Chapter 5 Gross Income and Exclusions Discussion Questions 1. [LO 1] Based on the definition of gross income in §61 and related regulations, what is the general presumption regarding the taxability of income realized? §61(a) defines gross income as all income from whatever source derived. Reg. §1.61-(a) provides further insight into the definition of gross income as follows: Gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, or services. Thus, the general presumption regarding any income realized is that it is taxable, unless otherwise excluded by law. 2. [LO 1] Based on the definition of gross income in §61, related regulations, and judicial rulings, what are the three criteria for recognizing taxable income? Based on §61(a), Reg. §1.61-(a), and various judicial rulings, taxpayers recognize gross income when: (1) they receive an economic benefit, (2) they realize the income, and (3) no tax provision allows them to exclude or defer the income from gross income for that year. 3. [LO 1] Describe the concept of realization for tax purposes. As indicated in Reg. §1.61-(a), the tax definition of income adopts the realization principle. Under this principle, income is realized when: (1) a taxpayer engages in a transaction with another party, and (2) the transaction results in a measurable change in property rights. In other words, assets or services are exchanged for cash, claims to cash, or other assets with determinable value. The concept of realization for tax purposes closely parallels the concept of realization for financial accounting purposes. Requiring a transaction to trigger realization reduces the uncertainty associated with determining the amount of income because a change in rights can typically be traced to a specific moment in time and is generally accompanied by legal documentation. 4. [LO 1] Compare and contrast realization of income with recognition of income. Realization is a judicial concept that determines the period in which income is generated, whereas, recognition is a statutory concept that determines whether realized income is going to be included in gross income during the period. Realization is a prerequisite to recognition, and absent an exclusion or deferral provision, recognition is automatic. 5. [LO 1] Tim is a plumber who joined a barter club. This year Tim exchanges plumbing services for a new roof. The roof is properly valued at $2,500, but Tim would have only billed $2,200 for the plumbing services. What amount of income should Tim recognize on the exchange of his services for a roof? Would your answer change if Tim would have normally billed $3,000 for his services? Assuming the roof is properly valued, the taxpayer should recognize the value of the property received or $2,500 regardless of the amount he would have billed. The value of the plumbing services, however, would help determine the value of the roof. 6. [LO 1] Andre constructs and installs cabinets in homes. Blair sells and installs carpet in apartments. Andre and Blair worked out an arrangement whereby Andre installed cabinets in Blair’s home and Blair installed carpet in Andre’s home. Neither Andre nor Blair believes they are required to recognize any gross income on this exchange because neither received cash. Do you agree with them? Explain. Both Andre and Blair are required to recognize gross income equal to the value of the goods and services they received. Reg. §1.61-(a) indicates that taxpayers realize income whether they receive money, property, or services in a transaction. That is, the form of the receipt does not matter. In this case, Andre should report gross income equal to the carpet he received and Blair should report gross income equal to the value of the cabinets he received. 7. [LO 1] What issue precipitated the return of capital principle? Explain. The issue was the amount of income taxpayers must realize when they sell property. Initially, the IRS was convinced that Congress’s all-inclusive definition of income required taxpayers to include all sale proceeds in gross income. Taxpayers, on the other hand, argued that a portion of proceeds from a sale represented a return of the cost or capital investment in the underlying property (called tax basis). The courts determined that when ¬receiving a payment for property, taxpayers are allowed to recover the cost of the property tax free. Consequently, when taxpayers sell property, they are allowed to reduce the sale proceeds by their unrecovered investment in the property to determine the realized gain from the sale. When the tax basis exceeds the sale proceeds, the return of capital principle generally applies to the extent of the sale proceeds. The excess of basis over sale proceeds is generally not considered to be a return of capital, but rather a loss that is deductible only if specifically authorized by the tax code. 8. [LO 1] Compare how the return of capital principle applies when (1) a taxpayer sells an asset and collects the sale proceeds all immediately and (2) a taxpayer sells an asset and collects the sale proceeds over several periods (installment sales). If Congress wanted to maximize revenue from installment sales, how would they have applied the return of capital principle for installment sales? The return of capital principle states that the proceeds from a sale are not income to the extent of the taxpayer’s cost or investment in the asset. When the proceeds are collected over several periods, the return of capital principle is usually modified by the law to provide that the return of capital occurs evenly (pro rata) over the collection period. To maximize revenues, the government might require for the return of capital to occur at the end of the collection; whereas, taxpayers normally prefer for the return of capital to occur at the beginning of the collection period to allow them to defer recognizing income from the transaction. 9. [LO 1] This year Jorge received a refund of property taxes that he deducted on his tax return last year. Jorge is not sure whether he should include the refund in his gross income. What would you tell him? If the refund is made for an expenditure deducted in a previous year, then under the tax benefit rule the refund is included in gross income to the extent that the prior deduction produced a tax benefit. In this case, if Jorge deducted the property taxes (and received a tax benefit or tax savings from the deduction) on his prior year tax return, he must include the refund in his gross income this year to the extent the property taxes resulted in a tax benefit. If he did not deduct property taxes on his tax return last year, he is not required to include the refund in his gross income. 10. [LO 1] Describe in general how the cash method of accounting differs from the accrual method. Under the cash method taxpayers recognize income in the period they receive it. Under the accrual method, they recognize income when they earn it rather than when they receive it. Likewise, cash basis taxpayers are entitled to claim deductions when they make expenditures. Under the accrual method, taxpayers deduct expenses when they incur or accrue the associated expenditure. 11. [LO 1] Janet is a cash-basis, calendar-year taxpayer. She received a check for services provided in the mail during the last week of December. However, rather than cash the check, Janet decided to wait until the following January because she believes that her delay will cause the income to be realized and recognized next year. What would you tell her? Would it matter if she didn’t open the envelope? Would it matter if she refused to check her mail during the last week of December? Explain. The constructive receipt doctrine states that a taxpayer realizes and recognizes income when it is actually or constructively received. Constructive receipt is deemed to occur when the income has been credited to the taxpayer’s account or when the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income. This doctrine prevents Janet, a cash basis taxpayer, from arbitrarily shifting income to a later period by postponing the delivery or acceptance of a payment. It does not matter if she refuses to open the envelope or check her mail, because the income is unconditionally available to her, she is aware of the income’s availability, and there are no restrictions on her control over the income. 12. [LO 1] The cash method of accounting means that taxpayers don’t recognize income unless they receive cash or cash equivalents. True or false? Explain. False - under the cash method, taxpayers recognize income in the period they receive it (in the form of cash, property, or services). 13. [LO 1] Contrast the constructive receipt doctrine with the claim of right doctrine. The constructive receipt doctrine states that a taxpayer realizes and recognizes income when it is actually or constructively received. Constructive receipt is deemed to occur when the income has been credited to the taxpayer’s account or when the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income. In contrast, the claim of right doctrine states that income has been realized if a taxpayer receives income and there are no restrictions on the taxpayers use of the income (for example, the taxpayer does not have an obligation to repay the amount). Thus, the constructive receipt applies where the taxpayer has not yet actually received income (but it has been credited to the taxpayer’s account or is unconditionally available), whereas the claim of right doctrine applies when the taxpayer has received an item of income and the question is whether the taxpayer has an unrestricted right to the income. 14. [LO 1] Dewey is a lawyer who uses the cash method of accounting. Last year Dewey provided a client with legal services worth $55,000, but the client could not pay the fee. This year Dewey requested that in lieu of paying Dewey $55,000 for the services, the client could make a $45,000 gift to Dewey’s daughter. Dewey’s daughter received the check for $45,000 and deposited it in her bank account. How much of this income is taxed, if any, to Dewey? Explain. A cash method taxpayer recognizes income on the value of property received, so $45,000 of income will be recognized in this year. The assignment of income doctrine holds that earned income is taxed to the taxpayer providing the goods or services. Hence, Dewey and not his daughter is taxed on the entire amount of service income. Because the money went to Dewey’s daughter, his daughter will be treated as though she received a gift from Dewey. 15. [LO 1] Clyde and Bonnie were married this year. Clyde has a steady job that will pay him about $37,000, while Bonnie does odd jobs that will produce about $28,000 of income. They also have a joint savings account that will pay about $400 of interest. If Clyde and Bonnie reside in a community property state and file married-separate tax returns, how much gross income will Clyde and Bonnie each report? Any difference if they reside in a common law state? Explain. In a community property state each spouse will report exactly half of the income earned by the other. Hence, Bonnie and Clyde will each report $32,700 ($18,500 + $14,000 + $200). In a common law state, Bonnie will report $28,200 which is her separate income ($28,000) plus half of the joint income ($200). Likewise, Clyde will report $37,200. 16. [LO 2] Distinguish earned income from unearned income, and provide an example of each. Earned income is income derived from services and includes compensation and other forms of business income received by a taxpayer even if the taxpayer’s business is selling inventory. In contrast, unearned income is income derived from property. Salary is a good example of earned income whereas interest is an example of unearned income. 17. [LO 2] Jim purchased 100 shares of stock this year and elected to participate in a dividend reinvestment program. This program automatically uses dividends to purchase additional shares of stock. This year Jim’s shares paid $350 of dividends, and he used these funds to purchase shares of stock. These additional shares are worth $375 at year-end. What amount of dividends, if any, should Jim declare as income this year? Explain. Jim is taxed on $350 of dividend income because under constructive receipt he had the ability or power to obtain or control the dividend income. That is, the tax laws treat the dividend as though Jim received the dividend and then used it to acquire the new stock. The value of the stock at the end of the year is not relevant, because Jim has not realized the appreciation on the stock he purchased. 