Test 1 Practice Problems Chapter 1: An into to Taxation and Understanding the Federal Tax Law 1.5: How does the pay-as-you-go procedure apply to wage earners? To persons who have income from sources other than wages? For wage earners, the tax law requires employers to withhold a specified dollar amount from wages paid to the employee to cover income taxes and payroll taxes. Persons with nonwage income generally are required to make quarterly payments to the IRS for estimated taxes. Both procedures ensure that taxpayers will be financially able to meet their annual tax liabilities. o That is, the amounts withheld are meant to prepay the employee’s income taxes and payroll taxes related to the wages earned. 1-7: Distinguish between taxes that are proportional and those that are progressive. A tax is proportional if the rate of tax remains constant for any given income level. The tax is progressive if a higher rate of tax applies as the tax base increases. 1-11: Sophia lives several blocks from her parents in the same residential subdivision. Sophia is surprised to learn that her ad valorem property taxes for the year were raised, while those of her parents were lowered. What is a possible explanation for the difference? A possible explanation is that Sophia made capital improvements (e.g., added a swimming pool) to her residence and her parents became retirees (e.g., reached age 65). 1-15: What is the difference between an excise tax and a general sales tax? a. Do all states impose a general sales tax? b. Does the Federal government impose a general sales tax? An excise tax is limited to a particular transaction (e.g., sale of gasoline), while a general sales tax covers a multitude of transactions (e.g., sale of all nonfood goods). o The following states do not impose a general sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon. o There is no Federal general sales tax. 1-16: The Grays live in Clay County, which is adjacent to Jackson County. Although the retail stores in both counties are comparable, the Grays usually drive a few extra miles to shop in Jackson County. As to why the Grays might do this, consider the following: a. Clay County is in a different state than Jackson County. b. Clay County and Jackson County are in the same state. Jackson County must be in a state that imposes a lower (or no) sales tax. With certain major purchases (i.e., big-ticket items), any use tax imposed by the state of the Grays’ residence could come into play. In some states, the sales tax rate varies depending on the county and/or city. 1-18: Distinguish between an estate tax and an inheritance tax. a. Do some states impose both? Neither? b. Which, if either, does the Federal government impose? If the tax is imposed on the right to pass property at death, it is classified as an estate tax. If it taxes the right to receive property from a decedent, it is termed an inheritance tax. o Some states impose both an estate tax and an inheritance tax. Some states (e.g., Florida and Texas) levy neither tax. o The Federal government imposes an estate tax. 1-36: With regard to the IRS audit process, comment on the following: a. The audit is resolved by mail. b. The audit is conducted at the office of the IRS. c. A “no change” RAR results. d. A special agent joins the audit tea a) A correspondence audit is probably involved. These audits involve a limited number of issues (i.e., taxpayer failed to report some dividend income) and most often are easily resolved. b) What is described is an office audit. c) The revenue agent’s report (RAR) accepts the taxpayer’s return as filed. d) When a special agent becomes involved, this usually means that fraud is suspected. 1-37: Aldo has just been audited by the IRS. He does not agree with the agent’s findings but believes that he has only two choices: pay the proposed deficiency or resort to the courts. Do you agree with Aldo’s conclusion? Why or why not? In many unresolved audit disagreements at the agent level, the taxpayer should consider an appeal to the Appeals Division. Although it is part of the IRS, it is authorized to resolve audit disputes. It has greater settlement authority than does the agent. In many cases, a compromise reached at the Appeals Division can avoid a costly and timeconsuming judicial proceeding. 1-38: What purpose is served by a statute of limitations? How is it relevant in the case of tax controversies? The purpose of a statute of limitations is to preclude parties from prosecuting stale claims. The passage of time makes the defense of such claims difficult because witnesses and other evidence may no longer be available. In the Federal tax area, statutes of limitations cover additional assessments by the IRS and the pursuit of refund claims by taxpayers. 1-39: Regarding the statute of limitations on additional assessments of tax by the IRS, determine the applicable period in each of the following situations. Assume a calendar year individual with no fraud or substantial omission involved. a. The income tax return for 2016 was filed on February 19, 2017. b. The income tax return for 2016 was filed on June 25, 2017. c. The income tax return for 2016 was prepared on April 4, 2017, but was never filed. Through some misunderstanding between the preparer and the taxpayer, each expected the other to file the return. d. The income tax return for 2016 was never filed because the taxpayer thought no additional tax was due. a) The normal three-year statute of limitations will begin to run on April 15, 2017 (actually April 18, 2017 because April 15, 2017 is a Saturday and Emancipation Day in the District of Columbia is observed on Monday, April 17, 2017, making the due date for 2016 individual returns April 18, 2017). When the return is filed early, the normal filing date controls. b) Now the statute of limitations starts to run on the filing date. If the date of filing controlled (see part a. above), the taxpayer could shorten the assessment period by filing late. c) If a return that is due is not filed, the statute of limitations does not start to run. It does not matter that the failure to file was due to an innocent error on the part of the taxpayer or adviser. d) Regardless of the fact that an innocent misunderstanding was involved, there is no statute of limitations when a return is not filed. 1-40: Brianna, a calendar year taxpayer, files her income tax return for 2016 on February 3, 2017. Although she makes repeated inquiries, she does not receive her refund from the IRS until May 28, 2017. Is Brianna entitled to interest on the refund? Explain. No. Interest is not paid if the refund is made within 45 days of when the return was filed. However, a return is not considered filed until its due date. Thus, the period from April 15 to May 28 does not satisfy the 45-day requirement. 1-41: On a Federal income tax return filed five years ago, Andy inadvertently omitted a large amount of gross income. a. Andy seeks your advice as to whether the IRS is barred from assessing additional income tax in the event he is audited. What is your advice? b. Would your advice differ if you were the person who prepared the return in question? Explain. c. Suppose Andy asks you to prepare his current year’s return. Would you do so? Explain. a) Normally, the three-year statute of limitations applies to additional assessments the IRS can make. However, if a substantial omission from gross income is made, the statute of limitations is increased to six years. A substantial omission is defined as omitting in excess of 25% of the gross income reported on the return. b) No, it would not. The proper procedure would be to advise Andy to disclose the omission to the IRS. Absent the client’s consent, do not make the disclosure yourself. c) If Andy refuses to make the disclosure and the omission has a material carryover effect to the current year, you should withdraw from the engagement. 