January 31,

2014
CONCEPTS IN
FEDERAL TAXATION

CHAPTER 2:
INCOME TAX CONCEPTS
Contact Detai l s
- Emai l : ronal d_espi nosa@haas. berkel ey. edu
- Offi ce Hours: By appoi ntment

Di scussi on Sessi ons
- Sol uti ons to homework probl ems.
- Addi ti onal probl ems
- In some occasi ons addi ti onal probl ems wi l l be graded (5 poi nts)

Homework
- Onl y hard copi es.
- Hand i n duri ng di scussi on sessi on or i n a box next to F- 433 (offi ce).
- Submi ssi ons recei ved after Fri day 11am wi l l be consi dered l ate and
graded on a hal f- poi nts basi s.
HOMEWORK PROBLEMS
Probl ems
- Qui z 1
- Chapter 2: P24, 29, 32, 56, 41 and 42
- Chapter 1: P59, 53, 54, 56,
HOMEWORK PROBLEMS
Ti na owns and operates Timely Turn Tables (TTT) as a sole
proprietorship. TTT s taxable i ncome duri ng the current year
i s $80,000. I n addi tion to the TTT income, Ti na has the
fol l owing i ncome and expenses duri ng the current year:

Interest i ncome $ 11, 000
Royal ty i ncome 28, 000
Deductions for AGI 2, 500
Deductions from AGI 15, 000

a. What i s Ti na s current year taxable i ncome and i ncome
tax l i ability?
QUIZ 1
Ti na s t axabl e i ncome i s $97, 600 and her i ncome t ax l i abi l i t y i s $20, 621:

Gross I ncome:
I ncome f rom TTT $ 80, 000
I nterest i ncome 11, 000
Royal t y i ncome 28, 000 $ 119, 000
Deduct i ons for adj usted gross i ncome ( 2, 500)
Adj usted gross i ncome $ 116, 500
Deduct i ons f rom adj usted gross i ncome
I temi zed deducti ons ( greater t han st andard) ( 15, 000)
Per sonal exempt i on ( 3, 900)
Taxabl e i ncome $ 97, 600

Tax on $97, 600, si ngl e t axpayer i s:
$17, 891. 25 + [ 28% x ( $97, 600 - $87, 850) ] = $20, 621
QUIZ 1
b. Ti na would like to lower her tax by i ncorporating Ti mely
Turn Tables. How much i ncome tax wil l she save if she
i ncorporates TTT and pays hersel f a sal ary of $40, 000?

If Ti na i ncorporates, only $40,000 of TTTs taxable income
wil l be taxed on her return. TTT wil l pay tax on $40, 000
($80,000 - $40,000 sal ary paid to Ti na). This will lower her
taxable i ncome to $57, 600 ($97, 600 - $40,000 taxed to the
corporati on). Ti nas i ncome tax will be $10,329 {$4,991.25
+ [25% x ($57,600 - $36, 250)]} and TTT wil l pay a tax of
$6,000 ($40, 000 x 15%) on i ts $40,000 taxable i ncome.
The total tax of $16,329 ($10, 329 + $6,000) is $4,292
($20, 621 - $16, 329) l ower than usi ng a sol e proprietorship.
QUIZ 1
Al ternatively, you can thi nk that the other sources of i ncome
of Ti na (i nterest i ncome and royalty i ncome) can al so be
i ncorporated. I n thi s case, the sol ution i s:
Corporati on I ncome = TTT I ncome + I nterest I ncome + Royalty
I ncome Sal ary
Corporati on I ncome = 80, 000 + 11, 000 + 28, 000 40000 =
79, 000

QUIZ 1
Corporation Tax l i ability =
13, 750+34%*(79, 000 75, 000) = 15,110

I ndivi dual Tax l i ability =
892. 5 + 15%*(18, 600- 8, 925) = 2, 343. 75

Total l i ability tax = 17, 453. 75

Di f ference = $ 3, 167. 25
QUIZ 1
Doiko Corporati on owns 90% of the stock i n Nall , Inc. Trebor
owns 40% of the stock of Doiko. Trebors sister owns the
remai ni ng 60% of Doiko. Duri ng the current year, Trebor
purchased land from Nall for $43,000. Nall had purchased the
land for $62, 000. Write a memorandum to the controller of
Nall , Inc. , explai ni ng the potential tax problem wi th the sale of
the l and to Trebor.
#24
Doiko Corporati on and Nall , Inc. are related parties because
Doi ko owns more than 50% of the stock i n Nal l .
Although Trebor di rectl y owns onl y 40% of Doiko, he i s
deemed to own his si sters Doiko shares for purposes of the
rel ated party rul es.
Therefore, Trebor is deemed to control Doiko, whi ch controls
Nal l . Thi s makes Trebor and Nal l rel ated parti es.
Because the sale to Trebor resul ts i n a $19, 000 l oss, Nall will
not be all owed to deduct the l oss because Trebor i s a related
party.

