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________________________________________________________________________ CHAPTER 3 INCOME SOURCES ____________________________________________________________________ DISCUSSION QUESTIONS 1. How is the definition of income for income tax purposes different from the definition used by economists to measure income? Economists measure income as the change in wealth that occurs during a year. As such, all increases and decreases in the value of assets, whether they are actually realized, are part of the change in wealth. The income tax definition includes only those changes in wealth that are realized by the taxpayer during the year. Thus, the income tax law does not tax as income increases (decreases) in the value of assets that have not been realized in an arm's-length transaction. 2. One of Adam Smith's four criteria for evaluating a tax is certainty. Does the income tax definition of gross income promote certainty in the U.S. tax system? Explain. Certainty means that a taxpayer should know when and how a tax should be paid. In addition, it means that the taxpayer should be able to determine the amount of tax to be paid. The income tax definition of gross income promotes certainty by requiring that a realization occur before income is recognized. This eliminates the need for taxpayers to revalue all their assets from year to year in determining the amount of the tax. The taxpayer only need ascertain those transactions in which a realization has occurred during the year and determine the income tax effects of those transactions. The use of exclusions in calculating gross income does not promote certainty. That is, the tax law contains so many instances in which income is excluded from tax that the taxpayer often has difficulty ascertaining which exclusions apply to them. 3. What is the difference between realized income and recognized income? Realized income occurs when a taxpayer receives an increase in wealth in an arm's-length transaction. Recognized income is income that is actually taxed in the current tax year. Therefore, all recognized income must first be realized. However, all realized income may not be recognized currently. Some forms of income are excluded permanently from tax (e.g., municipal bond interest), while other forms of income are deferred for recognition in a future period (e.g., gains from like-kind exchanges). 4. Buford purchased a new automobile in March for $23,000. In April, he receives a $500 rebate check from the manufacturer. The rebate was paid to all customers who purchased one of the manufacturer's automobiles in March. Should Buford include the $500 rebate in his gross income? Explain. The rebate check is not income. It is an adjustment of the sales price of the automobile. Buford's wealth has not increased as a result of the receipt of the check because rebate checks are used as sales tools. It is a reduction of the selling price paid directly by the manufacturer rather than the dealer. Therefore, Buford has really paid $22,500 (his basis is $22,500) for the new automobile as a result of the rebate.

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5.

What is a cash equivalent? How does a cash equivalent affect the reporting of income? A cash-equivalent is anything with a determinable fair market value. A cash basis taxpayer must recognize income when she or he is in constructive receipt of the income. Under the all-inclusive income concept, income may be received in any form. Therefore, the receipt of a cash equivalent is reported as income in the period of its actual or constructive receipt. The purpose of this approach is to stop cash basis taxpayers from realizing some of their income in the form of property or services to avoid reporting the income earned.

6.

What type of income does a sole proprietor of a business receive? A sole proprietor of a business produces earned income. The income earned by the business is the result of the labor and services of the owner and is considered earned. Earned income is ordinary income and it receives no special treatment by the tax law [in contrast to long-term capital gain income, which is taxed at a rate of 15% (5% for taxpayers in the 10% or 15% marginal tax bracket)].

7.

What is the difference between earned income and unearned income? Earned income is a payment for human capital. That is, it results from the provision of labor and services for which payment or a profit (in the case of a sole proprietor) is received. Unearned income is a payment for a return on an investment. The taxpayer invests money or other assets. An amount is received for the use of the assets. There is no direct investment of human capital.

8.

How is the gross income from a rental property or a royalty property determined? Gross Income from a rental or royalty property is defined as all income received less the costs of producing the income. It is an income number that is net of expenses, not a gross number from which expenses are deducted later in the return.

9.

Explain how the capital recovery concept applies to the taxation of annuities. Consider both purchased annuities and pension payments in your answer. Annuities are equal periodic payments. Under the capital recovery concept, no income is realized until all capital invested in the annuity contract is recovered. For purchased annuity contracts, each payment is considered to be partly a return of investment (excluded) and partly a return on investment (taxable). Using the annuity exclusion formula, the amount of capital invested in the contract is recovered over the period of the contract by excluding a pro rata share of each payment as a return of investment. For annuity contracts beginning on or after November 18, 1996, the simplified method is used to determine the non-taxable portion of the annuity. Under the simplified method, the recipient uses the IRS annuity table -- which represents the individuals life expectancy in months-- to determine the number of months the individual is expected to receive the annuity. To determine the monthly amount that can be excluded, the recipient divides their investment in the annuity by the number of months the annuity is expected to be received (i.e., the table number). If the annuity is not paid on a monthly basis, but rather on a yearly basis, the recipient must multiply the monthly amount that can be excluded by 12.

