CHAPTER 5



CHAPTER 5

GROSS INCOME: EXCLUSIONS

SOLUTIONS TO PROBLEM MATERIALS

| | | | |Status: | | Q/P |

|Question/ | | | |Present | | in Prior |

|Problem | |Topic | |Edition | |Edition |

| | | | | | |

|1 | |Life insurance proceeds and compensation | |Unchanged |1 |

|2 | |Income from gifts and bequests | |Unchanged |2 |

|3 | |Gift to employees | |Unchanged |3 |

|4 | |Gift versus compensation | |Unchanged |4 |

|5 | |Gift versus compensation | |Unchanged |5 |

|6 | |Life insurance: accelerated death benefits | |Unchanged |6 |

|7 | |Life insurance: transfer for valuable consideration | |New | |

|8 | |Life insurance: cash surrender value and accelerated death benefits | |Unchanged |8 |

|9 | |Scholarship and tuition waiver | |Unchanged |9 |

|10 | |Damages | |Unchanged |10 |

|11 | |Damages | |Unchanged |11 |

|12 | |Damages | |Unchanged |12 |

|13 | |Unemployment compensation | |New | |

|14 | |Accident and health plan | |Unchanged |14 |

|15 | |Cafeteria plan | |Unchanged |15 |

|16 | |Fringe benefits: no-additional-cost services | |Unchanged |16 |

|17 | |Fringe benefits: employee discounts | |Unchanged |17 |

|18 | |No-additional-cost service | |Unchanged |18 |

|19 | |Qualified employee discounts | |Modified |19 |

|20 | |Issue ID | |Unchanged |20 |

|21 | |Foreign earned income | |Unchanged |21 |

|22 | |Taxable versus tax-exempt bonds | |New | |

|23 | |Patronage dividends and the tax-benefit rule | |Unchanged |23 |

|24 | |Qualified state tuition program | |New | |

|25 | |Tax benefit rule | |New | |

|26 | |Income from discharge of indebtedness | |Unchanged |26 |

|27 | |Issue ID | |Unchanged |27 |

| | | | | | |

|* 28 | |Life insurance and inheritance | |Unchanged |28 |

|29 | |Life insurance and accident benefits | |New | |

|30 | |Accelerated death benefits | |New | |

|31 | |Gifts and fringe benefits | |Unchanged |31 |

|32 | |Death benefits | |New | |

|33 | |Life insurance: use of proceeds | |Unchanged |33 |

|34 | |Scholarship | |Unchanged |34 |

|35 | |Scholarship | |Unchanged |35 |

|36 | |Damages | |Unchanged |36 |

|37 | |Damages | |Unchanged |37 |

|38 | |Health insurance, medical reimbursement | |Unchanged |38 |

|39 | |Fringe benefits | |Modified |39 |

|40 | |Medical reimbursement plan versus flexible benefits plan | |Unchanged |40 |

|41 | |Long-term care insurance benefits | |Modified |41 |

|42 | |Meals and lodging | |Unchanged |42 |

|43 | |Meals and lodging | |Unchanged |43 |

|* 44 | |Accident and health plans, athletic facilities | |Modified |44 |

|45 | |Working condition fringe | |New | |

|* 46 | |Fringe benefits versus taxable compensation | |Modified |46 |

|47 | |Flexible benefits plan | |Modified |47 |

|48 | |Fringe benefits | |Unchanged |48 |

|* 49 | |Foreign earned income | |Unchanged |49 |

|50 | |Tax benefit rule, tax-exempt income | |Unchanged |50 |

| 51 | |Unrealized gains and losses | |Unchanged |51 |

|52 | |Tax-exempt bonds | |Modified |52 |

|53 | |Tax-favored educational savings programs | |Unchanged |53 |

|* 54 | |Educational savings bond exclusion | |Unchanged |54 |

|55 | |Qualified state tuition program | |Unchanged |55 |

|56 | |Tax benefit rule | |New | |

|57 | |Income from discharge of indebtedness | |Unchanged |57 |

|58 | |Income from discharge of indebtedness | |Unchanged |58 |

|* 59 | |Cumulative | |Modified |59 |

|* 60 | |Cumulative | |Unchanged |60 |

|Research | | | | | | |

|Problem | | | | | | |

| | | | | | |

|1 | |Tax-exempt housing | |Unchanged | |

|2 | |Fringe benefits | |New | |

|3 | |Internet activity | |Unchanged | |

*The solution to this problem is available on a transparency master.

CHECK FIGURES

28. $12,500.

29.a. $2,500.

29.b. $0.

29.c. $0.

29.d. $0.

30.a. Selling the life insurance policy provides $35,000 and no tax liability.

30.b. $0.

31.a. The tips are gross income.

31.b. The tips are gross income.

31.c. The hotel room may qualify for exclusion as a no-additional-cost service.

32. Include $5,000 in gross income.

33.a. Fay has $0 gross income on the receipt of the $1.5 million life insurance proceeds.

33.b. $15,000 of interest is included in gross income.

33.c. $0 gain.

34. Room and board of $7,500 is includible.

35. $2,700 is includible in 2005.

36.a. Liz must include $30,000 in gross income.

36.b. Yes, include $40,000 in gross income.

37.a. $150,000.

37.b. $50,000.

37.c. $50,000.

37.d. $30,000.

37.e. $300,000.

38. $3,600.

41. Include $800 in gross income.

42. $105 per month.

43.a. No.

43.b. Yes, $600.

43.c. Lodging, no.

43.d. IRS yes; courts no.

44. Decrease in disposable income $9,932.

46.a. $9,050; $10,393; $11,015.

