CHAPTER 1
AN INTRODUCTION TO TAXATION
AND UNDERSTANDING THE FEDERAL TAX LAW
SOLUTIONS TO PROBLEM MATERIALS
DISCUSSION QUESTIONS
1. (LO 1)
a. By becoming a dealer, any gains and losses John has are converted from capital to ordinary
classification.
b. Theresa has become self-employed. Now she will be subject to self-employment tax and will
have to make quarterly installment payments of estimated income and payroll taxes.
c. Due to the home mortgage interest deduction and property tax deduction, most new home-
owners will itemize their deductions from AGI. Thus, Paul probably will no longer claim the
standard deduction on his income tax return.
2. (LO 1) The income tax consequences that result are Marvin’s principal concern. Any rent he receives
is taxed as income, but operating expenses and depreciation will generate deductions that will offset
some or all of the income or even yield a loss. Marvin must also consider the effect of other taxes.
Because the property is being converted from residential to commercial use, he can expect an increase
in the ad valorem property taxes levied by the local (and perhaps even the state) taxing authorities.
Besides the real estate taxes, personal property taxes could be imposed on the furnishings.
3. (LO 2) The statement is only partly correct. The Federal income tax on corporations was not a
problem as it had previously been sanctioned by the Supreme Court. What had been declared
unconstitutional was the tax on individuals as it applied to the income from property.
4. (LO 2) To finance our participation in World War II, the scope of the income tax was expanded
considerably—from a limited coverage of 6% to over 74% of the population. Hence, the description
of the income tax as being a “mass tax” became appropriate.
5. (LO 2) For wage earners, the tax law requires employers to withhold a specified dollar amount from
wages paid to the employee to cover income taxes and payroll taxes. Persons with nonwage income
generally are required to make quarterly payments to the IRS for estimated taxes. Both procedures
ensure that taxpayers will be financially able to meet their annual tax liabilities. That is, the amounts
withheld are meant to prepay the employee’s income taxes and payroll taxes related to the wages
earned.
6. (LO 3) As to Adam Smith’s canon on economy, the Federal income tax yields a mixed result. From
the standpoint of the IRS, economy exists as collection costs are nominal (when compared with
revenue generated). The government's cost of collecting Federal taxes amounts to less than one-half
of 1 percent of the revenue collected. Economy is not present, however, if one looks to the
compliance effort and costs expended by taxpayers. According to recent estimates, about 56% of
individual taxpayers who file a return pay a preparer, and one-third purchase tax software.
1-1
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
,1-2 2016 Individual Income Taxes/Solutions Manual
7. (LO 3) A tax is proportional if the rate of tax remains constant for any given income level. The tax is
progressive if a higher rate of tax applies as the tax base increases.
8. (LO 4)
a. The parsonage probably was not listed on the property tax rolls because it was owned by a tax-
exempt church. Apparently, the taxing authorities are not aware that ownership has changed.
b. Ethan should notify the authorities of his purchase. This will force him to pay back taxes but
will eliminate future interest and penalties.
9. (LO 4) Although the Baker Motors bid is the lowest, from a long-term financial standpoint, it is the
best. The proposed use of the property by the state and the church probably will make it exempt from
the School District’s ad valorem tax. This would hardly be the case with a car dealership. In fact,
commercial properties (e.g., car dealerships) often are subject to higher tax rates.
10. (LO 4)
a. In this case, the “tax holiday” probably concerns exemption from ad valorem taxes.
“Generous” could involve an extended period of time (e.g., 10 years) and include both realty
and personalty.
b. The school district could be affected in two ways. First, due to the erosion of the tax base,
less revenue would be forthcoming. Second, new workers would mean new families and
more children to educate.
11. (LO 4) A possible explanation could be that Sophia made capital improvements (e.g., added a
swimming pool) to her residence and her parents became retirees (e.g., reached age 65).
12. (LO 4) Presuming that the dockage facilities are comparable in Massachusetts, the Morgans may be
trying to avoid ad valorem taxes. Taxes on nonbusiness personalty vary from one state to another and
are frequently avoided.
13. (LO 4) Until recently, it appeared that Federal excise taxes had declined significantly as to the
number of transactions covered. Taxes on the sale of jewelry, leather goods, cosmetics, and admission
to entertainment events are no longer taxed by the Federal government. But the enactment of the gas
guzzler tax and the tax on tanning salons, in addition to the increase in the tax on tobacco products,
seems to indicate an expansion of excise taxes at the Federal level.
14. (LO 4) Herman could have been overcharged, but at least part of the excess probably is attributable to
a hotel occupancy tax and a car rental tax. In major cities, these types of excise taxes have become a
popular way of financing capital improvements, such as sports arenas and stadiums. Consequently,
the amount of the taxes could be significant.
15. (LO 4) An excise tax is limited to a particular transaction (e.g., sale of gasoline), while a general sales
tax covers a multitude of transactions (e.g., sale of all nonfood goods).
a. The following states do not impose a general sales tax: Alaska, Delaware, Montana, New
Hampshire, and Oregon.
b. There is no Federal general sales tax.
16. (LO 4)
a. Jackson County must be in a state that imposes a lower (or no) sales tax. With certain major
purchases (i.e., big-ticket items), any use tax imposed by the state of the Grays’ residence
could come into play.
b. In some states, the sales tax rate varies depending on the county and/or city.
