Solution Manual for Prentice Hall's Federal Taxation 2013 Individuals, 26th Edition

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C:1-1Chapter C:1Tax ResearchDiscussion QuestionsC:1-1In a closed-fact situation, the facts have occurred, and the tax advisor’s task is to analyzethem to determine the appropriate tax treatment. In an open-fact situation, by contrast, the facts havenot yet occurred, and the tax advisor’s task is to plan for them or shape them so as to produce afavorable tax result. p. C:1-2.C:1-2According to the AICPA’sStatements on Standards for Tax Services, the tax practitionerowes the client the following duties:(1) to inform the client of (a) the potential adverseconsequences of a tax return position, (b) how the client can avoid a penalty through disclosure,(c)errors in a previously filed tax return, and (d) corrective measures to be taken; (2) to inquire ofthe client (a)when the client must satisfy conditions to take a deduction and (b) when informationprovided by him or her appears incorrect, incomplete, or inconsistent on its face; and (3) not todisclose tax-related errors without the client’s consent. pp. C:1-32 through C:1-35.C:1-3When tax advisors speak about“tax law,”they refer to the IRC as elaborated by TreasuryRegulations and administrative pronouncements and as interpreted by federal courts. The term alsoincludes the meaning conveyed by committee reports. p. C:1-7.C:1-4Committee reports concerning tax legislation explain the purpose behind Congress’proposing the legislation.Transcripts of hearings reproduce the testimonies of the persons whospoke for or against the proposed legislation before the Congressional committees.Committeereports are sometimes used to interpret the statute. p. C:1-7.C:1-5Committee reports can help resolve ambiguities in statutory language by revealingCongressional intent. They are indicative of this intent. pp. C:1-7 and C:1-8.C:1-6The Internal Revenue Code of 1986 is updated for every statutory change to Title 26subsequent to 1986. Therefore, it includes the post-1986 tax law changes enacted by Congress andtoday reflects the current state of the law. p. C:1-8.C:1-7No. Title 26 deals with all taxation matters, not just income taxation. It covers estate tax,gift tax, employment tax, alcohol and tobacco tax, and excise tax matters. p. C:1-8.C:1-8a.Subsection (c).It discusses the tax treatment of property distributions in general(e.g., amount taxable,amountapplied against basis, and amount exceeding basis).b.Because Sec. 301 applies to the entire chapter, one should look throughout that entirechapter (Chapter 1of the IRC–which covers Sec. 1 through Sec.1400U-3) for any exceptions. Onespecial rule–Sec. 301(e)–is found in Sec. 301. This special rule explains the tax treatment ofdividends received by a 20% corporate taxpayer. Section 301(f) indicates some of the importantspecial rules found in other IRC sections.

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C:1-2c.Legislative. Section 301(e)(4) authorizes the issuance of Treasury Regulations asmay be necessary to carry out the purposes of the subsection. pp. C:1-9through C:1-10.C:1-9Researchers should note the date on which a Treasury Regulation was adopted because theIRC may have been revised subsequent to that date.That is, the regulation may not interpretthe current version of the IRC. Discrepancies between the IRC and the regulation occur when theTreasury Department has not updated the regulation to reflect the statute as amended. p. C:1-9.C:1-10a.Proposed regulations are not authoritative, but they do provide guidance concerninghow the Treasury Department interprets the IRC. Temporary regulations, which are binding on thetaxpayer, often are issued after recent revisions to the IRC so that taxpayers and tax advisers willhave guidance concerning procedural and/or computational matters. Final regulations, which areissued after the public has had time to comment on proposed regulations, are considered to besomewhat more authoritative than temporary regulations. pp. C:1-9 and C:1-10.b.Interpretative regulations make the IRC’s statutory language easier to understand andapply. They also often provide computational illustrations. In the case oflegislativeregulations,Congress has delegated the rulemaking on a specific topic (either narrow or broad) to the TreasuryDepartment.However, after theMayoFoundationcase, both types of regulationswill have the sameauthoritative weight.p. C:1-10.C:1-11Legislative.In the past, itwasmore difficult for a taxpayer to successfully challenge this typeof regulation because Congress has delegated its rulemaking authority to the Treasury Department.However, after theMayoFoundationcase, both types of regulations will have the same authoritativeweight.p. C:1-10.C:1-12Under the legislative reenactment doctrine, a Treasury Regulation is deemed to have beenendorsed by Congress if the regulation was finalized before a related IRC provision was enacted andin the interim, Congress did not amend the statutory provision to which the regulation relates.p.C:1-10.C:1-13a.Revenue rulings are not as authoritative as court opinions, Treasury Regulations, orthe IRC. They represent interpretations by an interested party, the IRS. p. C:1-12.b.If the IRS audits the taxpayer’s return, the IRS likely will contend that the taxpayershould have followed the ruling and, therefore, owes a deficiency. p. C:1-12.C:1-14a.The Tax Court, the U.S. Court of Federal Claims, or the U.S. district court for thetaxpayer’s jurisdiction. p. C:1-14.b.The taxpayer might consider the precedent, if any, existing within each jurisdiction.The taxpayer might prefer to avoid expending cash to pay the proposed deficiency. If so, thetaxpayer would want to litigate in the Tax Court. If the taxpayer would like to have a jury trialaddress questions of fact, he or she should opt for the U.S. district court. pp. C:1-14 through C:1-19,p. C:1-21, and p. C:1-23.c.Appeals from Tax Court and U.S. district court decisions are made to the circuit courtof appeals for the taxpayer’s geographical jurisdiction. U.S. Court of Federal Claims decisions areappealable to the Court of Appeals for the Federal Circuit. Appeals from any of the circuit courts ofappeals may be brought to the U. S. Supreme Court. pp. C:1-20 through C:1-21.

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C:1-3C:1-15No.A taxpayer may not appeal a case litigated under the Tax Court’s Small CasesProcedure. p. C:1-17.C:1-16Tax Court regular and memo decisions have about the same precedential value. Decisionsissued under the Small Cases Procedure of the Tax Court have little or no precedential value.pp. C:1-15 and C:1-17.C:1-17Yes. The IRS can acquiesce (or nonacquiesce) in any federal court decision that is adverse tothe IRS if the IRS decides to do so. In many cases the IRS does not acquiesce or nonacquiesce.p.C:1-17.C:1-18In both the AFTR and USTC:decisions of U.S. district courts, U.S. bankruptcy courts, U.S.Court of Federal Claims, circuit courts of appeal, and the U.S. Supreme Court.Tax Court decisionsare reported in neither of the two reporters. pp. C:1-16 and C:1-17 through C:1-22.C:1-19When first issued,revenuerulings appear in the weekly Internal Revenue Bulletin (I.R.B.).Twice each year, the decisions published in the I.R.B. are bound together and published in theCumulative Bulletin (C.B.). The I.R.B. citation is appropriate only until the ruling is published inthe C.B. p. C:1-12.C:1-20According to theGolsenRule, the Tax Court will not follow a decision it made earlier, butrather will follow a decision of the circuit court of appeals to which the case under consideration isappealable. As an example, assume that the Tax Court, in a case involving a First Circuit taxpayer,ruled for the taxpayer. The issue had not been litigated earlier. Then, a U.S. district court in Georgiadecided a case involving the same issue in favor of another taxpayer.The Eleventh Circuit,however, reversed the decision. Now a taxpayer from the Eleventh Circuit litigates the same issue inthe Tax Court. Under theGolsenRule, the Tax Court will follow the Eleventh Circuit’s decisionfavoring the government. The Tax Court need not follow an appeals court decision if a case waslitigated by a taxpayer whose appeal would have been made to any circuit other than the Eleventh.p. C:1-21.C:1-21a.The precedent binding upon a California taxpayer would be the Tax Court case.The Tax Court has national jurisdiction. pp. C:1-21 and C:1-23.b.Under theGolsenRule, the Tax Court will depart from its earlier decision and followthe Fifth Circuit’s decision favoring the government. p. C:1-21.C:1-22a.Congressional Recordb.Internal Revenue Bulletinc.Tax Court of the United States Reportsd.Federal Register,Internal Revenue Bulletin, and/orCumulative Bulletine.Federal Supplement,American Federal Tax Reports(only tax-related),United StatesTax Cases(only tax-related).f.Not found in an“official”publication; published by tax servicespp. C:1-7, C:1-12 through C:1-14, and C:1-17 through C:1-19.

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C:1-4C:1-23A tax advisor might find the provisions of a tax treaty useful where a U.S. taxpayer engagesin transactions in a foreign country.The United States has tax treaties with over 55 countries.p.C:1-24.C:1-24Citators (1) trace the history of the case in question and (2) list other authorities that havecited such case. p. C:1-30.C:1-25First,CHECKPOINTlists all citing cases and not just those that the editors believe will serveas precedent.Second,CHECKPOINTindicates how the case in question was cited (favorably,unfavorably, distinguished, etc.). p. C:1-30.C:1-26Keyword, index, citation, or contentare thefour ways to search in CHECKPOINTandINTELLICONNECTdatabases.p. C:1-27.C:1-27a.TheprincipalprimarysourcesfoundinbothINTELLICONNECTandCHECKPOINT are as follows:•IRC•Treasury Regulations•Court opinions•Revenue rulings and procedures•Letter rulings•Committee reports•Tax treatiesb.The principal secondary sources found inINTELLICONNECT are as follows:•Standard Federal Income Tax Reporter•Federal Estate and Gift Tax Reporter•Federal Excise Tax Reporter•Tax Treaties Reporter•Master Tax GuideThe principal secondary sources found in CHECKPOINT are as follows:•Federal Tax Coordinator•United States Tax Reporter•RIA Federal Tax Handbook•Warren, Gorham & Lamont journals and treatisespp. C:1-26 through C:1-29.C:1-28The features (i.e., icons, templates, and command buttons) will vary depending upon theparticular tax service/Internet site accessed. Just about all commercial tax databases can be searchedby keyword and citation.Some can be searched by table of contents and topic.Mostnoncommercial tax databases can be searched by keyword. Some can be searched by citation andtable of contents.The advantages of using a commercial tax service (as opposed to a noncommercial service)are broader database scope, greater historical coverage, and more efficient search engines.Theprincipal disadvantage is cost.

