Pope Phft2012 Ind Sm 11

7/29/2019 Pope Phft2012 Ind Sm 11

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© 2012 Pearson Education, Inc. publishing as Prentice Hall

I:11-1

Chapter I:11

Accounting Periods and Methods

Discussion Questions

I:11-1 In the long run, the amount of income reported by a taxpayer will generally be the sameregardless of the accounting methods used by the taxpayer. In a given year the amount of incomereported by a taxpayer can vary significantly depending on the accounting method used by thetaxpayer. p. I:11-2.

I:11-2 The accounting methods used by a taxpayer can accelerate or defer the recognition of income,and, thereby, change when the tax must be paid. Also, because of the progressive tax rate structure,taxes can be saved by spreading income over several years, rather than having income bunched intoone year, pushing the taxpayer into higher brackets. p. I:11-2.

I:11-3 The tax year must coincide with the year used to keep books and records. Taxpayers who donot have books must use the calendar year. Most individuals who are wage earners do not keep booksand, therefore, must file using a calendar year. p. I:11-2.

I:11-4 Once a tax year is elected, it normally cannot be changed without IRS approval. Theappropriate tax year can make record keeping easier. If the year ends during the slow season,inventories may be lower and employees are available to take inventory and perform other accountingduties associated with the year end. pp. I:11-4 through I:11-5.

I:11-5 A partnership must use the same tax year of the partners who own the majority of the

partnership income and capital. If the majority does not have the same tax year the partnership mustuse a taxable year, which is the same as the taxable year of all its principal partners (or the sametaxable year of all its principal partners who do not have such taxable year concurrently change). If the principal partners do not have the same tax year, a taxable year that results in the least aggregatedeferral of income to the partners must be used. Partnerships may also elect a natural business year

even if it differs from the tax year of its partners. Also, a partnership may elect a fiscal year involvinga deferral period of three months or less if the partnership makes a required tax payment. pp. I:11-2and I:11-28.

I:11-6 Yes. S corporations are generally required to adopt a calendar year unless either thecorporation has a natural business year or elects to make required tax payments. Rules similar to those

imposed upon partnerships (see the answer to Question I:11-5 above) are applied to S corporations. pp. I:11-3 and I:11-4.

I:11-7 The 52- to 53- week year is especially useful to businesses with inventories. For example, amanufacturer might choose a 52- to 53- week year that ends on the last Friday in December so as to permit the inventory to be taken over the weekend without interfering with the company'smanufacturing process. p. I:11-3.

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I:11-8 A newly married person may change his or her tax year to conform to that of the other spouseso that a joint return may be filed. Also, a 52- to 53- week year can be adopted if the year ends on aday that refers to the same month in which the taxpayer's prior year ended. p. I:11-5.

I:11-9 A subsidiary corporation filing a consolidated return with its parent is required to change its

accounting period to conform with its parent. p. I:11-5.

I:11-10a. When a taxpayer files his or her first or final return or when the taxpayer changesaccounting periods.

b. Annualization is required when a change in the accounting period occurs.c. Due to our progressive tax rates, annualization generally increases the taxpayer's tax

liability. pp. I:11-4 through I:11-6.

I:11-11 The final return of a decedent is filed as though the decedent had lived throughout the entiretaxable year. Final returns are filed, and taxes are paid, as if they were returns for a 12-month periodending on the last day of the short period. p. I:11-5.

I:11-12 a. Taxpayers may use the cash method as long as average gross receipts do not exceed $1million for the prior three years ($10 million if the taxpayer’s primary business is not the sale of inventory). If receipts exceed the threshold, taxpayers with inventories are required to use the accrualmethod for sales and cost of sales. This is not a requirement that they use the accrual method for other items on their returns.

b. In general, other taxpayers may choose any accounting method they want. This, of course, assumes that the method chosen clearly reflects income. Also, C corporations and partnershipswith a corporate partner may use the cash method only if the average annual gross receipts for thethree preceding taxable years do not exceed $5 million or the business meets the professional servicesrequirements (owned by professionals who are using the business to provide professional services).

c. The cash method is preferred to the accrual method because it is simpler to use. It freesthe taxpayer from having to make the year-end accruals associated with the accrual method. Also, itenables taxpayers to accelerate deductions by prepaying expenses. Similarly, earned income is nottaxable until it is collected. Thus, the cash-method taxpayer does not have to report uncollectedreceivables. pp. I:11-7 through I:11-10.

