FTax IRGTB ch06 p001-038

FTax IRGTB ch06 p001-038 - 6 Gross Income: Inclusions and...

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Unformatted text preview: 6 Gross Income: Inclusions and Exclusions Solutions to Tax Research Problems 6-60 a. In a divorce, the custodial parent generally is allowed the exemption. Section 152(e), as revised by the Deficit Reduction Act of 1984 (DRA), simplified the rules concerning the support test for children of divorced parents or parents separated under a written separation agreement (and, as added by the Act, parents who live apart at all times during the last six months of the calendar year). Assuming divorced parents provide over one-half the child's support and the child is in the custody of one or both of the parents for more than half the calendar year, the parent who has custody for the greater portion of the year is deemed to provide more than half the child's support. This rule is followed unless the custodial parent signs a written declaration that is attached to the return of the noncustodial parent indicating that he or she will not claim the child as a dependent. If such a declaration is properly filed, the noncustodial parent is treated as providing more than half the child's support. The law generally grants the exemption to the custodial parent unless he or she releases the right to the noncustodial parent. Tax Planning. It might be advisable to adjust the agreement and the actual situation so that it is clear which parent is the custodial one. Since there are two children, both parents may qualify--one child live with J more than half the year and the other live with M more than half the year. This should not have much effect on their lives personally. The change would involve no more than one (or possibly a few) days personal adjustment and maintaining accurate records. Although either parent, by agreement, could claim both children as dependents, it may be desirable for each parent to claim one. The value of this is illustrated in (b) and (c) below. In addition, the change is necessary to qualify for the child care credit if all other requirements are met. Generally, head of household requires that the home be the principal place of abode for more than half the entire taxable year [ 437 and Reg. 1.2-2(c)(1)]. The custodial parent is permitted to claim headof-household status even if he or she does not claim the exemption deduction for such child, assuming all other tests are satisfied. Tax Planning. Whoever has custody for more than half the year may claim head of household. If the tax-planning change suggested in (a) above is made, both may qualify for head of household, unless of course, they qualify as married at the end of the year. Alimony is defined as any cash payment that 1. 2. 3. Is paid pursuant to a divorce or separation instrument; Is not designated in the instrument as something other than alimony that is nontaxable and nondeductible; Is not made to a member of the same household at the time the payment is made; b. c. 6-1 6-2 Chapter 6 Gross Income: Inclusions and Exclusions 4. Is terminable upon the death of the recipient; and 5. Is not child support. The $500 qualifies as alimony, since payments are to be made periodically under the divorce agreement and are not designated as child support [ 71(a) and Reg. 1.71-1]. The $50 qualifies as alimony for the same reasons if M is the owner and irrevocable beneficiary of the policy [Rev. Rul. 70-218, 1970-1 C.B. 19 and Lemuel A. Carmichael, 54 T.C. 577 (1970)]. Thus, J may deduct the $550 and M includes the $550 monthly transfers. [See 215(a) and 71(a)(1) and Temp. Reg. 1.71-1T.] Tax Planning. It may be advisable to change the agreement so that the $100 per month for each child is not designated as child support [see Item 2 in (c) above]. With this change, total alimony for the year becomes $9,000 ($750 12 months), which decreases J's A.G.I. to $31,000 and increases M's to $24,000. If J has custody of one child, his dependency claim is not jeopardized. Transfers made under a legal separation agreement are subject to the same rules as transfers made under a divorce agreement. Thus, the answer in (c) above is applicable. The DRA invalidates the longstanding decision of the Supreme Court in Davis, requiring recognition of gain when appreciated property is transferred as part of a divorce settlement. As added by the Act, 1041 provides that no gain or loss is recognized on any transfer to a spouse or, if incident to divorce, a former spouse. The transfer is incident to divorce if it occurs within one year after the date on which the marriage ceases or is related to the cessation of marriage. When the transfer qualifies for nonrecognition, the transferor's basis carries over to the recipient. Thus, neither M nor J recognize gain or loss on the transfer. J's basis is $10,000 and M's basis is $70,000 ($50,000 home $20,000 furnishings). This solution is discussed in (a)-(e). Meals and lodging provided employees by their employer are deductible expenses by the employer and excludable income for the employee when they are (1) provided for the employer's convenience, (2) on the employer's business premises, and (3) when the employee is required to occupy the lodging to perform employment duties [ 119 and Reg. 1.119-1(b)]. It appears logical that H and W should live on the farm and eat their meals there in order to perform the necessary duties, particularly since animals are part of the farm business. (Note, only 50 percent of the meal cost is deductible.) The major difficulty for H and W is that they must establish the farm as the employer and themselves as employees. If operated as a proprietorship, this employment relationship is not possible between the proprietorship and owner, but the proprietorship may have such a relationship with all nonowners. Thus, all of the benefits can be obtained for a nonowner who is an employee. In addition, these benefits are available to the spouse and dependents of qualifying employees. H could be the proprietor and employ W (or vice versa). Would the IRS and/or the courts allow meals and lodging benefits provided H through W? That is possible but unlikely. Similar difficulties are present for H and W if the farm is operated as a partnership. However, the Tax Court has held that meals and lodging furnished a partner by the partnership are deductible (subject to the 50 percent limitation) by the partnership and excludable by the partner when the other 119 requirements are met. The Third, Fourth, Eighth, and Tenth Circuit Courts of Appeals have reversed the Tax Court on this point [Comm. v. Robinson, 60-1 USTC {9152, 5 AFTR2d 315, 273 F.2d 503 (CA-3, 1960) cert. den., 363 U.S. 810; Comm. v. Doak, 56-2 USTC {9708, 49 AFTR 1461, 234 F.2d 704 (CA-4, 1956); Comm. v. Moran, 56-2 USTC {9879, 50 AFTR 64, 236 F.2d 595 (CA-8, 1956); and U.S. v. Briggs, 56-2 USTC {10,020, 50 AFTR 667, 238 F.2d 53 (CA-10, 1956)], but one has upheld the Tax Court [Armstrong v. Phinney, 68-1 USTC {9355, 21 AFTR2d 1260, 394 F.2d 661 (CA5, 1968)]. The Court of Claims also has held against partners on this issue [Wilson v. Comm., 67-1 USTC {9378, 19 AFTR2d 1225, 376 F.2d 280 (Ct. Cls., 1967)]. As a result, a partnership does not appear advisable unless the taxpayer resides in the fifth circuit. However, the partner in the fifth circuit case only held a 5 percent capital interest and may be a poor precedent for most partners. Since the children perform duties on the farm, they should be placed on the payroll as employees for income-splitting benefits. Presumably, all meals and lodging benefits would apply to them as employees. But, if they are not employees, benefits still apply to them as dependents of employees [see (b) above]. It has been held that adjustments are not required for personal enjoyment as a result of employer-furnished lodging (Lloyd N. Farnham, 6 TCM 1049). However, there appears to be no case or discussion directly concerning adjustments of food provided to friends and relatives who are neither employees nor dependents of employees. The Code discusses meals furnished to employees and does not require that they consume those meals personally. Thus, as long as the food is furnished to the employee and consumed on the premises, an argument exists that no adjustment is necessary. When d. e. f. 6-61 a. b. c. Solutions to Tax Research Problems 6-3 d. e. f. adjustments have been required in other contexts, the taxpayer must include the fair market value if the business is a corporation (see for example, Rev. Rul. 68-354, 1968-2 C.B. 60) and cost if a partnership (R. E. Moran, 17 TCM 791, T.C. Memo 1958-5 and Rev. Rul. 80, 1953-1 C.B. 62). Since owners can be employees of a corporation, the 119 benefits are potentially available for all employees, including those who are owners. However, if the corporation is electing to be taxed under Subchapter S, 119 benefits are not available to employees who own more than 2 percent of the outstanding stock. (See 1372, S. Rept., p. 22, and H. Rept., p. 21.) There is one exception. A grandfather clause to 1372 provides that fringe benefits for owners in effect on September 28, 1982 can be retained for taxable years beginning before 1988, as long as three rules are met during this period. They are: (1) the passive investment income test must not be violated; (2) the S election must have continued throughout the period; and (3) ownership changes during this period did not exceed 50 percent [See 1378(c)(2).] This clause would not apply to a new S corporation organized by H and W. Although not mentioned in the Code or Regulations, courts have held that all items directly and indirectly related to the cost of providing meals and lodging qualify if provided by the employer [see for example, Jacob v. Comm., 74-1 USTC {9316, 33 AFTR2d 74-972, 493 F.2d 1294 (CA-3, 1974) and Rev. Rul. 68-579, 1968-2 C.B. 61]. However, employer reimbursement paid to the employee for these costs has been held to be includable income [Kowalski v. Comm., 77-2 USTC {9748, 40 AFTR2d 6128, 43 U.S. 77 (USSC, 1977) and G. A. Turner, 68 T.C. 48 (1967)]. Consequently, grocery items and expenses related to the housing should be paid directly with corporate funds, preferably with a business check and a bill in the business' name. In order for the business to provide the lodging, it must either own the home or rent the home from the owners. In either situation, the home is a 1231 asset and is not available for the exclusion (121) or deferral of gain provisions allowed when a principal residence is sold and the proceeds are reinvested in a new principal residence (1034). (See Chapter 15.) If H and W own the home, they must establish a fair market rental value that would be paid in a transaction between unrelated parties. In order for the business to provide the meals, it must pay for them and for their preparation directly and they must be served on the business' premises. Thus, reimbursement presumably would not qualify. [See Kowalski, cited in (d) above.] Presumably, if employees of the business purchased groceries with the business' funds and prepared the meals in the employer-provided home, the meals would qualify under 119. In Sutphin v. U.S. 88-1 USTC {9269, 61 AFTR2d 88-990, 14F.2d 545 (Ct. Cls., 1988), the U.S. Claims Court ruled that a discount received for prepayment of taxpayers' mortgage was discharge of indebtedness income. The homeowners in this case accepted an offer from the Park View Federal Savings & Loan Association ("Park View") to receive a discount of $8,240.17 by prepaying an 8.5 percent mortgage on their home. The discount was computed as follows: Face value of the note (remaining principal amount) Amount paid by homeowners Discount received for payment $ 32,960.68 (24,720.51) $ 8,240.17 6-62 a. 11- Park View extended the above offer to the homeowners because of a significant rise in interest rates. In analyzing the tax consequences of the discount received by the taxpayers, the court used the following approach. First, it examined the general rule under 61(a)(12) that gross income includes amounts received from the discharge of indebtedness. Next, it gave consideration to statutory exceptions to this general rule by focusing on Code 102 and 108. Lastly, attention was given to judicial exceptions that have allowed taxpayers to reduce the basis of their property for the discount received rather than recognizing income immediately. Each of these steps is discussed below. Section 61(a) defines gross income as "all income from whatever source derived." Section 61(a)(12) provides that gross income includes amounts received from the discharge of indebtedness. In two landmark decisions the Supreme Court in U.S. v. Kirby Lumber Co. 284 U.S. 1, 10 AFTR 485, 2 USTC {814 (USSC, 1931) and Helvering v. American Chicle Co., 291 U.S. 426, 13 AFTR 876, 4 USTC {1240 (USSC, 1934) relied heavily on 61(a) and 61(a)(12). In both cases the Supreme Court emphasized that the underlying rationale for the principle that a taxpayer may realize income by paying an obligation at less than its face value is "that a reduction in debt without a corresponding reduction in assets causes an economic gain in income because assets are no longer encumbered." Consequently, the Claims Court concluded that unless a statutory or judicial exception could be found to the general rule of discharge of indebtedness income, the taxpayer in the Sutphin case would be required to recognize income equal to the discount received or $8,240.17. 