TEST BANK FOR South-Western Federal Taxation 2025 Comprehensive 48th Edition By James Young Mark, Pe

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law True / False 1. Because the law is complicated, most individual taxpayers are not able to complete their Federal income tax returns without outside assistance. a. True b. False 2. The ratification of the Sixteenth Amendment to the U.S. Constitution was necessary to validate the Federal income tax on corporations. a. True b. False 3. Before the Sixteenth Amendment to the Constitution was ratified, there was no valid Federal income tax on individuals. a. True b. False 4. The first income tax on individuals (after the ratification of the Sixteenth Amendment to the Constitution) levied tax rates from a low of 1% to a high of 6%. a. True b. False 5. The Federal income tax on individuals generates more revenue than the Federal income tax on corporations. a. True b. False 6. The pay-as-you-go feature of the Federal income tax on individuals conforms to Adam Smith’s canon (principle) of certainty. a. True b. False 7. The Medicare component of the FICA tax (1.45% on wages) is progressive as the tax due increases as wages increase. a. True b. False 8. The Federal estate and gift taxes are examples of progressive rate taxes. a. True b. False 9. The Federal excise tax on gasoline has a proportional effect on all taxpayers (that is, neither progressive or regressive). a. True b. False 10. Currently, the Federal corporate income tax is less progressive than the individual income tax. a. True b. False Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 11. Mona inherits her mother’s personal residence, which she converts to a furnished rental house. These changes should affect the amount of ad valorem property taxes levied on the properties. a. True b. False 12. A fixture will be subject to the ad valorem tax on personalty rather than the ad valorem tax on realty. a. True b. False 13. Even if property tax rates are not changed, the amount of ad valorem taxes imposed on realty may not remain the same. a. True b. False 14. The ad valorem tax on personal use personalty is more often avoided by taxpayers than the ad valorem tax on business use personalty. a. True b. False 15. An excise tax is often used to try to influence behavior. a. True b. False 16. There is a Federal excise tax on hotel occupancy. a. True b. False 17. The Federal gas-guzzler tax applies only to automobiles manufactured overseas and imported into the United States. a. True b. False 18. The amount of the state excise taxes on gasoline varies from state to state. a. True b. False 19. Not all of the states that impose a general sales tax also have a use tax. a. True b. False 20. Sales made over the internet are not exempt from the application of a general sales (or use) tax. a. True b. False 21. Two persons who live in the same state but in different counties may not be subject to the same general sales tax rate. a. True b. False Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 22. States impose either a state income tax or a general sales tax, but not both types of taxes. a. True b. False 23. A safe and easy way for a taxpayer to avoid local and state sales taxes is to make the purchase in a state that levies no such taxes. a. True b. False 24. On transfers by death, the Federal government relies on an estate tax, while states may impose an estate tax, an inheritance tax, both taxes, or neither tax. a. True b. False 25. An inheritance tax is a tax on a decedent’s right to pass property at death. a. True b. False 26. One of the major reasons for the enactment of the Federal estate tax was to prevent large amounts of wealth from being accumulated within a family unit. a. True b. False 27. Under Clint’s will, all of his property passes to either the Lutheran Church or to his spouse. No Federal estate tax will be due on Clint’s death. a. True b. False 28. Under the usual state inheritance tax, two heirs, a cousin and a son of the deceased, would not be taxed at the same rate. a. True b. False 29. The annual exclusion, currently $18,000, is available for gift and estate tax purposes. a. True b. False 30. In 2024, José, a widower, sells land (fair market value of $100,000) to his daughter, Linda, for $50,000. José has not made a taxable gift. a. True b. False 31. Julius, a married taxpayer, makes gifts to each of his six children. A maximum of twelve annual exclusions could be allowed as to these gifts. a. True Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law b. False 32. One of the motivations for making a gift is to save on income taxes. a. True b. False 33. The formula for the Federal income tax on corporations is the same as that applicable to individuals. a. True b. False 34. A state income tax can be imposed on nonresident taxpayers who earn income within the state on an itinerant basis. a. True b. False 35. For state income tax purposes, some states allow a credit for dependents rather than a deduction. a. True b. False 36. Some states use their state income tax return as a means of collecting unpaid use tax. a. True b. False 37. No state may offer an income tax amnesty program more than once. a. True b. False 38. For Federal income tax purposes, there never has been a general amnesty period. a. True b. False 39. Under state amnesty programs, all delinquent and unpaid income taxes are forgiven. a. True b. False 40. When a state decouples from a Federal tax provision, it means that this provision will not apply for state income tax purposes. a. True b. False 41. The principal objective of the FUTA tax is to provide some measure of retirement security. a. True b. False 42. Currently, the tax base for the Social Security component of the FICA is not limited to a dollar amount. a. True b. False Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 43. A parent employs her twin daughters, age 17, in her sole proprietorship. The daughters are not subject to FICA coverage. a. True b. False 44. Unlike FICA, FUTA requires that employers comply with state as well as Federal rules. a. True b. False 45. A major advantage of a flat tax type of income tax is its simplicity. a. True b. False 46. The value added tax (VAT) has not had wide acceptance in the international community. a. True b. False 47. If more IRS audits are producing a higher number of no change results, this indicates increased compliance on the part of taxpayers. a. True b. False 48. The amount of a taxpayer’s itemized deductions will increase the chance of being audited by the IRS. a. True b. False 49. An office audit by the IRS takes place at the office of the taxpayer. a. True b. False 50. The IRS agent auditing the return will issue an RAR even if the taxpayer owes no additional taxes. a. True b. False 51. If a special agent becomes involved in the audit of a return, this indicates that the IRS suspects that fraud is involved. a. True b. False 52. If a taxpayer files early (i.e., before the due date of the return), the statute of limitations on assessments begins on the date the return is filed. a. True b. False 53. For omissions from gross income in excess of 25% of that reported, there is no statute of limitations on additional income tax assessments by the IRS. Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law a. True b. False 54. If an income tax return is not filed by a taxpayer, there is no statute of limitations on assessments of tax by the IRS. a. True b. False 55. If fraud is involved, there is no time limit on the assessment of a deficiency by the IRS. a. True b. False 56. The IRS is required to redetermine the interest rate on underpayments and overpayments once a year. a. True b. False 57. A calendar year taxpayer files his 2023 Federal income tax return on March 4, 2024. The return reflects an overpayment of $6,000, and the taxpayer requests a refund of this amount. The refund is paid on May 16, 2024. The refund need not include interest. a. True b. False 58. For individual taxpayers, the interest rate for income tax refunds (overpayments) is the same as that applicable to assessments (underpayments). a. True b. False 59. During any month in which both the failure to file penalty and the failure to pay penalty apply, the failure to file penalty is increased by the amount of the failure to pay penalty. a. True b. False 60. When interest is charged on a deficiency, any part of a month counts as a full month. a. True b. False 61. For the negligence penalty to apply, the underpayment must be caused by intentional disregard of rules and regulations without intent to defraud. a. True b. False 62. Upon audit by the IRS, Faith is assessed a deficiency of $40,000 of which $25,000 is attributable to negligence. The 20% negligence penalty will apply to $25,000. a. True b. False 63. If a tax deficiency is attributable to fraud, the negligence penalty will not be imposed. Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law a. True b. False 64. The civil fraud penalty can entail large fines and possible incarceration. a. True b. False 65. Even though a client refuses to correct an error on a past return, it may be possible for a practitioner to continue to prepare returns for the client. a. True b. False 66. In preparing an income tax return, the use of a client’s estimates is not permitted. a. True b. False 67. In preparing a tax return, all questions on the return must be answered. a. True b. False 68. A CPA firm in California sends many of its less complex tax returns to be prepared by a group of accountants in India. If certain procedures are followed, this outsourcing of tax return preparation is proper. a. True b. False 69. The objective of pay-as-you-go (paygo) is to improve administrative feasibility. a. True b. False 70. When Congress enacts a tax cut that is phased in over a period of years, revenue neutrality is achieved. a. True b. False 71. A tax cut enacted by Congress that contains a sunset provision will make the tax cut temporary. a. True b. False 72. The tax law provides various tax credits, deductions, and exclusions that are designed to encourage taxpayers to obtain additional education. These provisions can be justified on both economic and equity grounds. a. True b. False 73. Various tax provisions encourage the creation of certain types of retirement plans. Such provisions can be justified on both economic and social grounds. a. True b. False Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 74. To lessen or eliminate the effect of multiple taxation, a taxpayer who is subject to both foreign and U.S. income taxes on the same income is allowed either a deduction or a credit for the foreign tax paid. a. True b. False 75. To mitigate the effect of the annual accounting period concept, the tax law permits the carryforward of excess charitable contributions of a particular year to other years. a. True b. False 76. Jason’s business warehouse is destroyed by fire. Because the insurance proceeds exceed the basis of the property, a gain results. If Jason shortly reinvests the proceeds in a new warehouse, no gain is recognized due to the application of the wherewithal to pay concept. a. True b. False 77. Because it is consistent with the wherewithal to pay concept, the tax law requires a seller to recognize a gain in the year the installment sale occurs. a. True b. False 78. Stealth taxes have the effect of generating additional taxes from all taxpayers. a. True b. False 79. A provision in the law that compels accrual basis taxpayers to pay a tax on prepaid income in the year received and not when earned is consistent with generally accepted accounting principles. a. True b. False 80. As a matter of administrative convenience, the IRS would prefer to have Congress decrease (rather than increase) the amount of the standard deduction allowed to individual taxpayers. a. True b. False 81. In cases of doubt, courts have held that tax relief provisions should be broadly construed in favor of taxpayers. a. True b. False 82. On occasion, Congress has to enact legislation that clarifies the tax law in order to change a result reached by the U.S. Supreme Court. a. True b. False 83. Ultimately, most taxes are paid by individuals. a. True Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law b. False 84. The majority of IRS audits are handled by correspondence. a. True b. False 85. Sally’s neighbor often brags that his employer often pays him in cash “off the books” to save him taxes. Sally is tired of hearing this and contacts the IRS to report the neighbor. If this tip results in taxes collected by the IRS, Sally will likely receive an award of a portion of the tax and penalties collected. a. True b. False 86. Bracket creep will not exist if there is only a single (flat) tax rate for the income tax. a. True b. False Multiple Choice 87. Which, if any, of the following statements best describes the history of the Federal income tax? a. It did not exist during the Civil War. b. The Federal income tax on corporations was held by the U.S. Supreme Court to be allowable under the U.S. Constitution. c. The Federal income tax on individuals was held by the U.S. Supreme Court to be allowable under the U.S. Constitution. d. Both the Federal income tax on individuals and on corporations was held by the U.S. Supreme Court to be contrary to the U.S. Constitution. 88. Which, if any, is not one of Adam Smith’s canons (principles) of taxation? a. Economy in collection b. Certainty c. Convenience of payment d. Simplicity 89. Which, if any, of the following taxes are regressive (rather than progressive)? a. State general sales tax b. Federal individual income tax c. Federal estate tax d. Federal gift tax 90. Which, if any, of the following transactions will increase a taxing jurisdiction’s revenue from the ad valorem tax imposed on real estate? a. A resident dies and leaves his farm to his church. b. A large property owner issues a conservation easement as to some of her land. c. A tax holiday issued 10 years ago has expired. d. A bankrupt motel is acquired by the Red Cross and is to be used to provide housing for homeless persons. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law e. None of these choices are correct. 91. Which, if any, of the following transactions will decrease a taxing jurisdiction’s ad valorem tax revenue imposed on real estate? a. A tax holiday is granted to an out-of-state business that is searching for a new factory site. b. An abandoned church is converted to a restaurant. c. A public school is razed and turned into a city park. d. A local university sells a dormitory that will be converted for use as an apartment building. 92. Which, if any, of the following is a typical characteristic of an ad valorem tax on personalty? a. Taxpayer compliance is greater for personal use property than for business use property. b. The tax on automobiles sometimes considers the age of the vehicle. c. Most states impose a tax on intangibles. d. The tax on intangibles generates considerable revenue as it is difficult for taxpayers to avoid. 93. Federal excise taxes that are no longer imposed include: a. Tax on air travel. b. Tax on wagering. c. Tax on alcohol. d. None of these choices are correct. 94. Taxes not imposed by the Federal government include: a. Tobacco excise tax. b. Customs duties (tariffs on imports). c. Tax on rental cars. d. Gas guzzler tax. 95. Taxes levied by both states and the Federal government include: a. General sales tax. b. Customs duties. c. Hotel occupancy tax. d. None of these choices are correct. 96. Taxes levied by all states include: a. Tobacco excise tax. b. Individual income tax. c. Inheritance tax. d. General sales tax. 97. A use tax is imposed by: a. The Federal government and all states. b. The Federal government and a majority of the states. c. All states but not the Federal government. d. Most of the states but not the Federal government. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 98. Gabriele and Lisa are married and live in a common law state. They want to make gifts to their four children in 2024. What is the maximum amount of the annual exclusion they will be allowed for these gifts? a. $18,000. b. $36,000. c. $72,000. d. $144,000. 99. Property can be transferred within the family group by gift or at death. One motivation for preferring the gift approach is: a. To take advantage of the higher unified transfer tax credit available under the gift tax. b. To avoid a future decline in value of the property transferred. c. To take advantage of the per donee annual exclusion. d. To shift income to higher bracket donees. 100. Indicate which, if any, statement is incorrect. State income taxes: a. Can piggyback to the Federal version. b. Cannot apply to visiting nonresidents. c. Can decouple from the Federal version. d. Can provide occasional amnesty programs. 101. State income taxes generally can be characterized by: a. The same date for filing as the Federal income tax. b. No provision for withholding procedures. c. Allowance of a deduction for Federal income taxes paid. d. Applying only to individuals but not to corporations. 102. A characteristic of FICA tax is that: a. It does not apply when one spouse works for the other spouse. b. It is imposed only on the employer. c. It provides a modest source of income in the event of loss of employment. d. None of these choices are correct. 103. A characteristic of FUTA is that: a. It is imposed on both employer and employee. b. It is imposed solely on the employee. c. Compliance requires following guidelines issued by both state and Federal regulatory authorities. d. It is applicable to spouses of employees but not to any children under age 18. 104. The United States (either Federal, state, or local) does not impose: a. Franchise taxes. b. Severance taxes. c. Custom duties. d. Export duties. 105. The proposed flat tax: Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law a. Would increase the number of deductions available to individuals. b. Would not require individuals to file returns. c. Would tax the increment in value as goods move through the production and manufacturing stages to the marketplace. d. Is a type of consumption tax. 106. A VAT (value added tax): a. Is regressive in its effect. b. Has not proved popular outside of the United States. c. Is not a tax on consumption. d. Is used exclusively by third world (less developed) countries. 107. Characteristics of the “fair tax” (i.e., national sales tax) include which, if any, of the following: a. Abolition of the Federal individual (but not the corporate) income tax. b. Abolition of all Federal income taxes but retention of payroll taxes (including the self-employment tax). c. Abolition of all Federal income taxes and payroll taxes but retention of the Federal estate and gift taxes. d. Abolition of all Federal income and payroll taxes as well as the Federal estate and gift taxes. 108. In terms of probability, which of the following taxpayers would be least likely to be audited by the IRS? a. Taxpayer owns and operates a check-cashing service. b. Taxpayer is an employed electrician. c. Taxpayer just received a $3 million personal injury award as a result of a lawsuit. d. Taxpayer just won a $1 million slot machine jackpot at a Las Vegas casino. 109. Which of the following is a characteristic of the audit process? a. Most taxpayer audits involve “special” agents. b. Self-employed taxpayers are less likely to be selected for audit than employed taxpayers. c. Less important issues are handled by means of a correspondence audit. d. If a taxpayer disagrees with the IRS auditor’s finding, the only resort is to the courts. 110. David files his tax return 45 days after the due date. Along with the return, David remits a check for $40,000. Which is the balance of the tax owed. Disregarding the interest element, David’s total failure to file and to pay penalties are: a. $400. b. $3,600. c. $4,000. d. $4,400. 111. A characteristic of the fraud penalties is: a. When negligence and civil fraud apply to a deficiency, the negligence penalty predominates. b. When criminal fraud can result in a fine and a prison sentence. c. When the criminal fraud penalty is 75% of the deficiency attributable to the fraud. d. When the IRS has the same burden of proof in the case of criminal fraud as with civil fraud. 112. Regarding proper ethical accounting guidelines, which, if any, of the following is correct? Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law a. The use of client estimates in preparing a return may be acceptable. b. Under no circumstances should a question on a tax return be left unanswered. c. If a client has made a mistake in a prior year’s return and refuses to correct it, the accountant should withdraw from the engagement. d. If the exact amount of a deduction is not certain (e.g., around mid-$600s), it should be recorded as an odd amount (i.e., $649) so as to increase the appearance of greater certainty. 113. Both economic and social considerations can be used to justify: a. Favorable tax treatment for accident and health plans provided for employees and financed by employers. b. Disallowance of any deduction for expenditures deemed to be contrary to public policy (e.g., fines, penalties, illegal kickbacks, bribes to government officials). c. Various tax credits, deductions, and exclusions that are designed to encourage taxpayers to obtain additional education. d. Allowance of a deduction for state and local income taxes paid. 114. Social considerations can be used to justify: a. Allowance of a credit for child care expenses. b. Allowing excess capital losses to be carried over to other years. c. Allowing accelerated amortization for the cost of installing pollution control facilities. d. Allowing a Federal income tax deduction for state and local sales taxes. 115. Allowing a tax credit for certain solar energy property can be justified: a. As helping small businesses. b. As promoting administrative feasibility. c. As promoting a government policy to use alternative energy sources. d. Based on the wherewithal to pay concept. 116. Provisions in the tax law that promote energy conservation and more use of alternative (nonfossil) fuels can be justified by: a. Political considerations. b. Economic and social considerations. c. Promoting administrative feasibility. d. Encouragement of small business. 117. Which, if any, of the following provisions cannot be justified as mitigating the effect of the annual accounting period concept? a. Nonrecognition of gain allowed for involuntary conversions. b. Net operating loss carryover provisions. c. Use of the installment method to recognize gain. d. Carryover of excess capital losses. 118. Which, if any, of the following provisions of the tax law cannot be justified as promoting administrative feasibility (simplifying the task of the IRS)? a. Penalties are imposed for failure to file a return or pay a tax on time. b. Annual adjustments for indexation increases the amount of the standard deduction allowed. Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law c. Personal casualty losses in Federally declared disaster areas must exceed 10% of AGI to be deductible. d. A deduction is allowed for charitable contributions. 119. A landlord leases property upon which the tenant makes improvements. The improvements are significant and are not made in lieu of rent. At the end of the lease, the value of the improvements is not income to the landlord. This rule is an example of: a. A clear reflection of income result. b. The tax benefit rule. c. The arm’s length concept. d. The wherewithal to pay concept. 120. Before proposing that the state’s sales tax be expanded to include food, a legislator should ask whether: a. The state tax agency will allow this expansion. b. A majority of his constituents agree. c. Grocery stores will be able to collect the tax. d. The state’s constitution allows for this tax. 121. Jane is the tax director for Tangent Software Corporation. She is unsure whether Tangent is required to charge sales tax when software is provided to customers in State X via the “cloud.” This indicates that the sales tax does not meet the principle of: a. Equity. b. Certainty. c. Neutrality. d. Economic growth and efficiency. 122. Two years ago, State Y enacted a new income tax credit for college prep materials. The credit is available to individuals and is equal to 40% of the cost of the items. The credit may not exceed $50 in any year. State Y's director of finance has discovered this year that the amount of credit claimed is far higher than expected. Which principle of good tax policy might not have been considered in designing this tax that caused the original cost estimate to be too low? a. Equity. b. Simplicity. c. Economy in collection. d. Minimum tax gap. 123. Which of the following statements about a value added tax (VAT) is false? a. Many countries use a VAT. b. The United States has imposed a VAT since 1913. c. A VAT has been proposed in the United States to replace part of the income tax. d. A VAT operates similarly to a sales tax. 124. The quote engraved on the IRS building in Washington, DC, at the entrance states: a. Nothing is certain, except death and taxes. b. Taxes are what we pay for civilized society. c. Everyone welcome. d. Taxes are the most difficult thing in the world to understand. Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 125. Tax functions that accounting and finance professionals may assist clients with include all but the following: a. Tax compliance. b. ESG reporting of certain tax information. c. Cash management to ensure timely payment of taxes. d. Tax evasion. 126. Who among the following individuals does not need to have a PTIN? a. Sally, a paid intern at a CPA firm, who helps prepare simple returns but does not sign them. b. Tam who reviews and signs returns for paying clients. c. Jeff who mostly does data entry at the CPA firm where he works but also occasionally handles interview with clients to obtain their tax information. d. Pooja who volunteers at an IRS tax preparation site to prepare simple returns for individuals eligible for the free assistance. 127. A rationale for the installment sale method tax rule is: a. Ability to pay. b. Equity and fairness. c. Simplicity. d. Revenue neutrality. 128. The AICPA Statements on Standards for Tax Services are: a. Enforceable. b. Educational. c. Out of date. d. Do not exist. 129. “Bracket creep” is avoided by: a. Using sunset provisions. b. Providing special tax rules for small businesses. c. The statute of limitations. d. Adjusting the rate brackets for inflation annually. 130. A CPA assisting a client with an IRS examination is subject to the following requirement. a. The Taxpayer Bill of Rights. b. Circular 230. c. The Safeguards Rule. d. Completion of the IRS Enrolled Agent exam. Matching Match the statements that relate to each other. Note: Some choices may be used more than once or not at all. a. Deferral of gains from involuntary conversions b. Carryforward of net operating losses Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law c. “No change” is a possible result d. State income tax applied to a visiting nonresident e. IRS special agent f. Undoing the “piggyback” result g. Ideal budget goal as to new tax legislation h. Every state that has a general sales tax has one i. Imposed by all states and the Federal government j. Imposed by some states but not the Federal government k. Imposed only by the Federal government l. No correct match provided 131. Employee temporarily working in another state for two months 132. Decoupling 133. Discriminant Function (DIF) 134. Tax fraud suspected 135. Revenue neutrality 136. Revenue Agent's Report (RAR) 137. Wherewithal to pay concept 138. Mitigation of the annual accounting period concept 139. Tax on transfers at death (inheritance type) 140. Excise tax on tobacco 141. Use tax 142. Income tax amnesty 143. Import taxes (customs duties) 144. “Pay as you go” (paygo) 145. Export taxes Using the following choices, show the justification for each provision of the tax law listed. a. Economic considerations b. Social considerations c. Equity considerations d. Both a. and b. 146. A tax credit for amounts spent to furnish care for children while the parent is at work. Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 147. Additional depreciation deduction allowed for the year the asset is acquired. 148. Tax brackets are increased for inflation. 149. A small business corporation can elect to avoid the corporate income tax. 150. A deduction for contributions by an employee to certain retirement plans. 151. A deduction for qualified tuition paid to obtain higher education. 152. A deduction for certain expenses (interest and taxes) incident to home ownership. 153. A Federal deduction for state and local income taxes paid. 154. A deduction for interest on student loans. 155. A bribe to the local sheriff, although business related, is not deductible. 156. Contributions to charitable organizations are deductible. 157. A Federal deduction for state and local sales taxes paid. 158. Tax credits available for the purchase of a vehicle that uses alternative (nonfossil) fuels. 159. Tax credits for home improvements that conserve energy. 160. More rapid expensing for tax purposes of the costs of installing pollution control devices. Match the statements that relate to each other. Note: Some choices may be used more than once. a. Three years from date return is filed b. Three years from due date of return c. 20% of underpayment d. 5% per month (25% limit) e. 0.5% per month (25% limit) f. Conducted at IRS office g. Conducted at taxpayer’s office h. Six years i. 45-day grace period allowed to IRS j. No statute of limitations (period remains open) k. 75% of underpayment l. No correct match provided 161. Office audit 162. Field audit 163. Failure to file penalty Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 164. Failure to pay penalty 165. Negligence penalty 166. Criminal fraud penalty 167. Fraud and statute of limitations 168. Early filing and statute of limitations (deficiency situations) 169. Late filing and statute limitations (deficiency situations) 170. No return and statute limitations 171. More than 25% gross income omission and statute of limitations 172. Interest due on refund Subjective Short Answer 173. Taylor, a widow, makes cash gifts to her five married children (including their spouses) and to her seven grandchildren. What is the maximum amount Taylor can give for calendar year 2024 without using her unified transfer tax credit? 174. For the tax year 2023, Noah reported gross income of $300,000 on his timely filed Federal income tax return. a. b. c.

Presuming that the general rule applies, when does the statute of limitations on assessments normally expire? Suppose that Noah inadvertently omitted gross income of $76,000. When does the statute of limitations on assessments expire? Suppose the omission was deliberate, not inadvertent. When does the statute of limitations on assessments expire?

175. Without obtaining an extension, Pam files her income tax return 55 days after the due date. With her return, she pays an additional tax of $60,000. Disregarding any interest element, what is Pam’s penalty for failure to pay and to file? 176. On his 2024 income tax return, Andrew omitted income and overstated deductions to the extent that his income tax was understated by $500,000. Disregarding any interest element, what is Andrew’s penalty if the understatement was due to: a. b. c.

Negligence. Civil fraud. Criminal fraud.

177. Several years ago, Logan purchased extra grazing land for his ranch at a cost of $240,000. In 2024, the land is condemned by the state for development as a highway maintenance depot. Under the condemnation award, Logan receives $600,000 for the land. Within the same year, he replaces the property with other grazing land. What is Logan’s tax situation if the replacement land cost: Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law a. b. c. d.

$210,000? $360,000? $630,000? Why?

178. Paige is the sole shareholder of Citron Corporation. During the year, she leases a building to Citron for a monthly rental of $80,000. If the fair rental value of the building is $60,000, what are the income tax consequences to the parties involved? 179. In 1993, Martina leased real estate to Drab Corporation for 20 years. Drab Corporation made significant capital improvements to the property. In 2012, Drab decided not to renew the lease and vacated the property. At that time, the value of the improvements was $800,000. Martina sells the real estate in 2024 for $1,200,000 of which $900,000 is attributable to the improvements. When is Martina taxed on the improvements made by Drab Corporation? Essay 180. The Federal income tax is based on a pay-as-you-go system and has become a “mass tax.” Explain this statement. 181. In terms of Adam Smith’s canons of taxation, how do state sales taxes fare as far as convenience of payment is concerned? 182. Due to population change, Goose Creek School District has decided to close one of its high schools. Since it has no further need of the property, the school is listed for sale. The two bids it receives are as follows: United Methodist Church $1,700,000 Planet Motors 1,600,000 The United Methodist Church would use the property to establish a sectarian middle school. Planet, a well-known car dealership, would revamp the property and operate it as a branch location. If you were a member of the School District board, what factors would you consider in evaluating the two bids? 183. Morgan inherits her father’s personal residence including all of the furnishings. She plans to add a swimming pool and sauna to the property and rent it as a furnished house. What are some of the ad valorem property tax issues Morgan can anticipate? 184. In 2022, Deborah became 65 years old. In 2023 she added a swimming pool and in 2024 she converted the residence to rental property and moved into an assisted living facility. Since 2021, Deborah’s ad valorem property taxes have decreased once and increased twice. Explain. 185. A lack of compliance in the payment of use taxes can be resolved by several means. In this regard, comment on the following: a. b.

Registration of automobiles. Reporting of Internet purchases on state income tax returns.

186. What are the pros and cons of the following state and local tax provisions? a. b. c.

An ad valorem property tax holiday made available to a manufacturing plant that is relocating. Hotel occupancy tax and a rental car surcharge. A back-to-school sales tax holiday.

Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 187. What is a severance tax? How productive can it be in terms of generating revenue? 188. What is the difference between an inheritance tax and an estate tax? Who imposes these taxes? 189. Antonio dies with an estate worth $20 million. Under his will, $10 million passes to his spouse and $10 million goes to his church. What is Antonio’s Federal estate tax result? 190. What might cause an individual to owe income taxes in more than one state? 191. Virtually all state income tax returns contain checkoff boxes for donations to various causes. On what grounds has this procedure been criticized? 192. State and local governments are sometimes forced to find ways to generate additional revenue. Comment on the pros and cons of the following procedures: a. b. c.

Decouple what would be part of the piggyback format of the state income tax. Tax amnesty provisions. Internet shaming.

193. Briana lives in one state and works in the adjoining state. Both states tax the income she earns from her job. Does Briana have any relief from this apparent double taxation of the same income? 194. In late June 2024, Art is audited by the state and a large deficiency is assessed. In November of the same year, his Federal income tax return is audited by the IRS. What has probably happened? 195. Two months after the burglary of his personal residence, Eric is audited by the IRS. Among the items taken in the burglary was a shoe box containing approximately $50,000 in cash. Eric is the owner and operator of a cash-and-carry liquor store. Eric wonders why he was audited. Can you help explain? 196. Rick, the sole proprietor of an adult entertainment club, is audited by the IRS. On the third day of the field audit, the regular IRS agent is accompanied by a special agent. Should Rick be concerned by this new development? Explain. 197. Tracy has just been audited and the IRS agent has issued an RAR that assesses a large deficiency. Since Tracy disagrees with the result, her next step is to go to court. Do you agree? 198. Brayden files his Federal income tax return by April 15 but does not pay the tax. Although he expects to pay interest on the large amount of tax he still owes, he feels that the timely filing has avoided any penalties. Is Brayden’s assumption correct? 199. Melinda has been referred to you by one of your clients. In the past, she has prepared her own income tax returns, but she has become overwhelmed by the increased complexity of the tax law. Consequently, Melinda wants you to prepare her return for calendar year 2024. In reviewing her 2023 return, you note that she has claimed as a deduction the entire cost of a business building that should have been capitalized and depreciated. What course of action should you follow? 200. Your client, Connie, won $12,000 in a football office pool. She sees no reason to include it in her income for several reasons. First, the amount won will not be reported to the IRS. Second, as an average income employee, she is unlikely to be audited by the IRS. Third, she feels that she has probably lost this much in other past office pools. How do you respond? 201. Under what conditions is it permissible, from an ethical standpoint, for a CPA firm to outsource tax return Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law preparation to a third party? 202. In terms of revenue neutrality, comment on a tax cut enacted by Congress that: a. b.

Contains revenue offsets. Includes a sunset provision.

203. The tax law contains various tax credits, deductions, and exclusions that are designed to encourage taxpayers to obtain additional education. On what grounds can these provisions be justified? 204. The tax law contains various provisions that encourage home ownership. a. b.

On what basis can this objective be justified? Are there any negative considerations? Explain.

205. The tax law allows an income tax deduction (or a credit) for foreign income taxes. Explain why. 206. The tax law allows, under certain conditions, deferral of gain recognition for involuntary conversions. a. b.

What is the justification for this relief measure? What happens if the proceeds are not entirely reinvested?

207. How do the net operating loss provisions in the tax law mitigate the effect of the annual accounting concept? 208. In connection with facilitating the function of the IRS in the administration of the tax laws, comment on the utility of the following: a. b. c.

An increase in the amount of the standard deduction. Dollar and percentage limitations on the deduction of personal casualty losses in Federally declared disaster areas. Availability of interest and penalties for taxpayer noncompliance.

209. Congress reacts to judicial decisions that interpret the tax law in different ways. When it approves of a decision, Congress may act to amend the Code to incorporate the holding. When it disapproves, Congress may amend the Code to nullify its effect. Give an example of each one of these congressional reactions. 210. Can a taxpayer start the three-year statute of limitations on additional assessments by the IRS by filing his income tax return early (i.e., before the due date)? Can the period be shortened by filing late (i.e., after the due date)? 211. Congressman Smith wants to impose a new tax on sugar drinks. Analyze this proposal against the principles of equity, simplicity, and neutrality. 212. Ultimately, most taxes are paid by individuals. Explain what this means in terms of income and payroll taxes paid by a corporation.

Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law Answer Key 1. True 2. False 3. False 4. True 5. True 6. False 7. False 8. True 9. False 10. True 11. True 12. False 13. True 14. True 15. True 16. False 17. False 18. True 19. False 20. True 21. True 22. False 23. False 24. True 25. False Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 26. True 27. True 28. True 29. False 30. False 31. True 32. True 33. False 34. True 35. True 36. True 37. False 38. True 39. False 40. True 41. False 42. False 43. True 44. True 45. True 46. False 47. False 48. True 49. False 50. True Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 51. True 52. False 53. False 54. True 55. True 56. False 57. True 58. True 59. False 60. False 61. True 62. True 63. True 64. False 65. True 66. False 67. False 68. True 69. True 70. False 71. True 72. False 73. True 74. True 75. True 76. True Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 77. False 78. False 79. False 80. False 81. False 82. True 83. True 84. True 85. True 86. True 87. b 88. d 89. a 90. c 91. a 92. b 93. d 94. c 95. d 96. a 97. d 98. d 99. c 100. b 101. a Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 102. d 103. c 104. d 105. d 106. a 107. d 108. b 109. c 110. c 111. b 112. a 113. c 114. a 115. c 116. b 117. a 118. d 119. d 120. d 121. b 122. d 123. b 124. b 125. d 126. d 127. a Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 128. a 129. d 130. b 131. d 132. f 133. l 134. e 135. g 136. c 137. a 138. b 139. j 140. i 141. h 142. j 143. k 144. g 145. l 146. b 147. a 148. c 149. a 150. d 151. d 152. d Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 153. c 154. d 155. b 156. b 157. c 158. a 159. a 160. a 161. f 162. g 163. d 164. e 165. c 166. l 167. j 168. b 169. a 170. j 171. h 172. i 173. $306,000 [$18,000 (annual exclusion) × 17 donees]. 174. a. Three years from April 15, 2024. If more than 25% of gross income is omitted, a six-year statute applies (i.e., six years from b. April 15, 2024). In this case, it does because $76,000 is more than $75,000 (25% × $300,000). c. If fraud is involved, the statute never expires.

Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law

175. $6,000. Disregarding the interest element, Pam’s total penalties are as follows: Failure to pay penalty (0.5% × $60,000 × 2 months) Plus: Failure to file penalty (5% × $60,000 × 2 months) Less failure to pay penalty for same period Total penalties

$ $6,000 (600)

600

5,400 $6,000

176. a. $100,000 (20% × $500,000). b. $375,000 (75% × $500,000). c. Various fines and/or prison sentence. 177. a. The full realized gain of $360,000 [$600,000 (condemnation proceeds) – $240,000 (cost of land)] must be recognized, because only $210,000 was reinvested. The condemnation proceeds of $600,000 exceed the amount reinvested by more than $360,000. b. Because only $360,000 was reinvested in replacement property, $240,000 ($600,000 – $360,000) of the gain must be recognized. c. Because the full $600,000 was reinvested, no realized gain need be recognized. If some of the gain is not reinvested, consistent with the wherewithal to pay concept, there d. exists the ability to pay the tax. Thus, gain is recognized to the extent the proceeds are not reinvested.

178. The rent charged by Paige is not “arms length”; as such, Citron Corporation’s rent deduction is $60,000 (not $80,000). The $20,000 difference is a nondeductible dividend distribution. For Paige, the change merely requires reclassification. Instead of $80,000 of rent income, she has $60,000 of rent income and $20,000 of dividend income. 179. Martina is not subject to taxation on the improvements until she disposes of the property (i.e., 2024). After a controversial Supreme Court decision years ago, Congress clarified the tax law to make it more consistent with the wherewithal to pay concept. 180. The pay-as-you-go system is present in the wage and other withholding procedures. In the case of self-employed persons, it is manifested in the required quarterly payments for estimated taxes. The income tax became a mass tax during World War II when its coverage was extended to 74% of the population (from less than 6% in 1939). 181. Because the sales tax is owed at the time of purchase, the taxpayer is able to determine if they can afford to pay the tax and it is collected at that time rather than say, for example, at the end of the buyer's tax year.. 182. Although the bid from the United Methodist Church is higher, several other factors need to be considered. Does, for example, Goose Creek School District exempt property owned by churches from its ad valorem taxes? If so, losing this property from the tax base could prove very costly over the long run. Also, it is probable that income-producing property (such as a car dealership) would be taxed at a higher rate than that owned by a nonprofit organization (a school operated by a church). This assumes, of course, that the school would be taxed at all. The auto dealership also would generate sales Powered by Cognero

Page 29

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law tax. 183. The real estate taxes probably will increase for several reasons. The capital improvements and the conversion from residential to rental will trigger the increase. Furthermore, the furnishings may generate an ad valorem tax on personalty. (Depending on applicable law, furniture might not be subject to tax unless used for business purposes—such as in this case.) 184. The decrease probably came in 2022 when Deborah reached age 65. The increases probably occurred in 2023 when she added the pool and in 2024 when the residence was converted to rental property with the property reassessed due to the change in use and/or removal of the homestead exemption. 185. a. As reflected in Example 5, re-registration of a car purchased out of state is the occasion for the owner’s home state to collect the use tax. b. Completing the state income tax return reminds (or forces) the taxpayer to pay use tax on out of state purchases.

186. a.

b.

c.

Such a holiday is designed to attract new industry to the area. This will bring more jobs and growth in consumption. On the other hand, if the tax holiday is too generous, this places a strain on available public revenue. The result could be that schools and capital maintenance (roads, public services) will suffer. The hotel occupancy tax and car rental surcharges are popular because they mainly impact visitors. Also, they can generate considerable revenue to finance major capital improvements. If these taxes become excessive, however, they could discourage major events (such as conventions). Such holidays are popular with both merchants and consumers and serve the social need of defraying some of the costs of sending children to school. Once established, however, they are difficult to get rid of. Thus, they become an annual drain on sales tax revenue. In addition, since they are available to buyers at all income levels, they provide tax savings to taxpayers who do not need them and who might obtain greater tax breaks than others, as they have more funds to spend on the tax free items.

187. A severance tax is one imposed when natural resources (e.g., oil, gas, iron ore, coal) are extracted. It is based on the notion that the state has an interest in such resources. For some states, the revenue from severance taxes can be significant. Alaska, for example, relies heavily on its severance taxes and has been able to avoid both a state income tax and a general sales tax. 188. An inheritance tax is a tax on the right to receive property from a decedent. An estate tax is imposed on the right to pass property at death. The Federal government imposes estate taxes and states impose inheritance taxes. Some states impose both, whereas others impose neither. 189. None. After a marital deduction of $10 million and a charitable deduction of $10 million, Antonio’s taxable estate is Powered by Cognero

Page 30

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law $0. 190. Working in more than one state or owning income-generating property in more than one state can cause this. 191. In many cases, the procedure is overused (i.e., a multiplicity of boxes). This overuse adds complexity to the return. Also, in most cases, the donation is being drawn from any income tax refund that might be due. Thus, taxpayers may not fully appreciate that they are paying for such checkoffs. 192. a. The decoupling process is easily accomplished regarding new Federal tax changes that have never taken effect at the state level. Taxpayers are not apt to miss what they never have enjoyed. b. Tax amnesty provisions generate considerable revenue. It also unmasks many taxpayers who have not previously paid taxes. Now that the taxing jurisdiction is aware of their existence, they will tend to pay taxes in the future. c. By use of a public internet site, the taxing authority posts the names of those taxpayers that are delinquent as to various taxes (e.g., sales, income). This public humiliation (or threat of) very often results in compliance.

193. Most states allow their residents some form of tax credit for the income taxes paid to other states. In Briana’s case, the credit would be allowed by the state where she lives for the taxes paid to the state where she works. 194. The IRS has been notified by the state concerning the results of the June audit. 195. Although Eric’s audit by the IRS could be the result of sheer chance, this appears unlikely. Press coverage of the burglary, particularly if the items stolen were enumerated, could have put the IRS on notice. Why would anyone keep such a large amount of cash at his personal residence? Also, Eric is in a business where tax evasion is easily accomplished. 196. Yes, he should. Special agents rarely appear during an audit unless the regular agent suspects that fraud may be involved. Considering the type of business Rick conducts, the heavy use of cash probably exists. With cash involved, tax evasion is easier to carry out. 197. Tracy might save herself time and expense by going to the Independent Office of Appeals of the IRS. Here, the IRS has the authority to negotiate a settlement based on the “hazards of litigation” (i.e., the probabilities of winning or losing). If a settlement is reached, resorting to the courts is avoided. 198. Although Brayden has avoided the failure to file penalty, the failure to pay penalty will apply. It is 0.5% per month up to a maximum of 25% of the tax due as shown on the return. 199. You should recommend to Melinda that an amended return be filed for 2023 correcting the error. If she refuses, you should assess the gravity of the error and how it impacts on your ability to file an accurate return for 2024. If you cannot do so, then you must decline the engagement. 200. As a practitioner, you cannot play the audit lottery. You must prepare a proper return for her. Although the use of estimates is allowed, Connie’s assumptions as to her losses are not realistic. Even if they were reliable, gambling losses cannot be offset against gambling winnings but must be separately deducted. Thus, the $12,000 must be reported as income or you cannot prepare Connie’s return. Powered by Cognero

Page 31

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 201. First, the clients’ confidentiality must be preserved. Second, the CPA firm must verify the accuracy of the work. Third, the clients must be advised as to the practice. 202. a. Ideally, to achieve revenue neutrality, all tax cuts should be accompanied by revenue offsets. b.

A sunset provision does not account for the immediate revenue losses generated by a tax cut. It merely provides that such losses will not continue beyond a specified date when the tax cut expires and the former tax law is reinstated.

203. Social and economic considerations are the justification. As to the latter, a better educated workforce carries a positive economic impact. 204. a. Home ownership can be justified on economic and social grounds. b. Granting tax advantages to persons who are purchasing their homes places the taxpayers who rent at a disadvantage. The result is inequality in treatment. 205. The deduction (or a credit) for foreign income taxes can be justified on the grounds that it mitigates the double tax imposed on the same income. 206. a. By recognizing that the taxpayer’s relative economic situation has not changed and that they lack the wherewithal to pay a tax, any recognition of realized gain is deferred. b. If the proceeds from an involuntary conversion are not fully reinvested in property that is similar or related in service or use, recognized gain results. Such recognized gain cannot exceed realized gain and will be limited to the amount of the proceeds not reinvested. Recognition is based on the notion that the taxpayer now has the wherewithal to pay the tax that results. 207. Without the allowance of a loss carryforward, the losses would disappear. As shown by Example 27, this result places a business with profit and loss fluctuations on a more level playing field with one that maintains a stable income pattern. 208. a. An increase in the amount of the standard deduction reduces the number of taxpayers who choose to itemize their personal deductions. This, in turn, reduces the deductions the IRS has to check. b. Limitations placed on casualty and theft losses curtail the number of taxpayers who can claim the deduction. c. The imposition of extra penalties, in addition to the tax owed, definitely deters taxpayer noncompliance. 209. Congress approved of the judicial conclusion that most stock dividends should be nontaxable and amended the Code to this effect. However, it disagreed as to when leasehold improvements should be taxed to a lessor. Consistent with the wherewithal to pay concept, the improvements are to be taxed on the termination of the lease. Thus, Congress overturned a judicial holding that would have taxed such improvements in the year they are made by the lessee. 210. The answer is no in both cases. When filing early, the statute starts to run on the due date of the return. When filing late however, the filing date controls. Powered by Cognero

Page 32

Name:

Class:

Date:

Chapter 01: An_Introduction_to_Taxation_and_Understanding_the_Federal_Tax_Law 211. •

Equity – The tax is regressive in that it will represent a larger portion of a low-income individual’s income relative to a higher-income individual.

•

Simplicity – While it sounds simple because the ingredients on a container should indicate if there is sugar, issues might arise as to how other forms of sugar, such as corn syrup, affect application of the tax. Also, the amount of sugar in beverages can vary, so some might argue that the tax should not apply if the sugar level is minimal. Will the tax apply to drinks already subject to the alcohol taxes? (Include some discussion of problems of defining sugar drink in the answer.)

•

Neutrality – The tax will likely reduce sales of sugar drinks.

212. A corporation pays many types of taxes, but like any other expenditure, some of these taxes are ultimately paid by an individual. Income taxes are included in the price the corporation charges for goods and services. Or all or part might result in reduced earnings affecting investors or through reduced wages affecting employees. The payroll taxes paid by the corporate employer are likely borne by workers in the form of lower wages. That is, if the employer did not have to pay the taxes, it could pay higher wages to employees. These taxes might also be borne by customers and investors.

Powered by Cognero

Page 33

Name:

Class:

Date:

Chapter 02: Working With the Tax Law True / False 1. A tax professional need not worry about the relative weight of authority within the various tax law sources. a. True b. False 2. Rules of tax law do not include Revenue Rulings and Revenue Procedures. a. True b. False 3. In recent years, Congress has been relatively successful in simplifying the Internal Revenue Code. a. True b. False 4. A taxpayer should always minimize their tax liability. a. True b. False 5. The first codification of the tax law occurred in 1954. a. True b. False 6. This Internal Revenue Code section citation is correct: § 212(1). a. True b. False 7. Subchapter D refers to the “Corporate Distributions and Adjustments” section of the Internal Revenue Code. a. True b. False 8. In general, Regulations are issued immediately after a statute is enacted. a. True b. False 9. Temporary Regulations are only published in the Internal Revenue Bulletin. a. True b. False 10. Revenue Rulings issued by the National Office of the IRS carry the same legal force and effect as Regulations. a. True b. False 11. A Revenue Ruling is an administrative source of Federal tax law. a. True b. False Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 02: Working With the Tax Law 12. The following citation could be a correct citation: Rev. Rul. 2021-42, 2021-64 I.R.B. 982. a. True b. False 13. Revenue Procedures deal with the internal management practices and procedures of the IRS. a. True b. False 14. Post-1984 letter rulings may be substantial authority for purposes of the accuracy-related penalty in § 6662. a. True b. False 15. A letter ruling applies only to the taxpayer who asks for and obtains a letter ruling. a. True b. False 16. The IRS is not required to make a letter ruling public. a. True b. False 17. Determination letters usually involve completed transactions. a. True b. False 18. Technical Advice Memoranda deal with completed transactions. a. True b. False 19. Technical Advice Memoranda may not be cited as precedents by taxpayers. a. True b. False 20. A taxpayer must pay any tax deficiency assessed by the IRS and sue for a refund to bring suit in the U.S. Court of Federal Claims. Only in the Tax Court can jurisdiction be obtained without first paying the assessed tax deficiency. a. True b. False 21. In a U.S. District Court, a jury can decide both questions of fact and questions of law. a. True b. False 22. Three judges will normally hear each U.S. Tax Court case. a. True b. False 23. A taxpayer can obtain a jury trial in the U.S. Tax Court. Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 02: Working With the Tax Law a. True b. False 24. A taxpayer must pay any tax deficiency assessed by the IRS and sue for a refund to bring suit in the U.S. District Court. a. True b. False 25. Arizona is in the jurisdiction of the Eighth Circuit Court of Appeals. a. True b. False 26. Texas is in the jurisdiction of the Second Circuit Court of Appeals. a. True b. False 27. The Golsen rule has been overturned by the U.S. Supreme Court. a. True b. False 28. The granting of a Writ of Certiorari indicates that at least four members of the Supreme Court believe that an issue is of sufficient importance to be heard by the full court. a. True b. False 29. The petitioner refers to the party against whom a suit is brought. a. True b. False 30. The term petitioner is a synonym for defendant. a. True b. False 31. The U.S. Tax Court meets most often in Washington, D.C. a. True b. False 32. There are 11 geographic U.S. Circuit Court of Appeals. a. True b. False 33. The following citation is correct: Larry G. Mitchell, 131 T.C. 215 (2008). a. True b. False 34. The IRS issues an acquiescence or nonacquiescence only for regular Tax Court decisions. Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 02: Working With the Tax Law a. True b. False 35. There is a direct conflict between an Internal Revenue Code section adopted in 2017 and a treaty with France (signed in 2016). The Internal Revenue Code section controls. a. True b. False 36. The Small Cases Division of the U.S. Tax Court will hear only those cases involving amounts of $100,000 or less. a. True b. False 37. A U.S. District Court is considered the lowest trial court. a. True b. False 38. The research process should always begin with a tax service. a. True b. False 39. Electronic (online) databases are most frequently searched by the keyword approach. a. True b. False 40. A treasure trove is taxable when sold or exchanged. a. True b. False 41. A Bluebook is substantial authority for purposes of the accuracy related penalty. a. True b. False 42. The primary purpose of effective tax planning is to reduce or defer the tax in the current tax year. a. True b. False 43. Deferring income to a subsequent year is considered to be tax avoidance. a. True b. False 44. Tax planning usually involves a completed transaction. a. True b. False 45. On the redesigned 2024 CPA exam, Business Law is allocated 15% to 25% of the REG section. a. True Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 02: Working With the Tax Law b. False 46. Tax changes passed as part of the Inflation Reduction Act of 2022 became part of the Internal Revenue Code of 1986. a. True b. False 47. Revenue tax measures typically originate in the Senate Finance Committee of the U.S. Congress. a. True b. False 48. Currently, the Internal Revenue Code of 1986 does not contain §§ 308, 309, and 310. This absence means these sections were repealed by Congress. a. True b. False 49. Before a tax bill can become a law, it must be approved (signed) by the President of the United States. a. True b. False 50. Normally, when the Senate version of a tax bill differs from that passed by the House, a Joint Conference Committee drafts a compromise tax bill. a. True b. False 51. Subchapter C refers to the subchapter in the Internal Revenue Code that deals with partnerships and partners. a. True b. False 52. Revenue Rulings issued by the National Office of the IRS carry the same legal force and effect as Regulations. a. True b. False 53. Revenue Rulings are first published in the Internal Revenue Bulletin. a. True b. False 54. A Temporary Regulation under § 303 of the Code would be cited as follows: Temp. Reg. § 303. a. True b. False Multiple Choice 55. The Internal Revenue Code was first codified in what year? a. 1913 b. 1923 c. 1939 Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 02: Working With the Tax Law d. 1954 56. Tax bills are handled by which committee in the U.S. House of Representatives? a. Taxation Committee b. Ways and Means Committee c. Finance Committee d. Budget Committee 57. Federal tax legislation generally originates in which of the following? a. Internal Revenue Service b. Senate Finance Committee c. House Ways and Means Committee d. Senate Floor 58. Subtitle A of the Internal Revenue Code covers which of the following taxes? a. Income taxes b. Estate and gift taxes c. Excise taxes d. Employment taxes 59. In § 212(1), the number (1) stands for the: a. Section number. b. Subsection number. c. Paragraph designation. d. Subparagraph designation. 60. Which of these is not a correct citation to the Internal Revenue Code? a. Section 211 b. Section 1222(1) c. Section 2(a)(1)(A) d. All of these choices are correct cites. 61. Which of the following is not an administrative source of tax law? a. Chief Counsel Advice (CCA) b. Notice c. Code § 199A d. General Counsel Memorandum 62. Which of the following sources has the highest tax authority? a. Revenue Ruling b. Revenue Procedure c. Regulations d. Internal Revenue Code section Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 02: Working With the Tax Law 63. Which of the following types of Regulations has the highest tax validity? a. Temporary b. Legislative c. Interpretive d. Proposed 64. Which statement is not true with respect to a Regulation that interprets the tax law? a. Issued by the U.S. Congress. b. Issued by the U.S. Treasury Department. c. Designed to provide an interpretation of the tax law. d. Carries more legal force than a Revenue Ruling. 65. In addressing the importance of a Regulation, an IRS agent must: a. Give equal weight to the Internal Revenue Code and the Regulations. b. Give more weight to the Internal Revenue Code rather than to a Regulation. c. Give more weight to the Regulation rather than to the Internal Revenue Code. d. Give less weight to the Internal Revenue Code rather than to a Regulation. 66. Which item may not be cited as a precedent? a. Regulations b. Temporary Regulations c. Technical Advice Memoranda d. U.S. District Court decision 67. What statement is not true with respect to Temporary Regulations? a. May not be cited as precedent. b. Issued with Proposed Regulations. c. Automatically expire within three years after the date of issuance. d. Found in the Federal Register. 68. What administrative release deals with a proposed transaction rather than a completed transaction? a. Letter Ruling b. Technical Advice Memorandum c. Determination Letter d. Field Service Advice 69. Which of the following indicates that a decision has precedential value for future cases? a. Stare decisis b. Golsen doctrine c. En banc d. Reenactment doctrine 70. A taxpayer who loses in a U.S. District Court may appeal to the: a. U.S. Supreme Court. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 02: Working With the Tax Law b. U.S. Tax Court. c. U.S. Court of Federal Claims. d. Appropriate U.S. Circuit Court of Appeals. 71. A taxpayer who decides not to pay a tax deficiency, must litigate in which court? a. Appropriate U.S. Circuit Court of Appeals b. U.S. District Court c. U.S. Tax Court d. U.S. Court of Federal Claims 72. A jury trial is available in the following trial court: a. U.S. Tax Court. b. U.S. Court of Federal Claims. c. U.S. District Court. d. U.S. Circuit Court of Appeals. 73. A taxpayer may not appeal a case from which court: a. U.S. District Court. b. U.S. Circuit Court of Appeals. c. U.S. Court of Federal Claims. d. Small Case Division of the U.S. Tax Court. 74. The IRS will not acquiesce to the following tax decisions: a. U.S. District Court. b. U.S. Tax Court. c. U.S. Court of Federal Claims. d. Small Case Division of the U.S. Tax Court. 75. Which publisher offers the Standard Federal Tax Reporter? a. Thomson Reuters Checkpoint (Research Institute of America) b. Wolters Kluwer (Commerce Clearing House) c. Bloomberg BNA d. LexisNexis 76. Which is presently not a commercial tax service? a. CCH Intelliconnect b. Federal Taxes c. Thomson Reuters Checkpoint d. Tax Management Portfolios 77. Which publisher offers the United States Tax Reporter? a. Thomson Reuters Checkpoint (Research Institute of America) b. Wolters Kluwer (Commerce Clearing House) c. LexisNexis Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 02: Working With the Tax Law d. Tax Analysts 78. When searching on an electronic (online) tax service, which approach is more frequently used? a. Internal Revenue Code section approach b. Keyword approach c. Table of contents approach d. Index 79. Which is not a judicial citation? a. CCA 200909002. b. T.C. Memo 2008-289. c. 39 TCM 32 (1979). d. 592 F.Supp.18. 80. Which of the following is the lowest authority in the Federal tax law system? a. Revenue Ruling. b. Proposed Regulation. c. Interpretive Regulation. d. Revenue Procedure. 81. Which tax-related website probably gives the best policy-orientation results? a. taxalmanac.org b. irs.gov c. EY.com d. taxanalysts.com 82. Which court decision would probably carry more weight? a. Regular U.S. Tax Court decision b. Reviewed U.S. Tax Court decision c. U.S. District Court decision d. Tax Court Memorandum decision 83. Which Regulations have the force and effect of law? a. Procedural Regulations b. Finalized Regulations c. Legislative Regulations d. Interpretive Regulations 84. Which items tell taxpayers the IRS’s reaction to certain court decisions? a. Notices b. Revenue Procedures c. Revenue Rulings d. Actions on Decisions Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 02: Working With the Tax Law 85. Which is not a primary source of tax law? a. Notice 89-99, 1989-2 C.B. 422. b. Estate of Harry Holmes v. Comm., 326 U.S. 480 (1946). c. Rev. Rul. 79-353, 1979-2 C.B. 325. d. Prop. Reg. § 1.752-4T(f). 86. Which of the following statements is incorrect as it relates to the redesigned 2024 CPA exam? a. The redesigned 2024 CPA exam now has three Core sections and three Discipline sections. b. There are no longer task-based simulations on the exam. c. A candidate must select a Discipline section. d. The previous BEC section material has been spread over other sections. 87. Which of the following court decisions carries more weight? a. Federal District Court b. Second Circuit Court of Appeals c. U.S. Tax Court decision d. Small Cases Division of U.S. Tax Court 88. Which company does not publish citators for tax purposes? a. John Wiley & Sons b. Wolters Kluwer (Commerce Clearing House) c. Thomson Reuters (RIA) d. Westlaw 89. Interpret the following citation: 64-1 USTC ¶9618, aff’d in 344 F.2d 966. a. A U.S. Tax Court Small Cases Division decision that was affirmed on appeal. b. A U.S. Tax Court decision that was affirmed on appeal. c. A U.S. District Court decision that was affirmed on appeal. d. A U.S. Circuit Court of Appeals decision that was affirmed on appeal. 90. Which citation refers to a Second Circuit Court of Appeals decision? a. 40 T.C. 1018. b. 159 F.2d 848 (CA-2, 1947). c. 354 F. Supp. 1003 (D.Ct. GA. 1972). d. 914 F.2d 396 (CA-3, 1990). 91. Which citation refers to a U.S. Tax Court decision? a. Apollo Computer, Inc. v. U.S., 95-1 (USTC ¶50,015 (Fed.Cl., 1994) b. Westreco, Inc., T.C. Memo. 1992-561 (1992). c. Bausch & Lomb, Inc. v. Comm., 933 F.2d 1084 (CA-2, 1991). d. Portland Manufacturing Co. v. Comm., 35 AFTR2d 1439 (CA-9, 1975). 92. If these citations appeared after a trial court decision, which one means that the decision was overruled? a. Aff’d 633 F.2d 512 (CA-7, 1980). Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 02: Working With the Tax Law b. Rem’d 399 F.2d 800 (CA-5, 1968). c. Aff’d 914 F.2d 396 (CA-3, 1990). d. Rev’d 935 F.2d 203 (CA-5, 1991). 93. Memorandum decision of the U.S. Tax Court could be cited as: a. T.C. Memo. 1990-650. b. 68-1 USTC ¶9200. c. 37 AFTR.2d 456. d. All of these choices are correct. 94. Which is a primary source of tax law? a. Serverino R. Nico, Jr., 67 T.C. 647 (1977). b. Article by a Federal judge in Tax Notes. c. An IRS publication. d. Written determination letter. 95. Which of the following statements about a nonacquiescence is correct? a. A nonacquiescence is issued in the Federal Registrar. b. Nonacquiescences are published only for certain regular decisions of the U.S. Tax Court. c. A nonacquiescence is published in the Internal Revenue Bulletin. d. The IRS does not issue nonacquiescences to adverse decisions that are not appealed. Essay 96. What are Treasury Department Regulations? 97. Compare Revenue Rulings with Revenue Procedures. 98. How can Congressional Committee Reports be used by a tax researcher? 99. What is a Technical Advice Memorandum? 100. Discuss the advantages and disadvantages of the Small Cases Division of the U.S. Tax Court. 101. Distinguish between the jurisdiction of the U.S. Tax Court and a U.S. District Court. 102. How do treaties fit within tax sources?

Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 02: Working With the Tax Law Answer Key 1. False 2. False 3. False 4. False 5. False 6. True 7. False 8. False 9. False 10. False 11. True 12. False 13. True 14. True 15. True 16. False 17. True 18. True 19. True 20. True 21. False 22. False 23. False 24. True 25. False Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 02: Working With the Tax Law 26. False 27. False 28. True 29. False 30. False 31. False 32. True 33. True 34. False 35. True 36. False 37. True 38. False 39. True 40. False 41. True 42. False 43. True 44. False 45. True 46. True 47. False 48. False 49. False 50. True Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 02: Working With the Tax Law 51. False 52. False 53. True 54. False 55. c 56. b 57. c 58. a 59. c 60. d 61. c 62. d 63. b 64. a 65. a 66. c 67. a 68. a 69. a 70. d 71. c 72. c 73. d 74. d 75. b 76. b Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 02: Working With the Tax Law 77. a 78. b 79. a 80. b 81. d 82. b 83. c 84. d 85. d 86. b 87. b 88. a 89. c 90. b 91. b 92. d 93. a 94. a 95. c 96. Regulations are issued by the U.S. Treasury Department under authority granted by Congress. Interpretive by nature, they provide taxpayers with considerable guidance on the meaning and application of the Internal Revenue Code. Regulations may be issued in proposed, temporary, or final form. Regulations carry considerable authority as the official interpretation of tax statutes. They are an important factor to consider in complying with the tax law. Courts generally ignore Proposed Regulations. 97. Revenue Rulings are official pronouncements of the National Office of the IRS. They typically provide one or more examples of how the IRS would apply a law to specific fact situations. Like Regulations, Revenue Rulings are designed to provide interpretation of the tax law. However, they do not carry the same legal force and effect as Regulations and usually deal with more restricted problems. Regulations are approved by the Secretary of the Treasury, whereas Revenue Rulings generally are not. Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 02: Working With the Tax Law Revenue Procedures are issued in the same manner as Revenue Rulings, but deal with the internal management practices and procedures of the IRS. Familiarity with these procedures can increase taxpayer compliance and help the IRS administer the tax laws more efficiently. A taxpayer’s failure to follow a Revenue Procedure can result in unnecessary delay or, in a discretionary situation, can cause the IRS to decline to act on behalf of the taxpayer.

98. Congressional Committee Reports often explain the provisions of proposed legislation and are a valuable source of ascertaining the intent of Congress. The intent of Congress is the key to interpreting new legislation by taxpayers, especially before Regulations are published. 99. The National Office of the IRS releases Technical Advice Memoranda (TAMs) weekly. TAMs resemble letter rulings in that they give the IRS’s determination of an issue. However, they differ in several respects. Letter rulings deal with proposed transactions and are issued to taxpayers at their request. In contrast, TAMs deal with completed transactions. Furthermore, TAMs arise from questions raised by IRS personnel during audits and are issued by the National Office of the IRS to its field personnel. TAMs are often requested for questions relating to exempt organizations and employee plans. TAMs are not officially published and may not be cited or used as precedent. 100. There is no appeal from the Small Cases Division. The jurisdiction of the Small Cases Division is limited to cases involving amounts of $50,000 or less. The proceedings of the Small Cases Division are informal (e.g., no necessity for the taxpayer to be represented by a lawyer or other tax adviser). Often, special trial judges rather than Tax Court judges preside over these proceedings. The decisions of the Small Cases Division are not precedents for any other court decision and are not reviewable by any higher court. Proceedings can be more timely and less expensive in the Small Cases Division. Some of these cases can now be found on the U.S. Tax Court Internet Website. 101. The U.S. Tax Court hears only tax cases and is the most popular tax forum. The U.S. District Court hears a wide variety of nontax cases, including drug crimes and other Federal violations, as well as tax cases. Some Tax Court justices have been appointed from IRS or Treasury Department positions. For these reasons, some people suggest that the U.S. Tax Court has more expertise in tax matters. 102. The U.S signs certain tax treaties (sometimes called tax conventions) with foreign countries to render mutual assistance in tax enforcement and to avoid double taxation. Tax legislation enacted in 1988 provided that neither a tax law nor a tax treaty takes general precedence. Thus, when there is a direct conflict with the Internal Revenue Code and a treaty, the most recent item will take precedence. A taxpayer must disclose on the tax return any position where a treaty overrides a tax law. There is a $1,000 penalty per failure to disclose for individuals and a $10,000 per failure to disclose penalty for corporations.

Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions True / False 1. Under the Federal income tax formula for individuals, a choice must be made between claiming deductions for AGI and itemized deductions. a. True b. False 2. Under the Federal income tax formula for individuals, the determination of adjusted gross income (AGI) precedes that of taxable income (TI). a. True b. False 3. Under the income tax formula, a taxpayer must choose between deductions for AGI and the standard deduction. a. True b. False 4. After Ellie moves out of the apartment she had rented as her personal residence, she recovers her damage deposit of $1,000. The $1,000 is not income to Ellie. a. True b. False 5. An above-the-line deduction refers to a deduction for AGI. a. True b. False 6. Because they appear on Schedule 1 of Form 1040, itemized deductions are also referred to as “Schedule 1 deductions.” a. True b. False 7. A decrease in a taxpayer’s AGI could increase the amount of medical expenses that can be deducted. a. True b. False 8. An increase in a taxpayer’s AGI could decrease the amount of charitable contribution that can be claimed. a. True b. False 9. Adjusted gross income (AGI) appears on page 1 of Form 1040. a. True b. False 10. All exclusions from gross income are reported on Form 1040. a. True b. False 11. The filing status of a taxpayer (e.g., single, head of household) must be identified before the applicable standard Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions deduction is determined. a. True b. False 12. The additional standard deduction for age and blindness is greater for married taxpayers than for single taxpayers. a. True b. False 13. The basic and additional standard deductions both are subject to an annual adjustment for inflation. a. True b. False 14. Many taxpayers who previously itemized will start claiming the standard deduction when they purchase a home. a. True b. False 15. Once they reach age 65, many taxpayers will switch from itemizing their deductions from AGI and start claiming the standard deduction. a. True b. False 16. Claude’s itemized deductions exceed the standard deduction allowed for the current year. Under these circumstances, Claude cannot claim the standard deduction. a. True b. False 17. As opposed to itemizing deductions from AGI, the majority of individual taxpayers choose the standard deduction. a. True b. False 18. Howard, age 82, died on January 2, 2024. On his final income tax return, the full amount of the basic and additional standard deductions will be allowed, even though Howard lived for only two days during the year. a. True b. False 19. In 2024, Ed is 66 and single. If he has itemized deductions of $15,000, he should not claim the standard deduction. a. True b. False 20. Jason and Peg are married and file a joint return. Both are over 65 years of age and Jason is blind. Their standard deduction for 2024 is $32,300. a. True b. False 21. Derek, age 46, is a surviving spouse. If he has itemized deductions of $30,250 for 2024, Derek should not claim the standard deduction. Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions a. True b. False 22. Buddy and Hazel are ages 72 and 71, respectively, and file a joint return. If they have itemized deductions of $30,000 for 2024, they should not claim the standard deduction. a. True b. False 23. Clara, age 68, claims head of household filing status. If she has itemized deductions of $22,000 for 2024, she should claim the standard deduction. a. True b. False 24. Monique is a resident of the United States and a citizen of France. If she files a U.S. income tax return, Monique cannot claim the standard deduction. a. True b. False 25. Dan and Donna are married and file separate returns for the year. If Dan itemizes his deductions from AGI, Donna cannot claim the standard deduction. a. True b. False 26. Benjamin, age 16, is claimed as a dependent by his parents. During 2024, he earned $1,100 at a car wash. Benjamin’s standard deduction is $1,750 ($1,300 + $450). a. True b. False 27. Debby, age 18, is claimed as a dependent by her mother. During 2024, Debby earned $1,200 in interest income on a savings account. Her standard deduction is $1,750 ($1,300 + $450). a. True b. False 28. Katrina, age 16, is claimed as a dependent by her parents. During 2024, she earned $5,600 as a checker at a grocery store. Her standard deduction is $6,050 ($5,600 earned income + $450). a. True b. False 29. When separate income tax returns are filed by married taxpayers, one spouse cannot claim the other spouse as a dependent. a. True b. False 30. The deduction for personal and dependency exemptions has been suspended from 2018 through 2025. a. True b. False Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 31. For the year a spouse dies, the surviving spouse is considered married for the entire year for income tax purposes. a. True b. False 32. In determining whether the gross income test is met for determining dependency status, only the taxable portion of a scholarship is considered. a. True b. False 33. Francisco and Maria divorced in December 2024. As they were married for more than one-half of the year, they are considered as married for 2024. a. True b. False 34. Albert buys his mother a TV. For purposes of meeting the support test, Albert cannot include the cost of the TV. a. True b. False 35. If an individual does not spend funds that have been received from another source (e.g., interest on municipal bonds), the unexpended amounts are not considered for purposes of the support test. a. True b. False 36. Using borrowed funds from a mortgage on her home, Leah provides 52% of her own support, and her sons furnished the rest. Leah can be claimed as a dependent under a multiple support agreement. a. True b. False 37. Roy and Linda divorced in 2023. The divorce decree awards custody of their children (all under age 17) to Linda but is silent as to who is entitled to treat them as dependents for purposes of claiming the child tax credit. If Roy furnished more than half of their support, he can claim the child tax credit for them in 2024. a. True b. False 38. In 2024, Hal furnishes more than half of the support of his ex-spouse and her father, both of whom live with him. The divorce occurred in 2023. Hal may claim the father-in-law and the ex-spouse as dependents. a. True b. False 39. After her divorce, Hope continues to support her ex-spouse’s sister, Cindy, who does not live with her. Hope can claim Cindy as a dependent. a. True b. False 40. Darren, age 20 and not disabled, earns $5,100 during 2024. Darren’s parents cannot claim him as a dependent unless he is a full-time student. a. True Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions b. False 41. Lucas, age 17 and single, earns $6,000 during 2024. His parents cannot claim him as a dependent if he does not live with them. a. True b. False 42. Sarah furnishes more than 50% of the support of her son and daughter-in-law who live with her. If the son and daughter-in-law file a joint return, Sarah cannot claim them as dependents. a. True b. False 43. Kim, a resident of Oregon, supports his parents who are residents of Canada but citizens of Korea. Kim can claim a dependent tax credit for his parents. a. True b. False 44. In determining the filing requirement based on gross income received, both additional standard deductions (i.e., age and blindness) are taken into account. a. True b. False 45. For dependents who have income, special filing requirements apply. a. True b. False 46. A taxpayer who itemizes completes Schedule A (Form 1040). a. True b. False 47. An individual taxpayer uses a fiscal year of March 1 to February 28. The due date of this taxpayer’s Federal income tax return is May 15 of each tax year. a. True b. False 48. Married taxpayers who file a joint return cannot later (i.e., after the filing due date) switch to separate returns for that year. a. True b. False 49. Married taxpayers who file separately cannot later (i.e., after the due date for filing) change to a joint return. a. True b. False 50. Surviving spouse filing status begins in the year in which the deceased spouse died. a. True Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions b. False 51. In January 2024, Jake’s spouse dies and he does not remarry. For tax year 2024, Jake may not be able to use the filing status available to married persons filing joint returns. a. True b. False 52. For tax purposes, married persons filing separate returns are treated the same as single taxpayers. a. True b. False 53. Katelyn is divorced and maintains a household in which she and her daughter, Crissa, live. Crissa, age 22, earns $11,000 during 2024 as a model. Katelyn does not qualify for head of household filing status. a. True b. False 54. Ed is divorced and maintains a home in which he and a dependent friend live. Ed does not qualify for head of household filing status. a. True b. False 55. In terms of income tax consequences, abandoned spouses are treated the same way as married persons filing separate returns. a. True b. False 56. As an abandoned spouse is treated as not married and has one or more dependent children, the abandoned spouse qualifies for the standard deduction available to head of household. a. True b. False 57. Currently, the top income tax rate in effect is not the highest it has ever been. a. True b. False 58. In any given year, that year's Tax Tables are released by the IRS before the Tax Rate Schedules for that year. a. True b. False 59. The kiddie tax does not apply to a child whose earned income is more than one-half of the child's support. a. True b. False 60. When the kiddie tax applies, the child need not file an income tax return because the child's income will be reported on the parents’ return. a. True Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions b. False 61. Once a child reaches age 19, the kiddie tax no longer applies. a. True b. False 62. In 2024, a child who has unearned income of $2,600 or less cannot be subject to the kiddie tax. a. True b. False 63. A child who is married cannot be subject to the kiddie tax. a. True b. False Multiple Choice 64. In terms of the tax formula applicable to individual taxpayers, which of the following statements is correct? a. In arriving at taxable income, a taxpayer must choose between the standard deduction and itemized deductions. b. In arriving at AGI, personal and dependency exemptions are subtracted from gross income. c. In arriving at taxable income, a taxpayer must choose between the standard deduction and the deduction for qualified business income. d. The tax formula does not apply if a taxpayer elects to claim the standard deduction. 65. Regarding the tax formula and its relationship to Form 1040, which of the following statements is correct? a. Most exclusions from gross income are reported on Schedule 2 of Form 1040. b. An above-the-line deduction refers to a deduction from AGI. c. A “Schedule 1 deduction” refers to a deduction for AGI. d. A taxpayer's AGI amount appears both at the bottom of page 1 and at the top of page 2 of Form 1040. 66. Which of the following items is deductible? a. Substantiated gambling losses (not in excess of gambling winnings) from state lottery. b. Contributions to mayor’s reelection campaign. c. Speeding ticket incurred while on business. d. Premiums paid on personal life insurance policy. 67. Which of the following is a deduction for AGI? a. State and local sales taxes. b. Interest on home mortgage. c. Charitable contributions. d. Unreimbursed moving expenses of an employee (who is in the military). 68. Which of the statements regarding the standard deduction is correct? a. Some taxpayers may qualify for two types of standard deductions. b. The standard deduction is not available to taxpayers who are dependents. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions c. The standard deduction may be taken as a for AGI deduction. d. The basic standard deduction is indexed for inflation but the additional standard deduction is not. 69. Which of the following is a deduction for AGI? a. Contributions to a traditional Individual Retirement Account. b. Child support payments. c. State income tax payments. d. Medical expenses. 70. Which of the following statements relating to the standard deduction is correct? a. If a taxpayer dies during the year, the standard deduction must be prorated. b. If a taxpayer is claimed as a dependent of another, the additional standard deduction is allowed in full (i.e., no adjustment is necessary). c. If spouses file separate returns, both must claim the standard deduction (rather than itemize their deductions from AGI). d. If a taxpayer is claimed as a dependent of another, no basic standard deduction is allowed. 71. During 2024, Hiroto had the following transactions: Salary Bank loan (proceeds used to buy personal auto) Alimony paid (divorce was finalized in 2010). Child support paid Gift from aunt

$50,000 10,000 12,000 6,000 20,000

Hiroto’s AGI is: a. $32,000. b. $38,000. c. $44,000. d. $56,000. 72. During 2024, Enrique had the following transactions: Salary Interest income on Xerox bonds Inheritance from uncle Contribution to traditional IRA Loss on sale of stock

$70,000 3,000 40,000 6,500 2,500

Enrique’s AGI is: a. $64,000. b. $66,500. c. $70,500. d. $104,000. Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 73. During 2024, Sandeep had the following transactions: Salary Interest income on City of Baltimore bonds Damages for personal injury (car accident) Punitive damages (same car accident) Cash dividends from Chevron Corporation stock

$ 80,000 1,000 100,000 200,000 7,000

Sandeep’s AGI is: a. $187,000. b. $285,000. c. $287,000. d. $387,000. 74. In 2024, Nai-Yu had the following transactions: Salary Gain from a stock investment Moving expense to change jobs Receipt of repayment of $20,000 loan she made to her sister in 2015 (includes no interest) State income taxes

$90,000 4,000 (11,000) 20,000 (5,000)

Nai-Yu’s AGI is: a. $103,000. b. $98,000. c. $94,000. d. $83,000. 75. Ayla, age 17, is claimed by her parents as a dependent. During 2024, she had interest income from a bank savings account of $2,000 and income from a part-time job of $4,200. Ayla’s taxable income is: a. $4,200 – $4,600 = $0. b. $6,200 – $14,600 = $0. c. $6,200 – $4,650 = $1,550. d. $6,200 – $4,200 = $2,000. 76. Tony, age 15, is claimed as a dependent by his grandmother. During 2024, he had interest income from Boeing Corporation bonds of $1,000 and earnings from a part-time job of $900. Tony’s taxable income is: a. $1,900. b. $1,900 – $14,600 = $0. c. $1,900 – $1,350 = $550. d. $1,900 – $1,300 = $600. 77. Hannah, age 70 and single, is claimed as a dependent by her daughter. During 2024, Hannah had interest income of $2,650 and $950 of earned income from babysitting. Hannah’s taxable income is: a. $0. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions b. $250. c. $2,200. d. $2,300. 78. Kyle and Liza are married and under 65 years of age. During 2024, they furnish more than half of the support of their 19-year old daughter, Kendra, who lives with them. She graduated from high school in May 2023. Kendra earns $15,000 from a part-time job, most of which she sets aside for future college expenses. Kyle and Liza also provide more than half of the support of Kyle’s cousin, who lives with them. Liza’s father, who died on January 3, 2024, at age 90, has for many years qualified as their dependent. How many dependents can Kyle and Liza claim? a. None b. One c. Two d. Three 79. Evan and Eileen Carter are married and file a joint return for 2024. Both are under 65 years of age. They provide more than half of the support of their daughter, Pamela (age 25), who is a full-time medical student. Pamela receives a $5,000 scholarship covering her tuition at college. Evan and Eileen furnish all of the support of Belinda (Evan’s grandmother), who is age 80 and lives in a nursing home. They also support Peggy (age 66), who is a friend of the family and lives with them. How many dependents may the Carters claim? a. None b. One c. Two d. Three 80. In which of the following situations may the individual not be claimed as a dependent of the taxpayer? a. A former spouse who lives with the taxpayer (divorce took place last year). b. A stepmother who does not live with the taxpayer. c. A married daughter who lives with the taxpayer. d. A half-brother who does not live with the taxpayer and is a citizen and resident of Honduras. 81. A qualifying child cannot include: a. A married son who files a joint return. b. A daughter who is away at college. c. A brother who is 28 years of age and disabled. d. A grandmother. 82. Ellen, age 12, lives in the same household with her father, grandfather, and uncle. The cost of maintaining the household is provided by her grandfather (40%) and her uncle (60%). Disregarding tie-breaker rules, Ellen is a qualifying child as to: a. Only her father. b. Only her grandfather and uncle. c. Only her uncle. d. All parties involved (i.e., father, grandfather, and uncle). 83. Millie, age 80, is supported during the current year as follows: Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions

Weston (a son) Faith (a daughter) Jake (a cousin) Brayden (unrelated close family friend)

Percent of Support 20% 35% 25% 20%

During the year, Millie lives in an assisted living facility. Under a multiple support agreement, indicate which parties can qualify to claim Millie as a dependent. a. Weston and Faith. b. Faith. c. Weston, Faith, Jake, and Brayden. d. Faith, Jake, and Brayden. 84. The Hutters filed a joint return for 2024. They provide more than 50% of the support of Carla, Ellie, and Aaron. Carla (age 18) is a cousin and earns $2,800 from a part-time job. Ellie (age 25) is their daughter and is a full-time law student. She received a $7,500 scholarship for tuition from her law school. Aaron is a brother who is a citizen of Israel but resides in France. Carla and Ellie live with the Hutters. How many dependents can the Hutters claim? a. None b. One c. Two d. Three 85. Regarding the rules applicable to filing of income tax returns, which of the following is an incorrect statement: a. Married persons who file joint returns cannot later (after the due date of the return) substitute separate returns. b. Married persons who file separate returns can later (after the due date of the return) substitute a joint return. c. The usual test as to when a taxpayer must file a return is based on the total of the following: personal exemption + basic standard deduction + both additional standard deductions. d. Special filing requirement rules exist for taxpayers who are claimed as dependents of another. 86. Kyle, whose spouse died in December 2021, filed a joint tax return for 2021. He did not remarry but has continued to maintain his home in which his two dependent children live. What is Kyle’s filing status in 2024? a. Head of household b. Surviving spouse c. Single d. Married filing separately 87. Kiran, whose spouse died in December 2023, maintains a household in which her dependent mother lives. Which of the following is her filing status for the tax year 2024? (Note: Kiran is the executor of her spouse’s estate.) a. Single b. Married, filing separately c. Surviving spouse d. Head of household 88. Which of the following taxpayers may file as a head of household in 2024? •

Marco provides all of the support for his mother, Sienna, who lives by herself in an apartment in Fort Lauderdale.

Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions Marco pays the rent and other expenses for the apartment and properly claims his mother as a dependent. •

Tammy provides over one-half the support for her 18-year old brother, Dan. He earned $5,200 in 2024 working at a fast-food restaurant and is saving his money to attend college in 2025. Dan lives in Tammy’s home.

•

Juan’s spouse left him late in December 2023. No legal action was taken, and Juan has not heard from his spouse in 2024. Juan supported his 6-year-old son, who lived with him throughout 2024.

a. Marco only b. Tammy only c. Marco and Juan only d. Marco, Tammy, and Juan 89. Natalie is married to Chad, who abandoned her in early June of 2024. She has not seen or communicated with him since then. She maintains a household in which she and her two dependent children live. Which of the following statements about Natalie’s filing status in 2024 is correct? a. Natalie can use the rates for single taxpayers. b. Natalie can file a joint return with Chad. c. Natalie can file as a surviving spouse. d. Natalie can file as a head of household. 90. Jeremy is married to Amy, who abandoned him in 2023. He has not seen or communicated with her since April of that year. He maintains a household in which their son, Evan, lives. Evan is age 25 and earns over $6,000 each year. For tax year 2024, Jeremy’s filing status is: a. Married, filing jointly. b. Head of household. c. Married, filing separately. d. Surviving spouse. 91. Regarding the Tax Tables related to the Federal income tax, which of the following statements is correct? a. For any one year, the Tax Tables are issued by the IRS after the Tax Rate Schedules. b. The Tax Tables will always yield the same amount of tax as the Tax Rate Schedules. c. Taxpayers can elect as to whether they use the Tax Tables or the Tax Rate Schedules. d. The Tax Tables can be used by an estate but not by a trust. 92. In which of the following situations will the kiddie tax not apply in 2024? a. The child is married but does not file a joint return. b. The child has unearned income of $2,600 or less. c. The child has unearned income that exceeds more than half of his (or her) support. d. The child is under age 24 and a full-time student. 93. Which the following is a correct statement relating to the kiddie tax in 2024? a. If the parents are divorced, the income of the noncustodial parent is used to determine the allocable parental tax. b. The components for the application of the kiddie tax are not subject to adjustment for inflation. Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions c. If the kiddie tax applies, the parents must include the income of the child on their own income tax return. d. The kiddie tax does not apply if both parents of the child are deceased. Matching Regarding classification as a dependent, classify each statement in one of the four categories: a. Could be a qualifying child. b. Could be a qualifying relative. c. Could be either a qualifying child or a qualifying relative. d. Could be neither a qualifying child nor a qualifying relative. 94. A son lives with taxpayer and earns $3,000. 95. A daughter who does not live with taxpayer. 96. A granddaughter, who lives with taxpayer, is 19 years old, earns $6,000, and is not a full-time student. 97. An uncle who lives with taxpayer. 98. A nephew who lives with taxpayer. 99. A niece who lives with taxpayer, is 20 years old, earns $6,000, and is a full-time student. 100. A half-brother who lives with taxpayer. 101. A cousin who does not live with taxpayer. 102. A stepdaughter who does not live with taxpayer. 103. A daughter-in-law who lives with taxpayer. 104. A family friend who is supported by and lives with the taxpayer. 105. An ex-spouse (divorce occurred last year) who lives with taxpayer. Match the statements that relate to each other. Note: Some choices may be used more than once. a. Not available to 65-year old taxpayer who itemizes. b. Exception for U.S. citizenship or residency test (for dependency exemption purposes). c. Largest basic standard deduction available to a dependent who has no earned income in 2024. d. Considered for dependency purposes. e. Qualifies for head of household filing status. f. A child (age 15) who is a dependent and has only earned income. g. Considered in applying gross income test (for dependency exemption purposes). h. Not considered in applying the gross income test (for dependency exemption purposes). i. Unmarried taxpayer who can use the same tax rates as married persons filing jointly. j. Exception to the support test (for dependency exemption purposes). k. A child (age 16) who is a dependent and has only unearned income of $4,500. Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions l. No correct match provided. 106. Surviving spouse 107. Scholarship funds for tuition 108. Additional standard deduction 109. Scholarship funds for room and board 110. Abandoned spouse 111. Basic standard deduction 112. Resident of Canada or Mexico 113. Age of a qualifying child 114. $1,300 115. Kiddie tax applies 116. Kiddie tax does not apply 117. Multiple support agreement Match the statements that relate to each other. Note: Choice i. may be used more than once. a. Available to a 70-year-old father claimed as a dependent by his son. b. Equal to tax liability divided by taxable income. c. The highest income tax rate applicable to a taxpayer. d. Not eligible for the standard deduction. e. No one qualified taxpayer meets the support test. f. Taxpayer’s ex-spouse does not qualify. g. A dependent child (age 18) who has only unearned income. h. Highest applicable rate is 37%. i. No correct match provided. 118. Multiple support agreement 119. Kiddie tax may be imposed 120. Nonresident alien 121. Tax Rate Schedule 122. Average income tax rate 123. Marginal income tax rate Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 124. Additional standard deduction 125. Relationship test (for dependency exemption purposes) Subjective Short Answer 126. Ashley had the following transactions during 2024: Salary Interest income on bonds— Issued by City of Nashville Issued by Chevron Corporation Alimony received (divorce finalized in 2015) Child support received (divorce finalized in 2015) City and state income taxes paid Bank loan obtained to pay for car purchase

$90,000 $4,000 5,000

9,000 5,000 20,000 (5,000) 28,000

What is Ashley’s AGI for 2024? 127. Kohsei had the following transactions for 2024: Salary Alimony paid (divorce finalized in 2016) Recovery from car accident— Personal injury damages Punitive damages Gift from parents Property sales— Loss on sale of boat (used for pleasure and owned 4 years) Gain on sale of ADM stock (held for 10 months as an investment)

$ 80,000 (4,000) $40,000 70,000

($4,000) 4,000

110,000 20,000

(–0–)

What is Kohsei’s AGI for 2024?

128. In 2024 Tom is single and has AGI of $50,000. He is age 70, has no dependents, and has itemized deductions (i.e., from AGI) of $7,000. Determine Tom’s taxable income for 2024. 129. Taylor, who works for a public accounting firm, had the following transactions for 2024: Salary Moving expenses incurred to change jobs Inheritance received from deceased uncle Life insurance proceeds from policy on uncle’s life (Taylor was named the beneficiary) Cash prize from church raffle Payment of church pledge Powered by Cognero

$ 85,000 (12,000) 300,000 200,000 3,000 (4,500) Page 15

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions What is Taylor’s AGI for 2024? 130. Michaella, age 23, is a full-time law student and is claimed by her parents as a dependent. During 2024, she received $1,500 interest income from a bank savings account and $14,450 from a part-time job. What is Michaella’s taxable income for 2024? 131. Warren, age 17, is claimed as a dependent by his father. In 2024, Warren has dividend income of $1,500 and earns $400 from a part-time job. a.

What is Warren’s taxable income for 2024?

b.

Suppose that Warren earned $1,200 (not $400) from the part-time job. What is his taxable income for 2024?

132. Helen, age 74 and a widow, is claimed as a dependent by her daughter. For 2024, Helen had income as follows: $2,500 interest on municipal bonds; $14,000 Social Security benefits; $3,000 income from a part-time job; and $2,800 dividends on stock investments. What is Helen’s taxable income for 2024? 133. Pedro is married to Consuela who lives with him. Both are U.S. citizens and residents of Nebraska. Pedro furnishes all of the support of his parents who are citizens and residents of the United States. He also furnishes all of the support of Consuela’s parents who are citizens and residents of El Salvador. Consuela has no gross income for the year. If Pedro and Consuela file as married persons filing jointly, how many dependents can they claim? 134. Hunter (age 68) and his wife Jenelle (age 70) file a joint return. They furnish all of the support of Luther (Hunter’s 90-year old father) who lives with them. In 2024, the couple received $6,000 of interest income on City of Chicago bonds and interest and dividend income on corporate stocks and bonds of $55,000. Compute Hunter and Jenelle’s taxable income for 2024. 135. In 2024, Ashley earns a salary of $63,000, has a gain on the sale of stock of $3,000, and receives interest income of $5,000. Her spouse died in 2023. Ashley has a dependent son, Tyrone, who is age eight. Her itemized deductions are $9,000. a. b.

What is her filing status? Calculate Ashley’s taxable income for 2024.

136. Black, Inc., is a domestic corporation with the following balance sheets for book and tax purposes at the end of the year. Assume a 21% corporate tax rate and no need for a valuation allowance. Tax Debit/(Credit) Assets Cash Accounts Receivable Buildings Accumulated Depreciation Furniture & Fixtures Accumulated Depreciation Total Assets Powered by Cognero

$

300 5,000 300,000 (150,000) 40,000 (21,000) $174,300

Book Debit/(Credit) $ 300 5,000 300,000 (80,000) 40,000 (15,000) $250,300 Page 16

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions

Liabilities Accrued Litigation Expense Note Payable Total Liabilities Stockholders’ Equity Paid in Capital Retained Earnings Total Liabilities and Stockholders’ Equity

$ –0– (116,000) ($116,000)

($ 27,000) (116,000) ($143,000)

($ 1,000) (57,300)

($ 1,000) (106,300)

($174,300)

($250,300)

Black, Inc.’s, gross deferred tax assets and liabilities at the beginning of Black’s year are as follows: Accrued litigation expense Subtotal Applicable tax rate Gross deferred tax asset Building – Accumulated depreciation Furniture & fixtures – Accumulated depreciation Subtotal Applicable tax rate Gross deferred tax liability

Beginning of Year $20,000 $20,000 × 21% $ 4,200 ($61,000) (3,000) ($64,000) × 21% ($13,440)

Black, Inc.’s, book income before tax is $6,000. Black records two permanent book-tax differences. It earned $250 in tax-exempt municipal bond interest, and it incurred $500 in nondeductible entertainment expense. Determine the change in Black’s deferred tax assets for the current year. Essay 137. The Deweys are expecting to save on their taxes for 2024. Not only have both incurred large medical expenses, but both reached age 65. During the year, they also recognized a $30,000 loss on stock they sold which was purchased as an investment several years ago. Are the Deweys under a mistaken understanding regarding their tax position? Explain. 138. Deductions for AGI are often referred to as “above-the-line” or “Schedule 1” deductions. Explain. 139. Adjusted gross income (AGI) sets the ceiling or the floor for certain deductions. Explain and illustrate what this statement means. 140. During the current year, Doris received a large gift from her parents and a sizeable inheritance from an uncle. She also paid premiums on an insurance policy on her life. Doris is confused because she cannot find any place on Form 1040 to report these items. Explain. Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 141. Mel is not quite sure whether an expenditure he made is a deduction for AGI or a deduction from AGI. Since he plans to choose the standard deduction option for the year, does the distinction matter? Explain. 142. When filing their Federal income tax returns, the Youngs always claimed the standard deduction. After they purchased a home, however, they started to itemize their deductions from AGI. a.

Explain the reason for the change.

b.

Suppose they purchased the home in November 2023, but did not start itemizing until tax year 2024. Why the delay as to itemizing?

143. The Dargers have itemized deductions that exceed the standard deduction. However, when they file their joint return, they choose the standard deduction option. a.

Is this proper procedure?

b.

Aside from a possible misunderstanding as to the tax law, what might be the reason for the Darger’s choice?

144. Under what circumstances, if any, may an ex-spouse be claimed as a dependent? 145. In resolving qualified child status for dependency purposes, why are tiebreaker rules necessary? Can these rules be waived? 146. In satisfying the support test and the gross income test for claiming someone as a dependent, a scholarship received by the person being claimed is handled the same way for each test. Do you agree or disagree with this statement? Why? 147. In order to claim someone other than a qualifying child as a dependent, a taxpayer must meet the support test. Generally, this is done by furnishing more than 50% of a dependent’s support. What exceptions exist, if any, where the support furnished need not be more than 50%? 148. In applying the gross income test in the case of dependents that are married, could the application of community property laws have any effect? Explain. 149. In meeting the criteria of a qualifying child for dependency purposes, when if ever, might the child’s income become relevant? 150. Lena is 66 years of age, single, and blind and is not claimed as a dependent. How much gross income must she have before she is required to file a Federal income tax return for 2024? 151. Contrast the tax consequences resulting from the following filing status situations: a.

Married filing jointly versus married filing separately.

b.

Married filing separately versus single.

c.

Married filing separately versus abandoned spouse status.

Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 152. Jayden and Dean Harper are married and use the calendar year for tax purposes. a.

If the Harpers file a joint return for 2024, can they later switch to separate returns for 2024?

b.

If the Harpers file separate returns for 2024, can they later switch to a joint return for 2024?

153. When married persons file a joint return, joint and several liability results. What does this mean? 154. Regarding head of household filing status, comment on the following: a.

A taxpayer qualifies even though he maintains a household which he and the dependent do not share.

b.

A taxpayer does not qualify even though the person sharing the household is a dependent.

c.

The usual eventual filing status of a surviving spouse.

155. The major advantage of being classified as an abandoned spouse is that the taxpayer is treated for tax purposes as being single and not married. This means that an abandoned spouse can use the more favorable tax rates available to single persons than those available to married persons filing separately. Comment on the accuracy of this conclusion. 156. For the past few years, Corey’s filing status has been as follows: 2020 (married/joint); 2021 (married/separate); 2022 (surviving spouse); 2023 (surviving spouse); and 2024 (head of household). Explain what probably has happened. 157. For 2024, Tom has taxable income of $48,005. When he uses the Tax Tables, Tom finds that his tax liability is higher than under the Tax Rate Schedules. a.

Why is there a difference?

b.

Can Tom use the Tax Rate Schedules?

158. List at least three exceptions to the application of the kiddie tax. 159. The Martins have a teenage son who has become an accomplished bagpiper. With proper promotion and scheduling, the son has good income potential by charging for his services at special events (particularly funerals). However, the Martins are fearful that the income could generate a kiddie tax and cause them the loss of a dependent tax credit. Are the Martins’ concerns justified? Explain. 160. After paying down the mortgage on their personal residence, the Hills have found that their itemized deductions for each year are always slightly less than the standard deduction option. a.

Explain what has happened.

b.

What remedy do you suggest?

161. Mandeep’s parents live in another state and she cannot claim them as her dependents. If Mandeep pays their medical expenses, can she derive any tax benefit from doing so? Explain.

Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions Answer Key 1. False 2. True 3. False 4. True 5. True 6. False 7. True 8. False 9. True 10. False 11. True 12. False 13. True 14. False 15. True 16. False 17. True 18. True 19. False 20. False 21. True 22. False 23. True 24. False 25. True Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 26. False 27. False 28. True 29. False 30. True 31. True 32. True 33. False 34. False 35. True 36. False 37. False 38. True 39. True 40. True 41. True 42. False 43. False 44. False 45. True 46. True 47. False 48. True 49. False 50. False Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 51. True 52. False 53. True 54. True 55. False 56. True 57. True 58. False 59. True 60. False 61. False 62. True 63. False 64. a 65. c 66. a 67. d 68. a 69. a 70. b 71. b 72. a 73. c 74. c 75. c 76. c Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 77. b 78. c 79. d 80. d 81. d 82. d 83. a 84. c 85. c 86. a 87. d 88. d 89. d 90. c 91. a 92. b 93. d 94. c 95. b 96. d 97. b 98. c 99. a 100. c 101. d Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 102. b 103. b 104. b 105. b 106. i 107. h 108. a 109. g 110. e 111. a 112. b 113. d 114. c 115. k 116. f 117. j 118. e 119. g 120. d 121. h 122. b 123. c 124. a 125. f 126. $100,000 [$90,000 (salary) + $5,000 (interest on Chevron Corporation bonds) + $5,000 (alimony received)]. Interest on the City of Nashville bonds is an exclusion from gross income. The bank loan has no tax effect, because Ashley is obligated to repay the amount borrowed. City and state income taxes are deductions from AGI. Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 127. $150,000 [$80,000 (salary) – $4,000 (alimony paid) + $70,000 (punitive damage award) + $4,000 (gain on the sale of stock investment)]. The personal injury recovery and the gift from Kohsei’s parents are exclusions from gross income. The loss from the sale of the boat is personal and therefore nondeductible. 128. $33,450. Tom’s standard deduction is $14,600 (basic) + $1,950 (additional) for a total of $16,550. Consequently, he should select the standard deduction option since it exceeds his itemized deductions of $7,000. As a result, his taxable income is $33,450: $50,000 (AGI) – $16,550 (standard deduction). 129. $88,000 [$85,000 (salary) + $3,000 (raffle prize)]. The moving expenses are not deductible (except for military personnel). The inheritance and life insurance proceeds are exclusions from gross income. The payment by Taylor of her church pledge is a deduction from AGI. As a result, it does not enter into the determination of AGI. 130. $1,600. Michaella’s standard deduction is the greater of $14,450 (earned income) + $450 or $1,300. But the $15,150 is limited to $14,600 (the standard deduction allowed a single person). So, $1,500 + $14,450 – $14,600 = $1,600 taxable income. 131. a.

$600. Warren’s standard deduction is $1,300 (the greater of $400 (earned income) + $450 or $1,300). So, $1,500 + $400 – $1,300 = $600 taxable income.

b.

$1,050. Warren’s standard deduction now becomes $1,650 ($1,200 + $450). So, $1,500 + $1,200 – $1,650 = $1,050 taxable income.

132. $400 [$3,000 (income from job) + $2,800 (dividends) – $3,450 (basic standard deduction is $3,000 + $450; this is greater than $1,300) – $1,950 (additional standard deduction for age)]. The Social Security benefits and the interest on municipal bonds are excludible from her gross income (i.e., not taxable). 133. Two. Only Pedro's parents are dependents. Consuela’s parents meet neither the citizenship nor residency tests. 134. $22,700. Their gross income is $55,000 (since the $6,000 interest on municipal bonds is an exclusion). They are entitled to a basic standard deduction of $29,200 and additional standard deductions of $1,550 each for being age 65 or older. Luther is a dependent (but this has no impact on their taxable income determination; it will provide a dependent tax credit). So taxable income is $22,700 [$55,000 – $29,200 – $3,100 (2 × $1,550)]. 135. a. Ashley satisfies the requirements for a surviving spouse. b. Salary Gain on sale of stock Interest AGI Less: Standard deduction Taxable income

Powered by Cognero

$63,000 3,000 5,000 $71,000 (29,200) $41,800

Page 25

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions

136.

Accrued litigation expense Subtotal Applicable tax rate Gross deferred tax asset Change in deferred tax Asset

Beginning Current of Year Year Difference End of Year $20,000 $7,000 $27,000 $20,000 $7,000 $27,000 × 21% × 21% $ 4,200 $ 5,670 $1,470

137. The Deweys are expecting to qualify for two additional standard deductions and anticipating a deduction for medical expenses. The two objectives cannot coexist. Claiming a medical deduction requires that they itemize. Taxpayers who itemize, however, cannot claim any type of standard deduction. Regarding the stock loss, and presuming no capital gains, only $3,000 can be deducted against their other income. The balance of $27,000 must be carried over to future years. 138. Above-the-line means before AGI (or for AGI deductions). These deductions appear on Schedule 1 of Form 1040. 139. By a ceiling what is meant is that the deduction cannot exceed a percentage of AGI. For example, the charitable contribution deduction cannot exceed 30% of a taxpayer’s AGI for certain contributions of property. By a floor what is meant is that a deduction is allowed only if it exceeds a percentage of AGI. For example, the deduction for medical expenses is limited to the excess of these expenses over 7.5% of AGI. 140. Gifts and inheritances are exclusions from gross income. Like most exclusions, they are not reported on Form 1040. Premiums on a personal life insurance policy are nondeductible. Nondeductible items, such as these premiums, are not reported on Form 1040 141. It makes a great deal of difference if the expenditure is a deduction for AGI. If it is, Mel will benefit taxwise. It makes no difference, however, if it is a deduction from. The standard deduction is in lieu of itemized deductions. 142. a.

The interest on the home mortgage and the property taxes gave the Youngs itemized deductions in excess of the applicable standard deduction.

b.

The home mortgage interest and property taxes for two months (i.e., November and December) may not have been enough to place the Youngs in a position to exceed the applicable standard deduction for 2023. In 2024, however, a full 12 months worth of home mortgage interest and property taxes in involved.

Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions 143. a. Yes. The choice between itemizing and claiming the standard deduction is elective and up to the taxpayer. b.

The excess of the itemized deductions over the standard deduction may be marginal, and the Dargers are willing to forgo the effort of itemizing for a small tax savings. Also, they may not maintain the records (i.e., substantiation) that some itemized deductions require. Additionally, it reduces their audit exposure.

144. As an ex-spouse does not meet the relationship test, the ex-spouse must be a member of the taxpayer’s household. The association cannot be in violation of local law and the year involved cannot be the year of the divorce. 145. A person being claimed as a dependent may satisfy qualified child status as to more than one taxpayer. See the concept summary (and the related examples) in the text. The tiebreaker rules can be waived. 146. Disagree. For purposes of the support test, all of the scholarship is disregarded. For purposes of the gross income test, only the taxable part is considered (i.e., the nontaxable part is disregarded). 147. One exception involves the multiple support agreement. Here, family members collectively furnish more than 50% of the support, but no one person does so. For those qualified individuals who contribute more than 10%, the group can designate which person may claim the dependency exemption. The second exception involves the divorced parents of children. The custodial parent is entitled to the dependency exemptions for the children. If this parent agrees not to claim the exemption(s), then the noncustodial parent may do so. 148. Most often, the application of community property laws will impact on the dependency status of the spouse of a qualifying child. Suppose, for example, Roger maintains a household that includes his 18-year-old daughter, Alice, and her husband, Craig. Assume further that, in 2024, Alice earns $12,000 from a part-time job while Craig has no income. In a common law state, Craig meets the gross income test (he has no gross income; in 2024, a non-qualifying child must have gross income less than $5,050) while Alice’s gross income, as a qualifying child, is immaterial. In a community property state, however, Craig now violates the gross income test with $6,000 (50% × $12,000) of income, while Alice remains immune. 149. The amount of income earned by the qualifying child normally is of no consequence. If, however, such income is used to make the child self-supporting, then the child can no longer be a qualifying child. Such child also would not be a qualifying relative due to the gross income and support tests. 150. $16,550 [$14,600 (basic standard deduction) + $1,950 (additional standard deduction for age)]. Note that the additional standard deduction for blindness does not come into play in determining the gross income required for filing a tax return. 151. a.

b. c.

Married persons filing jointly have a number of tax elections available to them that cannot be chosen if they file separate returns. For example, the credit for child and dependent care expenses and the earned income credit are not available unless married persons file joint returns. Married persons filing separately often will not fare as well as the couple that remains single. One advantage is that, each person has full flexibility in choosing between the standard deduction and itemizing and is not bound by what the companion does. Because abandoned spouse status means that the taxpayer is treated as being single, the same advantages mentioned in part a. above exist when compared to married persons filing separate

Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions returns. Even more advantageous is that abandoned spouse status permits the use of head of household filing status. Head of household tax rates are lower than those applicable to single persons (and married persons filing separate returns). Also, the standard deduction amount for head of household filing status is larger than that available to single persons (and married persons filing separate returns).

152. a. Unless the Harpers do so on or before the regular filing date (i.e., April 15, 2025), they cannot switch to separate returns. b.

Yes, they can unless the statute of limitations has run (usually three years from the filing date).

153. Joint and several liability means that either spouse is fully liable for any income tax due for the year. As a result, if more tax is due, the IRS can pursue either spouse for the deficiency. 154. a. If the household is that of a dependent parent, it need not be taxpayer’s household. b.

c.

If the household does not include a dependent that meets the relationship test, head of household filing status is unavailable. An example would be a taxpayer who maintains a household for a cousin who lives with her. Even if the cousin is a dependent under the member of the household test, taxpayer does not qualify for head of household filing status. A cousin does not satisfy the relationship test. Once the two-year surviving spouse period terminates, the taxpayer usually will qualify for head of household filing status if the taxpayer continues to maintain a household for a dependent child..

155. The conclusion is incorrect. The classification of abandoned spouse allows the taxpayer to the use of the rates for head of household filing status which are more favorable than married filing separately. 156. One probable explanation is that Corey’s wife died in 2021 and the executor of her estate refused to agree to filing a joint return. As surviving spouse status does not continue beyond two years, Corey is relegated to head of household status in 2024. 157. a. Even though the Tax Tables are based on the Tax Rate Schedules, minor differences in the tax liabilities will result. The variance is due to the fact that the tax for any table bracket amount is determined by using the midpoint amount. In Tom’s case, the tax on the $48,000 – $48,050 bracket is the tax on $48,025. Because Tom’s taxable income (i.e., $48,005) is below $48,025, his tax will be higher. Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 03 Tax Formula and Tax Determination An Overview of Property Transactions b.

No. Unless taxable income is $100,000 or more (or in some other special situations), taxpayers must use the Tax Tables.

158. ∙ Unearned income of $2,600 or less (in 2024). ∙ Age 19 (or age 24 if a full-time student) or older. ∙ Both parents deceased. ∙ Earned income in excess of 50% of support. ∙ Married and filing a joint return with spouse. 159. The income received by the son would be earned income. Therefore, the kiddie tax is not a problem since it applies only to unearned income. As long as the son is under age 19 (or a full-time student under age 24), he is a dependent as a qualifying child. Under these rules, the amount of the son’s income does not matter (unless he becomes self-supporting). If the son is age 19 (or older) and not a student, he must satisfy the qualifying relative rules. Here, not meeting the gross income test (in 2024, gross income must be less than $5,050) would mean their son would not be a dependent. 160. a. Paying down the mortgage reduced the interest expense deduction. With less interest expense, the Hills’ deductions from AGI no longer exceed the standard deduction amount. b.

The Hills should begin concentrating their other itemized deductions (e.g., charitable contributions) by paying for multiple years in the same year. Being on a cash basis, the timing of the deduction is based on the year of payment. In alternate years, moreover, the standard deduction is claimed.

161. If Mandeep could otherwise claim her parents as dependents except for not satisfying either the gross income or the joint return tests, she can claim any medical expenses paid on their behalf.

Powered by Cognero

Page 29

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions True / False 1. The realization requirement gives an incentive to own assets that have increased in value and to sell assets whose value has decreased. a. True b. False 2. Judy is a cash basis attorney. This year, she performed services in connection with the formation of a corporation and received stock with a value of $4,000 for her services. By the end of the year, the value of the stock had decreased to $2,000. She continued to hold the stock. Judy must recognize $4,000 of gross income from the stock for the current year. a. True b. False 3. Barney painted his house, which saved him $3,000. According to the realization requirement, Barney must recognize $3,000 of income. a. True b. False 4. Nicholas owned stock that decreased in value by $20,000 during the year, but he did not sell the stock. He earned $45,000 salary, but received only $34,000 because $11,000 in taxes were withheld. Nicholas saved $10,000 of his salary and used the remainder for personal living expenses. Nicholas’s economic income for the year exceeded his gross income for tax purposes. a. True b. False 5. The fact that the accounting method the taxpayer uses to measure income is consistent with GAAP does not ensure that the method will be acceptable for tax purposes. a. True b. False 6. The financial accounting principle of conservatism is not well suited to the task of measuring taxable income. a. True b. False 7. A cash basis taxpayer purchased a certificate of deposit for $1,000 on July 1, 2024 that will pay $1,100 upon its maturity on June 30, 2026. The taxpayer must recognize a portion of the income in 2024. a. True b. False 8. Ralph purchased his first Series EE bond during the year. He paid $709 for a 10-year bond with a $1,000 maturity value. The yield to maturity on the bonds was 3.5%. Ralph is not required to recognize the $291 ($1,000 – $709) original issue discount until the bond matures. However, Ralph can elect to amortize the discount over the 10-year period. a. True b. False 9. A sole proprietor purchased an asset for $1,000 in 2024. Its value was $1,500 at the end of 2024. In 2025, the taxpayer sold the asset for $1,400. In 2025, the proprietor realized a taxable gain of $400 but an economic loss of $100. Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions a. True b. False 10. At the beginning of 2024, Mary purchased a 3-year certificate of deposit (CD) for $8,760. The maturity value of the certificate was $10,000 and it was to yield 4.5%. She also purchased a Series EE bond for $6,400 with a maturity value in 10 years of $10,000. Mary must recognize $1,240 of income from the certificate of deposit in 2024 and $3,600 from the Series EE bonds in 2033. a. True b. False 11. In 2012, DeAndre purchased land for $150,000. He also received $10,000 from a local cable television company in exchange for allowing the company to run an underground cable across his property. DeAndre is not required to recognize income from receiving the $10,000 because it was a return of his capital invested in the land. a. True b. False 12. In December 2023, Adriana collected the December 2023 and January 2024 rent from a tenant. Adriana is a cash basis taxpayer. The amount collected in December 2023 for the 2024 rent should be included in her 2024 gross income. a. True b. False 13. On December 1, 2024, Daniel, an accrual basis taxpayer, collects $12,000 rent for December 2024 and $12,000 for January 2025. Daniel must include the $24,000 in 2024 gross income. a. True b. False 14. On January 1, 2024, an accrual basis taxpayer entered into a contract to provide termite inspection service each month for 24 months. The amount received for the contract was $2,400. The taxpayer reported $1,200 as income on its financial statement for 2024 and should do the same for its tax return. a. True b. False 15. An advance payment received in June 2024 by an accrual basis and calendar year taxpayer for services to be provided over a 36-month period can be spread over four tax years. a. True b. False 16. In 2024, Juan, a cash basis taxpayer, was offered $3,000,000 for signing a professional baseball contract. He counteroffered that he would receive $900,000 per year for four years beginning in 2025. The team accepted the counteroffer. Juan constructively received $3,000,000 in 2024. a. True b. False 17. The constructive receipt doctrine does not apply to accrual basis taxpayers. a. True b. False Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 18. Fred is a full-time teacher. He has written a book and receives royalties from it. Fred’s mother, Mabel, is age 65 and lives on her Social Security benefits and gifts from her son. This year Fred directed the publisher to make the royalty check payable to Mabel because she needs the money for support. Fred must include the amount of the royalty check in his gross income. a. True b. False 19. Jessica is a cash basis taxpayer. When she failed to repay a loan, the bank garnished her salary. Each week $60 was withheld from Jessica’s salary and paid to the bank. Jessica is required to include the $60 each week in her gross income even though it is the creditor that benefits from the income. a. True b. False 20. ABC Corporation declared a dividend for shareholders of record as of December 24, 2023. The dividend checks were mailed on December 31, 2023. Ed, a cash basis shareholder, received the dividend check on January 2, 2024. Ed can delay reporting the income from the dividend until 2024. a. True b. False 21. Tom, a cash basis taxpayer, purchased a bond on March 31 for $10,000, plus $100 accrued interest. In December, he collected $500 interest from the bond. Tom’s interest income from the bond for the year is $500. a. True b. False 22. When stock is sold after the date a dividend is declared but before the record date, the buyer must recognize as income the dividend declared. a. True b. False 23. Himari delivers pizzas for a pizza shop. On Wednesday, December 31, 2024, Himari made several deliveries and collected $400 from customers. However, Himari forgot to turn in the proceeds for the day to her employer until the following Friday, January 2, 2025. The pizza shop owner recognizes the income of $400 when he receives it from Himari in 2025. a. True b. False 24. Jake is the sole shareholder of an S corporation that earned $60,000 in 2024. The corporation was short on cash and therefore distributed only $15,000 to him in 2024. Jake is required to recognize $60,000 of income from the S corporation in 2024. a. True b. False 25. The B & W Partnership earned taxable income of $140,000 for the year. Bryan is entitled to 50% of the profits, but he withdrew only $60,000 during the year. Bryan’s gross income from the partnership for the year is $60,000. a. True b. False Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 26. When a business is operated as an S corporation, the shareholders must pay the tax on their share of the S corporation’s income even if the S corporation did not distribute the income to the shareholders. a. True b. False 27. Mark is a cash basis taxpayer. He is a partner in the M&M partnership, and his share of the partnership’s profits for 2024 is $90,000. Only $40,000 was distributed to him in January 2024, and this was his share of the 2023 partnership profits. None of the 2024 profits was distributed. Mark’s gross income from the partnership for 2024 is $40,000. a. True b. False 28. Rhonda has a 30% interest in the capital and profits of the ABC Partnership. In the first year of the partnership, 2024, it earned $150,000. However, the partners agreed that nothing would be distributed until the end of March 2025. The distributions were to be delayed because it was unclear as to whether business conditions would remain good in 2025. Things were going well in 2025 and, therefore, the partnership distributed $30,000 to Rhonda at the end of March. The partnership’s income for 2025 was $60,000. Rhonda must recognize $30,000 of gross income in 2024 and $18,000 in 2025. a. True b. False 29. Alvin is the sole shareholder of an S corporation that earned $200,000 in 2024 and distributed $75,000 to him. Alvin must recognize $75,000 as income from the S corporation in 2024. a. True b. False 30. Samantha and her son, Brent, are cash basis taxpayers. Samantha gave Brent a corporate bond with a face amount and fair market value of $10,000. On the date of the gift, March 31, 2024, the accrued interest on the bond was $100. On December 31, 2024, Brent collected $400 interest on the bond. Brent must include in gross income the $300 interest earned after the date of the gift. a. True b. False 31. In all community property states, the income from property that was inherited by a spouse after the marriage is treated as all earned by the spouse who inherited the property. a. True b. False 32. Ted earned $150,000 during the current year. He paid Alice, his former wife, $75,000 in alimony. The couple divorced in 2017. Alice must include $75,000 in her current year gross income. a. True b. False 33. George and Aaron divorced in 2024. Pursuant to the divorce agreement, George is required to pay Aaron $20,000 of alimony each year. George earns $75,000 a year. Aaron is required to include the alimony payments in gross income, although George earned the income. a. True b. False Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 34. After his divorce in 2015, Jeff was required to pay $18,000 per year to his former spouse, Darlene, who had custody of their child. Jeff’s payments will be reduced to $12,000 per year in the event the child dies or reaches age 21. During the year, Jeff paid the $18,000 required under the divorce agreement. Darlene must include $12,000 in gross income. a. True b. False 35. Paula transfers stock to her former spouse, Antonio, pursuant to a divorce agreement. Paula’s cost of the stock was $75,000 and its fair market value on the date of the transfer is $95,000. Paula must recognize a $20,000 gain on the transfer. a. True b. False 36. Jacob and Emily were co-owners of a personal residence. As part of their divorce agreement entered into in 2024, Emily paid Jacob cash for his interest in the personal residence. This cash payment results in a taxable gain to Jacob if he receives more cash than his share of the cost of the residence. a. True b. False 37. Father made an interest-free loan of $25,000 to Son who used the money to buy an SUV. Son had $1,600 interest income from a certificate of deposit for the year. Father is not required to impute interest income. a. True b. False 38. In the case of a below-market gift loan for which there is no exception to the imputed interest rules, the lender is deemed to have received interest income even though no interest is charged and collected. a. True b. False 39. In the case of a gift loan of less than $100,000, the imputed interest rules apply if the donee has net investment income of over $1,000. a. True b. False 40. Susan purchased an annuity for $200,000. She is to receive $18,000 each year and her life expectancy is 13 years. If Susan collects under the annuity for 14 years, the entire $18,000 received in the 14th year must be included in her gross income. a. True b. False 41. Terri purchased an annuity for $100,000. She was to receive $10,000 per year and her life expectancy was 20 years. She died after receiving eight payments. Terri’s final return should reflect a loss of $20,000 ($100,000 – $80,000). a. True b. False 42. If a lottery prize winner transfers the prize to a qualified government unit or nonprofit organization, then the prize is excluded from the winner’s gross income if the amount of the prize does not exceed 30% of the winner’s AGI. a. True Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions b. False 43. In the case of a person with other income of $300,000, 15% of their Social Security benefits received are excluded from gross income. a. True b. False 44. Norma’s income for the year is $27,000 from part-time work and $9,000 of Social Security benefits. Norma is not married. A portion of her Social Security benefits must be included in her gross income. a. True b. False 45. Lois, who is single, received $9,000 of Social Security benefits. She also received $25,000 from dividends, interest, and her employer’s pension plan. If Lois sells a capital asset that produces a $1,000 recognized loss, Lois’s taxable income will decrease by $1,000. a. True b. False Multiple Choice 46. On a particular Saturday, Tom had planned to paint a room in his house, but his employer gave him the opportunity to work that day. If Tom works, he must hire a painter for $120. Assuming Tom is in the 24% marginal tax bracket, what is the least amount he must get paid to be able to pay the painter and still have a positive cash flow from working? a. $0. b. $120. c. $158. d. $500. 47. The tax concept and economic concept of income are in agreement on which of the following? a. The fair rental value of an owner-occupied home should be included in income. b. The increase in value of assets held for the entire year should be included in income for the year. c. Rent income for 2024 collected in 2023 is income for 2023. d. Income includes the value of things grown or produced by the taxpayer for the taxpayer's own consumption. 48. The Blue Utilities Company paid Sue $2,000 for the right to lay an underground electric cable across her property anytime in the future. a. Sue must recognize $2,000 gross income in the current year if the company did not install the cable during the year. b. Sue is not required to recognize gross income from the receipt of the funds. c. Sue must recognize $2,000 gross income in the current year regardless of whether the company installed the cable during the year. d. Sue must recognize $2,000 gross income in the current year, and when the cable is installed, she must reduce her cost basis in the land by $2,000. 49. For purposes of determining gross income, which of the following is true? a. A mechanic completed repairs on an automobile during the year and collected money from the customer. The Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions customer was not satisfied with the repairs and sued the mechanic for a refund. The mechanic can defer recognition of the income until the suit has been settled. b. A taxpayer who finds and keeps a wallet full of money is required to recognize income. c. An employee receives stock worth $1,000 from her employer as compensation for her services. The employee cannot sell the stock for three years and must forfeit the stock if she leaves her job before she is able to sell it. The employee must include $1,000 in her gross income in the year she receives the stock. d. All of these choices are false. 50. Asia, a successful executive, is negotiating a compensation plan with her potential employer. The employer has offered to pay Asia a $600,000 annual salary, payable at the rate of $50,000 per month. Asia counteroffers to receive a monthly salary of $40,000 ($480,000 annually) and a $180,000 bonus in five years when Asia will be age 65. a. If the employer accepts Asia’s counteroffer, Asia will recognize $660,000 at the time the offer is accepted. b. If the employer accepts Asia’s counteroffer, Asia will recognize as gross income $55,000 per month [($480,000 + $180,000)/12]. c. If the employer accepts Asia’s counteroffer, Asia will recognize $40,000 income each month for the year and $180,000 in year 5. d. If the employer accepts Asia’s counteroffer, Asia must recognize imputed interest income on the $180,000 to be received in five years. 51. Maroon Corporation expects its employees’ income tax rates to increase next year. The employees use the cash method. The company presently pays on the last day of each month. The company is considering changing its policy so that the December salaries will be paid on the first day of the following year. What would be the effect on an employee of the proposed change in company policy beginning December 2024? a. The employee would be required to recognize the December 2024 salary in December 2024 because it is constructively received at the end of the month. b. The employee would be required to recognize the December 2024 salary in December 2024 because the employee has a claim of right to the income when it is earned. c. The employee will not be required to recognize the December 2024 salary until it is received, in 2025. d. The employee can elect to either include the December 2024 salary in 2024 or 2025. 52. The annual increase in the cash surrender value of a life insurance policy: a. Is taxed according to the original issue discount rules. b. Is not included in gross income because the policy must be surrendered to receive the cash surrender value. c. Reduces the deduction for life insurance expense. d. Is exempt because it is life insurance proceeds. 53. Assume a cash basis taxpayer purchased a three-year certificate of deposit on January 1 of the current year. Under the original issue discount (OID) rules which of the following is true? a. All of the income must be recognized in the year of maturity. b. The OID will be included in gross income for the year of purchase. c. The interest income will be recognized equally over three years. d. The interest income will be recognized over three years but will be greater in the third year than in the first year. 54. Freddy purchased a certificate of deposit for $20,000 on July 1, 2024. The certificate’s maturity value in two years (June 30, 2026) is $21,218, yielding 3% before-tax interest. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions a. Freddy must recognize $1,218 gross income in 2024. b. Freddy must recognize $1,218 gross income in 2026. c. Freddy must recognize $690 ($1,218 × 0.5) gross income in 2026. d. Freddy must recognize $300 (0.03 × $20,000 × 0.5) gross income in 2024. 55. Jerry purchased a U.S. Series EE savings bond for $744. The bond has a maturity value in 10 years of $1,000 and yields 3% interest. This is the first Series EE bond that Jerry has ever owned. a. Jerry can defer the interest income until the bond matures in 10 years. b. Jerry must report $25.60 [($1,000 – $744)/10] interest income each year he owns the bond. c. The interest on the bonds is exempt from Federal income tax. d. Jerry can report all of the $256 as a capital gain in the year it matures. 56. Office Palace, Inc., signed a contract to lease an all-in-one printer to a new customer, Ashley, on December 27, 2024. The contract called for rent of $600 per month for a period of 36 months beginning January 1, 2025. Ashley was required to pay the first and last month’s rent at the time the lease was signed. Ashley was also required to pay a $1,500 damage deposit. Office Palace must recognize as income for the lease: a. $0 in 2024, if Office Palace is an accrual basis taxpayer. b. $7,800 in 2025, if Office Palace is a cash basis taxpayer. c. $2,700 in 2024, if Office Palace is a cash or accrual basis taxpayer. d. $1,200 in 2024. 57. Maroon & Orange Gym, Inc., uses the accrual method of accounting. The corporation sells memberships that entitle the member to use the facilities at any time. A one-year membership costs $480 ($480/12 = $40 per month); a two-year membership costs $720 ($720/24 = $30 per month). Cash payment is required at the beginning of the membership period. On July 1, 2024, the company sold a one-year membership and a two-year membership. For financial reporting purposes, Maroon reports the membership income ratably over the number of months involved. How much gross income should the company report as gross income from the two contracts in 2025, the year following payment? a. $-0-. b. $600. c. $780. d. $1,200. 58. Orange Cable TV Company, an accrual basis taxpayer, allows its customers to pay by the year in advance ($600 per year) or two years in advance ($960). In September 2024, the company collected the following amounts applicable to future services: October 2024-September 2026 services (200 two-year contracts) October 2024-September 2025 services (200 one-year contracts) Total

$192,000 120,000 $312,000

As a result of this, Orange Cable should report as gross income for 2025, the year following receipt: a. $54,000. b. $78,000. c. $258,000. d. $312,000. Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 59. With respect to the unearned income from services, which of the following is true? a. The treatment of unearned income is the same for tax and financial accounting for accrual basis taxpayers. b. A cash basis taxpayer must report all of the income in the year received. c. An accrual basis taxpayer can spread the income over the period services are to be provided if all of the services will be completed within three years following the year of receipt. d. An accrual basis taxpayer can spread the income over the period services are to be provided on a contract for three years or less. 60. With respect to unearned income from services, which of the following is true? a. An accrual basis taxpayer will always recognize the income over the period the services will be rendered. b. A cash basis taxpayer can spread the income from a 24-month service contract over the contract period. c. If an accrual basis taxpayer sells a 36-month service contract on July 1, 2024 for $3,600, the taxpayer’s 2024 gross income from the contract is $600. d. If an accrual basis taxpayer sells a 24-month service contract on July 1, 2024, one-half (12/24) the income is recognized in 2025. 61. Green Company, an accrual basis taxpayer, provides business-consulting services. Clients generally pay a retainer at the beginning of a 12-month period. This entitles the client to no more than 40 hours of services. Once the client has received 40 hours of services, Green charges $500 per hour. Green Company allocates the retainer to income based on the number of hours worked on the contract. At the end of 2024, the company reported as a liability in its financial statements $50,000 of unearned revenues from these contracts. The company also reported $10,000 in unearned rent income received in 2024 from excess office space leased to other companies. Considering only this information, how much gross income must Green report in 2025 for tax purposes? a. $60,000. b. $50,000. c. $10,000. d. $-0-. 62. On January 2, 2024, Tim purchased a bond paying interest at 6% for $30,000. On March 31, 2024, he gave the bond to Jane. The bond pays $1,800 interest on December 31. Tim and Jane are cash basis taxpayers. When Jane collects the interest in December 2024: a. Tim must include all of the interest in his gross income. b. Jane must report $1,800 gross income. c. Jane reports $1,350 of interest income, and Tim reports $450 of interest income. d. Jane reports $450 of interest income, and Tim reports $1,350 of interest income. 63. Teal company is an accrual basis taxpayer. On December 1, 2024, a customer paid for an item that was on hand, but the customer wanted the item delivered in early January 2025. Teal delivered the item on January 4, 2025. Teal properly included the sale in its 2024 income for financial accounting purposes. a. Teal must recognize the sale in its gross income in 2024. b. Teal must recognize the sale in its gross income in the year title to the goods passed to the customer, as determined under the state laws in which the store is located. c. Teal can elect to recognize the sale in its gross income in either 2024 or 2025. d. Teal must recognize the sale in its gross income in 2025. 64. As a general rule: Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions I. II. III. IV.

Income from property is taxed to the person who owns the property. Income from services is taxed to the person who earns the income. The assignee of income from property must pay tax on the income. The person who receives the benefit of the income must pay the tax on the income. a. Only I and II are true. b. Only III and IV are true. c. I, II, and III are true, but IV is false. d. I, II, III, and IV are true.

65. On November 1, 2024, Bob, a cash basis taxpayer, gave Dave common stock. On October 30, 2024, the corporation had declared a dividend payable to shareholders of record as of November 22, 2024. The dividend was paid on December 15, 2024. The corporation has paid the $1,200 dividend once each year for the past ten years, during which Bob owned the stock. When Dave collected the dividend on December 15, 2024: a. Bob must include $1,000 (10/12 x $1,200) of the dividend in his gross income. b. Bob must include all of the dividend in his gross income. c. Dave must include all of the dividend in his gross income. d. Dave should treat the $1,200 as a recovery of capital. 66. Daniel purchased a bond on July 1, 2024, at par of $10,000 plus accrued interest of $300. On December 31, 2024, Daniel collected the $600 interest for the year. On January 1, 2025, Daniel sold the bond for $10,200. a. Daniel must recognize $300 interest income for 2024 and a $200 gain on the sale of the bond in 2025. b. Daniel must recognize $600 interest income for 2024 and a $200 gain on the sale of the bond in 2025. c. Daniel must recognize $600 interest income for 2024 and a $100 loss on the sale of the bond in 2025. d. Daniel must recognize $300 interest income for 2024 and a $100 loss on the sale of the bond in 2025. 67. Theresa, a cash basis taxpayer, purchased a bond on July 1, 2019, for $10,000, plus $400 of accrued interest. The bond paid $800 in interest each December 31. On March 31, 2024, she sold the bond for $9,800, which included $200 of accrued interest. a. Theresa has $200 interest income and a $400 loss from the bond in 2024. b. Theresa has $200 interest income and a $200 gain from the bond in 2024. c. Theresa has a $100 loss from the sale of the bond and no interest income. d. Theresa’s loss on the sale of the bond is $600. 68. Darryl, a cash basis taxpayer, gave 1,000 shares of Copper Company common stock to his daughter on September 29, 2024. Copper Company is a publicly held company that has declared a $2.00 per share dividend on September 30th every year for the last 20 years. Just as Darryl had expected, Copper Company declared a $2.00 per share dividend on September 30th, 2024 payable on October 15th, to stockholders of record as of October 10th. The daughter received the $2,000 dividend on October 18, 2024. a. The daughter must recognize the income because she owned the stock on October 10th. b. Darryl must recognize the income of $2,000 because the purpose of the gift was to avoid taxes. c. Darryl must recognize $1,500 of the dividend because he owned the stock for three-fourths of the year. d. Darryl must recognize the $2,000 dividend as his income because he constructively received the dividend. 69. Harry and Wanda were married in Texas, a community property state, but moved to Virginia, a common law state. The calculation of their income on a joint return: a. Will increase as a result of changing their state of residence. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions b. Will decrease as a result of changing their state of residence. c. Will not change as a result of changing their state of residence. d. Will not be permitted. 70. Jim and Nora, residents of a community property state, were married in early 2023. Late in 2023 they separated, and in 2024 they divorced. Each earned a salary, and they received income from community-owned investments in all relevant years. They filed separate returns in 2023 and 2024. Which of the following is true? a. In 2024, Nora must report only her salary and one-half of the income from community property on her separate return. b. In 2024, Nora must report on her separate return one-half of the salary earned by her and Jim for the entire year and one-half of the community property income. c. In 2024, Nora must report on her separate return one-half of the total salary earned by her and Jim for the period they were married as well as one-half of the community property income and her income earned after the divorce. d. In 2024, Nora must report only her salary on her separate return. 71. Under the alimony rules: a. To determine whether a cash payment is alimony, one must consult the state laws that define alimony. b. A person who receives a property division has experienced an increase in wealth and thus should be subject to tax. c. Alimony paid per a 2016 divorce agreement is included in the gross income of the recipient of the payments. d. A person who earns $90,000 and pays $20,000 in alimony per a divorce agreement entered into in 2022, is allowed to deduct the $20,000. 72. Abhijeet owns a 30% interest in the capital and profits of Emerald Company (a calendar year partnership). For tax year 2024, the partnership earned revenue of $900,000 and had operating expenses of $660,000. During the year, Abhijeet withdrew from the partnership a total of $90,000. He also invested an additional $30,000 in the partnership. For 2024, Abhijeet’s gross income from the partnership is: a. $72,000. b. $90,000. c. $132,000. d. $162,000. 73. Travis and Andrea were divorced in 2017. Their only marital property consisted of a personal residence (fair market value of $400,000, cost of $200,000), and publicly traded stocks (fair market value of $800,000, cost basis of $500,000). Under the terms of the divorce agreement, Andrea received the personal residence and Travis received the stocks. In addition, Andrea was to receive $50,000 for eight years. If the $50,000 annual payments are to be made to Andrea or her estate (if she dies I. before the end of the eight years), the payments will qualify as alimony. Andrea has a taxable gain from an exchange of her one-half interest in the stocks for II. Travis’ one-half interest in the house and cash. III. If Travis sells the stocks for $900,000, he must recognize a $400,000 gain. a. Only III is true. b. Only I and III are true. c. Only I and II are true. d. I, II, and III are true. Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 74. Which of the following is not a requirement for a payment between former spouses to be considered alimony? a. The payments must be in cash. b. The payments must cease upon the death of the payee. c. The payments must extend over at least three years. d. The payor and payee must not live in the same household at the time of the payments. 75. Thelma and Mitch were divorced in 2023. The couple had a joint brokerage account that included stocks with a basis of $600,000 and a fair market value of $1,000,000. Under the terms of the divorce agreement, Mitch would receive the stocks. Mitch eventually sold the stocks for $1,300,000. Mitch’s recognized gain from the sale is: a. $-0-. b. $1,000,000 ($1,300,000 – $300,000). c. $700,000 ($1,300,000 – $600,000). d. $300,000 ($1,300,000 – $1,000,000). 76. The alimony rules applicable to divorces entered into before 2019: a. Are based on the principle that the person who earns the income should pay the tax. b. Permit tax deductions for property divisions. c. Look to state law to determine the definition of alimony. d. Treat child support payments and alimony differently. 77. Under the terms of a divorce agreement entered into in 2017, Kim was to pay her husband Tom $7,000 per month in alimony. Kim’s payments will be reduced to $3,000 per month when their nine-year-old son becomes 21. Tom has custody of their son. For a 12-month period, Kim can deduct from gross income (and Tom must include in gross income): a. $60,000. b. $48,000. c. $36,000. d. $0. 78. Under the terms of a divorce agreement entered into in 2017, Maria was to pay her wife Joyce $2,000 per month in alimony and $500 per month in child support. For a 12-month period, Maria can deduct from gross income (and Joyce must include in gross income): a. $0. b. $6,000. c. $24,000. d. $30,000. 79. Tim and Janet divorced in 2017. Their only marital property was a personal residence with a value of $120,000 and cost of $50,000. Under the terms of the divorce agreement, Janet would receive the house and would pay Tim $15,000 each year for five years, or until Tim’s death, whichever should occur first. Tim and Janet lived apart when the payments were made to Tim. The divorce agreement did not contain the word “alimony.” a. Tim must recognize a $35,000 [$60,000 – 1/2($50,000)] gain on the sale of his interest in the house. b. Tim does not recognize any income from these transactions. c. Janet is not allowed any alimony deductions. d. Janet is allowed to deduct $15,000 each year for alimony paid. 80. Under the terms of a divorce agreement entered into in 2017, Abdul is to pay his former wife Jill $10,000 per month. Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions The payments are to be reduced to $7,000 per month when their child reaches age 18. During the current year, Abdul paid $120,000 under the agreement. Assuming all of the other conditions for alimony are satisfied, Abdul can deduct from gross income (and Jill must include in gross income) as alimony: a. $120,000. b. $84,000. c. $36,000. d. $0. 81. The purpose of the tax rules that apply to below-market loans between family members is to: a. Discourage loans between related parties. b. Prevent shifting of income among family members. c. Prevent gifts from being disguised as bad debt expenses. d. Prevent the artificial deferral of income recognition. 82. On January 1, Dave loaned his daughter, Debra, $200,000 to purchase a new car and to pay off college loans. There were no other loans outstanding between Dave and Debra. The relevant Federal rate on interest was 3 percent. The loan was outstanding for the entire year. a. If Debra has $15,000 of investment income, Dave must recognize $6,045 of imputed interest income. b. Dave must recognize $6,045 of imputed interest income regardless of the amount of Debra’s investment income. c. Debra must recognize $6,045 of imputed interest income. d. Debra must recognize $6,045 of imputed interest income if Dave has at least $6,045 of investment income. 83. What are the effects of a below-market loan for $100,000 made by a corporation to its chief executive officer as an enticement to get him to remain with the company? a. The corporation has imputed interest income and the employee is deemed to have received a gift. b. The corporation has imputed interest income and dividends paid. c. The employee has no income unless the funds are invested and produce investment income for the year. d. The employee has imputed compensation income and the corporation has imputed interest income. 84. Sarah, a majority shareholder in Teal, Inc., made a $200,000 interest-free loan to the corporation. Sarah is not an employee of the corporation. a. Sarah must recognize imputed interest expense and the corporation must recognize imputed interest income. b. Sarah must recognize imputed interest income and the corporation must recognize imputed interest expense. c. Sarah must recognize imputed dividend income and the corporation may recognize imputed interest expense. d. Neither Sarah’s nor the corporation’s gross income is affected by the loans because no interest was charged. 85. Jasmine made a $60,000 interest-free loan to her son, Farhad, who used the money to start a new business. Farhad’s only sources of income were $25,000 from the business and $490 of interest on his checking account. The relevant Federal interest rate was 5%. Based on this information: a. Farhad’s business net profit will be reduced by $3,000 (0.05 × $60,000) of interest expense. b. Jasmine must recognize $3,000 (0.05 × $60,000) of imputed interest income on the below-market loan. c. Farhad’s gross income must be increased by the $3,000 (0.05 × $60,000) imputed interest income on the below-market loan. d. Jasmine does not recognize any imputed interest income and Farhad does not recognize any imputed interest expense. Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 86. Jay, a single taxpayer, purchased an annuity to help provide income during his retirement. He paid $36,000 for the annuity that provided a monthly benefit starting at his retirement date for the rest of Jay's life. His life expectancy at the time of his retirement was 180 months. Jay collected 192 payments before he died. Which of the following is true? a. As Jay is no longer working, none of the payments must be included in his gross income. b. The first $36,000 received is a nontaxable recovery of capital, and all subsequent annuity payments are taxable. c. If Jay's income is below $25,000, none of the payments he receives are taxable. d. All of the last 12 payments he received are taxable. 87. In 2023, Todd purchased an annuity for $150,000. The annuity is to pay him $2,500 per month for the rest of his life. His life expectancy is 100 months. Which of the following is correct? a. Todd is not required to recognize any income until he has collected 60 payments (60 × $2,500 = $150,000). b. If Todd collects 20 payments and then dies in 2025, Todd’s estate should amend his tax returns for 2023 and 2024 and eliminate all of the reported income from the annuity for those years. c. For each $2,500 payment received in the first year, Todd must include $1,000 in gross income. d. For each $2,500 payment received in the first year, Todd must include $1,500 in gross income. 88. Mark, a calendar year taxpayer, purchased an annuity for $50,000 in 2023. The annuity was to pay him $3,000 on the first day of each year, beginning in 2023, for the remainder of his life. Mark’s life expectancy at the time he purchased the annuity was 20 years. In 2025, Mark developed a deadly disease, and doctors estimated that he would live for no more than 24 months. a. If Mark dies in 2026, a loss can be claimed on his final return for his unrecovered cost of the annuity. b. If Mark dies in 2026, his returns for the two previous years can be amended to allocate the entire cost of the annuity to the years in which he received payments and reported gross income. c. If Mark is still alive at the end of 2025, he is not required to recognize any gross income because of his terminal illness. d. If Mark is still alive in 2045, his recovery of capital for that year is $500. 89. Betty purchased an annuity for $24,000 in 2024. Under the contract, she will receive $300 each month for the rest of her life. According to the actuarial estimates, Betty will live to receive 96 payments and will receive a 3% return on her original investment. a. If Betty collects $3,000 in 2024, her gross income is $630 (0.03 × $21,000). b. Betty has no gross income until she has collected $24,000. c. If Betty lives to collect more than 96 payments, all of the amounts collected after the 96th payment must be included in taxable income. d. If Betty lives to collect only 60 payments before her death, she will report a $6,000 loss from the annuity [$24,000 – (60 × $300) = $6,000] on her final return. 90. The amount of Social Security benefits received by an individual that must be included in gross income: a. Is computed in the same manner as an annuity [exclusion = (cost/expected return) × amount received]. b. May not exceed the portion contributed by the employer. c. May not exceed 50% of the Social Security benefits received. d. May be zero or as much as 85% of the Social Security benefits received, depending upon the taxpayer’s Social Security benefits and other income.

Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 91. The taxable portion of Social Security benefits may be affected by: a. The taxpayer’s itemized deductions. b. The individual’s tax-exempt interest income. c. The number of quarters the individual worked. d. The individual’s standard deduction. 92. Debbie is age 67 and unmarried. Her only sources of income are $200,000 in taxable interest and $20,000 of Social Security benefits. Debbie’s adjusted gross income for the year is: a. $220,000. b. $217,000. c. $203,000. d. $200,000. 93. Our tax laws create an incentive for taxpayers to ____ assets that have appreciated in value and ____ assets that have declined in value. a. sell; keep. b. sell; sell. c. keep; sell. d. keep; keep. 94. Margaret owns land that appreciates at the rate of 5% each year. Luis owns a zero-coupon (i.e., all of the interest is paid at maturity) corporate bond with a yield to maturity of 5%. At the end of 10 years, the bond will mature and the land will be sold. At the end of the 10 years, a. Margaret and Luis will have accumulated the same after-tax amounts. b. Luis will have accumulated a greater after-tax amount because the interest on the bond is tax-exempt. c. Margaret will have accumulated the greater after-tax amount because the gain on the land is tax-exempt. d. Margaret will accumulate the greater after-tax amount because she earns a return on the deferred taxes. 95. During the year, Kim sold the following assets: business auto for a $1,000 loss, stock investment for a $1,000 loss, and pleasure yacht for a $1,000 loss. Presuming adequate income, how much of these losses may Kim claim? a. $0. b. $1,000. c. $2,000. d. $3,000. 96. Perry, a single taxpayer, has taxable income of $198,000 and is in the 32% tax bracket. During 2024, he had the following capital asset transactions: Gain from the sale of a stamp collection (held for 10 years) Gain from the sale of an investment in land (held for 4 years) Gain from the sale of stock investment (held for 8 months)

$30,000 10,000 4,000

Perry’s tax consequences from these gains are as follows: a. (15% × $30,000) + (32% × $4,000). b. (15% × $10,000) + (28% × $30,000) + (32% × $4,000). Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions c. (0% × $10,000) + (28% × $30,000) + (32% × $4,000). d. (15% × $40,000) + (32% × $4,000). 97. Kirby, a single taxpayer, has taxable income of $40,000 and is in the 12% tax bracket. During 2024, she had the following capital asset transactions: Long-term gain from the sale of a coin collection Long-term gain from the sale of a land investment Short-term gain from the sale of a stock investment

$11,000 10,000 2,000

Kirby’s tax consequences from these gains are as follows: a. (5% × $10,000) + (12% × $13,000). b. (12% × $13,000) + (28% × $11,000). c. (0% × $10,000) + (12% × $13,000). d. (12% × $23,000). 98. For the current year, David has wages of $80,000 and the following property transactions: Stock investment sales— Long-term capital gain Short-term capital loss Loss on sale of camper (purchased four years ago and used for family vacations)

$ 9,000 (12,000) (2,000)

What is David’s AGI for the current year? a. $76,000. b. $77,000. c. $78,000. d. $89,000. 99. During 2024, Trevor has the following capital transactions: LTCG Long-term collectible gain STCG STCL

$ 6,000 2,000 4,000 10,000

After the netting process, the following results: a. Long-term collectible gain of $2,000. b. LTCG of $6,000, long-term collectible gain of $2,000, and a STCL of $6,000. c. LTCG of $6,000, long-term collectible gain of $2,000, and a STCL carryover to 2023 of $3,000. d. LTCG of $2,000. Subjective Short Answer 100. Ted was shopping for a new automobile. He found one that met his needs and agreed to purchase it for $23,000. He had shopped around and concluded that he could not get a better price from another dealer. After he had paid for the Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions automobile, the dealer called to notify Ted that he was entitled to a manufacturer’s rebate of $1,500. The next week he received a $1,500 check from the manufacturer. How much should Ted include in gross income? 101. Determine the proper tax year for gross income inclusion in each of the following cases. a.

b.

c.

d.

A cash basis landlord makes new tenants pay first and last month's rent at the start of the lease. When does the landlord report these items? Purple Corporation, an exterminating company, is a calendar year taxpayer. It contracts to provide service to homeowners once a month under a one-, two-, or three-year contract. For financial reporting purposes, Purple reports the income ratably over the months of the contract. On April 1 of the current year, the company sold a customer a one-year contract for $120. How much of the $120 is taxable in the current and subsequent years if the company is an accrual basis taxpayer? If the $120 is payment on a two-year contract, how much is taxed in the year the contract is sold and in the following years? If the $120 is payment on a threeyear contract, how much is taxed in the year the contract is sold and in the following years? Pink, Inc., an accrual basis taxpayer, owns an amusement park whose fiscal year ends September 30. To increase business during the fall and winter months, Pink sold passes that would allow the holder to ride “free” during the months of October through March. During the month of September, $6,000 was collected from the sale of passes for the upcoming fall and winter. When will the $6,000 be taxable to Pink? A taxpayer is in the office equipment rental business and uses the accrual basis of accounting. In December he collected $5,000 in rents for the following January. When is the $5,000 taxable?

102. José, a cash method taxpayer, is a partner in J&T Accounting Services, a calendar year partnership. Under the partnership agreement, José is to receive 20% of the partnership’s profits or losses. Each partner is allowed to withdraw $10,000 each month for their living expenses. José withdrew $120,000 during the current year as his monthly draw. However, in December, the partnership was short on cash and José was required to invest an additional $10,000 in the partnership. In March, José received $40,000 as his share of the previous year's profits. The partnership's current year earnings before partners’ withdrawals totaled $1,000,000. Compute José’s gross income from the partnership for the current year. 103. On January 1, 2024, Faye gave Walt, her son, a 36-month certificate of deposit she had purchased on December 31, 2022, for $8,638. The certificate had a maturity value of $10,000 and the yield to maturity was 5%. On December 1, 2024, Faye gave Walt 200 shares of stock in ABC, Inc. On November 30, 2024, ABC, Inc., had declared a dividend of $1.00 payable to stockholders of record on December 5th. How much interest and dividends should Walt include in his gross income for 2024? 104. Margaret made a $90,000 interest-free loan to her son, Adam, who used the money to retire a mortgage on his personal residence and to buy a certificate of deposit. Adam’s only income for the year is his salary of $35,000 and $1,400 interest income on the certificate of deposit. Assume the relevant Federal interest rate is 4% compounded semiannually. The loan is outstanding for the entire year. a.

Based on this information, what is the effect of the loan on Margaret’s gross income for the year?

b.

The facts are the same as above except that you discovered that Margaret had made an

Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions additional loan of $15,000 to Adam in the previous year. Adam used the funds to pay his child’s private school tuition. What are the effects of the loans on Margaret’s gross income? 105. Arnold was employed during the first six months of 2024 and earned a $90,000 salary. During the next six months, he collected $7,200 of unemployment compensation. He borrowed $6,000 (using his personal residence as collateral) and withdrew $1,000 from his savings account (on which he had earned $60 interest). Arnold’s parents loaned him $10,000 (interest-free) on July 1 of the current year, when the Federal rate was 3%. Arnold did not repay the loan during the year and used the money for living expenses. Calculate Arnold’s adjusted gross income for the year. 106. Ted and Alice were in the process of negotiating a divorce agreement. They own bonds with a basis of $800,000 and a fair market value of $800,000. They also own common stock with a basis of $600,000 and a fair market value of $800,000. Alice is trying to decide whether to bargain to receive the bonds or the stock. She has no plans for selling the bonds or stock, whichever she receives. How would you advise Alice?

107. How does the taxation of Social Security benefits differ from the taxation of an annuity purchased by the taxpayer? 108. Sarah, a widow, is retired and receives $20,000 interest income and dividends and $10,000 in Social Security benefits. Sarah is considering selling a stock at an $8,000 gain. What will be the increase in Sarah’s gross income as a result of the sale of the stock? 109. Javier is considering purchasing land for $10,000. He expects the land to appreciate in value 8% each year (compounded), and he will sell it at the end of 10 years. Alternatively, he is considering purchasing a bond for $10,000. The bond does not pay any annual interest but will pay $21,589 at maturity in 10 years. The before-tax rate of return on the bond is 8%. Javier is in the 40% (combined Federal and state) marginal tax bracket. He has other investments that earn an 8% before-tax rate of return. Given that the compound interest factor at 8% is 2.1589 and at 4.8% is 1.5981, how much after-tax income will Javier have after ten years if he invests in the land? In the bond? 110. On January 2, 2024, Tammy purchased a corporate bond due in 24 months. The cost of the bond is $857 and its maturity value is $1,000. No interest is paid each year, but the compound interest rate on the bond is 8%. Tammy also purchased a Series EE United States Government bond for $558 with a maturity value in 10 years of $1,000. This is the only Series EE bond she has ever owned. The Series EE bond is sold to yield 6% interest. Tammy is 13 years old and has no other source of income. She is claimed as a dependent by her parents. Compute Tammy’s gross income from the bond and Series EE bond for 2024. 111. During the year, Professional Training, Inc. (PTI), an accrual basis taxpayer, entered into a $500,000 contract that requires them to design and deliver a continuing professional education program to a network of accounting firms. By the end of the year, PTI has completed, and the customer has approved, the program but the actual training has not yet begun. In its financial statements, PTI recognizes $250,000 of income related to the program’s design. a. Assuming PTI must complete both program design and delivery to fulfill the requirements of the contract, how much must it include in its gross income for the year? b. Would your answer to part a. change and, if so, how if the contract required the customer to pay $250,000 for the program design if the customer cancelled the contract prior to program delivery? Explain. 112. Kohsei had the following transactions for 2024: Salary Powered by Cognero

$ 80,000 Page 18

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions Alimony paid (divorce finalized in 2016) Recovery from car accident— Personal injury damages Punitive damages Gift from parents Property sales— Loss on sale of boat (used for pleasure and owned 4 years) Gain on sale of ADM stock (held for 10 months as an investment)

(4,000) $40,000 70,000

110,000 20,000

($4,000) 4,000

(–0–)

What is Kohsei’s AGI for 2024?

113. During the year, Irv had the following transactions: Long-term loss on the sale of business use equipment Long-term loss on the sale of personal use camper Long-term gain on the sale of personal use boat Short-term loss on the sale of stock investment Long-term loss on the sale of land investment How are these transactions handled for income tax purposes?

$7,000 6,000 3,000 4,000 5,000

114. During 2024, Addison, a single taxpayer, has the following gains and losses: LTCG LTCL STCG STCL a. b.

$10,000 3,000 2,000 7,000

How much is Addison’s tax liability if she has taxable income of $34,000 and is in the 12% tax bracket? How much is Addison's tax liability if her taxable income is $195,000 and her tax bracket is 32% (not 12%)?

115. During 2024, Jackson, a single taxpayer, had the following capital gains and losses: Gain from the sale of coin collection (held three years) Gain from the sale of land held as an investment for six years Gain from the sale of stock held as an investment (held for 10 months) a. b.

$12,000 9,000 3,000

How much is Jackson’s tax liability if his taxable income is $32,000 and he is in the 12% tax bracket? How much is his tax liability if his taxable income is $200,000 and his tax bracket is 32% (not 12%)?

116. During 2024, Madison had salary income of $80,000 and the following capital transactions: Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions LTCG LTCL STCG STCL

$13,000 15,000 13,000 6,000

How are these transactions handled for income tax purposes? Essay 117. In some foreign countries, the tax law specifically designates the types of income items that are includible in gross income. How does this approach compare with the U.S. Internal Revenue Code (§ 61)? What is a major advantage to the approach used in the U.S. tax law? 118. Katherine is 60 years old and is bargaining with her employer over deferred compensation. In exchange for reducing her current year’s salary by $50,000, she can receive a lump-sum amount in five years when she will retire. If she receives the $50,000 in the current year, she will invest in certificates of deposit that yield 5%. Katherine is in the 24% marginal tax bracket in all relevant years. What is the minimum amount Katherine should accept as a deferred pay option? [Hint: the compound interest factor is 1.1934.] 119. Dick and Jane divorced in 2017. At the time of the divorce, Dick had a lawsuit pending. He had filed suit against a former employer for overtime pay. As part of a divorce agreement, Dick agreed to pay Jane one-half of the proceeds from the lawsuit. In 2024, Dick collected $250,000 from the former employer and paid Jane $125,000. What are the tax consequences from Dick's receiving the $250,000 and then paying Jane the $125,000? 120. Rachel owns rental properties. When she rents to a new tenant, she usually requires the tenant to pay an amount in addition to the first month’s rent. The additional amount serves as security for damages to the property and the tenant’s failure to pay future rents. How should the payments be characterized (e.g., on lease documents) to minimize Rachel’s current tax liability? 121. Rachel, who is in the 35% marginal tax bracket, is considering purchasing an annuity that will pay her $10,000 per year for the remainder of her life. Her life expectancy is 15 years. The cost of the annuity is $97,120, and the cost is calculated to yield her an expected 6% return on her investment. As an alternative, Rachel could place the $97,120 in a savings account yielding 6% and she could withdraw $10,000 each year for 15 years (reducing the value of the account to zero at the end of 15 years). How might the tax laws applicable to annuities affect Rachel’s decision? 122. In the case of a zero interest below-market loan by a corporation to a shareholder-employee, what difference does it make to the corporation and the shareholder whether the loan is characterized as a corporation’s loan to its shareholder or a corporation’s loan to its employee? 123. Under the formula for taxing Social Security benefits, low-income taxpayers are not required to include any of the Social Security benefits in gross income. But as income increases, 50% of the Social Security benefits may be included in gross income. Further increases in income will cause as much as 85% of the Social Security benefits being subject to tax. Does this mean that the taxation of Social Security benefits is more or less progressive than the taxation of other types of income? 124. Your client is considering transferring $25,000 from his savings account in a local bank paying 2% interest

to a Mexico City bank paying 3%. What do you advise? 125. The federal government announced a new program about student loan repayments and possible cancellation. One of the new features is that if a married couple file separately, eligibility for this new program will be based on the income Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions reported just for the spouse with the student loan. Abigail and Sam are married, live in California and have only wage income. Abigail's wage income is $200,000 and Sam's is $60,000. Sam has student loans and is eligible for the program if his taxable income is below $100,000. Is Sam eligible for this program if he files separate from his spouse?

126. In early 2024, Ben sold a yacht, held for 9 months and for pleasure, for a $5,000 gain. Concerned about offsetting the gain before year-end, Ben is considering selling one of the following—each of which would yield a $5,000 loss: ∙ Houseboat used for recreation. ∙ Truck used in business. ∙ Stock investment held for 13 months. Evaluate each choice.

Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions Answer Key 1. True 2. True 3. False 4. False 5. True 6. True 7. True 8. True 9. True 10. False 11. True 12. False 13. True 14. True 15. False 16. False 17. True 18. True 19. True 20. True 21. False 22. True 23. False 24. True 25. False Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 26. True 27. False 28. False 29. False 30. True 31. False 32. True 33. False 34. True 35. False 36. False 37. False 38. True 39. True 40. True 41. False 42. False 43. True 44. True 45. False 46. c 47. c 48. b 49. b 50. c Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 51. c 52. b 53. d 54. d 55. a 56. d 57. c 58. c 59. b 60. c 61. b 62. c 63. a 64. a 65. b 66. a 67. a 68. a 69. c 70. a 71. c 72. a 73. a 74. c 75. c 76. d Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 77. c 78. c 79. d 80. b 81. b 82. a 83. d 84. b 85. d 86. d 87. c 88. a 89. c 90. d 91. b 92. b 93. c 94. d 95. c 96. b 97. c 98. b 99. d 100. $0. Perhaps in Ted’s mind, he is $1,500 richer as a result of the rebate, since he was willing to pay $23,000 for the automobile without any knowledge of the fact that he was entitled to the rebate. However, from the point of view of measuring gross income, one could reason that he purchased an automobile for a net cost of $21,500 ($23,000 – $1,500). The fact that the net cost is less than the amount Ted was willing to pay should not affect the determination of gross Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions income. 101. a. Both cash and accrual basis landlords report both months rent payments when received. The income deferral rule for accrual method taxpayers does not apply to rent. The payments are not considered nontaxable deposits. b.

Section 451(c) permits an accrual basis taxpayer to elect an accounting method that allows limited deferral of service income. Under this method, for the year the advance payment is received, the taxpayer reports the same amount as reported on its financial statement with the balance reported on the next year's tax return. Purple will report the following for the three contracts sold on April 1 of the current year.

Contract Term: 1 year 2 years 3 years

Year 2 Revenue (balance) $90 $30 $45 $75 $30 $90

Revenue per Month Year 1 Revenue $10 $5 $3.33

Pink may elect a deferral method for this income. Assuming Pink recognizes the c. income in its financial statements when it is earned, the year subsequent to its receipt, the same is allowed for tax purposes. d. Unearned rent is taxable in the year of receipt to both the accrual and cash basis taxpayers.

102. José’s gross income from the partnership is his share of the partnership profits of $200,000 (0.20 × $1,000,000). The amount of the distributions he receives (normally a recovery of capital) generally does not affect the amount he includes in his gross income. A withdrawal of profits is analogous to withdrawing cash from a bank account created with after-tax earnings. His investment is a $10,000 contribution to capital. 103. Walt must report $454 of interest income and no dividends. The certificate of deposit is an original issue discount instrument. Therefore, Faye should have reported $432 (0.05 × $8,638) of interest income in 2023, and thus the adjusted basis of the CD is $9,070 ($8,638 + $432). Walt must report interest income for 2024 of $454 (0.05 × $9,070). According to the IRS in this case, the dividend income belongs to Faye since she was the owner of the stock when the dividend was declared and she transferred the stock to Walt as a gift. 104. a. Margaret’s imputed interest income for the year is $1,400, which is the lesser of the imputed interest at the Federal rate of $3,636 [($90,000 × 4% × 1/2) + ($91,800 × 4% × 1/2)] or Adam’s net investment income of $1,400. b.

Margaret’s loans to Adam exceed $100,000 ($90,000 + $15,000). Therefore, Margaret must recognize interest income equal to the Federal rate times the outstanding loans.

Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions (0.04 × $105,000 × 1/2) = $2,100; (0.04 × $107,100 × 1/2) = $2,142 Total = $4,242

105. Salary Unemployment compensation Interest income Adjusted gross income

$ 90,000 7,200 60 $97,260

The interest-free loan does not result in gross income to Arnold because of the $10,000 exception.

106. One difference between the stock and bonds is that the income on the bonds will be taxed as it is paid while the stock will appreciate tax-deferred with any future gain eligible for lower capital gains rates. If neither investment is to be sold, the stock may provide a higher after-tax return. However, another significant difference between the assets from a tax perspective is that the person who receives the stock will have a $600,000 basis when the value is $800,000. Therefore, a taxable gain will be recognized if the assets are sold for more than $600,000. The bonds do not have this taxable gain possibility. As it is likely the investments will be sold at some time, Alice must weigh the annual taxation of the bond interest against the deferred tax, at capital gains rates, on the appreciation of the stock, including the $200,000 accruing before the divorce. 107. The taxable portion of most payments received under an annuity contract is based on an exclusion ratio determined only by the taxpayer's investment in the annuity and the total amount of payments expected to be received over the life of the contract. If a taxpayer fails to recover their entire investment, they may deduct the unrecovered investment as a loss. Conversely, after the entire investment is recovered, all future receipts are fully taxable. The taxable portion of annual Social Security benefits is based, in part, on a statutorily determined exclusion ratio regardless of how much the taxpayer has paid into the Social Security fund. Further, the ratio applies to all payments as long as they are received: the taxpayer is not entitled to a deduction for failing to recover their contributions nor fully taxed on their benefits regardless of how long they receive them. Finally, the taxability of Social Security benefits also takes in to account the taxpayer's overall ability to pay. First, the exclusion ratio falls from 100, to 50, to 15 percent as ability to pay increases. Second, taxable benefits are further limited to 0, 50 or 85 percent of the excess of the taxpayer's income over a threshold amount with the percentage again increasing with ability to pay. 108. None of Sarah’s Social Security benefits will be taxable if she does not sell the stock {50%[$20,000 + 50%($10,000) – $25,000] = $0}. The $8,000 gain will cause Sarah’s taxable Social Security benefits to increase by $4,000, which is the lesser of the following: ∙ 50%($10,000) ∙ 50%[$28,000 + 50%($10,000) – $25,000]

$5,000 $4,000

Therefore, the $8,000 gain will cause Sarah’s gross income to increase by $12,000 ($8,000 + $4,000). 109. Javier should select the investment in the land. Because the tax on the bond's original issue discount must be paid each year, the after-tax return on the bond is 4.8% (8% * (1-40%)). At the end of 10 years, Javier will have accumulated $15,981 (1.5981 × $10,000) after tax. With the land, Javier’s investment will appreciate to $21,589 (2.1589 × $10,000), leaving him with $19,581 after selling the land and paying the tax on the gain ($21,589 - .15 ($21,589-$10,000). Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 110. Tammy’s only recognized income is from the original issue discount of $69 ($857 × 8%) on the corporate bond. The Series EE bonds are exempt from the original issue discount rules. However, Tammy could elect to include the original issue discount on the Series EE bond each year, and it appears that the election should be made. The interest on the Series EE bond for 2024, if the election is made, is $33 ($558 × 6%).Because Tammy has no other sources of income, the effective tax rate on the accrued Series EE bond interest is zero because of the available standard deduction of $1,100. The interest reported will increase Tammy’s basis in the Series EE bond and, therefore, she will not have to recognize any income at maturity. 111. a. $0.Under the all events test, an accrual basis taxpayer does not recognize income until all of the events that give the taxpayer the right to income have occurred and the amount can be determined with reasonable accuracy. Because PTI has not yet delivered the program to the customer’s employees by the end of the year, the all events test has not yet been met. b. $250,000.The financial statement inclusion rule generally calls for the all events test to be considered met when income is included in a set of certified financial statements issued by the taxpayer. An important exception applies if the taxpayer does not have an enforceable right to the income at the end of the year. As such, PTI would not be required to recognize any income given the facts in part a. However, If PTI has a right to the income related to designing the program, even if the contract is cancelled, and has reported it in their financial statements, PTI is likely required to include the $250,000 in their gross income despite not having yet met all of its requirements under the contract. 112. $150,000 [$80,000 (salary) – $4,000 (alimony paid) + $70,000 (punitive damage award) + $4,000 (gain on the sale of stock investment)]. The personal injury recovery and the gift from Kohsei’s parents are exclusions from gross income. The loss from the sale of the boat is personal and therefore nondeductible. 113. The business equipment is an ordinary loss of $7,000. The $6,000 loss on the camper is personal and not deductible. However, the $3,000 gain on the boat is taxable and is applied against the long-term capital loss on the land, reducing it to $2,000. The $4,000 short-term capital loss on the stock offsets ordinary income up to $3,000. The unused remaining $1,000 short-term capital loss and the $2,000 long-term capital loss from the land sale are carried over to future years. 114. a. $0. After the initial netting process, there is a LTCG of $7,000 and a STCL of $5,000. The $5,000 of STCL is applied to the LTCG of $7,000. The final result is a net LTCG of $2,000 taxed at 0% for a tax liability of $0. b.