18. [LO 2] Jerry has a certificate of deposit at the local bank. The interest on this certificate was credited to his account on December 31 of last year but he didn’t withdraw the interest until January of this year. When is the interest income taxed? Jerry should include the interest in gross income last year, because he is a cash method taxpayer, and he is treated as having received the income when it is paid or credited to his account. At that point, he has control over the interest income. 19. [LO 2] Conceptually, when taxpayers receive annuity payments, how do they determine the amount of the payment they must include in gross income? Payments taxpayers receive from an annuity they have purchased consist of both income and return of the initial cost or investment in the annuity. Consistent with the return of capital principle the proceeds are not income to the extent of the taxpayer’s investment in the asset. As proceeds are collected over several periods, the law provides that the return of capital occurs evenly (pro rata) over the collection period for fixed term annuities or over the expected collection period for life annuities. 20. [LO 2] George purchased a life annuity to provide him monthly payments for as long as he lives. Based on IRS tables, George’s life expectancy is 100 months. Is George able to recover his cost of the annuity if he dies before he receives 100 monthly payments? Explain. What happens for tax purposes if George receives more than 100 payments? If George dies before receiving the expected number of payments, the amount of unrecovered investment (the initial investment less the amounts received treated as a nontaxable capital recovery) may be deducted on his final income tax return (as an itemized deduction). Conversely, if George lives longer than his estimated life expectancy, he will receive more than the expected number of payments. The entire amount of these “extra” payments is included in his gross income, because he would have completely recovered his investment in the annuity when he receives the payment in month number 100. 21. [LO 2] Brad purchased land for $45,000 this year. At year-end Brad sold the land for $51,700 and paid a sales commission of $450. What effect does this transaction have on Brad’s gross income? Explain. The sale increases Brad’s gross income by $6,250. The selling expenses reduce the amount realized on the sale from $51,700 to $51,250 and the $45,000 cost of the land is a return of capital. The excess of the amount realized over the cost is included in his gross income ($51,700 - $450 - $45,000 = $6,250). 22. [LO 2] Tomiko is a 50 percent owner (partner) in the Tanaka partnership. During the year, the partnership reported $1,000 of interest income and $2,000 of dividends. How much of this income must Tomiko include in her gross income? Because Tanaka is a partnership (a flow-through entity), Tomiko must include her share of the partnership’s income in her gross income. In this case, Tomiko’s ownership interest is 50%, so she will include $500 of interest income and $1,000 of dividends in her gross income and report it on her tax return just as if she had received these amounts directly. 23. [LO 2] Clem and Ida were married for several years, but in 2018 they finalized their divorce. In the divorce decree, Clem agreed to deed his car to Ida and pay Ida $10,000 per year for four years (but not beyond her death). Did these transfers qualify as alimony for tax purposes? Explain. For tax purposes, alimony is: (1) a transfer that is in cash, under a written separation agreement or divorce decree, (2) the separation or divorce decree does not designate the payment as something other than alimony, (3) in the case of legally separated (or divorced) taxpayers under a separation or divorce decree, the spouses do not live together when the payment is made, and (4) the payments cease upon the recipient's death. Consequently, the four yearly payments qualify as alimony. However, the automobile transfer cannot qualify for alimony, because it was not a cash payment. Because their divorce decree was finalized before January 1, 2019, Ida must include alimony payments of $10,000 in her gross income, and Clem would be allowed to deduct the amount of the alimony payments he makes to Ida as a for AGI deduction. 24. [LO 2] Larry Bounds has won the gold bat award for hitting the longest home run in major league baseball this year. The bat is worth almost $35,000. Under what conditions can Larry exclude the award from his gross income? Explain. Larry must include the value of the award in gross income. There are three specific, narrowly defined exclusions for awards. First, awards for scientific, literary, or charitable achievement (e.g., the Nobel prize) are excluded only if the recipient was selected without any action on his part to enter the contest or proceeding, the recipient is not required to render substantial future services as a condition to receive the prize or award, and the payor of the prize or award transfers the prize or award to a federal, state, or local governmental unit or qualified charity (e.g., church, school, charitable organization, etc.) designated by the taxpayer. The second exception is for employee awards for length of service or safety achievement. These nontaxable awards are limited to $400 of tangible property other than cash per employee per year. The third exclusion is for awards and prizes for Team USA athletes received from the U.S. Olympic Committee for competing in the Olympic or Paralympic games. Obviously, Larry’s award will not qualify under either of these provisions. 25. [LO 2] Rory and Nicholi, single taxpayers, each annually receive Social Security benefits of $15,000. Rory’s taxable income from sources other than Social Security exceeds $200,000. In contrast, the Social Security benefits are Nicholi’s only source of income. What percentage of the Social Security benefits must Rory include in his gross income? What percentage of Social Security benefits is Nicholi required to include in his gross income? Because Rory is a high-income taxpayer, he is required to include 85% of his social security benefits in his gross income. In contrast, because Nicholi is a low-income taxpayer (i.e., his modified AGI plus 50 percent of Social Security benefits is below $25,000), he is allowed to exclude the entire amount of his Social Security benefits from gross income. Two groups can exclude all Social Security benefits. Single taxpayers whose modified AGI plus 50 percent of their Social Security benefits are below $25,000 and married taxpayers whose modified AGI plus 50 percent of their social security benefits are below $32,000. Taxpayers are never required to include more than 85% of Social Security benefits in their gross income no matter how high their income level. 26. [LO 2] Rolando purchases a golf cart from his employer, E-Z-Go Golf Carts, for a sizable discount. Explain the rules for determining if Rolando’s purchase results in taxable income for him. Although the general rule is that bargain purchases by an employee from an employer creates taxable compensation income to the employee, the tax law does provide a limited exclusion for employee bargain purchases. Specifically, employees may exclude: a) a discount on employer-provided goods as long as the discount does not exceed the employer's gross profit percentage on all property offered to sale to customers, and (b) up to 20 percent employer-provided discount on services. Discounts in excess of these amounts are taxable as compensation. Thus, if Rolando purchases the golf cart for a price that equals or exceeds his employer’s cost, the purchase will not result in any taxable income for him. 27. [LO 2] When an employer makes a below-market loan to an employee, what are tax consequences to the employer and employee? The tax law requires the employer-lender and employee-borrower to treat the transaction as if: (1) The employee-borrower paid the employer-lender the difference between the applicable federal interest rate (compounded semiannually) and the actual interest paid (this difference is called “imputed interest”), and then (2) The employer-lender returned the imputed interest to the employee-borrower. The deemed “payment” of the imputed interest in these transactions is treated as interest income to the employer-lender and interest expense to the employee-borrower. The deductibility of the interest expense for the employee-borrower depends on how she used the loan proceeds (for business, investment, or personal purposes). Business interest expense is a deduction for AGI, investment interest expense is an itemized deduction subject to limitations, and personal interest is generally not deductible. The return of the imputed interest from an employer-lender to an employee-borrower is treated by both parties as taxable compensation paid to the employee, 28. [LO 2] Explain why an insolvent taxpayer is allowed to exclude income from the discharge of indebtedness if the taxpayer remains insolvent after receiving debt relief. This provision is meant to provide tax relief to taxpayers experiencing extreme financial difficulties. Taxpayers who are insolvent after being relieved of debt likely do not have the wherewithal to pay taxes on income generated by the debt relief. 29. [LO 3] What are the basic requirements to exclude the gain on the sale of a personal residence? Taxpayers meeting certain home ownership and use requirements can permanently exclude up to $250,000 ($500,000 if married filing jointly) of realized gain on the sale of their principal residence. Gain in excess of the excludable amount generally qualifies as long-term capital gain subject to tax at preferential rates. To satisfy the ownership test, the taxpayer must have owned the residence (house, condominium, trailer, or houseboat) for a total of two or more years during the five-year period ending on the date of the sale. To satisfy the use test, the taxpayer must have used the property as her principal residence for a total of two or more years (noncontiguous use is permissible) during the five-year period ending on the date of the sale. The tax law limits each taxpayer to one exclusion every two years. Married couples filing joint returns are eligible for the full $500,000 exclusion if either spouse meets the ownership test and both spouses meet the principal-use test. However, if either spouse is ineligible for the exclusion because he or she personally used the $250,000 exclusion on another home sale during the two years before the date of the current sale, the couple’s available exclusion is reduced to $250,000. 30. [LO 3] Explain why an employee should be concerned about whether his employer reimburses business expenses using an “accountable” plan? The employee should be concerned because absent an accountable plan, reimbursements are reported as income to the employee and the expense is not deductible. Thus, the reimbursements would be treated as “wages” for purposes of withholding and employment taxes, and the expense would not generate any reduction in taxable income. On the other hand, if the plan qualifies as an accountable plan, reimbursements from the plan are not required to be included in income, but the reimbursed expenses are not deductible, either. 31. [LO 3] Cassie works in an office and has access to several professional color printers. Her employer allows Cassie and her fellow employees to use the printers to print color postcards for the holidays. This year Cassie printed out two dozen postcards worth almost $76. Must Cassie include this amount in her gross income this year? Explain your answer. No - the benefit is considered a nontaxable de minimis fringe benefit because it is small in amount and infrequent. 