South-Western Federal Taxation 2017 Essentials of Taxation Individuals and Business Entities 20th Edition Raabe Solutions Manual 1

South-Western Federal Taxation 2017
Essentials of Taxation Individuals and

Business Entities 20th Edition Raabe
Solution Manual
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CHAPTER 5
BUSINESS DEDUCTIONS
SOLUTIONS TO PROBLEM MATERIALS
COMPUTATIONAL EXERCISES
1. (LO 2)
a. The entire $8,400 is deductible since the benefit from the payment will be completely received
by the end of 2017.
b. Since the benefit from the payment will not be completely received by the end of 2017,
the only payments deductible in 2016 are for the benefits received in 2016 (nine months;
$8,400 × 9/24 = $3,150).
5-1
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5-2 2017 Essentials of Taxation/Solutions Manual
2. (LO 3) All ordinary and necessary expenses incurred in operating an illegal business are deductible.
Expenses that are in violation of public policy are not deductible (bribes and illegal kickbacks). All
other expenses, which total $291,400, are deductible.
3. (LO 3) Since Stanford is not in the restaurant business and he does not acquire the restaurant, the
$28,000 is not deductible.
He cannot deduct all of the $51,000 related to the investigation of the bakery since he is not in that trade
or business already. Since he did purchase the bakery, the maximum deduction (before amortization)
of the $51,000 is $5,000.
The $5,000 deduction is reduced dollar for dollar for those expenses in excess of $50,000.
$51,000 – $50,000 = $1,000 reduction.
$5,000 – $1,000 = $4,000 deduction.
The remaining expenses of $47,000 ($51,000 – $4,000) can be amortized over 180 months beginning
with the month business begins, which is November.
$47,000/180 months = $261 per month.
$261 × 2 months = $522.
The total deduction is $4,522 ($4,000 + $522).
4. (LO 4) Research and experimental expenditures may be deferred and amortized if the taxpayer makes
an election. Under the election, research and experimental expenditures are amortized ratably over a
period of not less than 60 months. A deduction is allowed beginning with the month in which the
taxpayer first realizes benefits from the experimental expenditure. The election is binding, and a change
requires permission from the IRS.
Because the benefits from the project will be realized starting in July 2017, Sandstorm Corporation has
no deduction prior to July 2017, the month benefits from the project begin to be realized. The deduction
for 2017 is $12,750, computed as follows:
($85,000 + $30,000 + $12,500 = $127,500).

$127,500 × 6 months /60 months = $12,750.
5. (LO 6) The $5,200 real estate tax Ramona pays is allocated between her and Tabitha, based on the
relative number of days each owns the property during the year.
a. Therefore, $855 is allocated to Tabitha ($5,200 × 60/365) and $4,345 is allocated to Ramona
($5,200 − $855). Consequently, Tabitha may deduct $855 of real estate tax and Ramona may
deduct $4,345.
b. This calculation will also impact the basis in the real estate and the amount realized from the sale.
Ramona’s basis in the real estate is $260,855 [$260,000 (purchase price) + $855 (property taxes
paid by Ramona but allocated to Tabitha)]. Tabitha’s amount realized is $260,855 [$260,000
(sales price) + $855 (property taxes paid by Ramona but allocated to Tabitha)].
6. (LO 7) The mid-quarter convention applies if more than 40% of the value of property other than eligible
real estate is placed in service during the last quarter of the year. Hamlet acquired 100% of assets in the
last quarter of the year. Therefore mid-quarter convention applies.
Business Deductions 5-3
2016 $100,000 × .0357 = $3,570.

2017 $100,000 × .2755 = $27,550.
7. (LO 7) The IRS provides tables that specify cost recovery allowances for personalty and for realty.
Under MACRS, the cost recovery period for residential rental real estate is 27.5 years, and the straight-
line method is used for computing the cost recovery allowance. Nonresidential real estate uses a recovery
period of 39 years; it also is depreciated using the straight-line method. Cost recovery is computed by
multiplying the applicable rate by the cost recovery basis.
a. Residential rental real estate: $1,000,000 × .03636 = $36,360.
b. Nonresidential rental real estate: $1,000,000 × .02564 = $25,640.
8. (LO 7) In 2016, § 179 permits the taxpayer to elect to deduct up to $500,000 of the acquisition cost of
tangible personal property used in a trade or business.
Two additional limitations apply to the amount deductible under § 179. First, the ceiling amount on the
deduction is reduced dollar for dollar when § 179 property placed in service during the taxable year
exceeds a maximum amount ($2,010,000 in 2016). Second, the § 179 deduction cannot exceed the
taxpayer’s trade or business taxable income, computed without regard to the § 179 amount.
§ 179 deduction before adjustment $212,000
Less: Dollar limitation reduction ($212,000 < $2,010,000) (–0–)
Remaining § 179 deduction $212,000
§ 179 deduction allowed due to business income limitation $ 5,600
§ 179 deduction carryforward ($212,000 − $5,600) $206,400
9. (LO 7) The law places special limitations on cost recovery deductions for passenger automobiles. The
luxury auto limits are imposed before any percentage reduction for personal use. The cost recovery
limitations are maximum amounts. If the regular MACRS calculation produces a lesser amount of cost
recovery, the lesser amount is used.
Year MACRS Amount Recovery Limitation Deduction Allowed
2016 $5,040 $2,212 $2,212
($36,000 × .20 × 70%) ($3,160 × 70%)
2017 $8,064 $3,570 $3,570
($36,000 × .32 × 70%) ($5,100 × 70%)
10. (LO 9) Percentage depletion (also referred to as statutory depletion) uses a specified percentage
provided by the Code. The percentage varies according to the type of mineral interest involved. The
rate is applied to the gross income from the property, but in no event may percentage depletion exceed
50% of the taxable income from the property before the allowance for depletion.
Gross income $340,000
Less: Other expenses (229,000)
Taxable income before depletion $111,000
Depletion allowance $ 47,6001
1
[The lesser of $47,600 (14% × $340,000) or $55,500 (50% × $111,000)].
PROBLEMS
11. (LO 2)
Gross receipts $300,000

