1. Briefly state Adam Smith's four requirements for a good tax system: a.
Equality- A tax should be imposed Must reside in the foreign country for 330 days; 2.Claim a tax credit that is the lesser of Foreign taxes paid, or U.S.
based on the taxpayer's ability to pay. b. Certainty- The taxpayer should be able to determine the amount of tax and
how to make the required payment. c. Convenience- The tax should be levied as close as possible to the time the
taxpayer receives the amount subject to tax. d. Economy-The cost of taxpayer compliance and administering the
tax system should be small in relation to the revenue generated.
2. Identify three primary sources of tax law: 1. Legislative-The Internal Revenue Code of 1986. 2.
Administrative-The income tax regulations and other IRS documents. 3. Judicial-Trial and appellate court decisions.
3. How is a deferral different from an exclusion? An exclusion is income that is never subject to tax. A deferral
is income that is not taxed in the current period, but will be taxed in a future period. The future period tax may result
from inclusion of the income through either lower depreciation/amortization deductions and/or by the inclusion of
a larger gain than would have occurred without the deferral.
4. What are the three basic tests that an expense must satisfy to be deductible? 1. The expense must be ordinary,
2. The expense must be necessary, and 3. The expense must be reasonable in amount.
5. If you were in the 28% marginal tax bracket and you could choose either a $1,000 tax credit or a $3,000
tax deduction, which would give you the most tax savings? Why? The tax credit is a better choice in this case.
The tax credit will reduce the tax due by $1,000 (i.e., tax credits directly reduce the amount of tax due). The tax
deduction will reduce taxable income by $3,000, resulting in a reduction of the tax due of $840 ($3,000 x 28%).
The tax credit gives a $160 ($1,000- $840) tax advantage to a 28% marginal tax rate payer. The $1,000 tax credit is
the equivalent of a $3,571 tax deduction ($1,000 ÷ 28%).
6. What is the statute of limitations, and what role does it play in the filing of tax returns? The statute of
limitations is the period of time that the IRS and/or the taxpayer has to correct an error on a return. The general
statute of limitations period is three years from the due date of the return. This gives both the IRS and taxpayers’
time to correct errors on previously filed returns. If a taxpayer discovers an error in a previously filed return, the
error is corrected by filing an amended return before the end of the statute of limitations. Thus, the statute of
limitations provides an upper end on the amount of time that the taxpayer and the IRS have to correct a return.
7. Briefly describe the types of programs used by the IRS to select a return for audit. The two basic audit
programs are the document perfection program and the information matching program. Document perfection
involves checking all returns for mathematical, clerical, and tax calculation errors. Information matching uses
documents filed by third parties that report various income items to verify that they were properly claimed on the
taxpayer's return. These two types of programs do not generate audits per se; rather, taxpayers are notified when
errors are found, and the tax is recalculated based on the errors. Selection of returns for audit is done using either
the Discriminant Function System (DIF) or through special audit programs. The DIF is a computerized return
selection program that selects those returns with the highest probability of containing errors. This is done by
comparing items on returns with pre-determined standards. The standards are developed based on the audit results
of the Taxpayer Compliance Measurement Program (TCMP). The TCMP randomly selects returns from various
income levels and each item on the return is comprehensively audited. Special audit programs are designed to select
returns based on various parameters that the IRS believes may indicate that the returns are likely to contain errors.
Factors that have been used in such audit programs are size of refund and the size of certain deductions in relation
to income.
8. Susan is single with a gross income of $120,000 and a taxable income of $98,000. In calculating taxable
income, she properly excluded $10,000 of tax exempt interest income. Using the tax rate schedules in the
chapter, calculate Susan's a. Total tax b. Marginal tax rate. c. Average tax rate d. Effective tax rate:
a. Tax computation: single taxpayer rate schedule for 2014:
Taxable Income $ 98,000
Tax on $ 89,350 $18,193.75
Excess $ 8,650
Taxed at Marginal Rate x 28% 2,422.00
Total Tax $20,615.75
b. The marginal tax rate is the rate of tax that would be paid on an additional dollar of income. At a taxable income
of $98,000, a single taxpayer would be in the 28% marginal tax rate bracket (from the calculation above).
c. The average tax rate is the rate of tax paid on the total tax base; the total tax divided by taxable income. In this
case, the total tax is $20,615.75 on a taxable income of $98,000, which gives an average tax rate of 21.04%: 21.04%
= ($20,615.75 tax ÷$98,000 taxable income)
d. The effective tax rate is the rate of tax paid on all income (taxable and nontaxable). The total tax paid is divided
by the taxpayer's economic income (taxable income + nontaxable income). In this case, Susan has $10,000 of tax-
exempt income that increases her economic income to $108,000 ($98,000 taxable + $10,000 nontaxable). This
results in an effective tax rate of 19.1%: 19.1% = ($20,615.75 tax ÷$108,000 economic income)
9. A taxpayer has $95,000 of taxable income for the current year. Determine the total tax, the marginal tax
rate, and the average tax rate if the taxpayer is a: a. Single individual, b. Married couple, c. Corporation
a. Total tax on $95,000 for a single individual: 2014single rate schedule
Taxable Income $ 95,000
Tax on $ 89,350 $ 18,193.75
Excess $ 5,650
Taxed at Marginal tax rate x 28% 1,582.00
Total Tax $ 19,775.75
Average tax rate = 20.82% = $19,775.75 tax ÷$95,000 taxable income
b. Total tax on $95,000 for a married couple: 2014 married, filing jointly rate schedule
Taxable Income $ 95,000
Tax on $ 73,800 $ 10,162.50
Excess $ 21,200
Taxed at Marginal tax rate x 25% 5,300.00
Total Tax $ 15,462.50
Average tax rate = 16.28% = $15,462.50 tax ÷$95,000 taxable income
c. Total tax on $95,000 for a corporation: 2014 corporate rate schedule
Taxable Income $ 95,000
Constructive Receipt Doctrine: Applies only to cash basis taxpayers.
24. Income Concepts: Realization and its Constructs and Doctrines – Claim of Right: 1.Realization does not occur
until an amount has been received without restriction; 2. Applies when the taxpayer received payment but there is
a restriction the taxpayer’s right to keep some or all of it. 3. A modification that prevents cash basis taxpayers from
“turning their backs” on income. 4. Realization is deemed to have occurred if: (1) A taxpayer is aware an amount is
available, (2) The amount is unconditionally available (even without physical possession), (3) and Receipt of the
amount is within the taxpayer’s control. Example1: Pamela rented her garage apartment to Mahlon and collected
$450, the first-month’s rent, in advance. She also collected $500 as a security deposit that she will return to Mahlon
if he doesn’t damage the apartment. She must report only $450 as income because she has no claim of right to the
$500. Example2: Gale is a self-employed handyman. Tracy, one of his customers, brought a check for $250 on
December 30, 2016, to pay for work Gale had finished. Gale asked her to mail the check instead, so he could
check “delivery time.” Gale must report the $250 as income in 2016 even if the check isn’t delivered until 2017.
25. Income Concepts: Wherewithal-to-Pay: 1. Tax should be recognized and paid when the taxpayer has the
resources to pay. 2. Constructs used: (1) Deferrals (2) Recognition of unearned income
26. Deduction Concepts: Legislative Grace, Again: Any deduction allowed is the result of specific acts of Congress
which are applied and interpreted strictly.
27. Deduction Concepts: Business purpose: Only expenditures made in order to generate income and for a purpose
other than tax avoidance will be deductible. Examples: 1.Trade or business expenses; 2. Investment expenses;
3.Michael may not deduct depreciation on his personal-use automobile because he does not use it in his business.
28. Deduction Concepts: Capital Recovery: 1. A taxpayer may deduct the amount of capital invested before income
is reported. 2. Constructs used: (1) Basis (2) Capital expenditures
29. Types of Income: 1.Earned; 2.Unearned; 3. Transfer; 4.Imputed; 5. Capital Gains and Losses
30. Earned Income: 1. Compensation received for the provision of labor is earned income; 2. Two problems may
arise when determining taxability of earned income: (1) Cash-equivalent approach; (2) Assignment of income
31. Unearned Income: Earnings from investments and gains from the sale, exchange or disposition of investment
assets. Examples: 1. Interest and Dividend Income; 2. Rental and Royalty Income; 3. Annuities.
32. Annuity: A series of equal payments received at set time intervals for a determinable period. Capital Recovery
Concept: 1. Excludes the amount of original investment from taxable income; 2. Must be spread over the time of
receipt.
33. If the payment term and amount are fixed: Exclusion Ratio=Cost of the contract/Total expected return; If the
payment term depends on the life of the taxpayer: Must estimate the number of payments or Use the “simplified
method”.
34. Simplified Method: Excluded portion=Contract Cost/Number of payments
35. Example: George, age 64, purchased an annuity for $30,000. He begins receiving $300 per month in January.
What amount is included in his gross income? From Table 3-1, the number of payments to use is 260. $30,000 / 260
= $115 monthly exclusion; $115 x 12 = $1,380 excluded per year; $300 x 12 = $3,600 amount received; $3,600 -
$1,380 exclusion = $2,220 gross income.
36. Gains or losses may occur upon disposal of investment property: Proceeds from sale or disposition - Selling
expenses= Amount realized from disposition- Adjusted basis of property= Gain or loss from disposition.
37. Income from Flow Through Entities: 1. Income from a conduit entity is reported by the owners and taxed on
the owners’ returns; 2. Distributions from conduit entities to the owners are treated as a recovery of capital.
38. Some amounts of income are neither fully earned nor fully unearned: 1. Prizes and Awards; 2. Unemployment
Compensation; 3. Social Security Benefits; 4. Alimony Received
39. Prizes and Awards: 1. Amounts received as prizes and awards are generally taxable; 2. Exceptions: (1) Scientific
and literary achievements: Must be given by recipient to a qualified charity or government unit; (2) Employee
achievements: Must be given to employee for length of service or safety; Amount is limited to $400 per employee
(or $1,600 if qualified plan) and may not be cash.
40. Unemployment Compensation: Amounts received from unemployment compensation plans are considered
substitutes for earned income and are always taxable.
41. Social Security Benefits: A portion of Social Security benefits received may be taxable if modified AGI exceeds
certain limits: Adjusted gross income+1/2 social security benefits received+ tax exempt income+ foreign earned
income exclusions= Modified AGI. Example: Susan, a single taxpayer received $3,000 from Social Security
payments. Her AGI without the Social Security is $30,000. She has neither tax exempt interest nor foreign earned
income. Modified AGI= $30,000 + $1,500= $31,500
42. Social Security Benefits: 50% Formula: Affects: 1. MFJ taxpayers with modified AGI between $32,000 (the
base amount) and $44,000; 2. Unmarried taxpayers with modified AGI between $25,000 (the base amount) and
$34,000; 3. Others with modified AGI of more than $0. Calculation: The taxable portion of Social Security is equal
to the lesser of: 1/2 Social Security received, OR 1/2 of the amount by which modified AGI exceeds the base amount.
