6
Gross Income: Inclusions and Exclusions
Solutions to Tax Research Problems
6-60
a. In a divorce, the custodial parent generally is allowed the exemption. Section
152(e), as revised by the Deficit Reduction Act of 1984 (DRA), simplified the
rules concerning the support test for children of divorced parents or parents
separated under a written separation agreement (and, as added by the Act,
parents who live apart at all times during the last six months of the calendar
year). Assuming divorced parents provide over one-half the child’s support
and the child is in the custody of one or both of the parents for more than half
the calendar year, the parent who has custody for the greater portion of the
year is deemed to provide more than half the child’s support. This rule is
followed unless the custodial parent signs a written declaration that is attached
to the return of the noncustodial parent indicating that he or she will not claim
the child as a dependent. If such a declaration is properly filed, the
noncustodial parent is treated as providing more than half the child’s support.
The law generally grants the exemption to the custodial parent unless he or
she releases the right to the noncustodial parent.
Tax Planning. It might be advisable to adjust the agreement and the actual
situation so that it is clear which parent is the custodial one. Since there are
two children, both parents may qualify—one child live with J more than half
the year and the other live with M more than half the year. This should not
have much effect on their lives personally. The change would involve no more
than one (or possibly a few) days personal adjustment and maintaining
accurate records.
Although either parent, by agreement, could claim both children as
dependents, it may be desirable for each parent to claim one. The value of this
is illustrated in (b) and (c) below. In addition, the change is necessary to
qualify for the child care credit if all other requirements are met.
b. Generally, head of household requires that the home be the principal place of
abode for more than half the entire taxable year [§ 437 and Reg. § 1.2-
2(c)(1)]. The custodial parent is permitted to claim head- of-household status
even if he or she does not claim the exemption deduction for such child,
assuming all other tests are satisfied.
Tax Planning. Whoever has custody for more than half the year may claim
head of household. If the tax-planning change suggested in (a) above is made,
both may qualify for head of household, unless of course, they qualify as
married at the end of the year.
c. Alimony is defined as any cash payment that
1. Is paid pursuant to a divorce or separation instrument;
2. Is not designated in the instrument as something other than alimony that is
nontaxable and nondeductible;
3. Is not made to a member of the same household at the time the payment is
made;
4. Is terminable upon the death of the recipient; and
5. Is not child support.
The $500 qualifies as alimony, since payments are to be made periodically
under the divorce agreement and are not designated as child support [§ 71(a)
and Reg. § 1.71-1]. The $50 qualifies as alimony for the same reasons ifM is
the owner and irrevocable beneficiary of the policy [Rev. Rul. 70-218, 1970-1
C.B. 19 and Lemuel A. Carmichael, 54 T.C. 577 (1970)]. Thus, J may deduct
the $550 and M includes the $550 monthly transfers. [See §§ 215(a) and
71(a)(1) and Temp. Reg. § 1.71-1T.]
Tax Planning. It may be advisable to change the agreement so that the
$100 per month for each child is not designated as child support [see Item 2 in
(c) above]. With this change, total alimony for the year becomes $9,000 ($750
× 12 months), which decreases J’s A.G.I. to $31,000 and increases M’s to
$24,000. If J has custody of one child, his dependency claim is not
jeopardized.
d. Transfers made under a legal separation agreement are subject to the same
rules as transfers made under a divorce agreement. Thus, the answer in (c)
above is applicable.
e. The DRA invalidates the longstanding decision of the Supreme Court in
Davis, requiring recognition of gain when appreciated property is transferred
as part of a divorce settlement. As added by the Act, § 1041 provides that no
gain or loss is recognized on any transfer to a spouse or, if incident to divorce,
a former spouse. The transfer is incident to divorce if it occurs within one year
after the date on which the marriage ceases or is related to the cessation of
marriage. When the transfer qualifies for nonrecognition, the transferor‘s basis
carries over to the recipient. Thus, neither M nor J recognize gain or loss on
the transfer. J’s basis is $10,000 and M’s basis is $70,000 ($50,000 home +
$20,000 furnishings).
f. This solution is discussed in (a)-(e).
6-61
a. Meals and lodging provided employees by their employer are deductible
expenses by the employer and excludable income for the employee when they
are (1) provided for the employer’s convenience, (2) on the employer’s
business premises, and (3) when the employee is required to occupy the
lodging to perform employment duties [§ 119 and Reg. § 1.119-1(b)]. It
appears logical that H and W should live on the farm and eat their meals there
in order to perform the necessary duties, particularly since animals are part of
the farm business. (Note, only 50 percent of the meal cost is deductible.)
b. The major difficulty for H and W is that they must establish the farm as the
employer and themselves as employees. If operated as a proprietorship, this
employment relationship is not possible between the proprietorship and
owner, but the proprietorship may have such a relationship with all
nonowners. Thus, all of the benefits can be obtained for a nonowner who is an
employee. In addition, these benefits are available to the spouse and
dependents of qualifying employees. H could be the proprietor and employ W
(or vice versa). Would the IRS and/or the courts allow meals and lodging
benefits provided H through W? That is possible but unlikely.
Similar difficulties are present for H and W if the farm is operated as a
partnership. However, the Tax Court has held that meals and lodging
furnished a partner by the partnership are deductible (subject to the 50 percent
limitation) by the partnership and excludable by the partner when the other §
119 requirements are met. The Third, Fourth, Eighth, and Tenth Circuit
Courts of Appeals have reversed the Tax Court on this point [Comm. v.
Robinson, 60-1 USTC ¶9152, 5 AFTR2d 315, 273 F.2d 503 (CA-3, 1960)
cert. den., 363 U.S. 810; Comm. v. Doak, 56-2 USTC ¶9708, 49 AFTR 1461,
234 F.2d 704 (CA-4, 1956); Comm. v. Moran, 56-2 USTC ¶9879, 50 AFTR
64, 236 F.2d 595 (CA-8, 1956); and U.S. v. Briggs, 56-2 USTC ¶10,020, 50
AFTR 667, 238 F.2d 53 (CA-10, 1956)], but one has upheld the Tax Court
[Armstrong v. Phinney, 68-1 USTC ¶9355, 21 AFTR2d 1260, 394 F.2d 661
(CA-5, 1968)].
The Court of Claims also has held against partners on this issue [Wilson v.
Comm., 67-1 USTC ¶9378, 19 AFTR2d 1225, 376 F.2d 280 (Ct. Cls., 1967)].
As a result, a partnership does not appear advisable unless the taxpayer resides
in the fifth circuit. However, the partner in the fifth circuit case only held a 5
percent capital interest and may be a poor precedent for most partners.
c. Since the children perform duties on the farm, they should be placed on the
payroll as employees for income-splitting benefits. Presumably, all meals and
lodging benefits would apply to them as employees. But, if they are not
employees, benefits still apply to them as dependents of employees [see (b)
above]. It has been held that adjustments are not required for personal
enjoyment as a result of employer-furnished lodging (Lloyd N. Farnham, 6
TCM 1049). However, there appears to be no case or discussion directly
concerning adjustments of food provided to friends and relatives who are
neither employees nor dependents of employees. The Code discusses meals
furnished to employees and does not require that they consume those meals
personally. Thus, as long as the food is furnished to the employee and
consumed on the premises, an argument exists that no adjustment is
necessary. When adjustments have been required in other contexts, the
taxpayer must include the fair market value if the business is a corporation
(see for example, Rev. Rul. 68-354, 1968-2 C.B. 60) and cost if a partnership
(R. E. Moran, 17 TCM 791, T.C. Memo 1958-5 and Rev. Rul. 80, 1953-1
C.B. 62).
Since owners can be employees of a corporation, the § 119 benefits are
potentially available for all employees, including those who are owners.
