Printed: 8/12/2008 1. Annette, a tax attorney, hired Jim to paint her house for $200. Over the next several days, while Jim was painting Annette’s house, Annette was hired by Ginger to prepare Ginger’s taxes for $100. Annette finished preparing Ginger’s taxes at about the same time that Jim finished painting Annette’s house. Since Ginger owed Annette $100, but Annette owed Jim $200, Annette directed Ginger to pay her fee to Jim directly, and Annette paid the remaining $100 herself. Thus, Annette never received any money from Ginger. Is the $100 for tax preparation nevertheless includable in Annette’s gross income? 1. Under 61(a)(1), gross income includes “compensation for services, including fees.” So if Annette had received the money directly from Ginger, it certainly would have been included in income. Furthermore, under 61(a)(12), gross income includes “income from discharge of indebtedness.” Annette had a debt of $200 to Jim. When Ginger paid $100 of that debt, Annette gained income from discharge of indebtedness even though she did not have physical receipt of the cash at any time. Nevertheless, Annette is deemed to have “constructive receipt” of the cash. (See notes 6/13 and Old Colony). 2. Bill is the sole proprietor of a printing shop. Vicki is the sole proprietor of a janitorial service. Bill hires Vicki to clean his shop for $100, but proposes to pay her $50 in cash, and $50 in printing services for promotional flyers for Vicki’s business. Seeing a potential tax dodge, Vicki agrees. What would be the tax consequences to both Vicki and Bill under such an arrangement? 2. Under 61(a)(1), gross income includes “compensation for services.” The Regs. 1.61-2(d)(1) further state that “if services are paid for in exchange for other services, the fair market value of such other services taken in payment must be included in income as compensation.” Thus, both Vicki and Bill have income in this transaction for the entire fair market value of each other’s services to the extent that those services represent payment. Thus, Vicki must include the entire $100 ($50 cash plus $50 printing services) in her income. Likewise, Bill must include the $50 value of Vicki’s janitorial services in his income. Assuming that both the janitorial services and the printing services for promotional flyers were deductible under 162, Bill could deduct the $100 cost of the janitorial services for an adjusted gross income from this transaction of -$50 ($50-$100), and Vicki could deduct the $50 cost of printing services for an adjusted gross income from this transaction of $50 ($100-$50). Thus, both parties would be treated as receiving full compensation for their own services, and paying full price for each other’s services. (See also, Rooney concerning “cross accounting.”) 3. John was employed by General Dynamics. He chose voluntary early retirement at the age of 60 when the plant began to down-size in preparation for closure. As part of his early retirement plan, General Dynamics purchased a non-transferable annuity for him in the amount of $5,000, to begin paying when he reached 65. The company did this as a means to motivate John to retire early as a general cost-cutting measure. It was necessary because John still had 5 years worth of contributions to make to his ordinary pension plan, which would pay more money the longer he worked. What are the tax 1
Printed: 8/12/2008 consequences to John at the time he accepts the annuity at age 60? What are the tax consequences from the annuity when John reaches 65? 3. In this case, although the annuity could be confused with a pension plan, the two are separate. In this case, the annuity represents deferred compensation for services rendered, and thus is includable under 61(a)(1). More particularly, those services comprise John taking immediate retirement to relieve the company of the burden of paying him. (Remember retirement bonuses in contracts?) John would have presently taxable income equal to the present value of the annuity. If the annuity is non-transferable, then the present value is presumed to be the cost of the annuity contract (here $5,000. See Drescher).When John reaches 65, and the annuity starts paying, John may exclude a certain portion of each payment to the extent that it represents a return of his basis (which is the present value of the annuity). The exclusion ratio is calculated according to 72(b) and is equal to the “investment in the contract” divided by the “expected return under the contract”, but is limited to the unrecovered investment in the contract. 4. Joe works as a workout instructor at Gold’s Gym. During off-peak hours, Joe uses the Gym’s facilities to work out, and pays nothing for the privilege. If the cost of a normal membership is $90/month for unlimited use, then what, if any, is the benefit to Joe which is includable in his income? 