CHAPTER 5

GROSS INCOME: EXCLUSIONS

SOLUTIONS TO PROBLEM MATERIALS

Question/
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Topic
Life insurance proceeds and compensation
Income from gifts and bequests
Gift to employees
Gift versus compensation
Gift versus compensation
Life insurance: accelerated death benefits
Life insurance: transfer for valuable consideration
Life insurance: cash surrender value and
accelerated death benefits
Scholarship and tuition waiver
Damages
Damages
Damages
Unemployment compensation
Accident and health plan
Cafeteria plan
Fringe benefits: no-additional-cost services
Fringe benefits: employee discounts
No-additional-cost service
Qualified employee discounts
Issue ID
Foreign earned income
Taxable versus tax-exempt bonds
Patronage dividends and the tax-benefit rule
Qualified state tuition program
Tax benefit rule
Income from discharge of indebtedness
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Life insurance and inheritance

Life insurance and accident benefits
Accelerated death benefits
Gifts and fringe benefits
Death benefits
Life insurance: use of proceeds
Scholarship
Scholarship
Damages
Damages
Health insurance, medical reimbursement
Fringe benefits
Medical reimbursement plan versus flexible
benefits plan
Long-term care insurance benefits
Meals and lodging
Meals and lodging
Accident and health plans, athletic facilities
Working condition fringe
Fringe benefits versus taxable compensation
Flexible benefits plan
Fringe benefits
Foreign earned income
Tax benefit rule, tax-exempt income
Unrealized gains and losses
Tax-exempt bonds
Tax-favored educational savings programs
Educational savings bond exclusion
Qualified state tuition program
Tax benefit rule
Income from discharge of indebtedness
Income from discharge of indebtedness
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Tax-exempt housing
Fringe benefits
Internet activity

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GrossIncome:Exclusions

53

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

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2005ComprehensiveVolume/SolutionsManual
CHECK FIGURES
28.
29.a.
29.b.
29.c.
29.d.
30.a.

$12,500.
$2,500.
$0.
$0.
$0.
Selling the life insurance policy
provides $35,000 and no tax liability.
30.b. $0.
31.a. The tips are gross income.
31.b. The tips are gross income.
31.c. The hotel room may qualify for
exclusion as a no-additional-cost
service.
32.
Include $5,000 in gross income.
33.a. Fay has $0 gross income on the
receipt of the $1.5 million life
insurance proceeds.
33.b. $15,000 of interest is included in
gross income.
33.c. $0 gain.
34.
Room and board of $7,500 is
includible.
35.
$2,700 is includible in 2005.
36.a. Liz must include $30,000 in gross
income.
36.b. Yes, include $40,000 in gross
income.
37.a. $150,000.
37.b. $50,000.
37.c. $50,000.
37.d. $30,000.
37.e. $300,000.
38.
$3,600.
41.
Include $800 in gross income.
42.
$105 per month.
43.a. No.
43.b. Yes, $600.
43.c. Lodging, no.

43.d. IRS yes; courts no.

44.
Decrease in disposable income
$9,932.
46.a. $9,050; $10,393; $11,015.
46.b. $6,332; $7,272; $7,264.
46.c. $4,550; $4,550; $4,550.
47.a. $2,250.
47.b. $2,250.
47.c. No.
48.a. No exclusion.
48.b. Exclusion allowed.
48.c. Exclusion allowed.
48.d. Exclusion allowed.
48.e. No exclusion for Polly; plan is
discriminatory.
49.a. $189,671.
49.b. $195,000.
50.
$2,825.
51.
$500 in 2004 and $510 in 2005.
52.a. Bond price should decrease.
52.b. Bond price should increase.
54.a. Exclude $3,305.
54.b. Include $5,000 for Susie.
54.c. Include $5,000.
55.
Qualified tuition program.
56.a. $0.
56.b. $5,000.
56.c. $320.
57.a. Additional tax $7,000.
57.b. Fran can defer the tax.
58.a. $0 gross income.
58.b. $6,000.
58.c. $4,000.
59.
Refund due for 2004 $1,062.
60.
Refund due for 2003 $3,341.

GrossIncome:Exclusions

55

DISCUSSION QUESTIONS
1.