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Pension payments come in two basic forms. If the payments are from a qualified pension plan, then the amount invested in the plan has never been taxed. In such a case, all payments are a return on investment and are taxed. If the taxpayer is a member of a nonqualified pension plan, amounts invested by the taxpayer in the plan have been previously taxed. These amounts (as in a purchased annuity) are excluded using the methods described above. 10. Explain the difference in determining the amount of income recognized from a conduit entity versus a taxable entity. In a conduit entity, the income of the entity flows through proportionately to the owners of the entity. The entity itself does not pay tax on the income - the owners of the entity include the income on their tax returns. Distributions paid to owners of conduit entities are not taxable; they are returns of investment, not distributions of earnings. In a taxable entity, the entity is responsible for the payment of tax on its income. Distributions paid to owners of the entity represent returns on the owners investment and are subject to tax. 11. What effect does an asset's adjusted basis have in determining the gain or loss realized upon its sale? Under the capital recovery concept, income is not realized until all capital invested in an asset has been recovered. An asset's adjusted basis represents capital investment that has not been recovered. Therefore, a gain on the sale of an asset results when the asset is sold for more than its adjusted basis. A loss occurs when all capital investment has not been recovered through sale -- the asset is sold for less than its adjusted basis. 12. This chapter noted that returns on investment are taxable, whereas returns of investment are not taxable. What is the conceptual basis for this treatment? Cite examples of each type of return, and explain why they are or are not taxable. Returns of investment are not taxable due to the capital recovery concept. Returns on an investment represent increases in wealth and are taxed when realized. Examples include: Interest earned on a savings account - the interest is taxed when credited to the account (return on investment). When the taxpayer withdraws money from the account (return of investment), it is not taxed. Investment in stock - if the stock is from a corporation, cash dividends received represent returns on investment because they are distributions of corporate earnings to shareholders. When the stock is sold, no income is recognized until the amount invested in the stock is recovered (return of capital). Any gain on a sale is an increase in wealth through holding the stock (return on investment). If the stock is S corporation stock, a different result occurs. The income of the S corporation is owned proportionately by the shareholders and flows through the corporation to them for tax purposes. Thus, when the corporation has income, the shareholder has income (return on investment). The payment of dividends to shareholders are returns of their investment and are not subject to tax. Rental Property - Rents received on property are a return on investment because the owner's wealth increases. A return of investment does not occur until the

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owner sells or otherwise transforms the value of the property. For example, a realization could occur due to a casualty and would constitute a return of capital if a deduction for a loss is sustained. 13. Prizes and awards are generally taxable. Under what conditions is the receipt of a prize or award not taxable? There are two circumstances in which a prize or award is not taxable. If the award is for a scientific, literary, educational, musical, or other such achievement and there is no future obligation to perform services as a result of the award, the recipient of the award may exclude the value of the award if the award is given to a charitable, educational, or governmental organization. Awards to employees of tangible property that are based on length of service or safety achievements are also excluded. The maximum exclusion is $400, unless the award comes from a qualified plan, in which case the maximum exclusion is $1,600. 14. Are Social Security benefits taxable? Explain. Social Security payments are subject to tax based on the taxpayer's economic income. The maximum amount subject to tax is 85% of the Social Security benefits received. However, if the taxpayer's economic income (as defined by the Social Security formula) is below the base amount ($25,000 single, $32,000 married, filing joint), then the taxpayer pays no tax on the Social Security benefits received. 15. How is the taxation of an alimony payment different from the taxation of a child support payment? Alimony is considered to be a transfer of income from the payor of the alimony to the payee. The payee is taxed on the alimony received and the payor receives a deduction for adjusted gross income for the alimony paid. Child support payments have no tax effect. That is, married taxpayers receive no direct tax benefit from the payments they make in support of their children and divorced taxpayers are treated in a like manner. 16. What incentive does a taxpayer have to disguise a property settlement as an alimony payment? Property settlements between divorced taxpayers have no income tax effects. The receiver of property does not have income and the payor does not receive a deduction. Alimony payments are taxable to the payee and deductible by the payor. Therefore, the spouse who must make a property settlement payment can benefit by having the payment disguised as deductible alimony. 17. Does the tax treatment of below market-rate loans violate any income tax concepts? If so, how? Explain. The main concept violated is the wherewithal-to-pay concept. The imputation of interest income to the lender does not provide any means with which to pay the tax on the income. This is mitigated in the case of loans to employees because the employer-lender receives a counter balancing tax deduction for compensation paid. However, in gift loans and shareholder loans, there is no counterbalancing deduction.

