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Test Bank for Taxation for Decision Makers, 2020 10th

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Test Bank for Taxation for Decision Makers, 2020, 10th

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2 Taxation for Decision Makers Research Solutions
in the year of receipt must be included in gross income in the next tax year. Rev. Proc. 2011-18,
2011-5 I.R.B. 443 clarifies that the definition of an eligible advance payment includes gift cards
that are redeemable by the taxpayer or by other entities that are legally obligation to accept the
card from a customer as payment for goods or services. Rev. Proc. 2013-29, 2013-33 I.R.B. 141
further clarified that a taxpayer is not precluded from using the deferral method just because the
taxpayer never earns payment from eligible gift card sales.
73. [LO 3.4] Personal Use of Political Campaign Funds (can be solved using Checkpoint® or a similar
service)
Thomas ran for Congress, raising $2 million for his campaign. Six months after losing the election,
auditors discovered that Thomas kept $160,000 of the campaign funds using the money to purchase a
vacation home. What are the tax consequences of this use of campaign funds?
Hint: Rev. Rul. 71-449, 1971-2 C.B. 77 (clarified by Rev. Rul. 74-22, 1974-1 C.B. 16)
Issue: Does Thomas have income as a result of using the campaign funds to purchase a vacation
home?
Conclusion: Yes, Thomas must recognize $160,000 income in the year the campaign funds were
used to pay for his vacation home.
Discussion of Reasoning and Authorities: Code Section 61 states that gross income includes
income from all sources unless specifically excluded. Rev. Rul. 71-449, 1971-2 C.B.77 concluded
that political contributions used for personal purposes by a political candidate are included in
gross income in the year the funds are diverted to personal use. A candidate is not taxed on
campaign funds to the extent they are used for expenses of a political campaign or a similar
purpose. Therefore, Thomas must recognize $160,000 income in the year the campaign funds
were used to pay for his vacation home.
74. [LO 3.4] Income from Donation of Blood (can be solved using Checkpoint® or a similar service)
Samantha has been unemployed for some time and is very short of money. She learned that the local
blood bank has a severe shortage of her type of blood and, therefore, is willing to pay $120 for each
blood donation. Samantha gives blood twice a week for 12 weeks, receiving $120 for each donation.
Are these funds includable in Samantha's gross income?
Hint: Green v. Comm. 74 T.C. 1229 (1980)
Issue: Does Samantha have income as a result of the funds she received for donating her blood?
Conclusion: Yes, Samantha must recognize as income the payments she received for selling her
blood.
Discussion of Reasoning and Authorities: Code Section 61 states that gross income includes
income from all sources unless specifically excluded. In Green v. Comm, 74 T.C. 1229 (1980),
the Court concluded that payments received for “donations” of blood plasma were income
received in the trade or business of selling the product of blood plasma.
Note to instructor: This case also addresses the deductibility of expenses for transportation to
give blood, expenses for special food and drugs, health insurance, and a depletion allowance.
Although some expenses were deductible, the taxpayer was not permitted an allowance for
depletion.
75. [LO 3.4] Payment of Life Insurance Premiums as Alimony (can be solved using free Internet sources
if citations are provided to students)
Alice and Manny finalized their divorce agreement in late 2018. Manny purchase and assigned to
Alice a life insurance policy on his life as part of the divorce agreement. Manny agreed to continue
Solutions to Develop Research Skills Problems 3
paying the premiums on this policy for the next 10 years. Manny wants to know if the premium
payments will be treated as alimony.
Hints: Reg. Section 1.71-1T(b), Q&A 6 and Rev. Rul. 70-218, 1970-1 C.B. 19.
Issue: Will Manny’s payments of the life insurance premiums qualify as alimony?
Conclusion: Yes, the premium payments will qualify as alimony providing that Alice is the
irrevocable beneficiary of the life insurance policy assigned to her.
Discussion of Reasoning and Authorities: Reg. Section 1.71-1T(b), Q&A 6 states that
premiums paid by the payor spouse for term or whole life insurance on the payor’s life under the
terms of the divorce or separation instrument will qualify as payments on behalf of the payee
spouse to the extent that the payee spouse is the owner of the policy. Rev. Rul.70-218, 1970-1
C.B. determined that when a life insurance policy on the life of the husband is assigned to the
wife and she is the irrevocable beneficiary, the premiums are deductible as alimony by the
husband and taxable to the wife.
Note that due to the Tax Cuts and Jobs Act (TCJA), alimony covered under a divorce agreement
finalized after 2018 will not be taxable or deductible. The TCJA made no change to divorce
agreements finalized by December 31, 2018.
76. [LO 3.4 & 3.5] Income vs. Gift (can be solved using free Internet sources if citations are provided to
students)
A minister receives an annual salary of $16,000 in addition to the use of a church parsonage with an
annual rental value of $6,000. The minister accepted this minimal salary because he felt that was all
the church could afford to pay. He plans to report these amounts on his income tax return but he is
uncertain how to treat the cash gifts he receives from the members of his congregation. These gifts are
made out of love and admiration for him. During the year the congregation developed a regular
procedure for making gifts on special occasions. Approximately two weeks before each special
occasion when the minister was not present, the associate pastor announced before the service that
those who wished to contribute to the special occasion gifts could do so by placing cash in envelopes
and giving them to the associate who would give them to the minister. Only cash was accepted to
preserve anonymity. The church did not keep a record of the amounts given nor the contributors, but
the minister estimates that these gifts amount to about $10,000 in the current year. How should he treat
these gifts?
Hint: Goodwin, Lloyd L., Reverend v. U.S., 76 AFTR 2d 95-6716, 67 F3rd 149, 95-2 USTC
¶50534 (1995, CA8); affirming 74 AFTR 2d 94-6987 (DC IA).Also see Wayne Felton, TC Memo
2018-168, RIA TC Memo ¶2018-168, 116 CCH TCM 365.
Issue: How should the minister treat the $10,000 in cash gifts?
Conclusion: The minister should include the $10,000 in his gross income as compensation.
Discussion of Reasoning and Authorities: Code Section 61(a) provides that gross income
includes all income from whatever source derived unless excluded by a specific provision of the
Code. According to Section 61(a)(1), compensation for services, in whatever form received, is
includable in gross income. Section 102(a) excludes from gross income the value of property
acquired by gift. Whether a payment is a gift under Section 102(a) or gross income under section
61(a) is a factual question.
In Goodwin v. U.S., a minister received gifts from members of his congregation who believed
he was a good minister and wanted to reward him. The payments were made on a regular basis,
were systematically organized and collected by church personnel, were substantial compared to
the minister’s salary, and were made to retain the minister’s services. The court held that these
factors showed that the intent was to increase the minister’s compensation. The fact that the
payments were anonymous and were not coerced did not change the result. Therefore the so-
called gifts were part of the minister’s taxable compensation.
In Felton, a minister received gifts from members of his congregation via special envelopes
that were earmarked as nondeductible pastoral gifts and separate from regular church tithes and
offerings. Despite the gift label, the court determined that these donations were taxable income
because the members’ intent in giving them was to keep the pastor, who did not take a salary
during the years at issue.
Solutions to Chapter 3 Problem Assignments

Check Your Understanding
1. [LO 3.1] Realization Principle
Solution: Income is not recognized (included in gross income) until the taxpayer has
realization. Realization usually takes place when an arm’s-length transaction
occurs, such as the sale of goods or the rendering of services. Fluctuations in value
are not income unless that change is realized through some transaction.
2. [LO 3.1] GAAP vs. Tax

Solution: (1) The goals of financial accounting and tax reporting are very different. The
purpose of financial accounting is to provide information decision makers, such as
shareholders and creditors, find useful, while the goal of tax accounting is to
collect revenue equitably.
(2) Financial accounting often relies on the principle of conservatism, which tends
to understate income when uncertainty exists. In contrast, the income tax system
would be greatly hampered in its collection of revenue if taxpayers were allowed
the freedom of reporting income conservatively.
(3) Financial accounting often relies on estimates and probabilities. The tax system
would not function very efficiently or equitably if taxpayers were allowed to
estimate income or base their reported income on probabilities.
3. [LO 3.1] Book/Tax Differences

Solution: The two major categories are temporary (or timing) differences and permanent
differences. For temporary differences, income is taxed in a different period than it
is accrued for accounting purposes. Income that is not taxed but is included in
financial accounting income would be a permanent difference.
4. [LO 3.1] Tax-favored Investments

Solution: Tax law favors investments that yield appreciation rather than annual income. The
tax on appreciation (gain) is deferred until gain is recognized and then it is
frequently taxed at lower long-term capital gains rates. Congress wants to
encourage taxpayers to invest for the long-term as it helps the economy.
5. [LO 3.2] Choice of Tax Year

Solution: The sole proprietorship’s operating results will all be reported on Michelle’s tax
return. As a result, it will have to be on a calendar-year basis unless Michelle
applies for and receives permission to change her tax-year end to October 31.
6. [LO 3.2] Accounting Methods

Solution: Jabba must recognize the fair market value of the computer (assumed to be
approximately $2,000) as income in payment of the bill. Cash-basis taxpayers must
recognize income when cash or cash equivalents are received as payment. The
computer constitutes a cash equivalent.