I:11-13 a. The term method of accounting is used to refer not only to overall methods of accounting but also the accounting treatment of any item. Examples of accounting methods for specific items include Sec. 174 relating to research and experimentation, Sec. 451 relating to long-term

contracts, and Sec. 453 relating to installment sales. b. Accounting methods generally affect when income is reported not whether it is

reported. Thus, the total amount of income reported over time is not affected by a taxpayer'saccounting method.

c. Because an accounting method determines when income is reported, it can change thetotal amount of tax paid because tax brackets differ over time. p. I:11-7.

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I:11-3

I:11-14 a. A cash-method taxpayer deducts expenses when they are paid. A cash-methodtaxpayer is, however, required to capitalize fixed assets and recover the cost through depreciation or amortization. Prepaid expenses must also be capitalized and deducted over the term of the prepaymentif that term extends substantially beyond the end of the tax year. Typically, capitalization is requiredonly if the term of the prepayment extends beyond the close of the tax year following the year of

payment. b. No. Prepaid interest is not deductible. An exception permits a cash-method taxpayer to

deduct points paid on a home mortgage if the property is the taxpayer's principal residence and themortgage was for the purchase or improvement of the residence.

c. Yes. Cash-method taxpayers are subject to the same rules as other taxpayers. pp. I:11-7 and I:11-8.

I:11-15 Smaller companies (those whose average gross receipts for the three preceding years were $10million or less) may use the completed contract method for construction contracts that are expected totake two years or less to complete. In addition, the completed contract method may be used for homeconstruction contracts. pp. I:11-11 through I:11-15.

I:11-16 A taxpayer cannot deduct a deposit as long as he has a right to receive a refund. p. I:11-8.

I:11-17 Payment can be either by check that is honored in due course or by use of a credit card.Payment by credit card is considered to be the equivalent of borrowing funds and using the borrowed

funds to pay the expense. A taxpayer's note is not considered to be the equivalent of cash. p. I:11-8.

I:11-18 Economic performance of services or property to be provided to a taxpayer occurs when the property or the services is actually provided by the other party. If a taxpayer is obligated to provide property or services, economic performance occurs in the year the taxpayer provides the property or service. p. I:11-9.

I:11-19 Five conditions must be met. They are:

1. The all events test, without regard to economic performance, must be satisfied.

2. Economic performance must occur within a reasonable period (but in no event morethan 8 1/2 months) after the close of the taxable year.

3. The item is recurring and is treated consistently by the taxpayer.

4. Either the amount is not material or the earlier accrual of the item results in a better

matching of income and expense.

5. The taxpayer is not a tax shelter. p. I:11-9.

I:11-20 No. The all events and economic performance tests prevent the deduction of estimatedexpenses. The expense becomes deductible once the actual cost is known. Prepaid expenses aredeductible as long as the exception to the economic performance test is met. p. I:11-9.

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I:11-21 The Regulations state that inventory methods used by a taxpayer must conform to the bestaccounting practice in the trade or business and it must clearly reflect income. In Thor Power ToolCo., the Supreme Court held that the clear reflection of income standard shall prevail in cases wherethe two standards conflict. Regulation Sec. 1.471- 4(b) states that obsolete and other slow movinginventory cannot be written down unless the selling price is also reduced. Thor Power Tool Co. wrote-

off the cost of obsolete inventory. The Supreme Court held this practice was not acceptable as itconflicted with the clear reflection of income requirement. p. I:11-11.

I:11-22 a. Manufacturing overhead (such as factory repairs and maintenance, utilities, rent andother costs relating to the manufacturing process) must be included in inventory. Nonmanufacturingcosts (such as advertising and selling expenses) are not required to be included in inventory. Other overhead costs (such as employee benefits, and factory administration) must also be included ininventory unless they relate to the nonmanufacturing areas such as selling or advertising.

b. Retailers whose average gross receipts for the three preceding years exceeds $10million must include in inventory a portion of purchasing, warehousing, packaging, and relatedadministrative costs.

c. No. Financial accounting does not require retailers to include purchasing, warehousing, packaging, and related administrative costs in inventory. Financial accounting rules have not requiredmanufacturers to inventory employee benefits and certain administration costs that must now beincluded in inventory for tax purposes. Similarly, financial accounting rules do not require thatinterest be added to the cost of inventory with long-term production periods. For example, financialaccounting does not require that interest be added to the cost of whiskey that is being aged while suchinterest must be included in inventory cost for tax purposes. p. I:11-11.

I:11-23 Long-term contracts include building, installation, construction, or manufacturing contractsthat are not completed in the same taxable year in which they are entered into. A long-termmanufacturing contract involves the manufacture of either a unique item not normally carried in

finished inventory or items that normally require more than 12 calendar months to complete.Contracts for services do not qualify for long-term contract treatment. pp. I:11-15 and I:11-17.

I:11-24 a. The installment sales method is applicable only to transactions involving gains where atleast one payment is to be received after the close of the taxable year in which the disposition occurs.It may not be used in connection with the sale of publicly traded property or inventory.

b. One reason to elect out of the installment method could relate to the application of lower tax rates in the current year where higher tax rates are anticipated during the installment period.Also, a taxpayer with current operating and/or capital losses or expiring loss carryovers may prefer tooffset a gain against the losses in the current year. pp. I:11-17 through I:11-19.

I:11-25 In effect, the installment sale method is not available because the entire amount of ordinaryincome must be reported in the year of the sale. p. I:11-18.

I:11-26 The gifting of an installment obligation is a taxable event. The donor must recognize gainequal to the difference between the face of the obligation and its adjusted basis. p. I:11-19.

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I:11-27 Installment sales to related persons are subject to the same rules as other installment salesexcept when the property is resold by the related purchaser. In the case of a resale, the first seller isrequired to treat amounts received by the related person as having been received personally. Theacceleration provision is applicable only if the resale takes place within two years after the initial saleto the related party. p. I:11-21.

I:11-28 The imputed interest rules may reallocate the amount received from an installment sale between selling price and interest if the stated interest rate is below the applicable federal rate. Theresult is to increase the amount of interest (versus principal reported) in early years under aninstallment sale. All of the interest is taxable versus only a portion of the principal. As a result theamount of income reported in the early years is greater. Less income is reported in later years. Also,the imputed interest rules may convert a favorably taxed capital gain into interest, which is taxed atordinary rates. pp. I:11-22 and I:11-23.

I:11-29 Taxpayers may elect to change to the LIFO inventory method without IRS approval. p. I:11-26.

I:11-30 The IRS can require a taxpayer to change accounting methods if the method that has beenused does not clearly reflect income. If the accounting method used by a taxpayer clearly reflectsincome, the IRS cannot require a change to another method that would also clearly reflect income. p.I:11-26.

I:11-31 The purpose is to spread the amount of the change over four years in order to immediateimpact on taxes. The additional tax (or tax reduction) is spread over the current year and thesubsequent three years. The three year rule is generally simpler. p. I:11-27.

I:11-32 Although the answer is not clear, it would seem to be no. Book and tax accounting methods

must be the same, but the term "books" seems to include a supplemental reconciliation of income.Hence, if the two methods are reconciled, a taxpayer is presumably complying with the requirement. p.I:11-27.

Issue Identification Questions

I:11-33 There are two obvious questions. One question is how she should value the automobiles shereceives as trades. The second question is how Judy should value the automobiles that she has had onhand for two years or longer. Reg. Sec. 1.471-2(c) states that second-hand goods taken in exchangeshould be valued at bona fide selling pricing less direct cost of disposition. This suggests that Judy

should estimate how much she expects to receive when she sells a trade, and subtract from that amountthe estimated costs of disposition (e.g., commissions to salesperson).

Reg. Sec. 1.471-2(c) also applies to the vehicles that have been on hand for two years or longer. That is, they may not be valued at less than a bona fide selling price less the direct cost of disposition. The regulation further specifies that a bona fide selling price means an actual offering of goods during a period ending not later than 30 days after the inventory date. As selling prices arenegotiated by Judy and individual customers, she must somehow demonstrate that she has reduced the

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price of individual vehicles. The regulation states that she should maintain records of dispositions of goods so as to enable verification of the inventory valuation. pp. I:11-11 and I:11-12.

I:11-34 The principal issue is whether surveying constitutes a new and separate trade or business, or alternatively, is an extension of the existing trade or business. If it is judged to be a new trade or

business, Lana has the opportunity to elect different accounting methods than she currently uses for the appraisal activity. p. I:11-7.

I:11-35 Accepting the second offer will result in an transaction where the installment sales rules apply.Thus, an obvious question is how do they apply when the amount John will receive is unknown? It isnecessary to decide how to value the future payments. Also, as no interest is stated, the imputedinterest rules must be considered. pp. I:11-17 through I:11-21.

