Federal Taxation Chapter 3 Exam Bank Solution Manual (Rated A+)
Explain how income is recognized under the cash method of accounting. - Answers Income is recognized
under the cash method of accounting when the taxpayer receives or constructively receives cash,
property, or services.
Are there circumstances in which income is recognized even when a cash-basis taxpayer does not
receive cash? Explain. - Answers Yes. A taxpayer can indirectly receive cash. If a cash-basis taxpayer
owes money to a bank and someone else pays the loan to the bank on behalf of the taxpayer, the
taxpayer must record income for the amount of debt repaid by the third party. Another example is
interest on certain U.S. Savings Bonds. A taxpayer can elect to report the interest on the bonds annually
even though no cash is received.
What is meant by the concept of constructive receipt? - Answers Constructive receipt of income means
that the income is available to or in the control of the taxpayer regardless of whether the taxpayer
chooses to utilize the income. For example, income credited to a savings account at year-end is
constructively received even if the taxpayer does not withdraw it for use.
Refer to Example 3-4 in the chapter. Explain why Antonio is required to report income even though he
did not receive an asset (either cash or property). - Answers Antonio received a benefit (he was better
off economically) when Arturo paid Millie on Antonio's behalf. For Antonio, the economic outcome
would be exactly the same whether Arturo paid Millie on Antonio's behalf or whether Arturo paid
Antonio and then Antonio paid Millie.
Your friend John files his own tax returns. He received a computer as a dividend from a closely held
corporation. He says that he does not need to report the computer as dividend income because the
dividend was not paid in cash. Is he right? Why? - Answers No. The fact that a dividend was paid in cash
or property does not matter. Dividends are income to the recipient to the extent of the fair market value
of the asset received.
Interest on corporate bonds is taxable to the recipient whereas interest on municipal bonds is tax-free.
Would you expect that the interest rate on a corporate bond would be higher or lower than the rate on
a municipal bond of comparable quality and term? Why? - Answers Assuming comparable quality and
bond term, we should expect interest rates on corporate bonds to be higher than interest rates on
municipal bonds. Interest received on a corporate bond is fully taxable at rates of up to 39.6%. Thus, a
taxpayer in the highest tax bracket who receives $1,000 in interest will pay $396 in taxes, giving him or
her $604 after tax. If that taxpayer invested in municipal bonds that paid the same rate of interest, the
taxpayer would end up with $1,000 after tax (since the municipal bond interest is not taxed). We would
expect individuals to pay more for a bond that gives them $1,000 after tax than a bond that gives them
$604 after tax. Thus, the price of the municipal bonds will be "bid up" resulting in a lower interest rate
for the municipal bond and higher interest rate for the corporate bond. Recall from your Finance class
that bond prices and interest rates work in an inverse manner.
, What is a dividend? - Answers A dividend is a distribution of property by a corporation to its
shareholders. The dividend must be paid from the earnings and profits of the enterprise.
How are dividends taxed? - Answers Dividends are taxed at rates of either 15%, 20%, or 0%. If an
individual's marginal ordinary income tax rate is 25% and less than 39.60%, qualified dividends are taxed
at a rate of 15% but 20% when the marginal ordinary income tax rate is at 39.60%. If the individual's
marginal ordinary income tax rate is less than 25%, qualified dividends are taxed at a rate of 0% (no tax
is assessed).
Sam owns all of the stock in a newly formed corporation. During 2016, the first year of operation, the
corporation realized current earnings and profits of $10,000. Sam received a $12,000 distribution from
the corporation. How much, if any, of the distribution is taxable to Sam? Why? - Answers Sam will have
a taxable dividend of $10,000 and a nontaxable return of capital of $2,000. This assumes Sam has some
cost basis in his stock. Distributions in excess of earnings and profits are nontaxable and reduce the
recipient's basis in the stock of the corporation.
Under what circumstances is a dividend nontaxable to a shareholder recipient? - Answers When a
distribution is made by a corporation to its shareholders, the distribution is a taxable dividend to the
extent of current or accumulated earnings and profits of the corporation. If the distribution exceeds
E&P, it is nontaxable return of capital to the extent of the shareholder's basis in the stock. Once the
distribution exceeds basis, the excess is treated as a capital gain. Thus, a distribution is nontaxable if it is
in excess of the E&P of the corporation and the excess is less than the shareholder's basis in the stock.
How do dividends and earnings and profits relate to each other? - Answers A dividend is a distribution to
a shareholder that is made from the earnings and profits of the corporation. A distribution that is not
made from earnings and profits is not a dividend.
Under what circumstances is a state or local income tax refund included in the taxable income of a
taxpayer? - Answers If a taxpayer deducted state or local taxes as an itemized deduction in the prior
year, the taxpayer must report income in the year in which the refund was received. The taxable
amount is the lesser of (a) the amount received, or (b) the amount deducted in the prior year, or (c) the
amount by which the itemized deductions exceed the standard deduction. If the taxpayer did not
itemize deductions in the prior year (i.e., took the standard deduction), no amount of the refund is
taxable.
Under what circumstances are social security benefits taxable to a single taxpayer? - Answers If the
"provisional income" of a single taxpayer exceeds $25,000, then a portion of the social security benefits
received will be taxable. Provisional income is Adjusted Gross Income plus certain tax-exempt interest
plus half of the social security benefits received (some other items are also added, but they are less
common).