1-44: In March 2017, Jim asks you to prepare his Federal income tax returns for tax years 2014, 2015, and 2016. In discussing this matter with him, you discover that he also has not filed for tax year 2013. When you mention this fact, Jim tells you that the statute of limitations precludes the IRS from taking any action as to this year. a. Is Jim correct about the application of the statute of limitations? Why or why not? b. If Jim refuses to file for 2013, should you prepare returns for 2014 through 2016? Explain a) No. Because no return was filed, the statute of limitations never runs. But even if a return had been filed, the three-year period for the 2013 tax return would not expire until April 15, 2017, three years after the normal due date for filing. b) Although you can only recommend that the return be filed, you cannot force him to do so. However, you should not undertake the engagement for 2014 through 2016 if you cannot correctly reflect the tax liability due to the omission for 2013. Chapter 2: Working with the Tax Law 2-7: Rank the following items from the lowest to highest authority in the Federal tax law system: a. Interpretive Regulation. b. Legislative Regulation. c. Letter ruling. d. Revenue Ruling. e. Internal Revenue Code. f. Proposed Regulation. 1. Letter ruling (valid only to the taxpayer to whom issued). 2. Proposed Regulation (most courts ignore these). 3. Revenue Ruling. 4. Interpretive Regulation. 5. Legislative Regulation. 6. Internal Revenue Code. 2-9: Sally Andrews calls you on the phone. She says that she has found a 2007 letter ruling that agrees with a position she wants to take on her tax return. She asks you about the precedential value of a letter ruling. Draft a memo for the tax files outlining what you told Sally. 2-11: Where may private letter rulings be found? Letter rulings may be found in: o Private Letter Rulings (RIA). o BNA Daily Tax Reports. o Tax Notes (Tax Analysts). o Although not referenced in the text, letter rulings are also available in the IRS Letter Rulings Report (CCH). 2-14: List an advantage and a disadvantage of using the U.S. Court of Federal Claims as the trial court for Federal tax litigation The main advantage of the U.S. Court of Federal Claims occurs when a taxpayer’s applicable Circuit Court previously rendered an adverse decision. o Such a taxpayer may select the U.S. Court of Federal Claims because any appeal will be to the Federal Circuit. One disadvantage of the U.S. Court of Federal Claims is that the tentative deficiency must be paid before the Court will hear and decide the controversy. The U.S. Court of Federal Claims is a trial court that usually meets in Washington, D.C. It has jurisdiction for any claim against the United States that is based on the Constitution, any Act of Congress, or any Regulation of an executive department. 2-15: Eddy Falls is considering litigating a tax deficiency of approximately $229,030 in the court system. He asks you to provide him with a short description of his alternatives, indicating the advantages and disadvantages of each. Prepare your response to Eddy in the form of a letter. His address is 200 Mesa Drive, Tucson, AZ 85714. 2-16: List an advantage and a disadvantage of using the U.S. Tax Court as the trial court for Federal tax litigation. The U.S. Tax Court hears only tax cases and is the most popular forum for tax cases (generally viewed as an advantage). Some people suggest that the Tax Court has more expertise in tax matters. A taxpayer does not have to pay the tax deficiency assessed by the IRS before trial, but a taxpayer may deposit a cash bond to stop the running of interest (also viewed as an advantage). Appeals from a Tax Court are to the appropriate U.S. Court of Appeals. A disadvantage is that the taxpayer may not obtain a jury trial in the U.S. Tax Court. 2-17: A taxpayer lives in Michigan. In a controversy with the IRS, the taxpayer loses at the trial court level. Describe the appeal procedure under the following different assumptions: a. The trial court was the Small Cases Division of the U.S. Tax Court. b. The trial court was the U.S. Tax Court. c. The trial court was a U.S. District Court. d. The trial court was the U.S. Court of Federal Claim a) There is no appeal by either the taxpayer or the IRS from a decision of the Small Cases Division of the U.S. Tax Court. b) The first appeal would be to the Sixth Circuit Court of Appeals. Further appeal would be to the U.S. Supreme Court. c) Same as part b. above. d) The appeal would be to the Federal Circuit Court of Appeals and then to the U.S. Supreme Court. 2-19: An appellate court will often become involved in fact-finding determination. Discuss the validity of this statement. Both the Code and the Supreme Court indicate that the Federal appellate courts are bound by findings of facts unless they are clearly erroneous. Thus, the role of appellate courts is limited to a review of the record of trial compiled by the trial courts. Therefore, the appellate process usually involves a determination of whether the trial court applied the proper law in arriving at its decision. o Rarely will an appellate court disturb a lower court’s fact-finding determination. 2-22: What precedents must each of these courts follow? a. U.S. Tax Court. b. U.S. Court of Federal Claims. c. U.S. District Court. a) The Tax Court must follow its own cases, the pertinent U.S. Circuit Court of Appeals, and the Supreme Court. b) The Court of Federal Claims must follow its own decisions, the Federal Circuit Court of Appeals, and the Supreme Court. c) The District Court must follow its own decisions, the pertinent U.S. Circuit Court of Appeals, and the Supreme Court. 2-23: What determines the appropriate Circuit Court of Appeals for a particular taxpayer? The appropriate Circuit Court of Appeals for an appeal depends on where the litigation originated. For example, an appeal from Texas would go to the Fifth Circuit Court of Appeals and an appeal from Colorado would go to the Tenth Circuit Court of Appeals. 2-24: In assessing the validity of a prior court decision, discuss the significance of the following on the taxpayer’s issue: a. The decision was rendered by the U.S. District Court of Wyoming. Taxpayer lives in Wyoming. b. The decision was rendered by the U.S. Court of Federal Claims. Taxpayer lives in Wyoming. c. The decision was rendered by the Second Circuit Court of Appeals. Taxpayer lives in CA d. The decision was rendered by the U.S. Supreme Court. e. The decision was rendered by the U.S. Tax Court. The IRS has acquiesced in the result. f. Same as part (e) except that the IRS has issued a nonacquiescence as to the result. a) If the taxpayer chooses a U.S. District Court as the trial court for litigation, the U.S. District Court of Wyoming will be the forum to hear the case. Unless the prior decision has been reversed on appeal, one would expect the same court to follow its earlier holding. b) If the taxpayer chooses the U.S. Court of Federal Claims as the trial court for litigation, the decision that was rendered previously by this Court should have a direct bearing on the outcome. a. If the taxpayer selects a different trial court (i.e., the appropriate U.S. District Court or the U.S. Tax Court), the decision that was rendered by the U.S. Court of Federal Claims will be persuasive but not controlling. b. It is, of course, assumed that the result that was reached by the U.S. Court of Federal Claims was not reversed on appeal. c) The decision of a U.S. Circuit Court of Appeals will carry more weight than one that was rendered by a trial court. Because the taxpayer lives in California, however, any appeal from a U.S. District Court or the U.S. Tax Court will go to the Ninth Circuit Court of Appeals. Although the Ninth Circuit Court of Appeals might be influenced by what the Second Circuit Court of Appeals has decided, it is not compelled to follow such holding. d) Because the U.S. Supreme Court is the highest appellate court, one can place complete reliance upon its decisions. a. Nevertheless, one should investigate any decision to see whether the Code has been modified with respect to the result that was reached. There also exists the rare possibility that the Court may have changed its position in a later decision. e) When the IRS acquiesces to a decision of the U.S. Tax Court, it agrees with the result that was reached. As long as such acquiescence remains in effect, taxpayers can be assured that this represents the position of the IRS on the issue that was involved. Keep in mind, however, that the IRS can change its mind and can, at any time, withdraw the acquiescence and substitute a nonacquiescence. 