I:11-36 Because winter is the slow season, it is unlikely that Lee will be able to meet the 25% testnormally used by the IRS in deciding whether the business is sufficiently seasonal to warrant a fiscalyear. That is, it is unlikely that 25% of Lee's income is generated in January and February. Lee may,

however, meet the test for a fiscal year ending on July 31 or August 31 as much of his revenue may begenerated during summer months. Alternatively, Lee could request a fiscal year ending on September 30, October 31, or November 30. Such a year-end would result in required payments equal to 36%(35% + 1%) of the deferred income. The amount of the required payment is determined bymultiplying the maximum individual tax rate (35%) plus 1% times the previous year’s taxable incometimes a deferral ratio.

As Lee is likely to be in a lower tax bracket, such payments will probably be viewed as too burdensome. Even if the corporation obtains a fiscal year Lee's personal taxable period will still be thecalendar year. Therefore, Lee's individual return will still be due April 15. pp. I:11-3 and I:11-4.

Problems

I:11-37 a. Not acceptable. Year would have to end on the last day of the month (January 31 or December 31).

b. Acceptable.c. Acceptable.d. Not acceptable, based on the least aggregate deferral of income to the partners, a March

31 year-end would be required. The calculation is as follows:

Year-End A (3/31) B (4/30) C (6/30) Least Aggregate

Deferral

3/314/306/30

-0-3.673.00

.33-0-

3.33

1.00.67-0-

1.334.346.33

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The numbers in the table represent the percent of the partnership owned by the partner multiplied by the number of months between the end of the partnership’s year and the end of the partner’s year.

Since the March 31 year-end results in the least aggregate deferral, that year-end must be used.e. Acceptable. pp. I:11-3 through I:11-5.

I:11-38 Approval is not required in any of the situations. Iowa Corporation is required to change itsaccounting period to conform with its parent if a consolidated return is filed. pp. I:11-4 and I:11-5.

I:11-39 Only situation (c) involves a change in accounting year. Hence, annualization is required onlyfor situation (c). Annualization is required even though the change itself does not require IRSapproval. p. I:11-5.

I:11-40 1. Modified taxable income:Practice income $40,000Interest 3,000Itemized deductions ( 6,250)Exemption (7/12 x $3,700) ( 2,158)Modified taxable income $34,592

2. Annualized taxable income 12/7 x $34,592 $59,301

3. Tax on annualized income $10,950

4. Gross tax (7/12 x $10,950) $ 6,388 pp. I:11-5 and I:11-6.

I:11-41 Items (b) and (d) are not deductible. Prepaid interest is not deductible. A note does notconstitute payment. Payment by credit card and payment with borrowed funds constitute cash payment. Further, a check mailed (and postmarked) before year-end constitutes payment. pp. I:11-7and I:11-8.

I:11-42 a. Only warranty work actually performed this year is deductible. Hence, Camp candeduct $74,000.

b. As all work has been completed, $20,000 is deductible.c. As the $5,000 is refundable, no amount is deductible.d. The $18,000 of rent is deductible. The security deposit of $1,000 is not deductible. pp.

I:11-8 and I:11-9.

I:11-43 a, c, e, f, g, and h must be included. pp. I:11-11 and I:11-12.

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I:11-44 2012 inventory:2012 inventory at 2011 prices:130% x $134,000 = $130,000134%Base inventory (2011) $110,000

Plus: 2012 layer 134% x ($130,000 - $110,000)130% 20,6152012 ending inventory $130,615

2013 inventory:2013 inventory at 2011 price:130% x $125,000 = $116,071140%

Base inventory (2011) $110,000

Plus: 2012 layer 134% x ($116,071 - $110,000) 6,258130%2013 ending inventory $116,258

As there was a reduction in inventory from 2012 to 2013, there is no 2013 layer. Further, the 2012layer has been reduced. pp. I:11-13 and I:11-14.

I:11-45 The entire amount of $80,000 is taxable in 2011 as the amount is all ordinary income. Onlythe interest is taxable in subsequent years. p. I:11-18.

I:11-46 LIFO is undesirable because it will lock-in older, higher costing inventory layers. If thecompany is not doing so now, it might consider electing the “lower of cost or market” in conjunctionwith FIFO. This would enable the company to write down inventory on hand as prices are lowered. p. I:11-14.

I:11-47 a. First Company cannot use the installment method because the stock being sold is publicly held. As a result First Company must report the entire gain of $25,000 this year. The interestis reported as it accrues.

b. Because the transaction results in a loss, the installment method is unavailable. Theloss of $30,000 is reported currently. Interest is reported as it accrues.

c. The installment method cannot be used to report sales of merchandise. As a result the

company must report sale of $4,500,000 this year. It can deduct the cost of goods sold. Although theallowance method for reporting bad debts is not permitted for tax purposes, the company can deductthe amount of any specific receivables it writes off. pp. I:11-17 and I:11-18.

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I:11-48 a.Gross profit $ 6,000($20,000 - $14,000)

Gross profit percentage 30%($6,000 / $20,000)

Gain recognized in 2011 $ 1,500

(0.30 x $5,000) b. Selling price $13,800

Basis [$15,000 - (0.30 x $15,000)] ( 10,500)Gain $ 3,300

pp. I:11-17 and I:11-18.

I:11-49 a. Gross profit percent is 73.333% [($45,000 - $12,000)/$45,000]. The gain reported inthe year of sale is $11,000 ($15,000 x 73.333%).

b. The gain reported is $21,500 {$30,000 - $500 – [$30,000 – ($30,000 x 73.333%)]}.c. The rug’s basis is $30,000. pp. I:11-17 and I:11-18.

I:11-50 a. Joe reports a loss of $20,000 ($42,000 - $2,000 - $60,000). The loss is a capital loss,which means he can deduct only $3,000 from ordinary income. However, if he has sufficient capitalgains he can offset the full loss against the gains.

b. Joe reports the interest income as it accrues if he is an accrual basis taxpayer and whenhe collects it if he is a cash basis taxpayer.

c. No. All of the loss is available in the year of the sale. Should Joe be unable to deductthe full capital loss in the year of the sale because he has insufficient capital gains, he would have acapital loss carryover. The amount of the carryover that can be used depends on the amount of capitalgains reported in the carryover year. The collection of the installment payments does not affect theamount of loss available in carryover years.

I:11-51 a. $32,288 [$200,000 - ($200,000 x 0.83856)]. b. 2013. As the stated sales price is less than $250,000, no accrual of interest is required.c. $37,712 ($200,000 - $32,288 - $130,000).d. 2013. Assuming Amy does not elect out of the installment sales method, the gain is

reported in the year the sales price is collected.e. $167,712 ($200,000 - $32,288). pp. I:11-22 through I:11-24.

I:11-52 a. The amount of the adjustment is $800 ($16,000 - $15,200). The 2011 receivables hadnot been included in income in prior years, so this must be added to income. The 2011 payables hadnot been deducted in 2011 although they would have been deductible under accrual accounting.

b. As the amount of this adjustment is less than $3,000, the amount must be added to 2011income. pp. I:11-26 and I:11-27.

I:11-53a. The addition to the deposit is $8,000 ($400,000 x 36% x 9/12 - $100,000). b. The payment must be made by April 15, 2013.c. No. The amount cannot be subtracted from the partner's personal tax liability. The

amount of the deposit is adjusted up or down each year to reflect changes in the partnership's income.

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In the event of a decline in the partnership's income a portion of the deposit will be refunded to the partnership. pp. I:11-3 and I:11-4.

I:11-54 Yes. Changing to the LIFO inventory valuation method does not require IRS approval.Taxpayers may make the change by attaching Form 970 to the return for the year the change takes

place. Changes to LIFO from FIFO usually result in a reduced inventory value. Taxpayers, ingeneral, are expected to spread the amount of any adjustment resulting from changes in accountingmethods over four years. Typically, adjustments of $25,000 or less can be made in the year a changein accounting methods takes place. The IRS has not specifically said whether this option is availablein connection with adjustments that result from changes to LIFO. Form 970 does ask whether taxpayers plan to report the amount of the adjustment over three years. One reason for not spreadingthe amount of the adjustment over multiple years might be because the amount is relatively small. TheIRS states that any change in accounting method, is subject to its approval. In fact, the IRS notes thateven automatic changes may be disallowed. This means the taxpayer can make the change withoutIRS approval, but that the IRS can require the taxpayer to change again. pp. I:11-25 through I:11-27.

