solutions

5-4 CHAPTER 5

DISCUSSION QUESTIONS

1. Tom received the farm as compensation for services in accordance with the contract withUncle John. Therefore, when Tom receives the farm, the value of the farm must beincluded in his gross income. pp. 5-4 and 5-5

2. Albert received an excludible gift of $10,000, but he must include in his gross income the$400 interest received each year for five years. Samantha received life insuranceproceeds of $10,000 which are excluded from her gross income. However, the $2,000[($2,400 X 5) – $10,000] of income from the installment payments must be included inSamantha’s gross income. Each year, Samantha will report $400 gross income, ascomputed under the annuity rules.

$2,400 – [(cost/expected return)(annual payment)] =

$2,400 – [$10,000/(5 X $2,400) X $2,400] = $400

pp. 5-4 to 5-6

3. Because the majority of the beneficiaries of the nonprofit foundation created by Pearl areemployed by the company, the IRS may argue that the foundation was created for thebenefit of Pearl employees and, therefore, the benefits received by the employees cannotbe excluded from the employees’ gross income. pp. 5-4 and 5-5

4. The $6,000 of sales commissions earned at the time of Hannah’s death is income inrespect of a decedent and must be included in Wade’s gross income. The $4,000 forhospital expenses may qualify as a gift because it appears to have been paid on the basisof need. The payment may also be excluded as received under a medical reimbursementplan, 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 notmake the payment a gift, as indicated in Comm. v. Duberstein. The payment to Abby wasnot required by a contract, but was intended to compensate Abby for her services andthus would not be a gift. p. 5-5

6. Violet Capital has gross income of $20,000 ($100,000 – $80,000). The fund purchasedthe policy and therefore is not eligible for the life insurance proceeds exclusion. Ted hasno gross income, assuming that Violet Capital is a “qualified third party” because Tedwas suffering from a terminal interest when he sold the life insurance policy to VioletCapital. Therefore, the $80,000 he receives is excluded from gross income as anaccelerated death benefit. p. 5-7

7. Since Amber had taxable income in 2003, it received a tax benefit from writing off thereceivable. So Amber would include $5,000 in gross income in 2005 under the taxbenefit rule. The insurance proceeds would not be excluded from gross income becausethe insurance contract proceeds were in consideration of the loan and not payable merelyas the result of Aly’s death. p. 5-8

8. Ed must include his realized gain of $6,000 ($45,000 cash surrender value – $39,000adjusted basis) in his gross income. However, Sarah can exclude from her gross incomeher 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). Whatthe funds are used for is not relevant in determining the effect on the taxpayer’s grossincome. pp. 5-6 and 5-7

Gross Income: Exclusions 5-5

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

10. Assuming the $160,000 is a defensible amount, Sarah should accept the counter-offermade by the company and its insurance company. Under Sarah’s offer (partcompensatory and part punitive), she would receive $230,000 (with the $80,000 punitivedamages included in her gross income) and would have a tax liability of $26,400($80,000 X 33%) on the punitive damages. Thus, her after-tax cash flow would be$203,600 ($230,000 – $26,400). Under the company’s proposal, Sarah would receive$210,000 (with none of the compensatory damages included in her gross income becausethey result from her physical personal injury) but would not have any tax liability. So herafter-tax cash flow from the counter-offer would be $210,000. pp. 5-11 and 5-12

11. The entire $170,000 must be included in Sara’s gross income. The $45,000 payment wasreceived 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 mustbe included in her gross income because it is not associated with a physical personalinjury. 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 ascompensatory physical personal injury damages even though the amount received isbased on the projected lost income. The $10 million of punitive damages that Wesreceives must be included in his gross income. Sam’s salary of $25 million must beincluded in his gross income. pp. 5-11 and 5-12

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

14. Health Savings Accounts (HSAs) are an alternative to traditional health insurance. Theemployer provides a medical insurance plan with a high deductible. The high deductiblereduces the cost of the insurance premiums to the employer. The employer can thenmake contributions to the employee’s HSA to offset part of the high deductible. Theemployee can exclude employer contributions from gross income. Withdrawals used topay medical expenses not covered by the medical insurance plan are excluded from theemployee’s gross income. The employee can make taxable withdrawals for otherpurposes. The earnings on the HSA investments are exempt from tax. Deductiblesunder traditional health insurance plans are lower. The savings feature of an HSA is notpresent in a traditional plan. pp. 5-13 to 5-15