However, if the corporation is electing to be taxed under Subchapter S, § 119
benefits are not available to employees who own more than 2 percent of the
outstanding stock. (See § 1372, S. Rept., p. 22, and H. Rept., p. 21.) There is
one exception. A grandfather clause to § 1372 provides that fringe benefits for
owners in effect on September 28, 1982 can be retained for taxable years
beginning before 1988, as long as three rules are met during this period. They
are: (1) the passive investment income test must not be violated; (2) the S
election must have continued throughout the period; and (3) ownership
changes during this period did not exceed 50 percent [See § 1378(c)(2).] This
clause would not apply to a new S corporation organized by H and W.
d. Although not mentioned in the Code or Regulations, courts have held that all
items directly and indirectly related to the cost of providing meals and lodging
qualify if provided by the employer [see for example, Jacob v. Comm., 74-1
USTC ¶9316, 33 AFTR2d 74-972, 493 F.2d 1294 (CA-3, 1974) and Rev. Rul.
68-579, 1968-2 C.B. 61]. However, employer reimbursement paid to the
employee for these costs has been held to be includable income [Kowalski v.
Comm., 77-2 USTC ¶9748, 40 AFTR2d 6128, 43 U.S. 77 (USSC, 1977) and
G. A. Turner, 68 T.C. 48 (1967)]. Consequently, grocery items and expenses
related to the housing should be paid directly with corporate funds, preferably
with a business check and a bill in the business’ name.
e. In order for the business to provide the lodging, it must either own the home
or rent the home from the owners. In either situation, the home is a § 1231
asset and is not available for the exclusion (121) or deferral of gain provisions
allowed when a principal residence is sold and the proceeds are reinvested in a
new principal residence (1034). (See Chapter 15.) If H and W own the home,
they must establish a fair market rental value that would be paid in a
transaction between unrelated parties.
f. In order for the business to provide the meals, it must pay for them and for
their preparation directly and they must be served on the business’ premises.
Thus, reimbursement presumably would not qualify. [See Kowalski, cited in
(d) above.] Presumably, if employees of the business purchased groceries with
the business’ funds and prepared the meals in the employer-provided home,
the meals would qualify under § 119.
6-62
a. In Sutphin v. U.S. 88-1 USTC ¶9269, 61 AFTR2d 88-990, 14F.2d 545 (Ct.
Cls., 1988), the U.S. Claims Court ruled that a discount received for
prepayment of taxpayers’ mortgage was discharge of indebtedness income.
The homeowners in this case accepted an offer from the Park View Federal
Savings & Loan Association (“Park View”) to receive a discount of $8,240.17
by prepaying an 8.5 percent mortgage on their home. The discount was
computed as follows:
Face value of the note (remaining principal amount) $ 32,960.68
Amount paid by homeowners (24,720.51)
Discount received for payment $ 8,240.17
Park View extended the above offer to the homeowners because of a
significant rise in interest rates.
In analyzing the tax consequences of the discount received by the
taxpayers, the court used the following approach. First, it examined the
general rule under § 61(a)(12) that gross income includes amounts received
from the discharge of indebtedness. Next, it gave consideration to statutory
exceptions to this general rule by focusing on Code §§ 102 and 108. Lastly,
attention was given to judicial exceptions that have allowed taxpayers to
reduce the basis of their property for the discount received rather than
recognizing income immediately. Each of these steps is discussed below.
Section 61 (a) defines gross income as “all income from whatever source
derived.” Section 61(a)(12) provides that gross income includes amounts
received from the discharge of indebtedness. In two landmark decisions the
Supreme Court in U.S. v. Kirby Lumber Co. 284 U.S. 1, 10 AFTR 485, 2
USTC ¶814 (USSC, 1931) and Helvering v. American Chicle Co., 291 U.S.
426, 13 AFTR 876, 4 USTC ¶1240 (USSC, 1934) relied heavily on §§ 61(a)
and 61(a)(12). In both cases the Supreme Court emphasized that the
underlying rationale for the principle that a taxpayer may realize income by
paying an obligation at less than its face value is “that a reduction in debt
without a corresponding reduction in assets causes an economic gain in
income because assets are no longer encumbered.” Consequently, the Claims
Court concluded that unless a statutory or judicial exception could be found to
the general rule of discharge of indebtedness income, the taxpayer in the
Sutphin case would be required to recognize income equal to the discount
received or $8,240.17.
In the court’s opinion, Code §§ 102 and 108 were the statutory exceptions
deserving of special attention. The general rule of Code § 102 states that
“Gross income does not include the value of property acquired by gift.”
Therefore, if the forgiveness of a debt represents a gratuitous discharge, the
debtor realizes a gift rather than income. Unfortunately, few financial
institutions make a practice of gratuitously relieving debtors of their
obligations. Clearly, Park View’s motives in offering homeowners a discount
for prepayment of their mortgage were driven by economic factors. In other
words, Park View did not act “with a detached and disinterested generosity
arising from affection, respect, admiration, charity or like impulses.” Park
View’s offer to its debtors was simply a good business decision and was never
intended to be a gift. As a result, § 102 offers little to cushion the impact of
§61(a)(12).
The Claims Court then looked to Code § 108 for possible relief. Section
108(a)(1) allows an exclusion from gross income for the discharge of
indebtedness that (1) occurs in a title 11 bankruptcy case, (2) occurs when the
taxpayer is insolvent, or (3) constitutes qualified business indebtedness
(generally for discharges before 1987). Because the homeowners were solvent
and did not utilize their home in connection with a trade or business, §
108(a)(1) fails to provide the taxpayers with a safe harbor from the normal
discharge of indebtedness rule.
The final statutory exception the court examined was § 108(e)(5), which
reads as follows:
(5) Purchase-money debt reduction for solvent debtor treated as price
reduction. If
(A) the debt of a purchaser of property to the seller of such property that
arose out of the purchase of such property is reduced,
(B) such reduction does not occur—
(i) in a title 11 case, or
(ii) when the purchaser is insolvent and
(C) but for this paragraph, such reduction would be treated as income to
the purchaser from the discharge of indebtedness, then such reduction
shall be treated as a purchase price adjustment.
Because the taxpayers were not indebted to the seller of their residence but
rather to Park View, § 108(e)(5) may not be relied upon. Therefore, the
reduction by Park View of the principal amount of taxpayer’s mortgage
($8,240.17) cannot be considered a purchase price adjustment.
Next, the Claims Court took under consideration the taxpayers’ argument
that the discount of $8,240.17 should not be taken into income but rather used
to reduce the basis of their house. Under this approach, income would be
realized only when the residence is subsequently sold. The taxpayers relied
upon Commissioner v. Shermann, 135 F.2d 68, 30 AFTR 1378, 43-1 USTC
¶9367 (6th Cir., 1943) and Hirsch v. Commissioner, 115 F.2d 656, 25 AFTR
1038, 40-2 USTC ¶9791 (7th Cir., 1940) for their authority. However, both of
these cases were unique in that the FMV of the mortgaged property was less
than the remaining principal amount of the mortgage. Consequently, the
taxpayers received nothing of exchangeable value on the “forgiveness” of the
indebtedness other than a reduction of a capital loss yet to be realized. The
facts in Sutphin do not indicate that the residence had declined in value below
the unpaid mortgage balance. Therefore, neither of these cases represent
judicial exceptions to the general rule requiring recognition of discharge of
indebtedness income.
The decision of the Claims Court requiring the taxpayers to report as
income a discount received from prepayment of their mortgage is also
consistent with two recent decisions of the tax court. See Michaels v.
Commissioner, 87 TC 1412 (1986) and Juister v. Commissioner, 53 TCM
1079, T.C. Memo 1987-292.
