1 82 Solutions Manual for Taxation for Decision Makers Solutions to Chapter 5 Problem Assignments Check Your Understanding 1. Trade or Business What are the characteristics of a qualified trade or business? Solution: To be a qualified trade or business, an activity must have a profit motive (to make money) and the taxpayer must spend a sufficient amount of time in the business so that it is not considered simply an investment activity or a hobby. The motivation for the activity cannot be primarily personal pleasure, it must be profit. 2. Investment Expenses What is an investment activity and how are its expenses deducted? Solution: An investment activity is one in which the owner intends to make a profit but does not spend sufficient time to elevate it to a trade or business. Typically, the income from an investment activity comes from owning income-producing assets or from long-term appreciation in assets. Investment expenses are deductible but the deduction may be limited. Individuals are only permitted to deduct their investment expenses as miscellaneous itemized deductions subject to the 2 percent of AGI limitation. 3. Timing of Expense Deduction Marvin, an attorney, is a cash-basis, calendar-year taxpayer. Marvin's two daughters each own 50 percent of the stock of Marvil Corporation, a calendar-year, accrual-basis corporation. During year 1, Marvin completes some legal work for Marvil Corporation on December 18 and earns a $20,000 fee. In which year should Marvil Corporation deduct the legal expense if: a. payment is made to Marvin on December 30, year 1? b. payment is made to Marvin on January 6, year 2? Solution: a. Because Marvin s daughters own Marvil Corporation, it is a related entity. Marvil can only deduct the legal expense in the year Marvin recognizes the income. These events both happen in year 1; thus, Marvil can deduct the expense in year 1. b. Marvil cannot deduct the payment for the legal expense until year 2, the year Marvin recognizes the income. 4. Substantiation What records can the IRS require from a taxpayer to substantiate a tax deduction? Solution: Substantiation may be provided in the form of receipts, canceled checks, and paid bills. If the expense is for travel, entertainment, gifts or automobile expenses, the substantiation could include diaries, trip sheets, travel logs, paid bills, receipts, account books, and expense reports. These should document the amount of the expense, the time and place of the expense, the business purpose for the expense, the date and description of a gift and the business relationship to the person receiving a gift.
2 Chapter 5: Business Expenses Timing of Expense Deduction Aloha Airlines is required by law to have its aircraft engines tested and recertified after 5,000 flight hours. Molokai Maintenance performs the engine tests and recertification for $2,200 per aircraft. For financial accounting purposes, Aloha establishes a reserve account and accrues a maintenance expense of 44 cents per flight hour. When the maintenance is done, the amount paid for the maintenance is deducted from the reserve account. For tax purposes, when can the maintenance expense be deducted? Solution: Businesses are not permitted to use reserves for expenses for tax purposes. Aloha can only deduct the repair expenses in the year the repairs are performed, if it is an accrual-basis taxpayer, or when they are paid, if it is a cash-basis taxpayer. 6. Business Investigation Expenses Diane owns and manages a successful clothing store in Dallas. Just prior to the graduation of her brother, Cameron, they investigated the possibility of opening another store in Atlanta for Cameron to manage. Diane and Cameron each paid $1,600 in travel costs while looking for sites for the store. Each paid $300 in legal fees for a lawyer to compile a list of zoning regulations and other relevant city ordinances. They decide that it is not feasible to open a new store at the present time. Can Diane and Cameron deduct their business investigation expenses? Explain. Solution: Diane can deduct the $1,900 ($1,600 + $300) in the current year as business investigation expenses. Diane can deduct this amount because she is already in the clothing business and expenses for potential expansion are ordinary business expenses whether or not a new store is opened. Her brother, however, is not permitted any deduction for the $1,900 that he expended. Cameron could only capitalize and amortize the expenses if the new store was opened. 7. Organization Costs vs. Business Expenses In its first year of operations, Bell Corporation paid its attorney $4,000 and its accountant $2,000 for services related to the organization of the corporation. In its second year of operations, Bell paid the attorney $700 to handle contract negotiations with a new customer. Which expenses are immediately deductible and which ones must Bell Corporation amortize? Solution: The $6,000 of expenses paid in the first tax year related to the organization of the corporation are capitalized and amortized over 60 or more months starting with the month it begins business. The $700 legal fees will be immediately deductible as a business expense. 8. Business Gifts Randy gave one of his best customers a $150 bottle of wine. How much can he deduct for this business gift? Solution: The deduction for business gifts is limited annually to $25 per donee. 9. Domestic vs. Foreign Travel Explain the differences between the rules governing travel within the United States and those governing travel outside the United States.
3 84 Solutions Manual for Taxation for Decision Makers Solution: Domestic travel Actual transportation expenses (plane, train, etc.) as part of travel are fully deductible if the trip is primarily business (more business than nonbusiness days). If the trip is primarily personal, no transportation expenses are deductible. Meals and lodging are deductible only for business days. Foreign travel If the travel is purely for business, all transportation costs are deductible. If the travel combines business with some personal days, the transportations costs must be allocated between business and personal time unless the travel time does not exceed one week or less than 25 percent of the time is spent on personal pursuits. In these latter cases, all transportation expenses are deductible. If the travel is primarily personal (personal days exceed business days), no transportation expenses may be deducted. Costs of meals and lodging must be allocated between business and personal days with a deduction only allowed for business days. 10. UNICAP Rules What are the UNICAP rules, and which businesses do they affect? Solution: The uniform capitalization rules require a business to capitalize as part of inventory all the direct costs of manufacturing, purchasing, and storing inventory along with an extensive list of items that are part of overhead, such as factory administration, taxes, pension costs, and service support functions. Businesses whose average annual gross receipts in the three preceding years exceed $10 million are subject to the UNICAP rules for determining the costs of inventory. 11. UNICAP Rules Which of the following costs must be included in inventory by a manufacturer under the UNICAP rules? a. Factory insurance b. Advertising c. Payroll taxes for factory employees d. Research and experimentation costs e. Repairs to factory equipment Solution: a. Factory insurance - Included b. Advertising Not included c. Payroll taxes for factory employees - Included d. Research and experimentation costs Not included e. Repairs to factory equipment Included 12. LIFO Inventory Explain the advantages and disadvantages of a publicly held company using LIFO for inventory valuation. Solution: In an economy with rising prices, the LIFO inventory method for tax purposes matches the latest and highest costs for goods sold with the selling price of the goods. This reduces the business taxable income and its taxes payable. The disadvantage is that LIFO must then be used for financial reporting. Thus, financial accounting income reported will also be lower. The business can, however, report an alternative inventory valuation in supplementary material to the financial statements.
