor P, after tax ($45.00 31%) $ 75,000 (50,000) $ 25,000 0.15 $ 45.00 $ 13.95 11- [See Example 21, pp. 6-23 and 6-24, and Reg. 1.79-3(d)(2).] b. If the university paid the premium cost directly to Professor P as additional compensation, he would have additional income taxes of $93 ($300 31%). Furthermore, his after-tax cash flow of $207 ($300 $93) would likely be insufficient to purchase $75,000 of term insurance. No. Employees of educational institutions do not have taxable income for qualified tuition reduction provided by their employer below the graduate level. [See p. 6-33 and 117(d).] Assuming tuition remains constant (which is not realistic), Professor P will save a minimum of $120,000 in tuition payments for the triplets ($30,000 4 years). Clearly, this nontaxable fringe benefit is very attractive for employees of educational institutions. Professor P would have additional compensation of $30,000. This would result in at least additional income taxes of $9,300 ($30,000 31%). Consequently, he might not be able to send his triplets to a private university with the amount that remains after taxes (i.e., $30,000 $9,300 $20,700). $2,300. Their gross income consists of $16,500 salary and $4,500 unemployment compensation. [See p. 6-22 and Code 85(a).] The disability income is nontaxable because Mrs. B paid the insurance premiums. [See Example 25, p. 6-26, and 104(a)(3).] Social security income is nontaxable for this family. (See p. 6-21.) Mr. and Mrs. B's taxable income for 2011 is calculated as follows: Gross income Less: Deduction for A.G.I. A.G.I. Less: Standard deduction (2011) Personal exemptions (2011) (2 $3,700) Taxable income b. $ 21,000 ,000 $ 21,000 $11,600 7,400 (19,000) $ 2,000 c. d. e. 6-35 a. $8,500. Because Mrs. B's employer paid the disability insurance premiums, the income received is taxable. Thus, $16,500 $6,200 $4,500 $27,200. (See p. 6-23.) Mr. and Mrs. B's taxable income for 2011 is calculated as follows: Gross income Less: Deduction for A.G.I. A.G.I. Less: Standard deduction (2011) Personal exemptions (2011) (2 $3,700) Taxable income $ 27,200 ,000 $ 27,200 $11,600 7,400 (19,000) $ 8,200 6-36 a. The $5,000 awarded to D to penalize the XYZ Tool and Die Shop for its wrongdoing is taxable. Punitive damages are taxable even if they are related to physical injury or sickness. (See p. 6-53.) The $50,000 received for the lost finger is nontaxable because it represents a payment for the permanent loss or use of a function or member of the body (i.e., a physical injury). Incidentally, if D used the present value of future lost wages as a measure of the value of his index finger, the exclusion pertaining to personal injuries would still apply. This is true because lost wages are simply being used as a means to measure the value of a lost body part. (See Example 57 and p. 6-52.) 6-12 Chapter 6 Gross Income: Inclusions and Exclusions b. Because D did not receive a tax benefit from the medical expenses he incurred in 2011, the $8,000 is likewise nontaxable. (See Example 22 and p. 6-24.) Since D paid the premium on the disability insurance, the $3,000 is nontaxable. Note that payments made pursuant to accident or disability insurance policy for permanent loss or use of a function or member of the body or for permanent disfigurement of the employee, employee's spouse or dependent, are nontaxable (See Example 25 and pp. 6-25 and 6-26.) 6-37 Under 119, the value of meals and lodging provided by an employer to an employee and the employee's spouse and dependents is excluded from income if provided for the employer's convenience on the employer's business premises; and in the case of lodging, the employee is required to occupy the quarters in order to perform employment duties. a. 1. Meals and lodging provided by the corporation to Mr. and Mrs. G on the business premises and for the employer's convenience are deductible business expenses and nontaxable income to Mr. and Mrs. G. Their housing qualifies as being on the business premises. Being on call 24 hours a day substantiates the employer's convenience of such an arrangement and requirement for lodging. (See pp. 6-26 through 6-27 and 119.) However, see Code 274(n), which limits the deduction to 50 percent. The income exclusion and business deduction are not available to owners who do not qualify as employees. The cost of meals and lodging provided to Mr. and Mrs. G as partners is nondeductible business expenses regardless of whether paid by them or the partnership. (However, the chapter notes a disagreement that exists in the courts.) (See pp. 6-26 through 6-27.) 