Tom received the farm as compensation for services in accordance with the contract with Uncle John. Therefore, when Tom receives the farm, the value of the farm must be included in his gross income. pp. 5-4 and 5-5 Because the majority of the beneficiaries of the nonprofit foundation created by Pearl are employed by the company, the IRS may argue that the foundation was created for the benefit of Pearl employees and, therefore, the benefits received by the employees cannot be excluded from the employees‘ gross income. However the patients may quality for exclusion if Pearl is located in a ―qualified disaster area.‖ pp.5-4 and 5-5 Matt is incorrect. The intended tip, $1, is not a gift, but rather is compensation for services. The additional amount received, $99, was not received out of the generosity of the customer, but rather out of a mistake. Matt is $99 richer as a result of the mistake, and should include this amount in his gross income (rather than treating it as a gift). p. 5-5 Since Amber had taxable income in 2007, it received a tax benefit from writing off the receivable. So Amber would include $5,000 in gross income in 2008 under the tax benefit rule. The insurance proceeds would not be excluded from gross income because the insurance contract proceeds were in consideration of the loan and not payable merely as the result of Aly‘s death. p. 5-8 Joe‘s gross income is $1,500. The use of a room valued at $3,000 is excluded from gross income as mandatory lodging provided on the employer‘s business premises for the convenience of the employer. The scholarship also can be excluded from Joe‘s gross income. pp. 5-15 to 5-17 No. The $15 million amount that Wes received is excluded from his gross income as compensatory physical personal injury damages even though the amount received is based on the projected lost income. The $10 million of punitive damages that Wes receives must be included in his gross income. Sam‘s salary of $25 million must be included in his gross income. pp. 5-11 and 5-12 Health Savings Accounts (HSAs) are an alternative to traditional health insurance. The employer provides a medical insurance plan with a high deductible. The high deductible reduces the cost of the insurance premiums to the employer. The employee is expected to pay part (or all) of the deductible by withdrawing from the employee savings account created with the employee‘s tax deductible contributions or with the employer‘s contributions to the account. Any employer contributions to the savings account are excluded from the employee‘s gross income. Withdrawals used to pay medical expenses not covered by the medical insurance plan are excluded from the employee‘s gross income. The employee can make taxable withdrawals for other purposes. The earnings on the HSA investments are exempt from tax. Deductibles under traditional health insurance plans are lower. The savings feature of an HSA is not present in a traditional plan. pp. 5-13 to 5-15 Paul would find the first option the least objectionable. Under option (1) he would be required to pay $6,000 per year. Assuming he cannot deduct the insurance as a medical expense because of the 7.5% floor, his cash flow after-tax and health insurance premiums will decrease by $6,000. Under option (2) his cash flow aftertax and health insurance premiums would decrease by $6,375 [(1 – .15) × $7,500].
Betty would fare better under the second option. As in Paul‘s case, with option (1) she is $6,000 poorer than without any change. But under option (2) she would be only $4,875 [(1 – .35) × $7,500] worst off. pp. 5-13 to 5-15 15. With a cafeteria plan, the employee receives a salary and is also provided by the employer with a fixed amount that he or she can allocate among a range of possible nontaxable fringe benefits and taxable benefits. With a flexible spending plan, a portion of the employee‘s salary is set aside for specific uses that would have been excludible from gross income had the employer paid these expenses. The employee‘s gross income is reduced by the amount that goes into the flexible spending account and the withdrawals are excluded from gross income. However, any unused funds are forfeited by the employee. pp. 5-19 and 5-20 The second potential employer must offer Zack at least $58,000. Zack needs $8,000 in before-tax dollars to purchase health insurance costing $6,000 [($6,000 premiums)/(1 – .25) = $8,000]. Therefore, the second offer must have a salary of $58,000 ($50,000 + $8,000). p. 5-13 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? 21. Does the employee experience an economic benefit from using the facility? Does the walking trail qualify as an excludible ‗‗athletic facility‖? Is the benefit de minimis? Is the benefit a no-additional-cost service?
pp. 5-20 to 5-23 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., indexed statutory ceiling of $87,600 in 2008). This would be a substantial benefit. pp. 5-25 to 5-27 Sam would be required to include the $500 in gross income if he obtained a tax deduction for the taxes paid in 2007 and the deduction reduced his taxable income in 2007 by at least $500. p. 5-32
of interest income for the amount refunded. pp. 5-31 and 5-32 25. The tax benefit rule does not result in an increase in Mary‘s gross income. The tax benefit rule applies when the taxpayer takes a deduction in one year, but recovers the deduction in a subsequent year. Under the tax benefit rule, income generally must be recognized on the recovery, but only to the extent the taxpayer received a tax benefit from the deduction in the prior tax year. Instead, Mary‘s problem relates to income received in the wrong tax year, which must be recognized in the year received, regardless of when it was earned. Thus, Mary reports the $5,400 in 2008 and the $1,000 in 2009 when she receives it. p. 5-31
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? Is the debt secured by his personal residence? 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?
p. 5-34 29. a. The $4,000 in accrued salary and the $2,500 of vacation pay earned by Jose but received by his daughter must be included in her gross income in the tax year she receives it. Such income that has been earned, but not received, at the time of the decedent‘s death is income in respect of a decedent.
