Module 5 Essentials of Business Entity Taxation Flashcards
Lucy files jointly with her spouse, Linus. Linus had no income. Lucy had net earnings from self-employment in 2023 of $220,000. What is her total self-employment tax?
A)
$24,480
B)
$25,757
C)
$19,645
D)
$20,333
b
Lucy’s total self-employment tax is calculated as follows:
Self-employment income $220,000
Less: $220,000 × 0.0765 $16,830
Equals net earnings $203,170
Less: wage base −$160,200
Equals SE income in excess of Social Security wage base subject to Medicare tax $42,970
Multiplied by 0.029 × 0.029
Equals Medicare portion of SE tax $1,246
Add $160,200 × 0.153 +$24,511
Total self-employment tax $25,757
LO 5.3.1
Assume that a single taxpayer has wages of $150,000 for the current tax year. She also has a small business, operated as a sole proprietorship, that generates approximately $75,000 of net income each year. Her taxable income is approximately $185,000. Advantages for incorporating the small business as a C corporation include which of the following?
All business expenses are generally deductible in arriving at net income
Using the dividends-received deduction
earnings of the business are taxed to the regular corporation at special corporate income tax rates
Changing the form of business back to a sole proprietorship with ease once a corporation has been formed
A)
I, III, and IV
B)
I, II, and III
C)
II only
D)
III only
b
There are fewer restrictions on corporate deductions because all business expenses are generally deductible in arriving at net income for a business (except for those specifically limited or disallowed by law, such as bribes or other illegal activities). There are some deductions that are specific to corporations. An important deduction is the dividends-received deduction. The earnings of or profits from the business are taxed to the regular corporation at special corporate income tax rates. Changing a C corporation to other business forms (except for conversion to S status) can be difficult and costly.
LO 5.2.1
To elect S corporation status for the current calendar year, which of the following must be done for a newly incorporated business?
Secure the consent of the board of directors of the corporation.
File the election (IRS Form 2553) before the 15th day of the 3rd month of the tax year the election is to take place.
Issue two classes of stock.
File the election (IRS Form 2553) at any time before the end of the corporation’s tax year.
Elect S corporation status when filing the corporation’s initial tax return.
A)
V only
B)
I, III, and IV
C)
I, II, and IV
D)
II only
d
IRS Form 2553—Election by a Small Business Corporation has to be filed by the 15th day of the 3rd month of the tax year. The shareholders must secure the consent of the IRS to be taxed as an S corporation. In general, only one class of stock is allowed in an S corporation.
LO 5.2.2
ABC Corporation has the following items of income and expense:
Taxable income $300,000
Federal income tax $80,000
Dividends paid (all in current year) $40,000
Accumulated earnings and profits at end of preceding tax year $160,000
Assume that XYZ Corporation is not a personal service corporation and cannot establish a valid business purpose for the excess accumulations. What is the amount, if any, of the accumulated earnings tax payable?
A)
$0
B)
$26,000
C)
$6,000
D)
$18,000
d
Taxable income $300,000
Federal income tax (80,000)
Dividends paid (all in current year) (40,000)
Accumulated earnings credit ($250,000 – $160,000)1 (90,000)
Accumulated taxable income $90,000
20%
Accumulated earnings tax $18,000
1The accumulated earnings credit is the $250,000 accumulation limit minus accumulated earnings and profits at the end of the preceding tax year.
LO 5.2.1
Which of the following statements regarding calculating self-employment (SE) tax is CORRECT?
The method for calculating the deductible employer share of SE tax is to multiply the net SE income by 0.9235 × 0.0765 up to the taxable wage base of $160,200 in 2023.
The shortcut method for calculating total SE tax for SE income at or below the taxable wage base in 2023 is to simply multiply the amount of SE income by 0.1413 (0.9235 × 0.1530).
A)
I only
B)
Neither I nor II
C)
II only
D)
Both I and II
Both statements are correct.
LO 5.3.1
Jim is a single taxpayer. During the current year, he sold Section 1244 stock for $40,000. Jim had held the stock for three years. His basis in the stock was $130,000. What is the tax result from the sale of the stock?
A)
Jim has an ordinary loss of $50,000 this year and a carryforward of ordinary loss of $40,000.
B)
Jim has an ordinary loss of $100,000.
C)
Jim has a long-term capital loss of $100,000.
D)
Jim has an ordinary loss of $50,000 and a long-term capital loss of $40,000.
d
The loss on the sale, exchange, or worthlessness of Section 1244 stock may be treated as an ordinary loss up to $100,000 annually on a joint return or $50,000 annually on any other return. Thus, as a single taxpayer, Jim has a $50,000 ordinary loss. Any excess loss is a capital loss—short- or long-term depending on the holding period.
LO 5.1.1
Joe and Carter plan to combine their respective sole proprietorships to enable them to bid on a local automobile plant’s contract to provide uniforms, shoes, and safety equipment to 2,300 employees. Joe currently operates a business that sells uniforms and safety equipment. Carter has a shoe store that specializes in work shoes for many occupations. Joe’s spouse and Carter’s spouse each earn approximately $250,000 per year.
Joe and Carter anticipate operating losses over the first two years of approximately $75,000 per year, to be followed by substantial profits. They would like to be able to use the initial losses from the business against their spouses’ incomes. They plan to share the management responsibilities equally. Both Joe and Carter admit that the business is very risky, as neither one of them has had any experience with such large contracts. They anticipate having the business borrow funds to provide operating funds for the first two years.
Which of the following business forms would be most appropriate for Joe and Carter at this time?
A)
C corporation
B)
Limited liability company (LLC)
C)
General partnership
D)
S corporation
b
The LLC is the only entity that will fulfill all of the requirements of the situation; the S corporation is close, but the corporate borrowing will not establish basis for the shareholders. As a partnership for tax purposes, the LLC borrowing establishes basis for the members. Remember that the taxpayers may only deduct losses from a conduit entity to the extent that they have basis.
LO 5.2.3
Which of the following statements regarding inventory valuation techniques and cost of goods sold (COGS) is CORRECT?
During a period of rising prices, LIFO increases the COGS.
During a period of declining prices, LIFO increases the COGS.
During a period of rising prices, FIFO increases the COGS.
During a period of declining prices, FIFO increases the COGS.
A)
II and III
B)
I and IV
C)
II and IV
D)
I and III
b
During a period of rising prices, the last-in, first-out method (LIFO) treats the higher-priced inventory items as those first sold. This, therefore, increases the cost of goods sold (COGS). Conversely, during a period of declining prices, the first-in, first-out method (FIFO) matches the higher-priced inventory items against income. This naturally increases the COGS.
LO 5.1.1
S corporation shareholders have the ability to deduct losses to the extent of their
A)
adjusted basis in the stock, increased for corporate loans personally guaranteed.
B)
adjusted basis in the stock, increased for funds they have directly loaned to the corporation.
C)
original contribution of capital to the business.
D)
adjusted basis in the stock.
b
A shareholder’s basis and ability to deduct losses from an S corporation are determined by the shareholder’s adjusted basis in the stock, increased by loans she has made to the corporation (basis in debt). Original capital contributions are only one of the items considered in determining basis and ability to deduct losses from an S corporation. A personal guarantee of a corporate loan does not establish basis for purposes of S corporation stock.