32. [LO 3] What are some common examples of taxable and tax-free fringe benefits? In addition to paying salary and wages, many employers provide employees with fringe benefits. For example, an employer may provide an employee with an automobile to use for personal purposes, pay for an employee to join a health club, or pay for an employee’s home security. In general, the value of these benefits is included in the employee’s gross income as compensation for services. However, certain fringe benefits, called “qualifying” fringe benefits, are excluded from gross income.4 Exhibit 5-3 lists some of the most common fringe benefits that are excluded from an employee’s gross income. Exhibit 5-3 Common Qualifying Fringe Benefits (excluded from employee’s gross income) Item Description Medical and dental health (§ 106) An employee may exclude from income the cost of medical and insurance coverage and dental health insurance premiums the employer pays on an employee’s behalf. Life insurance coverage (§ 79) Employees may exclude from income the value of life insurance premiums the employer pays on an employee’s behalf for up to $50,000 of group-term life insurance. De minimis (small) benefits § 132(a)(4) As a matter of administrative convenience, Congress allows employees to exclude from income relatively small and infrequent benefits employees receive at work (such as limited use of a business copy machine). Meals and lodging provided for the employer's convenience (§ 119) Employees may exclude employer-provided meals and lodging if they are provided on the employer's business premises to the employee (and spouse and dependents), (2) are provided for the employer's convenience (such as allowing the employee to be on-call 24 hours a day or continue working on-site over lunch), and (3) for lodging only, the employee must accept the lodging as a condition of employment. Employee educational assistance programs (§ 127) Employees may exclude up to $5,250 of employer-provided educational assistance benefits covering tuition, books, and fees for any instruction that improves the taxpayer's capabilities, whether or not job-related or part of a degree program. No additional cost services (§ 132(a)(1)) Employees may exclude the value of services provided by an employer that generate no substantial costs to the employer (such as free flight benefits for airline employees on a space available basis, free hotel service for hotel employees) Qualified employee discounts (§132(a)(2)) Employees may exclude a) a discount on employer-provided goods as long as the discount does not exceed the employer's gross profit percentage on all property offered to sale to customers and (b) up to 20 percent employer-provided discount on services. Discounts in excess of these amounts are taxable as compensation. Dependent care benefits (§129) Employees may exclude up to $5,000 for benefits paid or reimbursed by employers for caring for children under age 13 or dependents or spouses who are physically or mentally unable to care for themselves. Working condition fringe benefits (§132(a)(3)) Employees may exclude from income any benefit or reimbursement of a benefit provided by an employer that would be deductible as an ordinary and necessary expense by the employee if the employee had paid the expense. Qualified transportation benefits (§132(a)(5)) Employees may exclude up to $270 per month of employer-provided parking and up to $270 per month of the combined value of employer-provided mass transit passes and the value of a car pool vehicle for employee use. Cafeteria plans (§ 125) A plan where employees choose among various nontaxable fringe benefits (such as health insurance and dental insurance) or cash. Tax-free to the extent the taxpayer chooses nontaxable fringe benefits. Taxable to the extent the employee receives cash. Flexible Spending Accounts (§ 125) Allow employees to set a portion of their before-tax salary for payment of either health and/or dependent-care benefits. Amounts set aside must be used by the end of year or within the first two and a half months of the next plan year, or employees forfeit the unused balance. In lieu of the two-and-a-half-month grace period each year for health-care flexible spending accounts, employers instead can allow employees to carry over up to $500 of unused amounts to be used anytime during the next year (i.e., it is the employer’s choice). This option does not apply to dependent-care flexible spending accounts. For 2020, the amount of before-tax salary that an employee may set aside for medical expenses is limited to $2,750 and for dependent-care expenses is limited to $5,000. 33. [LO 3] Explain how state and local governments benefit from the provisions that allow taxpayers to exclude interest on state and local bonds from their gross income. State and local governments benefit because it allows them to pay a lower interest rate on the debt because investors are willing to accept the lower rate since they are not taxed on the interest income. 34. [LO 3] Explain why taxpayers are allowed to exclude gifts and inheritances from gross income even though these payments are realized and clearly provide taxpayers with the wherewithal to pay. Gifts and inheritances are taxed by a separate tax system (the unified Federal gift and estate tax). Taxing gifts and inheritances as income to the recipient would subject these payments to double taxation. . 35. [LO 3] Describe the kinds of insurance premiums an employer can pay on behalf of an employee without triggering includible compensation to the employee. Health insurance premiums and a portion of life insurance premiums. The exclusion for health insurance premiums is limited to qualified plans that reimburse medical costs for the employee, spouse, and dependents. The cost of medical coverage paid by an employer and offered through a health insurance exchange is not an excludable benefit unless the employer is a small employer that elects to make all of its full-time employees eligible for plans offered through an exchange. For this purpose, a small employer is an employer that employed an average of at least one but 100 or fewer employees during business days in the prior year, and employs at least one employee on the first day of the plan year. The scope of the exclusion for life insurance premiums is limited to qualified group term policies up to a face amount of $50,000. 36. [LO3] How are state-sponsored 529 educational savings plans taxed if investment returns are used for educational purposes? Are the returns taxed differently if they are not ultimately used to pay for education costs? Investment returns from state sponsored 529 plans are never taxed if used to pay for “qualified higher education expenses” for college students (no annual limit) or for tuition expenses for students at public, private or religious elementary or secondary schools (subject to a $10,000 limit per beneficiary per year). Qualified higher education expenses include tuition, books, supplies, required equipment and supplies, computer equipment and software, and reasonable room and board costs attending a higher education institution. If distributed investment returns are used for any other purpose, or exceed the $10,000 limit for tuition expenses attributable to public, private or religious elementary or secondary schools, the distributee will pay tax on the investment returns in the year received at ordinary rates. In many instances, the distributee will also be required to pay an additional 10% penalty tax in addition to the normal tax on the investment returns. 37. [LO 3] Jim was injured in an accident and his surgeon botched the medical procedure. Jim recovered $5,000 from the doctors for pain and suffering and $2,000 for emotional distress. Determine the taxability of these payments and briefly explain to Jim the apparent rationale for including or excluding these payments from gross income. Payments to compensate taxpayers for personal injuries are excluded from gross income. Payments for emotional distress are included in gross income, unless they are associated with medical expenses or related to physical injuries. In this case all $7,000 is excluded from gross income because Jim’s emotional distress is associated with a physical injury. 38. [LO 3] Tom was just hired by Acme Corporation and has decided to purchase disability insurance. This insurance promises to pay him weekly benefits to replace his salary should he be unable to work because of disability. Disability insurance is also available through Acme as part of its compensation plan. Acme pays these premiums as a nontaxable fringe benefit, but the plan promises to pay about 10 percent less in benefits. If Tom elects to have Acme pay the premiums, then his compensation will be reduced by an equivalent amount. Should tax considerations play a role in Tom’s choice to buy disability insurance through Acme or on his own? Explain. Yes, tax considerations should play a role in the decision. The premiums paid by Acme are excluded from Tom’s gross income, but he must include in gross income any disability benefits he receives from the policy paid for by Acme. In contrast, if Tom pays the premiums, he is allowed to exclude any benefits he receives from the policy. However, he is not allowed to deduct the premium payments (he must pay premiums with after-tax dollars). This increases the effective cost of the premiums relative to the cost of the premiums paid for by Acme. Tom must weigh these tax factors and non-tax factors such as the amount of the benefit under either option among others, when making his decision. PROBLEMS 39. [LO 1] For the following independent cases, determine whether economic income is present and, if so, whether it must be included in gross income (i.e., is it realized and recognized for tax purposes?). a. Asia owns stock that is listed on the New York Exchange, and this year the stock increased in value by $20,000. b. Ben sold stock for $10,000 and paid sales commission of $250. Ben purchased the stock several years ago for $4,000. c. Bessie is a partner in SULU Enterprises LLC. This year SULU reported that Bessie’s share of rental income was $2,700 and her share of municipal interest was $750. a. Economic income of $20,000 is present, but there is no realization for tax purposes. Without realization, there can be no recognition. Hence this will not be included in the gross income. b. Economic income is present and has been realized through the sale. Return of capital limits the addition to gross income to the net gain on the sale, $5,750. The presumption in the law is that realized income is included in gross income. Thus, absent some additional facts which allow the deferral or exclusion of the income, recognition would follow realization, and the income would be taxed. c. Bessie’s share of rental income ($2,700) is included in gross income, and her share of municipal interest ($750) is excluded from her gross income. 40. [LO 1] [Research} Devon owns 1,000 shares of stock worth $10,000. This year he received 200 additional shares of this stock from a stock dividend. His 1,200 shares are now worth $12,500. Must Devon include the dividend paid in stock in income? No, § 305(a) states that dividends paid in stock are generally not included in gross income. If, however, the taxpayer has the option to receive the dividend in cash (instead of stock), the dividend is included in gross income. 41. [LO 1] {Research} XYZ declared a $1 per share dividend on August 15. The date of record for the dividend was September 1 (the stock began selling ex-dividend on September 2). The dividend was paid on September 10. Ellis is a cash-method taxpayer. Determine if he must include the dividends in gross income under the following independent circumstances. a. Ellis bought 100 shares of XYZ stock on August 1 for $21 per share. Ellis received a $100 dividend on September 10. Ellis still owns the shares at year-end. b. Ellis bought 100 shares of XYZ stock on August 1 for $21 per share. Ellis sold his XYZ shares on September 5 for $23 per share. Ellis received the $100 dividend on September 10 (note that even though Ellis didn’t own the stock on September 10, he still received the dividend because he was the shareholder on the record date). c. Ellis bought 100 shares of XYZ stock for $22 per share on August 20. Ellis received the $100 dividend on September 10. Ellis still owns the shares at year-end. a. Ellis has $100 of economic income and includes the $100 dividend in gross income. b. Ellis has $200 of income from the sale of the stock ($2,300-$2,100) that is included in gross income. Ellis also has $100 of income from the dividend, which he also includes in gross income [See Reg. §1.61-9(c).]. c. Ellis owns the XYZ shares on the record date, and received the $100 dividend. Hence, Ellis is taxed on the entire dividend. [See Reg. §1.61-9(c).] 