2. b. c. No. If the business is a corporation, the meals and lodging qualify for the 119 exclusion from gross income. If the business is a partnership, the cost of meals and lodging flows through the partnership to Mr. and Mrs. G as personal withdrawals of partnership assets. These withdrawals reduce their basis in the partnership but are not taxable income unless the costs exceed their basis in the partnership. 1. If Mr. and Mrs. G were charged an unvarying amount by the corporate employer irrespective of whether they accepted the meals, the amount paid would be considered nontaxable income to the employer and a reduction of their taxable compensation. But, if they paid directly for food and lodging received, there is no exclusion nor deduction. (See p. 6-27.) 2. The amount paid as partners would remain nondeductible business expenses. 6-38 Employees generally are allowed an exclusion of $13,170 (2011) per child for qualified adoption expenses paid or incurred by an employer. The exclusion begins to be phased out as modified A.G.I. exceeds $185,210 and is complete at $225,210. A nonrefundable credit is also available discussed in Chapter 13. a. Ray's salary Lori's salary Dividend income Adjusted gross income before considering adoption assistance Includible portion of adoption assistance Adjusted gross income $140,000 27,500 2,500 $170,000 0* $ 170,000 11*Adoption assistance is nontaxable if modified A.G.I. does not exceed $185,210 (2011). 11b. Interest on state and local bonds represents tax-exempt income. (See p. 6-28.) Adjusted gross income Less: Standard deduction Personal and dependency exemptions (3 $3,700) Taxable income $170,000 $11,600 11,100 (22,700) $147,300 116-39 a. Because the monthly value of the transit pass, $95, does not exceed the statutory limit of $230 per month (2011) nothing is included in A's gross income each month. (See Example 30 and p. 6-32.) Solutions to Problem Materials 6-13 b. c. d. Because the value of the parking exceeds the statutory limit by $70 ($300 $230 in 2011), $70 must be included in B's gross income each month. (See Example 31, p. 6-32 and IRS Notice 94-3.) Because the amount paid ($40) by C plus the amount excludable ($230 in 2011) for qualified parking exceeds the fair market value of the benefit, no amount is includable in C's gross income (See Example 31, p. 6-32 and IRS Notice 94-3.) None of the $15 per month is taxable. Taxpayers are entitled to exclude up to $20 per month of "qualified bicycle reimbursements" (reimbursements for costs relating to using a bicycle for commuting such as the costs of the bicycle, repairs, and storage). This is part of the qualified transportation fringe contained in Section 132. (See p. 6-32.) As provided on page 17 of IRS Notice 94-3, "Generally, the value of parking provided by an employer to an employee is based on the cost (including taxes or other added fees) that an individual would incur in an arm's-length transaction to obtain parking at the same site." The Notice further states that "If that cost is not ascertainable, then the value of parking is based on the cost that an individual would incur in an arm's-length transaction for a space in the same lot or a comparable lot in the same general location under the same or similar circumstances." (See Exhibit 6-7 and p. 6-34 and IRS Notice 94-3.) The parking provided by Employer G has a fair market value of $0 because an individual other than an employee ordinarily would not pay to park there. (See Exhibit 6-7 on p. 6-30 and p. 17 of IRS Notice 94-3, 1994-3 IRB.) 6-40 a. b. 6-41 $650. All military compensation is taxable unless specifically excluded. Allowances for subsistence, uniforms, and quarters are nontaxable. On-the-job training is excluded whether provided by the military or other employer. Moving expense reimbursement is nontaxable for the military although taxable for civilians. (See p. 6-34.) K's taxable income for 2011 is calculated as follows: Gross income Less: Deduction for A.G.I. A.G.I. Less: Standard deduction in 2011 Personal exemption in 2011 Taxable income $50,000 ,000 $50,000 $5,800 3,700 (9,500) $40,500 6-42 a. b. c. $6,000. The value of property received by inheritance, $87,000, is excluded from gross income. However, the taxpayer must include any income derived from such property. The rental income of $6,000 would be included in gross income and would be reduced by the expenses of $5,200 for a taxable income of $800. [See p. 6-35, 102(a), and Reg. 1.102-1.] 0. Amounts received as inheritance are excluded from gross income. However, an existence of an enforceable contract pledging the amount as inheritance for services performed until the employer's death could result in the $50,000 being taxable. [See p. 6-35 and 102(a).] $5,000. The existence of the loan places the taxpayer and his friend in a creditor/debtor relationship. In such instances, the beneficiary may exclude only insurance proceeds equal to the amount at risk. This prevents the creditor from excluding unreported interest due on the debt from taxable interest income. (See and p. 6-42.) 