Solutions to Chapter 4 Problem Assignments

Horizon deducts $60,000 salary + $120 life insurance + $2,100 medical insurance + $2,500 pension contributions + $100 watch = $64,820.

32. Individual Retirement Account

Nick, age 53, is single and has AGI of $58,000. He contributes $5,000 to his IRA in 2010.

a. How much can Nick deduct if he is not covered by an employer-sponsored qualified retirement plan?

b. How much can Nick deduct if he is covered by an employer-sponsored qualified retirement plan?

b. $4,000 is deductible. ($58,000 - $56,000)/$10,000 = 20% phased out. $5,000 – ($5,000 x 20%) = $4,000.

33. Roth IRA

Jennifer, age 35, is single and is an active participant in her employer's qualified retirement plan. Compute the maximum Roth IRA contribution that she can make in 2010 if:

a. Her adjusted gross income is $130,000.

b. Her adjusted gross income is $59,000.

c. Her adjusted gross income is $38,000 and she makes a $2,000 contribution to a traditional IRA.

Solution: a. Zero. Her adjusted gross income exceeds $120,000.

b. $5,000. Her income is below $105,000 where the phase-out of contributions begins.

c. $3,000. She must reduce her maximum allowable Roth contribution deduction of $5,000 by the $2,000 she contributes to her traditional IRA.
34. Self-Employment Tax

Carrie owns a business that she operates as a sole proprietorship. The business had a net profit of $25,000. This is Carrie’s only earned income.

a. How much must she pay for self-employment taxes?

b. How much can she deduct on her tax return?

c. If the business had a net loss of $10,000 (instead of a $25,000 profit), how much in self-employment taxes must Carrie pay?

Solution: a. $3,532 ($25,000 x 92.35% x 15.3%)

b. $1,766 ($3,532 x 50%)

c. Zero. No self-employment tax is owed when there is a loss.
35. Self-Employment Tax

George has $71,300 in salary from his full-time position and $43,000 in net income in 2010 from his sole proprietorship. What must he pay for self-employment tax? What portion of this can he deduct?

George deducts $2,776.80 ($5,553.60 x 50%) as a deduction for AGI.

Luis operates a bakery as a sole proprietorship. He has four bakers whom he employs on a full-time basis and who participate in a company-paid health insurance plan. Luis is also covered by this same plan. The annual premiums are $2,300 per person. The business paid $11,500 for health insurance premiums for the year. Are these insurance premiums deductible? If they are, where should Luis deduct them on his tax return?

$2,300 for Luis's own insurance is deductible for AGI on his Form 1040.

Alexander works as an electrician at a small company that provides no retirement benefits. He receives a salary of $45,000. In addition, Alexander operates a small roof repair service as a sole proprietor; this business has a net loss of $2,500. In addition, Alexander realizes $800 of net income from rental property and $1,500 in interest income. What is Alexander’s earned income for determining the amount he is eligible to contribute to an IRA?

Wendy is a single individual who works for MTP, Inc. During the entire calendar year she works in France and pays French taxes of $8,000 on her $90,000 salary. Her taxable income without considering her salary from MTP is $10,000. Should Wendy claim the income exclusion or tax credit and how much tax does she save by using the alternative selected?

Mark works in a foreign country for the entire calendar year. His salary is $120,000 and he pays $18,000 in tax to the foreign government. His other taxable income (from U.S. sources) after all deductions is $30,000. If he claims the foreign earned income exclusion, how much are his creditable foreign taxes?

These questions require answers that are beyond the material that is covered in this chapter.

40. Business Formation

Evan is setting up a new business. He can operate the business as a sole proprietorship or he can incorporate as a regular C corporation or as an S corporation. He expects that the business will have gross income of $130,000 in the first year with expenses of $25,000 excluding the following. He plans to take $35,000 from the business for living expenses as a salary and will have the business pay $3,000 annually for his health insurance premiums.

a. Compute the total tax cost in 2010 for each alternative if Evan is single and this is his only source of income.

b. Which alternative business form do you recommend based solely on the first year tax costs?

c. What are some of the other factors Evan should consider in deciding between a C corporation and an S corporation for his business?

Solution: a. (1) If Evan chooses to be a sole proprietorship, his total tax cost will be $32,410 ($14,836 + $17,574.21)

Self-employment tax: ($130,000 - $25,000) x 92.35% = $96,967.50 x 15.3% = $14,836.

Adjusted gross income: $105,000 income – ($14,836 x 50%) - $3,000 insurance premiums = $94,582 AGI. $94,582 - $5,700 standard deduction - $3,650 exemption = $85,232 taxable income. Income tax on $85,232 = $17,574.21 [$16,781.25+ 28%($85,232-$82,400)]. The income tax on $85,232 can also be calculated as: ($8,375 x 10%) + ($25,625 x 15%) + ($48,400 x 25%) + ($2,832 x 28%) = $17,574.21.
(2) If Evan chooses to be an S corporation, his total tax cost will be $24,570 ($2,678 + $434 + $18,780 + $2,678).