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C:1-5Because of their relative disadvantages, the noncommercial sites should not be regarded as asubstitute for a commercial tax service. Access is non-uniform.The scope and breadth of theirdatabases are limited. pp. C:1-26 through C:1-28.C:1-29The CPA should have a good faith belief that his or her position has a realistic possibility ofbeing sustained administratively or judicially on its merits if challenged. p. C:1-33.C:1-30Under the AICPA’sStatements on Standards for Tax Services(SSTSs), a tax preparer is notobligated (1) to verify client provided information if the information is not suspicious on its face and(2) to update professional advice based on developments following its original conveyance. pp. C:1-33 and C:1-34.C:1-31The two primary classifications of written advice underCircular 230are (1) covered opinionsand (2) other written advice. A covered opinion refers to tax advice rendered on a tax shelter typetransaction the IRS has identified (listed) as having a tax avoidance purpose.The TreasuryDepartment proposed changes to these rules in 2012.C:1-32.C:1-32Circular 230is a government issued document that dictates rules for practicing before theIRS. TheStatements on Standards for Tax Services(SSTSs) are ethical standards issued by theAICPA aimed at tax practitioners.Circular 230applies only to federal tax issues, and the SSTSsapply to both federal and state issues.Circular 230only applies to income taxes, and the SSTSsapply to all types of taxes. Finally,Circular 230does not provide the same depth of ethical guidancefound in the SSTSs. p. C:1-32.ProblemsC:1-33a.Yes. According to Secs. 71(a) and (b), the wife includes $25,000 per year. Also, thedivorce agreement must explicitly state that the husband has no liability to make payments after thewife’s death. See Sec. 71(b)(1)(D) and Temp. Reg. Sec. 1.71-1T(b), Q-11.b.Yes.The husband deducts $25,000 per year according to Secs. 215(a) and(b).According to Sec. 62(a)(10), the alimony is deductible for AGI. pp. C:1-8 and C:1-26 throughC:1-29.C:1-34a.Legislative. According to Sec. 385(a),“The Secretary is authorized to prescribe suchregulations as may be necessary or appropriate. . . .”b.Yes. Section 385(a) states that the regulations will be applicable“for purposes of thistitle.”“This title”is Title 26 of the federal statutes. Because Title 26 encompasses all tax statutes,the regulations would be relevant for estate tax purposes. pp. C:1-8 through C:1-10 and C:1-26through C:1-29.C:1-35a.Both rulings hold that contributions to a fund formed to acquire a portrait of a formerjudge and donated to a governmental agency are deductible under Sec. 170. p. C:1-29.b.Private letter rulings cannot be cited as precedence and applyonly to the taxpayer forwhom the IRS issued the ruling. pp. C:1-12 and C:1-13.c.Revenue rulings can be cited as precedence, and they are relied on by both taxpayersand the IRS for guidance in particular factual situations. pp. C:1-12 and C:1-13.

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C:1-6C:1-36Sections 355 and 856. The official IRS publication is theInternal Revenue Bulletin, whicheventually is incorporated into theCumulative Bulletin. pp. C:1-12 and C:1-29.C:1-37Results might vary as the service adds or deleted documents, but as of this writing:a.54.b.25.c.14.d.The program default presents results sorted by IRC section, and in this case thoseresults listed first are not on point.However, when sorted by relevance, the very first resultaddresses expenses related to a home office deduction.The effect is similar to using Booleanconnectors. pp. C:1-26 through C:1-28.C:1-38Results might vary as the service adds or deleted documents, but as of this writing:a.50.b.1.c.In Part a, the search engine uses the thesaurus to include in the search other terms forhome. Because most tax documents do not use the termhome, limiting the search results to onlythose documents including“home sale”is not ideal.The researcher will not see the majority ofdocuments relevant to the search question.The one result is fortunate, and provides a generalanswer, but if the student needs clarification, those documents are not presented.d.Principle residence. pp. C:1-26 through C:1-28.C:1-39a.Acquiescence. SeeAOD 1986-030,1986-1 C.B. 1.b.No. The acquiescence was only with respect to whether a transfer to the taxpayer’sspouse is a taxable disposition.pp. C:1-17 and C:1-29.C:1-40a.Acquiescence. See 1953-1 C.B. 6.b.Partial. It dealt with sales taxes.c.Yes. In 1981, he withdrew the acquiescenceon the issue of sales tax deductionandnonacquiesced (seeAOD 1981-184,1981-2 C.B. 3). pp. C:1-17 and C:1-29.C:1-41a.Nonacquiescence. SeeAOD 1988-014, 1988-2 C.B.1.b.Yes. In 2003, theCommissioner withdrew the 1988 AOD and acquiesced. See AOD2003-001, 2003-2 I.R.B.C:1-42a.Yes. The case was reviewed by the court. No. It was not a unanimous decision.Judges Korner, Swift, and Gerber did not participate. Judge Simpson dissented. pp. C:1-26 throughC:1-29.b.Yes. The decision was entered under Rule 155. p. C:1-17.c.Yes. The case was reviewed by theSixthCircuit Court of Appeals. pp. C:1-30 andC:1-31.C:1-43a.Yes. The case was reviewed by the court. The decision was not unanimous. JudgeQuealy dissented. Judge Tannenwald issued a concurring opinion with which five judges agreed.Judge Chabot issued a dissenting opinion with which three judges agreed, and Judge Nims issued adissenting opinion with which three judges agreed. pp. C:1-26 through C:1-29.

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C:1-7b.No. The decision was not entered under Rule 155. p. C:1-17.c.Yes. The case was reviewed by the Sixth Circuit Court of Appeals in 1982. pp. C:1-30and C:1-31.C:1-44a.National Cash Register Co.v.U.S., 400 F.2d 820, 22 AFTR 2d 5562, 68-2 USTC¶9576 (6th Cir., 1968).b.Thomas M. Dragoun, 1984 RIA T.C. Memo ¶84,094(T.C. Memo 1984-94),47 TCM1176.c.U.S.v.John M. Grabinski, 558 F. Supp. 1324, 52AFTR 2d 83-5169, 83-2 USTC¶9460 (DC MN, 1983).d.U.S.v.John M. Grabinski, 727 F.2d 681, 53 AFTR 2d 84-710, 84-1 USTC ¶9201(8th Cir., 1984).e.Rebekah Harknessv.U.S., 469 F.2d 310, 30 AFTR 2d 72-5754, 72-2 USTC ¶9740(Ct. Cl., 1972).Note that during this period, Court of Claims decisions were published in theFederal Reporter, Second Series. Alternatively, you could give the citation 199 Ct. Cls. 721, whichreferences the Court of Claims Reporter. In the RIA citator the name of the case is simplyHarkness.f.Hillsboro National Bankv.CIR, 460 U.S. 370, 51 AFTR 2d 83-874, 83-1 USTC¶9229 (USSC, 1983).g.Rev. Rul. 78-129, 1978-1 C.B. 67. pp. C:1-17 through C:1-22.C:1-45a.Rev. Rul. 99-7, 1999-1 C.B. 361.b.Frank H. Sullivan, 1 B.T.A. 93 (1924).c.Tate & Lyle, Inc.,103 T.C. 656 (1994).d.Ralph L. Rogersv.U.S., 539 F. Supp. 104, 49 AFTR 2d 82-1160, 82-1 USTC ¶9246(DC OH, 1982).e.Norman Rodmanv.CIR, 542 F.2d 845, 38 AFTR 2d 76-5840, 76-2 USTC ¶9710(2nd Cir., 1976).pp. C:1-17 through C:1-22.C:1-46a.Circuit Court of Appeals for the Ninth Circuit; page 1198 of Volume 648 of theFederal Reporter,Second Seriesand page 81-5353 of Volume 48 of theAmerican Federal TaxReports,Second Series.b.U. S. Court of Federal Claims; page 455 of Volume 14 of theClaims Court Reporterand paragraph (not page) 9231 of Volume 1 of the 1988U. S. Tax Cases.c.Supreme Court; page 13 of Volume 309 of theUnited States Supreme Court Reportsand page 816 of Volume 23 of theAmerican Federal Tax Reports.d.A U.S. District Court in Texas; page 76 of Volume 441 of theFederal Supplementand page 78-335 of Volume 41 of theAmerican Federal Tax Reports, Second Series.e.Not a court decision; page 72 of Volume 1 of the 1983Cumulative Bulletin.f.Circuit Court of Appeals for Sixth Circuit; page 474 of Volume 568 of theFederalReporter, Second Seriesand paragraph (not page) 9199 of Volume 1 of the 1978U.S. Tax Cases.pp. C:1-16 and C:1-22.