4 Chapter 5: Business Expenses Vacation Rental How are deductions for expenses of rental property limited if the taxpayer also uses the property as a vacation home? Solution: If a vacation home is used by the owner and rented out, the limit on deductions depends upon the relative use by each. If the home is rented for less than 15 days, only those normal expenses of a second home such as mortgage interest and taxes, are deductible. If the home is rented for more than 14 days and is used no more than the greater of 14 days or 10 percent of the rental days by the owner, the home is treated as rental property and all rental expenses are deductible against the rental income. Mortgage interest for the personal-use days is not deductible because it does not qualify as a home due to the limited personal use. Real estate taxes, however, are still deductible as itemized deductions. For rental of more that 14 days, with owner-use more than the greater of 14 days or 10 percent of rental days, the deduction for rental expenses is limited to the rental income, similar to expenses of a hobby. Both mortgage interest and taxes for the personal-use portion are deductible as itemized deductions. 14. Home Office Deduction What are the requirements for a self-employed person to claim a deduction for an office in the home? What are the additional requirements for an employee to take a home office deduction? Solution: For a self-employed person to claim a deduction for a home office, the space must be used exclusively and on a regular basis for the business, it must be the principal place of business for the taxpayer, a place where clients or customers are met regularly in the normal course of business, or it must be located in a structure separate from the home. In addition to the above requirements, an employee s home office must be for the convenience of the employer (for example, relieving the employer from providing the employee with an office). 15. Hobby vs. Business What factors differentiate a hobby from an active business? Solution: Factors that differentiate a hobby from a business include: The manner in which the taxpayer carries on the activity; The expertise of the taxpayer and/of the taxpayer s consultants; The time and effort spent by the taxpayer in the activity; The taxpayer s history of profits or losses for this activity; The success of the taxpayer in similar activities; The overall financial status of the taxpayer; and The elements of pleasure or recreation that are part of the activity. 16. Tax vs. Financial Accounting Differentiate permanent differences and temporary differences? Provide examples of each.
5 86 Solutions Manual for Taxation for Decision Makers Solution: A permanent difference between tax and financial accounting is one that results from a treatment that does not reverse over time (the difference remains imbedded in their respective net incomes permanently). A temporary or timing difference is one that does reverse in a later period. (Over two or more periods, the income or deductions for financial accounting will equal the income or deductions for tax accounting.) Examples of timing differences include differences in depreciation schedules, bad debt deductions vs. allowances for bad debt, and prepaid expenses. Examples of permanent differences include tax-exempt interest on municipal bonds, life insurance proceeds, and nondeductible fines. Crunch the Numbers 17. Expenses Related to Tax-Exempt Income Mary, a taxpayer in the 35 percent marginal tax bracket, borrows $500,000 at 10 percent interest to invest in 7 percent tax-exempt municipal bonds. The annual interest expense on the loan is $50,000. Mary earns $35,000 interest income on the bonds. What is Mary s interest expense deduction? Solution: Mary is allowed no interest deduction because the loan proceeds were used to invest in tax-exempt securities. 18. Prepaid Rent On October 1, Bender Company (a calendar-year, cash-basis taxpayer) signs a lease with Realco Corporation to rent office space for 36 months. Bender obtains favorable monthly payments of $600 by agreeing to prepay the rent for the entire 36-month period. a. If Bender Company pays the entire $21,600 on October 1, how much can it deduct in the current year? b. Assume the same facts above except that the lease requires Bender Company to make three annual payments of $7,200 each on October 1 of each year for the next 12 months rent. On October 1 of the current year, Bender Company pays $7,200 for the first 12- month rental period. How much can Bender Company deduct in the current year? Solution: a. Bender can only deduct $1,800 (3 x $600) rent for the three months remaining in the current year, because the rent payment is for a period extending beyond the end of the succeeding year. b. Bender can deduct the $7,200 in each year that it is paid. The contract calls for the advance payments and each payment does not extend beyond the end of the year following the year it is paid. 19. Prepaid Expenses On December 15, Simon Corporation (a cash-basis calendar-year corporation) paid $5,000 for five months of supplies and $9,000 for an insurance policy covering its office building for the next three calendar years. How much can Simon deduct this year for these expenses? Solution: Simon can only deduct the $5,000 paid for supplies. The insurance payment must be capitalized and written off one-third in each of the years it covers as if Simon was an accrual-basis taxpayer.
