CHAPTER 4 GROSS INCOME: EXCLUSIONS SOLUTIONS TO PROBLEM...

CHAPTER 4

GROSS INCOME: EXCLUSIONS

SOLUTIONS TO PROBLEM MATERIALS Status: Q/P Question/ Present in Prior Problem Topic Edition Edition

1 Life insurance proceeds and compensation New 2 Income from gifts and bequests Unchanged 23 Gift to employees New 4 Gift versus compensation Unchanged 45 Gift versus compensation Unchanged 56 Life insurance: accelerated death benefits Unchanged 67 Life insurance: transfer for valuable consideration Unchanged 78 Life insurance: cash surrender value and

accelerated death benefits New

9 Scholarship and tuition waiver Unchanged 910 Damages Unchanged 1011 Damages Unchanged 1112 Damages Unchanged 1213 Worker’s compensation Unchanged 1314 Accident and health plan Unchanged 1415 Cafeteria plan New 16 Fringe benefits: no-additional-cost services Unchanged 1617 Fringe benefits: employee discounts Unchanged 1718 No-additional-cost service Unchanged 1819 Qualified employee discounts Unchanged 1920 Issue ID Unchanged 2021 Foreign earned income Unchanged 2122 Taxable versus tax-exempt bonds Unchanged 2223 Patronage dividends and the tax-benefit rule Unchanged 2324 Qualified state tuition program Unchanged 2425 Tax benefit rule Unchanged 2526 Income from discharge of indebtedness Unchanged 2627 Issue ID Unchanged 27

4-1

4-2 2004 Comprehensive Volume/Solutions Manual

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

* 28 Life insurance and inheritance Unchanged 28

29 Life insurance Unchanged 2930 Accelerated death benefits Unchanged 3031 Gifts and fringe benefits Unchanged 3132 Death benefits Unchanged 3233 Life insurance: use of proceeds New 34 Scholarship Unchanged 3435 Scholarship Unchanged 3536 Damages Unchanged 3637 Damages Unchanged 3738 Health insurance, medical reimbursement Unchanged 3839 Fringe benefits Unchanged 3940 Medical reimbursement plan versus flexible

benefits plan Unchanged 40

41 Long-term care insurance benefits Unchanged 4142 Meals and lodging Unchanged 4243 Meals and lodging Unchanged 43

* 44 Accident and health plans, athletic facilities Unchanged 4445 Cafeteria plan and long-term care insurance Unchanged 45

* 46 Fringe benefits versus taxable compensation Unchanged 4647 Flexible benefits plan Unchanged 4748 Fringe benefits Unchanged 48

* 49 Foreign earned income New 50 Tax benefit rule, tax-exempt income Unchanged 50

51 Unrealized gains and losses New 52 Tax-exempt bonds Unchanged 5253 Tax-favored educational savings programs New

* 54 Educational savings bond exclusion Unchanged 5455 Qualified state tuition program Unchanged 5556 Tax benefit rule Unchanged 5657 Income from discharge of indebtedness Unchanged 5758 Income from discharge of indebtedness Unchanged 58

* 59 Cumulative New * 60 Cumulative Unchanged 60 *The solution to this problem is available on a transparency master.

Gross Income: Exclusions 4-3

CHECK FIGURES 28. $12,500. 29.a. $0. 29.b. $0. 30. Selling the life insurance policy

provides $75,000. 31.a. The tips are gross income. 31.b. The tips are gross income. 31.c. The hotel room may qualify for

exclusion as a no-additional-cost service.

32. Include $6,000 in gross income. 33.a. Fay has $0 gross income on the

receipt of the $1.5 million life insurance proceeds.

33.b. $15,000 of interest is included in gross income.

33.c. $0 gain. 34. Room and board of $7,500 is

includible. 35. $2,700 is includible in 2004. 36.a. Liz must include $30,000 in gross

income. 36.b. Yes. 37.a. $150,000. 37.b. $50,000. 37.c. $50,000. 37.d. $30,000. 37.e. $300,000. 38. $3,600. 41. Include $200 in gross income. 42. $110 per month. 43.a. No. 43.b. Yes, $600. 43.c. Lodging no.