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INSTRUCTOR'S NOTE: It may be interesting to discuss whether this is really a violation. For example, in the case of a loan to a shareholder, the imputed payment of the interest is considered to be a dividend paid to the shareholder. One could argue by making the loan, the corporation's obligation to pay dividends is reduced, thereby providing wherewithal-to-pay. Similar arguments could be made for gift loans and loans to corporations. Because of the complexity involved in the calculation of below-market rate loans, one could also argue that the administrative convenience concept is violated. That is, it is quite possible that the amount of revenue being generated by the provision exceeds the cost of taxpayers complying with the rules and the cost to the government of insuring that taxpayers comply with the rules. 18. Evaluate the following statement: Whenever another person pays an expense for you, you are in receipt of taxable income. The statement is false. When a payment is made in an employment or business setting, it is a form of compensation that represents a realization of income. However, not all payments made by an employer on behalf of an employee are taxable. These excludable fringe benefits are discussed in Chapter 4. In addition, payments of expenses that are not related to employment or that are not intended as compensation are excludable as gifts. 19. What is a bargain purchase? A bargain purchase occurs when a product or service is sold at a price below the normal selling price in an attempt to compensate the purchaser. That is, the transaction is not made at arms-length between the seller and the buyer, but is intended to be for the mutual benefit of both the seller and the buyer. This is distinguished from those situations in which the buyer of the product or services bargains at arms-length with the seller and obtains a price below the normal selling price. In such cases, the seller and the buyer both benefit from the immediate sale, but there is no long-term benefit to either the buyer or the seller from the reduced sales price.
20. How is capital gain income treated differently from other forms of income? Capital gains and losses are netted separately from all other forms of income. If the result of the netting is a long-term capital gain, the gain is taxed at a rate of 15% for individuals. The rate is reduced to 5% or taxpayers in the 10% or 15% marginal tax rate bracket. Net collectibles gains are taxed at a maximum rate of 28%. Corporations receive no special treatment for net capital gains. If the result of the capital gain and loss netting is a loss, individuals may only deduct $3,000 of net capital loss against other forms of income with any remaining loss carried forward to subsequent years' netting. Corporations are only allowed to deduct losses against capital gains and cannot deduct any of the capital loss against other forms of income. Any remaining capital loss can be carried back three years or forward for five years (see Chapter 7).

21.

What is the purpose of the capital gain-and-loss netting procedure? The primary purpose of the capital gain-and-loss netting procedure is to reduce all capital gains and losses for the year into a single position that is either a gain or loss for the year. The netting procedure also identifies gains and losses as being either net short-term or net long-term gains or losses. The purpose of this part of the netting is to allow favorable tax treatment for net long-term capital gains, and net collectibles gains.

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22.

Are all losses realized on the sale of capital assets deductible? All losses realized may not be currently deductible. Net capital loss deductions of individuals are limited to $3,000 per year with any excess loss carried forward to future years for deduction (subject to that year's netting and $3,000 limit). In addition, personal use assets are capital assets. However, losses on personal use assets are never deductible. Thus, the sale of a personal use asset at a loss is not deductible.

23.

Why is it important that a conduit entity separate the reporting of its capital gains and losses from its reporting of other forms of income? Capital gains and losses are subject to a separate netting before they enter into the taxable income computation. If a taxpayer has a net long-term capital gain for a tax year, the gain is taxed at a rate of 20%. Individuals can only deduct $3,000 of capital losses per year. Because the income of a conduit entity flows through to the owners for taxation, each owner must know his or her individual share of the conduit entity's capital gains and losses to properly compute their net capital gain or loss for the year. For example, if a conduit entity has a long-term capital gain, the owners of the conduit can use the capital gain to offset any capital losses they may have and avoid the $3,000 capital loss limitation. Even if the owners have no capital losses, the long-term capital gain will be taxed at the 20% long-term capital gains rate. If the gain is not separately reported, the owners will be taxed on the gain at their marginal tax rates and will not be able to offset the gain against any capital losses. Similar problems result from a failure to properly report conduit entity capital losses.

24.

Detail any significant differences in the recognition of income using the cash method and using the accrual method of accounting. The primary difference is that the receipt of cash or a cash equivalent constitutes income to the cash basis taxpayer. For an accrual basis taxpayer, the receipt of cash or a cash equivalent is not critical to income recognition. Income is recognized in the period in which is earned by an accrual basis taxpayer.

25.

Explain the hybrid method of accounting. In the hybrid method of accounting, sales of merchandise and the cost of merchandise sold (i.e., cost of goods sold) are accounted for on the accrual basis. All other income and expense items that are not related to the sale of merchandise are accounted for using the cash basis. That is, the hybrid method is a cash basis of accounting for all items except sales of merchandise and the related cost of goods sold.

26.

How does the wherewithal-to-pay concept affect the tax treatment of prepaid income? The wherewithal-to-pay concept affects the tax treatment of prepaid income received by accrual basis taxpayers. Under strict accrual accounting, prepaid income is deferred for recognition to the period in which the income is earned. However, the wherewithal-to-pay concept requires the tax to be paid in the period in which the taxpayer has the cash available to pay the tax. Under this concept, most receipts of prepaid income by an accrual basis taxpayer are included in gross income in the period of receipt, rather than the period in which the income is earned. NOTE: This concept does not affect a cash basis taxpayer who always recognizes income in the period of receipt.

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27.

Under what circumstances can the following taxpayers defer recognition of prepaid income beyond the year of receipt?

a. A cash basis taxpayer Cash basis taxpayers must always recognize income in the period in which it is received. Therefore, receipts of prepaid income are never deferred by cash basis taxpayers. b. An accrual basis taxpayer Accrual basis taxpayers are allowed to defer receipts of prepaid income under the following conditions: 1. Advance receipts for services may be deferred if the services will be performed before the end of the tax year following the year of receipt. Under this rule, one-year service contracts are always deferred; service contracts of two years or more are never deferred. Advance receipts for goods may be deferred if the amount of the receipt is less than the cost of the goods and the receipt (i.e., income) is also deferred for financial reporting purposes.