6 Chapter 5: Business Expenses Interest Deduction Foster Corporation, a cash-basis taxpayer, borrowed $100,000 on January 1, year 1, and received $98,000 in proceeds. The loan matures in 10 year and the $100,000 principal is due on that date. Interest of $10,000 is payable on January 1 of each year beginning January 1, year 2. How much of the interest in deductible in year 1 and in year 2? Solution: $200 for year 1 and $10,200 for year 2. Foster must amortize the loan discount ($100,000 - $98,000 = $2,000 discount) over the 10-year life of the loan at a rate of $200 per year. Foster can only deduct the $200 amortized discount in year 1; it can deduct $10,200 in year 2, consisting of the $10,000 interest paid on January 1 and the $200 amortization. 21. Interest Deduction When Kelley couldn t make several monthly payments on a business loan, her brother Mike made three of the monthly payments of $700 each, a total of $2,100 ($1,950 for interest expense and $150 for principal) for Kelley s loan. Kelley makes the other nine monthly payments herself ($5,850 for interest expense and $450 for principal). a. What is Mike s deduction for interest expense? b. What is Kelley s deduction for interest expense? c. What could they have done to preserve the tax deductions? Explain. Solution: a. Mike cannot deduct anything because it is not his loan. b. Kelly can only deduct the $5,850 interest expense for the nine monthly payments that she made. c. Mike should have given (or loaned) the money to Kelly and let Kelly make the loan payments. That way, Kelly could take a deduction for the $7,800 interest paid that year. 22. Business Meals and Club Dues Elisa spends $1,000 on business lunches to entertain her customers at the local country club. The club charges an annual membership fee of $800. Elisa uses the facility 80 percent of the time for business. Her employer does not reimburse her for any of these expenses. What is her deductible expense? Solution: Elisa can deduct $500 (50% x $1,000) of the business lunches only. She has no deduction for any portion of the club dues. 23. Entertainment Expenses Jim, a self-employed individual, takes an important customer to the hockey playoffs. Although the face value of a ticket is only $70, he pays a scalper $400 for each ticket. Assuming all other requirements are met, how much can Jim deduct for the two tickets? Solution: $70. Entertainment tickets are not only subject to the 50% limit, but the 50% limit applies to the face value of the tickets. Thus, Jim is allowed a deduction for only one-half of the face value of the tickets or $70 (50% x $140). 24. Travel Expenses Martha lives with her husband in Los Angeles but works in San Diego. During the week she stays in a hotel in San Diego and eats in nearby restaurants. On weekends she flies home to Los Angeles. During the year, Martha spent $5,000 for the hotel, and $2,000 for meals while
7 88 Solutions Manual for Taxation for Decision Makers in San Diego. Her airfare for travel between San Diego and Los Angeles was $2,500. What is Martha s deduction for travel expenses? Solution: Martha cannot deduct any travel expenses. Her tax home is in San Diego. Her travel to Los Angeles is purely personal and her expenses are nondeductible. 25. Travel Expenses Mark flew from Baltimore to Phoenix on business. He spent four days on business and visited friends for two days before returning home. He stayed at a hotel for the four business days but he stayed at his friend s home the last two days. He paid the following expenses: Airfare $420 Hotel 500 Meals for 4 business days 200 Meals for 2 days visiting friends 80 Gift for customer in Phoenix 80 Gift for friends 30 Rental car for 6 days at $20 per day 120 How much qualifies as deductible travel expenses? Solution: $1,100 deductible travel. The airfare of $420, $500 for the hotel, $100 (50% x $200) for meals for the 4 business days, and $80 ($20 x 4) for the cost of 4 days for the rental car = $1,100 deductible travel expenses. He may also deduct $25 of the cost of the gift for the customer in Phoenix, but that is not a travel expense. 26. Temporary Assignments Tim accepts a temporary assignment that is 500 miles away from his office. The assignment is expected to last 7 months. Tim spends $7,000 for lodging and transportation and $3,000 for meals during these 7 months. At the end of the 7 months, Tim is notified that the assignment is extended for another 10 months. Tim incurs $13,000 in travel expenses ($4,000 of which is for meals) during months 8 through 17. What qualifies as deductible travel expenses? Solution: $8,500. The $7,000 for lodging and transportation and $1,500 ($3,000 x 50%) for meals during the first seven months are deductible as travel expenses. At that point, the assignment was no longer temporary because of the 10-month extension; the expenses from that point on no longer qualify as travel expenses. 27. Temporary Assignments Dan s employer assigned him to the New York office for 18 months. During this 18-month assignment, Dan spent $18,000 for apartment rent and $8,500 for meals. During this time, Dan s family remained in St. Louis. At the end of the 18-month assignment, Dan returns to St. Louis. Dan s employer paid for his airfare from St. Louis to New York and back to St. Louis, but did not reimburse him for his other temporary living expenses. What expenses can Dan deduct for travel away from home? Solution: Dan cannot deduct any of his expenses incurred for the apartment rent or meals during the 18 months in New York. Because the assignment was for longer than a year, it is not temporary and his tax home shifted to New York.