0. This is not a clear-cut situation. The existence of a gift is determined by the intent of the donor, who must make the transfer with detached or disinterested generosity. It must not be a reward for past services or made in expectation of future services. Although the Uncle's implication that further stocks would be transferred if she continued managing his investment portfolio indicates compensation For services, such management activities are not a requirement. [See p. 6-35 and 102(a).] 0. The taxpayer received the land as a bona fide gift and its value is nontaxable income. Its basis is carried over from the donor, as explained in Chapter 14. (See p. 6-35.) $1,200. To be nontaxable, employer awards to employees for length of service or safety achievements must be made with tangible personal property. No exclusion is available for cash payments and therefore the $1,200 is included in the taxpayer's gross income. Note that a gift certificate is permissible but only if it allows the employee to acquire tangible personal property. [See p. 6-19 and 274(j).] 6-43 a. b. c. 6-14 Chapter 6 Gross Income: Inclusions and Exclusions 6-44 a. b. c. $17,200 ($16,000 $1,200). Prizes and awards are fully taxable. Note also that the amounts do not qualify as gifts when the donor deducts their costs as business expenses. Compensation is deductible by an employer, whereas a gift is not. The $4,000 loss on the sale of the car is a nondeductible personal loss. There is a possible argument that an amount less than $17,200 is taxable based on evidence, for example, that he could have purchased the items for less. (See p. 6-42, and 74.) $1,000. Prizes and awards are fully taxable. The sole exception is for certain situations where the taxpayer immediately transfers the award to charity before receiving any benefit. The taxpayer satisfies only three of the four conditions outlined in 74(b). To be nontaxable, the taxpayer must also designate the high school to give the award to a governmental unit or tax-exempt organization. [See pp. 6-42 and 6-43 and 74(b).] 0. The watch is nontaxable to T. The cost of the watch did not exceed $400 and was given in recognition of T's length of service to M, Inc. [See Example 18, pp. 6-19 and 6-20, and 274(j).] H has a deduction of $400 per month in arriving at his A.G.I. and W has taxable income of $400 per month. Amounts that are required to be paid through a written agreement that does not specify a fixed dollar amount payable for the support of minor children are considered to be alimony. [See Example 33, p. 6-35, and 71 and 215(a).] Agreements may be retroactively amended if convincing evidence can be presented that the amendment corrects a mistake, inadvertence, or clerical error. The change would force H to amend prior years' returns, increasing his A.G.I. by $300 per month. Child support is a nondeductible personal expense. W would amend prior years' returns by reducing the amount included in gross income to $100 per month. In current and future years, H would have a deduction for A.G.I., and W would have income of $100 per month. (See p. 6-35.) Once child support is fixed in amount, no payments are considered to be alimony until all past and current child support payments are made. H's payment of $4,000 in the first year is allocated as $3,600 for child support and $400 as alimony. In the second year, H has a deduction for alimony of $2,000 and nondeductible expenses for child support of $3,600. (See Example 39, and pp. 6-42 and 6-43.) Payments need not be made directly to the ex-spouse to qualify as alimony. Payments of cash by the ex-husband to the ex-wife's creditors in accordance with the terms of the divorce or separation instrument qualify. If the car loan represents W's legal obligation, the payment is alimony and H will have a deduction for A.G.I. in the first year of $1,128. The more likely case is that the loan remains the legal obligation of H even though W received the car. In such a situation, the payments represent assets transferred as a part of the property settlement and not alimony. H has no itemized deduction for the interest payment (i.e., considered personal interest), and W has no taxable income regarding the car. (See pp. 6-36 through 6-37.) Expenses paid by H for a home he owns that W and the children occupy are not treated as alimony. The amounts are not her legal obligation. H consequently benefits only by itemizing deductions for the $800 property taxes. The home is neither