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South Western Federal Taxation 2016 Essentials Of Taxation Individuals and Business Entities, 19th Edition By by William A. Raabe – 

Solution Manual 

 

 

 

CHAPTER1

Introduction to Taxation

 

Problems

 

  1. LO.1, 2, 5 James Corporation believes that it will have a better distribution location

for its product if it relocates the corporation to another state. What considerations

(both tax and nontax) should James weigh before making a decision on

whether to make the move?

  1. LO.1 Distinguish between taxes that are proportional and those that are progressive.
  2. LO.2 Several years ago, Ethan purchased the former parsonage of St. James Church

to use as a personal residence. To date, Ethan has not received any ad

valorem property tax bills from either the city or the county tax authorities.

  1. What is a reasonable explanation for this oversight?
  2. What should Ethan do?
  3. LO.1, 6 In terms of Adam Smith’s canon of economy, how does the Federal income

tax fare?

  1. LO.2 Jim, a resident of Washington (which imposes a general sales tax), goes to

Oregon (which does not impose a general sales tax) to purchase his automobile.

Will Jim successfully avoid the Washington sales tax? Explain.

  1. LO.2 The Irontown Independent School District wants to sell a parcel of unimproved

land that it does not need. Its three best offers are as follows: from the

State Department of Public Safety (DPS), $4.3 million; from Trinity Lutheran Church,

$4.2 million; and from Baker Motors, $3.9 million. DPS would use the property for a

new state highway patrol barracks, Trinity would start a church school, and Baker

would open a car dealership. As the financial adviser for the school district, which

offer would you prefer? Why?

  1. LO.2 Eileen, a resident of Wyoming, goes to Montana to purchase her new automobile.

She does this because Wyoming imposes a sales tax while Montana

does not. Has Eileen successfully avoided the Wyoming sales tax? Explain.

  1. LO.2 Sophia lives several blocks from her parents in the same residential subdivision.

Sophia is surprised to learn that her ad valorem property taxes for the

year were raised, while those of her parents were lowered. What is a possible explanation

for the difference?

  1. LO.4, 5 Marco and Cynthia have decided to go into business together. They will

operate a burrito delivery business. They expect to have a loss in the first

and second years of the business and subsequently expect to make a substantial

profit.

Marco and Cynthia are concerned about potential liability if a customer ever gets

sick after eating one of their products. They have called your office and asked for

advice about whether they should run their business as a partnership or as a corporation.

Write a letter to Cynthia Clay, at 1206 Seventh Avenue, Fort Worth, TX 76101,

describing the alternative forms of business they can select. In your letter, explain

what form or forms of business you recommend and why.

  1. LO.4, 5 Ashley runs a small business in Boulder, Colorado, that makes snow skis.

She expects the business to grow substantially over the next three years.

Because she is concerned about product liability and is planning to take the company

public in 2016, she is currently considering incorporating the business. Financial

data are as follows.

2015 2016 2017

Sales revenue $150,000 $320,000 $600,000

Tax-free interest income 5,000 8,000 15,000

Deductible cash expenses 30,000 58,000 95,000

Tax depreciation 25,000 20,000 40,000

Ashley expects her combined Federal and state marginal income tax rate to be

35% over the next three years before any profits from the business are considered.

Her after-tax cost of capital is 12%.

  1. Compute the present value of the future cash flows for 2015 to 2017 assuming

that Ashley incorporates the business and pays all after-tax income as dividends

(for Ashley’s dividends that qualify for the 15% rate).

  1. Compute the present value of the future cash flows for 2015 to 2017 assuming

that Ashley continues to operate the business as a sole proprietorship.

  1. Should Ashley incorporate the business this year? Why or why not?
  2. LO.3, 5 Mauve Supplies, Inc., reports total income of $120,000. The corporation’s

taxable income is $105,000. What are Mauve’s marginal, average, and

effective tax rates?

  1. LO.2 Franklin County is in dire financial straits and is considering a number of

sources for additional revenue. Evaluate the following possibilities in terms of

anticipated taxpayer compliance.

  1. A property tax on business inventories.
  2. A tax on intangibles (i.e., stocks and bonds) held as investments.
  3. A property tax on boats used for recreational purposes.
  4. LO.6 Discuss the probable justification for each of the following provisions of the

tax law.

  1. A tax credit allowed for electricity produced from renewable sources.
  2. A tax credit allowed for the purchase of a motor vehicle that operates on alternative

energy sources (e.g., nonfossil fuels).

  1. A deduction for state and local income taxes.
  2. The deduction for personal casualty losses that is subject to computational limitations.
  3. Favorable treatment accorded to research and development expenditures.
  4. A deduction allowed for income resulting from U.S. production (manufacturing)

activities.

  1. The deduction allowed for contributions to qualified charitable organizations.
  2. An election that allows certain corporations to avoid the corporate income tax

and pass losses through to their shareholders.

  1. LO.6 Discuss the probable justification for each of the following aspects of the tax

law.

  1. A tax credit is allowed for amounts spent to furnish care for minor children

while the parent works.

  1. Deductions for interest on home mortgage and property taxes on one’s personal

residence.

  1. The income splitting benefits of filing a joint return.
  2. Gambling losses in excess of gambling gains.
  3. Net operating losses of a current year can be carried back to profitable years.
  4. A taxpayer who sells property on an installment basis can recognize gain on the

sale over the period the payments are received.

  1. The exclusion from Federal tax of certain interest income from state and local

bonds.

  1. Prepaid income is taxed to the recipient in the year it is received and not in the

year it is earned.

  1. LO.2 Contrast a value added tax (VAT) with a national sales tax in terms of anticipated

taxpayer compliance.

  1. LO.2 Go to www.taxfoundation.org, and determine Tax Freedom Day for your

state for 1950, 1960, 1970, 1980, 1990, 2000, and 2010. Report your results as

a line graph.

  1. LO.5 Although the Federal income tax law is complex, most individual taxpayers

are able to complete their tax returns without outside assistance. Gather data

as to the accuracy of this statement. Summarize your comments in an e-mail to your

instructor.

  1. LO.5 President Franklin D. Roosevelt once said, “I am wholly unable to figure out

the amount of tax,” and wrote to the Federal Commissioner of Revenue, “may

I ask that [the agency] let me know the amount of the balance due.”

When a friend of FDR was ordered to pay $420,000 in tax penalties, the President

called the Commissioner within earshot of reporters and told him to cut the penalties

to $3,000. One listener, journalist David Brinkley, recalled years later: “Nobody

seemed to think it was news or very interesting.” Evaluate the President’s comments

and actions.

 

For the==================================

 latest in changes to tax legislation, visit

CHAPTER2

Working with the Tax Law

 

Problems

 

  1. LO.1 What precedents must each of these courts follow?
  2. U.S. Tax Court.
  3. U.S. Court of Federal Claims.
  4. U.S. District Court.
  5. LO.1, 3 Butch Bishop operates a small international firm named Tile, Inc. A new

treaty between the United States and Spain conflicts with a Section of the

Internal Revenue Code. Butch asks you for advice. If he follows the treaty position,

does he need to disclose this on this year’s tax return? If he is required to disclose,

are there any penalties for failure to disclose? Prepare a letter in which you respond

to Butch. Tile’s address is 100 International Drive, Tampa, FL 33620.

  1. LO.1 Distinguish between the following.
  2. Treasury Regulations and Revenue Rulings.
  3. Revenue Rulings and Revenue Procedures.
  4. Revenue Rulings and letter rulings.
  5. Letter rulings and determination letters.
  6. LO.1, 2 Rank the following items from the lowest to the highest authority in the

Federal tax law system.

  1. Interpretive Regulation.
  2. Legislative Regulation.
  3. Letter ruling.
  4. Revenue Ruling.
  5. Internal Revenue Code.
  6. Proposed Regulation.
  7. LO.1 Interpret each of the following citations.
  8. Temp.Reg. § 1.956–2T.
  9. Rev.Rul. 2012–15, 2012–23 I.R.B. 975.
  10. Ltr.Rul. 200204051.
  11. LO.1 List an advantage and a disadvantage of using the U.S. Court of Federal

Claims as the trial court for Federal tax litigation.

  1. LO.1, 3 Eddy Falls is considering litigating a tax deficiency of approximately $229,030

in the court system. He asks you to provide him with a short description of his

litigation alternatives, indicating the advantages and disadvantages of each. Prepare your

response to Eddy in the form of a letter. His address is 200Mesa Drive, Tucson, AZ 85714.

  1. LO.1 A taxpayer lives in Michigan. In a controversy with the IRS, the taxpayer loses at the

trial court level. Describe the appeal procedure for each of the following trial courts.

  1. Small Cases Division of the Tax Court.
  2. Tax Court.
  3. District Court.
  4. Court of Federal Claims.
  5. LO.1 For the Tax Court, the District Court, and the Court of Federal Claims, indicate

the following.

  1. Number of regular judges per court.
  2. Availability of a jury trial.
  3. Whether the deficiency must be paid before the trial.
  4. LO.1 A taxpayer living in the following states would appeal a decision of the U.S

District Court to which Court of Appeals?

  1. Wyoming.
  2. Nebraska.
  3. Idaho.
  4. Louisiana.
  5. Illinois.
  6. LO.1 What is meant by the term petitioner?
  7. LO.1, 2 In assessing the validity of a prior court decision, discuss the significance

of the following on the taxpayer’s issue.

  1. The decision was rendered by the U.S. District Court of Wyoming. Taxpayer

lives in Wyoming.

  1. The decision was rendered by the Court of Federal Claims. Taxpayer lives in

Wyoming.

  1. The decision was rendered by the Second Circuit Court of Appeals. Taxpayer

lives in California.

  1. The decision was rendered by the Supreme Court.
  2. The decision was rendered by the Tax Court. The IRS has acquiesced in the result.
  3. Same as (e), except that the IRS has nonacquiesced in the result.
  4. LO.1 What is the difference between a Regular decision, a Memorandum decision,

and a Summary Opinion of the Tax Court?

  1. LO.1 Explain the following abbreviations.
  2. CA–2.
  3. Fed.Cl.
  4. aff’d.
  5. rev’d.
  6. rem’d.
  7. Cert. denied.
  8. acq.
  9. B.T.A.
  10. USTC.
  11. AFTR.
  12. F.3d.
  13. F.Supp.
  14. USSC.
  15. S.Ct.
  16. D.Ct.
  17. LO.2 Referring to the citation only, determine which tax law source issued these

documents.

  1. 716 F.2d 693 (CA–9, 1983).
  2. 92 T.C 400 (1998).
  3. 70 U.S. 224 (1935).
  4. 3 B.T.A. 1042 (1926).
  5. T.C.Memo. 1957–169.
  6. 50 AFTR 2d 92–6000 (Cl.Ct., 1992).
  7. Ltr.Rul. 9046036.
  8. 111 F.Supp.2d 1294 (S.D. N. Y., 2000).
  9. 98–50, 1998–1 C.B. 10.
  10. LO.2 Interpret each of the following citations.
  11. 14 T.C. 74 (1950).
  12. 592 F.2d 1251 (CA–5, 1979).
  13. 95–1 USTC { 50,104 (CA–6, 1995).
  14. 75 AFTR 2d 95–110 (CA–6, 1995).
  15. 223 F.Supp. 663 (W.D. Tex., 1963).
  16. LO.2 Which of the following items may be found in the Internal Revenue Bulletin?
  17. Action on Decision.
  18. Small Cases Division of the Tax Court decision.
  19. Letter ruling.
  20. Revenue Procedure.
  21. Final Regulation.
  22. Court of Appeals decision.
  23. Acquiescences to Tax Court decisions.
  24. U.S. Circuit Court of Appeals decision.
  25. LO.2 Answer the following questions based upon this citation: United Draperies, Inc.
  26. Comm., 340 F.2d 936 (CA–7, 1964), aff’g 41 T.C. 457 (1963), cert. denied 382

U.S. 813 (1965).

  1. In which court did this decision first appear?
  2. Did the appellate court uphold the trial court?
  3. Who was the plaintiff?
  4. Did the Supreme Court uphold the appellate court decision?
  5. LO.2, 4 For her tax class, Yvonne is preparing a research paper discussing the tax

aspects of child support payments. Explain to Yvonne how she can

research the provisions on this topic.

  1. LO.1, 2 Tom, an individual taxpayer, has been audited by the IRS and, as a result, has

been assessed a substantial deficiency (which has not yet been paid) in additional

income taxes. In preparing his defense, Tom advances the following possibilities.

  1. Although a resident of Kentucky, Tom plans to sue in a U.S. District Court in

Oregon that appears to be more favorably inclined toward taxpayers.

  1. If (a) is not possible, Tom plans to take his case to a Kentucky state court where

an uncle is the presiding judge.

  1. Because Tom has found a B.T.A. decision that seems to help his case, he plans

to rely on it under alternative (a) or (b).

  1. If he loses at the trial court level, Tom plans to appeal either to the U.S. Court of

Federal Claims or to the U.S. Second Circuit Court of Appeals because he has relatives

in both Washington, D.C., and New York. Staying with these relatives could

save Tom lodging expense while his appeal is being heard by the court selected.

  1. Whether or not Tom wins at the trial court or appeals court level, he feels certain

of success on an appeal to the U.S. Supreme Court.

Evaluate Tom’s notions concerning the judicial process as it applies to Federal

income tax controversies.

  1. LO.1 Using the legend provided, classify each of the following statements (more

than one answer per statement may be appropriate).

Legend

D ¼ Applies to the District Court

T ¼ Applies to the Tax Court

C ¼ Applies to the Court of Federal Claims

A ¼ Applies to the Circuit Court of Appeals

U ¼ Applies to the Supreme Court

N ¼ Applies to none of the above

  1. Decides only Federal tax matters.
  2. Decisions are reported in the F.3d Series.
  3. Decisions are reported in the USTCs.
  4. Decisions are reported in the AFTRs.
  5. Appeal is by Writ of Certiorari.
  6. Court meets most often in Washington, D.C.
  7. Offers the choice of a jury trial.
  8. Is a trial court.
  9. Is an appellate court.
  10. Allows appeal to the Court of Appeals for the Federal Circuit and bypasses the

taxpayer’s own Circuit Court of Appeals.

  1. Has a Small Cases Division.
  2. Is the only trial court where the taxpayer does not have to first pay the tax

assessed by the IRS.

  1. LO.1, 2 Using the legend provided, classify each of the following citations as to the

type of court.

Legend

D ¼ District Court

T ¼ Tax Court

C ¼ Court of Federal Claims

A ¼ Circuit Court of Appeals

U ¼ Supreme Court

N ¼ None of the above

  1. Rev.Rul. 2009–34, 2009–42 I.R.B. 502.
  2. Joseph R. Bolker, 81 T.C. 782 (1983).
  3. Magneson, 753 F.2d 1490 (CA–9, 1985).
  4. Lucas v. Ox Fibre Brush Co., 281 U.S. 115 (1930).
  5. Ashtabula Bow Socket Co., 2 B.T.A. 306 (1925).
  6. BB&T Corp., 97 AFTR 2d 2006–873 (D.Ct. Mid.N.Car., 2006).
  7. Choate Construction Co., T.C.Memo. 1997–495.
  8. Ltr.Rul. 200940021.
  9. John and Rochelle Ray, T.C. Summary Opinion 2006–110.
  10. LO.1, 2 Using the legend provided, classify each of the following tax sources.

Legend

P ¼ Primary tax source

S ¼ Secondary tax source

B ¼ Both

N ¼ Neither

  1. Sixteenth Amendment to the U.S. Constitution.
  2. Tax treaty between the United States and India.
  3. Revenue Procedure.
  4. Chief Counsel Advice (issued 2009).
  5. U.S. District Court decision.
  6. Yale Law Journal article.
  7. Temporary Regulations (issued 2013).
  8. U.S. Tax Court Memorandum decision.
  9. Small Cases Division of the U.S. Tax Court decision.
  10. House Ways and Means Committee report.
  11. LO.1 In which Subchapter of the Internal Revenue Code would one find information

about corporate distributions?

  1. Subchapter S.
  2. Subchapter C.
  3. Subchapter P.
  4. Subchapter K.
  5. Subchapter M.
  6. LO.1, 2 To locate an IRS Revenue Procedure that was issued during the past week,

which source would you consult?

  1. Federal Register.
  2. Internal Revenue Bulletin.
  3. Internal Revenue Code.
  4. Some other source. Identify it.
  5. LO.1, 2 In the citation Schuster’s Express, Inc., 66 T.C. 588 (1976), aff’d 562 F.2d 39

(CA–2, 1977), nonacq., to what do the 66, 39, and nonacq. refer?

  1. LO.1 Is there an automatic right to appeal to the U.S. Supreme Court? If so, what is

the process?

  1. LO.2 An accountant friend of yours tells you that he “almost never” does any tax

research because he believes that “research usually reveals that some tax planning

idea has already been thought up and shot down.” Besides, he points out, most

tax returns are never audited by the IRS. Can a tax adviser who is dedicated to reducing

his client’s tax liability justify the effort to engage in tax research? Do professional

ethics demand such efforts? Which approach would a client probably prefer?

  1. LO.1, 4 Go to the U.S. Tax Court website.
  2. What different types of cases can be found on the site?
  3. What is a Summary Opinion? Find one.
  4. What is a Memorandum decision? Find one.
  5. Find the court’s Rules of Practice and Procedures.
  6. Is the site user-friendly? E-mail suggested improvements to the site’s webmaster.
  7. LO.2, 3 Locate the following Code provisions, and give a brief description of each

in an e-mail to your instructor.

  1. § 61(a)(13).
  2. § 643(a)(2).
  3. § 2503(g)(2)(A).

 

Research Problems

Note: Solutions to Research Problems can be prepared by using the Checkpoint_

Student Edition online research product, which is available to accompany this text. It

is also possible to prepare solutions to the Research Problems by using tax research

materials found in a standard tax library.

Research Problem 1. Locate the following items, and e-mail to your professor a brief

summary of the results.

  1. Charles Y. Choi, T.C. Memo. 2002–183.
  2. Ltr.Rul. 200231003.
  3. Action on Decision, 2000–004, May 10, 2000.

Research Problem 2. Locate the following Code citations, and give a brief topical

description of each.

  1. § 708(a).
  2. § 1371(a).
  3. § 2503(a).

Research Problem 3. Locate the following Regulations, and give a brief topical

description of each. Summarize your comments in an e-mail to your instructor.

  1. Reg. § 1.170A–4A(b)(2)(ii)(C).
  2. Reg. § 1.672(b)–1.
  3. Reg. § 20.2031–7(f).

Research Problem 4. Describe the material that is found in Subtitle E of the Code.

Would you expect these provisions not to be addressed anywhere else in the Code?

Explain.

Research Problem 5. Determine the missing data in these court decisions and rulings.

  1. Higgins v. Comm., 312 U.S.______ (1941).
  2. Talen v. U.S., 355 F.Supp.2d 22 (D.Ct. D.C., ______).
  3. Rev.Rul. 2008–18, 2008–13 I.R.B.______.
  4. Pahl v. Comm., 150 F.3d 1124 (CA–9, ______).
  5. Veterinary Surgical Consultants PC, 117 T.C._____(2001).
  6. Yeagle Drywall Co., T.C. Memo. 2001______.

Research Problem 6. Locate the following Tax Court case: Thomas J. Green, Jr., 59

T.C. 456 (1972). Briefly describe the issue in the case, and explain what the Tax Court

said about using IRS publications to support a research conclusion.

Research Problem 7. Can a Tax Court Small Cases decision be treated as a precedent

by other taxpayers? Explain.

Partial list of research aids:

  • 7463(b).

Maria Antionette Walton Mitchell, T.C. Summary Opinion 2004–160.

Research Problem 8. Find Kathryn Bernal, 120 T.C. 102 (2003), and answer the following

questions.

  1. What was the docket number?
  2. When was the dispute filed?
  3. Who is the respondent?
  4. Who was the attorney for the taxpayers?
  5. Who was the judge who wrote the opinion?
  6. What was the disposition of the dispute?

Research Problem 9. This year, Frank lived with and supported Daisy, an unrelated

20-year-old woman to whom he was not married. Frank lives in a state that has a statute

that makes cohabitation a misdemeanor for a man and a woman who are not

married to each other. May Frank claim Daisy as a dependent, assuming that he

meets all of the applicable tests to claim the exemption? Should Frank and Daisy

move to another state? Describe your research path in a PowerPoint presentation for

your classmates.

Partial list of research aids:

  • 152(f)(3).

John T. Untermann, 38 T.C. 93 (1962).

Research Problem 10. Go to www.legalbitstream.com, and find the case in

which Mark Spitz, the Olympic gold medalist, is the petitioner. Answer the following

questions.

  1. What tax years are at issue in the case?
  2. In what year was the case decided?
  3. What tax issues were involved? Did the court decide in favor of Spitz or the IRS?
  4. Were any penalties imposed on the taxpayer? Why or why not?

Research Problem 11. Find three blogs related to tax practice. On one PowerPoint

slide, list the URLs for each blog and the general topical areas addressed at each.

Send your slide to the others in your course.

Research Problem 12. Find one instance of each of the following using a nonsubscription

site on the Web or an online library at your school. In an e-mail to your professor,

give a full citation for the document and describe how you found it.

  1. Letter Ruling.
  2. Action on Decision.
  3. IRS Notice.
  4. Revenue Ruling.
  5. Revenue Procedure.
  6. Code Section.
  7. Tax Regulation.
  8. Tax treaty.
  9. Tax Court Summary Opinion.
  10. Tax Court Regular decision.

 

 

CHAPTER3

Taxes on the Financial Statements

Problems

  1. LO.2 Ovate, Inc., earns $140,000 in book income before tax and is subject to a 35%

marginal Federal income tax rate. Ovate records a single temporary difference:

Warranty expenses deducted for book purposes are $8,000, of which only

$2,000 are deductible for tax purposes. Determine the amount of Ovate’s deferred

tax asset or liability.

  1. LO.3 Ion Corporation reports an income tax expense/payable for book purposes

of $200,000 and $250,000 for tax purposes. According to Ion’s management

and financial auditors, Ion will only be able to use $30,000 of any deferred tax asset,

with the balance expiring. Determine the amount of Ion’s deferred tax asset and valuation

allowance from this year’s activities.

  1. LO.4 RadioCo, a domestic corporation, owns 100% of TVCo, a manufacturing facility

in the European country Adagio. TVCo has no operations or activities in

the United States. The U.S. tax rate is 35%, and the Adagio tax rate is 15%.

For the current year, RadioCo earns $200,000 in taxable income from its U.S.

operations. TVCo earns $800,000 in taxable income from its operations, pays

$120,000 in taxes to Adagio, and makes no distributions to RadioCo. Determine

RadioCo’s effective tax rate for book purposes with and without the permanent reinvestment

assumption of ASC 740-30 (APB 23).

  1. LO.2 Prance, Inc., earns pretax book net income of $800,000 in 2014. Prance

acquires a depreciable asset in 2014, and first-year tax depreciation exceeds

book depreciation by $80,000. Prance reported no other temporary or permanent

book-tax differences. The pertinent U.S. tax rate is 35%.

  1. Compute Prance’s total income tax expense, current income tax expense, and

deferred income tax expense.

  1. Determine the 2014 end-of-year balance in Prance’s deferred tax asset and

deferred tax liability balance sheet accounts.

  1. LO.1 Evaluate the following statement: For most business entities, book income differs

from taxable income because “income” has different meanings for the

users of the data in the income computation.

  1. LO.1 Parent, a domestic corporation, owns 100% of Block, a foreign corporation, and

Chip, a domestic corporation. Parent also owns 45% of Trial, a domestic corporation.

Parent receives no distributions from any of these corporations. Which of these entities’

net income is included in Parent’s income statement for current-year financial

reporting purposes?

  1. LO.1 Parent, a domestic corporation, owns 100% of Block, a foreign corporation,

and Chip, a domestic corporation. Parent also owns 45% of Trial, a domestic

corporation. Parent receives no distributions from any of these corporations. Which

of these entities’ taxable income is included in Parent’s current-year Form 1120, U.S.

income tax return? Parent consolidates all eligible subsidiaries.

  1. LO.1 Marcellus Jackson, the CFO of Mac, Inc., notices that the tax liability reported

on Mac’s tax return is less than the tax expense reported on Mac’s financial

statements. Provide a letter to Jackson outlining why these two tax expense numbers

differ. Mac’s address is 482 Linden Road, Paris, KY 40362.

  1. LO.1 Define the terms temporary difference and permanent difference as they pertain

to the financial reporting of income tax expenses. Describe how these

two book-tax differences affect the gap between book and taxable income. How

are permanent and temporary differences alike? How are they different?

  1. LO.1 In no more than three PowerPoint slides, list several commonly encountered

temporary and permanent book-tax differences. The slides will be used in

your presentation next week to your school’s Future CPAs Club.

  1. LO.2 Prance, in Problem 4, reports $600,000 of pretax book net income in 2015.

Prance’s book depreciation exceeds tax depreciation in this year by $20,000.

Prance reports no other temporary or permanent book-tax differences. Assuming

that the pertinent U.S. tax rate is 35%, compute Prance’s total income tax expense,

current income tax expense, and deferred income tax expense.

  1. LO.2 Using the facts of Problem 11, determine the 2015 end-of-year balance in

Prance’s deferred tax asset and deferred tax liability balance sheet accounts.

  1. LO.2 Mini, Inc., earns pretax book net income of $750,000 in 2014. Mini deducted

$20,000 in bad debt expense for book purposes. This expense is not yet

deductible for tax purposes. Mini records no other temporary or permanent differences.

Assuming that the U.S. tax rate is 35%, compute Mini’s total income tax expense,

current income tax expense, and deferred income tax expense.

  1. LO.2 Using the facts of Problem 13, determine the 2014 end-of-year balance in

Mini’s deferred tax asset and deferred tax liability balance sheet accounts.

  1. LO.2 Mini, in Problem 13, reports $800,000 of pretax book net income in 2015.

Mini did not deduct any bad debt expense for book purposes but did deduct

$15,000 in bad debt expense for tax purposes. Mini records no other temporary or

permanent differences. Assuming that the U.S. tax rate is 35%, compute Mini’s total

income tax expense, current income tax expense, and deferred income tax

expense.

  1. LO.2 Using the facts of Problem 15, determine the 2015 end-of-year balance in

Mini’s deferred tax asset and deferred tax liability balance sheet accounts.

  1. LO.3 You saw on the online Business News Channel that YoungCo has “released

one-third of its valuation allowances because of an upbeat forecast for sales

of its tablet computers over the next 30 months.” What effect does such a release

likely have on YoungCo’s current-year book effective tax rate? Be specific.

  1. LO.6 Jill is the CFO of PorTech, Inc. PorTech’s tax advisers have recommended

two tax planning ideas that will each provide $5 million of current-year

cash tax savings. One idea is based on a timing difference and is expected to

reverse in full 10 years in the future. The other idea creates a permanent difference

that never will reverse.

Determine whether these ideas will allow PorTech to reduce its reported book

income tax expense for the current year. Illustrate in a table or timeline your preference

for one planning strategy over the other. Which idea will you recommend

to Jill?

  1. LO.4 Underwood, the CFO of TechCo, Inc., has used ASC 740-30 (APB 23) to avoid

reporting any U.S. deferred tax expense on $50 million of the earnings of

TechCo’s foreign subsidiaries. All of these subsidiaries operate in countries with

lower tax rates than in the United States. Underwood wants to bring to the United

States $10 million in profits from these foreign subsidiaries in the form of dividends.

How will this profit repatriation affect TechCo’s book effective tax rate?

  1. LO.4 Jaime, the CFO of BuildCo, Inc., has used ASC 740-30 (APB 23) to avoid

reporting any U.S. deferred tax expense on $100 million of the earnings of

BuildCo’s foreign subsidiaries. All of these subsidiaries operate in countries with

higher tax rates than the ones that apply under U.S. law. Jaime wants to bring home

$30 million in profits from these foreign subsidiaries in the form of dividends. How

will this profit repatriation affect BuildCo’s book effective tax rate?

  1. LO.6 RoofCo reports total book income before taxes of $20 million and a total tax

expense of $8 million. FloorCo reports book income before taxes of $30 million

and a total tax expense of $12 million. The companies’ breakdown between

current and deferred tax expense (benefit) is as follows.

RoofCo FloorCo

Current tax expense $10.0 $13.0

Deferred tax benefit (2.0) (1.0)

Total tax expense $ 8.0 $12.0

RoofCo’s deferred tax benefit is from a deferred tax asset created because of differences

in book and tax depreciation methods for equipment. FloorCo’s deferred tax

benefit is created by the expected future use of an NOL. Compare and contrast these

two companies’ effective tax rates. How are they similar? How are they different?

  1. LO.6 LawnCo and TreeCo operate in the same industry, and both report a 30%

effective tax rate. Their book income and current, deferred, and total tax

expense are reported below.

LawnCo TreeCo

Book income before tax $500,000 $650,000

Current tax expense $200,000 $ 20,000

Deferred tax expense (benefit) (50,000) 175,000

Total tax expense $150,000 $195,000

Effective tax rate 30% 30%

ShrubCo is a competitor of both of these companies. Prepare a letter to Laura Collins,

VP-Taxation of ShrubCo, outlining your analysis of the other two companies’

effective tax rates, using only the preceding information. ShrubCo’s address is 9979

West Third Street, Peru, IN 46970.

  1. LO.6 HippCo and HoppCo operate in the same industry and report the following

tax rate reconciliations in their tax footnotes. Compare and contrast the effective

tax rates of these two companies.

HippCo HoppCo

Hypothetical tax at U.S. rate 35.0% 35.0%

State and local taxes 2.7 3.9

Foreign income taxed at less than U.S. rate (12.5) (7.8)

Tax Court settlement on disputed tax issue 6.0 —

Effective tax rate 31.2% 31.1%

  1. LO.6 In the current year, Dickinson, Inc., reports an effective tax rate of 36%, and

Badger, Inc., reports an effective tax rate of 21%. Both companies are domestic

and operate in the same industry. Your initial examination of the financial statements

of the two companies indicates that Badger apparently is doing a better job

with its tax planning, explaining the difference in effective tax rates. Consequently,

all else being equal, you decide to invest in Badger.

In a subsequent year, it comes to light that Badger had used some very aggressive

tax planning techniques to reduce its reported tax expense. After an examination

by the IRS, Badger loses the tax benefits and reports a very large tax expense in

that year. Over this multiple-year period, it turns out that Dickinson had the lower

effective tax rate after all.

Do you believe Badger was ethical in not fully disclosing the aggressiveness of its

tax positions in its current financial statements? How does ASC 740-10 (FIN 48) affect

Badger’s disclosure requirement? Does ASC 740-10 (FIN 48) still leave room for ethical

decision making by management in determining how to report uncertain tax

positions? Explain.

  1. LO.2 Phillips, Inc., a cash basis C corporation, completes $100,000 in sales for year

1, but only $75,000 of this amount is collected during year 1. The remaining

$25,000 from these sales is collected promptly during the first quarter of year 2. The

applicable income tax rate for year 1 and thereafter is 30%. Compute Phillips’s year

1 current and deferred income tax expense.

  1. LO.2 Continue with the results of Problem 25. Prepare the GAAP journal entries for

Phillips’s year 1 income tax expense.

  1. LO.2 Britton, Inc., an accrual basis C corporation, sells widgets on credit. Its book

and taxable income for year 1 totals $60,000 before accounting for bad debts.

Britton’s book allowance for uncollectible accounts increased for year 1 by $10,000,

but none of the entity’s bad debts received a specific write-off for tax purposes. The

applicable income tax rate for year 1 and thereafter is 30%. Compute Britton’s year 1

current and deferred income tax expense.

  1. LO.2 Continue with the results of Problem 27. Prepare the GAAP journal entries for

Britton’s year 1 income tax expense.

  1. LO.2 Rubio, Inc., an accrual basis C corporation, reports the following amounts for

the tax year. The applicable income tax rate is 30%. Compute Rubio’s taxable

income.

Book income, including the items below $80,000

Increase in book allowance for anticipated warranty costs 5,000

Interest income from City of Westerville bonds 10,000

Bribes paid to Federal inspectors 17,000

  1. LO.2 Continue with the results of Problem 29. Determine Rubio’s income tax

expense and GAAP income for the year.

  1. LO.2 Willingham, Inc., an accrual basis C corporation, reports pretax book income

of $1.6 million. At the beginning of the tax year, Willingham reported no

deferred tax accounts on its balance sheet. It is subject to a 35% U.S. income tax rate

in the current year and for the foreseeable future.

Willingham’s book-tax differences include the following. Compute the entity’s

current and deferred income tax expense for the year.

Addition to the book reserve for uncollectible receivables (no specific

write-offs occurred) $4,000,000

Tax depreciation in excess of book 3,000,000

Book gain from installment sale of nonbusiness asset, deferred for tax 2,000,000

Interest income from school district bonds 200,000

  1. LO.2 Continue with the results of Problem 31. Prepare the GAAP journal entries for

Willingham’s income tax expense.

  1. LO.2 Relix, Inc., is a domestic corporation with the following balance sheet for

book and tax purposes at the end of the year. Based on this information,

determine Relix’s net deferred tax asset or net deferred tax liability at year-end.

Assume a 34% corporate tax rate and no valuation allowance.

Tax

Debit/(Credit)

Book

Debit/(Credit)

Assets

Cash $ 500 $ 500

Accounts receivable 8,000 8,000

Buildings 750,000 750,000

Accumulated depreciation (450,000) (380,000)

Furniture & fixtures 70,000 70,000

Accumulated depreciation (46,000) (38,000)

Total assets $ 332,500 $ 410,500

Liabilities

Accrued litigation expense $ _0_ ($ 50,000)

Note payable (78,000) (78,000)

Total liabilities ($ 78,000) ($ 128,000)

Stockholders’ Equity

Paid-in capital ($ 10,000) ($ 10,000)

Retained earnings (244,500) (272,500)

Total liabilities and stockholders’ equity ($ 332,500) ($ 410,500)

  1. LO.2 Based on the facts and results of Problem 33 and the beginning-of-the-year

book-tax basis differences listed below, determine the change in Relix’s

deferred tax assets for the current year.

Beginning of Year

Accrued litigation expense $34,000

Subtotal $34,000

Applicable tax rate _ 34%

Gross deferred tax asset $11,560

  1. LO.2 Based on the facts and results of Problem 33 and the beginning-of-the-year

book-tax basis differences listed below, determine the change in Relix’s

deferred tax liabilities for the current year.

Beginning of Year

Building—accumulated depreciation ($57,000)

Furniture & fixtures—accumulated depreciation (4,200)

Subtotal ($61,200)

Applicable tax rate _ 34%

Gross deferred tax liability ($20,808)

  1. LO.2 Based on the facts and results of Problems 33–35, determine Relix’s change in

net deferred tax asset or net deferred tax liability for the current year. Provide

the journal entry to record this amount.

  1. LO.2 In addition to the temporary differences identified in Problems 33–36, Relix

reported two permanent differences between book and taxable income. It

earned $2,375 in tax-exempt municipal bond interest, and it incurred $780 in nondeductible

meals and entertainment expense. Relix’s book income before tax is $4,800.

With this additional information, calculate Relix’s current tax expense.

  1. LO.2 Provide the journal entry to record Relix’s current tax expense as determined

in Problem 37.

  1. LO.2 Based on the facts and results of Problems 33–38, calculate Relix’s total provision

for income tax expense reported in its financial statements and its book net

income after tax.

  1. LO.2 Based on the facts and results of Problems 33–39, provide the income tax

footnote rate reconciliation for Relix.

  1. LO.2 Kantner, Inc., is a domestic corporation with the following balance sheet for

book and tax purposes at the end of the year. Based on this information,

determine Kantner’s net deferred tax asset or net deferred tax liability at year-end.

Assume a 34% corporate tax rate and no valuation allowance.

Tax

Debit/(Credit)

Book

Debit/(Credit)

Assets

Cash $ 1,000 $ 1,000

Accounts receivable 9,000 9,000

Buildings 850,000 850,000

Accumulated depreciation (700,000) (620,000)

Furniture & fixtures 40,000 40,000

Accumulated depreciation (10,000) (8,000)

Total assets $190,000 $ 272,000

Liabilities

Accrued warranty expense $ _0_ ($ 40,000)

Note payable (16,000) (16,000)

Total liabilities ($ 16,000) ($ 56,000)

Stockholders’ Equity

Paid-in capital ($ 50,000) ($ 50,000)

Retained earnings (124,000) (166,000)

Total liabilities and stockholders’ equity ($190,000) ($ 272,000)

  1. LO.2 Based on the facts and results of Problem 41 and the beginning-of-the-year

book-tax basis differences listed below, determine the change in Kantner’s

deferred tax assets for the current year.

Beginning of Year

Accrued warranty expense $30,000

Subtotal $30,000

Applicable tax rate _ 34%

Gross deferred tax asset $10,200

  1. LO.2 Based on the facts and results of Problem 41 and the beginning-of-the-year

book-tax basis differences listed below, determine the change in Kantner’s

deferred tax liabilities for the current year.

Beginning of Year

Building—accumulated depreciation ($62,000)

Furniture & fixtures—accumulated depreciation (400)

Subtotal ($62,400)

Applicable tax rate _ 34%

Gross deferred tax liability ($21,216)

  1. LO.2 Based on the facts and results of Problems 41–43, determine Kantner’s

change in net deferred tax asset or net deferred tax liability for the current

year. Provide the journal entry to record this amount.

  1. LO.2 In addition to the temporary differences identified in Problems 41–44, Kantner

reported two permanent book-tax differences. It earned $7,800 in taxexempt

municipal bond interest, and it reported $850 in nondeductible meals and

entertainment expense. Kantner’s book income before tax is $50,000. With this additional

information, calculate Kantner’s current tax expense.

  1. LO.2 Provide the journal entry to record Kantner’s current tax expense as determined

in Problem 45.

  1. LO.2 Based on the facts and results of Problems 41–46, calculate Kantner’s total

provision for income tax expense reported on its financial statement and its

book net income after tax.

  1. LO.2 Based on the facts and results of Problems 41–47, provide the income tax

footnote rate reconciliation for Kantner.

 

Research Problems

 

Research Problem 1. Locate the web page of Citizens for Tax Justice. Find the report

“Corporate Taxpayers and Corporate Tax Dodgers, 2008-10.” In no more than four

PowerPoint slides for your classmates, summarize the following.

  • Methodology, motivation, and background of the study.
  • Five notable companies, their book income and their effective Federal income tax

rates, and where those rates are zero or negative.

  • Five industries, their effective tax rates, and the dollar amounts of the tax subsidies

they receive.

  • Five notable companies, their effective domestic effective Federal income tax rate,

and the effective tax rate on their overseas profits.

Research Problem 2. Locate the most recent financial statements of two companies in

the same industry using the companies’ websites or the SEC’s website (www.sec.gov).

Perform a benchmarking analysis of the two companies’ effective tax rates, components

of the effective tax rate reconciliation, levels of deferred tax assets and liabilities,

and other relevant data. Summarize this information in an e-mail to your instructor.

Research Problem 3. Locate articles or other discussions regarding the key differences

between ASC 740 (SFAS 109) and International Accounting Standard No. 12 (related

to income taxes). Summarize these key differences in an e-mail to your instructor.

Make certain you have found the most current information for this comparison. Provide

the URL for each of your sources.

Research Problem 4. Locate the financial statements of three different companies that

report information in the income tax footnote regarding uncertain tax positions under

ASC 740-10 (FIN 48). Create a schedule that compares and contrasts the changes in

uncertain tax positions reported by the three companies. E-mail the schedule to your

instructor.

Research Problem 5. Locate the financial statements of three different companies.

Review the income tax footnote information on deferred tax assets (DTAs) and

deferred tax liabilities (DTLs). Create a schedule that compares and contrasts the

end-of-the year amounts of DTAs and DTLs, including any valuation allowances. Email

the schedule to your instructor.

Research Problem 6. Using publicly available resources, locate summary financial

information for two companies in the same industry. Compare and contrast the following

items across the two companies: debt-to-equity ratio, return on assets,

shareholder yield, return on equity, inventory turnover ratio, and effective tax rate.

In your comparison, include the Federal, state/local, and international effective

rates for the entities. Summarize in one paragraph

 

CHAPTER4

Gross Income

 

Problems

  1. LO.1 Howard buys wrecked cars and stores them on his property. Recently, he

purchased a 1990 Ford Taurus for $400. If he can sell all of the usable parts,

his total proceeds from the Taurus will be over $2,500. As of the end of the year, he

has sold only the radio for $75, and he does not know how many, if any, of the

remaining parts will ever be sold. What are Howard’s income recognition issues?

  1. LO.1 Determine the taxpayer’s current-year (1) economic income and (2) gross

income for tax purposes from the following events.

  1. Sam’s employment contract as chief executive of a large corporation was terminated,

and he was paid $500,000 not to work for a competitor of the corporation

for five years.

  1. Elliot, a 6-year-old child, was paid $5,000 for appearing in a television commercial.

His parents put the funds in a savings account for the child’s education.

  1. Valerie found a suitcase that contained $100,000. She could not determine who

the owner was.

  1. Winn purchased a lottery ticket for $5 and won $750,000 from it.
  2. Larry spent $1,000 to raise vegetables that he and his family consumed. The cost

of the vegetables in a store would have been $2,400.

  1. Dawn purchased an automobile for $1,500 that was worth $3,500. The seller

was in desperate need of cash.

  1. LO.1 The roof of your corporation’s office building recently suffered some damage

as the result of a storm. You, the president of the corporation, are negotiating

with a carpenter who has quoted two prices for the repair work: $600 if you pay in

cash (“folding money”) and $700 if you pay by check. The carpenter observes that

the IRS can more readily discover his receipt of a check. Thus, he hints that he will

report the receipt of the check (but not the cash).

The carpenter holds another full-time job and will do the work after hours and

on the weekend. He comments that he should be allowed to keep all he earns after

regular working hours. Evaluate what you should do.

  1. LO.1 Dolly is a college student who works as a part-time server in a restaurant. Her

usual tip is 20% of the price of the meal. A customer ordered a piece of pie

and said that he would appreciate prompt service. Dolly fulfilled the customer’s

request. The customer’s bill was $8, but the customer left a $100 bill on the table

and did not ask for a receipt. Dolly gave the cashier $8 and pocketed the $100 bill.

Dolly concludes that the customer thought that he had left a $10 bill, although

the customer did not return to correct the apparent mistake. The customer had commented

about how much he appreciated Dolly’s prompt service. Dolly thinks that a

$2 tip would be sufficient and that the other $98 is like “found money.” How much

should Dolly include in her gross income?

  1. LO.2 Determine Amos’s gross income in each of the following cases.
  2. In the current year, Amos purchased an automobile for $25,000. As part of the

transaction, Amos received a $1,500 rebate from the manufacturer.

  1. Amos sold his business. In addition to the selling price of the stock, he received

$50,000 for a covenant not to compete—an agreement that he will not compete

directly with his former business for five years.

  1. Amos owned some land he held as an investment. As a result of a change in the

zoning rules, the property increased in value by $20,000.

  1. LO.2 The Bluejay Apartments, a new development, is in the process of structuring its

lease agreements. The company would like to set the damage deposits high

enough that tenants will keep the apartments in good condition. The company actually

is more concerned about such damage than about tenants not paying their rent.

  1. Discuss the tax effects of the following alternatives.
  • $500 damage deposit and $500 rent for the final month of the lease.
  • $1,000 rent for the final two months of the lease and no damage deposit.
  • $1,000 damage deposit with no rent prepayment.
  1. Which option do you recommend? Why?
  2. LO.2, 11 Julie is considering three alternative investments of $10,000. Julie is in the

28% marginal tax bracket for ordinary income and 15% for qualifying capital

gains in all tax years. The selected investment will be liquidated at the end of five years.

The alternatives are:

  • A taxable corporate bond yielding 5% before tax and the interest reinvested at 5%

before tax.

  • A tax-favored bond that will have a maturity value of $12,200 (a 4% pretax rate of

return).

  • Land that will increase in value.

The gain on the land will be classified and taxed as a long-term capital gain. The interest

from the bonds is taxed as ordinary income: the interest from the corporate

bond as it is earned annually, but that from the tax-favored bond is recognized only

upon redemption. How much must the land increase in value to yield a greater

after-tax return than either of the bonds?

The compound amount of $1 and compound value of $1 annuity payments at

the end of five years are given as:

Interest Rate

Future Value, $1 Compounded

for 5 Years

Future Value, 5-Year Annuity of

$1 Each

5% $1.28 $5.53

4% 1.22 5.42

3.6% 1.19 5.37

  1. LO.1 Determine the taxpayer’s gross income for tax purposes in each of the following

situations.

  1. Deb, a cash basis taxpayer, traded a corporate bond with accrued interest of

$300 for corporate stock with a fair market value of $12,000 at the time of the

exchange. Deb’s cost of the bond was $10,000. The value of the stock had

decreased to $11,000 by the end of the year.

  1. Deb needed $10,000 to make a down payment on her house. She instructed

her broker to sell some stock to raise the $10,000. Deb’s cost of the stock was

$3,000. Based on her broker’s advice, instead of selling the stock, she borrowed

the $10,000 using the stock as collateral for the debt.

  1. Deb’s boss gave her two tickets to the Rabid Rabbits rock concert because Deb

met her sales quota. At the time Deb received the tickets, each ticket had a face

price of $200 and was selling on eBay for $300 each. On the date of the concert,

the tickets were selling for $250 each. Deb and her son attended the concert.

  1. LO.2 Al is a medical doctor who conducts his practice as a sole proprietor. During

2015, he received cash of $280,000 for medical services. Of the amount collected,

$40,000 was for services provided in 2014. At the end of 2015, Al held

accounts receivable of $60,000, all for services rendered in 2015. In addition, at the

end of the year, Al received $12,000 as an advance payment from a health maintenance

organization (HMO) for services to be rendered in 2016. Compute Al’s gross

income for 2015:

  1. Using the cash basis of accounting.
  2. Using the accrual basis of accounting.
  3. LO.2 Selma operates a contractor’s supply store. She maintains her books using the

cash method. At the end of the year, her accountant computes her accrual basis

income that is used on her tax return. For 2015, Selma reported cash receipts of

$1.4 million, which included $200,000 collected on accounts receivable from 2014

sales. It also included the proceeds of a $100,000 bank loan. At the end of 2015, she

held $250,000 in accounts receivable from customers, all from 2015 sales.

  1. Compute Selma’s accrual basis gross receipts for 2015.
  2. Selma paid cash for all of the purchases. The total amount paid for merchandise

in 2015 was $1.3 million. At the end of 2014, she had merchandise on hand with

a cost of $150,000. At the end of 2015, the cost of merchandise on hand was

$300,000. Compute Selma’s gross income from merchandise sales for 2015.

  1. LO.2 Trip Garage, Inc. (459 Ellis Avenue, Harrisburg, PA 17111), is an accrual basis

taxpayer that repairs automobiles. In late December 2015, the company

repaired Samuel Mosley’s car and charged him $1,000. Samuel did not think the

problem had been fixed, so he refused to pay; thus, Trip refused to release the automobile.

In early January 2016, Trip made a few adjustments under the hood; Trip then

convinced Samuel that the automobile was working properly. At that time, Samuel

agreed to pay only $900 because he did not have the use of the car for a week. Trip

said “fine,” accepted the $900, and released the automobile to Samuel.

An IRS agent thinks Trip, as an accrual basis taxpayer, should report $1,000 of

income in 2015, when the work was done, and then deduct a $100 business loss in

  1. Prepare a memo to Susan Apple, the treasurer of Trip, with your recommended

treatment for the disputed income.

  1. LO.1, 4 Each Saturday morning, Ted makes the rounds of the local yard sales. He

has developed a keen eye for bargains, but he cannot use all of the items

he thinks are “real bargains.” Ted has found a way to share the benefits of his talent

with others. If Ted spots something priced at $40 that he knows is worth $100, for

example, he will buy it and list it on eBay for $70.

Ted does not include his gain in his gross income because he reasons that he is performing

a valuable service for others (both the original sellers and the future buyers)

and sacrificing profit he could receive. “Besides,” according to Ted, “the IRS does not

know about these transactions.” Should Ted’s ethical standards depend on his perception

of his own generosity and the risk that his income-producing activities will be discovered

by the IRS? Discuss.

  1. LO.2 Accounting students understand that the accrual method of accounting is

superior to the cash method for measuring the income and expenses from an

ongoing business for financial reporting purposes. Thus, CPAs advise their clients to

use the accrual method of accounting. Yet, CPA firms generally use the cash method

to prepare their own tax returns. Are the CPAs being hypocritical? Explain.

  1. LO.2 Drake Appliance Company, an accrual basis taxpayer, sells home appliances

and service contracts. Determine the effects of each of the following transactions

on the company’s 2015 gross income assuming that the company uses any

available options to defer its taxes.

  1. In December 2014, the company received a $1,200 advance payment from a

customer for an appliance that Drake had special ordered from the manufacturer.

The appliance did not arrive from the manufacturer until January 2015,

and Drake immediately delivered it to the customer. The sale was reported in

2015 for financial accounting purposes.

  1. In October 2015, the company sold a 6-month service contract for $240. The

company also sold a 36-month service contract for $1,260 in July 2015.

  1. On December 31, 2015, the company sold an appliance for $1,200. The company

received $500 cash and a note from the customer for $700 and $260 interest,

to be paid at the rate of $40 a month for 24 months. Because of the

customer’s poor credit record, the fair market value of the note was only $600.

The cost of the appliance was $750.

  1. LO.2 Dr. Randolph, a cash basis taxpayer, knows that he will be in a lower mar

his tax rate, Dr. Randolph instructs his office manager to delay filing the medical insurance

claims for services performed in November and December until January of

the following year. This will ensure that the receipts will not be included in his current

gross income. Is Dr. Randolph abusing the cash method of accounting rules?

Why or why not?

  1. LO.2 Your client is a new partnership, ARP Associates, which is an engineering

consulting firm. Generally, ARP bills clients for services at the end of each

month. Client billings are about $50,000 each month. On average, it takes 45 days to

collect the receivables. ARP’s expenses are primarily for salary and rent. Salaries are

paid on the last day of each month, and rent is paid on the first day of each month.

The partnership has a line of credit with a bank, which requires monthly financial

statements. These must be prepared using the accrual method. ARP’s managing partner,

Amanda Sims, has suggested that the firm also use the accrual method for tax

purposes and thus reduce accounting fees by $600.

The partners are in the 35% (combined Federal and state) marginal tax bracket.

Write a letter to your client explaining why you believe it would be worthwhile

for ARP to file its tax return on the cash basis even though its financial statements

are prepared on the accrual basis. ARP’s address is 100 James Tower, Denver,

CO 80208.

  1. LO.3 Alva received dividends on her stocks as follows.

Amur Corporation (a French corporation whose stock is traded on an

established U.S. securities market) $60,000

Blaze, Inc., a Delaware corporation 40,000

Grape, Inc., a Virginia corporation 22,000

  1. Alva purchased the Grape stock three years ago, and she purchased the Amur

stock two years ago. She purchased the Blaze stock 18 days before it went exdividend

and sold it 20 days later at a $5,000 loss. Alva reported no other capital

gains and losses for the year. She is in the 35% marginal tax bracket. Compute

Alva’s tax on her dividend income.

  1. Alva’s daughter, Veda, who is age 25 and who is not Alva’s dependent, reported

taxable income of $10,000, which included $1,000 of dividends on Grape stock.

Veda purchased the stock two years ago. Compute Veda’s tax liability on the

dividends.

  1. LO.4, 5 Roy decides to buy a personal residence, and he goes to the bank for a

$150,000 loan. The bank tells Roy that he can borrow the funds at 4% if his

father will guarantee the debt. Roy’s father, Hal, owns a $150,000 CD currently yielding

3.5%. The Federal rate is 3%. Hal agrees to either of the following.

  • Roy borrows from the bank with Hal’s guarantee provided to the bank.
  • Cash in the CD (with no penalty) and lend Roy the funds at 2% interest.

Hal is in the 33% marginal tax bracket. Roy, whose only source of income is his

salary, is in the 15% marginal tax bracket. The interest that Roy pays on the mortgage

will be deductible by him. Which option will maximize the family’s after-tax

wealth?

  1. LO.5 Brad is the president of the Yellow Corporation. He and other members of

his family control the corporation. Brad has a temporary need for $50,000,

and the corporation has excess cash. He could borrow the money from a bank at

9%, and Yellow is earning 6% on its temporary investments. Yellow has made loans

to other employees on several occasions. Therefore, Brad is considering borrowing

$50,000 from the corporation. He will repay the loan principal in two years plus interest

at 5%. Identify the relevant tax issues for Brad and Yellow Corporation.

  1. LO.5 Ridge is a generous individual. During the year, he made interest-free loans

to various family members when the Federal interest rate was 3%. What are

the Federal tax consequences of the following loans by Ridge?

  1. On June 30, Ridge loaned $12,000 to his cousin, Jim, to buy a used truck. Jim’s

only source of income was his wages on various construction jobs during the year.

  1. On August 1, Ridge loaned $8,000 to his niece, Sonja. The loan was meant to

enable her to pay her college tuition. Sonja reported $1,200 interest income

from CDs that her parents had given her.

  1. On September 1, Ridge loaned $25,000 to his brother, Al, to start a business. Al

reported only $220 of dividends and interest for the year.

  1. On September 30, Ridge loaned $150,000 to his mother so that she could enter

a nursing home. His mother’s only income was $9,000 in Social Security benefits

and $500 interest income received.

  1. LO.5 Indicate whether the imputed interest rules apply in the following situations.
  2. Mike loaned his sister $90,000 to buy a new home. Mike did not charge interest

on the loan. The Federal rate was 5%. Mike’s sister had $900 of investment

income for the year.

  1. Sam’s employer maintains an emergency loan fund for its employees. During

the year, Sam’s wife was very ill, and he incurred unusually large medical

expenses. He borrowed $8,500 from his employer’s emergency loan fund for

six months. The Federal rate was 5.5%. Sam and his wife had no investment

income for the year.

  1. Jody borrowed $25,000 from her controlled corporation for six months. She

used the funds to pay her daughter’s college tuition. The corporation charged

Jody 4% interest. The Federal rate was 5%. Jody had $3,500 of investment

income for the year.

  1. Kait loaned her son, Jake, $60,000 for six months. Jake used the $60,000 to pay

off college loans. The Federal rate was 5%, and Kait did not charge Jake any interest.

Jake had dividend and interest income of $2,100 for the tax year.

  1. LO.5 Vito is the sole shareholder of Vito, Inc. The corporation also employs him.

On June 30, 2015, Vito borrowed $8,000 from Vito, Inc., and on July 1, 2016,

he borrowed an additional $10,000. Both loans were due on demand. No interest

was charged on the loans, and the Federal interest rate was 4% for all relevant dates.

Vito used the money to purchase a boat. Elsewhere on his return, Vito recognized

$2,500 of investment income. Determine the tax consequences to Vito and

Vito, Inc., if:

  1. The loans are considered employer-employee loans.
  2. The loans are considered corporation-shareholder loans.
  3. LO.6 How does the tax benefit rule apply in the following cases?
  4. In 2013, the Orange Furniture Store, an accrual method taxpayer, sold furniture

on credit for $1,000 to Sammy. Orange’s cost of the furniture was $600. In

2014, Orange took a bad debt deduction for the $1,000 because Sammy would

not pay his bill.

In 2015, Sammy inherited some money and paid Orange the $1,000 he

owed. Orange was in the 35% marginal tax bracket in 2013, the 15% marginal

tax bracket in 2014, and the 35% marginal tax bracket in 2016.

  1. In 2014, Barb, a cash basis taxpayer, was in an accident and incurred $8,000 in

medical expenses, which she claimed as an itemized deduction for medical

expenses. Because of a limitation, though, the expense reduced her taxable

income by only $3,000. In 2015, Barb successfully sued the person who caused

the physical injury and collected $8,000 to reimburse her for the cost of her medical

expenses. Barb was in the 15% marginal tax bracket in all tax years.

  1. LO.7 Determine Hazel’s Federal gross income from the following receipts for the

year.

Gain on sale of Augusta County bonds $800

Interest on U.S. government savings bonds 400

Interest on state income tax refund 200

Interest on Augusta County bonds 700

  1. LO.7 Tammy, a resident of Virginia, is considering whether to purchase a North

Carolina bond that yields 4.6% before tax. She is in the 35% Federal marginal

tax bracket and the 5% state marginal tax bracket.