Solution: Murphy should recognize the income in year 1. The check was readily available
several days before the end of the year and, as a cash-basis taxpayer, Murphy cannot
turn its back on the income by failing to pick up the check.

Solution: Congress put several restrictions on the use of the cash method. But all businesses
whose average annual gross receipts for the three prior years do not exceed $26
million in 2019 ($25 million in 2018) may use the cash method. Personal service
corporations, no matter how large, can always use the cash method.
9. [LO 3.2] Tax vs. Financial Accounting

Solution: The government is concerned with collecting its tax revenue when the taxpayer has
the “wherewithal” to pay the tax. Thus, the government usually does not permit an
accrual taxpayer to postpone the recognition of income not yet earned but for which
the taxpayer has received payment. GAAP, however, requires the use of accrual
accounting even for prepaid items to properly match income to the periods over
which it is earned. This helps to maintain the comparability of financial statements
over time that would otherwise be distorted if prepaid items were recognized as
income when payment was received.
10. [LO 3.2] Long-Term Construction Contracts

Solution: A long-term contract is a contract for the manufacture, building, installation or
construction of property that will not be completed in the year the contract is entered
into. There are two permissible tax treatments: the completed contract method and
the percentage-of-completion method. The first allows the contractor to postpone
the recognition of income and expenses related to the contract until the year the
contract is completed. The percentage-of-completion method allows the taxpayer to
recognize income based on the ratio of actual expenses incurred to date to total
anticipated expenses for the contract as a whole. The latter method spreads income
recognition across the period of time over which the income is earned.
11. [LO 3.3] Assignment of Income

Solution: Ryan’s gross income is $120,000. He earned the income and he is responsible for
including it in his taxable income. He will be treated as making a gift of the $20,000
to his grandmother.
12. [LO 3.3] Community Property Laws

Solution: For tax purposes, community income is split evenly between spouses who file
separate returns in community property states. In common law states, income is
usually taxed to the individual who earns the income.
13. [LO 3.4] Income Tax Effects of Gifts

Solution: Tommy will recognize the $100 dividend income because he is the legitimate owner
of the stock at the time the dividend is paid. Virginia has no income.
14. [LO 3.4] Tax-Exempt Bonds

Solution: The interest exclusion for most state and local bond issues permits state and local
governments to finance their governmental activities at much lower interest rates
than they would be required to pay if they were competing with corporate bonds.
15. [LO 3.4] Original Issue Discount

Solution: Martha must include the $840 of accrued interest in her income. The bonds were
issued with original issue discount, so this accrued interest must be included in
income even by a cash-basis taxpayer.
16. [LO 3.4] Gross Income/Treasure Find

Solution: Jane should include the $100 in her gross income. Treasure finds also constitute
gross income.
17. [LO 3.4] Gross Income/Unemployment Compensation

Solution: Unemployment compensation is a substitute for the taxable wages a person would
receive from his or her employment. A substitute for a form of income that is
subject to tax will also be included in gross income and taxed. (The American
Reinvestment and Recovery Act allowed the first $2,400 of unemployment
compensation received in 2009 to escape taxation, but that provision was never
extended beyond the 2009 filing year.)
18. [LO 3.5] Gross Income/Gifts and Inheritances

Solution: No. The recipients of gifts and inheritances do not include the items received in
their gross income. Instead, the giver (donor or decedent) may be subject to a
transfer tax (gift or estate tax). Some people consider this transfer tax a second tax
because the donor may have been subject to income tax when he or she earned the
amounts that were later given as gifts or inheritances.
19. [LO 3.5] Life Insurance/Buy-Sell Agreement

Solution: A buy-sell agreement is an agreement between co-owners of a business that
provides for the purchase of one owner’s interest by the other (and the other heir’s
obligation to sell) should the owner die. Life insurance on the deceased payable to
the surviving owner(s) provides the funds necessary for the purchase of the
deceased owner’s interest.
20. [LO 3.6] Taxes for a U.S. Citizen vs. Nonresident Alien
Solution: United States citizens are subject to U.S. tax on their worldwide income. Income
earned by nonresident aliens is divided into three categories: U.S. business

income (called effectively connected income), non-U.S. business income, and U.S.
investment income. Nonresident aliens are taxed similar to U.S. citizens on their
effectively connected business income. Business income that is not effectively
connected with the United States is usually not subject to U.S. tax. U.S. investment
income includes interest, dividends, and royalties and is usually taxed at a flat 30
percent rate (or treaty rate if lower).
21. [LO 3.6] Tax Treaty

Solution: The objective of a tax treaty with a foreign country is to minimize double taxation
of the same income by the United States and the foreign country.
22. [LO 3.6] Foreign Tax Credit

Solution: The purpose of the foreign tax credit is to minimize double taxation of the same
income by two countries. Under the source principle, a country can claim the right
to tax income earned within its boundaries. To minimize the double tax, the
resident country then allows its citizens and corporations to offset the domestic tax
on their foreign income with a foreign tax credit up to the amount of tax paid to the
source country. The net tax paid will usually be the greater of the taxes imposed
by the two countries claiming jurisdiction over the income.
Crunch the Numbers

23. [LO 3.2] Cash Method
Solution: $575 is included in 2020 gross income for his sole proprietorship
24. [LO 3.2] Refunds of Prior Income

Solution: a. Because the refund exceeds $3,000, Specialty Training has two choices: it can
deduct the $5,000 in the current year or it can reduce the current year’s tax by the
amount of tax paid in the prior year on the $5,000.
b. At 37 percent marginal tax rate in the year of repayment, Specialty would be
better off taking a deduction for the amount repaid at that time. It will reduce its
taxes by $250 [(37% - 32%) x $5,000] more than taking the deduction for prior
year’s taxes paid.
c. With a marginal tax rate of 24 percent, Specialty should reduce the current
year’s tax for the $1,600 ($5,000 x 32%) of taxes paid in the prior year. It will be
$400 [(32% - 24%) x $5,000] better off.
25. [LO 3.2] Prepaid Rental Revenue

Solution: a. For tax purposes Realty will recognize $6,000 ($3,000 x 2 months’ rent) income
in year 1 because prepaid income is taxed when received for both cash and accrual
basis taxpayers. For financial accounting no income will be recognized in year 1.
b. For tax purposes, Realty will recognize $8,500 ($3,000 March rent + $3,000
April rent + $2,500 kept from deposit) income in year 2. For financial accounting,
Realty will recognize all $14,500 as income in year 2. (Note that a deduction
would be allowed for the costs to repair the damages.)
26. [LO 3.2] Prepaid Service Revenue

Solution: a. $1,000 (1/24 of $24,000) for both tax and financial accounting.
b. $23,000 for tax accounting and $12,000 for financial accounting. Deferral for
tax is not permitted beyond the year following the prepayment.
c. $0 for tax accounting and $11,000 ($24,000 - $1,000 - $12,000) for financial
accounting.
27. [LO 3.2] Long-Term Construction Contract