Tom must include $1,000 in gross income; that is, the amount received for services as
executor of his uncles estate. The inheritance of $6,000 is excluded from his gross
income. pp. 5-2 to 5-4

2.

Only Scott is required to include in gross income any of the amounts received. He will be
taxed on the interest portion of each installment payment of the life insurance proceeds or
$1,000 a year ($9,000 payment $8,000 return of capital). Ed received an excludible gift
and Amos received an excludible inheritance. The $40,000 of life insurance proceeds is an
excludible inheritance for Scott and provides him with a basis of $8,000 for each
installment payment ($40,000 5 payments). pp. 5-4 and 5-5

3.

The non-employees can exclude the $60,000 value of the lumber from their gross income
as nontaxable gifts. Employees are not permitted to exclude gifts from their employer
from gross income. Therefore, the employees must include the $30,000 value of the
lumber in their gross income. p. 5-5

4.

The $6,000 of sales commissions earned at the time of Hannahs death is income in respect
of a decedent and must be included in Wades 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 2002, it received a tax benefit from writing off the
receivable. So Amber would include $5,000 in gross income in 2004 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 Alys 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 taxpayers gross income.
pp. 5-6 and 5-7

9.

The tuition waiver could be part of a qualified tuition reduction program. However, Jos
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 Joss services. pp. 5-10
and 5-11

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2005ComprehensiveVolume/SolutionsManual

10.

All of the amounts received were the result of her physical injury. Therefore, the following
may be excluded from Nancys gross income:
Damage award for medical expenses
Damage award for loss of income

$15,000
4,000

The punitive damage award of $40,000 must be included in Nancys gross income.
pp. 5-11 and 5-12
11.

The entire $170,000 must be included in Saras 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. Sams 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.

Randy can exclude from his gross income the $1,200 insurance proceeds from the policy
he purchased. Sam is not taxed on the premiums his employer paid, but Sam must include
in gross income the $1,200 he collected on the employer-provided policy.
pp. 5-13 and 5-14

15.

With a cafeteria plan, the employees are able to choose benefits that they consider most
useful in their individual situations. For example, not all employees would need child care
benefits, or a young employee might decide she does not need group term life insurance.
p. 5-19

16.

The use of the phone would probably qualify as a no-additional-cost service, since the
employee is utilizing the employers fixed cost. Thus, none of the $75 is included in
Paulas gross income. pp. 5-20 and 5-21

17.

The discount Ted receives of $1,600 ($22,000 regular customer cost $20,400 employee
cost) is a qualified employee discount. Teds price for the automobile of $20,400 was
greater than the employers 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%.
Teds discount ($1,200 $720)
Less: 20% discount ($1,200 X 20%)
Excess discount

$480
( 240)
$240

GrossIncome:Exclusions

57

pp. 5-21 and 5-22

18.

The use of the country club facilities qualifies by Zack and his family as a no-additionalcost service. Thus, it is excluded from Zacks 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, Toms 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.
Teds after-tax cost of commuting is $0 because he is reimbursed for the out-ofpocket 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 2003).
This would be a substantial benefit. pp. 5-25 to 5-27

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. 5-27 and 5-28

23.

The patronage dividend is a recovery of Marias feed and fertilizer costs that were
deducted in 2003. The cost of the feed and fertilizer produced a tax benefit in 2003 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 Marias 2004 gross income under the tax benefit
rule. pp. 5-31 and 5-32

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. pp. 5-30 and 5-31

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2005ComprehensiveVolume/SolutionsManual

25.

The tax benefit rule does not result in an increase in Marys 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, Marys 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 2004 and the $1,000 in 2005 when she receives it. pp. 5-31
and 5-32

26.

a.

Ida realized $30,000 ($390,000 $360,000) 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 $30,000 ($390,000 $360,000) 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 fathers 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.
Cost of $100,000
X Payment of $30,000 = $25,000 exclusion
Expected return of $120,000
Installment payment
Exclusion
Include in gross income

$30,000
( 25,000)
$ 5,000

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

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

GrossIncome:Exclusions

59

been earned, but not received, at the time of the decedents 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.

Jays 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 Jays 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. 5-5 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 Jims 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 Taras 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 Sheilas
employer. The lodging exclusion is not applicable because the housing is not
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.