Tammy is aware that State of Virginia bonds of comparable risk are yielding

4.5%. Virginia bonds are exempt from Virginia tax, but the North Carolina bond interest

is taxable in Virginia.

Which of the two options will provide the greater after-tax return to Tammy?

Tammy can deduct all state taxes paid on her Federal income tax return.

  1. LO.7 Tonya, a Virginia resident, inherited a $100,000 State of Virginia bond this

year. Her marginal Federal income tax rate is 35%, and her marginal state tax

rate is 5%. The Virginia bond pays 3.3% interest, which is not subject to Virginia

income tax. Alternatively, Tonya can purchase a corporate bond of comparable risk

that will yield 5.2% or a U.S. government bond that pays 4.6% interest. Tonya does

not itemize her deductions. Which investment provides the greatest after-tax yield?

  1. LO.9 The Egret Company has a 40% combined Federal and state marginal tax

rate. Egret’s board estimates that, if its current president should die, the company

would incur $200,000 in costs to find a suitable replacement. In addition,

profits on various projects the president is responsible for would likely decrease

by $300,000. The president has recommended that Egret purchase a $500,000 life

insurance policy.

How much insurance should the company carry on the life of its president to

compensate for the after-tax loss that would result from the president’s death?

Assume that the $200,000 costs of finding a president are deductible and the lost

profits would have been taxable.

  1. LO.9 Ray and Carin are partners in an accounting firm. The partners have entered

into an arm’s length agreement requiring Ray to purchase Carin’s partnership

interest from Carin’s estate if she dies before Ray. The price is set at 120% of the

book value of Carin’s partnership interest at the time of her death.

Ray purchased an insurance policy on Carin’s life to fund this agreement. After

Ray had paid $45,000 in premiums, Carin was killed in an automobile accident, and

Ray collected $800,000 of life insurance proceeds. Ray used the life insurance proceeds

to purchase Carin’s partnership interest.

What amount should Ray include in his gross income from receiving the life insurance

proceeds?

  1. LO.9 Laura recently was diagnosed with cancer and has begun chemotherapy

treatments. A cancer specialist has given Laura less than one year to live. She

has incurred sizable medical bills and other general living expenses and is in need

of cash. Therefore, Laura is considering selling stock that cost her $35,000 in 2005

and now has a fair market value of $50,000. This amount would be sufficient to pay

her medical bills.

However, she has read about a company (VitalBenefits.com) that would purchase

her life insurance policy for $50,000. To date, Laura has paid $30,000 in premiums

on the policy.

  1. Considering only the Federal income tax effects, would selling the stock or selling

the life insurance policy result in more beneficial tax treatment?

  1. Assume that Laura is a dependent child and that her mother owns the stock

and the life insurance policy, which is on the mother’s life. Which of the alternative

means of raising the cash would result in more beneficial tax

treatment?

  1. LO.10 Vic, who was experiencing financial difficulties, was able to adjust his debts as

follows. Determine the Federal income tax consequences to Vic.

  1. Vic is an attorney. Vic owed his uncle $25,000. The uncle told Vic that if he

serves as the executor of the uncle’s estate, Vic’s debt will be canceled in the

uncle’s will.

  1. Vic borrowed $80,000 from First Bank. The debt was secured by land that Vic

purchased for $100,000. Vic was unable to pay, and the bank foreclosed

when the liability was $80,000, which was also the fair market value of the

property.

  1. The Land Company, which had sold land to Vic for $80,000, reduced the mortgage

principal on the land by $12,000.

  1. LO.11 During the year, Olivia recorded the following transactions involving capital

assets.

Gain on the sale of unimproved land (held as an investment for 4 years) $ 4,000

Loss on the sale of a camper (purchased 2 years ago and used for family

vacations) (5,000)

Loss on the sale of IBM stock (purchased 9 months ago as an investment) (1,000)

Gain on the sale of a fishing boat and trailer (acquired 11 months ago at an

auction and used for recreational purposes) 2,000

  1. If Olivia is in the 33% bracket, how much Federal income tax results?
  2. If Olivia is in the 15% bracket, how much Federal income tax results?
  3. LO.11 Andy reported the following gains and losses from the sale of capital assets.

Loss on Pigeon Corporation stock (held 9 months) ($14,000)

Gain on painting (held for 2 years as an investment) 5,000

Gain on unimproved land (held for 3 years as an investment) 3,000

  1. If Andy is in the 35% tax bracket, determine the Federal income tax consequences

of these transactions.

  1. What if Andy is in the 15% tax bracket?
  2. What if Andy is a C corporation in the 35% tax bracket?
  3. LO.11 Liz and Doug were divorced on July 1 of the current year after 10 years

of marriage. Their current year’s income received before the divorce

included:

Doug’s salary $41,000

Liz’s salary 55,000

Rent on apartments purchased by Liz 15 years ago 8,000

Dividends on stock Doug inherited from his mother 4 years ago 1,900

Interest on a savings account in Liz’s name funded with her salary 2,400

Allocate the income to Liz and Doug assuming that they live in:

  1. California.
  2. Texas.

 

CHAPTER5

Business Deductions

 

Computational Exercises

 

  1. LO.2 Glenda, a calendar year and cash basis taxpayer, rents property from Janice.

As part of the rental agreement, Glenda pays $8,400 rent on April 1, 2015 for

the 12 months ending March 31, 2016.

  1. How much is Glenda’s deduction for rent expense in 2015?
  2. Assume the same facts, except that the $8,400 is for 24 months rent ending

March 31, 2017. How much is Glenda’s deduction for rent expense in 2015?

  1. LO.3 Vella owns and operates an illegal gambling establishment. In connection

with this activity, he has the following expenses during the year:

Rent $ 24,000

Bribes 40,000

Travel expenses 4,000

Utilities 18,000

Wages 230,000

Payroll taxes 13,800

Property insurance 1,600

Illegal kickbacks 22,000

What are Vella’s total deductible expenses for tax purposes?

  1. LO.3 Stanford owns and operates two dry cleaning businesses. He travels to Boston

to discuss acquiring a restaurant. Later in the month, he travels to New York to

discuss acquiring a bakery. Stanford does not acquire the restaurant but does purchase

the bakery on November 1, 2015. Stanford incurred the following expenses:

Total investigation costs related to the restaurant $28,000

Total investigation costs related to the bakery 51,000

What is the maximum amount Stanford can deduct in 2015 for investigation expenses?

  1. LO.5 Tabitha sells real estate on March 2 for $260,000. The buyer, Ramona, pays

the real estate taxes of $5,200 for the calendar year, which is the real estate

property tax year. Assume that this is not a leap year.

  1. Determine the real estate taxes apportioned to and deductible by the seller,

Tabitha, and the amount of taxes deductible by Ramona.

  1. Calculate Ramona’s basis in the property and the amount realized by Tabitha

from the sale.

  1. LO.5 Sandstorm Corporation decides to develop a new line of paints. The project

begins in 2015. Sandstorm incurs the following expenses in 2015 in connection

with the project:

Salaries $85,000

Materials 30,000

Depreciation on equipment 12,500

The benefits from the project will be realized starting in July 2016. If Sandstorm Corporation

chooses to defer and amortize its research and experimental expenditures

over a period of 60 months, what are its related deductions in 2015 and 2016?

  1. LO.6 Hamlet acquires a 7-year class asset on November 23, 2015, for $100,000.

Hamlet does not elect immediate expensing under § 179. He does not claim

any available additional first-year depreciation. Calculate Hamlet’s cost recovery

deductions for 2015 and 2016.

  1. LO.6 Lopez acquired a building on June 1, 2010, for $1 million. Calculate Lopez’s

cost recovery deduction for 2015 if the building is:

  1. Classified as residential rental real estate.
  2. Classified as nonresidential real estate.
  3. LO.6 In 2015, McKenzie purchased qualifying equipment for his business that cost

$212,000. The taxable income of the business for the year is $5,600 before

consideration of any § 179 deduction. Calculate McKenzie’s § 179 expense deduction

for 2015 and any carryover to 2016.

  1. LO.6 On April 5, 2015, Kinsey places in service a new automobile that cost

$36,000. He does not elect § 179 expensing, and he elects not to take any

available additional first-year depreciation. The car is used 70% for business and

30% for personal use in each tax year.

Kinsey chooses the MACRS 200% declining-balance method of cost recovery (the

auto is a 5-year asset). Assume the following luxury automobile limitations: year 1:

$3,160; year 2: $5,100. Compute the total depreciation allowed for 2015 and 2016.

  1. LO.8 Jebali Company reports gross income of $340,000 and other property-related

expenses of $229,000 and uses a depletion rate of 14%. Calculate Jebali’s

depletion allowance for the current year.

 

Problems

  1. LO.2 Duck, an accrual basis corporation, sponsored a rock concert on December

29, 2015. Gross receipts were $300,000. The following expenses were

incurred and paid as indicated:

Expense Payment Date

Rental of coliseum $ 25,000 December 21, 2015

Cost of goods sold:

Food 30,000 December 30, 2015

Souvenirs 60,000 December 30, 2015

Expense Payment Date

Performers 100,000 January 5, 2016

Cleaning of coliseum 10,000 February 1, 2016

Because the coliseum was not scheduled to be used again until January 15, the

company with which Duck had contracted did not perform the cleanup until

January 8–10, 2016.

Calculate Duck’s net income from the concert for tax purposes for 2015.

  1. LO.3 Ted, an agent for Waxwing Corporation, which is an airline manufacturer,

is negotiating a sale with a representative of the U.S. government and with

a representative of a developing country. Waxwing has sufficient capacity to handle

only one of the orders. Both orders will have the same contract price. Ted believes

that if Waxwing authorizes a $500,000 payment to the representative of the foreign

country, he can guarantee the sale. He is not sure that he can obtain the same result

with the U.S. government. Identify the relevant tax issues for Waxwing.

  1. LO.3 Linda operates an illegal gambling operation and incurs the following

expenses. Which of these expenses can reduce her taxable income?

  1. Bribes paid to city employees.
  2. Salaries to employees.
  3. Security cameras.
  4. Kickbacks to police.
  5. Rent on an office.
  6. Depreciation on office furniture and equipment.
  7. Tenant’s casualty insurance.
  8. Utilities.
  9. LO.3 Cardinal Corporation is a trucking firm that operates in the Mid-Atlantic states.

One of Cardinal’s major customers frequently ships goods between Charlotte

and Baltimore. Occasionally, the customer sends last-minute shipments that are outbound

for Europe on a freighter sailing from Baltimore. To satisfy the delivery

schedule in these cases, Cardinal’s drivers must substantially exceed the speed limit.

Cardinal pays for any related speeding tickets. During the past year, two drivers

had their licenses suspended for 30 days each for driving at such excessive speeds.

Cardinal continues to pay each driver’s salary during the suspension periods.

Cardinal believes that it is necessary to conduct its business in this manner if it is

to be profitable, maintain the support of the drivers, and maintain the goodwill of

customers. Evaluate Cardinal’s business practices.

  1. LO.3 Quail Corporation anticipates that being positively perceived by the individual

who is elected mayor will be beneficial for business. Therefore, Quail

contributes to the campaigns of both the Democratic and Republican candidates.

The Republican candidate is elected mayor. Can Quail deduct any of the political

contributions it made? Explain.

  1. LO.3 Melissa, the owner of a sole proprietorship, does not provide health insurance

for her 20 employees. She plans to spend $1,500 lobbying in opposition

to legislation that would require her to provide such insurance. Discuss the tax

advantages and disadvantages of paying the $1,500 to a professional lobbyist rather

than spending the $1,500 on in-house lobbying expenditures.

  1. LO.3 Ella owns 60% of the stock of Peach, Inc. The stock has declined in value

since she purchased it five years ago. She is going to sell 5% of the stock to

a relative. Ella is also going to make a gift of 10% of the stock to another relative.

Identify the relevant tax issues for Ella.

  1. LO.3 Jarret owns City of Charleston bonds with an adjusted basis of $190,000. During

the year, he receives interest payments of $3,800. Jarret partially financed

the purchase of the bonds by borrowing $100,000 at 5% interest. Jarret’s interest

payments on the loan this year are $4,900, and his principal payments are $1,100.

  1. Should Jarret report any interest income this year? Explain.
  2. Can Jarret deduct any interest expense this year? Explain.
  3. LO.3 Nancy, the owner of a very successful hotel chain in the Southeast, is exploring

the possibility of expanding the chain into a city in the Northeast. She

incurs $35,000 of expenses associated with this investigation. Based on the regulatory

environment for hotels in the city, she decides not to expand. During the year,

she also investigates opening a restaurant that will be part of a national restaurant

chain. Her expenses for this are $53,000. The restaurant begins operations on

September 1. Determine the amount Nancy can deduct in the current year for investigating

these two businesses.

  1. LO.3 Brittany Callihan sold stock (basis of $184,000) to her son, Ridge, for

$160,000, the fair market value.

  1. What are the tax consequences to Brittany?
  2. What are the tax consequences to Ridge if he later sells the stock for $190,000?

For $152,000? For $174,000?

  1. Write a letter to Brittany in which you inform her of the tax consequences if she

sells the stock to Ridge for $160,000. Explain how a sales transaction could be

structured that would produce better tax consequences for her. Brittany’s

address is 32 Country Lane, Lawrence, KS 66045.

  1. LO.3 For each of the following independent transactions, calculate the recognized

gain or loss to the seller and the adjusted basis to the buyer.

  1. Bonnie sells Parchment, Inc. stock (adjusted basis $17,000) to Phillip, her

brother, for its fair market value of $12,000.

  1. Amos sells land (adjusted basis $85,000) to his nephew, Boyd, for its fair market

value of $70,000.

  1. Susan sells a tax-exempt bond (adjusted basis $20,000) to her wholly owned

corporation for its fair market value of $19,000.

  1. Ron sells a business truck (adjusted basis $20,000) that he uses in his sole proprietorship

to his cousin, Agnes, for its fair market value of $18,500.

  1. Martha sells her partnership interest (adjusted basis $175,000) in Pearl Partnership

to her adult daughter, Kim, for $220,000.

  1. LO.4 In 2015, Gray Corporation, a calendar year C corporation, holds a $75,000

charitable contribution carryover from a gift made in 2010. Gray is contemplating

a gift of land to a qualified charity in either 2015 or 2016. Gray purchased

the land as an investment five years ago for $100,000 (current fair market value is

$250,000).

Before considering any charitable deduction, Gray projects taxable income of

$1 million for 2015 and $1.2 million for 2016. Should Gray make the gift of the land

to charity in 2015 or in 2016? Provide support for your answer.

  1. LO.4 Dan Simms is the president and sole shareholder of Simms Corporation, 1121

Madison Street, Seattle, WA 98121. Dan plans for the corporation to make a

charitable contribution to the University of Washington, a qualified public charity.

He will have the corporation donate Jaybird Corporation stock, held for five years,

with a basis of $11,000 and a fair market value of $25,000. Dan projects a $310,000

net profit for Simms Corporation in 2015 and a $100,000 net profit in 2016. Dan calls

you on December 11, 2015, and asks whether Simms should make the contribution

in 2015 or 2016. Write a letter advising Dan about the timing of the contribution.

  1. LO.5 Blue Corporation, a manufacturing company, decided to develop a new line

of merchandise. The project began in 2015. Blue had the following expenses

in connection with the project.

2015 2016

Salaries $500,000 $600,000

Materials 90,000 70,000

Insurance 8,000 11,000

Utilities 6,000 8,000

Cost of inspection of materials for quality control 7,000 6,000

Promotion expenses 11,000 18,000

Advertising –0– 20,000

Equipment depreciation 15,000 14,000

Cost of market survey 8,000 –0–

The new product will be introduced for sale beginning in July 2017. Determine the

amount of the deduction for research and experimental expenditures for 2015, 2016,

and 2017 if:

  1. Blue Corporation elects to expense the research and experimental expenditures.
  2. Blue Corporation elects to amortize the research and experimental expenditures

over 60 months.

  1. LO.5 Sarah Ham, operating as a sole proprietor, manufactures printers in the

United States. For 2015, the proprietorship has QPAI of $400,000. Sarah’s

modified AGI was $350,000. The W–2 wages paid by the proprietorship to employees

engaged in the qualified domestic production activity were $60,000. Calculate

Sarah’s DPAD for 2015.

  1. LO.5 In 2015, Rose, Inc., has QPAI of $4 million and taxable income of $3 million.

Rose pays independent contractors $500,000. Rose’s W–2 wages are $600,000,

but only $400,000 of the wages are paid to employees engaged in qualified domestic

production activities.

  1. Calculate the DPAD for Rose, Inc., for 2015.
  2. What suggestions could you make to enable Rose to increase its DPAD?
  3. LO.6 On November 4, 2013, Blue Company acquired an asset (27.5-year residential

real property) for $200,000 for use in its business. In 2013 and 2014, respectively,

Blue took $642 and $5,128 of cost recovery. These amounts were incorrect;

Blue applied the wrong percentages (i.e., those for 39-year rather than 27.5-year

property). Blue should have taken $910 and $7,272 of cost recovery in 2013 and

2014, respectively.

On January 1, 2015, the asset was sold for $180,000. Calculate the gain or loss on

the sale of the asset for that year.

  1. LO.6 Juan, a sole proprietor, acquires a new 5-year class asset on March 14, 2015,

for $200,000. This is the only asset Juan acquired during the year. He does

not elect immediate expensing under § 179. Juan does not claim any available additional

first-year depreciation. On July 15, 2016, Juan sells the asset.

  1. Determine Juan’s cost recovery for 2015.
  2. Determine Juan’s cost recovery for 2016.
  3. LO.6 Debra acquired the following new assets during 2015.

Date Asset Cost

April 11 Furniture $40,000

July 28 Trucks 40,000

November 3 Computers 70,000

Determine Debra’s cost recovery deductions for the current year. Debra does not

elect immediate expensing under § 179. She does not claim any available additional

first-year depreciation.

  1. LO.6 On May 5, 2015, Christy purchased and placed in service a hotel. The hotel

cost $10.8 million. Calculate Christy’s cost recovery deductions for 2015 and

for 2025.

  1. LO.6 Janice acquired an apartment building on June 4, 2015, for $1.6 million.

The value of the land is $300,000. Janice sold the apartment building on

November 29, 2021.

  1. Determine Janice’s cost recovery deduction for 2015.
  2. Determine Janice’s cost recovery deduction for 2021.
  3. LO.6 During March 2015, Sam constructed new agricultural fences on his farm. The

cost of the fencing was $80,000. Sam does not elect immediate expensing

under § 179 and he does not claim any available additional first-year depreciation.

However, an election not to have the uniform capitalization rules apply is in effect.

Compute Sam’s cost recovery deduction for 2015. Sam wants to maximize his cost

recovery deductions.

  1. LO.6 Lori, who is single, purchased 5-year class property for $200,000 and 7-year

class property for $400,000 on May 20, 2015. Lori expects the taxable income

derived from her business (without regard to the amount expensed under § 179) to

be about $800,000. Lori wants to elect immediate § 179 expensing, but she doesn’t

know which asset she should expense under § 179. Lori does not claim any available

additional first-year depreciation.

  1. Determine Lori’s total deduction if the § 179 expense is first taken with respect

to the 5-year class asset.

  1. Determine Lori’s total deduction if the § 179 expense is first taken with respect

to the 7-year class asset.

  1. What is your advice to Lori?
  2. LO.6 Olga is the proprietor of a small business. In 2015, the business’s income,

before consideration of any cost recovery or § 179 deduction, is $250,000.

Olga spends $600,000 on new 7-year class assets and elects to take the § 179

deduction on them. She does not claim any available additional first-year depreciation.

Olga’s cost recovery deduction for 2015, except for the cost recovery with

respect to the new 7-year assets, is $95,000. Determine Olga’s total cost recovery for

2015 with respect to the 7-year class assets and the amount of any § 179 carryforward.

  1. LO.6 On June 5, 2014, Dan purchased and placed in service a 7-year class asset

costing $550,000. Determine the maximum deductions that Dan can claim

with respect to this asset in 2014 and 2015.

  1. LO.6 Jabari Johnson is considering acquiring an automobile at the beginning of

2015 that he will use 100% of the time as a taxi. The purchase price of the

automobile is $35,000. Johnson has heard of cost recovery limits on automobiles and

wants to know the maximum amount of the $35,000 he can deduct in the first year.

Write a letter to Jabari in which you present your calculations. Also prepare a

memo for the tax files, summarizing your analysis. Johnson’s address is 100 Morningside,

Clinton, MS 39058.

  1. LO.6 On October 15, 2015, Jon purchased and placed in service a used car. The

purchase price was $25,000. This was the only business-use asset Jon

acquired in 2015. He used the car 80% of the time for business and 20% for personal

use. Jon used the MACRS statutory percentage method. Calculate the total deduction

Jon may take for 2015 with respect to the car

  1. LO.6 On June 5, 2014, Leo purchased and placed in service a new car that cost

$20,000. The business-use percentage for the car is always 100%. Leo claims

any available additional first-year depreciation. Compute Leo’s cost recovery deduction

for 2014 and 2015.

  1. LO.6 On May 28, 2015, Mary purchased and placed in service a new $20,000 car.

The car was used 60% for business, 20% for production of income, and 20%

for personal use in 2015. In 2016, the usage changed to 40% for business, 30% for

production of income, and 30% for personal use. Mary did not elect immediate

expensing under § 179. She did not claim any available additional first-year depreciation.

Compute Mary’s cost recovery deduction and any cost recovery recapture

in 2016.

  1. LO.6 In 2015, Muhammad purchased a new computer for $16,000. The computer

is used 100% for business. Muhammad did not make a § 179 election with

respect to the computer. He does not claim any available additional first-year depreciation.

If Muhammad uses the MACRS statutory percentage method, determine his

cost recovery deduction for 2015 for computing taxable income and for computing

his alternative minimum tax.

  1. LO.6 Jamie purchased $100,000 of new office furniture for her business in June of

the current year. Jamie understands that if she elects to use ADS to compute

her regular income tax, there will be no difference between the cost recovery for

computing the regular income tax and the AMT. Jamie wants to know the regular

income tax cost, after three years, of using ADS rather than MACRS. Assume that

Jamie does not elect § 179 limited expensing and that her marginal tax rate is 28%.

She does not claim any available additional first-year depreciation.

  1. LO.7 Mike Saxon is negotiating the purchase of a business. The final purchase

price has been agreed upon, but the allocation of the purchase price to the

assets is still being discussed. Appraisals on a warehouse range from $1,200,000 to

$1,500,000. If a value of $1,200,000 is used for the warehouse, the remainder of the

purchase price, $800,000, will be allocated to goodwill. If $1,500,000 is allocated to

the warehouse, goodwill will be $500,000.

Mike wants to know what effect each alternative will have on cost recovery and

amortization during the first year. Under the agreement, Mike will take over the

business on January 1 of next year. Write a letter to Mike in which you present your

calculations and recommendation. Also prepare a memo for the tax files. Mike’s

address is 200 Rolling Hills Drive, Shavertown, PA 18708.

  1. LO.8 Sam Jones owns a granite stone quarry. When he acquired the land, Sam allocated

$800,000 of the purchase price to the quarry’s recoverable mineral

reserves, which were estimated at 10 million tons of granite stone. Based on these estimates,

the cost depletion was $.08 per ton. In April of the current year, Sam received a

letter from the State Department of Highways notifying him that part of his property

was being condemned so that state could build a new road. At that time, the recoverable

mineral reserves had an adjusted basis of $600,000 and 7.5 million tons of granite

rock. Sam estimates that the land being condemned contains about 2 million tons

of granite. Therefore, for the current year, Sam has computed his cost depletion

at $:11 per ton [$600,000=(7,500,000 _ 2,000,000)]. Evaluate the appropriateness of

what Sam is doing.

  1. LO.8 Wes acquired a mineral interest during the year for $10 million. A geological

survey estimated that 250,000 tons of the mineral remained in the deposit.

During the year, 80,000 tons were mined, and 45,000 tons were sold for $12 million.

Other related expenses amounted to $5 million. Assuming that the mineral depletion

rate is 22%, calculate Wes’s lowest taxable income, after any depletion deducti

 

Research Problems

Research Problem 1. Gray Chemical Company manufactured pesticides that were

toxic. Over the course of several years, the toxic waste contaminated the air and water

around the company’s plant. Several employees suffered toxic poisoning, and the

Environmental Protection Agency cited the company for violations. In court, the judge

found Gray guilty and imposed fines of $15 million. The company voluntarily set up a

charitable fund for the purpose of bettering the environment and funded it with

$8 million. The company incurred legal expenses in setting up the foundation and

defending itself in court. The court reduced the fine from $15 million to $7 million.

Gray deducted the $8 million paid to the foundation and the legal expenses

incurred. The IRS disallowed both deductions on the grounds that the payment was,

in fact, a fine and in violation of public policy.

Gray’s president, Ted Jones, has contacted you regarding the deductibility of the

$7 million fine, the $8 million payment to the foundation, and the legal fees. Write a

letter to Mr. Jones that contains your advice, and prepare a memo for the tax files.

Gray’s address is 200 Lincoln Center, Omaha, NE 68182.

Partial list of research aids:

  • § 162(a) and (f).

Reg. § 1.162–21(b).

Research Problem 2. In 2011, Jed James began planting a vineyard. The costs of the land

preparation, labor, rootstock, and planting were capitalized. The land preparation costs

do not include any nondepreciable land costs. In 2015, when the plants became viable,

Jed placed the vineyard in service. Jed wants to know whether he can claim a deduction

under § 179 on his 2015 income tax return for the 2011 costs for planting the vineyard.

Research Problem 3. Juan owns a business that acquires exotic automobiles that

are high-tech, state-of-the-art vehicles with unique design features or equipment. The –

exotic automobiles are not licensed, nor are they set up to be used on the road. Rather,

the cars are used exclusively for car shows or related promotional photography. With

respect to the exotic automobiles, can Juan take a cost recovery deduction on his Federal

income tax return? Prepare an outline for your classmates addressing this issue.

Partial list of research aids:

Bruce Selig, 70 TCM 1125, T.C.Memo. 1995–519.

Research Problem 4. Many states that have corporate income taxes “piggyback” onto

the Federal corporate income tax calculation. In other words, these states’ corporate

income tax calculations incorporate many of the Federal calculations and deductions

to make both compliance and verification of tax liability easier. However, some state

legislatures were concerned that the domestic production activities deduction, if

allowed for state tax purposes, would result in significant revenue losses. Determine

whether states with corporate income taxes allow or disallow the domestic production

activities deduction in the calculation of the state’s corporate income tax liability.

Be sure to state the sources for your answer.

Research Problem 5. Changes to depreciation systems often are discussed by policymakers

and observers of the tax system. Outline the terms and policy objectives of

one of the changes currently proposed by the Treasury, a member of Congress, or a

tax policy think tank.

 

Roger CPA Review Questions

  1. Regarding the tax treatment of a business’s research and experimental (R&E) expenditures,

which of the following statements is true?

  1. A common reason for electing tax deferral for such expenses is the expectation

of lower tax rates in the future.

  1. Expenses associated with the acquisition of land upon which a purpose-built

R&E facility is constructed are considered R&E expenditures for tax purposes.

  1. Companies generally prefer to expense R&E costs immediately, but may elect

instead to defer and amortize such costs over a minimum of 60 months.

  1. Companies may elect to immediately expense R&E costs incurred in the first

applicable taxable year and all future years through an appropriate filing

with the IRS.

  1. Identify the correct statement below regarding the Domestic Production Activities

Deduction (DPAD).

  1. Qualified Production Activities Income (QPAI) is calculated by applying a percentage

to net income from an IRS rate table based on specific criteria.

  1. The DPAD cannot exceed attributable W-2 wages paid.
  2. A sole proprietorship cannot claim the DPAD, but a partnership or S corporation

with more than one shareholder can.

  1. Taxable income for the purposes of calculating or amending the DPAD includes

any net operating loss (NOL) deduction, such as an NOL carryforward or NOL

carryback.

  1. Newton, a business owner, signed a ten-year lease beginning in July of 20X14, and

immediately paid rent for the remainder of 20X14, all of 20X15, and all of 20X16.

How much of the rent paid at the lease signing can be declared as a business

expense on Schedule C of Newton’s 20X14 tax return?

  1. All of it
  2. The July 20X14 – June 20X15 portion only
  3. None of it
  4. The 20X14 portion only
  5. A sale between which of the following could trigger a gain or a loss for federal tax

purposes?

  1. Husband and wife
  2. Cousin and cousin
  3. Majority shareholder and corporation
  4. Ancestor and descendent
  5. Quanti Co., a calendar-year taxpayer, purchased equipment for $5,000 on December

21, 20X14, representing the company’s only purchase of tangible personal

property that took place during 20X14. On its 20X14 tax return, how many months

of MACRS depreciation may Quanti Co. claim on the tools?

  1. One-and-a-half months
  2. One month
  3. Six months
  4. None
  5. Which of the following is correct about depreciation under federal tax law?
  6. The recovery period is longer than the useful life of the asset.
  7. There are different recovery periods for new and used property.

III. Salvage values are ignored.

  1. I and II only
  2. II only
  3. III only
  4. I, II, and III
  5. Joe purchased a van on February 1, 20X4 for use in his business, Crew Airport

Transport. The van was purchased for $30,000, has an estimated useful life of 10

years, and a salvage value of $2,000. No other assets were put into service that year.

What is Joe’s MACRS depreciation for the van in 20X4?

  1. $2,567
  2. $6,000
  3. $10,500
  4. $10,267
  5. Dolly purchased and placed into service qualifying depreciable property in 20X4 at

a total cost of $2,250,000. Dolly has elected to take the Section 179 deduction. What

is Dolly’s Section 179 deduction for 20X4?

  1. $0
  2. $250,000
  3. $500,000
  4. $1,750,000
  5. Christa purchased and placed into service five-year assets at a total cost of $2,250,000.

If Christa elects both the Section 179 deduction and additional first-year bonus depreciation,

but does not elect the straight-line method, what is Christa’s depreciation

expense for tax purposes for the year, assuming a half-year convention?

  1. $250,000
  2. $500,000
  3. $1,250,000
  4. $1,450,000
  5. Orange, Inc., a calendar-year C corporation, has $800,000 of qualified production

activities income (QPAI) and $950,000 of total taxable income in 20X14. All of the

QDPAI was produced by Orange’s manufacturing plant, which relies mainly on a

temporary employment agency for its workforce, employing only two W-2 employees

who in aggregate earned $140,000 in 20X14. Orange also has an office in

Mexico, which is unrelated to its domestic manufacturing plant and which employs

one W-2 employee, who earned $75,000 in 20X14. What amount of Domestic Production

Activities Deduction may Orange claim on its 20X14 corporate tax return?

  1. $73,350
  2. $72,000
  3. Depends on wages paid by employment agency
  4. $70,000

5-56 PART 2 Structure of the Federal Income Tax

Copyright

 

 

 

CHAPTER6

Losses and Loss Limitations

Computational Exercises

  1. LO.1 During the past tax year, Jane identified $50,000 as a nonbusiness bad debt.

In that tax year, Jane had $100,000 of taxable income, of which $5,000 consisted

of short-term capital gains. During the current tax year, Jane collected $10,000

of the amount she had previously identified as a bad debt. Determine Jane’s tax

treatment of the $10,000 received in the current tax year.

  1. LO.1 Bob owns a collection agency. He purchases uncollected accounts receivable

from other businesses at 60% of their face value and then attempts to collect

these accounts. During the current year, Bob collected $60,000 on an account with

a face value of $80,000. Determine the amount of Bob’s bad debt deduction.

  1. LO.2 On May 9, 2013, Calvin acquired 250 shares of stock in Aero Corporation,

a new startup company, for $68,750. Calvin acquired the stock directly from

Aero, and it is classified as § 1244 stock (at the time Calvin acquired his stock, the

corporation had $900,000 of paid-in capital). On January 15, 2015, Calvin sold all of

his Aero stock for $7,000. Assuming that Calvin is single, determine his tax consequences

as a result of this sale.

  1. LO.3 Mary’s diamond ring was stolen in 2014. She originally paid $8,000 for the

ring, but it was worth considerably more at the time of the theft. Mary filed an

insurance claim for the stolen ring, but the claim was denied. Because the insurance

claim was denied, Mary took a casualty loss deduction for the stolen ring on her

2014 tax return. In 2014, Mary had AGI of $40,000. In 2015, the insurance company

had a “change of heart” and sent Mary a check for $5,000 for the stolen ring. Determine

the proper tax treatment of the $5,000 Mary received from the insurance company

in 2015.

  1. LO.3 Determine the treatment of a loss on rental property under the following

facts:

Basis $650,000

FMV before the loss 800,000

FMV after the loss 200,000

  1. LO.6 In the current year, Ed invests $30,000 in an oil partnership. He has taxable

income for the current year of $2,000 from the oil partnership and withdraws

$10,000. What is Ed’s at-risk amount at the end of the year?

  1. LO.6 Lucy sells her partnership interest, a passive activity, with an adjusted basis of

$305,000 for $330,000. In addition, she has current and suspended losses of

$28,000 associated with the partnership and has no other passive activities. Calculate

Lucy’s total gain and her current deductible loss. Describe the type of income that

the deductible loss may offset.

  1. LO.8 Rhonda has an adjusted basis and an at-risk amount of $7,500 in a passive

activity at the beginning of the year. She also has a suspended passive loss

of $1,500 carried over from the prior year. During the current year, she has a loss

of $12,000 from the passive activity. Rhonda has no passive income from other

sources this year. Determine the following items relating to Rhonda’s passive activity

as of the end of the year.

  1. Adjusted basis and at-risk amount in the passive activity.
  2. Loss suspended under the at-risk rules.
  3. Suspended passive loss.
  4. LO.9 Noah, who has $62,000 of AGI before considering rental activities, has

$70,000 of losses from a real estate rental activity in which he actively participates.

He also actively participates in another real estate rental activity from which

he has $33,000 of income. He has other passive income of $20,000. What amount of

rental loss can Noah use to offset active or portfolio income in the current year?

  1. LO.10 Rose dies with passive activity property having an adjusted basis of $65,000,

suspended losses of $13,000, and a fair market value at the date of her death

of $90,000. Of the $13,000 suspended loss existing at the time of Rose’s death, how

much is deductible on her final return or by the beneficiary?

 

Problems

  1. LO.1 Several years ago, Loon Finance Company, which is in the lending business,

loaned Sara $30,000 to purchase an automobile to be used for personal purposes.

In August of the current year, Sara filed for bankruptcy, and Loon was notified

that it could not expect to receive more than $4,000. As of the end of the

current year, Loon has received $1,000. Loon has contacted you about the possibility

of taking a bad debt deduction for the current year.

Write a letter to Loon Finance Company that contains your advice as to whether

it can claim a bad debt deduction for the current year. Also prepare a memo for the

tax files. Loon’s address is 100 Tyler Lane, Erie, PA 16563.

  1. LO.1 Monty loaned his friend Ned $20,000 three years ago. Ned signed a note and

made payments on the loan. Last year, when the remaining balance was

$11,000, Ned filed for bankruptcy and notified Monty that he would be unable to

pay the balance on the loan. Monty treated the $11,000 as a nonbusiness bad debt.

Last year, Monty had capital gains of $4,000 and taxable income of $20,000. During

the current year, Ned paid Monty $10,000 in satisfaction of the debt. Determine

Monty’s tax treatment for the $10,000 received in the current year.

  1. LO.2 Many years ago, Jack purchased 400 shares of Canary stock. During the current

year, the stock became worthless. It was determined that the company

“went under” because several corporate officers embezzled a large amount of company

funds. Identify the relevant tax issues for Jack.

  1. LO.1 Jake and Mary Snow are residents of the state of New York. They are cash

basis taxpayers and file a joint return for the calendar year. Jake is a licensed

master plumber. Two years ago, Jake entered into a contract with New York City to

perform plumbing services. During the current year, Jake was declared to be in

breach of the contract, and he ceased performing plumbing services. Jake received

a Form W–2 that reported $50,000 for wages paid. He also maintains that the city

has not paid him $35,000 for work he performed. Jake is considering claiming a

$35,000 business bad debt on his tax return. Evaluate Jake’s plan.

  1. LO.1, 2 Mable and Jack file a joint return. For the current year, they had the following

items:

Salaries $120,000

Loss on sale of § 1244 stock acquired two years ago 105,000

Gain on sale of § 1244 stock acquired six months ago 20,000

Nonbusiness bad debt 19,000

Determine the impact of the above items on Mable and Jack’s income for the

current year.

  1. LO.2 Mary, a single taxpayer, purchased 10,000 shares of § 1244 stock several years

ago at a cost of $20 per share. In November of the current year, Mary receives

an offer to sell the stock for $12 per share. She has the option of either selling all of

the stock now or selling half of the stock now and half of the stock in January of

next year. Mary’s salary is $80,000 for the current year, and it will be $90,000 next

year. Mary has long-term capital gains of $8,000 for the current year and will have

$10,000 next year. If Mary’s goal is to minimize her AGI for the two years, determine

whether she should sell all of her stock this year or half of her stock this year and

half next year.

  1. LO.3 Olaf lives in the state of Minnesota. A tornado hit the area and damaged his

home and automobile. Applicable information is as follows:

Item

Adjusted

Basis

FMV

before

FMV

after

Insurance

Proceeds

Home $350,000 $500,000 $100,000 $280,000

Auto 60,000 40,000 10,000 20,000

Because of the extensive damage caused by the tornado, the President designated

the area a disaster area.

Olaf and his wife, Anna, always file a joint return. Their 2014 tax return shows

AGI of $180,000 and taxable income of $140,000. In 2015, their return shows AGI of

$300,000 and taxable income (exclusive of the casualty loss deduction) of $215,000.

Determine the amount of Olaf and Anna’s loss and the year in which they should

take the loss.

  1. LO.3 In 2012, John opened an investment account with Randy Hansen, who

held himself out to the public as an investment adviser and securities

broker. John contributed $200,000 to the account in 2012. John provided Randy

with a power of attorney to use the $200,000 to purchase and sell securities on

John’s behalf. John instructed Randy to reinvest any gains and income earned.

In 2012, 2013, and 2014, John received statements of the amount of income

earned by his account and included these amounts in his gross income for

these years. In 2015, it was discovered that Randy’s purported investment advisory

and brokerage activity was in fact a fraudulent investment arrangement

known as a Ponzi scheme. In reality, John’s account balance was zero, the

money having been used by Randy in his scheme. Identify the relevant tax

issues for John.

  1. LO.4 Mary, a single taxpayer with two dependent children, has the following items

of income and expense during 2015:

Gross receipts from business $144,000

Business expenses 180,000

Alimony received 22,000

Interest income 3,000

Itemized deductions (no casualty or theft) 24,000

  1. Determine Mary’s taxable income for 2015.
  2. Determine Mary’s NOL for 2015.
  3. LO.6 In 2014, Fred invested $50,000 in a general partnership. Fred’s interest is not

considered to be a passive activity. If his share of the partnership losses is

$35,000 in 2014 and $25,000 in 2015, how much can he deduct in each year?

  1. LO.6 In the current year, Bill Parker (54 Oak Drive, St. Paul, MN 55164) is considering

making an investment of $60,000 in Best Choice Partnership. The prospectus

provided by Bill’s broker indicates that the partnership investment is not a

passive activity and that Bill’s share of the entity’s loss in the current year will likely

be $40,000, while his share of the partnership loss next year will probably be

$25,000. Write a letter to Bill in which you indicate how the losses would be treated

for tax purposes in the current year and the following year.

  1. LO.6 A number of years ago, Kay acquired an interest in a partnership in which

she is not a material participant. Kay’s basis in her partnership interest at

the beginning of 2014 is $40,000. Kay’s share of the partnership loss is $35,000

in 2014, while her share of the partnership income is $15,000 in 2015. How

much may Kay deduct in 2014 and 2015, assuming she owns no other passive

activities?

  1. LO.6 Jorge owns two passive investments, Activity A and Activity B. He plans to

dispose of Activity A in the current year or next year. Juanita has offered to

buy Activity A this year for an amount that would produce a taxable passive gain

to Jorge of $115,000. However, if the sale, for whatever reason, is not made to

Juanita, Jorge believes that he could find a buyer who would pay about $7,000 less

than Juanita. Passive losses and gains generated (and expected to be generated) by

Activity B follow:

Two years ago ($35,000)

Last year (35,000)

This year (8,000)

Next year (30,000)

Future years Minimal profits

All of Activity B’s losses are suspended. Should Jorge close the sale of Activity A

with Juanita this year, or should he wait until next year and sell to another buyer?

Jorge is in the 28% tax bracket.

  1. LO.6 Sarah has investments in four passive activity partnerships purchased several

years ago. Last year, the income and losses were as follows:

Activity Income (Loss)

A $ 30,000

B (30,000)

C (15,000)

D (5,000)

In the current year, she sold her interest in Activity D for a $10,000 gain. Activity D,

which had been profitable until last year, had a current loss of $1,500. How will the

sale of Activity D affect Sarah’s taxable income in the current year?

  1. LO.6 Leon sells his interest in a passive activity for $100,000. Determine the tax

effect of the sale based on each of the following independent facts:

  1. Adjusted basis in this investment is $35,000. Losses from prior years that were

not deductible due to the passive loss restrictions total $40,000.

  1. Adjusted basis in this investment is $75,000. Losses from prior years that were

not deductible due to the passive loss restrictions total $40,000.

  1. Adjusted basis in this investment is $75,000. Losses from prior years that were

not deductible due to the passive loss restrictions total $40,000. In addition,

suspended credits total $10,000.

  1. LO.6 In the current year, White, Inc., earns $400,000 from operations and receives

$36,000 in dividends and interest from various portfolio investments. White

also pays $150,000 to acquire a 20% interest in a passive activity that produces a

$200,000 loss.

  1. Assuming that White is a personal service corporation, how will these transactions

affect its taxable income?

  1. Same as (a), except that White is closely held but not a personal service

corporation.

  1. LO.7 John, an engineer, operates a separate business that he acquired eight years

ago. If he participates 85 hours in the business and it incurs a loss of $34,000,

under what circumstances can John claim an active loss?

  1. LO.7 Rene retired from public accounting after a long and successful career of

45 years. As part of her retirement package, she continues to share in the

profits and losses of the firm, albeit at a lower rate than when she was working fulltime.

Because Rene wants to stay busy during her retirement years, she has invested

and works in a local hardware business, operated as a partnership. Unfortunately,

the business has recently gone through a slump and has not been generating profits.

Identify relevant tax issues for Rene.

  1. LO.6, 8 Kristin Graf (123 Baskerville Mill Road, Jamison, PA 18929) is trying to

decide how to invest a $10,000 inheritance. One option is to make an

additional investment in Rocky Road Excursions in which she has an at-risk basis of

$0, suspended losses under the at-risk rules of $7,000, and suspended passive losses

of $1,000. If Kristin makes this investment, her share of the expected profits this year

will be $8,000. If her investment stays the same, her share of profits from Rocky

Road Excursions will be $1,000. Another option is to invest $10,000 as a limited partner

in the Ragged Mountain Winery; this investment will produce passive income of

$9,000. Write a letter to Kristin to review the tax consequences of each alternative.

Kristin is in the 28% tax bracket.

  1. LO.8 The end of the year is approaching, and Maxine has begun to focus on ways

of minimizing her income tax liability. Several years ago, she purchased an

investment in Teal Limited Partnership, which is subject to the at-risk and the passive

activity loss rules. (Last year, Maxine sold a different investment that was subject

to these rules and that produced passive income.) She believes that her investment

in Teal has good long-term economic prospects. However, it has been generating

tax losses for several years in a row. In fact, when she was discussing last year’s

income tax return with her tax accountant, he said that unless “things change” with

respect to her investments, she would not be able to deduct losses this year.

  1. What was the accountant referring to in his comment?
  2. You learn that Maxine’s current at-risk basis in her investment is $1,000 and that

her share of the current loss is expected to be $13,000. Based on these facts,

how will her loss be treated?

  1. After reviewing her situation, Maxine’s financial adviser suggests that she invest

at least an additional $12,000 in Teal to ensure a full loss deduction in the current

year. How do you react to his suggestion?

  1. What would you suggest Maxine consider as she attempts to maximize her

current-year deductible loss?

  1. LO.8 A number of years ago, Lee acquired a 20% interest in the BlueSky Partnership

for $60,000. The partnership was profitable through 2014, and Lee’s

amount at risk in the partnership interest was $120,000 at the beginning of 2015.

BlueSky incurred a loss of $400,000 in 2015 and reported income of $200,000 in

  1. Assuming that Lee is not a material participant, how much of his loss from

BlueSky Partnership is deductible in 2015 and 2016? Consider the at-risk and passive

loss rules, and assume Lee owns no other investments.

  1. LO.6 Grace acquired an activity four years ago. The loss from the activity is

$50,000 in the current year (at-risk basis of $40,000 as of the beginning of the

year). Without considering the loss from the activity, she has gross income of

$140,000. If the activity is a convenience store and Grace is a material participant,

what is the effect of the activity on her taxable income?

  1. LO.5, 6, 8 Jonathan, a physician, earns $200,000 from his practice. He also receives

$18,000 in dividends and interest from various portfolio investments.

During the year, he pays $45,000 to acquire a 20% interest in a partnership that produces

a $300,000 loss. Compute Jonathan’s AGI assuming that:

  1. He does not participate in the operations of the partnership.
  2. He is a material participant in the operations of the partnership.
  3. LO.5, 6, 8 Five years ago, Gerald invested $150,000 in a passive activity, his sole

investment venture. On January 1, 2014, his amount at risk in the activity

was $30,000. His shares of the income and losses were as follows:

Year Income (Loss)

2014 ($40,000)

2015 (30,000)

2016 50,000

Gerald holds no suspended at-risk or passive losses at the beginning of 2014. How

much can Gerald deduct in 2014 and 2015? What is his taxable income from the

activity in 2016? Consider the at-risk rules as well as the passive loss rules.

  1. LO.5, 6, 7 You have just met with Scott Myers (603 Pittsfield Drive, Champaign, IL

61821), a successful full-time real estate developer and investor. During

your meeting, you discussed his tax situation because you are starting to prepare his

current Federal income tax return. During your meeting, Scott mentioned that he

and his wife, Susan, went to great lengths to maximize their participation in an

apartment complex that they own and manage. In particular, Scott included the following

activities in the 540 hours of participation for the current year:

Time spent thinking about the rentals.

  • Time spent by Susan on weekdays visiting the apartment complex to oversee

operations of the buildings (i.e., in a management role).

  • Time spent by both Scott and Susan on weekends visiting the apartment complex

to assess operations. Scott and Susan always visited the complex together on weekends,

and both counted their hours (i.e., one hour at the complex was two hours of

participation).

  • Time spent on weekends driving around the community looking for other potential

rental properties to purchase. Again, both Scott’s hours and Susan’s hours

were counted, even when they drove together.

After reviewing Scott’s records, you note that the apartment complex generated a

significant loss this year. Prepare a letter to Scott describing your position on the

deductibility of the loss.

  1. LO.6, 9 Bonnie and Jake (ages 35 and 36, respectively) are married with no dependents

and live in Montana (not a community property state). Because Jake

has large medical expenses, they seek your advice about filing separately to save

taxes. Their income and expenses for 2015 are as follows:

Bonnie’s salary $ 42,500

Jake’s salary 26,000

Interest income (joint) 1,500

Rental loss from actively managed rental property (23,000)

Jake’s unreimbursed medical expenses 8,500

All other itemized deductions:*

Bonnie 9,000

Jake 3,400

*None subject to limitations.

Determine whether Bonnie and Jake should file jointly or separately for 2015.

  1. LO.9 During the current year, Gene, a CPA, performs services as follows: 1,800

hours in his tax practice and 50 hours in an apartment leasing operation in

which he has a 15% interest. Because of his oversight duties, Gene is considered to

be an active participant. He expects that his share of the loss realized from the apartment

leasing operation will be $30,000 and that his tax practice will show a profit of

approximately $80,000. Gene is single and has no other income. Discuss the character

and treatment of the income and losses generated by these activities.

  1. LO.9 Ida, who has AGI of $80,000 before considering rental activities, is active in three

separate real estate rental activities. Ida has a marginal tax rate of 28%. She has

$12,000 of losses from Activity A, $18,000 of losses from Activity B, and income of

$10,000 from Activity C. She also has $2,100 of tax credits from Activity A. Calculate the

deductions and credits that she is allowed and the suspended losses and credits.

  1. LO.9 Ella has $105,000 of losses from a real estate rental activity in which she actively

participates. She has other rent income of $25,000 and other passive income of

$32,000. Her AGI before considering these items of income and loss is $95,000. How

much rental loss can Ella deduct against active and portfolio income (ignoring the

at-risk rules)? Does she have any suspended losses to carry over? Explain.

  1. LO.5, 6, 10 In the current year, Abe gives an interest in a passive activity to his

daughter, Andrea. The value of the interest at the date of the gift is

$25,000, and its adjusted basis to Abe is $13,000. During the time that Abe owned

the investment, losses of $3,000 could not be deducted because of the passive loss

limitations. What is the tax treatment of the suspended passive activity losses to Abe

and Andrea?

 

Research Problems

Research Problem 1. Esther owns a large home on the East Coast. Her home is surrounded

by large, mature oak trees that significantly increase the value of her home.

In August 2014, a hurricane damaged many of the trees surrounding her home. In

September 2014, Esther engaged a local arborist to evaluate and treat the trees, but

five of the largest trees were seriously weakened by the storm. These trees died from

disease in 2015. Esther has ascertained that the amount of the casualty loss from the

death of the five trees is $25,000; however, she is uncertain in which year to deduct

this loss. Discuss whether the casualty loss should be deducted in the calculation of

Esther’s 2014 or 2015 taxable income.

Partials list of research aids:

Reg. § 1.165–1.

Oregon Mesabi Corporation, 39 B.T.A. 1033 (1939).

Research Problem 2. Five years ago, Bridget decided to purchase a limited partnership

interest in a fast-food restaurant conveniently located near the campus of Southeast

State University. The general partner of the restaurant venture promised her that

the investment would prove to be a winner. During the process of capitalizing the

business, $2 million was borrowed from Northside Bank; however, each of the partners

was required to pledge personal assets as collateral to satisfy the bank loan in

the event that the restaurant defaulted. Bridget pledged shares of publicly traded

stock (worth $200,000, basis of $75,000) to satisfy the bank’s requirement.

The restaurant did a good business until just recently, when flagrant health code

violations were discovered and widely publicized by the media. As a result, business

has declined to a point where the restaurant’s continued existence is doubtful. In

addition, the $2 million loan is now due for payment. Because the restaurant cannot

pay, the bank has called for the collateral provided by the partners to be used to satisfy

the debt. Bridget sells the pledged stock for $200,000 and forwards the proceeds

to the bank. Bridget believes that her share of the restaurant’s current and suspended

passive losses can offset the $125,000 gain from the stock sale. As a result, after netting

the passive losses against the gain, none of the gain is subject to tax.

How do you react to Bridget’s position?

Research Problem 3. During 2015, John was the chief executive officer and a shareholder

of Maze, Inc. He owned 60% of the outstanding stock of Maze. In 2012, John

and Maze, as co-borrowers, obtained a $100,000 loan from United National Bank.

This loan was secured by John’s personal residence. Although Maze was listed as a

co-borrower, John repaid the loan in full in 2015. On Maze’s Form 1120 tax returns,

no loans from shareholders were reported. Discuss whether John is entitled to a bad

debt deduction for the amount of the payment on the loan.

Partial list of research aids:

U.S. v. Generes, 405 U.S. 93 (1972).

Dale H. Sundby, T.C.Memo. 2003–204.

Arrigoni v. Comm., 73 T.C. 792 (1980).

Estate of Herbert M. Rapoport, T.C.Memo. 1982–584.

Clifford L. Brody and Barbara J. DeClerk, T.C. Summary Opinion, 2004–149.

Research Problem 4. Find a newspaper article that discusses tax planning for casualty

losses when a disaster area designation is made. Does the article convey the pertinent

tax rules correctly? Then list all of the locations identified by the President as

Federal disaster areas in the last two years.

Research Problem 5. Investment advisers and tax professionals are continuously striving

to create sophisticated transactions and investment vehicles (i.e., tax-advantaged

investments) that are designed to provide economic benefits to investors by reducing

their taxes. These professionals might like to patent such schemes. Identify whether

patenting a tax shelter is a legal possibility.

Roger CPA Review Questions

  1. Glenn and Mary’s house was damaged by a hurricane in 20X4. The fair value of

their home before the hurricane was $150,000. After the hurricane, the fair value of

their home was $125,000. They received $10,000 from their homeowner’s insurance

policy. What is their casualty loss deduction for 20X4, if their adjusted gross income

was $40,000?

  1. $10,900
  2. $11,000
  3. $14,900
  4. $15,000
  5. Hank’s home is burglarized on December 22, 20X14. Personal property with a fair

market value of $40,000 and an adjusted basis to Hank of $25,000 is stolen. Hank

paid an independent appraiser $700 on December 29 to determine the fair market

value of the property at the time of the break-in. Hank’s homeowner’s insurance

policy leads him to believe he is entitled to receive $15,000 in reimbursement for

the event, but no settlement has been made with the insurance company by yearend.

Hank’s AGI in 20X14 is $30,000. How much may Hank deduct from AGI as a

result of these facts on his 20X14 tax return? Assume Hank itemizes and assume

there has still been no settlement with the insurance company at the time of filing.

  1. $7,000
  2. $21,900
  3. $6,900
  4. $22,000
  5. On the night of October 14, 20X14, a hurricane caused serious damage to Paige’s

personal vehicle and to the roof of her personal residence, a townhome. Just prior

to the hurricane, Paige had a $200,000 basis in her home and a $12,000 basis in her

vehicle, which had a fair market value just prior to the hurricane of $10,000. The

damage to the roof is appraised at $7,000, and the fair market value of the vehicle

immediately after the hurricane is appraised at $5,000. Paige is uninsured and has a

20X14 AGI of $40,000. What amount of casualty loss deduction may Paige claim on

her 20X14 tax return as a result of the hurricane?

  1. $9,800
  2. $7,900
  3. $9,900
  4. $7,800
  5. In 20X14, Adams, an individual, changed residences and converted her former residence

into a passive rental activity. In 20X14, Adams lived in the former residence

for 60 days; incurred $7,000 in qualifying expenses preparing the property for rental;

and rented it to a tenant for 90 days, receiving $3,000 in rent. Before considering the

rental activity, Adams’s adjusted gross income for 20X14 is $120,000. After considering

the rental activity, what should Adams’s 20X14 adjusted gross income be?

  1. $120,000
  2. $116,000
  3. $118,500
  4. $123,000
  5. Lee, a married individual, is an employee with three rental properties in which Lee

does not actively participate. In 20X14, Property 1 had a net loss of $10,000, Property

2 had a net gain of $25,000, and Property 3 had a net loss of $5,000. Lee’s W-2

income in 20X14 was $110,000. Considering only the foregoing facts, what is Lee’s

20X14 adjusted gross income?

  1. $120,000
  2. $125,000
  3. $110,000
  4. $135,000
  5. Anscomb is an employee who also solely owns and actively participates in a rental

activity which produced a $20,000 loss in the current year. Anscomb’s W-2 income

in the current year is $115,000. Considering only the foregoing facts, what should

Anscomb’s adjusted gross income be for the current year?

  1. $97,500
  2. $115,000
  3. $107,500
  4. $102,500
  5. Lewis is not an active participant in three rental activities which have turned profits

in recent years. The following profit and losses apply to the current year for Lewis:

Gain or (Loss)

Rental Activity 1 ($10,000)

Rental Activity 2 12,000

Rental Activity 3 (8,000)

Total ($ 6,000)

What amount of the suspended loss should Lewis allocate to Rental Activity 3?

  1. $4,500
  2. $2,667
  3. $0
  4. Suspended losses may be allocated according to the taxpayer’s preference
  5. Smith bought a rental property in Year 1 for $100,000. In Year 1, Smith’s Adjusted

Gross Income (AGI) was $125,000, and Smith sustained a $30,000 loss on the property.

In Year 2, Smith’s AGI was $175,000, and Smith sustained a $20,000 loss on the

property. In Year 3, Smith sold the property for $155,000. What amount of gain or

loss must Smith report on Smith’s Year 3 tax return as a result of the sale? Assume

Smith actively participated in the rental activity in all three years but is not considered

a real estate professional for tax purposes.

