Tax Ch 4 Flashcards by John Mussman

FEDERAL INCOME TAX FORMULA

Income (broadly defined)
Less: Exclusions
Gross Income

Less: Deductions for AGI (above-the-line deductions)

Adjusted Gross Income (“The Line”)

Less: Itemized or Standard Deduction (below-the-line deductions)
Less: Personal and Dependency Exemptions (suspended after 2017)
Less: 20% deduction for QBI (after 2017)

Taxable Income
Tax on Taxable Income
Less: Tax Credits

Tax Due (or Refund Due)

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When is Income Taxed?

Tax Year and Accounting Method
Realization and Recognition
Sources of Income
Investment Activities
Income
Exclusions
Personal Activities
Income
Exclusions

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TAXABLE YEAR

Generally, a 12-month period
Calendar year is used by most taxpayers
Fiscal year can be elected if adequate records are maintained
52 to 53-week year
Ends on specified day of week of last month of tax yea

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METHODS OF ACCOUNTING

Cash-basis taxpayers recognize income when it is received (or set
aside)
Individuals and some businesses
Accrual-basis taxpayers recognize income when it is earned
Most businesses are accrual-basis taxpayers
Hybrid Method
Used when inventory is a material income producing factor

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REALIZATION VS. RECOGNITION

Realization occurs when income is received, or when a gain on a
property transaction becomes fixed.
Recognition occurs when the income is reported on the tax return.
All realized gains are recognized, unless an exception applies

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RECOGNITION OF INCOME (1 OF 2)

Follows realization principal from accounting
Income is recognized (taxed) when realized unless an exception
applies.
Generally, any accretion to wealth is income.
Mere appreciation in wealth (economic income) that is not fixed
and measurable at a particular point in time (i.e., objectively
determined) is not considered realized income.
Congress has excluded certain accretions of wealth from the
definition of income for tax purposes

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RECOGNITION OF INCOME (2 OF 2)

Income is recognized if received
In cash
In kind (property or services)
– Barter transactions
Income does not include recovery of capital investment (capital
recovery doctrine).

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SOURCES OF INCOME

Investment Income
* Doctrine of the Fruit and the Tree
* Income taxed to owner

Employment Income
* Doctrine of the Fruit and Tree
* Income taxed to earner
* Self-employment Income
* Wages

Income from Personal Activities
* Alimony (from pre-2019 divorce

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INCOME TAX AND COMMUNITY PROPERTY

Half of income earned belongs to each spouse
–Same impact as married filing jointly (MFJ) for income tax
Married Filing Separately (MFS)
– Community-property income split equally
–Poses a problem if spouses are not cooperating

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INCOME FROM INVESTMENT ACTIVITIES
* Capital Gains
* Interest
–Original Issue Discount
–Gifting of Debt Instruments
* Dividend Income
* Rental and Royalty Income
* Annuity Distributions
* Income from Life Insurance and Endowment Contracts
* Traditional IRAs
* Income from Partnerships, S-Corps, and LLCs
* Income from Trusts and Estates

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CAPITAL GAINS TAX RATE: 2023

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CAPITAL GAINS TAX RATE

Exceptions:
Collectibles: 28%
Unrecaptured Section 1250 Gain: 25%
– Resulting from straight-line depreciation
Effective rate may be more than maximum
Capital gains increase a taxpayer’s AGI
Increased AGI may lead to phaseouts

Don’t forget the 3.8% Medicare tax imposed by the Affordable Care Act

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ORIGINAL ISSUE DISCOUNT (OID)

Doctrine of Constructive Receipt
OID = Maturity Value – Purchase Price
Taxpayer recognizes imputed interest each year. As interest is
recognized:
–OID is amortized (reduced by the amount recognized)
– The taxpayer’s basis increases (by the amount recognized)
Exceptions:
Series E and EE Savings Bonds

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ORIGINAL ISSUE DISCOUNT (OID): EXAMPLE

On January 1st of this year, Goldilocks purchases a 30-year zero
coupon government bond at a market rate of 8% paying $99.38.
How much interest income does she report this year?

