FTax IRGTB ch09 p001-044

FTax IRGTB ch09 p001-044 - 9 Capital Recovery Depreciation...

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Unformatted text preview: 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Cumulative Problems 9-43 5- Computation of the various elements of taxable income and comments on the treatment of the various items are given below. Note: This return is completed for 2010. For this purpose, the mileage rate for the entire year was assumed to be 50 cents per mile in 2010. Income Salary--David $60,000 Salary--Lauren's teaching 5,400 Interest Although a 1099-INT for interest of $30 was received, this entire amount is not treated as interest. The amount that had accrued to date of purchase, $25 ($1,000 6% 5/12), is considered part of the purchase price. Thus when the $30 payment is received, $25 represents a nontaxable return of ,005 capital and the other $5 is taxable interest income. Interest related to the Treasury Bill is reported in the year the instrument is redeemed. Schedule C: Lauren's clothing business Sales $120,000 Cost of goods sold (50,000) Gross profit $ 70,000 Advertising expense (6,000) Insurance No deduction for car insurance premium of $200 because the automatic mileage method is used. The entire $1,200 prepayment of fire insurance is deductible even though she is on the cash basis because she is contractually obligated to pay the expense (1,200) and the coverage does not extend beyond the close of the next tax year. Rent Same explanation as fire insurance above (9,000) Wages (15,000) Employment taxes (2,000) Car expense Only the car expense relating to the clothing business is reported on (10,000) this schedule (20,000 $0.50 for all of 2010). The remaining car expense is reported as an employee business expense on Schedule 2106. Travel expenses to Paris 9-1 9-2 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion 9-43 (cont.) Since more than 25 percent of the time is spent on business, the entire $500 travel expense is deductible and six days of meals, $90 ($30 6 50%), and lodging, $600 ($100 6), as well. Net income and self-employment income One-half of self-employment tax [($25,610 92.35% $23,651) 15.3% $3,619] 1=2 A.G.I. Deductions: Schedule A: Itemized deductions State income taxes County income taxes Real estate taxes Mortgage interest on their home Charitable contributions Miscellaneous: Form 2106, Lauren (mileage) (see below) Form 2106, David (see below) Total Less: 2% floor (2% $89,205) Total itemized deductions Adjusted gross income Itemized deductions Personal and dependent exemptions (3 $3,650 in 2010) Taxable income Tax on taxable income using tax table Child tax credit Income tax after credits Self-employment tax Total taxes Schedule 2106: Lauren Transportation Lauren may deduct transportation expenses of driving from one job to another. Here, she may deduct the cost of the lesser of the mileage from home to work (10 miles) or from the first job to the second job (16 miles) The deduction is $440 [(80 trips 10 miles 800) $0.50 in 2010)] and is subject to the 2% floor on miscellaneous itemized deductions. (1,190) 25,610 (1,810) 89,205 5- $ 5,500 , 500 2,400 3,600 2,000 $ ,400 3,636 $ 4,036 (1,784) 2,252 $ 16,252 $ 89,205 (16,252) (10,950) $ 62,003 $ 8,466 (1,000) $ 7,466 3,619 $ 12,085 Solutions to Cumulative Problems 9-3 Schedule 2106: David Automobile: Original cost Business use Depreciable basis Less: Portion elected to expense Unadjusted basis for recovery Recovery percentage for five-year property Depreciation deduction before limitation Section 280F limitation in 2010 (ignore bonus depreciation) Business use Limitation on depreciation Depreciation deduction $30,000 , 60% $18,000 ( 0) $18,000 , 20% $ 3,600 $ 3,060 , 60% $ 1,836 $1,836 Total operating expenses $ 3,000 Business use , 60% Business operating expenses 1,800 Total automobile expense $3,636 Other items: The employer of Lauren Hammack withheld more social security than was required ($429 instead of $413). The taxpayer must ask the employer for a refund of the excess. The amount cannot be claimed as a credit on the tax return. l l l l Medical insurance premiums of $750 paid by corporation are excluded. Life insurance proceeds of $40,000 are excluded. Specific bequest of stock of $30,000 is excluded. Redemption of Treasury Bill: the difference between the purchase price and redemption value is considered interest and is reported when the instrument is redeemed, not as it accrues. 9-4 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Cumulative Problems 9-5 9-6 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Cumulative Problems 9-7 9-8 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Cumulative Problems 9-9 9-10 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Cumulative Problems 9-11 9-12 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Cumulative Problems 9-13 9-14 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion 9-44 The computations for the 2010 tax return of Michelle Kay appear below. Form 1040 Computations Gross income: Alimony received Business income (loss) from Schedule C Subtotal Adjustments to income: IRA deduction Self-employed health insurance: $1,000 100% One-half of self-employment tax (1=2 $2,875) Adjusted gross income Less: Greater of itemized deductions or standard deduction: Itemized deductions from Schedule A Standard deduction (assumes no adjustments) Personal and dependency exemptions: 1 $3,650 Taxable income Regular income tax liability before credits* Less: Retirement savings credit Regular income tax liability after credits (zero or greater) Other taxes: Self-employment tax from Schedule SE Total tax Less: Prepayments Balance due (refund) $ 15,000 21,347 $ 36,347 $ 2,000 1,000 1,438 (4,438) $ 31,909 $15,500 8,350 (15,500) (3,650) $ 12,759 $ 1,319 (200) $ 1,119 2,875 $ 3,994 (16,000) $(12,006) *Note regarding filing status: Ms. Kay files as head of household. She is unmarried and provides over half the cost of the home in which she and her son live. The son is not required to be her dependent for head-of-household purposes. However, Ms. Kay does not qualify for the child credit because the child must be a dependent and the dependent exemption was not surrendered by the custodial parent. Ms. Kay is entitled to a retirement credit due to her contribution to an individual retirement account. The amount of the credit is a function of the taxpayer's income. Schedule A Computations Itemized Deductions Taxes: Real estate State income taxes County income taxes Interest