Less:
Coliseum rental $ 25,000
Food (cost of goods sold) 30,000
Souvenirs (cost of goods sold) 60,000
Performers 100,000 (215,000)
Net income for 2016 $ 85,000
Because Duck is an accrual basis taxpayer, it may accrue and deduct in 2016 the costs of the performers
of $100,000 even though it is not paid until January 5, 2017 (i.e., the economic performance test is
satisfied). However, the cleaning cost of $10,000 may not be deducted until 2017 when the services are
performed (i.e., at that time, the economic performance test is satisfied).
12. (LO 2) Code § 267 defines “family” to include the taxpayer’s ancestors, descendants, spouse and
siblings. Therefore, the following family members would be considered related parties:
Father
Brother
Grandson
Code § 267 also includes as related parties a corporation and a shareholder who owns more than 50
percent of the corporation’s outstanding stock. Therefore, a corporation and a 55 percent shareholder
would be considered related parties.
13. (LO 2, 3) Robin Corporation can take a deduction for interest of $2,800 in 2016 on the loan from Peter
but must defer the deduction of $2,800 on the loan from Isabelle until 2017, when it is paid. Both
Isabelle and Peter have interest income in 2017 when it is received. The reason for the different
treatment is that Peter owns his 19% plus (by attribution) Isabelle’s 26% for a total of 45%. Because
this is not greater than 50%, he is not a related party with respect to Robin.
Isabelle, however, owns her shares (26%) plus (by attribution) her husband’s shares (19%), her father’s
shares (25%), and her mother’s shares (15%) for a total of 85% ownership. Section 267 disallows the
deduction for the accrued expense in 2016 because Isabelle and Robin are related parties.
14. (LO 2, 3)
a. Brittany’s $24,000 loss ($160,000 amount realized − $184,000 adjusted basis) is not deductible
due to § 267.
b. If the stock is sold for $190,000, Ridge’s recognized gain is $6,000 [$190,000 (sales price) less
$160,000 (basis), reduced by the $24,000 loss that previously was not allowed to Brittany].
If the stock is sold for $152,000, an $8,000 loss [$152,000 (sales price) less $160,000 (basis)]
is recognized by Ridge. The $24,000 loss that was realized by Brittany is not deductible by
either Brittany or Ridge and is lost permanently.
If the stock is sold for $174,000, there is no recognized gain to Ridge [$174,000 (sales price)
less $160,000 (basis), reduced by $14,000 of the $24,000 loss that previously was not
recognized by Brittany]. The remaining $10,000 of unrecognized loss is lost permanently as a
deduction for both Brittany and Ridge.
c. Raabe, Maloney, Young, & Nellen, CPAs

5191 Natorp Boulevard
Mason, OH 45040
June 21, 2016
Ms. Brittany Callihan

32 Country Lane
Lawrence, KS 66045
Dear Ms. Callihan:
As you requested in your note, I am providing you with the tax consequences of the proposed
sale of stock to your son Ridge. Although you would have a potential loss of $24,000 ($160,000
selling price − $184,000 cost), you would not be able to recognize this loss on your tax return.
The tax law disallows the recognition of losses between certain related parties.
If you do sell the stock to Ridge, his tax basis for calculating gain or loss on a subsequent sale by
him would be his cost of $160,000. However, if he should sell it at a gain, he could use as much of
your $24,000 disallowed loss as necessary to reduce his gain to zero.
From a planning perspective, you could recognize the $24,000 loss on your tax return if you
were to sell the stock to an unrelated party rather than selling it to Ridge.
If you would like to discuss this further, please let me know.
Sincerely,
Ellen Allen, CPA
Tax Partner
15. (LO 2, 3)
a. Amount realized $12,000
Adjusted basis (17,000)
Realized loss ($ 5,000)
Recognized loss $ –0–
Bonnie and Phillip are related parties under § 267. Therefore, Bonnie’s realized loss of $5,000
is disallowed. Phillip’s adjusted basis for the stock is his cost of $12,000.
b. Amount realized $70,000
Realized loss ($15,000)
Recognized loss ($15,000)
Amos and Boyd are not related parties under § 267. Therefore, Amos’s realized loss of $15,000
is recognized. Boyd’s adjusted basis for the land is his cost of $70,000.
c. Amount realized $19,000
Recognized loss $ –0–
Susan and her wholly owned corporation are related parties under § 267 (i.e., she owns greater
than 50% in value of the outstanding stock). Therefore, Susan’s realized loss of $1,000 is
disallowed. The corporation’s adjusted basis for the bond is its cost of $19,000.
d. Amount realized $18,500
Recognized loss ($ 1,500)

