24211_ch05_final_p001-014 - 5 Gross Income Solutions to...

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Unformatted text preview: 5 Gross Income Solutions to Problem Materials DISCUSSION QUESTIONS 5-1 The discrimination that exists between renters and owners is attributable to the income definition adopted for tax purposes. The tax definition of income generally excludes benefits received in kind from property (e.g., the net rental value of using one's personal residence), while the economic definition would include such benefits as income, since these represent a type of consumption. For example, assume an individual in the 28 percent bracket has $100,000 to invest in either a home or a security. Also assume the consumption value of the house (what it would cost to rent the home) was $10,000, which is equivalent to the interest received on the bond. After taxes, the return on the investment in the house is $10,000, while the return on the bond investment is $7,200 [$10,000 (28% $10,000)]. As is apparent from this example, failure to treat the rental value of the house as taxable income creates an unfavorable bias against one who chooses to rent rather than buy. The taxpayer who chooses to invest in the security with the intention of using the income to rent a house, must pay tax on the income, which reduces the amount available for rent. (See Example 44, pp. 5-3, 5-4 and 5-41, and 61.) The economist's approach to measuring income has been applied for tax purposes and is referred to as the net-worth method. The net-worth method is an indirect way of computing income and is typically used when the taxpayer's records are an inadequate basis for determining the tax liability (e.g., no records have been maintained or the records have been destroyed or falsified). Income is determined using the net-worth approach by ascertaining the increase or decrease in net worth during the period and adding the taxpayer's nondeductible consumption expenditures. (See Example 1 and pp. 5-4 and 5-5.) Implementation of this approach requires the IRS to establish a definite opening net worth to serve as a starting point. This step is perhaps the most difficult. Taxpayers normally claim that the opening net worth shown by the IRS is inappropriate because of the existence of substantial cash that was hidden. In one case, U.S. v. Holland, 54-2 USTC {9714, 46 AFTR 943, 75 S. Ct. 127 (USSC, 1954), the IRS asserted that the taxpayer's opening net worth included $2,153 in cash, while the taxpayer claimed the Service had failed to include $113,000 in currency, which at various times had been in a canvas bag, a suitcase, and a metal box. In connection with the opening net worth, the taxpayer usually gives information to the IRS indicating the specific sources from which the cash has come, such as prior earnings, stock transactions, inheritance, and gifts. The Service typically investigates these leads in order to confirm or deny their validity. Problems in establishing the taxpayer's ending wealth may also exist. Often the Service is required to search for concealed assets. Existence of concealed assets (and thus unreported income) is generally supported by findings by the IRS of large consumption expenditures (cars, homes, etc.) that exceed the taxpayer's reported resources. (See Example 1 and pp. 5-3 and 5-4.) 5-2 5-1 5-2 Chapter 5 Gross Income 5-3 a. b. c. d. e. f. g. h. The economist would include the value of the beef as it was consumed by the taxpayer. For tax purposes, the beef's consumption is not considered income because realization through an exchange transaction with an external party has not occurred. Moreover, the expenses incurred in raising the cattle are also not deductible. (See pp. 5-3 through 5-5.) The interest received would constitute income for both economic and financial accounting purposes. On the other hand, for tax purposes, the amount would not be taxable, since the interest from State or local bonds is specifically exempted from tax under Code 103. (See pp. 5-3 through 5-5 and 103.) The economist includes in income all goods and services actually consumed. Therefore, the cost of the flight would be included in income. For tax purposes, this benefit clearly falls within the definition of gross income. However, many employee fringe benefits (including travel passes to airline employees) have been historically excluded for tax purposes. This treatment was maintained under the Proposed Regulations introduced in 1976 and codified in 132 concerning employee fringe benefits in 1984. Under 132, the benefit is nontaxable as long as the airline incurs no substantial additional cost (e.g., the employee uses a seat that would otherwise be empty) including foregone revenue in providing the benefit. (See Example 8; pp. 5-3 through 5-5, 5-7 and 5-8; and 61 and 132.) The economist would recognize $5,000 in income. The appreciation would not be recognized for either tax or financial accounting purposes until the gain is realized. (See pp. 5-3 through 5-5.) If the taxpayer reinvests in similar property, there will be no change in his net worth, and the proceeds will not be included in his economic income. As for tax purposes, the taxpayer can defer recognition of a gain from the proceeds by investing in property that is similar or related in service of the destroyed property (involuntary conversion). If the proceeds exceed the cost of the replacement property, the taxpayer will be taxed on the excess because of the wherewithal-to-pay concept. (See pp. 5-3 through 5-6 and 1033.) No income would be recognized for economic or tax purposes. The taxpayer's net worth did not change because both his assets and liabilities increased by the same amount. Note the "claim of right" doctrine does not apply as there is a definite obligation to repay the loan. (See Example 26 and pp. 5-3 through 5-5 and 5-24 and 5-25.) The $5 ($105 $100) is included as income for tax purposes because taxable income is computed using historical costs--the increase or decrease in the purchasing power of the dollar is irrelevant. Economists, however, would not include the $5 in income because the taxpayer has realized no real increase in his net worth. (See Example 4 and pp. 5-3 through 5-8.) Since the gift increases the taxpayer's wealth, the economist would include the gift's value in income. For tax purposes, gifts are specifically excluded. (See pp. 5-4 through 5-7 and 102.) 5-4 No. The cash-equivalent approach applies to situations where income is received in a form other than cash. Therefore, in barter transactions, taxpayers are required to recognize income equal to the fair market value of the services or goods received. (See p. 5-7.) The return of capital doctrine allows the taxpayer to recover his investment in an asset tax-free. Perhaps the best example of the return of capital doctrine is a loan by the taxpayer that is later repaid. No income is recognized because the repayment represents a return of capital (the amount originally loaned out) to the taxpayer. (See Example 4 and p. 5-8.) The return of capital doctrine applies in numerous situations, such as (1) the receipt of life insurance proceeds (e.g., the proceeds are considered a return of the premiums previously paid); (2) the receipt of an annuity (e.g., the proceeds are considered, in part, a return of the taxpayer's investment); and (3) a sale. The return of capital doctrine has also been used to determine if the amount awarded for injury inflicted on the taxpayer is taxable. Any amount awarded for personal injury is nontaxable because it represents a return of the personal capital destroyed. However, if the amount represents reimbursement for lost profits, the amounts are taxable because they are merely substitutions for income. (See Examples 5, 6 and 7, pp. 5-8 and 5-9 and 104.) This type of payment is generally referred to as "supper money." Historically, the IRS allows the employee to treat the payment as nontaxable because it is considered as being for the convenience of the employer and not compensation. (See O.D. 514, 2 C.B. 90.) Interestingly, this type of payment would have been excluded under the proposed regulations because it is provided with the specific intent to enable or facilitate the performance of services. (See Proposed Regulations 1.61-18 subsequently withdrawn.) The new fringe benefit rules enacted in 1984 generally allow the value of supper money to be excluded as a de minimis fringe benefit under 132. According to this provision any property or service the value of which is so small as to make accounting for it unreasonable or administratively impracticable may be excluded. (See Chapter 6.) (See Example 8 and p. 5-10 and 132.) 