42. [LO 1] {Research} For the following independent cases, determine whether economic income is present and, if so, whether it must be included in gross income. Identify a tax authority that supports your analysis. a. Hermione discovered a gold nugget (valued at $10,000) on her land. b. Jay embezzled $20,000 from his employer and has not yet been apprehended. c. Keisha found $1,000 inside an old dresser. She purchased the dresser at a discount furniture store at the end of last year and found the money after the beginning of the new year. No one has claimed the money. a. Hermione must include the value of the nugget in her gross income. The value of the nugget is realized income because gold is marketable in a nugget form and easily valued. The authorities (Reg § 1.61-14(a).; Rev. Rul. 61, 1953-1 C.B. 17) refer to the finder of a “treasure trove” and hold that there is gross income (to the extent of the ascertainable value in U.S. currency) in the tax year in which the property is reduced to the taxpayer’s undisputed possession. b. Jay might argue that no economic income is present because there is a liability to return the embezzled funds. The IRS argues that Jay does not intend to return the funds, so no liability exists at the time of the embezzlement, and therefore, income is present in that period. The Supreme Court has held that embezzled money is included in the embezzler's gross income if the funds are received without restriction on the use of the funds and without a consensual recognition, express or implied, of an obligation to repay the funds (see Eugene James v. U.S., (1961, S.Ct.) 366 US 213). So, Jay is unlikely to win this argument. c. The answer to this question depends on state law. If she is not required under state law to search for the owner of money or give the money to authorities, she must recognize gross income on the funds. If she is required under state law to search for the owner or return the funds, she does not recognize the income. If she ignores the law, she must include the amount in gross income because she has taken an undisputed claim on the income. When does she recognize the income? When she bought the dresser (last year) or when she found the money (this year)? In a Sixth Circuit case the taxpayer bought a piano for $15 at an auction and seven years later discovered $4,467 hidden inside. The Court held that the money was reduced to undisputed possession in the year of discovery and not in the year the taxpayer bought the piano at an auction (Ermenegildo Cesarini v. U.S., (1970, CA6) 428 F2d 812). 43. [LO 1] Although Hank is retired, he is an excellent handyman and often works part time on small projects for neighbors and friends. Last week his neighbor, Mike, offered to pay Hank $500 for minor repairs to his house. Hank completed the repairs in December of this year. Hank uses the cash method of accounting and is a calendar-year taxpayer. Compute Hank’s gross income for this year from each of the following alternative transactions: a. Mike paid Hank $200 in cash in December of this year and promised to pay the remaining $300 with interest in three months. b. Mike gave Hank tickets in December to the big game in January. The tickets have a face value of $50, but Hank could sell them for $400. Hank went to the game with his son. c. Mike bought Hank a new set of snow tires. The tires typically sell for $500, but Mike bought them on sale for $450. a. $200 this year. b. $400 this year. The value of the tickets was $400 when Hank received them. c. $450. This is the fair market value of the tires at the time Mike transferred them to Hank. 44. [LO 1] Jim recently joined the Austin Barter Club, an organization that facilitates the exchange of services between its members. This year Jim provided lawn-mowing services to other club members. Jim received the following from the barter club. Determine the amount, if any, Jim should include in his gross income in each of the following situations: a. Jim received $275 of car repair services from another member of the club. b. Jim received a $550 credit that gave him the option of receiving a season pass at a local ski resort from another member of the club. However, he forgot to request the pass by the end of the ski season and his credit expired. c. Jim received a $450 credit that can only be applied for goods or services from club members next year. a. In an exchange of services, income has been received in the amount of the value of services received (gross income includes the receipt of services as well as money and goods). Hence, Jim is taxed on the $275 of car repair services. b. The issue is whether the "credit" represents a valuable right. Because the right could be redeemed for property worth $550, then under constructive receipt Jim should recognize income of $550. c. If a barter credit can only be redeemed for future services, then the taxpayer could argue that no realization has yet occurred. But, it would be included in his gross income next year when the credit becomes a valuable right. 45. [LO 1] {Research} Last year Acme paid Ralph $15,000 to install a new air-conditioning unit at its headquarters building. The air conditioner did not function properly, and this year Acme requested that Ralph return the payment. Because Ralph could not repair one critical part in the unit, he refunded the cost of the repair, $5,000, to Acme. a. Is Ralph required to include the $15,000 payment he received last year in his gross income from last year? b. What are the tax implications of the repayment if Ralph was in the 35 percent tax bracket when he received the $15,000 payment from Acme, but he was in the 24 percent tax bracket when he refunded $5,000 to Acme? a. Under the claim of right doctrine (North American Oil Consol. v. Burnet (1932, S.Ct.) 286 US 417) Ralph has control over the property and an apparent claim of right to the payment. Hence, gross income is realized this year even though it may need to be repaid later. b. Under IRC §1341 Ralph can claim a $5,000 deduction when he refunds the money to Acme in this year. Because Ralph originally paid $1,750 of tax ($5,000 x 35 percent) on the receipt payment and will only save $1,200 on the deduction ($5,000 x 24%), the timing of the refund has resulted in $550 of additional taxes. Since the amount Ralph refunded is over $3,000, under IRC §1341(a). Ralph has the option of using the taxes paid on the original receipt to offset taxes in the subsequent year. Hence, in lieu of a $5,000 deduction Ralph can claim tax offset of $1,750. 46. [LO 1] Louis files as a single taxpayer. In April of this year he received a $900 refund of state income taxes that he paid last year. How much of the refund, if any, must Louis include in gross income under the following independent scenarios? Assume the standard deduction last year was $12,200. a. Last year Louis claimed itemized deductions of $12,450. Louis’s itemized deductions included state income taxes paid of $1,750 and no other state or local taxes. b. Last year Louis had itemized deductions of $10,800 and he chose to claim the standard deduction. Louis’s itemized deductions included state income taxes paid of $1,750 and no other state or local taxes. c. Last year Louis claimed itemized deductions of $13,640. Louis’s itemized deductions included state income taxes paid of $2,750 and no other state or local taxes. a. Louis received a tax benefit for the lesser of the refund ($900) or the excess of the itemized deductions above the standard deduction ($12,450-$12,200= $250). Hence, Louis must include $250 of the $900 refund in gross income. b. Because he didn’t itemize his deductions, Louis received no tax benefit from the $900 tax overpayment. Hence, none of the refund is included in his gross income. c. Louis received a tax benefit for the lesser of the refund ($900) or the excess of the itemized deductions above the standard deduction ($13,640-$12,200= $1,440). Hence, Louis must include the entire $900 refund in gross income. 47. [LO1] L. A. and Paula file as married taxpayers. In August of this year they received a $5,200 refund of state income taxes that they paid last year. How much of the refund, if any, must L. A. and Paula include in gross income under the following independent scenarios? Assume the standard deduction last year was $24,400. a. Last year L. A. and Paula had itemized deductions of $19,200, and they chose to claim the standard deduction. b. Last year L. A. and Paula claimed itemized deductions of $30,700. Their itemized deductions included state income taxes paid of $7,500 and no other state or local taxes. c. Last year L. A. and Paula claimed itemized deductions of $26,900. Their itemized deductions included state income taxes paid of $10,500, which were limited to $10,000 due to the cap on state and local tax deductions. a. Because they did not itemize their deductions, L. A. and Paula received no benefit from the $5,200 tax overpayment. Hence, none of the refund is included in gross income. b. L. A. and Paula received a tax benefit for the lesser of the refund ($5,200) or the excess of the itemized deductions above the standard deduction ($30,700-$24,400= $6,300). Hence, they must include the entire $5,200 refund in gross income. c. L. A. and Paula did not receive a tax benefit for the $500 state taxes refunded that previously were not deducted because of the $10,000 state and local tax deduction limit ($10,500 state incomes taxes paid less $10,000 state tax deduction = $500 taxes which produced no tax benefit previously). Thus, L. A. and Paula received a tax benefit for the lesser of the $5,200 refund minus the $500 state taxes previously not deducted (i.e., $5,200 - $500 = $4,700) or the excess of the itemized deductions above the standard deduction ($26,900-$24,400= $2,500). Hence, they must include $2,500 of the $5,200 refund in gross income. 48. [LO 1] Clyde is a cash-method taxpayer who reports on a calendar-year basis. This year Paylate Corporation has decided to pay Clyde a year-end bonus of $1,000. Determine the amount Clyde should include in his gross income this year under the following circumstances: a. Paylate Corporation wrote the check and put it in his office mail slot on December 30 of this year, but Clyde did not bother to stop by the office to pick it up until after year-end. b. Paylate Corporation mistakenly wrote the check for $100. Clyde received the remaining $900 after year-end. c. Paylate Corporation mailed the check to Clyde before the end of the year (and it was delivered before year-end). Although Clyde expected the bonus payment, he decided not to collect his mail until after year-end. d. Clyde picked up the check in December, but the check could not be cashed immediately because it was postdated January 10. a. Clyde is taxed on the $1,000 under the constructive receipt doctrine. b. Clyde is taxed on the $100 – the remaining $900 is taxed in the next year. c. Clyde is taxed on $1,000 unless the mail was not delivered until after year-end. Clyde would need to check his mail on December 31 or he would have the burden of proving he didn’t receive the check before year-end if the IRS alleges that the check was delivered before year-end. d. Clyde is not taxed until next year because the postdated check is a substantial restriction. 49. [LO 2] Identify the amount, if any, that these individuals must include in gross income in the following independent cases. Assume that the individuals are on the cash method of accounting and report income on a calendar-year basis. a. Elmer was an extremely diligent employee this year, and his employer gave him three additional days off with pay (Elmer’s gross pay for the three days totaled $1,200, but his net pay was only $948). b. Amax purchased new office furniture and allowed each employee to take home old office furniture valued at $250. a. Elmer should include in gross income the $1,200 gross pay he received for the three days he was not required to work but still received compensation. b. Amax employees should include the value of the furniture ($250) in gross income. 50. [LO 2] {Research} Ralph owns a building that he is trying to lease. Ralph is a calendar-year, cash-method taxpayer and is trying to evaluate the tax consequences of three different lease arrangements. Under lease 1, the building rents for $500 per month, payable on the first of the next month, and the tenant must make a $500 security deposit that is refunded at the end of the lease. Under lease 2, the building rents for $5,500 per year, payable at the time the lease is signed, but no security deposit is required. Under lease 3, the building rents for $500 per month, payable at the beginning of each month, and the tenant must pay a security deposit of $1,000 that is to be applied toward the rent for the last two months of the lease. a. What amounts are included in Ralph’s gross income this year if a tenant signs lease 1 on December 1 and makes timely payments under that lease? b. What amounts are included in Ralph’s gross income this year if the tenant signs lease 2 on December 31 and makes timely payments under that lease? c. What amounts are included in Ralph’s gross income this year if the tenant signs lease 3 on November 30 and makes timely payments under that lease? a. Under Kansas City Southern Industries ((1992), 98 TC 242) gross income does not include security deposits that must be returned to the taxpayer. Hence, Ralph does not include any of these payments in gross income this year. Moreover, the first rent payment is not included in his gross income this year because Ralph is a cash- method taxpayer and he does not receive the payment until next year. b. Ralph must include the entire $5,500 this year. c. Ralph must include both the rent paid ($500) and the security deposit ($1,000) in his gross income this year. Because the deposit can be applied toward rent it is treated as prepaid rent. Under Reg. §1.61-8(b) prepayments of rent are included in gross income regardless of the accounting method employed by the taxpayer. Because he is a cash-basis taxpayer, Ralph must include the rental payments he receives in gross income. 