6-4 Chapter 6 Gross Income: Inclusions and Exclusions In the court's opinion, Code 102 and 108 were the statutory exceptions deserving of special attention. The general rule of Code 102 states that "Gross income does not include the value of property acquired by gift." Therefore, if the forgiveness of a debt represents a gratuitous discharge, the debtor realizes a gift rather than income. Unfortunately, few financial institutions make a practice of gratuitously relieving debtors of their obligations. Clearly, Park View's motives in offering homeowners a discount for prepayment of their mortgage were driven by economic factors. In other words, Park View did not act "with a detached and disinterested generosity arising from affection, respect, admiration, charity or like impulses." Park View's offer to its debtors was simply a good business decision and was never intended to be a gift. As a result, 102 offers little to cushion the impact of 61(a)(12). The Claims Court then looked to Code 108 for possible relief. Section 108(a)(1) allows an exclusion from gross income for the discharge of indebtedness that (1) occurs in a title 11 bankruptcy case, (2) occurs when the taxpayer is insolvent, or (3) constitutes qualified business indebtedness (generally for discharges before 1987). Because the homeowners were solvent and did not utilize their home in connection with a trade or business, 108(a)(1) fails to provide the taxpayers with a safe harbor from the normal discharge of indebtedness rule. The final statutory exception the court examined was 108(e)(5), which reads as follows: (5) Purchase-money debt reduction for solvent debtor treated as price reduction. If (A) the debt of a purchaser of property to the seller of such property that arose out of the purchase of such property is reduced, (B) such reduction does not occur-- (i) in a title 11 case, or (ii) when the purchaser is insolvent and (C) but for this paragraph, such reduction would be treated as income to the purchaser from the discharge of indebtedness, then such reduction shall be treated as a purchase price adjustment. Because the taxpayers were not indebted to the seller of their residence but rather to Park View, 108(e)(5) may not be relied upon. Therefore, the reduction by Park View of the principal amount of taxpayer's mortgage ($8,240.17) cannot be considered a purchase price adjustment. Next, the Claims Court took under consideration the taxpayers' argument that the discount of $8,240.17 should not be taken into income but rather used to reduce the basis of their house. Under this approach, income would be realized only when the residence is subsequently sold. The taxpayers relied upon Commissioner v. Shermann, 135 F.2d 68, 30 AFTR 1378, 43-1 USTC {9367 (6th Cir., 1943) and Hirsch v. Commissioner, 115 F.2d 656, 25 AFTR 1038, 40-2 USTC {9791 (7th Cir., 1940) for their authority. However, both of these cases were unique in that the FMV of the mortgaged property was less than the remaining principal amount of the mortgage. Consequently, the taxpayers received nothing of exchangeable value on the "forgiveness" of the indebtedness other than a reduction of a capital loss yet to be realized. The facts in Sutphin do not indicate that the residence had declined in value below the unpaid mortgage balance. Therefore, neither of these cases represent judicial exceptions to the general rule requiring recognition of discharge of indebtedness income. The decision of the Claims Court requiring the taxpayers to report as income a discount received from prepayment of their mortgage is also consistent with two recent decisions of the tax court. See Michaels v. Commissioner, 87 TC 1412 (1986) and Juister v. Commissioner, 53 TCM 1079, T.C. Memo 1987-292. In a more recent case (Zarin, 92 TC No. 68), a sharply divided Tax Court held that a taxpayer realized income from the discharge of indebtedness when a gambling casino agreed to settle a taxpayer's gambling debts at a discount of nearly $3 million. The taxpayer, a compulsive gambler, owed Resorts International (a New Jersey casino) $3,435,000, but the casino agreed to settle for payments totalling $500,000. The taxpayer argued that the settlement could not generate income for two reasons: (1) under New Jersey law, the gambling debt was unenforceable, and (2) it should be treated as a purchase price adjustment (see earlier discussion above) under 108(e)(5). The taxpayer lost on both points. The Tax Court, relying on the Supreme Court decision in Tufts [461 U.S. 300, 83-1 USTC {9328, 51 AFTR2d 83-1132 (S. Ct., 1983)], concluded that the enforceability of the debt was not determinative for Federal income tax purposes. Furthermore, the Court refused to treat the settlement as a purchase price adjustment. Purchasing an "opportunity to gamble" in exchange for credit did not constitute, in the Court's view, the type of property intended by 108(e)(5). However, upon appeal the Third Circuit reversed the decision of the Tax Court. The appellate court concluded Solutions to Tax Research Problems 6-5 that 108 did not apply because the transaction involved a "contested liability." The Third Circuit reasoned as follows: 5Zarin owed an unenforceable debt to Resorts. After he in good faith disputed his obligation to repay the $3.5 million debt, the parties settled for $500,000, which Zarin paid. The court held that the $500,000 settlement fixed the amount of loss and the amount of debt recognizable for tax purposes. Thus, because Zarin was deemed to have owed $500,000, and because that was the amount paid, no tax liability resulted from the transaction. b. Consequently, Mr. Zarin did not realize income from the discharge of indebtedness. See Zarin, 66 AFTR2d 90-5679, 90-2 USTC {50-530 (CA-3, 1990). Concerning the facts of the problem, they closely resemble the fact-pattern of Sutphin v. U.S., supra. T will be required to report the $6,000 discount received for prepayment of her mortgage as discharge of indebtedness income. The statutory exceptions outlined above provide no relief. Clearly, FS&L was motivated for business reasons in offering T a discount for prepayment of her mortgage and therefore this was not a gratuitous discharge. Because T was a solvent taxpayer and never used her residence for business purposes, no exclusion from gross income is available under 108(a)(1). Furthermore, T cannot argue that the $6,000 discount represents a purchase price adjustment under 108(e)(5) in that she purchased the residence from the XYZ Construction Co. rather than FS&L. Judicial relief might be available if the market value of T's residence had declined below the unpaid mortgage balance. However, the facts of the problem show that the market value of T's residence has increased in value. In conclusion, the final result is rather harsh. T is required to recognize $6,000 of income, but yet the transaction produced no cash flow from which to pay the tax due. Because the fair market value (FMV) of the residence at the time of the settlement (i.e., $25,000) was less than the settlement price (i.e., $29,000), no taxable income results. Rather, T will be required to reduce the original purchase price of the home by the debt reduction of $6,000. Consequently, her basis in the house becomes $49,000 (i.e., $55,000 $6,000). As pointed out in Hirsch v. Comm., supra., "A transaction whereby nothing of exchangeable value comes to or is received by the taxpayer does not give rise to, or create, taxable income." T now owns a residence which has a FMV of $25,000. This is $30,000 less than what T agreed to pay for it and $24,000 less than she actually paid for it. As the court stated, "To say that anything of value has moved to the taxpayer is contrary to fact." As a result, the $6,000 reduction of the mortgage (although a forgiveness of indebtedness) was in actuality a reduction of the purchase price from $55,000 to $49,000. Whether T will eventually realize a gain or loss on the residence cannot be determined until she eventually sells the property. 6-63 55- The facts in Roemer, Jr. v. Comm., 83-2 USTC {9600, 52 AFTR2d 5954, 716 F.2d 693 (CA-9, 1983), revg. 79 TC 398 (1982) are, for the most part, identical to the problem. Paul F. Roemer, Jr. owned a very successful insurance agency in Oakland, California. In 1965, Roemer applied for an agency license from Penn Mutual Life Insurance Company. Because Penn Mutual received a grossly defamatory credit report from the Retail Credit Company, Roemer was denied agency licenses to sell life insurance by Penn Mutual and other companies. Roemer sued the Retail Credit Company for libel and was awarded compensatory damages of $40,000 and punitive damages of $250,000. Both the Internal Revenue Service and the Tax Court in Roemer v. Comm., 79 TC 398 (1982) ruled that the compensatory and the punitive damages were taxable. In reversing the Tax Court, the Ninth Circuit looked to state law and concluded that the defamation of an individual under California law is a personal injury. Consequently, the court concluded that the compensatory damages received, like those received as a result of any personal injury, were excludable from gross income under 104(a)(2). In further explaining its reasons for reversing the Tax Court, the circuit court stated that, "When an individual recovers damages for a physical personal injury, the lumpsum award is not allocated between the personal aspects of the injury and the economic loss occasioned by the personal injury, nor is the taxpayer precluded from use of 104(a)(2) when the predominant result of the injury is a loss of income." Clearly, the code in 104(a)(2) emphasizes that damages received on account of personal injuries are excluded from the taxpayer's gross income. The word physical does not appear. Consequently, the relevant distinction is not between physical and nonphysical injuries but rather between personal and non-personal injuries. 6-6 Chapter 6 Gross Income: Inclusions and Exclusions 5- 5- 5- 5- A recent Sixth Circuit Court of Appeals case involves James Threlkeld v. Comm., 88-1 USTC {9370, 61 AFTR2d 1285, 848 F.2d 81, who was sued in Tennessee by J. B. Williams, a Texas resident, alleging fraud in connection with a real estate sales contract. After Threlkeld had won the suit, he brought suit alleging malicious prosecution. In his complaint, Threlkeld alleged that Williams "instituted, continued, and prosecuted his claims without probable cause and with malice." Because of Williams' actions, Threlkeld claimed he was subjected to "indignity, humiliation, inconvenience, suffered injury to his professional reputation and to his credit reputation." In settlement of the suit, Threlkeld was awarded $300,000 of which $75,000 was allocated for damages to James' professional reputation. Although Threlkeld excluded the settlement from gross income on his 1980 tax return under 104(a)(2), the IRS claimed that the amount received for the damages to professional reputation were taxable. Upon appeal, the Tax Court in Threlkeld v. Comm., 87 TC 294 (1986) ruled in favor of the taxpayer. Likewise, relying on the Ninth Circuit's decision in Roemer, the Sixth Circuit concluded that the settlement for damages to Threlkeld's professional reputation was excludable. Like the Ninth Circuit, the Sixth Circuit looked to state law and concluded that an action for malicious prosecution would be classified as an action for personal injuries. In the court's opinion, no distinction should be made between an injury to a person's hand versus an injury to a person's reputation. Clearly, all income received in compensation of injury to an individual's hand or arm is excludable under 104(a)(2) even though the injury may affect a person's professional pursuits. Likewise, the court concluded that all income received in compensation of injury to taxpayer's reputation is excludable under 104(a)(2) even though it affected his professional pursuits. As previously indicated, the Tax Court in Roemer v. Comm., supra, ruled against the taxpayer. Because Roemer failed to show that the compensatory damages were received for injury to his personal reputation, the Tax Court concluded the $40,000 was not excludable under 104(a)(2). In other words, damages received primarily for injury to the taxpayer's business and professional reputation are includible in gross income. However, the Tax Court in Threlkeld v. Comm., supra, ruled in favor of the taxpayer holding "that there is no valid distinction between damages received for injury to personal reputation and those received for injury to professional or business reputation for the purposes of 104(a)(2)." The Tax Court's reasoning was based upon the Ninth Circuit's opinion in Roemer. As a result, the Tax Court reversed its decision in Roemer and now agrees with the Ninth Circuit's ruling. Concerning its new position, the Tax Court made the following statement: 5We do not lightly decline to follow one of our prior decisions; no court bound by the doctrine of stare decisis does. But where one of our decisions lacks a firm foundation in the case law and an appellate court issues a well-reasoned reversal of that decision, the weight of precedent must give way to a better approach. Therefore, we will no longer distinguish between personal reputation and professional reputation for the purpose of deciding whether a damage award received in a tort action is excludable from gross income under 104(a)(2). 