4. Joe appears to be receiving a no-additional cost fringe benefit incidental to his employment which is excludable from income under 132(a)(1). To qualify as a no-additional cost benefit under 132(b), the service must be “offered for sale to customers in the ordinary course of the line of business...in which the employee is performing services” and the employer must “incur[] no substantial additional cost (including foregone revenue) in providing such service to the employee.” Since Joe is a workout instructor, he is in the appropriate “line of business” to be eligible for the exclusion. Additionally, since he works out during “off-peak” hours, Gold’s Gym is not incurring any additional cost, including foregone revenue, because the equipment would be idle anyway. Gold’s would not have been able to sell the excess capacity that Joe is using to a paying customer. Thus, Joe may exclude the cost of using the otherwise idle equipment from his income. 5. Kim works at the Nordstrom cosmetic counter. As a standing benefit of her employment, Kim may buy merchandise in any department at Nordstrom for 15% off the marked retail price. Each month, the cosmetics employee with the most sales is given an additional 15% discount, over and above her normal 15% discount, on any merchandise in the store for the entire winning month. In April, Kim won the most-sales contest, and was thus entitled to the additional discount. If Nordstrom’s normal markup on televisions is 20%, what would be the tax consequences to Kim in April if she purchased a television under her employee discount for $700 that had a marked retail price of $1,000? 5. Kim purchased the television at a 30% discount. Under 132(a)(2) and 132(c), Kim may exclude the benefit of that discount from her income to the extent that it does not exceed the 2
Printed: 8/12/2008 “gross profit percentage of the price at which the property is being offered...to customers.” The gross profit percentage here is given to be 20% on televisions. Thus, Kim could exclude the benefit of her discount only to the extent that it did not exceed 20% of the sales price of the television, in this case, $200. However, Kim would be required to include the remaining benefit of her discount in her income, in this case, $100 ($1,000-$200-$700). The $100 excess would be treated as compensation under 61(a)(1). 6. Derek is the President of NextTel, an out-of-state telephone service provider. Additionally, Derek is a member of the board of directors of Foodmaker, Inc. in San Diego, which operates Jack-in-the-Box restaurants. Derek asks his secretary at NextTel to arrange a flight for him to San Diego in order to attend the monthly board meeting at Foodmaker. NextTel pays for the flight. What, if any, are the tax consequences to Derek? 6. A working condition fringe is defined in 132(d) as “any property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under section 162, or 167.” However, it is important to identify what the business of the employer who paid for the benefit is. The Regs. 1.132-5(a)(2)(i) explain that to be eligible for this benefit, the payment or service must be with respect to the employer’s trade or business, not just the employee’s trade or business. Thus, although an airline flight to attend a board meeting at Foodmaker is probably deductible by Derek under 162, it is not excludable from his income because his employer’s business is telephone service, not restauranteering. In this case, the wrong party paid for the flight. Had it been paid for by Foodmaker, it would have been excludable. However, since it was paid for by NextTel, it is merely deductible. (See 1.132-5(a)(2)(ii) example 1). 7. Jim broke his arm. During his treatment and recovery, he generated medical bills of $5,000 and missed 5 days of work. Under his employer provided medical insurance plan, the insurance company reimbursed Jim for 90% of the bills ($4,500), and Jim paid the rest ($500). Additionally, Jim’s employer paid him his full normal salary for the 5 days he missed, for a total of $1,000, but reduced his sick pay hours balance accordingly. On his Federal Tax return for that year, Jim included neither the $5,000 insurance reimbursement, nor the $1,000 sick pay in his gross income. However, deducted the full $5,000 of medical bills, as well as the $1,000 worth of sick hours that he expended. Where has Jim gone wrong? 7. Under 105(b) “gross income does not include amounts...paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by him for the medical care...of the taxpayer.” Thus, the $4,500 medical insurance reimbursement is properly excludable. However, 105(c) requires that amounts which are not “computed with reference to the nature of the injury without regard to the period the employee is absent from work” must be included in income. Thus, Jim improperly excluded the $1,000 “sick pay” from his income because it was based on the time he was absent from work, and not based on the nature of his injury. Under 213, a taxpayer may deduct expenses “for medical care of the taxpayer” that are “not compensated for 3
