1. Canary's allowable general business credit for 1998 is limited to $25,000, determined as follows:

* Net income tax = $125,000 (regular tax liability) + $0 [alternative minimum tax ($100,000 tentative minimum tax - $125,000 regular tax liability)] - $0 (nonrefundable credits).

p. 13-4 and Example 2

Therefore, the sources of the $160,000 general business credit allowed in 1999 are the carryovers of $90,000 from the four previous years and $70,000 of the $90,000 general business credit generated in 1999.

Because unused credits may be carried over for up to 20 years, the carryovers from each of the four previous years may be utilized.

pp. 13-5 to 13-7 and Example 3

3. a. The rehabilitation expenditures credit is 10% of $250,000, or $25,000.

pp. 13-5 and 13-6

4. Willis, Davis, Raabe, Kaplan, and Engle, CPAs

50 Kellogg Boulevard

St. Paul, Minnesota 55164

September 2, 1998

Ms. Diane Lawson

123 Sunview Avenue

Jacksonville, Florida 32231

Dear Ms. Lawson:

This letter is in response to your questions concerning the availability of the rehabilitation tax credit for expenditures that you plan to incur in the rehabilitation of your qualifying historic structure and their impact on the cost recovery basis of the structure. It is our understanding that you purchased the qualifying historic structure for $250,000 (excluding the cost of land) and that you intend to incur rehabilitation expenditures of either $245,000 or $255,000.

The law requires that in order for the credit to be available, a taxpayer must substantially rehabilitate the structure. In this case, the requirement calls for you to expend at least $250,000 on rehabilitation charges. Therefore, if you incur rehabilitation expenditures of $245,000, the credit is not available and the cost recovery basis of the structure would be $495,000 (original cost + capital improvements).

By incurring $255,000 on rehabilitation expenditures, a credit of $51,000 ($255,000 X 20%) would be available. However, the cost recovery basis of the property would be reduced to the extent of the available credit. Therefore, the cost recovery basis of the building would be $454,000 [$250,000 (original cost) + $255,000 (capital improvements) - $51,000 (amount of credit)].

Because the rehabilitation tax credit is available if you choose the renovation plan costing $255,000 (but not if you choose the one costing $245,000), you need to consider carefully the impact that the credit will have on your short-term cash flow position. Based solely on considering current cash flow due to the cost of the two projects and the potential tax credit, you would benefit by selecting the more expensive renovation project: while this selection would cost $10,000 more than the less expensive one, you would benefit from the $51,000 tax credit, for a net cash flow gain of $41,000. Of course, other considerations may impact your decision, but the benefit of the tax credit is indisputable.

Should you need more information or need clarification of our conclusions, please contact me.

Sincerely,

John J. Jones, CPA

Partner

August 28, 1998

TAX FILE MEMORANDUM

FROM: John J. Jones

SUBJECT: Ms. Diane Lawson

Impact of Rehabilitation Tax Credit

Diane Lawson has acquired a qualifying historic structure for $250,000 (excluding the cost of land) with the intention of substantially rehabilitating the building. She inquires as to the availability of the rehabilitation tax credit, and its impact on the structure's cost recovery basis, if she incurs either $245,000 or $255,000 of qualifying rehabilitation expenditures.

In order to qualify for the rehabilitation credit, Diane would have to substantially rehabilitate the structure. The substantial rehabilitation requirement provides that a taxpayer must incur rehabilitation expenditures which exceed the greater of (1) the adjusted basis of the property before the rehabilitation ($250,000), or (2) $5,000. Therefore, if Diane chose to incur only $245,000 on the rehabilitation, this amount would not be enough to qualify as a "substantial rehabilitation" and no credit would be available. The depreciable basis of the property would be the sum of its original cost plus the capital improvements, or $495,000 ($250,000 + $245,000).

If Diane incurs $255,000 for the rehabilitation project, a substantial rehabilitation would result. Therefore, the rehabilitation tax credit available to Diane would be $51,000 ($255,000 X 20%). The depreciable basis of the property, which would be reduced by the full amount of the credit, would be $454,000 [$250,000 (original cost) + $255,000 (capital improvements) - $51,000 (amount of credit)].

