CHAPTER 1
INTRODUCTION TO TAXATION
SOLUTIONS TO PROBLEM MATERIALS
Question/
Problem
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Status:
Present
Edition
Topic
Effect of state and local taxes on decision making
Unchanged
History of Federal income tax
Unchanged
Tax structure
Unchanged
Use taxes
Unchanged
Inheritance and estate taxes compared
Unchanged
Cumulative nature of the Federal gift tax
Unchanged
Federal gift tax and use of annual exclusions
Unchanged
Advantage of Federal gift tax election for spouses to Unchanged
split gifts
Ethics problem
Unchanged
Issue recognition
Unchanged
Issue recognition
Unchanged
Issue recognition
New
Ad-valorem on realty: effect of tax holiday
New
Proportional versus progressive tax
Unchanged
FICA and FUTA compared
Unchanged
Issue recognition
Unchanged
Issue recognition
Unchanged
General sales tax: excluded items
Modified
Income tax computation
Modified
Entity choice
Unchanged
Entity choice
Unchanged
Implicit tax
Unchanged
Tax rate determination
Unchanged
Tax rate determination
Unchanged
Justification for annual exclusion
New
Justification for several tax provisions
Unchanged
Economic and social considerations: home ownership Unchanged
Wherewithal to pay
Modified
Mitigating the effect of the annual accounting
Unchanged
period concept
Coping with inflation: indexation procedure
Unchanged
1-1
Q/P
in Prior
Edition
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2003 Entities Volume/Solutions Manual
Question/
Problem
31
32
Topic
Internet activity
VAT versus national sales tax: expected taxpayer
compliance compared
Status:
Present
Edition
Q/P
in Prior
Edition
New
Unchanged
32
Unchanged
1
Bridge Discipline
Problem
1
Bridge to Economics
PROBLEM MATERIAL
1.
Some tax considerations Aqua should investigate include the following:

State and local income taxes.

State and local sales taxes.

State and local property taxes.
Many such taxes could affect any cost-of-living differential. pp. 1-5, 1-12, 1-13, and 1-18
2.
This is not the case. During the Civil War, both the Federal Union and the Confederate
States of America had an income tax. Furthermore, an income tax was reenacted in 1894.
It was this tax that was held to be unconstitutional by the U. S. Supreme Court and
ultimately led to the passage of the Sixteenth Amendment. pp. 1-15 to 1-18
3.
Except for the Federal estate and gift taxes, all excise taxes are proportional. This is also
the case with ad valorem property taxes. Besides the Federal estate and gift taxes,
income taxes are progressive. pp. 1-4 and 1-17
4.
Jim probably will be required to pay the Washington use tax if, and when, he applies for
Washington license plates. In this case, the use tax probably is the same amount as the
Washington sales tax. p. 1-5 and Example 5
5.
An inheritance tax is a tax on the right to receive property due to the death of another. As
such it is a tax on the heir. An estate tax is a tax on the right to pass property by death. As
such, it is a tax on the decedent. The Federal government levies an estate tax. States levy
inheritance or estate taxes or both. pp. 1-9 and 1-10
6.
Since the gift tax is cumulative in effect, the 2000 taxable gift must be added to the 2002
taxable gift. As the tax rates are progressive, the tax on $500,000 is $155,800. From this
amount is subtracted the amount paid on the 2000 gift. Thus, $85,000 ($155,800 $70,800) is the amount of tax due on the 2002 gift. p. 1-11 and Example 12
7.
16 (donees) X $11,000 (annual exclusion) X 10 years = $1,760,000.
Example 14
p. 1-11 and
Introduction to Taxation
8.
The special election allows one-half of the gifts made by the donor-spouse to be treated
as being made by the nondonor-spouse. The effect of this election to split gifts of
property made to third persons is to increase the number of annual exclusions available
and to allow the use of the nondonor-spouse’s unified transfer tax credit. p. 1-11
9.
In all probability, the residence was not on the property tax rolls when it was owned by a
tax-exempt organization (i.e., St. Matthew's Catholic Church)—see p. 1-12 in the text.
Also clear is the fact that the taxing authority is not aware that the residence is no longer
owned by a tax-exempt organization.