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C:1-8C:1-47a.“Medical expenses, cosmetic surgery”is discussed at ¶2134.04 and 2135.05(42) andcosmetic surgery costs is discussed at ¶2134.04.b.Section213(d)(9) is referred to in ¶2135.04. Rev. Rul 76-332, 1976-2 C.B. 81 andRev. Rul. 2003-57, 2003-1 C.B. 959 are discussed at ¶2135.05(42).c.Generally no. Section 213(d)(9) (effective for tax years beginning after 1990)provides that the cost of cosmetic surgery is not deductible except in certain narrow circumstances.pp. C:1-28 and C:1-29.C:1-48No. The regulation does not reflect the amendments to Sec. 302 made in 1996, 1997, and1998. A caution to this effect appears at the beginning of the regulation of both services, althoughINTELLICONNECT does not refer to the 1998 amendments. pp. C:1-26 through C:1-29.C:1-49a.“Casualty losses for invasion by”is discussed at ¶10,005.029 and at ¶¶10,005.671-10,005.68.b.Authorities include: Rev. Rul. 63-232, 1963-2 C.B. 97;Henry L. Sutherland, 1966PH T.C. Memo ¶66,155, 25 TCM 822; andMartin A. Rosenbergv.CIR, 42 AFTR 2d 303, 52-2USTC ¶9377 (8th Cir., 1952). The first two authorities denied a deduction and the third allowed adeduction. pp. C:1-28 and C:1-29.C:1-50a.More than 35% of the excess of the value of the decedent’s gross estate over the sumof allowable Sec. 2053 and 2054 deductions. (CCH ¶15,350.)b.No.The regulation indicates the test is more than (1) 35% of the gross estate or(2)50% of the taxable estate. It does not reflect the P.L. 94-455 or P.L. 97-34 amendments to the IRC.Acautiontothiseffectappearsbeforethebeginningofthereprintoftheregulations.pp. C:1-26 through C:1-29.C:1-51a.645.b.572-3rd-Accounting Methods–Adoptions and Changes.570-2nd-Accounting Methods–General Principles.c.568-4th..d.367.e.523-2nd.p. C:1-25.C:1-52“Clergy, work clothes, deductibility”is discussed at ¶L-3806. The authority dealing with thistopic isJ.W. Ratcliff, 1983 PH T.C. Memo ¶83,636. This heading is listed in the topical index under“clergy.”pp. C:1-28 through C1-29.C:1-53a.7 (4 in 1954-1977 volume; 1 in 1978-1989 volume; 2 in 1990-1996 volume; 0 in the1997-2002 cumulative supplement; and 0 in the 2003-2007 cumulative supplements). All sevencitations have been integrated into one listing on CHECKPOINT.b.12 issues, but 13 issues are listed in the findings of fact.c.Yes. The Fourth Circuit reviewed the case.d.None.e.INTELLICONNECT does not list headnote numbers.(INTELLICONNECTindicates 11 cases, and two rulings citeBiltmore.) pp. C:1-30 and C:1-31.

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C:1-9C:1-54a.23.b.No. According to the headnote to the opinion, the decision dealt with one issue,deductions.c.No.The decision has not been cited unfavorably although the point made inHeadnote No. 1 has been distinguished in a number of cases and limited in one case.d.13.e.Indeterminable.ThereisonecitetotheTaxCourtdecision,buttheINTELLICONNECT citator does not indicate headnote numbers. pp. C:1-30 through C:1-31.C:1-55a.1972.b.The deductibility of the cost of a customer list under Sec. 162.c.The government. The cost was not currently deductible.d.No. The decision was not reviewed at the trial level.e.Yes. The decision was appealed to the Sixth Circuit Court of Appeals.f.Yes. The RIA citator and the CCH citator list eight citations to the decision. pp. C:1-26through C:1-31.C:1-56a.To file a tax return electronically, one must (1) purchase the requisite software from acommercial vendor or download it from a designated Internet site; (2) obtain a PersonalIdentification Number (PIN) from the IRS; (3) either prepare a tax return offline and upload, orprepare the return online; and (4) transmit the return to the IRS.b.The taxpayer can transmit funds electronically in one of three ways:(1) byauthorizing an electronic funds withdrawal from a checking or savings account; (2) by authorizingpayment by credit card; or (3) by mailing to the IRS a check or money order using a paymentvoucher.c.Electronic filing (1) allows the taxpayer to file a return from any personal computer;(2) is more accurate than manual filing; (3) offers the safety and security of direct deposit; (4) offersthe convenience of filing a tax return early and delaying payment up to the due date, and (5) allowsone to file federal and state tax returns simultaneously. pp. C:1-29 and C:1-30.C:1-57a.“Request for Copy of Tax Return.”b.“Corporation Claim for Deduction for Consent Dividends.”c.“Excise Tax on Greenmail.”pp. C:1-29 and C:1-30.C:1-58a.“Request for Copy of Tax Return.”b.“Credit for Tax Paid to Other States.”c.“New York Consolidated Franchise Tax Return.”pp. C:1-29 and C:1-30.C:1-59The latest data as of this writing was for 2010.a.7 (Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming).b.2 (New Hampshire and Tennessee).c.11%.d.Illinois, 3%.pp. C:1-29 and C:1-30.

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C:1-10Comprehensive ProblemC:1-60STEP ONE: In searching INTELLICONNECT’sStandard Federal Tax Reporter(SFTR),you would consult the topical index under“Yachts”or“Advertising, expenses for.”In searchingCHECKPOINT’sUnited States Tax Reporter(USTR), you would consult the topical index under“Advertising–special or unusual forms of.”In searching SFTR on INTELLICONNECT or USTRon CHECKPOINT, you would use the keyword“Yacht.”Either way, in SFTR you would likelyfind an annotation at ¶8851.1327; in USTR you would likely find an annotation at ¶1625.356(13).STEP TWO: In print research, you would leave the tax service reporter volume to look upthe case on page 879, Volume 36 ofTax Court of the United States Reports.In computerizedresearch, you would remain in the service and click on the hyperlinked citation. Either way, youwould find the text ofR.L. Henry, 36 T.C. 879. This case involved an attorney/accountant who triedto deduct the costs of insuring and maintaining a yacht on which he flew a pennant with thenumerals“1040.”It is analogous to your client’s case.STEP THREE: In print research, to check the status of the case, you would leaveTax Courtof the United States Reportsto consult a citator. In computerized research, you would remain in theservice and click on the citator command button. Either way, you would discover a listing of casesthat citeR.L. Henry. You also would discover that the case is still“good law.”STEP FOUR: In both print and computerized research, based on the ruling inR.L. Henry,you likely would conclude that the costs of maintaining and insuring the physician’s yacht are notdeductible as ordinary and necessary business expenses. pp. C:1-26through C:1-29.Tax Strategy ProblemC:1-61Choose Alternative 2; file the lawsuit in the Tax Court. HPU is likely to lose a lawsuit filedin the U. S. district court (Alternative 1) because that court is bound bydistrict courtprecedentadverse to the taxpayer.Likewise, HPU is likely to lose a lawsuit filed in the Court of FederalClaims(Alternative 3) because that court is bound bycircuit courtprecedent adverse to thetaxpayer. On the other hand, in the Tax Court (Alternative 2) the tax return position taken by HPUhas a realistic possibility of being sustained on its merits. In a case involving HPU, the Tax Courtwould not be bound by the other circuit court’s precedent, which is adverse to the taxpayer becauseof theGolsenRule. Rather, the Tax Court would be bound by HPU’s own circuit court precedent,which, based on the specific facts of the problem, is nonexistent because HPU’s circuit court hasmerely offereddictum, which is not binding. However, if the Tax Court issues a ruling consistentwith the circuit court’s second proposition, namely, that by opening the home improvement center,HPU is merely“improving customer access to its existing products,”HPU will win the lawsuit, andits deduction will be sustained. pp. C:1-21 and C:1-23.