Although the employer may have altruistic motives, because Josh is an employee, the payments cannot be treated as gifts for income tax purposes. Therefore, Josh must include the $1,500 in his gross income. However, if the employer expected to be repaid when Josh is able to work, the payments could be treated as a loan. c. Jay‘s wife does not recognize income from the receipt of $10,000, since the proceeds are from life insurance and are payable to her as the result of Jay‘s death. The mortgage holder received the proceeds from a policy as a result of a transaction for consideration. The mortgage holder must recognize gain if its basis (unrecovered amount of the loan) in the mortgage is less than $40,000.
d. Lavender, Inc. is the beneficiary of a life insurance policy it purchased and whose proceeds were paid upon the death of the insured. Therefore, the proceeds are excluded from its gross income. e. When Rex dies, Jackson will receive the life insurance proceeds of $75,000. Normally the $75,000 would be excludible from Jackson‘s gross income because the life insurance proceeds are payable as the result of death. However, since Jackson acquired the life insurance policy in exchange for valuable consideration, the exclusion treatment does not apply. So Jackson must include in his gross income the $75,000 life insurance proceeds reduced by the sum of $45,000 and the life insurance premiums that he pays.
pp. 5-4 to 5-8 Kara must include in gross income the $8,000 of tips. She may be able to exclude the $9,000 value of the free housing provided by her employer as a no-additionalcost service. The living expenses paid by the Federal government are excluded from gross income under § 139 as qualified disaster payments. pp. 5-20 and 5-21 a. Fay is the beneficiary of the life insurance policy and can exclude the proceeds of $1.75 million from her gross income.
b. The $20,000 of interest earned on the life insurance proceeds left with the insurance company is included in Fay‘s gross income. c. Fay did not recognize a gain on the bargain purchase. Fay simply got a good price on the purchase under an arm‘s length contract.
pp. 5-6 to 5-8 Alejandro received a total of $11,000 and spent $8,900 ($3,300 + $3,400 + $1,000 + $1,200) on tuition, books, and supplies. The amount received for room and board is not excludible. Therefore, he must include $2,100 ($11,000 – $8,900) in gross income. When he received the money in 2008, Alejandro‘s total expenses for the period covered by the scholarship were not known. Therefore, he is allowed to defer reporting the income until 2009, when all the uncertainty is resolved. pp. 5-9 and 5-10 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. Hoffman, Smith, and Willis, CPAs 5191 Natorp Boulevard Mason, OH 45040 September 27, 2008 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.
pp. 5-11, 5-12, and 5-32 39.
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 aftertax income—the employee‘s annual gross income will not change. The cafeteria plan will mean that some employees who now have excess medical coverage can substitute cash for the unneeded protection. The cash received will be taxable, but the employee‘s after-tax income will increase. In summary, the change with the broadest tax implications is the imposition of the $100 deductible for medical benefits. The employees would actually be better off with a $100 reduction in cash compensation and no deductible clause. This results because the after-tax cost of a $100 reduction in cash compensation is only $72 [(1 – .28) ($100)], whereas the $100 deductible clause means the employee has $100 less for other goods and services. Also, the cafeteria plan may be important for some employees, depending upon how many of them have working spouses whose employers provided medical benefits for the employee‘s entire family. Please contact me if you have any further questions. Sincerely yours, John J. Jones, CPA Partner pp. 5-13 to 5-15 and 5-19 41. Bertha must include $800 ($9,800 – $9,000) in her gross income for the long-term care insurance she received. The charges by the nursing home were less than the maximum exclusion ($270 per day). The potential exclusion is the greater of the following: $270 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 ($270 × 60 days = $16,200) [the cost of the long-term care of $12,000 is less] reduced by the Medicare payments. Thus, the exclusion is $9,000 ($16,200 – $7,200). p. 5-15 a. It appears that Ann‘s meals are not provided for the convenience of the employer, but rather as a fringe benefit for the employees. Therefore, Ann is required to include in gross income the difference between the amount she paid for meals of $3 and the amount she would be required to pay of $8 to an unrelated restaurant. The monthly salary of $200 must be included in gross income. The dormitory room provider Ira is done so for the convenience of his employer. Therefore, Ira can exclude the $250 value per month of the free lodging from gross income.