While other considerations would likely be relevant to Ms. Lawson as she decides which of the two renovation projects to pursue, certainly the impact of the rehabilitation tax credit on the current cash flow should not be overlooked. If she decides to undertake the more expensive project (i.e., the one costing $255,000 rather than the one costing $245,000), the higher cost would be more than offset in the current year by the benefit she would receive from the tax credit. Thus, the short-term cash flow advantage would total $41,000 [$51,000 (available tax credit) - $10,000 (incremental cost associated with the more expensive project)].

5. The taxpayer has been approached by a potential customer who is interested in buying some real property. On this same property, the taxpayer/seller subsequently would perform some renovation work that would qualify the buyer for the rehabilitation expenditures credit. The potential buyer has asked the seller to reduce the sales price by $25,000, in exchange for his promise to pay $25,000 more for the renovation services. This request appears to be made solely to maximize the tax benefits that would result to the buyer for the rehabilitation expenditures credit.

The issue is whether it is appropriate for the sales contract and the construction contract for the buyer to reflect amounts different from those the taxpayer normally would expect (i.e., $25,000 lower for sales contract and $25,000 higher for construction contract).

Factors supporting the willingness of the seller to sell the building for $75,000 and to charge $175,000 for the construction work include the following.

• While the normal selling price for the building would be approximately $100,000 and the normal price for the rehabilitation project would be approximately $150,000, these are what the prices would be if the building and rehabilitation were parts of separate contracts for different taxpayers. A package deal may provide some justification for different prices for the different components.
• The real concern to the seller likely is with the total price of $250,000 rather than with the price for each component.
• It has been a long time since the taxpayer has had an opportunity to close a sale and perform a construction project of this magnitude. Accepting the buyer's proposal will improve the taxpayer's cash flow position and will enable the taxpayer to keep many of his employees busy on the rehabilitation project.

Factors suggesting that modifying the price for the building and the price for the rehabilitation project as proposed by the buyer are inappropriate, include the following.

• The motivation of the buyer for the different allocations is tax avoidance (i.e., to qualify for a larger rehabilitation credit).
• The fair price for the building is $100,000 and the fair price for the rehabilitation project is $150,000.
• The taxpayer would not sell the building for $75,000 nor would the taxpayer be able to charge anyone else $175,000 for the rehabilitation project.
• While it may be appropriate to shift the prices of the two components somewhat, a shift of $25,000 is of too large a magnitude relative to the $100,000 and $150,000 amounts.

6. a. The work opportunity tax credit for the year is as follows:

b. $109,800 [$120,000 (total wages) - $10,200 (credit)].

p. 13-7

7. a. The welfare-to-work credit for 1998 is calculated as follows: 3 qualified

employees X $10,000 limit on wages for each employee X 35% = $10,500

The welfare-to-work credit for 1999 is calculated as follows:

1. The wage deduction for 1998 is $314,500 [$325,000 (total wages) - $10,500 (credit)]. Wage deduction for 1999 is $333,500 [$342,000 (total wages) - $8,500 (credit)].

p. 13-8 and Example 10

p. 13-9 and Example 9

b. The tax benefit of Martin's choices is determined as follows:

Choice 1 Reduce the deduction by 100% of the credit and claim the full
credit.

Choice 2 Claim the full deduction and reduce the credit by the product of
100% of the credit times 35% (the maximum corporate rate).

Thus, Choice 1 provides Martin a greater tax benefit. pp. 13-8, 13-9, and Example 11

9. John and Susie are faced with reporting their friend for tax fraud, but at a terrible cost, both for their friend Mitch, his children, and themselves. If they report him for his intentional misstatements on his Federal income tax return, Mitch could be sentenced to Federal prison. This would not only be a blow to Mitch, but his children could suffer due to the absence of their father and being placed in a state child-care institution or in foster care. Moreover, the personal cost to John and Susie would be directly felt because of the increased rents that they would be charged for their apartment.

The obvious solution to the problem for John and Susie is to inform the IRS of Mitch's fraudulent activity. However, they may try to justify to themselves that they should not inform the government because of the secondary consequences (i.e., prison and guardianship costs, increased rent) that could follow from informing the IRS. In addition, they could contend that it is possible that the costs of the prison incarceration and the institutional child care would exceed the amount that the government would gain from the proper reporting of the low-income housing credit. Moreover, they may feel that Mitch's actions are somewhat justified because of their perception that the government doesn't "deserve" more tax dollars because of its wasteful habits. While the consequences of informing the government may be painful and costly, they should be encouraged to inform the IRS and be dissuaded from trying to rationalize any inaction.