#24
Bi nh owns several businesses. The total i ncome generated by
all his businesses puts him i n the highest margi nal tax bracket.
Seeki ng to lower the overall tax on hi s busi ness i ncome, Bi nh i s
thi nki ng of creati ng two S corporati ons and putti ng hal f his
busi ness i nterests i n each. Will this arrangement l ower his
overall tax? Write a letter to Bi nh i n which you explai n the tax
ef fects of organizi ng his busi nesses as two S corporati ons. I n
your l etter, suggest an al ternative pl an that mi ght l ower hi s tax.
#29
Spl i tti ng hi s busi ness i ncome i nto two separate S corporati ons
wi l l not produce any tax savi ngs because S corporati ons are
condui t enti ti es. The i ncome from each S corporati on wi l l fl ow
through the corporati on and be taxed to Bi nh. Therefore, Bi nh s
taxabl e i ncome wi l l remai n the same.
One possi bl e way for Bi nh to take advantage of margi nal tax rate
di fferenti al s i s to organi ze hi s busi nesses i nto a C corporati on
and pay hi msel f a sal ary. The sal ary wi l l be i ncome for Bi nh and
deducti bl e by the corporati on. Thi s wi l l spl i t the i ncome i nto two
taxabl e streams - Bi nh at i ndi vi dual rates and the corporati on at
corporate rates. Because corporati ons are taxed at l ower rates
than i ndi vi dual s on up to $75, 000 of i ncome, an opti mal
pl anni ng strategy wi l l set Bi nh s sal ary such that the corporate
taxabl e i ncome i s $75, 000 wi th the remai ni ng i ncome taxed to
Bi nh.
#29
Esmeral da i s an attorney. Before 2013, she i s empl oyed by the l aw
fi rm of El l i s and Morgan (E&M). Esmeral da i s not a partner i n
E&M; her compensati on consi sts of a fi xed sal ar y and a percentage
of any fees generated by cl i ents she bri ngs or refers to the fi rm. In
January 2013, she becomes a partner i n the l aw fi rm of Thomas,
Gooch, and Frankel (TGF). As a partner, Esmeral da agrees to turn
over to TGF any i ncome from the practi ce of l aw from the date of
her admi ttance to the practi ce. In l eavi ng E&M, i t i s agreed that
she wi l l conti nue to recei ve her percentage of fees from cl i ents she
referred to E&M duri ng her empl oyment there. I n return,
Esmeral da agrees that, upon request she wi l l consul t wi th E&M
attorney s regardi ng these cl i ents. Duri ng 2013, she consul ts wi th
2 of her former E&M cl i ents and recei ves $12, 000 from E&M per
thei r agreement. The $12, 000 consi sts of $10, 000 as a
percentage of fees for cl i ent referral s after she l ef t E&M and
$2, 000 as a percentage for work done before she l ef t E&M.
Esmeral da turned the $12, 000 over to TGF per her partnershi p
agreement. Wri te a l etter to Esmeral da expl ai ni ng whether she i s
taxed on the $12, 000 she recei ves from E&M
#32
As a partner of TGF, Esmeralda i s enti tled to her share of the
partnershi p i ncome per the partnership agreement. Any
amounts she earns af ter entering the TGF partnership are
consi dered to be partnership i ncome.
The questi on to be resol ved regarding the $12, 000 payment i s
whether the assi gnment of i ncome doctri ne appl ies. If the
$12, 000 i s an amount that she had earned pri or to enteri ng
the partnershi p, she cannot escape taxation by assi gni ng the
payment to TGF.
the $2, 000 payment for work done pri or to l eaving E&M had
been earned before entering the TGF partnership and was
taxable to Esmeralda per the assi gnment of i ncome doctri ne.
The $10, 000 i n fees recei ved for cl i ent referrals af ter l eaving
E&M were hel d to have not been earned by Esmeralda pri or to
l eaving E&M and were taxable to the TGF partnership.