Since it is only a question of time before the omission is noticed by the taxing authority,
it would be advisable for the Toth's to get the matter cleared up. In many cases, further
delay can lead to additional interest and penalties. pp. 1-12 and 1-13
10.
Gull Company is trying to minimize the value of the real estate. This can be done by
keeping personalty from becoming a “fixture.” The jurisdiction where the building is
situated probably imposes an ad valorem tax on realty that is higher than that imposed on
personalty. pp. 1-12 and 1-13
11.
Probably John has no desire to experience the trouble and expense of paying the income
taxes imposed by other states and many cities. By limiting his performances to Las
Vegas, he avoids state and local income taxes. pp. 1-17 and 1-18
12.
Property owned by churches and various other charitable organizations often are not
included on the tax roll and are, therefore, not subject to ad valorem taxes. This probably
was the case of the parsonage. Furthermore, it appears that the taxing authorities are not
aware that the property is no longer entitled to a charitable exemption. Once this is
discovered, Curtis can expect to be assessed for back taxes and, perhaps, interest and
penalties. pp. 1-12 and 1-13
13.
One way to resolve an anticipated power shortage would be to offer generous tax
holidays to those who build and operate power generating facilities within the taxing
jurisdiction. p. 1-12
14.
As the Medicare tax component of the FICA tax rate is constant, the tax is proportional.
pp. 1-3, 1-8, and Example 3
15.
a.
The FICA tax burden is shared by both employer and employee, while the
incidence of FUTA falls entirely on the employer. pp. 1-8 and 1-9
b.
The justification for FICA is to provide retirement and disability security. FUTA,
on the other hand, is designed to provide modest unemployment benefits. p. 1-8
and 1-9
c.
For 2002, the FICA tax rate on employees and employers is 6.2 percent of wages
up to a maximum base amount of $84,900 and 1.45 percent on all wages (no limit).
FUTA applies at a maximum rate of 6.2 percent on the first $7,000 of covered
wages. p. 1-8 and 1-9
16.
In some states, counties (and cities) are given the option to impose additional sales tax
levies. It is possible that this is the situation with Wilson County. If so, this would
explain why Velma does her shopping in Grimes County. p. 1-5 and Example 4
1-3
1-4
2003 Entities Volume/Solutions Manual
17.
Earl probably purchased his computer out-of-state by use of a catalog or through the
Internet. In such cases, state collection of the sales (use) tax is improbable without
taxpayer compliance. p. 1-5
18.
Paul undoubtedly purchased some items (e.g., drugs) that are excluded from the purview
of the applicable general sales tax. p. 1-5
19.
a.
Using the individual income tax formula in Figure 1-2, Jill’s taxable income is
computed as follows:
Income broadly conceived
Less: exclusions
Gross income
Less: deductions for AGI
AGI
Less: greater of
Itemized deductions
Standard deduction
Less: personal exemption
Taxable income
$220,000
(30,000)
$190,000
(38,000)
$152,000
20,000
4,700
(24,700)
(3,000)
$124,300
Using the Tax Rate Schedule X inside the front cover of the textbook, Jill’s total
tax liability for 2002 would be $31,605 ($14,625 + 0.30 [$124,300 – $67,700]).
This tax liability of $31,605 would then be reduced by the tax credits of $19,000 to
$12,605. The $30,395 excess of estimated tax payments of $43,000 over the
$12,605 could be refunded or applied to the next year's tax liability.
b.
If Jill were a corporation, her taxable income would be computed using the formula
in Figure 1-1, as follows:
Income broadly conceived
Less: exclusions
Gross income
Less: deductions
Taxable income
$220,000
(30,000)
$190,000
(58,000)
$132,000
Note that the corporation receives no personal exemption and that no distinction is
made between deductions for and from AGI. Using the corporate tax rate schedule
inside the front cover of the textbook, Jill’s total tax liability for 2002 is $34,730.
$50,000
25,000
25,000
32,000
X
X
X
X
15%
25%
34%
39%
= $ 7,500
= 6,250
= 8,500
= 12,480
$34,730
This tax liability would then be reduced by the tax credits of $19,000 to $15,730
($34,730 - $19,000). The $27,270 excess of estimated tax payments of $43,000
over the $15,730 could be refunded or applied to next year’s tax liability.
pp. 1-16 and 1-17
Introduction to Taxation
20.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
February 25, 2002
Cynthia Clay
1206 Seventh Avenue
Fort Worth, TX 76101
Dear Cynthia:
I am writing this letter to help you decide on what form of entity to choose for your new
sandwich delivery business. In our phone conversation, you indicated that you expect to
have losses for the first two years in this business and then make substantial profits in
subsequent years. You and Cory also indicated that you are concerned about potential
personal liability.