51. [LO 2] Anne purchased an annuity from an insurance company that promised to pay her $20,000 per year for the next 10 years. Anne paid $145,000 for the annuity, and in exchange she will receive $200,000 over the term of the annuity. a. How much of the first $20,000 payment should Anne include in gross income? b. How much income will Anne recognize over the term of the annuity? a. $5,500. A part of each payment represents a return of the original $145,000 investment, and the remainder ($55,000) is income. The original investment ($145,000) is 72.5 percent of the expected value ($145,000/$200,000). Hence, $14,500 of each payment is a return of capital (72.5 percent x $20,000), and the remaining $5,500 is income. b. Since Anne paid $145,000 for total payments of $200,000, she will recognize a total of $55,000 over the ten-year term of the lease. 52. [LO 2] Larry purchased an annuity from an insurance company that promises to pay him $1,500 per month for the rest of his life. Larry paid $170,820 for the annuity. Larry is in good health and is 72 years old. Larry received the first annuity payment of $1,500 this month. Use the expected number of payments in Exhibit 5-1 for this problem. a. How much of the first payment should Larry include in gross income? b. If Larry lives more than 15 years after purchasing the annuity, how much of each additional payment should he include in gross income? c. What are the tax consequences if Larry dies just after he receives the 100th payment? a. A part of each payment represents a return of the original $170,820 investment but to calculate the income you need the expected amount. The expected amount is calculated using the expected return multiple for Larry’s age group (14.6 for a 72- year-old). Each $1,500 monthly payment is composed of $975 of return of capital and $525 of taxable income computed as follows: b. Because Larry has received all of his original investment as a return of capital by the end of year 15, the entire $1,500 monthly payment is included in gross income. c. Because Larry has only recognized $97,500 as a return of his original investment (100 x $975), his executor will be entitled to deduct the remaining $73,320 ($170,820-$97,500) on Larry’s final tax return as an itemized deduction. 53. [LO 2] {Research} Gramps purchased a joint survivor annuity that pays $500 monthly over his remaining life and that of his wife, Gram. Gramps is 70 years old and Gram is 65 years old. Gramps paid $97,020 for the contract. How much income will Gramps recognize on the first payment? This joint survivor annuity has an annual return multiple of 23.1 from Table VI in Reg. Sec 1.72-9. The expected return of $138,600 is calculated by multiplying the annual payment of $6,000 ($500 x 12) times the return multiple of 23.1. Hence, 70 percent of each payment ($97,020/$138,600) will be a return of capital and 30 percent will be income. Thus, the first payment will consist of $150 ($500 x 30% = $150) of income. 54. [LO 2] Lanny and Shirley divorced in 2018 and do not live together. Shirley has custody of their child, Art, and Lanny pays Shirley $22,000 per year. All property was divided equally. a. How much should Shirley include in income if Lanny’s payments are made in cash but will cease if Shirley dies or remarries? b. How much should Shirley include in income if $12,000 of Lanny’s payments is designated as “nonalimony” in the divorce decree? c. How much should Shirley include in income if Lanny’s payments drop to $15,000 once Art reaches the age of 18? a. $22,000 is includible in Shirley’s gross income as alimony. The payments do not continue after Shirley’s death. It is not important that the payments may cease earlier than Shirley’s death. b. $10,000 is includible in Shirley’s gross income as alimony. Amounts designated as “nonalimony” in the divorce or written separation agreement are not treated as alimony for tax purposes. c. $15,000 is includible in Shirley’s gross income as alimony. The additional $7,000 in payments is treated as child support because these payments cease upon the happening of a specific contingency related to the child. 55. [LO 2] For each of the following independent situations, indicate the amount the taxpayer must include in gross income and explain your answer: a. Phil won $500 in the scratch-off state lottery. There is no state income tax. b. Ted won a compact car worth $17,000 in a TV game show. Ted plans to sell the car next year. c. Al Bore won the Nobel Peace Prize of $500,000 this year. Rather than take the prize, Al designated that the entire award should go to Weather head Charity, a tax-exempt organization. d. Jerry was awarded $2,500 from his employer, Acme Toons, when he was selected most handsome employee for Valentine’s Day this year. e. Ellen won a $1,000 cash prize in a school essay contest. The school is a tax-exempt entity, and Ellen plans to use the funds to pay her college education. f. Gene won $400 in the office March Madness pool. a. All $500 is economic income realized this year and is, therefore, included in gross income. b. The value of the car, $17,000, is economic income realized this year and is, therefore, included in gross income. c. The entire award is excluded and therefore tax exempt. The award is excluded because it was for scientific, literary, or charitable achievement, and the taxpayer immediately transferred the award to a qualified charity. d. All $2,500 is economic income realized this year and is, therefore, included in gross income. e. All $1,000 is economic income realized this year and is, therefore, included in gross income. f. Gene should include $400 in his gross income. 56. [LO 2] Grady received $8,200 of Social Security benefits this year. Grady also reported salary and interest income this year. What amount of the benefits must Grady include in his gross income under the following two independent situations? a. Grady files single and reports salary of $12,100 and interest income of $250. b. Grady files single and reports salary of $22,000 and interest income of $600. c. Grady files married joint and reports salary of $75,000 and interest income of $500. d. Grady files married joint and reports salary of $44,000 and interest income of $700. e. Grady files married separate and reports salary of $22,000 and interest income of $600. a. Grady excludes the entire $8,200 because the sum of his modified AGI plus 50 percent of his Social Security benefits ($12,100 + $250 + $4,100 (50% of Social Security benefits) = $16,450) is below the minimum amount ($25,000 or less for single taxpayers) for including Social Security benefits. b. $850. Grady is single and his modified AGI plus 50 percent of his Social Security benefits ($22,000 + $600 + $4,100 (50% of Social Security benefits) = $26,700) falls between $25,000 and $34,000. His taxable Social Security benefits are the lesser of (a) 50 percent of the Social Security benefits ($8,200 x 50% = $4,100) or (b) 50 percent of [$22,600 modified AGI + $4,100 (50 percent of Social Security benefits) - $25,000] = $850). Thus, his taxable Social Security benefits are $850. c. Grady includes 85 percent of the benefits or $6,970 ($8,200 × 85 percent) because his modified AGI is well above the maximum amount ($44,000 for married joint) for including Social Security benefits. d. $6,970. Grady files married joint and his modified AGI plus 50 percent of his Social Security benefits ($44,000 + $700 + $4,100 (50% of Social Security benefits) = $48,800) exceeds $44,000. His taxable Social Security benefits are the lesser of (a) 85 percent of Social Security benefits (85% x $8,200 = $6,970) or (b) 85 percent of [$44,700 modified AGI + $4,100 (50% of Social Security benefits) - $44,000]= $4,080), plus the lesser of (1) $6,000 or (2) 50 percent of Social Security benefits ($4,100). This simplifies to the lesser of $6,970 or $8,180 ($4,080 + $4,100). Thus, his taxable Social Security benefits are $6,970. e. $6,970. Because Grady files married separate, his taxable Social Security benefits are the lesser of (a) 85 percent of the Social Security benefits (85% x $8,200 = $6,970) or (b) 85 percent of the taxpayer's modified AGI plus 50 percent of his Social Security benefits (85% x ($22,000+600+$4,100 (50% of Social Security benefits) = $22,695). Thus, his taxable Social Security benefits are $6,970. 57. [LO2] George and Weezy received $30,200 of Social Security benefits this year ($12,000 for George; $18,200 for Weezy). They also received $5,000 of interest from jointly owned City of Ranburne Bonds and dividend income. What amount of the Social Security benefits must George and Weezy include in their gross income under the following independent situations? a. George and Weezy file married joint and receive $8,000 of dividend income from stocks owned by George. b. George and Weezy file married separate and receive $8,000 of dividend income from stocks owned by George. c. George and Weezy file married joint and receive $30,000 of dividend income from stocks owned by George. d. George and Weezy file married joint and receive $15,000 of dividend income from stocks owned by George. a. George and Weezy exclude the entire $30,200 of Social Security benefits because the sum of their modified AGI plus 50 percent of their Social Security benefits ($5,000 + $8,000 + $15,100 (50% of Social Security benefits) = $28,100) is below the minimum amount ($32,000 or less for taxpayers filing married joint) for including Social Security benefits. b. $10,200 for George and $9,860 for Weezy. Because George files married separate, he must include in gross income the lesser of (a) $10,200 (85% of his $12,000 Social Security benefits) or (b) $14,025 (85% of the sum of his modified AGI+50% of his Social Security benefits= 85% x (2,500 interest + $8,000 dividends +50% ($12,000)=85% (16,500)=$14,025). Because Weezy files married separate, she must include in gross income the lesser of (a) $15,470 (85% of her $18,200 Social Security benefits) or (b) $9,860 (85% of the sum of her modified AGI+50% of her Social Security benefits= 85% x (2,500 interest + 50% ($18,200)=85% (11,600)=$9,860). c. $11,185. Because George and Weezy file married joint and their modified AGI + 50% of their Social Security benefits ($5,000 interest + $30,000 dividends + (50% ($30,200)) = $50,100) exceeds $44,000, they must include in gross income the lesser of (a) 85 percent of their Social Security benefits (85% ($30,200)= $25,670), (b) 85 percent of (their modified AGI + 50% of their Social Security benefits - $44,000 = ($5,000 interest + $30,000 dividends + (50% ($30,200) -$44,000) =$6,100), plus the lesser of (1) $6,000 or (2) 50 percent of Social Security benefits (50% ($30,200)=$15,100). Thus, they must include in income the lesser of (a) $25,670 or (b) 85 percent of $6,100 (5,185), plus the lesser of (1) $6,000 or (2) $15,100, which simplifies to $11,185. d. $1,550. Because George and Weezy file married joint and their modified AGI + 50% of their Social Security benefits ($5,000 interest + $15,000 dividends + (50% ($30,200)) = $35,100) falls between $32,000 and $44,000, they must include in gross income the lesser of (a) 50 percent of their Social Security benefits (50% ($30,200) = $15,100), (b)50 percent of (their modified AGI + 50% of their Social Security benefits - $32,000 = ($5,000 interest + $15,000 dividends + (50% ($30,200) -$32,000) =$3,100). Thus, they must include in income the lesser of (a) $15,100 or (b) 50 percent of $3,100 (1,550). 58. [L0 2] Nikki works for the Shine Company, a retailer of upscale jewelry. How much taxable income does Nikki recognize under the following scenarios? a. Nikki buys a diamond ring from Shine Company for $10,000 (normal sales price, $14,000; Shine Company’s gross profit percentage is 40 percent). b. Nikki receives a 25 percent discount on jewelry restoration services offered by Shine Company. This year, Nikki had Shine Company repair a set of antique earrings (normal repair cost $500; discounted price $375). a. Because Nikki’s 28.57% discount ([$14,000 – $10,000]/$14,000) is less than Shine Company’s gross profit percentage, the bargain purchase from her employer does not result in taxable income. b. Nikki will recognize $25 of taxable income from the discounted services provided by Shine Company. Discounts more than 20% for services are taxable. Thus, Nikki’s taxable discount is $25 ($125 Discount received – (20% x $500) = $25). 