5-5 5-6 Solutions to Problem Materials 5-3 5-7 "Income bunching" occurs when income earned over two or more years is realized in a single year, and thus, is recognized all in one period instead of over the period earned. For example, upon the sale of stock that has appreciated over several years, all of the gain is recognized in the year of sale rather than annually as the appreciation accrues. This creates a hardship for tax purposes because the system utilizes a progressive rate structure. Because of this structure, the income is taxed at a rate higher than what otherwise would have applied had the gain been recognized annually as it accrued. (See Example 11 and pp. 5-13 and 5-14.) Although only alluded to in the text (footnote 27), a 52-53 week year is a permissible fiscal year. It results from selecting a fiscal year that ends on a particular day each year (e.g., the last Saturday in December) rather than a particular date. Companies often do this so that their financial reports are more consistent. (e.g., 4 weeks per month, 13 weeks per quarter, 52 weeks per year). But this amounts to only 364 days for a 52 week year. Due to the extra day each year and another for a leap year, every 3 or 4 years, they will have 53 weeks in the year in order to still close on the Saturday nearest the end of the month. (See p. 5-12.) A search of Internet using Google and the words "52-53 week year" reveal that a number of publicly traded companies use this accounting period. These include: Whole Foods Market, CSX Corporation, ARK Restaurants; Rogers Corporation and Aztar Corporation. In Thor Power Tool Co., 79-1 USTC {9139, 43 AFTR2d 79-362, 99 S. Ct. 773 (USSC, 1979), the Supreme Court clearly indicated that conforming with generally accepted accounting principles does not ensure that income will be considered clearly reflected for tax purposes. The Court stated that the vastly different objectives of financial and tax accounting may require different accounting treatment of the same item. The primary goal of financial accounting is to provide useful information, while the primary goal of the income tax system is to provide an equitable collection of the revenue. These different goals have caused the courts to adopt accounting principles into the law of Federal income taxation only when they are found to be appropriate. Thus, income for tax purposes is to be determined by the tax statute and not accounting principles. (See p. 5-15.) One major difference between financial and tax accounting concerns the use of estimates. While reasonable estimates are acceptable for financial accounting, estimates are generally not permitted for tax accounting. For example, estimates of warranty expenses would not be deductible for tax purposes. The taxpayer may recognize income when a note is received because of the cash equivalent doctrine. Under this doctrine, the taxpayer reports income when the equivalent of cash is received. Notes received by a cash basis taxpayer may be considered as being equivalent to cash, while promises to pay not evidenced by a note (accounts receivable) are not treated the same as cash. In determining whether a note is equivalent to cash, the courts often look at the terms of the note. For example, if the note is secured by property or it could be easily sold without a significant discount (i.e., it is negotiable), it is more likely to be treated as cash. For a good illustration see Frank Cowden Sr. 7 AFTR 2d 1160, 289 F2d 20, 61-1 USTC {93820 (CA-5, 1961). (If a taxpayer receives a note in a sale transaction, some of the gain realized may be deferred under the installment sales provisions). (See p. 5-16.) Absent the constructive-receipt doctrine, the cash basis taxpayer would have the freedom to choose when he would report income by simply deferring the receipt of the income until the most advantageous time. For example, a cash basis taxpayer could simply postpone billing. In so doing, the taxpayer could frustrate the concept of progressive taxation and receive the income when it would be taxed at a lower rate. For example, a taxpayer could postpone picking up his paycheck until the next year to decrease this year's tax liability. The constructive-receipt doctrine curtails this freedom by requiring income recognition (regardless of when the income is actually reduced to the taxpayer's possession) when three conditions are satisfied. Income is treated as constructively received by the taxpayer if (1) the taxpayer has control over the amount without substantial limitation or restrictions; (2) the amount has been set aside or credited to the taxpayer's account; and (3) the funds are available (i.e., the payor has the ability to make the payment). The constructive receipt doctrine notwithstanding, cash basis taxpayers have far greater flexibility in reporting income (and claiming deductions) than accrual basis taxpayers since for the most part they can time their receipts and their payments. (See Examples 12 through 17 and pp. 5-16 and 5-17.) a. Taxpayers using the accrual method of accounting report income in the year in which it is considered earned under the all events test (i.e., when all the events have occurred that fix the taxpayer's right to receive such income and the amount of income can be determined with reasonable accuracy). (See pp. 5-20 and 5-21.) The claim of right doctrine requires taxpayers who receive income without restrictions regarding its use to report the income when received even though the right to the income has not been established. Although the claim of right doctrine originated in a case involving contested income, the Service has invoked the doctrine as support for taxation of prepaid income to an accrual basis taxpayer when it is 5-8 5-9 5-10 5-11 5-12 b. 5-4 Chapter 5 Gross Income received rather than as it is earned. According to the IRS's view, the claim of right doctrine requires this treatment because the taxpayer has received the income and has an unrestricted right to its use. An accrual basis taxpayer generally reports prepaid income in the same manner that a cash basis taxpayer reports it; that is, when the income is received. Prepaid interest, rents, and royalties are reported when they are received regardless of whether the accrual or cash method is used. Prepaid service income can be deferred on a limited basis. Special rules that limit deferral by accrual basis taxpayers apply to prepaid warranty income and prepaid insurance. (See Example 26 and pp. 5-24 and 5-25.) 