Problems
27. LO.1 Determine the taxpayer’s current-year (1) economic income and (2) gross income for tax purposes from the following events:
a. Sam’s employment contract as chief executive of a large corporation was terminated, and he was paid $500,000 not to work for a competitor of the corporation for five years.
b. Elliot, a 6-year-old child, was paid $5,000 for appearing in a television commercial. His parents put the funds in a savings account for the child’s education.
c. Valery found a suitcase that contained $100,000. She could not determine who the owner was.
d. Winn purchased a lottery ticket for $5 and won $750,000.
e. Larry spent $1,000 to raise vegetables that he and his family consumed. The cost of the vegetables in a store would have been $2,400.
f. Dawn purchased an automobile for $1,500 that was worth $3,500. The seller was in desperate need of cash.
28. LO.1, 2, 5 Harper is considering three alternative investments of $10,000. Assume that the taxpayer is in the 25% marginal tax bracket for ordinary income and 15% for qualifying capital gains in all tax years. The selected investment will be liquidated at the end of five years. The alternatives are:
• A taxable corporate bond yielding 5.333% before tax and the interest can be reinvested at 5.333% before tax.
• A Series EE bond that will have a maturity value of $12,200 (a 4% before-tax rate of return).
• Land that will increase in value.
The gain on the land is classified and taxed as a long-term capital gain. The income from the bonds is taxed as ordinary income. How much must the land increase in value to yield a greater after-tax return than either of the bonds?
Use the future value tables in Appendix G as needed for your calculations and comparisons.
29. LO.1 Determine the taxpayer’s gross income for tax purposes in each of the following situations:
a. Deb, a cash basis taxpayer, traded a corporate bond with accrued interest of $300 for corporate stock with a fair market value of $12,000 at the time of the exchange. Deb’s cost of the bond was $10,000. The value of the stock had decreased to $11,000 by the end of the year.
b. Deb needed $10,000 to make a down payment on her house. She instructed her broker to sell some stock to raise the $10,000. Deb’s cost of the stock was $3,000. Based on her broker’s advice, instead of selling the stock, she borrowed the $10,000 using the stock as collateral for the debt.
c. Deb’s boss gave her two tickets to the Rabid Rabbits rock concert because she met her sales quota. At the time she received the tickets, each ticket had a face price of $200 and was selling on eBay for $300. On the date of the concert, the tickets were selling for $250 each. Deb and her son attended the concert.
30. LO.1, 2 Determine Amos’s gross income in each of the following cases:
a. In the current year, Amos purchased an automobile for $25,000. As part of the transaction, Amos received a $1,500 rebate from the manufacturer.
b. Amos sold his business. In addition to the selling price of the stock, he received $50,000 for a covenant not to compete—an agreement that he will not compete with his former business for five years.
c. Amos owned some land he held as an investment. As a result of a change in the zoning rules, the property increased in value by $20,000.
31. LO.2, 5 Al is a medical doctor who conducts his practice as a sole proprietor. During
2016, he received cash of $280,000 for medical services. Of the amount collected, $40,000 was for services provided in 2015. At the end of 2016, Al had accounts receivable of $60,000, all for services rendered in 2016. In addition, at the end of the year, Al received $12,000 as an advance payment from a health maintenance organization (HMO) for services to be rendered in 2017. Compute Al’s gross income for 2016:
a. Using the cash basis of accounting.
b. Using the accrual basis of accounting.
c. Advise Al on which method of accounting he should use.
32. LO.2 Selma operates a contractor’s supply store. She maintains her books using the cash method. At the end of the year, her accountant computes her accrual basis income that is used on her tax return. For 2016, Selma had cash receipts of $1.4 million, which included $200,000 collected on accounts receivable from 2015 sales. It also included the proceeds of a $100,000 bank loan. At the end of 2016, she had $250,000 in accounts receivable from customers, all from
2016 sales.
a. Compute Selma’s accrual basis gross receipts for 2016.
b. Selma paid cash for all of the purchases. The total amount paid for merchandise in 2016 was $1.3 million. At the end of 2015, she had merchandise on hand with a cost of $150,000. At the end of 2016, the cost of merchandise on hand was $300,000. Compute Selma’s gross income from merchandise sales for 2016.
33. LO.2, 3, 5 Your client is a partnership, ARP Associates, which is an engineering consulting firm. Generally, ARP bills clients for services at the end of each month. Client billings are about $50,000 each month. On average, it takes
45 days to collect the receivables. ARP’s expenses are primarily for salary and rent.
Salaries are paid on the last day of each month, and rent is paid on the first day of each month. The partnership has a line of credit with a bank, which requires monthly financial statements. These must be prepared using the accrual method.
ARP’s managing partner, Amanda Sims, has suggested that the firm also use the accrual method for tax purposes and thus reduce accounting fees by $600. Assume that the partners are in the 35% (combined Federal and state) marginal tax bracket.