59. [LO 2] Wally is employed as an executive with Pay More Incorporated. To entice Wally to work for Pay More, the corporation loaned him $20,000 at the beginning of the year at a simple interest rate of 1 percent. Wally would have paid interest of $2,400 this year if the interest rate on the loan had been set at the prevailing federal interest rate. a. Wally used the funds as a down payment on a speedboat and repaid the $20,000 loan (including $200 of interest) at year-end. Does this loan result in any gross income to either party, and if so, how much? b. Assume instead Pay More forgave the loan and interest on December 31. What amount of gross income does Wally recognize this year? Explain. a. Pay More has actual interest income of $200 and imputed interest income of $2,200 (the market amount of interest on the loan). (Note that Pay More will also be entitled to a compensation deduction of $2,200). Wally has compensation income from the loan of $2,200, the amount of the imputed interest. The imputed interest expense is not deductible because he used the loan proceeds for personal purposes. b. Wally must include $2,200 in gross income from the discounted interest rate he received on the loan ($2,400 interest at federal rate minus $200 he actually was required to pay). Also, Wally must include the $20,000 in gross income because Pay More forgave the $20,000 loan, and he must include $200 in gross income because Pay More forgave the $200 interest Wally owed. 60. [LO 3] Jimmy has fallen on hard times recently. Last year he borrowed $250,000 and added an additional $50,000 of his own funds to purchase $300,000 of undeveloped real estate. This year the value of the real estate dropped dramatically, and Jimmy’s lender agreed to reduce the loan amount to $230,000. For each of the following independent situations, indicate the amount Jimmy must include in gross income and explain your answer: a. The real estate is worth $175,000 and Jimmy has no other assets or liabilities. b. The real estate is worth $235,000 and Jimmy has no other assets or liabilities. c. The real estate is worth $200,000 and Jimmy has $45,000 in other assets but no other liabilities. a. Jimmy recognizes no income. The loan reduction generates $20,000 of income from discharge of indebtedness, but Jimmy can exclude this income because he is insolvent even after the discharge (assets of $175,000 versus liabilities of $230,000). b. Jimmy recognizes $5,000 of income. The loan reduction generates $20,000 of income from discharge of indebtedness, but Jimmy can only exclude $15,000 of this income because he becomes solvent after this amount of discharge (assets of $235,000 versus liabilities of $230,000). c. Jimmy recognizes $15,000 of income. The loan reduction generates $20,000 of income from discharge of indebtedness, and Jimmy is insolvent before the cancellation of indebtedness (assets of $245,000 versus liabilities of $250,000) but he is solvent by $15,000 after the cancellation of debt ($245,000 assets and $230,000 of debt). 61. [LO 3] {Research} Grady is a 45-year-old employee with AMUCK Garbage Corporation. AMUCK pays group-term life insurance premiums for employees, and Grady chose the maximum face amount of $120,000. What amount, if any, of the premium AMUCK paid on his behalf must Grady include in his gross income for the year? Provide a tax authority to support your answer. The amount of taxable group-term coverage is determined by multiplying the face amount of the coverage in excess of $50,000 times the uniform cost provided for the age of the taxpayer at year-end under the tables in IRC §79(c) and Reg. Sec. 1.79-3. In Grady’s situation the amount he must include in gross income is $126 calculated as the excess coverage of $70,000 ($120,000 – 50,000) times the uniform cost of .15¢ per month per $1,000 (0.15 x 12 x $70). 62. [LO 3] Fred currently earns $9,000 per month. Fred has been offered the chance to transfer for three to five years to an overseas affiliate. His employer is willing to pay Fred $10,000 per month if he accepts the assignment. Assume that the maximum foreign earned income exclusion for next year is $107,600. a. How much U.S. gross income will Fred report if he accepts the assignment abroad on January 1 of next year and works overseas for the entire year? If Fred’s employer also provides him free housing abroad (cost of $20,000), how much of the $20,000 is excludable from Fred’s income? b. Suppose that Fred’s employer has offered Fred only a six-month overseas assignment beginning on January 1 of next year. How much U.S. gross income will Fred report next year if he accepts the six-month assignment abroad and returns home on July 1 of next year? c. Suppose that Fred’s employer offers Fred a permanent overseas assignment beginning on March 1 of next year. How much U.S. gross income will Fred report next year if he accepts the permanent assignment abroad? Assume that Fred will be abroad for 305 days out of 365 days next year. If Fred’s employer also provides him free housing abroad (cost of $16,000 for next year), how much of the $16,000 is excludable from Fred’s income? a. Fred will earn $120,000 by going abroad, but he can exclude $107,600 under the foreign earned income exclusion. Hence, Fred will report gross income of $12,400 from the salary earned. Since Fred meets the requirements for the foreign-earned income exclusion, he may also exclude the employer-provided housing costs that exceed $17,216 (16% x $107,600), up to a maximum exclusion of $15,064 (14% x $107,600). Thus, Fred may exclude $2,784 (the lesser of (a) ($20,000 housing cost less $17,216 = $2,784) or (b) $15,064). Thus, Fred includes $17,216 ($20,000 - $2,784 exclusion) of the employer-provided housing in gross income. b. Fred will earn $60,000 during the first half of the year and $54,000 during the second half of the year. However, because he is not physically abroad for 330 days during a consecutive 12-month period (and he would not have a foreign tax home), Fred will not be able to claim any foreign earned income exclusion. So, he will report $114,000 of gross income next year. c. Fred will earn $18,000 during January-February and $100,000 during the remainder of the year. However, he will be able to claim a partial exclusion of $89,912 based upon his time abroad [$107,600 full exclusion x 305/365 (days in foreign country/days in year)]. Thus, Fred will report gross income of $28,088 ($118,000 – 89,912). Note that Fred will be abroad the requisite 330 days during a consecutive 12-month period beginning in March. Since Fred is not abroad the entire year, the foreign housing exclusion is also reduced. To be excluded, the costs must exceed $14,386 ($107,600 x 305/365 x 16%), with a maximum exclusion of $12,588 ($107,600 x 305/365 x 14%). Thus, Fred may exclude the lesser of (a) $1,614 ($16,000 housing cost less $14,386 = $1,614) or (b) $12,588. Thus, Fred includes $14,386 ($16,000 - $1,614) of the employer-provided housing in gross income. 63. [LO 3] For each of the following situations, indicate how much the taxpayer is required to include in gross income and explain your answer: a. Steve was awarded a $5,000 scholarship to attend State Law School. The scholarship pays Steve’s tuition and fees. b. Hal was awarded a $15,000 scholarship to attend State Hotel School. All scholarship students must work 20 hours per week at the school residency during the term. a. The $5,000 scholarship is excluded from gross income because it is used to pay Steve’s tuition and fees. b. The $15,000 scholarship is included in gross income because the terms of the scholarship require Hal to perform services. 64. [LO 3] Cecil cashed in a Series EE savings bond with a redemption value of $14,000 and an original cost of $9,800. For each of the following independent scenarios, calculate the amount of interest Cecil will include in his gross income assuming he files as a single taxpayer: a. Cecil plans to spend all of the proceeds to pay his son's tuition at State University. Cecil's son is a full-time student, and Cecil claims his son as a dependent. Cecil estimates his modified adjusted gross income at $63,100. b. Assume the same facts in part (a), except Cecil plans to spend $4,200 of the proceeds to pay his son’s tuition at State University, and Cecil estimates his modified adjusted gross income at $60,600. a. Cecil will report no Series EE interest in gross income. All of the $4,200 of interest income ($14,000-$9,800) is eligible for exclusion because Cecil is using all the proceeds for a qualified purpose. All of the eligible interest is excluded because Cecil’s modified gross income is below the 2020 threshold for the phase-out of the exclusion ($82,350). b. Cecil will report $2,940 of Series EE interest in gross income. Cecil is eligible to exclude $1,260 or 30 percent of the $4,200 of interest income because he is only using 30 percent of the proceeds for a qualified purpose ($4,200/$14,000). Cecil is not required to phase-out the amount of the exclusion because his modified gross income is below the threshold for the phase out of the exclusion. 65. [LO 3] Grady is a member of a large family and received the following payments this year. For each payment, determine whether the payment constitutes realized income and determine the amount of each payment Grady must include in his gross income. a. A gift of $20,000 from Grady’s grandfather. b. One thousand shares of GM stock worth $120 per share inherited from Grady’s uncle. The uncle purchased the shares for $25 each, and the shares are worth $125 at year-end. c. A gift of $50,000 of Ford Motor Bonds. Grady received the bonds on October 31, and he received $1,500 of semiannual interest from the bonds on December 31. d. A loan of $5,000 for school expenses from Grady’s aunt. a. The gift is realized income that is entirely excluded from gross income. b. Inheritances are realized income but are entirely excluded from gross income. The increase in the value of the shares during the year has not yet been realized. c. The gift of the bonds is realized income that is entirely excluded from gross income. The interest accrued up to October 31st is excluded because it was accrued at the time of the gift. Hence, the accrued income was part of the gift. Grady is taxed on $500 of interest that accrued after the date of the gift (he is taxed on it when he receives it). d. A bona fide loan is not realized income. If the loan is actually a disguised gift, the gift would be realized income but the value is excluded from gross income. 66. [LO 3] Bart is the favorite nephew of his aunt Thelma. Thelma transferred several items of value to Bart. For each of the following transactions, determine the effect on Bart’s gross income. a. Thelma gave Bart an auto worth $22,000. Thelma purchased the auto three years ago for $17,000. b. Thelma elects to cancel her life insurance policy, and she gives the cash surrender value of $15,000 to Bart. c. Bart is the beneficiary of a $100,000 whole life insurance policy on the life of Thelma. Thelma died this year, and Bart received $100,000 in cash. d. Bart inherited 500 shares of stock from Thelma’s estate. Thelma purchased the shares many years ago for $1,200, and the shares are worth $45,000 at her death. a. $0. The value of the auto is excluded from Bart’s gross income (Note that Bart will take a tax basis of $17,000 in the auto). b. $0. The gift of cash is excluded from Bart’s gross income. c. $0. All $100,000 of insurance proceeds are excluded. d. $0. The value of the shares ($45,000) is excluded from Bart’s income (Note that Bart will take a tax basis of $45,000 in the shares). The increase in value has not been realized. 