LO 5.2.2
Which of the following would be considered self-employment income for purposes of the self-employment tax?
Net income from the rental of a vacation home
Net income from a part-time auto repair business
Fee paid by a nonprofit to a taxpayer for serving on the board of directors
Schedule C net income from a swimming pool care business
A)
II and III
B)
II, III, and IV
C)
I, II, III, and IV
D)
I and IV
b
Statement I is incorrect. Rental income is not self-employment income. For the director’s fee, it makes no difference that the payor is a nonprofit. It is still self-employment income to the director.
LO 5.3.1
Sandy operates a hairstyling sole proprietorship, and performs her business dealings from her home on a part-time basis. She also has a full time job as an esthetician and is paid as a W-2 employee earning $46,000. Her gross income for the current tax year is $71,000. The hairstyling income is $25,000. Due to supply and marketing costs, the business expenses not associated with the home office total $27,275. Expenses associated with the home office total $4,200.
How much of the home office expense, if any, may Sandy deduct for the current year?
A)
$2,000
B)
$0
C)
$4,200
D)
$275
b
The home office expense deduction is limited to the earned income from the business. In other words, the home office expense deduction can generally neither create nor add to a loss. In this situation, the $71,000 of gross income is reduced by the $27,275 of business expenses not associated with the home office. Sandy may claim a loss against ordinary income with her Schedule C; however, none of the home office expenses would be deductible in the current year. Note that the entire $4,200 of home office expenses would be subject to a carryforward.
LO 5.4.1
Which of the following is NOT self-employment income?
Net Schedule C income
The distributive share of income paid to a limited partner
Part-time earnings of an individual (e.g., a professional)
Board of directors fees
A)
II only
B)
I and II
C)
III and IV
D)
I, II, III, and IV
a
The distributive share of income paid to a limited partner is not considered self-employment income, but would be income received under the passive activity rules.
LO 5.3.1
Which of the following statements best describes a weakness of the sole proprietorship form of business?
A)
The owner has too many partners.
B)
The business depends solely on the owner.
C)
The business is in constant danger of bankruptcy.
D)
The owner has no control.
b
A sole proprietorship is owned by one individual who is personally liable for the business and all its operations. Therefore, the business depends solely on the owner.
LO 5.2.3
Which of the following statements regarding accounting periods is CORRECT?
All taxpayers may report taxable income on the basis of a calendar year.
If a partner has a different taxable year than that of the partnership, the partner must report his share of the entity’s income in the same taxable year within which the entity’s taxable or fiscal year begins.
A)
Neither I nor II
B)
Both I and II
C)
I only
D)
II only
c
Statement I is correct. All taxpayers may report taxable income on the basis of a calendar year. Such a year is a 12-month period ending on December 31. Statement II is incorrect. If a partner or S corporation shareholder/owner has a different taxable year than the business entity, the owner must report his share of the entity’s income in the same taxable year within which the entity’s taxable or fiscal year ends.
LO 5.1.1
Gil owns a portfolio of income-producing real estate. Gil retains ownership of the real estate but directs that the rental income be paid to his son, Kevin. The income is paid directly to Kevin, who reports it as part of his taxable income. Gil does not report the income on his tax return.
With which of the following potential tax traps should Gil be most concerned?
A)
Assignment of income
B)
Substance over form
C)
Constructive receipt
D)
Ownership attribution rules
a
The fact that Gil retains ownership of the property and merely assigns the income to someone else is a potential tax trap for him. The assignment of income doctrine serves to tax the person who actually owns the property producing the income. The income cannot merely be assigned to another to generate tax advantages.
LO 5.4.2
Which of the following is subject to the self-employment tax?
Distributive share of limited partnership operating income
Flow-through of S corporation income
Distributive share of general partnership operating income
Interest or dividends from investments
A)
II and III
B)
III only
C)
I, II, III, and IV
D)
I and III
b
The general partnership operating income is self-employment income. By definition, the other items of income are not subject to the self-employment tax.
LO 5.2.3
Yetunde has been selling sports memorabilia online for six years. It is not her primary employment, but she has been doing well with sales. While Yetunde will be itemizing her deductions this year, she believes she can report her income and expenses on Schedule C. Her gross sales from the sports memorabilia this year are $55,000. Her total expenses are $37,600, including cost of goods sold of $28,000. Yetunde has kept detailed records since she began selling memorabilia and can track her profit and loss for each year. In Year 1, she had a loss of $5,000; in Year 2, there was a loss of $2,000; in Year 3, she had a profit of $9,000; in Year 4, Yetunde had another loss of only $500; and Year 5 was a good year with a profit of $12,000. How should Yetunde report her sports memorabilia business for Year 6?
A)
Only cost of goods sold can be expensed on Schedule C; the rest of the business expenses are miscellaneous itemized deductions.
B)
Because this is not Yetunde’s primary employment, the business is deemed a hobby and she should use hobby rules to report the income and expenses.
C)
Yetunde can use Schedule C to report the expenses of her business but must report the $55,000 as other income on the front of the Form 1040.
D)
Because Yetunde has a profit from the business in three of the last five years, the business is presumed not to be a hobby and she will report income and expenses using Schedule C.
a
Because Yetunde had a profit in Years 3, 5, and 6, the hobby rules do not apply and Yetunde can use Schedule C to report income and expenses from her business.
LO 5.4.2
Which of the following statements regarding business expenses is NOT correct?
A)
For 2023, a self-employed person may deduct 100% of the cost of health insurance as an above-the-line deduction in calculating AGI.
B)
Expenses related to carrying on a taxpayer’s trade or business are deductible in calculating AGI.
C)
Self-employed taxpayers may deduct qualifying home office expenses only as a miscellaneous itemized deduction.
D)
If the taxpayer qualifies for the home office deduction, the deduction cannot exceed the gross income from the taxpayer’s business.
b
Self-employed taxpayers may deduct qualifying home office expenses when calculating AGI. The deduction is taken as a line item on Schedule C. The home office deduction cannot create a loss from the taxpayer’s business. Unused home office expenses may be carried forward.
LO 5.4.1
The Make Work Partnership has four partners; three partners are individuals and one is a C corporation. The partnership’s annual gross receipts for any three-year preceding period do not exceed $29 million. The partnership can use which method of accounting?
Cash method
Accrual method
A)
Both I and II
B)
Neither I nor II
C)
I only
D)
II only
d
Because one of the partners is a C corporation and the partnership’s average annual gross receipts for any three-year preceding period do not exceed $29 million, the partnership must use the accrual method of accounting.
LO 5.1.1
Which of the following incomes is NOT taxed under the Self Employed Contributions Act ?
Rental real estate income
A limited partner’s share of limited partnership net income
Shareholder’s share of an S corporation’s net income
Income of an individual working as an independent contractor
A)
II and IV
B)
I and III
C)
I, II, and III
D)
IV only
c
The income of an individual working as an independent contractor is subject to the self-employment tax. The income in the other situations specifically is not subject to the self-employment tax.
LO 5.3.1
April is an employee of an accounting firm. April has a very successful accounting practice as a side business that is currently operated as a C corporation. She is the sole shareholder and employee of the corporation. She is comfortable in her current salaried position and has rarely drawn any salary or declared any dividends from the accounting practice. Her corporation currently has retained earnings and profits of $400,000.