I:11-55 a. For income tax purposes, it is not necessary to impute interest on this gift loan becausethe amount of the loan is under the $100,000 threshold and John's net investment interest income isunder $1,000.

b. Assuming an applicable federal rate of 8%, imputed interest equals $10,000 (.08 x$125,000) per year.

c. The interest appears to be qualified residential interest and as such is deductible if Johnitemizes.

d. Jane is treated as having received the $10,000 as interest income for the year. Further,she is treated as having made a gift to John of an equal amount. Unless there are other gifts, however,the annual gift tax exclusion means there is no requirement that Jane file a gift tax return. pp. I:11-22through I:11-25.

I:11-56 a. King reports $360,000 of income during year one computed as follows:

Expected profit ($11,200,000 - $10,000,000) $1,200,000Percentage complete ($3,000,000 / $10,000,000) x 0.30Income--year one $ 360,000

b. The reported income for the second year is $480,000 computed as follows:

Expected profit $1,200,000Percentage complete ($8,000,000 / 10,000,000) x 0.80

Income--year one and two $ 960,000Minus: Previously reported income ( 360,000)Income--year two $ 600,000

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c. The reported loss for year three is $260,000 computed as follows:

Contract amount $11,200,000Minus: Actual costs (10,500,000)Income from contract $ 700,000

Minus: Previously reported income ( 60,000)Current loss ($ 260,000)

d. King overestimated its income from the contract, and as a result, overpaid its tax.Under the look-back interest rule, King is entitled to receive interest on the additional tax it paid because it overreported income in years one and two.

pp. I:11-15 through I:11-17.

I:11-57 a. Depreciation is $9,600 ($100,000 x .1920 x 0.50). b. The gain on the sale of the tugboat ($27,600) is less than the accumulated depreciation

($37,600). As a result, the full gain must be reported currently:

Selling Price $90,000Adjusted Basis:

Cost $100,000Accumulated depreciation ( 37,600) 62,400

Gain $27,600

c. Under the cash method of reporting income, interest income is reported as it iscollected. As Dan has not yet received any interest, none is taxable.

d.Business income $72,000Depreciation ( 9,600)Other expenses (30,000) Net business income $32,400

e. Net business income $32,400Gain on sale of tugboat 27,600IRA distribution 10,000

Social security benefits (85%) 1,700Adjusted gross income $71,700

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f.Contributions $ 4,000Real property taxes 2,000State income taxes ($200 + $800) 1,000Mortgage interest 6,500

Total $13,500

g.Adjusted gross income $71,700Itemized deductions (13,500)Personal exemption ( 3,700)Taxable income $54,500

I:11-58 The transactions are “gift loans” resulting in Leon reporting imputed interest income of $13,000 (6.5% x $200,000). The tax is $3,640 (0.28 x $13,000). The son includes $14,000 of bondinterest he receives in gross income and deducts the imputed interest as an itemized deduction

($13,000). The son’s tax is $100 (0.10 x $1,000). The total tax for the family is $3,740 ($3,640 +$100).

Had Leon invested the funds himself, the tax on the bond interest would have been $3,920

(0.28 x $14,000). The transactions produce a $180 tax savings for the family. First, the son’s tax bracket is lower than the father’s, and second; the interest rate on the investment is slightly higher thanthe applicable federal rate. The imputed interest rules prevent much larger tax savings. The relativelysmall savings associated with the transaction and its complexity is the reason such transactions areuncommon. In fact, a major objective of the imputed interest rules is to reduce the tax advantage of “gift loans.”

This answer does ignore some other possible tax implications. Leon would lose thedependency exemption for his son if the son becomes self-supporting. The question is whether thetuition represents more than one half of the son’s support. The dependency exemption would be worthmore on the father’s return than on the son’s.

Students familiar with the Hope and Lifetime Learning credits may raise the question as to howthese credits might impact this decision. A given dollar amount of credit produces the same tax savingfor either taxpayer. Nevertheless, the father may not be eligible to claim any credit because he has toomuch income (See Chapter I14). If the son paid the tuition, he would be eligible for the credit, but itwould be limited to his small tax liability.

I:11-59 If Linda chooses to receive cash she will owe an immediate income tax of $18,000 (0.15 x($200,000 - $80,000). She would receive $182,000 after taxes.

If she chooses to receive installments, she will receive the same amount of principal and paythe same tax on the gain, but both will be spread over two years. The question is whether the interestis sufficiently large to compensate Linda for the delayed receipt of the principal.