5-13 In practice, changes in accounting method are very common. For this reason, the practitioner must recognize what constitutes a change in acounting method and understand what procedures must be followed if the taxpayer seeks to make a change. Under 446(e), taxpayers wishing to change accounting methods are required to secure the consent of the IRS before making the change. The IRS normally approves such changes only if the taxpayer agrees to make any adjustments to taxable income that are necessary to ensure that income is not omitted or deductions are not duplicated (see 481). Without special treatment, the required adjustment may impose a severe hardship on the taxpayer (e.g., the required inclusion of several years of income in a single year). As a result, the IRS is authorized under 481(c) to alter this approach. The IRS has used its authority to allow the spreading of these adjustments so as to encourage taxpayers to voluntarily change from incorrect to correct accounting methods. As a general rule, taxpayers who voluntarily change receive more favorable treatment than those who change only after they have been notified by the IRS of an impending audit. Until 1992, these detailed rules were contained in Rev. Proc. 84-74. These rules were revised somewhat by Rev. Proc. 92-20, Rev. Proc. 97-27 and Rev. Proc. 2002-19. The period over which an adjustment is made to taxable income (the spread period) differs depending on whether the taxpayer voluntarily or involuntarily changes the accounting method. If the change is voluntary, the adjustment is spread over a four-year period. If the change is involuntary (i.e., the taxpayer is under audit and the rules of Rev. Proc. 97-27 do not allow a voluntary change at that point) and the adjustment is positive, the entire adjustment is reported in income in the earliest year under audit. (See Examples 24 through 25 and pp. 5-21 and 5-23.) The change in the way interest is reported is a change in accounting method because it involves the time that the income is reported. Taxpayers cannot arbitrarily change the method that they use to account for a particular item since it may result in omission of income or duplication of deductions. For example, if in contrast to the facts given, F had planned to report the interest income when the bond was redeemed and simply switched to annual reporting, all of the prior year's income would never be taxed. To ensure that this does not occur, 446(e) requires the taxpayer to secure the consent of the IRS before the accounting method is changed. The IRS does not have to honor the request. If it does, however, it will normally require the taxpayer to make whatever adjustment is necessary to ensure that income is not omitted. The taxpayer requests a change in accounting method by filing Form 3115, "Application for Change in Accounting Method," during the tax year in which the change is to become effective. (See pp. 5-21 through 5-23.) It is interesting to note why the taxpayer might want to make this change. Prior to 1986, taxpayers usually elected to report the interest income annually since it would normally be offset by the child's personal exemption. In addition, this practice avoided income bunching when the bond was redeemed. Because of changes made in 1986, a dependent child is no longer entitled to a personal exemption deduction, and, moreover, may be subject to the kiddie tax. The taxpayer may avoid the kiddie tax, however, if the income is not reported until the year in which the child turns age 19 (or if a full time student, at age 24). Thus, a taxpayer who has historically reported Series E or EE income annually might want to change the method of accounting. T's new accountant has detected an accounting error. T should file amended returns for any open years, correcting the amount of income reported to reflect the proper gross profit percentage of 50 percent rather than 40 percent. The income not reported in years that are closed due to the statute of limitations is never taxed. Note that the treatment of an error in accounting is much different than a change in accounting method. If T's change were considered a change in accounting method, T would be required to seek the consent of the IRS to change. More importantly, the IRS would no doubt grant T's request only if the income not reported in prior years is reported as an adjustment under 481. The Code does not define what constitutes an accounting method. As a practical matter, the Courts have typically viewed any consistent treatment of a particular item that involves the time when such item is reported as an accounting method. Unfortunately, this definition provides little guidance. The Regulations, however, make it quite clear that corrections of errors are not changes in accounting methods. (See p. 5-23.) 5-14 5-15 Solutions to Problem Materials 5-5 5-16 a. b. The claim of right doctrine requires accrual basis taxpayers who receive income without restrictions regarding its use to report the income when received even though the right to the income has not been established. Although the claim of right doctrine originated in a case involving contested income, the Service has invoked the doctrine as support for taxation of prepaid income to an accrual basis taxpayer when it is received rather than as it is earned. According to the IRS's view, the claim of right doctrine requires this treatment because the taxpayer has received the income and has an unrestricted right to its use. (See Examples 26 through 27 and pp. 5-24 through 5-26.) The claim of right doctrine should be distinguished from the constructive receipt doctrine. The constructive receipt doctrine concerns whether the taxpayer can be considered in receipt of income. For example, income set aside and made available for the taxpayer's use is considered received even though the taxpayer has not reduced it to his actual possession. In contrast, the claim of right doctrine concerns the taxation of income which, although received by the taxpayer (or constructively received), may or may not be rightfully his. Under the claim of right doctrine, any income that the taxpayer receives and treats as his own and for which he does not recognize an obligation to repay is taxable in the year of receipt. (See pp. 5-16, 5-24, and 5-25.) 5-17 If the landlord wants to postpone the recognition of the $500 as income, he should classify the amount received as a security deposit. A security deposit is not treated as income under the claim of right doctrine because the taxpayer recognizes an obligation to repay the amount if the lease agreement is not violated. (See p. 5-26.) The general rule regarding the reporting of prepaid service income is stated in Revenue Procedure 2004-34. This procedure permits the taxpayer to use the "full-inclusion method" or the "deferral method." Under the fullinclusion method all of the payments are reported in the year of receipt regardless of how the payments are reported for financial accounting purposes. Under the deferral method, the taxpayer reports the payments to the extent they are included in the revenues of the taxpayer's financial statements and the balance is reported as income in the following year. Thus the maximum deferral that a taxpayer can obtain for prepaid service income (and rentals that are considered services) is a single year. (See Example 28 and pp. 5-26 through 5-27.) The Code sets forth special rules for accounting for long-term contracts. A contract is considered long-term if it is for the manufacture, building, installation, or construction of property and is not completed within the same taxable year in which it was entered into. However, a manufacturing contract is still not considered long term unless it also involves either (1) the manufacture of a unique item not normally carried in finished goods inventory (e.g., a special piece of machinery) or (2) items that normally require more than 12 months to complete. Taxpayers are generally required to use the percentage of completion method to account for income from long-term contracts. However, there are several situations where the completed contract method can still be used. These include home construction contracts and contracts of a small business (i.e., a taxpayer whose average annual gross receipts for the three preceding taxable years do not exceed $10 million). (See p. 5-28.) a. Percentage of completion. The taxpayer does not meet the small business exception because the gross receipts of the business have exceeded $10 million for the last three years; furthermore, the contract does not meet the exception for home construction since it is an office building. (See p. 5-28.) b. Completed contract or percentage of completion. Home construction contracts need not be accounted for using the percentage of completion method regardless of the level of gross receipts. (See p. 5-28.) c. Percentage of completion. The