Solutions

CHAPTER 7 DISCUSSION QUESTIONS

1. No deduction is allowed for the bad debts of a cash basis taxpayer because no income hasbeen reported. p. 7-3

2. Ron has a nonbusiness bad debt. The debt is unrelated to Ron’s trade or business. Theuse to which the borrowed funds are put is of no consequence in classifying the bad debtas a nonbusiness bad debt. p. 7-5

3. A legal action need not be initiated against the debtor, but all of the surrounding facts andcircumstances must indicate that such an action would not result in a collection of thedebt. p. 7-4

4. If an account receivable has been written off as uncollectible during the current tax yearand is subsequently collected during the current tax year, the write-off entry is reversed.If the account receivable recovered was written off during a previous tax year, income iscreated subject to the tax benefit rule. pp. 7-4 and 7-5

5. A nonbusiness bad debt for an individual taxpayer is treated as a short-term capital loss.As such, the maximum amount of net short-term capital loss that an individual can deductagainst ordinary income in any one year is $3,000. p. 7-5

6. A bona fide debt exists when a debtor-creditor relationship is based on a valid andenforceable obligation to pay a fixed or determinable sum of money. The determinationis based on an examination of the prevailing facts and circumstances. p. 7-6

7. John should be concerned with the following issues:

• Is the loan a nonbusiness or business bad debt?

• Is the deduction a for AGI deduction?

• Is the deduction an itemized deduction?

• Is the deduction subject to the 2% floor?

pp. 7-3 to 7-6

8. Mary cannot take a loss on her current year’s tax return for the decline in the stock value.Since the securities have not been disposed of by Mary in a market transaction, arecognized loss is allowed only if the securities become completely worthless during theyear. p. 7-6

9. For small business stock, the ordinary loss treatment is limited to $50,000 ($100,000 formarried individuals filing jointly) per tax year. Thus, the taxpayer is able to receiveordinary loss treatment on what otherwise would have been a capital loss (i.e., stock is acapital asset). An ordinary loss may be used, without limitation, in computing taxableincome. A capital loss, after netting against capital gains, is limited to $3,000 per taxyear. pp. 7-7 and 7-8

10. If the sea wall damage is the result of progressive deterioration, the definition of acasualty loss has not been satisfied. Consequently, Jim can take no deduction for hispersonal use property. However, if Jim can show that the damage is the result of asudden, unexpected, and violent storm, then he can take a casualty loss. pp. 7-8 and 7-9

Deductions and Losses: Certain Business Expenses and Losses 7-5

11. A taxpayer may not take a deduction for a casualty loss if the loss is caused by thetaxpayer’s willful act or willful negligence. A DUI citation indicates willfulness. p. 7-9

12. The amount of the loss for the partial claim in 2004 is reduced by the $100 per eventfloor and by the 10% of AGI floor for the 2004 taxable year. The loss in 2005 is reducedby 10% of the 2005 AGI. p. 7-10 and Example 11

13. The reimbursement is included in gross income for the tax year in which it is received.However, it is only included in gross income to the extent that the previous deduction forthe casualty loss resulted in a tax benefit. p. 7-10

14. The amount of the loss is the lesser of (1) the difference between the fair market value ofthe property before the event and the fair market value of the property immediately afterthe event or (2) the adjusted basis of the property. Note that for personal use propertythis lesser of provision applies to both partial destruction and for complete destruction.For business or investment property, the lesser of rule applies only for partial destruction.p. 7-11

15. A taxpayer is not permitted to deduct a casualty loss for damage to insured personal useproperty unless a timely insurance claim is filed with respect to the damage to theproperty. If the taxpayer does not file an insurance claim, the loss must be reduced bythe proceeds that could have been received from the insurance company. p. 7-12

16. The cost of repairs can be used as a method for measuring the amount of a casualty loss ifthe repairs are necessary to restore the property to its condition before the casualty, theamount spent for the repairs is not excessive, and the repairs do not extend beyond thedamage suffered. In addition, the value of the property after the repairs must not, as aresult of the repairs, exceed the value of the property immediately before the casualty.p. 7-12

17. The 10% of AGI floor applies to both the first and second year. The AGI of the first yeardetermines the 10% floor for that year. The AGI of the second year determines the 10%floor for that year. p. 7-12

18. The loss from the theft of the bearer bonds would not be subject to the $100 and 10% ofadjusted gross income floors which apply for casualty and theft losses to personal useproperty. The loss is to investment property. However, this loss is a miscellaneousitemized deduction. p. 7-14