50% Formula Example: Going back to Susan, our single taxpayer – With modified AGI = $31,500, the taxable
portion of her $3,000 Social Security income is the lesser of: $1,500, or 1/2 ($31,500 - $25,000) = $3,250. Therefore,
taxable SS is $1,500.
43. Imputed Income: Personal Consumption: The value of the goods and services produced by individuals for
personal consumption generally are not taxable: 1. Realization concept; 2. Administrative Convenience concept.
44. Imputed Income: Below Market Rate Loans: Interest income and expense are imputed on below market-rate
loans: 1. Relationship between the lender and the borrower determines the tax treatment; 2.Lender has imputed
interest income,
Borrower has imputed interest expense; 3. Administrative Convenience grants exceptions for: (1) Loans of $10,000
or less (2) Gift loans of $100,000 or less
45. Imputed Income: Payment of Expense by Others: 1. A taxpayer whose expenses are paid by another has realized
an increase in wealth; 2. Payments made by family members may be considered nontaxable gifts; 3. Payments made
by employers are taxable income.
46. Imputed Income: Bargain Purchases: When a bargain purchase price does not result from an arms-length
transaction, the bargain amount is taxable income.
47. Capital asset: Any asset other than inventory, receivables, and depreciable or real property used in a trade or
business: 1. A sale or other disposition of capital assets results in a capital gain or loss; 2. Capital gains and losses
receive special tax treatment.
48. When is Income Reported? Accounting Method chosen by a taxpayer dictates when income is reported: 1. Cash
Method: Taxpayers report income when cash is actually or constructively received; 2. Accrual Method: Taxpayers
report income when it is earned; 3. Hybrid Method: Taxpayers mix accrual and cash methods.
49. Cash method taxpayers must follow the Constructive Receipt Concept; Exceptions to the cash method: 1.
Taxpayers who sell inventory must use the accrual method for inventory; 2. Taxpayers must use the accrual and the
effective interest method with Original Issue Discount securities; 3. Taxpayers who hold Series EE Bonds may elect
to use the accrual method.
50. Accrual Method: Exceptions: 1. Wherewithal-to-Pay concept requires income be reported in the year pre-
payment is received for rents, insurance, interest, and royalties; 2. One year deferral is allowed for some pre-
payments: (1) Report amount = Financial Accounting in first year; (2) Balance amount in full in second year; 3.
Pre-payments for goods may be accrued if the payment is less than the Cost of Goods Sold.
51. Hybrid Method: Taxpayers may mix the cash and accrual methods, using accrual for sales of inventories and
cash for other revenues and expenses.
52. Exceptions to All Methods: 1. Installment Sales Method: Any time one payment is received after the year of
sale, taxpayers must recognize income proportionately as the selling price is received unless they elect to report in
the year of sale; 2. Long-term Construction Contracts: The percentage-of-completion method must be used for all
long-term construction.
53. Income Exclusions: Categories: Four major categories of exclusions: 1. Donative items; 2. Employment-related;
3. Returns of human capital; 4. Investment related.
54. Donative Items: Gifts and Inheritances: Donative items are increases in wealth that are not earned or the result
of investment; Gifts: Excluded to relieve double taxation caused by the gift tax; Inheritances: Excluded to
relieve double taxation caused by the estate tax.
55. Donative Items: Life Insurance Proceeds: Life Insurance Proceeds – Excluded to provide equity with other types
of inheritances: (1) Proceeds from policies purchased for consideration are not excluded; 2. Interest income earned
from the proceeds due to electing receipt as an annuity are not excluded.
56. Donative Items :Scholarships: Excluded to provide incentive for education: To qualify, the scholarship: (1) Must
not require the performance of future services; (2)Must be used for direct costs of education such as tuition, fees,
books, and supplies. Example: Jekabs received an athletic scholarship to Small State University. Under the
scholarship agreement, he received tuition ($1,500), books ($400), and room and board ($5,000). Jekabs must report
$5,000 as income but may exclude $1,900.
57. Employment Related: Foreign Earned Income: Excluded to relieve double taxation, Taxpayers may choose one
of two options: Exclude up to $104,100 of foreign earned income: 1. Must be a resident of the foreign country, or
or if the debt is related to real property, part or all of the forgiveness could be excluded from income.
tax that would have been paid on the foreign income.
58. Employment Related: Payments Made by Employer: Payments made on behalf of an employee are excluded as
an incentive to employers to provide these benefits. Examples: 1.Contributions to qualified pension plans;
2.Premiums for group term life insurance; 3. Premiums for health and accident insurance; 4. Meals and lodging; 5.
Fringe benefits.
59. Exclusions for Payments Made By Employer: 1. Qualified pension plan: Payments made by employers to
qualified pension plans: (1) Are not included in income in the year of payment; (2) Are included in income in the
year of withdrawal. 2. Group term life insurance: Premiums paid for up to $50,000 of group term life insurance are
excluded from income: (1) Plan may not discriminate in favor of highly paid employees; (2) Premiums for insurance
in excess of $50,000 are included in taxable income. 3. Health and accident insurance: Premiums paid for health
and accident insurance are excluded from income to encourage employers to provide insurance. 4. Meals and
lodging: (1) The value of meals provided by the employer are excluded from income if the meals are provided:
(a)On the employer’s premises; (b) For the employer’s convenience; (2) The value of lodging provided must meet
these conditions and also be a condition of employment. 5. General fringe benefits: Two types of fringe benefits are
excludable from income if they are provided on a nondiscriminatory basis: (1) No additional cost services; (2)
Employee discounts: (a) On goods, limited to the gross profit %; (b) On services, limited to 20%. 6. Qualified
retirement planning services: Must be provided to all employees (and their spouses) who normally receive
information about the employer’s qualified plan. 7. Other types of fringe benefits are excludable from income even
if they are provided on a discriminatory basis: (1)Working condition; (2) De minimus (3)Child and dependent care
services up to $5,000; (3) Educational assistance programs up to $5,250; (4)Employer’s athletic facility on premises.
8.Employer benefit plans: (1) Cafeteria Plans: Allow employees to choose from a menu of benefits and are
excludable unless an employee elects to take cash in lieu of benefits; (2)Flexible Benefit (Salary Reduction) Plans:
Allow employees to use pre-tax compensation dollars to cover medical or child-care expenses. 9. Health Savings
Accounts: Excluded to encourage employers and employees to purchase adequate medical coverage: (1) May be
established for individuals covered only by high-deductible plans $6,900 for family or $3,450 for single; (2)
Employer contributions are excluded from income and individual contributions are deductible for AGI.
60. Returns of Human Capital: Payments received that are intended to reimburse an individual for physical injuries
are excluded under the capital recovery concept because they merely restore the individual to a previous condition:
Payments that are intended to replace lost income are not excluded.
61. Exclusions for Returns of Human Capital: 1. Workers’ compensation: Payments related to an injury suffered on
the job are excluded because they help restore individuals to their previous condition and do not add to their wealth.
2. Personal injury or sickness: (1) Compensatory damage payments: Received for a personal physical injury or
sickness and medical payments for emotional distress are excluded to provide a return to equity; (2) Loss of income
damage payments: Only excluded if they are related to personal physical injury or sickness; (3) Punitive damage
payments: Never excluded. 3. Health and accident insurance: (1) Payments or reimbursements for medical or health
costs: Excluded to provide an individual a return to equity; (2) Disability payments: Excluded if the policy was
purchased by the employee but not excluded if the policy was purchased by the employer.
62. Investment Related Exclusions: 1. Interest income: Received from investment in municipal bonds is excluded
to allow state and local municipalities to sell bonds for a lower interest rate. 2. Stock dividends: (1) Excluded from
income because their receipt does not qualify as income under the realization concept, (2) If any shareholder has
the option to receive cash instead of stock, realization has occurred and the value of the dividend is included in
income. 3. Discharge of indebtedness: (1) An amount received as a loan is generally excluded from income under
Tax on $75,000 $13,750
Excess $ 20,000
Taxed at Marginal tax rate x 34% 6,800
Total Tax $20,550
Average tax rate = 21.63% = $20,550 tax ÷$95,000 taxable income
10. Classify the following items as ordinary income, a gain, or an exclusion:
a. The gross revenues of $160,000 and deductible expenses of $65,000 of an individual's consulting business
Income from a business is ordinary income. In this case, the individual has $95,000 ($160,000 - $65,000) of ordinary
income.
b. Interest received on a checking account
Interest received on a checking account is ordinary income.
c. Sale for $8,000 of Kummel Corporation stock that cost $3,000
The sale of the stock produces a $5,000 ($8,000-$3,000) gain.
d. Receipt of $1,000 as a graduation present from grandfather
The $1,000 graduation present is a gift. Because gifts are subject to a separate tax on gifts (i.e., the gift tax), the
value of a gift is excluded from the income tax.
e. Royalty income from an interest in a gold mine
Royalty income is ordinary income.
f. The salary received by an employee is ordinary income.
g. Dividends of $400 received on 100 shares of corporate stock is ordinary income
11. For each of the following situations, state whether the taxpayer's action is tax evasion or tax avoidance:
a. Tom knows that farm rent received in cash or farm produce is income subject to tax. To avoid showing a cash
receipt on his records, he rented 50 acres for his choice of 5 steers to be raised by the tenant. He used 2 of the steers
for food for his family and gave 3 to relatives. Because he did not sell the livestock, he did not report taxable income.
Tom's actions would probably be considered tax evasion. Tom knew that farm produce (5 steers) received as rent is
income, but he took steps to conceal and not report the income. As a result, he underpaid his income tax.
b. Betty applied for and received a Social Security number for Kate, her pet cat. Surprised by how easy it was to get
a Social Security number, she decided to claim a dependent exemption on her tax return for Kate. Other than being
a cat, Kate met all the tests for a dependent. Betty's actions would probably be considered tax evasion. Claiming
fictitious dependent deductions is an act often associated with tax protesters. The tax law allows the exemption
deduction only for a qualified "individual" which does not include Kate. Betty intentionally claimed a deduction for
an amount she knew was not deductible. As a result, Betty underpaid her tax.
c. Glen has put money in savings account sin 50 banks. He knows a bank is not required to report to the IRS interest
it pays him that totals less than $10. Because the banks do not report the payments to the IRS, Glen does not show
the interest he receives as taxable income. Although Glen's accountant has told him all interest he receives is taxable,
Glen insists that the IRS will never know the difference. Glen's actions would probably be considered tax evasion.
