CHAPTER 4 GROSS INCOME EXCLUSIONS SOLUTIONS TO PROBLEM MATERIALS

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CHAPTER 4 GROSS INCOME EXCLUSIONS SOLUTIONS TO PROBLEM MATERIALS Powered By Docstoc
					                                     CHAPTER 4

                         GROSS INCOME: EXCLUSIONS

                    SOLUTIONS TO PROBLEM MATERIALS




                                                                  Status:       Q/P
Question/                                                         Present     in Prior
Problem                           Topic                           Edition     Edition

   1        Life insurance proceeds and compensation              New
   2        Income from gifts and bequests                        Unchanged      2
   3        Gift to employees                                     New
   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   Unchanged      7
   8        Life insurance: cash surrender value and              New
               accelerated death benefits
   9        Scholarship and tuition waiver                        Unchanged     9
  10        Damages                                               Unchanged    10
  11        Damages                                               Unchanged    11
  12        Damages                                               Unchanged    12
  13        Worker’s compensation                                 Unchanged    13
  14        Accident and health plan                              Unchanged    14
  15        Cafeteria plan                                        New
  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                          Unchanged    19
  20        Issue ID                                              Unchanged    20
  21        Foreign earned income                                 Unchanged    21
  22        Taxable versus tax-exempt bonds                       Unchanged    22
  23        Patronage dividends and the tax-benefit rule          Unchanged    23
  24        Qualified state tuition program                       Unchanged    24
  25        Tax benefit rule                                      Unchanged    25
  26        Income from discharge of indebtedness                 Unchanged    26
  27        Issue ID                                              Unchanged    27


                                           4-1
4-2                2004 Comprehensive Volume/Solutions Manual


                                                                      Status:        Q/P
Question/                                                             Present      in Prior
Problem                           Topic                               Edition      Edition


* 28        Life insurance and inheritance                           Unchanged      28
  29        Life insurance                                           Unchanged      29
  30        Accelerated death benefits                               Unchanged      30
  31        Gifts and fringe benefits                                Unchanged      31
  32        Death benefits                                           Unchanged      32
  33        Life insurance: use of proceeds                          New
  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                                          Unchanged      39
  40        Medical reimbursement plan versus flexible               Unchanged      40
              benefits plan
    41      Long-term care insurance benefits                        Unchanged      41
    42      Meals and lodging                                        Unchanged      42
    43      Meals and lodging                                        Unchanged      43
*   44      Accident and health plans, athletic facilities           Unchanged      44
    45      Cafeteria plan and long-term care insurance              Unchanged      45
*   46      Fringe benefits versus taxable compensation              Unchanged      46
    47      Flexible benefits plan                                   Unchanged      47
    48      Fringe benefits                                          Unchanged      48
*   49      Foreign earned income                                    New
    50      Tax benefit rule, tax-exempt income                      Unchanged      50
    51      Unrealized gains and losses                              New
    52      Tax-exempt bonds                                         Unchanged      52
    53      Tax-favored educational savings programs                 New
*   54      Educational savings bond exclusion                       Unchanged      54
    55      Qualified state tuition program                          Unchanged      55
    56      Tax benefit rule                                         Unchanged      56
    57      Income from discharge of indebtedness                    Unchanged      57
    58      Income from discharge of indebtedness                    Unchanged      58
*   59      Cumulative                                               New
*   60      Cumulative                                               Unchanged      60


            *The solution to this problem is available on a transparency master.
                                 Gross Income: Exclusions                                4-3