his first nor his second residence, and consequently the interest is considered personal--see Chapter 11. The loan principal, insurance, and repairs are nondeductible personal expenses. (See pp. 6-36 through 6-37.) Payments of a fixed sum over a period of time qualify as periodic under the alimony rules. The annual amount taxable in A.G.I. by W and deductible for A.G.I. by H is $2,500 the first year and $3,600 the second year. (See Example 34 and pp. 6-36 and 6-37.) Because the additional amount for alimony is made voluntarily, it is neither deductible by H nor taxable by W. It must be required under a decree or written instrument to qualify as alimony. H would benefit by amending the agreement to include the additional $150 per month as alimony for current and future years. Retroactive amendment here is prohibited because there was no error in the original agreement. (See pp. 6-36 and 6-37.) 6-45 a. b. c. d. e. f. g. 6-46 Alimony must be recaptured in the third year if, during the three-year period, alimony payments decrease by more than $15,000. Because the payments decreased by more than $15,000, alimony payments must be recaptured in the third year. The recapture for the second year is $0 ($26,000 paid in the second year $18,000 paid in the third year $15,000). The recapture for the first year is $19,000 [$56,000 paid in the first year ($26,000 paid in the second year $0 excess from the first calculation $26,000 $18,000 paid in the third year $44,000=2 $22,000 average for the two years) $15,000]. W's deduction for A. G.I. and H's taxable income are $56,000 in the first year and $26,000 in the second year. In the third year, the recaptures exceed payments; thus, W's taxable income and H's deduction for A.G.I. is $1,000 ($19,000 $18,000). (See Example 37 and pp. 6-37 through 6-39.) Solutions to Problem Materials 6-15 6-47 In property transfers as a result of divorce, the wife is deemed to be exchanging her dower rights for property of equal value. Consequently, she has no gain or loss on the exchange, and H's basis in the property received by W transfers with the property. Thus, her basis in the home is $35,000, and her basis in the investments is $3,000. H also has no gain or loss on the transfer. (See Example 33 and pp. 6-35 and 36.) a. Transfers of property between spouses incident to a divorce are nontaxable. H's basis and holding period transfer with the property to W. Therefore, W will report a LTCG as follows: Stocks $500,000 (300,000) $200,000 Land $550,000 (200,000) $350,000 6-48 Selling price Less: basis LTCG b. As noted above, transfers of property (including life insurance) between spouses incident to a divorce are nontaxable. Furthermore, the proceeds are also nontaxable because they were paid due to the death of the former husband. Ordinarily, the primary purpose of life insurance is to provide protection for beneficiaries who are financially dependent on the insured. Since the policy owner has the right to designate the beneficiaries, the IRS and the courts have held that the owner must possess an insurable interest in the insured. In addition to the insured, a spouse, dependents, business partners, and in some instances creditors and employers are considered to possess the requisite insurable interest. For the proceeds to be excluded from gross income, it is necessary only that the insurable interest exist when the policy is first acquired. A later change in relationship, such as divorce and remarriage, does not nullify the exclusion. [See Example 33, pp. 6-35 and 6-40, and 1041(b)(2).] 6-49 Viatical settlements or accelerated death benefits (i.e., surrender of the policy to the insurer for a lump sum or sale to a third party) generally may be excluded if the individual is chronically or terminally ill. While the exclusion for terminally ill individuals is unlimited, the exclusion for a chronically ill individual (who is not also terminally ill) is restricted to the amount of long-term care services actually incurred. An individual is considered terminally ill if he or she has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death in 24 months or less. A chronically-ill individual is generally a person who is unable to perform at least two activities of daily living (e.g., eating, toileting, transferring, bathing, dressing, and continence) for a period of at least 90 days due to a loss of functional capacity. (See p. 6-41.) a. A's gain on the sale of the policy is determined as follows: Sales proceed Less: premiums paid Gain realized $150,000 (15,000) $135,000 b. c. A is not required to include this gain in her gross income. (See Example 41 and p. 6-44.) The $135,000 of gain continues to be tax free even if A lives more than 24 months from the date of certification. (See p. 6-41.) When VSP collects the life insurance proceeds of $200,000, it must include a gain of $40,000 in its gross income computed as follows: Insurance proceeds Less: cost of policy additional premiums Gain recognized $200,000 (150,000) (10,000) $40,000 (See Example 42 and p. 6-42.) 