10. Willis, Davis, Raabe, Kaplan, and Raabe, CPAs

50 Kellogg Boulevard

St. Paul, Minnesota 55164

September 30, 1998

Mr. Ahmed Zinna

16 Southside Drive

Charlotte, NC 28204

Dear Ahmed:

This letter is in response to your inquiry regarding the tax consequences of the proposed capital improvement projects at your Oak Street and Maple Avenue locations.

As I understand your proposal, you plan to incur certain expenditures which are intended to make your businesses more accessible to disabled individuals in accordance with the Americans With Disabilities Act. The capital improvements that you are planning (i.e., ramps, doorways, and restrooms that are handicapped accessible) qualify for the disabled access credit if the costs are incurred for a facility that was placed into service before November 5, 1990. Therefore, only those projected expenditures of $8,000 for your Maple Avenue location qualify for the credit. In addition, the credit is calculated at the rate of 50% of the eligible expenditures that exceed $250 but do not exceed $10,250. Thus, the maximum credit in your situation would be $5,000 ($10,000 X 50%). You should also be aware that the basis for depreciation of these capital improvements would be reduced to $7,000, the amount of the expenditures of $12,000 reduced by the amount of the disabled access credit of $5,000. The capital improvements that you are planning for your Oak Street location, even though not qualifying for the disabled access credit, may be depreciated.

Should you need more information or need to clarify the information in this letter, please call me.

Sincerely,

Susan O. Anders, CPA

Partner

Foreign tax credit allowed: [lesser of $437.5 million (foreign tax credit

limitation) or $600 million (foreign taxes paid)] $437.5 million

Purple Corporation's Federal income tax, net of the foreign tax credit, is $612.5 million ($1.05 billion - $437.5 million).

pp. 13-11 and 13-12

12. a. Not a small corporation, since the company did not pass the $5 million average gross receipts test for the basic qualification year.

b. Not a small corporation because the average gross receipts of $5.016 million exceeds the $5 million test [($4.6 million + $5.5 million + $4.95 million)/3 = $5.016 million].

c. Yes, a small corporation because the company meets the $5 million test [($4.7 million + $4.9 million + $5.12 million)/3 = $4,906,667] .

p. 6-14

13. a. To produce the largest depreciation deduction for regular income tax purposes, Grackle will use Table 4-1 (200% DB method). For AMT purposes, it must use Table 4-5 (150% DB method).

b. Grackle could elect to depreciate the equipment using 150% DB method for regular income tax purposes rather than under the regular MACRS method (200% DB method). In addition to reducing the depreciation percentage factor, the election results in a longer life (9.5 years rather than 5 years). Therefore, the depreciation deduction for both AMT purposes and regular income tax purposes would be $19,725.

Making the election reduces the AMT adjustment to $0. Such an election may be beneficial if Grackle is going to be subject to the AMT. Such an election would not be beneficial if Grackle's regular tax liability is going to exceed its tentative AMT anyway.

c. Willis, Davis, Raabe, Kaplan, and Engle, CPAs

50 Kellogg Boulevard

St. Paul, Minnesota 55164

August 10, 1998

Ms. Helen Carlon

Controller, Grackle, Inc.

500 Monticello Avenue

Glendale, AZ 85306

Dear Ms. Carlon:

In response to your inquiry regarding the appropriate depreciation method for the $250,000 of equipment placed in service during March 1998, two options are available. The first will produce a larger depreciation deduction, but may result in the AMT being paid. The second option will produce a smaller depreciation deduction, but will have no effect on the AMT.

Under the first option, depreciation is calculated using the 200% declining balance method with a 5-year recovery period. The amount of the depreciation deduction under this method is $50,000 ($250,000 X 20%). However, for AMT purposes, the depreciation is calculated using the 150% declining balance method with a 9.5-year recovery period. The amount of the depreciation deduction for AMT purposes is $19,725 ($250,000 X 7.89%). Therefore, for AMT purposes, there is a positive adjustment of $30,275 ($50,000 - $19,725).

Under the second option, depreciation for regular income tax purposes and AMT purposes is calculated using the depreciation method and recovery period required for AMT purposes. Thus, in both cases, the amount of the depreciation deduction is $19,725. The benefit of electing to calculate the regular income tax depreciation this way is that the aforementioned positive adjustment for AMT purposes is avoided.