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C:1-11Case Study ProblemC:1-62Statements on Standards for Tax Services (SSTS)No. 3states that a CPA“may in good faithrely, without verification, on information furnished by the taxpayer or by third parties”(Para. 2,reproduced in Appendix E of the text). Thus, you may accept Mal’s information at face value. Hisincrease in AGI of over $30,000 may explain his increase in charitable contributions ofapproximately $10,000. In the second scenario the provision fromSSTSNo. 3that a CPA“shouldmake reasonable inquiries if the information furnished appears to be incorrect, incomplete, orinconsistent either on its face or on the basis of other facts known to a member”would be pertinent.Recently, the IRS audited Mal’s return, and Mal lacked substantiation for about 75 percent of thecharitable contributions he had claimed. (He may have made the contributions, but he could notprove that he did.) Further, the round amount ($25,000) reported by Mal suggests that Mal may beestimating what he contributed. You probably should request to see substantiation (canceled checks,etc.) for the contribution(s) claimed.For charitable contributions of $250 or greater made afterDecember 31, 1993, no deduction is allowed unless the donee organization substantiates thecontribution with a contemporaneous, written acknowledgement. Mal needs to be made aware ofthis rule for his current year’s return.All cash contributions, regardless of amount, must bedocumented with a bank record or written communication from the charity. The communicationmust include the name of the charity, date, and amount. p. C:1-33.Tax Research ProblemsC:1-63a.The primary issue is whether the amounts Thomas A. Curtis, M.D. Inc. paid to EllenCurtis as compensation during fiscal years 1988 and 1989 were reasonable.b.Neither party was totally victorious.In fiscal year 1988, Ellen Curtis was paid$410,500. The amount held to be reasonable compensation by the Tax Court for 1988 was $227,000.In fiscal year 1989, Ellen Curtis was paid $510,500.The amount held to be reasonablecompensation by the Tax Court for 1989 was $239,000.The amount held to be compensation,however, is more than the $100,000 and $105,000 the IRS asserted was reasonable compensation.c.The plaintiff is the corporation because it is the party that claimed a deduction for thecompensation.The IRS is attempting to disallow the corporation’s deduction for part of thecompensation paid. The disallowance of the deduction will have little effect on the two individualssince the amounts received will be either salary or dividends depending on the outcome of the case.d.Ellen Barnert married Dr. Thomas Curtis in 1984.e.Ms. Curtis worked approximately 60 to 70 hours supervising all departments setupwithin the corporation and the independent contractors, including scheduling and staffing of all thecorporation’s offices. Ms. Curtis was a registered nurse. She had a bachelor’s degree in science andtook worker’s compensation courses at the University of Southern California Law School. She hadworked as a nurse for a number of years and managed an ambulatory hospital system.f.In fiscal year 1989, Ellen Curtis was paid $510,500. The Tax Court held $239,000 tobe reasonable compensation in 1989.g.The corporation paid no dividends in either fiscal year.h.The case is appealable to the Ninth Circuit.i.The five factors mentioned in determining reasonable compensation according toElliott’sare: (1) the employee’s role in the company, (2) external comparison of the employee’ssalary with those paid by similar companies for similar services, (3) character and condition of the

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C:1-12company, (4) conflict of interest in the employee’s relationship to the corporation, and (5) theinternal consistency in the company’s treatment of payments to employees.C:1-64Judicial authority exists to exclude the Medicare payments from the amount the mother istreated as having provided for her own support. The IRS agrees with this authority; therefore, if theIRS audits the client’s return, the IRS will not argue that Josh’s mother provided the majority of herown support. (This information should be included in the client letter.)The work papers should include a discussion of the authorities summarized below. Section152(a) provides that one of the tests for claiming another as a dependent is to provide over one-halfof such person’s support. (Note:Josh’s mother’s gross income of $2,000 is not too high in thecurrent year for her to be claimed his dependent assuming all other requirements are met.) If heprovides over one-half of her support, he also may deduct any medical expenses he pays on herbehalf. Section 152 does not define“support.”Regulation Sec. 1.152-1(a)(2) states that supportincludes“food, shelter, clothing, medical and dental care, education, and the like.”It also providesthat in determining the amount an individual contributes to his own support, one must count the costof support items paid for from“income, which is ordinarily excludable from gross income, such asbenefits received under the Social Security Act.”InAlfred H. Turecamov.CIR, 39 AFTR 2d 77-1487, 77-1 USTC ¶9415 (2ndCir., 1977), thecourt held that hospitalcosts paid by Basic Medicare do not constitute support the ill personfurnishes for himself or herself. After studying the legislative history of the Medicare statute, thecourt could find no valid basis“for distinguishing between hospital benefits received under Part A ofMedicare [Basic Medicare] and either private insurance proceeds or supplemental benefits receivedunder Part B [of Medicare].”In Rev. Rul. 70-341, 1970-2 C.B. 31, the IRS ruled that Basic Medicare payments on aperson’s behalf must be treated as contributions by such person toward his own support.Suchtreatment was in contrast to that of Supplemental Medicare, which the IRS viewed as in the nature ofinsurance proceeds, and not self-support.Revenue Ruling 64-223, 1964-2 C.B. 50, held thatamounts paid by an insurance company for medical costs are disregarded in the support test.In Rev. Rul. 79-173, 1979-1 C.B. 86, the IRS revoked Rev. Rul. 70-341.Thus, the IRScurrently treats Basic Medicare payments consistently with Supplemental Medicare and ignoresamounts received from either source for purposes of the support test.InArcherv. Comm.73 T.C.963 (1980), the court held that both medicare and medicaid are disregarded in the support test.C:1-65In determining whether the property is used“too much”for personal purposes so thatSec. 280A applies, use of the residence by Amy or by family members constitutes personal use, asdoes use by persons who pay less than fair rental value (Sec. 280A(d)(2)).Use by Amy whenperforming repairs and maintenance full-time is totally disregarded (Sec. 280A(d)(2)). For purposesof allocating the expenses attributable to rental use, however, all the days on which the property isrented for fair rental value are considered, even if the property is rented to family members on someof these days (Prop. Reg. Sec. 1.280A-3(c)).

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C:1-13The total number of days rented at fair rental value–the numerator of the fraction used in theallocation–is determined as follows:Days rented to sister8Days rented to cousin4Days rented to three families120Total132The denominator for allocating interest and taxes is in dispute. Per Prop. Reg. Sec. 1.280A-3(d)(3), the denominator is the total number of days of actual use (exclusive of use by the ownerfor performing repairs). Thus, the denominator would be 146 (12 + 8 + 4 + 2 + 120). Case lawsupports using as the denominator the number of days in the year, or 365 days in this case forallocating interest and taxes.Dorrance D. Boltonv.CIR51 AFTR 2d 83-305, 82-2 USTC ¶9,699,(9thCir., 1982), affirming 77 T.C. 104 (1981), andEdith G. McKinneyv.CIR52 AFTR 2d83-6281, 83-2 USTC ¶9,665 (10th Cir., 1983).No dispute exists over the fraction to use for allocating repairs, insurance, and depreciation.It is the number of days rented at fair rental value divided by the total number of days of actual use,or 132/148(Sec. 280A(e)(1)).Note: The denominator is 148 instead of 146 (as above) because,here, it includes the two days of use for repairs.C:1-66a.The principal issue in both cases was whether the corporation could deduct amountspaid as compensation to the spouse (ex-spouse) of a sole shareholder. This issue, in turn, dependedon whether such compensation was“reasonable”under the circumstances.b.The Tax Court considered a number of factors, including (1) the employee’squalifications and training, (2) the nature, extent, and scope of her duties, (3) responsibilities andhours involved, (4) the size and complexity of the business, (5) the results of the employee’s efforts,(6) the prevailing rates for comparable employees in comparable businesses, (7) the scarcity of otherqualified employees, (8) the ratio of compensation to the gross and net income of the business,(9)the salary policy of the employer to other employees, and (10) the amount of compensation paidto the employee in prior years.c.The facts of these cases are similar in the following respect:in both cases, thetaxpayers were corporations that claimed a deduction for payments made to the spouse or ex-spouseof a sole shareholder. The facts are different in these respects: (1) InSummitthe IRS contendedthat only a portion of the salary payments were nondeductible; inJ.B.S., it argued that none of thesalary payments were deductible. (2) InSummit, the spouse performed extensive services for thefirm; inJ.B.S., the ex-spouse appears to have performed no services. (3) InSummit, the court tookinto consideration the corporation’s rising profits; inJ.B.S., the court did not. (In fact, the latteropinion does not mention the firm’s profits or loss position). (4) InSummit, the payments did notappear to be motivated by tax avoidance. (Because the corporation paid substantial dividends to itssole shareholder, the payments to the spouse did not appear to be“disguised dividends”). InJ.B.S.,the payments did appear to be motivated by tax avoidance.(Testimony indicated that some taxpositions had been taken to minimize the corporation’s tax liability).

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C:1-14C:1-67The memorandum should supply the following answers:a.Revenue Proc. 2012-6, I.R.B. 2012-1, 197and Rev. Proc. 2012-4, I.R.B. 2012-1,125, govern requests for determination letters.b.Form 5300,“Application for Determinationfor Employee Benefit Plan,”must befiled with the request.c.The following information must be provided in the request:1.Complete statement of facts and other information2.Copies of all contracts, wills, deeds, agreements, instruments, plans, andother documents3.Analysis of material facts4.Statement regarding whether the same issue was addressed in an earlierreturn5.Statement regarding whether the same or similar issue was previously ruledon or requested, or is currently pending6.Statement of supporting authorities7.Statement of contrary authorities8.Statement identifying pending litigation9.Statement identifying information to be deleted from the copy ofdetermination letter for public inspection10.Signature by the taxpayer or authorized representative11.Names of authorized representatives12.Power of attorney and declaration of representative13.Penalties of perjury statementd.Actions that must accompany the filing include payment of appropriate user fee andnotification of interested parties.e.The request must be filed at the following address:EP DeterminationsInternal Revenue ServiceP.O. Box 192Covington, KY 41012-0192

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C:1-15“WhatWouldYouDoInThisSituation?”SolutionCh. C:1, p. C:1-35.Inconsistent Figures.In this context, you have two professional duties: first, a duty of confidentiality to eachclient, and second, a duty to verify information that appears to be incorrect on its face. According toStatement No. 3 of theStatements on Standards for Tax Services, a CPA who is required to sign atax return should consider information actually known to the CPA from the tax return of anotherclient if (1) that information is relevant to the former return, (2) its consideration is necessary toproperly prepare that return, and (3) the use of such information does not violate any rule ofconfidentiality.Here, (1) the information relating to each return is relevant to the other;(2) its consideration is necessary to properly prepare the other return; and (3) the use of suchinformation does not violate any rule of confidentiality,so long as the information is not disclosed tothe other client.Your considering the tax return information should lead you to believe that it isincorrect on its face; therefore, you have a duty to verify it.Accordingly, without revealing the basis for your belief, you should request from each clientdocumentary evidence of its respective claim. Such evidence should consist of a paid invoice, acanceled check, a signed or certified receipt, a bill of lading, or any other document that indicates theessential terms of the contract of sale.