All income that is not specifically excluded must be reported as income regardless of the amount. Glen had reason
to know the interest income was taxable, he took steps to conceal the income and to omit it from his tax return. As
a result, Glen underpaid his tax.
d. Bob entered a contract to sell a parcel of land at a $25,000 gain in 2013. To avoid reporting the gain in 2013, he
closed the sale and delivered title to the land to the buyers on January 2, 2014. Bob's actions are considered tax
avoidance and are an acceptable method of planning the timing of income reporting. A sale of land occurs when
title passes to the buyer. Bob properly reported the gain in 2014.
e. Asha's taxable income for 2014 puts her in the 33% marginal tax bracket. She has decided to purchase new
equipment for her business during 2015. A special election allows Asha to treat the $25,000 of the cost of the
equipment as a current period expense. Because she expects to be in a lower tax bracket next year, Asha buy sand
begins using $25,000 worth of the equipment during December 2014. She claims a $25,000 expense deduction
under the special election for 2014. Asha's actions would be considered tax avoidance. The $25,000 expense election
is available for property placed in service in a trade or business during the year. Asha's decision to purchase the
equipment in 2014 to accelerate the tax deduction is an acceptable tax planning technique.
12. What is an arm's-length transaction? What is its significance to income taxation?
(1)An arm's-length transaction is one in which the parties to the transaction bargain in good faith for their individual
benefit, not for the mutual benefit of the group. That is, the price of the transaction is a fair market value.
(2)The importance for income taxation is that transactions not made at arm's-length are usually not given their
intended tax effect. This has led to the related party rules which define situations in which entities do not bargain at
arm's-length. Special rules for transactions between related parties have been developed to discourage such
transactions.
13. What is the difference between a taxable entity and a conduit entity?
A taxable entity is an entity that must pay tax on its income. The two primary taxable entities are individuals and
corporations. The owners of a corporation do not pay the income tax on the corporation's taxable income. However,
the owners are taxed when the corporation distributes income, in the form of dividends, to the owners. A conduit
entity is a tax reporting entity that reports its results to the government, but does not pay tax on its income. Rather,
the conduit entity's income flows through to its owners, who report their share of the conduit entity income on their
returns. Thus, the owners of the conduit entity pay the tax on the conduit’s income, not the conduit entity.
14. Ed runs an auto repair business out of the garage attached to his personal residence. How should he
account for each of the following items? Under the entity concept, Ed must segregate the income and expenses
associated with his auto repair business from those that are personal. The importance of this segregation is that all
trade or business expenses are deductible for adjusted gross income, while most personal expenditures are not
deductible. Those personal expenditures that are deductible must be deducted from adjusted gross income (itemized
deduction).
a. Cash received from repair services, $28,000.
The $28,000 is income from his business and is included in gross income from the auto repair business.
b. Interest paid on his home mortgage, $7,300.
Because the garage is attached to his personal residence, Ed will have to allocate a portion of the interest paid to the
garage for deduction as a business expense. The remaining interest is deducted on his individual return as home
mortgage interest, provided that he has enough deductions to itemize. The allocation can be made on any
reasonable basis; however the use of square footage is probably the best allocation basis for household expenses.
c. Power jack hoist purchased at a cost of $12,000.
This is a business capital expenditure and must be capitalized and depreciated over its tax life.
d. Electricity bills, $3,600. (Ed does not have separate electricity service to the garage.)
As with the mortgage interest, Ed will have to make an allocation of the electrical cost attributable to the garage.
The personal portion of the electric bill is not deductible on Ed's individual return.
e. Checks received from customers that were returned by his bank, $1,600. The bank charged Ed's account $35 for
processing the bad checks.
Assuming that Ed is a cash basis taxpayer and the checks all relate to the current year, he would not have to report
the $1,600 of bad checks as income because he does not have control over the income. If any of the $1,600 had
been reported as income in the previous year, Ed would be able to take a deduction for any income recognized that
he was unable to collect in the current year. The bank charge would be deductible as a business expense.
f. Telephone bill for phone in the garage, $420. (Ed has a separately listed phone in his house.)
Fully deductible as a business expense because Ed has a separate personal phone line.
g. Advertising in the local newspaper, $800. The advertising cost is deductible as a business expense.
h. Interest paid on home furniture loan, $600
Not deductible. Personal interest, other than that on a home mortgage (or a home equity loan), is not deductible.
15. Wendy owns 20% of the common stock of Britton Company. During the current year, Britton reported a
taxable income of $90,000 and paid $40,000 in cash dividends. What are the income tax effects for Wendy of
her investment in Britton Company if Britton is organized as:
a. A corporation? A corporation is a taxable entity. Therefore, Britton Company must pay tax on the $90,000 of
taxable income. Amounts paid to shareholders as cash dividends are taxable to the shareholders. Wendy will receive
$8,000 ($40,000 x 20%) of taxable dividends that she will report as income on her tax return. Note that the $40,000
in dividends is taxed twice ⎯ once as part of corporate taxable income and a second time when the earnings are
distributed to shareholders.
b. An S corporation? An S corporation is a conduit entity. The S corporation does not pay any tax on its income.
Each shareholder includes their proportionate share of the S corporation income on their return. In this case, Wendy
has $18,000 ($90,000 x 20%) of income that she reports on her tax return. Dividends paid to owners of conduit
entities are not taxed to the owners. They are considered to be returns of investment. Therefore, Wendy is not taxed
on the $8,000 of cash dividends received. The $18,000 of income recognized is added to her basis in the stock and
the $8,000 of dividends received is deducted from her stock basis as a capital recovery.
16. Christie purchases a one-third interest in the Corporate Capital Partnership (CCP) in 2013 for $40,000.
During 2013, CCP earns an income of $90,000, and Christie withdraws $30,000 in cash from the partnership.
In 2014, CCP suffers a loss of $30,000, and Christie withdraws $10,000. What are the tax consequences for
Christie of this investment in 2013 and 2014?
Christie will include her share of the partnership income, $30,000 ($90,000 x 1/3), on her individual return in 2013
and deduct her share of the partnership loss, $10,000 ($30,000 x 1/3) in 2014. The cash withdrawals do not affect
the taxability of the income from the partnership. It should be noted that Christie may not be able to deduct the loss
in 2014 if the activity is considered passive.
17. Determine whether the taxpayer in each of the following situations has realized income. Explain why
there has or has not been a realization, and determine the amount of income to be reported.
a. Alfredo owns a one-third interest in Bayou Partnership. During the current year, Bayou’s taxable income is
$45,000.
Alfredo realizes $15,000 ($45,000 x 1/3) of income from the partnership. Owners of conduit entities are taxed on
their share of the entity’s income. Because the partnership has realized income, the partners’ have also realized
income.
b. Janet owns a pest control service. She charges customers $50 per month for basic pest control. Alternatively,
customers can pay a lump sum of $500 for one year of basic monthly pest control. During the current year, Janet
receives $13,000 in monthly payments and $26,000 in 1-year prepayments.
Janet has realized income of $13,000 from the monthly receipts regardless of her method of accounting because she
has a claim of right to the income. Applying the wherewithal-to-pay concept, Janet would also include the $26,000
of prepayments in income even if she is an accrual basis taxpayer. Note: If Janet is an accrual basis taxpayer, she
could use the accrual method to account for the prepayments under the deferral method.
c. Monte owns 1,000 shares of Ali, Inc., common stock. During the current year, Ali declares and distributes a 20%
stock dividend. As a result, Monte receives an additional 200 shares of stock. (Monte has not realized any income
from the stock dividend because his wealth has not increased. That is, his percentage ownership in the firm remains
the same, as does the value of the firm. Therefore, his total wealth remains unchanged and his property interest in
the corporation has not changed.)
d. Rogers Trucking Company owes Big Truck Sales, Inc., $200,000 for the purchase of 3 trucks. Rogers is having
a bad year and is unable to make full payment on the debt to Big Truck. Rather than foreclose on Rogers, Big Truck
reduces the debt to $170,000 so that Rogers can stay in business.
Rogers wealth has increased by $30,000 ($200,000 - $170,000) as a result of a transaction with a second party.
Therefore, it has realized income of $30,000 from the discharge of debt. Rogers has obtained a claim of right to the
$30,000 because it is no longer under an obligation to repay the $30,000. If Rogers is insolvent before the discharge
18. Determine whether the taxpayer in each of the following situations has a claim of right to the income
received: A claim of right exists when amounts are received without restriction on their use and with no clear
obligation to repay. The fact that an amount received may have to be repaid due to some future contingency
does not negate a taxpayer's claim of right to the income.
a. Sulley's Spa Spot sells hot tubs that have a 2-year warranty. The warranty provides for the replacement of all
parts and the cost of labor to replace the parts. In addition, Sulley's may replace the hot tub in lieu of repairing it.
During the current year, Sulley's hot tub sales total $250,000. Sulley's estimates that 10% of all hot tubs sold will
require warranty work.
(Sulley's has a claim of right to the $250,000 in hot tub sales. Sulley's is under no obligation to repay any specific
hot tub sale. The provision of the warranty is a general obligation that applies to all sales. The fact that it may have
to replace or repair some of the hot tubs does not negate its claim of right to the hot tub sales.)
b. In 2012, Retro Fit Construction Company purchased equipment by borrowing $100,000 from Fifth State Bank.
After paying off $30,000 of the loan, Retro has financial problems in the current year and cannot afford to make its
regular payment. Rather than have Retro default on the loan, Fifth State Bank agrees to reduce the debt to $50,000.
When Retro borrowed the $100,000 in 2012, it did not have a claim of right because it was under an obligation to
repay the loan. When the loan is reduced to $50,000, Retro acquires a claim of right to the $20,000 ($100,000 -
$30,000 - $50,000) that it is no longer obligated to repay.
c. Larry's Lawncare Service provides lawn mowing and fertilization services to residential customers. Customers
can pay by the month, or they can purchase a one-season contract for $1,000. The contracts obligate Larry's to
provide the necessary mowing and fertilization from April through October. In September, Larry's has a “pre-season”
sale that lets current customers purchase next season's contract for $800. Fourteen customers buy the discounted
contract in September. (Larry's has a claim of right to the $11,200 ($800 x 14) in prepaid service contracts that it
receives. It is not under a strict obligation to repay the $800 prepayment price. Larry's obligation is to provide the
contracted services, not repay the contract price.)
d. Alexander Associates does computer consulting for Bertman, Inc., in September. Bertman pays Alexander's
$3,000 bill for the work in October 2014. In late November, Bertman's computer system crashes and Bertman sues
Alexander, seeking reimbursement of $3,000. The lawsuit is scheduled for court in March 2015.
Alexander Associates has a claim of right to the $3,000. The lawsuit does not provide a definitive obligation to
repay any part of the $3,000 and does not negate Alexander's claim of right to the income.