8 Chapter 5: Business Expenses Transportation Expense John is a teacher at a local high school. During the fall of 2004, he travels three days per week to a school in the next county to work with gifted children in an after-school program that does not end until 6:30 P.M. He normally eats dinner before driving home. If he drives 75 miles each way on 90 days to the gifted program, his meal expense is $900, and he maintains adequate records, how much may John deduct? Solution: $5,063 (90 days x 150 miles x 37.5 ); John is allowed to deduct his mileage only. He has no deduction for meals as he is not traveling away from home. 29. Foreign Travel Luis, a self-employed individual, flies from New York to Rome. He spends seven days in Rome on business and stays over in Rome for an additional three days to vacation. Transportation costs incurred were $1,400; his hotel cost $200 per day for a total of $2,000; and his meals cost $100 per day for a total of $1,000. What expenses can Luis deduct? Solution: $2,730. Luis can deduct $980 (7/10 x $1,400) transportation costs, $1,400 (7 x $200) for his hotel, and $350 (7 x $100 x 50%) for his meals, for a total of $2, Uncollectible Accounts Maria earns $50,000 from consulting contracts during the year. She collects only $48,000 from her clients and expects the $2,000 will remain uncollectible. a. If Maria s business is on the accrual basis, what is her gross income for the year and how much can she deduct for bad debt expense? b. If Maria s business is on the cash basis, what is her gross income for the year and how much can she deduct for bad debt expense? Solution: a. Maria must recognize $50,000 of income during the current year. She will deduct the $2,000 as a bad debt in the year she determines it is uncollectible. b. Maria will recognize only $48,000 of income in the current year. She has no deduction for the $2,000 that she cannot collect because it was never recognized as income. 31. Insurance In the current year, Melbourne Corporation pays the $2,000 annual premium for a life insurance policy on its president, for which Melbourne Corporation is the beneficiary. Melbourne also pays $20,000 in annual premiums for group term life insurance for its employees as an employee benefit; the employees designate the beneficiaries. Additionally, Melbourne pays $16,000 in annual premiums for business fire, casualty, and theft insurance. How much can Melbourne deduct as business expenses? Solution: Melbourne can deduct $36,000 ($16,000 + $20,000) in insurance expense. The $2,000 premium for the president s life insurance policy is not deductible because the insurance proceeds would be tax exempt. 32. Legal Expenses Jim, the owner of a tabloid magazine, is sued by an actor for libel and pays $15,000 in legal fees. Jim is found guilty. Jim also received many parking tickets while attending various business meetings in areas where legal parking spaces are extremely difficult to find. The tickets totaled $1,000. What is Jim s deduction for these business expenses?
9 90 Solutions Manual for Taxation for Decision Makers Solution: Jim may deduct the $15,000 in legal fees only. The fines for the parking tickets are nondeductible. 33. UNICAP Rules Tropical Patios Corporation manufactures patio furniture in a factory with 24 employees. The office staff consists of 4 employees who handle personnel, accounting, and other office responsibilities. The sales staff includes 6 employees who travel extensively selling the furniture to retail outlets. The remaining 14 employees work in the factory. If the allocation for UNICAP purposes is based on the number of employees, what percentage of the office costs should be allocated to inventory? Solution: 70% (14/20) of the office costs are allocated to inventory. 34. FIFO vs. LIFO Barley Corporation decides to use the FIFO method for inventory valuation when it begins operations because this reflects the true physical flow of inventory. Its inventory under FIFO is valued at $375,000 at the end of its first year of operations. If Barley instead used LIFO, its ending inventory would be valued at $75,000. Due to its first-year profitability, Barley is in the 34% marginal tax bracket. For the next several years, Barley expects to see a steady increase in the cost of its products. Barley expects that its inventory will probably remain at about the same quantity for the next several years. a. Is Barley Corporation required to use the inventory method that matches its actual physical flow? b. If Barley Corporation had used LIFO instead of FIFO, how much income tax could it have saved for the current year? c. If Barley changes from FIFO to LIFO for tax purposes, does this have any impact on what it reports on its financial statements? Solution: a. No. Inventory costing methods do not have to match the actual flow of inventory. b. $102,000 [($375,000 - $75,000) x 34%] could have been saved by using the LIFO inventory method. c. If Barley uses LIFO for tax reporting, it will be required to use LIFO in its financial statements; it will, however, be able to supply supplementary data on alternate inventory methods outside the financial statements. 35. Home Office Expenses Maureen operates a cosmetic sales business from her home. She uses 400 of 1,600 square feet of the home as an office. If her income before her home office deduction is $2,300, how much of the following unapportioned expenses for the home are deductible? If any of the expenses are not deductible currently, how are they treated for tax purposes? Mortgage interest $5,000 Property taxes 1,400 Utilities 1,200 Repairs and maintenance 600 Depreciation for the entire house 6,000 Solution: Maureen s deductible expenses for her home office are limited to the business income ($2,300) and she must account for expenses in the following order:
10 Chapter 5: Business Expenses 91 $1,600 Mortgage interest and property taxes [($5,000 + $1,400) x 400/1600] 450 Utilities and repairs [($1,200 + $600) x 400/1600] 250 Depreciation ($6,000 x 400/1600 = $1,500) limited to $250 ($2,300 - $1,600 - $450 = $250 remaining). The nondeductible portion of the depreciation ($1,250) will be carried forward to future years and subject to similar limitations. 36. Business vs. Hobby Teresa is an accomplished actress. During the summer, she rented a vacant store to stage productions of four plays, using the local townspeople as actors and stagehands. She sold $24,000 of tickets to the various plays. Her expenses included $10,000 for copyright fees, $3,000 store rental, $8,000 for costume purchases and rentals, $2,000 for props and other supplies, and $4,000 for all other miscellaneous expenses related to producing the series of plays. a. How does Teresa treat the revenue and expenses if the activity is deemed a business? b. How does Teresa treat the revenue and expenses if the activity is considered a hobby? c. What are some of the factors that should be considered in deciding if this constitutes a business or a hobby? Solution: a. If the activity is a business, Teresa may deduct all of the expenses from the revenue; she will report a loss of $3,000 ($24,000 - $10,000 - $3,000 - $8,000 - $2,000 - $4,000). b. If the activity is a hobby, Teresa will be able to deduct expenses only to the extent of her income from the activity. So she can deduct only $24,000 of the expenses. c. Some of the factors that should be considered are: The manner in which the taxpayer carries on the activity; The expertise of the taxpayer and/of the taxpayer s consultants; The time and effort spent by the taxpayer in the activity; The taxpayer s history of profits or losses for this activity; The success of the taxpayer in similar activities; The overall financial status of the taxpayer; and The elements of pleasure or recreation that are part of the activity. 37. Vacation Home Rental Neil owns a ski lodge in Aspen. His use of this lodge varies from year to year. The annual expenses for the lodge are as follows: Mortgage interest $24,000 Property taxes 12,000 Snow removal 1,000 Yard maintenance 800 Utilities 2,000 Repairs and other maintenance 1,200 Annual depreciation 12,000 How does Neil treat the income and expense if a. he uses the lodge for 100 days and rents it out for 10 days at a rate of $150 per day? b. he uses the lodge for 10 days and rents it out for 100 days at $150 per day?