5- 5- 5- The Internal Revenue Service has stated in Rev. Ruling 85-143 that it will not follow the opinion of the Ninth Circuit in Roemer, Jr. v. Comm., supra. Rather, the Service agrees with the Tax Court's original decision in Roemer, Jr. v. Comm., supra, that a taxpayer has not suffered a personal injury under 104(a)(2) when the primary harm suffered by the individual as a result of a libelous statement was loss of business income. The Service makes a distinction between defamatory statements directed at a business versus those directed at an individual. The former, when loss of business income results, is an injury to the business whereas the latter is a personal injury. Only damages attributable to a personal injury, as opposed to a business injury, are excludable under 104(a)(2). As the foregoing discussion illustrates, the courts and the service have reached various and conflicting opinions about the treatment of compensatory damages. Nonetheless, prior to the passage of the 1996 tax legislation, the weight of authority would have been in T.J. Taxpayer's favor. Both the Tax Court and the Ninth Circuit Court of Appeals have ruled, in facts very similar to T.J.'s, in the taxpayer's favor. Moreover, California is in the jurisdiction of the Ninth Circuit. However, under the 1996 Act, 104(a)(2) is amended to significantly limit the types of personal injury awards that can be excluded from a recipient's gross income. The new law provides that damages received for nonphysical injuries are not excluded from income. Furthermore, emotional distress is not considered a physical injury or sickness. The new law also states that, as a general rule, punitive damages are not excludable regardless of whether related to physical injury of physical sickness. Consequently, it would appear that the $100,000 represents taxable income to T.J. Solutions to Tax Research Problems 6-7 6-64 The facts in the Alice Johnson scenario are similar to those in Burke v. U.S. [91-1 USTC {50,175 67 AFTR2d 91-749, 929 F.2d 1119 (CA-6, 1991)]. The relevant facts in the Burke case are summarized in the following paragraph. 5In 1984, Judy A. Hutcheson, an employee of the Tennessee Valley Authority (TVA) filed a Title VII action alleging that TVA had discriminated in the payment of salaries on the basis of sex. The union, which represented the affected employees, intervened. Among the represented employees were Therese A. Burke, Cynthia R. Center, and Linda G. Gibbs. The complaint alleged that TVA had increased pay scales in certain male-dominated areas, but not in female-dominated areas. The affected female employees sought injunctive relief as well as back pay. Before the case went to trial, a settlement agreement was reached whereby TVA agreed to pay $4,200 to Hutcheson and a total of $5,000,000 for the other affected employees. Although TVA did not withhold taxes on the $4,200 for Hutcheson, it did withhold federal income taxes on the amounts allocated to the other affected employees. Subsequently, Therese A. Burke, Cynthia R. Center, and Linda G. Gibbs filed a refund claim for the taxes withheld from their settlement payments. 5- 5- 5- 5- 5- 5- The Internal Revenue Service (IRS) disallowed the claim. Consequently, Therese A. Burke, et. al., filed suit in the United States District Court for the Eastern District of Tennessee, arguing that the settlement payments should be excluded from gross income under 104(a)(2) as "damages received on account of personal injuries." The District Court ruled that, "because the affected female employees sought and obtained only back wages due them as a result of TVA's discriminatory under-payments rather than compensatory or other damages, the settlement proceeds could not be excluded from gross income as damages received ... on account of personal injuries." [90-1 USTC {50,203 (D.CT. TN, 1990)]. The United States Court of Appeals for the Sixth Circuit, by a divided vote, reversed the lower court's decision. According to the Sixth Circuit, determining whether 104(a)(2) exclusion applies requires an examination of the nature of the injury to determine whether the injury and claim are personal and tort-like in nature, and not whether the consequences of the injury resulted in an award of compensatory damages or damages for back pay. The court pointed out that injuries resulting from invidious discrimination, be it on the basis of race, sex, national origin, or some other unlawful category, are injuries to the individual rights and dignity of the person. Thus, the court held the award of back pay pursuant to Title VII was excludable from gross income under 104(a)(2). Because of the above decision, the government pointed out that there was a conflict among the Courts of Appeal concerning the exclusion of Title VII back pay awards from gross income under 104(a)(2). Back in 1989, the Fourth Circuit in Thompson held that back pay awarded under the Equal Pay Act for sex discrimination was taxable [Thompson v. Comm., 89-1 USTC {9164,63 AFTR2d 89-677, 866 F.2d 709 (CA-4, 1989)]. Although the Fourth Circuit's decision focused on a different statute (i.e., the Equal Pay Act rather than Title VII), the Supreme Court nonetheless agreed to review Burke (i.e., granted a writ of certiorari). The Supreme Court [U.S. v. Burke, 92-1 USTC {50254,112 U.S. 1867 (USSC, 1992)] looked to 61(a) and 104(a)(2). Section 61(a) provides that "gross income means all income from whatever source derived." Thus, all accessions of wealth are presumed to be "gross income" unless the taxpayer can show that accession falls within a specific exclusion under the Internal Revenue Code. The question then is whether the awards qualify for special exclusion from gross income under 104(a)(2) which provides that gross income does not include the amount of any damages received on account of personal injuries or sickness. Unfortunately, the legislative history of 104(a)(2) provides no explanation of the term personal injuries. Several courts have held that for the purposes of 104(a)(2), "personal injuries" means both physical and nonphysical injuries. See Pistillo v. C.I.R., 90-2 {50,469, 66 AFTR2d 90-5448, 912 F.2d 145 (CA-6, 1997 (injury involved age discrimination); Rickel v. Commissioner, 90-1 USTC {50,200, 65 AFTR2d 90-800, 900 F.2d 655 (CA-3, 1990) (age discrimination); Bent v. Commissioner, 88-1 USTC {9101,61 AFTR2d 88-301, 835 F.2d 67 (CA-3, 1987) (deprivation of first amendment rights); Roemer v. Commissioner, 83-2 USTC {9600,52 AFTR2d 83-5954, 716 F.2d 693 (CA-9, 1983) (defamation). However, the Regulations link identification of a personal injury for purposes of 104(a)(2) to traditional tort principles: "The term damages received means an amount received ... through prosecution of a legal suit or action based upon tort or tort type rights ..." Reg. 1.104-1(c). The Supreme Court next looked to the meaning of the term "tort." A "tort" has been defined broadly as: 5... a civil wrong, other than breach of contract, for which the court will provide a remedy in the form of "an action for damages." One of the hallmarks of traditional tort liability is the availability of a broad range of damages to compensate the plaintiff "fairly for injuries caused by the violation of his legal rights." Although these damages often are described in compensatory terms, in many cases they are larger than the amount necessary to reimburse 6-8 Chapter 6 Gross Income: Inclusions and Exclusions actual monetary loss sustained or even anticipated by the plaintiff, and thus redress intangible elements of injury that are "deemed important, even though not pecuniary in their immediate consequences." 5- 5- In its analysis, the Supreme Court provides illustrations to help explain the tort concepts discussed above. For example, "the victim of a physical injury may be permitted, under the relevant state law, to recover damages not only for lost wages, medical expenses, and diminished future earning capacity on account of the injury, but also for emotional distress and pain and suffering." Similarly, "the victim of a `dignitary' or nonphysical tort such as defamation may recover not only for any actual pecuniary loss (e.g., loss of business or customers), but impairment of reputation and standing in the community, personal humiliation, and mental anguish and suffering." The Supreme Court concludes it analysis with the following observations concerning Title VII: 5It is beyond question that discrimination in employment on the basis of sex, race, or any of the other classifications protected by Title VII is, as respondents argue and the Court consistently has held, an invidious practice that causes grave harm to it victims. The fact that employment discrimination causes harm to individuals does not automatically imply, however, that there exists a tort-like personal injury for purposes of federal income tax law. Indeed, in contrast to the tort remedies for physical and nonphysical injuries discussed above, Title VII does not allow awards for compensatory or punitive damages; instead, it limits available remedies to back pay, injunctions, and other equitable relief ... Nothing in this remedial scheme purports to recompense a Title VII plaintiff for any of the other traditional harms associated with personal injury, such as pain and suffering, emotional distress, harm to reputation, or other consequential damages (e.g., a ruined credit rating). 5- 5- The Court then concludes that "notwithstanding a common-law tradition of broad tort damages ..., Congress declines to recompense Title VII plaintiffs for anything beyond the wages properly due them-- wages that, if paid in the ordinary course, would have been fully taxable." Consequently, the Supreme Court reversed the Sixth Circuit's decision by holding that the back pay awards received by Therese A. Burke et al., in settlement of their Title VII claims are not excludable from gross income as "damages received ... on account of personal injuries" under 104(a)(2) of the IRC. It should be noted that the 1991 Civil Rights Act, which became effective on November 21, 1991, expanded Title VII's remedial scope to include compensatory and punitive damages. Although this signals a marked change in Title VII, the Supreme Court does not comment on whether back pay awarded under the 1991 act would be taxable. It would appear, however, that such damages would be taxable given the changes made by Congress in the 1996 Act. Under the new law, the exclusion from gross income applies only to damages received on account of a personal physical injury or physical sickness. Thus, the exclusion does not apply to damages received based on a claim of employment discrimination. Furthermore, the 1996 Act provides that, as a general rule, no exclusion from gross income is available for punitive damages. 6 Gross Income: Inclusions and Exclusions Test Bank True or False 1. In the calculation of gross income, income that is nontaxable in total is generally not reported on the tax return, while income that is partially taxable and partially nontaxable is generally reported on the return. 2. Distributions of cash and other assets to shareholders by U.S. corporations in excess of their current and accumulated earnings and profits qualify as dividends, provided the shareholder's basis in the stock has been reduced to zero. 3. When a mutual fund distributes dividends, the dividends are deductible by the fund and the undistributed income is taxable to the fund. 4. Any dividend declared, with the option of receiving cash or additional common stock, qualifies for the stock dividend exclusion if stock instead of cash is selected. 5. All interest from state and municipal bonds is excluded from gross income. 