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Solutions to Chapter 3 Problem Assignments Check Your Understanding 1. Choice of Tax Year Michelle (a calendar-year individual) begins a new business as a sole proprietorship. She would like to use an October 31 fiscal year-end for her business because the calendar year ends during her busy season. Can Michelle use a fiscal tax year? Solution: The sole proprietorship’s operating results will all be reported on Michelle’s tax return. As a result, it will have to be on a calendar-year basis unless Michelle applies for and receives permission to change her tax year to October 31. 2. Accounting Methods Jabba Company uses the cash method of accounting. Jabba received a computer from a customer as payment for a $2,000 bill. Can Jabba avoid recognizing income because it received payment in a noncash form? Explain. Solution: Jabba must recognize the fair market value of the computer (assumed to be approximately $2,000) as income in payment of the bill. Cash-basis taxpayers must recognize income when cash or cash equivalents are received as payment. The computer constitutes a cash equivalent. 3. Accounting Methods Murphy Company, a cash-basis, calendar-year taxpayer, received a call on December 28, year 1, from a client stating that a check for $9,000 as payment in full for their services could be picked up at their offices, two blocks away, any weekday afternoon between 1:00 and 6:00 P.M. Murphy does not pick up the check until January 3, year 2. In which year does Murphy recognize the income? Solution: Murphy should recognize the income in year 1. The check was readily available several days before the end of the year and, as a cash-basis taxpayer, Murphy cannot turn its back on the income by failing to pick up the check. 17. Nexus What is nexus? Solution: Nexus is the type and degree of connection between a taxpayer and a taxing jurisdiction (e.g., a state or city) necessary for that jurisdiction to have the right to impose a tax on the taxpayer. 18. Installment Method What is an installment sale? If a transaction qualifies for installment sale treatment, when will the taxpayer be taxed on the sale? What does a taxpayer do if the taxpayer does not want to use the installment method? Solution: An installment sale is a sale in which the payments are received over a period of time rather than the entire payment being received at the time of sale. For tax purposes a sale of certain qualifying goods is an installment sale if one or more 2 Solutions Manual for Taxation for Decision Makers payments are received in a future tax year. In a qualifying installment sale, the taxpayer recognizes gain (income) and is taxed on this gain only as payments are received. A proportion of each payment is gain; the proportion is the ratio of total gain to the total proceeds on the sale. The taxpayer must elect out of installment sale treatment if he or she does not want it to apply to a qualifying sale simply by reporting the entire gain on the sale in the year the sale is closed. Crunch the Numbers 23. Prepaid Service Revenue On December 1, year 1, Peak Advertising (a calendar-year, accrual-basis taxpayer) receives a $24,000 retainer fee for a two-year service contract. a. How much income should Peak report in year 1 for tax and financial accounting? b. How much income should Peak report in year 2 for tax and financial accounting? c. How much income should Peak report in year 3 for tax and financial accounting? Solution: a. $1,000 (1/24 of $24,000) for both tax and financial accounting. b. $23,000 for tax accounting and $12,000 for financial accounting. Deferral for tax is not permitted beyond the year following the prepayment. c. $0 for tax accounting and $11,000 ($24,000 - $1,000 - $12,000) for financial accounting. 24. Municipal Bonds Carl paid $40,000 to the City of Hollywood for general revenue bonds. During the current year, he receives $2,300 interest income from the bonds. Market interest rates drop, causing the value of the bonds to increase so Carl sells the bonds for $43,000. How much gross income must Carl report for the year? Solution: Carl recognizes gain of $3,000 ($43,000 - $40,000) on the sale of the stock. The interest is nontaxable because these are municipal bonds. 27. Employee/Shareholder Loans Sheldon Corporation loans $80,000 interest free for one year to Lynn, an employee. Assume that the applicable federal rate of interest is 5 percent. Lynn uses the loan to pay for personal debts. What are the tax consequences of this loan to Sheldon and to Lynn? How would your answer change if Lynn is a shareholder of Sheldon Corporation? Solution: Lynn is assumed to pay Sheldon Corporation $4,000 in interest (5% x $80,000) on the loan. Sheldon has $4,000 in interest income. If Lynn is an employee, Sheldon is assumed to then return the $4,000 to Lynn as taxable compensation, deductible by the corporation. If Lynn is a shareholder, the return of the $4,000 is assumed to be taxable dividend income to Lynn but nondeductible by the corporation. 