taxpayer does not meet the exception for contractors with less than $10 million in gross receipts. In addition, even though the contract is for residential housing, the contract does not qualify as a "home construction contract," (i.e., a contract in which 80% of the costs are related to a building containing four or fewer dwelling units). A 70 percent percentage of completion method may be used for certain residential contracts [See p. 5-28 and 460(e)(5) and (6).] d. This contract is not considered a long-term contract. To be considered long term, a manufacturing contract must be for a unique item or require a manufacturing period that exceeds 12 months. Because the contract is not long term, it is accounted for under the rules relating to advance payments for goods. If any payments are received prior to the shipment of the goods, the advance payment rules generally allow accrual basis taxpayers to defer recognition of the income to the same period when the income is reported for financial accounting, normally the period in which the items are shipped. (See p. 5-28.) e. Percentage of completion. The contract meets neither of the exceptions allowing the completed contract method (i.e., the contractor's gross receipts of $12 million exceed the $10 million threshold, and the contract is not for home construction). Even though the contract is a manufacturing contract it is still considered long term because it is for the manufacture of what appears to be a unique item (or alternatively, an item that requires more than 12 months to manufacture). (See p. 5-28.) The purpose of this arrangement is to shift the income to the beneficiaries of the trust where it presumably would be taxed at a lower rate. However, the assignment of income doctrine prohibits the transfer of 5-18 5-19 5-20 5-6 Chapter 5 Gross Income income between taxpayers as a device to escape taxation. Under this doctrine, income is taxed to the person who earns the income. (See Example 43 and p. 5-34.) 5-21 Because a partner or a shareholder in an S corporation reports his share of the entity's income in his tax year within which the entity's taxable year-ends, the taxpayer can defer recognition of the income for up to 11 months. For example, assuming a partnership's year ends January 31, 20X1, the taxpayer would not report his share of partnership income until he files his 20X1 tax return in 20X2. It is important to note that there are restrictions on the tax year that a partnership or S corporation may select. (See Example 9 and p. 5-12.) Knowledge of the community property system becomes significant for income tax purposes primarily when married taxpayers file separate returns by choice, or because they were married during the taxable year but were divorced at year-end. Filing of a separate return requires that the taxpayer determine his own taxable income. In this regard, community property law operates to classify the income as belonging to one spouse or the other. Thus, knowledge of community property law may be necessary to determine the amount of income that should be reported on an individual return. Practitioners practicing in common law states need to understand the community property system because clients may have moved from a community property state and may still have property acquired under the laws of those states. (See pp. 5-8 and 5-39.) Timing income recognition can produce significant tax savings. If the taxpayer expects that his tax bracket will be higher in future years, he will want to recognize as much current income as possible to minimize the tax rate that would apply. (See p. 5-40.) Several income-splitting techniques are available to R. Several of these techniques require the transfer of income-producing property, since the assignment of income doctrine precludes the shifting of income arising from personal services. Note, however, that under the kiddie tax rules any unearned income of a child under age 19 (or age 24 if a full-time student) that exceeds $1,900 in 2011 is taxed at R's rates. (See pp. 5-40 and 5-41.) One popular income-splitting technique used for family businesses involves establishing a partnership or an S corporation with family members as the partners or shareholders. R could form a partnership or an S corporation and transfer interests in the partnership or corporation to the family members. (These transfers may be subject to the gift tax if the value of the interest transferred exceeds the amount of the annual exclusion ($13,000 in 2011).) By transferring interests to family members, any income arising from the business will be allocated to the partners (or shareholders) and taxed to them. Note that control of the entity may be retained by the family. Because of the tax avoidance opportunities inherent in these arrangements, certain requirements must be satisfied [e.g., see 704(e) concerning family partnerships]. Another technique requires the transfer of an income-producing asset of the business to a family member or a trust whose beneficiaries are family members. For example, if the business owns the building in which it operates, the building could be transferred to a family member or trust and leased back to the business. The business would pay rent to the lessor, thus, shifting income from the business to the new owner of the property. As in the case of family partnerships or S corporations, trust-leaseback arrangements are successful only if certain judicial tests are satisfied. For example, the transfer must be generally motivated by a business purpose rather than an intent to avoid taxes. a. The enactment of the "kiddie tax" in 1986 severely restricted a taxpayer's ability to shift income to a lower tax bracket child. Under the kiddie tax, the unearned income of a child that exceeds $1,900 (in 2011) is taxed at the parents' rates. Until 2006, the kiddie tax applied to children less than 14 years of age. However, changes in 2006 significantly increased the scope of the tax by making it applicable to children less than 18 years old. In 2008, the law was changed once again so that the kiddie tax now applies if the child is less than 19 years old (or if the child is a full-time student, age 24). For the most part, the current rules make it difficult to shift investment income to the child to be taxed at a lower rate, particularly if the child goes to college. In such case, the kiddie tax applies until the child turns age 24. The kiddie tax does not completely eliminate income shifting or its benefits, however. The kiddie tax does not apply if the child reaches age 19 (or 24 if a full-time student) during the tax year. Assuming the child still relies on the parent until age 22 and is not a full-time student, income can be shifted and taxed at a lower bracket for four more years. For children to whom the kiddie tax applies, it should be emphasized that the kiddie tax does not apply until unearned income exceeds $1,900 (in 2011). As a result, for these children, the first $950 of unearned income bears no tax due to the standard deduction, and the next $950 is taxed at the child's rate. This rule allows modest amounts of income to be shifted before the child becomes 19 (or 24, if a full-time student) years of age. Assuming a 5 percent return, $38,000 could be accumulated before the child would be subject to the special tax ($38,000 5% $1,900). In addition, with investments where income is realized after the child reaches age 19 (or 24 if a full-time student), the kiddie tax is avoided. Such investments include series EE savings binds, growth stocks, and insurance policies. (See Example 43 and p. 5-40.) 