2-26: Is there an automatic right to appeal to the U.S. Supreme Court? If so, what is the process? There is no automatic right of appeal to the U.S. Supreme Court. Appeal is by Writ of Certiorari. If the Court agrees to hear the dispute, it will grant the Writ (Cert. granted). Most often, the highest court will deny jurisdiction (Cert. denied). 2-43: Classify each of the following statements: a) Sue writes a $707 check for a charitable contribution on December 28, 2017, but does not mail the check to the charitable organization until January 10, 2018. She takes a deduction in 2017. a. Tax evasion b) Sam decides not to report interest income from a bank because the amount is only $19.75. a. Tax evasion c) Harry pays property taxes on his home in December 2017 rather than waiting until February 2018. a. Tax avoidance d) Variet switches her investments from taxable corporate bonds to tax-exempt municipal bonds. a. Tax avoidance e) Mel encourages his mother to save most of her Social Security benefits so that he will be able to claim her as a dependent. a. Tax avoidance Chapter 17: Tax Practice and Ethics 17-3: Recently, a politician was interviewed about fiscal policy, and she mentioned reducing the “tax gap.” Explain what this term means. What are some of the pertinent political and economic issues relative to the tax gap? The tax gap is an indicator monitored by politicians and the IRS. It measures the difference between actual Federal income tax collections and the amount that the IRS projects should be collected if there is full compliance with all income tax laws. The issues that arise concerning the tax gap include the following. o What means should be employed to reduce the gap? Should the IRS hire more enforcement personnel and what items (e.g., income, deductions, or credits) should they examine? o How large can the IRS become without a public reaction to a Big Brother atmosphere and an abuse of confidential information that can result from too much audit activity? o Why should the government not attempt to close the tax gap in full and thereby eliminate most of the annual budget deficit? 17-13: Consider the ethical standards under which the tax profession operates. Who regulates the behavior of tax return preparers? What documents provide the major constraints on the conduct of the tax professions? The ethical behavior of a tax professional primarily is crafted by the ethics and morals that the individual brings to his/her work life. These standards might come from family, religious, or philosophical thinking, or from other broad, outside sources. On top of these pre-existing guidelines, tax preparers’ professional behavior is regulated by: o Congress (through the penalty provisions in the Code as to both taxpayers and tax preparers), o the Treasury (through Circular 230), and o the professional organizations of tax professionals (like the AICPA, the ABA, and the EA associations). These regulatory provisions often overlap, and they sometimes are in conflict—the penalty provisions seem to apply a “reasonable basis,” a “substantial authority,” and a “realistic possibility” standard in taking tax return positions—as they evolve at different paces. 17-27: Maureen, a calendar year individual taxpayer, files her 2016 return on November 4, 2018. She did not obtain an extension for filing her return, and the return reflects additional income tax due of $15,000. a. What are Maureen’s penalties for failure to file and to pay? b. Would your answer to part (a) change if Maureen, before the due date of the return, had retained a CPA to prepare the return and it was the CPA’s negligence that caused the delay? a) Failure to pay penalty (.5% × $15,000) × 19 months 1,425 Plus: Failure to file penalty (5% × $15,000) × 5 months 3,750 Less: Failure to pay penalty for same period (375) 3,375 Total Penalties $4,800 a. The failure to file penalty cannot exceed a total of 25%. Consequently, this penalty is capped after 5 months (i.e., 5% × 5 months = 25%). b. The failure to pay penalty also is limited to a total of 25%. (At the rate of .5% per month, such penalty can continue to run for as long as 50 months.) b) Reliance by a taxpayer on a CPA to file generally does not constitute reasonable cause so as to avoid the failure to file and pay penalties. 17-37: Jane filed her 2016 Form 1040 on April 4, 2017. What is the date on which the applicable statute of limitations expires in each of the following independent situations? a. Jane incurred a bad debt loss that she failed to claim. April 15, 2024. Although claims for refund normally are limited by the three-year rule, seven years applies in the case of bad debts and worthless securities. b. Jane inadvertently omitted a large amount of gross income. April 15, 2023. For a substantial omission (i.e., more than 25%) of gross income, a sixyear statute of limitations comes into play c. Same as part (b), except that the omission was deliberate. If the omission was deliberate, fraud probably is involved. There is no statute of limitations on fraud. d. Jane innocently overstated her deductions by a large amount. April 15, 2020. The normal three-year statute applies. o Unlike the substantial omission of income situation, the six-year statute does not materialize. e. No return was filed by Jane. The statute never expires. The absence of a return precludes the running of the statute of limitations. 17-40: Rod’s Federal income tax returns (Form 1040) for the indicated years were prepared by the following persons. Year 1 = Rod Year 2 = Ann Year 3 = Cheryl Ann is Rod’s next-door neighbor and owns and operates a pharmacy. Cheryl is a licensed CPA and is engaged in private practice. In the event Rod is audited and all three returns are examined, who may represent him before the IRS at the agent level? Who may represent Rod before the Appeals Division? Rod may represent himself for all years involved. The same holds true for Cheryl, who is a CPA. Ann may represent Rod only for tax year 2, and only at the agent level. Under Circular 230, only Rod and Cheryl may appear before the Appeals Division of the IRS. Chapter 4: Gross Income: Concepts and Inclusions 4-27: Determine the taxpayer’s current-year (1) economic income and (2) gross income for tax purposes from the following events: a. Sam’s employment contract as chief executive of a large corporation was terminated, and he was paid $500,000 not to work for a competitor of the corporation for five years. The $500,000 is economic income and gross income for tax purposes. Sam realized $500,000 for agreeing not to compete and must include the entire amount in gross income. o Pay for not performing is treated the same as pay for performing. b. Elliot, a 6-year-old child, was paid $5,000 for appearing in a television commercial. His parents put the funds in a savings account for the child’s education. The $5,000 is economic income and gross income for tax purposes. c. Valery found a suitcase that contained $100,000. She could not determine who the owner was. The $100,000 is an increase in wealth realized, must be included in Valery’s gross income, and is economic income. d. Winn purchased a lottery ticket for $5 and won $750,000. Winn’s economic income is $749,995 (the winnings less the cost of the ticket). For tax purposes, he has $750,000 of gross income. However, the $5 may be deductible