19. Junior bought some stock several years ago for $8,000. He is thinking of selling and has 2 offers. His
broker told him he could sell the stock for $8,300 and would have to pay a $600 commission, for a net
realization of $7,700. His sister Bonnie offered to pay Junior $7,700 with no commissions paid on the
transaction.
The issue is whether Junior will be able to deduct the $300 ($7,700-$8,000) loss if he sells the stock to his sister.
Bonnie is a related party. Transactions between related parties are given close scrutiny and a set of rules have been
constructed to prevent manipulations between related parties. Even though Junior would be selling the stock to
Bonnie at fair market value net of commissions (what he would have received from an unrelated party), the tax law
disallows the deduction of any loss on a sale between related parties.
20. What is the difference between realized income and recognized income? Realized income occurs when a
taxpayer receives an increase in wealth in an arm's-length transaction. Recognized income is income that is actually
taxed in the current tax year. Therefore, all recognized income must first be realized. However, all realized income
may not be recognized currently. Some forms of income are excluded permanently from tax (e.g., municipal bond
interest), while other forms of income are deferred for recognition in a future period (e.g., gains from like-kind
exchanges).
21. What is an installment sale? An installment sale is any sale of property at a gain in which payments are
received in more than one tax year. Qualifying taxpayers must use the installment sales method to recognize income
from the sale (they may make an election to recognize the entire gain in the period of sale).
22. Two Sisters is a partnership that owns and operates a farm. During the current year, the partnership
raised and harvested hay at a cost of $20,000. It then traded half the hay for quarter horse breeding stock---
young horses worth $30,000. Two Sisters fed the remainder of the hay to the horses, which was worth $50,000
at the end of the year. How much income does the partnership have from these transactions during the
current year?
Two Sisters realized $30,000 for hay that cost $10,000 ($20,000 x 50%) when it exchanged the hay for the horses.
Therefore, it has $20,000 ($30,000 - $10,000) of income from the exchange. The value of the hay that was fed to
the horses remains unrealized. Even though the horse's value has increased $20,000 ($50,000 - $30,000) by the end
of the year, the increase has not been realized in an arm's-length transaction and no income is recognized. Note:
Two Sisters could deduct the $10,000 cost of the hay that was fed to the horses in the current year.
23. Darcy borrowed $4,000 in 2011 from her employer to purchase a new computer. She repays $1,000 of the
loan plus 6% interest on the unpaid balance in 2011, 2012, and 2013. After closing a big deal in 2014, she
receives the original loan agreement stamped ``paid in full'' across the face. Does Darcy have to recognize
any income from the cancellation of the loan in 2014? Explain.
Darcy has obtained a claim of right to the $1,000 ($4,000 - $3,000) loan balance. Because she is no longer under a
strict obligation to repay the $1,000, it is included in her 2014 gross income. The cancellation of the loan balance
by her employer is a form of compensation and must be included in income when she obtains a claim of right to the
income.
24. In each of the following cases determine who is taxed on the income:
a. For $200, Lee purchases an old car that is badly in need of repair. He works on the car for 3 months and spends
$300 on parts to restore it. Lee's son Jason needs $2,000 to pay his college tuition. Lee gives the car to Jason, who
sells it for $2,000 and uses the money to pay his tuition. (Jason is taxed on the gain from the sale of the car. By
making a valid gift to Jason (which is not taxed), Jason becomes the owner of the auto. The assignment of income
doctrine does not tax Lee in this case because he has given away the property. NOTE: If Lee had sold the car and
given Jason the cash, then Lee would have been taxed on the gain from the sale of the car.)
b. Erica loaned a friend $20,000. The terms of the loan require the payment of $2,000 in interest each year to Erica's
daughter. At the end of 4 years, the $20,000 loan principal is to be repaid to Erica. Erica's daughter will use the
$2,000 to pay her college tuition. (The $2,000 of interest paid to Erica's daughter is taxed to Erica under the
assignment of income doctrine. Because Erica retains ownership of the property generating the income (the
principal is to be repaid to her), she is taxed on any income generated by the property even though she does not
actually receive it.)
25. Ratliff Development Corporation purchases a tract of land in 2013 at a cost of $120,000 and subdivides
the land into 30 building lots. The cost of subdividing is $6,000. In 2013, Ratliff installs roads and utilities at
a cost of $36,000 and pays property taxes totaling $2,000 in 2013 and 2014. Interest paid on the loan used to
purchase the land is $10,000 in 2013 and $6,000 in 2014. In 2014, Ratliff sells 10 lots for a total of $350,000.
What is the corporation's gain or loss on the sale of the lots?
Ratliff has a gain of $296,000 [$350,000 - ($5,400 x 10)] on the sale. The adjusted basis of each lot is $5,400. The
land had an initial basis of $120,000. The cost of subdividing the land ($6,000) and installing roads and utilities
($36,000) are capital expenditures that are added to the basis. The property taxes and interest on the loan are current
period deductions and do not affect the basis of the land. The adjusted basis of the land is $162,000 ($120,000 +
$6,000 + $36,000), which is $5,400 ($162,000 ÷ 30) per lot. Amount realized=$350,000, Adjusted basis=
($5,400x10) = (54,000), Gain on sale=$296,000.
26. Determine the amount of income that must be recognized in each of the following cases:
a. Ramona is a production supervisor for White Company. During the current year, her division had no accidents,
and White rewarded the achievement with a $200 cash award to each employee in the division.
Prizes and awards are generally taxable. Up to $400 of an award of tangible, personal property for length of service
or safety is excluded. Because Ramona's safety award is paid in cash (not tangible, personal property), it is a taxable
award.
b. Lenny retires from the Brice Company this year. At his retirement reception, the company gives him a set of golf
clubs valued at $600 in appreciation of his years of loyal service. (Up to $400 of an award of tangible, personal
property for length of service or safety is excluded. The exclusion is increased to $1,600 if the award is made from
a qualified plan. If Brice Co. does not have a qualified plan, then Lenny has $200 ($600 - $400) of income from the
receipt of the golf clubs. If Brice has a qualified plan, then Lenny has no income from the receipt of the golf clubs.)
c. Fatima is named Humanitarian of the Year by Local City for her volunteer service. She receives a plaque and an
all-expense-paid trip to Washington, D.C., where she will meet the president. The value of the trip is $1,400.
Prizes and awards are generally taxable. Awards for literary, scientific, and charitable achievements are excluded
from income if the recipient transfers the prize or award to a charitable or governmental organization. The individual
must not have taken any action to claim the award and no future services must be performed as a condition of
receiving the award. Assuming that Fatima does not transfer her award to a charitable or governmental
organization, she must include the $1,400 value of the trip in her gross income.
d. Sook is a college professor specializing in computer chip development. During the current year, he publishes a
paper that explains the design of a revolutionary new chip. Softmicro, Inc., awards him $10,000 for the best
breakthrough idea of the year. Sook uses the money to purchase a computer workstation to use in his research.
(Prizes and awards are generally taxable. Awards for literary, scientific, and charitable achievements are excluded
from income if the recipient transfers the prize or award to a charitable or governmental organization. The individual
must not have taken any action to claim the award and no future services must be performed as a condition of
receiving the award. Because Sook did not transfer the award to a charitable or governmental organization, he must
include the $10,000 award in his gross income.)
27. Will and Janine are divorced during the current year. Will is to have custody of their two children and
will receive their house as part of the divorce settlement. The house, which Will and Janine bought for $60,000,
is worth $100,000. Janine is to receive one of their automobiles, for which they paid $21,000 and which is now
worth $9,000. Will will get the other automobile, which cost $6,000 and is worth $2,000. Janine is to pay Will
alimony of $900 per month. However, the alimony payment is to be reduced $200 per month as each child
reaches age 18 or if a child should die or marry before reaching age 18. What are the tax effects of the divorce
settlement for Will and Janine?
Property settlements and child support payments have no income tax effect. The division of the property (house and
car to Will, and the car to Janine) has no effect on the income of either Will or Janine. Alimony payments are taxable
to the receiver of the alimony and deductible by the payor. However, when alimony payments are reduced as a result
of a contingency related to a child, the reduction is treated as child support. In this case, the alimony will be reduced
$400 ($200 per month per child), which is treated as child support. The remaining $500 ($900 - $400) is alimony
and is taxable to Will and deductible by Janine.
28. Determine whether the following taxpayers have gross income from the payment of their expenses:
a. Julia's mother, Henrietta, is short of cash when it comes time to pay her property taxes. Julia pays Henrietta's
property taxes of $350. (The payment of a relative's expenses is considered a gift. There is no intention to
compensate through payment of Henrietta's property taxes, and no income is recognized from the payment.)
b. Kurt fell asleep at the wheel one night and crashed his car into a telephone pole. Repairs to the car cost $600.
Kurt isn't covered by insurance and doesn't have the cash to pay the repair shop. Because he needs his car in his job
as a salesman, his employer pays the repair bill. (The $600 paid by the employer is compensation for Kurt. Most
payments of another's expense in an employment setting are compensation. Note: If Kurt's employer requires Kurt
to repay the $600, the payment is a loan and not compensation to Kurt.)
c. Leonard leases a building from the PLC partnership for $800 per month. The lease agreement requires Leonard
to pay the property taxes of $1,100 on the building. (The $1,100 is taxable to the PLC partnership. The payment of
PLC's property taxes by Leonard is a form of rental payment and should be included in PLC's rental income from
the property.)
d. On July 1, Gino bought some land from Harco Corporation for $14,000. As part of the sales agreement, Gino
agrees to pay the property taxes of $700 for the year. Harco had paid $10,000 for the land. (The sales price of the
land is $14,350. The $350 ($700 x 6÷ 12) of Harco Corporation's property taxes by Gino is part of the sales
agreement and is equivalent to paying Harco the cash. Thus, Harco's gain on the sale is $4,350 ($14,350- $10,000).)
29. Minnie owns a qualified annuity that cost $78,000. The annuity is to pay Minnie $650 per month for life
after she reaches age 65. Minnie turns 65 on September 28, 2014, and receives her first payment on November
1, 2014.
a. How much gross income does Minnie have from the annuity payments she receives in 2014?
The nontaxable portion of an annuity payment is determined using the annuity exclusion ratio. To determine the
monthly amount that can be excluded, the recipient divides their investment in the annuity by the number of months
the annuity is expected to be received. Because the annuity is based on the life of the taxpayer, the number of months
the annuity is expected to be received determined using the annuity table for a single taxpayer (Table 3-1).
Minnie is age 65 when she begins receiving the annuity payments and her expected number of payments is 260.
Her monthly exclusion of $300 ($78,000 ÷260 months) represents the monthly return of her $78,000 investment.
