Solution Manual For McGraw-Hill's Taxation of Business Entities 2020 Edition, 11th Edition

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Solutions Manual –Taxation of Business Entities, by Spilker et al.
Chapter 1
Business Income, Deductions, and Accounting Methods
SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] What is an “ordinary and necessary” business expenditure?
“Ordinary” and “necessary” imply that an expense must be customary and
helpful, respectively. Because these terms are subjective, the tests are ambiguous.
However, ordinary is interpreted by the courts as including expenses which may be
unusual for a specific taxpayer (but not for that type of business) and necessary is
not interpreted as only essential expenses. These limits can be contrasted with the
reasonable limit on amounts and the bona fide requirement for profit motivation.
2. [LO 1] Explain how cost of goods sold is treated when a business sells inventory.
Under the return of capital principle, cost of goods sold represents a reduction in
gross income rather than a business expense. For example, if a taxpayer sells
inventory for $100,000 and reports a cost of goods sold of $40,000, the business’s
gross income is $60,000 ($100,000 – 40,000) not $100,000.
3. [LO 1] Whether a business expense is “reasonable in amount” is often a difficult
question. Explain why determining reasonableness is difficult and describe a
circumstance where reasonableness is likely to be questioned by the IRS.
Reasonableness is an issue of fact and circumstance, and extravagance is difficult
to determine because of the subjectivity and multitude of factors involved in
determining price. Reasonableness is most likely to be an issue when a payment is
made to a related individual or the taxpayer enjoys some personal benefit
incidental to the expenditure.
4. [LO 1] Jake is a professional dog trainer who purchases and trains dogs for use by
law enforcement agencies. Last year Jake purchased 500 bags of dog food from a
large pet food company at an average cost of $30 per bag. This year, however,
Jake purchased 500 bags of dog food from a local pet food company at an average
cost of $45 per bag. Under what circumstances would the IRS likely challenge the
cost Jake’s dog food as unreasonable?
A common test for reasonableness is whether the expenditure is comparable to an
arm's length amount – a price charged by objective (unrelated) individuals who do
not receive any incidental personal benefits. Hence, the IRS is most likely to
challenge the cost of the dog food if Jake’s relatives control or own the local pet
food company and was benefiting from the increased price.

Solutions Manual –Taxation of Business Entities, by Spilker et al.
5. [LO 2] What kinds of deductions are prohibited as a matter of public policy? Why
might Congress deem it important to disallow deductions for expenditures that are
against public policy?
The IRC lists bribes, kickbacks, and “other” illegal payments as nondeductible.
Congress didn’t want the tax benefits associated with deductions to benefit or
subsidize wrongdoing. Of course, this rationale doesn’t really explain the
prohibition against deducting political contributions which is probably better
explained by the potential perception that political efforts are being subsidized by
taxpayers.
6. [LO 2] Provide an example of an expense associated with the production of tax-
exempt income, and explain what might happen if Congress repealed the
prohibition against deducting expenses incurred to produce tax-exempt income.
Two common examples are interest expense associated with debt used to purchase
municipal bonds and life insurance premiums paid on key man insurance. If this
prohibition were repealed, then taxpayers would have an incentive to borrow to
invest in municipal bonds or borrow to invest in employee life insurance. This
former practice would lead to higher demand for municipal bonds (less yield) and
less revenue for the government. The latter practice would lead to higher demand
for insurance (higher premiums?) and less revenue for the government. Both
practices could lead to a perception of inequity between those taxpayers able to
utilize the tax arbitrage to reduce taxes and those who could not use the practice.
7. [LO 2] {Research} Peggy is a rodeo clown, and this year she expended $1,000 on
special “funny” clothes and outfits. Peggy would like to deduct the cost of these
clothes as work-related because she refuses to wear the clothes unless she is
working. Under what circumstances can Peggy deduct the cost of her clown
clothes?
Taxpayers may deduct the cost of uniforms or special clothing they use in their
business when the clothing is not appropriate to wear as ordinary clothing outside
the place of business. In Peggy’s case, the clown clothes are analogous to special
uniforms or protective garments and could be deductible. See D. Techner, TC
Memo 1997-498. Erhard Seminar Training, TC Memo 1986-526 provides an
example of clothes that were not deductible because they were appropriate for
normal wear. However, the cost of clothing would not likely be deductible if the
clothes were unacceptable solely because of the taxpayer’s sense of fashion.
8. [LO 2] Jimmy is a sole proprietor of a small dry-cleaning business. This month
Jimmy paid for his groceries by writing checks from the checking account
dedicated to the dry-cleaning business. Why do you suppose Jimmy is using his
business checking account rather than his personal checking account to pay for
personal expenditures?