as an itemized deduction for tax purposes. e. Larry spent $1,000 to raise vegetables that he and his family consumed. The cost of the vegetables in a store would have been $2,400. Larry has economic income of $1,400 from the production in his garden. However, for tax purposes, no income is realized. The realization requirement is not satisfied because the vegetables are consumed by Larry and his family rather than sold to others. f. Dawn purchased an automobile for $1,500 that was worth $3,500. The seller was in desperate need of cash. Dawn has economic income of $2,000. Dawn did not realize gross income at the time of the bargain purchase. She will have realized gain when (and if) she sells the automobile for more than $1,500, her cost. 4-30: Determine Amos’s gross income in each of the following cases: a. In the current year, Amos purchased an automobile for $25,000. As part of the transaction, Amos received a $1,500 rebate from the manufacturer. The $1,500 is a reduction in the cost of the automobile and is not income. b. Amos sold his business. In addition to the selling price of the stock, he received $50,000 for a covenant not to compete—an agreement that he will not compete with his former business for five years. The $50,000 payment received under the covenant is included in Amos’s gross income because the payment is an increase in wealth realized. c. Amos owned some land he held as an investment. As a result of a change in the zoning rules, the property increased in value by $20,000. The change in the zoning rules that causes the property to increase in value is economic gain but is not a realized gain for tax purposes. Amos’s wealth increased, but the realization requirement is not satisfied because he did not receive any additional property, nor were any improvements made to his property. Amos will not realize this increase in wealth for tax purposes until he sells the property. 4-35: Determine the effects of the following on a cash basis taxpayer’s gross income for 2017 and 2018. a. On the morning of December 31, 2017, the taxpayer received a $1,500 check from a customer. The taxpayer did not cash the check until January 3, 2018. The check is a cash equivalent; therefore, the $1,500 must be included in the cash basis taxpayer’s 2017 gross income when it was actually received. b. The same as part (a), except the customer asked the taxpayer not to cash the check until January 3, 2018, after the customer’s salary check could be deposited. The check is not a cash equivalent because of the restrictive conditions placed upon it. Therefore, a cash basis taxpayer does not include the $1,500 in gross income until 2018. c. The same as part (a), except that the check was not received until after the bank had closed on December 31, 2017. The fact that the bank was closed is not relevant. The check is a cash equivalent; therefore, the $1,500 must be included in 2017 gross income. 4-37: Drake Appliance Company, an accrual basis taxpayer, sells home appliances and service contracts. Determine the effect of each of the following transactions on the company’s 2017 gross income assuming that the company uses any available options to defer its taxes. a. In December 2016, the company received a $1,200 advance payment from a customer for an appliance that Drake special ordered from the manufacturer. The appliance did not arrive from the manufacturer until January 2017, and Drake immediately delivered it to the customer. The sale was reported in 2017 for financial accounting purposes. The $1,200 is included in the 2017 gross income. o The advance payment received in 2016 for goods delivered in 2017 qualifies for deferral because the company satisfied the tax and financial accounting conformity requirement. b. In October 2017, the company sold a 6-month service contract for $240. The company also sold a 36-month service contract for $1,260 in July 2017. For the sale of the six-month service contract, $120 is included in 2017 gross income ($240 × 3/6 = $120). o The advance payment for services qualifies for proration over the life of the contract because all of the income will be earned by the end of the tax year following the year of receipt. Drake must include in 2017 gross income $210 ($1,260 × 6/36). o Drake would include in 2018 gross income $1,050 ($1,260 − $210), the balance on the contract sold in 2017 for services that would not all be performed by the end of the tax year of receipt. That is, the portion of the advance payment that relates to services to be performed after the tax year of receipt is included in gross income in the tax year following the tax year of receipt of the advance payment. c. On December 31, 2017, the company sold an appliance for $1,200. The company received $500 cash and a note from the customer for $700 and $260 interest, to be paid at the rate of $40 a month for 24 months. Because of the customer’s poor credit record, the fair market value of the note was only $600. The cost of the appliance was $750. The company must include $1,200 in gross receipts and can deduct the cost of the appliance, $750, in arriving at gross income of $450. o The fair market value of the note is not relevant for purposes of determining the accrual method taxpayer’s gross income. o The interest of $260 will be taxed as it accrues over the 24-month life of the contract. 4-38: Freda is a cash basis taxpayer. In 2017, she negotiated her salary for 2018. Her employer offered to pay her $21,000 per month in 2018 for a total of $252,000. Freda countered that she would accept $10,000 each month for the 12 months in 2018 and the remaining $132,000 in January 2019. The employer accepted Freda’s terms for 2018 and 2019. a. Did Freda actually or constructively receive $252,000 in 2018? No. Actual receipt applies to the $120,000 ($10,000 × 12 months) she received in 2018. The $132,000 deferred income is not constructively received in 2018 because under the actual contract terms, she did not have the right to receive the income in 2018. o The constructive receipt doctrine cannot change actual events to “what might have been done.” b. What could explain Freda’s willingness to spread her salary over a longer period of time? Freda may have expected to be in a lower marginal tax bracket in 2019. She also benefited by not having to pay the tax on the income shifted into 2019 until she filed her 2019 income tax return or made payments on estimated taxes for 2019. c. In December 2018, after Freda had earned the right to collect the $132,000 in 2019, the employer offered $133,000 to Freda at that time, rather than $132,000 in January 2019. The employer wanted to make the early payment so as to deduct the expense in 2018. Freda rejected the employer’s offer. Was Freda in constructive receipt of the income in 2018? Explain. Yes. The $132,000 actually received in 2019 was constructively received in 2018 because it was made available to her in that year. 4-41: Troy, a cash basis taxpayer, is employed by Eagle Corporation, also a cash basis taxpayer. Troy is a full-time employee of the corporation and receives a salary of $60,000 per year. He also receives a bonus equal to 10% of all collections from clients he serviced during the year. Determine the tax consequences of the following events to the corporation and to Troy: a. On December 31, 2017, Troy was visiting a customer. The customer gave Troy a $10,000 check payable to the corporation for appraisal services Troy performed during 2017. Troy did not deliver the check to the corporation until January 2018. The cash basis corporation must recognize the income of $10,000 in 2017, when its agent, Troy, received the check, which is a cash equivalent. Troy will not recognize any bonus until it is actually or constructively received. o The fact that the employer received the fees in 2018 does not affect the time Troy recognizes the bonus. b. The facts are the same as in part (a), except that the corporation is an accrual basis taxpayer and Troy deposited the check on December 31, but the bank did not add the deposit to the corporation’s account until January 2018. The corporation must recognize the income in 2017, when the agent, Troy, performed the services. Troy will recognize the 10% bonus in 2018 because neither actual nor constructive receipt of the bonus occurs in 2017. c. The facts are the same as in part (a), except that the customer told Troy to hold the check until January 2018 when the customer could make a bank deposit that would cover the check The fact that the customer admits that the check will not be honored if presented at the end of the year means that the check is not a “cash equivalent.” Furthermore, the restriction on when the check can be presented for payment is “substantial.” Thus, income is not realized in 2017. 