With which of the following should April be most concerned?
Personal service corporation (PSC) rules
Unreasonable compensation rules
Sham transaction doctrine
Accumulated earnings tax
A)
III and IV
B)
I and II
C)
II and III
D)
I and IV
d
In addition to income tax at the highest corporate rate of 35% for a PSC, corporations are taxed on earnings that are accumulated and not distributed to shareholders when a valid business purpose does not exist for the accumulation. An exemption of $150,000 is allowed to C corporations that are PSCs. An accumulation of $500,000 would potentially subject the corporation to an accumulated earnings tax of 20% on the $250,000 accumulated in excess of the exemption amount. A PSC is a C corporation in which substantially all of the stock is owned by employees, retired employees, or their estates, and where substantially all of the services are provided in one of the listed fields. Accounting is one of the listed fields.
LO 5.2.1
Which of the following statements is an advantage to the S corporation form of business ownership?
The S corporation election avoids double taxation of a corporate income upon the payment of dividends.
The S corporation election avoids the problems of a penalty on accumulated earnings as well as the personal holding company tax.
A)
II only
B)
I only
C)
Both I and II
D)
Neither I nor II
Which of the following statements is an advantage to the S corporation form of business ownership?
The S corporation election avoids double taxation of a corporate income upon the payment of dividends.
The S corporation election avoids the problems of a penalty on accumulated earnings as well as the personal holding company tax.
A)
II only
B)
I only
C)
Both I and II
D)
Neither I nor II
Which of the following statements regarding business expenses is CORRECT?
A)
If the taxpayer qualifies for the home office deduction, the deduction cannot exceed the gross income from the taxpayer’s business.
B)
Self-employed taxpayers may not deduct qualifying home office expenses as a miscellaneous itemized deduction.
C)
Expenses related to carrying on a taxpayer’s trade or business are a tax credit.
D)
For 2023, a self-employed person may deduct only 20% of the cost of health insurance as an above-the-line deduction in calculating AGI.
b
Self-employed taxpayers may deduct qualifying home office expenses when calculating AGI. The deduction is taken as a line item on Schedule C. The home office deduction cannot create a loss from the taxpayer’s business. Unused home office expenses may be carried forward.
LO 5.4.1
Gordon, who is married and files jointly with his spouse, purchased Section 1244 stock for $110,000. Seven years later, Gordon sold his shares of the stock for $15,000. What is the character of the loss?
A)
$95,000 Section 1244 loss against ordinary income in the year the stock is sold
B)
$110,000 Section 1244 loss against ordinary income in the year the stock is sold at a loss
C)
$100,000 Section 1244 loss against ordinary income in the year the stock is sold
D)
$95,000 Section 1244 loss deducted against ordinary income at a rate of $3,000 annually as a capital loss beginning in the year the stock is sold
a
Gordon and his spouse have a $95,000 Section 1244 loss ($110,000 purchase price − $15,000 sale price) against ordinary income in the year the stock is sold. If a married investor sells Section 1244 at a loss (or if the stock becomes worthless), up to $100,000 of the loss may be deducted as an ordinary loss and is not subject to the $3,000 loss limitation. Any amount over the $100,000 will be treated as a capital loss subject to the $3,000 annual limitation ($1,500 if married filing separately) under the capital loss rule.
LO 5.2.1
John has the following income for the 2023 tax year:
Schedule C net income: $74,100
Flow-through of general partnership operating income: $20,000
Net income from rental of real estate: $10,000
What is the amount of John’s self-employment tax?
A)
$14,397
B)
$13,296
C)
$10,600
D)
$15,927
b
The items included in the computation of self-employment income are the Schedule C (sole proprietorship) income and the flow-through of general partnership operating income. The total of these items is $94,100. This is then reduced by 7.65% of the $94,100 amount to give us $86,901. (Remember that this subtraction of 7.65% is ALWAYS the first step in the calculation.) This is subject to the full 15.3%, since it is under the wage base of $160,200 for 2023. This equals $13,296. The net income from rental of real estate is generally not subject to the self-employment tax, although the net income from the rental of personalty (e.g., equipment) generally is.
LO 5.3.1
All of the following statements regarding accounting methods are correct except
A)
under the hybrid method of accounting, a taxpayer may account for some items using the accrual method and some items using the cash method.
B)
the cash method of accounting is generally required when the sale of merchandise is an income-producing factor.
C)
once an accounting method has been adopted, it cannot be changed without approval from the IRS.
D)
individuals and sole proprietorships may use the cash method of accounting.
b
The accrual method of accounting is required when the sale of merchandise is an income-producing factor.
LO 5.1.1
Which of the following is subject to the self-employment tax?
Net income from rental of personalty
Net income from the rental of realty
$350 net income from a sole proprietorship
Flow-through of income from an S corporation
A)
I, II, III, and IV
B)
I only
C)
I and III
D)
II and III
b
Net income from the rental of realty and flow-through S corporation income are both excluded from the self-employment tax. Less than $400 of self-employment income is not subject to the self-employment tax.
LO 5.3.1
Christopher, who has an interest in multiple businesses, has the following income for 2023:
Net Schedule C income: $80,000
Dividends and interest: $11,000
General partnership K-1 income: $10,000
S corporation K-1 income: $29,000
What is Christopher’s total self-employment tax for 2023 (round up to the nearest dollar)?
A)
$6,359
B)
$12,717
C)
$11,304
D)
$16,955
b
Christopher’s self-employment income is $90,000. The dividends, interest, and K-1 distributions from the S corporation are not self-employment income. The self-employment tax is calculated as follows: $90,000 × 0.9235 = $83,115 net self-employment earnings. Total self-employment tax is $12,717 ($83,115 × 0.1530).
LO 5.3.1
Your client, Mary, and her neighbor, Phil, are developing an idea for a business. Phil is convinced that a C corporation is the best form of business for their new venture. Mary is not very familiar with the C corporation form of business. What can you accurately tell Mary about the characteristics of a C corporation?
The number of shareholders is limited.
The bankruptcy of shareholders has no effect on the business form.
Shareholder liability is limited.
Capital structure is dependent upon the resources of the shareholders.
A)
III and IV
B)
I and II
C)
I and IV
D)
II and III
d
Statements II and III are accurate. The number of shareholders is limited in an S corporation, not a C corporation. Capital may be raised by sale of stock and borrowing.
LO 5.2.3
In 2023, which of the following is a method of calculating total self-employment tax where net income from self-employment is below the taxable wage base?
Calculate self-employment income; multiply by 0.9235 (1 − 0.0765); and multiply the result by 15.3%.
Calculate self-employment income; multiply by 15.3%; and subtract 7.65%.
Calculate self-employment income; subtract 7.65%; and multiply the result by 15.3%.
Calculate self-employment income; multiply by 15.3%.
A)
I and III
B)
I and II
C)
II and IV
D)
III only
a
To calculate the self-employment tax in 2023 where net income from self-employment is below the taxable wage base, use the following steps:
Step 1: Calculate self-employment income.
Step 2: Subtract 7.65% or multiply by 0.9235 (1 − 0.0765).
Step 3: Multiply the resulting product by 15.3%.