  1. $17,500 gain
  2. $0 (no gain or loss)
  3. $22,500 gain
  4. $20,000 gain
  5. Patel bought a rental property in Year 1 for $150,000. In Year 1, Patel’s Adjusted

Gross Income (AGI) was $100,000, and Patel sustained a $15,000 loss on the property.

In Year 2, Patel’s AGI was $140,000, and Patel sustained a $10,000 loss on the

property. In Year 3, Patel sold the property for $175,000. What amount of gain or

loss must Patel report on Patel’s Year 3 tax return as a result of the sale? Assume

Patel did not actively participate in the rental activity in any of the three years.

  1. $25,000
  2. $0 (no income or loss)
  3. $5,000
  4. $20,000
  5. The following chart applies to Bettelli, an investor who owns two rental activities,

Property A and Property B, and has no other involvement in passive activities:

Property Income (Loss)

Year 1 A ($12,000)

B 5,000

Year 2 A (6,000)

B 1,000

Bettelli met the requirements for active participation in Year 1 but not in Year 2.

Bettelli’s AGI in Year 1 was $140,000; in Year 2, $180,000.

In Year 3, Bettelli sells Property A for a $15,000 gain. How much of the gain must

Bettelli report on Bettelli’s Year 3 tax return?

  1. $0
  2. $3,000
  3. $8,000
  4. $13,000

 

CHAPTER7

Property Transactions: Basis, Gain and Loss, and Nontaxable Exchanges

Computational Exercises

  1. LO.3 Luciana, a nonshareholder, purchases a condominium from her employer for

$85,000. The fair market value of the condominium is $120,000. What is Luciana’s

basis in the condominium and the amount of any income as a result of this

purchase?

  1. LO.3 Sebastian purchases two pieces of equipment for $100,000. Appraisals of the

equipment indicate that the fair market value of the first piece of equipment

is $72,000 and that of the second piece of equipment is $108,000. What is Sebastian’s

basis in these two assets?

  1. LO.2, 4 Lisa sells business property with an adjusted basis of $130,000 to her son,

Alfred, for its fair market value of $100,000.

  1. What is Lisa’s realized and recognized gain or loss?
  2. What is Alfred’s recognized gain or loss if he subsequently sells the property for

$138,000? For $80,000?

  1. LO.4 Arianna’s personal residence has an adjusted basis of $230,000 and a fair market

value of $210,000. Arianna converts the personal residence to rental property.

What is Arianna’s gain basis? What is her loss basis?

  1. LO.1, 4 Peyton sells an office building and the associated land on May 1, 2015.

Under the terms of the sales contract, Peyton is to receive $1,600,000 in

cash. The purchaser is to assume Peyton’s mortgage of $950,000 on the property.

To enable the purchaser to obtain adequate financing, Peyton is to pay the $9,000 in

points charged by the lender. The broker’s commission on the sale is $75,000. The

purchaser agrees to pay the $24,000 in property taxes for the entire year. What is

Peyton’s amount realized?

  1. LO.2, 5 Logan and Johnathan exchange land, and the exchange qualifies as like

kind under § 1031. Because Logan’s land (adjusted basis of $85,000) is

worth $100,000 and Johnathan’s land has a fair market value of $80,000, Johnathan

also gives Logan cash of $20,000.

  1. What is Logan’s recognized gain?
  2. Assume instead that Johnathan’s land is worth $90,000 and he gives Logan

$10,000 cash. Now what is Logan’s recognized gain?

  1. LO.2, 6 Camilo’s property, with an adjusted basis of $155,000, is condemned by

the state. Camilo receives property with a fair market value of $180,000 as

compensation for the property taken.

  1. What is Camilo’s realized and recognized gain?
  2. What is the basis of the replacement property?
  3. LO.2, 7 Constanza, who is single, sells her current personal residence (adjusted basis

of $165,000) for $450,000. She has owned and lived in the house for 30

years. Her selling expenses are $22,500. What is Constanza’s realized and recognized

gain?

 

Problems

  1. LO.1 If a taxpayer sells property for cash, the amount realized consists of the net

proceeds from the sale. For each of the following, indicate the effect on the

amount realized:

  1. The property is sold on credit.
  2. A mortgage on the property is assumed by the buyer.
  3. A mortgage on the property of the buyer is assumed by the seller.
  4. The buyer acquires the property subject to a mortgage of the seller.
  5. Stock that has a basis to the purchaser of $6,000 and a fair market value of

$10,000 is received by the seller as part of the consideration.

  1. LO.1, 2 Pam owns a personal-use boat that has a fair market value of $35,000 and

an adjusted basis of $45,000. Pam’s AGI is $100,000. Calculate the realized

and recognized gain or loss if:

  1. Pam sells the boat for $35,000.
  2. Pam exchanges the boat for another boat worth $35,000.
  3. The boat is stolen and Pam receives insurance proceeds of $35,000.
  4. Would your answer in (a) change if the fair market value and the selling price

of the boat were $48,000?

  1. LO.1, 2 Yancy’s personal residence is condemned as part of an urban renewal

project. His adjusted basis for the residence is $480,000. He receives

condemnation proceeds of $460,000 and invests the proceeds in stocks and bonds.

  1. Calculate Yancy’s realized and recognized gain or loss.
  2. If the condemnation proceeds are $505,000, what are Yancy’s realized and

recognized gain or loss?

  1. What are Yancy’s realized and recognized gain or loss in (a) if the house was

rental property?

  1. LO.1, 2, 3 Finch, Inc., purchases 1,000 shares of Bluebird Corporation stock on

October 3, 2015, for $300,000. On December 12, 2015, Finch purchases

an additional 750 shares of Bluebird stock for $210,000. According to market quotations,

Bluebird stock is selling for $285 per share on December 31, 2015. Finch sells

500 shares of Bluebird stock on March 1, 2016, for $162,500.

  1. What is the adjusted basis of Finch’s Bluebird stock on December 31, 2015?
  2. What is Finch’s recognized gain or loss from the sale of Bluebird stock on March

1, 2016, assuming the shares sold are from the shares purchased on December

12, 2015?

  1. What is Finch’s recognized gain or loss from the sale of Bluebird stock on March

1, 2016, assuming Finch cannot adequately identify the shares sold?

  1. LO.2, 3 Rod Clooney purchases Agnes Mitchell’s sole proprietorship for $990,000

on August 15, 2015. The assets of the business are as follows:

Asset Agnes’s Adjusted Basis FMV

Accounts receivable $ 70,000 $ 70,000

Inventory 90,000 100,000

Equipment 150,000 160,000

Furniture and fixtures 95,000 130,000

Building 190,000 250,000

Land 25,000 75,000

Total $620,000 $785,000

Rod and Agnes agree that $50,000 of the purchase price is for Agnes’s five-year

covenant not to compete.

  1. Calculate Agnes’s realized and recognized gain.
  2. Determine Rod’s basis for each of the assets.
  3. Write a letter to Rod informing him of the tax consequences of the purchase.

His address is 300 Riverview Drive, Delaware, OH 43015.

  1. LO.1, 2, 3 Roberto has received various gifts over the years. He has decided to dispose

of the following assets he received as gifts:

  1. In 1951, he received land worth $32,000. The donor’s adjusted basis was

$35,000. Roberto sells the land for $95,000 in 2015.

  1. In 1956, he received stock in Gold Company. The donor’s adjusted basis was

$19,000. The fair market value on the date of the gift was $34,000. Roberto sells

the stock for $40,000 in 2015.

  1. In 1962, he received land worth $15,000. The donor’s adjusted basis was

$20,000. Roberto sells the land for $9,000 in 2015.

  1. In 2003, he received stock worth $30,000. The donor’s adjusted basis was

$42,000. Roberto sells the stock for $38,000 in 2015.

What is the recognized gain or loss from each of the preceding transactions? Assume

for each of the gift transactions that no gift tax was paid.

  1. LO.1, 2, 3 Nicky receives a car from Sam as a gift. Sam paid $48,000 for the car. He

had used it for business purposes and had deducted $10,000 for depreciation

up to the time he gave the car to Nicky. The fair market value of the car is

$33,000.

  1. Assuming that Nicky uses the car for business purposes, what is her basis for

depreciation?

  1. Assume that Nicky deducts depreciation of $6,500 and then sells the car for

$32,500. What is her recognized gain or loss?

  1. Assume that Nicky deducts depreciation of $6,500 and then sells the car for

$20,000. What is her recognized gain or loss?

  1. LO.3 Simon owns stock that has declined in value since acquired. He has decided

either to give the stock to his nephew, Fred, or to sell it and give Fred the proceeds.

If Fred receives the stock, he will sell it to obtain the proceeds. Simon is in

the 15% tax bracket, while Fred’s bracket is 25%. In either case, the holding period

for the stock will be short-term. Identify the tax issues relevant to Simon in deciding

whether to give the stock or the sale proceeds to Fred.

  1. LO.3 On September 18, 2015, Gerald received land and a building from Frank as a

gift. Frank’s adjusted basis and the fair market value at the date of the gift are

as follows:

Asset Adjusted Basis FMV

Land $100,000 $212,000

Building 80,000 100,000

No gift tax was paid on the transfer.

  1. Determine Gerald’s adjusted basis for the land and building.
  2. Assume instead that the fair market value of the land was $87,000 and that of

the building was $65,000. Determine Gerald’s adjusted basis for the land and

building.

  1. LO.3 Dan bought a hotel for $2,600,000 in January 2011. In May 2015, he died and

left the hotel to Ed. While Dan owned the hotel, he deducted $289,000 of cost

recovery. The fair market value in May 2015 was $2,800,000. The fair market value

six months later was $2,850,000.

  1. What is the basis of the property to Ed?
  2. What is the basis of the property to Ed if the fair market value six months later

was $2,500,000 (not $2,850,000) and the objective of the executor was to minimize

the estate tax liability?

  1. LO.4 Sheila sells land to Elane, her sister, for the fair market value of $40,000. Six

months later when the land is worth $45,000, Elane gives it to Jacob, her son.

(No gift tax resulted.) Shortly thereafter, Jacob sells the land for $48,000.

  1. Assuming that Sheila’s adjusted basis for the land is $24,000, what are Sheila’s

and Jacob’s recognized gain or loss on the sales?

  1. Assuming that Sheila’s adjusted basis for the land is $60,000, what are Sheila’s

and Jacob’s recognized gain or loss on the sales?

  1. LO.1, 2, 3, 4 Tyneka inherited 1,000 shares of Aqua, Inc. stock from Joe. Joe’s basis

was $35,000, and the fair market value on July 1, 2015 (the date of

death), was $45,000. The shares were distributed to Tyneka on July 15, 2015.

Tyneka sold the stock on July 30, 2016, for $33,000. After giving the matter more

thought, she decides that Aqua is a good investment and purchases 1,000 shares for

$30,000 on August 20, 2016.

  1. What is Tyneka’s basis for the 1,000 shares purchased on August 20, 2016?
  2. Could Tyneka have obtained different tax consequences in (a) if she had

sold the 1,000 shares on December 27, 2015, and purchased the 1,000 shares

on January 5, 2016? Explain.

  1. LO.4 Sam owns 1,500 shares of Eagle, Inc. stock that he purchased over 10 years

ago for $80,000. Although the stock has a current market value of $52,000, Sam

still views the stock as a solid long-term investment. He has sold other stock during

the year with overall gains of $30,000, so he would like to sell the Eagle stock and offset

the $28,000 loss against these gains—but somehow keep his Eagle investment. He

has devised a plan to keep his Eagle investment by using funds in his traditional IRA

to purchase 1,500 Eagle shares immediately after selling the shares he currently owns.

Evaluate Sam’s treatment of these stock transactions. Can his plan work? Explain.

  1. LO.1, 2, 4 Abby’s home had a basis of $360,000 ($160,000 attributable to the land)

and a fair market value of $340,000 ($155,000 attributable to the land)

when she converted 70% of it to business use by opening a bed-and-breakfast. Four

years after the conversion, Abby sells the home for $500,000 ($165,000 attributable

to the land).

  1. Calculate Abby’s basis for gain, loss, and cost recovery for the portion of her

personal residence that was converted to business use.

  1. Calculate the cost recovery deducted by Abby during the four-year period of

business use assuming that the bed-and-breakfast is opened on January 1 of

year 1 and the house is sold on December 31 of year 4.

  1. What is Abby’s recognized gain or loss on the sale of the business-use portion?
  2. LO.4 Surendra’s personal residence originally cost $340,000 (ignore land). After living

in the house for five years, he converts it to rental property. At the date of

conversion, the fair market value of the house is $320,000. As to the rental property,

calculate Surendra’s basis for:

  1. Loss.
  2. Depreciation.
  3. Gain.
  4. Could Surendra have obtained better tax results if he had sold his personal residence

for $320,000 and then purchased another house for $320,000 to hold as

rental property? Explain.

  1. LO.5 Sue exchanges a sport utility vehicle (adjusted basis of $16,000; fair market

value of $19,500) for cash of $2,000 and a pickup truck (fair market value of

$17,500). Both vehicles are for business use. Sue believes that her basis for the truck

is $17,500. In calculating her basis, what has Sue failed to consider?

  1. LO.6 A warehouse owned by M&S (a partnership) and used in its business (i.e., to

store inventory) is being condemned by the city to provide a right-of-way for

a highway. The warehouse has appreciated by $180,000 based on an estimate of fair

market value. In the negotiations, the city is offering $35,000 less than what M&S

believes the property is worth. Alan, a real estate broker, has offered to purchase

the property for $20,000 more than the city’s offer. The partnership plans to invest

the proceeds it will receive in an office building that it will lease to various tenants.

  1. Identify the relevant tax issues for M&S.
  2. Would the answer in (a) change if M&S’s warehouse was property being held

for investment rather than being used in its business? Explain.

  1. LO.5 Tanya Fletcher owns undeveloped land (adjusted basis of $80,000 and fair

market value of $92,000) on the East Coast. On January 4, 2015, she

exchanges it with Martin (an unrelated party) for undeveloped land on the West

Coast and $3,000 cash. Martin has an adjusted basis of $72,000 for his land, and its

fair market value is $89,000. As the real estate market on the East Coast is thriving,

on September 1, 2016, Martin sells the land he acquired for $120,000.

  1. What are Tanya’s recognized gain or loss and adjusted basis for the West Coast

land on January 4, 2015?

  1. What are Martin’s recognized gain or loss and adjusted basis for the East Coast

land on January 4, 2015?

  1. What is Martin’s recognized gain or loss from the September 1, 2016 sale?
  2. What effect does Martin’s 2016 sale have on Tanya?
  3. Write a letter to Tanya advising her of the tax consequences of this exchange.

Her address is The Corral, El Paso, TX 79968.

  1. LO.5 Starling Corporation exchanges a yellow bus (used in its business) for Robin

Corporation’s gray bus and some garage equipment (used in its business).

The assets have the following characteristics:

Adjusted Basis Fair Market Value

Yellow bus $6,000 $15,000

Gray bus 3,000 11,000

Equipment 2,000 4,000

  1. What are Starling’s recognized gain or loss and basis for the gray bus and garage

equipment?

  1. What are Robin’s recognized gain or loss and basis for the yellow bus?
  2. LO.5 Maple Company owns a machine (adjusted basis of $90,000; fair market value

of $125,000) that it uses in its business. Maple exchanges it for another

machine (worth $100,000) and stock (worth $25,000). Determine Maple’s:

  1. Realized and recognized gain or loss on the exchange.
  2. Basis in the new machine.
  3. Basis in the stock Maple received.
  4. LO.5 Tulip, Inc., would like to dispose of some land it acquired four years ago

because the land will not continue to appreciate. Its value has increased by

$50,000 over the four-year period. The company also intends to sell stock that has

declined in value by $50,000 during the six months since its purchase. Tulip has four

offers to acquire the stock and land:

Buyer 1: Exchange land.

Buyer 2: Purchase land for cash.

Buyer 3: Exchange stock.

Buyer 4: Purchase stock for cash.

Identify the tax issues relevant to Tulip in disposing of this land and stock.

  1. LO.5 What is the basis of the new property in each of the following exchanges?
  2. Apartment building held for investment (adjusted basis of $145,000) for office

building to be held for investment (fair market value of $225,000).

  1. Land and building used as a barbershop (adjusted basis of $190,000) for land

and building used as a grocery store (fair market value of $350,000).

  1. Office building (adjusted basis of $45,000) for bulldozer (fair market value of

$42,000), both held for business use.

  1. IBM common stock (adjusted basis of $20,000) for ExxonMobil common stock

(fair market value of $28,000).

  1. Rental house (adjusted basis of $90,000) for mountain cabin to be held for personal

use (fair market value of $225,000).

  1. General partnership interest (adjusted basis of $400,000) for a limited partnership

interest (fair market value of $580,000).

  1. LO.1, 2, 5 Rose Company owns Machine A (adjusted basis of $12,000 and fair market

value of $15,000), which it uses in its business. Rose sells Machine A

for $15,000 to Aubry (a dealer) and then purchases Machine B for $15,000 from Joan

(also a dealer). Machine B would normally qualify as like-kind property.

  1. What are Rose Company’s realized and recognized gain on the sale of Machine A?
  2. What is Rose’s basis for Machine B?
  3. What factors would motivate Rose to sell Machine A and purchase Machine B

rather than exchange one machine for the other?

  1. Assume that the adjusted basis of Machine A is $15,000 and the fair market

value of both machines is $12,000. Respond to (a) through (c).

  1. LO.5 Cardinal Properties, Inc., exchanges real estate used in its business along with

stock for real estate to be held for investment. The stock transferred has an

adjusted basis of $45,000 and a fair market value of $50,000. The real estate transferred

has an adjusted basis of $85,000 and a fair market value of $190,000. The real

estate acquired has a fair market value of $240,000.

  1. What is Cardinal’s realized gain or loss?
  2. Its recognized gain or loss?
  3. The basis of the newly acquired real estate?
  4. LO.5 Tom and Frank are brothers. Each owns investment property in the other’s

hometown. To make their lives easier, they decide to legally exchange the

investment properties. Under the terms of the exchange, Frank will transfer realty

(adjusted basis of $52,000; fair market value of $80,000) and Tom will exchange

realty (adjusted basis of $60,000; fair market value of $92,000). Tom’s property is

subject to a mortgage of $12,000 that will be assumed by Frank.

  1. What are Frank’s and Tom’s recognized gains?
  2. What are their adjusted bases?
  3. As an alternative, Frank has proposed that rather than assuming the mortgage, he

will transfer cash of $12,000 to Tom. Tom would use the cash to pay off the mortgage.

Advise Tom on whether this alternative would be beneficial to him from a tax

perspective.

  1. LO.5 Determine the realized, recognized, and postponed gain or loss and the new

basis for each of the following like-kind exchanges:

Adjusted Basis

of Old Asset

Boot

Given

Fair Market Value of

New Asset

Boot

Received

  1. $ 7,000 $ –0– $12,000 $4,000
  2. 14,000 2,000 15,000 –0–
  3. 3,000 7,000 8,000 500
  4. 15,000 –0– 29,000 –0–
  5. 10,000 –0– 11,000 1,000
  6. 17,000 –0– 14,000 –0–
  7. LO.5 Turquoise Realty Company owns an apartment house that has an adjusted basis

of $760,000 but is subject to a mortgage of $192,000. Turquoise transfers

the apartment house to Dove, Inc., and receives from Dove $120,000 in cash and an

office building with a fair market value of $780,000 at the time of the exchange.

Dove assumes the $192,000 mortgage on the apartment house.

  1. What is Turquoise’s realized gain or loss?
  2. What is its recognized gain or loss?
  3. What is the basis of the newly acquired office building?
  4. LO.5 Randall owns an office building (adjusted basis of $250,000) that he has been

renting to a group of physicians. During negotiations over a new seven-year

lease, the physicians offer to purchase the building for $900,000. Randall accepts the

offer with the stipulation that the sale be structured as a delayed § 1031 transaction.

Consequently, the sales proceeds are paid to a qualified third-party intermediary on

the closing date of September 30, 2015. On October 2, 2015, Randall properly identifies

an office building that he would like to acquire. Unfortunately, on November

10, 2015, the property Randall selected is withdrawn from the market. Working with

the intermediary, on November 12, 2015, Randall identifies another office building

that meets his requirements. The purchase of this property closes on December 15,

2015, and the title is transferred to Randall. Randall treats the transaction as a § 1031

like-kind exchange. Even though the original office building identified was not

acquired, Randall concludes that in substance, he has satisfied the 45-day rule. He

identified the acquired office building as soon as the negotiations ceased on his first

choice. Should the IRS accept Randall’s attempt to comply? Explain.

  1. LO.6 Howard’s roadside vegetable stand (adjusted basis of $275,000) is destroyed

by a tractor-trailer accident. He receives insurance proceeds of $240,000

($300,000 fair market value – $60,000 coinsurance). Howard immediately uses the

proceeds plus additional cash of $45,000 to build another roadside vegetable stand

at the same location. What are the tax consequences to Howard?

  1. LO.6 For each of the following involuntary conversions, indicate whether the property

acquired qualifies as replacement property, the recognized gain, and the

basis for the property acquired.

  1. A warehouse is destroyed by a tornado. The space in the warehouse was rented

to various tenants. The adjusted basis was $470,000. The owner of the warehouse

uses all of the insurance proceeds of $700,000 to build a shopping mall

in a neighboring community where no property has been damaged by tornadoes.

The shopping mall is rented to various tenants.

  1. A warehouse is destroyed by fire. The adjusted basis is $300,000. Because of

economic conditions in the area, the owner decides not to rebuild the

warehouse. Instead, it uses all of the insurance proceeds of $400,000 to build a

warehouse in another state.

  1. Ridge’s personal residence is condemned as part of a local government project

to widen the highway from two lanes to four lanes. The adjusted basis is

$170,000. Ridge uses all of the condemnation proceeds of $200,000 to purchase

another personal residence.

  1. Swallow Fashions, Inc., owns a building that is destroyed by a hurricane. The

adjusted basis is $250,000. Because of an economic downturn in the area

caused by the closing of a military base, Swallow decides to rent space for its

retail outlet rather than replace the building. It uses all of the insurance proceeds

of $300,000 to buy a four-unit apartment building in another city. A realtor

in that city will handle the rental of the apartments.

  1. Susan and Rick’s personal residence is destroyed by a tornado. They had

owned it for 15 months. The adjusted basis was $170,000. Because they would

like to travel, they decide not to acquire a replacement residence. Instead, they

invest all of the insurance proceeds of $200,000 in a duplex, which they rent to

tenants.

  1. Ellen and Harry’s personal residence (adjusted basis of $245,000) is destroyed

in a flood. They had owned it for 18 months. Of the insurance proceeds of

$350,000, they reinvest $342,000 in a replacement residence four months later.

  1. LO.6 Edith’s warehouse (adjusted basis of $450,000) is destroyed by a hurricane in

October 2015. Edith, a calendar year taxpayer, receives insurance proceeds

of $525,000 in January 2016. Calculate Edith’s realized gain or loss, recognized gain

or loss, and basis for the replacement property if she:

  1. Acquires a new warehouse for $550,000 in January 2016.
  2. Acquires a new warehouse for $500,000 in January 2016.
  3. Does not acquire replacement property.
  4. LO.7 Wesley, who is single, listed his personal residence with a real estate agent

on March 3, 2015, at a price of $390,000. He rejected several offers in the

$350,000 range during the summer. Finally, on August 16, 2015, he and the purchaser

signed a contract to sell for $363,000. The sale (i.e., closing) took place on

September 7, 2015. The closing statement showed the following disbursements:

Real estate agent’s commission $ 21,780

Appraisal fee 600

Exterminator’s certificate 300

Recording fees 800

Mortgage to First Bank 305,000

Cash to seller 34,520

Wesley’s adjusted basis for the house is $200,000. He owned and occupied the

house for seven years. On October 1, 2015, Wesley purchases another residence for

$325,000.

  1. Calculate Wesley’s recognized gain on the sale.
  2. What is Wesley’s adjusted basis for the new residence?
  3. Assume instead that the selling price is $800,000. What is Wesley’s recognized

gain? His adjusted basis for the new residence?

  1. LO.7 Roby and James have been married for nine years. Roby sells Plum, Inc. stock

that she has owned for four years to James for its fair market value of

$180,000. Her adjusted basis is $200,000.

  1. Calculate Roby’s recognized gain or recognized loss.
  2. Calculate James’s adjusted basis for the stock.
  3. How would the tax consequences in (a) and (b) differ if Roby had made a gift

of the stock to James? Which form of the transaction would you recommend?

 

Research Problems

Research Problem 1. Ruth Ames died on January 10, 2015. In filing the estate tax

return, her executor, Melvin Sims, elects the primary valuation date and amount (fair

market value on the date of death). On March 12, 2015, Melvin invests $30,000 of

cash that Ruth had in her money market account in acquiring 1,000 shares of Orange,

Inc. ($30 per share). On January 10, 2015, Orange was selling for $29 per share. The

stock is distributed to a beneficiary, Annette Rust, on June 1, 2015, when it is selling

for $33 per share. Melvin wants you to determine the amount at which the Orange

shares should appear on the estate tax return and the amount of Annette’s adjusted

basis for the stock. Write a letter to Melvin in which you respond to his inquiry, and

prepare a memo for the tax files. His address is 100 Center Lane, Miami, FL 33124.

Research Problem 2. Terry owns real estate with an adjusted basis of $600,000 and a

fair market value of $1.1 million. The amount of the nonrecourse mortgage on the

property is $2.5 million. Because of substantial past and projected future losses associated

with the real estate development (occupancy rate of only 37% after three

years), Terry deeds the property to the creditor.

  1. What are the tax consequences to Terry?
  2. Assume that the data are the same, except that the fair market value of the property

is $2,525,000. Therefore, when Terry deeds the property to the creditor, she

also receives $25,000 from the creditor. What are the tax consequences to Terry?

Research Problem 3. Ted and Marvin Brown purchased an apartment building in

2004 as equal tenants in common. After a hectic decade of co-ownership, the brothers

decided that their business association should be terminated. This led to the sale

of the apartment building and a division of the proceeds.

The realized gain on the sale of the apartment building for each brother was

$350,000. Ted recognized gain on his share and used the net proceeds to invest in

stock. Marvin wanted to defer any recognized gain, so he worked with a realtor to

identify property that would be eligible for § 1031 like-kind exchange treatment. After

one prospect failed, the realtor identified a single-family home on Lake Tahoe that

was currently being rented by the owner. Marvin agreed with the choice and

acquired the single-family house, using the proceeds from the apartment building.

Because the single-family house qualified as like-kind property, Marvin deferred all

of his realized gain.

After attempting to rent the property for eight months without success, Marvin

concluded that he could not continue to make the mortgage payments on his primary

residence and this rental property. To ease his financial liquidity problem, Marvin

sold his principal residence for a realized gain of $190,000 and moved into the Lake

Tahoe house. He reported no recognized gain on the sale of his principal residence

as the sale qualified for § 121 exclusion treatment.

The IRS issued a deficiency notice to Marvin associated with the sale of the apartment

building. The position of the IRS was that Marvin did not hold the single-family

residence for investment purposes as required by § 1031. Instead, his intention was personal—

to use it as a replacement for his current residence that he planned on selling.

Who should prevail?

Research Problem 4. Many see the “step-up in basis at death” rule of § 1014 as an expensive

tax loophole enjoyed by the wealthy. Find the latest estimates of the revenue

loss to the Treasury that is attributable to this rule.

  1. How does Canada’s tax law determine the basis of property acquired from a

decedent?

  1. Send an e-mail to a member of the House Ways and Means Committee expressing

a preference for the preservation of the current § 1014 rule or the modifications

made to it by the Tax Relief Reconciliation Act of 2001 and the Tax Relief Act of

2010.

Research Problem 5. In general, the 45-day identification period and the 180-day

exchange period for like-kind exchanges cannot be extended. Does this rule change

if the like-kind property or the taxpayer involved in the exchange is located in a

Presidentially declared disaster area? Use the IRS’s website (www.irs.gov) to find

the answer.

 

Roger CPA Review Questions

  1. Kellye purchased her home in 20X4 for $140,000. After living in it for five years, she

sold it in 20X9 for $170,000, its market value. What is the tax treatment of the sale of

Kellye’s home?

  1. A $30,000 gain is recognized, but not reported.
  2. A $30,000 gain is recognized and reported.
  3. A $30,000 gain is carried forward.
  4. The transaction is not reported.
  5. Ike, a single taxpayer, is reassigned for his job and must move to a new state. While

searching for a place to live, he encounters a person who is selling their home in

order to move to Ike’s current city. The two agree to trade their properties to each

other without any further consideration. Ike’s house has a fair market value of

$200,000 and basis of $130,000. He has lived in the house for one year. The house

he is acquiring in the trade has a fair market value of $300,000. What gain will Ike

recognize for federal tax purposes?

  1. $50,000
  2. $100,000
  3. $0
  4. $300,000
  5. Mikhail owns real estate with a basis of $400,000 and a fair market value of

$650,000. He exchanges it for other real estate with a fair market value of $480,000.

In addition, Mikhail is relieved of a mortgage on the old property of $200,000,

assumes a mortgage on the new property of $100,000, and receives $70,000 in cash.

Under Code Section 1031, what is Mikhail’s recognized gain on the exchange?

  1. $170,000
  2. $270,000
  3. $70,000
  4. $350,000
  5. Stephen purchased a video game console five years ago for $500. In order to raise

money for the “latest and greatest” console, Stephen sold his console for $100.

Because of advances in technology, Stephen can purchase the new console for

$400. What is the tax treatment of Stephen’s sale of his console?

  1. Stephen recognizes a $400 loss.
  2. Stephen does not report the sale.
  3. Stephen recognizes a $300 loss.
  4. Stephen recognizes a $100 gain.
  5. Uncle Ubb gave his nephew, Leroy Lamprey, a gift of stock worth $10,000. Uncle

Ubb’s basis in the stock was $15,000. Leroy sold the stock to an unrelated party for

$11,000. What amount of gain or loss should Leroy report as a result of this sale?

  1. $0
  2. $4,000 loss
  3. $200 gain
  4. $1,000 gain
  5. On June 1, 20X13, Gary gave Gertrude a gift of stock worth $10,000, paying no gift

tax on the transaction. Gary had purchased the stock for $7,500 in 20X11. On October

1, 20X13, Gertrude sold the stock to an unrelated party for $11,000. What is the

amount and character of Gertrude’s gain upon the sale?

  1. $1,000 short-term capital gain
  2. $3,500 long-term capital gain
  3. $1,000 long-term capital gain
  4. $3,500 short-term capital gain
  5. Shomit purchases 100 shares of stock in Classy Corporation for $500 in Year 1. On

December 20 of Year 2, he purchases an additional 100 shares in the company for

$400. On December 27 of Year 2, Shomit sells the 100 shares acquired in Year 1 for

$410. What is Shomit’s resulting basis in the shares acquired on December 20 of

Year 2?

  1. $400
  2. $500
  3. $490
  4. $410
  5. Sengupta died on February 1, 20X14, and bequeathed two different assets to a beneficiary,

Roberts. Asset One was distributed to Roberts on April 24, 20X14; Asset Two

was distributed to Roberts on October 25, 20X14. The executor of Sengupta’s estate

makes a qualified alternate valuation date election. The basis of each bequeathed

asset will thus be the fair market value on which date?

Asset One Asset Two

  1. August 1, 20X14 August 1, 20X14
  2. April 24, 20X14 August 1, 20X14
  3. April 24, 20X14 October 25, 20X14
  4. August 1, 20X14 October 25, 20X14

For

 

CHAPTER8

Property Transactions: Capital Gains and Losses, Section 1231, and

Recapture Provisions

Computational Exercises

  1. LO.1 Dexter owns a large tract of land and subdivides it for sale. Assume that

Dexter meets all of the requirements of § 1237 and during the tax year sells

the first eight lots to eight different buyers for $22,000 each. Dexter’s basis in each

lot sold is $15,000, and he incurs total selling expenses of $900 on each sale. What

is the amount of Dexter’s capital gain and ordinary income?

  1. LO.2 Shelia purchases $50,000 of newly issued Gingo Corporation bonds for

$45,000. The bonds have original issue discount (OID) of $5,000. After Sheila

amortized $2,300 of OID and held the bonds for four years, she sold the bonds for

$48,000. What is the amount and character of her gain or loss?

  1. LO.2 Olivia wants to buy some vacant land for investment purposes. She currently

cannot afford the full purchase price. Instead, Olivia pays the landowner

$8,000 to obtain an option to buy the land for $175,000 anytime in the next four

years. Fourteen months after purchasing the option, Olivia sells the option for

$10,000. What is the amount and character of Olivia’s gain or loss?

  1. LO.4 Coline has the following capital gain and loss transactions for 2015.

Short-term capital gain $ 5,000

Short-term capital loss (2,100)

Long-term capital gain (28%) 6,000

Long-term capital gain (15%) 2,000

Long-term capital loss (28%) (10,500)

After the capital gain and loss netting process, what is the amount and character of

Coline’s gain or loss?

  1. LO.4 Elliott has the following capital gain and loss transactions for 2015.

Short-term capital gain $ 1,500

Short-term capital loss (3,600)

Long-term capital gain (28%) 12,000

Long-term capital gain (25%) 4,800

Long-term capital gain (15%) 6,000

Long-term capital loss (28%) (4,500)

Long-term capital loss (15%) (9,000)

After the capital gain and loss netting process, what is the amount and character of

Elliott’s gain or loss?

  1. LO.6, 7 Renata Corporation purchased equipment in 2013 for $180,000 and has

taken $83,000 of regular MACRS depreciation. Renata Corporation sells the

equipment in 2015 for $110,000. What is the amount and character of Renata’s gain

or loss?

  1. LO.6, 7 Jacob purchased business equipment for $56,000 in 2012 and has taken

$35,000 of regular MACRS depreciation. Jacob sells the equipment in 2015

for $26,000. What is the amount and character of Jacob’s gain or loss?

  1. LO.6, 7 Sissie owns two items of business equipment. Both were purchased in

2011 for $100,000, both have a 7-year MACRS recovery period, and both

have an adjusted basis of $37,490. Sissie is considering selling these assets in 2015.

One of them is worth $60,000, and the other is worth $23,000. Because both items

were used in her business, Sissie simply assumes that the loss on one will offset the

gain from the other and that the net gain or loss will increase or reduce her business

income. What is the amount and character of Sissie’s gain or loss?

  1. LO.7 An apartment building was acquired in 2006. The depreciation taken on the

building was $123,000, and the building was sold for a $34,000 gain. What is

the maximum amount of 25% gain?

  1. LO.7 In a § 1031 like-kind exchange, Rafael exchanges equipment that originally

cost $200,000. On the date of the exchange, the equipment given up has an

adjusted basis of $85,000 and a fair market value of $110,000. Rafael pays $15,000

and receives equipment with a fair market value of $125,000. What is the amount

and character of Rafael’s gain or loss?

  1. LO.7 Gaston Corporation distributes § 1245 property as a dividend to its shareholders.

The property’s fair market value is $580,000, and the adjusted basis

is $560,000. In addition, the amount of the recapture potential is $55,000. What is

the amount and character of Gaston’s gain or loss?

 

Problems

  1. LO.1 An individual taxpayer sells some used assets at a garage sale. Why are none

of the proceeds taxable in most situations?

  1. LO.1 Alison owns a painting that she received as a gift from her aunt 10 years ago.

The aunt created the painting. Alison has displayed the painting in her home

and has never attempted to sell it. Recently, a visitor noticed the painting and

offered Alison $5,000 for it. If Alison decides to sell the painting, what tax issues

does she face?

  1. LO.1 During the year, Eugene had the four property transactions summarized

below. Eugene is a collector of antique glassware and occasionally sells a

piece to get funds to buy another. What are the amount and nature of the gain or

loss from each of these transactions?

Property

Date

Acquired Date Sold

Adjusted

Basis

Sales

Price

Antique vase 06/18/04 05/23/15 $37,000 $42,000

Blue Growth Fund (100 shares) 12/23/06 11/22/15 22,000 38,000

Orange bonds 02/12/07 04/11/15 34,000 42,000*

Green stock (100 shares) 02/14/15 11/23/15 11,000 13,000

* The sales price included $750 of accrued interest income.

  1. LO.1 Rennie owns a video game arcade. He buys vintage video games from estates,

often at much less than the retail value of the property. He usually installs the

vintage video games in a special section of his video game arcade that appeals to

players of “classic” video games. Recently, Rennie sold a classic video game that a

customer “just had to have.” Rennie paid $11,250 for it, owned it for 14 months, and

sold it for $18,000. Rennie had suspected that this particular classic video game would

be of interest to collectors; so he had it refurbished, put it on display in his video

arcade, and listed it for sale on the Internet. No customers in the arcade had played it

other than those testing it before considering it for purchase. Rennie would like the

gain on the sale of the classic video game to be a long-term capital gain. Did he

achieve that objective? Why or why not?

  1. LO.1 George is the owner of numerous classic automobiles. His intention is to hold

the automobiles until they increase in value and then sell them. He rents the

automobiles for use in various events (e.g., antique automobile shows) while he is

holding them. In 2015, he sold a classic automobile for $1.5 million. He had held

the automobile for five years, and it had a tax basis of $750,000. Was the automobile

a capital asset? Why or why not?

  1. LO.1 Hyacinth, Inc., is a dealer in securities. The firm has spotted a fast-rising company

and would like to buy and hold its stock for investment. The stock is

currently selling for $2 per share, and Hyacinth thinks it will climb to $40 a share

within two years. How can Hyacinth ensure that any gain it realizes will be taxed as

long-term capital gain? Draft a letter responding to Hyacinth’s inquiry. The firm’s

address is 200 Catamon Drive, Great Falls, MT 59406.

  1. LO.1 Eagle Partners meets all of the requirements of § 1237 (subdivided realty). In

2015, Eagle Partners begins selling lots and sells four separate lots to four different

purchasers. Eagle Partners also sells two contiguous lots to another purchaser.

The sales price of each lot is $30,000. The partnership’s basis for each lot is $15,000.

Selling expenses are $500 per lot.

  1. What are the realized and recognized gain?
  2. Explain the nature of the gain (i.e., ordinary income or capital gain).
  3. Would your answers change if, instead, the lots sold to the fifth purchaser were

not contiguous? If so, how?

  1. LO.1, 2 Benny purchased $400,000 of Peach Corporation face value bonds

for $320,000 on November 13, 2014. The bonds had been issued with

$80,000 of original issue discount because Peach was in financial difficulty in

  1. On December 3, 2015, Benny sold the bonds for $283,000 after amortizing

$1,000 of the original issue discount. What are the nature and amount of Benny’s

gain or loss?

  1. LO.2 Carla was the owner of vacant land that she was holding for investment. She

paid $2 million for the land in 2013. Raymond was an investor in vacant land.

He thought Carla’s land might be the site of an exit ramp from a new freeway.

Raymond gave Carla $836,000 for an option on her land in 2014. The option was

good for two years and gave Raymond the ability to purchase Carla’s land for

$4,765,000. The freeway was not approved by the government, and Raymond’s

option expired in 2015. Does Carla have $836,000 of long-term capital gain upon

the expiration of the option? Explain.

  1. LO.2, 3, 4 Mac, an inventor, obtained a patent on a chemical process to clean old

aluminum siding so that it can be easily repainted. Mac has a $50,000

tax basis in the patent. Mac does not have the capital to begin manufacturing and

selling this product, so he has done nothing with the patent since obtaining it two

years ago.

Now a group of individuals has approached him and offered two alternatives.

Under one alternative, they will pay Mac $600,000 (payable evenly over the next 15

years) for the exclusive right to manufacture and sell the product. Under the other,

they will form a business and contribute capital to it to begin manufacturing and

selling the product; Mac will receive 20% of the company’s shares of stock in

exchange for all of his patent rights. Discuss which alternative is better for Mac.

  1. LO.2 Blue Corporation and Fuchsia Corporation are engaged in a contract negotiation

over the use of Blue’s trademarked name, DateSiteForSeniors. For a onetime

payment of $45,000, Blue licensed Fuchsia to use the name DateSiteForSeniors,

and the license requires that Fuchsia pay Blue a royalty every time a new customer

signs up on Fuchsia’s website. Blue is a developer of “website ideas” that it then

licenses to other companies such as Fuchsia. Did Fuchsia purchase a franchise right

from Blue, or did Fuchsia purchase the name DateSiteForSeniors from Blue?

  1. LO.2 Freys, Inc., sells a 12-year franchise to Red Company. The franchise contains

many restrictions on how Red may operate its store. For instance, Red cannot

use less than Grade 10 Idaho potatoes; must fry the potatoes at a constant 410

degrees; must dress store personnel in Freys-approved uniforms; and must have a

Freys sign that meets detailed specifications on size, color, and construction. When

the franchise contract is signed, Red makes a noncontingent $160,000 payment to

Freys. During the same year, Red pays Freys $300,000—14% of Red’s sales. How

does Freys treat each of these payments? How does Red treat each of the payments?

  1. LO.3 Maria held vacant land that qualified as an investment asset. She purchased

the vacant land on April 10, 2011. She exchanged the vacant land for a rental

house in a qualifying like-kind exchange on January 22, 2015. Maria was going to

hold the house for several years and then sell it. However, she got an “offer she

could not refuse” and sold it on November 22, 2015, for a substantial gain. What

was Maria’s holding period for the house?

  1. LO.3 Thrasher Corporation sells short 100 shares of ARC stock at $20 per share on

January 15, 2015. It buys 200 shares of ARC stock on April 1, 2015, at $25 per

share. On May 2, 2015, Thrasher closes the short sale by delivering 100 of the shares

purchased on April 1.

  1. What are the amount and nature of Thrasher’s loss upon closing the short sale?
  2. When does the holding period for the remaining 100 shares begin?
  3. If Thrasher sells (at $27 per share) the remaining 100 shares on January 20,

2016, what will be the nature of its gain or loss?

  1. LO.1, 3, 4 Elaine Case (single with no dependents) has the following transactions

in 2015:

AGI (exclusive of capital gains and losses) $240,000

Long-term capital gain 22,000

Long-term capital loss (8,000)

Short-term capital gain 19,000

Short-term capital loss (23,000)

What is Elaine’s net capital gain or loss? Draft a letter to Elaine describing how the

net capital gain or loss will be treated on her tax return. Assume that Elaine’s income

from other sources puts her in the 39.6% bracket. Elaine’s address is 300 Ireland

Avenue, Shepherdstown, WV 25443.

  1. LO.4 Sally has taxable income of $160,000 as of November 30 of this year. She

wants to sell a Rodin sculpture that has appreciated $90,000 since she purchased

it six years ago, but she does not want to pay more than $15,000 of additional

tax on the transaction. Sally also owns various stocks, some of which are

currently worth less than their basis. How can she achieve her desired result?

  1. LO.5 Platinum, Inc., has determined its taxable income as $215,000 before considering

the results of its capital gain or loss transactions. Platinum has a shortterm

capital loss of $24,000, a long-term capital loss of $38,000, and a short-term

capital gain of $39,000. What is Platinum’s taxable income? What (if any) are the

amount and nature of its capital loss carryover?

  1. LO.1, 4 The taxpayer is an antiques collector and is going to sell an antique purchased

many years ago for a large gain. The facts and circumstances indicate

that the taxpayer might be classified as a dealer rather than an investor in

antiques. The taxpayer will save $40,000 in taxes if the gain is treated as long-term

capital gain rather than as ordinary income. The taxpayer is considering the following

options as ways to ensure the $40,000 tax savings.

  • Give the antique to his daughter, who is an investment banker, to sell.
  • Merely assume that he has held the antique as an investment.
  • Exchange the antique in a like-kind exchange for another antique he wants.

One of the tax preparers the taxpayer has contacted has said that he would be willing

to prepare the return under the second option. Would you? Why or why not? Evaluate

the other options.

  1. LO.1, 4 In 2015, Bertha Jarow (head of household with three dependents) had a

$28,000 loss from the sale of a personal residence. She also purchased from

an individual inventor for $7,000 (and resold in two months for $18,000) a patent on

a rubber bonding process. The patent had not yet been reduced to practice. Bertha

purchased the patent as an investment. In addition, she had the following capital

gains and losses from stock transactions:

Long-term capital loss ($ 6,000)

Long-term capital loss carryover from 2014 (12,000)

Short-term capital gain 21,000

Short-term capital loss (7,000)

What is Bertha’s net capital gain or loss? Draft a letter to Bertha explaining the tax

treatment of all of these transactions. Assume that Bertha’s income from other sources

puts her in the 28% bracket. Bertha’s address is 1120 West Street, Ashland,

OR 97520.

  1. LO.1, 3, 4 Bridgette is known as the “doll lady.” She started collecting dolls as a

child, always received one or more dolls as gifts on her birthday, never

sold any dolls, and eventually owned 600 dolls. She is retiring and moving to a small

apartment and has decided to sell her collection. She lists the dolls on an Internet

auction site and, to her great surprise, receives an offer from another doll collector

of $45,000 for the entire collection. Bridgette sells the entire collection, except for

five dolls she purchased during the last year. She had owned all of the dolls sold

for more than a year. What tax factors should Bridgette consider in deciding how to

report the sale?

  1. LO.1, 2, 4 Two years ago, Harriet Company (an unincorporated entity) developed

a process for preserving doughnuts that gives the doughnuts a much longer

shelf life. The process is not patented or copyrighted, and only Harriet knows

how it works. A conglomerate has approached Harriet with an offer to purchase the

formula for the process. Specifically, the offer allows Harriet to choose between the

following. Which option should Harriet accept?

  • $650,000 cash for the formula and a 10-year covenant not to compete, paying

Harriet $65,000 per year for 10 years.

  • $650,000 cash for a 10-year covenant not to compete, and an annual $65,000 royalty

for the formula, payable for 10 years.

  1. LO.6 A sculpture that Tulip & Co. held for investment was destroyed in a flood.

The sculpture was insured, and Tulip had a $60,000 gain from this casualty. It

also had a $17,000 loss from an uninsured antique vase that was destroyed by the

flood. The vase was also held for investment. Tulip had no other property transactions

during the year and has no nonrecaptured § 1231 losses from prior years. Both

the sculpture and the vase had been held for more than one year when the flood

occurred. Compute Tulip’s net gain or loss, and identify how it would be treated.

Write a letter to Tulip, explaining the nature of the gain or loss. Tulip’s address is

2367 Meridian Road, Hannibal, MO 63401.

  1. LO.6 Harold, a CPA, has a new client who recently moved to town. Harold prepares

the client’s current-year tax return, which shows a net § 1231 gain.

Harold calls the client to request copies of the returns for the preceding five years to

determine if there are any § 1231 lookback losses. The client says that the returns

are “still buried in the moving mess somewhere” and cannot be found. The client

also says that he does not remember any § 1231 net losses on the prior year returns.

What should Harold do? Justify your answer.

  1. LO.6 Geranium, Inc., has the following net § 1231 results for each of the years

shown. What is the nature of the net gain in 2014 and 2015?

Tax Year Net § 1231 Loss Net § 1231 Gain

2010 $18,000

2011 33,000

2012 42,000

2013 $41,000

2014 30,000

2015 41,000

  1. LO.6 Delphinium Company owns two parcels of land (§ 1231 assets). One parcel

can be sold at a loss of $60,000, and the other parcel can be sold at a gain of

$70,000. The company has no nonrecaptured § 1231 losses from prior years. The

parcels could be sold at any time because potential purchasers are abundant. The

company has a $35,000 short-term capital loss carryover from a prior tax year

and no capital assets that could be sold to generate long-term capital gains. Both

land parcels have been held more than one year. What should Delphinium do

based upon these facts? (Assume that tax rates are constant, and ignore the present

value of future cash flows.)

  1. LO.6, 7 Siena Industries (a sole proprietorship) sold three § 1231 assets on October

10, 2015. Data on these property dispositions are as follows.

Asset Cost Acquired Depreciation Sold for

Rack $100,000 10/10/11 $62,000 $85,000

Forklift 35,000 10/16/12 23,000 5,000

Bin 87,000 03/12/14 34,000 60,000

  1. Determine the amount and the character of the recognized gain or loss from the

disposition of each asset in 2015.

  1. Assuming that Siena has no nonrecaptured net § 1231 losses from prior years,

how much of the recognized gains are treated as long-term capital gains?

  1. LO.6, 7 On December 1, 2013, Lavender Manufacturing Company (a corporation)

purchased another company’s assets, including a patent. The patent was

used in Lavender’s manufacturing operations; $49,500 was allocated to the patent,

and it was amortized at the rate of $275 per month. On July 30, 2015, Lavender sold

the patent for $95,000. Twenty months of amortization had been taken on the patent.

What are the amount and nature of the gain Lavender recognizes on the disposition

of the patent? Write a letter to Lavender, discussing the treatment of the gain.

Lavender’s address is 6734 Grover Street, Boothbay Harbor, ME 04538. The letter

should be addressed to Bill Cubit, Controller.

  1. LO.6, 7 Larry is the sole proprietor of a trampoline shop. During 2015, the following

transactions occurred.

  • Unimproved land adjacent to the store was condemned by the city on February 1.

The condemnation proceeds were $15,000. The land, acquired in 1986, had an

allocable basis of $40,000. Larry has additional parking across the street and plans

to use the condemnation proceeds to build his inventory.

  • A truck used to deliver trampolines was sold on January 2 for $3,500. The truck was

purchased on January 2, 2011, for $6,000. On the date of sale, the adjusted basis

was zero.

  • Larry sold an antique rowing machine at an auction. Net proceeds were $4,900.

The rowing machine was purchased as used equipment 17 years ago for $5,200

and is fully depreciated.

  • Larry sold an apartment building for $300,000 on September 1. The rental property

was purchased on September 1, 2012, for $150,000 and was being depreciated

over a 27.5-year MACRS life using the straight-line method. At the date of

sale, the adjusted basis was $124,783.

  • Larry’s personal yacht was stolen on September 5. The yacht had been purchased

in August at a cost of $25,000. The fair market value immediately preceding the

theft was $19,600. Larry was insured for 50% of the original cost, and he received

$12,500 on December 1.

  • Larry sold a Buick on May 1 for $9,600. The vehicle had been used exclusively for

personal purposes. It was purchased on September 1, 2011, for $20,800.

  • Larry’s trampoline stretching machine (owned two years) was stolen on May 5,

but the business’s insurance company will not pay any of the machine’s value

because Larry failed to pay the insurance premium. The machine had a fair market

value of $8,000 and an adjusted basis of $6,000 at the time of theft.

  • Larry had AGI of $102,000 from sources other than those described above.
  • Larry has no nonrecaptured § 1231 lookback losses.
  1. For each transaction, what are the amount and nature of recognized gain or

loss?

  1. What is Larry’s 2015 AGI?
  2. LO.6, 7 A business building on which straight-line depreciation of $13,000 was

taken is sold on the installment basis for $100,000 with $20,000 down and

four yearly installments of $20,000 plus interest. The adjusted basis for the building

is $35,000 at the time of the sale. The building had been held for more than

12 months. What are the amount and nature of the recognized gain?

  1. LO.7 Nicholas owns business equipment with a $155,000 adjusted basis; he paid

$200,000 for the equipment, and it is currently worth $173,000. Nicholas dies

suddenly, and his son Alvin inherits the property. What is Alvin’s basis for the property?

What happens to the § 1245 depreciation recapture potential?

Research Problems

Research Problem 1. Clyde had worked for many years as the chief executive of Red

Industries, Inc., and had been a major shareholder. Clyde and the company had a

falling out, and Clyde was terminated. Clyde and Red executed a document under

which Clyde’s stock in Red would be redeemed and Clyde would agree not to compete

against Red in its geographic service area. After extensive negotiations between

the parties, Clyde agreed to surrender his Red stock in exchange for $600,000.

Clyde’s basis in his shares was $143,000, and he had held the shares for 17 years.

The agreement made no explicit allocation of any of the $600,000 to Clyde’s agreement

not to compete against Red. How should Clyde treat the $600,000 payment on

his 2015 tax return?

Research Problem 2. Ali owns 100 shares of Brown Corporation stock. He purchased

the stock at five different times and at five different prices per share as indicated.

Share Block Number of Shares Per Share Price Purchase Date

A 10 $60 10/10/1998

B 20 20 08/11/1999

C 15 15 10/24/2000

D 35 30 04/23/2001

E 20 25 07/28/2002

On April 28, 2015, Ali will sell 40 shares of Brown stock for $40 per share. All of Ali’s

shares are held by his stockbroker. The broker’s records track when the shares were

purchased. May Ali designate the shares he sells? If so, which shares should he sell?

Assume that Ali wants to maximize his gain because he has a capital loss carryforward.

Research Problem 3. Siva Nathaniel owns various plots of land in Fulton County,

Georgia. He acquired the land at various times during the last 20 years. About every

fourth year, Siva subdivides into lots one of the properties he owns. He then has

water, sewer, natural gas, and electricity hookups put in each lot and paves new

streets. Siva has always treated his sales of such lots as sales of capital assets. His previous

tax returns were prepared by an accountant whose practice you recently purchased.

Has the proper tax treatment been used on the prior tax returns? Explain.

Partial list of research aids:

  • § 1221 and 1237.

Jesse W. and Betty J. English, 65 TCM 2160, T.C.Memo. 1993–111.

Research Problem 4. Find a website, other than the IRS website, that discusses the

taxation of short sales of securities.

Research Problem 5. Perform a Google search to find information about capital gains

tax rates worldwide (and across U.S. states). Try searching for: “capital gains rate by

country (state).” What jurisdiction has the highest capital gains tax rate? What U.S.

states have high capital gains tax rates?

Roger CPA Review Questions

  1. Identify which of the following is a capital asset:
  2. A canvas painting of a portrait client, in the painter’s hands
  3. Depreciable fixtures in a business parking lot

III. Treasury stock

  1. II only
  2. II and III only
  3. III only
  4. None of the above
  5. On January 15 of the current year, Kreutzer, an individual, inherited from Gladstone

shares of stock worth $25,000. Gladstone had purchased the shares in June of the

previous year for $20,000, and the shares were worth $23,000 at Gladstone’s date of

death. The executor of Gladstone’s estate did not elect to use the alternate valuation

date. In March of the current year, Kreutzer sold the shares for $27,000. As a result

of the sale, what will be the amount and type of gain reported by Kreutzer?

  1. $4,000 long-term capital gain
  2. $2,000 short-term capital gain
  3. $7,000 short-term capital gain
  4. $2,000 long-term capital gain
  5. In 20X14, Colossus Corporation incurred a net capital loss in the amount of $25,000.

Colossus had the following net capital gains in the previous five years:

20X13 – $7,000

20X12 – $2,000

20X11 – $5,000

20X10 – $4,000

20X09 – $3,000

How much of the 20X14 net capital loss may Colossus carry over to 20X15?

  1. $0
  2. $8,000
  3. $11,000
  4. $1,000
  5. The following facts apply to Eliot, an individual, in the current year:

April 1: Sold shares of stock, purchased on April 1 of the previous year, for a $2,000

gain

May 15: Sold equipment used in Eliot’s business, which had been purchased in July

of the previous year, for a $2,000 gain.

July 12: Sold shares of stock, purchased in February of the previous year, for a

$7,000 gain.

November 3: Sold equipment used in Eliot’s business, which had been purchased in

January of the current year, for a $1,000 loss.

December 9: Sold shares of stock, purchased on February 22 of the current year, for

a $3,000 loss.

Considering only the above facts, what is Eliot’s net capital gain for the current year?

  1. $7,000 long-term capital gain
  2. $9,000 long-term capital gain
  3. $5,000 long-term capital gain
  4. $6,000 long-term capital gain
  5. Joe purchased a van for $30,000 on February 1, 20X4, for use with his business, Crew

Airport Transport. Joe elected to take the Section 179 deduction. On January 1, 20X6,

Joe sold the van for $20,000. What were the tax effects of this transaction?

  1. $10,000 loss
  2. $20,000 capital gain
  3. $20,000 ordinary gain
  4. $10,000 capital gain, $10,000 ordinary gain
  5. In Year 3, Daniels, an individual, sold Section 1245 property for $21,000 that had an

adjusted basis of $12,000, resulting in a $9,000 gain. The property had cost Daniels

$20,000 when purchased in Year 1, and $8,000 of MACRS depreciation had been

taken. How should Daniels report the gain on Daniels’ Year 3 tax return?