$300. See part a. for the netting process. Now the $2,000 is taxed at 15% for a tax liability of $300.

115. a. $1,800. Gain of $12,000 on the sale of the coin collection is taxed at 12% (lesser of 28% or 12%). The same is true for the short-term gain of $3,000. The gain of $9,000 on the sale of the land is taxed at 0%. Thus (12% × $15,000) + (0% × $9,000) = $1,800. b.

$5,670 [(32% × $3,000) + (28% × $12,000) + (15% × $9,000)].

116. Combining the long-term transactions yields a net LTCL of $2,000 ($13,000 – $15,000), while the short-term process results in a net STCG of $7,000 ($13,000 – $6,000). A further combination leaves a net STCG of $5,000 ($7,000 – $2,000) which is taxed as ordinary income. Only net LTCG results in preferential tax treatment. 117. The Internal Revenue Code defines gross income as all income unless specifically excluded. The advantage of the U.S. system is that an all-inclusive list of types of income does not have to be developed. Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions 118. $59,670 The $50,000 salary will be $38,000 [(1 – 0.24)($50,000)] after-tax. When this is invested in a CD that yields 3.8% [(1 – 0.24)(0.05)] after-tax for five years, the compounded amount will be $45,349 ($38,000 × 1.1934). If a lump-sum is received in five years, it will be subject to tax. Therefore, Katherine should receive at least $59,670 [$45,349/(1 – 0.24)]. 119. The $250,000 payment is additional gross income to Dick. In order for Dick to avoid tax on the $125,000 he transferred to Jane, the payment must qualify as alimony. This means the payment must be made only if she is alive at the time Dick receives the award. 120. The payments should be characterized as damage deposits. This will ensure that the payments are not taxable as prepaid income. A payment to secure future rents would likely be treated as prepaid rent income. 121. The tax laws favor the purchase of the annuity. This results because the annuity rules allow the taxpayer to recover their investment more quickly than under the savings account plan. Each alternative yields the same taxable income over the 15 years. However, Rachel’s taxes are deferred with the annuity contract. Under the annuity rules, Rachel would treat as a recovery of capital $6,475 ($97,120/15) each year. With the savings account, Rachel has less recovery of capital in the early years than in the later years. For example, in the first year Rachel earns interest on the savings account of $5,827 ($97,120 × 0.06) and has a recovery of capital of $4,173 ($10,000 – $5,827). Thus, the present value of the taxes is greater with the savings account. 122. Imputed interest on the loan to an employee would create compensation expense equal to the amount of imputed interest that is not charged the employee. The compensation expense would be deductible by the corporation. On the other hand, the imputed interest on the shareholder loan creates a nondeductible dividend paid by the corporation. From the shareholder-employee’s perspective, dividend treatment might be preferable because the dividends are not subject to 1.45% Medicare tax and are eligible for the beneficial tax rate for qualified dividends. 123. The formula for the taxation of Social Security benefits is more progressive than the taxation of other sources of income. Under a progressive system, as income increases, the tax as a percentage of income increases. This is accomplished by increasing the marginal tax rate as income increases. With the Social Security taxing formula, as income increases and the taxpayer is subjected to higher marginal rates, the amount of taxable income increases as more of the Social Security benefits are subject to tax. 124. You should warn the client about complications and possible losses of value from changes in the value of the Mexican peso relative to U.S. dollars. Also, the foreign account will require your client file an FBAR form annually (provided the bank balance exceeds $10,000 on any day of the year). 125. No. California is a community property state and if Abigail and Sam file separate returns, they must each report half of the community income. Thus, Sam's income would be $130,000 which is too high to be eligible for the student loan program.

126. The sale of the houseboat produces no benefit since losses on personal use property are not deductible. The sale of the truck yields an ordinary loss of $5,000. The ordinary loss result offsets the ordinary income caused by a short-term capital gain. The best choice, however, is the stock investment. A net long-term capital loss can neutralize a net short-term capital gain and prevent ordinary income from materializing. By itself, a net long-term capital loss can only be offset against regular income to the extent of $3,000. Also, it might obviate long-term capital gains which are taxed at preferential tax rates. Powered by Cognero

Page 29

Name:

Class:

Date:

Chapter 04: Gross Income Concepts and Inclusions

Powered by Cognero

Page 30

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions True / False 1. For a person who is in the 35% marginal tax bracket, $1,000 of tax-exempt income is equivalent to $1,350 of income that is subject to tax. a. True b. False 2. John told his nephew, Steve, “If you maintain my house when I cannot, I will leave the house to you when I die." Steve maintained the house, and when John died, Steve inherited the house. The value of the residence can be excluded from Steve’s gross income as an inheritance. a. True b. False 3. Brooke works part-time as a waitress in a restaurant. For groups of seven or more customers, the customer is charged 15% of the bill for Brooke’s services. For parties of less than seven, the tips are voluntary. Brooke received $11,000 from the groups of seven or more and $7,000 in voluntary tips from all other customers. Using the customary 15% rate, her voluntary tips would have been only $6,000. Brooke must include $18,000 ($11,000 + $7,000) in gross income. a. True b. False 4. Mel was the beneficiary of a $45,000 group term life insurance policy on his deceased wife. His wife’s employer had paid all of the premiums on the policy. Mel used the life insurance proceeds to purchase a U.S. government bond, which paid him $2,500 interest during the current year. Mel’s Federal gross income from this is $2,500. a. True b. False 5. Zack was the beneficiary of a life insurance policy on his deceased wife. Zack had paid $20,000 in premiums on the policy. He collected $50,000 on the policy when his wife died from a terminal illness. Because it took several months to process the claim, the insurance company paid Zack $53,000, the face amount of the policy plus $3,000 interest. Zack must include $23,000 in his gross income. a. True b. False 6. Laura died while employed by Violet Company. Her wife collected $40,000 on a group term life insurance policy that Violet provided its employees and $6,000 of accrued salary Laura had earned prior to her death. All of the premiums on the group term life insurance policy were excluded from Laura’s gross income. Laura’s wife is required to recognize as gross income only the $6,000 she received for the accrued salary. a. True b. False 7. Gary cashed in an insurance policy on his life. He needed the funds to pay for his terminally ill wife’s medical expenses. He had paid $12,000 in premiums and he collected $30,000 from the insurance company. Gary is not required to include the gain of $18,000 ($30,000 – $12,000) in gross income. a. True b. False 8. When Betty was diagnosed as having a terminal illness, she sold her life insurance policy to Insurance Purchase, Inc., a company that is licensed to invest in these types of contracts. Betty sold the policy for $32,000, and Insurance Purchase, Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions Inc. became the beneficiary. She had paid total premiums of $19,000. Betty died eight months after the sale. Insurance Purchase, Inc., collected $50,000 on the policy. The company had paid additional premiums of $4,000 on the policy. Betty's estate is not required to recognize a $13,000 gain from the sale of her life insurance policy; and Insurance Purchase, Inc. is required to recognize a $14,000 gain from the insurance policy. a. True b. False 9. Agnes receives a $5,000 scholarship that covers her tuition at Parochial High School. She may not exclude the $5,000 because the exclusion applies only to scholarships to attend college. a. True b. False 10. If a scholarship does not satisfy the requirements for a gift, the scholarship must be included in gross income. a. True b. False 11. Ashley received a scholarship to be used as follows: tuition, $6,000; room and board, $9,000; and books and laboratory supplies, $2,000. Ashley is required to include only $9,000 in her gross income. a. True b. False 12. Shanice received a graduate teaching assistantship that was awarded on the basis of academic achievement. The payments must be included in her gross income. a. True b. False 13. In 2024, Theresa was in an automobile accident and suffered physical injuries. The accident was caused by Ramon’s negligence. In 2025, Theresa collected from his insurance company. She received $15,000 for loss of income, $10,000 for pain and suffering, $50,000 for punitive damages, and $6,000 for medical expenses that she had deducted on her 2024 tax return (the amount in excess of 7.5% of adjusted gross income). As a result of this, Theresa’s 2025 gross income is increased by $56,000. a. True b. False 14. Workers’ compensation benefits are included in gross income if the employer also pays the employee while the employee is recovering from their injury. a. True b. False 15. In December 2024, Emily, a cash basis taxpayer, received a $2,500 cash scholarship for the spring semester of 2025. However, she did not use the funds to pay the tuition until January 2025. Emily can exclude the $2,500 from her gross income in 2024. a. True b. False 16. Sam was unemployed for the first two months of 2024. During that time, he received $4,000 of state unemployment benefits. He worked for the next six months and earned $14,000. In September, he was injured on the job and collected Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions $5,000 of workers’ compensation benefits. Sam’s Federal gross income from this is $18,000 ($4,000 + $14,000). a. True b. False 17. Sarah’s employer pays the hospitalization insurance premiums for a policy that covers all employees and retired former employees. After Sarah retires, the hospital insurance premiums paid for her by her employer can be excluded from her gross income. a. True b. False 18. Meg’s employer carries insurance on its employees that will pay an employee their regular salary while the employee is away from work due to illness. The premiums for Meg’s coverage were $1,800. Meg was absent from work for two months as a result of a kidney infection. Her employer’s insurance company paid Meg's regular salary of $8,000 while she was away from work. Meg also collected $2,000 on a wage continuation policy she had purchased. Meg must include $11,800 in her gross income. a. True b. False 19. Melody works for a company with only 22 employees. Her employer contributed $2,000 to her health savings account (HSA), and the account earned $100 in interest during the year. Melody withdrew only $1,200 to pay medical expenses during the year. Melody is not required to recognize any gross income from the HSA for the year. a. True b. False 20. If an employer pays for an employee’s long-term care insurance premiums, the employee can exclude from gross income the premiums, but all of the benefits collected must be included in gross income. a. True b. False 21. Employees of a CPA firm located in Maryland may exclude from gross income the meals and lodging provided by the employer while they were on an audit in Delaware. a. True b. False 22. Carla is a deputy sheriff. Her employer requires that she live in the county where she is employed. Housing is very expensive; so the county agreed to pay her $4,800 per year to cover the higher cost of housing. Carla must include the housing supplement in her gross income. a. True b. False 23. Roger is in the 35% marginal tax bracket. Roger’s employer has created a flexible spending account for medical and dental expenses that are not covered by the company’s health insurance plan. Roger had his salary reduced by $1,200 during the year for contributions to the flexible spending plan. However, Roger incurred only $1,100 in actual expenses for which he was reimbursed. Under the plan, he must forfeit the $100 unused amount. His after-tax cost of overfunding the plan is $65. a. True b. False Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions 24. Mauve Company permits employees to occasionally use the copying machine for personal purposes. The copying machine is located in the office where the higher paid executives work, so they occasionally use the machine. However, the machine is not convenient for use by the lower paid warehouse employees and, thus, they never use the copier. The use of the copy machine may not be excluded from gross income because the benefit is discriminatory. a. True b. False 25. Fresh Bakery often has unsold donuts at the end of the day. The bakery allows employees to take the leftovers home. The employees are not required to recognize gross income because the bakery does not incur any additional cost. a. True b. False 26. In 2024, Nicole’s employer pays her $150 per month toward the cost of parking near a railway station where Nicole catches the train to work. The employer also pays the cost of the rail pass, $75 per month. Nicole can exclude both of these payments from her gross income. a. True b. False 27. If an employer provides all employees with group term life insurance equal to twice the employee’s annual salary, an employee with a salary of $50,000 has no gross income from the life insurance protection provided by the employer. a. True b. False 28. A U.S. citizen who works and lives in France from February 1, 2024, until January 31, 2025, is eligible for the foreign earned income exclusion in 2024 and 2025. a. True b. False 29. A U.S. citizen is always required to include in gross income the salary and wages earned while working in a foreign country even if the foreign country taxes the income. a. True b. False 30. Calvin miscalculated his income in 2022 and overpaid his state income tax by $3,000. In 2023, he amended his 2022 state income tax return and received a $3,000 refund and $200 interest. Calvin itemized his deductions in 2022 with $30,000 total itemized deductions. This included $10,000 of state taxes even though he paid state income taxes of $15,000 and property taxes of $4,000. As a result of the amended return in 2023, Calvin must recognize $3,000 of gross income. a. True b. False 31. Ji-ho, a single individual, took an itemized deduction of $5,500 for state income tax paid in 2024. His total itemized deductions in 2024 were $22,000 and did not include any other state or local taxes (the standard deduction for 2024 was $14,600). In 2025, he received a $900 refund of his 2024 state income tax. Ji-ho must include the $900 refund in his 2025 Federal gross income in accordance with the tax benefit rule. a. True b. False Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions 32. A taxpayer incorrectly took a $5,000 deduction (e.g., incorrectly calculated depreciation) in 2024 and as a result, his taxable income was reduced by $5,000. The taxpayer discovered his error in 2025. The taxpayer must add $5,000 to his 2025 gross income in accordance with the tax benefit rule to correct for the 2024 error. a. True b. False 33. Mia participated in a qualified state tuition program for the benefit of her son Michael. She contributed $15,000. When Michael entered college, the balance in the fund satisfied the tuition charge of $20,000. When the funds were withdrawn to pay the college tuition for Michael, neither Mia nor Michael must include $5,000 ($20,000 – $15,000) in gross income. a. True b. False 34. The earnings from a qualified state tuition program account are deferred from taxation until they are used for qualified higher education expenses. At that time, the amount taken from the fund must be included in the gross income of the person who contributed to the account. a. True b. False 35. Benny loaned $100,000 to his controlled corporation. When it became apparent that the corporation would not be able to repay the loan in the near future, Benny canceled the debt. The corporation should treat the cancellation as a nontaxable contribution to capital. a. True b. False 36. Zork Corporation was very profitable and had accumulated excess cash. The company decided to repurchase some of its bonds that had been issued for $1,000,000. Because of an increase in market interest rates, Zork was able to retire the bonds for $900,000. The company is not required to recognize $100,000 of income from the discharge of its indebtedness but must reduce the basis in its assets. a. True b. False 37. Amber Machinery Company purchased a building from Ted for $250,000 cash and a mortgage of $750,000. One year after the transaction, the mortgage had been reduced to $725,000 by principal payments by Amber, but it was apparent that Amber would not be able to continue to make the monthly payments on the mortgage. Ted reduced the amount owed by Amber to $600,000. This reduced the monthly payments to a level that Amber could pay. Amber must recognize $125,000 income from the reduction in the debt by Ted. a. True b. False Multiple Choice 38. The taxpayer’s marginal federal and state tax rate is 25%. Which would the taxpayer prefer? a. $1.00 taxable income rather than $1.25 tax-exempt income. b. $1.00 taxable income rather than $.75 tax-exempt income. c. $1.25 taxable income rather than $1.00 tax-exempt income. d. $1.40 taxable income rather than $1.00 tax-exempt income. Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions 39. Cash received by an employee from an employer: a. Is not included in gross income if it was not earned. b. Is not taxable unless the payor is legally obligated to make the payment. c. Must always be included in gross income. d. May be included in gross income although the payor is not legally obligated to make the payment. 40. Sharon had some insider information about a corporate takeover. She unintentionally informed a friend, who immediately bought the stock in the target corporation. The takeover occurred and the friend made a substantial profit from buying and selling the stock. The friend told Sharon about his stock dealings and gave her a pearl necklace because she “made it all possible.” The necklace was worth $10,000, but she already owned more jewelry than she desired. a. The necklace is a nontaxable gift received by Sharon because the friend was not legally required to make the gift. b. The value of the necklace is not included in Sharon’s gross income unless she sells it. c. The value of the necklace is not included in Sharon’s gross income because passing the information was an illegal act and the SEC can confiscate the necklace. d. The value of the necklace must be included in Sharon’s gross income for the tax year she received it. 41. Carin, a widow, elected to receive the proceeds of a $150,000 life insurance policy on the life of her deceased husband in 10 installments of $17,500 each. Her husband had paid premiums of $60,000 on the policy. In the first year, Carin collected $17,500 from the insurance company. She must include in gross income: a. $0. b. $2,500. c. $10,000. d. $25,000. 42. Iris collected $150,000 on her deceased husband’s life insurance policy. The policy was purchased by the husband’s employer under a group policy. Iris’s husband had included $5,000 in gross income from the group term life insurance premiums during the years he worked for the employer. She elected to collect the policy in 10 equal annual payments of $18,000 each. a. None of the payments must be included in Iris’s gross income. b. The amount she receives in the first year is a nontaxable return of capital. c. For each $18,000 payment that Iris receives, she can exclude $500 ($5,000/$180,000 × $18,000) from gross income. d. For each $18,000 payment that Iris receives, she can exclude $15,000 ($150,000/$180,000 × $18,000) from gross income. 43. Turquoise Company purchased a life insurance policy on the company’s chief executive officer, Joe. After the company had paid $400,000 in premiums, Joe died, and the company collected the $1.5 million face amount of the policy. The company also purchased group term life insurance on all its employees. Joe had included $16,000 in gross income for the group term life insurance premiums. Joe’s widow, Rebecca, received the $100,000 proceeds from the group term life insurance policy. a. Rebecca can exclude the life insurance proceeds of $100,000, but Turquoise must include $1,100,000 ($1,500,000 – $400,000) in gross income. b. Turquoise and Rebecca can exclude the life insurance proceeds of $1,500,000 and $100,000, respectively, from gross income. c. Turquoise can exclude $1,100,000 ($1,500,000 – $400,000) from gross income, but Rebecca must include $84,000 in gross income. Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions d. Turquoise must include $1,100,000 ($1,500,000 – $400,000) in gross income and Rebecca must include $100,000 in gross income. 44. Swan Finance Company, an accrual method taxpayer, requires all of its customers to carry credit life insurance. If a customer dies, the company receives from the insurance company the balance due on the customer’s loan. Ali, a customer, died owing Swan $1,500. The balance due included $200 accrued interest that Swan has included in income. When Swan collects $1,500 from the insurance company, Swan: a. Must recognize $1,500 income from the life insurance proceeds. b. Must recognize $1,300 income from the life insurance proceeds. c. Does not recognize income because life insurance proceeds are tax-exempt. d. Does not recognize income from the life insurance because the entire amount is a recovery of capital. 45. Ben was diagnosed with a terminal illness. His physician estimated that Ben would live no more than 18 months. After he received the doctor’s diagnosis, Ben cashed in his life insurance policy and used the proceeds to take a trip to see relatives and friends before he died. Ben had paid $12,000 in premiums on the policy, and he collected $50,000, the cash surrender value of the policy. Henry enjoys excellent health, but he cashed in his life insurance policy to purchase a new home. He had paid premiums of $12,000 and collected $50,000 from the insurance company. a. Neither Ben nor Henry is required to recognize gross income. b. Both Ben and Henry must recognize $38,000 ($50,000 – $12,000) of gross income. c. Henry must recognize $38,000 ($50,000 – $12,000) of gross income, but Ben does not recognize any gross income. d. Ben must recognize $38,000 ($50,000 – $12,000) of gross income, but Henry does not recognize any gross income. 46. Albert had a terminal illness that would require almost constant nursing care for the remaining two years of his estimated life, according to his doctor. Albert had a life insurance policy with a face amount of $100,000. He had paid $25,000 of premiums on the policy. The insurance company has offered to pay him $80,000 to cancel the policy, although its cash surrender value was only $55,000. He accepted the $80,000. Albert used $15,000 to pay his medical expenses. Albert made a miraculous recovery and lived another 20 years. As a result of cashing in the policy: a. Albert must recognize $55,000 of gross income, but he has $15,000 of deductible medical expenses. b. Albert must recognize $65,000 ($80,000 – $15,000) of gross income. c. Albert must recognize $40,000 ($80,000 – $25,000 – $15,000) of gross income. d. Albert is not required to recognize any gross income because of his terminal illness. 47. Carlos, age 19, is a full-time graduate student at City University. During 2024, he received the following payments: Cash award for being the outstanding resident adviser Resident adviser housing State scholarship for ten months (tuition and books) State scholarship (meals allowance) Loan from college financial aid office Cash support from parents

$ 1,500 2,500 6,000 2,400 3,000 2,000 $17,400

Carlos served as a resident adviser in a dormitory and, therefore, the university waived the $2,500 charge for the room he occupied. What is Carlos’s adjusted gross income for 2024? a. $1,500. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions b. $3,900. c. $9,000. d. $15,400. 48. A scholarship recipient at State University may exclude from gross income the scholarship proceeds used to pay for: a. Tuition only. b. Tuition, books, and supplies. c. Tuition, books, supplies, meals, and lodging. d. Meals and lodging. 49. Barney is a full-time graduate student at State University. He serves as a teaching assistant for which he is paid $700 per month for nine months and his $5,000 tuition is waived. The university waives tuition for all of its employees. In addition, Barney receives a $1,500 research grant to pursue his own research and studies. Barney’s gross income from the above is: a. $0. b. $6,300. c. $11,300. d. $12,800. 50. Jena is a full-time undergraduate student at State University and qualifies as a dependent of her parents. Her only source of income is a $10,000 athletic scholarship ($1,000, books; $5,500, tuition; $500, student activity fee; and $3,000, room and board). Jena’s gross income for the year is: a. $10,000. b. $4,000. c. $3,000. d. $500. 51. As an executive of Cherry, Inc., Ollie receives a fringe benefit in the form of annual tuition scholarships of $10,000 to each of his three children. The scholarships are paid by the company on behalf of the children of key employees directly to each child’s educational institution and are payable only if the student maintains a B average. a. The tuition payments of $30,000 may be excluded from Ollie’s gross income as a scholarship. b. The tuition payments of $10,000 each must be included in each child’s gross income. c. The tuition payments of $30,000 may be excluded from Ollie’s gross income because the payments are for the academic achievements of the children. d. The tuition payments of $30,000 must be included in Ollie’s gross income. 52. The taxpayer is a Ph.D. student in accounting at City University. The student is paid $1,500 per month for teaching two classes. The total amount received for the year is $13,500. a. The $13,500 is excludible if the money is used to pay for tuition and books. b. The $13,500 is taxable compensation. c. The $13,500 is considered a scholarship and, therefore, is excluded. d. The $13,500 is excluded because the total amount received for the year is less than her standard deduction and personal exemption. 53. During the current year, Khalid was in an automobile accident and suffered physical injuries. The accident was caused by Rashad’s negligence. Khalid threatened to file a lawsuit against Amber Trucking Company, Rashad’s employer, Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions claiming $50,000 for pain and suffering, $90,000 for loss of income, and $70,000 in punitive damages. Amber’s insurance company will not pay punitive damages; therefore, Amber has offered to settle the case for $100,000 for pain and suffering, $90,000 for loss of income, and nothing for punitive damages. Khalid is in the 35% marginal tax bracket. What is the after-tax difference to Khalid between Khalid’s original claim and Amber’s offer? a. Amber’s offer is $20,000 less. ($50,000 + $90,000 + $70,000 – $100,000 – $90,000). b. Amber’s offer is $7,000 less. [($50,000 + $90,000 + $70,000 – $100,000 – $90,000) × 0.35]. c. Amber’s offer is $4,500 more. {$190,000 – ($50,000 + $90,000) + [$70,000 × (1.00 – 0.35)]}. d. Amber’s offer is $22,000 more. [($190,000 – $210,000) + ($120,000 × 0.35)]. 54. Christie sued her former employer for a back injury she suffered on the job in 2024. As a result of the injury, she was partially disabled. In 2025, she received $240,000 for her loss of future income, $160,000 in punitive damages because of the employer’s flagrant disregard for the employee’s safety, and $15,000 for medical expenses. The medical expenses were deducted on her 2024 return, reducing her taxable income by $12,000. Christie’s 2025 gross income from the above is: a. $415,000. b. $412,000. c. $255,000. d. $172,000. 55. Early in the year, Marlon was in an automobile accident during the course of his employment. As a result of the physical injuries he sustained, he received the following payments during the year: Reimbursement of medical expenses Marlon paid by a medical insurance policy he purchased Damage settlement to replace his lost salary

$10,000 15,000

What is the amount that Marlon must include in gross income for the current year? a. $25,000. b. $15,000. c. $10,000. d. $0. 56. Theresa sued her former employer for age, race, and gender discrimination. She claimed $200,000 in damages for loss of income, $300,000 for emotional harm, and $500,000 in punitive damages. She settled the claim for $700,000. As a result of the settlement, Theresa must include in gross income: a. $700,000. b. $500,000. c. $490,000 [($700,000/$1,000,000) × $700,000]. d. $0. 57. Jack received a court award in a civil libel and slander suit against National Gossip. He received $120,000 for damages to his professional reputation, $100,000 for damages to his personal reputation, and $50,000 in punitive damages. Jack must include in his gross income as a damage award: a. $0. b. $100,000. c. $120,000. d. $270,000. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions 58. Olaf was injured in an automobile accident and received $25,000 for his physical injury, $50,000 for his loss of income, and $10,000 for punitive damages. As a result of the award, the amount Olaf must include in gross income is: a. $10,000. b. $50,000. c. $60,000. d. $85,000. 59. The exclusion for health insurance premiums paid by an employer applies to: a. Only current employees and their spouses. b. Only current employees and their spouses and dependents. c. Only current employees and their disabled spouses. d. Current employees, retired former employees, and their spouses and dependents. 60. Julie was suffering from a viral infection that caused her to miss work for 90 days. During the first 30 days of her absence, she received her regular salary of $8,000 from her employer. For the next 60 days, she received $12,000 under an accident and health insurance policy purchased by her employer. The premiums on the health insurance policy were excluded from her gross income. During the last 30 days, Julie received $6,000 on an income replacement policy she had purchased. Of the $26,000 she received, Julie must include in gross income: a. $6,000. b. $8,000. c. $14,000. d. $20,000. 61. Matilda works for a company with 1,000 employees. The company has a hospitalization insurance plan that covers all employees. However, the employee must pay the first $3,000 of their medical expenses each year. Each year, the employer contributes $1,500 to each employee’s health savings account (HSA). Matilda’s employer made the contributions in 2023 and 2024, and the account earned $100 interest in 2024. At the end of 2024, Matilda withdrew $3,100 from the account to pay the deductible portion of her medical expenses for the year and other medical expenses not covered by the hospitalization insurance policy. As a result, Matilda must include in her 2024 gross income: a. $0. b. $100. c. $1,600. d. $3,100. 62. All employees of United Company are covered by a group hospitalization insurance plan, but the employees must pay the premiums ($8,000 for each employee). None of the employees has sufficient medical expenses to deduct the premiums. Instead of giving raises next year, United is considering paying the employee’s hospitalization insurance premiums. If the change is made, the employee’s after-tax and insurance pay will: a. Decrease by the same amount for all employees. b. Increase more for the lower-paid employees (10% and 12% marginal tax bracket). c. Increase more for the higher income (35% marginal tax bracket) employees. d. Increase by the same amount for all employees. 63. The plant union is negotiating with the Eagle Company, which is on the verge of bankruptcy. Eagle has offered to pay for the employees’ hospitalization insurance in exchange for a wage reduction. Each employee currently pays premiums Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions of $4,000 a year for their insurance. Which of the following is correct? a. If an employee’s wages are reduced by $5,000 and the employee is in the 24% marginal tax bracket, the employee would benefit from the offer. b. If an employee’s wages are reduced by $4,000 and the employee is in the 12% marginal tax bracket, the employee would benefit from the offer. c. If an employee’s wages are reduced by $6,000 and the employee is in the 35% marginal tax bracket, the employee would benefit from the offer. d. Choices a., b., and c. 64. James, a cash basis taxpayer, received the following compensation and fringe benefits in the current year: Salary Disability income protection premiums Long-term care insurance premiums

$66,000 3,000 4,000

His actual salary was $72,000. He received only $66,000 because his salary was garnished and the employer paid the $6,000 owed on James’s credit card. The wage continuation insurance is available to all employees and pays the employee three-fourths of the regular salary if the employee is sick or disabled. The long-term care insurance is available to all employees and pays $150 per day toward a nursing home or similar facility. What is James’s gross income from the above? a. $66,000. b. $72,000. c. $73,000. d. $75,000. 65. The First Chance Casino has gambling facilities, a bar, a restaurant, and a hotel. All employees are allowed to obtain food from the restaurant at no charge during working hours. In the case of the employees who operate the gambling facilities, bar, and restaurant (60% of all of Casino’s employees), the meals are provided for the convenience of the Casino. However, the hotel workers demanded equal treatment and therefore were also allowed to eat in the restaurant at no charge while they are at work. Which of the following is correct? a. All the employees are required to include the value of the meals in their gross income. b. Only the restaurant employees may exclude the value of their meals from gross income. c. Only the employees who work in gambling, the bar, and the restaurant may exclude the meals from gross income. d. All of the employees may exclude the value of the meals from gross income. 66. An employee can exclude from gross income the value of meals provided by their employer whenever: a. The meal is not extravagant. b. The meals are provided on the employer’s premises for the employer’s convenience. c. There are no places to eat near the work location. d. The meals are provided for the convenience of the employee. 67. Randy is the manager of a motel. As a condition of his employment, Randy is required to live in a room on the premises so that he would be there in case of emergencies. Randy considered this a fringe benefit as he would otherwise be required to pay $800 per month rent. The room that Randy occupied normally rented for $70 per night, or $2,100 per month. On the average, 90% of the motel rooms were occupied. As a result of this rent-free use of a room, what amount is Randy required to include in gross income? a. $-0-. Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions b. $800 per month. c. $2,100 per month. d. $1,890 ($2,100 × 0.90). 68. Adam repairs power lines for the Egret Utilities Company. He is generally working on a power line during the lunch hour. He must eat when and where he can and still get his work done. He usually purchases something at a convenience store and eats in his truck. Egret reimburses Adam for the cost of his meals. a. Adam must include the reimbursement in his gross income. b. Adam can exclude the reimbursement from his gross income as the meals are provided for the convenience of the employer. c. Adam can exclude the reimbursement from his gross income because he eats the meals on the employer’s business premises (the truck). d. Adam may exclude from his gross income the difference between what he paid for the meals and what it would have cost him to eat at home. 69. Tommy, a senior at State College, receives free room and board as full compensation for working as a resident adviser at the university dormitory. The regular housing contract is $2,000 a year in total, $1,200 for lodging, and $800 for meals in the dormitory. He had the option of receiving the meals or $800 in cash and accepted the meals. What must Tommy include in gross income from working as a resident adviser? a. All items can be excluded from gross income as a scholarship. b. The meals must be included in gross income. c. The meals may be excluded because he did not receive cash. d. The lodging must be included in gross income because it was compensation for services. 70. Under Swan Company’s cafeteria plan, all full-time employees are allowed to select any combination of the following benefits, but the total received by each employee cannot exceed $8,000 a year. I. II. III. IV.

Group medical and hospitalization insurance for the employee, $3,600 a year. Group medical and hospitalization insurance for the employee’s spouse and children, $1,200 a year. Child care payments, actual cost but not more than $4,800 a year. Cash required to bring the total of benefits and cash to $8,000.

Which of the following statements is true? a. Sam, a full-time employee, selects choices II and III and $2,000 cash. His gross income must include the $2,000. b. Haruto, a full-time employee, elects to receive $8,000 cash because his wife’s employer provides these same insurance benefits, which would cover him (II). Haruto is not required to include the $8,000 in gross income. c. Sue, a full-time employee, elects to receive choices I, II, and $3,200 for III. Sue is required to include $3,200 in gross income. d. All of these choices are correct. 71. Heather is a full-time employee of Drake Company and participates in the company’s flexible spending plan that is available to all employees. Which of the following is correct? a. Heather reduced her salary by $1,200, actually spent $1,500, and received only $1,200 as reimbursement for her medical expenses. Heather’s gross income will be reduced by $1,500. b. Heather reduced her salary by $1,200 and received only $900 as reimbursement for her actual medical expenses. She is not refunded the $300 remaining balance, but her gross income is reduced by $1,200. Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions c. Heather reduced her salary by $1,200 and received only $800 as reimbursement for her medical expenses. She is not refunded the $400. Her gross income is reduced by $800. d. Heather reduced her salary by $1,200 and received only $900 as reimbursement for her medical expenses. She forfeits the $300. Her gross income is reduced by $300. 72. Employees of the Valley Country Club are allowed to use the golf course without charge before and after working hours on Mondays when the number of players on the course is at its lowest. Tom, an employee of the country club, played 40 rounds of golf during the year at no charge when the nonemployee charge was $20 per round. a. Tom must include $800 in gross income. b. Tom is not required to include anything in gross income because it is a de minimis fringe benefit. c. Tom is not required to include the $800 in gross income because the use of the course was a gift. d. Tom is not required to include anything in gross income because this is a no-additional-cost service fringe benefit. 73. The Royal Motor Company manufactures automobiles. Nonmanagement employees of the company can buy a new automobile for Royal’s cost plus 2%. The automobiles are sold to dealers at cost plus 20%. Generally, management employees of Local Dealer, Inc., are allowed to buy a new automobile from the company at the dealer’s cost. Which of the following statements is correct? a. The nonmanagement employees who buy automobiles at a discount are not required to recognize income from the purchase. b. None of the employees who take advantage of the fringe benefits described above are required to recognize income. c. Employees of Royal are required to recognize as gross income 18% (20% – 2%) of the cost of the automobile purchased. d. All of these choices are correct. 74. Peggy is an executive for the Tan Furniture Manufacturing Company. She purchased furniture from the company for $9,500, the price Tan ordinarily would charge a wholesaler for the same items. The retail price of the furniture was $12,500, and Tan’s cost was $9,000. The company also paid for Peggy’s parking space in a garage near the office. The parking fee was $600 for the year. All employees are allowed to buy furniture at a discounted price comparable to that charged to Peggy. However, the company does not pay other employees’ parking fees. Peggy’s gross income from the above is: a. $-0-. b. $600. c. $3,500. d. $4,100. 75. The employees of Mauve Accounting Services are permitted to use the copy machine for personal purposes, provided the privilege is not abused. Ed is the president of a civic organization and uses the copier to make several copies of the organization’s agenda for its meetings. The copies made during the year would have cost $150 at a local office supply. a. Ed must include $150 in his gross income. b. Ed may exclude the cost of the copies as a no-additional-cost fringe benefit. c. Ed may exclude the cost of the copies only if the organization is a client of Mauve. d. Ed may exclude the cost of the copies as a de minimis fringe benefit. 76. The de minimis fringe benefit: a. Exclusion applies only to property received by the employee. Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions b. Can be provided on a discriminatory basis. c. Exclusion is limited to $250 per year. d. Exclusion applies to employee discounts. 77. Evaluate the following statements: I. II. III.

De minimis fringe benefits are those that are so immaterial that accounting for them is impractical. De minimis fringe benefits are subject to strict antidiscrimination requirements. Generally, a fringe benefit of less than $50 is considered de minimis and can be excluded from gross income. a. Only I is true. b. Only III is true. c. Only I and III are true. d. I, II, and III are true.

78. Kristen’s employer owns its building and provides parking space for its employees. The value of the free parking is $150 per month. Karen’s employer does not have parking facilities but reimburses its employees for the cost of parking in a nearby garage up to $150 per month. a. Kristen and Karen must recognize gross income from the parking services. b. Kristen can exclude the employer-provided parking from gross income, but Karen must include her reimbursement in gross income. c. Kristen must include the value of the employer-provided parking from her gross income, but Karen can exclude her reimbursement from gross income. d. Neither Kristen nor Karen is required to include the cost of parking in gross income. 79. A company has a medical reimbursement plan for officers that covers all costs that the company's insurer will not pay. However, for all employees who are not officers, the medical reimbursement plan applies only after the employee has paid $1,000 from their own funds. An officer incurred $1,500 in medical expenses and was reimbursed for that amount. An hourly worker also incurred $1,500 in medical expense and was reimbursed $500. a. Both employees must include all benefits received in gross income. b. The officer must include $500 in gross income. c. The officer must include $1,500 in gross income. d. The hourly employee must include $1,000 in gross income. 80. Louise works in a foreign branch of her employer’s business. She earned $5,000 per month throughout the relevant period. Which of the following is correct? a. If Louise worked in the foreign branch from May 1, 2023, until October 31, 2024, she may exclude $40,000 from gross income in 2023 and exclude $50,000 in 2024. b. If Louise worked in the foreign branch from May 1, 2023, until October 31, 2024, she cannot exclude anything from gross income because she was not present in the country for 330 days in either year. c. If Louise began work in the foreign country on May 1, 2023, she must work through November 30, 2024, in order to exclude $55,000 from gross income in 2024 but none in 2023. d. Louise will not be allowed to exclude any foreign earned income because she made less than the annual ceiling in 2023 and 2024. Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions 81. A U.S. citizen lived and worked in a foreign country for the period July 1, 2023, through August 1, 2024. Her salary was $12,000 per month. Also, in 2023 she received $5,000 in dividends from foreign corporations (not qualified dividends). No dividends were received in 2024. Which of the following is correct? a. The taxpayer cannot exclude any of the income because she was not present in the foreign country more than 330 days in either 2023 or 2024. b. The taxpayer can exclude a portion of the salary from U.S. gross income in 2023 and 2024, and all of the dividend income. c. The taxpayer can exclude from U.S. gross income $72,000 salary in 2023, but in 2024 she will exceed the 12month limitation and, therefore, all of the 2024 compensation must be included in gross income. All of the dividends must be included in 2023 gross income. d. The taxpayer must include the dividend income of $5,000 in 2023 gross income, but she can exclude a portion of the compensation income from U.S. gross income in 2023 and 2024. 82. In the case of interest income from state and Federal bonds: a. Interest on U.S. government bonds received by a state resident can be subject to that state’s income tax. b. Interest on U.S. government bonds is subject to Federal income tax. c. Interest on bonds issued by State A received by a resident of State B cannot be subject to income tax in State B. d. All of these choices are correct. 83. Margarita’s interest and gains on investments for the current year are as follows: Interest on Madison County school bonds Interest on U.S. government bonds Interest on a Federal income tax refund Gain on the sale of Madison County school bonds

$600 700 200 500

Margarita must report gross income in the amount of: a. $2,000. b. $1,800. c. $1,400. d. $1,300. 84. Imani is in the 35% marginal tax bracket. She can purchase a York County school bond yielding 3.5% interest, which is not subject to a 5% state tax. But she is interested in earning a higher return for comparable risk. Which of the following is correct? a. If she buys a corporate bond that pays 6% interest, her after-tax rate of return will be less than if she had purchased the York County school bond. b. If she buys a U.S. government bond paying 5%, her after-tax rate of return will be less than if she had purchased the York County school bond. c. If she buys a common stock paying a 4% dividend, her after-tax rate of return will be higher than if she had purchased the York County school bond. d. All of these choices are correct. 85. Doug and Manuel received the following interest income in the current year: Savings account opened at Greenbacks Bank Powered by Cognero

$4,000 Page 15

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions U.S.Treasury bonds Interest on State of Iowa bonds Interest on Federal tax refund Interest on state income tax refund

250 200 150 75

Greenbacks Bank also gave Doug and Manuel a cellular phone (worth $100) for opening the savings account. What amount of interest income should they report on their joint income tax return? a. $4,775. b. $4,675. c. $4,575. d. $4,300. 86. George, an unmarried cash basis taxpayer, received the following amounts this year: Interest on savings accounts Interest on a state tax refund Interest on City of Salem school bonds Interest portion of proceeds of a 5% bank certificate of deposit purchased last year on July 1 and matured on June 30 of this year Dividends on USG common stock

$2,000 600 350 250 300

What amount should George report as gross income from dividends and interest this year? a. $2,300. b. $2,550. c. $3,150. d. $3,500. 87. Stuart owns 300 shares of Turquoise Corporation stock and 2,000 shares of Blue Corporation stock. During the year, Stuart received 150 shares of Turquoise as a result of a 1-for-2 stock split. The value of the shares received was $4,800. Stuart also received 100 shares of Blue Corporation stock as a result of a 5% stock dividend. Stuart did not have the option of receiving cash from Blue. The additional shares he received had a value of $7,200. Stuart’s gross income from the receipt of the additional Turquoise and Blue shares is: a. $0. b. $4,800. c. $7,200. d. $12,000. 88. Assuming a taxpayer qualifies for the exclusion treatment, the interest income on educational savings bonds: a. Is gross income to the person who purchased the bond in the year the interest is earned. b. Is gross income to the student in the year the interest is earned. c. Is included in the student’s gross income in the year the savings bonds are sold or redeemed to pay educational expenses. d. Is not included in anyone’s gross income if the proceeds are used to pay college tuition. 89. The exclusion of interest on educational savings bonds: a. Applies only to savings bonds owned by the child. Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions b. Applies to parents who purchase bonds for which the proceeds are used for their child’s education. c. Means that the child must include the interest in income if the bond is owned by the parent. d. Does apply even if used to pay for room and board. 90. Martha invested $6,000 in a qualified tuition program for the benefit of her son. Four years later her son withdrew $8,000, the entire balance in the program, to pay his college tuition. a. Martha is not required to include the $2,000 ($8,000 – $6,000) in her gross income when the funds are used to pay the tuition. b. Martha’s son must include the $2,000 ($8,000 – $6,000) in his gross income when the funds are used to pay the tuition. c. Martha must include $8,000 in her gross income. d. Martha’s son must include $8,000 in his gross income. 91. In December 2024, Todd, a cash basis taxpayer, paid $1,200 of fire insurance premiums for the calendar year 2025 on a building he held for rental income. Todd deducted the $1,200 of insurance premiums on his 2024 tax return. He had $150,000 of taxable income that year. On June 30, 2025, he sold the building and, as a result, received a $500 refund on his fire insurance premiums. As a result of the above: a. Todd should amend his 2024 return and claim $500 less insurance expense. b. Todd should include the $500 in 2025 gross income in accordance with the tax benefit rule. c. Todd should add the $500 to his sales proceeds from the building. d. Todd should include the $500 in 2025 gross income in accordance with the claim of right doctrine. 92. Tonya is a cash basis taxpayer. In 2024, she paid state income taxes of $8,000 and property taxes of $5,500. In early 2025, she filed her 2024 state income tax return and received a $900 refund. a. If Tonya itemized her deductions in 2024 on her Federal income tax return, she should amend her 2024 return and reduce her itemized deductions by $900. b. If Tonya itemized her deductions in 2024 on her Federal income tax return, the refund will not affect her 2025 tax return. c. If Tonya itemized her deductions in 2024 on her Federal income tax return, she must amend her 2024 Federal income tax return and use the standard deduction. d. If Tonya itemized her deductions in 2024 on her Federal income tax return and her itemized deductions exceeded the standard deduction by more than $900, she must recognize $900 income in 2025 under the tax benefit rule. 93. Harold bought land from Jewel for $150,000. Harold paid $50,000 cash and gave Jewel an 8% note for $100,000. The note was to be paid over a five-year period. When the balance on the note was $80,000, Jewel began having financial difficulties. To accelerate her cash inflows, Jewel agreed to accept $60,000 cash from Harold in final payment of the note principal. a. Harold must recognize $20,000 ($80,000 – $60,000) of gross income. b. Harold is not required to recognize gross income but must reduce his cost basis in the land to $130,000. c. Harold is not required to recognize gross income as he paid the debt before it was due. d. Jewel must recognize gross income of $20,000 ($80,000 – $60,000) from discharge of the debt. 94. Barry, a solvent individual but a recovering alcoholic, embezzled $6,000 from his employer. In the same year that he embezzled the funds, his employer discovered the theft. His employer did not fire him and told him he did not have to repay the $6,000 if he would attend Alcoholics Anonymous. Barry met the conditions and his employer canceled the debt. a. Barry did not realize any income because his employer made a gift to him. Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions b. Barry must include $6,000 in gross income from discharge of indebtedness. c. Barry must include $6,000 in gross income under the tax benefit rule. d. Barry may exclude the $6,000 from gross income because the debt never existed. 95. Gold Company was experiencing financial difficulties but was not bankrupt or insolvent. National Bank, which held a mortgage on other real estate owned by Gold, reduced the principal from $110,000 to $85,000. The bank had made the loan to Gold when it purchased the real estate from Silver, Inc. Pink, Inc., the holder of a mortgage on Gold’s building, agreed to accept $40,000 in full payment of the $55,000 due. Pink had sold the building to Gold for $150,000 that was to be paid in installments over eight years. As a result of the above, Gold must: a. Include $40,000 in gross income. b. Reduce the basis in its assets by $40,000. c. Include $25,000 in gross income and reduce its basis in its assets by $15,000. d. Include $15,000 in gross income and reduce its basis in the building by $25,000. 96. On January 1, 2014, Cardinal Corporation issued 5% 25-year bonds at par and used the $12,000,000 proceeds to finance the construction of a new plant. On January 1, 2024, the company acquired the bonds on the open market for $11,500,000. Assuming that Cardinal is neither bankrupt nor insolvent, the acquisition and retirement of the bonds results in which of the following? a. The company must recognize a $500,000 gain. b. The company can make an election to recognize a $500,000 gain or reduce the company’s basis in the plant by $500,000. c. The company must recognize a $500,000 gain and increase its basis in the plant by $500,000. d. The company can amortize the $500,000 gain, recognizing income over the remaining life of the bonds. 97. Flora Company owed $95,000, a debt incurred to purchase land that serves as security for the debt. a. If Flora had borrowed the funds from a bank, the bank accepts $85,000 in full payment of the debt, and Flora is solvent after the transfer, Flora does not recognize income, but the company must reduce the cost of the land by $10,000. b. If Flora had borrowed the funds from a bank and the bank accepts $85,000 in full payment of the debt, when the value of the property is $80,000, Flora can deduct a loss. c. If Flora transfers to the bank other property with a basis of $90,000 and a fair market value of $95,000 in full payment of the debt, Flora can recognize a $5,000 loss. d. If the $95,000 is owed to the person who sold the property to Flora and that person accepts $85,000 in full payment for the debt, Flora does not recognize gain but must reduce its basis in the land. 98. Gordon, an employee, is provided group term life insurance coverage equal to twice his annual salary of $125,000 per year. According to the IRS Uniform Premium Table (based on Gordon’s age), the amount is $12 per year for $1,000 of protection. The cost of an individual policy would be $15 per year for $1,000 of protection. As Gordon paid nothing towards the cost of the $250,000 protection, he must include in his 2024 gross income which of the following amounts? a. $1,350. b. $2,400. c. $3,000. d. $3,750. 99. Green, Inc., provides group term life insurance for all of its employees. The coverage equals twice the employee’s annual salary. Sam, a vice president, worked all year for Green, Inc., and received $200,000 of coverage for Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions the year at a cost to Green of $1,500. The Uniform Premiums (based on Sam’s age) are $0.25 per month for $1,000 of protection. How much must Sam include in gross income this year? a. $0. b. $375. c. $450. d. $600. Subjective Short Answer 100. Beverly died during the current year. At the time of her death, her accrued salary and commissions totaled $3,000 and were paid to her husband. The employer also paid the husband $35,000, which represented an amount equal to Beverly’s salary for the year prior to her death. The employer had a policy of making the salary payments to “help out the family in the time of its greatest need.” Beverly’s spouse collected her interest in the employer’s qualified profit sharing plan amounting to $30,000. As beneficiary of his wife’s life insurance policy, Beverly’s spouse elected to collect the proceeds in installments. In the year of her death, he collected $8,000, which included $1,500 interest income. Which of these items are subject to income tax for Beverly’s spouse? 101. Leilani is married, files a joint return, and expects to be in the 24% marginal tax bracket for the foreseeable future. All of her income is from salary and all of it is used to maintain the household. She has a paid up life insurance policy with a cash surrender value of $100,000. She paid $60,000 of premiums on the policy. Her gain from cashing in the life insurance policy would be ordinary income. If she retains the policy, the insurance company will pay her at least $3,000 (3%) interest each year. Leilani thinks she can earn a higher return if she cashes in the policy and invests the proceeds. a. b.

What before-tax rate of return would Leilani be required to earn on the proceeds from cashing in the policy to equal the return earned with the insurance company? Assume Leilani estimates she can earn a 6% before-tax rate of return on the proceeds from cashing in the policy. Assume she can earn a 6% return for the remainder of her life and that she will reinvest all earnings at the same 6% before-tax rate of return. If Leilani expects to live 10 more years, which alternative will yield the greater amount to her beneficiaries upon her death? (Given: The future value of an annuity in 10 years assuming a 4.32% after-tax return is 12.19. The future value of an annuity in 10 years assuming a 2.16% return is 11.03).

102. Barbara was injured in an automobile accident. She has threatened to file a suit against the other party involved in the accident and has proposed the following settlement: Damages for 25% loss of the use of her right arm Medical expenses Loss of wages Punitive damages

$200,000 30,000 10,000 100,000 $340,000

The defendant’s insurance company is reluctant to pay punitive damages. Also, the company disputes the amount of her loss of wages. Instead, the company offers to pay her $300,000 for damages to her arm and $30,000 medical expenses. Assuming Barbara is in the 35% marginal tax bracket, will her after-tax proceeds from accepting the offer be equal to what she considers to be her actual damages (listed above)? 103. George is employed by Quality Appliance Company. All full-time employees are allowed to purchase appliances at the company’s cost plus 10%. The employees are also given, at no cost, a one-year service contract on all the goods purchased from the company. George purchased a refrigerator for $500. The company’s normal selling price for the refrigerator is $800. George also received a service contract at no charge that had a value of $150. During the year, Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions George was required to have his refrigerator serviced once. The cost of the call would have been $75 if he had not had the service contract. Is George required to recognize any income from the purchase of the refrigerator, the receipt of the service contract, and the service call? 104. Juan was considering purchasing an interest in a tax-exempt bond fund for $100,000 when he discovered that the interest must be included on his state income tax return. The interest rate is 5%. His marginal Federal tax rate is 35%, and his marginal state income tax rate is 10%. Juan itemizes his deductions on his Federal income tax return. As an alternative, Juan can purchase a state bond (a double-exempt bond) yielding 4.9% interest that is exempt from both Federal and state income tax. Which investment would yield the greater after-tax return? 105. Margaret is trying to decide whether to place funds in a qualified tuition program. Her son will be attending college in four years. She is in the 35% marginal tax bracket and she believes she can earn an 7% before tax return on alternative investments. Thus, $10,000 will accumulate to $11,948 (after-tax) in four years. Margaret expects tuition to increase at the rate of 5% each year to $12,155 in four years. Her son will be in the 12% marginal tax bracket in all relevant years. Given these assumptions, should Margaret participate in the qualified tuition program? 106. Gull Corporation was undergoing reorganization under the bankruptcy laws. Its shareholders, who had made loans of $300,000 to the corporation, agreed to accept additional stock with a value of $200,000 instead of repayment on the debt. The Old Line Insurance Company, which had a $400,000 mortgage on the building, agreed to reduce the principal to $250,000. A trade creditor with a receivable of $150,000 from the company agreed to accept $70,000 in full payment for the debt incurred to purchase goods that were still on hand. Finally, the company transferred some equipment with an adjusted basis of $90,000 in satisfaction of a liability for $120,000. Compute the corporation’s gross income and other adjustments necessary as a result of the above transactions. Essay 107. Carmen had worked for Sparrow Corporation for 30 years when she died of a heart attack at age 60. She was practically penniless at the time of her death, owed a $12,000 hospital bill, and had a spouse with disabilities. The company was very concerned about its public image, and rather than run the risk of embarrassment from one of its longterm employees dying and leaving her spouse with insufficient means, the board of directors agreed to pay Carmen’s hospital bill and to give her spouse $6,000 per year for the rest of his life. Discuss both sides of the question of whether Carmen (or her estate) and her spouse realize any taxable income from these transactions. 108. What are the tax problems associated with payments received by a wife from her deceased husband’s employer? (Assume the wife renders no services to the employer.) 109. Bob had a terminal illness and realized that he “can’t take it with him.” Therefore, he cashed in his insurance policy and received $120,000. He had paid $50,000 in premiums on the policy. He used the money to fulfill his lifelong ambitions of going to the Super Bowl, driving an expensive sports car, and vacationing in Bermuda. Was Bob’s behavior consistent with the Congressional intent in providing the tax exemption he was permitted to use? 110. Ben was hospitalized for back problems. While he was away from the job, he collected his regular salary from an employer-sponsored income protection insurance policy. Ben’s employer-sponsored hospitalization insurance policy also paid for 90% of his medical expenses. Ben also collected on an income protection policy that he had purchased. Which of these sources of income is/are taxable? Explain the basis for excluding any item or items. 111. The CEO of Cirtronics Inc., discovered that the company’s competitor had adopted a cafeteria plan for its employees. The CEO is concerned about retaining her talented employees and would like you to provide a brief explanation as to why a cafeteria plan may be attractive to the company’s employees. Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions 112. What Federal income tax benefits are provided for college students? 113. Employers can provide numerous benefits to their employees and the employees are permitted to exclude the value of these benefits from gross income. What are the effects of the exclusions on the following? a. b.

The progressiveness of the tax system. The complexity of the tax system.

114. Both Molly and Darius own property with a fair market value less than the amount of the outstanding mortgage on the property and also less than the original cost basis. Each of them was able to convince the mortgage holder to reduce the principal amount on the mortgage. Molly’s mortgage is on her personal residence and Darius’s mortgage is on rental property he owns. Both debts are recourse. a.

Explain whether each of these individuals has realized income from the reduction in the debt.

b.

Assume that under the current system of measuring income, each of these taxpayers realized income from the reductions in the mortgages. Should either of these taxpayers be permitted to exclude any of the debt discharge income?

115. If a tax-exempt bond will yield approximately 0.65 (1 – 0.35) times the yield on a taxable bond of equal risk, who benefits from the tax exemption: the Federal government, the state and local governments who issue the bonds, or the investors?

Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions Answer Key 1. False 2. False 3. True 4. True 5. False 6. True 7. False 8. True 9. False 10. False 11. True 12. True 13. True 14. False 15. True 16. True 17. True 18. False 19. True 20. False 21. False 22. True 23. True 24. False 25. False Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions 26. True 27. False 28. True 29. False 30. False 31. True 32. False 33. True 34. False 35. True 36. False 37. False 38. d 39. d 40. d 41. b 42. d 43. b 44. d 45. c 46. d 47. b 48. b 49. b 50. c Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions 51. d 52. b 53. c 54. d 55. d 56. a 57. d 58. a 59. d 60. d 61. a 62. c 63. d 64. b 65. d 66. b 67. a 68. a 69. b 70. a 71. b 72. d 73. a 74. a 75. d 76. b Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions 77. a 78. d 79. c 80. a 81. d 82. b 83. c 84. b 85. c 86. c 87. a 88. d 89. b 90. a 91. b 92. b 93. b 94. b 95. c 96. a 97. d 98. b 99. c 100. Salary and commissions Profit sharing plan Interest income Powered by Cognero

$ 3,000 30,000 1,500 Page 25

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions Included in gross income

$34,500

All nonforfeitable rights to funds are includible in income (salary, commissions). This includes the accrued salary of $3,000. The collection of Beverly’s interest in the profit sharing plan of $30,000 is subject to taxation. The $35,000 payment by the employer was pursuant to a policy of charity to families of deceased employees, and there is authority for excluding this item as a gift. The IRS will probably challenge the exclusion of the $35,000. The IRS would argue that a policy of making the payment to all families of deceased employees makes the payment appear to be in the nature of compensation for prior services. Life insurance proceeds are tax-exempt. However, all interest paid on life insurance proceeds is includible in gross income. 101. a.

b.

If Leilani cashes in the policy, she must recognize a $40,000 gain and pay taxes of $9,600 [0.24($100,000 – $60,000) = $9,600]. Therefore, she will have only $90,400 to invest ($100,000 – $9,600 = $90,400). To earn about $3,000, the same as she receives from the insurance company, Leilani must earn a 0.03378 return on the after-tax proceeds ($90,400 ×0.03378 = $3,054). The life insurance proceeds will be exempt from income tax. Therefore, if Leilani retains the policy, the beneficiaries receive $100,000 plus the compound amount of (1.00 – 0.24)($3,000) = $2,280 interest earned each year. The interest will be reinvested at 6% before tax, or (1.00 – 0.24)(0.06) = 4.56% after-tax interest. Given the compound interest factor of 12.19, the annual income will accumulate to 12.19 × $2,280 = $27,793. The after-tax policy proceeds are $100,000. Therefore, if Leilani retains the policy, her beneficiaries would expect to receive $127,793 ($100,000 + $27,793). If Leilani cashed in the policy, her beneficiaries will receive the after-tax amount of the policy ($90,400), as computed in a., plus the compound amount of the earnings on the $90,400, at a 4.56% after-tax return. The annual after-tax earnings on $90,400 is $4,122 (0.0456 × $90,400). This will accumulate to $4,122 × 12.19 = $50,247 in 10 years. Therefore, her beneficiaries would receive $140,647 ($90,400 + $50,247). Cashing in the policy is the better alternative.

102. Barbara’s claim for punitive damages of $100,000 is the only taxable amount. Therefore, her after-tax proceeds from receiving the $340,000 would be $305,000 [$340,000 – 0.35($100,000)]. None of the offer from the insurance company ($330,000) would be taxable and therefore her after-tax proceeds from the settlement would be $330,000. Thus, both the insurance company and Barbara would benefit from her accepting the insurance company’s offer. 103. George will probably be required to recognize $120 income from the service contract. The company can sell the service contract to an employee at a 20% discount and the employee is not required to recognize income. George received a 100% discount; therefore, $120 (80% × $150) must be included in his gross income. However, George can perhaps make a convincing argument that he is merely receiving a no-additional-cost service, and thus would not be required to recognize income. George will not be required to recognize income from the bargain purchase of the refrigerator because he paid more than the employer’s cost (i.e. the company’s cost plus 10%). 104. Juan will receive $5,000 before-tax from the bond fund. The state income tax is $500 [(0.10)($5,000)]. The state income tax will be deductible on the Federal return; thus, the state taxes will reduce Juan’s after-tax income by only $325 Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions [(1.00 – 0.35)($500]. Therefore, the annual after-tax return is $4,675 ($5,000 – $325), or 4.675%. The double-exempt bonds will yield 4.9% after tax; therefore, they are the preferred investment, assuming equal risks. 105. Margaret can accumulate $11,948 by investing her funds for four years, but then she must pay the actual tuition. Alternatively, if she invests the $10,000 in a qualified tuition program, the tuition will be paid in four years regardless of the amount. The amount of the tuition less the $10,000 will not be subject to tax. Thus, the after-tax future value of the qualified tuition fund is $12,155 ($12,155 – $0), which is greater than the alternative accumulated value. Therefore, it appears that Margaret should participate. 106. Gull is not required to recognize income from the shareholders exchanging the debt for stock (a nontaxable contribution to capital). The $80,000 reduction in debt ($150,000 – $70,000) to trade creditors can be used to reduce the basis in the goods purchased. However, Gull is required to recognize $30,000 gain ($120,000 – $90,000) from transferring the equipment in satisfaction of the debt. However, because Gulf is in bankruptcy, the $150,000 income from discharge of indebtedness on the mortgage held by Old Line can be used to reduce tax attributes (e.g., net operating loss carryover, basis in assets). 107. The argument that Carmen and her spouse realize income from the payments is as follows: the employer was compensating for the employee’s prior services. The fact that the employer had no legal obligation to make the payments is not relevant since the employer realized a benefit (prevention of embarrassment). The argument that Carmen and her spouse do not realize income is predicated upon characterizing the payments as a gift. Conditions indicating that a gift was intended include the following: the spouse’s dire financial condition; the decedent had been fully compensated for her past services, and any benefits the corporation received from the payments were indirect because there was no obligation to pay such amounts. The $12,000 hospital payment is taxable because the gift is likely taxable income to her estate, as income in respect of the decedent because the gift exclusion does not apply to payments by the employer to the employee. The $6,000 annual payments by the employer to the spouse is likely excluded as a gift. The IRS will probably challenge the exclusion of the annual payments as being in the nature of compensation for prior services of the employee (i.e. wife). 108. An amount paid in respect of compensation owed to the employee at the time of his death is taxable to the spouse, just as the amount would have been taxable to the decedent if he had received the money prior to death. Additional noninvested amounts paid by the employer probably should be totally excluded from the spouse’s income as a gift. However, the IRS generally considers such payments to be compensation for past services rather than gifts. Payments received from the employer’s qualified pension or profit sharing plan are subject to taxation. Also, if the employee contributed to the pension and profit sharing plan, the beneficiary is allowed to treat this amount as a nontaxable recovery of capital. 109. No. Bob was permitted to exclude from his gross income the $70,000 gain ($120,000 – $50,000) he realized from cashing in the policy. The exclusion was permitted because he was terminally ill. The rationale for the exclusion is that often the person with the terminal illness will have the need for funds to be used for their medical care. Bob is clearly not using the funds for this purpose to be served by the law. Nevertheless, the law does not prevent Bob from obtaining the exclusion. 110. Only the collections on the employer-sponsored income protection policy are subject to tax. The hospitalization benefits received from the employer sponsored plan are specifically excluded. Both the premiums and the payments can be excluded. The amounts Ben collected on a policy he purchased are specifically excluded under the rationale that the payments are a recovery of Ben’s premiums. 111. Cafeteria plans are beneficial where employees desire different types of benefits. This often occurs when employees are married and their spouses receive some benefits from their employers. For example, if the husband is covered by Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 05: Gross Income Exclusions health insurance provided by his employer, there is no need for the wife’s employer to provide coverage for the husband also. Moreover, some employees may need child care benefits while those without children may prefer cash. The cafeteria plan provides much greater flexibility in planning benefits. 112. The Federal income tax system provides direct benefits to college students and indirect benefits by providing tax relief for the students' parents. College students can receive tax-exempt scholarships. The interest on educational savings bonds, which are often purchased by parents, may be exempt when the proceeds are used to pay qualified educational expenses. The qualified tuition program enables parents to fund the educational expenses of their children without any income being taxed to the parents or to the children. 113. a.

b.

The benefit of an exclusion varies directly with the recipient’s marginal tax rate. Thus, individuals with the highest marginal tax rate enjoy the greatest benefit from the exclusion and those taxpayers in the lowest marginal tax rate enjoy the least benefit. Also, the exclusions are generally available with the better-paying jobs. This also causes the tax system to be less progressive than were the exclusions not permitted. Any exclusion creates complexities in the system because tests must be established to determine whether the benefit is eligible (e.g., whether the benefit is provided in a discriminatory manner) for the special treatment. Also, often limitations are often created, which requires even more testing.

114. a.

b.

Each taxpayer’s liabilities were reduced. Therefore, the net worth of each has increased as measured using the cost basis in the assets. Each taxpayer also experienced a loss in the value of her or his assets. However, the losses were not realized (because each taxpayer still owns the property). Thus, each taxpayer had income from the reduction in debt but no recognized loss. Fortunately, the tax law allows the taxpayer whose property is a personal residence to exclude the income from debt discharge from gross income. The taxpayer who owns the rental home is not eligible for this debt discharge exclusion. Allowing the exclusion from income for the homeowner but not for the investor can be justified only on the basis of a value system that says we should modify the otherwise equitable rules to favor home ownership.

115. The state and local governments benefit from the exemption because they are required to pay less interest. The exemption costs the Federal government and thus shifts resources from the Federal to the state and local governments. The investors do not derive any benefit from the exemption in this example, because the market drives the price of the exempt bonds upward so that the after-tax yields on the bonds are equal for investors in the highest marginal tax bracket (35%).

Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 1. Deductions are allowed unless a specific provision in the tax law provides otherwise. a. True b. False 2. Mitch is in the 24% tax bracket. He may receive a different tax benefit for a $2,000 expenditure that is classified as a deduction from adjusted gross income (AGI) than he will receive for a $2,000 expenditure that is classified as a deduction for AGI. a. True b. False 3. Unreimbursed employment related expenses are classified as deductions for AGI. a. True b. False 4. Section 212 expenses that are related to rent and royalty income are deductions for AGI. a. True b. False 5. Alice incurs qualified moving expenses of $12,000 in the current year. If she is not reimbursed by her employer, the deduction is classified as a deduction for AGI. a. True b. False 6. Investment related expenses, such as paying a fee to an investment manager, generally are deductions from adjusted gross income in 2024. a. True b. False 7. The Code does not specifically define what constitutes a trade or business. a. True b. False 8. An expense need not be recurring in order to be “ordinary.” a. True b. False 9. Aaron, a shareholder–employee of Pigeon, Inc., receives a $300,000 salary. The IRS classifies $100,000 of this amount as unreasonable compensation. The effect of this reclassification is to decrease Aaron’s gross income by $100,000 and increase Pigeon’s gross income by $100,000. a. True b. False 10. The portion of a shareholder–employee’s salary that is classified as unreasonable has no effect on the amount of the shareholder–employee’s gross income but results in an increase in the taxable income of the corporation. a. True b. False Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 11. Generally, a closely held family corporation is not permitted to take a deduction for a salary paid to a family member in calculating corporate taxable income. a. True b. False 12. Only under limited circumstances can a loss on the sale of a personal use asset be deducted. a. True b. False 13. The income of a sole proprietorship is reported on Schedule C (Profit or Loss from Business). a. True b. False 14. Depending on the nature of the expenditure, expenses incurred in a trade or business may be deductible for or from AGI. a. True b. False 15. The cash method can always be used by a corporation even if inventory and cost of goods sold are a significant income-producing factor in the business. a. True b. False 16. A taxpayer’s note or promise to pay satisfies the “actually paid” requirement for the cash basis method of accounting. a. True b. False 17. Isabella owns two business entities. She may be able to use the cash method for one and the accrual method for the other. a. True b. False 18. Under the 12-month rule for the current-period deduction of prepaid expenses of cash basis taxpayers, the asset must expire or be consumed by the end of the tax year following the year of payment. a. True b. False 19. None of the prepaid rent paid on September 1 by a calendar year cash basis taxpayer for the next 18 months is deductible in the current period. a. True b. False 20. The period in which an accrual basis taxpayer can deduct an expense is determined by applying the economic performance and all events tests. a. True b. False Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 21. The amount of the addition to the reserve for bad debts for an accrual method taxpayer is allowed as a deduction for tax purposes but is not allowed for a cash method taxpayer. a. True b. False 22. All domestic bribes (i.e., to a U.S. official) are disallowed as deductions. a. True b. False 23. Fines and penalties paid for violations of the law (e.g., illegal dumping of hazardous waste) are deductible only if they relate to a trade or business. a. True b. False 24. Bernita is a sales representative for a U.S. weapons manufacturer. She pays a $100,000 "facilitation fee" to a U.S. government official associated with a weapons purchase by the U.S. Army. She makes a similar payment to a Saudi Arabian government official associated with a similar sale. Neither of these payments is deductible by Bernita’s employer. a. True b. False 25. The cost of legal advice associated with the preparation of an individual’s Federal income tax return that is paid in 2024 is not deductible because it is a personal expense. a. True b. False 26. Two-thirds of treble damage payments under the antitrust law are not deductible. a. True b. False 27. The legal cost of having a will prepared is not deductible. a. True b. False 28. Legal expenses incurred in connection with rental property are deductions from AGI. a. True b. False 29. Legal fees incurred in connection with a criminal defense are not deductible even if the crime is associated with a trade or business. a. True b. False 30. If a taxpayer operates an illegal business, no deductions are permitted. a. True b. False Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 31. Ordinary and necessary business expenses, other than cost of goods sold, of an illegal drug-trafficking business do not reduce taxable income. a. True b. False 32. Jacques, who is not a U.S. citizen, makes a contribution to the campaign of a candidate for governor. Cassie, a U.S. citizen, also makes a contribution to the same campaign fund. If contributions by noncitizens are illegal under state law, the contribution by Cassie is deductible, while that by Jacques is not. a. True b. False 33. A baseball team that pays a star player an annual salary of $25 million can deduct the entire $25 million as salary expense. If the same amount is paid to the CEO of IBM, only $1 million is deductible. a. True b. False 34. For a taxpayer who is engaged in a trade or business, the cost of investigating a business in the same field is deductible only if the taxpayer acquires the business. a. True b. False 35. Investigation of a business unrelated to one’s present business never results in a current-period deduction of the entire amount if the amount of the investigation expenses exceeds $5,000. a. True b. False 36. In determining whether an activity should be classified as a business or as a hobby, the satisfaction of the presumption (i.e., profit in at least three out of five years) ensures treatment as a business. a. True b. False 37. If a taxpayer derives personal pleasure from an activity, it is presumed to be a hobby rather than a profit-seeking activity. a. True b. False 38. If an activity involves horses, a profit in at least two of seven consecutive years meets the presumptive rule of § 183. a. True b. False 39. A hobby activity results in all of the hobby income being included in AGI and no deductions being allowed for hobbyrelated expenses. a. True b. False 40. If property taxes and home mortgage interest expense are related to a hobby, the excess amount of these items over the hobby income cannot be deducted even if the taxpayer itemizes deductions. Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General a. True b. False 41. If a publicly traded corporation hires a new CEO in the current year and she earns $12,000,000 from a performancebased compensation plan, the corporation can deduct the entire $12,000,000. a. True b. False 42. Martha rents part of her personal residence in the summer for three weeks for $3,000. Anne rents all of her personal residence for one week in December for $2,500. Anne is not required to include the $2,500 in her gross income, whereas Martha is required to include the $3,000 in her gross income. a. True b. False 43. If a vacation home is rented for less than 15 days during a year, the only expenses that can be deducted are mortgage interest, property taxes, and personal casualty losses. a. True b. False 44. If a vacation home is classified as primarily rental use, a deduction for all of the rental expenses is allowed. a. True b. False 45. If a vacation home is classified as primarily personal use (i.e., rented for fewer than 15 days), none of the related expenses can be deducted. a. True b. False 46. The portion of property tax on a vacation home that is attributable to personal use is an itemized deduction. a. True b. False 47. If a vacation home is classified as primarily personal use (i.e., rented for fewer than 15 days), part of the maintenance and utility expenses can be allocated and deducted as a rental expense. a. True b. False 48. A vacation home at the beach that is rented for 200 days and used personally for 16 days is classified in the personal/rental use category. a. True b. False 49. If a vacation home is a personal/rental residence, no maintenance and utility expenses can be claimed as a deduction. a. True b. False Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 50. Beulah’s personal residence has an adjusted basis of $450,000 and a fair market value of $390,000.

Beulah converts the property to rental use this year. The vacation home rules that limit the amount of the deduction to the rental income will apply, and the adjusted basis for depreciation is $390,000. a. True b. False 51. Miguel wants to give his daughter $1,800 for Christmas. As an alternative, she suggests that he pay the property taxes on her residence. If Miguel pays the property taxes, he can deduct them. a. True b. False 52. LD Partnership, a cash basis taxpayer, purchases land and a building for $200,000 with $150,000 of the cost being allocated to the building. The gross receipts of the partnership are less than $100,000. LD must capitalize the $50,000 paid for the land but can deduct the $150,000 paid for the building in the current tax year. a. True b. False 53. Purchased goodwill must be capitalized but can be amortized over a 60-month period. a. True b. False 54. Marge sells land to her adult son, Jason, for its $20,000 appraised value. Her adjusted basis for the land is $25,000. Marge’s recognized loss is $5,000, and Jason’s adjusted basis for the land is $25,000 ($20,000 cost + $5,000 recognized loss of Marge). a. True b. False 55. For purposes of the § 267 loss disallowance provision, a taxpayer’s aunt is a related party. a. True b. False 56. Sammy, a calendar year cash basis taxpayer who is age 66, has the following transactions in 2024: Salary from job Alimony received from ex-wife (2021 divorce) Medical expenses

$90,000 10,000 6,500

Based on this information, Sammy has: a. AGI of $100,000. b. AGI of $95,000. c. AGI of $93,500. d. Deduction for medical expenses of $0. 57. Trade or business expenses of a self-employed taxpayer should be treated as: a. Deductible for AGI on Schedule E. b. A deduction from AGI. Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General c. Deductible for AGI on Schedule C. d. An itemized deduction if not reimbursed. 58. Al is single, age 60, and has gross income of $140,000, of which $120,000 is salary and $20,000 is rental income. His deductible expenses are as follows: Charitable contributions Contribution to a traditional IRA Expenses paid on rental property Interest on home mortgage and property taxes on personal residence State income tax

$4,000 7,000 7,500 7,200 2,200

What is Al’s AGI? a. $140,000. b. $113,000. c. $125,500. d. $133,000. 59. Hannah is a teacher, single, had gross income of $50,000, and incurred the following expenses in 2024: Charitable contribution Taxes and interest on home Legal fees incurred in a tax dispute Medical expenses Supplies for her third grade class

$2,000 7,000 1,000 3,000 350

Her AGI is: a. $39,750. b. $49,700. c. $40,000. d. $39,700. 60. Which of the following can be claimed as a deduction for AGI? a. Personal casualty losses. b. Investment interest expenses. c. Property taxes on personal use real estate. d. Expenses associated with royalty income. 61. Which of the following is a deduction for AGI? a. Contribution to a traditional IRA. b. Roof repairs to a personal use home. c. Safe deposit box rental fee in which stock certificates are stored. d. Property tax on personal residence. 62. Which of the following is correct? a. A personal casualty loss incurred from a presidentially declared disaster is classified as a deduction from AGI. b. Real estate taxes on a taxpayer’s personal residence are classified as deductions from AGI. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General c. An expense associated with rental property is classified as a deduction for AGI. d. Choices a., b., and c. are correct. 63. Which of the following are deductions for AGI? a. Mortgage interest on a personal residence. b. Property taxes on a personal residence. c. Mortgage interest on a building used in a business. d. Fines and penalties incurred in a trade or business. 64. Which of the following is incorrect? a. The expenses associated with a proprietorship are a deduction for AGI. b. The expenses associated with rental property are a deduction from AGI. c. Contributions to a traditional IRA are a deduction for AGI. d. Property taxes on taxpayer’s personal residence are a deduction from AGI. 65. Which of the following is not a “trade or business” expense? a. Interest on business indebtedness. b. Property taxes on business property. c. Parking ticket paid on business auto. d. Depreciation on business property. 66. Which of the following is not a required test for the deduction of a business expense? a. Ordinary b. Necessary c. Reasonable d. Unavoidable 67. Paula is the sole shareholder of Violet, Inc. For 2024, she receives from Violet a salary of $450,000 and dividends of $100,000. Violet’s taxable income for 2024 is $500,000. On audit, the IRS treats $100,000 of Paula’s salary as unreasonable. Which of the following statements is correct? a. Paula’s gross income will increase by $100,000 as a result of the IRS adjustment. b. Violet’s taxable income will not be affected by the IRS adjustment. c. Paula’s gross income will decrease by $100,000 as a result of the IRS adjustment. d. Violet’s taxable income will increase by $100,000 as a result of the IRS adjustment. 68. During 2023, the first year of operations, Silver, Inc., pays salaries of $175,000. At the end of the year, employees have earned salaries of $20,000, which are not paid by Silver until early in 2024. What is the amount of the deduction for salary expense? a. If Silver uses the cash method, $175,000 in 2023 and $0 in 2024. b. If Silver uses the cash method, $0 in 2023 and $195,000 in 2024. c. If Silver uses the accrual method, $175,000 in 2023 and $20,000 in 2024. d. If Silver uses the accrual method, $195,000 in 2023 and $0 in 2024. 69. Benita incurred a business expense on December 10, 2024, which she charged on her bank credit card. She paid the credit card statement that included the charge on January 5, 2025. Which of the following is correct? Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General a. If Benita is a cash method taxpayer, she cannot deduct the expense until 2025. b. If Benita is an accrual method taxpayer, she can deduct the expense in 2024. c. If Benita uses the accrual method, she can choose to deduct the expense in either 2024 or 2025. d. Only b. and c. are correct. 70. Payments by a cash basis taxpayer of capital expenditures: a. Must be expensed at the time of payment. b. Must be expensed by the end of the first year after the asset is acquired. c. Must be deducted over the actual or statutory life of the asset. d. Can be deducted in the year the taxpayer chooses. 71. Petal, Inc. is an accrual basis taxpayer. Petal uses the aging approach to calculate the reserve for bad debts. During the current year, the following associated with bad debts occur. Credit sales Collections on credit sales Amount added to the reserve Beginning balance in the reserve Identifiable bad debts during the current year

$400,000 250,000 14,000 –0– 12,000

The amount of the deduction for bad debt expense for Petal for the current year is: a. $12,000. b. $14,000. c. $22,000. d. $140,000. 72. Which of the following legal expenses are deductible for AGI in 2024? a. Incurred in connection with a trade or business. b. Incurred in connection with rental or royalty property held for the production of income. c. Incurred for tax advice relative to the preparation of an individual’s income tax return. d. Only a. and b. qualify. 73. Ramon, a cash basis calendar year taxpayer, runs a bingo operation that is illegal under state law. During the current year, a bill designated H.R. 9 is introduced into the state legislature, which, if enacted, would legitimize bingo games. In the current year, Ramon had the following expenses: Operating expenses in conducting bingo games Payoff money to state and local police Newspaper ads supporting H.R. 9 Political contributions to legislators who support H.R. 9

$247,000 24,000 3,000 8,000

Of these expenditures, Ramon may deduct: a. $247,000. b. $250,000. c. $258,000. d. $282,000. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 74. Andrew, who operates a laundry business, incurred the following expenses during the year: ∙ ∙ ∙ ∙

Parking ticket of $250 for one of his delivery vans that parked illegally. Parking ticket of $75 when he parked illegally while attending a rock concert in Tulsa. DUI ticket of $500 while returning from the rock concert. Attorney’s fee of $600 associated with the DUI ticket.

What amount can Andrew deduct for these expenses? a. $0. b. $250. c. $600. d. $1,425. 75. Which of the following may be deductible? a. Illegal bribes that relate to a U.S. business. b. Fines paid for violations of the law. c. Campaign contribution to a candidate for mayor. d. Expenses associated with monitoring legislation. 76. Terry and Jim are both involved in operating illegal businesses. Terry operates a gambling business, and Jim operates a business selling narcotics. Both businesses have gross revenues of $500,000. The businesses incur the following expenses: Terry $200,000 25,000 50,000 –0–

Employee salaries Bribes to police Rent and utilities Cost of goods sold

Jim $200,000 25,000 50,000 125,000

Which of the following statements is correct? a. Neither Terry nor Jim can deduct any of these items in calculating the business profit. b. Terry should report profit from his business of $250,000. c. Jim should report profit from his business of $500,000. d. Jim should report profit from his business of $250,000. 77. Tom operates an illegal drug operation and incurred the following expenses: Salaries Illegal kickbacks Bribes to border guards Cost of goods sold Rent Interest Insurance on furniture and fixtures Utilities and telephone

$ 75,000 20,000 25,000 160,000 8,000 10,000 6,000 20,000

Which of the following amounts reduces his taxable income? a. $119,000. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General b. $160,000. c. $279,000. d. $324,000. 78. For a president of a publicly held corporation hired in the current year, which of the following is not subject to the $1 million limit on executive compensation? a. Contribution to medical insurance plan. b. Contribution to pension plan. c. Premiums on group term life insurance of $50,000. d. Choices a., b., and c. are not subject to the limit. 79. Karen, a salesperson employed by an auto dealership, is considering opening a fast-food franchise. If Karen decides not to acquire the fast-food franchise, any investigation expenses are: a. A deduction for AGI. b. A deduction from AGI. c. Deductible up to $5,000 in the current year with the balance being amortized over a 180-month period. d. Not deductible. 80. Which of the following statements is correct in connection with the investigation of a business? a. If the taxpayer is not already engaged in the trade or business, the expenses incurred are deductible if the project is abandoned. b. Expenses may be deducted immediately by a taxpayer engaged in a similar trade or business, regardless of whether the business being investigated is acquired. c. That business must be related to the taxpayer’s present business for any expense ever to be deductible. d. Regardless of whether the taxpayer is already engaged in the trade or business, the expenses must be capitalized and amortized. 81. Iris, a calendar year cash basis taxpayer, owns and operates several TV rental outlets in Florida and wants to expand to other states. During the current year, she spends $14,000 to investigate TV rental stores in South Carolina and $9,000 to investigate TV rental stores in Georgia. She acquires the South Carolina operations but not the outlets in Georgia. As to these expenses, Iris should: a. Capitalize $14,000 and not deduct $9,000. b. Expense $23,000 in the current year. c. Expense $9,000 in the current year and capitalize $14,000. d. Capitalize $23,000. 82. Which of the following is not relevant in determining whether an activity is profit-seeking or a hobby? a. Whether the activity is enjoyed by the taxpayer. b. The expertise of the taxpayers and time and effort expended. c. The relationship of profits earned and losses incurred. d. All of these choices are relevant factors. 83. For an activity classified as a hobby, the expenses are categorized as follows: (1) Amounts that affect adjusted basis and would be deductible under other Code sections if the activity had been engaged in for profit (e.g., depreciation, amortization, and depletion). Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General (2) Amounts deductible under other Code sections without regard to the nature of the activity, such as property taxes and home mortgage interest. (3) Amounts deductible under other Code sections if the activity had been engaged in for profit, but only if those amounts do not affect adjusted basis (e.g., maintenance, utilities, and supplies). For tax years before 2018, if these expenses exceed the gross income from the activity and are thus limited, the sequence in which they are deductible is: a. (1), (2), (3). b. (1), (3), (2). c. (2), (3), (1). d. (3), (2), (1). 84. Priscella pursued a hobby of making bedspreads in her spare time. Her AGI before considering the hobby is $40,000. During 2024, she sold the bedspreads for $10,000. She incurred expenses as follows: Fabric and other supplies needed to make bedspreads Interest on loan to get business started Advertising

$4,000 500 6,500

Assuming that the activity is deemed a hobby, how should she report these items on her tax return? a. Include $10,000 in income and deduct $11,000 for AGI. b. Ignore both income and expenses as hobby losses are disallowed. c. Include $10,000 in income and deduct nothing. d. Include $10,000 in income and deduct $4,000 for AGI as cost of goods sold. 85. Cory, a college professor, incurred and paid the following expenses in 2024: Tax return preparation fee Moving expenses Investment expenses Expenses associated with rental property Interest expense associated with loan to finance tax-exempt bonds

$ 600 2,000 500 1,500 400

Calculate the amount that Cory can deduct (before any percentage limitations). a. $5,000. b. $4,600. c. $3,000. d. $1,500. 86. Which of the following is deductible in 2024? a. Moving expenses in excess of reimbursement. b. Tax return preparation fees of an individual. c. Allowable hobby expenses in excess of hobby income. d. Cash contribution to the Salvation Army, a qualified charity. 87. If a residence is used primarily for personal use (rented for fewer than 15 days per year), which of the following is correct? Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General a. No income is included in AGI. b. No expenses are deductible. c. Expenses must be allocated between rental and personal use. d. Only a. and b. are correct. 88. Robyn rents her beach house for 60 days and uses it for personal use for 30 days during the year. The rental income is $6,000 and the expenses are as follows: Mortgage interest Real estate taxes Utilities Maintenance Insurance Depreciation (rental part)

$9,000 3,000 2,000 1,000 500 4,000

Using the IRS approach, total expenses that Robyn can deduct on her tax return associated with the beach house are: a. $0. b. $6,000. c. $8,000. d. $12,000. 89. If a vacation home is determined to be a personal/rental use residence, which of the following statements is correct? a. All rental income is included in gross income. b. All rental related expenses that are deductible are classified as deductions from AGI. c. Expenses must be allocated between rental and personal use. d. Only a. and c. are correct. 90. Bob and April own a house at the beach. The house was rented to unrelated parties for eight weeks during the year. April and the children used the house 12 days for their vacation during the year. After properly dividing the expenses between rental and personal use, it was determined that a loss was incurred as follows: Gross rental income Less: Mortgage interest and property taxes Other allocated expenses Net rental loss

$4,000 $3,500 2,000

(5,500) ($1,500)

What is the correct treatment of the rental income and expenses on Bob and April’s joint income tax return for the current year, assuming the IRS approach is used if applicable? a. A $1,500 loss should be reported. b. Only the mortgage interest and property taxes should be deducted. c. Since the house was used more than 10 days personally by Bob and April, the rental expenses (other than mortgage interest and property taxes) are limited to the gross rental income in excess of deductions for interest and taxes allocated to the rental use. d. Bob and April should include none of the rental income or expenses related to the beach house in their current year income tax return. 91. Because Scott is three months delinquent on the mortgage payments for his personal residence, Jeanette (his sister) is going to cover the arrearage. Based on past experience, she does not expect to be repaid by Scott. Which of the following statements is correct? Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General a. If Scott receives the money from Jeanette and pays the mortgage company, Jeanette can deduct the interest part. b. If Jeanette pays the mortgage company directly, neither Scott nor Jeanette can deduct the interest part. c. If Jeanette pays the mortgage company directly, she cannot deduct the interest part. d. Only b. and c. are correct. 92. Melba incurred the following expenses for her dependent daughter during the current year: Payment of principal on daughter’s automobile loan Payment of interest on daughter's automobile loan Payment of daughter’s property taxes Payment of principal on daughter’s personal residence loan Payment of interest on daughter’s personal residence loan

$3,600 2,900 1,800 2,800 7,000

How much may Melba deduct in computing her itemized deductions? a. $0. b. $8,800. c. $11,700. d. $18,100. 93. Velma and Bud divorced. Velma’s attorney fee of $5,000 is allocated as follows: General representation in obtaining the divorce Services in obtaining custody of the child Services in settlement of martial property Determining the tax consequences of: Dependency deduction for child Tax consequences of property settlement

$1,500 900 600 700 1,300

Of the $5,000 Velma pays to her attorney in 2024, the amount she may deduct as an itemized deduction is: a. $0. b. $700. c. $2,000. d. $5,000. 94. Which of the following must be capitalized by a business? a. Replacement of a windshield of a business truck that was broken in an accident. b. Repair of a roof of a building used in business. c. Amount paid for a covenant not to compete. d. Only b. and c. must be capitalized. 95. On January 2 of the current year, Fran acquires a business from Chuck. Among the assets purchased are the following intangibles: patent with a 7-year remaining life, a covenant not to compete for 10 years, and goodwill. Of the purchase price, $140,000 was paid for the patent and $60,000 for the covenant. The amount of the excess of the purchase price over the identifiable assets was $100,000. What is the amount of the amortization deduction for the current year? a. $10,667. b. $16,000. c. $20,000. Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General d. $32,667. 96. In January, Maurice sold stock with a cost basis of $26,000 to his brother, James, for $24,000, the fair market value of the stock on the date of sale. Five months later, James sold the same stock through his broker for $27,000. What is the tax effect of these transactions? a. Disallowed loss to James of $2,000; gain to Maurice of $1,000. b. Disallowed loss to Maurice of $2,000; gain to James of $3,000. c. Deductible loss to Maurice of $2,000; gain to James of $3,000. d. Disallowed loss to Maurice of $2,000; gain to James of $1,000. 97. Which of the following is not a related party for constructive ownership purposes under § 267? a. The taxpayer’s aunt. b. The taxpayer’s brother. c. The taxpayer’s grandmother. d. A corporation owned more than 50% by the taxpayer. 98. Nikeya sells land (adjusted basis of $120,000) to her adult son, Shamed, for its appraised value of $95,000. Which of the following statements is correct? a. Nikeya’s recognized loss is $25,000 ($95,000 amount realized – $120,000 adjusted basis). b. Shamed’s adjusted basis for the land is $120,000 ($95,000 cost + $25,000 disallowed loss for Nikeya). c. If Shamed subsequently sells the land for $112,000, he has no recognized gain or loss. d. Only a. and b. are correct. 99. Margarita, a single taxpayer, operates a sole proprietorship that reports $100,000 of qualified business income after deducting salaries of $300,000 in 2024. The sole proprietorship is not a specified service business. Assume her taxable income before the QBI deduction is $160,000. Margarita’s QBI deduction for 2024 is: a. $-0-. b. $20,000. c. $32,000. d. $60,000. 100. Rachel operates a sole proprietorship that earns $200,000 of qualified business income after deducting salaries of $60,000. The sole proprietorship is not a specified service business. She files a single tax return for 2024. Assume her taxable income before the QBI deduction is $250,000. Rachel’s QBI deduction for 2024 is: a. $-0-. b. $30,000. c. $35,000. d. $46,000. 101. Yuna owns an insurance agency. The following selected data are taken from the agency balance sheet and income statement prepared using the accrual method. Revenue Salaries and commissions Rent Insurance Powered by Cognero

$250,000 100,000 10,000 5,000 Page 15

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General Utilities Accounts receivable, 1/1/2024 Accounts receivable, 12/31/2024 Accounts payable, 1/1/2024 Accounts payable, 12/31/2024

6,000 40,000 38,000 12,000 11,000

Calculate Yuna’s net profit using the cash method for 2024. 102. Austin, a single individual with a salary of $135,000, incurred and paid the following expenses during 2024: Medical expenses Alimony (divorce finalized in 2023) Charitable contribution of car to public radio station Casualty loss (after $100 floor) Mortgage interest on personal residence Property taxes on personal residence Moving expenses Contribution to a traditional IRA Sales taxes (no state or local income tax is imposed)

$ 3,600 24,000 3,000 4,000 9,500 4,200 5,500 7,000 1,300

Calculate Austin’s deductions for AGI. 103. Arnold and Beth file a joint return in 2024. Use the following data to calculate their total for AGI deductions. Mortgage interest on personal residence Property taxes on personal residence Moving expenses Charitable contribution of furniture to Goodwill State income taxes Investment interest ($8,000 of expenses limited to net investment income of $7,500) Unreimbursed employee expenses Sales taxes

$ 6,000 2,500 7,000 1,500 5,000 7,500 2,500 2,600

104. Robin and Jeff own an unincorporated hardware store. They determine their salaries at the end of the year by using the amount required to reduce the net income of the hardware store to $0. Based on this policy, Robin and Jeff each receive a total salary of $125,000. This is paid as follows: $8,000 per month and $29,000 on December 31. Determine the amount of the salary deduction. 105. Amir’s Enterprises, an unincorporated entity, pays employee salaries of $100,000 during the year. At the end of the year, $12,000 of additional salaries have been earned but not paid until the beginning of the next year. a.

Determine the amount of the deduction for salaries if Amir is a cash method taxpayer.

b.

Determine the amount of the deduction for salaries if Amir is an accrual method taxpayer.

106. Taylor, a cash basis architect, rents the building in which his office is located for $5,000 per month. He commenced his practice on February 1, 2024. In order to guarantee no rent increases during an 18-month period, he signed an 18month lease and prepaid the $90,000 on February 1, 2024. How much can Taylor deduct as rent expense for 2024? 107. In order to protect against rent increases on the building in which she operates a dance studio, Mella signs an 18Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General month lease for $36,000. The lease commences on October 1, 2024. How much of the $36,000 payment can she deduct in 2024 and 2025? a.

If Mella is an accrual basis taxpayer?

b.

If Mella is a cash basis taxpayer?

108. Petula’s business sells heat pumps that have a one-year warranty. Based on historical data, the warranty costs amount to 11% of sales. During 2024, heat pump sales are $400,000. Actual warranty expenses paid in 2024 are $40,000. a.

Determine the amount of the warranty expense deduction for 2024 if Petula’s business uses the accrual method.

b.

How would your answer change if Petula used the cash method for extended warranties and the purchasers paid $25,000 for the warranties that covered the second and third years of ownership?

109. Beige, Inc., an airline manufacturer, is conducting negotiations for the sale of military aircraft. One negotiation is with a U.S. assistant secretary of defense. She can close the deal on the purchase of 50 attack helicopters if she is paid $750,000 under the table. Another negotiation is with the minister of defense of a third world country. To complete the sale of 20 jet fighters to his government, he demands that he be paid a $1 million facilitation fee. Beige makes the payments and closes the deals. How much of these payments are deductible by Beige, Inc.? 110. Albie operates an illegal drug-running business and has the following items of income and expense. What is Albie’s adjusted gross income from this operation? Income Expenses:

$800,000 Rent Utilities Bribes to police Medical expense Legal fees Depreciation Illegal kickbacks Cost of goods sold

24,000 9,000 55,000 5,000 25,000 30,000 30,000 300,000

111. Kitty runs a brothel (illegal under state law) and has the following items of income and expense. What is the amount that she must include in taxable income from her operation? Income Expenses:

$200,000 Rent Utilities Bribes to police Office supplies Legal fees Depreciation Illegal kickbacks

Powered by Cognero

8,000 2,000 10,000 5,000 20,000 14,000 15,000 Page 17

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 112. Janet is the CEO for Silver, Inc., a closely held corporation. Her total compensation for 2024 is $5 million. Of this amount, $2 million is a salary and $3 million is a bonus. The bonus was calculated as 5% of Silver’s net income of $60 million before the bonus and before taxes ($60 million × 5% = $3 million). The bonus provision has been in effect since Janet became CEO in 2020 and is related to Silver’s performance. It is approved annually by the entire board of directors (one of the five directors is an outside director) of Silver. How much of Janet’s compensation can Silver deduct for 2024? 113. Jada operates a Christmas shop in Atlantic City, NJ. She makes a weekend trip to Vero Beach, FL, for the purpose of determining the feasibility of opening another shop. Her travel expenses are $2,000 (includes $500 for meals). In addition, she pays $5,000 to a market research firm in Vero Beach to prepare a feasibility study. Determine the amount of the expenses that Jada can deduct if: a.

She opens a new shop in Vero Beach.

b.

She decides not to open a new shop in Vero Beach.

114. While she was a college student, Angel lived by a bookstore located near campus. She thinks a bookstore located on the other side of campus would be successful. She incurs expenses of $42,800 (legal fees, accounting fees, marketing survey, etc.) in exploring its business potential. Her parents have agreed to lend her the money required to start the business. What amount of these investigation costs can Angel deduct if: a.

She opens the bookstore on August 1 of the current year?

b.

She decides not to open the bookstore.

115. Calculate the net income includible in taxable income for the following hobby in 2024: Income Mortgage interest and property taxes allocable to hobby Depreciation Travel to competitions Dues and subscriptions

$23,000 12,000 4,000 7,000 3,000

116. During the year, Rita rented her vacation home for 12 days for $2,400 and she used it personally for three months. The following expenses were incurred on the home: Property taxes Mortgage interest Utilities and maintenance Depreciation Insurance

$ 2,200 10,800 1,900 5,000 900

Calculate her rental gain or loss and itemized deductions. 117. During the year, Jim rented his vacation home for 200 days and lived in it for 19 days. During the remaining days, the vacation home was available for rental use. Is the vacation home subject to the limitation on the deductions of a personal/rental vacation home? 118. During the year, Martin rented his vacation home for three months and spent one month there. Gross rental income from the property was $5,000. Martin incurred the following expenses: mortgage interest, $3,000; real estate taxes, $1,500; utilities, $800; maintenance, $500; and depreciation, $4,000. Compute Martin’s allowable deductions for the Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General vacation home under the court's approach and the IRS's approach. 119. Bridgett’s son, Clyde, is $12,000 in arrears on his residential mortgage payments. Of the $12,000, $7,500 represents interest and $4,500 represents principal. a. b. c. d.

If Bridgett pays the $12,000 to the lender, how much can she deduct? How much can Clyde deduct? If Bridgett pays the $7,500 of interest to the lender and lends or gives $4,500 to Clyde, who pays the $4,500 of principal, how much can Bridgett deduct? How much can Clyde deduct? If Bridgett gives or lends the $12,000 to Clyde who pays the lender, how much can he deduct? How much can Bridgett deduct? Advise Bridgett and Clyde on how the payment should be made.

120. Mattie and Elmer are separated and are in the process of obtaining a divorce. They incur legal fees in 2024 for their respective attorneys with the expenses being itemized as follows: For General costs of the divorce Determination of dependency exemptions Property settlement tax consequences

Mattie $3,500 1,500 400 $5,400

Elmer $3,000 –0– 1,500 $4,500

Although there is no requirement that he do so, Elmer pays Mattie’s lawyer as a gesture of the positive feelings he still has for her. Determine the deductions for Mattie and for Elmer. 121. Muhammad spends the following amounts on a house he owns: Repair to roof Carpeting for the living room Painting of the exterior Replacement of front door

$1,100 1,200 4,000 800

How much of these expenses can Muhammad deduct if the house is his principal residence? b. How much of these expenses can Muhammad deduct if he rents the house to a tenant? c. Classify any deductible expenses as deductions for AGI or as deductions from AGI. a.

122. Walter sells land with an adjusted basis of $175,000 and a fair market value of $160,000 to his mother, Shirley, for $160,000. Walter reinvests the proceeds in the stock market. Shirley holds the land for one year and a day and sells it in the marketplace for $169,000. a.

Determine the tax consequences to Walter.

b.

Determine the tax consequences to Shirley.

123. Sandra sold 500 shares of Wren Corporation to Bob, her brother, for its fair market value. She had paid $26,000 for the stock. Calculate Sandra’s and Bob’s gain or loss under the following circumstances: a.

Sandra sold the shares to Bob for $20,000. One year later, Bob sold them for $18,000.

Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General b.

Sandra sold the shares to Bob for $30,000. One year later, Bob sold them for $27,000.

c.

Sandra sold the shares to Bob for $20,000. One year later, Bob sold them for $28,000.

124. The stock of Eagle, Inc. is owned as follows: Tom 23% Tom’s uncle 22% Tom’s daughter 7% Tom’s sister 15% Tom’s spouse 15% Tom’s nephew 8% Tom’s CPA, unrelated 10% Tom sells land and a building to Eagle, Inc. for $212,000. His adjusted basis for these assets is $225,000. Calculate Tom’s realized and recognized loss associated with the sale. 125. Tracy invested in the following stocks and bonds during the current year. Blue, Inc. $25,000 City of Falcon bonds 75,000 To finance the investments, she borrowed $100,000 from Swan Bank. Interest expense paid on the loan during the current year was $5,000. During the current year, Tracy received $1,250 of dividend income from Blue, Inc. and $3,000 of interest income on the municipal bonds. a. Determine the amount of Tracy’s gross income. b. Determine the maximum amount of Tracy’s deductible interest expense. 126. Trade or business expenses are classified as deductions for AGI. Section 212 expenses, barring certain exceptions, are classified as deductions from AGI. What are these exceptions? 127. Are all personal expenses disallowed as deductions in 2024? 128. Under what circumstance can a bribe be deducted? 129. Can a trade or business expense be deductible if it is necessary but not ordinary? 130. Salaries are considered an ordinary and necessary expense of a trade or business if they meet what other requirement? What are the tax consequences if this requirement is not met? 131. If part of a shareholder/employee’s salary is classified as unreasonable, determine the effect on the: a. Shareholder/employee’s gross income. b. Corporation’s taxable income. 132. What losses are deductible by an individual taxpayer? 133. Bruce owns several sole proprietorships. Must he use the same accounting method for each of these businesses? Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 134. Max opened his dental practice (a sole proprietorship) in March of the current year. At the end of the year, he has unpaid accounts receivable of $62,000 and no unpaid accounts payable. Should Max use the accrual method or the cash method for his dental practice? 135. Discuss the application of the “12-month rule” on prepayments by a cash basis taxpayer. 136. Briefly discuss the two tests that an accrual basis taxpayer must apply before an expense can be deducted. 137. Graham, a CPA, has submitted a proposal to do the annual audit for a municipality. Owen, the city treasurer, tells Graham that for a $1,000 fee, he will use his influence to have the audit awarded to Graham. What factors are relevant in determining whether Graham can deduct the $1,000 payment assuming he pays the fee to Owen? 138. In what situations may individuals be able to take a qualified business income deduction? 139. If a taxpayer operated an illegal business (not drug trafficking), what expenses can be deducted and what expenses are disallowed? 140. Bobby operates a drug-trafficking business. Because he has an accounting background, he keeps detailed financial records. What expenses can Bobby deduct on his Federal income tax return? 141. Abner contributes $2,000 to the campaign of a candidate for governor, $1,000 to the campaign of a candidate for senator, and $500 to the campaign of a candidate for mayor. Can Abner deduct these political contributions? 142. Are there any circumstances under which lobbying expenditures are deductible? 143. In applying the $1 million limit on deducting executive compensation, what corporations are subject to the deduction limit? What executives are covered? 144. Under what circumstances may a taxpayer deduct the expenses of investigating a possible business acquisition, if (1) the business is not acquired or (2) the business is acquired? 145. What are the relevant factors to be considered in determining whether an activity is profit-seeking or a hobby? 146. In distinguishing whether an activity is a hobby or a trade or business, discuss the presumptive rule. 147. Assuming an activity is deemed to be a hobby, discuss the order and limits in which expenses must be deducted. 148. Describe the circumstances under which a taxpayer can receive rent income from a personal residence but does not have to report it as gross income. 149. For a vacation home to be classified in the primarily rental use category, what attributes must be present? 150. For a vacation home to be classified in the personal/rental use category, what attributes must be present? 151. What is the appropriate tax treatment for expenditures paid by a taxpayer for another’s benefit? 152. Are there any exceptions to the rule that personal expenditures cannot be deducted? 153. Briefly discuss the disallowance of deductions for capital expenditures. 154. Why are there restrictions on the recognition of gains and losses resulting from transactions between related parties? Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 155. In a related-party transaction where realized loss is disallowed, when can the disallowed loss be used by the buyer on the subsequent sale of the property? In the case of a related-party disallowed loss transaction, can the related-party seller’s disallowed loss be used by a taxpayer other than the related-party buyer? 156. Olive, Inc., an accrual method taxpayer, is a corporation that is equally owned by Maurice and Alex, who are brothers. The corporation uses the accrual method of accounting and the shareholders use the cash method. To provide Olive with funds to acquire additional working capital, each shareholder lends Olive $100,000 with a 6% interest rate. At the end of the tax year, there is unpaid accrued interest of $3,000 due to each shareholder. Olive pays the $3,000 to each shareholder early next year. From a timing perspective, when should Olive deduct this $6,000 and when should Maurice and Alex include the $3,000 in gross income? 157. Briefly explain why interest on money borrowed to buy tax-exempt municipal bonds is disallowed as a deduction.

Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General Answer Key 1. False 2. True 3. False 4. True 5. False 6. False 7. True 8. True 9. False 10. True 11. False 12. False 13. True 14. False 15. False 16. False 17. True 18. True 19. False 20. True 21. False 22. True 23. False 24. False 25. True Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 26. True 27. True 28. False 29. False 30. False 31. True 32. False 33. True 34. False 35. True 36. False 37. False 38. True 39. True 40. False 41. False 42. True 43. True 44. False 45. False 46. True 47. False 48. False 49. False 50. False Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 51. False 52. False 53. False 54. False 55. False 56. d 57. c 58. c 59. b 60. d 61. a 62. d 63. c 64. b 65. c 66. d 67. d 68. d 69. b 70. c 71. a 72. d 73. a 74. a 75. d 76. b Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 77. b 78. d 79. d 80. b 81. b 82. d 83. c 84. d 85. d 86. d 87. a 88. d 89. d 90. a 91. d 92. a 93. a 94. c 95. c 96. d 97. a 98. c 99. b 100. b 101. Yuna’s accrual method net profit is calculated as follows: Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General Revenue Less:

$250,000 Expenses Salaries and commissions Rent Insurance Utilities

$100,000 10,000 5,000 6,000

Net profit

(121,000) $129,000

To convert to cash method net profit, the following adjustments must be made. Net profit-accrual method Deduct: Decrease in accounts payable ($11,000 – $12,000) Add: Decrease in accounts receivable ($38,000 – $40,000) Net profit-cash method

$129,000 (1,000) 2,000 $130,000

102. Only the IRA contribution is deductible for AGI. Austin's divorce was finalized after 2018. As a result, the alimony payments are not deductible. As of 2018, moving expenses are not deductible (except for military personnel). The other expenses are deductions from AGI.

103. Arnold and Beth have no deductions for AGI. As of 2018, moving expenses and unreimbursed employee expenses are not deductible (except for military personnel). All of the other items are itemized deductions. Note that the taxpayer must choose between the state income taxes and the sales taxes for the itemized deduction of either of these taxes. 104. Since the hardware store is not incorporated, the issue of the reasonableness of the salaries is not relevant. Robin and Jeff will report income of $125,000 each regardless of whether it is labeled as salary or as a distribution of the hardware store’s net income. Therefore, there is nothing wrong with the hardware store (i.e., a partnership) taking a $250,000 salary deduction. 105. a. The deduction for salaries is the amount paid of $100,000. b.

The deduction for salaries is calculated as follows: Salaries paid Accrued salaries Salary deduction

$100,000 12,000 $112,000

106. Taylor is a cash basis taxpayer. Thus, he is eligible to use the 12-month rule on prepayments. However, since the 18month rental period extends beyond February 1, 2025, Taylor can only deduct the rent attributable to 2024 in 2024. His deduction is $5,000 x 11 months = $55,000. The 12-month rule applies when the prepayment does not extend beyond the the earlier of: (1) 12 months after the first date on which the taxpayer realizes the right or benefit; or (2) the end of the tax year following the tax year in which the payment is made. 107. a.

As an accrual basis taxpayer, Mella can deduct the 2024 amount of the rent expenses incurred in 2024 of $6,000 ($2,000 × 3 months). The $24,000 ($2,000 × 12 months) incurred in 2025 will be deducted in 2025.

Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General

b.

Since Mella is a cash basis taxpayer, she can deduct the entire $36,000 prepayment in 2024 if she can satisfy the 12-month rule. However, since the rental period of 18 months extends beyond the end of 2025, she fails the requirement for the 12-month rule. Consequently, she can deduct only $6,000 in 2024 and $24,000 in 2025.

108. a.

b.

Even though Petula’s business uses the accrual method, reserves for estimated warranty expenses are not permitted. Therefore, the deduction for warranty expenses is the amount paid of $40,000. Petula would record gross income in 2024 of $425,000 ($400,000 + $25,000). The deduction for warranty expense would still be $40,000.

109. The $750,000 payment to the U.S. assistant secretary of defense is a bribe and is not deductible. If the facilitation fee of $1 million to the minister of defense of the third world country does not violate the Foreign Corrupt Practices Act of 1977, then the entire $1 million payment is deductible. However, if the facilitation fee does violate the Act, then none of it is deductible. 110. Albie is allowed to reduce his AGI only by the cost of goods sold; thus, his AGI is $500,000 ($800,000 – $300,000). Note that the cost of goods sold is treated as a negative item in calculating gross income. 111. Income Expenses:

$200,000 Rent Utilities Office supplies Legal fees Depreciation

$ 8,000 2,000 5,000 20,000 14,000

(49,000) $151,000

The bribes to police of $10,000 and illegal kickbacks of $15,000 are not deductible. 112. Assuming that the compensation is reasonable, all of the $5 million is deductible by Silver. Since Silver is a closely held, rather than a publicly held corporation, the $1 million statutory limit on the deduction of certain executive compensation is not applicable. 113. a. Because Jada is already in the Christmas shop business, $6,750 of the investigation expenses [$1,500+($500 x 0.50)+$5,000=$6,750] is deductible regardless of whether or Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General not she opens a shop in Vero Beach. Note that, as discussed in Chapter 9, only 50% of the cost of the meals is deductible. b.

Same response as in a.

114. a.

If Angel opens the bookstore on August 1, she can deduct the following investigation expenses in the current year.

Allowed expense deduction in first year Amortization ($37,800/180 months × 5 months) Deductible investigation expenses b.

$5,000 1,050 $6,050

If Angel does not open the bookstore, she cannot deduct any of the $42,800 of expenses she incurred since she is not already in the same or a similar business.

115. Income (includible in gross income)

$23,000

The mortgage interest and taxes are deductible as itemized deductions even without the hobby income. The other expenses related to the hobby are not deductible. 116. Rita excludes the $2,400 of rental income from gross income because the home is classified as primarily personal. She can deduct the property taxes ($2,200) and mortgage interest ($10,800) as itemized deductions. No other expenses are deductible. 117. The vacation home is not subject to the limitations on the deductions of a personal/rental vacation home. It satisfies the rental part of the classification because it is rented for greater than 14 days. However, the personal use of 19 days does not exceed the greater of (1) 14 days or (2) 10% of the rental days, since 10% of the rental days is 20 (200 rental days × 10%) days. Therefore, the appropriate classification is primarily rental use rather than personal/rental use. 118. Since the vacation home is rented for 15 or more days and is used for personal purposes for more than the greater of (1) 14 days or (2) 10% of the rental days, the deductions are scaled down, using the court’s approach, as follows: Gross income Deduct: Taxes and interest (3/12 × $4,500) Remainder applicable to other rental expenses Deduct: Allocable share of utilities and maintenance [3/4 × ($800 + $500)] Balance applicable to depreciation Deduct: Depreciation (3/4 × $4,000 = $3,000) but limited to above balance Net income

$5,000 (1,125) $3,875 (975) $2,900 (2,900) $ –0–

Thus, Martin may deduct $1,125 taxes and interest, $975 utilities and maintenance, and $2,900 depreciation against the gross income of $5,000. The personal portion of taxes and interest ($3,375) is deductible as an itemized deduction. The Powered by Cognero

Page 29

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General $100 of depreciation that is not deductible in the current year is carried forward to future tax years. Using the IRS’s approach, though, the deductions are as follows: Gross income Deduct: Taxes and interest (3/4 × $4,500) Remainder applicable to other rental expenses Deduct: Allocable share of utilities and maintenance [3/4 × ($800 + $500)] Balance applicable to depreciation Deduct: Depreciation (3/4 × $4,000 = $3,000) but limited to above balance Net income

$5,000 (3,375) $1,625 (975) $ 650 (650) $ –0–

Thus, Martin may deduct $3,375 taxes and interest, $975 utilities and maintenance, and $650 depreciation against the gross income of $5,000. The personal portion of taxes and interest ($1,125) is deductible as an itemized deduction. The $2,350 of depreciation that is not deductible in the current year is carried forward to future tax years. 119. a.

b.

A deduction cannot be taken for paying another taxpayer’s obligation. So if Bridgett pays the lender, neither Bridgett nor Clyde could deduct the $7,500 of mortgage interest expense. (Clyde can deduct the $7,500 of mortgage interest expense only if he had actually paid the mortgage interest). Bridgett cannot deduct the $7,500 payment identified as interest since this represents the payment of another taxpayer’s obligation. Even though Clyde has identified the $4,500 payment as relating to the principal of the mortgage, he probably can deduct the $4,500 as mortgage interest expense since Bridgett is not allowed the deduction. In any event, Bridgett is not allowed a deduction.

c.

Clyde could deduct the $7,500 of mortgage interest expense, and Bridgett would receive no deduction.

d.

Bridgett should either lend or give the funds to Clyde who then makes the mortgage payments of $12,000 ($7,500 interest + $4,500 principal).

120. None of the legal expenses is deductible. Expenses related to determining one's tax liability are miscellaneous itemized deductions (subject to the 2%-of-AGI floor) and not deductible from 2018 through 2025.

121. a. Since these expenditures are personal expenditures, no deduction is allowed. b. Since these expenditures are for rental property, Muhammad can deduct $7,100 ($1,100 + Powered by Cognero

Page 30

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General c.

$1,200 + $4,000 + $800). The $7,100 deduction associated with the rental property is classified as a deduction for AGI.

122. a. Amount realized Adjusted basis Realized loss

$160,000 (175,000) ($ 15,000)

Walter’s realized loss of $15,000 is disallowed because Walter and Shirley are related parties. b.

Amount realized Adjusted basis Realized gain Walter’s disallowed loss needed to reduce Shirley’s gain to zero Recognized gain

$169,000 (160,000) $ 9,000 (9,000) $ –0–

Shirley may use as much of Walter’s disallowed loss as she needs to reduce her realized gain (i.e., $9,000) to $0. Thus, Shirley’s recognized gain is $0 and the $6,000 ($15,000 – $9,000) of Walter’s disallowed loss that is not used by Shirley is permanently lost. 123. a.

Sandra has no deductible loss. The $6,000 realized loss is disallowed as a related-party transaction. Bob’s recognized loss is $2,000.

b.

Sandra has a recognized gain of $4,000. Bob has a recognized loss of $3,000. Related-party transaction rules apply only to losses.

c.

Sandra has no deductible loss. The $6,000 realized loss is disallowed as a related-party transaction. Bob has a recognized gain of $2,000 ($28,000 – $20,000 = $8,000 less Sandra’s disallowed loss of $6,000).

124. Tom’s realized loss is $13,000. Amount realized Adjusted basis Realized loss

$212,000 (225,000) ($ 13,000)

However, his recognized loss is $0 because the loss is disallowed as a § 267 related-party transaction. A related party includes a corporation more than 50% (directly or indirectly) owned by the taxpayer. Tom’s total ownership (i.e., both direct and constructive) of Eagle, Inc. is 60%. Tom Tom’s daughter Tom’s sister Tom’s spouse

23% 7% 15% 15% 60%

Tom’s uncle, nephew, and the CPA are not related parties for § 267 purposes. Powered by Cognero

Page 31

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 125. a. Tracy must include the $1,250 of dividend income in her gross income. The interest on the municipal bonds of $3,000 is tax-exempt. b.

Tracy can deduct the interest paid of $1,250 ($5,000 × 1/4) on the portion of the loan that relates to the Blue, Inc. stock. The interest paid of $3,750 on the portion of the loan that relates to the municipal bonds is disallowed because the interest income from the bonds is tax-exempt.

126. The normal classification for § 212 expenses is as a deduction from AGI. However, expenses paid in connection with the determination, collection, or refund of taxes related to the income of sole proprietorships, rents and royalties, or farming operations are classified as deductions for AGI. In addition, other rental and royalty expenses are classified as deductions for AGI. 127. No. Selected personal expenses can be deducted as itemized deductions. The following are examples of deductible personal expenses. ∙ Contributions to qualified charitable organizations (not to exceed a specified percentage of AGI). ∙ Medical expenses (in excess of 7.5% of AGI). ∙ Certain state and local taxes (e.g., real estate taxes and state and local income or sales taxes; total cannot exceed $10,000). ∙ Personal casualty losses (if part of a presidentially declared disaster area and in excess of an aggregate floor of 10% of AGI and a $100 floor per casualty). ∙ Certain interest (e.g., mortgage interest on personal residence). 128. Bribes are disallowed if the bribe is illegal under the laws of the United States, or if it is associated with Medicare or Medicaid. An illegal bribe must be illegal under either Federal or state law and also must subject the payer to a criminal penalty or the loss of license or privilege to engage in a trade or business. For a bribe that is illegal under state law, a deduction is denied only if the state law is generally enforced. However, a bribe paid to a foreign official is disallowed only if it is unlawful under the Foreign Corrupt Practices Act of 1977. 129. No. To be deductible as a trade or business expense, the expense must be both ordinary and necessary. 130. “Reasonableness” is an additional requirement that applies to salaries. Generally, the unreasonable portion of the salary expense is disallowed as a deduction to the corporation and taxable as a dividend, rather than as salary, to the shareholder. 131. a.

b.

The reclassification of part of a shareholder/employee’s salary as unreasonable will have no effect on the shareholder/employee’s gross income. That is, the shareholder/employee’s salary income will decrease by the same amount as their dividend income increases. Note that if the dividends are qualified dividends, they are eligible for the same preferential tax rate of 20%/15%/0% applicable to long-term capital gains. Salaries are deductible in calculating corporate taxable income, whereas dividends are not.

Powered by Cognero

Page 32

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General So, the taxable income of the corporation will increase due to a reduced salary deduction.

132. Generally, deductible losses of individual taxpayers are limited to (1) those incurred in a trade or business or (2) those in a transaction entered into for profit. However, individuals are also allowed to deduct losses that are the result of a casualty (if part of a presidentially declared disaster area; subject to certain statutory materiality limitations). 133. No. If a taxpayer owns multiple businesses, it may be possible to use the cash method for some and the accrual method for others. 134. A service provider generally should use the cash method. Under the cash method, Max records income from his dental practice only as he collects from his patients and/or their insurance companies. Max has income from the uncollected accounts receivable only as he receives payment. Note that since his accounts payable can be deducted only when paid under the cash method, he should continue to minimize the accounts payable balance at the end of the tax year. 135. The Regulations set forth the general rule that an expenditure that creates an asset having a useful life that extends substantially beyond the end of the tax year must be capitalized. However, under the “12-month rule” on prepayments for cash basis taxpayers, the prepayment can be expensed in the current tax year if the asset will expire or be consumed by the earlier of: (1) 12 months after the first date on which the taxpayer realizes the right or benefit; or (2) the end of the tax year following the tax year in which the payment is made. Otherwise, the taxpayer must capitalize the prepayment and deduct it over the benefit period. 136. The two tests that an accrual basis taxpayer must apply before an expense can be deducted are (1) the all events test and (2) the economic performance test. The all events test provides that a deduction cannot be claimed until all the events that create the taxpayer's liability have occurred and that the amount of the liability can be determined with reasonable accuracy. The economic performance test provides that the service, property, or use of property giving rise to the liability must have been performed for, provided to, or used by the taxpayer. 137. The payment from Graham to Owen appears to be a bribe. To be disallowed, the bribe must be illegal under either Federal or state law and also must subject the payer to a criminal penalty or the loss of license or privilege to engage in a trade or business. For a bribe that is illegal under state law, a deduction is denied only if the state law is generally enforced. 138. The QBI deduction potentially applies to sole proprietors, partners in a partnership, and shareholders in an S corporation. 139. The usual expenses of operating a business are deductible. However, the following expenses are disallowed. ∙ Fines ∙ Bribes to public officials ∙ Illegal kickbacks ∙ Other illegal payments 140. Bobby cannot deduct any of the expenses associated with operating his illegal drug-trafficking business. However, gross income for tax purposes is defined as sales minus cost of goods sold. So in calculating the net income of the business for tax purposes, cost of goods sold is treated as a negative income item rather than as an expense. Powered by Cognero

Page 33

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 141. No. Political contributions cannot be deducted. 142. Yes. Lobbying expenditures are deductible under the following circumstances. ∙ Activities devoted solely to monitoring legislation. ∙ De minimis provision for annual in-house expenditures (lobbying expenses other than those paid to professional lobbyists) if such expenditures do not exceed $2,000. If the in-house expenditures exceed $2,000, none of the in-house expenditures can be deducted. 143. The $1 million limit on deducting the compensation of a covered executive applies to corporations that have at least one class of stock registered under the Securities Exchange Act of 1934 (i.e. publicly held corporations). Covered employees include the chief (or principal) executive officer, the chief (or principal) financial officer, the three other most highly compensated officers and anyone who served as CEO or CFO during the year. Any individual who is in this group of covered employees after 2016 will be subject to this rule for all future years. (For taxable years beginning after December 31, 2026, this provision will also apply to a second group of employees: the five highest compensated employees that are not included in the first group of covered employees. This second group of covered employees—not limited to officers—does not permanently retain this status in subsequent tax years). 144. (1)

(2)

The expenses of investigation may be deducted if the taxpayer is in the same or similar business to that being investigated, even if the business is not acquired. If the taxpayer is not in the same or similar trade or business to the one being investigated, the investigation expenses are nondeductible if the business is not acquired. The expenses of investigation must be capitalized by a taxpayer not in a similar business when the business is acquired. Such expenses may be immediately expensed (up to $5,000 if such expenses do not exceed $50,000) and the balance amortized over a 180month minimum period. If the taxpayer is in the same or similar trade or business as that acquired, investigation expenses are currently deductible.

145. The nine relevant factors detailed in Reg. § 1.183-2(b) are as follows: (1) Whether the activity is conducted in a businesslike manner. (2) The expertise of the taxpayers or their advisers. (3) The time and effort expended. (4) The expectation that the assets of the activity will appreciate in value. (5) The previous success of the taxpayer in the conduct of similar activities. (6) The history of income and losses from the activity. (7) The relationship of profits earned to losses incurred. (8) The financial status of the taxpayer. (9) Elements of personal pleasure or recreation in the activity. Powered by Cognero

Page 34

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General 146. The Code provides a rebuttable presumption that an activity is profit-seeking (i.e., a trade or business) rather than a hobby if the activity shows a profit in at least three of any five (two out of seven for horses) prior consecutive years. If this test is met, the activity is presumed to be a trade or business. The burden of proof thus shifts to the IRS to show otherwise. 147. Amounts deductible under other Code sections without regard to the nature of the activity (e.g., property taxes and mortgage interest) must be deducted first. Amounts deductible under other Code sections had the activity been profit-seeking that do not affect adjusted basis (e.g., maintenance, utilities and supplies) are deducted next. Deductions affecting adjusted basis (e.g., depreciation) are taken next. At any point where the expenses exceed income, the deduction is limited to the remaining income. For tax years from 2018 through 2025 the expenses in the 2nd and 3rd categories are not deductible at all since 2% miscellaneous itemized deductions are not allowed for these tax years. 148. If the personal residence is rented for fewer than 15 days in a year, the rent income is excluded from gross income. Only mortgage interest and real estate taxes can be deducted (as itemized deductions). 149. To be classified in the primarily rental use category, the following attributes must be present. ∙ The residence is rented for 15 days or more during the year. ∙ The residence is not used for personal purposes for more than the greater of: ∙ (1) 14 days or (2) 10 % of the total days rented. 150. To be classified in the personal/rental use category, the following attributes must be present. ∙ The residence is rented for 15 days or more in a year. ∙ The residence is used for personal purposes for more than the greater of (1) 14 days or (2) 10% of the total days rented. 151. To be deductible, an expense must be incurred for the taxpayer’s benefit or arise from the taxpayer’s obligation. An individual cannot claim a tax deduction for the payment of the expenses of another individual. One exception to this rule is the payment of medical expenses for a dependent. Such medical expenses are deductible by the payor subject to the normal rules that govern the deductibility of medical expenses. The Tax Court has ruled in one case that the individual for whom the expenditures are paid may still qualify for a deduction. In that case, it is deemed that the payer transferred the cash to the taxpayer as a gift, and then the taxpayer made the payment. 152. Generally, personal expenditures cannot be deducted. However, the Code provides that for a personal expenditure to be deductible, the taxpayer must be able to identify a particular section of the Code that permits the deduction (e.g., charitable contributions, medical expenses, certain taxes, certain interest). 153. Any expenditures that add to the value or prolong the life of property or adapt the property to a new or different use are capital expenditures that must be capitalized and depreciated or amortized. 154. Sham transactions can be structured between related parties such that no real economic change occurs in the status of the parties, but a tax savings results. This is an abuse of the tax law that has resulted in restrictions on the recognition of such transactions. 155. The related-party buyer is permitted to use as much of the disallowed loss of the seller as is needed to reduce any realized gain on the subsequent sale of the property. If the property in the hands of the buyer appreciates to at least the Powered by Cognero

Page 35

Name:

Class:

Date:

Chapter 06: Deductions and Losses in General amount of the seller’s adjusted basis at the date of the original sale, all of the disallowed loss can be used by the buyer on the subsequent sale, The related-party seller’s disallowed loss can be used only by the related-party buyer. 156. Maurice and Alex are related parties with Olive. So Olive (accrual method) must claim the deduction of $6,000 in the same tax year that the cash method shareholders include the $3,000 each in gross income (next year). Note that this matching provision applies only if the payor uses the accrual method and the payee uses the cash method. 157. Because the interest income on municipal bonds is excludible from gross income, the related expense should not be deductible. Otherwise, a taxpayer could borrow money, at say 10%, invest the funds in tax-exempt securities, at say 8%, and realize a profit if the interest expense were deductible. The entire profit would be derived from the tax treatment.

Powered by Cognero

Page 36

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses True / False 1. If a business debt previously deducted as partially worthless becomes totally worthless this year, only the amount not previously deducted can be deducted this year. a. True b. False 2. James is in the business of debt collection. He purchased a $20,000 account receivable from Green Corporation for $15,000. During the year, he collected $17,000 in final settlement of the account. James can take a $2,000 bad debt deduction in the current year. a. True b. False 3. Last year, a taxpayer had a $10,000 nonbusiness bad debt. The taxpayer also had an $8,000 short-term capital gain and taxable income of $35,000. If the taxpayer collects the entire $10,000 during the current year, $8,000 needs to be included in gross income. a. True b. False 4. A cash basis taxpayer must include as income the proceeds from the sale of an account receivable to a collection agency. a. True b. False 5. If an account receivable written off during a prior year is subsequently collected during the current year, the amount collected must be included in the gross income of the current year to the extent it created a tax benefit in the prior year. a. True b. False 6. A nonbusiness bad debt deduction can be taken any year after the debt becomes totally worthless. a. True b. False 7. A business bad debt is a debt unrelated to the taxpayer’s trade or business either when it was created or when it became worthless. a. True b. False 8. In determining whether a debt is a business or nonbusiness bad debt, the debtor’s use of the borrowed funds is important. a. True b. False 9. A corporation which makes a loan to a shareholder can have a nonbusiness bad debt deduction. a. True b. False Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses 10. A nonbusiness bad debt can offset an unlimited amount of long-term capital gain. a. True b. False 11. The amount of partial worthlessness on a nonbusiness bad debt is deducted in the year partial worthlessness is determined. a. True b. False 12. A bona fide debt cannot arise on a loan between father and son. a. True b. False 13. A bond held by an investor that is uncollectible will be treated as a worthless security and, hence, produce a capital loss. a. True b. False 14. A loss from a worthless security is always treated as a short-term capital loss. a. True b. False 15. A loss is not allowed for a security that declines in value. a. True b. False 16. Several years ago, John purchased 2,000 shares of Red Corporation's § 1244 stock from Mark for $40,000. Last year, John sold one-half of his Red Corporation stock to Mike for $12,000. During the current year, John sold the remaining Red Corporation stock for $3,000. John has a $17,000 ($3,000 – $20,000) ordinary loss for the current year. a. True b. False 17. If a taxpayer sells her or his § 1244 stock at a loss, all of the loss will be ordinary loss. a. True b. False 18. Al, who is single, has a gain of $40,000 on the sale of § 1244 stock (small business stock) and a loss of $80,000 on the sale of § 1244 stock. As a result, Al has a $40,000 ordinary loss. a. True b. False 19. An individual may deduct a loss on rental property even if it does not meet the definition of a casualty loss. a. True b. False 20. Other casualty means casualties similar to those associated with fires, storms, or shipwrecks. Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses a. True b. False 21. A father cannot claim a loss on his daughter’s rental use property. a. True b. False 22. Currently, a personal casualty loss deduction is allowed only for losses occurring in a Federally declared disaster area. a. True b. False 23. If the amount of the insurance recovery for a theft of business property is greater than the asset’s fair market value (FMV) but less than its adjusted basis, a gain is recognized. a. True b. False 24. A business theft loss is taken in the year of the theft. a. True b. False 25. If investment property is stolen, the amount of the loss is the adjusted basis of the property at the time of the theft reduced by $100 and 10% of AGI. a. True b. False 26. The cost of repairs to damaged property is not an acceptable measure of the loss in value of the property. a. True b. False 27. Taxpayer’s home was destroyed by a storm in 2024 in a Federally declared disaster area. If the taxpayer elects to treat the loss as having occurred in the prior year, it will be subject to the 10%-of-AGI reduction based on the AGI of the current year. a. True b. False 28. The amount of loss for partial destruction of business property is the decline in fair market value of the business property. a. True b. False 29. If personal casualty gains exceed personal casualty losses (after deducting the $100 floor), there is no itemized deduction. a. True b. False 30. The amount of a loss on insured personal use property is reduced by the insurance coverage even if no claim is made Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses against the insurer. a. True b. False 31. Losses on rental property are classified as deductions for AGI. a. True b. False 32. When a nonbusiness casualty loss is spread between two taxable years, the loss in the second year is reduced by 10% of adjusted gross income for the first year. a. True b. False 33. A theft loss of investment property is an itemized deduction not subject to the 2%-of-AGI floor. a. True b. False 34. Personal casualty gains are allowed to offset personal casualty losses. Currently, if an excess casualty loss results, it is not deductible unless attributable to a Federally declared disaster. a. True b. False 35. Research and experimental expenditures do not include the cost of consumer surveys. a. True b. False 36. The cost of obtaining a patent on research is not a research and experimental expenditure. a. True b. False 37. It will take six years for a taxpayer to fully amortize research and experimental expenditures incurred in the U.S. during the year. a. True b. False 38. If a noncorporate taxpayer has an excess business loss for the year, it is not allowed. a. True b. False 39. The purpose of the excess business loss rules is to limit the amount of nonbusiness income (e.g., salaries, interest, dividends, and capital gains) that can be sheltered from tax as a result of business losses. a. True b. False 40. The excess business loss rule applies to partnerships and S corporations (rather than partners and shareholders). a. True Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses b. False 41. Currently, a net operating loss can be carried forward only (no carryback exists). a. True b. False 42. For taxable years beginning after December 31, 2020, a net operating loss can be carried forward only and can offset no more than 80% of taxable income in a subsequent year. a. True b. False 43. A reimbursed employee business expense cannot create a NOL for an individual. a. True b. False 44. A taxpayer can carry back any NOL incurred for two years and then forward up to 20 years. a. True b. False 45. A taxpayer can carry an NOL forward indefinitely. a. True b. False 46. The amount of a business loss cannot exceed the amount of the taxpayer’s NOL for the taxable year. a. True b. False 47. Nonbusiness income for net operating loss purposes includes dividends received. a. True b. False 48. A theft of investment property can create or increase a net operating loss for an individual. a. True b. False 49. An NOL carryforward is used in determining the current-year’s charitable contribution deduction. a. True b. False 50. The excess of nonbusiness capital gains over nonbusiness capital losses must be added to taxable income to compute an individual's net operating loss. a. True b. False 51. An individual taxpayer who does not itemize deductions uses the standard deduction to compute the excess of nonbusiness deductions over the sum of nonbusiness income and net nonbusiness capital gains for purposes of computing Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses net operating loss. a. True b. False 52. When a net operating loss is carried forward, it can affect the medical expense deduction of that year. a. True b. False Multiple Choice 53. Peggy is in the business of purchasing accounts receivable from businesses at a discount and then collecting them. Last year, she purchased a $30,000 account receivable for $25,000. This year, the account was settled for $25,000. How much loss can Peggy deduct and in which year? a. $-0- for the current year. b. $5,000 for the prior year and $5,000 for the current year. c. $5,000 for the prior year. d. $5,000 for the current year. 54. Jed is an electrician. He and his wife are accrual basis taxpayers and file a joint return. Jed wired a new house for Alison and billed her $15,000. Alison paid Jed $10,000 and refused to pay the remainder of the bill, claiming the fee to be exorbitant. Jed took Alison to Small Claims Court for the unpaid amount and was awarded a $2,000 judgement. Jed was able to collect the judgement but not the remainder of the bill from Alison. What amount of loss may Jed deduct in the current year? a. $0 b. $2,000 c. $3,000 d. $5,000 55. On June 2, 2023, Juan’s TV Sales sold Mark a large HD TV on account for $12,000. Juan’s TV Sales uses the accrual method. In 2024, when the balance on the account was $8,000, Mark filed for bankruptcy. Juan was notified that he could not expect to receive any of the amount owed to him. In 2025, final settlement was made and Juan received $1,000. How much bad debt loss can Juan deduct in 2025? a. $0 b. $7,000 c. $8,000 d. $12,000 56. Mary incurred a $20,000 nonbusiness bad debt last year. She also had an $18,000 long-term capital gain last year. Her taxable income for last year was $25,000. During the current year, she unexpectedly collected $12,000 on the debt. How should Mary account for the collection? a. $0 income b. $8,000 income c. $11,000 income d. $12,000 income 57. Last year, Lucy purchased a $100,000 account receivable for $90,000. During the current year, Lucy collected Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses $97,000 on the account. What are the tax consequences to Lucy associated with the collection of the account receivable? No subsequent collections are expected. a. $7,000 gain b. $2,000 gain c. $3,000 loss d. $13,000 loss 58. Two years ago, Gina loaned Tom $50,000. Tom signed a note, the terms of which called for monthly payments of $2,000 plus 6% interest on the outstanding balance. Last year, when the balance owing on the loan was $18,000, Tom defaulted on the note. As of the end of last year, there appeared to be no reasonable prospect of Gina recovering the $18,000. As a consequence, Gina claimed the $18,000 as a nonbusiness bad debt. Last year, Gina had AGI of $50,000, which included $16,000 of net long-term capital gains. Gina did not itemize her deductions. During the current year, Tom paid Gina $13,000 in final settlement of the loan. How should Gina account for the payment in the current year? a. File an amended tax return for last year. b. Report $2,000 of income for the current year. c. Report $5,000 of income for the current year. d. Report $13,000 of income for the current year. 59. Five years ago, Tom loaned his son Liam $20,000 to start a business. A note was executed with an interest rate of 8%, which is the Federal rate. The note required monthly payments of the interest with the $20,000 due at the end of 10 years. Liam always made the interest payments until last year. During the current year, Liam notified his father that he was bankrupt and would not be able to repay the $20,000 or the accrued interest of $1,800. Tom is an accrual basis taxpayer whose only income is salary and interest income. The proper treatment for the nonpayment of the note is: a. No deduction. b. $3,000 deduction. c. $20,000 deduction. d. $21,800 deduction. 60. Three years ago, Sharon loaned her sister $30,000 to buy a car. A note was issued for the loan with the provision for monthly payments of principal and interest. Last year, Sharon purchased a car from the same dealer, Hank’s Auto. As partial payment for the car, the dealer accepted the note from Sharon’s sister. At the time Sharon purchased the car, the note had a balance of $18,000. During the current year, Sharon’s sister died. Hank’s Auto was notified that no further payments on the note would be received. At the time of the notification, the note had a balance due of $15,500. What is the amount of loss with respect to the note that Hank’s Auto may claim on the current year tax return? a. $0 b. $3,000 c. $15,500 d. $18,000 61. On September 3, 2018, Aaron, a single individual, purchased § 1244 stock in Red Corporation from his friend Peter for $60,000. On December 31, 2018, the stock was worth $85,000. On August 15, 2024, Aaron was notified that the stock was worthless. How should Aaron report this item on his 2024 tax return? a. $85,000 capital loss. b. $85,000 ordinary loss. c. $60,000 ordinary loss. d. $60,000 capital loss. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses 62. On February 20, 2023, Alicia purchased stock in Pink Corporation (the stock is not small business stock) for $1,000. On May 1, 2024, the stock became worthless. During 2024, Alicia also had an $8,000 loss on § 1244 small business stock purchased two years ago, a $9,000 loss on a nonbusiness bad debt, and a $5,000 long-term capital gain. How should Alicia treat these items on her 2024 tax return? a. $4,000 long-term capital loss and $9,000 short-term capital loss. b. $4,000 long-term capital loss and $3,000 short-term capital loss. c. $8,000 ordinary loss and $3,000 short-term capital loss. d. $8,000 ordinary loss and $5,000 short-term capital loss. 63. Samuel files a return as a single taxpayer. In 2024, he had the following items: ∙ ∙ ∙

Salary of $40,000. Loss of $65,000 on the sale of § 1244 stock acquired two years ago. Interest income of $6,000.

Determine Samuel’s AGI for 2024. a. ($5,000). b. $0. c. $45,000. d. $51,000. 64. Ahmed, who is single, had the following items for the current year: ∙ ∙ ∙

∙

Salary of $80,000. Gain of $20,000 on the sale of § 1244 stock acquired two years earlier. Loss of $75,000 on the sale of § 1244 stock acquired three years earlier. Worthless stock of $15,000. The stock was acquired on February 1 of the prior year and became worthless on January 15 of the current year.

Determine Ahmed’s AGI for the current year. a. $27,000 b. $38,000 c. $42,000 d. $47,000 65. On July 20, 2019, Matt (who files a joint return) purchased 3,000 shares of Orange Corporation stock (the stock is § 1244 small business stock) for $24,000 from a friend. On November 10, 2023, Matt purchased an additional 1,000 shares of Orange Corporation stock from another friend for $150,000. On September 15, 2024, Matt sold the 4,000 shares of stock for $120,000. How should Matt treat the sale of the stock on his 2024 return? a. $54,000 STCL. b. $100,000 ordinary loss; $46,000 net capital gain. c. $100,000 ordinary loss; $20,000 STCL. d. $130,000 ordinary loss; $66,000 LTCG. 66. Which of the following events would produce a deductible loss in 2024? a. Erosion of personal use land due to rain or wind. b. Termite infestation of a personal residence over a several year period. Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses c. Damages to personal residence from hurricane in a Federal disaster area. d. A misplaced diamond ring. 67. In 2024, Wally had the following insured personal casualty losses (arising from one casualty in a Federally declared disaster area). Wally also had $42,000 AGI for the year before considering the casualty.

Asset Adjusted Basis A $9,200 B 3,000 C 3,700 Wally’s casualty loss deduction is: a. $500. b. $1,600. c. $4,700. d. $4,800.

Fair Market Value Before After $8,000 $1,000 4,000 -01,700 -0-

Insurance Recovery $2,000 4,000 900

68. Jim had a car accident in 2024 in which his car was completely destroyed. At the time of the accident, the car had a fair market value of $30,000 and an adjusted basis of $40,000. Jim used the car 100% of the time for business use. He received an insurance recovery of 70% of the value of the car at the time of the accident. If Jim’s AGI for the year is $60,000, determine his deductible loss on the car. a. $900 b. $2,900 c. $3,000 d. $19,000 69. Norm’s car, which he uses 100% for personal purposes, was completely destroyed in an accident in 2024. The car’s adjusted basis at the time of the accident was $13,000. Its fair market value was $10,000. The car was covered by a $2,000 deductible insurance policy. Norm did not file a claim against the insurance policy because he feared that reporting the accident would result in a substantial increase in his insurance rates. His adjusted gross income was $14,000 (before considering the loss). What is Norm’s deductible loss? a. $0 b. $100 c. $500 d. $9,500 70. Kalani had adjusted gross income of $60,000 in 2024. During the year, her personal use summer home was damaged by a fire. Pertinent data with respect to the home follows: Cost basis Value before the fire Value after the fire Insurance recovery

$260,000 400,000 100,000 270,000

Kalani had an accident with her personal use car. As a result of the accident, she was cited with reckless driving and willful negligence. Pertinent data with respect to the car follows: Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Cost basis Value before the accident Value after the accident Insurance recovery

$80,000 56,000 20,000 18,000

What is Kalani’s itemized casualty loss deduction? a. $0 b. $2,000 c. $17,000 d. $18,000 71. In 2024, Grant’s personal residence was completely destroyed by fire. He was insured for 100% of his actual loss, and he received the insurance settlement. Grant had adjusted gross income before considering the casualty item of $30,000. Pertinent data with respect to the residence follows: Cost basis $280,000 Value before casualty 250,000 Value after casualty –0– What is Grant’s allowable casualty loss deduction? a. $0 b. $6,500 c. $6,900 d. $10,000 72. In 2024, Mary reported the following items: Salary Personal use casualty gain Personal use casualty loss (after $100 floor) Other itemized deductions

$40,000 10,000 17,000 4,000

Assuming that Mary files as head of household (has one dependent child), determine her taxable income for 2024. a. $18,100 b. $19,000 c. $28,100 d. $29,000 73. In 2024, Morley, a single taxpayer, had an AGI of $30,000 before considering the following items: Loss from damage to rental property Loss from theft of bonds Personal casualty gain Personal casualty loss (after $100 floor)

($6,000) (3,000) 4,000 (9,000)

The personal casualties occurred in a Federally declared disaster area. Determine the amount of Morley’s itemized deduction from the losses. a. $0 Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses b. $2,900 c. $5,120 d. $5,600 74. Alicia was involved in an automobile accident in 2024. Her car was used 60% for business and 40% for personal use. The car had originally cost $40,000. At the time of the accident, the car was worth $20,000 and Alicia had taken $8,000 of depreciation. The car was totally destroyed and Alicia had let her car insurance expire. If her AGI is $50,000 (before considering the loss), determine her AGI and itemized deduction for the casualty loss. a. $34,000; $-0-. b. $50,000; $-0-. c. $34,000; $4,500. d. $26,000; $5,700. 75. Alma is in the business of dairy farming. During the year, one of her barns was completely destroyed by fire. The adjusted basis of the barn was $90,000. The fair market value of the barn before the fire was $75,000. The barn was insured for 95% of its fair market value, and Alma recovered this amount under the insurance policy. She has adjusted gross income of $40,000 for the year (before considering the casualty). Determine the amount of loss she can deduct on her tax return for the current year. a. $3,750 b. $14,650 c. $14,750 d. $18,750 76. In the current year, Juan’s home was burglarized. He had the following items stolen: ∙ ∙ ∙

Securities worth $25,000. Juan purchased the securities four years ago for $20,000. New tools that Juan had purchased two weeks earlier for $8,000. He uses the tools in making repairs at an apartment house that he owns and manages. An antique worth $15,000. Juan inherited the antique (a family keepsake) when the property was worth $11,000.

Juan’s homeowner’s policy had a $50,000 deductible clause for thefts. If his salary for the year is $50,000, determine the amount of his itemized deductions as a result of the theft. a. $3,100 b. $6,000 c. $20,000 d. $26,500 77. Regarding research and experimental expenditures, which of the following are not qualified expenditures? a. Costs of ordinary testing of materials. b. Costs to develop a plant process. c. Costs of developing a formula. d. Depreciation on a building used for research. 78. In April 2024, Blue Corporation incurred the following expenses in connection with the development of a new product: Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Salaries Utilities Materials Advertising Market survey Depreciation on machine

$104,000 18,000 25,000 5,000 3,000 9,000

Blue expects to begin selling the product in 2025. Determine the amount of the deduction for research and experimental expenditures for 2024. a. $0 b. $15,600 c. $20,800 d. $156,000 79. In 2024, Green Corporation incurred the following expenditures in the development of a new plant process: Salaries Materials Utilities Quality control testing costs Management study costs Depreciation of equipment

$250,000 90,000 20,000 40,000 5,000 18,000

During 2025, benefits from the project began being realized in May. Determine the amount of the deduction for 2025. a. $50,400 b. $75,600 c. $83,600 d. $84,600 80. In the computation of a net operating loss, which of the following items is not added to the negative taxable income? a. Losses incurred in a transaction entered into for profit. b. Deductible alimony payments. c. Personal theft loss. d. Losses from theft of securities. 81. In 2024, Theo, a single taxpayer, operates a sole proprietorship in which he materially participates. His proprietorship generates gross income of $320,000 and deductions of $630,000, resulting in a loss of $310,000. The large deductions are due to the acquisition of equipment and the use of immediate expense and additional first-year depreciation to deduct all of the acquisitions. What is Theo’s excess business loss for the year? a. $-0-. b. $5,000. c. $305,000. d. $310,000 82. In 2024, Alaina is married and files a joint return. She operates a sole proprietorship in which she materially participates. Her proprietorship generates gross income of $225,000 and deductions of $525,000, resulting in a loss of $300,000. What is Alaina’s excess business loss for the year? Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses a. $-0-. b. $30,000. c. $250,000. d. $300,000. 83. Wu, who is single, reports the following items for 2024: Salary Interest income Itemized deductions ($27,000 attributable to deductible casualty loss)

$25,000 8,000 (32,000)

What is Wu’s net operating loss for 2024? a. $0 b. ($1,000) c. ($2,000) d. ($7,000) 84. Khalid, who is single, reports the following items for 2024: Salary Interest income on U.S. Treasury bonds Loss on theft of securities Interest income on New York state bonds

$40,000 8,000 (60,000) 12,000

What is Khalid’s NOL for 2024? a. ($10,000) b. ($12,000) c. ($16,100) d. ($24,050) 85. Janice, single, reports the following items for 2024: Salary Dividend income Loss on § 1244 small business stock held for three years Total itemized deductions

$30,000 8,000 (45,000) (5,000)

Determine Janice’s net operating loss for 2024. a. ($7,000) b. ($12,000) c. ($15,000) d. ($21,600) 86. Jack, age 30 and married with no dependents, is a self-employed individual. For 2024, his self-employed business sustained a net loss of $10,000 from operations. The following additional information was obtained from his personal records for the year: Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Nonbusiness long-term capital gain Interest income Itemized deductions—consisting of taxes and interest

$ 7,000 5,000 (30,000)

Based on this information, what is Jack’s net operating loss for 2024 if he and his spouse file a joint return? a. ($0) b. ($8,000) c. ($10,000) d. ($28,000) 87. Stella, age 38, is single with no dependents. The following information was obtained from her personal records for the 2024 year. Salary Interest income Alimony received Individual retirement account contribution Home mortgage interest expense Property taxes Personal casualty loss in a Federal disaster area (after the $100 floor) Stolen investment property

$30,000 7,000 12,000 2,000 4,000 2,000 38,000 16,000

Based on this information, what is Stella’s net operating loss for 2024? a. $0 b. ($7,200) c. ($8,300) d. ($13,000) 88. Ralph is single and reports the following items for 2024: Nonbusiness capital gains Nonbusiness capital losses Interest income Itemized deductions (none of the amount resulted from a casualty loss)

$

9,000 (3,000) 6,000 (10,000)

In calculating Ralph’s net operating loss and with respect to these amounts only, what amount must be added back to taxable income (loss)? a. $0 b. $2,600 c. $2,000 d. $3,000 89. Elizabeth reports the following items for the current year: Nonbusiness capital gains Nonbusiness capital losses Powered by Cognero

$

5,000 (3,000) Page 14

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Interest income Itemized deductions (including a $20,000 casualty loss in a Federal disaster area)

3,000 (27,000)

In calculating Elizabeth’s net operating loss and with respect to these amounts only, what amount must be added back to taxable income (loss)? a. $0 b. $1,000 c. $2,000 d. $20,000 90. DeAndre and Holly report the following items for 2024: Dividend income Interest income Itemized deductions (none of the amount resulted from a casualty loss) Business capital gains Business capital losses

$16,000 14,000 (26,000) 2,000 (10,000)

In calculating their net operating loss, and with respect to the above amounts only, what amount must be added back to taxable income (loss)? a. $0 b. $2,000 c. $4,000 d. $6,000 91. In 2025, Poseidon Corporation incurred the following expenditures in the development of a new plant process:

Salaries Materials Utilities

Quality control testing costs Management study costs Depreciation of equipment

$125,000 45,000 10,000 20,000 5,000 9,000

The benefits from the project began being realized in May 2026. What is Poseidon’s research and experimentation deduction in 2025? a. $-0-. b. $18,900. c. $25,200. d. $37,800. Subjective Short Answer 92. Tonya reports the following items for last year: Salary Powered by Cognero

$40,000 Page 15

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Short-term capital gain Nonbusiness bad debt Long-term capital gain

12,000 (23,000) 8,000

For the current year, Tonya reports the following items: Salary Collection of last year’s bad debt

$45,000 23,000

Determine Tonya’s adjusted gross income for the current year. 93. Maria, who is single, reports the following items for 2024: Salary Loss on sale of § 1244 small business stock acquired three years ago Stock acquired two years ago became worthless during the year Long-term capital gain Nonbusiness bad debt Federal disaster area casualty loss on property held six months Federal disaster area casualty gain on property held four years

$80,000 (60,000) (5,000) 25,000 (15,000) (6,000) 4,000

Determine Maria’s adjusted gross income for 2024. 94. Mike, single, age 31, reports the following items for 2024: Salary Nonbusiness bad debt Casualty Asset A (personal use property held for two years)—gain Dividends Interest expense on personal residence

$50,000 (6,000) 3,000 2,000 10,000

Compute Mike’s taxable income for 2024. 95. Jose, single, reports the following items for 2024: Salary § 1244 loss on stock acquired 3 years ago § 1244 gain on stock acquired 10 months ago Worthless security purchased in June of last year Nonbusiness bad debt Interest income

$44,000 (70,000) 26,000 (4,000) (7,000) 8,000

Compute Jose’s adjusted gross income for 2024.

Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses

96. Julie, who is single, reports the following items for 2024: ∙

∙

Salary—$100,000. A hurricane completely destroyed Julie’s duplex during the current year. She lived in one-half of the duplex and rented out the other half. Julie paid $400,000 for the duplex and has taken $80,000 of cost recovery on the rental portion of the duplex. The duplex was worth $420,000 at the time of the destruction. Julie’s insurance policy paid her 90% of the fair market value of the duplex. After the storm, her county was declared a Federal disaster area.

∙

Household items destroyed in the hurricane had a basis of $15,000 and a fair market value of $8,500. There was no insurance recovery on the household items.

∙

Julie purchased a painting three years ago for $4,000. At the time of the hurricane, the painting was worth $10,000. The painting was also completely destroyed in the hurricane. Julie purchased the painting as an investment with the intent that she would sell it when its value exceeded $12,000. There was no insurance recovery on the painting.

∙

Julie had an automobile accident in the current year. She used the car 100% for personal purposes. The car cost $37,000 and had a decline of $5,000 in FMV as a result of the accident. The car was insured, but the policy had a $2,000 deductible clause. Julie chose not to file a claim for the damage.

∙

Julie owned a computer that she used 100% for business as an employee. The computer was also completely destroyed in the hurricane. It had a basis of $6,000 and an FMV of $4,000 at the time it was destroyed. She was not reimbursed by her employer for the loss on the computer.

∙

Home mortgage interest—$10,000.

Determine the amount of Julie’s taxable income for 2024.

97. Juanita, single and age 43, reports the following items for 2024: Salary Interest income Casualty loss on business property Casualty loss on rental property Loss on theft of securities Personal casualty gains Personal casualty loss (after $100 floor) Powered by Cognero

$60,000 6,000 (15,000) (5,000) (8,000) 9,000 (13,000) Page 17

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Other itemized deductions

(9,000)

Compute Juanita’s taxable income for 2024. 98. While Maddie was on vacation during the current year, someone broke into her home and stole the following items: ∙ ∙ ∙ ∙

A computer used 60% in connection with Maddie as an employee and 40% for her personal use. The cost of the computer was $8,000. Depreciation of $3,000 had been taken on the computer and it had a fair market value of $4,000 at the time of the theft. A painting that Maddie purchased as an investment for $10,000 had a fair market value of $17,000. Silverware purchased for $3,000 had a fair market value of $5,000. Cash of $30,000.

Maddie’s adjusted gross income, before considering any of these items, is $60,000. Determine the total amount of her itemized deductions resulting from the theft. 99. Neal, single and age 37, reports the following items for 2024: Salary Casualty loss on business property Casualty loss on rental property

$50,000 (8,000) (5,000)

Federal disaster area personal casualty gains Federal disaster area personal casualty losses (after $100 floor) Interest expense and taxes on personal residence

3,000 (12,000) (11,700)

Determine Neal’s taxable income for 2024. 100. Gary, who is single and an employee of Red Corporation, reports the following items for 2024: Salary Federal disaster area personal casualty gain Federal disaster area personal casualty loss from one event (before the $100 floor) Loss on rental property Theft of bonds Unreimbursed loss from theft of a computer used 100% for business as an employee

$80,000 7,000 (15,000) (6,000) (18,000) (4,000)

Determine Gary’s AGI and total amount of itemized deductions for 2024. 101. Jasmine reports the following items for 2024: ∙ Loss on rental property caused by termites—$110,000. Insurance covered 80% of the loss. ∙ Loss on personal use automobile—$10,000. The insurance policy does not cover the first $3,000 of loss. Jasmine decided not to file a claim for the loss. Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses ∙ Loss on a painting stolen from Jasmine’s house. She purchased the painting three years ago as an investment for which she paid $40,000. It was worth $35,000 at the time of the theft. The painting was insured for the fair market value. ∙ Salary—$40,000. Determine Jasmine’s AGI and total amount of itemized deductions for 2024. 102. Roger, an individual, owns Green Options, a sole proprietorship. For 2024, Roger reports the following items: ∙ Business income—$200,000. ∙ Business expense—$150,000. ∙ Loss on a completely destroyed business machine. The machine had an adjusted basis of $25,000 and a fair market value of $20,000. ∙ Loss on a business truck. The truck had an adjusted basis of $8,000. The repairs to fix the truck cost $10,000. Determine Roger’s adjusted gross income for 2024. 103. In 2024, Robin Corporation incurred the following expenditures in connection with the development of a new product: Salaries Supplies Market survey Depreciation

$100,000 40,000 10,000 25,000

In 2025, Robin incurred the following additional expenditures in connection with the development of the product: Salaries Supplies Depreciation Advertising

$125,000 50,000 30,000 10,000

In October 2025, Robin began receiving benefits from the project. Determine the amount of the deduction in 2024 and 2025. 104. In 2024, Tan Corporation incurred the following expenditures in connection with the development of a new product: Salaries Supplies Depreciation on research equipment Testing for quality control Advertising

$ 60,000 22,000 10,000 5,000 8,000

Tan began selling the product in November 2024. Determine its deduction for 2024. 105. Nora, single, reports the following income and deductions for 2024: Sales Business expenses Powered by Cognero

$ 50,000 (100,000) Page 19

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Alimony received Interest income Dividends Nonbusiness capital gains § 1244 stock loss Itemized deductions Business capital loss Business capital gain

30,000 1,000 2,000 4,000 (18,000) (4,000) (2,000) 1,000

Compute Nora’s net operating loss for 2024. 106. Obuya, married and filing jointly, reports the following income and deductions for 2024: Sales Business expenses Interest income Dividends Federal disaster area personal casualty loss (after deducting the $100 floor) Taxes paid on personal residence Interest paid on personal residence Alimony paid (relates to a 2015 divorce)

$600,000 (650,000) 3,000 4,000 (25,000) (7,000) (9,000) (18,000)

Obuya has three dependent children. Calculate the net operating loss for 2024. 2 107. Jason, married and filing jointly, reports the following income for 2024: Salary Loss on the sale of § 1244 stock held for five years Dividends Interest income Itemized deductions (no casualty losses)

$ 70,000 (110,000) 25,000 10,000 (20,000)

Jason has four dependent children. Calculate his net operating loss for 2024. 108. Milt, married and filing jointly, reports the following items for 2024: Sales Business expenses Interest income Dividends Salary (spouse) Alimony received (from prior marriage that ended in 2015) Powered by Cognero

$200,000 210,000 5,000 5,000 20,000 8,000 Page 20

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Nonbusiness long-term capital gains Nonbusiness short-term capital losses Business short-term capital losses Business long-term capital gains IRA contributions Charitable contributions Medical expenses Property taxes Federal disaster area personal casualty loss on personal property (after the $100 floor) Loss on stolen bonds

5,000 7,000 4,000 2,000 7,000 9,000 7,550 7,450 35,000 12,640

Milt has two dependent children. If Milt and his wife file a joint return, compute their net operating loss for 2024. Essay 109. Identify the factors that should be considered in determining whether a transaction is a business bad debt or a nonbusiness bad debt. 110. Discuss the tax treatment of unreimbursed losses of an employee in connection with a trade or business. 111. A taxpayer who sustains a casualty loss in an area designated by the President of the United States as a disaster area may take the loss in the year in which the loss occurred or elect to take the loss in the previous year. Identify factors that should be considered in deciding in which year to take the loss. 112. Claire is an employee of Blue Corporation. Last year, she purchased a very expensive computer with her own funds. She used the computer 100% for business purposes. During the current year, the computer was completely destroyed in a fire. Blue did not reimburse her for her loss. Discuss whether Claire’s loss will create or increase Claire’s net operating loss. 113. Discuss the treatment of alimony paid and deductible individual retirement account contributions in computing an individual’s net operating loss. 114. Discuss the computation of NOL remaining to be carried forward after the NOL has been applied in a carryback year. 115. Discuss the effect of alimony in computing an NOL.

Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Answer Key 1. True 2. False 3. False 4. True 5. True 6. False 7. False 8. False 9. False 10. True 11. False 12. False 13. True 14. False 15. True 16. False 17. False 18. False 19. True 20. True 21. True 22. True 23. False 24. False 25. False Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses 26. False 27. False 28. False 29. True 30. True 31. True 32. False 33. True 34. True 35. True 36. False 37. True 38. True 39. True 40. False 41. True 42. True 43. True 44. False 45. True 46. False 47. True 48. True 49. True 50. False Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses 51. True 52. True 53. a 54. c 55. a 56. d 57. a 58. d 59. b 60. c 61. d 62. c 63. b 64. a 65. a 66. c 67. a 68. d 69. a 70. a 71. a 72. a 73. d 74. a 75. d 76. c Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses 77. a 78. b 79. b 80. b 81. b 82. a 83. a 84. b 85. c 86. c 87. c 88. b 89. c 90. c 91. b 92. Salary Income under tax benefit rule AGI

$45,000 23,000 $68,000

Income on collection of nonbusiness bad debt (classified as STCL) to the extent of tax benefit in the prior year ($20,000 offset against capital gain and $3,000 offset against ordinary income). 93. Salary Ordinary loss from § 1244 stock Capital gains and losses Long-term capital gain ($25,000 + $4,000) Less: Long-term capital loss [($60,000 – $50,000) + $5,000] Net long-term capital gain Less: Short-term capital loss ($15,000 + $6,000*) Net capital loss (limited to $3,000) Powered by Cognero

$23,000

$80,000 (50,000) $ 29,000 (15,000) $ 14,000 (21,000) (7,000)

(3,000) Page 25

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Adjusted gross income

$27,000

*Casualty losses to the extent of casualty gains.