In a more recent case (Zarin, 92 TC No. 68), a sharply divided Tax Court
held that a taxpayer realized income from the discharge of indebtedness when
a gambling casino agreed to settle a taxpayer’s gambling debts at a discount of
nearly $3 million. The taxpayer, a compulsive gambler, owed Resorts
International (a New Jersey casino) $3,435,000, but the casino agreed to settle
for payments totaling $500,000. The taxpayer argued that the settlement could
not generate income for two reasons: (1) under New Jersey law, the gambling
debt was unenforceable, and (2) it should be treated as a purchase price
adjustment (see earlier discussion above) under § 108(e)(5). The taxpayer lost
on both points. The Tax Court, relying on the Supreme Court decision in Tufts
[461 U.S. 300, 83-1 USTC ¶9328, 51 AFTR2d 83-1132 (S. Ct., 1983)],
concluded that the enforceability of the debt was not determinative for Federal
income tax purposes. Furthermore, the Court refused to treat the settlement as
a purchase price adjustment. Purchasing an “opportunity to gamble” in
exchange for credit did not constitute, in the Court’s view, the type of property
intended by § 108(e)(5). However, upon appeal the Third Circuit reversed the
decision of the Tax Court. The appellate court concluded that § 108 did not
apply because the transaction involved a “contested liability.” The Third
Circuit reasoned as follows:
Zarin owed an unenforceable debt to Resorts. After he in good faith
disputed his obligation to repay the $3.5 million debt, the parties settled
for $500,000, which Zarin paid. The court held that the $500,000
settlement fixed the amount of loss and the amount of debt recognizable
for tax purposes. Thus, because Zarin was deemed to have owed
$500,000, and because that was the amount paid, no tax liability resulted
from the transaction.
Consequently, Mr. Zarin did not realize income from the discharge of
indebtedness. See Zarin, 66 AFTR2d 90-5679, 90-2 USTC ¶50-530 (CA-3,
1990).
Concerning the facts of the problem, they closely resemble the fact-pattern
of Sutphin v. U.S., supra. T will be required to report the $6,000 discount
received for prepayment of her mortgage as discharge of indebtedness
income. The statutory exceptions outlined above provide no relief. Clearly,
FS&L was motivated for business reasons in offering T a discount for
prepayment of her mortgage and therefore this was not a gratuitous discharge.
Because T was a solvent taxpayer and never used her residence for business
purposes, no exclusion from gross income is available under § 108(a)(1).
Furthermore, T cannot argue that the $6,000 discount represents a purchase
price adjustment under § 108(e)(5) in that she purchased the residence from
the XYZ Construction Co. rather than FS&L. Judicial relief might be
available if the market value of T’s residence had declined below the unpaid
mortgage balance. However, the facts of the problem show that the market
value of T’s residence has increased in value.
In conclusion, the final result is rather harsh. T is required to recognize
$6,000 of income, but yet the transaction produced no cash flow from which
to pay the tax due.
b. Because the fair market value (FMV) of the residence at the time of the
settlement (i.e., $25,000) was less than the settlement price (i.e., $29,000), no
taxable income results. Rather, T will be required to reduce the original
purchase price of the home by the debt reduction of $6,000. Consequently, her
basis in the house becomes $49,000 (i.e., $55,000 – $6,000). As pointed out in
Hirsch v. Comm., supra., “A transaction whereby nothing of exchangeable
value comes to or is received by the taxpayer does not give rise to, or create,
taxable income.” T now owns a residence which has a FMV of $25,000. This
is $30,000 less than what T agreed to pay for it and $24,000 less than she
actually paid for it. As the court stated, “To say that anything of value has
moved to the taxpayer is contrary to fact.” As a result, the $6,000 reduction of
the mortgage (although a forgiveness of indebtedness) was in actuality a
reduction of the purchase price from $55,000 to $49,000. Whether T will
eventually realize a gain or loss on the residence cannot be determined until
she eventually sells the property.
6-63 The facts in Roemer, Jr. v. Comm., 83-2 USTC – 9600, 52 AFTR2d 5954, 716
F.2d 693 (CA-9, 1983), revg. 79 TC 398 (1982) are, for the most part, identical to
the problem. Paul F. Roemer, Jr. owned a very successful insurance agency in
Oakland, California. In 1965, Roemer applied for an agency license from Penn
Mutual Life Insurance Company. Because Penn Mutual received a grossly
defamatory credit report from the Retail Credit Company, Roemer was denied
agency licenses to sell life insurance by Penn Mutual and other companies.
Roemer sued the Retail Credit Company for libel and was awarded compensatory
damages of $40,000 and punitive damages of $250,000.
Both the Internal Revenue Service and the Tax Court in Roemer v. Comm., 79
TC 398 (1982) ruled that the compensatory and the punitive damages were
taxable.
In reversing the Tax Court, the Ninth Circuit looked to state law and
concluded that the defamation of an individual under California law is a personal
injury. Consequently, the court concluded that the compensatory damages
received, like those received as a result of any personal injury, were excludable
from gross income under § 104(a)(2). In further explaining its reasons for
reversing the Tax Court, the circuit court stated that, “When an individual
recovers damages for a physical personal injury, the lump-sum award is not
allocated between the personal aspects of the injury and the economic loss
occasioned by the personal injury, nor is the taxpayer precluded from use of §
104(a)(2) when the predominant result of the injury is a loss of income.” Clearly,
the code in § 104(a)(2) emphasizes that damages received on account of personal
injuries are excluded from the taxpayer’s gross income. The word physical does
not appear. Consequently, the relevant distinction is not between physical and
nonphysical injuries but rather between personal and non-personal injuries.
A recent Sixth Circuit Court of Appeals case involves James Threlkeld v.
Comm., 88-1 USTC ¶9370, 61 AFTR2d 1285, 848 F.2d 81, who was sued in
Tennessee by J. B. Williams, a Texas resident, alleging fraud in connection with a
real estate sales contract. After Threlkeld had won the suit, he brought suit
alleging malicious prosecution. In his complaint, Threlkeld alleged that Williams
“instituted, continued, and prosecuted his claims without probable cause and with
malice.” Because of Williams’ actions, Threlkeld claimed he was subjected to
“indignity, humiliation, inconvenience, suffered injury to his professional
reputation and to his credit reputation.” In settlement of the suit, Threlkeld was
awarded $300,000 of which $75,000 was allocated for damages to James’
professional reputation.
Although Threlkeld excluded the settlement from gross income on his 1980
tax return under § 104(a)(2), the IRS claimed that the amount received for the
damages to professional reputation were taxable. Upon appeal, the Tax Court in
Threlkeld v. Comm., 87 TC 294 (1986) ruled in favor of the taxpayer. Likewise,
relying on the Ninth Circuit’s decision in Roemer, the Sixth Circuit concluded that
the settlement for damages to Threlkeld’s professional reputation was excludable.
Like the Ninth Circuit, the Sixth Circuit looked to state law and concluded that an
action for malicious prosecution would be classified as an action for personal
injuries. In the court’s opinion, no distinction should be made between an injury to
a person’s hand versus an injury to a person’s reputation. Clearly, all income
received in compensation of injury to an individual’s hand or arm is excludable
under § 104(a)(2) even though the injury may affect a person’s professional
pursuits. Likewise, the court concluded that all income received in compensation
of injury to taxpayer’s reputation is excludable under § 104(a)(2) even though it
affected his professional pursuits.
As previously indicated, the Tax Court in Roemer v. Comm., supra, ruled
against the taxpayer. Because Roemer failed to show that the compensatory
damages were received for injury to his personal reputation, the Tax Court
concluded the $40,000 was not excludable under § 104(a)(2). In other words,
damages received primarily for injury to the taxpayer’s business and professional
reputation are includible in gross income.
However, the Tax Court in Threlkeld v. Comm., supra, ruled in favor of the
taxpayer holding “that there is no valid distinction between damages received for
injury to personal reputation and those received for injury to professional or
business reputation for the purposes of § 104(a)(2).” The Tax Court’s reasoning
was based upon the Ninth Circuit’s opinion in Roemer. As a result, the Tax Court
reversed its decision in Roemer and now agrees with the Ninth Circuit’s ruling.
Concerning its new position, the Tax Court made the following statement:
We do not lightly decline to follow one of our prior decisions; no court
bound by the doctrine of stare decisis does. But where one of our
decisions lacks a firm foundation in the case law and an appellate court
issues a well-reasoned reversal of that decision, the weight of precedent
must give way to a better approach. Therefore, we will no longer
distinguish between personal reputation and professional reputation for the
purpose of deciding whether a damage award received in a tort action is
excludable from gross income under § 104(a)(2).