6-16 Chapter 6 Gross Income: Inclusions and Exclusions 6-50 a. b. c. d. e. f. Nontaxable. All of the conditions specified under 132(b) pertaining to no-additional-cost services are satisfied. (See p. 6-31.) Taxable. The exclusion is limited to services sold in the normal course of business in which the employee works. C works in the airline business not the hotel business. Note: This answer assumes that North Central Airways does not relax the line of business limitation by paying a non-deductible 30 percent excise tax. [See p. 6-31 and 132(b).] Nontaxable. The exclusion is extended to benefits provided under a written reciprocal agreement by another employer that is in the same line of business. [See p. 6-31 and 132(i).] Nontaxable. This represents a qualified discount under 132(c). The discount of $50 that M received does not exceed J-Mart's normal gross profit of $60 ($300 20%). (See Example 29 and p. 6-31.) Nontaxable. This is an example of a working condition fringe benefit provided by 132(d). F would have deducted the $375 as an employee business expense had he paid for the subscription fees. (See p. 6-29.) Taxable. The value of parking provided on or near the business premises is nontaxable as a qualified transportation fringe benefit up to $230 per month for 2011. [See p. 6-34 and 132(f).] The taxable portion equals $70. Prizes and awards are generally taxable unless the taxpayer elects to give the award to a charity. Here, the amount taxable is $1,100, assuming the taxpayer does not designate the payor to give the award to a governmental unit or tax-exempt organization. She does meet the other requirements [i.e., she received the award and prize by distinguishing herself in charitable work, she was selected without any direct action on her part (nominated by the nurses), and is not required to perform any substantial future services]. [See p. 6-42 and 74(a).] $15,000 is fully taxable. This is not a scholarship. To qualify as a scholarship the individual must be a candidate for a degree and amounts are used for tuition and related expenses. Thus, the taxpayer will be required to include in income the $15,000 received, less any payments required to be spent for tuition, fees, books, supplies, and equipment at a qualified educational organization. [See Example 45 and pp. 6-42 and 6-44 and 117(a).] $165. The value of awards made for sporting achievements is taxable income. There is a possible argument that the value of the trophy is less than $65. (See p. 6-42.) $0 for the taxpayer who bought the ticket; however, $600 for the son. Since the gift was made before the drawing, the $600 (or a lower establishable value), less the cost of the tickets, is included in the son's gross income. (See p. 6-35.) $20,000. Prior to the TRA of 1986, an exclusion was available for non-degree candidates. However, effective in 1987, the entire amount is included in income. (See pp. 6-43 and 6-44 and 117.) $3,000. The recipient is expected to perform services as an intern for the CPA firm. This does not constitute a scholarship, but payment for services rendered. (See pp. 6-43 and 6-44 and 117.) $15,000. Amounts stipulated as compensation for an agreement not to compete are taxable as ordinary income. The $5,000 for goodwill is capital gain. (See p. 6-48.) $10,000 $5,000 $15,000 6-51 a. b. c. d. e. f. 6-52 a. b. c. d. $65,000. Insurance proceeds that provide for the loss of profits or for reimbursement of overhead expensessometimes referred to as business interruption insuranceare included in gross income. [See Example 51 and Rev. Rul. 55-264, Example 51 and pp. 6-48 and 6-50 and Reg. 1.1033(a)-2(c)(8).] $12,000 in year one; $12,000 in year two; and $18,000 in year three. Leasehold improvements are not taxable income to the lessor unless they are made in lieu of rent payments. This is true at either the time the improvements are made or when the lease is terminated even though the property's value is increased. Lease cancellation payments received by the lessor are viewed as a substitute for rent and included in gross income. (See Examples 53, 54, and 55, pp. 6-49 and 6-50 and, 109 and 1241.) $100,000. Compensatory awards for patent infringement are considered a reimbursement for loss of profits and are included in gross income. They may be reduced by any offsetting expenses incurred to obtain the awards. (See p. 6-49, and 186.) Solutions to