5-4 CHAPTER 5

DISCUSSION QUESTIONS

1. Tom received the farm as compensation for services in accordance with the contract with
Uncle John. Therefore, when Tom receives the farm, the value of the farm must be
included in his gross income. pp. 5-4 and 5-5

2. Albert received an excludible gift of $10,000, but he must include in his gross income the
$400 interest received each year for five years. Samantha received life insurance
proceeds of $10,000 which are excluded from her gross income. However, the $2,000
[($2,400 X 5) – $10,000] of income from the installment payments must be included in
Samantha’s gross income. Each year, Samantha will report $400 gross income, as
computed under the annuity rules.

$2,400 – [(cost/expected return)(annual payment)] =

$2,400 – [$10,000/(5 X $2,400) X $2,400] = $400

pp. 5-4 to 5-6

3. Because the majority of the beneficiaries of the nonprofit foundation created by Pearl are
employed by the company, the IRS may argue that the foundation was created for the
benefit of Pearl employees and, therefore, the benefits received by the employees cannot
be excluded from the employees’ gross income. pp. 5-4 and 5-5

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

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

6. Violet Capital has gross income of $20,000 ($100,000 – $80,000). The fund purchased
the policy and therefore is not eligible for the life insurance proceeds exclusion. Ted has
no gross income, assuming that Violet Capital is a “qualified third party” because Ted
was suffering from a terminal interest when he sold the life insurance policy to Violet
Capital. Therefore, the $80,000 he receives is excluded from gross income as an
accelerated death benefit. p. 5-7

7. Since Amber had taxable income in 2003, it received a tax benefit from writing off the
receivable. So Amber would include $5,000 in gross income in 2005 under the tax
benefit rule. The insurance proceeds would not be excluded from gross income because
the insurance contract proceeds were in consideration of the loan and not payable merely
as the result of Aly’s death. p. 5-8

8. Ed must include his realized gain of $6,000 ($45,000 cash surrender value – $39,000
adjusted basis) in his gross income. However, Sarah can exclude from her gross income
her realized gain of $6,000 ($45,000 cash surrender value – $39,000 adjusted basis)
because she has a terminal illness (i.e., the accelerated death benefits exclusion). What
the funds are used for is not relevant in determining the effect on the taxpayer’s gross
income. pp. 5-6 and 5-7
 Gross Income: Exclusions 5-5

9. The tuition waiver could be part of a qualified tuition reduction program. However, José
is allowed to exclude only $1,000 ($4,000 – $3,000) because only $1,000 of the tuition
reduction is received in addition to reasonable compensation for José’s services. pp. 5-10
and 5-11

10. Assuming the $160,000 is a defensible amount, Sarah should accept the counter-offer
made by the company and its insurance company. Under Sarah’s offer (part
compensatory and part punitive), she would receive $230,000 (with the $80,000 punitive
damages included in her gross income) and would have a tax liability of $26,400
($80,000 X 33%) on the punitive damages. Thus, her after-tax cash flow would be
$203,600 ($230,000 – $26,400). Under the company’s proposal, Sarah would receive
$210,000 (with none of the compensatory damages included in her gross income because
they result from her physical personal injury) but would not have any tax liability. So her
after-tax cash flow from the counter-offer would be $210,000. pp. 5-11 and 5-12

11. The entire $170,000 must be included in Sara’s gross income. The $45,000 payment was
received on account of an economic injury rather than a physical personal injury and,
therefore, the amounts received are subject to tax. Likewise, the $25,000 payment must
be included in her gross income because it is not associated with a physical personal
injury. The punitive damages are never excludible. pp. 5-11 and 5-12

12. No. The $15 million amount that Wes received is excluded from his gross income as
compensatory physical personal injury damages even though the amount received is
based on the projected lost income. The $10 million of punitive damages that Wes
receives must be included in his gross income. Sam’s salary of $25 million must be
included in his gross income. pp. 5-11 and 5-12

13. Unemployment compensation benefits are included in gross income for Holly. Under a
system that measures income on the basis of what was earned during the particular
timeperiod, Holly and Jill are equally able to pay their taxes. Each received the same
amount during the tax year. p. 5-12

14. Health Savings Accounts (HSAs) are an alternative to traditional health insurance. The
employer provides a medical insurance plan with a high deductible. The high deductible
reduces the cost of the insurance premiums to the employer. The employer can then
make contributions to the employee’s HSA to offset part of the high deductible. The
employee can exclude employer contributions from gross income. Withdrawals used to
pay medical expenses not covered by the medical insurance plan are excluded from the
employee’s gross income. The employee can make taxable withdrawals for other
purposes. The earnings on the HSA investments are exempt from tax. Deductibles
under traditional health insurance plans are lower. The savings feature of an HSA is not
present in a traditional plan. pp. 5-13 to 5-15