Solution: (1) Under the completed contract method, Highrise will recognize all $250,000 of
gross income and $226,000 of costs in year 2. It will recognize no income or
expenses in year 1.
(2) Under the percentage-of-completion method, Highrise will recognize $137,500
of gross income ($121,000/$220,000 x $250,000) and $121,000 of expenses in
year 1 for net taxable income of $16,500. In year 2, it will recognize the balance of
the revenue of $112,500 ($250,000 - $137,500) and expenses of $105,000 for net
taxable income of $7,500.
28. [LO 3.3] Shifting Income to Children

Solution: a. Alana has $10,970 gross income and Mac has none. Mac includes nothing in his
gross income because he gave the stock to Alana and is no longer the owner.
Alana is taxed on the dividend income ($170) because she was the owner when the
dividend was declared and paid. Alana also includes the $10,800 [600 x ($38 -
$20)] gain on the sale of the stock in her gross income. She will use Mac’s
purchase price (carryover basis) of the stock to determine her gain on the sale.
b. $1,969.50. Because the gain on the sale of the stock is short-term capital gain, it
will be taxed at ordinary income rates. Mac’s 32% marginal tax rate would apply
to the short-term capital gain and his rate for dividend income would be 15%.
Alana’s 12% marginal tax rate applies to the short-term capital gain and her rate
for dividend income is zero. The difference in the tax rates on the STCG between
Mac and Alana is 20% (32% - 12%) resulting in a $2,160 ($10,800 x 20%) tax
savings. The difference in the tax rates on the dividend income is 15% (15% for
Mac – zero for Alana) resulting in a $25.50 ($170 x 15%) tax savings. By having
the $10,970 total income taxed to Alana rather than Mac, the family has a total tax
savings of $2,185.50 ($2,160 + $25.50).
Note that this solution specifies that Alana is age 24. As discussed in Chapter 12,
the kiddie tax provision can cause some unearned income of children under age 24
to be taxed at using the tax rates for estates and trusts.
29. [LO 3.4] Municipal Bonds

Solution: Carl recognizes gain of $3,000 ($43,000 - $40,000) on the sale of the stock. The
interest is nontaxable because these are tax-exempt municipal bonds.
30. [LO 3.4] Taxable vs. Nontaxable Bonds

Solution: a. Jessica’s after-tax cash flow from the municipal bonds is $550 (5.5% x $10,000)
because this interest income is tax exempt. For the corporate bonds, Jessica will
receive $700 ($10,000 x 7%) in interest income but will pay $84 ($700 x 12%) in
tax on that income resulting in an after-tax cash flow of $616 ($700 - $84).
b. Jessica will now pay $224 ($700 x 32%) in tax on the corporate bond interest
income resulting in after-tax cash flow of only $476 ($700 - $224) while her after-
tax cash flow from the municipal bonds is still $550.

Solution: a. Nick’s after-tax cash flow from the municipal bonds is $1,350 (4.5% x $30,000)
because this interest income is tax exempt. For the corporate bonds, Nick will
receive $1,800 ($30,000 x 6%) in interest income but will pay $630 ($1,800 x
35%) in tax on that income resulting in an after-tax cash flow of only $1,170
($1,800 - $630).
b. Nick will now pay $396 ($1,800 x 22%) in tax on the corporate bond interest
income resulting in after-tax cash flow of $1,404 ($1,800 - $396) while his after-
tax cash flow from the municipal bonds is still $1,350.
32. [LO 3.4] Gift Loan

Solution: a. There are no tax consequences to Joshua or Seth because the loan is not in
excess of $100,000 and the proceeds are used for personal expenses (rather than
investment); the transaction is not subject to the imputed interest rules.
b. The imputed interest rules treat the transaction as if Seth paid $4,000 in interest
($100,000 x 4%) to Joshua each year with Joshua recognizing $4,000 of interest
income; Joshua would then be assumed to make a gift of $4,000 annually to Seth.
Thus, Joshua must recognize $4,000 in interest income (from the interest imputed
at the federal rate) annually and Seth recognizes $8,000 of interest income (from
his investment in corporate bonds). If Seth’s net investment income is less than
$4,000, the imputed interest will be limited to the lower net investment income.
33. [LO 3.4] Employee/Shareholder Loans

Solution: Lynn is assumed to pay Sheldon Corporation $3,200 in interest (4% x $80,000) on
the loan. Sheldon has $3,200 in interest income. If Lynn is an employee, Sheldon
is assumed to then return the $3,200 to Lynn as taxable compensation, deductible
by the corporation. If Lynn is a shareholder, the return of the $3,200 is assumed to
be taxable dividend income to Lynn but nondeductible by the corporation.
34. [LO 3.4] Gross Income from Investments

Solution: $11,800. George must include in gross income all except the $1,000 distributed by
ABC as a nontaxable distribution. Thus, his gross income must include the $4,000
taxable distribution from ABC and both the $6,500 dividend and the $1,300 capital
gain distribution from Brightstar for a total of $11,800.
35. [LO 3.4] Stock Dividend

Solution: Cheryl recognizes no income from the receipt of the stock dividend. She will
spread the basis of the original 100 shares over the new total of 300 shares. Each
of the 300 shares will now have a basis of $3.33 [(100 x $10)/300].
36. [LO 3.4] Annuities

Solution: a. $3,000. If Charles lives for 15 years, he will receive a total of $165,000 (15 x
$11,000). $120,000 of this represents a return of his investment; the remaining
$45,000 represents income earned on this investment and is taxable. Of each
$11,000 payment, $3,000 [($45,000/$165,000) x $11,000] must be included in
income. The remaining $8,000 is a tax-free return of his investment.
b. If Charles dies after receiving only $77,000 (7 years at $11,000 per year), he
will have recovered only $56,000 (7 x $8,000) of his total $120,000 investment.
The remaining $64,000 ($120,000 - $56,000) can be deducted on his final tax
return.
37. [LO 3.4] Annuities

Solution: $13,750. All of the contributions to Barney’s retirement plan except for the
$20,000 from after-tax employee contributions will be taxable when received
along with the excess received over the total investment. Thus, of the $240,000 in
expected payments, $220,000 is taxable. Of each $15,000 payment, $13,750
[$15,000 x ($220,000/$240,000)] must be included in Barney’s gross income.
38. [LO 3.4] Income from Lottery Winnings

Solution: Julie must include all $500,000 of each payment received in years 1 through 4 in
income when received. When she sells her rights to the remaining 26 payments for
$8,900,000, the $8,900,000 must be included in income when received.
39. [LO 3.4] Social Security Benefits

Solution: $31,600. Vera’s modified adjusted gross income is $64,000 [$18,000 + $38,000 +
($16,000 x 50%)]. Because her MAGI exceeds $34,000, she will have to include
up to 85 percent of her Social Security benefits in her income determined as the
lesser of (1) $13,600 (85% x $16,000) or $30,000 [85% ($64,000 - $34,000) +
$4,500] . The inclusion of the tax-exempt interest in MAGI is sufficient to put her
in the position of having to include $13,600 of her Social Security benefits in
income. Thus, her gross income is $31,600 ($18,000 dividend income + $13,600
Social Security benefit). Although the tax-exempt bond interest must be included
in determining modified adjusted gross income, it is not included in determining
gross income for tax purposes.

Solution: $5,000. Jeff’s modified adjusted gross income does not exceed $25,000 so none of
his $18,000 social security benefits are included in his gross income. His gross
income consists of only the $5,000 interest income.
41. [LO 3.4] Damage Payments for Injuries

Solution: $5,000. Mike must include the $2,000 for emotional distress and $3,000 for lost
wages in his income. The $12,000 for the physical injuries is excluded from
income as a return of his human capital. His gross income is $5,000.
42. [LO 3.4] Tax Consequences of Divorce

Solution: a. $95,600. Harriet must recognize the $1,300 monthly alimony payment as
ordinary income ($15,600 annually). She will also report an $80,000 ($170,000 -
$90,000) capital gain on the sale of the vacation home. She has no income from
the child support payments.
b. Stu is permitted to deduct the monthly alimony payments of $1,300 ($15,600
annually) in determining his adjusted gross income.
43. [LO 3.4] Cancellation of Debt

Solution: Markum must recognize a $15,000 ($60,000 - $45,000) taxable gain on the transfer
of the property as if it had sold the property for $60,000 and used the proceeds to
pay the debt.
44. [LO 3.4] Recovery of Bad Debt

Solution: a. Sandle would recognize $15,000 of income in year 1. In year 2 it would write
off (deduct) the $15,000 as a bad debt as a result of Jim’s bankruptcy. In year 3, it
would recognize $12,000 of income on the recovery of that portion of the debt that
had been written off in the prior year.
b. If Sandle is a cash-basis taxpayer, it would recognize no income in year 1,
would have no deduction in year 2, but would recognize $12,000 of income in year
3.