11 92 Solutions Manual for Taxation for Decision Makers c. he uses the lodge for 50 days and rents it out for 60 days at $150 per day? Solution: a. Neil does not include the $1,500 ($150 x 10) rent in income. He deducts the mortgage interest and taxes in full as itemized deductions. He is allowed no deduction for the other expenses. b. Neil must recognize $15,000 ($150 x 100) rent as income. He deducts 100/110 of each expense against this income. Thus, the expense deductions are $32,727 ($36,000 x 100/110) for interest and taxes; $10,909 ($12,000 x 100/110) for depreciation; and $4,545 ($5,000 x 100/110) for the other expenses resulting in a rental loss of $33,181 ($15,000 - $48,181). He is not allowed to deduct the balance of the mortgage interest because his personal-use did not meet the threshold to qualify as a home but he can deduct the personal portion of the taxes as an itemized deduction. c. His deductions are now limited to his rental income of $9,000 ($150 x 60). He must first deduct the rental portion of interest and taxes of $19,636 ($36,000 x 60/110); this deduction is limited to $9,000, however. The $27,000 ($36,000 - $9,000) balance of interest and taxes are deductible as itemized deductions. None of the other expenses are deductible. 38. Book/Tax Differences Maxwell Corporation has income per books before tax of $400,000. Included in the income per books is $8,000 interest income from tax-exempt municipal bonds. In computing income per books, Maxwell deducted $22,000 for meals and entertainment expenses, $3,300 for premiums on officers' life insurance policies (the corporation is the beneficiary for these policies), and $200 for fines. a. What is Maxwell Corporation's taxable income? b. What should Maxwell Corporation report as its income tax expense on its financial statements, assuming it uses a 34 percent tax rate? Solution: a. $406,500. ($400,000 - $8,000 tax-exempt interest income + $11,000 (50% x $22,000) meals and entertainment expense + $3,300 life insurance premium + $200 fines). b. $406,500 x 34% = $138,210; All of the adjustments are for permanent differences between tax and financial accounting income. 39. Book/Tax Differences Sorbon Corporation pays federal income tax at a 34 percent rate. In year 1, Sorbon deducts $80,000 as bad debt expense in computing its book income but deducts only $70,000 for bad debt expense on its tax return. a. What is the difference between Sorbon's book tax expense and its federal tax liability? b. How does Sorbon account for this difference on its financial statements? c. In year 2, Sorbon reports $50,000 for bad debt expense on its books and $60,000 bad debt expense in computing taxable income. How does Sorbon account for this difference on its financial statements? Solution: a. $3,400 [($80,000 - $70,000) x 34%] b. The $3,400 is a deferred tax asset as it results in a prepayment of the tax.
12 Chapter 5: Business Expenses 93 c. It will credit the $3,400 deferred tax asset created in the prior year for the difference. 40. Comprehensive Sole Proprietorship Problem for Chapters 4 and 5 Martin, the sole proprietor of a consulting business, has gross receipts of $45,000 in Expenses paid by his business are: Advertising $500 Supplies 2,900 Taxes and licenses 500 Travel (other than meals) 600 Meals and entertainment 400 Health insurance premiums (for Martin) 1,400 Individual retirement account contribution 2,500 During the year Martin drives his car a total of 15,000 miles (8,000 business miles and 7,000 personal miles). He paid $100 for business-related parking and tolls. He paid $120 for speeding tickets for speeding when he was late for appointments with clients. Martin s office is located in his home. His office occupies 500 of the 2,000 square feet in his home. His total (unallocated) expenses for his home are Mortgage interest 6,000 Real estate taxes 1,700 Insurance 700 Repairs and maintenance 300 Utilities 1,600 Depreciation for the business portion of his home is $1,364. a. What is Martin's net income (loss) from his business? b. How much self-employment tax must Martin pay? c. Based on this information, are there any other deductions that Martin can claim on his individual tax return other than those reported on his Schedule C? Solution: a. Net income from the business is $33,261. The expenses deductible from the $45,000 of gross income are: $ 500 for advertising 2,900 for supplies 500 for taxes and licenses 600 for travel (other than meals) 200 for meals (50% x $400) 3,000 for auto expense (37.5 x 8,000 miles) 100 parking and tolls 3,939 for home office expenses* $11,739 total expenses *Home office expense: 500/2,000 x $10,300 total expense other than depreciation = $2,575 + $1,364 depreciation for office = $3,939 Net income from the business is $33,261 ($45,000 - $11,619). b. Self-employment income = $33,261 x 92.35% x 15.3% = $4,700. c. Martin may claim the following additional deductions for AGI: $2,350 (½ of self-employment taxes); $1,400 health insurance premium; and $2,500
13 94 Solutions Manual for Taxation for Decision Makers contribution to his IRA. He would have itemized deductions of $5,775 (1500/2000 x $7,700 interest and taxes). The $120 for speeding tickets is not deductible. Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter. 41. Vacation Rental Orlando purchased a time-share property in Hawaii that he can use for five weeks each year. If Orlando uses this property for his vacations during the year and rents the property to others when he chooses not to use it, can he deduct any expenses related to this property? Explain. Solution: Yes, but there will be limitations on his deductible expenses similar to other vacation homes. The time-share property meets the definition of a dwelling unit. Prop. Reg A-3(f) states that the allocation for the rental expense on a time share shall be applied on the basis of the taxpayer s expenses for the unit, the number of days during the taxable year that the unit is rented at a fair rental, and the number of days during the taxable year that the unit is used for any purpose. 42. Book/Tax Differences List three types of expenses or allowances that can cause temporary differences between book and taxable income and explain how their financial accounting treatment differs from their tax treatment. Why do you think the treatments differ? Solution: (1) Prepaid rent expense: deductible under certain circumstances for tax purposes but not deductible for financial purposes until the rental term has passed. (2) Allowances for repairs: deductible for financial purposes when accrued but not deductible in computing taxable income until the expense is incurred. (3) Allowances for bad debts: deductible for financial purposes when accrued but not deductible for tax purposes until the debt is determined uncollectible. There are three reasons why financial accounting treatment differs from tax treatment. First, the goals of financial accounting and tax reporting are very different. The former seeks to provide information that decision makers (such as shareholders and creditors) find useful. The latter seeks to collect revenue equitably. Second, financial accounting often relies on the principle of conservatism, which tends to understate income when uncertainty exists. In contrast, the income tax system would be greatly hampered in its collection of revenue if taxpayers were allowed the freedom of reporting income conservatively. Third, financial accounting often relies on estimates and probabilities. The tax system would not function very efficiently or equitably if taxpayers were allowed to estimate expenses that may never actually be incurred. 