43.d. IRS yes; courts no. 44. Decrease in disposable income

$9,832. 45. Initiate a cafeteria plan. 46.a. $9,050; $10,712; $11,015. 46.b. $6,332; $7,495; $7,264. 46.c. $4,550; $4,550; $4,550. 47.a. $1,825. 47.b. $1,825. 47.c. No. 48.a. No exclusion. 48.b. Exclusion allowed. 48.c. Exclusion allowed. 48.d. Exclusion allowed. 48.e. No exclusion for Polly. 49.a. $189,671. 49.b. $195,000. 50. $2,825. 51. $500 in 2003 and $510 in 2004. 52.a. Bond price should decrease. 52.b. Bond price should increase. 54.a. Exclude $3,083. 54.b. Include $5,000 for Susie. 54.c. Include $5,000. 55. Qualified tuition program. 57.a. Additional tax $7,000. 57.b. Fran can defer the tax. 58.a. $0 gross income. 58.b. $6,000. 58.c. $4,000. 59. Refund due for 2003 $345. 60. Refund due for 2002 $1,413.


DISCUSSION QUESTIONS 1. Tom must include $1,000 in gross income; that is, the amount received for services as

executor of his uncle’s estate. The inheritance of $6,000 is excluded from his gross income. pp. 4-2 to 4-4

2. Only Scott is required to include in gross income any of the amounts received. He will

be taxed on the interest portion of each installment payment of the life insurance proceeds or $1,000 a year ($9,000 payment – $8,000 return of capital). Ed received an excludible gift and Amos received an excludible inheritance. The $40,000 of life insurance proceeds is an excludible inheritance for Scott and provides him with a basis of $8,000 for each installment payment ($40,000 ÷ 5 payments). pp. 4-4, 4-5 and 4-8

3. The non-employees can exclude the $60,000 value of the lumber from their gross income

as nontaxable gifts. Employees are not permitted to exclude gifts from their employer from gross income. Therefore, the employees must include the $30,000 value of the lumber in their gross income. p. 4-5

4. The $6,000 of sales commissions earned at the time of Hannah’s death is income in

respect of a decedent and must be included in Wade’s gross income. The $4,000 for hospital expenses may qualify as a gift because it appears to have been paid on the basis of need. The payment may also be excluded as received under a medical reimbursement plan, provided that similar benefits are provided to other employees. pp. 4-5 and 4-6

5. While a payment made under contract cannot be a gift, the absence of a contract does not

make the payment a gift, as indicated in Comm. v. Duberstein. The payment to Abby was not required by a contract, but was intended to compensate Abby for her services and thus would not be a gift. p. 4-5

6. Violet Capital has gross income of $20,000 ($100,000 – $80,000). The fund purchased

the policy and therefore is not eligible for the life insurance proceeds exclusion. Ted has no gross income, assuming that Violet Capital is a “qualified third party” because Ted was suffering from a terminal interest when he sold the life insurance policy to Violet Capital. Therefore, the $80,000 he receives is excluded from gross income as an accelerated death benefit. p. 4-7

7. The proceeds are not excluded from gross income under the § 101 life insurance proceeds

exclusion because Amber receives the proceeds as consideration under the terms of a contract. Amber would compare the amount received with its basis for the loan. p. 4-8

8. Ed must include his realized gain of $6,000 ($45,000 cash surrender value – $39,000

adjusted basis) in his gross income. However, Sarah can exclude from her gross income her realized gain of $6,000 ($45,000 cash surrender value – $39,000 adjusted basis) because she has a terminal illness (i.e., the accelerated death benefits exclusion). What the funds are used for is not relevant in determining the effect on the taxpayer’s gross income. pp. 4-6 and 4-7

9. The tuition waiver could be part of a qualified tuition reduction program. However, José

is allowed to exclude only $1,000 ($4,000 – $3,000) because only $1,000 of the tuition reduction is received in addition to reasonable compensation for José’s services. pp. 4-8 to 4-10

10. All of the amounts received were the result of her physical injury. Therefore, the

following may be excluded from Nancy’s gross income:


Damage award for medical expenses $15,000 Damage award for loss of income 4,000 The punitive damage award of $40,000 must be included in Nancy’s gross income.

pp. 4-11 and 4-12 11. The entire $170,000 must be included in Sara’s gross income. The $45,000 payment was

received on account of an economic injury rather than a physical personal injury and, therefore, the amounts received are subject to tax. Likewise, the $25,000 payment must be included in her gross income because it is not associated with a physical personal injury. The punitive damages are never excludible. pp. 4-11 and 4-12

12. No. The $15 million amount that Wes received is excluded from his gross income as

compensatory physical personal injury damages even though the amount received is based on the projected lost income. The $10 million of punitive damages that Wes receives must be included in his gross income. Sam’s salary of $25 million must be included in his gross income. pp. 4-11 and 4-12

13. The $400 worker’s compensation benefit Jill received is excludible from her gross

income. Holly’s wages are included in her gross income. Jill worked less but was allowed to keep more of what she received. p. 4-13