Solutions Manual –Taxation of Business Entities, by Spilker et al.
Jimmy might be trying to reduce his bank charges by using one account for both
personal and business expenditures, but he could also be trying to disguise
personal expenditures as business expenses. By commingling business and
personal expenditures, Jimmy will need to separate personal and business
expenditures before claiming any business deductions.
9. [LO 2] Troy operates an editorial service that often entertains prospective authors
to encourage them to use Troy's service. This year Troy paid $3,000 for the cost of
meals and $6,200 for the cost of entertaining authors. Describe the conditions under
which Troy can deduct a portion of the cost of the meals as a business expense.
To deduct half of the cost of meals as a business expense, the meals must be
ordinary and necessary to Troy’s business and the amount must be reasonable
under the circumstances. In addition, Troy or an employee must be present when
the meal is furnished, and the meal must be furnished to an actual or potential
business associate. Finally, the cost of the meals must be separately stated (by
invoice) from the cost of the entertainment (the cost of the entertainment is not
deductible).
10. [LO 2] Jenny uses her car for both business and personal purposes. She purchased
the auto this year and drove 11,000 miles on business trips and 9,000 miles for
personal transportation. Describe how Jenny will determine the amount of
deductible expenses associated with the auto.
Because only the expense relating to business use is deductible, the taxpayer must
allocate the expenses between the business and personal use portions. A common
method of allocation is relative use. In this instance Jenny would calculate the
business portion based upon the ratio of business miles to total miles (11/20 or 55
percent). She would then deduct the costs of operating the vehicle for business
purposes plus depreciation on the business portion (55 percent) of the vehicle’s tax
basis. Alternatively, in lieu of deducting these costs, Jenny may elect to deduct a
standard amount for each business mile she drives. The standard mileage rate (58
cents per mile for 2019) represents the per-mile cost of operating an automobile
(including depreciation or lease payments). Once Jenny has made this election,
she must continue to use it throughout the life of the auto.
11. [LO 1, LO 2] What expenses are deductible when a taxpayer combines both
business and personal activities on a trip? How do the rules for international travel
differ from the rules for domestic travel?
If the taxpayer has both business and personal motives for a trip, but the primary
or dominant motive is business, the taxpayer may deduct the transportation costs to
get to the place of business, but she may deduct only meals (50%), lodging,
transportation on site, and incidental expenditures for the business portion of the
travel. If the taxpayer’s primary purpose for the trip is personal, the taxpayer may
not deduct transportation costs to travel to and from the location but the taxpayer

Solutions Manual –Taxation of Business Entities, by Spilker et al.
may deduct meals (50%), lodging, transportation, and incidental expenditures for
the business portion of the trip. For international travel in excess of one week, the
taxpayer must allocate the cost of the transportation between personal
(nondeductible) and business (deductible) activities. Taxpayers generally
determine the nondeductible portion of the transportation costs by multiplying the
travel costs by a ratio of personal activity days to total days travelling. Finally,
remember that travel days are considered business activity days for both domestic
and international travel.
12. [LO 2] Clyde lives and operates a sole proprietorship in Dallas, Texas. This year
Clyde found it necessary to travel to Fort Worth (about 25 miles away) for
legitimate business reasons. Is Clyde’s trip likely to qualify as “away from home,”
and why would this designation matter?
Besides the cost of transportation, the deduction for travel expenses includes meals
(50%), lodging, and incidental expenses. However, travel expenses are only
deductible if the taxpayer is away from home overnight while traveling. For this
purpose, a taxpayer is considered to be away from home overnight if the trip is of
sufficient duration to require sleep or rest. It’s likely that Clyde’s trip will not
satisfy this condition and that he will not be able to deduct half the cost of meals
and the entire cost of lodging.
13. [LO 2] Describe the record-keeping requirements for business deductions expenses
including mixed-motive expenditures.
Taxpayers must keep specific, written, contemporaneous records of time, amount of
the expenditure, and business purpose of the travel. No deductions are allowed
absent sufficient records to document business purpose. Records of the
expenditure amount, however, may not be necessary if the taxpayer claims per
diem amounts.
14. [LO 2] Describe the computation of the limit placed on the business interest
deduction. Is the disallowed interest ever deductible?
The deduction of business interest expense is limited to the sum of business interest
income plus 30 percent of the business's adjusted taxable income. Business interest
is defined as any interest paid on debt allocable to a trade or business activity, and
adjusted taxable income is taxable income allocable to the business activity
computed before deductions for interest, depreciation, amortization, or depletion.
Disallowed business interest can be carried forward indefinitely.
15. [LO 3] Explain the difference between calculating a loss deduction for a business
asset that was partially damaged in an accident and a loss deduction for a business
asset that was stolen or completely destroyed in an accident.
When a business asset is completely destroyed or stolen, the amount of the
business’s loss is calculated as though the business sold the asset for the insurance
proceeds, if any (i.e., insurance proceeds minus adjusted basis). If the asset is