While I can’t make a conclusive recommendation based on the information you have
given me, I can provide you with some general guidelines that should simplify your
decision. First, given your concern about personal liability, a partnership does not appear
to be a desirable option (you would both be personally liable for any injuries to
customers). Similarly, given your expectation of losses in the first two years, it does not
appear that a regular “C” corporation would be a desirable choice, at least initially. This
is because any losses in the corporation could only be used to offset future corporate
profits—you could not use the losses to immediately offset your personal tax liability.
Thus, two choices exist which provide limited liability and deductibility of losses on your
personal income tax return. These are the “S” corporation and the limited liability
company. If you choose an “S” corporation, we would probably convert the entity to a
“C” corporation when the business becomes profitable. At that point, profits would be
taxed at the regular “C” corporation rates. A second tax would be levied on your personal
income tax return for any dividends paid by the corporation once it achieves “C” status.
In contrast, limited liability companies are taxed like partnerships—all income would be
taxed on your personal income tax return in profitable years. The relative desirability of
each of these two forms depends on a number of factors. One of the most important
factors in your situation is the relationship between your personal tax rate and the tax rate
of a regular “C” corporation. If you are in a high tax bracket and if the income in the
business is sufficiently low, you might be best off choosing the “S” corporation.
Alternatively, if you expect the business to generate a sufficiently large profit each year,
it might be best to choose the limited liability company.
If you would like me to give you a clearer recommendation, we should meet at your
earliest convenience. If you have any additional questions, please call me.
1-5
1-6
2003 Entities Volume/Solutions Manual
Best regards,
Julian Jackson, CPA
pp. 1-18 to 1-21
21.
a.
2002
2003
2004
Corporate Tax Liability
Sales Revenue
Cash Expenses
Depreciation
Taxable Income
Corporate Tax Liability
$150,000 $320,000 $600,000
(30,000) (58,000) (95,000)
(25,000) (20,000) (40,000)
$95,000 $242,000 $465,000
$20,550 $ 77,630 $158,100
Cash Available for Dividends
Sales Revenue
Tax-Free Interest Income
Cash Expenses
Corporate Tax Liability
Cash Available for Dividends
$150,000 $320,000 $600,000
5,000
8,000
15,000
(30,000) (58,000) (95,000)
(20,550) (77,630) (158,100)
$104,450 $192,370 $361,900
Ashley's After-Tax Cash Flow
Dividend Received
Tax on Dividend
After-Tax Cash Flow
PV of Cash Flow
Present Value
$104,450 $192,370 $361,900
(36,558) (67,330) (126,665)
$ 67,892 $125,040 $235,235
$ 61,721 $103,333 $176,732
$341,786
b.
2002
Individual Tax Liability
Sales Revenue
Cash Expenses
Depreciation
Taxable Income
Individual Tax Liability
2003
2004
$150,000 $320,000 $600,000
(30,000) (58,000) (95,000)
(25,000) (20,000) (40,000)
$ 95,000 $242,000 $465,000
$ 33,250 $ 84,700 $162,750
Ashley's After-Tax Cash Flow
Sales Revenue
$150,000 $320,000 $600,000
Tax-Free Interest Income
5,000
8,000
15,000
Cash Expenses
(30,000) (58,000) (95,000)
Individual Tax Liability
(33,250) (84,700) (162,750)
Introduction to Taxation
After-Tax Cash Flow
PV of Cash Flow
Present Value
c.
$ 91,750 $185,300
$ 83,410 $153,132
$504,944
1-7
$357,250
$268,402
If Ashley wants to have access to all available cash from the business, then she will
have to pay out dividends annually. As seen in the answers to a and b above, the
present value of future cash flows is substantially greater if she does not
incorporate under this assumption. Alternatively, if she does not need to pay out
dividends, then she may be better off by incorporating, since only the corporate tax
will be incurred, which is less than her individual tax. The value of her stock will
increase and she can then sell the stock at a later date at favorable capital gains
rates.
pp. 1-18 to 1-21
22.
a.