15. The company must increase the offer by $12,000 [$9,000 ÷ (1 – .25)]. pp. 5-2, 5-13, and
5-14

16. With a cafeteria plan, the employee receives a salary and is also provided by the
employer with a fixed amount that he or she can allocate among a range of possible
nontaxable fringe benefits and taxable benefits. With a flexible spending plan, a portion
of the employee’s salary is set aside for specific uses that would have been excludible
from gross income had the employer paid these expenses. The employee’s gross income
is reduced by the amount that goes into the flexible spending account and the
withdrawals are excluded from gross income. However, any unused funds are forfeited
by the employee. pp. 5-19 and 5-20
5-6 2006 Comprehensive Volume/Solutions

17. The discount Ted receives of $1,600 ($22,000 regular customer cost – $20,400 employee
cost) is a qualified employee discount. Ted’s price for the automobile of $20,400 was
greater than the employer’s cost of $20,000. Therefore, Ted is not required to recognize
any income from the purchase of the automobile. However, the service contract is
treated as his purchasing a service, since his discount is more than 20% of the price
charged regular customers. Therefore, Ted must include in his gross income the amount
of the discount in excess of 20%.

Ted’s discount ($1,200 – $600) $600

Less: 20% discount ($1,200 X 20%) ( 240)
Excess discount $360

pp. 5-21 and 5-22

18. The use of the country club facilities qualifies by Zack and his family as a no-additional-
cost service. Thus, it is excluded from Zack’s gross income. pp. 5-20 and 5-21

19. a. Tom must include the $100 in gross income. Ted is allowed to exclude the $100 as
a qualified transportation fringe.

b. Tom paid $100 for transportation cost and was reimbursed for that amount.
Therefore, Tom’s before-tax cost was $0. However, Tom is required to include the
$100 in gross income and thus must pay an additional $28 ($100 X .28) tax on the
reimbursement, which is his after-tax cost of commuting.

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

pocket cost and is not required to include the reimbursement in income.

p. 5-23

20. The issues all relate to whether the employees would realize gross income from the
employer providing the facilities? If the employee does have gross income, the next
question is: does the benefit qualify under one of the exclusions provided in the Code?

• Does the employee experience an economic benefit from using the facility?
• Does the walking trail qualify as an excludible “athletic facility"?
• Is the benefit de minimis?
• Is the benefit a no-additional-cost service?

pp. 5-20 to 5-22

21. A possible advantage to taking the three-month job in the foreign country is that Marla
may then satisfy the requirements for the foreign earned income exclusion for all of her
earned income for the twelve-month period (i.e., statutory ceiling of $80,000 in 2004).
This would be a substantial benefit. pp. 5-26 to 5-28

22. The State of Virginia bonds are the better investment. The after-tax yield on the U.S.
Government bonds is 3.64% [(1 – .35)(.056)], while the tax-exempt Virginia bonds yield
4%. pp. 5-28 and 5-29
 Gross Income: Exclusions 5-7

23. The patronage dividend is a recovery of Maria’s feed and fertilizer costs that were
deducted in 2004. The cost of the feed and fertilizer produced a tax benefit in 2004 since
the farm produced a $100,000 net profit. Since the patronage dividend is a recovery of a
prior deduction, it must be included in Maria’s 2005 gross income under the tax benefit
rule. pp. 5-29 and 5-30

24. Neither child must include anything in his or her gross income. The $15,000 ($40,000 –
$25,000) gain with respect to Peggy, the child who attended college, is exempt because
the fund was used for qualified higher education expenses associated with a qualified
tuition program. Robert, the child who did not attend college, never received anything.
Therefore, there is no effect on his gross income. Arthur must recognize $6,100 of
interest income for the amount refunded. p. 5-31

25. The tax benefit rule does not result in an increase in Mary’s gross income. The tax
benefit rule applies when the taxpayer takes a deduction in one year, but recovers the
deduction in a subsequent year. Under the tax benefit rule, income generally must be
recognized on the recovery, but only the extent the taxpayer received a tax benefit from
the deduction in the prior tax year. Instead, Mary’s problem relates to income received in
the wrong tax year, which must be recognized in the year received, regardless of when it
was earned. Thus, Mary reports the $5,400 in 2005 and the $1,000 in 2006 when she
receives it. pp. 5-31 and 5-32

26. a. Ida realized $70,000 ($420,000 – $350,000) of income from the early retirement
of the debt. However, rather than recognizing income, Ida reduces the basis of
the property that was financed by the debt.

b. If the creditor were a bank rather than the original seller of the ranch, Ida would
be required to include $70,000 ($420,000 – $350,000) in her gross income.

pp. 5-32 and 5-33

27. Harry needs to identify and resolve the following issues:

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

• Did the mortgage holder sell the property to Harry?