The Internal Revenue Service has stated in Rev. Ruling 85-143 that it will not
follow the opinion of the Ninth Circuit in Roemer, Jr. v. Comm., supra. Rather,
the Service agrees with the Tax Court’s original decision in Roemer, Jr. v. Comm.,
supra, that a taxpayer has not suffered a personal injury under § 104(a)(2) when
the primary harm suffered by the individual as a result of a libelous statement was
loss of business income. The Service makes a distinction between defamatory
statements directed at a business versus those directed at an individual. The
former, when loss of business income results, is an injury to the business whereas
the latter is a personal injury. Only damages attributable to a personal injury, as
opposed to a business injury, are excludable under § 104(a)(2).
As the foregoing discussion illustrates, the courts and the service have reached
various and conflicting opinions about the treatment of compensatory damages.
Nonetheless, prior to the passage of the 1996 tax legislation, the weight of
authority would have been in T.J. Taxpayer’s favor. Both the Tax Court and the
Ninth Circuit Court of Appeals have ruled, in facts very similar to T.J.’s, in the
taxpayer’s favor. Moreover, California is in the jurisdiction of the Ninth Circuit.
However, under the 1996 Act, § 104(a)(2) is amended to significantly limit the
types of personal injury awards that can be excluded from a recipient’s gross
income. The new law provides that damages received for nonphysical injuries are
not excluded from income. Furthermore, emotional distress is not considered a
physical injury or sickness. The new law also states that, as a general rule,
punitive damages are not excludable regardless of whether related to physical
injury of physical sickness.
Consequently, it would appear that the $100,000 represents taxable income to
T.J.
6-64 The facts in the Alice Johnson scenario are similar to those in Burke v. U.S. [91-1
USTC ¶50,175 67 AFTR2d 91-749, 929 F.2d 1119 (CA-6, 1991)]. The relevant
facts in the Burke case are summarized in the following paragraph.
In 1984, Judy A. Hutcheson, an employee of the Tennessee Valley
Authority (TVA) filed a Title VII action alleging that TVA had
discriminated in the payment of salaries on the basis of sex. The union,
which represented the affected employees, intervened. Among the
represented employees were Therese A. Burke, Cynthia R. Center, and
Linda G. Gibbs. The complaint alleged that TVA had increased pay scales
in certain male-dominated areas, but not in female-dominated areas. The
affected female employees sought injunctive relief as well as back pay.
Before the case went to trial, a settlement agreement was reached whereby
TVA agreed to pay $4,200 to Hutcheson and a total of $5,000,000 for the
other affected employees. Although TVA did not withhold taxes on the
$4,200 for Hutcheson, it did withhold federal income taxes on the amounts
allocated to the other affected employees. Subsequently, Therese A.
Burke, Cynthia R. Center, and Linda G. Gibbs filed a refund claim for the
taxes withheld from their settlement payments.
The Internal Revenue Service (IRS) disallowed the claim. Consequently,
Therese A. Burke, et. al., filed suit in the United States District Court for the
Eastern District of Tennessee, arguing that the settlement payments should be
excluded from gross income under § 104(a)(2) as “damages received on account
of personal injuries.” The District Court ruled that, “because the affected female
employees sought and obtained only back wages due them as a result of TVA’s
discriminatory under-payments rather than compensatory or other damages, the
settlement proceeds could not be excluded from gross income as damages
received … on account of personal injuries.” [90-1 USTC ¶50,203 (D.CT. TN,
1990)].
The United States Court of Appeals for the Sixth Circuit, by a divided vote,
reversed the lower court’s decision. According to the Sixth Circuit, determining
whether § 104(a)(2) exclusion applies requires an examination of the nature of the
injury to determine whether the injury and claim are personal and tort-like in
nature, and not whether the consequences of the injury resulted in an award of
compensatory damages or damages for back pay. The court pointed out that
injuries resulting from invidious discrimination, be it on the basis of race, sex,
national origin, or some other unlawful category, are injuries to the individual
rights and dignity of the person. Thus, the court held the award of back pay
pursuant to Title VII was excludable from gross income under § 104(a)(2).
Because of the above decision, the government pointed out that there was a
conflict among the Courts of Appeal concerning the exclusion of Title VII back
pay awards from gross income under § 104(a)(2). Back in 1989, the Fourth
Circuit in Thompson held that back pay awarded under the Equal Pay Act for sex
discrimination was taxable [Thompson v. Comm., 89-1 USTC ¶9164,63 AFTR2d
89-677, 866 F.2d 709 (CA-4, 1989)]. Although the Fourth Circuit’s decision
focused on a different statute (i.e., the Equal Pay Act rather than Title VII), the
Supreme Court nonetheless agreed to review Burke (i.e., granted a writ of
certiorari).
The Supreme Court [U.S. v. Burke, 92-1 USTC ¶50254,112 U.S. 1867
(USSC, 1992)] looked to §§ 61(a) and 104(a)(2). Section 61(a) provides that
“gross income means all income from whatever source derived.” Thus, all
accessions of wealth are presumed to be “gross income” unless the taxpayer can
show that accession falls within a specific exclusion under the Internal Revenue
Code. The question then is whether the awards qualify for special exclusion from
gross income under § 104(a)(2) which provides that gross income does not
include the amount of any damages received on account of personal injuries or
sickness.
Unfortunately, the legislative history of § 104(a)(2) provides no explanation
of the term personal injuries. Several courts have held that for the purposes of §
104(a)(2), “personal injuries” means both physical and nonphysical injuries. See
Pistillo v. C.I.R., 90-2 ¶50,469, 66 AFTR2d 90-5448, 912 F.2d 145 (CA-6, 1997
(injury involved age discrimination); Rickel v. Commissioner, 90-1 USTC
¶50,200, 65 AFTR2d 90-800, 900 F.2d 655 (CA-3, 1990) (age discrimination);
Bent v. Commissioner, 88-1 USTC ¶9101,61 AFTR2d 88-301, 835 F.2d 67 (CA-
3, 1987) (deprivation of first amendment rights); Roemer v. Commissioner, 83-2
USTC ¶9600,52 AFTR2d 83-5954, 716 F.2d 693 (CA-9, 1983) (defamation).
However, the Regulations link identification of a personal injury for purposes of §
104(a)(2) to traditional tort principles: “The term damages received means an
amount received … through prosecution of a legal suit or action based upon tort or
tort type rights …” Reg. § 1.104-1(c).
The Supreme Court next looked to the meaning of the term “tort.” A “tort” has
been defined broadly as:
… a civil wrong, other than breach of contract, for which the court will
provide a remedy in the form of “an action for damages.” One of the
hallmarks of traditional tort liability is the availability of a broad range of
damages to compensate the plaintiff “fairly for injuries caused by the
violation of his legal rights.” Although these damages often are described
in compensatory terms, in many cases they are larger than the amount
necessary to reimburse actual monetary loss sustained or even anticipated
by the plaintiff, and thus redress intangible elements of injury that are
“deemed important, even though not pecuniary in their immediate
consequences.”
In its analysis, the Supreme Court provides illustrations to help explain the
tort concepts discussed above. For example, “the victim of a physical injury may
be permitted, under the relevant state law, to recover damages not only for lost
wages, medical expenses, and diminished future earning capacity on account of
the injury, but also for emotional distress and pain and suffering.” Similarly, “the
victim of a ‘dignitary’ or nonphysical tort such as defamation may recover not
only for any actual pecuniary loss (e.g., loss of business or customers), but
impairment of reputation and standing in the community, personal humiliation,
and mental anguish and suffering.”
The Supreme Court concludes it analysis with the following observations
concerning Title VII:
It is beyond question that discrimination in employment on the basis of
sex, race, or any of the other classifications protected by Title VII is, as
respondents argue and the Court consistently has held, an invidious
practice that causes grave harm to it victims. The fact that employment
discrimination causes harm to individuals does not automatically imply,
however, that there exists a tort-like personal injury for purposes of federal
income tax law.