43. Book/Tax Differences Your friend recently read a newspaper article that said the largest of the Fortune 500 companies do not pay the federal income tax expense reported on their financial statements. The tax they pay is frequently a lower number. Your friend asks you to explain how this is possible. Do you believe this is good public policy? Solution: The provisions that determine taxable income and financial accounting income have many differences. There are two types of differences, permanent and
14 Chapter 5: Business Expenses 95 temporary. The permanent differences do not cause any differences in the tax reported for financial purposes than that actually paid. The timing differences, however, result in deferred tax liabilities or deferred tax assets because the differences will reverse in a later period. If there is a deferred tax liability created, the tax expense reported on the financial statement matches financial accounting income; but the taxable income is lower along with the taxes paid; the liability will have to be paid at a later date, however. The deferred tax liability account on the financial statement puts the financial statement users on notice that this tax will have to be paid sometime in the future. The opposite is true for a deferred tax asset; that is, taxes will be lower in the future because of the tax prepayment. In general, the matching of the tax expense to the financial accounting income is believed to provide better evaluative information for the users of financial statements. 44. Deferred Tax Assets and Liabilities If Congress reduces the corporate income tax rates, how would this affect deferred tax liabilities and deferred tax assets? Solution: If corporate income tax rates are reduced, corporations will benefit on their deferred tax liabilities. The amount of tax paid in the future will be lower than if paid today. The opposite is true for deferred tax assets. Deferred tax assets will provide lower future tax savings for the corporation. 45. Tax vs. Financial Accounting for Stock Options Five years ago, Bryant Corporation granted Julia a nonqualified stock option entitling her to buy 400 shares of Bryant stock for $50 per share at any time during the next six years. At the grant date, the stock was selling for $45 per share. This year Julia exercised her option when the market price of Bryant stock was $105 per share. Discuss how these options are reported for book and tax purposes. How does this affect the income tax expense reported on the financial statements? Solution: Under the intrinsic value method, Bryant recognizes no expense for financial accounting or tax when the options are granted. When Julia exercises the options, she must recognize income of $22,000 ($55 x 400) and Bryant recognizes $22,000 of expense for tax purposes. Bryant recognizes no expense for financial accounting, however. This results in a permanent $22,000 difference in income before taxes for Bryant. Bryant s financial accounting income must be adjusted for permanent differences before its tax expense per books is determined. On March 31, 2004, the Financial Accounting Board issued an exposure draft proposing that the fair value method be required for financial accounting, effective in This would require corporations to determine the value of options (preferably using a binomial method) and record compensation expense at the grant date. No adjustment would be permitted if the options are never exercised. This will result in a temporary difference when options are granted and may result in a permanent difference for options that are not exercised. (Refer to the solution for problem 40 in Chapter 4 for a more complete discussion of the differences between tax and financial accounting for stock options.)
15 96 Solutions Manual for Taxation for Decision Makers Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question. 46. Travel Expense Ken is a high school history teacher. Each summer he travels to a different location to further his knowledge of American history. This summer he plans to attend a four-day conference for high school history teachers in Philadelphia. Immediately following the conference he plans to spend a week exploring the battlefield area at Gettysburg. He plans to incorporate the information he learns from his trip into the classes he teaches. Solution: How much of Ken s expenses for the four-day conference and the week exploring Gettysburg can he deduct as unreimbursed travel expenses for business purposes? 47. Bad Debt Deductions In year 1, Sharon loaned her friend, Christina, $10,000 to start a new business. The loan was documented by a signed note, at market interest rate, and required repayment in two years. Christina appeared successful at first but her office manager embezzled a large amount of money, causing Christina to declare bankruptcy in year 2. In year 3 Sharon recovers only $1,000 of the $10,000 she loaned to Christina. Solution: Does Christina have a bad debt deduction for the amount she is unable to collect? How much and when is any allowable amount deducted? 48. Penalties Ace Builders begins construction on a building in January. Its contract specifies that the building must be complete by July 1 or it must pay a penalty of $100 for each day the building is delayed. Ace Builders completes the building on July 31 and pays a penalty of $3,000. Solution: Can Ace deduct the $3,000 penalty? 49. Vacation Home You rent your beach house to your friend, Sarah. Sarah rents her condo in Aspen to you. You each pay a fair rental price. Solution: What are the tax effects of their exchanging the use of their vacation homes? Does this exchange result in any taxable income and are any rental expenses deductible? 50. Travel Expenses Carl is the president of Carlton Corporation. He spends three days testifying before Congress on the impact that proposed legislation has on his industry. In his testimony he states that if the legislation passes, he will have to lay off 20 percent of his workforce. He spent $1,000 for airfare, $700 for the hotel and $310 for meals. Solution: Are the expenses incurred to testify deductible as business travel or lobbying expenses? 51. Office in Home Scott is the CEO of a large corporation in Chicago. He spends the month of August in Wisconsin at his vacation home where he has a separate structure furnished as an office.