• Is Harry insolvent or undergoing bankruptcy proceedings?

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

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

pp. 5-32 and 5-33

PROBLEMS

28. Wilbur must include in gross income the $7,500 of compensation for serving as executor
of his father’s estate and $5,000 from each of the 4 installment payments of the insurance
proceeds. Each installment consists of $25,000 of recovery of capital.
5-8 2006 Comprehensive Volume/Solutions

Policy proceeds of $100,000

X Payment of $30,000 = $25,000 exclusion
Expected return of $120,000

Installment payment $30,000

Exclusion ( 25,000)
Include in gross income $ 5,000

pp. 5-4, 5-6, and Chapter 13

29. a. The $2,500 of vacation pay earned by Jose but received by his daughter must be
included in her gross income in the tax year she receives it. Such income that has
been earned, but not received, at the time of the decedent’s death is income in
respect of a decedent.

b. The wife is not required to recognize any income. Since Josh purchased the
accident insurance policy, his benefits would not have been taxable had he lived
to collect them. The receipt by the wife of the $4,000 is not included in her gross
income.

c. Jay’s wife does not recognize income from the receipt of $10,000, since the
proceeds are from life insurance and are payable to her as the result of Jay’s
death. The mortgage holder received the proceeds from a policy as a result of a
transaction for consideration. The mortgage holder must recognize gain if its
basis (unrecovered amount of the loan) in the mortgage is less than $40,000.

d. Lavender, Inc. is the beneficiary of a life insurance policy it purchased and whose
proceeds were paid upon the death of the insured. Therefore, the proceeds are
excluded from its gross income.

pp. 5-4 to 5-7

30. a. Because Laura is terminally ill, she is not required to recognize gain of $20,000
($35,000 – $15,000) from assigning the life insurance proceeds to Viatical in
exchange for $35,000.

b. Laura is “chronically ill.” The life insurance proceeds can be received without
recognition of gain provided all of the proceeds are used for the care and
assistance necessitated by her illness or disease.

pp. 5-7 and 5-8

31. a. The $36,000 of tips are included in Jim’s gross income. The tips are not gifts
because the payments were in return for services, and thus were not made out of
detached and disinterested generosity.

b. The $1,800 of tips are included in Tara’s gross income since the money is
received because of the services provided by Tara, rather than out of detached
generosity. The fact that the customer is not required nor expected to make the
payments does not change the result.

c. The use of the hotel is not a gift because the property was provided by Sheila’s
employer. The lodging exclusion is not applicable because the housing is not
 Gross Income: Exclusions 5-9

provided as a condition of employment. However, the use of the hotel room may
qualify as a no-additional-cost service.

pp. 5-4, 5-5, 5-16, 5-17, 5-20, and 5-21

32. Darlene’s gross income in 2005 from these transactions is $5,000 associated with the
installment payment from the $200,000 life insurance policy. Of the $25,000 payment
she received in 2005, $20,000 is a return of capital and $5,000 is included in her gross
income. Her basis for the life insurance proceeds left with the insurance company is
$200,000. The return of capital portion is calculated as follows:

$200,000 X $25,000 = $20,000

$250,000

All of the life insurance proceeds ($150,000 and $200,000) are excluded from her gross
income. Likewise, the $80,000 of worker’s compensation received is excluded from her
gross income. pp. 5-6, 5-7, and 5-12

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

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

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

pp. 5-6 to 5-8

34. a. The $8,000 received for tuition, fees, books, and supplies can be excluded from
Sarah’s gross income as a scholarship. The $7,500 received for room and board
must be included in her gross income. The athletic scholarship is considered a
payment to further the recipient’s education and is not compensation for services.

b. The “scholarship” is additional compensation to Walt’s father. The fact that the
“scholarships” are only awarded to the children of executives indicates that the
employer is not simply making payments to assist the student seeking his or her
education, but rather to compensate an employee.

pp. 5-9 and 5-10

35. Alejandro received a total of $11,000 and spent $8,900 ($3,300 + $3,400 + $1,000 +
$1,200) on tuition, books, and supplies. The amount received for room and board is not
excludible. Therefore, he must include $2,100 ($11,000 – $8,900) in gross income.
When he received the money in 2005, Alejandro’s total expenses for the period covered
by the scholarship were not known. Therefore, he is allowed to defer reporting the
income until 2006, when all the uncertainty is resolved. pp. 5-9 and 5-10