Problem Materials 6-17 6-53 Cancellation of indebtedness normally results in taxable income. However, there are several exceptions such as bankruptcy or insolvency. a. As shown below, DEF is insolvent both before and after the debt cancellation. Before $750,000 (1,000,000) $(250,000) After $750,000 (820,000) $(70,000) Total assets Total liabilities Insolvent Consequently, DEF does not recognize taxable income currently. However, the $180,000 reduction in debt reduces DEF's tax attributes dollar for dollar as follows: Balance before Reduction $100,000 25,000 300,000 Balance after Reduction $ ,000 ,000 245,000 NOL carryover Capital loss carryover Basis of depreciable assets Reduction $100,000 25,000 55,000 b. c. d. The net effect of the above is simply to postpone (not to exclude) the recognition of income. Note: Tax credits are reduced in a 3 to 1 ratio. That is, for every dollar of income excluded due to forgiveness of indebtedness, general business credits and foreign tax credit carryovers are reduced 331=3 cents. (See Example 46 and pp. 6-44 through 6-45.) Yes. If DEF makes an election under 108(b)(5), the basis of its depreciable assets would be reduced to $120,000 (i.e., $300,000 $180,000). Such an election would allow DEF to retain its NOL and capital loss carryovers to offset future income, assuming the corporation becomes profitable in the future, thereby eliminating (or reducing) any tax liability in the first year of turnaround. (See pp. 6-44 through 6-45.) No. In this scenario, DEF must report the $180,000 reduction in debt as taxable income because DEF was neither insolvent nor bankrupt at the time the suppliers cancelled the debt. The corporation was therefore able to increase its net worth by $180,000. (See pp. 6-44 through 6-45 and 108.) 6-54 Although J and his wife have $10,000 of cancellation of indebtedness income ($100,000 mortgage reduced by $10,000 to $90,000), such income can be excluded since it relates to a principal residence. J's basis in the residence must be reduced by the amount of the exclusion or $10,000 to $100,000 ($110,000 $10,000 reduction). Note that the taxpayer need not be bankrupt or insolvent to take advantage of this rule. The exclusion is claimed on Form 982. (See Example 6-49 and pp. 6-46 and 6-47.) a. b. $0. Vehicle owners operating car pools for fellow commuters may exclude all the revenues received. (See Rev. Rul. 55-555 and p. 6-51.) $840. Cash or other assets found by a taxpayer are taxable income. ($850 received $10 expense to locate previous owner $840 gain realized on asset discovery.) Although the appraised value was $1,200, the sale price is an indication of the value to her. (See Rev. Rul. 53-61 at footnote 132 and p. 6-51.) $0. Government transfer payments that are classified as public assistance or paid from a general welfare fund are nontaxable (food stamps and welfare payments). Since taxpayer received worker's compensation because of an injury on the job, it is nontaxable income. (See Rev. Rul. at 71-425 1t footnote 112 and p. 6-47.) $33,500. Awards for injury due to slander (i.e., non-physical) and damages received that are specified for the loss of income are taxable income. The $200 award for reimbursement of medical expenses (to the extent taxpayer did not receive prior tax benefits from their deduction) is nontaxable. (See p. 6-53.) The $15,000 allocable to a covenant not to compete represents ordinary income. The $20,000 assigned to goodwill is taxable as a capital gain. (See Example 50 and p. 6-48.) Doug will treat the $800 as a substitute for rent (i.e., ordinary income). (See Example 53 and p. 6-50). 6-55 c. d. 6-56 a. b. 6-18 Chapter 6 Gross Income: Inclusions and Exclusions c. d. Jean will treat the $900 as proceeds from the sale of her lease agreement with Mary Ann. Because a lease agreement on a personal residence represents a capital asset, Jean is entitled to capital gain treatment. (See Example 54 and p. 6-50). Because John received a tax benefit by deducting the state income taxes withheld by his employer on his 2010 Federal income tax return of only $100 ($700 state income tax $600 state sales tax that he could have otherwise deducted), he must include the $100 refund in gross income on his 2011 Federal income tax return. (See Example 56 and pp. 6-51 and 6-52.) True. (See Example 15, p. 6-16 and 529.) True. Employees who receive reimbursements for their child care expenses or whose employer provides child care in kind (e.g., a daycare facility) may exclude up to $5,000 annually. (See Example 28, p. 6-28 and 129.) True. (See p. 6-28 and 127.) False. Section 127 provides an annual exclusion of up to $5,250 for employer-provided educational assistance (i.e., tuition, fees, books, supplies and equipment). The exclusion applies to reimbursements or direct payment of expenses related to both undergraduate and graduate level courses. (See p. 6-28 and 132(a)(7).) 