Carrie Morgan Tax Problem

Carrie A. Morgan, age 45, is single and lives with her dependent mother at 426 Grouse Avenue, Allentown, PA 18105. Her social security number is 111-11-1111.



1. Carrie is a licensed hairstylist and operates her own business. Located at 480 Laurel Street, Allentown, PA 18105, the business is conducted under the name of “Carrie's Coiffures.” Carrie's business activity code is 812112. In addition to 10 workstations (i.e., stylist chairs) and a small reception area, the shop has display and storage areas for the

products Carrie sells (see item 2 below). During the year, Carrie leased nine of the stations to other hairstylists. As is common practice in similar businesses in the area, the other stylists are considered to be self-employed. In fact, the IRS sanctioned the self-employment classification for the stylists in an audit of one of Carrie's prior tax returns. Each stylist pays Carrie a fixed rent for the use of a workstation, resulting in

$68,000 of rents received during 2012. From her own station, Carrie earned $44,000

(including tips of $12,000) for the styling services she provided to her own clients.



2. Carrie's Coiffures is the local distributor for several beauty products (e.g., conditioners,

shampoos) that cannot be purchased anywhere else. Carrie buys these items from the

manufacturers and sells them to regular patrons, walk-in customers, and other

beauticians (including those who lease chairs from her). Carrie's Coiffures is also

known for the selection and quality of its hairpieces (i.e., wigs, toupees). Through the

shop, Carrie made the following sales during the year:



Hairpieces and wigs $69,000

Beauty products 48,000



3. Although Carrie operates her business on a cash basis, she maintains inventory

accounts for the items she sells as required by law. Relevant information about the

inventories (based on lower of cost or market) is summarized below.

4.

12/31/11 12/31/12

Hairpieces and wigs $10,700 $12,600

Beauty products 11,400 9,900



5. Carrie's purchases for 2012 were $30,500 of hairpieces and wigs and $26,100 of beauty

products.



6. Carrie's Coiffures had the following operating expenses for 2012:



Utilities (i.e., gas, electric, telephone) $12,900

Ad valorem property taxes:

On realty (e.g., shop building and land) $4,200

On personalty (e.g., equipment, inventory) 1,800 6,000

Styling supplies (e.g., rinses, dyes, gels, hair spray) 5,700

Fire and casualty insurance 4,100

Liability insurance 4,000

Accounting services 3,800

Janitorial services 2,400

Sewer service, garbage pickup $ 2,300

Water 2,200

Occupation licenses (city and state) 1,500

Waiting room supplies (e.g., magazines, coffee) 1,300

7. As Carrie prefers to avoid employer-employee arrangements and the payroll tax

complexities, she retains outside agencies to handle her accounting and janitorial

needs.



8. In early 2012, Carrie decided to renovate the waiting room. On May 10, she spent

$10,400 for new chairs, a sofa, various lamps, coffee bar, and other furnishings. Carrie

follows a policy of claiming as much depreciation as soon as possible. The old

furnishings were thrown away or given to customers. For tax purposes, the old

furnishings had a zero basis.



9. Carrie's Coiffures is located in a building Carrie had constructed at 480 Laurel Street in

March 1998. The shop was built for a cost of $300,000 on a lot she purchased earlier

for $35,000. Except for a down payment from savings, the cost was financed by a 20-

year mortgage. For tax purposes, MACRS depreciation is claimed on the building.

During 2012, the following expenses were attributable to the property:



Repainting (both exterior and interior) $8,000

Repairs (plumbing and electrical) 1,900



10. In May (after her accident settlement discussed in item 11 below), Carrie paid the

balance due on the business mortgage. To do so, she incurred a prepayment penalty of

$4,400. Prior to paying it off, she paid regular interest on the mortgage in 2012 of

$6,000.



11. In February 2012, Carrie's Coiffures was cited by the city for improper disposal of

certain waste chemicals. Carrie questioned the propriety of the proposed fine of $2,000

and retained an attorney to represent her at the hearing. By pleading nolo contendere,

the attorney was able to get the fine reduced to $500. Carrie paid both the fine of $500

and the attorney's fee of $600 in 2012.



12. In August 2012, Carrie saw an ad in a trade publication that attracted her attention.

The owner of a well-respected styling salon in Reading (PA) had died, and his estate

was offering the business for sale. Carrie traveled to Reading, spent several days

looking over the business (including books and financial results), and met with the

executor. Carried treated the executor to dinner and a music concert. Immediately after

the concert, Carrie made an offer for the business, but the executor rejected it. Her

expenses in connection with this trip were as follows:



Car rental $140

Entertainment of executor 280

Motel (August 6-7) 220

Meals 110



13. In March 2011, Joan Myers, one of Carrie's best stylists, left town to get away from a

troublesome ex-husband. In order to help Joan establish a business elsewhere, Carrie

loaned her $7,000. Joan signed a note dated March 3, 2011, that was payable in one

year with 6% interest. On December 30, 2012, Carrie learned that Joan had declared

bankruptcy and was awaiting trial on felony theft charges. Carrie never received

payment from Joan, nor did she receive any interest on the loan.



14. At Christmas, Carrie gave each of her 35 best customers a large bottle of body lotion.

Each bottle had a wholesale cost to Carrie of $12 but a retail price of $24. Carrie also

spent $3 to have each bottle gift wrapped. (Note: The lotion was special order

merchandise and was not part of the business's inventory or purchases for the year—see item 2 above.) She also gave each of the nine stylists who leased chairs from her a

basket of fruit that cost $30 (not including $5 delivery cost).