Solutions Manual –Taxation of Business Entities, by Spilker et al.
damaged but not completely destroyed, the amount of the loss is the amount of the
insurance proceeds minus the lesser of (1) the asset’s tax basis or (2) the decline in
the value of the asset due to the casualty.
16. [LO 3] How does a casualty loss on a business asset differ when the asset is stolen
as opposed to destroyed in a fire?
The difference between a fire and a theft is that the casualty loss from the fire is
measured and deducted in the year of the casualty whereas the loss from the theft is
measured and deducted in the year the theft is discovered.
17. [LO 4] What is the difference between a full tax year and a short tax year?
Describe circumstances in which a business may have a short tax year.
A full tax year consists of 12 months while short years are less than 12 months. A
business may report income on a short year in its first year of existence (for
example, it reports income on a calendar year end and starts business after
January 1) or in its final year of existence (for example, a calendar year business
ends its business before December 31).
18. [LO 4] Explain why a taxpayer might choose one tax year-end over another if
given a choice.
A business might use a calendar year (ends on December 31), a fiscal year (ends
on the last day of a month other than December) or a 52/53 week fiscal year end
(ends on the same day of the week every year). Not all types of tax years are
available to all types of businesses. The rules for determining the tax years
available to the business depends on whether the business is a sole proprietorship,
a flow-through entity, or C corporation. If allowed an unfettered choice, taxpayers
with a flow-through business might choose a tax year other than a calendar year to
postpone the recognition of business income into the next calendar year (based
upon when income flows through the business to its owners). Also, a retail business
might choose a 52/53 week fiscal year to avoid inventory counts on busy day sales.
Further, a business might choose a fiscal year end that coincides with the end of
the season.
19. [LO 4] Compare and contrast the different year-ends available to sole
proprietorships, flow-through entities, and C corporations.
C corporations are generally allowed to select a calendar, fiscal, or 52/53 week
year-end whereas other business entities generally must adopt tax years consistent
with the owners’ tax years.
20. [LO 4] Why does the law generally require partnerships to adopt a tax year
consistent with the year used by the partners?
The tax laws impose the tax year consistency requirement to minimize income tax
deferral opportunities for the owners. To illustrate the deferral, suppose that a
partner’s tax year-end is December 31, year 1 and her partnership’s tax year-end

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Solutions Manual –Taxation of Business Entities, by Spilker et al.
is January 31, year 2. In year 2, the partner is treated as though she earned the
entire amount of her share of the partnership’s income on January 31, year 2.
Thus, even though 11/12ths of the partnership’s income was actually earned in
year 1 (February through December of year 1), for purposes of paying taxes on the
income, the partner gets to defer this income until year 2.
21. [LO 4] How does an entity choose its tax year? Is it the same process no matter
the type of tax year-end the taxpayer adopts?
A business adopts its calendar year end or fiscal year end by filing its initial tax
return. In contrast, a business adopts a 52/53 week year end by filing a special
election with the IRS. Once a business establishes its tax year, it generally must
receive permission from the IRS to change.
22. [LO 5] Explain when an expenditure should be “capitalized” based upon
accounting principles. From time to time, it is suggested that all business
expenditures should be deducted when incurred for tax purposes. Do you agree
with this proposition, and if so, why?
Under accounting principles an expenditure should be “capitalized” when the
benefits from the expenditure occur in two different periods. The cost is spread
across the applicable periods through a periodic charge such as depreciation or
amortization. The tax law differs from accounting principles, but the rationale for
the tax rules is based upon the same matching principle, expenditures should be
recognized in the period that revenues are generated. The proposition to deduct all
business expenditures is usually defended on the grounds of simplification,
encouraging capital investment, and lack of bias (at least over the long run) and
criticized on the grounds of potential economic bias (at least in the short run) and
revenue loss by the government.
23. [LO 5] Describe the 12-month rule for determining whether and to what extent
businesses should capitalize or immediately deduct prepaid expenses such as
insurance or security contracts. Explain the apparent rationale for this rule.
A business expenditure or business liability may be immediately deducted (rather
than capitalized) if the expenditure or liability relates to a business expense where
the contract period (1) does not last more than a year and (2) does not extend
beyond the end of the taxable year following the tax year in which the taxpayer
makes the payment. The rule could be rationalized as an attempt to simplify the
deduction for expenditures that merely span tax years and would not likely result in
material differences in taxable income should the expenditure be capitalized across
both periods.
24. [LO 5] Explain why Congress sometimes mandates that businesses use particular
accounting methods while other times Congress is content to require businesses to
use the same accounting methods for tax purposes that they use for financial
accounting purposes.