Write a letter to your client explaining why you believe it would be worthwhile for
ARP to file its tax return on the cash basis even though its financial statements are prepared on the accrual basis. ARP’s address is 100 James Tower, Denver, CO 80208.
34. LO.2 Trip Garage, Inc. (459 Ellis Avenue, Harrisburg, PA 17111), is an accrual basis taxpayer that repairs automobiles. In late December 2016, the company repaired Samuel Mosley’s car and charged him $1,000. Samuel did not think the problem had been fixed and refused to pay; thus, Trip refused to release the automobile.
In early January 2017, Trip made a few adjustments and convinced Samuel that the automobile was working properly. At that time, Samuel agreed to pay only $900 because he did not have the use of the car for a week. Trip said “fine,” accepted the $900, and released the automobile to Samuel. An IRS agent thinks Trip, as an accrual basis taxpayer, should report $1,000 of income in 2016, when the work was done, and then deduct a $100 loss in 2017. Prepare a memo to Susan Apple, the treasurer of
Trip, with the recommended treatment for the disputed income.
35. LO.2 Determine the effects of the following on a cash basis taxpayer’s gross income for 2016 and 2017.
a. On the morning of December 31, 2016, the taxpayer received a $1,500 check from a customer. The taxpayer did not cash the check until January 3, 2017.
b. The same as part (a), except the customer asked the taxpayer not to cash the check until January 3, 2017, after the customer’s salary check could be deposited.
c. The same as part (a), except that the check was not received until after the bank had closed on December 31, 2016.
36. LO.2 Marlene, a cash basis taxpayer, invests in Series EE U.S. government savings bonds and bank certificates of deposit (CDs). Determine the tax consequences of the following on her 2016 gross income:
a. On September 30, 2016, she cashed in Series EE bonds for $10,000. She purchased the bonds in 2006 for $7,090. The yield to maturity on the bonds was 3.5%.
b. On July 1, 2015, she purchased a CD for $10,000. The CD matures on June 30, 2017, and will pay $10,816, thus yielding a 4% annual return.
c. On July 1, 2016, she purchased a CD for $10,000. The maturity date on the CD was June 30, 2017, when Marlene would receive $10,300.
37. LO.2 Drake Appliance Company, an accrual basis taxpayer, sells home appliances and service contracts. Determine the effect of each of the following transactions on the company’s 2016 gross income assuming that the company uses any available options to defer its taxes.
a. In December 2015, the company received a $1,200 advance payment from a customer for an appliance that Drake special ordered from the manufacturer.
The appliance did not arrive from the manufacturer until January 2016, and
Drake immediately delivered it to the customer. The sale was reported in 2016 for financial accounting purposes.
b. In October 2016, the company sold a 6-month service contract for $240. The company also sold a 36-month service contract for $1,260 in July 2016.
c. On December 31, 2016, the company sold an appliance for $1,200. The company received $500 cash and a note from the customer for $700 and $260 interest, to be paid at the rate of $40 a month for 24 months. Because of the customer’s poor credit record, the fair market value of the note was only $600. The cost of the appliance was $750.
38. LO.2, 5 Freda is a cash basis taxpayer. In 2016, she negotiated her salary for 2017.
Her employer offered to pay her $21,000 per month in 2017 for a total of $252,000. Freda countered that she would accept $10,000 each month for the 12 months in 2017 and the remaining $132,000 in January 2018. The employer accepted Freda’s terms for 2017 and 2018.
a. Did Freda actually or constructively receive $252,000 in 2017?
b. What could explain Freda’s willingness to spread her salary over a longer period of time?
c. In December 2017, after Freda had earned the right to collect the $132,000 in
2018, the employer offered $133,000 to Freda at that time, rather than $132,000 in January 2018. The employer wanted to make the early payment so as to deduct the expense in 2017. Freda rejected the employer’s offer. Was Freda in constructive receipt of the income in 2017? Explain.
39. LO.2, 5 The Bluejay Apartments, a new development, is in the process of structuring its lease agreements. The company would like to set the damage deposits high enough that tenants will keep the apartments in good condition. The company is actually more concerned about damage than about tenants not paying their rent.
a. Discuss the tax effects of the following alternatives:
• $1,000 damage deposit with no rent prepayment.
• $500 damage deposit and $500 rent for the final month of the lease.
• $1,000 rent for the final two months of the lease and no damage deposit.
b. Which option do you recommend? Why?
40. LO.3 Rusty has been experiencing serious financial problems. His annual salary was $100,000, but a creditor garnished his salary for $20,000; so the employer paid the creditor (rather than Rusty) the $20,000. To prevent creditors from attaching his investments, Rusty gave his investments to his 21-year-old daughter, Rebecca.
