Solutions to Chapter 4 Problem Assignments
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Solutions to Chapter 4 Problem AssignmentsCheck Your Understanding 1. Deferred Compensation Ricardo is a professional football player. In negotiating his contract for the upcoming season, Ricardo is given two options. He can receive (1) 12 monthly checks of $325,000 with no deferred payments or (2) $250,000 monthly with the $900,000 balance placed in escrow and payable to him (with interest) after he retires from professional sports. What are the tax implications of these two alternatives?
(2) If the contract provides for $900,000 in deferred compensation, Ricardo includes only $3,000,000 ($250,000 x 12 months) in income this year and is taxed on the $900,000 in the year he receives it. His employer is allowed a deduction of $3,000,000 in the current year and will deduct the $900,000 deferred compensation when it is paid. 2. Excessive Compensation Gaudy Gift Gallery Corporation (owned 100 percent by Barbara) operates a gift shop. Barbara employs her daughter, Jenny, after school and on weekends. Other employees with similar responsibilities are paid $7 per hour while Jenny is paid $15 per hour. Jenny earned $15,000 in the current year from the store. Is Jenny’s salary fully deductible by the corporation? Explain. Solution: No. Jenny's excess $8,000 [($15 - $7) x 1,000 hours] salary over what other employees would earn is considered excessive compensation. The $8,000 would probably be reclassified as a dividend, treated as dividend income to Barbara (Jenny’s mother) but no longer deductible by the corporation. 5. Employee Discount vs. Bargain Purchase What is the difference between a qualified employee discount and a bargain purchase by an employee? Solution: A qualified employee discount is a discount within allowable limits provided on a nondiscriminatory basis and is excluded from the employee's income. The excludable discount on merchandise is limited to the gross profit percentage times the price charged to customers. The excludable discount for services cannot exceed 20 percent of the price normally charged to customers. Discounts in excess of the allowable limits are taxed to the employee as compensation. A bargain purchase is a discount that is made available only to select employees and is taxable as additional compensation income to the employee. 6. De Minimis Benefits In which of the following cases should the employees report the benefit received as gross income? a. The employer provides an annual picnic for employees and their families to celebrate Independence Day. b. Employees can use the company photocopier for small amounts of personal copying as long as the privilege is not abused. c. Employees receive a free ticket to watch the Dolphins play the Raiders. d. Each employee receives a $50 check on his or her birthday. Solution: Only the $50 check in part d is taxable. Items a, b, and c are excluded de minimis fringe benefits. 8. Stock Options What is the difference between an NQSO and an ISO? Solution: ISOs receive favorable tax treatment from the perspective of the employee because they do not trigger income recognition at either the grant date or at exercise. Instead, the employee recognizes income when the stock is sold and the employee recognizes long-term capital gain rather than ordinary income. A negative feature of ISOs is that the employer receives no compensation deduction at any time for the option. An ISO has certain restrictions imposed on the option price, transferability, and exercise. A NQSO is more flexible, but the tax treatment is not as favorable for the employee. An employee recognizes income on a NQSO if he or she exercises the option. The amount of income recognized is equal to the difference (called the bargain element) between the strike price and the fair market value of the stock on the exercise date. The employer claims a matching compensation deduction when the employee recognizes income. In addition, if the strike price is below the fair market value at the date the option is issued and the option is exercisable, the employee will have income equal to that difference at that time and the corporation has a corresponding deduction. 11. Qualified Retirement Plan What are the advantages of a qualified retirement plan? Solution: The employer gets an immediate tax deduction as contributions are paid into a plan while the earnings accumulate tax free and the employee's tax is deferred until the benefits are received in a future year. Employees can make contributions to the retirement plan with before-tax earnings, postponing the tax on both the contributions and the earnings until the funds are withdrawn from the plan. 14. Individual Retirement Accounts Identify the type of IRA (Roth or traditional) that would be best for a taxpayer in each of the following circumstances: a. Sharon believes she will be in a higher tax bracket when she withdraws the money in retirement. b. Ken believes he will be in the same or a lower tax bracket in retirement. c. Susan wants to use her retirement savings for building her estate to pass on to her children.
b. Ken should use a traditional IRA because he will get a deduction now for the contribution and he defers taxation on the earnings until he withdraws the funds in retirement when his tax rate will be the same or lower. c. Susan should use a Roth IRA because there is no minimum distribution requirement during the owner's lifetime. The funds can be left in the account to grow tax free and then passed to beneficiaries.
