Problem 2

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

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.

2/31/11 2/31/12
Hairpieces

2/31/11 2/31/12
and wigs

10,700 12,600
Beauty

products

11,400

9,900

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

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

E-5E-6
$
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
As Carrie prefers to avoid employer-employee arrangements and the payroll tax complexities, she retains

outside agencies to handle her accounting and janitorial needs.

4. 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.

5. 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 properly:

Repainting

(both

exterior

and interior)
Repairs
electrical)

$
8,000

(plumbing

and
1,900

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 penally of $4,400. Prior to paying it off, she paid regular
interest on the mortgage in 2012 of $6,000.

6. 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 nob 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.

7. In August 2012, Carrie saw an ad in a trade publication that attracted her attention. The owner of a wellrespected 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
Motel
6-7)

280
(August
220

Meals
110

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

9. 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).

10. 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.

11. 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 E-6E-7ticketed 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.

12. 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.

13. 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).

14. 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.

15. 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.

16. After her father's death, Carrie's mother (Mildred Morgan, Social Security number 123-45-6789) 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.

17. 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.

18. In addition to the items already mentioned, Carrie had the following receipts during 2012:

$
Car rental
140
Entertainment
of executor
Motel
6-7)

280
(August
220

Meals
110

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

9. 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).

10. 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.

11. 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 E-6E-7ticketed 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.

12. 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.

13. 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).

14. 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.

15. 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.

16. After her father's death, Carrie's mother (Mildred Morgan, Social Security number 123-45-6789) 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.

17. 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.

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

2012:

Federal

estimated

income

tax

payments

$
20,800

Pennsylvania estimated income tax

payments

2,400

Allentown City estimated income tax

payments

8
00

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

Make necessary assumptions for information not given in the problem.

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

The sales tax option was not chosen in 2011, and Carrie had no major purchases that qualify for the sales
tax deduction in 2012.

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

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

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

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