Deductible home mortgage interest Gifts to charity Total itemized deductions $ 2,000 3,500 1,500 $ 7,000 5,600 2,900 $15,500 Solutions to Cumulative Problems 9-15 9-44 (cont.) Schedule C Computations Profit or Loss from Sole Proprietorship Gross receipts Cost of goods sold Gross margin Operating expenses: Advertising Depreciation from Form 4562 (see discrepancy below) Insurance Interest Legal services Meals and entertainment Gross amount Less 50% Real estate taxes Wages for employees Payroll taxes per schedule (below) Total operating expenses Net profit or loss Supporting Schedule for Payroll Taxes on Schedule C Annual Earnings $ 20,000 20,000 20,000 20,000 20,000 $100,000 FUTA at 6.2% ($434 Maximum) $ ,434 ,434 ,434 ,434 ,434 $2,170 FICA at 7.65% $1,530 1,530 1,530 1,530 1,530 $7,650 Payroll Tax $1,964 1,964 1,964 1,964 1,964 $9,820 $950,000 625,000 $325,000 $ 25,000 80,583 3,000 60,000 20,000 $ 2,500 (1,250) 1,250 4,000 100,000 9,820 $303,676 $ 21,347 Employee #1 Employee #2 Employee #3 Employee #4 Employee #5 Total Schedule SE Computations Social Security Self-Employment Tax Net earnings from self-employment before special deduction Less: Self-employed health insurance (not deducted on Schedule C but on Form 1040 Line 29) Subtotal Portion subject to self-employment tax Subtotal Self-employment tax rate Self-employment tax $21,347 (1,000) $20,347 92.35% $18,790 15.30% $ 2,875 9-16 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion Form 4562 Computations: Depreciation and Amortization Section 179 immediate expensing: Machinery Personal computer* Printer* Seven-year property: Office furniture and fixtures $30,000 14,000 2,000 20,000 $66,000 $650,000 2.247%** Nonresidential real estate: Building Total expensing and depreciation 14,583 $80,583 *Note: The computer and printer are not considered listed property (for purposes of Form 4562-- Depreciation) because they are used exclusively at a regular business establishment. **Note: 2.247% is the depreciation rate published by the IRS in Publication 946; however, tax software normally uses 2.24353% which appears to be correct (1/39 10.5/12). In such case, the depreciation would be $14,583 or $23 less. The solution uses $14,583 the amount derived using the software. Solutions to Cumulative Problems 9-17 9-18 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Cumulative Problems 9-19 9-20 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Cumulative Problems 9-21 9-22 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Cumulative Problems 9-23 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Tax Research Problems 9-45 Internal Revenue Code 167 provides as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear of property used in a trade or business, or of property held for the production of income. In order to be eligible for a depreciation deduction, property must have a determinable useful life so that the cost of the property may be allocated among several periods, as is implied by Regulation 1.167(a)-2. The regulation indicates that the allowance for depreciation does not apply to land, apart from the improvements or physical developments added to it. In this case, there is no doubt that S should be allowed a depreciation deduction for the shopping mall and the office building, as these items are property held by S, as a land developer, for the production of income. These items are improvements made to land, which have a determinable useful life, and are therefore depreciable. A deduction for depreciation allowance will be allowed under the Modified Accelerated Cost Recovery System (MACRS) according to Internal Revenue Code 167(a) and 168, since these assets would qualify as recovery property. Regarding the landscaping costs, it is questionable whether these items are eligible for a depreciation deduction. The earlier U.S. Tax Court decisions held that landscaping items were nondepreciable, because they were inextricably associated with the land and therefore had an indeterminable useful life, as opposed to other improvements on the land. See Algernon Blair, Inc., 29 T.C. 1205 (1958). However, the Tax Court altered its position in Alabama-Georgia Syrup Co., 36 T.C. 747 (1961), reversed on other grounds, 1963-1 USTC {9124, 10 AFTR2d 6136, 311 F.2d 640 (1963), where it held that shrubbery and trees planted next to a recreation lodge were depreciable assets. The Commissioner later ruled that landscaping, including shrubbery and trees placed close to a building, were depreciable over the life of the building, basing this decision on the rationale that these shrubbery and trees would have to be destroyed with the building at the end of its useful life. The Commissioner disallowed a depreciation allowance for trees and shrubbery planted far enough from the building that they would not have to be destroyed with the building at the end of its useful life; see Revenue Ruling 74-265, 1974-1 C.B. 56. According to this latter ruling, S could deduct a depreciation allowance for the trees, gardens, and shrubbery close to those buildings; however, no depreciation allowance could be deducted for the items planted far enough away from the buildings so that they would not have to be destroyed if the buildings were removed at the end of their useful lives. It should be noted that any landscaping items subject to depreciation would be depreciated under MACRS. With regard to the art work, which includes the sculpture and the hanging pictures, S would not be allowed a depreciation deduction. It is generally held that a useful life for an art work cannot be estimated, and for this reason no depreciation deduction can be taken for it [see Rev. Rul. 68-232, 1968-1 C.B. 79, and J. R. Thompson Co., 73-1 USTC {9369, 31 AFTR2d 73-1207, 477 F.2d 164 (1973)]. In the latter case the depreciation deduction was denied because the art works' decline in value was deemed to be caused by 5- 5- 5- 5- 9-25 9-26 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion 5- a change in the art market rather than by a loss in the commercial usefulness of the art. In D. Judge, 35 T. C.M. 1264 (1976), the court held that although the art works were depreciable business assets, since they were office decorations instead of pure art, they were still allowed no depreciation deduction because their useful lives could not be estimated. The above decisions indicate that art work is typically not allowed a depreciation deduction because of the difficulty encountered in assigning it an estimated useful life. S will not be allowed a depreciation for his hanging pictures or his sculpture unless he can show that the items are business-property decorations rather than true art, and establish a useful life for each item. S may possibly be able to estimate a useful life for the sculpture based on the useful life of the complex, if it could be shown that the sculpture would have to be destroyed or would be of no further value when the complex reached the end of its useful life (and was presumably to be destroyed). S may look to the landscaping items placed close to the building for an analogy. In any event, S should be prepared to litigate the issue of the depreciation deduction for the art works, given the position of the Internal Revenue Service under Revenue Ruling, 68-232, supra. As with the other items, if a depreciation allowance were to be permitted, the depreciation would be done under MACRS rules. 