Income = $99.38 x 0.08 = $7.95

New Basis = $99.38 + 7.95 = $107.33 (at year end)

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INCOME TAX ISSUES ASSOCIATED WITH GIFTS OF DEBT INSTRUMENTS

Donee and donor report interest income based on number of days
the instrument was held, regardless of who receives the payment.
There may also be gift, estate, and generation-skipping transfer tax
consequences

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DIVIDENDS

Distribution of earnings by corporation
Taxable to shareholders to extent of earnings
If distribution exceeds earnings, it is taxed:
– First, as a return of basis
–Then, as capital gain
Qualified Dividends:
Tax Rates
–Follow the capital gains rate table
Paid by U.S. corporation or qualified foreign corporation
Shareholder must meet holding period requirement

Don’t forget the 3.8% Medicare tax imposed by the
Affordable Care Act

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ANNUITY TAXATION

                            Investment in contract Exclusion Ratio  = ---------------------------------- x distributions rec'd 
                               Expected return

For annuity starting dates after 12/31/1986
Total exclusion cannot exceed investment in the contract
Un-recovered investment is taken as a deduction on the
annuitant’s final income tax return
Withdrawals before age 59½ are also subject to a 10% early
distribution penalty
Exceptions: Death and disability
Distributions prior to annuitization are taxed on LIFO basis

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INCOME TAXATION AND LIFE INSURANCE

Endowment Contracts
Payout before death = taxable income
Surrender
Amount Realized – Basis = Taxable Income
Death Benefit excluded from income (see exclusions)
-Unless Transfer for Value Rule applies

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INCOME TAXATION AND IRAs

Generally, ordinary income
Exceptions:
Return of basis
– Use exclusion ratio
Roth IRAs (excluded from income)
Penalties
Too early (early distribution penalty before age 59½)) - 10%
Too much (excess contribution penalty) – 6%
Too late (late required distribution penalty) – 50%
–SECURE 2.0 Act, tax years after 12/29/2022, penalty decreased from
50% to 25% (or 10% if failure corrected timely)

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INCOME TAXATION OF BUSINESS ENTITIES

Pass-Through Entities
–Partnerships
– Limited Liability Companies
– S-Corporations
Income is taxed to owners based on ownership percentage.
– Depending on the type of business, adjustments may be
necessary to calculate the amount of business income subject to
tax in the owner’s hands.
–As income is recognized, owner’s basis increases

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INCOME TAX RATES FOR ESTATES AND
TRUSTS: 2023

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INVESTMENT INCOME EXCLUDED FROM GROSS INCOME

Municipal Bond Interest
–Some exceptions apply
Life Insurance
– Death Benefits
– Accelerated Death Benefits
Roth IRAs
Education-related exclusions
– Savings Bond Interest
– Qualified Tuition Programs/529 Plans
– Coverdell Savings Accounts
Improvement by Tenant to Landlord’s Property

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MUNICIPAL BOND INTEREST

Interest is exempt for regular tax purposes
Interest may also be excluded from state taxation
Capital gains are taxable

Tax Equivalent Yield

           tax free rate  TEY = ------------------------------
     1- marginal tax rate

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LIFE INSURANCE PROCEEDS

Death benefits paid by reason of the death of the insured are
exempt from income tax.
– Exception: Transfer for Value Rule
Distributions from regular in-force policies
– First, treated as return of basis
– Next, treated as a loan
Modified Endowment Contracts
–FIFO basis: distributions taxable to extent of gain
Accelerated Death Benefits are excluded from gross income if:
–Terminally Ill: death expected in 24 months, or
–Chronically Ill: unable to perform 2 of 6 activities of daily living

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ROTH IRAs

Contributions are not deductible.
Distribution is tax free if qualified: must meet 5-year rule and be made.
–After age 59½
– After death or disability of the owner
– For first-time home purchase (up to $10,000)
FIFO treatment applies
Basis distributions are always tax free and penalty free

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EDUCATION EXCLUSIONS (1 OF 4)

Savings Bond Interest Income Exclusion
* Qualified US Savings Bond
–Must be EE bonds issued after Dec 31, 1989
–Issued in the name of taxpayer and/or spouse
– Bond owner must be at least 24 years old on date of issue
* Subject to phaseout

Phaseout MAGI amounts for Savings Bond Interest Exclusion:

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EDUCATION EXCLUSIONS (2 OF 4)

529 Plans
* Distributions are tax free if used to cover qualified education
expenses.
* Sponsored by states or higher education institutions
* Can front-load with 5 annual exclusion gifts per donor per
beneficiary
* $17,000 x 5 = $85,000 for 2023 per donor / per donee
* No income phaseouts apply

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EDUCATION EXCLUSIONS (3 OF 4)
Coverdell Education Savings Accounts
* $2,000 maximum per year until beneficiary reaches age 18
* Distributions are tax free if used to cover educational expenses,
including.
* Qualified elementary/secondary school expenses
* Special needs expenses
* Contributions to 529 plans
* Account must be used or rolled over by the time the beneficiary
reaches age 30.