15. In March 2012, the Pennsylvania Department of Revenue audited Carrie's state income

tax returns for 2009 and 2010. She was assessed additional state income tax of $340

for these years. Surprisingly, no interest was included in the assessment. Carrie paid

the back taxes promptly.



16. On a morning walk in November 2011, Carrie was injured when she was sideswiped by

a delivery truck. Carrie was hospitalized for several days, and the driver of the truck

was ticketed and charged with DUI. The owner of the truck, a national parcel delivery

service, was concerned that further adverse publicity might result if the matter went to

court. Consequently, the owner offered Carrie a settlement if she would sign a release.

Under the settlement, her medical expenses were paid and she would receive a cash

award of $200,000. The award specified that the entire amount was for physical pain

and suffering. Because she suffered no permanent injury as a result of the mishap, she

signed the release in April 2012 and received the $200,000 settlement.



17. In January 2012, Carrie was contacted by the state of Pennsylvania regarding a tract of

land she owned in York County. The state intended to convert the property into a

district headquarters, barracks, and training center for its highway patrol. Carrie had

inherited the property from her father when he died on August 11, 2011. The property

had a value of $140,000 on that date and had been purchased by her father on March

3, 1980, for $30,000. On July 25, 2012, after considerable negotiation and after the

state threatened to initiate condemnation proceedings, she sold the tract to the state

for $158,000. Since Carrie is not comfortable with real estate investments, she does not

plan to reinvest any of the proceeds received in another piece of realty.



18. When her father died in 2011, Carrie did not know that he had an insurance policy on

his life (maturity value of $50,000) in which she was named as the beneficiary. When

her mother told her about the policy in July 2012, Carrie filed a claim with the carrier,

Falcon Life Insurance Company. In August 2012, she received a check from Falcon for

$51,500 (including $1,500 interest).



19. Upon the advice of a client who is a respected broker, Carrie purchased 1,000 shares of

common stock in Grosbeak Exploration for $40,000 on March 4, 2012. In the months

following her purchase, the share value of Grosbeak plummeted. Disgusted with the

unexpected erosion in the value of her investment, Carrie sold the stock for $28,000 on

December 23, 2012.



20. While on her way to work in 2011, Carrie was rear-ended by a hit-and-run driver. The

damage to her Lexus was covered by her insurance company, General Casualty, except

for the $1,000 deductible she was required to pay. In 2012, the insurance company

located the driver who caused the accident and was reimbursed by his insurer.

Consequently, Carrie received a $1,000 refund check from General Casualty in May

2012 to reimburse her for her $1,000 deductible.



21. After her father's death, Carrie's mother (Mildred Morgan, Social Security number

12345-6789) moved in with her. Mildred's persistent back trouble made it difficult for

her to climb the stairs to the second-floor bedrooms in Carrie's house. So Carrie had an

elevator installed in her personal residence at a cost of $12,000 in January 2012. A

qualified appraiser determined that the elevator increased the value of the personal

residence by $7,000. The appraisal cost $400. The operation of the elevator during

2012 increased Carrie's electric bill by $300.



22. As a favor to a long-time client who is a drama professor at a local state university,

Carrie spent a weekend as a stylist preparing hairdos for the key actresses in the annual Theater Department fund-raising event. The drama professor supplied all of the

resources that Carrie needed to provide her services. Carrie estimates that she would

have charged $800 for the services she donated to this charitable event.



23. In addition to the items already mentioned, Carrie had the following receipts during

2012:



Interest income—

CD at Scranton First National Bank $900

City of Lancaster general purpose bonds 490

Money market account at Allentown State Bank 340 $1,730

Qualified dividends on stock investments—

General Motors $470

AT&T common 380 850

Federal income tax refund (for tax year 2011) 791

Pennsylvania state income tax refund (for tax year 2011) 205



24. Expenditures for 2012, not previously noted, are summarized below.

Contribution to pension plan $10,000

Medical—

Premiums on medical insurance $4,800

Dental bills 1,400 6,200

Property taxes on personal residence 3,800

Interest on home mortgage 3,200

Professional expenses—

Subscriptions to trade journals $ 180

Dues to beautician groups 140 320

25. The $10,000 contribution to the pension plan is to a § 401(k) type of plan she

established in 2011. Previously, she had contributed to an H.R. 10 (Keogh) plan but

found that the § 401(k) retirement arrangement provides more flexibility and is less

complex. The medical insurance policy covers Carrie and her dependents and was

issued in the name of the business (i.e., “Carrie's Coiffures”). It does not cover dental

work or capital modifications to a residence (see item 16 above).



26. During 2012, Carrie made the following total estimated tax payments with respect to

her 2012 tax returns:



Federal estimated income tax payments $20,800

Pennsylvania estimated income tax payments 2,400

Allentown City estimated income tax payments 800



Requirements







Prepare an income tax return (with appropriate schedules) for Carrie for 2012. In doing this, use the

following guidelines:





1) Make necessary assumptions for information not given in the problem.







2) Carrie has itemized deductions ever since she became a homeowner many years ago.







3) The sales tax option was not chosen in 2011, and Carrie had no major purchases that

qualify for the sales tax deduction in 2012.







4) Carrie has substantiation (e.g., records, receipts) to support the transactions involved.







5) If a refund results, Carrie wants it sent to her.





6) Carrie is preparing her own return (i.e., no preparer is involved).







7) Carrie does not wish to contribute to the Presidential Election Campaign Fund.

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