James and Dean plan to start a new business and have not yet decided whether to organize as a partnership, an S corporation, or a C corporation. They are interested in taking advantage of any tax-free fringe benefits that may be available to them. Discuss the advantages and disadvantages from a fringe-benefit perspective of each form of business entity. Solution: Owners who are employees of a C corporation are eligible for all the employee fringe benefits discussed in this chapter such as group term life insurance, health insurance, cafeteria plan, and flexible spending arrangements. Partners are considered self-employed individuals and cannot participate in the fringe benefits provided on a tax-free basis to employees so they must use after-tax dollars for many of the benefits that employees can obtain with before-tax dollars. Some of the benefits that self-employed individuals cannot receive on a tax-free basis include health and accident insurance, group term life insurance, on-premises lodging, employee achievement awards, moving expenses, transit passes, and parking benefits. To mitigate the difference in this treatment, self-employed individuals may deduct the cost of health insurance premiums for AGI. Although S corporation shareholders can be paid a salary as an employee, if they own more than 2 percent of the S corporation's outstanding stock, they are ineligible for tax-free fringe benefits and are treated the same as partners for fringe benefit purposes. Crunch the Numbers 17. Excessive Compensation Charlie, who is in the 35 percent marginal tax bracket, is the president and sole owner of Charlie Corporation (a C corporation in the 34 percent tax bracket). His current salary is $700,000 per year. What are the income and FICA tax consequences if the IRS determines that $200,000 of his salary is unreasonable compensation?
$200,000 will not be deductible by Charlie Corporation increasing its tax liability by $68,000 ($200,000 x 34%). Charlie Corporation will save $2,900 ($200,000 x 1.45%) in Medicare taxes but lose the $986 ($2,900 x 34%) tax savings from deducting the Medicare taxes resulting in a net tax increase of $66,086 ($68,000 + $986 - $2,900). There is no change in Social Security taxes because the compensation is above the $106,800 limit. Charlie will save $2,900 in Medicare taxes. The $200,000 will be taxed at the 15% dividend income rate. Therefore, Charlie will save $40,000 [(35% - 15%) x $200,000] in income taxes in addition to the $2,900 savings in Medicare taxes for a total savings to him of $42,900. The net effect will be an increase in overall taxes of $23,186 ($66,086 - $42,900). 18. Timing of Compensation Amy, a cash-basis taxpayer, received a salary of $100,000 during year 1, year 2, and year 3. Amy also was awarded a bonus of $30,000 that was accrued by Amy's employer, Vargus Corporation (an accrual-basis, calendar-year C corporation), in December of year 1 but the bonus was not paid until March 31 of year 2. In December of year 2, Vargus accrued an additional $32,000 bonus that was paid to Amy in January of year 3. a. How much income does Amy recognize in year 1, year 2, and year 3? b. How much can Vargus Corporation take as a compensation deduction in year 1, year 2, and year 3? Solution: Because Amy is a cash-basis taxpayer she includes the salary and bonus in income in the year she receives it.
Vargus Corporation must pay the accrued bonus within 2½ months after year-end to deduct it in the year accrued. If paid later than 2½ months after year-end, it is deducted in the year paid. 19. Group Term Life Insurance Tom is 68 years old. His employer pays the premiums for group term life insurance coverage of $110,000. The cost of Tom’s coverage to the company is $3,000. a. If the plan providing this coverage is nondiscriminatory and Tom is not a key employee, how much gross income does Tom have? b. How does your answer to (a) change if Tom is a key employee? c. If the plan is discriminatory, but Tom is not a key employee, what is Tom’s gross income? d. How does your answer to (c) change if Tom is a key employee?