46.b. $6,332; $7,272; $7,264.

46.c. $4,550; $4,550; $4,550.

47.a. $2,250.

47.b. $2,250.

47.c. No.

48.a. No exclusion.

48.b. Exclusion allowed.

48.c. Exclusion allowed.

48.d. Exclusion allowed.

48.e. No exclusion for Polly; plan is discriminatory.

49.a. $189,671.

49.b. $195,000.

50. $2,825.

51. $500 in 2004 and $510 in 2005.

52.a. Bond price should decrease.

52.b. Bond price should increase.

54.a. Exclude $3,305.

54.b. Include $5,000 for Susie.

54.c. Include $5,000.

55. Qualified tuition program.

56.a. $0.

56.b. $5,000.

56.c. $320.

57.a. Additional tax $7,000.

57.b. Fran can defer the tax.

58.a. $0 gross income.

58.b. $6,000.

58.c. $4,000.

59. Refund due for 2004 $1,062.

60. Refund due for 2003 $3,341.

DISCUSSION QUESTIONS

1. Tom must include $1,000 in gross income; that is, the amount received for services as executor of his uncle’s estate. The inheritance of $6,000 is excluded from his gross income. pp. 5-2 to 5-4

2. Only Scott is required to include in gross income any of the amounts received. He will be taxed on the interest portion of each installment payment of the life insurance proceeds or $1,000 a year ($9,000 payment – $8,000 return of capital). Ed received an excludible gift and Amos received an excludible inheritance. The $40,000 of life insurance proceeds is an excludible inheritance for Scott and provides him with a basis of $8,000 for each installment payment ($40,000 ÷ 5 payments). pp. 5-4 and 5-5

3. The non-employees can exclude the $60,000 value of the lumber from their gross income as nontaxable gifts. Employees are not permitted to exclude gifts from their employer from gross income. Therefore, the employees must include the $30,000 value of the lumber in their gross income. p. 5-5

4. The $6,000 of sales commissions earned at the time of Hannah’s death is income in respect of a decedent and must be included in Wade’s gross income. The $4,000 for hospital expenses may qualify as a gift because it appears to have been paid on the basis of need. The payment may also be excluded as received under a medical reimbursement plan, provided that similar benefits are provided to other employees. pp. 5-5 and 5-6

5. While a payment made under contract cannot be a gift, the absence of a contract does not make the payment a gift, as indicated in Comm. v. Duberstein. The payment to Abby was not required by a contract, but was intended to compensate Abby for her services and thus would not be a gift. p. 5-5

6. Violet Capital has gross income of $20,000 ($100,000 – $80,000). The fund purchased the policy and therefore is not eligible for the life insurance proceeds exclusion. Ted has no gross income, assuming that Violet Capital is a “qualified third party” because Ted was suffering from a terminal interest when he sold the life insurance policy to Violet Capital. Therefore, the $80,000 he receives is excluded from gross income as an accelerated death benefit. p. 5-7

7. Since Amber had taxable income in 2002, it received a tax benefit from writing off the receivable. So Amber would include $5,000 in gross income in 2004 under the tax benefit rule. The insurance proceeds would not be excluded from gross income because the insurance contract proceeds were in consideration of the loan and not payable merely as the result of Aly’s death. p. 5-8

8. Ed must include his realized gain of $6,000 ($45,000 cash surrender value – $39,000 adjusted basis) in his gross income. However, Sarah can exclude from her gross income her realized gain of $6,000 ($45,000 cash surrender value – $39,000 adjusted basis) because she has a terminal illness (i.e., the accelerated death benefits exclusion). What the funds are used for is not relevant in determining the effect on the taxpayer’s gross income. pp. 5-6 and 5-7

9. The tuition waiver could be part of a qualified tuition reduction program. However, José is allowed to exclude only $1,000 ($4,000 – $3,000) because only $1,000 of the tuition reduction is received in addition to reasonable compensation for José’s services. pp. 5-10 and 5-11

10. All of the amounts received were the result of her physical injury. Therefore, the following may be excluded from Nancy’s gross income:

Damage award for medical expenses $15,000

Damage award for loss of income 4,000

The punitive damage award of $40,000 must be included in Nancy’s gross income.

pp. 5-11 and 5-12

11. The entire $170,000 must be included in Sara’s gross income. The $45,000 payment was received on account of an economic injury rather than a physical personal injury and, therefore, the amounts received are subject to tax. Likewise, the $25,000 payment must be included in her gross income because it is not associated with a physical personal injury. The punitive damages are never excludible. pp. 5-11 and 5-12

12. No. The $15 million amount that Wes received is excluded from his gross income as compensatory physical personal injury damages even though the amount received is based on the projected lost income. The $10 million of punitive damages that Wes receives must be included in his gross income. Sam’s salary of $25 million must be included in his gross income. pp. 5-11 and 5-12

13. Unemployment compensation benefits are included in gross income for Holly. Under a system that measures income on the basis of what was earned during the particular timeperiod, Holly and Jill are equally able to pay their taxes. Each received the same amount during the tax year. p. 5-12

14. Randy can exclude from his gross income the $1,200 insurance proceeds from the policy he purchased. Sam is not taxed on the premiums his employer paid, but Sam must include in gross income the $1,200 he collected on the employer-provided policy.

pp. 5-13 and 5-14

15. With a cafeteria plan, the employees are able to choose benefits that they consider most useful in their individual situations. For example, not all employees would need child care benefits, or a young employee might decide she does not need group term life insurance. p. 5-19

16. The use of the phone would probably qualify as a no-additional-cost service, since the employee is utilizing the employer’s fixed cost. Thus, none of the $75 is included in Paula’s gross income. pp. 5-20 and 5-21

17. The discount Ted receives of $1,600 ($22,000 regular customer cost – $20,400 employee cost) is a qualified employee discount. Ted’s price for the automobile of $20,400 was greater than the employer’s cost of $20,000. Therefore, Ted is not required to recognize any income from the purchase of the automobile. However, the service contract is treated as his purchasing a service, since his discount is more than 20% of the price charged regular customers. Therefore, Ted must include in his gross income the amount of the discount in excess of 20%.