6. If an annuitant dies before recovering the entire investment in the annuity contract, the amount of the unrecovered investment is allowed as a deduction on the taxpayer's final tax return. 7. Conceptually, reimbursement for employee business travel is included in gross income but there normally is an offsetting deduction for A.GI. so the effect is usually a wash. 8. The board of directors of Q Corporation votes to award the president of the company $5,000 in recognition of its appreciation for the president's hard work in securing a government contract. The president will pay no income tax on this bonus (award). 9. The current tax law requires that the portion of social security tax paid by the employer be included in gross income by the employee, because it represents a benefit of value to be received in the future. 10. Proceeds received from an employer-provided group-term life insurance policy are included in gross income of the employee's widow. 6-9 6-10 Chapter 6 Gross Income: Inclusions and Exclusions 11. Workers at Saltmine, Inc., are required to take their lunch in the company cafeteria at the bottom of the mine for the employer's convenience. The per diem reimbursement they receive in their paycheck for the cost of meals is excluded from the worker's income. For child and dependent care assistance provided through an employer plan, an employer is allowed a deduction, and an employee is allowed an exclusion for gross income. The employee's exclusion is subject to an annual limit. Assuming the existence of a written reciprocal agreement, employees of UFO Airlines who fly to Paris on otherwise empty seats on board another company's flight have no taxable income for the value of the transportation. H voluntarily pays W $200 a month for three months ($600) prior to their divorce and for five months after their divorce ($1,000). The divorce agreement requires that such payments be made until W's remarriage or death. They have no children. The entire $1,600 is included in the gross income of W. A mother and her 19-year-old son live together in a state that declares persons to be adults at age 18. She receives $120 a month for child support and $80 for alimony. The entire $200 per month is included in gross income. A taxpayer buys a $2 raffle ticket at the neighborhood school carnival. He wins the third prize of $20. The income is excluded from gross income since it is less than $25. Farmers are required to include in gross income fair market value of materials (e.g., seed corn) received from the government. Insurance proceeds received to cover lost profits or overhead expenses in the event of fire damage to a grocery are included in gross income. The value of leasehold improvements made by the lessee is nontaxable to the lessor at the time made and at the time of lease termination unless they were made in lieu of rent. T had $600 in state income tax withheld in 2010 and received a refund of $258 in 2011. T is single and always files Form 1040A. The refund is not included in gross income in 2011. 12. 13. 14. 15. 16. 17. 18. 19. 20. Multiple Choice 21. R received cash income in the current year from the following investments: bank savings account interest, $43; municipal bond interest, $88; Canadian corporate stock dividend, $112; U.S. public utility stock dividend, $58; and corporate bond interest, $196. All amounts received on stock were paid from current earnings. The amount included in gross income of R is a. b. c. d. $497 $439 $409 $351 22. D purchased all of the stock in SB, Inc., in 2005 for $76,000. On December 31 of the current year, SB, Inc., made a cash distribution of $135,000 to D. Assuming SB, Inc., has current E&P of $15,000 and accumulated E&P of $40,000, the distribution will be treated as a. b. c. d. Taxable dividend of $135,000 Taxable dividend of $55,000 and nontaxable return of investment of $80,000 Taxable dividend of $55,000, nontaxable return of investment of $76,000, and a capital gain of $4,000 Taxable dividend of $55,000 and capital gain of $80,000 Test Bank 6-11 23. S purchased 200 shares of C, Inc., common stock on January 1, 2005 for $2,200. On December 15 of the current year, C, Inc., issued a 10 percent common stock dividend giving him 20 additional shares. D's basis in each share of common stock after the dividend is a. b. c. d. $11 $10 $9 $8 24. S purchased 200 shares of C, Inc., common stock on January 1, 2005 for $2,200. On December 15 of the current year, C, Inc., issued a 10 percent common stock dividend giving him 20 additional shares. The holding period for the 20 additional shares of C, Inc., begins on a. b. c. d. January 1, 2005 December 15 of the current year December 31 of the current year None of the above 25. H owns 100 shares of A Corp. (or 1% of the stock), which he purchased two years ago for $30 each. A's net earnings this year were respectable--2 million--but their board decides to distribute $4 million. Assuming A Corp. had no AE&P before this year, how is the amount shareholder H receives reported on his individual return? a. b. c. d. $40,000 of taxable dividend $20,000 of taxable dividend; $17,000 capital gain; $3,000 nontaxable return of capital $20,000 of taxable dividend; $20,000 capital gain $37,000 capital gain; $3,000 nontaxable return of capital 26. Which of the following is a dividend for tax purposes? a. b. c. d. The dividend check from a mutual insurance company The dividend coupon from Health Food Co-op The dividend check from Utility Power and Light preferred The dividend entered in an account at Employee's Credit Union 27. A Corp. wants to throw something to its shareholders this year, but is cash poor. The board decides on a two-for-one stock dividend: common on common. The shareholders of record at the time of the dividend a. b. c. d. Realize a taxable dividend equal in amount to the value of their pre-split shares Have the value of their holdings doubled, taxation on which is postponed until the shares are sold Double their shares, allocating the pre-split basis in the stock equally among the shares Have nontaxable return of all their capital 28. S owns an extensive portfolio of stocks and bonds. When he sells his tax-exempt municipal bonds at the end of the year, which of the following best describes S's action? a. b. c. d. S will likely realize a gain or loss. S will have to pay the city a 10 percent penalty on the premature sale of the bonds. S will not be allowed to reacquire similar municipal bonds for two years. Both b. and c. 6-12 Chapter 6 Gross Income: Inclusions and Exclusions 29. An annuity has an annual compound interest rate of 9 percent. At this rate, the original investment will be doubled in approximately a. b. c. d. 10 years 8 years 5 years 4.75 years 30. H and W, a couple in their 40s, have taxable income of $50,000 per year. One of the advantages they are seeking from the deferred life annuity they have just purchased is a. b. c. d. The opportunity to report each year's interest as capital gain income Tax-free annuity installments in the early years, becoming taxable only after fully recovering their basis in the contract Current tax deductions for the annuity premiums Tax payments on the annuity installments at a lower marginal rate 31. B, who is single and 59 years old, purchased a single premium immediate annuity on January 1 of the current year for $12,000 that will pay him $100 every month for life beginning on January 15. Based on actuarial tables published by the IRS, his life expectancy multiple is 25.0. B's nontaxable return of capital for the current year is a. b. c. d. $0 $1,200 $480 $720 32. B, who is single and 59 years old, purchased a single premium immediate annuity on January 1 of the current year for $12,000 that will pay him $100 every month for life beginning on January 15. Based on actuarial tables published by the IRS, his life expectancy multiple is 25.0. Assuming B lives just 20 years, the unrecovered amount allowed as a deduction on B's final tax return is a. b. c. d. $0 $9,600 $720 $2,400 33. B, who is single and 59 years old, purchased a single premium immediate annuity on January 1 of the current year for $12,000 that will pay him $100 every month for life beginning on January 15. Based on actuarial tables published by the IRS, his life expectancy multiple is 25.0. Assuming B lives 26 years, the amount included in his gross income for year 26 is a. b. c. d. $1,200 $0 $720 $480 34. K purchased a single premium-deferred annuity 25 years ago for $6,000. Beginning in July of this year, he will receive $125 monthly for 20 years. The taxable amount in the current year is a. b. c. d. $150 $600 $750 $1,500 Test Bank 6-13 35. Lucky Employee received the following items during the taxable year. All were deducted by Lucky's employer as business expense. Assume that these were all of the awards given by his employer. Which item(s) would be included in Lucky's gross income? a. b. c. d. e. A 20-pound turkey (FMV $17) Christmas bonus of $400, cash A $100 watch for 20 years service A $300 silver cup for 15 years of safe machine operation Both c. and d. 36. E, who is 68 years old and married, retired on July 1 of the current year. His current year income is shown below. Salary (prior to retirement) Pension payments (all taxable) Dividends Tax-exempt bond interest Social security benefits $15,000 14,000 2,000 3,000 5,000 Assume E has no deductions for adjusted gross income and that Mrs. E has no income. The amount of social security benefits that E must include in taxable income on a joint return for the current year is a. b. c. d. 37. $5,000 $0 $2,250 $2,500 Which of the following employer awards is nontaxable to the employee? a. b. c. d. A, Inc., pays E $400 in recognition of her 10 years of service to the company. B, Inc., pays $375 for a watch that it awards to F in recognition of his four years of service to the company. C, Inc., pays $400 for a watch that it awards to G in recognition of his safety achievements with the company. All of the above awards are nontaxable. 38. T, Inc., pays $600 ($725 FMV) for a gold watch that is awarded to U for his 25 years of service to T. This is U's only award from T. The employer does not have a qualified plan for awards. The amount included in U's gross income and the amount deductible by T are, respectively, a. b. c. d. e. $725 and $600 $600 and $600 $325 and $400 $200 and $325 $0 and $600 39. H is a single, retired worker with $45,000 annual taxable income. H will begin to receive social security benefits this year that will only amount to $5,000 per year. His social security benefits will a. b. c. d. Come to him tax-free since he paid tax on the amounts when they were included in his gross wages Be partially taxed because of his high income bracket Be denied him and redirected to a congressionally formed social security trust fund Be denied him, but he will get a deduction against his taxable income for the full $5,000 6-14 Chapter 6 Gross Income: Inclusions and Exclusions 40. In the calculation of gross income, which of the following is not an example of nontaxable employee benefits? a. b. c. d. Purchase discounts for all employees equal to the employer's gross profit percentage Group-term life insurance for $100,000 of coverage Parking provided in the company garage Supper money for voluntarily working overtime 41. J is a 56-year-old executive who has worked for AM, Inc., since 1975. Her current contract with AM includes $100,000 of group-term life insurance. The taxable amount for each $1,000 of insurance protection, given J's age, is $5.16 annually. Assuming J is in the 28 percent marginal tax bracket, the after-tax cost of this policy to J in the current year is a. b. c. d. $204.20 $102.00 $0.00 $72.24 42. A closely held C corporation purchased the $250,000 whole life insurance policy held by one of its officers, and named itself as beneficiary. The officer died in an airplane crash after the corporation had paid only $1,000 on her policy. If the deceased officer's basis in the policy was $10,000 at time of transfer to the corporation, the tax consequences to the corporation are a. b. c. d. No taxable income $240,000 taxable income $250,000 taxable income $239,000 taxable income 43. W, who is married and files a joint return, had adjusted gross income last year of $50,000. The following is a list of W's itemized deductions for last year: Unreimbursed medical expenses before limitation Charitable contributions Interest paid on home mortgage State and local property taxes $6,000 3,000 5,000 3,500 This year, W received $6,000 as reimbursement from his insurance company for his medical expenses in the prior year. How much of the reimbursement must W include in this year's gross income? a. b. c. d. 44. $0 $2,250 $6,000 $3,750 In which of the following independent situations does the taxpayer have taxable income? a. b. c. d. W lost a finger when a stamping press he was working with