  1. As a long-term capital gain of $9,000
  2. As an ordinary gain of $1,800 and a long-term capital gain of $7,200
  3. As an ordinary gain of $8,000 and a long-term capital gain of $1,000
  4. As an ordinary gain of $7,200 and a long-term capital gain of $1,800
  5. Cowabunga Corp. had a highly profitable Year 4, during which it purchased

$1,000,000 in tangible personal property and elected to claim the highest depreciation

expense allowed for tax purposes under Code Section 179. In Year 6, Cowabunga

sells the tangible personal property, which now has an adjusted basis of

$200,000 as a result of the heavy depreciation taken in Years 4 and 5. Had only

MACRS depreciation been taken on the property, its adjusted basis at the time of

sale would have been $800,000. At a sales price of $930,000, how much of the

$730,000 realized gain must be reported as ordinary gain for tax purposes?

  1. $720,000
  2. $600,000
  3. $0
  4. $730,000

CHAPTER9

Individuals as the Taxpayer

Computational Exercises

  1. LO.2 Sam and Abby are dependents of their parents, and each has income of

$2,100 for the year. Sam’s standard deduction for the year is $1,050, while

Abby’s is $2,450. As their income is the same, what causes the difference in the

amount of the standard deduction?

  1. LO.2 Compute the 2015 standard deduction for the following taxpayers.
  2. Margie is 15 and claimed as a dependent by her parents. She has $800 in dividend

income and $1,400 in wages from a part-time job.

  1. Ruby and Woody are married and file a joint tax return. Ruby is age 66 and

Woody is 69. Their taxable retirement income is $10,000.

  1. Shonda is age 68 and single. She is claimed by her daughter as a dependent.

Her earned income is $500 and her interest income is $125.

  1. Frazier, age 55, is married but is filing a separate return. His wife itemizes her

deductions.

  1. LO.4 In 2015, Dominique and Felix are married and file a joint tax return. Their

AGI is $312,650 and they claim three exemptions. Determine their total

exemption amount for 2015.

  1. LO.5 Paul and Sonja, who are married, had itemized deductions of $8,200 and

$400, respectively, during 2015. Paul suggests that they file separately—he

will itemize his deductions from AGI, and she will claim the standard deduction.

  1. Evaluate Paul’s suggestion.
  2. What should they do?
  3. LO.6 Compute the 2015 tax liability and the marginal and average tax rates for the

following taxpayers (use the 2015 tax rate schedules in Appendix A for this

purpose).

  1. Chandler, who files as a single taxpayer, has taxable income of $91,000.
  2. Lazare, who files as a head of household, has taxable income of $56,000.
  3. LO.6 George and Aimee are married. George has wage income of $190,000 and

Aimee has a sole proprietorship that generated net income of $85,000. They

also have interest and dividend income of $21,000. Compute any NIIT and Additional

Medicare Tax they owe for the current year.

  1. LO.7 In 2015, Simon, age 12, has interest income of $800 and dividend income of

$4,000. He has no investment expenses. His parents have taxable income of

$80,200 and file a joint tax return. Assume that no parental election is made. Determine

Simon’s net unearned income, allocable parental tax, and total tax liability.

 

Problems

  1. LO.1, 5 During the year, Addison is involved in the following transactions:
  • Lost money gambling on a recent trip to a casino.
  • Helped pay for her neighbor’s dental bills. The neighbor is a good friend who is

unemployed.

  • Received from the IRS a tax refund due to Addison’s overpayment of last year’s

Federal income taxes.

  • Paid a traffic ticket received while double parking to attend a business meeting.
  • Contributed to the mayor’s reelection campaign. The mayor had promised Addison

to have some of her land rezoned. The mayor was reelected and got Addison’s land

rezoned.

  • Borrowed money from a bank to make a down payment on an automobile.
  • Sold a houseboat and a camper on eBay. Both were personal use items, and the

gain from one offset the loss from the other.

  • Her dependent grandfather died on June 3 of the year.
  • Paid for dependent grandfather’s funeral expenses.
  • Paid premiums on her dependent son’s life insurance policy.

What are the possible income tax ramifications of these transactions?

  1. LO.1 Which of the following items are inclusions in gross income?
  2. During the year, stock the taxpayer purchased as an investment doubled

in value.

  1. Amount an off-duty motorcycle police officer received for escorting a funeral

procession.

  1. While his mother was in the hospital, the taxpayer sold her jewelry and gave

the money to his girlfriend.

  1. Child support payments received.
  2. A damage deposit the taxpayer recovered when he vacated the apartment he

had rented.

  1. Interest received by the taxpayer on an investment in general purpose bonds

issued by IBM.

  1. Amounts received by the taxpayer, a baseball “Hall of Famer,” for autographing

sports equipment (e.g., balls and gloves).

  1. Tips received by a bartender from patrons. (Taxpayer is paid a regular salary by

the cocktail lounge that employs him.)

  1. Taxpayer sells his Super Bowl tickets for three times what he paid for them.
  2. Taxpayer receives a new BMW from his grandmother when he passes the CPA

exam.

  1. LO.1 Which of the following items are exclusions from gross income?
  2. Alimony payments received.
  3. Damages award received by the taxpayer for personal physical injury—none

were for punitive damages.

  1. A new golf cart won in a church raffle.
  2. Amount collected on a loan previously made to a college friend.
  3. Insurance proceeds paid to the taxpayer on the death of her uncle—she was

the designated beneficiary under the policy.

  1. Interest income on City of Chicago bonds.
  2. Jury duty fees.
  3. Stolen funds the taxpayer had collected for a local food bank drive.
  4. Reward paid by the IRS for information provided that led to the conviction of

the taxpayer’s former employer for tax evasion.

  1. An envelope containing $8,000 found (and unclaimed) by the taxpayer in a bus

station.

  1. LO.1 In late 2015, the Polks come to you for tax advice. They are considering

selling some stock investments for a loss and making a contribution to a

traditional IRA. In reviewing their situation, you note that they have large medical

expenses and a casualty loss, neither of which is covered by insurance. What advice

would you give the Polks?

  1. LO.1, 2, 3, 4 Compute the taxable income for 2015 in each of the following independent

situations:

  1. Drew and Meg, ages 40 and 41, respectively, are married and file a joint return.

In addition to four dependent children, they have AGI of $65,000 and itemized

deductions of $15,000.

  1. Sybil, age 40, is single and supports her dependent parents, who live with her,

as well as her grandfather, who is in a nursing home. She has AGI of $80,000

and itemized deductions of $8,000.

  1. Scott, age 49, is a surviving spouse. His household includes two unmarried stepsons

who qualify as his dependents. He has AGI of $75,000 and itemized

deductions of $10,100.

  1. Amelia, age 33, is an abandoned spouse who maintains a household for her

three dependent children. She has AGI of $58,000 and itemized deductions of

$9,500.

  1. Dale, age 42, is divorced but maintains the home in which he and his daughter,

Jill, live. Jill is single and qualifies as Dale’s dependent. Dale has AGI of $64,000

and itemized deductions of $9,900.

  1. LO.1, 2, 3, 4 Compute the taxable income for 2015 for Emily on the basis of the following

information. Her filing status is single.

Salary $85,000

Interest income from bonds issued by Xerox 1,100

Alimony payments received 6,000

Contribution to traditional IRA 5,500

Gift from parents 25,000

Short-term capital gain from stock investment 2,000

Amount lost in football office pool 500

Number of potential dependents (two cousins, who live in Canada) ?

Age 40

  1. LO.1, 2, 3, 4 Compute the taxable income for 2015 for Aiden on the basis of the following

information. Aiden is married but has not seen or heard from

his wife since 2013.

Salary $ 80,000

Interest on bonds issued by the City of Boston 3,000

Interest on CD issued by Wells Fargo Bank 2,000

Cash dividend received on Chevron common stock 2,200

Life insurance proceeds paid on death of aunt (Aiden was the designated

beneficiary of the policy) 200,000

Inheritance received upon death of aunt 100,000

Jackson (a cousin) repaid a loan Aiden made to him in 2009 (no interest was

provided for) 5,000

Itemized deductions (state income tax, property taxes on residence, interest on

home mortgage, and charitable contributions) 9,700

Number of dependents (children, ages 17 and 18, and mother-in-law, age 70) 3

Age 43

  1. LO.2 In choosing between the standard deduction and itemizing deductions from

AGI, what effect, if any, does each of the following have?

  1. The age of the taxpayer(s).
  2. The health (i.e., physical condition) of the taxpayer.
  3. Whether taxpayers rent or own their residence.
  4. Taxpayer’s filing status (e.g., single, married, filing jointly).
  5. Whether married taxpayers decide to file separate returns.
  6. The taxpayer’s uninsured personal residence was recently destroyed by fire.
  7. The number of personal and dependency exemptions the taxpayer can claim.
  8. LO.2, 3, 5 David is age 78, is a widower, and is being claimed as a dependent by

his son. How does this situation affect the following?

  1. David’s own individual filing requirement.
  2. David’s personal exemption.
  3. The standard deduction allowed to David.
  4. The availability of any additional standard deduction.
  5. LO.2 Determine the amount of the standard deduction allowed for 2015 in the following

independent situations. In each case, assume that the taxpayer is

claimed as another person’s dependent.

  1. Curtis, age 18, has income as follows: $700 interest from a certificate of deposit

and $6,100 from repairing cars.

  1. Mattie, age 18, has income as follows: $600 cash dividends from a stock investment

and $4,700 from handling a paper route.

  1. Mel, age 16, has income as follows: $675 interest on a bank savings account

and $800 for painting a neighbor’s fence.

  1. Lucy, age 15, has income as follows: $400 cash dividends from a stock investment

and $500 from grooming pets.

  1. Sarah, age 67 and a widow, has income as follows: $500 from a bank savings

account and $3,200 from babysitting.

  1. LO.4 Using the legend provided below, classify each statement as to the taxpayer

for dependency exemption purposes.

Legend

QC ¼ Could be a qualifying child

QR ¼ Could be a qualifying relative

B ¼ Could satisfy the definition of both a qualifying child and a qualifying relative

N ¼ Could not satisfy the definition of either a qualifying child or a qualifying relative

  1. Taxpayer’s son has gross income of $7,000.
  2. Taxpayer’s niece has gross income of $3,000.
  3. Taxpayer’s uncle lives with him.
  4. Taxpayer’s daughter is age 25 and disabled.
  5. Taxpayer’s daughter is age 18, has gross income of $8,000, and does not live

with him.

  1. Taxpayer’s cousin does not live with her.
  2. Taxpayer’s brother does not live with her.
  3. Taxpayer’s sister has dropped out of school, is age 17, and lives with him.
  4. Taxpayer’s older nephew is age 23 and a full-time student.
  5. Taxpayer’s grandson lives with her and has gross income of $7,000.
  6. LO.4 Caden and Lily are divorced on March 3, 2014. For financial reasons, however,

Lily continues to live in Caden’s apartment and receives her support

from him. Caden does not claim Lily as a dependent on his 2014 Federal income tax

return but does so on his 2015 return. Explain.

  1. LO.3, 4 For tax year 2015, determine the number of personal and dependency

exemptions in each of the following independent situations:

  1. Leo and Amanda (ages 48 and 46, respectively) are husband and wife and furnish

more than 50% of the support of their two children, Elton (age 18) and

Trista (age 24). During the year, Elton earns $4,500 providing transportation for

elderly persons with disabilities, and Trista receives a $5,000 scholarship for tuition

at the law school she attends.

  1. Audry (age 45) was divorced this year. She maintains a household in which

she, her ex-husband (Clint), and his mother (Olive) live and furnishes more

than 50% of their support. Olive is age 91 and blind.

  1. Crystal, age 45, furnishes more than 50% of the support of her married son, Andy

(age 18), and his wife, Paige (age 19), who live with her. During the year, Andy

earned $8,000 from a part-time job. All parties live in Iowa (a common law state).

  1. Assume the same facts as in (c), except that all parties live in Washington (a

community property state).

  1. LO.3, 4 Sam and Elizabeth Jefferson file a joint return and have three children—all

of whom qualify as dependents. If the Jeffersons have AGI of $332,000,

what is their allowable deduction for personal and dependency exemptions for

2015?

  1. LO.4 Wesley and Myrtle (ages 90 and 88, respectively) live in an assisted care facility

and for 2014 and 2015 received their support from the following sources:

Percentage of Support

Social Security benefits 16%

Son 20

Niece 29

Cousin 12

Brother 11

Family friend (not related) 12

  1. Which persons are eligible to claim the dependency exemptions under a multiple

support agreement?

  1. Must Wesley and Myrtle be claimed by the same person(s) for both 2014 and

2015? Explain.

  1. Who, if anyone, can claim their medical expenses?
  2. LO.2, 7 Taylor, age 18, is claimed as a dependent by her parents. For 2015, she has

the following income: $4,000 of wages from a summer job, $1,800 of interest

from a money market account, and $2,000 of interest from City of Boston bonds.

  1. What is Taylor’s taxable income for 2015?
  2. What is Taylor’s tax for 2015? [Her parents file a joint return and have taxable

income of $130,000 (no dividends or capital gains).]

  1. LO.4 Walter and Nancy provide 60% of the support of their daughter (age 18)

and son-in-law (age 22). The son-in-law (John) is a full-time student at a

local university, while the daughter (Irene) holds various part-time jobs from

which she earns $11,000. Walter and Nancy engage you to prepare their tax return

for 2015. During a meeting with them in late March 2016, you learn that John and

Irene have filed a joint return. What tax advice would you give based on the following

assumptions:

  1. All parties live in Louisiana (a community property state).
  2. All parties live in New Jersey (a common law state).
  3. LO.1, 4, 6 Charlotte (age 40) is a surviving spouse and provides all of the support of

her four minor children who live with her. She also maintains the household

in which her parents live and furnished 60% of their support. Besides interest on

City of Miami bonds in the amount of $5,500, Charlotte’s father received $2,400 from

a part-time job. Charlotte has a salary of $80,000, a short-term capital loss of $2,000, a

cash prize of $4,000 from a church raffle, and itemized deductions of $10,500. Using

the Tax Rate Schedules, compute the 2015 tax liability for Charlotte.

  1. LO.1, 2, 3, 4, 5, 6 Morgan (age 45) is single and provides more than 50% of the support

of Rosalyn (a family friend), Flo (a niece, age 18), and Jerold

(a nephew, age 18). Both Rosalyn and Flo live with Morgan, but Jerold (a French citizen)

lives in Canada. Morgan earns a salary of $95,000, contributes $5,000 to a traditional

IRA, and receives sales proceeds of $15,000 for an RV that cost $60,000 and

was used for vacations. She has $8,200 in itemized deductions. Using the Tax Rate

Schedules, compute the 2015 tax liability for Morgan.

  1. LO.5 Bob and Carol have been in and out of marital counseling for the past few

years. Early in 2015, they decide to separate. However, because they are

barely able to get by on their current incomes, they cannot afford separate housing

or the legal costs of a divorce. So, Bob moves out of their house in March and takes

up residence in their detached garage (which has an enclosed workshop and bathroom).

Carol stays in the house with their two children and pays more than half

of the costs of maintaining their residence. Bob does not enter the house for the

remainder of the year. Can Carol qualify as an abandoned spouse?

  1. LO.5 Which of the following individuals are required to file a tax return for 2015?

Should any of these individuals file a return even if filing is not required? Why

or why not?

  1. Patricia, age 19, is a self-employed single individual with gross income of

$5,200 from an unincorporated business. Business expenses amounted to

$4,900.

  1. Mike is single and is 67 years old. His gross income from wages was $10,800.
  2. Ronald is a dependent child under age 19 who received $6,500 in wages from a

part-time job.

  1. Sam is married and files a joint return with his spouse, Lana. Both Sam and Lana

are 67 years old. Their combined gross income was $24,250.

  1. Quinn, age 20, is a full-time college student who is claimed as a dependent by

his parents. For 2015, Quinn has taxable interest and dividends of $2,500.

  1. LO.5, 6 Roy and Brandi are engaged and plan to get married. During 2015, Roy is a

full-time student and earns $9,000 from a part-time job. With this income,

student loans, savings, and nontaxable scholarships, he is self-supporting. For the

year, Brandi is employed and has wages of $61,000. How much income tax, if any,

can Brandi save if she and Roy marry in 2015 and file a joint return?

  1. LO.6 Jayden calculates his 2015 income tax by using both the Tax Tables and the

Tax Rate Schedules. Because the Tax Rate Schedules yield a slightly lower tax

liability, he plans to pay this amount.

  1. Why is there a difference?
  2. Is Jayden’s approach permissible? Why or why not?
  3. LO.1, 3, 7 Paige, age 17, is claimed as a dependent on her parents’ 2015 return, on

which they report taxable income of $120,000 (no qualified dividends or

capital gains). Paige earned $3,900 pet sitting and $4,100 in interest on a savings

account. What are Paige’s taxable income and tax liability for 2015?

  1. LO.1, 3, 7 Terri, age 16, is claimed as a dependent on her parents’ 2015 return. During

the year, Terri earned $5,000 in interest income and $3,000 from

part-time jobs.

  1. What is Terri’s taxable income?
  2. How much of Terri’s income is taxed at her rate? At her parents’ rate?
  3. Can the parental election be made? Why or why not?

 

Research Problems

Research Problem 1. Kathy and Brett Ouray married in 1997. They began to experience

marital difficulties in 2011 and, in the current year, although they are not legally separated,

consider themselves completely estranged. They have contemplated getting a

divorce. However, because of financial concerns and because they both want to remain

involved in the lives of their three sons, they have not yet filed for divorce. In addition,

their financial difficulties have meant that Kathy and Brett cannot afford to live in separate

residences. So although they consider themselves emotionally estranged, they and

their three sons all reside in a single-family home in Chicago, Illinois.

Although Brett earns significantly more than Kathy, both contribute financially to

maintaining their home and supporting their teenage sons. In one of their few and

brief conversations this year, they determined that Brett had contributed far more

than Kathy to the maintenance of their home and the support of their sons. Thus,

Brett has decided that for the current tax year, they will file separate Federal income

tax returns and that he will claim head-of-household filing status. While they live

under the same roof, Brett believes that he and Kathy should maintain separate

households. Given this fact and the fact that he provides significantly more for the

support of his and Kathy’s sons, he believes he is eligible for head-of-household filing

status. Advise Brett on which filing status is most appropriate for him in the current

year. His address is 16 Lahinch, Chicago, IL 60608.

Research Problem 2. John and Janet Baker are husband and wife and maintain a

household in which the following persons live: Calvin and Florence Carter and Darin,

Andrea, and Morgan Baker.

  • Calvin and Florence are Janet’s parents, who are retired. During the year, they

receive $19,000 in nontaxable funds (e.g., disability income, interest on municipal

bonds, and Social Security benefits). Of this amount, $8,000 is spent equally

between them for clothing, transportation, and recreation (e.g., vacation) and the

balance of $11,000 is invested in tax-exempt securities. Janet paid $1,000 for her

mother’s dental work and paid the $1,200 premium on an insurance policy her

father owned on his own life. Calvin also had medical expenses, but he insisted on

paying for them with his own funds.

  • Darin is the Bakers’ 18-year-old son who is not a student but operates a poolcleaning

service on a part-time basis. During the year, he earns $14,000 from the

business, which he places in a savings account for later college expenses.

  • Andrea is the Bakers’ 19-year-old daughter who does not work or go to school.

Tired of the inconvenience of borrowing and sharing the family car, during the

year, she purchased a Camaro for $21,000. Andrea used funds from a savings

account she had established several years ago with an inheritance from her paternal

grandfather.

  • Morgan is the Bakers’ 23-year-old daughter. To attend graduate school at a local

university, she applied for and obtained a student loan of $20,000. She uses the full

amount to pay her college tuition.

The Bakers’ fair rental value of their residence, including utilities, is $14,000, while

their total food expense for the household is $10,500.

  1. How many dependency exemptions are the Bakers entitled to claim for the year?

Explain your answer.

  1. Froma planning standpoint, how might the Bakers have improved the tax result?

Partial list of research aids:

Reg. §§ 1.152–1(a) and –1(c).

Your Federal Income Tax (IRS Publication 17), Chapter 3.

Research Problem 3. Locate IRS Form 2120 (at www.irs.gov), and answer the following

questions.

  1. Who must sign the form?
  2. Who must file the form?
  3. Can it be used for someone who is not related to the taxpayer? Explain.

Research Problem 4. What purpose is served by Form 8857? Read the directions to

the form, and see IRS Publication 971 for additional information.

Research Problem 5. A nonresident alien earns money in the United States that is

subject to Federal income tax. What guidance does the IRS provide about what tax

form needs to be used and when it should be filed? In terms of the proper filing

date, does it matter whether the earnings were subject to income tax withholding?

Explain.

 

Roger CPA Review Questions

  1. Keller is a single individual who in 20X14 qualified for a foreign earned income

exclusion of $80,000. Keller’s 20X14 net investment income was $25,000, and

Keller’s 20X14 Adjusted Gross Income prior to the foreign earned income exclusion

was $220,000. Given a 3.8% Unearned Income Medicare Contribution Tax rate, what

is Keller’s 20X14 liability for this surtax?

  1. $760
  2. $0
  3. $950
  4. $570
  5. Walters, an individual, received the following in 20X13:

W-2 income $10,000

Federal tax refund for 20X12 1,250

Scholarship stipend, in return for teaching assistant duties performed 25,000

Cash inheritance from deceased great-uncle 5,000

Considering only the above, what is Walters’ 20X13 gross income?

  1. $35,000
  2. $36,250
  3. $15,000
  4. $16,250
  5. For “qualifying widow(er)” filing status, which of the following requirements must

be met?

  1. The surviving spouse does not remarry before the end of the current year.
  2. The surviving spouse was eligible to file a joint tax return in the year of the

spouse’s death.

III. The surviving spouse maintains the cost of the principal residence for six

months.

  1. I, II, and III
  2. I and II, but not III
  3. I and III, but not II
  4. I only
  5. Parker and his wife Marie would have been filing a joint tax return for 20X1; however,

Marie died in October of 20X1. Parker has not remarried and continues to

maintain a home for himself and his two children during 20X1, 20X2, 20X3, and

20X4. Parker’s filing statuses for 20X1, 20X2, 20X3, and 20X4 are as follows:

20X1 20X2 20X3 20X4

  1. Qualifying widower Married filing joint return Qualifying widower Head of household
  2. Married filing joint return Married filing joint return Head of household Qualifying widower
  3. Married filing joint return Qualifying widower Qualifying widower Head of household
  4. Qualifying widower Qualifying widower Head of household Qualifying widower

 

CHAPTER10

Individuals: Income, Deductions, and Credits

Computational Exercises

  1. LO.1 Casper and Cecile are divorced this year. As part of the divorce settlement,

Casper transferred stock to Cecile. Casper purchased the stock for $25,000,

and it had a market value of $43,000 on the date of the transfer. Cecile sold the stock

for $40,000 a month after receiving it. In addition Casper is required to pay Cecile

$1,500 a month in alimony. He made five payments to her during the year. What are

the tax consequences for Casper and Cecile regarding these transactions?

  1. How much gain or loss does Casper recognize on the transfer of the stock?
  2. Does Casper receive a deduction for the $7,500 alimony paid?
  3. How much income does Cecile have from the $7,500 alimony received?
  4. When Cecile sells the stock, how much gain or loss does she report?
  5. LO.1 Compute the taxable Social Security benefits in each of the following

situations:

  1. Erwin and Eleanor are married and file a joint tax return. They have adjusted

gross income of $46,000, no tax-exempt interest, and $12,400 of Social Security

benefits.

  1. Erwin and Eleanor have adjusted gross income of $12,000, no tax-exempt interest,

and $16,000 of Social Security benefits.

  1. LO.1 Jarrod receives a scholarship of $18,500 from Riggers University to be used to

pursue a bachelor’s degree. He spends $12,000 on tuition, $1,500 on books

and supplies, $4,000 for room and board, and $1,000 for personal expenses. How

much may Jarrod exclude from his gross income?

  1. LO.2 Pierre, a cash basis, unmarried taxpayer, had $1,400 of state income tax withheld

during 2015. Also in 2015, Pierre paid $455 that was due when he filed

his 2014 state income tax return and made estimated payments of $975 toward his

2015 state income tax liability. When Pierre files his 2015 Federal income tax return

in April 2016, he elects to itemize deductions, which amount to $10,650, including

the state income tax payments and withholdings, all of which reduce his taxable

income.

  1. What is Pierre’s 2015 state income tax deduction?
  2. As a result of overpaying his 2015 state income tax, Pierre receives a refund of

$630 early in 2016. The standard deduction for single taxpayers for 2015 was

$6,300. How much of the $630 will Pierre include in his 2016 gross income?

  1. LO.2 Troy’s financial records for the year reflect the following:

Interest income from bank savings account $ 900

Taxable annuity receipts 1,800

Safe deposit box rental (to hold annuity documents) 125

Investment interest expense 3,200

Calculate Troy’s net investment income and his current investment interest deduction.

Assume that Troy does not itemize his personal deductions. How is any potential

excess investment interest deduction treated?

  1. LO.2 Miller owns a personal residence with a fair market value of $195,000 and an

outstanding first mortgage of $157,500. Miller gets a second mortgage on the

residence and in return borrows $10,000 to purchase new jet skis. How much of the

first and second mortgage debt is treated as qualified residence indebtedness?

  1. LO.2 Donna donates stock in Chipper Corporation to the American Red Cross on

September 10, 2015. She purchased the stock for $18,100 on December 28,

2014, and it had a fair market value of $27,000 when she made the donation.

  1. What is Donna’s charitable contribution deduction?
  2. Assume instead that the stock had a fair market value of $15,000 (rather than

$27,000) when it was donated to the American Red Cross. What is Donna’s

charitable contribution deduction?

  1. LO.2 Issac has AGI of $73,400 and incurred the following expenses. How much of

the business and personal expenditures are deductible (after any limitation)

either as miscellaneous itemized deductions or as other itemized deductions?

Cost of uniforms $ 535

Tax return preparation fees 600

Fee paid for a safe deposit box used to store papers and

documents relating to taxable income-producing investments 65

Job-hunting costs 1,100

  1. LO.2 Pedro, who is a single taxpayer, had AGI of $328,000 for 2015. He incurred

the following expenses during the year:

Medical expenses before 10%-of-AGI limitation $12,000

State and local income taxes 8,900

Real estate taxes 1,600

Home mortgage interest 16,000

Charitable contributions 2,200

Deductible investment interest expense 1,700

Compute the amount of Pedro’s itemized deductions after any applicable reductions.

  1. LO.3 In late 2014, Randy and Rachel Erwin paid $7,000 in legal fees, adoption fees,

and other expenses directly related to the adoption of an infant son, Jameson.

In 2015, the year in which the adoption becomes final, they pay an additional

$8,000. Their AGI in 2015 is $135,000.

  1. Determine the amount of the Erwins’ adoption tax credit in 2015.
  2. Instead, assume that the Erwins’ 2015 AGI is $210,000. Determine the amount

of the Erwins’ adoption tax credit in 2015.

  1. LO.3 Santiago and Amy are married and file a joint tax return claiming their three

children, ages 12, 14, and 18, as dependents. Their AGI is $140,000. Determine

the amount of the couple’s child tax credit.

  1. LO.3 Paola and Isidora are married, file a joint tax return, report modified AGI of

$148,000, and have one dependent child, Dante. The couple paid $12,000

of tuition and $10,000 for room and board for Dante (a freshman). Dante is a fulltime

student. Determine the amount of the American Opportunity credit for the

year.

 

Problems

  1. LO.1 William and Abigail, who live in San Francisco, have been experiencing problems

with their marriage. They have a 3-year-old daughter, April, who stays

with William’s parents during the day because both William and Abigail are

employed. Abigail worked to support William while he attended medical school, and

now she has been accepted by a medical school in Mexico. Abigail has decided to

divorce William and attend medical school. April will stay in San Francisco because of

her strong attachment to her grandparents and because they can provide her with

excellent day care. Abigail knows that William will expect her to contribute to the cost

of raising April. Abigail also believes that to finance her education, she must receive

cash for her share of the property they accumulated during their marriage. In addition,

she believes that she should receive some reimbursement for her contribution to

William’s support while he was in medical school. She expects the divorce proceedings

to take several months. Identify the relevant tax issues for Abigail.

  1. LO.1 Alicia and Rafel are in the process of negotiating a divorce agreement. They

both worked during the marriage and contributed an equal amount to the

marital assets. They own a home with a fair market value of $400,000 (cost of

$300,000) that is subject to a mortgage of $250,000. They have lived in the home for

12 years. They also have investment assets with a cost of $160,000 and a fair market

value of $410,000. Thus, the net worth of the couple is $560,000 ($400,000 _

$250,000 þ $410,000). The holding period for the investments is longer than one

year. Alicia would like to continue to live in the house. Therefore, she has proposed

that she receive the residence subject to the mortgage, a net value of $150,000. In

addition, she would receive $17,600 each year for the next 10 years, which has a

present value (at 6% interest) of $130,000. Rafel would receive the investment assets.

If Rafel accepts this plan, he must sell one-half of the investments so that he can purchase

a home. Assume that you are counseling Alicia. Explain to Alicia whether the

proposed agreement would be “fair” on an after-tax basis.

  1. LO.1 For each of the following, determine the amount that should be included in

gross income:

  1. Peyton was selected the most valuable player in the Super Bowl. In recognition

of this, he was awarded an automobile with a value of $60,000. Peyton did not

need the automobile, so he asked that the title be put in his parents’ names.

  1. Jacob was awarded the Nobel Peace Prize. When he was presented the check

for $1.4 million, Jacob said, “I do not need the money. Give it to the United

Nations to use toward the goal of world peace.”

  1. Linda won the Craig County Fair beauty pageant. She received a $10,000 scholarship

that paid her $6,000 for tuition and $4,000 for meals and housing for the

academic year.

  1. LO.1 Linda and Don are married and file a joint return. In 2015, they received

$12,000 in Social Security benefits and $35,000 in taxable pension benefits

and interest.

  1. Compute the couple’s adjusted gross income on a joint return.
  2. Don would like to know whether they should sell for $100,000 (at no gain or

loss) a corporate bond that pays 8% in interest each year and use the proceeds

to buy a $100,000 nontaxable State of Virginia bond that will pay $6,000 in interest

each year.

  1. If Linda in (a) works part-time and earns $30,000, how much will Linda and

Don’s adjusted gross income increase?

  1. LO.1 Adrian was awarded an academic scholarship to State University for the

2015–2016 academic year. He received $6,500 in August and $7,200 in

December 2015. Adrian had enough personal savings to pay all expenses as they

came due. Adrian’s expenditures for the relevant period were as follows:

Tuition, August 2015 $3,700

Tuition, January 2016 3,750

Room and board

August–December 2015 2,800

January–May 2016 2,500

Books and educational supplies

August–December 2015 1,000

January–May 2016 1,200

Determine the effect on Adrian’s gross income for 2015 and 2016.

  1. LO.1 Leigh sued an overzealous bill collector and received the following

settlement:

Damage to her automobile that the collector attempted to repossess $ 3,300

Physical damage to her arm caused by the collector 15,000

Loss of income while her arm was healing 6,000

Punitive damages 80,000

  1. What effect does the settlement have on Leigh’s gross income?
  2. Assume that Leigh also collected $25,000 of damages for slander to her personal

reputation caused by the bill collector misrepresenting the facts to Leigh’s

employer and other creditors. Is this $25,000 included in Leigh’s gross income?

Explain.

  1. LO.2 Emma Doyle, age 55, is employed as a corporate attorney. For calendar year

2015, she had AGI of $100,000 and paid the following medical expenses:

Medical insurance premiums $3,700

Doctor and dentist bills for Bob and April (Emma’s parents) 6,800

Doctor and dentist bills for Emma 5,200

Prescription medicines for Emma 400

Nonprescription insulin for Emma 350

Bob and April would qualify as Emma’s dependents, except that they file a joint

return. Emma’s medical insurance policy does not cover them. Emma filed a claim

for reimbursement of $2,800 of her own expenses with her insurance company in

December 2015 and received the reimbursement in January 2016. What is Emma’s

maximum allowable medical expense deduction for 2015? Prepare a memo for your

firm’s tax files in which you document your conclusions.

  1. LO.2 Michael has always been overweight, and now he has decided to do something

about it. He recently read in a news story that the IRS allows a medical

expense deduction for the cost of certain weight reduction programs. He scheduled

an appointment with his doctor to discuss enrolling in the clinic’s weight reduction

program and mentioned that he was happy that he would be able to deduct the

cost. His doctor, who was familiar with the IRS’s position, informed Michael that he

was 10 pounds below the weight considered obese under the IRS guidelines and

would not be able to take the medical expense deduction. Michael scheduled

another appointment and proceeded to eat much more than usual for the next

month. He returned 20 pounds heavier than at the first appointment and joked with

the doctor that he now qualified for the medical expense deduction. Discuss

whether Michael is justified in deducting the cost of the weight reduction program.

  1. LO.2 Paul, age 62, suffers from emphysema and severe allergies and, upon the recommendation

of his physician, has a dust elimination system installed in his

personal residence. In connection with the system, Paul incurs and pays the following

amounts during 2015.

Doctor and hospital bills $ 2,500

Dust elimination system 10,000

Increase in utility bills due to the system 450

Cost of certified appraisal 300

In addition, Paul pays $750 for prescribed medicines.

The system has an estimated useful life of 20 years. The appraisal was to determine

the value of Paul’s residence with and without the system. The appraisal states

that his residence was worth $350,000 before the system was installed and $356,000

after the installation. Paul’s AGI for the year was $50,000. How much of the medical

expenses qualify for the medical expense deduction in 2015?

  1. LO.2 Norma, who uses the cash method of accounting, lives in a state that imposes

an income tax. In April 2015, she files her state income tax return for 2014

and pays an additional $1,000 in state income taxes. During 2015, her withholdings

for state income tax purposes amount to $7,400, and she pays estimated state

income tax of $700. In April 2016, she files her state income tax return for 2015,

claiming a refund of $1,800. Norma receives the refund in August 2016.

  1. Assuming that Norma itemized deductions in 2015, how much may she claim as

a deduction for state income taxes on her Federal return for calendar year 2015

(filed in April 2016)?

  1. Assuming that Norma itemized deductions in 2015, how will the refund of

$1,800 that she received in 2016 be treated for Federal income tax purposes?

  1. Assume that Norma itemized deductions in 2015 and that she elects to have the

$1,800 refund applied toward her 2016 state income tax liability. How will the

$1,800 be treated for Federal income tax purposes?

  1. Assuming that Norma did not itemize deductions in 2015, how will the refund

of $1,800 received in 2016 be treated for Federal income tax purposes?

  1. LO.2 In 2015, Kathleen Tweardy incurs $30,000 of interest expense related to her

investments. Her investment income includes $7,500 of interest, $6,000 of

qualified dividends, and a $12,000 net capital gain on the sale of securities. Kathleen

asks you to compute the amount of her deduction for investment interest, taking

into consideration any options she might have. In addition, she wants your suggestions

as to any tax planning alternatives that are available. Write a letter to

her that contains your advice. Kathleen lives at 11934 Briarpatch Drive, Midlothian,

VA 23113.

  1. LO.2 Helen borrowed $150,000 to acquire a parcel of land to be held for investment

purposes. During 2015, she paid interest of $12,000 on the loan. She

had AGI of $90,000 for the year. Other items related to Helen’s investments include

the following:

Investment income $11,000

Long-term capital gain on sale of stock 3,500

Investment counsel fees 200

Helen is unmarried and does not itemize her deductions.

  1. Determine Helen’s investment interest deduction for 2015.
  2. Discuss the treatment of the portion of Helen’s investment interest that is disallowed

in 2015.

  1. LO.2 In 2006, Liam, who is single, purchased a personal residence for $340,000

and took out a mortgage of $200,000 on the property. In May of the current

year, when the residence had a fair market value of $440,000 and Liam owed

$140,000 on the mortgage, he took out a home equity loan for $220,000. He used

the funds to purchase a recreational vehicle, which he uses 100% for personal use.

What is the maximum amount on which Liam can deduct home equity interest?

  1. LO.2 In December of each year, Eleanor Young contributes 10% of her gross

income to the United Way (a 50% organization). Eleanor, who is in the 28%

marginal tax bracket, is considering the following alternatives for satisfying the

contribution.

Fair Market Value

(1) Cash donation $23,000

(2) Unimproved land held for six years ($3,000 basis) 23,000

(3) Blue Corporation stock held for eight months ($8,000 basis) 23,000

(4) Gold Corporation stock held for two years ($28,000 basis) 23,000

Eleanor has asked you to help her decide which of the potential contributions listed

above will be most advantageous taxwise. Evaluate the four alternatives, and write a

letter to Eleanor to communicate your advice to her. Her address is 2622 Bayshore

Drive, Berkeley, CA 94709.

  1. LO.2 Ramon had AGI of $180,000 in 2015. He is considering making a charitable

contribution this year to the American Heart Association, a qualified charitable

organization. Determine the current allowable charitable contribution deduction

in each of the following independent situations, and indicate the treatment for any

amount that is not deductible currently.

  1. A cash gift of $95,000.
  2. A gift of OakCo stock worth $95,000 on the contribution date. Ramon acquired the

stock as an investment two years ago at a cost of $84,000.

  1. A gift of a painting worth $95,000 that Ramon purchased three years ago for

$60,000. The charity has indicated that it would sell the painting to generate

cash to fund medical research.

  1. LO.2 Linda, age 37, who files as a single taxpayer, had AGI of $280,000 for 2015.

She incurred the following expenses and losses during the year:

Medical expenses (before the 10%-of-AGI limitation) $33,000

State and local income taxes 4,500

State sales tax 1,300

Real estate taxes 4,000

Home mortgage interest 5,000

Automobile loan interest 750

Credit card interest 1,000

Charitable contributions 7,000

Casualty loss (before 10% limitation but after $100 floor) 34,000

Unreimbursed employee expenses subject to the

2%-of-AGI limitation 7,600

Calculate Linda’s allowable itemized deductions for the year.

  1. LO.3 Ann and Bill were on the list of a local adoption agency for several years, seeking

to adopt a child. Finally, in 2014, good news came their way, and an adoption

seemed imminent. They paid qualified adoption expenses of $5,000 in 2014 and

$11,000 in 2015. Assume that the adoption becomes final in 2015. Ann and Bill always

file a joint income tax return.

  1. Determine the amount of the adoption expenses credit available to Ann and

Bill, assuming that their combined annual income is $120,000. In what year(s)

will they benefit from the credit?

  1. Assuming that Ann and Bill’s modified AGI in 2014 and 2015 is $220,000, calculate

the amount of the adoption expenses credit.

  1. LO.3 Paul and Karen are married, and both are employed (Paul earns $44,000 and

Karen earns $9,000 during 2015). Paul and Karen have two dependent children,

both under the age of 13. So they can work, Paul and Karen pay $3,800 to various

unrelated parties to care for their children while they are working. Assuming

that Paul and Karen file a joint return, what, if any, is their tax credit for child and

dependent care expenses?

  1. LO.3 Jim and Mary Jean are married and have two dependent children under the

age of 13. Both parents are gainfully employed and during 2015 earn salaries

as follows: $16,000 (Jim) and $5,200 (Mary Jean). To care for their children while

they work, they pay Eleanor (Jim’s mother) $5,600. Eleanor does not qualify as a

dependent of Jim and Mary Jean. Assuming that Jim and Mary Jean file a joint tax

return, what, if any, is their credit for child and dependent care expenses?

  1. LO.3 Bernadette, a longtime client of yours, is an architect and the president of the

local Rotary chapter. To keep up to date with the latest developments in her profession,

she attends continuing education seminars offered by the architecture school at

State University. During 2015, Bernadette spends $2,000 on course tuition to attend such

seminars. She also spends another $400 on architecture books during the year.

Bernadette’s son, Pablo, is a senior majoring in engineering at the University of

the Midwest. During the 2015 calendar year, Pablo incurs the following expenses:

$8,200 for tuition ($4,100 per semester) and $750 for books and course materials.

Pablo, who Bernadette claims as a dependent, lives at home while attending school

full-time. Bernadette is married, files a joint return, and reports a combined AGI with

her husband of $112,000.

  1. Calculate Bernadette’s education tax credit for 2015.
  2. In her capacity as president of the local Rotary chapter, Bernadette has asked

you to make a 30- to 45-minute speech outlining the different ways the tax law

helps defray (1) the cost of higher education and (2) the cost of continuing education

once someone is in the workforce. Prepare an outline of possible topics

for presentation. A tentative title for your presentation is “How Can the Tax Law

Help Pay for College and Continuing Professional Education?”

  1. LO.3 Mark and Lisa are approaching an exciting time in their lives as their oldest

son, Austin, graduates from high school and moves on to college. What are

some of the tax issues Mark and Lisa should consider as they think about paying for

Austin’s college education?

  1. LO.3 For many years, Loretta Johnson, a single mother of three children, has been

struggling to make ends meet by working at two jobs that pay barely the minimum

wage and together provide just over $15,000. Fortunately, her housing and

food costs have been partially subsidized through various government programs. In

addition, she has been able to take advantage of the earned income credit, which

has provided around $3,000 annually to help her with living expenses. The credit

has truly made a difference in the lives of Loretta and her family by helping them

keep their creditors at bay. She is proud that she has worked hard and provided for

her family for many years without having to accept welfare.

Now, however, Loretta faces a problem as her children have grown up and

moved out of her home. With no qualifying children in her household, she no longer

qualifies for the earned income credit. Although she will continue working at

her two jobs, such a significant loss to her household budget cuts into her ability to

be self-reliant. As a survival strategy and as a way of keeping the earned income

credit, Loretta arranges to have one of her grandchildren live with her for just over

six months every year. This enables a significant percentage of her household

budget to be secure. How do you react to Loretta’s strategy?

  1. LO.3 Joyce, a widow, lives in an apartment with her two minor children (ages 8

and 10), whom she supports. Joyce earns $33,000 during 2015. She uses the

standard deduction.

  1. Calculate the amount, if any, of Joyce’s earned income credit.
  2. During the year, Joyce is offered a new job that has greater future potential than

her current job. If she accepts the job offer, her earnings for the year will be

$39,000; however, she is afraid she will not qualify for as much of the earned

income credit. Using after-tax cash-flow calculations, determine whether Joyce

should accept the new job offer.

Comprehensive Tax Return Problems

  1. Alice J. and Bruce M. Byrd are married taxpayers who file a joint return. Their Social

Security numbers are 123-45-6789 and 111-11-1111, respectively. Alice’s birthday is

September 21, 1967, and Bruce’s is June 27, 1966. They live at 473 Revere Avenue,

Lowell, MA 01850. Alice is the office manager for Lowell Dental Clinic, 433 Broad

Street, Lowell, MA 01850 (employer identification number 98-765432). Bruce is the

manager of a Super Burgers fast-food outlet owned and operated by Plymouth Corporation,

1247 Central Avenue, Hauppauge, NY 11788 (employer identification

number 11-1111111).

The following information is shown on their Wage and Tax Statements (Form W–2)

for 2014.

Line Description Alice Bruce

1 Wages, tips, other compensation $58,000 $62,100

2 Federal income tax withheld 4,500 6,300

3 Social Security wages 58,000 62,100

4 Social Security tax withheld 3,596 3,850

5 Medicare wages and tips 58,000 62,100

6 Medicare tax withheld 841 900

15 State Massachusetts Massachusetts

16 State wages, tips, etc. 58,000 62,100

17 State income tax withheld 2,950 3,100

The Byrds provide over half of the support of their two children, Cynthia (born January

25, 1990, Social Security number 123-45-6788) and John (born February 7,

1994, Social Security number 123-45-6786). Both children are full-time students and

live with the Byrds except when they are away at college. Cynthia earned $4,200

from a summer internship in 2014, and John earned $3,800 from a part-time job.

During 2014, the Byrds provided 60% of the total support of Bruce’s widower

father, Sam Byrd (born March 6, 1938, Social Security number 123-45-6787). Sam

lived alone and covered the rest of his support with his Social Security benefits. Sam

died in November, and Bruce, the beneficiary of a policy on Sam’s life, received life

insurance proceeds of $800,000 on December 28.

The Byrds had the following expenses relating to their personal residence during

2014:

Property taxes $5,000

Qualified interest on home mortgage 8,700

Repairs to roof 5,750

Utilities 4,100

Fire and theft insurance 1,900

The Byrds had the following medical expenses for 2014:

Medical insurance premiums $4,500

Doctor bill for Sam incurred in 2013 and not paid until 2014 7,600

Operation for Sam 8,500

Prescription medicines for Sam 900

Hospital expenses for Sam 3,500

Reimbursement from insurance company, received in 2014 3,600

The medical expenses for Sam represent most of the 60% that Bruce contributed

toward his father’s support.

Other relevant information follows:

  • When they filed their 2013 state return in 2014, the Byrds paid additional state

income tax of $900.

  • During 2014, Alice and Bruce attended a dinner dance sponsored by the Lowell

Police Disability Association (a qualified charitable organization). The Byrds paid

$300 for the tickets. The cost of comparable entertainment would normally be $50.

  • The Byrds contributed $5,000 to Lowell Presbyterian Church and gave used clothing

(cost of $1,200 and fair market value of $350) to the Salvation Army. All donations

are supported by receipts, and the clothing is in very good condition.

  • In 2014, the Byrds received interest income of $2,750, which was reported on a

Form 1099–INT from Second National Bank.

  • Alice’s employer requires that all employees wear uniforms to work. During 2014,

Alice spent $850 on new uniforms and $566 on laundry charges.

  • Bruce paid $400 for an annual subscription to the Journal of Franchise Management

and $741 for annual membership dues to his professional association.

  • Neither Alice’s nor Bruce’s employer reimburses for employee expenses.
  • The Byrds do not keep the receipts for the sales taxes they paid and had no major

purchases subject to sales tax.

  • Everyone in the Byrd family had health care coverage for all months of 2014.
  • Alice and Bruce paid no estimated Federal income tax. Neither Alice nor Bruce

wants to designate $3 to the Presidential Election Campaign Fund.

Part 1—Tax Computation

Compute net tax payable or refund due for Alice and Bruce Byrd for 2014. If they

have overpaid, they want the amount to be refunded to them. If you use tax forms

for your computations, you will need Forms 1040 and 2106 and Schedules A and B.

Suggested software: H&R BLOCK Tax Software.

Part 2—Tax Planning

Alice and Bruce are planning some significant changes for 2015. They have provided

you with the following information and asked you to project their taxable

income and tax liability for 2015.

The Byrds will invest the $800,000 of life insurance proceeds in short-term certificates

of deposit (CDs) and use the interest for living expenses during 2015. They

expect to earn total interest of $32,000 on the CDs.

Bruce has been promoted to regional manager, and his salary for 2015 will be

$88,000. He estimates that state income tax withheld will increase by $4,000 and the

Social Security tax withheld will be $5,456.

Alice, who has been diagnosed with a serious illness, will take a leave of absence

from work during 2015. The estimated cost for her medical treatment is $15,400, of

which $6,400 will be reimbursed by their insurance company in 2015. Their medical

insurance premium will increase to $9,769. Property taxes on their residence are

expected to increase to $5,100. The Byrds’ home mortgage interest expense and

charitable contributions are expected to be unchanged from the prior year.

John will graduate from college in December 2014 and will take a job in New

York City in January 2015. His starting salary will be $46,000.

Assume that all of the information reported in 2014 will be the same in 2015

unless other information has been presented.

  1. Paul and Donna Decker are married taxpayers, ages 44 and 42, respectively, who

file a joint return for 2015. The Deckers live at 1121 College Avenue, Carmel, IN

  1. Paul is an assistant manager at Carmel Motor Inn, and Donna is a teacher at

Carmel Elementary School. They present you with W–2 forms that reflect the following

information:

Paul Donna

Salary $68,000 $56,000

Federal tax withheld 6,770 6,630

State income tax withheld 900 800

FICA (Social Security and Medicare) withheld 5,202 4,284

Social Security numbers* 111-11-1111 123-45-6789

* In the interest of privacy and to protect against taxpayer identification misuse, Social Security numbers used

throughout the textbook have been replaced with fictitious numbers.

Donna is the custodial parent of two children from a previous marriage who reside

with the Deckers through the school year. The children, Larry and Jane

Parker, reside with their father, Bob, during the summer. Relevant information for

the children follows:

Larry Jane

Age 17 18

Social Security numbers 123-45-6788 123-45-6787

Months spent with Deckers 9 9

Under the divorce decree, Bob pays child support of $150 per month per child

during the nine months the children live with the Deckers. Bob says that he

spends $200 per month per child during the three summer months they reside

with him. Donna and Paul can document that they provide $2,000 of support per

child per year. The divorce decree is silent as to which parent can claim the

exemptions for the children.

In August, Paul and Donna added a suite to their home to provide more comfortable

accommodations for Hannah Snyder (Social Security number 123-45-6786),

Donna’s mother, who had moved in with them in February 2014 after the death of

Donna’s father. Not wanting to borrow money for this addition, Paul sold 300 shares

of Acme Corporation stock for $50 per share on May 3, 2015, and used the proceeds

of $15,000 to cover construction costs. The Deckers had purchased the stock on

April 29, 2010, for $25 per share. They received dividends of $750 on the jointly

owned stock a month before the sale.

Hannah, who is 66 years old, received $7,500 in Social Security benefits during

the year, of which she gave the Deckers $2,000 to use toward household

expenses and deposited the remainder in her personal savings account. The

Deckers determine that they have spent $2,500 of their own money for food,

clothing, medical expenses, and other items for Hannah. They do not know what

300 per month.

Interest paid during the year included the following:

Home mortgage interest (paid to Carmel Federal Savings and Loan) $7,890

Interest on an automobile loan (paid to Carmel National Bank) 1,660

Interest on Citibank Visa card 620

In July, Paul hit a submerged rock while boating. Fortunately, he was uninjured after

being thrown from the boat and landing in deep water. However, the boat, which

was uninsured, was destroyed. Paul had paid $25,000 for the boat in June 2014, and

its value was appraised at $18,000 on the date of the accident.

The Deckers paid doctor and hospital bills of $10,700 and were reimbursed

$2,000 by their insurance company. They spent $640 for prescription drugs and

medicines and $5,904 for premiums on their health insurance policy. They have

filed additional claims of $1,200 with their insurance company and have been told

they will receive payment for that amount in January 2016. Included in the amounts

paid for doctor and hospital bills were payments of $380 for Hannah and $850 for

the children. All members of the Decker family had health insurance coverage for

all of 2015.

Additional information of potential tax consequence follows:

Real estate taxes paid $3,850

Sales taxes paid (per table) 1,379

Contributions to church 1,950

Appraised value of books donated to public library 740

Paul’s unreimbursed employee expenses to attend hotel management

convention:

Airfare 340

Hotel 170

Meals 95

Registration fee 340

Refund of state income tax for 2014 (the Deckers itemized on their 2014

Federal tax return) 1,520

Compute net tax payable or refund due for the Deckers for 2015. Ignore the child

tax credit in your computations. If the Deckers have overpaid, the amount is to be

credited toward their taxes for 2016.

Research Problems

Research Problem 1. Aubrey Brown is a decorated veteran of the Vietnam War. As a

result of his exposure to Agent Orange during the war, Aubrey developed lung cancer

and is unable to work. He received $12,000 of Social Security disability payments

in the current year. He reasons that the payments should be excluded from his gross

income because the payments are compensation for the physical injury he suffered

as a result of his service in the armed forces. Is Aubrey correct? Explain.

Partial list of research aids:

Rev.Rul. 77–318, 1977–2 C.B. 45.

Reimels v. Comm., 2006–1 USTC {50,147, 97 AFTR 2d 2006–820, 436 F.3d 344 (CA–2, 2006).

Research Problem 2. Ken and Mary Jane Blough, your neighbors, have asked you for

advice after receiving correspondence in the mail from the IRS. You learn that the

IRS is asking for documentation in support of the itemized deductions the Bloughs

claimed on a recent tax return. The Bloughs tell you that their income in the year of

question was $75,000. Because their record-keeping habits are poor, they felt justified

in claiming itemized deductions equal to the amounts that represent the average

claimed by other taxpayers in their income bracket. These averages are calculated

and reported by the IRS annually based on actual returns filed in an earlier year.

Accordingly, they claimed medical expenses of $7,102, taxes of $6,050, interest of

$10,659, and charitable contributions of $2,693. What advice do you give the

Bloughs?

Partial list of research aids:

Cheryl L. de Werff, T.C. Summary Opinion, 2011–29.

Research Problem 3. Ashby and Curtis, a professional couple, have a 2-year-old son,

Jason. Curtis works full-time as an electrical engineer, but Ashby has not worked outside

the home since Jason was born. As Jason is getting older, Ashby thinks that

Jason would benefit from attending nursery school several times a week, which

would give her an opportunity to reinvigorate her love of painting at a nearby art studio.

Ashby thinks that if she is lucky, the proceeds from the sale of her paintings will

pay for the nursery school tuition. But in addition, she is planning to claim the credit

for child and dependent care expenses because the care provided Jason at

the nursery school is required for her to pursue her art career. Can Ashby and Curtis

claim the credit for child and dependent care expenses for the nursery school expenditure?

Why or why not?

Research Problem 4. Go to the web page of a consulting firm that offers counseling

services to individuals as they negotiate the terms of a divorce. What specific taxrelated

services do these firms offer? Suggest a new tax-related service the consulting

firm could offer.

Research Problem 5. The cutback adjustment that limits the amount of itemized

deductions for some taxpayers is otherwise known as the Pease limitation. This limitation

is named after former Congressman Donald Pease and was first in effect for tax

years after December 31, 1990. The purpose of this limitation is to raise additional

tax revenue by limiting some popular and common itemized deductions incurred by

high-income taxpayers. One such deduction is the charitable contribution deduction.

Search Google or a business press database to see what tax law analysts speculated

the consequences would be of limiting charitable contribution deductions. Also

determine whether such speculation has materialized.

Research Problem 6. In March 2015, the U.S. Supreme Court heard oral arguments in

King v. Burwell involving an issue about the Premium Tax Credit. Identify the issue,

the holding, and the response of the Secretary of Health and Human Services or the

Secretary of the Treasury.

 

Roger CPA Review Questions

  1. Walters, an individual, received the following in 20X13:

W-2 income $10,000

Federal tax refund for 20X12 1,250

Scholarship stipend, in return for teaching

assistant duties performed 25,000

Cash inheritance from deceased great-uncle 5,000

Considering only the above, what is Walters’ 20X13 gross income?

  1. $35,000
  2. $36,250
  3. $15,000
  4. $16,250
  5. The following pertain to Joyce in 20X14:

Medical insurance premiums paid by employer $4,800

Teacher of the Year Award, in the form of gift

cards redeemable at local businesses 500

Jewelry box, received from employer for 25 years

of service (FMV) 100

20X14 holiday bonus awarded in December 20X14,

to be paid in January 20X15 250

What total amount from the above may be excluded from Joyce’s 20X14 gross

income?

  1. $5,650
  2. $350
  3. $5,150
  4. $850
  5. Pierce, a married individual, received the following in 20X14:

Worker’s compensation award $25,000

W-2 income 20,000

Unemployment compensation 4,800

Damages awarded for emotional distress

experienced as a result of workplace bodily injury 10,000

Considering only the above, what is Pierce’s 20X14 gross income?

  1. $49,800
  2. $34,800
  3. $30,000
  4. $24,800
  5. Kellye, a teacher, volunteers for eight hours per week at a school for high-risk children,

a qualified charitable organization. Kellye’s normal rate for teaching is $30 per

hour. Kellye’s out-of-pocket costs in 20X4 were $250 for supplies, and she spent

$20 each week in transportation getting to and from the school. Kellye had no cash

contributions to charity in 20X4. If Kellye volunteered every week in 20X4, what is

her charitable contributions deduction?

  1. $0
  2. $250
  3. $1,290
  4. $13,770
  5. Aaron, age 55, has an adjusted gross income in 20X4 of $30,000. His expenses are

as follows:

Non-prescription medicine $ 100

Prescription medicine 500

Doctor visits 500

Weekly meal preparation for a diet plan 2,000

Removal of a benign facial mole 400

Contact lenses 500

Eyeglasses 200

Dental services 300

What is Aaron’s itemized deduction for medical expenses?