Indeed, in contrast to the tort remedies for physical and nonphysical
injuries discussed above, Title VII does not allow awards for
compensatory or punitive damages; instead, it limits available remedies to
back pay, injunctions, and other equitable relief … Nothing in this
remedial scheme purports to recompense a Title VII plaintiff for any of the
other traditional harms associated with personal injury, such as pain and
suffering, emotional distress, harm to reputation, or other consequential
damages (e.g., a ruined credit rating).
The Court then concludes that “notwithstanding a common-law tradition of
broad tort damages …, Congress declines to recompense Title VII plaintiffs for
anything beyond the wages properly due them—wages that, if paid in the ordinary
course, would have been fully taxable.” Consequently, the Supreme Court
reversed the Sixth Circuit’s decision by holding that the back pay awards received
by Therese A. Burke et al., in settlement of their Title VII claims are not
excludable from gross income as “damages received … on account of personal
injuries” under § 104(a)(2) of the IRC.
It should be noted that the 1991 Civil Rights Act, which became effective on
November 21, 1991, expanded Title VII’s remedial scope to include
compensatory and punitive damages. Although this signals a marked change in
Title VII, the Supreme Court does not comment on whether back pay awarded
under the 1991 act would be taxable. It would appear, however, that such
damages would be taxable given the changes made by Congress in the 1996 Act.
Under the new law, the exclusion from gross income applies only to damages
received on account of a personal physical injury or physical sickness. Thus, the
exclusion does not apply to damages received based on a claim of employment
discrimination. Furthermore, the 1996 Act provides that, as a general rule, no
exclusion from gross income is available for punitive damages.
6
Gross Income: Inclusions and Exclusions
Test Bank
True or False
________ 1. In the calculation of gross income, income that is nontaxable in total is
generally not reported on the tax return, while income that is partially
taxable and partially nontaxable is generally reported on the return.
________ 2. Distributions of cash and other assets to shareholders by U.S.
corporations in excess of their current and accumulated earnings and
profits qualify as dividends, provided the shareholder’s basis in the stock
has been reduced to zero.
________ 3. When a mutual fund distributes dividends, the dividends are deductible
by the fund and the undistributed income is taxable to the fund.
________ 4. Any dividend declared, with the option of receiving cash or additional
common stock, qualifies for the stock dividend exclusion if stock instead
of cash is selected.
________ 5. All interest from state and municipal bonds is excluded from gross
income.
________ 6. If an annuitant dies before recovering the entire investment in the
annuity contract, the amount of the unrecovered investment is allowed as
a deduction on the taxpayer’s final tax return.
________ 7. Conceptually, reimbursement for employee business travel is included in
gross income but there normally is an offsetting deduction for A.GI. so
the effect is usually a wash.
________ 8. The board of directors of Q Corporation votes to award the president of
the company $5,000 in recognition of its appreciation for the president’s
hard work in securing a government contract. The president will pay no
income tax on this bonus (award).
________ 9. The current tax law requires that the portion of social security tax paid
by the employer be included in gross income by the employee, because it
represents a benefit of value to be received in the future.
________ 10. Proceeds received from an employer-provided group-term life insurance
policy are included in gross income of the employee’s widow.
________ 11. Workers at Saltmine, Inc., are required to take their lunch in the
company cafeteria at the bottom of the mine for the employer’s
convenience. The per diem reimbursement they receive in their paycheck
for the cost of meals is excluded from the worker’s income.
________ 12. For child and dependent care assistance provided through an employer
plan, an employer is allowed a deduction, and an employee is allowed an
exclusion for gross income. The employee‘s exclusion is subject to an
annual limit.
________ 13. Assuming the existence of a written reciprocal agreement, employees of
UFO Airlines who fly to Paris on otherwise empty seats on board
another company’s flight have no taxable income for the value of the
transportation.
________ 14. H voluntarily pays W $200 a month for three months ($600) prior to
their divorce and for five months after their divorce ($1,000). The
divorce agreement requires that such payments be made until W’s
remarriage or death. They have no children. The entire $1,600 is
included in the gross income of W.
________ 15. A mother and her 19-year-old son live together in a state that declares
persons to be adults at age 18. She receives $120 a month for child
support and $80 for alimony. The entire $200 per month is included in
gross income.
________ 16. A taxpayer buys a $2 raffle ticket at the neighborhood school carnival.
He wins the third prize of $20. The income is excluded from gross
income since it is less than $25.
________ 17. Farmers are required to include in gross income fair market value of
materials (e.g., seed corn) received from the government.
________ 18. Insurance proceeds received to cover lost profits or overhead expenses in
the event of fire damage to a grocery are included in gross income.
________ 19. The value of leasehold improvements made by the lessee is nontaxable
to the lessor at the time made and at the time of lease termination unless
they were made in lieu of rent.
________ 20. T had $600 in state income tax withheld in 2011 and received a refund of
$258 in 2012. T is single and always files Form 1040A. The refund is
not included in gross income in 2012.
Multiple Choice
________ 21. R received cash income in the current year from the following
investments: bank savings account interest, $43; municipal bond interest,
$88; Canadian corporate stock dividend, $112; U.S. public utility stock
dividend, $58; and corporate bond interest, $196. All amounts received
on stock were paid from current earnings. The amount included in gross
income of R is
a. $497
b. $439
c. $409
d. $351
________ 22. D purchased all of the stock in SB, Inc., in 2006 for $76,000. On
December 31 of the current year, SB, Inc., made a cash distribution of
$135,000 to D. Assuming SB, Inc., has current E&P of $15,000 and
accumulated E&P of $40,000, the distribution will be treated as
a. Taxable dividend of $135,000
b. Taxable dividend of $55,000 and nontaxable return of investment of
$80,000
c. Taxable dividend of $55,000, nontaxable return of investment of
$76,000, and a capital gain of $4,000
d. Taxable dividend of $55,000 and capital gain of $80,000
________ 23. S purchased 200 shares of C, Inc., common stock on January 1, 2006 for
$2,200. On December 15 of the current year, C, Inc., issued a 10 percent
common stock dividend giving him 20 additional shares. D’s basis in
each share of common stock after the dividend is
a. $11
b. $10
c. $9
d. $8
________ 24. S purchased 200 shares of C, Inc., common stock on January 1, 2006 for
$2,200. On December 15 of the current year, C, Inc., issued a 10 percent
common stock dividend giving him 20 additional shares. The holding
period for the 20 additional shares of C, Inc., begins on
a. January 1, 2006
b. December 15 of the current year
c. December 31 of the current year
d. None of the above
________ 25. H owns 100 shares of A Corp. (or 1% of the stock), which he purchased
two years ago for $30 each. A’s net earnings this year were respectable—
2 million—but their board decides to distribute $4 million. Assuming A
Corp. had no AE&P before this year, how is the amount shareholder H
receives reported on his individual return?
a. $40,000 of taxable dividend
b. $20,000 of taxable dividend; $17,000 capital gain; $3,000 nontaxable
return of capital
c. $20,000 of taxable dividend; $20,000 capital gain
d. $37,000 capital gain; $3,000 nontaxable return of capital
________ 26. Which of the following is a dividend for tax purposes?
a. The dividend check from a mutual insurance company
b. The dividend coupon from Health Food Co-op
c. The dividend check from Utility Power and Light preferred
d. The dividend entered in an account at Employee’s Credit Union
________ 27. A Corp. wants to throw something to its shareholders this year, but is
cash poor. The board decides on a two-for-one stock dividend: common
on common. The shareholders of record at the time of the dividend
a. Realize a taxable dividend equal in amount to the value of their pre-
split shares
b. Have the value of their holdings doubled, taxation on which is
postponed until the shares are sold
c. Double their shares, allocating the pre-split basis in the stock equally
among the shares
d. Have nontaxable return of all their capital
________ 28. S owns an extensive portfolio of stocks and bonds. When he sells his
tax-exempt municipal bonds at the end of the year, which of the
following best describes S’s action?
a. S will likely realize a gain or loss.
b. S will have to pay the city a 10 percent penalty on the premature sale
of the bonds.
c. S will not be allowed to reacquire similar municipal bonds for two
years.
d. Both b. and c.