                                       CHECK FIGURES

28.   $12,500.                                  43.d.   IRS yes; courts no.
29.a. $0.                                       44.     Decrease in disposable income
29.b. $0.                                               $9,832.
30.   Selling the life insurance policy         45.     Initiate a cafeteria plan.
      provides $75,000.                         46.a.   $9,050; $10,712; $11,015.
31.a. The tips are gross income.                46.b.   $6,332; $7,495; $7,264.
31.b. The tips are gross income.                46.c.   $4,550; $4,550; $4,550.
31.c. The hotel room may qualify for            47.a.   $1,825.
      exclusion as a no-additional-cost         47.b.   $1,825.
      service.                                  47.c.   No.
32.   Include $6,000 in gross income.           48.a.   No exclusion.
33.a. Fay has $0 gross income on the            48.b.   Exclusion allowed.
      receipt of the $1.5 million life          48.c.   Exclusion allowed.
      insurance proceeds.                       48.d.   Exclusion allowed.
33.b. $15,000 of interest is included in        48.e.   No exclusion for Polly.
      gross income.                             49.a.   $189,671.
33.c. $0 gain.                                  49.b.   $195,000.
34.   Room and board of $7,500 is               50.     $2,825.
      includible.                               51.     $500 in 2003 and $510 in 2004.
35.   $2,700 is includible in 2004.             52.a.   Bond price should decrease.
36.a. Liz must include $30,000 in gross         52.b.   Bond price should increase.
      income.                                   54.a.   Exclude $3,083.
36.b. Yes.                                      54.b.   Include $5,000 for Susie.
37.a. $150,000.                                 54.c.   Include $5,000.
37.b. $50,000.                                  55.     Qualified tuition program.
37.c. $50,000.                                  57.a.   Additional tax $7,000.
37.d. $30,000.                                  57.b.   Fran can defer the tax.
37.e. $300,000.                                 58.a.   $0 gross income.
38.   $3,600.                                   58.b.   $6,000.
41.   Include $200 in gross income.             58.c.   $4,000.
42.   $110 per month.                           59.     Refund due for 2003 $345.
43.a. No.                                       60.     Refund due for 2002 $1,413.
43.b. Yes, $600.
43.c. Lodging no.
4-4                   2004 Comprehensive Volume/Solutions Manual


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. 4-2 to 4-4

 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. 4-4, 4-5 and 4-8

 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. 4-5

 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. 4-5 and 4-6

 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. 4-5

 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. 4-7

 7.   The proceeds are not excluded from gross income under the § 101 life insurance proceeds
      exclusion because Amber receives the proceeds as consideration under the terms of a
      contract. Amber would compare the amount received with its basis for the loan. p. 4-8

 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. 4-6 and 4-7

 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. 4-8
      to 4-10

10.   All of the amounts received were the result of her physical injury. Therefore, the
      following may be excluded from Nancy’s gross income:
                                 Gross Income: Exclusions                                    4-5



             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. 4-11 and 4-12

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. 4-11 and 4-12

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. 4-11 and 4-12

13.   The $400 worker’s compensation benefit Jill received is excludible from her gross
      income. Holly’s wages are included in her gross income. Jill worked less but was
      allowed to keep more of what she received. p. 4-13

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. 4-13 and 4-14

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. pp. 4-19 and 4-20

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. p. 4-21

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. 4-22 and 4-23

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. p. 4-21
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19.   a.      Tom must include the $90 in gross income. Ted is allowed to exclude the $90 as
              a qualified transportation fringe.

      b.      Tom paid $90 for transportation cost and was reimbursed for that amount.
              Therefore, Tom’s before-tax cost was $0. However, Tom is required to include
              the $90 in gross income and thus must pay an additional $24.30 ($90 X .27) 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.

      pp. 4-23 and 4-24

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. 4-19 and 4-23

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. 4-26 to 4-28

22.   The clients who purchase the tax-exempt bonds should be in the 35% marginal tax
      bracket or higher.
                      (1–X)(.066) = .044
                      =.066 – .066X = .044
                      = .66X = .22
                      X = .33

      The break-even is a 33% marginal tax rate, but the rate schedule jumps from 30% to
      35%. Therefore, only those taxpayers in the 35% or higher bracket should invest in the
      tax-exempt funds. pp. 4-28 and 4-29

23.   The patronage dividend is a recovery of Maria’s feed and fertilizer costs that were
      deducted in 2002. The cost of the feed and fertilizer produced a tax benefit in 2002 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 2003 gross income under the tax benefit
      rule. p. 4-29

24.   Under the exclusion provision for qualified tuition programs, Rachel is not required to
      include anything in gross income since the funds are used for qualified education
                                    Gross Income: Exclusions                                 4-7


      expenses. Since Arthur did not receive a refund, there are no tax consequences to him.
      p. 4-31

25.   The tax benefit rule is not relevant to this situation. Mary has an adjustment to income
      rather than a recovery of a prior deduction. pp. 4-32 and 4-33

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. 4-33 and 4-34

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. 4-33 and 4-34


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. 4-4, 4-5, and Chapter 3

29.   a.      José’s wife is not required to recognize any gross income. The insurance
              proceeds were paid to her as the beneficiary upon the death of the insured (José).

