Prentice Halls Federal Taxation 2013

Individuals 26th Edition Pope Solutions

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 Chapter I:9

Employee Expenses and Deferred Compensation

Discussion Questions

I:9-1 It is important to distinguish whether an individual is an employee or an independent

contractor (self-employed) because some expenses are only partially deductible by employees or not
deductible at all. A self-employed individual who incurs a business-related expenditure may deduct,
under Section 162, the expense for determining AGI on Schedule C, Form 1040. In addition,
employers pay certain payroll taxes on behalf of their employees. On the other hand, an individual's
employment-related activities, such as travel and transportation, are deductible from AGI and are
subject to different tax rules and regulations. Individuals may prefer to be classified as employees
because the employee portion of the social security tax rate in 2012 of 5.65% (7.65% after 2012) is
less than the self-employment tax rate of 13.3% (15.3% after 2012). This difference is mitigated
somewhat because self-employed individuals receive an income tax deduction equal to 50% of their
self-employment tax. Consideration should also be given to the hospital insurance portion of the
FICA tax, which continues to apply without limit at a 1.45% rate for both employees and employers
and at a 2.90% rate for self-employed individuals. p. I:9-3.
I:9-2 The deductibility and classification of Matt's transportation and unreimbursed travel
expenses depends upon the nature of the expenditure. The transportation and unreimbursed travel
expenses incurred in Matt's employment are deductible from AGI as an itemized deduction subject
to the 2% nondeductible floor for miscellaneous itemized deductions. The transportation and travel
expenses incurred in his CPA practice are business-related and are deductible for AGI and are not
subject to the aforementioned limitations. pp. I:9-2 through I:9-4.

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I:9-1
I:9-3

2%
Deductible For Non- Nondeductible 50%
From AGI AGI Deductible Floor Deductible

a. Reimbursed business meals Xa

b. Auto expenses going to and
from work
c. Legal expenses in preparation
of the taxpayer's tax return
d. Unreimbursed employee travel
and transportation expenses
e. Unreimbursed employee
entertainment expenses
f. Qualified moving expense of
an employee
X
X X
X X Xb
X X X
X X
X X

a
Since pursuant to an accountable plan, the reimbursement is not included in gross income and the
expense is not deductible. The 50% reduction is applied at the employer level.
b
Business meals are subject to the 50% deduction limit. pp. I:9-2 through I:9-23.

I:9-4

Are subject to Not subject to

2% nondeductible floor 2% nondeductible floor
a. Investment counseling fees X
b. Tax return preparation fees X
c. Unreimbursed professional dues
for an employee X
d. Gambling losses (to extent of X
winnings)
e. Interest on a personal residence X
f. Unreimbursed employee travel X
expense
g. Reimbursed employee travel X
expenses
h. Safe deposit box rental expenses X
for an investor

pp. I:9-3 and I:9-4.

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I:9-2
I:9-5 a. Marilyn may deduct the travel expenses including airfare, lodging, and meals for AGI
assuming that the trips are necessary and not personal in nature. (Note: the business meal portion of
this expense is reduced by 50%.)
b. Reimbursed travel expenses are generally deductible for AGI. However, since the
reimbursements are made pursuant to an accountable plan, Marc will not report the reimbursement
or the deductions on his return.
c. Marc may deduct unreimbursed expenses as a miscellaneous itemized deduction
subject to the 2% nondeductible floor.
d. Kay may deduct travel expenses for AGI. Any business meals are reduced by 50%.
pp. I:9-4 through I:9-8, I:9-16 through I:9-18.

I:9-6 Kelly may deduct $750 before applying the 2% nondeductible floor. The deduction is
computed as follows:

Total business meal expenses $2,000

Minus: lavish and extravagant expenses ( 500)
Balance of meal expenses $1,500
Times: Allowable percentage of expenses x 0.50
Deductible amount $ 750

pp. I:9-14 and I:9-15.

I:9-7 a. All expenses except personal clothing (e.g., transportation, meals and lodging) are
deductible from AGI and are subject to the 2% nondeductible floor. The meal costs of $1,000 must
be reduced by 50%. Thus, the total deductible amount is $8,500 ($9,000 - $500) (subject to the 2%
nondeductible floor). The expenses are deductible because her assignment is temporary in nature.
b. Same as a. Latoya could deduct the expenses for the nine-month assignment, as that
employment would be considered temporary under Rev. Rul. 93-86. None of her expenses incurred
in Texas after the nine-month assignment would be deductible. pp. I:9-4 through I:9-7.

I:9-8 The travel expenses related to attending the seminars are not deductible since they are related
to the production of rental income under Sec. 212. The registration fees of $1,000 are deductible for
AGI since they are not travel expenses and are related to the rental activity under Sec. 212.
pp. I:9-8 and I:9-9.

I:9-9 It is necessary to allocate a portion of the total reimbursement to each expense category
because the various unreimbursed amounts would be subject to various limitations such as the 2%
floor and 50% business meal rule. Reimbursed expenses are fully includible in gross income and are
deductible for AGI subject to the accountable plan rules. Unreimbursed employee business
expenses are deductible as a miscellaneous itemized deduction subject to the 2% floor. Meals and
entertainment expenses must be reduced by 50%. pp. I:9-16 through I:9-18.

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I:9-3
I:9-10 An employee may deduct the difference between the standard mileage rate and the
reimbursed rate as a miscellaneous itemized deduction subject to the 2% nondeductible floor. An
alternative way of claiming the deduction would be for the employee to record actual automobile
expenses and deduct those in excess of reimbursed expenses. Taxpayers have limited ability to
change methods. See the chapter coverage for more details. pp. I:9-11 and I:9-12.

I:9-11 The actual expense method may be used in subsequent years. However, MACRS under the
regular method may not be used for computing depreciation (straight-line method is required) and
the basis of the automobile must be reduced by 23 cents in 2012, 22 cents in 2011, 23 cents in 2010,
and 21 cents per mile in 2008 and 2009. p. I:9-11.

I:9-12 The taxpayer may not switch to the standard mileage rate method for the third year or
beyond. If a taxpayer depreciates an automobile under MACRS or expenses all or part of the
automobile under Sec. 179, a change to the standard mileage rate method is not permitted.
pp. I:9-11.

I:9-13 a. The employee must submit a detailed statement on the tax return of the
reimbursements and expense items. The reimbursements are included in gross income and the
expenses are deductible from AGI as miscellaneous itemized deductions (subject to the 2%
nondeductible floor rule) under a nonaccountable plan.
b. No reporting is required under an accountable plan by the employee.
c. No reporting is required for expenses equal to the reimbursement under the
accountable plan rules. The excess expenses are deductible from AGI as miscellaneous itemized
deductions. A proration of the reimbursement against the various expenses is required.
d. No reporting is required under an accountable plan assuming that the excess amount
is repaid to the employer. pp. I:9-16 through I:9-18.

I:9-14 Distance and time requirements were imposed to differentiate employment-related moves
from non-deductible personal motivated moves. The underlying rationale for the deduction is that
such moves are similar to a business expenditure because the move is often necessary to obtain
employment or is an employment-related job transfer. p. I:9-19.

I:9-15 Yes, qualifying moving expenses are not deductible if they are incurred by an unemployed or
a retired individual. To be deductible, qualifying moving expenses must be incurred by an employee
or a self-employed individual. In addition, the required time period to remain in the new location is
longer for self-employed taxpayers (78 weeks) than for employees (39 weeks). If the unemployed
individual incurred moving expenses to accept a job in the new location, the moving expenses would
be deductible assuming the other requirements are met. p. I:9-19.