19. By subjecting only the casualty loss in excess of casualty gains to a floor equal to 10% ofadjusted gross income, the taxpayer is given a loss deduction at least as great as thecasualty gains included in the tax return. If the entire casualty loss were subject to the10% of the adjusted gross income floor, the casualty loss deduction could be less than thecasualty gains. For example, if the taxpayer has $4,000 of casualty gains, $6,000 ofcasualty losses, and adjusted gross income of $100,000, the taxpayer will in effect have acasualty loss deduction of $4,000 since the loss offsets the gain. If the whole casualtyloss were subject to 10% of adjusted gross income, the deduction would be zero.pp. 7-14 and 7-15

20. Monte should be concerned with the following tax issues:

• Has a casualty loss been sustained?

7-6 2006 Comprehensive Volume/Solutions

• The amount of the loss.

• The year the loss should be claimed.

• What effect will the $40,000 expenditure have on Monte’s adjusted basis for theland?

pp. 7-8 to 7-12

21. The tax issues for Henry are as follows:

• Is this a casualty loss?

• Is this property used in a trade or business?

• What is the amount of the loss?

• The basis for computing the loss.

• The decline in fair market value.

pp. 7-8 to 7-12

22. Depreciation on a building (realty) or personal property (personalty) used for research isa research and experimental expenditure. pp. 7-16 and 7-17

23. The following three alternatives are allowed for research and experimental expenditures:

• Expense in the year paid or incurred.

• Defer and amortize over not less than 60 months.

• Capitalize and deduct when the project is abandoned or deemed worthless.

p. 7-17

24. The tax issues for Power and Light are as follows:

• Are the expenditures for environmental impact studies research and experimentalexpenditures?

• Are the expenditures for environmental impact studies deductible business expenses?

pp. 7-16 and 7-17

25. A net operating loss generally must be carried back initially to the second year precedingthe year of the loss. Unused amounts (after applying the loss against income of the twocarryback years) are carried forward chronologically for up to twenty years, beginningwith the first year subsequent to the year of the loss.

However, if the loss is attributable to a casualty or theft loss, the carryback period is threeyears, rather than two years. The three-year carryback rule also applies to NOLsattributable to Presidentially declared disasters which are incurred by a small business orby a taxpayer engaged in farming.


A taxpayer may elect to forgo the carryback period and, thus, only carry forward theNOL.

pp. 7-20 and 7-21

PROBLEMS

26. Willis, Hoffman, Maloney, and Raabe, CPAs5191 Natorp Boulevard

Mason, OH 45040

January 29, 2005

Mr. John Johnson100 Tyler LaneErie, PA 16563

Dear Mr. Johnson:

This letter is to inform you of the possibility of taking a bad debt deduction.Your loan to Sara is a nonbusiness bad debt; therefore, you are not allowed to take a baddebt deduction for partial worthlessness. You will be able to take a bad debt deduction inthe year in which the debt becomes wholly worthless.

Should you need more information or need to clarify anything, please contact me.

Sincerely,

John J. Jones, CPAPartner

TAX FILE MEMORANDUM

January 29, 2005

From: John J. Jones

Subject: Bad Debt Deduction

John Johnson’s $30,000 loan to Sara is a nonbusiness bad debt. Therefore, a bad debtdeduction is not allowed for partial worthlessness. John will be able to claim a bad debtdeduction in the year when the debt becomes wholly worthless.

p. 7-5

27. Sue probably cannot take a deduction for the nonbusiness bad debt because the loan wasbetween related parties and the facts seem to indicate that no debtor-creditor relationshipever existed (i.e., the loan is not a bona fide debt). p. 7-6

28. The bad debt is a business bad debt. However, the amount of Ron’s bad debt is limited toRon’s basis in the debt. Therefore, the bad debt of $80,000 (80% X $100,000 face value


of the receivable) is limited to a deduction of $72,000 for Ron; that is, his basis in thedebt. p. 7-4

29. Salary $180,000§ 1244 ordinary loss (95,000)Short-term capital gain on § 1244 stock $12,000Short-term capital loss (nonbusiness bad debt) (16,000)Net short-term capital loss (limit) (3,000)Adjusted gross income $ 82,000

pp. 7-5 to 7-8

30. Sell all of the stock in the current year:

Current year’s AGISalary $80,000Ordinary loss (§ 1244 limit) (50,000)Long-term capital gain $ 8,000Long-term capital loss (30,000) ($80,000 – $50,000)Long-term capital loss (limit) (3,000)AGI $27,000Next year’s AGISalary $90,000Long-term capital gain $10,000Long-term capital loss carryover (19,000) ($30,000 – $11,000)Long-term capital loss (limit) (3,000)AGI $87,000

