swft2014 vol01 ch06 sm final

CHAPTER 6

DEDUCTIONS AND LOSSES: IN GENERAL

SOLUTIONS TO PROBLEM MATERIALS

Status: Q/PQuestion/ Learning Present in PriorProblem Objective Topic Edition Edition

1 LO 1 Allowed income and deductions Unchanged 12 LO 1 Deductions for and from AGI Updated 23 LO 1 Deductions for and from AGI Unchanged 34 LO 1 Deductions for and from AGI New5 LO 1 Deductions for and from AGI Unchanged 56 LO 1 Deductions for and from AGI Unchanged 67 LO 1 Deductions for and from AGI;

deductions disallowanceUpdated 7

8 LO 1 Ordinary and necessary requirement New9 LO 1 Reasonable compensation Unchanged 9

10 LO 1 Business versus nonbusiness losses Unchanged 1011 LO 1 Reporting procedures Unchanged 1112 LO 2 Method of accounting: cash basis Unchanged 1213 LO 2 Prepayment provision for cash basis

taxpayerUnchanged 13

14 LO 2 All events and economic performance tests

Unchanged 14

15 LO 2 Reserves and economic performance test

Unchanged 15

16 LO 3 Illegal activities Unchanged 1617 LO 3 Domestic and foreign bribes Unchanged 1718 LO 3 Legal expenses Unchanged 1819 LO 3 Illegal activities Unchanged 1920 LO 3 Political contributions Unchanged 2021 LO 3 Lobbying expenditures New22 LO 3 Excessive executive compensation New23 LO 3 Investigation of a business New24 LO 3 Hobby/business New25 LO 3 Vacation home rental: classification New26 LO 3 Vacation home rental: deduction of loss Unchanged 26

6-1© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly

accessible website, in whole or in part.

6-2 2014 Individual Income Taxes/Solutions Manual


27 LO 3 Vacation home rental: exclusion Unchanged 2728 LO 3 Conversion of a residence to rental

propertyUnchanged 28


29 LO 3 Another taxpayer’s obligation Unchanged 2930 LO 3 Personal expenses versus deductible

legal expensesUnchanged 30

31 LO 3 Losses between related parties Unchanged 3132 LO 3 Tax-exempt income/expenses Unchanged 3233 LO 1 Deductions for and from AGI New34 LO 1 Deductions for and from AGI Updated 3435 LO 1 Deductions for and from AGI New36 LO 1 Reasonable salaries Unchanged 3637 LO 1 Business and nonbusiness losses New38 LO 2 Cash method versus accrual method Unchanged 3839 LO 2 Cash basis and prepaid expenses Unchanged 3940 LO 2 Economic performance test Unchanged 4041 LO 3 Legal expenses and public policy

limitationsUnchanged 41

42 LO 3 Illegal business Unchanged 4243 LO 3 Lobbying expenses and political

contributionsNew

44 LO 3, 4 Excessive executive compensation Unchanged 44*45 LO 3 Excessive executive compensation Unchanged 4546 LO 3 Investigation of a business Modified 4647 LO 3 Investigation of a business Unchanged 47

*48 LO 3 Hobby/business Unchanged 48*49 LO 3 Hobby losses/business New50 LO 3 Vacation home rental: exclusion Unchanged 50

*51 LO 3 Vacation home rental: court’s approach and IRS’s approach

Unchanged 51

*52 LO 3 Vacation home rental: primarily rental use

Unchanged 52

*53 LO 1, 3 Taxable income calculation and vacation home

Unchanged 53

*54 LO 1, 3, 4 Another taxpayer’s obligations Unchanged 5455 LO 3, 4 Capital expenditures and amortization Unchanged 5656 LO 3, 4 Losses between related parties Modified 5757 LO 3 Deductions between related parties and

constructive ownershipUnchanged 58

*58 LO 3 Losses between related parties Unchanged 5959 LO 3 Tax-exempt income/expenses Modified 60

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Deductions and Losses: In General 6-3


60 LO 1, 3, 4 Another taxpayer’s obligations and classifying deductions for and from AGI

New

*61 Cumulative Updated 62*62 Cumulative Modified 63

*The solution to this problem is available on a transparency master.



Status: Q/PResearch Present in PriorProblem Topic Edition Edition

1 Expenditures on another’s behalf New2 Fines and legal expenses Unchanged 23 Vacation home treatment Unchanged 34 Hobby versus trade or business Unchanged 45 Hobby loss New6 Deduction for AGI New7 Internet activity Unchanged 78 Internet activity Unchanged 8



CHECK FIGURES

33.34.a.34.b.

35.

36.a.

36.b.

37.38.a.38.b.39.40.41.42.a.42.b.42.c.43.44.

45.

46.47.a.47.b.47.c.47.d.48.

AGI reduced by $4,850.AGI is $50,500.Select itemized deductions of $8,500.With IRA contribution $5,600; without IRA contribution $5,400.Reduce taxable income of Thrush, Inc.Thrush’s taxable income $0 if deemed reasonable; children report $41,667 each; probably most of $125,000 will be classified as unreasonable.Deduct $4,000.$500,000 under cash method.$545,000 under cash method.$120,000.$85,000.$3,000.Increase AGI by $15,000.Increase AGI by $15,000.Increase AGI by $45,800.$0.Adopt the performance-based compensation program.Salary and bonus $8.16 million; retirement plan contribution $456,000.$38,132.$52,000.$52,000.$0.$3,817.Taxable income $39,300.

49.a.

49.b.

50.51.a.

51.b.

52.

53.54.a.54.b.54.c.

55.a.55.b.

56.a.56.b.57.

58.a.58.b.58.c.58.d.58.e.59.61.62.

Net increase in taxable income $5,860.Net decrease in taxable income $5,700.No impact on AGI.Net rental income $0; itemized deduction $10,555.Net rental income $0; itemized deduction $4,600.Net rental loss $12,053; deduction $325.$23,507.$17,000.$0.Chelsie should give or loan $1,000 to Elisa and Clyde who then pay $1,000 to Boyd.$173,000 allocated to listed assets.$27,000 is either for goodwill or covenant not to compete.Loss of $24,000 is not deductible.Gain $6,000; loss $8,000; $0.Robin may deduct $2,800 in 2013 for loan from Peter, but can’t deduct $2,800 for Isabelle’s loan until 2014; Isabelle and Peter have interest income of $2,800 each in 2014.$0.$15,000 loss.$0.$1,500 loss.$45,000 gain.$17,500.Refund due $616.Refund due $1,142.



DISCUSSION QUESTIONS

1. While the Code provides an all-inclusive definition of income, deductions must be specifically provided for in the Code in order to be permitted. p. 6-2

2. Aaron would prefer deductions for AGI because they are allowable in addition to the standard deduction. Deductions from AGI are claimed only when they exceed the standard deduction and are in lieu thereof. Additionally, deductions which reduce AGI may increase those itemized deductions which are subject to AGI floors [e.g., medical expenses (7.5% or 10%), miscellaneous itemized deductions (2%)]. p. 6-3

3. Michael should contribute the maximum amount of $5,000 for 2013 to his traditional IRA. Since his contribution is classified as a deduction for AGI, Michael also is eligible to take the standard deduction. p. 6-4

4. a. Not deductible.

b. Deduction from AGI.

c. Deduction from AGI (subject to 7.5% or 10% floor).

d. Deduction for AGI.

e. Deduction for AGI.

f. Deduction for AGI.

pp. 6-3, 6-4, and Concept Summary 6.3

5. a. Deduction for AGI.

b. Not deductible.

c. Deduction for AGI.

d. $400 deduction from AGI. The $100 principal payment is not deductible.

e. Deduction for AGI.

f. Deduction from AGI.

pp. 6-3 to 6-5 and Concept Summary 6.3

6. Investment expenses associated with rental property or royalty property are deductible for AGI. Other investment expenses are deductible from AGI. Susan evidently has invested in rental or royalty property, whereas Larry has invested in other investment property. p. 6-4

7. Nanette is eligible to deduct the charitable contributions of $800 and the personal property taxes of $240 as itemized deductions (deductions from AGI). However, since the standard deduction for 2013 of $6,100 is greater than her itemized deductions of $745, she should claim the standard deduction. In addition, she is allowed the $225 under the teacher’s supplies provision as a deduction for AGI. pp. 6-4 and 6-5



8. Three items which § 162 specifically excludes from classification as a trade or business expense are as follows:

Charitable contributions or gifts.

Illegal bribes and kickbacks and certain treble damage payments.

Fines and penalties.

p. 6-5

9. The statutory language of the Code refers to reasonableness only with respect to salaries and other compensation. However, the courts have held that for any business expense to be ordinary and necessary, it must also be reasonable in amount. p. 6-6

10. The tax consequences to Dave for the residence and the business portions are different. The casualty loss on the residence part must be reduced by $100 and then the aggregate of all allowable personal use property casualty losses for the year must exceed 10% of AGI. No such adjustments are required for the casualty loss on the business portion. p. 6-7

11. Rental income and expenses are reported on Schedule E (Supplemental Income or Loss) of Form 1040. Figure 6.1

12. Cash basis taxpayers can deduct an expense only when it has been paid with cash or other property. Borrowing the money to pay the expense (or charging it on a bank credit card) constitutes actual payment.

However, actual payment does not ensure a current deduction. For example, capital expenditures must be capitalized. Subsequently, the expenditure may be amortized, depleted, or depreciated. Except in certain circumstances, prepaid items cannot be currently deducted. p. 6-9

13. a. It is doubtful that Aubry could deduct the $65,000 of supplies in 2013 because he was motivated by tax considerations (i.e., to manipulate income). See the Keller case cited in Footnote 23.

b. If Aubry bought the supplies at a discount, he would be motivated by business reasons other than tax reduction. Since the supplies would be used within the following year, the Zaninovich case indicates that Aubry could deduct the supplies. p. 6-9 and Footnote 21

14. The all events test and the economic performance test must be met before an accrual basis taxpayer can deduct an expense. For the all events test to be satisfied, (1) all the events must have occurred to create the taxpayer’s liability, and (2) the amount of the liability can be determined with reasonable accuracy. Once these requirements are satisfied, the deduction is permitted only if economic performance has occurred. The economic performance test is met only when the service, property, or use of property giving rise to the liability is actually performed for, provided to, or used by the taxpayer. pp. 6-9 and 6-10

15. The reason the reserve method cannot be used for tax purposes is that it does not meet the economic performance test. Example 12

16. No, Clear cannot deduct the fines because they are payments in violation of tariff laws. p. 6-11



17. The two issues involved are whether the payment should be made and, if made, is it deductible. If made to the representatives of a U.S. company, it would be a bribe. Not only would it be nondeductible, it could result in criminal charges. If the payment is made to the representative of the foreign company, more than likely it would be an accepted trade practice in that country. In this case, since the payment would not violate the U.S. Foreign Corrupt Practices Act of 1977, it would therefore be deductible. p. 6-11

18. No. Legal fees incurred in connection with a criminal defense are deductible only if the crime is associated with the taxpayer’s trade or business or income-producing activity. Since Stuart does not satisfy this requirement, the attorney’s fee is not deductible. p. 6-12

19. Only c., the price paid for drugs purchased for resale. Whether the business is legal or illegal, cost of goods sold is allowed as a reduction from total sales in arriving at gross income from the business. Thus, cost of goods sold is treated as a negative income item rather than as a deduction. p. 6-13

20. No, a deduction is not permitted for political contributions. p. 6-14

21. Lobbying expenses generally are not deductible. Therefore, if Melissa pays the $1,500 to a professional lobbyist, the payment is not deductible. However, a de minimis exception provides that in-house lobbying expenditures not exceeding $2,000 per year can be deducted. Thus, if Melissa spends the $1,500 on in-house lobbying expenditures, she can deduct this amount. Note that if the in-house expenditures had exceeded $2,000, none of the in-house expenditures could have been deducted. p. 6-14

22. An employer can deduct a maximum of $1 million annually for compensation payments to a covered executive. Covered executives include the chief executive officer and the four other most highly compensated officers. The provision applies only if the employer is a publicly held corporation. Employee compensation excludes:

Commissions based on individual performance.

Certain performance-based compensation dependent on company performance.

Payments to tax-qualified retirement plans.

Payments that are excludible from the employee’s gross income (e.g., certain fringe benefits).

pp. 6-14 and 6-15

23. a. Apparently the business being investigated by Paul was a restaurant. Because Paul is already in the restaurant business, he can deduct all of the investigation expenses of $7,000.

b. Evidently the business being investigated was not a restaurant and Paul did not acquire the business. Consequently, he is not allowed any deduction for the expenses.

c. The business being investigated by Paul in Columbus was not a restaurant, but Paul did acquire the business. Therefore, he can take a limited deduction of $5,000 and amortize the balance as start-up costs over a 180-month period.

pp. 6-15, 6-16, and Concept Summary 6.1



24. a. Harold’s business decreases his AGI by $1,940.

Revenue $20,000Less:

Depreciation on car $3,960Operating expenses of car 3,100Rent 6,000Wages 8,200Amortization 680 (21,940)

Net income ($ 1,940)

The decline in the value of the land of $5,200 has no immediate tax consequence.

b. As the activity is a hobby, Harold cannot deduct any loss.

p. 6-17

25. a. The vacation home is classified as primarily personal because it was rented for fewer than 15 days during the year. As Sarah can exclude the $2,500 of rent income, the vacation home transactions have no effect on her AGI.

b. The only expenses that Sarah can deduct are those she normally would deduct as itemized deductions. This includes the following:

Mortgage interest $10,000Property tax 1,500Total $11,500

Sarah cannot deduct any of the utilities, insurance, and maintenance expenses or the depreciation. None of the expenses are deductible for AGI.

p. 6-20

26. For a rental loss on a vacation home to be deductible, the property must be classified as primarily rental. Consequently, the following requirements must be satisfied: the residence is rented for 15 days or more during the year and is not used for personal purposes for more than the greater of (1) 14 days or (2) 10% of the rental days. Even here, however, the expenses must be allocated between the rental and the personal days. p. 6-20

27. In prior years, the beach home has been classified as a rental property since the personal use (exactly 14 days) did not exceed the greater of 14 days or 10% of rental days (200 × 10% = 20 days). Thus, if the total available deductions exceeded the rental income, the loss could be deducted on Karen and Andy’s tax return. If Sarah is permitted to use the beach house for 7 days, the total personal use days of 21 will exceed the statutory limit of 20 days (i.e., 10% of rental days of 200). In this case, the deductions are permitted only to the extent of the rental income. What needs to be determined are whether the deductions do exceed the rental income and whether Sarah wants to use it for a full 7 days. pp. 6-20 to 6-22

28. Hank can deduct property taxes and mortgage interest from January 1 to March 1 as an itemized deduction from AGI. The home was his personal residence during that period. For the rest of the year, from March 1 through December 31, he can deduct property taxes, mortgage interest, depreciation, and all other expenses for AGI as rental expenses. The “qualified rental period” requirements have been met. He has converted his personal



residence into rental property and no allocation of expenses need be made, even if there is a rental loss. p. 6-23

29. a. For Ray to deduct the interest, he needs to make the payment to the mortgage company. Thus, Ted could give the money to Ray so Ray pays the mortgage company.

b. If Ted pays the mortgage company directly, Ted cannot deduct the interest since it is not his obligation. Ray would not be permitted the deduction since he did not make the payment.

c. The obligation is that of Ray and not that of Ted. Thus, Ted is not permitted to deduct the interest even if he makes the payment directly to the mortgage company.

Example 32

30. Edna can deduct only those legal expenses associated with the divorce for which the origin and character of the claim are directly related to a trade or business, an income-producing activity, or the determination, collection, or refund of a tax. As personal legal expenses are not deductible, only the expenses relating to the items mentioned above qualify. pp. 6-25, 6-26, and Example 33

31. The tax issue is whether Ella will be able to deduct the loss on the sale of the stock. If the transferee is a related party under § 267, the realized loss is disallowed. Otherwise, the realized loss is recognized.

The gift to the other relative has no effect on the sales transaction. Although no income tax consequences result, the imposition of a Federal gift tax should be considered.

pp. 6-27 and 6-28

32. a. Although Jarret receives interest payments of $3,800, all of this amount is excluded from his gross income. Interest on municipal bonds is tax-exempt.

b. None of Jarret’s interest payments of $4,900 on the loan can be deducted. The proceeds of the loan were used to purchase tax-exempt bonds. Consequently, the interest expense deduction is disallowed. Likewise, none of the principal payments of $1,100 can be deducted since this is merely the payment of a liability.

pp. 6-29 and 6-31

PROBLEMS

33. a. Since the expenses relate to Amos’s tax law practice and are paid by him, he can claim them in calculating AGI. The expenses reduce his AGI by $4,525, determined as follows:

Conference registration ($900 + $900) $1,800Airline tickets ($1,200 + $700) 1,900Taxi fares 100Lodging ($750 + $300) 1,050

$4,850

b. The answer in a. for Amos would not change. These expenses are associated with his business as a tax attorney.

Example 1



34. a. Gross income:Salary income $60,000Net rent 6,000Dividend income 3,500 $69,500

Deductions for AGI:Alimony paid $12,000Contribution to traditional IRA 5,000Loss on sale of real estate 2,000 (19,000)

Adjusted gross income $50,500

b. Itemized deductions:Mortgage interest on residence $ 4,900Property tax on residence 1,200Contribution to church 2,100State income tax 300Medical expenses

[$3,250 – ($50,500 × 10%)] –0–Total itemized deductions $ 8,500

Since the standard deduction for 2013 ($6,100) is less than Daniel’s itemized deductions ($8,500), Daniel should itemize his deductions from AGI. The Federal income tax of $7,000 is not deductible.

pp. 6-3 to 6-5

35. With IRA Without IRAContribution Contribution

Gross income $10,000 $10,000Contribution to IRA (1,000) (–0–) AGI $ 9,000 $10,000

Itemized deductions:Charitable contribution $1,000 $1,000Medical expenses [$3,000 – (10% × AGI)] 2,100 2,000Casualty loss [($3,500 – $100) – (10% × AGI)] 2,500 2,400

Total itemized deductions $5,600 $5,400

Thus, the $1,000 traditional IRA contribution would increase Janice’s itemized deductions by $200 ($5,600 – $5,400). Example 2

36. a. Kirby and Melinda are trying to use the salaries to reduce the taxable income of Thrush to zero ($975,000 – $500,000 – $350,000 – $125,000). By so doing, they can avoid the potential for double taxation.

b. If the salaries paid to the children are deemed reasonable, Thrush’s taxable income is reduced to zero. Each child will report gross income of $41,667.

The more likely result is that a substantial portion of the $125,000 salary payments will be labeled as unreasonable compensation. In this case, Thrush’s taxable income will be increased by the amount of unreasonable compensation. Each of the children will report gross income equal to the amount labeled reasonable compensation. Kirby and Melinda will have additional dividend income equal to the amount of the unreasonable compensation.

pp. 6-6 and 6-7



37. The following losses can be deducted by Peggy:

Loss on sale of Yellow, Inc., stock $1,600Theft loss of uninsured business use car 1,500Loss on sale of City of Newburyport bonds 900Deductible loss $4,000

Neither the $8,000 loss on the sale of Peggy’s personal use car nor the $10,000 loss on the sale of her personal residence is deductible because these assets are personal use assets. p. 6-7

38. a. Under the cash method, Falcon can deduct only the salaries paid of $500,000. The $45,000 of unpaid salaries can be deducted when paid next year.

b. Under the accrual method, the $500,000 is deductible because both the all events test and the economic performance test are satisfied. These tests also are satisfied for the $45,000 of unpaid and accrued salaries. Consequently, Falcon can deduct the $45,000 for a total deduction of $545,000 ($500,000 + $45,000).

pp. 6-8 to 6-10

39. Maud can deduct $120,000 in 2013 for the rent for February 2013 through July 2014. She does qualify under the one-year rule for prepaid expenses since the period for which prepayments have been made does not extend past December 31, 2014. Example 8

40. Gross receipts $300,000Less:

Coliseum rental $ 25,000Food (cost of goods sold) 30,000Souvenirs (cost of goods sold) 60,000

Performers 100,000 (215,000)Net income for 2013 $ 85,000

Since Duck is an accrual basis taxpayer, it may accrue and deduct in 2013 the costs of the performers of $100,000 even though not paid until January 5, 2014 (i.e., the economic performance test is satisfied). However, the cleaning cost of $10,000 may not be deducted until 2014 when the services are performed (i.e., at that time, the economic performance test is satisfied). Example 9

41. Only the $500 paid to the attorney to draft the lease and the $2,500 paid to the attorney to negotiate a reduction in the alimony payments to the former spouse are deductible by Doug. These expenses are ordinary and necessary expenses incurred in connection with rental property held for the production of income and for deductible alimony. The tickets and the related legal expenses are not deductible because they are personal in nature. Even if related to the conduct of a trade or business or the production of income, they are disallowed as a deduction because they violate public policy. The $1,000 payment for negotiating a reduction in child support payments is personal in nature. p. 6-12



42. a. The effect of the illegal gambling business on Trevor’s AGI is as follows:

Gross income $52,000Deductible expenses:

Salaries $ 8,000Payouts to winners 29,000 (37,000)

Increase in AGI $15,000

The bribe to police of $7,500 is not deductible since this expense violates public policy.

Trevor also must include the tip income of $16,000 in his gross income.

b. Trevor’s taxable income also increases by $15,000.

c. For an illegal drug activity, all of the expenses are disallowed. Therefore, it would appear that the illegal drug operation would increase Trevor’s AGI by $52,000. However, the $6,200 cost of goods sold is viewed as a reduction in calculating gross income rather than as an expense. Therefore, the illegal drug operation increases Trevor’s AGI by $45,800 ($52,000 – $6,200).

Example 16

43. Polly’s deduction for the political contributions is $0. Political contributions cannot be deducted. p. 6-14

44. a. Under the first option, the salary of Amber’s president would be $1,170,000 ($900,000 + $270,000). Since Amber is a publicly held corporation, only $1,000,000 of this salary is deductible, with the balance of $170,000 being disallowed as excessive executive compensation. The $26,000 ($20,000 + $6,000) contribution to the defined contribution pension plan would be deductible.

Under the second option, all of the compensation paid to the president is deductible assuming the statutory requirements for a performance-based compensation program are satisfied. Thus, only the second option provides Amber with a deduction for all of the president’s proposed compensation. pp. 6-14 and 6-15

b. Hoffman and Smith, CPAs5191 Natorp Boulevard

Mason, OH 45040September 16, 2013

Ms. Agnes RiddleChairperson of the Board of DirectorsAmber, Inc.100 James TowerCleveland, OH 44106

Dear Ms. Riddle:

I am responding to your inquiry regarding the proposed compensation plans for Amber’s president. Under one proposal, both the salary and the pension contribution will be increased by 30%. Under the other option, a performance-based compensation program will be implemented which is projected to provide about the same additional compensation and pension contribution for the president.



The 30% increase option will produce a salary of $1,170,000 and a pension contribution of $26,000. Of this amount, only $1,026,000 ($1,000,000 salary and $26,000 pension contribution) can be deducted by Amber. The salary paid to the president in excess of $1,000,000 is disallowed as excessive executive compensation.Under the performance-based compensation option, all of the compensation (salary, bonus, and pension contribution) can be deducted assuming that the performance-based compensation satisfies the following requirements:

Such compensation is based on company performance according to a formula approved by a board of directors compensation committee (comprised solely of two or more outside directors) and by shareholder vote. The performance must be certified by this compensation committee.

I recommend that you adopt the performance-based compensation option. I believe that it will better achieve Amber’s objective of placing a greater emphasis on the relationship between performance and compensation. In addition, under this approach, all of the compensation can be deducted on Amber’s Form 1120.

If you would like to have me work with you in developing this program, let me know.

Sincerely,

Rex Edward, CPAPartner

pp. 6-14 and 6-15

45. Since Vermillion is a publicly held corporation, it is subject to the excessive executive compensation deduction limit for the CEO and the four other most highly compensated officers of $1 million each. Since the 5% bonus does not satisfy the requirements that must be met to exclude it from covered compensation, the bonus is included with the salary in applying the limit. Thus, Vermillion may deduct the following:

Retirement Plan Salary Contribution

CEO $1,000,000 $ 80,000Executive vice president 1,000,000 72,000Treasurer 1,000,000 64,000Marketing vice president 1,000,000 60,000Operations vice president 1,000,000 56,000Distribution vice president 1,260,000 48,000Research vice president 1,100,000 44,000Controller 800,000 32,000

$8,160,000 $456,000

The limit does not apply to the distribution vice president or the research vice president because they are not included in the covered group (i.e., CEO plus top 4). The retirement plan contribution is excluded from the definition of covered compensation. pp. 6-14 and 6-15



46. Even though Nancy decides not to pursue the expansion of her hotel chain into another city, the investigation expenses of $35,000 are deductible in the current year. Because Nancy is in the hotel business, all investigation expenses associated with the hotel business are deductible in the year paid or incurred. Since Nancy was not in the restaurant business, she can deduct only part of these investigation expenses. Of the $53,000, an amount of $2,000 [$5,000 – $3,000 (reduction for excess over $50,000)] can be immediately expensed. The balance of $51,000 ($53,000 – $2,000) is amortized over a period of 180 months at the rate of $283 per month ($51,000 ÷ 180) commencing in September (the month the business is started). Consequently, the total deduction for the year is $35,000 for the hotel investigation + $3,132 [$2,000 + ($283 × 4 months)] for the restaurant investment, or a total of $38,132. pp. 6-15, 6-16, and Concept Summary 6.1

47. a. He could deduct $52,000. Example 18

b. He could deduct $52,000. Example 18

c. None of Terry’s expenses is deductible. Example 19

d. Terry can immediately expense $3,000 and amortize the $49,000 balance ($52,000 – $3,000) over a period of 180 months beginning in October (the month the business is started). The deduction for 2013 is $3,817 [$3,000 + $817 ($49,000 ÷ 180 × 3 months)]. Example 20

48. Alex must report the $18,000 as revenues. All of the property taxes of $3,000 can be deducted. Because the remaining expenses of $16,250 exceed the balance of $15,000 ($18,000 revenues – $3,000 property taxes), the $15,000 is deductible as follows:

Materials and supplies $ 4,500Utilities 2,000Advertising 5,000Insurance 750Depreciation (since depreciation is sequenced

last, only $2,750 of the $4,000 is eligible) 2,750Total deductible expenses $15,000

These expenses of $15,000 are classified as miscellaneous itemized deductions and will be subject to the 2%-of-AGI floor. Consequently, $1,200 [($42,000 + $18,000) × 2%] of these expenses are disallowed.

Other AGI $42,000Revenues from hobby $18,000Less: Expenses

Property taxes (3,000)Miscellaneous itemized

deduction ($15,000 – $1,200) (13,800)Reportable net income from hobby 1,200Less: Personal exemption (3,900)Taxable income $39,300

pp. 6-17 and 6-18



49. a. If the miniature horse activity is held to be a hobby, Samantha’s deductions associated with the hobby may not exceed her gross income from the activity.

Income $22,000Deduct: Mortgage interest (10% × $24,000) $2,400

Property taxes on horse farm improvements 800Property taxes on home (10% × $2,200) 220 (3,420)

Balance $18,580 Deduct: Other expenses

Entry fees $1,000Feed and veterinary bills 4,000Supplies 900Publications and dues 500Travel 2,300Salary and wages 8,000 (16,700)

Balance $ 1,880 Depreciation:

On horse equipment $ 3,000On horse farm improvements 7,000On home (10% office portion) 1,000Total $11,000Limited to: (1,880)

Net Income $ –0–

The items are handled as follows:

AGI $100,000Plus: Horse farm income 22,000New AGI $122,000

Itemized deductions:Interest and taxes on horse farm (hobby portion) $ 3,420Interest and taxes on home ($26,200 – $2,620) 23,580 $27,000Other expenses and depreciation of hobby ($16,700 + $1,880) $18,580Less: 2% of AGI ($122,000) (2,440) $16,140

Note that the deductions of the miniature horse operation are $19,560 ($3,420 + $16,140) of which $3,420 were deductible anyway. The net increase in taxable income is:

Income $22,000Otherwise nondeductible expenses (16,140)Net increase in taxable income $ 5,860

b. If the miniature horse activity is classified as a business, Samantha would be able to deduct $9,120 for AGI as follows:

Remainder of income after other expenses and before amounts that affect basis (depreciation) (see part a. above) $ 1,880

Less: depreciation (11,000)Deduction for AGI ($ 9,120)



In addition, Samantha could deduct the remaining property taxes and mortgage interest of $23,580 as an itemized deduction. The net effect is as follows:

Loss on horse farm ($9,120)Add: otherwise deductible taxes and interest 3,420 Net decrease is taxable income ($5,700)

Contrast this decrease of $5,700 with the increase of $5,860 in part a. The $11,560 difference is due to the difference between hobby and business treatment.

Examples 22 and 23

50. Since the house was rented for less than 15 days, the rental income of $5,000 is excluded from Adelene’s gross income. The only expenses that can be deducted in this case are the real property taxes of $3,800 and the mortgage interest of $7,500. These expenses are classified as itemized deductions (i.e., deductions from AGI). Therefore, there is no effect on AGI. p. 6-20

51. a. Gross income $7,000Deduct: Taxes and interest (30/365 × $11,500) (945)Remainder to apply to rental operating expenses and depreciation $6,055Utilities and repairs [30/50 × ($2,400 + $1,000)] (2,040)Remainder $4,015Depreciation (30/50 × $7,500 = $4,500, limited to remainder) (4,015)Net rental income $ –0–

She can itemize $10,555 of property taxes and mortgage interest ($11,500 total less $945 allocated to rental). Thus, under the court’s approach, Anna has no net rental income and has an itemized deduction of $10,555. Example 29

The roof replacement of $12,000 is a capital expenditure and the related depreciation is included in the $7,500 of depreciation.

b. Gross income $7,000Deduct: Taxes and interest (30/50 × $11,500) (6,900) Remainder to apply to rental operating expenses

and depreciation $ 100Utilities and repairs [30/50 × ($2,400 + $1,000)

= $2,040, limited to remainder] (100)Net rental income $ –0–

Anna can deduct the remaining taxes and interest of $4,600 ($11,500 less rental allocation of $6,900) as itemized deductions. Under the IRS’s approach, she has no net rental income and has an itemized deduction of $4,600. Example 28



52. Since Anna used it for less than 15 days, it is classified as rental property.

Rental PersonalPercentage of use 87% 13%

Gross income $ 7,000 $ –0–Expenses:

Interest and taxes ($9,000 + $2,500) $10,005 $1,495Utilities and repairs ($2,400 + $1,000) 2,958 442Depreciation ($7,000) 6,090 910

Total expenses $19,053 $2,847Net income (loss) ($12,053) $ –0–

Anna could deduct $325 ($2,500 × 13%) of property taxes as itemized deductions and take a rental loss deduction for AGI of $12,053. The mortgage interest of $1,170 ($9,000 × 13%) is not deductible as an itemized deduction because it is not qualified residence interest. Example 25

The roof replacement of $12,000 is a capital expenditure and the related depreciation is included in the depreciation of $7,500. pp. 6-26 and 6-27

53. Income:Salary $43,000Dividend 400Rental of vacation home (Note 2) –0– Adjusted gross income $43,400

Itemized deductions:State income taxes (greater than sales tax) $3,300Property tax on home 2,200Interest on home mortgage 8,400Interest and property taxes on vacation home (Note 2) 4,893Charitable contributions 1,100Tax return preparation fee (Note 3) –0– (19,893)

Taxable income before personal exemption $23,507

Notes

(1) The municipal bond interest of $2,000 is excludible from gross income and the interest expense of $3,100 on the loan to buy municipal bonds is not deductible. p. 6-29

(2) Rental income $4,000Less: Taxes and interest (60/365 × $5,856) (963)Remainder $3,037Less: Utilities and maintenance (1/2 × $2,600) (1,300)Remainder $1,737Less: Depreciation ($3,500, limited to $1,737) (1,737)Net income from vacation home $ –0–

Note that $4,893 ($5,856 total $963 vacation home portion) of property taxes and mortgage interest on the vacation home are itemized deductions. Example 29

(3) Tax preparation fees are reduced by 2% of AGI (in this case 2% of AGI exceeds $300).



54. a. Sales revenue $55,000Deduct: Cost of goods sold $21,000

Advertising 1,000Utilities 2,000Rent 4,500Insurance 1,500Wages to Boyd 8,000 (38,000)

AGI $17,000

Elisa and Clyde can deduct only the $8,000 in wages they paid to Boyd.

b. Chelsie is not entitled to a deduction on her tax return. The obligation is that of Elisa and Clyde since it related to their business.

c. If Chelsie had made a gift of the $1,000 to Elisa and Clyde or had she loaned the $1,000 to them, then they could deduct it assuming they pay the $1,000 to Boyd.

Example 32

55. a. Jay is selling the assets of the sole proprietorship. Of the sales price of $200,000, $173,000 is allocated to the listed assets in accordance with their fair market values. The recognized gain on each asset is the difference between its fair market value and its basis. The residual $27,000 ($200,000 – $173,000) appears to represent a payment for goodwill. Therefore, since Jay has a basis of $0 for the goodwill, he has a gain of $27,000. Since goodwill is a capital asset, the gain is classified as a long-term capital gain. Long-term capital gains are eligible for beneficial tax rates.

b. Lois is purchasing the assets of the sole proprietorship. Her basis for each asset is the amount paid for it (i.e., the fair market value). It appears that the excess $27,000 ($200,000 – $173,000) represents a payment for goodwill. The goodwill is amortized over a statutory 15-year period.

Another option for Lois would be to get Jay to agree that part or all of the $27,000 is a payment for a covenant not to compete. Even though Jay is age 70 and indicates he is going to retire, this would give Lois additional security. Like goodwill, the covenant is amortizable over a statutory 15-year period regardless of the life of the covenant.

c. Whether an allocation is made to a covenant does not affect the tax consequence to Lois (both are amortizable over a 15-year period). Goodwill is a capital asset to Jay, whereas the sale of a covenant not to compete would produce ordinary income. Since Jay is in the 35% marginal tax bracket, there is a benefit to him of using the alternative tax on capital gains in calculating his tax liability. Therefore, assuming Lois is secure that Jay is going to retire (i.e., she does not need the legal protection of a covenant), she may negotiate to have part of Jay’s tax benefit of the goodwill assigned to her through an adjustment of the $200,000 purchase price.

p. 6-27

56. a. Brittany’s $24,000 loss ($160,000 amount realized – $184,000 adjusted basis) is not deductible due to § 267.

b. If sold for $190,000, Ridge’s recognized gain is $6,000 [$190,000 (sales price) less $160,000 (basis), reduced by the $24,000 loss that previously was not allowed to Brittany].



If sold for $152,000, a $8,000 loss [$152,000 (sales price) less $160,000 (basis)] is recognized by Ridge. The $24,000 loss that was realized by Brittany is not deductible by either Brittany or Ridge and is lost permanently.

If sold for $174,000, there is no recognized gain to Ridge [$174,000 (sales price) less $160,000 (basis), reduced by $14,000 of the $24,000 loss that previously was not recognized by Brittany]. The remaining $10,000 of unrecognized loss is lost permanently as a deduction for both Brittany and Ridge.

c. Hoffman and Smith, CPAs5191 Natorp Boulevard

Mason, OH 45040June 21, 2013

Ms. Brittany Callihan32 Country LaneLawrence, KS 66045

Dear Ms. Callihan:

As you requested in your note, I am providing you with the tax consequences of the proposed sale of stock to your son Ridge. Although you would have a potential loss of $24,000 ($160,000 selling price – $184,000 cost), you would not be able to recognize this loss on your tax return. The tax law disallows the recognition of losses between certain related parties.

If you do sell the stock to Ridge, his tax basis for calculating gain or loss on a subsequent sale by him would be his cost of $160,000. However, if he should sell it at a gain, he could use as much of your $24,000 disallowed loss as necessary to reduce his gain to zero.

From a planning perspective, you could recognize the $24,000 loss on your tax return if you were to sell the stock to an unrelated party rather than selling it to Ridge.

If you would like to discuss this further, please let me know.

Sincerely,

Ellen Allen, CPATax Partner

Examples 35 to 37

57. Robin Corporation can take a deduction for interest of $2,800 in 2013 on the loan from Peter, but must defer the deduction of $2,800 on the loan from Isabelle until 2014 when it is paid. Both Isabelle and Peter have interest income in 2014 when it is received. The reason for the different treatment is that Peter owns his 19% plus (by attribution) Isabelle’s 26% for a total of 45%. Since this is not greater than 50%, he is not a related party with respect to Robin.