67. [LO 3] Terry was ill for three months and missed work during this period. During his illness, Terry received $4,500 in sick pay from a disability insurance policy. What amounts are included in Terry’s gross income under the following independent circumstances? a. Terry has disability insurance provided by his employer as a nontaxable fringe benefit. Terry’s employer paid $2,800 in disability premiums for Terry this year. b. Terry paid $2,800 in premiums for his disability insurance this year. c. Terry’s employer paid the $2,800 in premiums for Terry, but Terry elected to have his employer include the $2,800 as compensation on Terry’s W-2. d. Terry has disability insurance whose cost is shared with his employer. Terry’s employer paid $1,800 in disability premiums for Terry this year as a nontaxable fringe benefit, and Terry paid the remaining $1,000 of premiums from his after-tax salary. a. $4,500. The disability pay of $4,500 is included in Terry’s gross income because Terry’s employer paid the insurance premiums as a nontaxable fringe benefit to Terry. Consequently, the disability insurance premiums of $2,800 paid by Terry’s employer are excluded from Terry’s gross income. b. $0. The disability pay of $4,500 is excluded from Terry’s gross income because Terry paid the insurance premiums. Note: the cost of disability insurance premiums is not deductible as a medical expense. c. $0. Even though his employer paid the premium, the premium is taxable compensation to Terry, so he is treated as though he paid the premiums. Thus, the answer is the same as for part b.1 d. $2,893. A portion of the disability pay is excluded from Terry’s gross income because Terry paid a portion of the insurance premiums. Terry can exclude $1,607 = [($1,000/$2,800) x $4,500]. 68. [LO 3] {Planning} Tim’s parents plan to provide him with $50,000 to support him while he establishes a new landscaping business. In exchange for the support, Tim will maintain the landscape at his father’s business. Under what conditions will the transfer of $50,000 be included in Tim’s gross income? Explain. Do you have a recommendation for Tim and his parents? The transfer is nontaxable if it was either a bona fide loan or a gift (transfer for love and affection). In addition, depending on Tim’s circumstances (such as age) the payment might satisfy a pre-existing liability (the obligation to support imposed by state law). On the other hand, if there is an implicit or explicit understanding that Tim is providing landscaping services in exchange for the payment, then the transfer would constitute income to Tim. This latter treatment would be preferred if Tim’s father can deduct the cost of maintenance and if Tim’s tax rate is below his father’s tax rate. Tim and his parents should structure the transfer after considering total taxes and take special care to document the intent of the transfer (gift or loan or payment for services). 69. [LO 3] What amounts are included in gross income for the following taxpayers? Explain your answers. a. Janus sued Tiny Toys for personal injuries from swallowing a toy. Janus was paid $30,000 for medical costs and $250,000 for punitive damages. b. Carl was injured in a car accident. Carl’s insurance paid him $50,000 to reimburse his medical expenses and an additional $25,000 for the emotional distress Carl suffered as a result of the accident. c. Ajax published a story about Pete, and as a result Pete sued Ajax for damage to his reputation. Ajax lost in court and paid Pete an award of $20,000. d. Bevis was laid off from his job last month. This month he drew $800 in unemployment benefits. a. The $30,000 is excluded from Janus’s gross income because it is a payment for a physical injury. However, the $250,000 of punitive damages is included in Janus’s gross income because the payment is intended to punish Tiny Toys rather than compensate Janus for her injuries. b. The reimbursed medical costs and the payment for emotional distress associated with a physical injury are excluded. c. Pete must include the payments in gross income because the payments are not associated with a physical injury. d. Bevis must include the unemployment benefits in his gross income because unemployment benefits are a replacement for lost wages. 70. [LO 3] This year, Janelle received $200,000 in life insurance proceeds. Under the following scenarios, how much of the $200,000 is taxable? a. Janelle received the proceeds upon the death of her father, Julio. b. Janelle received the $200,000 proceeds because she was diagnosed with colon cancer (life expectancy of six months), and she needed the proceeds for her care. c. The proceeds related to a life insurance policy she purchased for $35,000 from a friend in need. After purchase, Janelle paid annual premiums that total $22,000. a. None of the $200,000 is taxable as life insurance proceeds are generally not taxable for income tax purposes. The $200,000 proceeds, however, would be included in her father’s estate, and thus, may be subject to estate tax. b. None. Because Janelle was medically certified as terminally ill with an illness expected to cause death within 24 months. c. $143,000. Because Janelle purchased the life insurance policy from a friend for valuable consideration, she may exclude the $200,000 proceeds up to the sum of the purchase price of the policy ($35,000) and any subsequent premiums ($22,000) with the remaining proceeds ($200,000 - $35,000 - $22,000 = $143,000) taxable as ordinary income. 71. [LO 3] This year, Leron and Sheena sold their home for $750,000 after all selling costs. Under the following scenarios, how much taxable gain does the home sale generate for Leron and Sheena? a. Leron and Sheena bought the home three years ago for $150,000 and lived in the home until it sold. b. Leron and Sheena bought the home 1 year ago for $600,000 and lived in the home until it sold. c. Leron and Sheena bought the home five years ago for $500,000. They lived in the home for three years until they decided to buy a smaller home. Their home has been vacant for the past two years. a. $100,000. Because Leron and Sheena satisfy the 2-year ownership and 2-year use test, they may exclude up to $500,000 of gain from the sale of their home. Thus, Leron and Sheena may exclude $500,000 of the $600,000 gain ($750,000 - $150,000 = $600,000 realized gain) that they realized on the sale. b. Because Leron and Sheena do not satisfy the 2-year ownership or 2-year use test, the entire $150,000 realized gain ($750,000 - $600,000= $150,000) is taxable. c. Despite not living in the house the past 2 years, Leron and Sheena still meet the 2-year ownership and 2-year use tests, and therefore, they may exclude up to $500,000 gain on the sale. Thus, Leron and Sheen may exclude the entire $250,000 gain realized on the sale ($750,000 - $500,000 = $250,000 realized gain). 72. [LO 3] Dontae’s employer has offered him the following employment package. What is Dontae’s gross income from his employment? $465,000. Dontae’s $400,000 salary + $20,000 club membership + $5,000 season tickets + $40,000 housing allowance are included in his gross income. The health insurance and dental insurance is an excludable benefit under §106, and the tuition reimbursement is excludable under §127. COMPREHENSIVE PROBLEMS 73. [LO 1, LO 2, LO3] Charlie was hired by Ajax this year as a corporate executive and a member of the board of directors. During the current year, Charlie received the following payments or benefits paid on his behalf. a. Charlie uses the cash method and calendar year for tax purposes. Calculate Charlie’s gross income for the current year. b. Suppose that Ajax agrees to pay Charlie an additional $100,000 once Charlie completes five years of employment. Will this agreement alter Charlie’s gross income this year relative to your part (a) answer? Explain. c. Suppose that in exchange for his promise to remain with the firm for the next four years, Ajax paid Charlie four years of director’s fees in advance. Will this arrangement alter Charlie’s gross income this year relative to your part (a) answer? Explain. d. Assume that in lieu of a year-end bonus Ajax transferred 500 shares of Bell stock to Charlie as compensation. Further assume that the stock was listed at $35 per share and Charlie would sell the shares by year-end, at which time he expected the price to be $37 per share. Will this arrangement alter Charlie’s gross income this year relative to your part (a) answer? Explain. e. Suppose that in lieu of a year-end bonus Ajax made Charlie’s house payments (a total of $23,000). Will this arrangement alter Charlie’s gross income this year relative to your part (a) answer? Explain. a. The salary, bonus, director’s fee, and whole life premiums are taxable, but the pension contributions, health insurance, group-term life insurance, and disability insurance premiums are excluded from income (Charlie did not elect to have the insurance premiums included as taxable compensation). Charlie’s gross income is $118,420. b. No change - the promise to make future payments is not taxable income to a cash-basis taxpayer. Income will be recognized once payment is made. c. This payment will increase Charlie’s gross income $40,000 (4 payments in advance x $10,000) because a cash-basis taxpayer is taxed on income when received regardless of whether the income is earned. d. Charlie would report the value of the stock (500 shares x $35/share = $17,500) as compensation. If Charlie did sell the stock at the expected price, the gain of $1,000 on the sale would also be included in his gross income. e. Charlie would report the value of the house payments ($23,000) as income. 74. [LO 1, LO 2, LO3] Irene is disabled and receives payments from a number of sources. The interest payments are from bonds that Irene purchased over past years and a disability insurance policy that Irene purchased herself. Calculate Irene’s gross income. Irene is not taxed on the disability payments because she purchased the insurance. In addition, Irene’s gross income is clearly below the Social Security phase-out threshold, so the Social Security benefits are also excluded. Interest from a municipal bond issued by a local government in the U.S. (e.g., City of Austin, Texas) is excluded from gross income. 75. {Tax Forms} [LO1, LO 2, LO3] Ken is 63 years old and unmarried. He retired at age 55 when he sold his business, Understock.com. Though Ken is retired, he is still very active. Ken reported the following financial information this year. Assume Ken files as a single taxpayer. Determine Ken’s gross income and complete page 1 of Form 1040 (through line 7b) and Schedule 1 for Ken. a. Ken won $1,200 in an illegal game of poker (the game was played in Utah, where gambling is illegal). b. Ken sold 1,000 shares of stock for $32 a share. He inherited the stock two years ago. His tax basis (or investment) in the stock was $31 per share. c. Ken received $25,000 from an annuity he purchased eight years ago. He purchased the annuity, to be paid annually for 20 years, for $210,000. d. Ken received $13,000 in disability benefits for the year. He purchased the disability insurance policy last year. e. Ken decided to go back to school to learn about European history. He received a $500 cash scholarship to attend. He used $300 to pay for his books and tuition, and he applied the rest toward his new car payment. f. Ken’s son, Mike, instructed his employer to make half of his final paycheck of the year payable to Ken as a gift from Mike to Ken. Ken received the check on December 30 in the amount of $1,100. g. Ken received a $610 refund of the $3,600 in state income taxes his employer withheld from his pay last year. Ken claimed $12,250 in itemized deductions last year (the standard deduction for a single filer was 12,200). h. Ken received $30,000 of interest from corporate bonds and money market accounts. $46,950, computed as follows: Ken’s Gross Income Description Amount Explanation a) Illegal income $1,200 Gross income includes income from all sources—legal or illegal b) Gain on stock sale 1,000 Ken recognizes a $1,000 gain on the sale [$32,000 (32 x $1,000) minus $31,000 (31 x $1,000)]. Note that only the sale proceeds in excess of the stock basis are included in gross income. c) Annuity 14,500 25,000 – (210,000 / 20) d) Disability benefits 0 excluded because the policy was purchased by the taxpayer e) Scholarship 200 $200 used towards car payment does not qualify for exclusion; $300 used for books may be excluded f) Paycheck from son 0 Under assignment of income doctrine, the income is taxed to the taxpayer who earned the income. The gift receipt is not taxable to Ken. g) State income tax refund 50 Portion of refund he received tax benefit for last year. See below for computation. h) Interest income 30,000 Included in gross income Gross income $46,950 State Tax Refund/Tax Benefit Rule Description Amount Explanation (1) Itemized deductions with $610 overpayment $12,250 (2) 2019 Standard deduction 12,200 Single filing status (3) Reduction in taxable income with $610 overpayment 12,250 Greater of (1) and (2) (4) Itemized deductions without the $610 overpayment that was refunded 11,640 (1) minus $610 (5) Reduction in taxable income without the $610 overpayment that was refunded 12,200 Greater of (2) and (4) Tax