Whether the election that produces a smaller depreciation deduction for regular income tax purposes but avoids a positive AMT adjustment is beneficial depends on your AMT status absent the effect of the depreciation deduction. To advise you regarding this election, I need to meet with you to obtain additional tax information. Please provide me with a date and time that is convenient to you.

Sincerely,

James Singer, CPA

Partner

pp. 13-19

14. a. Mining exploration and development costs can be expensed in the year incurred for income tax purposes. These expenditures must be amortized over a 10-year period for AMT purposes. Grebe's regular income tax deduction would be $180,000 in 1999 and his AMT deduction would be $18,000 ($180,000/10). Therefore, Grebe would have a positive adjustment of $162,000 in 1999 ($180,000 regular income tax deduction - $18,000 AMT deduction). His negative adjustment for each of the next nine years will be $18,000 ($0 regular income tax deduction - $18,000 AMT deduction).

b. Grebe can avoid having an adjustment by electing to amortize the mining exploration and development costs over a ten-year period for regular income tax purposes.

c. Grebe should consider the present value of the cash flows, different tax brackets between regular income tax and AMT, and the possible effect this adjustment will have on future AMT calculations.

Example 22 and related discussion

15. The AMT adjustment is the difference between the income reported for regular income tax purposes under the completed contract method versus that which would have been reported under the percentage of completion method. The adjustment is positive if the amount calculated for the percentage of completion method is greater than the amount reported for the completed contract method and is negative if the opposite occurs. Josepi's AMT adjustment for each of the years is as follows:

p. 13-20

p. 13-21

17. The 1999 loss will not be deductible for either regular income tax or AMT purposes. The suspended passive loss for regular income tax purposes is $22,500 ($150,000 gross income - $135,000 operating expenses - $37,500 regular income tax depreciation). The suspended passive loss for AMT purposes is $9,000 ($150,000 gross income - $135,000 operating expenses - $24,000 ADS depreciation). Example 24 and related discussion

18. Crane Corporation:

Note: In this case, there is no reduction in the exemption amount because AMTI does not exceed $150,000.

Rider Corporation:

Mallard Corporation:

Note: In this case, the exemption amount phased out at $310,000.

p. 13-27 and Example 29

pp. 13-16, 13-18 and 13-20

Figure 6-1

*$3,000,000 but limited to $1,500,000. Further, the unusable negative adjustment of $1,500,000 ($3,000,000 - $1,500,000) is lost forever.

pp. 13-23 to 13-25 and Example 25

pp. 13-23 to 13-25 and Example 26

22. The adjustment for adjusted current earnings is 75% of the excess, if any, of the ACE, over the pre-adjusted AMTI.

(a) 1998 has a potential negative adjustment for ACE. Since there has been no positive adjustment in a prior year, Orange is not allowed to use this negative adjustment to reduce AMTI.

(b) There is a positive adjustment in 1999 of:

($90,000 - $60,000) X 75% = $22,500

(c) In 2000, Orange is allowed a negative adjustment of $7,500 (75% X $10,000) because the positive adjustment incurred in 1999 exceeds the negative adjustments for the year.

(d) Orange has a potential negative adjustment of $30,000 (75% X $40,000) in 2001. Since only $15,000 ($22,500 - $7,500) remains in the cumulative adjustments, Orange is limited to a $15,000 negative adjustment.

pp. 13-23 to 13-25 and Example 25

24. Based on the amount of the corporation's regular income tax liability of $53,000, the corporation is in the 39% marginal tax bracket. Reporting the home construction contract using the percentage of completion method results in the additional income reported in 1999 being taxed at the 39% regular corporate tax rate (i.e., the same rate that would apply in 2000). Thus, the benefit of the completed contract method is a one-year postponement of reporting of the income on the home construction contract. The trade-off is that the use of the completed contract method results in a $5,000 AMT in 1999. Thus, Allie is correct that changing the accounting method can result in the elimination of the AMT.

A separate issue is whether an amended return could be filed to change the reporting for the home construction contract. A claim for refund generally can be filed within three years of the date the return was filed or within two years of the date the tax was paid, whichever is later. Allie therefore meets this requirement. Another separate issue that needs to be considered is that IRS permission is required to change accounting methods.