9-46 55- 5- 5- Treasury Regulation 1.167(a)-3 provides the general rule for depreciation of intangible assets (i.e., amortization). The regulation states, "If an intangible asset is known from experience or other factors to be of use in the business or in the production of income for only a limited period, the length of which can be estimated with reasonable accuracy, such an intangible asset may be the subject of a depreciation allowance." The regulation further states, "An intangible asset, the useful life of which is not limited, is not subject to the allowance for depreciation. No allowance will be permitted merely because in the unsupported opinion of the taxpayer, the intangible asset has a limited useful life." A license is clearly considered an intangible asset that may or may not be subject to a depreciation allowance; see Browning Co., 6 B.T.A. 914 (1927), Dec. 2363 (Acq.). The issue raised in this case is whether or not a license with a renewal privilege may be subject to a depreciation allowance. Regulation 1.167(a)-3 clearly states that an intangible asset with an unlimited life is not subject to a depreciation allowance. The question then becomes whether the renewal privilege of the license in this case causes the license to be viewed as having an unlimited useful life. The U.S. Court of Appeals for the Fifth Circuit has ruled on this issue, stating that a liquor license that is renewable has an indeterminable useful life, since the renewal privilege is of indefinite duration. The court stated that because the renewal privilege was dependent on the taxpayer's wishes as well as upon the license-granting city's future course of action, there was no rational basis for prediction as to duration. [See Morris Nachman v. Comm., 51-2 USTC {9483, 41 AFTR 172, 191 F.2d 934 (1951)]. The U.S. Tax Court reached a similar conclusion regarding a liquor license in E. W. Hill, 38 TCM 481, Dec. 26, 979(M), TC Memo, 1964-253. Aff'd on another issue, 66-2 USTC {9707, Sec. 79, 103 P-H Memo TC, 367 F.2d 646 (1981). In this case, which dealt with taxicab licenses, the U.S. Tax Court examined at great length the factual and legal situation of a taxpayer asserting that a renewable taxicab license was limited in life due to doubts about the future actions of the license-granting city. The court dismissed this argument, stating that the taxpayers did not establish from experience (or any other source) that the license was of limited useful life; thus, the court disallowed a depreciation allowance for the license, quoting the pertinent provisions of Regulation 1.167(a)-3 in the opinion. (See W. K. Co. v. Comm., 56 T.C. 434 (1971), aff'd in unpublished order by 7th Cir., 5/21/73.) In making its decision, the court also cited Toledo TV Cable Co., 55 T.C. 1107 (1971), wherein the U.S. Tax Court held that taxpayers failed to establish that certain municipal franchises for cable television had determinable useful lives, and thus disallowed depreciation deductions. The court cited numerous cases and stated the rule that whether or not a franchise will be renewed indefinitely is a question of fact to be answered in accordance with the facts known or reasonably anticipated at the end of the period for which the return is filed; the court noted that the burden of establishing a useful life is on the taxpayer and concluded that the taxpayer had not carried such burden. In that case the court emphasized the importance of foreseeable circumstances that could adversely affect a renewal privilege, indicating that if a taxpayer could show that the intangible asset (i.e., here, a franchise) would probably not be renewed, it would be deemed to have a limited life and be allowed a depreciation deduction. Solutions to Tax Research Problems 9-27 5- In the case at hand, there is significant uncertainty over whether the license of Cabletech will be renewed, the latter being contingent on the city's satisfaction with the services provided. Given the current regulations and case authority on this issue, it appears that Cabletech will not be able to carry a burden of proof to establish that renewal will not be granted if it bases its assertion only on the premise that such renewal is contingent on customer satisfaction. This argument did not carry sufficient weight in W. K. Co., supra; and even when the environment was shown to be fraught with substantial uncertainties and negotiations concerning renewal of franchises, the taxpayer did not establish a reasonable certainty that his franchise would not be renewed and was therefore of limited life; see Toledo TV Cable Co. supra. Thus, Cabletech will not be able to show that its license has a limited life that would allow it to be subject to depreciation under Regulation 1.167(a)-3, given the factual setting of the problem. 9 Capital Recovery: Depreciation, Amortization and Depletion Test Bank True or False 1. All methods of depreciation permitted by the IRS prior to the 1981 introduction of ACRS provided taxpayers the opportunity to manipulate the depreciation deduction by underestimating the useful lives of their property. 2. The facts-and-circumstances approach to determining the useful life of an asset remains permitted under some circumstances. 3. Property used in an income-producing activity that is neither a trade nor a business may be depreciated. 4. A depreciation deduction may be claimed for a decline in value that occurred while an item of property was held for personal purposes. 5. Taxpayer N purchased numerous tax texts totalling $1,000 while obtaining his master's degree in taxation. This year he began teaching taxation when the books were valued at $700. Assuming he uses the texts as references in his profession, he may compute depreciation using a basis of $1,000. 