Ron and Agnes are not related parties under § 267. Therefore, Ron’s realized loss of $1,500 is
recognized. Agnes’s adjusted basis for the truck is her cost of $18,500.
e. Amount realized $220,000
Realized gain $ 45,000
Recognized gain $ 45,000
Martha and Kim are related parties under § 267. However, § 267 applies only to loss
transactions. Martha’s realized gain of $45,000 is recognized, and Kim’s adjusted basis for her
partnership interest is her cost of $220,000.
16. (LO 2, 3) A corporation that uses the accrual method cannot claim a deduction for an expense
involving a related party (e.g., a more than 50% shareholder) until the recipient reports that amount
as income. Lupe, a cash basis taxpayer, must report the $100,000 bonus in 2017, the year he
receives the payment. Jasper Corporation may deduct the $100,000 bonus in 2017, the year Lupe is
required to report it as income.
17. (LO 2, 3)
a. Under the cash method of accounting, the salaries are deductible in the year that they are paid
by Broadbill. Thus, Broadbill deducts $440,000 ($220,000 × 2), the amount of salaries paid
by the corporation in 2016. The $40,000 of salaries paid by Broadbill in 2017 is deductible
by the corporation in 2017.
b. An accrual method corporation cannot claim a deduction for an accrual with respect to a related
party (e.g., more-than-50% shareholder). Instead, the deduction is deferred until such time the
recipient reports that amount as income. Thus, Broadbill deducts $460,000 [$220,000 (salary
paid in 2016 to related party Marcia) + $240,000 (salary paid and accrued to unrelated party
Zack)]. The $20,000 of Marcia’s 2016 salary that is accrued by Broadbill on December 31, 2016,
is deductible by the corporation in 2017 (the year it is paid to Marcia).
18. (LO 3) The two issues involved are whether the payment should be made and, if made, whether it is
deductible. If the payment was made to the representatives of a U.S. company, it would be a bribe. It
not only would be nondeductible but also could result in criminal charges. If the payment is made to
the representative of the foreign company, more than likely it would be an accepted trade practice in
that country. In this case, because the payment would not violate the U.S. Foreign Corrupt Practices
Act of 1977, it would be deductible. If the payment did violate the U.S. Corrupt Practices Act of 1977,
it would not be deductible.
19. (LO 3) Even though this is an illegal business, expenditures that are ordinary, necessary, and reasonable
are deductible. The bribes paid to city employees (a.) and kickbacks to police (d.) are not deductible
because they violate public policy. All of the other items are deductible (b., c., e., f., g., and h.).
20. (LO 3) From a legal perspective, Cardinal is responsible for having its drivers break the law by
speeding. The speeding fines that are levied are therefore not deductible by Cardinal. On the other hand,
the salaries paid to the suspended drivers are deductible by Cardinal.
From an ethical perspective, a case can be made both for and against having the drivers drive at
excessive speeds. Supporting the “for” perspective are the reasons mentioned by Cardinal and the fact
that Cardinal takes care of (i.e., continues the driver’s salary during the suspension period) its
employees. Supporting the “against” perspective are the following:
• The potential danger to the general public of such excessive speeding.

• Requiring or encouraging its employees to break the law and rewarding them for doing so.
• Business standards being subordinated to the demands of others.
21. (LO 3) No, a deduction is not permitted for political contributions.
22. (LO 3) Lobbying expenses generally are not deductible. Therefore, if Melissa pays the $1,500 to a
professional lobbyist, the payment is not deductible. However, a de minimis exception provides that in-
house lobbying expenditures not exceeding $2,000 per year can be deducted. Thus, if Melissa spends
the $1,500 on in-house lobbying expenditures, she can deduct this amount. Note that if the in-house
expenditures had exceeded $2,000, none of the in-house expenditures could have been deducted.
23. (LO 3) The tax issue is whether Ella will be able to deduct the loss on the sale of the stock. If the
transferee is a related party under § 267, the realized loss is disallowed. Otherwise, the realized loss is
recognized.
The gift to the other relative has no effect on the sales transaction. Although no income tax
consequences result, the imposition of a Federal gift tax should be considered.
24. (LO 3)
a. Although Jarret receives interest payments of $3,800, this entire amount is excluded from his
gross income. Interest on municipal bonds is tax-exempt.
b. None of Jarret’s interest payments of $4,900 on the loan can be deducted. The proceeds of the
loan were used to purchase tax-exempt bonds. Consequently, the interest expense deduction is
disallowed. Likewise, none of the principal payments of $1,100 can be deducted because this
is merely the payment of a liability.
25. (LO 3) All $41,500 of the expenditures are startup expenditures. Egret can elect under § 195 to
currently write off the first $5,000 and to amortize the remaining amount of such expenditures over
a 180-month period beginning with the month in which it begins business (i.e., July 1, 2016). Thus,
Egret’s deduction in 2016 for startup expenditures is $6,217 {$5,000 + $1,217 [($41,500 – $5,000)
÷ 180 months  6 months]}. Egret makes the § 195 election simply by claiming the deduction on its
2016 tax return. (If Egret decides to forgo the § 195 election, the $41,500 must be capitalized
and is deductible only when the corporation ceases to do business and liquidates.)
26. (LO 3) Even though Nancy decides not to pursue the expansion of her hotel chain into another city, the
investigation expenses of $35,000 are deductible in the current year. Because Nancy is in the hotel
business, all investigation expenses associated with the hotel business are deductible in the year paid or
incurred. Because Nancy was not in the restaurant business, she can deduct only part of these
investigation expenses. Of the $53,000, an amount of $2,000 [$5,000 − $3,000 (reduction for excess
over $50,000)] can be immediately expensed. The balance of $51,000 ($53,000 − $2,000) is amortized
over a period of 180 months at the rate of $283 per month ($51,000 ÷ 180) commencing in September
(the month the business is started). Consequently, the total deduction for the year is $35,000 for the hotel
investigation + $3,132 [$2,000 + ($283 × 4 months)] for the restaurant investment, or a total of $38,132.
27. (LO 4)
a. 2016
Salaries $500,000
Materials 90,000
Insurance 8,000
Utilities 6,000
Equipment depreciation 15,000
Total expenses $619,000

Cost of inspection of materials for quality control ($7,000), promotion expenses ($11,000), and
cost of market survey ($8,000) are not included as research and experimental expenditures.
2017
Salaries $600,000
Materials 70,000
Insurance 11,000
Utilities 8,000
Equipment depreciation 14,000
Total expenses $703,000
Cost of inspection of materials for quality control ($6,000), advertising ($20,000), and
promotion expenses ($18,000) are not included as research and experimental expenditures.
2018
No deduction based on data provided.
b. The research and experimental expenditures are amortized over a 60-month period beginning
with the month in which the taxpayer first realizes benefits from the experimental expenditures
(i.e., July 2018 for Blue Corporation). The monthly amortization is $22,033 ($1,322,000 ÷ 60).
2016
No deduction for research and experimental expenditures.
2017
No deduction for research and experimental expenditures.
2018
Deduction for research and experimental expenditures:
$22,033 × 6 months = $132,198
28. (LO 5) Sarah’s DPAD is $30,000 [9% × $350,000 (the smaller of $350,000 modified AGI or $400,000
QPAI)] [not to exceed $30,000 (50% × $60,000 of W–2 wages)].
29. (LO 5)
a. The DPAD is $200,000 (50% × $400,000 associated W–2 wages), which is less than $270,000
(9% × $3,000,000).
b. Because the wage base limits the deduction, Rose may want to outsource less of its work.
30. (LO 6) Gray Corporation should defer the gift of the land until 2017. This would allow Gray to fully
deduct in 2016 the carryover contribution amount of $75,000. If, instead, Gray gifted the land in
2016, the corporation would lose any otherwise allowable deduction as to the $75,000 carryover
amount. This occurs because current year gifts are applied against the taxable income limitation before
application of any carryover amounts. Thus, the taxable income limitation for 2016 would be
completely exhausted by the gift of land in 2016. Since 2016 represents the fifth and last year of the
carryover period, a gift of the land in 2016 precludes any deduction for the $75,000. A gift of
appreciated land held for more than one year as an investment results in a charitable deduction equal
to the land’s fair market value (subject to the taxable income limitation).
Assuming a gift of the land in 2017