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The natural tension between financial reporting incentives and tax reporting
incentives may be the reason the tax laws indicate that as a general rule businesses
must use the same accounting methods for tax purposes that they use for financial
accounting purposes. That is, businesses that want to accelerate book income (or
delay taxable income) are also required to accelerate taxable income (or delay
financial income). Thus, using the same method for both tends to neutralize
incentives to stretch numbers in one direction or the other. Congress specifies that
businesses are required to use other, presumably more appropriate, accounting
methods for tax purposes when financial accounting methods do not “clearly
reflect income” for tax purposes or when dictated by policy or administrative
concerns.
25. [LO 5] Why is it not surprising that specific rules differ between tax accounting
and financial accounting?
Tax policy objectives often differ from the objectives motivating financial
accounting rules. Tax accounting attempts to maximize revenue for the government
while financial accounting attempts to minimize overstatements that might mislead
investors and creditors. Hence, for policy and administrative reasons, the tax laws
identify several circumstances when businesses must use specific tax accounting
methods to determine taxable income no matter what accounting method they use
for financial reporting purposes.
26. [LO 5] Fred is considering using the accrual method for his next business venture.
Explain to Fred the conditions for recognizing income for tax purposes under the
accrual method.
A taxpayer must recognize income if (1) all the events have occurred that are
necessary to fix the right to receive a payment and (2) the amount of the payment
can be determined with reasonable accuracy.
27. [LO 5] Describe the all-events test for determining income and describe how to
determine the date on which the all-events test has been met.
The all events test requires a taxpayer to recognize income if the taxpayer has a
fixed right to receive a payment and the amount of the payment can be determined
with reasonable accuracy. The all-events test is typically met on the earliest of the
following three dates: (1) the date the business provides the service or transfers
goods, (2) the date payment is due, or (3) the date payment is received.
28. [LO 5] Compare and contrast the tax treatment for rental income received in
advance and advance payments for goods and services.
For tax purposes, businesses must immediately recognize prepaid rental or interest
income (it is recognized before it is earned). The all-events test generally requires
businesses receiving advance payments for services to recognize the income when
they receive the payment rather than when they perform the services. The IRS
provides that businesses receiving advance payments for services may defer