Printed: 8/12/2008 by insurance or otherwise,” but the deduction is subject to a 7.5% of AGI floor. Thus, in this case, Jim may not deduct the $1,000 reduction in his sick-pay hours because such expense was not “for the medical care of the taxpayer.” Furthermore, Jim may not deduct $4,500 of the medical expenses because they were “compensated for by insurance.” Thus, Jim is left with $500 of uncompensated medical expenses. However, Jim may only deduct that portion of the $500 that exceeds 7.5% of his AGI. In real numbers, Jim’s AGI would have to be $6,600 ($500/7.5%) or less for him to deduct the full amount of his uncompensated medical expenses. 8. Annette and Jim manage a mini-storage facility. As a condition of their employment they live in a one-bedroom apartment above the storage unit rental office. This allows them to maintain extended hours, as well as provide limited security. Their employer does not charge them rent on the apartment, and gives them a cash allowance for lunches so that they can get quick and convenient delivery food from local restaurants without having to leave the premises. What are the tax consequences to Jim and Annette for this lodging and meals arrangement? 8. Under 119(a), an employee may exclude the value of lodging furnished by his employer if “the employee is required to accept such lodging on the business premises of his employer as a condition of his employment.” Clearly, the value of rent of the one-bedroom apartment qualifies for such exclusion as being for “the convenience of the employer.” (See Regs. 1.119-1(b) and Bengalia).With regard to the cash meal allowance, meals “furnished on the business premises of the employer” are excludable. However, in Kowalski, the Supreme Court held that “furnished” meant that the meals must be provided in kind; cash allowances for meals were not excludable. Thus, even though the cash allowance is provided for the “convenience of the employer,” and are at least consumed on the business premises of the employer, (Regs. 1.119-1(a)(1)) since they are not furnished in kind, the amount of the meal allowance is includable in income to Annette and Jim. 9. John owns several guns which are collector’s items. Among them is a mint condition AK-47 rifle, for which he paid $500. When the federal ban on assault weapons was about to be enacted, the fair market value of the rifle jumped to $800. At that time, John gave the rifle to his son, Donald. Donald who is also a gun collector, but not a gun dealer, held the rifle for several years and now wishes to sell it. However, in anticipation of a repeal of the federal ban on assault weapons, the artificially inflated price of the rifle has dropped to about $450. What would be the tax consequences if Donald were to sell the rifle today for $450? 9. Under 102(a), “gross income does not include the value of property acquired by gift.” Thus, Donald would not be taxable on the $450 to the extent that it did not exceed his basis in the property as determined under 1015(a) which states that the basis of property acquired by gift “shall be the same as it would be in the hands of the donor...except that if such basis...is greater than the fair market value of the property at the time of the gift, then for the purpose of determining loss the basis shall be such fair market value.” Since John’s basis in the rifle under 1012 was his cost ($500), and the fair market value of the rifle at the time of the gift was $800, 4
Printed: 8/12/2008 the loss exception does not apply and Donald’s basis is $500. Thus, if Donald sells the rifle for $450, he would realize a loss of $50. Whether that $50 loss is deductible depends on the nature of Donald’s holding of the rifle. If Donald can establish that he held the rifle for appreciation as an investment, he would be able to deduct the loss under 165(c)(2). Otherwise, the loss would be a non-deductible “hobby loss” under 183. This example illustrates the difference between transferring losses by way of gift (which is forbidden by the operation of 1015(a)’s loss exception), and realizing losses on gifts due to depreciation. 10. Sharon becomes an editor on the San Diego Law Review. As such, the University waives $1,000 of her tuition for the year that she serves as an editor, on the condition that she perform her editorial duties. As an editor, Sharon is required to review articles, assign cite-checking, and do general editorial tasks. Is the $1,000 benefit of the tuition waiver includable in Sharon’s gross income, even though she receives no cash directly? 10. Under 117, Sharon may exclude from her income “any amount received...as a scholarship...to the extent the individual establishes that...such amount was used for qualified tuition and related expenses,” subject to the limitation that any portion “which represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship or qualified tuition reduction.” Thus, although the money was spent directly on reduction of tuition, it still represents payment for services, and thus is includable in income. 