14. Randy can exclude from his gross income the $1,200 insurance proceeds from the policy

he purchased. Sam is not taxed on the premiums his employer paid, but Sam must include in gross income the $1,200 he collected on the employer-provided policy. pp. 4-13 and 4-14

15. With a cafeteria plan, the employees are able to choose benefits that they consider most

useful in their individual situations. For example, not all employees would need child care benefits, or a young employee might decide she does not need group term life insurance. pp. 4-19 and 4-20

16. The use of the phone would probably qualify as a no-additional-cost service, since the

employee is utilizing the employer’s fixed cost. Thus, none of the $75 is included in Paula’s gross income. p. 4-21

17. The discount Ted receives of $1,600 ($22,000 regular customer cost – $20,400 employee

cost) is a qualified employee discount. Ted’s price for the automobile of $20,400 was greater than the employer’s cost of $20,000. Therefore, Ted is not required to recognize any income from the purchase of the automobile. However, the service contract is treated as his purchasing a service, since his discount is more than 20% of the price charged regular customers. Therefore, Ted must include in his gross income the amount of the discount in excess of 20%.

Ted’s discount ($1,200 – $720) $480 Less: 20% discount ($1,200 X 20%) (240) Excess discount $240

pp. 4-22 and 4-23 18. The use of the country club facilities qualifies by Zack and his family as a no-additional-

cost service. Thus, it is excluded from Zack’s gross income. p. 4-21


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

b. Tom paid $90 for transportation cost and was reimbursed for that amount.

Therefore, Tom’s before-tax cost was $0. However, Tom is required to include the $90 in gross income and thus must pay an additional $24.30 ($90 X .27) tax on the reimbursement, which is his after-tax cost of commuting.

Ted’s after-tax cost of commuting is $0 because he is reimbursed for the out-of-

pocket cost and is not required to include the reimbursement in income. pp. 4-23 and 4-24 20. The issues all relate to whether the employees would realize gross income from the

employer providing the facilities? If the employee does have gross income, the next question is: does the benefit qualify under one of the exclusions provided in the Code?

• Does the employee experience an economic benefit from using the facility?

• Does the walking trail qualify as an excludible “athletic facility”?

• Is the benefit de minimis?

• Is the benefit a no-additional-cost service?

pp. 4-19 and 4-23 21. A possible advantage to taking the three-month job in the foreign country is that Marla

may then satisfy the requirements for the foreign earned income exclusion for all of her earned income for the twelve-month period (i.e., statutory ceiling of $80,000 in 2003). This would be a substantial benefit. pp. 4-26 to 4-28

22. The clients who purchase the tax-exempt bonds should be in the 35% marginal tax

bracket or higher.

(1–X)(.066) = .044

=.066 – .066X = .044

= .66X = .22

X = .33

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

23. The patronage dividend is a recovery of Maria’s feed and fertilizer costs that were

deducted in 2002. The cost of the feed and fertilizer produced a tax benefit in 2002 since the farm produced a $100,000 net profit. Since the patronage dividend is a recovery of a prior deduction, it must be included in Maria’s 2003 gross income under the tax benefit rule. p. 4-29

24. Under the exclusion provision for qualified tuition programs, Rachel is not required to

include anything in gross income since the funds are used for qualified education


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

25. The tax benefit rule is not relevant to this situation. Mary has an adjustment to income

rather than a recovery of a prior deduction. pp. 4-32 and 4-33 26. a. Ida realized $30,000 ($390,000 – $360,000) of income from the early retirement

of the debt. However, rather than recognizing income, Ida reduces the basis of the property that was financed by the debt.

b. If the creditor were a bank rather than the original seller of the ranch, Ida would

be required to include $30,000 ($390,000 – $360,000) in her gross income. pp. 4-33 and 4-34 27. Harry needs to identify and resolve the following issues:

• Is the friend forgiving the debt as a gift to Harry?

• Did the mortgage holder sell the property to Harry?

• Is Harry insolvent or undergoing bankruptcy proceedings?

• If Harry must recognize income from the debt cancellation, does he have losses to offset?

• May Harry reduce the basis of the asset rather than recognizing income?

pp. 4-33 and 4-34 PROBLEMS 28. Wilbur must include in gross income the $7,500 of compensation for serving as executor

of his father’s estate and $5,000 from each of the 4 installment payments of the insurance proceeds. Each installment consists of $25,000 of recovery of capital.