Solution: a. Krystyna’s after-tax cash flow from the municipal bonds is $950 (4.75% x
$20,000) because this interest income is tax exempt. For the corporate bonds,
Krystyna will receive $1,000 ($20,000 x 5%) in interest income but will pay $120
($1,000 x 12%) in tax on that income resulting in an after-tax cash flow of $880
($1,000 - $120).
b. Krystyna will now pay $320 ($1,000 x 32%) in tax on the corporate bond
interest income resulting in after-tax cash flow of only $680 ($1,000 - $320) while
her after-tax cash flow from the municipal bonds is still $950.
46. [LO 3.3 & 3.4] Shifting Income to Children

Solution: a. Carlos has $9,200 gross income and Justin has none. Justin includes nothing in
his gross income because he gave the stock to Carlos and is no longer the owner.
Carlos is taxed on the dividend income ($200) because he was the owner when the
dividend was declared and paid. Carlos also includes the $9,000 [450 x ($38 -
$18)] gain on the sale of the stock in his gross income. He will use Justin’s
purchase price (carryover basis) of the stock to determine his gain on the sale.
b. $2,254. Because the gain on the sale of the stock is short-term capital gain, it
will be taxed at ordinary income rates. Justin’s tax rate is 37% for the short-term
capital gain and 20% for dividend income. The difference in the tax rates between
Justin and Carlos on the short-term capital gain is 25% (37% - 12%) resulting in a
$2,250 ($9,000 x 25%) tax savings. The difference in the tax rates on the dividend
income is 20% (20% for Justin – zero for Carlos) resulting in a $40 ($200 x 20%)
tax savings. By having Carlos taxed on the $9,200 total income rather than Justin,
the family has a total tax savings of $2,290 ($2,250 + $40).
c. $1,840. The gain on the sale of the stock is now long-term capital gain (8
months + 5 months = 13 months holding period) because Justin’s holding period
tacks on to the period the gift is held by Carlos. Justin’s tax rate is 20% for the
long-term capital gain and dividend income while Carlos has a zero rate for the
long-term capital gain and dividend income. The difference in the tax rates
between Justin and Carlos is 20% (20% for Justin – zero for Carlos) resulting in a
$1,840 ($9,200 x 20%) tax savings.
This solution does not include the 3.8% net investment income (NII) Medicare
surtax discussed in Chapter 5. Also note that this solution specifies that Carlos is
age 24. As discussed in Chapter 12, the kiddie tax provision can cause some
unearned income of children under age 24 to be taxed at the tax rate for estates and
trusts.
47. [LO 3.5] Property from Gift or Inheritance

Solution: Myra must include only the $7,000 interest from the bonds in her income. The
receipt of a gift or inheritance is not subject to income tax.
48. [LO 3.5] Life Insurance Proceeds

Solution: a. Zero. If Linda takes the lump-sum $500,000 payment, she recognizes no gross
income, as life insurance proceeds are usually are not taxable.
b. $8,000 each year. If she elects to take the insurance proceeds in annual
installments, $80,000 of the total $580,000 (10 x $58,000) expected to be received
will represent taxable interest. Of each annual $58,000 payment, $8,000
($80,000/$580,000 x $58,000) will be income and $50,000 ($500,000/$580,000 x
$58,000) will be tax free.
49. [LO 3.5] Disability Insurance

Solution: $16,500. A portion of each payment that represents the premium paid by Mark’s
employer is taxable income to Mark. Thus, if Mark collects $30,000 under the
disability policy, $16,500 (55% x $30,000) must be included in gross income and
the remaining $13,500 (45% x $30,000) is tax free.
50. [LO 3.5] Scholarships

Solution: $4,000 is included in income. Sara must include the $1,000 that was spent for
room and board and the $3,000 from her part-time job on campus in her income.
Only the money spent for tuition and required textbooks qualifies as the
nontaxable portion of the scholarship.
51. [LO 3.5] Scholarships

Solution: $400 in year 2. Larry spent only $6,600 ($3,200 + $3,400) on qualified expenses
from the scholarship money. Thus, he must include the $400 ($7,000 - $6,600) not
spent on qualified expenses in income. He does not have to include this amount
until year 2, however.
Develop Planning Skills

Solution: The cash method of recognizing income and expenses, if available, usually
provides the higher net present value for the company’s cash flow. Income is not
recognized until payment is received. This is usually later than when income
would be recognized under the accrual method. By delaying the recognition of
income, the payment of taxes on this income can be delayed. In addition, cash-
basis taxpayers may have the ability to make early payments for expenses at year-
end, accelerating their deductions. A deduction in the current year may be worth
more than the same deduction in the next year due to the time value of money
53. [LO 3.2] Prepaid Rent

Solution: If $4,000 is designated as the last two months’ rent, $4,000 must be included in
income when received. If only $2,000 is designated as rent, then only $2,000 must
be included in income when received. Thus, the designation of $4,000 as security
deposit is better for Palace Company from a tax standpoint (although they might
lose prospective tenants with a high security deposit).
54. [LO 3.4] Investment Alternatives

Solution: With a marginal tax rate of 37 percent, her after-tax return on the corporate bonds
is only 5.67 percent [9% x (1-.37)]. She would be better off investing in the tax
exempt bonds that pay 6 percent. With a marginal tax rate of only 22 percent, her
after-tax return on the corporate bonds improves to 7.02 percent [9% x (1- .22)],
and she would be better off investing in the corporate bonds.
Think Outside the Text

These questions require answers that are beyond the material that is covered in this chapter.
55. [LO 3.2] Doctrine of Constructive Receipt
Solution: Based on the doctrine of constructive receipt, the tax court judge would rule in
favor of the IRS. The doctrine of constructive receipt requires Walter to recognize
the income when the funds were made available to him. The $77,000 should be
included as income in the year the original check was received. The fact that a tear
slip exists, indicates that the check was received. If the check was detached and
not received with the tear slip, Walter should have contacted the customer and
requested another check to be sent immediately. This was the decision of the court
in Walter v. U.S., 92 AFTR 2d. 98-5115, 148 F. 3d 1027, 98-2 USTC ¶50546.
Solution: The student should present a logical argument for or against the 100 percent tax
rate on Social Security benefits of high-income individuals so answers will vary.
They may consider the following points.
The Social Security Act states that every individual who meets program eligibility
requirements is entitled to benefits so it is referred to as an entitlement program.
Social Security was originally designed as social insurance meant to ensure that,
regardless of which might happen with their personal finances and retirement
savings over the course of their lifetime, elderly Americans would be protected by
a government-based safety net that would prevent destitution in old age. The
concept of Social Security as an earned right has helped ensure its high level of
public support.
Public attention has recently focused on Social Security’s long-range financial

problems with policy reformers suggesting that Social Security should be subject
to some form of means testing. People in favor of means testing argue that this
would save a large amount of money by reclaiming benefits from wealthy
Americans who can get along fine without them while still allowing Social
Security to serve its basic purpose of providing a safety net to the elderly. Higher-
income individuals would be guaranteed that if their income level declined, they
would be able to keep a greater share of their benefits.
People against means testing argue that Social Security would be fundamentally
changed from social insurance to a redistributive welfare program. They argue that
means testing would create a disincentive for people to save, buy other insurance,
or work part-time in retirement. They also argue that such a system would create
pressure for younger workers to be able to opt out of Social Security, threatening
to undermine its political viability in the long term.
57. [LO 3.4] Retroactive Changes

