Chapter 5

4.

Compare and contrast realization of income with recognition of income.

Realization is a judicial concept that determines the period in which income is
generated, whereas, recognition is a statutory concept that determines whether
realized income is going to be included in gross income during the period.
Realization is a prerequisite to recognition and absent an exclusion or deferral
provision, recognition is automatic.

10. Describe in general how the cash method of accounting differs from the
accrual method.
Under the cash method taxpayers recognize income in the period they receive it.
Under the accrual method, they recognize income when they earn it rather than
when they receive it. Likewise, cash basis taxpayers are entitled to claim
deductions when they make expenditures. Under the accrual method, taxpayers
deduct expenses when they incur or accrue the associated expenditure.
12. The cash method of accounting means that taxpayers dont recognize
income unless they receive cash or cash equivalents. True or false?
Explain.
False - under the cash method, taxpayers recognize income in the period they
receive it (in the form of cash, property, or services).
16. Distinguish earned income from unearned income, and provide an example
of each.
Earned income is income derived from services and includes compensation and
other forms of business income received by a taxpayer even if the taxpayers
business is selling inventory. In contrast, unearned income is income derived
from property. Salary is a good example of earned income whereas interest is an
example of unearned income.
20. Conceptually, when taxpayers receive annuity payments, how do they
determine the amount of the payment they must include in gross income?
Payments taxpayers receive from an annuity they have purchased consist of
both income and return of the initial cost or investment in the annuity.
Consistent with the return of capital principle the proceeds are not income to the
extent of the taxpayers investment in the asset. As proceeds are collected over
several periods, the law provides that the return of capital occurs evenly (pro
rata) over the collection period for fixed term annuities or over the expected
collection period for life annuities.
33. What are the basic requirements to exclude the gain on the sale of a
personal residence?
Taxpayers meeting certain home ownership and use requirements can
permanently exclude up to $250,000 ($500,000 if married filing jointly) of
realized gain on the sale of their principal residence. Gain in excess of the
excludable amount generally qualifies as long-term capital gain subject to tax at

preferential rates. To satisfy the ownership test, the taxpayer must have owned
the residence (house, condominium, trailer, or houseboat) for a total of two or
more years during the five-year period ending on the date of the sale. To satisfy
the use test, the taxpayer must have used the property as her principal residence
for a total of two or more years (noncontiguous use is permissible) during the
five-year period ending on the date of the sale. The tax law limits each taxpayer
to one exclusion every two years. Married couples filing joint returns are eligible
for the full $500,000 exclusion if either spouse meets the ownership test and both
spouses meet the principal-use test. However, if either spouse is ineligible for the
exclusion because he or she personally used the $250,000 exclusion on another
home sale during the two years before the date of the current sale, the couples
available exclusion is reduced to $250,000.
35. What are some common examples of taxable and tax-free fringe benefits?
In addition to paying salary and wages, many employers provide employees with
fringe benefits. For example, an employer may provide an employee with an
automobile to use for personal purposes, pay for an employee to join a health
club, or pay for an employees home security. In general, the value of these
benefits is included in the employees gross income as compensation for services.
However, certain fringe benefits, called qualifying fringe benefits, are
excluded from gross income.4 Exhibit 5-3 lists some of the most common fringe
benefits that are excluded from an employees gross income.
Exhibit 5-4
Common Qualifying Fringe Benefits
Item
Medical and dental health
( 106)

Life insurance coverage (

79)

De minimis (small) benefits

132(a)(4)

Meals and lodging provided

for the employer's
convenience ( 119)

(excluded from employees gross income)

Description

An employee may exclude from income the cost of

medical and
insurance coverage
dental health insurance premiums the employer pays
on an employees behalf.
Employees may exclude from income the value of life
insurance premiums the employer pays on an
employees behalf for up to $50,000 of group-term life
insurance.
As a matter of administrative convenience, Congress
allows employees to exclude from income relatively
small and infrequent benefits employees receive at
work (such as limited use of a business copy machine).
Employees may exclude employer-provided meals and
lodging if they are provided on the employer's business
premises to the employee (and spouse and
dependents), (2) are provided for the employer's
convenience (such as allowing the employee to be

Employee educational
assistance programs ( 127)

No additional cost services

( 132(a)(1))

Qualified employee
discounts (132(a)(2))

Dependent care benefits (

129)

Working condition fringe

benefits (132(a)(3))

Qualified transportation
benefits (132(a)(5))

Qualified moving expenses

(132(a)(6))