94. Salary Dividends Casualty gain (long-term capital gain) Nonbusiness bad debt (short-term capital loss) Net short-term capital loss Adjusted gross income Less: Standard deduction Taxable income

95. Salary Ordinary loss from § 1244 stock Interest income Short-term capital gain Short-term capital loss Net short-term capital gain Long-term loss from § 1244 stock ($70,000 – $50,000) Worthless security Net long-term capital loss Limit (only $2,000 is needed to reduce AGI to zero) Adjusted gross income

$3,000 (6,000) (3,000) $49,000 (14,600) $34,400

$44,000 (50,000) 8,000 $26,000 (7,000) $19,000 ($20,000) (4,000)

96. Salary Plus: Gain on rental duplex Recovery [($420,000 × 90%) × 50%] Cost (50% × 400,000) Less: cost recovery Adjusted basis Casualty gain AGI Powered by Cognero

$50,000 2,000

(24,000) ($ 5,000) (2,000) $ –0–

$100,000 $189,000 $200,000 (80,000) (120,000) 69,000 $169,000 Page 26

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Less: Itemized deductions Casualty loss Dwelling Basis ($400,000 × 50%) Recovery Loss Household items Total loss Less: $100 floor Automobile (no casualty loss allowed; not in a Federal disaster area) Less: 10% × $169,000 (AGI) Deductible casualty loss Home mortgage interest Other miscellaneous itemized deduction— painting Computer loss (a miscellaneous itemized deduction; not allowed in 2024) Total itemized deductions (higher than standard deduction) Taxable income

97. Salary Interest income Casualty loss on business property Casualty loss on rental property Personal casualty gains Personal casualty loss AGI Powered by Cognero

$200,000 (189,000) $ 11,000 8,500 $ 19,500 (100)

$ 19,400

(16,900) $ 2,500 10,000

4,000

-0-

(16,500) $152,500

$60,000 6,000 (15,000) (5,000) $9,000 (9,000)

–0– $46,000 Page 27

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Less: Itemized deductions (higher than standard deduction): Theft of securities Other itemized deductions Taxable income

(8,000) (9,000) $29,000

98. Painting loss (investment property) Casualty losses (not allowed; not a result of a Federally declared disaster) Total itemized deductions

$10,000 -0$10,000

99. Salary Casualty loss on business property Casualty loss on rental property Personal casualty gains Personal casualty losses AGI Less:

$50,000 (8,000) (5,000) $3,000 (3,000)

$37,000 Itemized deductions Casualty loss ($12,000 – $3,000) Less: 10% × $37,000 (AGI) Casualty loss deduction Interest and taxes

$9,000 (3,700) $5,300 11,700

Taxable income

100. Salary Loss on rental property Personal casualty gain Personal casualty loss Adjusted gross income Powered by Cognero

–0–

(17,000) $20,000

$80,000 (6,000) 7,000 (7,000) $74,000 Page 28

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Personal casualty loss ($15,000 – $7,000) Less: $100 floor 10% × $74,000 (AGI) Theft of bonds Theft of computer (not allowed; miscellaneous itemized deduction) Total itemized deductions (greater than standard deduction)

$ 8,000 (100) (7,400) $ 500 18,000 -0$18,500

101. Salary Loss on rental property [(80% × $110,000) – $110,000] Adjusted gross income

$40,000 (22,000) $18,000

Casualty loss (not allowed; not a result of a disaster) Loss on stolen painting ($40,000 – $35,000) Total itemized deductions

$-05,000 $5,000*

* Jasmine would use the single standard deduction. 102. Business income Business expense Loss on business machine Loss on business truck Adjusted gross income

$200,000 (150,000) (25,000) (8,000) $ 17,000

103. First, determine total research and experimental expenditures in 2024 and 2025. 2024 Salaries Supplies Depreciation Total research and experimental expenses

$100,000 40,000 25,000 $165,000

The market survey is not a research and experimental expenditure. 2025 Salaries Supplies Depreciation Total research and experimental expenses

$125,000 50,000 30,000 $205,000

The advertising is not a research and experimental expenditure. Powered by Cognero

Page 29

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Research and experimentation expenditures incurred after December 31, 2021 are capitalized and amortized ratably over 5 years. Amortization begins at the midpoint of the year the expenses are incurred. As a result, in 2024, Robin will have a research and experimentation deduction of $16,500 ($165,000 ÷ 5 × ½). In 2025, Robin will have a research and experimentation deduction of $53,500, computed as follows: 2024 Expenditures: 2025 Expenditures:

$165,000 ÷ 5 $205,000 ÷ 5 × ½

104. Salaries Supplies Depreciation Total qualifying research expenditures

$33,000 20,500 $53,500

$60,000 22,000 10,000 $92,000

Research and experimentation expenditures incurred after December 31, 2021 are capitalized and amortized ratably over 5 years. Amortization begins at the midpoint of the year the expenses are incurred. As a result, in 2024, Tan will have a research and experimentation deduction of $9,200 ($92,000 ÷ 5 × ½). The testing for quality control and advertising are not research and experimental expenditures. 105. Sales Business expenses Alimony received Interest income Dividends § 1244 stock (ordinary loss) Capital gains ($4,000 + $1,000) Less: Capital losses Net capital gains Adjusted gross income Standard deduction (single) Taxable income

$ 50,000 (100,000) 30,000 1,000 2,000 (18,000) $5,000 (2,000) 3,000 ($ 32,000) (14,600) ($ 46,600)

Taxable income ($ 46,600) Excess of nonbusiness capital losses over nonbusiness capital gains –0– Excess of nonbusiness deductions over sum of nonbusiness income and net nonbusiness capital gains Standard deduction $14,600 Interest (1,000) Dividends (2,000) Alimony received (30,000) Nonbusiness capital gains (4,000) –0– Powered by Cognero

Page 30

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Excess of business capital losses over the sum of business capital gains and the excess of nonbusiness capital gains over nonbusiness deductions {$2,000 – [$1,000 + ($1,000 + $2,000 + $30,000 + $4,000 – $14,600)]} Net operating loss

106. Sales Business expense Interest income Dividends Alimony paid Adjusted gross income Less: Itemized deductions Casualty loss [$25,000 – (10% × $0)] Taxes on personal residence Interest on personal residence Taxable income

–0– ($ 46,600)

$600,000 (650,000) 3,000 4,000 (18,000) ($ 61,000)

$25,000 7,000 9,000

Taxable income Excess of nonbusiness deductions over nonbusiness income: Itemized deductions ($41,000 – $25,000) $16,000 Alimony paid 18,000 Total nonbusiness deductions $34,000 Interest income (3,000) Dividends (4,000) Net operating loss

107. Salary Ordinary loss (§ 1244 stock) Long-term capital loss [($110,000 – $100,000) = $10,000] limited to Dividends Interest income AGI Powered by Cognero

(41,000) ($102,000) ($102,000)

27,000 ($ 75,000)

$ 70,000 (100,000) (3,000) 25,000 10,000 $ 2,000 Page 31

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses Standard deduction (greater than itemized deductions) Taxable income

(29,200)) ($ 27,200)

Taxable income Excess of nonbusiness deductions over nonbusiness income [$29,200 – ($25,000 + $10,000 – $3,000)] Net operating loss

($ 27,200)

108. Sales Less: business expenses Net business loss Interest income Dividends Salary Alimony received Long-term capital gains ($5,000 + $2,000) Short-term capital losses ($7,000 + $4,000) Net short-term capital losses Limit IRA contributions Adjusted gross income (AGI) Less: Itemized deductions Charitable contributions Medical expenses [$7,550 – ($18,000 × 0.075)] Property taxes Casualty loss [$35,000 – ($18,000 × 0.10)] Theft loss on stolen bonds

$200,000 (210,000) (10,000) 5,000 5,000 20,000 8,000 $ 7,000 (11,000) ($ 4,000) (3,000) (7,000) $ 18,000 $ 9,000 6,200 7,450 33,200 12,640

Taxable income Nonbusiness capital losses in excess of nonbusiness capital gains ($7,000 – $5,000) Nonbusiness deductions in excess of nonbusiness income IRA Itemized deductions $68,490 Less: Casualty loss (33,200) Bonds theft loss (12,640) Total nonbusiness deductions Nonbusiness income Interest Dividends Alimony received Business capital losses in excess of business Powered by Cognero

–0– ($ 27,200)

(68,490) ($50,490) 2,000

$ 7,000

22,650 $29,650 $5,000 5,000 8,000

(18,000)

11,650 1,000 Page 32

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses capital gains ($4,000 – $2,000) limited to $1,000 (due to net capital loss limitation) Net operating loss (NOL)

($35,840)

109. Factors to be considered in determining whether a transaction is a business bad debt or a nonbusiness bad debt are as follows: ∙

Was the debt related to the taxpayer’s business when it was created?

∙

Was the debt related to the taxpayer’s business when it became worthless?

∙

Was the lender engaged in the business of lending money?

∙

Was there a proximate relationship between the creation of the debt and the lender’s business?

110. The loss is a miscellaneous itemized deduction (not deductible from 2018 through 2025). 111. Factors that should be considered include: ∙

The marginal tax rates of the two different years.

∙

The adjusted gross incomes of the two different years.

∙

Other casualty losses in the two different years.

∙

The benefits of a faster refund (or reduction of tax).

112. Because the loss did not occur in a Federally declared disaster area, the loss is not deductible. Therefore, the loss will not create or increase Claire's net operating loss. Even if it were deductible, it would be classified as an employee business expense (and a miscellaneous itemized deduction). Miscellaneous itemized deductions are not allowed from 2018 through 2025. 113. Alimony paid and deductible individual retirement account contributions are treated as nonbusiness deductions in computing a net operating loss. Hence, neither item can create or increase a net operating loss. 114. The NOL amount to be carried forward is the excess of the NOL over the taxable income of the year to which the NOL is being applied. However, the taxable income of the year to which the NOL is being applied must be computed with the following modifications: ∙

No deduction is allowed for the excess of capital losses over capital gains.

∙

No qualified business income deduction is allowed.

∙

No deduction is allowed for the NOL that is being carried back. However, deductions are Powered by Cognero

Page 33

Name:

Class:

Date:

Chapter 07: Deductions and Losses Certain Business Expenses and Losses allowed for NOLs occurring before the loss year. ∙

Any deductions claimed that are based on or limited by AGI must be determined after making the preceding adjustments. However, charitable contributions do not take into account any NOL carryback.

115. Alimony received is treated as nonbusiness income. Alimony paid is treated as a nonbusiness deduction.

Powered by Cognero

Page 34

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion True / False 1. Property that is classified as personalty may be depreciated. a. True b. False 2. The basis of cost recovery property must be reduced by at least the cost recovery allowable. a. True b. False 3. The key date for calculating cost recovery is the date the asset is placed in service. a. True b. False 4. Land improvements generally are not eligible for cost recovery. a. True b. False 5. The cost recovery basis for property converted from personal use to business use may be the fair market value of the property at the time of the conversion. a. True b. False 6. The maximum cost recovery method for all personal property under MACRS is 150% declining balance. a. True b. False 7. The cost recovery period for 3-year MACRS property is four years. a. True b. False 8. New and used personal property that is used in a trade or business qualifies for additional first-year depreciation. a. True b. False 9. If more than 40% of the value of property other than real property is placed in service during the last quarter, all of the property placed in service in the second quarter will be allowed 7.5 months of cost recovery. a. True b. False 10. Under MACRS, if the mid-quarter convention is applicable, all property sold is treated as being sold at the midpoint of the quarter in which it is placed in service. a. True b. False 11. Motel buildings have a cost recovery period of 27.5 years. Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion a. True b. False 12. The factor for determining the cost recovery for eligible real estate under MACRS in the year of disposition is taken from the month of the disposition. a. True b. False 13. Taxpayers may elect to use the straight-line method under MACRS for personalty. a. True b. False 14. Under the MACRS straight-line election for personalty, only the half-year convention is applicable. a. True b. False 15. For personal property placed in service in 2024, the § 179 maximum deduction is $1,220,000. a. True b. False 16. The § 179 deduction can exceed $1,220,000 in 2024 if the taxpayer had a § 179 amount that exceeded the taxable income limitation in the prior year. a. True b. False 17. Any § 179 expense amount that is carried forward is subject to the business income limitation in the carryforward year. a. True b. False 18. Property used for the production of income is not eligible for § 179 expensing. a. True b. False 19. The luxury auto cost recovery limits applies to all automobiles. a. True b. False 20. The § 179 limit for a sports utility vehicle with a GVW of 7,000 pounds will not apply if the sports utility vehicle is used as a taxi. a. True b. False 21. Once the more-than-50% business usage test is passed for listed property, it still matters if the business usage for the property drops to 50% or less during the recovery period. a. True Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion b. False 22. For a new car that is used predominantly in business, the luxury auto limit depends on whether the

taxpayer takes MACRS or straight-line depreciation. a. True b. False 23. If an automobile is placed in service in 2024, the limitation for cost recovery in 2026 will be based on the cost recovery limits for the year 2024. a. True b. False 24. The luxury auto cost recovery limits change if mid-quarter cost recovery is used. a. True b. False 25. The inclusion amount for a leased automobile is adjusted by a business usage percentage. a. True b. False 26. A used $35,000 automobile that is used 100% for business is placed in service in 2023. If the automobile fails the 50% business usage test in the second year, no cost recovery will be recaptured. a. True b. False 27. All listed property is subject to the substantiation requirements of § 274. a. True b. False 28. Under the alternative depreciation system (ADS), the half-year convention must be used for personalty. a. True b. False 29. An election to use straight-line under ADS is made on an asset-by-asset basis for property other than eligible real estate. a. True b. False 30. For real property, the ADS convention is the mid-month convention. a. True b. False 31. The cost of a covenant not to compete for 10 years incurred in connection with the acquisition of a business is amortized over 10 years. a. True b. False Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion 32. Goodwill associated with the purchase of a business cannot be amortized. a. True b. False 33. A purchased trademark is a § 197 intangible asset. a. True b. False 34. If startup expenses total $53,000, $51,000 of those costs are amortized over 180 months. a. True b. False 35. The amortization period for $58,000 of startup expenses is 180 months. a. True b. False 36. Cost depletion is determined by multiplying the depletion cost per unit by the number of units sold. a. True b. False 37. Percentage depletion enables the taxpayer to recover more than the cost of an asset in the form of tax deductions. a. True b. False 38. Intangible drilling costs are capitalized and recovered through depletion. a. True b. False 39. Under MACRS, equipment in the 7-year MACRS class are cost recovered over seven tax years. a. True b. False 40. If a taxpayer has a business with a net operating loss carryover reducing current year income, the taxpayer may want to elect to use straight-line depreciation to slow down the cost recovery. a. True b. False 41. When a business is being purchased, to accelerate deductions, the purchaser should bargain for more of the purchase price being allocated to goodwill and covenants not to compete rather than depreciable assets. a. True b. False 42. Under MACRS, the double-declining balance method is used for property other than real estate with a recovery period of 15 or 20 years. a. True Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion b. False 43. Assets that do not have a determinable useful life are not eligible for cost recovery under MACRS. a. True b. False 44. Land costs generally are amortized rather than being cost recovered under MACRS. a. True b. False 45. The amount of startup expenditures that can be deducted in the year incurred is the greater of the actual amount of such expenses or $5,000. a. True b. False Multiple Choice 46. Grape Corporation purchased a machine in December of the current year. This was the only asset purchased during the current year. The machine was placed in service in January of the following year. No assets were purchased in the following year. Grape's cost recovery would begin: a. In the current year, using a mid-quarter convention. b. In the current year, using a half-year convention. c. In the following year, using a mid-quarter convention. d. In the following year, using a half-year convention. 47. Which of the following assets would be subject to cost recovery? a. A painting by Picasso hanging on a physician’s office wall. b. An antique vase in a doctor’s waiting room. c. Landscaping around the doctor’s office. d. Choices a., b., and c. 48. On June 1 of the current year, Tab converted a machine from personal use to rental property. At the time of the conversion, the machine was worth $90,000. Five years ago, Tab purchased the machine for $120,000. The machine is still encumbered by a $50,000 mortgage. What is the basis of the machine for cost recovery? a. $70,000 b. $90,000 c. $120,000 d. $140,000 49. Tara purchased a machine for $40,000 to be used in her business. The cost recovery allowed and allowable for the three years the machine was used are computed as follows.

Year 1 Year 2 Year 3 Powered by Cognero

Cost Recovery Allowed $16,000 9,600 5,760

Cost Recovery Allowable $ 8,000 12,800 7,680 Page 5

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion If Tara sells the machine after three years for $15,000, how much gain should she recognize? a. $3,480 b. $6,360 c. $9,240 d. $11,480 50. Hazel purchased a new business asset (5-year property) on September 30, 2024, at a cost of $100,000. On October 4, 2024, she placed the asset in service. This was the only asset she placed in service in 2024. Hazel did not elect § 179 or additional first-year depreciation. On August 20, 2025, Hazel sold the asset. Determine the cost recovery for 2025 for the asset. a. $14,250 b. $19,000 c. $23,750 d. $38,000 51. Tan Company acquires a new machine (10-year MACRS property) on January 15, 2024, at a cost of $200,000. Tan also acquires another new machine (7-year MACRS property) on November 5, 2024, at a cost of $40,000. No election is made to use the straight-line method. The company does not make the § 179 election and elects to not take additional first-year depreciation. Determine the total deductions in calculating taxable income related to the machines for 2024. a. $24,000 b. $25,716 c. $102,000 d. $132,858 52. James purchased a new business asset (3-year MACRS property) on July 23, 2024, at a cost of $40,000. James takes additional first-year depreciation but does not elect § 179 expense on the asset. Determine the cost recovery deduction for 2024. a. $8,333 b. $26,666 c. $29,280 d. $40,000 53. Alice purchased office furniture on September 20, 2023, for $100,000. On October 10, 2023, she purchased business computers for $80,000. Alice placed all of the assets in service on January 15, 2024. She did not elect to expense any of the assets under § 179, did not elect straight-line cost recovery, and did not take additional first-year depreciation. Determine the cost recovery deduction for the business assets for 2024. a. $6,426 b. $14,710 c. $25,722 d. $30,290 54. Kenji purchased a used business asset (7-year MACRS property) on September 30, 2024, at a cost of $200,000. This is the only asset he purchased during the year. Kenji did not elect to expense any of the asset under § 179, did not claim additional first-year depreciation, and did not elect straight-line cost recovery. Kenji sold the asset on July 17, 2025. Determine the cost recovery deduction for 2025. Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion a. $19,133 b. $24,490 c. $34,438 d. $55,100 55. Bonnie purchased a new business asset (5-year MACRS property) on March 10, 2024, at a cost of $30,000. She also purchased a new business asset (7-year MACRS property) on November 20, 2024, at a cost of $13,000. Bonnie did not elect to expense either of the assets under § 179, nor did she elect straight-line cost recovery. Bonnie takes additional firstyear depreciation. Determine the cost recovery deduction for 2024 for these assets. a. $7,858 b. $9,586 c. $21,915 d. $43,000 56. Cora purchased a hotel building on May 17, 2024, for $3,000,000. Determine the cost recovery deduction for 2025. a. $48,150 b. $59,520 c. $69,000 d. $76,920 57. Carlos purchased an apartment building on November 16, 2024, for $3,000,000. Determine the cost recovery deduction for 2024. a. $9,630 b. $11,910 c. $13,650 d. $22,740 58. Diane purchased a factory building on April 15, 1993, for $5,000,000. She sells the factory building on February 2, 2024. Determine the cost recovery deduction for the year of the sale. a. $15,706 b. $19,838 c. $26,458 d. $125,650 59. On May 30, 2023, Jane purchased a factory building to use for her business. In August 2024, Jane paid $300,000 for improvements to the building. Determine Jane’s total deduction with respect to the building improvements for 2024. a. $2,889 b. $4,173 c. $4,815 d. $25,000 60. White Company acquires a new machine (7-year MACRS property) on January 10, 2024, at a cost of $620,000. White makes the election to expense the maximum amount under § 179 and wants to take any additional first-year depreciation allowed. No election is made to use the straight-line method. Determine the total deductions in calculating taxable income related to the machine for 2024, assuming that White reports taxable income of $800,000. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion a. $88,598 b. $301,159 c. $568,574 d. $620,000 61. In 2023, Mei had a § 179 deduction carryover of $30,000. In 2024, she elected § 179 for an asset acquired at a cost of $115,000. Mei’s § 179 business income limitation for 2024 is $140,000. Determine Mei’s § 179 deduction for 2024. a. $25,000 b. $115,000 c. $130,000 d. $140,000 62. The only asset Bill purchased during 2024 was a new 7-year MACRS asset. The asset, which was listed property, was acquired on June 17 at a cost of $50,000. The asset was used 40% for business, 30% for the production of income, and the rest of the time for personal use. Bill always elects to expense the maximum amount under § 179 whenever it is applicable. The net income from the business before the § 179 deduction is $100,000. Determine Bill’s maximum deduction with respect to the property for 2024. a. $1,428 b. $2,499 c. $26,749 d. $33,375 63. Angie purchased one new asset during the year (5-year MACRS property) on November 10, 2024, at a cost of $660,000. She would like to use the § 179 election (but will not take additional first-year depreciation). The income from the business before the cost recovery deduction and the § 179 deduction was $600,000. Determine the maximum cost recovery deduction available on this asset for 2024. a. $30,500 b. $580,200 c. $600,000 d. $660,000 64. Hans purchased a new passenger automobile on August 17, 2023, for $30,000. During the year, the car was used 40% for business and 60% for personal use. Determine his cost recovery deduction for the car for 2023. a. $500 b. $1,000 c. $1,200 d. $1,333 65. On June 1, 2023, Irene places in service a new automobile that cost $21,000. The car is used 70% for business and 30% for personal use. (Assume this percentage is maintained for the life of the car.) She does not take additional first-year depreciation. Determine the cost recovery deduction for 2024. a. $3,290 b. $3,570 c. $4,704 d. $11,200 Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion 66. On June 1, 2023, Nico places in service a new automobile that cost $40,000. The car is used 60% for business and 40% for personal use. (Assume this percentage is maintained for the life of the car.) Nico does not take additional firstyear depreciation. Determine the cost recovery deduction for 2023. a. $1,776 b. $1,896 c. $4,800 d. $7,320 67. On May 2, 2024, Imani placed in service a new sports utility vehicle that cost $60,000 and has a gross vehicle weight of 6,300 lbs. The vehicle is used 60% for business and 40% for personal use. Determine Imani's total cost recovery for 2024. Imani wants to use both §179 and additional first-year depreciation. a. $30,500 b. $31,600 c. $34,240 d. $36,000 68. On July 17, 2023, Hernan places in service a used automobile that cost $25,000. The car is used 80% for business and 20% for personal use. In 2024, he used the automobile 40% for business and 60% for personal use. Hernan chooses not to take § 179 or additional first-year depreciation. Determine the cost recovery recapture for 2024. a. $0 b. $528 c. $2,000 d. $2,500 69. On July 10, 2024, Ariff places in service a new SUV that cost $70,000 and weighed 6,300 pounds. The SUV is used 100% for business. Determine Ariff’s maximum deduction for 2024, assuming Ariff’s § 179 business income is $110,000. Ariff does not take additional first-year depreciation. a. $14,000 b. $30,500 c. $38,400 d. $70,000 70. On June 1, 2024, Norm leases a taxi and places it in service. The lease payments are $1,000 per month. Assuming the dollar amount from the IRS table for such leases is $241, determine Norm’s gross income inclusion amount. a. $0 b. $241 c. $907 d. $1,687 71. On March 1, 2024, Lana leases and places in service a passenger automobile. The lease will run for five years and the payments are $500 per month. During 2024, she uses her car 60% for business and 40% for personal activities. Assuming the dollar amount from the IRS table for auto leases is $70, determine Lana’s gross income attributable to the lease. a. $0 b. $35 c. $59 d. $70 Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion 72. Bhaskar purchased a new factory building and land on September 10, 2024, for $3,700,000. ($500,000 of the purchase price was allocated to the land.) He elected the alternative depreciation system (ADS). Determine the cost recovery deduction for 2025. a. $23,328 b. $80,000 c. $82,048 d. $92,500 73. During the past two years, through extensive advertising and improved customer relations, Orange Corporation estimated that it had developed customer goodwill worth $500,000. For the current year, determine the amount of goodwill Orange may amortize. a. $33,333 b. $26,667 c. $16,667 d. $-074. On June 1, 2024, Red Corporation purchased an existing business. With respect to the acquired assets of the business, Red allocated $300,000 of the purchase price to a patent. The patent will expire in 20 years. Determine the total amount that Red may amortize for 2024 for the patent. a. $0 b. $1,667 c. $11,667 d. $35,000 75. Mauve Corporation begins business on April 2, 2024. The corporation reports startup expenditures of $64,000 all incurred last year. Determine the total amount that Mauve can elect to deduct in 2024. a. $0 b. $3,200 c. $4,267 d. $7,950 76. Which of the following is not a characteristic of MACRS for property other than real estate? a. MACRS uses shorter asset lives. b. MACRS increases taxable income in the early years of the asset’s life. c. MACRS accelerates cost recovery. d. MACRS decreases taxable income in the early years of the asset's life. 77. Under MACRS, which one of the following is not considered in determining depreciation for tax purposes? a. Cost of asset. b. Property recovery class. c. Half-year convention. d. Salvage (or residual) value. 78. Which of the following depreciation conventions are not used under MACRS? Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion a. Full-month. b. Mid-month. c. Half-year. d. Mid-quarter. 79. A major objective of MACRS is to: a. Reduce the amount of the cost recovery deduction on businesses tax returns. b. Ensure that the amount of cost recovery for tax purposes will be the same as book depreciation. c. Help companies achieve a faster write-off of their capital assets. d. Require companies to use the actual economic lives of assets in calculating cost recovery for tax purposes. 80. On May 5 of the current tax year, Byrne purchased a patent that qualifies as a § 197 intangible. The cost of the patent was $207,000, and Byrne is a calendar year taxpayer. In the current tax year, how much of the patent’s cost may Byrne amortize? a. $1,150. b. $4,600. c. $9,200. d. $13,800. 81. Indigo Company acquires a new machine (5-year MACRS property) on February 2, 2024, at a cost of $100,000. On November 18, 2024, Indigo also acquires office equipment (7-year MACRS property) at a cost of $50,000. Indigo does not make a § 179 expense election and chooses not to take additional first-year depreciation. What is Indigo’s total MACRS deduction for 2024? a. $27,145. b. $30,000. c. $36,785. d. $150,000. 82. Maple Company purchases new equipment (7-year MACRS property) on January 10, 2024, at a cost of $430,000. Maple also purchases new machines (5-year MACRS property) on July 19, 2024, at a cost of $290,000. Maple wants to maximize its MACRS deductions; assume no taxable income limitations apply. What is Maple’s total MACRS deduction for 2024? a. $119,447. b. $560,000. c. $617,148. d. $720,000. 83. Simpson Company, a calendar year taxpayer, acquires an apartment building on March 22, 2024, for $900,000. What is the maximum cost recovery deduction it may take for 2024? a. $18,297. b. $22,617. c. $25,911. d. $31,365. 84. On January 1, 2024, SymboNet Company completed its acquisition of NetOpen. As part of the acquisition, $2 million was allocated to goodwill. What is SymboNet’s amortization deduction related to the goodwill for 2024? Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion a. $0. b. $100,000. c. $133,333. d. $200,000. 85. On January 15, 2024, Dillon purchased the rights to a mineral interest for $3,500,000. At that time, it was estimated that the recoverable units would be 500,000. During the year, 40,000 units were mined and 25,000 units were sold for $800,000. Dillon incurred expenses during 2024 of $500,000. The percentage depletion rate is 22%. Determine Dillon’s depletion deduction for 2024. a. $150,000. b. $175,000. c. $176,000. d. $200,000. Subjective Short Answer 86. Tom purchased and placed in service used office furniture on January 3, 2024, for $40,000. Tom’s accountant depreciated the furniture using straight-line depreciation over 10 years for financial reporting purposes. The accountant used the same depreciation amounts when filing Tom’s income tax returns. On January 10, 2029, Tom sold the furniture. Determine the tax basis of the furniture at the time of the sale. 87. Jenna acquires a new 7-year MACRS asset on September 20, 2024, for $80,000. She placed the asset in service on October 5, 2024. She does not elect to expense any of the asset under § 179 or elect straight-line, cost recovery. She takes additional first-year depreciation. She sells the asset on August 25, 2025. This is the only asset she acquires in 2024. Determine Jenna’s cost recovery in 2024 and 2025. 88. Darius paid $1,950,000 for a new warehouse on April 14, 2024. He sold the warehouse on September 29, 2029. Determine the cost recovery deduction for 2024 and 2029. 89. On March 3, 2024, Aiyana purchased and placed in service a building costing $12,000,000. The building has 10 floors. The bottom three floors are rented out to businesses. The top seven floors are residential apartments. The gross rents from the businesses are $60,000; the gross rents from the apartments are $110,000. Determine Aiyana’s cost recovery for the building in 2024. 90. Sid bought a new $1,320,000 7-year MACRS asset on August 2, 2024. On December 2, 2024, he purchased $800,000 of used 5-year MACRS assets. If Sid elects § 179 and does not take additional first-year depreciation, what is the maximum cost recovery deduction for these purchases for 2024 (assume that the taxable income limitation does not apply)? 91. Polly purchased a new hotel on July 20, 2024, for $6,000,000. On January 20, 2031, the building was sold. Determine the cost recovery deduction for the year of the sale. 92. Matt bought 7-year MACRS property on May 15, 2024, for $1,328,000. Matt elects § 179 and straight-line cost recovery, but not additional first-year depreciation.. Matt's taxable income would not create a limitation for purposes of the § 179 deduction. Determine the maximum cost recovery deduction Matt can claim for 2024. 93. Audra acquires the following new 5-year MACRS assets in 2024: Asset Powered by Cognero

Acquisition Date

Cost Page 12

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion A B C Total

January 10 July 5 November 15

$

106,000 70,000 1,950,000 $ 2,126,000

Audra elects § 179 treatment for Asset C. Her taxable income from her business would not create a limitation for purposes of the § 179 deduction. Audra does not claim any available additional first-year depreciation deduction. Determine her total cost recovery deduction (including the § 179 deduction) for the year. 94. On April 5, 2024, Orange Corporation purchased and placed in service 7-year MACRS assets costing $1,290,000 and 5-year MACRS assets costing $140,000. Orange elects to expense the maximum amount under § 179. Orange does not take additional first-year depreciation. Assume taxable income is not a limitation. Determine Orange’s maximum cost recovery with respect to the assets for 2024. 95. Mahbod is a sole proprietor of a sandwich business. On March 4, 2024, he purchased and placed in service new 7-year MACRS assets costing $580,000. Mahbod’s business reports taxable income of $160,000 for the year before any deductions associated with the purchased assets. Mahbod also received $30,000 of interest income for the year, which is not related to the business. Mahbod wants his adjusted gross income for the year to be as low as possible. With this objective in mind, determine how Mahbod should claim cost recovery deductions for the acquired assets. 96. On August 20, 2024, Rachel placed in service a building for her business. On November 28, 2024, she paid $80,000 for improvements to the building. What is Rachel’s cost recovery deduction for the building improvements in 2024? 97. On July 15, 2024, Priyanka paid $275,000 for improvements on a commercial building she owns. Determine the maximum total cost recovery from the improvements in 2024. 98. Jasmine purchased a new automobile on July 20, 2023, for $29,000. The car was used 60% for business and 40% for personal use. In 2024, the car was used 30% for business and 70% for personal use. Jasmine elects not to take additional first-year depreciation. Determine the cost recovery recapture and the cost recovery deduction for 2024. 99. Troy purchases a new SUV on October 12, 2024, for $60,400. The SUV has a gross vehicle weight of 6,200 lbs. It is used 100% of the time for business and it is the only business asset acquired by Troy during 2024. Compute the maximum deduction with respect to the SUV for 2024. Troy does not take additional first-year depreciation. 100. On June 1, 2024, Gabriella purchased a computer and peripheral equipment (5-year MACRS property) for $25,000. She used the assets 40% for business, 50% for the production of income, and 10% for personal use. These are the only assets Gabriella purchased during the current year. Determine her total cost recovery deduction for 2024. 101. In 2024, Marci is considering starting a new business. Marci incurs the following costs associated with this venture. Advertising Travel Market surveys Professional services Interest expense Taxes

$ 5,000 10,000 8,000 30,000 2,000 1,000

Marci started the new business on January 5, 2025. Determine the 2024 deduction for her startup costs. Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion 102. Lindsey purchased a uranium interest for $10,000,000 on January 3, 2024, when recoverable reserves were estimated at 200,000 units. A total of 10,000 units were extracted in 2024 and 7,000 units were sold in 2024. Gross income from the property was $2,800,000 and taxable income without the allowance for depletion was $1,000,000. Determine her depletion deduction for 2024. Essay 103. Discuss the criteria used to determine whether a building is residential or nonresidential realty. Also explain the tax consequences resulting from this determination. 104. Discuss the tax consequences of listed property being used for the production of income compared to being used in a trade or business. 105. Discuss the beneficial tax consequences of an SUV not being classified as a passenger automobile. 106. Discuss the reason for the inclusion amount with respect to leased automobiles. 107. Discuss the tax implications of a seller allocating the selling price to goodwill or a covenant not to compete.

Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion Answer Key 1. True 2. True 3. True 4. False 5. True 6. False 7. True 8. True 9. True 10. False 11. False 12. False 13. True 14. False 15. True 16. False 17. True 18. True 19. False 20. False 21. True 22. False 23. True 24. False 25. True Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion 26. False 27. True 28. False 29. False 30. True 31. False 32. False 33. True 34. True 35. True 36. True 37. True 38. False 39. False 40. True 41. False 42. False 43. True 44. False 45. False 46. d 47. c 48. b 49. d 50. c Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion 51. b 52. c 53. d 54. b 55. d 56. d 57. c 58. a 59. a 60. d 61. d 62. b 63. c 64. c 65. c 66. c 67. c 68. c 69. c 70. a 71. b 72. b 73. d 74. c 75. b 76. b Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion 77. d 78. a 79. c 80. c 81. a 82. d 83. c 84. c 85. b 86. The cost of the asset must be reduced by the greater of the cost recovery allowed or allowable in calculating the tax basis. Cost 2024 allowable ($40,000 × 0.1429) 2025 allowable ($40,000 × 0.2449) 2026 allowable ($40,000 × 0.1749) 2027 allowable ($40,000 × 0.1249) 2028 allowed ($40,000 × 0.0893) 2029 allowable ($40,000 × 0.0892 × 1/2) Tax basis

$40,000 (5,716) (9,796) (6,996) (4,996) (3,572) (1,784) $ 7,140

87. Although the mid-quarter convention applies, Jenna can use bonus depreciation (and escape the mid-quarter convention rules). 2024 Additional first-year depreciation ($80,000 × 60%) MACRS cost recovery [($80,000 - $48,000) x 0.1429] Total for 2024 2025 MACRS cost recovery [($80,000 - $52,573) x 0.2449 X 1/2] Powered by Cognero

$48,000 4,573 $52,573

$ 3,359 Page 18

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion

88. 2024: $1,950,000 × 0.01819 = $35,471. 2029: $1,950,000 × 0.02564 × 8.5/12 = $35,415. 89. The gross rents from the apartments are not 80% or more of the total gross rents and hence, the whole building cannot be treated as residential rental real estate. Residential [(70% × $12,000,000) × 0.02879] Nonresidential [(30% × $12,000,000) × 0.02033] Total cost recovery

$241,836 73,188 $315,024

90. § 179 expense (2024 maximum)

$1,220,000

Cost recovery deductions are maximized by taking the § 179 expense election on the longest-lived assets. Taking § 179 expense on 7-year property 7-year property § 179 expense MACRS cost recovery ([$100,000 ($1,320,000 - $1,220,000) × 0.1429)]

$1,220,000 14,290

5-year property MACRS cost recovery ($800,000 × 0.20) Total deduction

160,000 $1,394,290

91. $6,410 ($6,000,000 × 0.02564 × 0.5/12). 92. § 179 expense election Cost recovery [($1,328,000 – $1,220,000) × 0.0714 (Exhibit 8.5)] Total deduction Powered by Cognero

$1,220,000 7,711 $1,227,711 Page 19

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion

93. Audra's § 179 deduction is $1,220,000 (she has placed no more than $3,050,000 of assets in service during the year). Even with electing § 179 on Asset C, Audra has placed more than 40% of assets in service during the last quarter of the year. ($730,000/$906,000 = 80.6%) Therefore, Audra must use the mid-quarter convention. Asset A MACRS cost recovery ($106,000 × 0.35)

37,100

Asset B MACRS cost recovery ($70,000 × 0.15)

10,500

Asset C § 179 expense MACRS cost recovery ($730,000 × 0.05) Total deduction

1,220,000 36,500 $1,304,100

94. § 179 limit

$1,220,000

Cost recovery deductions are maximized by taking the § 179 expense election on the longest-lived assets. 7-year assets

5-year assets Total cost recovery

§ 179 expense Regular MACRS [($1,290,000 – $1,220,000) × 0.1429] Regular MACRS ($140,000 × 0.20)

$1,220,000 10,003

28,000 $1,258,003

95. Electing § 179 § 179 expense (limited to $1,220,000)

$580,000

Business income before MACRS deductions Additional first-year depreciation [($580,000 – $1,220,000) × 60%] MACRS cost recovery [($580,000 - $580,000) × 0.1429)] Business income limitation

$160,000

Powered by Cognero

(-0-) (-0-) $160,000 Page 20

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion § 179 Limit

$160,000

Business income Interest income Adjusted gross income

$

–0– 30,000 $ 30,000

Not Electing § 179 Business income before MACRS deductions Additional first-year depreciation ($580,000 × 60%) MACRS cost recovery [($580,000 - $348,000) × 0.1429)] Business income Interest income Adjusted gross income

$160,000 (348,000) (33,153) (221,153) 30,000 ($191,153)

Not electing § 179 will produce the lowest adjusted gross income, because the § 179 expense cannot create a business loss.

96. MACRS cost recovery [39-year real property; month 11 ($80,000 × 0.00321)] 97. Regular MACRS [39-year real property; month 7 ($275,000 × 0.01177)]

$ 257

$ 3,237

98. Cost Recovery Recapture in 2024 MACRS ($29,000 × 0.20) = $5,800 (limited to $12,200*); $5,800 × 60% Straight-line ($29,000 × 0.10) = $2,900 (limited to $12,200*); $2,900 × 60% Cost recovery recapture in 2024 Cost Recovery in 2024 Straight-line ($29,000 ×0 .20) = $5,800 (limited to $19,500*); $5,800 × 0.30

$3,480 (1,740) $1,740

$1,740

*These depreciation limits are indexed annually.

99. The SUV is not classified as a passenger automobile because of its GVW exceeding 6,000 lbs. Therefore, it is not Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 08: Depreciation Cost Recovery Amortization and Depletion subject to the cost recovery limits of § 280F. Section 179 expense (maximum for SUVs)* MACRS cost recovery [($60,400 - $30,500) × 0.05] Note: The mid-quarter convention applies Total deduction

$30,500 1,495 $31,995

* The § 179 maximum for SUVs is indexed annually. 100. A computer and peripheral equipment are not listed property. As a result, Gabriella can elect § 179 expensing on the 90% business and production of income use. So Gabriella can deduct $22,500 ($25,000 x 90%). 101. None; Marci is not allowed to deduct any startup costs in 2024 because the business was not started until 2025. 102. Cost Depletion

Percentage Depletion Lesser of: 22% × $2,800,000 = $616,000 50% × $1,000,000 = $500,000 Therefore the depletion deduction would be $500,000. 103. Residential realty is property for which 80% or more of the gross rental revenues are from nontransient dwelling units. Residential realty has a recovery period of 27.5 years. Nonresidential realty has a recovery period of 39 years. 104. Section 179 expensing cannot be taken on property used for the production of income. However, additional first-year depreciation can be taken. 105. If an automobile is not classified as a passenger automobile, it is not subject to the statutory dollar cost recovery limits under § 280F. In addition to a larger cost recovery deduction each year, it also results in the total recovery of the cost over a six-year period. While the automobile is still listed property, if it passes the more-than-50% business use test, MACRS cost recovery can be used as well as an election under § 179. However, the § 179 limit for SUVs is $30,500 rather than $1,220,000 in 2024. The SUV also is eligible for additional first-year depreciation. 106. The purpose of the inclusion amount is to prevent taxpayers from circumventing the cost recovery dollar limitations by leasing instead of purchasing an automobile. 107. Goodwill is a capital asset and any gain or loss recognized on the sale of the goodwill will be capital gain or loss. A covenant not to compete is a business asset and any gain or loss will be ordinary gain or loss.

Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses True / False 1. One indicator of independent contractor (rather than employee) status is when the individual performing the services is paid based on time spent (rather than on tasks performed). a. True b. False 2. In some cases, it may be appropriate for a taxpayer to deduct work-related expenses as both a sole proprietor and an employee. a. True b. False 3. Janet works at Green Company’s call center. If Janet’s compensation is based on the number of calls she handles, she is an independent contractor. a. True b. False 4. The IRS will issue advanced rulings as to whether a worker’s status is that of an employee or an independent contractor. a. True b. False 5. Jake performs services for Maude. If Maude provides a helper and tools, this is indicative of independent contractor (rather than employee) status. a. True b. False 6. For tax purposes, a statutory employee is treated the same way as a common law employee. a. True b. False 7. A statutory employee is not a common law employee but is subject to Social Security tax. a. True b. False 8. If an individual is subject to the direction or control of another only to the extent of the end result but not as to the means of accomplishment, an employer-employee relationship does not exist. a. True b. False 9. The work-related expenses of an independent contractor are treated as itemized deductions. a. True b. False 10. A taxpayer who maintains an office in the home to conduct his only business will not have nondeductible commuting expenses. a. True Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses b. False 11. After the automatic mileage rate has been set by the IRS for a year, it cannot later be changed by the IRS. a. True b. False 12. A self-employed taxpayer who uses the automatic mileage method to compute auto expenses can also deduct the business portion of automobile club dues. a. True b. False 13. Carol is self-employed and uses her automobile solely for her business. If she uses the actual expense method to compute expenses, she can include any interest paid on the loan taken out to purchase the car. a. True b. False 14. In choosing between the actual expense method and the automatic mileage method, a taxpayer should consider the cost of insurance on the automobile. a. True b. False 15. A taxpayer who uses the automatic mileage method to compute auto expenses can also deduct the business portion of tolls and parking. a. True b. False 16. A deduction for parking and other traffic violations incurred during business use of an automobile is allowed under the actual cost method but not the automatic mileage method. a. True b. False 17. A taxpayer who uses the automatic mileage method for the business use of an automobile can change to the actual cost method in a later year. a. True b. False 18. Under the automatic mileage method, depreciation is not taken into account in the mileage rate allowed. a. True b. False 19. Once the actual cost method is used, a taxpayer cannot change to the automatic mileage method in a later year. a. True b. False 20. For tax purposes, travel is a broader classification than transportation. a. True Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses b. False 21. Diya lives and works in St. Louis. In the morning she flies to Boston, has a three-hour business meeting, and returns to St. Louis that evening. For tax purposes, Diya was away from home. a. True b. False 22. James has a job that compels him to go to many different states during the year. It is possible that he was never away from his tax home during the year. a. True b. False 23. Marvin lives with his family in Alabama. He has two jobs: one in Alabama and one in North Carolina. His tax home is where he lives (Alabama). a. True b. False 24. A self-employed taxpayer who lives and works in Kansas City travels to Chicago on an eight-day business trip. While in Chicago, the taxpayer uses the hotel valet service to have some laundry done. The valet charge is a nondeductible personal travel expense. a. True b. False 25. The tax law specifically provides that a taxpayer cannot be temporarily away from home for any period of employment that exceeds one year. a. True b. False 26. A taxpayer who lives and works in Tulsa travels to Buffalo for five days. If three days are spent on business and two days are spent on visiting relatives, only 60% of the airfare is deductible. a. True b. False 27. A taxpayer who always claims the standard deduction (i.e., does not itemize their deductions from AGI) may still be able to receive a tax benefit from any education expenses incurred. a. True b. False 28. DeShawn lives and works in Newark, NJ. He travels to London for a three-day business meeting after which he spends three days touring Scotland. All of his airfare is deductible. a. True b. False 29. Eileen lives and works in Mobile. She travels to Rome for an eight-day business meeting after which she spends two days touring Italy. All of Eileen’s airfare is deductible. a. True b. False Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses 30. The moving expense deduction has been eliminated for all taxpayers. a. True b. False 31. Qualified moving expenses of an employee that are not reimbursed are a deduction for AGI. a. True b. False 32. An education expense deduction may be allowed even if the education results in a promotion or pay raise for the employee. a. True b. False 33. Lloyd, a practicing CPA, pays tuition to attend law school. As a law degree involves education leading to a new trade or business, the tuition is not deductible. a. True b. False 34. Under the right circumstances, a taxpayer’s meals and lodging expense can qualify as a deductible education expense. a. True b. False 35. Mallard Corporation pays for a trip to Aruba for its two top salespersons. This expense is subject to the overall limitation (50%). a. True b. False 36. Flamingo Corporation furnishes meals at cost to its employees at a cafeteria it maintains. The cost of operating the cafeteria is not subject to the overall limitation (50%). a. True b. False 37. A taxpayer takes six clients to an NBA playoff game. If all of the tickets (list price of $120 each) are purchased on the Internet for $1,800 ($300 each), only $60 ($120 × 50% overall limitation) per ticket is deductible. a. True b. False 38. Ethan, a bachelor with no immediate family, uses Pine Shadows Country Club exclusively for his business entertaining. All of Ethan’s annual dues for his club membership are deductible. a. True b. False 39. Jackson gives both his supervisor and his spouse a $30 box of chocolates at Christmas. Jackson may claim only $25 as a deduction. a. True Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses b. False 40. On their birthdays, Lily sends gift certificates (each valued at $25) to Caden (a key client) and to each of Caden’s two minor children. Lily can deduct only $25 for these gifts. a. True b. False 41. In the case of an office in the home deduction, the exclusive business use test does not apply when the home is used as a daycare center. a. True b. False 42. If a taxpayer does not own a home but rents an apartment, the office in the home deduction is not available. a. True b. False 43. A taxpayer who claims the standard deduction will not be able to claim an office in the home deduction. a. True b. False 44. Under the regular (actual expense) method, the portion of the office in the home deduction that exceeds the income from the business can be carried over to future years. a. True b. False 45. For tax year 2024, Taylor used the simplified method of determining her office in the home deduction. For 2025, Taylor must continue to use the simplified method and cannot switch to the regular (actual expense) method. a. True b. False 46. Madison is an instructor of fine arts at a local community college. If she spends $600 (not reimbursed) on art supplies for her classes, $300 of this amount can be claimed as a deduction for AGI. a. True b. False 47. Under the simplified method, the maximum office in the home deduction allowed is the greater of $1,500 or the office square feet × $5. a. True b. False 48. Both traditional and Roth IRAs possess the advantage of tax-free accumulation of income within the plan. a. True b. False 49. When contributions are made to a traditional IRA, they are deductible by the participant. Later distributions from the IRA upon retirement are fully taxed. Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses a. True b. False 50. By itself, credit card receipts will not constitute adequate substantiation for travel expenses. a. True b. False 51. The Federal per diem rates that can be used for “deemed substantiated” purposes are the same for all locations in the country. a. True b. False 52. For self-employed taxpayers, travel expenses are deductions for AGI. a. True b. False 53. Employees who render an adequate accounting to employers and are fully reimbursed will shift any potential limitation on meal expenses to their employer. a. True b. False 54. Every year, Teal Corporation gives each employee a turkey and a bottle of wine during the December holiday season. These gifts are subject to the 50% limitation. a. True b. False 55. A taxpayer who claims the standard deduction may be able to claim an office in the home deduction. a. True b. False 56. One of the purposes of the qualified business income deduction was to reduce the taxes on businesses that are operating in noncorporate business forms (e.g., sole proprietors, partnerships, and S corporations). a. True b. False 57. Code § 199A permits an individual to deduct 25% of the qualified business income generated through a sole proprietorship, a partnership, or an S corporation. a. True b. False 58. There are three limitations on the qualified business income deduction: an overall limitation (based on modified taxable income), another that applies to high-income taxpayers, and a third that applies to certain types of services businesses. a. True b. False Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses 59. Qualified business income (QBI) is defined as the ordinary income less ordinary deductions a taxpayer earns from a qualified trade or business (e.g., from a sole proprietorship, S corporation, or partnership) conducted in the United States by the taxpayer. a. True b. False 60. A qualified trade or business includes any trade or business providing services as an employee. a. True b. False 61. Qualified business income includes the reasonable compensation paid to the taxpayer by a qualified trade or business and guaranteed payments made to a partner for services rendered. a. True b. False Multiple Choice 62. Aiden performs services for Lucas. Which of the following factors indicates that Aiden is an employee rather than an independent contractor? a. Aiden provides his own support services (e.g., work assistants). b. Aiden obtained his training (i.e., job skills) from his father. c. Aiden is paid based on hours worked. d. Aiden makes his services available to others. 63. Cristiano performs services for Ryan. Which of the following factors, if any, indicates that Cristiano is an independent contractor rather than an employee? a. Ryan sets the work schedule. b. Ryan provides the tools used. c. Cristiano follows a specific set of instructions from Ryan to complete tasks. d. Cristiano is paid based on tasks performed. 64. Which of the following factors, if any, is not a characteristic of independent contractor status? a. Work-related expenses are reported on Schedule A (Form 1040). b. Form 1099-NEC is received from business customers. c. Workplace fringe benefits are not available. d. Services are performed for more than one party. 65. A worker may prefer to be treated as an independent contractor (rather than an employee) for which of the following reasons: a. Avoids the overall limitation (50%) on business meals. b. All of the self-employment tax is deductible for income tax purposes. c. Work-related expenses of an independent contractor are deductible for AGI. d. A Schedule C does not have to be filed. 66. A worker may prefer to be classified as an employee (rather than an independent contractor) for which of the following reasons: Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses a. To claim unreimbursed work-related expenses as a deduction for AGI. b. To avoid the self-employment tax. c. To avoid the limitation on unreimbursed business entertainment expenses. d. To avoid the limitations on unreimbursed work-related expenses. 67. The tax advantages of being self-employed (rather than being an employee) include: a. The self-employment tax is lower than the Social Security tax. b. The overall limitation (50%) on meals does not apply. c. An office in the home deduction (from AGI) is available. d. Job-related expenses are deductions for AGI. 68. Statutory employees: a. Report their expenses as miscellaneous itemized deductions. b. Include common law employees. c. Are subject to income tax withholdings. d. Claim their expenses as deductions for AGI. 69. Which of the following would constitute an employer-employee relationship? a. A plumber who comes to your home to fix a leaking faucet. b. A CPA who prepares a client’s tax return. c. A physician who hires a nurse to help her with patient screening and preliminary tests in the office. d. A gardener who takes care of individual lawns for a monthly fee. 70. Corey is the city sales manager for RIBS, a national fast food franchise. Every working day, Corey drives his car as follows: Home to office Office to RIBS No. 1 RIBS No. 1 to No. 2 RIBS No. 2 to No. 3 RIBS No. 3 to home

Miles 20 15 18 13 30

Corey renders an adequate accounting to his employer. As a result, Corey’s reimbursable mileage is: a. 0 miles. b. 46 miles. c. 66 miles. d. 76 miles. 71. Chang is a self-employed practical nurse who works from his home. He provides nursing care for disabled persons living in their residences. During the day, he drives his car as follows. Chang’s home to patient Louise Patient Louise to patient Carl Patient Carl to patient Betty Patient Betty to Chang’s home Powered by Cognero

Miles 12 4 6 10 Page 8

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses Chang’s deductible mileage for each workday is: a. 12 miles. b. 20 miles. c. 22 miles. d. 32 miles. 72. When using the automatic mileage method, which of the following expenses, if any, also can be claimed? a. Engine tune-up. b. Parking. c. Interest on automobile loan. d. MACRS depreciation. 73. For which of the following situations, if any, is the automatic mileage available? a. A limousine the owner rents out for special occasions (e.g., weddings, high school proms). b. An auto that belongs to the taxpayer’s mother. c. One of seven cars used to deliver pizzas. d. None of these. 74. Under the actual cost method, which of the following expenses, if any, will not be allowed? a. Car registration fees. b. Auto insurance. c. Interest expense on a car loan (taxpayer is an employee). d. Dues to auto clubs. 75. Which of the following trips, if any, will qualify for the travel expense deduction? a. Dr. Jones, a self-employed general dentist, attends a two-day seminar on developing a dental practice. b. Dr. Brown, a self-employed surgeon, attends a two-day seminar on financial planning. c. Paul, a romance language high school teacher, spends summer break in France, Portugal, and Spain improving his language skills. d. Myrna went on a two-week vacation in Boston. While there, she visited her employer’s home office to have lunch with former coworkers. 76. During 2024, John (a self-employed management consultant) went from Milwaukee to Hawaii on business. Preceding a five-day business meeting, he spent four days vacationing at the beach. Excluding the vacation costs, his expenses for the trip are: Airfare Lodging Meals Entertainment

$3,200 900 800 600

Presuming no reimbursement, deductible expenses are: a. $3,200. b. $3,900. c. $4,500. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses d. $5,500. 77. During 2024, Sophie (a self-employed marketing consultant) went from Omaha to Lima, Peru, on business. She spent four days on business, two days on travel, and four days on vacation. Disregarding the vacation costs, Sophie’s expenses are: Airfare Lodging Meals Entertainment

$3,000 800 600 400

Sophie’s deductible expenses are: a. $4,300. b. $2,900. c. $2,800. d. $2,500. 78. During 2024, Walt who is self-employed travels from Seattle to Tokyo, Japan, on business. His time was spent as follows: two days travel (one day each way), two days business, and two days personal. His expenses for the trip were as follows (meals and lodging reflect only the business portion): Airfare Lodging Meals

$3,000 2,000 1,000

Presuming no reimbursement, Walt’s deductible expenses are: a. $3,500. b. $4,500. c. $5,500. d. $6,000. 79. Which of the following, if any, is subject to an overall limitation on meals? a. Meals provided to employees during a business meeting. b. Meals provided at cost to employees at a cafeteria funded by the employer. c. A Fourth of July company picnic for employees. d. Meals provided to employees during a training event or retreat at an off-site location. 80. Robert entertains several of his key clients on January 1 of the current year; total expenses were $1,220 ($60 cab fare and $1,160 club charges). The charges at the club are combined into a single charge of $1,160. Robert estimates that if charged separately, the costs would be as follows: Cover charge at supper club Dinner at club Tips to waiter

$200 800 160

Presuming proper substantiation, Robert’s deduction is: a. $0. b. $640. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses c. $740. d. $1,220. 81. Ralph made the following business gifts during the year. To Robert (a key client) at Christmas To Angel (Robert’s 8-year old daughter) on her birthday To Art (Ralph’s secretary) on his birthday ($3 was for gift wrapping) To Paige (Ralph’s boss) at Christmas

$50 20 30 40

Presuming proper substantiation, Ralph’s deduction is: a. $0. b. $53. c. $73. d. $78. 82. Which of the following, if any, is an advantage of using the simplified method for determining the office in the home deduction? a. No depreciation on the personal residence has to be computed. b. The exclusive use requirement does not have to be met. c. It allows the expense to be classified as a deduction for AGI. d. It can also be used for a residence that is rented (not owned) by the taxpayer. 83. Which of the following expenses, if any, qualify as deductible? a. Contributions to a Coverdell Education Savings Account (CESA). b. Contributions to a qualified tuition program (§ 529 plan). c. Job-hunting expense of FBI agent who applies for the job of city manager of Beaumont, TX. d. Contribution to a traditional IRA. 84. Which of the following expenses, if any, are deductible? a. Safety shoes purchased by a plumber employed by a company. b. Bottled water purchased by a gig driver for passengers. c. Unreimbursed employee expenses. d. Tax return preparation fee paid by a nonemployed retiree. 85. In contrasting the reporting procedures of employees and self-employed persons regarding job-related transactions, which of the following items involve people who are self-employed? a. Schedule C (Form 1040). b. Form W-4. c. Form W-2. d. Schedule A (Form 1040). 86. Which of the following factors, if any, is a characteristic of independent contractor status? a. Services are performed for more than one business. b. Forms 1099-NEC received from business customers who paid $600 or more during the year. c. Workplace fringe benefits are not available. Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses d. All of these are characteristic of independent contractor status. 87. Under the actual expense method, which of the following expenses, if any, will not be allowed? a. Parking fines incurred during business use of a car. b. Interest expense on a car loan (taxpayer is self-employed). c. Auto insurance. d. Auto club dues. 88. Which of the following expenses, if any, is/are deductible? a. Contribution to an IRA. b. Costs involved in maintaining an office in the home by a self-employed insurance adjuster. Taxpayer’s wife also uses the office as a meeting place for her bridge club. c. Cost of moving to first job location. Taxpayer just graduated from college. d. Job-hunting expenses of a fishing guide to become an insurance salesman. 89. In which of the following plans is this statement true: A deduction is allowed for contributions to the plan, and no income tax consequences result from distributions to the participant at retirement. a. Roth IRAs. b. Traditional IRAs. c. Keogh (H.R. 10) plans. d. None of the above. 90. Which of the following miscellaneous expenses is deductible? a. Unreimbursed employee business expenses. b. Job-hunting expenses. c. Union dues. d. Losses from Ponzi-type investment schemes. 91. Fran is a CPA who has a small tax practice in addition to working as the controller for a local manufacturing business. Fran runs her tax practice out of a 150-square foot office in her home where she meets clients and works on their tax returns and researches their tax issues. She meets the exclusive use test for this space. The gross income from her tax practice amounts to $7,500 for the year. Business expenses amount to $1,000. Based on square footage, $4,000 of Fran’s mortgage interest and real estate taxes are allocable to the home office. The allocable portion of maintenance, utilities, and depreciation is $4,500. Assuming no other expenses related to the business were incurred, what amount of the maintenance, utilities, and depreciation is deductible by Fran? a. $0. b. $2,500. c. $3,500. d. $4,500. 92. Under the deemed substantiation method of accounting for expenses, what is the maximum amount taxpayers are allowed as a deduction without being required to substantiate the amount of the expenses? a. The appropriate Federal per diem amount. b. $75 per day. c. All expenses up to $25 per day. Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses d. The per diem rate established by the state in which they live. 93. Annika has $200,000 of QBI from her neighborhood clothing store (a sole proprietorship). Her proprietorship paid $30,000 in W-2 wages and has $20,000 of qualified property. Annika’s spouse earned $50,000 of wages as an employee, they earned $20,000 of interest income during the year, and they will be filing jointly. What is their QBI deduction for 2024? a. $0. b. $40,000. c. $50,000. d. $54,000. 94. Jenna owns and manages her single-member LLC, which provides a wide variety of financial services to her clients. She is married and will file a joint tax return with her spouse. Her LLC reports $300,000 of net income, W-2 wages of $120,000, and assets with an unadjusted basis of $75,000. Their taxable income before the QBI deduction is $285,000 (this is also their modified taxable income). What is their QBI deduction for 2024? a. $0. b. $57,000. c. $60,000. d. $70,000. 95. Ellie (a single taxpayer) is the owner of ABC, LLC. The LLC (a sole proprietorship) reports QBI of $900,000 and is not a specified services business. ABC paid total W-2 wages of $300,000, and the total unadjusted basis of property held by ABC is $30,000. Ellie’s taxable income before the QBI deduction is $740,000 (this is also her modified taxable income). What is Ellie’s QBI deduction for 2024? a. $75,750. b. $148,000. c. $150,000. d. $180,000. Matching Sue performs services for Lynn. Regarding this arrangement, use the legend provided to classify each statement. a. Indicates employee status. b. Indicates independent contractor status. 96. The services are performed at Sue’s premises. 97. Sue does not work for other parties. 98. Lynn determines when the services are to be performed. 99. Sue has unreimbursed expenses. 100. Sue was trained by Lynn. 101. Sue uses her own helpers. 102. Sue charges by the hour for her work. Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses 103. Sue does not file a Schedule SE with her Form 1040. 104. Sue files a Schedule SE with her Form 1040. 105. Sue uses her own tools. Subjective Short Answer 106. Paul is employed as an auditor by a CPA firm. On most days, he commutes by auto from his home to the office. During one month, however, he has an extensive audit assignment closer to home. For this engagement, Paul drives directly from home to the client’s premises and back. Mileage information follows: Home to office Office to audit client Audit client to home

12 miles 15 miles 10 miles

If Paul spends 20 days on the audit and provides an adequate accounting to his employer, what is his reimburseable mileage? 107. During 2024, Eva (a self-employed accountant who also works part-time for a CPA firm) used her car as follows: 12,000 miles (business), 1,400 miles (commuting), and 4,000 miles (personal). In addition, she spent $440 for tolls (business) and $620 for parking (business). If Eva uses the automatic mileage method, what is the amount of her deduction? 108. Alfredo, a self-employed patent attorney, flew from his home in Chicago to Miami, had lunch alone at the Chicago airport, conducted business in the afternoon, and returned to Chicago in the evening. His expenses were as follows: Airfare Airport parking (Chicago) Lunch Taxis (Miami)

$900 60 30 42

What is Alfredo’s deductible expense for the trip? 109. Rod uses his automobile for both business and personal use and claims the automatic mileage rate for all purposes. During 2024, his mileage was as follows:

Personal Business Medical Charitable Qualifying education (MBA program)

Miles Driven 4,000 8,000 1,800 1,500 800

How much can Rod claim for mileage? 110. Lily (self-employed) went from her office in Portland to Lisbon, Portugal, on business. While there, she spent part of the time on vacation. How much of the $5,000 airfare can she deduct based on the following assumptions: a.

Lily was gone five days (i.e., three business and two personal).

Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses b. c.

Lily was gone five weeks (i.e., four business and one personal). Lily was gone five weeks (i.e., three business and two personal).

111. During 2024, Cathy takes five key clients to dinner and incurs the following costs: $320 limousine rental, $920 drinks and dinner, and $200 tips; assume that there were substantive business discussions during dinner. Several days after the function, Cathy mails each client a pen costing $25. In addition, Cathy pays $4 for gift wrapping and mailing each pen. Assuming adequate substantiation and a business justification, what is Cathy’s deduction? 112. Brian makes gifts as follows: Recipient Mr. Brown (a client) Mrs. Brown (Mr. Brown’s wife) Ms. Smith (Brian’s receptionist) Mr. Jones (Brian’s boss)

Cost of Gift $27 * 15 30 40

* Includes $2 for gift wrapping Presuming adequate substantiation and no reimbursement, how much may Brian deduct? 113. Rocky has a full-time job as an electrical engineer for the city utility. In his spare time, he repairs electronic gear in the basement of his personal residence. Most of his business comes from friends and referrals from former customers, although occasionally he runs an ad in the local suburbia newspaper. Typically, the items are dropped off at Rocky’s house and later picked up by the owner when notified that the repairs have been made. The floor space of Rocky’s residence is 2,500 square feet, and he estimates that 20% of this is devoted exclusively to the repair business (i.e., 500 square feet). Gross income from the business is $13,000; expenses (other than home office) are $5,000. Expenses relating to the residence are as follows: Real property taxes Interest on home mortgage Operating expenses of residence Depreciation (based on 20% business use)

$4,500 8,000 3,000 1,000

What is Rocky’s net income from the repair business a. b.

If he uses the regular (actual expense) method of computing the deduction for office in the home? If he uses the simplified method?

Essay 114. If a business retains someone to provide services, that person may either be an employee or be self-employed (i.e., independent contractor). a. b.

What are the tax advantages to the business of having the service provider classified as self-employed? What are the advantages and disadvantages to the service provider of self-employed status?

115. In terms of income tax treatment, what is the difference between common law employees and statutory employees? Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses 116. Myra’s classification of those who work for her as independent contractors is being questioned by the IRS. It is the position of the IRS that these workers are really employees. What type of factors can Myra utilize to justify her classification? 117. Maria performs services for Jonathan on a regular basis. There exists considerable doubt as to whether Maria is an employee or an independent contractor. a. b.

What can Jonathan do to clarify the matter? Suppose that Jonathan treats Maria as an independent contractor but Maria thinks she is an employee. What is Maria’s recourse, if any?

118. Jacob is a landscape architect who works out of his home. He wonders whether or not he will have nondeductible commuting expenses when he drives to the locations of his clients. Please comment. 119. Under the automatic mileage method, one rate does not cover every type of expense. For 2024, what are the rates for business use, charitable, and medical? 120. Christopher just purchased an automobile for $40,000 on which he plans to claim 100% as being for business use. To take advantage of MACRS and § 179, he plans to use the actual cost method for determining his deduction in the first year. In subsequent years, he will switch to the automatic mileage method. Comment on Christopher’s proposed approach. 121. Once set for a year, when might the IRS change the rate for the automatic mileage method? 122. Travel status requires that the taxpayer be away from home overnight. a. b.

What does away from home overnight mean? What tax advantages result from being in travel status?

123. When is a taxpayer’s work assignment in a new locale temporary? Permanent? What difference does it make? 124. Nick Lee is a linebacker for the Baltimore Ravens (a professional football club). During the football season he rents an apartment in a Baltimore suburb. The rest of the time he lives with his family in Ann Arbor, MI, and works at a local bank as a vice president in charge of public relations. Can Nick deduct his expenses while away from Ann Arbor? Explain. 125. How are combined business/pleasure trips treated for travel within the United States as opposed to foreign travel? 126. In terms of IRS attitude, what do the following expenses have in common? a. b. c.

Cost of a CPA exam review course. Cost of a review course for the bar exam. Cost of a law degree by a taxpayer who does not intend to practice law.

127. Meg teaches fifth grade at a local school. During the year, she spends $1,200 for school supplies for use in her classroom. On her income tax return, some of this expense is not reported and the balance is deducted in two different places. Explain what has probably happened. 128. In connection with the office in the home deduction of a self-employed individual, comment on the following: a.

Mixed use (i.e., business and personal) of the portion of the home allocated to business.

b.

The difference between direct and indirect expenses for deduction purposes.

Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses c.

The classification of the expense (i.e., dfor or dfrom AGI).

129. Regarding the simplified method of computing the office in the home deduction, comment on the following independent factors. a. b. c. d.

Taxpayer has set aside 400 square feet for use as an office. Taxpayer has repainted and recarpeted the office area. In past years, taxpayer has always taken the deduction using the regular (actual expense) method. The net income from the business is not large.

130. Regarding tax favored retirement plans for employees and self-employed persons, comment on the following: a. b. c. d.

The exclusion versus deduction approaches as to contributions by participants. Tax-free accumulation of earnings. The deferral of income tax consequences. Employee versus self-employed status.

131. Ashley and Matthew are married and both are practicing CPAs. On a joint return, Ashley gets to deduct her professional dues but Matthew does not. Explain. 132. Isabella is a dental hygienist who works for five different dentists. She spends one day a week (i.e., Monday through Friday) with each. All of the dentists except Dr. Stanki (the Wednesday assignment) treat her as an employee. Dr. Stanki, however, classifies her as being self-employed. Comment on this discrepancy in treatment. 133. Felicia, a recent college graduate, is employed as an accountant by an oil company. She would like to continue her education and obtain a law degree. Discuss Felicia’s tax status if she attends a local law school on a: a.

Part-time basis.

b.

Full-time basis.

134. Discuss the 50% overall limitation in connection with various employee expenses under the following arrangements: a. b. c. d.

The employee is not reimbursed by the employer. The employee is fully reimbursed under a nonaccountable plan. The employee is partially reimbursed under an accountable plan. The employee is fully reimbursed under an accountable plan.

135. Aaron and Brad are married and will file jointly. Aaron earns $300,000 from his single-member LLC (a law firm). He reports his business as a sole proprietorship. Wages paid by the law firm amount to $40,000; the law firm has no significant property. Brad is employed as a tax manager by a local CPA firm. Their modified taxable income is $443,900 (this is also their taxable income before the deduction for qualified business income). Determine their QBI deduction for 2024. 136. Jane, single, owns a single-family residence that she rents out to a long-term tenant. Her tax adviser’s

newsletter explains that some rental property owners can obtain a deduction for their "qualified business income." The article notes that if clients have questions, they can contact the firm. Because Jane’s rental property generates a loss, she assumes that this new deduction is not relevant to her. Is Jane correct? Explain. Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses Answer Key 1. False 2. False 3. False 4. True 5. False 6. False 7. True 8. True 9. False 10. True 11. False 12. False 13. True 14. True 15. True 16. False 17. True 18. False 19. False 20. True 21. False 22. True 23. False 24. False 25. True Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses 26. False 27. True 28. True 29. True 30. False 31. False 32. True 33. True 34. True 35. False 36. False 37. False 38. False 39. False 40. True 41. True 42. False 43. False 44. True 45. False 46. False 47. False 48. True 49. True 50. True Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses 51. False 52. True 53. True 54. False 55. True 56. True 57. False 58. True 59. True 60. False 61. False 62. c 63. d 64. a 65. c 66. b 67. d 68. d 69. c 70. b 71. d 72. b 73. d 74. c 75. a 76. c Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses 77. b 78. c 79. b 80. a 81. b 82. a 83. d 84. b 85. a 86. d 87. a 88. a 89. d 90. d 91. b 92. a 93. b 94. b 95. b 96. b 97. a 98. a 99. b 100. a 101. b Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses 102. a 103. a 104. b 105. b 106. 400 miles [20 miles (each day) × 20 days]. 107. $9,100 [(12,000 miles × $0.67) + $440 + $620]. 108. $1,002 ($900 + $60 + $42). Because Alfredo was not away from home, his lunch is not deductible. 109. $6,484 [(8,800 miles × $0.67, business and education) + (1,800 miles × $0.21, medical) + (1,500 miles × $0.14, charitable)]. 110. a. $5,000. b. $5,000. c. $3,000. (60% × $5,000). Transportation costs for mixed use (i.e., both business and personal) need not be allocated as long as domestic trips are involved. Such allocation is necessary, however, for foreign trips unless one of two exceptions applies. One exception deals with trips lasting seven days or less and covers choice a. (but not choices b. or c.). The second exception, less than 25% of the time was for personal use, applies to choice b. but not to choice c. Thus, in choice b. no allocation is necessary, whereas, in choice c. the airfare must be allocated. 111. $1,025 {$320 + [($920 + $200) × 50%]=$880}. Also allowed are the gifts of $145 (5 × $29). The cost of gift wrapping and mailing each pen ($4) can be added to the maximum amount of gift allowed ($25). 112. $52 ($27 + $25). The deduction for Mr. Brown’s gift can include nominal costs for gift wrapping and engraving. No deduction is allowed for the gift to Mrs. Brown unless she is in a separate business. Otherwise, she falls under the $25 limit applicable to Mr. Brown. The deduction for Ms. Smith’s gift is limited to $25. No deduction is allowed for Brian’s gift to his boss. 113. a. Business income Less: Expenses Net business income before office in the home expenses Less: Real property taxes ($4,500 × 20%) Mortgage interest ($8,000 × 20%) Operating expenses($3,000 × 20%) Depreciation Net income from business b. Net business income before office in the home expense (see choice a. above) Office in the home expense Powered by Cognero

$13,000 (5,000) $ 8,000 (900) (1,600) (600) (1,000) $ 3,900

$ 8,000 (1,500) * Page 22

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses Net income from business

$ 6,500

*Because no more than 300 square feet can be considered, the maximum allowed is $1,500 (300 square feet x $5). 114. a.

b.

Self-employed persons do not have to be included in various fringe benefits programs (e.g., group-term life insurance, accident and health plans) and retirement plans. Because they are not covered by FICA and FUTA, these payroll costs are avoided. The advantages are that expenses qualify as deductions for AGI. Consequently, deductibility is not affected by the choice of the standard deduction, and the limitation on miscellaneous itemized deductions is avoided. In terms of disadvantages, being self-employed can lead to other state and local taxes (e.g., license fees, franchise taxes, occupation taxes, gross receipts levy). The most significant, however, is the self-employment tax to which the taxpayer is subject.

115. Although subject to Social Security tax, statutory employees are not subject to income tax withholding. Statutory employees may claim all of their unreimbursed expenses as deductions for AGI. For common law employees, such expenses are miscellaneous itemized deductions and are not deductible from 2018 through 2025. 116. Myra needs to show that she has a reasonable basis for not treating her workers as employees. In this regard, can she prove reliance on any of the following? ∙ Is there judicial precedent, published ruling, or technical advice? ∙ Was there a past IRS audit that resulted in no employment tax assessment? ∙ Is there a long-standing practice of independent contractor status in the same industry? ∙ Has Myra consistently treated these workers as independent contractors? ∙ Has she reported their earnings by filing Form 1099-NEC? 117. a. Jonathan can obtain a ruling from the IRS by filing Form SS–8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding). b.

Maria should file a Form 8919 (Uncollected Social Security and Medicare Tax on Wages) with the IRS.

118. Jacob has no commuting expenses since his tax home is his residence. Thus, his mileage to and from the premises of his clients should be fully deductible. 119. $0.67 (business use); $0.14 (charitable); and $0.21(medical). 120. First, limitations are imposed on how much depreciation can be claimed over each year of the five-year write-off period. In most cases, such limitations significantly reduce the depreciation normally allowed. Second, the use of MACRS and/or § 179 precludes later converting to the automatic mileage method. Lastly, if Christopher owns just one automobile, Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses 100% business use could be almost impossible to justify since it negates any personal use. 121. Changes in the past have been justified by significant increases or decreases in fuel prices. Such a change places a premium on keeping track of mileage on a monthly basis. 122. a. “Home” for this purpose is the place of taxpayer’s principal employment. “Overnight” need not be a 24-hour period, but it must be a time duration substantially longer than an ordinary day’s work such as to require rest or sleep. b.

If travel status exists, many otherwise nondeductible expenses (e.g., meals, lodging, transportation) become deductible.

123. Temporary indicates that the assignment’s termination is expected within a reasonably short period of time. In no event can the period of absence exceed one year. If the taxpayer’s assignment is indefinite, and not temporary, their tax home changes and travel status ends. 124. Probably not. Although his personal residence is in Ann Arbor, Nick’s tax home is likely to be the Baltimore area. Considering the salaries of professional football players, Nick’s income from the Ravens must heavily outweigh that received from the Ann Arbor bank. Furthermore, his principal activity and the time spent (e.g., conditioning, training, playing) is that of a player, not a banker. 125. The major difference is that transportation charges are fully deductible if the trip is primarily for business and within the United States. If the foreign trip is primarily business, transportation expenses must be allocated between business and personal unless (1) the taxpayer was away from home for seven days or less or (2) if less than 25% of the time was spent on personal pursuits. 126. a. It is the position of the IRS that the costs associated with becoming a CPA are incurred in order to acquire a basic skill and thus are not deductible as education expenses. b.

The same reasoning as noted in choice a. above applies to a review course taken to pass the bar exam.

c.

Regardless of a taxpayer’s career goals, the IRS considers a law degree to be the acquisition of a basic skill.

127. Meg probably has been reimbursed for some of these expenses. If she renders an adequate accounting to her employer, the reimbursement is not reported in her income nor is the expense involved deducted. As to the remaining expenses, she has claimed $300 as a deduction for AGI; the balance would be a miscellaneous itemized deduction (not deductible from 2018 through 2025). 128. a. In most cases, mixed use of the portion allocated to business is not allowed. Consequently, the office must be exclusively used for business. An exception is made, however, when the home is used as a daycare center for which mixed use is allowed. b.

Direct expenses (e.g., painting the office) are deductible in full because they benefit only the office area. Indirect expenses (e.g., homeowners casualty insurance) must be allocated since they relate to both the business and personal portions of the home. In the case of the simplified method of determining the deduction, the distinction between direct

Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses and indirect expenses is not relevant. c.

An office in the home expense for a self-employed taxpayer is a deduction for AGI.

129. a. Unfortunately, the deduction is limited to 300 square feet, so the maximum allowed is $1,500 (300 × $5). b. Direct expenses cannot be claimed under this method. c. Because the choice allowed is annual, the method used in the past does not matter. However, no carryover of unused deduction can be claimed. Also, a prior choice cannot be changed but is binding on the taxpayer. d. The deduction cannot exceed the net income from the property. Furthermore, any unused deduction amount cannot be carried over to future years. 130. a.

Contributions by employees to retirement plans that are qualified provide a tax benefit either in the form of an exclusion from gross income or as a deduction for AGI. The traditional IRA takes the deduction approach. This is also the case of contributions by a self-employed person to a Keogh (H.R. 10) plan.

b.

A characteristic of all tax-favored retirement plans is that income accumulates free of tax. This allows for a greater accumulation to take place up to the point of distribution.

c.

Except in the Roth IRA, the main objective of retirement plans is to defer taxation until distributions are made.

d.

Keogh (H.R. 10) plans are, in effect, the self-employed version of employee retirement plans.

131. Most likely Ashley is self-employed, whereas Matthew is employed. Thus, Ashley’s expenses are deductions for AGI and Matthew’s are miscellaneous itemized deductions (which are not deductible). 132. Unless Isabella’s Wednesday duties are significantly different than those in the rest of the week, Dr. Stanki has placed himself in a vulnerable position. In terms of the proper work classification of a service provider, one key consideration is how they are treated by other comparable businesses. In all likelihood, therefore, Dr. Stanki will have a tough time convincing the IRS that Isabella is an independent contractor when four of his colleagues consider her to be an employee. More likely, Dr. Stanki desires to save on payroll taxes and avoid covering Isabella in any fringe benefits offered to other employees. 133. a.

b.

Regarding the usual education expense justification of maintaining and improving on existing skills, Felicia will not succeed. The IRS has successfully maintained that obtaining a law degree leads to a new trade or business. If Felicia quits her job and returns to college on a full-time basis, she no longer is in a trade or business. A temporary break in employment status (e.g., leave of absence), however, will cure this problem if properly structured. However, Felicia will still encounter the new trade or business provision.

Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses 134. a.

Any overall limitation (50%) is imposed on the employee. The employee has the burden of being able to substantiate the expenses involved. Furthermore, these will be miscellaneous itemized deductions (and not deductible from 2018 through 2025).

b.

The reimbursement must be reported as income. Deductions are handled as in part a..

c.

Unless the reimbursement identifies the expenses covered, it must be allocated between the items that are and are not subject to the overall limitation (50%).

d.

A washout results. In effect the expenses are treated as deductions for AGI and fully offset the reimbursement. As far as the employee is concerned, the expenses are not subject to the overall limitation (50%).

135. Normally, Aaron and Brad would be entitled to a QBI deduction of $60,000 ($300,000 x 20%). But since their taxable income exceeds the threshold for married taxpayers ($383,900), and Aaron’s QBI is from a “specified services” business (a law firm), their QBI deduction is limited to $14,400, computed as follows: (1) Determine applicable percentage: Applicable percentage = 100% – $60,000 ($443,900 – $383,900) = 40% $100,000 (2) Determine QBI deduction: 1. 20% of qualified business income ($300,000 x 20%)

$60,000 x 40% $24,000

x Applicable percentage

2. But no more than the greater of: •

50% of W-2 wages ($40,000 x 50% x 40%), or

•

25% of W-2 wages ($40,000 x 25% x 40%) plus

•

2.5% of the unadjusted basis of qualified property ($0 x 2.5% x 40%)

$ 8,000 $4,000 -0- $4,000

Because Aaron and Brad’s modified taxable income exceeds $383,900, but is less than $443,900 and the W-2 Wages/Capital portion of the computation is the limiting factor, the general 20% QBI amount is used but reduced as follows: (1)

Determine difference between the general 20% QBI deduction amount and the W-2 Wages/Capital amount.

Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 09: Deductions: Employee and Self Employed Related Expenses General 20% QBI deduction amount Less: The W-2 Wages/Capital Investment limit Excess

$24,000 ( 8,000) $16,000

(2) Determine the Reduction Ratio: Reduction Ratio = $60,000 ($443,900 – $383,900) = 60% $100,000

(3)

Determine the reduction in the W-2 Wages/Capital Investment Limit: Excess ($16,000) x Reduction Ratio (60%) = $9,600

(4) Determine Final QBI Amount: General 20% QBI deduction amount Less: Reduction in the W-2 Wages/Capital limit Final QBI Amount

$24,000 ( 9,600) $14,400

136. No. The treatment of Jane’s rental property for purposes of the QBI deduction is relevant to her future tax

calculations. Assuming that the rental is a trade or business, the losses will offset future income from the rental and thus affect (lower) future QBI deductions when the property generates income.

Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions True / False 1. Adrienne sustained serious facial injuries in a motorcycle accident. To restore her physical appearance, Adrienne had cosmetic surgery. She cannot deduct the cost of this procedure as a medical expense. a. True b. False 2. A physician recommends a private school for Ellen’s dependent child. Because of the physician’s recommendation, the cost of the private school will qualify as a medical expense deduction (subject to percentage limitations). a. True b. False 3. Mindy paid an appraiser to determine how much a capital improvement made for medical reasons increased the value of her personal residence. The appraisal fee qualifies as a deductible medical expense. a. True b. False 4. On the recommendation of a physician, Mario has a swimming pool installed at his residence because of a heart condition. If he is allowed to deduct all or part of the cost of the pool, Mario’s increase in utility bills due to the operation of the pool qualifies as a medical expense. a. True b. False 5. Mason, a physically disabled individual, pays $10,000 this year for the installation of wheelchair ramps,

support bars, and railings in his personal residence. These improvements increase the value of his personal residence by $2,000. Only $8,000 of the expenditure qualifies as a medical expense for tax purposes. a. True b. False

6. Chad pays the medical expenses of his son, James. James would qualify as Chad’s dependent except that he earns $7,500 during the year. Chad may claim James’ medical expenses even if he is not a dependent. a. True b. False 7. Bill paid $2,500 of medical expenses for his daughter, Marie. She is married to Sonia and they file a joint return. Bill can include the $2,500 of expenses when calculating his medical expense deduction. a. True b. False 8. In 2024, Dena traveled 600 miles for specialized medical treatment that was not available in her hometown. She paid $90 for meals during the trip, $145 for a hotel room for one night, and $15 in parking fees. She did not keep records of other out-of-pocket costs for transportation. Dena can include $191 in computing her medical expenses. a. True b. False 9. Maria traveled to Rochester, MN with her son who had surgery at the Mayo Clinic. She stayed at the clinic for the Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions duration of his treatment. She paid airfare of $300 and $50 per night for lodging. The cost of Maria’s airfare and lodging cannot be included in determining her medical expense deduction. a. True b. False 10. In 2024, Brandon, age 72, paid $5,000 for long-term care insurance premiums. He may include the $5,000 in computing his medical expense deduction for the year. a. True b. False 11. Personal expenditures that are deductible as itemized deductions include medical expenses, Federal income taxes, state income taxes, property taxes on a personal residence, mortgage interest, and charitable contributions. a. True b. False 12. The election to itemize is appropriate when total itemized deductions are less than the standard deduction based on the taxpayer’s filing status. a. True b. False 13. Jim’s employer pays half of the premiums on a group medical insurance plan covering all employees, and employees pay the other half. Jim can exclude the half of the premium paid by his employer from his gross income and may include the half he pays in determining his medical expense deduction. a. True b. False 14. In 2024, Rhonda received an insurance reimbursement for medical expenses incurred in 2023. She is not required to include the reimbursement in gross income in 2024 if she claimed the standard deduction in 2023. a. True b. False 15. Matt, a calendar year taxpayer, pays $11,000 in medical expenses in 2024. He expects $5,000 of these expenses to be reimbursed by an insurance company in 2025. In determining his medical expense deduction for 2024, Matt must reduce his 2024 medical expenses by the amount of the reimbursement he expects in 2025. a. True b. False 16. Georgia contributed $2,000 to a qualifying Health Savings Account in the current year. The entire amount qualifies as an expense deductible for AGI. a. True b. False 17. Soraya pays the employer's share of FICA on the wages she pays her housekeeper to clean and maintain Soraya’s personal residence. The FICA payment is not deductible as an itemized deduction. a. True b. False Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions 18. Fees for automobile inspections, automobile titles and registration, bridge and highway tolls, parking meter deposits, and postage are not deductible if incurred for personal reasons, but they are deductible as deductions for AGI if incurred as a business expense by a self-employed taxpayer. a. True b. False 19. A taxpayer may not deduct the cost of new curbing (relative to a personal residence) even if the construction is required by the city and the curbing provides an incidental benefit to the public welfare. a. True b. False 20. Sergio was required by the city to pay $2,000 for the cost of new curbing installed by the city in front of his personal residence. The new curbing was installed throughout Sergio’s neighborhood as part of a street upgrade project. Sergio may not deduct $2,000 as a tax, but he may add the $2,000 to the basis of his property. a. True b. False 21. Neha, who is single, has itemized deductions totaling $20,000. She overpaid her 2023 state income tax and is entitled to a refund of $400 in 2024. Neha chooses to apply the $400 overpayment toward her state income taxes for 2024. She is required to recognize that amount as income in 2024. a. True b. False 22. Trent sells his personal residence to Chester on July 1, 2024. He had paid $7,000 in real property taxes on March 1, 2024, the due date for property taxes for 2024. Trent may not deduct the portion of the taxes he paid for the period the property was owned by Chester. a. True b. False 23. Hanson is the sole proprietor of a furniture store. He can deduct real property taxes on his store building as a business deduction but he cannot deduct state income taxes related to his net income from the furniture store as a business deduction. a. True b. False 24. Grace’s sole source of income is from a restaurant that she owns and operates as a proprietorship. Any state income tax Grace pays on the business net income must be deducted as a business expense rather than as an itemized deduction. a. True b. False 25. In April 2024, Bertie, a calendar year cash basis taxpayer, had to pay the state of Michigan additional income tax for 2023. Even though it relates to 2023, for Federal income tax purposes, the payment qualifies as a tax deduction for tax year 2024. a. True b. False 26. In January 2025, Pam, a calendar year cash basis taxpayer, made an estimated state income tax payment for 2024. The Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions payment is deductible in 2024. a. True b. False 27. Tom, whose MAGI is $40,000, paid $3,500 of interest on a qualified student loan in 2024. He is single and may deduct the $3,500 interest as an itemized deduction. a. True b. False 28. Interest paid or accrued during 2024 on aggregate acquisition indebtedness of $2 million or less ($1 million or less for married persons filing separate returns) is deductible as qualified residence interest. a. True b. False 29. For purposes of computing the deduction for qualified residence interest, a qualified residence includes only the taxpayer’s principal residence. a. True b. False 30. For purposes of computing the deduction for qualified residence interest, a qualified residence includes the taxpayer’s principal residence and two other residences of the taxpayer or spouse. a. True b. False 31. A taxpayer pays points to obtain financing to purchase a second residence. At the election of the taxpayer, the points can be deducted as interest expense for the year paid. a. True b. False 32. Points paid by the owner of a personal residence to refinance an existing mortgage must be capitalized and amortized over the life of the new mortgage. a. True b. False 33. Jesse sold a personal residence to Steven and paid points of $3,500 on the loan to help Steven finance the purchase. Jesse can deduct the points as interest. a. True b. False 34. Letha incurred a $1,600 prepayment penalty to a lending institution because she paid off the mortgage on her home early. The $1,600 is deductible as interest expense. a. True b. False 35. Leona borrows $100,000 from First National Bank and uses the proceeds to purchase City of Houston bonds. The Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions interest Leona pays on this loan is deductible as investment interest subject to the investment interest limits. a. True b. False 36. Joe, a cash basis taxpayer, took out a 12-month business loan on December 1, 2024. He prepaid all $3,600 of the interest on the loan on December 1, 2024. Joe can deduct only $300 of the prepaid interest in 2024. a. True b. False 37. Thania mailed a check for $2,200 to a qualified charitable organization on December 31, 2024. The $2,200 contribution is deductible on Thania’s 2024 tax return if she itemizes her deductions. a. True b. False 38. On December 31, Lynette used her credit card to make a $500 contribution to the United Way, a qualified charitable organization. She will pay her credit card balance in January of the following year. If Lynette itemizes, she can deduct the $500 in the year she used the card. a. True b. False 39. Judy paid $40 for Girl Scout cookies and $40 for Boy Scout popcorn. She may claim an $80 charitable contribution deduction. a. True b. False 40. For all of the current year, Randy (a calendar year taxpayer) allowed the Salvation Army to use rent-free a building he owns. The building normally rents for $24,000 a year. Randy will be allowed a charitable contribution deduction this year of $24,000. a. True b. False 41. Al contributed a painting to the Metropolitan Art Museum of St. Louis, MO. The painting, purchased six years earlier, was worth $40,000 when donated, and Al’s basis was $25,000. If this painting is immediately sold by the museum and the proceeds are placed in the general fund, Al’s charitable contribution deduction is $25,000 (subject to percentage limitations). a. True b. False 42. During the year, Victor spent $300 on bingo games sponsored by his church. If all profits went to the church, Victor has a charitable contribution deduction of $300. a. True b. False 43. This year Allison drove 800 miles to volunteer in a project sponsored by a qualified charitable organization in Utah. In addition, she spent $250 for meals while away from home. In total, Allison may take a charitable contribution deduction of $112 (800 miles × $0.14) relating to her volunteer work. a. True Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions b. False 44. During the year, Eve, a resident of Billings, MT, spends three consecutive weeks in Louisville, KY. One week is spent representing the Billings First Christian Church at the national convention, and two weeks are spent vacationing with relatives. One-third of Eve’s travel expenses will qualify as a charitable deduction. a. True b. False 45. To dissuade his pastor from resigning and taking a position with a larger church, Michael, an ardent leader of the congregation, gives the pastor a new car. The cost of the car is deductible by Michael as a charitable contribution. a. True b. False 46. Dan contributed stock worth $16,000 to his college alma mater, a qualified charity. He acquired the stock 11 months ago for $4,000. He may deduct $16,000 as a charitable contribution deduction (subject to percentage limitations). a. True b. False 47. Ronaldo contributed stock worth $12,000 to the Children’s Protective Agency, a qualified charity. He acquired the stock 20 months ago for $7,000. He may deduct $7,000 as a charitable contribution deduction (subject to percentage limitations). a. True b. False 48. Capital assets donated to a public charity that would result in long-term capital gain if sold are subject to the 30%-ofAGI ceiling limitation on charitable contributions for individuals. a. True b. False 49. Noah gave $750 to a good friend whose house was destroyed by an earthquake. In addition, Noah contributed his time, valued at $250, in the cleanup effort. Noah may claim a charitable deduction of $1,000 on his tax return for the current year. a. True b. False 50. Maria made significant charitable contributions of capital gain property in the current year. In fact, the amount of the contributions exceeds 30% of her AGI. The excess charitable contribution that is not deductible this year can be carried over for five years. a. True b. False 51. Charitable contributions that exceed the percentage limitations for the current year can be carried over for up to three years. a. True b. False 52. Excess charitable contributions that come under the 30%-of-AGI ceiling are always subject to the 30%-of-AGI ceiling Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions in the carryover year. a. True b. False 53. Contributions to public charities in excess of 50% of AGI may be carried back three years or forward for up to five years. a. True b. False 54. Employee business expenses for travel may be deducted as itemized deductions if they are not reimbursed. a. True b. False 55. Gambling losses may be deducted to the extent of the taxpayer’s gambling winnings. a. True b. False Multiple Choice 56. Which of the following is not allowed as an itemized deduction? a. Cash donation to a church. b. Interest expense on a $800,000 loan incurred in 2016 to buy a principal residence. c. A subscription to the Wall Street Journal to help with personal investment decisions. d. Gambling losses to the extent of gambling winnings. 57. Edna had an accident while competing in a rodeo. She sustained facial injuries that required cosmetic surgery. While having the surgery done to restore her appearance, she had additional surgery done to reshape her chin, which was not injured in the accident. The surgery to restore her appearance cost $9,000 and the surgery to reshape her chin cost $6,000. How much of Edna’s surgical fees will qualify as a deductible medical expense (before application of the 7.5%-of-AGI floor)? a. $0 b. $6,000 c. $9,000 d. $15,000 58. Fred and Lucy are married, ages 33 and 32, and together have AGI of $120,000 in 2024. They have four dependents and file a joint return. They pay $5,000 for a high deductible health insurance policy and contribute $2,600 to a qualified Health Savings Account. During the year, they paid the following amounts for medical care: $9,200 in doctor and dentist bills and hospital expenses, and $3,000 for prescribed medicine and drugs. In October 2024, they received an insurance reimbursement of $4,400 for the hospitalization. They expect to receive an additional reimbursement of $1,000 in January 2025. Determine the maximum itemized deduction allowable for medical expenses in 2024. a. $800 b. $3,800 c. $9,200 d. $12,800 Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions 59. Darnell, age 50, is employed as an actuary. For calendar year 2024, he had AGI of $130,000 and paid the following medical expenses: Medical insurance premiums Doctor and dentist bills for Derrick and Jane (Darnell’s parents) Doctor and dentist bills for Darnell Prescribed medicines for Darnell Nonprescribed insulin for Darnell

$5,300 7,900 5,100 830 960

Derrick and Jane would qualify as Darnell’s dependents except that they file a joint return. Darnell’s medical insurance policy does not cover them. Darnell filed a claim for $4,800 of his own expenses with his insurance company in November 2024 and received the reimbursement in January 2025. What is Darnell’s maximum allowable medical expense deduction for 2024? a. $0 b. $7,090 c. $10,340 d. $20,090 60. Sandra is single and does considerable business entertaining at home. Because Arthur, Sandra’s 80-year-old dependent grandfather who lived with Sandra, needs medical and nursing care, he moved to Twilight Nursing Home. During the year, Sandra made the following payments on behalf of Arthur: Room at Twilight Meals for Arthur at Twilight Doctor and nurse fees Cable TV service for Arthur’s room Total

$4,500 850 700 107 $6,157

Twilight has medical staff in residence. Disregarding the AGI floor, how much, if any, of these expenses qualify for a medical deduction by Sandra? a. $6,157 b. $6,050 c. $5,200 d. $1,550 61. Phillip, age 66, developed hip problems and was unable to climb the stairs to reach his second-floor bedroom. His physician advised him to add a first-floor bedroom to his home. The cost of constructing the room was $32,000. The increase in the value of the residence as a result of the room addition was determined to be $17,000. In addition, Phillip paid the contractor $5,500 to construct an entrance ramp to his home and $8,500 to widen the hallways to accommodate his wheelchair. Phillip’s AGI for 2024 was $75,000. What is the amount of Phillip's medical expense deduction in 2024? a. $0 b. $21,500 c. $23,375 d. $29,000 62. Quinn, who is single and lives alone, is physically disabled as a result of a diving accident. To live independently, he modifies his personal residence at a cost of $30,000. The modifications included widening halls and doorways for a wheelchair, installing support bars in the bathroom and kitchen, installing a stairway lift, and rewiring so he could reach Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions electrical outlets and appliances. Quinn pays $200 for an appraisal that places the value of the residence at $129,000 before the improvements and $140,000 after. As a result of the operation of the stairway lift, Quinn experienced an increase of $680 in his utility bills for the current year. Disregarding the AGI floor for medical expenses, how much of these expenditures qualify as medical expense deductions? a. $11,680 b. $30,680 c. $30,880 d. $34,880 63. Brad, who would otherwise qualify as Faye’s dependent, had gross income of $9,000 during the year. Faye, who had AGI of $120,000, paid the following medical expenses in 2024: Cataract operation for Brad Brad’s prescribed contact lenses Faye’s doctor and dentist bills Prescribed drugs for Faye Total

$ 5,400 1,800 12,600 2,550 $22,350

Faye has a medical expense deduction of: a. $6,150 b. $10,350 c. $13,350 d. $22,350 64. Tom, age 48, is advised by his family physician that he needs back surgery to correct a problem from his last back surgery. As Tom is in a wheel chair, he needs his wife, Jean, to accompany him on his trip to Rochester, MN, for inpatient treatment at the Mayo Clinic, which specializes in this type of surgery. Tom incurred the following costs in 2024: Round-trip airfare ($350 each) Jean’s hotel in Rochester for four nights ($95 per night) Jean’s meals while in Rochester Tom’s medical treatment Tom’s prescription medicine

$ 700 380 105 3,500 600

Compute Tom’s allowable medical expenses for the trip (before application of the AGI floor). a. $4,000 b. $5,000 c. $5,180 d. $5,285 65. Your friend Scotty informs you that in 2024 he received a tax-free reimbursement of some medical expenses he paid in 2023. Which of the following statements best explains why Scotty is not required to report the reimbursement in gross income? a. Scotty itemized deductions in 2023. b. Scotty did not itemize deductions in 2023. c. Scotty itemized deductions in 2024. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions d. Scotty did not itemize deductions in 2024. 66. In 2024, Boris pays a $3,800 premium for high-deductible medical insurance for himself and his family. In addition, he contributes $3,400 to a Health Savings Account. Which of the following statements is true? a. If Boris is self-employed, he may deduct $7,200 as a deduction for AGI. b. If Boris is self-employed, he may deduct $3,400 as a deduction for AGI and may include the $3,800 premium when calculating his itemized medical expense deduction. c. If Boris is an employee, he may deduct $7,200 as a deduction for AGI. d. If Boris is an employee, he may include $7,200 when calculating his itemized medical expense deduction. 67. Hugh, a self-employed individual, paid the following amounts during the year: Real estate tax on Iowa residence State income tax Real estate taxes on a vacation home Gift tax paid on gift to daughter State sales taxes State occupational license fee Property tax on value of his automobile (used 100% for business)

$3,800 1,700 2,100 1,200 1,750 300 475

What is the maximum amount Hugh can claim as taxes in itemizing deductions from AGI? a. $7,650 b. $8,850 c. $9,625 d. $10,000 68. In Lawrence County, the real property tax year is the calendar year. The real property tax becomes a personal liability of the owner of real property on January 1 in the current real property tax year (assume that this year is not a leap year). The tax is payable on June 1. On May 1, Reggie sells his house to Dana for $350,000. On June 1, Dana pays the entire real estate tax of $7,950 for the year ending December 31. Assuming that Reggie itemizes his deductions and the $10,000 limit on state and local taxes does not apply, how much of the property taxes may Reggie deduct? a. $0 b. $2,614 c. $2,625 d. $7,950 69. Nancy paid the following taxes during the year: Tax on residence (for the period from March 1 through August 31) State motor vehicle tax (based on the value of the personal use automobile) State sales tax State income tax

$5,250 430 3,500 3,050

Nancy sold her personal residence on June 30 of this year under an agreement in which the real estate taxes were not prorated between the buyer and the seller. What amount qualifies as a deduction from AGI for Nancy? a. $9,180 Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions b. $9,130 c. $7,382 d. $5,382 70. Sang-hoon, who uses the cash method of accounting, lives in a state that imposes an income tax (including withholding from wages). On April 14, 2024, he files his state return for 2023, paying an additional $600 in state income taxes. During 2024, his withholdings for state income tax purposes amount to $3,550. On April 13, 2025, he files his state return for 2024 claiming a refund of $800. Sang-hoon receives the refund on June 3, 2025. If he itemizes deductions, how much may Sang-hoon claim as a deduction for state income taxes on his Federal income tax return for calendar year 2024 (filed in April 2025)? a. $3,350 b. $3,550 c. $4,150 d. $5,150 71. This year, Carol, a single taxpayer, purchased a vacation home for $400,000 using a home equity loan of $350,000 on her principal residence. She has no other debt on her principal residence. Carol paid $16,000 of interest on the debt this year. How much of this interest is deductible assuming that Carol itemizes her deductions? a. $0 b. $10,000 c. $16,000 d. $125,000 72. Pedro’s child attends a school operated by the church the family attends. Pedro made a donation of $1,000 to the church in lieu of the normal registration fee of $200. In addition, Pedro paid the regular tuition of $6,000 to the school. Based on this information, what is Pedro’s charitable contribution? a. $0 b. $800 c. $1,000 d. $6,800 73. In the current year, Jerry pays $8,000 to become a charter member of Mammoth University’s Athletic Council. The membership ensures that Jerry will receive choice seating at all of Mammoth’s home basketball games. Also this year, Jerry pays $2,200 (the regular retail price) for season tickets for himself and his wife. For these items, how much qualifies as a charitable contribution? a. $0 b. $6,400 c. $8,000 d. $10,200 74. Emily, who lives in Indiana, volunteered to travel to Louisiana in March to work on a home-building project for Habitat for Humanity (a qualified charitable organization). She was in Louisiana for three weeks. She normally makes $500 per week as a carpenter’s assistant and plans to deduct $1,500 as a charitable contribution. In addition, she incurred the following costs in connection with the trip: $600 for transportation, $1,200 for lodging, and $400 for meals. What is Emily’s deduction associated with this charitable activity? a. $600 Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions b. $1,200 c. $1,800 d. $2,200 75. Hannah makes the following charitable donations in the current year:

Inventory held for resale in Hannah’s business (a sole proprietorship) Stock in HBM, Inc., held as an investment (acquired four years ago) Baseball card collection held as an investment (acquired six years ago)

Basis Fair Market Value $ 8,000 $ 7,200 16,000

40,000

4,000

20,000

The HBM stock and the inventory were given to Hannah’s church, and the baseball card collection was given to the United Way. Both donees promptly sold the property for the stated fair market value. Disregarding percentage limitations, Hannah’s current charitable contribution deduction is: a. $28,000. b. $51,200. c. $52,000. d. $67,200. 76. Byron owned stock in Blossom Corporation that he donated to a museum (a qualified charitable organization) on June 8 this year. What is the amount of Byron’s deduction assuming that he had purchased the stock for $10,500 last year on August 7, and the stock had a fair market value of $13,800 when he made the donation? a. $3,300 b. $10,500 c. $12,150 d. $13,800 77. Zeke made the following donations to qualified charitable organizations during the year:

Used clothing of taxpayer and his family (all acquired more than a year ago) Stock in ABC, Inc., held as an investment for 15 months Stock in MNO, Inc., held as an investment for 11 months Real estate held as an investment for two years

Basis Fair Market Value $ 1,350 $ 375 12,000 15,000 15,000

10,875 18,000 30,000

The used clothing was donated to the Salvation Army; the other items of property were donated to Eastern State University. Both are qualified charitable organizations. Disregarding percentage limitations, Zeke’s charitable contribution deduction for the year is: a. $43,350. b. $56,250. c. $59,250. d. $60,375. Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions 78. Matilda, a calendar year taxpayer, made the following donations to qualified charitable organizations during the year: Basis Cash donation to State University Unimproved land to the City of Terre Haute, IN

$30,000 70,000

Fair Market Value $30,000 210,000

The land had been held as an investment and was acquired four years ago. Shortly after receipt, the City of Terre Haute sold the land for $210,000. Matilda’s AGI is $450,000. The allowable charitable contribution deduction this year is: a. $100,000. b. $165,000. c. $225,000. d. $240,000. 79. Pat gave 5,000 shares of stock in Coyote Corporation (a publicly traded corporation) to her church (a qualified charitable organization) in the current year. The stock was worth $180,000. She had acquired it as an investment four years ago at a cost of $120,000. She reported AGI of $300,000 for the year. In completing her current income tax return, how much is her current-year charitable contribution deduction? a. $90,000 b. $120,000 c. $150,000 d. $180,000 80. Which of the following items would be an itemized deduction on Schedule A of Form 1040? a. Professional dues paid by an accountant (employed by Ford Motor Co.) to the National Association of Accountants. b. Gambling losses to the extent of gambling winnings. c. Job-hunting costs. d. Subscription to the Wall Street Journal. 81. Paul, a calendar year single taxpayer, has the following information for 2024: AGI State income taxes State sales tax Real estate taxes Gambling losses (gambling winnings were $12,000)

$175,000 13,500 3,000 18,900 6,800

Paul’s allowable itemized deductions for 2024 are: a. $10,000. b. $16,800. c. $39,200. d. $42,200. Subjective Short Answer Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions 82. Marilyn, age 38, is employed as an architect. For calendar year 2024, she had AGI of $204,000 and paid the following medical expenses: Medical insurance premiums Doctor bills for Peter and Esther (Marilyn’s parents) Doctor and dentist bills for Marilyn Prescription medicines for Marilyn Nonprescription insulin for Marilyn

$ 7,800 7,300 11,100 750 950

Peter and Esther would qualify as Marilyn’s dependents except that they file a joint return. Marilyn’s medical insurance policy does not cover them. Marilyn filed a claim for reimbursement of $6,000 of her own expenses with her insurance company in December 2024 and received the reimbursement in January 2025. What is Marilyn’s maximum allowable medical expense deduction for 2024? 83. Aaron, age 45, had AGI of $70,000 for 2024. He was injured in a skiing accident and paid $3,600 for hospital expenses and $2,400 for doctor bills. Aaron also incurred medical expenses of $1,200 for his child who lives with his former wife and is claimed as a dependent by her. In 2025, Aaron was reimbursed $1,300 by his insurance company for the medical expenses attributable to the skiing accident. For 2024, the standard deduction for single taxpayers is $14,600 and $21,900 for those claiming head-of-household status. a. Compute Aaron’s deduction for medical expenses in 2024. b.

Assume that Aaron would have elected to itemize his deductions even if he had no medical expenses in 2024. How much, if any, of the $1,300 reimbursement must be included in gross income in 2025?

c.

Assume that Aaron’s other itemized deductions in 2024 were $15,900 and that he filed as a head of household. How much of the $1,300 reimbursement must he include in gross income in 2025?

84. During 2024, Kathy, who is self-employed, paid $650 per month for an HSA contract that provides medical insurance coverage with a $3,000 deductible. The plan covers Kathy, her husband, and their three children. Of the $650 monthly fee, $300 was for the high-deductible policy, and $350 was deposited into an HSA. How much of the amount paid for the high-deductible policy can Kathy deduct as a deduction for AGI? 85. Shirley sold her personal residence to Mike for $400,000. Before the sale, she paid the real estate taxes of $7,030 for the calendar year. For income tax purposes, the deduction is apportioned as follows: $4,000 to Shirley and $3,030 to Mike. a. What is Mike’s basis in the residence? b. What is Shirley’s amount realized from the sale of the residence? c. What amount of real estate taxes can Mike deduct? d. What amount of real estate taxes can Shirley deduct? 86. In Piatt County, the real property tax year is the calendar year. The real property tax becomes a personal liability of the owner of real property on January 1 and is payable on July 1 in the real property tax year. On June 30 of this year (assume Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions it is not a leap year), Harry sells his house to Judy for $110,000 and on July 1, Judy pays the entire real estate tax of $4,380 for the current year ending December 31. a. b.

How much of the property taxes may Harry deduct? How much of the property taxes may Judy deduct?

87. Brian, a self-employed individual, pays state income tax payments of: $900 on January 15, 2024 (4th estimated tax payment for 2023) $1,000 on April 15, 2024 (1st estimated tax payment in 2024) $1,000 on June 15, 2024 (2nd estimated tax payment in 2024) $1,000 on September 15, 2024 (3rd estimated tax payment in 2024) $800 on January 15, 2025 (4th estimated tax payment of 2024) Brian had a tax overpayment of $500 on his 2023 state income tax return and applied this to his 2024 state income taxes. What is the amount of Brian’s state income tax itemized deduction for his 2024 Federal income tax return? 88. Saira had AGI of $100,000 in 2024. She donated Heron Corporation stock with a basis of $8,500 to a qualified charitable organization on July 5, 2024. a.

What is the amount of Saira’s deduction, assuming that she purchased the stock on December 4, 2023, and that the stock had a fair market value of $15,000 when she made the donation?

b.

Assume the same facts as in a. except that Saira purchased the stock on July 1, 2016.

c.

Assume the same facts as in a. except that the stock had a fair market value of $6,000 (rather than $15,000) when Saira donated it to the charity.

89. Linda, who has AGI of $120,000 in the current year, contributes stock worth $65,000 in Mauve Corporation (a publicly traded corporation) to the Salvation Army, a qualified charitable organization. Linda acquired it as an investment four years ago at a cost of $50,000. a.

b.

What is the total amount that Linda can deduct as a charitable contribution, assuming that she carries over any disallowed contribution from the current year to future years? Describe the restrictions that apply when calculating the deduction in the carryover years.

90. George is single and age 56, has AGI of $265,000, and incurs the following expenditures in 2024. Medical expenses (before 7.5%-of-AGI floor) $25,000 Interest on home mortgage 15,500 State income tax 7,500 State sales tax 4,500 Real estate tax 8,600 Charitable contribution 6,500 What is the amount of itemized deductions George may claim? Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions 91. For calendar year 2024, Anna and Betty Hansen (ages 59 and 60) file a joint return reflecting AGI of $280,000. They incur the following expenditures: Medical expenses before 7.5%-of-AGI floor $30,000 Casualty loss caused by electrical fire in their home 30,000 Interest on home mortgage 11,000 Interest on credit cards 800 Property taxes on home 13,000 Charitable contributions 17,000 State income tax 15,000 Tax return preparation fees 1,200 What is the amount of itemized deductions the Hansens may claim? 92. Charles, who is single and age 61, had AGI of $400,000 during 2024. He incurred the following expenses and losses during the year. Medical expenses before AGI floor State and local income taxes Real estate taxes Home mortgage interest Charitable contributions Unreimbursed employee expenses Gambling losses (Charles had $7,400 of gambling winnings)

$28,500 15,200 4,400 5,400 14,800 8,900 9,800

Compute Charles’s total itemized deductions for the year.

Essay 93. Helen pays nursing home expenses of $3,000 per month for her mother. The monthly charge covers the following items: $1,400 for medical care, $900 for lodging, and $700 for food. Under what circumstances can Helen include the $3,000 per month payment when computing her medical expense deduction for the year? If Helen is not allowed to include the entire payment, how much can she include? 94. Manny, age 57, developed a severe heart condition, and his physician advised him to install an elevator in his home. The cost of installing the elevator was $17,000, and the increase in the value of the residence was determined to be $5,800. Manny’s AGI for the year was $52,000. a.

How much of the expenditure can Manny deduct as a medical expense?

b.

Assume the same facts as in part a. except that Manny was paralyzed in an automobile accident and the expenditures were incurred to build entrance and exit ramps and widen the hallways in his home to accommodate his wheelchair. How much of the expenditure can Manny deduct as a medical expense?

95. Samuel, a 36-year-old individual who has been physically disabled for a year, paid $15,000 for the installation of Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions wheelchair ramps, support bars, railings, and widening doorways in his personal residence. These improvements increased the value of his personal residence by $4,000. How much of Samuel’s expenditures qualify as a medical expense deduction (subject to the 7.5%-of-AGI floor)? Explain. 96. Paul and Patty Kowalski (both age 66) are married and together have AGI of $105,000 in 2024. They have two dependents and file a joint return. During the year, they paid $8,000 for medical insurance, $15,000 in doctor bills and hospital expenses, and $1,000 for prescribed medicine and drugs. a.

In December 2024, the Kowalskis received an insurance reimbursement of $3,500 for hospitalization expenses. Determine the deduction allowable for medical expenses paid during the year.

b.

Assume instead that the Kowalskis received the $3,500 insurance reimbursement in February 2025. Determine the deduction allowable for medical expenses incurred in 2024.

c.

Assume that the Kowalskis received the $3,500 insurance reimbursement in February 2025. Discuss whether the reimbursement will be included in their gross income for 2025.

97. Harry and Sally were divorced three years ago. In July of the current year, their son, Joe, broke his arm falling out of a tree. Joe lives with Sally, and she claims him as a dependent on her tax return. Harry paid for the medical expenses related to Joe’s injury. Can Harry claim the medical expenses he paid for Joe on his tax return? 98. For the past several years, Jeanne and her two sisters have taken turns claiming a dependency exemption deduction for their mother under a multiple support agreement. This year Jeanne will be entitled to the exemption, and her mother needs money for surgery and new eyeglasses. Should Jeanne pay for the medical expenses as her share of her mother’s expenses? How would this benefit Jeanne? 99. Angélica is planning to buy Vicki’s home. They want to keep the transaction simple, so the sales agreement will not apportion the property taxes that Vicki has already paid on the home. Comment on the tax implications for Angélica and Vicki. 100. Linda borrowed $60,000 from her parents for a down payment on a condominium. She paid interest of $5,500 in 2022, $0 in 2023, and $9,000 in 2024. The IRS disallowed the deduction. Can you offer any explanation for the disallowance? 101. Adela contributed a parcel of land to the United Way. In addition, she contributed bibles and song books from her proprietorship’s book store inventory to First Church, a qualified charitable organization. Should Adela’s charitable contribution deduction for these contributions be determined by the basis or fair market value of the contributed items? 102. Joe, who is in the 32% tax bracket this year, expects to retire next year and be in the 22% tax bracket. He plans to donate $50,000 to his church. Because he will not have the cash available until next year, Joe donates land (long-term capital gain property) with a basis of $10,000 and fair market value of $50,000 to the church in December of the current year. He reacquires the land for $50,000 in February of the next year. Discuss Joe’s tax objectives and all tax issues related to his actions.

Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions Answer Key 1. False 2. False 3. False 4. True 5. False 6. True 7. True 8. True 9. False 10. True 11. False 12. False 13. True 14. True 15. False 16. True 17. True 18. True 19. True 20. True 21. True 22. True 23. True 24. False 25. True Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions 26. False 27. False 28. False 29. False 30. False 31. False 32. True 33. False 34. True 35. False 36. True 37. True 38. True 39. False 40. False 41. True 42. False 43. False 44. False 45. False 46. False 47. False 48. True 49. False 50. True Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions 51. False 52. True 53. False 54. False 55. True 56. c 57. c 58. b 59. c 60. b 61. c 62. b 63. c 64. b 65. b 66. a 67. a 68. b 69. c 70. c 71. a 72. b 73. a 74. d 75. b 76. b Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions 77. b 78. b 79. a 80. b 81. b 82. Marilyn’s medical expense deduction is $12,600, determined as follows: Medical insurance premiums Doctor and dentist bills for Peter and Esther Doctor and dentist bills for Marilyn Prescription medicines for Marilyn Nonprescription insulin for Marilyn Total medical expenses Less:7.5% of $204,000 (AGI) Deductible portion of medical expenses

$ 7,800 7,300 11,100 750 950 $27,900 (15,300) $ 12,600

Although Peter and Esther cannot be claimed as Marilyn’s dependents, they could have been had they not filed a joint return. Therefore, they qualify for the medical expense deduction. Insulin is an exception to the rule that nonprescribed drugs do not qualify as medical expenses. The insurance recovery was not received until 2025. Therefore, it has no effect on the medical expense deduction for 2024.

83. a.

Aaron can claim medical expenses he paid for his child even though his former wife is the custodial parent. His deduction for medical expenses in 2024 is computed as follows: Hospitalization Bills for doctor’s services Medical expenses for child Total Less: 7.5% of $70,000 AGI Medical expense deduction (assuming Aaron itemizes his deductions)

b.

$3,600 2,400 1,200 $7,200 (5,250) $ 1,950

If the reimbursement for medical care had occurred in 2024, the medical expense deduction would have been $650 [$7,200 (total medical expenses) – $1,300 (reimbursement) – $5,250 (7.5%-of-AGI floor)], and Aaron would have paid more income tax. Since the reimbursement was made in a subsequent year, Aaron would include $1,300 in gross income for 2025 (the deduction amount he would not have obtained in 2024 if the reimbursement had been received in 2024 rather than in 2025). If Aaron had not itemized in 2024, he would not include any reimbursement in 2025 gross income because he would have received no tax

Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions benefit in 2024. c.

Aaron’s deduction for medical expenses in 2024 would have been $1,950 (see computation in a. above). He would not include the reimbursement in gross income because he received no tax benefit. Other itemized deductions Medical expenses in excess of 7.5%-of-AGI floor Total itemized deductions Standard deduction for head of household in 2024

$15,900 1,950 $17,850 (21,900) $-0 -

Tax benefit from medical expense deduction

84. Because Kathy is self-employed, she can deduct $3,600 ($300 per month × 12 months) of the amount paid for the high-deductible policy as a deduction for AGI. In addition, she may deduct the $4,200 ($350 per month × 12 months) paid to the HSA as a deduction for AGI. Thus, Kathy may deduct $7,800 ($3,600 + $4,200) for AGI. 85. General discussion. For Federal income tax purposes, real estate taxes must be apportioned between the buyer and the seller. The taxes paid by the seller that are apportioned to the buyer affect both the basis of the buyer’s property and the amount realized by the seller. a. Mike’s basis in the residence is $396,970 [$400,000 (purchase price) – $3,030 (property taxes allocated to Mike but paid by Shirley)]. b. Shirley’s amount realized is $396,970 [$400,000 (sales price) – $3,030 (property taxes allocated to Mike but paid by Shirley)]. c. Mike can deduct the $3,030 apportioned to him even though the tax was paid by Shirley. Mike's total tax deduction is limited to $10,000. d. Shirley can deduct only the tax of $4,000 apportioned to her, even though she paid the entire amount of $7,030. Shirley's total tax deduction is limited to $10,000. 86. General discussion. Real property taxes must be apportioned, regardless of whether the buyer or seller pays the taxes. In making the apportionment, the date of sale counts as a day the property is owned by the buyer. a.

Rate of tax per day ($4,380/365) Days Harry owned property (January 1 - June 29) Taxes apportioned to Harry ($12 × 180)

$ 12 180 $2,160

b.

Rate of tax per day ($4,380/365) Days Judy owned property (June 30 - December 31) Taxes apportioned to Judy ($12 × 185)

$ 12 185 $2,220

Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions

87. $4,400 is the itemized deduction. [$900 + $1,000 + $1,000 + $1,000 + $500 (overpayment)]. 88. General discussion. The deduction for a contribution of capital gain property is based on the fair market value, whereas the deduction for a contribution of ordinary income property is equal to the lesser of the basis or the fair market value. a.

Because Saira did not hold the stock for the long-term holding period of more than one year (December 4, 2023 - July 5, 2024), it is short-term capital gain property that is subject to the rules for ordinary income property. Therefore, her deduction is limited to $8,500.

b.

Saira held the stock for the long-term holding period (July 1, 2016 - July 5, 2024), so it is capital gain property. Therefore, her deduction is equal to the fair market value of the stock, $15,000.

c.

The deduction for a contribution of loss property (FMV is less than adjusted basis) is limited to the fair market value. Therefore, Saira’s deduction is $6,000.

89. General discussion. The stock is appreciated long-term capital gain property. The general rule limits the deduction for the contribution of such property to 30% of AGI. a.

Linda can deduct a total of $65,000, the fair market value of the stock. The deduction for the current year is limited to $36,000 (30% of $120,000 AGI).

b.

The remaining $29,000 can be carried forward and deducted in the future (for up to a five year period), subject to the same 30%-of-AGI limitation.

90. Medical expenses ($25,000 less 7.5% of AGI) Interest on home mortgage State income taxes and real estate tax limited to $10,000 Charitable contributions Total

$5,125 15,500 10,000 6,500 $37,125

91. For the medical expenses, the taxpayers are allowed $9,000 [$30,000 – (7.5% × $280,000 AGI)]. The casualty loss is not deductible because it is not due to a Federally declared disaster. Also note that the tax return preparation fees are miscellaneous itemized deductions (deduction suspended from 2018 through 2025). Interest on credit cards are not Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions deductible. The itemized deductions total $47,000 ($11,000 mortgage interest + $10,000 taxes + $17,000 contributions + $9,000 medical ). 92. Charles’s itemized deductions are computed below: Medical expenses [$28,500 – (7.5% × $400,000 AGI)] State and local taxes (Limited to $10,000) Home mortgage interest Charitable contributions Gambling losses ($9,800 loss limited to $7,400 of gambling income) Total itemized deductions

$ -010,000 5,400 14,800 7,400 $37,600

93. Helen may include the entire amount paid to the nursing home ($3,000 per month) if the primary reason for being in the nursing home is to get medical care. If the primary reason for being in the nursing home is personal, Helen may include only the $1,400 cost of medical care in calculating her medical expense deduction. In computing the medical expense deduction a taxpayer may include medical expenses for a spouse and for a person who was a dependent at the time the expenses were paid or incurred. Of the requirements that normally apply in determining dependency status, neither the gross income nor the joint return test applies in determining dependency status for medical expense deduction purposes. 94. a. A capital improvement that ordinarily would not have a medical purpose qualifies as a medical expense if it is directly related to prescribed medical care and is deductible to the extent that the expenditure exceeds the increase in value of the related property. The medical expense deduction is $7,300 [($17,000 – $5,800) – ($52,000 × 7.5%)]. b.

The full cost of certain home-related capital expenditures incurred to enable a physically handicapped individual to live independently and productively qualifies as a medical expense. Qualifying costs include expenditures for constructing entrance and exit ramps to the residence, widening hallways and doorways to accommodate wheelchairs, installing support bars and railings in bathrooms and other rooms, and adjusting electrical outlets and fixtures. These expenditures are subject to the 7.5%-of-AGI floor only, and the increase in the home’s value is deemed to be zero. Manny’s deduction is $13,100 [$17,000 – ($52,000 × 7.5%)].

95. The full cost of certain home-related capital expenditures incurred to enable a physically disabled individual to live independently and productively qualifies as a medical expense. Qualifying costs include expenditures for constructing entrance and exit ramps to the residence, widening hallways and doorways to accommodate wheelchairs, installing support bars and railings in bathrooms and other rooms, and adjusting electrical outlets and fixtures. These expenditures are subject to the 7.5%-of-AGI floor only, and the increase in the home’s value is deemed to be zero. So even though the improvements increased the value of Samuel’s personal residence by $4,000, the entire $15,000 of the expenditure Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions qualifies as a medical expense deduction (subject to the 7.5%-of-AGI floor). 96. General discussion. All of the following expenses are deductible, subject to the 7.5%-of-AGI floor: $8,000 for medical insurance, $15,000 in doctor bills and hospital expenses, and $1,000 for prescribed medicine and drugs. a.

Assuming Paul and Patty received the insurance reimbursement in December 2024, their medical expense deduction would be $12,625, computed as follows:

Medical insurance Doctor bills and hospital expenses Prescribed medicine and drugs Total medical expenses incurred Minus: December 2024 reimbursement Total medical expenses after reimbursement Minus: 7.5% × $105,000 AGI Medical expense deduction b.

Assuming that Paul and Patty received the insurance reimbursement in February 2025, they could ignore the reimbursement in computing their 2024 medical expense deduction. Their medical expense deduction would be $16,125, computed as follows:

Medical insurance Doctor bills and hospital expenses Prescribed medicine and drugs Total medical expenses incurred Minus: 7.5% × $105,000 AGI Medical expense deduction c.

$ 8,000 15,000 1,000 $24,000 (3,500) $20,500 (7,875) $12,625

$ 8,000 15,000 1,000 $24,000 (7,875) $16,125

If Paul and Patty itemized in 2024, they would report the reimbursement as gross income in 2025, to the extent they received a tax benefit from itemizing in 2024. If they did not itemize in 2024 (i.e., took the standard deduction), they would not be required to report the reimbursement as gross income in 2025.

97. Harry may be able to include the payments related to Joe’s injury with his own medical expenses. For divorced parents with children, the noncustodial parent may claim any paid medical expenses even though the custodial parent claims the children as dependents. This rule applies if the dependency exemption could have been shifted to the noncustodial parent by the custodial parent’s waiver. 98. Since Jeanne is claiming her mother as a dependent on her tax return this year, she is allowed to deduct any medical expenses she pays for her. Jeanne can consider the medical expenses as part of her portion of her mother’s support. Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 10: Deductions and Losses Certain Itemized Deductions 99. Real estate taxes are apportioned between buyer and seller based upon the number of days the property is owned by each. Angélica and Vicki will each be able to deduct taxes based on the number of days they each own the home. When the seller pays the entire real estate tax bill, adjustments are made to the amount realized by the seller and the basis of the home in the hands of the buyer. Vicki will reduce the amount realized on the sale by the amount of taxes apportioned to Angélica, and Angélica will reduce her basis in the home by the same amount. 100. Because of the irregular patterns of Linda’s payments, it does not appear that this is a bona fide loan. Thus, the amounts paid could not be interest. Additionally, the interest would not represent deductible qualified residence interest unless the loan was secured by the condominium. 101. The land is a capital asset. Adela’s deduction for the land contribution will be determined by the fair market value if she has held the land for the long-term holding period of more than one year. Otherwise, it will be determined by the basis (i.e., assuming the FMV is at least equal to the basis). Inventory is ordinary income property, so Adela’s deduction will be determined by her basis in the bibles and song books. 102. Joe is attempting to accelerate his charitable contribution deduction into the current year. There are several potential advantages to accelerating the deduction by donating the land currently. ∙

His contribution will be deducted in a tax year when his marginal tax rate is 32% rather than 22%.

∙

He might avoid disallowance of part of the deduction due to AGI percentage limitations because his contribution base will be higher in the current year than next year.

∙

He can deduct the fair market value of the land without recognizing the $40,000 appreciation as income.

∙

He can step up his basis in the land from $10,000 to $50,000 when he reacquires it next year.

Joe’s plan will generate many favorable outcomes if he does not run afoul of the IRS. While it does not appear that Joe has done anything that does not comply with the tax law, the IRS might collapse the transaction; that is, focus on the outcome and ignore the steps involved. The outcome is that Joe has transferred $50,000 cash to his church. The IRS might disallow the deduction for the land contribution in the current year and treat the transaction as a cash contribution next year. In this case, Joe’s basis for the purchased land would be $10,000 and his deduction would be at the lower marginal tax rate for next year.

Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 11: Investor Losses True / False 1. Jack owns a 10% interest in a partnership (not real estate) in which his at-risk amount is $42,000 at the beginning of the year. During the year, the partnership borrows $80,000 on a nonrecourse note and incurs a loss of $60,000 from operations. Jack’s at-risk amount at the end of the year is $44,000. a. True b. False 2. Shanice owns an interest in a business that is not a passive activity and in which she has $20,000 at risk. If the business incurs a loss from operations during the year and her share of the loss is $32,000, this loss will be fully deductible. a. True b. False 3. In the current year, Don has a $55,000 loss from a business he owns. His at-risk amount at the end of the year, prior to considering the current-year loss, is $36,000. He will be allowed to deduct the $55,000 loss this year if he is a material participant in the business. a. True b. False 4. Aram owns a 20% interest in a partnership (not real estate) in which her at-risk amount was $35,000 at the beginning of the year. The partnership borrowed $50,000 on a recourse note and made a $40,000 profit during the year. Her at-risk amount at the end of the year is $43,000. a. True b. False 5. Tonya owns an interest in an activity (not real estate) that converted recourse financing to nonrecourse financing. Recapture of previously allowed losses is required if Tonya’s at-risk amount is reduced below zero as a result of the debt restructuring. a. True b. False 6. Kelly, who earns a yearly salary of $120,000, sold an activity with a suspended passive activity loss of $44,000. The activity was sold at a loss and Kelly has no other passive activities. The suspended loss is not deductible. a. True b. False 7. All of a taxpayer’s tax credits relating to a passive activity can be utilized when the activity is sold at a loss. a. True b. False 8. Jackson Company incurs a $50,000 loss on a passive activity during the year. The company has active income of $34,000 and portfolio income of $24,000. If Jackson is a personal service corporation, it may deduct $34,000 of the passive activity loss. a. True b. False 9. Oriole Corporation has active income of $45,000 and a passive activity loss of $23,000 in the current year. Under an Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 11: Investor Losses exception, Oriole can deduct the $23,000 loss if it is a personal service corporation. a. True b. False 10. Gray Company, a closely held C corporation, incurs a $50,000 loss on a passive activity during the year. The company has active income of $34,000 and portfolio income of $24,000. If Gray is not a personal service corporation, it may deduct $34,000 of the passive activity loss. a. True b. False 11. Wolf Corporation has active income of $55,000 and a passive activity loss of $33,000 in the current year. Wolf cannot deduct the $33,000 loss if it is a closely held C corporation that is not a personal service corporation. a. True b. False 12. Linda owns investments that produce portfolio income and Activity A that produces losses. From a tax perspective, Linda will be better off if Activity A is not passive. a. True b. False 13. Nathan owns Activity A, which produces income, and Activity B, which produces passive activity losses. From a tax planning perspective, Nathan will be better off if Activity A is passive. a. True b. False 14. A taxpayer is considered to be a material participant if the taxpayer spends more than 500 hours in the activity. a. True b. False 15. DeShawn participates in an activity for 90 hours during the year. He has no employees and there are no other participants. DeShawn is a material participant. a. True b. False 16. Mary Jane participates for 100 hours during the year in an activity she owns. She has no employees and is the only participant in the activity. The activity is a significant participation activity. a. True b. False 17. A taxpayer is considered to be a material participant in a significant participation activity if the taxpayer spends at least 400 hours in the activity. a. True b. False 18. Tomas participates for 300 hours in Activity A and 250 hours in Activity B, both of which are nonrental businesses. Both activities are active. a. True Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 11: Investor Losses b. False 19. Tom participates for 100 hours in Activity A and 450 hours in Activity B, both of which are nonrental businesses. Both activities are active. a. True b. False 20. From January through November, Vern participated for 420 hours as a salesman in a partnership in which he owns a 50% interest. The partnership has four full-time employees. During December, Vern spends 110 hours cleaning the store and painting the walls in order to meet the material participation standards. Vern qualifies as a material participant. a. True b. False 21. Joyce owns an activity (not real estate) in which she participates for 100 hours a year; her spouse participates for 450 hours. Joyce qualifies as a material participant. a. True b. False 22. When determining whether an individual is a material participant, participation by an owner’s spouse generally counts. a. True b. False 23. If an owner participates for more than 500 hours in a bicycle rental activity located at a beach resort, any loss from that activity is treated as an active loss that can offset active income. a. True b. False 24. A qualified real estate professional is allowed to treat income or loss from any real estate venture as active except for income or loss from a rental activity. a. True b. False 25. Bruce owns a small apartment building that produces a $25,000 loss during the year. His AGI before considering the rental loss is $85,000. Bruce must be a material participant with respect to the rental activity in order to deduct the $25,000 loss under the real estate rental exception. a. True b. False 26. Bai owns a small apartment building that produces a $45,000 loss during the year. His AGI before considering the rental loss is $85,000. Because Bai is an active participant with respect to the rental activity, he may deduct the $45,000 loss. a. True b. False 27. Services performed by an employee are treated as being related to a real estate trade or business if the employee performing the services has more than a 5% ownership interest in the employer. Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 11: Investor Losses a. True b. False 28. In the current year, Kelly had a $35,000 loss from a real estate rental activity in which she is a 10% owner. If she is an active participant and if her modified AGI is $100,000 or less, she can deduct $25,000 of the loss. a. True b. False 29. Individuals can deduct from active or portfolio income losses of up to $25,000 from real estate rental activities in which they actively participate. a. True b. False 30. Individuals with modified AGI of $100,000 can deduct against active or portfolio income losses of up to $25,000 from real estate rental activities in which they actively participate. a. True b. False 31. Roger owns and actively participates in the operations of an apartment building that produces a $40,000 loss during the year. He has AGI of $150,000 from an active business. He may deduct $25,000 of the loss. a. True b. False 32. Lucy owns and actively participates in the operations of an apartment complex that produces a $50,000 loss during the year. Her modified AGI is $125,000 from an active business. Disregarding any at-risk amount limitation, she may deduct $25,000 of the loss this year, and the remaining $25,000 is a suspended passive activity loss. a. True b. False 33. Kim dies owning a passive activity with a basis of $75,000, a fair market value of $140,000, and suspended losses of $80,000. All of the $80,000 passive activity loss can be deducted on Kim’s final income tax return. a. True b. False 34. Carlos receives a gift of a passive activity from his father whose basis is $60,000. Suspended losses related to the activity are $18,000. Carlos will be allowed to offset the $18,000 suspended losses against future passive activity income. a. True b. False 35. Eric makes an installment sale of a passive activity having suspended losses of $40,000. He collects 25% of the sales price in the current year and will collect 25% in each of the next three years. Eric can deduct $10,000 of the passive activity loss this year. a. True b. False 36. During the current year, David earned investment income of $20,000. In addition, he incurred investment interest expense of $12,000 and other investment expenses of $9,000. David can deduct $12,000 of investment interest expense Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 11: Investor Losses for this year. a. True b. False 37. Investment income can include gross income from interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business; income from a passive activity; and income from a real estate activity in which the taxpayer actively participates. a. True b. False 38. Bob realized a long-term capital gain of $8,000. In calculating his net investment income, Bob may elect to include the gain in investment income. a. True b. False 39. During the current year, Harry earned investment income of $18,500. In addition, he incurred investment interest expense of $15,500 and other investment expenses of $9,000. Harry may deduct $9,500 of investment interest expense this year and carry forward $6,000 to future years. a. True b. False 40. Stuart is the sole owner and a material participant in a business in which he has $50,000 at risk. If the business incurs a loss of $80,000 from operations, Stuart will be allowed the full amount as a deduction. a. True b. False 41. In the current year, Louise invests $50,000 for a 20% interest in a passive activity. Her share of the loss this year is $10,000. If this is her only passive activity, the $10,000 loss from the activity this year is suspended for use in a future year. a. True b. False 42. Mahina, an architect, earns $100,000 from her practice in the current year. In addition, she receives $35,000 in dividends, capital gains, and annuity income during the year. Further, she incurs a loss of $35,000 from an investment in a passive activity. Mahina’s AGI for the year after considering the passive investment is $100,000. a. True b. False 43. Anita owns Activity A, which produces active income, and Activity B, which produces losses. From a tax planning perspective, Anita will be better off if Activity B is a passive activity. a. True b. False 44. Gloria owns and works full-time at a shop that rents watercraft of various types to tourists who are vacationing at the beach. If she generates a loss from that activity, the loss is subject to the passive activity loss rules because it is rental property. a. True Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 11: Investor Losses b. False 45. Kathy, who is a real estate professional, owns an apartment building and devotes 550 hours to managing the activity. All losses from the rental activity will be considered nonpassive and deductible against active income. a. True b. False 46. Aaliyah gave her interest in a passive activity (fair market value of $75,000 and basis of $60,000) to Harrison. Associated with the interest is a suspended passive activity loss of $8,000. Upon making the gift, the suspended passive activity loss is not deductible to Aaliyah, but it will benefit Harrison. a. True b. False 47. Jared earned investment income of $22,000 and incurred investment interest expense of $14,000 during the year. He incurred other investment expenses of $7,000 during the year. Jared may deduct $14,000 of investment interest in the current year. a. True b. False 48. This year Seth had investment royalty income of $31,000, investment expenses of $28,000, and a long-term capital gain of $8,000 on an investment. In calculating his net investment income for the current year, Seth may deduct a maximum of $11,000 of investment interest. a. True b. False Multiple Choice 49. In 2024, George invests $80,000 for a 20% interest in a partnership in which he is a material participant. The partnership incurs a loss with $100,000 being George’s share. Which of the following statements is incorrect? a. As George has only $80,000 of capital at risk, he cannot deduct any more than this amount against his other income. b. George’s nondeductible loss of $20,000 can be carried over and used in future years (subject to the at-risk provisions). c. If George has taxable income of $40,000 from the partnership in 2025 and there are no other transactions that affect his at-risk amount, he can use all of the $20,000 loss carried over from 2024. d. George’s $100,000 loss is nondeductible in 2024 and 2025 under the passive activity loss provisions. 50. Last year, Ted invested $100,000 for a 50% interest in a partnership in which he was a material participant. The partnership incurred a loss, and Ted’s share was $150,000. Which of the following statements is incorrect? a. Ted’s nondeductible loss of $50,000 can be carried over and used in the future (subject to the at-risk provisions). b. If Ted has taxable income of $50,000 from the partnership in the current year and no other transactions that affect his at-risk amount, he can use all of the $50,000 loss carried over. c. As Ted has only $100,000 of capital at risk, he cannot deduct more than $100,000 against his other income. d. None of these is incorrect. 51. In 2024, Madison invested $90,000 for a 20% interest in a limited liability company (LLC) in which she is a material Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 11: Investor Losses participant. The LLC reported losses of $340,000 in 2024 and $180,000 in 2025. Madison’s share of the LLC’s losses was $68,000 in 2024 and $36,000 in 2025. How much of these losses can Madison deduct? a. $68,000 in 2024; $36,000 in 2025. b. $68,000 in 2024; $22,000 in 2025. c. $0 in 2024; $0 in 2025. d. $68,000 in 2024; $0 in 2025. 52. In 2024, Kipp invested $65,000 for a 30% interest in a partnership conducting a passive activity. The partnership reported losses of $200,000 in 2024 and $100,000 in 2025, Kipp’s share being $60,000 in 2024 and $30,000 in 2025. How much of the losses from the partnership can Kipp deduct assuming he owns no other investments and does not participate in the partnership’s operations? a. $0 in 2024; $0 in 2025. b. $60,000 in 2024; $30,000 in 2025. c. $60,000 in 2024; $5,000 in 2025. d. $60,000 in 2024; $0 in 2025. 53. Josh has investments in two passive activities. Activity A (acquired three years ago) produces income of $30,000 this year, while Activity B (acquired two years ago) produces a loss of $50,000. What is the amount of Josh’s suspended loss for the year? a. $0 b. $18,000 c. $20,000 d. $50,000 54. Carl, a physician, earns $200,000 from his medical practice in the current year. He receives $45,000 in dividends and interest during the year as well as $5,000 of income from a passive activity. In addition, he incurs a loss of $50,000 from an investment in a passive activity. What is Carl’s AGI for the current year after considering the passive investment? a. $195,000 b. $200,000 c. $240,000 d. $245,000 55. Nell sells a passive activity with an adjusted basis of $45,000 for $105,000. Suspended losses attributable to this property total $45,000. The total gain and the taxable gain are: a. $60,000 total gain; $105,000 taxable gain. b. $10,000 total gain; $15,000 taxable gain. c. $60,000 total gain; $0 taxable gain. d. $60,000 total gain; $15,000 taxable gain. 56. Matt has three passive activities and has at-risk amounts in excess of $100,000 for each. During the year, the activities produced the following income (losses). Activity A Activity B Activity C Net passive activity loss Powered by Cognero

($60,000) (40,000) 75,000 ($25,000) Page 7

Name:

Class:

Date:

Chapter 11: Investor Losses Matt’s suspended losses are as follows: a. $25,000 is allocated to C; $0 to A and B. b. $12,500 is allocated to A; $12,500 to B. c. $15,000 is allocated to A; $10,000 to B. d. $8,333 is allocated to A, B, and C. 57. Green Corporation earns active income of $50,000 and receives $40,000 in dividends during the year. In addition, Green incurs a loss of $70,000 from an investment in a passive activity acquired several years ago. Consider the following two statements:

(1) Green’s current deduction for passive activity losses is $50,000 if it is a closely held C corporation that is not a personal service corporation. (2)

Green’s current deduction for passive activity losses is $0 if it is a personal service corporation.

Which of the following answers is correct? a. Only statement 1. b. Only statement 2. c. Both statements 1 and 2. d. Neither statement 1 or 2. 58. White Corporation, a closely held personal service corporation, has $150,000 of passive activity losses, $120,000 of active business income, and $30,000 of portfolio income. How much of the passive activity loss can White Corporation deduct? a. $0 b. $30,000 c. $120,000 d. $150,000 59. Charles owns a business with two separate departments. Department A produces $100,000 of income and Department B incurs a $60,000 loss. Charles participates for 550 hours in Department A and 100 hours in Department B. He has fulltime employees in both departments. a. If Charles elects to treat both departments as a single activity, he cannot offset the $60,000 loss against the $100,000 income. b. Charles may not treat Department A and Department B as separate activities because they are parts of one business. c. If Charles elects to treat the two departments as separate activities, he can offset the $60,000 loss against the $100,000 income. d. If Charles elects to treat both departments as a single activity, he can offset the $60,000 loss against the $100,000 income. 60. Tara owns a shoe store and a bookstore. Both businesses are operated in a mall. She also owns a restaurant across the street and a jewelry store several blocks away. a. All four businesses can be treated as a single activity if Tara elects to do so. b. Only the shoe store and bookstore can be treated as a single activity, the restaurant must be treated as a separate activity, and the jewelry store must be treated as a separate activity. Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 11: Investor Losses c. The shoe store, bookstore, and restaurant can be treated as a single activity, and the jewelry store must be treated as a separate activity. d. All four businesses must be treated as separate activities. 61. Which of the following factors should be considered in determining whether an activity is treated as an appropriate economic unit? a. The similarities and differences in types of business. b. The extent of common ownership. c. The geographic location. d. All of these choices are correct. 62. Tess owns a building in which she rents apartments to tenants and operates a restaurant. Which of the following statements is incorrect? a. If 60% of Tess’s gross income is from apartment rentals and 40% is from the restaurant, the rental operation and the restaurant business must be treated as separate activities. b. If 95% of Tess’s gross income is from apartment rentals and 5% is from the restaurant, she may treat the rental operation and the restaurant business as a single activity that is a rental activity. c. If 5% of Tess’s gross income is from apartment rentals and 95% is from the restaurant, she may treat the rental operation and the restaurant business as a single activity that is not a rental activity. d. If 98% of Tess’s gross income is from apartment rentals and 2% is from the restaurant, the rental operation and the restaurant business must be treated as a single activity that is not a rental activity. 63. Rick, a computer consultant, owns a separate business (not real estate) in which he participates. He has one employee who works part-time in the business. a. If Rick participates for 500 hours and the employee participates for 620 hours during the year, Rick qualifies as a material participant. b. If Rick participates for 550 hours and the employee participates for 2,000 hours during the year, Rick qualifies as a material participant. c. If Rick participates for 120 hours and the employee participates for 120 hours during the year, Rick does not qualify as a material participant. d. If Rick participates for 95 hours and the employee participates for 5 hours during the year, Rick probably does not qualify as a material participant. 64. Ned, a college professor, owns a separate business (not real estate) in which he participates in the current year. He has one employee who works part-time in the business. a. If Ned participates for 120 hours and the employee participates for 120 hours during the year, Ned does not qualify as a material participant. b. If Ned participates for 95 hours and the employee participates for 5 hours during the year, Ned probably does not qualify as material participant. c. If Ned participates for 500 hours and the employee participates for 520 hours during the year, Ned qualifies as material participant. d. If Ned participates for 600 hours and the employee participates for 2,000 hours during the year, Ned qualifies as a material participant. 65. Ahmad owns four activities. He participated for 120 hours in Activity A, 150 hours in Activity B, 140 hours in Activity C, and 100 hours in Activity D. Which of the following statements is correct? a. Activities A, B, C, and D are all significant participation activities. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 11: Investor Losses b. Activities A, B, and C are significant participation activities. c. Ahmad is a material participant with respect to Activities A, B, and C. d. Ahmad is a material participant with respect to Activities A, B, C, and D. 66. Paula owns four separate activities. She elects not to group them together as a single activity under the “appropriate economic unit” standard. Paula participates for 130 hours in Activity A, 115 hours in Activity B, 260 hours in Activity C, and 100 hours in Activity D. She has one employee, who works 125 hours in Activity D. Which of the following statements is correct? a. Activities A, B, C, and D are all significant participation activities. b. Paula is a material participant with respect to Activities A, B, C, and D. c. Paula is not a material participant with respect to Activities A, B, C, and D. d. None of these is correct. 67. Dena owns interests in five businesses and has full-time employees in each business. She participates for 100 hours in Activity A, 120 hours in Activity B, 130 hours in Activity C, 140 hours in Activity D, and 125 hours in Activity E. a. All five of Dena’s activities are significant participation activities. b. Dena is a material participant with respect to all five activities. c. Dena is not a material participant in any of the activities. d. Dena is a material participant with respect to Activities B, C, D, and E. 68. Maria, who owns a 50% interest in a restaurant, has been a material participant in the restaurant activity for the last 20 years. She retired from the restaurant at the end of last year and will not participate in the restaurant activity in the future. However, she continues to be a material participant in a retail store in which she is a 50% partner. The restaurant operations produce a loss for the current year, and Maria’s share of the loss is $80,000. Her share of the income from the retail store is $150,000. She does not own interests in any other activities. a. Maria cannot deduct the $80,000 loss from the restaurant because she is not a material participant. b. Maria can offset the $80,000 loss against the $150,000 of income from the retail store. c. Maria will not be able to deduct any losses from the restaurant until she has been retired for at least three years. d. Assuming Maria continues to hold the interest in the restaurant, she will always treat the losses as active. 69. Leigh, who owns a 50% interest in a sporting goods store, was a material participant in the activity for the last 15 years. She retired from the sporting goods store at the end of last year and will not participate in the activity in the future. However, she continues to be a material participant in an office supply store in which she is a 50% partner. The operations of the sporting goods store resulted in a loss for the current year and Leigh’s share of the loss is $40,000. Leigh’s share of the income from the office supply store is $75,000. She does not own interests in any other activities. a. Leigh cannot deduct the $40,000 loss from the sporting goods store because she is not a material participant. b. Leigh can offset the $40,000 loss from the sporting goods store against the $75,000 of income from the office supply store. c. Leigh will not be able to deduct any losses from the sporting goods store until future years. d. Leigh will not be able to deduct any losses from the sporting goods store until she has been retired for at least four years. 70. Jed spends 32 hours a week, 50 weeks a year, operating a bicycle rental store that he owns at a resort community. He also owns a music store in another city that is operated by a full-time employee. He elects not to group them together as a single activity under the “appropriate economic unit” standard. Jed spends 40 hours per year working at the music store. a. Neither store is a passive activity. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 11: Investor Losses b. Both stores are passive activities. c. Only the bicycle rental store is a passive activity. d. Only the music store is a passive activity. 71. Jenny spends 32 hours a week, 50 weeks a year, operating a bicycle rental store that she owns at a resort community. She also owns a music store in another city that is operated by a full-time employee. Jenny spends 140 hours per year working at the music store. She elects not to group them together as a single activity under the “appropriate economic unit” standard. a. Neither store is a passive activity. b. Both stores are passive activities. c. Only the bicycle rental store is a passive activity. d. Only the music store is a passive activity. 72. Kwame has investments in two passive activities. Activity A, acquired three years ago, produces income in the current year of $60,000. Activity B, acquired last year, produces a loss of $100,000 in the current year. At the beginning of this year, Kwame’s at-risk amounts in Activities A and B are $10,000 and $100,000, respectively. What is the amount of Kwame’s suspended passive activity loss with respect to these activities at the end of the current year? a. $0 b. $36,000 c. $40,000 d. $100,000 73. Sandra acquired a passive activity three years ago. Until last year, the activity was profitable and her at-risk amount was $300,000. Last year, the activity produced a loss of $100,000, and in the current year, the loss is $50,000. Assuming Sandra has received no passive activity income in the current or prior years, her suspended passive activity loss from the activity is: a. $90,000 from last year and $50,000 from the current year. b. $100,000 from last year and $50,000 from the current year. c. $0 from last year and $0 from the current year. d. $50,000 from the current year. 74. David’s at-risk amount in a passive activity was $60,000 at the beginning of 2023. His loss from the activity in 2023 is $80,000, and he had no passive activity income during the year. David had $20,000 of passive activity income from the activity in 2024. Under the passive activity loss rules, David’s suspended loss at the end of 2024 is: a. $15,000. b. $20,000. c. $45,000. d. $60,000. 75. Rita earns a salary of $150,000, and invests $40,000 for a 20% interest in a passive activity. Operations of the activity result in a loss of $250,000, of which Rita’s share is $50,000. How is her loss characterized? a. $40,000 is suspended under the passive activity loss rules and $10,000 is suspended under the at-risk rules. b. $40,000 is suspended under the at-risk rules and $10,000 is suspended under the passive activity loss rules. c. $50,000 is suspended under the passive activity loss rules. d. $50,000 is suspended under the at-risk rules. Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 11: Investor Losses 76. Vic’s at-risk amount in a passive activity is $200,000 at the beginning of the current year. His current loss from the activity is $80,000. Vic had no passive activity income during the year. At the end of the current year: a. Vic has an at-risk amount in the activity of $120,000 and a suspended passive activity loss of $80,000. b. Vic has an at-risk amount in the activity of $200,000 and a suspended passive activity loss of $80,000. c. Vic has an at-risk amount in the activity of $120,000 and no suspended passive activity loss. d. Vic has an at-risk amount in the activity of $200,000 and no suspended passive activity loss. 77. Wes’s at-risk amount in a passive activity is $25,000 at the beginning of the current year. His current loss from the activity is $35,000 and he has no passive activity income. At the end of the current year, which of the following statements is incorrect? a. Wes has a loss of $25,000 suspended under the passive activity loss rules. b. Wes has an at-risk amount in the activity of $0. c. Wes has a loss of $10,000 suspended under the at-risk rules. d. Wes has a loss of $35,000 suspended under the passive activity loss rules. 78. Jon owns an apartment building in which he is a material participant and also owns a computer consulting business. Of the 2,000 hours he spends on these activities during the year, 55% of the time is spent operating the apartment building and 45% of the time is spent in the computer consulting business. a. The computer consulting business is a passive activity but the apartment building is not. b. The apartment building is a passive activity but the computer consulting business is not. c. Both the apartment building and the computer consulting business are passive activities. d. Neither the apartment building nor the computer consulting business is a passive activity. 79. During the current year, Ethan performs personal services as follows: 800 hours in his information technology consulting practice, 625 hours in a real estate development business, and 510 hours in a condominium leasing operation. He expects that losses will be realized from the two real estate ventures and that his consulting practice will show a profit. Ethan files a joint return with his spouse whose salary is $125,000. The income and losses from the following ventures are considered active and not subject to the passive activity loss limitations: a. Only the information technology consulting practice. b. Only the information technology consulting practice and the real estate development business. c. Only the information technology consulting practice and the condominium leasing operation. d. All three of the ventures are considered active and not subject to the passive activity loss limitations. 80. Pablo, who is single, has $95,000 of salary, $10,000 of income from a limited partnership, and a $27,000 passive activity loss from a real estate rental activity in which he actively participates. His modified adjusted gross income is $95,000. Of the $27,000 loss, how much is deductible? a. $0 b. $10,000 c. $25,000 d. $27,000 81. Josie, an unmarried taxpayer, has $155,000 in salary, $10,000 in income from a limited partnership, and a $26,000 passive activity loss from a real estate rental activity in which she actively participates. If her modified adjusted gross income is $155,000, how much of the $26,000 loss is deductible? a. $0 b. $10,000 Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 11: Investor Losses c. $25,000 d. $26,000 82. When Kate died, she owned a passive activity with an adjusted basis of $100,000. Its fair market value at that date is $130,000. Suspended losses relating to the property were $45,000. a. The heir’s adjusted basis is $130,000, and Kate’s final deduction is $15,000. b. The heir’s adjusted basis is $130,000, and Kate’s final deduction is $45,000. c. The heir’s adjusted basis is $100,000, and Kate’s final deduction is $45,000. d. The heir’s adjusted basis is $175,000, and Kate has no final deduction. 83. Carol made a gift to Tim of a passive activity (adjusted basis of $50,000, suspended losses of $20,000, and a fair market value of $80,000). No gift tax resulted from the transfer. a. Tim’s adjusted basis is $80,000, and he can deduct the $20,000 of suspended losses in the future. b. Tim’s adjusted basis is $50,000, and the suspended losses are lost. c. Tim’s adjusted basis is $50,000, and he can deduct the $20,000 of suspended losses in the future. d. None of these applies here. 84. Identify from the following list the type of disposition of a passive activity where the taxpayer keeps the suspended losses of the disposed activity and utilizes them on a subsequent taxable disposition. a. Disposition of a passive activity by gift. b. Disposition of a passive activity at death. c. Installment sale of a passive activity. d. None of these applies here. 85. Raul is married and files a joint tax return. His current investment interest expense of $95,000 is related to a loan used to purchase a parcel of unimproved land being held as an investment. Income from investments [dividends (not qualified) and interest] total $18,000. Raul paid and deducted $5,000 of real estate taxes on the unimproved land. He also has a $4,500 net long-term capital gain from the sale of another parcel of unimproved land. Raul’s maximum investment interest deduction for the year is: a. $95,000. b. $18,000. c. $17,500. d. $13,000. 86. Chen incurred $58,500 of interest expense this year related to his investments. His investment income includes $15,000 of interest, $9,000 of qualified dividends, and a $22,500 net capital gain on the sale of securities. The maximum amount of Chen’s investment interest expense deduction for the year is: a. $15,000. b. $24,000. c. $37,500. d. $46,500. 87. In 2024, Liam invested $100,000 for a 25% interest in a partnership involved in an activity in which he is a material participant. The partnership reported losses of $340,000 in 2024 and $180,000 in 2025 with Liam’s share being $85,000 in 2024 and $45,000 in 2025. How much of the losses can Liam deduct? a. $0 in 2024, $0 in 2025. Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 11: Investor Losses b. $85,000 in 2024, $0 in 2025. c. $85,000 in 2024, $15,000 in 2025. d. $85,000 in 2024, $45,000 in 2025. 88. Which of the following decreases a taxpayer’s at-risk amount? a. Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity. b. Taxpayer’s share of amounts borrowed for use in the activity that is qualified nonrecourse financing. c. Taxpayer’s share of the activity’s income. d. None of these. 89. In the current year, Crow Corporation, a closely held C corporation that is not a personal service corporation, has $100,000 of passive activity losses, $80,000 of active business income, and $20,000 of portfolio income. How much of the passive activity loss may Crow deduct in the current year? a. $0. b. $20,000. c. $80,000. d. $100,000. 90. George, an ophthalmologist, owns a separate business (not real estate) in which he participates. He has one employee who works part-time in the business. Which of the following statements is correct? a. If George participates for 500 hours and the employee participates for 520 hours during the year, George qualifies as a material participant. b. If George participates for 600 hours and the employee participates for 1,000 hours during the year, George qualifies as a material participant. c. If George participates for 120 hours and the employee participates for 120 hours during the year, George does not qualify as a material participant. d. If George participates for 95 hours and the employee participates for 5 hours during the year, George probably does not qualify as a material participant. 91. Lew owns five activities, and he elects not to group them together as a single activity under the “appropriate economic unit” standard. During the year, he participates for 120 hours in Activity A, 150 hours in Activity B, 140 hours in Activity C, 110 hours in Activity D, and 100 hours in Activity E. Which of the following statements is correct? a. Activities A, B, C, D, and E are all significant participation activities. b. Lew is a material participant in Activities A, B, C, and D only. c. Lew is a material participant in Activities A, B, C, D, and E. d. None of these. 92. Rachel acquired a passive activity several years ago. Until 2021, the activity was profitable, and Rachel’s at-risk amount at the beginning of 2021 was $300,000. The activity produced losses of $80,000 in 2021, $50,000 in 2022, and $70,000 in 2023. In 2024, the activity produced income of $90,000. How much is Rachel’s suspended passive activity loss at the beginning of 2025? a. $150,000. b. $110,000. c. $60,000. d. $0. Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 11: Investor Losses 93. Several years ago, Joy acquired a passive activity. Until 2022, the activity was profitable. Joy’s at-risk amount at the beginning of 2022 was $250,000. The activity produced losses of $100,000 in 2022, $80,000 in 2023, and $90,000 in 2024. During the same period, no passive activity income was recognized. How much is suspended under the at-risk rules and the passive activity loss rules at the beginning of 2025? At-risk Passive activity loss a. $0. $270,000. b. $20,000. $250,000. c. $30,000. $240,000. d. $260,000. $10,000. 94. Melinda earns wages of $80,000, income from a limited partnership of $10,000, and a $30,000 passive activity loss from a real estate rental activity in which she actively participates. Her modified adjusted gross income is $80,000. Of the $30,000 loss, Melinda may deduct: a. $0. b. $10,000. c. $25,000. d. $30,000. 95. Faye dies owning an interest in a passive activity property (adjusted basis of $150,000, suspended losses of $52,000, and a fair market value of $180,000). What, if any, can be deducted on her final income tax return? a. $52,000. b. $30,000. c. $22,000. d. $0. 96. Ramon incurred $83,100 of interest expense related to his investments this year. His investment income included $34,500 of interest and a $37,500 net capital gain on the sale of securities. Ramon has asked you to compute the amount of his deduction for investment interest, taking into consideration any options he might have. What is the maximum amount of Ramon’s investment interest expense deduction in the current year? a. $19,500. b. $34,500. c. $72,000. d. $83,100. Matching Match the term with the correct response. More than one response may be correct. a. Taxpayer devotes time aggregating more than 500 hours in all significant participation activities during the year. b. Taxpayer participates in making management decisions in a significant and bonafide sense. c. It is one in which the individual’s participation equals more than 100 hours during the year. d. Taxpayer devotes time in the activity, which constitutes substantially all of the participation in the activity of all individuals. e. Both options a. and d. are correct. Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 11: Investor Losses f. No correct choice is given. 97. Significant participation activity. 98. At-risk amount. 99. Material participation. 100. Active participation. Match the treatment for the following types of transactions. a. The losses are allowed in the years in which gain is recognized. b. Suspended losses are allowed to offset the income from the activity, other passive activities, or active income. c. Suspended losses are allowed to the taxpayer to the extent that they exceed the amount, if any, of the step-up in basis allowed. d. Any suspended losses may be used in the current year. e. The suspended losses are added to the basis of the property. f. No correct choice is given. 101. Treatment of a disposition of a passive activity by gift. 102. Treatment of a disposition of a passive activity at death. 103. Treatment of an installment sale of a passive activity. 104. Treatment of a sale of a passive activity for which all of the realized gain or loss is recognized currently. 105. Treatment of suspended credits when passive activity is sold at a loss. Subjective Short Answer 106. Sarah purchased for $100,000 a 10% interest in a business venture that is not subject to the passive activity rules. During the first year, her share of the entity’s loss was $120,000. At the beginning of the second year, the entity obtained $800,000 of recourse financing. Also during the second year, Sarah withdrew cash of $20,000, and her share of the entity’s loss was $25,000. Calculate the amount of loss that Sarah may claim in each of the two years and determine her at-risk amount at the end of each year. 107. In 2024, Emily invests $120,000 in a limited partnership that is not a passive activity. During 2024, her share of the partnership loss is $90,000. In 2025, her share of the partnership loss is $50,000. How much can Emily deduct in 2024 and 2025? 108. In 2023, Naomi earns a salary of $200,000 and invests $40,000 for a 20% interest in a partnership not subject to the passive activity loss rules. Through the use of $800,000 of nonrecourse financing, the partnership acquires assets worth $1 million. The activity produces a loss of $150,000 of which Naomi’s share is $30,000. In 2024, Naomi’s share of the loss from the partnership is $15,000. How much of the loss from the partnership can Naomi deduct? 109. Lindsey, an attorney, earns $125,000 from her law practice in the current year. In addition, she receives $50,000 in dividends and interest during the year. Further, she incurs a loss of $40,000 from an investment in a passive activity. What is Lindsey’s AGI for the year after considering the passive investment? Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 11: Investor Losses 110. Anne sells a rental house for $300,000 (adjusted basis of $255,000). During her ownership, $60,000 of losses have been suspended under the passive activity loss rules. Determine the tax treatment to Anne on the disposition of the property. 111. Hugh has four passive activities that generate the following income and losses in the current year. Activity A B C D Total

Gain (Loss) ($60,000) (20,000) (10,000) 10,000 ($80,000)

How much of the $80,000 net passive activity loss can Hugh deduct this year? Calculate the suspended losses (by activity). 112. Pat sells a passive activity for $100,000 that has an adjusted basis of $55,000. During the years of her ownership, $60,000 of losses have been incurred that were suspended under the passive activity loss rules. In addition, the passive activity generated tax credits of $10,000 that were not utilized and suspended. Determine the tax treatment to Pat on the disposition of the property. 113. Purple Corporation, a personal service corporation, earns active income of $600,000. The corporation receives $60,000 in dividends and incurs a loss of $100,000 from an investment in a passive activity acquired three years ago. What is Purple’s income after considering the passive investment? 114. Orange Corporation, a closely held (nonpersonal service) C corporation, earns active income of $300,000 in the current year. The corporation also receives $35,000 in dividends and incurs a loss of $50,000 from an investment in a passive activity. What is Orange’s income for the year after considering the passive investment? 115. Malik, a life insurance salesman, earns a $400,000 salary in the current year. Because he works only 30 hours per week in this job, he has time to participate in several other businesses. He owns an ice cream parlor and a car repair shop in Tampa. He also owns an ice cream parlor and a car repair shop in Portland and a car repair shop in St. Louis. A preliminary analysis on December 1 of the current year shows projected income and losses for the various businesses as follows: Tampa ice cream parlor (95 hours participation) Tampa car repair shop (140 hours participation) Portland ice cream parlor (90 hours participation) Portland car repair shop (170 hours participation) St. Louis car repair shop (180 hours participation)

Income (Loss) $56,000 (89,000) 34,000 (41,000) (15,000)

Malik has full-time employees at each of the five businesses listed above. Review all possible groupings for Malik’s activities. Which grouping method and other strategies should Malik consider that will provide the greatest tax advantage? 116. Vail owns interests in a beauty salon, a natural foods store, and a tanning salon. Several full-time employees work at each of the enterprises. As of the end of November of the current year, Vail has worked 180 hours in the beauty salon, 220 hours at the natural foods store, and 80 hours at the tanning salon. These three ventures collectively will produce income. Vail also owns one other passive activity that is producing a loss (a limited partnership in which she has reported no participation). How should Vail plan her activities for the remainder of the year? 117. Ken has a $40,000 loss from an investment in a partnership in which he does not materially participate. He paid Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 11: Investor Losses $30,000 for his interest. How much of the loss is disallowed by the at-risk rules? How much is disallowed by the passive activity loss rules? 118. During the current year, Ryan performs personal services as follows: 700 hours in his management consulting practice, 650 hours in a real estate development business, and 550 hours in an apartment leasing operation. He expects that losses will be realized from the two real estate ventures and his consulting practice will show a profit. Ryan files a joint return with his spouse whose salary is $125,000. Discuss the character and treatment of the income and losses generated by these activities. 119. In the current year, Lucile, who is single and has AGI of $90,000 before considering rental activities, is active in three separate real estate rental activities and is in the 22% tax bracket. She had $15,000 of losses from Activity A, $25,000 of losses from Activity B, and income of $20,000 from Activity C. She also had $3,100 of tax credits from Activity A. Calculate her deductions and credits currently allowed and the suspended losses and credits. 120. Last year, Wanda gave her daughter a passive activity (adjusted basis of $80,000; fair market value of $160,000) with suspended losses of $20,000. In the current year, her daughter realizes income of $10,000 from the activity. What are the tax effects to Wanda and her daughter? 121. Juana borrowed $100,000 to acquire a parcel of land to be held for investment purposes and paid interest of $11,000 on the loan. She has AGI of $75,000 for the year. Other items related to Juana’s investments include the following: Interest and annuity income Long-term capital gain on sale of stock Real estate tax paid and deducted on investment property

$10,000 7,500 500

a.