5-22 5-23 5-24 5-25 Solutions to Problem Materials 5-7 b. Several techniques are available to shift income. The most common are: Gifts of income producing property such as stocks, bonds, rental property and the like. Employment of the individual. This takes advantage of the individual's standard deduction in that the standard deduction is generally allowed to the extent of earned income. (See p. 5-40 and Example 43.) YOU MAKE 5-26 THE CALL Aware of the dim view the IRS takes of tax evasion, Al may want to explain to his client, in no uncertain terms, the potential consequences of omitting $150,000 of income from his return. In the event the omission is discovered, Dr. Floss would undoubtedly invite, at best, the assessment of the substantial understatement penalty, although the far more significant penalty for civil fraud (not to mention criminal fraud) lurks in the background. Either way, the dentist will have incurred the wrath of the IRS and earned the close scrutiny of future returns for years to come. Given that the possibility of discovery, with all its ramifications, is not enough to sway the daring dentist. Al needs to consider his own position if he elects to stay with this client. Section 6694(b) imposes a $1,000 preparer penalty in the event an understatement is due to a willful attempt to understate a taxpayer's liability or a reckless or intentional disregard for rules and regulations. Reg 1.6694-3(b) provides that a preparer is subject to this penalty if he disregards, in an attempt wrongfully to understate the liability, information furnished by the taxpayer or other persons. The AICPA addresses preparer knowledge in its Statements on Standards for Tax Services (SSTS No. 3, which states that "the CPA should not ignore the implications of information furnished [by the taxpayer or a third party] and should make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to the CPA." If Al chooses not to prepare the return under the circumstances outlined here, he is not required to take any action with regard to either Dr. Moller or Dr. Floss, aside from severing his professional relationship with the latter. He is not obligated to report the matter to the IRS and is, in fact, proscribed from doing so by his profession, except where required by law. (See SSTS No. 6, which relates to preparer knowledge of error. Although it addresses the management of the situation where an error is discovered in a previous filed return, presumably the same confidentiality standard applies to information relating to a return not yet filed.) Should Dr. Floss take his business to Al's competitor down the street, Al has no responsibility to relate to the new accountant any information regarding his client and is prohibited from doing so except with his client's permission. (See Chapter 2.) PROBLEMS 5-27 a. b. No. The increase in value is not recognized as income until it is realized (e.g., when Q sells or otherwise disposes of the property). (See p. 5-5.) Yes. This is a bargain purchase. The $4,000 difference between the sales price of $3,000 and the property's value of $7,000 would constitute compensation unless R can establish that the bargain element of the sale was a gift. Note, however, that so-called qualified employee discounts are excludable, as discussed in Chapter 6. These discounts must be on property other than real property that is offered for sale to customers in the employer's ordinary line of business in which the employee is performing services and they must not exceed the employer's gross profit margin. (See p. 5-7 and 132.) No. Although I has "cashed in" on the increase in value of the property, no income is realized because there has not been a disposition of the property, and I still remains obligated to repay the $10,000 loan. Moreover, I's net worth has not increased. Assets have increased, but so have liabilities. (See p. 5-8.) Yes. S would be treated as having received $60 (30% $200) per month as income from using the car for personal purposes. Because S is controlling shareholder of the business, the income probably would be treated as a constructive dividend from the corporation. (See p. 5-10 and 61.) No. No income will be recognized until it is realized (e.g., when R sells or disposes of the land). (See p. 5-5.) Yes. L would recognize as income the fair market value of the radio, $200. (See p. 5-5.) Yes. Since the services are provided in lieu of rents, E has rental income of $1,000 and should capitalize $300 of improvements. F would recognize $300 as compensation for services rendered. (See pp. 5-5 through 5-6.) Yes. Because D has no intention of repaying the notes, that is, he recognized no obligation to repay, the amounts borrowed represent income under the claim of right doctrine. (See pp. 5-24 through 5-26.) c. d. 5-28 a. b. c. d. 5-8 Chapter 5 Gross Income 5-29 a. b. c. Yes. The $39,000 reimbursement for mental anguish might appear to be excluded from income because it represents a return of capital. However, 104(a)(2) as amended in 1996 allows an exclusion only for physical personal injury. Section 104 makes it clear that emotional distress shall not be treated as a physical injury or physical sickness. The remaining $61,000 is included as it is in lieu of compensation. (See Example 6 and p. 5-9.) No. The discount is an employee fringe benefit that historically has been excluded. This treatment was codified in 132 in 1984. Now, so-called qualified employee discounts are excludable, as discussed in Chapter 6. These are discounts on property other than real property and services that are offered for sale to customers in the ordinary course of the line of business of the employer in which the employee is performing services, and do not exceed the employer's gross profit margin. (See p. 5-10 and 132.) No. Historically, noncash transfers of small value to employees are treated as nontaxable employee fringe benefits. This treatment was codified in 1984 under the de minimum fringe benefit rules of 132, as discussed in Chapter 6. According to these rules, property with a value that is so small as to make accounting for it (e.g., as salary and for payroll tax purposes) unreasonable or administratively impracticable are excluded. (See 5-10 and 132.) Because the check was available on December 31, R is treated as having constructively received it as of December 31 and must recognize the income that year. (See p. 5-16.) Although the coupons were not cashed until January 7, the taxpayer is treated as having constructively received the income on December 31, since he has control over receipt. (See p. 5-16.) Because R could control when the payment was to be made, his bonus may be treated as having been constructively received in the year the bonus was authorized, assuming the corporation has adequate funds to make payment. The other officers will not include the bonus until the next year because they lack the control of R. (See pp. 5-16 and 5-17.) Yes. In the case of checks, a taxpayer is deemed to have received payment when the check is received rather than when it is cashed. As a practical matter, R's W-2 no doubt would control. (See Example 12 and pp. 5-16 and 5-17.) No. D is not in constructive receipt of the check because it was not available to him for his immediate use and enjoyment. (See Example 13 and p. 5-17.) Yes. E has control over the property. The fact that he is unable to find a buyer is not a substantial limitation. (See p. 5-16.) No. Although Z has received the check, the funds are not available. (See Example 17 and p. 5-17.) No. As long as the corporation customarily pays the dividends by mail so that the shareholder receives it after year-end, the shareholder is not considered in constructive receipt. (See Example 15 and p. 5-17.) Yes. Funds received by the taxpayer's agent are considered received by the taxpayer. (See Example 16 and p. 5-17.) No. The fact that the funds are available only if the taxpayer cancels the policy is a substantial restriction. Therefore, L is not in constructive receipt of the annual increase in value. (See p. 5-16.) If the IRS requires JB to change his method of accounting (i.e., an involuntary change), JB would have a positive adjustment of $180,000 as computed below. Note that because the IRS initiated the adjustment (i.e., it was involuntary), the entire $180,000 must be included in income in the year of the change. (See pp. 21-through 23.) Income: Accounts receivable balance (sales otherwise