36. a. Liz must include in gross income the punitive damages of $30,000. The other
amounts ($8,000 and $6,000) may be excluded as arising out of the physical
injury, except the $1,000 amount received for damage to her automobile. This
amount is a nontaxable recovery of capital (i.e., it reduces her basis for the
automobile by $1,000).
5-10 2006 Comprehensive Volume/Solutions

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

pp. 5-11 and 5-12

37. a. The settlement in the sex discrimination case did not arise out of physical
personal injury or sickness. Therefore, the $150,000 is included in Eloise’s gross
income.

b. The damages to Nell’s personal reputation are not for physical personal injury or
sickness. Therefore, Nell must include the $10,000 in her gross income. She
must also include the $40,000 punitive damages in her gross income.

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

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

d. The compensatory damages of $10,000 for the physical personal injury are not
included in Beth’s gross income, but the punitive damages of $30,000 must be
included in her gross income.

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

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

pp. 5-11, 5-12, and 5-31

38. Rex is required to include in gross income the $4,500 received from the wage
continuation policy while he was ill. This amount is included in gross income only
because the employer paid for the policy. The other items can be excluded from gross
income. pp. 5-13 to 5-15

39. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard
Mason, OH 45040

September 27, 2005

UVW Union
905 Spruce Street
Washington, D.C. 20227

Dear Union Members:

You asked me to explain the tax consequences of HON Corporation’s proposed changes
in the employees’ compensation package. The proposed changes include (1) the
imposition of a $100 deductible clause in the medical benefits plan, (2) an additional paid
holiday, and (3) a cafeteria plan that would allow the employee to receive cash rather
than medical insurance.

The deductible clause will cost each employee $100 after-tax. That is, the employee will
be required to pay an additional $100 for the same medical benefits that the employee
presently receives and, generally, none of the $100 will be deductible in arriving at
taxable income. The additional paid holiday will have no effect on after-tax income—the
 Gross Income: Exclusions 5-11

employee’s annual gross income will not change. The cafeteria plan will mean that some
employees who now have excess medical coverage can substitute cash for the unneeded
protection. The cash received will be taxable, but the employee’s after-tax income will
increase.

In summary, the change with the broadest tax implications is the imposition of the $100
deductible for medical benefits. The employees would actually be better off with a $100
reduction in cash compensation and no deductible clause. This results because the after-
tax cost of a $100 reduction in cash compensation is only $72 [(1 – .28) ($100)], whereas
the $100 deductible clause means the employee has $100 less for other goods and
services.

Also, the cafeteria plan may be important for some employees, depending upon how
many of them have working spouses whose employers provided medical benefits for the
employee’s entire family.

Please contact me if you have any further questions.

Sincerely yours,

John J. Jones, CPA

Partner

pp. 5-13, 5-14, and 5-19

40. With a medical reimbursement plan, Mauve would be paying all of the employee’s
medical expenses. The employee would have no incentive to control costs. With the
flexible benefit plan, the employee must contribute to the costs through a salary reduction
under the flexible benefit plan. Therefore, for this plan the employee has an incentive to
minimize costs. pp. 5-15, 5-19, and 5-20

41. Bertha must include $700 ($8,000 – $7,300) in her gross income for the long-term care
insurance she received. The charges by the nursing home were less than the maximum
exclusion ($240 per day). The potential exclusion is the greater of the following:

• $240 indexed amount for each day the patient receives the long-term care.

• The actual cost of the long-term care.

Therefore, the amount excluded from her gross income is the statutory indexed amount
($240 X 60 days = $14,400) [the cost of the long-term care of $12,000 is less] reduced by
the Medicare payments. Thus, the exclusion is $7,300 ($14,400 – $7,100). pp. 5-15 and
5-16

42. The concern in this situation for Tim is that the house will not be considered “on the
employer’s premises” in order for Tim to qualify for the meal and lodging exclusion.
However, Tim could effectively argue that the house is an extension of the employer’s
office because of the extensive business activities (communications, entertaining)
conducted in the house. He should be prepared to document the extent of business
activities conducted at the house. The presence of an administrative assistant would
suggest that much more than incidental business activities are conducted in the home.
Gross income would include $125 ($325 – $200) per month because the benefit exceeds
the qualified parking monthly exclusion limit of $200. pp. 5-16 to 5-18 and 5-23
5-12 2006 Comprehensive Volume/Solutions

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

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

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

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

pp. 5-16 to 5-18

44. Only Betty can decide whether she should take early retirement. However, as an aid in
making her decision, you can inform her that her disposable income after the effect of the
medical insurance and health club dues will decrease by approximately $828 per month.