Total AGICurrent year $ 27,000Next year 87,000Total $114,000

Sell half of the stock this year and half next year:

Current year’s AGISalary $80,000Ordinary loss (§ 1244 stock) (40,000)Long-term capital gain 8,000AGI $48,000

Next year’s AGISalary $90,000Ordinary loss (§ 1244 stock) (40,000)Long-term capital gain 10,000AGI $60,000

Total AGICurrent year $ 48,000Next year 60,000Total $108,000


Mary’s combined AGI for the two years is lower if she sells half of her § 1244 stock thisyear and half next year. pp. 7-7 and 7-8

31. Casualty gainHome [$70,000 – ($400,000 – $350,000)] $20,000

Casualty lossCar [$20,000 – ($55,000 – $0)] ($35,000)Contents [$10,000 – ($60,000 – $10,000)] (40,000)Total ($75,000)Less: $100 floor (100)

($74,900)

Casualty loss in excess of casualty gain ($54,900)Less: 10% AGI (10% X $100,000) (10,000)Total itemized deduction ($44,900)

pp. 7-11 to 7-16

32. The loss is a business loss. Therefore, for the farm building and the farm equipment thatwere completely destroyed, the adjusted basis is used in calculating the amount of thecasualty loss. For the barn that was damaged, the lower of the adjusted basis or thedecline in value is used in calculating the amount of the casualty.

Building ($90,000 – $70,000) $20,000Equipment ($40,000 – $25,000) 15,000Barn ($50,000 – $25,000) 25,000Total loss $60,000

Because the President declared the area a disaster area, Olaf and Anna could claim theloss on last year’s return or on the current year’s tax return.

If Olaf applies the loss to the prior year, the benefit of the loss will be at a tax rate of28%. If the loss is applied to the current year, the benefit will be at a tax rate of 33%rather than 28% and thus, provide a tax savings of $19,800 ($60,000 X 33%) rather than$16,800 ($60,000 X 28%).

Olaf should include the loss on the current year’s tax return, since the tax savings is$3,000 ($19,800 – $16,800) greater.

pp. 7-8 to 7-16

33. Business Personal Portion Portion

Total (50%) (50%)

Cost $800,000 $400,000 $400,000Depreciation (150,000) (150,000) -0-Adjusted basis $650,000 $250,000 $400,000

Loss on building:Loss ($900,000 – $200,000) $700,000 $250,000* $350,000Less: Insurance reimbursement $600,000 (300,000) (300,000)Loss (gain) ($ 50,000) $ 50,000


Business contents loss $220,000Less: Insurance recovery (175,000)Loss $ 45,000

AGI before effects of accident $100,000Business gain—building 50,000Business loss—contents (45,000)AGI $105,000

Personal casualty loss—building $ 50,000Personal casualty loss—contents ($65,000 – $65,000) -0-Less: $100 per event floor (100)

10% of AGI floor (10% X $105,000) (10,500)Itemized deduction $ 39,400

*Adjusted basis is less than the decline in FMV of $350,000 ($700,000 X 50%).

pp. 7-8 to 7-16

34. Willis, Hoffman, Maloney, and Raabe, CPAs5191 Natorp Boulevard

Mason, OH 45040

January 26, 2005

Mr. Sam Smith450 Colonel’s WayWarrensburg, MO 64093

Dear Mr. Smith:

This letter is to inform you of the tax and cash flow consequences of filing a claim versusnot filing a claim with your insurance company for reimbursement for damages to yourbusiness use car.

If an insurance claim is filed, you will have a taxable gain of $2,000 computed asfollows:

Insurance recovery $12,000Less: Lesser of adjusted basis of $10,000 or decline of FMV of $12,000 (10,000)Gain $ 2,000

This will produce a net cash flow of $11,300 computed as follows:

Insurance reimbursement received $12,000Less: Tax on gain (35% X $2,000) (700)Net cash flow $11,300

If no insurance claim is filed, you will have a deductible loss of $10,000 which willreduce your tax liability by $3,500 (35% X $10,000).

The net cash benefit resulting from filing an insurance reimbursement claim would be$7,800 ($11,300 – $3,500).


Should you need more information or need to clarify anything, please contact me.