The S corporation deducts FICA taxes paid of $2,678 ($35,000 x 7.65%) and FUTA taxes of $434 ($7,000 x 6.2%). The total amount of income that will pass through to Evan’s on the K-1 will be $63,888 ($130,000 - $25,000 - $35,000 - $2,678 - $434 - $3,000) plus $3,000 for health insurance. Because Evan owns more than 2% of the S corporation stock, he is taxed on the health insurance and then can deduct the $3,000 for AGI.

Evan’s gross income is $101,888 [$35,000 wages + $63,888 S corporation income + $3,000 health insurance]. Evan’s adjusted gross income is $98,888 ($101,888 - $3,000 insurance premiums). Evan’s taxable income is: $89,538 ($98,888 AGI - $5,700 standard deduction - $3,650 exemption). His income tax is $18,780 [$16,781.25 + 28%($89,538-$82,400)]. The income tax on $89,538 can also be calculated as: ($8,375 x 10%) + ($25,625 x 15%) + ($48,400 x 25%) + ($7,138 x 28%) = $18,780. Evan also pays his employee share of FICA tax of $2,678 ($35,000 x 7.65%).
(3) If Evan chooses a C corporation, his total tax cost will be $20,192 ($10,972 corporation income taxes + $2,678 employer FICA taxes + $434 FUTA taxes + $3,428.75 personal income taxes + $2,678 employee FICA taxes). The C corporation will pay $2,678 ($35,000 x 7.65%) for FICA taxes and $434 ($7,000 x 6.2%) FUTA taxes. The C corporation will have taxable income of $63,888 ($130,000 - $25,000 - $35,000 - $2,678 - $434 - $3,000). The tax liability for the C corporation will be $10,972 [$7,500 + 25% ($63,888-$50,000)].

Evan has taxable income of $25,650 ($35,000 AGI - $5,700 standard deduction - $3,650 exemption). His personal income tax liability is $3,428.75 [$837.50 + 15%($25,650-$8,375)]. The income tax on $25,650 can also be calculated as: ($8,375 x 10%) + ($17,275 x 15%) = $3,428.75.He also pays employee FICA taxes of $2,678.

• 
  Shareholders of both C and S corporations can be employees of a corporation, but more than 2% shareholder-employees of S corporations are not eligible for most tax-free fringe benefits and therefore will have to use after-tax dollars for fringe benefits (except health insurance which is deductible for AGI).
  
• 
  If $35,000 is considered to be an unreasonably low salary, the IRS might reclassify some of the S corporation’s distribution as salary, requiring the payment of additional employment taxes (and possibly penalties).
  
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  An S corporation’s income is taxed to the shareholders when earned, even if not distributed.
  
• 
  What will the expected profits (losses) be in future years? Based on the expectations, the overall marginal tax cost may be higher for a C corporation in future years. If there are losses, the losses flow through to and S corporation owner and are immediately deductible. Losses of a C corporation can only offset profits from other C corporation years.
  
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  Will the C corporation pay dividends? The dividend tax rate is 15%.
  

41. Reasonable Compensation

Cindy is President and sole shareholder of Chipsmart Corporation. Through her hard work (frequently putting in 70 hours per week), she has managed to triple the number of clients and revenue in the past year. Chipsmart has never paid a dividend to Cindy, although it does have retained earnings. Last year, Cindy's salary was $200,000; this year, due to her success, she would like to pay herself a $600,000 salary. As Chipsmart's tax adviser, prepare a list of questions you would like to ask Cindy when you meet her to discuss the salary increase.

Solution: Some possible questions include:

• 
  What is the extent and scope of Cindy's duties for the corporation?
  
• 
  What do other executives in comparable positions in comparable companies earn annually?
  
• 
  Have other executives been as successful in expanding their business as Cindy has been?
  
• 
  How does Cindy's salary compare to the corporation's gross and net income?
  
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  Was her salary kept unusually low in the beginning with the expectation that it would be increase significantly if she proved to be successful in expanding the company?
  
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  Does the corporation plan to pay dividends?
  

42. Exercising Incentive Stock Options

What tax planning should be done before exercising incentive stock options?

Solution: Although the taxpayer pays no regular income tax when an ISO is exercised, the taxpayer must include the bargain element (the difference between the strike price and the fair market value when exercised) in alternative minimum taxable income (AMTI) for the year exercised. The alternative minimum tax (AMT) is assessed at a 26 – 28% rate (refer to Chapter 11 for details). The taxpayer must include the bargain element in AMTI even if the value of the stock declines after exercising the ISO, so tax planning should be done to minimize the AMT. The following four strategies should be considered when exercising ISOs:

1. Exercise sooner rather than later

If the value of the stock is expected to rise steadily, exercising the ISOs soon after they vest will minimize the amount of bargain element that is subject to the AMT.