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Solutions Manual –Taxation of Business Entities, by Spilker et al.
recognizing the prepayment as income until the tax year following the year they
receive the payment. This one-year deferral does not apply if (or the extent to
which) the income is actually earned by the end of the year of receipt, if the
prepayment was included in financial reporting income, or if the prepayment was
for rent (unless rental receipts are bundled with goods or services, prepayments
are taxed on receipt).
29. [LO 5] Compare and contrast the rules for determining the tax treatment of advance
payments for services versus advance payments for goods.
For tax purposes, the all-events test generally requires businesses receiving
advance payments for services to recognize the income when they receive the
payment, rather than when they perform the services. Under the Tax Cuts and Jobs
Act businesses using the accrual method and receiving advance payments for goods
or services may elect one of two accounting methods. Under the full inclusion
method, the business can elect to recognize the income. Under the deferral method,
the business can elect to defer recognizing the prepayment as income until the tax
year following the year they receive the payment. This one-year deferral election
does not apply if (or the extent to which) the income is actually earned by the end
of the year of receipt, if the prepayment was included in financial reporting income,
or if the prepayment was for interest or rent (taxpayers must recognize prepaid
interest and rental income on receipt). In contrast, when a cash basis business
receives an advance payment for goods or services to be provided in the future, the
business must recognize the income immediately.
30. [LO 5] {Research} Jack operates large home repair business as a sole
proprietorship. Besides providing services, Jack also sells home repair supplies to
homeowners. However, these sales constitute a relatively small portion of Jack’s
income. Describe the conditions under which Jack would need to account for sales
and purchases of plumbing supplies using the accrual method. Hint: read §471(a)
and Reg. §1.471-1.
Jack can use the cash method and avoid using accrual for sales if his business
reports average gross receipts of $25 million or less or less for the three-tax year
period ending with the prior tax year. In addition, under §471(a) the Secretary is
empowered to determine when a business must account for inventories. Even if
Jack’s business exceeds the $25 million threshold, under Reg/ §1.471-1 a business
must only account for inventories when sales of “merchandise” are a material
“income-producing factor.” The determination of what is “merchandise” and
what amount of inventory sales constitute a “material” income-producing factor is
determined by facts and circumstances on a case-by-case basis. One likely
characteristic is the level of sales and another is the income generated by sales of
inventory relative to the overall income of the business. In addition, there is an
exception under Reg.§1.162-3 and Rev. Proc. 2001-10, 2001-1 CB 272, for cash-
method businesses that also provide services. If the business has average annual

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Solutions Manual –Taxation of Business Entities, by Spilker et al.
gross receipts of less than $1 million over a three-year period, then it can elect to
treat inventories as incidental materials and supplies. Thus, Jack is not required to
use the accrual method for sales and purchases of plumbing supplies if he satisfies
the average annual gross receipts test. In addition, Prop. Reg. §1.162-3(a) allows
taxpayers to deduct the costs of buying incidental materials and supplies in the
year of purchase if no physical inventory is taken at the beginning and end of the
tax year (assuming taxable income is clearly reflected).
31. [LO 5] Explain why Congress enacted the UNICAP rules and describe the burdens
these rules place on taxpayers.
Congress enacted these rules primarily for two reasons. First, the rules accelerate
tax revenues for the government by deferring deductions for the capitalized costs
until the business sells the associated inventory. Second, Congress enacted these
“uniform” rules to reduce variation in the costs businesses include in inventory.
The burden placed on taxpayers is primarily related to record-keeping (identifying
an allocation method and keeping records of indirect costs). In addition, there is
the time value related to the deduction of the indirect costs. When UNICAP was
imposed, the indirect costs allocated to ending inventory were not deductible until
the following period whereas without UNICAP these would have been deducted
immediately. Hence, in a sense taxpayers subject to the UNICAP rules made an
interest free loan to the government of the taxes associated with this deferral.
32. [LO 5] Compare and contrast financial accounting rules with the tax rules under
UNICAP (§263A). Explain whether the UNICAP rules tend to accelerate or defer
income relative to the financial accounting rules.
Under GAAP, businesses generally include in inventory only those costs incurred
within their production facility. In contrast, the UNICAP rules require businesses
to allocate to inventory the costs they incur not only inside the production facility
but also the costs they incur outside the facility to support production (or inventory
acquisition) activities. Uniform capitalization requires that both direct and certain
indirect costs be capitalized into inventories (full absorption costing). Hence,
businesses generally capitalize more costs to inventory for tax purposes than they
capitalize under financial accounting rules.
33. [LO 5] Compare and contrast the tests for accruing income and those for accruing
deductions for tax purposes.
To record an expense and the corresponding deduction for tax purposes, the
business must meet (1) an all-events test for the liability and (2) an economic
performance test with respect to the liability. While the all-events test for
recognizing deductions is similar to the all-events test for recognizing income, the
additional economic performance requirement makes the deduction recognition
rules more stringent than the income recognition rules. The deduction rules
generally preclude businesses from deducting estimated expenses or reserves.