      b.      Cardinal Software Company is not required to recognize any gross income upon
              the receipt of the $1,000,000 in insurance proceeds as the beneficiary of the life
              insurance policy. The executive’s estate may have gross income from the receipt
              of the $1,000,000 in exchange for the deceased executive’s stock.
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      c.     The seller of the land is required to recognize gross income because the insurance
             proceeds were received for consideration. The amount of the gross income is the
             excess of the amount realized over the adjusted basis for the installment note
             receivable.

      pp. 4-6 to 4-8

30.   The gain on the sale of the life insurance policy of $25,000 is not included in Laura’s
      gross income, whereas the gain on the sale of the stock of $65,000 ($75,000 – $10,000) is
      taxable. Since Laura is in the 27% marginal tax bracket, the sale of the stock will
      generate a $17,550 ($65,000 recognized gain X 27%) tax liability. Thus, her after-tax
      proceeds from the stock sale are $57,450 ($75,000 – $17,550). [Note that if Laura’s
      holding period for the stock is greater than 1 year, the alternative tax liability on the stock
      sale would be only $13,000 ($65,000 X 20%). In this case, her after-tax proceeds would
      be $62,000 ($75,000 – $13,000)]. In either case, the amount is less than her target of
      $75,000. If this option is accepted, she will have to scale down her anticipated uses of
      the funds. With the insurance alternative, she receives $75,000 of after-tax proceeds,
      since the amount received from Viatical can be excluded from her gross income.
      However, by selling the policy, Laura reduces the assets available to her heirs by
      $25,000. That is, if she continues to own the life insurance policy, her estate or other
      beneficiary will receive $100,000. The sale of the life insurance policy is the only
      alternative that will provide her with the $75,000 that she needs. pp. 4-7 and 4-8

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. 4-4, 4-5, 4-16, 4-17, 4-21, and 4-22

32.   The accrued vacation and sick leave pay of $6,000 were accrued at the time of Donald’s
      death. Therefore, the $6,000 is included in their gross income. The $10,000 paid to
      Sally may qualify as a gift because it was given based on her circumstances. The
      worker’s compensation benefit of $15,000 and group-term life insurance proceeds of
      $60,000 are not taxable. pp. 4-4 to 4-6 and Chapter 3

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.
                                 Gross Income: Exclusions                                  4-9


      pp. 4-6 to 4-8

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. 4-9 and 4-10

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 2003, Alejandro’s total expenses for the period covered
      by the scholarship were not known. Therefore, he is allowed to defer reporting the
      income until 2004, when all the uncertainty is resolved. pp. 4-9 and 4-10

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. 4-11 and 4-12

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. 4-11, 4-12, and 4-32

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. 4-13 to 4-16
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39.                         Willis, Hoffman, Maloney, and Raabe, CPAs
                                       5191 Natorp Boulevard
                                         Mason, OH 45040

       September 27, 2003

       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 $73 [(1 – .27) ($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. 4-13, 4-14, 4-20, and 4-21

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. 4-13, 4-14, and 4-20
                                  Gross Income: Exclusions                                  4-11


41.   Bertha must include $200 ($7,500 – $7,300) in her gross income for the long-term care
      insurance she received. The charges by the nursing home were less than the maximum
      exclusion ($220 per day). The potential exclusion is the greater of the following:

      •    $220 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
      ($220 X 60 days = $13,200) [the cost of the long-term care of $11,900 is less] reduced by
      the Medicare payments. Thus, the exclusion is $7,300 ($13,200 – $5,900). pp. 4-15 and
      4-16

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 $110 ($300 – $190) per month because the benefit exceeds
      the qualified parking monthly exclusion limit of $190. pp. 4-16 to 4-18 and 4-24

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 Court of Appeals
              allow this exclusion. Thus, the taxpayer may win if he is willing to litigate the
              issue.

      pp. 4-16 to 4-18

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 $819 per month.

                                                                        Now             Retired
      Salary/retirement                                               $40,000          $24,000
      Part-time job                                                        -0-          11,000
      Social Security tax                                              (3,060)            (842)
      Income tax (.27)                                                (10,800)          (9,450)
      Medical insurance                                                    -0-          (7,800)
      Health club dues                                                     -0-            (600)
                                                                      $26,140          $16,308
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       Disposal income associated with employment                                     $26,140
       Less: Disposable income associated with retirement                             (16,308)
       Decrease in disposable income                                                 ($ 9,832)

       pp. 4-13, 4-14, and 4-19

45.                         Willis, Hoffman, Maloney, and Raabe, CPAs
                                       5191 Natorp Boulevard
                                         Mason, OH 45040

       September 27, 2004

       Sparrow, Inc.
       300 Harbor Drive
       Vermillion, SD 57069

       Dear Management:

       You asked me to suggest improvements to your company’s employee benefits plan. You
       mentioned that your employees have varying needs.