Cafteria plans ( 125)

on-call 24 hours a day or continue working on-site

over lunch), and (3) for lodging only, the employee
must accept the lodging as a condition of employment.
Employees may exclude up to $5,250 of
employer-provided educational assistance benefits
covering tuition, books, and fees for any instruction
that improves the taxpayer's capabilities, whether or
not job-related or part of a degree program.
Employees may exclude the value of services provided
by an employer that generate no substantial costs to the
employer (such as free flight benefits for airline
employees on a space available basis, free hotel
service for hotel employees)
Employees may exclude a) a discount on
employer-provided goods as long as the discount does
not exceed the employer's gross profit percentage on
all property offered to sale to customers and (b) up to
20 percent employer-provided discount on services.
Discounts in excess of these amounts are taxable as
compensation.
Employees may exclude up to $5,000 for benefits paid
or reimbursed by employers for caring for children
under age 13 or dependents or spouses who are
physically or mentally unable to care for themselves.
Employees may exclude from income any benefit or
reimbursement of a benefit provided by an employer
that would be deductible as an ordinary and necessary
expense by the employee if the employee had paid the
expense.
Employees may exclude up to $250 per month of
employer-provided parking and up to $130 per month
of the combined value of employer-provided mass
transit passes and the value of a car pool vehicle for
employee use.
Employees may exclude employer reimbursement for
qualified moving expenses (cost of moving household
items and costs of travel, including lodging, to new
home for employee and dependents) that would
otherwise be deductible by employee.
A plan where employees choose among various
nontaxable fringe benefits (such as health insurance
and dental insurance) or cash. Tax-free to the extent
the taxpayer chooses nontaxable fringe benefits.
Taxable to the extent the employee receives cash.

Flexible Spending Accounts

( 125)

Allow employees to set a portion of their before-tax

salary for payment of either health and/or
dependent-care benefits. Amounts set aside must be
used by the end of year or within the first two and a
half months of the next plan year, or employees forfeit
the unused balance. In lieu of the two and a half month
grace period each year for health-care flexible
spending accounts, employers instead can allow
employees to carry over up to $500 of unused amounts
to be used anytime during the next year (i.e., it is the
employers choice). This option does not apply to
dependent-care flexible spending accounts. For 2014,
the amount of before-tax salary that an employee may
set aside for medical expenses is limited to $2,500 and
for dependent-care expenses is limited to $5,000.
37. Explain why taxpayers are allowed to exclude gifts and inheritances from
gross income even though these payments are realized and clearly provide
taxpayers with the wherewithal to pay.
Gifts and inheritances are taxed by a separate tax system (the unified Federal gift
and estate tax). Taxing gifts and inheritances as income to the recipient would
subject these payments to double taxation.

Chapter 6
2. How is a business activity distinguished from an investment activity? Why is
this distinction important for the purpose of calculating federal income
taxes?
Both business and investment activities are motivated primarily by profit intent,
but they can be distinguished by the level of profit-seeking activity. A business
activity is commonly described as a sustained, continuous, high level of
profit-seeking activity, whereas investment activities dont require a high level of
involvement. The distinction can be important for the location of deductions,
because business deductions are claimed above the line (for AGI on Schedule C)
while investment deductions are generally itemized or from AGI deductions (with
the exception of rent and royalty expenses which are deductible for AGI.
4. What types of losses may potentially be characterized as passive losses?
Losses from limited partnerships, and from rental activities, including rental real
estate, are generally considered passive losses. In addition, losses from any other
activity involving the conduct of a trade or business in which the taxpayer does
not materially participate are also treated as passive losses. Material participation
is defined as regular, continuous, and substantial.
6.

What tests are applied to determine if losses should be characterized as

passive?
In general, losses are from trade or business activities are passive unless

8.

9.