2016 taxable income limitation: 10% × $1,000,000 = $100,000.
2016 charitable contribution deduction: $75,000 (carryover from 2011 gift).

2017 charitable contribution deduction: $120,000 (gift of land; excess contribution of $130,000 is
carried forward for up to five years).
Assuming a gift of the land in 2016

2016 charitable contribution deduction: $100,000 (gift of land; excess contribution of $150,000 is
carried forward for up to five years). Carryover from 2011 gift ($75,000) disappears, as 2016 is the
last year of the carryover period.
2017 charitable contribution deduction: $120,000 (carryover from 2016 gift; remaining $30,000 of
carryover from 2016 gift carries over to 2018).
31. (LO 6) Raabe, Maloney, Young, & Nellen, CPAs

Mason, OH 45040
December 17, 2016
Mr. Dan Simms, President

Simms Corporation
1121 Madison Street
Seattle, WA 98121
Dear Mr. Simms:
On December 12 you asked me to advise you on the timing of a contribution by Simms Corporation
to the University of Washington. My calculations show that the corporation will maximize its tax
savings by making the contribution in 2016.
If the corporation makes the contribution in 2016, it can deduct $25,000 as a charitable contribution,
which will save $9,750 (39% tax rate × $25,000 deduction) in Federal income tax. However, if the
corporation makes the contribution in 2017, the percentage limitations applicable to corporations will
limit the 2017 deduction to $10,000 ($100,000 projected profit × 10% limit). The corporation will
save $3,400 (34% tax rate × $10,000 deduction) in taxes as a result of this deduction. The corporation
may carry the remaining $15,000 forward for five years or until exhausted. If the corporation
continues at the 2017 profit level, it will save an additional $5,100, for a total tax savings of $8,500.
This analysis makes it clear that the corporation will save $1,250 more ($9,750 – $8,500) if it makes
the contribution in 2016. In addition, all of the savings will occur in 2016. If the corporation makes
the contribution in 2017, its tax savings will be split among several years. My advice is that the
corporation should make the contribution immediately so ownership of the stock can be transferred
by December 31.
Sincerely,
Alicia Gomez, CPA
32. (LO 6) In order to be deductible by an accrual basis corporation in the year authorized by its
board of directors, a charitable contribution must be paid within 3 1/2 months of the end of the
year of authorization (April 15, 2017, in this case). Because payment was made within the required
time period, the charitable contribution is deductible in 2016.
33. (LO 6) The total amount of Aquamarine’s charitable deduction for the year is $118,500. The painting is
capital gain property, but it is tangible personal property which was not used for a purpose related to the
qualified organization’s exempt function. Thus, the amount of the contribution is limited to the painting’s
basis, or $15,000. The Apple stock is capital gain property and the amount of the contribution is the
stock’s fair market value, or $90,000. The canned groceries are ordinary income property but the donation
qualifies for the enhanced deduction for corporate contributions of inventory. As such, the amount of the
contribution of the inventory is equal to the lesser of (1) the sum of the property’s basis plus 50% of the
appreciation on the property, or (2) twice the property’s basis. Thus, the amount of the contribution of the
canned groceries is $13,500 [$10,000 (basis) + 0.5($17,000 – $10,000)].

Mason, OH 45040
December 10, 2016
Mr. Joseph Thompson

Jay Corporation
1442 Main Street
Freeport, ME 04032
Dear Mr. Thompson:
I have evaluated the proposed alternatives for your 2016 year-end contribution to the University of
Maine (University). I recommend that you sell the Brown Corporation stock and donate the
proceeds to the University. The four alternatives are discussed below.
Donation of cash, the unimproved land, or the Brown Corporation stock each will result in a $200,000
charitable contribution deduction. Donation of the Maize Corporation stock will result in only a
$140,000 charitable contribution deduction.
Contribution of the Brown Corporation stock will result in a less desirable outcome from a tax
perspective. However, you will benefit in two ways if you sell the stock and give the $200,000 in
proceeds to the University. Donation of the proceeds will result in a $200,000 charitable contribution
deduction. In addition, sale of the stock will result in a $160,000 long-term capital loss. If Jay
Corporation had capital gains of at least $160,000 and paid corporate income tax in the past three
years, the entire loss can be carried back and Jay will receive tax refunds for the carryback years. If
Jay Corporation had no capital gains in the carryback years, the capital loss can be carried forward
and offset against capital gains of the corporation for up to five years.
Jay Corporation should make the donation in time for the ownership to change hands before the end
of the year. Therefore, I recommend that you notify your broker immediately so there will be no
problem in completing the donation on a timely basis.
I will be pleased to discuss my recommendation in further detail if you wish. Please call me if you
have questions. Thank you for consulting my firm on this matter. We look forward to serving you in
the future.
Sincerely,
Richard Stinson, CPA
Note to instructor: The land and stock are “unrelated use property” but they are not “tangible personal
property.”
35. (LO 7)
Cost of asset $200,000
Less: Greater of allowed and allowable cost recovery:
2014 $ 910
2015 7,272 (8,182)
Basis at the end of 2015 $191,818
Less: Cost recovery for 2016 ($200,000 × .03636 × .5/12) (303)
Basis on date of sale $ 191,515
Loss on sale of asset ($180,000 − $191,515) ($ 11,515)
36. (LO 7)
a. 2016
MACRS cost recovery ($200,000 × 20%) (Exhibit 5.4) $40,000
b. 2017
MACRS cost recovery [$200,000 × 32% (Exhibit 5.4) × 1/2] $32,000
37. (LO 7) The mid-quarter convention must be used because the cost of the computers acquired in the
fourth quarter exceeds 40% of the cost of all the personal property acquired during the year
($70,000/$150,000 = 47%).
Furniture (7-year class property)
MACRS cost recovery
[$40,000 × .1785 (Exhibit 5.5)] $ 7,140
Trucks (5-year class property)
MACRS cost recovery
[$40,000 × .15 (Exhibit 5.5)] 6,000
Computers (5-year class property)