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I:11-13

Current year Next year Principal $100,000 $100,000Tax on gain ( 9,000) ( 9,000) Net $ 91,000 $ 91,000

Interest (8% x $100,000) 8,000Tax on interest (0.28 x $8,000) ( 2,240) Net $ 5,760

If Linda accepts the installment option, she will have to wait one-year to receive the installment payment and will receive interest as compensation. In after tax dollars, she will receive interest of $5,760 in exchange for waiting a year for the after tax installment of $91,000. Thus, the return is6.33% ($5,760/$91,000). This is less than the minimum 10% return specified in the problem.

Students familiar with present value computations may present the computation differently. They

might discount the payments associated with the installment option.

Installment net of tax $91,000 $91,000Interest net of tax ______ 5,760Total $91,000 $96,760Present value $91,000 $87,955*

Total ($91,000 + $87,955) $178,955.

*$96,760 x .909

The present value of the installment payments of $178,953 is less than the $182,000 realized after taxes from the cash sale indicating that the installment payments are worth less than the paymentsassociated with the cash sale.

Tax Form/Return Preparation Problem

I:11-60 (See Instructor’s Resource Manual)

Case Study Problems

I:11-61 It is important for Lavonne to make the correct election on the first corporate return, as theelection cannot be changed without IRS approval. Approval is usually granted only if a sound business reason can be given for the change.

Lavonne can elect either the cash or accrual method of reporting income from her medical practice. One aspect of many professional practices is that collections often lag. Doctors must fileclaims with insurance companies, Medicare, and others. Payments may be delayed many months.Doctors also experience bad debts. Under the accrual method these amounts must be included in grossincome when the services are provided without any allowance for uncollectible accounts. This can

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result in the doctor having to pay taxes on income that has not been collected and, in fact, may never be collected. As a result the cash method has a distinct advantage because Lavonne can wait to reportincome from her practice if and when it is received.

Income from a medical practice is not ordinarily seasonal. Therefore, Lavonne's corporationwill likely not have a natural business year. Also, the corporation will almost surely be classified as a

personal service corporation. As a personal service corporation it is subject to several limitationsincluding one on the choice of taxable years. Assuming Lavonne reports on the calendar year, thecorporation will have to either report on a calendar year, or a fiscal year ending September 30, October 31, or November 30. If the corporation elects one of the available fiscal years, the corporation willhave to make required distributions to Lavonne. These distributions will reduce or eliminate any taxdeferral that might be obtained from the fiscal year. (Some knowledgeable students may mention an Selection). An S corporation will have the same available years, but the S corporation will makerequired payments to the government instead of required distributions to Lavonne. In either case thereis no real advantage of a fiscal year to Lavonne. pp. I:11-3 and I:11-7.

I:11-62 Don is faced with a significant tax on the sale especially in the first year even if he applies the

installment method. The proceeds from the sale total $600,000, and the basis of the property is$290,000 ($400,000 - $110,000). Thus, Don will have to report $310,000 of income from the sale.This consists of a combination of depreciation recapture, Sec. 1231 gain, which is subject to specialrules (discussed in Chapter I12), and interest income which must be imputed. The amount of imputed

interest depends upon the applicable federal rate at the time of the sale. Although the sale can bereported under the installment method, depreciation recapture of $110,000 has to be reported in theyear of the sale and is taxed at ordinary rates. The tax, assuming a 25% rate, would be $27,500. Inaddition, Don will have to report a portion of the Sec. 1231 gain in the year of the sale. As Don will pay $90,000 to retire the mortgage, he will have to find some other source of funds in order to pay thetax on the depreciation recapture and Sec. 1231 gain.

There are some things that Don can do to improve his situation. First, he could probably

request that the contract specify interest at a rate not less than the applicable federal rate so as to avoidthe need to impute interest. The selling price would normally be reduced to reflect the interest charge.Secondly, the contract should be written so as to avoid the problem of the negative cash flow in thecurrent year. This could be done by requiring a larger down payment or by obtaining outsidefinancing. The buyer, however, may object to a larger down payment, and outside financing maymean that Don has to report all of the income currently. (Knowledgeable students may suggest wraparound or subject to financing, but most students will not propose these solutions as they are notdiscussed in the text.) Alternatively, a rental agreement with an option to buy might enable thetaxpayer to defer gain recognition until after retirement when Don may be in a lower tax bracket. pp.I:11-17 through I:11-21.

I:11-63 The uniform capitalization rules clearly require that indirect manufacturing costs be includedin inventory, and the taxpayer must comply with the rule. This leaves the taxpayer with two problems.How can the corporation comply with the rule without spending excessive amounts to determine howmuch to include in inventory? What procedures must be followed in bringing the company intocompliance? It is an acceptable professional practice to use estimates if actual amounts areunavailable or too difficult to determine (see SRTP No. 4). In this situation, it might be acceptable tochange how inventories are valued by increasing the overhead application rate or making similar adjustments. Such an effort could produce a reasonable estimate of the additional costs that should be

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included in inventory under the uniform capitalization rules. It is not entirely clear whether thischange in the overhead application rate represents a change in accounting methods requiring IRSapproval. Changing cost patterns cause businesses to change the application rate, sometimes annuallyor more often. In this case, adding to the list of costs may be a change of methods. The safestapproach would be to request IRS approval. The company could ask that the amount of the change be

spread over four years. pp. I:11-11 and I:11-12.

Tax Research Problems

I:11-64 All three cited authorities indicate that amounts placed in escrow constitute constructivereceipt by the seller. As a result, the entire sales price is considered to have been received by Eagle in2011. In the absence of any contrary authority, the entire gain is taxable in 2011. In the situationdescribed, financial security and tax security are inversely related. Since the seller faces little financialrisk, the gain is taxable in the year of sale.

I:11-65 Reg. Sec. 1.471-2 refers to "trade customs" and "best accounting practice in the particular

trade or business". Reg. Sec. 1.471-3 states if, "the usual rules for computation of cost of productionare inapplicable, costs may be approximated upon such basis as may be reasonable and in conformitywith established trade practice in the particular industry." In Justice & Parker Co., the court placedgreat weight on the judgment and experience of the taxpayer's personnel, and in Morris Chaitlen, thecourt accepted a practice similar to the one described in the case, but questioned the experience and judgment of the taxpayer's personnel. As a result, the acceptability of the Texas Corporation'sinventory value depends on the judgment and experience of the taxpayer's personnel.

I:11-66 According to Reg. Sec. 1.446-(1)(e)(3)(i), consent must be secured from the Commissioner tochange from the cost method in valuing inventory to the lower cost or market method. AppleCorporation must file an application Form 3115 with the Commissioner. Apple Corporation must also

furnish all necessary information, including all items that would be treated differently. AmericanLiberty Pipe Line Co. v. CIR [32 AFTR 1099, 44-2 USTC ¶9408 (5th Cir., 1944)] exemplified this point. The company was unable to value its inventory at lower of cost or market method withoutobtaining permission from the Commissioner.

Thor Power Tool Co. v. CIR [43 AFTR 2d 79-362, 79-1 USTC ¶9139 (USSC, 1979)] statesthat inventory is valued at cost unless market value is lower. Market value will be lower than costwhen the taxpayer has offered to sell merchandise at a price lower than replacement cost and wherethe merchandise is defective. Thor Power Tool attempted to write down excess inventory to its ownestimate of the net realizable value, although the parts were kept on hand and the asking price was notreduced. According to Reg. Sec. 1.471-4(b) the selling price must be reduced for inventories to bewritten down. The Supreme Court ruled that the reflection of income test was paramount.

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“What Would You Do In This Situation?” Solution

Ch. I:11, p. I:11-15. Inventory Value.

There are hints that Jack wants to use the year-end inventory value to control his tax liability.

The lower the reported year-end inventory value the lower the reported taxable income. AICPAethical guidelines (SRTP No. 3) indicate that CPAs may rely without verification upon informationfurnished by a client. The guidelines, however, further state that the CPA cannot "ignore theimplications of information furnished and should make reasonable inquiries if the information appearsto be incorrect, incomplete, or inconsistent..." The client reports that he could not get along with his previous accountant. This could well mean that the problem is not new.

The accountant should review prior returns and ask permission to contact the previousaccountant. If not satisfied with information obtained from these steps, the accountant could visit the

client's place of business and observe the inventory. Further, the accountant could examine invoicesand other documentation to ascertain the reasonableness of an inventory figure presented by the client.

In the event the inventory value provided by the client is judged to be understated, the accountantshould discuss the matter with the client. The accountant can point out that the IRS could also conducta similar examination. An accountant cannot use an inventory value simply because the client wantsto pay a lower tax.

One constructive effort by the accountant can be to offer tax-planning ideas that permit theclient to minimize his tax liability while still complying with the tax law. For example, the accountantcould review the records to determine whether LIFO inventory valuation is being employed.

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