6. The straight-line method must be used for amortizing intangible property such as copyrights. 7. During 2003, Y purchased a new warehouse, which he sold on June 10, 2012. In 2012, Y may claim depreciation equal to 6/12 of the MACRS statutory percentage. 8. All depreciable property is eligible to be depreciated by means of at least one straight-line method. 9. In computing depreciation using MACRS, a taxpayer who elects to expense all or a portion of an asset must adjust the basis of the asset. 10. Auto leasing for business purposes yields the same tax advantage as auto ownership despite the limitations applied to depreciation of automobiles. 9-29 9-30 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion 11. The use of MACRS is precluded for property placed in service prior to the enactment of either version of MACRS, unless the property is transferred in a transaction where both the owner and the user change. Taxpayers may use component depreciation to depreciate the various components (e.g., plumbing, electrical) of a building under MACRS. A covenant not to compete may be amortized over the period of the covenant. Sellers prefer allocating a portion of their sales price to goodwill rather than a covenant not to compete even though a buyer is generally indifferent. A deduction for percentage depletion is allowed even though the entire cost of the asset has been recovered (i.e., the basis of the asset is zero). The entire cost of recovery property that constitutes a research and experimental expenditure (e.g., lab equipment costing $50,000) can be expensed entirely in the year of acquisition. Expenditures for research and experimentation that are deferred must be amortized ratably over a period of 17 years. Capitalizing an expenditure for research and experimentation decreases the basis of the property to which the expense relates. Livestock owned by ranchers and farmers and held for resale may be depreciated as a capital expenditure. Farmers may deduct expenditures for ponds and drainage ditches rather than capitalize them. 12. 13. 14. 15. 16. 17. 18. 19. 20. Multiple Choice 21. Which is not depreciable under the Modified Accelerated Cost Recovery System (MACRS)? a. b. c. d. New buildings Used buildings Used machinery Patents 22. Which statement concerning depreciation is not true? a. b. c. d. Only property that has a determinable life is depreciable. Deductions for depreciation must be claimed for the year when the depreciation occurred or they will be forfeited. Personal property converted to business use is not depreciable since it was once used for personal purposes. Land is not depreciable. 23. Which of the following statements is true regarding depreciation and amortization? a. b. c. d. e. Goodwill can be amortized for tax purposes. Property used in a trade or business may be eligible for depreciation if it has been used previously for personal purposes. Only property used in a trade or business is depreciable. More than one of the above are true. None of the above is true. Test Bank 9-31 24. Which of the following statements is true? a. b. c. d. e. Salvage value is not considered for any of the depreciation methods allowed under MACRS. The taxpayer's estimate of an asset's useful life is totally irrelevant in computing depreciation under MACRS. All methods of depreciation under MACRS reflect a half-year's depreciation in the year of acquisition. More than one but less than all of the above statements are true. All of the above are true. 25. MACRS prescribes rates of depreciation determined by three criteria. What are they? a. b. c. d. Useful life, property classification, and recovery period Accounting convention, useful life, and property classification Accounting convention, useful life, and recovery period Accounting convention, property classification, and recovery period 26. Which property is depreciable using MACRS? a. b. c. d. e. Manufacturing equipment purchased new Automobiles used in a business Apartment building purchased from a previous, unrelated owner Computers used in a business All of the above are depreciable using MACRS. 27. Which statement concerning class life and recovery period is not true? a. b. c. d. The class life of an asset and its recovery period under the Alternative Depreciation System (ADS) are generally the same. Except for very short-lived property, the recovery period of an asset under MACRS is generally less than its class life. A class life has been assigned by the IRS to each asset to which a recovery period has been assigned. The class life of an asset is constant, regardless of which straight-line method is used to calculate its depreciation. 28. During the year, Fine Furnishings, a manufacturer of furniture, purchased the following assets: Date February 15 March 3 October 9 Asset Lathes Saws Warehouse Cost $ 40,000 50,000 110,000 In computing depreciation of these assets, which of the following conventions will be used? a. b. c. d. e. Half-year, mid-month Mid-quarter, mid-month Half-year, mid-quarter, mid-month Mid-quarter Some combination other than those given above 9-32 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion 29. Company G, a calendar year taxpayer, purchased a five-story building on April 2 of the current year for $1 million. The building, which has no historical or architectural significance, was constructed in 1946 by the previous owner, who had fully depreciated it before selling it to Company G. The first floor is occupied by shops and restaurants, the other four by apartments. Income will be $50,000 from commercial rents and $150,000 from residential rents. The deduction for depreciation that the company may claim for the building is about a. b. c. d. e. $0 $18,162 $19,231 $25,104 $25,758 30. Personal property is a. b. c. d. Not depreciable Depreciable using the 150 percent declining-balance and 200 percent declining-balance methods only Depreciable using the 150 percent declining-balance, 200 percent declining-balance, and straightline methods Depreciable using only those methods available for real property 31. Which of the following statements is true regarding the computation of depreciation under MACRS? a. b. c. d. e. A full year of depreciation is never allowed in the year of acquisition. The averaging conventions ensure that never more than a half-year of depreciation is allowed with respect to personal property. Straight-line is used in the