MACRS cost recovery
[$70,000 × .05 (Exhibit 5.5)] 3,500
Total cost recovery $16,640
38. (LO 7)
2016 $10,800,000 × .01605 (Exhibit 5.6) = $173,340

2026 $10,800,000 × .02564 (Exhibit 5.6) = $276,912
39. (LO 7) The building’s depreciable basis is $1,300,000 [$1,600,000 (cost) − $300,000 (land)].
a. 2016 $1,300,000 × .01970 (Exhibit 5.6) = $25,610
b. 2022 $1,300,000 × .03636 (Exhibit 5.6) × 10.5/12 = $41,360

40. (LO 7)
a. 5-year class property
Immediate expense deduction under § 179 $200,000
7-year class property
Immediate expense deduction under § 179 300,000
($500,000 − $200,000)
MACRS cost recovery
[($400,000 − $300,000) × .1429] 14,290
Total deduction $514,290
b. 7-year class property

Immediate expense deduction under § 179 $400,000
5-year class property
Immediate expense deduction under § 179 100,000
[($200,000 − $100,000) × .20] 20,000
c. The deduction for the year would be $5,710 larger ($520,000 − $514,290) if § 179 expense was
first allocated to the 7-year class property (i.e., the longer lived asset). Therefore, she should
elect to expense the 7-year property (the furniture) first.
d. The present value of the tax savings is $147,595.

5-Year 7-Year Tax Savings PV PV of Tax
Year Asset Asset Total (@ 25%) Factor Savings
1 $120,000 $400,000 $520,000 $130,000 1.0000 $130,000
2 32,000 0 32,000 8,000 0.9434 7,547
3 19,200 0 19,200 4,800 0.8900 4,272
4 11,520 0 11,520 2,880 0.8396 2,418
5 11,520 0 11,520 2,880 0.7921 2,281
6 5,760 0 5,760 1,440 0.7473 1,076
7 0 0 0 0.7050 0
8 0 0 0 0.6651 0
Total $200,000 $400,000 $600,000 $150,000 $147,595
e. If Lori chooses not to use the § 179 expense election, the present value of the tax savings
generated from using MACRS deductions is $131,637. As a result, the present value of the tax
savings from using the § 179 deduction on the 7-year asset is $15,958 ($147,595 less $131,637).
5-Year 7-Year Tax Savings PV PV of Tax

Year Asset Asset Total (@ 25%) Factor Savings
1 $ 40,000 $ 57,160 $ 97,160 $ 24,290 1.0000 $ 24,290
2 64,000 97,960 161,960 40,490 0.9434 38,198
3 38,400 69,960 108,360 27,090 0.8900 24,110
4 23,040 49,960 73,000 18,250 0.8396 15,323
5 23,040 35,720 58,760 14,690 0.7921 11,636
6 11,520 35,680 47,200 11,800 0.7473 8,818
7 35,720 35,720 8,930 0.7050 6,296
8 17,840 17,840 4,460 0.6651 2,966
Total $200,000 $400,000 $600,000 $150,000 $131,637
41. (LO 7)
Section 179 limit $500,000
Cost recovery for 7-year class assets
[($600,000 − $500,000) × .1429] $ 14,290
Income limitation
Income before § 179 and cost recovery $250,000
Cost recovery ($95,000 + $14,290) (109,290)
Income before § 179 amount $140,710
Section 179 amount of $500,000 (limited to $140,710) 140,710

Total deduction with respect to the 7-year assets in 2016 $155,000
Section 179 carryforward ($500,000 − $140,710) $359,290
42. (LO 7)
2015
Section 179 expense $500,000
Additional first-year depreciation
[($550,000 − $500,000) × .50] 25,000
MACRS cost recovery
[($550,000 − $500,000 − $25,000) × .1429] 3,573
2016
MACRS cost recovery
[($550,000 − $500,000 − $25,000) × .2449] $ 6,123
Total deduction $ 6,123

Mason, OH 45040
December 20, 2016
Mr. Jabari Johnson
100 Morningside
Clinton, MS 39058
Dear Mr. Johnson:
I am responding to your inquiry concerning the amount of cost recovery you may deduct in the first year
of operation of a new taxi. If the automobile is purchased at the beginning of 2016 for $35,000, the total
cost recovery deductions in the first year will be $35,000 (via an expense election under § 179).
Because the car will be used as a taxi, it is not subject to the cost recovery limitations imposed on
passenger automobiles. This $35,000 cost recovery assumes that your income from your taxi business
before consideration of this cost recovery will be at least $35,000 and an election is made under § 179
to expense the maximum allowable amount.
If you need additional information or need clarification of our calculations, please contact me.
Sincerely yours,
John J. Jones, CPA
Partner
TAX FILE MEMORANDUM