b. Same answer as part a. c. Same answer as part a. d. $3,000. Tom is a key employee and the plan is discriminatory so he must include in income the greater of the actual premiums ($3,000) or the $1,676.40 computed from the table without excluding the first $50,000 (110 increments x $1.27 table rate x 12 months = $1,676.40). 20. Fringe Benefits under Cafeteria Plan Priscilla, an employee of Choice Corporation, receives an annual salary of $70,000. Choice has a cafeteria plan that allows all employees to choose an amount equal to 8 percent of their annual salary from a menu of nontaxable fringe benefits or to take cash. Priscilla selects $50,000 of group term life insurance that costs the company $900 and also selects health insurance that costs the company $2,000; she takes the remaining $2,700 in cash. How much compensation income does Priscilla recognize from Choice Corporation? Solution: Priscilla includes $72,700 in income ($70,000 salary + $2,700 cash benefits). The group term life insurance and health insurance are tax-free benefits. 21. Flexible Spending Arrangement Jennifer elects to reduce her salary by $3,500 so she can participate in her employer's flexible spending arrangement. Her salary reduction is allocated as follows: $2,400 for medical and dental expenses and $1,100 for child care expenses. During the year, Jennifer uses $2,000 of her salary reduction for medical and dental care and $1,000 for childcare assistance. a. How much of the $3,500 set aside in the FSA is included in Jennifer's gross income? b. How much of the $3,000 reimbursed from the FSA is included in Jennifer's gross income? c. What happens to the remaining $500?
b. Zero. It is all excluded. c. It is forfeited. There is no adjustment to Jennifer's income or taxes for the unused amount placed in the FSA.
Clark works all year at the front desk of the Dew Drop Inn and earns a salary of $30,000. He is offered the option of a $400-per-month living allowance or rent-free use of a room at the Dew Drop Inn. Clark chooses to live at the inn in a room that normally rents for $400 per month. How much gross income does Clark have from the Dew Drop Inn? Solution: Clark must include $34,800 in income [$30,000 salary + ($400 x 12 months)]. Lodging must be required as a condition of employment to be excluded. 23. Employee Discount Kevin is an employee of One Hour Dry Cleaners, Inc. All employees of One Hour are eligible for a 40 percent discount on their dry cleaning. During the year, Kevin paid $300 for cleaning that would normally have cost $500. Does Kevin have any taxable income as a result of this discount? Solution: Yes, $100 is taxable. The excludable discount for services cannot exceed 20 percent (20% x $500 = $100 maximum tax-free discount). Kevin's discount was $200 - $100 maximum tax-free discount = $100 excess discount that is taxable. 24. Tax-Free Fringe Benefits Betsy receives a salary of $50,000 from her employer (a retail clothing store) and several fringe benefits. Her employer pays premiums of $300 for her $40,000 group term life insurance coverage and pays $2,400 for medical insurance premiums. Her employer provides dependent care facilities (where she places her young children while she is at work) valued at $4,500 per year. Her employer also allows employees to purchase clothing (the employer’s inventory) at 50 percent off the retail sales price (which is 5 percent more than the employer’s cost). During the year, Betsy purchases clothing with a retail value of $10,000 for $5,000. In addition to her salary, how much must Betsy include in gross income? Solution: Zero. All of the fringe benefits are tax free. An employer can provide up to $50,000 in group term life insurance and an unlimited amount of medical insurance tax free. Up to $5,000 of dependent care benefits can be provided tax free. Employee discounts for merchandise are tax free as long as the employee pays at least the employer's cost. 25. Moving Expense Qualification Jill worked for a business in Denver. She took a new job with a different company in Colorado Springs, 90 miles away. Her commuting distance from her old home to her old employer in Denver was 15 miles. If she does not move to Colorado Springs, her commuting distance from her old home near Denver to her new place of employment in Colorado Springs would be 70 miles. She decides to move to Colorado Springs. The commuting distance from her new home in Colorado Springs to her new place of employment is 10 miles. a. Which commuting distances are important in meeting the mileage test for deductibility of moving expenses? b. By how many miles does Jill’s commute exceed the minimum necessary to pass the test? Solution: a. The important distances are the 15 miles from the old home to the old employer and the 70-mile distance the commute would be if she did not move. b. She exceeds the minimum by 5 miles. (70 miles - 15 miles = 55 miles - 50 mile minimum = 5 miles) 26. Moving Expense Deduction and Reimbursement In January, Susan's employer transferred her from Chicago to Houston (where she continues to work for the remainder of the year). Her expenses are as follows:
a. If Susan is not reimbursed for any of these expenses, how much of her moving expenses can she deduct? b. If Susan’s employer reimburses her $3,600 for all of these moving expenses except for the lease cancellation fee, will she have any taxable income? Solution: a. Susan can deduct $2,500 ($2,300 transportation for household goods + $200 airfare). b. Susan will have $1,100 in taxable income ($3,600 reimbursement - $2,500 qualified expenses = $1,100). 27. Restricted Stock Luis received 400 shares of his employer’s stock as a bonus. He must return the stock to the company if he leaves before the 5-year vesting period ends. The fair market value of the stock at the time it was issued was $20,000. After five years, the stock vests when it has a fair market value of $75,000. Two years after vesting, Luis sells the stock for $100,000. a. If Luis makes no election, how much income or gain does he recognize (1) when the stock is issued, (2) when the stock vests, and (3) when the stock is sold? b. If Luis makes an election to accelerate the recognition of income, how much income or gain does he recognize (1) when the stock is issued, (2) when the stock vests, and (3) when the stock is sold? c. If Luis makes an election to accelerate the recognition of income but he leaves the company after three years, is he eligible for a refund of taxes paid?