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EDUCATION EXCLUSIONS (4 OF 4)
Coverdell Education Savings Accounts
* Income phaseouts apply

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COVERDELL: CALCULATION OF REDUCTION & CONTRIBUTIONS EXAMPLE

Ziggy and his wife, Marley, would like to make a contribution to a
Coverdell Education Savings Account for their son, Jethro. Ziggy and
Marley are married filing jointly and their AGI is $200,500. Because
they are in the phase-out range, Ziggy and Marley will not be able to
make the maximum contribution of $2,000. Instead, their contribution will be reduced by $700.
Their contribution limit is $1,300 ($2,000 - $700).

                $200,500 - $190,000 $2,000 x-   -----------------------------    = $700 (Reduction)
               $220,000 - $190,000

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INCOME FROM PERSONAL ACTIVITIES

Prizes and Awards
Alimony and Separate Maintenance (divorce before 2019)
Income from Discharge of Indebtedness
Imputed Interest on Below Market Loans
Other Income
– Gambling winnings
– Fees for jury duty
–Fees for being executor or personal representative
–Hobby income

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PRIZES AND AWARDS

General Rule: Included in Income

If paid directly to charity at request of recipient, excluded from gross income if:
–The prize was given primarily in recognition of religious,
charitable, scientific, educational, artistic, literary, or civic
achievement.
–The recipient must not apply for the award.
–The recipient must not be required to render substantial future
services.
Employee achievement awards are excluded if:
Award is not in excess of $400.
Total awards to employee cannot exceed $1,600.
Awards must be in the form of tangible personal property

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PAYMENTS TO FORMER SPOUSES

Alimony pursuant to a decree entered into on or prior to December 31, 2018
– Deducted (above the line) by payor
–Taxable to payee
Alimony pursuant to a decree entered into after December 31, 2018, or a
decree substantially modified after that date:
– No deduction by payor
–Not taxable to payee
Child Support
– No deduction permitted
Property Settlement
– No deduction permitted

ALIMONY” DEFINED

Payment in cash
Pursuant to a divorce or separation instrument
–Instrument must not designate the payment as something other
than alimony.
Parties are not members of the same household
Payments do not extend beyond death of payee
Not between spouses filing jointly

WHAT IS NOT ALIMONY

Elective Non-Alimony Payments
Child Support
–Payments reduced upon a contingency specifically relating to a
child will be treated as child support.
Rent-Free Occupancy of the Home

ALIMONY VS. CHILD SUPPORT: EXAMPLE

Under a provision of a divorce decree entered into before 2019,
Hector is to pay his former spouse, Lydia, $5,000 per month. Lydia
has custody of their only child, Tuco. When Tuco reaches age 18,
the payments are to be reduced to $3,000 per month. The $3,000 is
to be paid to Lydia for as long as she lives or until she remarries.
$2,000 of the $5,000 is child support because the payment is
reduced when Tuco reaches age 18 (a contingency related to a
child).
The remaining $3,000 is alimony.

PROPERTY SETTLEMENT AT DIVORCE

Transfer property between divorcing spouses
No income tax deduction available
Treated as a gift to a spouse for income tax purposes (IRC Section 1014)
– No gain/loss recognized
– Carry-over basis

SPECIAL ISSUES WITH DIVORCE SETTLEMENTS

Medical Insurance
–Treated as alimony in entirety if the agreement does not specify
what part was for the child’s support
Life Insurance
Payee spouse is owner
– Premium payments made by payor spouse are alimony
Cash values are not considered to be alimony
Payee spouse is named as beneficiary
– Premium payments are not alimony
–Death benefit included in payor spouse’s estate
– Death benefit is tax free to payee spouse

DISCHARGE OF INDEBTEDNESS

Debt forgiveness is an accretion to wealth.

To the extent the taxpayer is solvent, must include debt forgiven
as income.
Other exceptions:
– Certain student loans
– Debt forgiven as a gift
– Debt discharged is qualified principal residence
indebtedness which is discharged before January 1, 2026

IMPUTED INTEREST RULES

BELOW-MARKET LOANS

Corporation to Shareholder
–Treated as a dividend to shareholder
– Returned to employer as interest income
Loan to Employee
Treated as paid compensation for employee
– Subject to employment taxes
Returned to employer as interest income
– Not deductible by the employee
– Taxable to the employer

BELOW-MARKET RULES
* Apply to:
* Term or demand loans that are gift loans, or
* Tax avoidance loans

DE MINIMIS EXCEPTIONS

TAX BENEFIT RULE

Taxpayer takes a deduction in one tax year, and
Recovers (e.g., receives a refund) part or all of the expenditure in a
later year,
The recovered amount should be included in gross income in that
later year (to the extent of the tax benefit derived from the
deduction).