individuals are material participants in the activity. Regulations provide seven

separate tests for material participation, and individuals can be classified as
material participants by meeting any one of the seven tests. The seven tests are
as follows:
1. The individual participates in the activity more than 500 hours during the
year.
2. The individuals activity constitutes substantially all of the participation in
such activity by the individuals including non-owners.
3. The individual participates more than 100 hours during the year and the
individuals participation is not less than any other individuals
participation in the activity.
4. The activity qualifies as a significant participation activity (more than
100 hours spent during the year) and the aggregate of all significant
participation activities is greater than 500 hours for the year.
5. The individual materially participated in the activity for any five of the
preceding 10 taxable years.
6. The individual materially participated for any three preceding years in any
personal service activity (personal services in health, law, accounting,
architecture, etc.)
7. Taking into account all the facts and circumstances, the individual
participates on a regular, continuous, and substantial basis during the year.
Is it possible for a taxpayer to receive rental income that is not subject to
taxation? Explain.
Yes. A taxpayer (owner) who lives in a home for at least 15 days and rents it out
for 14 days or less (residence with minimal rental use) is not required to include
the gross receipts in rental income but is not allowed to deduct any expenses
related to the rental.
Halle just acquired a vacation home. She plans on spending several months
each year vacationing in the home and on renting the property for the rest
of the year. She is projecting tax losses on the rental portion of the property
for the year. She is not too connected about the losses because she is
confident she will be able to use the losses to offset her income from other
sources. Is her confidence misplaced? Explain.
Because Halle will be living in the home for several months, the home will be
considered a residence with significant rental use. Consequently, she may deduct
expenses to obtain tenants (direct rental expenses such as advertising and realtor
commissions) and mortgage interest and real property taxes allocated to the
rental use of the home. To the extent that these expenses exceed gross rental
income she may deduct the loss (the passive loss rules do not apply). However,
the remaining expenses allocated to the rental use of the home may only be
deducted to the extent of the net rental income after deducting the direct rental
expenses and rental mortgage interest and real property taxes allocated to the
property. This limitation reduces her ability to deduct a rental loss from the
home.

10. A taxpayer stays in a second home for the entire month of September. He
would like the home to fail into the residence with the significant rental use
category for tax purpose. What is the maximum number of days he can rent
out the home and have it qualify?
To qualify for the residence with significant rental use category, the taxpayer
must have used the home for personal purposes more than the greater of (1) 14
days or (2) 10% of the total days it is rented out during the tax year and rented
the house for more than 14 days. In this situation, the taxpayer used the second
home for personal purposes for 30 days (the entire month of September). To
qualify, the 30 days of personal use must be greater than 10% of the number of
days the property is rented out. If the taxpayer rents the property out for 300 days,
the number of personal use days will be exactly 10% of the number of rental
days, and the property would not qualify as residence. However, if the taxpayer
rents out the property for 299 days, the 30 days of personal use will be greater
than 10% of the number of rental days, so the property would qualify as a
residence with significant rental use. So, the maximum number of days the
taxpayer can rent out the home and have it qualify as a residence with significant
rental use is 299 days. Anything more than that and the property would be
considered a nonresidence with rental use.
12. In what circumstances is the IRS method for allocating expense between
personal use and rental use for second homes more beneficial to a taxpayer
than the Tax Court method?
The IRS method is generally more beneficial than the Tax Court method when
the property is considered to be a nonresidence with rental use. When the
property is not a residence, the interest allocated to personal use is not deductible.
Thus, under these circumstances, the taxpayer is better off by allocating as little
interest as possible to personal use. The IRS method accomplishes this by
allocating interest (a tier 1 expense) to rental use by dividing the total rental days
by the total days used and allocating the remainder to personal use. The Tax
Court method would allocate less interest to rental use because the denominator
is the number of days in the year, rather than total days used.
14. Describe the circumstances in which a taxpayer acquires a home and rents
it out and is not allowed to deduct a portion of the interest expense on the
loan the taxpayer used to acquire the home.
When a rental home is not a residence, the interest allocable to any personal-use
days is nondeductible.
16. How are the tax issues associated with home offices and vacation homes
used as rentals similar? How are the tax issues or requirements dissimilar?
The tax issues facing renters of second homes are similar in a lot of ways with
tax issues facing taxpayers qualifying for home office deductions. Both
taxpayers with home offices and taxpayers with vacation homes are allowed to
deduct business or rental expenses not associated with the use of the home as for
AGI deductions without income limitations. Taxpayers with home offices
allocate expenses of the entire home between personal use of the home and