I:9-16 a. Len’s moving expenses are deductible for AGI so that it does not matter whether Len
uses the standard deduction. The $2,000 reimbursement would offset the $2,000 of moving
expenses. Thus, no amount would be reported on Len's tax return.
b. The reimbursement for nondeductible moving expenses of $800 ($2,000 - $1,200)
must be included in Len’s gross income. pp. I:9-19 and I:9-20.

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I:9-4
I:9-17 The record-keeping requirements are strict due to the perceived widespread abuse of
entertainment expense deductions. Code Sec. 274 and the related Treasury Regulations include
classification rules, restrictive tests, and specific record-keeping requirements to prove that the
expenditures are business-related and not lavish or extravagant. p. I:9-12.

I:9-18 a. These amounts are reported on Louis's return as follows:

Since the reimbursement is pursuant to an accountable plan, neither the $3,000 reimbursement is
included in gross income nor are expenses of $3,000 deductible. They are netted together and not
reported on Louis's return. Of the remaining $1,000 of expenses, $500 [($4,000 - $3,000) x 0.50] is
deductible from AGI as a miscellaneous itemized deduction (subject to 2% non-deductible floor).
b. If Louis is unable to provide adequate documentation of the expenditures during the
course of an IRS audit on his tax return, all of the deductions will be disallowed. This disallowance
is due to the strict substantiation rules enacted by Congress and the IRS for entertainment expenses
under Sec. 274. pp. I:9-14, I:9-16 and I:9-17.

I:9-19 a. To be deductible the expenditure must be either (1) "directly related to" the active
conduct of a trade or business or (2) "associated with" the active conduct of a trade or business.
b. If there is some direct business benefit expected to be received, the entertainment of
clients should be classified as "directly related" expenses. Entertainment of potential clients
constitutes "associated with" entertainment. “Associated with” entertainment expenses must be
incurred prior to or after a bona fide business meeting. pp. I:9-13 and I:9-14.

I:9-20 a. $3,000 ($6,000 x 0.50) is deductible as a miscellaneous itemized deduction and

subject to the 2% nondeductible floor. Such amounts are classified as deductions from AGI.
b. Liz would not include the $6,000 in gross income nor deduct the $6,000 of expense
since an adequate accounting is made and the reimbursement procedures constitute an accountable
plan. Her employer can deduct $3,000 of the expenses ($6,000 x 0.50), as a trade or business
expense. pp. I:9-12 through I:9-18.

I:9-21 No, they are business fringe benefits under Sec. 132 and are not subject to the 50% limit.
p. I:9-13.

I:9-22 No, the business meal expenditure does not qualify as entertainment expenses. Even though
there is a reasonable expectation of business benefit, no business is discussed prior to, during, or
after the meal. Neither the “directly related” nor the “associated with” tests for deductibility of
entertainment expenses have been met. pp. I:9-14 and I:9-15.

I:9-23 None, the club dues are considered to be a personal, nondeductible expense despite the fact
that the use of the facility is primarily for business. Specific business expenses (e.g., meals with
customers) incurred at the club are deductible subject to the 50% disallowance rule. p. I:9-15.

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I:9-5
I:9-24 Bass may deduct $450 in 2012. The deduction is computed as follows:

$ 900 (The deduction is limited to the face value of the tickets)

x 0.50 (Then the 50% limit is applied)
$ 450 Deduction.

p. I:9-16.

I:9-25 a. An employee reimbursement plan is treated as an accountable plan if it meets the

following two requirements:
1. The employee must make an adequate accounting of expenses to his employer.
An adequate accounting is simply the substantiation of expenses by the
employee to his employee via an expense report or some other reporting
method, and
2. Within a reasonable period of time, the employee is required to return to the
employer any portion of the reimbursement in excess of the substantiated
expenses.
b. Under an accountable plan, neither the reimbursement nor the expenses are reported
on the employee's return. However, because the expenses are substantiated to the employer, this
treatment for accountable plans is intended to simplify the reimbursed expense area for employees
and employers. The general treatment of reimbursed expenses is to include the reimbursement in the
employee's gross income and the expenses are deductible by the employee as a deduction for AGI.
c. Under a nonaccountable plan, the employee expenses are treated as unreimbursed
expenses. Therefore, the reimbursement must be included in the employee's gross income and the
expenses are deductible by the employee as a miscellaneous itemized deduction subject to the 2%
nondeductible floor. pp. I:9-16 through I:9-18.

I:9-26 $400 expense incurred for the CPA review course is nondeductible because these expenses
were incurred to meet minimum standards for entry into the profession. The $4,000 incurred for law
school tuition and books is nondeductible because these expenses qualify the taxpayer for a new
trade or business. $500 [$400 + (0.50 x $200)] of continuing education expenses are deductible from
AGI, subject to the 2% nondeductible floor. The $200 of travel related to meals is subject to the
50% deduction limit. pp. I:9-21 through I:9-23.

I:9-27 Public school teachers may generally deduct educational expenses from AGI as a
miscellaneous itemized deduction because the expenditures are incurred to meet the requirements
imposed by law for retention of employment. In addition, the expenditures are incurred to maintain
or improve skills required by the individual in his employment, trade, or business and are deductible.
p. I:9-23.

I:9-28 a. Yes, Maggie is entitled to an office-in-home deduction because the office is used
exclusively on a regular basis as the principal place of business for a trade or business, and it is used
as a place for meeting or dealing with patients, clients, or customers in the normal course of
business. Additionally, her office is the most significant place for the conduct of her business
activities.

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I:9-6
 b. No, Marty must prove that working at home is for the convenience of his employer
and that it is not merely helpful or appropriate to work at home. An employee must also meet the
other requirements described in part a.
c. For years after 1998, an office in home qualifies as a taxpayer’s principal place of
business if (1) the office is used by the taxpayer for administrative or management activities of the
taxpayer’s trade or business, and (2) there is no other fixed location of the trade or business where
the taxpayer conducts substantial administrative or management activities of the trade or business.
Since Bobby does not have an office at another location and he conducts substantially all of his
administrative and management activities from his office in his home, he will be able to deduct
office in home expenses. pp. I:9-24 through I:9-26.

I:9-29 Employer contributions to a qualified plan are immediately deductible (subject to specific
limitations upon annual contribution amounts) and such amounts are not taxable to an employee
until the pension payments are received. If an employee contributes to the qualified plan, such
amounts may be made on either a pre-tax or after-tax basis. Currently, most employees contribute to
qualified plans on a pre-tax basis. Thus, when pension payments are received upon retirement, the
amounts received are fully taxable. Under a nonqualified deferred compensation plan (such as a
restricted property plan), the employee is taxed upon the FMV of the property contributed at the
earliest date when the property is no longer subject to risk of forfeiture or when the property is
transferable. The employer receives a corresponding compensation deduction at that time. Clearly,
substantial tax benefits are available in qualified plans over nonqualified plans . However, qualified
plans must meet highly restrictive rules and, in some situations, may not be permitted. pp. I:9-27
through I:9-32.

I:9-30 In a defined contribution plan, fixed amounts (e.g., 8% of each participant's salary) are
contributed for each participant to a separate account. The retirement benefits for that participant are
based on the value of the participant's account at the time of retirement. Defined benefit plans
establish in advance the value of the retirement benefits and a contribution amount is established
based on actuarial tables to fund this amount (e.g., 40% of an employee's average salary for the five
years prior to retirement). A distinguishing feature of a defined benefit plan is that forfeitures of
nonvested amounts (e.g., due to employee resignations) must be used to reduce the employer
contributions that would otherwise be made under the plan. In a defined contribution plan, however,
the forfeitures may either be reallocated to the other participants in a nondiscriminatory manner or
used to reduce future employer contributions. p. I:9-28.