2.

28.

What is an installment sale? An installment sale is any sale of property at a gain in which payments are received in more than one tax year. Qualifying taxpayers must use the installment sales method to recognize income from the sale (they may make an election to recognize the entire gain in the period of sale).

29.

How is the degree of completion of a long-term construction contract determined?

The degree of completion of a long-term construction contract is determined by the ratio of costs incurred during the year to the total estimated cost of the contract. PROBLEMS 30. Mitch travels extensively in his job as an executive vice president of Arthur Consulting Company. During the current year, he used frequent flier miles that he had obtained during his business travel to take his family on a vacation to Europe. The normal airfare for the trip would have been $6,000. a. Discuss whether Mitch has realized income from the use of the frequent flier miles for personal purposes. Mitch has realized income in this situation. He has experienced an increase in his wealth by converting miles credited during business trips into personal use, thus avoiding payment for the trips. The transaction changes the form of the property rights from credits to actual usage and the transaction is made at arm's length with the airlines. Therefore, all the criteria for realization have been met in this instance. b. Will Mitch have to recognize any income from the use of the frequent flier miles? Explain. Mitch will not have to recognize any income from the use of frequent flier miles for personal purposes. The IRS has been studying this problem for several years and has not been able to come up with a way to administer such forms of income.

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Among the many problems this type of arrangement generates are valuation issues (some routes have as many as 15 different fares), attribution issues (how do you segregate personal mileage from business mileage), and reporting issues (should the airlines be required to report such trips; if so, how do they determine which miles are for business and which are for pleasure). For these reasons, it is likely to remain excluded based on administrative convenience. Instructor's Note: The purpose of this problem is to stimulate application of the concepts to various everyday circumstances and to point out some of the implementation problems that would result if every item that met the definition of income was required to be reported. 35. In each of the following cases determine who is taxed on the income:

a. For $200, Lee purchases an old car that is badly in need of repair. He works on the car for 3 months and spends $300 on parts to restore it. Lee's son Jason needs $2,000 to pay his college tuition. Lee gives the car to Jason, who sells it for $2,000 and uses the money to pay his tuition. Jason is taxed on the gain from the sale of the car. By making a valid gift to Jason (which is not taxed), Jason becomes the owner of the auto. The assignment of income doctrine does not tax Lee in this case because he has given away the property. NOTE: If Lee had sold the car and given Jason the cash, then Lee would have been taxed on the gain from the sale of the car. b. Erica loaned a friend $20,000. The terms of the loan require the payment of $2,000 in interest each year to Erica's daughter. At the end of 4 years, the $20,000 loan principal is to be repaid to Erica. Erica's daughter will use the $2,000 to pay her college tuition. The $2,000 of interest paid to Erica's daughter is taxed to Erica under the assignment of income doctrine. Because Erica retains ownership of the property generating the income (the principal is to be repaid to her), she is taxed on any income generated by the property even though she does not actually receive it. 36. Determine whether Frank or Dorothy, Franks friend, is taxed on the income of each of the following situations:

a. Frank owns 8% bonds with a $10,000 face value. The bonds pay interest annually on June 30. On September 30, Frank makes a bona fide gift of the bonds to Dorothy. Both Frank and Dorothy must recognize the interest earned during the period they held the bonds. Of the total interest payment of $800, Frank held the bonds for 3 months and must recognize $200 [(3 12) x $800] of interest. The remaining $600 of interest is attributable to Dorothy. This is an application of the assignment of income doctrine. Frank is taxed on the income from the bond during the time he owns the bond. The $200 of interest that has accrued by the date of the gift is considered to be part of the gift and is not taxed to Dorothy. b. A few years ago, Frank wrote a best selling book about computers. On August 1, Frank instructs the publisher to pay all future royalties to Dorothy. Frank must still recognize the income from the royalties even though Dorothy receives all royalty payments after August 1. The payments are for services performed by Frank prior to August 1, and cannot be assigned to another for tax purposes under the assignment of income doctrine.

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c. Frank owns 1,000 shares of Pujan stock. On May 1, Pujan declares a $12-per-share dividend to shareholders of record as of June 1. On May 15, Frank gives the Pujan stock to Dorothy. She receives the $12,000 dividend on June 30. Frank is taxed on the dividend, even though Dorothy was the shareholder of record for payment purposes. The dividend was fixed at the declaration date and is taxable to the owner then. Note that if Frank had gifted the stock prior to May 1, the dividend would have been taxable to Dorothy. 39. Partha owns a qualified annuity that cost $52,000. Under the contract, when he reaches age 65, he will receive $500 per month until he dies. Partha turns 65 on June 1, 2003 and receives his first payment on June 3, 2003. How much gross income will Partha report from the annuity payments in 2003? The nontaxable portion of an annuity payment is determined using the annuity exclusion ratio. To determine the monthly amount that can be excluded, the recipient divides their investment in the annuity by the number of months the annuity is expected to be received. Because the annuity is based on the life of the taxpayer, the number of months the annuity is expected to be received determined using the annuity table for a single taxpayer (Table 3-1). Partha is age 65 when he begins receiving the annuity payments and his expected number of payments is 260. His monthly exclusion of $200 ($52,000 260 months) represents the monthly return of his $52,000 investment. Partha must include the remaining $300 of each payment in gross income because it represents the return on his investment. His 2003 gross income is $2,100 ($300 x 7 payments): Monthly amount to be excluded: $52,000 260 = $200 Payment received Excluded amount Taxable amount 40. $ 500 ( 200) $ 300