6-57 a. b. c. d. 6-58 Part I: 2010 Joint Return Income: H's salary at the bank W's salary as a nurse Net profit from jewelry store $150,000 50,000 75,000 $275,000 Other income: Dividend from ABC Corporation Interest on corporate bonds W's check for outstanding service (1) Group-term life insurance (2) Land rent (3) Gain on sale of DEF stock (4) Adjusted gross income Less: Itemized deductions Interest on home mortgage Property taxes Charitable contributions Total itemized deductions Personal exemptions (4 $3,650 in 2010) Taxable income Computation of tax liability (2010 married filing jointly rates) Tax on ordinary income ($259,048 $6,200 $252,848) Tax on $209,250 Plus 33% on excess of $43,598 Tax on LTCG (15% $3,200) Tax on dividend (15% $3,000) Tax before credits Less: Federal income tax withheld ($11,000 $30,000) Estimated taxes Federal income tax refund 3,000 7,000 ,400 ,048 13,000 3,200 $301,648 $18,000 4,000 6,000 $28,000 (28,000) (14,600) $259,048 $46,834 14,387 $ 61,221 ,,480 ,,450 $ 62,151 (41,000) (35,000) $ 13,849 Solutions to Problem Materials 6-19 Notes concerning taxable items: 1. Although the money was received as a length-of-service award, it is taxable to H because only awards of tangible personal property (i.e., not money) qualify as such. (See p. 6-19.) 2. H's taxable income is $48, computed as follows: Total insurance coverage $90,000 Less "tax-free" insurance (50,000) Insurance coverage subject to tax $40,000 Cost of coverage per $1,000 of protection for one-month period Cost per year per $1,000 coverage includible in H's gross income (0.10 40 12) (See Exhibit 6-6, Example 21, and pp. 6-23 and 6-24.) 3. The value of property received as an inheritance is nontaxable. However, this exclusion does not extend to the $13,000 received from rental of land to the neighboring farmer. (See p. 6-35.) 4. H has an LTCG of $3,200, calculated as follows: Sales proceeds (50 shares $100 per share) Less: basis LTCG (See pp. 3-28 through 3-33.) $5,000 (1,800) $3,200 0000.10 $,00048 Additional comments concerning nontaxable items: The $750 in interest on the State of Michigan bonds is nontaxable. (See Example 4 and p. 6-7.) This distribution will be treated as a nontaxable stock dividend (i.e., common stock distributed to common shareholders with no option to receive cash or other assets in lieu of the XYZ stock). H and W's basis of $15,000 is allocated among the 10,000 shares (9,000 original shares plus 1,000 new shares) of common stock, or a basis of $1.50 per share ($15,000 10,000 shares). (See Example 2 and p. 6-6.) The meals eaten by W were consumed on the hospital's premises and were provided for the hospital's convenience. Consequently, the value of the lunches is nontaxable. (See pp. 6-26 and 6-27.) Assuming these improvements were not made in lieu of rent payments, they are not taxable to W. (See p. 6-50.) Dividends from mutual life insurance companies are treated as a nontaxable return of premiums paid on the policy. (See p. 6-5.) Note: All wages and self-employment income are subject to the Medicare Hospital Insurance tax. However, to simplify calculations, the Medicare tax payable on the net profit from the jewelry store was ignored. Part II: Explanation of Each Tax Strategy 1. The $9,000 in wages paid to M and N would be deductible in computing the net profit of the jewelry store. As a result, this strategy will be effective in shifting $9,000 of income from H and W to their children. Note: The income tax savings would be partially reduced by the additional FICA tax that would be due. 2. The purchase of the Series EE savings bonds with the proceeds received from the sale of the corporate bonds will be an effective means of shifting income from the present to future years when the bonds are redeemed. Consequently, H and W's taxable income for 2011 will be reduced by $7,000. When H and W redeem the Series EE savings bonds to pay for their children's qualified educational expenses, the interest income will likely be subject to tax because of their high adjusted gross income. 6-20 Chapter 6 Gross Income: Inclusions and Exclusions 3. 4. Gifting the ABC, Inc., stock to the children represents an effective way of shifting $3,000 of income from H and W to M and N. The "kiddie tax" will be avoided because each child has unearned income of less than $1,900 in 2011. Although the FMV of the ABC stock is $40,000 at the date of the gift, H and W are each allowed a $13,000 gift tax exclusion (i.e., $26,000 per child) and consequently no gift tax will be due. This strategy will be ineffective in shifting income from the parents to the children. Under the assignment of income doctrine, income from property is included in the gross income of the taxpayer who owns the property. Because H owns the land, the $13,000 in rent must be included in his gross income. If, however, the farmer paid the $13,000 in rent directly to M and N, H would be deemed to have made a gift to his children. Assuming H and W implement the first three strategies discussed above, their tax liability for 2011 and the tax savings resulting from their tax planning are shown below.