malfunctioned. His employerprovided accident insurance policy paid him $25,000 X received $10,000 of disability income during the year under an employer-financed disability plan Y received $12,000 of disability income during the year. Y paid the $225 annual premium on the disability policy Z, a spouse, received $40,000 in life insurance proceeds from the ABC Corporation due to the death of her husband Test Bank 6-15 45. Unlucky Employee is injured. Unlucky is covered under two accident and disability plans. One is partially financed by her employer and the other is financed by her. Which of the following could account for the non-taxing of an amount distributed to Unlucky under one of those plans? a. b. c. d. Amounts attributable to the loss of an eye under either plan Any amount paid under the personally financed plan Amounts attributable to the percentage paid by Unlucky under the employer plan All of the above 46. Which of the following death benefits are wholly included in gross income? a. b. c. d. $10,000 death benefit paid by the decedent's employer to the decedent's spouse The Christmas bonus attributable to the decedent, but paid to the decedent's spouse A $10,000 lump sum distribution from a qualified pension plan paid to the decedent's spouse All of the above 47. M, Inc., operates a funeral home out of a nineteenth-century mansion. M, Inc., requires R to be on call 24 hours and provides the second floor of the mansion as an apartment. Rent expense for comparable accommodations would amount to $24,000 per year. R has taxable income on this perquisite of a. b. c. d. $24,000 $12,000 $5,000 $0 48. During the summer, P is employed by a local charity as the director of a camp for handicapped children. She receives weekly benefits of $225 salary, lodging in a private cabin valued at $55, and meals in the dining hall worth $40. In case an emergency arises, P is required to be available at all times during the seven weeks of camp. The amount included in P's gross income is a. b. c. d. $1,855 $1,960 $2,240 $1,575 49. Which of the following benefits provided by an employer to its employees is taxable? a. b. c. d. Employees of the ABC Department Store are allowed a 15 percent discount (which does not exceed the employer's gross profit percentage) on the retail price of all merchandise purchased from the store. Undergraduate tuition is waived by the XYZ University for dependent children of employees who are admitted to the school. The MNO Airline provides free standby flights to its employees. None of the above benefits are taxable. 50. Poolco builds and installs swimming pools. The company will discount the price of a pool to its employees that choose to have one built. Given the information shown below, how much would an employee have to include as income if he took advantage of this discount? Normal Selling Price $2,500 2,500 $5,000 Poolco's Cost $1,750 1,250 $3,000 Employee's Cost $1,625 1,625 $3,250 Materials Labor a. b. c. d. $1,750 $750 $500 $0, because employee's cost exceeds Poolco's cost 6-16 Chapter 6 Gross Income: Inclusions and Exclusions 51. Sgt. C is transferred to a post in California. During the year, he received compensation from the U.S. Army valued as follows: active duty pay, $15,000; allowance for moving expenses, $1,400; re-enlistment bonus, $1,500; and meals and lodging, $6,000. Included in Sgt. C's gross income is a. b. c. d. $23,900 $17,900 $16,500 $15,000 52. In which of the following independent situations does the taxpayer have taxable income? a. b. c. d. Taxpayer L inherited land valued at $200,000 from the estate of his wealthy grandfather. Taxpayer M, who manages a hotel, is required to live in the hotel for the employer's convenience and as a condition of employment. The value of the lodging, provided without charge, is equal to $500 per month. Taxpayer N, who is an emergency room nurse, is required to eat in the hospital cafeteria to be available for emergencies. The meals are free to N. Taxpayer O received $1,000 in interest on $15,000 that her aunt gave her last year. 53. H and W are divorced. Pursuant to the divorce decree, H transferred stock with a FMV of $60,000 (basis to H of $25,000) to W. W's basis in the stock received is a. b. c. d. $60,000 $25,000 $35,000 $0 54. Which of the following would best improve the tax position of a divorcing husband who will be required to contribute toward the support of his ex-wife? a. b. c. d. Pay her alimony A large property settlement with the ex-wife Voluntary cash payments to the ex-wife Transfer assets to ex-wife before divorce or separation 55. In a verbal agreement, W is to receive $150 per month for her maintenance and support (ending on her death or remarriage) and $250 for child support. The $250 payment is to stop when the child reaches age 18. During the current year, she received 12 payments of $400 each. The amount included in W's gross income is a. b. c. d. $0 $2,400 $1,800 $4,800 56. Alimony payments by H to W for the first three years after divorce are as follows: First year Second year Third year $90,000 60,000 30,000 The recapture amount in the third year from the second year is a. b. c. d. $15,000 $30,000 $20,000 $10,000 Test Bank 6-17 57. Alimony payments by H to W for the first three years after divorce are as follows First year Second year Third year $90,000 60,000 30,000 The recapture amount in the third year from the first year is a. b. c. d. 58. $30,000 $60,000 $45,000 $37,500 Alimony payments by H to W for the first three years after divorce are as follows: First year Second year Third year $90,000 60,000 30,000 The recaptured amounts from the second and first years will be treated as follows in the third year: a. b. c. d. 59. H's gross income is increased by $52,500 and W's deduction for A.G.I. is increased by $52,500. W's gross income is increased by $52,500 and H's deduction for A.G.I. is increased by $52,500. H's gross income is increased by $52,500 and W's deduction from A.G.I. is increased by $52,500. W's gross income is increased by $52,500 and H's deduction from A.G.I. is increased by $52,500. D and M are divorcing. D loves his two children and agrees to support them with the amount of $500 per month, ending on the later of the child's 18th birthday or 22nd birthday, if the child pursues a full-time college education. He further agrees to pay his ex-wife $1,500 per month for her maintenance and support, ending on her death or remarriage. These agreements are contained in their divorce decree. D pays his ex-wife the $2,000 per month under the terms of the decree, using one check. How much of each $2,000 check is a nondeductible child support expense for D? a. b. c. d. $2,000 $500 $0 Cannot figure amount without information on amount wife actually uses for child support 60. H and W divorced six months ago. W is supposed to get H's Picasso painting, which he had bought for $20,000. At the time of transfer to W, the work of Picasso is valued at $100,000. Which of the following tax consequences would occur? a. b. c. d. H has an $80,000 taxable gain. W has an $80,000 taxable gain. W has a $20,000 taxable gain. There was no taxable income on this transfer. 61. A divorce decree states that H is to pay $600 per month as alimony and support of three minor children. The decree also provides that the payments will decrease by one-fourth: (1) if the former spouse dies or remarries, and (2) as each child reaches 21 years of age. The first payment was due November 1. H paid $400 in November and $550 in December. How are these payments allocated between child support and alimony? a. b. c. d. $950.00 child support and zero alimony $650.00 child support and $300.00 alimony $900.00 child support and $50.00 alimony $712.50 child support and $237.50 alimony 6-18 Chapter 6 Gross Income: Inclusions and Exclusions 62. Which of the following represents taxable income to the recipient? a. b. c. d. Scholarship used to pay tuition at a state university Scholarship used to purchase books required for a course of study at a state university Scholarship used to purchase equipment required for a course of study at a state university Scholarship used to pay for room and board at a state university 63. L, an undergraduate accounting major, received a $5,000 scholarship during the year. She used the money for the following school-related expenses: tuition $800, books $300, room and board $3,000, and supplies $100. How much of the scholarship is included in L's gross income? a. b. c. d. $5,000 $4,200 $800 $3,800 64. S is selling a shoe repair shop this spring and is unsure how to word the sales agreement to his best advantage. The price he is to receive exceeds the fair market value (FMV) of all identifiable net assets. Also, the purchaser insists on a non-competition arrangement. S would be best served by a. b. c. d. Allocating all amounts in excess of FMV to the non-competition clause Allocating all amounts in excess of FMV to goodwill Allocating 50 percent of excess amounts to the non-competition clause and 50 percent to goodwill Allocating 25 percent of excess amounts to the non-competition clause and 75 percent to goodwill 65. For which of the following independent situations would the recipient be required to recognize taxable income? a. b. c. d. Fire to a building resulted in a bookstore being closed for two months. An insurance company paid the proprietor of the bookstore $12,000 for lost profits during the two-month period. As part of the sale price of a drug store, the seller received $12,000 for agreeing not to compete with the buyer in the same town. On January 1 of the current year, X leased a building from Y. In lieu of paying Y rent of $1,000 per month, X made improvements to the building amounting to $12,000. All of the above; each recipient is required to recognize $12,000 of taxable income. 66. H purchases a farm with an abandoned farmhouse on it. In the attic, he finds a mattress stuffed with $20,000 in old silver certificate bills. The tax consequences of this find are a. b. c. d. Taxable income of $20,000 to the former owner of the mattress Taxable income of $20,000 to H No tax consequences at this time Capital gain of $20,000 67. A flood forced A to live in a hotel for two months before she could return home. On average, it cost A $600 per month to live in her home. A's insurer paid out to A a total of $3,600: $1,800 for each of the two months to cover temporary living costs. A paid a corresponding $3,000 hotel bill. Of the $3,600 paid by the insurance company, how much, if any, is taxable to A? a. b. c. d. e. $1,800 $3,600, reduced by the statutory multiplier $600 $0 $2,400 68. Which of the following types of interest income are taxable for Federal income tax purposes? a. b. c. d. Interest on New York City School bonds Interest on State of Michigan bonds Interest on life insurance proceeds that the beneficiary elected to receive in installments over a 10-year period None of the above is taxable. Test Bank 6-19 69. Which of the following would not be a good purchase for someone seeking to defer taxable income? a. b. c. d. Rare coins Deferred life annuity Six-month CDs compounded daily A lot located near a recreational lake 70. G was injured when an elevator at his place of work fell three floors, permanently losing the use of his left hand. As a result, he received disability income of $700 per month for six months during the current year. G's employer paid 60 percent of the annual premium on the disability policy, and G paid the remainder. The amount included in G's gross income is a. b. c. d. $0 $2,520 $4,200 $1,680 71. Items that generally may be excluded by businesses from gross income are: a. b. c. d. Debt cancellation (under bankruptcy proceedings), lease cancellation payments, and leasehold improvements (not in lieu of rent) Lease cancellation payments, contributions to capital, and leasehold improvements (not in lieu of rent) Debt cancellation (under bankruptcy proceedings), lease cancellation payments, and contributions to capital Debt cancellation (under bankruptcy proceedings), contributions to capital, and leasehold improvements (not in lieu of rent) 72. Alimony payments are to be paid by A to Z according to the following schedule: Year Amount One $50,000 Two $32,000 Three $10,000 What is the required recapture in year three from year two? a. b. c. d. 73. $0 $32,000 $22,000 $7,000 Alimony payments are to be paid by A to Z according to the following schedule: Year Amount One $50,000 Two $32,000 Three $10,000 What is the required recapture amount in year three from year one? a. b. c. d. 74. $17,500 $25,000 $3,000 $10,000 A and B, who are married and file a joint return, have AGI for the current year of $32,000. In addition, they received tax-exempt interest income of $3,000 and Social Security benefits of $8,600. The Social Security benefits to be included in A and B's gross income for the current year is a. b. c. d. $0 $3,650 $7,300 $4,300 6-20 Chapter 6 Gross Income: Inclusions and Exclusions 75. A and B, who are married and file a joint return, have AGI for the current year of $42,000. In addition, they received tax-exempt interest income of $6,000 and Social Security benefits of $15,000. The Social Security benefits to be included in A and B's gross income for the current year is a. b. c. d. $0 $7,500 $12,750 $11,750 76. A is employed in Chicago as a stewardess for AMX Airlines. The airline has a policy that allows employees to fly without charge on a standby basis only. In September, A flies from Chicago to Los Angeles to visit her father. The value of the ticket is $400. B is employed as a manager of the HMO Hotel in Chicago. HMO has a reciprocal agreement with the DEF Hotel in Boston that allows employees of both hotels to stay free of charge at either hotel provided space is available. In October, B spends two nights in Boston at the DEF Hotel. The value of the room for the two nights is $350. The tax consequences of these benefits are: a. b. c. d. A can exclude the value of the airplane ticket from the gross income and B can exclude the value of the hotel room from gross income. A must include the value of the airplane ticket in gross income but the value of the hotel room to B is tax-free. B must include the value of the hotel room in gross income but the value of the airplane ticket to A is tax-free. A must include the value of the airplane ticket in gross income and B must include the value of the hotel room in gross income. 