       The Sparrow, Inc. situation is ideal for a cafeteria plan. Each employee could be allowed
       to decide at the beginning of the year whether he or she would receive a particular benefit
       (e.g., hospitalization insurance, child care costs) or a cash equivalent. Those who did not
       need the benefits could receive the taxable cash compensation and those who needed the
       benefits could receive the nontaxable compensation. However, long-term care insurance
       cannot be among the benefits of a cafeteria plan. This type of insurance must be
       provided to all employees in order to be excluded from gross income.

       Please contact me and we can discuss the details of such a plan.

       Sincerely,

       Amy Evans, CPA
       Partner

       pp. 4-19 and 4-20

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             0.27         0.35
              Social Security and Medicare tax rate      0.0765           0.0765       0.0145
              Total marginal tax rate (MTR)              0.2265           0.3465       0.3645
              MTR + 1                                    1.2265           1.3465       1.3645
              Before tax compensation =
                  [$7,000 + MTR(X)]                      $9,050           $10,712     $11,015

       b.     Employer’s cost of before-tax compensation equivalent to $7,000 exempt
              compensation:
                                Gross Income: Exclusions                                    4-13


             Before tax compensation =                  $9,050        $10,712        $11,015
             Employer’s Social Security Tax                692            819            160
                                                        $9,742        $11,531        $11,175
             Less: reduced income tax (.35)             (3,410)        (4,036)        (3,911)
             Employer’s after-tax cost of
                 taxable compensation                   $6,332        $ 7,495        $ 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, $10,712, and $11,015, respectively, depending on the employee’s
             marginal tax bracket. It would cost the company $6,332, $7,495, 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.

      pp. 4-13 and 4-14

47.   a.     Rosa reduced her salary by $2,500 and thus reduced her tax liability by $675
             ($2,500 X 27%). Her after-tax cost of her daughter’s dental expenses is $1,825
             ($2,500 – $675).

      b.     A flexible benefits plan is also referred to as a “use or lose” plan. Since Rosa did
             not use the $2,500, she loses this amount. Her out-of-pocket costs are $1,825
             ($2,500 – $675).

      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. 4-19 and 4-20

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. 4-23

      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 $190 per month limit on the exclusion. pp. 4-23 and 4-24

      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 5). 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. 4-23

      d.     The freight is a no-additional-cost benefit made available to all employees
             (nondiscriminatory). The $600 can be excluded. p. 4-21
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       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. 4-22 to 4-25

49.    a.     For the 12-month period ending June 30, 2004, George satisfies the 330 day
              requirement (i.e., was in London and Paris for 366 days). Therefore, he qualifies
              for the foreign earned income exclusion treatment for this period which includes
              184 days in 2003. For 2003, 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 2003.

              George must include $189,671 ($230,000 – $40,329) in his gross income for
              2003.

       b.     For the 12-month period ending December 31, 2004, George satisfies the 330 day
              requirement (i.e., was in London and Paris for 366 days). Therefore, he qualifies
              for the foreign earned income exclusion treatment for this period which includes
              366 days in 2004. For 2004, George can exclude the following amount from his
              gross income:

                          366 days X $80,000* of salary = $80,000
                          366 days

              *Lower of earned income of $275,000 or statutory ceiling of $80,000 for 2004.

              George must include $195,000 ($275,000 – $80,000) in his 2004 gross income.

       pp. 4-26 to 4-28

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. 4-28 and 4-29

51.    Ezra’s gross income for 2003 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 2003. Therefore, nothing is recognized by him from the increase in the
       value of the fund in 2003. His 2004 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. 4-29 and 4-30

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 – .386)(.10) =
              .0614. 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.
                                  Gross Income: Exclusions                                    4-15


      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. 4-28 and 4-29

53.                          Willis, Hoffman, Maloney, and Raabe, CPAs
                                        5191 Natorp Boulevard
                                          Mason, OH 45040

      September 7, 2003

      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
           the Eric’s marginal tax rate after he is allowed a $750 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
4-16                     2004 Comprehensive Volume/Solutions Manual


            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. 4-30 and 4-31

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 $87,750 for 2003, part of the potential exclusion is phased
               out.