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
, An Introduction to Taxation and Understanding the Federal Tax Law 1-3
17. (LO 4) Earl probably purchased his computer out of state through a catalog or via the Internet. In such
cases, state collection of the sales (use) tax is not likely.
18. (LO 4) If the tax is imposed on the right to pass property at death, it is classified as an estate tax. If it
taxes the right to receive property from a decedent, it is termed an inheritance tax.
a. Some states impose both an estate tax and an inheritance tax. Some states (e.g., Florida and
Texas) levy neither tax.
b. The Federal government imposes an estate tax.
19. (LO 4) Jake either has a severe misunderstanding as to the rules regarding transfer taxes or is lying to
Jessica to delay any parting with his wealth. The marital deduction allows interspousal transfers
(whether by gift or at death) free of any tax (either gift or estate). There is no tax reason, therefore, in
the case of spousal transfers to prefer transfers at death over lifetime gifts.
20. (LO 4)
a. The purpose of the unified transfer tax credit is to eliminate the tax on all but substantial gifts
and estates.
b. Yes. The credit for 2015 is $2,117,800; for 2014, it is $2,081,800.
c. Yes. The credit is available to cover transfers by gift or by death (or both), but the amount
can be used only once.
21. (LO 4) $532,000. 19 donees (5 married children + 5 spouses + 9 grandchildren) × $14,000 (annual
exclusion for 2015) × 2 donors (Elijah and Anastasia) = $532,000.
22. (LO 4) Both taxes are progressive in nature, but the corporate income tax does not make any
distinction as to deductions—only business deductions are allowed. Nor does it require the
computation of adjusted gross income (AGI) or provide for the standard deduction and personal and
dependency exemptions.
23. (LO 4)
a. For state income tax purposes, “piggyback” means making use of what was done for Federal
income tax purposes. By “decoupling,” a state decides not to allow a particular Federal
provision (e.g., exclusion, deduction, credit) for state income tax purposes.
b. A diminishing number of states allow a deduction for Federal income taxes paid.
c. Most states allow their residents some form of tax credit for income taxes paid to other states.
24. (LO 4) What happened here likely is not a coincidence. The IRS probably notified the state of
California regarding Hernando’s omission of income. Thus, California followed up with its own audit.
25. (LO 4) If Mike is drafted by a team in one of the listed states, he will escape state income tax on
income earned within that state (e.g., training camp, home games). He will not, however, escape the
income tax (state and local) imposed by jurisdictions where he plays away games. Called the “jock
tax,” it is applied to out-of-state athletes and entertainers.
26. (LO 4, 5)
a. This type of question has no relevance to the state income tax, but is a less than subtle way of
encouraging taxpayers to pay any use tax due on Internet and mail-order purchases.
b. As the preparer of the state income tax return, you should not leave questions unanswered
unless there is a good reason for doing so. It appears that Harriet has no justifiable reason.
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
, 1-4 2016 Individual Income Taxes/Solutions Manual
27. (LO 4) The checkoff boxes add complexity to the return and mislead taxpayers into presuming that
they are not paying for the donation.
28. (LO 4)
a. They uncover taxpayers who were previously unknown to the taxing authority.
b. Amnesty provisions can apply to other than income taxes (e.g., sales, franchise, severance).
c. As of yet, no general amnesty program has been offered for the Federal income tax.
29. (LO 4)
a. FICA offers some measure of retirement security, and FUTA provides a modest source of
income in the event of loss of employment.
b. FICA is imposed on both employer and employee, while FUTA is imposed only on the
employer.
c. FICA is administered by the Federal government. FUTA, however, is handled by both the
Federal and state government.
d. This applies only to FUTA. The merit system rewards employers who have low employee
turnover, because this reduces the payout of unemployment benefits.
30. (LO 4)
a. Unlike the Social Security portion of FICA, there is no dollar limit on the imposition of the
Medicare tax.
b. The .9% Medicare addition applies to taxpayers with wages or net self-employment income
in excess of $200,000 ($250,000 for married filing jointly).
31. (LO 4) Only children under age 18 are excluded from FICA. Other family members, including
spouses, must be covered.
32. (LO 4)
a. Severance taxes are transaction taxes that are based on the notion that the state has an interest
in its natural resources. The tax is imposed on the extraction of minerals.
b. Franchise taxes are levied on the right to do business in the state. Typically, they are imposed
on corporations and are based on their capitalization.
c. Occupational fees are applicable to trades or businesses and are licenses to practice. Most are
not significant revenue producers, and the amounts collected are utilized to defray the cost of
regulating the profession.
d. Customs duties are taxes on the importation of certain foreign goods. They are imposed by
the Federal government and are not found at the state and local level.
e. Export duties are taxes imposed on the export of certain commodities (e.g., oil, coffee). They
are common to less-developed nations and are not levied by the United States.
33. (LO 4)
a. The United States is the only country in the OECD (Organization of Economic Cooperation
and Development) that does not have a value added tax (VAT). Approximately 80 countries
use a VAT. In spite of its extensive use by other countries, the adoption of a VAT by the
United States appears doubtful. Instead, the U.S. places high reliance on the income tax as its
major revenue source.
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