Now Retired
Salary/retirement $40,000 $24,000
Part-time job -0- 11,000
Social Security tax (3,060) (842)
Income tax (.25) (10,000) (8,750)
Medical insurance -0- (7,800)
Health club dues -0- (600)
$26,940 $17,008

Disposal income associated with employment $26,940

Less: Disposable income associated with retirement (17,008)
Decrease in disposable income ($ 9,932)
pp. 5-13, 5-14, and 5-19

45. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard
Mason, OH 45040

September 18, 2006

Finch Construction Company

300 Harbor Drive
Vermillion, SD 57069

Dear Management:

You asked me to determine the tax implications of requiring the company’s employees
who are carpenters to furnish their own tools, with a compensating increase in their
salaries of about $1,500 each. In short, most employees would experience a net decrease
in after-tax income.
 Gross Income: Exclusions 5-13

Under the company’s present way of doing business, the carpenters do not recognize
income when the employer provides tools. This is a “working condition fringe.” If the
employee’s salary is increased and he or she must purchase the necessary tools, the
employee must include the additional $1,500 in salary in gross income. But the cost of
the tools in many cases will not be deductible, or less than the actual cost will be
deductible. This results from the employee’s expense being a deduction from adjusted
gross income as a miscellaneous itemized deduction. If the employee takes the standard
deduction, no deduction for the tool expenses is allowed. If the taxpayer does itemize
deductions, the total miscellaneous itemized deductions must be reduced by 2% of the
employee’s adjusted gross income. In many cases, the total miscellaneous itemized
deductions will be less than 2% of AGI. When the total miscellaneous itemized
deductions does exceed 2% of AGI, less than the entire expenses are deductible because
of the 2% factor.

Another possibility would be for the employees to purchase the tools, but account to you
for their cost, and obtain reimbursement. Under this plan, the employee would be
allowed to directly offset the reimbursement with the expense, in arriving at adjusted
gross income. The request for reimbursement would also provide you with a means of
controlling costs.

Please contact me if you would like to discuss this further.

Sincerely,

Amy Evans, CPA

Partner

p. 5-22

46. a. Employee’s before-tax compensation equivalent to $7,000 exempt compensation:

Income groups Low Middle High

Benefits $7,000 $7,000 $7,000
Income tax rate 0.15 0.25 0.35
Social Security and Medicare tax rate 0.0765 0.0765 0.0145
Total marginal tax rate (MTR) 0.2265 0.3265 0.3645
1 – MTR .7735 .6735 .6355
Before tax compensation =
[$7,000 ÷ (1 – MTR)] $9,050 $10,393 $11,015

b. Employer’s cost of before-tax compensation equivalent to $7,000 exempt

compensation:

Before tax compensation = $9,050 $10,393 $11,015

Employer’s Social Security Tax 692 795 160
$9,742 $11,188 $11,175
Less: reduced income tax (.35) (3,410) (3,916) (3,911)
Employer’s after-tax cost of
taxable compensation $6,332 $ 7,272 $ 7,264

c. Exempt compensation $7,000 $ 7,000 $ 7,000

Less: reduction in income tax (.35) (2,450) (2,450) (2,450)
Employer after-tax cost of
tax-exempt benefits $4,550 $ 4,550 $ 4,550
5-14 2006 Comprehensive Volume/Solutions

d. For an after-tax cost of $4,550 per employee, Redbird can provide tax-exempt
benefits to its employees that are equivalent to before-tax taxable compensation
of $9,050, $10,393, and $11,015, respectively, depending on the employee’s
marginal tax bracket. It would cost the company $6,332, $7,272, and $7,264,
respectively, to provide the taxable compensation equivalent of $7,000 tax-
exempt income. Both the employer and the employee benefit from the exemption.
Note, however, that if an employee is already covered in a similar medical benefit
plan under a spouse’s plan that the employee may want the cash compensation.

pp. 5-13 and 5-14

47. a. Rosa reduced her salary by $3,000 and thus reduced her tax liability by $750
($3,000 X 25%). Her after-tax cost of her daughter’s dental expenses is $2,250
($3,000 – $750).

b. A flexible benefits plan is also referred to as a “use or lose” plan. Since Rosa did
not use the $3,000, she loses this amount. Her out-of-pocket costs are $2,250
($3,000 – $750).

c. No. Since a flexible benefits plan is a “use or lose” plan, she should contribute
only the amount she expects to use to the plan.