Cost of $100,000

Expected return of $120,000 X Payment of $30,000 = $25,000 exclusion Installment payment $30,000 Exclusion (25,000) Include in gross income $ 5,000 pp. 4-4, 4-5, and Chapter 3 29. a. José’s wife is not required to recognize any gross income. The insurance

proceeds were paid to her as the beneficiary upon the death of the insured (José).

b. Cardinal Software Company is not required to recognize any gross income upon the receipt of the $1,000,000 in insurance proceeds as the beneficiary of the life insurance policy. The executive’s estate may have gross income from the receipt of the $1,000,000 in exchange for the deceased executive’s stock.


c. The seller of the land is required to recognize gross income because the insurance proceeds were received for consideration. The amount of the gross income is the excess of the amount realized over the adjusted basis for the installment note receivable.

pp. 4-6 to 4-8

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

31. a. The $36,000 of tips are included in Jim’s gross income. The tips are not gifts

because the payments were in return for services, and thus were not made out of detached and disinterested generosity.

b. The $1,800 of tips are included in Tara’s gross income since the money is

received because of the services provided by Tara, rather than out of detached generosity. The fact that the customer is not required nor expected to make the payments does not change the result.

c. The use of the hotel is not a gift because the property was provided by Sheila’s

employer. The lodging exclusion is not applicable because the housing is not provided as a condition of employment. However, the use of the hotel room may qualify as a no-additional-cost service.

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

32. The accrued vacation and sick leave pay of $6,000 were accrued at the time of Donald’s

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

33. a. Fay is the beneficiary of the life insurance policy and can exclude the proceeds of $1.5 million from her gross income.

b. The $15,000 of interest earned on the life insurance proceeds left with the insurance company is included in Fay’s gross income.

c. Fay did not recognize a gain on the bargain purchase. Fay simply got a good price on the purchase under an arm’s length contract.


pp. 4-6 to 4-8 34. The $9,000 received for tuition, fees, books, and supplies can be excluded as a

scholarship. The $7,500 received for room and board must be included in gross income. The athletic scholarship is considered a payment to further the recipient’s education and is not compensation for services. pp. 4-9 and 4-10

35. Alejandro received a total of $11,000 and spent $8,300 ($3,100 + $3,200 + $900 +

$1,100) on tuition, books, and supplies. The amount received for room and board is not excludible. Therefore, he must include $2,700 ($11,000 – $8,300) in gross income. When he received the money in 2003, Alejandro’s total expenses for the period covered by the scholarship were not known. Therefore, he is allowed to defer reporting the income until 2004, when all the uncertainty is resolved. pp. 4-9 and 4-10

36. a. Liz must include in gross income the punitive damages of $30,000. The other

amounts ($8,000 and $6,000) may be excluded as arising out of the physical injury, except the $1,000 amount received for damage to her automobile. This amount is a nontaxable recovery of capital (i.e., it reduces her basis for the automobile by $1,000).

b. The $40,000 is included in Liz’s gross income because it did not arise out of a

physical personal injury. pp. 4-11 and 4-12 37. a. The settlement in the sex discrimination case did not arise out of physical

personal injury or sickness. Therefore, the $150,000 is included in Eloise’s gross income.

b. The damages to Nell’s personal reputation are not for physical personal injury or

sickness. Therefore, Nell must include the $10,000 in her gross income. She must also include the $40,000 punitive damages in her gross income.

c. The damages of $50,000 are included in Orange Corporation’s gross income

under the tax benefit rule, assuming the company received tax benefit from deducting the audit fees in a previous year.

d. The compensatory damages of $10,000 for the physical personal injury are not

included in Beth’s gross income, but the punitive damages of $30,000 must be included in her gross income.

e. Since the compensatory damages of $75,000 arose from a physical personal

injury, they are excluded from Joanne’s gross income. The punitive damages of $300,000 are included in her gross income.

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

38. Rex is required to include in gross income only the $3,600 received from the wage continuation policy (d). This amount is included in his gross income only because the employer paid for the policy. pp. 4-13 to 4-16


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

September 27, 2003 UVW Union 905 Spruce Street Washington, D.C. 20227 Dear Union Members: You asked me to explain the tax consequences of HON Corporation’s proposed changes in the employees’ compensation package. The proposed changes include (1) the imposition of a $100 deductible clause in the medical benefits plan, (2) an additional paid holiday, and (3) a cafeteria plan that would allow the employee to receive cash rather than medical insurance. The deductible clause will cost each employee $100 after-tax. That is, the employee will be required to pay an additional $100 for the same medical benefits that the employee presently receives and, generally, none of the $100 will be deductible in arriving at taxable income. The additional paid holiday will have no effect on after-tax income—the employee’s annual gross income will not change. The cafeteria plan will mean that some employees who now have excess medical coverage can substitute cash for the unneeded protection. The cash received will be taxable, but the employee’s after-tax income will increase. In summary, the change with the broadest tax implications is the imposition of the $100 deductible for medical benefits. The employees would actually be better off with a $100 reduction in cash compensation and no deductible clause. This results because the after-tax cost of a $100 reduction in cash compensation is only $73 [(1 – .27) ($100)], whereas the $100 deductible clause means the employee has $100 less for other goods and services. Also, the cafeteria plan may be important for some employees, depending upon how many of them have working spouses whose employers provided medical benefits for the employee’s entire family. Please contact me if you have any further questions. Sincerely yours, John J. Jones, CPA Partner