Minnie owns a qualified annuity that cost $78,000. The annuity is to pay Minnie $650 per month for life after she reaches age 65. Minnie turns 65 on September 28, 2003 and receives her first payment on Nov. 1, 2003.

a. How much gross income does Minnie have from the annuity payments she receives in 2003? The nontaxable portion of an annuity payment is determined using the annuity exclusion ratio. To determine the monthly amount that can be excluded, the recipient divides their investment in the annuity by the number of months the annuity is expected to be received. Because the annuity is based on the life of the taxpayer, the number of months the annuity is expected to be received determined using the annuity table for a single taxpayer (Table 3-1). Minnie is age 65 when she begins receiving the annuity payments and her expected number of payments is 260. Her monthly exclusion of $300 ($78,000 260 months) represents the monthly return of her $78,000 investment. Minnie must include the remaining $350 of each payment in gross income because it represents the return on her investment. Her 2003 gross income from the annuity is $700 ($350 x 2 payments): Monthly amount to be excluded: $78,000 260 = $300 Payment received $ 650

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Excluded amount Taxable amount

( 300) $ 350

b. Shortly after receiving her payment on October 1, 2018, Minnie is killed in an automobile accident. How does the executor of Minnie's estate account for the annuity on her return for the year 2018? The 2018 payments will be treated as $3,500 ($350 x 10 months) of income per the calculation in part a. At the date of her death Minnie will have received 180 payments (12 x 15 years) on the contract and she will only have recovered $54,000 ($300 x 180 payments) of her $78,000 investment in the annuity. Therefore, she will be allowed a deduction of $24,000 ($78,000 - $54,000) on her year 2018 return for the unrecovered investment in the annuity. Total investment to recover Capital recovery through exclusion ($300 x 180) Capital recovery through deduction $ 78,000 (54,000) $ 24,000 How does the

c. Assume that the accident does not occur until November 1, 2027. executor of Minnie's estate account for the annuity on her 2027 return?

The entire $7,150 ($650 x 11) of payments she received will be taxable. On June 1, 2025, she receives her 260th payment, at which time she will have excluded $78,000 (260 x $300) of the payments from income. At this point in time, she has fully recovered her capital investment. Therefore, all payments received after June 1, 2025 are fully taxable. 44. The Rosco Partnership purchases a rental property in 1998 at a cost of $150,000. From 1998 through 2003, Rosco deducts $14,000 in depreciation on the rental. The partnership sells the rental property in 2003 for $160,000 and pays $9,000 in expenses related to the sale. What is Rosco's gain or loss on the sale of the rental property? Under the capital recovery concept, Rosco's gross income from the sale of the rental property is the excess of the net sales price over its investment in the property. Investment in property is measured by its adjusted basis. Adjusted basis is equal to the original basis of the property adjusted for capital expenditures (additions to basis) and recoveries of investment (depreciation deductions). The net sales price is referred to as the amount realized, which is equal to the sales price less the costs of sale. The net sales price of the property is $151,000 ($160,000 - $9,000) and the basis of the property is $136,000 ($150,000 - $14,000), resulting in a gain of $15,000: Selling price Less: Selling expenses Amount realized from sale Less: Adjusted basis of property Original basis Less: Depreciation deductions Gain on sale 46. $ 160,000 (9,000) $ 151,000 $ 150,000 (14,000) (136,000) $ 15,000

How much income should the taxpayer recognize in each of the following situations? Explain.

a. Julius owns a 25% interest in the Flyer Company, which is organized as a partnership. During the current year, he is paid $14,000 by Flyer as a distribution of earnings. Flyer's taxable income for the year (calculated without any payments made to partners) is $60,000.