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Solution Manual for Prentice Hall's Federal Taxation 2013 Individuals, 26th Edition - Page 18 preview image

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C:2-1Chapter C:2CorporateFormations and Capital StructureDiscussion QuestionsC:2-1Various.A new business can be conducted as a sole proprietorship, partnership, C corporation,S corporation, LLC, or LLP. Each form has tax and nontax advantages and disadvantages. See pagesC:2-2 through C:2-7 for a listing of the tax advantages and disadvantages of each form. A comparisonof the C corporation, S corporation, and partnership alternative business forms appears in Appendix F.pp. C:2-2 through C:2-8.C:2-2Alice and Bill should consider forming a corporation and making an S corporation election.An S corporation election will permit the losses incurred during the first few years to be passedthrough to Alice and Bill and be used to offset income from other sources.The corporate formaffords them limited liability.As an alternative to incorporating, Alice and Bill might considersetting upa limited liability company that is taxed as a partnership. pp. C:2-6 through C:2-8.C:2-3Yes,several alternative classifications.The only default tax classification for the LLC is apartnership. Because the LLC has two owners, it cannot be taxed as a sole proprietorship.Theentity can elect to be taxed as a C corporation or an S corporation.If the entity makes such anelection, Sec. 351 applies to the deemed corporate formation. The entity would have to make aseparate election to be treated as an S corporation. pp. C:2-8 and C:2-9.C:2-4The default tax classification for White Corporation is a C corporation.However,White canbe treatedas an S corporation if it makes the necessary election.Following an S corporationelection, the entity’s income will be taxed to its owners. The S corporation election is made by filingForm 2553 within the first 2½ months of the corporation’s existence (see Chapter C:11).pp. C:2-6 and C:2-7.C:2-5The only default tax classification for the LLC is a sole proprietorship. Because the LLC hasonly a single owner, it cannot be treatedas a partnership.Thus,the default classification is a“disregarded entity”taxed as a sole proprietorship.The entity can elect to be taxed as a C corporationor an S corporation. If the entity makes such an election, Sec. 351 applies to the deemed corporateformation. pp. C:2-8 and C:2-9.C:2-6Possible argumentsinclude:PRO (Corporate formations should be taxable events):1.A corporate formation is an exchange transaction; therefore, parties to the exchange shouldrecognize gains and losses.2.Making a corporate formation a taxable event increases tax revenues.3.Simplification is achieved by eliminating one of the two options-whether a transaction istaxable or not. This change will make administration of the tax laws easier.

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C:2-24.This change eliminates the need for taxpayers to artificially structure transactions to avoidSec. 351 to recognize gains and/or losses.CON (No change should occur to current law):1.Achangein current lawwould hurt start-up corporations by reducing their capital throughthe income tax paid by transferors on an asset transfer.2.No economic gains or losses are realized. Just a change in the form of ownership (direct vs.indirect) has occurred. Therefore, it is not appropriate to recognize gains and losses at thistime.3.With taxation, corporations will have to raise more capital because transferors of noncashproperty will havelesscapital to invest and because money must be diverted to pay taxes.4.Taxpayers are prevented from recognizing losses under the current system, therebyincreasing revenues to the government.5.With taxation, businesses would bedeterredfrom incorporating because of the taxconsequences, and therefore economic growth in the U.S. would be adversely affected.pp. C:2-9 and C:2-10.C:2-7The following tax consequences, if Sec. 351 applies:Neither the transferor nor the transfereecorporation recognizes gain or loss when property is exchanged for stock.Unless boot property isreceived, the transferor’s realized gain or loss is deferred until he or she sells or exchanges the stockreceived. If boot property is received, the recognized gain is the lesser of (1) the amount of moneyplus the FMV of the nonmoney boot property received or (2) the realized gain.The transferorrecognizes no losses even if boot property is received. The transferor’s basis in the stock receivedreferences his or her basis in the property transferred and is increased by any gain recognized and isreduced by the amount of money plus the FMV of the nonmoney boot property received and theamount of any liabilities assumed by the transferee corporation. The basis of the boot property is itsFMV. The transferee corporation recognizes no gain on the transfer. The transferee corporation’sbasis in the property received is the same basis that the transferor had in the property transferredincreased by any gain recognized by the transferor. pp. C:2-12, C:2-16, and C:2-17.C:2-8The following items are considered tobe property:Money and almost any other kind oftangible or intangible property, including installment obligations, accounts receivable, inventory,equipment, patents, trademarks, trade names, and computer software. Property does not includeservices, an indebtedness of the transferee corporation that is not evidenced by a security, or intereston an indebtedness that accrued on or after the beginning of the transferor’s holding period for thedebt. pp. C:2-12 and C:2-13.C:2-9“Control”is defined as follows:Transferrers as a groupmustown at least 80% of the totalcombined voting power of all classes of stock entitled to vote and at least 80% of the total number ofshares of all other classes of stock. The nonvoting stock ownership is tested on a class-by-classbasis. pp. C:2-13 through C:2-16.C:2-10The IRShas interpreted the phrase as follows:Sec. 351 requires the transferors to control thetransferee corporation immediately after the exchange but does not specify how long this controlmust be maintained. The transferors, however, must not have a prearranged plan to dispose of their

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C:2-3stock outside the control group. If they have such a plan, the IRS may not treat the transferors as incontrol immediately after the exchange. p. C:2-16.C:2-11No.The Sec. 351 requirements are not met because Peter is not considered a transferor ofproperty. Even though he transferred $1,000 of money, this property is of nominal value--less than10% of the value of the stock he received for services ($49,000). Therefore, only John and Mary aredeemed to have transferred property and, since they own only 66-2/3% of the stock of NewCorporation, they are not in control. The 10% minimum is specified in Rev. Proc. 77-37 and appliesonly for advance ruling purposes. The shareholders may choose to engage in the transaction withoutan advance ruling, report it as nontaxable, and run the risk of being audited, with the result that theIRS treats the transaction as taxable. Alternatively, they might restructure the transaction by havingPeter provide a larger amount of cash to the corporation and take more shares of stock. Anotheroption would be for Peter to provide fewer services with the increased amount of cash and stillreceive 100 shares of stock. pp. C:2-14 and C:2-15.C:2-12No.Section 351 does not require that the shareholders receive stock equal in value to theproperty transferred.Section 351 would apply to the transfer by Susan and Fred if all otherrequirements are met. However, Fred probably will be deemed to have made a gift of 25 shares ofstock, paid compensation of $25,000, or repaid a $25,000 debt to Susan by transferring the Spadestock. pp. C:2-15 and C:2-16.C:2-13Yes.Section 351 applies to property transfers to an existing corporation. For the exchange tobe tax-free, the transferors must be in control of the corporation after the exchange. In this example,Carl isnotin control since he owns only 75 out of 125 shares, or 60% of the North stock. Therefore,the Sec. 351 requirements are not met. To qualify under Sec. 351, Carl can transfer enough propertyto acquire a total of 200 shares out of 250 (200 shares held by Carl and 50 shares held by Lynn)outstanding shares. In this situation, Carl would own exactly 80% of North stock (250 shares x 0.80= 200 shares).A less expensive alternative would be for Lynn to transfer property equal to orexceeding $10,000 (50 shares owned x $2,000 per share x 10% minimum) to be considered atransferor. pp. C:2-14 and C:2-15.C:2-14The transferor’sbasis in stock received in a Sec. 351 exchange is determined as follows(Sec. 358(a)):Adjusted basis of property transferred to the corporationPlus:Any gain recognized by the transferorMinus:FMV of boot received from the corporationMoney received from the corporationThe amount of any liabilities assumed by thetransfereecorporationAdjusted basis of stock receivedFor purposes of calculating stock basis, liabilities assumed by the transferee corporation areconsidered money and reduce the shareholder’s basis in any stock received (Sec. 358(d)).

