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Chapter 16 Accounting Periods And Methods
Problems
28. LO.1 Red, White, and Blue are unrelated corporations engaged in real estate development. The three corporations formed a joint venture (treated as a partnership) to develop a tract of land. Assuming that the venture does not have a natural business year, what tax year must the joint venture adopt under the following circumstances?
Tax Year Ending Interest in Joint Venture
a. Red March 31 60%
Blue June 30 20%
White October 31 20%
b. Red October 31 30%
White September 30 40%
Blue January 31 30%
29. LO.1 Zorn conducted his professional practice through Zorn, Inc. The corporation uses a fiscal year ending September 30 even though the business purpose test for a fiscal year cannot be satisfied. For the year ending September 30, 2016, the corporation paid Zorn a salary of $180,000, and during the period January through
September 2016, the corporation paid him a salary of $150,000.
a. How much salary should Zorn receive during the period October 1 through December
31, 2016?
b. Assume that Zorn received only $24,000 salary during the period October 1 through December 31, 2016. What would be the consequences to Zorn, Inc.?
30. LO.1 Mauve Corporation began operations as a farm supplies business and used a fiscal year ending October 31. The company gradually went out of the farm supplies business and into the mail-order Christmas gifts business.
The company has received permission from the IRS to change to a fiscal year ending January 31, effective for the year ending January 31, 2017. For the short period November 1, 2016, through January 31, 2017, Mauve earned $20,000.
Calculate Mauve’s tax liability for the short period November 1, 2016, through
January 31, 2017.
31. LO.2 Gold, Inc., is an accrual basis taxpayer. In 2016, an employee accidentally spilled hazardous chemicals on leased property. The chemicals destroyed trees on neighboring property, resulting in $30,000 of damages. In 2016, the owner of the property sued Gold, Inc., for the $30,000. Gold’s attorney believes that it is liable and that the only issue is whether the neighbor will also seek punitive damages that could be as much as three times the actual damages. In addition, as a result of the spill, Gold was in violation of its lease and was therefore required to pay the landlord $15,000. However, the amount due for the lease violation is not payable until the termination of the lease in 2019. None of these costs were covered by insurance.
Jeff Stuart, the president of Gold, Inc., is generally familiar with the accrual basis tax accounting rules and is concerned about when the company will be allowed to deduct the amounts the company is required to pay as a result of this environmental disaster. Write Mr. Stuart a letter explaining these issues. Gold’s address is 200 Elm Avenue, San Jose, CA 95192.
32. LO.2 Compute Mary’s income or deductions for 2016 using (1) the cash basis and
(2) the accrual basis for each of the following:
a. In May 2016, Mary paid a license fee of $1,200 for the period June 1, 2016, through May 31, 2017.
b. In December 2016, Mary collected $10,000 for January 2017 rents. In January
2017, Mary collected $2,000 for December 2016 rents.
c. In June 2016, Mary paid $7,200 for an office equipment service contract for the period July 1, 2016, through December 31, 2017.
d. In June 2016, Mary purchased office furniture for $273,000. She paid $131,000 in cash and gave a $142,000 interest-bearing note for the balance.
The office furniture has an MACRS cost recovery period of seven years. Mary did not make the § 179 election and elected not to take additional first-year depreciation.
33. LO.2, 5 What accounting method (cash or accrual) would you recommend for the following businesses?
a. A gift shop with average annual gross receipts of $900,000.
b. An accounting partnership with annual gross receipts of $12 million.
c. A drywall subcontractor who works on residences and has annual gross receipts of $3 million.
d. An incorporated insurance agency with annual gross receipts of $6 million.
34. LO.2 How do the all events and economic performance requirements apply to the following transactions by an accrual basis taxpayer?
a. The company guarantees its products for six months. At the end of 2016, customers had made valid claims for $600,000 that were not paid until 2017. Also, the company estimates that another $400,000 in claims from 2016 sales will be filed and paid in 2017.
b. The accrual basis taxpayer reported $200,000 in corporate taxable income for
2016. The state income tax rate was 6%. The corporation paid $7,000 in estimated state income taxes in 2016 and paid $2,000 on 2015 state income taxes when it filed its 2015 state income tax return in March 2016. The company filed its 2016 state income tax return in March 2017 and paid the remaining $5,000 of its 2016 state income tax liability.
c. An employee was involved in an accident while making a sales call. The company paid the injured victim $15,000 in 2016 and agreed to pay the victim $15,000 a year for the next nine years.