I:9-31 The plan is discriminatory because it favors highly-compensated employees. As a result the
plan should be considered to be a nonqualified plan by the IRS. The employer should not be able to
receive the immediate tax deduction for pension contributions. Under a nonqualified plan the
employer's deduction is generally deferred until the employee recognizes income from the plan.
p. I:9-29.

I:9-32 No, generally employer-provided benefits must be 100% vested after five years of service.
p. I:9-29.

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I:9-7
I:9-33 a. Fully taxable when the payment is received.
b. The taxability of payments received depends on whether the employee contributions
were made on a pre-tax or after-tax basis. If the employee contributions were made on a pre-tax
basis, all amounts received are fully taxable. If the employee contributions were made on an after-
tax basis, amounts received are taxed under the Sec. 72 annuity rules. The employee’s contributions
are considered the employee’s investment in the contract. pp. I:9-29 and I:9-30.

I:9-34 Limitations for the year 2012 include:

• Defined contribution plan contributions are limited to the smaller of $50,000 (in
2012) or 100% of the employee's compensation.
• Defined benefit plans are restricted to an annual benefit to an employee equal to the
greater of $200,000 (2012) or 100% of the participant's average compensation for the
highest three years.
• An overall maximum annual employer deduction of 25% of compensation paid or
accrued to plan participants is placed upon profit sharing and stock bonus plans.
p. I:9-31.

I:9-35 Nonqualified deferred compensation plans are particularly well-suited for use in executive
compensation arrangements because they are not subject to the same restrictions which are imposed
upon qualified plans such as the nondiscrimination and vesting rules. pp. I:9-31 and I:9-32.

I:9-36 Yes, he should make the Sec. 83(b) election because he will pay a higher tax when the
restrictions lapse due to the substantial appreciation. If the employee does not make the Sec. 83(b)
election the tax consequences from the stock transfer are deferred for both the employee and the
corporation until the lapse of the nontransferability or forfeiture restrictions.

If the election is made, the employee will be taxed on the fair market value of the stock today and
the corporation will receive a deduction for the same amount immediately. The capital gain rates at
a maximum of 15% may increase the attractiveness of this option because capital gain treatment is
accorded upon the eventual sale of the stock, and the marginal tax rate for high-income taxpayers is
35% when taxable income is in excess of $388,350 for 2012. pp. I:9-31 through I:9-33.

I:9-37 ISO requirements include:

• The option price must be equal to or greater than the FMV of the stock on the
option's grant date.
• The option must be granted within 10 years of the date the plan is adopted and the
employee must exercise the option within 10 years from the grant date.
• The option must be exercisable only by the employee and is nontransferable except
in the event of death.
• The employee cannot own more than 10% of the voting power of the employer
corporation's stock immediately prior to the option's grant date.
• The total FMV of the stock options that become exercisable in any one year to an
employee may not exceed $100,000 (e.g., an employee can be granted ISOs to

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I:9-8
 acquire $200,000 of stock in one year provided that no more than $100,000 is
exercisable in any one year).
• Other procedural requirements must be met (e.g., shareholder approval of the plan,
etc).

If an employee meets the requirements of an ISO, no tax consequences occur on the grant date
(except that the excess of the stock’s FMV over the option price is a tax preference item) and LTCG
or loss is recognized when the stock is sold. Under a nonqualified stock option arrangement,
ordinary income is recognized either on the grant date or on the exercise date (depending upon
whether the option has a readily ascertainable FMV). LTCG treatment should favor the ISO for the
employee's tax consequences because of the spread between the maximum 15% capital gain rate and
the highest rate on ordinary income (i.e., 35%). However, the employer is more favorably treated
under the nonqualified stock option rules because the employer receives a tax deduction for the
amount of compensation that is recognized by the employee. pp. I:9-34 and I:9-35.

I:9-38 If a nonqualified stock option has a readily ascertainable FMV on the grant date, the
employee recognizes ordinary income on the grant date equal to the difference between FMV and
the option price. The employer receives a compensation deduction on the grant date equal to the
same amount that is recognized by the employee. In such case, no tax consequences occur on the
date the option is exercised and the employee recognizes capital gain or loss upon the sale or
disposition of the stock. If a nonqualified stock option has no readily ascertainable FMV, no tax
consequences occur on the grant date. On the exercise date, the employee recognizes ordinary
income equal to the spread between the FMV and the option price and the employer receives a
corresponding compensation deduction. pp. I:9-35 and I:9-36.

I:9-39 Yes, a self-employed individual who is covered by an employer's qualified pension plan is
eligible to establish an H.R. 10 or an SEP plan relative to his or her self-employment income.
p. I:9-37.

I:9-40 For a defined contribution H.R. 10 plan, a self-employed individual may contribute the lesser
of $50,000 or 25% of earned income for 2012 (before the H.R. 10 plan contribution but after the
deduction for one-half of self-employment taxes paid) from the self-employment activity. The
full-time employees must be covered, as required in the rules for qualified plans. p. I:9-37.

I:9-41 Most tax advisers would be more favorably inclined to advise the 50-year old to establish a
traditional deductible IRA since he could take advantage of the IRA deduction and would only have
to wait 9 1/2 years to withdraw from the IRA without penalty. The 30-year old would have to wait
considerably longer. The same applies to nondeductible IRAs only that such contribution amounts
are nontaxable when withdrawn because such amounts were previously subject to tax. However, the
benefit for a 30-year-old individual is that the funds in the IRA have a much longer investment
horizon. Unless a specific hardship provision applies, distributions made before age 59 ½ are subject
to regular taxation and to a 10% premature distribution penalty. Obviously, a 30-year old has a long
period of time without access to the IRA funds. pp. I:9-37 through I:9-41.

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I:9-9
I:9-42 The essential differences between a traditional IRA and a Roth IRA are, first, amounts
contributed to a traditional IRA are tax-deductible whereas amounts contributed to a Roth IRA are
not tax-deductible. However, upon withdrawal of amounts from the IRA at retirement, the
withdrawn amounts are fully taxable from a traditional IRA but not taxable from a Roth IRA.
Second, Roth IRAs are available to many more taxpayers as the AGI limits are much higher for Roth
IRAs than for traditional IRAs. pp. I:9-37 through I:9-41.

I:9-43 It is generally advisable for a 30-year old individual to invest in a Roth IRA rather than a
traditional deductible IRA. This is because of the tremendous growth potential of the funds in the
Roth IRA and the ability to withdraw the funds tax-free at retirement. Further, tax rates are
anticipated to be higher in future years than now. pp. I:9-37 through I:9-41.

I:9-44 If Charley rolls his traditional IRA into a Roth IRA, he must include the rollover in his gross
income and pay income taxes on such amount. The principal benefit of doing the rollover is that
when Charley withdraws amounts from his Roth IRA at retirement, no further taxes will be due.
While a precise analysis should be performed, since Charley’s marginal tax rate at retirement will be
no higher than his present rate and he has the funds outside of his IRA to pay the tax, most analysts
conclude that Charley will be better off to do the rollover and pay the tax now. The principal
economic benefit is that the rollover funds in the Roth IRA are able to grow tax-free and be
ultimately withdrawn tax-free. Thus, in Charley’s case, he should be advised to rollover his
traditional IRA into a Roth IRA. Charley is permitted to rollover amounts from his traditional IRA to
a Roth IRA because there are no AGI restrictions after December 31, 2009. pp. I:9-40 and I:9-41.