pp. 5-19 and 5-20

48. Polly is both an employee and a controlling shareholder in the corporation. Therefore,
benefits she receives that are not excludible from gross income may be characterized as a
dividend. This would mean that she might enjoy the lower tax rate applicable to
dividends as compared to compensation; however, the corporation will not be allowed to
deduct any amount that is considered a dividend.

a. The $600 value of the tickets to football games does not fit any of the possible
categories of excludible employee fringe benefits. Moreover, the benefit of
receiving the tickets discriminates in favor of executives. Even though she does
not personally use the tickets, she enjoys the benefit of determining who will use
them. Therefore, Polly must include the $600 value of the tickets in gross
income. p. 5-25

b. Employee parking is specifically excluded from gross income. However, the

value of Polly’s free parking of $2,700 ($2,700/12 = $225 per month) exceeds the
permitted exclusion amount of $2,400 ($2,400/12 = $200 per month). Note that
parking can be provided on a discriminatory basis. p. 5-23

c. The use of the phone is excluded from Polly’s gross income as a no-additional
cost benefit. It also may fit the requirements for a de minimis fringe benefit.
p. 5-21

d. The value of the use of the condominium is a no-additional cost fringe benefit that
Polly can exclude from gross income. p. 5-21

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

(nondiscriminatory). The $750 can be excluded from Polly’s gross income.
p. 5-21
 Gross Income: Exclusions 5-15

f. The plan is discriminatory. Therefore, the highly compensated employees must

pay tax on all of their discounts. Polly includes $900 in her gross income.
pp. 5-22 and 5-26

49. a. For the 12-month period ending June 30, 2006, George satisfies the 330 day
requirement (i.e., was in London and Paris for 365 days). Therefore, he qualifies
for the foreign earned income exclusion treatment for this period which includes
184 days in 2005. For 2005, George can exclude the following amount from his
gross income:

184 days X $80,000* = $40,329

365 days

*Lower of earned income of $230,000 or statutory ceiling of $80,000 for 2005.

George must include $189,671 ($230,000 – $40,329) in his gross income for
2005.

b. For the 12-month period ending December 31, 2006, George satisfies the 330 day
requirement (i.e., was in London and Paris for 365 days). Therefore, he qualifies
for the foreign earned income exclusion treatment for this period which includes
365 days in 2006. For 2006, George can exclude the following amount from his
gross income:

365 days
365 days X $80,000* of salary = $80,000

*Lower of earned income of $275,000 or statutory ceiling of $80,000 for 2006.

George must include $195,000 ($275,000 – $80,000) in his 2006 gross income.

pp. 5-26 to 5-28

50. Hazel must include all of the items in gross income, except the interest received of $900
on Augusta County bonds. The patronage dividend is included in gross income under the
tax benefit rule because the dividend is a recovery of costs deducted in a prior year. All
other items are simply gross income not otherwise excluded. Therefore, Hazel must
include in gross income $2,825 ($600 + $100 + $125 + $1,600). pp. 5-28 and 5-29

51. a. Ezra must include in his gross income the $700 cash he constructively received.
He will have a $700 basis in the additional shares he received. The decrease in
the value of the fund shares of $1,200 ($15,700 – $14,500) is not taken into
account because he has not realized (e.g., from a sale or exchange) the loss.

b. Ezra received stock dividends, which are essentially more shares to represent his
same relative interest in the corporation. Because his interest in the corporation
did not change, and he did not have the option of receiving cash, Ezra has no
gross income from the receipt of the stock dividends. Ezra must allocate his
original cost of his Giant, Inc., shares among the original shares owned and the
additional shares received as a nontaxable stock dividend.

pp. 5-29 and 5-30

5-16 2006 Comprehensive Volume/Solutions

52. a. The price of the bond should decrease because the value of the exemption from
Federal income taxes has decreased. Before the change in tax rates, the after-tax
yield on the corporate bond was (1 – .396)(.10) = .0604. After the change in tax
rates, the after-tax yield on the corporate bond increased to (1 – .35)(.10) = .065.
With no change in the interest paid on the Virginia bonds, the yield on the
Virginia bond is still 6%. The price of those bonds should decrease, increasing
the yield to come closer to the after-tax yield on the corporate bond.

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

pp. 5-28 and 5-29

53. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard
Mason, OH 45040

September 7, 2005

Ms. Lynn Schwartz

100 Myrtle Cove
Fairfield, CT 06432

Dear Lynn:

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

• Your parents could purchase stock certificates, bonds, certificates of deposit, or other
investments in Eric’s name with them as custodian. The income would be subject to
Eric’s marginal tax rate after he is allowed a $800 standard deduction. This option
provides the maximum flexibility while removing the income from your parents’ high
marginal tax bracket.

