CHAPTER 7

DISCUSSION QUESTIONS
1. No deduction is allowed for the bad debts of a cash basis taxpayer because no income has
been reported. p. 7-3

2. Ron has a nonbusiness bad debt. The debt is unrelated to Ron’s trade or business. The
use to which the borrowed funds are put is of no consequence in classifying the bad debt
as a nonbusiness bad debt. p. 7-5

3. A legal action need not be initiated against the debtor, but all of the surrounding facts and
circumstances must indicate that such an action would not result in a collection of the
debt. p. 7-4

4. If an account receivable has been written off as uncollectible during the current tax year
and is subsequently collected during the current tax year, the write-off entry is reversed.
If the account receivable recovered was written off during a previous tax year, income is
created subject to the tax benefit rule. pp. 7-4 and 7-5

5. A nonbusiness bad debt for an individual taxpayer is treated as a short-term capital loss.
As such, the maximum amount of net short-term capital loss that an individual can deduct
against ordinary income in any one year is $3,000. p. 7-5

6. A bona fide debt exists when a debtor-creditor relationship is based on a valid and
enforceable obligation to pay a fixed or determinable sum of money. The determination
is based on an examination of the prevailing facts and circumstances. p. 7-6

7. John should be concerned with the following issues:

• Is the loan a nonbusiness or business bad debt?

• Is the deduction a for AGI deduction?

• Is the deduction an itemized deduction?

• Is the deduction subject to the 2% floor?

pp. 7-3 to 7-6

8. Mary cannot take a loss on her current year’s tax return for the decline in the stock value.
Since the securities have not been disposed of by Mary in a market transaction, a
recognized loss is allowed only if the securities become completely worthless during the
year. p. 7-6

9. For small business stock, the ordinary loss treatment is limited to $50,000 ($100,000 for
married individuals filing jointly) per tax year. Thus, the taxpayer is able to receive
ordinary loss treatment on what otherwise would have been a capital loss (i.e., stock is a
capital asset). An ordinary loss may be used, without limitation, in computing taxable
income. A capital loss, after netting against capital gains, is limited to $3,000 per tax
year. pp. 7-7 and 7-8

10. If the sea wall damage is the result of progressive deterioration, the definition of a
casualty loss has not been satisfied. Consequently, Jim can take no deduction for his
personal use property. However, if Jim can show that the damage is the result of a
sudden, unexpected, and violent storm, then he can take a casualty loss. pp. 7-8 and 7-9
 Deductions and Losses: Certain Business Expenses and Losses 7-5

11. A taxpayer may not take a deduction for a casualty loss if the loss is caused by the
taxpayer’s willful act or willful negligence. A DUI citation indicates willfulness. p. 7-9

12. The amount of the loss for the partial claim in 2004 is reduced by the $100 per event
floor and by the 10% of AGI floor for the 2004 taxable year. The loss in 2005 is reduced
by 10% of the 2005 AGI. p. 7-10 and Example 11

13. The reimbursement is included in gross income for the tax year in which it is received.
However, it is only included in gross income to the extent that the previous deduction for
the casualty loss resulted in a tax benefit. p. 7-10

14. The amount of the loss is the lesser of (1) the difference between the fair market value of
the property before the event and the fair market value of the property immediately after
the event or (2) the adjusted basis of the property. Note that for personal use property
this lesser of provision applies to both partial destruction and for complete destruction.
For business or investment property, the lesser of rule applies only for partial destruction.
p. 7-11

15. A taxpayer is not permitted to deduct a casualty loss for damage to insured personal use
property unless a timely insurance claim is filed with respect to the damage to the
property. If the taxpayer does not file an insurance claim, the loss must be reduced by
the proceeds that could have been received from the insurance company. p. 7-12

16. The cost of repairs can be used as a method for measuring the amount of a casualty loss if
the repairs are necessary to restore the property to its condition before the casualty, the
amount spent for the repairs is not excessive, and the repairs do not extend beyond the
damage suffered. In addition, the value of the property after the repairs must not, as a
result of the repairs, exceed the value of the property immediately before the casualty.
p. 7-12

