Chapter 5 Solutions

PROBLEMS
5-27
a. No. The increase in value is not recognized as income until it is realized (e.g.,
when Q sells or otherwise disposes of the property). (See p. 5-5.)
b. Yes. This is a bargain purchase. The $4,000 difference between the sales price
of $3,000 and the property's value of $7,000 would constitute compensation
unless R can establish that the bargain element of the sale was a gift. Note,
however, that so-called qualified employee discounts are excludable, as
discussed in Chapter 6. These discounts must be on property other than real
property that is offered for sale to customers in the employer's ordinary line of
business in which the employee is performing services and they must not
exceed the employer's gross profit margin. (See p. 5-7 and 132.)
c. No. Although I has "cashed in" on the increase in value of the property, no
income is realized because there has not been a disposition of the property,
and I still remains obligated to repay the $10,000 loan. Moreover, I's net worth
has not increased. Assets have increased, but so have liabilities. (See p. 5-8.)
d. Yes. S would be treated as having received $60 (30% $200) per month as
income from using the car for personal purposes. Because S is controlling
shareholder of the business, the income probably would be treated as a
constructive dividend from the corporation. (See p. 5-10 and 61.)

5-29
a. Yes. The $39,000 reimbursement for mental anguish might appear to be
excluded from income because it represents a return of capital. However,
104(a)(2) as amended in 1996 allows an exclusion only for physical personal
injury. Section 104 makes it clear that emotional distress shall not be treated
as a physical injury or physical sickness. The remaining $61,000 is included
as it is in lieu of compensation. (See Example 6 and p. 5-9.)
b. No. The discount is an employee fringe benefit that historically has been
excluded. This treatment was codified in 132 in 1984. Now, so-called
qualified employee discounts are excludable, as discussed in Chapter 6. These
are discounts on property other than real property and services that are offered
for sale to customers in the ordinary course of the line of business of the
employer in which the employee is performing services, and do not exceed the
employer's gross profit margin. (See p. 5-10 and 132.)
c. No. Historically, noncash transfers of small value to employees are treated as
nontaxable employee fringe benefits. Under the de minimis fringe benefit
rules of 132, property with a value that is so small as to make accounting for
it unreasonable or administratively impracticable are excluded. (See 5-10 and
132.)
5-39
a. Technically, LL has two options for reporting the $200,000 of advanced
payments for services. These are: a "full-inclusion method" and a "deferral
method." Under the full-inclusion method all $200,000 of the payments are
reported in the year of receipt regardless of how the payments are reported for
financial accounting purposes. Under the deferral method, in the first year,
2016, LL reports the payments to the extent they are included in the revenues
of the taxpayer's financial statements and the balance is reported as income in
the following year. In this case, LL probably would report the income for
financial accounting purposes as it is earned. Since one-fourth of the services
are provided in the first year, 2016, LL would report one-fourth or $50,000 in
the first year, 2016, for financial accounting purposes. Tax would follow this
approach and LL would report $50,000 as income for tax purposes in the first
year, 2016, as well. For tax purposes, the balance of the payments received,
$150,000 ($200,000 - $50,000) would be reported in the following year, 2017.
(See Example 28 and pp. 26 and 27.)
b. The answer is the same as in (a) in terms of the full-inclusion method. When
the deferral method is used $25,000 should be reported in 2016 and $175,000
in 2017. This result occurs notwithstanding the fact that services are
performed over three accounting periods and would be reported over three
accounting periods for financial accounting purposes. (See Example 28 and
pp. 26 and 27.)
c. As in parts (a) and (b), the taxpayer may use the full inclusion method or the
deferral method. If the full inclusion method is used, all $700,000 of the
payments are reported in the year of the receipt regardless of how the
payments are reported for financial accounting purposes. Under the deferral
method, the basketball operation would report the income in the same manner
as it does for financial accounting purposes, as it is earned (as the games are
played). Therefore $256,098 [(15 games played/41 total games during season)
$700,000] will be included in the income of 2015. The remainder will be
deferred because the services (i.e., the games) will be provided in 2016 (See
Example 28 and pp. 26 and 27.)
d. The rules applying to prepaid services are used rather than those for prepaid
rents, since significant services are provided in addition to the room. As in
parts (a), (b), and (c) the taxpayer may use the full inclusion method or the
deferral method. Under the full inclusion method, all $10,000 of the payments
would be included in the earlier year. If the deferral method is used, as long as
the rooms are to be rented prior to the end of 2017, the income not included
under financial accounting purposes in 2016 will be deferred until 2017 when
it is earned for financial accounting purposes. (See Example 28 and pp. 26 and
27.)