omitted) $ 70,000 Inventory balance (previously expensed, now capitalized) 130,000 $200,000 Expense Accounts payable (no deduction was taken yet since not paid) (20,000) Total adjustment $180,000 5-30 a. b. c. 5-31 a. b. c. d. 5-32 a. b. c. 5-33 a. 11b. As above, the taxpayer will be required to include $180,000 in income. However, by voluntarily making the change, the taxpayer is entitled to a forward spread of four years, the year of the change and the following three years. (See Example 24 and p. 5-22.) Yes. The Regulations permit the taxpayer to use a combination of accounting methods. Thus, JB may use the accrual method to account for inventories and sales but may use the cash method for other items such as interest income or supplies. (See p. 5-15.) c. Solutions to Problem Materials 5-9 5-34 No. HIJ may defer the $60,000 until that time when it is properly accrued. Accrual basis taxpayers normally report advanced payments for goods when the goods are shipped, assuming this method is followed for financial accounting purposes. If the goods are on hand at year-end and substantial payments (payments exceeding the goods' cost) have been received, the advanced payments must be reported at the earlier of the year reported for financial accounting purposes, or the second year following the year of receipt. (See Example 29 and pp. 5-27 and 5-28.) a. It appears that the taxpayer would be required to use the percentage of completion method. The completed contract method can be used only if the taxpayer has average annual gross receipts for the three preceding tax years of less than $10 million or the contract qualifies as a home construction contract. The taxpayer is a large contractor and it seems apparent that its gross receipts would exceed the $10 million threshold, prohibiting him from qualifying for the completed contract method under the small business exception. Similarly, the taxpayer would not qualify under the home construction contract exception since the contract is for a performing arts building. (See p. 5-28.) When using the percentage of completion method, the portion of the total contract price reported during the year and matched against current costs is computed as follows. (See Example 30 and p. 5-28.) Total contract price Direct and allocable indirect costs incurred this period Total estimated costs of contract 5-35 b. Using the formula above, the taxpayer would report the income from the contracts as follows: Contract price Percentage complete this period (a fraction) Revenue earned (% $5 million) Costs incurred Gross profit Year 1 $ 5,000,000 $ 2,000,000 50% $ 4,000,000 $ 2,500,000 (2,000,000) $ ,500,000 Year 2 $5,000,000 $ ,500,000 12.5% $4,000,000 $ ,625,000 (500,000) $ ,125,000 Year 3 $ 5,000,000 Contract complete $ 1,875,000* (1,000,000) $ ,875,000 *Balance of contract ($5,000,000 $2,500,000 $625,000 $1,875,000) c. The corporation's actual costs to complete the contract were $3,500,000 rather than $4,000,000 as it had estimated. As a result, the look-back rules of 460(b)(3) require that annual income based on actual costs must be computed and compared to income previously reported. If income is understated, the taxpayer must pay interest on the tax that otherwise would have been paid. In this case, the corporation owes interest computed as follows Year 1 Revised Contract price Percentage complete this period using actual costs of $3,500,000 Revenue earned (Revised percentage 57.1% $5,000,000) Costs incurred Gross profit based on actual costs Gross profit originally estimated Understatement of income Tax rate Underpayment of tax Interest rate Simple interest for first year (4/15/2 to 4/15/3) $ 5,000,000 $ 2,000,000 $ 3,500,000 $ 2,855,000 (2,000,000) $ ,855,000 (500,000) $ ,355,000 34% $ ,120,700 10% $ ,012,070 57.1% Technically, interest is computed using the overpayment rate established by 6621, compounded on a daily basis. A similar procedure would be used to compute the amount of interest due for subsequent years. (See Example 31 and p. 5-29.) 5-10 Chapter 5 Gross Income 5-36 The taxpayer may elect to include in his income for the current year the $56 increase in the redemption price of the bond during the current year. This election applies to all Series EE bonds the taxpayer owns at that time as well as any subsequent bond acquisitions. If the taxpayer does not make the election, the income is not reported until the bond is redeemed. The amount to be reported would be the entire difference between the redemption and the issue price. (See Example 36 and p. 5-31.) a. Yes. Because the payment was received and GLX has an unrestricted claim to the income (i.e., the claim of right doctrine applies), GLX must include the $10,000 in income in 2011 although the right to income may be in question. (See Examples 26 and 27 and pp. 5-24 and 5-25.) Yes. If GLX had not received the payment, the income would not be includible under the claim of right doctrine. In addition, since GLX's rights to the income had not been fixed, the all events test would not be satisfied and the income would not be accruable. (See pp. 5-24 and 5-25.) 5-37 b. 5-38 Q must include $2,700 [$2,400 (prepaid rent) $300 (security agreement deposits where lease agreement was violated)] as income. The $1,000 collected for security deposits will not be included unless the terms of the lease are violated because it is refundable. A security deposit is not treated as income under the claim of right doctrine, since the taxpayer recognizes an obligation to repay the amount if the lease is not violated. (See p. 5-26.) a. LL Corporation would include $50,000 in income in the first year, 2011. Technically, LL has two options for reporting the $200,000 of advanced payments for services. These are: a "full-inclusion method" and a "deferral method." Under the full-inclusion method all $200,000 of the payments are reported in the year of receipt regardless of how the payments are reported for financial accounting purposes. Under the deferral method, in the first year, 2011, LL reports the payments to the extent they are included in the revenues of the taxpayer's financial statements and the balance is reported as income in the following year. In this case, LL probably would report the income for financial accounting purposes as it is earned. Since one-fourth of the services are provided in the first year, 2011, LL would report one-fourth or $50,000 in the first year, 2011, for financial accounting purposes. Tax would follow this approach and LL would report $50,000 as income for tax purposes in the first year, 2011, as well. For tax purposes, the balance of the payments received, $150,000 ($200,000 $50,000) would be reported in the following year, 2012. (See Example 28 and pp. 26 and 27.) The answer is the same as in (a) in terms of the full-inclusion method. When the deferral method is used $25,000 should be reported in 2011 and $175,000 in 2012. This result occurs notwithstanding the fact that services are performed over three accounting periods and would be reported over three accounting periods for financial accounting purposes. (See Example 28 and pp. 26 and 27.) As in parts (a) and (b), the taxpayer may use the full inclusion method or the deferral method. If the full inclusion method is used, all $700,000 of the payments are reported in the year of the receipt regardless of how the payments are reported for financial accounting purposes. Under the deferral method, the basketball operation would report the income in the same manner as it does for financial accounting purposes, as it is earned (as the games are played). Therefore $256,098 [(15 games played/41 total games during season) $700,000] will be included in the income of 2011. The remainder will be deferred because the services (i.e., the games) will be provided in 2012. (See Example 28 and pp. 26 and 27.) The rules applying to prepaid services are used rather than those for prepaid rents, since significant services are provided in addition to the room. As in parts (a) and (b), the taxpayer may use the full inclusion method or the deferral method. Under the full inclusion method, all $10,000 of the payments would be included in the earlier year. If the deferral method is used, as long as the rooms are to be rented prior to the end of 2012, the income will be deferred until 2012, when it is earned for financial accounting purposes. (See Example 28 and pp. 26 and 27.) 5-39 b. c. d. 5-40 Because E's grandmother owns the vending machines, the $5,000 must be included in her gross income. Under the assignment of income doctrine, income from property is taxed to the owner of the property and not to the person who collects the income. (See p. 5-34.) A partner reports her share of partnership income in her year in which the partnership year ends. Thus, on her 2011 tax return, Q must report her share of the partnership income, $36,000 (30% of $120,000), even though she only withdrew $12,000. As for her share of the first quarter income (ending December 31, 2011), Q would not report this income until she files her 2012 tax return. (See Example 9 and p. 5-13.) 5-41 Solutions to Problem Materials 5-11 5-42 a. 1. The discount on government securities with maturities of less than one year is reported under 454(b) as ordinary income in the year in which the instrument is disposed of (when the cash method of accounting is used). Thus, G reports the $100 discount ($10,000 par value $9,900 purchase price) in 2011. It is important to point out that the redemption is treated as a sale and without these special rules, the gain would be capital gain. (See Example 38 and p. 5-33.). 2. Under the accrual method of accounting, G is required to amortize the discount on a daily basis under 1281(a). The $100 discount is amortized at $1.11 per day ($100/90). Thus, G reports $67.71 of interest income in 2010 ($1.11 61 days), and $32.29 ($100 $67.71) in 2011. [See Example 37, p. 5-32, and 1281(a) and 1283(b).] b. Under the cash method of accounting, G reports all of the interest when it is received in 2010. In this case, however, only the $3,333 ($100,000 10% 4/12) interest accruing from the date of purchase, November 1, 2010, through February 28, 2011 is considered interest income in 2011. The remaining $1,667 of interest is considered a nontaxable return of capital, and reduces G's basis to $93,333 ($95,000 $1,667). Note that the special rules governing discounted instruments do not apply, since the bonds were issued at par (thus, no OID). (See Examples 32 through 34 and p. 5-30.) 2. Under the accrual method of accounting, G would report $1,667 ($100,000 10% 2/12) interest accrued to December 31, 2010. With respect to the payment received in March, two months of interest accrued prior to purchase, $1,667, is a nontaxable return of capital, while the remaining $3,333 represents $1,667 of accrued interest from November through December, 2010, and another $1,667 of interest for January and February, 2011. (See Example 34 and pp. 5-29 and 5-30.) 1. 5-43 Because the couple has made an interest free loan to the trust and none of the special exceptions apply, interest must be imputed under 7872. Under these rules, the trust is deemed to have paid the foregone interest of $23,000 to the parents and the parents are deemed to have re-transferred the $23,000 back to the trust as a gift to D. If the gift qualifies for the annual exclusion ($13,000 per donee in 2011) and gift splitting is elected, the parents will not have made a taxable gift. [The gift may not qualify for the annual exclusion because it is a gift of a future interest under 2503 unless the trust meets the requirements of 2503(c) or a Crummey power exists.] The trust will probably treat the interest payment as investment interest and deduct it to the extent of any investment income. (See Example 38, p. 5-36.) The corporation appears to have made an interest free loan to J, requiring the imputation of interest. According to 7872, if the loan is less than $10,000, there are no special tax consequences. In this case, however, the loan is $15,000. As a result, J is treated as having paid the interest on the loan to the corporation and the corporation is deemed to have re-transferred the interest back to J. The loan is a corporate shareholder loan and because J owns all of the stock of the company, the payment will be treated as a dividend. The corporation receives no deduction for the payment of dividends. J's treatment of the deemed interest payment depends on how he used the loan proceeds. If the proceeds were put to personal use, the interest payment is not deductible. (See Example 38 and pp. 5-35 through 5-37.) a. In this case, F is no doubt attempting to lower the family's total tax liability by shifting interest income to his son who presumably is in a lower tax bracket. Before 1984, such a plan would be effective. Currently, however, 7872 applies to prohibit the shifting of income. Under the basic rules, S is deemed to make a payment of interest to F of $3,000; this is treated as having been transferred by F back to S as a gift. However, when the loan is less than $100,000, the amount of interest income deemed to be paid by S to F is limited to S's investment income, which in this case is $1,200. Thus, S would be entitled to a deduction for interest expense of $1,200 if he itemizes, which is unlikely. F would include the $1,200 in income, thus eliminating the benefits of shifting. F would also be deemed to have made a gift of $3,000, which would not be a taxable gift because it is less than the annual exclusion of $13,000 in 2011. Note that the amount of the imputed gift is not affected by the taxpayer's net investment income. (See Example 40 and pp. 5-36 through 5-38.) No. If S invests in income-producing assets, the $10,000 exemption does not apply, and hence, interest income is imputed to F. (See p. 5-37.) No effect. Section 7872 governing interest-free loans does not apply when the loan is a gift loan less than $10,000 and the donee does not use the funds to purchase income-producing assets. In this case, the loan is less than $10,000, and it is used to purchase a car, not income-producing property. (See p. 5-37.) 5-44 5-45 b. 5-46 a. 5-12 Chapter 5 Gross Income Because the loan was used to purchase income-producing property, the $10,000 exemption does not apply. However, when the loan is between individuals and does not exceed $100,000, the amount of interest income imputed to the lender cannot exceed the borrower's net investment. In addition, if the borrower's net investment income is less than $1,000, no interest income is imputed to the lender. Thus, in this case, since the borrower's total net investment income of $1,200 (not just the $800) does exceed the $1,000 threshold, interest income is imputed to the lender, and the borrower has an interest deduction for a like amount. In addition, J is treated as having made a gift to K. Here, the gift that would equal the amount of imputed interest on $8,000 (the loan amount) would be less than the amount of annual exclusion. Thus, there would be no taxable gift. (See pp. 5-35 through 5-37.) c. The $10,000 exemption does not apply because the loan exceeds $10,000. However, the special rule for loans between individuals not exceeding $100,000 is applicable. Because investment income is zero, no interest income is imputed to J, nor is B entitled to a deduction. However, J is still deemed to have made a gift equal to the imputed interest, which in this case would fall below the annual exclusion of $13,000 (2011). (See pp. 5-38 and 5-39.) d. None of the exceptions apply. Thus, interest income is imputed to P corporation, and a deduction for interest expense of the same amount may be available for Q. Because the loan is to the corporation's sole shareholder, it is presumed to be a corporation-shareholder loan. Thus, P would be deemed to have paid a nondeductible dividend that Q must report in income. (See Example 38 and pp. 5-35 through 5-38.) e. None of the exceptions apply. Thus, interest income is imputed to P Corporation, and a deduction for