17. The 10% of AGI floor applies to both the first and second year. The AGI of the first year
determines the 10% floor for that year. The AGI of the second year determines the 10%
floor for that year. p. 7-12

18. The loss from the theft of the bearer bonds would not be subject to the $100 and 10% of
adjusted gross income floors which apply for casualty and theft losses to personal use
property. The loss is to investment property. However, this loss is a miscellaneous
itemized deduction. p. 7-14

19. By subjecting only the casualty loss in excess of casualty gains to a floor equal to 10% of
adjusted gross income, the taxpayer is given a loss deduction at least as great as the
casualty gains included in the tax return. If the entire casualty loss were subject to the
10% of the adjusted gross income floor, the casualty loss deduction could be less than the
casualty gains. For example, if the taxpayer has $4,000 of casualty gains, $6,000 of
casualty losses, and adjusted gross income of $100,000, the taxpayer will in effect have a
casualty loss deduction of $4,000 since the loss offsets the gain. If the whole casualty
loss were subject to 10% of adjusted gross income, the deduction would be zero.
pp. 7-14 and 7-15

20. Monte should be concerned with the following tax issues:

• Has a casualty loss been sustained?

7-6 2006 Comprehensive Volume/Solutions

• The amount of the loss.

• The year the loss should be claimed.

• What effect will the $40,000 expenditure have on Monte’s adjusted basis for the
land?

pp. 7-8 to 7-12

21. The tax issues for Henry are as follows:

• Is this a casualty loss?

• Is this property used in a trade or business?

• What is the amount of the loss?

• The basis for computing the loss.

• The decline in fair market value.

pp. 7-8 to 7-12

22. Depreciation on a building (realty) or personal property (personalty) used for research is
a research and experimental expenditure. pp. 7-16 and 7-17

23. The following three alternatives are allowed for research and experimental expenditures:

• Expense in the year paid or incurred.

• Defer and amortize over not less than 60 months.

• Capitalize and deduct when the project is abandoned or deemed worthless.

p. 7-17

24. The tax issues for Power and Light are as follows:

• Are the expenditures for environmental impact studies research and experimental
expenditures?

• Are the expenditures for environmental impact studies deductible business expenses?

pp. 7-16 and 7-17

25. A net operating loss generally must be carried back initially to the second year preceding
the year of the loss. Unused amounts (after applying the loss against income of the two
carryback years) are carried forward chronologically for up to twenty years, beginning
with the first year subsequent to the year of the loss.

However, if the loss is attributable to a casualty or theft loss, the carryback period is three
years, rather than two years. The three-year carryback rule also applies to NOLs
attributable to Presidentially declared disasters which are incurred by a small business or
by a taxpayer engaged in farming.
 Deductions and Losses: Certain Business Expenses and Losses 7-7

A taxpayer may elect to forgo the carryback period and, thus, only carry forward the
NOL.

pp. 7-20 and 7-21

PROBLEMS

26. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard
Mason, OH 45040

January 29, 2005

Mr. John Johnson

100 Tyler Lane
Erie, PA 16563

Dear Mr. Johnson:

This letter is to inform you of the possibility of taking a bad debt deduction.
Your loan to Sara is a nonbusiness bad debt; therefore, you are not allowed to take a bad
debt deduction for partial worthlessness. You will be able to take a bad debt deduction in
the year in which the debt becomes wholly worthless.

Should you need more information or need to clarify anything, please contact me.

Sincerely,

John J. Jones, CPA

Partner

TAX FILE MEMORANDUM

January 29, 2005

From: John J. Jones

Subject: Bad Debt Deduction

John Johnson’s $30,000 loan to Sara is a nonbusiness bad debt. Therefore, a bad debt
deduction is not allowed for partial worthlessness. John will be able to claim a bad debt
deduction in the year when the debt becomes wholly worthless.

p. 7-5

27. Sue probably cannot take a deduction for the nonbusiness bad debt because the loan was
between related parties and the facts seem to indicate that no debtor-creditor relationship
ever existed (i.e., the loan is not a bona fide debt). p. 7-6