business use of the home. In a similar way, renters of second homes generally
allocate expenses of the second home between personal use of the home and
rental use of the home. Taxpayers with home offices and vacation homes may
deduct mortgage interest and real property taxes allocated to the business or
rental use of the home as for AGI deductions without income limitations.
Further, the non mortgage interest and non real property tax expenses allocated
to business use of the home and rental use of a residence with significant rental
use may be limited by the income generated by the property (after deducting
business and rental expenses unrelated to the home and after deducting mortgage
interest and real property taxes allocated to the business or rental use of the
home). Disallowed expenses are carried over and treated as incurred in the next
year.
The treatment of home offices and vacation homes are also dissimilar. By
definition, a home office is located in the taxpayers home and the home office
must be used exclusively for business purposes. In contrast, the tax consequences
of owning a second home depend on the extent to which the property is used for
personal and for rental purposes. Personal use of a rental property is allowed.
This is not the case for home offices.
21. Explain when a taxpayer will be subject to the 10 percent penalty when
receiving distributions from a Roth IRA.
Traditional IRA contributions are deductible and distributions when received are
taxable. Roth IRA contributions are not deductible and distributions when
received are not taxable
27. Explain when a taxpayer will be subject to the 10 percent penalty when
receiving distributions from a Roth IRA.
Only nonqualified distributions made from the earnings of a Roth IRA are
subject to ordinary taxes and a 10% penalty. Nonqualified distributions are any
distributions if the taxpayer has not had the Roth IRA account open for at least
five years.1 If the Roth account has been open for five years, all distributions
other than distributions (1) made on or after the date the taxpayer reaches 59
years of age, (2) made to a beneficiary (or to the estate of the taxpayer) on or
after the death of the taxpayer, (3) attributable to the taxpayer being disabled, or
(4) used to pay qualified acquisition costs for first-time homebuyers (limited to
$10,000) are considered to be disqualified distributions.
32. Explain why Congress allows self-employed taxpayers to deduct the
employer portion of their self-employment tax.
To put self-employed individuals on somewhat equal footing with other
employers that are allowed to deduct the employers share of the social security
tax. Hence, self-employed taxpayers are allowed to deduct the employer portion
of the self-employment tax
35. Describe the mechanical limitation on the deduction for interest on qualified
educational loans.

The maximum deduction for interest expense on qualified education loans is the
amount of interest expense paid up to $2,500. However, the deduction is reduced
(phased-out) for taxpayers depending on the taxpayers filing status and
modified AGI. Specifically, the deduction for interest on educational loans is
subject to proportional phase-out over a range of $15,000 ($30,000 for married
filing jointly). The range begins for taxpayers at $65,000 of modified AGI
($130,000 for MFJ) and ends at $80,000 of modified AGI ($160,000 for married
filing jointly). Modified AGI for this purpose is AGI before deducting interest
expense on the qualified education loans and before deducting qualified
education expenses. Married individuals who file separately are not allowed to
deduct this expense under any circumstance

Chapter 7
1.

3.

4.

5.

Explain why the medical expense and casualty loss provisions are sometimes
referred to as wherewithal deductions and how this rationale is reflected
in the limits on these deductions.
These deductions are designed to reduce the tax burden on taxpayers whose
circumstances have involuntarily reduced their ability to pay. Both deductions
are restricted to expenses that exceed insurance reimbursements and a floor limit
based upon AGI. These limits ensure that taxpayers claiming the deduction have
exceedingly large involuntary expenditures as measured by their ability to pay.
Under what circumstances can a taxpayer deduct medical expenses paid for
a member of his family? Dose it matter if the family member reports
significant amounts of gross income and cannot be claimed as a dependent?
A taxpayer can deduct medical expenses incurred for members of his family if
they are dependents. For purposes of deducting medical expenses, a dependent
need not meet the gross income test.
What types of taxes qualify to be deducted as itemized deductions? Would a
vehicle registration fee qualify as a deductible tax?
Taxes qualifying for this deduction include state, local, and foreign income taxes,
real estate taxes, and personal property taxes. State and local sales taxes may
also be deducted but only in lieu of state and local income taxes. The deduction
for sales tax can be based upon either the amount paid or the amount published
in the IRS tables (IRS Publication 600).At press time, the deduction for state and
local sales taxes is set to expire after 2013.Vehicle registration fees are not
deductible (unless calculated based on the value of the vehicle rather than its
weight).
Compare and contrast the limits on the deduction of interest on home
acquisition indebtedness versus home equity loans. Are these limits
consistent with horizontal equity? Explain.
Taxpayers can deduct qualified residence interest defined as either (1) interest
paid on a loan to purchase or improve a residence (acquisition indebtedness) or
(2) interest paid on a loan secured by the residence but not used to purchase or
improve the residence (home equity loan). Interest paid can be deducted on $1

million of acquisition indebtedness and $100,000 of home equity debt regardless

of the rate of interest on the loan. These limits are consistent with horizontal
equity inasmuch as the limits treat taxpayers consistently across loan amounts.
However, the deduction for interest on home equity loans is definitely not
consistent with providing horizontal equity across homeowners and
non-homeowners.
7.

Cash donations to charity are subject to a number of very specific

substantiation requirements. Describe these requirements and how
charitable gifts can be substantiated. Describe the substantiation
requirements for property donations.
Charitable contributions are only deductible if substantiated with written records
such as a cancelled check, bank record, or a written communication from the
charity showing the name of the charity and the date and amount of the
contribution. 170(a)(1) and Reg 1.170A-13(a)(1). Additional substantiation is
required for: contributions of $250 or more ( 170(f)(8)), non-cash contributions
exceeding $500 (170(f)(11)(B)), and contributions of cars, boats and planes (
170(f)(12)). For donations of property, including clothing and household items,
taxpayers should keep a written record of the donation that includes a description
of the property and its condition. Deductions are not allowed for used property
unless the property is in good condition. Taxpayers must keep a
contemporaneous, written acknowledgement from a charity for each deductible
donation (either money or property) of $250 or more. For contributions of
property in excess of $500, a description of the property must be attached to the
tax return. A qualified appraisal of the property must be attached with the return
for donations of property with a value in excess of $5,000.

8.

Describe the conditions in which a donation of property to a charity will

result in a charitable contribution deduction of fair market value and when
it will result in a deduction of the tax basis of the property.
Taxpayers deduct the fair market value of property (noncash) donations when
they donate:
(1) a capital asset that has appreciated in value (the value is greater than the basis
of the property) and the taxpayer has owned the asset for more than a year before
donating it (but see exceptions below), or
(2) appreciated business assets (value greater than basis) the taxpayer owned for
more than a year before donating but only to the extent that the gain on the asset
would not be treated as ordinary income if it had been sold.
However, the deduction for an appreciated capital asset that is tangible, personal
property is limited to the adjusted basis of the property if the charity uses the
property for a purpose unrelated to its charitable purpose.
Taxpayers donating ordinary income property (or capital loss property) deduct
the lesser of (1) the fair market value of the property and (2) the adjusted basis of
the property. Thus when the value of ordinary income property (or capital loss
property) is less than the basis, taxpayers deduct the value.

Thus, taxpayers deduct the basis of the property when they contribute:
ordinary income property that has appreciated in value.
capital gain property donated to private nonoperating foundations (other than
stock).
capital gain property consisting of tangible personal property and the charity uses
the property (and the taxpayer should have reasonably expected that) for a
purpose unrelated to the reason it is a charity.
appreciated business assets held more than a year to the extent that the gain
would be recaptured as ordinary income under the depreciation recapture rules.
9.

Describe the type of event that qualifies as a casualty for tax purposes.
A casualty is defined as an unexpected, unforeseen, or unusual event such as a
fire, storm, or shipwreck or loss from theft.
11. This week Jims residence was heavily damaged by a storm system that
spread destruction throughout the region. While Jims property insurance
covers some of the damage, there is a significant amount of uninsured loss.
The governor of Jims state has requested that the president declare the
region a federal disaster area and provide federal disaster assistance.
Explain to Jim the income tax implications of such a declaration and any
associated tax planning possibilities.
Under IRC 165(i), individuals who incur a disaster loss are subject to the
regular casualty loss floor limits ($100/10 percent of AGI), but they may elect to
claim a disaster loss for the tax year before the loss occurred. This deduction
could accelerate the tax benefit of the loss (and any attendant refund), but also
allow the taxpayer to choose the year with the most attractive tax outcome (in
terms of AGI limits, other casualty losses (or gains), and marginal tax rate).
14. When is the cost of education deductible as an employee business expense?
The cost of education is deductible as an employee business expense if the
education maintains or improves the employees skill in the business, but not if
the education is required to qualify a taxpayer for a new business or profession.
For example, an IRS agent could not deduct the cost of a legal education even
though the education would maintain or improve his skill as a tax auditor. This
is because a law degree would also qualify the agent for a new profession
(lawyer).
17. Jack is retired jockey who takes monthly trips to Las Vegas to gamble on
horse races. Jack also trains race horses part time t his Louisville rar.ch. So
far this year, Jake has won almost $47,500 during his trips to Las Vegas
while spending $27,250 on travel expenses and incurring $62,400 of
gambling losses. Jake also received $60,000 in revenue from his training
activities and his incurred $72,000 of associated costs. Explain how Jakes
gambling winnings and related costs of associated costs. Explain how Jakes
gambling winnings and related costs will be treated for tax purposes.
Describe the factors that will influence how Jakes ranch expenses are
treated for tax purposes.