Determine Juana’s current investment interest deduction, assuming she does not make any special election regarding the computation of investment income.

b.

Discuss the treatment of Juana’s investment interest that is disallowed in the current year.

c.

What election could Juana make to increase the amount of her current investment interest deduction?

Essay 122. Describe the types of activities and taxpayers that are subject to the at-risk rules. 123. Identify how the passive activity loss rules broadly classify various types of income and losses. Provide examples of each category. 124. Discuss the treatment given to suspended passive activity losses and credits. What happens to an activity’s unused losses and credits when the activity is sold? 125. List the taxpayers that are subject to the passive activity loss rules and summarize the general impact of these rules on these taxpayers. 126. What special passive activity loss treatment is available to real estate activities? Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 11: Investor Losses 127. When a taxpayer disposes of a passive activity by gift, what happens to any unused passive activity losses? 128. Describe the general rules that limit the deduction of investment interest expense. 129. Identify the types of income that are classified as investment income. Discuss the flexibility that a taxpayer has with respect to certain types of income that may potentially be considered investment income.

Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 11: Investor Losses Answer Key 1. False 2. False 3. False 4. False 5. True 6. False 7. False 8. False 9. False 10. True 11. False 12. True 13. True 14. True 15. True 16. False 17. False 18. True 19. False 20. False 21. True 22. True 23. True 24. False 25. False Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 11: Investor Losses 26. False 27. True 28. True 29. True 30. True 31. False 32. False 33. False 34. False 35. True 36. False 37. False 38. True 39. True 40. False 41. True 42. False 43. False 44. False 45. False 46. True 47. True 48. True 49. d 50. d Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 11: Investor Losses 51. b 52. a 53. c 54. d 55. d 56. c 57. c 58. a 59. d 60. a 61. d 62. d 63. b 64. d 65. b 66. d 67. d 68. b 69. b 70. d 71. a 72. c 73. b 74. d 75. a 76. a Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 11: Investor Losses 77. d 78. d 79. d 80. d 81. b 82. a 83. d 84. d 85. c 86. d 87. c 88. d 89. c 90. b 91. b 92. b 93. b 94. d 95. c 96. c 97. c 98. f 99. e 100. b 101. e Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 11: Investor Losses 102. c 103. a 104. d 105. f 106. Initial at-risk amount Subtract: Deductible first year loss of $120,000, limited to at-risk amount of $100,000

$100,000 (100,000) –0–

At-risk amount at the end of first year

$

Suspended loss at the end of first year

$ 20,000

At-risk amount at the beginning of the second year Add: Share of recourse debt Subtract: Withdrawal Deductible $25,000 second year loss + $20,000 loss suspended from prior year

$ –0– 80,000 (20,000)

At-risk amount at the end of second year

$ 15,000

Suspended loss at the end of second year

$

(45,000)

–0–

107. Although the passive activity loss rules do not apply, the at-risk rules limit Emily’s deductions. She can deduct $90,000 in 2024 and her at-risk amount will be reduced to $30,000 ($120,000 – $90,000 deducted). She will be limited to a $30,000 deduction in 2025 unless she increases her amount at risk. For example, if Emily invests an additional $20,000 in 2025, her at-risk amount would be $50,000 ($30,000 balance + $20,000 additional investment), and she would be able to deduct the entire $50,000 loss in 2025. 108. Naomi has $40,000 at risk at the end of 2023 and can deduct the $30,000 loss in that year. This decreases her at-risk amount to $10,000. Consequently, at the end of 2024, she can deduct only $10,000 of the $15,000 loss. 109. Lindsey cannot deduct the passive activity loss against active or portfolio income. Her AGI after considering the passive investment is $175,000 ($125,000 active income + $50,000 portfolio income). 110. Because Anne disposes of her entire interest in the passive activity, she is able to fully recognize the suspended losses. By utilization of the $60,000 suspended loss, a deductible loss of $15,000 results. Net sales price Less: Adjusted basis Total gain Less: Suspended losses Deductible (nonpassive activity) loss

$300,000 (255,000) $ 45,000 (60,000) ($ 15,000)

111. None. The suspended losses of $80,000 are allocated as follows: Activity Powered by Cognero

Suspended Loss Page 24

Name:

Class:

Date:

Chapter 11: Investor Losses $53,333 17,778 8,889 $80,000

A $60,000/$90,000 × $80,000 B $20,000/$90,000 × $80,000 C $10,000/$90,000 × $80,000 Total suspended loss

112. Because Pat disposes of her entire interest in the passive activity, she is able to recognize fully the losses that had been suspended during the years of her ownership. With the current utilization of the $60,000 suspended loss, a net deductible loss of $15,000 results, which is treated as a loss that is not from a passive activity. However, the suspended credits are lost and may not be used. The tax credits are allowed on dispositions only when there is sufficient tax on the disposition (i.e., due to a gain) to absorb them. Net sales price Less: Adjusted basis Total gain Less: Suspended losses Deductible loss

$100,000 (55,000) $ 45,000 (60,000) ($ 15,000)

113. A personal service corporation cannot offset passive activity losses against active or portfolio income. Purple’s income is $660,000 ($600,000 active income + $60,000 dividend income). The $100,000 passive activity loss is suspended. 114. A closely held (nonpersonal service) C corporation can offset passive activity losses against active but not portfolio income. Orange’s income is $285,000 [($300,000 active income – $50,000 passive activity loss) + $35,000 portfolio income]. 115. The basic issue relates to how the car repair shops and ice cream parlors should be grouped under the passive activity rules to maximize the tax benefit to Malik. The $400,000 salary is active income. If the participation levels stay the same in the ice cream parlor and car repair shop businesses, all profits and losses will be passive, assuming each location is a separate activity. As a result, a net passive activity loss of $55,000 ($89,000 loss + $41,000 loss + $15,000 loss – $56,000 profit – $34,000 profit) would be suspended and not be available to offset his salary. To mitigate this result, three options should be considered. Option 1 is based on the significant participation activity rule. If all of the businesses are treated as separate activities, Malik would not be considered a material participant, even under the significant participation activity rule. Under the significant participation activity rule, the car repair shops would be considered significant activities, but the ice cream parlors would not. But even with the car repair shops, the total participation is not expected to exceed the more-than-500 hour threshold (140 + 170 + 180 = 490). If Malik could participate 11 more hours in any of the car repair shop businesses, they would be treated as active and the net loss from the car repair shops of $145,000 ($89,000 + $41,000 + $15,000) could be offset against his salary. Further, if Malik does not participate any more in the other ice cream parlor businesses, their combined $90,000 of income will be reported as passive activity income. This characterization as passive could be helpful if Malik were to acquire additional businesses in the future that produce passive activity losses. Under option 2, both the ice cream parlor and car repair shop businesses could be combined as a “single activity” based on common ownership. Because Malik has participated more than 500 hours in the five businesses, the net loss of $55,000 would be considered active and could be used to offset his salary. Option 3 would combine the car repair shops as one activity based on product and the ice cream parlors would be treated as a separate activity based on product. As with option 1, if Malik could participate 11 more hours in any of the car repair shop businesses, they would be treated as active, and the net loss of $145,000 ($89,000 + $41,000 + $15,000) could be offset against his salary. Also, he could treat the ice cream parlors as a single business and the net income would be passive, which could be helpful in the future if other passive ventures would be acquired. Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 11: Investor Losses 116. If Vail spends an additional 21 hours in the tanning salon activity, she has participated more than 500 hours in all of her significant participation activities. Consequently, she is considered a material participant in the ventures, and the resulting active income is not available to absorb the passive activity loss generated by the limited partnership. As a result, Vail should avoid devoting additional time to the ventures. Instead, she should plan to fail the material participation standard to keep the income classified as passive. 117. The at-risk limits disallow $10,000 of the deduction ($40,000 loss – $30,000 at risk). Ken is not a material participant, so the remaining $30,000 is disallowed by the passive activity loss rules. 118. Ryan is considered a material participant in all three ventures, so the income and loss from these operations will be fully reflected on his income tax return. The losses from the rental real estate activity will not be subject to the passive activity loss rules because Ryan is a real estate professional (more than 50% of his personal services were devoted to real property trades or businesses in which he is a material participant, and this participation exceeded 750 hours). As a result, Ryan is allowed to apply a material participation test to the rental real estate. He meets the over 500 hours material participation test for this rental activity. Given this outcome, the losses from these activities can offset the income from his management consulting practice and his spouse’s salary. 119. Lucile can utilize $20,000 of losses and $1,100 of credits under the real estate rental activities exception as follows: Income (Loss):

Activity A Activity B Activity C

Suspended loss

($15,000) (25,000) 20,000 ($20,000) 20,000 $ –0–

Utilized credit

$ 1,100

Suspended credit

$ 2,000

Net loss Utilized loss

After deducting the $20,000 loss, Lucile has an available deduction equivalent of $5,000 [$25,000 (maximum loss allowed) – $20,000 (utilized loss)]. Then the maximum amount of credits Lucile may claim is $1,100 [$5,000 deduction equivalent × 0.22 (marginal tax bracket)] that is allocated to Activity A. The balance of the credits from Activity A ($2,000) are suspended. 120. Wanda loses the suspended losses of $20,000 but they are added to the basis of the gifted property. Wanda may or may not have to pay gift taxes, depending on the value of other gifts she has given during her lifetime. Wanda’s daughter can add the suspended losses to the basis in the property but she cannot apply them against the income received. 121. a. Juana’s investment interest deduction is limited to net investment income, which is computed as follows: Income from investments Less: Investment expenses Net investment income

$10,000 (500) $ 9,500

As a result, Juana’s deduction for investment interest is limited to $9,500, the amount of net investment income. The balance of $1,500 is disallowed in the current year. Total investment interest expense Powered by Cognero

$11,000 Page 26

Name:

Class:

Date:

Chapter 11: Investor Losses Less: Net investment income Investment interest disallowed in the current year

(9,500) $ 1,500

b. The $1,500 of investment interest disallowed may be carried over and becomes investment interest expense in the subsequent year subject to the net investment income limitation in that year. c. Juana could increase her investment interest deduction by electing to treat the LTCG as investment income. This would increase her investment income for purposes of calculating her investment interest deduction. She would be able to deduct the full $11,000 of investment interest expense. If she makes the election, the amount so elected could not be taxed using the beneficial capital gains tax rate.

122. The at-risk provisions limit the deductibility of losses from business and income-producing activities. The provisions apply to individuals and closely held corporations. In the case of an S corporation or a partnership, the at-risk limits apply at the owner level. 123. The passive activity loss rules require income and losses to be classified into one of three categories: active, passive, or portfolio. Active income includes salary and wages, profit from a trade or business in which the taxpayer is a material participant, and gain on the sale of assets used in an active trade or business. Portfolio income includes interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business. The final category, passive activity income or loss, is generated by a passive activity. The following activities are treated as passive: (1) any trade or business or income-producing activity in which the taxpayer does not materially participate and (2) subject to exceptions, all rental activities, whether the taxpayer materially participates or not. 124. In general, passive activity losses are deductible to the extent of passive activity income from all of the taxpayer’s current-year passive activities. Passive credits can be utilized only against regular tax attributable to passive activity income. If passive activity losses or credits are not used in the current year, they are carried over indefinitely for potential use in the succeeding years to offset passive income (or regular tax attributable to passive activity income) in those years. An activity’s unused (or suspended) passive activity losses that exist when a taxpayer sells the passive activity may be used to reduce the gain from the sale, or increase the recognized loss. As a result, the suspended passive activity losses are fully utilized in the year of disposition. In contrast, passive activity credits are allowed on dispositions only when there is sufficient tax on passive activity income to absorb them. 125. The passive activity loss rules apply to individuals, estates, trusts, personal service corporations, and closely held C corporations. Passive activity income or loss from investments held by S corporations or partnerships flows through to the owners and the passive activity loss rules apply at the owner level. For individuals, estates, trusts, and personal service corporations, losses or expenses generated by passive activities can be deducted only to the extent of income from all of the taxpayer’s passive activities. The application of the passive activity loss rules to closely held (nonpersonal service) C corporations is slightly different: these taxpayers may use passive activity losses to offset active income but not portfolio income. Any unused passive activity losses are suspended and carried forward to future years to offset passive activity income generated in those years. Otherwise, suspended Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 11: Investor Losses activity losses may be used when a taxpayer disposes of the entire interest in an activity. 126. The special passive activity loss rules available to real estate activities allow the deduction of all or part of real estate rental losses against active or portfolio income even though the activity otherwise is defined as a passive activity. The special rules are available in two situations:

∙

Losses from real estate rental activities are not treated as passive activity losses for certain qualifying real estate professionals who materially participate in the rental real estate activity(ies).

∙

Qualifying individuals may deduct up to $25,000 of losses from real estate rental activities against active and portfolio income. The potential annual $25,000 deduction is reduced by 50 percent of the taxpayer’s AGI in excess of $100,000.

127. In a disposition of a taxpayer’s interest in a passive activity by gift, the suspended losses are added to the basis of the property in the hands of the donee. 128. The deduction of investment interest expense is limited to net investment income for the year. Any investment interest expense not deducted in the current year is carried over for potential use in succeeding years. Investment interest expense is interest incurred on borrowed funds used to acquire or continue to hold investment assets. Net investment income is investment income (e.g., interest, annuities, royalties) reduced by investment expenses (i.e., deductible expenses directly connected to the production of investment income). 129. Investment income for this purpose is gross income from interest, dividends (in certain cases), annuities, and royalties not derived in the ordinary course of a trade or business. Passive activity income and income from a real estate activity in which the taxpayer actively participates are not included as investment income. The taxpayer may elect to treat net capital gain and qualified dividends as investment income. Net capital gain includes gain attributable to the dispositions of property producing investment income or held for investment purposes. Qualified dividends are dividends that are taxed at the same marginal rate that is applicable to a net capital gain. If the taxpayer elects to treat net capital gain and qualified dividend income as investment income, they may not be taxed using the preferential capital gains rates.

Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments True / False 1. The tax benefit received from a tax credit is unaffected by the tax rate of the taxpayer. a. True b. False 2. The tax benefits resulting from tax credits and tax deductions are affected by the tax rate of the taxpayer. a. True b. False 3. Nonrefundable credits are those that reduce the taxpayer’s tax liability but are not paid when the amount of the credit (or credits) exceeds the taxpayer’s tax liability. a. True b. False 4. The credit for child and dependent care expenses is an example of a refundable credit. a. True b. False 5. Any unused general business credit must be carried back three years and then forward 20 years. a. True b. False 6. A LIFO method is applied to general business credit carryovers, carrybacks, and utilization of credits earned during a particular year. a. True b. False 7. The purpose of the tax credit for rehabilitation expenditures is to encourage the relocation of businesses from older, economically distressed areas to newer locations. a. True b. False 8. Qualified rehabilitation expenditures include the cost of acquiring a building, but not the cost of acquiring the land. a. True b. False 9. The purpose of the work opportunity tax credit is to encourage employers to hire individuals from specified target groups traditionally subject to high rates of unemployment. a. True b. False 10. Some, or all, of the tax credit for rehabilitation expenditures is recaptured if the rehabilitated property is disposed of prematurely or if it ceases to be qualifying property. a. True b. False Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments 11. Employers are encouraged by the work opportunity tax credit to hire individuals who have been long-term recipients of family assistance welfare benefits. a. True b. False 12. The work opportunity tax credit is available only for wages paid to qualifying individuals during their first year of employment. a. True b. False 13. An employer’s tax deduction for wages is affected by the work opportunity tax credit. a. True b. False 14. The incremental research activities credit is 20% of the qualified research expenses that exceed the base amount. a. True b. False 15. All taxpayers are eligible to take the basic research credit. a. True b. False 16. The low-income housing credit is available to low-income tenants who reside in qualifying low-income housing. a. True b. False 17. A taxpayer who qualifies for the low-income housing credit claims the credit over a 20-year period. a. True b. False 18. The disabled access credit was enacted to encourage small businesses to make their businesses more accessible to disabled individuals. a. True b. False 19. The disabled access credit is computed at the rate of 50% of all access expenditures incurred by the taxpayer during the year without limitation. a. True b. False 20. The cost of a building constructed and placed into service by an eligible small business in the current year includes the cost of a wheelchair ramp, which qualifies for the disabled access credit. a. True b. False 21. A small employer incurs $31,500 for consulting fees related to establishing a qualified retirement plan for its 75 Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments employees. As a result, the employer may claim the credit for small employer pension plan startup costs for $750. a. True b. False 22. BlueCo incurs $900,000 during the year to construct a facility that will be used exclusively for the care of its employees’ pre-school age children during normal working hours. The credit for employer-provided child care available to BlueCo this year is $225,000. a. True b. False 23. Cardinal Company incurs $800,000 during the year to construct a facility that will be used exclusively for the care of its employees’ preschool age children during normal working hours. Assuming that Cardinal claims the credit for employer-provided child care this year, its basis in the newly constructed facility is $640,000. a. True b. False 24. The earned income credit is a refundable credit. a. True b. False 25. The earned income credit is available only if the taxpayer has at least one qualifying child in the household. a. True b. False 26. A taxpayer’s earned income credit is computed using the number of any qualifying children. a. True b. False 27. Only married taxpayers with children can claim the earned income credit. a. True b. False 28. The child tax credit is based on the number of the taxpayer’s qualifying children under age 17. a. True b. False 29. The maximum child tax credit is $1,500 per qualifying child. a. True b. False 30. The maximum credit for child and dependent care expenses is $2,100 if only one spouse is employed and the other spouse is a full-time student. a. True b. False 31. Expenses that are reimbursed by a taxpayer’s employer and excluded from gross income under a dependent care Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments assistance program can qualify for the credit for child and dependent care expenses. a. True b. False 32. For purposes of computing the credit for child and dependent care expenses, the qualifying employment-related expenses are limited to the actual or deemed earned income of the taxpayer or their spouse. a. True b. False 33. A taxpayer may qualify for the credit for child and dependent care expenses if the taxpayer’s dependent is age 17. a. True b. False 34. Child care payments to a relative are not eligible for the credit for child and dependent care expenses if the relative is a child (under age 19) of the taxpayer. a. True b. False 35. Child and dependent care expenses include amounts paid for general household services. a. True b. False 36. The education tax credits (i.e., the American Opportunity credit and the lifetime learning credit) are available to help defray the cost of higher education, regardless of the income level of the taxpayer. a. True b. False 37. Both education tax credits are available for qualified tuition expenses, and in certain instances, also may be available for room and board. a. True b. False 38. Qualifying tuition expenses paid from the proceeds of a tax-exempt scholarship do not give rise to an education tax credit. a. True b. False 39. The base amount for the Social Security portion (old age, survivors, and disability insurance) is different from that for the Medicare portion of FICA. a. True b. False 40. If an employee holds two jobs during the year, an overwithholding of FICA tax always results. a. True b. False Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments 41. In the event that overwithholding of FICA tax occurs because the taxpayer has more than one employer, the excess amount should be claimed as a credit on the Federal income tax return of the employee. a. True b. False 42. John owns and operates a real estate agency as a sole proprietor. On a full-time basis, he employs his 17-year old daughter as a receptionist and his 22-year old son as a bookkeeper. Both children are subject to FICA withholding. a. True b. False 43. Only self-employed individuals are required to make estimated tax payments. a. True b. False 44. An employee with another source of income may be able to avoid the penalty for underpayment of estimated tax by having his employer increase income tax withholdings. a. True b. False 45. Certain high-income individuals are subject to additional Medicare taxes on wages, unearned income, and tax credits claimed. a. True b. False 46. The additional Medicare taxes assessed on high-income individuals carry differing tax rates depending on the tax base. a. True b. False 47. In computing the foreign tax credit, the greater of the foreign income taxes paid or the overall limitation is allowed. a. True b. False 48. All foreign taxes qualify for the foreign tax credit. a. True b. False 49. The residential energy credit is subject to a lifetime limit of $1,200. a. True b. False 50. A home energy audit of $500 results in the maximum residential energy credit of $150 for this type of expenditure. a. True b. False 51. Installing solar panels on your home is likely to generate a residential clean energy credit of 30% times the cost Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments of the panels. a. True b. False 52. Provided an individual has at least $7,500 of tax liability, they will qualify for the clean vehicle credit for the purchase of a qualifying vehicle. a. True b. False 53. The clean vehicle credit is $7,500 provided the battery has a capacity of at least 7 kilowatt hours. a. True b. False 54. If the MSRP for a new electric car exceeds $55,000, the $7,500 credit amount is reduced by $50 for every $1,000 above $55,000. a. True b. False 55. To potentially qualify the buyer for the previously-owned clean vehicle credit, the vehicle must be at least two years older than its model year and have a sales price of $25,000 or less. a. True b. False 56. In deciding whether to enact the alternative minimum tax, Congress was concerned about the inequity that resulted when taxpayers with substantial economic incomes could avoid paying regular income tax. a. True b. False 57. AMT adjustments can be positive or negative, whereas AMT preferences always are positive. a. True b. False 58. Since most tax preferences are timing differences, they eventually reverse and net to zero. a. True b. False 59. Assuming no phaseout, the AMT exemption amount for a married taxpayer filing separately for 2024 is exactly half of the AMT exemption amount for an individual taxpayer. a. True b. False 60. For 2024, if the AMT base is greater than $232,600, the AMT rate for an individual taxpayer is the same as the AMT rate for married taxpayers filing jointly. a. True b. False Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments 61. The net capital gain included in an individual taxpayer’s AMT base is eligible for the preferential tax rate on net capital gains. This favorable alternative rate applies in calculating both the regular tax and the AMT. a. True b. False 62. Business tax credits reduce the AMT and the regular tax in the same way. a. True b. False 63. Prior to consideration of tax credits, Clarence’s regular income tax liability is $200,000 and his tentative minimum tax (TMT) is $180,000. Clarence holds personal nonrefundable tax credits of $35,000. His tax liability for the year is $165,000. a. True b. False 64. Gabriella’s tentative minimum tax (TMT) is $112,000. Her regular income tax liability is $99,000. Gabriella’s AMT is $13,000. a. True b. False 65. The phaseout of the AMT exemption amount for a taxpayer filing as a head of household both begins and ends at a higher income level than the phaseout for a single taxpayer. a. True b. False 66. The standard deduction is allowed for regular tax purposes but is disallowed for AMT purposes. This results in a positive AMT adjustment. a. True b. False Multiple Choice 67. Roger is considering making a $6,000 investment in a venture that its promoter promises will generate immediate tax benefits for him. Roger, who does not anticipate itemizing his deductions, is subject to a 30% marginal income tax bracket. If the investment is of a type that produces a tax credit of 40% of the amount of the expenditure, by how much will Roger’s tax liability decline because of the investment? a. $0 b. $1,800 c. $2,200 d. $2,400 68. Ahmad is considering making a $10,000 investment in a venture whose promoter promises will generate immediate tax benefits for him. Ahmad, who normally itemizes his deductions, is subject to a 32% marginal tax bracket. If the investment is of a type where the taxpayer may claim either a tax credit of 25% of the amount of the expenditure or an itemized deduction for the amount of the investment, what treatment is likely most beneficial to Ahmad, and by how much will Ahmad’s tax liability decline because of the investment? a. $0, take neither the itemized deduction nor the tax credit. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments b. $2,500, take the tax credit. c. $3,200, take the itemized deduction. d. Both options produce the same benefit. 69. Refundable tax credits include the: a. Foreign tax credit. b. Tax credit for rehabilitation expenses. c. Credit for certain retirement plan contributions. d. Earned income credit. 70. The components of the general business credit include all of the following except: a. Credit for employer-provided child care. b. Disabled access credit. c. Research activities credit. d. All of these choices are components of the general business credit. 71. Which of the following best describes the treatment applicable to unused business credits? a. Are carried forward indefinitely. b. Are first carried back one year and then forward for 20 years. c. Are first carried back one year and then forward for 10 years. d. Are first carried back three years and then carried forward for 15 years. 72. Molly has generated general business credits over the years that have not been utilized. The amounts generated and not utilized equal: 2020 2021 2022 2023

$2,500 7,500 5,000 4,000

In the current year, 2024, her business generates an additional $15,000 general business credit. In 2024, based on her tax liability before credits, she can utilize a general business credit of up to $20,000. After utilizing the carryforwards and the current year credits, how much of the general business credit generated in 2024 is available for future years? a. $0. b. $1,000. c. $14,000. d. $15,000. 73. Which of the following correctly describes an attribute of the tax credit for rehabilitation expenditures? a. The cost of enlarging any existing business building is a qualifying expenditure. b. The cost of facilities related to the building (e.g., a parking lot) is a qualifying expenditure. c. No recapture provisions apply. d. No credit is allowed for the rehabilitation of a nonhistoric structure. 74. Several years ago, Sarah purchased a certified historic structure for $150,000 that was placed in service in 1930. In the Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments current year, she incurred qualifying rehabilitation expenditures of $200,000. The amount of the tax credit for rehabilitation expenditures and the amount by which the building’s basis for cost recovery would increase as a result of the rehabilitation expenditures are the following amounts. a. $20,000 credit; $180,000 basis. b. $40,000 credit; $200,000 basis. c. $40,000 credit; $350,000 basis. d. $40,000 credit; $160,000 basis. 75. Cardinal Corporation hires two individuals who are certified to be eligible employees for the work opportunity tax credit under the general rules (e.g., food stamp recipients), each of whom is paid $9,000 during 2024. As a result of this event, Cardinal Corporation may claim a work opportunity credit of: a. $1,440. b. $2,880. c. $4,800. d. $7,200. 76. In 2024, Black Company paid wages of $180,000 of which $40,000 was qualified for the work opportunity tax credit under the general rules. Black Company’s deduction for wages for the year is: a. $140,000. b. $164,000. c. $166,000. d. $180,000. 77. In March 2024, Gray Corporation hired two individuals, both of whom were certified as long-term recipients of family assistance benefits. Each employee was paid $11,000 during 2024. Gray’s work opportunity tax credit amounts for 2024 is: a. $2,400. b. $4,800. c. $6,000. d. $12,000. 78. During the year, Green, Inc., incurs the following research expenditures. In-house wages and supplies Paid to Blue Foundation for research

$60,000 30,000

Green’s qualifying research expenditures for the year are: a. $60,000. b. $75,000. c. $79,500. d. $90,000. 79. Which of the following, if any, correctly describes the research activities credit? a. The research activities credit is the greater of the incremental research credit, the basic research credit, or the energy research credit. b. The credit is only available if the taxpayer's research expenditures exceed an annual dollar amount published by the IRS. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments c. The credit is not available for research conducted outside the United States. d. All corporations qualify for the basic research credit. 80. In the renovation of its building, Green Company incurs $9,000 of expenditures that qualify for the disabled access credit. The disabled access credit is: a. $8,750. b. $4,500. c. $4,375. d. $4,250. 81. Amber is in the process this year of renovating the office building (placed in service in 1978) used by her business. Because of current Federal Regulations that require the structure to be accessible to disabled individuals, she incurs an additional $11,000 for various features, such as ramps and widened doorways, to make her office building more accessible. The $11,000 incurred will produce a disabled access credit of what amount? a. $0 b. $5,000 c. $5,125 d. $5,500 82. Which of the following, if any, correctly describes the earned income credit? a. Would be available regardless of the amount of the taxpayer’s adjusted gross income. b. Is not available to a surviving spouse. c. Requires a taxpayer to have a qualifying child to take advantage of the credit. d. Is a refundable credit. 83. Rex and Dena are married and have two children, Michelle (age seven) and Nancy (age five). During 2024, Rex earned a salary of $30,800 and filed a joint income tax return with Dena. Dena had $0 gross income. Their earned income credit for the year is: a. $0. b. $6,716. c. $6,960. d. $7,830. 84. Cheryl is single, has one child (age six), and files as head of household during 2024. Her salary for the year is $24,700. She qualifies for an earned income credit of the following amount. a. $0. b. $3,897. c. $4,213. d. $6,960. 85. Jane, a single taxpayer, purchased an electric car this year with an MSRP of $54,000. Jane's modified AGI was $140,000 last year, and is expected to be $180,000 this year. If all of the technological requirements are satisfied for this vehicle, Jane's credit amount is: a. $0. b. $3,750. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments c. $4,000. d. $7,500. 86. In 2024, George and Martha are married and file a joint tax return claiming their two children, ages 10 and 8 as dependents. Assuming their AGI is $119,650, George and Martha’s child tax credit is: a. $0. b. $2,000. c. $3,000. d. $4,000. 87. Harry and Wei are married and file a joint income tax return. On their 2024 tax return, they report $44,000 of adjusted gross income ($20,000 salary earned by Harry and $24,000 salary earned by Wei) and report two dependent children. During the year, they pay the following amounts to care for their four-year old son and six-year old daughter while they work. ABC Day Care Center Blue Ridge Housekeeping Services Mindy Mason (Harry’s mother)

$3,200 2,000 1,000

Harry and Wei may claim a credit for child and dependent care expenses of: a. $840. b. $1,040. c. $1,200. d. $1,240. 88. Kevin and Shuang have two children, ages 8 and 14. In 2024 they spend $6,400 on eligible employment related expenses for the care of their children after school. Kevin earned a salary of $15,200 and Shuang earned a salary of $68,000. What is the amount of the couple's credit for child and dependent care expenses for 2024? a. $600 b. $620 c. $1,200 d. $1,280 89. Which of the following statements concerning the credit for child and dependent care expenses is not correct for 2024? a. A taxpayer is not allowed both an exclusion from income and the credit for child and dependent care expenses on the same amount. b. A taxpayer is not allowed both a deduction as a medical expense and the credit for child and dependent care expenses on the same amount. c. If a taxpayer’s adjusted gross income is over $43,000, the rate for the credit for child and dependent care expenses is 20%. d. If a taxpayer is a full-time student with no earned income, no credit for child and dependent care expenses can be claimed. 90. Jermaine and Kesha are married, file a joint tax return, have AGI of $82,500, and have two children. Devona is beginning her freshman year at State University during fall 2024, and Arethia is beginning her senior (4th) year at Northeast University during fall 2024 after having completed her junior year during the spring of that year. Both Devona and Arethia qualify as dependents of their parents. Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments Devona’s qualifying tuition expenses and fees total $4,000 for the fall semester and Arethia’s qualifying tuition expenses and fees total $6,200 for each semester during 2024. Full payment is made for the tuition and related expenses for both children during each semester. The American Opportunity credit available to Jermaine and Kesha for 2024 is: a. $2,500. b. $3,000. c. $5,000. d. $6,000. 91. Bob and Sally are married, file a joint tax return, report AGI of $123,000, and have two children. Del is beginning her freshman year at State College during fall 2024, and Owen is beginning his senior year at Southwest University during fall 2024. Owen completed his junior year during the spring semester of 2023 (i.e., he took a “gap year” for the 20232024 school year). Both Del and Owen qualify as dependents of their parents. For the fall 2024 semester, Del’s qualifying tuition expenses and fees total $5,000 and Owen’s qualifying tuition expenses were $6,100. Del’s room and board costs were $3,200 for the fall 2024 semester. Owen did not incur room and board costs; he lived with his aunt and uncle during the year. Full payment is made for the tuition and related expenses for both children at the beginning of each semester. In addition to the children’s college expenses, Bob also spent $3,000 on professional education seminars during the year to maintain his license as a practicing dentist. Bob attended the seminars during July and August 2024. Compute the available education tax credits for Bob and Sally for 2024. a. $2,500 b. $3,100 c. $5,000 d. $5,600 92. Which of the following statements is true regarding the education tax credits? a. The lifetime learning credit is available for qualifying tuition and related expenses incurred by students pursuing only graduate degrees. b. The American Opportunity credit permits a maximum credit of 20% of qualified expenses up to $10,000 per year. c. The American Opportunity credit is calculated per eligible student and the lifetime learning credit is available per taxpayer. d. Continuing education expenses do not qualify for either education credit. 93. Realizing that providing for a comfortable retirement is up to them, Jim and Julie commit to regular contributions to traditional IRAs, beginning this year. Consequently, each makes a $2,000 contribution to his or her traditional IRA. If their AGI is $35,000 on their joint return, what is the amount of any "saver's credit" for retirement plan contributions? a. $2,000 b. $1,000 c. $400 d. $200 94. An employer calculates the amount of income tax withheld from salary or wages based on the information an employee provides on the: a. Form W-2. b. Form W-3. Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments c. Form W-4. d. Form 941. 95. Identify the following statement that is false. a. If an employer is not required to withhold income taxes from an employee’s wages, the wages are not taxable to the employee. b. In certain situations, income tax withholding by an employer is voluntary. c. An employer must deposit with the government an amount of FICA tax that is twice the amount withheld from the employee’s salary (i.e., the employee’s and employer’s shares). d. If an excess amount of FICA is withheld for an employee because the employee has multiple jobs, the employee may claim a credit for the excess amount withheld on the employee's income tax return. 96. In describing FICA taxes, which (if any) of the following statements is incorrect? a. The base amounts for 2025 probably will increase from the 2024 amounts. b. The base amounts for the Social Security and Medicare portions are the same. c. If both spouses work, excess FICA taxes need not result. d. Excess FICA taxes can be claimed as an income tax credit. 97. Which of the following correctly reflects current rules regarding estimated tax payments for individuals? a. Employees are not subject to the estimated tax payment provisions. b. Any penalty imposed for underpayment is deductible for income tax purposes. c. Married taxpayers may not make joint estimated tax payments unless they file a joint income tax return. d. No quarterly payments are required if the taxpayer’s estimated tax is under $1,000. 98. During the current year, Eleanor earns $120,000 in wages as an employee of an accounting firm. She also earns $13,000 in gross income from a consulting service she operates. Deductible expenses paid in connection with the consulting work amount to $3,000. Eleanor also incurs a recognized long-term capital gain of $1,000 from the sale of a stock investment. She must pay a self-employment tax on: a. $0. b. $10,000. c. $13,000. d. $14,000. 99. Pat generated self-employment income in 2024 of $76,000. The self-employment tax is: a. $0. b. $5,369. c. $10,738. d. $11,628. 100. The ceiling amounts and percentages for 2024 for the two portions of the self-employment tax are: Social Security Portion a. $160,200; 12.4% b. $160,200; 15.3% c. $168,600; 12.4% Powered by Cognero

Medicare Portion Unlimited; 2.9% Unlimited; 2.9% Unlimited; 2.9% Page 13

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments d. $168,600; 2.9%

Unlimited; 13.3%

101. During the year, Green Corporation (a U.S. corporation) reports U.S.-source income of $750,000 and foreign income of $500,000. The foreign-source income generates foreign income taxes of $240,000. The U.S. income tax before the foreign tax credit is $157,500. Green Corporation’s overall limitation on the foreign tax credit is: a. $63,000. b. $157,500. c. $240,000. d. $500,000. 102. During the year, Purple Corporation (a U.S. Corporation) reports U.S.-source income of $1,800,000 and foreign income of $600,000. The foreign-source income generates foreign income taxes of $75,000. The U.S. income tax before the foreign tax credit is $378,000. Purple Corporation’s foreign tax credit is: a. $75,000. b. $94,500. c. $283,500. d. $378,000. 103. Which of the following statements describing the alternative minimum tax (AMT) is correct? a. Generally, those taxpayers most concerned about being in AMT are low-income taxpayers who elect the standard deduction. b. The AMT was enacted in an attempt to limit the ability of taxpayers to engage in questionable tax planning activities. c. The goal of the AMT is to try to ensure that all taxpayers with economic income pay at least some income tax. d. As a result of recent tax law changes, more taxpayers are expected to be in AMT. 104. Max, who is single and age 30, provides you with the following information from his financial records for 2024. Regular income tax liability AMTI Taxable income

$73,625 689,000 295,000

Calculate his AMT exemption for 2024. a. $0 b. $19,913 c. $65,787 d. $85,700 105. Which of the following statements is correct? a. If the tentative minimum tax is $100,000 and the regular income tax liability is $120,000, AMT is $20,000. b. If the tentative minimum tax is $120,000 and the regular income tax liability is $100,000, AMT is $120,000. c. If the tentative minimum tax is $100,000 and the regular income tax liability is $120,000, AMT is a negative $20,000. d. If the tentative minimum tax is $120,000 and the regular income tax liability is $100,000, AMT is $20,000. 106. Which of the following statements is correct? Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments a. If the tentative minimum tax exceeds the regular tax liability, AMT is $0. b. The AMT exemption amount decreases as AMTI increases. c. The highest AMT rate for individuals is 26%. d. The highest AMT rate for married individuals filing jointly is 26%. 107. For regular tax purposes, Yolanda, who is single, is in the 32% tax bracket. For 2024, her AMT base is $420,000. Her tentative minimum tax (TMT) is: a. $60,476. b. $109,200. c. $112,948. d. $117,600. 108. Which of the following statements concerning capital gains and losses and the AMT is correct? a. The preferential tax rate on net capital gain is not allowed in the calculation of tentative minimum tax. b. Net capital losses disallowed for regular tax purposes are deductible in the calculation of AMTI. c. The preferential tax rate on net capital gain applies in calculating both regular tax and the tentative minimum tax. d. Net capital gain is always taxed at the 26% AMT rate. 109. Prior to the effect of the tax credits, Justin’s regular income tax liability is $200,000, and his tentative minimum tax is $195,000. Justin reports the following credits. Child tax credit Adoption expenses credit

$1,000 5,000

Calculate Justin’s tax liability after credits. a. $190,000 b. $194,000 c. $195,000 d. $200,000 110. Prior to the effect of tax credits, Eunice’s regular income tax liability is $325,000 and her tentative minimum tax is $312,000. Eunice has general business credits available of $20,000. Calculate Eunice’s tax liability after tax credits. a. $0 b. $305,000 c. $312,000 d. $325,000 111. Celia and Christian, who are married filing jointly, have one dependent and do not itemize deductions. They report taxable income of $492,000 and tax preferences of $53,000 in 2024. What is their AMT base for 2024? a. $0. b. $440,900. c. $492,000. d. $574,200. Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments 112. In the current tax year, David, a 32-year-old single taxpayer, reported itemized deductions of $24,500, composed of the following amounts. $6,000 of medical expenses (in excess of 7.5%-of-AGI) $4,500 of property taxes on his home $2,500 of investment expenses (not limited by investment income) $3,000 of charitable contributions $8,500 of home mortgage interest on principal residence Which of David’s itemized deductions could create an AMT preference? a. All of the itemized deductions potentially create an AMT preference. b. The deduction for medical expenses and property taxes potentially create an AMT preference. c. The deduction for investment expenses and property taxes potentially create an AMT preference. d. None of these itemized deductions potentially creates an AMT preference. 113. In 2024, Liam’s filing status is married filing separately. For regular tax purposes, he has three dependents. Liam does not itemize deductions; his regular taxable income is $456,000. What is Liam’s 2024 AMT base? a. $389,350. b. $403,950. c. $456,000. d. $470,600. 114. In the current year, Brenda has regular tax liability of $32,500 and her tentative minimum tax (TMT) is $36,300. Additionally, Brenda has an alternative minimum tax credit carryover of $6,200 from 2019. What is Brenda’s total Federal income tax liability? a. $26,300. b. $30,100. c. $32,500. d. $36,300. 115. In the current year, Bianca has regular tax liability of $32,500 and tentative minimum tax (TMT) of $36,300. Additionally, Bianca has an adoption expense credit (personal, nonrefundable credit) of $6,200. What is Bianca’s total Federal income tax liability? a. $26,300. b. $30,100. c. $32,500. d. $36,300. Subjective Short Answer 116. In January 2024, Tammy acquired an office building in downtown Syracuse, NY, for $400,000. The building was Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments constructed in 1934 and is a certified historic structure. Of the $400,000 cost, $40,000 was allocated to the land. Tammy immediately placed the building into service, but she quickly realized that substantial renovation would be required to keep and attract new tenants. The renovations costing $600,000 were of the type that qualifies for the rehabilitation credit. The improvements were completed in October 2024. a.

Compute Tammy’s rehabilitation tax credit for the year of acquisition.

b.

Determine the cost recovery deduction for 2024.

c.

What is the basis in the property at the end of its first year of use by Tammy?

117. Steve records a tentative general business credit of $110,000 for the current year. His net regular tax liability before the general business credit is $125,000, and his tentative minimum tax is $100,000. Compute Steve’s allowable general business credit for the year. 118. Rick spends $750,000 to build a qualified low-income housing project, which is placed in service on January 1, 2024. He financed the project using his personal funds. What is the amount of the low-income housing credit that Rick may claim in 2024 (assuming a rate of 7.10%)? What is the total amount of the credit that Rick may claim as a result of the $750,000 expenditure? 119. Golden Corporation is an eligible small business for purposes of the disabled access credit. During the year, Golden makes the following expenditures on a structure originally placed in service in 1990. Removal of architectural barriers Acquired equipment for disabled persons

$ 8,500 6,250 $14,750

In addition, Golden expended $8,000 on a building originally placed in service in the current year to ensure easy accessibility by disabled individuals. Calculate the amount of the disabled access credit available to Golden. 120. Julia is 30 years old, unmarried with a nine year-old daughter, and has earnings during 2024 of $24,700. Does she qualify for the earned income credit? If so, calculate the amount of credit that is available to her. 121. Jack and Jill are married and will file a joint return. They, have three children, and they report earnings during 2024 of $31,500. Do they qualify for the earned income credit? If so, calculate the amount of credit that is available to them. 122. Eduardo and Julia are married, both gainfully employed, and they have two children who are three and six years old. In 2024 Eduardo’s salary is $35,000 while Julia’s is $80,000. During 2024 they spend $7,200 for child care expenses that are required so they can work outside the home. Calculate the couple's credit for child and dependent care expenses for 2024. 123. Bradley and Allie have two college-age children, Clint, a freshman at State University, and Abigail, a junior at Northwest University. Both Clint and Abigail are full-time students. Clint’s expenses during the 2024 fall semester are as follows: $2,400 tuition, $250 books and course materials, and $1,600 room and board. Abigail’s expenses for the 2024 calendar year are as follows: $10,200 tuition, $1,200 books and course materials, and $3,600 room and board. Tuition and the applicable room and board costs are paid at the beginning of each semester. Bradley and Allie file a joint tax return, claims both children as dependents, and reports a combined AGI of $114,000 for 2024. Determine the available education tax credit for 2024. 124. Phil and Marco, a married couple, are both employed by Laurel Corporation. Phil earns $75,000 in salary in 2024, Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments and Marco earns $155,000. How much FICA tax must they pay for 2024? 125. Jain generated $66,000 of net earnings from the conduct of a tax preparation business that she operated during the tax-filing season. She also received wages of $105,200 from her full-time job. Compute Jain's self-employment tax due for 2024. 126. In May 2024, Blue Corporation hired Camilla, Jolene, and Tyrone, all of whom are certified as long-term family assistance recipients. Each employee is paid $27,500 during 2024. a.

Compute Blue’s work opportunity tax credits for 2024.

b.

Assume that Blue pays total wages of $500,000 to its employees during 2024. How much may Blue claim as a wage deduction for 2024 if the work opportunity tax credit is claimed?

127. Use the following selected data to work backward and calculate Devon’s taxable income. Devon itemizes deductions. Tax preferences Positive AMT adjustments Negative AMT adjustments AMTI

$ 45,000 52,000 15,000 290,000

128. Arlene, who is single and itemizes deductions, reports taxable income for 2024 of $612,000. Calculate her alternative minimum tax, if any, given the following additional information. AMT adjustments Positive Negative Tax preferences

$22,000 (25,000) 146,000

129. Michael and Clint are married, have no dependents, and file a joint return in 2024. Use the following information to calculate their Federal income tax liability. AMTI Regular income tax liability AMT preferences

$985,000 121,100 190,000

130. Tad and Audra, who are married filing a joint return, have AMTI of $1,256,000 for 2024. Calculate their AMT exemption. Essay 131. Discuss the Federal income tax treatment of unused general business credits. 132. Explain the purpose of the tax credit for rehabilitation expenditures, and describe the general characteristics of its computation. 133. Explain the purpose of the disabled access credit and describe the general characteristics of its computation. 134. Describe the withholding requirements to be followed by employers. 135. Consider the FICA tax and the self-employment tax. How are these two taxes similar and how do they differ? Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments 136. What is the purpose of the second tax system known as the alternative minimum tax? 137. What is the relationship between taxable income and AMTI? Use formulas as part of your answer. 138. What is the relationship between the regular tax liability and the TMT? 139. Do AMT adjustments and AMT preferences increase or decrease AMTI? 140. What is the purpose of the AMT exemption amount? 141. Explain why the corporate minimum tax could be described as a “book minimum tax.” 142. Explain why some tax policy makers refer to the AMT as a penalty tax. 143. Discuss the relationship between the amount of AMT preferences a taxpayer has and the likelihood of the taxpayer having an AMT liability.

Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments Answer Key 1. True 2. False 3. True 4. False 5. False 6. False 7. False 8. False 9. True 10. True 11. True 12. True 13. True 14. True 15. False 16. False 17. False 18. True 19. False 20. False 21. False 22. False 23. False 24. True 25. False Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments 26. True 27. False 28. True 29. False 30. True 31. False 32. True 33. False 34. True 35. True 36. False 37. False 38. True 39. True 40. False 41. True 42. False 43. False 44. True 45. False 46. True 47. False 48. False 49. False 50. True Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments 51. True 52. False 53. False 54. False 55. True 56. True 57. True 58. False 59. False 60. True 61. True 62. False 63. True 64. True 65. False 66. True 67. d 68. c 69. d 70. d 71. b 72. c 73. d 74. d 75. c 76. b Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments 77. b 78. c 79. c 80. c 81. b 82. d 83. b 84. b 85. d 86. d 87. c 88. a 89. d 90. c 91. d 92. c 93. a 94. c 95. a 96. b 97. d 98. b 99. c 100. c 101. a Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments 102. a 103. c 104. c 105. d 106. b 107. c 108. c 109. b 110. c 111. b 112. d 113. b 114. d 115. b 116. a. Tammy’s adjusted basis in the building before the rehabilitation expenditures and current-year cost recovery is $360,000 ($400,000 – $40,000) minus the cost recovery for the period January through September. Because the rehabilitation expenditures of $600,000 exceed the greater of (1) the adjusted basis of the building before the rehabilitation ($360,000 minus the cost recovery for the period January through September) or (2) $5,000, Tammy is allowed a rehabilitation tax credit of $120,000 (20% × $600,000). Tammy will claim the credit ratably over five years ($24,000 per year). b.

The improvements are treated as separate property items for purposes of computing cost recovery. The recovery period for these improvements begins in October 2024 when the improvements are placed in service by Tammy. (See Rev. Rul. 87-57, 1987-2 C.B. 687.) The cost recovery period for the underlying structure begins in January 2024 when it was placed in service by Tammy. The straight-line method § 168(c) over 39 years under MACRS of § 168(c) must be used. Using Table 8.6 in Chapter 8 for straight-line depreciation for 39-year nonresidential real property, the appropriate cost recovery percentage for the building is 2.461%, and the percentage for the improvements is 0.535%.

Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments Cost recovery of building ($360,000 × 2.461%) Plus: Cost recovery of improvements Cost of improvements Less: Credit (20%) Cost recovery basis

$ 8,860 $600,000 (120,000) $480,000

Cost recovery of improvements ($480,000 × 0.535%) Total cost recovery for 2024

2,568 $11,428

c. Land Building: Cost [$400,000 – $40,000 (land)] Less: Cost recovery Adjusted basis of building Improvements: Cost [$600,000 – $120,000 (credit)] Less: Cost recovery Adjusted basis of improvements Total adjusted basis of property

$ 40,000 $360,000 (8,860) 351,140 $480,000 (2,568)

117. Net income tax Less:

The greater of: ∙ $100,000 (tentative minimum tax) or ∙ $25,000 [25% × ($125,000 – $25,000)] Amount of general business credit allowed

477,432 $868,572

$125,000 * (100,000) $ 25,000

*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). 118. Rick may claim a credit of $53,250 in 2024 ($750,000 × 7.10%). In addition, he may claim a credit of $53,250 per year for each of the next nine years, beginning in 2025, for a total credit of $532,500. 119. Eligible access expenditures ($8,500 + $6,250); limited to $10,250 Less: Threshold amount Powered by Cognero

$10,250 (250) Page 25

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments Disabled access credit base Tax credit rate Disabled access credit

$10,000 × 50% $ 5,000

The expenditures of $8,000 incurred on the building originally placed in service in the current year do not qualify for the credit. The outlay is not considered an eligible expenditure because it is incurred on a structure placed in service after the enactment of the disabled access credit provision in November 5, 1990. 120. Maximum credit available for 2024 ($12,390 × 34%) Less: Credit phaseout Earned income Base for phaseout Excess Phaseout rate Available earned income credit

$4,213 $24,700 (22,720) $ 1,980 × 15.98%

(316) $3,897

121. Earned income ceiling (married with three children) $17,400 Rate × 45.00% Tentative credit $ 7,830 Less: Credit phase-out Earned income $31,500 Base for phase-out (29,640) Excess $1,860 Phase-out rate × 21.06% ( 392) Available earned income credit $7,438

122. For two or more qualifying children, the maximum expense allowed for purposes of the credit for child and dependent care expenses is $6,000. The couple's combined AGI is more than $43,000, so the applicable rate for the credit is 20%. Thus, the credit allowed is $1,200 (20% × $6,000). 123. In 2024, both Clint and Abigail qualify for the American Opportunity credit. Clint’s qualifying expenses are $2,650 ($2,400 tuition and $250 books and course materials); Abigail’s qualifying expenses are $11,400 ($10,200 tuition and $1,200 books and course materials). Clint’s American Opportunity credit is $2,163 [100% of the first $2,000 of qualifying expenses plus 25% of the next $2,000 of qualifying expenses; $2,000 + ($650 × 25%)]. Abigail’s American Opportunity credit is $2,500 (100% of the Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments first $2,000 of qualifying expenses plus 25% of the next $2,000 of qualifying expenses; $2,000 + ($2,000 × 25%)]. Although the American Opportunity credits are subject to a phaseout for higher income taxpayers, Bradley’s AGI of $114,000 is less than the phase-out starting point in 2024 ($160,000 for married taxpayers filing jointly). Thus, the total education credit available for the year is $4,663 ($2,163 + $2,500). 124. Phil will pay $5,738 [(6.2% × $75,000) + (1.45% × $75,000)]. Marco will pay $11,858 [(6.2% × $155,000) + (1.45% × $155,000)], for a total of $17,595 for the couple. 125. Ceiling amount Less: FICA wages Net ceiling

$168,600 (105,200) $ 63,400

Net self-employment income ($66,000 × 92.35%)

$ 60,951

Lesser of net ceiling or net self-employment income

$ 60,951

Social Security portion of the tax ($60,951 × 12.4%) Self-employment earnings subject to the Medicare portion of the self-employment tax: $60,951 × 2.9% Total self-employment tax

$ 7,558 1,768 $ 9,326

126. a. The work opportunity tax credit for 2024 is computed as follows: 3 qualified employees × $6,000 limit on wages for each employee × 40% = b.

$7,200

The wage deduction for 2024 is $492,800 [$500,000 (total wages) – $7,200 (credit)].

Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments

127. AMTI Plus: Negative AMT adjustments Minus: Positive AMT adjustments Minus: Tax preferences Equals: Taxable income

$290,000 15,000 (52,000) (45,000) $208,000

128. Taxable income Plus: Positive AMT adjustments Minus: Negative AMT adjustments Plus: Tax preferences AMTI Minus: Exemption [$85,700 – (25% ($755,000 – $609,350)] AMT base

$612,000 22,000 (25,000) 146,000 $755,000 (49,287)

Tentative minimum tax:

$60,476

$232,600 × 26% $473,113 × 28%

$705,713

Less: Regular income tax liability AMT

$132,472 $192,948 (184,628) $ 8,320

129. AMTI AMT exemption AMT base

$985,000 (133,300) $851,700

$232,600 × 26% = $619,100 × 28% = TMT Regular income tax liability AMT

$ 60,476 173,348 $ 233,824 (121,100) $ 112,724

The AMT preferences of $190,000 are included in the calculation of AMTI. The Federal income tax liability is the sum of Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments the regular income tax liability and the AMT ($121,100 + $112,724 = $233,824).

130. Statutory amount Less phaseout: 25%($1,256,000 – $1,218,700) AMT exemption

$133,300 (9,325) $123,975

131. Unused general business credits are initially carried back one year and applied to reduce the income tax liability during that year. Thus, the taxpayer may receive a tax refund as a result of the carryback. Any remaining unused credits are then carried forward 20 years. A FIFO method is applied to the carrybacks, carryovers, and utilization of credits earned during a particular year. This procedure minimizes the potential for loss of a general business credit benefit. The oldest credits are used first in determining the amount of the general business credit. The FIFO method minimizes the potential for loss of a general business credit benefit due to the expiration of credit carryovers, because the earliest years are used before the current credit for the taxable year. 132. The rehabilitation expenditures credit is intended to discourage businesses from moving from older, economically distressed areas to newer locations, while encouraging the preservation of historic structures. To that end, taxpayers are allowed a tax credit for expenditures incurred to rehabilitate certified historic structures. The credit is 20% of qualified rehabilitation expenditures related to a certified historic structure (either residential or nonresidential). The 20% credit is taken ratably over a 5-year period starting with the year the rehabilitated building is placed in service. To qualify for the credit, certified historic structures must be substantially rehabilitated. A building has been substantially rehabilitated if qualified rehabilitation expenditures exceed the greater of: (1) the adjusted basis of the property before the rehabilitation expenditures, or (2) $5,000. Qualified rehabilitation expenditures do not include the cost of acquiring a building, the cost of facilities related to a building (such as a parking lot), and the cost of enlarging an existing building. 133. The disabled access credit is designed to encourage small businesses to make their businesses more accessible to disabled individuals. The credit is available only to eligible small businesses and is based on eligible access expenditures made by such taxpayers. In general, the credit is calculated at the rate of 50% of the eligible expenditures that exceed $250 but do not exceed $10,250. Therefore, the maximum credit is $5,000 [50% x ($10,250 - $250)]. The credit applies only to buildings placed in service before November 6, 1990. 134. Employers are required to withhold employment taxes (i.e., FICA, which commonly is referred to as Social Security tax) and appropriate amounts for income taxes from each employee’s compensation payments. Though not withheld from the employees’ compensation, the employer also is required to match the FICA portion withheld and fully absorb the cost of FUTA. The FICA tax is comprised of two elements: the Social Security tax and the Medicare tax. In 2024, the withholding for the Social Security component is equal to the gross compensation paid (up to $168,600) × 6.2%, while the entire amount of compensation paid is subject to the Medicare tax at the rate of 1.45%. Employers are also required to withhold the additional Medicare tax of 0.9 percent for employees with wages greater than $200,000. So that the employer can determine the appropriate amount of income tax withheld, the employee must complete a Form W-4, which is used and retained by the employer. Powered by Cognero

Page 29

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments 135. These taxes, commonly referred to as the "Federal payroll taxes,” are levied to support the Social Security and Medicare benefits paid to taxpayers during their retirement years. The FICA tax is levied on salary and wages earned by an employee; the self-employment tax is levied on earnings from self-employment (e.g., gross income from a trade or business less allowable trade or business deductions, and the net income for rendering personal services as an independent contractor). Both taxes have two components: the Social Security tax and the Medicare tax. For Social Security, withholdings from employees must continue until the maximum base amount is reached. In 2024, Social Security withholding (calculated at 6.2% times earned wages subject to Social Security) ceases once the employee has earned wages in the amount of $168,600. For the Medicare portion, the employer is required to withhold at the rate of 1.45% on all wages without limit. In addition, the employer is required to contribute an amount equal to the amount withheld from an employee’s earnings. For 2024, the self-employment tax is 12.4% of self-employment income up to $168,600 and 2.9% of the total amount of self-employment earnings. 136. The AMT was enacted as a backup to the regular tax. Its chief purpose is to ensure that no taxpayer with significant economic income can avoid income tax liability by using the exclusions, deductions, and credits in the regular income tax system. 137. The indirect method typically is used to calculate the AMT (i.e., the starting point of the AMTI calculation is taxable income adjusted for the standard deduction). If the direct method was used, AMTI could be calculated as follows: Gross income computed by applying the AMT rules Minus: Equals: Plus: Equals:

Deductions computed by applying the AMT rules AMTI before tax preferences Tax preferences Alternative minimum taxable income

If the indirect method is used, the model is as follows.

Plus: Minus: Equals: Plus: Equals:

Taxable income Positive AMT adjustments Negative AMT adjustments Taxable income after AMT adjustments Tax preferences Alternative minimum taxable income (AMTI)

138. If the TMT exceeds the regular tax liability, the AMT is the amount of the excess. If the regular tax liability is equal to or greater than the TMT, the AMT is zero. 139. AMT adjustments can be both positive and negative. AMT preferences can be only positive. So, AMT adjustments can increase or decrease AMTI, whereas AMT preferences can only increase AMTI. 140. The AMT exemption amount can be thought of as a materiality provision. As such, it enables a taxpayer with a small amount of positive AMT adjustments and tax preferences to avoid being subject to the AMT.

141. Unlike the individual AMT, where AMTI is the result of adjustments to an individual’s regular taxable income amount, in the corporate minimum tax calculation, the “AMTI” equivalent is an adjusted financial statement (or book) Powered by Cognero

Page 30

Name:

Class:

Date:

Chapter 12: Tax Credits and Payments income amount. As a result, the corporate minimum tax can be described as a book minimum tax. 142. AMT is calculated as the excess of the tentative minimum tax (TMT) over the regular tax liability. Thus, AMT is owed only if TMT is greater than regular tax liability. As a result, those policy makers are suggesting that taxpayers with TMT in excess of regular tax liability are being “penalized” and required to pay additional tax. 143. All else being equal, the higher the dollar amount of preferences that a particular taxpayer has, the greater the likelihood of an AMT liability. Preference amounts strictly increase the taxable income starting point of the AMTI calculation. And, preferences are permanent differences (i.e., they do not reverse in future tax years). As a result, a larger dollar amount of preferences is correlated with a higher AMTI and a higher likelihood of having an AMT liability.

Powered by Cognero

Page 31

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges True / False 1. Realized gain or loss is measured by the difference between the amount realized from the sale or other disposition of property and the property’s adjusted basis at the date of disposition. a. True b. False 2. In computing the amount realized when the fair market value of the property received cannot be determined, the fair market value of the property surrendered may be used. a. True b. False 3. If Wal-Mart stock increases in value during the tax year by $6,000, the amount realized is $6,000. a. True b. False 4. If the buyer assumes the seller’s liability on the property acquired, the seller’s amount realized is decreased by the amount of the liability assumed. a. True b. False 5. The fair market value of property received in a sale or other disposition is the price at which property will change hands between a willing seller and a willing buyer when neither is compelled to sell or buy. a. True b. False 6. If a seller assumes the buyer’s liability on the property acquired, the buyer’s adjusted basis for the property is increased by the amount of the liability assumed. a. True b. False 7. Expenditures made for ordinary repairs and maintenance of property are not added to the original basis in the determination of the property’s adjusted basis, whereas capital expenditures are added to the original basis. a. True b. False 8. Manuel purchases land and a factory building for his business for $300,000 with $100,000 being allocated to the land. During the first year, Manuel deducts cost recovery of $4,922. The adjusted basis for the building at the end of the first year is $195,078 ($200,000 – $4,922). a. True b. False 9. Monroe’s delivery truck is damaged in an accident. His adjusted basis for the delivery truck prior to the accident is $20,000. If Monroe receives insurance proceeds of $21,000 and recognizes a casualty gain of $1,000, his adjusted basis for the delivery truck after the accident is $21,000. a. True Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges b. False 10. Reggie owns all the stock of Amethyst, Inc. (adjusted basis of $100,000). If he receives a distribution from Amethyst of $90,000 and corporate earnings and profits are $15,000, Reggie reports a capital gain of $5,000 and takes an adjusted basis for his Amethyst stock of $0. a. True b. False 11. The amount of a corporate distribution qualifying for capital recovery treatment that exceeds the shareholderrecipient’s basis in the stock investment is treated as a capital gain. a. True b. False 12. The adjusted basis for a taxable bond purchased at a premium is reduced if the amortization election is made. The amount of the amortized premium is treated as an interest deduction. a. True b. False 13. Helen purchases a $10,000 corporate bond at a premium of $1,000 and elects to amortize the premium. On the later sale of the bond for $10,800, she has amortized $300 of the premium. Helen reports a recognized gain of $800 ($10,800 amount realized – $10,000 adjusted basis). a. True b. False 14. A realized gain on the sale or exchange of a personal use asset is recognized, but a realized loss on the sale, exchange, or condemnation of a personal use asset is not recognized. a. True b. False 15. Wade is a salesman for a real estate development company. Because he is the “salesperson of the year,” he is permitted to purchase a lot from the developer for $90,000. The fair market value of the lot is $150,000 and the developer’s adjusted basis is $100,000. Wade must recognize a gain of $10,000 ($100,000 developer’s adjusted basis – $90,000 cost to Wade), and his adjusted basis for the lot is $100,000 ($90,000 cost + $10,000 recognized gain). a. True b. False 16. A taxpayer who has purchased several lots of stock on different dates at different purchase prices and cannot identify the lot of stock that is being sold should use either a weighted average approach or a LIFO approach. a. True b. False 17. Lump-sum purchases of land and a building are allocated on the basis of the relative fair market values of the individual assets acquired. a. True b. False Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 18. Purchased goodwill is assigned a basis equal to cost, which is calculated using the residual method associated with the purchase of a business. a. True b. False 19. The holding period for nontaxable stock dividends that are the same type (i.e., common on common) includes the holding period of the original shares, but the holding period for nontaxable stock dividends that are not the same type (i.e., preferred on common) is new and begins on the date the dividend is received. a. True b. False 20. The amount of the loss basis of a gift will differ from the amount of the gain basis only if at the date of the gift the adjusted basis of the property exceeds the property’s fair market value. a. True b. False 21. The basis for depreciation on depreciable gift property received is the donor’s adjusted basis of the property at the date of the gift (assuming no gift taxes are paid). The rule applies regardless of whether the fair market value at the date of the gift is greater than or less than the donor’s adjusted basis. a. True b. False 22. The holding period for property acquired by gift is automatically long term. a. True b. False 23. The basis of inherited property usually is its fair market value on the date of the decedent’s death. a. True b. False 24. If the fair market value of the property on the date of death is greater than on the alternate valuation date, the use of the alternate valuation amount is mandatory. a. True b. False 25. If a husband inherits his deceased wife’s share of jointly owned property in a common law state, both the husband’s original share and the share inherited from the deceased wife are stepped-up or down to the fair market value at the date of the wife’s death. a. True b. False

26. Parker bought a brand new Ferrari on January 1, for $125,000. Parker was fatally injured in an auto accident on June 23, when the fair market value of the car was $105,000. Parker was driving a loaner car from the Ferrari dealership while his car was being serviced. In his will, Parker left the Ferrari to his best friend, Ryan. Ryan’s holding period for the Ferrari begins on January 1. Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges a. True b. False 27. Transactions between related parties that result in disallowed losses might later provide a tax benefit to the related party buyer. a. True b. False 28. If losses are disallowed in a related-party transaction, the holding period for the buyer includes the holding period of the seller. a. True b. False 29. Ben sells stock (adjusted basis of $25,000) to his son, Ray, for its fair market value of $15,000. Ray gives the stock to his daughter, Trish, who subsequently sells it for $26,000. Ben’s recognized loss is $0 and Trish’s recognized gain is $1,000 ($26,000 – $15,000 – $10,000). a. True b. False 30. The basis of property acquired in a wash sale is its cost plus the loss not recognized on the wash sale. a. True b. False 31. Realized losses from the sale or exchange of stock are disallowed if within 30 days before or 30 days after the sale or exchange, the taxpayer acquires substantially identical stock. a. True b. False 32. Gene purchased for $45,000 an SUV that he uses 100% for personal purposes. When the SUV is worth $30,000, he contributes it to his business. The gain basis is $45,000, the loss basis is $30,000, and the basis for cost recovery is $45,000. a. True b. False 33. The basis for gain and loss of personal use property converted to business use is the lower of the adjusted basis or the fair market value on the date of conversion. a. True b. False 34. Stuart owns land with an adjusted basis of $190,000 and a fair market value of $500,000. If the property is going to be given to Stuart’s nephew, Alex, it is preferable for Federal income tax purposes for the transfer to be by inheritance rather than by gift. a. True b. False 35. The taxpayer owns stock with an adjusted basis of $15,000 and a fair market value of $8,000. If the stock or cash is Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges going to be given to her niece, it is preferable for the taxpayer to sell the stock and give the $8,000 cash to her niece. a. True b. False 36. Broker’s commissions, legal fees, and points paid by the seller reduce the seller’s amount realized. a. True b. False 37. Nontaxable stock dividends result in no change to the total basis of the old and new stock, but the basis per

share decreases. a. True b. False 38. The terms “realized gain” and “recognized gain” can be used interchangeably; they mean the same thing. a. True b. False 39. In general, the amount realized from a sale of property does not include any liability assumed by the buyer. a. True b. False 40. The adjusted basis of an asset is the original cost (or basis) plus capital recoveries less capital additions. a. True b. False 41. A loss from the sale of a personal use asset that would be disallowed cannot be recognized even if the taxpayer converts the asset to business use prior to its sale. a. True b. False 42. The basis of property acquired in a bargain purchase is its cost. a. True b. False 43. The wash sales rules apply to both gains and losses. a. True b. False 44. Gains and losses on nontaxable exchanges are deferred because the tax law recognizes that nontaxable exchanges result in a change in the substance but not the form of the taxpayer’s relative economic position. a. True b. False 45. In a nontaxable exchange, recognition is postponed. In a tax-free transaction, nonrecognition is permanent. a. True Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges b. False 46. In a nontaxable exchange, the replacement property is assigned a carryover basis if there is a realized gain but receives a new basis if there is a realized loss. a. True b. False 47. The nonrecognition of gains and losses for like-kind exchanges is mandatory for gains and elective for losses. a. True b. False 48. To qualify as a like-kind exchange, real property must be exchanged either for other real property or for personal property. a. True b. False 49. The exchange of unimproved real property located in Topeka, KS, for improved real property located in Atlanta, GA, does not qualify as a like-kind exchange. a. True b. False 50. Lola owns land as an investor. She exchanges the land for a warehouse that she leases to a tenant who uses it to store his business inventory. The exchange qualifies for like-kind exchange treatment. a. True b. False 51. A building located in Virginia (used in business) exchanged for a building located in France (used in business) cannot qualify for like-kind exchange treatment. a. True b. False 52. An exchange of two items of personal property that belong to different general business asset classes qualifies for nonrecognition as a like-kind exchange if both properties are used in the taxpayer’s trade or business. a. True b. False 53. If boot is received in a like-kind exchange, the recognized gain cannot exceed the realized gain. a. True b. False 54. Shari exchanges an office building in New Orleans (adjusted basis of $700,000) for an apartment building in Baton Rouge (fair market value of $900,000). In addition, she receives $100,000 of cash. Shari’s recognized gain is $100,000 and her basis for the apartment building is $800,000 ($700,000 adjusted basis + $100,000 recognized gain). a. True b. False Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 55. When boot in the form of cash is given in a like-kind exchange, recognized gain is the greater of the boot or the realized gain. a. True b. False 56. Cole exchanges an asset (adjusted basis of $15,000; fair market value of $25,000) for another asset (fair market value of $19,000). In addition, he receives cash of $6,000. If the exchange qualifies as a like-kind exchange, his recognized gain is $6,000, and his adjusted basis for the property received is $21,000 ($15,000 + $6,000 recognized gain). a. True b. False 57. The basis of boot received in a like-kind exchange is its fair market value unless the realized gain is a smaller amount. a. True b. False 58. Terry exchanges real estate (acquired on August 25, 2018) held for investment for other real estate to be held for investment on September 1, 2024. None of the realized gain of $10,000 is recognized, and Terry’s adjusted basis for the new real estate is a carryover basis of $80,000. Consequently, Terry’s holding period for the new real estate begins on August 25, 2018. a. True b. False 59. If boot is received in a like-kind exchange that results in some of the realized gain being recognized, the holding period for both the like-kind property and the boot received begins on the date of the exchange. a. True b. False 60. If a taxpayer exchanges like-kind property and assumes a liability associated with the property received, the taxpayer is considered to have received boot in the transaction. a. True b. False 61. An involuntary conversion results from the destruction (complete or partial), theft, seizure, requisition or condemnation, or the sale or exchange under threat or imminence of requisition or condemnation of the taxpayer’s property. a. True b. False 62. Section 1033 (nonrecognition of gain from an involuntary conversion) applies to both gains and losses. a. True b. False 63. Antonio’s building, which houses his retail sporting goods store, is destroyed by a flood. Sandra’s warehouse, which she is leasing to Antonio to store the inventory of his business, is also destroyed in the same flood. Both Antonio and Sandra receive insurance proceeds that result in a realized gain. Sandra will have less flexibility than Antonio in the type of building in which she can invest the proceeds and qualify for postponement treatment under § 1033 (nonrecognition of Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges gain from an involuntary conversion). a. True b. False 64. Sidney, a calendar year taxpayer, owns a building (adjusted basis $450,000) in Columbus, OH, in which he conducts his retail computer sales business. The building is destroyed by fire on December 12, 2024, and two weeks later he receives insurance proceeds of $600,000. Due to family ties, Sidney decides to move to Columbia, SC. He reinvests all of the insurance proceeds in a building in Columbia where he opens a retail computer sales business on April 2, 2025. By electing § 1033, Sidney incurs a zero recognized gain and takes a basis in the new building of $450,000 ($600,000 cost – $150,000 postponed gain). a. True b. False 65. Dennis, a calendar year taxpayer, owns a warehouse (adjusted basis of $190,000) that is destroyed by a tornado in October 2024. He receives insurance proceeds of $250,000 in January 2025. If before 2027, Dennis replaces the warehouse with another warehouse costing at least $250,000, he can elect to postpone the recognition of any realized gain. a. True b. False 66. If a taxpayer reinvests the net proceeds (amount received minus related expenses) received in an involuntary conversion in qualifying replacement property within the statutory time period, it is possible to defer the recognition of the realized gain. a. True b. False 67. If an election to postpone gain under § 1033 is made, the holding period of replacement property includes the holding period of the involuntarily converted property. a. True b. False 68. Bria’s office building (basis of $225,000 and fair market value of $275,000) is destroyed by a hurricane. Bria receives insurance proceeds of $192,500 two months after the date of the loss. One month later, Bria uses the insurance proceeds and other funds to purchase a new office building for $275,000. Her adjusted basis for the new building is $307,500 ($275,000 cost + $32,500 postponed loss). a. True b. False 69. Casualty losses and condemnation losses on the involuntary conversion of a personal residence receive the same tax treatment. a. True b. False 70. If the recognized gain on an involuntary conversion equals the realized gain because of a reinvestment deficiency, the basis of the replacement property will be more than its cost (cost plus realized gain). a. True b. False Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 71. The taxpayer must elect to have the exclusion of gain under § 121 (sale of principal residence) apply. a. True b. False 72. At one point in time, a taxpayer can have two principal residences for § 121 exclusion purposes. a. True b. False 73. To qualify for the § 121 exclusion, the property must have been used by the taxpayer for the five years preceding the date of sale and owned by the taxpayer as the principal residence for the last two of those years. a. True b. False 74. A taxpayer who sells their principal residence at a realized loss can elect to recognize the loss if a qualified residence is acquired during the statutory time period. a. True b. False 75. Wyatt sells his principal residence in December 2024 and qualifies for the § 121 exclusion. He sells another principal residence in November 2025. Under no circumstance can Wyatt qualify for the § 121 exclusion on the sale of the second residence. a. True b. False 76. Kendra owns a home in Atlanta. Her company transfers her to Chicago on January 2, 2024, and she sells the Atlanta house in early February 2024. She purchases a residence in Chicago on February 3, 2024. On December 15, 2024, Kendra’s company transfers her to Los Angeles. In January 2025, she sells the Chicago residence and purchases a residence in Los Angeles. Because multiple sales have occurred within a two-year period, § 121 treatment does not apply to the sale of the second home. a. True b. False 77. The maximum amount of the § 121 gain exclusion on sale of a principal residence is $250,000 for a single individual and $500,000 for a married couple. a. True b. False 78. Deidra has owned and occupied her principal residence for 10 years. Two and one-half years ago, she married Doug, who moved into her house. Doug never owned a home. When Deidra is transferred to another city, she sells the house at a realized gain of $425,000. Deidra can exclude the realized gain of $425,000 from her gross income under § 121 if she and Doug file a joint return. a. True b. False 79. Kelly, who is single, sells her principal residence, which she has owned and occupied for eight years, for $375,000. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges The adjusted basis is $64,000 and selling expenses are $22,000. She purchases another principal residence three months later for $200,000. Her recognized gain is $39,000 and her basis for the new principal residence is $200,000. a. True b. False 80. Matt, who is single, sells his principal residence, which he has owned and occupied for five years, for $435,000. The adjusted basis is $140,000 and the selling expenses are $20,000. Three days after the sale, he purchases another residence for $385,000. Matt’s recognized gain is $25,000 and his basis for the new residence is $385,000. a. True b. False 81. Abby exchanges an SUV that she has held for personal use plus $24,000 for a new SUV that she will use exclusively in her business. This is a qualified like-kind exchange. a. True b. False Multiple Choice 82. Albert purchased a tract of land for $140,000 in 2021 when he heard that a new highway was going to be constructed through the property and that the land would soon be worth $200,000. Highway engineers surveyed the property and indicated that he would probably get $180,000. The highway project was abandoned in 2024 and the value of the land fell to $100,000. What is the amount of loss Albert can claim in 2024? a. $0 b. $40,000 c. $80,000 d. $100,000 83. Abby sells real property for $300,000. The buyer pays $5,000 in property taxes that had accrued during the year while the property was still legally owned by Abby. In addition, Abby pays $15,000 in commissions and $3,000 in legal fees in connection with the sale. How much does Abby realize (the amount realized) from the sale of her property? a. $277,000 b. $282,000 c. $287,000 d. $300,000 84. Bayarmaa owns land with an adjusted basis of $610,000 subject to a mortgage of $350,000. On April 1, Bayarmaa sells her land subject to the mortgage for $650,000 in cash, a note for $600,000, and property with a fair market value of $120,000. What is the amount realized? a. $1,250,000 b. $1,370,000 c. $1,720,000 d. $1,820,000 85. Pedro borrowed $250,000 to purchase a machine costing $300,000. He later borrowed an additional $25,000 using the machine as collateral. Both notes are nonrecourse. Eight years later, the machine has an adjusted basis of zero and two outstanding note balances of $145,000 and $18,000. Pedro sells the machine subject to the two liabilities for $45,000. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges What is his realized gain or loss? a. $0 b. $45,000 c. $163,000 d. $208,000 86. The bank forecloses on Lisa’s apartment complex. The property had been pledged as security on a nonrecourse mortgage whose principal amount at the date of foreclosure is $750,000. The adjusted basis of the property is $480,000, and the fair market value is $750,000. What is Lisa’s recognized gain or loss? a. $270,000 b. ($750,000) c. $0 d. ($480,000) 87. Carlton purchases land for $550,000. He incurs legal fees of $10,000 and broker’s commission of $28,000 associated with the purchase. He subsequently incurs additional legal fees of $25,000 in having the land rezoned from agricultural to residential. He subdivides the land and installs streets and sewers at a cost of $800,000. What is Carlton’s basis for the land and the improvements? a. $1,350,000 b. $1,378,000 c. $1,385,000 d. $1,413,000 88. Janice bought her house about 10 years ago for $395,000. Since then, she has deducted $70,000 in depreciation associated with her home office and has spent $45,000 replacing all the old pipes and plumbing. She sells the house on July 1, this year. Her realtor charged $34,700 in commissions. Prior to listing the house with the realtor, she spent $300 advertising in the local newspaper. Don buys the house for $500,000 in cash and assumes her mortgage of $194,000. What is Janice’s adjusted basis at the date of the sale and the amount realized? a. $370,000 adjusted basis; $661,400 amount realized. b. $370,000 adjusted basis; $659,000 amount realized. c. $370,000 adjusted basis; $665,200 amount realized. d. $325,000 adjusted basis; $663,200 amount realized. 89. Gianna’s automobile, which is used exclusively in her trade or business, was damaged in an accident. The adjusted basis prior to the accident was $11,000. The fair market value before the accident was $10,000 and the fair market value after the accident is $6,000. Insurance proceeds of $3,200 are received. What is Gianna’s adjusted basis for the automobile after the casualty? a. $0 b. $7,000 c. $7,800 d. $10,200 90. Yolanda buys a house in the mountains for $450,000 that she uses as her personal vacation home. She builds an additional room on the house for $40,000. She sells the property for $560,000 and pays $28,000 in commissions and $4,000 in legal fees in connection with the sale. What is the recognized gain or loss on the sale of the house? Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges a. $0 b. $38,000 c. $70,000 d. $110,000 91. In computing asset basis, capital recoveries include: a. The cost of capital improvements. b. Ordinary repair and maintenance expenditures. c. Payments made on the principal of a mortgage on taxpayer’s building. d. Amortization of bond premium. 92. Joyce’s office building was destroyed in a fire (adjusted basis of $350,000; fair market value of $400,000). Of the insurance proceeds of $360,000 she receives, Joyce uses $310,000 to purchase additional inventory and invests the remaining $50,000 in short-term certificates of deposit. She received only $360,000 because of a co-insurance clause in her policy. What is Joyce’s recognized gain or loss? a. $0 b. $10,000 loss c. $10,000 gain d. $40,000 gain 93. Jason owns Blue Corporation bonds (face value of $10,000), purchased on January 1, 2024, for $11,000. The bonds have an annual interest rate of 3% and a maturity date of December 31, 2033. Jason elects to amortize the bond premium and, using the effective interest rate method, determines that the bond premium amortization for 2024 is $100. What are his taxable interest income for 2024 and the adjusted basis for the bonds at the end of 2024? a. $300 and $11,000 b. $300 and $10,900 c. $200 and $11,000 d. $200 and $10,900 94. A strip along the boundary of Joy’s land is condemned for a utility easement. She receives a payment of $7,500 from the utility company. Her basis in the land is $80,000. Which of the following is correct? a. Joy must include the $7,500 in gross income. b. Joy must reduce the basis of the land by $7,500. c. Joy must include the $7,500 in the gross income and increase the basis of the land by $7,500. d. Only choices a. and c. are correct. 95. In 2020, Jin purchased a classic car that he planned to restore for $12,000. However, Jin is too busy to work on the car and he gives it to his daughter Wei in 2024. At that time, the fair market value of the car had declined to $10,000. Jin paid no gift tax on the transaction. Wei completes some of the restoration herself with out-of-pocket costs of $5,000. She later sells the car for $30,000. What is Wei’s recognized gain or loss on the sale of the car? a. $0 b. $13,000 c. $15,000 d. $18,000 Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 96. Katie sells her personal use automobile for $12,000. She purchased the car three years ago for $25,000. What is Katie’s recognized gain or loss? a. $0 b. $12,000 c. ($13,000) d. ($25,000) 97. Noelle owns an automobile for personal use. Her adjusted basis is $45,000 (i.e., the original cost). The car is worth $22,000. Which of the following statements is correct? a. If Noelle sells the car for $22,000, her realized loss of $23,000 is not recognized. b. If Noelle exchanges the car for another car worth $22,000, her realized loss of $23,000 is not recognized. c. If the car is stolen and it is uninsured, Noelle will not be able to recognize part of her realized loss of $23,000. d. Choices a., b., and c. are correct. 98. Mary sells her personal use automobile for $20,000. She purchased the car two years ago for $17,000. What is Mary’s recognized gain or loss? It increased in value due to its excellent mileage and high safety ratings. a. $0 b. $3,000 c. $17,000 d. $20,000 99. Nat is a salesman for a real estate developer. His employer permits him to purchase a lot for $75,000. The employer’s adjusted basis for the lot is $45,000, and its normal selling price is $90,000. What is Nat’s recognized gain and his basis for the lot? Recognized Gain Basis a. $0 $ 75,000 b. $0 $ 90,000 c. $15,000 $ 75,000 d. $15,000 $ 90,000 100. Over the past 20 years, Alfred has purchased 380 shares of Green, Inc., common stock. His first purchase was in 2001 when he acquired 30 shares for $20 a share. In 2008, Alfred bought 150 shares at $10 a share. In 2023, Alfred acquired 200 shares at $50 a share. He intends to sell 125 shares at $60 per share in 2024. If Alfred’s objective is to minimize gain and assuming he can adequately identify the shares to be sold, what is his recognized gain? a. $1,250 b. $3,520 c. $5,950 d. $6,250 101. Mona purchased a business from Judah for $1,000,000. Judah’s records and an appraiser provided her with the following information regarding the assets purchased. Land

Adjusted Basis $195,000

Powered by Cognero

FMV $270,000 Page 13

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges Building Equipment

310,000 95,000

450,000 180,000

What is Mona’s adjusted basis for the land, building, and equipment? a. Land $270,000, building $450,000, equipment $180,000. b. Land $195,000, building $575,000, equipment $230,000. c. Land $195,000, building $310,000, equipment $95,000. d. Land $270,000, building $521,429, equipment $208,571. 102. Nontaxable stock dividends result in: a. A higher cost per share for all shares than before the stock dividend. b. A lower cost per share for all shares than before the stock dividend. c. An increase in the total cost of the old and new stock combined. d. A decrease in the total cost of the old and new stock combined. 103. Kevin purchased 5,000 shares of Purple Corporation stock at $10 per share. Two years later, he receives a 5% common stock dividend. At that time, the common stock of Purple Corporation had a fair market value of $12.50 per share. What is the basis of the Purple stock, the per share basis, and gain recognized upon receipt of the common stock dividend? a. $50,000 basis in stock, $10 basis per share for the original stock and $0 basis per share for the dividend shares, $0 recognized gain. b. $50,000 basis in stock, $9.52 basis per share, $0 recognized gain. c. $53,125 basis in stock, $10 basis per share for the original stock and $12.50 basis per share for the dividend shares, $3,125 recognized gain. d. $53,125 basis in stock, $10.12 basis per share, $3,125 recognized gain. 104. Ralph gives his daughter, Angela, stock (basis of $8,000; fair market value of $6,000). A $0 gift tax results. If Angela subsequently sells the stock for $10,000, what is her recognized gain or loss? a. $0 b. $2,000 c. $4,000 d. $10,000 105. Gift property (disregarding any adjustment for gift tax paid by the donor): a. Has a $0 basis to the donee because they did not pay anything for the property. b. Has the same basis to the donee as the donor’s adjusted basis if the donee disposes of the property at a gain. c. Has the same basis to the donee as the donor’s adjusted basis if the donee disposes of the property at a loss, and the fair market value on the date of gift was less than the donor’s adjusted basis. d. Has a $0 basis to the donee if the fair market value on the date of gift is less than the donor’s adjusted basis. 106. Shontelle received a gift of income-producing property with an adjusted basis of $49,000 to the donor and fair market value of $35,000 on the date of gift. No Federal gift tax was paid by the donor. Shontelle subsequently sold the property for $31,000. What is the recognized gain or loss? a. $0 b. ($4,000) Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges c. ($10,000) d. ($18,000) 107. Noelle received dining room furniture as a gift from her friend, Jane. Jane’s adjusted basis was $9,200 and the fair market value on the date of the gift was $7,000. Noelle decided she did not need the furniture and sold it to a neighbor six months later for $6,500. What is her recognized gain or loss? a. $0 b. ($500) c. ($2,700) d. $6,500 108. The holding period of property acquired by gift may begin on: a. The date the property was acquired by the donor only. b. The date of gift only. c. Either the date the property was acquired by the donor or the date of gift. d. The last day of the tax year in which the property was originally acquired by the donor. 109. Nancy gives Manuel a crane to use in his business with a fair market value of $61,000 and a basis in Nancy’s hands of $80,000. No Federal gift tax was paid. What is Manuel’s basis for depreciation (cost recovery)? a. $0 b. $19,000 c. $61,000 d. $80,000 110. Which of the following is correct? a. The gain basis for property received by gift is the lesser of the donor’s adjusted basis or the fair market value on the date of the gift. b. The gain basis for property received by gift is the same as the donor’s basis. c. The gain basis for inherited property is the same as the decedent’s basis. d. The loss basis for inherited property is the lesser of the decedent’s basis or the fair market value on the date of the decedent’s death. 111. Tobin inherited 100 acres of land on the death of his father in 2024. A Federal estate tax return was filed and the land was valued at $300,000 (its fair market value at the date of the death). Tobin's father originally acquired the land in 1983 for $19,000 and prior to his death made permanent improvements of $6,000. What is Tobin’s basis in the land? a. $19,000 b. $25,000 c. $300,000 d. $325,000 112. Neal and his wife Faye reside in Texas, a community property state. Their community property consists of real estate (adjusted basis of $800,000; fair market value of $6 million) and personal property (adjusted basis of $390,000; fair market value of $295,000). Neal dies first and leaves his estate to Faye. What is Faye’s basis in the property after Neal’s death? a. $800,000 real estate and $295,000 personal property. Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges b. $800,000 real estate and $390,000 personal property. c. $3,400,000 real estate and $295,000 personal property. d. $6,000,000 real estate and $295,000 personal property. 113. Robert and Diane, husband and wife, live in Pennsylvania, a common law state. They purchased land as joint tenants in 2020 for $300,000. In 2024, Diane dies and bequeaths her share of the land to Robert. The land has a fair market value of $450,000. What is Robert’s adjusted basis for the land? a. $300,000 b. $375,000 c. $450,000 d. $750,000 114. Taylor inherited 100 acres of land on the death of his father in 2024. A Federal estate tax return was filed and this land was valued in the return at $650,000, its fair market value at the date of the father’s death. The father acquired the land in 2000 for $112,000. Prior to his death, he had expended $20,000 on permanent improvements. Taylor’s holding period for the land: a. Will begin with the date his father acquired the property. b. Will automatically be long term. c. Will begin with the date of his father’s death. d. Will begin with the date the property is distributed to him. 115. Ayla inherits land that had a basis to the decedent of $95,000 and a fair market value of $50,000 on August 4, 2024, the date of the decedent’s death. The executor distributes the land to Ayla on November 12, 2024, at which time the fair market value is $49,000. The fair market value on February 4, 2025, is $45,000. In filing the estate tax return, the executor elects the alternate valuation date. Ayla sells the land on June 10, 2025, for $48,000. What is her recognized gain or loss? a. ($1,000) b. ($2,000) c. ($47,000) d. $1,000 116. Arthur owns a tract of undeveloped land (adjusted basis of $145,000) that he sells to his son, Ned, for its fair market value of $105,000. What is Arthur’s recognized gain or loss and Ned’s basis in the land? a. $0 and $105,000. b. $0 and $145,000. c. ($40,000) and $105,000. d. ($40,000) and $145,000. 117. Ricardo sells property with an adjusted basis of $45,000 to his daughter Teresa for $38,000. Teresa subsequently sells the property to her brother, Jorge, for $38,000. Three years later, Jorge sells the property to Han, an unrelated party, for $50,000. What is Jorge’s recognized gain or loss on the sale of the property to Han? a. $0 b. $5,000 c. $12,000 d. ($5,000) Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 118. The basis of personal use property converted to business use is: a. Always the lower of its adjusted basis or fair market value on the date of conversion. b. Always its adjusted basis on the date of conversion. c. Always the higher of its adjusted basis or fair market value on the date of conversion. d. None of these choices are correct. 119. Lynn purchases a house for $52,000. She converts the property to rental property when the fair market value is $115,000. After deducting depreciation (cost recovery) expense of $1,130, she sells the house for $120,000. What is her recognized gain or loss? a. $0 b. $6,130 c. $37,630 d. $69,130 120. Under the Internal Revenue Code, the holding period for property acquired by inheritance is always: a. Long term. b. Short term. c. Determined by the date acquired by the individual who died. d. Determined by the date of death. 121. Todd converts his house into a rental property on January 2, 2024. Todd’s basis in the house is $400,000, and its fair market value on the date of conversion is $376,000. What is Todd’s basis for purposes of MACRS cost recovery? a. $0; because it was converted from personal use, it cannot be depreciated. b. $376,000. c. $388,000. d. $400,000. 122. Anya owns land with an adjusted basis of $305,000, subject to a mortgage of $175,000. On April 1, 2024, Anya sells her land subject to the mortgage for $325,000 in cash, a note for $300,000, and property with a fair market value of $60,000. What is Anya’s amount realized on this sale? a. $685,000. b. $800,000. c. $840,000. d. $860,000. 123. Valarie purchases a rental house and land for $180,000 during a depressed real estate market. Appraisals place the value of the house at $140,000 and the land at $60,000 (a total of $200,000). What is Valarie’s basis in the house? a. $126,000. b. $140,000. c. $180,000. d. $200,000. 124. Karen purchased 100 shares of Gold Corporation stock for $11,500 on January 2, 2024. During 2024, she sells 25 shares of the 100 shares purchased on January 2, 2024, for $2,500. Twenty-five days earlier, she had purchased 30 shares Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges for $3,000. What is Karen’s recognized gain or loss on the sale of the stock, and what is her basis in the 30 shares purchased 25 days earlier? a. $375 recognized loss, $3,000 basis in new stock. b. $0 recognized loss, $3,000 basis in new stock. c. $0 recognized loss, $3,375 basis in new stock. d. $0 recognized loss, $3,450 basis in new stock. 125. Terry owns Lakeside, Inc. stock (adjusted basis of $80,000), which she sells to her brother, Jake, for $64,000 (its fair market value). Eighteen months later, Jake sells the stock to Pamela, a friend, for $78,000 (its fair market value). What is Terry’s recognized loss, Jake’s recognized gain or loss, and Pamela’s adjusted basis for the stock? Terry's Recognized Loss a. $0 b. $0 c. $0 d. $16,000

Jake's Recognized Gain (Loss) $0 $14,000 $14,000 $14,000

Pamela's Basis $78,000 $64,000 $78,000 $78,000

126. Which of the following statements is correct? a. In a nontaxable exchange in which gain is realized, the transaction results in a permanent recovery of more than the taxpayer’s cost or other basis for tax purposes. b. In a nontaxable exchange in which loss is realized, the transaction results in a permanent recovery of less than the taxpayer’s cost or other basis for tax purposes. c. In a tax-free transaction in which gain is realized, the transaction results in the permanent recovery of more than the taxpayer’s cost or other basis for tax purposes. d. All of these choices are correct. 127. To qualify for like-kind exchange treatment under § 1031, which of the following requirements must be satisfied? a. The form of the transaction is a sale or exchange. b. Both the property transferred and the property received are held either for productive use in a trade or business or for investment. c. The exchange must be completed by the end of the second tax year following the tax year in which the taxpayer relinquishes their like-kind property. d. Only choices a. and b. 128. Which of the following exchanges qualifies for nonrecognition treatment as a like-kind exchange? a. Partnership interest for a partnership interest. b. Inventory for inventory. c. Securities for personalty. d. Business realty for investment realty. 129. Amir owns investment land located in Tucson, AZ. He exchanges it for other investment land. In which of the following locations may the other investment land be located and enable Amir to qualify for like-kind exchange treatment? a. Tokyo, Japan. Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges b. Toronto, Canada. c. Paris, France. d. None of these choices are correct. 130. Lily exchanges a building she uses in her rental business for a building owned by Kendall. She will use the building in her rental business. The adjusted basis of Lily’s building is $120,000 and the fair market value is $170,000. Which of the following statements is correct? a. Lily’s recognized gain is $50,000 and her basis for the building received is $120,000. b. Lily’s recognized gain is $50,000 and her basis for the building received is $170,000. c. Lily’s recognized gain is $0 and her basis for the building received is $120,000. d. Lily’s recognized gain is $0 and her basis for the building received is $170,000. 131. Which of the following statements is correct? a. The receipt of boot in a like-kind exchange can result in the recognition of gain. b. The receipt of boot in a like-kind exchange cannot result in the recognition of loss. c. The giving of boot in a like-kind exchange can result in the recognition of gain. d. All of these. 132. Alissa exchanges land with an adjusted basis of $22,000 and a fair market value of $30,000 for another parcel of land with a fair market value of $28,000 and $2,000 cash. What is Alissa’s recognized gain or loss? a. $0 b. $2,000 c. $6,000 d. $8,000 133. Mateo exchanges a rental house at the beach with an adjusted basis of $225,000 and a fair market value of $200,000 for a rental house at the mountains with a fair market value of $180,000 and cash of $20,000. What is the recognized gain or loss? a. $0 b. $20,000 c. ($20,000) d. ($25,000) 134. Martin exchanges a warehouse for a building he will use as an office building. The adjusted basis of the warehouse is $600,000 and the fair market value of the office building is $350,000. In addition, Martin receives cash of $150,000. What is the recognized gain or loss and the basis of the office building? a. $0 and $350,000. b. $0 and $450,000. c. ($150,000) and $300,000. d. ($200,000) and $350,000. 135. Isabis exchanges a rental building, which has an adjusted basis of $520,000, for investment land which has a fair market value of $700,000. In addition, Isabis receives $100,000 in cash. What is the recognized gain or loss and the basis of the investment land? Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges a. $0 and $420,000. b. $100,000 and $420,000. c. $100,000 and $520,000. d. $280,000 and $700,000. 136. If boot is received in a like-kind exchange and gain is recognized, which formula correctly calculates the basis for the like-kind property received? a. Adjusted basis of like-kind property surrendered + gain recognized – fair market value of boot received. b. Fair market value of like-kind property surrendered + gain recognized + fair market value of boot received. c. Fair market value of like-kind property received – postponed gain. d. Only choices a. and c. 137. In determining the basis of like-kind property received, postponed losses are: a. Added to the basis of the old property. b. Subtracted from the basis of the old property. c. Added to the fair market value of the like-kind property received. d. Subtracted from the fair market value of the like-kind property received. 138. Molly exchanges land (adjusted basis of $85,000; fair market value of $78,000) used in her business and common stock held for investment (adjusted basis of $10,000; fair market value of $15,000) for a single parcel of land (fair market value of $93,000) to be used in her business in a like-kind exchange. What is Molly’s recognized gain or loss? a. $0 b. $5,000 c. ($2,000) d. ($7,000) 139. In October 2024, Ben and Jerry exchange investment realty in a like-kind exchange. Ben bought his real estate in 2013, while Jerry purchased his in 2016. In addition to the realty, Ben receives Pearl, Inc. stock worth $10,000 from Jerry. Ben’s realized gain is $30,000. On what date does the holding period for Ben’s realty received from Jerry begin? When does the holding period for the stock he receives begin? a. 2013, 2024. b. 2013, 2013. c. 2016, 2016. d. 2016, 2024. 140. Daniella owns 500 acres of farm land in southeastern Maryland. Her adjusted basis for the land is $480,000 and there is a $400,000 mortgage on the land. She exchanges the land for an office building owned by Chris in Newark, NJ. The building has a fair market value of $900,000. Chris assumes Daniella’s mortgage on the land. What is the amount of Daniella’s recognized gain or loss on the exchange? a. $0 b. $400,000 c. $500,000 d. $820,000 Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 141. On October 1, Paula exchanged an apartment building (adjusted basis of $375,000 and subject to a mortgage of $125,000) for another apartment building owned by Nick (fair market value of $550,000 and subject to a mortgage of $125,000). The property transfers were made subject to the mortgages. What amount of gain should Paula recognize? a. $0 b. $25,000 c. $125,000 d. $175,000 142. Nancy and Tonya exchanged assets. Nancy gave Tonya her personal residence with an adjusted basis of $280,000 and a fair market value of $560,000. The house has a mortgage of $200,000, which is assumed by Tonya. Tonya gave Nancy a yacht used in her business with an adjusted basis of $250,000 and a fair market value of $360,000. What is Tonya’s realized and recognized gain? a. $310,000 realized and $310,000 recognized gain. b. $310,000 realized and $0 recognized gain. c. $110,000 realized and $110,000 recognized gain. d. $110,000 realized and $0 recognized gain. 143. Lei, a farmer, has the following events occur during the tax year. Which of the events qualifies for nonrecognition of gain from an involuntary conversion? a. Lei's farm tractor is hauled to the city dump because it is worn out. b. She sells 10 acres of pasture land at a loss of $40,000 because she has reduced the size of her dairy herd in preparation for her retirement. c. Her personal residence, adjusted basis of $100,000, is condemned to make way for an interstate highway. She recovers condemnation proceeds of $175,000. d. Lei sells 10 acres of pasture land at a loss of $40,000 because she has reduced the size of her dairy herd due to a reduction in milk prices. 144. If the taxpayer qualifies under § 1033 (nonrecognition of gain from an involuntary conversion), makes the appropriate election, and reinvests less in the replacement property than the amount realized, realized gain is: a. Recognized to the extent of the investment deficiency (amount realized not reinvested). b. Recognized to the extent of realized gain. c. Recognized to the extent of the amount reinvested in excess of the adjusted basis. d. Permanently not subject to taxation. 145. Libby owns a horse farm with 500 acres of land (adjusted basis of $600,000). Fifty acres of the land are condemned by the state for $400,000 in order to build a municipal stadium. Since the fair market value of Libby’s farm is significantly decreased by the proximity to the future stadium, the state awards Libby $300,000 in severance damages. Libby does not use the $300,000 to restore the usefulness of the farm; all of the $700,000 ($400,000 + $300,000) proceeds are invested in the stock market. What is her recognized gain or loss associated with the receipt of the severance damages? a. $0 b. $100,000 c. $300,000 d. $340,000 146. An office building with an adjusted basis of $320,000 was destroyed by fire on December 30, 2024. On January 11, Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 2025, the insurance company paid the owner $450,000. The fair market value of the building was $500,000, but the insurance company is responsible for only 90 percent of the loss. The owner reinvested $410,000 in a new office building on February 12, 2025, that was smaller than the original office building. What is the recognized gain and the basis of the new building if § 1033 (nonrecognition of gain from an involuntary conversion) is elected? a. $0 and $320,000. b. $0 and $410,000. c. $40,000 and $320,000. d. $130,000 and 410,000. 147. Which of the following statements is correct with respect to qualified replacement property in an involuntary conversion? a. If the functional use test applies, a warehouse used to store inventory can be replaced with a smaller building to be used to sell inventory. b. If the taxpayer use test applies, an office building rented to tenants can be replaced with an office building to be used in the taxpayer’s business. c. If the like-kind exchange test applies, a building used by the taxpayer for manufacturing can be replaced with an office building to be used in the taxpayer’s business. d. Only choices b. and c. 148. Jared, a fiscal year taxpayer with a August 31 year-end, owns an office building (adjusted basis of $800,000) that was destroyed by fire on December 24, 2024. If the insurance settlement was $950,000 (received March 1, 2025), what is the latest date that Jared can replace the office building to qualify for nonrecognition of gain under the involuntary conversion rules? a. December 31, 2024. b. August 31, 2025. c. December 31, 2026. d. August 31, 2027. 149. Which of the following satisfy the time period requirement for postponement of gain as an involuntary conversion? a. Al’s business warehouse is destroyed by a tornado on October 31, 2024. Al is a calendar year taxpayer. He receives insurance proceeds on December 5, 2024. He reinvests the proceeds in another warehouse to be used in his business on December 29, 2026. b. Heather’s personal residence is destroyed by fire on October 31, 2024. She is a calendar year taxpayer. She receives insurance proceeds on December 5, 2024. She purchases another principal residence with the proceeds on October 31, 2026. c. Mack’s office building is condemned by the city as part of a road construction project. The date of the condemnation is October 31, 2024. He is a calendar year taxpayer. He receives condemnation proceeds from the city on that date. He purchases another office building with the proceeds on December 5, 2027. d. All of these choices are correct. 150. Sam’s office building with an adjusted basis of $750,000 and a fair market value of $900,000 is condemned on November 30, 2024. Sam is a calendar year taxpayer. She receives a condemnation award of $875,000 on March 1, 2025. She builds a new office building at a cost of $845,000 that is completed and paid for on December 31, 2027. What is Sam’s recognized gain on receipt of the condemnation award and basis for the new office building assuming that her objective is to minimize current-year gain recognition? a. $0; $720,000. Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges b. $30,000; $750,000. c. $30,000; $845,000. d. $150,000; $750,000. 151. A factory building owned by Amber, Inc. is destroyed by a hurricane. The adjusted basis of the building was $400,000 and the appraised value was $425,000. Amber receives insurance proceeds of $390,000. A factory building is constructed during the nine-month period after the hurricane at a cost of $450,000. What is the recognized gain or loss, and what is the basis of the new factory building? a. $0 and $450,000. b. $0 and $460,000. c. ($10,000) and $440,000. d. ($10,000) and $450,000. 152. If the taxpayer qualifies under § 1033 (nonrecognition of gain from an involuntary conversion) and the amount reinvested in replacement property exceeds the amount realized, the basis of the replacement property is: a. The cost of the replacement property. b. The fair market value of the involuntarily converted property minus the postponed gain. c. The cost of the replacement property minus the postponed gain. d. The amount realized. 153. Inka’s personal residence (adjusted basis of $100,000) was condemned, and she received a condemnation award of $80,000. Inka used the condemnation proceeds to purchase a new residence for $90,000. What is Inka's recognized gain or loss and her basis in the new residence? a. $0; $70,000. b. $0; $90,000. c. ($20,000); $90,000. d. ($20,000); $70,000. 154. Francisco was transferred from Phoenix to Atlanta. He sold his Phoenix residence (adjusted basis of $250,000) for a realized loss of $50,000 and purchased a new residence in Atlanta for $375,000. Francisco had owned and lived in the Phoenix residence for six years. What is his recognized gain or loss on the sale of the Phoenix residence and his basis for the residence in Atlanta? a. $0 and $375,000. b. $0 and $425,000. c. ($50,000) and $325,000. d. ($50,000) and $375,000. 155. Danielle, a calendar year taxpayer, lists her principal residence with a realtor on February 7, 2024, enters into a contract to sell on July 12, 2024, and sells (i.e., the closing date) the residence on August 1, 2024. The realized gain on the sale is $225,000. Which date is the appropriate ending date in determining if the residence has been owned and used by the Danielle as the principal residence for at least two years during the prior five-year period? a. February 7, 2024. b. July 12, 2024. c. August 1, 2024. d. December 31, 2024. Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 156. During 2024, Jack and LaTonya, a married couple, decided to sell their residence. The residence has a basis of $162,000 and has been owned and occupied by them for 11 years. The house was sold in May for $395,000 with broker’s commissions and other selling expenses totaling $24,000. They purchased a new residence in June for $400,000. What is the adjusted basis of the new residence? a. $0 b. $162,000 c. $191,000 d. $400,000 157. During 2024, Jamal and Judy, a married couple, decided to sell their residence, which had a basis of $300,000. They had owned and occupied the residence for 20 years. To make it more attractive to prospective buyers, they had the outside painted in April at a cost of $6,000 and paid for the work immediately. They sold the house in May for $880,000. Broker’s commissions and other selling expenses amounted to $53,000. Since they both are age 68, the couple decides to move into a rented apartment. What is the recognized gain? a. $0 b. $17,000 c. $27,000 d. $527,000 158. During 2024, Christian and Danielle, a married couple, decided to sell their residence, which had a basis of $200,000. They had owned and occupied the residence for 20 years. To make it more attractive to prospective buyers, they had the inside painted in April at a cost of $5,000 and paid for the work immediately. They sold the house in May for $800,000. Broker’s commissions and other selling expenses amounted to $50,000. The couple purchased a new residence in July for $400,000. What is the recognized gain and the adjusted basis of the new residence? a. $45,000 and $400,000. b. $50,000 and $400,000. c. $100,000 and $600,000. d. $550,000 and $800,000. 159. Carlito sells his principal residence, which has an adjusted basis of $150,000, for $200,000. He incurs selling expenses of $20,000 and legal fees of $2,000. He had purchased another residence for $380,000 one month prior to the sale. What is the recognized gain or loss and the basis of the replacement residence if Carlito elects to forgo the § 121 exclusion (exclusion of gain on sale of principal residence)? a. $0 and $380,000. b. $0 and $408,000. c. $28,000 and $352,000. d. $28,000 and $380,000. 160. Ross lives in a house he received as a gift from his father Clem, who had lived in the house for 12 years. The adjusted basis of the house to Clem was $160,000 and the fair market value at the time of the gift was $140,000. Ross sells this residence after living in it for 18 months for $150,000 and purchases a new home for $125,000. He incurs selling expenses of $7,000. What is Ross’ recognized gain or loss and basis for the new residence? a. ($17,000); $125,000. b. ($17,000); $142,000. c. $0; $125,000. Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges d. $3,000; $128,000. 161. Cho inherits a home on July 1, 2024 that had a basis in the hands of the decedent at death of $290,000 and a fair market value of $500,000 at the date of the decedent’s death. Cho decides to sell her old principal residence, which she has owned and occupied for nine years, with an adjusted basis of $125,000 and move into the inherited home. On September 16, 2024, she sells the old residence for $600,000. Cho incurs selling expenses of $30,000 and legal fees of $2,000. She decides to add a pool, deck, pool house, and recreation room to the inherited home at a cost of $100,000. These additions are completed and paid for on November 1, 2024. What is Cho's recognized gain on the sale of her old principal residence and her basis in the inherited home? a. $0; $500,000. b. $193,000; $600,000. c. $443,000; $600,000. d. $475,000; $600,000. 162. Weston sells his residence to Joanne on October 15, 2024. Indicate which of the following statements is correctly associated with § 121 (exclusion of gain on sale of principal residence). a. Selling expenses decrease the seller’s amount realized and increase the buyer’s adjusted basis. b. Repair expenses of the seller decrease the seller’s amount realized and have no effect on the buyer’s adjusted basis. c. Capital expenditures made by the seller prior to the sale increase the seller’s adjusted basis and have no effect on the buyer’s adjusted basis. d. Only choices a. and c. 163. Eric and Mario, who are married, jointly own a house in which they have resided for the past 17 years. They sell the house for $375,000 with realtor’s fees of $10,000. Their adjusted basis for the house is $80,000. Since they are in their retirement years, they plan on moving around the country and renting. What is their recognized gain on the sale of the residence if they use the § 121 exclusion? What is it if they elect to forgo the § 121 exclusion? With Exclusion a. $0 b. $35,000 c. $0 d. $35,000

Elect to Forgo $0 $35,000 $285,000 $285,000

164. Brian and Becca have been married and living together in Brian’s home for 6 years. He lived in the home alone for 20 years prior to their marriage. They sell the home, which has an adjusted basis of $120,000, for $700,000. Brian and Becca plan to use the § 121 exclusion (exclusion of gain on sale of principal residence). In Becca’s prior marriage to Dan, Dan sold his principal residence and used the § 121 exclusion. Becca and Dan filed joint returns during their seven years of marriage. They had lived in Dan’s house throughout their marriage. Dan’s sale had occurred one year prior to the divorce. Brian and Becca purchase a replacement residence for $650,000 one month after the sale of their home. What is the recognized gain and basis for the new home? a. $0; $80,000. b. $80,000; $150,000. c. $80,000; $650,000. d. $330,000; $650,000. Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges Subjective Short Answer 165. Malik sold his ranch, which was his principal residence, during the current taxable year. At the date of the sale, the ranch had an adjusted basis of $460,000 and was encumbered by a mortgage of $200,000. The buyer paid him $500,000 in cash, agreed to take the title subject to the $200,000 mortgage, and agreed to pay him $100,000 with interest at 3.5 percent one year from the date of sale. How much is Malik’s realized gain on the sale? 166. Ken is considering two options for selling land for which he has an adjusted basis of $100,000 and on which there is a mortgage of $80,000. Under the first option, Ken will sell the land for $225,000 with a stipulation in the sales contract that he liquidate the mortgage before the sale is complete. Under the second option, Ken will sell the land for $145,000, and the buyer will assume the mortgage. Calculate Ken’s recognized gain under both options. 167. Annette purchased stock on March 1 for $200,000. At December 31, it was worth $210,000. She also purchased a bond on September 1, for $20,000. At year-end, it was worth $15,000. Determine Annette’s realized and recognized gain or loss. 168. Nigel purchased a blending machine for $125,000 for use in his business. As to the machine, he has deducted MACRS cost recovery of $31,024, maintenance costs of $5,200, and repair costs of $4,000. Calculate Nigel’s adjusted basis for the machine. 169. Peggy uses a delivery van in her business. The adjusted basis is $39,000, and the fair market value is $34,000. The delivery van is stolen and Peggy receives insurance proceeds of $34,000. Determine Peggy’s realized and recognized gain or loss. 170. Jan purchases taxable bonds with a face value of $250,000 for $265,000. The annual interest paid on the bonds is $10,000. Assume Jan elects to amortize the bond premium. The total premium amortization for the first year is $1,600. a. b. c.

What is Jan’s interest income for the first year? What is Jan’s interest deduction for the first year? What is Jan’s adjusted basis for the bonds at the end of the first year?

171. Boyd acquired tax-exempt bonds for $430,000 in December 2024. The bonds, which mature in December 2029, have a maturity value of $400,000. Boyd does not make any elections regarding the amortization of the bond premium. Determine the tax consequences to Boyd when he redeems the bonds in December 2029. 172. Kiara owns 100% of the stock of Lilac, Inc., with an adjusted basis of $45,000. She receives a cash distribution of $160,000 from Lilac when its earnings and profits are $90,000. a. b. c.

What is Kiara’s dividend income? What is Kiara’s recognized gain or loss? What is Kiara’s adjusted basis for her stock after the distribution?

173. Hilary receives $10,000 for a 15-foot wide utility easement along one of the boundaries to her property. The easement provides that no structure can be built on that portion of the property. Her adjusted basis for the property is $200,000, and the easement covers 15% of the total acreage. Determine the effect of the $10,000 payment on Hilary’s gross income and her basis for the property. 174. Ollie owns a personal use car for which he originally paid $48,000. He trades the car in on a sports utility vehicle (SUV) paying the automobile dealer cash of $30,000. If the negotiated price of the SUV is $49,000, what is Ollie’s recognized gain or loss and his adjusted basis for the SUV? Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 175. Hubert purchases Fran’s jewelry store for $950,000. The identifiable assets of the business are as follows: Basis FMV Inventory $ 90,000 $ 97,000 Accounts receivable 55,000 50,000 Building 100,000 225,000 Land 280,000 300,000 Hubert and Fran agree to assign $110,000 to a seven-year covenant not to compete. How should Hubert allocate the $950,000 purchase price to the assets? 176. Omar has the following stock transactions during 2024: Stock

Date Number of Purchased/Sold Shares Sold

Orange Blue Yellow Blue Yellow Blue Yellow

1/2022 6/2022 4/2023 2/2024 3/2024 7/2024 11/2024

Number of Shares Purchased 100 200 50 150 175

250 200

Basis

Selling Price

$1,000 3,000 1,250 1,800 5,250 $3,500 7,200

a.

What is Omar’s recognized gain or loss on the stock sales if his objective is to minimize the recognized gain and to maximize the recognized loss?

b.

What is Omar’s recognized gain or loss if he does not identify the shares sold?

177. Lauren purchases the Kentwood Trackers, a AAA baseball team, for $1,500,000. The appraised values of the identified assets are as follows. Prepaid season tickets Stadium lease Player contracts Equipment

$150,000 400,000 100,000 500,000

The Trackers have won the pennant for the past two years. Determine Lauren’s adjusted basis for the assets of the Kentwood Trackers. 178. Melody’s adjusted basis for 10,000 shares of Cardinal, Inc. common stock is $1,000,000. During the year, she receives a 5% nontaxable stock dividend. a. b. c.

What is the amount of Melody’s gross income? What is Melody’s total basis for the stock? What is Melody’s basis per share?

179. On September 18, 2024, Jerry received land and a building from Ted as a gift. Ted had purchased the land and Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges building on March 5, 2021, and his adjusted basis and the fair market value at the date of the gift were as follows: Asset Land Building

Adjusted Basis $150,000 90,000

FMV $200,000 100,000

Ted paid no Federal gift tax on the transfer. a.

Determine Jerry’s adjusted basis and holding period for the land and building.

b.

Assume instead that the FMV of the land was $89,000 and the FMV of the building was $60,000. Determine Jerry’s adjusted basis and holding period for the land and building.

180. Emma gives her personal use automobile (cost of $32,000; fair market value of $12,000) to her son, Liam, on July 3, 2024. She has owned the automobile since July 1, 2021. a. b.

What is Louis’s basis for the car? When does his holding period begin?

181. Faith inherits an undivided interest in a parcel of land from her father on February 15, 2024. Her father purchased the land on August 25, 1997; his basis for the land was $325,000. The fair market value of the land is $12,500,000 on the date of her father’s death and is $11,000,000 six months later. The executor elects the alternate valuation date. Faith has nine brothers and sisters; each sibling inherited a one-tenth interest. a.

What is Faith’s adjusted basis for her one-tenth undivided interest in the land?

b.

What is her holding period for the land?

182. On January 15 of the current taxable year, Merle sold stock with a cost of $40,000 to his brother Ned for $25,000, its fair market value. On June 21, Ned sold the stock to a friend for $26,000. a. b.

What are the tax consequences to Merle and Ned? Would Ned recognize any gain if he sold the stock for $41,000?

183. Ed and Cheryl have been married for 27 years. They own land jointly with a basis of $300,000. Ed dies in 2024, when the fair market value of the land is $500,000. Under a joint ownership arrangement, the land passed to Cheryl. a.

If Ed and Cheryl reside in a community property state, what is Cheryl’s basis in the land?

b.

If Ed and Cheryl reside in a common law state, what is Cheryl’s basis in the land?

184. Monica sells a parcel of land to her son, Elbert, for $90,000. Monica’s adjusted basis is $100,000. Three years later, Elbert gives the land to his fiancée, Karen. At that date, the land is worth $104,000. No gift tax is paid. Since Elbert is going to be stationed in the U.S. Army in Germany for three years, they do not plan to be married until his tour is completed. Six months after receiving the land, Karen sells it for $110,000. At the same time, Karen sends Elbert a “Dear John” e-mail. Calculate Karen’s realized and recognized gain or loss. 185. Inka transfers her personal use automobile to her business (a sole proprietorship). The car’s adjusted basis is $30,000 Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges and the fair market value is $16,000. No cost recovery had been deducted by Inka, as she held the car for personal use. Determine the adjusted basis of the car to Inka’s sole proprietorship including the basis for cost recovery. 186. Jacob owns land with an adjusted basis of $140,000 and a fair market value of $115,000. Determine the amount of realized and recognized gain or loss to the seller and the adjusted basis for the buyer for each of the following. a. b.

Jacob sells the land for $115,000 to a corporation in which he owns 60% of the stock. Jacob sells the land for $115,000 to a partnership in which he has a capital and profits interest of 60%.

187. Mitch owns 1,000 shares of Oriole Corporation common stock (adjusted basis of $15,000). On April 27, 2024, he sells 400 of these shares for $5,200, while on May 5, 2024, he purchases 300 shares of Oriole Corporation for $3,600. a. What is Mitch’s recognized gain or loss resulting from these transactions? b. What is Mitch’s basis for the stock acquired on May 5, 2024? c. Could Mitch have obtained different tax consequences in a. and b. if he had sold the 400 shares on December 27, 2024, and purchased the 300 shares on January 5, 2025? 188. Williams owned an office building (but not the land) that was destroyed by a fire. The building was insured and he has a $156,000 gain because his insurance recovery exceeded his adjusted basis for the building. Williams may replace the building. He had taken $145,000 of depreciation on the building, has no § 1231 lookback loss, has no other § 1231 transactions for the year, and has no Schedule D transactions for the year. What is final nature of his gain for the year and what tax rate(s) apply to the gain if: a.

He does reinvest the insurance proceeds.

b.

If he does not reinvest the insurance proceeds.

189. For the following exchanges, indicate which qualify as like-kind property. a. b. c. d. e.

Inventory of a sporting goods store in Charleston for land in Savannah. Investment land in Virginia Beach for office building in Williamsburg. Used automobile used in a business for a new automobile to be used in the business. Investment land in Paris for investment land in San Francisco. Shares of Texaco stock for shares of Exxon Mobil stock.

190. Rashida exchanges land used in her business for another parcel of land. The adjusted basis for her land is $32,000. The land she will receive has a fair market value of $33,000. In addition, Rashida receives cash of $4,000. a. b.

Calculate Rashida’s realized and recognized gain or loss. Calculate Rashida’s basis for the assets she received.

191. Sandoval exchanges land used in his business in a like-kind exchange. The property exchanged is as follows. The other party assumes the liability.

Land Cash Powered by Cognero

Property Surrendered Adj. Basis FMV $44,000 $60,000

Property Received Adj. Basis FMV $50,000 $43,000 $ 5,000 $ 5,000 Page 29

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges Liability on land

$12,000

$12,000

a.

What is Sandoval’s recognized gain or loss?

b.

What is Sandoval’s basis for the assets he received?

192. Julio exchanges land used in his business for a different parcel of land to be used in his business. His adjusted basis for the land is $325,000; the fair market value is $310,000. The fair market value of the new parcel of land is $300,000. In addition, Julio receives cash of $10,000. Calculate Julio’s realized and recognized gain or loss and his adjusted basis for the assets received. 193. Respond to each of the following situations: a. Orange Corporation exchanges a warehouse located in Michigan (adjusted basis of $560,000) for a warehouse located in Ohio (adjusted basis of $450,000; fair market value of $525,000). Indicate the amount of gain or loss that is recognized by Orange on the exchange and the basis of the warehouse acquired. b.

Assume that, in addition to the warehouse, Orange Corporation also received $100,000 in cash. Indicate the amount of gain or loss that Orange recognized on the exchange and the basis of the warehouse acquired.

c.

How would your answer in b. change if, instead of receiving $100,000 in cash, the other party assumed Orange’s $100,000 mortgage on the Michigan warehouse?

194. Javier’s hotel is condemned by the City Housing Authority on July 5, 2024, for which he is paid condemnation proceeds of $950,000. He first received official notification of the pending condemnation on May 2, 2024. Javier’s adjusted basis for the hotel is $600,000 and he uses a fiscal year for tax purposes with a September 30 tax year-end. a.

How much must Javier reinvest in qualifying replacement property to postpone the recognition of realized gain?

b.

If Javier reinvests the minimum amount required to avoid recognition of realized gain, what is his basis for the replacement property?

c.

What is qualifying replacement property?

d.

What is the earliest date that Javier can acquire qualifying replacement property?

e.

What is the latest date that Javier can acquire qualifying replacement property?

f.

How would the answer in e. change if Javier’s hotel had been destroyed in a flood?

Powered by Cognero

Page 30

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 195. Lucinda, a calendar year taxpayer, owned a rental property with an adjusted basis of $312,000 in a major coastal city. Her property was condemned by the city government on October 12, 2024 to build a convention center. Lucinda eventually received qualified replacement property from the city government on March 9, 2025, with a fair market value of $410,000. a.

What is Lucinda’s recognized gain or loss on the condemnation?

b.

What is her adjusted basis for the new property?

c.

If, instead of receiving qualifying replacement property, Lucinda was paid $410,000, what is the latest date that she can acquire qualifying replacement property?

196. Kitty’s factory building, which has an adjusted basis of $475,000, is destroyed by fire on April 8, 2024. Insurance proceeds of $500,000 are received on June 1, 2024. She has a new factory building constructed for $490,000, which she occupies on October 1, 2024. Assuming Kitty’s objective is to minimize her current-year tax liability, calculate her recognized gain or loss and the basis of the new factory building. 197. Janling’s office building is destroyed by fire on July 12, 2024. The adjusted basis is $315,000. She receives insurance proceeds of $350,000 on August 31, 2024. Calculate the amount that Janling must reinvest in qualifying property so that her recognized gain will be $20,000. Assume she elects to postpone any involuntary conversion gain. 198. Carlos, who is single, sells his personal residence on November 5, 2024, for $400,000. His adjusted basis was $125,000. He pays realtor’s commissions of $20,000. He had owned and occupied the residence for 12 years. Having decided that he no longer wants the burdens of home ownership, he invests the sales proceeds in a mutual fund and enters into a 1-year lease on an apartment. The detriments of renting, including a crying child next door, cause Carlos to rethink his decision. As a result, he purchases another residence on November 6, 2025, for $275,000. Is Carlos eligible for exclusion of gain treatment under § 121 (exclusion of gain on sale of principal residence)? Calculate Carlos’s recognized gain and his basis for the new residence. 199. On January 5, 2024, Amin sells his principal residence with an adjusted basis of $270,000 for $690,000. He has owned and occupied the residence for 15 years. He pays $35,000 in commissions and $2,000 in legal fees in connection with the sale. One month before the sale, Amin painted the exterior of the house at a cost of $5,000 and repaired various items at a cost of $3,000. On October 15, 2024, Amin purchases a new home for $600,000. On November 15, 2025, he pays $25,000 for completion of a new room on the house, and on January 14, 2026, he pays $15,000 for the construction of a pool. What is the Amin’s recognized gain on the sale of his old principal residence, and what is the basis for the new residence? 200. Katrina, age 58, rented the house that was her principal residence from January 1, 2024 through December 31, 2025. She purchased the house on January 1, 2026, for $150,000 and continued to occupy it through June 30, 2027. She leased it to a tenant from July 1, 2027, through December 31, 2028. On January 1, 2029, she sells the house for $350,000. She incurs a realtor’s commission of $20,000. Calculate her recognized gain if her objective is to minimize the recognition of gain and she does not intend to acquire another residence. 201. Liz, age 55, sells her principal residence for $600,000. She purchased it 22 years ago for $175,000. Selling expenses are $30,000 and repair expenses to get the house in a marketable condition to sell are $15,000. Liz’s objective is to minimize the taxes she must pay associated with the sale. Calculate her recognized gain. Essay Powered by Cognero

Page 31

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 202. When a property transaction occurs, what four questions should be considered with respect to the sale or other disposition? 203. Define fair market value as it relates to property transactions. 204. What is the general formula for calculating the adjusted basis of property? 205. What effect does a deductible casualty loss have on the adjusted basis of property? 206. For a corporate distribution of cash or other property to a shareholder, when does dividend income or a return of capital result? 207. Under what circumstances will a distribution by a corporation to its only shareholder result in a capital gain? 208. If a taxpayer purchases taxable bonds at a premium, the amortization of the premium is elective. However, if a taxpayer purchases tax-exempt bonds at a premium, the amortization of the premium is mandatory. Explain this difference in the treatment. 209. Maurice sells his personal use automobile at a realized loss. Under what circumstances can Maurice deduct the loss? What if the personal use asset was sold at a realized gain? 210. If a taxpayer purchases a business and the price exceeds the fair market value of the acquired assets, how is the excess allocated among the purchased assets? 211. Tara owns common stock in Taupe, Inc., with an adjusted basis of $250,000. She receives a preferred stock dividend which is nontaxable. a. b. c.

What effect does the preferred stock dividend have on Tara’s adjusted basis of the common stock? How is the basis of the preferred stock calculated? What effect does the preferred stock dividend have on Tara’s gross income?

212. Joseph converts a building (adjusted basis of $50,000 and fair market value of $40,000) from personal use to business use. Justin receives a building with a $40,000 fair market value ($50,000 donor’s adjusted basis) from his mother as a gift. Discuss the tax consequences with respect to Joseph’s and Justin’s adjusted basis. 213. Describe the holding period rules to property acquired by gift and inheritance. 214. Ai and Lianne, are married and own property jointly. The property has an adjusted basis of $400,000 and a fair market value of $500,000. a. b.

Discuss the rules for the calculation of the adjusted basis of the property to Ai if she inherits her wife’s share of the property and Ai and Lianne live in a community property state. If they live in a common law state?

215. Explain how the sale of investment property at a loss to a brother is treated differently from a sale to a niece. 216. Tariq sold certain U.S. Government bonds and State of Oregon bonds at a loss to offset short-term capital gain from a previous transaction. He felt that the U.S. Government and State of Oregon bonds were “good” investments, so he repurchased identical securities within one week. Will the "wash sale" rules apply to these transactions? Powered by Cognero

Page 32

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 217. Jamie is terminally ill and does not expect to live much longer. Pondering the consequences of her estate, she decides how to allocate her property to her nephews. She makes a gift of depreciated property (i.e., adjusted basis exceeds fair market value) to Will, a gift of appreciated property (i.e., fair market value exceeds adjusted basis) to Jim, and leaves appreciated property to Sam in her will. Each of the properties has the same fair market value. From an income tax perspective, which nephew is her favorite? 218. Why is it generally undesirable to pass property by death when its fair market value is less than basis? 219. Discuss the logic for mandatory deferral of realized gain or loss for a like-kind exchange. 220. What requirements must be satisfied to receive like-kind exchange treatment? 221. What kinds of property do not qualify under the like-kind provisions? 222. Discuss the relationship between the postponement of realized gain for like-kind exchanges and the adjusted basis and holding period for the replacement property. 223. Discuss the relationship between realized gain and boot received in a like-kind exchange. 224. What effect does the assumption of liabilities have on a like-kind exchange? 225. Define an involuntary conversion. 226. Discuss the treatment of realized gains from involuntary conversions. 227. Discuss the treatment of losses from involuntary conversions. 228. To be eligible to elect postponement of gain treatment for an involuntary conversion, what are the tests for qualifying replacement property? 229. How does the replacement time period differ for the condemnation of real property used in a trade or business or held for investment when compared with that for other involuntary conversions? 230. Louis owns a condominium in New Orleans that has been his principal residence for 12 years. He wants to be near Lake Ponchartrain because he enjoys water activities. Therefore, he sells the condominium. His original intent was to purchase a house in New Orleans near the lake. However, the cost of such properties far exceeded his sales proceeds. He was able to purchase a house on the lake in Covington, which is located across the causeway. He invested all of his sales proceeds in the Covington house. After two months of commuting over an hour to and from work each day, he decides to rent an efficiency apartment in New Orleans near his office. He spends the weekends and vacations at his home in Covington. a. b.

Does Louis qualify for exclusion of gain under § 121? Does his Covington house qualify as his principal residence?

231. Byron, who lived in New Hampshire, acquired a personal residence 10 years ago when he was 52 years old. During this period, he has occupied the residence for only eight months each year due to winter vacations in Florida. Is Byron eligible for exclusion of gain under § 121? 232. Melissa, age 58, marries Matt, age 50, on June 1, 2024. On August 1, 2024, Melissa decides to sell her principal Powered by Cognero

Page 33

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges residence, which she has owned and occupied for the past 30 years. Matt has never owned a house. However, while he was married to Kelly who died 6 months prior to his marriage to Melissa, Kelly used the § 121 election on the sale of her residence in January 2022 to reduce her realized gain from $123,000 to $0. Kelly used the sales proceeds to pay off Matt’s outstanding debts. Can Melissa elect the § 121 exclusion on the sale of her residence? What is the maximum § 121 exclusion available to Melissa and Matt if they file a joint return? 233. Under what circumstances may a partial § 121 exclusion be available, where the taxpayer has used the § 121 exclusion within the two-year period preceding the sale of the current residence?

Powered by Cognero

Page 34

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges Answer Key 1. True 2. True 3. False 4. False 5. True 6. False 7. True 8. True 9. False 10. False 11. True 12. True 13. False 14. True 15. False 16. False 17. True 18. True 19. False 20. True 21. True 22. False 23. True 24. False Powered by Cognero

Page 35

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 25. False 26. False 27. True 28. False 29. False 30. True 31. True 32. False 33. False 34. True 35. True 36. True 37. True 38. False 39. False 40. False 41. True 42. False 43. False 44. False 45. True 46. False 47. False 48. False 49. False Powered by Cognero

Page 36

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 50. True 51. True 52. False 53. True 54. False 55. False 56. False 57. False 58. True 59. False 60. False 61. True 62. False 63. False 64. True 65. True 66. True 67. True 68. False 69. False 70. False 71. False 72. False 73. False 74. False Powered by Cognero

Page 37

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 75. False 76. False 77. True 78. True 79. True 80. True 81. False 82. a 83. c 84. c 85. d 86. a 87. d 88. b 89. b 90. b 91. d 92. c 93. d 94. b 95. b 96. a 97. d 98. b 99. d Powered by Cognero

Page 38

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 100. a 101. a 102. b 103. b 104. b 105. b 106. b 107. a 108. c 109. d 110. b 111. c 112. d 113. b 114. b 115. a 116. a 117. c 118. d 119. d 120. a 121. b 122. d 123. a 124. c Powered by Cognero

Page 39

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 125. a 126. c 127. b 128. d 129. d 130. c 131. d 132. b 133. a 134. b 135. c 136. d 137. c 138. b 139. a 140. b 141. a 142. c 143. c 144. a 145. a 146. c 147. c 148. d 149. d Powered by Cognero

Page 40

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 150. b 151. d 152. a 153. b 154. a 155. c 156. d 157. c 158. b 159. d 160. c 161. b 162. c 163. c 164. c 165. Cash Mortgage (property taken subject to) Note receivable Amount realized Adjusted basis Realized gain

$500,000 200,000 100,000 $800,000 (460,000) $340,000

166. Amount realized Less: Adjusted basis Recognized gain

Option 1 $225,000 (100,000) $125,000

Option 2 $225,000 (100,000) $125,000

Since the liability assumption is included in the calculation of Ken’s amount realized, the recognized gain is $125,000, the same as for the cash sale. 167. Annette’s realized gain or loss is zero and her recognized gain or loss is zero. Since a sale or other disposition has not occurred, there is no realization or recognition on either the stock or the bond. Powered by Cognero

Page 41

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 168. Cost Less: Cost recovery Adjusted basis

$125,000 (31,024) $ 93,976

Neither the maintenance cost of $5,200 nor the repair cost of $4,000 is a capital expenditure. These costs are deducted in the tax year incurred. 169. Amount realized Adjusted basis Realized loss Recognized loss

$34,000 (39,000) ($ 5,000) ($ 5,000)

170. a. Jan receives interest payments of $10,000 each year. This amount is included in her gross income because the bonds are taxable. b.

Jan deducts the premium amortization of $1,600 for the first year because the bonds are taxable.

c.

Jan’s adjusted basis for the bonds at the end of the first year is $263,400 ($265,000 cost – $1,600 premium amortization).

171. Amount realized Adjusted basis for bonds Realized gain Recognized gain

$400,000 (400,000) $ –0– $ –0–

Amortization of the premium on tax-exempt bonds is mandatory. Thus, the adjusted basis of the bonds at the maturity date is $400,000 ($430,000 cost – $30,000 premium amortized). Since the bonds are tax-exempt, the amount of interest income included in Boyd’s gross income (i.e., $0) is not affected by the amortization of the bond premium. 172. a. and b. Dividend income (Lilac’s earnings and profits) Return of capital (Kiara’s basis in the stock) Capital gain (presuming the stock is a capital asset) Total distribution c.

$ 90,000 45,000 25,000 $160,000

Kiara’s adjusted basis for her stock is $0.

173. Hilary does not include the $10,000 payment in her gross income. Instead, she reduces the basis for the property by the $10,000 payment from $200,000 to $190,000. 174. Powered by Cognero

Page 42

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges Amount realized (trade-in value) Adjusted basis Realized loss

$19,000 (48,000) ($29,000)

Since the car was a personal use asset, none of the realized loss of $29,000 is recognized. Ollie’s adjusted basis for the SUV is his cost of $49,000. 175. Inventory Accounts receivable Building Land Covenant Goodwill Purchase price to allocate Purchase price to allocate

$ 97,000 50,000 225,000 300,000 110,000 168,000 $950,000

176. a.

Since Omar’s objective is to minimize recognized gain and maximize recognized loss, he will identify the specific shares (i.e., specific identification method) being sold. He will select high basis shares to achieve his objective.

Sale of Blue Stock Amount realized Basis: 200 shares from 6/2022 lot ($15 per share) 50 shares from 2/2024 lot ($12 per share)

$3,500 $3,000 600

(3,600)

Realized loss

($ 100)

Recognized loss

($ 100)

Sale of Yellow Stock $7,200

Amount realized Basis: 175 shares from 3/2024 lot ($30 per share)

$5,250

25 shares from 4/2023 lot ($25 per share)

625

Realized gain Powered by Cognero

(5,875) $1,325 Page 43

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges $1,325

Recognized gain

b.

Since Omar does not identify the shares sold, he is required to use the FIFO method.

Sale of Blue stock Amount realized Basis: 200 shares from 6/2022 lot ($15 per share) 50 shares from 2/2024 lot ($12 per share)

$3,500 $3,000 600

(3,600)

Realized loss

($ 100)

Recognized loss

($ 100)

Sale of Yellow stock Amount realized Basis: 50 shares from 4/2023 lot ($25 per share) 150 shares from 3/2024 lot ($30 per share) Realized gain

$7,200 $1,250 4,500

Recognized gain

(5,750) $1,450 $1,450

177. The portion of the purchase price of $1,500,000 million assigned to the identified assets is as follows. Prepaid season tickets Stadium lease Player contracts Equipment

$ 150,000 400,000 100,000 500,000 $1,150,000

The residual value of $350,000 ($1,500,000 – $1,150,000) is assigned to goodwill. 178. a. Melody reports no gross income because the dividend is a nontaxable stock dividend. Powered by Cognero

Page 44

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges b.

Melody’s total stock basis remains at $1,000,000.

c.

The basis per share decreases to $95.24 per share ($1,000,000/10,500 shares)

179. a. Because the fair market value of each asset exceeds Ted's basis, Jerry has a carryover basis in the assets (land: $150,000; building: $90,000). Jerry’s holding period (which also carries over from Ted) begins on March 5, 2021. b. Because the land and building have declined in value, Jerry will have different gain and loss bases. Jerry’s basis for gain is: Land Building

$150,000 90,000

Jerry’s basis for loss (the lower of Ted’s adjusted basis or the FMV at the date of the gift) is: Land Building

$89,000 60,000

Jerry’s holding period begins on March 5, 2021 (for the gain basis) and September 18, 2024 (for the loss basis) (The holding period for the loss basis is the date of the gift).

180. a. b.

Liam’s gain basis is $32,000 and his loss basis is $12,000. Liam’s holding period for gain begins on July 1, 2021 and his holding period for loss begins on July 3, 2024.

181. Faith’s adjusted basis is $1,100,000 ($11,000,000 × 10%), which is her share of the fair a. market value of the land on the alternate valuation date. Powered by Cognero

Page 45

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges Since the property is inherited, Faith’s holding period is automatically long term.

b. 182.

Merle realizes a loss of $15,000 [i.e., $25,000 (amount realized) – $40,000 (adjusted basis)], which is disallowed because the stock was sold to a related party. Ned realizes a gain of $1,000 [i.e., $26,000 (amount realized) – $25,000 (adjusted basis)] on the sale to a friend but does not recognize any gain. Ned’s gain of $1,000 is less than Merle’s previously disallowed loss of $15,000.

a.

Ned would realize a gain of $16,000 [i.e., $41,000 (amount realized) – $25,000 (adjusted basis)]. Gain of $1,000 would be recognized [i.e., $16,000 (gain realized) – $15,000 (previously disallowed loss)].

b.

183. a. Cheryl’s basis in the land is $500,000 ($250,000 + $250,000). Cheryl’s basis in the land is $400,000 [($300,000 × 50%) + $250,000].

b.

184. Elbert’s adjusted basis for the land is his purchase price of $90,000. When Elbert gives the land to Karen, her adjusted basis is a carryover basis of $90,000. Amount realized Adjusted basis Realized gain Recognized gain

$110,000 (90,000) $ 20,000 $ 20,000

Monica’s disallowed loss of $10,000 ($90,000 amount realized – $100,000 adjusted basis) could have been used as an offset by Elbert if he had sold the land at a realized gain. But, it cannot be used by Karen; she is not the original transferee (i.e., related-party buyer). 185. In this circumstance, the car is dual basis property. The adjusted basis to the sole proprietorship for gain is $30,000 and the adjusted basis for loss is $16,000. The loss basis of $16,000 is used in calculating cost recovery. 186. a. Amount realized Adjusted basis Realized loss Recognized loss

$115,000 (140,000) ($ 25,000) $ –0–

Losses on sales to a controlled corporation (greater than 50%) are disallowed under the related-party rules. The corporation’s adjusted basis for the land is its cost of $115,000. b. Amount realized Adjusted basis Realized loss Recognized loss Powered by Cognero

$115,000 (140,000) ($ 25,000) $ –0– Page 46

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges Losses on sales to a controlled partnership (greater than 50%) are disallowed under the related-party rules. The partnership’s adjusted basis for the land is its cost of $115,000.

187.

a.

To the extent of the substantially identical shares purchased during the 61-day period beginning 30 days before April 27 and ending 30 days after April 27, the transaction is a wash sale. The realized loss on the April 27 sale is $800 ($5,200 amount realized – $6,000 adjusted basis of 400 shares). Because Mitch acquired fewer shares than he sold, only a portion of the realized loss is disallowed. The disallowed loss is $600 [(300 shares acquired/400 shares sold) × $800] and the recognized loss is $200 ($800 – $600).

b.

Mitch’s adjusted basis for the stock acquired on May 5, 2024, is $4,200 ($3,600 purchase price + $600 disallowed loss).

c.

The tax consequences would have been the same. Mitch has a wash sale to the extent of the 300 shares purchased. To avoid the limitations of the wash sale, he should not purchase substantially identical stock within the 61-day window for a wash sale.

188. Williams initially has a casualty gain of $156,000 from business use property. If he reinvests a. the insurance proceeds, he will be able to postpone this gain. b.

If Williams does not reinvest, he will have a recognized gain. Since he has a net casualty gain, the gain is treated as a § 1231 gain that is treated as a long-term capital gain because he has no § 1231 lookback loss. Williams has a net long-term capital gain of $156,000 because he has no other Schedule D transactions. The unrecaptured § 1250 portion of the gain is $145,000 (equal to the depreciation taken on the destroyed property). That portion of the gain is subject to an alternative tax rate of 25%. The $11,000 ($156,000 – $145,000) remaining gain is subject to the 0%/15%/20% alternative tax rate.

189. Only item b. (investment realty for investment realty or business realty) qualifies. Items a. (inventory for land) and c.(business personalty for business personalty) do not qualify because some of the property is not real property. Item d. does not qualify because foreign realty is exchanged for domestic realty. Item e. does not qualify because it involves nonreal property (shares of stock are not eligible for like-kind exchange treatment). 190. a. Amount realized ($33,000 + $4,000) Adjusted basis Powered by Cognero

$37,000 (32,000) Page 47

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges

b.

Realized gain

$ 5,000

Recognized gain

$ 4,000

Fair market value Less: Postponed gain Basis of the land

$33,000 (1,000) $32,000

Basis of the cash

$ 4,000

191. a. Amount realized: Land Cash Liability assumed Adjusted basis

$43,000 5,000 12,000

Realized gain

$60,000 (44,000) $16,000

Recognized gain

$16,000

The recognized gain is the lesser of the boot received of $17,000 ($12,000 + $5,000) or the realized gain of $16,000. b. Basis for new land: Fair market value Less: Postponed gain Basis

$43,000 –0– $43,000

Basis of the cash

$ 5,000

192. Amount realized ($300,000 + $10,000) Adjusted basis Realized loss Recognized loss

$310,000 (325,000) ($ 15,000) $ –0–

A realized gain or loss must be postponed if a like-kind exchange occurs. Basis for land: Fair market value Plus: Postponed loss Basis Basis of the cash

$300,000 15,000 $315,000 $ 10,000

193. a. This is a nontaxable like-kind exchange. No gain or loss is Powered by Cognero

Page 48

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges recognized, and the basis for the new warehouse (in Ohio) is $560,000, the same as the basis for the old warehouse (in Michigan). b.

FMV of Ohio warehouse Cash Amount realized Adjusted basis of Michigan warehouse Realized gain

$525,000 100,000 $625,000 (560,000) $ 65,000

Recognized gain

$ 65,000

FMV of Ohio warehouse Less: Postponed gain Basis of New Jersey warehouse

$525,000 –0– $525,000

c. The answer would the same as in b. (The assumption of liability by the other party is treated as boot received.)

194. a. Javier must reinvest at least $950,000, an amount equal to the amount realized. This results in a postponed gain of $350,000 ($950,000 amount realized – $600,000 adjusted basis). b.

Javier’s basis for the replacement property would be:

FMV of replacement property Less: Postponed gain Basis

$950,000 (350,000) $600,000

c.

Since business real property has been condemned, the broader like-kind exchange rules apply. Thus, any realty (i.e., improved or unimproved) will suffice as replacement property.

d.

The earliest date that Javier can acquire another hotel is May 2, 2024, the date of the threat or imminence of requisition or condemnation of the property.

e.

The latest date that Javier can acquire another hotel is September 30, 2027 (three years after the close of the tax year in which the proceeds received are large enough to produce a realized gain).

f.

The latest date that Javier can acquire another hotel is September 30, 2026 (two years after the close of the tax year in which the proceeds received are large enough to produce a realized gain).

Powered by Cognero

Page 49

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges

195. a.

Because the conversion of Lucinda’s original property was directly into qualified replacement property, the nonrecognition of the realized gain of $98,000 ($410,000 amount realized – $312,000 adjusted basis) is mandatory.

b.

Due to the mandatory nonrecognition, the basis in the replacement property is a carryover basis of $312,000 ($410,000 – $98,000).

c.

The latest date that Lucinda can acquire qualifying replacement property is December 31, 2028 (three years after the close of the tax year in which the proceeds received are large enough to produce a realized gain).

196. Amount realized Adjusted basis of building Realized gain Amount realized Less: Reinvestment Deficiency

$500,000 (475,000) $ 25,000 $500,000 (490,000) $ 10,000

Since Kitty’s objective is to minimize the tax liability, she would elect to postpone any qualified involuntary conversion gain. Thus, her recognized gain would be $10,000. The basis of the new factory building would be $475,000 ($490,000 cost – $15,000 postponed gain). 197. Amount realized Adjusted basis Realized gain

$350,000 (315,000) $ 35,000

Required reinvestment Less: Deficiency (recognized gain) Actual reinvestment

$350,000 (20,000) $330,000

198. Carlos is eligible for § 121 exclusion treatment. At the date of the sale of his residence, he owned and occupied it as his principal residence for at least two years during the 5-year period ending on the date of sale. Amount realized ($400,000 – $20,000) Adjusted basis Realized gain § 121 exclusion Recognized gain Powered by Cognero

$380,000 (125,000) $255,000 (250,000) $ 5,000 Page 50

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges Whether Carlos replaces his principal residence is not relevant in determining his qualification for the § 121 exclusion. His basis for his new residence is the cost of $275,000. 199. Amount realized ($690,000 – $35,000 – $2,000) Adjusted basis Realized gain § 121 exclusion Recognized gain

$653,000 (270,000) $383,000 (250,000) $133,000

The $5,000 for painting and $3,000 for repairs are personal expenses that do not decrease the amount realized or increase the adjusted basis. Cost of house Cost of new room Cost of pool Adjusted basis of residence

$600,000 25,000 15,000 $640,000

200. To qualify for § 121 exclusion treatment on the sale of a principal residence, Katrina must have owned and used the residence as her principal residence for at least two years during the five-year period ending on the date of sale. Katrina meets this requirement. The ownership and use requirements do not have to be the same period of time. She resided in the house from January 1, 2024 through June 30, 2027 (a period of three and one-half years). She owned it from January 1, 2026 through December 31, 2028 (a period of three years). It is not necessary that the property be Katrina’s principal residence at the date of the sale. Amount realized ($350,000 – $20,000) Adjusted basis Realized gain § 121 exclusion Recognized gain 201. Amount realized ($600,000 – $30,000) Adjusted basis Realized gain § 121 exclusion Recognized gain

$330,000 (150,000) $180,000 (180,000) $ –0–

$570,000 (175,000) $395,000 (250,000) $145,000

The repair expenses of $15,000 do not affect the calculation. 202. The following questions need to be answered: 1. 2.

Is there a realized gain or loss? If so, is the gain or loss recognized?

Powered by Cognero

Page 51

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 3.

If the gain or loss is recognized, is it ordinary or capital?

4. What is the basis of any replacement property that is acquired?

203. The fair market value of property received in a sale or other disposition has been defined by the courts as the price at which property will change hands between a willing seller and a willing buyer when neither is compelled to sell or to buy. 204. Adjusted basis is determined as follows: Cost (or other adjusted basis) on date of acquisition + Capital additions – Capital recoveries = Adjusted basis 205. A deductible casualty loss reduces the basis of property. In addition, the adjusted basis is reduced by the amount of insurance proceeds received, if any. 206. To the extent of corporate earnings and profits, a distribution to a shareholder is treated as dividend income. When the distribution exceeds corporate earnings and profits, a distribution to a shareholder is treated as a return of capital (i.e., tax-free to the extent of shareholder basis and capital gain for any excess). 207. Capital gain will result if the amount of the distribution exceeds the corporation’s earnings and profits and the shareholder’s basis in the stock. 208. If mandatory amortization were not required for tax-exempt bonds, a taxpayer who held such bonds to maturity would have a recognized loss to the extent of the premium. This is not consistent with the rule that interest earned on the bonds is tax-exempt. Mandatory amortization, therefore, results in the adjusted basis of the bonds ultimately being equal to the maturity value. Thus, no loss results upon maturity. Furthermore, the amortization of the premium on tax-exempt bonds is not deductible. For the taxable bonds and if the taxpayer does not elect to amortize the premium, a recognized capital loss results to this extent at maturity. Typically, the taxpayer will elect to amortize the premium so that it can be claimed over the life of the bond as an ordinary (rather than capital) deduction. 209. Under no circumstance can Maurice recognize (deduct) a loss on the sale of a personal use asset. Note that if the automobile had been used in a trade or business or held for the production of income, the loss could have been deducted. If the personal use asset was sold at a realized gain, the realized gain would be recognized. 210. The excess is not allocated among the acquired assets. Instead, the excess is assigned to goodwill. 211. a. Part of the adjusted basis of the common stock must be allocated to the preferred stock, thereby decreasing the basis of the common. b.

The amount that is allocated to the preferred stock is based on the relative fair market values of the common stock and the preferred stock on the date of the distribution.

c.

Since the preferred stock dividend is nontaxable, it has no effect on Tara’s gross income.

Powered by Cognero

Page 52

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges 212. Upon conversion from personal use to business use, the building receives dual basis treatment. That is, Joseph’s gain basis for the building is $50,000, the adjusted basis on the date of the conversion from personal use to business use. Joseph’s loss basis is $40,000, the lower of the adjusted basis or the fair market value on the date of the conversion. Justin’s basis for the building upon receipt of the gift is treated in the same manner according to gift basis rules (i.e., dual basis treatment). 213. The holding period for inherited property is always long term. For gift property, if the donee’s basis is the donor’s adjusted basis (i.e., gain basis), the holding period starts on the date the property was acquired by the donor. If the donee’s basis is fair market value (i.e., loss basis), the holding period starts on the date of the gift. 214. a. In a community property state, Ai’s basis for the property will be stepped up to fair market value for both the decedent’s share and the survivor’s share of the community property (i.e., $250,000 + $250,000 = $500,000). b.

In a common law state, her basis will be stepped-up only for the decedent’s share (i.e., $250,000 + $200,000 = $450,000).

215. The brother is a related party under the § 267 loss disallowance provision. Consequently, the realized loss on the sale of the investment property is disallowed. The brother’s basis for the investment property is its cost. However, if the brother sells the investment property at a realized gain, he can offset this gain with as much of the prior disallowed loss as is needed to reduce it to zero. Otherwise, the disallowed loss is wasted. Because a niece is not treated as a related party under § 267, the realized loss on the sale of the investment property is recognized. The niece’s basis for the investment property is its cost. 216. Yes; the wash sale rules apply because Tariq purchased substantially identical securities within the 61-day window that applies under § 1091. 217. Jamie appears to like Sam best. Sam receives the most beneficial tax treatment by receiving a stepped-up basis (i.e., fair market value on the date of Jamie’s death) in the inherited property. Therefore, he would recognize less gain than Jim. Further, he would not have to deal with the dual basis issue like Will if he decided to sell the property. Because Jim receives a gift of appreciated property, he will realize gain equal to the amount of appreciation if he decides to sell. This is because his basis (i.e., carryover) is equal to Jamie’s adjusted basis. Jamie appears to be indifferent about Will. A gift of depreciated property receives a loss basis to Will of the lower of the adjusted basis or the fair market value on the date of the gift. This eliminates a possible loss deduction for Jamie and prevents Will from taking a loss deduction for the decline in value while Jamie owned the property. On the other hand, Will’s gain basis is equal to Jamie’s adjusted basis for the property (and is greater than Sam’s basis). Therefore, if the property appreciates while owned by Will, he will have recognized gain on the sale only if the property appreciates to a fair market value in excess of Jamie’s adjusted basis for the property. 218. Assuming the property is not personal use property (where neither the decedent nor the beneficiary is able to deduct any of the loss), the decedent should sell the property prior to their death. This allows the decedent to recognize the loss on the property. 219. The property received is considered to be a continuation of the property exchanged (i.e., nothing of economic Powered by Cognero

Page 53

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges significance has occurred). Therefore, a realized gain or realized loss is not recognized, and the property received has a carryover basis and holding period. 220. The following requirements must be satisfied to receive like-kind exchange treatment: ∙ ∙ ∙

The form of the transaction is an exchange. Both the property transferred and the property received are held either for productive use in a trade or business or for investment. The property is like-kind property (i.e., real property).

221. The property exchanged may not qualify for like-kind exchange treatment for several reasons. First, the property involved in the exchange (i.e., transferred and received) must be business use or investment property. Thus, personal use property does not qualify. In addition, only realty qualifies as like-kind property (i.e., inventory, partnership interests, stocks and bonds are not like-kind property). Second, one kind or class of property may not be exchanged for a different kind or class (i.e., real property for personal property; only real property for real property qualifies for like-kind exchange treatment). Third, real property located in the United States exchanged for foreign real property (and vice versa) does not qualify as like-kind property. 222. There is a mandatory postponement of realized gain or realized loss on like-kind exchanges. Therefore, the basis for the replacement property is a carryover basis, and the holding period is a carryover holding period. 223. Realized gain serves as the ceiling on the amount of the gain that is recognized in a like-kind exchange. If no boot is received, then none of the realized gain is recognized. If boot is received and its fair market value is less than the realized gain, then gain is recognized to the extent of the boot received. If boot is received and its fair market value is greater than the realized gain, then gain is recognized to the extent of the realized gain (i.e., full recognition occurs). 224. For the taxpayer who is transferring the liability, the liability increases the amount realized because it is treated as boot received. For the taxpayer who is assuming the liability, the liability increases this taxpayer’s adjusted basis for the property and is treated as boot given. 225. An involuntary conversion results from the destruction (complete or partial), theft, seizure, requisition, condemnation, or sale or exchange under threat or imminence of requisition or condemnation of the taxpayer’s property. 226. Realized gains from involuntary conversions are recognized unless the taxpayer elects postponement treatment under § 1033. To defer the realized gain, the taxpayer must reinvest an amount at least equal to the amount realized in qualifying property within the statutory time period. If there is an investment deficiency, realized gain is recognized to the extent of the deficiency. The ceiling on gain recognition is the realized gain. Note that for a direct conversion (i.e., into property), the deferral provision is mandatory (i.e., an election is not required). 227. Business losses are § 1231 losses, personal casualty and theft losses are itemized deductions, and personal condemnation losses are not recognized. 228. The tests for qualifying replacement property are: ∙ ∙ ∙

Functional use test: This test applies to owners-users. The taxpayer’s use of the replacement property and the involuntary converted property must be the same. Taxpayer use test: This test applies to owner-investors. The properties must be used by the taxpayer (owner-investor) in similar endeavors. Special test for condemnations: This test applies when business real property or Powered by Cognero

Page 54

Name:

Class:

Date:

Chapter 13: Property Transactions - Determination of Gain or Loss, Basic Considerations, and Nontaxable Exchanges investment real property is condemned. In this case, the broader replacement rules for like-kind exchanges replace the narrower replacement rules discussed above. 229. Plus two years is replaced with plus three years (i.e., an additional year to make the replacement is provided). 230. a. Louis satisfies the § 121 exclusion requirement. He has owned and occupied the residence for at least two years during the 5-year period ending on the date of sale. b.

No. The Covington home does not qualify as his principal residence. The principal residence is where the taxpayer lives most of the time. For Louis, this is the efficiency apartment in New Orleans.

231. Yes, temporary absences such as vacations do not invalidate the requirement that the taxpayer use the house as a principal residence for at least two years during the 5-year period ending on the date of the sale. 232. Melissa is eligible for a maximum § 121 exclusion of $250,000. Even if Melissa and Matt file a joint return, the maximum § 121 exclusion still is $250,000. To increase the § 121 maximum exclusion amount from $250,000 to $500,000 on a joint return, Matt would need to be eligible for the § 121 exclusion. He is ineligible on Melissa’s sale of her residence because he has not occupied the residence for at least two years. 233. The relief provision that permits partial § 121 exclusion treatment is available in any of the following situations: ∙ ∙ ∙

Change in place of employment. Health effects. To the extent provided for in the Regulations, other unforeseen circumstances.