  1. $0
  2. $1,500
  3. $2,000
  4. $4,500
  5. Which of the following deductions for taxes paid may be taken in the same year?
  6. Real estate taxes, state income taxes, state sales taxes
  7. Real estate taxes, property taxes, state income taxes
  8. Property taxes, state income taxes, state sales taxes
  9. Real estate taxes, property taxes, state income taxes, state sales taxes
  10. Zunilda is a 77-year-old individual with an AGI of $25,000 in 2014. She began living

in a nursing home in 2014 upon the recommendation of her primary care physician

in order to receive medical care for a specific condition. She had the following unreimbursed

expenses in 2014:

Expense Amount

Nursing home health care costs $5,000

Nursing home meal and lodging costs 8,000

Prescription drugs 1,500

As a result of these unreimbursed expenses, how much may Zunilda deduct from

AGI on her 2014 tax return? Assume Zunilda elects to itemize deductions.

  1. $12,000
  2. $4,000
  3. $12,625
  4. $4,625
  5. Which of the following credits is not refundable?
  6. Child Tax Credit
  7. Child and Dependent Care Credit
  8. American Opportunity Tax Credit
  9. Earned Income Credit
  10. Which of the following credits is refundable?
  11. Child Tax Credit
  12. Child and Dependent Care Credit
  13. Lifetime Learning Credit
  14. Foreign Tax Credit
  15. Which of the following education-related expenses can be used to claim an education

credit?

Tuition Fees Room & Board Meals

  1. Yes Yes Yes Yes
  2. Yes Yes Yes No
  3. Yes Yes No Yes
  4. Yes Yes No No
  5. Michael and Kathy have one dependent, Dustin, who is in his third year of college.

Additionally, Michael is taking classes in the evening towards an MBA. What credits

are Michael and Kathy allowed to claim?

  1. American Opportunity Tax Credit
  2. Lifetime Learning Credit
  3. I only
  4. II only
  5. I and II
  6. I or II
  7. Which of the following best describes the effect of a tax credit?
  8. It reduces a person’s gross income.
  9. It reduces a person’s adjusted gross income.
  10. It reduces a person’s taxable income.
  11. It reduces a person’s tax liability.

 

CHAPTER11

Individuals as Employees and Proprietors

Computational Exercises

  1. LO.2 Valentino is a patient in a nursing home for 45 days in 2015. While in the

nursing home, he incurs total costs of $13,500. Medicare pays $8,000 of the

costs. Valentino receives $15,000 from his long-term care insurance policy, which

pays while he is in the facility. Assume that the daily Federal statutory amount for

Valentino is $330. Of the $15,000, what amount may Valentino exclude from his

gross income?

  1. LO.2 Mio was transferred from New York to Germany. He lived and worked in

Germany for 340 days in 2015. Mio’s salary for 2015 is $190,000. What is Mio’s

foreign earned income exclusion?

  1. LO.3 Michael holds a full-time job with Brown Company and a part-time job with

Tan Corporation. During a workday, he drives 20 miles to Brown, returns

home, has a meal, and then drives 15 miles to Tan. Tan is located 12 miles from

Brown. What is Michael’s deductible mileage?

  1. LO.3 Fred travels from Denver to Miami primarily on business. He spends five days

conducting business and two days sightseeing. His expenses are $400 (airfare),

$150 per day (meals), and $300 per night (lodging). What are Fred’s deductible

expenses?

  1. LO.3 After accepting his first job upon graduating from college, Christian has the

following moving expenses:

Rental of moving van $450

Meals 200

Lodging 250

Presuming no reimbursement, what is Christian’s moving expense deduction?

  1. LO.3 Samantha was recently employed by an accounting firm. During the year, she

spends $2,500 for a CPA exam review course and begins working on a law

degree in night school. Her law school expenses were $4,200 for tuition and $450

for books. Assuming no reimbursement, how much can Samantha deduct for the:

  1. CPA exam review course?
  2. Law school expenses?
  3. LO.3 Robert entertains four key clients and their spouses at a nightclub. Expenses

were $200 (limo charge), $120 (cover charge), $700 (drinks and dinner), and

$140 (tips to servers). If Robert is self-employed, how much can he deduct for this

event?

  1. LO.3 Andrew sends Godiva chocolates to 10 of his key clients at Christmas. The

chocolates cost $50 a box not including $4 for gift wrapping and shipping.

How much can Andrew deduct?

  1. LO.5 In 2015, Miranda records net earnings from self-employment of $146,000. She

has no other income. Determine the amount of Miranda’s self-employment

tax and her for AGI income tax deduction.

  1. LO.5 Myers, who is single, has compensation income of $68,000 in 2015. He is an

active participant in his employer’s qualified retirement plan. Myers contributes

$5,500 to a traditional IRA. Of the $5,500 contribution, how much can Myers

deduct? See Exhibit 11.3, Phaseout of Traditional IRA Deduction of an Active Participant

in 2015.

  1. LO.5 Meredith, who is single, would like to contribute $5,500 to her Roth IRA. What

is the maximum amount that Meredith can contribute if her AGI is $117,000?

 

Problems

  1. LO.1 Mason performs services for Isabella. In determining whether Mason is an

employee or an independent contractor, comment on the relevance of each

of the factors listed below.

  1. Mason performs services only for Isabella and does not work for anyone else.
  2. Mason sets his own work schedule.
  3. Mason reports his job-related expenses on a Schedule C.
  4. Mason obtained his job skills from Isabella’s training program.
  5. Mason performs the services at Isabella’s business location.
  6. Mason is paid based on time worked rather than on task performed.
  7. LO.2 Rex, age 55, is an officer of Blue Company, which provides him with the following

nondiscriminatory fringe benefits in 2015:

  • Hospitalization insurance premiums for Rex and his dependents. The cost of the

coverage for Rex is $2,900 per year, and the additional cost for his dependents is

$3,800 per year. The plan has a $2,000 deductible, but his employer contributed

$1,500 to Rex’s Health Savings Account (HSA). Rex withdrew only $800 from the

HSA, and the account earned $50 of interest during the year.

  • Insurance premiums of $840 for salary continuation payments. Under the plan,

Rex will receive his regular salary in the event he is unable to work due to illness.

Rex collected $4,500 on the policy to replace lost wages while he was ill during

the year.

  • Rex is a part-time student working on his bachelor’s degree in engineering. His

employer reimbursed his $5,200 tuition under a plan available to all full-time

employees.

Determine the amount Rex must include in gross income.

  1. LO.2 Casey is in the 15% marginal tax bracket, and Jean is in the 35% marginal tax

bracket. Their employer is experiencing financial difficulties and cannot continue

to pay for the company’s health insurance plan. The annual premiums are

approximately $8,000 per employee. The employer has proposed to either (1)

require the employee to pay the premiums or (2) reduce each employee’s pay by

$10,000 per year with the employer paying the premium. Which option is less objectionable

to Casey, and which is less objectionable to Jean?

  1. LO.2 Belinda spent the last 60 days of 2015 in a nursing home. The cost of the services

provided to her was $18,000 ($300 per day). Medicare paid $8,500 toward

the cost of her stay. Belinda also received $5,500 of benefits under a long-term

care insurance policy she had purchased. What is the effect on Belinda’s gross income?

  1. LO.2 Does the taxpayer recognize gross income in the following situations?

Explain.

  1. Ava is a filing clerk at a large insurance company. She is permitted to leave the

premises for her lunch, but she usually eats in the company’s cafeteria because

it is quick and she is on a tight schedule. On average, she pays $2 for a lunch

that would cost $12 at a restaurant. However, if the prices in the cafeteria were

not so low and the food was not so delicious, she would probably bring her

lunch at a cost of $3 per day.

  1. Scott is an executive for an international corporation located in New York City.

Often he works late, taking telephone calls from the company’s European

branch. Scott often stays in a company-owned condominium when he has a

late-night work session. The condominium is across the street from the company

office.

  1. Ira recently moved to take a new job. For the first month on the new job, Ira

was searching for a home to purchase or rent. During this time, his employer

permitted Ira to live in an apartment the company maintains for customers during

the buying season. The month that Ira occupied the apartment was not during

the buying season, however, and the apartment would not otherwise have

been occupied.

  1. LO.2 Tim is the vice president of western operations for Maroon Oil Company and

is stationed in San Francisco. He is required to live in an employer-owned

home, which is three blocks from his company office. The company-provided home

is equipped with high-speed Internet access and several telephone lines. Tim

receives telephone calls and e-mails that require immediate attention any time of

day or night because the company’s business is spread all over the world. A full-time

administrative assistant resides in the house to assist Tim with the urgent business

matters. Tim often uses the home for entertaining customers, suppliers, and employees.

The fair market value of comparable housing is $9,000 per month. Tim is also

provided with free parking at his company’s office. The value of the parking is $350

per month. Calculate the amount associated with the company-provided housing

and free parking that Tim must include in his gross income.

  1. LO.1, 4 Finch Construction Company provides the carpenters it employs with all of

the required tools. However, the company believes that this has led to

some employees not taking care of the tools and to the mysterious disappearance of

some of the tools. The company is considering requiring all of its employees to provide

their own tools. Employees’ salaries would be increased by $1,500 to compensate

for the additional costs. Write a letter to Finch’s management, explaining the tax

consequences of this plan to the carpenters. Finch’s address is 300 Harbor Drive,

Vermillion, SD 57069.

  1. LO.2 Rosa’s employer has instituted a flexible benefits program. Rosa will use the

plan to pay for her daughter’s dental expenses and other medical expenses

that are not covered by health insurance. Rosa is in the 28% marginal tax bracket

and estimates that the medical and dental expenses not covered by health insurance

will be within the range of $4,000 to $5,000. Her employer’s plan permits her to set

aside as much as $5,000 in the flexible benefits account. Rosa does not itemize her

deductions.

  1. Rosa puts $4,000 in her flexible benefits account, and her actual expenses are

$5,000. What is her cost of underestimating the expenses?

  1. Rosa puts $5,000 in her flexible benefits account, and her actual expenses are

only $4,000. What is her cost of overestimating her expenses?

  1. What is Rosa’s cost of underfunding as compared with the cost of overfunding

the flexible benefits account?

  1. Does your answer in part (c) suggest that Rosa should fund the account closer

to the low end or to the high end of her estimates?

  1. LO.2 Sparrow Corporation would like you to review its employee fringe benefits

program with regard to the tax consequences of the plan for the company’s

president (Polly), who is also the majority shareholder.

  1. The company has a qualified retirement plan. The company pays the cost of

employees attending a retirement planning seminar. The employee must be

within 10 years of retirement, and the cost of the seminar is $1,500 per

attendee.

  1. The company owns a parking garage that is used by customers, employees,

and the general public. Only the general public is required to pay for parking.

The charge to the general public for Polly’s parking for the year would have

been $3,600 (a $300 monthly rate).

  1. All employees are allowed to use the company’s fixed charge long-distance

telephone services as long as the privilege is not abused. Although no one has

kept track of the actual calls, Polly’s use of the telephone had a value (what she

would have paid on her personal telephone) of approximately $600.

  1. The company owns a condominium at the beach, which it uses to entertain customers.

Employees are allowed to use the facility without charge when the

company has no scheduled events. Polly used the facility 10 days during the

year. Her use had a rental value of $1,000.

  1. The company is in the household moving business. Employees are allowed to

ship goods without charge whenever there is excess space on a truck. Polly

purchased a dining room suite for her daughter. Company trucks delivered the

furniture to the daughter. Normal freight charges would have been $750.

  1. The company has a storage facility for household goods. Officers are allowed a

20% discount on charges for storing their goods. All other employees are

allowed a 10% discount. Polly’s discounts for the year totaled $900.

  1. LO.2 Ted works for Azure Motors, an automobile dealership. All employees can

buy a car at the company’s cost plus 2%. The company does not charge

employees the $300 dealer preparation fee that nonemployees must pay. Ted purchased

an automobile for $29,580 ($29,000 þ $580). The company’s cost was

$29,000. The price for a nonemployee would have been $33,900 ($33,600 þ $300

preparation fee). What is Ted’s gross income from the purchase of the automobile?

  1. LO.2 Several of Egret Company’s employees have asked the company to create a

hiking trail that employees could use during their lunch hour. The company

owns vacant land that is being held for future expansion, but would have to spend

approximately $50,000 if it were to make a trail. Nonemployees would be allowed

to use the facility as part of the company’s effort to build strong community support.

What are the relevant tax issues for the employees?

  1. LO.2 Bluebird, Inc., does not provide its employees with any tax-exempt fringe

benefits. The company is considering adopting a hospital and medical benefits

insurance plan that will cost approximately $9,000 per employee. To adopt this

plan, the company may have to reduce salaries and/or lower future salary increases.

Bluebird is in the 35% (combined Federal and state rates) bracket. Bluebird is also

responsible for matching the Social Security and Medicare taxes withheld on

employees’ salaries (at the full 7.65% rate). The hospital and medical benefits insurance

plan will not be subject to the Social Security and Medicare taxes, and the company

is not eligible for the small business credit for health insurance. The

employees generally fall into two marginal tax rate groups:

Income Tax Social Security and Medicare Tax Total

.15 .0765 .2265

.35 .0145 .3645

The company has asked you to assist in its financial planning for the hospital and

medical benefits insurance plan by computing the following:

  1. How much taxable compensation is the equivalent of $9,000 of exempt compensation

for each of the two classes of employees?

  1. What is the company’s after-tax cost of the taxable compensation computed in

part (a)?

  1. What is the company’s after-tax cost of the exempt compensation?
  2. Briefly explain your conclusions from the preceding analysis.
  3. LO.2 George is a U.S. citizen who is employed by Hawk Enterprises, a global company.

Beginning on June 1, 2015, George began working in London. He

worked there until January 31, 2016, when he transferred to Paris. He worked in

Paris the remainder of 2016. His salary for the first five months of 2015 was

$100,000, and it was earned in the United States. His salary for the remainder of

2015 was $175,000, and it was earned in London. George’s 2016 salary from Hawk

was $300,000, with part being earned in London and part being earned in Paris.

What is George’s gross income in 2015 and 2016 (assume that the 2016 indexed

amount is the same as the 2015 indexed amount)?

  1. LO.3 William is employed by an accounting firm and uses his automobile in connection

with his work. During the month of October 2015, he works at the

office for 3 days and participates in the audit of a key client for 19 days. In the audit

situation, William goes directly from his home to the client’s office. On all other

days, he drives to his employer’s office. On four Saturdays in October, he drives

from his home to a local university, where he attends classes in a part-time MBA

program. Relevant mileage is as follows:

Home to office 12

Office to audit client 13

Home to audit client 14

Home to university 10

Using the automatic mileage method, what is William’s deduction for the month?

  1. LO.3 Kristen, the regional manager for a national hardware chain, is based in

Atlanta. During March and April of this year, she has to replace temporarily

the district manager in Jackson (Mississippi). During this period, Kristen flies to Jackson

on Sunday night, spends the week at the district office, and returns home to

Atlanta on Friday afternoon. The cost of returning home is $550, while the cost of

spending the weekend in Jackson would have been $490.

  1. Presuming no reimbursement by her employer, how much, if any, of these

weekend expenses may Kristen deduct?

  1. Would your answer in (a) change if the amounts involved were reversed (i.e.,

the trip home cost $490; staying in Jackson would have been $550)? Explain.

  1. LO.3 In June of this year, Dr. and Mrs. Bret Spencer traveled to Denver to attend a

three-day conference sponsored by the American Society of Implant Dentistry.

Bret, a practicing oral surgeon, participated in scheduled technical sessions

dealing with the latest developments in surgical procedures. On two days, Mrs.

Spencer attended group meetings where various aspects of family tax planning were

discussed. On the other day, she went sightseeing. Mrs. Spencer does not work for

her husband, but she does their tax returns and handles the family investments.

Expenses incurred in connection with the conference are summarized as follows:

Airfare (two tickets) $2,000

Lodging (single and double occupancy are the same rate—$250 each day) 750

Meals ($200 _ 3 days)* 600

Conference registration fee (includes $120 for Family Tax Planning sessions) 620

Car rental 300

* Split equally between Dr. and Mrs. Spencer.

How much, if any, of these expenses can the Spencers deduct?

  1. LO.3 On Thursday, Justin flies from Baltimore (his home office) to Cadiz (Spain).

He conducts business on Friday and Tuesday; vacations on Saturday, Sunday,

and Monday (a legal holiday in Spain); and returns to Baltimore on Thursday. Justin

was scheduled to return home on Wednesday, but all flights were canceled due

to bad weather. Therefore, he spent Wednesday watching floor shows at a local

casino.

  1. For tax purposes, what portion of Justin’s trip is regarded as being for business?
  2. Suppose Monday had not been a legal holiday. Would this change your answer

to (a)? Explain.

  1. Under either (a) or (b), how much of Justin’s airfare qualifies as a deductible

business expense?

  1. LO.3 Veronica is a key employee of Perdiz Corporation, an aerospace engineering

concern located in Seattle. Perdiz would like to establish an office on the east

coast of Florida and wants Veronica to be in charge of the branch. Veronica is hesitant

about making the move because she fears she will have to sell her residence in

Seattle at a loss. Perdiz buys the house from Veronica for $420,000, its cost to her.

She has owned and occupied the house as her principal residence for eight years.

One year later, Perdiz resells the property for $370,000. Nothing regarding the sale

of the residence is ever reflected on Veronica’s income tax returns. Needless to say,

Perdiz absorbs all of Veronica’s moving expenses. Do you have any qualms as to

the way these matters have been handled for income tax purposes? Explain.

  1. LO.3 Upon losing his job as a plant manager in Quincy, Massachusetts, Anthony

incurs $6,200 in job search expenses. Having no success in finding new

employment in the same type of work, Anthony moves to Clearwater, Florida, in

2015 and begins a charter boat business. His expenses in connection with the move

are summarized below.

Penalty for breaking lease on Quincy rented residence $2,800

Forfeiture of membership in Quincy Country Club 2,200

Packing and moving van charges 7,100

Lodging during move (3 nights) 380

Meals during move 360

Mileage (total for two automobiles) 2,400 miles

How much of these expenses may Anthony deduct?

  1. LO.3 Elijah is employed as a full-time high school teacher. The school district for which

he works recently instituted a policy requiring all of its teachers to start working

on a master’s degree. Pursuant to this new rule, Elijah spent most of the summer of

2015 taking graduate courses at an out-of-town university. His expenses are as follows:

Tuition $6,600

Books and course materials 1,500

Lodging 1,700

Meals 2,200

Laundry and dry cleaning 200

Campus parking 300

In addition, Elijah drove his personal automobile 2,200 miles in connection with the

education. He uses the automatic mileage method.

  1. How much, if any, of these expenses might qualify as a deduction for AGI?
  2. How much, if any, of these expenses might qualify as a deduction from AGI?
  3. LO.3 In each of the following independent situations, determine how much, if any,

qualifies as a deduction for AGI under § 222 (qualified tuition and related

expenses).

  1. Lily is single and is employed as an architect. During 2015, she spent $4,100 in

tuition to attend law school at night. Her MAGI is $64,000.

  1. Liam is single and is employed as a pharmacist. During 2015, he spent $2,400

($2,100 for tuition and $300 for books) to take a course in herbal supplements

at a local university. His MAGI is $81,000.

  1. Hailey is married and is employed as a bookkeeper. She spends $5,200 for tuition

and $900 for books and supplies to pursue a bachelor’s degree in accounting.

Her MAGI is $40,000 on the separate return she files.

  1. John spends $6,500 of his savings for tuition to attend Carmine State College.

John is claimed as a dependent by his parents.

  1. How much, if any, of the preceding amounts not allowed under § 222 might

otherwise qualify as a deduction from AGI?

  1. LO.3 During the year, Brenda has the following expenses related to her employment:

Airfare $8,500

Meals 4,000

Lodging 4,900

Transportation while in travel status (taxis and limos) 940

Entertainment of clients 8,000

Although Brenda renders an adequate accounting to her employer, she is reimbursed

for only $12,000 of the above expenses. What are Brenda’s tax consequences

based on the following assumptions?

  1. The $12,000 reimbursement does not designate which expenses are covered.
  2. The reimbursement specifically covers only the meals and entertainment expenses.
  3. The reimbursement covers any of the expenses other than meals and entertainment.
  4. If Brenda has a choice of reimbursement procedures [parts (a), (b), or (c)

above], which should she select? Why?

  1. LO.3, 4 Charles has AGI of $94,000 during the year and the following expenses

related to his employment:

Lodging while in travel status $5,000

Meals during travel 4,000

Business transportation 6,000

Entertainment of clients 3,800

Professional dues and subscriptions 800

Charles is reimbursed $14,000 under his employer’s accountable plan. What are his

deductions for and from AGI?

  1. LO.5 Janet, age 29, is unmarried and is an active participant in a qualified retirement

plan. Her modified AGI is $63,000 in 2015.

  1. Calculate the amount Janet can contribute to a traditional IRA and the amount

she can deduct.

  1. Assume instead that Janet is a participant in a SIMPLE IRA and that she elects to

contribute 4% of her compensation to the account, while her employer contributes

3%. What amount will be contributed for 2015? What amount will be

vested?

  1. LO.5 Carri and Dane, ages 34 and 32, respectively, have been married for 11 years,

and both are active participants in employer qualified retirement plans. Their

total AGI in 2015 is $186,000, and they earn salaries of $87,000 and $95,000, respectively.

What amount may Carri and Dane:

  1. Contribute to regular IRAs?
  2. Deduct for their contributions in (a)?
  3. Contribute to Roth IRAs?
  4. Deduct for their contributions in (c)?
  5. LO.5 Dana, age 54, has a traditional deductible IRA with an account balance of

$107,600, of which $77,300 represents contributions and $30,300 represents

earnings. In 2015, she converts her traditional IRA into a Roth IRA. What amount

must Dana include in her gross income for 2015?

  1. LO.6 In 2015, Susan’s sole proprietorship earns $300,000 of self-employment net

income (after the deduction for one-half of self-employment tax).

  1. Calculate the maximum amount Susan can deduct for contributions to a defined

contribution Keogh plan.

  1. Suppose Susan contributes more than the allowable amount to the Keogh plan.

What are the tax consequences to her?

  1. Can Susan retire and begin receiving Keogh payments at age 58 without incurring

a penalty? Explain.

  1. LO.6 Harvey is a self-employed accountant with earned income from the business

of $120,000 (after the deduction for one-half of his self-employment tax). He

has a profit sharing plan (e.g., defined contribution Keogh plan). What is the maximum

amount Harvey can contribute to his retirement plan in 2015?

  1. LO.6 In each of the following independent situations, determine the amount of

FICA (Social Security and Medicare) the employer should withhold from the

employee’s 2015 salary.

  1. Harry earns a $50,000 salary, files a joint return, and claims four withholding

allowances.

  1. Hazel earns a $115,000 salary, files a joint return, and claims four withholding

allowances.

  1. Tracy earns a $190,000 salary, files a joint return, and claims four withholding

allowances.

  1. LO.6 In 2015, Maria records self-employed earnings of $135,000. Following the format

illustrated in the example in the text, compute Maria’s self-employment tax

liability and the allowable income tax deduction for the self-employment tax paid.

  1. LO.7 Samantha, an executive, has AGI of $100,000 before considering income or

loss from her miniature horse business. Her outside income comes from

prizes for winning horse shows, stud fees, and sales of yearlings. Samantha’s home

is on 20 acres, half of which she uses for the horse activity (i.e., stables, paddocks,

fences, tack houses, and other related improvements).

Samantha’s office in her home is 10% of the square footage of the house. She

uses the office exclusively for maintaining files and records on the horse activities.

Her books show the following income and expenses for the current year:

Income from fees, prizes, and sales $22,000

Expenses

Entry fees 1,000

Feed and veterinary bills 4,000

Supplies 900

Publications and dues 500

Travel to horse shows (no meals) 2,300

Salaries and wages of employees 8,000

Depreciation—

Horse equipment $3,000

Horse farm improvements 7,000

On 10% of personal residence 1,000 11,000

Total home mortgage interest 24,000

Total property taxes on home 2,200

Total property taxes on horse farm improvements 800

The mortgage interest is only on her home because the horse farm improvements

are not mortgaged.

  1. What are Samantha’s tax consequences if the miniature horse activity is a hobby?
  2. If it is a business?

Comprehensive Tax Return Problems

  1. Beth R. Jordan lives at 2322 Skyview Road, Mesa, AZ 85201. She is a tax accountant

with Mesa Manufacturing Company, 1203 Western Avenue, Mesa, AZ 85201

(employer identification number 11-1111111). She also writes computer software

programs for tax practitioners and has a part-time tax practice. Beth is single and

has no dependents. Beth’s birthday is July 4, 1972, and her Social Security number is

123-45-6789. She wants to contribute $3 to the Presidential Election Campaign Fund.

The following information is shown on Beth’s Wage and Tax Statement (Form

W–2) for 2014.

Line Description Amount

1 Wages, tips, other compensation $65,000.00

2 Federal income tax withheld 10,500.00

3 Social Security wages 65,000.00

4 Social Security tax withheld 4,030.00

5 Medicare wages and tips 65,000.00

6 Medicare tax withheld 942.50

15 State Arizona

16 State wages, tips, etc. 65,000.00

17 State income tax withheld 1,954.00

During the year, Beth received interest of $1,300 from Arizona Federal Savings

and Loan and $400 from Arizona State Bank. Each financial institution reported the

interest income on a Form 1099–INT. She received qualified dividends of $800 from

Blue Corporation, $750 from Green Corporation, and $650 from Orange Corporation.

Each corporation reported Beth’s dividend payments on a Form 1099–DIV.

Beth received a $1,100 income tax refund from the state of Arizona on April 29,

  1. On her 2013 Federal income tax return, she reported total itemized deductions

of $8,200, which included $2,200 of state income tax withheld by her employer.

Fees earned from her part-time tax practice in 2014 totaled $3,800. She paid $600

to have the tax returns processed by a computerized tax return service.

On February 8, 2014, Beth bought 500 shares of Gray Corporation common stock

for $17.60 a share. On September 12, 2014, she sold the stock for $14 a share.

Beth bought a used sports utility vehicle for $6,000 on June 5, 2014. She purchased

the vehicle from her brother-in-law, who was unemployed and was in need

of cash. On November 2, 2014, she sold the vehicle to a friend for $6,500.

On January 2, 2014, she acquired 100 shares of Blue Corporation common stock

for $30 a share. She sold the stock on December 19, 2014, for $55 a share.

During the year, Beth records revenues of $16,000 from the sale of a software

program she developed. She incurred the following expenditures in connection with

her software development business.

Cost of personal computer $7,000

Cost of printer 2,000

Furniture 3,000

Supplies 650

Fee paid to computer consultant 3,500

Beth elected to expense the maximum portion of the cost of the computer, printer,

and furniture allowed under the provisions of § 179. These items were placed in

service on January 15, 2014, and used 100% in her business.

Although her employer suggested that Beth attend a convention on current

developments in corporate taxation, she was not reimbursed for the travel expenses

of $1,420 she incurred in attending the convention. The $1,420 included $200 for

the cost of meals.

During the year, Beth paid $300 for prescription medicines and $2,875 for doctor

bills and hospital bills. Medical insurance premiums were paid for her by her

employer. Beth paid real property taxes of $1,766 on her home. Interest on her home

mortgage was $3,845, and interest to credit card companies was $320. She contributed

$30 each week to her church and $10 each week to the United Way. Professional dues

and subscriptions totaled $350. Beth paid estimated Federal income taxes of $1,000.

Part 1—Tax Computation

Compute the net tax payable or refund due for Beth R. Jordan for 2014. If you use

tax forms for your solution, you will need Forms 1040, 2106-EZ, and 4562 and

Schedules A, B, C, D, and SE. Suggested software: H&R BLOCK Tax Software.

Part 2—Tax Planning

Beth is anticipating significant changes in her life in 2015, and she has asked you to

estimate her taxable income and tax liability for 2015. She just received word that

she has been qualified to adopt a 2-year-old daughter. Beth expects that the adoption

will be finalized in 2015 and that she will incur approximately $2,000 of adoption

expenses. In addition, she expects to incur approximately $3,500 of child and

dependent care expenses relating to the care of her new daughter, which will enable

her to keep her job at Mesa Manufacturing Company. However, with the additional

demands on her time because of her daughter, she has decided to

discontinue her two part-time jobs (i.e., the part-time tax practice and her software

business), and she will cease making estimated income tax payments. In your computations,

assume that all other income and expenditures will remain at approximately

the same levels as in 2014.

  1. David R. and Ella M. Cole (ages 39 and 38, respectively) are husband and wife who

live at 1820 Elk Avenue, Denver, CO 80202. David is a regional sales manager for

Wren Industries, a national wholesaler of plumbing and heating supplies, and Ella is

a part-time dental hygienist for a chain of dental clinics.

  • David is classified by Wren as a statutory employee with compensation for 2014

(based on commissions) of $95,000. He is expected to maintain his own office

and pay for all business expenses from this amount. Wren does not require him

to render any accounting as to the use of these funds. It does not withhold Federal

and state income taxes but does withhold and account for the payroll taxes

incurred (e.g., Social Security and Medicare). The Coles are adequately covered

by Wren’s noncontributory medical plan but have chosen not to participate in its

  • 401(k) retirement plan.

David’s employment-related expenses for 2014 are summarized below.

Airfare $8,800

Lodging 5,000

Meals (during travel status) 4,800

Entertainment 3,600

Ground transportation (e.g., limos, rental cars, and taxis) 800

Business gifts 900

Office supplies (includes postage, overnight delivery, and copying) 1,500

The entertainment involved business meals for purchasing agents, store owners,

and building contractors. The business gifts consisted of $50 gift certificates to

a national restaurant. These were sent by David during the Christmas holidays to

18 of his major customers.

In addition, David drove his 2012 Ford Expedition 11,000 miles for business

and 3,000 for personal use during 2014. He purchased the Expedition on August

15, 2011, and has always used the automatic (standard) mileage method for tax

purposes. Parking and tolls relating to business use total $340 in 2014.

  • When the Coles purchased their present residence in April 2011, they devoted

450 of the 3,000 square feet of living space to an office for David. The property

cost $440,000 ($40,000 of which is attributable to the land) and has since appreciated

in value. Expenses relating to the residence in 2014 (except for mortgage interest

and property taxes; see below) are as follows:

Insurance $2,600

Repairs and maintenance 900

Utilities 4,700

Painting office area; area rugs and plants (in the office) 1,800

In terms of depreciation, the Coles use the MACRS percentage tables applicable

to 39-year nonresidential real property. As to depreciable property (e.g., office

furniture), David tries to avoid capitalization and uses whatever method provides

the fastest write-off for tax purposes.

  • Ella works part-time as a substitute for whichever hygienist is ill or on vacation or

when one of the clinics is particularly busy (e.g., prior to the beginning of the

school year). Besides her transportation, she must provide and maintain her own

uniforms. Her expenses for 2014 appear below.

Uniforms $690

State and city occupational licenses 380

Professional journals and membership dues in the American Dental

Hygiene Association 340

Correspondence study course (taken online) dealing with teeth

whitening procedures 420

Ella’s salary for the year is $42,000, and her Form W–2 for the year shows

income tax withholdings of $4,000 (Federal) and $1,000 (state) and the proper

amount of Social Security and Medicare taxes. Because Ella is a part-time employee,

she is not included in her employer’s medical or retirement plans.

  • In addition to those items already mentioned, the Coles had the following receipts

during 2014.

Interest income—

State of Colorado general purpose bonds $2,500

IBM bonds 800

Wells Fargo Bank CD 1,200 $ 4,500

Federal income tax refund for year 2013 510

Life insurance proceeds paid by Eagle Assurance Corporation 200,000

Inheritance of savings account from Sarah Cole 50,000

Sales proceeds from two ATVs 9,000

For several years, the Coles’s household has included David’s divorced mother,

Sarah, who has been claimed as their dependent. In late November 2014, Sarah

unexpectedly died of coronary arrest in her sleep. Unknown to Ella and David,

Sarah had a life insurance policy and a savings account (with David as the designated

beneficiary of each). In 2013, the Coles purchased two ATVs for $14,000.

After several near mishaps, they decided that the sport was too dangerous. In

2014, they sold the ATVs to their neighbor.

  • Additional expenditures for 2014 include:

Funeral expenses for Sarah $ 4,500

Taxes—

Real property taxes on personal residence $6,400

Colorado state income tax due (paid in April 2014 for tax

year 2013) 310 6,710

Mortgage interest on personal residence 6,600

Paid church pledge 2,400

Contributions to traditional IRAs for Ella and David

($5,500 þ $5,500) 11,000

In 2014, the Coles made quarterly estimated tax payments of $1,400 (Federal) and

$500 (state) for a total of $5,600 (Federal) and $2,000 (state).

Part 1—Tax Computation

Using the appropriate forms and schedules, compute the Coles’s Federal income tax

for 2014. Disregard the alternative minimum tax (AMT) and various education credits.

Education credits were discussed in Chapter 10, and the AMT is discussed in

Chapter 17. Relevant Social Security numbers are:

David Cole 123-45-6788

Ella Cole 123-45-6787

Sarah Cole 123-45-6799

The Coles do not want to contribute to the Presidential Election Campaign Fund.

Also, they want any overpayment of tax refunded to them and not applied toward

next year’s tax liability. Suggested software: H&R BLOCK Tax Software.

Part 2—Follow-Up Advice

Ella has always wanted to pursue a career in nursing. To this end, she has earned a

substantial number of college credits on a part-time basis. With Sarah no longer

requiring home care, Ella believes that she can now complete her degree by attending

college on a full-time basis.

David would like to know how Ella’s plans will affect their income tax position.

Specifically, he wants to know:

  • How much Federal income tax they will save if Ella quits her job.
  • Any tax benefits that might be available from the cost of the education.

Write a letter to David, addressing these concerns. Note: In making your projections,

assume that David’s salary and expenses remain the same. Also disregard any

consideration of the educational tax credits (i.e., American Opportunity and lifetime

learning).

 

Research Problems

Research Problem 1. The employees of the city of Greenville must make mandatory

contributions to the city’s postretirement health benefit plan. The employees’ contributions

are placed in a trust and are used exclusively for the employees’ benefits.

The employees believe that because they are required to make the contributions

from their base salaries, the result should be the same as if the employer made the

contribution and had reduced their salaries by the amount of the contributions.

Therefore, the employees believe they should be permitted to exclude the payments

from gross income. The employees have asked you to research the issue.

Research Problem 2. Rick Beam has been an independent sales representative for

various textile manufacturers for many years. His products consist of soft goods such

as tablecloths, curtains, and drapes. Rick’s customers are clothing store chains,

department stores, and smaller specialty stores. The employees of these companies

who are responsible for purchasing merchandise are known as buyers. These companies

generally prohibit their buyers from accepting gifts from manufacturers’ sales

representatives.

Each year, Rick gives cash gifts (never more than $25) to most of the buyers who

are his customers. Generally, he cashes a large check in November and gives the

money personally to the buyers around Christmas. Rick says, “This is one of the ways

that I maintain my relationship with my buyers.” He maintains adequate substantiation

of all of the gifts.

Rick’s deductions for these gifts have been disallowed by the IRS based on

  • 162(c)(2). Rick is confused and comes to you, a CPA, for advice.
  1. Write a letter to Rick concerning his tax position on this issue. Rick’s address is

948 Octavia Street, Baton Rouge, LA 70821.

  1. Prepare a memo for your files supporting the advice you have given.

Research Problem 3. Aaron, a resident of Minnesota, has been a driver for Green

Delivery Service for the past six years. For this purpose, he leases a truck from

Green, and his compensation is based on a percentage of the income resulting from

his pickup and delivery services. Green allows its drivers to choose their 10-hour

shifts and does not exercise any control on how these services are carried out (e.g.,

the route to be taken or the order in which parcels are delivered or picked up).

Under Green’s operating agreement with its drivers, Green can terminate the

arrangement after 30 days’ notice. In practice, however, Green allows its truckers to

quit immediately without giving advance notice. The agreement also labels the drivers

as independent contractors. Green maintains no health or retirement plans for its

drivers, and each year it reports their income by issuing Forms 1099–MISC (and not

Forms W–2). Green requires its drivers to maintain a commercial driver’s license and

be in good standing with the state highway law enforcement division.

Citing the employment tax Regulations in §§ 31.3121(d)–1(c)(2) and 31.3306(i)–

1(b), an IRS agent contends that Aaron is an independent contractor and, therefore,

is subject to the self-employment tax. Based on Peno Trucking, Inc. (93 TCM 1027,

T.C.Memo. 2007–66), Aaron disagrees and contends that he is an employee (i.e., not

self-employed). Who is correct? Why?

Research Problem 4. Search the Internet for a U.S. 801(k) plan. Explain what it is.

Research Problem 5. Sarah was contemplating making a contribution to her traditional

IRA in 2014. She determined she would contribute $5,000 in December 2014,

but forgot about making the contribution until she was preparing her 2014 tax return

in February 2015. Use the website of any well-known IRA provider (e.g., Fidelity,

Vanguard, T. Rowe Price) to determine if Sarah can make a 2014 contribution to her

IRA after the tax year has ended.

Research Problem 6. In reporting the transactions of a self-employed taxpayer, when

can a Schedule C–EZ be used instead of the regular Schedule C of Form 1040?

Roger CPA Review Questions

  1. The following facts pertain to Catch Ewe Later, a sole proprietorship owned by

Shepherd:

20X09 net profit or (loss) ($ 3,000)

20X10 net profit or (loss) 10,000

20X11 net profit or (loss) 1,000

20X12 net profit or (loss) 1,700

20X13 net profit or (loss) 5,000

In 20X14 Shepherd gave out 50 livestock vests to prospective clients, at a cost of

$10 per vest. What amount of business expense can Shepherd include, as a result of

the vests, on Shepherd’s 20X14 Schedule C?

  1. $500
  2. $200
  3. $0
  4. $1,000
  5. On February 15 of the current year, Young received a $10,000 lump-sum payment

from a qualified profit-sharing plan, the full amount of which Young rolled over into

an IRA 46 days later. How much of this lump-sum payment may Young exclude

from current year gross income?

  1. $0
  2. $10,000
  3. Depends on contribution limit
  4. $8,000
  5. Claire is a self-employed individual who owns and runs Claire’s Creations LLC. In

20X14 she had $225,000 in net self-employment earnings, including a deduction for

50% of the self-employment tax, prior to any Keogh deduction. Claire has a defined

contribution stock bonus Keogh plan. What is the highest deductible Keogh contribution

Claire can make for the 20X14 tax year? Assume no excess contribution carryover

from prior years.

  1. $56,250
  2. $225,000
  3. $52,000
  4. $45,000

CHAPTER12

Corporations: Organization, Capital Structure, and Operating Rules

 

Computational Exercises

  1. LO.2 Marie and Ethan form Roundtree Corporation with the transfer of the following.

Marie performs personal services for the corporation with a fair market

value of $80,000 in exchange for 400 shares of stock. Ethan contributes an installment

note receivable (basis $25,000; fair market value $30,000), land (basis $50,000;

fair market value $170,000), and inventory (basis $100,000; fair market value

$120,000) in exchange for 1,600 shares. Determine Marie and Ethan’s current

income, gain, or loss; calculate the basis that each takes in the Roundtree stock.

  1. LO.2 Grady exchanges qualified property, basis of $12,000 and fair market value of

$18,000, for 60% of the stock of Eadie Corporation. The other 40% of the stock

is owned by Pedro, who acquired it five years ago. Calculate Grady ‘s current income,

gain, or loss and the basis he takes in his shares of Eadie stock as a result of this transaction.

  1. LO.3 Jocelyn contributes land with a basis of $60,000 and fair market value of $90,000

and inventory with a basis of $5,000 and fair market value of $8,000 in exchange

for 100% of Zion Corporation stock. The land is subject to a $15,000 mortgage. Determine

Jocelyn’s recognized gain or loss and the basis in the Zion stock received.

  1. LO.3 Martin transfers real estate with an adjusted basis of $260,000 and fair market

value of $350,000 to a newly formed corporation in exchange for 100% of the

stock. The corporation assumes the liability on the transferred real estate in the

amount of $300,000. Determine Martin’s recognized gain on the transfer and the

basis for his stock.

  1. LO.4 Yvonne and Simon form Ion Corporation. Yvonne transfers equipment (basis

of $110,000 and fair market value of $165,000). Simon invests $130,000 of

cash. They each receive 100 shares in Ion Corporation, worth $130,000, but Yvonne

also receives $35,000 of cash from Ion. Calculate Ion Corporation’s basis in the

equipment. In addition, determine Yvonne and Simon’s basis in the Ion stock.

  1. LO.6 Chaz transfers cash of $60,000 to a newly formed corporation for 100% of the

stock. In its initial year, the corporation has net income of $15,000. The

income is credited to the earnings and profits account of the corporation. The corporation

distributes $5,000 to Chaz.

  1. How do Chaz and the corporation treat the $5,000 distribution?
  2. Assume, instead, that Chaz transfers to the corporation cash of $30,000 for stock

and cash of $30,000 for a note of the same amount. The note is payable in equal

annual installments of $3,000 each (beginning at the end of the corporation’s

initial year of operations) and bears interest at the rate of 6%. At the end of the

year, the corporation pays an amount to meet this obligation. Determine the

total amount of the payment and its tax treatment to Chaz and the corporation.

  1. LO.7 Crane and Loon Corporations, two unrelated C corporations, have the following

transactions for 2015:

Crane Loon

Gross income from operations $180,000 $300,000

Expenses from operations 255,000 310,000

Dividends received from domestic

corporations (15% ownership) 100,000 230,000

  1. Compute the dividends received deduction for Crane Corporation.
  2. Compute the dividends received deduction for Loon Corporation.
  3. LO.7 Cherry Corporation, a calendar year C corporation, is formed and begins business

on April 1, 2015. In connection with its formation, Cherry incurs organizational

expenditures of $54,000. Determine Cherry Corporation’s deduction for

organizational expenditures for 2015.

  1. LO.8 Compute the income tax liability for each of the following unrelated C corporations.
  2. Darter Corporation has taxable income of $68,000.
  3. Owl Corporation has taxable income of $10,800,000.
  4. Toucan Corporation, a personal service corporation, has taxable income of $170,000.

 

Problems

  1. LO.1 Janice is the sole owner of Catbird Company. In the current year, Catbird had

operating income of $100,000, a long-term capital gain of $15,000, and a charitable

contribution of $5,000. Janice withdrew $70,000 of profit from Catbird. How should

Janice report this information on her individual tax return if Catbird Company is:

  1. An LLC?
  2. An S corporation?
  3. A C corporation?
  4. LO.1 Can a sole proprietor form as a single-member limited liability company

(LLC)? If so, how would such an LLC be taxed?

  1. LO.1 In the current year, Riflebird Company had operating income of $220,000,

operating expenses of $175,000, and a long-term capital loss of $10,000. How

do Riflebird Company and Roger, the sole owner of Riflebird, report this information

on their respective Federal income tax returns for the current year under the following

assumptions?

  1. Riflebird Company is a proprietorship (Roger did not make any withdrawals

from the business).

  1. Riflebird Company is a C corporation (no dividends were paid during the year).
  2. LO.1 Ellie and Linda are equal owners in Otter Enterprises, a calendar year business.

During the current year, Otter Enterprises has $320,000 of gross income

and $210,000 of operating expenses. In addition, Otter has a long-term capital gain

of $15,000 and makes distributions to Ellie and Linda of $25,000 each. Discuss the

impact of this information on the taxable income of Otter, Ellie, and Linda if Otter is:

  1. A partnership.
  2. An S corporation.
  3. A C corporation.
  4. LO.1 In the current year, Azure Company has $350,000 of net operating income

before deducting any compensation or other payments to its sole owner,

Sasha. In addition, Azure has interest on municipal bonds of $25,000. Sasha has significant

income from other sources and is in the 39.6% marginal tax bracket. Based

on this information, determine the income tax consequences to Azure Company

and to Sasha during the year for each of the following independent situations.

  1. Azure is a C corporation and pays no dividends or salary to Sasha.
  2. Azure is a C corporation and distributes $75,000 of dividends to Sasha.
  3. Azure is a C corporation and pays $75,000 of salary to Sasha.
  4. Azure is a sole proprietorship, and Sasha withdraws $0.
  5. Azure is a sole proprietorship, and Sasha withdraws $75,000.
  6. LO.2 Sarah incorporates her small business but does not transfer the machinery

and equipment used by the business to the corporation. Instead, the machinery

and equipment are leased to the corporation for an annual rent. What tax reasons

might Sarah have for not transferring the machinery and equipment to the

corporation when the business was incorporated?

  1. LO.2, 4 Seth, Pete, Cara, and Jen form Kingfisher Corporation with the following

consideration:

Consideration Transferred

Basis to

Transferor

Fair Market

Value

Number of

Shares Issued

From Seth—

Inventory $30,000 $96,000 30*

From Pete—

Equipment ($30,000 of depreciation

taken by Pete in prior years) 45,000 99,000 30**

From Cara—

Proprietary process 15,000 90,000 30

From Jen—

Cash 30,000 30,000 10

* Seth receives $6,000 in cash in addition to the 30 shares.

** Pete receives $9,000 in cash in addition to the 30 shares.

Assume that the value of each share of Kingfisher stock is $3,000. As to these transactions,

provide the following information:

  1. Seth’s recognized gain or loss. Identify the nature of any such gain or loss.
  2. Seth’s basis in the Kingfisher Corporation stock.
  3. Kingfisher Corporation’s basis in the inventory.
  4. Pete’s recognized gain or loss. Identify the nature of any such gain or loss.
  5. Pete’s basis in the Kingfisher Corporation stock.
  6. Kingfisher Corporation’s basis in the equipment.
  7. Cara’s recognized gain or loss.
  8. Cara’s basis in the Kingfisher Corporation stock.
  9. Kingfisher Corporation’s basis in the proprietary process.
  10. Jen’s recognized gain or loss.
  11. Jen’s basis in the Kingfisher stock.
  12. LO.2, 4 Tom and Gail form Owl Corporation with the following consideration:

Consideration Transferred

Basis to

Transferor

Fair Market

Value

Number of

Shares Issued

From Tom—

Cash $ 50,000 $ 50,000

Installment note 240,000 350,000 40

From Gail—

Inventory $ 60,000 $ 50,000

Equipment 125,000 250,000

Patentable invention 15,000 300,000 60

The installment note has a face amount of $350,000 and was acquired last year from

the sale of land held for investment purposes (adjusted basis of $240,000). As to

these transactions, provide the following information:

  1. Tom’s recognized gain or loss.
  2. Tom’s basis in the Owl Corporation stock.
  3. Owl Corporation’s basis in the installment note.
  4. Gail’s recognized gain or loss.
  5. Gail’s basis in the Owl Corporation stock.
  6. Owl Corporation’s basis in the inventory, equipment, and patentable invention.
  7. How would your answers to the preceding questions change if Tom received

common stock and Gail received preferred stock?

  1. How would your answers change if Gail was a partnership?
  2. LO.2 Jane, Jon, and Clyde incorporate their respective businesses and form Starling

Corporation. On March 1 of the current year, Jane exchanges her property

(basis of $50,000 and value of $150,000) for 150 shares in Starling Corporation. On

April 15, Jon exchanges his property (basis of $70,000 and value of $500,000) for

500 shares in Starling. On May 10, Clyde transfers his property (basis of $90,000 and

value of $350,000) for 350 shares in Starling.

  1. If the three exchanges are part of a prearranged plan, what gain will each of the

parties recognize on the exchanges?

  1. Assume that Jane and Jon exchanged their property for stock four years ago,

while Clyde transfers his property for 350 shares in the current year. Clyde’s

transfer is not part of a prearranged plan with Jane and Jon to incorporate their

businesses. What gain will Clyde recognize on the transfer?

  1. Returning to the original facts, if the property that Clyde contributes has a basis of

$490,000 (instead of $90,000), how might the parties otherwise structure the transaction?

  1. LO.2 Dan and Patricia form Crane Corporation. Dan transfers land (worth

$200,000, basis of $60,000) for 50% of the stock in Crane. Patricia transfers

machinery (worth $150,000, adjusted basis of $30,000) and provides services worth

($50,000) for 50% of the stock.

  1. Will the transfers qualify under § 351? Explain.
  2. What are the tax consequences to Dan and Patricia?
  3. What is Crane Corporation’s basis in the land and the machinery?
  4. LO.2 John organized Toucan Corporation 10 years ago. He contributed property

worth $1 million (basis of $200,000) for 2,000 shares of stock in Toucan (representing

100% ownership). John later gave each of his children, Julie and Rachel,

500 shares of the stock. In the current year, John transfers property worth $350,000

(basis of $170,000) to Toucan for 1,000 more of its shares. What gain, if any, will

John recognize on the transfer?

  1. LO.2 Rhonda owns 50% of the stock of Peach Corporation. She and the other 50%

shareholder, Rachel, have decided that additional contributions of capital are

needed if Peach is to remain successful in its competitive industry. The two shareholders

have agreed that Rhonda will contribute assets having a value of $200,000 (adjusted basis

of $15,000) in exchange for additional shares of stock. After the transaction, Rhonda

will hold 75% of Peach Corporation and Rachel’s interest will fall to 25%.

  1. What gain is realized on the transaction? How much of the gain will be recognized?
  2. Rhonda is not satisfied with the transaction as proposed. How will the consequences

change if Rachel agrees to transfer $1,000 of cash in exchange for additional

stock? In this case, Rhonda would own slightly less than 75% of Peach,

and Rachel’s interest would be slightly more than 25%.

  1. If Rhonda still is not satisfied with the result, what should be done to avoid any

gain recognition?

  1. LO.2, 3, 4 Adam transfers property with an adjusted basis of $50,000 (fair market

value of $400,000) to Swift Corporation for 90% of the stock. The property

is subject to a liability of $60,000, which Swift assumes.

  1. What is the basis of the Swift stock to Adam?
  2. What is the basis of the property to Swift Corporation?
  3. LO.2, 3, 4 Allie forms Broadbill Corporation by transferring land (basis of $125,000,

fair market value of $775,000), which is subject to a mortgage of $375,000.

One month prior to incorporating Broadbill, Allie borrows $100,000 for personal reasons

and gives the lender a second mortgage on the land. Broadbill Corporation issues

stock worth $300,000 to Allie and assumes the mortgages on the land.

  1. What are the tax consequences to Allie and to Broadbill Corporation?
  2. How would the tax consequences to Allie differ if she had not borrowed the

$100,000?

  1. LO.2, 4 Rafael transfers the following assets to Crane Corporation in exchange for

all of its stock. (Assume that neither Rafael nor Crane plans to make any

special tax elections at the time of incorporation.)

Assets Rafael’s Adjusted Basis Fair Market Value

Inventory $ 60,000 $100,000

Equipment 150,000 105,000

Shelving 80,000 65,000

  1. What is Rafael’s recognized gain or loss?
  2. What is Rafael’s basis in the stock?
  3. What is Crane’s basis in the inventory, equipment, and shelving?
  4. If Rafael has no intentions of selling his Crane stock for at least 15 years, what

action would you recommend that Rafael and Crane Corporation consider?

How does this change the previous answers?

  1. LO.2, 3, 4 Kesha, a sole proprietor, is engaged in a cash basis service business. In the

current year, she incorporates the business to form Kiwi Corporation. She

transfers assets with a basis of $500,000 (fair market value of $1.2 million), a bank loan

of $450,000 (which Kiwi assumes), and $80,000 in trade payables in return for all of

Kiwi’s stock. What are the tax consequences of the incorporation of the business?

  1. LO.2 Nancy and her daughter, Kathleen, have been working together in a cattery

called “The Perfect Cat.” Nancy formed the business in 2000 as a sole proprietorship,

and it has been very successful. Assets have a fair market value of $450,000

and a basis of $180,000. On the advice of their tax accountant, Nancy decides to incorporate

“The Perfect Cat.” Because of Kathleen’s participation, Nancy would like her to

receive shares in the corporation. What are the relevant tax issues?

  1. LO.2 Early in the year, Charles, Lane, and Tami form the Harrier Corporation for the

express purpose of developing a shopping center. All parties are experienced

contractors, and they transfer various business assets (e.g., building materials, land) to

Harrier in exchange for all of its stock. Three months after it is formed, Harrier purchases

two cranes from Lane for their fair market value of $400,000 by issuing four annual

installment notes of $100,000 each. Because the adjusted basis of the cranes is

$550,000, Lane plans to recognize a § 1231 loss of $150,000 in the year of the sale.

Does Lane have any potential income tax problemwith this plan? Explain.

  1. LO.2, 4 Alice and Jane form Osprey Corporation. Alice transfers property, basis of

$25,000 and fair market value of $200,000, for 50 shares in Osprey Corporation.

Jane transfers property, basis of $50,000 and fair market value of $165,000,

and agrees to serve as manager of Osprey for one year; in return, Jane receives 50

shares in Osprey. The value of Jane’s services to Osprey is $35,000.

  1. What gain or income will Alice and Jane recognize on the exchange?
  2. What basis will Osprey Corporation have in the property transferred by Alice

and Jane? How should Osprey treat the value of the services that Jane renders?

  1. LO.2, 4 Assume in Problem 28 that Jane receives the 50 shares of Osprey Corporation

stock in consideration for the appreciated property and for the provision

of accounting services in organizing the corporation. The value of Jane’s

services is $35,000.

  1. What gain or income does Jane recognize?
  2. What is Osprey Corporation’s basis in the property transferred by Jane? How

should Osprey treat the value of the services that Jane renders?

  1. LO.2, 4 In January 2015, Wanda transferred machinery worth $200,000 (adjusted basis

of $30,000) to a controlled corporation, Oriole, Inc. The transfer qualified

under § 351. Wanda had deducted $165,000 of depreciation on the machinery while it

was used in her proprietorship. Later in 2015, Oriole sells the machinery for $190,000.

What are the tax consequences to Wanda and to Oriole on the sale of the machinery?

  1. LO.5 Red Corporation wants to set up a manufacturing facility in a midwestern

state. After considerable negotiations with a small town in Ohio, Red accepts

the following offer: land (fair market value of $3 million) and cash of $1 million.

  1. How much gain or income, if any, must Red Corporation recognize?
  2. What basis will Red Corporation have in the land?
  3. Within one year of the contribution, Red constructs a building for $800,000 and

purchases inventory for $200,000. What basis will Red Corporation have in each

of those assets?

  1. LO.6 Emily Patrick (36 Paradise Road, Northampton, MA 01060) formed Teal Corporation

a number of years ago with an investment of $200,000 of cash, for

which she received $20,000 in stock and $180,000 in bonds bearing interest of 8%

and maturing in nine years. Several years later, Emily lent the corporation an additional

$50,000 on open account. In the current year, Teal Corporation becomes insolvent

and is declared bankrupt. During the corporation’s existence, Emily was

paid an annual salary of $60,000. Write a letter to Emily in which you explain how

she should treat her losses for tax purposes.

  1. LO.7 In each of the following independent situations, determine the dividends

received deduction. Assume that none of the corporate shareholders owns

20% or more of the stock in the corporations paying the dividends.

Almond

Corporation

Blond

Corporation

Cherry

Corporation

Income from operations $ 700,000 $ 800,000 $ 900,000

Expenses from operations (600,000) (850,000) (910,000)

Qualifying dividends 100,000 100,000 100,000

  1. LO.7 Gull Corporation, a cash method, calendar year C corporation, was formed and

began business on November 1, 2015. Gull incurred the following expenses

during its first year of operations (November 1, 2015–December 31, 2015):

Expenses of temporary directors and organizational meetings $21,000

Fee paid to state of incorporation 3,000

Expenses for printing and sale of stock certificates 11,000

Legal services for drafting the corporate charter and bylaws (not paid

until January 2016) 19,000

  1. Assuming that Gull Corporation elects under § 248 to expense and amortize

organizational expenditures, what amount may be deducted in 2015?

  1. Assume the same facts as above, except that the amount paid for the legal services

was $28,000 (instead of $19,000). What amount may be deducted as

organizational expenditures in 2015?

  1. LO.7 Egret Corporation, a calendar year C corporation, was formed on March 6,

2015, and opened for business on July 1, 2015. After its formation but prior to

opening for business, Egret incurred the following expenditures:

Accounting $ 7,000

Advertising 14,500

Employee payroll 11,000

Rent 8,000

Utilities 1,000

What is the maximum amount of these expenditures that Egret can deduct in 2015?