Jakes $47,500 of gambling winnings is included in his gross income. The

gambling losses are (total of $62,400) are only deductible as miscellaneous
itemized deductions (not subject to the 2% of AGI floor) to the extent of the
gambling winnings (thus, only $47,500 will be deductible). His travel costs are
personal expenditures and are nondeductible. Likewise, the $60,000 revenues
from Jakes training activities are included in Jakes gross income. The
expenses associated with the ranch (assuming the expenses are ordinary and
necessary and not capitalized) should be deductible as itemized deductions
(mortgage interest, real estate taxes, and as miscellaneous itemized deductions
subject to the 2% floor) to the extent of the related gross income if this activity is
treated as a hobby. The factors in the regulations would likely dictate whether
the activity is a hobby or a business. For example, how much time does Jake
spend at the rancha few hours each week or does he work full time? It is
unclear if he operates the ranch in a professional manner, takes the advice of
professionals, or whether his success as a jockey would lead to success in
training horses. Of course, his financial status (retired) and personal pleasure
would likely count against business treatment.
22. Explain how the standard deduction is rationalized and why the standard
deduction might be viewed as a floor limit on itemized deductions.
From the governments standpoint, the standard deduction serves two purposes.
First, to help taxpayers with lower income, it automatically provides a minimum
amount of income that is not subject to taxation. Second, it eliminates the need
for the IRS to verify and audit itemized deductions for those taxpayers who
chose to deduct the standard deduction. From the taxpayers perspective, the
standard deduction allows them to avoid taxation on a portion of their income,
and for those not planning to itemize deductions, it eliminates the need to
substantiate and collect information about them. The standard deduction
essentially eliminates the tax benefits of itemized deductions up to the amount of
the standard deduction and thus may be viewed as a floor limit on itemized
deductions because most taxpayers will not elect to itemize if the standard
deduction exceeds itemized deductions.
Chapter 8
1. What is a tax bracket? What is the relationship between filing status and the
width of the tax brackets in the tax rate schedule?
A tax bracket is a range of taxable income that is taxed at a specified tax rate.
Because only the income in the particular range is taxed at the specified rate, tax
brackets are often referred to as marginal tax brackets or marginal tax rates.
The level and width of the brackets depend on the taxpayers filing status. The
tax rate schedules include seven tax rate brackets. The rates for these brackets
are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. In general, the tax brackets are
widest for Married filing jointly (for example, more income is taxed at 10%),
followed by Head of household, Single, and then Married filing separately (the
brackets for Married filing separately are exactly one-half the width of the
brackets for Married filing jointly, and the width of the 10% and 15% brackets
for Single and Married filing separately are the same).

3.

4.

5.

6.

What is the tax marriage penalty and when does it apply? Under what
circumstances would a couple experience a tax marriage benefit?
A marriage penalty (benefit) occurs when, for a given level of income, a married
couple has a greater (lesser) tax liability when they use the married filing jointly
tax rate schedule to determine the tax on their joint income than they would have
owed (in total) if each spouse would have used the single tax rate schedule to
compute the tax on each spouses individual income. The marriage penalty
applies to couples with two wage earners while a marriage benefit applies to
couples with single breadwinners.
Once theyve computed their taxable income, how do taxpayers determine
their regular tax liability? What additional steps must taxpayers take to
compute their tax liability when they have preferentially taxed income?
Once taxpayers have determined their taxable income, they should split the
income into two portions: (1) ordinary income and (2) income taxed at
preferential rates (if any), and compute tax on each portion separately.
Taxpayers compute the tax on the ordinary income portion by applying the
appropriate tax rate schedule (based on their filing status).
For dividends and capital gains taxed at preferential tax rates, the preferential tax
rate is 0 percent, 15 percent, or 20 percent. The preferential tax rate is 0 percent
to the extent the income would have been taxed in the 10 percent or 15 percent
tax rate bracket if it were ordinary income, 20 percent to the extent the income
would have been taxed in the 39.6 percent tax rate bracket if it were ordinary
income, and 15 percent for all other taxpayers.
A taxpayers total regular income tax liability is the sum of the tax on ordinary
income and the tax on preferentially taxed income.
Are there circumstances in which preferentially taxed income (long-term
capital gains and qualified dividends) is taxed at the same rate as ordinary
income? Explain.
Generally, no. The preferential tax rate is 0 percent to the extent the income
would have been taxed in the 10 percent or 15 percent tax rate bracket if it were
ordinary income, 20 percent to the extent the income would have been taxed in
the 39.6 percent tax rate bracket if it were ordinary income, and 15 percent for all
other taxpayers. This is why we refer to the income as preferentially taxed
income. However, there are certain types of long-term capital gains that are
taxed at a maximum rate of 25% (unrecaptured 1250 gain) and 28% (capital
gains from collectibles). These gains are taxed at the taxpayers marginal
ordinary rate unless the ordinary rate exceeds the maximum rate. Then these
gains are taxed at the maximum rate. However, we did not address these special
situations in this chapter
Augustana received $10,000 of qualified dividends this year. Under what
circumstances would all $10,000 be taxed at the same rate? Under what
circumstances might the entire $10,000 of income not be taxed at the same
rate?
The entire qualified dividend will be taxed at the same rate in three scenarios.