OTHER PERSONAL SOURCE INCOME

Gambling winnings
Fees for:
– Jury duty
–Serving as executor, administrator, or personal representative of
an estate (unless you are a professional)

Income from a hobby

PERSONAL EXCLUSIONS
* Gifts
* Inheritances
* Scholarships
* Compensation for Injuries and Sickness (Limited)
* Child Support and Property Settlements
* Gain on the Sale of Personal Residence (Limited)
* Amounts Received under Insurance Contracts for Certain Living Expenses
* Qualified Foster Care Payments
* Disaster Relief Payments

SCHOLARSHIPS

Excluded if:
Candidate for a degree
At an eligible educational institution
Proceeds are used for qualified tuition and related expenses
– Tuition
– Fees
– Course-related expenses (books, supplies, equipment)
Qualified Tuition Reductions
–Excluded from income
– Pell Grants

COMPENSATION FOR INJURIES AND SICKNESS

Inclusion or Exclusion of Compensation for Damages from Injuries:

QUALIFIED DISASTER RELIEF PAYMENTS

Received for:
Payment of reasonable and necessary expenses as a result of a qualified disaster
–Personal, family, living or funeral expenses
–Expenses to repair or rehabilitate a personal residence or its contents
Promoting general welfare
Paid by common carrier by reason of the death or personal physical
injuries incurred
Qualified Disaster
–Terroristic/military action
– Presidentially declared disaster
– Accidents involving common carriers

Brian had the following items of income this year.
* Salary - $22,000
* Child support received - $6,000
* Alimony received - $10,000 (2006 divorce decree)
* Personal injury award from an auto accident. He lost the use of his left hand and was awarded compensatory damages of $200,000. He also received $50,000 in punitive damages.

Calculate Brian’s gross income for the current year.

$82,000.

Rationale

Salary of $22,000 + Alimony of $10,000 + $50,000 in punitive damages = $82,000.

The child support is not taxable.

The personal injury award is for bodily injuries and therefore is not taxable; however, the punitive damages are.

Which of the following statements concerning the proceeds of a life insurance policy is correct?

Proceeds paid by reason of the death of the insured are always included in the income of the recipient.

When the owner of a life insurance policy surrenders a life insurance policy to the issuing insurance company in exchange for the cash surrender value of the policy, the owner of the policy is not required to recognize any gross income.

Life insurance proceeds are not included in gross income of the new owner if the life insurance policy is sold (“transferred for value”) by the original owner of the policy.

Accelerated death benefits paid by an insurance company under a life insurance policy before the death of the insured are excluded from gross income if the insured person is terminally ill.

Rationale

Option a is incorrect because proceeds of an insurance policy paid by reason of the death of the insured are generally excluded from the income of the recipient.

Option b is incorrect because the owner of the policy is required to recognize gross income upon surrendering a life insurance policy in exchange for the cash surrender value of the policy.

Option c is incorrect because the proceeds are included in the gross income of the new owner if the life insurance policy is transferred for value by the original owner.

Which of the following payments would not qualify as a qualified disaster relief payment?

Payments for unlimited funeral expenses incurred as a result of a qualified disaster.

Payments for reasonable and necessary expenses to repair a personal residence as a result of a qualified disaster.

Payments to promote the general welfare in connection with a qualified disaster and paid by the federal government.

Payments made by a person engaged in the furnishing or sale of transportation as a common carrier by reason of personal physical injuries incurred as a result of a qualified disaster.

Payments for unlimited funeral expenses incurred as a result of a qualified disaster.

Rationale

Only payments for reasonable and necessary funeral expenses incurred as a result of a qualified disaster would qualify as a qualified disaster relief payment and therefore be excluded from gross income.

Frankie is awarded $55,000 in compensatory damages for harm to her reputation and $30,000 in compensatory damages for bodily injury. In addition, she is awarded $275,000 in punitive damages. How much of these awards must Frankie recognize in taxable
income?

$85,000.
$275,000.
$330,000.
$360,000

$330,000.

Rationale

Only compensatory damages for bodily injury are excludable from gross income. Compensatory damages without bodily injury are includible, as are punitive damages.