Minnie must include the remaining $350 of each payment in gross income because it represents the return on her
investment. Her 2014 gross income from the annuity is $700 ($350 x 2 payments): Monthly amount to be excluded:
$78,000 ÷260 = $300; Payment received $650; Excluded amount (300); Taxable amount $ 350.
b. Shortly after receiving her payment on October 1 M m
M
m m m
M m
m m
m
m
m m M
m
m m m m m
m m m
m
m
m
W m m
m %m
Capital gains and losses from collectibles are treated as being held long term in the capital gain and loss netting
procedure. Rikki has a $1,000 net short-term capital gain and a $14,000 net long-term capital gain:
Netting of short-term and long-term gains and losses:
Short-term gain and loss netting:
Net short-term capital gain $ 1,000
Long-term gain and loss netting:
Long-term capital gain $ 11,000
Long-term capital loss (3,000)
Collectibles gain 8,000
Collectibles loss (2,000)
Net long-term capital gain $ 14,000
Because all capital gains and losses have been reduced to a net gain position, no further netting is necessary. The
net short-term and long term capital gains are added to her gross income. Rikki's taxable income increases by
$15,000.
Short-term gain = $1,000, Net 28% rate gain= $ 8,000-$2,000 = $6,000 Adjusted net capital gain=$14,000-$6,000
= $ 8,000
The short-term gain is taxed at Rikki's 33% marginal tax rate (ordinary income). Her net collectible gain of $6,000
is taxed at a maximum rate of 28%. The $8,000 adjusted net capital gain is taxed at 15%. Her tax liability increases
by $3,210:
Tax on $ 1,000 short-term capital gain - $ 1,000 x 33% $ 330
Tax on $ 6,000 net 28% rate gain - $ 6,000 x 28% 1,680
Tax on $22,000 adjusted net capital gain - $ 8,000 x 15% 1,200
Increase in tax liability $3,210
Note: If Rikki’s AGI is greater than $200,000, the $14,000 net long term capital gain is subject to the Medicare
Surtax. Assuming that her AGI is greater than $214,000, Rikki will pay an additional $532($14,000 x 3.8%) tax on
her $14,000 long term capital gain.
31. Jason and Jill are married and have a six-year-old daughter. During the year they sell one acre of land
for $80,000. Three years ago, they paid $70,000 for two acres of land. Their other income and deductions are
as follows:
Jill’s commissions $82,000
Jason’s salary 46,000
Dividend income 5,000
Interest income 8,000
Short-term loss on sale of stock in Nippon Inc. (15,000)
Deductions for adjusted gross income 28,000
Calculate Jason and Jill’staxable income and income tax liability for the current year.
The basis in the one acre Jason and Jill sold is $35,000 ($70,000 ÷2 acres). They have a $45,000 ($80,000 - $35,000)
long-term capital gain on the sale of the land. The long-term gain is netted against the $15,000 short-term capital
loss, resulting in a net long-term capital gain of $30,000 ($45,000 - $15,000). The net long-term capital gain is
included in their gross income. Jason and Jill's taxable income is $118,750:
Salary $ 82,000
Commissions 46,000
Interest income 8,000
Dividend income 5,000
Net long-term capital gain 30,000
Gross income $ 171,000
Deductions for adjusted gross income (28,000)
Adjusted gross income $ 143,000
Deductions from adjusted gross income
Standard deduction (12,400)
Personal and dependency exemptions ($3,950 x 3) (11,850)
Taxable income $ 118,750
Because dividends and net long-term capital gains are taxed at a rate of 15%, the tax on the $5,000 dividend income
and the $30,000 long-term capital gain must be computed separately from the tax on their other income. This results
in a tax of $17,900:
Tax on $83,750 ($118,750 - $35,000) other income:
$10,162.50 + [25% x ($83,750 - $73,800)] $12,650
Tax on $35,000
($5,000 dividends + $30,000 long-term capital gain):
$35,000 x 15% 5,250
Total tax liability $ 17,900
Without the 15% dividend and capital gains tax, Clark and Jill's tax would have been $21,400. Therefore, the
dividend and capital gains relief has saved them $3,500 ($21,400 - $17,900) in tax.
32. What tax relief is provided to U.S. citizens who earn income in a foreign country and pay taxes in that
country?
To prevent double taxation of income, foreign earned income may either be excluded from gross income (up to
$99,200 in 2014) or the income may be included in gross income and a tax credit taken for the taxes paid to the
foreign country. However, the tax credit cannot exceed the amount of U.S. taxes the taxpayer would have paid on
the income.
33. What is a Health savings account? An HSA is a savings account used to pay medical expenses with pre-tax
income. Earnings on an HSA are not taxed. Distributions from an HSA that are used to pay medical expenses are
excluded from gross income. To be eligible to establish an HSA, an individual must be covered by a high-deductible
health insurance plan. Contributions to an HSA can be made by an employer or the individual establishing the
account. Contributions by an employer are excluded from the employee’s gross income. Contributions by an
individual are deductible for adjusted gross income. In addition, unlike a flexible benefits plan, the unused balance
in the HSA is carried forward to future tax years.
34. Are all stock dividends received excluded from gross income? The general rule is that a dividend received in
the form of stock is not taxable because it does not represent an increase in the wealth of the taxpayer. However,
when the stockholder has the option of taking cash in lieu of the stock, the dividend is taxable (even if the stock is
taken). In this case, the stock is deemed to have a cash-equivalent that represents an increase in wealth and therefore,
is subject to tax.
35. A fire extensively damaged a small Alaska town where Intech Company had its primary plant. Intech
decided to give $200 to each household that lost its residence. About 12% of the payments were made to
Intech employees. Is the receipt of $200 by some Intech employees taxable as compensation or excludable
as a gift?
The question to be resolved is whether the payments made to Intech employees are gifts (excluded) or are a form
of compensation. In order to be a gift, the payment must be made with a "detached and disinterested generosity"
that is out of "affection, respect, admiration, charity, or like impulses." In making this determination, the courts have
held that it is the intention of the transferor that is the controlling factor in determining whether a payment is a gift.
The facts would indicate that the payments to Intech employees do constitute gifts. Because Intech gave $200 to all
households that suffered damage, the payments show detachment (payments to individuals that are not its employees)
and charitable intent (helping out the community), with no specific intent to compensate its employees.
36. During the current year, Alexis gives her daughter Tabatha stocks worth $80,000 on the condition that
she pay her son Rory the first $7,000 in dividends on the stock each year. Discuss the taxability of this
arrangement in each of the following cases. The value of a gift is excluded from income. The receipt of the stock
would not be taxable. Any subsequent earnings on the stock would be taxable. The question to be resolved is whether
the transfer of the dividends from Tabatha to Rory is an assignment of income that will be taxed to Tabatha. In this
case, Alexis is making a gift of up to $7,000 of the income from the stock to Rory. The gift of income is not
excludable; it is taxed to Rory. Tabatha will only have income from any dividends she retains.
a. The stocks pay total dividends of $8,000. Tabatha pays Rory $7,000 under the agreement. (Rory includes the
$7,000 in his gross income. Tabatha is taxed on the $1,000 of dividends that she retains.)
b. The stocks pay total dividends of $5,500. Tabatha pays Rory $5,500 under the agreement. (Rory is taxed on the
entire $5,500. Tabatha receives no dividends and has no income from the dividends.)
Instructor's Note: If the terms of the gift required Tabatha to always pay Rory $7,000 regardless of the amount of
dividends, then Tabatha would have to sell some of the stock in part b to make the required payment. In this case,
the additional $1,500 payment would have been from principal and therefore, not subject to tax under the capital
recovery concept.
37. Herman inherits stock with a fair market value of $100,000 from his grandfather on March 1. On May 1,
Herman sells half of the stock at a gain of $10,000 and invests the $60,000 proceeds in Jordan County school
bonds. The bonds' annual interest rate is 6%, which is paid on July 31 and January 31. On October 15,
Herman receives a $2,200 dividend on the remaining shares of stock. How much gross income does Herman
have from these transactions?
Herman must include the $10,000 capital gain from the sale of half of the stock and the $2,200 of dividend income
in his gross income. The receipt of the inherited stock is excluded from income. However, any subsequent earnings
on the stock is not part of the inheritance and must be included in gross income. The interest Herman receives from
the Jordan County school bonds is excludable municipal bond interest.
38. Earl is a student at Aggie Tech. He receives a $5,000 general scholarship for his outstanding grades in
previous years. Earl is also a residence hall assistant, for which he receives a $1,000 tuition reduction and
free room and board worth $6,000 per year. Earl's annual costs for tuition, books, and supplies are $8,000.
Does Earl have any taxable income from the scholarship or the free room and board?
Earl has $7,000 ($6,000+$1,000) of income from the receipt of the free room and board. Even if the room and board
were considered to be a scholarship, it could not be excluded because it is designated for payment of costs that are
not direct education costs. The $5,000 general scholarship is excluded because it is less than the actual direct costs.
NOTE: Earl may be able to exclude the value of the room and board and the $1,000 tuition reduction if it meets the
requirements for meals and lodging provided by an employer. To exclude the value of meals, the meals must be
provided on the employer's premises and be for the convenience of the employer. The same requirements are
applicable to lodging with the extra provision that the lodging be required in order to accept employment. In
determining whether this exclusion applies, one would first have to determine whether Earl is an employee of the
residence hall. Assuming that he is, the meals may not meet the convenience of employer test (there is no advantage
to the employer in having Earl eat in the residence hall cafeteria) and would not be excludable. The lodging would
meet the convenience test and would be excludable.
39. Assume the same facts as in problem 27, except that Earl is not a residence hall assistant and his general
scholarship is for $10,000.
Scholarships can be excluded up to the amount of the direct education costs. In case a, the scholarship is less than
the $8,000 of direct costs and fully excludable. In case b, the scholarship exceeds Earl's direct costs and he is taxed
on the $2,000 excess.
40. Determine whether the taxpayers in each of the following situations have realized taxable income:
a. Alexander inherited a tract of land from his uncle who died during the current year. A friend of Alexander's who
is a petroleum engineer told him he thought there might be oil on the land. Alexander had the land surveyed, and an
oil deposit worth an estimated $5,000,000 was discovered on the property. (The value of the land is excluded
because it is received through inheritance. The discovery of the oil deposit does not constitute a realization. Although
the form of the property may be altered by the discovery, the value of the discovery has not been realized through
an arm's-length transaction.)
b. Mickey was given 2 tickets to the World Series by a friend. Mickey sold the tickets for $500 apiece. (Mickey
has realized income of $1,000 less his basis in the tickets. The receipt of the tickets is excluded as a gift. However,
the subsequent sale of the tickets is not excludable. Note: The tickets have a basis equal to Mickey's friend's basis,
which reduces the gain on the sale.)
c. Hannah is the purchasing agent for Slim Diet Centers. Harold, a salesman who does considerable business with
Hannah, gave her a set of golf clubs worth $750. Harold told Hannah that he was giving her the clubs to show his
appreciation for being such a good friend throughout their business dealings. (The question to be answered is
whether the golf clubs are a valid gift or a payment for past, present or future services. In this case, the business
relationship is so strong that is likely that the golf clubs would not meet the criteria for a gift. It appears that Harold
is attempting to compensate Hannah for their past relationship in hopes of continuing the relationship. )
d. Melanie's father died during the current year. She was the beneficiary of a $200,000 insurance policy on her
father's life. She received the proceeds on August 1 and immediately invested them in a bank certificate of deposit
with a 9% annual earnings rate. (The receipt of the $200,000 face value of the life insurance policy is excluded from
tax. However, any subsequent earnings on the $200,000 would be taxable.)