4-15: Patrick and Eva are planning to divorce. Patrick has offered to pay Eva $12,000 each year until their 11-year-old daughter reaches age 21. Alternatively, Patrick will transfer to Eva common stock that he owns with a fair market value of $100,000. What factors should Eva and Patrick consider in deciding between these two option Patrick and Eva should consider the tax implications of the agreement. The property can be transferred without recognition of gain by Patrick or Eva. However, Eva’s cost basis in the stock will be the same as Patrick’s. o If his basis is less than the fair market value of the stock, Eva will recognize gain when the stock is sold, assuming that the stock maintains its value. The cash payments, as presently structured, will not qualify as alimony deductible by Patrick and income to Eva. o The payments are not alimony because they are subject to a contingency related to the daughter, which suggests that the payments are for child support. In addition, to qualify as alimony, the cash payments must cease with the death of the payee, the agreement must not specify that the payments are not alimony, and Patrick and Eva cannot live in the same household when the payments are made. o Because the cash payments do not qualify as alimony, Patrick will not be allowed a deduction and Eva will not be required to recognize income. 4-19: For a person who receives Social Security benefits, what effect, if any, can an increase in other income have on that person’s taxable income? Under the formula for computing taxable Social Security benefits, o an increase in other income increases modified adjusted gross income, o which can cause an increase in the taxable benefits, o thus causing taxable income to increase by more than the other income. 4-45: Nell and Kirby are in the process of negotiating their divorce agreement. What should be the tax consequences to Nell and Kirby if the following, considered individually, became part of the agreement? a. In consideration for her one-half interest in their personal residence, Kirby will transfer to Nell stock with a value of $200,000 and $50,000 of cash. Kirby’s cost of the stock was $150,000, and the value of the personal residence is $500,000. They purchased the residence three years ago for $300,000. The transfers of the stock and residence pursuant to the divorce are nontaxable to Nell and Kirby. o Nell assumes Kirby’s basis in the stock of $150,000, and Kirby’s basis in the house is $300,000. o However, the $50,000 cash paid by Kirby will be alimony unless the agreement specifies that the payment is “not alimony.” b. Nell will receive $1,000 per month for 120 months. If she dies before receiving all 120 payments, the remaining payments will be made to her estate. The cash payments of $1,000 per month do not qualify as alimony because they will not cease upon Nell’s death. o The payments are excluded from Nell’s gross income as they are received by her, and Kirby may not deduct the payments (would be a deduction for AGI if the payments had been classified as alimony). c. Nell is to have custody of their 12-year-old son, Bobby. She is to receive $1,200 per month until Bobby (1) dies or (2) attains age 21 (whichever occurs first). After either of these events occurs, Nell will receive only $300 per month for the remainder of her life. The monthly payments of $1,200 are in part child support and in part alimony. The monthly amount that will continue after the occurrence of the contingency related to the child is considered alimony. o Therefore, $300 per month is alimony that must be included in Nell’s gross income, and the other $900 received each month is child support. o Kirby can deduct the alimony payments of $300 as a deduction for AGI. 4-51: Pam retires after 28 years of service with her employer. She is 66 years old and has contributed $42,000 to her employer’s qualified pension fund. She elects to receive her retirement benefits as an annuity of $3,000 per month for the remainder of her life. a. Assume that Pam retires in June 2017 and collects six annuity payments this year. What is her gross income from the annuity payments in the first year? Collections in 2017 (6 payments × $3,000) 18,000 Exclusion for capital recovery ($200 × 6 payments) (1,200) Include in gross income 16,800 b. Assume that Pam lives 25 years after retiring. What is her gross income from the annuity payments in the twenty-fourth year? Pam will have recovered her investment as a return of capital prior to the twenty-fourth year (i.e., 17 years and 6 months). o Thus, all annuity payments received in the twenty-fourth year ($36,000) are includible in her gross income. c. Assume that Pam dies after collecting 160 payments. She collected eight payments in the year of her death. What are Pam’s gross income and deductions from the annuity contract in the year of her death? Investment in the contract $42,000 Less: Capital recovered ($200 exclusion × 160 payments) (32,000) Unrecovered cost (loss in the final year return) Income from collections in final year: [$24,000 collected – (8 × $200 = $1,600 exclusion)] $10,000 $22,400 4-52: For each of the following, determine the amount that should be included in gross income: a. Peyton was selected the most valuable player in the Super Bowl. In recognition of this, he was awarded an automobile with a value of $60,000. Peyton did not need the automobile, so he asked that the title be put in his parents’ names. Peyton is required to include $60,000 in gross income, the value of the automobile. o The award does not satisfy the right type of achievement requirement to qualify for exclusion from gross income. o In addition, the provision that requires the recipient to contribute the award to a qualified governmental unit or nonprofit organization is not satisfied. b. Jacob was awarded the Nobel Peace Prize. When he was presented the check for $1.4 million, Jacob said, “I do not need the money. Give it to the United Nations to use toward the goal of world peace.” Jacob can exclude from his gross income the $1.4 million Nobel Peace Prize received and then given to the United Nations, assuming that the United Nations is a qualified nonprofit organization. c. Linda won the Craig County Fair beauty pageant. She received a $10,000 scholarship that paid her $6,000 for tuition and $4,000 for meals and housing for the academic year. The $10,000 Linda received cannot be excluded as a prize because it was not received in recognition of a qualifying achievement (e.g., scientific, artistic). o Moreover, she entered the contest. o However, the $6,000 tuition award (but not the $4,000 received for meals and housing) can qualify as a scholarship. 