Therefore, Frankie must include $330,000 ($275,000 punitive damages + $55,000 compensatory damages for harm to reputation) in her income

Trip loans $11,000 to his sister, Tish, and does not charge her interest. Which of the following statements describes the income tax consequences of this transaction?

Interest would not be imputed because the loan is less than the amount of the gift tax annual exclusion.

Interest would be imputed because loans of $100,000 or less are always exempt from both income tax and gift tax consequences.

Interest would be imputed if Tish has unearned income of $1,100.

Interest would not be imputed if Tish’s earned income is less than $1,000.

interest would be imputed if Tish has unearned income of $1,100.

Rationale

Option a is incorrect because gift loans do not qualify for the gift tax annual exclusion.

Option b is incorrect; loans of less than $10,000 are exempt from both income tax and gift tax consequences.

Option d is incorrect because whether interest is imputed on this loan is based on Tish’s level of unearned income, not earned income.

Option c is correct; because the loan was for more than $10,000 and Tish has unearned income of more than $1,000, interest should be imputed on the loan.

Sean owns stock in the McNamara Corporation. Sean has a basis in his stock of $100. Which of the following would not be included in Sean’s income?

Qualified dividends received from McNamara Corporation.

A distribution by McNamara Corporation to its shareholders in excess of earnings and profits, of which Sean’s share of the distribution is $50.

Dividends paid by the McNamara Corporation of less than $10.

Dividends paid by the McNamara Corporation, assuming that it is not a U.S. corporation.

A distribution by McNamara Corporation to its shareholders in excess of earnings and profits, of which Sean’s share of the distribution is $50.

Rationale

Distributions in excess of earnings and profits are treated as a nontaxable return of invested dollars until the shareholder’s entire tax basis in the stock has been recovered.

Sean’s basis in his stock is $100 and the distribution is only $50. Therefore, the distribution is not included in Sean’s income.

Which of the following can be excluded from Ellen’s gross income?

The value of a diamond ring that Ellen received as a gift from Andy
The value of a mansion that Ellen inherited from her parents
The value of concert tickets that Ellen won in a radio contest
The value of a scholarship for room and board that Ellen received to her state university

1 only.
1 and 2.
1, 2, and 3.
2, 3, and 4.

1 and 2.

Rationale

The concert tickets that Ellen won in a radio contest are a prize/award and therefore the value is included in her gross income.

The value of the scholarship is also included in Ellen’s gross income because the scholarship was for room and board, which is not considered to be qualified tuition and related expenses.

Conway owns 100 shares of Darling Company stock. On December 29, 2024, Darling Company prepared the dividend checks for its shareholders. On December 31, 2024, Darling Company mailed dividend checks to all of its shareholders. Conway did not receive his dividend check until January 3, 2025. On what date must Conway include the dividends in his income?

Conway is not required to include the dividends in his income.

Conway must include the dividends in his income on December 29, 2024.

Conway must include the dividends in his income on December 31, 2024.

Conway must include the dividends in his income on January 3, 2025

Conway must include the dividends in his income on January 3, 2025.

Rationale

Conway is not required to include the dividends in his income until 2025 because the dividends were not readily available to Conway in 2024.

All of the following statements concerning community property are correct, except?

If two married taxpayers file married filing separately, the community property income is divided equally, but the separate property income is reported by the spouse owning the separate property.

In community property states, half of the income earned (wages, salaries, etc.) by a spouse is deemed to be earned by each spouse and half of the income earned from community property is deemed to be the income of each spouse.

Community property rules that characterize earned income continue to apply after a married couple divorces.

Property acquired before marriage or acquired by gift or inheritance before or after marriage is normally considered to be the separate property of the spouse

Community property rules that characterize earned income continue to apply after a married couple divorces.

Rationale

Upon divorce, all future earned income of the former spouses is separate income.

The subsequent sale of community property acquired during marriage, however, will be impacted by the community property rules that applied when the property was acquired.

Addison pays $15,000 for an annuity that will pay $1,000 a year, starting this year. If the annuity is for a term of 20 years, how much taxable income will Addison have from the annuity each year?

Addison will never have taxable income resulting from annuity distributions.

Addison will have $250 of taxable income from the annuity each year.

Addison will have $750 of taxable income from the annuity each year.

Addison will have $1,000 of taxable income from the annuity each year.

Addison will have $250 of taxable income from the annuity each year.

Rationale

Addison’s exclusion ratio is 0.75 (amount paid of $15,000 divided by total payments to be received of $20,000).

The exclusion ratio is then multiplied by the annual payment.