Powered by Cognero

Page 55

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions True / False 1. Tax law requires that capital gains and losses be separated from other types of gains and losses because an alternative tax calculation may be used when taxable income includes net long-term capital gain. a. True b. False 2. Tax law requires that capital gains and losses be separated from other types of gains and losses because there are limitations on the deduction of net capital losses. a. True b. False 3. If a capital asset is sold at a gain, the holding period is important. a. True b. False 4. An accrual basis taxpayer accepts a note receivable from a retail customer with a weak credit rating. The taxpayer immediately sells the note to a bank for less than the note’s stated value. The taxpayer has an ordinary loss. a. True b. False 5. A business taxpayer sells depreciable business property with an adjusted basis of $40,000 for $32,000. The taxpayer held the property for more than a year and has an $8,000 capital loss. a. True b. False 6. An individual taxpayer received a valuable painting from his uncle, a famous artist who painted it. After the taxpayer held the painting for two years, he sold it for a $400,000 gain. The gain is a long-term capital gain. a. True b. False 7. As the Code section that defines capital asset says what is not a capital asset, other Code sections have to help determine what is and what is not a capital gain or loss. a. True b. False 8. Individuals who are not professional real estate developers may get capital gain treatment for the sale of their real property if they engage only in limited development activities. a. True b. False 9. The subdivision of real property into lots for resale when no substantial physical improvements have been made to the property never causes the gain from sale of the lots to be treated as ordinary income. a. True b. False 10. A security that was purchased by an individual and qualifies as § 1244 stock becomes worthless. The taxpayer is Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions single and the loss is $30,000. The loss is treated as an ordinary loss. a. True b. False 11. For tax purposes, there is no original issue discount on a bond unless the bond is issued for less than its face value and the difference between the face value and the bond issue price is at least one-fourth of 1% of the redemption price at maturity multiplied by the number of years to maturity. a. True b. False 12. If the holder of an option fails to exercise the option, the lapse of the option is considered a sale or exchange on the option expiration date. a. True b. False 13. The only thing that the grantee of an option may do with the option is to exercise it or let it expire. a. True b. False 14. When a patent is transferred, the most common forms of payment received by the transferor are a lump sum and/or a periodic payment. a. True b. False 15. A franchisor licenses its mode of business operation to a franchisee. a. True b. False 16. A lease cancellation payment received by a lessee is generally treated as an exchange because the lease extinguished is usually a capital asset. a. True b. False 17. Lease cancellation payments received by a lessor are always ordinary income because they are considered to be in lieu of rental payments. a. True b. False 18. To compute the holding period, start counting on the day after the property was acquired and include the day of disposition. a. True b. False 19. The holding period of property given up in a like-kind exchange includes the holding period of the asset received if the property that has been exchanged is a capital asset. a. True Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions b. False 20. Tom has owned 40 shares of Orange Corporation stock for five years. He sells the stock short for a total of $1,100. One month later, he closes the short sale by purchasing and delivering 40 shares of Orange Corporation stock for a total of $600. Tom has a $500 short-term capital gain. a. True b. False 21. Short-term capital losses are netted against long-term capital gains, and long-term capital losses are netted against short-term capital gains. a. True b. False 22. Short-term capital gain is eligible for a special tax rate only when it exceeds long-term capital gain. a. True b. False 23. A net short-term capital loss first offsets any 28% net long-term capital gain before it offsets either 25% net long-term capital gain or 0%/15%/20% net long-term capital gain. a. True b. False 24. An individual taxpayer with 2024 net short-term capital loss of $5,000 generally can deduct up to $3,000 for AGI and carry the balance forward to 2025. a. True b. False 25. The tax status of an asset refers to whether the asset is a capital asset, a § 1231 asset, or an ordinary asset. a. True b. False 26. Confusingly, §1221 defines what is not a capital asset. a. True b. False 27. The effect of § 1244 may be to convert a capital loss into an ordinary loss deductible for adjusted gross income. a. True b. False 28. In order to be long term, the holding period must include at least parts of two tax years. a. True b. False 29. A corporation has a $50,000 short-term capital loss for the year. The corporation has $1,200,000 of taxable income from other sources. The taxable income for the year is $1,200,000. a. True Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions b. False 30. Section 1231 applies to the sale or exchange of business properties but not to personal use activity casualties. a. True b. False 31. Rental use depreciable machinery held more than 12 months is an example of a § 1231 asset. a. True b. False 32. A net § 1231 loss is treated as an ordinary loss. a. True b. False 33. Section 1231 property includes nonpersonal use property whose casualty gains exceed casualty losses for the taxable year. a. True b. False 34. Section 1231 property generally includes certain purchased intangible assets (such as patents and goodwill) that are eligible for amortization and held for more than one year. a. True b. False 35. Section 1231 property generally does not include artistic compositions. a. True b. False 36. Section 1231 property generally does not include accounts receivables arising in the ordinary course of business. a. True b. False 37. An individual business taxpayer owns land on which he grows trees for logging. The land has been held more than 10 years and the trees growing on the land were planted eight years ago. Normally, the timber would be inventory for this taxpayer, but the tax law allows the taxpayer to elect to treat cutting the timber as the disposition of a § 1231 asset. a. True b. False 38. A sheep must be held 18 months or more to qualify as a § 1231 asset. a. True b. False 39. Casualty gains and losses from nonpersonal use assets are not netted against casualty gains and losses from personal use assets. a. True b. False Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions 40. If § 1231 asset casualty gains and losses net to a gain, the gain is treated as a § 1231 gain. a. True b. False 41. Involuntary conversion gains may be deferred if the proceeds of the involuntary conversion are reinvested. a. True b. False 42. Personal use property casualty gains and losses are not subject to the § 1231 rules. a. True b. False 43. Once § 1231 gains are netted against § 1231 losses, if the gains exceed the losses, the net gain is offset by the lookback nonrecaptured § 1231 losses. a. True b. False 44. Nonrecaptured § 1231 losses from the six prior tax years may cause current-year net § 1231 gain to be treated as ordinary income. a. True b. False 45. A personal use property casualty loss that occurs in a nonfederally declared disaster area is deductible only to the extent it exceeds 10% of AGI. a. True b. False 46. The Code contains two major depreciation recapture provisions: § 1245 and § 1250. a. True b. False 47. The maximum § 1245 depreciation recapture generally equals the accumulated depreciation. a. True b. False 48. Section 1245 applies to amortizable § 197 intangible assets. a. True b. False 49. For § 1245 recapture to apply, accelerated depreciation must have been taken on the property. a. True b. False 50. Section 1250 depreciation recapture will apply when accelerated depreciation has been used on property employed outside the United States and that is sold at a gain. Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions a. True b. False 51. The maximum amount of the unrecaptured § 1250 gain (25% gain) is the depreciation taken on real property sold at a recognized gain. a. True b. False 52. Section 1231 lookback losses may convert some or all of § 1245 gain into ordinary income. a. True b. False 53. Section 1245 depreciation recapture potential does not carry over from a deceased taxpayer to the beneficiary taxpayer. a. True b. False 54. The § 1245 depreciation recapture potential does not reduce the amount of the charitable contribution deduction under § 170. a. True b. False 55. Property sold to a related party that is depreciable by the purchaser may cause the seller to have ordinary gain. a. True b. False 56. Depreciation recapture under § 1245 and § 1250 is reported on Form 4797. a. True b. False 57. Part III of 2023 Form 4797 is used to report gains from the sale of depreciable business equipment sold at a gain and held more than one year. a. True b. False Multiple Choice 58. The tax law requires that capital gains and losses be separated from other types of gains and losses. Among the reasons for this treatment are: a. Long-term capital gains may be taxed at a lower rate than ordinary gains. b. Short-term capital losses are not deductible. c. Net capital loss is deductible only up to $3,000 per year for individual taxpayers. d. Choices a. and c. 59. Recognized gains and losses from the disposition of a capital asset may occur as a result of a: a. Performance of services. Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions b. Purchase of an asset. c. Casualty. d. Collection of an ordinary receivable. 60. The possible holding periods for capital assets include: a. Short-term = held 14 months or less. b. Long-term = greater than six months. c. Long-term = greater than 12 months. d. Short-term = greater than 12 months. 61. A business taxpayer sells inventory for $80,000. The adjusted basis of the property is $58,000 at the time of the sale, and the inventory had been held more than one year. The taxpayer has: a. No gain or loss. b. Sold a long-term capital asset. c. Sold a short-term capital asset. d. An ordinary gain. 62. Stanley operates a restaurant as a sole proprietorship. Which of the following items are capital assets in his hands? a. The restaurant’s tables and chairs. b. A portable sound system used to play theme music for the restaurant. c. The restaurant building that is an asset of the sole proprietorship. d. An interest-bearing savings account used to keep the restaurant’s excess cash. 63. Michaela is in the business of creating posters (display art) for the movie industry. She creates a poster and sells it for a lump sum. She has: a. Sold a capital asset. b. Sold an ordinary asset. c. An ordinary gain. d. Choices b. and c. 64. Ramon is in the business of buying and selling securities. Which of the following is a capital asset for Ramon? a. The securities he designates as held for investment at the end of the day of acquisition. b. The securities he holds more than 12 months. c. All the securities he owns. d. Choices a., b., and c. 65. Stella purchased vacant land in 2017 that she subdivided for resale as lots. All 10 of the lots were sold during 2024. Each lot had a tax basis of $12,000 and was sold for $35,000. Stella made no substantial improvements to the lots. She acted as her own real estate broker; so there were no sales expenses for selling the lots. Which of the following statements is correct? a. Stella must hold the lots for at least five years before she is eligible for the special capital gain treatment of § 1237. b. The $230,000 gain from the sale of the 10 lots is all ordinary income. c. All of the $230,000 gain from the sale of the 10 lots is long-term capital gain. d. To be eligible for the special capital gain treatment of § 1237, Stella must be a real estate dealer. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions 66. A worthless security had had a holding period of six months when it became worthless on December 10, 2024. The investor who had owned the security had a basis of $20,000 for it. Which of the following statements is correct? a. The investor has a long-term capital loss of $20,000. b. The investor has a short-term capital loss of $20,000. c. The investor has a nondeductible loss of $20,000. d. The investor has a short-term capital gain of $20,000. 67. Lana purchased for $1,410 a $2,000 bond when it was issued two years ago. She amortized $200 of the original issue discount and then sold the bond for $1,800. Which of the following statements is correct? a. Lana has $10 of long-term capital loss. b. Lana has $190 of long-term capital gain. c. Lana has no capital gain or loss. d. Lana has $190 of long-term capital loss. 68. On June 1, 2024, Brady purchased an option to buy 1,000 shares of General, Inc. at $40 per share. He purchased the option for $3,000. It was to remain in effect for five months. The market experienced a decline during the latter part of the year, so Brady decided to let the option lapse as of December 1, 2024. On his 2024 tax return, what should Brady report? a. A $3,000 long-term capital loss. b. A $3,000 short-term capital loss. c. A $3,000 § 1231 loss. d. A $3,000 ordinary loss. 69. Which of the following events causes the purchaser of an option to add its cost to the basis of the property to which the option relates? a. The option is exercised. b. The option is sold. c. The option lapses. d. The option is rescinded. 70. Hiram is a computer engineer and, while unemployed, invents a switching device for computer networks. He patents the device but does not reduce it to practice. Hiram has a zero tax basis for the patent. In consideration of $800,000 plus a $1 royalty per device sold, Hiram assigns the patent to a computer manufacturing company. He assigns all substantial rights in the patent. Which of the following is correct? a. Hiram automatically has long-term capital gain from the lump-sum payment, but not from the royalty payments. b. Hiram automatically has long-term capital gain from the royalty payments but not from the lump-sum payment. c. Hiram automatically has long-term capital gain from both the lump-sum payment and the royalty payments. d. Hiram does not have automatic long-term capital gain from either the lump-sum payment or the royalty payments. 71. Gold Company signs a 13-year franchise agreement with Silver. Silver retained significant powers, rights, and a continuing interest. Gold (the franchisee) makes noncontingent payments of $18,000 per year for the first four years of the franchise. Gold also pays a contingent fee of 2% of gross sales every month. Which of the following statements is correct? a. Gold may deduct the $18,000 per year noncontingent payments in full as they are made. Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions b. Gold may deduct the monthly contingent fee as it is paid. c. Gold may deduct both the noncontingent annual fee and the contingent monthly fees as they are paid. d. Gold may not deduct either the noncontingent annual fee or the contingent monthly fees as they are paid. 72. A lessor is paid $45,000 by its commercial tenant as a lease cancellation fee. The tenant wanted to get out of its lease so it could move to a different building. The lessor had held the lease for three years before it was canceled. The lessor had a zero tax basis for the lease. The lessor has received: a. Ordinary income of $45,000. b. Long-term capital gain of $45,000. c. Short-term capital gain of $45,000. d. Neither gain nor loss. 73. Virgil was leasing an apartment from Marple, Inc. Marple paid Virgil $1,000 to cancel his lease and move out so that Marple could demolish the building. As a result: a. Virgil has a $1,000 capital gain. b. Virgil has a $1,000 capital loss. c. Marple has a $1,000 capital loss. d. Marple has a $1,000 capital gain. 74. On June 10, 2024, Ebon, Inc., acquired an office building as a result of a like-kind exchange. Ebon had given up a factory building that it had owned for 26 months as part of the like-kind exchange. Which of the following statements is correct? a. The holding period of the factory building includes the holding period of the office building. b. The holding period of the office building starts on June 11, 2024. c. The holding period of the office building starts on June 10, 2024. d. The holding period of the office building includes the holding period of the factory building. 75. Tan, Inc., sold a forklift on April 12, 2024, for $8,000 (its FMV) to its 100% shareholder, Ashley. Tan’s adjusted basis for the forklift was $12,000. Ashley’s holding period for the forklift: a. Includes Tan’s holding period for the forklift. b. Begins on April 12, 2024. c. Begins on April 13, 2024. d. Does not begin until Ashley sells the forklift. 76. Hank inherited Green stock from his mother when she died. She had a tax basis of $366,000 for the Green stock when she died and the Green stock was worth $437,000 at the date of her death. Which of the following statements is correct? a. Hank’s holding period for the Green stock includes his mother’s holding period for the stock. b. Hank’s holding period for the Green stock does not include his mother’s holding period for the stock. c. Hank’s holding period for the Green stock is automatically long term. d. Choices b. and c. 77. Which of the following is correct concerning short sales of stock at the time the short sale is made? a. The taxpayer does not deliver to the purchaser the shares sold short. b. The taxpayer delivers to the purchaser the shares sold short. c. The taxpayer may already own the shares sold short. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions d. The taxpayer always already owns the shares sold short. 78. Ryan has the following capital gains and losses for 2024: $6,000 STCL, $5,000 28% gain, $2,000 25% gain, and $6,000 0%/15%/20% gain. Which of the following is correct? a. The net capital gain is composed of $1,000 25% gain and $6,000 0%/15%/20% gain. b. The net capital gain is composed of $5,000 28% gain and $2,000 0%/15%/20% gain. c. The net capital gain is composed of $3,000 28% gain, $2,000 25% gain, and $2,000 0%/15%/20% gain. d. The net capital gain is composed of $1,000 28% gain and $6,000 0%/15%/20% gain. 79. In 2024, Mark has $18,000 short-term capital loss, $7,000 28% gain, and $6,000 0%/15%/20% gain. Which of the following statements is correct? a. Mark has a $5,000 capital loss deduction. b. Mark has a $3,000 capital loss deduction. c. Mark has a $13,000 net capital gain. d. Mark has a $5,000 net capital gain. 80. In 2023, Jenny had a $12,000 net short-term capital loss and deducted $3,000 as a capital loss deduction. In 2024, Jenny has a $18,000 0%/15%/20% long-term capital gain and no other capital gain or loss transactions. Which of the statements below is correct for 2024? a. Jenny has a $18,000 net capital gain. b. Jenny has a $9,000 net capital gain. c. Jenny has a $9,000 net capital loss. d. Jenny has a $3,000 capital loss deduction. 81. In 2024, Satesh has $5,000 short-term capital loss, $13,000 0%/15%/20% long-term capital gain, and $7,000 qualified dividend income. Satesh is single and has other taxable income of $15,000. Which of the following statements is correct? a. No more than $13,000 of Satesh’s taxable income is taxed at 0%. b. No more than $7,000 of Satesh’s taxable income is taxed at 0%. c. No more than $15,000 of Satesh’s taxable income is taxed at 0%. d. None of Satesh’s taxable income is taxed at 0%. 82. Cason is filing as single and has 2024 taxable income of $36,000 which includes $34,000 0%/15%/20% net long-term capital gain. What is his tax on taxable income using the alternative tax method? Note: Use the tax rate schedule rather than the tax table. a. $0 b. $200 c. $300 d. $4,088 83. Sara is filing as head of household and has 2024 taxable income of $69,000, which includes $3,000 of net long-term capital gain. The net long-term capital gain is made up of $1,000 25% gain and $2,000 0%/15%/20% gain. What is the tax on her taxable income using the alternative tax method? Note: Use the tax rate schedule rather than the tax table. a. $0 b. $8,329. c. $8,399. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions d. $8,539. 84. Seamus had $16,000 of net short-term capital loss in 2023. In 2024, he has $17,000 of long-term capital loss and $26,000 of long-term capital gain. Which of the following statements is correct? a. Seamus had a $13,000 short-term capital loss carryover to 2024. b. Seamus reports an overall $9,000 net capital gain in 2024. c. Seamus reports an overall $4,000 net short-term capital loss in 2024. d. Choices a. and c. 85. In 2024, an individual taxpayer has $863,000 of taxable income that includes $48,000 of 0%/15%/20% long-term capital gain. Which of the following statements is correct? a. All of the LTCG will be taxed at 0%. b. All of the LTCG will be taxed at 15%. c. All of the LTCG will be taxed at 20%. d. Some of the LTCG will be taxed at 15% and some at 20%. 86. Martha has both long-term and short-term 2024 capital gains and losses. The result of netting these gains and losses is a net long-term capital loss. Martha has no qualified dividend income. Also, her 2024 taxable income puts her in the 24% tax bracket. Which of the following is correct? a. Martha will use Parts I, II, and III of 2024 Form 1040 Schedule D. b. Martha will not benefit from the special treatment for long-term capital gains. c. Martha will have a capital loss deduction. d. All of these choices are correct. 87. Which of the following comparisons is correct? a. Corporations may carry back capital losses; individuals may not. b. Both corporation and individual long-term capital losses carry over as short-term capital losses. c. Corporations may carry forward capital losses indefinitely; individuals may carry forward capital losses for only five years. d. Both corporations and individuals may use an alternative tax rate on net capital gains. 88. Robin Corporation has ordinary income from operations of $30,000, net long-term capital gain of $10,000, and net short-term capital loss of $15,000. What is the taxable income for 2024? a. $25,000 b. $27,000 c. $28,500 d. $30,000 89. Violet, Inc., has a 2024 $80,000 long-term capital gain included in its $285,000 taxable income. Which of the following is correct? a. Violet will benefit from an alternative tax on net capital gains computation. b. Violet’s regular tax on taxable income is computed because there is no corporate alternative tax on net capital gains approach. c. Violet’s $80,000 net capital gain is not taxable. d. Violet’s regular tax on taxable income will be greater than its tax using an alternative tax on net capital gain Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions approach. 90. Which of the following is not a tax status for an asset? a. Capital loss asset. b. Capital asset. c. Section 1231 asset. d. Ordinary asset. 91. A painting that is not of investment quality is acquired by an individual for use in his home. It is later sold at a loss of $45. Which of the following statements is correct? a. The painting was a capital asset. b. The loss on the painting is not deductible. c. The loss on the painting is a deductible capital loss. d. Choices a. and b. 92. Emilio owns vacant land he is holding for investment. Two years ago he granted an option to purchase the land. The option grantee paid $25,000 for the option. This year the option expired unexercised. As a result, Emilio has: a. A $25,000 long-term capital gain. b. A $25,000 short-term capital gain. c. A $25,000 ordinary gain. d. No recognized gain or loss. 93. Property is acquired in a qualifying like-kind exchange. The acquired property is sold three months after it is acquired. Which of the following is correct? a. Since the holding period of the property given up in the exchange tacks to the holding period of the acquired property, the holding period of the acquired property could be long-term. b. The holding period of the acquired property is short-term. c. The holding period of property acquired in a like-kind exchange is always long-term. d. When property acquired in a like-kind exchange is disposed of, the holding period is not relevant. 94. Thoren has the following items for the year: $4,000 of short-term capital gain, $5,000 of 0%/15%/20% long-term capital gain, and $1,500 of 28% capital loss. Which of the following is correct? a. The $1,500 loss will first be offset by the $4,000 short-term gain. b. The $1,500 loss will first be offset by the $5,000 long-term gain. c. The $4,000 short-term gain will first be offset by the $5,000 long-term gain. d. The taxpayer will have a net short-term capital loss. 95. Jillian, a single taxpayer, has a net long-term capital gain for the year, and it is all made up of 25% long-term capital gain. She has positive taxable income for the year. Which of the following is not a possible tax rate that could be applied in taxing this gain as part of her taxable income? a. 0%. b. 12%. c. 20%. d. Choices a. and c. Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions 96. White Company acquires a new machine for $75,000 and uses it in White’s manufacturing operations. A few months after White places the machine in service, it discovers that the machine is not suitable for White’s business. White had fully expensed the machine in the year of acquisition using § 179. White sells the machine for $60,000 in the tax year after it was acquired but held the machine only for a total of 10 months. What was the tax status of the machine when it was disposed of and the amount of the gain or loss? a. A capital asset and $60,000 gain. b. An ordinary asset and $60,000 gain. c. A § 1231 asset and $60,000 gain. d. A § 1231 asset and $60,000 loss. 97. Which of the following assets held by a manufacturing business is a § 1231 asset? a. Inventory. b. Office furniture used in the business and held less than one year. c. A factory building used in the business and held more than one year. d. Accounts receivable. 98. Which of the following assets held by a cash basis accounting firm is a § 1231 asset? a. An account receivable from a client. b. A desk used in the business and held more than one year. c. A computer used in the business held more than one year and fully depreciated under § 179 when acquired. d. Choices b. and c. 99. A barn held more than one year and used in a business is destroyed in a tornado. The barn originally cost $356,000 and was fully depreciated using straight-line depreciation. The barn was insured for its $543,000 replacement cost minus a deductible of $1,000. Which of the following statements is correct concerning these facts? a. The barn was a long-term personal use asset. b. There is a casualty loss from disposition of the barn. c. The recognized gain from disposition of the barn is $186,000. d. The recognized gain from disposition of the barn is subject to special netting rules. 100. Which of the following would be included in the netting of § 1231 gains and losses? a. Personal use property net casualty gain. b. Section 1231 loss. c. Section 1231 gain. d. Choices b. and c. 101. Vertigo, Inc., has a 2024 net § 1231 loss of $64,000 and had a $32,000 net § 1231 gain in 2023. For 2024, Vertigo’s net § 1231 loss is treated as: a. Ordinary loss. b. Ordinary gain. c. Capital loss. d. Capital gain. 102. Vertical, Inc., has a 2024 net § 1231 gain of $67,000 and had a $22,000 net § 1231 loss in 2023. For 2024, Vertical’s net § 1231 gain is treated as: Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions a. $45,000 long-term capital gain and $22,000 ordinary loss. b. $67,000 ordinary gain. c. $45,000 long-term capital gain and $22,000 ordinary gain. d. $67,000 capital gain. 103. Verway, Inc., has a 2024 net § 1231 gain of $55,000 and had a $62,000 net § 1231 loss in 2023. For 2024, Verway’s net § 1231 gain is treated as: a. $55,000 ordinary loss. b. $55,000 ordinary gain. c. $55,000 capital loss. d. $55,000 capital gain. 104. The following assets in Jack’s business were sold in 2024: Asset Office equipment Automobile ABC stock (capital asset)

Holding Period 6 years 8 months 2 years

Gain/(Loss) $1,100 ($ 800) $1,400

Office equipment, purchased for $8,000, had a zero adjusted basis. The automobile was purchased for $2,000 and sold for $1,200. The ABC stock was purchased for $1,800 and sold for $3,200. In 2024 (the year of sale), Jack should report what amount of net capital gain and net ordinary income? a. $1,700 LTCG. b. $600 LTCG and $300 ordinary gain. c. $1,400 LTCG and $300 ordinary gain. d. $2,500 LTCG and $800 ordinary loss. 105. During 2024, an individual had the following gains and losses on property held for the long-term holding period: sale of Orange common stock ($8,000 gain); sale of real property used in the taxpayer’s business ($1,800 loss); destruction of real property used in the taxpayer’s business by fire ($1,000 loss). Which of the following statements is correct? a. The fire loss would reduce the real property sale loss. b. The fire loss would reduce the stock sale gain. c. The sale of real property loss would be netted against the stock sale gain. d. The sale of real property is a § 1231 loss. 106. Which of the following is correct? a. Improperly classifying a § 1231 loss as a capital loss might affect adjusted gross income. b. Improperly classifying a capital loss as a § 1231 loss might affect adjusted gross income. c. Misclassifying a § 1231 gain as a short-term capital gain might affect adjusted gross income. d. All of these choices are correct. 107. Spencer has an investment in two parcels of vacant land. Parcel 1 is a capital asset, and parcel 2 is a § 1231 asset. Spencer already has a short-term capital loss for the year that he would like to offset with capital gain. He has a § 1231 lookback loss that exceeds the gain from the disposition of either land parcel. Spencer wants to sell only one land parcel: Each of them would yield the same amount of gain. The gain that would be recognized exceeds the short-term capital loss Spencer already has. Which of the following statements is correct? Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions a. Spencer will have a net capital loss no matter which land parcel he sells. b. Spencer will have a net capital loss if he sells parcel 2. c. Spencer will have a net capital loss if he sells parcel 1. d. Spencer will have a net capital gain if he sells either parcel 1 or parcel 2. 108. Copper Corporation sold machinery for $47,000 on December 31, 2024. The machinery had been purchased on January 2, 2021, for $60,000 and had an adjusted basis of $41,000 at the date of the sale. For 2024, what should Copper report? a. Ordinary income of $6,000. b. A § 1231 gain of $3,000 and $3,000 of ordinary income. c. A § 1231 gain of $6,000. d. A § 1231 gain of $6,000 and $3,000 of ordinary income. 109. Blue Company sold machinery for $45,000 on December 23, 2024. The machinery had been acquired on April 1, 2022, for $69,000 and its adjusted basis was $34,200. The § 1231 gain, § 1245 recapture gain, and § 1231 loss from this transaction are: a. $0 § 1231 gain, $10,800 § 1245 recapture gain, and $0 § 1231 loss. b. $0 § 1231 gain, $0 § 1245 recapture gain, and $14,800 § 1231 loss. c. $0 § 1231 gain, $34,200 § 1245 recapture gain, and $0 § 1231 loss. d. $0 § 1231 gain, $10,800 § 1245 recapture gain, and $34,200 § 1231 loss. 110. Red Company had an involuntary conversion on December 23, 2024. The machinery had been acquired on April 1, 2022, for $49,000, and its adjusted basis was $14,200. The machinery was completely destroyed by fire, and Red received $10,000 of insurance proceeds for the machine and did not replace it. This was Red’s only casualty or theft event for the year. As a result of this event, Red initially has: a. $10,000 § 1231 loss. b. $10,000 § 1245 recapture gain. c. $4,200 casualty loss. d. $4,200 § 1231 loss. 111. Orange Company had machinery completely destroyed by a fire on December 23, 2024. The machinery had been acquired on April 1, 2022, for $49,000, and its adjusted basis was $14,200. Orange received $30,000 of insurance proceeds for the machinery and did not replace it. This was Orange’s only casualty or theft event for the year. As a result of this event, Orange has: a. $4,200 ordinary loss. b. $15,800 § 1245 recapture gain. c. $14,200 § 1245 recapture gain. d. $30,000 § 1231 gain. 112. Which of the following events could result in § 1250 depreciation recapture? a. Sale at a loss of a depreciable business building held more than one year. b. Sale at a gain of qualified improvement property held more than a year on which bonus depreciation [§ 168(k)] was taken. c. Sale at a loss of a depreciable business building held for nine months. d. Sale at a gain of depreciable equipment held more than a year on which straight-line depreciation was taken. Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions 113. Which of the following real property could be subject to § 1250 depreciation recapture? a. Property placed in service after 1986 on which straight-line depreciation was taken. b. A building on which § 168(k) depreciation was taken. c. Equipment on which accelerated depreciation was taken. d. Land that was not depreciated. 114. Assume that a building is subject to § 1250 depreciation recapture because bonus depreciation [§ 168(k)] was used. The building is destroyed in a hurricane, which is the taxpayer’s only casualty or theft for the year. In which of the following situations could there be a § 1250 depreciation recapture gain? a. There is a loss because the insurance recovery is less than the adjusted basis. b. There is a gain because the insurance recovery exceeds the adjusted basis. c. Because of the length of time the building has been held, there is no remaining additional depreciation. d. There is no insurance recovery, and the adjusted basis of the building is greater than zero. 115. Maria owns depreciable residential rental real estate that has accumulated depreciation of $65,000 (all from straightline). If Maria sold the property, she would have a $53,000 gain. The initial characterization of the gain would be: a. Section 1245 gain. b. Section 1231 gain. c. Section 1250 gain. d. Section 1239 gain. 116. A retail building used in the business of a sole proprietor is sold on March 10, 2024, for $342,000. The building was acquired in 2014 for $400,000 and straight-line depreciation of $104,000 had been taken on it. What is the maximum unrecaptured § 1250 gain from the disposition of this building? a. $400,000 b. $322,000 c. $104,000 d. $26,000 117. Which of the following statements is correct? a. When depreciable property is gifted to another individual taxpayer, the depreciation recapture potential is extinguished. b. When depreciable property is inherited by a taxpayer, the depreciation recapture potential is extinguished. c. When corporate depreciable property is distributed as a dividend, the depreciation recapture potential is generally not recognized. d. When depreciable property is contributed to charity, the depreciation recapture potential has no effect on the amount of the charitable contribution deduction. 118. Which of the following would cause recognition of § 1245 recapture? a. An exchange of depreciable business equipment for like-kind business equipment with gain realized and recognized. b. A nontaxable incorporation under § 351. c. A nontaxable contribution to a partnership under § 721. d. A nontaxable reorganization. 119. Section 1239 (relating to the sale of certain property between related taxpayers) does not apply unless the property: Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions a. Was depreciated by the transferor. b. Is depreciable in the hands of the transferee. c. Is a capital asset. d. Is real property. 120. An individual has a $40,000 § 1245 gain, a $35,000 § 1231 gain, a $33,000 § 1231 loss, a $3,000 § 1231 lookback loss, and a $15,000 long-term capital gain. The net long-term capital gain is: a. $30,000. b. $40,000. c. $17,000. d. $15,000. 121. An individual has the following recognized gains and losses from disposition of § 1231 assets (all were vacant land): $15,000 gain, $10,000 loss, $25,000 gain, and $2,000 loss. The individual has a $5,500 § 1231 lookback loss. The individual also has a $16,000 net short-term capital loss from the disposition of stock. Which of the following statements is correct? a. The taxpayer has $5,500 ordinary gain and $6,500 net long-term capital gain. b. The taxpayer has $12,000 net long-term capital gain. c. The taxpayer has $28,000 ordinary gain and $16,000 net short-term capital loss. d. The taxpayer has $5,500 ordinary loss and $6,500 net long-term capital gain. 122. Section 1231 gain that is treated as long-term capital gain carries from the 2023 Form 4797 to the 2023 Form 1040, Schedule D, line ____. a. 8 b. 9 c. 10 d. 11 123. Business equipment is purchased on March 10, 2023, used in the business until September 29, 2023, and sold at a $23,000 loss on October 10, 2023. The equipment was not suitable for the work the business had purchased it for. The loss on the disposition should be reported on the 2023 Form 4797, Part: a. I. b. II. c. III. d. IV. Subjective Short Answer 124. Theresa and Oliver, both over 65 years of age and married filing jointly, have no dependents. Their 2024 income tax facts are: Theresa’s wages Oliver’s wages Short-term capital gain Long-term capital loss Powered by Cognero

$165,000 33,000 36,000 (41,000) Page 17

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions What is their taxable income for 2024? 125. Carol had the following transactions during 2024: a painting held for two years and sold at a gain of $85,000; 100 shares of Gray stock held six months and sold for a loss of $6,000; 50 shares of Yellow stock held 18 months and sold for a gain of $36,000. Carol also had $264,000 of taxable income from other sources than these property transactions. What is Carol’s net capital gain (or net capital loss) and what is her taxable income? 126. On January 10, 2024, Wally sold an option for $2,000 on vacant land he held as an investment. He had purchased the land in 2020 for $76,000. The option allowed the option holder to purchase the property for $122,000 plus the cost of the option. On March 1, 2024, the option holder exercised the option. What is the amount and nature of Wally’s gain or loss from disposition of the land? 127. Willie is the owner of vacant land that he purchased in 2020 for $1,400,000 and held for investment. On January 22, 2023, he was paid $145,000 for a 13-month option on the land by Susan. She could buy the land for an additional $1,200,000 by exercising the option. Susan had hoped to build a luxury home on the land but was unable to get approval to build a big enough home to satisfy her needs. Consequently, Susan did not exercise her option, which expired on February 22, 2024. (1) What is Willie’s basis, gain or loss, and type of gain or loss from these events? (2) What is Susan’s basis, gain or loss, and type of gain or loss from these events? 128. Samuel, head of household with two dependents, has 2024 wages of $26,000, paid deductible alimony of $3,000, has taxable interest income of $2,000, and a $12,000 0%/15%/20% net long-term capital gain. Samuel uses the standard deduction and is age 38. What is his 2024 taxable income and the tax on the taxable income? 129. Ahmed was the holder of a patent on a video game. During 2024, he sold all substantial rights in the patent for $365,000 in cash and a 3% royalty on the purchaser’s first $10,200,000 of sales each year related to the product in which the patent is incorporated. Ahmed had not reduced the patent to practice. He had a $86,000 basis for the patent. During 2024, he received $30,000 in royalties. What is the nature and amount of Ahmed’s gain? 130. Tyrone’s father who died on January 10, 2024 had owned stock for 20 years with a basis of $45,000 that was transferred to Tyrone as a gift on August 10, 2023, when the stock was worth $430,000. Tyrone's father had paid no gift taxes. This stock was worth $566,000 at the date of the father’s death. Tyrone sold the stock for $545,000 net of commissions on February 23, 2024. What is the amount and nature of his gain or loss from disposition of this property? 131. On January 18, 2023, Martha purchased 200 shares of Blue Corporation stock for $2,000. On November 11, 2024, she sold short 200 shares of Blue stock, which she borrowed from her broker for $2,300. On February 10, 2025, Martha closed the short sale by delivering the 200 shares of Blue stock which she had acquired in 2023. On that date, Blue stock had a market price of $4 per share. What is Martha’s recognized gain or loss and its character in 2024? In 2025? 132. Sharon has the following results of netting her short-term and long-term capital gains and losses for 2024: $56,000 short-term capital loss and $82,000 net long-term capital gain ($21,000 0%/15%/20% long-term capital gain and $61,000 25% long-term capital gain). a.

What is her net capital gain or loss for 2024?

b.

If there is a net capital loss, how much and what type of the loss carries over to 2025?

c.

If there is a net long-term capital gain, what is it made up of?

133. The following chart details Sheen’s 2022, 2023, and 2024 stock transactions. What is the capital loss carryover to 2024 and what is the net capital gain or loss for 2024? Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions

Tax Year 2022 2023 2024

Short-Term Capital Gains $ 4,000 $16,000 $55,000

Short-Term Capital Losses $ 6,000 $14,000 $52,000

Long-Term Capital Gains $ 2,000 $23,000 $67,000

Long-Term Capital Losses $13,000 $28,000 $33,000

134. Kiara is unmarried with one dependent and files as head of household. She had 2024 taxable income of $45,000, which included $16,000 of 0%/15%/20% net long-term capital gain. What is her tax on taxable income using the alternative tax on net long-term capital gain method? Use the tax rate schedules in your computations. 135. Harold is a head of household, has $27,000 of taxable income in 2024 from noncapital gain or loss sources, and has the following capital gains and losses: 28% long-term capital gain 28% long-term capital loss 0%/15%/20% long-term capital gain Short-term capital loss

$ 4,300 (2,000) 19,000 (1,700)

What is Harold’s taxable income and the tax on that taxable income? Use the appropriate tax rate schedules for your tax computations. 136. Mike is a self-employed TV technician. He is usually paid as soon as he completes repairs but occasionally bills a customer with payment expected within 30 days. At the end of the year, he has $2,500 of receivables outstanding. He expects to collect $1,200 of this and write off the remainder. Mike is a cash basis taxpayer and had net earnings from his business (not including the effect of the items above) of $55,000. He also had $3,500 interest income and $200 gambling winnings, and he sold corporate stock for $7,000. The stock had been purchased in 2020 for $8,200. Mike is single and claims the standard deduction. What is his 2024 taxable income? (Ignore the self-employment tax deduction.) 137. A business taxpayer sold all the depreciable assets of the business, calculated the gains and losses, and would like to know the final character of those gains and losses. The taxpayer had $353,000 of adjusted gross income before considering the gains and losses from sale of the business assets. The taxpayer had unrecaptured § 1241 lookback loss of $22,000. What is the treatment of the gains and losses summarized in the following table after all possible netting and reclassification have been completed? What is the taxpayer’s adjusted gross income? (Ignore the self-employment tax deduction.) Asset Machine 1 Machine 2 Machine 3 Machine 4

Purchase Date 10/10/22 10/02/21 09/23/20 09/23/20

Sale Date 11/11/24 11/11/24 11/11/24 11/11/24

Depreciation $323,000 65,000 183,000 28,000

Gain (Loss) $66,000 (15,000) 23,000 34,000

138. A business taxpayer sold all depreciable assets of the business, calculated the gains and losses, and would like to know the final character of those gains and losses. The taxpayer had $353,000 of adjusted gross income before Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions considering the gains and losses from sale of the business assets. The taxpayer had unrecaptured § 1231 lookback loss of $12,000. What is the treatment of the gains and losses summarized in the following table after all possible netting and reclassification have been completed? What is the taxpayer’s adjusted gross income? (Ignore the self-employment tax deduction.) Asset Machine 1 Machine 2 Machine 3 Machine 4

Purchase Date 10/10/22 10/02/22 09/23/20 09/23/20

Sale Date 11/11/24 11/11/24 11/11/24 11/11/24

Depreciation $323,000 65,000 183,000 28,000

Gain (Loss) $66,000 (15,000) 23,000 64,000

139. A business machine purchased April 10, 2022, for $98,000 was fully depreciated in 2022 using § 179 immediate expensing. On August 15, 2024, the machine was sold for $67,000. What is the amount and nature of the gain or loss from disposition of the machine? 140. An individual taxpayer has the following gains and losses. There is $3,000 of § 1231 lookback losses. What is the net long-term capital gain? Character of Gain or Loss 5 years/vacant land § 1231 gain 2 years/business equipment § 1245 gain 3 years/publicly traded stock Long-term capital gain 8 months/publicly traded stock Short-term capital loss

Amount

Holding Period/Property

$7,000 3,200 890 (1,870)

141. Vanna owned an office building that had been held more than one year when it was sold for $567,000. The real estate had an adjusted basis of $45,000 for the land and $233,000 for the building. Straight-line depreciation of $162,000 had been taken on the building. What are the amount and initial character of the gain or loss from disposition of the real estate? Is any of the gain unrecaptured § 1250 (25%) gain? 142. The following table describes the § 1231 assets sold by Ecru Company (a sole proprietorship) this year. Compute the gain or loss from each asset disposition and determine the net § 1231 gain treated as long-term capital gain for the year. Assume there is a § 1231 lookback loss of $4,000. Asset Stamping machine Factory building Tractor Overhead crane

Acquired 3/10/20

Sold 8/10/24

Cost $40,000

Depreciation $29,736

Sale Price $32,000

2/12/17

7/23/24

80,000

18,838

90,000

5/16/19 11/12/13

11/13/24 2/25/24

52,000 74,000

52,000 74,000

30,000 18,000

Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions

143. The following table describes the § 1231 assets sold by Tan Company (a sole proprietorship) this year. Compute the gain or loss from each asset disposition and determine the net § 1231 gain treated as long-term capital gain for the year. Assume that there is a § 1231 lookback loss of $14,000. Asset Stamping machine Factory building Tractor Overhead crane

Acquired 3/10/20 2/12/17 5/16/19 11/12/13

Sold 8/10/24 7/23/24 11/13/24 2/25/24

Cost $40,000 80,000 52,000 74,000

Depreciation $29,736 18,838 52,000 74,000

Sale Price $ 2,000 90,000 60,000 18,000

144. Residential real estate was purchased in 2021 for $345,000, held as rental property, and depreciated straight-line. Assume that the land cost was $45,000 and the building cost was $300,000. Depreciation totaled $34,089. The building and land were sold on June 10, 2024, for $683,000 total. What are the tax status of the property and the nature of the gain from the disposition, and is any of it § 1250 depreciation recapture gain or unrecaptured § 1250 gain? 145. Williams owned an office building (but not the land) that was destroyed by a fire. The building was insured and he has a $156,000 gain because his insurance recovery exceeded his adjusted basis for the building. Williams may replace the building. He had taken $145,000 of depreciation on the building, has no § 1231 lookback loss, has no other § 1231 transactions for the year, and has no Schedule D transactions for the year. What is final nature of his gain for the year and what tax rate(s) apply to the gain if: a.

He does reinvest the insurance proceeds.

b.

If he does not reinvest the insurance proceeds.

146. A business machine purchased April 10, 2023, for $62,000 was fully depreciated in 2023 using § 179 immediate expensing. On August 15, 2024, the sole proprietor who owned the machine gave it to his son. On that date, the machine’s fair market value was $57,000. The son did not use the machine in business or hold it as inventory and sold it on November 22, 2024, for $53,000.What are the amount and nature of the gain or loss from disposition of the machine? Where is it reported in the son’s tax return? 147. Betty, a single taxpayer with no dependents, has the following gains and losses. Before considering these transactions, she has $45,000 of other taxable income. What is the treatment of the gains and losses and what is Betty’s taxable income? § 1245 gain #1 § 1245 gain #2 Business equipment long-term casualty loss Business real property long-term casualty gain § 1231 gain § 1231 lookback loss

$18,000 5,000 (8,000) 12,000 13,000 (2,000)

148. In 2024, Ha-yoon, a single taxpayer with no dependents, disposed of a business building for $44,000 that cost $100,000. Depreciation of $60,000 had been taken on the building. Ha-yoon has a short-term capital loss of $3,000 this Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions year. She has taxable income (not related to property transactions) of $125,000 and no § 1231 lookback loss. What is the amount and nature of the gain or loss, what is Ha-yoon’s taxable income, and what is her tax on the taxable income? 149. Charmine, a single taxpayer with no dependents, has already incurred a $10,000 § 1231 gain in 2024 and has no § 1231 lookback losses. She purchased a business machine for $100,000 five years ago; $70,000 of depreciation has been taken on it, and the machine is now worth $90,000. How will the net § 1231 gain or loss be affected if Charmine trades in the business machine for a like-kind business machine and pays an additional $12,000 in cash to obtain the replacement machine? If Charmine already has $352,000 of taxable income, which does not include a $10,000 § 1231 gain or any capital gains or losses, what is her taxable income? Essay 150. Mei (now 37 years old) owns a collection of porcelain dolls that she acquired when she was a grade-schooler. She had forgotten about them until her mother sent them to her. Her mother had discovered them in a box in her attic while she was cleaning out her house before selling it. Mei had originally acquired all the dolls as gifts from her parents, so she has no way to establish a basis for them. Using information from the Internet, she prepares a careful inventory of the dolls that includes their name, when they were first available for sale, their current value, and other pertinent information. She then lists them for sale on the Internet. To her surprise, she quickly gets an offer of $5,000 for all of them, which she accepts. Mei has no other gain or loss transactions for the year and is in the 24% marginal tax bracket. What issues do these facts create? 151. Hilda lent $2,000 to a close personal friend to help the friend avoid overdrawing the friend’s checking account. The friend was supposed to repay the $2,000 within a month. Instead, the friend declared personal bankruptcy and Hilda will never recover any of the $2,000. What are the tax implications of these events for Hilda? 152. Ranja acquires $200,000 face value corporate bonds for $186,000 when the bonds are issued. He holds the bonds as an investment for two years and then sells them for $198,000. He amortizes $2,000 of the original issue discount. What tax issues does Ranja have with respect to these bonds? 153. In early 2023, Wanda paid $33,000 for an option on a parcel of land she intended to hold as an investment. After a survey of the land (paid for by the grantor) determined that the parcel was much smaller than the grantor said it was, she let the option lapse when it expired in 2024 after 14 months. How should Wanda treat these events in 2023? In 2024? 154. Jambo invented a new flexible cover for a popular brand of cell phone, but did not have the finances to produce it. Instead, he sold all his rights to the invention (after patenting it) for $450,000 plus $0.10 for each cover sold by the company that purchased the patent. Jambo had a zero tax basis for the invention. What is the character of his gain from disposition of the patent? 155. Collectibles that are held long-term and sold at a gain are subject to maximum tax rate of 28%. An individual taxpayer recently sold an antique car for $40,000. The taxpayer had originally paid $30,000 for the car and had held it for for several years. Explain why the car is or is not a collectible. 156. When an individual taxpayer has a net long-term capital gain that includes both a 28% gain and a 0%/15%/20% gain, which of these gains will be taxed first when the alternative tax on net long-term capital gain method is used and what difference does it make? 157. In 2020, Aaron purchased a classic car for $12,000 that he planned to restore. However, Aaron is too busy to work on the car and gives it to his daughter Ellie in 2024. At this time, the fair market value of the car has declined to $10,000. Aaron paid no gift tax on the transaction. Ellie completes some of the restoration herself with out-of-pocket costs of $5,000. She later sells the car for $30,000. What is Ellie’s recognized gain or loss on the sale of the car? Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions 158. Annabelle, a trader in securities, works for a national securities firm. She occasionally buys and sells securities for her personal account. On May 10, 2023, she purchased 100 shares of Acorn, Inc. common stock for a total of $40,000. She sold all of those shares for a total of $46,000 on July 11, 2024. What was the amount and nature of her gain or loss from this transaction? What could she have done to change this result? 159. May an individual who has purchased a patent be a holder of that patent? 160. Alexis received stock worth $4,000 at the time it was gifted to her by her father. He had acquired the stock several years earlier for $2,200. He paid no gift tax on the transfer to Alexis. Alexis sells the stock for $6,600 two months after receiving it. What are the nature and amount of Alexis’s gain or loss? 161. An individual taxpayer has a $2,500 short-term capital loss for the year. The taxpayer, who has significant taxable income from other sources, could sell stock and generate a $2,500 long-term capital gain. Explain the impact on the taxpayer’s taxable income if he did or did not sell the stock. 162. Why is it generally better to have a net § 1231 gain year followed by a net § 1231 loss year rather than a net § 1231 loss year followed by a net § 1231 gain year? 163. Describe the circumstances in which the potential § 1245 depreciation recapture is extinguished. 164. Describe the circumstances in which the maximum unrecaptured § 1250 gain (25% gain) does not become part of the Schedule D netting process for an individual taxpayer? 165. Depreciable personal property was sold at a gain in 2023. On what 2023 form would this transaction be reported, where initially in that form, and what will the form most likely do with the gain?

Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions Answer Key 1. True 2. True 3. True 4. True 5. False 6. False 7. True 8. True 9. False 10. True 11. True 12. True 13. False 14. True 15. True 16. True 17. True 18. True 19. False 20. True 21. False 22. False 23. True 24. True 25. True Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions 26. True 27. True 28. True 29. True 30. True 31. True 32. True 33. True 34. True 35. True 36. True 37. True 38. False 39. True 40. True 41. True 42. True 43. True 44. False 45. False 46. True 47. True 48. True 49. False 50. True Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions 51. True 52. False 53. True 54. False 55. True 56. True 57. True 58. d 59. c 60. c 61. d 62. d 63. d 64. a 65. a 66. b 67. b 68. b 69. a 70. c 71. b 72. a 73. a 74. d 75. c 76. d Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions 77. b 78. a 79. b 80. b 81. c 82. b 83. c 84. d 85. c 86. d 87. a 88. d 89. b 90. a 91. d 92. c 93. a 94. b 95. d 96. b 97. c 98. d 99. d 100. d 101. a Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions 102. c 103. b 104. c 105. d 106. d 107. b 108. a 109. a 110. c 111. b 112. b 113. b 114. b 115. b 116. c 117. b 118. a 119. b 120. d 121. a 122. d 123. b 124. The couple’s taxable income is $162,700. Their long-term capital loss carryover is $2,000 ($5,000 – $3,000). Wages ($165,000 + $33,000) Short-term capital gain Long-term capital loss Net long-term capital loss Powered by Cognero

$198,000 $36,000 (41,000) ($ 5,000) Page 28

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions Capital loss deduction (limited to $3,000) Adjusted gross income Standard deduction Additional standard deduction (2 × $1,550) Taxable income

(3,000) $195,000 (29,200) (3,100) $162,700

125. Carol has taxable income of $379,000. Long-term capital gain from painting Long-term capital gain from Yellow stock Net long-term capital gain Short-term capital loss from Gray stock Net long-term capital gain (net capital gain) Other taxable income Total taxable income

$ 85,000 36,000 $121,000 (6,000) $115,000 264,000 $379,000

126. Wally’s proceeds from selling the land are $124,000 ($2,000 option proceeds + $122,000 sale proceeds). Wally’s gain is $48,000 ($124,000 – $76,000) and is all long-term capital gain because the asset was a capital asset held more than 12 months. 127. (1) Willie held the land for investment; consequently, it was a capital asset. Willie had no recognized gain or loss in 2023 from the receipt of the $145,000 option proceeds. When the option expired in 2024, the $145,000 option price is ordinary income because the option property was not stocks, securities, commodities, or commodity futures. The basis of the property remains $1,400,000. (2) The tax status of an option is determined by what would be the tax status of the property to be acquired with the option. The land would have been used in a personal use activity and, therefore, would have been a capital asset. Consequently, the option on the land was a capital asset. The lapse of the option is considered a sale or exchange on the option expiration date. However, the $145,000 loss on the lapse of the option is not usable because losses on sale or exchange of personal use activity property are not deductible. 128. Samuel has $15,100 taxable income and the tax on that taxable income using the alternative tax on net long-term capital gain is $310. Wages Interest income Net long-term capital gain Gross income Alimony paid Adjusted gross income Powered by Cognero

$26,000 2,000 12,000 $40,000 (3,000) $37,000 Page 29

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions Standard deduction (head of household) Taxable income Tax on other taxable income ($15,100 – $12,000) @ 10% Alternative tax on $12,000 net long-term capital gain @ 0% Total tax

(21,900) $15,100 $310 –0– $310

The regular tax liability on $15,100 taxable income would have been $1,510.

129. Ahmed was the holder of a patent and transferred all substantial rights to it. Consequently, § 1235 grants automatic long-term capital gain treatment to both the cash received and the royalties received. Ahmed recovers his $86,000 basis and has a $309,000 ($365,000 + $30,000 – $86,000) 0%/15%/20% long-term capital gain. 130. Tyrone had a tax basis for the stock equal to its $45,000 basis at the date of his father’s gift of the stock. He also had a long-term holding period because the father’s 20-year holding period is added to Tyrone’s holding period. Consequently, he had a $500,000 ($545,000 – $45,000) long-term capital gain when he sold the stock.

131. Since Martha owned substantially identical stock on the date of the short sale and did not close the short sale before January 31, 2025, she is deemed to have closed the short sale on November 11, 2024 (the date of the short sale). On her 2024 tax return, she would report a $300 long-term capital gain ($2,300 short sale price – $2,000 cost). On February 10, 2025, Martha has a $1,500 short-term capital loss [$2,300 basis for the shares sold – $800 (200 shares × $4 per share)] because the holding period of the shares used to close the short sale commences with the date of the short sale. 132. a.

Sharon has a 2024 net long-term capital gain of $26,000 ($82,000 net long-term capital gain – $56,000 net short-term capital loss).

b.

There is no net capital loss.

c.

The $56,000 short-term capital loss first absorbs the $61,000 of 25% gain, leaving $5,000 of 25% long-term capital gain and $21,000 of 0%/15%/20% long-term capital gain.

133. The 2023 capital loss carryforward is $10,000 and the 2024 net capital gain is $3,000 short-term and $24,000 longterm. There was a $2,000 net short-term capital loss and a $11,000 net long-term capital loss in 2022. All of the short-term capital loss and $1,000 of the long-term capital loss were used for the $3,000 capital loss deduction and $10,000 of longterm capital loss carried forward to 2023. The $10,000 long-term capital loss carryforward is grouped with the 2023 longPowered by Cognero

Page 30

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions term losses. In 2023, there is $2,000 net short-term capital gain that is netted against the $15,000 ($23,000 long-term gain – $28,000 2023 long-term loss – $10,000 long-term loss carryforward) net long-term capital loss, resulting in a $13,000 net long-term capital loss for 2023. After the $3,000 capital loss deduction, $10,000 is carried forward as long-term capital loss to 2024. In 2024, the $10,000 is added to the long-term capital losses. There is a 2024 net short-term capital gain of $3,000 and a net long-term gain of $24,000 ($67,000 long-term gain – $33,000 2024 long-term loss – $10,000 long-term loss carryforward). The net result for 2024 is both net short-term capital gain of $3,000 and long-term capital gain of $24,000. 134. Kiara has a tax of $3,149. Her tax on other taxable income of $29,000 ($45,000 – $16,000) is $3,149. Her tax on the $16,000 of 0%/15%/20% at 0% is $0 (her taxable income does not exceed $63,000, so she pays 0% on the entire net longterm capital gain of $16,000). Kiara would have paid tax of $5,069 on her taxable income if it had not included any net long-term capital gain. 135. Harold has taxable income of $46,600 and the tax (as a head of household) on that taxable income is $2,981. 28% long-term capital gain 28% long-term capital loss Net 28% long-term capital gain Net short-term capital loss Remaining 28% long-term gain 0%/15%/20% long-term capital gain Net long-term capital gain Other taxable income Taxable income Tax on $27,000 other taxable income Tax on 28% gain portion of net long-term capital gain; Harold is still in 12% bracket ($600 × 12%) Tax on 0%/15%/20% net long-term capital gain; Harold is still in 12% bracket [($46,600 – $27,000 – $600) × 0%] Total tax using the alternative tax

$ 4,300 (2,000) $ 2,300 (1,700) $ 600 19,000 $19,600 27,000 $46,600 $2,909 72 –0– $2,981

The regular tax liability on the $46,600 of taxable income would have been $5,261. 136. Since Mike is a cash basis taxpayer, he may not deduct bad debts from accounts receivable because he would not have included the accounts receivable in his gross income. His 2024 taxable income is $42,900, computed as follows. Net business income Interest income Gambling winnings Long-term capital loss ($7,000 – $8,200) Adjusted gross income Standard deduction Taxable income Powered by Cognero

$55,000 3,500 200 (1,200) $57,500 (14,600) $42,900 Page 31

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions

137. The taxpayer has adjusted gross income of $461,000 after including the effect of the property transactions. Machine 1’s $66,000 gain is all ordinary income due to § 1245 depreciation recapture. Machine 3’s $23,000 gain is all ordinary income due to § 1245 depreciation recapture. Machine 4 has $28,000 of ordinary income due to § 1245 depreciation recapture (equals depreciation taken) and $6,000 § 1231 gain ($34,000 – $28,000). Machine 2’s $15,000 loss is a § 1231 loss. There is a $9,000 net § 1231 loss ($6,000 gain – $15,000 loss) for the year. The net ordinary gain for the year is $108,000 ($66,000 + $23,000 + $28,000 – $9,000). There is no net § 1231 gain, so the $22,000 § 1231 unrecaptured lookback loss does not affect the character of the current year’s gains. Adjusted gross income is $461,000 ($353,000 + $108,000). 138. The taxpayer has adjusted gross income of $491,000 after including the effect of the property transactions. Machine 1’s $66,000 gain is all ordinary income due to § 1245 depreciation recapture. Machine 3’s $23,000 gain is all ordinary income due to § 1245 depreciation recapture. Machine 4 has $28,000 of ordinary income due to § 1245 depreciation recapture (equals depreciation taken) and $36,000 § 1231 gain ($64,000 – $28,000). Machine 2’s $15,000 loss is a § 1231 loss. There is a $21,000 net § 1231 gain ($36,000 gain – $15,000 loss) for the year. The $12,000 § 1231 unrecaptured lookback loss converts $12,000 of this gain to ordinary income, leaving $9,000 of the net § 1231 gain to be treated as long-term capital gain. The net ordinary gain for the year is $129,000 ($66,000 + $23,000 + $28,000 + $12,000). Adjusted gross income is $491,000 ($353,000 + $129,000 + $9,000). 139. The machine was a § 1231 asset because it was held for more than 12 months. However, all of the $67,000 ($67,000 sales price – $0 adjusted basis) gain is ordinary gain due to § 1245 depreciation recapture. 140. The taxpayer has a net long-term capital gain of $4,890 and a net short-term capital loss of $1,870. The $3,200 of § 1245 gain is ordinary income and does not affect the net long-term capital gain computation. Since there is $3,000 of § 1231 lookback loss, $3,000 of the $7,000 § 1231 gain is treated as ordinary income and the remaining $4,000 of § 1231 gain is treated as long-term capital gain. The $1,870 of short-term capital loss offsets the $4,890 of long-term capital gain, resulting is a net capital gain of $3,020 (0%/15%/20% gain). Summary: $6,200 ordinary income, $4,890 LTCG, $1,870 STCL. 141. The real estate was used in business and held more than one year. Therefore, the property was a § 1231 asset. Since straight-line depreciation was taken, there is no § 1250 depreciation recapture because no accelerated depreciation was taken. The entire gain of $289,000 [$567,000 sale price – ($45,000 land adjusted basis + $233,000 building adjusted basis)] is § 1231 gain. Since the recognized gain is greater than the $162,000 of depreciation, there is $162,000 of unrecaptured § 1250 gain in the $289,000 recognized gain. 142. The stamping machine ($21,736), tractor ($30,000), and overhead crane ($18,000) are sold at a gain, which is ordinary due to § 1245 depreciation recapture. The factory building yields a § 1231 gain of $28,838. There is no § 1250 depreciation recapture because straight-line depreciation was used (i.e., the building was placed in service after 1986). Of the $28,838 gain, $4,000 is treated as ordinary income because of the $4,000 § 1231 lookback loss. Consequently, the net § 1231 gain treated as long-term capital gain is $24,838 ($28,838 – $4,000). The following table provides detail on the computations: Asset

Acquired

Stamping 3/10/20 machine Factory 2/12/17 Powered by Cognero

Sold

Cost Depreciation Basis Sale Price Gain (Loss) 8/10/24 $40,000 $29,736 $10,264 $32,000 $21,736 7/23/24 80,000

18,838

61,162

90,000

28,838 Page 32

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions building Tractor 5/16/19 11/13/24 52,000 Overhead 11/12/13 2/25/24 74,000 crane

52,000 74,000

–0– –0–

30,000 18,000

30,000 18,000

143. The stamping machine is sold at a $8,264 loss, which is a § 1231 loss. The factory building yields a § 1231 gain of $28,838. There is no § 1250 depreciation recapture because straight-line depreciation was used (i.e., the building was placed in service after 1986). The tractor has $60,000 of gain, $52,000 of ordinary gain due to § 1245 depreciation recapture (equal to the deprecation taken) and $8,000 of § 1231 gain. The $18,000 gain on the overhead crane is ordinary due to § 1245 depreciation recapture. Of the net § 1231 gain, $14,574 ($28,838 + $8,000 – $8,264 – $14,000 § 1231 lookback loss) is treated as long-term capital gain. The following table provides details on the computations: Asset

Acquired

Sold

Cost Depreciation Basis

Stamping 3/10/20 8/10/24 $40,000 machine Factory 2/12/17 7/23/24 80,000 building Tractor 5/16/19 11/13/24 52,000 Overhead 11/12/13 2/25/24 74,000 crane

Sale Price

Gain (Loss)

$29,736

$10,264 $2,000 ($ 8,264)

18,838

61,162 90,000

28,838

52,000

–0–

60,000

60,000

74,000

–0–

18,000

18,000

144. The adjusted basis of the property at the date of sale is $310,911 ($345,000 cost – $34,089 depreciation). The asset is a § 1231 asset because it was depreciable property or real property used in business (rental is a form of business) and it was held more than one year. The recognized gain is $372,089 ($683,000 sale price – $310,911 adjusted basis) and it is all § 1231 gain since only straight-line depreciation was taken on the building. Thus, there is no § 1250 depreciation recapture because there was no additional depreciation due to accelerated depreciation. However, there is potential unrecaptured § 1250 gain of $34,089 because the depreciation taken is less than the recognized gain. The $338,000 ($372,089 – $34,089) balance of the gain is potential 0%/15%/20% long-term capital gain. 145. Williams initially has a casualty gain of $156,000 from business use property. If he reinvests a. the insurance proceeds, he will be able to postpone this gain. b.

If Williams does not reinvest, he will have a recognized gain. Since he has a net casualty gain, the gain is treated as a § 1231 gain that is treated as a long-term capital gain because he has no § 1231 lookback loss. Williams has a net long-term capital gain of $156,000 because he has no other Schedule D transactions. The unrecaptured § 1250 portion of the gain is $145,000 (equal

Powered by Cognero

Page 33

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions to the depreciation taken on the destroyed property). That portion of the gain is subject to an alternative tax rate of 25%. The $11,000 ($156,000 – $145,000) remaining gain is subject to the 0%/15%/20% alternative tax rate. 146. A gift does not extinguish potential § 1245 depreciation recapture potential. The son who received the machine had a $0 basis for the asset because he has a carryover basis from the donor. The father’s holding period tacks to the son’s holding period; therefore, the son had a long-term holding period on the date of the gift and potential § 1245 depreciation recapture of $57,000 [the lesser of the depreciation taken ($62,000) or the realized gain at the date of the gift ($57,000)]. However, since the machine was sold for only $53,000, there is only $53,000 of § 1245 depreciation recapture gain. The son should complete Form 4797 Part III for this transaction and then carry the gain to Part II as ordinary income. 147. The § 1245 recapture gains are combined and result in a $23,000 ordinary gain. The nonpersonal use property casualty gain and loss are combined and result in a $4,000 net gain. The net gain is treated as a § 1231 gain and when combined with the other $13,000 § 1231 gain results in a $17,000 net § 1231 gain. Due to the $2,000 § 1231 lookback loss, $2,000 of the net § 1231 gain is an ordinary gain, and the $15,000 balance of the gain is treated as a long-term capital gain. Since this is the only capital gain or loss, there is a $15,000 net long-term capital gain. Other taxable income Ordinary gain due to recapture Ordinary gain due to § 1231 look back Net long-term capital gain Taxable income

$45,000 23,000 2,000 15,000 $85,000

148. The adjusted basis of the building is $40,000 ($100,000 cost – $60,000 depreciation). The building is sold for a gain of $4,000 ($44,000 sale price – $40,000 adjusted basis). Since the building was held more than one year, it is a § 1231 asset, and the gain is a § 1231 gain. Ha-yoon has a $4,000 net § 1231 gain treated as a long-term capital gain. The gain is netted against her $3,000 short-term capital loss, resulting in a $1,000 net long-term capital gain. Since the other taxable income is $125,000, the taxable income after adding this gain is $126,000 ($125,000 + $1,000). The tax on her $125,000 other taxable income is $23,043 {$17,169 + [($125,000 - $100,525) X 24%]}. All of the gain included in her taxable income is unrecaptured § 1250 gain because the depreciation on the building exceeded the gain included in her taxable income. However, the 25% alternative tax rate on unrecaptured § 1250 gain exceeds her 24% marginal tax rate. Consequently, the tax on the $1,000 net long-term capital gain is $240 ($1,000 X 24%). Her total tax is $23,283 ($23,043 + $240). 149. The current-year § 1231 gain will be affected because gain or loss is recognized on the exchange of the machine. A nontaxable like-kind exchange occurs only when real property is exchanged. The potential § 1245 depreciation recapture of $70,000 exceeds the $60,000 ($90,000 fair market value - $30,000 adjusted basis) gain, so $60,000 ordinary income is recognized. The taxable income is $422,000 ($352,000 + $10,000 § 1231 gain + $60,000 ordinary gain). 150. Mei has to determine the holding period, tax status, basis, gain or loss from the disposition of the dolls and, if they are sold at a gain, the tax rate applicable to the gain. At the time of the sale, it appears that Mei is holding the dolls as an investment and, therefore, they are a capital asset. Her original intent was to hold the dolls as a personal use activity. However, when she discovered what they were worth, her intent seems to have become as an investment. She has no determinable basis for the dolls, so their basis is zero. They have been held long-term, so the $5,000 gain is a long-term capital gain. The alternative tax rate applicable to the gain is 15% because Mei’s other taxable income puts her above the 12% regular tax bracket. The gain is not subject to the collectibles 28% alternative tax rate because the dolls are neither works of art nor antiques. 151. Assuming that Hilda is not in the trade or business of lending money, the loan was a capital asset for Hilda. Her basis was $2,000 and her loss is $2,000. This is a nonbusiness bad debt and the tax law treats this as a short-term capital loss. Powered by Cognero

Page 34

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions 152. The bonds have original issue discount of $14,000 ($200,000 – $186,000). Ranja must amortize this discount while he holds the bonds. The discount amortization of $2,000 increases Ranja’s basis for the bonds. Consequently, when he sells the bonds, his basis is $186,000 plus the $2,000 discount amortization, so his long-term capital gain is $10,000 ($198,000 – $188,000). 153. If an option holder (grantee) fails to exercise the option, the lapse of the option is considered a sale or exchange on the option expiration date. Thus, the loss is a capital loss if the property subject to the option is (or would be) a capital asset in the hands of the grantee. Wanda has no gain or loss in 2023 because the option had not yet expired. She has a $33,000 long-term capital loss in 2024 when the option expires because the land would have been a capital asset if Wanda had exercised the option. 154. Jambo is the holder of a patent because he is an individual and either created the patented invention or the invention was not yet reduced to practice. Therefore, the $450,000 received for the patent and each $0.10 when (and if) he receives it are treated as long-term capital gain automatically under § 1235. 155. The definition of collectibles is quite ambiguous. Consequently, the antique car is a collectible if it is a work of art or an antique. Also, the § 408(m) regulations add “historical object” to the list of collectibles. The car fits these categories, so it is a collectible for tax purposes. 156. The 28% gain is taxed after the other taxable income is taxed, after the 25% gain is taxed, and before the 0%/15%/20% gain is taxed. Taxing the 28% gain first may mean that some or all of the 0%/15%/20% gain will not be eligible for the 0% tax if the individual’s taxable income after taxing the other taxable income, the 25% gain, and the 28% gain puts the taxpayer out of the regular 12% bracket. 157. Ellie’s recognized gain on the sale of the car is calculated as follows: Amount realized Less: Adjusted basis ($12,000 + $5,000) Realized gain

$30,000 (17,000) $13,000

Recognized gain

$13,000

Ellie’s gain basis for the gift is $12,000. She increases her adjusted basis by the out-of-pocket costs of $5,000 she incurs in the restoration. 158. The ordinary gain is $6,000. Since Annabelle is in the business of buying and selling securities, the ones that she buys for her personal account are ordinary assets. She has a $6,000 ($46,000 sale price - $40,000 basis) ordinary gain from the disposition of the Acorn stock. If she had designated the Acorn stock as held for investment by the end of the day she purchased it, the gain would have been long-term capital gain. 159. Yes, as long as the patent is purchased by an individual from a holder and the patent has not been reduced to practice. 160. Since the stock was worth more than her father paid for it when he gifted it to Alexis, the basis for gain is the father’s $2,200 basis. Also, the father’s holding period tacks to Alexis’s holding period. Consequently, Alexis has a $4,400 ($6,600 selling price - $2,200 basis) long-term capital gain from disposition of the stock. 161. If the taxpayer does not sell the stock, taxable income will be reduced by $2,500 due to the capital loss deduction. If he does sell the stock, taxable income will remain the same because the $2,500 long-term gain will offset the $2,500 short-term capital loss. Therefore, considering only the tax implications, the taxpayer should not sell the stock. 162. It is generally better to have a net § 1231 gain year followed by a net § 1231 loss year rather than a net § 1231 loss year followed by a net § 1231 gain year because the § 1231 lookback loss rules will be avoided. The net § 1231 gain in Powered by Cognero

Page 35

Name:

Class:

Date:

Chapter 14: Property Transactions - Capital Gains and Losses, Section 1231 and Recapture Provisions the first year is treated as a long-term capital gain and, therefore, potentially eligible for the reduced long-term capital gain rates. The second year net § 1231 loss is deductible for AGI as an ordinary deduction. 163. Section 1245 depreciation recapture potential is extinguished in at least two circumstances: (1) when the property with the depreciation recapture potential is sold at a loss and (2) when the owner of the property with the depreciation recapture potential dies. 164. Unrecaptured § 1250 gain (25% gain) is some or all of the § 1231 gain that is treated as long-term capital gain and relates to a sale of depreciable real estate. The maximum amount of this 25% gain is the depreciation taken on the real property sold at a gain. That maximum amount is reduced in one or more of the following ways: ∙

The gain recognized from disposition is less than the depreciation taken. The 25% gain is reduced to the gain amount.

∙

There is § 1250 depreciation recapture because the property was depreciated using § 179 and/or § 168(k) and, therefore, accelerated depreciation was taken. The § 1250 recapture reduces the 25% gain.

∙

There is § 1245 depreciation because the property is nonresidential real estate acquired in 1981-1986 on which accelerated depreciation was used. There will be no 25% gain left because § 1245 will recapture all the depreciation or the gain, whichever is less. Refer to Example 12. There was $100,000 of depreciation taken, but all of it was recaptured as ordinary income by § 1245. Thus, there is no remaining potential 25% gain. The entire $20,000 § 1231 gain in Example 12 is potential 0%/15%/20% gain.

∙

Section 1231 loss from disposition of other § 1231 assets held long-term reduced the gain from real estate. According to the IRS, § 1231 losses first absorb potential 0%/15%/20% § 1231 gain and then 25% § 1231 gain.

∙

Section 1231 lookback losses convert some or all of the 25% gain to ordinary income. According to the IRS, § 1231 lookback losses first absorb 28% net § 1231 gain, then 25% § 1231 gain, and then 0%/15%/20% § 1231 gain.

165. The transaction will initially be reported on Form 4797, Part III. In that Part, the gain recaptured by § 1245 will be determined. Most likely, all of the gain will be treated as an ordinary gain (unless the selling price exceeds the original cost of the property).

Powered by Cognero

Page 36

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers True / False 1. Tomas owns a sole proprietorship, and Lucy is the sole shareholder of a C corporation. In the current year, both businesses make a net profit of $60,000. Neither business distributes any funds to the owners in the year. For the current year, Tomas must report $60,000 of income on his individual tax return, but Lucy is not required to report any income from the corporation on her individual tax return. a. True b. False 2. Carol and Candace are equal partners in Peach Partnership. In the current year, Peach had a net profit of $75,000 ($250,000 gross income – $175,000 operating expenses) and distributed $25,000 to each partner. Peach must pay tax on $75,000 of income. a. True b. False 3. Rajib is the sole shareholder of Cardinal Corporation, a calendar year S corporation. In the current year, Cardinal generated a net profit of $350,000 ($520,000 gross income – $170,000 operating expenses) and distributed $80,000 to Rajib. Rajib must report the Cardinal Corporation profit of $350,000 on his Federal income tax return. a. True b. False 4. Donald owns a 45% interest in a partnership that earned $130,000 in the current year. He also owns 45% of the stock in a C corporation that earned $130,000 during the year. Donald received $20,000 in distributions from each of the two entities during the year. With respect to this information, Donald must report $78,500 of income on his individual income tax return for the year. a. True b. False 5. Quail Corporation is a C corporation that generates net income of $125,000 during the current year. If Quail paid dividends of $25,000 to its shareholders, the corporation must pay tax on $100,000 of net income. Shareholders must report the $25,000 of dividends as income. a. True b. False 6. Eagle Company, a partnership, had a short-term capital loss of $10,000 during the current year. Aaron, who owns 25% of Eagle, will report $2,500 of Eagle’s short-term capital loss on his individual tax return. a. True b. False 7. Matt, the sole shareholder of Pastel Corporation (a C corporation), has the corporation pay him a salary of $600,000 in the current year. The Tax Court has held that $200,000 represents unreasonable compensation. Matt must report a salary of $400,000 and a dividend of $200,000 on his individual tax return. a. True b. False 8. Double taxation of corporate income results because dividend distributions are included in a shareholder’s gross income and are not deductible by the corporation. Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers a. True b. False 9. Jake, the sole shareholder of Peach Corporation (a C corporation), has the corporation pay him $100,000. For income tax purposes, Jake would prefer to have the payment treated as a dividend instead of salary. a. True b. False 10. Thrush Corporation files its Form 1120, which reports taxable income of $200,000 in the current year. The corporation’s tax is $42,000. a. True b. False 11. The corporate marginal income tax rate is lower than the top individual tax rate. a. True b. False 12. Under the Check-the-box Regulations, a two-owner LLC that fails to elect to be treated as a corporation will be taxed as a sole proprietorship. a. True b. False 13. Employment taxes apply to all entity forms of operating a business. As a result, employment taxes are a neutral factor in selecting the most tax-effective form of operating a business. a. True b. False 14. A C corporation with taxable income of $100,000 in the current year will have a tax liability of $22,250. a. True b. False 15. Katherine, the sole shareholder of Penguin Corporation, has the corporation pay her a salary of $300,000 in the current year. The Tax Court has held that $90,000 represents unreasonable compensation. Katherine has avoided double taxation only to the extent of $210,000 (the portion of the salary that is considered reasonable compensation). a. True b. False 16. One of the purposes of the qualified business income deduction is to reduce the taxes on businesses that are operating in noncorporate business forms (e.g., sole proprietors, partnerships, and S corporations). a. True b. False 17. Instead of providing the qualified business income deduction to owners of noncorporate businesses, Congress could have applied a special tax rate to the business income to achieve a similar result. a. True b. False Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers 18. A qualified trade or business includes any trade or business including providing services as an employee. a. True b. False 19. Unless Congress makes a change, the QBI deduction will expire after 2025. a. True b. False 20. The QBI deduction percentage matches the 21% tax rate applicable to C corporations. a. True b. False 21. Code § 199A permits an individual to deduct 25% of the qualified business income generated through a sole proprietorship, a partnership, or an S corporation. a. True b. False 22. There are three limitations on the qualified business income deduction: an overall limitation (based on modified taxable income), another that applies to high income taxpayers, and a third that applies to certain types of service businesses. a. True b. False 23. The QBI deduction will reduce both the income tax and self-employment taxes owed by a self-employed individual. a. True b. False 24. Qualified business income (QBI) is defined as the ordinary income less ordinary deductions that a taxpayer

earns from a qualified trade or business (e.g., from a sole proprietorship, S corporation, or partnership) conducted in the United States by the taxpayer. a. True b. False 25. Jane is a self-employed attorney and single. Her annual net earnings from her law practice always exceed $275,000. Jane also has a business selling stained glass windows that she makes. Her earnings from this business are usually about $35,000 per year. Jane claims the standard deduction. Because Jane’s 2024 taxable income exceeds the $241,950 threshold, she may not claim a QBI deduction for either business. a. True b. False 26. Qualified business income includes the reasonable compensation paid to the taxpayer by a qualified trade or business and guaranteed payments made to a partner for services rendered. a. True b. False 27. Ginger is a self-employed driver finding rides via a few different platform companies, such as Lyft. In 2024, she is single and claims the $14,600 standard deduction. For 2024, her income from driving is $67,000 and she has no other Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers income. Ginger’s QBI deduction for 2024 is $13,400 ($67,000 x 20%). a. True b. False 28. A partnership will need to report wages paid to its employees as a separate line item on Schedule K-1 to help partners calculate their QBI deduction. a. True b. False 29. Qualified property is used to determine one of the limitations to the qualified business income (QBI)

deduction. Specifically, 2.5% of the unadjusted basis (immediately after acquisition) of qualified property is added to 50% of W-2 wages to determine this limitation. a. True b. False 30. Once a taxpayer reaches certain taxable income thresholds, § 199A limits the qualified business income (QBI) deduction. These thresholds are indexed for inflation every year. a. True b. False 31. For purposes of the qualified business income (QBI) deduction, qualified business income does not include

certain types of investment income [e.g., capital gains or capital losses, dividends, and interest income (unless properly allocable to a trade or business, such as lending)]. a. True b. False 32. Carla is a self-employed online retailer and single. She has no employees. Her annual taxable income is usually around $200,000. Carla could increase her QBI deduction if she incorporated her business, made an S election, and paid herself wages. a. True b. False Multiple Choice 33. Luis is the sole shareholder of a regular C corporation, and Eduardo owns a proprietorship. In the current year, both businesses make a profit of $80,000, and each owner withdraws $50,000 from his business. With respect to this information, which of the following statements is incorrect? a. Eduardo must report $80,000 of income on his return. b. Luis must report $80,000 of income on his return. c. Eduardo’s proprietorship is not required to pay its own income tax, separate from Eduardo, on its $80,000 of income. d. Luis’s corporation must pay income tax on $80,000. 34. Which of the following statements is incorrect about LLCs and the Check-the-box Regulations? a. If an LLC with more than one owner does not make an election, the entity is taxed as a corporation. b. An entity with more than one owner and formed as a corporation cannot elect to be taxed as a partnership. Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers c. If an LLC with one owner does not make an election, the entity is taxed as a sole proprietorship. d. An LLC with one owner can elect to be taxed as a corporation. 35. An individual in a specified service business, such as accounting, with taxable income over the threshold amounts ($241,950 for single or head-of-household taxpayers, or $483,900 if married filing jointly in 2024), will not lose the QBI deduction on such income if: a. Taxable income exceeds the thresholds due to income of a spouse. b. Taxable income did not exceed the thresholds in the prior three years. c. Taxable income exceeds the thresholds because of net capital gain income. d. None of these choices are correct. 36. In 2024, Sam and Betty, each single, both generate sole proprietor income of $250,000. Sam’s income is generated from a wholesale business, while Betty’s is earned from her law practice. Neither has any employees or qualified assets. Both claim the standard deduction and have other income equal to the standard deduction amount. a. Both Sam and Betty will have a QBI deduction of $50,000. b. Sam can obtain a QBI deduction, but Betty cannot because of the taxable income level and law practice is a specified service business. c. Neither Sam nor Betty will be allowed a QBI deduction due to their taxable income levels. d. None of these choices are correct. 37. In 2024, Layla has $200,000 of QBI from her neighborhood clothing store (a sole proprietorship). Her proprietorship paid $30,000 in W-2 wages and has $20,000 of qualified property. Layla’s spouse earned $51,500 of wages as an employee, and the couple earned $20,000 of interest income during the year. They will be filing jointly and take the standard deduction of $29,200. What is their QBI deduction for 2024? a. $-0-. b. $40,000. c. $48,460. d. $54,000. 38. Jenna owns and manages her single-member LLC, which provides a wide variety of financial services to her clients. She is married and will file a joint tax return with her spouse, Paul. In 2024, her LLC reports $300,000 of net income, W2 wages of $120,000, and assets with an unadjusted basis of $75,000. Their taxable income before the QBI deduction is $285,000 (this is also their modified taxable income). What is their QBI deduction for 2024? a. $0. b. $57,000. c. $60,000. d. $70,000. 39. Ellie (a single taxpayer) is the owner of ABC, LLC. In 2024, the LLC (a sole proprietorship) reports QBI of $900,000 and is not a specified services business. ABC paid total W-2 wages of $300,000, and the total unadjusted basis of property held by ABC is $30,000. Ellie’s taxable income before the QBI deduction is $740,000 (this is also her modified taxable income). What is Ellie’s QBI deduction for 2024? a. $75,750. b. $148,000. c. $150,000. d. $180,000. Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers 40. Danielle is a partner in and sales manager for DG Partners, a domestic business that is not a specified service

trade or business. During the tax year, she receives guaranteed payments of $250,000 from DG Partners for her services to the partnership as its sales manager. In addition, her distributive share of DG Partners’ ordinary income (its only item of income or loss) was $175,000. What is Danielle’s qualified business income? a. $-0-. b. $175,000. c. $250,000. d. $425,000. 41. Aaron is the sole shareholder and CEO of ABC, Inc., an S corporation that is a qualified trade or business.

During the current year, ABC has net income of $325,000 after deducting Aaron’s $100,000 salary. In addition to his compensation, ABC pays Aaron dividends of $250,000. What is Aaron’s qualified business income? a. $-0-. b. $100,000. c. $250,000. d. $325,000. 42. Alicia is the sole shareholder and CEO of ABC, Inc., an S corporation that is a qualified trade or business.

During the current year, ABC has net income of $325,000 after deducting Alicia’s $100,000 salary. In addition to her compensation, ABC pays Alicia dividends of $250,000. After reviewing comparable companies, you determine that reasonable compensation for someone with her experience and responsibilities is $200,000. What is Alicia’s qualified business income? a. $-0-. b. $200,000. c. $225,000. d. $325,000. 43. Taylor, a single taxpayer, has taxable income before the QBI deduction of $221,950 in 2024. Taylor, a CPA,

operates an accounting practice as a single-member LLC (which he reports as a sole proprietorship). During 2024, his proprietorship reports net income of $150,000, W-2 wages of $125,000, and $10,000 of qualified property. What is Taylor’s qualified business income deduction? a. $-0-. b. $12,000. c. $30,000. d. $31,500. 44. Jason and Paula are married. They file a joint return for 2024 on which they report taxable income before the

QBI deduction of $200,000. Jason operates a sole proprietorship, and Paula is a partner in the PQRS Partnership. Both are a qualified trade or business and neither is a specified services business. Jason’s sole proprietorship reports $150,000 of net income, W-2 wages of $45,000, and has qualified property of $50,000. Paula’s partnership reports a loss for the year, and her allocable share of the loss is $40,000. The partnership reports no W-2 wages and Paula’s share of the partnership’s qualified property is $20,000. What is their qualified business income deduction for the year? a. $-0-. Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers b. $11,750. c. $22,000. d. $30,000. e. None of these. 45. Tanuja Singh is a CPA and operates her own accounting firm (Singh CPA, LLC). As a single-member LLC, she reports her accounting firm operations as a sole proprietor. In 2024, Tanuja has QBI from her accounting

firm of $540,000, reports W-2 wages of $156,000, and the unadjusted basis of property used in the LLC is $425,000. Tanuja is married and will file a joint tax return with her spouse. Their taxable income before the QBI deduction is $520,000, and their modified taxable income is $448,000. What is Tanuja’s QBI deduction for 2024? a. $-0-. b. $49,625. c. $78,000. d. $89,600. 46. Which of the following types of income are included in qualified business income (QBI)? a. Income generated from a qualified trade or business. b. Guaranteed payments made in compensation for services performed by a partner to a partnership. c. Wages paid to an employee. d. Income earned from foreign business operations. 47. What happens to the § 199A deduction if a qualified trade or business generates a loss? a. If the net amount of income, gain, deduction, and loss is less than zero, the net amount of the

deduction can be carried back to a previous year or the taxpayer can elect to carry it forward. b. If the net amount of income, gain, deduction, and loss is less than zero, the net amount of the deduction is lost and is not available to carryforward or carryback. c. If the net amount of income, gain, deduction, and loss is less than zero, the net amount is treated as a loss in the succeeding year. d. None of these choices are correct. 48. Where is the § 199A deduction taken on Form 1040? a. It is a deduction from AGI, much like the standard deduction or itemized deductions, and is the last

deduction taken in determining taxable income. b. It is a business deduction and is taken on Schedule C (Form 1040). c. It is a deduction that reduces self-employment income and is taken on Schedule SE (Form 1040). d. It is an itemized deduction taken on Schedule A (Form 1040). 49. Which of the following is considered qualified property in the calculation of the deduction for qualified

business income (§ 199A)? a. All business property (both tangible and intangible). b. Tangible business property subject to depreciation. c. Tangible property placed in service during the year, but not used in the production of qualified Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers business income. d. Fully depreciated tangible business property. 50. In 2024, Kendra has taxable income before the QBI deduction of $274,000. Kendra is single and has income

from her law firm (a sole proprietorship operating as an LLC) of $200,000. Her law firm paid wages of $82,000 and has qualified property of $20,000. What is Kendra’s QBI deduction? a. $0. b. $40,000. c. $41,000. d. $54,800. Multiple Response 51. Which of the following taxpayers is eligible for a qualified business income deduction regarding the activity noted? (Circle all that apply.) a. Tom’s Burger Place, a sole proprietorship. b. A driver for Uber or Lyft. c. An employee working for Apple, Inc. d. A partner of a Big 4 firm. 52. Which of the following taxpayers is potentially eligible for a qualified business income deduction based on the noted activity? (Circle all that apply.) a. A shareholder of General Electric. b. A sole proprietor operating a restaurant. c. A self-employed doctor. d. Jennifer, owner of a winery operated as an S corporation. 53. Which of the following self-employed individuals are in a specified service trade or business? (Circle all that apply.) a. Dentist. b. Consultant. c. Architect. d. CPA. Subjective Short Answer 54. Rebecca and Elizabeth are married and will file jointly in 2024. Rebecca earns $300,000 from her single-member LLC (a law firm). She reports her business as a sole proprietorship. Wages paid by the law firm amount to $40,000; the law firm has no significant property. Elizabeth is employed as a tax manager by a local CPA firm. Their modified taxable income is $443,900 (this is also their taxable income before the deduction for qualified business income). Determine their QBI deduction for 2024. 55. Ashley (a single taxpayer) is the owner of ABC, LLC. In 2024, the LLC (a sole proprietorship) reports QBI

of $900,000 and is not a specified services business. ABC paid total W-2 wages of $300,000, and the total unadjusted basis of property held by ABC is $30,000. Ashley’s taxable income before the QBI deduction is $740,000 (this is also her modified taxable income). What is Ashley’s QBI deduction for 2024? Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers 56. Susan, a single taxpayer, owns and operates a bakery (as a sole proprietorship). The business is not a

specified services business. In 2024, the business pays $60,000 in W-2 wages, has $150,000 of qualified property, and $200,000 in net income (all of which is qualified business income). Susan also has a part-time job earning wages of $15,200, receives $4,000 of interest income, and will take the standard deduction. What is Susan’s qualified business income deduction? 57. Ben owns and operates a machine repair shop as a sole proprietorship. It generates a profit of about

$180,000 annually. The business pays wages of about $50,000 annually. The building and most of the equipment are leased so there is no qualified property. Ben files as single and claims the standard deduction. He has a large unrealized gain in bitcoin that he acquired in 2019 and is wondering when he should sell it and whether he should sell it all in one year or over a few years. Advise Ben as to how the sale of the bitcoin and its resulting capital gain can affect his QBI deduction in 2024. 58. Sergio owns and manages his single-member LLC which provides a wide variety of accounting services to

his clients. He is married and will file a joint tax return with his spouse, Goretty. His LLC reports $250,000 of net income, W-2 wages of $120,000, and assets with an unadjusted basis of $75,000. Their taxable income before the QBI deduction is $215,000 (this is also their modified taxable income). Determine their QBI deduction for 2024. 59. Taylor owns a wide variety of commercial rental properties held in a single-member LLC. Her LLC reports

rental income of $750,000. The LLC pays no W-2 wages; rather, it pays a management fee to an S corporation that Taylor controls. The management company pays W-2 wages, but reports no income (or loss). Taylor’s total unadjusted basis of the commercial rental property is $5,000,000 and her taxable income before the QBI deduction (and her modified taxable income) is $1,000,000. What is Taylor’s QBI deduction for 2024? 60. Jansen, a single taxpayer, owns and operates a restaurant (as a sole proprietorship). The business is not a

specified services business. In 2024, the business pays $125,000 in W-2 wages, has $187,500 of qualified property, and $440,000 in net income (all of which is qualified business income). Jansen has no other items of income or loss and will take the standard deduction. What is Jansen’s qualified business income deduction? 61. Felicia, who is single, operates three sole proprietorships that generate the following information in 2024

(none are “specified services” businesses): Business A B C

QBI $240,000 $(108,000) $120,000

W-2 Wages $72,000 $48,000 $-0-

Capital Investment $ -0$ -0$ -0-

Felcia chooses not to aggregate the businesses. She also earns $150,000 of wages from an unrelated business and her modified taxable income (before any QBI deduction) is $304,000. a. b.

What is Felicia’s QBI deduction? Assume that Felicia can aggregate these businesses. Determine her QBI deduction if she decides to aggregate the businesses.

Essay Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers 62. Compare the basic tax and nontax factors of doing business as a partnership, an S corporation, and a C

corporation. Circle the correct answers. Tax Questions

Column A Partnership

Column B S Corporation

Who pays tax on the entity’s income?

Partners Partnership

Shareholders S corporation

Column C C Corporation Shareholders C Corporation

Are operating losses passed through to owners?

Yes No

Yes No

Yes No

Yes No

Yes No

Yes No

Are distributions of profits taxable to owners?

Yes No

Yes No

Yes No

Nontax Factors

Partnership

S Corporation

C Corporation

Is the liability of owners limited?

Yes No

Yes No

Yes No

Is there free transferability of ownership interests?

Yes No

Yes No

Yes No

Are capital gains (losses) reported on owners’ tax returns as such?

63. Sofía is the sole shareholder of Thrush Corporation, a C corporation. In the current year, Thrush earned $350,000 and distributed $75,000 to Sofía. Kirk is the sole shareholder of Swallow Corporation, an S corporation. In the current year, Swallow earned $350,000 and distributed $75,000 to Kirk. Contrast the tax treatment of Thrush Corporation and Sofía with the tax treatment of Swallow Corporation and Kirk. 64. What is a limited liability company? What favorable nontax and tax attributes does the LLC entity form offer taxpayers? 65. The qualified business income deduction is severely limited for specified services businesses. What is a specified services trade or business? 66. Describe the limitations on the qualified business income deduction that apply to high income taxpayers. 67. How does property used in a qualified trade or business factor into the QBI deduction calculation? What

types of property are considered for the QBI deduction? Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers Answer Key 1. True 2. False 3. True 4. True 5. False 6. True 7. True 8. True 9. True 10. True 11. True 12. False 13. False 14. False 15. True 16. True 17. True 18. False 19. True 20. False 21. False 22. True 23. False 24. True 25. False Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers 26. False 27. False 28. True 29. False 30. True 31. True 32. True 33. b 34. a 35. d 36. c 37. b 38. b 39. b 40. b 41. d 42. c 43. b 44. c 45. a 46. a 47. c 48. a 49. b 50. a Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers 51. a, b, d 52. b, c, d 53. a, b, d 54. Normally, Rebecca and Elizabeth would be entitled to a QBI deduction of $60,000 ($300,000 x 20%). But

since their taxable income exceeds the threshold for married taxpayers ($383,900), and Rebecca’s QBI is from a specified services business (a law firm), their QBI deduction is limited to $14,400, computed as follows: (1)

Determine Applicable Percentage:

Applicable % = 100%–$60,000 ($443,900 – $383,900) $100,000 (2) Determine QBI deduction: 1. 20% of QBI ($300,000 x 20%)

= 40%

$60,000

x Applicable percentage

2.

x 40% $24,000

But no more than the greater of: •

50% of W-2 wages ($40,000 x 50% x 40%), or

•

25% of W-2 wages ($40,000 x 25% x 40%) plus

$ 8,000

$4,000 •

2.5% of the unadjusted basis of qualified property 2.5% x 40%)

($-0- x

-0- $ 4,000

Because Rebecca and Elizabeth’s modified taxable income exceeds $383,900, but is less than $483,900 and the W-2 Wages/Capital portion of the computation is the limiting factor, the general 20% QBI amount is used, but reduced as follows:

(1)

Determine difference between the general 20% QBI deduction amount and the W-2 Wages/Capital amount.

General 20% QBI deduction amount Less: The W-2 Wages/Capital Investment limit Excess

$ 24,000

( 8,000) $16,000

(2) Determine the Reduction Ratio: Reduction Ratio = $60,000 ($443,900 – $383,900) = 60% Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers $100,000

(3)

Determine the reduction in the W-2 Wages/Capital Investment limit: Excess ($16,000) x Reduction Ratio (60%) = $9,600

(4) Determine final QBI amount:

General 20% QBI deduction amount Less: Reduction in the W-2 Wages/Capital limit Final QBI amount

$24,000 ( 9,600) $14,400

55. As Ashley’s taxable income before the QBI deduction exceeds the $241,950 threshold, the W-2

Wages/Capital Investment Limit must be considered. Ashley’s QBI deduction is $148,000, computed as follows: 1.

20% of QBI ($900,000 x 20%)

2.

But no more than the greater of: •

50% of W-2 wages ($300,000 x 50%), or

•

25% of W-2 wages ($300,000 x 25%) plus

•

2.5% of the unadjusted basis of qualified property ($30,000 x 2.5%)

$180,000

$150,000 $ 75,000 750 $ 75,750

And, no more than: 3.

20% of modified taxable income ($740,000 x 20%)

$148,000

56. Susan’s taxable income before the QBI deduction is $204,600 (her proprietorship net income of

$200,000 plus her wages of $15,200 and her $4,000 of interest income less her $14,600 standard deduction). Because Susan’s taxable income before the QBI deduction exceeds $191,950, the W-2 Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers Wages/Capital Investment limit must be considered: $ 40,000

1. 20% of QBI ($200,000 x 20%) 2.

But no more than the greater of: •

50% of W-2 wages ($60,000 x 50%), or

•

25% of W-2 wages ($60,000 x 25%) plus

• •

2.5% of the unadjusted basis of qualified property ($150,000 x 2.5%)

$ 30,000 $ 15,000

3,750

$ 18,750

And, no more than:

$ 40,920

3. 20% of modified taxable income ($204,600 x 20%)

So, initially, Susan’s QBI deduction is limited to $30,000. However, as Susan’s taxable income before the QBI deduction exceeds $191,950, but is less than $241,950 and the W-2 Wages/Capital Investment portion of the computation is the limiting factor, the general 20% QBI amount is used, but reduced as follows: (1)

Determine difference between the general 20% QBI deduction amount and the W-2 Wages/Capital amount.

General 20% QBI deduction amount Less: The W-2 Wages/Capital limit Excess

$40,000 (30,000) $10,000

(2) Determine the Reduction Ratio: Reduction Ratio = $12,650 ($204,600 – $191,950) = 25.3% $50,000

(3)

Determine the reduction in the W-2 Wages/Capital Limit: excess ($10,000) x Reduction Ratio (25.3%) = $2,530

(4) Determine Final QBI Amount:

General 20% QBI deduction amount Less: Reduction in the W-2 Wages/Capital limit Powered by Cognero

$40,000 ( 2,530) Page 15

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers Final QBI Amount

$37,470

57. The capital gain might increase Ben’s taxable income to the point that it could exceed $191,950. At that

point, his QBI deduction will be limited to 50% of the W-2 wages paid ($25,000). If taxable income remains at $191,950 or less, his QBI deduction will be 20% of his income from the repair business ($36,000; $180,000 x 20%). Ben might want to sell all of the bitcoin in one year rather than over several years if doing so prevents his taxable income from exceeding $191,950 and thereby imposing a limit on his QBI deduction. 58. Even though this is a “specified services” business, Sergio and Goretty’s taxable income before the QBI

deduction is below the $383,900 threshold in 2024. As a result, their QBI deduction is $43,000, computed as follows: 1.

20% of qualified business income ($250,000 x 20%), or $50,000

2.

20% of modified taxable income ($215,000 x 20%)

$43,000

59. Because Taylor’s modified taxable income exceeds the $483,900 threshold in 2024, the W-2 Wages/Capital

Investment Limit comes into play. Taylor’s QBI deduction is $125,000, computed as follows:

1. 20% of qualified business income ($750,000 x 20%)

$150,000

2. But no more than the greater of: $

-50% of W-2 wages ($-0- x 50%), or -25% of W-2 wages ($-0- x 25%) plus 0-2.5% of the unadjusted basis of qualified property ($5,000,000 x 2.5%)

$

-0-

-

125,000 $ 125,000

And, no more than: 20% of modified taxable income ($1,000,000 x 3. 20%)

$ 200,000

60. Jansen’s taxable income before the QBI deduction is $425,400 (his proprietorship net income of Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers $440,000 less the $14,600 single standard deduction); this is also his modified taxable income. Because Jansen’s taxable income before the QBI deduction exceeds the $241,950 threshold, the W-2 Wages/Capital Investment

limit must be considered. Jansen’s QBI deduction is $62,500, computed as follows: 1. 20% of qualified business income ($440,000 x 20%) $ 88,000 2. But no more than the greater of: 50% of W-2 wages ($125,000 x 50%), or 25% of W-2 wages ($125,000 x 25%) plus 2.5% of the unadjusted basis of qualified property ($187,500 x 2.5%)

$ 62,500 $31,250 4,688

$ 35,938

And, no more than:

3. 20% of modified taxable income ($425,400 x 20%)

$ 85,080

61. a. Under Reg. § 1.199A-1(d), Felicia must allocate Business B’s negative QBI

to Business A and Business C in proportion to their positive QBI amounts ($240,000 for Business A; $120,000 for Business C). As a result, the negative QBI from Business B is apportioned 66.66% to Business A and 33.33% to Business C. So $(72,000) is apportioned to Business A and $(36,000) to Business C. Business A

Adjusted QBI $168,000 ($240,000 – $72,000) $-0- [$(108,000) + $108,000] $84,000 ($120,000 $36,000)

B C

W-2 Wages $72,000

Capital Investment $ -0-

$48,000

$ -0-

$-0-

$ -0-

Felicia now applies the “W-2 Wages” limitation by determining the lesser of 20% of QBI and 50% of W-2 wages for each business.

Business

QBI x 20%

A B C

$33,600 ($168,000 x 20%) $ -0$16,800 ($84,000 x 20%)

W-2 Wages x 50% $36,000 $24,000 $ -0-

Lesser $33,600 $ -0$ -0-

Felicia’s “combined qualified business income amount” is $33,600 ($33,600 + $-0- + $-0-). Because this amount is less than 20% of Felicia’s modified taxable income ($60,800; $304,000 x 20%), Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers Felicia’s QBI deduction is $33,600 and her taxable income is $270,400. There is no carryover of any loss into the following taxable year for purposes of § 199A (the Business B negative QBI was completely used).

b. Because Felicia’s taxable income is above the threshold amount, her QBI deduction is subject to the W-2 wages and capital investment limitations. Because the businesses are aggregated, these limitations are applied on an aggregated basis. Business A B C Total

QBI $240,000 $(108,000) $120,000 $252,000

W-2 Wages $72,000 $48,000 $-0$120,000

Capital Investment $ -0$ -0$ -0$ -0-

None of the businesses own “qualified property.” As a result, only the “W-2 Wages” limitation applies. Felicia’s “combined qualified income amount” is $50,400, the lesser of 20% of the QBI from the aggregated businesses ($50,400; $252,000 x 20%), or 50% of W-2 wages from the aggregated businesses ($60,000; $120,000 x 50%). Felicia’s QBI deduction is equal to the lesser of $50,400 or 20% of her modified taxable income ($60,800; $304,000 x 20%). As a result, Felicia’s QBI deduction is $50,400, and her taxable income is $253,600. By aggregating her businesses, Felicia has increased the size of her QBI deduction.

62. The correct answers are shaded. Tax Questions

Column A Partnership

Column B S Corporation

Column C C Corporation

Who pays tax on the entity’s income?

Partners Partnership

Shareholders S corporation

Shareholders C Corporation

Are operating losses passed through to owners?

Yes No

Yes No

Yes No

Are capital gains (losses) reported on owners’ tax returns as such?

Yes No

Yes No

Yes No

Are distributions of profits taxable to owners?

Yes No

Yes No

Yes No

Nontax Factors

Partnership

S Corporation

C Corporation

Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers Is the liability of owners limited?

Yes No

Yes No

Yes No

Is there free transferability of ownership interests?

Yes No

Yes No

Yes No

63. A C corporation is a separate taxable entity; thus, Thrush Corporation is taxed on the $350,000 of earnings. Income of a C corporation has no effect on the shareholders until such time a dividend is paid. When dividends are paid, shareholders must report dividend income on their tax returns. Thus, Sofía is taxed on $75,000 of dividends, and the 0%/15%/20% preferential tax rate applies with respect to the dividends. Generally, an S corporation is not subject to an entity-level Federal income tax. Instead, the corporation’s income, gains, deductions, and losses are passed through to and reported by the shareholders on their tax returns. Thus, Swallow reports the $350,000 of earnings on its tax return (Form 1120S) but pays no income tax. Kirk is taxed on the $350,000 of earnings from Swallow on his individual income tax return (Form 1040). Distributions from S corporations are not taxable to the shareholder (to the extent of stock basis). Thus, Kirk is not taxed on the $75,000 distribution from Swallow. 64. Similar to the corporate entity form, a limited liability company is an entity created under the laws of a specific state (or the District of the Columbia) and, pursuant to such laws, an LLC has the corporate feature of limited liability. This is the primary nontax characteristic that makes LLC status attractive. Other nontax attributes that are available with the LLC entity form include centralized management, continuity of life, and free transferability of ownership interests. Which of these nontax attributes are allowed will be dependent on the laws of the state of LLC organization. The principal tax advantage of the LLC entity form is the ability to avoid double taxation of the entity’s profits. Most LLCs will be taxed as either partnerships (two or more owner LLCs) or sole proprietorships (one-owner LLCs), although the Check-the-box Regulations do provide the opportunity to have an LLC taxed as a corporation (including an S corporation). 65. A specified service trade or business includes those involving: The performance of services in certain fields, including health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services; Services consisting of investing and investment management, trading or dealing in securities, partnership interests, or commodities; and Any trade or business in which its principal asset is the reputation of one or more of its employees or owners. Architects and engineers are specifically excluded from this definition.

66. The basic application of § 199A becomes considerably more complex once a taxpayer reaches certain taxable income thresholds. These taxable income thresholds – determined without regard to the QBI deduction are $383,900 for married taxpayers filing jointly and $191,950 for single taxpayers in 2024. These amounts will be indexed for inflation annually. Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 15 The Deduction for Qualified Business Income for Noncorporate Taxpayers Once these thresholds are reached, § 199A imposes two independent limitations:

1.

2.

First, § 199A imposes a cap on the QBI deduction that is determined by reference to a percentage of the W-2 wages paid by the business (i.e., wages paid to its employees) or by references to a smaller percentage of W-2 wages paid and a percentage of the cost of its depreciable property used to produce QBI. Second, the QBI deduction generally is not available for income earned from certain specified service businesses.

67. Qualified property is used to determine one of the limitations to the QBI deduction. Specifically, 2.5 percent

of qualified property is added to 25 percent of W-2 wages to determine this limitation. Qualified property includes depreciable tangible property – real or personal – that is used by the QTB during the year and whose “depreciable period” has not ended before the end of the taxable year. As a result, land and intangible assets are not qualified property. Given the broad-based changes to MACRS – allowing taxpayers to expense (via § 179 and/or bonus depreciation) property other than real estate – the depreciable period for qualified property under § 199A is a minimum of 10 years.

Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods True / False 1. The tax year of a physician’s incorporated medical practice may end on the last day of any month of the year. a. True b. False 2. A C corporation that does not have a natural business year must use a calendar year as its tax year. a. True b. False 3. A C corporation’s selection of a tax year generally is independent of the tax year of its principal shareholders. a. True b. False 4. The DEF Partnership had three equal partners when it was formed. Partners D and E were calendar year taxpayers and Partner F’s tax year ended on June 30th before she joined the partnership. The partnership may use a calendar year and F may continue to use the tax year ending June 30th. a. True b. False 5. The Seagull Partnership has three equal partners. Partner A’s tax year ends June 30th, and Partners B and C use a calendar year. If the partnership uses the calendar year to report its income, Partner A is permitted to defer partnership income earned from July through December 2024 until filing the tax return for the year ending June 30, 2025. a. True b. False 6. An S corporation may select any tax year as long as it ends on the last day of a month. a. True b. False 7. The ability of the CPA to prepare a tax return in a timely manner is justification for the partnership’s use of a particular tax year. a. True b. False 8. Laura Corporation changed its tax year-end from July 31 to December 31 in 2024. The income for the period August 1, 2024, through December 31, 2024, was $35,000. The corporate tax rate in the state where the corporation performs all of its business is 5% on the first $50,000 of income and 7% on income above $50,000. Laura's state tax for the short period is $2,033. a. True b. False 9. In 2024, T Corporation changed its tax year from ending each April 30 to ending each December 31. The corporation earned $60,000 during the period May 1, 2024, through December 31, 2024. The annualized income for the short year is $90,000. a. True b. False Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods 10. Ted, a cash basis taxpayer, received a $150,000 bonus in 2024 when he was in the 35% marginal tax bracket. In 2025, when Ted was in the 24% marginal tax bracket, it was discovered that the bonus was incorrectly computed, and Ted was required to refund $40,000 to his employer. As a result of the refund, Ted can reduce his 2025 tax liability by $14,000 (.35 × $40,000). a. True b. False 11. Generally, an advantage to using the cash method of accounting is that gross income is not recognized until it is collected, rather than being taxed as soon as the taxpayer has the right to collect the income. a. True b. False 12. A calendar year, cash basis corporation began business on April 1, 2024, and paid $2,400 for a 24-month liability insurance policy. An accrual basis, calendar year taxpayer also began business on April 1, 2024, and purchased a 24month liability insurance policy. The accrual basis taxpayer must amortize the premiums over 24 months, but the cash basis taxpayer may deduct the total premiums in 2024. a. True b. False 13. Alice, Inc., is an S corporation that has been in business for 18 years. Its annual gross receipts never have exceeded $30 million. The corporation operates a retail store and also owns rental property. The sales from the retail store and the rental income may be reported using the cash method. a. True b. False 14. A retailer sells widgets with a 90-day warranty and uses the accrual method. The retailer may estimate its warranty expense and deduct it. a. True b. False 15. A C corporation provides lawn maintenance services to various businesses and homeowners. The corporation has average annual gross receipts of $7 million. The corporation may use the cash method of accounting. a. True b. False 16. A positive § 481 adjustment from a change in method of accounting initiated by the taxpayer is spread equally over the year of change and the three following years. a. True b. False 17. Sandstone, Inc., consistently has included some factory overhead as a current expense rather than as a cost of producing goods. As a result, the beginning inventory for 2024 is understated by $10,000. If Sandstone voluntarily changes accounting methods effective January 1, 2024, $2,500 must be added to taxable income for each year 2024, 2025, 2026, and 2027. a. True b. False Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods 18. A cash basis taxpayer sold investment land in 2024 for $200,000. He received $40,000 in the year of sale and $160,000 in 2025. The cost of the land was $80,000. Under the installment method, the taxpayer would report a $24,000 gain in 2024. a. True b. False 19. In the case of a sale reported under the installment method, gain is recognized in each year the seller collects on the installment contract. a. True b. False 20. If an installment sale contract does not charge interest on the sale of a capital asset, only capital gain is recognized over the life of the contract. a. True b. False 21. In 2024, Cashmere Construction Company, a small business, enters into a contract to build a beach cottage for Martha and Rico for a total price of $500,000. Cashmere estimates the total cost to complete the cottage to be $400,000. In 2024, Cashmere incurred $300,000 of costs on the contract, and in 2025 the contract was completed at a total cost of $425,000. Cashmere is not required to recognize any gross income from the contract until 2025. a. True b. False 22. When a taxpayer with average annual gross receipts in excess of $30 million finances the construction of its building by borrowing, the interest is added to the cost of the building. a. True b. False 23. A taxpayer who is required to use the percentage of completion method can elect to defer the recognition of income and the related costs until the taxable year in which cumulative contract costs comprise at least 10% of the estimated contract costs. a. True b. False 24. Under both the cash and accrual methods of accounting for tax purposes, a taxpayer may elect to defer prepaid revenue. a. True b. False Multiple Choice 25. Which of the following statements regarding a 52-53 week tax year is not correct? a. Some tax years will include more than 366 calendar days. b. Whether the particular tax year includes 52 weeks or 53 weeks is not elective. c. The year-end must be the same day of the week in all years. d. All of these choices are correct. Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods 26. Gold Corporation, Silver Corporation, and Copper Corporation are equal partners in the GSC Partnership. The partners’ tax year-ends are as follows. Gold December 31 Silver April 30 Copper September 30 a. The partnership is free to elect any tax year. b. The partnership may use any of the three year-end dates that its partners use. c. The partnership must use a September 30 year-end. d. The partnership must use an April 30 year-end. 27. Gold Corporation, Silver Corporation, and Platinum Corporation are equal partners in the GSP Partnership, which was formed on July 1, 2024. Gold and Silver use a calendar tax year, and Platinum’s tax year ends June 30. GSP is not a seasonal business. a. GSP must use a tax year ending December 31, and Platinum can retain its tax year ending June 30. b. GSP must use a tax year ending June 30, and the partners must change their tax years to end on June 30. c. GSP must use a tax year ending December 31, and Platinum must change its tax year to December 31. d. GSP may elect its tax year without regard to the partners’ tax years. 28. With regard to choosing a tax year for a business owned by individuals, which form of business provides the greater number of options in regard to the tax year? a. A C corporation formed by physicians to conduct their practice. b. A C corporation that is in the retail grocery business. c. A real estate partnership. d. An S corporation engaged in manufacturing. 29. Which of the following statements regarding a 52-53 week tax year is correct? a. The year-end must be the same day of the week in all years. b. The year cannot contain more than 366 calendar days. c. Every four years, there will be only 51 weeks. d. The year cannot end on a Sunday. 30. A C corporation is required to annualize taxable income for: a. The first year the corporation is in existence if the first tax return includes less than 12 months. b. The last year the corporation is in existence. c. A year in which the corporation changes its tax year. d. A year when there has been a greater than 50% change in the ownership of the stock. 31. In 2024, Godfrey received a $50,000 sales commission on a long-term contract. But in 2025, the customer filed for bankruptcy and his employer was not able to collect from the customer. Under the bonus agreement, Godfrey was required to repay the employer $20,000 of the bonus. Godfrey was in the 35% marginal tax bracket in 2024 but he is in the 24% marginal tax bracket in 2025. a. Godfrey can amend his 2024 tax return and reduce his taxable income by $20,000. b. Godfrey should deduct the $20,000 paid in 2025 and thus his tax savings will be $4,800. c. Godfrey can reduce his 2025 tax liability by 35% × $20,000 = $7,000. d. Godfrey should not have reported the income in 2024 because of the contingencies. Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods 32. Which of the following taxpayers is required to use the accrual method of accounting? a. A retail business with average annual gross receipts of $8,000,000. b. An attorney with average annual gross receipts of $2 million. c. An insurance agency with average annual gross receipts of $5 million. d. None of these choices are required to use the accrual method. 33. Imani, an accrual basis taxpayer, sold goods in December 2024 for $20,000. The customer was unable to pay cash. So the customer gave Imani a note for $20,000 that was payable in April 2025. The note bore interest at the Federal rate. The fair market value of the note at the end of 2024 was $18,000. Imani collected $20,500 from the customer in April 2025, $20,000 principal plus $500 interest. Under the accrual method, Imani must recognize gross income of: a. $20,500 in 2024. b. $18,000 in 2024 and $2,500 in 2025. c. $20,000 in 2024 and $500 in 2025. d. $20,500 in 2025. 34. Andrew owns 100% of the stock of Crow’s Farm Inc., an S corporation, that raises cattle and corn. The farm’s annual gross receipts never exceeded $30 million, and the farm is not considered a tax shelter. a. The farm must report its sales and cost of goods sold by the accrual method because inventories are material to the business. b. The income from the farm may be reported by the cash method. c. The income from the sales of cattle may be reported by the cash method, but the income from the sales of corn must be reported by the accrual method. d. The income from the sales of corn may be reported by the cash method, but the income from cattle sales must be reported by the accrual method. 35. In the case of an accrual basis taxpayer, an item of income: a. Is not recognized until cash is received. b. From services is never recognized until the services are performed. c. Is not recognized if the customer can return the goods. d. Is recognized when all the events have occurred to fix the taxpayer’s right to receive the income and the amount of the income can be determined with reasonable accuracy. 36. Which of the following must use the accrual method of accounting? I.

A property management company, operating as a C corporation, with average annual gross receipts of $50,000,000. II. An incorporated law firm with average annual gross receipts of $50,000,000. III. An unincorporated grocery store with average annual gross receipts of $50,000,000. a. All of these must use the accrual method. b. None of these must use the accrual method. c. Only I and II must use the accrual method. d. Only I and III must use the accrual method. 37. The accrual method generally is required for: a. A real estate management company operating as an S corporation with more than $30 million of gross Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods receipts. b. An incorporated public accounting firm with gross receipts in excess of $30 million. c. A grocery store with average annual gross receipts of $800,000. d. None of these choices are correct. 38. Ivory Fast Delivery Company, an accrual basis taxpayer, frequently has claims for damages to property the company delivered. Often the claim is not filed until a month after the delivery. In the past, Ivory has paid approximately 80% of the claims. In 2024, claims for $80,000 were filed. The company refused to pay $20,000 of the claims (believing they were not valid) and paid $50,000. The remaining $10,000 in claims were processed and paid in January 2025. In January 2025, claims for $8,000 were filed for deliveries made in 2024, and $6,000 was paid on these claims by March 15, 2025. Ivory has not elected to use the recurring item exception to economic performance. Under the all-events and economic performance tests, Ivory can accrue which of the following as an expense for 2024? a. $68,000. b. $66,000. c. $60,000. d. $50,000. 39. Color, Inc., is an accrual basis taxpayer. In December 2024, the company received from a customer a $500 claim for defective merchandise. Color paid the customer in January 2025. Also, in December 2024, the company received a bill of $800 for office supplies that had been purchased and used in November 2024. The bill was not paid until January 2025. In January 2025, the company received a claim for $600 for defective merchandise purchased in 2024. Color paid the customer the $600 in February 2025. Assuming that Color uses the recurring item exception to economic performance, the company’s deduction for 2024 is: a. $500. b. $600. c. $800. d. $1,300. 40. Pink Corporation is an accrual basis taxpayer that uses the recurring item exception to the economic performance test for all relevant years. For 2024, the corporation’s income subject to state income tax was $500,000 and the state corporate tax rate was 6%. During 2024, the corporation paid $24,000 on its estimated state income tax liability for that year. The remaining $6,000 of 2024 state income tax was paid in April 2025. In June 2024, the corporation paid $9,000 on its year 2023 state income tax liability as a result of an audit of the 2023 return that was conducted in 2024. The company has elected to use the recurring item exception to economic performance. Pink should deduct in 2024 on its Federal income tax return state income taxes of: a. $24,000. b. $30,000. c. $33,000. d. $39,000. 41. Gray Company, a calendar year taxpayer, allows customers to return defective merchandise for a full refund within 30 days of the purchase. In 2024, the company refunded $400,000 for claims involving sales. The $400,000 consisted of $350,000 in refunds from 2024 sales and $50,000 in refunds from 2023 sales. All of the refunds from 2023 sales were for claims filed in 2023 and were paid in January and February 2024. At the end of 2024, the company had $12,000 in refund claims for sales in 2024 for which payment had been approved. These claims were paid in January 2024. In January 2025, the company received an additional $30,000 in claims for sales in 2024. This $30,000 was paid by Gray in February 2025. Gray can deduct: Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods a. $350,000 in 2024. b. $362,000 in 2024. c. $392,000 in 2023. d. $442,000 in 2024. 42. Generally, deductions for additions to reserves for estimated future costs (e.g., an allowance for estimated warranty costs) are not allowed for Federal income tax purposes because allowing the deduction would: a. Result in a mismatching of revenues and expenses. b. Violate established public policy. c. Violate the all events test and economic performance requirement. d. Violate the tax benefit rule. 43. In 2024, Swan Company discovered that it had for the past 10 years capitalized as a production cost certain expenses that are properly classified as administrative expenses. The total amount of the expense for 2023 was $300,000, $60,000 of the item was included in the ending inventory that year, and $240,000 was deducted as cost of goods sold. a. The company should amend its 2023 tax return and reduce its gross income by $240,000. b. The company should change its accounting method in 2024, with a $60,000 negative § 481 adjustment which decreases its 2024 taxable income. c. The company should change its accounting method in 2024, and increase its 2024 income by $60,000, the amount of the positive § 481 adjustment to income. d. The company should change its accounting method in 2024 and recognize a $60,000 negative § 481 adjustment that will be spread equally over 2024-2027. 44. The taxpayer has consistently but incorrectly used an allowance for bad debts. At the beginning of the year, the balance in the allowance account is $90,000. a. If the IRS examines the taxpayer’s return and requires the taxpayer to change accounting methods, the taxpayer will be required to recognize an additional $90,000 of income (one-half in the current year and onehalf in the following year) as the adjustment due to the change in accounting methods. b. If the taxpayer voluntarily changes methods, the $90,000 adjustment can be spread over the current and three following years. c. If the taxpayer voluntarily changes methods, the $90,000 reserve can be used to absorb bad debts until the account balance is zero. d. If the IRS examines the taxpayer’s return, no adjustment to the reserve account will be required if the balance is consistent with prior bad debt experience. 45. When the IRS requires a taxpayer to change accounting methods: a. The taxpayer may be subject to penalties and interest. b. The taxpayer generally is required to make the change as of the beginning of the earliest open year. c. The adjustments due to the change cannot be spread over subsequent years. d. Choices a., b., and c. are correct. 46. The taxpayer had consistently used the cash method of accounting even though inventories were a material incomeproducing factor to its business and average annual gross receipts in the prior three-year period exceeded $30 million. The taxpayer decided to voluntarily change to the accrual method of accounting. The adjustment to income due to the change was that the correct beginning balances for the year of the change as follows: $600,000 for inventories, $300,000 for accounts receivable, and $120,000 for accounts payable. The adjustment due to the change in accounting method is: Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods a. A positive adjustment for $1,020,000. b. A positive adjustment for $900,000. c. A positive adjustment for $780,000. d. A positive adjustment for $600,000. 47. Simplex had incorrectly been using the cash method of accounting. For 2024, it voluntarily changed to the accrual method. The adjustment due to the change in method as calculated at the beginning of 2024 was $120,000 (positive). The adjustment as calculated as of the end of 2024 was $80,000 (positive). As a result of the change in method, Simplex increases its 2024 gross income by: a. $120,000. b. $80,000. c. $30,000. d. $40,000. 48. The accrual basis taxpayer sold land for $100,000 on December 31, 2024. It did not collect the $100,000 until January 2, 2025. The land was held as an investment. a. If the basis in the land was $110,000, the loss would be recognized in 2025. b. If the basis in the land was $60,000, the gain must be reported in 2024. c. If the basis in the land was $60,000, the gain must be reported in 2025, unless the taxpayer elects to not use the installment method. d. The taxpayer must recognize the gain or loss in the year of sale. 49. The installment method can be used for which of the following sales with payments being made in the year following the year of sale? a. A retailer’s credit card sales. b. An individual’s sale of common stock in a family-owned business. c. An individual’s sale of Alphabet common stock. d. Depreciable equipment sold for less than its original cost. 50. The installment method applies when a payment will be received after the tax year of the sale: a. By an investor who sold real estate at a gain. b. By an investor who sold real estate at a loss. c. By an appliance dealer who sold inventory at a gain. d. By an investor who sold Netflix common stock at a gain. 51. In 2024, Beth sold equipment used in her business. Her basis in the property was $300,000 ($500,000 cost less $200,000 of depreciation). Beth sold the property for $400,000, with $100,000 due on the date of the sale and $300,000 (plus interest at the Federal rate) due in 2025. Beth’s recognized gain from the installment sale in 2024 is: a. $0. b. $50,000. c. $100,000. d. $200,000. 52. Abby sold her unincorporated business that consisted of equipment and goodwill. The equipment had an original cost of $200,000 and Abby had claimed $120,000 in depreciation (adjusted basis = $80,000). Abby had a zero basis in the goodwill. The sales price for the business was $250,000, with $150,000 for the equipment and $100,000 for the goodwill. Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods The buyer agreed to pay $120,000 on June 30, 2024, and $130,000 (plus interest at the Federal rate) in two years. Abby’s gain to be reported in 2023 (exclusive of interest) is: a. $40,000. b. $51,000. c. $102,000. d. $118,000. 53. Hal sold land held as an investment with a fair market value of $100,000 for $36,000 cash and a note for $64,000 that was due in two years. The note bore interest of 7% when the applicable Federal rate was 6%. Hal’s cost of the land was $40,000. Because of the buyer’s good credit record and the high interest rate on the note, Hal thought the fair market value of the note was at least $74,000. a. Hal can elect to treat the $36,000 as a recovery of capital. b. Hal must recognize $60,000 gain in the year of sale. c. Hal must recognize $36,000 gain in the year of sale. d. Unless Hal elects not to use the installment method, he must recognize $21,600 gain in the year of sale. 54. Todd, a CPA, sold land for $300,000 cash on the date of sale plus a note for $500,000 due in one year. The interest rate on the note was equal to the Federal rate. The fair market value of the note was $400,000. Todd’s basis in the land was $80,000. a. If Todd uses the cash basis to report the income from his practice, he cannot use the installment method to report the gain on the sale of the land. b. If Todd uses the accrual basis to report the income from his practice, he cannot use the installment method to report the gain from the sale of the land. c. If Todd uses the installment method to report the gain, the contract price is $800,000. d. If Todd does not use the installment method, his gain in the year of sale is $620,000 ($700,000 – $80,000). 55. Juan, not a dealer in real property, sold land that he owned. His adjusted basis in the land was $700,000 and it was encumbered by a mortgage for $100,000. The terms of the sale required the buyer to pay Juan $200,000 on the date of the sale. The buyer assumed Juan’s mortgage and gave him a note for $900,000 (plus interest at the Federal rate) due in the following year. What is the gross profit percentage (gain ÷ contract price)? a. $700,000/$1,100,000 = 63.64%. b. $500,000/$1,200,000 = 41.67%. c. $700,000/$1,200,000 = 58.33%. d. $500,000/$1,100,000 = 45.45%. 56. Pedro, not a dealer, sold real property that he owned with an adjusted basis of $120,000 and encumbered by a mortgage for $56,000 to Pat in 2022. The terms of the sale required Pat to pay $28,000 cash, assume the $56,000 mortgage, and give Pedro 11 notes for $12,000 each (plus interest at the Federal rate). The first note was payable two years from the date of sale, and each succeeding note became due at two-year intervals. Pedro did not elect out of the installment method for reporting the transaction. If Pat pays the 2024 note as promised, what is the recognized gain to Pedro in 2024 (exclusive of interest)? a. $12,000 b. $7,200 c. $4,800 d. $0 57. Charlotte sold her unincorporated business for $600,000 in 2024. The sales contract allocated $120,000 to equipment, Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods $300,000 to land, and $180,000 to goodwill. Charlotte had a $0 basis in the goodwill, the land cost $150,000, and the equipment originally cost $250,000 but it was fully depreciated. What is the amount of the gain eligible for installment sales treatment? a. $0 b. $330,000 c. $450,000 d. $600,000 58. In 2024, Norma sold Zinc, Inc., common stock for $100,000 cash and a note receivable for $900,000. The note was due in 2025 with accrued interest at the Federal rate. Norma’s basis in the stock was $250,000. This was Norma’s only installment sale transaction. Which of the following statements is correct? a. Norma cannot use the installment method to report her gain if the stock is listed on the New York Stock Exchange. b. Norma must recognize $75,000 gain in 2024 and she is liable for interest on taxes deferred under the installment method. c. Norma must recognize $75,000 gain in 2024 and she will not be liable for interest on the taxes deferred under the installment method if the stock is not publicly traded. d. Norma should treat the $100,000 received as a recovery of capital. 59. Hashem sold land (a capital asset) to an unrelated party for $100,000 cash and a 4% note for $150,000 due in three years. His basis in the land was $40,000. Hashem and the purchaser are cash basis taxpayers. Which of the following statements is correct? a. If the Federal rate is 3%, interest will be imputed at that rate. b. If the Federal rate is 5%, interest will be imputed at that rate and the capital gain will be reduced. c. If the Federal rate is 4.5%, interest will be imputed at that rate and the capital gain will be increased. d. All of these statements are correct. 60. Singh sold a capital asset on the installment basis and did not charge interest on the deferred payment due in three years. a. Interest will be imputed, thus increasing the total gross income from the transactions. b. Interest will be imputed, thus decreasing the capital gain. c. Interest will not be imputed because the contract is for less than five years. d. Interest will be imputed, thus increasing the buyer’s basis in the asset. 61. Related-party installment sales include all of the following except the first seller’s: a. Brothers and sisters. b. Lineal descendants and ancestors. c. Uncles and aunts. d. All of these individuals are considered related parties. 62. Father sold land to Son for $500,000 in 2024. Father’s basis in the land was $100,000. Son paid Father $50,000 and gave Father a note for $450,000 due in 2027. In 2025, Son sold the land for $600,000 cash. The note bore interest at the appropriate Federal rate; both Father and Son held the land as an investment. a. Father must recognize $400,000 of income in 2025. b. The installment method is not permitted because this is a related-party transaction. c. Father’s gain is all ordinary income. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods d. Father must recognize a $360,000 gain in 2025. 63. In 2024, Father sold land to Daughter for $50,000 cash and an installment note for $150,000 due in 2028. Father’s basis was $100,000. In 2025, after paying $8,000 interest but nothing on the principal, Daughter sold the land for $300,000 cash. What gain, if any, must Father recognize in 2025? a. $0 b. $75,000 c. $100,000 d. $200,000 64. Kathy was a shareholder in Matrix, Inc., when she sold the corporation a commercial building. The building cost $500,000 and the balance in the accumulated depreciation account was $400,000. Matrix, Inc., paid $100,000 in the year of sale and gave Kathy a note for $400,000 plus adequate interest due in 2025. a. Because Kathy is a shareholder in Matrix, she cannot report the gain by the installment method. b. Generally, if Kathy owned 100% of the Matrix stock, she cannot use the installment method. c. Generally, if Kathy owned only 60% rather than 100% of the Matrix stock, she could use the installment method. d. Kathy cannot use the installment method to report the gain because the realized gain is equal to the depreciation she claimed on the building. 65. Robin Construction Company began a long-term contract in 2024. The contract price was $800,000. The estimated cost of the contract at the time it was begun was $500,000. The actual cost incurred in 2024 was $350,000. The contract was completed in 2025 and the cost incurred that year was $125,000. Under the percentage of completion method: a. Robin should report $300,000 of income in 2024. b. Robin should report $90,000 of income in 2025. c. Robin must pay interest (under the look-back method) on the underpayment of taxes in 2024. d. Robin should report $325,000 of income in 2024. 66. Which of the following statements is true concerning the disposition of an installment note? a. Deferred gain is not recognized by the transferor if the installment note is a non-taxable transfer to a controlled corporation. b. Deferred gain must be recognized only if the installment note was transferred as a gift to a related party. c. Transfer of an installment obligation to another party will not trigger immediate recognition of deferred gain. d. Deferred gain must be recognized if the note is transferred to the owner’s estate at his death. 67. In the case of a small home construction company that uses long-term contracts, generally: a. The percentage of completion method is required to report the income from the construction contracts. b. The percentage of completion method can be elected and will defer income until the contract is completed. c. The completed contract method can be used and will defer income. d. The accrual method must be used because inventories are an income-producing factor. 68. Under the percentage of completion method, if the actual costs are ____, the taxpayer must pay interest on the underpayment of prior years’ taxes. a. Greater than the estimated costs b. Less than the estimated costs c. Equal to or greater than the estimated costs Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods d. Equal to the estimated costs 69. Camelia Company is a large commercial real estate contractor that reports its income by using the percentage of completion method. In 2024, the company entered into a contract to construct a building for $900,000. Camelia estimated that the cost of constructing the building would be $600,000. In 2024, the company incurred $150,000 in costs under the contract. In 2025, the company incurred an additional $500,000 in costs to complete the contract. a. Camelia must report $300,000 of income in 2024. b. Camelia is not required to report any income from the contract until 2025 when the contract is completed. c. Camelia must recognize $75,000 of income in 2024. d. Camelia should amend its 2024 tax return to decrease the profit on the contract for that year. 70. Mallard Auto Parts, Inc. has on hand 1,000 fenders for 1953 Studebakers. Mallard purchased the fenders in 1968 for $30 each and the selling price is $400 each. Only rarely does Mallard sell a Studebaker fender and it is highly unlikely that more than 100 of the remaining fenders will ever be sold. However, Mallard has ample storage space and feels an obligation to Studebaker owners. Therefore, the company will not salvage the fenders and will continue to sell them for $400 each. Scrap value of the fenders is $5 each. Under the lower of cost or market inventory method: a. Mallard can expense the 900 excess fenders. b. Mallard can expense all 1,000 of the fenders because of the unlikelihood they will be sold. c. Mallard should value the fenders at $5,000 (1,000 × $5). d. None of these choices are correct. 71. Mehta Department Store takes physical inventories at each of its 300 stores on various dates between August 1 and September 30 each year. The company’s tax year ends on the Monday closest to January 31. The company’s reduction in inventory due to breakage and theft after the last physical inventory in September 2024: a. Cannot be determined until the physical inventory is actually taken; therefore breakage that occurs in December 2024 will not be deductible until the year ending in January 2025. b. Must be delayed until the inventory has been taken as a result of the all-events test. c. Can be estimated and deducted for the year ending in January 2025. d. Can be estimated and deducted as of the end of the tax year, but only if the taxpayer uses the lower of cost or market inventory method. 72. This year, Sarah started a business selling unique kitchen items both in stores and online. She purchased $70,000 of goods during the year. Her ending inventory was $8,000, and she owed suppliers $15,000 at year end, including all of the ending inventory. For tax purposes, Sarah adopted the cash method and the treatment of inventory as nonincidental supplies. Her deduction for inventory for the year is: a. $55,000. b. $62,000. c. $70,000. d. $85,000. 73. Barbara operates a sporting goods store. She uses the cash method of tax accounting and treats inventory as nonincidental supplies. At the beginning of the year, she had inventory of $26,000. She purchased $470,000 of goods during the year. Her ending inventory was $42,000. She pays all of her suppliers by the last day of her tax year. What is Barbara’s inventory deduction for the year? a. $428,000. b. $454,000. c. $470,000. Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods d. $538,000. 74. This year, Yuan started a business selling computer parts both in store and online. He purchased $60,000 of goods during the year via credit card. His ending inventory was $9,000. For tax purposes, Yuan adopted the cash method and the treatment of inventory as deductible when purchased, per his books. His deduction for inventory for the year is: a. $51,000. b. $60,000. c. $69,000. d. $0. Subjective Short Answer 75. In 2024, Ramon sold land that had cost $80,000 for $200,000. The sales agreement called for a $50,000 down payment and a $50,000 payment plus 8% interest to be received on the first day of each year for the next three years. What would be the consequences of the following? Treat each part independently, and assume that Ramon uses the installment method whenever it is to his advantage. a.

In 2024, Ramon gave one of the $50,000 installment obligations to a close relative.

b.

In 2024, Ramon transferred the installment obligations ($50,000) to his 100% owned corporation.

c.

Ramon collected the $50,000 plus $12,000 interest on January 1, 2025, and died on January 2, 2025.

76. Brown Corporation elected dollar-value LIFO in 2019. Its ending inventory at base year cost and its LIFO indexes are stated as follows. (1) Ending Inventory at Year-End Prices

LIFO Index

(3) = (1)/(2) Ending Inventory at Base Year Prices

$1,000,000 1,100,000 1,200,000 1,300,000 1,250,000 1,550,000

1.00 1.06 1.10 1.11 1.20 1.23

$1,000,000 1,037,736 1,090,909 1,171,171 1,041,667 1,260,163

2019 2020 2021 2022 2023 2024

(2)

Compute the LIFO inventory at the end of 2024. 77. In 2025, Brown Corporation, a service business, no longer qualifies as a small business. Thus, it must change from the cash to the accrual method starting with its 2025 tax year. At the beginning of 2025, Brown had accounts receivable of $575,000 and accounts payable of $345,000. Determine the adjustment to Federal gross income due to the change in accounting method and the amount that is allocated to 2025. Essay Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods 78. The buyer and seller have tentatively agreed to a contract for the sale of a building that the buyer will use in its business. The buyer will pay the seller $100,000 (principal and interest) each year for five years. The seller’s cost of the asset is $200,000, and she will report the capital gain using the installment method. The buyer and seller are now negotiating the interest rate that will be used to compute the interest included in each $100,000 payment. The relevant Federal rate is 5%, but the market rate on similar contracts is in the area is 7%. a. b.

Why would the seller bargain for a 5% interest rate for the contract rather than a 7% interest rate? How does the interest rate affect the buyer’s future taxable income?

79. BhattCo has consistently used the LIFO inventory method and has deferred over $1 million of gross income from using that method. However, in the last two years, the prices it pays for goods has been decreasing. Therefore, the company is considering changing to the FIFO inventory method. What would be some tax consequences of the change? 80. Janet, a self-employed attorney is a cash basis taxpayer. She received $10,000 from a client in 2022. In that year, the client demanded a refund of the fee. In 2023, Janet refunded the client $6,000. In 2022, Janet paid $5,000 in estimated state income tax. In May 2023, Janet received a state income tax refund of $2,000 for overpayment of its 2022 income tax. Janet was in the 35% marginal tax bracket in 2022 and in the 12% marginal tax bracket in 2023. What are the Federal income tax effects of the 2023 payment to the client and the collection of the state income taxes overpaid? 81. Mogo Manufacturing Company accounts for its inventories using the FIFO method. The company has consistently allocated building depreciation to production and general administration on the basis of the number of square feet occupied. According to the measurements used, manufacturing requires 90% of the square footage and general administration utilizes 10%. This year, the accountant found that five years ago an addition was made to the portion of the building used for general administration, and that the depreciation allocation had not been adjusted. What are the tax accounting implications of this discovery?

Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods Answer Key 1. False 2. False 3. True 4. True 5. True 6. False 7. False 8. True 9. True 10. True 11. True 12. False 13. True 14. False 15. True 16. True 17. True 18. True 19. True 20. False 21. True 22. True 23. True 24. False 25. d Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods 26. c 27. a 28. b 29. a 30. c 31. c 32. d 33. c 34. b 35. d 36. d 37. d 38. d 39. d 40. d 41. b 42. c 43. b 44. b 45. d 46. c 47. c 48. c 49. b 50. a Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods 51. c 52. d 53. d 54. c 55. d 56. b 57. b 58. a 59. b 60. b 61. d 62. d 63. b 64. b 65. c 66. a 67. c 68. b 69. c 70. d 71. c 72. a 73. b 74. b 75. a.

The gift is a taxable disposition and, thus, Ramon must recognize a $30,000 gain

Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods ($120,000/$200,000 × $50,000). b.

The transfer to the controlled corporation is not a taxable disposition. The corporation will recognize the gain when it collects the amount due.

c.

Death is not a taxable disposition. Ramon’s beneficiaries will recognize the gain (as income in respect of a decedent) when the payments are collected. Ramon recognizes a $30,000 gain ($120,000/$200,000 × $50,000) plus $12,000 interest on his final return for 2025.

76. The company experienced a decrease in inventory in 2023. This eliminated the 2022 layer and decreased the 2021 layer added. (1)

(2)

(3) = (1)/(2)

(4)

(5) = (4) × (2)

2019

Ending Inventory At End-ofYear Prices $1,000,000

2020

1,100,000

1.06

1,037,736

37,736

40,000

2021

1,200,000

1.10

1,090,909

53,173

58,491

2022

1,300,000

1.11

1,171,171

80,262

89,091

2023

1,250,000

1.20

1,041,667

(129,504)

(155,405)

2024

1,550,000

1.23

1,260,163

218,496

268,750

Layer LIFO Ending Inventory Added Layer Index Base Year Prices at Base at Current 1.00 $1,000,000 $1,000,000 $1,000,000

Ending Inventory

$1,300,927

2023 Reduction At base From 2022

$ 80,262

Index 1.11

From 2021

49,242

1.10

$129,504

Powered by Cognero

Reduction at Current Prices $ 89,091 54,167 $143,258

Page 18

Name:

Class:

Date:

Chapter 16: Accounting Periods of Methods

77. Accounts receivable Accounts payable Total adjustment

$ 575,000 (345,000) $ 230,000

The positive adjustment is spread over four years. The company must add $57,500 ($230,000 divided by 4) to 2025 income. The balance of the adjustment is included in gross income ratably over the next three years. 78. a. The total payments the seller will receive is not affected by the interest rate included in the contract. However, the interest rate will affect the seller’s ordinary income and capital gain. The seller would bargain for a 5% interest rate rather than 7% because the lower interest rate will result in less ordinary income and more capital gain, with no change in the total taxable income from the contract. In addition, with the lower interest rate, more of each payment is allocable to the recovery of capital and thus more of the gain is deferred. b.

The interest rate affects the buyer’s interest and cost recovery deductions. Each dollar allocated to interest generates a deduction for the buyer in each year for the 5 years of the installment contract. However, the amount allocated to the building must be recovered over the MACRS cost recovery period, which may be more than 30 years. Therefore, the present value of the tax benefits of the interest deductions is much greater than the cost recovery deductions.

79. BhattCo could voluntarily change to FIFO, but this would require that the company restate its beginning inventory for the year of change to equal its cost using the FIFO method. Because the LIFO deferral is $1 million, this means that the beginning inventory would be increased by $1 million, BhattCo would have a $1 million addition to its gross income that can be spread equally over the year of the change and three subsequent years. Thus, deciding whether the change would be beneficial would require further analyses of the projected price changes and inventory levels. The recapture of the LIFO reserve would be a critical consideration. 80. The payment to the client is eligible for § 1341 treatment. Because the amount received from the client in 2022 was taxed at 35%, the refund to the client in 2023 will reduce the tax for that year by $2,100 ($6,000 × 0.35). On the other hand, the state income taxes were deducted when the marginal tax rate was 35%, but the recovery of the prior deduction is taxed at only 12%. 81. The company has consistently used an incorrect accounting method to allocate its costs to production. The incorrect method has allocated too much of the depreciation to production and thus to ending inventories. The company should apply for permission to change its method of allocating depreciation. The adjustment due to the change will be negative (reducing taxable income). Because Mogo is changing from an incorrect to a correct method, the negative adjustment can be used to reduce the income in the year of change, assuming that the request for changing methods is filed in a timely manner.

Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules True / False 1. Thrush Corporation, a calendar year C corporation, files its current year Form 1120, which reports taxable income of $200,000 for the year. The corporation’s tax is $42,000. a. True b. False 2. For taxable years beginning in 2024, the corporate income tax is a flat 25%. a. True b. False 3. A personal service corporation must use a calendar year and is not permitted to use a fiscal year. a. True b. False 4. As a general rule, C corporations must use the accrual method of accounting. However, under several exceptions to this rule (e.g., average annual gross receipts of $30,000,000 or less for the most recent 3-year period), a C corporation can use the cash method. a. True b. False 5. On December 31, 2024, Lavender, Inc., (an accrual basis, calendar year C corporation), accrues a $50,000 bonus to Barry, its vice president and a 40% shareholder. Lavender pays the bonus to Barry, who is a cash basis taxpayer, on March 10, 2025. Lavender can deduct the bonus in 2025, the year in which it is included in Barry’s gross income. a. True b. False 6. Azure Corporation, a C corporation, had a long-term capital gain of $50,000 in the current year. The amount of tax applicable to the capital gain is $10,500 ($50,000 × 21%). a. True b. False 7. Albatross, a C corporation, had $140,000 net income from operations and a $25,000 short-term capital loss in the current year. Albatross Corporation’s taxable income is $140,000. a. True b. False 8. If a C corporation uses straight-line depreciation on real estate (§ 1250 property), no portion of a recognized gain on the sale of the property will be recaptured as ordinary income. a. True b. False 9. The passive activity loss rules apply to closely held C corporations and to personal service corporations but not to S corporations. a. True b. False Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules 10. Peach Corporation had $210,000 of net active income, $45,000 of portfolio income, and a $230,000 passive activity loss during the current year. If Peach is a closely held C corporation that is not a PSC, it can deduct $210,000 of the passive activity loss in the year. a. True b. False 11. On December 16, 2024, the directors of Quail Corporation (an accrual basis, calendar year C corporation) authorized a cash donation of $5,000 to the American Cancer Society, a qualified charity. The payment, which is made on April 6, 2025, may be claimed as a deduction for tax year 2024. a. True b. False 12. In the current year, Oriole Corporation donated a painting worth $30,000 to the Texas Art Museum, a qualified public charity. The museum included the painting in its permanent collection. Oriole Corporation purchased the painting five years ago for $10,000. Oriole’s charitable contribution deduction is $30,000 (ignoring the taxable income limitation). a. True b. False 13. In the current year, Crow Corporation, a C corporation, donated scientific property (basis of $30,000, fair market value of $50,000) to State University, a qualified charitable organization, to be used in research. Crow had held the property for four months as inventory. Crow Corporation may deduct $50,000 for the charitable contribution (ignoring the taxable income limitation). a. True b. False 14. The $1,000,000 limitation on the deduction of executive compensation currently applies to compensation paid to a publicly traded corporation's principal executive officer, principal financial officer, and board of directors. a. True b. False 15. Heron Corporation, a calendar year C corporation, had an excess charitable contribution for 2023 of $5,000. In 2024, Heron made a further charitable contribution of $20,000. Heron’s 2024 deduction is limited to $15,000 (10% of taxable income). The 2024 contribution must be applied first against the $15,000 limitation. a. True b. False 16. A corporate net operating loss arising in 2024 for a calendar year C corporation can be carried back 2 years and forward 20 years to offset taxable income for those years. a. True b. False 17. In the current year, Azul Corporation, a calendar year C corporation, received a dividend of $30,000 from Naranja Corporation. Azul owns 25% of the Naranja Corporation stock. Assuming it is not subject to the taxable income limitation, Azul’s dividends received deduction is $19,500. a. True b. False Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules 18. Because of the taxable income limitation, no dividends received deduction is allowed if a corporation has an NOL for the current taxable year. a. True b. False 19. No dividends received deduction is allowed unless the corporation has held the stock for more than 90 days. a. True b. False 20. Hornbill Corporation, a cash basis and calendar year C corporation, was formed and began operations on May 1, 2024. Hornbill incurred the following expenses during its first year of operations (May 1 – December 31, 2024): temporary directors meeting expenses of $10,500, state of incorporation fee of $5,000, stock certificate printing expenses of $1,200, and legal fees for drafting corporate charter and bylaws of $7,500. Wanting to deduct as much as possible in the current year, Hornbill Corporation’s 2024 deduction for organizational expenditures is $5,800. a. True b. False 21. Lilac Corporation incurred $4,700 of legal and accounting fees associated with its incorporation. The $4,700 is deductible as startup expenditures on Lilac’s tax return for the year in which it begins business. a. True b. False 22. A calendar year personal service corporation with taxable income of $100,000 in the current year will have a tax liability of $21,000. a. True b. False 23. The accumulated earnings and personal holding company taxes both can be avoided by distributing sufficient dividends. a. True b. False 24. A calendar year C corporation can receive an automatic 9-month extension to file its corporate return (Form 1120) by timely filing a Form 7004 for the tax year. a. True b. False 25. A corporation must file a Federal income tax return even if it has no taxable income for the year. a. True b. False 26. For purposes of the estimated tax payment rules, a “large corporation” is defined as a corporation that had taxable income of $1,000,000 or more in any of the three preceding years. a. True b. False 27. Schedule M-1 is used to reconcile net income as computed for financial accounting purposes with taxable income Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules reported on the corporation’s income tax return. a. True b. False 28. An expense that is deducted in computing net income per books but not deductible in computing taxable income is a subtraction item on Schedule M-1. a. True b. False 29. On December 31, 2024, Flamingo, Inc., a calendar year, accrual method C corporation, accrues a bonus of $50,000 to its president (a cash basis taxpayer) who owns 75% of the corporation’s outstanding stock. The $50,000 bonus is paid to the president on February 4, 2025. For Flamingo’s 2024 Form 1120, the $50,000 bonus will be a subtraction item on Schedule M-1. a. True b. False 30. Income that is included in net income per books but not included in taxable income is a subtraction item on Schedule M-1. a. True b. False 31. Schedule M-2 is used to reconcile unappropriated retained earnings at the beginning of the year with unappropriated retained earnings at the end of the year. a. True b. False 32. A corporation with $5,000,000 or more in assets must file Schedule M-3 (instead of Schedule M-1). a. True b. False 33. Schedule M-3 is similar to Schedule M-1 in that the form is designed to reconcile net income per books with taxable income. However, an objective of Schedule M-3 is more transparency between financial statements and tax returns than that provided by Schedule M-1. a. True b. False 34. Katherine, the sole shareholder of Penguin Corporation, has the corporation pay her a salary of $300,000 in the current year. The Tax Court has held that $90,000 represents unreasonable compensation. Katherine has avoided double taxation only to the extent of $210,000 (the portion of the salary that is considered reasonable compensation). a. True b. False 35. In general, all corporations that maintain inventory for sale to customers are required to use the accrual method of accounting for determining sales and cost of goods sold. a. True b. False Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules 36. Canary Corporation, a calendar year C corporation, received an $80,000 dividend from Stork Corporation. Canary owns 18% of the Stork Corporation stock. Assuming it is not subject to the taxable income limitation, Canary’s dividends received deduction is $40,000. a. True b. False 37. The limitation on the deduction of business interest does not apply to noncorporate taxpayers. a. True b. False 38. The accumulated earnings and personal holding company taxes are designed to prevent the accumulation of earnings within a corporation. a. True b. False 39. Canary Corporation, which sustained a $5,000 net short-term capital loss during the year, will enter $5,000 as an addition on Schedule M-1 of Form 1120. a. True b. False 40. In tax planning for charitable contributions, a current-year’s contribution might have to be deferred to a later year in order to deduct a contribution carryover amount. a. True b. False 41. An alternative minimum tax applies to a 2024 calendar year C corporation with more than $1 billion average annual adjusted financial statement income for the 3-year period ending December 31, 2023. a. True b. False 42. A consolidated Federal income tax return may be the product of a merger of the affiliates or another corporate combination. a. True b. False 43. Business reasons, and not tax incentives, constitute the primary motivation for most corporations to form a conglomerate and file tax and financial accounting reports on a consolidated basis. a. True b. False 44. Most of the Federal consolidated income tax return rules are found in detailed sections of the tax Regulations. a. True b. False 45. The rules for computing Federal consolidated taxable income are some of the most complex in the tax law. a. True Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules b. False 46. For consolidated tax return purposes, purchased goodwill is amortized as a deduction to taxable income over 15 years. Under financial accounting rules, 40-year amortization is allowed. a. True b. False 47. A limited partnership can join the parent’s consolidated group for book and for tax purposes. a. True b. False 48. After a takeover, the parent’s balance sheet shows a fair market value basis in the subsidiary for both book and tax purposes. a. True b. False 49. When the parent acquires 51% of a subsidiary U.S. corporation, the subsidiary can join the consolidated financial statements and the consolidated tax return of the parent. a. True b. False 50. The right to file on a consolidated basis is available to a group of corporations when they constitute a “parentsubsidiary affiliated group.” a. True b. False 51. A Federal consolidated group can claim a dividends received deduction for payments that the parent receives from other affiliates. a. True b. False 52. Giant Ltd. owns 100% of the stock of Middle Corporation. Bottom Corp is owned 60% by Giant and 40% by Middle. Giant’s Federal consolidated income tax return includes both Middle and Bottom. a. True b. False 53. A subsidiary corporation must leave the consolidated group if it is restructured as an LLC. a. True b. False 54. A corporation organized in Germany and wholly owned by the U.S. parent can be included in a Federal consolidated return. a. True b. False 55. A tax-exempt charitable trust created by a U.S. C corporation can join in a Federal consolidated return. Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules a. True b. False 56. A calendar year parent corporation wants to file its tax returns on a consolidated basis with its affiliates. The group’s election to file consolidated Federal corporate income tax returns must be made by the extended due date of the first return on which the consolidation is applied (i.e., October 15). a. True b. False 57. The calendar year Sterling Group files its Federal corporate income tax return on a consolidated basis. The group’s Form 1120 is due on April 15, or October 15 if the group files an extension request with the IRS. a. True b. False 58. All affiliates joining in a newly formed consolidated return must consent to the election on Form 1122, as attached to the Form 1120 for the group. a. True b. False 59. Consolidated group members each are jointly and severally liable for the entire consolidated Federal income tax liability. a. True b. False 60. With the filing of its first consolidated return, the parent corporation of a Federal consolidated group makes an irrevocable election as to how the group will allocate a tax year’s income tax liability among the group members. a. True b. False 61. A Federal consolidated tax return group can apply the “relative taxable income” method as a means to apportion the tax liabilities of the members among the affiliates. a. True b. False 62. Each member of a consolidated group must use the same tax year-end, and all of the members must use the same tax accounting methods (e.g., LIFO or FIFO). a. True b. False 63. When the net accumulated taxable losses of a subsidiary exceed the parent’s acquisition price, the parent’s basis in the subsidiary’s stock becomes negative. a. True b. False 64. In computing consolidated taxable income, capital gains and losses are removed from the taxable incomes of the group members and determined on a group basis. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules a. True b. False 65. The starting point in computing consolidated taxable income are the separate Federal taxable income amounts of the affiliated group members. a. True b. False 66. An example of an intercompany transaction is the use of the trademarks of the parent corporation by a subsidiary, compensated by an arm’s length licensing fee. a. True b. False 67. When a subsidiary sells to the parent some business-use property that has appreciated from its $20,000 basis to a $50,000 fair market value, the subsidiary immediately recognizes $30,000 ordinary income on the consolidated return. a. True b. False 68. A Federal consolidated filing group aggregates its separate charitable contributions for the tax year, deductions for which are then limited to 10% of consolidated taxable income. a. True b. False Multiple Choice 69. Elk, a C corporation, has $370,000 operating income and $290,000 operating expenses during the current year. In addition, Elk has a $10,000 long-term capital gain and a $17,000 short-term capital loss. Elk’s taxable income is: a. $63,000. b. $73,000. c. $80,000. d. $90,000. 70. Patrick, an attorney, is the sole shareholder of Gander Corporation, a C corporation. Gander is a personal service corporation with a fiscal year ending November 30 (pursuant to a § 444 election). The corporation paid Patrick a salary of $180,000 during its fiscal year ending November 30, 2024. How much salary must Gander pay Patrick during the period December 1 through December 31, 2024, to permit the corporation to continue to use its fiscal year without negative tax effects? a. $0 b. $15,000 c. $30,000 d. $180,000 71. Copper Corporation, a C corporation, had gross receipts of $30,000,000 in 2021, $31,000,000 in 2022, and $28,000,000 in 2023. Gold Corporation, a personal service corporation (PSC), had gross receipts of $28,000,000 in 2021, $31,000,000 in 2022, and $32,000,000 in 2023. Which of the corporations will be allowed to use the cash method of accounting in 2024? a. Copper Corporation only. Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules b. Gold Corporation only. c. Both Copper Corporation and Gold Corporation. d. Neither Copper Corporation nor Gold Corporation. 72. Saleh, an accountant, is the sole shareholder of Turquoise Corporation, a C corporation. Turquoise is a personal service corporation with a fiscal year ending September 30 (pursuant to a § 444 election). The corporation paid Saleh a salary of $330,000 during its fiscal year ending September 30, 2024. How much salary must Turquoise pay Saleh during the period October 1 through December 31, 2024, if the corporation is to continue to use its fiscal year without negative tax effects? a. $0 b. $27,500 c. $82,500 d. $247,500 73. On December 31, 2024, Peregrine Corporation, an accrual method, calendar year taxpayer, accrued a performance bonus of $100,000 to Charles, a cash basis, calendar year taxpayer. Charles is president and sole shareholder of the corporation. When can Peregrine deduct the bonus? a. In 2024, if the bonus was authorized by the Board of Directors and payment was made on or before April 15, 2025. b. In 2025, if payment was made at any time during that year. c. In 2024, if payment was made on or before April 15, 2025. d. In 2025, but only if payment was made on or before April 15, 2025. 74. Ivory Corporation, a calendar year, accrual method C corporation, has two cash method, calendar year shareholders who are unrelated to each other. Craig owns 35% of the stock, and Oscar owns the remaining 65%. During 2024, Ivory paid a salary of $100,000 to each shareholder. On December 31, 2024, Ivory accrued a bonus of $25,000 to each shareholder. Assuming that the bonuses are paid to the shareholders on February 1, 2025, compute Ivory Corporation’s 2024 deduction for the above amounts. a. $250,000 b. $225,000 c. $200,000 d. $125,000 75. Carrot Corporation, a C corporation, has a net short-term capital gain of $65,000 and a net long-term capital loss of $250,000 during 2024. Carrot Corporation had taxable income from other sources of $720,000. Prior years’ transactions included the following: 2020 2021 2022 2023

Net long-term capital gain Net short-term capital gain Net short-term capital gain Net long-term capital gain

$150,000 60,000 45,000 35,000

Compute the amount of Carrot’s capital loss carryover to 2025. a. $0 b. $32,000 c. $45,000 Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules d. $185,000 76. In 2024, Bluebird Corporation had net income from operations of $100,000. Further, Bluebird recognized a long-term capital gain of $30,000 and a short-term capital loss of $45,000. Which of the following statements is correct? a. Bluebird Corporation will have taxable income in 2024 of $100,000 and will have a net capital loss of $15,000 that can be carried back 3 years and forward 5 years. b. Bluebird Corporation may use the capital loss to offset the capital gain and must carry the net capital loss of $15,000 forward five years as a short-term capital loss. c. Bluebird Corporation may deduct $33,000 of the capital loss in 2024 and may carry forward the remainder of the capital loss indefinitely to offset capital gains. d. Bluebird Corporation will have taxable income in 2024 of $85,000. 77. In the current year, Sunset Corporation (a C corporation) had operating income of $200,000 and operating expenses of $175,000. In addition, Sunset had a $30,000 long-term capital gain, a $52,000 short-term capital loss, and $5,000 taxexempt interest income. What is Sunset Corporation’s taxable income for the year? a. $0 b. $3,000 c. $22,000 d. $25,000 78. Beige Corporation, a C corporation, purchases a warehouse on August 1, 2008, for $1,000,000. Straight-line depreciation is taken in the amount of $411,750 before the property is sold on June 12, 2024, for $1,200,000. What is the amount and character of the gain recognized by Beige on the sale of the realty? a. Ordinary income of $0 and § 1231 gain of $611,750. b. Ordinary income of $411,750 and § 1231 gain of $200,000. c. Ordinary income of $82,350 and § 1231 gain of $529,400. d. Ordinary income of $117,650 and § 1231 gain of $494,100. 79. In the current year, Woodchuck, Inc., a closely held personal service corporation, has $115,000 of net active income, $40,000 of portfolio income, and $135,000 of passive activity loss. What is Woodchuck’s taxable income for the current year? a. $0 b. $20,000 c. $40,000 d. $155,000 80. Grackle Corporation, a personal service corporation, had $230,000 of net active income, $40,000 of portfolio income and a $250,000 passive activity loss during the current year. How much is Grackle’s taxable income for the year? a. $20,000 b. $40,000 c. $270,000 d. $520,000 81. Grebe Corporation, a closely held corporation that is not a PSC, had $75,000 of net active income, $60,000 of portfolio income, and a $105,000 passive activity loss during the current year. How much of the passive activity loss can Grebe deduct in the current year? Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules a. $0 b. $60,000 c. $75,000 d. $105,000 82. In the current year, Violet, Inc., a closely held corporation (not a PSC), has $55,000 of passive activity loss, $80,000 of net active income, and $20,000 of portfolio income. How much is Violet’s taxable income for the current year? a. $20,000 b. $45,000 c. $80,000 d. $100,000 83. Kingbird Corporation (a calendar year C corporation) reports the following income and expenses in the current year: Income from operations Expenses from operations Dividends received (15% ownership)

$200,000 140,000 15,000

On October 1, Kingbird Corporation made a contribution to a qualified charitable organization of $9,000 in cash (not included in any of the above items). Determine Kingbird’s charitable contribution deduction for the year. a. $9,000 b. $7,500 c. $6,750 d. $6,525 84. Owl Corporation (a C corporation), a retailer of children’s apparel, made the following donations to qualified charitable organizations in the current year. Adjusted Basis Fair Market Value Children’s clothing held as inventory, to Haven for Hope

$10,000

$15,000

Stock in Exxon Corporation acquired two years ago and held as an investment, to City University

5,000

3,000

Land acquired four years ago and held as an investment, to Humane Society

50,000

75,000

How much qualifies for the charitable contribution deduction (ignoring the taxable income limitation)? a. $63,000 b. $65,000 c. $90,500 d. $92,500 85. Plum Corporation (a C corporation and a computer manufacturer) donated 100 laptop computers to a local university Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules (a qualified educational organization) in the current year. The computers were constructed by Plum earlier this year, and the university will use the computers for research and research training. Plum’s basis in the computers is $35,000, and their fair market value is $120,000. What is Plum’s deduction for the contribution of the computers (ignoring the taxable income limitation)? a. $35,000 b. $70,000 c. $77,500 d. $85,000 86. Wanda is the Chief Executive Officer of Pink corporation, a publicly traded, calendar year C corporation. For the current year, Wanda's compensation package consists of: Cash compensation Nontaxable fringe benefits Taxable fringe benefits Bonus tied to company performance

$ 2,500,000 250,000 150,000 2,000,000

How much of Wanda's compensation is deductible by Pink Corporation? a. $1,000,000. b. $1,250,000. c. $3,250,000. d. $4,900,000. 87. In the current year, Crimson, Inc., a calendar year C corporation, has income from operations of $180,000 and operating deductions of $225,000. Crimson also had $30,000 of dividends from a 15% stock ownership in a domestic corporation. Which of the following statements is correct with respect to Crimson for the current year? a. Crimson’s NOL is $15,000. b. A dividends received deduction is not allowed in computing Crimson’s NOL. c. The NOL is carried back 3 years and forward 10 years by Crimson. d. Crimson’s dividends received deduction is $15,000. 88. In the current year, Red Corporation (a calendar year C corporation), which owns stock in Blue Corporation, had net operating income of $200,000 for the year. Blue pays Red a dividend of $40,000. Red takes a dividends received deduction of $20,000. Which of the following statements is correct? a. Red owns 80% of Blue Corporation. b. Red owns 20% or more but less than 80% of Blue Corporation. c. Red owns 80% or more of Blue Corporation. d. Red owns less than 20% of Blue Corporation. 89. Which of the following statements is incorrect with respect to the treatment of a net operating loss arising in 2024? a. The deduction for any carryover year of the NOL is limited to 80% of taxable income (determined without regard to the NOL deduction). b. A corporation may claim a dividends received deduction in computing an NOL. c. An NOL is generally carried back 2 years and forward 20 years. Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules d. Unlike individuals, corporations do not adjust their NOLs for net capital losses or nonbusiness deductions. 90. Eagle Corporation, a calendar year C corporation, owns stock in Hawk Corporation and has taxable income of $100,000 for the year before considering the dividends received deduction. In the current year, Hawk Corporation pays Eagle a dividend of $130,000, which was considered in calculating the $100,000. What amount of dividends received deduction may Eagle claim if it owns 15% of Hawk’s stock? a. $0 b. $50,000 c. $65,000 d. $84,500 91. Copper Corporation, a calendar year C corporation, owns stock in Bronze Corporation and has net operating income of $900,000 for the current year. Bronze Corporation pays Copper a dividend of $150,000. What amount of dividends received deduction may Copper claim if it owns 85% of Bronze stock (and the two corporations are members of the same affiliated group)? (Assume Copper’s dividends received deduction is not limited by its taxable income.) a. $75,000 b. $97,500 c. $120,000 d. $150,000 92. Orange Corporation, a calendar year C corporation, owns stock in White Corporation and has net operating income of $400,000 for the current year. White Corporation pays Orange a dividend of $60,000. What amount of dividends received deduction may Orange claim if it owns 45% of White stock (assuming Orange’s dividends received deduction is not limited by its taxable income)? a. $30,000 b. $39,000 c. $42,000 d. $60,000 93. Which of the following statements is incorrect regarding the dividends received deduction? a. A corporation must hold stock for more than 90 days in order to qualify for a deduction with respect to dividends on such stock. b. The taxable income limitation does not apply with respect to the 100% deduction available to members of an affiliated group. c. If a stock purchase is financed 75% by debt, the deduction for dividends on such stock is reduced by 75%. d. The taxable income limitation does not apply if the normal deduction (i.e., 50% or 65% of dividends) results in a net operating loss for the corporation. 94. Emerald Corporation, a calendar year C corporation, was formed and began operations on April 1, 2024. The following expenses were incurred during the first tax year (April 1 through December 31, 2024) of operations. Expenses of temporary directors and of organizational meetings Fee paid to the state of incorporation Accounting services incident to organization Legal services for drafting the corporate charter and bylaws Expenses incident to the printing and sale of stock certificates Powered by Cognero

$27,000 1,000 15,500 9,500 6,000 Page 13

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules Assuming a § 248 election, what is Emerald’s deduction for organizational expenditures for 2024? a. $0 b. $4,550 c. $5,000 d. $7,400 95. During the current year, Sparrow Corporation, a calendar year C corporation, had operating income of $425,000, operating expenses of $280,000, a short-term capital loss of $10,000, and a long-term capital gain of $25,000. How much is Sparrow’s income tax liability for the year? a. $32,700 b. $33,600 c. $45,650 d. $62,400 96. Nancy Smith is the sole shareholder and employee of White Corporation, a calendar year C corporation that is engaged exclusively in accounting services. During the current year, White has operating income of $320,000 and operating expenses (excluding salary) of $150,000. Further, White Corporation pays Nancy a salary of $100,000. The salary is reasonable in amount and Nancy is in the 32% marginal tax bracket regardless of any income from White. Assuming that White Corporation distributes all after-tax income as dividends, how much total combined income tax do White and Nancy pay in the current year? (Ignore any employment tax considerations.) a. $40,295 b. $54,995 c. $63,325 d. $64,396 97. Which of the following statements is incorrect regarding the taxation of C corporations? a. NOLs may be carried forward indefinitely. b. A corporation with total assets of $1 million or more is required to file Schedule M–3. c. A tax return must be filed whether or not the corporation has taxable income. d. The alternative minimum tax does not apply to most corporations. 98. Which of the following statements is correct regarding the taxation of C corporations? a. Schedule M-1 is used to reconcile net income computed for financial accounting purposes with taxable income reported on the corporation’s tax return. b. The corporate tax return is filed on Form 1120S. c. Corporations can receive an automatic extension of nine months for filing the corporate return by filing Form 7004 by the due date for the return. d. A corporation with total assets of $7,500,000 or more is required to file Schedule M-3. 99. Robin Corporation, a calendar year C corporation, had taxable income of $700,000, $1,200,000, and $1,000,000 for 2022, 2023, and 2024, respectively. Robin has taxable income of $1,800,000 for 2025. The minimum 2025 estimated tax installment payments for Robin are: a. April 15, 2025, $52,500; June 17, 2025, $52,500; September 16, 2025, $52,500; December 16, 2025, $52,500. b. April 15, 2025, $52,500; June 17, 2025, $94,500; September 16, 2025, $94,500; December 16, 2025, $94,500. c. April 15, 2025, $94,500; June 17, 2025, $94,500; September 16, 2025, $94,500; December 16, 2025, $94,500. Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules d. April 15, 2025, $52,500; June 17, 2025, $136,500; September 16, 2025, $94,500; December 16, 2025, $94,500. 100. Schedule M-1 of Form 1120 is used to reconcile financial net income with taxable income reported on the corporation’s income tax return as follows: net income per books + additions – subtractions = taxable income. Which of the following items is an addition on Schedule M-1? a. Tax depreciation in excess of book depreciation. b. Proceeds of life insurance paid on death of key employee. c. Excess of capital losses over capital gains. d. Tax-exempt interest. 101. Schedule M-1 of Form 1120 is used to reconcile financial net income with taxable income reported on the corporation’s income tax return as follows: net income per books + additions – subtractions = taxable income. Which of the following items is a subtraction on Schedule M-1? a. Book depreciation in excess of tax depreciation. b. Excess of capital losses over capital gains. c. Proceeds on key employee life insurance. d. Income subject to tax but not recorded on the books. 102. Luis is the sole shareholder of a regular C corporation, and Eduardo owns a proprietorship. In the current year, both businesses make a profit of $80,000 and each owner withdraws $50,000 from his business. With respect to this information, which of the following statements is incorrect? a. Eduardo must report $80,000 of income on his return. b. Luis must report $80,000 of income on his return. c. Eduardo’s proprietorship is not required to pay income tax on $80,000. d. Luis’s corporation must pay income tax on $80,000. 103. Rodney, the sole shareholder of Orange Corporation, an accrual method, calendar year corporation, loaned the corporation a substantial amount of money on January 1, 2024. Orange Corporation accrued $45,000 of interest expense on the loan on December 31, 2024. Orange pays the interest to Rodney, a cash basis taxpayer, on January 1, 2025. Based on these facts: a. Orange Corporation will be allowed to deduct the interest expense in 2024 and Rodney will be required to report the interest income in 2025. b. Orange Corporation will be allowed to deduct the interest expense in 2025 and Rodney will be required to report the interest income in 2024. c. Orange Corporation will be allowed to deduct the interest expense in 2024 and Rodney will be required to report the interest income in 2024. d. Orange Corporation will be allowed to deduct the interest expense in 2025 and Rodney will be required to report the interest income in 2025. 104. Opal Corporation, an accrual method, calendar year C corporation, was formed and began operations on July 1, 2024. The following expenses were incurred during the first tax year (July 1 through December 31, 2024) of operations. Expenses of temporary directors and of organizational meetings Fee paid to the state of incorporation Accounting services incident to organization Powered by Cognero

$8,000 2,000 3,500 Page 15

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules Legal services for drafting the corporate charter and bylaws Expenses incident to the printing and sale of stock certificates

4,300 6,000

Assuming a § 248 election, what is Opal’s deduction for organizational expenditures for 2024? a. $593. b. $460. c. $5,427. d. $5,627. 105. During the current year, Jay Corporation, a calendar year personal service C corporation, had operating income of $300,000, operating expenses of $200,000, a short-term capital gain of $5,000, and a long-term capital loss of $35,000. How much is Jay’s income tax liability for the year? a. $14,700. b. $21,000. c. $22,250. d. $35,000. 106. In working with Schedule M-2 (analysis of unappropriated retained earnings per books) of Form 1120, which of the following is an addition to beginning retained earnings? a. Cash dividends. b. Net loss per books. c. Property dividends. d. Net income per books. 107. In the current year, Tern, Inc., a calendar year C corporation, has $9,000,000 of adjusted taxable income, $300,000 of business interest income, zero floor plan financing interest, and $3,200,000 million of business interest expense. Tern has average gross receipts for the prior three-year period of $45,000,000. Which of the following statements is correct about the treatment of Tern's business interest expense? a. Current year deduction of $3,200,000. b. Current year deduction of $2,790,000, carryforward of $410,000. c. Current year deduction of $2,790,000, carryback of $410,000. d. Current year deduction of $3,000,000, carryforward of $200,000. 108. Plum Corporation, a calendar year C corporation, reports net income of $2.3 billion on its 2024 financial statements, including financial statement depreciation of $300 million. Also, for 2024, Plum reports taxable income of $1.1 billion, including tax depreciation of $500 million. Assume that Plum’s average annual AFSI for the 3-year period ending December 31, 2024, is in excess of $1 billion. Also assume that Plum has no AMT foreign tax credit for 2024. What is Plum 's 2024 corporate AMT? a. $0. b. $84 million. c. $114 million. d. $315 million. 109. Which of the following is not generally a disadvantage of filing Federal corporate income tax returns on a consolidated basis? a. Net capital losses from one affiliate can offset the capital gains from another. This can reduce the tax liabilities Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules of the group as a whole. b. Realized losses from transactions between affiliates are not recognized immediately. c. Compliance costs usually are higher when a consolidation election is in effect. d. The election generally is binding for future tax years. 110. Which of the following potentially is a disadvantage of electing to file a Federal corporate income tax consolidated return? a. Increased deduction amounts when computations are made on a group basis. b. Deferral of gains realized in transactions between group members. c. Increased basis in the stock of a subsidiary that generates annual taxable income. d. Additional administrative costs in complying with the election. 111. Which of the following is not a requirement that must be met before a group files a consolidated return? a. None of the corporations can be ineligible under the Code to file on a consolidated basis with the others. b. All of the corporations must be members of an affiliated group. c. The group members must share the same inventory accounting method (e.g., they all must use FIFO). d. The group members must share a common tax year end. 112. Under the consolidated return rules, the realized gain from an intercompany transaction is deferred. For most taxpayers, this produces: a. An advantage in terms of the time value of money. b. A disadvantage in terms of the time value of money. c. A compliance issue that cannot be resolved. d. A 20% penalty on the consolidated group. 113. Which of the following entities is eligible to file Federal income tax returns on a consolidated basis? a. A U.S. C corporation that files on a separate basis for its state income tax returns. b. The charitable foundation of a U.S. C corporation. c. The liquidating trust of a U.S. C corporation. d. A wholly owned French subsidiary of a U.S. C corporation. 114. Which of the following entities is eligible to join in a Federal consolidated return? a. A sole proprietor with annual sales of more than $50 million. b. A U.S. corporation’s § 401(k) plan. c. A partnership organized in Germany. d. A corporation that operates in seven different U.S. states. 115. Which of the following entities is eligible to file Federal income tax returns on a consolidated basis? a. Professional sports team operating as a limited partnership. b. Japanese corporation engaged in multinational operations, including two-thirds of its activities in the United States. c. Japanese corporation engaged in multinational operations, including one-third of its activities in the United States. d. U.S. corporation engaged in the marijuana industry. Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules 116. Conformity among the members of a consolidated group must be implemented for which of the following tax items? a. Use of foreign tax payments (i.e., as a credit or deduction). b. Tax accounting method (i.e., cash or accrual). c. Inventory accounting method (e.g., FIFO or dollar-cost averaging). d. Tax year-end. 117. Azure Corporation joins the Colorful Corporation Federal consolidated return group. As a result: a. Azure continues to file its own Form 1120. b. The existing Colorful consolidation election is terminated. c. Azure’s tax results immediately are added to the Colorful group’s consolidated Form 1120. d. Azure’s tax results first are added to the Colorful group’s consolidated Form 1120 for the next tax year. 118. Calendar year ParentCo acquired all of the stock of SubCo on January 1, year 1, for $1,000,000. The parties immediately elected to file consolidated income tax returns. SubCo generated taxable income of $250,000 for year 1 and paid a dividend of $100,000 to ParentCo. In year 2, SubCo generated an operating loss of $350,000, and in year 3, it produced taxable income of $750,000. As of the last day of year 3, what was ParentCo’s basis in the stock of SubCo? a. $1,650,000 b. $1,550,000 c. $1,000,000 d. $0 119. Calendar year ParentCo purchased all of the stock of SubCo on January 1, year 1, for $500,000. In year 1, SubCo produced a loss of $150,000 and distributed cash of $25,000 to ParentCo. In year 2, SubCo generated a loss of $450,000; in year 3, it recognized net income of $90,000. What is ParentCo’s capital gain or (loss) if it sells all of its SubCo stock to a nongroup member on year 4 for $150,000? a. $185,000 b. $150,000 c. ($35,000) d. ($535,000) e. All gain/loss is ordinary when subsidiary stock is sold. 120. In computing a group’s consolidated taxable income, a subsidiary’s net capital gain is: a. Removed from group taxable income. b. Used to compute the group’s net capital gain/loss. c. Both a. and b. occur. d. Neither a. nor b. occurs. 121. In computing a group’s consolidated taxable income, the first step is to: a. Compute the taxable income amounts for each affiliate on a standalone basis. b. Obtain IRS permission to file on a consolidated basis for another tax year. c. Eliminate the results of all intercompany transactions for the tax year. d. Compute the allowable group NOL carryforward. 122. ParentCo owned 100% of SubCo for the entire year, and both companies use the accrual method of tax accounting. During the year, SubCo provided internal audit services to ParentCo, which were worth $40,000. Including these Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules transactions, ParentCo’s separate taxable income was $75,000, and SubCo’s separate taxable income was $100,000. What is the group’s consolidated taxable income for the year? a. $215,000 b. $195,000 c. $175,000 d. $155,000 123. Which of the following items is not computed on a group basis for a Federal consolidated income tax return? a. Dividends received deduction. b. Cost recovery deduction. c. Charitable contributions. d. Net capital losses. 124. Which of the following statements is true with regard to intercompany transactions? a. An intercompany transaction is eliminated from consolidated taxable income. b. All intercompany gains are recognized, but losses must be deferred. c. A cash sale of a business asset by the purchasing member to an acquirer outside of the group triggers immediate recognition of the gain or loss. d. The gain or loss on an intercompany transaction is deferred for up to 10 years after which it is recognized. 125. ParentCo purchased all of the stock of ChildCo on January 2, year 2, and the two companies filed consolidated returns for year 2 and thereafter. Both entities were incorporated in year 1. Taxable income computations for the members include the following. Neither group member incurred any capital gain or loss transactions during these years, nor did they make any charitable contributions. No § 382 limit applies. All tax years occur after 2020.