77. ABC Video sells VCRs and television sets. On July 1 of the current year, ABC sells a color T.V. to D, one of its sales clerks, for $400. The T.V. normally retails to customers for $600 and ABC's gross profit rate is 20%. J is an attorney for the JKL law firm. The firm pays J's annual dues to the American Bar Association. The tax consequences of these benefits are: a. b. c. d. D can exclude the entire discount on the purchase of the T.V. from gross income and J can exclude the annual dues to the American Bar Association from gross income. Although J is not required to include the payment of the dues in gross income, D must include $80 of the discount in gross income. Although D is only required to include a portion of the purchase of the T.V. in gross income, J must include the annual dues paid to the American Bar Association in gross income. D must include the entire discount on the purchase of the T.V. in gross income and J must include the annual dues to the American Bar Association in gross income. 78. Employer P provides qualified parking with a fair market value of $250 per month to Employee D, but charges Employee D $45 per month. How much is includible in Employee D's gross income? a. b. c. d. $250 per month $205 per month $45 per month None of the above. The correct answer is $ per month. 79. During the current year, U made a $36,000 contribution to a 529 plan to help cover the cost of an undergraduate degree for D, her 15-year-old daughter. Assume that in the year D enrolls as a freshman at State University, the balance in the 529 plan has grown to $45,000. If D receives an $11,000 distribution to pay for her tuition, she may exclude from her gross income: a. b. c. d. $11,000 $0 $8,800 $2,200 Test Bank 6-21 80. During the current year, U made a $36,000 contribution to a 529 plan to help cover the cost of an undergraduate degree for D, her 15-year-old daughter. Assume three years later D elects to join the work force when she graduates from high school (rather than attend college) and the entire $45,000 accumulated in the 529 plan is distributed to U. How much is included in U's gross income? a. b. c. d. $45,000 $36,000 $9,000 $0 81. L and M are married and file a joint return. Having no children of their own, they adopted a three year old "special needs" child. L and M incurred $10,000 in qualified adoption expenses such as adoption fees, attorney fees and court costs. The $10,000 was furnished to M under an adoption assistance program maintained by his employer. Assuming L and M's AGI for the current year amounts to $105,000 before considering adoption assistance, how much of the $10,000 payment must the couple include in their gross income? a. b. c. d. $0 $10,000 $6,000 $8,500 82. C was recently diagnosed with a rare liver disorder and has been certified by his medical doctor, on June 1 of the current year, as terminally ill. C immediately resigned from his sales position with IBM and, on July 1 of the current year, sold his life insurance policy with a face value of $300,000 to a viatical "settlement provider" (VSP) for $240,000. Assuming C paid $30,000 in premiums, how much of the $240,000 proceeds must he include in his gross income for the current year? a. b. c. d. $0 $300,000 $210,000 $240,000 83. Refer to the facts in Question 82. If C dies 10 months later, how much must VSP include in its gross income assuming it paid additional premiums of $12,000 after purchasing the policy? a. b. c. d. $0 $48,000 $300,000 $60,000 84. Which of the following should not be included in taxable income for individuals? a. b. c. d. e. Alimony Child Support Dividends from a corporation that is 100% owned by the taxpayer. Interest from a checking account Tips 85. Hunter is deciding between purchasing General Motors Corporate bonds and State of Michigan bonds. In either case, Hunter will invest $10,000. The corporate bonds pay 15% annually. Assuming Hunter's marginal tax rate is 34%, he will be indifferent to choosing either option if the state bonds pay an annual rate of: a. b. c. d. e. 5.1% 9.9% 15% 19% 22.7% 6-22 Chapter 6 Gross Income: Inclusions and Exclusions 86. During the current year K reported the following items: Wages: Alimony paid: Child support paid: Federal income tax refund: State income tax refund: $50,000 5,000 10,000 1,000 ,300 The Federal and State income tax refunds were for taxes paid in the prior year. During the current and prior year, K used the standard deduction rather than itemizing. How will these items affect K's taxable income for the current year? a. b. c. d. e. 87. Increase taxable income by $45,000 Increase taxable income by $45,300 Increase taxable income by $35,000 Increase taxable income by $35,300 Increase taxable income by $46,300 Which of the following would render an otherwise nontaxable scholarship/fellowship at least partially taxable: I. The recipient is engaged in a post-doctoral research effort (i.e., not a degree candidate). II. The recipient used scholarship proceeds to pay for books III. The recipient used scholarship proceeds to pay for room and board. a. b. c. d. e. I. only III. only I. and II. only I. and III. only I., II. and III. 88. W and B are married, file a joint return, and report the following income during the current year: Dividends $70,000 Social Security Benefits $10,000 Calculate the taxable amount of their social security benefits. a. b. c. d. e. $5,000 $8,500 $10,000 $21,500 $31,350 6 Gross Income: Inclusions and Exclusions Solutions to Test Bank True or False 1. True. An example is that nontaxable employee fringe benefits do not have to be recorded on the tax return; yet total dividend income, while divided into two parts--the nontaxable portion (e.g., return of capital) and the taxable portion--is reported in full and the nontaxable portion is subtracted in arriving at gross income. (See p. 6-2.) 2. False. Distributions in excess of current and accumulated earnings and profits are considered a return of capital until the shareholder's basis in the stock is reduced to zero and are thereafter capital gains. (See pp. 6-4 and 6-5.) 3. True. Mutual funds can deduct dividends, whereas C corporations cannot. (See p. 6-5.) 4. False. Regardless of whether the shareholder elects to take stock or cash, he or she has dividend income as long as the choice is available. [See p. 6-6 and 305(b)(2).] 5. False. For example, interest received from industrial development and arbitrage bonds is included in the gross income of the recipient. [See p. 6-8 and 103(b) and (c).] 6. True. If the annuitant dies before the entire investment is recoverd, the unrecovered amount is deductible. (See Example 12 and p. 6-12) 7. True. The reimbursement by the employer is included in gross income of the employee but may be offset by an employee business deduction. Note that there is an exception to this general rule when employees have properly accounted for the expense that was reimbursed to their employer. (See p. 6-19.) 8. False. Amounts transferred from an employer to an employee in the form of cash or other property ("employer gifts" or "employer awards") are not excludable as a gift. [See p. 6-19 and 102(a).] 9. False. The Social Security Amendments Act of 1983 requires that a portion of social security benefits received by high income bracket recipients after 1983 be included as taxable income. Under the 1993 legislation, retired individuals with high incomes may find that more of their social security benefits could be taxable beginning in 1994. (See pp. 6-20 through 6-22.) 6-23 6-24 Chapter 6 Gross Income: Inclusions and Exclusions 10. False. Since its inception the tax law has contained an exclusion for life insurance proceeds received by a beneficiary after an insured person's death. (See p. 6-40.) False. The Kowalski case states that there is no exclusion from income of reimbursement for meals that are taken for the employer's convenience. The exclusion is only for meals furnished in kind. (See footnote 60 and p. 6-27.) True. The employee's exclusion for dependent care assistance is limited to $5,000 annually ($2,500 for married, filing separately). (See pp. 6-28 and 129.) True. Since the latter company would not incur any additional cost in this case, there would be no taxable income for UFO Airlines' employees who took advantage of the empty seats. The exclusion is extended to benefits provided under a written reciprocal agreement by another employer that is in the same line of business. [(See Exhibit 6-7 and p. 6-31.) and 132(b) and 132(i).] False. The payments received before the divorce were paid voluntarily and before any divorce or separate maintenance agreement was made; consequently, they are excludable. W has taxable income of $1,000 for the alimony payments received after the divorce. [See Example 34 and pp. 6-36 through 6-37 and 71(a).] False. Amounts received for child support are nontaxable for children under age 21, regardless of state laws. (See pp. 6-39 and 6-40.) False. Prizes and awards are fully taxable. The winnings are included in gross income to the extent the winnings exceed the cost of entering the contest--$18. [See p. 6-42, 74(a), and Reg. 1.74-1(a)(2).] True. If materials are received instead of cash by farmers from the government, the fair market value of the materials is included in gross income. (See p. 6-47.) True. Business interruption insurance proceeds are included in gross income regardless of whether they are a reimbursement for the loss of the use of property, to pay overhead expenses, or to compensate for lost profits. [See p. 6-48, Reg. 1.1033(a)-2(c)(8), and Rev. Rul. at footnote 120.] True. Even if the leasehold improvements substantially increase the property's value, they are excluded from gross income if they were not made in place of rent payments. (See p. 6-50 and 109, and Reg. 1.109-1.) True. State income tax refunds are nontaxable except to the extent the taxpayer received a tax benefit in a prior year. Unless an individual taxpayer itemizes deductions, a tax benefit is not obtained. It is not possible to itemize deductions when filing Form 1040A. [See p. 6-51 and 111(a).] 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. Multiple Choice 21. c. Interest on obligations of a state or any of their political subdivisions such as a municipal government is nontaxable. [See pp. 6-7 through 6-8, and 103(a) and 301.] 22. c. Distribution Dividend (Taxable) Current E&P Accumulated E&P Return of investment (Nontaxable) Capital gain Totals $135,000 $ 15,000 40,000 76,000 4,000 $135,000 [See Example 1, p. 6-4, and 316(a) and 301(c)(3).] Solutions to Test Bank 6-25 23. b. The basis of each share after the common stock dividend is $10 ($2,200 divided by 220 shares). [See Example 2, p. 6-6 and 307(a).] 24. a. The holding period for the new common stock begins on the same date that the original common stock was acquired, or January 1, 2005. (See p. 6-6 and 1223.) H's share of the distribution 1% of $4 million Less taxable dividend from E&P 1% of $2 million Less nontaxable return of H's capital (100 shares $30) Capital gain (See Example 1 and p. 6-4.) 25. b. $ 40,000 (20,000) $ 20,000 (3,000) $ 17,000 26. 