I:9-45 While Sally’s AGI of $70,000 is still too high to deduct contributions to a deductible
traditional IRA (maximum AGI of $68,000 (2012) for single taxpayers who are active participants in
an employer-sponsored plan), she is certainly eligible to contribute up to $5,000 to a Roth IRA as
the Roth IRA AGI limit is $105,000 before the phase-out begins. She also is eligible to contribute to
a nondeductible IRA, but the Roth IRA is much superior to the nondeductible IRA. pp. I:9-37
through I:9-41.

I:9-46 The Coverdale Education Savings Account (CESA) has several important features, including:
(1) the annual contribution into such plans is $2,000, (2) CESAs may be used for elementary and
secondary education expenses, and (3) a distribution from a CESA may be excluded even if the Hope
credit or lifetime learning credit was claimed in the same year. Of course, the same expenses cannot be
used for both the CESA exclusion and one of the two credits. pp. I:9-41 and I:9-42.

I:9-47 a. An SEP offers small business owners the opportunity to provide retirement benefits
for its employees that are comparable with qualified pension and profit sharing plans with reduced
administrative compliance costs (i.e., reduced paperwork and need for actuaries and CPA tax
specialists in the pension area to assure that the plan qualification requirements are met).
b. A sole proprietor of a small business may establish an SEP for himself rather than
using an H.R. 10 plan. p. I:9-43.

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I:9-10
Issue Identification Questions

I:9-48 The principal issue is whether Georgia is entitled to deduct travel expenses for the 11 month
away-from-home time period. To be deductible, she must be away from her tax home. The IRS's
position in Rev. Rul. 93-86 is that the initial realistic expectation of a 15-month assignment controls
despite the fact that the assignment lasts only 11 months. Therefore, the assignment was for an
indefinite period (more than one year) and the expenses are not deductible because her tax home
shifts to the new location. Another ancillary issue is the classification of the expenses, if deductible,
as for AGI or from AGI expenses. pp. I:9-6 and I:9-7.

I:9-49 The tax issues related to the possible relocation include the following:

1. The treatment of reimbursements, in particular for any reimbursements in excess of

allowable moving expenses.
2. The types of moving expenses (i.e., direct and indirect) which are deductible.
3. The reporting of the reimbursements on Jeremy's form W-2 and any state or federal
withholding requirements.
4. The classification of deductible moving expenses and the reporting of excess
reimbursements on Jeremy's tax return. pp. I:9-19 and I:9-20.

I:9-50 The primary tax issue is whether the office-in-home qualifies as a deduction under the tax
law. To make this determination, the office must meet several tests. First of all, the office must be
used exclusively and on a regular basis as the principal place of business for a trade or business.
Juan does not meet with patients, so the office must be the principal place of business. Second, the
exclusive use of the office must be for the convenience of the employer. Since Juan is self-
employed, he meets this test. Third, for tax years beginning after December 31, 1998, an office
meets the definition of “principal place of business” if (1) the office is used by the taxpayer for
administrative or management activities of the taxpayer’s trade or business, and (2) there is no other
fixed location of the trade or business where the taxpayer conducts substantial administrative or
management activities of the trade or business. pp. I:9-24 through I:9-26.

I:9-51 The major issues that David must address are as follows:

1. Does the education qualify David for a new trade or business? If so, the education
expense would be nondeductible. However, the courts have generally ruled favorably
on the deductibility of education expenses incurred to obtain an MBA degree.
2. Is the education directly connected with David's employment or trade or business?
Since David is not employed, the IRS may attempt to assert that the education
expenses are not deductible because the taxpayer does not have a current trade or
business. However, some courts have held that education expenses are deductible if
the education is deemed to be only a temporary cessation of a business activity.

pp. I:9-21 through I:9-23.

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I:9-11
Problems

I:9-52 a. Mike's deduction for employment-related expenses is computed as follows:

Subject to 2% floor:
Automobile expenses $2,500
Entertainment ($1,500 x 0.50) 750
Travel (excluding meals) 2,000
Meals ($500 x 0.50) 250
Professional dues 500
Total $6,000

The moving expenses are deductible for AGI, thus Mike's AGI is $116,000 ($120,000 -
$4,000).
$116,000 AGI x 0.02 = $2,320 nondeductible expense floor
$6,000 - $2,320 = $3,680 miscellaneous itemized deductions from AGI
+ 4,000 moving expenses for AGI not subject to any limit
$7,680 total deductible expenses

b. Moving expenses are deducted for AGI whereas the remaining items are deducted
from AGI on Schedule A. pp. I:9-4, I:9-5, I:9-13 and I:9-14, I:9-19 and I:9-20.

I:9-53 a. Travel $4,000

Business meals ($1,000 x 0.50) 500
Transportation 2,000
Entertainment ($2,000 x 0.50) 1,000
Total deductible expenses $7,500

Commuting expenses are not deductible. For the local transportation expenses, Monique can
compute her deductible expense under either the actual or standard mileage rate method.

b. Each of these items are classified as a for AGI deduction because she is self-
employed.

c. If Monique is an employee, then these employment-related expenses are deductible

from AGI (subject to the 2% limitation on miscellaneous itemized deductions). pp. I:9-4 and I:9-5,
I:9-9 and I:9-10, I:9-13 and I:9-14, I:9-19 and I:9-20.

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I:9-12
I:9-54 a. The total amount of Mary's deductible expenses is $3,050.

The deduction is computed as follows:

Subject to 2% nondeductible floor:

Air fare $1,500
Taxi (transportation) 100
Meals while traveling ($300 x 0.50) 150
Laundry 50
Lodging 650
Business meals ($500 x 0.50) 250
Entertainment ($500 x 0.50) 250
Investment counseling fees 1,000
Tax return preparation fees 500
Total deductible amounts $4,450
Minus: 2% of $70,000 AGI ( 1,400)
Total deductible expenses $3,050

b. The deductible expenses are classified as a from AGI deduction.

pp. I:9-4 through I:9-16.

I:9-55 a. Since Marilyn is on a temporary assignment of less than one year, her tax home is
still considered to be Cleveland and she is “away from home” while in Atlanta. Thus, all of her
expenses are considered travel expenses and she can deduct the following expenses:
Airfare ($800 + 8,000) $ 8,800
Apartment Rent 10,000
Meals ($8,500 x 0.50) 4,250
Entertainment ($2,000 x 0.50) 1,000
Total $24,050

b. Expenses are classified as from AGI and are subject to the 2% of AGI nondeductible
floor.
c. $21,650 is deductible computed as follows:
$120,000 x 0.02 = $2,400 nondeductible floor
$24,050 - $2,400 = $21,650 deductible.
d. The airfare for weekend trips, apartment rent and meals would be personal
nondeductible expenses. A portion of the airfare might qualify as a moving expense under Sec. 217.
e. Only the expenses associated with the first ten months would be deductible if the
position of the IRS is upheld by the courts. The $10,000 of expenses for the last seven months is not
deductible because the move lasts more than one year and is considered indefinite for the extended
period. pp. I:9-4 through I:9-16.