4-53: The LMN Partnership has a group term life insurance plan. Each partner has $150,000 of protection, and each employee has protection equal to twice his or her annual salary. Employee Alice (age 32) has $90,000 of insurance under the plan, and partner Kay (age 47) has $150,000 of coverage. Because the plan is a “group plan,” it is impossible to determine the cost of coverage for an individual employee or partner. a. Assuming that the plan is nondiscriminatory, how much must Alice and Kay each include in gross income as a result of the partnership paying the insurance premiums? Alice’s gross income from the excess coverage is computed as follows: Uniform premiums for $1,000 of protection for 1 month $ .08 Coverage for 12 months (age 32) × 12 Excess coverage: $90,000 − $50,000 / $1,000 $ .96 × 40 Includible amount for Alice $38.40 Kay’s gross income from the excess coverage as a Partner is computed as follows: Uniform premiums for $1,000 of protection for 1 month $ .15 Coverage for 12 months × 12 Excess coverage: $150,000 − $0 / $1,000 $ 1.80 × 150 Includible amount for Kay $270.00 b. Assume that the partnership is incorporated. Kay becomes a shareholder and an employee who receives a $75,000 annual salary. The corporation provides Kay with $150,000 of group term life insurance coverage under a nondiscriminatory plan. What is Kay’s gross income as a result of the corporation paying the insurance premiums? Uniform premiums for $1,000 of protection for 1 month $ .15 Coverage for 12 months × 12 Excess coverage: $150,000 − $50,000 / $1,000 $1.80 x 100 Includible amount for Kay $180.00 Chapter 5: Gross Income: Exclusions 5-27: Ed, an employee of the Natural Color Company, suffered from a rare disease that was very expensive to treat. The local media ran several stories about Ed’s problems, and the family created a website that generated more than $10,000 in gifts from individuals to help pay the medical bills. Ed’s employer provided hospital and medical insurance for its employees, but the policy did not cover Ed’s illness. When it became apparent that Ed could not pay all of his medical expenses, the hospital canceled the $25,000 Ed owed at the time of his death. After Ed’s death, his former employer paid Ed’s widow $12,000 in “her time of need.” Ed’s widow also collected $50,000 on a group term life insurance policy paid for by Ed’s employer. What are Ed’s and his widow’s gross income? The $10,000 received from the general public is an excludible gift. The $12,000 that Ed’s widow received in her “time of need” may be excluded from gross income if the company has a general policy of making such payments. o Otherwise, the IRS may challenge the payment as a taxable payment for Ed’s prior services. The $25,000 debt canceled by the hospital should not increase gross income. This results because to the extent the debt cancellation is included in gross income, Ed should be allowed a medical expense deduction that is subject to the percentage of AGI nondeductible amount. o The debt attributable to the nondeductible portion should be excluded from gross income under the tax benefit rule because the recovery of the expense is excluded from gross income to the extent the expense did not yield a tax benefit. The life insurance proceeds are excluded from gross income because they were paid to the beneficiary of a life insurance policy. 5-28: Determine the gross income of the beneficiaries in the following cases: a. Justin’s employer was downsizing and offered employees an amount equal to one year’s salary if the employee would voluntarily retire. The payments received for not working must be included in Justin’s gross income because he experienced an increase in wealth when the payment was received (although he may experience a decrease in future income). b. Trina contracted a disease and was unable to work for six months. Because of her dire circumstances, her employer paid her one-half of her regular salary while she was away from work. The payments received by Trina must be included in her gross income. The payments were not gifts, although they were made because of her dire circumstances, because the Internal Revenue Code specifically provides that employers cannot be considered donors to their employees. c. Coral Corporation collected $1 million on a key person life insurance policy when its chief executive died. The corporation had paid the premiums on the policy of $77,000, which were not deductible by the corporation. The life insurance proceeds are excluded from Coral Corporation’s gross income. The corporation collected the proceeds as the beneficiary of the policy upon the death of the insured. d. Juan collected $40,000 on a life insurance policy when his wife, Leona, died in 2016. The insurance policy was provided by Leona’s employer, and the premiums were excluded from Leona’s gross income as group term life insurance. In 2017, Juan collected the $3,500 accrued salary owed to Leona at the time of her death. The life insurance proceeds of $40,000 are excluded from Juan’s gross income. He collected the proceeds as the beneficiary of the policy upon the death of the insured. o The fact that the corporation paid the premiums and the premiums were excluded from Leona’s gross income does not affect the tax treatment of the proceeds. The accrued salary of $3,500 must be included in Juan’s gross income because it would have been taxable to Juan’s wife if she had collected it (“income in respect of a decedent”). 5-30: What is the taxpayer’s gross income in each of the following situations? a. Darrin received a salary of $50,000 in 2017 from his employer, Green Construction. $50,000 salary. b. In July 2017, Green gave Darrin an all-expense-paid trip to Las Vegas (value of $3,000) for exceeding his sales quota. $3,000, the value of the trip. c. Megan received $10,000 from her employer to help her pay medical expenses not covered by insurance. The $10,000 as compensation, unless this is paid under a nondiscriminatory medical reimbursement plan available to other employees. d. Blake received $15,000 from his deceased wife’s employer “to help him in his time of greatest need.” The $15,000 is an excluded gift because it was paid based on Blake’s need. e. Clint collected $50,000 as the beneficiary of a group term life insurance policy when his wife died. The premiums on the policy were paid by his deceased wife’s employer. Zero. Life insurance proceeds paid to the beneficiary upon death of the insured are excluded from gross income. 5-34: Adrian was awarded an academic scholarship to State University for the 2017–2018 academic year. He received $6,500 in August and $7,200 in December 2017. Adrian had enough personal savings to pay all expenses as they came due. Adrian’s expenditures for the relevant period were as follows: Tuition, August 2017 $3,700 Tuition, January 2018 3,750 Room and board August–December 2017 2,800 January–May 2018 2,500 Books and educational supplies August–December 2017 1,000 January–May 2018 1,200 Determine the effect on Adrian’s gross income for 2017 and 2018 Adrian received a total of $13,700 and spent $9,650 ($3,700 + $3,750 + $1,000 + $1,200) on tuition, books, and supplies. o The amount received for room and board is not excludible from gross income. Therefore, he must include $4,050 ($13,700 − $9,650) in gross income. When he received the money in 2017, Adrian’s total expenses for the period covered by the scholarship were not known. Therefore, he is allowed to defer reporting the income until 2018, when all the uncertainty is resolved 5-35: Leigh sued an overzealous bill collector and received the following settlement: Damage to her automobile that the collector attempted to repossess $ 3,300 Physical damage to her arm caused by the collector 15,000 Loss of income while her arm was healing 6,000 Punitive damages 80,000 a. What effect does the settlement have on Leigh’s gross income? Leigh must include in gross income the punitive damages of $80,000. The other amounts ($15,000 and $6,000) may be excluded as arising out of the physical personal injury, except the $3,300 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 $3,300). b. Assume that Leigh also collected $25,000 of damages for slander to her personal reputation caused by the bill collector misrepresenting the facts to Leigh’s employer and other creditors. Is this $25,000 included in Leigh’s gross income? Explain. The $25,000 is included in Leigh’s gross income because it did not arise out of a physical personal injury. 