LO 5.3.1
Home office deductions are allowed if the residence or portion of the residence falls within any of the following categories of use except
A)
the self-employed taxpayer may use either the simplified method or the regular method to calculate home office expenses.
B)
the home office is used exclusively and regularly as the principal business place of the self-employed taxpayer for the business under consideration.
C)
the home office is separate from the main home (an office, studio, garage, greenhouse, darkroom, or therapy room) and used exclusively and regularly in connection with the self-employed taxpayer’s trade or business.
D)
the home office is sometimes used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of the taxpayer’s trade or business.
d
To fulfill the deduction requirement using this category, the home office must be used exclusively and regularly by patients, clients, or customers meeting or dealing with the self-employed taxpayer in the normal course of the taxpayer’s trade or business.
LO 5.4.1
Which of the following statements regarding common tax traps is NOT accurate?
A)
Tax traps may result in the unexpected recognition of income.
B)
A transaction is based solely on its economic form.
C)
Tax traps are of particular concern to owners of closely held businesses.
D)
A transaction must be based on economic reality as well as economic form.
b
A transaction cannot be based solely on form; it must also be based on economic reality.
LO 5.4.2
Claudia will begin a private tutoring business for students for whom English is a second language and who need assistance preparing for the SAT. She will be using a room at the university library for the tutoring sessions, and except for some small initial costs for materials, she does not expect any expenses. If Claudia receives $9,000 in tutoring income this year, how does she account for it on her income tax return?
A)
Because the tutoring is similar to the teaching she does at the university, Claudia is required to report it to the university, which will put the income on her W-2.
B)
Because her expenses are negligible, Claudia is not allowed to deduct the expenses from her tutoring income.
C)
Claudia must report the tutoring income and expenses on Schedule C of Form 1040.
D)
Until Claudia can prove the tutoring is not a hobby (achieve a profit in three of the next five years), she will report gross tutoring income on the front of Form 1040.
c
The tutoring business is engaged in for profit, not as a hobby. The income and expenses are reported on Schedule C of Form 1040.
LO 5.4.2
A taxpayer has Schedule C net income of $60,000. What is the taxpayer’s total self-employment tax? Round your answer to the nearest dollar.
A)
$4,239
B)
$9,180
C)
$3,825
D)
$8,478
d
The total self-employment tax is $8,478 ($60,000 × 0.9235 = $55,410; $55,410 × 0.1530 = $8,478).
LO 5.3.1
Which of the following incomes is not taxed under Social Security self-employment tax?
Rental real estate income
Small part-time repair shop income
Shareholder’s share of S corporation’s income in excess of salary
Income of an individual working as an independent contractor
A)
II and IV
B)
I, II, III, and IV
C)
I and III
D)
I, II, and III
c
Income from rental property is not subject to Social Security tax, nor are dividends to S corporation shareholders/employees as long as the employees’ compensation is considered reasonable.
LO 5.3.1
Which of the following statements regarding S corporations is CORRECT?
A)
An S corporation must pay self-employment tax on its ordinary income.
B)
The maximum number of shareholders an S corporation may have is 100.
C)
An S corporation may have more than one class of stock.
D)
Any individual, estate, corporation, or trust may be an S corporation shareholder.
b
Only certain types of trusts, individuals, and estates may be shareholders of an S corporation. They are limited to one class of stock, and neither the corporation nor its owners pay self-employment tax. The maximum number of shareholders is 100.
LO 5.2.2
Sam had the following items of income during the 2023 tax year:
Sole proprietorship net income: $30,000
Interest income: $2,000
Flow-through of S corporation income: $10,000
What is the amount of self-employment tax Sam owes?
A)
$6,120
B)
$4,590
C)
$4,400
D)
$4,239
d
The equation is $30,000 - 7.65% = $27,705 × 15.3% = $4,239. Remember that the first step in computing the self-employment tax is always the 7.65% subtraction. The flow-through of income from an S corporation (or limited partnership income to a limited partner) is not considered to be self-employment income.
LO 5.3.1
How much of the self-employment tax is deductible by a taxpayer on her income tax return whose income is below the taxable wage base?
A)
15.3%
B)
2.90%
C)
6.20%
D)
7.65%
d
The deductible share of the self-employment tax is 7.65%.
LO 5.3.1
Only certain types of trusts, individuals, and estates may be shareholders of an S corporation. They are limited to one class of stock, and neither the corporation nor its owners pay self-employment tax. The maximum number of shareholders is 100.
LO 5.2.2
d
Multiple ownership of an unincorporated business is characteristic of a general partnership. More than one owner personally liable indicates a general partnership business form. Common shareholders, preferred shareholders, and limited partners do not have personal property at risk; only their investment in the company is at risk.
LO 5.2.3
Which of the following statements regarding LLCs is CORRECT?
A)
LLCs may not be liquidated without the adverse tax consequences of a C corporation if that tax form is chosen by the LLC.
B)
They are permitted in only a few states.
C)
They offer the advantage of not being subject to some of the tax rules and restrictions that apply to S corporations.
D)
They are incorporated legal entities owned by one or more members.
c
LLCs are unincorporated legal entities owned by one or more members and are created by filing Articles of Organization with the state. LLCs may be liquidated without the adverse tax consequences of a C corporation, even when choosing to be taxed as a C corporation. They are now permitted in all 50 states and the District of Columbia.
LO 5.2.2c
Landry has been baking pies and cakes for several years that are very popular when he sells them locally. He works full-time in the oil field and baking has become a hobby he enjoys. He is meeting with his new financial planner, Richard, to review his plans for retirement in 10 years. He explains that he will continue his baking after retirement but not necessarily full time. Richard has asked for as much documentation as possible about his current and prior years’ sales and expenses for this hobby. Landry is confused about why it matters. What should Richard do for Landry as his planner?
Richard should review Landry’s previous income tax returns to ascertain if the hobby income was reported.
When reviewing the documentation for the hobby, Richard is also determining whether or not the hobby could be classified as a business.
Landry should file amended returns and deduct all of his hobby expenses from the hobby income before it is entered on his Form 1040 if Landry has not previously reported the hobby.
A)
I and II
B)
II and III
C)
I, II, and III
D)
I only
a
Statement III is incorrect. If Landry has not previously reported the hobby income and expenses, Richard should advise him to file amended returns, reporting the income on the front of the Form 1040. Hobby expenses are not deductible except for allocated property taxes and mortgage interest.
LO 5.4.2
Which of the following forms of business would file a Schedule C to report the income or loss from the business?
A)
C corporation
B)
S corporation
C)
Limited partnership
D)
Sole proprietorship
d
The sole proprietorship is the business that files a Schedule C with the individual’s Form 1040. The limited partnership files a Form 1065, and the C corporation files a Form 1120. The S corporation files an 1120-S.
Note that a single-member LLC would also file a Schedule C, as it would be treated as a disregarded entity for income tax purposes.
LO 5.2.2
Which of the following statements comparing a C corporation and a general partnership is CORRECT?
Both a C corporation and general partnership can have more than one owner.
Both a C corporation and general partnership are regarded as distinct entities for tax purposes.
Profits are divided equally in both business forms.
Neither a C corporation nor general partnership pays federal tax on income.