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I:9-13
I:9-56 a. Mike may only deduct his expenses that are related to business. Since Mike's
business-related employee expenses are fully reimbursed, the reimbursed expenses are deductible for
AGI and are offset by the reimbursement. Therefore, assuming the employer reimbursement is
pursuant to an accountable plan, Mike reports nothing on his individual return related to the trip.
The business-related expenses of $1,400 ($450 + $150 + $300 + $500) and the reimbursement of
$1,400 are treated as a wash. The airfare of $450 is not prorated because Mike’s trip was primarily
for business. The personal expenses of meals (2 days x $50 = $100) and hotel (2 days x $100 =
$200) are not deductible. If Mike were able to obtain excursion airfare rates due to travel extending
over Saturday night because of the vacation, the incremental expenses of one night's lodging and one
day's meals would be deductible as an unreimbursed employee expense (subject to the employer
reimbursement).
b. No amount of income or expense is reported by Mike (assuming that an adequate
accounting has been made) because the employee expenses were fully reimbursed pursuant to an
accountable plan.
c. Mike’s employer may deduct $1,075 ($450 + $75 + $300 + $250). Only 50% of the
meals (3 X $50 per day x 0.50 = $75) and 50% of the entertainment ($500 x 0.50 = $250) are
deductible by Mike's employer. pp. I:9-4 through I:9-18.

I:9-57 a. Since the reimbursement is less than the expenses, an allocation is required. The
$3,000 reimbursement is prorated to the various expenses based upon the amount reimbursed to the
total expenditures (3,000/5,000 = 60%). The deductible amounts are shown below.

Expense Total For From

AGI (60%) AGI (40%)
Professional dues and subscriptions $1,000 600 400
Airfare and lodging 2,000 1,200 800
Local transportation 1,000 600 400
Entertainment 1,000 600 200 (400 x 50%)
Totals $5,000 $3,000 $1,800

b. The $3,000 of reimbursed expenses is deductible for AGI and the $1,800 of
unreimbursed expenses are from AGI subject to the 2% of AGI nondeductible floor. Since the
reimbursement is pursuant to an accountable plan, the $3,000 of for AGI expenses and the $3,000
reimbursement are netted together and are not reported on Maxine’s return. Because Maxine has
other miscellaneous itemized deductions of $1,000, a total of $1,600 of miscellaneous itemized
deductions are deductible ($2,800 miscellaneous itemized deductions - [0.02 x $60,000 AGI] =
$1,600).
c. If Maxine received a $6,000 reimbursement, the $5,000 of employment-related
expenses is fully deductible for AGI and Maxine must return the $1,000 excess amount to her
employer. Since the reimbursement is pursuant to an accountable plan, the $5,000 of for AGI
expenses and the $5,000 reimbursement is netted together and is not reported on Maxine’s return. If
she does not return the $1,000 excess amount, the $1,000 is includible in her gross income.
pp. I:9-4 through I:9-18.

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I:9-14
I:9-58 a. $5,240 miscellaneous itemized deductions are computed as follows:
Subject to 2% nondeductible floor:
Safety deposit box rental $ 100
Tax return preparation fees 500
Unreimbursed employee expenses 6,000
Unreimbursed employee expenses (for business meals)($1,200 x 0.50) 600
Miscellaneous itemized deductions $7,200
Minus: 0.02 x $98,000a (1,960)
Total $5,240
a
Melissa’s moving expenses are deductible for AGI. Thus, Melissa’s AGI is $98,000
($100,000 - $2,000).

b. Total itemized deductions are computed as follows:

Other itemized deductions: Mortgage interest $12,000
Real estate taxes 1,800 $ 13,800
Plus: Miscellaneous itemized deductions 5,240
Total itemized deductions $ 19,040
c. Miscellaneous itemized deductions (before 2% floor) $ 7,200
Minus: 0.02 x $190,000 AGI ( 3,800)
Miscellaneous itemized deductions $ 3,400
Other itemized deductions 13,800
Total itemized deductions $ 17,200

pp. I:9-4 and I:9-5.

I:9-59 a. $5,000. The transportation expenses for trips within the metropolitan area are
deductible because Cassady has a regular work location at her employer’s office.
b. From AGI as a miscellaneous itemized deduction.
c. $5,000 for AGI. The transportation expenses from Cassady's home to clients within
the metropolitan area are deductible because her residence is her principal place of business (i.e.,
office in home). pp. I:9-9 and I:9-10.

I:9-60 a. $3,820 of the unreimbursed expenses are deductible from AGI, computed as follows:

24,000 miles unreimbursed x $.555 (per mile in 2012) $13,320

Plus: parking and tolls + 100
Total expenditures $13,420
Minus: Reimbursement (24,000 miles x $.40 per mile) ( 9,600)
Deductible from AGI $ 3,820

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I:9-15
 b. Under the actual cost method, $340 is deductible from AGI, computed as follows:

Expenses (excluding parking and tolls) $16,400

Business use x 0.60
$ 9,840
Parking and tolls 100
Total expenses $ 9,940
Minus: employer's reimbursement ( 9,600)
Deduction $ 340

c. Although taxpayers are permitted to change from one method to another, there are
specific requirements that must be met. A change from the mileage method to the
actual method must reduce the basis of the automobile by a mileage rate and the
straight-line method must be used in subsequent years. A change from the actual
method to the mileage method is only permitted if the taxpayer used the straight-line
method of depreciation.

pp. I:9-11 and I:9-12.

I:9-61 a. Deductible expenses include:

Dues to the local chamber of commerce $1,000
Entertainment ($2,000 x 0.50) 1,000
Entertainment of clients ($1,500 x 0.50) 750
Total $2,750

The business meals are not deductible because bona fide business discussions must be
conducted. The country club dues are not deductible despite the fact that the club was used
exclusively for business. Dues to the chamber of commerce are not subject to the club disallowance
rules.
b. For AGI, since Milt is self-employed.

pp. I:9-12 through I:9-16.

I:9-62 $5,400 is deductible in the current year computed as follows:

Football tickets (100 x $36 each) $ 3,600 (limited to face value)

Skybox tickets (20 x $60/seats for each of six games) 7,200
Total outlay $10,800
Percentage limitation by IRS x 0.50
Deduction $ 5,400

p. I:9-16.

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I:9-16
I:9-63 a. 1. Since the Cooper Company maintains an accountable plan and the
reimbursement is equal to the expenses, Latrisha will not report the reimbursement nor deduct the
expenses. Cooper Company may deduct the amount of $9,450 on its return, computed as follows:
Airfare $5,850
Lodging 1,800
Meals ($1,200 x 50%) 600
Entertainment ($2,400 x 50%) 1,200
Total deductible outlays $9,450

2. The reimbursement is less than the expenses, so a proration of expenses is

required. The reimbursement is equal to 80% of the expenses ($9,000/11,250).

EXPENSES TOTAL 80% 20%

FOR AGI FROM AGI
Airfare $ 5,850 $4,680 $1,170
Lodging 1,800 1,440 360
Meals 1,200 960 120 (240 x 50%)
Entertainment 2,400 1,920 240 (480 x 50%)
$11,250 $9,000 $1,890

Latrisha will not report the $9,000 reimbursement or the $9,000 of deductions for AGI (accountable
plan). She will report the $1,890 as miscellaneous itemized deductions. Cooper Company may
deduct $7,560 on its return [$4,680 + 1,440 + (960 x 50%) + (1,920 x 50%)].
3. Since the reimbursement is greater than the expenses, Latrisha is required to
return the excess ($14,000 - 11,250 = 2,750) to Cooper Company. In addition, she will not report
the $11,250 reimbursement as gross income or deduct the expenses. If Latrisha does not return the
excess reimbursement (even though she is required to under the plan), she must report the excess of
$2,750 as gross income. Assuming Latrisha reimburses Cooper Company the $2,750, the company
can deduct $11,250.

b. Under a nonaccountable plan, any reimbursement is included in gross income and the
deductions are treated as miscellaneous itemized deductions. Thus, Latrisha would include the
reimbursements ($11,250, $9,000, or $14,000) in her gross income and deduct the following as
miscellaneous itemized deductions:
Airfare $5,850
Lodging 1,800
Meals ($1,200 x 50%) 600
Entertainment ($2,400 x 50%) 1,200
Total miscellaneous itemized deductions $9,450
Cooper Company could deduct $11,250, $9,000, or $14,000 respectively.
pp. I:9-16 through I:9-18.