41. Courtney is an employee of Freemont Company. An average of three times a week, she works out during
her lunch hour at a health club provided by Freemont. Discuss the taxability of Freemont’s provision of the
health club in the following situations.
a. The health club is owned by Freemont and is located on its business premises. All employees and their dependents
are allowed to use the facility. The cost of joining a comparable facility is $60 per month. (Employees can exclude
the value of using an employer's athletic facility if the facility is on the employer's premises and substantially all of
the use of the facility is by employees and their families. These conditions are met and Courtney does not have any
income from the use of health club.)
b. The health club is located in Freemont’s office building, but is owned by Manzer Fitness World. Freemont pays
the $60 per month health club dues. (Because the health club is not owned by Freemont Co., Courtney cannot
exclude the value of the health club dues. Courtney must include the $720 ($60 x 12) of health club dues paid by
Freemont in her gross income.)
c. Freemont is in the health club business. The health club is used primarily by customers, although several
employees, including Courtney, use it, too. (Courtney cannot exclude the value of the health club dues under the
provision for use of an employer's athletic facility because the primary use of the facility is by customers, not
employees. However, if free use of the health club is available to all of Freemont's employees, it is excluded as a
no-additional cost service. If all employees are not allowed to use the health club, then Courtney must include the
$720 ($60 x 12) of health club dues in her gross income.)
42. Determine the taxability of the damages received in each of the following situations:
a. Helio Corporation sues Wrongo Corporation, charging that Wrongo made false statements about one of Helio's
products. Helio claims that the statements injured its business reputation with its customers. The court awards
Helio $2,000,000 in damages. (Helio must include the $2,000,000 in damages in gross income. The exclusion for
damages is based on personal physical injuries to the taxpayer. Because a corporation is an artificial entity, it cannot
suffer a personal injury and must include any damages it receives in gross income.)
b. Lien is injured when a chair on a ski lift she is riding on comes loose and crashes to the ground. Lien sues the ski
resort and receives $12,000 in full payment of her medical expenses, $4,000 for pain and suffering, and $6,500 for
income lost while she recovers from the accident. The company that manufactured the ski lift also pays Lien $50,000
in punitive damages. (Lien has gross income of $50,000. Payments received for personal physical injury or sickness
are excluded from income. Loss of income payments are included in income unless they are paid as a result of a
personal physical injury. Because the $6,500 loss of income payment is made on account of personal injury, it
qualifies for exclusion. Punitive damages are included in gross income. Therefore, the $50,000 payment to Lien is
included in her gross income. The $12,000 she receives for medical expenses and the $4,000 of pain and suffering
payments are payments for a personal physical injury, and are excludable.)
c. A major broadcasting company reports that Dr. Henry Mueller was engaged in Medicare fraud. The doctor is
incensed and sues the company for libel. The court rules that the report was made with reckless disregard for the
truth and awards Mueller $20,000 for the humiliation he suffered because of the allegation, $200,000 for loss of his
business reputation, and $150,000 in punitive damages.(Dr. Mueller has gross income of $370,000. The $20,000
payment for humiliation is not a personal physical injury and is included in gross income. The $150,000 punitive
damage payment and $200,000 for loss of business reputation are also included in gross income.)
43. Determine the tax treatment of the payments received in each of the following cases:
a. Anastasia is covered by her employer's medical insurance policy. During the current year, the policy reimburses
her for $960 of the $1,200 in medical costs she incurred. (Payments received for medical expenses from an
employer-provided insurance policy are excluded from income. The exclusion is limited to the actual medical costs
incurred. Because the reimbursement is less than actual costs, Anastasia excludes the $960 reimbursement.)
b. Alfredo, who is self-employed, is injured in a snowmobile accident. The insurance he purchased covers $3,200
of the $3,900 in medical costs related to the accident. It also pays him $2,000 to cover the income he loses during
his recuperation. (All payments received from medical insurance policies purchased by the taxpayer are excluded
from income. Because Alfredo purchased the policy, he excludes all amounts received from the policy (even the
$2,000 loss of income payment).)
c. Libby is injured when a company truck backs over her at a warehouse. The company pays her $2,200 in medical
expenses from its self-insured medical reimbursement plan. (All employees are covered by the plan.) During her
recuperation, the company pays her normal $1,300 salary. In addition, she receives $600 from an insurance policy
the company purchased to cover its liability to injured employees. (Libby has gross income of $1,900 ($1,300+$600).
Payments received from a non-discriminatory self-insured medical reimbursement plan are excluded from income.
The $1,300 in salary she receives is not a payment related to the personal physical injury (she would have received
it without the injury). Payments for medical expenses, loss of limbs, disfigurement, etc. received from employer-
provided medical policies are excluded. The payment from the employer's liability policy does not meet these
criteria and cannot be excluded from gross income.)
d. Shortly after beginning work for El Dorado Corporation, Manny is injured when a lathe he is operating breaks
his leg. Because he has not worked for the company long enough to qualify for employee medical insurance
coverage, the company pays his $800 medical bill. (Manny has $800 of gross income. The payment is not made
from an employer-provided insurance policy or from a non-discriminatory medical reimbursement plan.)
44. Vito is having financial difficulties. Among other debts, he owes More Bank $300,000. Rather than lend
Vito more money to help him out, More Bank agrees to reduce his debt to $200,000.
Discharges of debt generally constitute taxable income. However, if the taxpayer is insolvent (liabilities exceed
assets) before the discharge, no income is recognized if the taxpayer remains insolvent after the discharge. However,
if the discharge makes the taxpayer solvent, income must be recognized to the extent of the taxpayer's solvency (a
measure of wherewithal-to-pay) after the discharge.
a. How much gross income must Vito recognize if his assets total $600,000 and his liabilities are $400,000 before
the forgiveness of debt? (Because Vito is solvent before the forgiveness of debt, the full $100,000 (300,000 -
$200,000) debt reduction is included in his gross income.)
b. Assume the same facts as in part a, except that Vito's liabilities are $800,000 before the forgiveness of debt. (In
this case, Vito is insolvent before ($600,000-$800,000) and after [$600,000-($800,000-$100,000) = ($100,000)] the
discharge. Therefore, he is not taxed on the $100,000 forgiveness of debt.)
c. Assume the same facts as in part a, except that Vito's total liabilities are $625,000 before the forgiveness of debt.
(Vito is insolvent before the forgiveness ($600,000-$625,000) and solvent [$600,000-($625,000-$100,000) =
$75,000] after the forgiveness. He must recognize $75,000 of the forgiveness as gross income, the extent to which
he is solvent after the discharge.)
45. Joan is a single individual who works for Big Petroleum,Inc. During all of 2014, she is stationed in West
Africa. She pays West African taxes of $19,000 on her Big Petroleum salary of $88,000. Her taxable income
without considering her salary from Big is $36,000. How should Joan treat the salary she receives from Big
Petroleum on her 2014 U.S. tax return?
Because Joan has worked in West Africa for the entire year, she has the option of excluding the $88,000 salary from
her income (less than $99,200) or including the entire salary in her income and taking a foreign tax credit for the
West African taxes she paid (the foreign tax credit cannot exceed the U.S. tax that would have been paid on her
West African income). If Joan elects the exclusion option, her taxable income will be $36,000 ($88,000 - $88,000
+ $36,000). The exclusion cannot exceed her salary. The tax on the $36,000 is the difference between the tax on
the taxable income without the exclusion ($124,000) and the tax on the excluded amount ($88,000). Under the
foreign tax credit option, her taxable income will be $124,000 ($88,000 + $36,000). Joan's net tax payable will be
$1,144 ($8,896 versus $10,040) lower with the tax credit option:
Options:
Options:
1. Exclude $88,000 from taxable income:
Income tax on $124,000:
$18,193.75 + [28% x ($124,000 - $89,350)] $ 27,896
Less: Tax on $88,000
$5,081.25 + [25% x ($88,000 - $36,900)] 17,856
Equals: Tax on $36,000 $ 10,040
2. Foreign Tax Credit Alternative:
Income tax on $124,000:
$18,193.75 + [28% x ($124,000 - $89,350)] $ 27,896
Tax credit for West African taxes paid* (19,000)
Net tax due $ 8,896
Tax savings using tax credit option $ 1,144
* The foreign tax credit cannot exceed the amount of U.S. tax that would have been paid on the West African income.
In this case, the U.S. tax on her West African income is $19,797 and Joan is allowed a foreign tax credit for the
$19,000 of actual taxes paid: $27,896 x ($88,000 ÷$124,000) = $19,797
46. Differentiate primary tax law authorities and secondary tax law authorities.
Primary tax law authorities are those authorities that contain the actual provisions and official interpretations of the
tax law. As such, they correspond to the three functions of government: legislative (the actual tax law),
administrative (government interpretation of and compliance with the tax law), and judicial (resolution of
interpretation differences between taxpayers and the government). Secondary tax law authorities serve as tools for
locating the primary authorities and also offer commentary on the authorities that aid in the interpretation and
understanding of the primary tax law authorities.
47. What is a Treasury regulation? Is it binding on the courts?
A Treasury regulation is the Treasury Department's official interpretation of a provision in the Internal Revenue
Code. Because of the extensive review and public comment process that goes into the issuance of a regulation, they
are considered to have the force and effect of the law. However, they are not binding on the courts. That is, if the
courts find that a Treasury regulation is inconsistent with the expressed or implied intention of the related Code
Section, they will overturn the regulation and not give effect to its interpretation.
48. What does it mean when the IRS issues an acquiescence or non-acquiescence?
An acquiescence or non-acquiescence is the IRS response to a court decision that it loses. An acquiescence is used
to notify taxpayers that it agrees with (i.e., will follow) the court’s decision. A non-acquiescence indicates that the
IRS does not agree with (i.e., will not follow) the court’s decision and is usually taken as a signal that the IRS will
continue to litigate this issue.
49. What is meant by the Golsen rule?
The Golsen rule is used by the Tax Court. Under this rule, the Tax Court will always follow a decision in the circuit
court to which an appeal of the Tax Court decision lies. That is, if the Tax Court is considering a case that would be
appealed to the 3rd circuit, the Tax Court will always follow a decision on the issue being litigated that has been
issued by the 3rd circuit. The Tax Court is not generally bound by decisions in other circuits although they often
look to these decisions for guidance.