Ted’s discount ($1,200 – $720) $480

Less: 20% discount ($1,200 X 20%) (240)

Excess discount $240

pp. 5-21 and 5-22

18. The use of the country club facilities qualifies by Zack and his family as a no-additional-cost service. Thus, it is excluded from Zack’s gross income. pp. 5-20 and 5-21

19. a. Tom must include the $100 in gross income. Ted is allowed to exclude the $100 as a qualified transportation fringe.

b. Tom paid $100 for transportation cost and was reimbursed for that amount. Therefore, Tom’s before-tax cost was $0. However, Tom is required to include the $100 in gross income and thus must pay an additional $28 ($100 X .28) tax on the reimbursement, which is his after-tax cost of commuting.

Ted’s after-tax cost of commuting is $0 because he is reimbursed for the out-of-pocket cost and is not required to include the reimbursement in income.

p. 5-23

20. The issues all relate to whether the employees would realize gross income from the employer providing the facilities? If the employee does have gross income, the next question is: does the benefit qualify under one of the exclusions provided in the Code?

• Does the employee experience an economic benefit from using the facility?

• Does the walking trail qualify as an excludible “athletic facility”?

• Is the benefit de minimis?

• Is the benefit a no-additional-cost service?

pp. 5-20 to 5-22

21. A possible advantage to taking the three-month job in the foreign country is that Marla may then satisfy the requirements for the foreign earned income exclusion for all of her earned income for the twelve-month period (i.e., statutory ceiling of $80,000 in 2003). This would be a substantial benefit. pp. 5-25 to 5-27

22. The State of Virginia bonds are the better investment. The after-tax yield on the U.S. Government bonds is 3.64% [(1 – .35)(.056)], while the tax-exempt Virginia bonds yield 4%. pp. 5-27 and 5-28

23. The patronage dividend is a recovery of Maria’s feed and fertilizer costs that were deducted in 2003. The cost of the feed and fertilizer produced a tax benefit in 2003 since the farm produced a $100,000 net profit. Since the patronage dividend is a recovery of a prior deduction, it must be included in Maria’s 2004 gross income under the tax benefit rule. pp. 5-31 and 5-32

24. Neither child must include anything in his or her gross income. The $15,000 ($40,000 – $25,000) gain with respect to Peggy, the child who attended college, is exempt because the fund was used for qualified higher education expenses associated with a qualified tuition program. Robert, the child who did not attend college, never received anything. Therefore, there is no effect on his gross income. Arthur must recognize $6,100 of interest income for the amount refunded. pp. 5-30 and 5-31

25. The tax benefit rule does not result in an increase in Mary’s gross income. The tax benefit rule applies when the taxpayer takes a deduction in one year, but recovers the deduction in a subsequent year. Under the tax benefit rule, income generally must be recognized on the recovery, but only the extent the taxpayer received a tax benefit from the deduction in the prior tax year. Instead, Mary’s problem relates to income received in the wrong tax year, which must be recognized in the year received, regardless of when it was earned. Thus, Mary reports the $5,400 in 2004 and the $1,000 in 2005 when she receives it. pp. 5-31 and 5-32

26. a. Ida realized $30,000 ($390,000 – $360,000) of income from the early retirement of the debt. However, rather than recognizing income, Ida reduces the basis of the property that was financed by the debt.

b. If the creditor were a bank rather than the original seller of the ranch, Ida would be required to include $30,000 ($390,000 – $360,000) in her gross income.

pp. 5-32 and 5-33

27. Harry needs to identify and resolve the following issues:

• Is the friend forgiving the debt as a gift to Harry?

• Did the mortgage holder sell the property to Harry?

• Is Harry insolvent or undergoing bankruptcy proceedings?

• If Harry must recognize income from the debt cancellation, does he have losses to offset?

• May Harry reduce the basis of the asset rather than recognizing income?

pp. 5-32 and 5-33

PROBLEMS

28. Wilbur must include in gross income the $7,500 of compensation for serving as executor of his father’s estate and $5,000 from each of the 4 installment payments of the insurance proceeds. Each installment consists of $25,000 of recovery of capital.

|Cost of $100,000 | X Payment of $30,000 = $25,000 exclusion |

|Expected return of $120,000 | |

Installment payment $30,000

Exclusion (25,000)

Include in gross income $ 5,000

pp. 5-4, 5-5, and Chapter 4

29. a. The $2,500 of vacation pay earned by Jose but received by his daughter must be included in her gross income in the tax year she receives it. Such income that has been earned, but not received, at the time of the decedent’s death is income in respect of a decedent.

b. The wife is not required to recognize any income. Since Josh purchased the accident insurance policy, his benefits would not have been taxable had he lived to collect them. The receipt by the wife of the $4,000 is not included in her gross income.

c. Jay’s wife does not recognize income from the receipt of $10,000, since the proceeds are from life insurance and are payable to her as the result of Jay’s death. The mortgage holder received the proceeds from a policy as a result of a transaction for consideration. The mortgage holder must recognize gain if its basis (unrecovered amount of the loan) in the mortgage is less than $40,000.