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34. [LO 5] Compare and contrast when taxpayers are allowed to deduct the cost of
warranties provided by others to the taxpayer (i.e., purchased by the taxpayer) and
when taxpayers are allowed to deduct the costs associated with warranties they
provide (sell) to others.
Insurance, warranties, and service contracts provided to the taxpayer are payment
liabilities and accrual method taxpayers that prepay business expenses for payment
liabilities (insurance contracts, warranties, and product service contracts provided
to the taxpayer) are allowed to immediately deduct the prepayments subject to the
12-month rule for prepaid expenses. A warranty provided by the taxpayer to others
is deductible as the taxpayer incurs costs associated with these liabilities.
35. [LO 5] Describe when economic performance occurs for the following expenses:
a) Workers’ compensation,
b) Rebates and refunds
c) Insurance, warranties, and service contracts provided to the business
d) Taxes
Workers’ compensation, rebates, refunds, and service contracts are payment
liabilities and economic performance occurs upon payment regardless of actual
performance. Taxes are also payment liabilities, but under § 461 accrual-method
taxpayers that pay certain real estate taxes are allowed to elect to deduct tax
payments ratably over the tax accrual period.
36. [LO 5] On December 31 of the current year, a taxpayer prepays an advertising
company to provide advertising services for the next 10 months. Using the 12-
month rule and the economic performance rules, contrast when the taxpayer would
be able to deduct the expenditure if the taxpayer uses the cash method of
accounting versus if the taxpayer uses the accrual method of accounting.
Under economic performance an accrual-method taxpayer can deduct the cost of
advertising as the services are provided to the taxpayer or with payment if the
taxpayer reasonably expects actual performance within 3 ½ months. A cash-
method business that prepays businesses expenses may immediately deduct the
prepayment if the contract period (1) does not last more than a year and (2) does
not extend beyond the end of the taxable year following the tax year in which the
taxpayer makes the payment.
37. [LO 5] Compare and contrast how bad debt expense is determined for financial
accounting purposes and how the deduction for bad debts is determined for accrual-
method taxpayers. How do cash-method taxpayers determine their bad debt
expense for accounts receivable?
For financial reporting purposes, the business estimates the amount of the bad
debt, debits bad debt expense, and credits an allowance for doubtful accounts.
However, for tax purposes, accrual-method taxpayers are only allowed to deduct
bad debt expense in the tax year when an account receivable or debt becomes

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thless. Cash-method taxpayers do not create accounts receivable for sales on
credit so no bad debt deductions are ever claimed.
38. [LO 5] Describe the related-person limitation on accrued deductions. What tax
savings strategy is this limitation designed to thwart?
An accrual-method business is not allowed to deduct amounts they accrue for
expenses payable to related persons until the related person includes the payment
in income. When a business accrues an expense payable to a related person at
year end, and the related person is a cash-method taxpayer, the business is not
allowed to deduct the expense until the next year when the related person receives
the payment and includes it in income. This limit prevents businesses and related
persons from working to accelerate a tax deduction into the earlier year and the
related person from deferring the income until the later year.
39. [LO 5] What are the relative advantages of the cash and accrual methods of
accounting?
The two primary advantages of the cash method over the accrual method are that
(1) the cash method provides the business with more flexibility to time income and
deductions by accelerating or deferring payments and (2) the ease of bookkeeping.
The primary advantage of the accrual method over the cash method is that it better
matches revenues and expenses.
40. [LO 5] Describe how a business adopts a permissible accounting method. Explain
whether a taxpayer can adopt an impermissible accounting method.
A business adopts a permissible accounting method by using and reporting the
results of the method for at least one year. A business adopts an impermissible
method by using and reporting the results of the method for two consecutive years.
41. [LO 5] Describe why the IRS might be skeptical of permitting requests for changes
in accounting method without a good business purpose?
The reluctance of the IRS probably stems from the possibility that taxpayers will
manipulate accounting methods to defer taxable income. For example, a taxpayer
might use LIFO in a period of rising costs, but want to switch to FIFO in a period
of stable or declining costs.
42. [LO 5] What is a §481 adjustment, and what is the purpose of this adjustment?
When a business changes an accounting method, the business is required to make a
§481 adjustment that represents the cumulative difference between the accounting
method the business was using and the accounting method the taxpayer is changing
to. The adjustment prevents the duplication or omission of items of income or
deduction due to a change in accounting method. If the adjustment increases
income, the taxpayer includes 25 percent of the adjustment (beginning in the year
of adjustment) in income for four years. If the adjustment reduces taxable income,
the taxpayer recognizes the entire adjustment in the year of change.

