Fundamentals of Federal Taxation Exam Solution Manual
Gross Income - Answers All income from whatever source derived. Includes income, realized in any
form, whether in money, property, or services.
Taxpayers recognize gross income when: - Answers 1) they receive an economic benefit (borrowed
funds represent a liability, not gross income)
2) they realize the income ( -taxpayer engages in a transaction with another party or - transaction results
in a measurable change in property rights)
3) the tax law does not provide for exclusion or deferral (realized income is assumed to be recognized
absent a deferral or exclusion provision
Return of Capital Principle - Answers - The cost of an asset is called *tax basis*
- Return of capital means the tax basis is excluded when calculating realized income (return of capital
does not represent an economic benefit)
- Gain from the sale or disposition of an asset is included in realized income
Tax benefit rule - Answers Refunds of expenditures deducted in a prior year are included in gross income
to the extent that the refund reduced taxes in year of the deduction
Accounting Methods - Answers Corporation: accrual method
Individuals: cash method
Constructive Receipt - Answers - Taxpayer must realize and recognize income when it is actually or
constructively received
- Deemed to occur when the income is credited to the taxpayers account
Claim of Right - Answers Income recognized when there are no restrictions on use of income (no
obligation to repay)
Assignment of Income - Answers - This doctrine holds that the taxpayer who earns income from services
must recognize the income
- Income from property such as dividends and interest is taxable to the person who actually owns the
income-producing property
- To shift income from property to another person, a taxpayer must also transfer the ownership in the
property to the other person
Income from Services (Earned Income) - Answers - Income from labor; most common source of gross
income
, - Generated by the efforts of taxpayer
Employee Stock Options - Answers NQOs: Ordinary income on bargain element at exercise date
ISOs: No taxable income until sale date; Long-term capital gain at sale unless disqualifying disposition
Nonqualified Stock Options (NQO) - Answers - No tax effect on the date of the grant
- At exercise, record ordinary income for the bargain purchase element
- When sold, capital gain (loss) is the difference between the exercise price and the selling price of the
stock
NQO Example - Answers An employee receives 100 NQOs. Each option allows the purchase of 20 shares
of stock at $10 per share (2000 total shares).
On the exercise date, the stock is trading at $35 per share. The employee will recognize ordinary income
of $50,000 upon exercise:
50,000 = (100 * 20)($35 - $10)
If the stock is later sold for $75,000, the employee will report a capital gain of $5,000:
($75,000 - $70,000^)
Incentive Stock Options (ISO) example - Answers An employee receives 100 ISOs. Each option allows the
purchase of 20 shares of stock at $10 per share (2000 total shares).
On the exercise date, the stock is trading at $35 per share. The employee will pay $20,000 for the stock
and that will be the basis. No gain or loss is recognized unless it is sold immediately.
If the stock is later sold for $75,000, the employee will report a capital gain of $55,000:
($75,000 - $20,000)
If held for 2 years after grant date and one year after exercise date, the gain will be LTCG. So even the
bargain element is capital gain and not ordinary
Income from Property
(Unearned Income) - Answers - Include gain or losses from sale of property, dividends, interests, rents,
royalties, and annuities
- Depends on type of income and type of transaction generating income
Annuities - Answers - A portion of each annuity payment as a non-taxable return of capital and the
remainder as gross income
Gross Income - Answers All income from whatever source derived. Includes income, realized in any
form, whether in money, property, or services.
Taxpayers recognize gross income when: - Answers 1) they receive an economic benefit (borrowed
funds represent a liability, not gross income)
2) they realize the income ( -taxpayer engages in a transaction with another party or - transaction results
in a measurable change in property rights)
3) the tax law does not provide for exclusion or deferral (realized income is assumed to be recognized
absent a deferral or exclusion provision
Return of Capital Principle - Answers - The cost of an asset is called *tax basis*
- Return of capital means the tax basis is excluded when calculating realized income (return of capital
does not represent an economic benefit)
- Gain from the sale or disposition of an asset is included in realized income
Tax benefit rule - Answers Refunds of expenditures deducted in a prior year are included in gross income
to the extent that the refund reduced taxes in year of the deduction
Accounting Methods - Answers Corporation: accrual method
Individuals: cash method
Constructive Receipt - Answers - Taxpayer must realize and recognize income when it is actually or
constructively received
- Deemed to occur when the income is credited to the taxpayers account
Claim of Right - Answers Income recognized when there are no restrictions on use of income (no
obligation to repay)
Assignment of Income - Answers - This doctrine holds that the taxpayer who earns income from services
must recognize the income
- Income from property such as dividends and interest is taxable to the person who actually owns the
income-producing property
- To shift income from property to another person, a taxpayer must also transfer the ownership in the
property to the other person
Income from Services (Earned Income) - Answers - Income from labor; most common source of gross
income
, - Generated by the efforts of taxpayer
Employee Stock Options - Answers NQOs: Ordinary income on bargain element at exercise date
ISOs: No taxable income until sale date; Long-term capital gain at sale unless disqualifying disposition
Nonqualified Stock Options (NQO) - Answers - No tax effect on the date of the grant
- At exercise, record ordinary income for the bargain purchase element
- When sold, capital gain (loss) is the difference between the exercise price and the selling price of the
stock
NQO Example - Answers An employee receives 100 NQOs. Each option allows the purchase of 20 shares
of stock at $10 per share (2000 total shares).
On the exercise date, the stock is trading at $35 per share. The employee will recognize ordinary income
of $50,000 upon exercise:
50,000 = (100 * 20)($35 - $10)
If the stock is later sold for $75,000, the employee will report a capital gain of $5,000:
($75,000 - $70,000^)
Incentive Stock Options (ISO) example - Answers An employee receives 100 ISOs. Each option allows the
purchase of 20 shares of stock at $10 per share (2000 total shares).
On the exercise date, the stock is trading at $35 per share. The employee will pay $20,000 for the stock
and that will be the basis. No gain or loss is recognized unless it is sold immediately.
If the stock is later sold for $75,000, the employee will report a capital gain of $55,000:
($75,000 - $20,000)
If held for 2 years after grant date and one year after exercise date, the gain will be LTCG. So even the
bargain element is capital gain and not ordinary
Income from Property
(Unearned Income) - Answers - Include gain or losses from sale of property, dividends, interests, rents,
royalties, and annuities
- Depends on type of income and type of transaction generating income
Annuities - Answers - A portion of each annuity payment as a non-taxable return of capital and the
remainder as gross income