#32
Si dney l i ves i n Hayes, Kansas. He owns l and i n Cotul l a, Texas,
that he i nherited from hi s father several years ago. The l and i s
uni mproved and has never produced i ncome. On January 26,
2013, Si dney receives a statement of del inquent taxes on the
property for 2010, 2011, and 2012 for $120. On February 10,
2013, Si dney and hi s wi fe, El l en, start to dri ve to Cotul la; they
arri ve on February 20 and pay the taxes on the same day. The
cost of the tri p for Si dney and El l en i s $450. Si dney and El l en
woul d l i ke to deduct the cost of the tri p. Wri te a l etter to
Si dney and El l en i n whi ch you expl ain what they can deduct.
#56
To be deducti ble, an expendi ture must have a busi ness
purpose. This means that the pri mary motive for the
expenditure i s to make a profi t.
The tax law all ows the deducti on of all ordi nary and necessary
trade or busi ness expenses and producti on of i ncome
(i nvestment) rel ated expenses.

#56
Al though the l and i s hel d for i nvestment, expenditures on
the l and must be ordi nary and necessary.
The payment of the property taxes i s ordi nary and necessary
and woul d be deductible.
The deductibility of the cost of the tri p depends on whether
the tri p i s ordi nary and necessary.
Making such a l engthy tri p i s not the ordi nary means of payi ng
property taxes. In addition, taki ng 10 days to make the tri p
i ndi cates that the pri mary purpose of the tri p was personal.
Therefore, the cost of the tri p does not have a busi ness
purpose and i s not deductible, even though i t rel ates to
i ncome producing property.
#56
Reba s 2013 i ncome tax cal culation i s as fol l ows:

Gross i ncome $120, 000
Deductions for adj usted gross i ncome (3, 000)
Adj usted gross i ncome $117, 000
Deductions from adj usted gross i ncome:
Standard deduction (6,100)
(Total i temized deductions are $2, 300)
Personal exempti on (3, 900)
Taxable i ncome $107, 000


# CH1-59
Before fil i ng her return, Reba fi nds an $8, 000 deducti on
that she omi tted from these cal culati ons. Al though the i tem
i s clearly deductible, she is unsure whether she should deduct
i t for or from adjusted gross i ncome. Reba doesn t thi nk i t
matters where she deducts the item, because her taxable
i ncome wil l decrease by $8,000 regardless of how the i tem is
deducted. I s Reba correct? Calculate her taxable i ncome
both ways. Write a letter to Reba explai ni ng any dif ference i n
her taxable i ncome arisi ng from whether the $8,000 i s
deducted for or from adj usted gross i ncome.

# CH1-59
Because Reba does not currently itemi ze her deducti ons,
i f the item i s deductible from adjusted gross income, $3,800
of the deducti on wi ll be l ost i n taki ng her itemized
deducti ons from $2, 300 to the $6,100 standard deducti on
amount. Therefore, her taxable i ncome will onl y decrease by
$4,200 ($8,000 - $3,800) i f the i tem i s deductible from AGI .
Because there i s no mi ni mum amount deductible for AGI, the
enti re $8,000 deduction will reduce taxable i ncome if the
deducti on is for AGI . Note: I f Reba had al ready been
itemizi ng (i .e. , her i temized deductions had exceeded $6,100),
both deducti ons woul d have lowered her taxable i ncome by
$8, 000.



# CH1-59


# CH1-59
Chel sea, who i s si ngle, purchases land for i nvestment
purposes i n 2008 at a cost of $22,000. I n 2013, she sells the
land for $38, 000. Chelsea s taxable income without
consi deri ng the land sale i s $90, 000. What i s the ef fect of
the sale of the land on her taxable i ncome, and what i s her
tax l i ability?

# CH2-41
Land hel d for investment is a capi tal asset. The sale of the l and
results in a $16, 000 ($38, 000 - $22, 000) long- term capi tal
gai n. Assumi ng that she has no other capi tal gai ns or losses in
2013, her taxabl e income increases by the amount of the gain to
$106, 000 ($16, 000 + $90, 000). However, net long- term
capi tal gains are taxed at 15%. Therefore, the $16, 000 long-
term capital gain is taxed separately at the 15% long- term
capi tal gai n rate. Thi s resul ts i n a total tax of $20, 893:

Tax on $90, 000:
= $17, 891. 25 +[28% x($90, 000 - $87, 850)] = $18, 493
Tax on $16, 000 l ong- term capi tal gai n:
= $16, 000 x 15% = 2, 400
Total tax l i abi l i ty $20, 893
# CH2-41
George purchases stock i n Dodo Corporati on i n 2009 at a cost
of $50,000. I n 2013, he sells the stock for $32, 000. What is
the ef fect of the sale of stock on George s taxable i ncome?
Assume that George sel ls no other assets i n 2013.
# CH2-42
The sale of stock resul ts i n a l oss of $18, 000 ($32,000 -
$50, 000). Stock is a capi tal asset and the l oss woul d be a
capi tal l oss. The maximum deducti on for a net capi tal l oss of
an i ndi vidual i s $3, 000 per year. Any excess l oss that is not
deducted is carried forward and deducted i n subsequent
years. Therefore, George will only be able to deduct $3, 000
of the l oss i n 2013 wi th the remai ni ng $15,000 carried
forward to 2014. Thus, hi s taxable i ncome wil l decrease by
$3, 000 i n 2013.

I f George has no capi tal asset sales i n 2014, he will deduct
$3,000 of the $15, 000 l oss carried forward from 2013. The
remai ni ng $12, 000 of capital l oss i s then carried forward to
2015.

# CH2-42
Cl assify the fol l owing i tems as ordi nary i ncome, a gai n, or an
excl usion:
a. The gross revenues of $160, 000 and deductible expenses
of $65, 000 of an i ndi vidual s consul ting busi ness
Income from a busi ness i s ordi nary i ncome. I n this case, the
i ndi vidual has $95,000 ($160, 000 - $65, 000) of ordi nary
i ncome.
b. Interest received on a checking account
I nterest received on a checki ng account i s ordinary i ncome.
c. Sale for $8, 000 of Kummel Corporati on stock that cost
$3, 000
The sale of the stock produces a $5,000 ($8, 000 - $3, 000)
gai n.
# CH1-53

d. Recei pt of $1, 000 as a graduati on present from
grandfather

The $1,000 graduati on present is a gi ft. Because gif ts are
subject to a separate tax on gi f ts (i .e. , the gi ft tax), the value
of a gi f t i s excluded from the i ncome tax.

e. Royal ty i ncome from an i nterest i n a gol d mi ne
Royalty i ncome i s ordinary i ncome.
# CH1-53
Cl assify each of the foll owi ng transacti ons as a deductible
expense, a nondeductible expense, or a l oss:
a. Ni ra sel l s for $4, 300 stock that cost $6, 000.
The sale of stock costing $6, 000 for $4,300 results i n a loss of
$1, 700 ($4, 300 - $6, 000).
b. Chiro Medical , Inc. , pays $2, 200 for subscripti ons to
popular magazines that i t pl aces i n i ts wai ti ng room.
Because the magazi nes are provided to i ts customers, the
subscripti ons have a busi ness purpose and are a deductible
expense.
c. Lawrence pays $200 for subscripti ons to fl y- fi shing
magazines.
Assumi ng that Lawrence is not i n the fl y-fi shi ng busi ness, the
use of the magazi nes i s personal and therefore,
nondeductible.


# CH1-56
d. The Mendota Partnership pays $200,000 to i nstall an
el evator i n one of i ts rental properties.
The i nstallati on of the elevator has a busi ness purpose.
However, because the useful ness of the elevator extends
substanti ally beyond the end of the current year, it cannot be
deducted i n total as a busi ness expense i n the year of the
expenditure. The $200, 000 cost must be capi talized and
deducted through depreciation over i ts tax l i fe.

e. Sterli ng Corporati on pays $6,000 for lawn mai ntenance
at i ts headquarters.
The l awn mai ntenance rel ates to a busi ness and therefore, i t is
a deductible business expense.

# CH1-56
Cl assify the fol l owing i tems as ordi nary i ncome, a gai n,
or an excl usion:

a. The sal ary recei ved by an employee
Salaries received by employees are ordinary i ncome.

b. Di vi dends of $400 recei ved on 100 shares of corporate
stock
Di vi dends on stock are ordinary i ncome.

c. Sal e for $10, 000 of an anti que chai r that cost $3, 500
The sal e of the chai r results i n a gai n of $6, 500 ($10, 000 -
$3, 500).

# CH1-54

d. Rental i ncome from an apartment bui lding
Rental i ncome i s ordinary i ncome.

e. Recei pt of an automobile worth $20,000 as an
i nheritance from Aunt Ruby s estate
The value of property received by inheri tance is excl uded from
gross i ncome.
# CH1-54