pp. 4-13, 4-14, 4-20, and 4-21 40. With a medical reimbursement plan, Mauve would be paying all of the employee’s

medical expenses. The employee would have no incentive to control costs. With the flexible benefit plan, the employee must contribute to the costs through a salary reduction under the flexible benefit plan. Therefore, for this plan the employee has an incentive to minimize costs. pp. 4-13, 4-14, and 4-20


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

• $220 indexed amount for each day the patient receives the long-term care.

• The actual cost of the long-term care.

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

42. The concern in this situation for Tim is that the house will not be considered “on the employer’s premises” in order for Tim to qualify for the meal and lodging exclusion. However, Tim could effectively argue that the house is an extension of the employer’s office because of the extensive business activities (communications, entertaining) conducted in the house. He should be prepared to document the extent of business activities conducted at the house. The presence of an administrative assistant would suggest that much more than incidental business activities are conducted in the home. Gross income would include $110 ($300 – $190) per month because the benefit exceeds the qualified parking monthly exclusion limit of $190. pp. 4-16 to 4-18 and 4-24

43. a. No gross income is recognized since the meals are furnished on the business premises of the employer and for the convenience of the employer.

b. Ira must recognize gross income of $600 per month since the lodging is not required by the employer and, therefore, fails the test for exclusion.

c. Seth recognizes no gross income from the lodging since it is furnished for the convenience of the employer. However, according to one court, the fair market value of the groceries is included in gross income because they do not qualify as “meals.”

d. According to the IRS, a partner is not an employee and, therefore, cannot claim the § 119 exclusion. However, the Tax Court and the Fifth Court of Appeals allow this exclusion. Thus, the taxpayer may win if he is willing to litigate the issue.

pp. 4-16 to 4-18

44. Only Betty can decide whether she should take early retirement. However, as an aid in making her decision, you can inform her that her disposable income after the effect of the medical insurance and health club dues will decrease by approximately $819 per month.

Now Retired Salary/retirement $40,000 $24,000 Part-time job -0- 11,000 Social Security tax (3,060) (842) Income tax (.27) (10,800) (9,450) Medical insurance -0- (7,800) Health club dues -0- (600) $26,140 $16,308


Disposal income associated with employment $26,140 Less: Disposable income associated with retirement (16,308) Decrease in disposable income ($ 9,832)

pp. 4-13, 4-14, and 4-19 45. Willis, Hoffman, Maloney, and Raabe, CPAs 5191 Natorp Boulevard Mason, OH 45040

September 27, 2004 Sparrow, Inc. 300 Harbor Drive Vermillion, SD 57069 Dear Management: You asked me to suggest improvements to your company’s employee benefits plan. You mentioned that your employees have varying needs. The Sparrow, Inc. situation is ideal for a cafeteria plan. Each employee could be allowed to decide at the beginning of the year whether he or she would receive a particular benefit (e.g., hospitalization insurance, child care costs) or a cash equivalent. Those who did not need the benefits could receive the taxable cash compensation and those who needed the benefits could receive the nontaxable compensation. However, long-term care insurance cannot be among the benefits of a cafeteria plan. This type of insurance must be provided to all employees in order to be excluded from gross income. Please contact me and we can discuss the details of such a plan. Sincerely, Amy Evans, CPA Partner pp. 4-19 and 4-20

46. a. Employee’s before-tax compensation equivalent to $7,000 exempt compensation: Income groups Low Middle High Benefits $7,000 $7,000 $7,000 Income tax rate 0.15 0.27 0.35 Social Security and Medicare tax rate 0.0765 0.0765 0.0145 Total marginal tax rate (MTR) 0.2265 0.3465 0.3645 MTR + 1 1.2265 1.3465 1.3645 Before tax compensation = [$7,000 + MTR(X)] $9,050 $10,712 $11,015 b. Employer’s cost of before-tax compensation equivalent to $7,000 exempt

compensation:


Before tax compensation = $9,050 $10,712 $11,015 Employer’s Social Security Tax 692 819 160 $9,742 $11,531 $11,175 Less: reduced income tax (.35) (3,410) (4,036) (3,911) Employer’s after-tax cost of taxable compensation $6,332 $ 7,495 $ 7,264 c. Exempt compensation $7,000 $ 7,000 $ 7,000 Less: reduction in income tax (.35) (2,450) (2,450) (2,450) Employer after-tax cost of tax-exempt benefits $4,550 $ 4,550 $ 4,550 d. For an after-tax cost of $4,550 per employee, Redbird can provide tax-exempt

benefits to its employees that are equivalent to before-tax taxable compensation of $9,050, $10,712, and $11,015, respectively, depending on the employee’s marginal tax bracket. It would cost the company $6,332, $7,495, and $7,264, respectively, to provide the taxable compensation equivalent of $7,000 tax-exempt income. Both the employer and the employee benefit from the exemption.

pp. 4-13 and 4-14

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

b. A flexible benefits plan is also referred to as a “use or lose” plan. Since Rosa did

not use the $2,500, she loses this amount. Her out-of-pocket costs are $1,825 ($2,500 – $675).

c. No. Since a flexible benefits plan is a “use or lose” plan, she should contribute

only the amount she expects to use to the plan. pp. 4-19 and 4-20 48. a. The football tickets probably do not qualify as a de minimis fringe benefit

exclusion. Their exclusion seems unlikely because it is easy to account for the cost. In addition, Temp. Reg. § 1.132–6T(f)(2) specifically provides that season tickets to sporting events do not qualify as de minimis fringes. p. 4-23

b. Parking is a qualified transportation fringe and, thus, can be made available in a

discriminatory manner. Therefore, the $1,200 is not taxable because it is less than the $190 per month limit on the exclusion. pp. 4-23 and 4-24

c. Other employee’s use of the copying machine may be a de minimis fringe, but

Polly’s use was probably so extensive that it will not qualify for this exclusion. However, Polly may be able to relate these expenses to the company’s business. The company benefits from her involvement with the trade association and, thus, the company could justify the expenses under § 162 (see Chapter 5). The $900 is the company’s expense and not Polly’s income. The expenses should qualify as a working condition fringe because Polly could deduct the expenses if she had paid them. p. 4-23

d. The freight is a no-additional-cost benefit made available to all employees

(nondiscriminatory). The $600 can be excluded. p. 4-21


e. The plan is discriminatory. Therefore, the highly compensated employees must pay tax on all of their discounts. Polly includes $400 in her gross income. pp. 4-22 to 4-25

49. a. For the 12-month period ending June 30, 2004, George satisfies the 330 day

requirement (i.e., was in London and Paris for 366 days). Therefore, he qualifies for the foreign earned income exclusion treatment for this period which includes 184 days in 2003. For 2003, George can exclude the following amount from his gross income:

184 days

X $80,000* = $40,329 365 days *Lower of earned income of $230,000 or statutory ceiling of $80,000 for 2003. George must include $189,671 ($230,000 – $40,329) in his gross income for

2003. b. For the 12-month period ending December 31, 2004, George satisfies the 330 day

requirement (i.e., was in London and Paris for 366 days). Therefore, he qualifies for the foreign earned income exclusion treatment for this period which includes 366 days in 2004. For 2004, George can exclude the following amount from his gross income:

366 days

X $80,000* of salary = $80,000366 days *Lower of earned income of $275,000 or statutory ceiling of $80,000 for 2004. George must include $195,000 ($275,000 – $80,000) in his 2004 gross income. pp. 4-26 to 4-28 50. Hazel must include all of the items in gross income, except the interest received of $900

on Augusta County bonds. The patronage dividend is included in gross income under the tax benefit rule because the dividend is a recovery of costs deducted in a prior year. All other items are simply gross income not otherwise excluded. Therefore, Hazel must include in gross income $2,825 ($600 + $500 + $125 + $1,600). pp. 4-28 and 4-29

51. Ezra’s gross income for 2003 is $500, his share of the fund earnings which he invested in

additional shares in the fund. The change in value of his share of the fund is not a realized gain in 2003. Therefore, nothing is recognized by him from the increase in the value of the fund in 2003. His 2004 gross income is $510. He is not allowed to deduct the unrealized loss from the decrease in the value of his share of the fund because the loss was not realized. pp. 4-29 and 4-30

52. a. The price of the bond should decrease because the value of the exemption from

Federal income taxes has decreased. Before the change in tax rates, the after-tax yield on the corporate bond was (1 – .396)(.10) = .0604. After the change in tax rates, the after-tax yield on the corporate bond increased to (1 – .386)(.10) = .0614. With no change in the interest paid on the Virginia bonds, the yield on the Virginia bond is still 6%. The price of those bonds should decrease, increasing the yield to come closer to the after-tax yield on the corporate bond.