d. Lavender, Inc. is the beneficiary of a life insurance policy it purchased and whose proceeds were paid upon the death of the insured. Therefore, the proceeds are excluded from its gross income.

pp. 5-5 to 5-7

30. a. Because Laura is terminally ill, she is not required to recognize gain of $20,000 ($35,000 – $15,000) from assigning the life insurance proceeds to Viatical in exchange for $35,000.

b. Laura is “chronically ill.” The life insurance proceeds can be received without recognition of gain provided all of the proceeds are used for the care and assistance necessitated by her illness or disease.

pp. 5-7 and 5-8

31. a. The $36,000 of tips are included in Jim’s gross income. The tips are not gifts because the payments were in return for services, and thus were not made out of detached and disinterested generosity.

b. The $1,800 of tips are included in Tara’s gross income since the money is received because of the services provided by Tara, rather than out of detached generosity. The fact that the customer is not required nor expected to make the payments does not change the result.

c. The use of the hotel is not a gift because the property was provided by Sheila’s employer. The lodging exclusion is not applicable because the housing is not provided as a condition of employment. However, the use of the hotel room may qualify as a no-additional-cost service.

pp. 5-4, 5-5, 5-16, 5-17, 5-20, and 5-21

32. Darlene’s gross income in 2004 from these transactions is $5,000 associated with the installment payment from the $200,000 life insurance policy. Of the $25,000 payment she received in 2004, $20,000 is a return of capital and $5,000 is included in her gross income. Her basis for the life insurance proceeds left with the insurance company is $200,000. The return of capital portion is calculated as follows:

|$200,000 |X |$25,000 |= |$20,000 |

|$250,000 | | | | |

All of the life insurance proceeds ($150,000 and $200,000) are excluded from her gross income. Likewise, the $80,000 of worker’s compensation received is excluded from her gross income. pp. 5-5 to 5-7

33. a. Fay is the beneficiary of the life insurance policy and can exclude the proceeds of $1.5 million from her gross income.

b. The $15,000 of interest earned on the life insurance proceeds left with the insurance company is included in Fay’s gross income.

c. Fay did not recognize a gain on the bargain purchase. Fay simply got a good price on the purchase under an arm’s length contract.

pp. 5-6 to 5-8

34. The $9,000 received for tuition, fees, books, and supplies can be excluded as a scholarship. The $7,500 received for room and board must be included in gross income. The athletic scholarship is considered a payment to further the recipient’s education and is not compensation for services. pp. 5-9 and 5-10

35. Alejandro received a total of $11,000 and spent $8,300 ($3,100 + $3,200 + $900 + $1,100) on tuition, books, and supplies. The amount received for room and board is not excludible. Therefore, he must include $2,700 ($11,000 – $8,300) in gross income. When he received the money in 2004, Alejandro’s total expenses for the period covered by the scholarship were not known. Therefore, he is allowed to defer reporting the income until 2005, when all the uncertainty is resolved. pp. 5-9 and 5-10

36. a. Liz must include in gross income the punitive damages of $30,000. The other amounts ($8,000 and $6,000) may be excluded as arising out of the physical injury, except the $1,000 amount received for damage to her automobile. This amount is a nontaxable recovery of capital (i.e., it reduces her basis for the automobile by $1,000).

b. The $40,000 is included in Liz’s gross income because it did not arise out of a physical personal injury.

pp. 5-11 and 5-12

37. a. The settlement in the sex discrimination case did not arise out of physical personal injury or sickness. Therefore, the $150,000 is included in Eloise’s gross income.

b. The damages to Nell’s personal reputation are not for physical personal injury or sickness. Therefore, Nell must include the $10,000 in her gross income. She must also include the $40,000 punitive damages in her gross income.

c. The damages of $50,000 are included in Orange Corporation’s gross income under the tax benefit rule, assuming the company received tax benefit from deducting the audit fees in a previous year.

d. The compensatory damages of $10,000 for the physical personal injury are not included in Beth’s gross income, but the punitive damages of $30,000 must be included in her gross income.

e. Since the compensatory damages of $75,000 arose from a physical personal injury, they are excluded from Joanne’s gross income. The punitive damages of $300,000 are included in her gross income.

pp. 5-11, 5-12, and 5-31

38. Rex is required to include in gross income only the $3,600 received from the wage continuation policy (d). This amount is included in his gross income only because the employer paid for the policy. pp. 5-13 to 5-15

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

5191 Natorp Boulevard

Mason, OH  45040

September 27, 2004

UVW Union

905 Spruce Street

Washington, D.C. 20227

Dear Union Members:

You asked me to explain the tax consequences of HON Corporation’s proposed changes in the employees’ compensation package. The proposed changes include (1) the imposition of a $100 deductible clause in the medical benefits plan, (2) an additional paid holiday, and (3) a cafeteria plan that would allow the employee to receive cash rather than medical insurance.

The deductible clause will cost each employee $100 after-tax. That is, the employee will be required to pay an additional $100 for the same medical benefits that the employee presently receives and, generally, none of the $100 will be deductible in arriving at taxable income. The additional paid holiday will have no effect on after-tax income—the employee’s annual gross income will not change. The cafeteria plan will mean that some employees who now have excess medical coverage can substitute cash for the unneeded protection. The cash received will be taxable, but the employee’s after-tax income will increase.

In summary, the change with the broadest tax implications is the imposition of the $100 deductible for medical benefits. The employees would actually be better off with a $100 reduction in cash compensation and no deductible clause. This results because the after-tax cost of a $100 reduction in cash compensation is only $72 [(1 – .28) ($100)], whereas the $100 deductible clause means the employee has $100 less for other goods and services.

Also, the cafeteria plan may be important for some employees, depending upon how many of them have working spouses whose employers provided medical benefits for the employee’s entire family.

Please contact me if you have any further questions.

Sincerely yours,

John J. Jones, CPA

Partner

pp. 5-13, 5-14, and 5-19

40. With a medical reimbursement plan, Mauve would be paying all of the employee’s medical expenses. The employee would have no incentive to control costs. With the flexible benefit plan, the employee must contribute to the costs through a salary reduction under the flexible benefit plan. Therefore, for this plan the employee has an incentive to minimize costs. pp. 5-14, 5-19, and 5-20

41. Bertha must include $800 ($7,500 – $6,700) in her gross income for the long-term care insurance she received. The charges by the nursing home were less than the maximum exclusion ($230 per day). The potential exclusion is the greater of the following:

• $230 indexed amount for each day the patient receives the long-term care.

• The actual cost of the long-term care.

Therefore, the amount excluded from her gross income is the statutory indexed amount ($230 X 60 days = $13,800) [the cost of the long-term care of $11,900 is less] reduced by the Medicare payments. Thus, the exclusion is $6,700 ($13,800 – $7,100). p. 5-15

42. The concern in this situation for Tim is that the house will not be considered “on the employer’s premises” in order for Tim to qualify for the meal and lodging exclusion. However, Tim could effectively argue that the house is an extension of the employer’s office because of the extensive business activities (communications, entertaining) conducted in the house. He should be prepared to document the extent of business activities conducted at the house. The presence of an administrative assistant would suggest that much more than incidental business activities are conducted in the home. Gross income would include $105 ($300 – $195) per month because the benefit exceeds the qualified parking monthly exclusion limit of $195. pp. 5-15 to 5-17 and 5-23

43. a. No gross income is recognized since the meals are furnished on the business premises of the employer and for the convenience of the employer.

b. Ira must recognize gross income of $600 per month since the lodging is not required by the employer and, therefore, fails the test for exclusion.

c. Seth recognizes no gross income from the lodging since it is furnished for the convenience of the employer. However, according to one court, the fair market value of the groceries is included in gross income because they do not qualify as “meals.”

d. According to the IRS, a partner is not an employee and, therefore, cannot claim the § 119 exclusion. However, the Tax Court and the Fifth Circuit Court of Appeals allow this exclusion. Thus, the taxpayer may win if he is willing to litigate the issue.

pp. 5-15 to 5-17

44. Only Betty can decide whether she should take early retirement. However, as an aid in making her decision, you can inform her that her disposable income after the effect of the medical insurance and health club dues will decrease by approximately $828 per month.

Now Retired

Salary/retirement $40,000 $24,000

Part-time job -0- 11,000

Social Security tax (3,060) (842)

Income tax (.25) (10,000) (8,750)

Medical insurance -0- (7,800)

Health club dues -0- (600)

$26,940 $17,008

Disposal income associated with employment $26,940

Less: Disposable income associated with retirement (17,008)

Decrease in disposable income ($ 9,932)

pp. 5-13, 5-14, and 5-18

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

5191 Natorp Boulevard

Mason, OH  45040

September 18, 2005

Finch Construction Company

300 Harbor Drive

Vermillion, SD 57069

Dear Management:

You asked me to determine the tax implications of requiring the company’s employees who are carpenters to furnish their own tools, with a compensating increase in their salaries of about $1,500 each. In short, most employees would experience a net decrease in after-tax income.

Under the company’s present way of doing business, the carpenters do not recognize income when the employer provides tools. This is a “working condition fringe.” If the employee’s salary is increased and he or she must purchase the necessary tools, the employee must include the additional $1,500 in salary in gross income. But the cost of the tools in many cases will not be deductible, or less than the actual cost will be deductible. This results from the employee’s expense being a deduction from adjusted gross income as a miscellaneous itemized deduction. If the employee takes the standard deduction, no deduction for the tool expenses is allowed. If the taxpayer does itemize deductions, the total miscellaneous itemized deductions must be reduced by 2% of the employee’s adjusted gross income. In many cases, the total miscellaneous itemized deductions will be less than 2% of AGI. When the total miscellaneous itemized deductions does exceed 2% of AGI, less than the entire expenses are deductible because of the 2% factor.

Another possibility would be for the employees to purchase the tools, but account to you for their cost, and obtain reimbursement. Under this plan, the employee would be allowed to directly offset the reimbursement with the expense, in arriving at adjusted gross income. The request for reimbursement would also provide you with a means of controlling costs.

Please contact me if you would like to discuss this further.

Sincerely,

Amy Evans, CPA

Partner

p. 5-22

46. a. Employee’s before-tax compensation equivalent to $7,000 exempt compensation:

Income groups     Low   Middle  High 

Benefits $7,000 $7,000 $7,000

Income tax rate 0.15 0.25 0.35

Social Security and Medicare tax rate 0.0765 0.0765 0.0145

Total marginal tax rate (MTR) 0.2265 0.3265 0.3645

1 – MTR .7735 .6735 .6355

Before tax compensation =

[$7,000 ( (1 – MTR)] $9,050 $10,393 $11,015

b. Employer’s cost of before-tax compensation equivalent to $7,000 exempt compensation:

Before tax compensation = $9,050 $10,393 $11,015

Employer’s Social Security Tax 692 795 160

$9,742 $11,188 $11,175

Less: reduced income tax (.35) (3,410) (3,916) (3,911)

Employer’s after-tax cost of

taxable compensation $6,332 $ 7,272 $ 7,264

c. Exempt compensation $7,000 $ 7,000 $ 7,000

Less: reduction in income tax (.35) (2,450) (2,450) (2,450)

Employer after-tax cost of

tax-exempt benefits $4,550 $ 4,550 $ 4,550

d. For an after-tax cost of $4,550 per employee, Redbird can provide tax-exempt benefits to its employees that are equivalent to before-tax taxable compensation of $9,050, $10,393, and $11,015, respectively, depending on the employee’s marginal tax bracket. It would cost the company $6,332, $7,272, and $7,264, respectively, to provide the taxable compensation equivalent of $7,000 tax-exempt income. Both the employer and the employee benefit from the exemption. Note, however, that if an employee is already covered in a similar medical benefit plan under a spouse’s plan that the employee may want the cash compensation.

pp. 5-13 and 5-14

47. a. Rosa reduced her salary by $3,000 and thus reduced her tax liability by $750 ($3,000 X 25%). Her after-tax cost of her daughter’s dental expenses is $2,250 ($3,000 – $750).

b. A flexible benefits plan is also referred to as a “use or lose” plan. Since Rosa did not use the $3,000, she loses this amount. Her out-of-pocket costs are $2,250 ($3,000 – $750).

c. No. Since a flexible benefits plan is a “use or lose” plan, she should contribute only the amount she expects to use to the plan.

pp. 5-19 and 5-20

48. a. The football tickets probably do not qualify as a de minimis fringe benefit exclusion. Their exclusion seems unlikely because it is easy to account for the cost. In addition, Temp. Reg. § 1.132–6T(f)(2) specifically provides that season tickets to sporting events do not qualify as de minimis fringes. p. 5-22

b. Parking is a qualified transportation fringe and, thus, can be made available in a discriminatory manner. Therefore, the $1,200 is not taxable because it is less than the $195 per month limit on the exclusion. p. 5-23

c. Other employee’s use of the copying machine may be a de minimis fringe, but Polly’s use was probably so extensive that it will not qualify for this exclusion. However, Polly may be able to relate these expenses to the company’s business. The company benefits from her involvement with the trade association and, thus, the company could justify the expenses under § 162 (see Chapter 6). The $900 is the company’s expense and not Polly’s income. The expenses should qualify as a working condition fringe because Polly could deduct the expenses if she had paid them. p. 5-22

d. The freight is a no-additional-cost benefit made available to all employees (nondiscriminatory). The $600 can be excluded. p. 5-20

e. The plan is discriminatory. Therefore, the highly compensated employees must pay tax on all of their discounts. Polly includes $400 in her gross income.

pp. 5-21 to 5-24

49. a. For the 12-month period ending June 30, 2005, George satisfies the 330 day requirement (i.e., was in London and Paris for 365 days). Therefore, he qualifies for the foreign earned income exclusion treatment for this period which includes 184 days in 2004. For 2004, George can exclude the following amount from his gross income:

|184 days | X $80,000* = $40,329 |

|365 days | |

*Lower of earned income of $230,000 or statutory ceiling of $80,000 for 2004.

George must include $189,671 ($230,000 – $40,329) in his gross income for 2004.

b. For the 12-month period ending December 31, 2005, George satisfies the 330 day requirement (i.e., was in London and Paris for 365 days). Therefore, he qualifies for the foreign earned income exclusion treatment for this period which includes 365 days in 2005. For 2005, George can exclude the following amount from his gross income:

|365 days | X $80,000* of salary = $80,000 |

|365 days | |

*Lower of earned income of $275,000 or statutory ceiling of $80,000 for 2005.

George must include $195,000 ($275,000 – $80,000) in his 2005 gross income.

pp. 5-25 to 5-27

50. Hazel must include all of the items in gross income, except the interest received of $900 on Augusta County bonds. The patronage dividend is included in gross income under the tax benefit rule because the dividend is a recovery of costs deducted in a prior year. All other items are simply gross income not otherwise excluded. Therefore, Hazel must include in gross income $2,825 ($600 + $500 + $125 + $1,600). pp. 5-27 and 5-28

51. Ezra’s gross income for 2004 is $500, his share of the fund earnings which he invested in additional shares in the fund. The change in value of his share of the fund is not a realized gain in 2004. Therefore, nothing is recognized by him from the increase in the value of the fund in 2004. His 2005 gross income is $510. He is not allowed to deduct the unrealized loss from the decrease in the value of his share of the fund because the loss was not realized. pp. 5-27 and 5-28

52. a. The price of the bond should decrease because the value of the exemption from Federal income taxes has decreased. Before the change in tax rates, the after-tax yield on the corporate bond was (1 – .396)(.10) = .0604. After the change in tax rates, the after-tax yield on the corporate bond increased to (1 – .35)(.10) = .065. With no change in the interest paid on the Virginia bonds, the yield on the Virginia bond is still 6%. The price of those bonds should decrease, increasing the yield to come closer to the after-tax yield on the corporate bond.

b. The decrease in the state income tax should increase the after-tax yield and therefore the market price of the bond should increase.

pp. 5-28 and 5-29

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

5191 Natorp Boulevard

Mason, OH  45040

September 7, 2004

Ms. Lynn Schwartz

100 Myrtle Cove

Fairfield, CT 06432

Dear Lynn:

You asked me to consider the tax-favored options for accumulating the funds for Eric’s college education. An added complication (and opportunity for tax planning) in your case is that the funds will come from your parents who are in a much higher tax bracket than either you or Eric. Various options are discussed below. Within some of the options, there are sub-options available; that is, your parents could give the funds to you or to Eric before the investments are made.