  1. LO.8 In each of the following independent situations, determine the corporation’s

income tax liability. Assume that all corporations use a calendar year for tax

purposes and that the tax year involved is 2015.

Taxable Income

Purple Corporation $ 65,000

Azul Corporation 290,000

Pink Corporation 12,350,000

Turquoise Corporation 19,000,000

Teal Corporation (a personal service corporation) 130,000

  1. LO.9 The outstanding stock in Red, Blue, and Green Corporations, each of which

has only one class of stock, is owned by the following unrelated individuals:

Corporations

Shareholders Red Blue Green

Marrin 20% 10% 30%

Murray 10% 50% 20%

Moses 50% 30% 35%

  1. Determine whether Red, Blue, and Green Corporations constitute a brother-sister

controlled group.

  1. Assume that Murray does not own stock in any of the corporations. Would a

brother-sister controlled group exist? Explain.

  1. LO.10 Emerald Corporation, a calendar year and accrual method taxpayer, provides

the following information and asks you to prepare Schedule M–1 for 2015:

Net income per books (after-tax) $257,950

Federal income tax per books 41,750

Tax-exempt interest income 15,000

Life insurance proceeds received as a result of death of corporate

president 150,000

Interest on loan to purchase tax-exempt bonds 1,500

Excess of capital losses over capital gains 6,000

Premiums paid on life insurance policy on life of Emerald’s president 7,800

  1. LO.10 The following information for 2015 relates to Sparrow Corporation, a calendar

year, accrual method taxpayer.

Net income per books (after-tax) $174,100

Federal income tax per books 86,600

Tax-exempt interest income 4,500

MACRS depreciation in excess of straight-line depreciation used for

financial accounting purposes 7,200

Excess of capital loss over capital gains 9,400

Nondeductible meals and entertainment 5,500

Interest on loan to purchase tax-exempt bonds 1,100

Based on the above information, use Schedule M–1 of Form 1120, which is available

on the IRS website, to determine Sparrow’s taxable income for 2015.

  1. LO.10 In the current year, Woodpecker, Inc., a C corporation with $8.5 million in

assets, deducted amortization of $40,000 on its financial statements and

$55,000 on its Federal tax return. Is Woodpecker required to file Schedule M–3? If

a Schedule M–3 is filed by Woodpecker, how is the difference in amortization

amounts treated on that schedule?

  1. LO.10 Dove Corporation, a calendar year C corporation, had the following information

for 2015:

Net income per books (after-tax) $386,250

Taxable income 120,000

Federal income tax per books 30,050

Cash dividend distributions 150,000

Unappropriated retained earnings as of January 1, 2015 796,010

Based on the above information, use Schedule M–2 of Form 1120 (see Example 50

in the text) to determine Dove’s unappropriated retained earnings balance as of

December 31, 2015.

  1. LO.10 In the current year, Pelican, Inc., incurs $50,000 of nondeductible fines and

penalties. Its depreciation expense is $245,000 for financial statement purposes

and $310,000 for tax purposes. How is this information reported on Schedule M–3?

  1. LO.10 In January 2015, Pelican, Inc., established an allowance for uncollectible

accounts (bad debt reserve) of $70,000 on its books and increased the

allowance by $120,000 during the year. As a result of a client’s bankruptcy, Pelican,

Inc., decreased the allowance by $60,000 in November 2015. Pelican, Inc., deducted

the $190,000 of increases to the allowance on its 2015 income statement, but was

not allowed to deduct that amount on its tax return. On its 2015 tax return, the corporation

was allowed to deduct the $60,000 actual loss sustained because of its client’s

bankruptcy. On its financial statements, Pelican, Inc., treated the $190,000

increase in the bad debt reserve as an expense that gave rise to a temporary difference.

On its 2015 tax return, Pelican, Inc., took a $60,000 deduction for bad debt

expense. How is this information reported on Schedule M–3?

Comprehensive Tax Return Problems

  1. On November 1, 2005, Janet Morton and Kim Wong formed Pet Kingdom, Inc., to

sell pets and pet supplies. Pertinent information regarding Pet Kingdom is summarized

as follows:

  • Pet Kingdom’s business address is 1010 Northwest Parkway, Dallas, TX 75225; its telephone

number is (214) 555-2211; and its e-mail address is [email protected]

  • The employer identification number is 11-1111111, and the principal business

activity code is 453910.

  • Janet and Kim each own 50% of the common stock; Janet is president and Kim is

vice president of the company. No other class of stock is authorized.

  • Both Janet and Kim are full-time employees of Pet Kingdom. Janet’s Social Security

number is 123-45-6789, and Kim’s Social Security number is 987-65-4321.

  • Pet Kingdom is an accrual method, calendar year taxpayer. Inventories are determined

using FIFO and the lower of cost or market method. Pet Kingdom uses the

straight-line method of depreciation for book purposes and accelerated depreciation

(MACRS) for tax purposes.

  • During 2014, the corporation distributed cash dividends of $250,000.

Pet Kingdom’s financial statements for 2014 follow.

Income Statement

Income

Gross sales $5,750,000

Sales returns and allowances (200,000)

Net sales $5,550,000

Cost of goods sold (2,300,000)

Gross profit $3,250,000

Dividends received from stock

investments in less-than-

20%-owned U.S. corporations 43,750

Interest income:

State bonds $15,000

Certificates of deposit 20,000 35,000

Total income $3,328,750

(continued)

Expenses

Salaries—officers:

Janet Morton $262,500

Kim Wong 262,500 $525,000

Salaries—clerical and sales 725,000

Taxes (state, local, and payroll) 238,000

Repairs and maintenance 140,000

Interest expense:

Loan to purchase state bonds $ 9,000

Other business loans 207,000 216,000

Advertising 58,000

Rental expense 109,000

Depreciation* 106,000

Charitable contributions 38,000

Employee benefit programs 60,000

Premiums on term life insurance policies

on lives of Janet Morton and Kim

Wong; Pet Kingdom is the

designated beneficiary 40,000

Total expenses (2,255,000)

Net income before taxes $1,073,750

Federal income tax (356,023)

Net income per books $ 717,727

* Depreciation for tax purposes is $136,000. You are not provided enough detailed data to complete a Form

4562 (depreciation). If you solve this problem using H&R BLOCK Tax Software, enter the amount of depreciation

on line 20 of Form 1120.

Balance Sheet

Assets January 1, 2014 December 31, 2014

Cash $ 1,200,000 $ 1,037,750

Trade notes and accounts receivable 2,062,500 2,147,000

Inventories 2,750,000 3,030,000

Stock investment 1,125,000 1,125,000

State bonds 375,000 375,000

Certificates of deposit 400,000 400,000

Prepaid Federal tax –0– 3,977

Buildings and other depreciable assets 5,455,000 5,455,000

Accumulated depreciation (606,000) (712,000)

Land 812,500 812,500

Other assets 140,000 128,500

Total assets $13,714,000 $13,802,727

Liabilities and Equity January 1, 2014 December 31, 2014

Accounts payable $ 2,284,000 $ 1,975,000

Other current liabilities 175,000 155,000

Mortgages 4,625,000 4,575,000

Capital stock 2,500,000 2,500,000

Retained earnings 4,130,000 4,597,727

Total liabilities and equity $13,714,000 $13,802,727

During 2014, Pet Kingdom made estimated tax payments of $90,000 each quarter to

the IRS. Prepare a Form 1120 for Pet Kingdom for tax year 2014. Suggested software:

H&R BLOCK Tax Software.

 

Research Problems

Research Problem 1. Tim is a real estate broker who specializes in commercial real

estate. Although he usually buys and sells on behalf of others, he also maintains a

portfolio of property of his own. He holds this property, mainly unimproved land, either

as an investment or for sale to others.

In early 2013, Irene and Al contact Tim regarding a tract of land located just outside

the city limits. Tim bought the property, which is known as the Moore farm, several

years ago for $600,000. At that time, no one knew that it was located on a

geological fault line. Irene, a well-known architect, and Al, a building contractor,

want Tim to join them in developing the property for residential use. They are aware

of the fault line but believe that they can circumvent the problem by using newly

developed design and construction technology. Because of the geological flaw,

however, they regard the Moore farm as being worth only $450,000. Their intent is to

organize a corporation to build the housing project, and each party will receive stock

commensurate to the property or services contributed.

After consulting his tax adviser, Tim agrees to join the venture if certain modifications

to the proposed arrangement are made. The transfer of the land would be structured

as a sale to the corporation. Instead of receiving stock, Tim would receive a

note from the corporation. The note would be interest-bearing and be due in five

years. The maturity value of the note would be $450,000—the amount that even Tim

concedes is the fair market value of the Moore farm.

What income tax consequences ensue from Tim’s suggested approach? Compare

this result with what would happen if Tim merely transferred the Moore farm in

return for stock in the new corporation.

Research Problem 2. A new client, John Dobson, recently formed John’s Premium

Steakhouse, Inc., to operate a new restaurant. The restaurant will be a first-time business

venture for John, who recently retired after 30 years of military service. John

transferred cash to the corporation in exchange for 100% of its stock, and the corporation

is considering leasing a building and restaurant equipment. John has asked

you for guidance on the tax treatment of various expenses (e.g., licensing, training,

advertising) he expects the corporation to incur during the restaurant’s pre-opening

period. Research the tax treatment of startup expenditures, including the point at

which a business begins for purposes of determining what expenses are included.

Prepare a memo for the client files describing the results of your research.

Partial list of research aids:

  • 195.

Reg. § 1.195–1.

Research Problem 3. Lynn Jones, Shawn, Walt, and Donna are trying to decide

whether they should organize a corporation and transfer their shares of stock in several

corporations to this new corporation. All of their shares are listed on the New

York Stock Exchange and are readily marketable. Lynn would transfer shares in

Brown Corporation, Shawn would transfer stock in Rust Corporation, Walt would

transfer stock in White Corporation, and Donna would transfer stock in several corporations.

The stock would be held by the newly formed corporation for investment

purposes. Lynn asks you, her tax adviser, whether she would have gain on the transfer

of her substantially appreciated shares in Brown Corporation if she transferred

the shares to a newly formed corporation. Your input will be critical as they make

their decision. Prepare a letter to your client, Lynn Jones, and a memo for the firm’s

files. Lynn’s address is 1540 Maxwell Avenue, Highland, KY 41099.

Research Problem 4. On November 21, 2013, Max Baucus, Chairman of the Senate

Finance Committee, released a proposal to change several provisions related to the

taxation of business income including, but not limited to, that earned by corporations.

The proposal deals primarily with cost recovery and tax accounting methods.

Many of the proposed changes are similar to ones contained in House Ways and

Means Committee Chairman Dave Camp’s small business tax reform discussion draft

released earlier in the year. Locate the staff discussion draft of Chairman Baucus’s proposal,

and prepare a PowerPoint presentation of no more than five slides highlighting

the major reforms contained in the proposal.

Research Problem 5. Limited liability company (LLC) status has become a popular

form of operating a business in the United States. Investigate how the growth of LLC

status has affected the relative number of new businesses that have chosen to operate

as corporations.

 

Roger CPA Review Questions

  1. What is the filing deadline for a C Corporation?
  2. March 15
  3. April 15
  4. The 15th day of the 3rd month after year end
  5. The 15th day of the 4th month after year end
  6. Crimson Corp. was organized as a calendar-year corporation in January 20X14,

incurring $51,000 in qualified organizational expenses, and began business in March

20X14. What is the maximum amount Crimson may deduct for organizational

expenditures on its 20X14 corporate tax return?

  1. $4,000
  2. $6,611
  3. $6,350
  4. $7,133
  5. Kellye and Becky formed Whoop! Shotz Corporation by contributing property with

a fair market value of $50,000 and $70,000 cash, respectively, each for a 50% ownership

in the newly formed company. What is Kellye’s taxable gain in this situation if

the adjusted basis in the property is $25,000 and the company is valued at $120,000?

  1. $0
  2. $10,000
  3. $25,000
  4. $35,000
  5. Kellye, Becky, and Emily formed Whoop! Shotz Corporation on 1/1/20X4 with the

following contributions:

Kellye $50,000 cash

Becky $50,000 cash

Emily Legal services

Each was given a one-third ownership in Whoop! Shotz. What amount of income

will Emily recognize if the company is valued at $150,000 after formation?

  1. $50,000
  2. $33,333
  3. $0
  4. $40,000
  5. Kellye and Becky create Whoop! Shotz Corporation by contributing property with a

fair market value of $50,000 and cash of $70,000, respectively. Each receives a 50%

share in the company, which is valued at $150,000 immediately after the formation.

The property has an adjusted basis of $25,000 and is subject to a $10,000 mortgage,

which is assumed by the company. What gain will Kellye recognize in this situation?

  1. $0
  2. $10,000
  3. $15,000
  4. $25,000

 

CHAPTER13

Corporations: Earnings & Profits and Distributions

Computational Exercises

  1. LO.1 At the beginning of the year, Myrna Corporation (a calendar year taxpayer)

holds E & P of $32,000. The corporation generates no additional E & P during

the year. On December 31, the corporation distributes $50,000 to its sole shareholder,

Abby, whose stock basis is $10,000. How does the Federal income tax law

treat this distribution?

  1. LO.3 On January 1 of the current year, Rhondell Corporation holds accumulated

E & P of $13,000. Current E & P for the year is $84,000, earned evenly throughout

the year. Elizabeth and Jonathan are the sole equal shareholders of Rhondell from

January 1 to April 30. On May 1, Elizabeth sells all of her stock to Marshall.

Rhondell makes two distributions to shareholders during the year, as indicated

below. Analyze the distributions by completing the table that follows. Assume that

the shareholders have sufficient basis in their stock for any amount that is treated as

return of capital.

Total Distribution

From

Current E & P

From

Accumulated E & P

Return of

Capital

April 30, $42,000 cash $________ $________ $________

December 31, $58,000 cash ________ ________ ________

  1. LO.5 Global Corporation distributed property with an $850,000 fair market value

and a $415,000 adjusted basis to Kang, one of its shareholders. The property

was subject to a $230,000 mortgage, which Kang assumed. Global’s accumulated

E & P totals $3 million.

What is the amount of Kang’s dividend income on the distribution? What is

Kang’s basis in the property received?

  1. LO.5 Fargo Corporation holds $5 million in accumulated E & P. It distributes to

Leilei, one of its shareholders, land worth $310,000; basis of the land to Fargo

is $260,000. Determine the Federal income tax consequences of the distribution to

Fargo.

  1. LO.7 During the current year, Gnatcatcher, Inc. (E & P of $1 million), distributed

$200,000 each to Brandi and Yuen in redemption of some of their Gnatcatcher

stock. The two shareholders are not related; they acquired their shares five

years ago. Brandi and Yuen are in the 33% income tax bracket, and each had a

$45,000 basis in her redeemed stock.

  1. Assume that the distribution to Brandi is a qualifying stock redemption. Determine

Brandi’s tax liability on the distribution.

  1. Assume that the distribution to Yuen is a nonqualified stock redemption. Determine

Yuen’s tax liability on the distribution.

  1. LO.7 Rosalie owns 50% of the outstanding stock of Salmon Corporation. In a qualifying

stock redemption, Salmon distributes $80,000 to Rosalie in exchange for

one-half of her shares, which have a basis of $100,000. Compute Rosalie’s recognized

loss, if any, on the redemption.

  1. LO.7 Derk owns 250 shares of stock in Rose Corporation. The remaining 750

shares of Rose are owned as follows: 150 by Derk’s daughter Rosalie, 200 by

Derk’s aunt Penelope, and 400 by a partnership in which Derk holds an 80% interest.

Determine the number of shares that Derk owns (directly and indirectly) in Rose

Corporation.

  1. LO.7 Caramel Corporation has 5,000 shares of stock outstanding. In a qualifying

stock redemption, Caramel distributes $145,000 in exchange for 1,000 of its

shares. At the time of the redemption, Caramel has recorded paid-in capital of

$800,000 and E & P of $300,000. Calculate the reduction to Caramel’s E & P as a

result of the distribution.

 

Problems

  1. LO.1, 3 At the start of the current year, Blue Corporation (a calendar year taxpayer)

holds accumulated E & P of $100,000. Blue’s current E & P is $60,000. At

the end of the year, it distributes $200,000 ($100,000 each) to its equal shareholders,

Pam and Jon. Their basis in the stock is $11,000 for Pam and $26,000 for Jon. How

is the distribution treated for tax purposes?

  1. LO.2 Cardinal Corporation, a calendar year taxpayer, receives dividend income of

$250,000 from a corporation in which it holds a 10% interest. Cardinal also

receives interest income of $35,000 from municipal bonds. (The municipality used

the proceeds from the bond issue to construct a public library.) Cardinal borrowed

funds to purchase the municipal bonds and pays $20,000 of interest on the loan.

Excluding these items, Cardinal’s taxable income is $500,000.

  1. What is Cardinal’s taxable income after these items are taken into account?
  2. What is Cardinal’s accumulated E & P at the start of next year if its beginning

balance this year is $150,000?

  1. LO.2 Compute current E & P for Sparrow Corporation (a calendar year, accrual

basis taxpayer). Sparrow reported the following transactions during 2015, its

second year of operation.

Taxable income $330,000

Federal income tax liability paid 112,000

Tax-exempt interest income 5,000

Meals and entertainment expenses (total) 3,000

Premiums paid on key employee life insurance 3,500

Increase in cash surrender value attributable to life insurance premiums 700

Proceeds from key employee life insurance policy 130,000

Cash surrender value of life insurance policy at distribution 20,000

Excess of capital losses over capital gains 13,000

MACRS deduction 26,000

Straight-line depreciation using ADS lives 16,000

Section 179 expense elected during 2014 25,000

Dividends received from domestic corporations (less than 20% owned) 25,000

  • Sparrow uses the LIFO inventory method, and its LIFO recapture amount

increased by $10,000 during 2015.

  • Sparrow sold some property on installments during 2014. The property was sold

for $40,000 and had an adjusted basis then of $32,000. During 2015, Sparrow

received a $15,000 payment on the installment sale.

  1. LO.1, 2, 3 On September 30, Silver Corporation, a calendar year taxpayer, sold a

parcel of land (basis of $400,000) for a $1 million note. The note is payable

in five installments, with the first payment due next year. Because Silver did

not elect out of the installment method, none of the $600,000 gain is taxed this year.

Silver Corporation had a $300,000 deficit in accumulated E & P at the beginning

of the year. Before considering the effect of the land sale, Silver had a deficit in current

E & P of $50,000.

Sam, the sole shareholder of Silver, has a basis of $200,000 in his stock. If Silver

distributes $900,000 to Sam on December 31, how much income must he report for

tax purposes?

  1. LO.2 In determining Blue Corporation’s current E & P for this tax year, how should

taxable income be adjusted as a result of the following transactions?

  1. A capital loss carryover from two years ago, fully used this year.
  2. Nondeductible meal expenses.
  3. Interest income on municipal bonds.
  4. Nondeductible lobbying expenses.
  5. Loss on a sale between related parties.
  6. Federal income tax refund from last year’s return, received this year.
  7. LO.1, 3 Sparrow Corporation is a calendar year taxpayer. At the beginning of the

current year, Sparrow holds accumulated E & P of $33,000. The corporation

incurs a deficit in current E & P of $46,000 that accrues ratably throughout the

year. On June 30, Sparrow distributes $20,000 to its sole shareholder, Libby. If Libby’s

stock has a basis of $4,000, how is she taxed on the distribution?

  1. LO.1, 3 Complete the following schedule for each case. Unless otherwise indicated,

assume that the shareholders have ample basis in the stock investment. All

taxpayers use a calendar tax year.

Accumulated

E & P

Beginning of

Year Current E & P

Cash

Distributions

(All on Last Day

of Year)

Dividend

Income

Return of

Capital

  1. ($200,000) $ 70,000 $130,000 $________ $________
  2. 150,000 (120,000) 210,000 ________ ________
  3. 90,000 70,000 150,000 ________ ________
  4. 120,000 (60,000) 130,000 ________ ________
  5. Same as (d), except that the distribution of

$130,000 is made on June 30. ________ ________

  1. LO.1, 3 Larry, the sole shareholder of Brown Corporation, sold his stock to Ed on

July 30 for $270,000. Larry’s basis in the stock was $200,000 at the beginning

of the year. Brown had accumulated E & P of $120,000 on January 1 and current

E & P of $240,000. During the year, Brown made the following distributions:

$450,000 cash to Larry on July 1 and $150,000 cash to Ed on December 30. How will

Larry and Ed be taxed on the distributions? How much gain will Larry recognize on

the sale of his stock to Ed?

  1. LO.1, 2 In each of the following independent situations, indicate the effect on taxable

income and E & P, stating the amount of any increase (or decrease) in

each as a result of the transaction. Assume that E & P has already been increased by

taxable income.

Taxable Income

Increase

(Decrease)

E & P Increase

(Decrease)

  1. Realized gain of $80,000 on involuntary

conversion of building ($10,000 of gain is

recognized). _____________ _____________

  1. Mining exploration costs incurred on May 1 of

current year; $24,000 is deductible from currentyear

taxable income. _____________ _____________

  1. Sale of equipment to unrelated third party for

$240,000; basis is $120,000 (no election out of

installment method; no payments are received in

current year). _____________ _____________

  1. Dividends of $20,000 received from 5% owned

corporation, together with dividends received

deduction (assume that the taxable income limit

does not apply). _____________ _____________

  1. Domestic production activities deduction of

$45,000 claimed in current year. _____________ _____________

  1. Section 179 expense deduction of $25,000 in

current year. _____________ _____________

  1. Continue with the facts of (f) for the next tax year. _____________ _____________
  2. MACRS depreciation of $80,000. ADS depreciation

would have been $90,000. _____________ _____________

  1. Federal income taxes of $80,000 paid in current year. _____________ _____________
  2. LO.2 Penguin Corporation (a cash basis, calendar year taxpayer) recorded the following

income and expenses in the current year.

Income from services $400,000

Salaries paid to employees 70,000

Tax-exempt interest income 24,000

Dividends from a corporation in which Penguin

holds a 12% interest 40,000

Short-term capital loss on the sale of stock 17,000

Estimated Federal income taxes paid 110,000

Penguin purchased seven-year MACRS property in the current year for $80,000; it

did not claim any § 179 or additional first-year depreciation. The property has a

10-year ADR midpoint life. Determine Penguin’s taxable income and current E & P.

  1. LO.1, 3 At the beginning of the year, Teal Corporation held accumulated E & P of

$225,000. On March 30, Teal sold an asset at a loss of $225,000. For the

calendar year, Teal incurred a deficit in current E & P of $305,000, which includes

the $225,000 loss on the sale of the asset. If Teal made a distribution of $50,000 to

its sole shareholder on April 1, how is the shareholder taxed?

  1. LO.1, 3 Green Corporation (a calendar year taxpayer) had a deficit in accumulated

E & P of $250,000 at the beginning of the current year. Its net profit for the

period January 1 through July 30 was $300,000, but its E & P for the entire taxable

year was only $40,000. If Green made a distribution of $60,000 to its sole shareholder

on August 1, how will the shareholder be taxed?

  1. LO.1, 3 Black Corporation and Tom each own 50% of Tan Corporation’s common

stock. On January 1, Tan holds a deficit in accumulated E & P of $200,000.

Its current E & P is $90,000. During the year, Tan makes cash distributions of

$40,000 each to Black and Tom.

  1. How are the two shareholders taxed on the distribution?
  2. What is Tan’s accumulated E & P at the end of the year?
  3. LO.1, 4 Heather, an individual, owns all of the outstanding stock in Silver Corporation.

Heather purchased her stock in Silver nine years ago, and her basis is

$56,000. At the beginning of this year, the corporation has $76,000 of accumulated

E & P and no current E & P (before considering the effect of the distributions as

noted below). What are the tax consequences to Heather (amount and type of

income and basis in property received) and Silver Corporation (gain or loss and

effect on E & P) in each of the following situations?

  1. Silver distributes land to Heather. The land was held as an investment and has a

fair market value of $54,000 and an adjusted basis of $42,000.

  1. Assume that Silver has no current or accumulated E & P prior to the distribution.

How would your answer to (a) change?

  1. Assume that the land distributed in (a) is subject to a $46,000 mortgage (which

Heather assumes). How would your answer change?

  1. Assume that the land has a fair market value of $54,000 and an adjusted basis of

$62,000 on the date of the distribution. How would your answer to (a) change?

  1. LO.1, 4 Lime Corporation, with E & P of $500,000, distributes land (worth $300,000,

adjusted basis of $350,000) to Harry, its sole shareholder. The land is subject

to a liability of $120,000, which Harry assumes. What are the tax consequences to

Lime and to Harry?

  1. LO.4 Raven Corporation owns three machines that it uses in its business. It no longer

needs two of these machines and is considering distributing them to its

two shareholders as a property dividend. The machines have a fair market value of

$20,000 each. The basis of each machine is as follows: A, $27,000; B, $20,000; and

C, $12,000. Raven has asked you for advice. What do you recommend?

  1. LO.1, 2, 3, 4 Cerulean Corporation has two equal shareholders, Eloise and Olivia.

Eloise acquired her Cerulean stock three years ago by transferring

property worth $700,000, basis of $300,000, for 70 shares of the stock. Olivia

acquired 70 shares in Cerulean Corporation two years ago by transferring property

worth $660,000, basis of $110,000. Cerulean Corporation’s accumulated E & P as of

January 1 of the current year is $350,000.

On March 1 of the current year, the corporation distributed to Eloise property

worth $120,000, basis to Cerulean of $50,000. It distributed cash of $220,000 to Olivia.

On July 1 of the current year, Olivia sold her stock to Magnus for $820,000. On

December 1 of the current year, Cerulean distributed cash of $90,000 each to

Magnus and Eloise. What are the tax issues?

  1. LO.1, 2, 4 Petrel Corporation has accumulated E & P of $85,000 at the beginning of

the year. Its current-year taxable income is $320,000. On December 31,

Petrel distributed business property (worth $140,000, adjusted basis of $290,000) to

Juan, its sole shareholder. Juan assumes a $70,000 liability on the property.

Included in the determination of Petrel’s current taxable income is $16,000 of

income recognized from an installment sale in a previous year. In addition, the corporation

incurred a Federal income tax liability of $112,000, paid life insurance premiums

of $4,500, and received term life insurance proceeds of $150,000 on the

death of an officer.

  1. What is Juan’s gross income from the distribution?
  2. What is Petrel’s E & P after the property distribution?
  3. What is Juan’s tax basis in the property received?
  4. How would your answers to (a) and (b) change if Petrel had sold the property

at its fair market value, used $70,000 of the proceeds to pay off the liability, and

distributed the remaining cash and any tax savings to Juan?

  1. LO.5 Parrot Corporation is a closely held company with accumulated E & P of

$300,000 and current E & P of $350,000. Tom and Jerry are brothers; each

owns a 50% share in Parrot, and they share management responsibilities equally.

What are the tax consequences of each of the following independent transactions

involving Parrot, Tom, and Jerry? How does each transaction affect Parrot’s E & P?

  1. Parrot sells an office building (adjusted basis of $350,000; fair market value of

$300,000) to Tom for $275,000.

  1. Parrot lends Jerry $250,000 on March 31 of this year. The loan is evidenced by a

note that is payable on demand. No interest is charged on the loan (the current

applicable Federal interest rate is 7%).

  1. Parrot owns an airplane that it leases to others for a specified rental rate. Tom

and Jerry also use the airplane for personal use and pay no rent. During the

year, Tom used the airplane for 120 hours, and Jerry used it for 160 hours. The

rental value of the airplane is $350 per hour, and its maintenance costs average

$80 per hour.

  1. Tom leases equipment to Parrot for $20,000 per year. The same equipment can

be leased from another company for $9,000 per year.

  1. LO.5 Robin Corporation would like to transfer excess cash to its sole shareholder,

Adam, who is also an employee. Adam is in the 28% tax bracket, and Robin is

in the 34% bracket.

Because Adam’s contribution to Robin’s profit is substantial, Robin believes that a

$25,000 bonus in the current year is reasonable compensation and should be deductible

in full. However, Robin is considering paying Adam a $25,000 dividend

because Adam’s tax rate on dividends is lower than his tax rate on compensation. Is

Robin correct in believing that a dividend is the better choice? Why or why not?

  1. LO.6 Your client, Raptor Corporation, declares a dividend permitting its common

shareholders to elect to receive 9 shares of cumulative preferred stock or 3

additional shares of Raptor common stock for every 10 shares of common stock

held. Raptor has only common stock outstanding (fair market value of $45 per

share). One shareholder elects to receive preferred stock, while the remaining

shareholders choose the common stock.

Raptor asks you whether the shareholders recognize any taxable income on the

receipt of the stock. Prepare a letter to Raptor or a memo for the tax research file

regarding this matter. Raptor’s address is 1812 S. Camino Seco, Tucson, AZ 85710.

  1. LO.6 Ken purchased 10,000 shares of Gold Corporation common stock six years

ago for $160,000. In the current year, Ken received a preferred stock dividend

of 800 shares, while the other holders of common stock received a common stock

dividend. The preferred stock that Ken received is worth $80,000, and his common

stock has a fair market value of $240,000. Assume that Gold holds ample E & P to

cover any distributions made during the year. What is Ken’s basis in the preferred

and common stock after the dividend is received? When does his holding period

commence for the preferred stock?

  1. LO.6 Denim Corporation declares a nontaxable dividend payable in rights to subscribe

to common stock. One right and $60 entitle the holder to subscribe to

one share of stock. One right is issued for every two shares of stock owned. At the

date of distribution of the rights, the market value of the stock is $110 per share, and

the market value of the rights is $55 each. Lauren owns 300 shares of stock that she

purchased two years ago for $9,000. Lauren receives 150 rights, of which she exercises

105 to purchase 105 additional shares. She sells the remaining 45 rights for

$2,475. What are the tax consequences of this transaction to Lauren?

  1. LO.6 Jacob Corcoran bought 10,000 shares of Grebe Corporation stock two years

ago for $24,000. Last year, Jacob received a nontaxable stock dividend of

2,000 shares in Grebe. In the current tax year, Jacob sold all of the stock received as

a dividend for $18,000. Prepare a letter to Jacob or a memo for the tax research file

describing the tax consequences of the stock sale. Jacob’s address is 925 Arapahoe

Street, Boulder, CO 80304.

  1. LO.7 Joseph and Erica, husband and wife, jointly own all of the stock in Velvet

Corporation. The two are currently involved in divorce proceedings, and pursuant

to those negotiations, they have agreed that only one of them will remain a

shareholder in Velvet after the divorce. Because Erica has been more involved in

Velvet’s management and operations over the years, the parties have agreed that

Joseph’s ownership should be acquired by either Erica or Velvet. What issues should

be considered in determining whether Erica or Velvet should acquire Joseph’s

shares in the corporation?

  1. LO.1, 7 Julio is in the 33% tax bracket. He acquired 2,000 shares of stock in Gray

Corporation seven years ago at a cost of $50 per share. In the current year,

Julio received a payment of $150,000 from Gray Corporation in exchange for 1,000

of his shares in Gray. Gray has E & P of $1 million. What tax liability would Julio

incur on the payment in each of the following situations? Assume that Julio has no

capital losses.

  1. The stock redemption qualifies for sale or exchange treatment.
  2. The stock redemption does not qualify for sale or exchange treatment.
  3. LO.1, 7 How would your answer to Problem 34 differ if Julio were a corporate

shareholder (in the 34% tax bracket) rather than an individual shareholder

and the stock ownership in Gray Corporation represented a 25% interest?

  1. LO.1, 7 Assume in Problem 34 that Julio has a capital loss carryover of $50,000 in

the current tax year. Julio has no other capital gain transactions during the

year. What amount of the capital loss may Julio deduct in the current year in the following

situations?

  1. The payment from Gray Corporation is a qualifying stock redemption for tax

purposes (i.e., receives sale or exchange treatment).

  1. The payment from Gray does not qualify as a stock redemption for tax purposes

(i.e., does not receive sale or exchange treatment).

  1. If Julio had the flexibility to structure the transaction as described in either

(a) or (b), which form would he choose?

  1. LO.1, 7 How would your answer to parts (a) and (b) of Problem 36 differ if Julio

were a corporate shareholder (in the 34% tax bracket) rather than an individual

shareholder and the stock ownership in Gray Corporation represented a 25%

interest?

  1. LO.7 Silver Corporation has 2,000 shares of common stock outstanding. Howard

owns 600 shares, Howard’s grandfather owns 300 shares, Howard’s mother

owns 300 shares, and Howard’s son owns 100 shares. In addition, Maroon Corporation

owns 500 shares. Howard owns 70% of the stock of Maroon.

  1. Applying the stock attribution rules, how many shares does Howard own in

Silver?

  1. Assume that Howard owns only 40% of the stock in Maroon. How many shares

does Howard own, directly and indirectly, in Silver?

  1. Assume the same facts as in (a) above, but in addition, Howard owns a 25% interest

in the Yellow Partnership. Yellow owns 200 shares in Silver. How many

shares does Howard own, directly and indirectly, in Silver?

  1. LO.7 Shonda owns 1,000 of the 1,500 shares outstanding in Rook Corporation

(E & P of $1 million). Shonda paid $50 per share for the stock seven years

ago. The remaining stock in Rook is owned by unrelated individuals. What are the

tax consequences to Shonda in the following independent situations?

  1. Rook redeems 450 shares of Shonda’s stock for $225,000.
  2. Rook redeems 600 shares of Shonda’s stock for $300,000.
  3. LO.7 Broadbill Corporation (E & P $650,000) has 1,000 shares of common stock

outstanding. The shares are owned by the following individuals: Tammy,

300 shares; Yvette, 400 shares; and Jeremy, 300 shares. Each of the shareholders

paid $50 per share for the Broadbill stock four years ago.

In the current year, Broadbill distributes $75,000 to Tammy in redemption of 150

of her shares. Determine the tax consequences of the redemption to Tammy and to

Broadbill under the following independent circumstances.

  1. Tammy and Jeremy are grandmother and grandson.
  2. The three shareholders are siblings.
  3. LO.7 For the last 11 years, Lime Corporation has owned and operated four different

trades or businesses. Lime also owns stock in several corporations that it purchased

for investment purposes.

The stock of Lime is held equally by Sultan, an individual, and by Turquoise

Corporation. Sultan and Turquoise each own 1,000 shares in Lime, purchased 9 years

ago at a cost of $200 per share.

Determine whether either of the following independent transactions qualify as

partial liquidations under § 302(b)(4). In each transaction, determine the tax consequences

to Lime, to Turquoise, and to Sultan. Lime holds E & P of $2.1 million on

the date of the distribution. Lime redeems 250 shares from each shareholder.

  1. Lime sells one of its business lines (basis $500,000, fair market value $700,000)

and distributes the proceeds equally to Sultan and Turquoise.

  1. Lime equally distributes stock (basis $425,000, fair market value $700,000) that

it holds in other corporations to Sultan and Turquoise.

  1. LO.7 Compare the tax treatment of liquidating and redemption distributions in

terms of the following.

  1. Recognition of gain or loss by the shareholder.
  2. Basis of property received by the shareholder.
  3. LO.7 Dove Corporation (E & P of $800,000) has 1,000 shares of stock outstanding.

The shares are owned as follows: Julia, 600 shares; Maxine (Julia’s sister), 300

shares; and Janine (Julia’s daughter), 100 shares. Dove owns land (basis $300,000,

fair market value $260,000) that it purchased as an investment seven years ago.

Dove distributes the land to Julia in exchange for all of her shares in the corporation.

Julia had a basis of $275,000 in the shares. What are the tax consequences for

both Dove and Julia if the distribution is:

  1. A qualifying stock redemption?
  2. A liquidating distribution?
  3. LO.5 Pink Corporation has several employees. Their names and salaries are listed

below.

Judy $470,000

Holly (Judy’s daughter) 100,000

Terry (Judy’s son) 100,000

John (an unrelated third party) 320,000

Holly and Terry are the only shareholders of Pink. Judy and John share equally in

the management of the company’s operations. Holly and Terry are both full-time

college students at a university 200 miles away. Pink has substantial E & P and never

has distributed a dividend. Discuss any income tax issues related to Pink’s salary

arrangement.

 

Research Problems

Research Problem 1. Kenny Merinoff and his son, John, own all of the outstanding

stock of Flamingo Corporation. John and Kenny are officers in the corporation and,

together with their uncle, Ira, comprise the entire board of directors. Flamingo uses

the cash method of accounting and adopted a calendar year-end.

In late 2008, the board of directors adopted the following legally enforceable resolution

(agreed to in writing by each of the officers).

Salary payments made to an officer of the corporation that are disallowed in whole or in

part as a deductible expense for Federal income tax purposes shall be reimbursed by such

officer to the corporation to the full extent of the disallowance. It shall be the duty of the

board of directors to enforce the collection of each such amount.

In 2013, Flamingo paid Kenny $800,000 in compensation. John received $650,000.

As part of an audit in late 2014, the IRS found the compensation of both officers to

be excessive. It disallowed deductions for $400,000 of the payment to Kenny and

$350,000 of the payment to John. The IRS recharacterized the disallowed payments

as constructive dividends. Complying with the resolution by the board of directors,

both Kenny and John repaid the disallowed compensation to Flamingo Corporation

in 2015.

John and Kenny have asked you to determine how their repayments are treated

for Federal income tax purposes. John still is working as a highly compensated executive

for Flamingo, while Kenny is retired and living off of his savings. Prepare a

memo for your firm’s tax research files describing the results of your review.

Partial list of research aids:

  • 1341.

Vincent E. Oswald, 49 T.C. 645 (1968).

Research Problem 2. Your client, White Corporation, has done well since its formation

20 years ago. This year, it recognized a $50 million capital gain from the sale of a

subsidiary. White’s CEO has contacted you to discuss a proposed transaction to

reduce the tax on the capital gain. Under the proposal, White will purchase all of the

common stock in Purple Corporation for $200 million. Purple is a profitable corporation

that has $63 million in cash and marketable securities, $137 million in operating

assets, and approximately $280 million in E & P.

After its acquisition, Purple will distribute $50 million in cash and marketable securities

to White. Due to the 100% dividends received deduction, no taxable income

results to White from the dividend. White then will resell Purple for $150 million.

The subsequent sale of Purple generates a $50 million capital loss

[$150 million ðsale priceÞ _ $200 million ðstock basisÞ]. The loss from the stock sale

can then be used to offset the preexisting $50 million capital gain. Will the proposed

plan work? Why or why not?

Partial list of research aids:

  • 1059.

Research Problem 3. Emerald Corporation must change its method of accounting for

Federal income tax purposes. The change will require that an adjustment to income

be made over three tax periods. Jonas, the sole shareholder of Emerald, wants to better

understand the implications of this adjustment for E & P purposes, as he anticipates

a distribution from Emerald in the current year. Prepare a memo for your firm’s

files describing the results of your research.

Partial list of research aids:

  • 481(a).

Rev.Proc. 97–27, 1997–1 C.B. 680.

Research Problem 4. In July 2013, Windstream Corp. (Nasdaq: WIN), a Fortune 500

and S&P 500 company, made an announcement regarding the taxation of a recent

distribution. It also made a projection regarding the anticipated tax consequences of

future distributions.

Locate articles or press releases regarding Windstream’s announcement and

related distribution. What might have led Windstream to make the announcement?

What implications might the information contained in the announcement have had

for investors’ expectations regarding the company’s future earnings? On what might

the predictions regarding the taxation of future distributions have been based?

Research Problem 5. Write an e-mail query to two tax consultants who practice in

your state. Ask each for an example or two of a constructive dividend that a client

recently paid. Give your instructor copies of your query and the responses you

receive.

Research Problem 6. Publicly traded corporations reacquire their own shares for various

reasons. Through the use of a tender offer, a corporation can purchase a substantial

percentage of the company’s stock. Prepare an outline discussing (1) why

publicly traded corporations reacquire their own shares and (2) how the tender offer

process works for both corporations and shareholders. E-mail your outline to your

tax professor.

 

Roger CPA Review Questions

  1. Candy Corp. is a C Corporation that began operations in Year 1. Candy Corp.’s

Year 1 through Year 3 taxable earnings and profits (E & P) are as follows:

Year E & P

1 ($25,000)

2 5,000

3 10,000

On the last day of Year 3, Candy Corp. makes a $12,500 cash shareholder distribution,

distributed equally among its two shareholders, Goode and Plenteau. How

much of Goode’s distribution is a nontaxable return of capital? Assume sufficient

basis in Goode’s stock investment.

  1. $5,000
  2. $0
  3. $1,250
  4. $6,250
  5. As of December 31, 20X14, Eliot Corp. has net income per books of $100,000, which

includes municipal bond interest of $4,000, a deduction for business meals of

$5,000, a deduction for a net capital loss of $5,000, and a deduction for Federal

income taxes of $22,000. What is Eliot Corp.’s current earnings and profits (E & P)

for 20X14?

  1. $98,500
  2. $107,500
  3. $125,500
  4. $102,500
  5. As of December 31, 20X15, Hardy Corp. has net income per books of $120,000,

which includes straight-line depreciation expense of $5,000. Hardy Corp. claimed

accelerated depreciation of $15,000 for tax purposes. Also included in book income

were lobbying expenses of $4,000 and a Federal income tax refund of $5,000. What

is Hardy Corp.’s current earnings and profits (E & P) for 20X15?

  1. $119,000
  2. $109,000
  3. $124,000
  4. $114,000
  5. As of December 31, 20X15, Caledonia Corp. has taxable income of $150,000,

which includes a $20,000 accelerated depreciation deduction; had straight-line

depreciation been used, the deduction would have been $6,000. Also included

in taxable income is an operating loss carryforward from a prior year of $3,000.

Additionally, Caledonia earned $4,000 in municipal bond interest during the

year. What is Caledonia Corp.’s current earnings and profits (E & P) for 20X15?

  1. $164,000
  2. $171,000
  3. $157,000
  4. $168,000
  5. At the beginning of the year, Crispin, a C corporation, had a deficit of $35,000 in

accumulated earnings and profits (E & P). For the current year, Crispin reported E & P

of $12,000. Crispin distributed $10,000 during the year. What was the amount of Crispin’s

accumulated E & P deficit at year-end?

  1. $23,000
  2. $33,000
  3. $27,000
  4. $37,000
  5. On January 1 of the current year, Quail Corp., an accrual-basis, calendar-year C corporation,

had accumulated earnings and profits (E & P) of $20,000. On December 31 of

the current year, Quail Corp. has current E & P of $24,000, earned evenly throughout

the year. Ray and Devi were sole equal shareholders of Quail throughout the year.

Quail made two distributions to the shareholders during the year: $30,000 on July 1

and $30,000 on December 31. How much of the December 31 distribution is taxable

dividend income for Devi?

  1. $7,000
  2. $11,000
  3. $6,000
  4. $1,000
  5. Compendium Corp. distributed cash and personal property to its sole shareholder.

Considering the following facts, what is the amount of gain that would be recognized

by Compendium as the result of making this distribution to its shareholder?

Item Amount

Cash $25,000

Personal property

Fair market value 10,000

Adjusted basis 4,000

Liability on property assumed by

shareholder 12,000

  1. $4,000
  2. $6,000
  3. $8,000
  4. $29,000
  5. Calvin owns 40% of the outstanding shares of Copernicus Corp., which has accumulated

earnings and profits of $100,000 as of December 31, Year 1. The outstanding

shares not owned by Calvin are owned by parties unrelated to Calvin. On January 1

of Year 2, Calvin, wishing to pursue another business opportunity, sells his stock

back to Copernicus Corp. Copernicus distributes cash of $250,000 in redemption of

all of Calvin’s stock. If Calvin’s adjusted basis for the stock on the date of redemption

is $125,000, what will be the tax effect of the redemption to Calvin?

  1. $125,000 capital gain
  2. $25,000 dividend
  3. $125,000 dividend
  4. $150,000 dividend
  5. Katsu Corp. distributes property to its shareholders as part of a complete liquidation.

The fair market value of the property is $500,000, Katsu’s adjusted basis in the property

is $150,000, and the property is subject to a liability of $200,000. What amount

of gain will Katsu recognize as a result of the transaction?

  1. $150,000
  2. $550,000
  3. $300,000
  4. $350,000
  5. Close Corp. distributed cash and a parcel of land in a nonliquidating distribution to

its sole shareholder. The following facts apply to this distribution:

Item Amount

Cash $50,000

Land

Fair market value 30,000

Adjusted basis 40,000

Based on these facts, what amount of gain or loss should be recognized by Close

Corp. as a result of this distribution?

  1. $60,000 loss
  2. No gain or loss should be recognized
  3. $10,000 loss
  4. $40,000 gain
  5. Callow Corp. has 400 shares of stock outstanding. Callow exchanges $150,000 cash

for 100 of the shares in a qualifying stock redemption. Just prior to the redemption,

Callow had earnings and profits (E & P) of $300,000. By what amount will Callow

Corp.’s E & P be reduced as a result of this redemption? Assume a sufficiently large

additional paid-in capital account balance.

  1. $150,000
  2. E & P will not be reduced
  3. $75,000
  4. Depends on balance in Additional Paid-In Capital

 

CHAPTER14

Partnerships and Limited Liability Entities

Computational Exercises

  1. LO.4 Enerico contributes $100,000 cash in exchange for a 40% interest in the calendar

year ABC LLC. This year, ABC generates $80,000 of ordinary taxable

income. Enerico withdraws $10,000 cash from the partnership at the end of the

tax year.

  1. Compute Enerico’s gross income from ABC’s ordinary income for the tax year.
  2. Compute Enerico’s gross income from the LLC’s cash distribution.
  3. LO.2 Henrietta transfers cash of $75,000 and equipment with a fair market value of

$25,000 (basis to her as a sole proprietor, $10,000) in exchange for a 40%

profit and loss interest worth $100,000 in the XYZ Partnership.

  1. Compute Henrietta’s realized and recognized gains from the asset transfers.
  2. Compute Henrietta’s basis in her interest in XYZ.
  3. What is XYZ’s basis in the equipment that it now holds?
  4. LO.2 Wozniacki and Wilcox form Jewel LLC, with each investor receiving a onehalf

interest in the capital and profits of the LLC. Wozniacki receives his

one-half interest as compensation for tax planning services that he rendered prior

to the formation of the LLC. Wilcox contributes $50,000 cash. The value of a onehalf

capital interest in the LLC (for each of the parties) is $50,000.

  1. Compute Wozniacki’s realized and recognized gain from joining Jewel.
  2. Compute Wozniacki’s basis in his interest in Jewel.
  3. How does Jewel treat the services that Wozniacki has rendered?
  4. LO.5 At the beginning of the tax year, Barnaby’s basis in the BBB Partnership was

$50,000, including his $5,000 share of partnership debt. At the end of the tax

year, his share of the entity’s debt was $8,000.

Barnaby’s share of BBB’s ordinary income for the year was $20,000, and he

received cash distributions totaling $12,000. In addition, his share of the partnership’s

tax-exempt income was $1,000. Determine Barnaby’s basis at the end of the

tax year.

  1. LO.3 Candlewood LLC began its business on September 1; it uses a calendar tax

and accounting year. Candlewood incurred $6,500 in legal fees for drafting

the LLC’s operating agreement and $3,000 in accounting fees for tax advice of an

organizational nature, for a total of $9,500 of organizational costs.

Candlewood also incurred $30,000 of preopening advertising expenses and

$24,500 of salaries and training costs for new employees before opening for business,

for a total of $54,500 of startup costs. The LLC desires to take the largest

deduction available for these costs. Compute Candlewood’s deductions for the first

year of its operations for:

  1. Organizational expenses.
  2. Startup expenses.
  3. LO.4 Franco owns a 60% interest in the Dulera LLC. On December 31 of the current

tax year, his basis in the LLC interest is $128,000. The fair market value of the

interest is $140,000. Dulera then distributes to Franco $30,000 cash and equipment

with an adjusted basis of $5,000 and a fair market value of $8,000.

  1. Compute Franco’s basis in Dulera after the distribution.
  2. Compute Franco’s basis in the equipment that he received from Dulera.
  3. LO.4 When Bruno’s basis in his interest in the MNO LLC is $150,000, he receives

cash of $55,000, a proportionate share of inventory, and land in a distribution

that liquidates MNO and his interest in the LLC. The inventory has a basis to the

entity of $45,000 and a fair market value of $48,000. The land’s basis is $70,000, and

its fair market value is $60,000. Compute Bruno’s recognized gain or loss from the

liquidating distribution.

 

Problems

  1. LO.2 Janda and Kelsey contributed $1 million each to the JKL LLC in exchange for

45% capital and profits interests in the entity. Lilli will contribute no cash, but

has agreed to manage the LLC’s business operations in exchange for an $80,000 annual

salary and a 10% interest in the LLC’s capital and profits (valued at $200,000).

What are the consequences of the entity formation and Lilli’s compensation arrangement

to the LLC members? To the LLC itself?

  1. LO.2 Emma and Laine form the equal EL Partnership. Emma contributes cash of

$100,000. Laine contributes property with an adjusted basis of $40,000 and a

fair market value of $100,000.

  1. How much gain, if any, must Emma recognize on the transfer? Must Laine recognize

any gain? If so, how much?

  1. What is Emma’s basis in her partnership interest?
  2. What is Laine’s basis in her partnership interest?
  3. What basis does the partnership take in the property transferred by Laine?
  4. LO.2 Kenisha and Shawna form the equal KS LLC with a cash contribution of

$360,000 from Kenisha and a property contribution (adjusted basis of

$380,000, fair market value of $360,000) from Shawna.

  1. How much gain or loss, if any, does Shawna realize on the transfer? Does

Shawna recognize any gain or loss? If so, how much?

  1. What is Kenisha’s basis in her LLC interest?
  2. What is Shawna’s basis in her LLC interest?
  3. What basis does the LLC take in the property transferred by Shawna?
  4. Are there more effective ways to structure the formation? Explain.
  5. LO.2 Liz and John formed the equal LJ Partnership on January 1 of the current year.

Liz contributed $80,000 of cash and land with a fair market value of $90,000

and an adjusted basis of $75,000. John contributed equipment with a fair market

value of $170,000 and an adjusted basis of $20,000. John previously used the equipment

in his sole proprietorship.

  1. How much gain or loss will Liz, John, and LJ realize?
  2. How much gain or loss will Liz, John, and LJ recognize?
  3. What bases will Liz and John take in their partnership interests?
  4. What bases will LJ take in the assets it receives?
  5. How will LJ depreciate any assets it receives from the partners?
  6. LO.2, 5 Sam and Drew are equal members of the SD LLC, formed on June 1 of the

current year. Sam contributed land that he inherited from his uncle in 2007.

Sam’s uncle purchased the land in 1982 for $30,000. The land was worth $100,000

when Sam’s uncle died. The fair market value of the land was $200,000 at the date it

was contributed to SD.

Drew has significant experience developing real estate. After SD is formed, he

will prepare a plan for developing the property and secure zoning approvals for the

LLC. Drew normally would bill a third party $50,000 for these efforts. Drew will also

contribute $150,000 of cash in exchange for his 50% interest in SD. The value of

Drew’s 50% interest is $200,000.

  1. How much gain or income does Sam recognize on his contribution of the land

to SD? What is the character of any gain or income recognized?

  1. What basis does Sam take in his LLC interest?
  2. How much gain or income will Drew recognize on the formation of SD? What

is the character of any gain or income recognized?

  1. What basis will Drew take in his LLC interest?
  2. LO.2 Continue with the facts presented in Problem 12. At the end of the first year,

SD distributes $100,000 cash to Sam. No distribution is made to Drew.

  1. How does Sam treat the payment?
  2. How much income or gain would Sam recognize as a result of the payment?
  3. Under general tax rules, what basis would SD take in the land Sam contributed?
  4. LO.3 On July 1 of the current year, the R&R Partnership was formed to operate

a bed-and-breakfast inn. The partnership paid $3,000 in legal fees for drafting

the partnership agreement and $5,000 for accounting fees related to organizing the

entity. It also paid $10,000 in syndication costs to locate and secure investments from

limited partners.

In addition, before opening the inn for business, the entity paid $15,500 for

advertising and $36,000 in costs related to an open house just before the grand

opening of the property. The partnership opened the inn for business on October 1.

  1. How are these expenses classified?
  2. How much may the partnership deduct in its initial year of operations?
  3. How are costs treated that are not deducted currently?
  4. LO.2, 4 Phoebe and Parker are equal members of Phoenix Investors LLC. They are

real estate investors who formed the entity several years ago with equal

cash contributions. Phoenix then purchased a parcel of land.

On January 1 of the current year, to acquire a one-third interest in the entity,

Reece contributed to Phoenix some land she had held for investment. Reece purchased

the land five years ago for $75,000; its fair market value at the contribution

date was $90,000. No special allocation agreements were in effect before or after

Reece was admitted to the LLC. Phoenix holds all land for investment.

Immediately before Reece’s property contribution, the Phoenix balance sheet

was as follows.

Basis FMV Basis FMV

Land $30,000 $180,000 Phoebe, capital $15,000 $ 90,000

Parker, capital 15,000 90,000

$30,000 $180,000 $30,000 $180,000

  1. At the contribution date, what is Reece’s basis in her interest in Phoenix?
  2. When does the LLC’s holding period begin for the contributed land?
  3. On June 30 of the current year, the LLC sold the land contributed by Reece for

$90,000. How much is the recognized gain or loss? How is it allocated among

the LLC members?

  1. Prepare a balance sheet reflecting basis and fair market value for the entity immediately

after the land sale.

  1. LO.4, 5 Amy and Mitchell are equal partners in the accrual basis AM Partnership.

At the beginning of the current tax year, Amy’s capital account has a balance

of $300,000, and the partnership has recourse debts of $200,000 payable to

unrelated parties. All partnership recourse debt is shared equally between the

partners.

The following information about AM’s operations for the current year is obtained

from the partnership’s records.

Ordinary income $400,000

Interest income from P&G bond 4,000

Long-term capital loss 6,000

Short-term capital gain 12,000

Charitable contribution 4,000

Cash distribution to Amy 20,000

Year-end partnership debt payable to unrelated parties is $140,000. If all transactions

are reflected in her beginning capital and basis in the same manner:

  1. What is Amy’s basis in the partnership interest at the beginning of the year?
  2. What is Amy’s basis in the partnership interest at the end of the current year?
  3. LO.4, 5 Assume the same facts as in Problem 16. What income, gains, losses, and

deductions does Amy report on her income tax return? Based on the information

provided, what other calculations is she required to make?

  1. LO.4, 5 Continue with the same facts of Problem 16. Consider Amy’s tax-basis capital

account.

  1. What is Amy’s capital account at the beginning of the year?
  2. What is Amy’s capital account at the end of the year?
  3. How do the capital account balances differ from her basis amounts in

Problem 16?

  1. LO.3 Cerulean, Inc., Coral, Inc., and Crimson, Inc., form the Three Cs Partnership

on January 1 of the current year. Cerulean is a 50% partner, and Crimson and

Coral are 25% partners. For reporting purposes, Crimson uses a fiscal year with an

October 31 year-end, Coral uses the calendar year, and Cerulean uses a fiscal year

with a February 28/29 year-end. What is the required tax year for Three Cs under

the least aggregate deferral method?

  1. LO.2, 4, 5 The JM Partnership was formed to acquire land and subdivide it as residential

housing lots. On March 1, 2015, Jessica contributed land valued

at $600,000 to the partnership in exchange for a 50% interest. She had purchased

the land in 2007 for $420,000 and held it for investment purposes (capital asset).

The partnership holds the land as inventory.

On the same date, Matt contributed land valued at $600,000 that he had purchased

in 2005 for $720,000. He became a 50% owner. Matt is a real estate developer, but he

held this land personally for investment purposes. The partnership holds this land as

inventory.

In 2016, the partnership sells the land contributed by Jessica for $620,000. In

2017, the partnership sells the real estate contributed by Matt for $580,000.

  1. What is each partner’s initial basis in his or her partnership interest?
  2. What is the amount of gain or loss recognized on the sale of the land contributed

by Jessica? What is the character of this gain or loss?

  1. What is the amount of gain or loss recognized on the sale of the land contributed

by Matt? What is the character of this gain or loss?

  1. How would your answer in (c) change if the property were sold in 2022?
  2. LO.2, 5 Lee, Brad, and Rick form the LBR Partnership on January 1 of the current

year. In return for a 25% interest, Lee transfers property (basis of $15,000,

fair market value of $17,500) subject to a nonrecourse liability of $10,000. The liability

is assumed by the partnership. Brad transfers property (basis of $16,000, fair market

value of $7,500) for a 25% interest, and Rick transfers cash of $15,000 for the

remaining 50% interest.