year of acquisition for five-year property only if the taxpayer so elects. More than one of the above are true. None of the above is true. 32. On March 27 of the current year, T Inc., a greeting card manufacturer, placed a new building in service to house its operations. The portion of the cost allocated to the building was $200,000. T's maximum depreciation deduction for the year is a. b. c. d. e. $3,970 $4,060 $3,214 $5,128 None of the above 33. Placid Places Incorporated, a calendar year taxpayer, purchased an apartment building on October 1 of the current year for $1,200,000, of which $200,000 was allocable to the land. The corporation's depreciation for the building for the year will be the product of the building's basis and a. b. c. d. e. 1/27.5 and 2.5/12 1/27.5 and 9.5/12 1/39 and 2.5/12 1/39 and 1=2 1/39 and 9.5/12 34. Riverview Incorporated, a calendar year taxpayer, purchased an apartment building on June 1 last year for $1,200,000, of which $200,000 was allocable to the land. The corporation sold the property on June 27 of the current year. The corporation's depreciation for the building for the current year will be approximately a. b. c. d. e. $0 $16,665 $18,180 $36,360 None of the above Test Bank 9-33 35. In November of this year, Creative Corn Products, a calendar year taxpayer, placed in service its only equipment purchased during the year. The equipment cost $3,000,000. All of the equipment qualified as five-year property under MACRS. Ignore bonus depreciation. The maximum deduction that the taxpayer may claim with respect to the equipment is a. b. c. d. e. $150,000 $375,000 $500,000 $1,000,000 $600,000 36. During the year a calendar year taxpayer, Heavenly Hamhocks, a chain of specialty food shops, purchased equipment as follows: Date February 15 March 3 October 9 Asset Ovens Refrigerators Equipment Cost $ ,400,000 ,500,000 1,100,000 Assuming the property is all seven-year property, depreciation for the assets this year would be a. b. c. d. e. 37. $71,400 $264,270 $285,800 $500,000 None of the above Which statement is not true of straight-line depreciation under MACRS? a. b. c. d. Each of the three accounting conventions (half-year, mid-month, and mid-quarter) are eligible for MACRS straight-line depreciation. MACRS straight-line depreciation is required for real property. MACRS straight-line depreciation must be used for either all or none of the assets of a given class placed in service during a given year. The class life of an asset is used as its recovery period. 38. During the year, R purchased two items of machinery. One item is five-year property and the other is seven-year property. Which of the following statements is true regarding his options for depreciation? a. b. c. d. If R elects to depreciate the five-year property using the straight-line method alternative, he may adopt any other method under MACRS for the seven-year property. If R elects the straight-line method alternative for a particular asset, he must depreciate all other assets placed into service during the year under the straight-line method. If R elects the straight-line method alternative for the five-year property, he may still use accelerated MACRS percentages for the other assets in that property class. None of the above is true. 9-34 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion 39. Which of the following statements is true regarding the alternative depreciation system (ADS)? a. b. c. d. e. ADS always must be used in computing depreciation for listed property not used more than 50 percent for business. Depreciation for real property is the same under ADS and MACRS because the straight-line method must be used under both systems. ADS is identical to MACRS if the straight-line alternative under MACRS is elected to depreciate personal property. More than one of the above are true. All of the above are true. 40. During the year, T purchased the items shown below. Indicate which item qualifies for both 179 limited expensing and bonus depreciation. a. b. c. d. e. A new computer used to monitor his investments A new office building to be used in his business A truck purchased from XYZ Corporation, which had used it in its sand and gravel business New office furniture for the new office building None of the above 41. In 2011 Kay Smart operates a cosmetic manufacturing business. During the year, the business placed in service $2,040,000 of five-year property eligible for limited expensing under 179. Ms. Smart wisely elected 179. The maximum amount that she can expense under 179 is a. b. c. d. e. $0 $460,000 $500,000 $840,000 None of the above 42. In 2011, B purchased a crane to be used entirely for business. He spent a total of $694,000. He decided to use the limited-expensing election. What is the total depreciable basis for the mini-computer? a. b. c. d. e. $500,000 $694,000 $0 $194,000 None of the above 43. Which of the following is not considered eligible property for limited expensing under 179? a. b. c. d. e. Automobile used by a salesman Warehouse purchased by XYZ Corporation to store inventory Computer used by Nick Knight to do the accounting for his video tape rental business Equipment used by Serendipity Tea Company in its operations All of the above are eligible. 44. In 2011, Ozzie Ostentatious purchased a new Porsche convertible for $80,000 to be used in his business, Tract Homes Are Us. Ozzie drove the car 80 percent of the time for business. The maximum amount of the car's cost that Ozzie may deduct this year is a. b. c. d. e. $3,060 $1,775 $64,000 $2,448 None of the above Test Bank 9-35 45. S purchased a used automobile to be used in his sole proprietorship. For the year, S's business mileage was 20,000 miles, while his personal mileage was 30,000 miles. S may a. b. c. d. e. Claim no depreciation because the car was used predominantly for personal purposes Elect limited expensing under 179 Deduct a maximum of $3,060 of depreciation Claim depreciation using the straight-line method More than one of the above statements are true 46. As a consequence of the ceiling on the amount of annual depreciation, and first-year expensing and depreciation deductions that may be claimed for automobiles, the basis of a car that costs $15,300 or more a. b. c. d. Is fully recovered in less time than is that of a car costing less Is fully recovered in the same amount of time as that of a car costing less Is fully recovered in more time than is that of a car costing less Is never fully recovered 47. Certain "listed property" is subject to limitations