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C:2-4The shareholder’s holding period for the stock includes the holding period of any capitalassets or Sec. 1231 assets transferred.If the shareholder transfers any other property (e.g.,inventory), the holding period for any stock received begins on the day after the exchange date. Thisrule can cause some shares of transferee corporation stock to have two different holding periods.The shareholder’s basis for any boot property is its FMV and the holding period begins on the dayafter the exchange date (Sec. 358(a)(2)). pp. C:2-18 and C:2-19.C:2-15Two sets of circumstances may require recognition of gain when liabilities are transferred.•First,allliabilities assumed by a controlled corporation are considered boot if theprincipal purpose of the transfer of any portion of such liabilities is tax avoidance orif no bona fide business purpose exists for the transfer (Sec. 357(b)).•Second,ifthe total amount of liabilities transferred to a controlled corporationexceeds the total adjusted basis of all property transferred by the transferor, theexcess liability amount is treated as a gain taxable to the transferor without regard towhether the transferor had actually realized gain or loss (Sec. 357(c)).Under the second set of circumstances, the transferor recognizes gain, but the excessliabilities are not considered to be boot. Section 357(c)(3) provides special rules for cash and hybridmethod of accounting transferors who transfer excess liabilities to a corporation. pp. C:2-22 throughC:2-25.C:2-16The IRS likely would considerthefollowingtwofactors: (1) The transferor’sreason forincurring the liability (e.g., did the liability relate to the transferor’s trade or business).(2) The lengthof time from when the liability was incurred to the transfer date.If the transferor incurred theliability in connection with his or her trade or business, a Sec. 357(b)“problem”probably would notexist even if the transferor incurred the liability shortly before the transfer date.pp. C:2-12 throughC:2-27.C:2-17If Mark receives no boot, depreciation is not recaptured (Secs. 1245(b)(3) and 1250(d)(3)).The recapture potential is transferred to Utah Corporationalongwith the property. If Markdoesreceive boot and must recognize gain, the recognized gain is treated as ordinary income but not in anamount exceeding the recapture potential. Any remaining recapture potential is transferred to Utah.If Utah sells the property at a gain, it must recapture depreciation deducted by Mark and notrecaptured at the time of the transfer, as well as depreciation that it has claimed. Depreciation in theyear of transfer must be allocated between the transferor and transferee according to the number ofmonths each party has held the property. The transferee is considered to have held the property forthe entire month in which the property was transferred. pp. C:2-25 through C:2-27.C:2-18The assignment of income doctrine could apply to a transfer of unearned income. However,the assignment of income doctrine does not apply to a transfer of accounts receivable by a cashmethod transferor in a Sec. 351 exchange if (1) the transferor transfers substantially all the assets andliabilities of a business and (2) a business purpose exists for the transfer. (See Rev. Rul. 80-198,1980-2 C.B. 113.) p. C:2-27.

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C:2-5C:2-19In enacting Sec. 385, Congress mandated that the following factors be taken into account indetermining whether an amount advanced to a corporation should be characterized as debt or equitycapital:•Whether there is a written unconditional promise to pay on demand or on a specifieddate a sum certain in money in return for an adequate consideration in money ormoney’s worth, and to pay a fixed rate of interest,•Whether the debt is subordinate to or preferred over other indebtedness of thecorporation,•The ratio of debt to equity of the corporation,•Whether the debt is convertible into the stock of the corporation, and•The relationship between holdings of stock in the corporation and holdings of theinterest in question.Although Congress enacted Sec. 385 in an attempt to provide statutory guidelines for the debt/equityquestion, the lack of a subsequent set of interpretative regulations has required taxpayers, the IRS,and the courts to continue to use these statutory factors and other factors identified by the courts inascertaining whether an instrument is debt or equity. Amendment of Sec. 385 in 1989 to permitpart-debt and part-equity corporate instruments has lead to the issuance of administrativepronouncements (e.g., Notice 94-97, 1947-1 C.B. 357) that interpret the Sec. 385 statutoryguidelines. See alsoO.H. Kruse Grain & Millingv.CIR, 5 AFTR 2d 1544, 60-2 USTC ¶9490 (9thCir., 1960)cited in footnote 47 of the text, which lists additional factors the courts might consider.pp. C:2-27 and C:2-28.C:2-20Advantages of using debt include:Interestis deductible by the payor while adividendpayment is not deductible, and the repayment of an indebtedness generally is treated as a return ofcapital while a stock redemptionoftenis treated as a dividend. Disadvantages of using debt includethat dividend payments are eligible for a dividends-received deduction when received by a corporateshareholder; stock can be received tax-free as part of a corporate formation and/or reorganizationwhile the receipt of debt usually is treated as boot; a distribution of stock to shareholders can be anontaxable stock dividend while a distribution of a debt usually results in dividend income; andworthless stock results in an ordinary loss under Sec. 1244 while a worthless debt instrumentgenerally results in a capital loss. pp. C:2-29 and C:2-30.C:2-21Ordinary loss treatment.The principal advantage of satisfying the Sec. 1244 small businessstock requirements is the ordinary loss treatment available for individual shareholders and certainpartnerships reporting up to $50,000 (or $100,000 if married and filing jointly) of losses incurred ona sale or exchange of the stock. Ordinary loss treatment is available only if the loss is incurred by aqualifying shareholder who acquired the stock from the small business corporation; the corporationwas a small business corporation at the time it issued the stock (i.e., a corporation whose aggregatemoney and other property received for stock is less than $1 million); the corporation issued the stockfor money or property (other than stock or securities); and the issuing corporation derived more than50% of its aggregate gross receipts from active sources during the most recent five tax years endingon the date when the stock was sold or exchanged. pp. C:2-32 and C:2-33.

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C:2-6C:2-22The two advantages of business bad debt treatment are (1) a business bad debt deduction canbe claimed for partial worthlessness and (2) a business bad debt can be deducted as an ordinary loss. Anonbusiness bad debt can be deducted only in the year in which total worthlessness occurs. No partialwrite-offs of nonbusiness bad debts are permitted. A nonbusiness bad debt can be deducted only as ashort-term capital loss.These losses can offset capital gains or be deducted by individuals up to$3,000 in a tax year.No limit exists on business bad debt deductions and, if such losses exceedincome, they can be carried back as part of a net operating loss.To claim a business bad debtdeduction, the holder must show that the dominant motivation for the loan was related to thetaxpayer’s business and was not related to the taxpayer’s investment activities. pp. C:2-33 and C:2-34.C:2-23To recognize gain or loss.Shareholders might avoid Sec. 351 treatment if, in transferringproperty, they realize a gain or loss that they want to recognize. They may be able to avoid Sec. 351treatment by violating one or more of its requirements, for example, by selling the property to thecorporation for cash, by selling the property to a third party who contributes it to the corporation, orby receiving sufficient boot to recognize the gain. pp. C:2-34 through C:2-36.C:2-24The reporting requirements areas follows:Every person who receives stock, securities, orother property in a Sec. 351 exchange must attach a statement to his or her tax return for the period thatincludes the date of the exchange. The statement must include all the facts pertinent to the exchange(see Reg. Sec. 1.351-3(a)). Similarly, the transferee corporation must attach a statement to its taxreturn for the year in which the exchange took place (see Reg. Sec. 1.351-3(b)). The transferee’sstatement requires a description of the property and liabilities received from the transferors and thestock and property transferred to the transferors in exchange for the property. p. C:2-36.Issue IdentificationQuestionsC:2-25Mary and Peter should consider the following tax issues:•Does the property transfer meet the Sec. 351 requirements?•Have Peter and Mary transferred property? Does Peter’s controlling TrentonCorporation prior to the transfer change the tax result?•Are the transferors in control of the corporation following the transfer?•Do the transferors receive transferee corporation stock?•What is each shareholder’s recognized gain?•What is each shareholder’s basis in his or her stock?•What is each shareholder’s holding period for his or her stock?•Does Trenton recognize gain when it issues its stock?•What is Trenton’s basis in the property received from Mary?•What is Trenton’s holding period for the property received from Mary?The property transfer meets all the Sec. 351 requirements. Peter and Mary are considered toown all 195 of the Trenton shares immediately after the exchange. Peter’s contribution of cash forstock is not considered to be a nominal amount according to IRS rules relating to the issuance ofprivate letter rulings (i.e., it equals or exceeds 10% of the value of Peter’s prior stock holdings).Thus, his stock is counted towards the 80% minimum stock ownership for control. Mary recognizesno gain on the asset transfer and takes a $50,000 basis in the Trenton shares she receives. The

Solution Manual for Prentice Hall's Federal Taxation 2013 Individuals, 26th Edition - Page 24 preview image

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C:2-7holding period for the Trenton shares includes her holding period for the property transferred.Trenton recognizes no gain when it issues its stock and takes a $50,000 basis in the property.pp. C:2-12 through C:2-30.C:2-26Carl and his son should consider the following tax issues:•Does the property transfer meet the Sec. 351 requirements?•Have Carl and his son transferred property?•Are the transferors in control of the corporation immediately after thetransfer?•Do the transferors receive transferee corporation stock?•Does the property contribution/receipt of stock as described in the facts reflect thetrue nature of the transaction? Or, has a deemed gift or other event occurred?•What is each shareholder’s recognized gain?•What is each shareholder’s basis in his stock?•What is each shareholder’s holding period in his stock?•If a deemed gift has been made, is it a taxable gift from Carl to his son?(Thisquestion could be rewritten for events other than a gift (e.g., repayment of a loan.))•What is Cook Corporation’s basis in the property received from Carl?•What is Cook’s holding period for the property received from Carl?The contribution is nontaxable because it meets all the Sec. 351 requirements, and Carl andCarl, Jr. own all the Cook stock. Carl, Jr. receives a disproportionate amount of stock relative to his$20,000 capital contribution. It appears that the transaction should be recast so that Carl is deemedto receive 80 shares of stock, each valued at $1,000. He then gifts 30 shares to Carl, Jr. The deemedgift leaves each shareholder with 50 shares of stock. Neither shareholder recognizes any gain, andCarl takes a $50,000 adjusted basis in the 80 shares he receives. He recognizes no gain on thetransfer of 30 shares to Carl, Jr., and $18,750 [(30/80) x $50,000] of his basis accompanies thedeemed gifted shares. Carl’s basis in his remaining 50 shares is $31,250 ($50,000-$18,750). Carl,Jr’sbasis in his 50 shares is $38,750 ($20,000 + $18,750). pp. C:2-9 through C:2-27.C:2-27Bill should consider the following tax issues:•Was the stock sold to a related party (Sam), as defined by Sec. 267(b)? If so, Bill cannotrecognize the loss, and the remaining issues need not be examined. If not, then...•Is the stock a capital asset?•Is Bold a qualifying small business corporation?•If so, does the stock qualify for Sec. 1244 stock treatment?•If Sec. 1244 stock, what is Bill’s marital and filing status?•Has Bill’s basis in the stock changed relative to its initial acquisition cost?•What is the amount and character of Bill’s recognized loss?Bill’s stock sale results in the realization of a $65,000 ($100,000-$35,000) long-term capitalloss.If the purchaser is a related party, Sec. 267(a) precludes Bill from recognizing the loss.Because Bill is the original holder of the stock, the loss may be characterized as ordinary under Sec.1244, assuming the various requirements of that provision are satisfied. pp. C:2-32 and C:2-33.