The implicit tax rate on the Kiowa County bonds is (8% - 5%) / 8%, or 37.5%.
Implicit tax can be thought of as the tax rate that would generate the tax-free return
if it were applied to the taxable bond.
b.
Given that Sienna only faces a 25% marginal tax rate, the tax-free bonds would not
be a good investment because the implicit tax rate is too high.
p. 1-23 and Example 23
23.
Without the new product line, Chartreuse would offset all of its 2002 and 2003 income
with the NOL carryforward and would have no regular tax liability until 2004. With the
new product line, Chartreuse would have taxable income of $20,000 ($50,000 income $30,000 NOL carryforward) in 2003. That is, all $70,000 of 2002 income would be offset
by the NOL carryforward and $30,000 of the 2003 income would be offset. Assuming no
changes in corporate tax rates, Chartreuse would face a 0% tax rate in 2002 and a 15%
tax rate in 2003 if the new product line were chosen versus a 0% tax rate if the line were
not chosen. The tax rate faced in 2003 in the new product line would be the discounted
value of the 15% rate over one year. For example, assuming a 10% discount rate, the tax
rate would be 13.6% (15% / 1.1). pp. 1-22 and 1-23 and Example 22
24.
Using the corporate tax rate schedule inside the cover of the textbook, Mauve’s tax
liability (on $105,000) is $24,200. Since Mauve would pay $0.39 on the next dollar of
taxable income earned, its marginal tax rate is 39%. Its average tax rate is the ratio of tax
liability to taxable income or approximately 23% ($24,200 / $105,000). Its effective tax
rate is the ratio of tax liability to total income or approximately 20% ($24,200 /
$120,000). p. 1-23 and Example 21
25.
The purpose of the annual exclusion is to avoid the need to report and pay taxes on
modest gifts. Without the exclusion, the IRS could have a real problem of taxpayer
noncompliance. p. 1-33
26.
a.
Control of the economy. Lower tax rates, for example, lead to additional spendable
funds. p. 1-26
b.
Encourages saving and is socially desirable to provide retirement funds. p. 1-28
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2003 Entities Volume/Solutions Manual
c.
Encouragement of the farm industry. p. 1-28
d.
Justified by social considerations. p. 1-29
e.
Social considerations dictate that the tax law will not encourage activities that are
contrary to public policy. p. 1-29
27.
The encouragement of home ownership is largely a social consideration. However, the
equitable aspects of providing the home owner a tax benefit that is not available to one
who rents is subject to criticism. pp. 1-29 and 1-30
28.
Under the involuntary conversion provision, Wilma can avoid recognizing $115,000 of
her $135,000 realized gain. She must recognize $20,000 of gain because $20,000 of the
condemnation proceeds were not reinvested in property that is similar or related in
service or use. p. 1-30
29.
The installment method of recognizing gain on the sale of property allows a taxpayer to
spread the tax consequences over the payout period. The harsh effect of taxing all of the
gain in the year of sale is thereby avoided. p. 1-31
30.
Indexation is provided for various components of the Federal income tax structure (e.g.,
tax rates and personal exemptions). p. 1-31
31.
The Internet Activity research problems require that the student access various sites on
the Internet. Thus, each student’s solution likely will vary from that of the others.
You should determine the skill and experience levels of the students before making the
assignment, coaching them where necessary so as to broaden the scope of the exercise to
the entire available electronic world.
Make certain that you encourage students to explore all parts of the World Wide Web in
this process, including the key tax sites, but also information found through the web sites
of newspapers, magazines, businesses, tax professionals, government agencies, political
outlets, and so on. They should work with Internet resources other than the Web as well,
including newsgroups and other interest-oriented lists.
Build interaction into the exercise wherever possible, asking the student to send and
receive e-mail in a professional and responsible manner.
32.
Although a certain amount of noncompliance can be expected to arise in both forms of
taxation, the national sales tax will generate greater opportunity. Since only the ultimate
retailer is responsible for collecting the national sales tax, it is more easily circumvented.
In the case of a VAT, however, complete avoidance usually requires the collusion of
multiple parties. pp. 1-6 and 1-7
BRIDGE DISCIPLINE PROBLEM
1.
Answer will vary with each student.