Concepts in Federal Taxation Chapter 3: Income Sources

1. Concepts in Federal TaxationChapter 3: Income Sources September 14, 2012

2. Introduction Course: UGBA 121 Section Hours: Friday 3:30-5PM Classroom: C220 GSI: Jennifer Chen Email: jenchen1204@gmail.com Office Hours: By appointment Reader: Ronald Espinosa Email: ronald_espinosa@haas.berkeley.edu

3. Homework Problems Problems Assignment #3 Chapter 3 P33, 39, 42, 48, 51

4. #33 In December, Hilga sells her German language translation business to Chia-Ching. The sales agreement includes a provision that for an extra $6,000, Hilga will not open another German language translation business in the area for two years. Chia-Ching pays Hilga the $6,000 in January. In June, Hilga opens a European language translation business in a neighboring state and advertises it in Chia-Ching’s locality. Has Hilga realized income? If so, when does she realize the income?

5. #33 1. Has there been an increase in wealth? Yes. Hilga’s wealth has been increased by $6,000. Income as an increase in wealth: “any increase in the wealth of the taxpayer that has been realized is subject to income tax” 2. Is this an arm’s length transaction? Yes. Hilga’s wealth has increased through an arm’s length transaction with a third party, which constitutes a realization of income. Arm’s length transaction concept: All parties to the transaction have bargained in good faith and for their individual benefit, not for the benefit of the transaction group. Transactions not made at arm’s length are generally given no tax effect.

6. #33 Realization of income: • Constructive receipt—income is credited into accounts or otherwise made unconditionally available • Claim of right—realization occurs whenever an amount is received without restriction as to its disposition Answer: Hilga has gross income from the receipt of the $6,000 for her agreement not to compete in January.

7. #33 Additional considerations: Even though Chia-Ching has legal recourse against Hilga for violating their agreement, Hilga must recognize the income because she has receipt of the funds and a claim of right (until a court decides otherwise) to the money. If in the future, Hilga has to repay Chia-Ching, she will be allowed a deduction for the $6,000 payment.

8. #39 Partha owns a qualified annuity that cost $52,000. Under the contract, when he reaches age 65, he will receive $500 per month until he dies. Parthaturns 65 on June 1, 2012 and receives his first payment on June 3, 2012. How much gross income will Partha report from the annuity payments in 2012?

9. #39 The nontaxable portion of an annuity payment is determined using the annuity exclusion ratio. To determine the monthly amount that can be excluded, the recipient divides their investment in the annuity by the number of months the annuity is expected to be received. Because the annuity is based on the life of the taxpayer, the number of months the annuity is expected to be received determined using the annuity table for a single taxpayer (Table 3-1).

10. #39 • Exclusion Ratio = Cost of the contract • Number of Payments Partha is age 65 when he begins receiving the annuity payments and his expected number of payments is 260. His monthly exclusion of $200 ($52,000  260 months) represents the monthly return of his $52,000 investment (capital recovery). Partha must include the remaining $300 of each payment in gross income because it represents the return on his investment. His 2012 gross income is $2,100 ($300 x 7 payments): Monthly amount to be excluded: $52,000  260 = $200 Payment received $ 500 Excluded amount ( 200) Taxable amount $ 300

11. #42 Hank retires this year after working 30 years for Local Company. Per the terms of his employment contract, Hank is to receive a pension of $600 per month for the rest of his life. During the current year, he receives 7 pension payments from Local. At the time of his retirement, Hank is single and 67 years old. a. How much taxable income does Hank have if his employer’s plan was noncontributory (i.e. Local Company paid the entire cost of the plan; Hank made no contributions to it)? Because Hank has made no investment in the pension, his pension is fully taxable. The payments by Local constitute compensation to Hank that is deferred until he begins receiving it. Hank was not taxed on the pension contributions to the plan as Local made the payments, therefore everything he receives from the plan is taxable. In this case, Hank has $4,200 of gross income ($600 x 7).