  1. How much gain must Lee recognize on the transfer?
  2. What is Lee’s basis in his interest in the partnership?
  3. How much loss may Brad recognize on the transfer?
  4. What is Brad’s basis in his interest in the partnership?
  5. What is Rick’s basis in his interest in the partnership?
  6. What basis does the LBR Partnership take in the property transferred by Lee?
  7. What is the partnership’s basis in the property transferred by Brad?
  8. LO.2, 5 Assume the same facts as in Problem 21, except that the property contributed

by Lee has a fair market value of $27,500 and is subject to a nonrecourse

mortgage of $20,000.

  1. What is Lee’s basis in his partnership interest?
  2. How much gain must Lee recognize on the transfer?
  3. What is Brad’s basis in his partnership interest?
  4. What is Rick’s basis in his partnership interest?
  5. What basis does the LBR Partnership take in the property transferred by Lee?
  6. LO.5, 6 The BCD Partnership plans to distribute cash of $20,000 to partner Barb at

the end of the tax year. The partnership reported a loss for the year, and

Barb’s share of the loss is $10,000. Barb holds a basis of $15,000 in the partnership

interest, including her share of partnership liabilities. The partnership expects to

report substantial income in future years.

  1. How does Barb calculate the ending basis in the BCD partnership interest?
  2. How much income or loss must Barb report for the tax year?
  3. Will the deduction for any of the $10,000 loss be suspended? Why or why not?
  4. Could any planning opportunities be used to minimize the tax ramifications of

the distribution? Explain.

  1. LO.2, 3 The Pelican Partnership was formed on August 1 of the current year and

admitted Morlan and Merriman as equal partners on that date. The partners

both contributed $300,000 of cash to establish a children’s clothing store in the local

mall. The partners spent August and September buying inventory, equipment, supplies,

and advertising for their “Grand Opening” on October 1. The partnership will

use the accrual method of accounting. The following are some of the costs incurred

during Pelican’s first year of operations.

Legal fees to form partnership $ 8,000

Advertising for “Grand Opening” 18,000

Advertising after opening 30,000

Consulting fees for establishing accounting system 20,000

Rent, at $2,000 per month 10,000

Utilities, at $1,000 per month 5,000

Salaries to salesclerks (beginning in October) 50,000

Payments to Morlan and Merriman for services

($6,000 per month each for three months) 36,000

Tax return preparation expense 12,000

In addition, on October 1, Pelican purchased all of the assets of Granny Newcombs,

Inc. Of the total purchase price for these assets, $200,000 was allocated to the

Granny Newcombs trade name and logo.

Determine how each of the listed costs is treated by Pelican, and identify the

period over which the costs can be deducted, if any.

  1. LO.7 Four GRRLs Partnership is owned by four unrelated friends. Lacy holds a 40%

interest; each of the others owns 20%. Lacy sells investment property to the

partnership for its fair market value of $200,000. Her tax basis in the property was

$250,000.

  1. How much loss, if any, may Lacy recognize?
  2. If Four GRRLs later sells the property for $260,000, how much gain must it

recognize?

  1. How would your answers in (a) and (b) change if Lacy owned a 60% interest in

the partnership?

  1. If Lacy’s basis in the investment property was $120,000 (instead of $250,000)

and she was a 60% partner, how much, if any, gain would she recognize on the

sale of the property to Four GRRLs? How is it characterized?

  1. LO.7 Burgundy, Inc., and Violet Gomez are equal partners in the calendar year BV

LLC. Burgundy uses a fiscal year ending April 30, and Violet uses a calendar

year. Burgundy receives an annual guaranteed payment of $100,000 for use of capital

contributed by Burgundy. BV’s taxable income (after deducting the payment to

Burgundy) is $80,000 for 2015 and $90,000 for 2016.

  1. How much income from BV must Burgundy report for its tax year ending April

30, 2016?

  1. How much income from BV must Violet report for her tax year ending December

31, 2016?

  1. LO.4, 7 Mona and Denise, mother and daughter, operate a local restaurant as an

LLC. The MD LLC earned a profit of $200,000 in the current year. Denise’s

equal LLC interest was acquired by gift from Mona. Assume that capital is a material

income-producing factor and that Mona manages the day-to-day operations of the

restaurant without any help from Denise. Reasonable compensation for Mona’s services

is $50,000.

  1. How much of the MD income is allocated to Mona?
  2. What is the maximum amount of LLC income that can be allocated to Denise?
  3. Assuming that Denise is 15 years old, has no other income, and is claimed as a

dependent by Mona, how is Denise’s income from the restaurant taxed?

  1. LO.5 In each of the following independent cases in which the partnership owns no

hot assets, indicate the following. All of the partners received proportionate

distributions.

  • Whether the partner recognizes gain or loss.
  • Whether the partnership recognizes gain or loss.
  • The partner’s adjusted basis for the property distributed.
  • The partner’s outside basis in the partnership after the distribution.
  1. Kim receives $20,000 of cash in partial liquidation of her interest in the partnership.

Kim’s outside basis for her partnership interest immediately before the distribution

is $3,000.

  1. Kourtni receives $40,000 of cash and land with a $30,000 inside basis to the

partnership (value $50,000) in partial liquidation of her interest. Kourtni’s outside

basis for her partnership interest immediately before the distribution is

$80,000.

  1. Assume the same facts as in (b), except that Kourtni’s outside basis for her partnership

interest immediately before the distribution is $60,000.

  1. Klois receives $50,000 of cash and inventory with a basis of $30,000 and a fair

market value of $50,000 in partial liquidation of her partnership interest. Her basis

was $90,000 before the distribution.

  1. LO.4, 5, 7 At the beginning of the tax year, Melodie’s basis in the MIP LLC was

$60,000, including Melodie’s $40,000 share of the LLC’s liabilities. At the

end of the year, MIP distributed to Melodie cash of $10,000 and inventory (basis of

$6,000, fair market value of $10,000). MIP repaid all of its liabilities by the end of

the year.

  1. If this is a proportionate nonliquidating distribution, what is the tax effect of the

distribution to Melodie and MIP? After the distribution, what is Melodie’s basis

in the inventory and in her MIP interest?

  1. Would your answers to (a) change if this had been a proportionate liquidating

distribution? Explain.

  1. LO.2, 4, 5 Suzy contributed assets valued at $360,000 (basis of $200,000) in

exchange for her 40% interest in Suz-Anna GP (a general partnership).

Anna contributed land and a building valued at $640,000 (basis of $380,000) in

exchange for the remaining interest. Anna’s property was encumbered by a

qualified nonrecourse debt of $100,000, which was assumed by the partnership.

The partnership reports the following income and expenses for the current

tax year.

Sales $560,000

Utilities, salaries, and other operating expenses 360,000

Short-term capital gain 10,000

Tax-exempt interest income 4,000

Charitable contributions 8,000

Distribution to Suzy 10,000

Distribution to Anna 20,000

At the end of the year, Suz-Anna held recourse debt of $100,000 for partnership

accounts payable and qualified nonrecourse debt of $200,000.

  1. What is Suzy’s basis after formation of the partnership? Anna’s basis?
  2. What income and separately stated items does Suz-Anna report on Suzy’s

Schedule K–1? What items does Suzy report on her tax return?

  1. All partnership debts are shared proportionately. At the end of the tax year,

what are Suzy’s basis and amount at risk in her partnership interest?

  1. LO.2, 4, 5, 8 Continue with the facts presented in Problem 30, except that Suz-Anna

was formed as an LLC instead of a general partnership.

  1. How would Suz-Anna’s ending liabilities be treated?
  2. How would Suzy’s basis and amount at risk be different? Explain.
  3. LO.4 The Sparrow Partnership plans to distribute $200,000 cash to its partners at

the end of the year. Marjorie is a 40% partner and would receive $80,000. Her

basis in the partnership is only $10,000, however, so she would recognize a $70,000

gain if she receives the proposed cash distribution.

Marjorie has asked Sparrow instead to purchase a parcel of land that she has

found, on which she will build her retirement residence. The partnership then will

distribute that land to her. Under the partnership distribution rules, Marjorie would

take a $10,000 basis in the land worth $80,000. Her basis in the partnership would

be reduced to $0, but recognition of the $70,000 gain is deferred.

Do you think this is an appropriate transaction? Explain your conclusion in an email

to your instructor.

Comprehensive Tax Return Problems

  1. Ryan Ross (111-11-1111), Oscar Omega (222-22-2222), Clark Carey (333-33-3333),

and Kim Kardigan (444-44-4444) are equal active members in ROCK the Ages LLC.

ROCK serves as agent and manager for prominent musicians in the Los Angeles

area. The LLC’s Federal ID number is 55-5555555. It uses the cash basis and a calendar

tax year, and it began operations on January 1, 2003. Its current address is 6102

Wilshire Boulevard, Suite 2100, Los Angeles, CA 90036.

ROCK was the force behind such music icons as Rhiannon, Elena Gomez, Tyler

Quick, and Conjuring Dragons, and it has had a very profitable year. The following

information was taken from the LLC’s income statement for the current year.

Revenues

Fees and commissions $4,800,000

Taxable interest income from bank deposits 1,600

Tax-exempt interest 3,200

Net gains on stock sales 4,000

Total revenues $4,808,800

Expenses

Advertising and public relations $ 380,000

Charitable contributions 28,000

Section 179 expense 20,000

Employee salaries and wages 1,000,000

Guaranteed payment (services), Ryan Ross, office manager 800,000

Guaranteed payment (services), other members 600,000

Entertainment, subject to 50% disallowance 200,000

Travel 320,000

Legal and accounting fees 132,000

Office rentals paid 80,000

Interest expense on line of credit for operations 10,000

Insurance premiums 52,000

Office expense 200,000

Payroll taxes 92,000

Utilities 54,800

Total expenses $3,968,800

During the past few years, ROCK has taken advantage of bonus depreciation

and § 179 deductions and fully remodeled the premises and upgraded its leasehold

improvements. This year, ROCK wrapped up its remodeling with the purchase

of $20,000 of office furniture, for which it will claim a § 179 deduction.

ROCK uses the same cost recovery methods for both tax and financial

purposes. There is no depreciation adjustment for alternative minimum tax

purposes.

ROCK invests much of its excess cash in non-dividend-paying growth stocks

and tax-exempt securities. During the year, the LLC sold two securities. On

June 15, 2014, ROCK purchased 1,000 shares of Tech, Inc. stock for $100,000;

it sold those shares on December 15, 2014, for $80,000. On March 15, 2013,

ROCK purchased 2,000 shares of BioLabs, Inc. stock for $136,000; it sold those

shares for $160,000 on December 15, 2014. These transactions were reported

to the IRS on Forms 1099–B; ROCK’s basis in these shares was reported on

the form.

Net income per books for 2014 is $840,000. The firm’s activities do not constitute

“qualified production activities” for purposes of the § 199 deduction. On January 1,

the members’ capital accounts equaled $200,000 each. No additional capital contributions

were made. In addition to their guaranteed payments, each member withdrew

$250,000 cash during the year.

ROCK’s book balance sheet as of December 31, 2014, is as follows.

Beginning Ending

Cash $ 444,000 $ ??

Tax-exempt securities 120,000 120,000

Marketable securities 436,000 300,000

Leasehold improvements, furniture, and

equipment 960,000 980,000

Accumulated depreciation (960,000) (980,000)

Total assets $1,000,000 $ ??

Line of credit for operations $ 200,000 $ 160,000

Capital, Ross 200,000 ??

Capital, Omega 200,000 ??

Capital, Carey 200,000 ??

Capital, Kardigan 200,000 ??

Total liabilities and capital $1,000,000 $ ??

All debt is shared equally by the members. Each member has personally guaranteed

the debt of the LLC.

The business code for “Agents and Managers for Artists, Athletes, Entertainers,

and Other Public Figures” is 711410. The LLC’s Form 1065 was prepared by Ryan

Ross and sent to the Ogden, UT IRS Service Center. All of the owners are active in

ROCK’s operations.

  1. Prepare pages 1, 4, and 5 of the Form 1065 for ROCK the Ages LLC.
  2. If you are using tax return preparation software, prepare Form 4562 and

Schedule D.

  1. Prepare Schedule K-1 for Ryan Ross, 15520 W. Earlson Street, Pacific Palisades,

CA 90272.

 

Research Problems

Research Problem 1. Fredstone Consolidated, Inc., and Gradison Enterprises, Inc. are

both real estate developers. Each entity owns a 50% general partner interest in Realty

Partners, GP, a general partnership.

Fredstone and Gradison each contributed $15,000 to form the partnership. The

partnership uses the $30,000 contributed by the partners and a recourse loan of

$100,000 obtained from an unrelated third-party lender to acquire $130,000 of rental

properties. (All amounts are in thousands.)

The partners believe that they will generate extensive tax losses in the first year

due to depreciation expense and initial cash-flow requirements. Fredstone and Gradison

agreed to share losses equally. To make sure that the losses can be allocated

as intended, they included a provision in the partnership agreement requiring each

partner to restore any deficit balance in their partnership capital account upon liquidation

of the partnership.

Fredstone also was willing to include a provision that requires it to make up any

deficit balance within 90 days of liquidation of the partnership. This provision does

not apply to Gradison; instead, it must restore any deficit balance in its capital

account within two years of liquidation of the partnership. No interest accrues on the

deferred restoration payment.

Can Realty allocate the $100,000 recourse debt equally to the two partners, so that

they can deduct their respective shares of partnership losses? Explain.

Research Problem 2. Barney Chang and Aldrin, Inc., a domestic C corporation, have

decided to form BA LLC. The new entity will produce a product that Barney recently

developed and patented. Barney and Aldrin each will own a 50% capital and profits

interest in the LLC. Barney is a calendar year taxpayer, while Aldrin is taxed using a

June 30 fiscal year end. BA does not have a “natural business year” and elects to be

taxed as a partnership.

  1. Determine the taxable year of the LLC under the Code and Regulations.
  2. Two years after formation of BA, Barney sells half of his interest (25%) to Aldrin.

Can BA retain the taxable year determined in part (a)? Why or why not?

Research Problem 3. Find an article posted by a law firm that comments on pitfalls to

avoid in drafting partnership agreements. Ideally, use the home page of a firm that

has offices in your state. Summarize the posting in no more than four PowerPoint

slides, and send your file to your instructor.

Research Problem 4. Find a blog that concentrates on the taxation of partners and

partnerships. Post a message defining the terms inside basis and outside basis and

illustrating why the distinction between them is important. Respond to any replies

you receive. Print your message and one or two of the replies.

Research Problem 5. Determine the statutory tax treatment in your state of a onemember

LLC. Write an e-mail to your professor, comparing this rule with Federal

tax law.

Research Problem 6. Graph the increases in the numbers of LLCs and LLPs filing

Federal tax returns for five-year periods beginning with 1970. Explain any trends in

the data that you identify. Send your report as an e-mail to your instructor.

Roger CPA Review Questions

  1. Which of the following is (are) correct about the holding period of the property

acquired by a partnership as a contribution to the contributing partner’s capital

account?

  1. The holding period begins on the date the partner’s holding period of the contributed

asset began

  1. The holding period depends on the character of the property transferred

III. The holding period excludes the period during which the property was held

by the contributing partner

  1. I and II
  2. II and III
  3. I only
  4. None of the above
  5. Guaranteed payments made by a partnership to partners for services rendered to

the partnership include which of the following?

  1. Sales of partners’ assets to the partnership at guaranteed amounts regardless of

market values

  1. A salary of $170,000 annually without regard to partnership income
  2. Payments of principal on secured notes honored at maturity
  3. Net long-term capital gains earned by the partnership
  4. Properly reported guaranteed payments have the following effect(s):
  5. The guaranteed payment increases the receiving partner’s ordinary income by

the entire amount paid during the tax year

  1. The guaranteed payment decreases every partner’s tax basis in the partnership

by the entire amount paid during the tax year

III. The guaranteed payment is deductible by the partnership in computing its ordinary

income or loss for the tax year

  1. All of the above
  2. I and III, but not II
  3. I and II, but not III
  4. None of the above
  5. On March 17, 20X4, Packer became a partner in Cats & Dogs Co., an already

formed partnership. Packer does not have property to contribute and thus contributes

services in exchange for his 5% interest in Cats & Dogs. Cats & Dogs’ net

assets are as follows:

Basis Fair Market Value

January 1, 20X4 $150,000 $150,000

March 17, 20X4 150,000 170,000

December 31, 20X4 150,000 175,000

On Packer’s 20X4 tax return, what amount must Packer include as ordinary income

from the receipt of the partnership interest?

  1. $0
  2. $7,500
  3. $8,500
  4. $8,750
  5. On a partnership tax return, all of the following are subject to special limitations and

must be separately passed through to the partners, except:

  1. Charitable contributions
  2. Guaranteed payments
  3. Long-term capital gains
  4. Dividend income
  5. Prairee partnership has four equal partners, Dodd, Crank, Pick, and Mack. Each of

the partners had a tax basis of $320,000 as of January 1, 20X5. Prairee’s 20X5 net

business income was $152,000. During 20X5, Prairee paid Mack guaranteed payments

of $4,000 for deductible services rendered, which were not included in determining

Prairee’s net business income. During 20X5, each of the four partners took a

distribution of $50,000. What amount from Prairee should be included on Dodd’s

20X5 tax return?

  1. $152,000
  2. $42,000
  3. $38,000
  4. $37,000
  5. Prairee partnership has four equal partners, Dodd, Crank, Pick, and Mack. Each of

the partners had a tax basis of $320,000 as of January 1, 20X5. Prairee’s 20X5 net

business income was $152,000. During 20X5, Prairee paid Mack guaranteed payments

of $4,000 for deductible services rendered. During 20X5, each of the four

partners took a distribution of $50,000. What is Mack’s tax basis in Prairee on

December 31, 20X5?

  1. $307,000
  2. $358,000
  3. $422,000
  4. $472,000
  5. Osha, a cash basis calendar-year partnership, began business on April 1, 20X5. Osha

incurred and paid the following during 20X5:

Legal work associated with formation of the partnership $15,260

Accounting work associated with raising additional capital 10,000

What is the maximum amount of deductible organizational costs on Osha’s 20X5

partnership return?

  1. $5,000
  2. $5,513
  3. $5,684
  4. $6,013
  5. Catherine has a $100,000 basis in her partnership interest. On April 28 of the current

tax year, the partnership distributes to her cash of $32,000, cash basis receivables

with an inside basis of $0 and a fair market value of $12,000, and a parcel of land

with a fair market value of $75,000 and a basis to the partnership of $65,000. After

accounting for this distribution, what is Catherine’s basis in the land?

  1. $65,000
  2. $53,000
  3. $63,000
  4. $56,000

 

CHAPTER15

S Corporations

Computational Exercises

  1. LO.4 Dion, a shareholder, owned 20% of MeadowBrook’s stock for 292 days and

25% for the remaining 73 days in the year. Using the per-day allocation

method, compute Dion’s share of the following S corporation items.

Schedule K Totals Dion’s Schedule K–1 Totals

Ordinary income $60,000 $_________________

Tax-exempt interest 1,000 $_________________

Charitable contributions 3,400 $_________________

  1. LO.4, 6 Greiner, Inc., a calendar year S corporation, holds no AEP. During the year,

Chad, an individual shareholder, receives a $30,000 cash distribution from

Greiner. Prior to the distribution, Chad’s basis in his Greiner stock is $25,000.

  1. Determine Chad’s ordinary income and capital gain, if any, from the distribution.
  2. What is the basis of Chad’s Greiner stock after accounting for the distribution?
  3. LO.5, 6 Holbrook, a calendar year S corporation, distributes $15,000 cash to its only

shareholder, Cody, on December 31. Cody’s basis in his stock is $20,000,

Holbrook’s AAA balance is $8,000, and Holbrook holds $2,500 AEP before the distribution.

Complete the chart below.

Distribution from Account Effect on Stock Basis Balance after Distribution

From AAA Account $_________________ $_________________ $_________________

From AEP Account $_________________ $_________________ $_________________

From Cody’s stock basis $_________________ $_________________ $_________________

  1. LO.5 Ten years ago, Vogel Inc., an S corporation, purchased a plot of investment

land for $45,000. This year, Vogel distributed the land, now worth $120,000,

to Jamari, its majority shareholder.

  1. Determine the effects of the distribution on the gross income of Vogel and

Jamari, and on Vogel’s AAA balance.

  1. How would your responses change if the land had been purchased for

$120,000 and now was worth $45,000?

  1. LO.7 Kaiwan, Inc., a calendar year S corporation, is partly owned by Sharrod,

whose beginning stock basis is $32,000. During the year, Sharrod’s share of a

Kaiwan long-term capital gain (LTCG) is $5,000, and his share of an ordinary loss is

$18,000. Sharrod then receives a $20,000 cash distribution. Compute the following.

  1. Sharrod’s deductible loss.
  2. Sharrod’s suspended loss.
  3. Sharrod’s new basis in the Kaiwan stock.

 

Problems

  1. LO.2 Which of the following can be a shareholder of an S corporation?
  2. Resident alien.
  3. Partnership.
  4. IRA.
  5. C corporation.
  6. LO.2 Isaac and 121 of his close friends want to form an S corporation. Isaac reasons

that if he and his friends form a partnership, the partnership then can

establish an S corporation and act as a single shareholder, thereby avoiding the 100

shareholder rule. Will Isaac’s plan work? Why or why not?

  1. LO.2 Joey lives in North Carolina, a common law state. He is a shareholder in an S

corporation. If he marries a nonresident alien, will the S election terminate?

Would your answer change if he lived in Louisiana? Explain.

  1. LO.3 On March 2, the two 50% shareholders of a calendar year corporation decide

to elect S status. One of the shareholders, Terry, purchased her stock from a

previous shareholder (a nonresident alien) on January 18 of the same year. Identify

any potential problems for Terry or the corporation.

  1. LO.5, 6 Scott Tyrney owns 21% of an S corporation. He is confused with respect to

the amounts of the corporate AAA and his stock basis. Write a memo to the

tax research file, identifying the key differences between AAA and an S shareholder’s

stock basis.

  1. LO.6 For each of the following independent statements, indicate whether the transaction

will increase (þ), decrease (_), or have no effect (NE) on the basis of

a shareholder’s stock in an S corporation.

  1. Expenses related to tax-exempt income.
  2. Short-term capital gain.
  3. Nonseparately computed loss.
  4. Section 1231 gain.
  5. Depletion not in excess of basis.
  6. Separately computed income.
  7. Nontaxable return-of-capital distribution by the corporation.
  8. Advertising expenses.
  9. Business gifts in excess of $25.
  10. Depreciation recapture income.
  11. Dividends received by the S corporation from an investment in ExxonMobil stock.
  12. LIFO recapture tax paid.
  13. Long-term capital loss.
  14. Cash distribution to shareholder out of AAA.
  15. LO.6, 7 Junie’s share of her S corporation’s net operating loss is $50,000, but her

stock basis is only $30,000. Point out the Federal income tax consequences

that Junie must face.

  1. LO.5, 6 Mary is a shareholder in CarrollCo, a calendar year S corporation. At the beginning

of the year, her stock basis is $10,000, her share of the AAA is

$2,000, and her share of corporate AEP is $6,000. At the end of the year, Mary

receives a $6,000 cash distribution from CarrollCo.

Mary’s share of S corporation items includes a $2,000 long-term capital gain and

a $10,000 ordinary loss. Determine the effects of these events on Mary’s share of

CarrollCo’s AAA, on CarrollCo’s AEP, and on Mary’s stock basis.

  1. LO.4 The profit and loss statement of Kitsch Ltd., an S corporation, shows $100,000

book income. Kitsch is owned equally by four shareholders. From supplemental

data, you obtain the following information about items that are included in book income.

Selling expenses ($21,200)

Tax-exempt interest income 3,000

Dividends received 9,000

  • 1231 gain 7,000

Depreciation recapture income 11,000

Collected bad debts previously deducted 5,000

Long-term capital loss (6,000)

Salary paid to owners (each) (12,000)

Cost of goods sold (91,000)

  1. Compute Kitsch’s nonseparately stated income or loss for the tax year.
  2. What would be the share of this year’s nonseparately stated income or loss

items for James Billings, one of the Kitsch shareholders?

  1. LO.4 Maul, Inc., a calendar year S corporation, incurred the following items.

Tax-exempt interest income $ 7,000

Sales 140,000

Depreciation recapture income 12,000

Long-term capital gain 20,000

  • 1231 gain 7,000

Cost of goods sold (42,000)

Administrative expenses (15,000)

Depreciation expense (MACRS) (17,000)

Charitable contributions (7,000)

  1. Calculate Maul’s nonseparately computed income or loss.
  2. If Carl is a 40% shareholder of Maul, what is Carl’s share of Maul’s long-term

capital gain?

  1. LO.4 Zebra, Inc., a calendar year S corporation, incurred the following items this

year. Sammy is a 40% Zebra shareholder throughout the year.

Operating income $100,000

Cost of goods sold (40,000)

Depreciation expense (MACRS) (10,000)

Administrative expenses (5,000)

  • 1231 gain 21,000

Depreciation recapture income 25,000

Short-term capital loss from stock sale (6,000)

Long-term capital loss from stock sale (4,000)

Long-term capital gain from stock sale 15,000

Charitable contributions (4,500)

  1. Calculate Sammy’s share of Zebra’s nonseparately computed income or loss.
  2. Calculate Sammy’s share of any Zebra long-term capital gain.
  3. LO.4 On January 1, Bobby and Alicia own equally all of the stock of an electing S

corporation called Prairie Dirt Delight. The company has a $60,000 loss for the

year (not a leap year). On the 219th day of the year, Bobby sells his half of the stock

to his son, Bubba. How much of the $60,000 loss, if any, is allocated to Bubba?

  1. LO.4, 5 McLin, Inc., a calendar year S corporation, holds $90,000 of AEP. Tobias,

the sole McLin shareholder, has an $80,000 basis in his stock with a zero

balance in the AAA.

  1. Determine the tax aspects if a $90,000 salary is paid to Tobias.
  2. Same as (a), except that Tobias receives a cash distribution of $90,000 from AEP.
  3. LO.4, 5 Tiger, Inc., a calendar year S corporation, is owned equally by four shareholders:

Ann, Becky, Chris, and David. Tiger owns investment land that

was purchased for $160,000 four years ago. On September 14, when the land is

worth $240,000, it is distributed to David. Assuming that David’s basis in his S corporation

stock is $270,000 on the distribution date, discuss any Federal income tax

ramifications.

  1. LO.4, 5, 6 Spence, Inc., a calendar year S corporation, generates an ordinary loss of

$110,000 and makes a distribution of $140,000 to its sole shareholder,

Storm Nelson. Nelson’s stock basis and AAA at the beginning of the year both total

$200,000. Write a memo to your senior manager, Aaron McMullin, discussing the tax

treatment of Spence’s activities.

  1. LO.5 Polly has been the sole shareholder of a calendar year S corporation since its

inception. Polly’s stock basis is $15,500, and she receives a distribution of $19,000.

Corporate-level accounts are as follows. How is Polly taxed on the distribution?

AAA ………………….. $6,000 AEP …………………. $500

  1. LO.4, 7 Sweetie, a calendar year S corporation, reports an ordinary loss of $80,000

and a capital loss of $20,000. Mei Freiberg owns 30% of the corporate stock

and holds a $24,000 basis in the stock. Determine the amounts of the ordinary loss

and capital loss, if any, that flow through to Freiberg. Prepare a memo for the tax

research files explaining your computations.

  1. LO.4, 5, 6 Valence Corporation’s Form 1120S shows ordinary income of $88,000 for

the year. Daniel owns 40% of the Valence stock throughout the year.

The following information is obtained from the corporate records.

Salary paid to Daniel ($40,000)

Tax-exempt interest income 5,000

Charitable contributions (6,000)

Dividends received from a non-U.S. corporation 5,000

Long-term capital loss (6,000)

Depreciation recapture income 11,000

Refund of prior-year state income taxes 5,000

Cost of goods sold (80,000)

Short-term capital loss (7,000)

Administrative expenses (18,000)

Short-term capital gain 14,000

Selling expenses (11,000)

Daniel’s beginning stock basis 32,000

Daniel’s additional stock purchases 9,000

Beginning AAA 45,000

Daniel’s loan to corporation 20,000

  1. Compute Valence’s book income or loss.
  2. Compute Daniel’s ending stock basis.
  3. Calculate ending corporate AAA.
  4. LO.5 If the beginning balance in Swan, Inc.’s OAA is $6,700 and the following

transactions occur, what is Swan’s ending OAA balance?

Depreciation recapture income $ 21,600

Payroll tax penalty (4,200)

Tax-exempt interest income 4,012

Nontaxable life insurance proceeds 100,000

Life insurance premiums paid (nondeductible) (3,007)

  1. LO.5, 6 Cougar, Inc., is a calendar year S corporation. Cougar’s Form 1120S shows

nonseparately stated ordinary income of $80,000 for the year. Johnny owns

40% of the Cougar stock throughout the year. The following information is obtained

from Cougar’s corporate records.

Tax-exempt interest income $ 3,000

Salary paid to Johnny (52,000)

Charitable contributions (6,000)

Dividends received from a non-U.S. corporation 5,000

Short-term capital loss (6,000)

Depreciation recapture income 11,000

Refund of prior state income taxes 5,000

Cost of goods sold (72,000)

Long-term capital loss ($ 7,000)

Administrative expenses (18,000)

Long-term capital gain 14,000

Selling expenses (11,000)

Johnny’s beginning stock basis 32,000

Johnny’s additional stock purchases 9,000

Beginning AAA 31,000

Johnny’s loan to corporation 20,000

  1. Compute Cougar’s book income or loss.
  2. Compute Johnny’s ending stock basis.
  3. Calculate Cougar’s ending AAA balance.
  4. LO.6 Maple, Inc., is an S corporation with a single shareholder, Bob Maple. Bob

believes that his stock basis in the entity is $50,000, but he has lost some of

the records to substantiate this amount. Maple reports an ordinary loss for the year

of $80,000. What are the Federal income tax aspects to consider?

  1. LO.6, 7 Orange, Inc., a calendar year corporation in Clemson, South Carolina,

elects S corporation status for 2015. The company generated a $74,000

NOL in 2014 and another NOL of $43,000 in 2015.

Orange stock always is owned by the same four shareholders, each owning 25%

of the stock. Pete, one of the shareholders, holds a $6,020 basis in this Orange stock

at the beginning of 2015. Identify the Federal income tax issues that Pete faces.

  1. LO.7 Samuel Reese sold 1,000 shares of his stock in Maroon, Inc., an S corporation.

He sold the stock for $15,700 after he had owned it for six years. Samuel had

paid $141,250 for the stock, which was issued under § 1244. Samuel is married and

separately owns the 1,000 shares. Determine the appropriate Federal income tax

treatment of any gain or loss on the stock sale.

  1. LO.7 Blue is the owner of all of the shares of Blue Bell, an S corporation. Blue is

considering receiving a salary of $110,000 from the business. She will pay the

7.65% FICA taxes on the salary, and the S corporation will pay the same amount of

FICA tax. If Blue reduces her salary to $50,000 and takes an additional $60,000 as a

cash distribution from AAA, how would her Federal income tax liabilities change?

  1. LO.1 One of your clients, Texas, Inc., is considering electing S status. Both of Texas’s

equal shareholders paid $30,000 for their stock. As of the beginning of

2013, Texas’s Subchapter C NOL carryforward is $110,000. Its taxable income projections

for the next few years are as follows. Will you counsel Texas to make the S

election? Explain.

2013 $40,000

2014 25,000

2015 25,000

2016 25,000

  1. LO.6, 7 C&C Properties is an S corporation that owns two rental real estate undertakings:

Carrot Plaza and Cantaloupe Place. Both properties produce an annual

$10,000 operating loss. C&C’s Schedule K aggregates the results of the two

locations into one number.

Dan and Marta, C&C’s two equal shareholders, both hold a $7,000 stock basis in

C&C as of the beginning of the year. Marta actively participates in the Cantaloupe

location, but not at Carrot. Dan actively participates at neither location. Determine

the amount of the available loss pass-throughs for both shareholders.

 

Comprehensive Tax Return Problems

  1. John Parsons (123-45-6781) and George Smith (123-45-6782) are 70% and 30% owners,

respectively, of Premium, Inc. (11-1111111), a candy company located at 1005 16th

Street, Cut and Shoot, TX 77303. Premium’s S election was made on January 15, 2008,

its date of incorporation. The following information was taken from the company’s

2014 income statement. Premium’s book income for the year was $704,574.

Interest income $ 100,000

Gross sales receipts 2,410,000

Beginning inventory 9,607

Direct labor (203,102)

Direct materials purchased (278,143)

Direct other costs (249,356)

Ending inventory 3,467

Salaries and wages (442,103)

Officers’ salaries (150,000)

Repairs (206,106)

Depreciation expense (15,254)

Interest expense (35,222)

Rent expense (operating) (40,000)

Taxes (65,101)

Charitable contributions (cash) (20,000)

Advertising expenses (20,000)

Payroll penalties (15,000)

Other deductions (59,899)

A 2014 comparative balance sheet appears below.

January 1 December 31

Cash $ 47,840 $ ?

Accounts receivable 93,100 123,104

Inventories 9,607 3,467

Prepaid expenses 8,333 17,582

Building and equipment 138,203 185,348

Accumulated depreciation (84,235) (?)

Land 2,000 2,000

Total assets $214,848 $844,422

Accounts payable $ 42,500 $ 72,300

Notes payable (less than 1 year) 4,500 2,100

Notes payable (more than 1 year) 26,700 24,300

Capital stock 30,000 30,000

Retained earnings 111,148 ?

Total liabilities and capital $214,848 $844,422

Premium’s accounting firm provides the following additional information.

Cash distributions to shareholders $100,000

Beginning balance, accumulated

adjustments account $111,148

Using the preceding information, prepare a complete Form 1120S and Schedule

K–1s for John Parsons and George Smith, both of whom live at 5607 20th Street, Cut

and Shoot, TX 77303. Do not complete the Form 4562. If any information is missing,

make realistic assumptions.

 

Research Problems

Research Problem 1. Eel Corporation, in Spivey Corners, North Carolina, has filed a

Form 1120S for six years, and the local office of the IRS has sent the company a letter

requesting an audit next month. Carrie, who is in charge of tax matters at Eel, cannot

find a copy of the original S election, Form 2553.

The original shareholders and officers all agree that a local accountant filed the

form, but he passed away last year. Several of the shareholders instruct Carrie to prepare

a backdated Form 2553, which they will sign. Carrie could then copy the form

and tell the agent that this was a copy of the original Form 2553. What should Carrie

do? She estimates that any proposed deficiency would be in the range of $625,000.

Partial list of research aids:

  • § 1362(b)(5) and (f).

Rev.Proc. 97–48, 1997–2 C.B. 521.

Ltr.Rul. 9748033.

Research Problem 2. Sean Moon is president, secretary, treasurer, sole director, and

sole shareholder of Streetz, an S corporation real estate company. He manages all

aspects of the company’s operations, and he is the only person working at the company

that holds a real estate broker’s license. Sean works 12-hour days and takes few

days off. Corporate records indicate the following.

Year Gross Receipts Net Income

2014 $376,453 $122,605

2015 405,244 161,660

2016 518,189 231,454

Moon and his wife, Kim, filed joint Federal income tax returns, but they did not

report any wages or salaries on their returns. During 2016, Moon transferred

$240,000 from Streetz to his personal account.

You are an expert witness for the IRS. Identify the items that you would present to

the U.S. Tax Court with respect to the amount of Moon’s compensation that is subject

to employment taxes and any other taxes due for 2016 (especially the additional

Medicare net investment income tax). Hint: This is a reasonable compensation issue.

Research Problem 3. Use spreadsheet software to graph the growth in the number of

S corporation returns filed. Obtain data for these years: 1975, 1980, 1985, 1990, 1995,

2000, and 2005. In a note to your instructor, explain the trends that you found in S

returns filed.

Research Problem 4. Summarize the trends in court decisions concerning salaries paid

to shareholders of small S corporations. Title your essay “S Corporation Salaries: Too

Much or Too Little?” Send your essay in an e-mail to your instructor.

Research Problem 5. Summarize in no more than five slides the purpose and provisions

of the S Corporation Modernization Act of 2009.

Roger CPA Review Questions

  1. Mindy, an individual, owns 100% of Markee, an S corporation and has an initial

stock basis of $10,000. 20X4 is the first year of Markee’s operations. Additional items

reported by Markee during the current year are:

Municipal bond interest $10,000

Ordinary income 3,400

Shareholder distributions 5,000

What was Mindy’s basis in Markee at the end of 20X4?

  1. $5,000
  2. $8,400
  3. $15,000
  4. $18,400
  5. Mindy, an individual, owns 100% of Markee, an S corporation and has an initial

stock basis of $10,000. 20X4 is the first year of Markee’s operations. Additional items

reported by Markee during the current year are:

Municipal bond interest $10,000

Ordinary income 3,400

Shareholder distributions 5,000

What amount of the $5,000 distribution is taxable to Mindy?

  1. $0
  2. $1,600
  3. $3,400
  4. $5,000
  5. Monie, an individual taxpayer, owns 50% of Monie & Co, an S corporation. At the beginning

of 20X4, Monie’s basis in Monie & Co stock was $55,000. During 20X4, Monie

& Co realized ordinary loss in the amount of $45,000 and a short-term capital loss of

$15,000. Monie & Co made total distributions of $70,000 to its shareholders during this

taxable year. What amount of the $70,000 distribution is taxable to Monie?

  1. $70,000
  2. $35,000
  3. $25,000
  4. $10,000
  5. Which of the following would cause a revocation of S status for an already formed

S corporation?

  1. A partnership becomes a shareholder of an S corporation
  2. An S corporation becomes a partner in a partnership

III. An S corporation becomes a shareholder in a C corporation

  1. A nonresident alien becomes a shareholder of an S corporation
  2. None of the above
  3. II and III
  4. I and IV
  5. All of the above
  6. Rocket Co, an S corporation, pays single coverage health insurance premiums of

$17,000 per year. Philip is a 1% shareholder-employee in Rocket. On Philip’s behalf,

Rocket pays Philip’s family coverage under the health insurance plan. What amount

of insurance premiums is includible in Philip’s gross income?

  1. $17,000
  2. $170
  3. $17
  4. $0
  5. Shareholders of Rayle Co, a calendar year corporation whose S status was terminated

during 20X4, are looking to re-apply for the S status as soon as possible. What

is the earliest year a new S election can be made, in the absence of IRS consent to

an earlier election?

  1. 20X9
  2. 20X8
  3. 20X7
  4. 20X4
  5. Pankee Inc., was originally formed as a C corporation and made an S election 5 years

ago. Which of the following statements correctly describes the taxability of Pankee’s

distributions to its shareholders?

  1. A distribution to the shareholders will be taxable to the shareholders, if it is

treated as coming from the S corporation’s accumulated adjusted account and

represents an amount already taxed to the shareholders

  1. A distribution to the shareholders will be nontaxable to the shareholders, if it is

treated as coming from the S corporation’s accumulated adjusted account and

represents an amount already taxed to the shareholders

  1. A distribution to the shareholders will be nontaxable to the shareholders, if it is

treated as coming from the S corporation’s accumulated earnings and profits,

earned during its years as a C corporation

  1. A distribution to the shareholders will be nontaxable to the shareholders regardless

of whether it is treated as coming from the S corporation’s accumulated

adjusted account or its accumulated earnings and profits

  1. As of January 1, 20X4, Kirk owed all 300 shares of Cork Inc., a calendar year S corporation.

On September 1, 20X4 (243 days after January 1), Kirk sold 50 shares each

to Steve and Moe and kept the remaining 200 shares for himself. For the year ended

December 31, 20X4, Cork reported nonseparately computed income of $109,500

and made no distributions to its shareholders. What amount of nonseparately stated

income from Cork should Kirk report on his 20X4 tax return?

  1. $97,300
  2. $109,500
  3. $73,000
  4. $36,500

 

 

CHAPTER16

Multijurisdictional Taxation

Computational Exercises

  1. LO.3 Cordero, Inc., is a calendar-year taxpayer and a CFC for the entire tax year.

Vance Company, a U.S. corporation, owns 75% of Cordero’s one class of

stock for the entire year. Cordero’s Subpart F income for the year is $450,000, and

no distributions were made to the parent. Determine Vance’s gross income from the

Subpart F constructive dividend from Cordero.

  1. LO.3 Enders, Inc., a domestic corporation, reports $290,000 total taxable income

for the year, consisting of $208,800 in U.S.-source business profits and

$81,200 of income from foreign investment securities. Overseas tax authorities withheld

$24,000 in income taxes on the investment income. Enders’s U.S. tax before

the FTC is $78,000. Compute Enders’s foreign tax credit for the year.

  1. LO.6 Castle Corporation conducts business and has nexus in states A, B, and C. All

of the states use a three-equal-factors apportionment formula, with the factors

evenly weighted. Castle generates $555,000 apportionable income and $75,000

allocable income related to state C activities. Castle’s sales, payroll, and property are

divided evenly among the three states. Compute taxable income for:

  1. State A.
  2. State B.
  3. State C.
  4. LO.6 Fillon operates manufacturing facilities in states A and B. Fillon has nexus

with both states; apportionment factors are .70 for A and .30 for B. Taxable

income for the year totaled $150,000, with a $200,000 A profit and a $50,000 B loss.

Calculate taxable income for the year for:

  1. State A.
  2. State B.
  3. LO.6 Beckett Corporation has nexus with states A and B. Apportionable income for

the year totals $800,000. Beckett’s apportionment factors for the year use the

following data. Compute Beckett’s B taxable income for the year; B uses a threefactor

apportionment formula, with a double-weighted sales factor.

State A State B Totals

Sales $960,000 $640,000 $1,600,000

Property 180,000 –0– 180,000

Payroll 220,000 –0– 220,000

  1. LO.6 Chirp Corporation owns two subsidiaries. Song, located in State A, generated

$500,000 taxable income this year. Bird, located in State B, generated a

$100,000 loss for the period.

  1. Determine Song’s taxable income in States A and B, assuming that the subsidiaries

constitute independent corporations under the tax law.

  1. How does your answer change if the companies constitute a unitary business?

 

Problems

  1. LO.3 BlueCo, a domestic corporation, incorporates GreenCo, a new wholly owned

entity in Germany. Under both German and U.S. legal principles, this entity is

a corporation. BlueCo faces a 35% U.S. tax rate.

GreenCo earns $1,500,000 in net profits from its German activities, and GreenCo

makes no dividend distributions to BlueCo. How much Federal income tax will

BlueCo pay for the current year as a result of GreenCo’s earnings, assuming that

there is no deemed dividend under Subpart F? Ignore any foreign tax credit (FTC)

implications.

  1. LO.3 Evaluate this statement: It is unfair that the United States taxes its citizens and

residents on their worldwide income.

  1. LO.3 Describe the different approaches used by countries to tax the earnings of

their citizens and residents generated outside the borders of the country.

  1. LO.3 Create, Inc., produces inventory in its foreign manufacturing plants for sale in

the United States. Its foreign manufacturing assets have a tax book value of

$5 million and a fair market value of $15 million. Its assets related to the sales activity

have a tax book value of $2 million and a fair market value of $5 million. Create’s

interest expense totaled $400,000 for the current year.

  1. What amount of interest expense is allocated and apportioned to foreign-source

income using the tax book value method? What amount of Create’s interest

expense is allocated and apportioned to foreign-source income using the fair market

value method?

  1. If Create wants to maximize its FTC, which method should it use?
  2. LO.3 Chock, a U.S. corporation, purchases inventory for resale from distributors

within the United States and resells this inventory at a $1 million profit to customers

outside the United States. Title to the goods passes outside the United States.

What is the source of Chock’s inventory sales income?

  1. LO.3 Willa, a U.S. corporation, owns the rights to a patent related to a medical device.

Willa licenses the rights to use the patent to IrishCo, which uses the

patent in its manufacturing facility located in Ireland. What is the source of the

$1 million royalty income received by Willa from IrishCo for the use of the patent?

  1. LO.3 USCo incurred $100,000 in interest expense for the current year. The tax book

value of USCo’s assets generating foreign-source income is $5 million. The

tax book value of USCo’s assets generating U.S.-source income is $45 million. How

much of the interest expense is allocated and apportioned to foreign-source

income?

  1. LO.3 QuinnCo could not claim all of the income taxes it paid to Japan as a foreign

tax credit (FTC) this year. What computational limit probably kept QuinnCo

from taking its full FTC? Explain.

  1. LO.3 FoldIt, a U.S. business, paid income taxes to Mexico relative to profitable

sales of shipping boxes it made in that country. Can it claim a deduction for

these taxes in computing U.S. taxable income? A tax credit? Both? Explain.

  1. LO.3 Klein, a domestic corporation, receives a $10,000 dividend from ForCo, a

wholly owned foreign corporation. The deemed-paid (indirect) foreign tax

credit associated with this dividend is $3,000. What is the total gross income

included in Klein’s tax return as a result of this dividend?

  1. LO.3 ABC, Inc., a domestic corporation, reports $50 million of taxable income,

including $15 million of general limitation foreign-source taxable income, on

which ABC paid $5 million in foreign income taxes. The U.S. tax rate is 35%. What is

ABC’s foreign tax credit?

  1. LO.3 Mary, a U.S. citizen, is the sole shareholder of CanCo, a Canadian corporation.

During its first year of operations, CanCo earns $14 million of foreign-source

taxable income, pays $6 million of Canadian income taxes, and distributes a $2 million

dividend to Mary. Can Mary claim a deemed-paid (indirect) foreign tax credit

on her Form 1040 with respect to receipt of a dividend distribution from CanCo?

Why or why not?

  1. LO.3 ABC, Inc., a domestic corporation, owns 100% of HighTax, a foreign corporation.

HighTax has $50 million of undistributed E & P, all of which is attributable

to general limitation income, and $30 million of foreign income taxes paid.

HighTax distributes a $5 million dividend to ABC. The dividend, which is subject to

a 5% foreign withholding tax, is ABC’s only item of income during the year. ABC’s

marginal U.S. tax rate is 35%. How much foreign tax credit and carryover is produced

by the dividend?

  1. LO.3 USCo, a domestic corporation, reports worldwide taxable income of $1.5 million,

including a $400,000 dividend from ForCo, a wholly owned foreign corporation.

ForCo’s undistributed E & P totals $16 million, and it has paid $10 million

of foreign income taxes attributable to these earnings. All foreign income is in the

general limitation basket. What is USCo’s deemed-paid (indirect) foreign tax credit

related to the dividend received (before consideration of any limitation)?

  1. LO.3 USCo, a domestic corporation, reports worldwide taxable income of

$500,000, including a $300,000 dividend from ForCo, a wholly owned foreign

corporation. ForCo’s undistributed E & P totals $1 million, and it has paid $200,000

of foreign income taxes attributable to these earnings. All foreign income is in the

general limitation basket. What is USCo’s deemed-paid (indirect) foreign tax credit

related to the dividend received (before consideration of any limitation)?

  1. LO.3 Fleming, Inc., a domestic corporation, operates in both Canada and the

United States. This year, the business generated taxable income of $400,000

from foreign sources and $300,000 from U.S. sources. All of Fleming’s foreign-source

income is in the general limitation basket. Fleming’s total worldwide taxable income

is $700,000. Fleming pays Canadian taxes of $152,000. What is Fleming’s allowed

FTC for the tax year? Assume a 35% U.S. income tax rate.

  1. LO.3 Drake, Inc., a U.S. corporation, operates a branch sales office in Turkey. During

the current year, Drake earned $500,000 in taxable income from U.S.

sources and $100,000 in taxable income from sources in Turkey. Drake paid

$40,000 in income taxes to Turkey. All of the income is characterized as general limitation

income. Compute Drake’s U.S. income tax liability after consideration of any

foreign tax credit. Drake’s U.S. tax rate is 35%.

  1. LO.3 Crank, Inc., a U.S. corporation, operates a branch sales office in Ghana. During

the current year, Crank earned $200,000 in taxable income from U.S. sources

and $50,000 in taxable income from sources in Ghana. Crank paid $5,000 in

income taxes to Ghana. All of the income is characterized as general limitation

income. Compute Crank’s U.S. income tax liability after consideration of any foreign

tax credit. Crank’s U.S. tax rate is 35%.

  1. LO.3 Harold, Inc., a domestic corporation, earned $500,000 from foreign manufacturing

activities on which it paid $150,000 of foreign income taxes. Harold’s foreign

sales income is taxed at a 45% foreign tax rate. Both sales and manufacturing

income are assigned to the general limitation basket. What amount of foreign sales

income can Harold earn without generating any excess FTCs for the current year?

Assume a 35% U.S. rate.

  1. LO.3 Food, Inc., a domestic corporation, owns 70% of the stock of Drink, Inc., a

foreign corporation. For the current year, Food receives a dividend of $20,000

from Drink. Drink’s E & P (after taxes) and foreign taxes are $6 million and

$800,000, respectively. What is Food’s total gross income from receipt of this dividend

if it elects to claim the FTC for deemed-paid foreign taxes?

  1. LO.3 Orion, Inc., a U.S. corporation, reports foreign-source income and pays foreign

taxes for the tax year as follows.

Income Taxes

Passive category $150,000 $ 13,000

General category 300,000 150,000

Orion’s worldwide taxable income is $600,000, and U.S. taxes before the FTC are

$210,000 (assume a 35% rate). What is Orion’s U.S. tax liability after the FTC?

  1. LO.3 Discuss the policy reasons for the existence of the Subpart F rules. Give two

examples of Subpart F income.

  1. LO.3 USCo owns 65% of the voting stock of LandCo, a Country X corporation.

Terra, an unrelated Country Y corporation, owns the other 35% of LandCo.

LandCo owns 100% of the voting stock of OceanCo, a Country Z corporation.

Assuming that USCo is a U.S. shareholder, do LandCo and OceanCo meet the definition

of a CFC? Explain.

  1. LO.3 Is a foreign corporation owned equally by 100 unrelated U.S. citizens considered

to be a controlled foreign corporation (CFC)? Explain.

  1. LO.3 Hart Enterprises, a domestic corporation, owns 100% of OK, Ltd., an Irish corporation.

OK’s gross income for the year is $10 million. Determine whether

any of the following transactions produce Subpart F gross income for the current

year.

  1. OK earned $600,000 from sales of products purchased from Hart and sold to

customers outside Ireland.

  1. OK earned $1 million from sales of products purchased from Hart and sold to

customers in Ireland.

  1. OK earned $400,000 from sales of products purchased from unrelated suppliers

and sold to customers in Germany.

  1. OK purchased raw materials from Hart, used these materials to manufacture finished

goods, and sold these goods to customers in Italy. OK earned $300,000 from

these sales.

  1. OK earned $50,000 in dividend income from Canada and Mexico passive investments.
  2. LO.3 HiramCo, a U.S. entity, operates a manufacturing business in both Mexico

and Costa Rica, and it holds its investment portfolio in Sweden. How many

foreign tax credit computations must HiramCo make? Be specific, and use the term

basket in your answer.

  1. LO.4 Give a simple answer to Andre’s question: “If I move to the United States,

how will the Federal government tax my widget sales and capital gains?”

Andre will be living in New York City, where state and local taxes are very high.

Ignore the effects of tax treaties in your answer.

  1. LO.3 Skills, Inc., a U.S. corporation, reports current foreign-source income classified

in two different FTC income baskets. It earns $50,000 in passive foreignsource

income, and it suffers a net loss of $30,000 in the general limitation basket.

What is the numerator of Skills’s FTC limitation formula for the passive basket in the

current year? Explain.

  1. LO.3 Night, Inc., a domestic corporation, earned $300,000 from foreign manufacturing

activities, on which it paid $90,000 of foreign income taxes. Night’s foreign

sales income is taxed at a 50% foreign tax rate. What amount of foreign sales income

can Night earn without generating any excess FTCs for the current year? Assume a

34% U.S. tax rate.

  1. LO.4 Evaluate the following statement: Foreign persons never are subject to U.S.

taxation on U.S.-source investment income so long as they are not engaged

in a U.S. trade or business.

  1. LO.3 Lili, Inc., a domestic corporation, operates a branch in France. The earnings

record of the branch is as follows.

Year Taxable Income (Loss) Foreign Taxes Paid

2013 ($ 25,000) $ –0–

2014 (40,000) –0–

2015 (10,000) –0–

2016 120,000 40,000

For 2013–2016, Lili, Inc., reports U.S.-source taxable income of $500,000 each year.

What is the allowed FTC for 2016? Assume a 35% U.S. tax rate.

  1. LO.3, 4 Write a memo for the tax research file on the difference between

“inbound” and “outbound” activities in the context of U.S. taxation of

international income.

  1. LO.3 Warwick, Inc., a U.S. corporation, owns 100% of NewGrass, Ltd., a foreign

corporation. NewGrass earns only general limitation income. During the current

year, NewGrass paid Warwick a $10,000 dividend. The deemed-paid foreign

tax credit associated with this dividend is $3,000. The foreign jurisdiction requires a

withholding tax of 10%, so Warwick received only $9,000 in cash as a result of the

dividend. What is Warwick’s total U.S. gross income reported as a result of the cash

dividend?

  1. LO.5 Evaluate this statement: A state can tax only its resident individuals and the

corporations and partnerships that are organized in-state.

  1. LO.5 You are working with the top management of one of your clients in selecting

the U.S. location for a new manufacturing operation. Craft a plan for the CEO

to use in discussions with the economic development representatives of each of the

top candidate states. In no more than two PowerPoint slides, list some of the tax

incentives the CEO should request from a particular state during the bilateral negotiations

between the parties. Your list should be both creative and aggressive in its

requests.

  1. LO.5 Considering only the aggregate state income tax liability, how should a taxpayer

who is a resident in State A selling widgets deploy its sales force? The

states that entail the taxpayer’s entire customer base use the following flat income

tax rates.

State A 5%

State B 3

State C 6

State D 0

  1. LO.5 Continue to consider the case of the taxpayer in Problem 42. Is it acceptable

to you if the taxpayer purposely shifts its sales force among the states to

reduce its tax liabilities?

  1. LO.6 Compute state taxable income for HippCo, Inc. Its Federal taxable income for

the year is $1 million. Its operations are confined to Oregon and Montana.

HippCo generates only business and interest income for the year.

  • Federal cost recovery deductions totaled $200,000. Montana used this amount,

but Oregon allowed only $120,000.

  • Interest income of $25,000 from Oregon bonds was excluded from Federal taxable

income. Oregon taxes all municipal bond income, while Montana taxes all

such interest except that from its own bonds.

  • Interest income from Treasury bonds that was recognized on the Federal return

came to $11,000. Neither state taxes such income.

  1. LO.6 Continue with the facts of Problem 44. Using the format of Exhibit 16.3, compute

state taxable income for HippCo, assuming also that the taxpayer recognized

$225,000 of net rent income during the year from a warehouse building in

Montana. Federal taxable income still is $1 million.

  1. LO.6 PinkCo, Inc., operates in two states. It reports the following results for the

year. Compute the apportionment percentage for both states. Amounts are

stated in millions of dollars.

State A State B Totals

Sales $25 $ 75 $100

Payroll 20 30 50

Property 0 100 100

  1. LO.6 Repeat the computations of Problem 46, but now assume that State B uses a

double-weighted sales factor in its apportionment formula.

  1. LO.6 Repeat the computations of Problem 46, but now assume that State A is a

sales-factor-only state and that State B uses the following weights: sales .70,

payroll .15, and property .15.

  1. LO.6 State A enjoys a prosperous economy, with high real estate values and compensation

levels. State B’s economy has seen better days—property values

are depressed, and unemployment is higher than in other states. Most consumer

goods are priced at about 10% less in B as compared with prices in A. Both A and B

apply unitary income taxation on businesses that operate in-state. Does unitary taxation

distort the assignment of taxable income between A and B? Explain.

  1. LO.6 Hernandez, which has been an S corporation since inception, is subject to tax

in States Y and Z. On Schedule K of its Federal Form 1120S, Hernandez

reported ordinary income of $500,000 from its business, taxable interest income of

$10,000, capital loss of $30,000, and $40,000 of dividend income from a corporation

in which it owns 30%.