Sincerely,


TAX FILE MEMORANDUM

January 26, 2005

From: John J. Jones

Subject: Tax consequences for Sam Smith if he does not file an insurance claim forreimbursement for damages to his business use car

If an insurance claim is filed, Sam will have taxable gain of $2,000 computed as follows:

Insurance recovery $12,000Less: Lesser of adjusted basis of $10,000 or decline of FMV of $12,000 (10,000)Gain $ 2,000

This will produce a net cash flow of $11,300 computed as follows:

Insurance reimbursement received $12,000Less: Tax on gain (35% X $2,000) (700)Net cash flow $11,300

If no insurance claim is filed, Sam will have a deductible loss of $10,000 which willreduce his tax liability by $3,500 (35% X $10,000).

In my correspondence with Sam, I pointed out the net cash benefit from filing aninsurance reimbursement claim would be $7,800 ($11,300 – $3,500).

pp. 7-11 to 7-13

35. a. 2005Salaries $300,000Materials 80,000Insurance 10,000Utilities 7,000Equipment depreciation 10,000Total expenses $407,000

Cost of inspection of materials for quality control ($4,000), promotion expenses($10,000), and cost of market survey ($8,000) are not included as research andexperimental expenditures.


2006Salaries $400,000Materials 70,000Insurance 15,000Utilities 8,000Equipment depreciation 12,000Total expenses $505,000

Cost of inspection of materials for quality control ($4,000), advertising ($30,000),and promotion expenses ($7,000) are not included as research and experimentalexpenditures.

2007No deduction based on data provided.

b. The research and experimental expenditures are amortized over a 60-monthperiod beginning with the month in which the taxpayer first realizes benefits fromthe experimental expenditures (i.e., July 2007 for Blue Corporation). Themonthly amortization is $15,200 ($912,000 ÷ 60)

2005No deduction for research and experimental expenditures.

2006No deduction for research and experimental expenditures.

2007Deduction for research and experimental expenditures:

$15,200 X 6 months = $91,200

pp. 7-16 to 7-18

36. Salary $40,000Interest income 1,000Business bad debt (2,000)Nonbusiness bad debt (short-term capital loss) ($6,000) Short-term capital loss (3,000) Total short-term capital loss ($9,000) Long-term capital gain 4,000Net short-term capital loss ($5,000) Capital loss limit (3,000)Adjusted gross income $36,000

p. 7-5

37. Salary $40,000Interest income 1,000Business bad debt (2,000)Nonbusiness bad debt ($ 6,000) Short-term capital loss (3,000) Total short-term capital loss ($ 9,000) Short-term capital gain* 10,000Net short-term capital gain 1,000


Long-term capital gain $ 4,000Long-term capital loss* (1,000) Net long-term capital gain 3,000Adjusted gross income $43,000

*Personal casualty gains exceed personal casualty losses ($10,000 – $1,000 = $9,000)and therefore, all personal casualty items are treated as capital gains and losses.

pp. 7-5 and 7-14 to 7-16

CUMULATIVE PROBLEMS

38. Salary $100,000Rental income $35,000Less: Rental expenses (20,000) 15,000Casualty loss on rental property (8,000)2004 NOL carryover (14,000)Short-term capital gain

§ 1244 stock (Note 1) $25,000Nonbusiness bad debt (10,000)Total short-term capital gain 15,000

AGI $108,000Less: Itemized deductions

Personal casualty loss $23,000Less: $100 floor (100)Less: 10% AGI (10,800) (12,100)

Other itemized deductions (21,000)Less: Personal exemption ($3,200 X 2) (6,400)Taxable income $ 68,500

Tax on $68,500 (Note 2) $ 10,455Income tax withholdings (12,500)Net tax payable (or refund due) for 2005 ($ 2,045)

Notes

(1) The gain of $25,000 on the § 1244 stock is classified as a short-term capital gain.

(2) Alan and Ruth’s filing status is that of married filing jointly.

Tax on $59,400 $ 8,180($68,500 – $59,400) X 25% 2,275

$10,455

39. Part 1—Tax Computation

Salary and bonus ($50,000 + $1,000) $51,000Typing service business net receipts ($20,000 – $24,580) (4,580)Interest income (Note 1) 700Life insurance proceeds (Note 2) -0-Gift (Note 3) -0-Bingo prize 100


Alimony 10,000Nonbusiness bad debt (Note 4) (2,100)Adjusted gross income $55,120Less: Itemized deductions

Home mortgage interest $8,346Sales taxes 654Casualty loss: Lesser of adjusted basis

of $4,000 or FMV of $5,000 $4,000Less: Insurance proceeds (1,500)

$2,500Less: $100 floor (100) Less: 10% AGI floor (5,512) -0-Total itemized deductions (9,000)

Less: Personal exemption (3,100)Taxable income $43,020

Tax on taxable income (from Tax Table) $ 7,494Less: Federal income tax withheld and estimated tax payments

($7,500 + $1,000) (8,500)Net tax payable (or refund due) for 2004 ($ 1,006)

Notes

(1) The $800 interest on the City of Boca Raton bonds is tax-exempt.