Income: H's salary at the bank W's salary as a nurse Net profit from jewelry store ($75,000 $9,000 wages) Other income: W's check for outstanding service Group-term life insurance Land rent Gain on sale of DEF stock AGI Less: Itemized deductions Interest on home mortgage Property taxes Charitable contributions $150,000 50,000 66,000 $266,000 ,400 ,048 13,000 3,200 $282,648 $18,000 4,000 6,000 $28,000 (28,000) (14,600) $240,048 Personal exemption (4 $3,650 in 2010) Taxable income Computation of tax liability (using 2010 joint rate schedule): Tax on ordinary income ($240,048 $3,200 $236,848): Tax on $209,250 Plus 33% on excess of $27,598 Tax on LTCG (15% $3,200) Total tax on a joint return Tax on each child's income: (2) Taxable income ($4,500 $4,800 0) Tax on $1,500 @ 0% $0 0 Total tax for the whole family Income tax savings resulting from tax planning ($62,151 $56,421) Notes: 1. Standard deduction equal to the lesser of: a. $5,700 in 2010 or b. Earned income of $4,500 $300 $4,800 $46,834 9,107 $ 55,941 ,480 $ 56,421 ,000 $ 56,421 $ 5,730 Solutions to Problem Materials 6-21 6-59 Part I: 2010 Joint Return A's Salary STCG from sale of land ($200,000 $50,000) Interest income from bond redemption Interest income on savings account Group term life insurance premium $150,000 50,000) $1:80 $1000 Adjusted gross income Less: Itemized deductions Exemption deduction ($3,650 in 2010 4) Taxable Income Federal income tax for 2010 married filing jointly Tax on $373,650 Tax on excess ($475,580 $373,650 $101,930) 35% Less: Taxes withheld by employer Estimated Taxes Tax due Notes: $ 400,000 150,000 16,000 2,000 ,0000 180 $ 568,180 78,000 (14,600) $475,580 $ 101,086 35,676 (100,000) (40,000) $ 3,238 The stock dividend is common stock distributed to common shareholders and is therefore nontaxable. A and B's basis of $22,000 is allocated among the 1,100 shares of GHI, Inc. common for a $20 per share basis. (See Example 2 and p. 6-6.) The premiums paid by A's employer for the health insurance and accident and disability insurance are excludable from A's gross income. Also excludable up to $215 per month, is the cost of the parking space. (See pp. 6-24 and 6-34.) Part II: Explanation of Each Tax Strategy 1. Deferring the sale of the 50 acres from October 20, 2010 to June 16, 2011 will convert the gain of $150,000 from a short-term capital gain to a long-term capital gain. Because long-term capital gains are taxed at a maximum rate of 15% (versus 35% for short-term capital gains), A and B will save $30,000 in taxes ($150,000 20%) by simply waiting a few more months before closing on the sale. Because the after-tax earnings on the corporate bonds are less than the earnings on the State of Michigan bonds, A and B would generate an additional $1,900 in cash flow by purchasing the state bonds. Corporate State Bonds Bonds Annual interest income $14,000 $11,000 Federal income tax (35%) (4,900) ,000 After-tax income $ 9,100 $11,000 By exchanging the Series EE bonds for Series HH bonds, A and B are able to postpone the recognition of the $16,000 of interest income attributable to the Series EE bonds to the year in which the Series HH bonds are redeemable. Not only would this strategy save A and B $5,600 in taxes for 2010 ($16,000 35%), it would also enable A and B to recognize the interest income in a year in which a lower tax rate would apply (e.g., their retirement years). Note: shifting the income away from 2010 also increases A and B's allowable itemized deductions by $160 ($16,000 1%) which reduces their federal income tax liability by another $56 ($160 35%). 2. 3. 6-22 Chapter 6 Gross Income: Inclusions and Exclusions TAX RETURN PROBLEMS
Solutions to the Tax Return Problems (6-606-64) are contained in the Instructor's Resource Guide and Test Bank for 2012. TAX RESEARCH PROBLEMS
Solutions to the Tax Research Problems (6-606-64) are contained in the Intstructor's Resource Guide and Test Bank for 2012. ...
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This note was uploaded on 02/05/2012 for the course ACCT 110 taught by Professor Smith during the Spring '11 term at Adrian College.
- Spring '11