________ 29. An annuity has an annual compound interest rate of 9 percent. At this
rate, the original investment will be doubled in approximately
a. 10 years
b. 8 years
c. 5 years
d. 4.75 years
________ 30. H and W, a couple in their 40s, have taxable income of $50,000 per year.
One of the advantages they are seeking from the deferred life annuity
they have just purchased is
a. The opportunity to report each year’s interest as capital gain income
b. Tax-free annuity installments in the early years, becoming taxable
only after fully recovering their basis in the contract
c. Current tax deductions for the annuity premiums
d. Tax payments on the annuity installments at a lower marginal rate
________ 31. B, who is single and 59 years old, purchased a single premium
immediate annuity on January 1 of the current year for $12,000 that will
pay him $100 every month for life beginning on January 15. Based on
actuarial tables published by the IRS, his life expectancy multiple is
25.0. B’s nontaxable return of capital for the current year is
a. $0
b. $1,200
c. $480
d. $720
________ 32. B, who is single and 59 years old, purchased a single premium
immediate annuity on January 1 of the current year for $12,000 that will
pay him $100 every month for life beginning on January 15. Based on
actuarial tables published by the IRS, his life expectancy multiple is
25.0. Assuming B lives just 20 years, the unrecovered amount allowed as
a deduction on B’s final tax return is
a. $0
b. $9,600
c. $720
d. $2,400
________ 33. B, who is single and 59 years old, purchased a single premium
immediate annuity on January 1 of the current year for $12,000 that will
pay him $100 every month for life beginning on January 15. Based on
actuarial tables published by the IRS, his life expectancy multiple is
25.0. Assuming B lives 26 years, the amount included in his gross
income for year 26 is
a. $1,200
b. $0
c. $720
d. $480
________ 34. K purchased a single premium-deferred annuity 25 years ago for $6,000.
Beginning in July of this year, he will receive $125 monthly for 20
years. The taxable amount in the current year is
a. $150
b. $600
c. $750
d. $1,500
________ 35. Lucky Employee received the following items during the taxable year.
All were deducted by Lucky’s employer as business expense. Assume
that these were all of the awards given by his employer. Which item(s)
would be included in Lucky’s gross income?
a. A 20-pound turkey (FMV $ 17)
b. Christmas bonus of $400, cash
c. A $100 watch for 20 years service
d. A $300 silver cup for 15 years of safe machine operation
e. Both c. and d.
________ 36. E, who is 68 years old and married, retired on July 1 of the current year.
His current year income is shown below.
Salary (prior to retirement) $15,000
Pension payments (all taxable) 14,000
Dividends 2,000
Tax-exempt bond interest 3,000
Social security benefits 5,000
Assume E has no deductions for adjusted gross income and that Mrs. E
has no income. The amount of social security benefits that E must
include in taxable income on a joint return for the current year is
a. $5,000
b. $0
c. $2,250
d. $2,500
________ 37. Which of the following employer awards is nontaxable to the employee?
a. A, Inc., pays E $400 in recognition of her 10 years of service to the
company.
b. B, Inc., pays $375 for a watch that it awards to F in recognition of his
four years of service to the company.
c. C, Inc., pays $400 for a watch that it awards to G in recognition of
his safety achievements with the company.
d. All of the above awards are nontaxable.
________ 38. T, Inc., pays $600 ($725 FMV) for a gold watch that is awarded to U for
his 25 years of service to T. This is U’s only award from T. The
employer does not have a qualified plan for awards. The amount
included in U’s gross income and the amount deductible by T are,
respectively,
a. $725 and $600
b. $600 and $600
c. $325 and $400
d. $200 and $325
e. $0 and $600
________ 39. H is a single, retired worker with $45,000 annual taxable income. H will
begin to receive social security benefits this year that will only amount to
$5,000 per year. His social security benefits will
a. Come to him tax-free since he paid tax on the amounts when they
were included in his gross wages
b. Be partially taxed because of his high income bracket
c. Be denied him and redirected to a congressionally formed social
security trust fund
d. Be denied him, but he will get a deduction against his taxable income
for the full $5,000
________ 40. In the calculation of gross income, which of the following is not an
example of nontaxable employee benefits?
a. Purchase discounts for all employees equal to the employer’s gross
profit percentage
b. Group-term life insurance for $100,000 of coverage
c. Parking provided in the company garage
d. Supper money for voluntarily working overtime
________ 41. J is a 56-year-old executive who has worked for AM, Inc., since 1975.
Her current contract with AM includes $100,000 of group-term life
insurance. The taxable amount for each $1,000 of insurance protection,
given J’s age, is $5.16 annually. Assuming J is in the 28 percent marginal
tax bracket, the after-tax cost of this policy to J in the current year is
a. $204.20
b. $102.00
c. $0.00
d. $72.24
________ 42. A closely held C corporation purchased the $250,000 whole life
insurance policy held by one of its officers, and named itself as
beneficiary. The officer died in an airplane crash after the corporation
had paid only $1,000 on her policy. If the deceased officer’s basis in the
policy was $10,000 at time of transfer to the corporation, the tax
consequences to the corporation are
a. No taxable income
b. $240,000 taxable income
c. $250,000 taxable income
d. $239,000 taxable income
________ 43. W, who is married and files a joint return, had adjusted gross income last
year of $50,000. The following is a list of W’s itemized deductions for
last year:
Unreimbursed medical expenses before limitation $6,000
Charitable contributions 3,000
Interest paid on home mortgage 5,000
State and local property taxes 3,500
This year, W received $6,000 as reimbursement from his insurance
company for his medical expenses in the prior year. How much of the
reimbursement must W include in this year’s gross income?
a. $0
b. $2,250
c. $6,000
d. $3,750
________ 44. In which of the following independent situations does the taxpayer have
taxable income?
a. W lost a finger when a stamping press he was working with
malfunctioned. His employer-provided accident insurance policy
paid him $25,000
b. X received $10,000 of disability income during the year under an
employer-financed disability plan
c. Y received $12,000 of disability income during the year. Y paid the
$225 annual premium on the disability policy
d. Z, a spouse, received $40,000 in life insurance proceeds from the
ABC Corporation due to the death of her husband
________ 45. Unlucky Employee is injured. Unlucky is covered under two accident
and disability plans. One is partially financed by her employer and the
other is financed by her. Which of the following could account for the
non-taxing of an amount distributed to Unlucky under one of those
plans?
a. Amounts attributable to the loss of an eye under either plan
b. Any amount paid under the personally financed plan
c. Amounts attributable to the percentage paid by Unlucky under the
employer plan
d. All of the above
________ 46. Which of the following death benefits are wholly included in gross
income?
a. $10,000 death benefit paid by the decedent’s employer to the
decedent’s spouse
b. The Christmas bonus attributable to the decedent, but paid to the
decedent’s spouse
c. A $10,000 lump sum distribution from a qualified pension plan paid
to the decedent’s spouse
d. All of the above
________ 47. M, Inc., operates a funeral home out of a nineteenth-century mansion. M,
Inc., requires R to be on call 24 hours and provides the second floor of
the mansion as an apartment. Rent expense for comparable
accommodations would amount to $24,000 per year. R has taxable
income on this perquisite of
a. $24,000
b. $12,000
c. $5,000
d. $0
________ 48. During the summer, P is employed by a local charity as the director of a
camp for handicapped children. She receives weekly benefits of $225
salary, lodging in a private cabin valued at $55, and meals in the dining
hall worth $40. In case an emergency arises, P is required to be available
at all times during the seven weeks of camp. The amount included in P’s
gross income is
a. $1,855
b. $1,960
c. $2,240
d. $1,575
________ 49. Which of the following benefits provided by an employer to its
employees is taxable?
a. Employees of the ABC Department Store are allowed a 15 percent
discount (which does not exceed the employer’s gross profit
percentage) on the retail price of all merchandise purchased from the
store.
b. Undergraduate tuition is waived by the XYZ University for
dependent children of employees who are admitted to the school.
c. The MNO Airline provides free standby flights to its employees.
d. None of the above benefits are taxable.