• Your parents could purchase stock certificates, bonds, certificates of deposit, or other investments in Eric’s name with them as custodian. The income would be subject to Eric’s marginal tax rate after he is allowed a $800 standard deduction. This option provides the maximum flexibility while removing the income from your parents’ high marginal tax bracket.

• Your parents could buy tax-exempt bonds and accumulate the interest, which is excludible from gross income. However, the rate of return on the investment may be much lower than could be obtained with taxable options.

• Your parents may give the $4,000 a year to you and you could purchase Series EE bonds in your name and use the proceeds to pay Eric’s educational expenses. No tax will be due on the interest. This option would not be available if your parents purchased the bonds because the exemption is not available to taxpayers in your parent’s income class. That is, the potential exclusion would be completely phased out for your parents.

• Your parents could invest the funds in Connecticut’s Qualified Tuition Program. This program provides a hedge against inflation in tuition cost, but little or no other return on the investment. The earnings of the fund, including the tuition savings, will not be included in gross income provided the contribution and earnings are used for qualified education expenses.

• Your parents could give you $4,000 a year, from which you can contribute $2,000 to a Coverdell Education Savings Account (CESA) for Eric. Your parents could not create the account and make the direct contributions because such plans are not available to taxpayers in their income class. The funds earnings will not be taxed to you or Eric provided the entire account balance is used for qualified education expenses. This would give you substantial control over the funds, with relative assurance that the financial means for the college education will be available. The other $2,000 your parents are willing to contribute each year could be used in any of the other options.

If I can be of further assistance in helping you to make this decision and explain the options to your parents, please call me.

Sincerely your,

John J. Jones, CPA

Partner

pp. 5-27 to 5-31

54. a. The savings bonds qualify as educational savings bonds. The savings bonds were issued to Chuck and Luane who were at least 24 years of age (actually older) and the savings bonds were issued after 1989.

Paying the tuition and fees ($8,000) for Susie, their dependent, qualifies as higher education expenses. The room and board of $4,000 does not qualify. Since the redemption amount ($12,000) exceeds the $8,000 of qualified higher education expenses, only part of the interest qualifies for exclusion treatment as follows:

$5,000 X ($8,000 ÷ $12,000) = $3,333

Since their modified adjusted gross income (MAGI) of $90,000 exceeds the threshold amount of $89,750 for 2004, part of the potential exclusion is phased out.

MAGI $90,000

Less: Threshold amount (89,750)

Excess over threshold amount $ 250

The amount of the potential exclusion that is phased out is as follows:

$3,333 X ($250 ÷ $30,000) = $28

Thus, Chuck and Luane can exclude $3,305 ($3,333 – $28) of the savings bond interest received and $1,695 ($5,000 – $3,305) must be included in their gross income.

b. All of the $5,000 of savings bond interest must be included in Susie’s gross income. The educational savings bond exclusion under § 135 applies only if the savings bonds are issued to an individual who is at least age 24 at the time of issuance.

c. If Chuck and Luane file separate returns, they do not qualify for exclusion treatment under § 135. Thus, they must include the $5,000 of savings bond interest in their gross income.

pp. 5-29 and 5-30

55. The Qualified Tuition Program is the slightly preferable investment in terms of return on investment. The compounded value of the bond fund at the end of the 8 years is expected to be $5,760 ($4,000 X 1.44). The Qualified Tuition Program will pay $6,000 for the son’s tuition, and the son does not include anything in his gross income. Thus, the after-tax proceeds will be $6,000. It should be noted that the Qualified Tuition Program also provides a hedge against even greater possible increases in tuition. pp. 5-30 and 5-31

56. a. The tax benefit rule applies when the taxpayer takes a deduction and subsequently experiences a recovery of part or all of the prior deduction. Since the automobile is not used in a trade or business, its cost is not deductible. It follows that the $1,500 rebate is not a recovery of a prior deduction. The rebate is simply a reduction of Wilma’s cost.

b. Wilma deducted the $5,000 of state income tax as an itemized deduction on her 1999 Federal income tax return. Therefore, the recovery of the $5,000 is included in her gross income under the tax benefit rule.

b. The cattle feed purchases would be deductible, since Wilma is in the trade or business of farming. The purchases of household items are not deductible. The patronage dividend allocable to the cattle feed purchase is a recovery of a prior deduction and therefore is included in gross income under the tax benefit rule. The patronage dividend allocable to the household purchases is a recovery of a nondeductible cost and therefore is not included in her gross income. The taxable patronage dividend should be computed as follows:

|Deductible Purchases |X |$400 | = |$10,000 |X |$400 | = |$320 |

|Total Purchases | | | |$12,500 | | | | |

pp. 5-31 and 5-32

57. a. If Fran retires the debt on the residence, she must recognize $20,000 as income from discharge of indebtedness. She would be required to pay $7,000 ($20,000 X 35%) of additional income tax in the year the debt is retired. Thus, she must pay $7,000 to reduce future after-tax interest expense of 5.2% [(1 – .35)(.08)] of the outstanding principal and to retain the other $20,000 that would otherwise be paid as principal on the debt.

b. This alternative yields the same result as a., except Fran can choose to reduce her basis in the business assets instead of recognizing $20,000 income, assuming the liability is qualified business indebtedness. The basis reduction is, in effect, a deferral of the tax (that will be paid when the asset is sold or as depreciation deductions are reduced). Fran should retire the mortgage on the business property and thus defer the tax on the $20,000 gain.