50. Provide the correct citations for the following:
a. The fifteenth revenue procedure issued in 1993 and found on page 12 of the third Internal Revenue Bulletin issued
in 1993.
Rev. Proc. 1993-15, 1993-3, I.R.B. 12.
b. Subsection (a) of the first temporary income tax regulation interpreting Section 63.
Temp. Reg. Sec. 1.63-1(a) or Reg. Sec. 1.63-1T (a).
c. An acquiescence issued by the IRS on page 1 of volume 1 of the 1992 Cumulative Bulletin related to Chasteen v.
Comm., which was reported on page 132 of volume 77 of Reports of the United States Tax Court in 1991.
Chasteen, 77 T.C. 132 (1991), acq. 1992-1 C.B. 1
51. Use any print or CATR service or the Internet to find a Code section(s) on the following income topics.
For each item, indicate the Code section number(s) and full title of the relevant Code section(s).
a. Discharge of indebtedness The Code Section that discusses discharge of indebtedness is Sec. 108 and is entitled:
Income from discharge of indebtedness.
Other related sections include:
Sec. 1017. Discharge of indebtedness (basis adjustment).
Sec. 1234A. Gains or losses from certain terminations.
Sec. 6050P. Returns relating to the cancellation of indebtedness by certain entities (information returns).
Sec. 61(a) (12) is clause that includes income from discharge of indebtedness as an item of gross income.
b. Exclusion for employees’ educational expenses
The Code Section that discusses the exclusion for employees’ educational expenses is Sec. 127 and is entitled:
Educational assistance plans.
c. Prizes: The Code Section that discusses prizes is Sec. 74 and is entitled: Prizes and awards.
52. Differences between regulations:
Proposed regulations do not become effective until after comments and testimony are received ("notice and
comment"), and a final regulation is issued.
Temporary regulations are effective upon publication in the Federal Register and may be valid for no more than
three years from their date of issuance. [2] Because the notice and comment process can take several months or
even years, if the Treasury wants a regulation to become effective more quickly, it will often issue a proposed
regulation simultaneously as a temporary regulation.
Under treasury regulation authority, the Secretary of the Treasury can promulgate final regulations. In the process
of enacting final regulations, the Treasury issues proposed or temporary regulations.
Temporary Regulations
Temporary regulations are issued to provide immediate guidance to the public and IRS and Counsel employees
prior to publishing final regulations. Temporary regulations are effective when published by the Office of the
Federal Register.
IRC § 7805(e) requires the IRS to publish a cross-referencing NPRM when it publishes a temporary regulation.
Section 7805(e) also provides that a temporary regulation expires (sunsets) within three years of issuance.
1. Definition of a Tax: 1. An enforced, involuntary contribution; 2. Required and determined by law; 3. Providing
revenue for public and governmental purposes; 4. For which no specific benefits or services are received
2. Tax Rates for Income Tax: 1. Marginal Tax Rate: The rate of tax on the next dollar of taxable income; 2. Average
Tax Rate: The rate equal to the total tax divided by the tax base; 3. Effective Tax Rate: The rate equal to the total
tax divided by economic income
3. Tax Formula: Adjusted Gross Income=Income Broadly Conceived-Exclusions=Gross Income- Deductions For
Adjusted Gross Income=Adjusted Gross Income
4. Tax Formula: Taxable Income= Gross Income – for deductions= adjusted Gross income –from
deductions=Taxable income
5. Deduction Types: For Deductions [Not restricted based on taxpayer’s income; generally trade, business, rent or
royalty expenses; From Deductions [Restricted based on Adjusted Gross Income;
Generally personal expenses Itemized or; Standard Amount (changes with filing status)
6. Tax Formula: Tax Due= Taxable income * Tax rate= income tax liability – prepayments & Credits= Tax or
(Refund) due
7. Tax Planning: 1. Goal is to maximize after-tax wealth. 2. Considers the Time Value of money: (1) Defer income;
(2) Accelerate deductions; 3. Considers marginal tax rates: (1) Recognize income in year of lower marginal rate; (2)
Recognize deductions in year of higher marginal rate; (3) Shift income to taxpayer with lower marginal rate.
8. Tax Avoidance: Taxpayers have no obligation to pay more tax than the law requires
9. Tax Evasion: Taxpayers may not use fraudulent or deceptive behavior to hide tax liability
10. Four Major Groupings of Concepts:1.General concepts;2.Accounting concepts;3.Income concepts;4. Deduction
concepts.
11. General Concepts: Ability to Pay; 1.Tax should be based on an amount that a taxpayer can afford to pay. 2.
Constructs used: (1) Deductions (2) Exclusions (3)Credits (4)Progressive tax rates
12. General Concepts: Administrative Convenience: 1.The benefit derived from a concept, construct, or doctrine
should always exceed the cost of implementation. 2. Constructs used: (1) Standard deduction amounts; (2) Fringe
benefit exclusions; Example: Bow Company allows its employees to make copies for personal reasons without
charge on the company copy machine. The employees are not required to include the value of the copies in taxable
income.
13. General Concepts: Arms-Length Transaction: 1. A transaction between related parties must reflect economic
reality. 2. Constructs used (1) Related-party provisions (2) Constructive ownership rules. Example: Gaby sells 100
shares of IBM stock to her brother for $10,000. The shares had originally cost Gaby $12,000. Because this is not an
arms-length transaction Gaby is not allowed to use the $2,000 loss from the sale to reduce her taxable income.
14. General Concepts: Pay as You Go: 1. Taxpayers are required to pay tax as they generate income. 2. Constructs
used: (1) Withholding; (2) Estimated tax payments.
15. Accounting Concepts: Entity: 1. Each tax entity must keep separate records and report operations separately; 2.
Constructs used: (1) Taxable entities; (2) Conduit entities; (3) Sole Proprietorships; 3. Doctrine used: Assignment
of Income
16. Accounting Concepts: Assignment of Income: All income earned from services provided by an entity or property
owned by an entity are to be taxed to that entity. Example: Sage is a self-employed electrician. She deposits all cash
payments she receives in a bank account in her son’s name. Sage does not have use of the funds; however, she is
required to include the amount of the cash payments in her gross income.
17. Accounting Concepts: Annual Accounting Period: Each taxpayer must select: 1. A tax year: (1) Calendar; (2)
Fiscal; 2. An accounting method: (1) Cash (2) Accrual; (3) Hybrid
18. Accounting Concepts: Annual Accounting Period Constructs & Doctrines: Tax Benefit Rule, If a tax benefit is
derived from a deduction in one year, any refund received in a subsequent year must be reported as income. Example:
Abner had $4,000 of state income taxes withheld from his salary during 2017. He deducted the $4,000 as part of
his itemized deductions on his 2017 federal return. On May 15, 2018, he received a refund of $1,000 from the state.
When he files his 2018 federal return, Abner will be required to report the $1,000 as income.
19. Accounting Concepts: Annual Accounting Period Constructs & Doctrines: Substance-Over-Form Doctrine: A
transaction must be realistic in an ordinary sense and not contrived merely to avoid tax. Example: Jacee “hired” her
4-year old son as office manager for her real estate firm. When she filed her federal tax return she deducted $20,000
as Salary Expense for him. The IRS disallowed the deduction when they examined her return.
20. Income Concepts: All-Inclusive Income: All income received is taxable unless a provision of the law specifically
excludes it.
21.Income Concepts: Legislative Grace: 1. Any tax relief provided is the result of specific acts of Congress which
are applied and interpreted strictly. 2. Constructs used: (1) Exclusions, deductions and credits; (2) Special
classifications such as capital assets.
22. Income Concepts: Capital Recovery: 1. A taxpayer may recover all invested capital before income is taxed. 2.
Constructs used: (1) Basis (2) Gains and Losses. Example: Nash sold 200 shares of common stock for $2,000.
Because he had paid $800 for the shares, he is required to report only $1,200 as income.
23. Income Concepts: Realization: 1. No income is recognized as taxable income until it has been realized by the
taxpayer. 2. Doctrines used: (1) Claim of Right Doctrine: Applies to both accrual and cash basis taxpayers; (2)
Constructive Receipt Doctrine: Applies only to cash basis taxpayers.
24. Income Concepts: Realization and its Constructs and Doctrines – Claim of Right: 1.Realization does not occur
until an amount has been received without restriction; 2. Applies when the taxpayer received payment but there is
a restriction the taxpayer’s right to keep some or all of it. 3. A modification that prevents cash basis taxpayers from
“turning their backs” on income. 4. Realization is deemed to have occurred if: (1) A taxpayer is aware an amount is
available, (2) The amount is unconditionally available (even without physical possession), (3) and Receipt of the
amount is within the taxpayer’s control. Example1: Pamela rented her garage apartment to Mahlon and collected
$450, the first-month’s rent, in advance. She also collected $500 as a security deposit that she will return to Mahlon
if he doesn’t damage the apartment. She must report only $450 as income because she has no claim of right to the
$500. Example2: Gale is a self-employed handyman. Tracy, one of his customers, brought a check for $250 on
December 30, 2016, to pay for work Gale had finished. Gale asked her to mail the check instead, so he could
check “delivery time.” Gale must report the $250 as income in 2016 even if the check isn’t delivered until 2017.
25. Income Concepts: Wherewithal-to-Pay: 1. Tax should be recognized and paid when the taxpayer has the
resources to pay. 2. Constructs used: (1) Deferrals (2) Recognition of unearned income
26. Deduction Concepts: Legislative Grace, Again: Any deduction allowed is the result of specific acts of Congress
which are applied and interpreted strictly.
27. Deduction Concepts: Business purpose: Only expenditures made in order to generate income and for a purpose
other than tax avoidance will be deductible. Examples: 1.Trade or business expenses; 2. Investment expenses;
3.Michael may not deduct depreciation on his personal-use automobile because he does not use it in his business.
28. Deduction Concepts: Capital Recovery: 1. A taxpayer may deduct the amount of capital invested before income
is reported. 2. Constructs used: (1) Basis (2) Capital expenditures
29. Types of Income: 1.Earned; 2.Unearned; 3. Transfer; 4.Imputed; 5. Capital Gains and Losses
30. Earned Income: 1. Compensation received for the provision of labor is earned income; 2. Two problems may
arise when determining taxability of earned income: (1) Cash-equivalent approach; (2) Assignment of income
31. Unearned Income: Earnings from investments and gains from the sale, exchange or disposition of investment
assets. Examples: 1. Interest and Dividend Income; 2. Rental and Royalty Income; 3. Annuities.
32. Annuity: A series of equal payments received at set time intervals for a determinable period. Capital Recovery
Concept: 1. Excludes the amount of original investment from taxable income; 2. Must be spread over the time of
receipt.