DATE: December 20, 2016
FROM: John J. Jones
SUBJECT: Jabari Johnson: Calculations for cost recovery in year of acquisition
Facts. Jabari Johnson is considering purchasing an automobile at the beginning of 2016 to be used 100%
as a taxi. The cost of the automobile is $35,000. Jabari wants to know the total recovery for the year of
acquisition of the car.
Calculations. Because the automobile will be used as a taxi, it is not subject to the cost recovery
limitations for passenger automobiles. Therefore, Jabari can elect § 179 expensing and expense the
entire cost of the automobile (which is less than the $500,000 maximum § 179 election amount). In
deducting the full § 179 amount of $35,000, the assumption is made that Jabari’s income from the taxi
business before consideration of the § 179 expense will equal or exceed $35,000.
44. (LO 7) Because the car is a used car, it is not eligible for additional first-year depreciation, if available.
MACRS cost recovery:
Cost $25,000
Statutory percentage (mid-quarter convention) × 5%
Cost recovery but subject to the limitation $ 1,250
Recovery limit (limited to $3,160*) $ 1,250
Less: Personal usage (20% × $1,250) (250)
Cost recovery $ 1,000
*These cost recovery limits are indexed annually. The 2015 amounts are used.
45. (LO 7)
2015
Additional first-year depreciation ($20,000 × 50%) $10,000
MACRS cost recovery [($20,000 − $10,000) × 20%] 2,000
Limited to $11,160* ($3,160 + $8,000) $12,000
2016
($10,000 × .32) = $3,200 (limited to $5,100*) $3,200
So the deduction for 2015 is $11,160; for 2016, it is $3,200.

46. (LO 7)
Deduction for 2016
MACRS cost recovery ($20,000 × 20%) = $4,000
(limited to $3,160*) × 80% $2,528
Deduction for 2017

Straight-line ($20,000 × 20%) = $4,000 (limited to $5,100*) × 70% $2,800
Cost recovery recapture in 2017

2016 deduction $2,528
Straight-line ($20,000 × 10%) = $2,000
(limited to $3,160*) × 80% (1,600)
Excess $ 928
47. (LO 7)
For regular income tax liability
MACRS cost recovery ($16,000 × .20) $3,200
For AMT liability
($16,000 × .15) $2,400
48. (LO 7)
a. Using ADS over the first three years generates $44,870 of depreciation (versus $56,270 using
MACRS). The total tax cost of this difference is $3,192, and the PV of this tax cost is $3,031.
Tax Cost PV PV of Tax
Year ADS MACRS Difference (@ 28%) Factor Cost
1 $10,710 $14,290 ($ 3,580) ($1,002) 1.0000 ($1,002)
2 19,130 24,490 (5,360) (1,501) 0.9434 (1,416)
3 15,030 17,490 (2,460) (689) 0.8900 (613)
Total $44,870 $56,270 ($11,400) ($3,192) ($3,031)
b. Over the life of the asset, total depreciation is the same (and the overall tax cost or savings is
zero). However, the present value of tax savings generated via ADS in the later years of the
asset’s life is not sufficient to overcome the present value of the tax cost of this choice in the
asset’s early years. Overall, the present value of the tax cost of using ADS (versus MACRS) is
$688.
Tax (Cost) PV of Tax

or Savings PV (Cost) or
Year ADS MACRS Difference (@ 28%) Factor Savings
1 $ 10,710 $ 14,290 ($3,580) ($1,002) 1.0000 ($1,002)
2 19,130 24,490 (5,360) (1,501) 0.9434 (1,416)
3 15,030 17,490 (2,460) (689) 0.8900 (613)
4 12,250 12,490 (240) (67) 0.8396 (56)
5 12,250 8,930 3,320 930 0.7921 736
6 12,250 8,920 3,330 932 0.7473 697
7 12,250 8,930 3,320 930 0.7050 655
8 6,130 4,460 1,670 467 0.6651 311
Total $100,000 $100,000 ($ 0) $ 0 ($ 688)