Therefore, $750 of each annuity payment will be excluded from Addison’s income and $250 will be included in Addison’s gross income.

Juliette and Lewis were divorced in 2017. The divorce decree requires that Lewis pay alimony to Juliette in the amount of $2,000 per month until their only child turns age 18, then $1,500 per month until the earlier of Juliette’s death or remarriage.
What is the correct tax treatment for Juliette and Lewis?

There are no tax consequences since alimony payments are not tax deductible by the payor nor taxable to the receiver.

Lewis can deduct $2,000 per month and Juliette will report income of $1,500 per month.

Lewis can deduct $1,500 per month and Juliette will report income of $1,500 per month.

Lewis cannot deduct the payments, however, the entire $2,000 per month is taxable income to Juliette.

Lewis can deduct $1,500 per month and Juliette will report income of $1,500 per month.

Rationale

Option a is incorrect as this rule applies to divorces executed after 2018. The $500 per month that is reduced when the child turns age 18 is child support and, therefore, not deductible by Lewis nor taxable to Juliette.

Twenty-five years ago, Deidra paid $11,000 for an annuity that paid $625 a year for life. At the time she purchased the annuity, Deidra’s life expectancy was 22 years. How much taxable income will Deidra have from the annuity this year?

Deidra will have no taxable income from the annuity.
Deidra will have $125 of taxable income from the annuity this year.
Deidra will have $500 of taxable income from the annuity this year.
Deidra will have $625 of taxable income from the annuity this year.

Deidra will have $625 of taxable income from the annuity this year.

Rationale

Because Deidra has exceeded her life expectancy of 22 years,

the entire annuity payment received this year must be included in her gross income.

Which of the following must be included in Raven’s income?

Short-term capital gains of $10,000 from the sale of stock
Long-term capital gains of $80,000 from the sale of real property
Interest income from Raven’s savings account
A gift from Raven’s brother of $15,000

1 and 2.
3 and 4.
1, 2, and 3.
1, 2, 3, and 4.

1, 2, and 3.

Rationale

Gifts are not included in the income of the recipient.
All of the other items must be included in Raven’s income.

Jay, a single taxpayer, retired from his job as a public school teacher in the current year. He is to receive a retirement annuity of $1,000 each month and his life expectancy is 150 months. He contributed $30,000 to the pension plan during his 35-year career; so his adjusted basis is $30,000. What is the correct method for reporting the pension income?

A. Since Jay is no longer working, none of the pension must be included in his gross income.

B. The first $30,000 received is a nontaxable recovery of capital, and all subsequent annuity payments are taxable.

C. The first $120,000 he receives is taxable and the last $30,000 is a nontaxable recovery of capital.

D. For the first 150 months, 20% ($30,000/$150,000) of the amount received is a nontaxable recovery of capital and the balance is included in gross income

The correct answer is D.

Jay is collecting under an annuity contract and the cost must be allocated among the payments received on the basis of the cost/expected return, until the total cost has been recovered.

Thus, for each annuity payment received for the 150-month period, $200 ($1,000 × 20%) is excluded from gross income and $800 ($1,000 × 80%) is included in gross income.

Any payments received after the 150-month period are included in his gross income.

Jack received a court award for $100,000 for damages to his personal reputation by the National Gossip. He also received $50,000 in punitive damages. Jack must include in his gross income as a damage award:

A. $0
B. $50,000
C. $100,000
D. $150,000

The correct answer is D.

The punitive damages of $50,000 must be included in his gross income. In addition, since the compensatory damages of $100,000 are not for physical personal injury or physical sickness, they must be included in his gross income.

Joe and Bonnie were divorced.
Their only marital property was a personal residence with a fair market value of $850,000 and a cost of $525,000.
Under the terms of the divorce agreement dated 2016, Joe would get the house and Joe would pay Bonnie $75,000 each year for 6 years, or until Bonnie’s death, whichever comes first. Joe and Bonnie lived apart when the payments were made to Bonnie.
The divorce agreement did not contain the word “alimony.” Joe paid the $450,000 to Bonnie over the six year period.
Then, Joe sold the house for $1,200,000. How much total alimony may Joe deduct?

A. $0
B. $75,000
C. $450,000
D. $1,200,000

correct answer is C.

The $75,000 Bonnie receives each year is alimony because it is a cash payment arising out of a divorce agreement, the agreement does not specify that the payments are not alimony, Bonnie and Joe are not members of the same household, and the payments cease upon the death of Bonnie.