2. Spread the exercise over several years

If the ISO does not expire before the end of the year, and the stock has already increased substantially in value, a partial exercise in one year, with the balance exercised in a future year or years, will minimize the amount of bargain element subject to the AMT in any one year.

3. Minimize the other elements of AMTI

If a large bargain element cannot be avoided, then try to minimize other elements that increase AMTI. For example, it may be possible to defer a year-end bonus into the next year.

4. Avoid AMT through a disqualifying disposition

The AMT can be completely avoided if the shares acquired with the ISO are sold in the same year as the ISO is exercised. This will be considered a disqualifying disposition (because the stock is not held for more than one year from exercise date) and any gain will be taxed at ordinary income tax rates (instead of favorable long-term capital gains rates). If the stock starts to decline in value, a disqualifying disposition may result in lower tax and increased cash flow compared to holding the stock while it continues to decline.
43. Stock Option Taxation

Construct a scenario in which the tax treatment of stock options is very unfavorable for the employee.

The recent scandal on backdating stock options has introduced new terminology to describe these controversial practices. Describe what you think each of these terms means.

a. Backdating

b. Repricing

c. Reloading

d. Spring-loading

e. Bullet-dodging

Solution: a. Backdating is claiming an option was granted earlier than it actually was, to take advantage of a more favorable exercise price, to enhance its potential value.

b. Repricing involves setting a new, lower exercise price for existing options, because of a decline in the market price of the stock subsequent to the original award.

c. Reloading is automatically granting new options, at current market prices, to replace some or all of the options that are being exercised.

d. Spring-loading is awarding options just before the release of positive news that is likely to increase the stock price.

e. Bullet-dodging involves postponing the award of options until after bad news has driven down the stock price.

See Maremont and Forelle, “Bosses’ Pay: How Stock Options Became Part of the Problem,” The Wall Street Journal, December 27, 2006, page A1, for a discussion of these terms and additional information on the stock option backdating problem.

Would an employee who first becomes a participant in a pension plan at age 52 generally prefer to have a defined benefit plan or a defined contribution plan? Explain.

What do you think the effect would be if Congress changes the law so that retirement plan contributions are included in taxable income at the time they are made rather than taxing the payment when received in retirement?

Identify the issues or problems suggested by the following situations. State each issue as a question.

47. Reasonable Compensation

Susan is the second-highest-paid executive for Sanibel Corporation, a publicly traded corporation. Her salary is $1,600,000.

Virginia is the president and founder of VT Corporation. She is extremely devoted to the business, frequently working 70-hour weeks. She did not take any salary from the business for its first two years of operations. She is now receiving a salary that is 150 percent of what comparable businesses pay their presidents.

George just accepted a job as an apartment manager and is paid a salary of $28,000 per year. In addition to the salary, he is offered the choice of rent-free use of an apartment or a $500 per month housing allowance. George decides to accept the rent-free apartment.

Victor has the full-time use of a company owned Jaguar automobile. This year Victor drove 24,000 miles for business and 10,000 personal miles. His employer does not require him to report his personal mileage but, instead, includes the lease value of the full-time use of the automobile as additional compensation on his Form W-2.

In February, Margaret's employer asked her to move from the Miami office to the Atlanta office. In March, Margaret spent $900 on a house-hunting trip to Atlanta. She located a home and moved into it in April. Margaret's employer reimbursed her for all direct costs of moving to Atlanta and also for the cost of the house-hunting trip.

Sarah is single and earns $60,000 in salary. She wants to invest $2,500 per year in an IRA but is not sure which type she qualifies for and whether this would be a better investment than investing the money in preferred stock paying a 6 percent annual dividend.

Ken is single and earns a salary of $60,000 per year. He also receives $4,000 a year in taxable interest and dividend income. Ken would like to contribute the maximum allowable to his company's qualified pension plan.

Solutions to research problems are included in a separate file.

58. Excess Mileage Allowance

Go to www.legalbitstream.com. Locate and read Regulation Section 1.62-2(j), example 6. If an employer has an otherwise accountable plan but reimburses employees at 60 cents per mile, how is the reimbursement treated?

Solution: The amount that exceeds the standard mileage allowance [number of miles x (60 cents – 50 cents)] is treated as taxable compensation to the employee. No later than the first payroll period following the payroll period in which the business miles of travel are substantiated, the employer must withhold and pay employment taxes on the amount that exceeds the standard mileage allowance.
59. Flexible Spending Arrangement

Go to www.legalbitstream.com. Locate and read Revenue Ruling 2003-102. What type of medicines and drugs can be reimbursed through a flexible spending arrangement (FSA)? What change takes effect in 2011?

Go to www.irs.gov and print Form 1040 and Schedule SE. Complete the first page of Form 1040 and Schedule SE for Angelina, a single individual, who reports $75,000 of net profit on her Schedule C from her sole proprietorship.

a. What is Angelina’s adjusted gross income?

b. What is Angelina’s self-employment tax?