27. c. The mere labeling of a distribution as a dividend does not qualify it as a dividend. (See p. 6-5.) c. As long as the shareholders do not have the option of receiving cash or assets in lieu of the stock, a stock dividend is nontaxable. The value of the outstanding shares has not been affected, just the number. (See Example 2 and p. 6-6.) a. Only the interest on tax-exempt bonds is nontaxable. The sale of tax-exempt bonds results in a gain or loss. (See p. 6-8.) b. Although not discussed in the text, this is commonly referred to as the "rule of 72." Dividing 72 by the annual rate of return produces a close approximation of the time it will take the investment to double. The formula to approximate the number of years is 72/9 8 years. d. After H and W retire, their taxable income will undoubtedly decrease, putting them in a lower tax bracket. The tax on the income generated by the annuity is not only deferred until payments are made out of the annuity, but those payments will be taxed at the annuitant's tax rate at time of receipt. (See pp. 6-10 and 6-11.) c. $12; 000 $1; 200 $480 $100 12 25:0 $30; 000 28. 29. 30. 31. [See Example 10, pp. 6-12 and 6-13 and 72(b)(1).] 32. d. The total amount B excludes is $9,600 ($480 20.0 years $9,600), and the unrecovered amount of $2,400 is allowed as a deduction on B's final tax return. [See Example 12, pp. 6-12 and 6-13 and 72(b)(3).] a. If B lives 26 years, the total amount he excludes is limited to $12,000 ($480 25.0 years $12,000). Therefore, the amount that B must include in gross income for year 26 is the entire $1,200 received. [See Example 12, pp. 6-12 and 6-13 and 72(b)(2).] b. $6; 000 $125 6 $150 nontaxable return of capital $125 12 20 and ($125 6) $150 $600 taxable portion. [See Example 11, pp. 6-12 and 6-13 and 72(b).] 35. b. The entire $400 cash Christmas bonus would be included in the recipient's gross income as compensation. The turkey is treated as a de minimis fringe benefit and is nontaxable to the employee. Choices c and d do not exceed the $400 statutory amount for employer awards for two specific types of achievements: lengthof-service and safety. The maximum award total awards that can be given is $400 per year or $1,600 for all qualified plan awards. Thus, the watch and silver cup are excluded from gross income. [See pp. 6-19 through 6-20 and 74(c) and 274( j).] 33. 34. 6-26 Chapter 6 Gross Income: Inclusions and Exclusions 36. c. Salary Pension Dividends Tentative A.G.I. Taxable social security benefits: Tentative A.G.I. Plus: tax-exempt interest 1= of social security benefits 2 Combined income E's taxable social security is $2,250 computed as follows: Step 1 Amount Lessor of 50% social security of $5,000 Or 50% ($36,500 $32,000) $4,500) Step 1 amount and taxable social security benefits $15,000 14,000 2,000 $31,000 $31,000 3,000 2,500 $36,500 $ 2,500 $ 2,250 $2,250 (See Examples 19 and 20, pp. 6-20 through 6-22, and 86.) 37. c. Employer awards to employees are generally nontaxable if given for length of service or safety achievement. However, to be nontaxable, the awards must be made with tangible personal property (i.e., no exclusion for cash payments). Also, length-of-service awards are not excludable if made within five years of employment. [See p. 6-19 and 74(c) and 274( j).] 38. c. Qualifying employer awards to employees are deductible by the employer and nontaxable to the employee if the amount does not exceed statutory limits. A $400 annual limit applies in this problem. Excess costs are taxable income (for U) to the extent of the greater of (1) the nondeductible cost to the employer due to limitations ($600 $400, or $200) or (2) the property's market value in excess of the limitations ($725 $400, or $325). (See Example 18 and p. 6-20.) b. High income bracket recipients have their social security benefits taxed according to a formula found on pp. 6-20 and 6-21. b. Nontaxable income for group-term life insurance is limited to $50,000 coverage. (See pp. 6-23 and 6-24 and 6-29 through 6-33.) d. $5.16 $50,000 $1,000 $258 28% $72.24. [See Example 21, pp. 6-23 and 6-24, and 79(a).] a. Ordinarily, when a policy is transferred, any gain from the death proceeds is taxable income. There are four exceptions noted in the text. One exception to this is when the transferee is a corporation in which the insured is a shareholder or an officer. [See p. 6-42 and 101(a)(2)(B).] 39. 40. 41. 42. 43. b. The reimbursement is included in this year's gross income to the extent a tax benefit was obtained last year: Total medical expenses Less: 7.5% of $50,000 (A.G.I.) Medical expense deduction from last year (i.e., tax benefit) (See Example 22, p. 6-24, and 111.) $ 6,000 (3,750) $ 2,250 Solutions to Test Bank 6-27 44. b. All income received under an employer-financed disability plan is taxable. In contrast, all disability income is nontaxable if the taxpayer paid the premiums on the disability policy. Life insurance proceeds are nontaxable to the beneficiary and all payments received for loss of function or loss of part of the body are nontaxable. [See pp. 6-25, 6-26 and 6-40; Examples 24, 25, and 40; and 101(b), 105(a) and (c), and 104(a)(3).] 45. d. When the employee pays for the coverage, amounts received are nontaxable or only partially taxed if the employer pays a percentage of the coverage. Payments for permanent bodily injury are nontaxable regardless of who purchased the coverage. (See pp. 6-25 and 6-26.) d. Choices a. and c. are correct because all payments that qualify as death benefits are deductible by the employer and taxable income for the beneficiaries. Choice b is correct because the Christmas bonus is taxable income and reported on the recipient's return as income in respect of a decedent. (See pp. 6-17 and 6-42.) d. R's lodging is provided for the convenience of the employer and is located on the business premises. Additionally, R is required to occupy the quarters in order to perform employment duties. Therefore, it is nontaxable to R. (See pp. 6-26 and 6-27 and 119.) d. Meals and lodging provided for the convenience of the employer are excludable. Gross income is computed as follows: $225 salary 7 weeks $1,575. (See pp. 6-26 and 6-27 and 119.) 46. 47. 48. 49. d. In 1984, Congress enacted Code 132, which excludes the following benefits from taxation: working condition fringe benefits, no-additional-cost services, qualified employee discounts, de minimis fringe benefits, and qualified tuition reduction by educational institutions. (See pp. 6-29 through 6-33.) c. Employee's taxable income for materials is $125 [($2,500 $1,625 $875) ($2,500 $1,750 $750)] and for the labor is $375 [($2,500 $1,625 $875) ($2,500 20% $500)]. (See Example 29 and p. 6-31.) c. Active duty pay and re-enlistment bonuses are taxable compensation, but the rest are nontaxable. (See p. 6-34.) d. Section 102 excludes the value of property received as a gift or inheritance. However, this exclusion does not include interest received by taxpayer O on the money she received from her aunt. Also, 119 excludes the value of meals and lodging provided for the convenience of the employer, on the employer's premises, and in regards to lodging, as a condition of employment. (See pp. 6-26, 6-27, and 6-35.) b. H's basis of $25,000 carries over to W so that her basis is also $25,000. (See Example 33 and p. 6-35.) 50. 51. 52. 53. 54. a. Payments classified as alimony would be deductible by the ex-husband. The other alternatives listed in the problem do not qualify as deductions, and thus would have no immediate tax advantage to the husband. (See Example 62 and pp. 6-35 through 6-40 and 6-56.) a. Amounts do not qualify as alimony unless they are agreed to by written decree, instrument, or agreement. Child support is always nontaxable: it is a nondeductible personal expense of the payor and nontaxable to the payee. (See pp. 6-35 through 6-44 and 71.) a. Payments made in second year Less payments made in third year Excess Less safe harbor amount Amount recaptured $ 60,000 (30,000) $ 30,000 (15,000) $ 15,000 55. 56. [See Example 36, p. 6-37, and 71(f ).] 6-28 Chapter 6 Gross Income: Inclusions and Exclusions 57. d. Payments made in first year Less average of: Second year payments Less recapture Net Third year payments Total Average ($75,000/2) Subtotal Less safe harbor amount Amount recaptured $ 90,000 $ 60,000 (15,000) $ 45,000 30,000 $ 75,000 (37,500) $ 52,500 (15,000) $ 37,500 [See Example 36, p. 6-37, and 71(f ).] 58. a. H's gross income in the third year following divorce will be increased by $52,500 (i.e., $15,000 $37,500) and W's deduction for A.G.I. is increased by a like amount. [See Example 36, p. 6-37, and 71(f).] 59. b. Payments qualify as child support only if they meet the requirements of (1) specific amount fixed or contingent on child's status, (2) paid solely for support of minor, and (3) payable under the terms of decree or agreement. In this problem, the amount of child support was properly specified in the decree. There is no requirement that it be paid by separate check. [See pp. 6-39 and 6-40 and Reg. 1.71-1(e).] d. Transfers of property between former spouses incident to a divorce and within one year of the divorce are nontaxable. Note, however, that H's basis transfers with the property. (See p. 6-35 and 1041.) c. Based on the wording in the divorce decree, child support amounts to $450 per month (3 $150) and alimony $150 per month. Once child support is established, no payments are considered to be alimony until all past and current child support payments are made. In other words, amounts can be allocated to alimony until all past and current child support payments are satisfied. Therefore, of the total payments of $950 made in November and December, $900 is allocated to child support and only $50 is allocated to alimony. [See Examples 38 and 39, pp. 6-39 and 6-40, 71(b), and Reg. 1.71-1(e).] d. Amounts received for room and board cannot be excluded. (See pp. 6-43 and 6-44 and 117.) d. L may exclude the amount spent for tuition, books, and supplies. Therefore, her taxable amount is $5,000 ($800 $300 $100) or $3,800. (See pp. 6-43 and 6-44 and 117.) b. Amounts assigned to the non-competition agreement are included in ordinary income. However, the amount assigned to goodwill is taxable as a capital gain. (See p. 6-48 and Example 50.) d. Amounts received for a covenant not to compete, leasehold improvements made in lieu of rent, and business interruption insurance proceeds are all taxable. [See pp. 6-48 through 6-50 and Reg. 1.1033(a)2(c)(8) and 1.109-1.] b. Cash or other assets found by a taxpayer (asset discovery) are taxable income even if found accidentally, with no effort expended in discovering them. (See footnote 132 and p. 6-51.) c. When a person's residence is damaged to the extent that he or she cannot live there, proceeds from an insurance contract that are paid to reimburse for temporary living costs are not included in the taxpayer's gross income unless the extra costs ($3,000) are less than the insurance proceeds ($3,600). Therefore, A has $600 of taxable income. (See p. 6-52 and 123.) c. Each installment payment includes a ratable portion of the life insurance proceeds plus taxable interest. (See Example 58, pp. 6-53 and 6-54, and 61 and 103.) 60. 61. 62. 63. 64. 65. 66. 67. 68. Solutions to Test Bank 6-29 69. c. Interest on the CDs will be taxable during the current year because the interest is constructively received on a daily basis. (See pp. 6-53 and 6-54.) b. $700 6 $4,200 60% $2,520. All disability income is nontaxable if the taxpayer paid for the disability coverage. However, in this problem the employer paid 60 percent of the premium. Consequently, 60 percent of the disability payments must be included in G's gross income. (See Example 25 and p. 6-26.) d. Lease cancellation payments received by the lessor are considered to be a substitute for rent. When received by the lessee, they are considered to be proceeds from the sale of the lease. (See p. 6-52 and 1241.) The other three items are nontaxable. (See pp. 6-49 through 6-50 and 6-44 through 6-46 and 108, 109, 118, and 721.) d. Since payments decrease by more than $15,000, recapture is required in the third year. The recapture from the second year is $7,000 ($32,000 paid in the second year $10,000 paid in the third year $15,000). (See Example 37 and pp. 6-37 and 6-38.) a. The recapture from the first year is $17,500 [$50,000 paid in the first year ($32,000 paid in the second year $7,000 excess from 72 above $25,000 $10,000 paid in the third year $35,000/2 $17,500 average for the two years) $15,000]. (See Example 37 and pp. 6-37 and 6-38.) b. A and B's modified AGI amounts to $39,300 [$32,000 $3,000 50% ($8,600)]. Therefore, the Social Security benefits to be included in gross income is $3,650 computed as follows: Step 1 Amount Lesser of (1) 50% $8,600 or (2) 50% ($39,300 $32,000) Step 1 amount and taxable Social Security benefits (See Examples 19 and 20, pp. 6-20 through 6-22 and 86.) 70. 71. 72. 73. 