Therefore, Joe deducts $75,000 each year and Bonnie must include $75,000 each year in gross income.
So the total alimony is $450,000. The transfer of the personal residence to Joe is not taxable.

Divorces finalized on or before 12/31/2018 are grandfathered into the old rules. Divorces finalized 1/1/2019 or after follow the new rules set forth under TCJA 2017.

In the current year, Ted was diagnosed with a terminal illness. His physician estimated that Ted would live no more than 18 months. Ted elected to use his accelerated death benefit rider in his life insurance policy to pay some medical bills, after he received the doctor’s diagnosis. Ted has paid $12,000 in premiums and he collected $25,000, the cash surrender value of the policy. George enjoys excellent health, but he cashed in his life insurance policy to purchase a new home.
He had paid premiums of $12,000 and collected $25,000 from the insurance company.

A. Neither Ted nor George is required to recognize gross income.
B. Both Ted and George must recognize $13,000 ($25,000 – $12,000) gross income.
C. Ted must recognize $13,000 ($25,000 – $12,000) of gross income, but George does not recognize any gross income.
D. George must recognize $13,000 ($25,000 – $12,000) of gross income, but Ted does not recognize any gross income.

d. George must recognize $13,000 ($25,000 – $12,000) of gross income, but Ted does not recognize any gross income.

Solution: The correct answer is D.

Ted qualifies as for accelerated death benefits. Thus, the realized gain is excluded from his gross income.

Under the terms of a 2015 divorce agreement, Lanny was to pay his wife Joyce $2,500 per month in alimony and $500 per month in child support. For a twelve-month period, Lanny can deduct from gross income (and Joyce must include in gross income):

A. $0
B. $6,000
C. $30,000
D. $36,000

The correct answer is C.

The $500 per month for child support is not deductible by Lanny.

Divorces finalized on or before 12/31/2018 are grandfathered into the old rules. Divorces finalized 1/1/2019 or after follow the new rules set forth under TCJA 2017.

A scholarship recipient at City University must include in gross income the scholarship proceeds used to pay for:

Only tuition
Tuition, books, and supplies, but not meals and lodging
Books, supplies, meals, and lodging
Meals and lodging

Solution: The correct answer is D.

MEALS AND LODGING

Carin, a widow, elected to receive the proceeds of a $100,000 life insurance policy on the life of her deceased husband in 10 installments of $15,000 each. Her husband had paid premiums of $75,000 on the policy. Over the life of the installment contract, Carin must include in gross income:

A. $0
B. $50,000

C. $75,000
D. $100,000

Solution: The correct answer is B.

The interest element of $50,000 ($150,000 – $100,000) is included in Carin’s gross income.

Gianna has an account at First Maryland Bank. $10,000 of her account balance is invested in a certificate of deposit (CD). When must interest paid on the CD be included in Gianna’s income?

Interest on a CD is never included in income.

The interest is included in Gianna’s income when it is added to her account balance.

The interest is included in Gianna’s income when she withdraws it from the account.

The interest is included in Gianna’s income when she spends it.

The interest is included in Gianna’s income when it is added to her account balance.

Rationale

When interest is paid on the CD and added to Gianna’s account balance, that interest must be included in Gianna’s income even if she does not withdraw the interest from her account. The interest is includible in Gianna’s income because, even though she has not withdrawn it, it has been constructively received. The interest is constructively received because it is readily available to Gianna and is not subject to any substantial limitations or restrictions.

Karen, a widow, elected to receive the proceeds of a $500,000 life insurance policy on the life of her deceased husband in 20 installments of $30,000 each. Her husband had paid premiums of $85,000 on the policy. Over the life of the installment contract, Karen must include in gross income:

A. $0
B. $30,000
C. $85,000
D. $100,000

Solution: The correct answer is D.

The interest element of $100,000 ($600,000 - $500,000) is included in Karen’s gross income and the $500,000 death benefit is excludable from her gross income.

Which of the following must be included in Roger’s income?

Inheritance of $5,000 of bonds.
Child Support of $40,000 from his ex-wife.
Interest income from his savings account.
A gift from a family member of $15,000.

A. III only.
B. III and IV only.
C. I and III only.
D. I, II, III and IV.

Solution: The correct answer is A.

Items I, II and IV are all excluded from taxable income.

Cary invested $100,000 in an annuity contract. This year, Cary annuitized the contract. The insurance company agreed to pay Cary $520.83 per month for 20 years. Assume that Cary receives eight payments this year. Using this information, how much must Cary include in gross income this year?

A. $833.33
B. $3,333.31
C. $4,164.64
D. $6,249.96

Solution: The correct answer is A.