A)
I and III
B)
II only
C)
I only
D)
I and IV
c
One similarity of a partnership and a C corporation is that they may both have more than one owner. However, only a C corporation is regarded as a distinct, separate entity for tax purposes. Partnerships are flow-through entities. C corporations may retain profits. Partnerships are not required to distribute profits equally. C corporations pay tax on income.
LO 5.2.3
Which of the following forms of business has to meet the fewest legal requirements to be established as a business?
A)
Limited partnership
B)
S corporation
C)
Sole proprietorship
D)
C corporation
c
To be established as a business, the sole proprietorship certainly has to meet the fewest legal requirements. The C corporation and the S corporation are required to file articles of incorporation, at a minimum, with the secretary of state. The limited partnership also is subject to certain state registration requirements. The sole proprietorship is the only business entity that essentially does not have to meet any legal requirements to be established as a business.
LO 5.2.3
Chris has been actively buying and selling science fiction memorabilia for many years. He has a booth at several conventions he attends each year. His tax professional has been tracking his profit and loss and reports that Chris made a profit in four of the last five years. Which of the following statements regarding Chris’s profit and loss is CORRECT?
The IRS will presume that Chris’s activity is a hobby.
If the hobby rules do not apply, Chris can use Schedule C to report the income and expenses from this activity.
A)
Neither I nor II
B)
II only
C)
I only
D)
Both I and II
b
Statement I is incorrect. An activity is presumed not to be a hobby if there are profits from the activity in any three of five consecutive tax years ending with the tax year in question (unless the IRS proves otherwise). Statement II is correct; if the hobby rules do not apply, Chris can report his income and expenses on Schedule C.
LO 5.4.2
For purposes of the accumulated earnings tax (AET), what amount may a regular corporation retain in accumulated earnings before having to prove a reasonable business need for the retained funds?
A)
$25,000
B)
$250,000
C)
15% of the current year’s earnings
D)
None of these
b
Every regular corporation can accumulate up to $250,000 in retained earnings without having to prove a reasonable business need.
LO 5.2.1
The sole proprietorship is the business that files a Schedule C with the individual’s Form 1040. The limited partnership files a Form 1065, and the C corporation files a Form 1120. The S corporation files an 1120-S.
Note that a single-member LLC would also file a Schedule C, as it would be treated as a disregarded entity for income tax purposes.
LO 5.2.2
c
Statements II, III, and IV are correct. Statement I is incorrect. Stock issued in exchange for services rendered to the issuing corporation does not qualify as Section 1244 stock.
LO 5.2.1
Statements II, III, and IV are correct. Statement I is incorrect. Stock issued in exchange for services rendered to the issuing corporation does not qualify as Section 1244 stock.
LO 5.2.1
b
Jan may use the cash method of accounting because her gross receipts are less than $29 million (2023) annually.
LO 5.1.1
A shareholder’s basis in an S corporation includes funds that are
A)
borrowed by the corporation and guaranteed by the shareholder.
B)
loaned to the corporation by the shareholder.
C)
loaned to the shareholder by the corporation.
D)
borrowed by the corporation.
b
Only funds loaned directly to the corporation by the shareholder establish shareholder basis in an S corporation.
LO 5.2.2
Jessica is self-employed selling insurance. She uses a bedroom in her apartment as an office about 60% of the time. The square footage of the bedroom represents 15% of the overall space in the apartment. She also uses the bedroom to store personal items and, occasionally, as a bedroom for guests. Jessica’s annual rental payments this calendar year were $7,500 and the annual utility costs were $1,200. How much of a deduction can Jessica take as an office expense for this tax year?
A)
$0
B)
$675
C)
$567
D)
$1,125
a
No deduction is allowed because the office is not used regularly and exclusively as a principal place of business for Jessica’s insurance business, as required by the Internal Revenue Code to qualify as a deductible office expense.
LO 5.4.1
MNO Corporation has the following items of income and expense:
Taxable income: $330,000
Federal income tax: $100,000
Dividends paid in current year: $20,000
Accumulated earnings and profits at the end of the preceding tax year: $60,000
Assume MNO is not a service corporation and cannot establish a valid business purpose for its excess accumulations.
What is the amount of accumulated earnings tax payable?
A)
$4,000
B)
$18,000
C)
$13,057
D)
$2,176
a
The accumulated earnings tax rate of 20% applied to the accumulated taxable income of $20,000 equals $4,000. The taxable income is reduced by the income tax and dividends paid, and further reduced by the $190,000 accumulated earnings tax credit ($250,000 accumulation limit less the $60,000 accumulated earnings and profits). The 20% rate is tied to the highest tax rate that may apply to qualified dividends.
LO 5.2.1
Which of the following factors may be considered a strength of the partnership form of business entity?
Ease of management
Ease of establishment
Lack of special taxes
A)
II and III
B)
I, II, and III
C)
I only
D)
II only
b
All of these factors are strengths of the partnership form of business entity.
LO 5.2.3
Which of the following is most often considered an advantage of an S corporation?
A)
There is pass-through of ordinary loss.
B)
The business may be a foreign corporation.
C)
The number of shareholders is limited.
D)
Two classes of shareholders are permitted.
a
The ability to have losses flow through to the shareholders to offset other income is one of the primary advantages of the S corporation. The limitation on the number of shareholders is not considered an advantage. Only one class of stock is permitted, the business must be a domestic corporation, and there are restrictions on who may be a shareholder.
LO 5.2.2
Which of the following is CORRECT regarding the LIFO method of accounting for inventory?
A)
During periods of declining inventory prices, lower taxable income will result.
B)
During periods of increasing inventory prices, lower taxable income will result.
C)
During periods of increasing inventory prices, higher taxable income will result.
D)
During periods of declining inventory prices, the cost of goods sold (COGS) will be higher.
b
Under the LIFO method, when prices are increasing, COGS will be higher; thus, taxable income will be lower.
LO 5.1.1
Which one of the following employee benefits is NOT currently deductible by a C corporation?
A)
Group term life insurance of $100,000
B)
Health and accident insurance
C)
Qualified employee discounts
D)
Group legal services
c
Items that are currently deductible by a C corporation would include group term life insurance, group legal services, and health and accident insurance. Qualified employee discounts do not generate a deduction for the corporation—the discount merely results in less sales revenue being brought into the organization.
LO 5.2.1
Bill, an engineer, is contemplating forming an S corporation for his practice. He will be the sole employee of the corporation. Which of the following statements accurately describe the income tax consequences of such an arrangement?
All of the flow-through of net income from his S corporation is subject to the self-employment tax.
Bill must draw a reasonable salary as an employee of the S corporation.
The net income of the corporation will be taxed at Bill’s individual tax rate.
The net income of the corporation will be subject to a flat 21% tax rate.
A)
I and IV
B)
II and III
C)
II and IV
D)
I, II, and IV
b
The S corporation income will flow through to Bill and be taxed at his marginal rate. The flow-through is not subject to the self-employment tax. However, Bill must receive reasonable wages or salary, or the IRS will reclassify part of the net income as salary and impose penalties.
LO 5.2.2
Which of the following forms does an S corporation file?
A)
Form 1120-S
B)
Form 1120-C
C)
Form 1065
D)
Form 1120
b Which of the following forms does an S corporation file?