b. (1) $20,000; (2) zero; (3) $80,000. If Luis makes an election to accelerate the recognition of income, he will recognize the fair market value of the stock as income in the year of receipt. His ordinary income in the first year would be $20,000. There is no recognition of income or gain when the stock vests. Upon sale of the stock, Luis will recognize a long-term capital gain of $80,000 ($100,000 - $20,000 basis). c. No. If Luis leaves the company before the stock vests, he will not be allowed a deduction for the loss on the stock forfeited, nor will he be allowed a refund of any taxes paid as a result of the prior income recognition.
Five years ago, Cargo Corporation granted a nonqualified stock option to Mark to buy 3,000 shares of Cargo common stock at $10 per share exercisable for five years. At the date of the grant, Cargo stock was selling for $9 per share. This year, Mark exercises the option when the price is $50 per share. a. How much income should Mark have recognized in the year the option was granted? b. How much income does Mark recognize when he exercises the option? c. What are the tax consequences for Cargo from the NQSO in the year of grant and in the year of exercise?
b. $120,000 bargain element is ordinary income. [($50 FMV - $10 strike price) x 3,000 shares = $120,000] c. There are no tax consequences in the year of grant but Cargo deducts the $120,000 bargain element as compensation paid in the year Mark exercises the options.
Three years ago, Netcom granted an ISO to Karen to buy 2,000 shares of Netcom stock at $6 per share exercisable for five years. At the date of the grant, Netcom stock was selling for $5 per share. This year, Karen exercises the ISO when the price is $30 per share. a. How much income should Karen have recognized in the year the ISO was granted? b. How much income does Karen recognize when she exercises the ISO? c. What are the tax consequences for Netcom from the ISO in the year of grant and in the year of exercise? d. What are the tax consequences to Karen and to Netcom if Karen sells all of the stock for $50 per share two years after exercising the options? Solution: a. Zero. No income is recognized when the option is granted. b. Zero. No taxable income when the option is exercised (however, the bargain element is subject to the alternative minimum tax). c. Zero. No tax consequences for Netcom in the year of grant or exercise. d. Karen has an $88,000 capital gain [($50 selling price - $6 cost) x 2,000 shares]. Netcom receives no tax deduction and thus no tax benefit. 30. Stock Appreciation Rights Four years ago, Handcock Corporation granted 300 SARs to Maria as a bonus. Handcock's stock was worth $20 a share on the date of grant. Maria exercises her SARs this year when the stock is worth $60 a share. a. How much income should Maria have recognized in the year she received the SARs? b. How much income does Maria recognize when she exercises the SARs? c. If Maria is in the 35 percent marginal tax bracket, what is her after-tax cash flow from the exercise of the SARs? d. Does Handcock Corporation get a tax deduction for the SARs and if yes, when and in what amount? Solution: a. Zero. There is no income when the SARs are granted. b. $12,000 income recognized when she exercises the SARs. [($60 - $20) x 300 SARs] c. $7,800. Maria will pay a tax of $4,200 ($12,000 x 35%) on the exercised SARs. Maria's after-tax cash flow from the exercise of the SARs is $7,800 ($12,000 - $4,200 tax). d. Yes. Handcock deducts $12,000 as compensation expense the same year that Maria exercises the SARs and is taxed on the income. 31. Employee Benefits Larry, age 32, works for Horizon Corporation. His annual salary is $60,000. Horizon provides the following benefits to all employees:
How much income must Larry recognize and how much can Horizon Corporation deduct in the current year? Download 112.4 Kb. Share with your friends:
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