b. The decrease in the state income tax should increase the after-tax yield and therefore the market price of the bond should increase.

pp. 4-28 and 4-29 53. Willis, Hoffman, Maloney, and Raabe, CPAs 5191 Natorp Boulevard Mason, OH 45040

September 7, 2003 Ms. Lynn Schwartz 100 Myrtle Cove Fairfield, CT 06432 Dear Lynn: You asked me to consider the tax-favored options for accumulating the funds for Eric’s college education. An added complication (and opportunity for tax planning) in your case is that the funds will come from your parents who are in a much higher tax bracket than either you or Eric. Various options are discussed below. Within some of the options, there are sub-options available; that is, your parents could give the funds to you or to Eric before the investments are made.

• Your parents could purchase stock certificates, bonds, certificates of deposit, or other investments in Eric’s name with them as custodian. The income would be subject to the Eric’s marginal tax rate after he is allowed a $750 standard deduction. This option provides the maximum flexibility while removing the income from your parents’ high marginal tax bracket.

• Your parents could buy tax-exempt bonds and accumulate the interest, which is excludible from gross income. However, the rate of return on the investment may be much lower than could be obtained with taxable options.

• Your parents may give the $4,000 a year to you and you could purchase Series EE bonds in your name and use the proceeds to pay Eric’s educational expenses. No tax will be due on the interest. This option would not be available if your parents purchased the bonds because the exemption is not available to taxpayers in your parent’s income class. That is, the potential exclusion would be completely phased out for your parents.

• Your parents could invest the funds in Connecticut’s Qualified Tuition Program. This program provides a hedge against inflation in tuition cost, but little or no other return on the investment. The earnings of the fund, including the tuition savings, will not be included in gross income provided the contribution and earnings are used for qualified education expenses.

• Your parents could give you $4,000 a year, from which you can contribute $2,000 to a Coverdell Education Savings Account (CESA) for Eric. Your parents could not create the account and make the direct contributions because such plans are not available to taxpayers in their income class. The funds earnings will not be taxed to you or Eric provided the entire account balance is used for qualified education expenses. This would give you substantial control over the funds, with relative assurance that the financial means for the college education will be available. The


other $2,000 your parents are willing to contribute each year could be used in any of the other options.

If I can be of further assistance in helping you to make this decision and explain the options to your parents, please call me.

Sincerely your,

John J. Jones, CPA Partner

pp. 4-30 and 4-31 54. a. The savings bonds qualify as educational savings bonds. The savings bonds were

issued to Chuck and Luane who were at least 24 years of age (actually older) and the savings bonds were issued after 1989.

Paying the tuition and fees ($8,000) for Susie, their dependent, qualifies as higher

education expenses. The room and board of $4,000 does not qualify. Since the redemption amount ($12,000) exceeds the $8,000 of qualified higher education expenses, only part of the interest qualifies for exclusion treatment as follows:

$5,000 X ($8,000 ÷ $12,000) = $3,333 Since their modified adjusted gross income (MAGI) of $90,000 exceeds the

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

MAGI $90,000 Less: Threshold amount (87,750) Excess over threshold amount $ 2,250 The amount of the potential exclusion that is phased out is as follows: $3,333 X ($2,250 ÷ $30,000) = $250 Thus, Chuck and Luane can exclude $3,083 ($3,333 – $250) of the savings bond

interest received and $1,917 ($5,000 – $3,083) must be included in their gross income.

b. All of the $5,000 of savings bond interest must be included in Susie’s gross

income. The educational savings bond exclusion under § 135 applies only if the savings bonds are issued to an individual who is at least age 24 at the time of issuance.

c. If Chuck and Luane file separate returns, they do not qualify for exclusion

treatment under § 135. Thus, they must include the $5,000 of savings bond interest in their gross income.

pp. 4-30 and 4-31 55. The Qualified Tuition Program is the slightly preferable investment in terms of return on

investment. The compounded value of the bond fund at the end of the 8 years is expected to be $5,760 ($4,000 X 1.44). The Qualified Tuition Program will pay $6,000 for the


son’s tuition, and the son does not include anything in his gross income. Thus, the after-tax proceeds will be $6,000. It should be noted that the Qualified Tuition Program also provides a hedge against even greater possible increases in tuition. p. 4-31

56. The receipts in a. and d. represent possible recoveries of deductions taken in prior years.

If Wilma had sufficient income to utilize the deductions in the previous year, the $5,000 and $400 in recoveries must be included in gross income under § 111.