A)
Form 1120-S
B)
Form 1120-C
C)
Form 1065
D)
Form 1120
old Citywear, Inc., manufactures clothing in styles from the 1940s and 1950s. The company has been in existence four years and had the following taxable income or loss:
Tax Year Taxable Income
2020 $5,000
2021 $15,000
2022 $15,000
2023 ($25,000)
Which of the following statements regarding Old Citywear’s net operating loss in 2023 is CORRECT?
A)
Old Citywear may carry back $5,000 of its 2023 NOL to 2022.
B)
Old Citywear may carry back $15,000 of its 2023 NOL to 2022.
C)
Because it cannot utilize all of the net operating loss in 2023, Old Citywear may carry back the loss to prior tax years.
D)
Old Citywear may carry forward the $25,000 loss indefinitely.
d
NOLs cannot be carried back but can be carried forward indefinitely following the loss year. The loss is limited in amount to 80% of the total of taxable income reported for the carryforward years.
LO 5.1.1
This year, Laura’s Schedule C reflected a profit of $44,500. Assume that the related total self-employment tax was $6,288. What is Laura’s AGI?
A)
$38,212
B)
$50,788
C)
$41,356
D)
$44,500
c
Laura will deduct the employer share of the total self-employment tax in arriving at AGI: $44,500 × 0.9235 × 0.0765 = $3,144; $44,500 − $3,144 = $41,356.
LO 5.3.1
The basis that is used in determining gains from mutual funds sales may be calculated by using all of the following methods except
A)
the last-in, first-out (LIFO) method.
B)
the specific identification method.
C)
the average cost method.
D)
the first-in, first-out (FIFO) method.
a
The basis of mutual fund shares may not be determined by using the LIFO method.
LO 5.1.1
Which of the following forms of business entity is NOT a statutory entity?
A)
Limited partnership
B)
General partnership
C)
S corporation
D)
Limited liability company (LLC)
b
The general partnership business form does not require registration with the state. The other entities are all chartered by the state.
LO 5.2.3
Your client’s share of general partnership net income is $100,000 in 2023, with a distributive share of S corporation income of $20,000. What is your client’s self-employment tax, if any, for 2023? Round your answer to the nearest dollar.
A)
$16,955
B)
$15,300
C)
$14,130
D)
$0
c
The distributive share of income from an S corporation is not subject to the self-employment tax.
Actual earnings $100,000
Less: 7.65% (7,650)
Net earnings from self-employment $92,350
SE tax rate x 15.3%
Self-employment tax $14,129.55
Rounded $14,130
LO 5.3.1
Carina has the following items of income to report in 2023:
Salary of $65,000 from an S corporation for which Carina is a 10% shareholder
Her share of the net income from the same S corporation of $95,000 as reported on Schedule K-1
Schedule C net income of $15,000 from a small side business she owns
How much of Carina’s income in 2023 will be subject to self-employment taxes?
A)
$17,000
B)
$95,000
C)
$15,000
D)
$110,000
c
Taxes are withheld from Carina’s salary at the S corporation in the same manner as any other employee of the S corporation. Income reported on the Schedule K-1 to shareholders of an S corporation is not considered self-employment income. Only the income from the small side business reported on Schedule C is subject to self-employment taxes.
LO 5.3.1
Your client, Mary, and her neighbor, Phil, are developing an idea for a business. Phil is convinced that a C corporation is the best form of business for their new venture. Mary is not very familiar with the C corporation form of business. What can you accurately tell Mary about the characteristics of a C corporation?
The number of shareholders is limited.
The bankruptcy of shareholders has no effect on the business form.
Shareholder liability is limited.
Capital structure is dependent upon the resources of the shareholders.
A)
II and III
B)
II and IV
C)
I and IV
D)
III and IV
a
Statements II and III are accurate. The number of shareholders is limited in an S corporation, not a C corporation. Capital may be raised by the sale of stock and borrowing.
LO 5.2.1
Which of the following statements regarding inventory valuation techniques and Cost of Goods Sold (COGS) is CORRECT?
During a period of declining prices, LIFO decreases the COGS.
During a period of rising prices, LIFO decreases the COGS.
During a period of declining prices, FIFO decreases the COGS.
During a period of rising prices, FIFO decreases the COGS.
A)
II and III
B)
I and IV
C)
II and IV
D)
I and III
b
During a period of declining prices, the last-in, first-out (LIFO) method treats the later-purchased, lower-priced inventory items as those first sold. This, therefore, decreases the cost of goods sold (COGS). Conversely, during a period of rising prices, the first-in, first-out (FIFO) method matches the earlier-purchased, lower-priced inventory items against income. This naturally decreases the COGS.
LO 5.1.1
Ken Brandt (a single taxpayer), age 28, holds the following securities.
Stock Purchase Date Fair Market Value Cost Basis
ABC (300 shares) October 3, 2005 $12,200 $5,500
DEF (500 shares) February 15, 2023 $22,600 $15,600
GHI (100 shares) June 2, 2008 $4,350 $6,250
LMN (700 shares) December 9, 2022 $19,360 $28,560
XYZ small-cap fund (500 shares) October 20, 2013 $1,200 $3,700
VWL (750 shares, §1244 stock) July 17, 2007 $4,050 $115,600
Bonds Purchase Date Fair Market Value Cost Basis
EE savings bonds May 1, 2014 $8,500 $6,000
If Ken sells the VWL stock at its fair market value, what is the result?
A)
Of the $111,550 loss, $100,000 is an ordinary loss, and $11,500 is a long-term capital loss.
B)
Of the $111,550 loss, $50,000 is an ordinary loss, and $61,550 is a long-term capital loss.
C)
The $111,550 loss is a long-term capital loss, deductible up to $3,000 per year.
D)
The $111,500 is an ordinary loss, fully deductible against other income.
b
The annual ordinary loss on a sale of Section 1244 stock is limited to $50,000 for single taxpayers or for married taxpayers filing separately. On a joint return, $100,000 of ordinary loss may be deducted. The remainder of the loss (the excess over the ordinary loss) is treated as a capital loss (long term, in this situation).
LO 5.2.1
Your client is contemplating forming either a sole proprietorship or an LLC for her new business. She asks you to discuss the differences between the two business forms. Which of the following is a characteristic of a sole proprietorship but is NOT a characteristic of an LLC?
Unlimited personal liability
Tax-free formation
Limited life
Flow-through entity
A)
I and IV
B)
I only
C)
I, III, and IV
D)
II and III
b
The sole proprietorship involves unlimited personal liability for the owner, potential tax-free formation, limited life, and is clearly a flow-through entity. The LLC enjoys potential tax-free formation, has a limited life, and is also a flow-through entity. The LLC members have limited liability.
LO 5.2.3
Which of these businesses is a conduit entity?
A)
Partnership
B)
All of these
C)
Sole proprietorship
D)
S corporation
b
All of these meet the definition of a conduit entity.
LO 5.2.2
Which one of the following is NOT a permissible method for determining the business part of a residence for purposes of the home office expense deduction?
A)
Relative use method of allocation
B)
Simplified method
C)
Square footage of the office area compared to the total square footage of the home
D)
Number of rooms in the house used for business compared to total rooms in the house
a Which one of the following is NOT a permissible method for determining the business part of a residence for purposes of the home office expense deduction?