25. Based on the facts of this case, the primary issue is whether Isabella may move a structure from its original location, incur rehabilitation expenditures, and still claim the tax credit for rehabilitation expenditures. To claim the credit, qualified expenditures must be made with respect to a qualified building. Section 47(c)(1)(A)(iii) stipulates that a qualified building is one where specified portions of exterior and interior walls be "retained in place" in the rehabilitation process. Regulation § 1.48-12(b)(5) states that, with respect to the "retained in place" requirement, "a building, other than a certified historic structure is not a qualified rehabilitated building unless it has been located where it is rehabilitated since before 1936...." In other words, this Regulation states that a building that is relocated prior to its rehabilitation does not constitute a qualified rehabilitated building because it has not been retained in place. Therefore, it would seem that Isabella would not be allowed to claim the tax credit for rehabilitation expenditures if she moved the building from its original location.

In a similar fact pattern (Nalle, III, 99 T.C. 187), the Court upheld the validity of this Regulation by claiming that the Secretary correctly gauged the congressional intent for the rehabilitation credit to be a means of stemming inner city blight. In the Court's view, the statute never was intended to benefit taxpayers who relocated a building prior to making renovations, as there would be no benefit to the communities from which buildings were removed. However, in the appeal of this case [93-2 USTC ¶ 50,468, 72 AFTR2d ¶ 93-5705, 997 F.2d 1134 (CA-5, 1993)], the denial of the credit was reversed. The Circuit Court of Appeals for the Fifth Circuit concluded that Reg. § 1.48-12(b)(5) was an invalid interpretation of § 47(c)(1)(A)(iii) because the statute was unambiguous and contained no such exclusion or restrictions regarding relocation. Essentially, the Court felt that the impact of the Regulation went beyond the intent of Congress. Therefore, based on the statute and its interpretation, Isabella would be able to benefit by claiming the rehabilitation credit.

26. August 8, 1998

TAX FILE MEMORANDUM

FROM: Jane J. Jones

SUBJECT: Research activities credit

In order to claim the research activities credit for the in-house software development costs, Oriole Corporation must satisfy four tests under § 41. Specifically, the credit is available only if the activity (1) qualifies as a deduction under § 174 (research and experimentation deduction), (2) was undertaken for the purpose of discovering information which is technological in nature, (3) is intended to be useful in the development of a new or improved business component, and (4) had substantially all of the research activities constitute elements of a process of experimentation. In addition, even if the four requirements enumerated in § 41 are met, an entity seeking the research activities tax credit must not have its research activity fall into one of eight expressly precluded areas enumerated in § 41(d)(4).

It is reasonably clear that Oriole Corporation meets the first and third of the four enumerated requirements. Therefore, the credit availability turns on the corporation's ability to meet requirements 2 and 4, and avoid the § 41(d)(4) exceptions.

As indicated in United Stationers, Inc. v. U.S. [79 AFTR2d 97-1761, 97-1 USTC ¶ 50,457], a case with a comparable fact set, the phrase "technological in nature" encompasses research activities that benefit aspects of the U.S. economy by changing the way companies operate and ultimately conduct their business activities. Further, the Court in United Stationers defined a "process of experimentation" to mean a process involving scientific experimentation to design a business component where the outcome is uncertain at the outset. Ultimately, the District Court in United Stationers held that the in-house software development was neither technological in nature nor involved a process of experimentation. The development activities were not technological in nature since no other companies were using or otherwise benefiting from the software. The development activities did not involve a process of experimentation since the corporation was not venturing into an uncertain field. In addition, the Court concluded that the § 41(d)(4) exception prohibiting the research activities credit for research with respect to computer software which is developed by the taxpayer primarily for internal use could not be overcome. Also, see Prop. Reg. § 1.41-4(e)(4).

Based on the foregoing, Oriole Corporation should not claim the research activities credit for costs incurred in connection with the software programs.

Note 1: $12,000 - ($100,700 X 10%) = $1,930 medical expense for AMT. $4,448 - $1,930 = $2,518 adjustment.

Note 2: Investment income for income tax purposes was only $3,700 ($1,800 + $1,900), so the income tax deduction for investment interest expense was limited to that amount. For AMT purposes, the net interest on the private activity bonds of $30,000 is included in calculating net investment income. Therefore, all of the investment interest of $5,500 is deducted for AMT purposes. This produces a negative adjustment of $1,800 ($5,500 - $3,700). For AMT purposes, net interest on private activity bonds is treated as a tax preference. Therefore, Lynn will have a tax preference of $30,000.

pp. 13-28 and 13-29

28. Pat's tentative AMT for 1998 is computed as shown below.

pp. 13-28 and 13-29

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