Accounting 5135 Answer Sheet

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realized loss. He will then take a “cost” basis of $5,000 in the new asset.

3. Annuities are taxed by dividing each payment between a recovery of capital (not taxable) and a "profit" component (taxable). Social security is not taxed until certain thresholds are reached, and for high-income taxpayers up to 85% of their social security may be taxable. Consequently, low-income taxpayers would not want to change the current system for taxing social security since taxing it the same as annuities would force them to pay some tax. On the other hand, high-income taxpayers taking 85% of their social security into their gross incomes would likely benefit from being allowed to exclude the portion of their social security as a return of capital.

4. First, Mr. Gaines can give $168,000/year to his 6 children/grandchildren with no tax consequences if his wife elects to split gifts and use the annual exclusion of $14,000 ($28,000 with splitting). Thus there can be a net reduction of $68,000/year in the value of his estate with no tax consequences. If he leaves everything to his wife upon his death the unlimited marital deduction would prevent any taxation. Moreover, due to portability of the lifetime exemption ($5.45 million in 2016 increasing with inflation) the two of them can leave up to $10.9 million to their family with no tax consequences.

5. First Lillian may be eligible for the Lifetime Learning credit, which would be a $2,000 credit (based on a $10,000 of eligible expenses x 20%). For the excess amount Lillian can claim an above-the-line deduction under Section 222 (limited to $4,000 on her income). She can’t claim a deduction on the same amount used to compute a credit. Since there will still be left over expenses, Lillian would have to rely on Section 162. Under Reg. 1.162-5 education expenses are deductible if the education maintains/improves skills in the taxpayer's trade/business. Since Lillian is not employed in psychology, she will not qualify under this provision.

6. One possibility is that the art will be considered to be personal use assets, which means the loss will be ignored for tax purposes, and the gain will be capital. The fact that the art is in her home is support for this. Another possibility is that the art will be considered to be investments. In that case both the gain and loss will be capital. Separate insurance and the security system might support this. The final possibility is that the art will be considered business assets, i.e., inventory, which will result in ordinary income and loss. The fact that people come regularly to her home to perhaps make purchases support this. Although treatment as business assets gives Diane the best results, she does not appear to be running this as a business. Consequently, I would recommend reporting as investment assets, although the IRS may challenge this. But personal use assets are not normally bought and sold regularly.

7.

(a) Life insurance proceeds are generally included in the gross estate. Since Ernie retained the incidents of ownership (the right to change beneficiaries) even after the transfer of the policy, the general rule will apply and the $300,000 will be included in his gross estate.

(b) Section 1235(d)(2) (3-year rule) does not apply unless the transferor retained incidents of ownership. Here Ernie did not retain any incidents of ownership when he transferred the policy. Thus it doesn’t matter that he died within a year. None of the proceeds will be included in his estate. (He gave a gift at FMV of purchased policy the year before).

(c) Same as (a). Section 1235(d)(2) will still bring the $300,000 into Ernie's gross estate because he held the incidents of ownership within 3 years of his death. Again, we are dealing with Sec. 2042, not Sec. 2038.

8. (i) The taxpayer has the right to choose in which trial court to litigate. The U.S. Court of Appeals (Federal Circuit) is the appeals court of the Court of Federal Claims which Carla may choose to litigate. Therefore it would constitute precedent and the only way to overturn it would be for it to reverse its decision or to be overruled by the Supreme Court. On the other hand it is an older decision that two more recent courts (one the Tax Court the other another appeals court) have strongly rejected the position. Reasonable persons may disagree on the percentage and anything between 25-75% is arguable. Key is to understand arguments.

(ii) Determination is important to you as preparer for two reasons. One is you have to meet ethical obligations under Circular 230; the other is possible preparer penalties.

(iii) Carla cares because of various penalties might apply to her, such as the negligence penalty if she takes the position which has less than a 40% chance of success.