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

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

• Your parents could invest the funds in Connecticut’s Qualified Tuition Program.
This program provides a hedge against inflation in tuition cost, but little or no other
return on the investment. The earnings of the fund, including the tuition savings, will
not be included in gross income provided the contribution and earnings are used for
qualified education expenses.
 Gross Income: Exclusions 5-17

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

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

Sincerely your,

John J. Jones, CPA

Partner

pp. 5-30 and 5-31

54. a. The savings bonds qualify as educational savings bonds. The savings bonds were
issued to Chuck and Luane who were at least 24 years of age (actually older) and
the savings bonds were issued after 1989.

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

$5,000 X ($8,000 ÷ $12,000) = $3,333

Since their modified adjusted gross income (MAGI) of $94,000 exceeds the
threshold amount of $91,850 for 2005, part of the potential exclusion is phased
out.

MAGI $94,000
Less: Threshold amount (91,850)
Excess over threshold amount $ 2,150
The amount of the potential exclusion that is phased out is as follows:

$3,333 X ($2,150 ÷ $30,000) = $239

Thus, Chuck and Luane can exclude $3,094 ($3,333 – $239) of the savings bond
interest received and $1,906 ($5,000 – $3,094) must be included in their gross
income.

b. All of the $5,000 of savings bond interest must be included in Susie’s gross
income. The educational savings bond exclusion under § 135 applies only if the
savings bonds are issued to an individual who is at least age 24 at the time of
issuance.
5-18 2006 Comprehensive Volume/Solutions

c. If Chuck and Luane file separate returns, they do not qualify for exclusion
treatment under § 135. Thus, they must include the $5,000 of savings bond
interest in their gross income.

pp. 5-30 and 5-31

55. The Qualified Tuition Program is the slightly preferable investment in terms of return on
investment. The compounded value of the bond fund at the end of the 8 years is expected
to be $5,760 ($4,000 X 1.44). The Qualified Tuition Program will pay $6,000 for the
son’s tuition, and the son does not include anything in his gross income. Thus, the after-
tax proceeds will be $6,000. It should be noted that the Qualified Tuition Program also
provides a hedge against even greater possible increases in tuition. pp. 5-30 and 5-31

56. a. The tax benefit rule applies when the taxpayer takes a deduction and subsequently
experiences a recovery of part or all of the prior deduction. Since the automobile
is not used in a trade or business, its cost is not deductible. It follows that the
$1,500 rebate is not a recovery of a prior deduction. The rebate is simply a
reduction of Wilma’s cost.

b. Wilma deducted the $5,000 of state income tax as an itemized deduction on her
2000 Federal income tax return. Therefore, the recovery of the $5,000 is included
in her gross income under the tax benefit rule.

c. The cattle feed purchases would be deductible, since Wilma is in the trade or
business of farming. The purchases of household items are not deductible. The
patronage dividend allocable to the cattle feed purchase is a recovery of a prior
deduction and therefore is included in gross income under the tax benefit rule.
The patronage dividend allocable to the household purchases is a recovery of a
nondeductible cost and therefore is not included in her gross income. The taxable
patronage dividend should be computed as follows:

Deductible purchases $10,000

X $400 = X $400 = $320
Total purchases $12,500
pp. 5-31 and 5-32

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

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

pp. 5-32 and 5-33

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

Therefore, Robin does not include the $10,000 in his gross income.
 Gross Income: Exclusions 5-19

b. The corporation’s cancellation of the $6,000 debt is income from discharge of

indebtedness to Robin. (Note that if the debt was not actually cancelled, but
Robin never attempted to pay it, the IRS would treat the loan as a dividend).

c. The $12,000 reduction in the debt owed to the seller (Trust Land Company) is not
included in Robin’s gross income. Instead, his basis in the land must be reduced
by the amount of the debt cancelled. Robin must include $4,000 in gross income
from the cancellation of the $4,000 liability for accrued interest. This is a
recovery of a prior deduction and is subject to the tax benefit rule.

pp. 5-32 and 5-33

CUMULATIVE PROBLEMS

59. Part 1—Tax Computation

Salary $103,000
Less: Foreign earned income exclusion (Note 1) (12,932)
Interest on U.S. savings bonds and Bahamian account (Note 2) 1,100
State income tax refund (Note 3) 900
Stock dividend (Note 4) -0-
Gross income $ 92,068
Less: Deductions for adjusted gross income
Alimony paid (6,000)
AGI $ 86,068
Less: Itemized deductions
State income tax (Note 5) $5,100
Real estate taxes on residence 3,400
Interest on personal residence 4,500
Charitable contributions 2,800 (15,800)
Less: Personal and dependency exemptions (4 X $3,200) (12,800)
Taxable income $ 57,468

Tax on $57,468 (Note 6) $ 7,890

Less: Withholding by employer (9,000)
Net tax payable (or refund due) for 2005 ($ 1,110)
Notes

(1) Since Martin satisfies the 330 out of 365 day requirement, he qualifies for the
foreign earned income exclusion for the 59 days in 2005 (January and February)
he worked in Mexico. His actual pay of $103,000 exceeded the limit on the
exclusion. Thus, he is allowed to exclude only $12,932 (59/365 X $80,000).