Both states apportion income by use of a three-factor formula that equally

weights sales, payroll, and the average cost of property; both states treat interest and

dividends as business income. In addition, both Y and Z follow Federal provisions

with respect to the determination of corporate taxable income. Y recognizes S status,

but Z does not.

Based on the following information, write a memo to the shareholders of Hernandez,

detailing the amount of taxable income on which Hernandez will pay tax in Y

and Z. Hernandez corporate offices are located at 5678 Alabaster Circle, Bowling

Green, KY 42103.

State Y State Z

Sales $1,000,000 $800,000

Property (average cost) 500,000 100,000

Payroll 800,000 200,000

  1. LO.6 Prepare a PowerPoint presentation (maximum of six slides) entitled “Planning

Principles for Our Multistate Clients.” The slides will be used to lead a

20-minute discussion with colleagues in the corporate tax department. Keep the

outline general, but assume that your colleagues already work with clients operating

in at least 15 states. Address only income tax issues.

  1. LO.3, 7 Miha Ohua is the CFO of a U.S. company that has operations in Europe

and Asia. The company has several manufacturing subsidiaries in low-tax

foreign countries where the tax rate averages 6%. These subsidiaries purchase raw

materials used in the production process from related subsidiaries located in countries

where the tax rate averages 33%.

Miha is considering establishing a transfer price for the raw materials so that the

higher-tax subsidiaries charge a low price for the raw materials. In this way, little of

the profit is left in these subsidiaries, and most of the profits end up in the low-tax

subsidiaries. This approach might reduce the U.S. company’s overall global tax rate.

Write a memo to Miha, outlining the issues with this plan.

Research Problems

Research Problem 1. Jerry Jeff Keen, the CFO of Boots Unlimited, a Texas corporation,

has come to you regarding a potential restructuring of business operations.

Boots long has manufactured its western boots in plants in Texas and Oklahoma.

Recently, Boots has explored the possibility of setting up a manufacturing subsidiary

in Ireland, where manufacturing profits are taxed at 10%. Jerry Jeff sees this as a

great idea, given that the alternative is to continue all manufacturing in the United

States, where profits are taxed at 34%. Boots plans to continue all of the cutting, sizing,

and hand tooling of leather in its U.S. plants. This material will be shipped to Ireland

for final assembly, with the finished product shipped to retail outlets all over

Europe and Asia. Your initial concern is whether the income generated by the Irish

subsidiary will be considered foreign base company income. Address this issue in a

research memo, along with any planning suggestions.

Partial list of research aids:

  • 954(d).

Reg. § 1.954–3(a).

Bausch & Lomb, 71 TCM 2031, T.C.Memo. 1996–57.

Research Problem 2. Polly Ling is a successful professional golfer. She is a resident

of a country that does not have a tax treaty with the United States. Ling plays

matches around the world, about one-half of which are in the United States. Ling’s

reputation is without blemish; in fact, she is known as being exceedingly honest

and upright, and many articles discuss how she is a role model for young golfers

due to her tenacious and successful playing style and her favorable character traits.

Every year, she reports the most penalty strokes on herself among the participants

in women’s matches, and this is seen as reinforcing her image as an honest and

respectful competitor.

This combination of quality play and laudable reputation has brought many riches

to Ling. She comes to you with several Federal income tax questions. She knows that

as a non-U.S. resident, any of her winnings from tournament play that occurs in the

United States are subject to U.S. income taxation. But what about each of the following

items? How does U.S. tax law affect Ling? Apply the sourcing rules in this regard,

and determine whether the graduated U.S. Federal income tax rate schedules apply.

  • Endorsement income from YourGolf, for wearing clothing during matches with its

logo prominently displayed. Ling must play in at least 10 tournaments per year

that are televised around the world. She also must participate in photo sessions

and in blogs and tweets associated with the tournaments. Payment to Ling is structured

as a flat fee, with bonuses paid if she finishes in the top five competitors for

each match. This is known as an on-court endorsement.

  • Endorsement income from GolfZone, for letting the company use her likeness in a

video game that simulates golf tournaments among known golfers and other players

that the (usually middle-aged men and women) gamers identify. In this way,

the gamer seems to be playing against Ling on famous golf courses. Two-thirds of

all dollar sales of the game licenses are to U.S. customers.

  • Endorsement income from Eliteness, for appearing in print and Internet ads that

feature Ling wearing the company’s high-end watches. One-fifth of all dollar

sales of the watches are to U.S. customers. The latter two items are known as offcourt

endorsements.

Research Problem 3. Supervise and Wager Company produces consumer goods that

are distributed and sold primarily in North America, Europe, and Asia. The business

includes a U.S. parent company, S&W, Inc., and separate operating subsidiaries in

each region in which the company conducts significant business.

The company’s board is considering a structural reorganization to reduce the

global tax costs. Options include reorganizing the parent company in either Bermuda

or Ireland. Under any option, current shareholders will contribute their stock in the

U.S. parent company in return for an equivalent amount of stock in the new parent.

The U.S. parent will be liquidated, and the new corporation then will be the sole

shareholder of the operating subsidiaries.

  1. What might S&W be trying to achieve with the proposed organizational restructuring?
  2. What insight can you provide regarding the immediate and longer-term tax consequences

of the reorganization? Hint: Use the word inversion in your search

term.

Research Problem 4. Make a list of the countries with which the United States currently

is negotiating an income tax treaty. Include the date on which negotiations

started and the current status of the negotiations. Then list five countries with which

the United States does not have in force a bilateral income tax treaty.

Research Problem 5. For your analysis, choose 10 countries, one of which is the

United States. Create a table showing whether each country applies a worldwide or

territorial approach to international income taxation. Then list the country’s top

income tax rate on business profits. Send a copy of this table to your instructor.

Research Problem 6. Locate data on the size of the international economy, including

data on international trade, foreign direct investment of U.S. firms, and investments

in the United States by foreign firms. Useful Web locations include www.census.gov

and www.bea.gov. Prepare an analysis of these data for a three-year period, using

spreadsheet and graphing software, and e-mail your findings to your instructor.

Research Problem 7. Read the “tax footnote” of five publicly traded U.S. corporations.

Find the effective state/local income tax rates of each. Create a PowerPoint presentation

(maximum of five slides) for your instructor, summarizing the search and reporting

your findings.

Research Problem 8. Identify three states considered to be in the same economic

region as your own. For each of the three states, answer the following questions.

Answers to most can be found at www.taxadmin.org.

  • What is the overall tax burden per capita, and where does it rank among all states?
  • What is the overall tax burden as a percentage of personal income, and where

does it rank among all states?

  • From what source(s) does it raise most of its revenues (e.g., sales/use tax, highway

tolls)?

  • What is the highest marginal tax rate on corporate income?
  • What is its apportionment formula, including factors and weights?

What advice or insight might you provide to your state legislature regarding your

state’s tax system, based on your responses to the above?

 

CHAPTER17

Business Tax Credits and Corporate Alternative Minimum Tax

Computational Exercises

  1. LO.2 Carlson’s general business credit for the current year is $84,000 His net

income tax is $190,000, tentative minimum tax is $175,000, and net regular

tax liability is $185,000. He has no other tax credits. Determine the amount of

Carlson’s general business credit for the year.

  1. LO.2 Emily spent $135,000 to rehabilitate a building (adjusted basis of $90,000) that

originally had been placed in service in 1935.

  1. What is Emily’s rehabilitation expenditures tax credit?
  2. What would be your answer if the building was a historic structure?
  3. LO.2 During 2015, Lincoln Company hires seven individuals who are certified to

be members of a qualifying targeted group. Each employee works in excess

of 600 hours and is paid wages of $7,500 during the year. Determine the amount of

Lincoln’s work opportunity credit.

  1. LO.2 Dorcas incurs the following research expenditures.

In-house wages $60,000

In-house supplies 5,000

Paid to ABC, Inc., for research 80,000

  1. Determine the amount of qualified research expenditures.
  2. Assuming that the base amount is $50,000, determine Dorcas’s incremental

research activities credit.

  1. LO.3 Siga, Inc., a calendar year corporation, records the following gross receipts

and taxable income for 2013 through 2015.

Year Gross Receipts Taxable Income

2013 $4,200,000 $ 900,000

2014 7,000,000 1,600,000

2015 7,700,000 1,900,000

Siga’s first year of operations was 2013. Is Siga exempt from AMT in 2013, 2014, or

2015?

  1. LO.4 In 2015, Brennen sold a machine used in his business for $180,000. The

machine was purchased eight years ago for $340,000. Depreciation up to the

date of the sale for regular income tax purposes was $210,000 and $190,000 for

AMT purposes.

What, if any, AMT adjustment arises as a result of the sale of the machine?

  1. LO.4 Pineview Corporation placed an asset (three-year MACRS class life) costing

$5,000 in service on June 1, 2015. Complete the table below by providing the

AMT adjustment and indicate whether the adjustment increases or decreases taxable

income.

Year Tax Deduction AMT Deduction AMT Adjustment Increases or Decreases

2015 $1,667 $1,250 $ ________ ____________

2016 2,222 1,875 $ ________ ____________

2017 740 1,250 $ ________ ____________

2018 371 625 $ ________ ____________

  1. LO.6 Given the following information, determine the ACE adjustment for each year.

2015 2016 2017

Unadjusted AMTI $ 800,000 $2,000,000 $1,500,000

Adjusted current earnings 1,200,000 2,000,000 900,000

 

Problems

  1. LO.2 Charles has a tentative general business credit of $42,000 for the current year.

His net regular tax liability before the general business credit is $107,000, and

his tentative minimum tax is $88,000. Compute Charles’s allowable general business

credit for the year.

  1. LO.2 Oak Corporation holds the following general business credit carryovers.

2011 $ 5,000

2012 15,000

2013 6,000

2014 19,000

Total carryovers $45,000

If the general business credit generated by activities during 2015 equals $36,000 and

the total credit allowed during the current year is $60,000 (based on tax liability), what

amounts of the current general business credit and carryovers are utilized against the

2015 income tax liability? What is the amount of the unused credit carried forward to

2016?

  1. LO.2 In January 2014, Iris Corporation purchased and placed in service a 1933

building that houses retail businesses. The cost was $300,000, of which

$25,000 applied to the land. In modernizing the facility, Iris Corporation incurred

$312,000 of renovation costs of the type that qualify for the rehabilitation credit.

These improvements were placed in service in October 2015.

  1. Compute Iris Corporation’s rehabilitation tax credit for 2015.
  2. Calculate the cost recovery deductions for the building and the renovation costs

for 2015.

  1. LO.2 In the current year, Paul Chaing (4522 Fargo Street, Geneva, IL 60134)

acquires a qualifying historic structure for $350,000 (excluding the cost of the

land) and plans to substantially rehabilitate the structure. He is planning to spend either

$320,000 or $380,000 on rehabilitation expenditures. Write a letter to Paul and a

memo for the tax files explaining, for the two alternative expenditures, (1) the computation

that determines the rehabilitation expenditures tax credit available to Paul,

(2) the effect of the credit on Paul’s adjusted basis in the property, and (3) the cashflow

differences as a result of the tax consequences related to his expenditure

choice.

  1. LO.2 The tax credit for rehabilitation expenditures is available to help offset the

costs related to substantially rehabilitating certain buildings. The credit is calculated

on the rehabilitation expenditures incurred and not on the acquisition cost

of the building itself.

You are a developer who buys, sells, and does construction work on real estate

in the inner city of your metropolitan area. A potential customer approaches you

about acquiring one of your buildings that easily could qualify for the 20% rehabilitation

credit on historic structures. The stated sales price of the structure is $100,000

(based on appraisals ranging from $80,000 to $120,000), and the rehabilitation

expenditures, if the job is done correctly, would be about $150,000.

Your business has been slow recently due to the sluggish real estate market in

your area, and the potential customer makes the following proposal: if you reduce

the sales price of the building to $75,000, he will pay you $175,000 to perform the

rehabilitation work. Although the buyer’s total expenditures would be the same, he

would benefit from this approach by obtaining a larger tax credit ($25,000 increased

rehabilitation costs _ 20% ¼ $5,000).

It has been a long time since you have sold any of your real estate. How will you

respond?

  1. LO.2 Green Corporation hires six individuals on January 4, 2015, all of whom qualify

for the work opportunity credit. Three of these individuals receive wages

of $8,500 during 2015, and each individual works more than 400 hours during the

year. The other three individuals each work 300 hours and receive wages of $5,000

during the year.

  1. Calculate the amount of Green’s work opportunity credit for 2015.
  2. If Green pays total wages of $140,000 to its employees during the year, how

much of this amount is deductible in 2015 assuming that the work opportunity

credit is taken?

  1. LO.2 In March 2015, Sparrow Corporation hired three individuals—Austin, Adam,

and Angela—all of whom are certified as long-term family assistance recipients.

Each of these individuals earned $11,000 during 2015. Only Adam continued

to work for Sparrow in 2016, and he earned $13,500 then. In March 2016, Sparrow

hired Sam, who also is certified as a long-term family assistance recipient. During

2016, Sam earned $12,000.

  1. Compute Sparrow Corporation’s work opportunity credit for 2015 and 2016.
  2. If Sparrow pays total wages to its employees of $325,000 in 2015 and $342,000

in 2016, what is its wage deduction in each of those years?

  1. LO.2 Tom, a calendar year taxpayer, informs you that during the year, he incurs

expenditures of $40,000 that qualify for the incremental research activities

credit. In addition, it is determined that his research-credit base amount for the year

is $32,800.

  1. Determine Tom’s incremental research activities credit for the year.
  2. Tom is in the 25% tax bracket. Determine which approach to the research

expenditures and the research activities credit (other than capitalization and

subsequent amortization) would provide the greater tax benefit to Tom.

  1. LO.2 Ahmed Zinna (16 Southside Drive, Charlotte, NC 28204), one of your clients,

owns two retail establishments in downtown Charlotte and has come to you

seeking advice concerning the tax consequences of complying with the Americans

with Disabilities Act. He understands that he needs to install various features at his

stores (e.g., ramps, doorways, and restrooms that are handicapped-accessible) to

make them more accessible to disabled individuals.

Ahmed asks whether any tax credits will be available to help offset the cost of

the necessary changes. He estimates the cost of the planned changes to his facilities

as follows.

Location Projected Cost

Calvin Street $22,000

Stowe Avenue 8,500

Ahmed reminds you that the Calvin Street store was constructed in 2004, while the

Stowe Avenue store is in a building that was constructed in 1947. Ahmed operates

his business as a sole proprietorship and has approximately eight employees at each

location. Write a letter to Ahmed in which you summarize your conclusions concerning

the tax consequences of the proposed capital improvements.

  1. LO.2 Blue Horizons, Inc., a U.S. corporation, is a manufacturing concern that sells

most of its products in the United States. It also does some business in the

European Union through various branches. During the current year, Blue Horizons

has taxable income of $700,000, of which $500,000 is U.S.-sourced and $200,000

is foreign-sourced. Foreign income taxes paid amounted to $45,000. Blue Horizons’s

U.S. income tax liability is $238,000. What is its U.S. income tax liability net of the

allowable foreign tax credit?

  1. LO.3 Aqua, Inc., a calendar year corporation, has the following gross receipts and

taxable income for 2012 through 2015:

Year Gross Receipts Taxable Income

2012 $6,000,000 $1,400,000

2013 7,000,000 1,312,000

2014 7,500,000 985,000

2015 7,200,000 1,002,000

Aqua’s first year of operations was 2012.

  1. When is Aqua first exempt from the AMT as a small corporation?
  2. Is Aqua subject to the AMT for 2015? Explain.
  3. LO.4 Falcon, Inc., owns a silver mine that it purchased several years ago for

$925,000. The adjusted basis at the beginning of the year is $400,000. For the

year, Falcon deducts depletion of $700,000 (greater of cost depletion of $290,000 or

percentage depletion of $700,000) for regular income tax purposes.

  1. Calculate Falcon’s AMT preference.
  2. Calculate Falcon’s adjusted basis for regular income tax purposes.
  3. Calculate Falcon’s adjusted basis for AMT purposes.
  4. LO.5 In March 2015, Grackle, Inc., acquired used equipment for its business at a

cost of $300,000. The equipment is five-year class property for regular income

tax purposes and for AMT purposes. Grackle does not claim any available additional

first-year depreciation.

  1. If Grackle depreciates the equipment using the method that will produce the

greatest deduction for 2015 for regular income tax purposes, what is the amount

of the AMT adjustment? Grackle does not elect §179 limited expensing.

  1. How can Grackle reduce the AMT adjustment to $0? What circumstances would

motivate Grackle to do so?

  1. Draft a letter to Helen Carlon, Grackle’s controller, regarding the choice of

depreciation methods. Helen’s address is 500 Monticello Avenue, Glendale,

AZ 85306.

  1. LO.5 Rust Company is a real estate construction business with average annual

gross receipts of $3 million. Rust uses the completed contract method on a

particular contract that requires 16 months to complete. The contract is for $500,000,

with estimated costs of $300,000. At the end of 2015, $180,000 of costs had been

incurred. The contract is completed in 2016, with the total cost being $295,000.

Determine the amount of adjustments for AMT purposes for 2015 and 2016.

  1. LO.5 Allie, who was an accounting major in college, is the controller of a mediumsize

construction corporation. She prepares the corporate tax return each

year. Due to reporting a home construction contract using the completed contract

method, the corporation is subject to the AMT in 2015. Allie files the 2015 corporate

tax return in early February 2016. The total tax liability is $58,000 ($53,000

regular income tax liability þ $5,000 AMTÞ.

In early March, Allie reads an article on minimizing income taxes. Based on this

article, she decides that it would be beneficial for the corporation to report the home

construction contract using the percentage of completion method on its 2015 return.

Although this will increase the corporation’s 2015 income tax liability, it will minimize

the total income tax liability over the two-year construction period. Therefore,

Allie files an amended return on March 14, 2016. Evaluate Allie’s actions from both a

tax avoidance and an ethical perspective.

  1. LO.5 Buford sells an apartment building for $720,000. His adjusted basis is

$500,000 for regular income tax purposes and $550,000 for AMT purposes.

Calculate Buford’s:

  1. Gain for regular income tax purposes.
  2. Gain for AMT purposes.
  3. AMT adjustment, if any.
  4. LO.5 Pheasant, Inc., is going to be subject to the AMT in 2015. The corporation

owns an investment building and is considering disposing of it and investing

in other realty. Based on an appraisal of the building’s value, the realized gain

would be $85,000. Ed has offered to purchase the building from Pheasant with a December

29, 2015 closing date.

Ed wants to close the transaction in 2015 because he will receive certain beneficial

tax consequences only if the transaction is closed prior to 2016. Abby has

offered to purchase the building with a January 2, 2016 closing date. The adjusted

basis of the building is $95,000 greater for AMT purposes than for the regular

income tax. Pheasant expects to be in the 34% regular income tax bracket.

What are the relevant Federal income tax issues that Pheasant faces in making its

decision?

  1. LO.5 Flicker, Inc., a closely held corporation, acquired a passive activity this year.

Gross income from operations of the activity was $160,000. Operating

expenses, not including depreciation, were $122,000. Regular income tax depreciation

of $49,750 was computed under MACRS. AMT depreciation, computed using

the ADS, was $41,000. Compute Flicker’s passive loss deduction and passive loss

suspended for regular income tax purposes. Then determine the same amounts for

AMT purposes.

  1. LO.6 Maize Corporation (a calendar year corporation) reports the following information

for the years listed.

2014 2015 2016

Adjusted current earnings $5,000,000 $5,000,000 $7,000,000

Unadjusted AMTI 8,000,000 5,000,000 3,000,000

Compute the ACE adjustment for each year.

  1. LO.6 Based on the following facts, calculate adjusted current earnings (ACE).

Alternative minimum taxable income (AMTI before ACE adjustment) $5,120,000

Municipal bond interest 630,000

Expenses related to municipal bonds 50,000

Key employee life insurance proceeds in excess of cash surrender value 2,000,000

Organization expense amortization 100,000

Cost of goods sold 6,220,000

Advertising expenses 760,000

Loss between related parties 260,000

Life insurance premiums paid 300,000

  1. LO.6 Purple Corporation, a calendar year taxpayer, began operations in 2013. It

reported the following amounts for its first four tax years. Calculate Purple’s

positive and negative ACE adjustments for each year.

Unadjusted AMTI ACE

2013 $85,000,000 $70,000,000

2014 70,000,000 90,000,000

2015 54,000,000 40,000,000

2016 60,000,000 20,000,000

  1. LO.4, 5, 6 Determine whether each of the following transactions is a preference (P),

is an adjustment (A), or is not applicable (NA) for purposes of the

corporate AMT.

  1. Depletion in excess of basis taken by Giant Oil Company.
  2. Accelerated depreciation on property.
  3. Charitable contributions of cash.
  4. Adjusted current earnings.
  5. Untaxed appreciation on property donated to charity.
  6. Dividends received deduction.
  7. LO.7 In each of the following independent situations, determine the tentative minimum

tax. Assume that the company is not in small corporation status.

AMTI (before the

Exemption Amount)

Quincy Corporation $150,000

Redland Corporation 160,000

Tanzen Corporation 320,000

  1. LO.7 Peach Corporation (a calendar year company) recorded the following transactions.

Taxable income $5,000,000

Regular tax depreciation on realty in excess of ADS (placed in

service in 1991) 1,700,000

Amortization of certified pollution control facilities

(in excess of ADS amortization) 200,000

Tax-exempt interest on private activity bonds issued in 2006 300,000

Percentage depletion in excess of the property’s adjusted basis 700,000

  1. Determine Peach Corporation’s AMTI.
  2. Determine the alternative minimum tax base (refer to Exhibit 17.3).
  3. Determine the tentative minimum tax.
  4. What is the amount of the AMT?
  5. LO.7 Included in Alice’s regular taxable income and in her AMT base is a $300,000

capital gain on the sale of stock she owned for three years. Alice is in the 35%

bracket for regular income tax purposes. In calculating her regular income tax

liability, she uses the appropriate alternative tax rate on net capital gain of 20%.

  1. What rate should Alice use in calculating her tentative AMT?
  2. What is Alice’s AMT adjustment?
  3. How would your answers in (a) and (b) change if the taxpayer were a C corporation

in the 34% tax bracket for regular income tax purposes?

  1. LO.7 Calculate the AMT for the following cases in 2015. The individual taxpayer

reports regular taxable income of $450,000 and no tax credits.

Tentative Minimum Tax

Filing Status Case 1 Case 2

Single $200,000 $100,000

Married, filing jointly 200,000 100,000

  1. LO.4, 5 Jane and Robert Brown are married and have eight children, all of whom are

eligible to be claimed as the couple’s dependents. Robert earns $94,000 working

as an accountant, and Jane earns $35,000 as a teaching aide. Given their large family,

they live in a frugal manner. The family maintains a large garden and some fruit

trees from which they get most of their produce, and the children take family and consumer

science classes so that they can help make their clothing. The couple has no

other income besides their salaries (all of their investment income is earned in retirement

savings), and their itemized deductions are less than the standard deduction. In

addition, they have no additional adjustments or preferences for AMT purposes.

  1. What is the couple’s 2015 regular tax liability?
  2. What is the couple’s 2015 AMT?

Research Problems

Research Problem 1. During a recent Sunday afternoon excursion, Miriam, an admirer

of early twentieth-century architecture, discovers a 1920s-era house in the countryside

outside Mobile, Alabama, during a recent Sunday excursion. She wants not only

to purchase and renovate this particular house but also to move the structure into

Mobile so that her community can enjoy its architectural features.

Being aware of the availability of the tax credit for rehabilitation expenditures, she

wants to maximize her use of the provision, if it is available in this case, once the renovation

work begins in Mobile. However, Miriam also informs you that she will pursue

the purchase, relocation, and renovation of the house only if the tax credit is available.

Comment on Miriam’s decision and on whether any renovation expenditures

incurred will qualify for the tax credit for rehabilitation expenditures.

Partial list of research aids:

George S. Nalle III v. Comm., 72 AFTR 2d 93–5705, 997 F.2d 1134, 93–2 USTC {50,468 (CA–5,

1993).

Research Problem 2. Your ophthalmologist, Dr. Hunter Francis (55 Wheatland Drive,

Hampton, CT 06247), has been very pleased with the growth of his practice in the

15 years he has been in business. This growth has resulted, at least in part, because

he has aggressively marketed his services and tried to accommodate clients with various

needs. This year, Dr. Francis purchased a sophisticated piece of equipment that

enables him to diagnose persons with mental handicaps, hearing impairments, and

physical disabilities without having to go through a series of questions. In addition,

he can treat his patients who are not disabled more accurately and efficiently by

using this equipment.

Since purchasing the machine this year for $9,500, Dr. Francis has used it on many

occasions. Unfortunately, he has not been able to attract any patients with disabilities,

even though previously he referred such people to other ophthalmologists who

owned the necessary equipment. Therefore, the primary purpose for acquiring the

equipment (i.e., to attract patients with disabilities) has not been realized, but he has

put it to good use in treating other patients. Write a letter to Dr. Francis explaining

whether he may claim the disabled access credit for this acquisition.

Research Problem 3. Teal, Inc., owns two warehouses that were placed in service

before 1987. This year, accelerated depreciation on Warehouse A is $36,000

(straight-line depreciation would have been $30,000). On Warehouse B, accelerated

depreciation was $16,000 (straight-line depreciation would have been $20,000). What

is the amount of Teal’s AMT tax preference for excess depreciation?

Research Problem 4. The foreign tax credit is especially valuable when a U.S. business

earns income in a country whose income tax rates exceed those of the United

Research Problem 5. Ascertain whether your state’s income tax has an AMT component.

If your state does not levy an income tax, choose a contiguous state that does.

List the AMT tax rate for corporations, and describe if or how the AMT tax base follows

Federal AMTI.

Roger CPA Review Questions

  1. When an entity is responsible for paying the alternative minimum tax (AMT) due

to adjustments related to the timing of income, how might that excess tax be

recovered?

  1. File a claim for a refund in the year paid.
  2. Carryforward to offset against a future AMT liability only.
  3. Carryforward to offset against future AMT or regular tax liabilities.
  4. Carryforward to offset against a future regular tax liability only.
  5. Identify any item or items below which are added to Alternative Minimum Taxable

Income (AMTI) in order to compute the Adjusted Current Earnings (ACE) adjustment.

  1. Dividends-received deduction on dividends received from a 20%-owned

corporation.

  1. Municipal bond interest, excluding any municipal bond interest already

included in AMTI.

III. Life insurance proceeds on the death of a key employee.

  1. I and III only
  2. I, II and III
  3. I and II only
  4. II and III only
  5. Mary, a 65 year-old taxpayer, had an adjusted gross income of $150,000 in 20X4. In

the same year, Mary also incurred $20,000 in medical expenses. In computing Mary’s

alternative minimum tax, what will be the adjustment for Mary’s medical expenses?

  1. $3,750
  2. $5,000
  3. $8,750
  4. $11,250
  5. Which of the following will increase a taxpayer’s alternative minimum taxable

income (AMTI)?

Personal Exemption Property Taxes

Medical Expenses

Over 10% of AGI

  1. Yes Yes Yes
  2. Yes Yes No
  3. No Yes Yes
  4. Yes No Yes
  5. Which of the following best describes the effect of a tax credit?
  6. It reduces a person’s gross income.
  7. It reduces a person’s adjusted gross income.
  8. It reduces a person’s taxable income.
  9. It reduces a person’s tax liability.

CHAPTER18

Comparative Forms of Doing Business

Computational Exercises

  1. LO.5 Roscoe contributes a personal-use asset, adjusted basis $15,000 and fair market

value $28,000, to a new business in which he is an owner. Determine

Roscoe’s recognized gain on the transfer, and the basis of the asset to the business,

if the new operation is a:

  1. Sole proprietorship.
  2. Partnership, where Roscoe holds a 10% interest.
  3. Corporation, where Roscoe holds a 25% interest and all shareholders contribute

assets for stock in the transaction.

  1. LO.5 Mira and Lemma are equal owners of a business entity. Each contributed

$25,000 cash to the business. Then the entity acquired a $100,000 loan from a

bank. This year, operating profits totaled $30,000. Determine Lemma’s interest basis

at the end of the tax year, assuming that the entity is:

  1. A partnership.
  2. A C corporation.
  3. An S corporation.
  4. LO.5 Castle and Dorabella formed an S corporation; Castle owns 75% of the

outstanding shares, and Dorabella owns the rest. When the entity’s AAA

balance is $1 million, it distributes an asset to each shareholder; the basis of

each asset to the corporation is $45,000. Castle’s asset is worth $90,000, and

Dorabella’s is worth $50,000. Determine the indicated amounts that result from

the distribution.

  1. The corporation’s recognized gain, if any.
  2. Dorabella’s recognized gross income.
  3. Castle’s recognized gross income.

 

Problems

  1. LO.2, 3, 4, 5, 6, 7 Using the legend provided, indicate which form of business entity

each of the following characteristics describes. Some of the characteristics

may apply to more than one form of business entity.

Legend

SP ¼ Applies to sole proprietorship

P ¼ Applies to partnership and LLC

S ¼ Applies to S corporation

C ¼ Applies to C corporation

N ¼ Applies to none

  1. Has limited liability.
  2. Greatest ability to raise capital.
  3. Subject to double taxation.
  4. Subject to the ACE adjustment in computing AMT income.
  5. Limit on types and number of shareholders.
  6. Has unlimited liability.
  7. Sale of the business can be subject to double taxation.
  8. Contribution of property to the entity in exchange for an ownership interest can

result in the nonrecognition of realized gain.

  1. Profits and losses affect the basis for an ownership interest.
  2. Entity liabilities affect the basis for an ownership interest.
  3. Distributions of earnings are taxed as dividend income to the owners.
  4. Total invested capital cannot exceed $1 million.
  5. AAA is an account that relates to this entity.
  6. LO.5 Using the legend provided, indicate which form of business entity each of the

following characteristics describes. Some of the characteristics may apply to

more than one form of business entity.

Legend

P ¼ Applies to partnership and LLC

S ¼ Applies to S corporation

C ¼ Applies to C corporation

  1. Basis for an ownership interest is increased by an investment by the owner.
  2. Basis for an ownership interest is decreased by a distribution to the owner.
  3. Basis for an ownership interest is increased by entity profits.
  4. Basis for an ownership interest is decreased by entity losses.
  5. Basis for an ownership interest is increased as the entity’s liabilities increase.
  6. Basis for an ownership interest is decreased as the entity’s liabilities decrease.
  7. LO.2 Sea Green Enterprises reports the following assets and liabilities on its balance

sheet.

Net Book Value Fair Market Value

Assets $600,000 $925,000

Liabilities 200,000 200,000

Sea Green has just lost a product liability suit with damages of $10 million being

awarded to the plaintiff. Although Sea Green will appeal the judgment, legal counsel

indicates that the judgment is highly unlikely to be overturned by the appellate court.

The product liability insurance carried by Sea Green includes a payout ceiling of $6

million. What is the amount of liability of the entity and its owners if Sea Green is:

  1. A sole proprietorship?
  2. A partnership or an LLC?
  3. A C corporation?
  4. An S corporation?
  5. LO.3, 4 Bryan operates his business as a C corporation. He is the only shareholder.

The accumulated E & P is $800,000. Starting next year, Bryan will distribute

$200,000 cash per year, plus all of the annual current-year earnings. Recognizing

that the distribution would be taxed as dividend income, he has developed the following

tax strategy.

  • Sell the corporate assets to himself for the fair market value.
  • Have the corporation invest the sales proceeds in a mutual fund.
  • Contribute the assets to an LLC and operate his business in this legal form.

Evaluate Bryan’s proposal to avoid double taxation.

  1. LO.3 Red, White, Blue, and Orange report taxable income as follows.

Corporation Taxable Income

Red $ 99,000

White 330,000

Blue 900,000

Orange 40,000,000

  1. Calculate the marginal tax rate and the effective tax rate for each of the

C corporations.

  1. Explain why the marginal tax rate for a C corporation can exceed 35% but the

effective tax rate cannot.

  1. LO.1, 2, 3 Amy and Jeff Barnes will operate their florist shop as a partnership or as

an S corporation. Their mailing address is 5700 Richmond Highway,

Alexandria, VA 22301. After paying salaries of $100,000 to each of the owners, the

shop’s annual earnings are projected to be about $150,000. The earnings are to be

invested in the growth of the business. Write a letter to Amy and Jeff, advising them

of which of the two entity forms they should select.

  1. LO.3 Gerald is an entrepreneur who likes to be actively involved in his business

ventures. He is going to invest $500,000 in a business that he projects will

produce a tax loss of approximately $125,000 per year in the short run. However,

Gerald is confident that, once consumers become aware of the new product being

sold by the business and the quality of the service it provides, the business will generate

a profit of at least $200,000 per year. Gerald generates substantial other

income (from both business ventures and investment activities) each year. Advise

Gerald on the business form he should select for the short run. He will be the sole

owner of the business.

  1. LO.2, 3 Duke and Jacquie Coleman, married filing jointly, will establish a manufacturing

business. The couple anticipates that the business will be profitable

immediately due to a patent that Jacquie holds; profits for the first year will be about

$300,000 and will increase at a rate of about 20% per year for the foreseeable future.

Advise the Colemans as to the form of business entity that they should select. The

Colemans are in the 39.6% Federal income tax bracket.

  1. LO.3 Plum Corporation will begin operations on January 1. Earnings for the next

five years are projected to be relatively stable at about $80,000 per year. The

shareholders of Plum are in the 33% tax bracket.

  1. Plum will reinvest its after-tax earnings in the growth of the company. Should

Plum operate as a C corporation or as an S corporation?

  1. Plum will distribute its after-tax earnings each year to its shareholders. Should

Plum operate as a C corporation or as an S corporation?

  1. LO.3 Mabel and Alan, who are in the 35% tax bracket, recently acquired a fast-food

franchise. Both of them will work in the business and receive a salary of

$175,000. They anticipate that the annual profits of the business, after deducting salaries,

will be approximately $450,000. The entity will distribute enough cash each year

to Mabel and Alan to cover their Federal income taxes associated with any flowthrough

income from the franchise.

  1. What amount will the entity distribute if the franchise operates as a C

corporation?

  1. What amount will the entity distribute if the franchise operates as an S

corporation?

  1. What will be the amount of the combined entity/owner tax liability in (a)

and (b)?

  1. LO.3 Owl is a closely held corporation owned by eight shareholders (each has

12.5% of the stock). Selected financial information provided by Owl follows.

Taxable income $6,250,000

Positive AMT adjustments (excluding ACE adjustment) 600,000

Negative AMT adjustments (30,000)

Tax preferences 5,000,000

Retained earnings 900,000

Accumulated E & P 2,000,000

ACE adjustment 750,000

  1. Calculate Owl’s regular Federal income tax liability and AMT if it is a C corporation.
  2. Calculate Owl’s regular Federal income tax liability and AMT if it is an S corporation.
  3. How would your answers in (a) and (b) change if Owl was not closely held

(e.g., 5,000 shareholders with no shareholder owning more than 2% of the

stock)?

  1. LO.3 Falcon Corporation, a calendar year taxpayer, is a deepwater offshore

drilling company that is planning to sell drilling equipment that it no longer

needs. The drilling equipment has an adjusted basis of $400,000 ($700,000 _

$300,000 depreciationÞ and a fair market value of $500,000. The AMT adjusted

basis of the equipment is $425,000.

The buyer of the drilling equipment would like to close the transaction prior to

the end of the calendar year. Falcon is considering the following options.

  • $500,000 in cash payable on December 31, 2015.
  • The sale is closed on December 31, 2015; the consideration is a $500,000 note

issued by the buyer. The maturity date of the note is January 2, 2016, with the

equipment pledged as security.

Falcon projects that its taxable income for 2015 and 2016 will be $400,000 (gross

receipts of about $9.5 million) without the sale. Falcon has other AMT adjustments

and tax preferences of $425,000 in 2015, which will not recur in 2016. Determine

the tax consequences to Falcon under both options, and recommend the option that

is preferable.

  1. LO.4 Heron Corporation has been in operation for 10 years. Since Heron’s creation,

all of its stock has been owned by Andy, who initially invested $200,000

in the corporation. Heron has been successful far beyond Andy’s expectations, and

the current fair market value of the stock is $10 million. While he has been paid a

salary of $200,000 per year by the corporation, all of Heron’s earnings have been

reinvested in the growth of the corporation.

Heron currently is being audited by the IRS. One of the issues raised by the IRS

agent is the possibility of the assessment of the accumulated earnings tax. Andy is

not concerned about this issue because he believes Heron can easily justify the

accumulations based on its past rapid expansion by opening new outlets. The

expansion program is fully documented in the minutes of Heron’s board of directors.

Andy has provided this information to the IRS agent.

Two years ago, Andy decided that he would curtail any further expansion into

new markets by Heron. In his opinion, further expansion would exceed his ability

to manage the corporation effectively. Because the tax year under audit is

three years in the past, Andy sees no reason to provide the IRS agent with this

information.

Heron will continue its policy of no dividend payments into the foreseeable

future. Andy believes that if the accumulated earnings issue is satisfactorily resolved

on this audit, it probably will not be raised again on any subsequent audits. Thus,

double taxation in the form of the tax on dividends at the shareholder level or the

accumulated earnings tax at the corporate level can be avoided.

What is Heron’s responsibility to disclose to the IRS agent the expected change in

its growth strategy? Are Andy’s beliefs regarding future accumulated earnings tax

issues realistic? Explain.

  1. LO.4 Two sisters and their brother, all unmarried, own and operate a dairy farm.

They live on the farm and take their meals there for the “convenience of the

employer.” The fair market value of their lodging is $45,000, and the fair market

value of their meals is $18,000. The meals are prepared by the farm cook, who provides

their meals along with those of the eight other farm employees.

  1. Determine the tax consequences of the meals and lodging to the sisters and

their brother if the farm is incorporated.

  1. Determine the tax consequences of the meals and lodging to the sisters and

their brother if the farm is not incorporated.

  1. LO.4 A business entity has four equal owners. Its taxable income before the cost of

certain fringe benefits paid to owners and other employees is $400,000. The

amounts paid for these fringe benefits are reported as follows.

Owners Other Employees

Group term life insurance $20,000 $ 40,000

Meals and lodging incurred for the

convenience of the employer 50,000 75,000

Qualified retirement plan 30,000 90,000

  1. Calculate the Federal taxable income of the entity, assuming that it is a(n):
  • Partnership.
  • C corporation.
  • S corporation.
  1. Determine the Federal income effects on the owners, assuming the use of each

of the three business forms.

  1. LO.4 Turtle, a C corporation, reports taxable income of $300,000 before paying salaries

to the three equal shareholder-employees, Britney, Shania, and Alan.

Turtle follows a policy of distributing all after-tax earnings to the shareholders.

  1. Determine the tax consequences for Turtle, Britney, Shania, and Alan if the corporation

pays salaries to Britney, Shania, and Alan as follows.

Option 1 Option 2

Britney $135,000 Britney $67,500

Shania 90,000 Shania 45,000

Alan 75,000 Alan 37,500

  1. Is Turtle likely to encounter any tax problems associated with either option?

Explain.

  1. LO.4 Parrott, Inc., a C corporation, is owned by Abner (60%) and Deanna (40%).

Abner is the president, and Deanna is the vice president for sales. Parrott,

Abner, and Deanna are cash basis taxpayers. Late in the year, Parrott encounters

working capital difficulties. Therefore, Abner loans the corporation $810,000 and

Deanna loans the corporation $540,000. Each loan uses a 5% note that is due in five

years with interest payable annually.

  1. Determine the tax consequences to Parrott, Abner, and Deanna if the notes are

classified as debt.

  1. Determine the tax consequences to Parrott, Abner, and Deanna if the notes are

classified as equity.

  1. LO.4 Laurie Gladin owns land and a building that she has been using in her sole

proprietorship. She is going to incorporate her sole proprietorship as a

C corporation. Laurie must decide whether to contribute the land and building to

the corporation or to lease them to the corporation. The net income of the sole

proprietorship for the past five years has averaged $250,000. Advise Laurie on the

tax consequences. Summarize your analysis in a memo for the tax file.

  1. LO.4 Marci and Jennifer each own 50% of the stock of Lavender, a C corporation.

After each of them is paid a “reasonable” salary of $150,000, the taxable

income of Lavender typically is about $800,000.

The corporation is about to purchase a $2 million shopping mall ($1,500,000 allocated

to the building and $500,000 allocated to the land). The mall will be rented to

tenants at a net rental rate (including rental commissions, depreciation, etc.) of

$600,000 annually. Marci and Jennifer will contribute $1 million each to the corporation

to provide the cash required for the acquisition.

Their CPA has suggested that Marci and Jennifer purchase the shopping mall as individuals

and lease it to Lavender for a fair rental of $400,000. Both Marci and Jennifer are

in the 35% tax bracket. The acquisition will occur on January 2 next year. Determine

whether the shopping mall should be acquired by Lavender or by Marci and Jennifer in

accordance with their CPA’s recommendation. Depreciation on the shopping mall for

the year is $37,000.

  1. LO.4 Since Garnet Corporation was formed five years ago, its stock has been held

as follows: 525 shares by Frank and 175 shares by Grace. Their basis in the

stock is $350,000 for Frank and $150,000 for Grace. As part of a stock redemption,

Garnet redeems 125 of Frank’s shares for $175,000 and 125 of Grace’s shares for

$175,000.

  1. What are the tax consequences of the stock redemption to Frank and Grace?
  2. How would the tax consequences to Frank and Grace be different if, instead of

the redemption, they each sell 125 shares to Chuck (an unrelated party)?

  1. What factors should influence their decision on whether to redeem or sell the

250 shares of stock?

  1. LO.4 Oscar created Lavender Corporation four years ago. The C corporation has

paid Oscar as president a salary of $200,000 each year. Annual earnings after

taxes approximate $700,000 each year. Lavender has not paid any dividends, nor

does it intend to do so in the future. Instead, Oscar wants his heirs to receive the

stock with a step-up in stock basis when he dies. Identify the relevant tax issues.

  1. LO.4 Tammy and Willy own 40% of the stock of Roadrunner, an S corporation. The

other 60% is owned by 99 other shareholders, all of whom are single and

unrelated. Tammy and Willy have agreed to a divorce and are in the process

of negotiating a property settlement. Identify the relevant tax issues for Tammy

and Willy.

  1. LO.4 Clay Corporation has been an S corporation since its incorporation 10 years

ago. During the first three years of operations, it incurred total losses of

$250,000. Since then, Clay has generated earnings of approximately $180,000 each

year. None of the earnings have been distributed to the three equal shareholders,

Claire, Lynn, and Todd, because the corporation has been in an expansion mode.

At the beginning of this year, Claire sells her stock to Nell for $400,000. Nell has

reservations about the utility of the S election. Therefore, Lynn, Todd, and Nell are

discussing whether the election should be continued. They expect the earnings to

remain at approximately $180,000 each year. However, because they perceive that

the company’s expansion period is over and Clay has adequate working capital,

they may start distributing the earnings to the shareholders. All of the shareholders

are in the 33% tax bracket.

Advise the three shareholders as to whether Clay’s S election should be

maintained.

  1. LO.5 Phillip and Evans form a business entity. Each contributes the following property.

Phillip Evans

Cash $600,000

Land $600,000*

* Fair market value. Evans’s adjusted basis is $200,000.

Three months later, the entity sells the land for $652,000 because of unexpected

zoning problems. The proceeds are to be applied toward the purchase of another

parcel of land, to be used for real estate development. Determine the Federal

income tax consequences to the entity and to the owners upon both the formation

and the later sale of the land. Perform your analysis assuming that the entity is:

  1. A partnership.
  2. An S corporation.
  3. A C corporation.

How could the parties structure the transaction so as to defer any recognized tax

gain? Be specific.

  1. LO.5 Agnes, Becky, and Carol form a business entity with each contributing the

following.

Adjusted Basis Fair Market Value

Agnes: Cash $100,000 $100,000

Becky: Land 60,000 120,000

Carol: Services 50,000

Their ownership percentages will be as follows.

Agnes 40%

Becky 40%

Carol 20%

Becky’s land has a $20,000 mortgage that is assumed by the entity. Carol is an attorney

who receives her ownership interest in exchange for legal services. Determine

the recognized gain to the owners, the basis for their ownership interests, and the

entity’s basis for its assets if the entity is organized as:

  1. A partnership.
  2. A C corporation.
  3. An S corporation.
  4. LO.5 Eloise contributes $40,000 to MeldCo in exchange for a 30% ownership interest.

During the first year of operations, MeldCo earns a profit of $200,000. At

the end of that year, MeldCo holds liabilities of $75,000.

  1. Calculate Eloise’s basis for her stock if MeldCo is a C corporation.
  2. Calculate Eloise’s basis for her stock if MeldCo is an S corporation.
  3. Calculate Eloise’s basis for her partnership interest if MeldCo is a partnership.
  4. LO.5 ListCo reports the following income for the current tax year.

Operations $92,000

Tax-exempt interest income 19,000

Long-term capital gain 60,000

ListCo holds earnings and profits (AAA for an S corporation) of $900,000 at the

beginning of the year. Then ListCo distributes $200,000 in total to the owners.

  1. Calculate the taxable income if ListCo is (1) a C corporation and (2) an S

corporation.

  1. Determine the effect of the distribution on the shareholders if ListCo is (1) a

C corporation and (2) an S corporation.

  1. LO.5 For many years, Sophie has owned and operated several apartment buildings.

In 2011 and upon the advice of her attorney, Sophie transferred the apartment

buildings to a newly created corporation. Her main reason for incorporating

the business was to achieve the legal protection of limited liability.

Every year since 2011, Sophie has prepared and filed a Form 1120 for the corporation.

No corporate income tax has been paid because, after the deduction of various

expenses (including Sophie’s “management fee”), the corporation reports zero

taxable income.

This year, Sophie decides that filing Form 1120 is a waste of time and serves no

useful purpose. Instead, she plans to report all of the financial activities of the apartment

business on her own individual Form 1040.

Comment on the propriety of what Sophie plans to do.

  1. LO.5 The Coffee Company engages in the following transactions during the taxable

year.

  • Sells stock held for three years as an investment for $30,000 (adjusted basis of

$20,000).

  • Sells land used in the business for $65,000. The land has been used as a parking

lot and originally cost $40,000.

  • Receives tax-exempt interest on municipal bonds of $5,000.
  • Receives dividends on IBM stock of $80,000.

Describe the effect of these transactions on the entity and its owners if the entity is

organized as:

  1. A partnership.
  2. A C corporation.
  3. An S corporation.
  4. LO.5 Swift Corporation distributes land (basis of $55,000 and fair market value of

$120,000) to Sam and cash ($240,000) to Allison in exchange for part of their

stock. Other shareholders do not redeem any of their stock. Sam surrenders shares

of stock that have a basis of $25,000. Prior to the stock redemption, Sam owned 20%

of the Swift stock, and after the redemption, he owns 15%.

At the same time, Swift distributes cash to Allison, and she surrenders shares of

stock with a basis of $40,000. Prior to the stock redemption, Allison owned 70% of

the Swift stock, and after the redemption, she owns 60%.

Determine the tax consequences to Swift, Sam, and Allison if Swift is:

  1. A C corporation.
  2. An S corporation.
  3. LO.5 Indigo, Inc., a personal service corporation, incurs the following income and

losses.

Active income $325,000

Portfolio income 49,000

Passive activity loss 333,000

  1. Calculate Indigo’s taxable income.
  2. Assume that instead of being a personal service corporation, Indigo is a closely

held C corporation. Calculate Indigo’s taxable income.

  1. Would the answer in (b) change if the passive loss was $320,000 rather than

$333,000? Explain.

  1. LO.5 Rosa contributes $50,000 to FlipCo in exchange for a 10% ownership interest.

Rosa materially participates in FlipCo’s business.

FlipCo incurs a loss of $900,000 for the current tax year. Entity liabilities at the end of

the year are $700,000. Of this amount, $150,000 is for recourse debt, and $550,000 is for

nonrecourse debt.

  1. Assume that FlipCo is a partnership. How much of Rosa’s share of the loss can

she deduct for the year on her individual tax return? What is Rosa’s basis for her

partnership interest at the end of the year?

  1. Assume that FlipCo is a C corporation. How much of Rosa’s share of the loss

can she deduct for the year on her individual tax return? What is Rosa’s basis for

her stock at the end of the year?

  1. LO.5 Bishop contributes undeveloped land to a business entity in January for a

40% ownership interest. Bishop’s basis for the land is $140,000, and the fair

market value is $600,000. The business entity was formed three years ago by Petula

and Rene, who have equal ownership. The entity is successful in getting the land

rezoned from agricultural to residential use, but the owners decide to sell the land

so that the entity can invest in another project.

In August, the land is sold for $650,000. Determine the tax consequences of the

sale of the undeveloped land for the business entity and the three owners if the entity

is organized as:

  1. A C corporation.
  2. An S corporation.
  3. A partnership.
  4. An LLC.
  5. LO.5 Jo and Velma are equal owners of the JV Partnership. Jo invests $500,000 cash

in the partnership. Velma contributes land and a building (basis to her of

$125,000, fair market value of $500,000). The entity then borrows $250,000 cash

using recourse financing and $100,000 using nonrecourse financing.

  1. Compute the outside basis in the partnership interest for Jo and Velma.
  2. Compute the at-risk amount for Jo and Velma.
  3. LO.5 Megan owns 55% and Vern owns 45% of a business entity. The owners would

like to use the entity to share profits (55% for Megan and 45% for Vern) and

to share losses (80% for Vern and 20% for Megan). Determine the tax consequences

if the entity has a tax loss of $160,000 and is organized as:

  1. A partnership.
  2. A C corporation.
  3. An S corporation.
  4. LO.5 Sanjay contributes land to a business entity in January of the current year for

a 30% ownership interest. Sanjay’s basis for the land is $60,000, and the fair

market value is $100,000. The business entity was formed three years ago by Polly

and Rita, who have equal ownership. The entity is unsuccessful in getting the land

rezoned from agricultural to residential. In October of the current year, the land is

sold for $110,000.

Determine the tax consequences of the sale of the land for the entity and its owners

if the entity is organized as:

  1. A C corporation.
  2. An S corporation.
  3. A partnership.
  4. LO.7 Emily and Freda are negotiating with George to purchase the business he

operates as Pelican, Inc. The assets of Pelican, Inc., a C corporation, are

recorded as follows.

Asset Basis FMV

Cash $ 20,000 $ 20,000

Accounts receivable 50,000 50,000

Inventory 100,000 110,000

Furniture and fixtures 150,000 170,000*

Building 200,000 250,000**

Land 40,000 150,000

* Potential depreciation recapture is $45,000.

** The straight-line method was used to depreciate the building. Accumulated

depreciation is $340,000.

George’s basis for the Pelican stock is $560,000. George is subject to a 35% marginal

tax rate, and Pelican faces a 34% marginal tax rate.

  1. Emily and Freda purchase the stock of Pelican from George for $908,000. Determine

the tax consequences to Emily and Freda, Pelican, and George.

  1. Emily and Freda purchase the assets from Pelican for $908,000. Determine the

tax consequences to Emily and Freda, Pelican, and George.

  1. The purchase price is $550,000 because the fair market value of the building is

$150,000, and the fair market value of the land is $50,000. No amount is assigned

to goodwill. Emily and Freda purchase the stock of Pelican from George. Determine

the tax consequences to Emily and Freda, Pelican, and George.

  1. LO.7 Linda is the owner of a sole proprietorship. The entity has the following assets.

Asset Basis FMV

Cash $10,000 $10,000

Accounts receivable –0– 25,000

Office furniture and fixtures* 15,000 17,000

Building** 75,000 90,000

Land 60,000 80,000

* Potential depreciation recapture is $5,000.

** The straight-line method has been used to depreciate the building.

Linda sells the business for $260,000 to Juan.

  1. Determine the tax consequences to Linda, including the classification of any

recognized gain or loss.

  1. Determine the tax consequences to Juan.
  2. Advise Juan on how the purchase agreement could be modified to produce

more beneficial tax consequences for him.

  1. LO.7 Gail and Harry own the GH Partnership. They have conducted the business

as a partnership for 10 years. The bases for their partnership interests are as

follows.

Gail Harry

$100,000 $150,000

GH Partnership holds the following assets.

Asset Basis FMV

Cash $ 10,000 $ 10,000

Accounts receivable 30,000 28,000

Inventory 25,000 26,000

Building* 100,000 150,000

Land 250,000 400,000

* The straight-line method has been used to depreciate the building. Accumulated

depreciation is $70,000.

Gail and Harry sell their partnership interests to Keith and Liz for $307,000 each.

  1. Determine the tax consequences of the sale to Gail, Harry, and GH Partnership.
  2. From a tax perspective, should it matter to Keith and Liz whether they purchase

Gail and Harry’s partnership interests or the partnership assets from GH Partnership?

Explain.

  1. LO.7 Hector and Walt are purchasing the Copper Partnership from Jan and Gail for

$700,000; Hector and Walt will be equal partners. During the negotiations,

Jan and Gail succeeded in having the transaction structured as the purchase of the

partnership rather than as a purchase of the individual assets. The adjusted basis of

the individual assets of Copper is $580,000.

  1. What are Hector’s and Walt’s bases for their partnership interests (i.e., outside

bases)?

  1. What is Copper’s adjusted basis for its assets after the transaction? Would an

optional adjustment-to-basis election be helpful? Why or why not?

  1. LO.7 Vladimir owns all of the stock of Ruby Corporation. The fair market value of

the stock (and Ruby’s assets) is about four times his adjusted basis for the

stock. Vladimir is negotiating with an investor group for the sale of the corporation.

Identify the relevant tax issues for Vladimir.

  1. LO.7 Maurice Allred is going to purchase either the stock or the assets of Jewel

Corporation. All of the Jewel stock is owned by Charley. Maurice and

Charley agree that Jewel is worth $700,000. The tax basis for Jewel’s assets is

$500,000.

Write a letter to Maurice, advising him on whether he should negotiate to purchase

the stock or the assets. Prepare a memo for the tax research file on this matter.

Maurice’s address is 100 Aspen Green, Chattanooga, TN 37403.

 

Research Problems

Research Problem 1. The Turnaround LLC was formed several years ago. It incurred

losses for several years, reducing many of its members’ bases in their interests to

zero. However, the business recently obtained some new and promising contracts,

and there is an expectation of profits in the coming years.

Turnaround then admitted several new members, who each made capital contributions

for their interests. The new owners anticipate that it will be necessary to

reinvest any profits back into the business for some time. As there no longer will

be losses to pass through, and any double taxation of profits will be delayed for

some time, the owners of Turnaround are considering converting the business to a

C corporation.

The business controls the following assets. There is no § 754 election in effect.

Fair Market Value Adjusted Basis

Cash $ 500,000 $500,000

PP&E 500,000 500,000

Customer contracts 1,000,000 0

The original owners of Turnaround now hold a 50% capital and profits interest. They

have come to you for advice regarding the potential tax consequences of the conversion

for them, as well as for the new corporation.

Partial list of research aids:

Rev.Rul. 70–239, 1970–1 C.B. 74.

Rev.Rul. 84–111, 1984–2 C.B. 88.

Rev.Rul. 2004–59, 2004–24 I.R.B 1050.

Treas. Reg. § 301.7701–3(g)(i).

Research Problem 2. Crane is a partner in the Cardinal Partnership. A dispute arose

with the partnership regarding Crane’s share of current earnings. The partnership

contends that the amount is $75,000, while Crane believes his share is $100,000.

Crane ceased being a partner on November 1. As a result of the dispute, the partnership

distributed only $75,000 to Crane. It placed the disputed $25,000 in escrow.

However, Crane’s Schedule K–1 from the partnership included the full $100,000.

Crane believes that the K–1 should include only the $75,000 that is not in dispute. Is

Crane correct? Explain.

Research Problem 3. Find a blog posting or discussion thread with comments from

tax professionals about Federal income tax consequences that occur when a business

converts from an LLC to an S corporation or when a C corporation converts to a

pass-through entity. Summarize the comments and suggestions that you find in these

discussions in a one-page memo to your instructor.

Research Problem 4. For your state, list the forms that are required to be filed when a

pass-through entity incorporates or when a corporation converts to a pass-through

entity. Give statutory citations for the conversion rules, due dates for any required

forms, and addresses for where the forms are to be sent. Attach a copy of one of the

forms to a memo summarizing your findings, and send the documents to your

instructor.