benefit from prior year $610 overpayment of state taxes $50 (3) – (5) Form 1040, Page 1, Lines 1-7b: Form 1040, Schedule 1, Lines 1-9: 76. {Tax Forms} [LO 1, LO 2, LO 3] Consider the following letter and answer Shady’s question. To my friendly student tax preparer: Hello, my name is Shady Slim. I understand you are going to help me figure out my gross income for the year…whatever that means. It’s been a busy year and I’m a busy man, so let me give you the lowdown on my life and you can do your thing. I was unemployed at the beginning of the year and got $2,000 in unemployment compensation. I later got a job as a manager for Roca Cola. I earned $55,000 in base salary this year. My boss gave me a $5,000 Christmas bonus check on December 22. I decided to hold on to that check and not cash it until next year, so I won’t have to pay taxes on it this year. Pretty smart, huh? My job’s pretty cool. I get a lot of fringe benefits like a membership to the gym that costs $400 a year and all the Roca Cola I can drink, although I can’t really drink a whole lot. I figure $40 worth this year. As part of my manager duties, I get to decide on certain things like contracts for the company. My good buddy, Eddie, runs a bottling company. I made sure that he won the bottling contract for Roca Cola for this year (even though his contract wasn’t quite the best). Eddie bought me a Corvette this year for being such a good friend. The Corvette cost $50,000, and I’m sure he bought it for me out of the goodness of his heart. What a great guy! Here’s a bit of good luck for the year. Upon leaving my office one day, I found $8,000 lying in the street! Well, one person’s bad luck is my good luck, right? I like to gamble a lot. I won a $27,000 poker tournament in Las Vegas this year. I also won $5,000 over the year playing the guys at our Friday night poker game. Can you believe that I didn’t lose anything this year? Speaking of the guys, one of them hit me with his car as we were leaving the game one night. He must have been pretty ticked that he lost! I broke my right leg and my left arm. I sued the guy and got $11,000 for my medical expenses and $3,000 to pay my psychotherapist for the emotional problems I had relating to the injuries (I got really depressed!), and I won $12,000 in punitive damages. That’ll teach him that he’s not so tough without his car! Another bit of bad luck. My uncle Monty died this year. I really liked the guy, but the $200,000 inheritance I received from him made me feel a little better about the loss. I did the smart thing with the money and invested it in stocks and bonds and socked a little into my savings account. As a result, I received $600 in dividends from the stock, $200 in interest from the municipal bonds, and $300 in interest from my savings account. My ex-wife, Alice, is still paying me alimony. She’s a lawyer who divorced me in 2015 because I was “unethical” or something like that. Because she was making so much money and I was unemployed at the time, the judge ruled that she had to pay ME alimony. Isn’t that something? She sent me $3,000 in alimony payments this year. She still kind of likes me, though. She sent me a check for $500 as a Christmas gift this year. I didn’t get her anything, though. So there you go. That’s the year in a nutshell. Can you figure out my gross income and complete page 1 of Form 1040 (through line 7b) and Schedule 1 for me? And because you’re a student, this is free, right? Thanks, I owe you one! Let me know if I can get you a six-pack of Roca Cola or something. $168,300 calculated as follows: Included in Gross Income Amount Excluded from Gross Income Amount Gym membership $400 Unemployment Compensation 2,000 Salary 55,000 Christmas Bonus-Check 5,000 Medical and psychotherapist expenses 14,000 Corvette 50,000 Inheritance 200,000 Found Money 8,000 Municipal Bond Interest 200 Gambling Winnings 32,000 Christmas gift from ex-wife 500 Punitive Damages from Lawsuit 12,000 Dividends 600 Total Exclusions* $214,700 Savings Account Interest 300 Alimony 3,000 Total Gross Income $168,300 *Value of Roca Cola excluded as de minimis fringe benefit. Form 1040, Page 1, Lines 1-7b: Form 1040, Schedule 1, Lines 1-9: Shady Slim Form 1040, Schedule1, Line 8 Detail Schedule 77. {Tax Forms} [LO 1, LO 2, LO 3] Diana and Ryan Workman were married on January 1 of last year. Diana has an eight-year-old son, Jorge, from her previous marriage. Ryan works as a computer programmer at Datafile Inc. (DI) earning a salary of $96,000. Diana is self-employed and runs a day care center. The Workmans reported the following financial information pertaining to their activities during the current year. a. Ryan earned a $96,000 salary for the year. b. Ryan borrowed $12,000 from DI to purchase a car. DI charged him 2 percent interest ($240) on the loan, which Ryan paid on December 31. DI would have charged Ryan $720 if interest was calculated at the applicable federal interest rate. c. Diana received $2,000 in alimony and $4,500 in child support payments from her former husband. They divorced in 2016. d. Diana won a $900 cash prize at her church-sponsored Bingo game. e. The Workmans received $500 of interest from corporate bonds and $250 of interest from a municipal bond. Diana owned these bonds before she married Ryan. f. The couple bought 50 shares of ABC Inc. stock for $40 per share on July 2. The stock was worth $47 a share on December 31. The stock paid a dividend of $1.00 per share on December 1. g. Diana’s father passed away on April 14. She inherited cash of $50,000 from her father and his baseball card collection, valued at $2,000. As beneficiary of her father’s life insurance policy, Diana also received $150,000. h. The couple spent a weekend in Atlantic City in November and came home with gross gambling winnings of $1,200. i. Ryan received $400 cash for reaching 10 years of continuous service at DI. j. Ryan was hit and injured by a drunk driver while crossing a street at a crosswalk. He was unable to work for a month. He received $6,000 from his disability insurance. DI paid the premiums for Ryan but they reported the amount of the premiums as compensation to Ryan on his year-end W-2. k. The drunk driver who hit Ryan in part (j) was required to pay his $2,000 medical costs, $1,500 for the emotional trauma he suffered from the accident and $5,000 for punitive damages. l. For meeting his performance goals this year, Ryan was informed on December 27 that he would receive a $5,000 year-end bonus. DI (located in Houston, Texas) mailed Ryan’s bonus check from its payroll processing center (Tampa, Florida) on December 28. Ryan didn’t receive the check at his home until January 2. m. Diana is a 10 percent owner of MNO Inc., a Subchapter S corporation. The company reported ordinary business income for the year of $92,000. Diana acquired the MNO stock two years ago. n. Diana’s daycare business collected $35,000 in revenues. In addition, customers owed her $3,000 at year-end. During the year, Diana spent $5,500 for supplies, $1,500 for utilities, $15,000 for rent, and $500 for miscellaneous expenses. One customer gave her use of his vacation home for a week (worth $2,500) in exchange for Diana allowing his child to attend the day care center free of charge. Diana accounts for her business activities using the cash method of accounting. o. Ryan’s employer pays the couple’s annual health insurance premiums of $5,500 for a qualified plan. Required: A. Assuming the Workmans file a joint tax return, determine their gross income minus expenses on the daycare business (this is called total income on the Form 1040). $130,730, computed as follows: Workman’s Gross Income Description Amount Explanation a) Ryan’s salary and other employee compensation $96,000 b) Imputed interest income from bargain loan 480 See below for computation. Included in income as compensation. c) Alimony/child support 2,000 Alimony is included in gross income; child support is not included in gross income d) Cash prize from Bingo game 900 Included in gross income even if received from charitable organization e) Interest income 500 $500 interest from corporate bond is included in gross income and interest on municipal bond is excluded from gross income f) Dividend income 50 $1.00 per share x 50 shares (ABC stock); the stock appreciation is not realized so it is not included in gross income g) Inheritance and life insurance proceeds 0 Inheritance and life insurance proceeds are excluded from gross income h) Gambling income 1,200 Gambling winnings are included in gross income i) 10-year service award 400 May only be excluded if award is tangible property other than cash. This is a cash award so it is taxable as compensation. j) Disability insurance proceeds 0 Because the premiums paid by DI represent taxable compensation to Ryan he is treated as though he paid the premiums. Consequently, he may exclude the entire benefit from gross income. k) Payments associated with accident 5,000 Punitive damages are included in gross income. Payments for medical expenses and emotional trauma associated with the accident are excluded. l) Year-end bonus 0 Constructive receipt does not apply because Ryan received the bonus on January 2 of next year. Note that if DI includes the bonus in Ryan’s W2 in the previous year, then Ryan would need to make an adjustment to his income on his W-2 to avoid taxation in that year. Also note that if the check was made available to Ryan in the previous year, constructive receipt would apply and Ryan would include the bonus in his income for the previous year. m) Flow-through income 9,200 10 percent ownership x 92,000 income n) Daycare gross income less expenses 15,000 35,000 from revenues plus 2,500 from services received less deductible expenses of $22,500 o) Health insurance premiums $0 Health insurance premiums paid by an employer are excluded Gross income minus expenses on the daycare business $130,730 Employer Loan Included in Gross Income Description Amount Explanation (1) Loan principal $12,000 (2) Interest on loan principal at federal rate 720 (4) Interest paid by Ryan 240 12,000 x 2 percent Imputed interest included in Ryan’s gross income $480 (3) – (4) B. Using your answer in part (a), complete page 1 of Form 1040 through line 7b and Schedule 1 for the Workmans. Form 1040, Page 1, Lines 1-7b: Form 1040, Schedule 1, Lines 1-9: Diane & Ryan Workman Form 1040, Schedule 1, Line 8 Detail Schedule C. Assuming the Workmans live in California, a community property state, and that Diana and Ryan file separately, what is Ryan’s gross income minus expenses on the daycare business? Answer: $59,515, computed as follows: Workman’s Gross Income Description Amount Explanation a) Ryan’s salary and other employee compensation $48,000 One half of his salary is in Diana’s gross income b) Imputed interest income from bargain loan 240 One half of his compensation is included in Diana’s gross income. c) Alimony/child support 0 All Diana’s income d) Cash prize from Bingo game 450 One half of Diana’s winnings are included in his gross income. e) Interest income 0 Bonds were Diana’s before the marriage so not included in Ryan’s income f) Dividend income 25 One half of dividend income because they both own the stock. g) Inheritance and life insurance proceeds 0 Inheritance and life insurance proceeds are excluded from gross income (and these items are also considered Diana’s separate property). h) Gambling income 600 One-half of gambling winnings i) 10-year service award 200 One half of his compensation j) Disability insurance proceeds 0 Because the premiums paid by DI represent taxable compensation to Ryan he is treated as though he paid the premiums. Consequently, he may exclude the entire benefit from gross income. k) Payments associated with accident 2,500 One half of punitive damages l) Year-end bonus 0 Not constructively received m) Flow-through income 0 Diana owned stock before their marriage n) Daycare gross income less expenses 7,500 One-half of Diana’s earning less one-half of deductible expenses o) Health insurance premiums $0 Health insurance premiums paid by an employer are excluded Gross income minus expenses on the daycare business $59,515 D. Using your answer in part (c), complete page 1 of Form 1040 through line 7b and Schedule 1 for Ryan Workman. Form 1040, Page 1, Lines 1-7b: Form 1040, Schedule 1, Lines 1-9: Ryan Workman Form 1040, Schedule 1, Line 8 Detail Schedule Solution Manual for McGraw-Hill's Taxation of Individuals and Business Entities 2021 Brian C. Spilker, Benjamin C. Ayers, John A. Barrick, Troy Lewis, John Robinson, Connie Weaver, Ronald G. Worsham 9781260247138, 9781260432534
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