First, the dividend will all be taxed at 15% if (a) Augustanas ordinary income
exceeds the threshold for the 15% marginal tax bracket (it is taxed at a rate
higher than 15%) and (b) her total taxable income (including the $10,000
qualified dividend) is equal to or less than the threshold for the 39.6% tax
bracket. Second, the entire dividend will be taxed at 0% as long as Augustanas
ordinary income plus her $10,000 qualified dividend does not exceed the
threshold for the 15% marginal tax bracket. Third, the entire dividend will be
taxed at 20% as long as Augustanas ordinary income exceeds the threshold for
the 39.6% marginal tax bracket.
The qualified dividend will be taxed at different rates if the amount of
Augustanas ordinary income is below the 15% marginal tax bracket, but the
qualified dividend causes her total taxable income to exceed the 15% marginal
tax bracket threshold. In this scenario, her qualified dividends will be taxed at
0% to the extent they would have been taxed at 15% as ordinary income, and the
remainder would be taxed at 15%. Likewise, the qualified dividend will be taxed
at different rates if the amount of Augustanas ordinary income is below the 39.6%
marginal tax bracket, but the qualified dividend causes her total taxable income
to exceed the 39.6% marginal tax bracket threshold. In this scenario, her
qualified dividends will be taxed at 15% to the extent they would have been
taxed at 35% (or less) as ordinary income, and the remainder would be taxed at
20%.
7. What is the difference between earned and unearned income?
Earned income is income earned by the taxpayer from services or labor.
Unearned income is from investment property such as dividends from stocks or
interest from bonds.
8. Does the kiddie tax eliminate the tax benefits gained by a family when
parents transfer income-producing assets to children? Explain.
No. Though the kiddie tax significantly limits the benefit of shifting income
producing assets to children, it does not eliminate it. The kiddie tax does not
apply unless the child has unearned income in excess of $2,000 ($1,000 standard
deduction plus an additional $1,000). That is, parents can shift up to $2,000 of
unearned investment income to a child without the child paying the kiddie tax
(paying tax on income at the parents marginal tax rate).
9. Does the kiddie tax apply to all children no matter their age? Explain.
No, the kiddie tax applies to children who have net unearned income in excess of
$2,000 if the children (1) are under age 18 at the end of the year, (2) are age 18 at
the end of the year and do not have earned income in excess of half of their
support, or (3) are over age 18 and under age 24, are full-time students, and dont
have earned income in excess of half of their support (excluding scholarships).
13. Describe, in general terms, why Congress implemented the AMT.
Congress implemented the AMT to ensure that all taxpayers who were
generating economic income paid some minimum amount of tax each year.
Prior to the AMT, the public perceived high income taxpayers to be able to
reduce or eliminate their total tax liability by taking excessive advantage of tax

preference items such as exclusions, deferrals, and deductions. The AMT was
designed as a response requiring these high income taxpayers to pay at least
some tax.
19. What is the difference between the tentative minimum tax (TMT) and the
AMT?
The tentative minimum tax is the AMT base multiplied by the AMT rates. The
AMT is the excess of the TMT over the taxpayers regular tax liability for the
year. Thus, taxpayers only pay AMT to the extent their TMT exceeds their
regular tax liability.
20. Lee is single and he runs his own business. He uses the cash method of
accounting to determine his business income. Near the end of the year,
Lee performed work that he needs to bill a client for. The value of his
services is $5,000. Lee figures that if he immediately takes the time to put
the bill together and send it out, the client will pay him before year-end.
However, if he doesnt send out the bill for one week, he wont receive the
clients payment until the beginning of next year. Lee expects that he will
owe AMT this year and that his AMT base will be around $200,000 before
counting any of the additional business income. Further, Lee anticipates
that he will not owe AMT next year. He anticipates his regular taxable
income next year will be in the $200,000 range. Would you advise Lee to
immediately bill his client or to wait? What factors would you consider in
making your recommendation?
Lee would likely choose to bill his client next year rather than now. It appears
that if Lee bills his client now and receives payment before the end of the year,
the income will be subject to AMT and will be taxed at a marginal rate of 28%.
However, Lee is likely in the phase-out range for the AMT exemption this year,
so the $5,000 income would be subject to a marginal rate of 35% (28% x 1.25)
because the $5,000 of income would increase his tax base by $6,250. In
contrast, if Lee were to wait to bill the client until next year when he likely will
not be subject to AMT, Lees $5,000 of additional ordinary income will be taxed
at a marginal rate of 33% (see tax rates for Single individuals). Consequently,
Lee should wait to bill the client by doing so the income will be taxed at a
lower rate and it will allow him to defer reporting the income until next year.
However, as a non-tax consideration, Lee would likely prefer to bill his client
this year because he would prefer to be paid for his services sooner rather than
later given the time value of money. Further, by waiting to bill the client, Lee
runs an increased risk of not ever receiving payment.
21. Are an employees entire wages subject to the FICA tax? Explain.
Employees must pay FICA taxes on their wages. This tax consists of a Social
Security and a Medicare component. The Social Security tax is intended to
provide basic pension coverage for the retired and disabled. The Medicare tax
helps pay medical costs for qualified individuals. The Social Security tax rate
for employees is 6.2% of their salary or wages. The Medicare tax rate for
employees is 1.45% on salary or wages up to $200,000 ($125,000 for married