33. If the payment term and amount are fixed: Exclusion Ratio=Cost of the contract/Total expected return; If the
payment term depends on the life of the taxpayer: Must estimate the number of payments or Use the “simplified
method”.
34. Simplified Method: Excluded portion=Contract Cost/Number of payments
35. Example: George, age 64, purchased an annuity for $30,000. He begins receiving $300 per month in January.
What amount is included in his gross income? From Table 3-1, the number of payments to use is 260. $30,000 / 260
= $115 monthly exclusion; $115 x 12 = $1,380 excluded per year; $300 x 12 = $3,600 amount received; $3,600 -
$1,380 exclusion = $2,220 gross income.
36. Gains or losses may occur upon disposal of investment property: Proceeds from sale or disposition - Selling
expenses= Amount realized from disposition- Adjusted basis of property= Gain or loss from disposition.
37. Income from Flow Through Entities: 1. Income from a conduit entity is reported by the owners and taxed on
the owners’ returns; 2. Distributions from conduit entities to the owners are treated as a recovery of capital.
38. Some amounts of income are neither fully earned nor fully unearned: 1. Prizes and Awards; 2. Unemployment
Compensation; 3. Social Security Benefits; 4. Alimony Received
39. Prizes and Awards: 1. Amounts received as prizes and awards are generally taxable; 2. Exceptions: (1) Scientific
and literary achievements: Must be given by recipient to a qualified charity or government unit; (2) Employee
achievements: Must be given to employee for length of service or safety; Amount is limited to $400 per employee
(or $1,600 if qualified plan) and may not be cash.
40. Unemployment Compensation: Amounts received from unemployment compensation plans are considered
substitutes for earned income and are always taxable.
41. Social Security Benefits: A portion of Social Security benefits received may be taxable if modified AGI exceeds
certain limits: Adjusted gross income+1/2 social security benefits received+ tax exempt income+ foreign earned
income exclusions= Modified AGI. Example: Susan, a single taxpayer received $3,000 from Social Security
payments. Her AGI without the Social Security is $30,000. She has neither tax exempt interest nor foreign earned
income. Modified AGI= $30,000 + $1,500= $31,500
42. Social Security Benefits: 50% Formula: Affects: 1. MFJ taxpayers with modified AGI between $32,000 (the
base amount) and $44,000; 2. Unmarried taxpayers with modified AGI between $25,000 (the base amount) and
$34,000; 3. Others with modified AGI of more than $0. Calculation: The taxable portion of Social Security is equal
to the lesser of: 1/2 Social Security received, OR 1/2 of the amount by which modified AGI exceeds the base amount.
50% Formula Example: Going back to Susan, our single taxpayer – With modified AGI = $31,500, the taxable
portion of her $3,000 Social Security income is the lesser of: $1,500, or 1/2 ($31,500 - $25,000) = $3,250. Therefore,
taxable SS is $1,500.
43. Imputed Income: Personal Consumption: The value of the goods and services produced by individuals for
personal consumption generally are not taxable: 1. Realization concept; 2. Administrative Convenience concept.
44. Imputed Income: Below Market Rate Loans: Interest income and expense are imputed on below market -rate
loans: 1. Relationship between the lender and the borrower determines the tax treatment; 2.Lender has imputed
interest income,
Borrower has imputed interest expense; 3. Administrative Convenience grants exceptions for: (1) Loans of $10,000
or less (2) Gift loans of $100,000 or less
45. Imputed Income: Payment of Expense by Others: 1. A taxpayer whose expenses are paid by another has realized
an increase in wealth; 2. Payments made by family members may be considered nontaxable gifts; 3. Payments made
by employers are taxable income.
46. Imputed Income: Bargain Purchases: When a bargain purchase price does not result from an arms-length
transaction, the bargain amount is taxable income.
47. Capital asset: Any asset other than inventory, receivables, and depreciable or real property used in a trade or
business: 1. A sale or other disposition of capital assets results in a capital gain or loss; 2. Capital gains and losses
receive special tax treatment.
48. When is Income Reported? Accounting Method chosen by a taxpayer dictates when income is reported: 1. Cash
Method: Taxpayers report income when cash is actually or constructively received; 2. Accrual Method: Taxpayers
report income when it is earned; 3. Hybrid Method: Taxpayers mix accrual and cash methods.
49. Cash method taxpayers must follow the Constructive Receipt Concept; Exceptions to the cash method: 1.
Taxpayers who sell inventory must use the accrual method for inventory; 2. Taxpayers must use the accrual and the
effective interest method with Original Issue Discount securities; 3. Taxpayers who hold Series EE Bonds may elect
to use the accrual method.
50. Accrual Method: Exceptions: 1. Wherewithal-to-Pay concept requires income be reported in the year pre-
payment is received for rents, insurance, interest, and royalties; 2. One year deferral is allowed for some pre-
payments: (1) Report amount = Financial Accounting in first year; (2) Balance amount in full in second year; 3.
Pre-payments for goods may be accrued if the payment is less than the Cost of Goods Sold.
51. Hybrid Method: Taxpayers may mix the cash and accrual methods, using accrual for sales of inventories and
cash for other revenues and expenses.
52. Exceptions to All Methods: 1. Installment Sales Method: Any time one payment is received after the year of
sale, taxpayers must recognize income proportionately as the selling price is received unless they elect to report in
the year of sale; 2. Long-term Construction Contracts: The percentage-of-completion method must be used for all
long-term construction.
53. Income Exclusions: Categories: Four major categories of exclusions: 1. Donative items; 2. Employment-related;
3. Returns of human capital; 4. Investment related.
54. Donative Items: Gifts and Inheritances: Donative items are increases in wealth that are not earned or the result
of investment; Gifts: Excluded to relieve double taxation caused by the gift tax; Inheritances: Excluded to
relieve double taxation caused by the estate tax.
55. Donative Items: Life Insurance Proceeds: Life Insurance Proceeds – Excluded to provide equity with other types
of inheritances: (1) Proceeds from policies purchased for consideration are not excluded; 2. Interest income earned
from the proceeds due to electing receipt as an annuity are not excluded.
56. Donative Items :Scholarships: Excluded to provide incentive for education: To qualify, the scholarship: (1) Must
not require the performance of future services; (2)Must be used for direct costs of education such as tuition, fees,
books, and supplies. Example: Jekabs received an athletic scholarship to Small State University. Under the
scholarship agreement, he received tuition ($1,500), books ($400), and room and board ($5,000). Jekabs must report
$5,000 as income but may exclude $1,900.
57. Employment Related: Foreign Earned Income: Excluded to relieve double taxation, Taxpayers may choose one
of two options: Exclude up to $104,100 of foreign earned income: 1. Must be a resident of the foreign country, or
Must reside in the foreign country for 330 days; 2.Claim a tax credit that is the lesser of Foreign taxes paid, or U.S.
tax that would have been paid on the foreign income.
58. Employment Related: Payments Made by Employer: Payments made on behalf of an employee are excluded as
an incentive to employers to provide these benefits. Examples: 1.Contributions to qualified pension plans;
2.Premiums for group term life insurance; 3. Premiums for health and accident insurance; 4. Meals and lodging; 5.
Fringe benefits.
59. Exclusions for Payments Made By Employer: 1. Qualified pension plan: Payments made by employers to
qualified pension plans: (1) Are not included in income in the year of payment; (2) Are included in income in the
year of withdrawal. 2. Group term life insurance: Premiums paid for up to $50,000 of group term life insurance are
excluded from income: (1) Plan may not discriminate in favor of highly paid employees; (2) Premiums for insurance
in excess of $50,000 are included in taxable income. 3. Health and accident insurance: Premiums paid for health
and accident insurance are excluded from income to encourage employers to provide insurance. 4. Meals and
lodging: (1) The value of meals provided by the employer are excluded from income if the meals are provided:
(a)On the employer’s premises; (b) For the employer’s convenience; (2) The value of lodging provided must meet
these conditions and also be a condition of employment. 5. General fringe benefits: Two types of fringe benefits are
excludable from income if they are provided on a nondiscriminatory basis: (1) No additional cost services; (2)
Employee discounts: (a) On goods, limited to the gross profit %; (b) On services, limited to 20%. 6. Qualified
retirement planning services: Must be provided to all employees (and their spouses) who normally receive
information about the employer’s qualified plan. 7. Other types of fringe benefits are excludable from income even
if they are provided on a discriminatory basis: (1)Working condition; (2) De minimus (3)Child and dependent care
services up to $5,000; (3) Educational assistance programs up to $5,250; (4)Employer’s athletic facility on premises.
8.Employer benefit plans: (1) Cafeteria Plans: Allow employees to choose from a menu of benefits and are
excludable unless an employee elects to take cash in lieu of benefits; (2)Flexible Benefit (Salary Reduction) Plans:
Allow employees to use pre-tax compensation dollars to cover medical or child-care expenses. 9. Health Savings
Accounts: Excluded to encourage employers and employees to purchase adequate medical coverage: (1) May be
established for individuals covered only by high-deductible plans $6,900 for family or $3,450 for single; (2)
Employer contributions are excluded from income and individual contributions are deductible for AGI.
60. Returns of Human Capital: Payments received that are intended to reimburse an individual for physical injuries
are excluded under the capital recovery concept because they merely restore the individual to a previous condition:
Payments that are intended to replace lost income are not excluded.
61. Exclusions for Returns of Human Capital: 1. Workers’ compensation: Payments related to an injury suffered on
the job are excluded because they help restore individuals to their previous condition and do not add to their wealth.
2. Personal injury or sickness: (1) Compensatory damage payments: Received for a personal physical injury or
sickness and medical payments for emotional distress are excluded to provide a return to equity; (2) Loss of income
damage payments: Only excluded if they are related to personal physical injury or sickness; (3) Punitive damage
payments: Never excluded. 3. Health and accident insurance: (1) Payments or reimbursements for medical or health
costs: Excluded to provide an individual a return to equity; (2) Disability payments: Excluded if the policy was
purchased by the employee but not excluded if the policy was purchased by the employer.
62. Investment Related Exclusions: 1. Interest income: Received from investment in municipal bonds is excluded
to allow state and local municipalities to sell bonds for a lower interest rate. 2. Stock dividends: (1) Excluded from
income because their receipt does not qualify as income under the realization concept, (2) If any shareholder has
the option to receive cash instead of stock, realization has occurred and the value of the dividend is included in
income. 3. Discharge of indebtedness: (1) An amount received as a loan is generally excluded from income under
the realization concept because it must be returned; (2) If a lender forgives all or a portion of the debt, realization
occurs and the forgiven portion is income: Discharge due to insolvency or bankruptcy is excluded from income; 4.
Leasehold improvements: The value of improvements to property made by a lessee are excluded under the
wherewithal-to-pay concept.