28. The bad debt is a business bad debt. However, the amount of Ron’s bad debt is limited to
Ron’s basis in the debt. Therefore, the bad debt of $80,000 (80% X $100,000 face value
7-8 2006 Comprehensive Volume/Solutions

of the receivable) is limited to a deduction of $72,000 for Ron; that is, his basis in the
debt. p. 7-4

29. Salary $180,000

§ 1244 ordinary loss (95,000)
Short-term capital gain on § 1244 stock $12,000
Short-term capital loss (nonbusiness bad debt) (16,000)
Net short-term capital loss (limit) (3,000)
Adjusted gross income $ 82,000

pp. 7-5 to 7-8

30. Sell all of the stock in the current year:

Current year’s AGI

Salary $80,000
Ordinary loss (§ 1244 limit) (50,000)
Long-term capital gain $ 8,000
Long-term capital loss (30,000)
($80,000 – $50,000)
Long-term capital loss (limit) (3,000)
AGI $27,000
Next year’s AGI
Salary $90,000
Long-term capital gain $10,000
Long-term capital loss carryover (19,000)
($30,000 – $11,000)
Long-term capital loss (limit) (3,000)
AGI $87,000

Total AGI
Current year $ 27,000
Next year 87,000
Total $114,000
Sell half of the stock this year and half next year:

Current year’s AGI

Salary $80,000
Ordinary loss (§ 1244 stock) (40,000)
Long-term capital gain 8,000
AGI $48,000

Next year’s AGI

Salary $90,000
Ordinary loss (§ 1244 stock) (40,000)
Long-term capital gain 10,000
AGI $60,000

Total AGI
Current year $ 48,000
Next year 60,000
Total $108,000
 Deductions and Losses: Certain Business Expenses and Losses 7-9

Mary’s combined AGI for the two years is lower if she sells half of her § 1244 stock this
year and half next year. pp. 7-7 and 7-8

31. Casualty gain

Home [$70,000 – ($400,000 – $350,000)] $20,000

Casualty loss
Car [$20,000 – ($55,000 – $0)] ($35,000)
Contents [$10,000 – ($60,000 – $10,000)] (40,000)
Total ($75,000)
Less: $100 floor (100)
($74,900)

Casualty loss in excess of casualty gain ($54,900)

Less: 10% AGI (10% X $100,000) (10,000)
Total itemized deduction ($44,900)

pp. 7-11 to 7-16

32. The loss is a business loss. Therefore, for the farm building and the farm equipment that
were completely destroyed, the adjusted basis is used in calculating the amount of the
casualty loss. For the barn that was damaged, the lower of the adjusted basis or the
decline in value is used in calculating the amount of the casualty.

Building ($90,000 – $70,000) $20,000

Equipment ($40,000 – $25,000) 15,000
Barn ($50,000 – $25,000) 25,000
Total loss $60,000

Because the President declared the area a disaster area, Olaf and Anna could claim the
loss on last year’s return or on the current year’s tax return.

If Olaf applies the loss to the prior year, the benefit of the loss will be at a tax rate of
28%. If the loss is applied to the current year, the benefit will be at a tax rate of 33%
rather than 28% and thus, provide a tax savings of $19,800 ($60,000 X 33%) rather than
$16,800 ($60,000 X 28%).

Olaf should include the loss on the current year’s tax return, since the tax savings is
$3,000 ($19,800 – $16,800) greater.

pp. 7-8 to 7-16

33. Business Personal

Portion Portion
Total (50%) (50%)

Cost $800,000 $400,000 $400,000

Depreciation (150,000) (150,000) -0-
Adjusted basis $650,000 $250,000 $400,000

Loss on building:
Loss ($900,000 – $200,000) $700,000 $250,000* $350,000
Less: Insurance reimbursement $600,000 (300,000) (300,000)
Loss (gain) ($ 50,000) $ 50,000
7-10 2006 Comprehensive Volume/Solutions

Business contents loss $220,000

Less: Insurance recovery (175,000)
Loss $ 45,000

AGI before effects of accident $100,000

Business gain—building 50,000
Business loss—contents (45,000)
AGI $105,000

Personal casualty loss—building $ 50,000

Personal casualty loss—contents ($65,000 – $65,000) -0-
Less: $100 per event floor (100)
10% of AGI floor (10% X $105,000) (10,500)
Itemized deduction $ 39,400

*Adjusted basis is less than the decline in FMV of $350,000 ($700,000 X 50%).

pp. 7-8 to 7-16

34. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard
Mason, OH 45040

January 26, 2005

Mr. Sam Smith

450 Colonel’s Way
Warrensburg, MO 64093

Dear Mr. Smith:

This letter is to inform you of the tax and cash flow consequences of filing a claim versus
not filing a claim with your insurance company for reimbursement for damages to your
business use car.

If an insurance claim is filed, you will have a taxable gain of $2,000 computed as
follows:

Insurance recovery $12,000

Less: Lesser of adjusted basis of $10,000
or decline of FMV of $12,000 (10,000)
Gain $ 2,000

This will produce a net cash flow of $11,300 computed as follows:

Insurance reimbursement received $12,000

Less: Tax on gain (35% X $2,000) (700)
Net cash flow $11,300

If no insurance claim is filed, you will have a deductible loss of $10,000 which will
reduce your tax liability by $3,500 (35% X $10,000).

The net cash benefit resulting from filing an insurance reimbursement claim would be
$7,800 ($11,300 – $3,500).
 Deductions and Losses: Certain Business Expenses and Losses 7-11

Should you need more information or need to clarify anything, please contact me.

Sincerely,

John J. Jones, CPA

Partner

TAX FILE MEMORANDUM

January 26, 2005

From: John J. Jones

Subject: Tax consequences for Sam Smith if he does not file an insurance claim for
reimbursement for damages to his business use car

If an insurance claim is filed, Sam will have taxable gain of $2,000 computed as follows:

Insurance recovery $12,000

Less: Lesser of adjusted basis of $10,000
or decline of FMV of $12,000 (10,000)
Gain $ 2,000

This will produce a net cash flow of $11,300 computed as follows:

Insurance reimbursement received $12,000

Less: Tax on gain (35% X $2,000) (700)
Net cash flow $11,300

If no insurance claim is filed, Sam will have a deductible loss of $10,000 which will
reduce his tax liability by $3,500 (35% X $10,000).

In my correspondence with Sam, I pointed out the net cash benefit from filing an
insurance reimbursement claim would be $7,800 ($11,300 – $3,500).

pp. 7-11 to 7-13

35. a. 2005
Salaries $300,000
Materials 80,000
Insurance 10,000
Utilities 7,000
Equipment depreciation 10,000
Total expenses $407,000

Cost of inspection of materials for quality control ($4,000), promotion expenses

($10,000), and cost of market survey ($8,000) are not included as research and
experimental expenditures.
7-12 2006 Comprehensive Volume/Solutions

2006
Salaries $400,000
Materials 70,000
Insurance 15,000
Utilities 8,000
Equipment depreciation 12,000
Total expenses $505,000

Cost of inspection of materials for quality control ($4,000), advertising ($30,000),

and promotion expenses ($7,000) are not included as research and experimental
expenditures.

2007
No deduction based on data provided.

b. The research and experimental expenditures are amortized over a 60-month

period beginning with the month in which the taxpayer first realizes benefits from
the experimental expenditures (i.e., July 2007 for Blue Corporation). The
monthly amortization is $15,200 ($912,000 ÷ 60)

2005
No deduction for research and experimental expenditures.

2006
No deduction for research and experimental expenditures.

2007
Deduction for research and experimental expenditures:
$15,200 X 6 months = $91,200

pp. 7-16 to 7-18

36. Salary $40,000

Interest income 1,000
Business bad debt (2,000)
Nonbusiness bad debt (short-term capital loss) ($6,000)
Short-term capital loss (3,000)
Total short-term capital loss ($9,000)
Long-term capital gain 4,000
Net short-term capital loss ($5,000)
Capital loss limit (3,000)
Adjusted gross income $36,000

p. 7-5

37. Salary $40,000

Interest income 1,000
Business bad debt (2,000)
Nonbusiness bad debt ($ 6,000)
Short-term capital loss (3,000)
Total short-term capital loss ($ 9,000)
Short-term capital gain* 10,000
Net short-term capital gain 1,000
 Deductions and Losses: Certain Business Expenses and Losses 7-13

Long-term capital gain $ 4,000

Long-term capital loss* (1,000)
Net long-term capital gain 3,000
Adjusted gross income $43,000
*Personal casualty gains exceed personal casualty losses ($10,000 – $1,000 = $9,000)
and therefore, all personal casualty items are treated as capital gains and losses.

pp. 7-5 and 7-14 to 7-16

CUMULATIVE PROBLEMS

38. Salary $100,000

Rental income $35,000
Less: Rental expenses (20,000) 15,000
Casualty loss on rental property (8,000)
2004 NOL carryover (14,000)
Short-term capital gain
§ 1244 stock (Note 1) $25,000
Nonbusiness bad debt (10,000)
Total short-term capital gain 15,000
AGI $108,000
Less: Itemized deductions
Personal casualty loss $23,000
Less: $100 floor (100)
Less: 10% AGI (10,800) (12,100)

Other itemized deductions (21,000)

Less: Personal exemption ($3,200 X 2) (6,400)
Taxable income $ 68,500

Tax on $68,500 (Note 2) $ 10,455

Income tax withholdings (12,500)
Net tax payable (or refund due) for 2005 ($ 2,045)
Notes
(1) The gain of $25,000 on the § 1244 stock is classified as a short-term capital gain.

(2) Alan and Ruth’s filing status is that of married filing jointly.

Tax on $59,400 $ 8,180

($68,500 – $59,400) X 25% 2,275
$10,455

39. Part 1—Tax Computation

Salary and bonus ($50,000 + $1,000) $51,000

Typing service business net receipts ($20,000 – $24,580) (4,580)
Interest income (Note 1) 700
Life insurance proceeds (Note 2) -0-
Gift (Note 3) -0-
Bingo prize 100
7-14 2006 Comprehensive Volume/Solutions

Alimony 10,000
Nonbusiness bad debt (Note 4) (2,100)
Adjusted gross income $55,120
Less: Itemized deductions
Home mortgage interest $8,346
Sales taxes 654
Casualty loss: Lesser of adjusted basis
of $4,000 or FMV of $5,000 $4,000
Less: Insurance proceeds (1,500)
$2,500
Less: $100 floor (100)
Less: 10% AGI floor (5,512) -0-
Total itemized deductions (9,000)
Less: Personal exemption (3,100)
Taxable income $43,020

Tax on taxable income (from Tax Table) $ 7,494

Less: Federal income tax withheld and estimated tax payments
($7,500 + $1,000) (8,500)
Net tax payable (or refund due) for 2004 ($ 1,006)

Notes

(1) The $800 interest on the City of Boca Raton bonds is tax-exempt.

(2) Life insurance proceeds of $60,000 payable as the result of the death of Jane’s
sister are excludible from gross income.

(3) The $5,000 gift from Jane’s aunt is excludible from gross income.

(4) The $2,100 loss on the loan to her friend, Joan Jensen, is deductible as a
nonbusiness bad debt (i.e., short-term capital loss). The assumption is made that
the loan is a bona fide loan.

See the tax return solution beginning on page 7-18 of the Solutions Manual.

Part 2—Tax Planning

Salary and bonus $51,000

Gross receipts from business $26,000
Less:
Office rent $7,000
Supplies 4,840
Utilities and telephone 5,148
Wages 5,500
Payroll taxes 550
Equipment rentals 3,300 (26,338)
Net business income (338)
Interest income 700
Alimony 10,000
Adjusted gross income $61,362
 Deductions and Losses: Certain Business Expenses and Losses 7-15

Less:
Itemized deductions $ 9,000
Personal exemption 3,200 (12,200)
Taxable income $49,162

Tax on $49,162 [$4,090 + .25($49,162 – $29,700)] $ 8,956

Less: Federal income tax withheld (7,500)
Net tax payable (or refund due) $ 1,456

Jane would need to make estimated tax payments of $1,456 because the Federal income
tax withholdings are expected to be less than the tax liability.

Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard
Mason, OH 45040

January 26, 2005

Ms. Jane Smith

2020 Oakcrest Road
Boca Raton, FL 33431

Dear Ms. Smith:

This letter is in response to your request concerning the minimum amount of estimated
tax you will have to pay for 2005, so that you will not have to pay any additional tax
upon filing your 2005 Federal income tax return.

Based on the 2005 estimates you provided to us, we have determined that your estimated
tax payments for the 2005 calendar year should total $1,456. This estimate is based on
the following computation.

Salary and bonus $51,000

Gross receipts from business $26,000
Less:
Office rent $7,000
Supplies 4,840
Utilities and telephone 5,148
Wages 5,500
Payroll taxes 550
Equipment rentals 3,300 (26,338)
Net business income (338)
Interest income 700
Alimony 10,000
Adjusted gross income $61,362
Less:
Itemized deductions $ 9,000
Personal exemption 3,200 (12,200)
Taxable income $49,162

Tax on $49,162 $ 8,956

Less: Federal income tax withheld (7,500)
Net tax payable $ 1,456
7-16 2006 Comprehensive Volume/Solutions

Should you need more information or need to clarify anything, please contact me.
Sincerely yours,

John J. Jones, CPA

Partner

TAX FILE MEMORANDUM

January 10, 2005

From: John J. Jones

Subject: Jane Smith’s 2005 estimated tax

Today I talked with Jane Smith concerning her 2005 estimated tax. She wanted to know
the minimum amount of estimated tax she would have to pay for the calendar year 2005
so that she would not have to pay any additional tax upon filing her 2005 Federal income
tax return.

The following projections for 2005 were provided by Jane Smith:

Items remaining unchanged from 2004:

Salary—$50,000
Christmas bonus—$1,000
Interest expense on home mortgage—$9,000
Interest income—$700
Alimony—$10,000
Gross receipts from typing services—$26,000
Office rent will remain unchanged—$7,000

All other expenses for typing services will increase 10% from 2004:
Supplies—$4,400 in 2004; $4,840 in 2005
Utilities and telephone—$4,680 in 2004; $5,148 in 2005
Wages—$5,000 in 2004; $5,500 in 2005
Payroll taxes—$500 in 2004; $550 in 2005
Equipment rentals—$3,000 in 2004; $3,300 in 2005

The following 2004 items will not recur in 2005:

Life insurance proceeds—$60,000
Gift—$5,000
Bingo winnings—$100
Bad debt—$2,100
Stolen silverware

Based on these estimates for 2005, Jane Smith should make 2005 estimated tax payments
totaling $1,456. The determination was made as follows:

Salary and bonus $51,000

Gross receipts from business $26,000
Less:
Office rent $7,000
Supplies 4,840
Utilities and telephone 5,148
Wages 5,500
Deductions and Losses: Certain Business Expenses and Losses 7-17

Payroll taxes 550

Equipment rentals 3,300 (26,338)
Net business income (338)
Interest income 700
Alimony 10,000
Adjusted gross income $61,362
Less:
Itemized deductions $ 9,000
Personal exemption 3,200 (12,200)
Taxable income $49,162

Tax on $49,162 $ 8,956

Less: Federal income tax withheld (7,500)
Net tax payable $ 1,456
7-18 2006 Comprehensive Volume/Solutions

39.
 Deductions and Losses: Certain Business Expenses and Losses 7-19

39. continued
7-20 2006 Comprehensive Volume/Solutions

39. continued
 Deductions and Losses: Certain Business Expenses and Losses 7-21

39. continued
7-22 2006 Comprehensive Volume/Solutions

39. continued
 Deductions and Losses: Certain Business Expenses and Losses 7-23

39. continued
7-24 2006 Comprehensive Volume/Solutions

39. continued
 Deductions and Losses: Certain Business Expenses and Losses 7-25

39. continued