Darlenes gross income in 2004 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 2004, $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

510 2005ComprehensiveVolume/SolutionsManual

All of the life insurance proceeds ($150,000 and $200,000) are excluded from her gross
income. Likewise, the $80,000 of workers compensation received is excluded from her
gross income. pp. 5-5 to 5-7
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 Fays gross income.

c.

Fay did not recognize a gain on the bargain purchase. Fay simply got a good price
on the purchase under an arms length contract.

pp. 5-6 to 5-8

34.

The $9,000 received for tuition, fees, books, and supplies can be excluded as a
scholarship. The $7,500 received for room and board must be included in gross income.
The athletic scholarship is considered a payment to further the recipients education and is
not compensation for services. pp. 5-9 and 5-10

35.

Alejandro received a total of $11,000 and spent $8,300 ($3,100 + $3,200 + $900 +
$1,100) on tuition, books, and supplies. The amount received for room and board is not
excludible. Therefore, he must include $2,700 ($11,000 $8,300) in gross income. When
he received the money in 2004, Alejandros total expenses for the period covered by the
scholarship were not known. Therefore, he is allowed to defer reporting the income until
2005, 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).

b.

The $40,000 is included in Lizs 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 Eloises gross income.

b.

The damages to Nells 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 Corporations 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 Beths gross income, but the punitive damages of $30,000 must be
included in her gross income.

GrossIncome:Exclusions

e.

511

Since the compensatory damages of $75,000 arose from a physical personal injury,
they are excluded from Joannes gross income. The punitive damages of $300,000
are included in her gross income.

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

38.

39.

Rex is required to include in gross income only the $3,600 received from the wage
continuation policy (d). This amount is included in his gross income only because the
employer paid for the policy. pp. 5-13 to 5-15
Willis, Hoffman, Maloney, and Raabe, CPAs
5191 Natorp Boulevard
Mason, OH 45040
September 27, 2004
UVW Union
905 Spruce Street
Washington, D.C. 20227
Dear Union Members:
You asked me to explain the tax consequences of HON Corporations 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 incomethe
employees 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 employees 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 aftertax 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
employees entire family.
Please contact me if you have any further questions.
Sincerely yours,

512 2005ComprehensiveVolume/SolutionsManual
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 employees 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. 5-14, 5-19, and 5-20

41.

Bertha must include $800 ($7,500 $6,700) in her gross income for the long-term care
insurance she received. The charges by the nursing home were less than the maximum
exclusion ($230 per day). The potential exclusion is the greater of the following:

$230 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
($230 X 60 days = $13,800) [the cost of the long-term care of $11,900 is less] reduced by
the Medicare payments. Thus, the exclusion is $6,700 ($13,800 $7,100). p. 5-15
42.

The concern in this situation for Tim is that the house will not be considered on the
employers 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 employers
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 $105 ($300 $195) per month because the benefit exceeds
the qualified parking monthly exclusion limit of $195. pp. 5-15 to 5-17 and 5-23

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. 5-15 to 5-17

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.

GrossIncome:Exclusions

513

Salary/retirement
Part-time job
Social Security tax
Income tax (.25)
Medical insurance
Health club dues
Disposal income associated with employment
Less: Disposable income associated with retirement
Decrease in disposable income

Now
$40,000
-0(3,060)
(10,000)
-0-0$26,940

Retired
$24,000
11,000
(842)
(8,750)
(7,800)
(600)
$17,008
$26,940
(17,008)
($ 9,932)

pp. 5-13, 5-14, and 5-18

45.

Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard
Mason, OH 45040
September 18, 2005
Finch Construction Company
300 Harbor Drive
Vermillion, SD 57069
Dear Management:
You asked me to determine the tax implications of requiring the companys 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.
Under the companys present way of doing business, the carpenters do not recognize
income when the employer provides tools. This is a working condition fringe. If the
employees 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 employees 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 employees
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.

514 2005ComprehensiveVolume/SolutionsManual

Sincerely,
Amy Evans, CPA
Partner
p. 5-22
46.

a.

Employees before-tax compensation equivalent to $7,000 exempt compensation:

Income groups
Benefits
Income tax rate
Social Security and Medicare tax rate
Total marginal tax rate (MTR)
1 MTR
Before tax compensation =
[$7,000 (1 MTR)]

b.