Mason, OH 45040
October 15, 2016
Mr. Mike Saxon
200 Rolling Hills Drive
Shavertown, PA 18708
Dear Mr. Saxon:
This letter is in response to your request concerning the tax consequences of allocating the purchase
price of a business between the two assets purchased: a warehouse and goodwill.
If the purchase price of $2,000,000 is allocated $1,200,000 to the warehouse and $800,000 to goodwill,
the total recovery in the first year of operations will be $82,865. Cost recovery on the warehouse will
be $29,532, and amortization of the goodwill will be $53,333. If the purchase price is allocated
$1,500,000 to the warehouse and $500,000 to goodwill, the total recovery in the first year of operations
will be $70,248. Cost recovery on the warehouse will be $36,915, and amortization of the goodwill will
be $33,333.
Therefore, under the first option, your deductions in the first year will be $12,617 greater ($82,865 −
$70,248). The building is written off over 39 years, whereas the goodwill is written off over 15 years.
Thus, the higher the allocation to goodwill, the faster the write-off. Should you need more information
or clarification of calculations, please contact us.
Sincerely yours,
John J. Jones, CPA
Partner
TAX FILE MEMORANDUM
DATE: October 15, 2016
FROM: John J. Jones
SUBJECT: Mike Saxon: Calculations of amount of recovery depending on the allocation of purchase
price between a warehouse and goodwill
Facts. Mike is negotiating the purchase of a business. The final purchase price ($2 million) has been
determined, but the allocation of the purchase price between a warehouse and goodwill is still subject
to discussion. Two alternatives are being considered. The first alternative allocates $1,200,000 to the
warehouse and $800,000 to goodwill. The second alternative allocates $1,500,000 to the warehouse
and $500,000 to goodwill. Mike wants to know the total recovery during the first year of operation
from each alternative.
Calculations
Alternative 1
Warehouse [$1,200,000 × 2.461% (Exhibit 5.6)] $29,532
Goodwill ($800,000/15 years) 53,333
Total recovery $82,865
Alternative 2
Warehouse [$1,500,000 × 2.461% (Exhibit 5.6)] $36,915
Goodwill ($500,000/15 years) 33,333
Total recovery $70,248
Additional deductions in first year under Alternative 1
($82,865 − $70,248) $12,617
50. (LO 9) Computing Cost Depletion. It is proper for Sam to re-compute a new cost depletion amount
based on a revised estimate of the tons of granite stone remaining in the quarry. However, Sam should
reduce the adjusted basis ($600,000) for the portion of the basis allocable to the condemned land. Sam’s
computation determines a cost per ton based on a basis for the whole tract of land and a revised stone
reserve estimate for only a portion of the land.
Percentage Depletion. Percentage depletion is based on a specified percentage provided for in the Code.
(a) The percentage varies in accordance with the type of mineral interest involved.
(b) The rate is applied to the gross income from the property, but it generally may not exceed 50%
of the taxable income from the property before the allowance for depletion.
(c) Special rules apply to certain oil and gas wells under § 613A (e.g., the 50% ceiling is replaced
with a 100% ceiling, and the percentage depletion may not exceed 65% of the taxpayer’s
taxable income from all sources before the allowance for depletion).
51. (LO 9)
Gross income $12,000,000
Less: Expenses (5,000,000)
Taxable income before depletion $ 7,000,000
Cost depletion ($10,000,000/250,000 × 45,000) = $1,800,000
Percentage depletion (22% × $12,000,000 = $2,640,000, limited
to 50% × $7,000,000 = $3,500,000) (2,640,000)
Taxable income $ 4,360,000
BRIDGE DISCIPLINE PROBLEMS
1. The analysis below shows that Sparrow Corporation would incur a smaller cost if the asset is leased
($10,439) as compared to the cost of the purchase ($10,757).
If the asset is purchased, the present value of the after-tax cash flows follows:
Tax Benefit
from Depreciation Discount Net Present
Year Cash Flow Deduction* Factor Value
0 ($15,000) 1.000 ($15,000)
1 $1,700 0.909 1,545
2 2,267 0.826 1,873
3 755 0.751 567
4 378 0.683 258
5
Net Present
Value ($10,757)
*The tax benefit is calculated based on the MACRS depreciation deduction for the year times
Sparrow’s tax rate of 34%. For each year, this benefit is assumed to arise at the beginning of the
following year when the tax liability is paid. The tax benefit from the initial year’s depreciation
is $1,700 ($15,000 × 33.33% × 34%).
If the asset is leased, the present value of the after-tax cash flows follows:
Tax Benefit
from Lease Net Discount Net Present
Year Cash Flow Deduction* Cash Flow Factor Value
0 ($3,625) ($3,625) 1.000 ($ 3,625)
1 (3,625) $1,233 (2,392) 0.909 (2,174)
2 (3,625) 1,233 (2,392) 0.826 (1,976)
3 (3,625) 1,233 (2,392) 0.751 (1,796)
4 (3,625) 1,233 (2,392) 0.683 (1,634)
5 1,233 1,233 0.621 766
Net Present
Value ($10,439)
*The tax benefit is calculated based on the lease deduction for the year times Sparrow’s tax rate
of 34%. For each year, this benefit is assumed to arise at the beginning of the following year
when the tax liability is paid. The annual benefit is $1,233 ($3,625 × 34%).
2. The analysis below shows that Lark Corporation would incur a smaller cost if the asset is purchased
($10,364) as compared to the cost of leasing the asset ($10,439).
If the asset is purchased and the expensing election is made, the present value of the after-tax
cash flows follows:
Tax Benefit
from Depreciation Discount Net Present
Year Cash Flow Deduction* Factor Value
0 ($15,000) 1.000 ($15,000)
1 $5,100 0.909 4,636
2
3
4
5
Net Present
Value ($10,364)
*The tax benefit is calculated based on the amount expensed under § 179 ($15,000) for the year
times Lark’s tax rate of 34%. This benefit is assumed to arise at the beginning of the following
year when the tax liability is paid.
If the asset is leased, the present value of the after-tax cash flows follows:
Tax Benefit
from Lease Net Discount Net Present
Year Cash Flow Deduction* Cash Flow Factor Value
0 ($3,625) ($3,625) 1.000 ($ 3,625)
1 (3,625) $1,233 (2,392) 0.909 (2,174)
2 (3,625) 1,233 (2,392) 0.826 (1,976)
3 (3,625) 1,233 (2,392) 0.751 (1,796)
4 (3,625) 1,233 (2,392) 0.683 (1,634)
5 1,233 1,233 0.621 766
Net Present
Value ($10,439)
*The tax benefit is calculated based on the lease deduction for the year times Lark’s tax rate of
34%. For each year, this benefit is assumed to arise at the beginning of the following year when
the tax liability is paid. The annual tax benefit is $1,233 ($3,625 × 34%).
3. Sales revenue $185,000

Less: Operating expenses (125,000)
Depreciation for book (13,000)
Loss on sale of delivery truck to Neil’s brother (5,000)
Amount paid to fruit inspector to overlook below
standard fruit shipped to various vendors (bribe) (3,000)
Net income before tax for book purposes $ 39,000
Deductions allowed for tax purposes not expensed per books

Excess of cost recovery for tax over book depreciation
($17,500 – $13,000) (4,500)
Deductions not allowed for tax purposes but expensed per books
Loss on sale of delivery truck to Neil’s brother 5,000
Amount paid to fruit inspector to overlook below standard
fruit shipped to various vendors (bribe) 3,000
Taxable income $ 42,500
See Chapter 3, which discusses differences between financial accounting income and taxable income.
RESEARCH PROBLEMS
1. a. CLIENT LETTER
Raabe, Maloney, Young, & Nellen, CPAs

Mason, OH 45040
March 25, 2017
Mr. Ted Jones, President
Gray Chemical Company
200 Lincoln Center
Omaha, NE 68182
Dear Mr. Jones:
This letter is in response to your request to provide Gray Chemical Company with tax advice
regarding the deductibility of the following:
• $8 million contribution to a charitable fund whose purpose is bettering the environment.
• $7 million fine for EPA violations.
• Related legal fees for both of the above.

Based on our research, neither the $8 million contribution nor the $7 million fine is deductible.
The deduction of the fine is disallowed under Internal Revenue Code § 162(f). Because the
$8 million contribution resulted in the court reducing the fine from $15 million to $7 million,
the $8 million payment is in substance viewed as a fine or similar penalty and is therefore not
deductible. All of the related legal fees are deductible under § 162(a).
If we can be of additional service, please let me know.

Sincerely,
Gayle B. Anders, CPA
Partner
b. TAX FILE MEMORANDUM

DATE: March 21, 2017
FROM: Gayle B. Anders
SUBJECT: Deductibility of Costs Associated with EPA Violations by Gray Chemical
Company
Ted Jones, the president of Gray Chemical Company, a regular audit client, has requested that
we provide tax advice regarding the deductibility of the following:
• $8 million contribution to a charitable fund whose purpose is bettering the environment.
• $7 million fine for EPA violations.
• Related legal expenses for both of the above.

Gray deducted the $8 million contribution and the related legal expenses incurred in setting up
the foundation. In addition, Gray deducted the legal costs of defending itself in court. Gray did
not deduct the $7 million fine. On audit, the IRS disallowed the deductions taken by Gray on
the grounds that the payment was, in fact, a violation of public policy and therefore not
deductible under § 162(f). Of additional relevance is the fact that the court initially imposed a
fine of $15 million for the EPA violations. After Gray set up the foundation with the
$8 million contribution, the court reduced the fine to $7 million.
A case in point on the issues involved is Allied-Signal, Inc., 63 TCM 2672, T.C.Memo.
1992–204. The court held that the $8 million paid to the foundation was in substance a “fine or
similar penalty” within the meaning of § 162(f). Its reasoning was based, in part, on the fact
that negotiations with the judge indicated that he wanted to find a way to keep some of the
penalty in the injured state, rather than have the entire fine go to the Federal government. The
defendant’s lawyer also discussed with the client and the judge techniques for making the
foundation payment tax deductible. The reduction of the fine, while not guaranteed, was
implied by the court during these discussions.
The legal fees incurred by Allied in defense of its prosecution and in setting up the foundation
were deductible with the intent of § 162(a).
I have notified Gray that only the legal expenses can be deducted.
2. The facts of the case are similar to Chief Counsel Advice Memorandum 201234024, May 9, 2012. In
the memorandum, it was determined that a vineyard constituted § 179 property. Hence, taxpayers were
entitled to elect to expense the costs incurred when the vineyard was planted on the current year’s
income tax return. Therefore, Jed should be able to deduct the costs incurred in planting the vineyard
in 2012 on his 2016 income tax return. This is assuming that all of the other requirements under § 179
have been satisfied.
3. The facts of the case are similar to Bruce Selig, 70 TCM 1125, T.C.Memo. 1995–519. In this case, the
court ruled that a deduction was allowable. The Court found that over time, the exotic automobiles
would, because of those exotic features, become obsolete in the petitioner’s business. The fact that
petitioner failed to show the useful lives of the automobiles was irrelevant to the decision.
Research Problems 4 and 5
The Internet Activity research problems require that students utilize online resources to research and answer
the questions. As a result, solutions may vary among students and courses. You should determine the skill and
experience levels of the students before assigning these problems, coaching where necessary. Encourage
students to explore all parts of the Web in this research process, including tax research databases, as well as
the websites of the IRS, newspapers, magazines, businesses, tax professionals, other government agencies, and
political outlets. Students should also work with resources such as blogs, Twitter feeds, and other interest-
oriented technologies to research their answers.
4. See the Internet Activity comment above.
5. In a November 2013, tax reform proposal released by Max Baucus (formerly a senator from Montana
and the Chair of the Senate Finance Committee), a change to the current system of depreciation was
proposed. In theory, this change would generate additional tax revenue that would allow the corporate
tax rate to be lowered. Search on www.finance.senate.gov to find this proposal.
SOLUTIONS TO ROGER CPA REVIEW QUESTIONS
Detailed answer feedback for Roger CPA Review questions is available on the instructor companion site
(www.cengage.com/login).
1. c 6. c
2. d 7. b
3. d 8. b
4. b 9. d
5. a 10. d
NOTES

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SOLUTIONS TO PROBLEM MATERIALS

$51,000 – $50,000 = $1,000 reduction.

$5,000 – $1,000 = $4,000 deduction.

$47,000/180 months = $261 per month.

$261 × 2 months = $522.

The total deduction is $4,522 ($4,000 + $522).

($85,000 + $30,000 + $12,500 = $127,500).

2016 $100,000 × .0357 = $3,570.

Gross receipts $300,000

c. Raabe, Maloney, Young, & Nellen, CPAs

Ms. Brittany Callihan

Recognized loss ($ 1,500)

• The potential danger to the general public of such excessive speeding.

Total expenses $619,000

Assuming a gift of the land in 2017

2017 taxable income limitation: 10% × $1,200,000 = $120,000.

Assuming a gift of the land in 2016

31. (LO 6) Raabe, Maloney, Young, & Nellen, CPAs

December 17, 2016

Mr. Dan Simms, President

34. (LO 6) Raabe, Maloney, Young, & Nellen, CPAs

Mr. Joseph Thompson

Dear Mr. Thompson:

Computers (5-year class property)

2016 $10,800,000 × .01605 (Exhibit 5.6) = $173,340

b. 2022 $1,300,000 × .03636 (Exhibit 5.6) × 10.5/12 = $41,360

b. 7-year class property

d. The present value of the tax savings is $147,595.

5-Year 7-Year Tax Savings PV PV of Tax

Section 179 amount of $500,000 (limited to $140,710) 140,710

43. (LO 7) Raabe, Maloney, Young, & Nellen, CPAs

TAX FILE MEMORANDUM

So the deduction for 2015 is $11,160; for 2016, it is $3,200.

Deduction for 2017

Cost recovery recapture in 2017

Tax (Cost) PV of Tax

49. (LO 8) Raabe, Maloney, Young, & Nellen, CPAs

BRIDGE DISCIPLINE PROBLEMS

3. Sales revenue $185,000

Deductions allowed for tax purposes not expensed per books

Raabe, Maloney, Young, & Nellen, CPAs

• $8 million contribution to a charitable fund whose purpose is bettering the environment.

• $7 million fine for EPA violations.

• Related legal fees for both of the above.

If we can be of additional service, please let me know.

b. TAX FILE MEMORANDUM

• $8 million contribution to a charitable fund whose purpose is bettering the environment.

• $7 million fine for EPA violations.

• Related legal expenses for both of the above.

Research Problems 4 and 5

4. See the Internet Activity comment above.

SOLUTIONS TO ROGER CPA REVIEW QUESTIONS

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