interest expense of the same amount may be available for Q. In this case, the loan is a compensationrelated loan. Thus, P would be entitled to a deduction for the imputed interest, while Q must include the amount in income. In addition, P would be required to withhold and pay the proper income and employment taxes. (See Example 38 and pp. 5-35 through 5-38.) b 5-47 a. Yes. A regular C corporation is normally prohibited from using the cash method. An exception is provided, however, for any entity other than a tax shelter that has average annual gross receipts (AAGR) for all prior years not exceeding $5 million. This test is satisfied for any prior year only if the AAGR for the three-year period ending with such year does not exceed $5 million. Corporate AAGR for all years prior to 2008 satisfy this test, since annual receipts never exceeded $1 million. AAGR for 2009 are $1,666,667 [($1,000,000 $1,000,000 $3,000,000) divided by 3], and thus, the cash method could be used for 2010. AAGR for 2010 was $4 million [($1 million $3 million $8 million)/3], and thus, the cash method can be used in 2011. (See Example 19 and pp. 5-18 through 5-19.) Yes. Partnerships that have no regular C corporations as partners may use the cash method. (See p. 5-18.) Yes. This corporation is a qualified personal service corporation (i.e., a regular C corporation is qualified if substantially all of the activities consist of performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and at least 95 percent of its stock is held by the employees who are providing the services--the latter test is considered satisfied if the stock is owned by a retired employee, a deceased employee's estate, or his or her heirs.) (See Example 18 and p. 5-19.) Yes. Only regular C corporations are prohibited. S corporations can use the cash method because they are not specifically prohibited. (See p. 5-18.) Yes. A trust is eligible because it is neither a partnership, corporation, nor tax shelter. (See p. 5-18.) No. All tax shelters are prohibited from using the cash method. The various exceptions (e.g., less than $5 million in average annual gross receipts, partnerships, qualified personal service corporations, and farming) do not apply to tax shelters. A tax shelter generally is defined as any enterprise (other than a regular C corporation) if interests in such enterprise have been offered for sale in any offering required to be registered under Federal or state security agencies. The fact that the partnership is publicly traded implies that this condition is satisfied. (See p. 5-18.) b. c. d. e. f. 5-48 In this case, the Tax Court held that the company must accrue the income from the goods and services in the taxable year in which performance occurred. It believed that the company's preparation and sending of the invoices were ministerial acts that did not postpone accrual of the income otherwise earned. Thus, accrual may be required if the only remaining actions consist of such ministerial acts as submitting the requisite bill. However, if the required billing is a significant part of the sales contract, billing may be more than a mere ministerial act and a different result may be warranted. (See Examples 20, 21 and 22 and pp. 5-20 through 5-21.) The issue in this question is whether the all events test has occurred with respect to the refund claim. In other words, does the corporation have an unconditional right to the refund. Rev. Rul. 2003-3, 2002-3 CB 252 held that approval by state tax authorities of a refund claim based on a carryback is not ministerial but 5-49 Solutions to Problem Materials 5-13 involves substantive review. The ruling concluded that the refund accrues for federal tax purposes when the taxpayer receives payment of the refund or notice that it will be allowed. (See Examples 20, 21 and 22 and pp. 5-20 through 5-21.) 5-50 In TAM 9823003, the government indicated that the taxpayer in this situation is not required to report the income until a sale actually occurs. According to the TAM, the IRS agent contended that the taxpayer should report the income when it received the prints since at this point in time, the taxpayer had a fixed right to receive income because the required performance has occurred (the film had been developed), and the amount of the income can be determined with reasonable accuracy. The National Office agreed that the objective in these cases is to determine when the seller acquired an unconditional right to receive payment under the contract. However, it disagreed with the agent's claim. It explained that in the case of a taxpayer selling goods, the taxpayer's claim for the purchase price arises at the time the sale is made. Until a sale occurs, the required performance has not occurred to fix a taxpayer's right to receive income. Therefore, a taxpayer selling goods generally accrues income from the sale of goods at the time of the sale. It pointed out that since customers were not obligated to purchase the prints, the taxpayer's right to receive income under all-events test did not arise until customers actually purchased the prints. The TAM also noted that a sale occurs for tax purposes when the seller relinquishes the benefits and burdens of ownership of the goods. Such a determination (i.e., when a sale takes place) depends on the totality of the circumstances, including when title passes and when possession is transferred. In this case, the TAM believed the circumstances indicated that the benefits and burdens of ownership were transferred from the taxpayer to the customer when the customer purchased the finished prints. Before this sale occurred the taxpayer did not have an unconditional right to receive payment for the prints. (See Examples 20, 21 and 22 and pp. 5-20 through 5-21.) a. b. No. Mr. and Mrs. D receive no deduction for the payment of the allowance, and consequently, no income is shifted. Yes. Because Mr. and Mrs. D may deduct the wages paid to their son, this income is not taxed to them. Moreover, because this income is earned income for their son C, it is not taxed at the parents' rates but rather at the son's rates. In addition, the son may use the standard deduction to offset this earned income without limitation. Finally, the wages are not subject to social security taxes--assuming the car wash is operated as a sole proprietorship or partnership operated by his parents--since wages paid by a parent to a child under age 18 are exempt from social security. Yes. The purchase of savings bonds circumvents the "kiddie tax," since the interest income on the bonds may be deferred until the bonds are redeemed after C reaches the age of 19 (or 24, if the child is a full-time student). No. Under the assignment of income doctrine, income is taxed to the person who earns it. Thus, the salary would be taxed to Mrs. D who would then be considered as having made a gift to her son. Wages paid by parents to children under age 18 are exempt from social security. Consequently, the social security provisions do not impose a cost on the shifting of income from parent to child when wages are paid. Because C can no doubt be claimed as a dependent on Mr. and Mrs. D's return, C cannot claim an exemption for himself. Consequently, C's personal exemption deduction is unavailable to offset any income that might be shifted to him. However, C is entitled to a minimum standard deduction of $950 (in 2011), which can be increased by any earned income that he might have. 5-51 c. d. e. f. (See Examples 43 and pp. 5-34, 5-40 and 5-41.) TAX RETURN PROBLEMS Solutions to the Tax Return Problems (5-52) are contained in the Instructor's Resource Guide and Test Bank for 2012. TAX RESEARCH PROBLEMS Solutions to the Tax Research Problems (5-535-60) are contained in the Instructor's Resource Guide and Test Bank for 2012. ...
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This note was uploaded on 02/05/2012 for the course BIS 101 taught by Professor Simonchan during the Spring '08 term at UC Davis.

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