Apparently Seth is not being provided the housing for the convenience of his employer. Therefore, the fair rental value of the housing must be included in Seth‘s gross income. Hoffman, Smith, and Willis, CPAs 5191 Natorp Boulevard Mason, OH 45040
pp. 5-15 to 5-17 45. September 18, 2008 Finch Construction Company 300 Harbor Drive Vermillion, SD 57069 Dear Management: You asked me to determine the tax implications of requiring the company‘s employees who are carpenters to furnish their own tools, with a compensating increase in their salaries of about $1,500 each. In short, most employees would experience a net decrease in after-tax income. Under the company‘s present way of doing business, the carpenters do not recognize income when the employer provides tools. This is a ‗‗working condition fringe.‘‘ If the employee‘s salary is increased and he or she must purchase the necessary tools, the employee must include the additional $1,500 in salary in gross income. But the cost of the tools in many cases will not be deductible, or less than the actual cost will be deductible. This results from the employee‘s expense being a deduction from adjusted gross income as a miscellaneous itemized deduction. If the employee takes the standard deduction, no deduction for the tool expenses is allowed. If the taxpayer does itemize deductions, the total miscellaneous itemized deductions must be reduced by 2% of the employee‘s adjusted gross income. In many cases, the total miscellaneous itemized deductions will be less than 2% of AGI. When the total miscellaneous itemized deductions do exceed 2% of AGI, less than the entire expenses are deductible because of the 2% factor. Another possibility would be for the employees to purchase the tools, but account to you for their cost, and obtain reimbursement. Under this plan, the employee would be allowed to directly offset the reimbursement with the expense, in arriving at adjusted gross income. The request for reimbursement would also provide you with a means of controlling costs. Please contact me if you would like to discuss this further. Sincerely, Amy Evans, CPA Partner p. 5-22 47. a. If Rosa underfunds the account by $2,000, the cost of the error is her marginal tax rate times the underfunded amount or $500 (.25 × $2,000).
b. If Rosa overfunds the account by $2,000, the cost of the error is $1,500 [(1 – .25) × $2,000]. c. The cost of underfunding is a .25 × error, and the cost of overfunding is a .75 × (1 – .25) error; that is, the underfunding error costs only one-third (.25/.75) the cost of overfunding.
d. Rosa should fund the flexible benefit account using an amount closer to the low end of the estimate rather than to the upper end. p. 5-20 49. a. For the 12-month period ending May 31, 2009, George satisfies the 330-day requirement (i.e., was in London and Paris for 365 days). Therefore, he qualifies for the foreign earned income exclusion treatment for this period which includes 214 days in 2008. For 2008, George can exclude the following amount from his gross income: 214 days * 365 days × $87,600 = $51,360 *Lower of earned income of $230,000 or indexed statutory ceiling of $87,600 for 2008. George must include $178,640 ($230,000 – $51,360) in his gross income for 2008. For the 12-month period ending December 31, 2009, George satisfies the 330-day requirement (i.e., was in London and Paris for 365 days). Therefore, he qualifies for the foreign earned income exclusion treatment for this period which includes 365 days in 2009. For 2009, George can exclude the following amount from his gross income: 365 days $87,600* of salary = $87,600 365 days *Lower of earned income of $275,000 or indexed statutory ceiling of $87,600 for 2009. George must include $187,400 ($275,000 – $87,600) in his 2009 gross income. pp. 5-25 to 5-27 51. a. Ezra must include in his gross income the $700 cash he constructively received. He will have a $700 basis in the additional shares he received. The decrease in the value of the fund shares of $1,200 ($15,700 – $14,500) is not taken into account because he has not realized (e.g., from a sale or exchange) the loss.
b. Ezra received stock dividends, which are essentially more shares to represent his same relative interest in the corporation. Because his interest in the corporation did not change, and he did not have the option of receiving cash, Ezra has no gross income from the receipt of dthe stock dividends. Ezra must allocate his original cost of his Giant, Inc., shares among the original shares owned and the additional shares received as a nontaxable stock dividend.
pp. 5-29 and 5-30 53. Hoffman, Smith, and Willis, CPAs 5191 Natorp Boulevard Mason, OH 45040 September 7, 2008 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 first $850 of the income (after subtracting an $850 standard deduction) would be subject to Eric‘s marginal tax rate. Income above that would be taxed at your marginal tax rate. 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.