Tax Year Year 1 Year 2 Year 3 Year 4

ParentCo’s Taxable Income $100,000 $100,000 $100,000 $100,000

ChildCo’s Taxable Income ($ 75,000) ($ 40,000) $ 10,000 $125,000

Consolidated Taxable Income N/A $60,000 ? ?

To what extent can ChildCo’s year 1 losses be used by the group in year 4? a. $135,000 b. $125,000 c. $75,000 d. $10,000 e. $0 126. ParentCo purchased all of the stock of ChildCo on January 2, year 2, and the two companies filed consolidated returns for that year and thereafter. Both entities were incorporated in year 1. Taxable income computations for the members include the following. Neither group member incurred any capital gain or loss transactions during these years, nor did either member make any charitable contributions. No § 382 limit applies. All tax years occur after 2020.

Tax Year

ParentCo’s Taxable Income

Powered by Cognero

ChildCo’s Taxable Income

Consolidated Taxable Income Page 19

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules Year 1 Year 2 Year 3 Year 4

$10,000 $10,000 ($25,000) $10,000

($95,000) $50,000 $40,000 $10,000

N/A ? ? ?

To what extent are ChildCo’s year 1 losses used by the group in year 2–year 4? a. $100,000 b. $95,000 c. $75,000 d. $0 127. ParentCo and SubCo report the following items of income and deduction for the current year. Item Income (loss) from operations § 1231 loss Capital gain Charitable contribution

ParentCo’s SubCo’s Taxable Taxable Income Income $100,000 ($10,000) (5,000) 15,000 12,000

Compute ParentCo and SubCo’s 2023 taxable income or loss computed on a separate basis. ParentCo SubCo a. $85,000 $5,000 b. $85,000 $3,000 c. $85,500 $5,000 d. $85,500 $3,000 128. ParentCo and SubCo report the following items of income and deduction for the current year. Item Income (loss) from operations § 1231 loss Capital gain Charitable contribution

ParentCo’s Taxable Income $100,000 (5,000)

SubCo’s Taxable Income ($10,000) 15,000

12,000

Compute ParentCo and SubCo’s current year consolidated taxable income or loss. a. $81,000 b. $88,000 c. $90,000 d. $90,500 Subjective Short Answer 129. During the current year, Skylark Company (a calendar year entity) had operating income of $420,000 and operating expenses of $250,000. In addition, Skylark had a long-term capital loss of $20,000, and a charitable contribution of $5,000. How does Toby, the sole owner of Skylark Company, report this information on his individual income tax return Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules under following assumptions? a.

Skylark is an LLC, and Toby does not withdraw any funds from the company during the year.

b.

Skylark is an S corporation, and Toby does not withdraw any funds from the company during the year.

c.

Skylark is a regular (C) corporation, and Toby does not withdraw any funds from the company during the year.

130. Canary Corporation, an accrual method C corporation, uses the calendar year for tax purposes. Leticia, a cash method taxpayer, is both a shareholder of Canary and the corporation’s CFO. On December 31, 2024, Canary has accrued a $75,000 bonus to Leticia. Describe the tax consequences of the bonus to Canary and to Leticia under the following independent situations. a.

Leticia owns 35% of Canary Corporation’s stock and the corporation pays the bonus to Leticia on February 4, 2025.

b.

Leticia owns 75% of Canary Corporation’s stock and the corporation pays the bonus to Leticia on May 6, 2025.

c.

Leticia owns 75% of Canary Corporation’s stock and the corporation pays the bonus to Leticia on April 7, 2025.

131. Ostrich, a C corporation, has a net short-term capital gain of $20,000 and a net long-term capital loss of $90,000 during 2024. Ostrich also has taxable income from other sources of $1,000,000. Prior years’ transactions included the following: 2020 net short-term capital gains 2021 net long-term capital gains 2022 net short-term capital gains 2023 net long-term capital gains a. b. c. d.

$20,000 15,000 25,000 5,000

How are the capital gains and losses treated on Ostrich’s 2024 tax return? Determine the amount of the 2024 net capital loss that is carried back to each of the previous years. Compute the amount of capital loss carryover, if any, and indicate the years to which the loss may be carried. If Ostrich were a proprietorship, how would Ellen, the owner, report these transactions on her 2024 tax return?

132. During the current year, Gray Corporation, a C corporation in the financial services business, made charitable contributions to qualified organizations as follows: ∙

Stock (basis of $20,000, fair market value of $45,000) in Drab Corporation, held for six months as an investment, to the Salvation Army. (Salvation Army plans on selling the stock.) Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules Painting (basis of $90,000, fair market value of $250,000), held for four years as an investment, to the Museum of Fine Arts. (The Museum plans on including the painting in its collection.)

∙

Gray Corporation’s taxable income (before any charitable contribution deduction) is $1,800,000. a.

What is the total amount of Gray’s charitable contributions for the year?

b.

What is the amount of Gray’s charitable contribution deduction in the current year, and what happens to any excess charitable contribution, if any?

133. On December 28, 2024, the board of directors of Taupe Corporation, a calendar year, accrual method C corporation, authorized a contribution of land to a qualified charitable organization. The land (basis of $75,000, fair market value of $125,000) was acquired five years ago and held as an investment. For purposes of the taxable income limitation applicable to charitable deductions, Taupe has taxable income of $800,000 and $950,000 for 2024 and 2025, respectively. Describe the tax consequences to Taupe Corporation under the following independent situations. a.

The donation is made on February 15, 2025.

b.

The donation is made on May 10, 2025.

134. During the current year, Quartz Corporation (a calendar year C corporation) has the following transactions: Income from operations Expenses from operations Dividends received from ABC Corporation

$350,000 370,000 50,000

Quartz owns 25% of ABC Corporation’s stock. How much is Quartz Corporation’s taxable income (loss) for the year? 135. Warbler Corporation, an accrual method regular corporation, was formed and began operations on March 1, 2024. The following expenses were incurred during its first year of operations (March 1 - December 31, 2024): Expenses of temporary directors and organizational meetings Incorporation fee paid to state Expenses incurred in printing and selling stock certificates Accounting services incident to organization

$25,000 2,000 10,000 12,000

a.

Assuming a valid election under § 248 to amortize organizational expenditures, what is the amount of Warbler’s deduction for 2024?

b.

Same as a., except that Warbler also incurred in 2024 legal fees of $15,000 for the drafting of the corporate charter and bylaws. What is the amount of Warbler’s 2024 deduction for organizational expenditures?

136. During the current year, Coyote Corporation (a calendar year C corporation) has the following transactions: Income from operations Expenses from operations Dividends received from Roadrunner Corporation Powered by Cognero

$260,000 305,000 115,000 Page 22

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules a.

Coyote owns 5% of Roadrunner Corporation’s stock. How much is Coyote Corporation’s taxable income (loss) for the year?

b.

Would your answer change if Coyote owned 25% of Roadrunner Corporation’s stock?

137. In each of the following independent situations, determine the C corporation’s income tax liability. Assume that all corporations use a calendar year 2024.

Violet Corporation Indigo Corporation Orange Corporation Blue Corporation Green Corporation (personal service corporation)

Taxable Income $ 63,000 180,000 510,000 11,100,000 225,000

138. Tonya, an actuary, is the sole shareholder of Shrike Corporation, a professional C corporation. The corporation paid Tonya a salary of $360,000 during its fiscal year ending September 30, 2024. How much salary must Shrike Corporation pay Tonya during the period October 1 through December 31, 2024, to enable the corporation to continue to use its fiscal year without negative tax effects?

139. Almond Corporation, a calendar year C corporation, had taxable income of $900,000, $1,100,000 million, and $1,200,000 million for 2022, 2023, and 2024, respectively. Almond’s taxable income is $2,000,000 for 2025. Compute the minimum estimated tax payments for 2025 for Almond Corporation. 140. Heron Corporation, a calendar year, accrual basis taxpayer, provides the following information for the current year and asks you to prepare Schedule M-1. Net income per books (after-tax) Taxable income Federal income tax liability Interest income from tax-exempt bonds Interest paid on loan incurred to purchase tax-exempt bonds Life insurance proceeds received as a result of death of Heron’s president Premiums paid on policy on life of Heron’s president Excess of capital losses over capital gains Retained earnings at beginning of year Cash dividends paid Tax depreciation in excess of book depreciation

$258,050 195,000 40,950 5,000 2,000 100,000 4,500 2,000 375,000 90,000 7,500

141. ParentCo’s controlled group includes the following members. ParentCo owns all of the stock in each of the listed Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules entities. Which entities can join ParentCo in a consolidated return? ∙

SubCoA, a manufacturer incorporated in India.

∙

SubCoB, a U.S. manufacturer.

∙

SubCoC, a U.S. S corporation.

∙

SubCoD, a U.S. partnership.

∙

SubCoE, a U.S. limited liability company (LLC).

∙

SubCoF, a U.S. manufacturer incorporated in Puerto Rico.

∙

SubCoG, a U.S. manufacturer that claims a deduction for its research activities.

∙

SubCoH, a U.S. tax-exempt museum.

Essay 142. Adrian is the president and sole shareholder of Pigeon Corporation. He also lends money and rents a building to the corporation. Discuss how these business relationships between Adrian and Pigeon Corporation can help avoid double taxation. What limitations are there on the use of such relationships? 143. Nancy is a 40% shareholder and president of Robin Corporation, a calendar year C corporation. The board of directors of Robin has decided to pay Nancy a $75,000 bonus for the current year based on her outstanding performance. The directors want to pay the $75,000 as salary, but Nancy would prefer to have it paid as a dividend. If Nancy is in the 37% marginal tax bracket regardless of the treatment of the bonus, discuss which form of payment would be most beneficial for each party. (Ignore any employment tax considerations.) 144. Dawn is the sole shareholder of Thrush Corporation, a calendar year C corporation. In the current year, Thrush earned $350,000 and distributed $75,000 to Dawn. Kirk is the sole shareholder of Swallow Corporation, an S corporation. In the current year, Swallow earned $350,000 and distributed $75,000 to Kirk. Contrast the tax treatment of Thrush Corporation and Dawn with the tax treatment of Swallow Corporation and Kirk. 145. Explain the rules regarding the accounting periods available to corporate taxpayers. 146. Huan, a cash basis taxpayer, owns 70% of the stock of Black Corporation, a calendar year, accrual basis C corporation. On December 31, 2024, Black accrued a bonus of $80,000 to Huan, and paid the bonus to Huan on January 1, 2025. When does Huan report the bonus, and when does Black Corporation deduct the bonus? Would your answers change if Huan was a 40% shareholder of Black? 147. Briefly describe the accounting methods available for adoption by a C corporation. 148. Contrast the tax treatment of capital gains and losses of C corporations with that of individual taxpayers. 149. Briefly describe the charitable contribution deduction rules applicable to C corporations. 150. Briefly discuss the current-year requirements for the dividends received deduction. 151. In connection with the deduction for startup expenditures, comment on the following: Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules a. b. c.

Qualifying expenditures. Election process. Amount of deduction.

152. What is the annual required estimated tax payment for a C corporation? What are the rules regarding payment of the estimated tax? 153. What is the purpose of Schedule M-3? Which corporations are required to file Schedule M-3? 154. For purposes of the accumulated earnings tax, earnings can be accumulated for reasonable needs of the business. List several examples of what is included and several examples of what is not included in the reasonable needs of the business. 155. In applying the $1,000,000 limit on deducting executive compensation, what corporations are subject to the deduction limit? What executives are covered? What compensation is included in the limit? 156. How is the limitation on the deduction of business interest computed? Does it apply to all taxpayers? What happens to any business interest deduction disallowed by the limitation?

157. List some of the nontax reasons that groups of corporations form conglomerates and may be eligible also to file consolidated Federal income tax returns. 158. Where are the controlling Federal income tax rules regarding consolidated tax returns to be found? What is the general philosophy of those rules? 159. Outline the major advantages and disadvantages of filing Federal corporate income tax returns on a consolidated basis. Limit your comments to the income tax effects of the election. 160. Certain business entities are ineligible to join an affiliated group and file a consolidated Federal income tax return. List three or more entities that cannot be part of a Federal consolidated tax return group. 161. When a corporate group elects to file Federal income tax returns on a consolidated basis, it is subject to several tax return filing requirements for its first and subsequent tax years. List the most important of those requirements. 162. Gold and Bronze elect to form a Federal consolidated group. Gold, the parent entity, uses a calendar tax year while Bronze’s tax year ends on March 31. Which tax year(s) does the new consolidated group use? 163. Describe the general computational method used by a Federal consolidated group in computing taxable income.

Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules Answer Key 1. True 2. False 3. False 4. True 5. False 6. True 7. True 8. False 9. True 10. True 11. True 12. True 13. False 14. False 15. True 16. False 17. True 18. False 19. False 20. True 21. False 22. True 23. True 24. False 25. True Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules 26. True 27. True 28. False 29. False 30. True 31. True 32. False 33. True 34. True 35. True 36. True 37. False 38. True 39. True 40. True 41. True 42. True 43. True 44. True 45. True 46. False 47. False 48. False 49. False 50. True Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules 51. False 52. True 53. True 54. False 55. False 56. True 57. True 58. True 59. True 60. False 61. True 62. False 63. False 64. True 65. True 66. True 67. False 68. True 69. c 70. b 71. c 72. c 73. b 74. b 75. c 76. a Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules 77. d 78. c 79. d 80. c 81. c 82. b 83. b 84. c 85. b 86. b 87. d 88. d 89. c 90. b 91. d 92. b 93. a 94. b 95. b 96. b 97. b 98. a 99. d 100. c 101. c Powered by Cognero

Page 29

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules 102. b 103. d 104. c 105. b 106. d 107. d 108. b 109. a 110. d 111. c 112. a 113. a 114. d 115. d 116. d 117. c 118. b 119. a 120. c 121. a 122. c 123. b 124. c 125. c 126. c 127. c Powered by Cognero

Page 30

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules 128. c 129. a.

b.

c.

A single-member LLC is taxed as a proprietorship. Consequently, Toby reports the $170,000 operating profit, $20,000 long-term capital loss, and $5,000 charitable contribution on his individual return (Form 1040). The LTCL will be subject to the capital loss limitations applicable to individual taxpayers. Toby would report any related deduction for qualified business income on his Form 1040. Income, deductions, gains, and losses of an S corporation flow through to the shareholders. Separately stated items (e.g., LTCL and charitable contribution) retain their character at the shareholder level. Consequently, Toby reports the $170,000 operating profit, $20,000 longterm capital loss, and $5,000 charitable contribution on his individual return (Form 1040). The LTCL will be subject to the capital loss limitations applicable to individual taxpayers. Toby would report any related deduction for qualified business income on his Form 1040. Shareholders of a regular (C) corporation report income from the corporation to the extent of dividends received. Therefore, Toby does not report any of Skylark’s operating profit, longterm capital loss, or charitable contribution on his individual return. [Skylark Company would report taxable income of $165,000 ($170,000 operating profit – $5,000 charitable contribution) on its corporate return (Form 1120). The net capital loss of $20,000 is not deductible in the current year; rather, the loss is carried back three years and forward five years (as STCL).]

130. Under § 267(a)(2), an accrual method taxpayer must defer a deduction for an expenditure attributable to a cash method related party until such time the related party reports the amount as income. For purposes of this limitation, a more-than-50% shareholder of the corporation is a related party. a.

Leticia is not a related party for purposes of the § 267(a)(2) limitation; thus, Canary deducts the bonus, under the accrual method, in 2024. Since Leticia is on the cash method, she includes the bonus in her income in 2025.

b.

Since Leticia, a cash method related party, does not include the bonus in her income until its receipt in 2025, Canary’s deduction for the bonus occurs in 2025.

c.

Again, Leticia is a cash method related party who does not include the bonus in her income until its receipt in 2025; thus, Canary’s deduction for the bonus is deferred until 2025. The fact that the payment to Leticia occurs prior to the filing date for Canary’s 2024 tax return is of no consequence.

131. a. Net short-term capital gain Powered by Cognero

$ 20,000 Page 31

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules Net long-term capital loss Net capital loss

(90,000) ($70,000)

The net capital loss of $70,000 is not deductible in 2024 but must be carried back to the three preceding years, applying it to 2021, 2022, and 2023, in that order. Such net capital loss is carried back or forward as a short-term capital loss. b.

c.

d.

2024 net capital loss Offset against— 2021 net long-term capital gains 2022 net short-term capital gains 2023 net long-term capital gains Total carrybacks

($70,000) $15,000 25,000 5,000 $45,000

$25,000 ($70,000 – $45,000) STCL carryover to 2025, 2026, 2027, 2028, and 2029 in that order. Ellen would net these transactions with all other capital transactions for 2024. Assuming these were her only capital transactions in 2024, she would offset $20,000 of capital losses against the capital gains and deduct an additional $3,000 in capital losses on her return. The remaining $67,000 ($90,000 – $20,000 – $3,000) would be carried forward indefinitely as a LTCL.

132. a.

Gray’s total amount of charitable contributions is $270,000 [$20,000 (stock) + $250,000 (painting)], computed as follows: Stock: this is ordinary income property, because a sale of the stock would not result in a long-term capital gain or a § 1231 gain for Gray (i.e., STCG). Thus, the amount of the contribution is the stock’s basis, or $20,000. Painting: this is capital gain property, because a sale of the painting would result in a longterm capital gain for Gray. The painting is tangible personal property and its use is related to the charitable organization's exempt function. Thus, the amount of the contribution is the painting’s fair market value, or $250,000.

b.

Gray’s current-year charitable deduction is limited to $180,000 [10% × $1,800,000 (taxable income before charitable deduction)], and the excess charitable contribution of $90,000 ($270,000 – $180,000) is carried forward to the five succeeding tax years.

133. In general, charitable contributions are deductible in the year made. However, in the case of an accrual method Powered by Cognero

Page 32

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules corporation, a deduction can be claimed in the current year for a charitable contribution made in the subsequent year if (1) the contribution is approved by the board of directors of the corporation in the current year, and (2) the contribution is made on or before the fifteenth day of the fourth month of the subsequent year. The land is capital gain property; thus, the amount of the charitable contribution is the land’s fair market value of $125,000. a.

b.

The requirements for an accrual of the charitable deduction are satisfied; thus, the $125,000 contribution is deductible by Taupe in 2024, subject to the taxable income limitation. For 2024, the taxable income limitation for charitable deductions is $80,000 (10% × $800,000). The excess contribution amount of $45,000 carries forward to 2025 (five-year carryover limit). The requirements for an accrual of the charitable deduction are not satisfied; thus, the $125,000 contribution is deductible by Taupe in 2025 (the year the contribution is made), subject to the taxable income limitation. For 2025, the taxable income limitation for charitable deductions is $95,000 (10% × $950,000). The excess contribution amount of $30,000 carries forward to 2026 (five-year carryover limit).

134. Quartz has an NOL, computed as shown here: Gross income: From operations Dividends Less: Expenses from operations Dividends received deduction ($50,000 × 65%) Net operating loss

$350,000 50,000

$400,000

$370,000 32,500

(402,500) ($ 2,500)

The dividends received deduction is not limited to the taxable income limitation because it creates a net operating loss.

135. a.

b.

Warbler has qualifying organizational expenditures of $39,000 [$25,000 (expenses of temporary directors and organizational meetings) + $2,000 (incorporation fee) + $12,000 (accounting fees)]. Expenses related to the printing or selling of stock or other securities do not qualify as organizational expenditures. Warbler’s 2024 deduction for the organizational expenditures is $6,889 {$5,000 (amount immediately expensed) + [($39,000 – $5,000)/180 × 10 months]}. Warbler now has qualifying organizational expenditures of $54,000 [$39,000 (as computed in part a., above) + $15,000 (legal fees)]. Warbler’s 2024 deduction for the organizational expenditures is $3,944 {$1,000 (amount immediately expensed) + [($54,000 – $1,000)/180 × 10 months]}. The $5,000 immediate expensing amount is reduced to the extent that qualifying organizational expenditures exceed $50,000; thus, only $1,000 of the expenditures is immediately deductible, and the remainder of the expenditures is amortized over 180 months.

Powered by Cognero

Page 33

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules

136. The key to this question is the relationship between the dividends received a. deduction and the NOL deduction. The dividends received deduction is limited to a percentage of taxable income of the corporation (unless taking the full dividends received deduction would cause or increase an NOL). In this case, the dividends received deduction is limited to 50% of taxable income. Gross income: From operations Dividends Less: Expenses from operations Taxable income before the dividends received deduction Dividends received deduction (50% × $70,000) Taxable income

$260,000 115,000

$375,000 (305,000) $ 70,000 (35,000) $ 35,000

The dividends received deduction is limited to 50% of taxable income because taking 50% of $115,000 ($57,500) would not create an NOL. If Coyote Corporation owns 25% of Roadrunner Corporation’s stock, the b. percentage for calculating the dividends received deduction is 65%. Under these circumstances, taking the full dividends received deduction would create an NOL. Gross income: From operations Dividends Less: Expenses from operations Taxable income before the dividends received deduction Dividends received deduction (65% × $115,000) Net operating loss

$260,000 115,000

$375,000 (305,000) $ 70,000 (74,750) ($ 4,750)

137. Violet Corporation: Tax on $63,000 × 0.21

$13,230

Indigo Corporation: Tax on $180,000 × 0.21

$37,800

Orange Corporation: Powered by Cognero

Page 34

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules Tax on $510,000 × 0.21

$107,100

Blue Corporation: Tax on $11,100,000 × 0.21

$2,331,000

Green Corporation (personal service corporation): Tax on $225,000 × 0.21

$47,250

A flat 21% tax rate applies to all C corporations (including PSCs). 138. The salary for the deferral period (October 1 through December 31) must be at least proportionate to the employee’s salary received for the fiscal year. The amount that Shrike Corporation must pay Tonya during the period October 1 through December 31, 2024, to permit the continued use of its fiscal year without negative tax effects is $90,000 [($360,000 × (3 ÷ 12)].

139. A corporation that had taxable income of $1,000,000 or more in any of the three preceding years is a “large corporation” for purposes of utilizing the prior year’s tax exception for estimated tax payments. As such, Almond Corporation can use the prior year’s tax exception for computing its first 2024 estimated tax payment only, and any shortfall as a result of such use must be paid with the second installment. Payment April 15, 2025 June 16, 2025 September 15, 2025 December 15, 2025 Total

Amount $ 63,000 * 147,000 ** 105,000 105,000 $420,000

*Based on preceding year’s tax, for first installment only: ($1,200,000 taxable income × 21%) = $252,000 ÷ 4 = $63,000. **Based on current year’s tax, for remaining installments: ($2,000,000 taxable income × 21%) = $420,000 ÷ 4 = $105,000. Second installment must include shortfall from first installment: [$105,000 + ($105,000 – $63,000)] = $147,000.

140. Net income per books is reconciled to taxable income as follows: Net income per books (after tax) Powered by Cognero

$258,050 Page 35

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules Plus: Items that decreased net income per books but did not affect taxable income + Federal income tax liability + Excess of capital losses over capital gains + Interest paid on loan incurred to purchase tax-exempt bonds + Premiums paid on policy on life of president of the corporation Subtotal Minus: Items that increased net income per books but did not affect taxable income – Interest income from tax-exempt bonds – Life insurance proceeds received as a result of the death of the corporate president – Tax depreciation in excess of book depreciation Taxable income

40,950 2,000 2,000 4,500 $307,500

(5,000) (100,000) (7,500) $195,000

141. ParentCo can include only its subsidiaries B and G on a consolidated return. The other entities are not eligible to file on a consolidated basis. 142. As president of Pigeon Corporation, Adrian can have the corporation pay him a salary. As a creditor, he can have the corporation pay him interest on the loans. As a landlord, he can have the corporation pay him rent. All of these expenses can be deducted by the corporation. In order to avoid disallowance of any of these deductions at the corporate level, the payments to Adrian must be reasonable in amount. Payments deemed to be unreasonable in amount will be treated as corporate dividends to Adrian and nondeductible by Pigeon. However, to the extent that the payments are reasonable in amount and deductible by Pigeon Corporation, the corporate tax is avoided on such amounts. The payments received by Adrian would be income (i.e., salary, interest, and rent) to him and taxed as such, but this would be the only tax incurred on such amounts (i.e., double taxation is avoided to the extent of any payments deductible by Pigeon). 143. Robin Corporation prefers treating the payment as salary, because a $75,000 deduction for such would provide the corporation with a tax savings of $15,750 [$75,000 (salary deduction) × 21%]. If, instead, the payment were treated as a dividend, none of the $75,000 would deductible by Robin. Nancy prefers treating the payment as a dividend, because a preferential tax rate of 20% would apply to the $75,000 and result in only $15,000 of tax. If, instead, the payment were treated as salary, Nancy would incur tax of $27,750 [$75,000 (salary) × 37% (marginal tax rate)]. Thus, Nancy would save $12,750 of tax if the payment were treated as a dividend instead of salary. 144. A C corporation is a separate taxable entity; thus, Thrush Corporation is taxed on the $350,000 of earnings. Income of a C corporation has no effect on the shareholders until such time a dividend is paid. When dividends are paid, shareholders must report dividend income on their tax returns. Thus, Dawn is taxed on $75,000 of dividends and the 0%/15%/20% preferential tax rate applies with respect to the dividends. Generally, an S corporation is not subject to an entity level Federal income tax. Instead, the corporation’s income, gains, deductions, and losses are passed through to and reported by the shareholders on their tax returns. Thus, Swallow reports the $350,000 of earnings on its tax return (Form 1120S), but pays no income tax. Kirk is taxed on the $350,000 of earnings from Swallow on his individual income tax return (Form 1040). Kirk would report any related deduction for qualified business income on his Form 1040. Distributions from S corporations are not taxable to the shareholder (to the extent of stock basis). Thus, Kirk is not taxed on the $75,000 distribution from Swallow. 145. In general, a corporate taxpayer may select a calendar year or a fiscal year for tax return reporting purposes. A newly formed corporation generally can select its initial reporting period without having to obtain IRS consent. However, certain Powered by Cognero

Page 36

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules types of corporate taxpayers are subject to restrictions on their reporting period. In general, personal service corporations (PSCs) and S corporations are required to use the calendar year for tax reporting. Exceptions to this rule apply, and a fiscal year can be elected by a PSC (or S corporation) under any of the following conditions:

•

A business purpose for the year can be demonstrated.

•

The PSC tax year results in a deferral of not more than three months’ income. An election under § 444 is required, and the PSC will be subject to the deduction limitations of § 280H. The corporation must pay the shareholder/employee’s salary during the portion of the calendar year after the close of the fiscal year. In addition, the salary for that period must be at least proportionate to the employee’s salary for the fiscal year. (For an S corporation electing a § 444 deferral, the required payments provision of § 7519 must be satisfied. See Chapter 11.)

•

The PSC (or S corporation) retained the same year that was used for its fiscal year ending 1987, provided an election was made under § 444 and subject to the deduction limitations of § 280H (or § 7519, in the case of an S corporation).

146. Huan is a more than 50% shareholder of Black Corporation; thus, the taxpayers are related parties under § 267. Huan, a cash basis taxpayer, reports the salary income in 2025, the year of receipt. Under § 267, Black Corporation, an accrual basis taxpayer, cannot deduct the salary expense when accrued in 2024. Instead, Black’s deduction for the bonus is in 2025, the year Huan reports the salary as income. If Huan were a 40% shareholder, the § 267 related party rules would not apply to the bonus deduction. Instead, Black Corporation, an accrual basis taxpayer, deducts the bonus in 2024, the year of accrual. Huan, a cash basis taxpayer, still reports the bonus as income in 2025, the year of receipt. 147. In general, a C corporation must adopt the accrual method of accounting. However, there are several exceptions to this rule, and the following C corporations can use the cash method of accounting: •

Corporations engaged in the trade or business of farming or timber.

•

Qualified personal service corporations.

•

Corporations with average annual gross receipts of $30,000,000 million or less for the previous 3-year period.

There is a limitation on the use of the cash method by otherwise qualifying corporations that maintain inventories. In general, these corporations must use the accrual method in determining sales and cost of goods sold. However, corporations with average annual gross receipts of $30,000,000 or less for the most recent 3-year period are generally not subject to the limitation. Accrual method corporations are subject to a limitation on the deductibility of an accrued expenditure attributable to a cash method related party (e.g., a more-than-50% shareholder). In such cases, the corporation’s deduction for the expenditure is deferred until the recipient includes the amount in income.

Powered by Cognero

Page 37

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules 148. The definition of capital assets is the same for both corporate and individual taxpayers. Also, both types of taxpayers net short- and long-term gains and losses to arrive at a net capital gain or loss. In the case of a net capital gain, individual taxpayers receive a preferential tax rate (0%/15%/20%) with respect to LTCGs but corporations do not receive any preference as to LTCG tax rates. In the case of a net capital loss, individual taxpayers can deduct up to $3,000 of net capital loss against ordinary income in the current year but corporations cannot deduct any amount of a net capital loss in the current year. Individual taxpayers carry forward capital losses indefinitely, with such losses retaining their character as short term or long term. Corporate taxpayers carry capital losses back three years and forward five years, and such losses are treated as STCL in such years. 149. Tax year of deduction: In general, a charitable contribution is deductible only in the year the gift is made. For an accrual basis corporation, however, a charitable contribution can be deducted in the current year for a contribution that is (1) approved by the corporation’s board of directors by the end of such year and (2) paid on or before the fifteenth day of the fourth month of the next year. Amount of contribution: In addition to cash gifts, property contributions to qualified charitable organizations are also deductible. For property that is depreciated (fair market value less than basis), the amount of the contribution is the property’s fair market value. For property that is appreciated (fair market value greater than basis), the amount of the contribution depends on whether the property is “capital gain property” or “ordinary income property.” Capital gain property is property that, if sold, would result in a long-term capital gain or § 1231 gain. A contribution of capital gain property generally results in a deductible amount equal to the property’s fair market value. If the capital gain property is tangible personal property and the charitable organization’s use of the property is unrelated to its exempt function, the amount of the contribution is equal to the property’s basis. (Contributions of capital gain property to certain private foundations are similarly limited to the property’s basis.) Ordinary income property is property that, if sold, would not result in a long-term capital gain or § 1231 gain. Typically, the deduction for a contribution of ordinary income property is equal to the property’s basis. However, charitable contributions of certain inventory property by corporations can result in an enhanced deduction amount. For such inventory property, the deductible amount is equal to the lesser of (1) the sum of the property’s basis plus 50% of the appreciation on the property or (2) twice the property’s basis. Annual limitation on deduction: A corporate taxpayer’s charitable deduction is limited to 10% (15% for contributions of food inventory) of taxable income (determined without regard to the charitable contribution deduction, any net operating loss carryback or capital loss carryback, and dividends received deduction). Any contributions in excess of the 10% limitation may be carried forward for five years. In any tax year for which there is a charitable contribution carryover, current year’s gifts are applied against the 10% limitation first, with carryover amounts deducted in order of time. 150. The dividends received deduction (DRD) is available to C corporations with respect to dividends received from domestic corporations. The amount of the DRD is generally equal to 50% (for stock ownership of less than 20%) or 65% (for stock ownership of 20% or more but less than 80%) of the dividends received. A limitation applies if the applicable percentage (50% or 65%) of taxable income (computed without regard to the DRD, NOL deduction, and capital loss carryback) is less than the normal DRD amount. However, the taxable income limitation does not apply if the normal DRD amount creates or increases an NOL. (For stock ownership interests of 80% or more, the applicable DRD percentage is 100% and the taxable income limitation does not apply.) Two additional limitations apply to the DRD. First, no DRD is allowed unless the corporation has held the stock for more than 45 days. Second, the amount of the DRD is reduced by the percentage of the investment in the stock that is debt financed. This reduction in the DRD cannot exceed that amount of the interest expense deduction allocable to the dividend. 151. a. “Startup expenditures” are expenses incurred after the organization of a trade or business but before such trade or business has begun operations. Examples of startup expenditures include rent, payroll, accounting, advertising, insurance, utilities, and other operating expenses associated with the prePowered by Cognero

Page 38

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules opening of a trade or business. b. A corporation is deemed to have made the election to amortize startup expenditures for the taxable year in which the corporation begins business. The startup expenditures deduction is claimed on the corporation’s return for such taxable year without any separate statement or specific identification of the deduction. If a corporation wants to forgo the deduction of startup expenditures, a separate statement to that effect should accompany the corporation’s tax return for its first taxable year. c. In general, startup expenditures are amortized over a 180-month period beginning with the month the corporation begins business. However, the first $5,000 of startup expenditures is expensed in the first taxable year with the remaining amount of expenditures amortized over the 180-month period. The $5,000 expensing amount is reduced to the extent that startup expenditures exceed $50,000 (i.e., there is no immediate expensing if startup expenditures equal or exceed $55,000). 152. Estimated tax payments are required if the corporation’s tax liability is expected to be $500 or more. The required annual payment is the lesser of (1) 100% of the corporation’s tax for the current year or (2) 100% of the corporation’s tax for the preceding year. Estimated payments are made quarterly, due on or before the 15th day of the 4th, 6th, 9th, and 12th months of the taxable year. Underpayment of estimated tax penalty can be avoided if the quarterly payments are filed timely and equal to the corporation’s tax liability for the prior year (or tax liability computed on an annualized method). A corporation with taxable income of $1,000,000 or more in any of its three preceding years can use the prior year’s tax liability for computing only the first installment payment. In such cases, the corporation’s second installment payment must include any shortfall resulting from using the prior year’s liability (instead of the current-year’s liability) for the first installment. 153. Schedule M-3 was created, in part, in response to financial reporting scandals, such as Enron and WorldCom. Schedule M-3 requires corporations to report much more information regarding the differences between financial net income (loss) and taxable income than is required of Schedule M-1. This greater transparency should allow the IRS to more easily identify corporations that engage in aggressive tax practices, because those transactions generally result in book/tax differences that must be reported on Schedule M-3. Entities with total assets of $10,000,000 or more must file Schedule M-3 (in lieu of Schedule M-1). The financial figures (e.g., amount of total assets, net income or loss) required of the Schedule M-3 are drawn from the corporation’s Form 10-K. If Form 10-K is not filed, then another financial source (e.g., certified financial statements) is used. 154. Reasonable needs of the business include expansion of the business, replacement of plant and equipment, working capital needs, product liability losses, debt retirement, self-insurance, and loans to suppliers and customers. Reasonable needs do not include loans to shareholders, investments in unrelated properties or businesses, and unrealistic hazards and contingencies. 155. The $1,000,000 limit on deducting the compensation of a covered employee applies to publicly traded corporations. Covered employees include the principal (or chief) executive officer, the principal (or chief) financial officer, and the three other most highly compensated officers. The limitation applies to all compensation for services performed by a covered employee, including commissions and performance-based compensation. However, the limitation does not apply to retirement plan contributions or tax-free employer provided benefits.

156. The deduction of business interest for any year is limited to the sum of (1) the taxpayer's business interest income for the year, (2) 30% of the taxpayer's adjusted taxable income for the year, and (3) the taxpayer's floor plan financing interest for the year. In general, the limitation applies to all taxpayers but there is a small business exception (i.e., taxpayers having average gross receipts for the prior three-year period of $30,000,000 or less). Any business interest deduction Powered by Cognero

Page 39

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules disallowed by the limit is treated as business interest paid or accrued in the succeeding tax year. 157. Conglomerates are formed to reduce overall tax liabilities and to: ∙

Isolate the assets of some affiliates from the liabilities of others.

∙

Disguise the true owners of certain assets and income.

∙

Preserve intangible assets such as trade names.

∙

Accomplish estate planning objectives.

∙

Expand into underserved markets.

158. Most of the rules controlling the use of consolidated Federal tax returns are found in the extensive Regulations under IRC §§ 1501-1504. The rules are designed to tax the group as if it was one corporation. In addition, the rules limit the tax advantages that otherwise might be available to affiliated groups of corporations. The Treasury seems to want to discourage profitable corporations from “trafficking” in the shares of businesses that generate deductible net losses and tax credits. 159. Assessing only the Federal income tax aspects of the consolidation election, the major advantages include the following. ∙

Application of operating and capital losses of one member against the gains/income of others.

∙

Elimination of all tax liabilities on intercompany dividends.

∙

Deferral of gains from certain intercompany transactions.

∙

Optimization of other deductions, losses, and credits computed on a group basis.

∙

Optimization of the group’s estimated tax payments.

∙

Increase in basis in subsidiary stock when net gains are recognized by the group.

∙

Shareholdings of all group members can be used in meeting other statutory requirements .

Major Federal income tax disadvantages relative to the consolidation election include the following. ∙

The binding status of the election and the five-year cooling-off period after termination thereof.

∙

Deferral of losses from certain intercompany transactions.

∙

Reduction of basis in subsidiary stock when net losses are recognized by the group.

∙

Standardization of the tax year, perhaps resulting in income bunching and loss of flexibility. Powered by Cognero

Page 40

Name:

Class:

Date:

Chapter 17: Corporations Introduction and Operating Rules ∙

Additional costs incurred to meet compliance and administrative requirements, which can be burdensome.

160. These are some of the entities ineligible for membership in a consolidated group. ∙

Non-U.S. entities.

∙

Tax-exempt entities.

∙

Partnerships, trusts, estate, and limited liability entities.

∙

Other noncorporate entities.

161. The major filing requirements for a Federal consolidated group include the following. ∙

File the Form 1120 using consolidated taxable income.

∙

File Form 1122 listing the group members consenting to the election to consolidate with the first consolidated return.

∙

File Form 851, another less-detailed listing of the affiliates included in the return, with all subsequent consolidated 1120s.

162. Affiliates must switch to the parent’s tax year (calendar year in this case), but they can continue to use their existing tax accounting methods. A short tax year is created for a new affiliate that joins the parent’s group and needs to change its tax year. 163. Consolidated taxable income is determined in the following manner. ∙ Taxable income is computed for each group member on a separate basis.

Realized gain/losses from most intercompany transactions are deferred until later tax years. ∙

Certain transactions are accounted for on a group basis using group floors, ceilings, and other computational limits. These items include capital gain/loss and charitable contributions.

∙

A few intercompany transactions (such as dividend payments) are eliminated from all computations of taxable income.

Powered by Cognero

Page 41

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure True / False 1. Similar to the like-kind exchange provision, § 351 can be partly justified under the wherewithal to pay concept. a. True b. False 2. Similar to like-kind exchanges, the receipt of “boot” under § 351 can cause loss to be recognized. a. True b. False 3. Tina incorporates her sole proprietorship with assets having a fair market value of $100,000 and an adjusted basis of $110,000. Even though § 351 applies, Tina may recognize her realized loss of $10,000. a. True b. False 4. In a § 351 transfer, a shareholder receives boot of $10,000 but ends up with a realized loss of $3,000. Only $7,000 of the boot will be taxed to the shareholder. a. True b. False 5. A taxpayer may never recognize a loss on the transfer of property in a transaction subject to § 351. a. True b. False 6. If a transaction qualifies under § 351, any recognized gain is equal to the value of the boot received. a. True b. False 7. Allen transfers marketable securities with an adjusted basis of $120,000, fair market value of $300,000, for 85% of the stock of Heron Corporation. In addition, he receives cash of $40,000. Allen recognizes a capital gain of $40,000 on the transfer. a. True b. False 8. When consideration is transferred to a corporation in return for stock, the definition of “property” is important because tax deferral treatment of § 351 is available only to taxpayers who transfer property. a. True b. False 9. The transfer of an installment obligation in a transaction qualifying under § 351 is a taxable disposition of the obligation to the transferor. a. True b. False 10. Gabriella and Maria form Luster Corporation with each receiving 50 shares of its stock. Gabriella transfers cash of $50,000, while Maria transfers a proprietary formula (basis of $0; fair market value of $50,000). Neither Gabriella nor Maria will recognize gain on the transfer. Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure a. True b. False 11. Because services are not considered property under § 351, a taxpayer must report as income the fair market value of stock received for such services. a. True b. False 12. For § 351 purposes, stock rights and stock warrants are included in the definition of “stock.” a. True b. False 13. In a § 351 transaction, if a transferor receives consideration other than stock, the transaction can result in taxable income. a. True b. False 14. The receipt of nonqualified preferred stock in exchange for the transfer of appreciated property to a controlled corporation results in recognition of gain to the transferor. a. True b. False 15. Ruth transfers property worth $200,000 with a basis of $60,000 to Goldfinch Corporation. In return, she receives 80% of its stock worth $180,000 and a long-term note executed by Goldfinch and made payable to Ruth worth $20,000. Ruth will recognize no gain on the transfer. a. True b. False 16. The control requirement under § 351 requires that the person or persons transferring property to the corporation immediately after the transfer own stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation. a. True b. False 17. To retain the services of Eve, a key employee in Ted’s sole proprietorship, Ted agrees to make Eve a 30% owner. Ted incorporates the business, receiving in return 100% of the stock. Three days later, Ted transfers 30% of the stock to Eve. Under these circumstances, § 351 will apply to the incorporation of Ted’s business. a. True b. False 18. Sofia forms Lark Corporation with a transfer of appreciated property in exchange for all of its shares. Shortly thereafter, she transfers half her shares to her son, Ted. The later transfer to Ted could cause the original transfer to be taxable. a. True b. False 19. A person who performs services for a corporation in exchange for stock cannot be treated as a member of the § Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure 351 transferring group even if that person also transfers some property to the corporation. a. True b. False 20. The use of § 351 is not limited to the initial formation of a corporation, and it can apply to later transfers as well. a. True b. False 21. Because boot is generated under § 357(b) (i.e., the liability has no bona fide business purpose), the transferor shareholder will always recognize gain. a. True b. False 22. When incorporating her sole proprietorship, Samantha transfers all of her assets and liabilities to the corporation. Included in the $30,000 of liabilities assumed by the corporation is $500 that relates to a personal expenditure. Under these circumstances, the entire $30,000 will be treated as boot. a. True b. False 23. To determine whether § 357(c) applies, the taxpayer must assess whether the liabilities involved exceed the bases of all assets a shareholder transfers to the corporation. a. True b. False 24. A taxpayer transfers assets and liabilities to a corporation in return for its stock. If the liabilities exceed the basis of the assets transferred, the taxpayer will have a negative basis in the stock. a. True b. False 25. If both §§ 357(b) and (c) apply to the same transfer (i.e., the liability lacks a bona fide business purpose and also exceeds the basis of the properties transferred), only § 357(c) applies. a. True b. False 26. When a taxpayer transfers property subject to a mortgage to a controlled corporation in an exchange qualifying under § 351, the transferor shareholder’s basis in stock received in the transferee corporation is increased by the amount of the mortgage on the property. a. True b. False 27. Basis of appreciated property transferred minus boot received (including liabilities transferred) plus gain recognized equals basis of stock received in a § 351 transfer. a. True b. False 28. Carl and Ben form Eagle Corporation. Carl transfers cash of $50,000 for 50 shares of stock of Eagle. Ben transfers proprietary information with a tax basis of zero and a fair market value of $50,000 for the remaining 50 shares in Eagle. Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure Carl will have a tax basis of $50,000 in his stock in Eagle Corporation and Ben’s basis in his stock will be zero. a. True b. False 29. In general, the basis of property to a corporation in a transfer that qualifies as a nontaxable exchange under § 351 is the basis in the hands of the transferor shareholder decreased by the amount of any gain recognized on the transfer. a. True b. False 30. In return for legal services worth $60,000 rendered incident to its formation, Crimson Corporation issues stock to Greta, an attorney. Crimson cannot immediately deduct the value of any of this stock but instead must capitalize it as an organizational expenditure. a. True b. False 31. Yuna, a real estate dealer, and others form Eagle Corporation under § 351. Yuna contributes inventory (land held for resale) in return for Eagle stock. The holding period for the stock includes the holding period of the inventory. a. True b. False 32. A shareholder transfers a capital asset to Red Corporation for its stock. If the transfer qualifies under § 351, Red’s holding period for the asset begins on the day of the exchange. a. True b. False 33. A shareholder’s holding period for stock received under § 351 can include the holding period of the property transferred to the corporation. a. True b. False 34. When depreciable property is transferred to a controlled corporation under § 351, any recapture potential disappears and does not carry over to the corporation. a. True b. False 35. To encourage the development of an industrial park, a county donates land to Ecru Corporation. The donation results in gross income to Ecru. a. True b. False 36. A city contributes $500,000 to a corporation as an inducement to locate in the city. Within the next 12 months, the corporation uses the money to purchase property worth $500,000. The corporation has income of $500,000 and must reduce its tax basis in the property by the same amount. a. True b. False 37. To ease a cash shortage, all of the shareholders of Osprey Corporation contribute additional cash to its capital. Osprey Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure has no tax consequences from the contribution. a. True b. False 38. A shareholder contributes land to his wholly owned corporation but receives no stock in return. The corporation has a zero basis in the land. a. True b. False 39. In structuring the capitalization of a corporation, the tax law is neutral for the investor as to debt versus equity financing. a. True b. False 40. To help avoid the thin capitalization problem, it is advisable to make the repayment of the debt contingent upon the corporation’s earnings. a. True b. False 41. Ira, a calendar year taxpayer, purchases as an investment stock in Redbird Corporation on November 3, 2023. On February 2, 2024, Redbird Corporation is declared bankrupt, and Ira’s stock becomes worthless. Presuming § 1244 (stock in a small business corporation) does not apply, Ira has a short-term capital loss for 2024. a. True b. False 42. Amy owns 20% of the stock of Wren Corporation, which she acquired several years ago at a cost of $10,000. Amy is vice president of Wren and earns a salary of $80,000 annually. Last year, Wren Corporation was experiencing financial problems, and Amy loaned the corporation $25,000. In the current year, Wren becomes bankrupt, and both Amy's stock investment and the loan become worthless. Amy has a nonbusiness bad debt deduction this year of $25,000. a. True b. False 43. If a shareholder owns stock received as a gift from her mother, it cannot be § 1244 or § 1202 stock. a. True b. False 44. A transferor who receives stock for both property and services may not be included in the control group in determining whether an exchange meets the requirements of § 351. a. True b. False 45. One month after Sally incorporates her sole proprietorship, she gives 25% of the stock to her children. Section 351 cannot apply to Sally because she has not satisfied the 80% control requirement. a. True b. False 46. A long-term note is treated as “boot.” Thus, the note received could trigger gain for Eve. Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure a. True b. False 47. When a taxpayer incorporates her business, she transfers several liabilities to the corporation. If one of the liabilities is personal in origin, the release of only that liability is treated as boot. a. True b. False 48. A corporation’s holding period for property received under § 351 includes the holding period of the transferor shareholder. a. True b. False 49. Alan, an Owl Corporation shareholder, makes a contribution to capital of equipment to Owl, basis of $40,000 and fair market value of $50,000. Owl’s basis of the equipment that Alan contributes is equal to $50,000, the property’s fair market value. a. True b. False 50. Silver Corporation receives $1 million in cash from Madison County as an inducement to expand its operations there. Within one year, Silver spends $1.5 million to enlarge its existing plant. Silver Corporation’s basis in the expansion is $500,000. a. True b. False 51. Under Federal tax law, a bias for corporate issuers exists in favor of debt as compared to equity when financing the operations of a corporation. a. True b. False 52. If a corporation is thinly capitalized, all debt is reclassified as equity. a. True b. False 53. A shareholder lends money to his corporation in his capacity as an investor. If the loans become worthless, a business bad debt results. a. True b. False Multiple Choice 54. Mitchell and Powell form Green Corporation. Mitchell transfers property with a basis of $105,000 and worth $90,000 while Powell transfers land with a basis of $8,000 and worth $75,000 plus $15,000 of cash. Each receives 50% of Green Corporation’s stock (total value of $180,000). As a result of these transfers: a. Mitchell has a recognized loss of $15,000, and Powell has a recognized gain of $67,000. b. Neither Mitchell nor Powell has any recognized gain or loss. c. Mitchell has no recognized loss, but Powell has a recognized gain of $15,000. Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure d. Green Corporation will have a basis in the land of $23,000. 55. Jane transfers property with a $180,000 basis worth $500,000 to Green Corporation for 80% of its stock and a longterm note payable to Jane worth $75,000. a. Jane recognizes no gain. b. Jane recognizes a gain of $75,000. c. Jane recognizes a gain of $270,000. d. Jane recognizes a gain of $320,000. 56. Eileen transfers property worth $200,000 with a basis of $190,000 to Goldfinch Corporation. In return, she receives 80% of the stock in Goldfinch Corporation worth $180,000 and $20,000 cash. Eileen recognizes gain on the transfer of: a. $0. b. $10,000. c. $20,000. d. $190,000. 57. Gabriella and Juanita form Luster Corporation. Gabriella transfers cash of $50,000 for 50 shares of stock, and Juanita transfers information concerning a proprietary process with a basis of zero and worth $50,000 for 50 shares of stock. a. The transfers to Luster are fully taxable to both Gabriella and Juanita. b. Juanita must recognize gain of $50,000. c. Because Juanita is required to recognize gain on the transfer, Gabriella also must recognize gain. d. Neither Gabriella nor Juanita will recognize gain on the transfer. 58. Three individuals form Skylark Corporation with the following contributions: Cliff, cash of $50,000 for 50 shares; Brad, land worth $20,000 (basis of $11,000) for 20 shares; and Ron, cattle worth $9,000 (basis of $6,000) for 9 shares and services worth $21,000 for 21 shares. a. These transfers are fully taxable and not subject to § 351. b. Ron’s basis in his stock is $27,000. c. Ron’s basis in his stock is $6,000. d. Brad’s basis in his stock is $20,000. 59. Seoyun and Nicole form Indigo Corporation with the following transfers: inventory from Seoyun (basis of $360,000 and fair market value of $400,000) and improved real estate from Nicole (basis of $320,000 and fair market value of $375,000). Nicole, an accountant, also agrees to contribute her services (worth $25,000) in organizing Indigo. The corporation’s stock is distributed equally to Seoyun and Nicole. As a result of these transfers: a. Indigo can deduct $25,000 immediately as a business expense. b. Nicole has a recognized gain of $55,000 on the transfer of the real estate. c. Indigo has a basis of $360,000 in the inventory. d. Indigo has a basis of $375,000 in the real estate. 60. Ann transferred land worth $200,000 with a tax basis of $40,000 to Brown Corporation, an existing entity, for 100 shares of its stock. Brown Corporation has two other shareholders, Bill and Bob, each of whom holds 100 shares. With respect to the transfer: a. Ann has no recognized gain. b. Brown Corporation has a basis of $160,000 in the land. c. Ann has a basis of $200,000 in her 100 shares in Brown Corporation. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure d. Ann has a basis of $40,000 in her 100 shares in Brown Corporation. 61. Roberto, a cash basis taxpayer, incorporates his sole proprietorship. He transfers the following items to newly created Orange Corporation. Adjusted Basis Cash $ 10,000 Building 120,000 Mortgage payable (secured by the building and held 135,000 for 15 years)

Fair Market Value $ 10,000 175,000 135,000

With respect to this transaction: a. Orange Corporation’s basis in the building is $120,000. b. Roberto has no recognized gain. c. Roberto has a recognized gain of $5,000. d. Roberto has a recognized gain of $10,000. 62. Albert transfers land with a basis of $140,000 and worth $320,000 to Gold Corporation for 80% of its stock plus a note payable in the amount of $80,000. Gold assumes Albert’s mortgage on the land of $200,000. a. Albert's recognized gain on the transfer is $140,000. b. Albert's total recognized gain on the transfer is $80,000. c. Albert's total recognized gain on the transfer is $60,000. d. Gold Corporation has a basis in the land of $220,000. 63. Rachel owns 100% of the stock of Cardinal Corporation. In the current year Rachel transfers an installment obligation that has a tax basis of $180,000 and fair market value of $350,000 for additional stock in Cardinal worth $350,000. a. Rachel has a taxable gain of $180,000. b. Rachel has a taxable gain of $170,000. c. Rachel recognizes no gain on the transfer. d. Rachel has a basis of $350,000 in the additional stock she received in Cardinal Corporation. 64. Rob and Yi form Bluebird Corporation with the following investments. Adjusted Basis

Fair Market Value

From Rob— Cash

$400,000

$400,000

From Yi— Land

500,000

440,000

Each receives 50% of Bluebird’s stock. In addition, Yi receives cash of $40,000. One result of these transfers is that Yi has a: a. Recognized loss of $60,000. b. Recognized loss of $20,000. c. Basis of $460,000 in the Bluebird stock (assuming Bluebird reduces its basis in the land to $440,000). Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure d. Basis of $400,000 in the Bluebird stock (assuming Bluebird reduces its basis in the land to $440,000). 65. Dwayne and Paul form Swan Corporation with the following investments. Dwayne transfers machinery (basis of $40,000 and fair market value of $100,000) and Paul transfers land (basis of $20,000 and fair market value of $90,000) and services rendered (worth $10,000) in organizing the corporation. Each is issued 25 shares in Swan Corporation. With respect to the transfers: a. Dwayne has no recognized gain; Paul recognizes income/gain of $80,000. b. Neither Dwayne nor Paul has recognized gain or income on the transfers. c. Swan Corporation has a basis of $30,000 in the land transferred by Paul. d. Paul has a basis of $30,000 in the 25 shares he acquires in Swan Corporation. 66. Rick transferred the following assets and liabilities to Warbler Corporation.

Building Equipment Trucks Mortgage (held for four years) on building

Adjusted Basis

Fair Market Value

$210,000 45,000 15,000 30,000

$225,000 75,000 30,000 30,000

In return, Rick received $75,000 in cash plus 90% of Warbler Corporation’s only class of stock outstanding (fair market value of $225,000). a. Rick has a recognized gain of $60,000. b. Rick has a recognized gain of $75,000. c. Rick’s basis in the stock of Warbler Corporation is $270,000. d. Warbler Corporation has the same basis in the assets received as Rick does in the stock. 67. Sarah and Tony (mother and son) form Dove Corporation with the following investments: cash by Sarah of $65,000; land by Tony (basis of $25,000 and fair market value of $35,000). Dove Corporation issues 400 shares of stock, 200 each to Sarah and Tony. Thus, each receives stock in Dove worth $50,000. a. Section 351 cannot apply as Sarah should have received 260 shares instead of only 200. b. Section 351 may apply because stock need not be issued to Sarah and Tony in proportion to the value of the property transferred. c. Tony’s basis in the stock of Dove Corporation is $50,000. d. As a result of the transfer, Tony recognizes a gain of $10,000. 68. Rhonda and Marta form Blue Corporation. Rhonda transfers land (basis of $55,000 and fair market value of $180,000) for 50 shares plus $20,000 cash. Marta transfers $160,000 cash for 50 shares in Blue Corporation. a. Rhonda’s basis in the Blue Corporation stock is $55,000. b. Blue Corporation’s basis in the land is $55,000. c. Blue Corporation’s basis in the land is $180,000. d. Rhonda recognizes a gain on the transfer of $125,000. 69. Erica transfers land worth $500,000 with a basis of $100,000 to newly formed Robin Corporation, for all of it's stock worth $300,000 and a $200,000 10-year note payable to Erica. As a result of the transfer: a. Erica does not recognize gain. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure b. Erica recognizes gain of $400,000. c. Robin Corporation has a basis of $100,000 in the land. d. Robin Corporation has a basis of $300,000 in the land. 70. Donghai transferred the following assets to Starling Corporation.

Cash Machinery Land

Adjusted Basis $120,000 48,000 108,000

Fair Market Value $120,000 36,000 144,000

In exchange, Donghai received 50% of Starling Corporation’s only class of stock outstanding. The stock has no established value. However, all parties believe that the value of the stock Donghai received is the equivalent of the value of the assets she transferred. The only other shareholder, Rick, formed Starling Corporation five years ago. a. Donghai has no gain or loss on the transfer. b. Starling Corporation has a basis of $48,000 in the machinery and $108,000 in the land. c. Starling Corporation has a basis of $36,000 in the machinery and $144,000 in the land. d. Donghai has a basis of $276,000 in the stock of Starling Corporation. 71. Danielle, a sole proprietor, was engaged in a service business and reported her income on a cash basis. Later, she incorporates her business and transfers the assets of the business to the corporation in return for all the stock in the corporation plus the corporation’s assumption of the liabilities of her proprietorship. All the receivables and the unpaid trade payables are transferred to the newly formed corporation. The assets of the proprietorship had a basis of $105,000 and fair market value of $300,000. The trade accounts payable totaled $25,000. The corporation also assumed a note payable to the bank for $95,000 that financed the purchase of computers and other business equipment. a. Danielle has a gain on the transfer of $15,000. b. The basis of the assets to the corporation is $300,000. c. Danielle has a basis of $10,000 in the stock she receives. d. Danielle has a zero basis in the stock she receives. 72. Carl transfers land to Cardinal Corporation for 90% of Cardinal stock worth $20,000 plus a $40,000 note payable to Carl. Cardinal also assumed a $100,000 mortgage on the land. The land, which has a basis to Carl of $70,000, is worth $160,000. a. Carl will have a recognized gain on the transfer of $90,000. b. Carl will have a recognized gain on the transfer of $70,000. c. Cardinal Corporation will have a basis of $70,000 in the land transferred by Carl. d. Cardinal Corporation will have a basis of $160,000 in the land transferred by Carl. 73. Kirby and Helen form Red Corporation. Kirby transfers property with a basis of $20,000 and worth $300,000, for 100 shares in Red Corporation. Helen transfers property with a basis of $40,000 and worth $280,000, and provides $20,000 of legal services in organizing the corporation. In return, Helen receives 100 shares in Red Corporation. Regarding these transfers: a. Kirby will recognize gain. b. Helen will not recognize any gain or income. c. Red Corporation will have a basis of $280,000 in the property it acquired from Helen. d. Red must capitalize Helen's services. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure 74. Chang and Kay form Gull Corporation. Chang transfers cash of $250,000 for 200 shares in Gull Corporation. Kay transfers property with a basis of $50,000 and fair market value of $240,000. She agrees to accept 200 shares in Gull Corporation for the property and for providing bookkeeping services to the corporation in its first year of operation. The value of Kay’s services is $10,000. With respect to the transfer: a. Gull Corporation has a basis of $240,000 in the property transferred by Kay. b. Neither Chang nor Kay recognizes gain or income on the exchanges. c. Gull Corporation has a compensation deduction of $10,000. d. Gull capitalizes $10,000 as organizational costs. 75. Earl and Mary form Crow Corporation. Earl transfers property with a basis of $200,000 and worth $1,600,000, for 50 shares in Crow Corporation. Mary transfers property with a basis of $80,000 and worth $1,480,000 and agrees to serve as manager of Crow for one year. In return, Mary receives 50 shares of Crow. The value of Mary’s services is $120,000. With respect to the transfers: a. Mary will not recognize gain or income. b. Earl will recognize a gain of $1,400,000. c. Crow Corporation has a basis of $1,480,000 in the property it received from Mary. d. Crow will have a business deduction of $120,000 for the value of the services Mary will render. 76. Four individuals form Chickadee Corporation under § 351. Two of these individuals, Shanice and Walt, made the following contributions: Adjusted Basis

Fair Market Value

From Shanice— Cash Patent

$360,000 –0–

$360,000 40,000

From Walt— Equipment (depreciation claimed of $100,000)

240,000

370,000

Both Shanice and Walt receive stock in Chickadee Corporation equal to the value of their investments. a. Shanice must recognize income of $40,000; Walt has no income. b. Neither Shanice nor Walt recognize income. c. Walt must recognize income of $130,000; Shanice has no income. d. Walt must recognize income of $100,000; Shanice has no income. 77. Leah transfers equipment with a basis of $400,000 and worth $500,000 for additional stock in Crow Corporation. After the transfer, Leah owns 80% of Crow’s stock. Associated with the equipment is § 1245 depreciation recapture potential of $70,000. As a result of the transfer: a. Leah recognizes ordinary income of $70,000. b. The § 1245 depreciation recapture potential carries over to Crow Corporation. c. The § 1245 depreciation recapture potential disappears. d. Leah recognizes ordinary income of $70,000 and § 1231 gain of $30,000. 78. To induce Yellow Corporation to build a new manufacturing facility in Knoxville, Tennessee, the city donates land (fair market value of $400,000) and cash of $100,000 to the corporation. Several months after the donation, Yellow Corporation spends $450,000 (which includes the $100,000 received from Knoxville) on the construction of a new plant located on the donated land. Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure a. Yellow recognizes income of $100,000 as to the donation. b. Yellow has a zero basis in the land and a basis of $450,000 in the plant. c. Yellow recognizes income of $500,000 as to the donation. d. Yellow has a zero basis in the land and a basis of $350,000 in the plant. 79. George transfers cash of $150,000 to Finch Corporation, a newly formed corporation, for 100% of the stock in Finch worth $80,000 and debt in the amount of $70,000, payable in equal annual installments of $7,000 plus interest at the rate of 9% per annum. In the first year of operation, Finch has net taxable income of $40,000. If Finch pays George interest of $6,300 and $7,000 principal payment on the note: a. George has dividend income of $13,300. b. Finch Corporation does not have a tax deduction with respect to the payment. c. George has dividend income of $7,000. d. Finch Corporation has an interest expense deduction of $6,300. 80. Angel transfers cash of $300,000 and land worth $200,000 to Camel Corporation for 100% of the stock in Camel. In the first year of operation, Camel has net taxable income of $70,000. If Camel distributes $50,000 to Angel: a. Angel has a taxable dividend of $50,000. b. Camel Corporation has a tax deduction of $50,000. c. Angel has no taxable income from the distribution. d. Camel Corporation reduces its basis in the land to $150,000. 81. Wren Corporation (a minority shareholder in Lark Corporation) has made loans to Lark Corporation that become worthless in the current year. a. Wren Corporation is not permitted a deduction for the loans. b. The loans result in a nonbusiness bad debt deduction to Wren Corporation. c. The loans provide Wren Corporation with a business bad debt deduction. d. Wren claims a capital loss due to the uncollectible loans. 82. George (an 80% shareholder) has made loans to Mountainview Corporation that become worthless in the current year. George is not employed by Mountainview. a. George is not permitted a deduction for the worthless loans. b. The loans provide a nonbusiness bad debt deduction to George in the current year. c. The loans provide George with a business bad debt deduction. d. George may claim an ordinary loss as to the worthless loans. 83. When Pheasant Corporation was formed under § 351, Kristen transferred property (basis of $26,000 and fair market value of $22,500) for § 1244 stock. Kristen’s basis in the Pheasant stock is $26,000. Three years later, Pheasant Corporation goes bankrupt and its stock becomes worthless. Kristen, who is single, owned the stock as an investment. Kristen’s loss is: a. $26,000 capital. b. $22,500 ordinary and $3,500 capital. c. $3,500 ordinary and $22,500 capital. d. $26,000 ordinary. 84. Art, an unmarried individual, transfers property with a basis of $130,000 and worth $120,000 to Condor Corporation in exchange for § 1244 stock. The transfer qualifies as a nontaxable exchange under § 351. Because the property is loss Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure property, Condor takes a basis of $120,000 in the property. Five years later, Art sells the Condor stock for $50,000. With respect to the sale, Art has: a. An ordinary loss of $80,000. b. An ordinary loss of $70,000 and a capital loss of $10,000. c. A capital loss of $80,000. d. A capital loss of $30,000 and an ordinary loss of $50,000. 85. Lindsay and Malcolm form Yellow Corporation. Lindsay transfers equipment worth $950,000 with a basis of $200,000 plus cash of $50,000 to Yellow Corporation for 50% of its stock. Malcolm transfers a building and land worth $1,050,000 with a basis of $400,000 for 50% of Yellow’s stock and $50,000 in cash. a. Lindsay recognizes no gain; Malcolm recognizes gain of $50,000. b. Lindsay recognizes a gain of $50,000; Malcolm has no gain. c. Neither Lindsay nor Malcolm recognizes gain. d. Lindsay recognizes a gain of $750,000; Malcolm recognizes gain of $650,000. 86. Eve transfers property with a basis of $120,000 and worth $400,000 to Green Corporation for 80% of its stock worth $350,000 and a long-term note worth $50,000 executed by Green Corporation and made payable to Eve. As a result of the transfer: a. Eve recognizes no gain. b. Eve recognizes a gain of $230,000. c. Eve recognizes a gain of $280,000. d. Eve recognizes a gain of $50,000. 87. Mary transfers a building with an adjusted basis of $15,000 and worth $90,000 to White Corporation. In return, Mary receives 80% of White Corporation’s stock worth $65,000 and an automobile worth $5,000. In addition, there is an outstanding mortgage of $20,000 (taken out 15 years ago) on the building, that White Corporation assumes. For this transaction: a. Mary’s recognized gain is $10,000. b. Mary’s recognized gain is $5,000. c. Mary has no recognized gain. d. White Corporation’s basis in the building is $15,000. 88. Hunter and Warren form Tan Corporation. Hunter transfers equipment with a basis of $210,000 and worth $180,000 while Warren transfers land with a basis of $15,000 and worth $150,000 plus $30,000 of cash. Each receives 50% of Tan’s stock. As a result of these transfers: a. Hunter has a recognized loss of $30,000, and Warren has a recognized gain of $135,000. b. Neither Hunter nor Warren has any recognized gain or loss. c. Hunter has no recognized loss, but Warren has a recognized gain of $30,000. d. Tan Corporation will have a basis in the land of $45,000. 89. Blue Corporation (a seller of goods to Cedar Corporation) has made loans to Cedar Corporation, which become worthless in the current year. a. Blue Corporation cannot claim a deduction for the worthless loans. b. The loans provide a nonbusiness bad debt deduction to Blue Corporation. c. The loans provide Blue Corporation with a business bad debt deduction. d. Blue must recognize income. Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure 90. Lynn transfers property with a basis of $225,000 and worth $300,000 to Condor Corporation in exchange for § 1244 stock. The transfer qualifies as a nontaxable exchange under § 351. In the current year, Lynn sells the Condor stock for $100,000. Assume Lynn files a joint return with her husband, Ricky. For this sale, Lynn has: a. An ordinary loss of $125,000. b. An ordinary loss of $100,000 and a capital loss of $25,000. c. A capital loss of $125,000. d. An ordinary loss of $100,000 and a capital loss of $100,000. Subjective Short Answer 91. Penny, Miesha, and Sabrina transfer property to Owl Corporation for 75% of its stock. Nancy, their attorney, receives 25% of the stock in Owl for legal services rendered in incorporating the business. What are the tax consequences of these transactions? How could they have structured this transaction to defer tax? 92. Nick exchanges property with a basis of $100,000 and worth $3,000,000 for 65% of the stock of Yellow Corporation. The other 35% of the stock is owned by Gloria who acquired it several years ago. What are the tax consequences to Nick? 93. Perry organized Cardinal Corporation 10 years ago by contributing property worth $2 million with a basis of $450,000 for 2,500 shares of stock in Cardinal, representing 100% of the stock in the corporation. Five years ago, Perry later gave each of his children, Brittany and Julie, 750 shares of stock in Cardinal Corporation. This year, Perry transfers property worth $600,000 with a basis of $150,000 to Cardinal for 1,000 shares in the corporation. What gain, if any, will Perry recognize on the transfer? 94. Ashley, a 70% shareholder of Wren Corporation, transfers property with a basis of $250,000 and a fair market value of $900,000 to Wren Corporation for additional stock. Ashley owns 78% of Wren after the transfer. Two other shareholders in Wren transfer a nominal amount of property to Wren along with Ashley’s transfer so that Ashley and the two shareholders own 90% of the Wren stock after the transfer. Does Ashley have taxable gain on the transfer? 95. Rita forms Finch Corporation by transferring land with a basis of $125,000 and worth $750,000, which is subject to a mortgage of $375,000. Two weeks prior to incorporating Finch, Rita borrows $125,000 for personal purposes and gives the lender a second mortgage on the land. Finch Corporation issues stock worth $250,000 to Rita and assumes the two mortgages on the land. What are the tax consequences to Rita and to Finch Corporation? 96. Nancy, Guy, and Rod form Goldfinch Corporation with the following consideration. Adjusted Basis

Fair Market Value

From Nancy— Cash Inventory

$120,000 90,000

$120,000 130,000

From Guy— Land and building

120,000

250,000

–0–

50,000

From Rod— Legal and accounting services to incorporate

Goldfinch issues its 500 shares of stock as follows: 250 to Nancy, 200 to Guy, and 50 to Rod. In addition, Guy gets $50,000 in cash. Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure a.

Does Nancy, Guy, or Rod recognize gain (or income)?

b.

What basis does Guy have in the Goldfinch stock?

c.

What basis does Goldfinch Corporation have in the inventory? In the land and building?

d.

What basis does Rod have in the Goldfinch stock?

97. Sean, a sole proprietor, is engaged in a service business and uses the cash basis of accounting. In the current year, Sean incorporates his business by forming Aqua Corporation. In exchange for all of its stock, Aqua receives: assets with a basis of $400,000 and worth $2,000,000, trade accounts payable of $110,000, and loan of $390,000 due to a bank. The proceeds from the bank loan were used by Sean to provide operating funds for the business. Aqua Corporation assumes all of the liabilities transferred to it. a.

Does Sean recognize any gain on the incorporation? Explain.

b.

What basis does Sean have in the Aqua stock?

c.

What basis does Aqua Corporation have in the assets it receives?

98. Trish and Tyrone form Pine Corporation. Trish transfers inventory with a basis of $60,000 and worth $110,000 for 50% of the stock in Pine. Tyrone transfers machinery with a basis of $20,000 and worth $60,000 and agrees to serve as manager of Pine Corporation for one year for 50% of the stock. What are the tax consequences to Trish, Tyrone, and Pine Corporation? 99. Tan Corporation desires to set up a manufacturing facility in the western part of the United States. After considerable negotiations with Butte, Montana, Tan accepts the following offer: land worth $4,500,000 and cash of $1,500,000. a.

How much income, if any, must Tan recognize?

b.

What basis will Tan Corporation have in the land?

c.

Within one year of the contribution, Tan purchases equipment for $1,600,000. What basis will Tan have in the equipment?

100. Lark City donates land worth $300,000 and cash of $100,000 to Orange Corporation as an inducement to locate in the city. Ann, the sole shareholder, contributes equipment with a basis of $70,000 and worth $200,000 to help Orange in its new operations. What are the tax consequences of these transfers to Orange Corporation? 101. Stock in Merlin Corporation is held equally by Jane, Eve, and Fred. Merlin seeks additional capital to buy a valuable tract of land that will cost $6,000,000. Jane, Eve, and Fred propose to loan Merlin $2,000,000 each, taking from Merlin a $2,000,000 10-year note with interest payable annually at five points above the prime rate. Merlin Corporation has current taxable income of $7,000,000. How are the payments on the notes treated for tax purposes? 102. Karen formed Grebe Corporation with an investment of $100,000 cash for which she received $10,000 in stock and $90,000 in 7% interest-bearing bonds maturing in 10 years. A few years later, Karen loaned Grebe an additional $60,000 on open account. Grebe becomes insolvent in the current year and is adjudged bankrupt. Karen was the president of Grebe Corporation and was paid an annual salary of $50,000 for the past three years. Karen has no other employment. How will Karen treat her losses for tax purposes? 103. Four years ago, Don, a single taxpayer, acquired stock in a corporation that qualified as a small business corporation Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure under § 1244, at a cost of $60,000. Don wants to give his son, Ron, $20,000 to help finance Ron’s college education. The stock is currently worth $20,000. Don is considering selling the stock in the current year for $20,000 and giving the cash to Ron. As an alternative, Don could give the stock to Ron and let Ron sell it for $20,000. Which alternative should Don choose? 104. Joyce, a single taxpayer, transfers property with a basis of $120,000 and worth $60,000 to Wren Corporation in exchange for shares of § 1244 stock. Because the transfer qualifies under § 351, Joyce takes a $120,000 basis in the Wren stock. In the current year, Joyce sells the Wren Corporation stock for $40,000. What are the consequences of the sale to Joyce? Essay 105. What is the rationale underlying the tax deferral treatment available under § 351? 106. How is the transfer of liabilities in a property transaction generally treated for tax purposes? How is a transfer of liabilities generally treated in a § 351 transaction? What exceptions could arise to this usual treatment in a § 351 setting? 107. For transfers falling under § 351, what are the holding period rules for stock received by the shareholder and for the assets transferred to the corporation? 108. When forming a corporation, a transferor-shareholder may choose to receive some corporate debt along with stock. Identify some of the issues the transferor must consider when deciding whether debt should be a part of the transaction. 109. What are the tax consequences if an individual investor incurs a loss because of worthlessness on the following:

a.

Stock that is not § 1244 stock.

b.

Stock that is § 1244 stock.

c.

A corporate bond.

d.

An uncollectible loan made to a corporation.

110. Tom sold all of his corporate stock in Blazer Corporation to an unrelated party for $28,000,000. Tom invested $1,500,000 plus his proprietary know-how in January 2013 and his stock basis had not changed since that investment. Tom is the sole shareholder of Blazer. What is Tom's taxable gain and income tax liability from the sale, assuming that he is in the 37% tax bracket and has no other property sales during the year?

Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure Answer Key 1. True 2. False 3. False 4. False 5. True 6. False 7. True 8. True 9. False 10. True 11. True 12. False 13. True 14. True 15. False 16. True 17. False 18. True 19. False 20. True 21. False 22. True 23. True 24. False 25. False Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure 26. False 27. True 28. True 29. False 30. True 31. False 32. False 33. True 34. False 35. True 36. False 37. True 38. False 39. False 40. False 41. False 42. False 43. True 44. False 45. False 46. True 47. False 48. True 49. False 50. False Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure 51. True 52. False 53. False 54. b 55. b 56. b 57. d 58. b 59. c 60. c 61. c 62. a 63. c 64. c 65. d 66. a 67. b 68. a 69. d 70. c 71. c 72. b 73. d 74. c 75. d 76. b Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure 77. b 78. c 79. d 80. a 81. c 82. b 83. b 84. d 85. a 86. d 87. a 88. b 89. c 90. b 91. Based on the facts provided, the transaction will be taxable to all persons involved. Section 351 treatment will be lost if stock is transferred to persons who did not contribute property, causing those who did to lack control immediately after the exchange. However, if a person performs services for the corporation in exchange for stock and also transfers some property, they may be treated as a member of the transferring group although the value of the stock issued for services is taxed. 92. Nick has a taxable gain of $2,900,000. Section 351 does not apply because Nick failed to receive at least 80% control of Yellow Corporation. Therefore, the transaction is a taxable exchange. Nick has a $3 million basis in his stock and Yellow Corporation has a basis of $3,000,000 in the property. 93. Perry recognizes a gain of $450,000 on the transfer [$600,000 (value of the stock received) – $150,000 (basis in the property)]. The transfer does not qualify under § 351. Although Perry originally owned 100% of Cardinal Corporation, he only owns 57% of Cardinal Corporation after the transfer [2,500 (shares originally owned) – 1,500 (shares transferred to Brittany and Julie) + 1,000 (shares acquired in the transfer), or 2,000 shares out of a total of 3,500 shares]. The ownership of the shares held by Brittany and Julie cannot be counted because the attribution rules of § 318 do not apply to a § 351 transfer. 94. Ashley would have a taxable gain of $650,000 on the transfer. She does not have the requisite 80% control. The transfer by the two shareholders will not qualify the transfer for § 351 treatment because the primary purpose of the transfer was to qualify under this section. If the transfer of property by the two shareholders has a value equal to or in excess of 10% of the fair market value of the stock owned by them after the transfer, the transfer would qualify. Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure 95. Both §§ 357(b) and (c) are applicable. Because the land is subject to two mortgages that are in excess of basis, under § 357(c) Rita would have a recognized gain of $375,000 on the transfer. But § 357(b) also is applicable because Rita borrowed the $125,000 shortly before incorporating and used the money for personal purposes. As § 357(b) causes all the liabilities to be tainted, Rita has boot of $500,000. Of Rita’s realized gain of $625,000 [$750,000 (value of the stock received and release of mortgages) – $125,000 (basis in the land)], $500,000 gain (the amount of boot) is recognized. When §§ 357(b) and (c) both apply to the same transfer, § 357(b) applies. Finch Corporation has a basis of $625,000 in the land, computed as follows: $125,000 (carryover basis from Rita) + $500,000 (gain recognized by Rita). Rita has a basis of $125,000 in her stock, computed as follows: $125,000 (basis in the land) + $500,000 (gain recognized) – $500,000 (liabilities assumed by Finch Corporation). 96. a. Nancy recognizes no gain. Due to the boot he receives, Guy recognizes $50,000 of gain. Rod has ordinary income of $50,000 for the services he performs. b.

Guy’s basis in the Goldfinch stock is $120,000 [$120,000 (basis in the land and building) + $50,000 (gain recognized) – $50,000 (boot received)].

c.

Goldfinch Corporation’s basis in the inventory is $90,000. Its basis in the land and building is $170,000 [$120,000 (Guy’s basis) + $50,000 (gain recognized by Guy)].

d.

Rod’s basis in the Goldfinch stock is $50,000.

97. a. Initially, it seems as if the liabilities of $500,000 [$110,000 (trade accounts payable) + $390,000 (bank loan)] exceed the basis of the assets so as to make § 357(c) apply. However, for this purpose the trade accounts payable are not counted since they originate from a cash basis taxpayer and would give rise to a deduction. Thus, Sean has no recognized gain. b.

$10,000 [$400,000 (basis in the assets) – $390,000 (bank loan assumed by Aqua Corporation)].

c.

$400,000 (Sean’s basis in the assets).

98. Tyrone’s stock in Pine Corporation is counted in determining control for purposes of § 351. All of Tyrone’s stock, not just the shares received for the machinery, is included because the property he transfers has more than a nominal value in comparison to the value of the services rendered. (The property transferred has a value of at least 10% of the value of the services provided.) Trish recognizes no gain on the transfer and has a basis of $60,000 in the stock received. Pine Corporation has a basis of $60,000 in the inventory it receives. Tyrone recognizes ordinary income of $50,000 on the transaction. Even though the transfer of the machinery qualifies under § 351, his transfer of services for stock does not. Tyrone has a basis of $70,000 in his stock computed as follows: $20,000 (his basis in the machinery) + $50,000 (value of his services). [His services are valued at $50,000 because this is the difference between the value of the property transferred ($60,000) and the value of the stock received ($110,000).] Pine Corporation has a basis of $20,000 in the machinery and can claim a deduction of $50,000 for the services Tyrone will render. 99. a. Tan Corporation recognizes $6 million ($4,500,000 land + $1,500,000 cash) of income from the receipt of land and cash because it does not qualify as a nontaxable capital contribution under § 118. b.

Tan has a $4,500,000 basis in the land.

Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure c.

Tan Corporation takes a $1,600,000 basis in the equipment (i.e., the cost of the equipment).

100. Orange Corporation does not have income on the transfers from Ann (a shareholder), but it does recognize $400,000 of income on the transfers from Lark City (a nonshareholder). Orange will have a basis of $70,000 in the equipment it receives from Ann and a $300,000 basis in the land it receives from Lark City. Finally, the transfer, which is a capital contribution by Ann, increases her stock basis in Orange by $70,000. 101. Payments on the notes will probably be treated as dividends for tax purposes. The debt instruments have too many features of stock. The debt does not bear a legitimate rate of interest, and the debt is proportionate to the stock holdings of Jane, Eve, and Fred. Merlin Corporation has substantial current taxable income indicating an attempt to withdraw earnings in the form of principal and interest payments on debt obligations rather than as dividends. 102. If the stock is § 1244 stock, Karen has an ordinary loss on the worthless stock. Otherwise, her $10,000 stock investment is a capital loss. The IRS could argue thin capitalization to make the long-term debt equity, and thus result in a capital loss. Also, the IRS could contend that both the long-term debt (regardless of whether it can be deemed hybrid stock) and the $60,000 open account debt are nonbusiness bad debts and, therefore, short-term capital losses. Karen would counter with the argument that the $60,000 open account debt is a business bad debt because the primary motive in loaning money to the corporation was to protect her employment. Although the loan is more than her annual salary, she is paid the salary continually. Thus, in that context, the salary is more than the investment. Further, she only works for the corporation. 103. Don should sell the stock. He will have a $40,000 ordinary loss deduction in the current year. Only the original holder of the stock (Don) qualifies under § 1244 for ordinary loss treatment. If Don gives the stock to Ron, Ron will have a basis of $20,000 in the stock and, thus, will have no loss deduction. A carryover basis for gifts applies unless the fair market value of the property is less on the date of the gift and the property is sold at a loss. 104. Joyce recognizes a loss of $80,000 [$40,000 (selling price of the stock) – $120,000 (basis)]. She has an ordinary loss under § 1244 of $20,000 [$40,000 (selling price) – $60,000 (basis under § 1244)] and a capital loss of $60,000. 105. Realized gain or loss is not recognized in a § 351 transaction when a taxpayer’s economic status has not changed. This provision reflects the principle that gain should not be recognized when a taxpayer’s investment has not substantively changed. When a business is incorporated, the owner’s economic status remains the same; only the form of the investment has changed. Gain deferral is also justified under the wherewithal to pay concept discussed in Chapter 1. This concept recognizes that if the shareholder receives solely stock in the exchange, they are hardly in a position to pay a tax on any realized gain. Finally, § 351 was enacted because Congress believed that incorporating a business should not trigger a tax cost. Otherwise, recognizing gain and paying tax could discourage corporate formations when otherwise optimal. 106. Generally, when another party assumes a liability in a property transaction, the party no longer responsible for the debt is treated as having received cash or boot. This is consistent with the form of benefit doctrine and with like-kind exchange treatment under § 1031. However, when the acquiring corporation assumes a liability in a § 351 transaction, § 357(a) provides that the transfer does not result in boot to the transferor-shareholder for gain recognition purposes. To do so could trigger gain to the property transferor if the corporation assumed a mortgage on the transfer of encumbered property, which could, in turn, discourage the use of the corporate form of business. The general rule of § 357(a) has two exceptions: (1) § 357(b) provides that if the principal purpose of the assumption of Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 18: Corporations Organization and Capital Structure the liabilities is to avoid tax or if there is no bona fide business purpose behind the exchange, the liabilities are treated as boot, and (2) § 357(c) provides that if the sum of the liabilities exceeds the adjusted basis of the properties transferred, the excess is taxable gain. 107. In a § 351 transaction, the shareholder’s holding period for stock received in exchange for a capital asset or § 1231 property includes the holding period of the property transferred to the corporation. That is, the holding period of the property is “tacked on” to the holding period of the stock. The holding period for stock received for any other property begins on the day after the exchange. The corporation’s holding period for property acquired in a § 351 transfer is the holding period of the transferor-shareholder, regardless of the character of the property in the transferor’s hands. 108. Significant tax differences exist between debt and equity in the capital structure. ∙

Interest payments on debt are deductible by the corporation while dividend payments on stock are not.

∙

Loan repayments of debt are not taxable to investors unless the repayments exceed basis; however, a shareholder’s nonliquidating receipt of property from a corporation cannot be taxfree as long as the corporation has earnings and profits.

∙

Dividend income on equity holdings is taxed to individual investors at the preferential capital gains rates while interest income on debt is taxed at the higher ordinary income tax rates.

109. a. Stock that is not § 1244 stock: If stock is a capital asset, losses from its worthlessness results in capital loss treatment as of the last day of the taxable year in which the stock becomes worthless. No deduction is allowed for a mere decline in value. A loss on partial worthlessness may be recognized if the stock is sold in a taxable transaction. b.

Stock that is § 1244 stock: Section 1244 provides ordinary (rather than capital) loss treatment on the sale or worthlessness. The amount of ordinary loss treatment is limited in any one year to $50,000 ($100,000 on a joint return). If the loss exceeds the amount allowed as ordinary, the excess is a capital loss.

c.

Corporate bond: If a bond is a capital asset, losses result in capital loss treatment as of the last day of the taxable year in which the bond becomes worthless. No deduction is allowed for a mere decline in value. A loss on partial worthlessness may be recognized if the bond is sold in a taxable transaction.

d.

An uncollectible loan made to a corporation: An uncollectible loan is treated either as a business bad debt or a nonbusiness bad debt. Business bad debts are ordinary losses while nonbusiness bad debts are short-term capital losses. For individuals lending money to a corporation in their capacity as investors, bad debts are classified as nonbusiness. If a loan is made in a capacity that qualifies as a trade or business, business bad debt treatment results.

110. If the stock qualifies as qualified small business stock, section 1202 will apply. If section 1202 applies, Tom's gain equals $11,500,000, which is the gain ($28,000,000 - $1,500,000 basis) less the § 1202 exclusion of $15,000,000 ($1,500,000 * 10, which exceeds $10,000,000). His tax liability at the top capital gain rate of 23.8% is $2,737,000.

Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation True / False 1. Distributions by a corporation to its shareholders are presumed to be a dividend unless the parties can prove otherwise. a. True b. False 2. A distribution from a corporation will be taxable to the recipient shareholders only to the extent of the corporation’s E & P. a. True b. False 3. All distributions that are not dividends are a return of capital and decrease the shareholder’s basis. a. True b. False 4. All cash distributions received from a corporation with a positive balance in accumulated E & P at the beginning of the year will be taxed as dividend income. a. True b. False 5. A distribution in excess of E & P is treated as capital gain by shareholders. a. True b. False 6. The terms “earnings and profits” and “retained earnings” are identical in meaning. a. True b. False 7. To determine E & P, some (but not all) previously excluded income items are added back to taxable income. a. True b. False 8. When computing E & P, taxable income is not adjusted for § 179 expense. a. True b. False 9. When computing current E & P, taxable income must be adjusted for the deferred gain in a § 1031 like-kind exchange. a. True b. False 10. An increase in the LIFO recapture amount must be added to taxable income to determine E & P. a. True b. False 11. Use of MACRS cost recovery when computing taxable income does not require an E & P adjustment. a. True Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation b. False 12. No E & P adjustment is required for regular tax gains under the installment method. a. True b. False 13. A corporation borrows money to purchase State of Texas bonds. The interest on the loan has no impact on either taxable income or current E & P. a. True b. False 14. Federal income tax paid in the current year must be subtracted from taxable income to determine E & P. a. True b. False 15. To determine current E & P, taxable income must be increased for any dividends received deduction. a. True b. False 16. Nondeductible meal expense must be subtracted from taxable income to determine current E & P. a. True b. False 17. The dividends received deduction has no impact on E & P. a. True b. False 18. A realized gain from an involuntary conversion under § 1033 that is not recognized for income tax purposes has no effect on E & P. a. True b. False 19. In the current year, Carnation Corporation has a § 179 expense of $20,000. As a result, in the current year, taxable income must be increased by $16,000 to determine current E & P. a. True b. False 20. A deficit in current E & P is treated as occurring ratably during the year unless the taxpayer can show otherwise. a. True b. False 21. When current E & P has a deficit and accumulated E & P is positive, the two accounts are netted at the date of the distribution. If a positive balance results, the distribution is a dividend to the extent of the balance. a. True b. False Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 22. When current E & P is positive and accumulated E & P has a deficit balance, the two accounts are netted for dividend determination purposes. a. True b. False 23. Regardless of any deficit in current E & P, distributions during the year are taxed as dividends to the extent of accumulated E & P. a. True b. False 24. Corporate distributions are presumed to be paid out of E & P and are treated as dividends unless the parties to the transaction can show otherwise. a. True b. False 25. Dividends paid to shareholders who hold both long and short positions do not qualify for the reduced tax rate available to individuals in certain years. a. True b. False 26. Dividends taxed as ordinary income are considered investment income for purposes of the investment interest expense limitation. a. True b. False 27. Certain dividends from foreign corporations can be qualified dividends for purposes of the preferential rate available to individuals. a. True b. False 28. During the year, Blue Corporation distributes land to its sole shareholder. If the fair market value of the land is less than its adjusted basis, Blue will not be able to recognize a loss on the distribution. a. True b. False 29. In a property distribution, the amount of dividend income recognized by a shareholder is always reduced by the amount of liability assumed by a shareholder. a. True b. False 30. Property distributed by a corporation as a dividend is subject to a liability in excess of its basis. For purposes of determining gain on the distribution, the basis of the property is treated as being not less than the amount of liability. a. True b. False 31. A corporation that distributes a property dividend must reduce its E & P by the adjusted basis of the property less any liability on the property. Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation a. True b. False 32. Under certain circumstances, a distribution can generate (or add to) a deficit in E & P. a. True b. False 33. Constructive dividends do not need to satisfy the legal requirements for a dividend as set forth by applicable state law. a. True b. False 34. Constructive dividends have no effect on a distributing corporation’s E & P. a. True b. False 35. If a stock dividend is taxable, the shareholder’s basis in the newly received shares is equal to the fair market value of the shares received in the distribution. a. True b. False 36. A corporate shareholder who receives a constructive dividend cannot apply a dividends received deduction to the distribution. a. True b. False 37. If a distribution of stock rights is taxable and their fair market value is less than 15 percent of the value of the old stock, then either a zero basis or a portion of the old stock basis may be assigned to the rights at the shareholder’s option. a. True b. False 38. If there is sufficient E & P, a distribution of nonconvertible preferred stock to common shareholders is taxable. a. True b. False 39. The rules used to determine the taxability of stock dividends also apply to distributions of stock rights. a. True b. False 40. If stock rights are taxable, the recipient has income to the extent of the fair market value of the rights. a. True b. False 41. The Code treats corporate distributions that are a return of a shareholder’s investment as sales or exchanges and corporate distributions that are a return from a shareholder’s investment as dividends. a. True b. False Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 42. In general, if a shareholder’s ownership interest is not diminished as a result of a stock redemption, the Code will treat the transaction as a sale or exchange. a. True b. False 43. Corporate shareholders generally receive less favorable tax treatment from a qualifying stock redemption than from a dividend distribution. a. True b. False 44. Yolanda owns 60% of the outstanding stock of Amber Corporation. In a qualifying stock redemption, Amber distributes $20,000 to Yolanda in exchange for one-half of her shares (basis of $35,000). As a result of the redemption, Yolanda has a recognized capital loss of $15,000. a. True b. False 45. A shareholder’s basis in property acquired in a stock redemption is the property’s fair market value as of the date of redemption. a. True b. False 46. Vireo Corporation redeemed shares from its sole shareholder pursuant to a written agreement between the parties that clearly identified the transaction as a stock redemption (not a dividend distribution). As the agreement is binding under state law, the shareholder will receive sale or exchange treatment with respect to the redemption. a. True b. False 47. In applying the § 318 stock attribution rules to a stock redemption, a shareholder is treated as owning the stock of her spouse, children, grandchildren, parents, and siblings. a. True b. False 48. A redemption will qualify as a not essentially equivalent redemption only if the shareholder’s interest in the redeeming corporation has been meaningfully reduced. a. True b. False 49. As a result of a redemption, a shareholder’s interest (direct and indirect) in the corporation decreased from 80% to 55%. The redemption qualifies for sale or exchange treatment as a disproportionate redemption. a. True b. False 50. Puffin Corporation’s 2,000 shares outstanding are owned as follows: Paul, 800 shares; Sandra (Paul’s sister), 800 shares; and Greta (Paul’s granddaughter), 400 shares. During the current year, Puffin (E & P of $1,000,000) redeemed 600 shares of Paul’s stock for $100,000. If Paul acquired the 600 shares five years ago for $30,000, he will have a long-term capital gain of $70,000 from the redemption. Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation a. True b. False 51. For purposes of the waiver of the family attribution rules in a complete termination redemption, the former shareholder must notify the IRS within 30 days of acquiring a prohibited interest in the corporation during the 10-year period following the redemption. a. True b. False 52. Reginald and Roland (Reginald’s son) each own 50% of the stock of Robin Corporation. Reginald’s stock interest is entirely redeemed by Robin. Two years later, Reginald loans Robin $250,000. The loan to Robin Corporation is not a prohibited interest for purposes of the family attribution waiver. a. True b. False 53. Six years ago, both Ronald and his mom owned 50% of the stock of Bronze Corporation. At such time, Bronze redeemed all of Ronald’s stock. For the redemption year, Ronald filed the agreement required of the family attribution waiver and reported the transaction as a complete termination redemption (i.e., sale or exchange). In the current year, the mom passed away and willed her entire stock interest in Bronze to Ronald. The inheritance of Bronze stock by Ronald is a prohibited interest for purposes of the family attribution waiver. a. True b. False 54. For purposes of a partial liquidation, a distribution is not essentially equivalent to a dividend if it results in a genuine contraction of the business of the corporation. a. True b. False 55. For purposes of a partial liquidation, the termination of a business test is a subjective test that should be relied upon only after obtaining a favorable ruling from the IRS. a. True b. False 56. To qualify for a partial liquidation under the termination of a business test, the distribution must consist of the assets of a qualified trade or business. a. True b. False 57. In determining whether a distribution qualifies as a § 303 redemption to pay death taxes, the stock attribution rules must be applied. a. True b. False 58. Betty’s adjusted gross estate is $18,000,000. The death taxes and funeral and administration expenses of her estate total $2,400,000. Included in Betty’s gross estate is stock in Heron Corporation valued at $6,600,0000 as of the date of her death. Betty had acquired the stock six years ago at a cost of $1,620,000. If Heron Corporation redeems $2,400,000 of Heron stock from the estate, the transaction will qualify under § 303 as a redemption to pay death taxes and receive sale or Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation exchange treatment. a. True b. False 59. Grackle Corporation (E & P of $600,000) distributes cash of $200,000 and land (fair market value of $400,000; basis of $250,000) to a shareholder in a qualifying stock redemption. The land distributed is subject to a mortgage of $460,000. Grackle will recognize a gain of $210,000 as a result of the distribution. a. True b. False 60. At a time when Blackbird Corporation had E & P of $700,000 and 1,000 shares of stock outstanding, the corporation distributed $300,000 to redeem 400 shares of its stock. The transaction qualified as a disproportionate redemption for the shareholder. Blackbird’s E & P is reduced by $300,000 as a result of the distribution. a. True b. False Multiple Choice 61. The tax treatment of corporate distributions at the shareholder level does not depend on: a. The character of the property being distributed. b. The earnings and profits of the corporation. c. The basis of stock in the hands of the shareholder. d. Whether the distributed property is received by an individual or a corporation. 62. Rose Corporation (a calendar year taxpayer) has taxable income of $300,000, and its financial records reflect the following for the year. Federal income taxes paid Net operating loss carryforward deducted currently Gain recognized this year on an installment sale from a prior year Depreciation deducted on tax return (ADS depreciation would have been $10,000) Interest income on Iowa state bonds

$110,000 70,000 44,000 40,000 8,000

Rose Corporation’s current E & P is: a. $254,000. b. $214,000. c. $194,000. d. $104,000. 63. Tern Corporation, a cash basis taxpayer, has taxable income of $500,000 for the current year. Tern elected $25,000 of § 179 expense. It also had a related-party loss of $20,000 and a realized (not recognized) gain from an involuntary conversion of $75,000. It paid Federal income tax of $150,000 and paid a nondeductible fine of $10,000. Tern’s current E & P is: a. $415,000. b. $350,000. c. $340,000. d. $320,000. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 64. Silver Corporation, a calendar year taxpayer, has taxable income of $550,000. Among its transactions for the year are the following: Collection of proceeds from insurance policy on life of corporate officer (in excess of cash surrender value) Realized gain (not recognized) on an involuntary conversion Nondeductible fines and penalties

$82,500 11,000 44,000

Disregarding any provision for Federal income taxes, Silver Corporation’s current E & P is: a. $500,500. b. $588,500. c. $599,500. d. $687,500. 65. Which of the following statements is incorrect with respect to determining current E & P? a. All tax-exempt income should be added back to taxable income. b. Dividends received deductions should be subtracted from taxable income. c. Current-year charitable contributions in excess of the 10% of taxable income limit should be subtracted from taxable income. d. Federal income tax refunds should be added back to taxable income. 66. Aaron and Michele, equal shareholders in Cavalier Corporation, receive $25,000 each in distributions on December 31 of the current year. During the current year, Cavalier sold an appreciated asset for $60,000 (basis of $15,000). Payment for the sale of the asset will be made as follows: 50% next year and 50% in the following year with interest payable at a rate of 6 percent. Before considering the effect of the asset sale, Cavalier’s current-year E & P is $40,000 and it has no accumulated E & P. How much of Aaron’s distribution will be taxed as a dividend? a. $0 b. $20,000 c. $25,000 d. $42,500 67. Tracy and Jerome, equal shareholders in Macaw Corporation, receive $600,000 each in distributions on December 31 of the current year. Macaw’s current-year taxable income is $1,000,000 and it has no accumulated E & P. Last year, Macaw sold an appreciated asset for $1,200,000 (basis of $400,000). Payment for one-half of the sale of the asset was made this year. How much of Tracy’s distribution will be taxed as a dividend? a. $0 b. $300,000 c. $500,000 d. $600,000 68. Falcon Corporation ended its first year of operations with taxable income of $250,000. At the time of Falcon’s formation, it incurred $50,000 of organizational expenses. In calculating its taxable income for the year, Falcon claimed an $8,000 deduction for the organizational expenses. What is Falcon’s current E & P? a. $200,000 b. $208,000 c. $250,000 d. $258,000 Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 69. During the current year, Hawk Corporation sold equipment for $600,000 (adjusted basis of $360,000). The equipment was purchased a few years ago for $760,000 and $400,000 in MACRS deductions have been claimed. ADS depreciation would have been $300,000. As a result of the sale, the adjustment to taxable income needed to determine current E & P is: a. No adjustment is required. b. Subtract $100,000. c. Add $100,000. d. Add $80,000. 70. On January 2, 2024, Orange Corporation purchased equipment for $300,000 with an ADS recovery period of 10 years and a MACRS useful life of 7 years. Section 179 was not elected. MACRS depreciation properly claimed on the asset, including depreciation in the year of sale, totaled $79,605. The equipment was sold on July 1, 2025, for $290,000. As a result of the sale, the adjustment to taxable income needed to arrive at current E & P is: a. No adjustment is required. b. Decrease $49,605. c. Increase $49,605. d. Decrease $79,605. 71. Tungsten Corporation, a calendar year cash basis taxpayer, made estimated tax payments of $800 each quarter in 2024, for a total of $3,200. Tungsten filed its 2024 tax return in 2025 and the return showed a tax liability $4,200. When it filed its tax return in 2025, Tungsten paid an additional $1,000 in Federal income taxes. How does the additional payment of $1,000 impact Tungsten’s E & P? a. Increase by $1,000 in 2024. b. Increase by $1,000 in 2025. c. Decrease by $1,000 in 2024. d. Decrease by $1,000 in 2025. 72. Inka and Eva each own one-half of the stock in Parakeet Corporation, a calendar year taxpayer. Cash distributions from Parakeet are $350,000 to Inka on April 1 and $150,000 to Eva on May 1. If Parakeet’s current E & P is $60,000, how much is allocated to Eva’s distribution? a. $5,000 b. $10,000 c. $18,000 d. $30,000 73. Cedar Corporation is a calendar year taxpayer formed in 2020. Cedar’s E & P before distributions for each of the past five years is listed below. 2024 2023 2022 2021 2020

$28,000 $40,000 $39,000 $68,000 $16,000

Cedar Corporation made the following distributions in the previous five years. 2023

Land (basis of $70,000, fair market value of $80,000)

Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 2020

$20,000 cash

Cedar’s accumulated E & P as of January 1, 2025 is: a. $91,000. b. $95,000. c. $101,000. d. $105,000. 74. Maria and Christopher each own 50% of Cockatoo Corporation, a calendar year taxpayer. Distributions from Cockatoo are $750,000 to Maria on April 1 and $250,000 to Christopher on May 1. Cockatoo’s current E & P is $300,000 and its accumulated E & P is $600,000. How much of the accumulated E & P is allocated to Christopher’s distribution? a. $0 b. $75,000 c. $150,000 d. $300,000 75. Robin Corporation, a calendar year taxpayer, has a deficit in current E & P of $200,000 and a $580,000 positive balance in accumulated E & P. If Robin determines that a $700,000 distribution to its shareholders is appropriate at some point during the year, what is the maximum amount of the distribution that could potentially be treated as a dividend? a. $0 b. $380,000 c. $480,000 d. $580,000 76. Pheasant Corporation, a calendar year taxpayer, has $400,000 of current E & P and a deficit in accumulated E & P of $180,000. If Pheasant pays a $600,000 distribution to its shareholders on July 1, how much dividend income do the shareholders report? a. $0 b. $20,000 c. $220,000 d. $400,000 77. Jasmine is the sole shareholder of Condor Corporation. She sold her stock to Melissa on October 31 for $150,000. Jasmine’s basis in Condor stock was $50,000 at the start of the year. Condor distributed land to Jasmine immediately before the sale. Condor’s basis in the land was $20,000 (fair market value of $25,000). On December 31, Melissa received a $75,000 cash distribution from Condor. During the year, Condor has $20,000 of current E & P and its accumulated E & P balance on January 1 is $10,000. Which of the following statements is true? a. Jasmine recognizes a $110,000 gain on the sale of her stock. b. Jasmine recognizes a $100,000 gain on the sale of her stock. c. Melissa receives $5,000 of dividend income. d. Jasmine receives $20,000 of dividend income. 78. Blue Corporation has a deficit in accumulated E & P of $300,000 and has current E & P of $225,000. On July 1, Blue distributes $250,000 to its sole shareholder, Sam, who has a basis in his stock of $52,500. As a result of the distribution, Sam has: a. Dividend income of $225,000 and reduces his stock basis to $27,500. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation b. Dividend income of $52,500 and reduces his stock basis to zero. c. Dividend income of $225,000 and no adjustment to stock basis. d. No dividend income, reduces his stock basis to zero, and has a capital gain of $250,000. 79. Renee, the sole shareholder of Indigo Corporation, sold her stock to Chad on July 1 for $180,000. Renee’s stock basis at the beginning of the year was $120,000. Indigo made a $60,000 cash distribution to Renee immediately before the sale and Chad received a $120,000 cash distribution from Indigo on November 1. As of the beginning of the current year, Indigo had $26,000 in accumulated E & P and current E & P (before distributions) was $90,000. Which of the following statements is correct? a. Renee recognizes a $60,000 gain on the sale of the stock. b. Renee recognizes a $64,000 gain on the sale of the stock. c. Chad recognizes dividend income of $120,000. d. Chad recognizes dividend income of $30,000. 80. Tangelo Corporation has an August 31 year-end. Tangelo had $50,000 in accumulated E & P at the beginning of its 2025 fiscal year (September 1, 2024) and during the year, it incurred a $75,000 operating loss. It also distributed $65,000 to its sole shareholder, Cass, on November 30, 2024. If Cass is a calendar year taxpayer, how should she treat the distribution when she files her 2024 income tax return (assuming the return is filed by April 15, 2025)? a. $65,000 of dividend income. b. $60,000 of dividend income and $5,000 recovery of capital. c. $50,000 of dividend income and $15,000 recovery of capital. d. The distribution has no effect on Cass in the current year. 81. As of January 1, Cassowary Corporation has a deficit in accumulated E & P of $100,000. For the tax year, current E & P (accrued ratably) is $240,000 (prior to any distributions). On July 1, Cassowary Corporation distributes $275,000 to its sole shareholder. The amount of the distribution that is a dividend is: a. $20,000. b. $140,000. c. $240,000. d. $275,000. 82. At the beginning of the current year, both Doug and Amelia each own 50% of Amaryllis Corporation (a calendar year taxpayer). In July, Doug sold his stock to Kevin for $140,000. At the beginning of the year, Amaryllis Corporation had accumulated E & P of $240,000 and its current E & P is $280,000 (prior to any distributions). Amaryllis distributed $300,000 on February 15 ($150,000 to Doug and $150,000 to Amelia) and distributed another $300,000 on November 1 ($150,000 to Kevin and $150,000 to Amelia). Kevin has dividend income of: a. $150,000. b. $140,000. c. $110,000. d. $70,000. 83. On January 1, Eagle Corporation (a calendar year taxpayer) has accumulated E & P of $300,000. During the year, Eagle incurs a net loss of $420,000 from operations that accrues ratably. On June 30, Eagle distributes $180,000 to Libby, its sole shareholder, who has a basis in her stock of $112,500. How much of the $180,000 is a dividend to Libby? a. $0 b. $90,000 Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation c. $112,500 d. $180,000 84. Which of the following is not a consequence of the double tax on dividends? a. Corporations have an incentive to retain earnings and structure distributions to avoid dividend treatment. b. Corporations have an incentive to invest in noncorporate rather than corporate businesses. c. The cost of capital for corporate investments is decreased. d. Corporations have an incentive to finance operations with debt rather than equity. 85. Which one of the following statements is false? a. Most countries that trade with the United States impose a double tax on dividends. b. Tax proposals that include corporate integration would eliminate the double tax on dividends. c. The double tax on dividends may make corporations more financially vulnerable during economic downturns. d. Many of the arguments in support of the double tax on dividends relate to fairness. 86. In June of the current year, Marigold Corporation declares a $4 dividend out of E & P on each share of common stock to shareholders of record on August 1. Ellen and Tim each purchase 100 shares of Marigold stock on July 1. On July 15, Ellen also purchases a short position in Marigold. Tim sells 50 of his shares on August 10 and continues to hold the remaining 50 shares through the end of the year. Ellen closes her short position in Marigold on October 15. With respect to the dividends, which of the following is correct? a. Ellen will have $400 of qualifying dividends subject to reduced tax rates and $400 of ordinary income (from dividends paid on the short position of Marigold stock). b. Tim will have $200 of qualifying dividends subject to reduced tax rates and $200 of ordinary income. c. All $800 of Ellen’s dividends will qualify for reduced tax rates. d. All $400 of Tim’s dividends will qualify for reduced tax rates. 87. In the current year, Warbler Corporation (E & P of $250,000) made the following property distributions to its shareholders (all corporations):

Pink Corporation stock (held for investment) Non-LIFO inventory

Adjusted Basis $150,000 80,000

Fair Market Value $120,000 110,000

Warbler Corporation is not a member of a controlled group. As a result of the distribution: a. The shareholders have dividend income of $200,000. b. The shareholders have dividend income of $230,000. c. Warbler has a recognized gain of $30,000 and a recognized loss of $30,000. d. Warbler has no recognized gain or loss. 88. Purple Corporation makes a property distribution to its sole shareholder, Kyung. The property distributed is a house (fair market value of $189,000; basis of $154,000) that is subject to a $245,000 mortgage that Kyung assumes. Before considering the consequences of the distribution, Purple’s current E & P is $35,000 and its accumulated E & P is $140,000. Purple makes no other distributions during the current year. What is Purple’s taxable gain on the distribution of the house? a. $0 b. $21,000 Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation c. $35,000 d. $91,000 89. Puffin Corporation makes a property distribution to its sole shareholder, Bonnie. The property distributed is a car (basis of $30,000; fair market value of $20,000) that is subject to a $6,000 liability, which Bonnie assumes. Puffin has no accumulated E & P and $30,000 of current E & P from other sources during the year. What is Puffin’s E & P after taking into account the distribution of the car? a. $4,000 b. $6,000 c. $10,000 d. $14,000 90. Navy Corporation has E & P of $240,000. It distributes land with a fair market value of $70,000 (adjusted basis of $25,000) to its sole shareholder, Troy. The land is subject to a liability of $55,000 that Troy assumes. Troy has: a. A taxable dividend of $15,000. b. A taxable dividend of $25,000. c. A taxable dividend of $70,000. d. A basis in the machinery of $55,000. 91. Which one of the following statements about property distributions is false? a. When the basis of distributed property is greater than its fair market value, a deficit may be created in E & P. b. When the basis of distributed property is less than its fair market value, the distributing corporation recognizes gain. c. When the basis of distributed property is greater than its fair market value, the distributing corporation does not recognize loss. d. The amount of a distribution received by a shareholder is measured by using the property’s fair market value. 92. Brett owns stock in Oriole Corporation (basis of $100,000) as an investment. Oriole distributes property (fair market value of $375,000; basis of $187,500) to him during the year. Oriole has current E & P of $25,000 (which includes the E & P gain on the property distribution), accumulated E & P of $100,000, and makes no other distributions during the year. What is Brett’s capital gain on the distribution? a. $0 b. $100,000 c. $150,000 d. $187,500 93. Rust Corporation distributes property to its sole shareholder, Andre. The property has a fair market value of $350,000, an adjusted basis of $205,000, and is subject to a liability of $220,000. Current E & P is $500,000. With respect to the distribution, which of the following statements is correct? a. Rust has a gain of $15,000 and Andre has dividend income of $350,000. b. Rust has a gain of $145,000 and Andre’s basis in the distributed property is $130,000. c. Rust has a gain of $130,000 and Andre’s basis in the distributed property is $350,000. d. Rust has a gain of $145,000 and Andre has dividend income of $130,000. 94. Purple Corporation has accumulated E & P of $100,000 on January 1, 2024. In 2024, Purple has current E & P of $130,000 (before any distribution). On December 31, 2024, the corporation distributes $250,000 to its sole shareholder, Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation Cara (an individual). Purple Corporation’s E & P as of January 1, 2025 is: a. $0. b. ($20,000). c. $100,000. d. $130,000. 95. Starling Corporation has accumulated E & P of $60,000 on January 1, 2024. In 2024, Starling Corporation had an operating loss of $80,000. It distributed cash of $40,000 to Zoe, its sole shareholder, on December 31, 2024. Starling Corporation’s balance in its E & P account as of January 1, 2025, is: a. $60,000 deficit. b. $20,000 deficit. c. $0. d. $60,000. 96. Robin Corporation distributes furniture (basis of $40,000; fair market value of $50,000) as a property dividend to its shareholders. The furniture is subject to a liability of $55,000. Robin Corporation recognizes gain of: a. $55,000. b. $15,000. c. $10,000. d. $0. 97. Pink Corporation declares a nontaxable dividend payable in rights to subscribe to common stock. Each right entitles the holder to purchase one share of stock for $25. One right is issued for every two shares of stock owned. Jocelyn owns 100 shares of stock in Pink, which she purchased three years ago for $3,000. At the time of the distribution, the value of the stock is $45 per share and the value of the rights is $2 per share. Jocelyn receives 50 rights. She exercises 25 rights and sells the remaining 25 rights three months later for $2.50 per right. a. Jocelyn must allocate a part of the basis of her original stock in Pink to the rights. b. If Jocelyn does not allocate a part of the basis of her original stock to the rights, her basis in the new stock is zero. c. Sale of the rights produces ordinary income to Jocelyn of $62.50. d. If Jocelyn does not allocate a part of the basis of her original stock to the rights, her basis in the new stock is $625. 98. Ten years ago, Carrie purchased 2,000 shares of common stock in Osprey Corporation for $20,000. In the current year, Carrie receives a nontaxable stock dividend of 20 shares of Osprey preferred. Values at the time of the dividend are $8,000 for the preferred stock and $72,000 for the common. Based on this information, Carrie’s basis in the stock is: a. $20,000 in the common and $8,000 in the preferred. b. $2,000 in the common and $18,000 in the preferred. c. $18,000 in the common and $2,000 in the preferred. d. $19,802 in the common and $198 in the preferred. 99. Which of the following statements regarding constructive dividends is not correct? a. Constructive dividends do not need to be formally declared or designated as a dividend. b. Constructive dividends need not be paid pro rata to the shareholders. c. Corporations that receive constructive dividends may not use the dividends received deduction. d. Constructive dividends are taxable as dividends only to the extent of earnings and profits. Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 100. On January 30, Juan receives a nontaxable distribution of stock rights from Platinum Corporation. Each right entitles the holder to purchase one share of stock for $40. One right is issued for every share of stock owned. Juan owns 100 shares of stock purchased two years ago for $4,000. At the date of distribution, the rights are worth $1,000 (100 rights at $10 per right) and Juan’s stock in Platinum is worth $5,000 (or $50 per share). On December 1, Juan sells all 100 stock rights for $12 per right. How much gain does Juan recognize on the sale? a. $1,200 b. $533 c. $400 d. $0 101. Seven years ago, Eleanor transferred property she had used in her sole proprietorship to Blue Corporation for 2,000 shares of Blue Corporation in a transaction that qualified under § 351. The assets had a tax basis to her of $400,000 and a fair market value of $700,000 on the date of the transfer. In the current year, Blue Corporation (E & P of $1,000,000) redeems 600 shares from Eleanor for $260,000 in a transaction that does not qualify for sale or exchange treatment. With respect to the redemption, Eleanor will have a: a. $140,000 dividend. b. $260,000 dividend. c. $140,000 capital gain. d. $260,000 capital gain. 102. Seven years ago, Eleanor transferred property she had used in her sole proprietorship to Blue Corporation for 2,000 shares of Blue Corporation in a transaction that qualified under § 351. The assets had a tax basis to her of $400,000 and a fair market value of $700,000 on the date of the transfer. In the current year, Blue Corporation (E & P of $1,000,000) redeems 600 shares from Eleanor for $260,000 in a transaction that qualifies for sale or exchange treatment. With respect to the redemption, Eleanor will have a: a. $140,000 dividend. b. $260,000 dividend. c. $140,000 capital gain. d. $260,000 capital gain. 103. Finch Corporation distributes property (basis of $225,000, fair market value of $300,000) to a shareholder in a distribution that is a qualifying stock redemption. The property is subject to a liability of $160,000, which the shareholder assumes. The basis of the property to the shareholder is: a. $0. b. $140,000. c. $225,000. d. $300,000. 104. Coffee Corporation has 2,000 shares of common stock outstanding. John owns 700 of the shares, John’s grandfather owns 100 shares, John’s father owns 100 shares, John’s former spouse owns 700 shares, and Redbird Partnership owns 400 shares. John is a 50% partner in Redbird Partnership. How many shares is John deemed to own in Coffee Corporation under the § 318 attribution rules? a. 700 b. 1,000 c. 1,100 d. 1,700 Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 105. Kite Corporation has 1,000 shares of stock outstanding. Kent owns 300 shares, Kent’s father owns 200 shares, Kent’s daughter owns 100 shares, and Kent’s aunt owns 200 shares. Plover Corporation owns the other 200 shares in Kite Corporation. Kent owns 75% of the stock in Plover Corporation. Applying the § 318 stock attribution rules, how many shares does Kent own in Kite Corporation? a. 500 b. 600 c. 750 d. 950 106. Keshia owns 200 shares in Parakeet Corporation. Keshia has a 30% beneficiary interest in her deceased grandmother’s estate. The estate owns 400 shares in Parakeet Corporation. None of the other beneficiaries of the estate owns stock in Parakeet. In applying the § 318 attribution rules,: a. The estate owns 400 shares. b. Keshia owns 320 shares. c. Keshia owns 600 shares. d. The estate owns 460 shares. 107. Which of the following is an incorrect statement regarding the application of the § 318 stock attribution rules? a. An individual is not deemed to own the shares owned by their siblings. b. Stock owned by an estate is deemed to be owned in full by a beneficiary. c. Stock owned by any shareholder owning 50% or more of a corporation’s stock is deemed to be owned in full by the corporation. d. Stock owned by a partnership is deemed to be owned proportionately by a partner. 108. Bristlebird Corporation (E & P of $700,000) has 3,000 shares of common stock outstanding. Juan owns 1,500 shares and his spouse, Roberta, owns 1,500 shares. Both Juan and Roberta have a basis of $90,000 in their Bristlebird stock. In the current year, Bristlebird Corporation redeems 1,000 shares from Juan for $250,000. With respect to the distribution in redemption of the Bristlebird stock: a. Juan has dividend income of $250,000. b. Juan has dividend income of $190,000. c. Juan has a capital gain of $250,000. d. Juan has a capital gain of $190,000. 109. Hazel, Emily, and Frank, unrelated individuals, own all of the stock in Wren Corporation (E & P of $1,200,000) as follows: Hazel, 1,500 shares; Emily, 300 shares; and Frank, 200 shares. Wren redeems 900 of Hazel’s shares (basis of $210,000) for $625,000. With respect to the distribution in redemption of the stock: a. Hazel has a capital gain of $415,000. b. Hazel has a capital gain of $625,000. c. Hazel has dividend income of $415,000. d. Hazel has dividend income of $625,000. 110. Lucinda owns 1,100 shares of Blackbird Corporation stock at a time when Blackbird has 2,000 shares of stock outstanding. The remaining shareholders are unrelated to Lucinda. What is the minimum number of shares Blackbird must redeem from Lucinda so that the transaction will qualify as a disproportionate redemption? a. 220 Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation b. 393 c. 484 d. 880 111. Hannah, Greta, and Winston own the stock in Redpoll Corporation (E & P of $900,000) as follows: Hannah, 600 shares; Greta, 400 shares; and Winston, 1,000 shares. Greta is Hannah’s daughter, and Winston is Hannah’s brother. Redpoll Corporation redeems 400 of Hannah’s shares (basis of $55,000) for $240,000. Hannah purchased the stock three years ago as an investment. With respect to the stock redemption, Hannah has: a. Long-term capital gain of $185,000. b. Long-term capital gain of $240,000. c. Dividend income of $185,000. d. Dividend income of $240,000. 112. Kiyoshi, Hannah, and Samuel, unrelated individuals, own the stock in Broadbill Corporation (E & P of $700,000) as follows: Kiyoshi, 300 shares; Hannah, 300 shares; and Samuel, 400 shares. Broadbill redeems 200 of Samuel’s shares (basis of $175,000) for $250,000. If Samuel’s stock is a capital asset and has been held for over three years, Samuel has: a. A long-term capital gain of $75,000. b. A short-term capital gain of $75,000. c. Ordinary income of $250,000. d. Ordinary income of $75,000. 113. Julian, Berta, and Maria own 400 shares, 400 shares, and 200 shares, respectively, in Caramel Corporation (E & P of $750,000). Berta is Julian’s sister, and Maria is Julian’s aunt. Caramel Corporation redeems all of Julian’s stock for $420,000. Julian paid $200 a share for the stock five years ago. Julian continued to serve on Caramel’s board of directors after the redemption. With respect to the redemption: a. Dividend income is $340,000. b. Dividend income is $420,000. c. Long-term capital gain is $340,000. d. Long-term capital gain is $420,000. 114. Both Lupe and Rodrigo, father and son, own 50% of the stock outstanding of Heron Corporation (E & P of $400,000). During the current year, Heron redeems all of Lupe’s shares for $250,000. The transaction cannot qualify as a complete termination redemption if: a. Lupe received a $250,000 note receivable from Heron in the stock redemption. b. Lupe loaned Heron Corporation $50,000 two years following the redemption. c. Lupe continued to serve on Heron Corporation’s board of directors for two years following the redemption. d. Three years after the redemption, Lupe inherited Rodrigo’s shares in Heron as a result of his son’s death. 115. Leon owns 750 shares of the 2,000 outstanding shares of Crane Corporation (E & P of $900,000). None of the other shareholders of Crane is related to Leon. Leon acquired his Crane shares 10 years ago for $80,000. Crane has operated several trades or businesses for more than 5 years. In the current year, Crane sells the assets of one of those trades or businesses and distributes the proceeds from the asset sale to the shareholders in a pro rata stock redemption. In this transaction, Leon receives $250,000 in redemption of 300 shares of Crane. As a result of this transaction, Leon will recognize: a. $218,000 dividend income. b. $250,000 dividend income. Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation c. $218,000 long-term capital gain. d. $250,000 long-term capital gain. 116. Which of the following statements is correct with respect to a partial liquidation? a. The genuine contraction of a corporate business requirement is an objective test that taxpayers can rely upon with certainty. b. The distribution of proceeds from the sale of excess inventory to shareholders in exchange for part of their stock will not satisfy the not essentially equivalent to a dividend test. c. A stock redemption pursuant to a partial liquidation cannot be pro rata with respect to the shareholders. d. The termination of a business test requires that the distributing corporation actively conducted at least three trades or businesses for at least five years. 117. The adjusted gross estate of Keith, decedent, is $24,000,000. Included in the gross estate is stock in Gold Corporation (E & P of $2,600,000), a closely held corporation, valued at $9,200,000 as of the date of Keith’s death. Keith had acquired the stock 12 years ago at a cost of $1,800,000. Death taxes and funeral and administration expenses for Keith’s estate are $4,600,000. Gold Corporation redeems one-half of the stock from Keith’s estate in a § 303 redemption to pay death taxes using property with a fair market value of $4,600,000 (adjusted basis of $3,800,000). Which of the following is a correct statement regarding the tax consequences of this redemption? a. The estate will have a basis of $4,600,000 in the property received from Gold Corporation in redemption of the estate’s stock. b. Gold Corporation will not reduce its E & P as a result of the distribution of the property to Keith’s estate. c. The estate will recognize a $2,800,000 long-term capital gain on the redemption. d. Gold Corporation recognizes no gain (or loss) on the distribution of the property to Keith’s estate. 118. The adjusted gross estate of Debra, decedent, is $16,000,000. Debra’s estate will incur death taxes and funeral and administration expenses of $2,000,000. Debra’s gross estate includes stock in Silver Corporation that she had purchased 12 years ago for $1,200,000 (date of death fair market value of $6,000,000). At the time of her death, Debra owned 80% of the stock in Silver Corporation. Silver Corporation (E & P of $8,000,000) redeems all of the estate’s stock in the corporation for $6,000,000 million. Debra’s will names her daughter, Dena, who owns the remaining 20% interest in Silver Corporation, as the sole heir of the estate. With respect to this redemption, Debra’s estate has the following income: a. $0. b. $4,000,000 long-term capital gain. c. $4,000,000 dividend. d. $6,000,000 dividend. 119. Which of the following is a correct statement regarding a redemption to pay death taxes under § 303? a. An estate recognizes gain on the redemption equal to the excess of the distribution proceeds over the decedent’s basis in the stock. b. The § 318 stock attribution rules do not apply to the redemption. c. The value of the stock in the decedent’s gross estate must exceed 40% of the value of the adjusted gross estate. d. A corporation recognizes gains and losses on the distribution of property in the redemption. 120. Copper Corporation (E & P of $1,200,000) distributes land (basis of $410,000, fair market value of $650,000) to Lauren, a shareholder, to carry out a qualifying stock redemption. Lauren had a basis of $90,000 in the shares redeemed. Which of the following is an incorrect statement regarding the redemption? a. If the land is distributed subject to a $500,000 liability, Copper Corporation will recognize a gain of $90,000. b. If the land is distributed subject to a $500,000 liability, Lauren will have a basis in the land of $650,000. Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation c. If the land is distributed subject to a $500,000 liability, Lauren will recognize a gain of $60,000. d. If the land is distributed subject to a $700,000 liability, Copper Corporation will recognize a gain of $290,000. 121. To carry out a qualifying stock redemption, Turaco Corporation (E & P of $800,000) transfers land held for investment purposes to Aida, a shareholder. The land had a basis of $250,000, a fair market value of $400,000, and is subject to a $300,000 liability. Aida has a basis of $70,000 in the shares redeemed. Which of the following is a correct statement regarding the tax consequences of this redemption? a. Aida will recognize a gain of $30,000. b. Aida will have a $100,000 basis in the land. c. Turaco Corporation will recognize a gain of $50,000. d. Aida will have $400,000 of dividend income. 122. Canary Corporation has 5,000 shares of stock outstanding. It redeems in a qualifying stock redemption 1,200 shares for $475,000 at a time when it has paid-in capital of $300,000 and E & P of $1,500,000. What would be the charge to Canary’s E & P as a result of the redemption? a. $72,000 b. $300,000 c. $360,000 d. $475,000 123. In the current year, Quail Corporation distributed installment notes payable in redemption of some of its shares. Quail incurred the following expenditures in connection with the redemption: accounting fees of $7,000 and legal fees of $8,000. In addition, Quail paid $10,000 of interest expense on the installment notes payable. The distribution was a qualifying stock redemption. How much of the $25,000 is deductible in the current year? a. $0 b. $7,000 c. $10,000 d. $25,000 Matching Using the legend provided, classify each statement accordingly. In all cases, assume that taxable income is being adjusted to arrive at current E & P for 2024. a. Increase b. Decrease c. No effect 124. Gain on installment sale in 2024 deferred until 2025. 125. Interest received from municipal bonds in 2024. 126. Federal income tax refunds from tax paid in prior years. 127. Loss on sale between related parties in 2024. 128. Meal expense not deducted in 2024 because of the 50% limitation. Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 129. Cash dividends distributed to shareholders in 2024. 130. Gain realized but not recognized in a like-kind exchange transaction in 2024. 131. Additional first-year (bonus) depreciation deduction claimed in 2024. 132. Premiums paid on key employee life insurance policy (assume no increase in cash surrender value of policy) in 2024. 133. Section 179 expense in second year following election. Using the legend provided, classify each statement accordingly. In All cases, assume that taxable income is being adjusted to arrive at current E & P for 2024. a. Increase b. Decrease c. No effect 134. Penalties paid to state government for failure to comply with state law. 135. Dividends received deduction. 136. Charitable contribution carryforward deducted in the current year. 137. Intangible drilling costs deducted currently. 138. Gain realized (but not recognized) on a like-kind exchange. 139. A decrease in the LIFO recapture amount during the year. 140. Excess capital loss in year incurred. 141. State income tax paid in the current year. 142. Proceeds of life insurance received upon the death of a key employee (policy had no cash surrender value). Subjective Short Answer 143. On January 1, Gold Corporation (a calendar year taxpayer) has E & P of $30,000 and generates no additional E & P during the year. On March 31, the corporation distributes $40,000 to its sole shareholder, Ava (basis in stock of $8,000). Determine the effect of the distribution on Ava’s taxable income and stock basis. 144. On January 1, Tulip Corporation (a calendar year taxpayer) has accumulated E & P of $300,000. Its current E & P for the year is $90,000 (before considering dividend distributions). During the year, Tulip distributes $600,000 ($300,000 each) to its equal shareholders, Anne and Tom. Anne has a basis in her stock of $65,000, and Tom’s basis is $120,000. What is the effect of the distribution by Tulip Corporation on Anne and Tom? 145. Daisy Corporation is the sole shareholder of Ostrich Corporation, which it hopes to sell within the next three years. The Ostrich stock (basis of $25,000,000) is currently worth $30,000,000, but Daisy believes that it would be easier to find a buyer if it was worth less. To lower the value of its stock, Ostrich distributes $4,000,000 cash to Daisy (sufficient E & P exists to cover the distribution). At a later date, Daisy sells Ostrich for $26,000,000. Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation a.

What are the tax consequences to Daisy on the sale?

b.

What would be the tax consequences if Ostrich had not first distributed the $4,000,000 in cash and Daisy sold the Ostrich stock for $30,000,000?

146. Ashley, the sole shareholder of Hawk Corporation, has a stock basis of $200,000 at the beginning of the year. On July 1, she sells all of her stock to Francisco for $1,000,000. On January 1, Hawk has accumulated E & P of $90,000 and during the year, current E & P of $160,000. Hawk makes the following cash distributions: $270,000 to Ashley on March 31 and $90,000 to Francisco on December 1. How are the distributions to Ashley and Francisco taxed? What is Ashley’s recognized gain on the sale to Francisco? 147. Brown Corporation, an accrual basis corporation, has taxable income of $150,000 in the current year. Included in its determination of taxable income are the following transactions. ∙ ∙ ∙ ∙ ∙

Brown incurred a $65,000 capital loss from the sale of stock. Because Brown had no capital gains this year, none of the loss is deductible. The corporation’s Federal income tax liability is $31,500. Brown incurred $18,000 in nondeductible meal expenses. Brown uses the LIFO method when accounting for inventory. This year, the company’s LIFO recapture amount increased by $3,000. Brown claimed a dividends received deduction of $1,500.

What is Brown’s current E & P for the year?

148. Finch Corporation (E & P of $400,000) distributed machinery ($10,000 adjusted basis, $150,000 fair market value) to its sole shareholder, Kathleen. The property is subject to a $50,000 mortgage, which Kathleen assumed. How much dividend income does Kathleen recognize as a result of the distribution and what is her basis in the machinery? 149. Sylvia owns 25% of Cormorant Corporation, which sells diamonds to retail jewelry businesses. While Cormorant has a deficit in accumulated E & P of $56,000 at the beginning of the year, its current E & P is $500,000. Since the company had a successful year, Cormorant pays a $36,000 distribution to each of the company’s four shareholders on December 15. Three shareholders receive cash, but Cormorant distributes a diamond (adjusted basis of $40,000 and a fair market value of $36,000) to Sylvia in lieu of cash. Determine the effect of distributing the diamond on Cormorant’s and on Sylvia’s taxable income. What is Sylvia’s basis in the diamond? Was the distribution good tax planning on the part of Cormorant? Why or why not? 150. Thrush, Inc., is a calendar year, accrual basis corporation with Haruki as its sole shareholder (basis in his stock is $90,000). On January 1 of the current year, Thrush has accumulated E & P of $200,000. Before considering the effect of the distribution described below, the corporation’s current E & P is $50,000. On November 1, Thrush distributes an office building to Haruki. The office building has an adjusted basis of $80,000 (fair market value of $100,000) and is subject to a mortgage of $110,000. Assume that the building has been depreciated using the ADS method for both income tax and E & P purposes. What are the tax consequences of the distribution to Thrush and to Haruki? (In your answer, be sure to describe the effects on taxable income for both Thrush and Haruki, the impact of the distribution on Thrush’s E & P, and Haruki’s basis in the building.) 151. Scarlet Corporation is an accrual basis, calendar year corporation. Scarlet distributes inventory (basis of $20,000; fair market value of $40,000) to Frank, its shareholder. Assuming that Scarlet has $500,000 of current E & P, what is the impact of the distribution on Scarlet Corporation and on Frank? 152. Pebble Corporation, an accrual basis taxpayer, has struggled to survive since its formation six years ago. As a result, Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation it has a deficit in accumulated E & P of $340,000 at the beginning of the year. This year, however, Pebble earned a significant profit; taxable income was $240,000. Consequently, Pebble made two cash distributions to Martha, its sole shareholder: $150,000 on July 1 and $200,000 December 31. The following information might be relevant to determining the tax treatment of the distributions. ∙

This year’s taxable income included a net operating loss carryover of $50,000.

∙

The corporation’s Federal income tax liability is $50,400 for the year.

∙

Pebble paid nondeductible fines and kickbacks of $10,000. The company also paid nondeductible life insurance premiums of $22,000.

∙

The cash surrender value of the corporate-owned life insurance policies increased by $11,000 during the year. The company sold a piece of equipment during the year and reported a § 1231 gain of $105,000 and recapture income under § 1245 of $35,000. There were no other § 1231 transactions during the year, but the corporation did have a capital loss carryforward of $30,000.

∙

∙

MACRS depreciation exceeds E & P depreciation by $14,000. In addition, an election under § 179 was made this year for $18,000 of assets.

a.

Compute Pebble’s E & P for the year.

b.

What are the tax consequences of the two distributions made during the year to Martha (her stock basis is $64,000)?

153. Stephanie is the sole shareholder and president of Hawk Corporation. She feels that she can justify at least a $220,000 bonus this year because of her performance. However, rather than a bonus in the form of a salary, she plans to have Hawk pay her a $220,000 dividend. Because Stephanie’s marginal tax rate is 32%, she prefers to receive a dividend taxed at 15%. Her accountant, however, suggests a $275,000 bonus in lieu of the $220,000 dividend since Hawk Corporation is in the 21% tax bracket. Should Stephanie take the $220,000 dividend or the $275,000 bonus? Support your answer by computing the after-tax cost of the two alternatives to Hawk and to Stephanie. 154. Thistle Corporation declares a nontaxable dividend payable in rights to subscribe to common stock. One right and $25 entitle the holder to subscribe to one share of stock. One right is issued for each share of stock held. Annette, a shareholder, owns 200 shares of stock that she purchased five years ago for $3,000. At the date of distribution of the rights, the market values were $50 per share for the stock and $25 for a right. Annette received 200 rights. She exercises 160 rights and purchases 160 additional shares of stock. She sells the remaining 40 rights for $1,080. What are the tax consequences to Annette? 155. Albatross Corporation acquired land for investment purposes in 2009 at a cost of $100,000. Albatross sold the land to Monty on December 30, 2024, and did not elect out of the installment method of accounting. The selling price of the property was $400,000. Monty made a cash down payment of $50,000 on the date of sale and executed a $350,000 note, payable in seven annual installments of $50,000 each plus interest at the rate of 6% per annum. The first installment of $50,000 was due in 2025 which Monty paid, plus interest of $21,000. Discuss the effect of this sale on Albatross’s taxable income and its E & P account in 2024 and 2025. Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 156. Kite Corporation, a calendar year taxpayer, has taxable income of $360,000 for 2025. Among its transactions for the year are the following: Collection of proceeds from insurance policy on life of corporate officer (in excess of cash surrender value) $ 9,000 Realized gain (not recognized) on an involuntary conversion 10,000 Nondeductible fines and penalties 21,000 Disregarding any provision for Federal income taxes, determine Kite Corporation’s current E & P for 2025. 157. Maria owns 75% and Christopher owns 25% of Cockatoo Corporation, a calendar year taxpayer. Cockatoo makes a $600,000 distribution to Maria on April 1 and a $200,000 distribution to Christopher on May 1. Cockatoo’s current E & P is $120,000 and its accumulated E & P is $500,000. What are the tax implications of the distributions to Maria and Christopher? 158. Jen, the sole shareholder of Mahogany Corporation, sold her stock to Jason on July 1 for $90,000. Jen’s stock basis at the beginning of the year was $60,000. Mahogany made a $30,000 cash distribution to Jen immediately before the sale, and Jason received a $60,000 cash distribution from Mahogany on November 1. As of the beginning of the current year, Mahogany had $16,000 in accumulated E & P, and current E & P (before distributions) is $30,000. What are the tax consequences of these transactions to Jen and Jason? 159. At the beginning of the current year, both Paul and John own 50% of Apple Corporation. In July, Paul sold his stock to Sarah for $110,000. At the beginning of the year, Apple Corporation had accumulated E & P of $200,000 and its current E & P is $250,000 (prior to any distributions). Apple distributed $260,000 on March 1 ($130,000 to Paul and $130,000 to John) and distributed another $260,000 on October 1 ($130,000 to Sarah and $130,000 to John). What are the tax implications of the $130,000 distribution to Sarah? 160. Tanya is in the 32% tax bracket. She acquired 1,000 shares of stock in Swan Corporation seven years ago for $100 a share. In the current year, Swan Corporation (E & P of $1,200,000) redeems all of Tanya's shares for $160,000. What are the income tax consequences to Tanya if: a.

The redemption qualifies for sale or exchange treatment and Tanya has no other transactions in the current year involving capital assets?

b.

The redemption does not qualify for sale or exchange treatment?

161. Steve has a capital loss carryover of $30,000 in the current year. He owns 3,000 shares of stock in Carmine Corporation, which he purchased six years ago for $20 per share. In the current year, Carmine Corporation (E & P of $750,000) redeems all of his shares for $140,000. Steve is in the 32% tax bracket. What is his income tax liability with respect to the corporate distribution if: a.

The redemption qualifies for sale or exchange treatment, and Steve has no other transactions in the current year involving capital assets?

b.

The redemption does not qualify for sale or exchange treatment, and Steve has no other transactions in the current year involving capital assets?

162. Hawk Corporation has 2,000 shares of stock outstanding: Marina owns 800 shares, Russell owns 500 shares, Velvet Partnership owns 400 shares, and Yellow Corporation owns 300 shares. Marina and Russell, unrelated individuals, are equal partners of Velvet. Marina owns 35% of the stock in Yellow. Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation

a.

Applying the § 318 stock attribution rules, determine how many shares in Hawk Corporation each shareholder owns, directly and indirectly: Marina Russell Velvet Partnership Yellow Corporation

b.

Assume, instead, that Marina owns 60% of Yellow Corporation. How many shares does Marina own, directly and indirectly, in Hawk Corporation?

163. Starling Corporation was organized fifteen years ago to construct office furniture. Eight years ago, Starling began a fast-food business. In the current year, Starling discontinues its fast-food business and sells all of the assets used in that business for $2,000,000. Further, Starling distributes the entire sales proceeds in a pro rata redemption of 250 shares of stock from each of its two equal shareholders—Morgan, an individual, and Magpie Corporation. Morgan has a basis of $100,000 in her redeemed stock, Magpie Corporation has a basis of $125,000 in its redeemed stock, and both shareholders have held their stock interest in Starling for several years. Starling Corporation has E & P of $4,000,000 and 2,000 shares outstanding at the time of the distribution. What are the tax consequences of the stock redemption to Morgan, to Magpie, and to Starling? 164. Raul’s gross estate includes 1,500 shares of stock of Orange Corporation (basis to Raul of $1,200,000, fair market value on date of death of $8,200,000). The estate will incur $4,400,000 of death taxes and funeral and administration expenses, and the adjusted gross estate is $22,000,000. Denise, Raul’s daughter and sole heir of his estate, owns the remaining 500 shares of Orange Corporation’s shares outstanding. In the current year, Orange (E & P of $10,000,000) redeems all of the estate’s 1,500 shares for $8,200,000. What are the tax consequences of the redemption to Raul’s estate? 165. Ivory Corporation (E & P of $1,000,000) has 2,000 shares of common stock outstanding owned by unrelated parties as follows: Veronica, 1,000 shares, and Tommie, 1,000 shares. Both Veronica and Tommie paid $150 per share for the Ivory stock 12 years ago. In May of the current year, Ivory distributes land held as an investment (basis of $180,000, fair market value of $390,000) to Veronica in redemption of 350 of her shares. a.

What are the tax results to Veronica on the redemption of her Ivory stock?

b.

What are the tax results to Ivory Corporation on the distribution of the land?

Essay 166. Gold Corporation has accumulated E & P of $2,000,000 as of January 1 of the current year. During the year, it expects to have earnings from operations of $1,680,000 and to distribute $900,000 in cash to shareholders. Gold Corporation also expects to sell an asset for a loss of $2,000,000. Thus, it anticipates incurring a deficit of $320,000 for the year. What can Gold do to minimize the amount of dividend income to its shareholders? 167. Antonio owns 100% of Forsythia Corporation’s stock. Corporate employees and annual salaries include Antonio ($300,000); Richard, Antonio’s son ($80,000); Rita, Antonio’s daughter ($100,000); and Sandy ($120,000). The operation of Forsythia Corporation is shared about equally between Antonio and Sandy (an unrelated party). Richard and Rita are full-time college students at a university about 150 miles away. Forsythia Corporation has substantial E & P but has not distributed a dividend for the past five years. Discuss problems related to the salary arrangement for Forsythia Corporation. Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 168. Briefly describe the reason a corporation might distribute a property dividend to a shareholder in lieu of a cash distribution. Describe the tax effects of the property distribution on the shareholder and on the corporation. 169. How does the definition of accumulated E & P differ from the definition of current E & P? 170. How does the payment of a property dividend affect E & P? 171. Goldfinch Corporation distributes stock rights to its shareholders. How is the basis of the stock rights received by Goldfinch’s shareholders determined? 172. Briefly describe the rationale for the reduced tax rate on dividends for individual taxpayers. 173. Christian, the president and sole shareholder of Venture Corporation, is paid an annual salary of $150,000. Christian would like to draw additional funds from the corporation but is concerned that an increased salary might cause the IRS to contend that his salary is unreasonable. Further, Christian does not want the corporation to pay any dividends. He would like to contribute $40,000 to his alma mater to establish scholarships for needy students. If Christian makes a pledge to the university to provide $40,000 for scholarships, would there be a problem if Venture Corporation paid the pledge on his behalf? Explain. 174. Briefly define the term “earnings and profits.” 175. Provide a brief outline on computing current E & P. 176. In general, how are current and accumulated earnings and profits allocated to corporate distributions? 177. Briefly discuss the rules related to distributions of noncash property. 178. What is a constructive dividend? Provide several examples of the term. 179. Do noncorporate and corporate shareholders typically have the same preference for the tax treatment of a stock redemption? Explain. 180. Explain the stock attribution rules that apply in the case of stock redemptions. 181. When does a redemption qualify as a not essentially equivalent redemption under § 302(b)(1)? 182. What are the requirements that must be satisfied for a distribution to qualify under § 302(b)(2) as a disproportionate redemption? 183. When is a redemption to pay death taxes under § 303 most advantageous?

Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation Answer Key 1. True 2. False 3. False 4. False 5. False 6. False 7. False 8. False 9. False 10. True 11. False 12. False 13. False 14. True 15. True 16. True 17. False 18. True 19. True 20. True 21. True 22. False 23. False 24. True 25. True Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 26. True 27. True 28. True 29. True 30. False 31. False 32. False 33. True 34. False 35. True 36. False 37. False 38. False 39. True 40. True 41. True 42. False 43. True 44. False 45. True 46. False 47. False 48. True 49. False 50. True Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 51. True 52. True 53. False 54. True 55. False 56. False 57. False 58. True 59. True 60. False 61. a 62. a 63. c 64. b 65. b 66. c 67. b 68. d 69. b 70. b 71. d 72. c 73. d 74. b 75. d 76. d Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 77. a 78. a 79. b 80. a 81. c 82. c 83. b 84. c 85. a 86. b 87. b 88. d 89. b 90. a 91. a 92. c 93. d 94. a 95. b 96. b 97. d 98. c 99. c 100. b 101. b Powered by Cognero

Page 29

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 102. c 103. d 104. b 105. c 106. b 107. b 108. a 109. d 110. b 111. a 112. a 113. c 114. c 115. c 116. b 117. a 118. c 119. b 120. a 121. a 122. c 123. c 124. a 125. a 126. a 127. b Powered by Cognero

Page 30

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 128. b 129. b 130. c 131. a 132. b 133. b 134. b 135. a 136. a 137. a 138. c 139. b 140. b 141. c 142. a 143. Ava recognizes dividend income of $30,000 (the amount of E & P distributed). In addition, she reduces her stock basis from $8,000 to zero and recognizes a taxable capital gain of $2,000 (the excess of the distribution over the stock basis). 144. Anne and Tom each have dividend income of $195,000 {[$300,000 (Tulip’s accumulated E & P) + $90,000 (Tulip’s current E & P)] ÷ 2}. The remaining $210,000 distributed reduces the basis in Tulip stock with the excess treated as capital gain. Thus, Anne reduces her stock basis to zero and has a capital gain of $40,000 [($210,000 distribution in excess of E & P ÷ 2) – $65,000 basis]. Tom reduces his stock basis to $15,000 [$120,000 basis – ($210,000 distribution in excess of E & P ÷ 2)]. 145. a.

Because Daisy is the sole shareholder of Ostrich, it has a 100% dividends received deduction on the $4,000,000 cash distribution. Thus, Daisy Corporation is not taxed on the $4,000,000 distribution, and it has a gain on the sale of its stock in Ostrich of $1,000,000 [$26,000,000 (sales price) – $25,000,000 (stock basis)].

b.

If Daisy had sold the stock for $30,000,000, Daisy would have a taxable gain on the sale of $5,000,000 [$30,000,000 (sales price) – $25,000,000 (stock basis)].

146. The $160,000 in current E & P is allocated pro rata to the two distributions made during the year; thus, $120,000 is Powered by Cognero

Page 31

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation allocated to Ashley and $40,000 is allocated to Francisco. Because accumulated E & P is applied in chronological order, it is allocated entirely to Ashley. Consequently, of the $270,000 distribution to Ashley on March 31, $210,000 is taxed as dividend income [$90,000 (accumulated E & P) + $120,000 (current E & P)] and the remaining $60,000 reduces her stock basis to $140,000. She then recognizes a capital gain of $860,000 on the sale of her stock [$1,000,000 (sales price) – $140,000 (remaining stock basis)]. As to the $90,000 distribution to Francisco, $40,000 is taxed as a dividend (from current E & P) and the remaining $50,000 reduces his basis to $950,000 [$1,000,000 (original basis) – $50,000 (return of capital)]. 147. Taxable income Current-year capital loss Federal income tax Nondeductible meal expenses LIFO recapture adjustment Dividends received deduction Current E & P

$ 150,000 (65,000) (31,500) (18,000) 3,000 1,500 $ 40,000

148. As a result of the distribution, Kathleen has a taxable dividend of $100,000 [$150,000 (fair market value) – $50,000 (liability)].The basis of the property to Kathleen is its fair market value, or $150,000. 149. Losses on distributed property are not recognized at the corporate level, so there is no impact on Cormorant’s taxable income. Because there is sufficient current E & P to cover the distribution, Sylvia has a taxable dividend of $36,000 and her basis in the diamond is also $36,000. The distribution reflects poor tax planning by Cormorant because the built-in $4,000 loss on the diamond ($36,000 fair market value – $40,000 adjusted basis) has been wasted. If Cormorant had sold the diamond for its $36,000 fair market value, it could have recognized the loss. The $36,000 cash received from the sale would be distributed to Sylvia instead. 150. Thrush recognizes gain of $30,000 [$110,000 (liability) – $80,000 (adjusted basis)]. The $30,000 gain increases the corporation’s current E & P from $50,000 to $80,000. Because the liability exceeds the fair market value of the property, the distribution itself will not impact E & P. Haruki has no taxable income because the liability exceeds the fair market value of the property received. Further, Haruki’s basis in the office building is its deemed fair market value, or $110,000 (the amount of the liability assumed). 151. Scarlet’s E & P is increased by the $20,000 gain [$40,000 (fair market value) – $20,000 (adjusted basis)] and decreased by the $40,000 fair market value of the distribution. Frank has dividend income of $40,000. 152. a. Taxable income Net operating loss carryover Federal income tax Fines and kickbacks Life insurance premiums Cash surrender value of life insurance Capital loss carryforward Excess of MACRS depreciation over E & P depreciation Section 179 expense (80% × $18,000) Current E & P b.

$ 240,000 50,000 (50,400) (10,000) (22,000) 11,000 30,000 14,000 14,400 $ 277,000

Martha has a dividend of $277,000 (the amount of the current E & P). The distributions

Powered by Cognero

Page 32

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation during the year exceed current E & P by $73,000 ($350,000 – $277,000). Consequently, Martha’s stock basis is reduced to $0 and she has a capital gain equal to the extent to which the $73,000 exceeds her stock basis ($64,000), or $9,000.