regarding capital recovery if it is not used more than 50 percent for business. What category below is not a kind of listed property? a. b. c. d. e. Computer equipment not used exclusively at a regular business establishment Passenger automobiles Motorcycles Photographic equipment Furniture 48. Taxpayer K purchased a used stereo system for $12,000 in May. K uses the system 20 hours each week for her business as a music critic, and she and her family use it 30 hours each week for educational and personal purposes. How much may K claim in deductions for depreciation and current expenses associated with the system? (Assume that stereo equipment has a recovery period of five years, regardless of the depreciation method employed.) a. b. c. d. e. $0 depreciation, $0 expensed $80 depreciation, $4,000 expensed $0 depreciation, $4,800 expensed $480 depreciation, $0 expensed $960 depreciation, $0 expensed 49. What conditions are necessary and sufficient to demonstrate that the use of personal use property is qualified business use? I. Use is for the convenience of the employer. II. Use is for a business or trade. III. Use is required as a condition of employment. a. b. c. d. e. I. only II. only III. only I. and II. only I., II. and III. 9-36 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion 50. Rapid Reproduction Corporation provides automobiles for all of their salespersons. Most of the salespersons, including Sam Sell, use their cars for business as well as personal use. Assuming Sam uses the car 90 percent for business and 10 percent for personal purposes, which of the following statements best describes the corporation's treatment of the car? a. b. c. The corporation can depreciate only 90 percent of the cost of Sam's car. The corporation can depreciate 100 percent of the cost of Sam's car if Sam includes as income an amount equal to the value of the personal use. The corporation can depreciate 100 percent of the cost of Sam's car if Sam pays the corporation an amount equal to the value of the personal use that the corporation includes as income and that Sam may deduct. Assuming Sam owns 30 percent of the Rapid stock, the corporation can depreciate 100 percent of the cost of the car if Sam includes the entire value of the car's use (business and personal) as income. d. 51. Last year, Taxpayer N purchased a car for $12,000 and used it entirely for his construction business. Depreciation that year was $2,400. N hired his son T in February of the current year and allowed him to put the car to personal use on weekends. The value of T's personal use of the car was included as part of his income. If T's personal use of the car this year represented 60 percent of its total use, what income and depreciation expense related to the car should N include on the tax return for his business? a. b. c. d. e. $0 income, $960 depreciation $0 income, $1,920 depreciation $1,200 income, $960 depreciation $1,200 income, $1,920 depreciation $2,400 income, $0 depreciation 52. The keeping of records required for listed property is extensive but not limitless. What is not required to substantiate the use of listed property? a. b. c. d. e. The date of use The amount of each business use The amount of each nonbusiness use The amount of total use The amount of each expenditure related to the property 53. The Bloomingulch Company mines limestone. During the year the company purchased property south of town for $180,000. Engineers estimate that 200,000 tons of limestone are recoverable from the property. Given the following information, compute the company's depletion deduction for year two. Assume the depletion rate is 5 percent. Taxable Income before Depletion $290,000 100,000 Year One Two Tons Sold 150,000 45,000 Gross Income $3,000,000 600,000 a. b. c. d. e. $30,000 $31,500 $40,500 $50,000 None of the above Test Bank 9-37 54. Ageless Oil Corporation is still eligible to use percentage depletion. During the year its only well produced 6,000 barrels of oil at a cost of $6 per barrel. The corporation subsequently sold all of their production for $8 per barrel. Assuming that the production and sale of oil represented all revenues and expenses for the year, the corporation's deduction for percentage depletion would be (assume the statutory depletion rate for oil is 22%) a. b. c. d. e. $3,950 $10,560 $30,000 $6,000 None of the above 9 Capital Recovery: Depreciation, Amortization and Depletion Solutions to Test Bank True or False 1. True. Between 1942 and 1954, Bulletin F of the IRS prescribed useful lives for assets. Between 1955 and 1981, manipulation was possible. (See p. 9-4.) True. The facts-and-circumstances approach is permitted for determining the value to an employee of an asset, such as the employee's use of the employer-owned vehicle. (See pp. 9-4 and 9-35.) True. Property that is not used in a trade or a business must be used in an income-producing activity to be eligible for the depreciation deduction. [See p. 9-3 and 167(a).] False. The depreciable basis of a property is the lower of its FMV or its adjusted basis at the time of its conversion from personal to business or income-producing use, because depreciation may not be claimed for assets held for personal use. [See Example 2 and p. 9-3 and Reg. 1.167(g)-1.] False. Property converted to business use is depreciated using the lesser of the property's value or its basis at the time of the conversion. In this case the lower value of $700 is used. [See Example 2, p. 9-3, and Reg. 1.167(g)-1.] True. MACRS does not apply to intangible property. Generally, intangibles are amortized using the straightline method over their estimated useful life. However, certain intangibles, like goodwill, covenants not to compete and other customer based intangibles, must be amortized over 15 years. (See pp. 9-5, 9-37 and 9-38.) False. The mid-month convention must be used for real property. Thus the fraction is 5.512. [See p. 9-14 and 168(d)(4)B).] True. The option of straight-line depreciation using either MACRS straight-line or ADS, is available for all property and is required in certain cases, and it may be more advantageous for some taxpayers than the double-declining method. (See pp. 9-17 through 9-18.) True. The basis subject to depreciation must be reduced by any amount expensed under 179. (See Example 17 and pp. 9-21 and 9-22.) 2. 3. 4. 5. 6. 7. 8. 9. 