15. The company must increase the offer by $12,000 [$9,000 ÷ (1 – .25)]. pp. 5-2, 5-13, and5-14

16. With a cafeteria plan, the employee receives a salary and is also provided by theemployer with a fixed amount that he or she can allocate among a range of possiblenontaxable fringe benefits and taxable benefits. With a flexible spending plan, a portionof the employee’s salary is set aside for specific uses that would have been excludiblefrom gross income had the employer paid these expenses. The employee’s gross incomeis reduced by the amount that goes into the flexible spending account and thewithdrawals are excluded from gross income. However, any unused funds are forfeitedby the employee. pp. 5-19 and 5-20

5-6 2006 Comprehensive Volume/Solutions

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

Ted’s discount ($1,200 – $600) $600Less: 20% discount ($1,200 X 20%) (240)Excess discount $360

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 asa 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 thereimbursement, 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 theemployer providing the facilities? If the employee does have gross income, the nextquestion 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 Marlamay then satisfy the requirements for the foreign earned income exclusion for all of herearned income for the twelve-month period (i.e., statutory ceiling of $80,000 in 2004).This would be a substantial benefit. pp. 5-26 to 5-28

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 yield4%. pp. 5-28 and 5-29


23. The patronage dividend is a recovery of Maria’s feed and fertilizer costs that werededucted in 2004. The cost of the feed and fertilizer produced a tax benefit in 2004 sincethe farm produced a $100,000 net profit. Since the patronage dividend is a recovery of aprior deduction, it must be included in Maria’s 2005 gross income under the tax benefitrule. pp. 5-29 and 5-30

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 becausethe fund was used for qualified higher education expenses associated with a qualifiedtuition 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 ofinterest income for the amount refunded. p. 5-31

25. The tax benefit rule does not result in an increase in Mary’s gross income. The taxbenefit rule applies when the taxpayer takes a deduction in one year, but recovers thededuction in a subsequent year. Under the tax benefit rule, income generally must berecognized on the recovery, but only the extent the taxpayer received a tax benefit fromthe deduction in the prior tax year. Instead, Mary’s problem relates to income received inthe wrong tax year, which must be recognized in the year received, regardless of when itwas earned. Thus, Mary reports the $5,400 in 2005 and the $1,000 in 2006 when shereceives it. pp. 5-31 and 5-32

26. a. Ida realized $70,000 ($420,000 – $350,000) of income from the early retirementof the debt. However, rather than recognizing income, Ida reduces the basis ofthe property that was financed by the debt.

b. If the creditor were a bank rather than the original seller of the ranch, Ida wouldbe required to include $70,000 ($420,000 – $350,000) 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 tooffset?

• 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 executorof his father’s estate and $5,000 from each of the 4 installment payments of the insuranceproceeds. Each installment consists of $25,000 of recovery of capital.


Policy proceeds of $100,000Expected return of $120,000 X Payment of $30,000 = $25,000 exclusion

Installment payment $30,000Exclusion (25,000)Include in gross income $ 5,000

pp. 5-4, 5-6, and Chapter 13

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

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

c. Jay’s wife does not recognize income from the receipt of $10,000, since theproceeds are from life insurance and are payable to her as the result of Jay’sdeath. The mortgage holder received the proceeds from a policy as a result of atransaction for consideration. The mortgage holder must recognize gain if itsbasis (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 whoseproceeds were paid upon the death of the insured. Therefore, the proceeds areexcluded from its gross income.

pp. 5-4 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 inexchange for $35,000.

b. Laura is “chronically ill.” The life insurance proceeds can be received withoutrecognition of gain provided all of the proceeds are used for the care andassistance 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 giftsbecause the payments were in return for services, and thus were not made out ofdetached and disinterested generosity.

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

c. The use of the hotel is not a gift because the property was provided by Sheila’semployer. The lodging exclusion is not applicable because the housing is not


provided as a condition of employment. However, the use of the hotel room mayqualify 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 2005 from these transactions is $5,000 associated with theinstallment payment from the $200,000 life insurance policy. Of the $25,000 paymentshe received in 2005, $20,000 is a return of capital and $5,000 is included in her grossincome. 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$250,000 X $25,000 = $20,000

All of the life insurance proceeds ($150,000 and $200,000) are excluded from her grossincome. Likewise, the $80,000 of worker’s compensation received is excluded from hergross income. pp. 5-6, 5-7, and 5-12

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 theinsurance company is included in Fay’s gross income.