35. LO.3 Ross Company is a corporation providing medical diagnostic services. Ross has used the cash method since inception because its gross receipts did not exceed $5,000,000. This year, its average annual gross receipts for the prior three years crossed the $5,000,000 mark, requiring Ross to change from the cash method to the accrual method (per § 448). At the end of its prior year, Ross had accounts receivable of $850,000 and accounts payable of $540,000.
a. Compute and explain the adjustment to taxable income that Ross must make due to the change in accounting method.
b. When must Ross include this adjustment in its income?
36. LO.4, 6 Floyd, a cash basis taxpayer, has received an offer to purchase his land.
The cash basis buyer will pay him either $100,000 at closing or $50,000 at closing and $56,000 two years after the date of closing. If Floyd recognizes the entire gain in the current year, his marginal tax rate will be 25% (combined
Federal and state rates). However, if he spreads the gain over the two years, his marginal tax rate on the gain will be only 20%. Floyd does not consider the buyer a credit risk, and he understands that shifting the gain to next year with an installment sale will save taxes. But he realizes that the deferred payment will, in effect, earn only $6,000 for waiting two years for the other $50,000. Floyd believes he can earn a 10% before-tax rate of return on his after-tax cash. Floyd’s adjusted basis for the land is $25,000, the buyer is also a cash basis taxpayer, and the short-term Federal rate is 4%. Floyd has asked you to evaluate the two alternatives on an after-tax basis.
37. LO.4 Kay, who is not a dealer, sold an apartment house to Polly during the current year (2016). The closing statement for the sale is as follows:
Total selling price $ 190,000
Add: Polly’s share of property taxes (six months) paid by Kay 3,000
Less: Kay’s 8% mortgage assumed by Polly $55,000
Polly’s refundable binder (“earnest money”) paid in 2015 1,000
Polly’s 8% installment note given to Kay 99,000
Kay’s real estate commissions and attorney’s fees 8,000 (163,000)
Cash paid to Kay at closing $ 30,000
Cash due from Polly ? $30,000 t $8,000 expenses $ 38,000
During 2016, Kay collected $9,000 in principal on the installment note and $2,000 of interest. Kay’s basis in the property was $110,000 [$125,000 _ $15,000 edepreciationT].
The Federal rate is 6%.
a. Compute the following:
1. Total gain.
2. Contract price.
3. Payments received in the year of sale.
4. Recognized gain in the year of sale and the character of such gain. (Hint: Think carefully about the manner in which the property taxes are handled before you begin your computations.)
b. Same as parts (a)(2) and (3), except that Kay’s basis in the property was $35,000.
38. LO.4 On June 30, 2016, Kelly sold property for $240,000 cash and a $960,000 note due on September 30, 2017. The note will also pay 6% interest, which is slightly higher than the Federal rate. Kelly’s cost of the property was $400,000. She is concerned that Congress may increase the tax rate that will apply when the note is collected. Kelly’s after-tax rate of return on investments is 6%.
a. What can Kelly do to avoid the expected higher tax rate?
b. Assuming that Kelly’s marginal combined Federal and state tax rate is 25% in 2016, how much would the tax rates need to increase to make the option identified in part (a) advisable?
39. LO.4 On December 30, 2015, Maud sold land to her son, Charles, for $50,000 cash and a 7% installment note for $350,000, payable over 10 years. Maud’s cost of the land was $150,000. In October 2017, after Charles had paid $60,000 on the principal of the note, he received an offer to sell the land for $500,000 cash. What advice can you provide Charles that will minimize the present value of the tax liability for
Maud and him?
40. LO.4 George sold land to an unrelated party in 2015. His basis in the land was $45,000, and the selling price was $120,000—$30,000 payable at closing and $30,000 (plus 10% interest) due January 1, 2016, 2017, and 2018. What would be the tax consequences of the following? [Treat each part independently, and assume that (1) George did not elect out of the installment method and (2) the installment obligations have values equal to their face amounts. Ignore interest in your calculations.]
a. In 2016, George borrowed $40,000 from the bank. The loan was partially secured by the installment notes, but George was personally liable for the loan.
b. In 2016, George gave to his daughter the right to collect all future payments on the installment obligations.
c. On December 31, 2016, George received the payment due on January 1, 2017. On December 15, 2017, George died, and the remaining installment obligation was transferred to his estate. The estate collected the amount due on January 1, 2018.