Solution: The student should try to present logical arguments why the retroactive inclusion
of certain items in income should or should not be permitted by laws passed late in
the year. For a long time it has been understood that interest on tax-exempt bonds
has been excluded from income because Congress has continued the exclusion; it
could change the law whenever it votes to do so. For a number of years now,
Congress has retroactively reinstated deductions so there is significant precedence
for Congress to be allowed to act at any time during the year and have those
actions apply retroactively to the beginning of the tax year. The primary argument
against allowing this type of retroactive law is that it does not allow taxpayers to
plan adequately. However, it is hard to argue that the law that states Congress can
tax income from whatever source would not apply to income earned during the
year the law is passed. It would be a different matter if Congress were to act
retroactively to tax items received in prior tax years as there has always been the
concept of tax years to provide closure for the taxpayer for prior years.
58. [LO 3.4] Alimony Recapture

Solution: Part of any payments structured as alimony payments that decrease by more than
$15,000 per year from year 1 to year 2 and then again from year 2 to year 3 can be
recharacterized as property settlements. The portion so recharacterized must be
recaptured (taken into income) by the payor and can be deducted by the recipient
in the third year. To prevent this reclassification as nondeductible property
settlement, alimony payments during the first three years should not decrease by
more than $15,000 between years.
59. [LO 3.5] Insurance Transfer

Solution: Joe will have income for the $800 ($5,000 - $4,200) portion of the debt that Willy
forgives as part of accepting the cash surrender value of the policy to cancel the
debt. When Joe is killed, Willy’s basis in the insurance policy is $5,050 ($5,000
debt + $50 premium payment). He will have income of $19,950 on the collection
of the $25,000 from the insurance policy. When a policy is transferred to a third
party for money or money’s worth, the receipt of the face value of the policy is no
longer tax free. Income must be recognized based on the proceeds received and the
purchaser’s investment in the policy at the time of the decedent’s death.
60. [LO 3.2, 3.4 & 3.5] Doctrine of Constructive Receipt
Solution: This question is based on an Oprah Winfrey show. The only significant difference
is that Oprah gave more than 300 audience members debit cards for only $1,000
each.
1. Does the receipt of the debit card (“prize”) result in $16,000 taxable income to
the recipient even if the recipient does nothing further with the card? Even though
the prize is not supposed to be used for one’s own use, would the recipient’s
control over the disbursement of the proceeds from the debit card be sufficient to
cause the recipient to have taxable income under Section 61? Do constructive
receipt principles apply? Reg. Sec. 1.451-2 states “...income is not constructively
received if the taxpayer’s control of its receipt is subject to substantial limitations
or restrictions.” Will the stipulation that the use of the card be for a charitable
cause amount to a “substantial limitation or restriction”? There does not appear to
be a way for the show to effectively enforce this so it is doubtful that this
stipulation will qualify as a substantial restriction but there is no authority directly
on point.
2. If the receipt of the card is not itself a taxable event, what about the actual usage
of the card? What are the ramifications for the audience participants who transfer
the $16,000 to their selected person or cause? The drawing down of cash
(regardless of the intent for so doing) is actual (not merely constructive) receipt of
the money. This will substantially increase the risk that the recipient of the debit
card has gross income under Section 61 at the moment of cash withdrawal. Again,
there is no authority directly on point.
3. If the audience members give the money to a qualified charitable organization,
the individuals can claim a charitable contribution deduction only if they itemize
their deductions. If they have no other itemized deductions, their tax benefit from
the contribution will be limited to the amount it exceeds their standard deduction
(thus, not completely offsetting their $16,000 gross income).
4. If the audience members donate the money to a needy person instead of a
qualifying charitable organization, they would have $15,000 of gross income and
would have made a taxable gift of $1,000 ($16,000 gift less $15,000 annual
exclusion) assuming they had not given other amounts that year to the same donee.
5. Will the Bank of America be able to deduct the payouts on the debit cards as a
business expense (possibly as marketing)? Most likely it will get some deduction.
The bank would not, however, qualify for any charitable contribution deductions
because it has no control over which donees are selected by the audience members.
6. Must the value of the DVD recorders be included as taxable income as a prize?
Alternatively were the DVD recorders merely “loaned” to the audience members,
to be returned when the future show is taped? Will only those audience members
who return for the future show (with a recorded story for use on the show) be
permitted to keep the recorder? Will they have taxable compensation income from
providing their video recording services in exchange for being permitted to keep
the DVD recorders? It certainly seems likely they would have taxable income.
Search the Internet
61. [LO 3.4] Locate IRS Publication and Calculate Income
Solution: $2,500. Add one-half of $10,000 social security benefits to the $20,000 dividend
income and the $5,000 of tax-exempt bond interest, resulting in a total of $30,000.
Subtract the $25,000 base amount for a single individual from the $30,000 total
yielding $5,000 in excess of the base amount. Because the excess beyond the base
amount ($5,000 excess) is less than $9,000, no more than half the benefits will be
taxed. Compare $2,500 (half of the $5,000 excess beyond the base amount) to
$5,000 (half of the Social Security benefits of $10,000). The smaller of these two
($2,500) is included in the taxpayer’s gross income. Thus, the taxpayer’s gross
income is $22,500 ($20,000 dividend income + $2,500 taxable Social Security
income).
62. [LO 3.4] Locate IRS Publication and Determine Countries Where Exempt
Solution: U.S. citizens who are residents of the following countries are exempt from U.S. tax
on their benefits: Canada, Egypt, Germany, Ireland, Israel, Romania, and the
United Kingdom. A resident of Italy is exempt but only if also a citizen of Italy.
63. [LO 3.4] Dividend Income from Foreign Corporations

Solution: Dividend income received from foreign corporations located in China or Jamaica
will be treated as qualified dividends eligible for the reduced tax rate. However,
dividend income from Bermuda and the Netherland Antilles is not eligible for the
reduced dividend tax rate.
64. [LO 3.5] Consequences of Frequent Flyer Miles

Solution: The IRS policy for now is that it will not assert that a taxpayer has understated his
or her federal tax liability because of the receipt or personal use of frequent flyer miles
attributable to business or official travel. Any future guidance on the taxability of these
benefits will be applied prospectively only.
Identify the Issues

Identify the issues or problems suggested by the following situations. State each issue as a
question.
65. [LO 3.2] Barter Transactions
Solution: Will Jason or Bob’s Auto Repairs be required to recognize any income as a result
of this barter arrangement? Will they be entitled to a deduction for repair
expenses?
66. [LO 3.2] Prepaid Rent

Solution: How should the landlord treat the prepayment of 3 months’ rent that is
characterized as part rent and part security deposit? In which year(s) is income
recognized and does the answer change if the landlord is an accrual basis taxpayer
rather than cash basis?
67. [LO 3.2] Timing and Amount of Income

Solution: When should Sid’s Body Shop recognize the income for the repair work? How
should it handle the reduction in expected payment from $2,000 to $1,700?
68. [LO 3.4] Treasure Find

Solution: Does Gillian have any taxable income as a result of her treasure find? If yes, how
would the amount of income be determined?
69. [LO 3.4] Treasure Find

Solution: Does Nelson have any taxable income as a result of find the money?
70. [LO 3.4] Cancellation of Debt

Solution: Does Sharp Corporation have income or other tax consequences as a result of the
creditor writing off $20,000 of its debt?
71. [LO 3.6] Bond Interest

Solution: Is interest income on bonds issued by a foreign governmental entity taxable or tax-
exempt?
Develop Research Skills

Solutions to research problems 72 – 76 are included in the Instructor’s Manual.
Fill-in the Forms

The solution to tax form problem 77 is included in the Instructor’s Manual.
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© Wide World Photos
PARIS, FRANCE—A SALUTATION FROM M. BLERIOT