9-39 9-40 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion 10. True. Although deductions for lease payments are not limited as are those for auto depreciation, auto lessees must add certain amounts to their income to offset the tax benefit that leasing would otherwise provide. [See p. 9-28 and 280F(c).] True. Anti-churning laws limit the availability of MACRS in order to prevent transactions made solely for the purpose of obtaining more favorable depreciation deductions. [See Example 31 and pp. 9-36 and 9-37 and 168(e)(4).] False. Taxpayers may not use component depreciation under MACRS. However, component depreciation has been replaced by a similar technique referred to as cost segregation. (See p. 9-47.) False. A covenant not to compete must be amortized over 15 years. (See p. 9-38.) True. Sellers prefer allocations to goodwill since goodwill is a capital asset and such an allocation would produce favorable capital gain while allocations to a covenant produce ordinary income. In contrast, buyers are indifferent since they can amortize both goodwill and covenants over 15 years. [See p. 9-47 and 167(k).] True. Total deductions for percentage depletion may exceed the cost of the asset. Percentage depletion is based on the amount of income derived from the property. (See pp. 9-40 and 9-41 and 613.) False. The recovery deduction (i.e., the amount of the depreciation for the tax period) constitutes the research and development expense for this tax period and only that amount may be deducted. [See Example 36, pp. 9-42 and 9-43, and 174(c).] False. Deferred research and experimentation expenditures may be amortized over a period of not less than 60 months, unless a patent is obtained, in which case the cost must be amortized over the life of the patent. [See p. 9-43 and 174(b).] False. Capitalizing the research expenditures increases the basis of the asset to which the research relates. Once capitalized, the expenditure cannot be depreciated. Upon the disposition of a research project, such a sale or exchange enables the taxpayer to offset capitalized expenditures against any realized income. (See pp. 9-42 and 9-43 and Example 36.) False. Livestock held for resale are included in inventory and may not be depreciated. (See p. 9-44.) True. If such expenditures (e.g., ponds, ditches, dams and others that control the flow of water) are consistent with a conservation plan approved by the Soil Conservation Service, they are deductible as expenses for soil and water conservation. (See p. 9-44 and 175.) 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. Multiple Choice 21. 22. d. Patents are not subject to MACRS because they are intangible property. (See p. 9-5.) c. Property which has been converted from personal use to business use can be depreciated. The basis for depreciation is the lesser of the value of the property or its cost at the time of conversion. [See p. 9-3 and 167(a).] d. Item a. is true because goodwill can be amortized for tax purposes. Item b. is true because property converted from personal to business use is depreciable using the lesser of the property's value or basis at the time of conversion. Item c. is false because property used in an income-producing activity is depreciable. [See pp. 9-3 and 9-38, 167(a), and Reg. 1.167(g)-1.] d. Answer a. is true since salvage value is not considered under MACRS (See p. 9-4.). Answer b. is true since the recovery period for depreciation is prescribed by MACRS (See p. 9-5.). Answer c. is false since realty is depreciated using the mid-month convention. [See p. 9-14 and 168(g)(9).] d. Under MACRS, depreciation is a function of three factors: the recovery period, the method and the accounting convention. (See p. 9-9.) 23. 24. 25. Solutions to Test Bank 9-41 26. 27. e. All of the assets listed are property subject to MACRS. (See p. 9-5.) c. Class life has not been defined for a limited number of assets for which a recovery period has been defined. (See Exhibits 9-1 through 9-3 and 9-9 and pp. 9-6 and 9-15 through 9-17.) a. The lathes and saws are personal property and must be depreciated using the half-year convention unless more than 40 percent of the personal property (i.e., not real property) placed in service during the year was done so in the final quarter of the year. In this case, all of the personal property was placed in service in the first quarter of the year. The warehouse, which is real property, must be depreciated using the midmonth convention. [See Example 13, p. 9-15, and 168(d)(3).] b. Because less than 80 percent of the gross income of the building is from residential rents, its recovery period is 39 years (See p. 9.). Depreciation in the first year is 1/39 8.5/12 $1,000,000. [See Exhibits 91 through 9-3; Example 10 and p. 9-14; and 168(d)(2), 168(d)(4)(B), and 168(e)(2).] c. Personal property is depreciated under MACRS using the double-declining method (200% if its class life is less than 20 years, 150%), a method that is unavailable for real property, which is depreciated only by means of the straight-line method. The taxpayer also has the option of using either MACRS or ADS straight-line depreciation for personal property. (See pp. 9-5, and 9-9 and Exhibit 9-1.) d. The conventions that must be used in computing depreciation prevent the taxpayer from obtaining a full year of depreciation for any type of property. Item b. is false because the mid-quarter convention allows the taxpayer up to 87.5 percent of the annual amount of depreciation if the asset is placed in service during the first quarter. Item c. is true. [See Exhibit 9-1, pp. 9-9 and 9-15, and 168(b)(1)(B) and 168(d).] b. $200,000 2.030% $4,060. In computing the depreciation for the building, the percentages for nonresidential property must be used. Answer a. incorrectly reflects use of the residential depreciation percentage. Answer c. incorrectly multiplies the correct answer by the mid-month factor, 9.512, which is already reflected in the depreciation factor of 2.030 percent. Answer d. ignores use of the table (and therefore the mid-month percentage which is built-in). (See Exhibits 9-1 through 9-3 and 9-9, and p. 9-14.) 28. 29. 30. 31. 32. 