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

pp. 5-6 to 5-8

34. a. The $8,000 received for tuition, fees, books, and supplies can be excluded fromSarah’s gross income as a scholarship. The $7,500 received for room and boardmust be included in her gross income. The athletic scholarship is considered apayment to further the recipient’s education and is not compensation for services.

b. The “scholarship” is additional compensation to Walt’s father. The fact that the“scholarships” are only awarded to the children of executives indicates that theemployer is not simply making payments to assist the student seeking his or hereducation, but rather to compensate an employee.

pp. 5-9 and 5-10

35. Alejandro received a total of $11,000 and spent $8,900 ($3,300 + $3,400 + $1,000 +$1,200) on tuition, books, and supplies. The amount received for room and board is notexcludible. Therefore, he must include $2,100 ($11,000 – $8,900) in gross income.When he received the money in 2005, Alejandro’s total expenses for the period coveredby the scholarship were not known. Therefore, he is allowed to defer reporting theincome until 2006, 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 otheramounts ($8,000 and $6,000) may be excluded as arising out of the physicalinjury, except the $1,000 amount received for damage to her automobile. Thisamount is a nontaxable recovery of capital (i.e., it reduces her basis for theautomobile by $1,000).


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

pp. 5-11 and 5-12

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

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

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

d. The compensatory damages of $10,000 for the physical personal injury are notincluded in Beth’s gross income, but the punitive damages of $30,000 must beincluded in her gross income.

e. Since the compensatory damages of $75,000 arose from a physical personalinjury, 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 the $4,500 received from the wagecontinuation policy while he was ill. This amount is included in gross income onlybecause the employer paid for the policy. The other items can be excluded from grossincome. pp. 5-13 to 5-15

39. Willis, Hoffman, Maloney, and Raabe, CPAs5191 Natorp Boulevard

Mason, OH 45040

September 27, 2005

UVW Union905 Spruce StreetWashington, D.C. 20227

Dear Union Members:

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

The deductible clause will cost each employee $100 after-tax. That is, the employee willbe required to pay an additional $100 for the same medical benefits that the employeepresently receives and, generally, none of the $100 will be deductible in arriving attaxable 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 someemployees who now have excess medical coverage can substitute cash for the unneededprotection. The cash received will be taxable, but the employee’s after-tax income willincrease.

In summary, the change with the broadest tax implications is the imposition of the $100deductible for medical benefits. The employees would actually be better off with a $100reduction 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)], whereasthe $100 deductible clause means the employee has $100 less for other goods andservices.

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

Please contact me if you have any further questions.

Sincerely yours,

John J. Jones, CPAPartner

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

40. With a medical reimbursement plan, Mauve would be paying all of the employee’smedical expenses. The employee would have no incentive to control costs. With theflexible benefit plan, the employee must contribute to the costs through a salary reductionunder the flexible benefit plan. Therefore, for this plan the employee has an incentive tominimize costs. pp. 5-15, 5-19, and 5-20

41. Bertha must include $700 ($8,000 – $7,300) in her gross income for the long-term careinsurance she received. The charges by the nursing home were less than the maximumexclusion ($240 per day). The potential exclusion is the greater of the following:

• $240 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($240 X 60 days = $14,400) [the cost of the long-term care of $12,000 is less] reduced bythe Medicare payments. Thus, the exclusion is $7,300 ($14,400 – $7,100). pp. 5-15 and5-16

42. The concern in this situation for Tim is that the house will not be considered “on theemployer’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’soffice because of the extensive business activities (communications, entertaining)conducted in the house. He should be prepared to document the extent of businessactivities conducted at the house. The presence of an administrative assistant wouldsuggest that much more than incidental business activities are conducted in the home.Gross income would include $125 ($325 – $200) per month because the benefit exceedsthe qualified parking monthly exclusion limit of $200. pp. 5-16 to 5-18 and 5-23


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

b. Ira must recognize gross income of $600 per month since the lodging is notrequired by the employer and, therefore, fails the test for exclusion.

c. Seth recognizes no gross income from the lodging since it is furnished for theconvenience of the employer. However, according to one court, the fair marketvalue 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 claimthe § 119 exclusion. However, the Tax Court and the Fifth Circuit Court ofAppeals allow this exclusion. Thus, the taxpayer may win if he is willing tolitigate the issue.

pp. 5-16 to 5-18

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

Now RetiredSalary/retirement $40,000 $24,000Part-time job -0- 11,000Social 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 $26,940Less: Disposable income associated with retirement (17,008)Decrease in disposable income ($ 9,932)

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


Mason, OH 45040

September 18, 2006

Finch Construction Company300 Harbor DriveVermillion, SD 57069

Dear Management:

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


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

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

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

Sincerely,

Amy Evans, CPAPartner

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 $7,000Income tax rate 0.15 0.25 0.35Social Security and Medicare tax rate 0.0765 0.0765 0.0145Total marginal tax rate (MTR) 0.2265 0.3265 0.36451 – MTR .7735 .6735 .6355Before tax compensation =

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

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

Before tax compensation = $9,050 $10,393 $11,015Employer’s Social Security Tax 692 795 160

$9,742 $11,188 $11,175Less: 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 $ 7,000Less: 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-exemptbenefits to its employees that are equivalent to before-tax taxable compensationof $9,050, $10,393, and $11,015, respectively, depending on the employee’smarginal 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 benefitplan 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 didnot 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 contributeonly the amount she expects to use to the plan.

pp. 5-19 and 5-20

48. Polly is both an employee and a controlling shareholder in the corporation. Therefore,benefits she receives that are not excludible from gross income may be characterized as adividend. This would mean that she might enjoy the lower tax rate applicable todividends as compared to compensation; however, the corporation will not be allowed todeduct any amount that is considered a dividend.

a. The $600 value of the tickets to football games does not fit any of the possiblecategories of excludible employee fringe benefits. Moreover, the benefit ofreceiving the tickets discriminates in favor of executives. Even though she doesnot personally use the tickets, she enjoys the benefit of determining who will usethem. Therefore, Polly must include the $600 value of the tickets in grossincome. p. 5-25

b. Employee parking is specifically excluded from gross income. However, thevalue of Polly’s free parking of $2,700 ($2,700/12 = $225 per month) exceeds thepermitted exclusion amount of $2,400 ($2,400/12 = $200 per month). Note thatparking can be provided on a discriminatory basis. p. 5-23

c. The use of the phone is excluded from Polly’s gross income as a no-additionalcost benefit. It also may fit the requirements for a de minimis fringe benefit.p. 5-21

d. The value of the use of the condominium is a no-additional cost fringe benefit thatPolly can exclude from gross income. p. 5-21

e. The freight is a no-additional-cost benefit made available to all employees(nondiscriminatory). The $750 can be excluded from Polly’s gross income.p. 5-21


f. The plan is discriminatory. Therefore, the highly compensated employees mustpay tax on all of their discounts. Polly includes $900 in her gross income.pp. 5-22 and 5-26

49. a. For the 12-month period ending June 30, 2006, George satisfies the 330 dayrequirement (i.e., was in London and Paris for 365 days). Therefore, he qualifiesfor the foreign earned income exclusion treatment for this period which includes184 days in 2005. For 2005, George can exclude the following amount from hisgross income:

184 days365 days X $80,000* = $40,329

*Lower of earned income of $230,000 or statutory ceiling of $80,000 for 2005.

George must include $189,671 ($230,000 – $40,329) in his gross income for2005.

b. For the 12-month period ending December 31, 2006, George satisfies the 330 dayrequirement (i.e., was in London and Paris for 365 days). Therefore, he qualifiesfor the foreign earned income exclusion treatment for this period which includes365 days in 2006. For 2006, George can exclude the following amount from hisgross income:

365 days365 days X $80,000* of salary = $80,000

*Lower of earned income of $275,000 or statutory ceiling of $80,000 for 2006.

George must include $195,000 ($275,000 – $80,000) in his 2006 gross income.

pp. 5-26 to 5-28

50. Hazel must include all of the items in gross income, except the interest received of $900on Augusta County bonds. The patronage dividend is included in gross income under thetax benefit rule because the dividend is a recovery of costs deducted in a prior year. Allother items are simply gross income not otherwise excluded. Therefore, Hazel mustinclude in gross income $2,825 ($600 + $100 + $125 + $1,600). pp. 5-28 and 5-29

51. a. Ezra must include in his gross income the $700 cash he constructively received.He will have a $700 basis in the additional shares he received. The decrease inthe value of the fund shares of $1,200 ($15,700 – $14,500) is not taken intoaccount because he has not realized (e.g., from a sale or exchange) the loss.

b. Ezra received stock dividends, which are essentially more shares to represent hissame relative interest in the corporation. Because his interest in the corporationdid not change, and he did not have the option of receiving cash, Ezra has nogross income from the receipt of the stock dividends. Ezra must allocate hisoriginal cost of his Giant, Inc., shares among the original shares owned and theadditional shares received as a nontaxable stock dividend.

pp. 5-29 and 5-30


52. a. The price of the bond should decrease because the value of the exemption fromFederal income taxes has decreased. Before the change in tax rates, the after-taxyield on the corporate bond was (1 – .396)(.10) = .0604. After the change in taxrates, 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 theVirginia bond is still 6%. The price of those bonds should decrease, increasingthe 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 andtherefore the market price of the bond should increase.

pp. 5-28 and 5-29


Mason, OH 45040

September 7, 2005

Ms. Lynn Schwartz100 Myrtle CoveFairfield, CT 06432

Dear Lynn:

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

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

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

• Your parents may give the $4,000 a year to you and you could purchase Series EEbonds in your name and use the proceeds to pay Eric’s educational expenses. No taxwill be due on the interest. This option would not be available if your parentspurchased the bonds because the exemption is not available to taxpayers in yourparent’s income class. That is, the potential exclusion would be completely phasedout 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 otherreturn on the investment. The earnings of the fund, including the tuition savings, willnot be included in gross income provided the contribution and earnings are used forqualified education expenses.


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

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

Sincerely your,


pp. 5-30 and 5-31

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

Paying the tuition and fees ($8,000) for Susie, their dependent, qualifies as highereducation expenses. The room and board of $4,000 does not qualify. Since theredemption amount ($12,000) exceeds the $8,000 of qualified higher educationexpenses, 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 $94,000 exceeds thethreshold amount of $91,850 for 2005, part of the potential exclusion is phasedout.

MAGI $94,000Less: Threshold amount (91,850)Excess over threshold amount $ 2,150

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

$3,333 X ($2,150 ÷ $30,000) = $239

Thus, Chuck and Luane can exclude $3,094 ($3,333 – $239) of the savings bondinterest received and $1,906 ($5,000 – $3,094) must be included in their grossincome.

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


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

pp. 5-30 and 5-31

55. The Qualified Tuition Program is the slightly preferable investment in terms of return oninvestment. The compounded value of the bond fund at the end of the 8 years is expectedto be $5,760 ($4,000 X 1.44). The Qualified Tuition Program will pay $6,000 for theson’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 alsoprovides 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 subsequentlyexperiences a recovery of part or all of the prior deduction. Since the automobileis 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 areduction of Wilma’s cost.

b. Wilma deducted the $5,000 of state income tax as an itemized deduction on her2000 Federal income tax return. Therefore, the recovery of the $5,000 is includedin her gross income under the tax benefit rule.

c. The cattle feed purchases would be deductible, since Wilma is in the trade orbusiness of farming. The purchases of household items are not deductible. Thepatronage dividend allocable to the cattle feed purchase is a recovery of a priordeduction and therefore is included in gross income under the tax benefit rule.The patronage dividend allocable to the household purchases is a recovery of anondeductible cost and therefore is not included in her gross income. The taxablepatronage dividend should be computed as follows:

Deductible purchases $10,000Total purchases X $400 = $12,500 X $400 = $320

pp. 5-31 and 5-32

57. a. If Fran retires the debt on the residence, she must recognize $20,000 as incomefrom discharge of indebtedness. She would be required to pay $7,000 ($20,000 X35%) 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 theoutstanding principal and to retain the other $20,000 that would otherwise be paidas principal on the debt.