One of the first lessons was the “three sixty”—so named because its
completion required a total change in direction of three hundred and
sixty degrees. The cadet would take-off and climb to eight hundred
or a thousand feet. The higher he went the less difficulty he had in
properly completing the maneuver. Then he would fly into the wind
directly over a landing “T” in the center of the field. As the plane
passed over the “T” he throttled his motor and made a quick bank
either to the right or left depending upon his preliminary instructions.
The object was to make a complete circle and land without using the
motor, bringing the plane to a stop beside the “T.”
“One eightys” were the next requirement and they were probably the
cause of more crashes than any other maneuver. They were started
in the same manner as the “three sixty,” but with the plane heading
down wind and at only five hundred feet altitude. They required quick
manipulation of controls and a steep bank into the field just before
landing.
Next came acrobatics. Loops, spins, barrel rolls, Jenny Immelmans,
figure-eights, wing-overs, and reversements, every one of which
each cadet had to master thoroughly during his course at Brooks.
After the first few weeks had passed we became more or less
accustomed to life in the cadet detachment, and found a little time
now and then to look around the country and even spend a night in
San Antonio. Our examinations were purposely given on Saturday
morning so that we would not spend the week-end studying. It was
well known that too much studying affected a cadet’s flying and the
school schedule was arranged with that in mind.
Our day began with first call at five forty-five and flying started about
seven. At eleven we returned to the barracks and from one to five
o’clock was devoted to ground school. After supper we could study
until bed check at ten o’clock. Plenty of sleep is a necessity for the
student pilot, and that fact is recognized nowhere more than in the
army schools. Every week night at ten p.m. the cadet officer of the
day checks each bunk and turns in the names of any vacant ones.
Some of our academic subjects, such as aerodynamics and machine
guns required nearly all of our time after school because of
approaching examinations, whereas others were comparatively easy
and the classroom instruction was sufficient in itself. When we were
not studying there were always plenty of other things to attract our
attention. If one of the boys left the post, as sometimes happened,
he often returned to find his belongings heaped together in the
middle of the floor with the army cots piled on top. Several times
some cadet returned at midnight to find his equipment carefully
transferred and set up on the roof or in the mess-hall. Another one of
the favorite sports was to put a hose in the bed of a sound sleeper at
two a.m. or, if he slept with his mouth open, to fill it from a tube of
shaving cream or hair grease.
One of the fellows found a scorpion in his bed and each night for a
week thereafter looked through the bedding for another, but finally
became careless and forgot to look. His nearest neighbor promptly
placed a number of grasshoppers between the sheets near the foot
of the bed.
Another evening it was reported that three pole-cats had crawled into
a culvert in front of the barracks. For an hour we attempted to smoke
them out. When that failed the fire department was called and we
washed them out. The smoke had evidently taken effect, however,
and soon three dead pole-cats came floating out from the culvert.
The next problem was how to make use of such possibilities. That
question was worthy of a most careful consideration. After a survey
of the barracks we found that our cadet first sergeant was in San
Antonio. There was scarcely one of us who did not have some small
score to settle with him so we took one of the pillows from his bed
and after removing the pillow case, placed it behind one of the pole-
cats. The desired results were then obtained by stepping on the back
end of the cat, and after cautiously inserting the pillow back in its
case, we replaced it on the first sergeant’s bunk. The results were far
above expectation. One by one the occupants of that bay arose and
carried their cots outside, until by midnight, when our sergeant
returned, there were only a half dozen bunks left including his own.
By that time the odor had permeated through the other bedding and
he was unable to locate the pillow as being the primary cause of
offense. Any night for nearly two weeks thereafter our first sergeant
and his cot might be located out behind the barracks, and the
inspection of quarters, which was to have been held the following
morning, was postponed indefinitely.
During our last six weeks at Brooks, life became much less difficult.
Most of us who had survived the check pilots and “Benzine Board”
were reasonably sure of graduating and although our studies were
just as exacting as ever, we were able to absorb them much more
easily. Also we had passed our primary flying tests and were making
cross country flights in T.W.3’s; and learning formation flying in
Voughts. And finally we were given a few hours in De Havilands in
preparation for the advanced training at Kelly.
We were paired up for the cross country flights. One of us flew on
the way out, while the second acted as observer. On the return flight
we traded about, so that each achieved an equal amount of
experience, both as an observer and as a pilot. These trips were
usually laid out in a triangular course, and included landing at each
corner of the triangle.
While on one of our first trips from the home airdrome, we landed in
the designated field alongside of a road just as a load of
watermelons was passing by, so we carried several of them back to
the Detachment in our plane.
Always there was some new experience, always something
interesting going on to make the time spent in Brooks and Kelly one
of the banner years in a pilot’s life. The training is rigid and difficult
but there is none better. A cadet must be willing to forget all other
interest in life when he enters the Texas flying schools and he must
enter with the intention of devoting every effort and all of the energy
during the next twelve months towards a single goal. But when he
receives the wings at Kelly a year later he has the satisfaction of
knowing that he has graduated from one of the world’s finest flying
schools.
VI
RECEIVING A PILOT’S WINGS
IN September, 1924, we were transferred to Kelly. The time we had

looked forward to for half a year had arrived. We were through the
period of just learning how to fly and were entering a new
experience; that of learning how to make use of our flying ability in
actual service. We would no longer be floating around the airdrome
in machines whose only purpose was to stand up under the hard
knocks of inexperienced pilots; but we were going to fly planes which
had an actual military value in warfare.
PARIS, FRANCE—PAUL PAINLEVÉ, FRENCH MINISTER OF

WAR, EXTENDS HIS WELCOME. ON THE RIGHT IS
AMBASSADOR MYRON T. HERRICK
PARIS, FRANCE—WITH M. DOUMERQUE AND AMBASSADOR

HERRICK
We were old cadets and felt the importance of our experience. We

were no longer treated as rookies but as potential officers. Before
leaving Brooks we had conformed with cadet traditions and allowed
groups of the new class to gather around us while we gravely spoke
of examinations, check pilots, “Benzine Boards,” and “washouts.” We
thoroughly enjoyed the awe inspired by our seventy-five hours of
flying experience.
At Kelly our difficulties set in with renewed vigor. The De Havilands
did not maneuver like the training Jennies, and we were required to
fly as we had never flown before. If a cadet was not able to handle
his ship in a maneuver which was at least equal to the standard, he
was usually heading towards home within a week.
We were allowed a few days to become accustomed to flying the
new type of plane, then an instructor would go up with us to see if
our progress had been satisfactory. If so we were sent to the next
stage; if not we went up with a check pilot.
From landings we went to the “eight” stage, where were assigned
two landmarks such as a tree and a haystack several hundred feet
apart, and required to do figure-eights around them. Then came the
spot landing stage, when we throttled our engine at about a
thousand feet and were required to land in a large white circle
without using our motor. On this stage we were graded on our take-
off, climb, approach, landing, roll, distance from mark, and method of
handling the ship. In fact at Kelly we were constantly under
observation and our only method of relaxation while flying was when
the sky was cloudy and we could get above the clouds.
On one occasion we were flying with a low ceiling and the visibility
was not very good. In fact it was an ideal day to do the things we
were not supposed to. I was hedgehopping along over the country
when I saw another D.H. playing around on my right. I flew over, and
after chasing each other around for a while we proceeded to do
chandelles, vertical banks, wing-overs, and everything else we could
think of; all within a few feet of the ground as the clouds themselves
were only about three hundred feet high. At last I decided to go up
close to the other plane for a little low formation flying, but as I
approached I saw that there were two men in the ship and that I had
been breaking every rule ever established about low flying with an
instructor watching me from another ship. I left that locality with wide
open motor and for several days expected to be called on the carpet
before the commanding officer on a washout offense. That instructor
must have been a good sport, however, because I never heard from
him and never was able to find out who he was.
On another occasion, near the end of my course, I came very near
being washed out for something I knew nothing about. I had been
practicing landings in an S.E.-5 on one corner of Kelly Field. When
my time had expired, I landed on the pursuit stage, taxied up to the
line, and turned the ship over to the mechanics. That afternoon I was
called from class and ordered to report to the operations officer;
whereupon he informed me that my flying days were over and that
as I knew why, there was no use in explaining further. I was then
ordered to report back to my studies.
It came out of a clear sky. I knew of a number of offenses I had
committed but none of them at that time. I had actually no idea of
what the operations officer was talking about.
When school was over I returned to the operations hut and
requested an account of the alleged offense. It appeared that the
propeller on my S.E.-5 was cracked, and the spreader board broken
on the landing gear. The crew chief had reported this together with a
statement that there were corn stalks hanging on the landing gear,
and as there was no corn growing on Kelly Field, that was a sure
sign that I had landed away from the airdrome without reporting the
fact. A washout offense. We drove to the pursuit stage and found
conditions exactly as stated, except that the corn stalks turned out to
be weeds, and it was decided that the damage had been caused by
a stake left standing in the corner of Kelly Field where I had been
landing, although I had not felt the ship strike anything. The cadet
who flew the plane earlier in the morning was using the same part of
the field and said that he felt it strike a bump on one of his take-offs
but did not believe any damage had been done. Who was flying the
ship made little difference, however, because as long as he had not
landed away from the airdrome without authority, the slight damage
was of no consequence. I had come very close to the “Benzine
Board” for an offense of which I knew nothing, but it was probably
only the open-mindedness and sense of fair play of the operations
officer that kept me from being washed out as a result.
PARIS, FRANCE—CROWDS AT THE CITY HALL AT THE