$520.83 × 240 = (100,000.00/124,999.20) = 80%

80% exclusion; 20% inclusion

($520.83 × 12 × 20%) × (8/12) = 833.33

Cary invested $100,000 in an annuity contract. This year, Cary annuitized the contract. The insurance company agreed to pay Cary $520.83 per month for 20 years. Assuming that Cary receives eight payments this year, how much can Cary exclude from his gross income this year?

$833.33
$3,333.31
$4,164.64
$6,249.96

Solution: The correct answer is B.

Cary’s expected return is $125,000 (20 years × 12 months × $520.83). Therefore, his exclusion ratio is 80% ($100,000/$125,000). Cary will receive $4,166.64 in annuity payments this year (8 payments × $520.83), of which $3,333.31 can be excluded.

Therefore, Cary must include $833.33 in his income this year.

Which of the following can be excluded from Jill’s gross income?

The value of a car that Jill received as a gift from Brandon.
A property settlement as part of a divorce.
The value of concert tickets that Jill won in a radio contest.
The value of a scholarship for room and board that Jill received to her state university.

A. I only.
B. I and II only.
C. I, II and III only.
D. II, III, and IV only.

The correct answer is B.

The concert tickets that Jill won in a radio contest are a prize/award and therefore are included in her gross income.

The value of the scholarship is also included in Jill’s gross income because the scholarship was for room and board, which is not considered to be qualified tuition and course-related expenses.

Gifts and property settlements from divorce are not taxable to the recipient.

Laureen lends her sister Jill $50,000 for cosmetic surgery. Laureen has $2,000 of investment income and Jill has $300 in investment income. How much must Laureen impute in interest income?

A. $0
B. $300
C. $1,700
D. $2,000

The correct answer is A.

Since the loan is <$100,000 and the borrower’s investment income is less than $1,000, the amount of imputed interest income is $0.

Lisa received a scholarship to Expensive University. Her scholarship consisted of $38,000 used to pay for:

Tuition $30,000 per year
Books and Supplies $2,000 per year
Meals $1,000 per year
Dorm Fees $5,000 per year

How much of the $38,000 scholarship must she include in gross income?

A. $3,000
B. $6,000
C. $30,000
D. $38,000

Solution: The correct answer is B.

Scholarship proceeds can be excluded from gross income when used for tuition and course-related expenses. Proceeds not used for these purposes (such as meals and dorm fees) must be included in gross income.

Brian had the following items of income this year:

Salary $32,000
Child support received $6,000
Personal Injury award from an auto accident. He lost the use of his left hand and was awarded compensatory damages of $200,000. He also received $50,000 in punitive damages.

Calculate Brian’s gross income for the current year.

A. $82,000
B. $90,000
C. $282,000
D. $288,000

Solution: The correct answer is A.

Salary of $32,000 + $50,000 in punitive damages = $82,000. The child support is not taxable. The personal injury award is for bodily injuries and therefore is not taxable; however, the punitive damages are includible in income.

Which of the following is true regarding the proceeds of a life insurance policy?

A. Proceeds paid by reason of the death of the insured are always included in the income of the recipient.
B. When the owner of a life insurance policy surrenders a life insurance policy to the issuing insurance company in exchange for the cash surrender value of the policy, the owner of the policy is not required to recognize any gross income.
C. Life insurance proceeds are not included in gross income of the new owner if the life insurance policy is sold (“transferred for value”) by the original owner of the policy.
D. Accelerated death benefits paid by an insurance company under a life insurance policy before the death of the insured are excluded from gross income if the insured person is terminally ill.

Solution: The correct answer is D.

Option A is incorrect because proceeds of an insurance policy paid by reason of the death of the insured are generally excluded from the income of the recipient.

Option B is incorrect because the owner of the policy is required to recognize gross income upon surrendering a life insurance policy in exchange for the cash surrender value of the policy.

Option C is incorrect because the proceeds are included in the gross income of the new owner if the life insurance policy is transferred for value by the original owner.

Under the terms of a divorce agreement made January 1, 2019, Lanny was to pay his wife Joyce $2,500 per month in alimony and $500 per month in child support. For a twelve-month period, Lanny can deduct from gross income (and Joyce must include in gross income):

A. $0
B. $6,000
C. $30,000
D. $36,000

Solution: The correct answer is A.

The $500 per month for child support was never deductible by Lanny. Alimony paid under divorce contracts post 12/31/2018 not deductible by payor nor includible by payee.

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Tax Ch 4 Flashcards

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