If I can be of further assistance in helping you to make this decision and explain the options to your parents, please call me. Sincerely your, John J. Jones, CPA Partner pp. 5-30 to 5-32
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 × 1.44). The Qualified Tuition Program will pay $6,000 for the son‘s tuition, and the son does not include anything in his gross income. Thus, the after-tax proceeds will be $6,000. It should be noted that the Qualified Tuition Program also provides a hedge against even greater possible increases in tuition. pp. 5-31 and 5-32 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 × 35%) of additional income tax in the year the debt is retired. Thus, she must pay $7,000 to reduce future after-tax interest expense of 5.2% [(1 – .35) (.08)] of the outstanding principal and to retain the other $20,000 that would otherwise be paid as principal on the debt.
b. This alternative yields the same result as a., except Fran can choose to reduce her basis in the business assets instead of recognizing $20,000 income, assuming the liability is qualified business indebtedness. The basis reduction is, in effect, a deferral of the tax (that will be paid when the asset is sold or as depreciation deductions are reduced). Fran should retire the mortgage on the business property and thus defer the tax on the $20,000 gain. pp. 5-33 and 5-34 Salary ($100,000 + $40,000) Group term life insurance (Note 1) Dividends State tax refund (Note 2) Deductions for adjusted gross income Alimony paid (Note 3) Adjusted gross income Itemized deductions State income taxes ($3,400 + $2,300) (Note 4) Home mortgage interest Real estate taxes Cash contributions Personal and dependency exemptions ($3,400 × 2) Taxable income Tax on $111,330 (Note 5) Less: Tax withheld ($14,400 + $6,500) Net tax payable (or refund due) for 2007 $140,000 180 1,500 1,600 $143,280 (12,000) $131,280 $5,700 4,800 1,450 1,200
(13,150) (6,800) $111,330 $ 20,529 (20,900) ($ 371)
See the tax return solution beginning on page 5-22 of the Solutions Manual. Notes (1) Group term life insurance results in gross income for Alfred of $180 as follows: ($200,000 – $50,000) × $.10 × 12 months = $180 $1,000
(2) Under the § 111 tax benefit rule, Alfred must include the $1,600 state tax refund in his gross income. Beulah is not required to include her refund of $950 in her gross income because she claimed the standard deduction in 2006 and thus did not get a tax benefit from the state income taxes paid. (3) The $12,000 is deductible alimony. The $50,000 payment is a property settlement and is not deductible by Alfred. (4) The state income taxes paid of $5,700 exceed the sales taxes paid of $1,400. (5) The tax liability on taxable income of $101,206 is calculated using the Tax Rate Schedule for married filing jointly (applying the 15% rate for the qualified dividends of $1,500) and the amount is $20,529. Tax on dividend income ($1,500 × 15%) Tax on remainder of $109,830 ($111,330 – $1,500) using the Tax Table 60. Part 1—Tax Computation Salary Less: Foreign earned income exclusion (Note 1) Interest on Bahamian account (Note 2) 2,300 State income tax refund (Note 3) Dividends (Note 4) Gross income Less: Deductions for adjusted gross income Alimony paid AGI Less: Itemized deductions State income tax (Note 5) Real estate taxes on residence Interest on personal residence Charitable contributions Less: Personal and dependency exemptions (4 × $3,500) Taxable income Tax on $67,160 (Note 6) 9,398 Less: Withholding by employer Net tax payable (or refund due) for 2008 Notes (1) Since Martin satisfies the 330 out of 365 day requirement, he qualifies for the foreign earned income exclusion for the 46 days in 2008 (January and February through February 15) he worked in Mexico. His actual pay of $108,000 exceeded the limit on the exclusion. Thus, he is allowed to exclude only $11,040 (46/365 × $87,600). (2) The $2,300 interest on the Bahamian bank account is included in gross income. The $400 interest on the Montgomery County school bonds is excluded from gross income. $108,000 (11,040) 900 800 $100,960 (6,000) $ 94,960 $5,100 3,400 2,500 2,800 $ 225
(13,800) (14,000) $ 67,160 $ ($ (9,500) 102)
(3) The state income tax refund of $900 is included in gross income under the tax benefit rule because the state income taxes were taken as an itemized deduction in 2007. (4) The fair market value of $2,000 the Applegate Corporation stock dividend is not included in gross income, since no option was available for receiving cash. (5) The state income taxes paid of $5,100 exceed the sales taxes paid of $1,100. (6) Their filing status is married filing jointly. Tax on $65,100 On ($66,360 – $65,100) × 25% On $800 × 15% Part 2—Tax Planning Hoffman, Smith, and Willis, CPAs 5191 Natorp Boulevard Mason, OH 45040 December 29, 2008 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 25% marginal tax bracket in 2008 and you should be in the 25% bracket in 2009 and thereafter, unless there is a change in your income. Therefore, the increase in after-tax payments in 2009 and thereafter would be $413 [$500 – ($350 × 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 = = = $8,963 315 120 $9,398