153. Stephanie should choose the $275,000 bonus instead of the $220,000 dividend because the after-tax benefit to her is the same and the after-tax cost for Hawk is less. Stephanie’s after-tax benefit for the bonus is $187,000 [$275,000 × (1 – 0.32)], while her after-tax benefit for the dividend is $187,000 [$220,000 × (1 – 0.15)]. Hawk Corporation’s after-tax cost for the bonus is $217,250 [$275,000 bonus – ($275,000 × 0.21) taxes saved], and its after-tax cost for the dividend is $220,000 (the dividend is not deductible). 154. Because the fair market value of the rights is 15% or more of the value of the old stock, Annette allocates her basis in the stock between the stock and the stock rights. Annette allocates basis as follows. Fair market value of stock: 200 shares × $50 Fair market value of rights: 200 rights × $25

$10,000 5,000 $15,000

Basis of stock: 10/15 × $3,000 = $2,000 Basis of rights: 5/15 × $3,000 = $1,000 = $5 per right There is a capital gain on the sale of the rights of $880, computed as follows. Sales price of 40 rights Less: basis of 40 rights Long-term capital gain

$ 1,080 (200) $ 880

Basis of the new stock is $4,800, computed as follows. 160 rights × $5 Additional consideration (160 × $25)

$ 800 4,000 $4,800

The holding period of the 160 new shares begins on the date of purchase. 155. The gross profit percentage on the sale is 75%, computed as follows: [$300,000 (gross profit) ÷ $400,000 (selling price)]. In 2024, Albatross includes a long-term capital gain of $37,500 in its taxable income (75% of the $50,000 cash down payment). However, the entire gain of $300,000 increases E & P in 2024. Thus, to compute E & P, taxable income will be increased by the $262,500 gain not already recognized ($300,000 total gain less $37,500 gain recognized in 2024). In 2025, Albatross Corporation again includes a long-term capital gain of $37,500 in taxable income (75% of the $50,000 installment), plus ordinary interest income of $21,000. In determining its 2025 E & P, it reduces taxable income by $37,500. 156. Taxable Income Plus: Life insurance proceeds in excess of CSV Less: Fines and penalties Current Earning & Profits

$ 360,000 9,000 (21,000) $ 348,000

The realized gain (not recognized) on the involuntary conversion has no effect on E & P. Powered by Cognero

Page 33

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 157. Current E & P is allocated on a pro rata basis to each distribution made during the year. Cockatoo Corporation made $800,000 of distributions during the year. Christopher’s distribution represents 25% ($200,000/$800,000) of that amount. Consequently, 25% of Cockatoo’s current E & P, or $30,000 ($120,000 × 25%), is allocated to Christopher’s distribution. Maria’s distribution represents 75% ($600,000/$800,000) of total distributions. Consequently, 75% of Cockatoo’s current E & P, or $90,000 ($120,000 × 75%), is allocated to Maria’s distribution. Accumulated E & P is applied in chronological order beginning with the earliest distribution. When Maria’s distribution is made, Cockatoo has $590,000 of dividend-paying capacity ($500,000 of accumulated E & P plus $90,000 of current E & P). Therefore, $590,000 of Maria’s distribution is treated as a dividend with the balance ($10,000) being a return of capital (to the extent of her stock basis) and then a capital gain. After this distribution, Cockatoo has no accumulated E & P remaining. When Christopher’s distribution is made, Cockatoo has $30,000 remaining in current E & P. Therefore, $30,000 of Christopher’s distribution is treated as a dividend with the balance ($170,000) being a return of capital (to the extent of his stock basis) and then a capital gain. After the distribution to Christopher, Cockatoo has no remaining current or accumulated E & P.

158. The $30,000 in current E & P is allocated on a pro rata basis to the two distributions made during the year; thus, $10,000 of current E & P is allocated to Jen ($30,000 × $30,000/$90,000) and $20,000 is allocated to Jason ($30,000 × $60,000/$90,000). Because accumulated E & P is allocated in chronological order, all of Mahogany’s $16,000 of accumulated E & P is allocated to Jen’s distribution. Therefore, the distribution to Jen is treated as a $26,000 dividend and a $4,000 reduction in stock basis. Jason’s distribution consists of a $20,000 dividend and a $40,000 reduction in stock basis. Because Jen sells her stock for $90,000 and her basis immediately after the distribution is $56,000 ($60,000 original basis – $4,000 recovery of capital), she has a $34,000 gain on the sale. 159. Because current E & P is allocated on a pro rata basis to distributions made during the year, one-half, or $125,000 ($250,000 × $260,000/$520,000), is allocated to the March 1 distribution and one-half ($125,000) is allocated to the October 1 distribution. The $200,000 of accumulated E & P is allocated chronologically. As a result, on March 1, Apple has $325,000 of dividend-paying capacity ($125,000 of current E & P and $200,000 of accumulated E & P). Therefore, the March 1 distribution is entirely treated as a dividend and Apple has $65,000 of accumulated E & P remaining after the distribution. On October 1, Apple has $190,000 of dividend-paying capacity ($125,000 of current E & P and $65,000 of accumulated E & P). So, of the $260,000 distribution, $190,000 is treated as a dividend and, as a 50% shareholder, Sarah’s share of this is $95,000. Thus, of the $130,000 received by Sarah, $95,000 is a dividend distributed from E & P ($62,500 current E & P + $32,500 accumulated E & P), and the remaining $35,000 is a nontaxable recovery of capital. Consequently, her stock basis is reduced to $75,000 ($110,000 – $35,000). 160. a. If the redemption qualifies for sale or exchange treatment, Tanya will have a long-term capital gain of $60,000 [$160,000 (amount realized) – $100,000 (stock basis)]. Her income tax liability on the $60,000 gain will be $9,000 ($60,000 × 15%). Powered by Cognero

Page 34

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation b.

If the redemption distribution of $160,000 does not qualify as a sale or exchange, it will be treated as dividend income and Tanya's tax liability will be $24,000 ($160,000 × 15%). (The entire $160,000 will be subject to tax at the 15% rate; Tanya will have no basis offset.)

161. a. Steve will have a long-term capital gain of $80,000 on the redemption [$140,000 (amount realized) – $60,000 (stock basis)]. Steve can offset the $30,000 capital loss carryover against the $80,000 of capital gain. His income tax liability on the remaining $50,000 gain will be $7,500 ($50,000 × 15%). b.

If the redemption distribution does not qualify for sale or exchange treatment, the entire $140,000 will be taxed as a dividend at 15%, producing a tax of $21,000. With no other capital gain transactions in the current year, Steve can deduct only $3,000 of the $30,000 capital loss carryover to offset his other (ordinary) income.

162. a. Marina owns 1,000 shares [800 shares directly and 200 shares indirectly from Velvet Partnership (400 shares × 50% partnership interest)]. The stock attribution rules do not apply to stock held by a corporation if the shareholder owns less than 50% of the stock in that corporation. Russell owns 700 shares [500 shares directly and 200 shares indirectly from Velvet Partnership (400 shares × 50% partnership interest)]. Velvet Partnership owns 1,700 shares (400 shares directly plus 800 shares indirectly from Marina plus 500 shares indirectly from Russell). Stock owned by a partner is deemed to be owned in full by a partnership. Yellow Corporation owns 300 shares in Hawk Corporation. There is no attribution to Yellow Corporation from Marina, a less than 50% shareholder. b.

Marina owns 1,180 shares [800 shares directly plus 200 shares indirectly from Velvet Partnership (400 shares × 50% partnership interest) plus 180 shares indirectly from Yellow Corporation (300 shares × 60% shareholder interest)]. Stock owned by a corporation is deemed to be owned proportionately by any shareholder owning 50% or more of the corporation’s stock.

163. The redemption satisfies the termination of a business test under the partial liquidation rules. As a result, the redemption is a partial liquidation as to Morgan but not as to Magpie Corporation. Section 302(b)(4) permits sale or exchange treatment only to noncorporate shareholders. Morgan has a long-term capital gain of $900,000 [$1,000,000 (one-half of the sales proceeds) – $100,000 (basis in shares redeemed)]. Magpie Corporation has dividend income of $1,000,000 (one-half of the sales proceeds), reduced by a dividends received deduction under § 243 of $650,000 (65% × $1,000,000) or a net increase in taxable income of $350,000. Magpie’s $125,000 basis in the redeemed shares is added to the basis in its remaining shares of Starling stock. Starling Corporation’s E & P will be decreased $1,500,000 {$500,000 [12.5% (percentage of shares outstanding redeemed from Morgan) × $4,000,000 (E & P as of the redemption date)], plus $1,000,000 (dividend distribution to Magpie Corporation)}. 164. A portion of the redemption qualifies under § 303 as a sale or exchange. The value of the stock in Orange Corporation exceeds 35% of the value of the adjusted gross estate [($8,200,000 ÷ $22,000,000) = 37.3%]. A redemption Powered by Cognero

Page 35

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation to pay death taxes applies to the extent of the sum of the death taxes and funeral and administration expenses, or $4,400,000. The estate’s basis in the shares redeemed under § 303 is $4,400,000 (stepped-up basis); thus, this portion of the redemption results in no gain or loss to the estate. The remainder of the distribution ($3,800,000) must be tested under the qualifying stock redemption provisions of § 302 for sale or exchange treatment. For purposes of § 302, the stock attribution rules of § 318 apply and the shares owned by Denise, the estate’s sole beneficiary, are deemed to be owned by the estate. As such, the estate owns (directly and indirectly) 100% of the Orange shares outstanding after the redemption and none of the § 302 provisions are satisfied. The $3,800,000 therefore is treated as a dividend distribution to the estate. The estate’s basis in the shares not qualifying for sale or exchange treatment ($3,800,000 stepped-up basis) attaches to the basis of Denise’s shares in Orange Corporation. 165. a. Veronica has a long-term capital gain of $337,500 [$390,000 (amount realized) – $52,500 (stock basis)]. The distribution qualifies as a disproportionate redemption under § 302(b)(2). Veronica has a 50% (1,000 shares ÷ 2,000 shares) ownership interest in Ivory Corporation before the redemption and a 39.4% (650 shares ÷ 1,650 postredemption shares) ownership interest after the redemption. Both the 50% and the 80% [i.e., 39.4% < 40% (80% × 50%)] tests are met. Veronica will have a basis of $390,000 in the land. b.

Ivory Corporation has a recognized capital gain of $210,000 [$390,000 (fair market value) – $180,000 (adjusted basis)] on the distribution of the land. Gains (but not losses) are recognized in nonliquidating distributions. In a qualifying stock redemption, E & P is reduced by no more than the ratable share of the E & P attributable to the stock redeemed; thus, Ivory reduces its E & P by $175,000 [$1,000,000 E & P × 17.5% (percentage of stock redeemed) (less than the redemption price of $390,000)].

166. Gold should recognize the loss as soon as possible and immediately thereafter make the cash distribution. For example, assume these two steps took place on January 2. Because current E & P is a deficit, accumulated E & P is brought up to date. At the time of the distribution, the combined E & P balance is zero [$2,000,000 (beginning balance in E & P) – $2,000,000 (existing deficit in current E & P)], and the entire $900,000 is a return of capital. Current deficits are allocated pro rata throughout the year unless the parties can provide otherwise. Here they can. 167. The salaries paid to Richard and Rita are vulnerable to constructive dividend treatment. Neither appears to earn their salary. Although they are not shareholders, their relationship to Antonio is enough of a tie-in to raise the unreasonable compensation issue. There is also a problem regarding the $300,000 salary payment to Antonio. Why is he receiving $180,000 more than Sandy when it appears they share equally in the operation of the corporation? Forsythia Corporation has not distributed a dividend for the past five years although it has substantial E & P. The IRS might be successful in contending that the entire salaries paid to Richard and Rita are unreasonable compensation and that $180,000 of the salary paid to Antonio is unreasonable. 168. A corporation could distribute property to a shareholder because a shareholder may want a particular piece of property held by the corporation. Another reason might be that the corporation has low cash reserves but still wants to make a distribution to its shareholders. The amount distributed to the shareholder is measured by the fair market value of the property on the date of distribution. Like cash, the portion of a property distribution covered by existing E & P is a dividend, and any excess is treated as a return of capital. If the market value of the property distributed exceeds the corporation’s E & P and the shareholder’s basis in the stock investment, a capital gain usually results. The amount distributed is reduced by any liabilities to which the distributed property is subject immediately before and immediately after the distribution and by any liabilities of the corporation assumed by the shareholder. The basis of the distributed property for the shareholder is the fair market value of the property on the date of the distribution. Powered by Cognero

Page 36

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation All distributions of appreciated property generate gain to the distributing corporation. In effect, a corporation that distributes gain property is treated as if it had sold the property to the shareholder for its fair market value. However, the distributing corporation does not recognize loss on the distributions of property. If the distributed property is subject to a liability in excess of basis or the shareholder assumes such a liability, a special rule applies. For purposes of determining gain on the distribution, the fair market value of the property is treated as not being less than the amount of the liability (and this deemed fair market value will also be the basis of the property in the shareholder's hands). Corporate distributions reduce E & P by the greater of the fair market value or the adjusted basis of property distributed, less the amount of any liability on the property. E & P is increased by gain recognized on appreciated property distributed as a property dividend. A property distribution cannot generate a deficit in E & P or add to a deficit in E & P. 169. Accumulated E & P is the total of all previous years’ current E & P (since February 28, 1913) reduced by distributions made from E & P in previous years. Current E & P is determined by making a series of adjustments to the corporation’s taxable income. Current E & P is determined at year-end and is not reduced by current year distributions. 170. Corporate distributions reduce E & P by the greater of the fair market value or the adjusted basis of property distributed less the amount of any liability on the property. E & P is also increased by the gain recognized on appreciated property distributed as a property dividend. However, reductions to E & P due to distributions cannot generate or add to an E & P deficit. 171. The determination of the basis differs, depending on whether the distribution of the stock rights is a taxable event. If the distribution of stock rights is taxable, then shareholders’ basis in the rights is equal to their fair market value. If the distribution of stock rights is not taxable and if their value is less than 15% of the value of the stock on which they are distributed, then the basis of the rights is zero. However, shareholders in this case can elect to have some of the basis in their stock allocated to the stock rights. If the fair market value of the stock rights is 15% or more of the value of the stock on which they are received, and the rights are exercised or sold, then shareholders are required to allocate some of the basis in their stock to the rights. When basis is allocated to stock rights, it is allocated based on the relative proportion of the value of the rights to the overall value of the stock and rights. 172. The double tax on dividends creates a number of distortions in the economy, including (1) an incentive to invest in noncorporate taxpayers rather than corporate taxpayers, (2) a preference by corporations to finance operations with debt rather than equity, and (3) a motivation for corporations to retain earnings and to structure distributions to avoid the double tax. Taken together, these distortions raise the cost of capital for corporate investments by causing reliance on debt financing. This increases the vulnerability of corporations during economic downturns. By taxing dividends at a lower rate, policy makers argue that the negative impacts of the double tax are mitigated. As a result, capital formation in the corporate sector should increase, stimulating the economy. Reducing the double tax through a lower tax rate on dividends should also make the United States more competitive internationally. 173. There would be a problem. Venture Corporation will have satisfied Christian’s obligation. Thus, the payment to the university may be treated as indirect compensation. In determining whether the corporation has paid Christian “unreasonable” compensation, both the direct payment (his salary) of $150,000 and the indirect payment to the university of $40,000 would be considered. If Christian had not made a pledge, the corporation could have established the scholarships on his behalf. 174. In general, earnings and profits (E & P) represents the dividend-paying capacity of a corporation (i.e., the upper limit on the amount of dividend income a shareholder must recognize on corporate distributions). It represents a corporation’s economic income (i.e., its “economic ability” to pay dividends) without impairing its capital. E & P is computed on an annual basis at the end of the tax year (without reduction for any distributions made during the year). The term “earning and profits” is not defined in the Internal Revenue Code. It is roughly analogous to—but different than—the financial accounting concept of retained earnings. Powered by Cognero

Page 37

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 175. In general, the following formula can be used to compute current E & P:

+ – +/– +/– =

Taxable income (computed at end of tax year) Additions to taxable income Subtractions from taxable income Timing adjustments Accounting method adjustments Current E & P

176. (1) Current E & P is applied first to distributions on a pro rata basis; then accumulated E & P is applied (as necessary) in chronological order beginning with the earliest distribution. (2) When a deficit exists in accumulated E & P and a positive balance exists in current E & P, distributions are regarded as dividends to the extent of the current E & P balance. Current and accumulated E & P are not netted. (3) When a deficit exists in current E & P and a positive balance exists in accumulated E & P, the two accounts are netted at the date of distribution. If the resulting balance is zero or a deficit, the distribution is treated as a return of capital, first reducing the basis of the stock to zero and generating taxable gain. If a positive balance results, the distribution is a dividend to the extent of the balance. Any loss in current E & P is deemed to accrue ratably throughout the year unless the corporation can show otherwise. (4) When a deficit exists in both current E & P and accumulated E & P, the distribution is treated as a return of capital, first reducing the basis of the stock to zero and then generating taxable gain. 177. Amounts distributed as dividends in the form of property rather than cash are measured by the fair market value of the property on the date of distribution. This amount is reduced by any liabilities associated with the property that are assumed by the shareholder. A shareholder’s basis in the distributed property is its fair market value on the distribution date. Under § 311(b), gain (but not loss) is recognized to a corporation that distributes property as a dividend. The distribution of appreciated property is treated as if the property were sold to the shareholder at its fair market value. If the property distributed is subject to a liability, or if the shareholder assumes a liability that exceeds the basis of the distributed property, the fair market value of the property will not be less than the amount of the liability (and this deemed fair market value will also be the basis of the property in the shareholder's hands). The distributing corporation’s E & P is increased by any gain recognized on the appreciated property distributed. The distributing corporation’s E & P is reduced by the greater of the fair market value or the adjusted basis of the property distributed less the amount of any liability on the property. 178. Constructive dividends generally occur in closely held corporations where dealings with shareholders are often informal. They result in an economic benefit to the shareholder from the corporation that are not labeled as a dividend. Constructive dividends have the same general Federal tax consequences as regular dividends. That is, the dividend is income to the shareholder but not deductible by the corporation. A number of different scenarios may lead to the determination that a constructive dividend has occurred. Amounts paid to a shareholder in excess of what the IRS considers reasonable may give rise to a constructive dividend. Personal shareholder expenses paid by the corporation without expectation of repayment can also be classified as constructive dividends to the shareholder in an amount equal to the fair market value of the benefit received. Depending upon the facts and circumstances of the transaction, the IRS may attempt to treat a shareholder advance that is not a bona fide loan (e.g., poor or nonexistent documentation) as a constructive dividend. Interest on shareholder loans with below-market interest rates can also constitute a constructive dividend. Likewise, if a corporation, without adequate consideration, assumes a debt or other legal obligation of a shareholder or makes payments on the debt, a constructive Powered by Cognero

Page 38

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation dividend may result. Use of corporate property by shareholders can also result in a constructive dividend. Typical situations include the use of corporate-owned autos, boats, airplanes, vacation homes, and other property if the shareholder does not repay the corporation for the use of this property at a fair rental value. In addition, the value of improvements made by the corporation to property leased from a shareholder that were in excess of normal lessee improvements (based on the type and value of the property and the term of the lease) can be a constructive dividend. Finally, bargain purchases of corporate property by a shareholder can also result in a constructive dividend to the extent the FMV of the property exceeds the purchase price. 179. No, noncorporate and corporate shareholders typically do not have the same preference for the tax treatment of a stock redemption. Noncorporate taxpayers generally prefer sale or exchange treatment (a qualifying stock redemption) over that of a dividend distribution. In a qualifying stock redemption, the shareholder is allowed to recover their redeemed stock basis tax-free. Also, the excess of the redemption distribution over the stock basis is (typically) a capital gain. If the shareholder has capital losses from other transactions, the capital gain resulting from a qualifying stock redemption can increase the shareholder’s deductibility of such capital losses. In a nonqualified stock redemption, the entire distribution is taxable as a dividend (assuming adequate E & P) that cannot be used to increase the utilization of capital losses. Corporate taxpayers, however, generally prefer dividend treatment (a nonqualified stock redemption) for a stock redemption. This preference stems from the availability of the dividends received deduction for such taxpayers. As a result of the dividends received deduction, only a nominal amount of any dividend resulting from a nonqualified stock redemption would be subject to tax. 180. In general, the § 318 stock attribution rules apply in determining a taxpayer’s ownership interest (direct and indirect) in a corporation before and after a stock redemption. The stock attribution rules do not apply in the case of partial liquidations or redemptions to pay death taxes. Further, the family attribution rules can be waived in the case of some complete termination redemptions (e.g., taxpayer has no prohibited interest for 10 years after redemption). Family attribution: An individual is deemed to own the stock owned by their spouse, children, grandchildren, and parents (not siblings or grandparents). Partnership attribution: A partner is deemed to own the stock owned by a partnership to the extent of the partner’s proportionate interest in the partnership. Stock owned by a partner is deemed to be owned in full by a partnership. Estate or trust attribution: A beneficiary or heir is deemed to own the stock owned by an estate or trust to the extent of the beneficiary or heir’s proportionate interest in the estate or trust. Stock owned by a beneficiary or heir is deemed to be owned in full by an estate or trust. Corporation attribution: Stock owned by a corporation is deemed to be owned proportionately by any shareholder owning 50% or more of the corporation’s stock. Stock owned by a shareholder who owns 50% or more of a corporation is deemed to be owned in full by the corporation. 181. To qualify as a not essentially equivalent redemption, the distribution must result in a meaningful reduction in the shareholder’s interest in the redeeming corporation. In determining whether a shareholder’s interest has been meaningfully reduced, the courts place greatest emphasis on the decrease in the shareholder’s voting control that results from the redemption. Other factors considered in the application of the meaningful reduction test include reductions in the shareholder’s rights to current and liquidating distributions. The stock attribution rules of § 318 apply for purposes of the meaningful reduction test. Powered by Cognero

Page 39

Name:

Class:

Date:

Chapter 19: Corporations Distributions Not In Complete Liquidation 182. To qualify as a disproportionate redemption, the stock redemption must satisfy the following requirements: (1) The shareholder’s ownership interest in the corporation after the redemption must be less than 80% of their ownership interest in the corporation before the redemption. (2) After the redemption, the shareholder must own less than 50% of the total combined voting power of all classes of stock entitled to vote. The stock attribution rules apply in determining a shareholder’s ownership interest before and after the redemption.

183. The principal advantage of a § 303 redemption to pay death taxes is that the stock attribution rules do not apply to such redemptions. Thus, a redemption to pay death taxes is most fortuitous when a redemption would not satisfy any of the other qualifying stock redemption provisions due to the attribution rules. Such would be the case when a corporation’s stock is owned entirely by the decedent’s estate and the beneficiaries of the estate. In such cases, a redemption of stock from the estate would not satisfy any of the § 302 qualifying stock redemptions because under that provision the estate is deemed to own the stock owned by the beneficiaries. However, since the stock attribution rules do not apply to a redemption to pay death taxes, sale or exchange treatment is available under § 303. While sale or exchange treatment under § 303 is limited to the sum of the death taxes and funeral and administration expenses, there is no requirement that the redemption proceeds be used for such expenditures or that the estate even require additional funds to pay such expenditures. An estate might have sufficient liquidity to meet the death-related expenses and still use a § 303 redemption to cash out some of its stock holdings at little or no tax consequence.

Powered by Cognero

Page 40

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations

Indicate whether the statement is true or false. 1. Legal dissolution under state law is required for a liquidation to be complete for tax purposes. a. True b. False 2. One similarity between the tax treatment accorded liquidating and nonliquidating distributions is with respect to a shareholder’s basis in property received in such distributions. For each type of distribution, the shareholder’s basis is the property’s fair market value on the date of distribution. a. True b. False 3. As a general rule, a liquidating corporation recognizes gains but not losses on the distribution of property in complete liquidation. a. True b. False 4. Liquidation expenses incurred by a corporation are generally deductible as § 162 trade or business expenses. a. True b. False 5. The related-party loss limitation applies to distributions to related parties and either the distribution is pro rata or the property distributed is disqualified property. a. True b. False 6. The built-in loss limitation in a complete liquidation does not apply to losses attributable to a decline in a property’s fair market value after its transfer to the corporation. a. True b. False 7. The related-party loss limitation in a complete liquidation applies only to distributions of property, while the built-in loss limitation can apply to a distribution or sale of property. a. True b. False 8. Pursuant to a liquidation, Coral Corporation distributes to Lucinda, a shareholder, land (basis of $90,000, fair market value of $200,000). The land is subject to a $75,000 liability. Lucinda will have a basis of $125,000 in the land. a. True b. False 9. Section 332 does not apply to a parent-subsidiary liquidation if the subsidiary corporation is insolvent on the date of the liquidation. a. True b. False 10. If a liquidation qualifies under § 332, any minority shareholder will recognize gain or loss equal to the difference Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations between the fair market value of assets received and the basis of the shareholder’s stock. a. True b. False 11. A subsidiary corporation is liquidated at a time when it is indebted to its parent corporation. The subsidiary corporation distributes property to the parent corporation in satisfaction of the indebtedness. If the liquidation is governed by § 332, neither the subsidiary nor the parent recognizes gain or loss on the transfer of property in satisfaction of indebtedness. a. True b. False 12. Brown Corporation purchased 85% of the stock of Green Corporation five years ago for $850,000. In the current year, Brown Corporation liquidates Green Corporation and acquires assets with a basis to Green Corporation of $700,000 (fair market value of $1,100,000). Brown Corporation will have a basis in the assets of $850,000, the same as Brown’s basis in its Green stock. a. True b. False 13. Sparrow Corporation purchased 90% of the stock of Warbler Corporation eight years ago for $1,000,000. In the current year, Sparrow liquidates Warbler and acquires assets with a basis to Warbler of $850,000 (fair market value of $1,200,000). Sparrow will have a basis in the assets of $850,000 (Warbler’s basis in the assets), and no recognized gain or loss. a. True b. False 14. A subsidiary is liquidated pursuant to § 332. The parent has held 100% of the stock in the subsidiary for the past 10 years. The subsidiary has a net operating loss carryover of $400,000. The net operating loss does not carry over to the parent. a. True b. False 15. If a parent corporation makes a § 338 election, the subsidiary corporation is treated as a new corporation as of the day following the qualified stock purchase date. a. True b. False 16. If a parent corporation makes a § 338 election, the subsidiary corporation recognizes gain but not loss on the deemed sale of its assets on the qualified stock purchase date. a. True b. False 17. If a parent corporation makes a § 338 election, the subsidiary corporation must be liquidated. a. True b. False 18. One advantage of acquiring a corporation via an asset purchase instead of a stock purchase is that an asset purchase avoids the transfer of the acquired corporation’s liabilities. Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations a. True b. False 19. A liquidation can occur for tax purposes even though the corporation has retained some assets to pay remaining debts and preserve legal status. a. True b. False 20. Gains and losses are recognized by the liquidating corporation on distributions to a minority shareholder in a § 332 liquidation. a. True b. False 21. Ruby Corporation has announced plans to liquidate. Bronze Corporation owns 85% of Ruby’s stock. If Bronze wants to avoid the nontaxable treatment associated with a § 332 liquidation (e.g., nonrecognition of loss), it could reduce its stock ownership in Ruby to below 80%. a. True b. False 22. Obtaining a favorable letter ruling from the IRS can ensure the desired tax treatment for parties contemplating a corporate reorganization. a. True b. False 23. For corporate restructurings, meeting the § 368 reorganization “Type” requirements is all that needs to be considered when planning the structure of the transaction. a. True b. False 24. For a corporate restructuring to qualify as a tax-free reorganization, the step transaction doctrine must apply. a. True b. False 25. The tax treatment of reorganizations almost parallels the Federal income tax treatment for like-kind exchanges. a. True b. False 26. In corporate reorganizations, if an acquiring corporation is using property other than stock or debt as consideration, it may recognize gains but not losses on the transaction. a. True b. False 27. The gain recognized by a shareholder in a corporate reorganization is based on the shareholder’s proportionate share of E & P. a. True b. False Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations 28. The gains that shareholders recognize as a part of a corporate reorganization may be treated as a dividend to the extent of the corporation’s E & P. a. True b. False 29. Target shareholders recognize gain or loss when they receive assets (boot) as well as stock in the acquiring corporation in a transaction meeting the § 368 requirements. a. True b. False 30. As debt holders do not own stock, they do not fall under the corporate reorganization rules. a. True b. False 31. The basis for the acquiring corporation in the target’s assets is increased by any gain recognized by the target. a. True b. False

Indicate the answer choice that best completes the statement or answers the question. 32. Pursuant to a complete liquidation, Lilac Corporation distributes the following assets to its unrelated shareholders: land held for three years as an investment (basis of $300,000, fair market value of $600,000), inventory (basis of $100,000, fair market value of $80,000), and marketable securities held for four years as an investment (basis of $200,000, fair market value of $240,000). What are the tax consequences to Lilac Corporation as a result of the liquidation? a. Lilac Corporation would recognize no gain or loss on the liquidation. b. Lilac Corporation would recognize a net capital gain of $320,000. c. Lilac Corporation would recognize a net capital gain of $340,000 and an ordinary loss of $20,000. d. Lilac Corporation would recognize a net capital gain of $340,000. 33. Pursuant to a complete liquidation, Oriole Corporation distributes to its shareholders land with a basis of $350,000 and a fair market value of $800,000. The land is subject to a liability of $920,000. What is Oriole’s recognized gain or loss on the distribution? a. $0 b. $120,000 loss c. $450,000 gain d. $570,000 gain 34. The stock in Rhea Corporation is owned by Jennifer (80%) and Lucy (20%), mother and daughter. In a liquidation of the corporation in the current year, Rhea distributes land that it purchased two years ago for $675,000 to Lucy. The property has a fair market value on the date of distribution of $450,000. One year later, Lucy sells the land for $400,000. What loss, if any, will Rhea Corporation recognize with respect to the distribution of land? a. $0 b. $45,000 c. $225,000 d. $275,000 Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations 35. The stock in Toucan Corporation is held equally by two brothers. Four years ago, the shareholders transferred property (basis of $200,000, fair market value of $220,000) to Toucan Corporation as a contribution to capital. In the current year and pursuant to a complete liquidation of Toucan, the property is distributed proportionately to the brothers. At the time of the distribution, the property had a fair market value of $40,000. What amount of loss will Toucan Corporation recognize on the distribution of the property? a. $0 b. $20,000 c. $160,000 d. $180,000 36. Magenta Corporation acquired land in a § 351 exchange one year ago. The land had a basis of $320,000 and a fair market value of $350,000 on the date of the transfer. Magenta Corporation has two shareholders, Mark (70%) and Megan (30%), who are brother and sister. Magenta Corporation adopts a plan of liquidation in the current year. On this date, the land has decreased in value to $250,000. Magenta Corporation sells the land for $250,000 and distributes the proceeds pro rata to Mark and Megan. What amount of loss may Magenta Corporation recognize on the sale of the land? a. $0 b. $21,000 c. $30,000 d. $70,000 37. Purple Corporation has two equal shareholders, Joshua and Ellie, who are father and daughter. One year ago, the two shareholders transferred properties to Purple in a § 351 exchange. Joshua transferred land (basis of $600,000, fair market value of $450,000) and securities (basis of $70,000, fair market value of $250,000), and Ellie transferred equipment (basis of $420,000, fair market value of $700,000). In the current year, Purple Corporation adopts a plan of liquidation, sells all of its assets, and distributes the proceeds pro rata to Joshua and Ellie. The only loss realized upon disposition of the properties was with respect to the land that had decreased in value to $310,000 and was sold for this amount. Purple never used the land for any business purpose during the time it was owned by the corporation. What amount of loss can Purple Corporation recognize on the sale of the land? a. $0 b. $140,000 c. $150,000 d. $290,000 38. Last year, Crow Corporation acquired land in a transaction that qualified under § 351. The land had a basis of $400,000 to the contributing shareholder and a fair market value of $310,000. Assume that the shareholder also transferred equipment (basis of $100,000, fair market value of $200,000) in the same § 351 exchange. In the current year, Crow Corporation adopted a plan of liquidation and distributed the land to Ali, a shareholder who owns 20% of the stock in Crow Corporation. The land’s fair market value was $230,000 on the date of the distribution to Ali. Crow Corporation acquired the land to use as security for a loan it had hoped to obtain from a local bank. In negotiating with the bank for a loan, the bank required the additional capital investment by Crow as a condition of its making a loan to Crow Corporation. How much loss can Crow Corporation recognize on the distribution of the land? a. $0 b. $80,000 c. $90,000 d. $170,000 39. During the current year, Ecru Corporation is liquidated and distributes its only asset, land, to Kena, the sole shareholder. On the date of distribution, the land has a basis of $250,000, a fair market value of $650,000, and is subject Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations to a liability of $500,000. Kena, who takes the land subject to the liability, has a basis of $120,000 in the Ecru stock. With respect to the distribution of the land, which of the following statements is correct? a. Kena recognizes a gain of $530,000. b. Ecru Corporation recognizes a gain of $250,000. c. Kena recognizes a gain of $30,000. d. Kena has a basis of $250,000 in the land. 40. In the current year, Dove Corporation (E & P of $1,000,000) distributes all of its property in a complete liquidation. Alexandra, a shareholder, receives land having a fair market value of $200,000. Dove Corporation had purchased the land as an investment three years ago for $125,000, and the land was distributed subject to a $100,000 liability. Alexandra took the land subject to the $100,000 liability. What is her basis in the land? a. $0 b. $100,000 c. $125,000 d. $200,000 41. Indigo corporation has a basis of $1,000,000 in the stock of Owl Corporation, a subsidiary in which it owns 100% of all classes of stock. Indigo purchased the stock in Owl 10 years ago. In the current year, Indigo liquidates Owl and acquires assets worth $1,200,000. At the time of its liquidation, Owl Corporation had a basis of $800,000 in the assets and E & P of $500,000. Which of the following statements is correct with respect to the liquidation? a. Owl recognizes a gain of $400,000. b. Indigo has an $800,000 basis in the assets. c. Owl’s E & P of $500,000 is eliminated. d. Indigo recognizes a gain of $200,000. 42. The stock of Lavender Corporation is held as follows: 80% by Jade Corporation (basis of $400,000) and 20% by Tiffany (basis of $100,000). Lavender Corporation is liquidated in December of the current year, pursuant to a plan adopted earlier in the year. Pursuant to the liquidation, Lavender Corporation distributed Asset A (basis of $600,000, fair market value of $900,000) to Jade, and Asset B (basis of $250,000, fair market value of $225,000) to Tiffany. No election is made under § 338. With respect to the liquidation of Lavender: a. Lavender recognizes a loss of $25,000 on the distribution of Asset B. b. Jade has a basis in Asset A of $900,000. c. Tiffany has a basis in Asset B of $225,000. d. Jade recognizes a gain of $500,000. 43. Penguin Corporation purchased bonds (basis of $190,000) of its 100% owned subsidiary, Finch Corporation, at a discount. Pursuant to a § 332 liquidation and in satisfaction of the indebtedness, Finch distributes land worth $200,000 (basis of $160,000) to Penguin. Which of the following statements is correct with respect to the distribution of land? a. Neither Finch nor Penguin recognize gain (or loss). b. Finch recognizes no gain and Penguin recognizes a gain of $10,000. c. Finch recognizes a gain of $40,000 and Penguin recognizes no gain. d. Finch recognizes a gain of $40,000 and Penguin recognizes a gain of $10,000. 44. Scarlet Corporation, the parent corporation, has a basis of $600,000 in the stock of Brown Corporation, a subsidiary in which Scarlet owns 90% of all classes of stock. Scarlet purchased the stock in Brown Corporation 10 years ago. In the current year, Scarlet Corporation liquidates Brown Corporation and acquires assets worth $800,000 and with a tax basis to Brown Corporation of $950,000. What basis will Scarlet Corporation have in the assets acquired from Brown Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations Corporation? a. $0 b. $600,000 c. $800,000 d. $950,000 45. The stock of Loon Corporation is held as follows: 85% by Duck Corporation and 15% by Gerald, an individual. Loon Corporation is liquidated in December of the current year pursuant to a plan adopted earlier in the year. Loon Corporation distributes land with a basis of $350,000 and fair market value of $390,000 to Gerald in liquidation of his stock interest. Gerald had a basis of $200,000 in his Loon stock. How much gain will Loon Corporation recognize in this liquidating distribution? a. $0 b. $40,000 c. $190,000 d. $390,000 46. During the current year, Goldfinch Corporation purchased 100% of the stock of Dove Corporation and made a qualified election under § 338. Which of the following statements is incorrect with respect to the § 338 election? a. Dove is treated as a new corporation as of the day following the qualified stock purchase date. b. Dove must be liquidated pursuant to the § 338 election. c. Dove is treated as having sold its assets on the qualified stock purchase date. d. Dove can recognize gain or loss as a result of the § 338 election. 47. Which of the following statements is correct with respect to the § 338 election? a. The subsidiary corporation makes the § 338 election. b. A qualified stock purchase occurs when a corporation acquires in a taxable transaction at least 80% of the stock (voting power and value) of another corporation within an 18-month period. c. The parent recognizes no gain (loss) as a result of the election. d. Gain but not loss is recognized by the subsidiary as a result of a deemed sale of its assets. 48. Pursuant to a complete liquidation, Rust Corporation distributes to its shareholders land with a basis of $150,000 and a fair market value of $400,000. The land is subject to a liability of $300,000. What is Rust’s recognized gain on the distribution? a. $0. b. $100,000. c. $150,000. d. $250,000. 49. Skylark Corporation owned 100% of the outstanding stock of Quail Corporation having purchased the stock six years ago for $200,000. Pursuant to a plan of liquidation adopted by Quail Corporation earlier in the current year, Quail distributed all its property to its shareholder. Quail Corporation had never been insolvent and had E & P of $700,000 on the date of liquidation. Pursuant to the liquidation, Quail distributes property worth $650,000 (basis of $340,000) to Skylark Corporation. How much gain must the parties recognize on the transfer of this property to Skylark? a. $0 as to both Skylark and Quail. b. $140,000 as to Skylark. c. $310,000 as to Quail. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations d. $450,000 as to Skylark. 50. Which of the following statements is true? a. The dollar amounts involved in reorganizations are generally substantial; thus, it is important that the financial and tax treatment of the reorganization be consistent. b. A letter ruling indicates the income tax treatment the IRS likely applies to the proposed corporate restructuring transaction. c. Careful planning can ensure that all gains recognized by individual shareholders receive beneficial dividend treatment. d. If boot is transferred in a reorganization qualifying under § 368, losses can be recognized. 51. All the following statements are true about corporate reorganization except: a. Taxable amounts for shareholders are classified as a dividend or capital gain. b. Reorganizations receive treatment similar to corporate formations under § 351. c. The transfers of stock to and from shareholders qualify for like-kind exchange treatment. d. The value of the stock received by the shareholder less the gain not recognized (postponed) will equal the shareholder’s basis in the stock received. 52. A shareholder bought 10,000 shares of Coral Corporation for $50,000 several years ago. When the stock is valued at $90,000, Coral redeems the shares in exchange for 5,000 shares of Blush Corporation stock and a $10,000 Blush bond. This transaction meets the requirements of § 368. Which of the following statements is false regarding this transaction? a. The shareholder has a realized gain of $40,000. b. The shareholder has a postponed gain of $30,000. c. The shareholder has a basis in the Blush stock of $60,000. d. The shareholder has a recognized gain of $10,000. 53. Bobcat Corporation redeems all of Zed’s 4,000 shares and distributes to him 2,000 shares of Van Corporation stock plus $50,000 cash. Zed’s basis in his 20% interest in Bobcat is $100,000 and the stock’s value is $250,000. At the time Bobcat is acquired by Van, the accumulated earnings and profits of Bobcat are $200,000 and of Van are $75,000. How does Zed treat this transaction for tax purposes? a. Zed recognizes no gain in this reorganization. b. Zed reports a $50,000 recognized dividend. c. Zed reports a $50,000 recognized capital gain. d. Zed reports a $40,000 recognized dividend and a $10,000 capital gain. 54. Mars Corporation merges into Jupiter Corporation by exchanging all of its assets for 300,000 shares of Jupiter stock valued at $2 per share and $100,000 cash. Wanda, the sole shareholder of Mars, surrenders her Mars stock (basis of $900,000) and receives all of the Jupiter stock transferred to Mars plus the $100,000. How does Wanda treat this transaction on her Federal income tax return? a. Wanda recognizes a $100,000 gain. Her Jupiter stock basis is $900,000. b. Wanda recognizes a loss of $100,000. Her Jupiter stock basis is $800,000. c. Wanda recognizes a $100,000 gain. Her Jupiter stock basis is $700,000. d. Wanda recognizes a loss of $0. Her Jupiter stock basis is $800,000. 55. Acquiring Corporation transfers $1 million of its voting common stock and $100,000 cash to Target Corporation in exchange for 90% of Target's assets. The assets retained by Target are used to settle its liabilities. Target then distributes Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations the Acquiring stock and cash received to its shareholders in exchange for all their Target shares, after which it liquidates. This restructuring is a: a. “Type A” reorganization. b. “Type B” reorganization. c. “Type C” reorganization. d. Taxable exchange.

56. The stock in Crimson Corporation is owned by Angel and Melawi, who are unrelated. Angel owns 60% and Melawi owns 40% of the stock. All of Crimson Corporation’s assets were acquired by purchase. The following assets are to be distributed in complete liquidation of Crimson Corporation:

Cash Inventory Equipment Land

Adjusted Basis $300,000 110,000 180,000 460,000

Fair Market Value $300,000 100,000 200,000 400,000

a.

What gain or loss, if any, would Crimson Corporation recognize if it distributes the cash, inventory, and equipment to Angel and the land to Melawi?

b.

What gain or loss, if any, would Crimson Corporation recognize if it distributes the equipment and land to Angel and the cash and inventory to Melawi?

57. Mary and Jane, unrelated taxpayers, own Gray Corporation’s stock equally. One year before the complete liquidation of Gray, Mary transfers land (basis of $200,000, fair market value of $130,000) to Gray Corporation as a contribution to capital. Assume that Mary also contributed other property in the same transaction having a basis of $20,000 and fair market value of $100,000. In liquidation, Gray distributes the land to Jane. At the time of the liquidation, the land is worth $110,000.

a. b.

How much loss, if any, may Gray Corporation recognize on the distribution of the land to Jane? Assume that the transfer of land to Gray Corporation was made so that the corporation could subdivide the land and build residential housing. However, a subsequent deterioration of the housing market forced Gray Corporation to abandon its plans. What amount of loss may Gray Corporation recognize on the distribution of the land to Jane?

58. The stock of Tan Corporation (E & P of $1,500,000) is owned as follows: 90% by Egret Corporation (basis of $900,000), and 10% by Zoe (basis of $70,000). Both shareholders acquired their shares in Tan more than six years ago. In the current year, Tan Corporation liquidates and distributes land (fair market value of $1,100,000, basis of $1,300,000) and equipment (fair market value of $700,000, basis of $410,000) to Egret Corporation, and securities (fair market value of $200,000, basis of $260,000) to Zoe. What are the tax consequences of these distributions to Egret, to Tan, and to Zoe? 59. On March 17, 2023, Blue Corporation purchased 10% of the Gold Corporation stock outstanding. Blue Corporation purchased an additional 40% of the stock in Gold on October 21, 2023, and an additional 25% on April 1, 2024. On July 22, 2024, Blue Corporation purchased the remaining 25% of Gold Corporation stock outstanding. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations

a.

For purposes of the § 338 election, on what date does a qualified stock purchase occur?

b.

What is the due date for making the § 338 election?

60. Cotinga Corporation is acquiring Petrel Corporation through a “Type C” reorganization by exchanging 20% of its voting stock and $50,000 for all of Petrel’s assets (value of $800,000 and basis of $600,000) and liabilities ($100,000). Jerrika owns 48% of Petrel (basis $270,000), and Allen owns the remaining 52% (basis $380,000). They exchange their stock in Petrel for their proportionate shares of the Cotinga stock and cash. What is the value of the Cotinga stock received by Jerrika and Allen? What are the amounts of gains/losses each recognizes due to the reorganization? What is Jerrika’s and Allen’s basis in the Cotinga stock? 61. Acquiring Corporation transfers $500,000 stock and land with a value of $400,000 (basis of $250,000) to Target for most of its assets. The assets not acquired in the “Type A” reorganization are distributed to Target’s shareholder, Tia. They are valued at $100,000 (basis of $120,000). Acquiring stock and the land also are distributed to Tia in exchange for her stock in Target. Tia’s basis in her stock is $650,000. What is the gain or loss recognized by Acquiring, Target, and Tia on this restructuring? What is Tia’s basis in the Acquiring stock? 62. Dipper Corporation is acquiring Bulbul Corporation by exchanging 220,000 shares of Dipper stock and $80,000 cash for all of Bulbul’s assets (valued at $500,000), liabilities ($200,000), and accumulated earnings and profits ($120,000). Betty purchased 40% of Bulbul five years ago for $60,000, and Keith purchased the remaining 60% for $90,000. What is the amount of the gain or loss (if any) that Betty and Keith recognize, assuming that the exchange qualifies as a § 368 reorganization? What is the basis in their new Dipper stock?

63. Do noncorporate and corporate shareholders typically have the same preference for the tax treatment of a stock redemption? Explain. 64. Explain the stock attribution rules that apply in the case of stock redemptions. 65. Explain whether shareholders are exempted from gain/loss recognition in nontaxable corporate reorganization or the gain/loss recognition is merely postponed. If it is postponed, how does the Federal income tax law ensure that the postponed gain/loss will be recognized in the future? 66. What will cause the corporations involved in a § 368 reorganization to recognize gain or loss? What will cause shareholders of the companies involved in the corporate reorganization to recognize gain or loss? If gain is recognized by shareholders, how might it be taxed?

Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations Answer Key 1. False 2. True 3. False 4. True 5. False 6. True 7. True 8. False 9. True 10. True 11. False 12. False 13. True 14. False 15. True 16. False 17. False 18. True 19. True 20. False 21. True 22. True 23. False 24. False 25. True Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations 26. True 27. False 28. True 29. False 30. False 31. True 32. c 33. d 34. a 35. a 36. d 37. b 38. d 39. c 40. d 41. b 42. c 43. b 44. d 45. b 46. b 47. c 48. d 49. a 50. b 51. c Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations 52. c 53. d 54. d 55. c 56. a. With respect to the distributions to Angel, Crimson Corporation will recognize a gain of $20,000 on the distribution of the equipment but not the loss of $10,000 on the distribution of the inventory. This is a distribution of loss property to a related party and the distribution is not pro rata; thus, the related-party loss limitation applies. With respect to the distribution of the land to Melawi, Crimson Corporation will recognize a loss of $60,000. Melawi is not a related party and the built-in loss limitation does not apply.

b.

With respect to the distributions to Angel, Crimson Corporation will recognize a gain of $20,000 on the distribution of the equipment but not the loss of $60,000 on the distribution of the land. Again, this is a distribution of loss property to a related party and the distribution is not pro rata. With respect to the distribution of the inventory to Melawi, Crimson Corporation will recognize a loss of $10,000. Melawi is not a related party and the built-in loss limitation does not apply.

57. a. Since the land was acquired by Gray Corporation as a contribution to capital within two years of liquidation, a tax avoidance purpose is assumed and the built-in loss limitation applies. As a result, Gray will recognize only $20,000 of the loss. This represents the amount of decline in value occurring after Gray acquired the property. The built-in loss of $70,000 [$130,000 (fair market value) – $200,000 (land basis)] existing at the time of transfer to Gray is disallowed. Since Jane does not own more than 50% of the Gray stock, the related-party loss limitation does not apply.

b.

Because there was a business purpose for the transfer of the property to Gray, all of the $90,000 loss realized [$110,000 (fair market value) – $200,000 (land basis)] on the distribution is recognized. Since Jane does not own more than 50% of the Gray stock, the related-party loss limitation does not apply.

Note that the § 362(e)(2) basis step-down rules for loss properties acquired in carryover basis transactions does not apply to the undeveloped land, as there was no net built-in loss on the two properties transferred by Mary. Section § 362(e)(2) is discussed in Chapter 4. 58. The liquidating distribution to Egret is governed by § 332, resulting in no recognized gain or loss to either Egret or Tan. Egret has a carryover basis in both the land ($1,300,000) and the equipment ($410,000), and the basis in its Tan stock disappears. Tan’s E & P and other tax attributes carry over to Egret as provided under § 381. In distributions from a subsidiary corporation to a minority shareholder pursuant to a § 332 parent-subsidiary liquidation, gains but not losses are recognized [§ 336(d)(3)]. Thus, in the case of Tan, the $60,000 loss realized [$200,000 (fair market value) – $260,000 (basis)] on the distribution of the securities to Zoe is not recognized. Zoe recognizes a long-term capital gain of $130,000 Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations [$200,000 (fair market value of securities) – $70,000 (basis in Tan stock)], and Zoe has a basis in the securities equal to their fair market value, or $200,000. 59. a.

b.

A qualified stock purchase occurs when one corporation acquires in a taxable transaction stock representing at least 80% of the total voting power and at least 80% of the value of another corporation within a 12-month period. For purposes of Blue Corporation, a qualified stock purchase occurs with the July 22, 2024 purchase [90% = 40% (October 21, 2023) + 25% (April 1, 2024) + 25% (July 22, 2024)]. The § 338 election must be made by the fifteenth day of the ninth month beginning after the month in which a qualified stock purchase occurs. Since Blue’s qualified stock purchase date is July 22, 2024, the election must be filed by April 15, 2025.

60. Value of Cotinga stock received: Jerrika $312,000; Allen $338,000. Jerrika has $24,000 recognized gain; Allen cannot recognize his loss. Basis in Cotinga stock: Jerrika $270,000; Allen $354,000. Total Cotinga stock exchanged $650,000 ($800,000 assets – $100,000 liabilities – $50,000). Jerrika receives $312,000 in Cotinga stock ($650,000 × 48%) and $24,000 cash for a total of $336,000. Allen receives $338,000 in Cotinga stock ($650,000 × 52%) and $26,000 cash for a total of $364,000. The gain recognized for Jerrika and Allen on the exchange and their basis in the Cotinga stock is computed as follows.

Jerrika

Allen

Realized Gain/Loss $ 336,000 (270,000) $ 66,000

Recognized Gain/Loss $24,000

Postponed Gain/Loss $ 66,000 (24,000) $ 42,000

Adjusted Basis in Cotinga Stock $312,000 (42,000) $270,000

$ 364,000 (380,000) ($ 16,000)

$

–0–

($16,000) (–0–) ($16,000)

$338,000 + 16,000 $354,000

61. Acquiring recognizes $150,000 gain on land; Target cannot recognize its loss on the assets; and Tia recognizes a $350,000 gain. Tia’s basis in her stock $500,000. Acquiring’s gain on the land is $400,000 value – $250,000 basis. While Target realizes a $20,000 loss on the assets ($100,000 value – $120,000 basis), loss recognition is disallowed. Tia receives $1 million for her Target stock ($500,000 Acquiring stock + $400,000 land + $100,000 assets), and her basis in the stock is $650,000. The gain recognized Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations by Tia is caused by the boot received ($400,000 land + $100,000 assets). Since Tia’s recognized gain cannot be greater than her realized gain, her gain is limited to $350,000. Thus, Tia’s stock basis is $500,000. Gain and basis amounts are computed as follows.

Tia

Realized

Recognized

Postponed

Gain $1,000,000 (650,000) $ 350,000

Gain $350,000

Gain $350,000 (350,000) $ –0–

Adjusted Basis in Acquiring Stock $500,000 (–0–) $500,000

62. Bulbul is worth $300,000 ($500,000 – $200,000). Betty receives $120,000 (40%) of this amount;

Keith receives $180,000.

Betty’s and Keith’s gains and stock basis are computed as follows.

Betty

Keith

Realized Gain $120,000 (60,000) $ 60,000

Recognized Gain $32,000

Postponed Gain $60,000 (32,000) $28,000

Adjusted Basis in Dipper Stock $ 88,000 (28,000) $ 60,000

$180,000 (90,000) $ 90,000

$48,000

$90,000 (48,000) $42,000

$132,000 (42,000) $ 90,000

63. No, noncorporate and corporate shareholders typically do not have the same preference for the tax treatment of a stock redemption. Noncorporate taxpayers generally prefer sale or exchange treatment (a qualifying stock redemption) over that of a dividend distribution. In a qualifying stock redemption, the shareholder is allowed to recover their redeemed stock basis tax-free. Also, the excess of the redemption distribution over the stock basis is (typically) a capital gain. If the shareholder has capital losses from other transactions, the capital gain resulting from a qualifying stock redemption can increase the shareholder’s deductibility of such capital losses. In a nonqualified stock redemption, the entire distribution is taxable as a dividend (assuming adequate E & P) that cannot be used to increase the utilization of capital losses. Corporate taxpayers, however, generally prefer dividend treatment (a nonqualified stock redemption) for a stock redemption. This preference stems from the availability of the dividends received deduction for such taxpayers. As a result of the dividends received deduction, only a nominal amount of any dividend resulting from a nonqualified stock redemption would be subject to tax. 64. In general, the § 318 stock attribution rules apply in determining a taxpayer’s ownership interest (direct and indirect) in a corporation before and after a stock redemption. The stock attribution rules do not apply in the case of partial liquidations or redemptions to pay death taxes. Further, the family attribution rules can be waived in the case of some complete termination redemptions (e.g., taxpayer has no prohibited interest for 10 years after redemption). Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 20: Corporations Distributions in Complete Liquidation & an Overview of Reorganizations Family attribution: An individual is deemed to own the stock owned by their spouse, children, grandchildren, and parents (not siblings or grandparents). Partnership attribution: A partner is deemed to own the stock owned by a partnership to the extent of the partner’s proportionate interest in the partnership. Stock owned by a partner is deemed to be owned in full by a partnership. Estate or trust attribution: A beneficiary or heir is deemed to own the stock owned by an estate or trust to the extent of the beneficiary or heir’s proportionate interest in the estate or trust. Stock owned by a beneficiary or heir is deemed to be owned in full by an estate or trust. Corporation attribution: Stock owned by a corporation is deemed to be owned proportionately by any shareholder owning 50% or more of the corporation’s stock. Stock owned by a shareholder who owns 50% or more of a corporation is deemed to be owned in full by the corporation. 65. In reorganizations, neither gain nor loss is recognized in the year of the deal by the shareholders as long as the corporations meet the legislative and judicial requirements for nontaxable treatment. However, this does not mean that the shareholders are exempted from taxation. Rather, the recognition of the gain/loss is merely postponed until there is a taxable transaction. The vehicle for postponing gain/loss that is not recognized is the basis in the new stock received. If no gain or loss is recognized, the basis in the new stock is carried over from the basis in the old stock. If gain is recognized because the shareholder received “boot,” the basis in the new stock is adjusted to account for the remaining gain realized but not recognized (postponed gain). The four-column template of Concept Summary 7.1 is useful for determining the consequences of a corporate reorganization. 66. Corporations involved in § 368 reorganizations are not permitted to recognize losses. The acquiring corporation can recognize gain if it transfers appreciated property (boot) along with its stock to the target. The target will recognize gain if it fails to distribute the boot to its shareholders. The target also can recognize gain if it distributes its own appreciated property to its shareholders. Shareholders recognize gains when they receive boot (nonstock property) in exchange for their stock in their corporation. Shareholders can recognize losses if they only receive boot and no stock. Shareholder recognized gain in a corporate reorganization may have the following tax characteristics. ∙ Dividend to the extent of the shareholder’s proportionate share of corporate earnings and profits (E & P). The remaining gain is capital gain. ∙ If the requirements of § 302(b) can be met, the transaction will qualify for stock redemption treatment, usually as a capital gain.

Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis True / False 1. A partnership is an association formed by two or more taxpayers (which may be any type of entity) to carry on a trade or business. a. True b. False 2. In a limited liability company, all members may participate in management (the operating agreement cannot limit participation), and all entity debts are treated as nonrecourse liabilities for purposes of allocating the LLC’s liabilities to basis. a. True b. False 3. In a limited liability company, all members are protected from the debts of the LLC unless they personally guaranteed the debt. a. True b. False 4. In a limited liability partnership, all members may participate in management and generally have personal liability for entity debts except for malpractice committed by the other partners. a. True b. False 5. A limited partnership (LP) offers all partners protection from claims by the LP’s creditors. a. True b. False 6. The primary purpose of the partnership agreement is to document the various tax elections made by the partners regarding items such as depreciation methods, treatment of research and experimental costs, and the § 754 election. a. True b. False 7. The taxable income of a partnership flows through to the partners, who report the income on their tax returns. a. True b. False 8. An example of the aggregate concept underlying partnership taxation is the fact that the partners (rather than the partnership) pay tax on partnership income. a. True b. False 9. An example of the aggregate concept of partnership taxation is that the partnership makes elections related to depreciation, tax credit calculations (except the foreign tax credit), and whether to claim a § 179 deduction. a. True b. False 10. The partnership agreement might provide, for example, that the first $40,000 of ordinary income is allocated to Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis Partner A. Allocating income in this manner is an example of a separately stated item. a. True b. False 11. A partner's profit-sharing, loss-sharing, and capital-sharing ownership percentages are the same. a. True b. False 12. The inside basis is defined as a partner’s basis in the partnership interest. a. True b. False 13. A partnership reports each partner’s share of income to the partner on a Form 1099-MISC. a. True b. False 14. Section 721 provides that, in general, no gain or loss is recognized by the partnership or the partner on contribution of appreciated or depreciated property to a partnership in exchange for an interest in the partnership. a. True b. False 15. Ken and Linh formed the equal KL Partnership during the current year; Ken contributes $100,000 in cash and Linh contributes land (basis of $60,000, fair market value of $40,000) and equipment (basis of $0, fair market value of $60,000). Linh recognizes a $40,000 gain on the contribution and her basis in her partnership interest is $100,000. a. True b. False 16. When Kevin and Marshall formed the equal KM LLC, the fair market values of their interests were each $100,000. Kevin contributed $60,000 cash, equipment with a basis of $0 and a fair market value of $10,000, and a small parcel of land in which he had a basis of $50,000 and that was valued at $30,000. Marshall contributed a cash basis account receivable that was valued at $100,000 and in which his basis was $0. Kevin has a basis in his partnership interest of $110,000 and Marshall’s basis is $0. a. True b. False 17. Morgan and Kristen formed an equal partnership on August 1 of the current year. Morgan contributed $60,000 cash and land with a basis of $18,000 and a fair market value of $40,000. Kristen contributed equipment with a basis of $42,000 and a value of $100,000. Kristen and Morgan both have a basis of $100,000 in their partnership interests. a. True b. False 18. Section 721 provides that no gain or loss is recognized on a contribution of property to a partnership in exchange for an interest in the partnership. An exception might apply if the taxpayer receives a cash distribution from the partnership soon after the property contribution is made. a. True Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis b. False 19. George received a fully vested 10% interest in partnership capital and a 20% interest in future partnership profits in exchange for services rendered to the GHP, LLC (not a publicly traded partnership interest). The future profits of the partnership are subject to normal operating risks. George will report ordinary income equal to the fair market value of the profits interest, but the capital interest will not be currently taxed to him. a. True b. False 20. Laura is a real estate developer and owns property that is treated as inventory (not a capital asset) in her business. She contributes a parcel of this land (basis of $15,000) to a partnership, also to be held as inventory. The fair market value of the property is $12,000 at the contribution date. After three years, the partnership sells the land for $10,000. The partnership will recognize a $5,000 ordinary loss on sale of the property. a. True b. False 21. If a partnership properly makes an election for treatment of a specific tax item, the partner is bound by that treatment. a. True b. False 22. JLK Partnership incurred $6,000 of organizational costs and $50,000 of startup costs. JKL may deduct $5,000 each of organizational and startup costs, and the remaining costs ($1,000 of organizational costs and $45,000 of startup costs) may be amortized over 60 months. a. True b. False 23. Syndication costs arise when partnership interests are being marketed to investors. These costs cannot be amortized or deducted on income tax returns. a. True b. False 24. The BMR LLC conducted activities that were eligible for a $20,000 credit for increasing research activities. In addition, the LLC paid foreign taxes of $1,200. On the partners’ Schedules K-1, BMR will allocate the $20,000 research credit, and it will provide the necessary information so the partners can calculate the foreign tax credit if they so choose. a. True b. False 25. Seven years ago, Pooja purchased residential rental estate that she has been depreciating as MACRS property over 27.5 years. This year, when her adjusted basis in the property was $250,000, she transferred the property to the newly formed PLA LLC in exchange for a one-third interest in it. PLA incurred $10,000 of transfer taxes and fees related to the property. The LLC must treat the $260,000 basis in the property, fees, and expenses, as new MACRS property depreciable over 27.5 years. a. True b. False 26. A partnership cannot use the cash method of accounting if one of its partners is a C corporation. a. True Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis b. False 27. Greene Partnership had average annual gross receipts for the past three years of $25,800,000. One of the partners is Jackson, Inc., a C corporation. Because Greene meets the average annual gross receipts test, it may use the cash method of accounting even though it has a partner that is a C corporation. a. True b. False 28. ABC, LLC is equally owned by three corporations. Two corporations have June 30 fiscal year-ends and the third is a calendar year taxpayer. ABC will use the least aggregate deferral method to determine its taxable year-end. a. True b. False 29. PaulCo, DavidCo, and Sean form a partnership with cash contributions of $80,000, $50,000, and $30,000, respectively, and agree to share profits and losses in the ratio of their original cash contributions. PaulCo uses a January 31 fiscal year-end, whereas DavidCo and Sean use a November 30 and December 31 year-end, respectively. The partnership must use the least aggregate deferral method to determine its year-end. a. True b. False 30. MNO Partnership has three equal partners. Moon, Inc. and Neptune, Inc. each have fiscal years ending March 31. Omega uses the calendar year. MNO's required taxable year-end is March 31 under the majority partner rule. a. True b. False 31. A partnership must provide any information to the partners that they would need to calculate deductions not permitted at the partnership level, such as for oil and gas depletion or the corporate dividends received deduction. a. True b. False 32. Items that are not required to be shown on the partners’ Schedules K-1 include AMT adjustments and preferences and taxes paid to foreign countries because any AMT and the foreign tax credit are calculated by the partnership. a. True b. False 33. The amount of a partnership’s income and loss from operating activities is combined with separately stated income and expenses to determine the partnership’s equivalent of taxable income. This amount is reconciled to book income on the partnership’s Schedule M-1 or Schedule M-3. a. True b. False 34. BRW Partnership reported gross income from operations of $60,000, interest income of $3,000, utilities expense of $20,000, and a charitable contribution of $6,000. On its Schedule K, the partnership reports ordinary business income of $40,000, separately stated interest income ($3,000), and charitable contributions ($6,000). a. True b. False Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 35. DDP Partnership reported gross income from operations of $125,000, a long-term capital gain of $5,000, a short-term capital loss of $2,000, and a charitable contribution of $5,000. On its Schedule K, the partnership reports ordinary business income of $120,000, and a net long-term capital gain of $3,000. a. True b. False 36. To meet the substantial economic effect tests, a partnership’s allocations of income and deductions to the partners are required to be proportionate to the partners’ percentage ownership of partnership capital. a. True b. False 37. Tom and William are equal partners in the TW Partnership. Just before TW liquidated, Tom’s § 704(b) book capital account balance was $50,000 and William’s § 704(b) book capital account balance was $30,000. To meet the substantial economic effect requirements, any liquidating cash distribution must be allocated in proportion to those ending capital account balances. a. True b. False 38. Blaine contributes property valued at $50,000 (basis of $40,000) in exchange for a 25% interest in the BIKE Partnership. If the property is later sold for $70,000, gain of $15,000 will be allocated to Blaine. a. True b. False 39. The RGBY LLC operating agreement provides that 50% of depreciation expense is allocated to Red, and all remaining income (including the remaining 50% of depreciation) is allocated equally among the four partners. Before guaranteed payments and depreciation, RGBY’s net income is $120,000 for the year. RGBY’s depreciation expense is $20,000, and it paid a guaranteed payment to Yellow of $8,000. Assume that all allocations and payments meet the substantial economic effect rules. After all deductions and special allocations are taken into account, Red is allocated net income of $15,500 from the partnership. a. True b. False 40. Nicholas, a one-third partner, received a guaranteed payment in the current year of $50,000. Partnership income before consideration of the guaranteed payment was $20,000. Assuming that no loss limitation rules apply, Nicholas reports a $10,000 ordinary loss from partnership operations and the $50,000 guaranteed payment as ordinary income. a. True b. False 41. Emma’s basis in her BBDE LLC interest is $60,000 at the beginning of the tax year. Her allocable share of LLC items are as follows: $20,000 of ordinary income, $2,000 tax-exempt interest income, and a $6,000 long-term capital gain. In addition, the LLC distributed $12,000 of cash to Emma during the year. Assuming that the LLC had no liabilities at the beginning or the end of the year, Emma’s ending basis in her LLC interest is $76,000. a. True b. False 42. Stella’s tax basis in her SAW Partnership interest is $200,000 including all adjustments at the beginning of the tax year. Her allocable share of partnership items is: ($120,000) of ordinary loss, $6,000 tax-exempt interest income, and a Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis $14,000 long-term capital gain. In addition, during the year, the LLC distributed $20,000 of cash to Stella. Also during the year, Stella’s share of partnership debt increased by $10,000. Stella’s ending basis in her LLC interest is $80,000. a. True b. False 43. Ashley purchased her partnership interest from Lindsey on the first day of the current year for $40,000 cash. The partnership had no liabilities at that time. Ashley received a $10,000 cash distribution from the partnership during the year, and her share of partnership income is $15,000. Her share of partnership liabilities on the last day of the partnership year is $20,000. Ashley’s outside basis for her partnership interest at the end of the year is $45,000. a. True b. False 44. Julie and Kate form an equal partnership during the current year. Julie contributes cash of $200,000, and Kate contributes property (adjusted basis of $90,000, fair market value of $260,000) subject to a nonrecourse liability of $60,000. As a result of these transactions, Kate has a basis in her partnership interest of $120,000. a. True b. False 45. Debt of a limited liability company is allocated among its members using the nonrecourse debt allocation rules unless an LLC member has personally guaranteed the debt. a. True b. False 46. Belinda owns a 30% profit and loss interest in the BOW LLC, and her basis in the interest is $30,000 excluding her share of the LLC’s liabilities. Belinda guarantees a $40,000 LLC debt. Remaining liabilities (not guaranteed by any of the LLC members) are $100,000. Belinda’s basis in the LLC is $100,000. a. True b. False 47. The sum of the partners’ ending tax basis amounts equals the partners’ ending tax basis capital account balances. These amounts are shown on the partnership's Schedule K. a. True b. False 48. Micah’s beginning tax basis capital account on his Schedule K-1 is $60,000. During the year, he is allocated $20,000 of partnership income, $8,000 of nondeductible expenses, and a $12,000 share of tax-exempt income. His Schedule K-1s show allocations of nonrecourse debt of $20,000 (last year) and $30,000 (this year). Micah’s ending tax basis capital account is $94,000. a. True b. False 49. If a partnership allocates losses to the partners, the partners first apply the passive loss limitations, then the basis limitation, and finally the at-risk limitations. If all three hurdles are met, a partner may deduct the loss. a. True b. False 50. Harry’s basis in his partnership interest was $10,000 at the beginning of the tax year. For the year, his share of the Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis partnership’s loss was $8,000, and he also received a distribution of $4,000. Harry can deduct an $8,000 loss, and he recognizes a gain of $2,000 on the distribution of cash in excess of his remaining basis. a. True b. False 51. Wei is a general partner in the WST partnership. During the current year, she receives a guaranteed payment of $10,000 for services she provides to the partnership, and her distributive share of partnership income is $30,000. Wei is required to pay self-employment tax on the $10,000 guaranteed payment but not on her distributive share of partnership income. a. True b. False 52. Maria owns a 60% interest in the KLM Partnership. Four years ago, her father gave her a parcel of land. The gift basis of the land to Maria is $60,000. In the current year, Maria still had not figured out how to use the land for her own personal or business use; consequently, she sold it to the partnership for $50,000. The partnership immediately started using the land as a parking lot for its employees. Maria may recognize her $10,000 loss on the sale. a. True b. False 53. Gina is a single taxpayer and an active partner in the GMA LLC. Gina’s Schedule K-1 reflects a $20,000 ordinary income share, $2,000 of interest income, and a $10,000 guaranteed payment for services. Gina’s self-employment income from other sources and modified adjusted gross income is about $300,000. With respect to the income from the LLC, Gina is subject to the 0.9% additional Medicare tax on $30,000 and the 3.8% net investment income tax of $2,000. a. True b. False 54. One of the disadvantages of the partnership form is that the partner’s share of the partnership’s taxable income is taxed to the partner even if it is not distributed. a. True b. False 55. The total tax burden on entity income is greater for a partner in a partnership (up to 37% for an individual partner) than on a shareholder in a corporation (21% for an individual shareholder), so partnerships are used only in special situations. a. True b. False 56. The qualified business income deduction is calculated at the partner level. The partnership reports information the partner needs to calculate the deduction, such as W-2 wages and the unadjusted basis of the partnership’s depreciable property. a. True b. False 57. The partner's ending tax basis capital account plus the partner's allocable share of liabilities (both amounts shown on Schedule K-1) will typically equal the partner's ending tax basis in the partnership. a. True Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis b. False Multiple Choice 58. Which of the following entity owners cannot participate in the management of an entity? a. A general partner in a general partnership. b. A member of a limited liability company. c. A partner in a limited liability partnership. d. A limited partner in a limited partnership. 59. Which one of the following statements is true regarding a partner’s personal liability for partnership debts? a. LLC members can never be liable for entity debts. b. In a limited partnership, all partners have limited liability for partnership debts. c. In a limited liability partnership, a partner might be subject to liability for other partners’ malpractice. d. In a general partnership, all partners are liable for entity debts. 60. Which one of the following statements regarding partnership taxation is incorrect? a. A partnership is liable for federal income taxes based upon its taxable income. b. Partnership income is comprised of ordinary partnership income or loss and separately stated items. c. A partnership is required to file a return with the IRS. d. A partner’s profit-sharing percentage may differ from the partner’s loss-sharing percentage. 61. Which of the following is a correct definition of a concept related to partnership taxation? a. The aggregate concept treats partners and partnerships as separate units and gives the partnership its own tax personality. b. A partner’s capital-sharing ratio is defined as the percentage of partnership assets (capital) that would be allocated to the partner upon liquidation of the partnership. c. The partnership’s outside basis is defined as the sum of each partner’s capital account balance. d. A special allocation is defined as an amount that could differently affect the tax liabilities of two or more partners. 62. Which one of the following is an example of a special allocation of partnership income? a. The partnership’s capital gains and losses are shown separately on Schedule K-1. b. Distributions from the partnership to the partner are shown on Schedule K-1 line 20. c. The partnership agreement provides that all charitable contributions will be allocated to a specific partner rather than the partner's 20% distributive share. d. The Schedule K-1 reports each partner’s share of the information they need to calculate the § 199A (qualified business income) deduction. 63. On January 1 of the current year, Anna and Jason form an equal partnership. Anna contributes $50,000 cash and a parcel of land (adjusted basis of $200,000; fair market value of $150,000) in exchange for her interest in the partnership. Jason contributes property (adjusted basis of $180,000; fair market value of $200,000) in exchange for his partnership interest. Which of the following statements is true concerning the income tax results of this partnership formation? a. Jason recognizes a $20,000 gain on his property transfer. b. Jason has a $200,000 tax basis for his partnership interest. Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis c. Anna has a $250,000 tax basis for her partnership interest. d. The partnership has a $150,000 adjusted basis in the land contributed by Anna. 64. Tim, Al, and Pat contributed assets to form the equal TAP Partnership. Tim contributed cash of $40,000 and land with a basis of $80,000 (fair market value of $60,000). Al contributed cash of $60,000 and land with a basis of $50,000 (fair market value of $40,000). Pat contributed cash of $60,000 and a fully depreciated property ($0 basis) valued at $40,000. Which of the following tax treatments is not correct? a. Tim’s basis in his partnership interest is $120,000. b. Al realizes and recognizes a loss of $10,000. c. Pat realizes a gain of $40,000 but recognizes $0 gain. d. TAP has a basis of $80,000, $50,000, and $0 in the land and property (excluding cash) contributed by Tim, Al, and Pat, respectively. 65. Xena and Xavier form the XX LLC. Xena contributes cash of $20,000, land (basis = $40,000; fair market value = $25,000), equipment (basis = $0; fair market value = $35,000), and inventory (basis = $30,000; fair market value = $40,000). Xavier contributed $120,000 of cash. How much is the partnership’s basis in the land, equipment, and inventory, and how much is Xena’s basis in the partnership interest? a. $25,000 land, $0 equipment, $30,000 inventory; $55,000 partnership interest. b. $40,000 land, $0 equipment, $30,000 inventory; $90,000 partnership interest. c. $25,000 land, $35,000 equipment, $30,000 inventory; $105,000 partnership interest. d. $40,000 land, $35,000 equipment, $40,000 inventory; $135,000 partnership interest. 66. In which of the following independent situations is the transaction most likely to be characterized as a disguised sale? a. Partner George contributes appreciated property to the GM Partnership, and three years later GM distributes $100,000 proportionately to the partners. b. Brianna contributes property with a basis of $20,000 and a fair market value of $50,000 to the BGB Partnership in exchange for a 20% interest therein. The partnership agrees to distribute $20,000 to Brianna in 15 months if partnership cash flows from operations exceed $100,000 at that time. The partnership does not expect to produce operating cash flows of over $100,000 for at least five years. c. Luis contributes appreciated property to the BLP Partnership. Thirty months later, he receives a distribution from the partnership of $15,000 cash. None of the other partners received a distribution. There was no agreement that BLP would make the distribution, and Luis would have made the contribution whether or not the partnership made the distribution. d. Partner Skylar contributes appreciated property to the equally-owned four-member SANE LLC in exchange for a 25% interest. After 20 months, the LLC distributes $10,000 to partners Azariah, Nikita, and Eastyn, and $50,000 to Skylar. 67. Tara and Robert formed the TR Partnership four years ago. Because they decided the company needed some expertise in multimedia presentations, they offered Katie a one-third interest in partnership capital if she would come to work for the partnership. On July 1 of the current year, the unrestricted partnership interest (fair market value of $25,000) was transferred to Katie. How should Katie treat the receipt of the partnership interest in the current year? a. Nontaxable. b. Carried interest. c. $25,000 ordinary income. d. $25,000 long-term capital gain. 68. Which of the following would be currently taxable as ordinary income to the service partner if received in exchange Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis for services performed for the partnership? (In all cases, assume that the interest is not sold within two years after the time it is granted to the service partner.) a. A 10% interest in the capital of the partnership that will vest if the partner remains in the partnership for three years. b. A 20% interest in the future profits of the partnership received in exchange for future services to be performed for the partnership. c. A 25% interest in the capital of the partnership when there are no restrictions on transferability of the interest. d. A 30% interest in the capital of the partnership when the partner contributes intangible property with a $0 basis that the partner developed. 69. Which of the following is an election or calculation made by the partner rather than the partnership? a. Calculation of a § 199A (qualified business income) deduction amount. b. Tax treatment (e.g., credit, amortization) of research and experimental costs. c. The partnership’s accounting method (e.g., cash, accrual). d. Claiming a § 179 deduction related to property acquired by the partnership. 70. Which of the following statements is always correct regarding assets acquired by a newly formed partnership? If a partner contributes: a. Depreciable property: The partnership treats the property as newly acquired depreciable property and may claim a § 179 deduction. b. Unrealized (cash-basis) receivables: The partnership will report a capital gain when the receivable is collected. c. Inventory (in the partner’s hands): The partnership reports ordinary income if the property is held as a capital asset and sold within five years of the contribution date. d. Land valued at less than its basis: The partnership reports a § 1231 (ordinary) loss if the property is sold at a loss within five years of the contribution date. 71. The partner (rather than the partnership) will make which of the following elections? a. To claim straight-line depreciation. b. To claim a credit or deduction for foreign taxes paid. c. To claim a low-income housing credit. d. To claim a § 179 deduction for certain property placed in service during the year. 72. Which of the following statements is always true regarding accounting methods available to a partnership? a. If a partnership is a tax shelter, it can use the cash method of accounting. b. If a nontax-shelter partnership had average annual gross receipts of less than $30,000,000 (2024) for the last three tax years, it can use the cash method. c. If a partnership has a partner that is a personal service corporation, it cannot use the cash method. d. If a partnership has a partner that is a C corporation, it cannot use the cash method. 73. ACME Partnership, a consulting firm, has had the following gross receipts since its formation: $22,800,000 in year 1, $28,600,000 in year 2, $39,800,000 in year 3, and $41,700,000 in year 4. ACME is not a tax shelter. Assume the gross receipts threshold for Year 3 is $29,000,000 and Year 4 is $30,000,000. In which tax years must ACME start using the accrual method? a. Year 3 if none of the partners is a C corporation. b. Year 4 if none of the partners is a C corporation. c. Year 3 if one of the partners is a C corporation. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis d. Year 4 if one of the partners is a C corporation. 74. Fern, Inc., Ivy, Inc., and Jeremy formed a general partnership. Fern owns a 50% interest, and Ivy and Jeremy both own 25% interests. Fern, Inc., files its tax return on an October 31 year-end; Ivy, Inc., files with a May 31 year-end, and Jeremy is a calendar year taxpayer. Which of the following statements is true regarding the taxable year the partnership can choose? a. The partnership must choose the calendar year because it has no principal partners. b. The partnership must choose an October year-end because Fern, Inc., is a principal partner. c. The partnership can request permission from the IRS to use a January 31 fiscal year under § 444. d. The partnership must use the least aggregate deferral method to determine its required taxable year. 75. SQRLY LLC has about 25 LLC members. SwanCo (30% owner) and QuinnCo (16% owner) both have June 30 tax year-ends. Royce, Inc.; Larry, Inc.; and Yolanda, Inc. each own 4% (12% total) and have September 30 taxable year-ends. Each of the other LLC members (42% total) owns interests of 4% or less and use the calendar year (December 31). Which of the following statements is true regarding the LLC’s required taxable year end? a. The taxable year is determined under the least aggregate deferral rule. b. The taxable year is determined under the majority interest rule because a majority of members have the same year-end. c. The taxable year is determined under the principal partner rule because the 5% owners (SwanCo and QuinnCo) have the same taxable year. d. The taxable year ends on December 31 because more LLC members use a calendar year than any other year. 76. In the current year, the POD Partnership received revenues of $200,000 and paid the following amounts: $50,000 in rent and utilities and $20,000 as a distribution to partner Olivia. In addition, the partnership earned $6,000 of long-term capital gains during the year. Partner Donald owns a 50% interest in the partnership. How much income must Donald report for the tax year? a. $68,000 ordinary income. b. $78,000 ordinary income. c. $65,000 ordinary income; $3,000 of long-term capital gains. d. $75,000 ordinary income; $3,000 of long-term capital gains. 77. DIP LLC reports ordinary income (before guaranteed payments) of $120,000, rent expense of $40,000, and interest income of $4,000 for the year. In addition, DIP paid guaranteed payments of $20,000 to partner Percy. If Percy owns a 40% capital and profits interest, how much income will he report for the year and what is its character? a. $24,000 ordinary income. b. $24,000 ordinary income, $1,600 interest income, $20,000 guaranteed payment. c. $32,000 ordinary income, $1,600 interest income. d. $32,000 ordinary income, $1,600 interest income, $20,000 guaranteed payment. 78. Kristie is a 30% partner in the KKM Partnership. During the current year, KKM reported gross receipts of $280,000 and a charitable contribution of $30,000. The partnership paid office expenses of $80,000. In addition, KKM distributed $20,000 each to partners Kaylyn and Megan, and paid partner Kaylyn $20,000 for administrative services. Kristie reports the following income from KKM during the current tax year. a. $54,000 ordinary income; $9,000 charitable contribution. b. $60,000 ordinary income; $9,000 charitable contribution. c. $33,000 ordinary income. Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis d. $54,000 ordinary income. 79. Which of the following is not shown on the partnership’s Schedule K of Form 1065? a. The partnership’s self-employment income. b. The partnership’s separately stated income and deductions. c. The partnership’s tax preference and adjustment items. d. The partnership’s net operating loss carryforward. 80. Concerning a partnership’s Form 1065, which of the following statements is not true? a. The partnership reconciles its "Income (Loss) per Books" with "Income (Loss) per Return" on Schedule M-1 or M-3. b. The partnership balance sheet on Schedule L can be presented on a financial (book) basis. c. All taxable/deductible partnership income and expense items are reported on Form 1065, page 1. d. The partnership’s equivalent of taxable income is reported in the “Analysis of Income (Loss).” 81. ABC LLC reported the following items on the LLC’s Schedule K: ordinary income, $100,000; interest income, $3,000; long-term capital loss, ($4,000); charitable contributions, $1,000; AMT depreciation adjustment, $10,000; and cash distributions to partners, $50,000. How much will ABC show as net income (loss) on its Analysis of Income (Loss)? a. $68,000 b. $78,000 c. $95,000 d. $98,000 82. Which of the following is not a requirement of the substantial economic effect test? a. Income, gains, losses, and deductions must be allocated to the partners in accordance with their capital contributions. b. An allocation of income must increase the partner’s § 704(b) book capital account balance, and an allocation of deduction must decrease the partner’s § 704(b) book capital account balance. c. A partner with a negative § 704(b) book capital account balance must restore that capital account, generally by contributing cash to the partnership. d. On liquidation of the partner’s interest in the partnership, the partner must receive assets that have a fair market value equal to that partner’s (positive) § 704(b) book capital account balance. 83. Which of the following allocations is most likely to meet the substantial test in the substantial economic effect rules? (Assume all economic effect tests are met.) a. The ROY LLC specially allocates $20,000 of income each year to partner Red with no offsetting loss allocations in other years. b. The YGB LLC specially allocates $30,000 of ordinary income this year to partner Green with an offsetting allocation of loss in that same amount next year. c. The BPV LLC specially allocates $10,000 of capital gains to Violet and $10,000 of interest income to Purple because Purple is in a lower tax bracket. d. The PIR LLC specially allocates $60,000 of income to Indigo with no offsetting allocations. Indigo has expiring net operating losses. 84. Brooke and John formed a partnership. Brooke received a 40% interest in partnership capital and profits in exchange for contributing land (basis of $30,000 and fair market value of $120,000). John received a 60% interest in partnership Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis capital and profits in exchange for contributing $180,000 of cash. Three years after the contribution date, the land contributed by Brooke is sold by the partnership to a third party for $150,000. How much taxable gain will Brooke recognize from the sale? a. $102,000 b. $90,000 c. $48,000 d. $36,000 85. Mark and Addison formed a partnership. Mark received a 25% interest in partnership capital and profits in exchange for land with a basis of $40,000 and a fair market value of $60,000. Addison received a 75% interest in partnership capital and profits in exchange for $180,000 of cash. Three years after the contribution date, the land contributed by Mark is sold by the partnership to a third party for $76,000. How much taxable gain will Mark recognize from the sale? a. $0 b. $9,000 c. $16,000 d. $24,000 86. Molly is a 30% partner in the MAP Partnership. During the current tax year, the partnership reported ordinary income of $200,000 before any permitted deduction for guaranteed payments and distributions to partners. The partnership made an ordinary cash distribution of $20,000 to Molly and made guaranteed payments to partners Molly, Amber, and Pat of $20,000 each ($60,000 total guaranteed payments). How much will Molly’s adjusted gross income increase as a result of these items? a. $36,000 b. $42,000 c. $60,000 d. $62,000 87. Stephanie is a calendar year cash basis taxpayer. She owns a 50% profit and loss interest in a cash basis partnership with a September 30 year-end. The partnership’s operating income (after deducting guaranteed payments) was $120,000 ($10,000 per month) and $144,000 ($12,000 per month), respectively, for the partnership tax years ended September 30, 2024 and 2025. The partnership paid guaranteed payments to Stephanie of $2,000 and $3,000 per month during the fiscal years ended September 30, 2024 and 2025. How much will Stephanie’s adjusted gross income be increased by these partnership items for her tax year ended December 31, 2024? a. $60,000 b. $72,000 c. $84,000 d. $90,000 88. Ryan is a 25% partner in the ROCC Partnership. At the beginning of the tax year, his basis in the partnership interest was $90,000, including his share of partnership liabilities. During the current year, ROCC reported net ordinary income of $100,000. In addition, ROCC distributed $10,000 to each of the partners ($40,000 total). At the end of the year, Ryan’s share of partnership liabilities increased by $10,000. His basis in the partnership interest at the end of the year is: a. $90,000. b. $100,000. c. $115,000. d. $125,000. Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 89. Brad is a 40% member in the BB LLC. At the beginning of the tax year, his tax basis capital account showed a balance of $120,000. In this case, his capital account equals his tax basis in the LLC interest excluding his share of the LLC’s debts. His prior year-end Schedule K-1 showed recourse debt (guaranteed by Brad) and nonrecourse debt of $10,000 and $20,000, respectively. During the current year, BB reported net ordinary income of $200,000 and nondeductible expenses of $2,000. There were no distributions during the year. At the end of the year, Brad’s Schedule K-1 showed recourse (guaranteed) and nonrecourse debt of $20,000 and $30,000, respectively. How much is Brad’s basis in the LLC interest at the end of the year? a. $199,200. b. $200,000. c. $249,200. d. $250,000. 90. Allison is a 40% partner in the BAM Partnership. At the beginning of the tax year, her basis in the partnership interest was $100,000, including her share of partnership liabilities. During the current year, BAM reported an ordinary loss of $60,000 (before the following payments to the partners). In addition, BAM made an ordinary distribution of $8,000 to Allison and paid partner Brian a $20,000 consulting fee. At the end of the year, Allison’s share of partnership liabilities decreased by $10,000. Assuming loss limitation rules do not apply, Allison’s basis in the partnership interest at the end of the year is: a. $2,000. b. $50,000. c. $58,000. d. $70,000. 91. Binita contributed property with a basis of $40,000 and a value of $50,000 to the BE Partnership in exchange for a 20% interest in partnership capital and profits. During the first year of partnership operations, BE had net taxable income of $30,000 and tax-exempt interest income of $10,000. The partnership distributed $10,000 cash to Binita. Her adjusted basis (outside basis) for her partnership interest at year-end is: a. $36,000. b. $38,000. c. $60,000. d. $70,000. 92. At the beginning of the year, Heather’s tax basis capital account balance in the HEP Partnership was $85,000. During the tax year, Heather contributed property with a basis of $6,000 and a fair market value of $10,000. Her share of the partnership’s ordinary income and separately stated income and deduction items was $40,000. At the end of the year, the partnership distributed $15,000 of cash to Heather. In addition, the partnership allocated $12,000 of recourse debt and $10,000 of nonrecourse debt to Heather. What is Heather’s ending capital account balance determined using the tax basis method? a. $116,000 b. $120,000 c. $126,000 d. $128,000 93. At the beginning of the year, Ryan’s tax basis capital account balance in the RUS Partnership (in which he owned a 40% interest) was $200,000. During the year, Ryan contributed cash ($40,000) and property (basis = $20,000, fair market value = $30,000). RUS reported ordinary income of $100,000 and tax-exempt income of $6,000. At the end of the year, the partnership distributed $6,000 of cash to Ryan. On the Schedule K-1, the partnership shows that Ryan had a $50,000 Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis share of nonrecourse LLC debt at the end of the year. How much is Ryan’s ending tax basis capital account balance? a. $294,000. b. $296,400. c. $306,400. d. $346,400. 94. Misty and John formed the MJ Partnership. Misty contributed $50,000 of cash in exchange for her 50% interest in the partnership capital and profits. During the first year of partnership operations, the following events occurred: the partnership had a net taxable income of $20,000; Misty received a distribution of $12,000 cash from the partnership; and Misty had a 50% share in the partnership’s $60,000 of recourse liabilities on the last day of the partnership year. Misty’s adjusted basis for her partnership interest at year end is: a. $48,000. b. $60,000. c. $78,000. d. $88,000. 95. Which of the following statements is correct regarding the manner in which partnership liabilities are reflected in the partners’ bases in their partnership interests? a. Nonrecourse debt is allocated to the partners based on the partners' economic risk of loss. b. Recourse debt is allocated to the partners according to their profit-sharing ratios. c. An increase in partnership debts results in a decrease in the partners’ bases in the partnership interest. d. A decrease in partnership debt is treated as a distribution from the partnership to the partner and reduces the partner’s basis in the partnership interest. 96. AmCo and BamCo form the AB General Partnership at the start of the current year with a land contribution by BamCo and a cash contribution by AmCo. BamCo’s contributed property is subject to a recourse mortgage assumed by the partnership. BamCo has an 80% interest in AB’s profits and losses. The land has been held by BamCo for the past 6 years as an investment. It will be used by AB as an operating asset in its parking lot business. Which of the following statements is correct? a. Immediately after formation, AmCo’s basis in the partnership equals the cash that it contributed. b. Immediately after formation, AmCo’s basis in the partnership equals the cash that it contributed plus AmCo's share of the recourse debt contributed by BamCo. c. Because the debt is recourse, it can be allocated only to the general partners if one of them personally guarantees the debt. d. AB’s basis in the land contributed by BamCo equals BamCo’s basis in the land immediately before the contribution date, less the amount of the recourse debt assumed by the partnership. 97. Sharon contributed property to the newly formed QRST Partnership. The property had a $100,000 adjusted basis to Sharon and a $160,000 fair market value on the contribution date. The property was also encumbered by a $90,000 nonrecourse debt, which was transferred to the partnership on that date. Sharon is treated as a general partner. She is allocated 30% of QRST's profits and 20% of QRST's losses. Sharon's basis in the partnership interest after the formation transaction is: a. $28,000. b. $37,000. c. $88,000. d. $127,000. Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 98. Which of the following is not a specific adjustment to the partners’ basis in the partnership interest? a. Increased by contributions the partner made to the partnership. b. Decreased by the amount of guaranteed payments shown on the partner’s Schedule K-1. c. Increased by the partner’s share of tax-exempt income. d. Decreased by any decrease in the partner’s share of partnership liabilities. 99. Rebecca is a limited partner in the RST Partnership, which is not publicly traded. Her allocable share of RST’s passive ordinary losses from a nonrealty activity for the current year is ($60,000). Rebecca has a $40,000 adjusted basis (outside basis) for her interest in RST (before deduction of any of the passive losses). Her amount “at risk” is $30,000 (before deduction of any of the passive losses). She also has $25,000 of passive income from other sources. She has no business losses for the year from other sources. How much of her ($60,000) allocable RST loss can Rebecca deduct on her currentyear tax return? a. $25,000 b. $30,000 c. $40,000 d. $60,000 100. At the beginning of the tax year, Zach’s basis for his partnership interest and his amount at risk in the partnership was $30,000. His share of partnership items for the year consisted of tax-exempt interest income of $2,000 and an ordinary loss of $44,000. He also received a distribution of $20,000 cash from the partnership during the year. He is an active general partner and has no passive income or business losses from other sources. For the tax year, Zach will report: a. A nontaxable distribution of $20,000, an ordinary loss of $10,000, and a suspended loss carryforward of $34,000. b. An ordinary loss of $32,000, a suspended loss carryforward of $12,000, and a taxable distribution of $20,000. c. A nontaxable distribution of $20,000, an ordinary loss of $12,000, and a suspended loss carryforward of $32,000. d. An ordinary loss of $44,000 and a nontaxable distribution of $20,000. 101. Meredith is a passive 30% member of the MNO LLC. She is not a managing member and she does not participate in any activities of the LLC. Her interest is more in the nature of an investment. In the current year, Meredith’s distributive share of income from the LLC was $50,000. In addition, she received a guaranteed payment of $40,000 for the use of her capital. Assume that her income from other sources exceeds $500,000. How much of Meredith’s LLC income will be subject to the self-employment (SE) tax and the net investment income (NII) tax? (Disregard the additional Medicare tax on upper-income taxpayers.) a. $0 SE tax; $0 NII tax. b. $0 SE tax; $40,000 NII tax. c. $0 SE tax; $90,000 NII tax. d. $50,000 SE tax; $40,000 NII tax. 102. Paul sells one parcel of land (basis of $100,000) for its fair market value of $160,000 to a partnership in which he owns a 60% capital interest. Paul held the land for investment purposes. The partnership is in the real estate development business and will build residential housing (for sale to customers) on the land (the land is inventory to the partnership). Paul will recognize: a. $0 gain or loss. b. $36,000 ordinary income. c. $36,000 capital gain. d. $60,000 ordinary income. Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 103. Samuel is the managing general partner of STU in which he owns a 25% interest. For the year, STU reported ordinary income of $400,000 (after deducting all guaranteed payments). In addition, the LLC reported interest income of $12,000. Samuel received a guaranteed payment of $120,000 for services he performed for STU. How much income from self-employment did Samuel earn from STU? a. $100,000 b. $120,000 c. $220,000 d. $223,000 104. Which of the following is not a correct statement regarding the advantages of the partnership entity form over the C corporation form? a. A partnership typically has easier administrative and filing requirements than does a C corporation. b. Partnership income is subject to a single level of taxation; corporate income is double taxed. c. Partnerships may specially allocate income and expenses among the partners provided the substantial economic effect requirements are met; corporate dividends must be proportionate to shareholdings. d. Partners in a general partnership have less personal liability for entity claims than shareholders of a C corporation. 105. Which of the following statements is correct regarding potential partnership or C corporation taxes? a. Partnership income is always taxed at higher rates than for a Subchapter C corporation because the individual tax rates are higher than corporate tax rates. b. Partners pay a single tax on their distributive shares of income at the tax rate that applies to the partner. c. C corporations pay a single level of tax on corporate income at rates up to 35%. d. Partnership income is preferred because the income is not subject to employment taxes and the income might be eligible for the qualified business income deduction. Matching Match each of the following statements with the numbered terms below that provide the best definition. a. Organizational choice of many large accounting firms. b. Partner’s allocation of partnership items, in general. c. Might affect any two partners’ tax liabilities in different ways. d. Amount that might be reported on either form 1065, page 1 or, on Schedule K. e. Transfer of asset to partnership followed by immediate distribution of cash to partner. f. Must have at least one general and one limited partner. g. Long-term capital gain might be recharacterized as ordinary income. h. All partners are jointly and severally liable for entity debts. i. Theory treating the partner and partnership as separate economic units. j. Partner’s basis in partnership interest after tax-free contribution of asset to partnership. k. Partnership’s basis in asset after tax-free contribution of asset to partnership. l. Owners are members. m. Theory treating the partnership as a collection of taxpayers joined in an agency relationship. n. Participates in management. o. Not liable for entity debts. Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis p. No correct match provided. 106. Limited partnership 107. General partner 108. Distributive share 109. Limited liability partnership 110. Carried interest 111. Aggregate concept 112. Substituted 113. Limited liability company 114. Limited partner 115. Publicly traded partnership 116. Disguised sale 117. Interest expense 118. Separately stated item 119. Carryover 120. Entity concept 121. General partnership Match each of the following statements with the terms below that provide the best definition. a. Adjusted basis of each partnership asset. b. Operating expenses incurred after entity is formed but before it begins doing business. c. Each partner’s basis in the partnership. d. Reconciles book income to taxable income. e. Percentage allocation of most nonrecourse debt. f. Tax accounting election made by partnership. g. Tax accounting calculation made by partner. h. Tax accounting election made by partner. i. Rolls forward tax basis capital accounts. j. Designed to prevent excessive deferral of taxation of partnership income. k. Amount that may be received by partner for performance of services for the partnership. l. Concept under which a partnership's recourse debt is shared among the partners. m. Recourse debt, if not guaranteed and all allocations have been proportionate to capital. Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis n. Will eventually be allocated to partner making tax-free property contribution to partnership. o. Partner’s share of partnership items. p. Any allocation to the partner must generally meet this requirement. q. Used to determine liquidating distributions. r. Shown on Schedules K-1 and does not include liabilities. 122. Tax basis capital account 123. Required taxable year 124. Foreign tax credit vs. deduction 125. Loss-sharing ratio 126. Schedule K-1 127. Inside basis 128. Section 704(b) book capital account 129. Start-up costs 130. Schedule M-1 131. § 179 deduction 132. Economic effect test 133. Precontribution gain 134. Profit-sharing ratio 135. Schedule M-2 136. Qualified business income deduction 137. Outside basis 138. Guaranteed payment 139. Economic risk of loss Subjective Short Answer 140. Mateo and James are forming the MJ Partnership. Mateo contributes $600,000 cash and James contributes nondepreciable property with an adjusted basis of $400,000 and a fair market value of $750,000. The property is subject to a $150,000 liability, which is transferred into the partnership and is shared equally by the partners for basis purposes. Mateo and James share in all partnership profits equally except for any precontribution gain, which must be allocated according to the statutory rules for built-in gain allocations. Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis a.

What is James’s adjusted tax basis for his partnership interest immediately after the partnership is formed?

b.

What is the partnership’s adjusted basis for the property contributed by James?

c.

If the partnership sells the property contributed by James for $800,000, how is the tax gain allocated between the partners?

141. Palmer contributes property with a fair market value of $4,000,000 and an adjusted basis of $3,000,000 to AP Partnership. Palmer shares in $3,000,000 of partnership debt under the liability sharing rules, giving him an initial adjusted basis for his partnership interest of $6,000,000. One month after the contribution, Palmer receives a cash distribution from the partnership of $2,000,000. Palmer would not have contributed the property if the partnership had not contractually obligated itself to make the distribution. Assume that Palmer’s share of partnership liabilities will not change as a result of this distribution. a.

Under the IRS’s likely treatment of this transaction, what is the amount of gain or loss that Palmer will recognize because of the $2,000,000 cash distribution?

b.

What is the partnership’s basis for the property after the distribution?

c.

If Palmer is unhappy with this result, can you suggest a possible alternative that may provide him with a better answer?

142. During the current year, MAC Partnership reported the following items of receipts and expenditures: $600,000 sales, $80,000 utilities and rent, $200,000 salaries to employees, $20,000 guaranteed payment to partner Antonio for services to the partnership, investment interest income of $4,000, a charitable contribution of $8,000, and a distribution of $30,000 to partner Carl. Antonio is a 25% general partner. Based on this information, what information will be shown on Antonio’s Schedule K-1? What income and deductions will Antonio report? What taxes and other calculations might Antonio need to report? 143. The LN partnership reported the following items of income and deduction during the current tax year: revenues, $300,000; cost of goods sold, $160,000; tax-exempt interest income, $2,000; salaries to employees, $80,000; and longterm capital gain, $10,000. It paid business interest expense of $18,000 and investment interest expense of $2,000. In addition, the partnership distributed $20,000 of cash to 50% partner Nina and $10,000 of cash to 50% partner Len. What is Nina’s share of ordinary partnership income and separately stated items? 144. Carli contributes land to the newly formed CD Partnership in exchange for a 30% interest. The land has an adjusted basis and fair market value of $300,000 and is subject to a liability of $100,000, which the partnership assumes. None of this liability is repaid at year-end. At the end of the year, the partnership owes payables of $20,000. Assume that all liabilities are allocated proportionately to the partners. Total partnership income for the year is $400,000. What is Carli’s basis in her partnership interest at the end of the year? 145. An examination of the RB Partnership’s tax books provides the following information for the current year. Operating (ordinary) income before guaranteed payments Long-term capital gain Guaranteed payment to Rachel for services Cash distributions to Rachel Interest on Colorado state bonds (exempt interest income) Powered by Cognero

$300,000 6,000 30,000 (20,000) 2,000 Page 20

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis Charitable contributions made by partnership Decrease in all partnership liabilities from 1/1-12/31

(10,000) (20,000)

Rachel is a 30% general partner in partnership capital, profits, and losses. Assume that the adjusted basis of her partnership interest (including liability share) is $60,000 at the beginning of the year, and she shares in 30% of the partnership’s liabilities for basis purposes. a.

What is Rachel’s adjusted basis for the partnership interest at the end of the year?

b.

How much income must Rachel report on her tax return for the current year? What deductions might be available? What is the character of the income and what types of tax might apply to it?

146. Katherine invested $80,000 this year to purchase a 30% interest in the KLM Partnership. The partnership reported $200,000 of net income from operations, a $2,000 short-term capital loss, and a $10,000 charitable contribution. In addition, the partnership distributed $20,000 to Katherine and $10,000 each to partners Lauren and Missy. If the partnership has no beginning or ending liabilities, what is Katherine’s basis in her partnership interest at the end of the year? 147. Sarah contributed fully depreciated ($0 basis) property valued at $50,000 to the RSTU Partnership in exchange for a 25% interest in partnership capital and profits. During the first year of partnership operations, RSTU had net taxable income of $200,000 and tax-exempt income of $4,000. The partnership distributed $10,000 cash to Sarah. Her share of partnership recourse liabilities on the last day of the partnership year was $20,000. What is Sarah’s adjusted basis (outside basis) for her partnership interest at the end of the tax year? 148. In the current year, the DOE LLC received revenues of $200,000 and paid the following amounts: $50,000 of business expenses (rent, utilities, wages, depreciation, etc.), a $40,000 guaranteed payment (for services) to 50% member Dave, $10,000 to member Ethan for consulting services, and $10,000 as a distribution to member Olivia. In addition, the LLC earned $2,000 of tax-exempt interest income during the year. Dave is the managing member of the LLC. His basis in his LLC interest was $50,000 at the beginning of the year, which includes a $12,000 share of LLC liabilities. At the end of the year, his share of the LLC’s liabilities was $20,000. a. How much income must Dave report for the tax year and what is the character of the income? b. What is Dave’s basis in his LLC interest at the end of the tax year? c. On what income will Dave’s self-employment tax be calculated? d. What is the maximum amount Dave might be able to deduct for this business under § 199A? What additional information would Dave need to make this calculation? 149. Sharon and Sue are equal partners in the S&S Partnership. On January 1 of the current year, each partner’s adjusted basis in S&S was $80,000 (including each partner’s $20,000 share of the partnership’s $40,000 of liabilities). During the current year, S&S repaid $30,000 of the debt and borrowed $20,000 for which Sharon and Sue are equally liable. In the current year ended December 31, S&S also sustained a net operating loss of $40,000 and earned $10,000 of interest income from investments. If liabilities are shared equally by the partners, on January 1 of the next year, how much is each partner’s basis in her interest in S&S? 150. In the current year, the CAR Partnership received revenues of $400,000 and paid the following amounts: $160,000 in rent, utilities, and salaries; a $40,000 guaranteed payment to partner Ryan; $20,000 to partner Amy for consulting services; and a $40,000 distribution to 25% partner Cameron. In addition, the partnership realized a $12,000 net long-term capital gain. Cameron’s basis in his partnership interest was $60,000 at the beginning of the year which included his Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis $25,000 share of partnership liabilities. At the end of the year, his share of partnership liabilities was $15,000. a.

How much income must Cameron report for the tax year?

b.

What is Cameron’s basis in the partnership interest at the end of the year?

151. In the current year, Derek formed an equal partnership with Cody. Derek contributed land with an adjusted basis of $110,000 and a fair market value of $200,000. Derek also contributed $50,000 cash to the partnership. Cody contributed land with an adjusted basis of $80,000 and a fair market value of $230,000. The land contributed by Derek was encumbered by a $60,000 nonrecourse debt. The land contributed by Cody was encumbered by $40,000 of nonrecourse debt. Assume that the partners share debt equally. Immediately after the formation, what is the basis of Cody’s partnership interest? 152. Morgan is a 50% managing member in the calendar year, cash basis MKK LLC. The LLC received $150,000 income from services and paid the following other amounts. Rent expense Salary expense to employees Payment to Morgan for services per the operating agreement Distributions to partners Kristin and Katie ($6,000 each) Payment to 30% cash basis partner Katie for tax and accounting services

$10,000 40,000 40,000 12,000 10,000

How much will Morgan’s adjusted gross income increase as a result of these items? What other deductions must be considered? What amount will be included in Morgan’s self-employment tax calculation?

153. Cassandra is a 10% limited partner in C&C, Ltd. Her basis in the interest is $60,000 before loss allocations, including her $30,000 share of the partnership’s nonrecourse debt. (This debt is not qualified nonrecourse financing.) Cassandra is also a 10% limited partner in MNOP in which her basis is $30,000. Cassandra is allocated an $80,000 loss from C&C and $20,000 of income from MNOP. How much of the loss from C&C may Cassandra deduct? Under what Code provisions are the remaining losses suspended? Assume that Cassandra has no business losses from other sources. 154. The MOP Partnership is involved in construction activities. On January 1 of the current year, Patricia has an adjusted basis of $650,000 for her partnership interest consisting of the following. Capital account Share of partnership recourse debt Share of partnership nonrecourse debt

$400,000 50,000 200,000 $650,000

During the year, the partnership has an operating loss of $1.2 million and distributes $60,000 of cash to Patricia. Partnership liabilities were the same at the end of the tax year, and the nonrecourse debt is not qualified nonrecourse debt. If she owns a 60% share of partnership profits, capital, and losses, and is an active (material) participant in the partnership, how much of her share of the operating loss can Patricia deduct? (Assume that Patricia is a single taxpayer and has no business losses from other sources.) What Code provisions could cause a suspension of the loss? How would your answer change if MOP were an LLC and Patricia had not personally guaranteed any of the debt? 155. Jeordie and Kendis created the JK Partnership by contributing $100,000 each. The $200,000 cash was used by the Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis partnership to acquire a depreciable asset. The partnership agreement provides that the partners’ capital accounts will be maintained in accordance with Reg. § 1.704-1(b) (the economic effect Regulations) and that any partner with a deficit capital account will be required to restore that capital account when the partner’s interest is liquidated. The partnership agreement provides that MACRS will be allocated 20% to Jeordie and 80% to Kendis. All other items of partnership income, gain, loss, deduction, and credit will be allocated equally between the partners. In the first year, MACRS is $40,000 and no other operating transactions occur. The property is sold at the end of the first year for $160,000 (which, coincidentally, corresponds to JK's basis in the property), and the partnership is liquidated immediately thereafter. To satisfy the economic effect test, how much of the $160,000 cash (from the sale) is allocated each to Jeordie and Kendis? 156. Emma and Laine form the equal EL Partnership. Emma contributes cash of $100,000. Laine contributes

property with an adjusted basis of $40,000 and a fair market value of $100,000. a. How much gain, if any, must Emma recognize on the transfer? Must Laine recognize any gain? If so, how much? b. What is Emma’s tax basis in her partnership interest? Her § 704(b) book basis? c. What is Laine’s tax basis in her partnership interest? Her § 704(b) book basis? d. What tax basis does the partnership take in the assets contributed by Laine and Emma? e.

How will the partnership account for the difference between the basis and value of the property transferred by Laine?

157. The JM Partnership was formed to acquire land and subdivide it as residential housing lots. On March 1,

2022, Jessica contributed land valued at $600,000 to the partnership in exchange for a 50% interest. She had purchased the land in 2015 for $420,000 and held it for investment purposes (capital asset). The partnership holds the land as inventory. On the same date, Matt contributed land valued at $600,000 that he had purchased in 2013 for $720,000. He also became a 50% owner. Matt is a real estate developer, but he held this land personally for investment purposes. The partnership holds this land as inventory. In 2024, the partnership sells the land contributed by Jessica for $620,000. In 2025, the partnership sells the real estate contributed by Matt for $580,000. a. What is each partner’s initial basis in his or her partnership interest?

What is the amount of gain or loss recognized on the sale of the land contributed by Jessica? What is the character of this gain or loss? What is the amount of gain or loss recognized on the sale of the land c. contributed by Matt? What is the character of this gain or loss? How would your answer in part (c) change if the property was sold in d. 2029? b.

158. Sam and Drew are equal partners in SD LLC formed on June 1 of the current year. Sam contributed

land that he inherited from his uncle in 2015. Sam’s uncle purchased the land in 1988 for $30,000. Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis The land was worth $100,000 when Sam’s uncle died. The fair market value of the land was $200,000 at the date it was contributed to the partnership. Drew has significant experience developing real estate. After the LLC is formed, he will prepare a plan for developing the property and secure zoning approvals for the LLC. Drew would normally bill a third party $50,000 for these efforts. Drew also will contribute $150,000 cash in exchange for his 50% interest in the LLC. The value of his 50% interest is $200,000. a.

How much gain or income will Sam recognize on his contribution of the land to the LLC? What is the character of any gain or income recognized?

b. What basis will Sam take in his LLC interest?

How much gain or income will Drew recognize on the formation of the LLC? c. What is the character of any gain or income recognized? Does Drew have a “carried interest”? d. What basis will Drew take in his LLC interest?

Construct a balance sheet for SD LLC assuming that Drew’s services are completed immediately after forming SD. The balance sheet should show two e. numeric columns, including the LLC’s basis in assets and the fair market value of these assets. f.

Outline any planning opportunities that may minimize current taxation to any of the parties.

159. Tom and Missy form TM Partnership, Ltd. (a limited partnership), to own and operate certain real estate.

Tom contributed land, and Missy contributed cash to be used for setting up the entity and creating a plan for developing the property. Once a development plan was in place, the partnership sold interests in the partnership to investors to raise funds for constructing a shopping center. The partnership incurred expenses of $30,000 for forming the entity and $60,000 for starting the business (e.g., setting up the accounting systems, locating tenants, and negotiating leases). It also paid $5,000 in transfer taxes for changing the ownership of the property to the partnership’s name. The brokerage firm that sold the interests to the limited partners charged a 6% commission, which totaled $600,000. The calendar year partnership started business in November this year. How are these initial expenses treated by the partnership? How much is currently deductible, and how is the remainder treated for tax purposes? Show your calculations. 160. The RB LLC is owned equally by Romer and Brad. At the beginning of the year,

Romer’s basis is $40,000 and Brad’s is $32,000. RB reported the following income and expenses for the current tax year. Net ordinary business income (loss) (Form 1065, page 1, line 28) Powered by Cognero

($64,000) Page 24

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis Long-term capital gains Distribution to Brad Payment to Great Health Hospital for Romer’s medical expenses

12,000 (30,000) (24,000)

Use the ordering rules of Exhibit 9.2 (and the loss limitation rules) and a. calculate Romer’s basis in his partnership interest at the end of the year.

Based on this calculation, what does Romer report on his tax return? b.

Make the same calculation for Brad. What will Brad report on his tax return?

161. On June 1 of the current tax year, Elisha and Ezra (who are equal partners) contribute property to form the

Double E General Partnership. Elisha contributes cash of $200,000. Ezra contributes a building and land with an adjusted basis and fair market value of $340,000, subject to a liability of $140,000. The partnership borrows $20,000 to finance construction of a parking lot in front of the building. At the end of the first year (December 31), the accrual basis partnership owes $8,200 in trade accounts payable to various creditors. The partnership reported net income of $30,000 for the year that the partners share equally. Assume that Elisha and Ezra share equally in partnership liabilities. How much is Elisha’s basis in the partnership interest on December 31? Ezra’s? 162. Four GRRLs Partnership is owned by four girlfriends. Lacy holds a 40% interest; each of the others owns

20%. Lacy sells investment property to the partnership for its fair market value of $200,000 (Lacy’s basis is $250,000). a. How much loss, if any, may Lacy recognize? b. If the partnership later sells the property for $260,000, how much gain must it recognize? c. How would your answers in parts (a) and (b) change if Lacy owned a 60% interest in the

partnership? d. If Lacy owned a 60% interest and her basis in the investment property was

$120,000 (instead of $250,000), how much, if any, gain would she recognize on the original sale for $200,000? How would the gain be characterized?

Essay 163. On the formation of a partnership, when might a disguised sale occur? How can this treatment be avoided? 164. Your client owns a parcel of land that has depreciated in value. He wants to know if there is a way he can

contribute the property to his partnership, have the partnership sell the property, and convert the existing capital loss into an ordinary loss. He also wants to know if part of the loss would be allocated to his other partners. What is your reaction? Powered by Cognero

Page 25

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 165. What are syndication costs, and how are they treated for tax purposes? 166. Harry and Sally are considering forming a partnership for a new consulting business. Both taxpayers use the calendar year and are cash basis taxpayers. The partnership will not be a tax shelter. The partners are uncertain as to whether the partnership should use the cash or accrual method of accounting. Moreover, the idea of a tax deferral in the first year of operations has led them to consider using a June 30 fiscal year-end for the partnership. As their tax adviser, identify the issues that must be considered in selecting an accounting method and tax year for the partnership. 167. The MOG Partnership reports ordinary income of $60,000, long-term capital gain of $12,000, and tax-exempt income of $12,000. The partnership agreement provides that Molly will receive all long-term capital gains and George will receive all tax-exempt interest income. Their allocation of ordinary income will be reduced accordingly, and Olivia will be allocated a proportionately greater share of ordinary income. (In other words, each partner will receive allocations totaling one-third of the total $84,000 of partnership income.) This allocation was agreed upon because Molly and George are in a high marginal tax bracket and Olivia is in a low marginal tax bracket. a.

Describe the elements that must be included in a partnership agreement for an allocation to have economic effect.

b.

Discuss whether or not the MOG allocation would be permitted and provide your reasoning.

168. What is the difference between a partner’s basis in the partnership interest and a partner’s tax basis capital account? Section 704(b) book capital account? What are the purposes of these amounts? Why are these amounts typically different? 169. Describe how a partnership calculates depreciation on property that is contributed by a partner? If the

partnership incurs additional costs that must be capitalized (i.e., transfer taxes related to changing the title), how are those costs treated? 170. Jasmine Gregory is a 20% member in Sparrow Properties LLC, which is a lessor of residential rental

property. Her share of the LLC’s losses for the current year is $100,000. Immediately before considering the deductibility of this loss, Jasmine’s tax basis capital account (which, in this case, corresponds to her tax basis in the LLC interest, excluding liabilities) reflected a balance of $50,000. Jasmine has personally guaranteed a $10,000 debt of the LLC that is allocated to her as a recourse debt. Her share of the LLC’s nonrecourse debt is $30,000. This debt cannot be treated as qualified nonrecourse financing. Jasmine spends several hundred hours a year working for Sparrow Properties. Jasmine is also a managing member of Starling Rentals LLC, which is engaged in long-term (more than 30 days) equipment rental activities. (This is considered a passive activity.) Jasmine’s share of Starling’s income is $36,000. Jasmine is a single taxpayer. Her modified adjusted gross income before considering the LLCs’ activities is $300,000, and she has no other business losses. The “active participation” rental real estate deduction is not available to Jasmine. Determine how much of Sparrow’s $100,000 loss Jasmine can deduct on her current calendar year return. Using the format (1) facts, (2) issues, (3) conclusion, and (4) law and analysis, draft a memo for the client’s tax file describing the loss limitations. Identify the Code sections, if any, under which losses are suspended. Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis

Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis Answer Key 1. True 2. False 3. True 4. True 5. False 6. False 7. True 8. True 9. False 10. False 11. False 12. False 13. False 14. True 15. False 16. True 17. False 18. True 19. False 20. True 21. True 22. False 23. True 24. True 25. False Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 26. False 27. True 28. False 29. True 30. True 31. True 32. False 33. True 34. True 35. False 36. False 37. True 38. True 39. True 40. True 41. True 42. False 43. False 44. False 45. True 46. True 47. False 48. False 49. False 50. False Powered by Cognero

Page 29

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 51. False 52. False 53. True 54. True 55. False 56. True 57. True 58. d 59. d 60. a 61. b 62. c 63. c 64. b 65. b 66. d 67. c 68. c 69. a 70. c 71. b 72. b 73. d 74. d 75. c 76. d Powered by Cognero

Page 30

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 77. b 78. a 79. d 80. c 81. d 82. a 83. a 84. a 85. d 86. d 87. c 88. c 89. c 90. b 91. b 92. a 93. b 94. c 95. d 96. b 97. b 98. b 99. a 100. c 101. c Powered by Cognero

Page 31

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 102. d 103. c 104. d 105. b 106. f 107. n 108. b 109. a 110. g 111. m 112. j 113. l 114. o 115. p 116. e 117. d 118. c 119. k 120. i 121. h 122. r 123. j 124. h 125. m 126. o 127. a Powered by Cognero

Page 32

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 128. q 129. b 130. d 131. f 132. p 133. n 134. e 135. i 136. g 137. c 138. k 139. l 140. a. Basis of property contributed Plus: James’s share of partnership liability Less: James’s liability transferred to partnership Basis in partnership interest b.

$400,000 75,000 (150,000) $325,000

Partnership’s basis (carryover basis) is $400,000.

c. Sales price Less: Adjusted basis

$800,000 (400,000)

Total gain on sale

$400,000

James Built-in $350,000 (precontribution) gain Remaining gain 25,000 Gain allocated to $375,000 partner

Powered by Cognero

$

Mateo –0–

25,000 $25,000

Page 33

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 141. a.

b.

c.

Palmer likely will recognize a $500,000 [($4,000,000 – $3,000,000) × 50% ] gain on the transaction. Palmer received a cash payment equal to one-half the value of the property he contributed. The IRS would likely treat this as a disguised sale of the property which is presumed to occur when a contractual agreement requires a contribution by a partner to be followed within two years by a specified distribution by the partnership and the distribution is made without regard to partnership profits. Both these issues occur in this scenario. While Palmer could argue that the intent of this transaction is not to create a disguised sale, it is doubtful that he would be successful. The partnership’s total basis for the property is $3,500,000. Its basis for the purchased property is the $2,000,000 cost of the property (the partnership is deemed to have paid for the property). In addition, the partnership has a $1,500,000 carryover basis for the portion of the property that was contributed rather than purchased. If Palmer can wait for more than two years to receive the distribution and if the distribution is not contractually guaranteed, the contribution and distribution transactions will be presumed not to be a disguised sale. The distribution will be treated as a normal distribution that will not create capital gain for Palmer unless the distribution amount exceeds the adjusted basis for his partnership interest when the distribution is made.

142. Sales Utilities and rent Salaries Guaranteed payment to Antonio Partnership ordinary income

$600,000 (80,000) (200,000) (20,000) $300,000

Separately stated interest income

$ 4,000

Guaranteed payment to partner

$20,000

Separately stated charitable contribution

$ 8,000

The distribution to Carl is not deductible by the partnership and will not affect Antonio's Schedule K-1. Antonio’s share of the partnership’s ordinary income is $75,000 ($300,000 × 25%). He also reports his separately stated share of interest income of [$1,000 ($4,000 × 25%)] and charitable contributions [$2,000 ($8,000 × 25%)]. Antonio’s K-1 will also show his guaranteed payment of $20,000, his net earnings from self-employment ($95,000 = $75,000 ordinary income + $20,000 guaranteed payment), and other information he might need in order to prepare his return (e.g., AMT, QBI, and/or investment income information). Antonio will report his shares of ordinary income, interest income, and the guaranteed payment and might be able to deduct the charitable contributions. He might be able to claim a QBI deduction. He might need to calculate alternative minimum tax, self-employment tax, additional Medicare tax, and the net investment income tax. 143. Revenues Cost of goods sold Powered by Cognero

$300,000 (160,000) Page 34

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis Salaries Business interest expense (exactly 30% of net of above) Partnership ordinary income

(80,000) (18,000) $ 42,000

Nina’s share of: Partnership ordinary income ($42,000 × 50%)

$ 21,000

Separately stated tax-exempt income (not reported)

$ 1,000

Separately stated long-term capital gain (reported)

$ 5,000

Separately stated investment interest expense

($ 1,000)

The distributions to the partners are not deductible although the $20,000 distribution to Nina is shown on her Schedule K1 so she can calculate her basis in the partnership interest and determine whether the distribution is taxable (probably not in this situation as it is less than the net $26,000 increase to her basis for current activity) 144. Basis in land contributed to CD Less: Relief of liability assumed by partnership Plus: Share of liability related to land ($100,000 × 30%) Plus: Share of trade accounts payable ($20,000 × 30%) Plus: Share of partnership income ($400,000 × 30%) Ending basis in partnership interest

$300,000 (100,000) 30,000 6,000 120,000 $356,000

145. a. Adjusted basis, beginning of year Plus: Share of income after guaranteed payment ($270,000 × 30%) Long-term capital gain ($6,000 x 30%) Share of interest on Colorado state bonds ($2,000 × 30%) Share of partnership charitable contributions ($10,000 x 30%) Decrease in share of partnership liabilities ($20,000 × 30%) Cash distributions Adjusted basis, 12/31 Powered by Cognero

$60,000 $81,000 1,800 600

83,400

$3,000 6,000 20,000 (29,000) $114,400 Page 35

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis

b.

Rachel will report $81,000 of income from the partnership plus a long-term capital gain of $1,800. She may be able to deduct $3,000 of charitable contributions as an itemized deduction. She might also be able to claim the QBI deduction. In addition, Rachel must report the $30,000 guaranteed payment as ordinary income. The bond interest income is nontaxable. The cash distribution and debt reduction are not taxable because they do not exceed her basis before those items. Her guaranteed payment ($30,000) and her distributive share ($81,000) are subject to SE tax (and possibly additional Medicare tax) because she is a general partner. The capital gain might be subject to the net investment income tax.

146. $116,400. Katherine’s initial basis of $80,000 is increased by her 30% share of partnership income from operations ($60,000). Her basis is decreased by her 30% share of the partnership’s charitable contribution ($3,000) and the shortterm capital loss ($600). It is also decreased by the $20,000 distribution she received. The distributions to Lauren and Missy do not affect Katherine’s basis. Katherine’s ending basis, then, is $116,400 ($80,000 + $60,000 – $600 – $3,000 – $20,000). 147. $61,000. Sarah's contributed property has a $0 basis. Sarah is a 25% partner and will share in 25% of the partnership’s taxable income and tax-exempt income. In addition, her basis will include her allocable share of the partnership’s recourse liabilities. Her basis will be reduced by the cash distribution during the year. Beginning basis Plus: Share of partnership ordinary income (25% × $200,000) Plus: Share of tax-exempt income (25% × $4,000) Plus: Share of partnership liabilities Basis before losses and distributions Less: Distribution Ending basis 148. a. Revenues Less: Business expenses Less: Guaranteed payment (for services) to Dave Less: Consulting expenses to Ethan Ordinary business income

$ –0– 50,000 1,000 20,000 $71,000 (10,000) $61,000

$200,000 (50,000) (40,000) (10,000) $100,000

The distribution to Olivia is not deductible. The payment to Ethan is a deductible business expense. Dave’s share of DOE’s ordinary income is $50,000. The $2,000 of tax-exempt interest income is a separately stated item, of which Dave’s share is $1,000. (It is not taxable to Dave but will increase his basis.) In addition, Dave must report the $40,000 guaranteed payment as gross income. Dave's total ordinary income from the partnership, then, is $90,000 (plus the $1,000 of exempt income). b.

Beginning basis Plus: Increase in share of the LLC’s liabilities Plus: Share of ordinary income

Powered by Cognero

$ 50,000 8,000 50,000 Page 36

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis Plus: Share of tax- exempt interest income Dave's ending basis

1,000 $109,000

Dave’s guaranteed payment does not affect his basis. Dave’s distributive share of $50,000 and his $40,000 guaranteed payment ($90,000 total) are subject to SE tax.

c.

d. Dave's maximum deduction under § 199A is $10,000, or 20% of Dave's 50% share of DOE's ordinary income. QBI does not include income from guaranteed payments, as they are treated (for this purpose) as being more in the nature of salary/wages or investment income. To determine whether this amount is limited, DOE would need to provide Dave's share of any W-2 wages paid to DOE's employees, and his share of the LLC's unadjusted basis of depreciable property. This information is used to calculate two amounts: The higher of the amounts is the limitation. Dave's QBI for this business is the lesser of $10,000 or the limitation. An additional taxable income limitation applies, plus Dave will have additional calculations if he has additional activities subject to QBI.

149. Beginning basis Plus: Share of interest income Less: Net decrease in share of partnership debt Less: Share of S&S loss Ending basis

$80,000 5,000 (5,000) (20,000) $60,000

150. a. $45,000 ordinary income and $3,000 LTCG. The partnership’s ordinary income is calculated as follows. Revenues Less: Rent, utilities, and salaries Less: Guaranteed payment to Ryan Less: Consulting expenses to Amy Ordinary income

$400,000 (160,000) (40,000) (20,000) $180,000

The distribution to Cameron is not deductible. The guaranteed payment to Ryan and the consulting service payment to Amy are deductible business expenses. Cameron’s 25% share of CAR’s ordinary income is $45,000. The $12,000 net long-term capital gain Powered by Cognero

Page 37

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis is a separately stated item of which Cameron’s share is $3,000. Ryan (not Cameron) reports the guaranteed payment as income.

b. Beginning basis Plus: Share of ordinary income Plus: Share of net long-term capital gain Less: Decrease in share of partnership liabilities Less: Cash distribution to Cameron

$60,000 45,000 3,000 (10,000) (40,000) $58,000

Ending basis

151. Basis of land Deemed cash distribution (relief of Cody’s debt) Share of Cody’s debt Share of Derek’s debt Cody’s basis

$80,000 (40,000) 20,000 30,000 $90,000

152. $65,000 income and amount included in SE tax calculation. Morgan might be able to claim a QBI deduction of $5,000 (20% of the $25,000 share of partnership ordinary income). The $40,000 payment to Morgan is a guaranteed payment and is deductible by the partnership. The $10,000 payment to Katie is deductible under § 707(a), because it was an ordinary business expense paid during the year. The distributions to Kristen and Katie are not deductible by the partnership. Income from services Less: Rent expense Salaries to employees Guaranteed payment to Morgan Payment to Katie for services Partnership income

$150,000 $10,000 40,000 40,000 10,000

(100,000) $ 50,000

Of this $50,000 partnership income, 50%, or $25,000, is allocated to Morgan. She must also include the $40,000 guaranteed payment in her gross income this year, because she and the partnership use the same reporting period. The guaranteed payment is not eligible for the QBI deduction. This $65,000 is included in Morgan’s SE tax calculation. 153. Cassandra can deduct a $20,000 loss after application of all rules. Her $80,000 loss from C&C is first limited by the basis rules of § 704(d); $20,000 of the loss ($80,000 loss – $60,000 basis) is limited under this rule. The remaining loss of $60,000 is tested under the at-risk rules. Cassandra’s amount at risk is $30,000 (her basis less the nonrecourse debt); $30,000 of the loss ($60,000 – $30,000) is suspended under the at-risk rules. As a limited partner, the remaining $30,000 loss is treated as a passive loss. That loss can be deducted to the extent of Cassandra’s passive income from MNOP, or $20,000. The remaining $10,000 of loss is suspended under the passive loss rules. Adjusted basis [§ 704(d)] At risk amount (§ 465) Powered by Cognero

Deductible $60,000 30,000

Suspended $20,000 30,000 Page 38

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis Passive loss rules

20,000

10,000

154. Patricia can deduct only $305,000 (2024) of her $720,000 share of the partnership’s operating loss on her tax return. Her adjusted basis for her partnership interest immediately before the deduction of any portion of the loss is $590,000 ($650,000 – $60,000 distribution). The amount of the loss that can be deducted is first limited by the $590,000 adjusted basis. Then, the remaining loss is limited by the at-risk amount of $390,000 ($650,000 – $60,000 distribution – $200,000 nonrecourse debt). (Patricia is not at-risk for her $200,000 share of the nonrecourse debt.) The passive loss rules do not apply, because Patricia is a material participant in the partnership. The last hurdle is that the loss cannot exceed the excess business loss limitation. As a single taxpayer, Patricia's limitation is $305,000 in 2024, and she carries forward (as a net operating loss) the $70,000 remaining loss that passed the other hurdles. Therefore, she can deduct a $305,000 loss on her return.

Adjusted basis [§ 704(d)] At risk amount (§ 465) Passive loss rules (§ 469) Excess business loss rules (§ 461(l)) *Net operating loss carryover

Deductible $590,000 390,000 Not applicable $305,000

Suspended $130,000 200,000 $85,000*

If MOP were an LLC, the nominally recourse debt of $50,000 would not be included in Patricia’s amount at risk because she did not personally guarantee the debt. Her loss at that level would be limited to $340,000 ($390,000 – $50,000). The excess business loss remains $305,000, but the net operating loss carryover would be reduced to $35,000 ($340,000 allowed under the at-risk rules - $305,000 limitation for 2024). 155. Jeordie will receive $92,000 and Kendis will receive $68,000. Distributions upon liquidation must follow the § 704(b) book capital accounts for each partner. Depreciation is allocated $8,000 (20%) to Jeordie and $32,000 (80%) to Kendis. After MACRS allocations, Jeordie will have a capital account balance of $92,000 ($100,000 – $8,000) and Kendis’s capital account balance will be $68,000 ($100,000 – $32,000). If the asset is sold for its $160,000 carrying value on the partnership books, no gain or loss will be recognized on the sale and, therefore, no further adjustment needs to be made to the partner’s capital accounts. Upon liquidation, the partners will receive assets valued at the balances in their capital accounts. 156.

Under § 721, neither the partnership nor the partners recognizes any gain on formation of the entity. Emma will take a tax and § 704(b) book basis of $100,000 in b. her partnership interest. Laine will take a substituted tax basis of $40,000 in her partnership interest ($40,000 tax basis in the property c. contributed to the entity). Her § 704(b) book basis will equal the fair market value of the property, or $100,000. The partnership will take a carryover basis in the assets it d. receives ($100,000 basis in cash and $40,000 basis in property). The partnership will treat the $60,000 difference between the e. basis and fair market value of the property Laine contributed a.

Powered by Cognero

Page 39

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis as a precontribution gain that must be allocated to Laine when the property is sold or as described under the Regulations if the property is depreciable. 157. a. The partners’ initial bases in their partnership interests are the same

amounts as their bases in the contributed property (§ 722). Jessica’s basis Matt’s basis

$420,000 $720,000

b. The 2024 sale results in ordinary income of $200,000 to the

partnership. Selling price Basis Gain

$620,000 (420,000) $200,000

The gain is ordinary income because the land is held as inventory by the partnership. The land was a capital asset to Jessica, but no Code provision allows treatment of the gain based on Jessica’s use rather than the partnership’s use.

c. The 2025 sale results in a $140,000 loss (including a $120,000 capital

loss and a $20,000 ordinary loss. Selling price Basis Loss

$580,000 (720,000) ($140,000)

As a sale of inventory (determined at the partnership level), the sale in 2025 of the land contributed by Matt would normally result in an ordinary loss. However, § 724 overrides the usual treatment. The character of the precontribution loss, instead, is determined based on the character of the property in Matt’s hands. This sale was within five years of the capital contribution date, so the loss is capital in nature to the extent of the built-in loss at the contribution date, which is: FMV at contribution Basis Capital loss Powered by Cognero

$600,000 (720,000) ($120,000) Page 40

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis The remaining $20,000 loss in 2025 is an ordinary loss because the character of the post-contribution loss is based on the partnership’s ownership and use of the property as inventory. If the property Matt contributed was sold by the partnership in 2029, the entire $140,000 loss would be treated as an ordinary loss. A sale in d.

2029 would not be within five years of the contribution date, so the character of the loss would be determined solely by reference to the character of the asset to the partnership. Because the land is inventory to the partnership, the loss in 2029 would be ordinary.

158. a.

None. Under § 721, neither the LLC nor any of the members recognize gain on contribution of property to an LLC in exchange for an interest in the LLC.

$100,000. Sam’s basis in his LLC interest will equal the basis he held in the property he inherited from his uncle. The basis a beneficiary takes in b. property received from an estate generally equals the fair market value of the asset at the date of death or at the alternate valuation date (six months later) if available and elected. Drew will recognize $50,000 of ordinary income. The fair market value of Drew’s 50% LLC interest is $200,000. Because Drew will contribute only $150,000 of property, the difference between the amount contributed and the value of the interest will be treated as being for services rendered c. to the LLC. Services do not constitute “property” for purposes of § 721 nonrecognition treatment. Drew does not have a carried interest because (1) it is a capital interest, and (2) Drew “paid” for the interest by recognizing income equal to the value of the interest. d.

Drew’s basis in his LLC interest will be $200,000 [$150,000 (cash contributed) + $50,000 (the amount of ordinary income recognized for services rendered to the partnership)].

SD’s balance sheet is as follows immediately after formation. (The e. column totals are calculated using the “sum” command.) Powered by Cognero

Page 41

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis Assets Cash Land Land Improvements Total assets

Basis $150,000 100,000 50,000 $300,000

FMV $150,000 200,000 50,000 $400,000

Partners’ capital Sam’s capital Drew’s capital Total capital

$100,000 200,000 $300,000

$200,000 200,000 $400,000

SD LLC will capitalize the $50,000 deemed payment for Drew’s services, because the services relate to a capitalizable expenditure. The LLC will reflect this $50,000 in “cost of lots sold” as the development lots are sold. Drew could prepare a development plan and secure zoning permits before the LLC is formed. He could then contribute these plans and permits to SD in addition to the $150,000 cash. Because a completed plan would be considered f. “property,” no portion of his LLC interest would be received in exchange for services if this were done. The entire transaction would be considered under § 721.

159. TM Partnership, Ltd., has incurred costs for organizing the partnership ($30,000), starting the business

($60,000), transferring property ($5,000), and securing investors ($600,000) for the partnership. The organizational costs are treated under § 709. Under this section, the first $5,000 of such expenses are deducted (provided the total is less than $50,000); the remainder is amortized over 180 months. The startup costs are treated under § 195. The first $5,000 of such expenses are deducted, provided the total is less than $50,000. If costs exceed $50,000, the $5,000 deduction is phased out, dollar for dollar, by the amount of costs in excess of $50,000. When total costs equal or exceed $55,000, no portion of the expense is currently deductible. Instead, the full amount is amortized over 180 months. Under these rules, TM deducts $5,278 [$5,000 + ($25,000 × 2/180)] of organizational costs and $667 ($60,000 × 2/180) of startup expenses. The $5,000 transfer tax is treated as a cost of acquiring the land and is added to the partnership’s basis in the land (nondepreciable property). The $600,000 of brokerage commissions is treated as a syndication cost of the partnership. Under § 709, these costs cannot be deducted. If newly capitalized costs arise on a contribution of assets to the partnership (e.g., transfer taxes or legal fees), the partnership treats these costs as newly acquired MACRS property and commences depreciation at the date the partnership places the property in service. 160. a.

Romer’s basis in his partnership interest at the end of the tax year is determined as follows, using the ordering rules in Exhibit 9.2.

Powered by Cognero

Page 42

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis Beginning basis Share of separately stated income items: Long-term capital gain Basis before loss allocation and distribution Less: Distribution (partnership payment of medical expenses) Basis before loss allocation Less: Ordinary loss allowed under § 704(d) Ending basis in interest

$40,000 6,000 $46,000 (24,000) $22,000 (22,000) -0-

Romer reports the long-term capital gain as income. Per the ordering rules of Exhibit 9.2, the distribution is considered before the loss. The distribution from the partnership is not taxable because it is less than Romer’s basis after current income items. Romer’s ordinary loss from the partnership is limited under § 704(d) to $22,000. The remaining $10,000 ordinary loss is carried forward (as a suspended loss) until such time as Romer has sufficient basis in his partnership interest to utilize the loss. b. Brad’s basis in his partnership interest at the end of the tax year is

determined as follows.

Beginning basis Share of separately stated income items: Long-term capital gain Basis before loss allocation and distribution Less: Distribution Basis before loss allocation Less: Ordinary loss allowed under § 704(d) Ending basis in interest

$32,000 6,000 $38,000 (30,000) $8,000 (8,000) -0-

Brad reports the long-term capital gain. The distribution is again considered before determining the allowable loss. Brad’s basis is $8,000 lower than Romer’s, and the distribution Brad received is $6,000 higher than the distribution to Romer, so Brad’s deductible loss is $14,000 less than Romer’s. Brad may only deduct $8,000 of the loss. The remaining $24,000 loss is carried forward.

Powered by Cognero

Page 43

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis 161. Both Elisha’s and Ezra’s bases in the partnership interests are $299,100 at the end of the year. Elisha’s

initial basis of $200,000 (cash contribution) is increased by a $70,000 share of the liability on the contributed land, a $10,000 share of the construction debt, and a $4,100 share of the accounts payable debt. In addition, Elisha’s basis is increased by the $15,000 share of the partnership’s taxable income. Ezra’s initial basis of $340,000 (building and land basis) is reduced by the $140,000 debt assumed by the partnership and then increased by a $70,000 share of the liability on the contributed land, a $10,000 share of the construction debt, and a $4,100 share of the accounts payable debt. In addition, Ezra’s basis is also increased by the $15,000 share of the partnership’s taxable income. The bases are the same because the fair market value of Ezra’s contributed property was the same as its tax basis and because both partners (logically) contributed net assets with equal net fair market values. 162. a.

$50,000 loss. As a 40% owner, Lacy’s loss on the sale to the partnership is not disallowed.

b. $60,000 gain. The partnership has a cost basis in the property of

$200,000. Lacy would claim no loss. Section 707(b)(1)(A) would apply, and Lacy’s $50,000 realized loss would not be deductible. c.

On the partnership’s later sale of the property, it would recognize a gain of $10,000. Section 267(d) permits the partnership to offset any subsequent gain by the loss previously disallowed ($60,000 gain less $50,000 previously disallowed loss).

$80,000 gain. Lacy’s $80,000 gain would be ordinary under § 707(b)(2) if the investment property immediately after the transfer is d. not a capital asset of the Four GRRLs Partnership; otherwise it would probably be a capital gain.

163. A disguised sale might occur when a partner contributes appreciated property to a partnership and soon thereafter receives a cash distribution from the partnership. Under §§ 721 and 731, the contribution and distribution transactions normally would not be taxable events if the partner has sufficient basis to cover the distribution. If the appearance of the transaction is that the contribution and distribution are related, the IRS may take the position that the partnership form was simply used to accommodate a transaction that was intended to be a sale. Disguised sale treatment can be avoided if the other partners receive similar and proportionate distributions; the partnership is not obligated to make the distribution; at the contribution date, the partner’s rights to future distributions are clearly subject to entrepreneurial risk; or the distribution is more than two years after the contribution occurred. 164. In the short run, it would not be possible to convert the capital loss into an ordinary loss. If the client can wait more than five years for the partnership to sell the property, the character of the loss would be determined by reference to the partnership’s use of the land. The built-in (precontribution) loss would be allocated to the client and any loss arising after Powered by Cognero

Page 44

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis the contribution date would be allocated according to the provisions in the partnership agreement. Section 724 provides that when property is sold by a partnership at a loss within five years of the date the property is contributed, any built-in capital loss at the contribution date remains a capital loss, regardless of the partnership’s use of the property. For example, even if the land was considered inventory by the partnership rather than a capital asset, sale of that land within five years would result in a capital loss to the extent of the built-in loss at the contribution date. When a partner contributes property to a partnership, any built-in gain or loss must be tracked and allocated to the contributing partner under § 704(c). Therefore, the built-in loss (whether capital or ordinary) would be allocated to the client when the property is eventually sold; that loss cannot be allocated to the other partners. 165. Syndication costs are costs incurred in bringing an investment partnership to market. These costs include brokerage commissions and fees; registration fees; legal and accounting fees for developing the offering document; and printing and distribution costs for the prospectus, placement memoranda, and related documents. Under § 709, syndication costs cannot be deducted and no amortization is permitted. Upon termination of the partnership, the partners’ bases will theoretically still include those costs, so the partner might have a lower gain or a greater loss at that time. 166. Because neither partner is a C corporation and the partnership is not a tax shelter, the partnership may select any accounting method: cash, accrual, or a hybrid of the two methods. (If one partner was a C corporation, the cash method could still be used unless the average annual gross receipts exceeded a threshold amount ($30,000,000 for 2024). If the partnership uses the accrual method of accounting in determining its income, the partners will be taxed on partnership revenues from all closed transactions. In this regard, it does not matter whether cash has been received by the partnership and whether the partners use the accrual method on their individual tax returns. Thus, if the partnership adopts the accrual method for tax purposes, the partners may be faced with reporting and paying taxes on partnership income long before cash is available for distribution. However, under accrual accounting, expenses incurred but not paid may serve to mitigate or eliminate this possibility. Regarding the July 1 to June 30 fiscal year, the desired tax deferral has little chance of success. Under § 706(b), the partnership must use the calendar year unless Harry and Sally can convince the IRS that a business purpose exists for a tax year other than the calendar year. Nothing in the fact pattern indicates that a valid business purpose exists for a fiscal year. The partnership may also elect to use a tax year other than the required tax year if the deferral period is three months or less (e.g., September, October or November year-end), and if the partnership agrees to deposit tax on the deferred income at a specified tax rate. This election cannot be used in this situation to obtain a July 1 to June 30 fiscal year. 167. a. For partnership allocations to meet the economic effect tests under the § 704(b) Regulations, a partnership agreement should provide that (1) capital accounts will be maintained, (2) liquidating proceeds will be distributed according to capital account balances, and (3) any partner with a deficit capital account balance will contribute cash to the partnership to eliminate the deficit. b.

The MOG allocation will not be permitted. In addition to the three requirements above, the allocations must also meet the "substantial" requirement. Though the partnership agreement may meet the economic effect tests under § 704, the allocation does not produce pre-tax economic consequences to Molly and George. Therefore, the allocations are not effective for tax purposes because they have no function other than the reduction of the partners’ combined tax liability.

168. Tax basis in partnership interest. A partner’s basis in the partnership interest is the tax measure by which any Powered by Cognero

Page 45

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis taxable gain or loss is determined upon sale of the interest or receipt of cash distributions from the partnership. Basis is also used as the measure for determining whether the partner’s share of partnership losses can be deducted. Section 704(b) book capital. The partner's § 704(b) book capital account balance is an accounting measure of the partner’s ownership interest in the entity. Section 704(b) book capital accounts are referenced in determining the partnership’s allocations of income, gains, losses, deductions, and credits among the partners under § 704(b). In addition, liquidating distributions must be in accordance with ending § 704(b) book capital account balances under the substantial economic effect rules. Tax basis capital account. A partner's tax basis capital account is a measure of the partner's share of the tax basis of partnership assets. The tax basis capital account is reported on the partner's Schedule K-1. The partner’s initial tax basis (cost, gift, or inherited basis) is increased by her or his contributions to and decreased by distributions from the partnership (including changes in the partner’s share of partnership liabilities). In addition, tax basis is increased by the partner’s share of income and gains and decreased by her or his share of deductions and losses. Section 704(b) book capital accounts are similarly adjusted, except the adjustments are based on fair market value determinations and the calculation generally does not include the partner’s share of partnership liabilities. The partner's tax basis capital accounts are subject to these same increases and decreases, but the amounts are determined on a tax rather than fair market value basis; and again, liabilities are not included. On Schedule K-1, the tax basis capital account plus the partner's share of partnership debt will typically approximate the partner's tax basis in the partnership interest. (An exception would be if a step-up/down event occurred but the partnership decided not to make a § 754 election.) In contrast, the partner's (1) basis in the partnership and (2) § 704(b) book capital account are not typically shown in the partnership's tax return. 169. For property contributed by a partner to a partnership, the partnership “steps into the shoes” of the

contributing partner and continues to use the depreciation schedule used by the partner. For example, assume that at the midpoint of year 4, a calendar year partner contributes nonresidential real property that was purchased in August of year 1. The current year’s cost recovery will be calculated using the 39-year MACRS table for the “eighth month,” fourth recovery year. One-half of the cost recovery would be allocated to the partner, and the remainder would be allocated to the partnership. The following year would be the fifth recovery year, and the cost recovery would be allocated completely to the partnership. If newly capitalized costs arise on a contribution of assets to the partnership (e.g., transfer taxes or legal fees), the partnership treats these costs as newly acquired MACRS property and commences depreciation at the date the partnership places the property in service. 170. TAX FILE MEMORANDUM

DATE FROM SUBJECT

January 30, 2024 Beth Mullins Deductibility of loss from LLC

Facts. Jasmine Gregory reports the following allocations and bases in her LLC interests for the current year. Sparrow Starling Income (loss) allocation ($100,000) $36,000 Basis excluding liabilities 50,000 N/A Recourse liability allocation 10,000 N/A Nonrecourse liability allocation 30,000* N/A Powered by Cognero

Page 46

Name:

Class:

Date:

Chapter 21 Partnerships Formation Operations and Basis *This debt cannot be treated as qualified nonrecourse financing. Jasmine spends significant time working for each LLC during the year. Her modified AGI is $300,000 before considering the LLCs’ activities. She has no other business losses. Issues. How much of the $100,000 loss from Sparrow Properties LLC can Jasmine deduct in the current year? Under what Code provision are any disallowed losses suspended? Conclusion. Jasmine can deduct $36,000 of the $100,000 loss. Of the disallowed loss, $10,000 is suspended under § 704(d). An additional $30,000 is suspended under the at-risk limitations. The remaining suspended loss of $24,000 is suspended under the passive activity loss rules of § 469. The special $25,000 deduction for active participation in a passive real estate activity is not available because Jasmine’s modified AGI is too high. None of the loss is suspended under the excess business loss limitation. Law and analysis. Under § 704(d), Jasmine may deduct a portion of the Sparrow loss equal to her basis in her LLC interest, including recourse and nonrecourse liabilities. The basis is $90,000 ($50,000 + $10,000 + $30,000), and the excess $10,000 loss is suspended. The $30,000 of nonrecourse debt cannot be included in the amount at risk, because it is not qualified nonrecourse indebtedness. Therefore, an additional $30,000 is suspended under the at-risk limitation rules of § 465. (After this limitation, $60,000 of the loss is still available for testing under the passive loss limitation rules.) The activities of both LLCs are treated as rental activities, which, by definition, are passive for purposes of § 469. The Sparrow loss is deductible to the extent of the $36,000 of income from Starling. Also, because Sparrow conducts rental real estate activities and Jasmine is an active participant owning more than 10%, this loss is eligible for an additional $25,000 deduction. However, none of this additional $25,000 deduction is available to Jasmine, because her modified AGI exceeds $150,000 (the top of the phaseout range for the additional deduction allowance). The $36,000 loss allowed under the passive activity loss rules exactly equals the passive income from Starling, so the net deductible loss from all activities is $0. Therefore, the excess business loss limitation does not apply.