5-36: Determine the effect on gross income in each of the following cases: a. Eloise received $150,000 in settlement of a sex discrimination case against her former employer. 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. Nell received $10,000 for damages to her personal reputation. She also received $40,000 in punitive damages. 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. Orange Corporation, an accrual basis taxpayer, received $50,000 from a lawsuit filed against its auditor who overcharged for services rendered in a previous year. The damages of $50,000 are included in Orange Corporation’s gross income under the tax benefit rule, assuming that the company received tax benefit from deducting the audit fees in a previous year. d. Beth received $10,000 in compensatory damages and $30,000 in punitive damages in a lawsuit she filed against a tanning parlor for severe burns she received from using its tanning equipment. The compensatory damages of $10,000 for the physical personal injury are not included in Beth’s gross income, o but the punitive damages of $30,000 must be included in her gross income. e. Joanne received compensatory damages of $75,000 and punitive damages of $300,000 from a cosmetic surgeon who botched her nose job. Because 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. 5-46: Rosa’s employer has instituted a flexible benefits program. Rosa will use the plan to pay for her daughter’s dental expenses and other medical expenses that are not covered by health insurance. Rosa is in the 28% marginal tax bracket and estimates that the medical and dental expenses not covered by health insurance will be within the range of $4,000 to $5,000. Her employer’s plan permits her to set aside as much as $5,000 in the flexible benefits account. Rosa does not itemize her deductions. a. Rosa puts $4,000 into her flexible benefits account, and her actual expenses are $5,000. What is her cost of underestimating the expenses? If Rosa underfunds the account by $1,000, o the cost of the error is her marginal tax rate times the underfunded amount, or $280 (.28 × $1,000). b. Rosa puts $5,000 into her flexible benefits account, and her actual expenses are only $4,000. What is her cost of overestimating her expenses? If Rosa overfunds the account by $1,000, the cost of the error is $720 [(1 − .28) × $1,000]. c. What is Rosa’s cost of underfunding as compared with the cost of overfunding the flexible benefits account? The cost of underfunding is a .28 error, and the cost of overfunding is a .72 × (1 − .28) error; o that is, the underfunding error costs only 39% (.28/.72) of the cost of overfunding. d. Does your answer in part (c) suggest that Rosa should fund the account closer to the low end or to the high end of her estimates? Rosa should fund the flexible benefit account using an amount closer to the low end than the high end of the estimate. 5-47: Sparrow Corporation would like you to review its employee fringe benefits program with regard to the tax consequences of the plan for the company’s president (Polly), who is also the majority shareholder. Polly is both an employee and a controlling shareholder in the corporation. o Therefore, benefits she receives that are not excludible from gross income may be characterized as a dividend. o This means that she might enjoy the lower tax rate applicable to dividends as compared to compensation; however, the corporation will not be allowed to deduct any amount that is considered a dividend. a. The company has a qualified retirement plan. The company pays the cost of employees attending a retirement planning seminar. The employee must be within 10 years of retirement, and the cost of the seminar is $1,500 per attendee. The $1,500 cost of the retirement planning seminar can be excluded from Polly’s gross income because it is provided on a nondiscriminatory basis. b. The company owns a parking garage that is used by customers, employees, and the general public. Only the general public is required to pay for parking. The charge to the general public for Polly’s parking for the year would have been $3,600 (a $300 monthly rate). Employee parking is specifically excluded from gross income. However, the value of Polly’s free parking of $3,600 ($3,600/12 = $300 per month) exceeds the permitted exclusion amount of $3,060 ($255 per month). So Polly must include $540 ($3,600 − $3,060) in her gross income. Note that parking can be provided on a discriminatory basis. c. All employees are allowed to use the company’s fixed charge long-distance telephone services, as long as the privilege is not abused. Although no one has kept track of the actual calls, Polly’s use of the telephone had a value (what she would have paid on her personal telephone) of approximately $600. The use of the phone is excluded from Polly’s gross income as a no-additional-cost benefit. o It also may fit the requirements for a de minimis fringe benefit. d. The company owns a condominium at the beach, which it uses to entertain customers. Employees are allowed to use the facility without charge when the company has no scheduled events. Polly used the facility 10 days during the year. Her use had a rental value of $1,000. The value of the use of the condominium is a no-additional-cost fringe benefit that Polly can exclude from gross income. e. The company is in the household moving business. Employees are allowed to ship goods without charge whenever there is excess space on a truck. Polly purchased a dining room suite for her daughter. Company trucks delivered the furniture to the daughter. Normal freight charges would have been $750. The freight is a no-additional-cost benefit made available to all employees (nondiscriminatory). The $750 can be excluded from Polly’s gross income. f. The company has a storage facility for household goods. Officers are allowed a 20% discount on charges for storing their goods. All other employees are allowed a 10% discount. Polly’s discounts for the year totaled $900. The plan is discriminatory. o Therefore, the highly compensated employees must pay tax on all of their discounts. Polly includes $900 in her gross income. 5-48: George is a U.S. citizen who is employed by Hawk Enterprises, a global company. Beginning on June 1, 2017, George began working in London. He worked there until January 31, 2018, when he transferred to Paris. He worked in Paris the remainder of 2018. His salary for the first five months of 2017 was $100,000, and it was earned in the United States. His salary for the remainder of 2017 was $175,000, and it was earned in London. George’s 2018 salary from Hawk was $300,000, with part being earned in London and part being earned in Paris. What is George’s gross income in 2017 and 2018? (Assume that the 2018 indexed amount is the same as the 2017 indexed amount.) 2017: For the 12-month period ending May 31, 2018, 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 215 days in 2017. For 2017, George can exclude the following amount from his gross income: 215/365 days x $102,100* = $60,141 o *Lower of earned income of $275,000 or indexed statutory ceiling of $102,100 for 2017. o George must include $214,859 ($275,000 − $60,141) in his gross income for 2017. 2018: George can exclude the following amount from his gross income: 365/365 days x $102,100* of salary = $102, 100 o *Lower of earned income of $300,000 or indexed statutory ceiling of $102,100 for 2018. o George must include $197,900 ($300,000 – $102,100) in his 2018 gross income. 