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I:9-17
I:9-64 a. Only direct moving expenses are deductible. Thus, Michael's moving expense
deduction is $4,200 computed as follows:
Direct Moving Expenses
Automobile expenses $ 230
Moving van expenses 3,970
Total deductible expenses $4,200

None of the other expenses qualify as moving expenses under Sec. 217. Specifically, no
deduction for meals en route to Chicago is allowed. The points paid to acquire the new
residence should qualify as interest expense if Michael itemizes his deductions.

b. The moving expenses are deductible for AGI.

c. $4,200 of the reimbursement is used to offset the otherwise deductible moving
expenses. The excess reimbursed amount of $6,900 ($11,100 - $4,200) is included in Michael's
gross income. pp. I:9-19 and I:9-20.

I:9-65 a. Not deductible, the education qualifies the taxpayer for a new trade or business
b. Yes, deductible for AGI (except that only $100 of meals [$200 x 0.50] is deductible)
c. Yes, deductible from AGI (assuming the business executive is an employee)
d. Yes, deductible from AGI
e. Not deductible

pp. I:9-21 through I:9-24.

I:9-66 Anne’s education expenses will qualify for the American Opportunity tax (AOTC) and
lifetime learning credits. (See Chapter I14 for a more in-depth discussion of education credits). She
qualifies for the AOTC scholarship credit as the credit now applies to four years of college study.
Her college expenses are not deductible under Reg. Sec. 1.162-5 as the courses will qualify her for a
new trade or business. Only the tuition and fees qualify for the tuition deduction or the lifetime
learning or AOTC credits. Books and supplies do not qualify. pp. I:9-21.

I:9-67 a. Total deductible expenses are $1,200. The for AGI deduction is computed as follows:
Real estate taxes and mortgage interest:
Real estate taxes $2,000
Plus: Mortgage interest 5,000
$7,000
Percent of house used for business x 0.10a
Allocable to the office $ 700
a
Only the studio qualifies for the office-in-home deduction. The den is not allowed because it is not
used exclusively as the principal place of business.

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I:9-18
 Other Office-in-Home Expenses
Insurance $ 500
Depreciation 3,500
Repairs and utilities 1,000
$5,000
Percent of house used for business x 0.10
Other expenses $ 500

Nancy's home office expenses (other than mortgage interest and real estate taxes) are limited
to $37,300 [$40,000 gross income – ($700 mortgage interest and real estate taxes + $2,000 of
expenses directly related to the business)].
Thus, the full amount of $1,200 ($700 + $500) deductible expenses is allowed. In addition,
$1,800 of real estate taxes ($2,000 - $200) and $4,500 ($5,000 - $500) of mortgage interest are
deductible as itemized deductions.

b. Yes, because Nancy’s home office expenses exceed the gross income from the
business, her deductions are limited. Using the ordering rules under Reg. Sec. 1.280A-2, Nancy’s
deductions for the year are computed as follows:

Gross Income $2,500

1. Mortgage interest and real estate taxes ( 700)
$1,800

2. Expenses directly related to the business

other than home office expenses. $2,000
Limited to ($1,800)
-0-
Thus, Nancy will be allowed $700 of mortgage interest and real estate taxes and $1,800 of
the direct expenses. The other $200 of direct expenses and the $500 of insurance, repairs and
utilities, and depreciation are not allowed because of the gross income limitation. However, the
disallowed expenses may be carried over to next year subject to the gross income limitation in the
later year. pp. I:9-24 through I:9-26.

I:9-68 a. His total deductions for 2012 are $8,400, as follows:

Directly-related expenses $6,000

Indirect expenses (15% x $18,000) 2,700
Total $8,700
Darrell’s indirect expenses are deductible because the office in home qualifies as his
principal place of business. His office is used for administrative or management activities and there
is no other fixed location of the trade or business where the taxpayer conducts substantial
administrative or management activities of the trade or business. Further, since his gross income
derived from the business is higher than his deductions, no limitation applies. Since Darrell is self-
employed, the deductions would be for AGI.

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I:9-19
 b. Darrell could only deduct the $6,000 as the other expenses would not qualify because
the office in home does not qualify as his principal place of business. The office in home is not used
exclusively on a regular basis as the principal place of business nor does he regularly meet with
clients or customers in the normal course of business. Further, since Darrell has an office at the
consulting company, he does not meet the exceptions to claim deductions for an office in the home.
Also, Darrell maintains the office for his convenience and does not meet the “convenience of the
employer” test. Assuming the direct expenses are not reimbursed by Darrell’s employer, the
expenses would be deductible from AGI, subject to the 2% of AGI floor. pp. I:9-24 through I:9-26.

I:9-69 a. qualified profit sharing plan

b. qualified pension plan
c. defined benefit plan
d. nonqualified plan
e. employee stock ownership plan. pp. I:9-26 through I:9-32.

I:9-70 a. The entire $12,000 would be taxable to Pat in 2012 because she made the pension
contributions on a pre-tax (deferred) basis. Most employees make their pension
contributions on a pre-tax basis.
b. Since the pension contributions were made on an after-tax basis and relates to a
qualified retirement plan, the $12,000 pension payments will be taxed under the
simplified method for qualified retirement plan annuities. (For a discussion of the
simplified method, see Chapter I:3.) The taxation of the $12,000 is determined as
follows:

Investment in contract: $30,000

Number of anticipated payments: 260
Exclusion amount per month: $30,000/260 months = $115.38 per month
Exclusion amount for the year: $115.38 x 12 months = $1,384.56
Includible amount for the year:
Amount received $12,000.00
Excluded amount ( 1,384.56)
Includible amount $10,615.44

c. Pat’s final return in 2013 will include $10,615.44 of income from the pension
payments and an itemized deduction for the unrecovered investment in the contract of $27,230.88
[$30,000 – (24 months x $115.38)]. pp. I:9-29 and I:9-30.

I:9-71 a. The tax consequences from the stock transfer are deferred for both employee Patrick
and Bear Corporation until the lapse of the nontransferability and forfeiture restrictions in year 2017.
Thus, Patrick recognizes no compensation income on the receipt of the stock in 2012 and Bear
receives no deduction.
b. Patrick would recognize $1,000 (100 shares x $10) of ordinary income subject to tax.
Bear Corporation receives a $1,000 deduction.

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I:9-20
 c. 1. No effect to Patrick despite the fact that he was previously taxed. Bear must
include $1,000 in gross income because it received tax benefit due to the prior deduction.
2. No tax effect
d. 1. There is no tax effect
2. Patrick reports income of $10,000 and Bear receives a $10,000 deduction (100
shares x $100).
e. 1. $120/share x 100 shares = $12,000 - $1,000 basis = $11,000 LTCG for Patrick. No
effect to Bear.
2. $120/share x 100 shares = $12,000 - $10,000 basis = $2,000 LTCG for Patrick. No
effect to Bear. p. I:9-33.