12. #42 b. How would your answer change if Hank had contributed $42,000 to the pension plan? Assume that the $42,000 had been included in Hank’s income (i.e., he has already paid tax on the $42,000). Because Hank has already been taxed on the $42,000 when it was contributed to the plan, it will not be taxed when it is withdrawn from the plan (i.e., capital recovery). Using the annuity exclusion ratio, Hank will exclude $200 ($42,000 ÷ 210) of each payment. His gross income from the pension is $2,800 ($400 x 7).

13. #42 c. What if Hank had contributed $42,000 to the plan and none of the $42,000 were taxed (i.e., the tax law allows certain pension contributions to go untaxed during the contribution period)? The payments Hank made to the plan were not taxed when they were initially earned - they are deferred until he receives the payments at retirement. Thus, all amounts received from the pension plan are taxable when received. In this case, Hank has $4,200 of gross income ($600 x 7).

14. #48 Pablo wins a new automobile on a television game show. The car has a listed sticker price of $31,500. A dealer advertises the same car for $30,000. How much income does Pablo have from the receipt of the car? Explain. Prizes and awards are taxable. Because the prize was won, it does not meet the exception for exclusion of certain types of awards. Pablo is taxed on the fair market value of the car. The sticker price of $31,500 provides only a guide to the fair market value of the car. However, if the car can be bought in an arm’s-length transaction at a lower amount than the sticker price, then that is the value to be included in gross income.

15. #48 Two exceptions for tax exclusions for certain types of awards: • Immediately transfer the prize or award to a government body or other qualified charitable organization such as a church, school, or charity. • Employee achievement awards that are paid in the form of property and are based on length of service or on safety achievements.

16. #51 Elwood had to retire early because of a job-related injury. During the current year, he receives $10,000 in Social Security benefits. In addition, he receives $6,000 in cash dividends on stocks that he owned and $8,000 in interest on tax-exempt bonds. Assuming that Elwood is single, what is his gross income if: a. He receives no other income? Elwood’s gross income before considering the taxability of the Social Security benefits is $6,000; the interest is excluded from gross income. None of the $10,000 of Social Security benefits are taxable because his modified adjusted gross income is less than the $25,000 base amount. Elwood must include the lesser of: 1. .5 x ($10,000) = $5,000 or 2. .5 x ($6,000 + $8,000 + $5,000 - $25,000) < 0

17. #51 b. He also receives $11,000 in unemployment compensation? Elwood’s gross income increases by the receipt of the unemployment compensation to $17,000 ($6,000 + $11,000). He must include $2,500 of the Social Security in gross income. 1. .5 x ($10,000) = $5,000 or 2. .5 x ($6,000 + $11,000 + $8,000 + $5,000 - $25,000) .5 x ($5,000) = $2,500 Elwood’s gross income is $19,500 ($6,000 + $11,000 + $2,500). Because his modified adjusted gross income of $30,000 is less than $34,000, the 2nd tier inclusion rule does not apply.

18. #51 c. He sells some land for $80,000? He paid $45,000 for the land. Elwood’s gross income is $41,000 [($80,000 - $45,000) + $6,000]. His modified adjusted gross income increases to $54,000 ($41,000 + $8,000 + $5,000) and he becomes subject to the 2nd tier inclusion rule (>$34,000). Under the first tier inclusion rule, Elwood would include $5,000 of the Social Security benefits in his gross income. The lesser of: 1. .5 x ($10,000) = $5,000 or 2. .5 x ($41,000 + $8,000 + $5,000 - $25,000) =$14,500

19. #51 Under the 2nd tier inclusion rule, $8,500 of the Social Security benefits are included in his gross income: The lesser of: 1. 85% x $10,000= $8,500 or 2. The sum of: a. 85% x ($54,000 - $34,000) = $17,000 b. the smaller of i.$5,000 ii. $4,500 = $21,500 Elwood’s gross income is $49,500 ($6,000 + $35,000 + $8,500)