OFFICIAL RECEPTION
PARIS, FRANCE—GUESTS AT THE LUNCHEON OF M. BLERIOT

LEFT TO RIGHT: PAUL PAINLEVÉ, CHARLES LINDBERGH, M.
BLERIOT, AMBASSADOR HERRICK
One day during the beginning of our term at Kelly, someone decided
that the cadets should stand reveille. How it came about or who
caused the decision was never known by the detachment, but there
was a strong rumor circulated to the effect that our beloved Cadet
Sergeant had not forgotten the episode of the pole-cats. It was an
unheard of thing for the cadets of Kelly to stand formations. We had
graduated from that when we left Brooks, and the thought of
continuing it in our advanced status was, we concluded,
degenerating to the morale of the detachment.
Consequently, when our first sergeant himself delighted us with
verbal visions of being tumbled out of bed at first call if we were not
up at the blast of his whistle, we decided that if it were in the
combined power of the detachment, the first call should not sound
the next morning. We could not disobey an order; army training
banishes even the remotest thought of that; but we might prevent
that order from being given. The Cadet Captain and first sergeant
were assigned to a private room together. The rest of us were given
cots in the barracks. While supper was in progress that night the
hands on the sergeant’s alarm clock were so manipulated that the
alarm would sound exactly one hour after the time set. At two o’clock
the next morning a padlock was placed on the hasp outside of his
door, and when first call blew a few hours later the cadet detachment
slept soundly on.
From spot landings we passed to hurdles. Hurdles require the ship to
be brought down without assistance from the engine, and after just
passing over a line stretched about eight feet above the ground, to
be landed as close as possible to the hurdle. This gave us excellent
practice for landing over a fence in a small field.
One of the traditions at Kelly was that anyone knocking down the
hurdle must treat the rest to a case of refreshments. It often
happened that a pilot was so intent on getting over the hurdle string
that he did not notice that his plane was in a stall, and about the time
he was over the hurdle the bottom would fall out from under him and
his plane would pancake into the ground. Almost every class had
one or two minor crack-ups as a result of stalling over the hurdle
string.
The De Havilands were not considered safe for hard stunting and as
a result we were only allowed to do wing-overs and split air turns.
Diving in excess of one hundred and fifty miles per hour was also
forbidden. Consequently only air work allowing us to be thoroughly
accustomed to the plane was included in the flying schedule before
our formation training began.
The strange field landing training was one of the most interesting
parts of our schooling. An instructor would lead a number of planes
and land in some field we had never seen before. Then each cadet
was required to land and take-off after the instructor. Some of the
fields were small and full of obstructions. Yet we had comparatively
few even minor crack-ups. Later each cadet was given an
opportunity to lead the rest and pick out a field for them to land in
while the instructor trailed.
At Kelly we were given more and longer cross country trips than at
Brooks. One of the most important parts of flying training is cross
country experience. We made flights to Corpus Christi, Galveston,
Laredo and a number of other places.
Each class spent about two weeks on a gunnery expedition at
Ellington Field between Houston and Galveston. Ellington Field was
one of the few double fields built during the war, but was later
abandoned and, except for a National Guard squadron, was entirely
deserted.
We set up our mess in the clubhouse and made the old building
which had served as officers’ quarters as comfortable as possible.
This was in winter and the weather was cold, even in Texas, unusual
though it might have been. There were no stoves available so we
contrived all sorts of makeshifts to hold a little fire in. If nothing better
was obtainable, we shovelled several inches of earth on the floor
and devised a hood of some kind leading through a few lengths of tin
pipe to the chimney. Of course these fires could not be left
unguarded, so it was necessary to put them out in the morning to be
rekindled at the close of operations for the day.
Our gunnery work was divided into three parts: ground targets,
shadow targets and tow targets. The ground targets were large
sheets of paper similar to those used on a rifle range and were set
up at an angle on the ground. We shot at these with both the
Browning and Lewis machine guns.
The Browning guns on a De Haviland were mounted rigidly in front of
the pilot and were synchronized with the engine to shoot between
the blades of the propeller. They were capable of firing up to twelve
hundred rounds a minute, depending on the motor R.P.M. when they
were fired.
Several of us would form a large circle with our planes, and starting
our dive from about one thousand feet, would fire short bursts into
the target on the ground. After completing our bursts we would zoom
back up into the circle while the next ship started its dive. Each plane
had its individual target.
After emptying the Browning guns we gave our observers a chance
with their Lewises by circling low around the targets. On the next
flight the pilot and observer traded places.
The Lewis gun is mounted on a turret on the rear cockpit. Two guns
were usually used together and they could be pointed in any
direction.
After a few days on ground targets we were sent out over Trinity Bay
for shadow targets. One plane is flown fairly high over the water
while another fires at its shadow. The splashes from the bullets are
easily seen and the accuracy of marksmanship very apparent.
The tow targets are by far the most difficult of the three varieties, and
require skillful maneuvering and excellent marksmanship. They
consist of a cloth sleeve similar to a wind sock which is towed a few
hundred feet behind a De Haviland flying at sixty or sixty-five miles
an hour.
When the forward or Browning guns were used, the attacking ship
approached the tow target head on, firing one or two short bursts as
it passed. In this way there was no danger of the occupants of the
towing plane being struck by a wild shot. The De Havilands were
much too large to use the forward guns effectively on a tow target.
Any accurate shooting required the quick maneuverability of a
pursuit ship.
The Lewis guns were used while flying parallel with the target and
were very effective. When we were close enough we could often see
the tracers pass directly through the cloth sleeve.
After returning from Ellington Field we were given a few hours in
each of the various types of service airplanes. The M.B.-3 and the
S.E.-5 scouts; the Martin Bombers with their twin Liberty engines;
the T.W.-5 two-place transition planes; and the little Sperry
messengers. In this way we obtained experience in each branch:
pursuit, attack, observation and bombardment. Later we were given
our choice of which we desired to specialize in. If our wishes
corresponded with the judgment of the instructors we were assigned
to that branch.
Together with three other cadets and four student officers, I was sent
to the pursuit stage, where we spent the few remaining weeks of our
course, piloting the S.E.-5 and the M.B.-3 single seaters.
Pursuit combines a little of every branch of the air corps. In addition
to formation combat, dog fighting, and ground strafing, the pursuit
pilot is often called upon to make observations and do light bombing.
A great deal of our time was devoted to formation flying. Air combat
of the future will probably often be between large formations rather
than individual pilots, and it is accordingly of utmost importance for
the pursuit pilot to hold his place in formation instinctively, so that his
entire attention can be devoted to the enemy rather than to his own
formation.
We often maneuvered our flights while the individual planes were
less than ten feet apart and it was not unusual to dive vertically for
several thousand feet in a fairly close formation.
We learned the use of Lufberry circles, cross over turns, and other
formation tactics. Our formations were often tight, it is true, but
strange as it may seem, very few accidents occur from too close
flying. A pilot is constantly alert when his plane is only a short
distance from the one in front and nothing is allowed to distract his
attention. On the other hand, when there is quite some distance
separating them he is often more engrossed in lighting a cigarette or
watching some object on the ground than in his own formation.
In pursuit flying we came to have great confidence in our parachutes.
The planes we were flying were kept in excellent condition and none
ever failed, notwithstanding the fact that we placed them under every
conceivable strain imaginable. But the knowledge that we did not
have to concern ourselves about whether they did fall apart or not
was an invaluable factor in building up our morale. Our formations
were tighter, the combats faster, and our flying better as a result.
We had a number of close calls but considering the amount of flying
we had done, and that all of it was military flying, which cannot be
ever compared to commercial traffic as far as safety is concerned,
our accidents were remarkably few and none resulted seriously.
No one knows of the risk he takes better than the pursuit pilot and no
one is less concerned about it. Every move, although at lightning
speed, is made with a coolness born of experience and love of flying.
The army Air Corps is built up of men who fly for the love of flying.
Their only mission in life is to build up the finest air corps in the
world, and their greatest desire is to be given the opportunity to do
so without restriction. If an officer is lost in duty he would be the last
one to wish for resulting restrictions on his comrades.
A week of our pursuit training was spent on a gunnery expedition at
Galveston. We flew there from Kelly Field in M.B.3A. machines and
fired on tow targets exclusively. Our field was close to the Gulf, and
when the day’s operations had been completed we were free to go
about as we chose. Consequently a large part of the evening was
spent along the rocky beach.
On the night of our last day at Galveston several of us were holding
a contest to decide which could reach the most distant rock between
the breakers, before the next wave rolled in. One of the fellows was
outstanding in his accomplishments. In fact he was so dextrous that
none of us could compete, so we were all loud in our praises and
unanimously agreed that there was not a rock in the gulf too obscure
for him. There was, however, a rock a number of feet beyond the
most distant point any of us had attained, which was visible only for
an instant as the last breaker receded and before the next arrived.
Even this was possible, we confidently assured him.
He watched that rock intently for several minutes; then bolstered up
by our praise and his own confidence, he stood poised and ready. At
the proper moment he nimbly leaped from boulder to boulder after
the retreating surf but just before the final rock was touched a large
wave towered above it. Too late! The chance of retreat had never
been considered and its opportunity had passed. With do or die
determination he leaped onto the boulder and into the breaking
wave. This incident would not have been serious or its
consequences important had we been able to carry any extra
equipment in our pursuit planes, but as it was, extra clothing was a
scarce article, and when we took off for San Antonio and Kelly the
following morning, it was necessary for him to send his wet clothes
back in a De Haviland and make his flight in a bearskin flying suit
without insulation against the bearskin.
In warm weather these suits acquired an odor similar to that of a
goat which has been in the barn all winter and the fur itself was far
from comfortable. On the trip back a piston froze in the engine. For
two days the cadet was alternately roasting in the southern sun and
freezing in the Texas nights while he guarded his ship and waited for
a new engine.
After our return from Galveston while we were practicing formation
attack on two seaters, I experienced one of the incidents of the
military pilot’s life. I made my first emergency parachute jump. When
an Army plane crashes, the pilot is required to write a detailed report
of the crash. My account was as follows:
“A nine-ship SE-5 formation, commanded by Lieut. Blackburn, was
attacking a DH4B, flown by Lieut. Maughan at about a 5,000 foot
altitude and several hundred feet above the clouds. I was flying on
the left of the top unit, Lieut. McAllister on my right, and Cadet Love
leading. When we nosed down on the DH, I attacked from the left
and Lieut. McAllister from the right. After Cadet Love pulled up, I
continued to dive on the DH for a short time before pulling up to the
left. I saw no other ship nearby. I passed above the DH and a
moment later felt a slight jolt followed by a crash. My head was
thrown forward against the cowling and my plane seemed to turn
around and hang nearly motionless for an instant. I closed the
throttle and saw an SE-5 with Lieut. McAllister in the cockpit, a few
feet on my left. He was apparently unhurt and getting ready to jump.
“Our ships were locked together with the fuselages approximately
parallel. My right wing was damaged and had folded back slightly,
covering the forward right-hand corner of the cockpit. Then the ships
started to mill around and the wires began whistling. The right wing
commenced vibrating and striking my head at the bottom of each
oscillation. I removed the rubber band safetying the belt, unbuckled
it, climbed out past the trailing edge of the damaged wing, and with
my feet on the cowling on the right side of the cockpit, which was
then in a nearly vertical position, I jumped backwards as far from the
ship as possible. I had no difficulty in locating the pull-ring and
experienced no sensation of falling. The wreckage was falling nearly
straight down and for some time I fell in line with its path and only
slightly to one side. Fearing the wreckage might fall on me, I did not
pull the rip cord until I dropped several hundred feet and into the
clouds. During this time I had turned one-half revolution and was
falling flat and face downward. The parachute functioned perfectly;
almost as soon as I pulled the rip cord the riser jerked on my
shoulders, the leg straps tightened, my head went down, and the
chute fully opened.
“I saw Lieut. McAllister floating above me and the wrecked ships
pass about 100 yards to one side, continuing to spin to the right and
leaving a trail of lighter fragments along their path. I watched them
until, still locked together, they crashed in the mesquite about 2000
feet below and burst into flames several seconds after impact.
PARIS, FRANCE—WITH AMBASSADOR HERRICK ON THE