5-49: Determine Hazel’s gross income from the following receipts for the year: Gain on sale of Augusta County bonds $800 Interest on U.S. government savings bonds 400 Interest on state income tax refund 200 Interest on Augusta County bonds 700 Patronage dividend from Potato Growers Cooperative 350 The patronage dividend was received in March of the current year for amounts paid for her (nondeductible) garden and lawn supplies. Hazel must include all of the items in gross income except the interest received of $700 on Augusta County bonds and the $350 patronage dividend. o The patronage dividend is not included in gross income under the tax benefit rule because the cost of the materials used on her lawn and garden were not deducted. All other items are simply gross income not otherwise excluded. o Therefore, Hazel must include in gross income $1,400 ($800 + $400 + $200). 5-51: Tonya, who lives in California, inherited a $100,000 State of California bond in 2017. Her marginal Federal tax rate is 35%, and her marginal state tax rate is 5%. The California bond pays 3.3% interest, which is not subject to California income tax. She can purchase a corporate bond of comparable risk that will yield 5.2% or a U.S. government bond that pays 4.6% interest. Which investment will provide the greatest after-tax yield? The California bond has the greatest after-tax yield: 5-53: Starting in 2006, Chuck and Luane have been purchasing Series EE bonds in their name to use for the higher education of their daughter Susie, who currently is age 18. During the year, they cash in $12,000 of the bonds to use for freshman year tuition, fees, and room and board. Of this amount, $5,000 represents interest. Of the $12,000, $8,000 is used for tuition and fees, and $4,000 is used for room and board. Chuck and Luane’s AGI, before the educational savings bond exclusion, is $120,000. Review § 135, and answer the following questions. a. Determine the tax consequences for Chuck and Luane, who will file a joint return, and for Susie. The savings bonds qualify as educational savings bonds. o Paying the tuition and fees ($8,000) for Susie, their dependent, qualifies as higher education expenses. o The room and board of $4,000 does not qualify. Because 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: o $5,000 × ($8,000 ÷ $12,000) = $3,333 b. Assume that Chuck and Luane purchased the bonds in Susie’s name. Determine the tax consequences for Chuck and Luane and for Susie. All of the $5,000 of savings bond interest must be included in Susie’s gross income. o 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. How would your answer to part (a) change if Chuck and Luane filed separate returns? 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. 5-54: Albert established a qualified tuition program for each of his twins, Kim and Jim. He started each fund with $20,000 when the children were 5 years old. Albert made no further contributions to his children’s plans. Thirteen years later, both children have graduated from high school. Kim’s fund has accumulated to $45,000, while Jim’s has accumulated to $42,000. Kim decides to attend a state university, which will cost $60,000 for four years (tuition, fees, room and board, and books). Jim decides to go to work instead of going to college. During the current year, $7,500 is used from Kim’s plan to pay the cost of her first semester in college. Because Jim is not going to college now or in the future, Albert withdraws the $42,000 plan balance and gives it to Jim to start his new life after high school. a. During the period since the plans were established, should Albert or the twins have been including the annual plan earnings in gross income? Explain. All of the plan earnings during this period are excluded from gross income because the expectation is that the entire amount in the accounts will be used for higher education expenses. b. What are the tax consequences to Kim and Albert of the $7,500 being used for the first semester’s higher education costs? Neither Albert nor Kim report gross income associated with the $7,500 because it is used for qualified higher education expenses. c. Because of her participation in the qualified tuition program, Kim received a 10% reduction in tuition charges; so less than $7,500 was withdrawn from her account. Is either Albert or Kim required to include the value of this discount in gross income? Explain. Neither Albert nor Kim will be required to include the 10% discount in gross income. d. What are the tax consequences to Albert and Jim of Jim’s qualified tuition program being closed? Albert’s basis in the account is $20,000. So he must include $22,000 ($42,000 − $20,000) in his gross income. o He is also subject to a 10% additional tax of $2,200, reported on Form 5329. 5-55: How does the tax benefit rule apply in the following cases? a. In 2015, the Orange Furniture Store, an accrual method taxpayer, sold furniture on credit for $1,000 to Sammy. The cost of the furniture was $600. In 2016, Orange took a bad debt deduction for the $1,000. In 2017, Sammy inherited some money and paid Orange the $1,000 he owed. Orange was in the 35% marginal tax bracket in 2015, the 15% marginal tax bracket in 2016, and the 35% marginal tax bracket in 2017. Orange Furniture must include $1,000 in gross income as the recovery of a prior deduction that produced a tax benefit. It should be noted that the original income in 2015 was taxed at 35%, the bad debt deduction reduced taxes at the 15% rate in 2016, and the recovery in 2017 would also be taxed at 35%. o The timing of the income and deductions cost Orange (.35 − .15) × $1,000 = $200. b. In 2016, Marvin, a cash basis taxpayer, took a $2,000 itemized deduction for state income taxes paid. This increased his itemized deductions to a total that was $800 more than the standard deduction. In 2016, Marvin received a $1,600 refund when he filed his 2016 state income tax return. Marvin was in the 15% marginal tax bracket in 2016, but was in the 35% marginal tax bracket in 2017. Marvin must include $800 of the refund in his gross income for 2017 because he received a tax benefit for the deduction in 2016. The other $800 of the refund is not included in his gross income because it did not produce a tax benefit. Marvin suffered an economic loss from the overpayment in 2016, when his marginal tax rate (15%) was lower than in the year of the recovery (35%) of the prior deduction, 2017. c. In 2016, Barb, a cash basis taxpayer, was in an accident and incurred $8,000 in medical expenses, which she claimed as an itemized deduction for medical expenses. Because of the 10%-of-AGI reduction, the expense reduced her taxable income by only $3,000. In 2017, Barb successfully sued the person who caused the physical injury and collected $8,000 to reimburse her for the cost of her medical expenses. Barb was in the 15% marginal tax bracket in both 2016 and 2017. Barb must include $3,000 in her 2017 gross income, the amount of the reduction in taxable income from the medical expenses paid in 2016. The remainder of the amount received can be excluded as resulting from a personal physical injury. 5-57: Vic, who was experiencing financial difficulties, was able to adjust his debts as follows: a. Vic is an attorney. Vic owed his uncle $25,000. The uncle told Vic that if he serves as the executor of the uncle’s estate, Vic’s debt will be canceled in the uncle’s will. When the debt is canceled, Vic’s debt will be canceled in consideration of his service to the estate. o Therefore, the $25,000 debt cancellation must be included in Vic’s gross income when the uncle dies and Vic fulfills his obligation. b. Vic borrowed $80,000 from First Bank. The debt was secured by land that Vic purchased for $100,000. Vic was unable to pay, and the bank foreclosed when the liability was $80,000, which was also the fair market value of the property. Vic’s debt was not canceled. Rather, Vic transferred property in satisfaction of the debt and Vic will have a $20,000 loss ($80,000 − $100,000 basis in the property). c. The Land Company, which had sold land to Vic for $80,000, reduced the mortgage on the land by $12,000. Determine the tax consequences to Vic. The $12,000 reduction in the debt is not included in Vic’s gross income because the debt reduction was made by the seller of the property. Vic must reduce his basis in the property by $12,000.