pp. 5-33 and 5-34

58. a. Father’s admonishment clearly indicates that he is making a gift to Robin. Therefore, Robin does not include the $10,000 in his gross income.

b. The corporation’s cancellation of the $6,000 debt is income from discharge of indebtedness to Robin. (Note that if the debt was not actually cancelled, but Robin never attempted to pay it, the IRS would treat the loan as a dividend).

c. The $12,000 reduction in the debt owed to the seller (Trust Land Company) is not included in Robin’s gross income. Instead, his basis in the land must be reduced by the amount of the debt cancelled. Robin must include $4,000 in gross income from the cancellation of the $4,000 liability for accrued interest. This is a recovery of a prior deduction and is subject to the tax benefit rule.

ap. 5-32 and 5-33

CUMULATIVE PROBLEMS

59. Part 1—Tax Computation

Salary $103,000

Less: Foreign earned income exclusion (Note 1) (13,115)

Interest on U.S. savings bonds and Bahamian account (Note 2) 1,100

State income tax refund (Note 3) 900

Stock dividend (Note 4) -0-

Gross income $ 91,885

Less: Deductions for adjusted gross income  

Alimony paid (6,000)

AGI $ 85,885

Less: Itemized deductions

State income tax $5,100

Real estate taxes on residence 3,400

Interest on personal residence 4,500

Charitable contributions 2,800 (15,800)

Less: Personal and dependency exemptions (4 X $3,100) (12,400)

Taxable income $ 57,685

Tax on $57,685 (Note 5) $ 7,938

Less: Withholding by employer (9,000)

Net tax payable (or refund due) for 2004 ($ 1,062)

Notes

1) Since Martin satisfies the 330 out of 365 day requirement, he qualifies for the foreign earned income exclusion for the 60 days in 2004 (January and February) he worked in Mexico. His actual pay of $103,000 exceeded the limit on the exclusion. Thus, he is allowed to exclude only $13,115 (60/366 X $80,000).

2) The $800 interest on the U.S. savings bonds is included in gross income as well as the $300 interest on the Bahamian bank account. Only the $400 interest on the Montgomery County school bonds can be excluded.

(3) The state income tax refund is included in gross income under the tax benefit rule because the state income taxes were taken as an itemized deduction in 2003.

(4) The fair market value of the stock dividend is not included in gross income, since no option was available for receiving cash.

(5) Their filing status is married filing jointly.

Tax on $14,300 = $1,430

On ($57,685 – $14,300) X 15% = 6,508

$7,938

Part 2—Tax Planning

Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard

Mason, OH  45040

December 29, 2004

Mr. and Mrs. Martin S. Albert

512 Ferry Road

Newport News, VA 23100

Dear Mr. and Mrs. Albert:

You asked me to determine the after-tax effect of a $500 increase in your monthly mortgage payment as the result of buying another house. The $500 increase in your monthly mortgage payment will result in approximately a $350 monthly increase in mortgage interest and property tax deductions. As the payments are made on the mortgage, the interest portion will decrease and the principal portion will increase over the next several years.

You are in the 15% marginal tax bracket in 2004 you should be in the 15% bracket in 2005 and thereafter, unless there is a change in your income. Therefore, the increase in after-tax payments in 2005 and thereafter would be $448 [$500 – ($350 X 15%)]. Note, however, that your taxable income amount is approaching the end of the 15% marginal tax bracket and the beginning of the 25% marginal tax bracket. If your income should increase such that some of it is taxable at the 25% rate, the increase in your after tax payments would decrease [$500 – ($350 X 25%) = $413].

I hope this will help you make your decision. If you have any further questions, please contact me.

Sincerely yours,

John J. Jones, CPA

Partner

60. Gross income

Salary ($65,000 + $37,000) $102,000

Group term life insurance (Note 1) 96

Dividends 1,800

State tax refund (Note 2) 1,200

$105,096

Deductions for adjusted gross income

Alimony paid (Note 3) (9,600)

Adjusted gross income $ 95,496

Itemized deductions

State income taxes ($3,400 + $2,200) $5,600

Home mortgage interest 4,300

Real estate taxes 1,200

Cash contributions 1,000 (12,100)

Personal and dependency exemptions ($3,050 X 2) (6,100)

Taxable income $ 77,296

Tax on $77,296 (Note 4) $ 12,759

Less: Tax withheld ($10,900 + $5,200) (16,100)

Net tax payable (or refund due) for 2003 ($ 3,341)

See the tax return solution beginning on p. 5-22 of the Solutions Manual.

Notes

1) Group term life insurance results in gross income for Alfred of $96 as follows:

|($130,000 – $50,000) |X $.10 X 12 months = $96 |

|$1,000 | |

(2) Under the § 111 tax benefit rule, Alfred must include the $1,200 state tax refund is his gross income. Beulah is not required to include her refund in her gross income because she claimed the standard deduction in 2002 and thus did not get a tax benefit from the state income taxes paid.

3) The $9,600 is deductible alimony. The $50,000 payment is a property settlement and is not deductible by Alfred.

4) The tax liability on taxable income of $77,296 is calculated using the Tax Table for married filing jointly and the amount is $12,759. The dividends are taxed at 15%.

Tax on dividend income ($1,800 X 15%) $ 270

Tax on remainder of $75,496 ($77,296 – $1,800) 12,489

$12,759

The answers to the Research Problems are incorporated into the 2005 Comprehensive Volume of the Instructor’s Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION: COMPREHENSIVE VOLUME.

60.

60. continued

60. continued

60. continued

NOTES

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