Solution Manual for Prentice Hall's Federal Taxation 2013 Individuals, 26th Edition - Page 25 preview image

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C:2-8ProblemsC:2-28With the given facts, the C corporation option with the salary payment results in the lowesttotal tax, as determined in the following analysis:SoleProprietorshipC CorporationWith SalaryC CorporationWith DividendS CorporationWith SalaryS CorporationWith DistributionEntity Level:Income before salary$50,000$50,000$50,000$50,000$50,000Salary deduction-0-(20,000)-0-(20,000)-0-Taxable income$50,000$30,000$50,000$30,000$50,000Entity level tax$-0-$ 4,500$7,500$-0-$-0-Lucia:Pass-through income$50,000$-0-$-0-$30,000$50,000Salary income-0-20,000-0-20,000-0-Dividend income-0--0-20,000-0--0-Total income to Lucia$50,000$20,000$20,000$50,000$50,000Lucia’s tax$12,500a$5,000b$3,000c$12,500d$12,500eTotal Tax$12.500$ 9,500$10,500$12.500$12.500a$50,000 x 0.25 = $12,500b$20,000 x 0.25 = $5,000c$20,000 x 0.15 = $3,000d$50,000 x 0.25 = $12,500e$50,000 x 0.25 = $12,500Because corporate taxable income is low enough to be taxed at 15% and dividends are taxed at 15%,the C corporation options are better than the sole proprietor and S corporation options because, underthe latter options, all income is taxed at Lucia’s 25% ordinary tax rate. Within the C corporationoptions, the salary situation is better than the dividend situation because less income is subject todouble taxation as a result of the salary deduction. These results apply only to the given factualcircumstances. For example, if the corporation’s income were taxed at higher marginal tax rates,such as 35% or 39%, the C corporation options would be less attractive than the sole proprietor andS corporation options. pp. C:2-2 through C:2-8.

Solution Manual for Prentice Hall's Federal Taxation 2013 Individuals, 26th Edition - Page 26 preview image

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C:2-9C:2-29a.None.Dick does not recognize his $10,000 realized loss.b.$60,000basisinTriton shares received.Dick’sholding period begins in 2011.c.None.Evan does not recognize his $15,000 realized loss.d.$45,000basisinTriton shares received.Evan’sholding period begins in 2010.e.Fran recognizes$20,000 of ordinary income.f.$20,000basisinTriton shares received.Fran’sholding period begins the day after theexchange date in 2013.g.Triton takes a $50,000basisin the land anda$30,000basisin the machinery.Because of the loss property limitation rule, the bases of these assets are reduced to their respectiveFMVs, assuming the parties do not elect to reduce stock basis. Thus, both assets have a holdingperiod that begins the day after the transfer in 2013.The services, if capitalized, would have a$20,000 basis and a holding period starting in 2013. pp. C:2-9 through C:2-22.C:2-30a.$20,000 gain.The Sec. 351 requirements have not been met because 30% of the stockis issued for services. Therefore, Ed recognizes$20,000 ($35,000-$15,000) of capital gain.b.$35,000basis in Jet shares received. Ed’sholding period begins on the day after theexchange date.c.Fran recognizes a $10,000 ($35,000-$45,000) Sec. 1231 loss.d.$35,000basis in Jet shares received. Fran’sholding period begins on the day after theexchange date.e.George recognizes$30,000 ofordinaryincome.f.$30,000basis in Jet shares received.George’sholding period begins the day after theexchange date.g.Jet Corporationtakesa $35,000 basis in the land and a $35,000 basis in themachinery. Its holding period for each asset begins the day after the exchange date. The services, ifcapitalized, would have a $30,000 basis.h.Because the Sec. 351 requirementswouldnow have been met, the answers change asfollows:a.Ed recognizes no gain or loss.b.$15,000basis in the Jet sharesreceived.Ed’sholding period begins in 2009.c.Fran recognizes no loss.d.$45,000basis in the Jet sharesreceived.Fran’sholding period begins in 2009.e.George recognizes $25,000 of ordinary income.f.$30,000 ($5,000 cash + $25,000 FMV of services)basis in the Jet sharesreceived.George’sholding period begins the day after the exchange date.g.Jet’s basis in the land and machinery are $15,000 and $35,000, respectively.The loss property limitation rule limits the corporation’s basis in themachinery to its FMV. Jet’s holding period for the land begins in 2009. Theholding period for the machinery begins the day after the exchange datebecause, by having its basis reduced to FMV, it no longer has a basis thatreferences the transferor’s basis before the exchange. The services, ifcapitalized, would have a $25,000 basis.pp. C:2-12 through C:2-22.C:2-31a.The control requirement is not met. Transferors of property receive only 75% andthus do not have 80% control.

Solution Manual for Prentice Hall's Federal Taxation 2013 Individuals, 26th Edition - Page 27 preview image

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C:2-10b.The control requirement is met. Robert transferred more than a nominal amount ofproperty. The 80% control requirement has been met since all of Robert’s stock is counted for thispurpose.c.The control requirement is not met.Sam owns only 33-1/3% of the Vast stockimmediately after the exchange. No stock ownership is attributed from Sam’s parents to Sam.d.The control requirement is met. Charles and Ruth own 100% of the Tiny stock. Thetransfers do not have to be simultaneous.e.The control requirement is not met.Charles had a prearranged plan to sell asufficient amount of shares to fail the control test. Only if Sam were considered to be a transferor(i.e., the sale took place as part of a public offering) would the transaction meet the requirements ofSec. 351. pp. C:2-13 through C:2-16.C:2-32a.The control requirement is met. The property transferred by Fred is not considered tobe nominal relative to the value of stock received for services.Therefore, Fred and Greta areconsidered to own 100% of the New stock.b.The control requirement is not met. For advance ruling purposes, Maureen’s sharesare not counted towards determining whether the control requirement has been met because theproperty she contributed was nominal (i.e., does not meet the 10% property minimum of Rev. Proc.77-37) compared to the value of the stock received for services. The taxpayer may choose to enterinto the transaction without an advance ruling, report it as nontaxable, and run the risk of beingaudited, with the result that the IRS treats the transaction as taxable. Alternatively, Maureen cancontribute additional property so that the amount of property equals or exceeds the 10% minimum.The minimum property contribution is $4,545 [$4,545 = 0.1 x ($50,000-$4,545)].pp. C:2-13through C:2-16.C:2-33Veronica needs to receive 1,000 additional shares in exchange for $25,000 worth of silverbullion. The 200 shares currently held by Veronica equal 40% of the 500 shares outstanding. Toavoid recognizing a gain, Veronica must be“in control”of Poly-Electron immediately after theexchange. Control implies ownership of at least 80% of the total number of Poly-Electron sharesoutstanding.The number of additional shares that Veronica must acquire to achieve control can becalculated as follows, where A = additional shares needed:(200 + A) / (500 + A) = 0.80200 + A = 0.80 x (500 + A)200 + A = 400 + 0 .80 A0.20 A = 200A = 1,000 additional sharesThus, with the additional 1,000 shares, Veronica will have 80% control after the exchange(i.e., 1,200 / 1,500 = 80%.) If each share is worth $25, the value of silver bullion that Veronica mustcontribute is $25,000 (1,000 shares x $25).Having achieved control, Veronica’s exchange willqualify for nontaxable treatment under Sec. 351. pp. C:2-13 through C:2-15.C:2-34a.No. The exchange does not qualify as nontaxable under Sec. 351 because Al and Bobdo not control West Corporation. (Al owns only 1,000/1,300 = 76.9% of the voting common stock

Solution Manual for Prentice Hall's Federal Taxation 2013 Individuals, 26th Edition - Page 28 preview image