Powered by Cognero

Page 47

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations True / False 1. A cash distribution from a partnership to a partner generally is taxable to the partner. a. True b. False 2. For Federal income tax purposes, a distribution from a partnership to a partner is treated the same as a distribution from a C corporation to its shareholders. a. True b. False 3. In a current (nonliquidating) distribution, loss never is recognized by the partnership. a. True b. False 4. Anna and Brad are equal partners in the AB LLC. If AB distributes $10,000 of cash to Anna and a capital asset valued at $10,000 to Brad and if both Anna and Brad continue to be members of the LLC, the distribution is classified as a proportionate current distribution. a. True b. False 5. Generally, a proportionate distribution of property does not result in a gain to a partner on either a current or liquidating distribution. A situation in which a gain may arise, however, is when a partner contributed appreciated property to the partnership and that property is distributed back to that same contributing partner within seven years of the contribution. a. True b. False 6. Loss cannot be recognized on a current (nonliquidating) distribution from a partnership unless cash, unrealized receivables, and/or § 1231 assets are the only items distributed. a. True b. False 7. Generally, no gain is recognized on a proportionate liquidating or current (nonliquidating) distribution of noncash property, even if the fair market value of property distributed exceeds the partner’s basis in the partnership interest. a. True b. False 8. In a proportionate current (nonliquidating) distribution of cash and a capital asset, the partner recognizes gain to the extent the amount of cash plus the fair market value of property distributed exceeds the partner’s basis in the partnership interest. a. True b. False 9. In a proportionate current (nonliquidating) distribution, cash is deemed to be distributed first, followed by capital and § 1231 assets, and last, unrealized receivables and inventory. a. True b. False Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations 10. A gain arises only on a distribution from a partnership of cash that exceeds the partner’s basis in the partnership interest. For this purpose, only cash, checks, and credit card charges are treated as cash. a. True b. False 11. The ELF Partnership distributed $20,000 cash to Emma in a proportionate, current (nonliquidating) distribution. Emma’s basis in her partnership interest was $12,000 immediately before the distribution. As a result of the distribution, Emma’s basis is reduced to $0 and she recognizes an $8,000 gain. a. True b. False 12. Scott owns a 30% interest in the capital and profits of the SOS Partnership. Immediately before he receives a proportionate current (nonliquidating) distribution from SOS, the basis of his partnership interest is $40,000. The distribution consists of $30,000 in cash and land with a fair market value of $80,000. SOS’s adjusted basis in the land immediately before the distribution is $50,000. As a result of the distribution, Scott recognizes no gain or loss and his basis in the land is $10,000. a. True b. False 13. Randi owns a 40% interest in the capital and profits of the RAY Partnership. Immediately before she receives a proportionate current (nonliquidating) distribution from RAY, the basis for her partnership interest is $60,000. The distribution consists of $45,000 in cash and land with a fair market value of $72,000. RAY’s adjusted basis in the land immediately before the distribution is $36,000. As a result of the distribution, Randi recognizes a gain of $57,000. a. True b. False 14. Lori, a partner in the JKL partnership, received a proportionate current (nonliquidating) distribution of $10,000 cash, unrealized receivables with a basis of $0 and a fair market value of $15,000, and land with a basis of $6,000 and a fair market value of $10,000. Her basis in the partnership interest immediately before the distributions was $14,000. She will recognize $0 gain on the distribution, and her basis in the receivables and land will be $0 and $4,000, respectively. a. True b. False 15. Matt, a partner in the MB Partnership, receives a proportionate, current (nonliquidating) distribution of property having a fair market value of $16,000 and a partnership basis of $23,000. Matt’s basis in the partnership is $10,000 before the distribution. In this situation, Matt will recognize no gain or loss. He takes a $10,000 basis in the property, and his basis in the partnership interest is reduced to zero. a. True b. False 16. Tim and Darby are equal partners in the TD Partnership, which owns no hot assets. Partnership income for the year is $60,000. Tim needs cash to pay tax on his share of the partnership income, but Darby wants to leave the cash in the partnership for expansion. If the partners agree, it is acceptable for TD to distribute $8,000 to Tim but no cash or other property to Darby. a. True b. False Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations 17. Marcie is a 40% member of the M&A LLC. Her basis is $10,000 immediately before the LLC distributes to her $30,000 of cash and land (basis to the LLC of $20,000 and fair market value of $25,000). As a result of the proportionate current (nonliquidating) distribution, Marcie recognizes a gain of $20,000, and her basis in the land is $0. a. True b. False 18. The BAM Partnership distributed the following assets to partner Barbie in a proportionate current (nonliquidating) distribution: $10,000 cash, land parcel A (basis of $5,000, fair market value of $30,000) and land parcel B (basis of $10,000, fair market value of $30,000). Barbie’s basis in her partnership interest was $40,000 immediately before the distribution. Barbie will allocate a basis of $10,000 and $20,000, respectively, to the two land parcels, and her basis in her partnership interest will be reduced to $0. a. True b. False 19. Carl’s basis in his LLC interest is $10,000. In a proportionate current (nonliquidating) distribution, Carl receives land (basis = $10,000; fair market value = $12,000) and inventory (basis = $6,000; fair market value = $8,000). Carl takes a $10,000 basis in the land and a $0 basis in the inventory and has a $0 basis in the LLC interest. a. True b. False 20. In a liquidating distribution that liquidates the partnership, each partner recognizes gain or loss equal to the difference between the value of assets received less the partner’s basis in the partnership interest. a. True b. False 21. In a proportionate liquidating distribution, RST Partnership distributes to partner Riley cash of $30,000, accounts receivable (basis of $0, fair market value of $40,000), and land (basis of $65,000, fair market value of $50,000). Riley’s basis was $40,000 before the distribution. On the liquidation, Riley recognizes a gain of $0, and her basis is $10,000 in the land and $0 in the accounts receivable. a. True b. False 22. In a proportionate liquidating distribution, WYX Partnership distributes to partner William cash of $40,000, cash basis accounts receivable (basis of $0, fair market value of $10,000), and land (basis of $30,000, fair market value of $50,000). William’s basis was $80,000 before the distribution. On the liquidation, William recognizes a $20,000 gain, and he takes a basis of $10,000 in the accounts receivable and $50,000 in the land. a. True b. False 23. Zach’s partnership interest basis is $100,000. Zach receives a proportionate liquidating distribution from a liquidating partnership of $50,000 cash and inventory having a basis of $20,000 to the partnership and a fair market value of $30,000. Zach assigns a basis of $20,000 to the inventory and recognizes a $30,000 loss. a. True b. False 24. The JIH Partnership distributed the following assets to partner James in a proportionate liquidating distribution in which the partnership also liquidated: $25,000 cash, land parcel A (basis of $5,000, fair market value of $30,000), and land parcel B (basis of $5,000, fair market value of $15,000). James’s basis in his partnership interest was $85,000 Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations immediately before the distribution. James will allocate bases of $40,000 to parcel A and $20,000 to parcel B, and he will have no remaining basis in his partnership interest. a. True b. False 25. Carlos receives a proportionate liquidating distribution consisting of $8,000 cash and inventory with a basis to the partnership of $5,000 and a fair market value of $6,000. His basis in his partnership interest was $15,000 immediately before the distribution. Carlos assigns a basis of $7,000 to the inventory and recognizes no gain or loss. a. True b. False 26. In a proportionate liquidating distribution in which the partnership is also liquidated, Ralph received cash of $30,000, accounts receivable (basis of $0, fair market value of $20,000), and land (basis of $1,000, fair market value of $10,000; treated as a capital asset by the partnership). Immediately before the distribution, Ralph’s basis in the partnership interest was $40,000. Ralph realizes and recognizes a loss of $9,000, and his basis is $0 in the accounts receivable and $1,000 in the land. a. True b. False 27. Two years ago, Marcus contributed land with a basis of $6,000 and a fair market value of $20,000 in exchange for a 30% interest in the MNO LLC. The partnership has no hot assets. This year when the value was $25,000, that property was distributed to Jamal whose basis in the LLC interest was $50,000 before the distribution. Marcus recognizes a gain of $14,000 and increases his basis in his LLC interest by that same amount; Jamal takes a $20,000 basis in the distributed property. a. True b. False 28. Normally a distribution of property from a partnership does not result in gain recognition. However, a distribution of marketable securities may trigger gain recognition. a. True b. False 29. The Crimson Partnership is a service-providing consulting firm, and Jana is a 20% general partner with a $100,000 basis in her partnership interest. Crimson's assets consist of unrealized receivables (basis of $0, fair market value of $400,000), cash of $300,000, and land (basis of $200,000, fair market value of $300,000). If Crimson distributes $200,000 cash to Jana in liquidation of her interest in the partnership (and Crimson does not liquidate), Jana will recognize ordinary income of $80,000 and a capital gain of $20,000. a. True b. False 30. Midway through the current tax year, Georgie sells her 40% interest in the GHI Partnership to new partner Kelly for $150,000, including Georgie’s share of partnership liabilities. At the beginning of the tax year, Georgie’s basis in her partnership interest was $40,000 (excluding her share of partnership debt). The partnership reported income of $120,000 for the year, and Georgie’s share of partnership debt was $50,000 at the sale date. (Assume that the partnership uses a monthly proration of income.) On the sale date, the partnership’s assets consist of cash ($195,000), land (basis of $90,000, fair market value of $120,000), and unrealized receivables (basis of $0, fair market value of $60,000). Georgie will recognize ordinary income of $24,000 and a capital gain of $12,000, for a total of $36,000 on the sale. a. True Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations b. False 31. Mark contributed property to the MDB Partnership in year 1. At the time of the contribution, the basis in the property was $40,000 and its value was $50,000. In year 5, MDB distributed that property to partner Dara. The partnership has no hot assets. Because this is a distribution of precontribution gain property, Dara may recognize a gain. a. True b. False 32. In addition to its non-hot assets, BC LLC owns unrealized receivables (basis = $0, fair market value = $60,000). If BC distributes $60,000 cash to Bart and the unrealized receivable to Charles in a current (nonliquidating) distribution, then Bart will recognize ordinary income of $30,000, and Charles will take a basis of $30,000 in receivables valued at $60,000. a. True b. False 33. Taylor’s basis in his partnership interest is $140,000, including his $60,000 share of partnership debt. Sandy buys Taylor’s partnership interest for $100,000 cash, and she assumes Taylor’s $60,000 share of the partnership’s debt. If the partnership owns no hot assets, Taylor will recognize a capital loss of $40,000. a. True b. False 34. James received a distribution of $110,000 cash in liquidation of his 25% managing (general partner) interest in the JKL LLP. JKL is a service-oriented entity. Before the distribution, the LLP’s assets consisted of $200,000 cash, land (basis of $40,000, value of $100,000), unrealized receivables (basis of $0, value of $100,000), and goodwill (basis of $0, value of $40,000). $10,000 of the total payment is for James' share of partnership goodwill, which is not provided for in the partnership agreement. James will recognize $35,000 of ordinary income from his §736(a) payment; the remaining $75,000 distribution is treated as a § 736(b) property payment for his partnership interest. a. True b. False 35. Nick sells his 25% interest in the LMNO Partnership to new partner Katrina for $67,500. The partnership’s assets consist of cash ($100,000), land (basis of $90,000, fair market value of $110,000), and inventory (basis of $40,000, fair market value of $60,000). Nick’s basis in his partnership interest was $57,500. On the sale, Nick will recognize ordinary income of $5,000 and a capital gain of $5,000. a. True b. False 36. If one partner in a two-partner partnership dies, the estate cannot be a partner, so the partnership is terminated. a. True b. False 37. A partnership has accounts receivable with a basis of $0, a fair market value of $30,000, and depreciation recapture potential of $20,000. All other assets of the partnership are either cash, capital assets, or § 1231 assets. If a purchaser acquires a 40% interest in the partnership from another partner, the selling partner recognizes ordinary income of $12,000. a. True b. False 38. A § 754 election is made for a tax year in which the partner recognizes gain or loss on a distribution from the partnership or the distributee partner’s basis in distributed property is increased or decreased from the inside basis the Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations partnership held in those assets. The election is made by the partnership each year in which it is necessary to adjust a partner’s share of the inside basis of partnership assets; in a year in which an unfavorable result would arise, the partnership can forgo making the election. a. True b. False 39. Orson was a 40% partner in the calendar year ORP LLC. When Orson died on June 30, the interest transferred to his estate. On October 1 of that year, Yolanda, an unrelated third party, purchased Orson’s interest from his estate (with the approval of the other LLC members). The LLC’s operating agreement provides that a monthly allocation (annual income divided by 12) will be used to prorate income when required. For the year, the LLC will issue three Schedules K-1 related to this interest: (1) 20% of the year’s income to Orson, (2) 10% to Orson's Estate, and (3) 10% to Yolanda. a. True b. False 40. A partnership must make a downward adjustment to the basis of its assets if a partnership interest is sold and if the total basis of partnership assets exceeds their value by more than $250,000, even if a § 754 election is not in effect. a. True b. False 41. Beth sold her 25% partnership interest to Katie for $50,000 cash on July 1 (the halfway point) of the current tax year. Katie also assumed Beth’s share of the partnership’s liabilities. Beth’s basis in her partnership interest at the beginning of the year was $40,000, including a $15,000 share of partnership liabilities. The partnership’s income for the entire year was $100,000, and Beth’s share of partnership debt was $10,000 as of the date she sold the partnership interest. Assume the calendar year partnership has no hot assets, all of its income is earned evenly throughout the year, and the partnership uses the monthly proration method to allocate its income among the partners. Beth recognizes a gain of $12,500 on the sale. a. True b. False 42. The MBA Partnership makes a § 736(b) cash payment of $20,000 to partner Amanda in liquidation of her interest in the partnership. The partnership owns no hot assets and has no outstanding liabilities. Amanda’s basis in her partnership interest before the distribution was $50,000. If the partnership has a § 754 election in effect, it will record a $30,000 decrease in its inside basis in partnership assets, affecting all the remaining partners in the partnership. a. True b. False 43. Jeremy sold his 40% interest in the HIJ Partnership to Ashley for $400,000. The inside basis of all partnership assets was $600,000 at the time of the sale. If the partnership makes a § 754 election, it will record a $160,000 step-up in the basis of the partnership assets, and the step-up will be attributed solely to Ashley. a. True b. False 44. In the year that a donor gives a partnership interest to a donee, their share of the partnership’s income is prorated between the donor and donee. a. True b. False 45. Bob received a proportionate current (nonliquidating) distribution of land from the BZ Partnership. The land had a fair market value of $15,000 and a basis to the partnership of $10,000. The land was held for investment purposes by the Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations partnership. Bob’s basis in his partnership interest immediately before the distribution was $6,000. If the partnership has a § 754 election in effect, it will record a $4,000 step-down in the basis of remaining assets, and the step-down will be attributed to all partners in the partnership. a. True b. False 46. A two-person partnership terminates when one partner sells his, her, or its partnership interest to the other partner. This termination triggers a deemed liquidating distribution to the partners and a second level of tax on the realized gain (fair market value less partnership basis) in the partnership’s assets. a. True b. False 47. A limited liability company generally provides limited liability for those owners that are not active in the management of the LLC but requires owner–managers of the LLC to have unlimited personal liability for LLC debts. a. True b. False 48. Fred and Wilma formed the equally owned FW partnership several years ago. On the last day of the prior tax year, they each transferred a 20% interest in the FW partnership (a capital-intensive business) to their son, Rocky, in a bona fide transaction (40% total to Rocky; Fred and Wilma each retained 30% interests). For the current tax year, FW reported income of $200,000. Fred provides services to the partnership valued at $60,000; Wilma and Rocky provide no services. The $200,000 of income will be allocated $102,000 to Fred, $56,000 to Rocky, and $42,000 to Wilma. a. True b. False 49. GHI Partnership is a service-providing partnership owned 60% by Greg and 20% each by Howard and Isaac. Greg is an active general partner and wants to dispose of his partnership interest for $100,000, including $20,000 for partnership goodwill (a goodwill payment to a retiring partner is not provided for in the partnership agreement). The partnership owns no hot assets. Greg will have the same tax result if he sells his interest to Howard and Isaac for $50,000 each ($100,000 total) or if GHI redeems Greg's interest by distributing $100,000 of cash to Greg. a. True b. False 50. Jeremiah received a proportionate nonliquidating distribution of land from the JZ Partnership. The land had a fair market value of $65,000 and a basis to the partnership of $50,000. The land was held for investment purposes by the partnership. Jeremiah’s basis in his partnership interest immediately before the distribution was $40,000. The partnership’s only remaining assets were cash, another parcel of land, and a building on that land. If the partnership has a § 754 election in effect, it will record a $10,000 basis step-up; a portion of the step-up will be allocated to the building and will be depreciated; and the step-up and any related depreciation expense will be allocated among all the partners in the partnership. a. True b. False Multiple Choice 51. Which of the following would be classified as disproportionate distributions? Assume that both A and B own 50% interests in the AB Partnership, the partnership owns hot assets, and the partners remain partners in AB after the distribution. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations a. Partner A receives $6,000 cash and Partner B receives a capital asset valued at $6,000. b. Partner A receives $6,000 cash and Partner B receives inventory items valued at $6,000 (basis $3,500). c. Both partners receive unrealized receivables with a basis of $0 and a value of $6,000. d. Choices a. and c. represent disproportionate distributions. 52. Dan receives a proportionate current (nonliquidating) distribution when the basis of his partnership interest is $30,000. The distribution consists of $10,000 in cash and property with an adjusted basis to the partnership of $24,000 and a fair market value of $26,500. Dan's basis in the noncash property is: a. $26,500. b. $24,000. c. $20,000. d. $10,000. 53. At the beginning of the year, Elsie’s basis in the E&G Partnership interest is $90,000. She receives a proportionate current (nonliquidating) distribution from the partnership consisting of $10,000 of cash, unrealized accounts receivable (basis of $0, fair market value of $40,000), and land (basis of $30,000, fair market value of $50,000). After the distribution, Elsie’s bases in the accounts receivable, land, and partnership interest are: a. $0; $30,000; and $50,000. b. $0; $50,000; and $30,000. c. $40,000; $30,000; and $10,000. d. $40,000; $40,000; and $0. 54. Megan’s basis was $120,000 in the MYP Partnership interest just before she received a proportionate current (nonliquidating) distribution consisting of land held for investment (basis of $100,000, fair market value of $130,000) and inventory (basis of $80,000, fair market value of $70,000). After the distribution, Megan’s bases in the received assets are, respectively: a. $100,000 (land) and $20,000 (inventory). b. $120,000 (land) and $0 (inventory). c. $50,000 (land) and $70,000 (inventory). d. $40,000 (land) and $80,000 (inventory). 55. Mark receives a proportionate current (nonliquidating) distribution. At the beginning of the partnership year, the basis of his partnership interest is $80,000 and his share of the partnership's income for the year is $20,000. During the year, he received a cash distribution of $40,000 and a property distribution (basis of $30,000, fair market value of $25,000). In addition, Mark’s share of partnership liabilities was reduced by $10,000 during the year. How much gain or loss does Mark recognize; what is his basis in the property he received; and what is his remaining basis in the partnership interest? a. $25,000 loss; $25,000 basis in property; $0 remaining basis. b. $30,000 loss; $30,000 basis in property; $0 remaining basis. c. $0 gain or loss; $25,000 basis in property; $25,000 remaining basis. d. $0 gain or loss; $30,000 basis in property; $20,000 remaining basis. 56. Mack has a basis in a partnership interest of $200,000, including his share of partnership debt. At the end of the current year, the partnership distributed to Mack, in a proportionate current (nonliquidating) distribution, cash of $20,000, inventory (basis to the partnership of $30,000 and fair market value of $40,000), and land (basis to the partnership of $40,000 and fair market value of $42,000). In addition, Mack’s share of partnership debt decreased by $12,000 during the year. What basis does Mack take in the inventory and land and in the partnership interest (including debt share) following the distribution? Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations a. $30,000 basis in inventory; $40,000 basis in land; $98,000 basis in partnership. b. $30,000 basis in inventory; $42,000 basis in land; $110,000 basis in partnership. c. $40,000 basis in inventory; $40,000 basis in land; $86,000 basis in partnership. d. $40,000 basis in inventory; $42,000 basis in land; $98,000 basis in partnership. 57. On December 31, the last day of the current taxable year, Jack has a basis in a partnership interest of $300,000, including his $80,000 share of partnership debt. On that date, the partnership pays off its liabilities and makes a proportionate current (nonliquidating) distribution to its partners. Jack receives a parcel of land (partnership basis = $120,000, value = $135,000) and inventory (partnership basis = $160,000, value = $180,000). Following the distribution, what is Jack’s basis in the land, inventory, and partnership interest? a. $120,000 basis in land; $160,000 basis in inventory; $20,000 basis in partnership interest. b. $40,000 basis in land; $180,000 basis in inventory; $0 basis in partnership interest. c. $60,000 basis in land; $160,000 basis in inventory; $0 basis in partnership interest. d. $60,000 basis in land; $160,000 basis in inventory; $80,000 basis in partnership interest. 58. Frank receives a proportionate current (nonliquidating) distribution from the AEF Partnership. The distribution consists of $10,000 cash and property (adjusted basis to the partnership of $54,000 and fair market value of $60,000). Immediately before the distribution, Frank’s adjusted basis in the partnership interest was $50,000. His basis in the noncash property received is: a. $0. b. $40,000. c. $50,000. d. $54,000. 59. Alyce owns a 30% interest in a continuing partnership. The partnership distributes a $35,000 year-end cash payment to Alyce. In a proportionate current (nonliquidating) distribution, the partnership also distributed property (basis of $20,000, fair market value of $30,000) to Alyce. Immediately before the distributions of cash and property, Alyce’s basis in the partnership interest was $60,000. As a result of the distribution, Alyce recognizes: a. No gain or loss. b. Ordinary loss of $5,000. c. Capital loss of $5,000. d. Ordinary gain of $5,000. 60. Catherine’s basis was $50,000 in the CAR Partnership just before she received a proportionate current (nonliquidating) distribution consisting of land held for investment with a basis to CAR of $40,000 (value of $60,000) and inventory with a basis of $40,000 (value of $60,000). After the distribution, Catherine’s bases in the land and inventory are: a. $40,000 (land); $40,000 (inventory). b. $40,000 (land); $10,000 (inventory). c. $10,000 (land); $40,000 (inventory). d. $60,000 (land); $40,000 (inventory). 61. Misha receives a proportionate current (nonliquidating) distribution when the basis of his partnership interest is $60,000. The distribution consists of $80,000 cash and inventory (adjusted basis to the partnership of $10,000, fair market value of $20,000). How much gain or loss does Misha recognize, and what is his basis in the distributed inventory and in the partnership interest following the distribution? Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations a. $0 gain or loss; $10,000 basis in inventory; $0 basis in partnership interest. b. $0 gain or loss; $20,000 basis in inventory; $50,000 basis in partnership interest. c. $20,000 capital gain; $0 basis in inventory; $0 basis in partnership interest. d. $20,000 ordinary income; $0 basis in inventory; $20,000 basis in partnership interest. 62. Nicky’s basis in her partnership interest was $150,000, including her $40,000 share of partnership liabilities. The partnership decides to liquidate, and after repaying all liabilities, distributes all remaining assets proportionately to the partners. Nicky receives $30,000 cash and inventory with a $50,000 basis and a $58,000 fair market value to the partnership. What loss does Nicky recognize, and what is her basis in the inventory? a. $70,000 loss; $50,000 basis. b. $30,000 loss; $50,000 basis. c. $22,000 loss; $58,000 basis. d. $0 loss; $80,000 basis. 63. Anthony’s basis in the WAM Partnership interest was $200,000 just before he received a proportionate liquidating distribution consisting of investment land (basis of $90,000, fair market value of $100,000) and inventory (basis of $30,000, fair market value of $70,000). After the distribution, Anthony’s recognized gain or loss and his basis in the land and inventory are: a. $80,000 loss; $90,000 (land); $30,000 (inventory). b. $70,000 loss; $100,000 (land); $30,000 (inventory). c. $30,000 loss; $100,000 (land); $70,000 (inventory). d. $0 gain or loss; $170,000 (land); $30,000 (inventory). 64. Beth has an outside basis of $100,000 in the BJDE Partnership as of December 31 of the current year. On that date, the partnership liquidates and distributes to Beth a proportionate distribution of $50,000 cash and inventory with an inside basis to the partnership of $10,000 and a fair market value of $16,000. In addition, Beth receives an antique desk (not inventory) that has an inside basis (and fair market value) of $5,000. None of the distribution is for partnership goodwill. How much gain or loss will Beth recognize on the distribution, and what basis will she take in the desk? a. $40,000 loss; $0 basis. b. $35,000 loss; $5,000 basis. c. $0 gain or loss; $5,000 basis. d. $0 gain or loss; $40,000 basis. 65. Landis received $90,000 cash and a capital asset (basis of $50,000, fair market value of $60,000) in a proportionate liquidating distribution. His basis in his partnership interest was $120,000 prior to the distribution. How much gain or loss does Landis recognize, and what is his basis in the asset received? a. $0 gain or loss; $30,000 basis. b. $0 gain or loss; $50,000 basis. c. $20,000 gain; $50,000 basis. d. $30,000 gain; $60,000 basis. 66. Suzy owns a 30% interest in the JSD LLC. In liquidation of the entity, Suzy receives a proportionate distribution of $30,000 cash, inventory (basis of $16,000, fair market value of $18,000), and land (basis of $25,000, fair market value of $30,000). Suzy’s basis in the entity immediately before the distribution was $80,000. As a result of the distribution, what is Suzy’s basis in the inventory and land, and how much gain or loss does she recognize? a. $0 basis in inventory; $25,000 basis in land; $0 gain or loss. Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations b. $16,000 basis in inventory; $34,000 basis in land; $0 gain or loss. c. $16,000 basis in inventory; $25,000 basis in land; $9,000 loss. d. $18,000 basis in inventory; $32,000 basis in land; $0 gain or loss. 67. Jonathon owns a one-third interest in a liquidating partnership that owns no hot assets. Immediately before the liquidation, his basis in the partnership interest is $60,000. The partnership distributes cash of $32,000 and two parcels of land (each with a fair market value of $10,000). Parcel A has a basis of $2,000 to the partnership and Parcel B has a basis of $6,000. Jonathon’s basis in the two parcels of land is: a. Parcel A, $2,000; Parcel B, $6,000. b. Parcel A, $7,000; Parcel B, $21,000. c. Parcel A, $10,000; Parcel B, $10,000. d. Parcel A, $14,000; Parcel B, $14,000. 68. Janella’s basis in her partnership interest was $120,000, including her $150,000 share of partnership debt. At the end of the current year, the partnership pays off its debts and liquidates. Janella receives a proportionate liquidating distribution consisting of $42,000 cash and inventory valued at $24,000 (adjusted basis to the partnership = $20,000). How much gain or loss does Janella recognize, and what is her basis in the distributed property? a. $0 gain or loss; $78,000 basis in property. b. $58,000 capital loss; $20,000 basis in property. c. $30,000 capital gain; $24,000 basis in property. d. $72,000 capital gain; $0 basis in property. 69. Michelle receives a proportionate liquidating distribution when the basis of her partnership interest is $50,000. The distribution consists of $58,000 cash and noninventory property (adjusted basis to the partnership of $10,000 and fair market value of $12,000). The partnership has no hot assets. How much gain or loss does Michelle recognize, and what is her basis in the distributed property? a. $0 gain or loss; $10,000 basis in property. b. $0 gain or loss; $50,000 basis in property. c. $8,000 ordinary income; $0 basis in property. d. $8,000 capital gain; $0 basis in property. 70. In a proportionate liquidating distribution, Sam receives a distribution of $30,000 cash, accounts receivable (basis of $0, fair market value of $50,000), and land (basis of $20,000, fair market value of $50,000). In addition, the partnership repays all liabilities of which Sam’s share was $40,000. Sam’s basis in the entity immediately before the distribution was $120,000. As a result of the distribution, what is Sam’s basis in the accounts receivable and land, and how much gain or loss does he recognize? a. $0 basis in accounts receivable; $50,000 basis in land; $0 gain or loss. b. $0 basis in accounts receivable; $90,000 basis in land; $0 gain or loss. c. $50,000 basis in accounts receivable; $40,000 basis in land; $0 gain or loss. d. $50,000 basis in accounts receivable; $50,000 basis in land; $50,000 gain. 71. In a proportionate liquidating distribution, Ashleigh receives a distribution of $30,000 cash, accounts receivable (basis of $0, fair market value of $40,000), and land (basis of $40,000, fair market value of $50,000). In addition, the partnership repays all liabilities of which Ashleigh’s share was $70,000. Ashleigh’s basis in the entity immediately before the distribution was $60,000. As a result of the distribution, what is Ashleigh’s basis in the accounts receivable and land, and how much gain or loss does she recognize? a. $0 basis in accounts receivable; $30,000 basis in land; $20,000 gain. Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations b. $0 basis in accounts receivable; $0 basis in land; $40,000 gain. c. $0 basis in accounts receivable; $40,000 basis in land; $0 gain or loss. d. $40,000 basis in accounts receivable; $20,000 basis in land; $20,000 gain. 72. In a proportionate liquidating distribution, Sara receives a distribution of $40,000 cash, accounts receivable (basis of $0, fair market value of $30,000), and inventory (basis of $50,000, fair market value of $60,000). Her basis in the entity immediately before the distribution was $120,000. As a result of the distribution, what is Sara’s basis in the accounts receivable and inventory, and how much gain or loss does she recognize? a. $0 basis in accounts receivable; $50,000 basis in inventory; $30,000 loss. b. $0 basis in accounts receivable; $80,000 basis in inventory; $0 gain or loss. c. $40,000 basis in accounts receivable; $40,000 basis in inventory; $0 gain or loss. d. $30,000 basis in accounts receivable; $50,000 basis in inventory; $30,000 loss. 73. Which of the following statements correctly reflects one of the rules regarding proportionate liquidating distributions? a. A partner’s basis in distributed unrealized receivables is the lesser of the partnership’s basis in the receivables or their fair market value. b. The basis of unrealized receivables cannot be stepped up to their fair market value unless the partner has adequate unabsorbed basis. c. Assets are deemed distributed in the following order: cash, unrealized receivables and inventory, and finally, capital assets. d. The partner can recognize gain but not loss on a proportionate liquidating distribution. 74. Which of the following distributions would never result in gain recognition to the recipient (distributee) partner? a. A distribution of cash that follows a contribution of appreciated property to the partnership. b. A distribution of property to a partner who, three years ago, contributed other property with a built-in gain. c. A distribution to a second partner of property contributed by the first partner two years ago. d. A distribution of inventory property that is proportionate to the partners. 75. Last year, Darby contributed land (basis of $60,000, fair market value of $80,000) to the Seagull LLC in exchange for a 25% interest in the LLC. In the current year, the LLC distributes the land (now worth $82,000) to Shelby, who is also a 25% owner. Immediately prior to the distribution, Darby’s basis in the LLC was $70,000, and Shelby’s basis in the LLC was $110,000. The partnership owns no hot assets. How much gain or loss must be recognized and by whom? What is Shelby’s basis in the property she receives and Darby’s basis in her partnership interest following the distribution? a. No gain or loss; Shelby’s basis in the property is $80,000; Darby’s basis in interest is $70,000. b. $20,000 gain recognized by Darby; Shelby’s basis in the property is $80,000; Darby’s basis in interest is $90,000. c. $22,000 gain recognized by Darby; Shelby’s basis in the property is $82,000; Darby’s basis in interest is $92,000. d. $20,000 gain recognized by Shelby; Shelby’s basis in the property is $80,000; Darby’s basis in interest is $90,000. 76. Which of the following is not typically considered a hot asset? a. Accounts receivable of a cash basis partnership. b. Inventory with a basis of $16,000 and a fair market value of $15,000. c. Depreciation recapture potential. Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations d. Land held for development. 77. Tom, Tina, Tatum, and Terry are equal owners (treated as general partners) in the 4-Ts LLC, a cash basis service entity. 4-Ts has unrealized receivables of $400,000 (basis of $0) and no other hot assets. A goodwill payment of $50,000 per partner is provided for in the LLC’s operating agreement. If 4-Ts distributes cash of $300,000 to Tom in liquidation of his LLC interest, which of the following statements is correct? a. The $50,000 payment that relates to LLC goodwill cannot be deducted by the LLC. b. The partnership treats the $100,000 payment for Tom's share of unrealized receivables as part of Tom's § 736(b) payment. c. The $150,000 § 736(a) payment will result in a capital gain to Tom. d. The $200,000 § 736(b) payment will be taxed to Tom as ordinary income. 78. The December 31 balance sheet of the RST General Partnership reads as follows.

Cash Receivables Capital and § 1231 assets Total

Adjusted Basis $ 65,000 –0– 55,000 $120,000

FMV $ 65,000 7,500 100,000 $172,500

Roy, capital Sue, capital Ted, capital Total

$ 40,000 40,000 40,000 $120,000

$ 57,500 57,500 57,500 $172,500

The partners share equally in partnership capital, income, gain, loss, deduction, and credit. Ted’s adjusted basis for his partnership interest is $40,000. On December 31, general partner Ted retires from the partnership, receiving a $60,000 cash payment in liquidation of his interest. The partnership agreement states that $2,500 of the payment is for goodwill. Which of the following statements about this distribution is false? a. If capital is not a material income-producing factor to the partnership, the § 736(a) payment will be $2,500. b. If capital is a material income-producing factor, the entire $60,000 payment will be a § 736(b) property payment. c. The payment for Ted’s share of goodwill will create $2,500 of ordinary income to him. d. The partnership can deduct any amount that is a § 736(a) payment because it will be determined without regard to partnership profits. 79. Rajesh contributed appreciated property to the RS Partnership in year 1. In year 4, that property was distributed to Simon. Which one of the following statements best captures the tax consequences of the distribution? Assume the partnership has no hot assets, the property value has increased since the original contribution, and none of the precontribution gain has previously been recognized. a. Distributions are tax-deferred transactions; because no cash is distributed, neither the partners nor the partnership recognize gain on the distribution. b. The partnership recognizes the precontribution gain; Simon’s basis in the property is increased by the amount of recognized gain. c. Simon recognizes the precontribution gain and increases his basis in the partnership interest; the partnership’s Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations basis in other property is increased by the amount of recognized gain. d. Rajesh recognizes the precontribution gain and increases his basis in the partnership interest; Simon’s basis in the distributed property is increased by the amount of recognized gain. 80. The December 31 balance sheet of GST Services, LLP reads as follows.

Cash Receivables Capital assets Total

Adjusted Basis $300,000 –0– 120,000 $420,000

FMV $300,000 150,000 150,000 $600,000

George, capital Sue, capital Tom, capital Total

$140,000 140,000 140,000 $420,000

$200,000 200,000 200,000 $600,000

The partners share equally in partnership capital, income, gain, loss, deduction, and credit. Capital is not a material income-producing factor to the partnership, and all partners are active in the business. On December 31, general partner Sue receives a distribution of $200,000 cash in liquidation of her partnership interest under § 736. Sue’s outside basis for the partnership interest immediately before the distribution is $150,000. (Her basis does not correspond to her capital account because she purchased the interest a few years ago at a $10,000 premium and the partnership did not make a § 754 election.) How much is Sue’s gain or loss on the distribution and what is its character? a. $50,000 ordinary income. b. $40,000 ordinary income; $10,000 capital gain. c. $40,000 capital gain; $10,000 ordinary income. d. $50,000 ordinary income; $10,000 capital gain. 81. Which of the following statements is true regarding the sale of a partnership interest? a. The selling partner’s share of partnership liabilities is disregarded in determining the proceeds from the sale of a partnership interest. b. For purposes of computing the selling partner’s gain or loss, the partner’s basis in the partnership interest is determined as of the last day of the partnership tax year ending before the year in which the interest is sold. c. If a partner sells an interest in a partnership, income related to that interest for the year of the sale is allocated to the purchaser. d. The selling partner could be required to report both ordinary income and a capital gain or loss on the sale of the partnership interest. 82. The BR LLC owns an unrealized receivable with a basis of $0 and fair market value of $200,000 plus cash of $200,000. If BR distributes $20,000 of the receivable to 50% member Brenda and $20,000 of cash to 50% member Renee, which one of the following statements is true? Assume each partner has a partnership interest basis of $100,000. a. Brenda recognizes $20,000 of capital gain. b. The partnership recognizes $20,000 of ordinary income. c. Renee recognizes $10,000 of ordinary income. d. Brenda recognizes $10,000 of ordinary income. Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations 83. Miguel contributed substantially appreciated property to the MR Partnership in year 1. In year 4, other property was distributed to Miguel. The partnership does not have any hot assets. Which of the following statements is most likely to be true regarding the contribution and/or distribution? a. Miguel recognizes precontribution gain in year 4 when the second property is distributed to him. b. Miguel recognizes the precontribution gain on an amended tax return for year 1 when the second property is distributed to him. c. The partnership recognizes the precontribution gain in year 4 and allocates that gain to all the partners. d. The partnership recognizes the precontribution gain in year 1 and allocates that gain to Miguel. 84. Nicholas is a 25% owner in the DDBN LLC (a calendar year entity). At the end of the last tax year, Nicholas’s basis in his interest was $50,000, including his $20,000 share of LLC liabilities. On July 1 of the current tax year, Nicholas sells his LLC interest to Anna for $80,000 cash. In addition, Anna assumes Nicholas’s share of LLC liabilities, which, at that date, was $15,000. During the current tax year, DDBN’s taxable income is $120,000 (earned evenly during the year and allocated using the monthly proration method). Nicholas’s share of the LLC’s unrealized receivables is valued at $6,000 ($0 basis). At the sale date, what is Nicholas’s basis in his LLC interest, how much gain or loss must he recognize, and what is the character of the gain or loss on the sale of the partnership interest? a. $45,000 basis; $6,000 ordinary income; $44,000 capital gain. b. $60,000 basis; $6,000 ordinary income; $29,000 capital gain. c. $60,000 basis; $0 ordinary income; $35,000 capital gain. d. $75,000 basis; $0 ordinary income; $20,000 capital gain. 85. On June 30 of the current tax year, Sal sells her 40% interest in the STU Partnership to new partner James for $300,000, including Sal’s share of partnership liabilities. At the beginning of the tax year, Sal’s basis in her partnership interest was $80,000 (excluding her share of partnership debt). The partnership reported income of $240,000 for the year, and Sal’s share of partnership debt was $100,000 at the sale date. (Assume the partnership uses a monthly proration of income.) At the sale date, the partnership’s assets consist of cash ($390,000), land (basis of $180,000, fair market value of $210,000), and unrealized receivables (basis of $0, fair market value of $150,000). What is Sal’s basis at the sale date, and how much gain must Sal recognize on sale of the partnership interest, and what is the character of the gain? a. $180,000 basis, $60,000 ordinary income, $60,000 capital gain. b. $128,000 basis, $60,000 ordinary income, $112,000 capital gain. c. $228,000 basis, $60,000 ordinary income, $12,000 capital gain. d. $228,000 basis, $12,000 ordinary income, $60,000 capital gain. 86. The BLM LLC’s balance sheet on August 31 reads as follows.

Cash Receivables Capital assets

Nonrecourse debt Barney, capital Lillie, capital Marshall, capital

Adjusted Basis $ 60,000 –0– 90,000 $150,000

FMV $ 60,000 150,000 300,000 $510,000

$ 90,000 20,000 20,000 20,000 $150,000

$ 90,000 140,000 140,000 140,000 $510,000

The nonrecourse debt is shared equally among the LLC members. On that date, Lillie sells her one-third interest to Robyn Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations for $170,000, including cash and relief of Lillie’s share of the nonrecourse debt. Lillie’s outside basis for her interest in the LLC is $50,000, including her share of the LLC’s debt and after allocation of Lillie's share of income for the period. How much capital gain and/or ordinary income will Lillie recognize on the sale? a. $100,000 capital gain; $50,000 ordinary income. b. $120,000 capital gain; $0 ordinary income. c. $150,000 capital gain; $0 ordinary income. d. $70,000 capital gain; $50,000 ordinary income. 87. Which of the following statements about the transfer of a partnership interest is not true? a. The seller’s adjusted basis for the partnership interest is increased by the seller’s share of undistributed partnership income (or reduced by partnership loss) for the portion of the partnership’s taxable year ending on the date of the sale. b. The partnership taxable year generally does not close with respect to a partner who transfers a partnership interest at death; all amounts are allocated to the successor. c. The amount realized on the sale of a partnership interest is the sum of any money and the fair market value of any property received for the interest plus the selling partner’s share of partnership liabilities under § 752. d. The selling partner will report (1) income/loss from the Schedule K–1 for the portion of the year in which the interest was owned and (2) gain/loss on sale of the interest. 88. Brittany, Jennifer, and Daniel are equal partners in the BJD Partnership. The partnership balance sheet reads as follows on December 31.

Cash Unrealized receivables Land Total

Adjusted Basis $ 75,000 –0– 45,000 $120,000

FMV $ 75,000 51,000 63,000 $189,000

Brittany, capital Jennifer, capital Daniel, capital Total

$ 40,000 40,000 40,000 $120,000

$ 63,000 63,000 63,000 $189,000

Partner Daniel has an adjusted basis of $40,000 for his partnership interest. If he sells his entire partnership interest to new partner Amber for $73,000 cash, by how much can the partnership step up the basis of Amber’s share of partnership assets under §§ 754 and 743(b)? a. $6,000 b. $17,000 c. $23,000 d. $33,000 89. Marcella is a 40% nonmanaging member (treated as a limited partner) in the MNO LLC in which capital is a material income-producing factor. MNO has inventory with a basis of $200,000 and a value of $250,000 but no other hot assets. Marcella’s basis in the LLC interest is $80,000. Total value of partnership assets recorded on the books is $450,000. If she receives a distribution of $180,000 cash in liquidation of her interest in the LLC, which one of the following statements is not true? a. Because this is a capital-intensive business, the entire payment is a §736(b) payment. b. Because Marcella is treated as a limited partner, the entire payment is a §736(b) payment. Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations c. MNO can deduct the $20,000 paid for Marcella’s share of ordinary income related to the inventory. d. None of the $180,000 payment to Marcella is for partnership goodwill. 90. Partner Jordan received a distribution of $90,000 cash from the JKL Partnership in complete liquidation of his partnership interest. If his outside basis immediately before the distribution was $80,000 and if the partnership has made (and not revoked) a § 754 election in a prior year, which of the following statements is true? (Assume the partnership owns no hot assets.) a. The partnership will step down the basis of its assets by $10,000. b. The partnership will step up the basis of its assets by $10,000. c. Jordan will recognize a $10,000 capital gain on the distribution. d. Both b. and c. are true. 91. The RST Partnership makes a proportionate distribution of its assets to Ryan in complete liquidation of his partnership interest. The distribution consists of $40,000 in cash and capital assets with a basis to the partnership of $30,000 and a fair market value of $48,000. None of the payment is for partnership goodwill. At the time of the distribution, Ryan’s partnership basis is $45,000, and the partnership has no liabilities and no hot assets. If the partnership makes an optional basis adjustment election on a timely filed return, the partnership recognizes: a. Capital gain of $25,000 and increases the basis of its remaining assets by $12,500. b. Capital loss of $5,000 and decreases the basis of its remaining assets by $5,000. c. No gain or loss and increases the basis of its remaining assets by $12,500. d. No gain or loss and increases the basis of its remaining assets by $25,000. 92. Cynthia sells her 1/3 interest in the CAR Partnership to Brandon for $95,000 cash. On the date of sale, the partnership balance sheet and agreed-upon fair market values were as follows.

Cash Receivables Land Total

Adjusted Basis $40,000 –0– 50,000 $90,000

FMV $ 40,000 60,000 125,000 $225,000

Cynthia, capital Arnold, capital Ralph, capital Total

$30,000 30,000 30,000 $90,000

$ 75,000 75,000 75,000 $225,000

If the partnership has a § 754 election in effect, the total “step up” in basis of partnership assets allocated to Brandon is: a. $75,000. b. $65,000. c. $45,000. d. $0. 93. BLC Partnership makes a proportionate distribution of its assets to Blake in complete liquidation of his partnership interest. At that time, Blake’s basis in his partnership interest is $160,000, and the partnership has no liabilities and no hot assets. The distribution consists of $100,000 in cash and capital assets with a basis to the partnership of $15,000 and a fair market value of $70,000. Assume that the entire payment is a § 736(b) payment with the same result as under the normal liquidating distribution rules and that none of the payment is for partnership goodwill. If the partnership made an optional Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations basis adjustment election in a prior tax year, what is the adjustment amount for the current year? a. Increase the basis of remaining assets by $55,000. b. Decrease the basis of remaining assets by $10,000. c. Increase the basis of remaining assets by $45,000. d. Decrease the basis of remaining assets by $45,000. 94. Which of the following transactions will not result in the termination of a partnership for Federal tax purposes? a. The partnership is incorporated. b. The sole surviving partner buys the interest of the deceased second partner through a buy-sell agreement taking place upon the second partner's death. c. Cash is distributed in liquidation of a 60% partner’s interest in a five-partner partnership. d. A 40% interest in partnership capital and profits is sold to the other partner in a two-partner partnership. 95. Which of the following statements is correct regarding termination of a three-person partnership? a. The partnership can terminate only when it distributes all of its assets in a complete liquidation. b. Redemption of one partner’s 60% interest under § 736 will terminate the partnership. c. If one partner dies, the partnership year closes, and the partnership must file a return as of the date of death. d. An incorporation of the partnership will terminate the partnership. 96. Roman was a 40% partner in the calendar year POR LLC. When Roman died on April 30, the interest transferred to his estate. On November 1 of that year, Tiwanda, an unrelated third party, negotiated a buyout and acquired Roman’s interest from the estate (with the approval of the other LLC members). The LLC’s operating agreement provides that a monthly allocation will be used to prorate income when required. If the LLC’s income for the year was $300,000, how will it be allocated? a. $0 to Roman, $0 to Roman's estate, $120,000 to Tiwanda. b. $40,000 to Roman, $60,000 to Roman's estate, $20,000 to Tiwanda. c. $0 to Roman, $100,000 to Roman's estate, $20,000 to Tiwanda. d. $100,000 to Roman, $0 to Roman's estate, $20,000 to Tiwanda. 97. Leonard and Penny, a married couple, formed the equally owned calendar year PL LLC several years ago. Capital is a material income-producing factor for the LLC. On July 1 of this year, they each transferred a 20% interest to their son, Sheldon (after the transfer, 40% is owned by Sheldon; Leonard and Penny each retained 30% interests). For the current tax year, PL reported income of $300,000, which was earned evenly throughout the year. Penny provides uncompensated services to the partnership valued at $100,000; Leonard and Sheldon provide no services. The partnership uses a monthly proration of income. How much income will be allocated to Penny, Leonard, and Sheldon for the year? a. $300,000 to Penny, $0 to Leonard, $0 to Sheldon. b. $90,000 to Penny, $90,000 to Leonard, $120,000 to Sheldon. c. $120,000 to Penny, $120,000 to Leonard, $60,000 to Sheldon. d. $180,000 to Penny, $80,000 to Leonard, $40,000 to Sheldon. 98. On December 31 of last year, Maria gave her daughter, Chelsea, a gift of a 25% interest in a partnership in which capital is a material income-producing factor. For the current calendar year, the partnership’s ordinary income was $100,000. Maria and Chelsea were the only partners, and there were no guaranteed payments. Maria’s services performed for the partnership were worth $60,000, and Chelsea has never performed any services. What is Maria’s distributive share of partnership income for the current year? a. $25,000 Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations b. $60,000 c. $75,000 d. $90,000 99. Which of the following statements, if any, about a multimember LLC is false? a. A multimember LLC is usually taxed like a partnership. b. Members of an LLC generally have limited personal liability for debts of the LLC except for the managing member who has unlimited liability for LLC debts. c. Members of an LLC can participate in management of the LLC unless the member agrees not to participate. d. Liquidating distributions from an LLC are subject to a single level of taxation in the same manner as a liquidating distribution from a general partnership. 100. The POD Partnership will soon be liquidating the 20% interest of partner Daniel by making a cash distribution of $200,000 to him under § 736. Much of that payment is in return for Daniel’s share of partnership goodwill. Which of the following conditions would have to be true to increase the portion of that payment that POD could claim as a current deduction? a. Daniel is treated as a general partner. b. The partnership agreement is silent regarding payment of partnership goodwill. c. The partnership is an entity in which capital is not a material income-producing factor. d. To maximize the partnership’s deductions under § 736, a., b., and c. would have to be true. 101. On July 1, George is planning to retire from the GDP LLC where he is an active managing member owning a 60% interest. Capital is not a material income-producing factor to GDP. The LLC can either redeem his interest under § 736 or he can sell his interest to Dale, who currently owns a 20% interest. The LLC’s operating agreement is silent regarding treatment of goodwill. As to George’s alternatives, which one of the following statements is true? a. Under either alternative, on July 1, the partnership closes its books and starts a new tax year. b. Payments to George for his share of GDP’s goodwill would be treated the same for either a sale or a redemption. c. George will report ordinary income related to his share of hot assets under either the sale or the redemption scenario. d. If GDP/Dale negotiate payments over several years, either an installment sale or a redemption over time would result in the same tax situation to George. Matching Match the following statements with the best match from the following choices. Choice K may be used more than once. a. Cash basis accounts receivable, for example. b. Fair market value exceeds 120% of basis. c. Inside basis of partnership property can be adjusted to reflect the purchase price paid. d. Terminates the partner’s interest in the partnership. e. Ordinary income-producing items. f. Cash, then inventory and unrealized receivables, and then other assets. g. Does not eliminate the partner’s interest in the partnership. h. Changes the partner’s or the partnership’s ordinary income potential. i. Any partnership assets other than cash, capital, or § 1231 assets. Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations j. Sometimes treated as an unrealized receivable. k. No correct match provided. 102. Nonqualified distribution 103. Ordering rules 104. Hot assets 105. Substantially appreciated inventory 106. Current distribution 107. Potential depreciation recapture 108. Inventory 109. Unrealized receivable 110. Disproportionate distribution 111. Liquidating distribution 112. Optional adjustment election Match the following statements with the best match from the following choices. Choice M may be used more than once. a. Includes the partner’s share of partnership liabilities. b. Could result from sale of a partnership interest for more than the partner’s share of the inside basis of assets. c. Liquidation payments from this type of partnership are always § 736(b) payments. d. Could arise if a distribution results in loss to the distributee partner. e. May be a § 736(a) payment. f. May receive § 736(a) payments. g. Probably treated as a general partner for § 736 purposes h. Conversion of an LLC to a C corporation i. Liquidation payments from this type of partnership may include § 736(a) payments. j. A § 736(b) payment. k. Adjustment designed to bring inside and outside bases into balance. l. Partnership asset basis is at least $250,000 > FMV. m. No correct match is provided. 113. Limited partner 114. General partner 115. Limited liability partnership 116. Active member of LLC Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations 117. Unstated goodwill 118. Stated goodwill 119. Capital intensive partnership 120. Service-providing partnership 121. Sales price of partnership interest 122. Section 754 123. Mandatory step down 124. Step up 125. Step down 126. Partnership terminates Match the following independent distribution payments in liquidation of a partner’s interest in an ongoing partnership with the statements below. a. A payment for the partner’s share of partnership income under § 736(a). b. A payment for the partner’s share of partnership property under § 736(b). c. The payment includes both a § 736(a) and a § 736(b) element. 127. Distribution of $10,000 cash to a limited partner for goodwill when goodwill is not provided for in the partnership agreement. 128. Distribution of $10,000 cash to a general partner for goodwill when goodwill is provided for in the partnership agreement, and the partnership derives most of its income from services. 129. Distribution of $25,000 cash for a partner’s share of substantially appreciated inventory. 130. Distribution of $60,000 cash for a partner’s share of unrealized receivables when the partner is a general partner and most of the partnership’s income is derived from services. 131. Distribution of $60,000 cash for a partner’s share of unrealized receivables when the partner is a limited partner and most of the partnership’s income is derived from services. 132. Distribution of $100,000 cash to a managing member (general partner) in a cash basis service-oriented LLC for the member's share of unrealized receivables and land held for investment. 133. Distribution of $100,000 cash representing the partner’s share of the value of partnership equipment that has potential depreciation recapture of $25,000. Match the following independent descriptions with the following statements. a. Hot assets for purposes of distributions, liquidation of a partnership interest under § 736, and sale of a partnership interest. Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations b. May be a hot asset for some but not all the purposes stated in (a). c. Not a hot asset. 134. Inventory with a basis of $10,000 and a fair market value of $15,000. 135. Marketable securities (not held as inventory). 136. Cash basis accounts receivable. 137. Installment receivables for sale of a capital asset. 138. Highly appreciated land held by the partnership for the purpose of subdividing and selling lots. 139. Inventory with a basis of $10,000 and a fair market value of $10,500. Subjective Short Answer 140. Randy owns a one-fourth capital and profits interest in the calendar year RUSR Partnership. His adjusted basis for his partnership interest was $200,000 when he received a proportionate nonliquidating distribution of the following assets. Cash Inventory

Partnership’s Basis in Asset $120,000 60,000

Asset’s Fair Market Value $120,000 90,000

a.

Calculate Randy’s recognized gain or loss on the distribution, if any. Explain.

b.

Calculate Randy’s basis in the inventory received.

c.

Calculate Randy’s basis for his partnership interest after the distribution.

141. Connie owns a one-third capital and profits interest in the calendar year CAB Partnership. Her adjusted basis for her partnership interest was $120,000 when she received a proportionate current (nonliquidating) distribution of the following assets. Cash Land held for investment

Partnership’s Basis in Asset $140,000 30,000

Asset’s Fair Market Value $140,000 60,000

a.

Calculate Connie’s recognized gain or loss (if any) on the distribution.

b.

Calculate Connie’s basis in the land received.

c.

Calculate Connie’s basis for her partnership interest after the distribution.

142. Karli owns a 25% capital and profits interest in the calendar year KJDV Partnership. Her adjusted basis for her partnership interest on July 1 of the current year is $200,000. On that date, she receives a proportionate current (nonliquidating) distribution of the following assets. Cash Inventory Land (held for investment) Powered by Cognero

Partnership’s Basis in Asset $120,000 50,000 70,000

Asset’s Fair Market Value $120,000 60,000 100,000 Page 22

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations a.

Calculate Karli’s recognized gain or loss on the distribution if any.

b.

Calculate Karli’s basis in the inventory received.

c.

Calculate Karli’s basis in land received.

d.

Calculate Karli’s basis for her partnership interest after the distribution.

143. In a proportionate current (nonliquidating) distribution of his 30% interest in the MNO LLC, Neil received cash ($60,000), land (basis of $40,000 and value of $75,000), and unrealized receivables (basis of $0 and value of $22,000). In addition, Neil is relieved of his $40,000 share of the LLC’s liabilities. Neil’s basis in MNO (including his share of LLC liabilities) was $80,000 immediately prior to this distribution. a.

How much gain or loss does Neil recognize on this distribution?

b.

What is Neil’s basis in the receivables and land he receives in the distribution?

c.

What is Neil’s basis in the LLC interest following the distribution?

144. Melissa is a partner in a continuing partnership. At the end of the current year, the partnership makes a proportionate, current (nonliquidating) distribution to Melissa of $50,000 cash, inventory (basis of $22,000, fair market value of $20,000), and land (basis of $30,000, fair market value of $60,000). Melissa’s basis in the partnership interest was $90,000 before the distribution. What is Melissa’s basis in the inventory, land, and partnership interest following the distribution? Show your calculations. 145. In a proportionate liquidating distribution of his 40% interest in the RST LLC, Stuart received cash ($100,000), land (basis of $60,000 and value of $90,000), and inventory (basis of $30,000 and value of $40,000). (The partnership also liquidates.) In addition, Stuart is relieved of his $80,000 share of the LLC’s liabilities. Stuart’s basis in RST (including his share of LLC liabilities) was $200,000 immediately prior to this distribution. a.

How much gain or loss does Stuart recognize on this distribution?

b.

What is Stuart’s basis in the land and inventory he receives in the distribution?

146. In a proportionate liquidating distribution in which the partnership is liquidated, Bill received cash of $120,000, inventory (basis of $6,000, fair market value of $8,000), and a capital asset (basis and fair market value of $16,000). Immediately before the distribution, Bill’s basis in the partnership interest was $90,000. a.

How much gain or loss will Bill recognize on the distribution?

b.

What is Bill’s basis in the inventory and the capital asset?

147. Josh owns a 25% capital and profits interest in the calendar year GDJ Partnership. His adjusted basis for his partnership interest on October 15 of the current year is $300,000. On that date, the partnership liquidates and makes a proportionate distribution of the following assets to Josh. Cash Inventory a.

Partnership’s Basis in Asset $ 70,000 120,000

Asset’s Fair Market Value $ 70,000 150,000

Calculate Josh’s recognized gain or loss on the liquidating distribution, if any, and his basis in the distributed inventory.

Powered by Cognero

Page 23

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations b.

How would your answer to a. change if the partnership also distributed a small parcel of land it had held for investment to Josh? Assume the land has a $5,000 adjusted basis (FMV is $8,000) to the partnership.

148. The December 31 balance sheet of DBW, LLP, a service-providing partnership, reads as follows.

Cash Receivables Capital assets Total

Adjusted Basis $180,000 –0– 90,000 $270,000

FMV $180,000 60,000 120,000 $360,000

Dana, capital Brooke, capital Whitney, capital Total

$ 90,000 90,000 90,000 $270,000

$120,000 120,000 120,000 $360,000

The partners share equally in partnership capital, income, gain, loss, deductions, and credits. Capital is not a material income-producing factor to the partnership. On December 31, partner Dana (who is an active managing partner in the partnership) receives a distribution of $120,000 cash in liquidation of her partnership interest under § 736. Dana’s outside basis for the partnership interest immediately before the distribution is $90,000. How much is her gain or loss on the distribution and what is its character? 149. The December 31 balance sheet of the calendar-year BCD LLP reads as follows.

Cash Receivables Capital assets Total

Adjusted Basis $210,000 –0– 42,000 $252,000

FMV $210,000 120,000 69,000 $399,000

Ben, capital Christina, capital Danielle, capital Total

$ 84,000 84,000 84,000 $252,000

$133,000 133,000 133,000 $399,000

Each partner shares in 1/3 of the partnership capital, income, gain, loss, deductions, and credits. Capital is not a material income-producing factor to the partnership. On December 31, Christina (treated as a general partner) receives a distribution of $140,000 cash in liquidation of her partnership interest under § 736. Nothing is stated in the partnership agreement about goodwill. Christina’s outside basis for the partnership interest immediately before the distribution is $84,000. How much is Christina’s recognized gain from the distribution and what is the character of the gain? How much, if anything, can the partnership deduct? If a § 754 election is in effect, what (if any) adjustment is made? Show your calculations.

Powered by Cognero

Page 24

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations 150. Jeremy is an active partner who owns a 30% interest in the JS LLP (in which capital is not a material incomeproducing factor). Partnership assets consist of land (fair market value of $200,000, basis of $140,000), accounts receivable (fair market value of $200,000, basis of $0), and cash of $400,000. JS distributes $220,000 of the cash to Jeremy in liquidation of his interest. In addition, Jeremy is relieved of his $40,000 share of the LLP’s liabilities. The total payment includes $20,000 for Jeremy’s share of JS goodwill (not stated in the partnership agreement). Jeremy’s basis in the partnership interest (including his share of the partnership’s liabilities) is $120,000 immediately before the distribution. How much gain or loss does Jeremy recognize and what is its character? How much can the partnership deduct? Are any planning opportunities available to the LLP? 151. Serena owns a 40% interest in the RST LLP. Partnership assets consist of land (fair market value of $100,000, basis of $80,000), accounts receivable (fair market value of $120,000, basis of $0), and cash of $180,000. Serena sells her interest in RST to Jaclyn for cash of $140,000. In addition, Jaclyn assumes Serena’s $40,000 share of the LLP’s liabilities. Serena’s basis in the partnership interest (including her share of the partnership’s liabilities) is $120,000 immediately before the sale. a. How much gain or loss does Serena recognize and what is its character? b.

What is Jaclyn’s basis in the partnership interest?

c.

If the LLP has a § 754 election in effect, how much is the adjustment and to which partner(s) is it allocated?

152. On August 31 of the current tax year, the balance sheet of the RBD General Partnership reads as follows Adjusted Basis FMV Cash $150,000 $150,000 Receivables –0– 90,000 Capital assets 600,000 660,000 Total $750,000 $900,000 Nonrecourse debt Rachel, capital Barry, capital Dale, capital Total

$150,000 200,000 200,000 200,000 $750,000

$150,000 250,000 250,000 250,000 $900,000

On that date, Rachel sells her one-third partnership interest to Lisa for $300,000, consisting of cash and relief of Rachel’s share of the nonrecourse debt. The nonrecourse debt is shared equally among the partners. Rachel’s outside basis for her partnership interest is $250,000 (including her share of partnership debt). How much capital gain and/or ordinary income will Rachel recognize on the sale? 153. Hannah sells her 25% interest in the HIJK Partnership to Alyssa for $120,000 cash. At the end of the year prior to the sale, Hannah’s basis in HIJK was $70,000. The partnership allocates $15,000 of income to Hannah for the portion of the year she was a partner. The partnership had no debt. On the date of the sale, the partnership assets and the agreed fair market values were as follows.

Cash Accounts Receivable Land Total Powered by Cognero

Adjusted Basis $100,000 –0– 240,000 $340,000

FMV $100,000 80,000 220,000 $400,000 Page 25

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations Determine the amount and character of any gain that Hannah recognizes on the sale. 154. Gil’s outside basis in his interest in the GO Partnership is $100,000. In a proportionate current

distribution, the partnership distributes to him cash of $30,000, inventory (fair market value of $40,000, basis to the partnership of $20,000), and land (fair market value of $90,000, basis to the partnership of $40,000). The partnership continues in existence. a. Does the partnership recognize any gain or loss as a result of this distribution? Explain. b. Does Gil recognize any gain or loss as a result of this distribution? Explain.

c. Calculate Gil’s basis in the land, in the inventory, and in his partnership interest

immediately following the distribution.

155. Parker’s basis in his PQ Partnership interest is $180,000. Parker receives a pro rata liquidating distribution

consisting of $20,000 cash, land with a basis of $80,000 and a fair market value of $100,000, and his proportionate share of inventory with a basis of $60,000 to PQ and a fair market value of $75,000. Assume that PQ also liquidates. a. How much gain or loss, if any, must Parker recognize on the distribution? b. What basis will Parker take in the inventory and land? c. What are the tax consequences to the partnership? d. Would your answer to part (a) or (b) change if this had been a current

distribution? Explain. 156. Ten years ago, Dudley contributed land to the Prosperity LLC. His basis in the land was $100,000.

The fair market value at the contribution date was $115,000. This year, when the property’s value was $200,000, the LLC distributed that property to partner Nicki. At the distribution date, Dudley’s basis in his LLC interest was $150,000 and Nicki’s basis was $160,000. Assume that the partnership continues in existence and has no hot assets. a. What gain or loss is recognized as a result of this distribution of precontribution

gain property contributed ten years earlier? b.

What is Dudley’s basis in his partnership interest following the distribution? What is Nicki’s basis in the property received and her partnership interest following the distribution?

c. Would your answer change if Dudley had originally contributed the property

two years ago? Answer conceptually (no calculations required). Powered by Cognero

Page 26

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations Essay 157. Your client has operated a sole proprietorship for several years and is now interested in raising capital for expansion. The client is considering forming either a C corporation or an LLC. a.

Describe the treatment of an LLC and discuss any advantages the LLC offers over the C corporation.

b. Assume instead the client has previously operated as a C corporation. Describe the tax consequences of converting to an LLC. 158. Julie is an active owner of a 52% interest in the JIR LLP, a consulting company (service provider). Her basis in the partnership interest is $100,000, and her share of the partnership’s inside basis in assets is $120,000. Julie can sell her interest in the LLP on the first day of the tax year to Irene and Rachel (the other partners) for $100,000 each ($200,000 total). Alternatively, the LLP can distribute $200,000 of cash to redeem Julie’s interest. Assume the following: $10,000 of the redemption payment would be for the LLP’s goodwill (which is not provided for in the partnership agreement); Julie’s share of JIR’s unrealized receivables is $40,000; and JIR has a § 754 election in effect. What are the advantages and disadvantages of the sale versus the redemption from Julie’s and JIR’s perspective? What is your recommendation? Explain. 159. George (a calendar year taxpayer) owns a 40% interest in the cash basis GLO LLP, which has substantial accounts receivable from its customers. GLO has a natural business year ending March 31. George has found another opportunity and would like to sell his interest on July 1 of the current tax year to new partner Monica. What are some of the issues that should be considered by George, Monica, and GLO? 160. Compare the different tax results (gains, losses, basis) that might arise for a partner in a proportionate current (nonliquidating) distribution versus a proportionate liquidating distribution, under the general tax rules. 161. Your client, Greg, contributed precontribution gain property to BIG LLC on December 31, 2023, in exchange for a 30% interest.

a.

Describe two types of distributions that might result in some or all of this precontribution gain being recognized by Greg.

b.

In general terms, what is the purpose of these rules?

162. Cindy, a 20% general partner in the CDE Partnership, wants to retire and has approached the other partners about having the partnership buy her out. The partnership is a cash basis, service-oriented partnership in which Cindy is an active partner. The partnership’s assets consist primarily of unrealized receivables and cash. The partnership also has substantial going concern value (goodwill) which is probably its most valuable asset. Goodwill payments are not currently provided for in the partnership agreement, but the partnership agreement can be amended to include goodwill payments if that is advantageous. The other partners in the partnership are also active in the business and are not related to Cindy. Discuss from Cindy’s viewpoint how you would structure the liquidation of her interest under § 736. Answer as if you are her advocate. Do you think the other partners will agree with this structure? If not, what structure would they prefer?

Powered by Cognero

Page 27

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations Answer Key 1. False 2. False 3. True 4. True 5. False 6. False 7. True 8. False 9. False 10. False 11. True 12. True 13. False 14. True 15. True 16. True 17. True 18. False 19. False 20. False 21. True 22. False 23. True 24. True 25. False Powered by Cognero

Page 28

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations 26. False 27. True 28. True 29. True 30. True 31. False 32. True 33. False 34. True 35. True 36. False 37. False 38. False 39. True 40. True 41. True 42. True 43. True 44. True 45. False 46. False 47. False 48. True 49. False 50. True Powered by Cognero

Page 29

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations 51. b 52. c 53. a 54. d 55. d 56. a 57. c 58. b 59. a 60. c 61. c 62. b 63. d 64. d 65. a 66. b 67. d 68. d 69. d 70. a 71. b 72. a 73. c 74. d 75. b 76. b Powered by Cognero

Page 30

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations 77. a 78. c 79. d 80. a 81. d 82. c 83. a 84. b 85. c 86. d 87. b 88. d 89. c 90. d 91. d 92. b 93. d 94. c 95. d 96. b 97. d 98. d 99. b 100. d 101. c Powered by Cognero

Page 31

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations 102. k 103. f 104. e 105. b 106. g 107. j 108. i 109. a 110. h 111. d 112. c 113. m 114. f 115. m 116. g 117. e 118. j 119. c 120. i 121. a 122. k 123. l 124. b 125. d 126. h 127. b Powered by Cognero

Page 32

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations 128. b 129. b 130. a 131. b 132. c 133. b 134. a 135. c 136. a 137. c 138. a 139. b 140. a. Randy recognizes no gain or loss. Because the cash received does not exceed his basis in the partnership interest, no gain is recognized. Because this is a nonliquidating distribution, no loss is recognized. b.

Randy’s basis in the inventory is $60,000. The cash distribution reduces his basis to $80,000. When the inventory is distributed, it takes the lesser of a carryover basis of $60,000 or Randy’s remaining basis.

c.

The inventory distribution reduces Randy’s basis from $80,000 (after the cash distribution) to $20,000.

141. a. $20,000 gain. Connie recognizes a gain of $20,000 on the distribution, which is the amount by which the $140,000 cash distribution exceeds her $120,000 outside basis. b.

$0 basis in land. The cash distribution reduces Connie’s basis to $0. When the land is distributed, it takes the lesser of a carryover basis of $30,000 or Connie’s remaining basis of $0.

c.

$0 basis in partnership interest. Because Connie has no remaining basis for her partnership interest after the cash distribution, her outside basis is $0.

142. a. No gain or loss. Karli will not recognize any gain or loss on the distribution because the Powered by Cognero

Page 33

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations $120,000 cash distributed does not exceed her $200,000 outside basis. b.

$50,000 basis in inventory. The inventory has an adjusted basis of $50,000 to Karli. The partnership will distribute the $120,000 cash first, thereby reducing her outside basis for her partnership interest to $80,000 ($200,000 – $120,000). The inventory will be distributed next, taking a carryover basis of $50,000 and reducing the adjusted basis for her partnership interest to $30,000.

c.

$30,000 basis in land. The land parcel is distributed last and takes a $30,000 substituted basis because the basis in the land cannot exceed Karli’s remaining basis in her partnership interest.

d.

$0 basis in partnership interest. Karli’s basis for her partnership interest after the distribution is $0. Her entire $200,000 outside basis has been allocated to the distributed assets in the following amounts. Cash Inventory Land

$120,000 50,000 30,000

143. a. Neil recognizes a gain of $20,000. He received a cash distribution of $100,000 (including his relief of liabilities), against his basis of $80,000. His basis in the partnership interest is reduced to $0 after the cash distribution. b.

Neil has a carryover/substituted basis in the unrealized receivables of $0. He also has a $0 substituted basis in the land.

c.

Neil’s basis in the LLC interest is $0 following the distribution.

144. Beginning basis in Melissa’s interest Less: Cash distribution Basis before property distributions Less: Inventory distribution Less: Land distribution Basis after property distributions

$ 90,000 (50,000) $ 40,000 (22,000) (18,000) $ –0–

Melissa’s basis in the inventory equals the partnership’s basis in the inventory of $22,000. Whether the property is appreciated or depreciated does not matter. Her basis in the land is a substituted basis equal to the basis in the partnership interest following the inventory and cash distributions, or $18,000. 145. a. Stuart recognizes no gain or loss. He received a cash distribution of $180,000 (including his relief of liabilities), which did not exceed his basis of $200,000. b.

Stuart’s basis is reduced to $20,000 by the cash distribution. The inventory is distributed next.

Powered by Cognero

Page 34

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations He has a substituted basis in the inventory of $20,000, and the partnership interest basis is reduced to $0.Therefore, the land takes a $0 basis.

146. a. Bill recognizes a capital gain of $30,000 on the liquidation of his partnership interest. This equals the excess of the cash distribution over Bill’s basis in his partnership interest before the distribution ($120,000 cash – $90,000 basis). b.

Bill’s bases in the inventory and capital asset are both $0. His partnership interest basis is reduced to $0 by the cash distribution so he has no remaining basis to allocate to the other properties.

147. a. Josh takes a carryover basis of $120,000 in the distributed inventory and recognizes a $110,000 capital loss on the distribution. The loss is the difference between his $300,000 adjusted basis and the $190,000 ($70,000 + $120,000) inside basis of the cash and inventory distributed to him. b.

Josh would not recognize any loss on the distribution and the land would take a $110,000 adjusted basis. A loss cannot be recognized if any assets other than cash, unrealized receivables, and inventory are received in the distribution. Because land is generally a capital asset, it will absorb all of the remaining basis of $110,000. The capital loss would be deferred until the land is sold. If, however, the land is converted to business use, its later sale would result in a § 1231 loss, which is generally an ordinary loss.

148. $20,000 ordinary income and $10,000 capital gain. The payment for Dana’s share of the unrealized receivables is a § 736(a) payment, taxed as ordinary income. Dana’s share of the receivables is $20,000 ($60,000 × 1/3). The § 736(b) payment is $100,000, consisting of the amount paid for Dana’s 1/3 share of the partnership cash and capital assets. The § 736(b) payment is treated first as a return of her $90,000 outside basis. The rest of the § 736(b) payment is taxed to Dana as a $10,000 capital gain. 149. Christina will recognize $47,000 of ordinary income and $9,000 of capital gain. The partnership can deduct, as a § 736(a) payment, $47,000, and it will record a step up of $9,000. Under § 736(a), the $40,000 ($120,000 × 1/3) paid for Christina’s share of unrealized receivables will be taxed to her as a $40,000 guaranteed payment. In addition, the $7,000 ($140,000 – $133,000) paid for her share of unstated goodwill will be treated as a guaranteed payment. The remaining $93,000 ($140,000 – $47,000) cash distribution will be treated as a § 736(b) payment. The first $84,000 of this payment will be a return of Christina’s outside basis. The remaining $9,000 will be taxed to her as capital gain. As mentioned, the partnership can deduct, as a guaranteed payment, the amount treated as a § 736(a) payment, which is $47,000. In addition, because a § 754 election is in effect, the partnership records a step up in the basis of its remaining assets for the $9,000 Christina recognizes as a gain. 150. Jeremy recognizes $80,000 of ordinary income and a $60,000 capital gain. The ordinary income equals Jeremy’s $60,000 share of accounts receivable ($200,000 × 30%) and his $20,000 payment for goodwill. [Total asset value is $800,000 ($200,000 + $200,000 + $400,000) and Jeremy’s share is $240,000 ($800,000 × 30%). Because Jeremy receives $260,000 (including relief of $40,000 of partnership debt), the $20,000 excess ($260,000 – $240,000) is for unstated goodwill).] The remaining payment to Jeremy of $180,000 ($260,000 – $80,000 ) is treated as a § 736(b) payment, which is offset by Jeremy’s basis of $120,000. Powered by Cognero

Page 35

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations Jeremy is treated as a general partner and a goodwill payment is not provided for in the partnership agreement. Therefore, JS’s $80,000 payment for Jeremy’s share of receivables and unstated goodwill is a § 736(a) payment that is deductible by the partnership. In addition (as a planning note), the partnership could make a § 754 election to step up the basis of its other assets for the $60,000 of gain Jeremy recognizes. 151. a. Serena recognizes a gain of $60,000, including ordinary income of $48,000 and a capital gain of $12,000. She received $140,000 plus relief of $40,000 of liabilities for a total of $180,000. Her basis in the LLP interest was $120,000, resulting in a net gain of $60,000. Of this gain, she reports ordinary income in the amount of her share of the LLP’s unrealized receivables, or $48,000 ($120,000 × 40%). The remaining gain is a capital gain. b.

Jaclyn’s basis equals the $180,000 paid, including the $40,000 share of the LLP’s liabilities.

c.

If the LLP has a § 754 election in effect, it records an adjustment of $76,000 {$180,000 paid – $104,000 share of inside asset basis [($80,000 + $0 + $180,000) × 40%]}. This step up is allocated to Jaclyn.

152. Rachel’s realized gain is $50,000 ($300,000 received less $250,000 outside basis), consisting of a capital gain of $20,000 and $30,000 of ordinary income. Because the receivables are a § 751 “hot asset,” Rachel is treated as having sold her 1/3 share and, therefore, will recognize $30,000 ordinary income. The rest of the sale is taxed under the general rule of § 741 and generates a capital gain of $20,000. 153. Hannah recognizes $20,000 of ordinary income and a $15,000 capital gain for a total gain of $35,000. Hannah’s basis is increased from $70,000 at the beginning of the year to $85,000 at the sale date as a result of HIJK’s allocation of $15,000 of income to her during the sale year. Her total gain is $35,000 ($120,000 sales price – $85,000 basis). Hannah recognizes $20,000 of ordinary income under § 751(a) and a $15,000 capital gain under § 741. Hannah recognizes ordinary income to the extent of her share of the partnership’s inventory and unrealized receivables. Her 25% share of the receivables is $20,000 (25% × $80,000). The difference between the amount Alyssa paid ($120,000) and Hannah’s share of the value of partnership assets ($100,000) is probably the value of the partnership’s intangible assets or goodwill. Whereas the goodwill might result in ordinary income under § 736, that is not the case for the sale of a partnership interest. 154. a. No. The partnership recognizes no gain or loss as a result of the

distribution per § 731(b). No. Because this is a proportionate current distribution, Gil would

only recognize gain if the cash received exceeded his outside basis. b. He would only recognize loss under limited conditions and only if

his interest in the partnership terminated. Therefore, he has no recognized gain or loss. Gil’s bases are $20,000 (inventory), $40,000 (land), and $10,000

(partnership interest). Gil takes a basis in the inventory equal to the partnership’s basis in the inventory, or $20,000. His $100,000 c. basis in the partnership is reduced first by the $30,000 cash distribution, then by the $20,000 inventory distribution. He takes a basis in the land equal to the partnership’s basis in the Powered by Cognero

Page 36

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations land, or $40,000. The land distribution reduces his basis in the partnership interest to $10,000.

155. No gain or loss. The cash is distributed first, followed by the inventory. The a. land is distributed last and absorbs Parker’s remaining basis in partnership

interest of $100,000 ($180,000 basis – $20,000 cash – $60,000 inventory). Parker’s basis in the inventory is a carryover basis of $60,000. His basis

b.

in the land is $100,000 (see calculation in part a.). c. The partnership has no gain or loss. No change to part a., but the answer for part b. would differ. If this had

been a current distribution, Parker’s basis in the land (part b.) would have been limited to the partnership’s $80,000 basis. Parker would have a remaining basis in the partnership interest of $20,000.

d.

156.

No gain or loss is recognized on the distribution. Dudley’s basis in his partnership interest remains $150,000. Nicki takes a carryforward basis in the property of $100,000, and her basis in the a. partnership interest is reduced to $60,000. Here are the details: Dudley contributed the property more than seven years before the property was distributed to the other partner. Therefore, the precontribution gain distribution rules do not apply, and this is a normal proportionate current distribution. Dudley’s basis in the partnership interestis not affected by the distribution to the other partner. Nicki takes a $100,000 basis in the property, which is b. the lesser of the $100,000 carryover basis in the property or her $160,000 basis in the partnership interest before the distribution. Her basis in the partnership interest following the distribution is $60,000. If the property had been contributed only two years ago, Dudley would

recognize the precontribution gain when the property was distributed to c. Nicki. Nicki’s basis in the property and Dudley’s basis in the partnership interest would be adjusted to reflect the recognized gain. NOTE: The actual amounts (not required) are that Dudley would recognize a $15,000 gain, and his basis in the partnership interest would be increased to $165,000. Powered by Cognero

Page 37

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations Nicki’s basis in the distributed property would be increased to its value at Dudley's contribution date, or $115,000.

157. a. The limited liability company (LLC) generally provides for Federal taxation under Subchapter K (partnership taxation) and limited liability for all owners. Therefore, an LLC provides for the same protection from personal liability as a C corporation while providing for (pass-through) taxation of LLC operations at the owner level. The C corporation double taxation does not apply to an LLC. Partnership provisions such as optional adjustments to basis; special allocations of income, gain, loss, deduction, and credit; and inclusion of all LLC liabilities in outside basis are additional advantages of an LLC over a C corporation. b.

An existing C corporation should carefully weigh the consequences before converting to an LLC. The IRS has ruled that a C corporation must liquidate and re-form as an LLC. When a C corporation liquidates, any appreciation in corporate assets triggers a corporate level gain. This results in immediate double taxation of the gain (at the corporate level and then as a shareholder gain or loss on liquidation of the entity). A partnership, on the other hand, does not liquidate when it converts to an LLC, and any appreciation in partnership assets remains untaxed.

158. Sale. On a sale of the partnership interest for $200,000, Julie recognizes a gain of $100,000, which is classified as $40,000 of ordinary income and a $60,000 capital gain. The partnership reflects a step-up allocated to Irene and Rachel of $80,000 ($200,000 purchase price less $120,000 share of JIR’s inside basis). The goodwill portion of the payment does not affect Julie’s treatment of the sales price. [Instructor note: Although not specifically discussed in the chapter, the existing § 754 election applies with respect to the purchasing partners, allowing (requiring) the step up in basis.] Redemption. On a distribution from JIR to Julie in redemption of her interest, Julie recognizes a gain of $100,000, which is classified as $50,000 of ordinary income and a $50,000 capital gain. Julie is deemed to receive a § 736(a) payment of $50,000, including $40,000 for her share of unrealized receivables and $10,000 for unstated goodwill. (This result applies because Julie is treated as being a general partner in a service-providing partnership, and the goodwill is not provided for in the partnership agreement.). The remaining distribution of $150,000 is a § 736(b) payment in exchange for her interest in partnership property. On this portion of the payment, Julie recognizes a capital gain of $50,000 ($150,000 § 736(b) payment less $100,000 basis). JIR deducts the $50,000 § 736(a) payment. In addition, JIR reflects a step-up equal to the $50,000 capital gain recognized by Julie. Recommendation. In both situations, Irene and Rachel bear the burden of $100,000 of payment, and Julie receives $200,000 of cash before taxes. Therefore, the preferred treatment hinges on the tax ramifications of the payments. Powered by Cognero

Page 38

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations Under § 736, the partnership claims a deduction for $50,000 and a step-up of $50,000 ($100,000 total). For a sale of the interest, the step up is $80,000 (and the partnership claims no current deduction) because the partnership’s inside basis is higher than Julie’s outside basis. In addition, a step up can be recovered only through depreciation, amortization, or sale by the partnership of an underlying asset. From Irene and Rachel’s perspective, the redemption is much preferred. From Julie’s perspective, she reports $100,000 of gain in either situation. In the redemption, she has $10,000 of additional ordinary income and $10,000 less of capital gain. The sale is slightly more favorable for her if capital gains tax rates are preferable to ordinary income rates. 159. Upon the sale of a partnership interest, the income share is allocated between the buyer and the seller. The allocation can be based on an interim closing of the books or the proration method. Because the tax year closes with respect to George, he would report income from two GLO K-1’s that will eventually be prepared as of March 1 and July 1. Income bunching occurs, in that George must report income from both Schedules K-1 in his current-year personal tax return. However, George might not receive the second (July 1) Schedule K-1 in time to file his tax return because GLO is not required to issue a Schedule K-1 until its normal due date (June 15 of the following year, or as extended). Thus, George might have to file an extension for his personal tax return for the year of the sale, or he might have to estimate the income and file an amended tax return later. George recognizes a gain or loss on sale of his partnership interest. George's basis on the sale date must reflect his shares of income from the periods ended March 31 and July 1, and, again, he might not know the July amount in time to calculate the gain or loss on the sale. George's share of partnership liabilities would be included in both the sales price and his basis in the LLP interest. Because the partnership uses the cash method, it probably has substantial unrealized receivables, and this results in ordinary income to George. His remaining gain or loss is from the sale of his partnership interest and is capital in nature. Because of the value inherent in the unrealized receivables, Monica would probably pay a premium over her share of GLO’s inside basis in its assets. Monica should request that the partnership make a § 754 election (if an election is not already in effect). The resulting step up in the inside basis of the assets would be allocated to her, and this reduces her allocable share of income when the receivables are collected. 160. Gains. For both a proportionate liquidating and a current (nonliquidating) distribution, gain generally arises only upon distribution of cash in excess of the partner’s basis in the partnership. Cash includes relief of the partner’s share of partnership liabilities as well as a portion of certain marketable security distributions. Losses. In a current (nonliquidating) distribution, a loss deduction is not permitted. Because the partner remains a partner in the partnership, any eventual loss cannot be determined and, therefore, is not realized. In a liquidating distribution, a realized loss might be deductible if the partner receives only cash and ordinary-income producing property (unrealized receivables and inventory). If other property (capital or § 1231 assets) is distributed, that property absorbs any remaining basis and the loss is not currently deductible. Basis. In a current (nonliquidating) distribution, the basis of distributed property is the lesser of the partnership’s basis in the property or the partner’s remaining basis in the partnership interest. This same result holds for a liquidating distribution except that if third-tier (capital or § 1231) assets are distributed, those assets absorb any remaining basis in the partnership interest. 161. a. Distribution of the precontribution gain property to another partner. Any previously unrealized precontribution gain would be recognized by Greg if BIG distributed the property to another partner before 2031. Distribution of other property to contributing partner. If BIG distributes a second property to Greg before 2031, he might be taxed on any previously unrecognized built-in gain. Powered by Cognero

Page 39

Name:

Class:

Date:

Chapter 22: Partnerships Distributions Transfer of Interests and Terminations b.

Purpose and effect of rules. These rules are designed to ensure that any precontribution gain is taxed to the person who owned the property at the time the gain arose.

162. Cindy will prefer to treat the cash received for her share of the partnership goodwill as a § 736(b) payment. Section 736(b) payments are taxed as a return of basis and result in capital gain to the recipient partner. The goodwill can be treated as a § 736(b) payment if the partnership agreement provides for the goodwill. Unfortunately, the partnership probably will prefer to treat the payment for goodwill as a § 736(a) payment because this will allow the partnership to deduct the amounts paid for Cindy’s share of partnership goodwill. As currently structured, the payment for Cindy’s share of the goodwill will be treated as a § 736(a) payment because the goodwill is not provided for in the partnership agreement. Cindy and the partnership can control how the goodwill will be treated. In situations such as this, the partnership typically has the more powerful position in the negotiations. This typically allows the partnership to dictate the treatment of goodwill as a § 736(a) payment.

Powered by Cognero

Page 40

Name:

Class:

Date:

Chapter 23: S Corporations True / False 1. Liabilities affect the owner’s basis differently in an S corporation than they do in a partnership. a. True b. False 2. An S corporation cannot incur a tax liability at the corporation level. a. True b. False 3. Distributions of appreciated property by an S corporation are not taxable to the entity. a. True b. False 4. A newly formed S corporation does not receive any tax benefit from a C corporation's NOL incurred in its first election tax year. a. True b. False 5. S corporation status allows shareholders to realize tax benefits from corporate losses immediately (assuming sufficient stock basis). a. True b. False 6. NOL carryforwards from C years can be used in an S corporation year against ordinary income. a. True b. False 7. Tax-exempt income at the S corporation level flows through as taxable income to the shareholder. a. True b. False 8. A one-person LLC can be a shareholder of an S corporation. a. True b. False 9. A corporation may alternate between S corporation and C corporation status each year depending on which results in more tax savings. a. True b. False 10. An estate may be a shareholder of an S corporation. a. True b. False 11. A former spouse is treated as being in the same family as the individual to whom they were married for purposes of Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 23: S Corporations determining the number of S corporation shareholders. a. True b. False 12. A corporation can revoke its S election as of a future date. a. True b. False 13. Most limited liability partnerships can own stock in an S corporation. a. True b. False 14. The AAA begins with a zero balance on the first day of an S corporation’s first tax year. a. True b. False 15. An S corporation's AAA can have a negative balance. a. True b. False 16. A distribution from the other adjustment account (OAA) is not taxable to an S shareholder. a. True b. False 17. An S election made before becoming a corporation is valid only beginning with the first 12-month tax year. a. True b. False 18. At least 51% of the shareholders must consent to an S election. a. True b. False 19. Persons who were S shareholders during any part of the year before the election date but were not shareholders when the election was made also must consent to an S election. a. True b. False 20. The termination of an S election occurs on the day after a corporation ceases to be a qualifying S corporation. a. True b. False 21. The passive investment income of an S corporation includes gains from the sale of securities. a. True b. False 22. Tax-exempt income at the corporate level flows through as exempt income to S shareholders. Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 23: S Corporations a. True b. False 23. The Section 179 expense deduction is a Schedule K (separately stated) item on the Form 1120S. a. True b. False 24. Depreciation recapture income is a Schedule K (separately stated) item on the Form 1120S. a. True b. False 25. A per-day, per-share allocation of flow-through S corporation items must be used. a. True b. False 26. Any distribution of cash or other property by a corporation that does not exceed the balance of AAA with respect to S stock during a post-termination transition period of approximately one year is applied against and reduces the basis of the S stock. a. True b. False 27. A capital loss allocated to a shareholder always reduces the Other Adjustments Account. a. True b. False 28. An item such as tax-exempt interest that appears in the Other Adjustments Account affects stock basis, but not AAA. a. True b. False 29. An S corporation does not recognize a loss when distributing assets that are worth less than their basis. a. True b. False 30. When loss assets are distributed by an S corporation, a shareholder’s basis is equal to the asset’s fair market value. a. True b. False 31. An S shareholder’s basis is increased by stock purchases and capital contributions. a. True b. False 32. An S shareholder’s basis is decreased by distributions treated as being paid from AAA. a. True b. False 33. An S corporation shareholder’s stock basis includes their direct investments plus a ratable share of any corporate Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 23: S Corporations liabilities. a. True b. False 34. An S shareholder’s stock basis can be reduced below zero. a. True b. False 35. An S shareholder’s stock basis is reduced by flow-through losses before accounting for distributions. a. True b. False 36. An S shareholder’s stock basis does not include a ratable share of S corporation liabilities. a. True b. False 37. An S corporation can claim a deduction for its operating loss amounts. a. True b. False 38. The corporate-level tax on recognized built-in gains applies when an S corporation disposes of an asset in a taxable disposition within five years after the date on which the S election took effect. a. True b. False 39. The LIFO recapture tax is a variation of the passive investment income penalty tax. a. True b. False 40. The passive investment income of an S corporation includes net capital gains from the sale of stocks and securities. a. True b. False 41. Compensation paid to employees by an S corporation generates a corporate-level FICA tax liability. a. True b. False 42. The exclusion of gain on disposition of small business stock is not available on disposition of S corporation stock. a. True b. False 43. There are no advantages for an S corporation to issue § 1244 stock. a. True b. False Multiple Choice Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 23: S Corporations 44. An S corporation is subject to the following tax(es): a. Corporate income tax. b. Built-in gains tax. c. Alternative minimum tax. d. None of these choices are correct. 45. Which statement is incorrect? a. S corporations are treated as corporations under state law. b. S corporations are treated as partnerships for Federal income tax purposes. c. Distributions of appreciated property are taxable to the S corporation. d. All of these choices are correct. 46. An S corporation must possess which of the following characteristics? a. Not more than 100 shareholders. b. Corporation organized in the United States. c. Only one class of stock. d. All of these choices are correct. 47. Which entity is eligible to make the S election? a. Non-U.S. corporation. b. One-person limited liability company. c. Insurance company. d. U.S. bank. 48. Identify a disadvantage of being an S corporation. a. Estates can be shareholders. b. Losses flow through immediately to the shareholders. c. The exclusion of gain on disposition of small business stock is not available for S stock. d. Tax-exempt income at the S level does not lose its special tax treatment for shareholders. 49. Which of the following, if any, can be eligible shareholders of an S corporation? a. A Roth IRA. b. A partnership. c. A non-U.S. corporation. d. None of these choices are correct. 50. Which statement is incorrect with respect to filing an S election? a. Form 2553 must be filed. b. All shareholders must consent. c. The election may be filed in the previous year. d. An extension of time is available for filing the application. 51. Which of the following, if any, are eligible shareholders of an S corporation? Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 23: S Corporations a. A partnership. b. A nonresident alien. c. A three-person LLC. d. The estate of a deceased shareholder. 52. Several individuals acquired assets on behalf of Skip Corporation on May 28, purchased assets on June 3, and began business on June 11. They subscribe to shares of stock, file articles of incorporation for Skip, and become shareholders on June 21. The S election must be filed no later than two and one-half months after: a. May 28. b. June 3. c. June 11. d. June 21. 53. The theoretical maximum number of actual shareholders in an S corporation is: a. 75. b. 100. c. 200. d. Unlimited. 54. Which statement is incorrect with respect to the number-of-shareholders test in filing an S election? a. Husband Jaime and wife Maria count as one shareholder. b. Grandmother Adela and granddaughter Maria count as one shareholder. c. Husband Jaime and ex-wife Isabel count as one shareholder. d. All of these statements are correct. 55. A new S corporation shareholder can revoke the S election unilaterally if they own how much of the existing S corporation’s stock? a. More than 50%. b. 50% or more. c. The election can be revoked only if all of the shareholders consent. d. The election cannot be revoked during the first year of the new shareholder’s ownership. 56. Which statement is incorrect with respect to an S shareholder’s consent? a. Both spouses must consent if one owns the stock as community property. b. An S election requires a consent from all of the S corporation’s shareholders. c. A consent must be in writing. d. All of these statements are correct. 57. Which of the following is not a separately stated item on Schedule K of Form 1120S? a. Tax-exempt interest income. b. Section 1231 gain. c. Section 179 depreciation deduction. d. Depreciation recapture income. 58. Which item is not included in an S corporation’s nonseparately computed income? Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 23: S Corporations a. Net sales. b. Cost of goods sold. c. Dividends received. d. Depreciation recapture. 59. Which of the following is not a separately stated item on Schedule K of Form 1120S? a. Intangible drilling costs. b. Foreign loss. c. Utilities expense. d. Recovery of a tax benefit. 60. What method is used to allocate S corporation income or losses (unless an election to the contrary is made)? a. Any method agreed to by all of the shareholders. b. Per-day allocation. c. FIFO method. d. LIFO method. 61. If an S corporation’s beginning balance in OAA is zero and the following transactions occur, what is the entity's ending OAA balance? Depreciation recapture income Payroll tax penalty Tax-exempt interest income Nontaxable life insurance proceeds Life insurance premiums paid (nondeductible)

$21,000 4,200 5,300 5,100 2,800

a. $1,300 b. $7,600 c. $23,300 d. $27,500 62. Which transaction affects the Other Adjustments Account on an S corporation’s Schedule M-2? a. Payroll penalty. b. Unreasonable compensation. c. Life insurance proceeds (nontaxable to the recipient S corporation). d. Taxable interest. 63. Which of the following items, if any, decreases an S corporation’s AAA? a. Section 1231 loss. b. Expenses related to tax-exempt income. c. Depletion in excess of basis. d. Distribution from earnings and profits. 64. During the year, Marcus, the sole shareholder of a calendar year S corporation, received a distribution of $16,000. At the end of last year, his stock basis was $4,000. The corporation earned $11,000 ordinary income during the year. It holds a zero balance in accumulated E & P. Which statement is correct? Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 23: S Corporations a. Marcus recognizes a $1,000 LTCG. b. Marcus’s stock basis is $2,000. c. Marcus’s ordinary income is $15,000. d. Marcus’s tax-free return of capital is $11,000. 65. Amit, Inc., an S corporation, holds an AAA balance of $614,000 at the beginning of the tax year. During the year, the following items occur. Operating income Interest income Dividend income Municipal bond interest income Long-term capital loss from sale of investment land Section 179 depreciation deduction Charitable contributions Cash distributions

$501,000 6,500 13,020 6,000 7,400 6,000 19,000 57,000

Amit’s ending AAA balance is: a. $1,045,120. b. $1,185,150. c. $1,191,150. d. $1,242,150. 66. Kinney, Inc., an electing S corporation, holds $5,000 of AEP and $9,000 in AAA at the beginning of the calendar tax year. Kinney has two shareholders, Eric and Maria, each of whom owns 500 shares of Kinney’s stock. Kinney’s taxable income is $6,000 for the year. Kinney distributes $6,000 to each shareholder on February 1, and it distributes another $3,000 to each shareholder on September 1. How is Eric taxed on the distribution? a. $500 dividend income. b. $1,000 dividend income. c. $1,500 dividend income. d. $3,000 dividend income. 67. Fred is the sole shareholder of an S corporation in Fort Deposit, Alabama. At a time when his stock basis is $20,000, the corporation distributes appreciated property worth $100,000 (basis of $20,000). Fred’s taxable gain is: a. $0. b. $10,000. c. $80,000. d. $100,000. 68. You are given the following facts about a solely owned S corporation. What is the shareholder’s ending stock basis? Increase in AAA Increase in OAA Payroll tax penalty Beginning stock basis Stock purchases Powered by Cognero

$31,000 6,300 2,140 39,800 22,000 Page 8

Name:

Class:

Date:

Chapter 23: S Corporations Tax-exempt life insurance proceeds Life insurance premiums paid (nondeductible)

4,800 2,700

a. $61,800 b. $68,100 c. $99,100 d. $100,100 69. Which of the following reduces a shareholder’s S corporation stock basis? a. Depletion deductions in excess of the basis of property. b. Illegal kickbacks paid. c. Nontaxable income. d. A 20% QBI deduction. 70. You are given the following facts about a 50% owner of an S corporation. Compute her ending stock basis. Increase in AAA Increase in OAA Payroll tax penalty Owner's beginning stock basis Tax-exempt interest income Insurance premiums paid (nondeductible) Owner's additional stock purchases Owner's 20% QBI deduction

$32,000 6,300 2,140 39,800 4,800 2,700 22,000 21,000

a. $80,950. b. $85,750. c. $100,100. d. $106,225. 71. Samantha owned 1,000 shares in Evita, Inc., an S corporation, that uses the calendar year. On October 11, Samantha sells all of her Evita stock. Her stock basis at the beginning of the tax year was $60,000. Evita's ordinary income for the year was $22,000 through the date of sale, and Samantha receives a distribution of $35,000 on May 3rd. Her stock basis at the time of the sale is: a. $117,000. b. $82,000. c. $60,000. d. $47,000. 72. You are given the following facts about a 40% owner of an S corporation. Calculate her ending stock basis. Owner's beginning stock basis Increase in AAA Increase in OAA Payroll tax penalty Tax-exempt interest income Life insurance premiums paid (nondeductible) Powered by Cognero

$36,800 32,000 6,300 2,140 4,800 2,700 Page 9

Name:

Class:

Date:

Chapter 23: S Corporations Owner's purchases of additional stock

22,000

a. $71,600 b. $74,120 c. $76,220 d. $78,920 73. Oxen Corporation incurs the following transactions. Net income from operations Interest income from savings account Long-term capital gain from sale of securities Short-term capital loss from sale of securities

$100,000 3,000 10,000 4,000

Oxen maintains a valid S election and does not distribute any assets (cash or property) to its sole shareholder, Megan. As a result, Megan must recognize (ignore 20% QBI deduction): a. Ordinary income of $103,000. b. Ordinary income of $103,000 and long-term capital gain of $6,000. c. Ordinary income of $103,000, long-term capital gain of $10,000, and $4,000 short-term capital loss. d. Ordinary income of $109,000. 74. On January 1, Bobby and Alice equally own all of the stock of an electing S corporation called Prairie Dirt Delight. The entity incurs a $60,000 loss for the year. On the 200th day of the year (not a leap year), Bobby sells his one-half of the stock to his son, Saul. How much of the $60,000 loss, if any, is allocated to Bobby? a. $-0b. $13,562 c. $16,438 d. $32,877 75. A cash basis calendar year C corporation reports $100,000 of accounts receivable on the date of its conversion to S status on February 7. By the end of the year, $60,000 of these receivables have been collected. Calculate any built-in gains tax, assuming that there is sufficient taxable income. a. $0 b. $12,600 c. $21,000 d. $35,000 76. Mock Corporation converts to S corporation status in 2025. Mock used the LIFO inventory method in 2024 and had a LIFO inventory of $435,000 (FIFO value of $550,000) on the date of the S election. How much tax must be added to Mock’s 2024 corporate tax liability? a. $-0b. $6,038 c. $24,150 d. $115,000 77. A calendar year C corporation reports a $41,000 NOL in 2024, but it elects S status for 2025 and generates an NOL of Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 23: S Corporations $30,000 in that year. At all times during 2025, the stock of the corporation was owned by the same 10 shareholders, each of whom owned 10% of the stock. Kris, one of the 10 shareholders, holds an S stock basis of $2,300 at the beginning of 2025. How much of the 2025 loss, if any, can she deduct? a. $-0b. $2,300 c. $3,000 d. $7,100 78. Pepper, Inc., an S corporation, holds a $1 million balance in accumulated E&P. The corporation reports sales revenues of $400,000, taxable interest of $380,000, operating expenses of $250,000, and deductions attributable to the interest income of $140,000. What is Pepper’s passive income penalty tax payable, if any? a. $380,000. b. $116,842. c. $24,537. d. $-0-. 79. If the beginning balance in OAA is zero and the following transactions occur, what is the ending OAA balance? Depreciation recapture income Payroll tax penalty Tax-exempt interest Nontaxable life insurance proceeds Insurance premiums paid (nondeductible) Charitable contributions a. $1,300. b. $6,700. c. $23,300. d. $27,500.

$21,000 4,200 5,700 3,900 2,900 17,000

80. At the beginning of the year, the AAA of Rose, Inc. shows a balance of $682,000. During the year, the following items occur. Compute the end-of-year AAA balance. Operating income Interest income Dividend income Municipal bond interest income Short-term capital loss from sale of building Section 179 expense Charitable contributions Cash distributions Depreciation recapture

$452,000 6,550 14,050 12,000 7,400 6,500 19,000 57,000 3,500

a. $1,064,700. b. $1,185,150. c. $1,191,150. d. $1,242,150. 81. This year, Jiang, the sole shareholder of a calendar year S corporation, received a distribution of $17,000. On Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 23: S Corporations December 31 of the prior year, his stock basis was $3,000. The corporation earned $12,000 ordinary income during the year. The corporation has a zero balance in accumulated E&P. Which statement is correct? Ignore the 20% QBI deduction. a. Jiang recognizes a $2,000 LTCG. b. Jiang’s stock basis will be $2,000. c. Jiang’s ordinary income is $15,000. d. Jiang’s return of capital is $11,000. 82. Which of the following items, if any, has no effect on the stock basis of an S corporation shareholder? a. Operating income. b. Short-term capital gain. c. Advertising expenses. d. The 20% QBI deduction. 83. Lemon Corporation incurs the following transactions. Net income from operations Interest income from saving account Long-term capital gain from sale of securities Short-term capital loss from sale of securities

$110,000 5,000 9,000 4,000

Lemon maintains a valid S election and does not distribute any dividends to its shareholder, Nina. As a result, which of the following must Nina recognize? Ignore the 20% QBI deduction. a. Ordinary income of $115,000 and long-term capital gain of $5,000. b. Ordinary income of $115,000, long-term capital gain of $9,000, and $4,000 short-term capital loss. c. Ordinary income of $120,000. d. Capital gain of $120,000. 84. Lent Corporation, calendar year taxpayer, converts to S corporation status beginning in 2024. Lent had been using the LIFO inventory method and held a LIFO inventory value of $510,000 (FIFO value of $650,000). How much tax, if any, is added for these items for the final C corporation year? a. $-0-. b. $7,350. c. $29,400. d. $140,000. Completion 85. As with partnerships, the income, deductions, and tax credits of an S corporation ____________________ to the shareholders annually. 86. Some ____________________and

taxation rules apply to an S corporation.

87. The choice of a flow-through entity for a closely held corporation often is between a(n) ____________________ (a Federal tax entity) and a(n) ____________________ (a state tax entity). 88. If any entity electing S status is currently a C corporation, NOL carryovers from prior years Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 23: S Corporations generally____________________ (can/cannot) be used in an S corporation year. 89. An S corporation is limited to a theoretical maximum of ____________________ shareholders. 90. Shareholders owning a(n) ____________________ of shares (voting and nonvoting) may ____________________ revoke an S election. 91. If an S corporation has C corporation E & P and passive investment income in excess of ____________________ % of its gross receipts for ____________________ consecutive taxable years, the S election is terminated at the beginning of the ____________________ year. 92. Depreciation recapture income is a ____________________ (separately, nonseparately) computed amount. 93. An S corporation’s separately stated items generally are identical to those reported by _________________________. 94. Separately stated items are listed on Schedule _________________________ of the Form 1120S. 95. In the case of a complete termination of an S corporation interest, a ____________________ tax year may occur. 96. Since loss property receives a ____________________ in basis without any loss recognition, S corporation distributions of loss property generally should be ____________________. 97. Nonseparately computed loss ____________________ (increases, reduces) an S shareholder’s stock basis. 98. An S corporation recognizes a ____________________ on any distribution of appreciated property. 99. Stock basis first is increased by income items, then ____________________ by distributions, and finally decreased by ____________________. 100. An S corporation’s LIFO recapture amount equals the excess of the inventory’s value under ____________________ over the ____________________ value. 101. The exclusion of _________________ on the disposition of small business stock (is/is not) _________________ available for S stock. Subjective Short Answer 102. Estella, Inc., a calendar year S corporation, incurred the following items during the tax year. Municipal bond interest Sales Depreciation recapture income Long-term capital gain Cost of goods sold Administrative expenses Depreciation expense Charitable contributions 20% QBI deduction Powered by Cognero

$ 7,000 120,000 14,000 20,000 (42,000) (15,000) (13,000) (10,000) 4,370 Page 13

Name:

Class:

Date:

Chapter 23: S Corporations Calculate Estella’s nonseparately computed income. 103. Towne, Inc., a calendar year S corporation, holds AAA of $627,050 at the beginning of the tax year. During the year, the following items occur. Sales income Loss from real estate operations Officers’ life insurance proceeds Premiums paid for officers’ life insurance Dividend income Interest income Charitable contributions § 179 depreciation expense Administrative expenses Cash distributions to shareholders

$216,000 (4,000) 100,000 (3,600) 17,000 3,000 (22,000) (2,500) (35,000) (73,220)

Calculate Towne’s ending AAA balance. 104. Ridden, Inc., a calendar year S corporation, incurred the following items. Sales Depreciation recapture income Short-term capital gain Cost of goods sold Municipal bond interest income Administrative expenses Depreciation expense Charitable contributions

$130,000 12,000 30,000 (42,000) 7,000 (15,000) (17,000) (14,000)

Calculate Ridden’s nonseparately computed income. 105. Gene Grams is a 45% owner of a calendar year S corporation during the tax year. His beginning stock basis is $230,000, and the S corporation reports the following items. Ordinary income Short-term capital gain § 1231 loss Tax-exempt interest income

$72,000 16,000 6,000 5,000

Calculate Grams’s stock basis at year-end. 106. You are a 60% owner of an S corporation. Calculate your ending stock basis based upon these facts. Beginning stock basis Purchases of additional stock Insurance premiums paid (nondeductible) Tax-exempt interest income Payroll tax penalty Increase in AAA Powered by Cognero

$52,600 15,000 3,600 5,230 3,770 22,400 Page 14

Name:

Class:

Date:

Chapter 23: S Corporations Increase in OAA

5,800

107. On December 31, Erica Sumners owns one share of an S corporation’s 10 outstanding shares of stock. The basis of Erica’s share is $300. The next year, the S corporation incurs a loss of $3,650. Determine the amount of the loss allocated to Erica, and calculate her stock basis at the end of the second year. 108. Alomar, a cash basis S corporation in Orlando, FL, holds the following assets and liabilities on January 1, 2024, the date the S election is made.

Cash Accounts receivable Equipment Land Accounts payable

Adjusted Basis $ 200,000 –0– 110,000 1,800,000 –0–

Fair Market Value $ 200,000 105,000 100,000 2,500,000 110,000

During the year, Alomar collects the accounts receivable and pays the accounts payable. The land is sold for $3 million, and the taxable income for the year is $590,000. Calculate any built-in gains tax. 109. Pepper, Inc., an S corporation in Norfolk, VA, has revenues of $400,000, taxable interest of $380,000, operating expenses of $250,000, and deductions attributable to the interest income of $140,000. Calculate any passive investment income penalty tax payable by this corporation. Essay 110. Discuss two ways that an S election may be terminated. 111. Advise your client how income, expenses, gain, and losses are allocated to shareholders of an S corporation. 112. Explain the OAA concept.

Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 23: S Corporations Answer Key 1. True 2. False 3. False 4. False 5. True 6. False 7. False 8. True 9. False 10. True 11. True 12. True 13. False 14. True 15. True 16. True 17. False 18. False 19. True 20. False 21. True 22. True 23. True 24. False 25. True Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 23: S Corporations 26. False 27. False 28. True 29. True 30. True 31. True 32. True 33. False 34. False 35. False 36. True 37. False 38. True 39. False 40. True 41. True 42. True 43. False 44. b 45. b 46. d 47. b 48. c 49. d 50. d Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 23: S Corporations 51. d 52. a 53. b 54. d 55. a 56. d 57. d 58. c 59. c 60. b 61. b 62. c 63. a 64. a 65. a 66. c 67. c 68. c 69. b 70. a 71. d 72. b 73. c 74. c 75. b 76. b Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 23: S Corporations 77. b 78. c 79. b 80. a 81. a 82. d 83. b 84. b 85. flow through 86. partnership C corporation 87. S corporation, limited liability company 88. cannot 89. 100 90. majority, voluntarily 91. 25, 3, fourth 92. nonseparately 93. partnerships 94. K 95. short 96. step-down, avoided 97. reduces 98. gain 99. decreased, losses 100. FIFO, LIFO 101. gain, is not Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 23: S Corporations 102. Sales Depreciation recapture income Less: Cost of goods sold Administrative expenses Depreciation expense Nonseparately computed income 103. Beginning AAA Add: Sales income Dividend income Interest income Less: Real estate loss Charitable contributions § 179 expense Administrative expenses

$120,000 14,000 $134,000 $42,000 15,000 13,000

(70,000) $ 64,000

$627,050 $216,000 17,000 3,000

$236,000

$ 4,000 22,000 2,500 35,000

(63,500)

Less distributions Ending AAA 104. Sales Depreciation recapture income Cost of goods sold Administrative expenses Depreciation expense

$130,000 12,000 $142,000 $42,000 15,000 17,000

Nonseparately computed income 105. Beginning stock basis Ordinary income (45% × $72,000) STCG (45% × $16,000) Tax-exempt interest (45% × $5,000) § 1231 loss (45% × $6,000) Ending basis

172,500 $799,550 (73,220) $726,330

(74,000) $ 68,000

$230,000 32,400 7,200 2,250 (2,700) $269,150

106. $84,520 [$52,600 + $15,000 +0.60($22,400) + 0.60($5,800)]. 107. The loss assigned to each day of the S corporation’s tax year is $10 ($3,650/365 days). For each day, $1 is allocated to each outstanding share ($10/10 shares). Erica is allocated $365 of loss for her one share owned during the tax year. However, she is limited to a loss deduction of $300, i.e., until her stock basis reaches zero. Her stock basis is zero at the end of the year. She has a $65 loss carryforward available for deduction in subsequent years. Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 23: S Corporations 108. $123,900. The net unrealized built-in gain on the conversion date is $685,000 ($105,000 – $10,000 + $700,000 – $110,000), the maximum amount subject to the § 1374 tax. The recognized built-in gains and losses are: Accounts receivable collected Accounts payable Gain on the land (limited to builtin gain) Total Limited to net unrealized built-in gain

$105,000 (110,000) 700,000 $695.000 $685,000

Taxable income is $590,000 and the built-in gains tax is assessed on the smaller amount ($590,000 × 21% = $123,900). However, there is a carryforward of the built-in gains amount that escapes taxation due to the taxable income limitation to be taxed in subsequent years when taxable income is sufficient. Therefore, $95,000 is carried into the next tax year and treated as a recognized built-in gain then. 109. The S corporation pays a § 1375 penalty tax of $24,537, calculated as follows. ENPI =

Net Passive Income PII

× (PII – 25% GR)

ENPI =

$380,000 – $140,000 $380,000

× [$380,000 – (25% × $780,000)]

$240,000 $380,000

×

0.6315789 × $116,842

×

($380,000 – $195,000) $185,000 0.21 = $24,537

110. Broadly, there are two ways to terminate the S election—voluntary termination and involuntary termination. If shareholders owning a majority of shares consent, an election can be voluntarily terminated. If the revocation is filed by the fifteenth day of the third month of the tax year, the revocation is effective for the entire tax year (unless a prospective effective date is specified). An S election may be involuntarily terminated if a disqualifying event occurs (i.e., issues a second class of stock, too many shareholders, etc.). The loss of the election applies as of the date on which the disqualifying event occurs. 111. In general, S corporation items are divided into (1) nonseparately computed income or losses and (2) separately stated income, losses, deductions, and credits that could uniquely affect the tax liability of any shareholder. Each shareholder is allocated a pro rata portion of nonseparately computed income or loss. Separately stated items (e.g., LTCG, charitable contributions) also are allocated on a pro rata share method. 112. S corporations report changes in the AAA on Schedule M-2 of Form 1120S. Schedule M-2 contains a column labeled Other Adjustments Account (OAA). This account includes items that affect S stock basis but not the AAA, such as taxexempt income and any related nondeductible expenses. For example, life insurance proceeds received and insurance premiums paid are traced through the OAA. Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 23: S Corporations Distributions are made from the OAA after AEP and the AAA equal zero. Distributions from the OAA generally are taxfree to the receiving shareholder.

Powered by Cognero

Page 22

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements True / False 1. Temporary differences involve items that appear in both the GAAP financial statements and the Federal income tax return but not in the same reporting period. a. True b. False 2. Permanent differences include items that appear in both the GAAP financial statements and the Federal income tax return but not in the same reporting period. a. True b. False 3. In general, the purpose of ASC 740 is to ensure that all of the income tax consequences related to current-year book income are reported in the current-year financial statements. a. True b. False 4. The current tax expense reported on the GAAP financial statements generally represents the tax liabilities reflected on all current year tax returns. a. True b. False 5. A deferred tax liability represents a current tax liability associated with income or expense to be reported in future year GAAP financial statements. a. True b. False 6. A deferred tax asset is the expected future tax benefit (savings) associated with items reported in the current-year GAAP financial statements. a. True b. False 7. An example of a book-tax difference resulting in a deferred tax asset is the excess of accelerated MACRS depreciation over GAAP straight-line depreciation. a. True b. False 8. The valuation allowance can reduce either a deferred tax asset or a deferred tax liability. a. True b. False 9. If a valuation allowance is decreased in the current year, the corporation’s effective tax rate is lower than had the valuation allowance not decreased. a. True b. False 10. A valuation allowance expresses in the financial statements that there exists uncertainty that the taxpayer will be able Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements to recover a deferred tax asset. a. True b. False 11. A valuation allowance expresses in the financial statements that there exists uncertainty regarding the level of authoritative support for a tax position taken. a. True b. False 12. The income tax footnote to the GAAP financial statements includes a reconciliation of (1) a corporation’s hypothetical tax on book income as if it were taxed in full at the applicable U.S. income tax rates and (2) its reported tax expense. a. True b. False 13. A deferred tax liability represents a potential future tax benefit associated with items reported in the current-year GAAP financial statements. a. True b. False 14. The tax rate reconciliation included in the income tax footnote uses temporary book-tax differences to reconcile the reported tax expense to what would be expected if all book income were currently taxable at the U.S. tax rate. a. True b. False 15. Kling Corporation has a $150,000 favorable temporary book-tax difference. This item has the same effect on Kling’s current-year effective tax rate as a $150,000 favorable permanent book-tax difference. a. True b. False 16. ASC 740 addresses how an entity should report uncertain tax positions in its financial statements. a. True b. False 17. The release of a valuation allowance may relate to a tax planning strategy adopted by the taxpayer that will produce taxable income in the future. a. True b. False 18. A chief financial officer (CFO) probably prefers a tax planning strategy that produces a favorable temporary book-tax savings difference to one that produces a favorable permanent difference. a. True b. False 19. The income tax expense recorded by a corporation on its GAAP financial statements includes its Federal and state income taxes but not its foreign income taxes. a. True Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements b. False 20. The current tax expense reported on the GAAP financial statements generally represents the taxes actually payable to domestic or foreign governmental authorities. a. True b. False Multiple Choice 21. Which of the following items produces a temporary book-tax difference? a. Municipal bond interest. b. Federal income tax paid. c. Addition to bad debt allowance. d. Nondeductible penalties. 22. Phyllis, Inc., earns book net income before tax of $600,000. Phyllis puts into service a depreciable asset this year, and its first-year tax depreciation exceeds book depreciation by $120,000. Phyllis has recorded no other temporary or permanent book-tax differences. Assuming that the applicable tax rate is 21%, what is Phyllis’s total income tax expense reported on its GAAP financial statements? a. $151,200 b. $126,000 c. $100,800 d. $25,200 23. Gravel, Inc., earns book net income before tax of $600,000. Gravel puts into service a depreciable asset this year, and its first-year tax depreciation exceeds book depreciation by $120,000. Gravel has recorded no other temporary or permanent book-tax differences. Assuming that the applicable tax rate is 21%, what is Gravel’s current income tax expense reported on its GAAP financial statements? a. $151,200 b. $126,000 c. $100,800 d. $25,200 24. Clipp, Inc., earns book net income before tax of $600,000. Clipp puts into service a depreciable asset this year, and its first-year tax depreciation exceeds book depreciation by $120,000. Clipp has recorded no other temporary or permanent book-tax differences. Assuming that the applicable tax rate is 21%, what is Clipp’s deferred tax liability reported on its GAAP financial statements? a. $151,200 b. $126,000 c. $100,800 d. $25,200 25. Jogg, Inc., earns book net income before tax of $600,000. It puts into service a depreciable asset this year, and its firstyear tax depreciation exceeds book depreciation by $120,000. Jogg has recorded no other temporary or permanent booktax differences. Assuming that the applicable tax rate is 21%, and that this is Jogg’s first year of operations, what is Jogg’s balance in its deferred tax asset and deferred tax liability accounts at year-end? Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements a. $25,200 and $0. b. $0 and $0. c. $0 and $25,200. d. $25,200 and $25,200. 26. Qute, Inc., earns book net income before tax of $500,000. In computing its book income, Qute expenses $50,000 more in warranty expense for book purposes than it is allowed to deduct for tax purposes. Qute records no other temporary or permanent book-tax differences. Assuming that the applicable tax rate is 21% and no valuation allowance is required, what is Qute’s total income tax expense reported on its GAAP financial statements? a. $115,500 b. $105,000 c. $94,500 d. $10,500 27. Morrisson, Inc., earns book net income before tax of $500,000. In computing its book income, Morrisson expenses $50,000 more in warranty expense for book purposes than it is allowed to deduct for tax purposes. Morrisson records no other temporary or permanent book-tax differences. Assuming that the applicable tax rate is 21% and no valuation allowance is required, what is Morrisson’s current income tax expense reported on its GAAP financial statements? a. $115,500 b. $105,000 c. $94,500 d. $10,500 28. Never, Inc., earns book net income before tax of $500,000. In computing its book income, Never expenses $50,000 more in warranty expense for book purposes than it is allowed to deduct for tax purposes. Never records no other temporary or permanent book-tax differences. Assuming that the applicable tax rate is 21% and no valuation allowance is required, what is Never’s deferred tax asset reported on its GAAP financial statements? a. $115,500 b. $105,000 c. $94,500 d. $10,500 29. South, Inc., earns book net income before tax of $400,000 in year 1. It acquires a depreciable asset in year 1, and its first-year tax depreciation exceeds book depreciation by $50,000. In year 2, South earns $500,000 book net income before tax, and its book depreciation exceeds tax depreciation by $20,000. South records no other temporary or permanent booktax differences. Assuming that the applicable tax rate is 21%, what is South’s total provision for income tax expense reported on its GAAP financial statements for year 2? a. $4,200 b. $94,500 c. $105,000 d. $109,200 30. South, Inc., earns book net income before tax of $400,000 in year 1. It acquires a depreciable asset in year 1, and its first-year tax depreciation exceeds book depreciation by $50,000. In year 2, South earns $500,000 book net income before tax, and its book depreciation exceeds tax depreciation by $20,000. South records no other temporary or permanent booktax differences. Assuming that the applicable tax rate is 21% in both years, what is South’s current income tax expense reported on its GAAP financial statements for year 2? Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements a. $4,200 b. $94,500 c. $105,000 d. $109,200 31. South, Inc., earns book net income before tax of $400,000 in year 1. It acquires a depreciable asset in year 1, and its first-year tax depreciation exceeds book depreciation by $50,000. In year 2, South earns $500,000 book net income before tax, and its book depreciation exceeds tax depreciation by $20,000. South records no other temporary or permanent booktax differences. Assuming that the applicable tax rate is 21% in both years, what is South’s balance in its deferred tax liability account at the end of year 2? a. $0 b. $4,200 c. $6,300 d. $10,500 32. Van Dyke, Inc., tentatively expects to report total tax expense of $150,000 in its current-year financial statements. This amount consists of $200,000 in current tax expense and a $50,000 tax benefit related to the expected future use of an NOL. If management determines that a valuation allowance of $20,000 must be placed against Van Dyke’s deferred tax assets, what will be the total tax expense reported in Van Dyke's financial statements? a. $150,000 b. $170,000 c. $200,000 d. $250,000 33. Cold, Inc., reported a $100,000 total tax expense for financial statement purposes in year 1. This total expense consisted of $150,000 in current tax expense and a deferred tax benefit of $50,000. The deferred tax benefit consisted of $90,000 in deferred tax assets reduced by a valuation allowance of $40,000. In year 2, Cold reports $600,000 in book net income before tax. Cold records no other permanent or temporary book-tax differences. At the end of year 2, Cold’s management determines that the existing valuation allowance of $40,000 should be reduced to zero. What is Cold’s total tax expense for year 2? a. $250,000 b. $126,000 c. $86,000 d. $40,000 34. Which of the following items is not included in the GAAP financial statement income tax footnote’s effective tax rate reconciliation? a. Hypothetical tax on book income at U.S. Federal corporate tax rate. b. Total tax expense per the GAAP financial statements. c. Tax effect of temporary differences. d. Tax effect of permanent differences. 35. Which of the following items is not included in the income tax footnote for a publicly traded company? a. Rate reconciliation. b. Analysis of deferred tax assets and liabilities. c. Breakdown of income tax between foreign and domestic. Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements d. Breakdown of income tax among U.S. states. 36. Hot, Inc.’s primary competitor is Cold, Inc. When comparing its deferred tax assets and liabilities with Cold's, which of the following benchmarking activities should Hot undertake? a. Scale the deferred tax assets and liabilities by total sales or total assets. b. Compare raw dollar amounts of deferred tax assets and liabilities. c. Ignore deferred tax assets and liabilities and focus on overall effective tax rate. d. Ignore all tax information other than the current tax expense. 37. Healy, Inc., reports an effective tax rate in its income tax footnote of 6%. The only reconciling item with regard to the hypothetical tax at 21% is a valuation allowance reversal of negative 15%. Which of the following statements is true concerning comparing Healy's effective tax rate with its competitors, all of whom have an effective tax rate between 20 and 24%? a. Healy is managing its tax burden in a more efficient manner than its competitors are. b. Healy's structural effective tax rate is actually quite close to that of its competitors. c. Healy earned more cash profits because of its lower effective tax rate. d. Healy is likely to be engaged in tax shelter activities. 38. Which of the following statements is true? a. The breakdown of tax expense between current and deferred may provide useful information regarding the comparison of tax burdens between companies. b. An analysis of earnings before interest, taxes, depreciation, and amortization (EBITDA) is often a better approach to comparing the operating results of two companies. c. One-time effects within a company’s effective tax rate should be removed before comparing the effective tax rates across companies (or across years for the same company). d. All these observations are correct. 39. The best estimate of the income tax reflected on a corporation's current-year tax returns is the: a. Change in the deferred tax asset account balance. b. Change in the deferred tax liability account balance. c. Current tax expense. d. Total tax expense. 40. From a tax planning perspective, a taxpayer would generally prefer to see a(n): a. Increase in the current tax expense. b. Increase in the deferred tax asset account balance. c. Decrease in the deferred tax liability account balance. d. Increase in the deferred tax liability account balance. 41. An increase to an entity’s valuation allowance might be called for when: a. The entity’s last book profit occurred 10 years ago. b. The entity’s assets have appreciated greatly in value, but there is no inclination to sell them. c. Both a. and b. d. Neither a. nor b. Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements 42. A GAAP valuation allowance relates to a: a. Deferred tax liability. b. Deferred tax asset. c. Both a. and b. d. Neither a. nor b. 43. Income tax information can be found in an entity’s GAAP financial statements in the: a. Balance sheet. b. Income statement. c. Both a. and b. d. Neither a. nor b. 44. A GAAP financial statement includes footnotes that: a. Give estimates of the dates on which the deferred tax liability will be paid. b. Show the journal entries to determine the deferred income tax expense. c. Break down the state-by-state profitability of the entity. d. Include a reconciliation of the book effective tax rate with the applicable statutory tax rate. 45. JiangCo constructs the following table related to its filing position for a research activities credit. Its book tax provision for the year, including $3 million for the credit, is $10 million. Resulting Estimated Tax Benefit $3 million $2 million $1.6 million $1.1 million

Probability of Realizing the Estimated Benefit 10% 35% 40% 15%

Cumulative Probability of Realization 10% 45% 85% 100%

JiangCo’s book income tax expense is: a. $13 million. b. $11.6 million. c. $11.4 million. d. $10 million. 46. JuarezCo constructs the following table related to its filing position for a research activities credit. Its book-tax provision for the year, including $3 million for the credit, is $10 million. Resulting Estimated Tax Benefit $3 million $2 million $1.6 million $1.1 million

Probability of Agreement between JuarezCo and IRS 10% 45% 40% 5%

Cumulative Probability of Realization 10% 55% 95% 100%

JuarezCo’s book income tax expense is: Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements a. $13 million. b. $12 million. c. $11.4 million. d. $11 million. 47. An investment analyst would prefer to see that an entity’s effective tax rate is: a. Sustainable over time. b. Less than that of competitors. c. Both a. and b. d. Neither a. nor b. 48. OldTown, Inc. claimed $100,000 of rehabilitation credits on its prior year tax return. There was sufficient tax authority to claim the credits. However, due to uncertainty regarding the eligibility of some of the expenditures, OldTown only recognized $70,000 of the benefits in its prior year financial statements. Upon the audit of its tax return in the current year, the IRS challenged the eligibility of some of the expenditures and OldTown agreed to pay $45,000 additional tax to settle the dispute. By how much does the settlement impact OldTown’s current-year book tax expense? a. $0. b. $15,000. c. $30,000. d. $45,000. 49. An increase to an entity’s valuation allowance might be called for when: a. The entity’s last book profit occurred 10 years ago. b. The entity’s assets have appreciated greatly in value, but there is no inclination to sell them. c. Both a. and b. d. Neither a. nor b. Subjective Short Answer 50. Budlow, Inc., reported the following results for the current year.

Book income (before tax) Tax depreciation in excess of book Warranty expense, not deductible currently Municipal bond interest income

$500,000 75,000 17,500 10,000

Determine Budlow’s current tax expense for the year assuming a combined federal, state, and foreign tax rate of 25%. 51. Black, Inc., is a domestic corporation with the following balance sheets for book and tax purposes at the end of the year. Assume a 21% corporate tax rate and no need for a valuation allowance. Tax Debit/(Credit) Assets Cash Accounts Receivable Powered by Cognero

$

300 5,000

Book Debit/(Credit) $ 300 5,000 Page 8

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements Buildings Accumulated Depreciation Furniture & Fixtures Accumulated Depreciation Total Assets

300,000 (150,000) 40,000 (21,000) $174,300

Liabilities Accrued Litigation Expense Note Payable Total Liabilities Stockholders’ Equity Paid in Capital Retained Earnings Total Liabilities and Stockholders’ Equity

300,000 (80,000) 40,000 (15,000) $250,300

$ –0– (116,000) ($116,000)

($ 27,000) (116,000) ($143,000)

($ 1,000) (57,300)

($ 1,000) (106,300)

($174,300)

($250,300)

Black, Inc.’s, gross deferred tax assets and liabilities at the beginning of Black’s year are as follows: Beginning of Year $20,000 $20,000 × 21% $ 4,200

Accrued litigation expense Subtotal Applicable tax rate Gross deferred tax asset Building – Accumulated depreciation Furniture & fixtures – Accumulated depreciation Subtotal Applicable tax rate Gross deferred tax liability

($61,000) (3,000) ($64,000) × 21% ($13,440)

Black, Inc.’s, book income before tax is $6,000. Black records two permanent book-tax differences. It earned $250 in tax-exempt municipal bond interest, and it incurred $500 in nondeductible entertainment expense. Determine the change in Black’s deferred tax assets for the current year. 52. Black, Inc., is a domestic corporation with the following balance sheets for book and tax purposes at the end of the year. Assume a 21% corporate tax rate and no valuation allowance. Tax Debit/(Credit) Assets Cash Accounts Receivable Buildings Powered by Cognero

$

300 5,000 300,000

Book Debit/(Credit) $

300 5,000 300,000 Page 9

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements Accumulated Depreciation Furniture & Fixtures Accumulated Depreciation Total Assets Liabilities Accrued Litigation Expense Note Payable Total Liabilities Stockholders’ Equity Paid-in Capital Retained Earnings Total Liabilities and Stockholders’ Equity

(150,000) 40,000 (21,000) $174,300

(80,000) 40,000 (15,000) $250,300

$ –0– (116,000) ($116,000)

($ 27,000) (116,000) ($143,000)

($ 1,000) (57,300)

($ 1,000) (106,300)

($174,300)

($250,300)

Black, Inc.’s, gross deferred tax assets and liabilities at the beginning of Black’s year are as follows: Beginning of Year Accrued litigation expense $20,000 Subtotal $20,000 Applicable tax rate × 21% Gross deferred tax asset $ 4,200 Building – Accumulated depreciation Furniture & fixtures – Accumulated depreciation Subtotal Applicable tax rate Gross deferred tax liability

($61,000) (3,000) ($64,000) × 21% ($13,440)

Black, Inc.’s, book income before tax is $6,000. Black records two permanent book-tax differences. It earned $250 in tax-exempt municipal bond interest, and it incurred $500 in nondeductible entertainment expense. Determine the net deferred tax asset or net deferred tax liability at year-end. 53. Black, Inc., is a domestic corporation with the following balance sheet for book and tax purposes at the end of the year. Assume a 21% corporate tax rate and no need for a valuation allowance. Tax Debit/(Credit) Assets Cash Accounts receivable Buildings Accumulated depreciation Furniture & fixtures Accumulated depreciation Total Assets Liabilities Accrued litigation expense Powered by Cognero

Book Debit/(Credit)

$

300 5,000 300,000 (150,000) 40,000 (21,000) $174,300

$ –0–

$

300 5,000 300,000 (80,000) 40,000 (15,000) $250,300

($ 27,000) Page 10

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements Note payable Total liabilities Stockholders’ Equity Paid-in capital Retained earnings Total liabilities and stockholders’ equity

(116,000) ($116,000)

(116,000) ($143,000)

($ 1,000) (57,300)

($ 1,000) (106,300)

($174,300)

($250,300)

Black, Inc.’s, gross deferred tax assets and liabilities at the beginning of Black’s year are listed below. Accrued litigation expense Subtotal Applicable tax rate Gross deferred tax asset

Beginning of Year $20,000 $20,000 × 21% $ 4,200

Building – Accumulated depreciation Furniture & fixtures – Accumulated depreciation Subtotal Applicable tax rate Gross deferred tax liability

($61,000) (3,000) ($64,000) × 21% ($13,440)

Black, Inc.’s, book income before tax is $6,000. Black records two permanent book-tax differences. It earned $250 in tax-exempt municipal bond interest and incurred $500 in nondeductible entertainment expense. Determine the change in Black’s gross deferred tax liabilities for the current year.

54. Black, Inc., is a domestic corporation with the following balance sheet for book and tax purposes at the end of the year. Assume a 21% corporate tax rate and no valuation allowance. Tax Debit/(Credit) Assets Cash Accounts receivable Buildings Accumulated depreciation Furniture & fixtures Accumulated depreciation

Book Debit/(Credit)

$

Total Assets

300 5,000 300,000 (150,000) 40,000 (21,000) $174,300

300 5,000 300,000 (80,000) 40,000 (15,000) $250,300

Liabilities Accrued litigation expense Note payable Total liabilities

$ –0– (116,000) ($116,000)

($ 27,000) (116,000) ($143,000)

Powered by Cognero

$

Page 11

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements

Stockholders’ Equity Paid-in capital Retained earnings Total liabilities and stockholders’ equity

($ 1,000) (57,300)

($ 1,000) (106,300)

($174,300)

($250,300)

Black, Inc.’s, gross deferred tax assets and liabilities at the beginning of Black’s year are as follows:

Accrued litigation expense Subtotal Applicable tax rate Gross deferred tax asset Building – Accumulated depreciation Furniture & fixtures – Accumulated depreciation Subtotal Applicable tax rate Gross deferred tax liability

Beginning of Year $20,000 $20,000 × 21% $ 4,200 ($61,000) (3,000) ($64,000) × 21% ($13,440)

Black, Inc.’s, book income before tax is $6,000. Black records two permanent book-tax differences. It earned $250 in tax-exempt municipal bond interest, and it incurred $500 in nondeductible entertainment expense. Calculate Black’s current tax expense. 55. Black, Inc., is a domestic corporation with the following balance sheet for book and tax purposes at the end of the year. Assume a 21% corporate tax rate and no valuation allowance. Tax Book Debit/(Credit) Debit/(Credit) Assets Cash $ 300 $ 300 Accounts receivable 5,000 5,000 Buildings 300,000 300,000 Accumulated depreciation (150,000) (80,000) Furniture & fixtures 40,000 40,000 Accumulated depreciation (21,000) (15,000) $174,300 $250,300 Total assets Liabilities Accrued litigation expense Powered by Cognero

$ –0–

($ 27,000) Page 12

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements Note payable Total liabilities Stockholders’ Equity Paid-in capital Retained earnings Total liabilities and stockholders’ equity

(116,000) ($116,000)

(116,000) ($143,000)

($ 1,000) (57,300)

($ 1,000) (106,300)

($174,300)

($250,300)

Black, Inc.’s, gross deferred tax assets and liabilities at the beginning of Black’s year are as follows: Accrued litigation expense Subtotal Applicable tax rate Gross deferred tax asset Building – Accumulated depreciation Furniture & fixtures – Accumulated depreciation Subtotal Applicable tax rate Gross deferred tax liability

Beginning of Year $21,000 $21,000 × 21% $4,410 ($61,000) (3,000) ($64,000) × 21% ($13,440)

Black, Inc.’s, book income before tax is $6,000. Black records two permanent book-tax differences. It earned $250 in tax-exempt municipal bond interest and incurred $500 in nondeductible entertainment expense. Provide the income tax footnote rate reconciliation for Black, using either dollars or percentages. 56. At the beginning of the year, Schrader, Inc., holds a net operating loss carryforward, and its balance sheet shows a related deferred tax asset of $500,000. At the end of the year, the balance in the deferred tax asset account has not changed, but Schrader’s management believes a $90,000 valuation allowance is needed, because of a persistent downturn in Schrader’s profitability. Provide the journal entry to record the valuation allowance. 57. At the beginning of the year, the balance sheet of Schrader, Inc., shows a $500,000 deferred tax asset relating to a net operating loss carryforward offset by a $90,000 valuation allowance. At the end of the year, Schrader’s management believes there is sufficient positive evidence to support releasing $20,000 of the allowance. Provide the journal entry to record this change in the valuation allowance. Essay 58. A corporation’s taxable income almost never is the same as its GAAP financial accounting income. Discuss the types of differences that exists between the two. Use the terms permanent and temporary book-tax differences in your answer. Give at least two examples of each type of book-tax difference. 59. Jacobsen Corporation has determined the appropriate changes to its deferred tax assets and liabilities. It is now considering whether to place a valuation allowance against the deferred tax asset on the balance sheet. List some of the factors that Jacobsen should consider in this regard. 60. You are the tax adviser to a publicly traded U.S. corporation. How might you use a “benchmarking” analysis to begin your review of the entity’s tax situation and planning opportunities? 61. Bryden Corporation is considering two tax planning strategies. Both would produce a $1 million tax savings. One of Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements the strategies involves a temporary book-tax difference, and the other would generate a permanent difference. In general, which plan would the Bryden CFO prefer? Which would a stock analyst reviewing the Bryden valuation prefer? 62. The tax expense reported by a corporation in its financial statements is unlikely equal to the tax reported on

its Federal income tax return for the same period. Identify and briefly explain the items that cause the two to differ.

Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements Answer Key 1. True 2. False 3. True 4. True 5. False 6. True 7. False 8. False 9. True 10. True 11. False 12. True 13. False 14. False 15. False 16. True 17. True 18. False 19. False 20. True 21. c 22. b 23. c 24. d 25. c Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements 26. b 27. a 28. d 29. c 30. d 31. c 32. b 33. c 34. c 35. d 36. a 37. b 38. d 39. c 40. d 41. a 42. b 43. c 44. d 45. c 46. d 47. c 48. b 49. a 50. Budlow reports net income before tax of $500,000 on its GAAP financial statement, but it must adjust this amount for book-tax differences. Tax depreciation in excess of book is a tax deduction not deducted for book purposes, and warranty Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements expense is deductible for book purposes but not yet deductible for tax. Both these items are temporary differences because they eventually reverse (with book depreciation eventually exceeding tax depreciation and the warranty expense ultimately deducted for tax when incurred). The municipal bond adjustment is a permanent difference because this income never is subject to Federal income tax. Book income (before tax) Tax depreciation in excess of book Nondeductible warranty expense Municipal bond interest income Taxable income (Form 1120) Tax rate Current tax expense

$500,000 (75,000) 17,500 (10,000) $432,500 x 25% $108,125

51.

Accrued litigation expense Subtotal Applicable tax rate Gross deferred tax asset Change in deferred tax Asset

Beginning Current of Year Year Difference End of Year $20,000 $7,000 $27,000 $20,000 $7,000 $27,000 × 21% × 21% $ 4,200 $ 5,670 $1,470

52. Tax Debit/(Credit) Assets Cash Accounts receivable Buildings Accumulated depreciation Furniture & fixtures accumulated Depreciation Total Assets

Book Debit/(Credit)

Difference

$ 300 5,000 300,000

$ 300 5,000 300,000

(150,000)

(80,000)

40,000

40,000

(21,000)

(15,000)

(6,000)

$174,300

$250,300

($76,000)

$ –0– (116,000) ($116,000)

($ 27,000)

$27,000

(116,000) ($143,000)

$27,000

($70,000)

Liabilities Accrued litigation Expense Note payable Total liabilities Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements Stockholders’ Equity Paid-in capital Retained earnings Total liabilities & stockholders’ equity

($ 1,000) (57,300)

($ 1,000) (106,300)

($174,300)

($250,300)

Given these basis differences, the gross DTA and gross DTL are calculated as follows. Gross deferred tax asset ($27,000 × 21%) Gross deferred tax liability ($76,000 × 21%) Net deferred tax liability

$ 5,670 (15,960) ($10,290)

53. Building – Accumulated depreciation Furniture & fixtures – Accumulated depreciation Subtotal Applicable tax rate Gross deferred tax liability Change in deferred tax Liability

Beginning Current of Year Year Difference ($61,000) ($ 9,000)

54. Pre-tax book income

End of Year ($70,000)

(3,000)

(3,000)

(6,000)

($64,000) × 21% ($13,440)

($12,000)

($76,000) × 21% ($15,960)

($ 2,520)

$6,000

Book-tax adjustments Permanent Items Tax exempt income Nondeductible entertainment expense Temporary differences Building depreciation Furniture & fixtures depreciation Accrued litigation expenses Taxable income Current tax expense (21%)

(250) 500

(9,000) (3,000) 7,000 $1,250 $ 263

55. Powered by Cognero

Page 18

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements $ 1,260 (53) 105 1,312

Tax on book income at statutory rate Tax-exempt income Nondeductible entertainment expense Provision for income tax expense

56. Income Tax Expense (provision), Current Year

% 21.00 (0.88) 1.75 21.87

$90,000

Valuation Allowance 57. Valuation Allowance

$90,000

$20,000

Income Tax Expense (provision), Current Year

$20,000

58. Temporary differences are caused by income and expenses appearing in both the financial statement and tax return, but in different periods (i.e., a timing difference). Permanent differences are caused by items appearing in the financial statement or the tax return, but not both. Examples of temporary differences include the following. ∙

Cost recovery on fixed assets.

∙

Compensation related expenses where under GAAP, corporations must accrue the future expenses related to providing postretirement benefits other than pension (e.g., health insurance coverage), but these expenses are deductible for tax purposes only when paid.

∙

Warranty expenses accrued for book purposes but not deductible for tax purposes until incurred.

∙

Inventory write-offs accrued for book but not deductible for tax until incurred.

∙

Goodwill is not amortizable for book purposes unless and until impairment is recorded.

Examples of permanent differences include the following. ∙

Municipal bond interest income.

∙

The disallowed portion of business meals expense.

∙

Certain penalties.

∙

Tax credits.

59. To determine whether a valuation allowance is required, both positive and negative evidence must be evaluated. The key issue is whether the taxpayer will generate sufficient income (and tax liability) in the future to use the deferred tax asset before any benefits expire. Examples of negative evidence (i.e., evidence suggesting that the deferred tax asset will Powered by Cognero

Page 19

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements not be realized) include: ∙

History of losses.

∙

Expected future losses.

∙

Short tax credit carryback/carryforward periods.

∙

Adverse tax and legal results such as the expiration of a patent or trademark.

∙

History of tax credits expiring unused.

Examples of positive evidence (i.e., support for realizing the current benefit of future tax savings) include: ∙

Strong earnings history.

∙

Existing contracts.

∙

Unrealized appreciation in assets.

∙

Sales backlog of profitable orders.

∙

Turnaround of temporary differences that produce future taxable income.

60. Companies may benchmark their tax situation to other companies within the same industry or to their own previous tax years. The starting point for a benchmarking exercise is the data from the income tax rate reconciliation. When comparing effective tax rates it is important to consider which components of the effective rate produce one-time effects and which components represent structural (long-lasting) effects. In addition to comparing effective tax rates, companies can compare levels of deferred tax assets and liabilities. 61. In most cases, the CFO would prefer the permanent difference because that approach would reduce Bryden’s effective tax rate for the year, probably increasing its share price and the CFO’s possibility for a performance bonus. The stock analyst would prefer the strategy employing a permanent difference as it generates a $1 million overall increase in cash flows rather than a deferral of an expense. However, an analyst would like even more a plan that generates sustainable tax reductions, not one-time refunds. 62. The two may differ if the company operates in a foreign country or in a state or local jurisdiction that

imposes an income tax. Income tax expense reported on a corporation’s financial statements is the combination of Federal, state, local, and foreign income taxes. The two may also differ because financial reporting requires an inter-period allocation of tax expense, recognizing the tax consequences of all items reflected in current-year financial income regardless of when they are reflected in taxable income. While the tax reflected on the current-year tax return is captured in current tax Powered by Cognero

Page 20

Name:

Class:

Date:

Chapter 24: Taxes in the Financial Statements expense, the tax consequences related to items included in current-year book income but in the taxable income of another (i.e., book-tax temporary differences) are nonetheless captured in deferred tax expense. The two may also differ because of the different standards that must be met before a tax benefit may be recognized. A corporation may be unable to recognize in its financial statements tax saving legally taken on its tax return that nonetheless fail to meet the criteria to be recognized for financial accounting purposes (i.e., unrecognized tax benefits due to uncertain tax position). Finally, the two may differ due to the intra-period allocation of tax expense for financial reporting purposes. Any tax expense or benefit attributable to items included in comprehensive income but not in income from operations must be netted with those items when reported on the income statement. Therefore, what is reported as tax expense in the financial statements may omit the tax consequences of some items included in taxable income but not in pre-tax book income.

Powered by Cognero

Page 21

Name:

Class:

Date:

Chapter 25 Exempt Entities True / False 1. A church is one of the types of exempt organizations. a. True b. False 2. All organizations that are exempt from Federal income tax are "charities." a. True b. False 3. An exempt entity is not subject to any Federal income tax. a. True b. False 4. To satisfy the “not-for-profit” requirement for exempt status, the entity may not be engaged in a trade or business. a. True b. False 5. General requirements for exempt status include the organization serving the common good and the organization being a not-for-profit entity. a. True b. False 6. A church can elect to make a limited amount of lobbying activities. a. True b. False 7. The League of Women Voters is a § 501(c)(3) organization. a. True b. False 8. Section 501(c)(3) exempt organizations are permitted to engage in substantial lobbying activities. a. True b. False 9. Relative to the election to engage in limited lobbying activities, grass roots expenditures are made to influence the opinions of voting legislators. a. True b. False 10. An intermediate sanction in the form of an excise tax imposed by the IRS on an exempt organization is a more stringent sanction than revocation of exempt status. a. True b. False 11. A feeder organization is exempt from Federal income taxation because it carries on a trade or business for the benefit Powered by Cognero

Page 1

Name:

Class:

Date:

Chapter 25 Exempt Entities of an exempt organization and remits its profits to the exempt entity. a. True b. False 12. Theater, Inc., an exempt organization, owns a media company, Printers, Inc., that remits 85% of its profits (i.e., taxable income of $100,000) to Theater. Since Printers remits at least 85% of its profits to Theater, neither Theater nor Printers must pay Federal income tax on this $85,000. a. True b. False 13. The tax consequences to a donor of making a charitable contribution to a private foundation may be less favorable than the tax consequences to a donor of making a charitable contribution to a public charity. a. True b. False 14. To satisfy the broadly supported provision to avoid classification as a private foundation, an exempt organization must satisfy an internal support test. Under the internal support test, more than one-third of the exempt organization’s support for the taxable year must come from gross investment income and unrelated business taxable income. a. True b. False 15. The excise taxes such as the tax on self-dealing and the tax on excess business holdings are imposed on exempt organizations classified as private foundations. These taxes are not imposed on exempt organizations classified as public charities. a. True b. False 16. Some of the excise taxes on private foundations may be imposed on both the private foundation and the foundation management. a. True b. False 17. The purpose of the excise tax imposed on a private foundation for failure to distribute sufficient levels of income is to motivate the foundation to distribute more of its income to outside recipients. a. True b. False 18. The unrelated business income tax (UBIT) is calculated by multiplying unrelated business taxable income by the appropriate Federal income tax rate. a. True b. False 19. Federal agencies are not subject to the unrelated business income tax (UBIT). a. True b. False 20. For purposes of the unrelated business income tax (UBIT), a trade or business consists of any activity conducted for Powered by Cognero

Page 2

Name:

Class:

Date:

Chapter 25 Exempt Entities the production of income through the sale of merchandise or from the performance of services for which profits have been earned during at least three of the five previous tax years. a. True b. False 21. The trade or business of selling merchandise where substantially all of the merchandise has been received as contributions or gifts is not subject to the unrelated business income tax. a. True b. False 22. If an exempt organization conducts a trade or business that is regularly carried on by the organization and the business relates to the organization's exempt purpose, the organization is subject to the unrelated business income tax (UBIT). a. True b. False 23. For an exempt organization to be subject to the unrelated business income tax, the trade or business must not be substantially related to the exempt purpose of the organization. a. True b. False 24. A corporate sponsorship payment that is contingent on attendance at a sporting event increases the recipient's unrelated business income. a. True b. False 25. The income from a bingo game or a casino game conducted by an exempt organization may be unrelated business income. a. True b. False 26. Revenue generated by an exempt organization from the distribution of low-cost items to its donors is not income from an unrelated trade or business. a. True b. False 27. If an exempt organization sells or rents its donor or membership list to another exempt organization, such trade or business is an unrelated trade or business. a. True b. False 28. If personal property is leased with real property and more than 45% of the rent income under the lease is from personal property, all of the rent income is subject to the unrelated business income tax. a. True b. False 29. If the unrelated business income of an exempt organization is $25,000 or less, the unrelated business income tax (UBIT) is $0. Powered by Cognero

Page 3

Name:

Class:

Date:

Chapter 25 Exempt Entities a. True b. False 30. Debt-financed property consists of all real property of a tax-exempt organization on which there is a mortgage. a. True b. False 31. Only certain exempt organizations must obtain IRS approval to obtain exempt status. a. True b. False 32. Even though a church is not required to obtain IRS approval of its exempt status, it still must annually file a Form 990. a. True b. False 33. The due date for the Exempt Organization Business Income Tax Return (Form 990-T) is the fifteenth day of the third month after the end of the taxable year. a. True b. False 34. All exempt organizations that are subject to the unrelated business income tax must file Form 990-T (Exempt Organization Business Income Tax Return). a. True b. False 35. A § 501(c)(3) exempt organization (excluding churches and private foundations) must make its current Form 990 available to the general public. a. True b. False Multiple Choice 36. Which of the following is not an example of an exempt organization? a. Public high school. b. Private high school. c. Farmers' cooperative. d. Stock exchange. 37. Which of the following attributes are associated with exempt organizations? a. The organization serves some type of common good. b. The organization is not a for-profit entity. c. Net earnings do not benefit the members of the organization. d. All of these statements are true. 38. Garden, Inc., a qualifying § 501(c)(3) organization, incurs lobbying expenditures of $210,000 during the taxable year. Exempt purpose expenditures are $900,000. If Garden makes the election under § 501(h) to make lobbying expenditures Powered by Cognero

Page 4

Name:

Class:

Date:

Chapter 25 Exempt Entities on a limited basis, its tax liability resulting from the lobbying expenditures is: a. $0. b. $12,500. c. $40,000. d. $50,000. 39. Which of the following statements regarding intermediate sanction via excise taxes is correct? a. Intermediate sanctions are self-assessing (i.e., calculated and paid by the taxpayer, not imposed by the IRS). b. The excise tax is imposed on the exempt organization and on disqualified persons. c. Both a first-level tax and a second-level tax may apply. d. The corporate Federal income tax rates apply in calculating the amount of the tax liability. 40. A § 501(c)(3) organization that otherwise would be classified as a private foundation can avoid such classification if it satisfies: a. Only an external support test. b. Only an internal support test. c. Both an external support test and an internal support test. d. An external support test, an internal support test, and a good faith test. 41. Blue, Inc., receives its support from the following sources. Governmental unit A for services rendered $18,000 General public for services rendered 25,000 Gross investment income 8,000 Contributions from individual disqualified persons 19,000 Which of the following statements is correct? a. Blue is a private foundation because it satisfies the external support test and fails the internal support test. b. Blue is not a private foundation because it fails both the internal and external support tests. c. Blue is a private foundation because it satisfies both the external support test and the internal support test. d. Blue is not a private foundation because it satisfies both the external support test and the internal support test. 42. Which of the following statements is correct? a. A private foundation is, in general, exempt from Federal income tax. b. A private foundation may be subject to certain types of Federal income tax. c. If the organization satisfies two support tests, an exempt organization that otherwise would be classified as a private foundation is instead classified as a public charity. d. Choices a., b., and c. are correct. 43. Which of the following excise taxes are imposed on private foundations? a. Tax on failure to distribute income. b. Tax on excess business holdings. c. Tax on excess charitable contributions. d. Only a. and b. 44. Which of the following taxes can be imposed on private foundations? a. Tax on self-dealing. Powered by Cognero

Page 5

Name:

Class:

Date:

Chapter 25 Exempt Entities b. Tax on failure to distribute income. c. Tax on excess business holdings. d. All of these choices are correct. 45. Teal, Inc., is a private foundation that failed to distribute an adequate amount of income. Which of the following statements is correct? a. An excise tax in the form of an initial tax at the rate of 10% may be imposed on Teal. b. An excise tax in the form of an initial tax at the rate of 5% may be imposed on the foundation manager. c. An excise tax in the form of an additional tax at the rate of 100% may be imposed on Teal. d. An excise tax in the form of an additional tax at the rate of 50% may be imposed on the foundation manager. 46. Which of the following statements regarding the unrelated business income tax is not correct? a. Unrelated business income is income from activities not related to the exempt purpose of the organization. b. The unrelated business income tax is levied because the exempt organization is engaging in substantial commercial activities unrelated to its exempt purpose. c. If the unrelated business income tax were not levied, taxable organizations would be placed at a substantial disadvantage when trying to compete with the exempt organization. d. A flat 30% tax rate is applied to unrelated business taxable income. 47. Which of the following statements is correct regarding the unrelated business income tax (UBIT)? a. To be subject to the UBIT, the exempt organization must conduct a trade or business, the trade or business is not substantially related to the exempt purpose of the organization, and the trade or business is regularly carried on by the organization. b. To be subject to the UBIT, the exempt organization must conduct a trade or business, the trade or business must be substantially related to the exempt purpose of the organization, and the trade or business must be regularly carried on by the organization. c. To be subject to the UBIT, the exempt organization must conduct a trade or business, the trade or business is not substantially related to the exempt purpose of the organization, and the trade or business is carried on during more than half the year. d. An exempt entity that conducts a business that competes with for-profit businesses automatically is subject to the UBIT. 48. Third Church operates a gift shop in its parish house. The total income of the church is $800,000. Of this amount, $300,000 comes from offerings and $500,000 comes from the net income of the gift shop. The gift shop operations are conducted by six full-time, paid employees. Which of the following statements is correct? a. The $800,000 is unrelated business income. b. The $500,000 of gift shop net income is unrelated business income. c. The $300,000 is unrelated business income because the gift shop is a feeder organization. d. None of the $800,000 is unrelated business income. 49. Which of the following statements regarding the unrelated business income tax is correct? a. Churches are subject to the unrelated business income tax. b. Bingo games are not subject to the unrelated business income tax if they are conducted by an exempt organization. c. The exchange or rental of membership lists with other exempt and nonexempt organizations is not an unrelated trade or business. Powered by Cognero

Page 6

Name:

Class:

Date:

Chapter 25 Exempt Entities d. All of these statements are correct. 50. Which of the following are qualified corporate sponsorship payments? a. The amount of the advertiser's payment to the exempt organization is contingent on the attendance at one or more events. b. The corporation's payment is determined by the number of likes on the exempt organization's Facebook page for the advertiser's products. c. The advertiser's payment to the exempt organization results in it's corporate logo appearing in the exempt organization’s daily Instagram post. d. Only b. and c. 51. Which of the following requirements must be satisfied for a bingo game to be classified as not being an unrelated trade or business? a. The bingo game is legal under both state and local law. b. The bingo game is conducted by volunteers. c. For-profit bingo games ordinarily are not permitted in the jurisdiction. d. Only a. and c. must be satisfied. 52. Which of the following statements regarding the distribution of low-cost articles by an exempt entity is correct? a. The distribution of low-cost articles can be classified as not being an unrelated trade or business. b. For 2024, a low-cost article is one that costs the entity $13.20 or less. c. Any contributions received that trigger the distribution of low-cost articles is included in unrelated business income. d. Only a. and b. are correct. 53. Tan, Inc., a tax-exempt organization, records $65,000 of current year net unrelated business income. Total charitable contributions by Tan total $7,500. Assuming that the $7,500 was deducted for these gifts in calculating net unrelated business income, what is Tan’s unrelated business taxable income? a. $65,000 b. $65,250 c. $66,000 d. $72,500 54. Maroon, Inc., a tax-exempt organization, leases a building and equipment to Brown Partnership. The rental income from the building is $100,000 and from the equipment is $9,000. Rental expenses are $40,000 for the building and $4,000 for the equipment. What adjustment must be made to net unrelated business income? a. $-0b. ($60,000) c. ($65,000) d. ($109,000) 55. For purposes of the unrelated business income tax (UBIT), land that is acquired by an exempt organization for later exempt use is excluded from debt-financed property if certain requirements are satisfied. Which of the following is not such a requirement? a. The principal purpose of acquiring the land is for use (substantially all) in achieving the organization’s exempt purpose. Powered by Cognero

Page 7

Name:

Class:

Date:

Chapter 25 Exempt Entities b. The fair market value of the land is not over 50% of the fair market value of land presently owned by the exempt organization. c. The use of the land by the exempt organization will begin within 10 years of the acquisition date. d. At the date the land is acquired, the land is located in the neighborhood of other exempt-purpose property of the organization. 56. Which of the following is a requirement that will enable mortgaged land acquired by an exempt organization for later exempt use to be excluded from debt-financed property for purposes of the unrelated business income tax? a. The principal purpose of acquiring the land is for investment. b. The land is used within 10 years of the acquisition date in the organization’s exempt purpose. c. The land is located in the United States. d. Only a. and b. are correct. 57. Which of the following exempt organizations are required to file a Form 990? a. Federal agencies. b. Churches. c. Exempt organizations whose annual gross receipts do not exceed $50,000. d. None of these entities must file Form 990. 58. Which of the following statements is/are correct? a. If an exempt organization records annual gross receipts of less than $50,000, it files Form 990-N. b. Private foundations must file Form 990-PF (Return of Private Foundation). c. An exempt organization with less than $250,000 in gross receipts may file a Form 990-EZ. d. Only a. and b. are correct. 59. Which of the following statements regarding exempt organization filing requirements is incorrect? a. A church is required to file Form 990 (Return of Organization Exempt from Income Tax) only if its annual gross receipts exceed $50,000. b. The due date for Form 990 (Return of Organization Exempt from Income Tax) is the fifteenth day of the fifth month after the end of the taxable year, whereas for private foundations, the due date for Form 990-PF (Return of Private Foundation) is the fifteenth day of the fourth month after the end of the tax year. c. Exempt organizations whose annual gross receipts do not exceed $100,000 can file an e-Postcard (Form 990N). d. Choices a., b., and c. are incorrect. 60. Which of the following statements is correct regarding the disclosure of tax documents by exempt entities? a. Posting the required tax forms on the Internet is an acceptable technique for satisfying the “widely available" requirement. b. Forms 990 and 1023 must be readily available to the general public. c. Copies of the three most recent Forms 990 must be made available to the public. d. Choices a., b., and c. are all correct. 61. Both of the organizations listed below are exempt from Federal income tax. A donor can claim a charitable contribution for a gift to: a. The Dubuque Art Museum. Powered by Cognero

Page 8

Name:

Class:

Date:

Chapter 25 Exempt Entities b. The Buffalo VFW (Veterans of Foreign Wars) post. c. Both a. and b. d. Neither a. nor b. 62. A museum’s lobbying nontaxable amount is $600,000. Its grass roots nontaxable amount is: a. $600,000. b. $300,000. c. $150,000. d. $0. 63. Ballet’s lobbying nontaxable amount is $600,000. Its lobbying expenditures ceiling is: a. $0. b. $600,000. c. $900,000. d. $1,200,000. 64. To provide the greatest Federal income tax benefits for its donors, Orchestra would prefer to be a: a. Public charity. b. Private foundation. c. C corporation. d. Feeder organization. 65. By default, an exempt entity is a: a. Public charity. b. Private foundation. c. Private charity. d. Feeder organization. 66. A private foundation can be subject to an excise tax on: a. Making jeopardizing investments. b. Engaging in self-dealing. c. Both a. and b. d. Neither a. nor b. 67. The Jimenez Group, a private foundation, has been found guilty of self-dealing. To minimize its Federal excise taxes from this activity, Jimenez should: a. Surrender its tax-exempt status. b. Reorganize as a C corporation. c. Pay the second-level excise tax immediately. d. Undo (i.e., “correct”) the violation immediately. 68. Hospital wants to avoid the UBIT on its gift shop sales. To the extent possible, Hospital should: a. Sell on-site flowers and other items that will cheer up its patients. b. Sell through its website inspirational books and music to customers around the world. Powered by Cognero

Page 9

Name:

Class:

Date:

Chapter 25 Exempt Entities c. Both a. and b. d. Neither a. nor b. 69. Riverside Show Choir reports $20,000 of sales of pizzas at the local high school ballgames this year. Related expenses total $6,000. UBTI equals: a. $-0-. b. $13,000. c. $14,000. d. $20,000. 70. The Form 990-N: a. Is filed by newly exempt entities. b. Records the asset holdings and liabilities of the exempt organization. c. Is also known as the e-Postcard. d. No longer exists. 71. Gallery, a public charity, reports annual gross receipts of $100,000 and has total assets of $425,000. It should file a(n): a. Form 990. b. Form 990-PF. c. Form 990-N (e-Postcard). d. Form 990-EZ. 72. School has been paying the UBIT every year. To reduce or eliminate this year’s tax liability, School might: a. Relate the profit-making activities to its educational purpose. b. Conduct the profit-making activities on a regular basis. c. Both a. and b. d. Neither a. nor b. 73. School has been paying the UBIT every year. To reduce or eliminate this year’s tax liability, School might: a. Accelerate gross income from the profit-making activity into the current tax year. b. Accelerate deductions from the profit-making activity into the current tax year. c. Both a. and b. d. Neither a. nor b. Matching Give an example of the indicated types of exempt organizations. a. League of Women Voters. b. Teachers’ union. c. American Plywood Association. d. Six Flags over Texas theme park. e. Salvation Army. 74. § 501(c)(3) organization Powered by Cognero

Page 10

Name:

Class:

Date:

Chapter 25 Exempt Entities 75. § 501(c)(4) civic league 76. § 501(c)(5) labor organization 77. § 501(c)(6) business league 78. Not an exempt organization For each of the following taxes that are imposed on private foundations and/or foundation managers, match the appropriate initial tax or additional tax. a. 10% initial tax and 25% additional tax on private foundation. b. 30% initial tax and 100% additional tax on private foundation. c. 10% initial tax and 200% additional tax on private foundation. d. 10% initial tax and 100% additional tax on disqualified person. e. 10% initial tax and 200% additional tax on the disqualified person. 79. Tax on self-dealing 80. Tax on failure to distribute adequate amounts of income 81. Tax on excess business holdings 82. Tax on jeopardizing investments Match the following statements. a. May be subject to some Federal income taxation, and classification may adversely affect the amount of charitable contributions received. b. Tax imposed for engaging in transactions with disqualified persons. c. Tax imposed for making investments that are too risky. d. Tax imposed on investments that enable a private foundation to control unrelated for-profit businesses. 83. Private foundation 84. Tax on self-dealing 85. Tax on excess business holdings Match the following statements. a. Exempt from tax on unrelated business. b. Inappropriate definition. c. Exempt organization may be subject to the tax on unrelated business income. d. Annual information return of an exempt organization that is required to file a return and which is not a private foundation. e. Appropriate definition. f. Annual information return of a private foundation. 86. The trade or business is not substantially related to the exempt purpose of the organization. Powered by Cognero

Page 11

Name:

Class:

Date:

Chapter 25 Exempt Entities 87. The trade or business consists of selling merchandise, and substantially all of the merchandise has been received as gifts or contributions to the entity. 88. Unrelated business income is generally that derived from the unrelated trade or business reduced by the deductions directly connected with the conduct of the unrelated trade or business. 89. Debt-financed income is the net income from leveraged assets that produce UBI. 90. Form 990. 91. Form 990-PF. Match the following tax forms. a. Return of Private Foundation. b. Application for Recognition of Exemption under § 501(c)(3). c. Return of Organization Exempt from Income Tax. d. Return of organization reporting UBI. 92. Form 990 93. Form 990-PF 94. Form 1023 95. Form 990-T Match the following statements. a. Distribution of such items to donors is not considered an unrelated trade or business if they are "low-cost items". b. Is considered an unrelated trade or business if the amount received is contingent upon the level of attendance at one or more events c. Is considered an unrelated trade or business if legally it can be conducted by commercial (for-profit) entities. d. A trade or business that consists of either renting or exchanging these with another exempt organization is not an unrelated trade or business. 96. Bingo games 97. Corporate sponsorship payments 98. Branded tote bags 99. Membership lists Subjective Short Answer 100. Miracle, Inc., is a § 501(c)(3) organization involved in medical research. Based on its expectation that proposed legislation will adversely affect the funding supporting its mission, Miracle hires a lobbyist to work in Washington to represent its views. Miracle is eligible for and thus makes the § 501(h) election. Its exempt purpose expenditures are $500,000. The total lobbying expenditures for the year were $115,000. Is Miracle in danger of losing its tax exemption? Why or why Powered by Cognero

Page 12

Name:

Class:

Date:

Chapter 25 Exempt Entities not? Calculate Miracle’s tax on excess lobbying expenditures. 101. Help, Inc., a tax-exempt organization, incurs lobbying expenses of $275,000 during the tax year. Help makes the § 501(h) lobbying expenditure election. During the year, Help spends $1,200,000 carrying out its exempt purpose. a.

Will the lobbying expense result in Help losing its exempt status?

b.

Calculate the amount of any tax that Help must pay associated with its lobbying expenses.

102. Restful, Inc., a § 501(c)(3) exempt organization, hires a registered lobbyist to promote its position on pending legislation. For the year, its lobbying expenses are $100,000. Restful makes the § 501(h) election. The lobbying nontaxable amount is $90,000. a.

Will the lobbying expenses result in Restful losing its exempt status?

b.

Calculate the amount of any tax that Restful must pay associated with the lobbying expenses.

103. Medical, Inc., a § 501(c)(3) exempt organization, engages in an excess benefit transaction such that the intermediate sanction rules may apply. The amount of the excess benefit is $50,000. For the organization management, the participation in the excess benefit transaction was not willful and was supported by reasonable cause. Calculate the amount of the excise tax (first-level tax only) imposed under the intermediate sanctions provision. 104. All of the stock of Hot Dog, Inc., a fast-food franchise operating in nine southeastern states, is owned by Winsome America, Inc., a § 501(c)(3) organization. The stock was received last year as an inheritance from Rob, the entrepreneur who founded the chain. During the current year, Hot Dog reports profits before taxes and taxable income of $8 million. Hot Dog distributes $5 million to its parent, as required under the bequest, and it retains the balance for expansion purposes. a. What are the tax consequences to Hot Dog and to Winsome America?

b. How would your answer in a. change if Hot Dog distributes $8 million to Winsome, rather than $5 million? 105. Assist, Inc., a § 501(c)(3) organization, receives the following sources of support during the tax year.

General public for services rendered Governmental unit A for services rendered Governmental unit B for services rendered Governmental unit C for services rendered Gross investment income Contributions from individual disqualified persons Is Assist, Inc., classified as a private foundation? Explain.

$22,000 30,000 3,000 8,000 19,000 18,000

106. Spirit, Inc., a § 501(c)(3) organization, is classified as a private foundation. It reports investment income of $175,000. Calculate Spirit’s tax on its investment income. 107. Well, Inc., a private foundation, makes a speculative investment of $400,000 that puts the foundation's assets at excessive risk. Calculate the tax on jeopardizing investments. Well Inc. made corrective action so that a second-level tax Powered by Cognero

Page 13

Name:

Class:

Date:

Chapter 25 Exempt Entities does not apply. 108. First Americans, Inc., a § 501(c)(3) organization, operates a museum that depicts the lives of a tribe of Native Americans. It charges an admission fee but also finances its operations through endowment income, contributions, and gift shop sales. The gift shop is operated by 50 volunteers, and the museum is operated by 15 employees. The entity's revenue by source is: Admission fees Endowment income Gift shop net income Contributions

$700,000 75,000 300,000 100,000

a.

Determine the amount of First Americans’ unrelated business income (UBI).

b.

Determine the amount of First American’s unrelated business income tax (UBIT).

109. Rattler, Inc., an exempt organization, trains individuals with disabilities to design smartphone apps. Rather than hold a traditional graduation exercise, the graduates compete in an app design contest. Such activities are held four times each year. An admission fee of $10 is charged to the general public to attend the contest awards ceremony. Eight hundred people attended the ceremony this year, and prizes of $2,000 were given to the three graduates with the highest app ratings. Calculate the amount of Rattler’s unrelated business income from this activity. 110. The Dispensary is a pharmacy that is part of a § 501(c)(3) hospital. Its primary mission is to distribute medicines for hospital patients. In addition, the pharmacy dispenses medicines to former hospital patients for a period of up to 30 days after discharge from the hospital. It does this for the dual purpose of convenience to the former patients (i.e., the closest pharmacy is six miles away), and to ensure that the former patients receive the medicines that have been prescribed for them immediately after discharge. The Dispensary carries out the policy of the hospital board that no more than 25% of its gross revenues come from former-patient medicine sales. If necessary, in December of each year, sales to former patients are curtailed to ensure compliance with this policy. Sales revenue from each of the two sources is as follows for the tax year. Medicine dispensed to hospital patients Medicine sales to former patients

$900,000 100,000

Calculate the amount of The Dispensary’s unrelated business income. 111. Midnight Basketball, Inc., an exempt entity that organizes and conducts basketball games for youths ages 18-25, receives a $20,000 contribution from Brock Shoe Company. Midnight agrees to put Brock’s logo on the cover of its monthly newsletter.

a.

Is the contribution unrelated business income to Midnight?

b.

Assume that instead of putting Brock’s logo on the cover of its newsletter, Midnight agrees to include a statement in the newsletter that youth playing in the games conducted by Midnight only wear shoes manufactured by Brock. Is the contribution unrelated business income to Midnight?

c.

Would your answer in b. change if the amount of the payment was $7,500 instead of $20,000?

Powered by Cognero

Page 14

Name:

Class:

Date:

Chapter 25 Exempt Entities 112. Faith Church, a § 501(c)(3) organization, operates a bingo game two times each week to raise money to support the youth activities of the church. For the current year, net proceeds from the bingo game are $900,000. a.

b.

Determine the tax consequences for Faith Church if the bingo game is conducted in a jurisdiction where for-profit bingo games are illegal and where the bingo game is legal for exempt entities. Determine the tax consequences for Faith Church if the bingo game is conducted in a jurisdiction where bingo games are legal for both for-profit and exempt entities.

113. Watch, Inc., a § 501(c)(3) exempt organization, solicits contributions through its website. An executive who recently completed an executive MBA degree program recommends that a $10 gift card be distributed to those who make a gift. What is the effect of the gift card program on Watch’s unrelated business income? 114. Ice, Inc., a § 501(c)(3) organization, has been leasing a building to Soft, Inc., a taxable entity, for 15 years. The lease terminates in the current tax year. Ice’s adjusted basis for the building is $225,000. It sells the building to the Development Partnership, a taxable entity, for $440,000. Selling expenses are $26,400. Calculate Ice's realized gain and any effect of the sale on Ice’s UBTI.

115. Arbor, Inc., an exempt organization, leases land, building, and machinery to a tenant for a 5-year period. The rent income for the land and building is $400,000 per year and that from the related machinery is $80,000 per year. Expenses incurred by Arbor for the land and building during the year are $60,000, and those for the machinery are $36,000. Net unrelated business income, which includes the above rental income and expenses, is $800,000. Calculate Arbor’s unrelated business taxable income from these items. 116. Pearl Inc., a tax-exempt organization, leases land, building, and machinery to Purple Partnership for a 5-year period. This year, the rental income from the land and building is $100,000, with related expenses of $40,000. The rental income from the machinery is $9,000 with related expenses of $3,000. What adjustment must be made in computing any net unrelated business income from these items? Essay 117. Why are some organizations exempt from Federal income tax? 118. Are organizations that qualify for exempt organization status completely exempt from Federal income taxation? 119. Name at least three common characteristics of organizations that receive exempt status. 120. Discuss benefits for which an exempt organization may be eligible, other than exemption from Federal income tax. 121. Describe how a public charity can be eligible to make lobbying expenditures without losing its tax exemption. Be specific. 122. An eligible § 501(c)(3) organization has made the § 501(h) election to participate in lobbying on a limited basis. If the lobbying nontaxable amount is exceeded, what are the potential tax consequences to the exempt organization? 123. What are intermediate sanctions and to what types of exempt organizations do they apply? Powered by Cognero

Page 15

Name:

Class:

Date:

Chapter 25 Exempt Entities 124. Agnes is aware that a feeder organization is subject to Federal income taxation. She wonders whether an organization that is otherwise taxable as a feeder organization can avoid such status if it remits at least 80% of its profits to the § 501(c)(3) entity. 125. Define a private foundation. 126. How can an exempt organization otherwise classified as a private foundation become a public charity? 127. Discuss any negative tax consequences that result from an exempt organization being classified as a private foundation. 128. List at least three of the excise taxes imposed on private foundations. Why are they imposed? 129. Construct the tax model for unrelated business taxable income. 130. What is the purpose of the unrelated business income tax? 131. Which requirements must be satisfied for an exempt organization to be classified as an unrelated trade or business? Is being classified as an unrelated trade or business good or bad? Explain. 132. Define a qualified corporate sponsorship payment. 133. Under what circumstances are bingo games not treated as an unrelated trade or business? 134. If an exempt organization distributes “low-cost items” as an incidental part of its solicitation for charitable contributions, the activity is not considered an unrelated trade or business. a.

At what dollar amount is a distribution no longer a "low-cost item"?

b.

Provide examples of low-cost items.

135. A § 501(c)(3) organization exchanges its membership lists with another exempt organization. What are the Federal income tax consequences of such an exchange? 136. What tax forms are used to apply for exempt status? Be specific. 137. If an exempt organization is required to file an annual information return, on what form is it filed? Be specific.

Powered by Cognero

Page 16

Name:

Class:

Date:

Chapter 25 Exempt Entities Answer Key 1. True 2. False 3. False 4. False 5. True 6. False 7. False 8. False 9. False 10. False 11. False 12. False 13. True 14. False 15. True 16. True 17. True 18. True 19. True 20. False 21. True 22. False 23. True 24. True 25. True Powered by Cognero

Page 17

Name:

Class:

Date:

Chapter 25 Exempt Entities 26. True 27. False 28. False 29. False 30. False 31. True 32. False 33. False 34. False 35. True 36. d 37. d 38. b 39. c 40. c 41. d 42. d 43. d 44. d 45. c 46. d 47. a 48. b 49. a 50. c Powered by Cognero

Page 18