When determining the taxability of social security benefits, the IRC uses the concept of provisional
income. How is provisional income calculated? - Answers Provisional income is equal to Adjusted Gross
Income plus the following items:
Explain how income is recognized under the cash method of accounting. - Answers Income is recognized
under the cash method of accounting when the taxpayer receives or constructively receives cash,
property, or services.
Are there circumstances in which income is recognized even when a cash-basis taxpayer does not
receive cash? Explain. - Answers Yes. A taxpayer can indirectly receive cash. If a cash-basis taxpayer
owes money to a bank and someone else pays the loan to the bank on behalf of the taxpayer, the
taxpayer must record income for the amount of debt repaid by the third party. Another example is
interest on certain U.S. Savings Bonds. A taxpayer can elect to report the interest on the bonds annually
even though no cash is received.
What is meant by the concept of constructive receipt? - Answers Constructive receipt of income means
that the income is available to or in the control of the taxpayer regardless of whether the taxpayer
chooses to utilize the income. For example, income credited to a savings account at year-end is
constructively received even if the taxpayer does not withdraw it for use.
Refer to Example 3-4 in the chapter. Explain why Antonio is required to report income even though he
did not receive an asset (either cash or property). - Answers Antonio received a benefit (he was better
off economically) when Arturo paid Millie on Antonio's behalf. For Antonio, the economic outcome
would be exactly the same whether Arturo paid Millie on Antonio's behalf or whether Arturo paid
Antonio and then Antonio paid Millie.
Your friend John files his own tax returns. He received a computer as a dividend from a closely held
corporation. He says that he does not need to report the computer as dividend income because the
dividend was not paid in cash. Is he right? Why? - Answers No. The fact that a dividend was paid in cash
or property does not matter. Dividends are income to the recipient to the extent of the fair market value
of the asset received.
Interest on corporate bonds is taxable to the recipient whereas interest on municipal bonds is tax-free.
Would you expect that the interest rate on a corporate bond would be higher or lower than the rate on
a municipal bond of comparable quality and term? Why? - Answers Assuming comparable quality and
bond term, we should expect interest rates on corporate bonds to be higher than interest rates on
municipal bonds. Interest received on a corporate bond is fully taxable at rates of up to 39.6%. Thus, a
taxpayer in the highest tax bracket who receives $1,000 in interest will pay $396 in taxes, giving him or
her $604 after tax. If that taxpayer invested in municipal bonds that paid the same rate of interest, the
taxpayer would end up with $1,000 after tax (since the municipal bond interest is not taxed). We would
expect individuals to pay more for a bond that gives them $1,000 after tax than a bond that gives them
$604 after tax. Thus, the price of the municipal bonds will be "bid up" resulting in a lower interest rate
for the municipal bond and higher interest rate for the corporate bond. Recall from your Finance class
that bond prices and interest rates work in an inverse manner.
, What is a dividend? - Answers A dividend is a distribution of property by a corporation to its
shareholders. The dividend must be paid from the earnings and profits of the enterprise.
How are dividends taxed? - Answers Dividends are taxed at rates of either 15%, 20%, or 0%. If an
individual's marginal ordinary income tax rate is 25% and less than 39.60%, qualified dividends are taxed
at a rate of 15% but 20% when the marginal ordinary income tax rate is at 39.60%. If the individual's
marginal ordinary income tax rate is less than 25%, qualified dividends are taxed at a rate of 0% (no tax
is assessed).
Sam owns all of the stock in a newly formed corporation. During 2016, the first year of operation, the
corporation realized current earnings and profits of $10,000. Sam received a $12,000 distribution from
the corporation. How much, if any, of the distribution is taxable to Sam? Why? - Answers Sam will have
a taxable dividend of $10,000 and a nontaxable return of capital of $2,000. This assumes Sam has some
cost basis in his stock. Distributions in excess of earnings and profits are nontaxable and reduce the
recipient's basis in the stock of the corporation.
Under what circumstances is a dividend nontaxable to a shareholder recipient? - Answers When a
distribution is made by a corporation to its shareholders, the distribution is a taxable dividend to the
extent of current or accumulated earnings and profits of the corporation. If the distribution exceeds
E&P, it is nontaxable return of capital to the extent of the shareholder's basis in the stock. Once the
distribution exceeds basis, the excess is treated as a capital gain. Thus, a distribution is nontaxable if it is
in excess of the E&P of the corporation and the excess is less than the shareholder's basis in the stock.
How do dividends and earnings and profits relate to each other? - Answers A dividend is a distribution to
a shareholder that is made from the earnings and profits of the corporation. A distribution that is not
made from earnings and profits is not a dividend.
Under what circumstances is a state or local income tax refund included in the taxable income of a
taxpayer? - Answers If a taxpayer deducted state or local taxes as an itemized deduction in the prior
year, the taxpayer must report income in the year in which the refund was received. The taxable
amount is the lesser of (a) the amount received, or (b) the amount deducted in the prior year, or (c) the
amount by which the itemized deductions exceed the standard deduction. If the taxpayer did not
itemize deductions in the prior year (i.e., took the standard deduction), no amount of the refund is
taxable.
Under what circumstances are social security benefits taxable to a single taxpayer? - Answers If the
"provisional income" of a single taxpayer exceeds $25,000, then a portion of the social security benefits
received will be taxable. Provisional income is Adjusted Gross Income plus certain tax-exempt interest
plus half of the social security benefits received (some other items are also added, but they are less
common).
When determining the taxability of social security benefits, the IRC uses the concept of provisional
income. How is provisional income calculated? - Answers Provisional income is equal to Adjusted Gross
Income plus the following items:
