CONCEPTS IN
FEDERAL TAXATION
September 14,
2012
CHAPTER 3:
INCOME SOURCES
INTRODUCTION
Course: UGBA 121
Section Hours: Friday 3:30 -5PM
Classroom: C220
GSI: Jennifer Chen
Email: jenchen1204@gmail.com
Of fice Hours: By appointment
Reader: Ronald Espinosa
Email: ronald_espinosa@haas.berkeley.edu
HOMEWORK PROBLEMS
Problems
Assignment #3
Chapter 3
P33, 39, 42, 48, 51
#33
In December, Hilga sells her German language translation
business to Chia-Ching. The sales agreement includes a
provision that for an extra $6,000, Hilga will not open another
German language translation business in the area for two years.
Chia-Ching pays Hilga the $6,000 in January. In June, Hilga
opens a European language translation business in a
neighboring state and advertises it in Chia -Ching’s locality. Has
Hilga realized income? If so, when does she realize the income ?
#33
1 . Has there been an increase in wealth?
Yes. Hilga’s wealth has been increased by $6,000.
Income as an increase in wealth:
“any increase in the wealth of the taxpayer that has been realized
is subject to income tax”
2. Is this an arm’s length transaction?
Yes. Hilga’s wealth has increased through an arm’s length
transaction with a third party, which constitutes a realization of
income.
Arm’s length transaction concept:
All parties to the transaction have bargained in good faith and for
their individual benefit, not for the benefit of the transaction
group. Transactions not made at arm’s length are generally given
no tax effect.
#33
Realization of income:
 Constructive receipt—income is credited into accounts or
otherwise made unconditionally available
 Claim of right—realization occurs whenever an amount is
received without restriction as to its disposition
Answer: Hilga has gross income from the receipt of the $6,000
for her agreement not to compete in January.
#33
Additional considerations:
Even though Chia-Ching has legal recourse against Hilga for
violating their agreement, Hilga must recognize the income
because she has receipt of the funds and a claim of right (until
a court decides otherwise) to the money. If in the future, Hilga
has to repay Chia-Ching, she will be allowed a deduction for the
$6,000 payment.
#39
Partha owns a qualified annuity that cost $52,000 . Under the
contract, when he reaches age 65, he will receive $500 per
month until he dies. Partha turns 65 on June 1 , 2012 and
receives his first payment on June 3, 2012. How much gross
income will Partha report from the annuity payments in 2012?
#39
The nontaxable portion of an annuity payment is determined
using the annuity exclusion ratio. To determine the monthly
amount that can be excluded, the recipient divides their
investment in the annuity by the number of months the annuity
is expected to be received. Because the annuity is based on the
life of the taxpayer, the number of months the annuity is
expected to be received determined using the annuity table for
a single taxpayer (Table 3 -1).
Age on Annuity Starting Date
Number of Payments
55 and under
360
56-60
310
61-65
260
66-70
210
71 and over
160
#39
Exclusion Ratio =
Cost of the contract
Number of Payments
Partha is age 65 when he begins receiving the annuity payments and his
expected number of payments is 260. His monthly exclusion of $200 ($52,000
 260 months) represents the monthly return of his $52,000 investment (capital
recovery). Partha must include the remaining $300 of each payment in gross
income because it represents the return on his investment. His 2012 gross
income is $2,100 ($300 x 7 payments):
Monthly amount to be excluded: $52,000  260 = $200
Payment received
Excluded amount
Taxable amount
$ 500
( 200)
$ 300
#42
Hank retires this year af ter working 30 years for Local Company.
Per the terms of his employment contract, Hank is to receive a
pension of $600 per month for the rest of his life. During the
current year, he receives 7 pension payments from Local. At the
time of his retirement, Hank is single and 67 years old .
a. How much taxable income does Hank have if his employer’s plan
was noncontributor y (i.e. Local Company paid the entire cost of the
plan; Hank made no contributions to it) ?
Because Hank has made no investment in the pension, his pension
is fully taxable. The payments by Local constitute compensation to
Hank that is deferred until he begins receiving it. Hank was not
taxed on the pension contributions to the plan as Local made the
payments, therefore everything he receives from the plan is
taxable. In this case, Hank has $4,200 of gross income ($600 x
7).
#42
b. How would your answer change if Hank had contributed
$42,000 to the pension plan? Assume that the $42,000 had
been included in Hank’s income (i.e., he has already paid tax on
the $42,000).