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C:2-11while Bob owns 100% of the nonvoting preferred stock).Al recognizes $25,000 of gain on thetransfer of the patent.His basis in his West stock is $25,000.Bob recognizes no gain or lossbecause he contributed cash. His basis in the preferred stock is $25,000. Carl recognizes $7,500 ofordinary income. His basis in his West stock is $7,500. West recognizes no gain or loss on theexchange. Its basis for the assets is: cash, $25,000; patent, $25,000; and services, $7,500.b.Nontaxable.The exchange now qualifies as nontaxable under Sec. 351 because Aland Bob together own 1,200/1,500 = 80% of the voting common stock and 100% of the nonvotingpreferred stock.Al recognizes no gain or loss, and his basis in his West stock is zero.Bobrecognizes no gain or loss, and his basis in his West stock is $25,000. Carl recognizes $7,500 ofordinary income, and his basis in his West stock is $7,500. The consequences to West are the sameas in Part a, except the basis for the patent is zero instead of $25,000.c.Nontaxable.The exchange apparently would qualify under Sec. 351. Assuming the$800 of cash contributed is acceptable under Rev. Proc. 77-37 because it meets the 10% propertyminimum for advance ruling purposes, Al and Bob would recognize no gain or loss. Carl wouldrecognize $6,700 of ordinary income. The consequences to West are the same as in Part b except thecash contributed by Carl takes an $800 basis and the services generate $6,700 of taxable income.pp. C:2-13 through C:2-16.C:2-35CashEquipmentBuildingLandTotalFMV of assets$ 5,000$90,000$40,000$30,000$165,000Fraction of total value0.0303030.5454550.2424240.1818181.0000FMV of stock received$ 3,788$68,182$30,303$22,727$125,000Plus: Boot property1,21221,8189,6977,27340,000Total proceeds$ 5,000$90,000$40,000$30,000$165,000Minus: Adj. basis ofassets(5,000)(60,000)(51,000)(24,000)(140,000)Gain (loss) realized$-0-$30,000($11,000)$ 6,000$ 25,000Allocation of boot$ 1,212$21,818$ 9,697$ 7,273$ 40,000Gain recognized$-0-$21,818$-0-$ 6,000$ 27,818a.$27,818gain recognized:Gain on equipment, ordinary income(recapture on Sec. 1245 property)$21,818Gain on land, Sec. 1231 gain6,000Total gain recognized$27,818

Solution Manual for Prentice Hall's Federal Taxation 2013 Individuals, 26th Edition - Page 29 preview image

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C:2-12b.$40,000basis in stock:Adj. basis of property transferred$140,000Minus: FMV of boot received(40,000)Plus: Gain recognized by transferor27,818Basis in stock$127,818Basis in interest-bearing notes ($10,000 each):$40,000c.$165,000 total basis in the property received:Tom’s BasisRecog. GainReduction*TotalCash$5,000$-0-$-0-$5,000Equipment60,00021,818-0-81,818Building51,000-0-(2,818)48,182Land24,0006,000-0-30,000Total$140,000$27,818$(2,818)$165,000pp. C:2-16 through C:2-22.*Total adjusted basis = $167,818 ($140,000 + $27,818); total FMV = $165,000. Thus, thereduction under Sec. 362(e)(2) = $2,818 ($167,818-$165,000).Per Prop. Reg. Sec. 1.362-4(b)(4)(ii), adjusted basis includes the increase for gain recognized by the shareholder.C:2-36$15,000.Ann must recognize $15,000 ($25,000-$10,000) of gain on the exchange.Tocomply with the advance ruling requirements of Rev. Proc. 77-37, Fred must receive more than anominal amount of stock in exchange for his property. If Fred obtained additional stock worth atleast 10% of the value of the stock he already owned (i.e., at least five shares of stock in exchangefor $5,000), his stock likely would be counted for control purposes, and the Sec. 351 requirementswould be met.Ann may choose to enter into the transaction without increasing her propertycontribution so as to acquire at least 80% of Zero’s stock or without having Fred increase hiscontribution to at least $5,000, proceed without an advance ruling, and report the transaction asbeing nontaxable.Ann and Fred then run the risk of being audited and the IRS’s arguing thetransaction is taxable. pp. C:2-14 and C:2-15.C:2-37$4,000.Lucy recognizes $4,000 ($12,000-$8,000)gain on the exchangebecause she ownsless than 80% of the stock after the exchange [(50+10)/110=54.5%]. To qualify under Sec. 351:(1) Lucy could contribute additional property for enough additional stock to obtain 80% control. Tomeet the 80% control requirement, she would have to purchase an additional 150 shares to own 200shares (of the 250 shares outstanding).(2) Marvin could exchange enough property as part of the same transaction to qualify as a transferorunder Sec. 351.For advance ruling purposes under Rev. Proc. 77-37, Marvin would have tocontribute at least $6,000 for an additional five shares of stock to be considered a transferor ofproperty.The taxpayers may choose to engage in the transaction without Lucy’s and Marvin’sincreasing their property contributions, proceed without an advance ruling, and report it as beingnontaxable. However, they would run the risk of being audited and the IRS’s arguing the transactionis taxable. pp. C:2-14 and C:2-15.

Solution Manual for Prentice Hall's Federal Taxation 2013 Individuals, 26th Edition - Page 30 preview image

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C:2-13C:2-38a.None.Neither Jerry nor Frank recognizes any gain or loss on the exchange becausethe Sec. 351 requirements have been met.b.$44,000.Because the exchange is disproportionate, Frank probably could be deemedto have made a gift of 25 shares of Texas stock to Jerry. Jerry’s basis in his 75 shares is $44,000($28,000 basis in property transferred by Jerry + $16,000 basis in the 25 shares received fromFrank). This calculation presumes that no gift taxes are paid on the transfer. If gift taxes are paid, asecond basis adjustment may be needed for the portion of the gift tax attributable to the appreciation.c.$16,000.Frank’s basis in his 25 Texas shares is $16,000 [$32,000 basis in propertytransferred x (25/50)]. pp. C:2-15 and C:2-16.C:2-39a.$20,000 capital gain:Amount realized$170,000Minus: Basis in land(30,000)Realized gain$140,000Boot received (note)$20,000Gain recognized (capital in character)$20,000b.$30,000.Basis of common stock and preferred stock: $30,000 + $20,000-$20,000 =$30,000. This basis must be allocated to the common and preferred stock based on their relative fairmarket values.Basis of common stock: $100,000$150,000x $30,000 = $20,000Basis of preferred stock: $50,000$150,000x $30,000 = $10,000Basis of short-term note: $20,000 (FMV).c.Basis of land to Temple Corporation: $50,000= $30,000 +$20,000pp. C:2-16 through C:2-22.C:2-40a.None for Karen and Larry; $7,000 capital gain toJoe.Karen and Larry recognize nogain or loss under Sec. 351 because they receive only stock. Joe recognizes a $7,000 ($15,000-$8,000) capital gain because he receives onlynotes and therefore does not qualify for Sec. 351treatment.b.Joe’s basis in thenotesis $15,000. Karen’s basis in the stock is $18,000. Larry’sbasis in the stock is $25,000.c.Gray Corporation’s basis in the land is $15,000. Gray’s basis in the equipment is$18,000. The $10,000 of depreciation recapture potential is inherited by Gray because Karen doesnot recognize a gain on the asset transfer. pp. C:2-16 through C:2-19.C:2-41a.$4,000 gain.Nora realizes a $7,000 gain [($18,000 + $4,000)-$15,000] and mustrecognize a gain of $4,000, the amount of the boot (note) received. Of the $4,000 gain, $3,000 isordinary income recaptured under Sec. 1245. The remaining $1,000 is a Sec. 1231 gain.b.$4,000 and $15,000.Nora’s basis in the note is $4,000, its FMV. Nora’s basis in thestock is $15,000 ($15,000 + $4,000 gain-$4,000 FMV of note).

Solution Manual for Prentice Hall's Federal Taxation 2013 Individuals, 26th Edition - Page 31 preview image

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C:2-14c.$19,000.Needle Corporation’s basis in the machinery is $19,000 ($15,000 + $4,000gain recognized). pp. C:2-16 through C:2-22 and C:2-25 through C:2-27.C:2-42a.$3,000 of ordinary income:Jim realizes a $3,500 [($5,000 + $1,000 + $2,000)-$4,500] gain and recognizes a $3,000 gain. Because the $2,000 education loan assumed by GoldCorporation has no apparent business purpose, all liabilities transferred to Gold are treated as bootunder Sec. 357(b). All of Jim’s gain is ordinary income recaptured under Sec. 1245.b.$4,500.Jim’s basis in his stock is $4,500 ($4,500 + $3,000-$3,000).c.Jim’s holding period for the additional shares includes his holding period for theautomobile.d.$7,500.Gold’s basis in the automobile is $7,500 ($4,500 + $3,000). pp. C:2-22 andC:2-23.C:2-43a.$3,000 of ordinary income, determined as follows:Stock (FMV) received$17,000Release from liability28,000Amount realized$45,000Minus: Basis of property transferredMachinery$15,000Money10,000(25,000)Realized gain$20,000Liability assumed$28,000Minus: Basis of all property transferred(25,000)Recognized gain (Sec. 357(c))$3,000The gain is treated as ordinary income under Sec. 1245 recapture rules.b.Zero basis:Property transferred$25,000Minus: Boot received (including liability)( 28,000)Plus: Gain recognized3,000Basis in Moore stock$-0-c.$18,000 basis:Barbara’s basis in the machine$15,000Plus: Barbara’s recognized gain3,000Moore corporation’s total basis in machinery$18,000d.Sam recognizes no gain or loss.e.$17,000basis, the amount of money he contributed to Moore for the stock.f.Barbara’s holding period for her stock includes her holding period for the machinery.Sam’s holding period starts on the day after the exchange date.g.Sec. 351 would not apply, so the answers would change as follows:a.$20,000 ordinary income.Barbara would recognize $20,000 of ordinaryincome recaptured under Sec. 1245.b.$17,000 basis.Barbara’s basis in the stock would be $17,000, its FMV.c.$35,000 basis.Moore’s basis in the machinery would be $35,000, its FMV.d.$17,000 ordinary income.Sam would recognize $17,000 of ordinary incomefrom compensation.

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