Rebecca received $5,000 in dividends and interest from the investments during the year. Rusty transferred some cash to a Swiss bank account that paid him $6,000 interest during the year. Rusty did not withdraw the interest from the Swiss bank account.
Rusty also hid some of his assets in his wholly owned corporation that received $150,000 rent income but had $160,000 in related expenses, including a $20,000 salary paid to Rusty. Rusty reasons that his gross income should be computed as follows:
Salary received $ 80,000
Loss from rental property ($150,000 _ $160,000) (10,000)
Gross income $ 70,000
Compute Rusty’s correct gross income for the year, and explain any differences between your calculation and Rusty’s.
41. LO.2, 3 Troy, a cash basis taxpayer, is employed by Eagle Corporation, also a cash basis taxpayer. Troy is a full-time employee of the corporation and receives a salary of $60,000 per year. He also receives a bonus equal to 10% of all collections from clients he serviced during the year. Determine the tax consequences of the following events to the corporation and to Troy:
a. On December 31, 2016, Troy was visiting a customer. The customer gave Troy a $10,000 check payable to the corporation for appraisal services Troy performed during 2016. Troy did not deliver the check to the corporation until January 2017.
b. The facts are the same as in part (a), except that the corporation is an accrual basis taxpayer and Troy deposited the check on December 31, but the bank did not add the deposit to the corporation’s account until January 2017.
c. The facts are the same as in part (a), except that the customer told Troy to hold the check until January 2017 when the customer could make a bank deposit that would cover the check.
42. LO.3, 4 Faye, Gary, and Heidi each have a one-third interest in the capital and profits of the FGH Partnership. Each partner had a capital account of $50,000 at the beginning of the tax year. The partnership profits for the tax year were $270,000. Changes in their capital accounts during the tax year were as follows:
Faye Gary Heidi Total
Beginning balance $ 50,000 $ 50,000 $ 50,000 $150,000
Withdrawals (20,000) (35,000) (10,000) (65,000)
Additional contributions –0– –0– 5,000 5,000
Allocation of profits 90,000 90,000 90,000 270,000
Ending balance $120,000 $105,000 $135,000 $360,000
In arriving at the $270,000 of partnership profits, the partnership deducted $2,400 ($800 for each partner) in premiums paid for group term life insurance on the partners.
Faye and Gary are 39 years old, and Heidi is 35 years old. Other employees are also eligible for group term life insurance equal to their annual salary. These premiums of $10,000 have been deducted in calculating the partnership profits of $270,000.
Compute each partner’s gross income from the partnership for the tax year.
43. LO.3, 5 In 2016, Alva received dividends on her stocks as follows:
Amur Corporation (a French corporation whose stock is traded on an established U.S. securities market) $60,000
Blaze, Inc., a Delaware corporation 40,000
Grape, Inc., a Virginia corporation 22,000
a. Alva purchased the Grape stock three years ago, and she purchased the Amur stock two years ago. She purchased the Blaze stock 18 days before it went exdividend and sold it 20 days later at a $5,000 loss. Alva had no other capital gains and losses for the year. She is in the 35% marginal tax bracket. Compute
Alva’s tax on her dividend income for 2016.
b. Alva’s daughter, who is 25 and not Alva’s dependent, had taxable income of $6,000, which included $1,000 of dividends on Grape, Inc. stock. The daughter had purchased the stock two years ago. Compute the daughter’s tax liability on the dividends.
c. Alva can earn 5% before-tax interest on a corporate bond or a 4% dividend on a preferred stock. Assuming that the appreciation in value is the same, which investment produces the greater after-tax income?
d. The same as part (c), except that Alva’s daughter is to make the investment.
44. LO.3 Liz and Doug were divorced on December 31 of the current year after 10 years of marriage. Their current year’s income received before the divorce was as follows:
Doug’s salary $41,000
Liz’s salary 55,000
Rent on apartments purchased by Liz 15 years ago 8,000
Dividends on stock Doug inherited from his mother 4 years ago 1,900
Interest on a savings account in Liz’s name funded with her salary 2,400
Allocate the income to Liz and Doug assuming that they live in:
a. California.
b. Texas.
45. LO.4 Nell and Kirby are in the process of negotiating their divorce agreement.
What should be the tax consequences to Nell and Kirby if the following, considered individually, became part of the agreement?
a. In consideration for her one-half interest in their personal residence, Kirby will transfer to Nell stock with a value of $200,000 and $50,000 of cash. Kirby’s cost of the stock was $150,000, and the value of the personal residence is $500,000.
They purchased the residence three years ago for $300,000.
b. Nell will receive $1,000 per month for 120 months. If she dies before receiving all 120 payments, the remaining payments will be made to her estate.
c. Nell is to have custody of their 12-year-old son, Bobby. She is to receive $1,200 per month until Bobby (1) dies or (2) attains age 21 (whichever occurs first).
After either of these events occurs, Nell will receive only $300 per month for the remainder of her life.