A)
Relative use method of allocation
B)
Simplified method
C)
Square footage of the office area compared to the total square footage of the home
D)
Number of rooms in the house used for business compared to total rooms in the house
Which of the following statements is CORRECT regarding a non-employee, minority interest shareholder in an S corporation?
Reports income when the corporation has net income for a tax year
Can vote for the board of directors at the annual shareholders meeting
Receives a Form K-1 annually to prepare a personal income tax return
Reports on a personal income tax return a pro rata share of corporate profit or loss
A)
I and IV
B)
I, II, and IV
C)
II and IV
D)
I, II, III, and IV
d
All of the statements are correct. The fact that the shareholder has a minority interest in the corporation has no bearing on the correct answers. The flow-through of a proportionate share of net income is reported on the K-1. The shareholder is allowed to vote for the board.
LO 5.2.2
Which of the following is a requirement for an election to be taxed as an S corporation for a particular year?
A)
All shareholders must consent in writing to the election.
B)
The election must be filed on or before the 15th day of the fourth month of the tax year.
C)
A judicial hearing must be held.
D)
The corporation may have no more than 35 shareholders.
a
To be taxed as an S corporation for a given year, all shareholders must consent in writing to such election, and the election must be filed by the 15th day of the third month (generally, March 15) of the taxable year. Also, the corporation may have no more than 100 shareholders. A judicial hearing is not necessary.
LO 5.2.2
The home office expense deduction is limited to
A)
taxable income of the taxpayer.
B)
$100,000
C)
net income from the trade or business.
D)
gross income from the trade or business.
c
The home office expense deduction is limited to the tentative net income from the trade or business—the net income before taking the home office expense deduction, not a set amount.
LO 5.4.1
On which Schedule of the Form 1040 would a sole proprietor of an appliance repair business report self-employment income?
A)
Schedule F
B)
Schedule A
C)
Schedule E
D)
Schedule C
d
Schedule C of Form 1040 (Profit or Loss From Business) would be used to report the income from a sole proprietorship. If it were a farm, the taxpayer would use Schedule F.
LO 5.2.2
Miguel, a shareholder in ABC Corporation, received a cash distribution from the corporation in the amount of $22,000. The corporation had $8,000 of accumulated earnings and profits and $5,000 and current earnings and profits. Miguel had basis in the stock of $6,000. Which one of the following correctly identifies the proper treatment of the distribution from the corporation?
A)
$13,000 ordinary dividend; $6,000 capital gain; $3,000 return of capital
B)
$7,000 ordinary dividend; $6,000 return of capital; $9,000 capital gain
C)
$13,000 ordinary dividend; $6,000 return of capital; $3,000 capital gain
D)
$5,000 ordinary dividend; $6,000 return of capital; $11,000 capital gain
c
The distribution from a corporation is determined in a three-step manner. To the extent of current and accumulated earnings and profits, the distribution is an ordinary dividend, subject to short-term capital gain rates. Next, the distribution is treated as a nontaxable return of capital until the basis in the stock is exhausted. Any distribution after that is considered long-term capital gain.
LO 5.2.1
Greg, Justin, and Mel are all engineer-owners of GJM, Inc., a C corporation that is a qualified personal service corporation (PSC). Historically, their gross receipts have been as follows: $4.75 million annually in Years 1–4; and $5.75 million in Year 5. This year, gross receipts are expected to be $6.1 million. Can GJM use the cash method of accounting this year if it clearly reflects income?
A)
Yes, the cash method is available to GJM because it is a PSC.
B)
No, GJM is a C corporation and must use the accrual method.
C)
Because GJM provides services to the construction industry, it must use the long-term contract method.
D)
No, GJM must use the accrual method because the average earnings for the preceding three years are more than $5 million.
a
GJM, Inc., is a PSC and may use the cash method of accounting.
LO 5.1.1
Tom is a self-employed accountant. He uses one room of his house exclusively and regularly as an office for the business. The square footage of the room comprises 10% of the total square footage of the home. Tom incurred the following expenses related to the home during the tax year:
Utilities $1,500
Property tax $600
Mortgage interest $4,000
Insurance on home $750
Maid service $1,200
Misc. repairs $950
If Tom’s office meets the tax law requirements of a qualified home office and the gross income from the business limitations on the deduction are ignored, what is the maximum business deduction Tom can take?
A)
$805 plus a depreciation deduction based on 10% of the cost of the home
B)
$780 plus a depreciation deduction based on 10% of the cost of the home
C)
$900
D)
$900 plus a depreciation deduction based on 10% of the cost of the home
d
Tom can deduct 10% of all the expenses. The calculation is $9,000 × 10% = $900. A 10% depreciation deduction is also allowed based on the cost of the home. It should be noted that in order to take this deduction, Tom’s gross income from the business must be sufficient to cover all of his other operating expenses in addition to the home office deduction. The deduction for home office expenses cannot create a loss from the business for the taxpayer.
LO 5.4.1
Michael had $200,000 of net income from his LLC and $10,000 of net income (interest and dividends) from an investment partnership. What is Mike’s self-employment tax for 2023? Round your answer to the nearest dollar.
A)
$29,672
B)
$25,221
C)
$19,645
D)
$21,568
b Explanation
Net income from the investment partnership is not subject to the self-employment tax.
Actual earnings $200,000
Less: 7.65% (15,300)
Net earnings from self-employment $184,700
Less: maximum amount of SE earnings subject to 15.3% tax (160,200)
Excess over wage base $24,500
Medicare rate × 2.9%
Tax on excess over wage base $710
($160,200 × 15.3%) $24,511
Self-employment tax $25,221
Or, as an alternative, is the following:
Self-employment income $200,000
Less: 7.65% of S/E income ($15,300)
Self-employment earnings subject to self-employment taxes $184,700
Social Security Tax Calculation (OASDI) Medicare Tax Calculation (HI)
Earnings subject to self-employment tax $160,200 $184,700
Times tax rate 12.4%
2.9%
(OASDI tax rate) = (HI tax rate) =
Equals self-employment taxes
$19,865
$5,356
(Social Security taxes) (Medicare taxes)
Total self-employment tax $25,221
Also remember that half of the self-employment tax is deductible as an adjustment to income.
LO 5.3.1
Three investors wish to start a manufacturing business. The business is expected to generate a large income, which it will reinvest for many years. John has substantial assets that he plans to contribute to the business. John is also concerned about showing too much business income on his personal return. Which business structure would be most appropriate for the business?
A)
A limited partnership with John as the limited partner
B)
A C corporation with all three as shareholders
C)
An S corporation with all three as equal shareholders
D)
A business trust with all three as equal interests
b
A C corporation is the only listed entity that is not a conduit. Since John is concerned about showing too much business income on his personal return, a separate taxable entity is appropriate.
LO 5.2.3
Which of the following forms of inventory valuation provides the greatest flexibility in managing inventory?
A)
First-in, first-out (FIFO)
B)
Last-in, first-out (LIFO)
C)
General identification
D)
Specific identification
d
The major advantage of the specific identification method is that it allows maximum flexibility in managing inventory. For example, if the taxpayer has two identical inventory items, he may choose to sell the higher- or lower-cost item. The FIFO method treats inventory items that were purchased first as being sold first. There is no flexibility with this method. The LIFO method treats inventory items that were purchased most recently as being sold first. There is no flexibility with this method.