Isabelle, however, owns her shares (26%), plus (by attribution) her husband’s shares (19%), her father’s shares (25%), and her mother’s shares (15%) for a total of 85% ownership. Section 267 disallows the deduction for the accrued expense in 2013 because Isabelle and Robin are related parties.

pp. 6-27 and 6-28



58. a. Amount realized $12,000Adjusted basis (17,000)Realized loss ($ 5,000)

Recognized loss $ –0–

Bonnie and Phillip are related parties under § 267. Therefore, Bonnie’s realized loss of $5,000 is disallowed. Phillip’s adjusted basis for the stock is his cost of $12,000.

b. Amount realized $70,000Adjusted basis (85,000)Realized loss ($15,000)

Recognized loss ($15,000)

Amos and Boyd are not related parties under § 267. Therefore, Amos’s realized loss of $15,000 is recognized. Boyd’s adjusted basis for the land is his cost of $70,000.

c. Amount realized $19,000Adjusted basis (20,000)Realized loss ($ 1,000)

Recognized loss $ –0–

Susan and her wholly owned corporation are related parties under § 267 (i.e., she owns greater than 50% in value of the outstanding stock). Therefore, Susan’s realized loss of $1,000 is disallowed. The corporation’s adjusted basis for the bond is its cost of $19,000.

d. Amount realized $18,500Adjusted basis (20,000)Realized loss ($ 1,500)

Recognized loss ($ 1,500)

Ron and Agnes are not related parties under § 267. Therefore, Ron’s realized loss of $1,500 is recognized. Agnes’s adjusted basis for the truck is her cost of $18,500.

e. Amount realized $220,000Adjusted basis (175,000)Realized gain $ 45,000

Recognized gain $ 45,000

Martha and Kim are related parties under § 267. However, § 267 applies only to loss transactions. Martha’s realized gain of $45,000 is recognized, and Kim’s adjusted basis for her partnership interest is her cost of $220,000.

pp. 6-27 and 6-28

59. Murphy can deduct only the interest expense attributable to taxable income. The interest attributable to the municipal interest income is not deductible. Thus, only $17,500 ($350,000/$400,000 × $20,000) is deductible. Example 39



60. a. Robert can only deduct amounts which are his obligations. He may not deduct amounts that are obligations of his daughter, Anne. Therefore, Robert can deduct only the following as itemized deductions:

Property taxes on his home $ 3,000Mortgage interest on his home 8,000Total $11,000

The repairs of $1,200 and the utilities of $2,700 paid by Robert associated with his home are nondeductible personal expenditures. The roof replacement costs of $4,000 on Robert’s home are not deductible, but he can add them to his adjusted basis for the home.

b. Anne cannot deduct any of the expenses that would otherwise be deductible by her (i.e., property taxes of $1,500 and mortgage interest of $4,500) because she did not pay them.

c. Robert’s deductions are deductions from AGI (itemized deductions).

d. Anne could deduct the property taxes of $1,500 and the mortgage interest of $4,500 as itemized deductions if she paid them. Therefore, Robert should make a gift of $6,000 to Anne so that she could pay these expenses.

pp. 6-3, 6-4, 6-24, 6-25, and 6-32

CUMULATIVE PROBLEMS

61. Salary $ 75,000Inheritance (Note 1) –0–Gift (Note 1) –0–Life insurance proceeds (Note 1) –0–Net gain on stock sale (Note 2) 2,500Interest income (Note 3) 2,000Dividend income 1,800Prize 750Alimony 15,000Partnership income (Note 4) 5,300 AGI $102,350Itemized deductions:

Charitable contributions ($3,500 + $1,500) $5,000Home mortgage interest 7,800Property taxes ($3,100 + $1,100) 4,200State income taxes ($3,100 + $1,000) (Note 5) 4,100Medical expenses (Note 6) –0– (21,100)

$ 81,250Less: Personal and dependency exemptions (Note 9) (11,400) Taxable income $ 69,850

Tax on $69,850 (Note 10) $ 11,684Less: Withholding and estimated tax ($8,500 + $3,800) (12,300) Net tax payable (or refund due) for 2012 ($ 616)

See the tax return solution beginning on page 6-26 of the Solutions Manual.



Notes

(1) The inheritance of $625,000, life insurance proceeds of $300,000, and the gift of $13,000 all are excludible from Roberta’s gross income.

(2) Roberta’s adjusted basis for the Amber stock is $24,000, the purchase price. A cousin is not a related party. Even if a cousin were a related party, Roberta’s adjusted basis would still be the purchase price of $24,000. Therefore, Roberta has a recognized loss of $4,000 ($20,000 amount realized – $24,000 adjusted basis). Since her holding period for the stock is long term, the loss is classified as long-term capital loss. Roberta has a gain on the sale of the Falcon stock of $6,500 ($13,500 amount realized – $7,000 adjusted basis). Since her holding period for the stock is long-term, the gain is classified as long-term capital gain. Thus, she has capital gain net income and net capital gain of $2,500 ($6,500 – $4,000).

(3) The $2,000 of interest received from First Savings Bank is includible in Roberta’s gross income. The $3,750 of interest received on the City of Springfield School bonds is excludible from gross income.

(4) Roberta reports her distributive share of the partnership taxable income of $5,300 rather than the amount of the distribution she received of $4,800.

(5) The state income taxes of $4,100 exceed the sales tax table amount of $994.

(6) Roberta’s deductible medical expenses are $0.

Roberta $5,000Jason (Note 9) 800

$5,800Less reimbursement (1,500)

$4,300Less 7.5% of $102,350 (7,676)Deductible medical expenses $ –0–

(7) The parking ticket of $1,000 and the related attorney’s fee of $500 cannot be deducted.

(8) The political contribution of $250 cannot be deducted.

(9) Roberta can take a dependency exemption for Jason since she is the custodial parent and did not waive (i.e., no Form 8332) the exemption in 2012. Wayne providing more of Jason’s support than Roberta does is irrelevant. Roberta also can take a dependency exemption for June. Therefore, Roberta’s deduction for personal and dependency exemptions is $11,400 ($3,800 × 3).

(10) The tax liability is $11,684.

The dividend income and net capital gain are taxed at a 15% rate.