28.

31.

35.

45.

filing separate; $250,000 of combined salary or wages for married filing joint)
and is 2.35% on salary or wages in excess of $200,000 ($125,000 for married
filing separate; $250,000 of combined salary or wages for married filing joint).
The wage base on which Social Security taxes are paid is limited to an annually
determined amount. The 2014 limit is $117,000. Because there is no wage
base for the Medicare component of the FICA tax, a taxpayers entire wages will
be subject to this portion of the FICA tax.
How are tax credits and tax deductions similar? How are they dissimilar?
A tax credit and a tax deduction both reduce a taxpayers taxes payable.
However, a credit is more valuable than a deduction. Though a deduction
reduces taxable income, a tax credit reduces the taxes payable dollar for dollar.
What is the difference between a refundable and nonrefundable tax credit?
Nonrefundable credits can reduce a taxpayers regular tax liability and AMT
liability, but cannot reduce other taxes (including self-employment taxes).
Further, when a taxpayers nonrefundable credits exceed the sum of a taxpayers
regular tax liability and AMT liability, the taxpayer reduces these taxes to zero
but the unused credits expire without providing any tax benefit unless that
unused credit can be carried to a different tax year. In contrast, refundable
credits can reduce a taxpayers regular tax liability, AMT liability, and other
taxes (including self-employment taxes). If the amount of a taxpayers
refundable credits exceeds the taxpayers tax liability, the taxpayer receives a
refund of the excess credit.
Compare and contrast the lifetime learning credit with the American
opportunity credit.
The credits are similar in the sense that they are credits for postsecondary
education. Also, a taxpayer may claim either credit for qualifying expenditures
they make on behalf of the taxpayer, spouse, or dependent of the taxpayer.
Both credits are phased-out based on AGI and both credits are at least partially
nonrefundable.
The credits are different in the sense that qualifying
expenditures for the American opportunity credit (AOC) include tuition, fees,
and required course materials (including books) while qualifying expenditures
for the lifetime learning credit includes tuition and fees but not required course
materials.
Further, the AOC applies only to the first four years of
postsecondary education while the lifetime learning credit has no such restriction.
Also, the AOC carries a per student limit (a taxpayer may claim more than one
credit in a year if the taxpayer pays the education costs of more than one student)
while the lifetime learning credit limit is a per taxpayer credit (the taxpayer may
claim only one credit per year). The maximum AOC (per student) for a year is
$2,500 while the maximum lifetime learning credit for a taxpayer is $2,000.
Finally, the AOC phases out at higher levels of AGI than the lifetime learning
credit and 40% of the otherwise allowable AOC is refundable while the entire
lifetime learning credit is nonrefundable.
Describe how the underpayment penalty is calculated.
If the taxpayer does not satisfy either of the available safe harbor provisions, the

taxpayer can compute the underpayment penalty owed using Form 2210. The
underpayment penalty is determined by multiplying the federal short-term
interest rate plus 3 percentage points by the amount of tax underpayment per
quarter. For purposes of this computation, the quarterly tax underpayment is
the difference between the taxpayers quarterly withholding and estimated tax
payments and the required minimum tax payment under the first or second safe
harbor (whichever is lesser). If the taxpayer does not complete the Form 2210
and remit the underpayment penalty with the taxpayers tax return, the IRS will
compute and assess the penalty for the taxpayer

Practice Questions
Chapter 5: Example 5-1, 5-2, 5-16 ,
Chapter 6: Problem 36, 40, 41, 42, 43, 44
Chapter 7: Example 7-1, 7-4, 7-21