I:9-72 a. Jamal may deduct $2,000 of the contribution for tax year 2012, as the contribution
was made by the due date for the 2012 income tax return. The $58,000 ceiling is exceeded by
$6,000 so 60% ($6,000/$10,000) of the contribution is not deductible. Jamal could elect to treat the
IRA contribution as made for 2013. Since Jamal’s AGI is only $57,000 in 2013 and the income for
2012 is less than the $58,000 limit, he would be eligible to deduct the full $5,000 in 2013. (2013
limitation almost certainly will not decrease.)
b. The deduction is for AGI.
c. Jamal may then deduct $5,000 because the special income limitations in part (a) do
not apply if taxpayer is not an active participant in a qualified plan
d. $5,000 would then be deductible since Jamal's AGI does not exceed the $90,000
(2012) married joint return limit. Since Jamal has at least $10,000 of earned income, Jamal is
eligible to put $5,000 into an IRA and his spouse is eligible to put $5,000 into a spousal IRA. Thus,
they can put a total of $10,000 into IRAs during 2012. pp. I:9-38 through I:9-40.

I:9-73 a. The full $10,000, $5,000 each.

b. 2012 because the contribution is made on or before the due date of the 2012 return,
i.e., April 15, 2013.
c. For AGI
d. No change since their joint AGI does not exceed $92,000 (2012).
e. Yes, nondeductible contributions to an IRA are permitted to the extent that an
individual is ineligible to make deductible contributions. However, total IRA deductions (to all
types of IRAs, traditional deductible and nondeductible, and both IRAs) may not exceed $5,000.
f. Phil’s spouse is eligible to make a $5,000 contribution to an IRA for the tax year
2012. Even though Phil is covered under an employer-sponsored plan, since their AGI is less than
$173,000, Phil’s spouse may contribute and deduct $5,000 to a traditional IRA. Phil is not eligible
to contribute and deduct any amount to an IRA because he is an active participant in a qualified plan
and their AGI is greater than $112,000. pp. I:9-37 through I:9-39.

I:9-74 a. Chatham Mae is eligible to contribute $3,000 into a Roth IRA. She is not eligible to
contribute and deduct amounts to a traditional IRA because her income exceeds $68,000. Since her
AGI exceeds $110,000, (2012) she is limited as to how much she can put into a Roth IRA, as follows:

Limitation reduction: $5,000 x ($116,000 - $110,000)/$15,000 = $2,000.

Contribution ceiling amount: $5,000 ceiling - $2,000 reduction = $3,000.

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If Chatham Mae elects to not put any money into a Roth IRA, she can contribute $5,000 to a
nondeductible traditional IRA. Finally, if she contributes $3,000 to a Roth IRA, she also can put
$2,000 into a nondeductible traditional IRA. Taxpayers are allowed to put a combined maximum of
$5,000 into all IRAs.
b. The $15,000 distribution to pay off her car loan is not a qualified distribution
because
Chatham Mae is not yet age 59½ and does not meet any of the other requirements. However, under
the special ordering rules for nonqualified distribution, Chatham Mae may first withdraw $12,000
tax-free, to the extent of her contribution to the Roth IRA. The additional $3,000 is includible in her
gross income and also subject to the 10% withdrawal penalty ($3,000 x 10% = $300). Alternatively,
if the $15,000 was used for first-time homebuyer expenses, the first $10,000 is treated as a qualified
distribution and, therefore, not taxable. The remaining $5,000 is treated as being made from
contributions, first and then, nontaxable amounts.
c. Chatham Mae is eligible to rollover her traditional IRA to a Roth IRA because, in
2012 and later years, the $100,000 AGI limitation has been repealed and Chatham Mae will be able
to rollover her traditional IRA to a Roth IRA in these future years. She must include the entire
rollover amount in her gross income in the year of the rollover. pp. I:9-39 through I:9-41.

I:9-75 a. Since Jack and Katie’s AGI exceeds $190,000, the minimum $2,000 amount that can
be contributed to the CEA accounts must be reduced as follows:

$2,000 x ($196,000 - $190,000)/$30,000 = $400

Thus, the maximum that can be contributed to each of the grandchildren ages 10, 12, 15, and 16 is
($2,000 - $400) = $1,600. No contribution may be made for the 19-year old, as she is over 17 years
old.

b. The granddaughter may exclude $4,500 of the $7,000 distribution, as these are
qualified education expenses. However, the excess $2,500 is includible in the granddaughter’s
income in 2012 and she is also subject to a 10% penalty, or $250. pp. I:9-41 and I:9-42.

I:9-76 a. Paula must provide comparable coverage for her nurse who is an eligible full-time
employee. For example, if she contributes 25% of her earned income, a comparable benefit rate
must be contributed based upon the salary payments to the nurse.
b. For AGI. The deductible amount is the lesser of 25% of compensation or $50,000 for
2012. However, if Paula elects the maximum 25% rate, she must reduce the percentage for her
contribution. Paula’s rate would be 20% (0.25/1.0 + 0.25). Thus, her maximum contribution in 2012
would be $20,000 ($100,000 x 0.20).
c. Yes, because she is a full-time employee. In addition, she must contribute 25% of the
nurse’s earned income.
d. If the contributions were deductible then they are taxable when the funds are
withdrawn and a nondeductible 10% penalty tax is imposed upon the amounts withdrawn unless one
of the exceptions provided in Sec. 72(t) applies such as death, or disability of the taxpayer.
pp. I:9-37.

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I:9-22
I:9-77 a. January 1, 2012 - no effect since no tax consequences occur on the grant of an
incentive stock option.

April 1, 2014 - no effect except for a $200 [($100 - $80) x 10 shares] tax preference
item for purposes of the alternative minimum tax.

May 1, 2016 - $500 long term capital gain is recognized by Peggy, computed as
follows:
Sale price $ 1,200 ($120 x 10 shares)
Minus: Basis ( 800) ($80 x 10 shares)
LTCG $ 400

Peggy is entitled to long-term capital gain treatment since both of the requirements for incentive
stock options were met. Bell Corporation does not receive a corresponding compensation deduction.
b. Since Peggy did not hold the stock the required holding period, she would recognize
$200 ordinary income on the sale date equal to the spread between the option price and the exercise
price [($100 - $80) x 10 shares = $200] ordinary income on May 1, 2014. Bell Corporation is
permitted a $200 deduction for compensation on May 1, 2014 because the option is treated as a
nonqualified stock option. On the sale date Peggy also recognizes a STCG of $300 [$1,300 - ($100
x 10 shares)]. pp. I:9-34 and I:9-35.

I:9-78 a. January 1, 2012 - Penny recognizes ordinary income of $20,000 [($100 - $80) x
1,000] shares on the grant date equal to the difference between FMV and option price. Bender
Corporation receives a compensation deduction of $20,000.

January 1, 2013 - There is no tax effect on the exercise date.

January 1, 2015 - Penny recognizes long-term capital gain of $10,000 computed as

follows:
Selling price ($200 x 1,000 shares) $200,000
Minus: Basis ($100 x 1,000 shares) (100,000)
LTCG recognized by Penny $100,000

No tax effect to Bender Corporation.

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I:9-23
 b. January 1, 2012 - There are no tax consequences on the grant date.

January 1, 2013 - Penny recognizes ordinary income of $70,000 [($150 - $80) x

1,000 shares]. Bender Corporation receives a compensation deduction of $70,000.