$4,300 × 15% = $645

The tax liability as a head of household on the balance of $65,550 ($69,850 – $4,300) from the Tax Table is $11,039. So the tax liability is $11,684 ($645 + $11,039).



62. Tax Compliance

Salaries ($95,000 + $52,000) (Note 1) $147,000Interest on certificates of deposit 3,300Share of S corporation income (Note 2) 1,500Award 3,000Child support (Note 3) –0– AGI (Note 4) $154,800Itemized deductions:

Medical expenses (Note 5) $ –0–Charitable contributions 3,700State income taxes ($4,700 + $3,100 + $1,600)(Note 6) 9,400Home mortgage interest 8,200Property taxes 4,900 (26,200)

$128,600Personal and dependency exemptions (2 × $3,800) (Notes 7 and 8) (7,600) Taxable income $120,700

Tax on $120,800 (Note 10) $ 22,058Less: Withholding ($20,200 + $3,000) (23,200)Net tax payable (or refund due) for 2012 ($ 1,142)

Notes

(1) The medical insurance premiums of $12,960 ($8,000 + $4,960) paid by their employers are excludible from gross income. Likewise, the $7,300 of medical benefits received under the plan by Mary Jane are excludible.

(2) Mary Jane includes her share of the S corporation income of $1,500 in her gross income even though she received cash distributions of only $1,100.

(3) Child support payments of $15,000 are not deductible. See Chapter 4.

(4) The investigation expenses of $15,000 incurred by John and associated with the retail computer franchise are not deductible. This result occurs because John was not in a business that was the same as or similar to the one being investigated, and the new business was not acquired.

(5) John pays medical insurance premiums of $2,000 and Mary Jane pays $1,240. Mary Jane pays noncovered medical expenses of $1,300. Their medical expense deduction is $0 since their payments are less than 10% of AGI (10% × $154,800 = $15,480).

(6) The state income taxes paid of $9,400 ($4,700 + $3,100 + $1,600) exceed the state sales taxes of $2,000.

(7) Mary Jane’s father does not qualify as a dependent. John and Mary Jane do provide over half of his support (i.e., $9,500 furnished by them compared to $5,400 provided by her father). However, the father’s gross income of $6,300 ($2,800 salary + $3,500 unemployment compensation benefits) exceeds the allowable amount of less than $3,900. Since the gross income test is not satisfied, John and Mary Jane may not take the dependency deduction for her father. Note that the Social Security benefits of $4,100 were not included in the father’s gross income.



(8) June is the custodial parent. Since there is no indication that June has waived her right to the dependency deduction for Rod, she qualifies for the dependency deduction rather than John.

(9) The $150 ticket associated with Mary Jane running a red light is a nondeductible personal expenditure.

(10) Since they are filing jointly, their tax liability for 2013 is calculated as follows:

On $72,500 $ 9,983 48,300 × 25% 12,075

$22,058

Tax Planning

CLIENT LETTER

Hoffman and Smith, CPAs5191 Natorp Boulevard

Mason, OH 45040December 16, 2013

Mr. and Ms. John Diaz204 Shoe LaneBlacksburg, VA 24061

Dear Mr. and Ms. Diaz:

I am responding to your inquiry regarding whether Mr. Diaz should receive a $30,000 bonus in 2013 or delay receiving it until 2014. Based on the data provided by you, I have calculated your tax liability for both years assuming the bonus is received in 2013 and assuming the bonus is received in 2014.* The tax liability results are as follows:

Bonus received in 20132013 tax liability $29,6902014 tax liability 8,858Total $38,548

Bonus received in 20142013 tax liability $22,0582014 tax liability 15,608Total $37,666

If you delay the receipt of the bonus until 2014, you will save $882 ($38,548 – $37,666). This ignores any earnings (net of taxes) you could receive on the $30,000 if you receive the bonus in 2013. However, since the decision is to receive the bonus in December 2013 or January 2014, the amount of such earnings is likely to be negligible.

If I can be of further assistance, let me know.

Sincerely,

Rene Ross, CPAPartner

*2013 tax rates used.



TAX FILE MEMORANDUM

December 9, 2013

FROM: Gene Ross

SUBJECT: John and Mary Jane DiazTax Planning Regarding Timing of Bonus

John Diaz, a regular tax client, has an opportunity to receive a $30,000 bonus in December 2013 or in January 2014. He has asked that we recommend to him whether he should receive the bonus in 2013 or delay it until 2014. Expected differences in the data provided for the 2014 return and that for the 2013 return are as follows:

(1) They are expecting a child in January 2014.(2) Mary Jane will quit work on December 31, 2013 to stay home with the child.

Therefore, her salary will decrease by $52,000 and the state income taxes withheld on the $52,000 will decrease by $3,100.

(3) Mary Jane does not expect to receive the $3,000 award.(4) Medical benefits received by Mary Jane in 2014 will be $9,000 rather than the $7,300

received in 2013.Based on the data provided for the 2013* taxes and the above assumptions, I made the following calculations:

Tax with the Bonus: 2013 2014 Taxable income in 2013 $120,800 $120,800Bonus 30,000 30,000Less: Mary Jane’s salary (52,000)

Award (3,000)Additional exemption for child (3,900)

($3,900 × 1)Plus: Decrease in itemized deductions 3,100 Taxable income with bonus $150,800 $95,000

Tax $ 29,690 $15,608

Tax without the Bonus:Taxable income with bonus $150,800 $95,000Less: Bonus (30,000) (30,000)Taxable income without bonus $120,800 $65,000 Tax $ 22,058 $ 8,858

Tax taking the bonus in 2013For 2013 $29,690For 2014 8,858 Total tax $38,548

Tax taking the bonus in 2014For 2013 $22,058For 2014 15,608 Total tax $37,666

They will save $882 ($38,548 – $37,666) by deferring the bonus to January 2014.

*2013 tax rates used.

Proposed solutions to the Research Problems are found in the Instructor’s Guide. Previously, these items were a part of the Instructor’s Companion Site for the textbook.



61.



61. continued



NOTES


swft2014 vol01 ch06 sm final

Documents

vacation home rental

rental useunchanged52

vacation homeunchanged53

cash method

cash basis unchanged12

cash basis taxpayerunchanged13

lobbying expenses

related partiesunchanged31