41. LO.5 The Wren Construction Company reports its income by the completed contract method. At the end of 2016, the company completed a contract to construct a building at a total cost of $800,000. The contract price was $1.2 million, and the customer paid Wren $900,000. However, the customer refused to accept the work and would not pay anything else on the contract because he claimed that the roof did not meet specifications. Wren’s engineers estimated that it would cost $140,000 to bring the roof up to the customer’s standards. In 2017, the dispute was settled in the customer’s favor; the roof was improved at a cost of $150,000, and the customer accepted the building and paid the remaining $300,000.
a. What would be the effects of the above on Wren’s taxable income for 2016 and 2017?
b. Same as part (a), except that Wren had $1,100,000 of accumulated costs under the contract at the end of 2016.
42. LO.5 Rust Company is a real estate construction company with average annual gross receipts of $4 million. Rust uses the completed contract method, and the contracts require 18 months to complete.
a. Which of the following costs would be allocated to construction in progress by Rust?
1. The payroll taxes on direct labor.
2. The current services pension costs for employees whose wages are included in direct labor.
3. Accelerated depreciation on equipment used on contracts.
4. Freight charges on materials assigned to contracts.
5. The past service costs for employees whose wages are included in direct labor.
6. Bidding expenses for contracts awarded.
b. Assume that Rust generally builds commercial buildings under contracts with the owners and reports the income using the completed contract method. The company is considering building a series of similar stores for a retail chain. The gross profit margin would be a low percentage, but the company’s gross receipts would triple. Write a letter to your client, Rust Company, explaining the tax accounting implications of entering into these contracts. Rust’s mailing address is PO Box 1000, Harrisonburg, VA 22807.
43. LO.5 On March 31, 2014, Big Boats Company entered into a contract with Vacations
Unlimited to produce a state-of-the-art cruise ship, to be completed within three years. Big Boats estimated the total cost of building the ship at $300 million. The contract price was $400 million. The ship was completed on February 15, 2017.
a. What tax accounting method must Big Boats use for the contract? Why?
b. Using the financial data provided relating to the contract’s performance, complete the following schedule:
Date
Total Costs
Incurred to
Date
Total
Percentage of Contract
Completed
Current-Year
Revenue
Accrued
Current-Year
Costs
Deductible
12/31/14 $ 90 million ——— ——— ———
12/31/15 150 million ——— ——— ———
12/31/16 270 million ——— ——— ———
12/31/17 360 million N/A ——— ———
c. What are the consequences of the total cost of $360 million exceeding the estimated total cost of $300 million?
44. LO.5 Ostrich Company makes gasoline storage tanks. Everything produced is under contract (that is, the company does not produce until it gets a contract for a product). Ostrich makes three basic models. However, the tanks must be adapted to each individual customer’s location and needs (e.g., the location of the valves and the quality of the materials and insulation). Discuss the following issues relative to Ostrich’s operations:
a. An examining IRS agent contends that each of the company’s contracts is to produce a “unique product.” What difference does it make whether the product is unique or a “shelf item”?
b. Producing one of the tanks takes over one year from start to completion, and the total cost is in excess of $1 million. What costs must be capitalized for this contract that are not subject to capitalization for a contract with a shorter duration and lower cost?
c. What must Ostrich do with the costs of bidding on contracts?
d. Ostrich frequently makes several cost estimates for a contract, using various estimates of materials costs. These costs fluctuate almost daily. Assuming that Ostrich must use the percentage of completion method to report the income from the contract, what will be the consequence if the company uses the highest estimate of a contract’s cost and the actual cost is closer to the lowest estimated cost?
45. LO.5, 6 Swallow Company is a large real estate construction company that has made a Subchapter S election. The company reports its income using the percentage of completion method. In 2017, the company completed a contract at a total cost of $4.8 million. The contract price was $7.2 million. At the end of 2016, the year the contract was begun, Swallow estimated that the total cost of the contract would be $5.4 million. Total accumulated cost on the contract at the end of 2016 was $1.8 million. The relevant tax rate is 35%, and the relevant Federal interest rate is 5%. Assume that all income tax returns were filed and taxes were paid on March
15 following the end of the calendar tax year.
a. Compute the gross profit on the contract for 2016 and 2017.
b. Compute the lookback interest due or receivable with the 2017 tax return.
c. Before bidding on a contract, Swallow generally makes three estimates of total contract costs: (1) optimistic, (2) pessimistic, and (3) most likely (based on a blending of optimistic and pessimistic assumptions). The company has asked you to write a letter explaining which of these estimates should be used for percentage of completion purposes. In writing your letter, you should consider the fact that Swallow is incorporated and has made an S corporation election.
Therefore, the income and deductions flow through to the shareholders who are all individuals in the 35% marginal tax bracket. The relevant Federal interest rate is 8%. Swallow’s mailing address is 400 Front Avenue, Ashland, OR 97520.