January 1, 2015 - Penny recognizes long-term capital gain of $50,000 computed as

follows:
Selling price ($200 x 1,000 shares) $200,000
Minus: Basis ($80 x 1,000 shares)
+ $70,000 ordinary income reported (150,000)
LTCG recognized by Penny $ 50,000
pp. I:9-35 and I:9-36.

Comprehensive Problem
I:9-79 Dan and Cheryl’s taxable income tax liability for 2012 is determined below.

Wages and salaries: Dan $ 125,000

Cheryl 45,400 $ 170,400
Interest 1,450
Dividends 5,950
Net short-term capital loss ( 3,000)
Adjusted gross income (AGI) $ 174,800

Itemized deductions:
Medical expenses $ 4,870
Minus: 7.5% of AGI ( 13,110) -0-

Real estate taxes $ 2,200

Minus: 10% home office ( 220) 1,980
Personal property taxes 400

Mortgage interest $ 15,600

Minus: 10% home office ( 1,560) 14,040

Charitable contributions ($9,000 + $12,000) 21,000

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Miscellaneous itemized deductions:
Tax preparation fees 750
Employee business expenses* 10,520
Office-in-home expenses** 4,265
15,535
Minus: 2% of AGI (2% of $174,800) ( 3,496) 12,039
( 49, 459)

Personal exemptions ($3,800 x 2) ( 7,600)

Taxable income $117,741
Income tax liability*** 20,901
Income taxes withheld ( 25,000)
Overpayment – refund to Dan and Cheryl $ 4,099

*Employee business expenses (travel $1,080a + automobile $8,440b + Cheryl 1,000) $ 10,520
(See below for detail of travel expenses; automobile expenses are below.)
a
Travel expenses
Expense Total Reimbursed Unreimbursed
Hotel $4,200 $3,360 $ 840
Meals 820 656 82 ($164 x 50%)
Entertainment 1,080 864 108 ($216 x 50%)
Tips 100 80 20
Cleaning 150 120 30

Totals $6,350 $5,080 $1,080

Reimbursed expenses = 80% ($5,080/$6,350)

b
Automobile: Mileage: 32,000 x .555 = $17,760 – (32,000 x .30) = $ 8,160
Parking and tolls 280
$ 8,440

** Office-in-home expenses

Direct expenses
Supplies $ 290
Telephone 1,100 1,390

Indirect expenses
Utilities ($3,400 x 10%) 340
Homeowner’s insurance ($600 x 10%) 60
Repairs and maintenance ($800 x 10%) 80
Depreciation (see computation below) 615
Mortgage interest ($15,600 x 10%) 1,560

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Real estate taxes ($2,200 x 10%) 220 2,875

$4,265
Depreciation: $240,000 x 2.564% x 10% = $615

***Taxable income $ 117,741

Less: dividends ( 5,950)
$ 111,791
Tax per rate schedule on $111,791 $ 20,008
Tax on dividends ($5,950 x 0.15) 893
Total tax liability $ 20,901

Tax Strategy Problem

I:9-80 a. Yes, assuming that Laura is a bona fide employee of Lightmore Communications,
Inc., her travel expenses would be deductible. Since the facts state that Laura’s presence would be
helpful to Paul and the corporation, it would appear that making Laura an employee would be
accepted by the IRS. To establish her employment status, she would probably need to be assigned
other duties with the corporation other than just traveling.
b. If Laura is an employee of the corporation, she would be entitled to all of the benefits
that are available to other employees, including retirement plan, group life insurance, health
insurance, etc. Thus, there are certainly more benefits than just travel expenses in having Laura be
an employee of the corporation.
c. The major detriment is that Laura’s salary with the corporation would be subject to
income taxes (stacked on top of her husband’s income) and payroll taxes (Social Security and
Medicare). The benefits above would certainly need to be greater than the additional taxes to make
this a viable planning option. pp. I:9-8.

Tax Form/Return Preparation Problems

I:9-81 (See Instructor’s Resource Manual)

I:9-82 (See Instructor’s Resource Manual)

Case Study Problems

I:9-83 The following points should be stressed in the client memo:

1. Ajax needs to expand its equity base because of its high debt/equity ratio and needs
for growth.
2. Management philosophy favors employee stock ownership for employees and
executives.
3. Conditions are favorable to offer compensation arrangements involving qualified and
nonqualified plan arrangements because the company's stock is publicly traded.

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 4. A Sec. 401(k) and or an ESOP plan should be considered for employees as a
supplement to the existing qualified pension plan because current pension benefits
are minimal. An ESOP offers attractive cash flow advantages to the company.
5. A nonqualified plan such as a restricted property arrangement involving Ajax stock
is needed to attract, motivate, and retain key executives. A nonqualified plan may
discriminate in favor of key executives.
6. An incentive stock option plan should be considered for employees and/or executives
as a means to raising additional equity capital. An ISO results in deferral of
immediate taxation to employees and eventual capital gain treatment although Ajax
receives no direct tax benefit unless a nonqualified stock option plan is adopted.

I:9-84 Contained in the new standards of the AICPA's Statements on Standards for Tax Services
(SSTS) is Statement No. 4, which explains that a CPA can use taxpayers' estimates if it is
impractical to obtain exact data and the estimated amounts are reasonable under the facts and
circumstances known to the CPA. However, certain expenses must be evidenced by proper
documentation. Travel and entertainment expenses must, under Sec. 274(d), be substantiated by
adequate documentation by the taxpayer as prescribed in that section. The CPA cannot use
estimates for these amounts.

The client letter should explain to the taxpayer that a deduction cannot be allowed for the
travel and entertainment expenses incurred unless proper documentation has been made under the
requirements of Sec. 274(d) of the Internal Revenue Code. Documentation should include an
expense book or diary containing the time, place, business purpose, and proof of the amount.

Tax Research Problem

I:9-85 The primary issue in this case is whether Charley is “away from home”. If Charley is
considered away from home, his travel expenses would be deductible. The IRS and the courts have
struggled with this type of situation in several previous cases. In Williams v. Patterson, 286 F.2d
333 (CA-5, 1961), the court established the “sleep or rest” rule which suggests that a trip long
enough to require interruption for rest was equivalent to being away overnight.

Due to the discrepancies in applying the “sleep or rest” rule, the Supreme Court granted
certiorari in U.S. vs. Correll, 389 U.S. 299 (1967), where the Court ruled unfavorably for the
taxpayer in a situation where a traveling salesman pulled his car over to the side of the road and slept
for several hours during trips. Soon after the Correll decision, the Treasury Department issued Rev.
Rul. 75-168, 1974 C.B. 58, which addressed trips of less than 24 hours. According to the ruling,
travel expenses may be deductible for trips of less than 24 hours if it was reasonable for the taxpayer
to require sleep or rest.

In this case, the result is not absolutely clear. It appears that Charley Long used his judgment
to determine whether he needed sleep or rest. It seems fairly clear that he should be able to deduct
his food and lodging on the nights he stayed in a motel. However, on the nights he slept in his cab,
the Correll case may be unfavorable to Charley’s position.

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“What Would You Do In This Situation?” Solution

Ch. I:9, p. I:9-14 .

Joe Windsack is clearly committing an act of tax fraud by claiming fictitious deductions. You
as a CPA have the ethical responsibility to inform Windsack that the excess deductions are not
allowable and must not be claimed on his return. Under the Statement on Standards for Tax Services
#6, you cannot associate yourself with a tax return (by signing the return as tax preparer) if you
know that an error exists on the return. If he objects to this treatment, you must withdraw from this
client engagement and not prepare his return for the taxable year.

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