33. a. The apartment is residential real property. Thus depreciation is computed via the straight-line method using a 27.5-year life and the mid-month convention that allows for 2.5 months of depreciation. Depreciation is the product of 2.5/12, 1/27.5 and $1,000,000. (See Exhibits 9-1 and 9-3, Example 10 and p. 9-14.) b. Riverview's depreciation is $16,665. Using the table for residential real property in Exhibit 9-5 (p. 9-14) the depreciation factor is 3.636 percent. This factor must be multiplied by 5.512 to give effect to the midmonth convention that allows five-and-one-half months depreciation in the year of disposition. Depreciation is $16,665 ($1,000,000 3.636% 5.5/12). (See Example 12 and p. 9-12.) a. Creative Corn Products may claim a depreciation deduction of $25,000. Depreciation must be computed using the mid-quarter convention because more than 40 percent of the taxpayer's assets were placed in service during the last three months of its taxable year. No limited expensing is allowed because more than $2,500,000 (2011) of equipment was placed in service during the year. Depreciation is $150,000 (1/5 or 20% 200% DDB = 40% 12.5% $3,000,000). [See Exhibit 9-7, Example 14, and p. 9-16 and p. 9-22, and 168(d)(3) and 179.] b. Depreciation must be computed using the mid-quarter convention because more than 40 percent of the total amount of personalty was placed in service during the last quarter. Depreciation for the ovens and the refrigerators would be $225,000 ($900,000 25%), while depreciation for the equipment would be $39,270 ($1,100,000 3.57%) for a total of $264,270. [See Exhibit 9-7, Examples 13 and 14, pp. 9-15 and 9-16, and 168(d)(3).] d. ADS, not MACRS, uses the class life of an asset as its recovery period. [See pp. 9-17 through 9-19, and 168(b)(3)(C).] 34. 35. 36. 37. 9-42 Chapter 9 Capital Recovery: Depreciation, Amortization and Depletion 38. a. A taxpayer electing the straight-line method alternative for a particular asset must depreciate all assets in that property class that he or she places in service that year under the same method and recovery period. [See p. 9-18 and 168(b)(3)(B)(I)-(ii).] a. ADS is required if qualified business use does not exceed 50 percent. (See p. 9-24.). Item b. is false because the useful life for real estate under ADS is 40 years, and less than 40 for MACRS (See p. 9-17.). Item c. is false because different recovery periods are used for ACRS and ADS. [See pp. 9-18 through 9-20; Exhibits 9-1, 9-3, and 9-9; and 280F(b).] d. The office furniture qualifies for both limited expensing and additional first-year depreciation. The new computer qualifies for bonus depreciation (see p. 9-24.) but does not qualify for expensing since it is used for investment purposes (See pp. 9-22 and 9-23.). Buildings do not qualify for bonus depreciation since their lives exceed 20 years and also do not qualify for limited expensing. The truck does not qualify since it had been previously used. b. The taxpayer can expense $460,000. The $500,000 amount that can be expensed under 179 in 2011 is reduced $1 for each $1 of assets placed in service in excess of $2,000,000. Because $2,040,000 was placed in service, the $500,000 amount is reduced by $460,000 to $460,000. (See Example 17 and p. 9-22.) d. The depreciable basis should be the original cost less the portion expensed: $694,000 $500,000 $194,000. (See Example 17, p. 9-22, and 179.) b. Buildings are not eligible. [See p. 9-22 and 48(a)(1)(B).] d. The maximum amount of depreciation for an automobile is limited in the first year to $3,060. However, this amount must be reduced for personal use. Because the car was used only 80 percent for business, the maximum is $2,448 ($3,060 80%). (See Example 20, p. 9-26, and 280F.) d. If the car is not used more than 50 percent for business, the taxpayer must use straight-line depreciation under ADS. In addition, 179 cannot be used. The maximum depreciation amount must be adjusted for personal use ($3,060 in 2011 20/50 $1,224). (See Example 24, pp. 9-34 through 9-36, and 280F.) c. The limitations on annual depreciation of automobiles do not prohibit full recovery of depreciable basis, but so extend the effective recovery period that a taxpayer is more likely to dispose of the vehicle than fully depreciate it. (See Example 21 and pp. 9-26 and 9-27 and 280F.) e. Listed property includes transportation and entertainment equipment. It also includes computers and peripheral equipment not used at a regular business. [See p. 9-32 and 280F(d)(4).] a. Listed property not used more than 50 percent for business is ineligible for limited expensing and for MACRS depreciation. The IRS takes the position that if qualified business use does not exceed 50%, then no depreciation or limited expensing is allowed. Some might argue that straight-line depreciation should be permitted but the IRS position is clear. Foil (d) represents the ADS depreciation but this is incorrect. K's deduction for depreciation is 6/12 1/5 $12,000 40%. [See pp. 9-22 through 9-33 and 179, 280F(b), and 280F(d)(4).] e. To meet the qualified business use test, all three conditions must be met. [See Example 26, pp. 9-32 and 9-33, 280F(b) and 280F(d), and Prop. Reg. 1.280F-6(d)(2).] b. Item a. is false because depreciation of 100 percent is allowed under several circumstances. Item c. is false because Sam cannot deduct the payment for personal use. Item d. is false because the corporation can depreciate only the actual business percentage used when a holder of five percent or more of a company's stock uses the automobile. [See Example 28, pp. 9-34 through 9-35, and Prop. Reg. 1.280F-6T(d)(4)(iv).] c. N's business must declare income to defray the advantage of using accelerated depreciation for the first year of the car's life ($2,400 $1,200) and must calculate subsequent depreciation using the straight-line method ($12,000 20% 40%). [See Example 29, pp. 9-33 through 9-35, 280F(b), and Prop. Reg. 1.280F-6T(d)(4)(iv).] 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. Solutions to Test Bank 9-43 52. c. Details of nonbusiness use need not be substantiated, and the aggregate amount of such use can be determined by subtracting business use from total use. [See p. 9-35, 274(d), and Temp. Reg. 1.2745T(b)(6).] b. Cost depletion for year one is $135,000 (150,000/200,000 $180,000). Percentage depletion for year one is limited to $145,000 ($3,000,000 5% $150,000 but not to exceed $290,000 50% $145,000). Thus, percentage depletion is claimed for year one. In year two, cost depletion is $31,500 (45,000/50,000 $35,000 remaining basis) while percentage depletion is $30,000 ($600,000 5% $30,000 which is less than 50% $100,000 $50,000). Thus, cost depletion is claimed for year two in the amount of $31,500. [See Examples 33 through 35, pp. 9-40 and 9-41, 613, and Reg. 1.611-2(a).] b. Percentage depletion of $10,560 ($8 6,000 22%) is limited to net income, which is $12,000 [6,000 ($8 $6)]. Thus, $10,560 may be deducted. (See Example 33, p. 9-40, and 613.) 53. 54. ...
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