28. Gross Income from Investments George owns 1,000 shares of ABC common stock and 3,000 shares of Brightstar mutual fund. George elects to participate in Brightstar's dividend reinvestment plan, reinvesting his annual dividends and capital gains distributions in additional Brightstar shares. George Chapter 3: Determining Gross Income 3 receives a $5,000 distribution from ABC and a Form 1099-DIV indicating that $4,000 of the distribution is a dividend and $1,000 is a nontaxable distribution. He also receives a Form 1099-DIV from Brightstar mutual fund indicating that he has a dividend of $6,500 and a capital gains distribution of $1,300 for a gross distribution of $7,800 that is reinvested in 90 additional shares of Brightstar mutual fund. How much does George include in his gross income for the year? Solution: $11,800. George must include in gross income all except the $1,000 distributed by ABC as a nontaxable distribution. Thus, his gross income must include the $4,000 taxable distribution from ABC and both the $6,500 dividend and the $1,300 capital gain distribution from Brightstar for a total of $11,800. However, this income will be taxed at the 15% (or 0% on any amount that does not exceed the 15% tax bracket) rate. 32. Income from Lottery Winnings Julie wins $15 million in the lottery payable over 30 years. In years 1 through 4, she receives annual installments of $500,000. At the beginning of year 5, Julie sells her right to receive the remaining 26 payments to a third party for a lump-sum payment of $8,900,000. How much does Julie include in income each year? Solution: Julie must include all $500,000 of each payment received in years 1 through 4 in income when received. When she sells her rights to the remaining 26 payments for $8,900,000, the $8,900,000 must be included in income when received. 33. Social Security Benefits Vera, a single individual, receives $18,000 of dividend income and $38,000 of interest income from tax-exempt bonds. Vera also receives Social Security benefits of $16,000. What is Vera's gross income? Solution: $31,600. Vera’s modified adjusted gross income is $64,000 [$18,000 + $38,000 + ($16,000 x ½)]. Because her MAGI exceeds $34,000, she may have to include up to 85 percent of her Social Security benefits in her income determined as the lesser of (1) $13,600 (85% x $16,000) or $30,000 [85% ($64,000 - $34,000) + $4,500] . The inclusion of the tax-exempt interest in MAGI is sufficient to put her in the position of having to include $13,600 of her Social Security benefits in income. Thus, her gross income is $31,600 ($18,000 dividend income + $13,600 Social Security benefit). Although the tax-exempt bond interest must be included in determining modified adjusted gross income, it is not included in determining gross income for tax purposes. 37. Cancellation of Debt Markum Corporation owes a creditor $60,000. Markum transfers property to the creditor to satisfy the debt. Markum purchased the property four years ago for $45,000 and it is currently worth $60,000. Does Markum have any gross income as a result of this transaction? Solution: Markum must recognize a $15,000 ($60,000 - $45,000) taxable gain on the transfer of the property as if it had sold the property for $60,000 and used the proceeds to pay the debt. 38. Recovery of Bad Debt 4 Solutions Manual for Taxation for Decision Makers Sandle Corporation, an accrual-basis, calendar-year taxpayer, sold $15,000 of its products on account to Jim in November, year 1. In year 2, Jim declares bankruptcy and Sandle writes off the account as a bad debt. In year 3, Jim unexpectedly inherits a large sum of money and uses part of it to repay his creditors, including a $12,000 payment to Sandle Corporation. a. What does Sandle Corporation report on its tax returns for years 1, 2, and 3? b. How would your answers change if Sandle is a cash-basis taxpayer? Solution: a. Sandle would recognize $15,000 of income in year 1. In year 2 it would write off (deduct) the $15,000 as a bad debt as a result of Jim’s bankruptcy. In year 3, it would recognize $12,000 of income on the recovery of that portion of the debt that had been written off in the prior year. b. If Sandle is a cash-basis taxpayer, it would recognize no income in year 1, would have no write off in year 2, but would recognize $12,000 of income in year 3. 39. Shifting Income to Children Mac’s 24-year-old daughter, Alana, is a full-time student. In 2010, Mac gives Alana 600 shares of Highgrowth stock. Mac purchased the stock 10 months ago at $20 per share. On the gift date, the stock is worth $35 per share. After the gift, Highgrowth declares and pays a $170 dividend to Alana. The next month, Alana sells her 600 shares for $38 per share. Mac and Alana are in the 35 and 15 percent marginal tax brackets, respectively. a. How much must Alana and Mac include in gross income? b. What family tax savings are achieved through this gift? Solution: a. Alana has $10,970 gross income and Mac has none. Mac includes nothing in his gross income because he gave the stock to Alana and is no longer the owner. Alana is taxed on the dividend income ($170) because she was the owner when the dividend was declared and paid. Alana also includes the $10,800 [600 x ($38 - $20)] gain on the sale of the stock in her gross income. She will use Mac’s purchase price (carryover basis) of the stock to determine her gain on the sale. b. $2,185.50. Because the gain on the sale of the stock is short-term capital gain, it will be taxed at ordinary income rates. The difference in the tax rates between Mac and Alana is 20% (35% - 15%) resulting in a $2,160 ($10,800 x 20%) tax savings. The difference in the tax rates on the dividend income is 15% (15% for Mac – zero for Alana) resulting in a $25.50 ($170 x 15%) tax savings. By having the $10,970 total income taxed to Alana rather than Mac, the family has a total tax savings of $2,185.50 ($2,160 + $25.50). Note that this solution specifies that Alana is age 24. As discussed in Chapter 12, the kiddie tax provision can cause some unearned income of children under age 24 to be taxed at their parent’s marginal tax rate. 40. Gift Property Myra receives a $20,000 gift from her cousin and inherits $80,000 in corporate bonds from her aunt. Myra receives $7,000 in interest income from the bonds. How much does Myra include in gross income? Solution: Myra must include only the $7,000 interest from the bonds in her income. The receipt of a gift or inheritance is not subject to income tax. Chapter 3: Determining Gross Income 5 41. Life Insurance Proceeds Linda's husband dies, naming her the sole beneficiary of a $500,000 life insurance policy. The insurance company informs her that she has two options: (1) she can receive the entire $500,000 in one lump-sum payment or (2) she can receive annual installments of $58,000 for 10 years. a. How much does Linda include in gross income if she takes the lump-sum payment? b. How much does Linda include in gross income each year if she elects the installment payments? Solution: a. Zero. If Linda takes the lump-sum $500,000 payment, she recognizes no gross income, as life insurance proceeds in general are not taxable. b. $8,000 each year. If she elects to take the insurance proceeds in annual installments, $80,000 of the total $580,000 (10 x $58,000) expected to be received will represent taxable income. Of each annual $58,000 payment, $8,000 ($80,000/$580,000 x $58,000) will be income and $50,000 ($500,000/$580,000 x $58,000) will be tax free. 46. Installment Sale In year 1, Randy sells a parcel of land that he held as an investment for a number of years. The land has a basis to Randy of $8,500. The buyer makes a $6,000 down payment in year 1 and will make a $7,000 payment in year 2 and a $7,000 payment in year 3. In addition, a reasonable rate of interest is charged on the year 2 and year 3 payments. How much income will Randy recognize in years 1, 2, and 3, assuming that he uses the installment method? What is the result if Randy elects out of the installment method for this sale? Solution: Randy has a total gain of $11,500 [($6,000 + $7,000 + $7,000) - $8,500 basis] on the sale of the land. On an installment sale, Randy must recognize 57.5% ($11,500/$20,000) of each payment as gain. Thus, his gain in year 1 is $3,450 (57.5% x $6,000); in each of years 2 and 3, he will recognize $4,025 (57.5% x $7,000). If he elects out of the installment sale method, Randy must recognize the entire $11,500 of gain in year 1. Develop Planning Skills 71. Investment Alternatives Sandra, a single taxpayer in the 35 percent marginal tax bracket, has $60,000 she can invest in either corporate bonds with a stated interest rate of 9 percent or general revenue bonds issued by her municipality with a stated interest rate of 6 percent. What do you recommend she do? Would your answer change if her marginal tax rate is only 28 percent? Solution: With a marginal tax rate of 35 percent, her after tax return on the corporate bonds is only 5.85 percent [9% x (1-.35)]. She would be better off investing in the tax exempt bonds paying 6 percent. With a marginal tax rate of only 28 percent, her after tax return on the corporate bonds improves to 6.48 percent [9% x (1- .28)], and she would be better off investing in the corporate bonds.
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