STEPS OF THE EMBASSY, JUST AFTER ARRIVAL IN PARIS
LONDON, ENGLAND—THE WELCOME AT CROYDEN FIELD

WHERE A MILLING MOB OF NEARLY HALF A MILLION HAD
GATHERED
“Next I turned my attention to locating a landing place. I was over

mesquite and drifting in the general direction of a plowed field which
I reached by slipping the chute. Shortly before striking the ground, I
was drifting backwards, but was able to swing around in the harness
just as I landed on the side of a ditch less than 100 feet from the
edge of the mesquite. Although the impact of landing was too great
for me to remain standing, I was not injured in any way. The
parachute was still held open by the wind and did not collapse until I
pulled in one group of shroud fines.

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Solutions to Chapter 3 Problem Assignments

2. [LO 3.1] GAAP vs. Tax

3. [LO 3.1] Book/Tax Differences

4. [LO 3.1] Tax-favored Investments

5. [LO 3.2] Choice of Tax Year

6. [LO 3.2] Accounting Methods

7. [LO 3.2] Accounting Methods

8. [LO 3.2] Accounting Methods

9. [LO 3.2] Tax vs. Financial Accounting

10. [LO 3.2] Long-Term Construction Contracts

11. [LO 3.3] Assignment of Income

12. [LO 3.3] Community Property Laws

13. [LO 3.4] Income Tax Effects of Gifts

14. [LO 3.4] Tax-Exempt Bonds

15. [LO 3.4] Original Issue Discount

16. [LO 3.4] Gross Income/Treasure Find

17. [LO 3.4] Gross Income/Unemployment Compensation

18. [LO 3.5] Gross Income/Gifts and Inheritances

19. [LO 3.5] Life Insurance/Buy-Sell Agreement

earned by nonresident aliens is divided into three categories: U.S. business

21. [LO 3.6] Tax Treaty

22. [LO 3.6] Foreign Tax Credit

Crunch the Numbers

24. [LO 3.2] Refunds of Prior Income

25. [LO 3.2] Prepaid Rental Revenue

26. [LO 3.2] Prepaid Service Revenue

27. [LO 3.2] Long-Term Construction Contract

28. [LO 3.3] Shifting Income to Children

29. [LO 3.4] Municipal Bonds

30. [LO 3.4] Taxable vs. Nontaxable Bonds

31. [LO 3.4] Taxable vs. Nontaxable Bonds

32. [LO 3.4] Gift Loan

33. [LO 3.4] Employee/Shareholder Loans

34. [LO 3.4] Gross Income from Investments

35. [LO 3.4] Stock Dividend

36. [LO 3.4] Annuities

37. [LO 3.4] Annuities

38. [LO 3.4] Income from Lottery Winnings

39. [LO 3.4] Social Security Benefits

40. [LO 3.4] Social Security Benefits

41. [LO 3.4] Damage Payments for Injuries

42. [LO 3.4] Tax Consequences of Divorce

43. [LO 3.4] Cancellation of Debt

44. [LO 3.4] Recovery of Bad Debt

45. [LO 3.4] Taxable vs. Nontaxable Bonds

46. [LO 3.3 & 3.4] Shifting Income to Children

47. [LO 3.5] Property from Gift or Inheritance

48. [LO 3.5] Life Insurance Proceeds

49. [LO 3.5] Disability Insurance