Less: reduced income tax (.35)

Employers after-tax cost of
taxable compensation

d.

Middle
$7,000
0.25
0.0765
0.3265
.6735

High
$7,000
0.35
0.0145
0.3645
.6355

$9,050

$10,393

$11,015

Employers cost of before-tax compensation equivalent to $7,000 exempt

compensation:
Before tax compensation =
Employers Social Security Tax

c.

Low
$7,000
0.15
0.0765
0.2265
.7735

Exempt compensation
Less: reduction in income tax (.35)
Employer after-tax cost of
tax-exempt benefits

$9,050
692
$9,742
(3,410)

$10,393
795
$11,188
(3,916)

$11,015
160
$11,175
(3,911)

$6,332

$ 7,272

$ 7,264

$7,000
(2,450)

$ 7,000
(2,450)

$ 7,000
(2,450)

$4,550

$ 4,550

$ 4,550

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 employees 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
spouses 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 daughters 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).

GrossIncome:Exclusions

515

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.

49.

a.

The football tickets probably do not qualify as a de minimis fringe benefit

exclusion. Their exclusion seems unlikely because it is easy to account for the
cost. In addition, Temp. Reg. 1.1326T(f)(2) specifically provides that season
tickets to sporting events do not qualify as de minimis fringes. p. 5-22

b.

Parking is a qualified transportation fringe and, thus, can be made available in a

discriminatory manner. Therefore, the $1,200 is not taxable because it is less than
the $195 per month limit on the exclusion. p. 5-23

c.

Other employees use of the copying machine may be a de minimis fringe, but
Pollys use was probably so extensive that it will not qualify for this exclusion.
However, Polly may be able to relate these expenses to the companys business.
The company benefits from her involvement with the trade association and, thus,
the company could justify the expenses under 162 (see Chapter 6). The $900 is
the companys expense and not Pollys income. The expenses should qualify as a
working condition fringe because Polly could deduct the expenses if she had paid
them. p. 5-22

d.

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

(nondiscriminatory). The $600 can be excluded. p. 5-20

e.

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

pay tax on all of their discounts. Polly includes $400 in her gross income.
pp. 5-21 to 5-24

a.

For the 12-month period ending June 30, 2005, 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 2004. For 2004, 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 2004.
George must include $189,671 ($230,000 $40,329) in his gross income for 2004.

b.

For the 12-month period ending December 31, 2005, 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 2005. For 2005, George can exclude the following amount from his
gross income:
365 days X $80,000* of salary = $80,000
365 days
*Lower of earned income of $275,000 or statutory ceiling of $80,000 for 2005.

516 2005ComprehensiveVolume/SolutionsManual

George must include $195,000 ($275,000 $80,000) in his 2005 gross income.
pp. 5-25 to 5-27
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 + $500 + $125 + $1,600). pp. 5-27 and 5-28

51.

Ezras gross income for 2004 is $500, his share of the fund earnings which he invested in
additional shares in the fund. The change in value of his share of the fund is not a realized
gain in 2004. Therefore, nothing is recognized by him from the increase in the value of the
fund in 2004. His 2005 gross income is $510. He is not allowed to deduct the unrealized
loss from the decrease in the value of his share of the fund because the loss was not
realized. pp. 5-27 and 5-28

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, 2004
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 Erics
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 Erics name with them as custodian. The income would be subject to
Erics marginal tax rate after he is allowed a $800 standard deduction. This option

GrossIncome:Exclusions

517

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 Erics 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
parents income class. That is, the potential exclusion would be completely phased out
for your parents.

Your parents could invest the funds in Connecticuts 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.

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. 5-27 to 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 $90,000 exceeds the
threshold amount of $89,750 for 2004, part of the potential exclusion is phased
out.

518 2005ComprehensiveVolume/SolutionsManual

GrossIncome:Exclusions

519
MAGI
Less: Threshold amount
Excess over threshold amount

$90,000
( 89,750)
$ 250

The amount of the potential exclusion that is phased out is as follows:

$3,333 X ($250 $30,000) = $28
Thus, Chuck and Luane can exclude $3,305 ($3,333 $28) of the savings bond
interest received and $1,695 ($5,000 $3,305) must be included in their gross
income.
b.

All of the $5,000 of savings bond interest must be included in Susies 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.