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Partnerships are conduit entities. Partners are taxed on their individual share of the partnership income. Julius must include $15,000 (25% x $60,000) in his income for his share of partnership income. The $14,000 distribution to Julius is not taxable; it is a return of partnership investment that reduces his basis in the investment. b. Felix owns 1,000 shares of Furr Company, which is a publicly traded corporation. Furr has 1,000,000 shares of stock outstanding during the current year. The company has a net income of $2,500,000 and pays out a $3 per share dividend during the current year. Felix is taxed on the $3,000 (1,000 x $3) of cash dividends received. Furr Co. is responsible for the payment of tax on its income of $2,500,000. c. Andrea is the sole proprietor of Andrea's Art Shop. During the current year, Andrea's has total revenue of $157,000 and total expenses of $110,000. Andrea draws a monthly salary of $2,600 from the shop that is not included in the $110,000 in expenses. Andrea's income is $47,000 ($157,000 - $110,000) from Andrea's Art Shop. She does not include the salary paid to herself as income to her or as an expense of the business -- you cannot be an employee of yourself. A sole proprietorship is similar to a conduit entity and the owner is taxed on the income of the business, not on amounts withdrawn. d. Maryanne owns 50% of the stock of Sterling Safe Company, an S corporation. During the current year, Sterling has a taxable income of $300,000 and pays out dividends of $120,000 to its shareholders. An S corporation is a conduit entity. Owners of S corporations recognize their share of the corporation's income on their tax returns. In this case, Maryanne must include $150,000 (50% x $300,000) in her income. Dividends paid to S corporation shareholders are returns of their investment and are not taxed (they reduce the basis in the investment). Therefore, Maryanne does not include the $60,000 of dividends received in her income. e. Assume the same facts as in part d, except that Sterling incurs a loss of $60,000 during the current year. In the case of a loss, S corporation shareholders recognize their share of the loss. Therefore, Maryanne has a loss of $30,000 (50% x $60,000). Note: This loss may not be deductible in full in the current period if the activity is considered to be passive. See Chapter 7 for the definition and treatment of passive losses. 48. Pablo wins a new automobile on a television game show. The car has a listed sticker price of $31,500. A dealer advertises the same car for $30,000. How much income does Pablo have from the receipt of the car? Explain. Prizes and awards are taxable. Because the prize was won, it does not meet the exception for exclusion of certain types of awards. Pablo is taxed on the fair market value of the car. The sticker price of $31,500 provides only a guide to the fair market value of the car. However, if the car can be bought in an arm's-length transaction at a lower amount than the sticker price, then that is the value to be included in gross income. 52. Hermano and Rosetta are a retired couple who receive $10,000 in Social Security benefits during the current year. They also receive $3,000 in interest on their savings account and taxable pension payments of $28,000. What is their gross income if

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a. They receive no other sources of income? Their gross income before considering Social Security is $31,000 ($3,000 + $28,000). Their modified adjusted gross income is $36,000 [$31,000 + (1/2 x $10,000)]. Under the first tier inclusion rule, $2,000 of the Social Security benefits are taxable per the following: The lesser of: 1. or 2. .5 x ($31,000 + $5,000 - $32,000) = $2,000 .5 x ($10,000) = $5,000

Their gross income is $33,000 ($31,000 + $2,000). Because their modified adjusted gross income of $33,000 is less than $34,000, the 2nd tier inclusion rule does not apply. b. They receive $13,000 in interest from tax-exempt bonds they owned? Their gross income before considering Social Security remains at $31,000 (the interest is tax-exempt). However, through inclusion of the tax-exempt interest in the Social Security formula, $10,200 of the Social Security benefits are taxable: Social Security subject to tax under the first tier inclusion rule: The lesser of : 1. or 2. .5 x ($31,000 + $5,000 + $13,000 - $32,000) = $8,500 .5 x ($10,000) = $5,000

Under the 2nd tier inclusion rule, $8,500 (the maximum) of the Social Security benefits are subject to tax: The lesser of: 1. or 2. The sum of: $ 4,250 85% x $10,000 $ 8,500

a. 85% x ($49,000 - $44,000) b. the smaller of i. ii. $5,000 $6,000

5,000

$ 9,250

Their gross income is $39,500 ($31,000 + $8,500)

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55.

Will and Janine are divorced during the current year. Will is to have custody of their two children and will receive their house as part of the divorce settlement. The house, which Will and Janine bought for $60,000, is worth $100,000. Janine is to receive one of their automobiles, for which they paid $21,000 and which is now worth $9,000. Will will get the other automobile, which cost $6,000 and is worth $2,000. Janine is to pay Will alimony of $900 per month. However, the alimony payment is to be reduced $200 per month as each child reaches age 18 or if a child should die or marry before reaching age 18. What are the tax effects of the divorce settlement for Will and Janine? Property settlements and child support payments have no income tax effect. The division of the property (house and car to Will, and the car to Janine) has no effect on the income of either Will or Janine. Alimony payments are taxable to the receiver of the alimony and deductible by the payor. However, when alimony payments are reduced as a result of a contingency related to a child, the reduction is treated as child support. In this case, the alimony will be reduced $400 ($200 per month per child), which is treated as child support. The remaining $500 ($900 - $400) is alimony and is taxable to Will and deductible by Janine.

58.

Laura makes the following interest-free loans during the current year. Discuss the income tax implications of each loan for both Laura and the borrower. In all cases, the applicable federal interest rate is 8%.

a. On April 15, Laura loans $30,000 to her brother Hyun to pay his income taxes. Hyun is financially insolvent and has no sources of investment income. This is a gift loan of less than $100,000. Therefore, interest is only imputed to the extent of the borrower's net investment income. Since her brother has no investment income, no interest is imputed and there are no tax effects from this loan. b. On March 1, Laura loans $12,000 to her secretary, George. He uses the money as a down payment on a new house. This is an employee loan and interest must be imputed. The interest of $800 [$12,000 x 8% x (10 12)] is income to Laura and an interest payment by George. In addition, the $800 is compensation paid to George that is included in George's gross income and deductible by Laura. c. On July 1, Laura loans her father $150,000. He uses the money to buy a franchise to open a yogurt store. He makes $5,000 on the yogurt store during the current year. Laura must recognize interest income of $6,000 [$150,000 x 8% x (6 12)] and her father has interest expense of $6,000. The $6,000 of imputed cash payment is considered to be a gift from Laura to her father and is not taxable. Because the loan amount is greater than $100,000, none of the gift loan exceptions apply. d. On January 1, Laura loans $70,000 to Lotta, Inc. She is the sole shareholder of Lotta, Inc., which is organized as a corporation. Laura must recognize interest income of $5,600 ($70,000 x 8%) and Lotta, Inc. has interest expense of the same amount. Because this is a loan from a shareholder, the imputed cash payment is considered to be a capital contribution to the corporation. There is no tax effect for making a contribution of capital to a corporation.

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60.

Determine whether the following taxpayers have gross income from the payment of their expenses:

a. Julia's mother, Henrietta, is short of cash when it comes time to pay her property taxes. Julia pays Henrietta's property taxes of $350. The payment of a relative's expenses is considered a gift. There is no intention to compensate through payment of Henrietta's property taxes, and no income is recognized from the payment. b. Kurt fell asleep at the wheel one night and crashed his car into a telephone pole. Repairs to the car cost $600. Kurt isn't covered by insurance and doesn't have the cash to pay the repair shop. Because he needs his car in his job as a salesman, his employer pays the repair bill. The $600 paid by the employer is compensation for Kurt. Most payments of another's expense in an employment setting are compensation. Note: If Kurt's employer requires Kurt to repay the $600, the payment is a loan and not compensation to Kurt. c. Leonard leases a building from the PLC partnership for $800 per month. The lease agreement requires Leonard to pay the property taxes of $1,100 on the building. The $1,100 is taxable to the PLC partnership. The payment of PLC's property taxes by Leonard is a form of rental payment and should be included in PLC's rental income from the property. d. On July 1 Gino bought some land from Harco Corporation for $14,000. As part of the sales agreement, Gino agrees to pay the property taxes of $700 for the year. Harco had paid $10,000 for the land. The sales price of the land is $14,350. The $350 ($700 x 6 12) of Harco Corporation's property taxes by Gino is part of the sales agreement and is equivalent to paying Harco the cash. Thus, Harco's gain on the sale is $4,350 ($14,350 - $10,000). 70. Jawan has the following capital gains and losses in the current year: Short-term capital gain Short-term capital loss Long-term capital gain Long-term capital loss Collectibles gain $ 500 3,000 6,000 12,000 2,000

What is the effect of the capital gains and losses on Jawan's taxable income? In the capital gain and loss netting, the collectibles gain is treated as a long-term capital gain. The result of netting the short and long-term gains and losses is a net short-term loss of $2,500 and a net long-term loss $4,000: First netting: Short-term gain and loss netting: Short-term gain Short-term loss Net short-term loss 500 (3,000) $ (2,500) $

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Long-term gain and loss netting: Long-term gain Long-term loss Collectibles gain Net long-term loss $ 6,000 (12,000) $ 2,000 $ (4,000)

Because the first netting results in both short-term and long-term losses, no further netting is necessary. Individuals are limited to a deduction of $3,000 per year for net capital losses. Any remaining loss is carried forward to the next year's netting. In determining the $3,000 deduction, short-term losses are deducted first. Therefore, Jawan's $3,000 deduction consists of the $2,500 shortterm loss and $500 of the long-term loss. The remaining $3,500 ($4,000 - $500) of long-term loss is carried forward and used in next year's netting. Jawan's gross income decreases $3,000 by the capital loss deduction. 80. In January 2003, Conan, a cash basis taxpayer, purchases for $4,000 a Series EE savings bond with a maturity value of $4,800 (a 6% annual yield). At the same time, he also purchases for $5,000 a 3-year bank certificate of deposit with a maturity value of $6,650 (a 10% annual yield). Both securities mature in 2005. Must Conan recognize any income in 2003? How much income must Conan recognize in 2005? Conan must recognize the income from the certificate of deposit each year using the effective interest method because it is an OID security with a term of more than one year. Interest on the savings bond is deferred until maturity unless Conan elects to amortize the interest using the effective interest method. Under the general rule for Series EE Savings Bonds Conan will recognize $800 ($4,800 maturity value - $4,000 cost) of interest income on the Savings Bonds in 2005. The recognition of interest on the certificate of deposit would be as follows: Year 2003 2004 2005 Beginning Book Value $ 5,000 $ 5,500 $ 6,050 Interest Income $ 500 $ 550 $ 600* Ending Book Value $ 5,500 $ 6,050 $ 6,650

* last year rounding to bring book value to maturity value Conan recognizes the $1,650 in interest ($6,650 maturity value - $5,000 cost) over the three year life of the certificate by multiplying the book value of the security at the beginning of the year by the 10% earnings rate. The book value of the security is increased each year by the interest income recognized until the security has a book value equal to its maturity value at maturity of the certificate. 84. How much income would an accrual basis taxpayer report in 2003 in each of the following situations?