The receipts in b. and c. are not taxable. The amount paid to the attorney was not

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

57. a. If Fran retires the debt on the residence, she must recognize $20,000 as income from discharge of indebtedness. She would be required to pay $7,000 ($20,000 X 35%) of additional income tax in the year the debt is retired. Thus, she must pay $7,000 to reduce future after-tax interest expense of 5.2% [(1 – .35)(.08)] of the outstanding principal and to retain the other $20,000 that would otherwise be paid as principal on the debt.

b. This alternative yields the same result as a., except Fran can choose to reduce her

basis in the business assets instead of recognizing $20,000 income, assuming the liability is qualified business indebtedness. The basis reduction is, in effect, a deferral of the tax (that will be paid when the asset is sold or as depreciation deductions are reduced). Fran should retire the mortgage on the business property and thus defer the tax on the $20,000 gain.

pp. 4-33 and 4-34

58. a. Father’s admonishment clearly indicates that he is making a gift to Robin.

Therefore, Robin does not include the $10,000 in his gross income.

b. The corporation’s cancellation of the $6,000 debt is income from discharge of indebtedness to Robin. (Note that if the debt was not actually cancelled, but Robin never attempted to pay it, the IRS would treat the loan as a dividend).

c. The $12,000 reduction in the debt owed to the seller (Trust Land Company) is not

included in Robin’s gross income. Instead, his basis in the land must be reduced by the amount of the debt cancelled. Robin must include $4,000 in gross income from the cancellation of the $4,000 liability for accrued interest. This is a recovery of a prior deduction and is subject to the tax benefit rule.

pp. 4-33 and 4-34


CUMULATIVE PROBLEMS 59. Part 1—Tax Computation

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

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

(1) Since Martin satisfies the 330 out of 365 day requirement, he qualifies for the

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

(2) The $200 interest on the U.S. savings bonds is included in gross income as well

as the $300 interest on the Bahamian bank account. Only the $400 interest on the Montgomery County school bonds can be excluded.

(3) The state income tax refund is included in gross income under the tax benefit rule

because the state income taxes were taken as an itemized deduction in 2002. (4) The fair market value of the stock dividend is not included in gross income, since

no option was available for receiving cash. (5) Their filing status is married filing jointly.

Tax on $47,450 = $6,517 On ($55,368 – $47,450) X 27% = 2,138

$8,655


Part 2—Tax Planning

Willis, Hoffman, Maloney, and Raabe, CPAs 5191 Natorp Boulevard

Mason, OH 45040

December 29, 2003 Mr. and Mrs. Martin S. Albert 512 Ferry Road Newport News, VA 23100 Dear Mr. and Mrs. Albert: You asked me to determine the after-tax effect of a $500 increase in your monthly mortgage payment as the result of buying another house. The $500 increase in your monthly mortgage payment will result in approximately a $350 monthly increase in mortgage interest and property tax deductions. As the payments are made on the mortgage, the interest portion will decrease and the principal portion will increase over the next several years. You are in the 27% marginal tax bracket in 2003 you should be in the 26% bracket in 2004 and 2005 and the 25% bracket in 2006 and thereafter, unless there is a substantial change in your income. Therefore, the increase in after-tax payments in 2004 and 2005 would be $409 [$500 – ($350 X 26%)] and in 2006 and thereafter would be $413 [$500 – ($350 X 25%)].

I hope this will help you make your decision. If you have any further questions, please contact me.

Sincerely yours, John J. Jones, CPA Partner

60. Gross income:

Salary ($65,000 + $37,000) $102,000 Group term life insurance (Note 1) 96 Dividends 1,800 State tax refund (Note 2) 1,200 $105,096 Deductions for adjusted gross income: Alimony paid (Note 3) (9,600) Adjusted gross income $ 95,496 Itemized deductions:

State income taxes ($3,400 + $2,200) $5,600 Home mortgage interest 4,300 Real estate taxes 1,200 Cash contributions 1,000 (12,100) Personal and dependency exemptions ($3,000 X 2) (6,000) Taxable income $ 77,396


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

See the tax return solution beginning on p. 4-21 of the Solutions Manual. Notes

(1) Group term life insurance results in gross income for Alfred of $96 as follows:

($130,000 – $50,000)

$1,000 X $.10 X 12 months = $96

(2) Under the § 111 tax benefit rule, Alfred must include the $1,200 state tax refund is his gross income. Beulah is not required to include her refund in her gross income because she claimed the standard deduction in 2001 and thus did not get a tax benefit from the state income taxes paid.

(3) The $9,600 is deductible alimony. The $50,000 payment is a property settlement

and is not deductible by Alfred. (4) The tax liability on taxable income of $77,396 is calculated using the Tax Table

for married filing jointly and the amount is $14,687.


60.


60. continued

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