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. 5-29 and 5-30

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
sons tuition, and the son does not include anything in his gross income. Thus, the aftertax 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 Wilmas cost.

b.

Wilma deducted the $5,000 of state income tax as an itemized deduction on her
1999 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 X $400 = $10,000 X $400 = $320
Total Purchases
$12,500

pp.531and532

520 2005ComprehensiveVolume/SolutionsManual
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. 5-33 and 5-34

58.

a.

Fathers admonishment clearly indicates that he is making a gift to Robin.

Therefore, Robin does not include the $10,000 in his gross income.

b.

The corporations 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 Robins 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 1Tax Computation

Salary
Less: Foreign earned income exclusion (Note 1)
Interest on U.S. savings bonds and Bahamian account (Note 2)
State income tax refund (Note 3)
Stock dividend (Note 4)
Gross income
Less: Deductions for adjusted gross income
Alimony paid
AGI
Less: Itemized deductions
State income tax
Real estate taxes on residence
Interest on personal residence
Charitable contributions
Less: Personal and dependency exemptions (4 X $3,100)
Taxable income

$103,000
(13,115)
1,100
900
-0$ 91,885
(6,000)
$ 85,885
$5,100
3,400
4,500
2,800

(15,800)
( 12,400)
$ 57,685

GrossIncome:Exclusions

521

Tax on $57,685 (Note 5)

Less: Withholding by employer
Net tax payable (or refund due) for 2004

7,938
(9,000)
($ 1,062)

Notes
(1)

Since Martin satisfies the 330 out of 365 day requirement, he qualifies for the
foreign earned income exclusion for the 60 days in 2004 (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 $13,115 (60/366 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 2003.

(4)

The fair market value of the stock dividend is not included in gross income, since
no option was available for receiving cash.

(5) Their filing status is married filing jointly.

Tax on $14,300
On ($57,685 $14,300) X 15%

=
=

$1,430
6,508
$7,938

Part 2Tax Planning

Willis, Hoffman, Maloney, and Raabe, CPAs
5191 Natorp Boulevard
Mason, OH 45040
December 29, 2004
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 2004 you should be in the 15% bracket in
2005 and thereafter, unless there is a change in your income. Therefore, the increase in
after-tax payments in 2005 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

522 2005ComprehensiveVolume/SolutionsManual
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 ($65,000 + $37,000)
Group term life insurance (Note 1)
Dividends
State tax refund (Note 2)
Deductions for adjusted gross income
Alimony paid (Note 3)
Adjusted gross income
Itemized deductions
State income taxes ($3,400 + $2,200)
Home mortgage interest
Real estate taxes
Cash contributions
Personal and dependency exemptions ($3,050 X 2)
Taxable income

$102,000
96
1,800
1,200
$105,096
(9,600)
$ 95,496
$5,600
4,300
1,200
1,000

Tax on $77,296 (Note 4)

Less: Tax withheld ($10,900 + $5,200)
Net tax payable (or refund due) for 2003

(12,100)
(6,100)
$ 77,296
$ 12,759
(16,100)
($ 3,341)

See the tax return solution beginning on p. 5-22 of the Solutions Manual.
Notes
(1)

Group term life insurance results in gross income for Alfred of $96 as follows:
($130,000 $50,000) X $.10 X 12 months = $96
$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 2002 and thus did not get a tax
benefit from the state income taxes paid.

(3)

The $9,600 is deductible alimony. The $50,000 payment is a property settlement

and is not deductible by Alfred.

(4)

The tax liability on taxable income of $77,296 is calculated using the Tax Table for
married filing jointly and the amount is $12,759. The dividends are taxed at 15%.

GrossIncome:Exclusions

523

Tax on dividend income ($1,800 X 15%)

Tax on remainder of $75,496 ($77,296 $1,800)

270
12,489
$12,759

The answers to the Research Problems are incorporated into the 2005 Comprehensive Volume of
the Instructors Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION:
COMPREHENSIVE VOLUME.

524 2005ComprehensiveVolume/SolutionsManual
60.

GrossIncome:Exclusions
60. continued

525

526 2005ComprehensiveVolume/SolutionsManual
60. continued

GrossIncome:Exclusions
60. continued

527

528 2005ComprehensiveVolume/SolutionsManual
NOTES