11. Why are funds which are awarded to a taxpayer as part of a trial court judgment includable in income at the time of judgment even when the opposing party appeals and subsequently wins? How do these funds differ from the proceeds of a loan which are not currently taxable to the recipient? 11. In North Am. Oil, the court reasoned that upon the first judgment of a court in the taxpayer’s favor, the taxpayer has constructive receipt of the money if there are no restrictions on its use, and the taxpayer has dominion over it. This is true even if the outcome of a pending appeal, and thus right to retain the property in the future, is uncertain. It is immaterial if the taxpayer must later return the money, because at that later time he may claim a deduction if he loses. In the meantime, the taxpayer is free to use the money to generate more income. These awards differ from non-taxable loan proceeds because the loan involves “true” debt, which is accompanied by an unconditional obligation to repay. In the case of judgment proceeds, their return is conditional upon their opponent winning the appeal. 12. Roger and Amber have a son, Riley who is 1 year old. In order for both Amber and Roger to become gainfully employed outside the home, they must put Riley in a qualified daycare facility during working hours. If Roger earns $20,000 per year, and Amber earns $6,000 per year, and they spend $3,600 per year for daycare services, what are the tax consequences of this daycare arrangement to Roger and Amber. 12. Under 21(a)(1), a child care credit equal to a percentage of the employment related expenses may be applied to the tax. 21(a)(2) defines the applicable percentage as 30% reduced (but not 5
Printed: 8/12/2008 below 20%) by 1% fro every $2,000 (or fraction thereof) by which the taxpayer’s AGI exceeds $10,000. 21(c) limits the expenses to be taken into account to $2,400 for 1 qualifying child. Since Riley is a dependent child less than 13, he is a qualifying child under 21(b). Since the daycare expenses are incurred to allow both spouses to be gainfully employed, they meet the test of “employment-related expenses” under 21(b)(2). Although they spend $3,600 per year, their maximum allowable expenses are $2,400 per year. Since Amber earns $6,000 additional income, the earned income limitation of 21(d)(1)(B) does not apply ($6,000 is > $2,400). Since the couple must file jointly under 21(e)(2), both spouses’ income must be totalled in determining the applicable percentage. On adjusted gross income of $26,000, their applicable percentage is 22% (30%-8%). So they can claim a credit for 22% of $2,400, or $528. However, they must include the name, address and SSN of their daycare provider on the return under 21(e)(9). 13. Greg is a teacher who lives and teaches in Escondido, and owns a vacation home at Big Bear Lake. Len has converted one of the rooms in his Escondido house to an office. In that office, he spends about 2 hours/day grading papers, writing parental correspondence, and planing the school’s water-polo team schedule. During the summers, when school is out, Greg spends 2-3 months at his vacation home on the lake. For the rest of the year, he rents the vacation home out. What are the tax consequences of Greg’s home/office arrangement and his vacation home rental? 13. 280A generally denies all deductions for use of a taxpayer’s residence as an office, unless the deduction is “allocable to a portion of the dwelling unit which is exclusively used on a regular basis” as the “principle place of business.” As for the home/office room, Greg appears to meet the exclusive use on a regular basis test, however, he fails to principle place of business test as interpreted by Soliman which takes into account the relative importance of the activites performed at each location, as well as the time spent at each location. Since the office is only used for administrative work, it is not as important as his primary teaching activities which are performed at the school. Futhermore, since he only spends 2 hours a day in the home office, and more at the school, it is not his principle place of business for teaching. Thus, the home/office expenses (such as depreciation) are non-deductible under 280A. As for the vacation home, 280A(c)(3) provides that the general disallowance of 280A(a) is not applicable to rental of the dwelling unit. However, 280A(e) limits the deductions to a percentage of the rental use, if the taxpayer uses it for personal purposes. Thus, in this case, Greg would have to reduce his otherwise allowable deductions for rental business expenses by 3/12 (3 months of personal use divided by 12 months of total use). However, the mortgage interest on the vacation home would still be deductible under 163(h) because he spends more than 14 days per year there and thus it qualifies as a second home.
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