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Problems
43. [LO 1] Manny hired his brother’s firm to provide accounting services to his
business. During the current year, Manny paid his brother’s firm $82,000 for
services even though other firms were willing to provide the same services for
$40,000. How much of this expenditure, if any, is deductible as an ordinary and
necessary business expenditure?
Only reasonable amounts of compensation are deductible ($40,000), and the
remainder would be reclassified probably as a gift to his brother.
44. [LO 1, LO 2] Michelle operates a food truck. Indicate the amount (if any) that she
can deduct as an ordinary and necessary business deductions in each of the
following situations and explain your solution.
a) Michelle moves her food truck between various locations on a daily rotation.
Last week, Michelle was stopped for speeding. She paid a fine of $125 for
speeding including $80 for legal advice in connection with the ticket.
b) Michelle paid $750 to reserve a parking place for her food truck for the fall
football season outside the local football arena. Michelle also paid $95 for
tickets to a game for her children.
c) Michelle provided a candidate with free advertising painted on her truck
during the candidate's campaign for city council. Michelle paid $500 to have
the ad prepared and an additional $200 to have the ad removed from the truck
after the candidate lost the election.
a) No deduction for the fine, but the legal advice is fully deductible.
b) The cost of the reserve parking ($750) is deductible, but the cost of the tickets
is likely personal and not deductible.
c) No deduction for expenditures for political purposes (in cash or in kind).
45. [LO 1, LO 2] Indicate the amount (if any) that Josh can deduct as an ordinary and
necessary business deduction in each of the following situations and explain your
solution.
a) Josh borrowed $50,000 from the First State Bank using his business assets as
collateral. He used the money to buy City of Blanksville bonds. Over the
course of a year, Josh paid interest of $4,200 on the borrowed funds, but he
received $3,500 of interest on the bonds.
b) Josh purchased a piece of land for $45,000 in order to get a location to
expand his business. He also paid $3,200 to construct a new driveway for
access to the property.

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Solutions Manual –Taxation of Business Entities, by Spilker et al.
c) This year Josh paid $15,000 to employ the mayor’s son in the business. Josh
would typically pay an employee with these responsibilities about $10,000
but the mayor assured Josh that after his son was hired, some city business
would be coming his way.
d) Josh paid his brother, a mechanic, $3,000 to install a robotic machine for
Josh’s business. The amount he paid to his brother is comparable to what he
would have paid to an unrelated person to do the same work. Once the
installation was completed by his brother, Josh began calibrating the machine
for operation. However, by the end of the year, he had not started using the
machine in his business.
a) $0. The interest expense is not deductible (expense associated with tax-
exempt income).
b) $0. Capital expenditures are not deductible.
c) Only $10,000 is deductible and the remaining $5,000 is either unreasonable
in amount or against public policy (as a bribe).
d) $0. The amount paid to install a machine is capitalized because the cost
benefits the useful life of the machine.
46. [LO 2] {Research} Ralph operates a business that acts as a sales representative for
firms that produce and sell precious metals to electronic manufacturers. Ralph
contacts manufacturers and convinces them to sign contracts for delivery of metals.
Ralph earns a commission on the sales. This year, Ralph contacted a jeweler to
engrave small lapel buttons for each of his clients. Ralph paid $20 each for the
lapel buttons and the jeweler charged Ralph an additional $7 for engraving. The
electronic manufacturers, however, prohibit their employees from accepting gifts
related to sales contracts. Can Ralph deduct the cost of the lapel buttons as
business gifts?
§274(b) denies business deductions for gifts that exceed $25 in amount, but Reg.
§1.274-3(c) indicates that “the term expense for a gift means the cost of the gift to
the taxpayer, other than incidental costs such as for customary engraving on
jewelry.” Hence, it would appear that the amount of the gift ($27) is likely
deductible. It might also be argued that the expenditure is not deductible because it
violates the §162(c) prohibition against deducting expense against illegal bribes
and kickbacks. However, in Arthur E. Bondy, TC Memo 1991-545, the Tax Court
found similar gifts deductible as business expenses as long as the payments were
not illegal under state or federal law.
47. [LO 2] Melissa recently paid $400 for round-trip airfare to San Francisco to attend
a business conference for three days. Melissa also paid the following expenses:
$250 fee to register for the conference, $300 per night for three nights lodging,
$200 for meals, and $150 for cab fare.