(2) Life insurance proceeds of $60,000 payable as the result of the death of Jane’ssister are excludible from gross income.

(3) The $5,000 gift from Jane’s aunt is excludible from gross income.

(4) The $2,100 loss on the loan to her friend, Joan Jensen, is deductible as anonbusiness bad debt (i.e., short-term capital loss). The assumption is made thatthe loan is a bona fide loan.

See the tax return solution beginning on page 7-18 of the Solutions Manual.

Part 2—Tax Planning

Salary and bonus $51,000Gross receipts from business $26,000Less:

Office rent $7,000Supplies 4,840Utilities and telephone 5,148Wages 5,500Payroll taxes 550Equipment rentals 3,300 (26,338)

Net business income (338)Interest income 700Alimony 10,000Adjusted gross income $61,362


Less:Itemized deductions $ 9,000Personal exemption 3,200 (12,200)

Taxable income $49,162

Tax on $49,162 [$4,090 + .25($49,162 – $29,700)] $ 8,956Less: Federal income tax withheld (7,500)Net tax payable (or refund due) $ 1,456

Jane would need to make estimated tax payments of $1,456 because the Federal incometax withholdings are expected to be less than the tax liability.

Willis, Hoffman, Maloney, and Raabe, CPAs5191 Natorp Boulevard

Mason, OH 45040

January 26, 2005

Ms. Jane Smith2020 Oakcrest RoadBoca Raton, FL 33431

Dear Ms. Smith:

This letter is in response to your request concerning the minimum amount of estimatedtax you will have to pay for 2005, so that you will not have to pay any additional taxupon filing your 2005 Federal income tax return.

Based on the 2005 estimates you provided to us, we have determined that your estimatedtax payments for the 2005 calendar year should total $1,456. This estimate is based onthe following computation.


Office rent $7,000Supplies 4,840Utilities and telephone 5,148Wages 5,500Payroll taxes 550Equipment rentals 3,300 (26,338)

Net business income (338) Interest income 700Alimony 10,000Adjusted gross income $61,362Less:

Itemized deductions $ 9,000Personal exemption 3,200 (12,200)


Tax on $49,162 $ 8,956Less: Federal income tax withheld (7,500)Net tax payable $ 1,456


Should you need more information or need to clarify anything, please contact me.Sincerely yours,


TAX FILE MEMORANDUM

January 10, 2005

From: John J. Jones

Subject: Jane Smith’s 2005 estimated tax

Today I talked with Jane Smith concerning her 2005 estimated tax. She wanted to knowthe minimum amount of estimated tax she would have to pay for the calendar year 2005so that she would not have to pay any additional tax upon filing her 2005 Federal incometax return.

The following projections for 2005 were provided by Jane Smith:

Items remaining unchanged from 2004:Salary—$50,000Christmas bonus—$1,000Interest expense on home mortgage—$9,000Interest income—$700Alimony—$10,000

Gross receipts from typing services—$26,000Office rent will remain unchanged—$7,000

All other expenses for typing services will increase 10% from 2004:Supplies—$4,400 in 2004; $4,840 in 2005Utilities and telephone—$4,680 in 2004; $5,148 in 2005Wages—$5,000 in 2004; $5,500 in 2005Payroll taxes—$500 in 2004; $550 in 2005Equipment rentals—$3,000 in 2004; $3,300 in 2005

The following 2004 items will not recur in 2005:Life insurance proceeds—$60,000Gift—$5,000Bingo winnings—$100Bad debt—$2,100Stolen silverware

Based on these estimates for 2005, Jane Smith should make 2005 estimated tax paymentstotaling $1,456. The determination was made as follows:


Office rent $7,000Supplies 4,840Utilities and telephone 5,148Wages 5,500


Payroll taxes 550Equipment rentals 3,300 (26,338)

Net business income (338)Interest income 700Alimony 10,000Adjusted gross income $61,362Less:

Itemized deductions $ 9,000Personal exemption 3,200 (12,200)


Tax on $49,162 $ 8,956Less: Federal income tax withheld (7,500)Net tax payable $ 1,456


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