________ 50. Poolco builds and installs swimming pools. The company will discount
the price of a pool to its employees that choose to have one built. Given
the information shown below, how much would an employee have to
include as income if he took advantage of this discount?
Normal Selling Price Poolco s Cost Employee s Cost
Materials $2,500 $1,750 $1,625
Labor 2,500 1,250 1,625
$5,000 $3,000 $3,250
a. $1,750
b. $750
c. $500
d. $0, because employee’s cost exceeds Poolco’s cost
________ 51. Sgt. C is transferred to a post in California. During the year, he received
compensation from the U.S. Army valued as follows: active duty pay,
$15,000; allowance for moving expenses, $1,400; re-enlistment bonus,
$1,500; and meals and lodging, $6,000. Included in Sgt. C’s gross
income is
a. $23,900
b. $17,900
c. $16,500
d. $15,000
________ 52. In which of the following independent situations does the taxpayer have
taxable income?
a. Taxpayer L inherited land valued at $200,000 from the estate of his
wealthy grandfather.
b. Taxpayer M, who manages a hotel, is required to live in the hotel for
the employer’s convenience and as a condition of employment. The
value of the lodging, provided without charge, is equal to $500 per
month.
c. Taxpayer N, who is an emergency room nurse, is required to eat in
the hospital cafeteria to be available for emergencies. The meals are
free to N.
d. Taxpayer O received $1,000 in interest on $15,000 that her aunt gave
her last year.
________ 53. H and W are divorced. Pursuant to the divorce decree, H transferred
stock with a FMV of $60,000 (basis to H of $25,000) to W. W’s basis in
the stock received is
a. $60,000
b. $25,000
c. $35,000
d. $0
________ 54. Which of the following would best improve the tax position of a
divorcing husband who will be required to contribute toward the support
of his ex-wife?
a. Pay her alimony
b. A large property settlement with the ex-wife
c. Voluntary cash payments to the ex-wife
d. Transfer assets to ex-wife before divorce or separation
________ 55. In a verbal agreement, W is to receive $150 per month for her
maintenance and support (ending on her death or remarriage) and $250
for child support. The $250 payment is to stop when the child reaches
age 18. During the current year, she received 12 payments of $400 each.
The amount included in W’s gross income is
a. $0
b. $2,400
c. $1,800
d. $4,800
________ 56. Alimony payments by H to W for the first three years after divorce are as
follows:
First year $90,000
Second year 60,000
Third year 30,000
The recapture amount in the third year from the second year is
a. $15,000
b. $30,000
c. $20,000
d. $10,000
________ 57. Alimony payments by H to W for the first three years after divorce are as
follows
First year $90,000
Second year 60,000
Third year 30,000
The recapture amount in the third year from the first year is
a. $30,000
b. $60,000
c. $45,000
d. $37,500
________ 58. Alimony payments by H to W for the first three years after divorce are as
follows:
First year $90,000
Second year 60,000
Third year 30,000
The recaptured amounts from the second and first years will be treated as
follows in the third year:
a. H’s gross income is increased by $52,500 and W’s deduction for
A.G.I. is increased by $52,500.
b. W’s gross income is increased by $52,500 and H’s deduction for
A.G.I. is increased by $52,500.
c. H’s gross income is increased by $52,500 and W’s deduction from
A.G.I. is increased by $52,500.
d. W’s gross income is increased by $52,500 and H’s deduction from
A.G.I. is increased by $52,500.
________ 59. D and M are divorcing. D loves his two children and agrees to support
them with the amount of $500 per month, ending on the later of the
child’s 18th birthday or 22nd birthday, if the child pursues a full-time
college education. He further agrees to pay his ex-wife $1,500 per month
for her maintenance and support, ending on her death or remarriage.
These agreements are contained in their divorce decree. D pays his ex-
wife the $2,000 per month under the terms of the decree, using one
check. How much of each $2,000 check is a nondeductible child support
expense for D?
a. $2,000
b. $500
c. $0
d. Cannot figure amount without information on amount wife actually
uses for child support
________ 60. H and W divorced six months ago. W is supposed to get H’s Picasso
painting, which he had bought for $20,000. At the time of transfer to W,
the work of Picasso is valued at $100,000. Which of the following tax
consequences would occur?
a. H has an $80,000 taxable gain.
b. W has an $80,000 taxable gain.
c. W has a $20,000 taxable gain.
d. There was no taxable income on this transfer.
________ 61. A divorce decree states that H is to pay $600 per month as alimony and
support of three minor children. The decree also provides that the
payments will decrease by one-fourth: (1) if the former spouse dies or
remarries, and (2) as each child reaches 21 years of age. The first
payment was due November 1. H paid $400 in November and $550 in
December. How are these payments allocated between child support and
alimony?
a. $950.00 child support and zero alimony
b. $650.00 child support and $300.00 alimony
c. $900.00 child support and $50.00 alimony
d. $712.50 child support and $237.50 alimony
________ 62. Which of the following represents taxable income to the recipient?
a. Scholarship used to pay tuition at a state university
b. Scholarship used to purchase books required for a course of study at
a state university
c. Scholarship used to purchase equipment required for a course of
study at a state university
d. Scholarship used to pay for room and board at a state university
________ 63. L, an undergraduate accounting major, received a $5,000 scholarship
during the year. She used the money for the following school-related
expenses: tuition $800, books $300, room and board $3,000, and
supplies $100. How much of the scholarship is included in L’s gross
income?
a. $5,000
b. $4,200
c. $800
d. $3,800
________ 64. S is selling a shoe repair shop this spring and is unsure how to word the
sales agreement to his best advantage. The price he is to receive exceeds
the fair market value (FMV) of all identifiable net assets. Also, the
purchaser insists on a non-competition arrangement. S would be best
served by
a. Allocating all amounts in excess of FMV to the non-competition
clause
b. Allocating all amounts in excess of FMV to goodwill
c. Allocating 50 percent of excess amounts to the non-competition
clause and 50 percent to goodwill
d. Allocating 25 percent of excess amounts to the non-competition
clause and 75 percent to goodwill
________ 65. For which of the following independent situations would the recipient be
required to recognize taxable income?
a. Fire to a building resulted in a bookstore being closed for two
months. An insurance company paid the proprietor of the bookstore
$12,000 for lost profits during the two-month period.
b. As part of the sale price of a drug store, the seller received $12,000
for agreeing not to compete with the buyer in the same town.
c. On January 1 of the current year, X leased a building from Y. In lieu
of paying Y rent of $1,000 per month, X made improvements to the
building amounting to $12,000.
d. All of the above; each recipient is required to recognize $12,000 of
taxable income.
________ 66. H purchases a farm with an abandoned farmhouse on it. In the attic, he
finds a mattress stuffed with $20,000 in old silver certificate bills. The
tax consequences of this find are
a. Taxable income of $20,000 to the former owner of the mattress
b. Taxable income of $20,000 to H
c. No tax consequences at this time
d. Capital gain of $20,000
________ 67. A flood forced A to live in a hotel for two months before she could
return home. On average, it cost A $600 per month to live in her home.
A’s insurer paid out to A a total of $3,600: $1,800 for each of the two
months to cover temporary living costs. A paid a corresponding $3,000
hotel bill. Of the $3,600 paid by the insurance company, how much, if
any, is taxable to A?
a. $1,800
b. $3,600, reduced by the statutory multiplier
c. $600
d. $0
e. $2,400
________ 68. Which of the following types of interest income are taxable for Federal
income tax purposes?
a. Interest on New York City School bonds
b. Interest on State of Michigan bonds
c. Interest on life insurance proceeds that the beneficiary elected to
receive in installments over a 10-year period
d. None of the above is taxable.