74. $4,300 $3,650 $3,650 75. c. A and B's modified AGI amounts to $55,500 [$42,000 $6,000 50% ($15,000)]. Therefore, the Social Security benefits to be included in gross income is $12,750 computed as follows: Step 1 Amount Lesser of (1) 50% $15,000 or (2) 50% ($55,000 $32,000) Step 1 amount Step 2 Amount Lesser of (1) Step 1 amount ($7,500), not to exceed $6,000 85% ($55,000 $44,000) or 85% $15,000 $ 7,500 $11,750 $ 7,500 $ 6,000 9,775 $15,775 $12,750 $12,750 (2) Step 2 amount and taxable Social Security benefits (See Examples 19 and 20, pp. 6-20 through 6-22 and 86.) 6-30 Chapter 6 Gross Income: Inclusions and Exclusions 76. a. Because AMX Airline incurs no substantial additional cost (i.e., A flies on a standby basis), the value of the ticket is excludable from A's gross income under 132(b). Furthermore, under 132(I), B has nontaxable income for the free use of the hotel room provided by the DEF Hotel which has a qualified reciprocal agreement with B's employer (the HMO Hotel). (See Exhibit 6-7 and pp. 6-30 through 6-31.) b. J may exclude the annual fees paid by her law firm to the ABA as a working condition fringe benefit under 132(d). However, under 132(c) pertaining to employee discounts, D must report $80 of gross income computed as follows: Price charged to regular customers Less: Gross profit percentage (20%) Price charged to employee D Amount included in D's gross income (See Example 29 and pp. 6-29 through 6-31.) $ ,600 ( ,120) $ ,480 ( ,400) $ ,080 77. 78. d. Employee D must include $0 per month in his gross income computed as follows: FMV of the parking Less: Amount paid by D Exclusion for parking Includible in gross income (See Example 31, p. 6-33 and IRS Notice 94-3). $250 (45) (230) $,0 0 79. 80. a. As long as the amounts are used to pay for tuition, the distribution is tax free. (See Example 15, p. 6-16.) c. U must include $9,000 in her gross income (i.e., total proceeds received of $45,000 less total contributions of $36,000. (See p. 6-16.) b. The Code allows a $13,170 per child exclusion. The exclusion begins to be phased out for taxpayers with modified AGI above $185,210. (p. 6-28.) a. Because C is expected to die in 24 months or less, the accelerated death benefit of $240,000 is excluded from his gross income. (See Example 41, p. 6-41.) b. When VSP collects the life insurance proceeds of $300,000, it must include a gain of $48,000 in it gross income computed as follows: Insurance proceeds Less: cost of policy additional premiums Gain recognized (See Example 41, p. 6-41.) $ 300,000 (240,000) (12,000) $ 48,000 81. 82. 83. 84. b. Amounts that qualify as child support are nondeductible personal expenses for the payor and nontaxable income to the payee. (See p. 6-39). b. 15% (1 .34 .66) 9.9%. (See p. 6-7). a. Wages of $50,000 are included in K's gross income and alimony paid of $5,000 is deductible in arriving at K's AGI. Therefore, K's taxable income will increase by $45,000. Federal income tax refunds are not included in gross income and state income tax refunds are included in gross income only when the taxpayer itemizes his or her deductions (i.e., the tax benefit theory). Child support payments represent nondeductible expenditures. (See Example 22, pp. 6-3, and 6-35). 85. 86. Solutions to Test Bank 6-31 87. d. An exclusion of scholarships is allowed if the amounts received are used for tuition and related expenses, including fees, books, supplies, equipment, etc. but not room and board. Also, the individual must be a candidate for a degree. (See Examples 44 and 45, pp. 6-43 and 6-44). b. W and B's modified AGI $70,000 (50% $10,000) $75,000. The taxable portion of their social security benefits is calculated as follows: Step 1 Amount Lesser of (1) 50% $10,000 or (2) 50% ($75,000 $32,000) Step 1 amount 88. $5,000 21,500 $5,000 Step 2 Amount Lesser of (1) $5,000 85% ($75,000 $44,000) or (2) 85% $10,000 Step 2 amount (See Examples 19 and 20, pp. 6-20 through 6-23). $31,350 $8,500 $13,600 6 Gross Income: Inclusions and Exclusions Comprehensive Problems 1. H, who is 48 years old, lives in a suburb of Chicago and is president of ABC, Inc. H's 2011 salary from ABC, Inc., is $70,000. H is also the sole owner of a travel agency, XYZ, Inc., which is managed by his brother-in-law. On January 1, 2011, H signed a divorce decree with W. Their two children, ages 12 and 13, live with W. Other facts concerning H's financial situation are as follows. Corporate distributions. XYZ, Inc., distributed $20,000 to H on December 31, 2011. The corporation's current E&P was $12,000 and its accumulated E&P was zero. H's basis in the XYZ stock before the distribution was $40,000. The building in which XYZ, Inc., is located is owned by H. The firm paid H $8,000 in lease payments during 2011, and H's expenses in maintaining the building, including depreciation, amounted to $4,500. Employee benefits. ABC, Inc., provided H with the following benefit package: Annual Cost to ABC, Inc. Fringe Benefit Group-term life insurance of $100,000 Parking space Health insurance Accident and disability insurance $ ,900 ,600 1,800 ,400 Stock dividend. H owns 1,000 shares of ABC, Inc., common stock (FMV $40,000) with a basis of $22,000. H acquired the stock on March 14, 2005. He received 100 shares of nonconvertible preferred stock (FMV $10,000) as a stock dividend on April 1, 2011. H could not elect to receive cash or other property in lieu of the stock. Award. H has been very active in the Boy Scouts over the years. To show its appreciation, the local Boy Scout chapter took up a collection in the community and awarded H a set of golf clubs (FMV $600) at the chapter's annual banquet. Alimony and child care. Under the divorce agreement, H's house (cost $45,000 and current FMV $75,000) was transferred to W. H moved into an apartment. Also, H pays $3,000 per month as alimony and support of the two children. The agreement provides that the monthly payments will decrease by one-sixth as each child becomes 21 years old. 6-33 6-34 Chapter 6 Gross Income: Inclusions and Exclusions a. Calculate the following, showing your work. (1) (2) (3) b. The dividend income resulting from the XYZ, Inc., cash distribution of $20,000 H's basis in the XYZ, Inc., stock after the $20,000 distribution H's net rental income from the building leased to XYZ, Inc Calculate the following, showing your work. The amount included in H's gross income from the group-term life insurance provided by ABC, Inc. (Note: the regulations show that H's includable income factor per $1,000 per month is 0.15.) (2) The taxable portion of the ABC preferred stock dividend, if any (3) H's basis for the common stock and the preferred stock (4) The holding period of the preferred stock (1) c. Calculate the following, showing your work. (1) (2) (3) The gain, if any, on the transfer of the house to W W's basis in the house The monthly child support H is paying d. Calculate the following, showing your work. (1) (2) H's 2011 A.G.I. H's 2011 taxable income (assume H does not itemize his deductions) 2. H and W, 67 and 59 years old respectively, are married and file a joint return. H is retired and W continues to work part-time as a substitute teacher. Information concerning their financial situation follows. Annuity. On January 1, 2011, H purchased a single premium immediate life annuity for $11,040. It will pay $100 a month for the remainder of his life. Stock dividend. H and W own 200 shares of XYZ common stock. They paid $4,400 for the stock on July 20, 2005. On August 15, 2011, they received 20 shares of XYZ common as a stock dividend. They did not have the right to receive cash or other assets in lieu of the stock. Inherited property. On February 1, 2011, W inherited 100 acres valued at $100,000 from her father's estate. She leased the land to a local farmer, who paid her $5,000 on June 1 and $5,000 on October 1, 2011. W paid $2,000 in property taxes during 2011. Other items. In addition to the above, H and W received the following during 2011: Tax-exempt bond interest H's social security benefits W's wages Taxable interest income on corporate bonds a. $12,000 8,400 3,000 11,000 Calculate the following, showing your work. (1) (2) (3) The taxable portion of the XYZ common stock dividend, if any The per share basis in the 220 shares of XYZ common stock The holding period of the new common stock b. Calculate the following, showing your work. (1) (2) H's taxable income from the annuity for 2011 (H's expected return multiple is 18.4.) W's taxable income from the 100 acres she inherited from her father and subsequently leased c. Calculate the following, showing your work. (1) (2) H and W's A.G.I. (before considering H's social security benefits) The taxable portion of H's social security benefits d. Calculate H and W's 2011 taxable income, showing your work. (Note: H and W do not itemize their deductions.) Solutions to Comprehensive Problems 6-35 Solutions to Comprehensive Problems 1. a. (1) The $20,000 cash distribution on December 31, 2011 is treated as follows: From XYZ's current E&P--dividend Return of capital--nontaxable [See Example 1, p. 6-4 and 316(a) and 301(c)(3).] (2) Basis in stock before the distribution Less: Return of capital Basis in stock after the distribution $12,000 8,000 $40,000 (8,000) $32,000 11(3) Lease payments Less: Maintenance expenses (including depreciation) Net rental income 8,000 (4,500) $3,500 11b. (1) Total insurance coverage Less: "Tax-free" insurance Insurance coverage subject to tax Cost of coverage per $1,000 of protection for one-month period Amount included in H's gross income (0.15 12 50) $100,000 (50,000) $ 50,000 0.15 $ 90 11(2) (3) [See Example 21, pp. 6-24 and 6-25, and Reg. 1.79-3(d)(2).] Nonconvertible preferred stock distributed to common shareholders as a stock dividend is nontaxable. [See Example 3, p. 6-6, and 305(a).] H's basis for the 100 shares of ABC preferred stock is computed as follows: $10; 000 $22; 000 $4; 400 $10; 000 $40; 000 H's basis in the 1,000 shares of ABC common stock is $22,000 $4,400 = $17,600 [See Example 3, p. 6-6, and 305(a).] (4) The holding period of the ABC preferred stock takes on the holding period of the ABC common stock on March 14, 2005. [See Example 3, and p. 6-6.] 6-36 Chapter 6 Gross Income: Inclusions and Exclusions c. (1) (2) (3) Transfers of property between spouses or former spouses incident to a divorce are nontaxable regardless of the type of property. (See Example 33 on p. 6-36.) W's basis in the house is the same as H's basis or $45,000. (See Example 33 on p. 6-36.) This type of divorce agreement satisfies the contingency rule for child support. Therefore, $2,000 per month qualifies as alimony and $1,000 per month ($3,000 1/6 = $500 2 = $1,000) qualifies as child support. (See Example 38 on p. 6-40.) H's A.G.I. is computed as follows: Gross Income Salary Dividend from XYZ, Inc. Rental income Premiums on group-term life insurance over $50,000 Award from Boy Scouts (FMV) Less: Deductions for AGI Alimony ($2,000 12) Rental expenses A.G.I. d. (1) $70,000 12,000 8,000 ,090 ,600 $24,000 4,500 $ 90,690 (28,500) $ 62,190 $62,190 (2) A.G.I. Less: Standard deduction in 2011 Personal exemption Taxable income $5,800 3,700 (9,500) $52,690 112. a. (1) (2) (3) The stock dividend is common stock distributed to common shareholders and is therefore nontaxable. H and W's basis of $4,400 is allocated among the 220 shares of XYZ common for a $20 per share basis. The holding period for the new 20 shares of XYZ common is the same as the holding period of the original 200 shares of XYZ common or July 20, 2005. [See Example 2, p. 6-7 and 305(a) and 307(a).] H's nontaxable return of capital each year is $11; 040 $1; 200 $600 $1; 200 18:4 22; 080 Therefore, H's taxable income is $600 ($1,200 $600). [See Example 10, p. 6-12, 72(c)(3), and Reg. 1.72-9.] b. (1) (2) The FMV of the 100 acres that she inherited is excluded from gross income. (See p. 35 and 102.) However, the lease payments received of $10,000 minus the $2,000 in property taxes paid represents taxable income. Solutions to Comprehensive Problems 6-37 c. (1) W's wages Interest on corporate bonds Rental income Income from annuity Gross income Less: Deductions for A.G.I. Property taxes on land Tentative A.G.I. $ 3,000 11,000 10,000 ,600 $24,600 (2,000) $22,600 11(2) Taxable social security benefits: Tentative A.G.I. Plus: Tax-exempt interest One-half of social security benefits Modified AGI $22,600 12,000 4,200 $38,800 11- H's taxable social security is $3,400 computed as follows: Step 1 Amount Lessor of 50% social security of $8,400 Or 50% ($38,800 $32,000 = $6,800) Step 1 amount and taxable social security benefits (See Example 19, pp. 6-20 through 6-23, and 86.) $ 4,200 $ 3,400 $3,400 d. Tentative A.G.I. (from above) Plus: Includible social security benefits A.G.I. Less: Standard deduction ($11,600 $1,150) Personal exemptions (2 $3,700) Taxable income $ 22,600 3,400 $ 26,000 $12,750 7,400 (20,150) $ 5,850 11- ...
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