                       MAGI                                                              $90,000
                       Less: Threshold amount                                            (87,750)
                       Excess over threshold amount                                      $ 2,250

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

                       $3,333 X ($2,250 ÷ $30,000) = $250

               Thus, Chuck and Luane can exclude $3,083 ($3,333 – $250) of the savings bond
               interest received and $1,917 ($5,000 – $3,083) 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. 4-30 and 4-31

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
                                 Gross Income: Exclusions                                   4-17


      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. p. 4-31

56.   The receipts in a. and d. represent possible recoveries of deductions taken in prior years.
      If Wilma had sufficient income to utilize the deductions in the previous year, the $5,000
      and $400 in recoveries must be included in gross income under § 111.

      The receipts in b. and c. are not taxable. The amount paid to the attorney was not
      deducted in the previous year because it was a capital expenditure for land. The recovery
      will reduce the cost of the land. The dividend of $90 on the life insurance policy simply
      reduces the economic cost of life insurance coverage which is not a deductible expense.
      pp. 4-32 and 4-33

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. 4-33 and 4-34

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.

      pp. 4-33 and 4-34
4-18                    2004 Comprehensive Volume/Solutions Manual


CUMULATIVE PROBLEMS

59.    Part 1—Tax Computation

       Salary                                                                        $98,000
       Less: Foreign earned income exclusion (Note 1)                                (12,932)
       Interest on U.S. savings bonds and Bahamian account (Note 2)                      500
       State tax refund (Note 3)                                                         800
       Stock dividend (Note 4)                                                            -0-
       Gross income                                                                  $86,368
       Less: Deductions for adjusted gross income
              Alimony paid                                                            (6,000)
       AGI                                                                           $80,368
       Less: Itemized deductions
              State income tax                                      $4,800
              Real estate taxes on residence                         1,900
              Interest on personal residence                         3,300
              Charitable contributions                               2,800           (12,800)
       Less: Personal and dependency exemptions (4 X $3,050)                         (12,200)
       Taxable income                                                                $55,368

       Tax on $55,368 (Note 5)                                                        $ 8,655
       Less: Withholding by employer                                                   (9,000)
       Net tax payable (or refund due) for 2003                                      ($ 345)

       Notes

       (1)     Since Martin satisfies the 330 out of 365 day requirement, he qualifies for the
               foreign earned income exclusion for the 59 days in 2003 (January and February)
               he worked in Mexico. His actual pay of $98,000 exceeded the limit on the
               exclusion. Thus, he is allowed to exclude only $12,932 (59/365 X $80,000).

       (2)     The $200 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 2002.

       (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 $47,450                          =        $6,517
               On ($55,368 – $47,450) X 27%            =         2,138
                                                                $8,655
                                  Gross Income: Exclusions                                4-19


      Part 2—Tax Planning

                            Willis, Hoffman, Maloney, and Raabe, CPAs
                                       5191 Natorp Boulevard
                                         Mason, OH 45040

      December 29, 2003

      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 27% marginal tax bracket in 2003 you should be in the 26% bracket in
      2004 and 2005 and the 25% bracket in 2006 and thereafter, unless there is a substantial
      change in your income. Therefore, the increase in after-tax payments in 2004 and 2005
      would be $409 [$500 – ($350 X 26%)] and in 2006 and thereafter would be $413 [$500 –
      ($350 X 25%)].

      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 ($3,000 X 2)                               (6,000)
      Taxable income                                                              $ 77,396
4-20                   2004 Comprehensive Volume/Solutions Manual


       Tax on $77,396 (Note 4)                                                       $ 14,687
       Less: Tax withheld ($10,900 + $5,200)                                          (16,100)
       Net tax payable (or refund due) for 2002                                     ($ 1,413)

       See the tax return solution beginning on p. 4-21 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 2001 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 $77,396 is calculated using the Tax Table
               for married filing jointly and the amount is $14,687.
      Gross Income: Exclusions   4-21


60.
4-22            2004 Comprehensive Volume/Solutions Manual


60. continued
                Gross Income: Exclusions   4-23


60. continued
4-24            2004 Comprehensive Volume/Solutions Manual


60. continued