a. Toby's Termite Services Inc. provides monthly pest control on a contract basis. Toby sells a 1-year contract for $600 and a 2-year contract for $1,100. In October, Toby sells 10 1-year contracts and 5 two-year contracts. The one year contracts would be eligible for accrual under the one-year rule for prepayments of services. Toby's would recognize $1,500 [($600 12) = $50 per month x 10 contracts x 3 months earned] of income from these contracts in 2003. The entire $5,500 received from the two-year contracts would be taxable in the year of receipt. The two-year contracts extend beyond December 31, 2004, and

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therefore are ineligible for accrual under the one-year rule. Toby's total income from the contracts in 2003 is $7,000 ($1,500 + $5,500). b. John's Tractor Sales receives a $150 deposit from a customer for a new tractor that the customer orders in December. The tractor arrives the following February, at which time the customer pays the remaining $9,800 of the agreed-upon sales price. John's would be able to defer recognition of any income from the deposit until the sale is closed in 2004, provided that it defers recognition for financial accounting purposes and the cost of the tractor is more than $150. c. A customer of First Financial Lending sends First Financial two $600 checks in December in payment of December and January interest on a loan. First Financial must include both interest checks received as income in the year of receipt under the wherewithal-to-pay concept. No deferral is allowed for advanced receipts of interest. d. First Financial Lending receives interest payments totaling $8,400 in January 2004 in payment of December 2003 interest on loans. As an accrual basis taxpayer, First Financial will report the $8,400 received in January as 2003 income. Accrual basis taxpayers recognize income when it is earned (2003) without regard to the year of actual receipt (2004). 85. Daryl purchases land in 1999 at a cost of $65,000. $100,000. In 2003, he sells the land for

a. How much gain or loss does Daryl realize on the sale of the land? Daryl's realized gain on the sale is $35,000 ($100,000 - $65,000). b. Assume that the sales contract on the land calls for the buyer to pay Daryl $40,000 at the time of sale and $15,000 per year for the next 4 years with interest on the unpaid balance at 8%. How much income must Daryl recognize in 2003? in 2004? This is an installment sale of property. Assuming that Daryl is not a dealer in such property, he must use the installment sales method to account for the sale, unless he elects to have the gain fully taxed in 2003. His recognition for 2003 and 2004 would be $14,000 and $5,250 respectively, with interest income of $4,800 ($60,000 x 8%) in 2003 and $3,600 ($45,000 x 8%) in 2004. 2003 - $40,000 payment x ($35,000 gain $100,000 sales price) = $14,000 2004 - $15,000 payment x ($35,000 gain $100,000 sales price) = $ 5,250 89. Quapaw Construction Company enters into an agreement with Paine County to resurface 30 miles of highway. The contract is for $600,000. Quapaw estimates its total cost of the project to be $500,000. During the current year, Quapaw completes 18 miles of resurfacing, incurs $250,000 in actual costs, and receives $300,000 in advance payments on the project. How much income will Quapaw have to recognize during the current year? Quapaw must recognize gross income from the contract using the percentage of completed contract method. Under this method, the degree of completion is calculated using the ratio of actual costs incurred to total estimated contract costs. Quapaw will recognize $300,000 of gross income from the contract:

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Percentage of completion = $250,000 $500,000 Gross income recognized = $600,000 x 50%

= 50% = $300,000

Note: When using the percentage of completed contract method, actual cash advance receipts are not taxed. The percentage of completed contract method is essentially an accrual based method of recognition and therefore, the receipt of cash does not affect recognition under the method. ISSUE IDENTIFICATION PROBLEMS In each of the following problems, identify the tax issue(s) posed by the facts presented. Determine the possible tax consequences of each issue that you identify. 91. Herman sells his carpet-cleaning business to Elki. As part of the sales agreement, Elki pays Herman $3,000 for his agreement not to open another carpet-cleaning business in the area for 3 years. The issue is whether Herman has to recognize income from the $3,000 he received for the agreement not to open another carpet cleaning business. Herman has gross income from receipt of the $3,000 for the agreement not to compete. His wealth has increased through an arm's-length transaction with a third party, which constitutes a realization of income. In addition, Herman has a claim of right to the $3,000; he has no strict obligation to repay the $3,000. Gilbert got married this year. Because he couldn't afford a wedding reception, his employer gave him the $5,000 he needed to pay for it. The issue is whether Gilbert is taxed on the $5,000 his employer gave him. Is this a valid gift (nontaxable) or is it additional compensation? In general, payments made in business settings (employer and employee in this case) are taxable compensation. However, if all the facts and circumstances indicate that the employer intended the $5,000 to be a gift (i.e., a wedding present), then the $5,000 would not be taxable. 97. RealTime Rentals leases space on its Internet server. Its standard one-year lease agreement requires new customers to pay the first and last months' rent upon signing the lease and a $500 deposit that is returned after the customer has been with RealTime for one year. The issue is the amount of income that is recognized upon the signing of a lease. The $500 deposit is not taxable because RealTime does not have a claim of right to it (i.e., it is under obligation to repay the $500 after one year). The first and last month's rent is taxable when received, regardless of RealTime's accounting method. Prepaid rent is taxable in the year it is received based on the wherewithal-to-pay concept.

95.