16 Chapter 5: Business Expenses 97 Scott uses the office each August for long-range corporate planning because he can avoid the interruptions that occur in Chicago and he finds the isolation he needs to concentrate. The rest of the year the office is not used. Solution: What, if any, of the expenses related to the office at the vacation home are deductible by Scott? 52. Business vs. Hobby Anne operates a dog-training business out of her home. She started the business four years ago but has not yet made a profit. She gets all of her business by word-of-mouth and thinks that she might try running some ads in the newspaper to increase her business. Solution: Will Anne s business be considered a hobby or a legitimate business given the lack of profits and the manner in which the business has been conducted? Develop Research Skills Solutions to research problems are included in the Instructor s Manual. Search the Internet 56. Business Travel Go to the IRS Web site (www.irs.gov) and locate the publication on travel, entertainment, and gifts. Julie plans to attend a business convention in Costa Rica. Her friend told her that she cannot deduct expenses for attending a convention outside of North America. Does Costa Rica qualify as part of North America? Solution: Yes. According to Publication 463, Costa Rica qualifies as part of North America. 57. Employee Business Expenses Go to the IRS Web site (www.irs.gov) and print Form 2106: Employee Business Expenses. Use the following information to complete this form. Carl is an employee of Intelligent Devices, Inc. in San Jose. In a typical week, Carl spends a lot of time on the road showing products to prospective customers. He also frequently takes customers out to lunch to discuss new products. Carl purchased his car on January 1, Carl s wife has her own automobile that is used for most of their personal driving. Carl uses the standard mileage rate for his automobile expenses. He keeps a written log of his mileage that shows he drove a total of 30,000 miles during the year of which 25,000 miles were for business. His records also show that he spent $300 for business parking and tolls, $2,800 for business meals, $1,200 for business entertainment, and $1,100 for hotel expenses while traveling away from home on business. He also paid $250 for a business-related seminar. He was not reimbursed for any of these expenses. Solution for 2003: $12,650 total employee business expenses $ 9000 Vehicle expense (36 x 25,000 miles) 300 Parking and tolls 1,100 Travel expense 250 Other business expenses - business seminar 2,000 Meals & entertainment [($2,800 + $1,200) x 50%] $12,650 Total employee business expenses A filled-in 2003 tax form is included at the end of the solutions for this chapter.
17 98 Solutions Manual for Taxation for Decision Makers Solution for 2004: $13,025 total employee business expenses $ 9,375 Vehicle expense (37.5 x 25,000 miles) 300 Parking and tolls 1,100 Travel expense 250 Other business expenses - business seminar 2,000 Meals & entertainment [($2,800+ $1,200) x 50%] $13,025 Total employee business expenses Tax forms for 2004 have not yet been released by IRS. 58. Vacation Home Rentals Go to the IRS Web site (www.irs.gov) and print Schedule E: Supplemental Income and Loss. Use the following information to complete this form. Gillian rented her vacation home for 60 days during the year receiving $6,900 in rental income. She used the property herself for 15 days. Her total expenses include: $4,000 mortgage interest, $2,000 property taxes, $500 utilities, $400 insurance, $200 cleaning, $700 depreciation, and a $600 rental commission paid to the real estate agent who found the tenant Solution: $60 net rental income 160 Cleaning [(60/75) x $200] 600 Commissions 320 Insurance [(60/75 x $400] 3,200 Mortgage interest [(60/75) x $4,000] 1,600 Taxes [(60/75) x $2,000)] 400 Utilities [(60/75) x $400] 560 Depreciation [(60/75) x $700] $6,840 Total rental expense $6,900 rents received - $6,840 rental expenses = $60 net rental income A filled-in tax form is included at the end of the solutions for this chapter. 59. Sole Proprietor with Home Office Go to the IRS Web site (www.irs.gov) and print Schedule C: Profit or Loss for Business (Sole Proprietorship), Schedule SE: Self-Employment Tax, and Form 8829: Expenses for Business Use of Your Home. Use the information in problem 40 to complete these forms. Solution for 2003: Net income is $33,381 and SE tax is $4,717. $45,000 Gross income (500) Advertising (2,980) Car and truck expenses [(36 x 8,000 miles = $2,880) + $100] (2,900) Supplies (500) Taxes and licenses (600) Travel (200) Meals ($400 x 50%) (7,680) Total expenses before home office expenses (3,939) Home office expenses* (from Form 8829) $33,381 Net Profit
18 Chapter 5: Business Expenses 99 *Home office expense: 500/2,000 x $10,300 total expense before depreciation = $2,575 + $1,364 depreciation for office = $3,939 Schedule SE Self-employment income: $33,381 x 92.35% x 15.3% = $4,717. Filled-in 2003 tax forms are included at the end of the solutions for this chapter. Solution for 2004: Net income is $33,261 and self-employment tax is $4,700. $45,000 Gross income (500) Advertising (3,100) Car and truck expenses [(37.5 x 8,000 miles = $3,000) + $100] (2,900) Supplies (500) Taxes and licenses (600) Travel (200) Meals ($400 x 50%) (7,800) Total expenses before home office expenses (3,939) Home office expenses* (from Form 8829) $33,261 Net Profit *Home office expense: 500/2,000 x $10,300 total expense = $2,575 + $1,364 depreciation = $3,939 Schedule SE Self-employment income: $33,261 x 92.35% x 15.3% = $4,700. Tax forms for 2004 have not yet been released by IRS. 60. Locate IRS Publication Go to the IRS Web site (www.irs.gov) and print the fourth page of Form 1120: U.S. Corporate Income Tax Return. Use the information in example 40 to complete Schedule M- 1. Solution: $4,000,000 Income per books (before tax) (10,000) Interest income from tax-exempt municipal bonds (500,000) Life insurance proceeds 30,000 Nondeductible portion of meals and entertainment 5,000 Nondeductible premiums on officer s life insurance $3,525,000 Income modified for permanent differences (40,000) Excess of tax over book depreciation 20,000 Excess of bad debt allowance over direct write off $3,505,000 Taxable income Book income modified for permanent differences x 34% = $1,198,500 income tax expense. $4,000,000 - $1,198,500 tax = $2,801,500 net income per books. A filled-in Schedule M-1 is included at the end of the solutions for this chapter. 61. Locate IRS Publication Go to Enron s Web site (www.enron.com/corp/investors) and locate its annual report for What is its effective book tax rate for 1999 and 2000? Solution: In 1999, the effective book tax rate was 9.2%. In 2000, the effective book tax rate was 30.7%.