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Solutions Manual –Taxation of Business Entities, by Spilker et al.
a) What amount of the travel costs can Melissa deduct as business expenses?
b) Suppose that while Melissa was on the coast, she also spent two days
sightseeing the national parks in the area. To do the sightseeing, she paid
$1,000 for transportation, $800 for lodging, and $450 for meals during this
part of her trip, which she considers personal in nature. What amount of the
travel costs can Melissa deduct as business expenses?
c) Suppose that Melissa made the trip to San Francisco primarily to visit the
national parks and only attended the business conference as an incidental
benefit of being present on the coast at that time. What amount of the airfare
can Melissa deduct as a business expense?
d) Suppose that Melissa’s permanent residence and business was located in San
Francisco. She attended the conference in San Francisco and paid $250 for
the registration fee. She drove 100 miles over the course of three days and
paid $90 for parking at the conference hotel. In addition, she spent $150 for
breakfast and dinner over the three days of the conference. She bought
breakfast on the way to the conference hotel and she bought dinner on her
way home each night from the conference. What amount of these costs can
Melissa deduct as business expenses?
a) Since business was the primary reason for the trip, Melissa can deduct
$1,800 of travel costs [$250 registration + $400 airfare + $900 lodging +
(50%*$200) meals + $150 cab fare]
b) None of the costs of sightseeing is deductible. However, because her primary
purpose for the trip appears to be business (3 days business vs. 2 days
personal) she is allowed to deduct her airfare to San Francisco and her other
expenses in part (a) relating to the business portion of the trip.
c) If the purpose of the trip is primarily personal, then none of the air fare is
deductible and only those direct costs associated with the conference
($1,400) can be deducted (the registration, lodging, 50 percent of the meals,
and cab fare).
d) Melissa would be allowed to deduct the registration fee for the conference of
$250 and she could deduct $58 (in 2019) for the 100 miles she drove to and
from the conference (58 cents per mile x 100 miles) and the parking fee of
$90. However, because her travel did not require her to be away from home
overnight, she is not allowed to deduct the cost of her meals going to and
coming from the conference each day.
48. [LO 2] Kimberly is a self-employed taxpayer. She recently spent $1,000 for
airfare to travel to Italy. What amount of the airfare is deductible in each of the
following alternative scenarios?
a) Her trip was entirely for personal purposes.

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Solutions Manual –Taxation of Business Entities, by Spilker et al.
b) On the trip, she spent eight days on personal activities and two days on
business activities.
c) On the trip, she spent seven days on business activities and three days on
personal activities.
d) Her trip was entirely for business purposes.
a) $0 since the sole purpose of the trip was for personal purposes.
b) $0 since the primary purpose of the trip appears to be personal.
c) $700 ($1,000 x 7/10). Since the primary purpose of the trip appears to be
business, she may deduct the portion of the airfare allocated to the business
trip (prorated because this is foreign travel). Using the number of days of
business activities to total days of travel, she may deduct 70 percent (7/10ths)
of the cost (conversely, she may not deduct 30 percent (3/10ths) of the cost.
d) $1,000 since the sole purpose of the trip is business, she may deduct the
entire airfare.
49. [LO 2] Ryan is self-employed. This year Ryan used his personal auto for several
long business trips. Ryan paid $1,500 for gasoline on these trips. His depreciation
on the car if he was using it fully for business purposes would be $3,000. During
the year, he drove his car a total of 12,000 miles (combination of business and
personal travel).
a) Ryan can provide written documentation of the business purpose for trips
totaling 3,000 miles. What business expense amount can Ryan deduct (if
any) for these trips?
b) Ryan estimates that he drove approximately 1,300 miles on business trips, but
he can only provide written documentation of the business purpose for trips
totaling 820 miles. What business expense amount can Ryan deduct (if any)
for these trips?
a) Ryan can claim the direct cost of these trips, including gas ($1,500) and
depreciation on the auto. However, the deduction for auto use is limited to
direct costs (such as gas and oil) and the pro-rata portion of indirect costs
(such as depreciation). The pro rata portion would be calculated as the
business percentage of total mileage ($3,000 x [3,000/12,000]) or $750.
Hence, Ryan could deduct $2,250. Alternatively, Ryan can claim a standard
mileage rate, and based on the standard mileage rate of 58¢ per mile (in
2019), he can deduct $1,740 (i.e., 3,000 x 58¢).
b) Ryan is allowed to deduct the cost of using his personal auto in his business
activities only if he can substantiate the business use. If he has records to
substantiate the business use, Ryan can claim the direct cost of these trips
including depreciation on the auto (for the business portion of the total
mileage). Ryan’s total expense deduction would consist of depreciation and

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Solution Manual For McGraw-Hill's Taxation of Business Entities 2020 Edition, 11th Edition

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