Because Hank has already been taxed on the $42,000 when it
was contributed to the plan, it will not be taxed when it is
withdrawn from the plan (i.e., capital recovery). Using the
annuity exclusion ratio, Hank will exclude $200 ($42,000 ÷
210) of each payment. His gross income from the pension is
$2,800 ($400 x 7).
#42
c. What if Hank had contributed $42,000 to the plan and none
of the $42,000 were taxed (i.e., the tax law allows certain
pension contributions to go untaxed during the contribution
period)?
The payments Hank made to the plan were not taxed when they
were initially earned - they are deferred until he receives the
payments at retirement. Thus, all amounts received from the
pension plan are taxable when received . In this case, Hank has
$4,200 of gross income ($600 x 7).
#48
Pablo wins a new automobile on a television game show. The
car has a listed sticker price of $31 ,500. A dealer advertises
the same car for $30,000. How much income does Pablo have
from the receipt of the car? Explain .
Prizes and awards are taxable. Because the prize was won, it
does not meet the exception for exclusion of certain types of
awards. Pablo is taxed on the fair market value of the car. The
sticker price of $31 ,500 provides only a guide to the fair
market value of the car. However, if the car can be bought in an
arm’s-length transaction at a lower amount than the sticker
price, then that is the value to be included in gross income.
#48
Two exceptions for tax exclusions for certain types of awards:
1. Immediately transfer the prize or award to a government
body or other qualified charitable organization such as a
church, school, or charity.
2. Employee achievement awards that are paid in the form of
property and are based on length of service or on safety
achievements.
#51
Elwood had to retire early because of a job -related injur y. During
the current year, he receives $10,000 in Social Security benefits.
In addition, he receives $6,000 in cash dividends on stocks that he
owned and $8,000 in interest on tax -exempt bonds. Assuming that
Elwood is single, what is his gross income if:
a. He receives no other income?
Elwood’s gross income before considering the taxability of the
Social Security benefits is $6,000; the interest is excluded from
gross income. None of the $10,000 of Social Security benefits are
taxable because his modified adjusted gross income is less than
the $25,000 base amount. Elwood must include the lesser of:
1.
2.
.5 x ($10,000) = $ 5,000
or
.5 x ($6,000 + $8,000 + $5,000 - $25,000) < 0
#51
b. He also receives $11 ,000 in u nemployment compensation?
Elwood’s g ross income increases by t he receipt of t he unemployment
compensation to $17,000 ( $6,000 + $11 ,000). He must include $2,500
of the Social Security in g ross income.
1.
.5 x ($10,000) = $5,000
or
2.
.5 x ($6,000 + $11 ,000 + $8,000 + $5,000 - $25,000)
.5 x ($5,000) = $2,500
Elwood’s g ross income is $19,500 ( $6,000 + $11 ,000 +
$2,500). Because his modified adjusted g ross income of $30,000 is less
t han $34,000, t he 2nd t ier inclusion rule does not apply.
#51
c. He sells some land for $80,000? He paid $45,000 for the land .
Elwood’s gross income is $41 ,000 [($80,000 - $45,000) +
$6,000]. His modified adjusted gross income increases to
$54,000 ($41 ,000 + $8,000 + $5,000) and he becomes subject
to the 2nd tier inclusion rule (>$34,000). Under the first tier
inclusion rule, Elwood would include $5,000 of the Social Security
benefits in his gross income. The lesser of:
1.
.5 x ($10,000) = $5,000
or
2.
.5 x ($41 ,000 + $8,000 + $5,000 - $25,000)
=$14,500
#51
U n d e r t h e 2 n d t i e r i n c l us io n r u le , $ 8 , 5 0 0 o f t h e S o c i a l S e c ur i t y b e n e fi t s a r e i n c l ud e d
in his gross income:
The lesser of:
1.
85% x $10,000 = $8,500
or
2.
The sum of:
a.
8 5 % x ( $ 5 4 , 0 0 0 - $ 3 4 ,0 0 0 )
b.
t h e s m a l le r o f
i.
$5,000
ii.
$4,500
= $ 17 ,0 0 0
= $ 21 ,5 0 0
E l w o od ’ s g r o s s i n c o m e i s $ 4 9 ,5 0 0 ( $ 6 , 0 0 0 + $ 3 5 , 0 0 0 + $ 8 , 5 0 0 )