19 100 Solutions Manual for Taxation for Decision Makers Develop Planning Skills 62. Timing of Payments Kondex, a cash-basis corporation, is considering paying $50,000 of expenses at the end of this year rather than waiting until next year. Kondex's marginal tax rate for the current year is 25 percent but it expects to be in the 34 percent marginal tax bracket next year. Kondex uses a 7 percent discount rate for evaluation purposes. Should Kondex pay the expenses at the end of the current year? Solution: Kondex should pay the expenses next year. Pay in current year: $50,000 x 25% = $12,500 tax reduction from expense. Pay next year: $50,000 x 34% x.935 = $15,895 present value of tax reduction in the following year. 63. Combined Business and Pleasure Travel Bob lives in Atlanta and needs to set up three days of business meetings with customers in San Francisco. While he is in California, he would like to spend two days sightseeing in the wine country. Bob's customers are willing to meet any weekday with him, so the scheduling is totally up to him. Bob wants to maximize the deductible portion of his travel expenses. What should he consider in scheduling his business meetings? Solution: Bob should arrange business meetings on Friday and Monday. His third business day could be either Thursday or Tuesday. By arranging the meetings on both sides of the weekend, he may be able to deduct all of his travel expenses as business expenses even though he spends Saturday and Sunday on personal pleasure. If it is less expensive for him to stay over for the weekend rather than return home after the meeting on Friday and return for the meeting on Monday, then he will be able to stay over and consider the weekend hotel and meals costs as business expenses. 64. Temporary Business Assignments Ken, owner of Kendrick Corporation, realizes that he needs to send an employee to a temporary assignment at a plant in another state. He can either send one employee for an 18- month assignment or two employees for 9-month assignments. Kendrick Corporation will pay for all the meal and lodging expenses while the employees are on their out-of-town assignments. Does it make any difference from a tax perspective to Kendrick and to the employees which option he chooses? Solution: Yes. If Ken sends two employees, both will be on temporary assignments of less than one year. Kendrick will be able to deduct all of the expenses for lodging (and 50 percent of meals) for the two employees, but they will have no income from the reimbursement. If he sends only one employee for 18 months, that employee s tax home will change to the new location. Although Kendrick will be able to deduct the reimbursements for meals and lodging as employee compensation, it will be taxable income to the transferred employee, who will have no deduction for any of these expenses.
20 Chapter 5: Business Expenses Vacation Rental John has a vacation condo in the Florida Keys that he has rented out for two weeks in December for $250 a day. John has used this vacation home himself for a total of three weeks during the year. His total (unallocated) expenses for the condo are Taxes $1,500 Insurance 2,000 Repairs and maintenance 1,100 Interest 4,500 Depreciation for year 1,000 John received a call from his tenants who want to extend their rental of the condo for another week. John is in the 35 percent marginal tax bracket. What tax factors should John consider in making the decision to extend the rental of the condo? Solution: If John does not extend the rental, none of the tenant s $3,500 (14 x $250) rent payment is income and John simply deducts the $6,000 taxes and interest that he pays on the vacation condo as itemized deductions. If he extends the rental, John will have to include $5,250 (21 x $250) in income; he will allocate one-half (3/6 weeks) of all the expenses to the rental income in the following order: taxes and interest, repairs and insurance, then depreciation. The total deduction is limited to the rental income of $5,250, however. Thus, he can deduct $3,000 (50% x $6,000) of the taxes and interest and $1,550 (50% x $3,100) of the allocated repairs and insurance. He takes a depreciation deduction of $500 (50% x $1,000) and reduces the basis of the property accordingly. His total deduction for rental expenses is $5,050 resulting in $200 ($5,250 - $5,050) net rental income. The remaining $3,000 of his interest and taxes may be deducted as itemized deductions. If he extends the rental he will receive an additional $1,750 (7 x $250) in cash for the rental, but will be taxed on $3,200 more income ($3,000 difference in itemized deductions + $200 net rental income). John would incur $1,120 ($3,200 x 35%) additional taxes to generate $1,750 additional cash from rent. Therefore, he should extend the rental because he will have a positive after-tax cash flow of $630 ($1,750 - $1,120).
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