(2) The $800 interest on the U.S. savings bonds is included in gross income as well
as the $300 interest on the Bahamian bank account. Only the $400 interest on the
Montgomery County school bonds can be excluded.

(3) The state income tax refund is included in gross income under the tax benefit rule
because the state income taxes were taken as an itemized deduction in 2004.

(4) The fair market value of the stock dividend is not included in gross income, since
no option was available for receiving cash.
5-20 2006 Comprehensive Volume/Solutions

(5) The state income taxes paid of $5,100 exceed the sales taxes paid of $1,100.

(6) Their filing status is married filing jointly.

Tax on $14,600 = $1,460

On ($57,468 – $14,600) X 15% = 6,430
$7,890

Part 2—Tax Planning

Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard
Mason, OH 45040

December 29, 2005

Mr. and Mrs. Martin S. Albert

512 Ferry Road
Newport News, VA 23100

Dear Mr. and Mrs. Albert:

You asked me to determine the after-tax effect of a $500 increase in your monthly
mortgage payment as the result of buying another house. The $500 increase in your
monthly mortgage payment will result in approximately a $350 monthly increase in
mortgage interest and property tax deductions. As the payments are made on the
mortgage, the interest portion will decrease and the principal portion will increase over
the next several years.

You are in the 15% marginal tax bracket in 2005 and you should be in the 15% bracket in
2006 and thereafter, unless there is a change in your income. Therefore, the increase in
after-tax payments in 2006 and thereafter would be $448 [$500 – ($350 X 15%)]. Note,
however, that your taxable income amount is approaching the end of the 15% marginal
tax bracket and the beginning of the 25% marginal tax bracket. If your income should
increase such that some of it is taxable at the 25% rate, the increase in your after tax
payments would decrease [$500 – ($350 X 25%) = $413].

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

Sincerely yours,

John J. Jones, CPA

Partner

60. Gross income

Salary ($70,000 + $38,000) $108,000
Group term life insurance (Note 1) 108
Dividends 1,500
State tax refund (Note 2) 1,200
$110,808
Deductions for adjusted gross income
Alimony paid (Note 3) (10,800)
Adjusted gross income $100,008
 Gross Income: Exclusions 5-21

Itemized deductions
State income taxes ($3,400 + $2,300) (Note 4) $5,700
Home mortgage interest 4,300
Real estate taxes 1,450
Cash contributions 1,000 (12,450)
Personal and dependency exemptions ($3,100 X 2) (6,200)
Taxable income $ 81,358

Tax on $81,358 (Note 5) $ 13,669

Less: Tax withheld ($10,900 + $4,900) (15,800)
Net tax payable (or refund due) for 2004 ($ 2,131)

See the tax return solution beginning on page 5-22 of the Solutions Manual.

Notes

(1) Group term life insurance results in gross income for Alfred of $108 as follows:

($140,000 – $50,000) X $.10 X 12 months = $108

$1,000

(2) Under the § 111 tax benefit rule, Alfred must include the $1,200 state tax refund
is his gross income. Beulah is not required to include her refund in her gross
income because she claimed the standard deduction in 2003 and thus did not get a
tax benefit from the state income taxes paid.

(3) The $10,800 is deductible alimony. The $50,000 payment is a property

settlement and is not deductible by Alfred.

(4) The state income taxes paid of $5,700 exceed the sales taxes paid of $1,400.

(5) The tax liability on taxable income of $81,358 is calculated using the Tax Table
for married filing jointly (applying the 15% rate for the qualified dividends of
$1,500) and the amount is $13,669.

Tax on dividend income ($1,500 X 15%) $ 225

Tax on remainder of $79,858 ($81,358 – $1,500) 13,444
$13,669
5-22 2006 Comprehensive Volume/Solutions

60.
 Gross Income: Exclusions 5-23

60. continued
5-24 2006 Comprehensive Volume/Solutions

60. continued
 Gross Income: Exclusions 5-25

60. continued
5-26 2006 Comprehensive Volume/Solutions

60. continued