________ 69. Which of the following would not be a good purchase for someone
seeking to defer taxable income?
a. Rare coins
b. Deferred life annuity
c. Six-month CDs compounded daily
d. A lot located near a recreational lake
________ 70. G was injured when an elevator at his place of work fell three floors,
permanently losing the use of his left hand. As a result, he received
disability income of $700 per month for six months during the current
year. G’s employer paid 60 percent of the annual premium on the
disability policy, and G paid the remainder. The amount included in G’s
gross income is
a. $0
b. $2,520
c. $4,200
d. $1,680
________ 71. Items that generally may be excluded by businesses from gross income
are:
a. Debt cancellation (under bankruptcy proceedings), lease cancellation
payments, and leasehold improvements (not in lieu of rent)
b. Lease cancellation payments, contributions to capital, and leasehold
improvements (not in lieu of rent)
c. Debt cancellation (under bankruptcy proceedings), lease cancellation
payments, and contributions to capital
d. Debt cancellation (under bankruptcy proceedings), contributions to
capital, and leasehold improvements (not in lieu of rent)
________ 72. Alimony payments are to be paid by A to Z according to the following
schedule:
Year One Two Three
Amount $50,000 $32,000 $10,000
What is the required recapture in year three from year two?
a. $0
b. $32,000
c. $22,000
d. $7,000
________ 73. Alimony payments are to be paid by A to Z according to the following
schedule:
Year One Two Three
Amount $50,000 $32,000 $10,000
What is the required recapture amount in year three from year one?
a. $17,500
b. $25,000
c. $3,000
d. $10,000
________ 74. A and B, who are married and file a joint return, have AGI for the
current year of $32,000. In addition, they received tax-exempt interest
income of $3,000 and Social Security benefits of $8,600. The Social
Security benefits to be included in A and B’s gross income for the
current year is
a. $0
b. $3,650
c. $7,300
d. $4,300
________ 75. A and B, who are married and file a joint return, have AGI for the
current year of $42,000. In addition, they received tax-exempt interest
income of $6,000 and Social Security benefits of $15,000. The Social
Security benefits to be included in A and B’s gross income for the
current year is
a. $0
b. $7,500
c. $12,750
d. $11,750
________ 76. A is employed in Chicago as a stewardess for AMX Airlines. The airline
has a policy that allows employees to fly without charge on a standby
basis only. In September, A flies from Chicago to Los Angeles to visit
her father. The value of the ticket is $400. B is employed as a manager
of the HMO Hotel in Chicago. HMO has a reciprocal agreement with the
DEF Hotel in Boston that allows employees of both hotels to stay free of
charge at either hotel provided space is available. In October, B spends
two nights in Boston at the DEF Hotel. The value of the room for the
two nights is $350. The tax consequences of these benefits are:
a. A can exclude the value of the airplane ticket from the gross income
and B can exclude the value of the hotel room from gross income.
b. A must include the value of the airplane ticket in gross income but
the value of the hotel room to B is tax-free.
c. B must include the value of the hotel room in gross income but the
value of the airplane ticket to A is tax-free.
d. A must include the value of the airplane ticket in gross income and B
must include the value of the hotel room in gross income.
________ 77. ABC Video sells VCRs and television sets. On July 1 of the current year,
ABC sells a color T.V. to D, one of its sales clerks, for $400. The T.V.
normally retails to customers for $600 and ABC’s gross profit rate is
20%. J is an attorney for the JKL law firm. The firm pays J’s annual dues
to the American Bar Association. The tax consequences of these benefits
are:
a. D can exclude the entire discount on the purchase of the T.V. from
gross income and J can exclude the annual dues to the American Bar
Association from gross income.
b. Although J is not required to include the payment of the dues in
gross income, D must include $80 of the discount in gross income.
c. Although D is only required to include a portion of the purchase of
the T.V. in gross income, J must include the annual dues paid to the
American Bar Association in gross income.
d. D must include the entire discount on the purchase of the T.V. in
gross income and J must include the annual dues to the American
Bar Association in gross income.
________ 78. Employer P provides qualified parking with a fair market value of $250
per month to Employee D, but charges Employee D $45 per month. How
much is includible in Employee D’s gross income?
a. $250 per month
b. $205 per month
c. $45 per month
d. None of the above. The correct answer is $_________per month.
________ 79. During the current year, U made a $36,000 contribution to a 529 plan to
help cover the cost of an undergraduate degree for D, her 15-year-old
daughter. Assume that in the year D enrolls as a freshman at State
University, the balance in the 529 plan has grown to $45,000. If D
receives an $11,000 distribution to pay for her tuition, she may exclude
from her gross income:
a. $11,000
b. $0
c. $8,800
d. $2,200
________ 80. During the current year, U made a $36,000 contribution to a 529 plan to
help cover the cost of an undergraduate degree for D, her 15-year-old
daughter. Assume three years later D elects to join the work force when
she graduates from high school (rather than attend college) and the entire
$45,000 accumulated in the 529 plan is distributed to U. How much is
included in U’s gross income?
a. $45,000
b. $36,000
c. $9,000
d. $0
________ 81. L and M are married and file a joint return. Having no children of their
own, they adopted a three year old “special needs” child. L and M
incurred $10,000 in qualified adoption expenses such as adoption fees,
attorney fees and court costs. The $10,000 was furnished to M under an
adoption assistance program maintained by his employer. Assuming L
and M’s AGI for the current year amounts to $105,000 before
considering adoption assistance, how much of the $10,000 payment must
the couple include in their gross income?
a. $0
b. $10,000
c. $6,000
d. $8,500
________ 82. C was recently diagnosed with a rare liver disorder and has been
certified by his medical doctor, on June 1 of the current year, as
terminally ill. C immediately resigned from his sales position with IBM
and, on July 1 of the current year, sold his life insurance policy with a
face value of $300,000 to a viatical “settlement provider” (VSP) for
$240,000. Assuming C paid $30,000 in premiums, how much of the
$240,000 proceeds must he include in his gross income for the current
year?
a. $0
b. $300,000
c. $210,000
d. $240,000
________ 83. Refer to the facts in Question 82. If C dies 10 months later, how much
must VSP include in its gross income assuming it paid additional
premiums of $12,000 after purchasing the policy?
a. $0
b. $48,000
c. $300,000
d. $60,000
________ 84. Which of the following should not be included in taxable income for
individuals?
a. Alimony
b. Child Support
c. Dividends from a corporation that is 100% owned by the taxpayer.
d. Interest from a checking account
e. Tips
________ 85. Hunter is deciding between purchasing General Motors Corporate bonds
and State of Michigan bonds. In either case, Hunter will invest $10,000.
The corporate bonds pay 15% annually. Assuming Hunter’s marginal tax
rate is 34%, he will be indifferent to choosing either option if the state
bonds pay an annual rate of:
a. 5.1%
b. 9.9%
c. 15%
d. 19%
e. 22.7%
________ 86. During the current year K reported the following items:
Wages: $50,000
Alimony paid: 5,000
Child support paid: 10,000
Federal income tax refund: 1,000
State income tax refund: 300
The Federal and State income tax refunds were for taxes paid in the prior
year. During the current and prior year, K used the standard deduction
rather than itemizing. How will these items affect K’s taxable income for
the current year?
a. Increase taxable income by $45,000
b. Increase taxable income by $45,300
c. Increase taxable income by $35,000
d. Increase taxable income by $35,300
e. Increase taxable income by $46,300
________ 87. Which of the following would render an otherwise nontaxable
scholarship/fellowship at least partially taxable:
I. The recipient is engaged in a post-doctoral research effort (i.e.,
not a degree candidate).
II. The recipient used scholarship proceeds to pay for books
III. The recipient used scholarship proceeds to pay for room and
board.
a. I. only
b. III. only
c. I. and II. only
d. I. and III. only
e. I., II. and III.
________ 88. W and B are married, file a joint return, and report the following income
during the current year:
Dividends = $70,000
Social Security Benefits = $10,000
Calculate the taxable amount of their social security benefits.
a. $5,000
b. $8,500
c. $10,000
d. $21,500
e. $31,350
6
Gross Income: Inclusions and Exclusions
Solutions to Test Bank
True or False