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

pp. 5-32 and 5-33

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 ofindebtedness to Robin. (Note that if the debt was not actually cancelled, butRobin 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 notincluded in Robin’s gross income. Instead, his basis in the land must be reducedby the amount of the debt cancelled. Robin must include $4,000 in gross incomefrom the cancellation of the $4,000 liability for accrued interest. This is arecovery of a prior deduction and is subject to the tax benefit rule.

pp. 5-32 and 5-33

CUMULATIVE PROBLEMS

59. Part 1—Tax Computation

Salary $103,000Less: Foreign earned income exclusion (Note 1) (12,932)Interest on U.S. savings bonds and Bahamian account (Note 2) 1,100State income tax refund (Note 3) 900Stock dividend (Note 4) -0-Gross income $ 92,068Less: Deductions for adjusted gross income

Alimony paid (6,000)AGI $ 86,068Less: Itemized deductions

State income tax (Note 5) $5,100Real estate taxes on residence 3,400Interest on personal residence 4,500Charitable contributions 2,800 (15,800)

Less: Personal and dependency exemptions (4 X $3,200) (12,800)Taxable income $ 57,468

Tax on $57,468 (Note 6) $ 7,890Less: Withholding by employer (9,000)Net tax payable (or refund due) for 2005 ($ 1,110)

Notes

(1) Since Martin satisfies the 330 out of 365 day requirement, he qualifies for theforeign earned income exclusion for the 59 days in 2005 (January and February)he worked in Mexico. His actual pay of $103,000 exceeded the limit on theexclusion. Thus, he is allowed to exclude only $12,932 (59/365 X $80,000).

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

(3) The state income tax refund is included in gross income under the tax benefit rulebecause the state income taxes were taken as an itemized deduction in 2004.

(4) The fair market value of the stock dividend is not included in gross income, sinceno option was available for receiving cash.


(5) The state income taxes paid of $5,100 exceed the sales taxes paid of $1,100.

(6) Their filing status is married filing jointly.

Tax on $14,600 = $1,460On ($57,468 – $14,600) X 15% = 6,430

$7,890

Part 2—Tax Planning

Willis, Hoffman, Maloney, and Raabe, CPAs5191 Natorp Boulevard

Mason, OH 45040

December 29, 2005

Mr. and Mrs. Martin S. Albert512 Ferry RoadNewport News, VA 23100

Dear Mr. and Mrs. Albert:

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

You are in the 15% marginal tax bracket in 2005 and you should be in the 15% bracket in2006 and thereafter, unless there is a change in your income. Therefore, the increase inafter-tax payments in 2006 and thereafter would be $448 [$500 – ($350 X 15%)]. Note,however, that your taxable income amount is approaching the end of the 15% marginaltax bracket and the beginning of the 25% marginal tax bracket. If your income shouldincrease such that some of it is taxable at the 25% rate, the increase in your after taxpayments would decrease [$500 – ($350 X 25%) = $413].

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

Sincerely yours,


60. Gross incomeSalary ($70,000 + $38,000) $108,000Group term life insurance (Note 1) 108Dividends 1,500State tax refund (Note 2) 1,200

$110,808Deductions for adjusted gross income

Alimony paid (Note 3) (10,800)Adjusted gross income $100,008


Itemized deductionsState income taxes ($3,400 + $2,300) (Note 4) $5,700Home mortgage interest 4,300Real estate taxes 1,450Cash contributions 1,000 (12,450)

Personal and dependency exemptions ($3,100 X 2) (6,200)Taxable income $ 81,358

Tax on $81,358 (Note 5) $ 13,669Less: Tax withheld ($10,900 + $4,900) (15,800)Net tax payable (or refund due) for 2004 ($ 2,131)

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

Notes

(1) Group term life insurance results in gross income for Alfred of $108 as follows:

($140,000 – $50,000)$1,000 X $.10 X 12 months = $108

(2) Under the § 111 tax benefit rule, Alfred must include the $1,200 state tax refundis his gross income. Beulah is not required to include her refund in her grossincome because she claimed the standard deduction in 2003 and thus did not get atax benefit from the state income taxes paid.

(3) The $10,800 is deductible alimony. The $50,000 payment is a propertysettlement and is not deductible by Alfred.

(4) The state income taxes paid of $5,700 exceed the sales taxes paid of $1,400.

(5) The tax liability on taxable income of $81,358 is calculated using the Tax Tablefor married filing jointly (applying the 15% rate for the qualified dividends of$1,500) and the amount is $13,669.

Tax on dividend income ($1,500 X 15%) $ 225Tax on remainder of $79,858 ($81,358 – $1,500) 13,444

$13,669


60.


60. continued

solutions

Documents

employees gross income

samanthas gross income

saras gross income

wades gross income

taxpayers gross income

taxable income

projected lost income

punitive damages