LO 5.1.1
Which one of the following is CORRECT regarding the hybrid method of accounting?
A)
The hybrid method of accounting is a combination of the accrual method and the income method of accounting.
B)
The inventory side of the business typically uses the cash method of accounting.
C)
Purchases and sales are generally accounted for using the accrual method of accounting.
D)
The service side of the business typically uses the accrual method of accounting.
c
Sales of goods and purchases of inventory are generally accounted for under the accrual method when the taxpayer uses a hybrid method of accounting. The service side of the business typically uses the cash method of accounting to increase the flexibility of the overall accounting method. The inventory side of the business typically will use the accrual method of accounting to comply with the general requirement that the accrual method be used when inventory is a material income-producing factor. There is no income method of accounting.
LO 5.1.1
Jim, a married taxpayer filing a joint return, owns Section 1244 stock. Jim paid $195,000 for the stock many years ago. This year, the corporation filed for bankruptcy and the stock became worthless. What is the nature and character of the loss on the stock?
A)
$0 loss, as worthlessness of the stock is not a recognition event
B)
$100,000 ordinary loss; $95,000 long-term capital loss
C)
$50,000 ordinary loss; $145,000 long-term capital loss
D)
$195,000 ordinary loss
b
Loss on the sale, exchange, or worthlessness of Section 1244 stock is deductible as an ordinary loss up to $50,000 per year, and $100,000 per year on a jointly filed return. Any excess loss in a given year is treated as a capital loss. In this case, the capital loss is long term, due to the more than one-year holding period.
LO 5.2.1
Bobby is considering changing his jewelry store from a sole proprietorship to a form which will afford him some liability protection. He does not want to have to change how he reports his income and expenses each year, but he is willing to file the appropriate paperwork to change the business form and accomplish his goal. Which of the following business forms is best suited to Bobby’s business?
A)
C corporation
B)
One-member limited liability company (LLC)
C)
Personal service corporation (PSC)
D)
Limited liability partnership (LLP)
B bobby is considering changing his jewelry store from a sole proprietorship to a form which will afford him some liability protection. He does not want to have to change how he reports his income and expenses each year, but he is willing to file the appropriate paperwork to change the business form and accomplish his goal. Which of the following business forms is best suited to Bobby’s business?
A)
C corporation
B)
One-member limited liability company (LLC)
C)
Personal service corporation (PSC)
D)
Limited liability partnership (LLP)
Which of the following is a permissible method for determining the business part of a residence for purposes of the home office expense deduction?
A)
Number of rooms in the house used for business compared to total rooms in the house
B)
Relative use method of allocation
C)
Amount of utility use compared to that of the whole house
D)
Accrual method of allocation
a
Both the relative square footage of the home office area and the relative number of rooms may be used in determining the business part of a home. The amount of utility use can be a deduction, but is not used in determining the business part of a home. There is no recognized method known as the relative use method of allocation.
LO 5.4.1
Nick had $190,000 of Schedule C net income and $15,000 of net income from the rental of real estate.
What is Nick’s self-employment tax for 2023? Round your answer to the nearest dollar.
A)
$23,626
B)
$24,965
C)
$24,954
D)
$25,057
c Explanation
Net income from the rental of real estate is not subject to the self-employment tax.
Actual earnings $190,000
Less: 7.65% (14,535)
Net earnings from self-employment $175,465
Less: maximum amount of SE earnings subject to 15.3% tax (160,200)
Excess over wage base $15,265
Medicare rate × 2.9%
Tax on excess over wage base $443
Add ($160,200 × 15.3%) $24,511
Self-employment tax $24,954
Or, as an alternative, is the following:
Self-employment income $190,000
Less: 7.65% of S/E income ($14,535)
Self-employment earnings subject to self-employment taxes $175,465
Social Security Tax Calculation (OASDI) Medicare Tax Calculation (HI)
Earnings subject to self-employment tax $160,200 $175,465
Times tax rate 12.4%
2.9%
(OASDI tax rate) = (HI tax rate) =
Equals self-employment taxes
$19,865
$5,089
(Social Security taxes) (Medicare taxes)
Total self-employment tax $24,954 (rounding difference)
Also remember that one-half of the self-employment tax is deductible as an adjustment to income.
LO 5.3.1
Which one of the following types of investors derives the greatest tax benefit from investing in preferred stocks?
A)
Government investors
B)
Corporate investors
C)
Nonprofit institutional investors
D)
Mutual funds investors
b
Because 50% of the preferred dividends received by a corporation are exempt from federal income taxes, a corporation gains a tax advantage. The government and nonprofit organizations pay no income taxes. Mutual funds are also exempt from taxation.
LO 5.2.1
Carol owns and operates a retail electronics store with annual sales of approximately $2 million. The store also specializes in repairing computers and other small electronics. Approximately 30% of her sales are with extended credit terms.
What method of tax accounting may be used for Carol’s business?
The accrual method, because inventory is such a large component of the business
The cash method, because it provides flexibility in the timing of income and expenses
The hybrid method, because the business involves both inventory and service
The installment sale method, to spread the gain over a longer time frame
A)
I, II, and III
B)
I only
C)
I, II, III, and IV
D)
III only
a
The cash method may be used because average annual gross receipts are under $29 million for the prior tax years. The accrual method may always be used. The hybrid method may be used because the business involves both inventory and service. The installment method may not be used, as dealers are not allowed to use the installment method.
LO 5.1.1
Which of the following is a permissible method for determining the business part of a residence for purposes of the home office expense deduction?
A)
Number of rooms in the house used for business compared to total rooms in the house
B)
Relative use method of allocation
C)
Amount of utility use compared to that of the whole house
D)
Accrual method of allocation
a Both the relative square footage of the home office area and the relative number of rooms may be used in determining the business part of a home. The amount of utility use can be a deduction, but is not used in determining the business part of a home. There is no recognized method known as the relative use method of allocation.
LO 5.4.1
Which one of the following types of investors derives the greatest tax benefit from investing in preferred stocks?
A)
Government investors
B)
Corporate investors
C)
Nonprofit institutional investors
D)
Mutual funds investors
b Because 50% of the preferred dividends received by a corporation are exempt from federal income taxes, a corporation gains a tax advantage. The government and nonprofit organizations pay no income taxes. Mutual funds are also exempt from taxation.
LO 5.2.1
Carol owns and operates a retail electronics store with annual sales of approximately $2 million. The store also specializes in repairing computers and other small electronics. Approximately 30% of her sales are with extended credit terms.
What method of tax accounting may be used for Carol’s business?
The accrual method, because inventory is such a large component of the business
The cash method, because it provides flexibility in the timing of income and expenses
The hybrid method, because the business involves both inventory and service
The installment sale method, to spread the gain over a longer time frame
A)
I, II, and III
B)
I only
C)
I, II, III, and IV
D)
III only
a
The cash method may be used because average annual gross receipts are under $29 million for the prior tax years. The accrual method may always be used. The hybrid method may be used because the business involves both inventory and service. The installment method may not be used, as dealers are not allowed to use the installment method.
LO 5.1.1
In 2023, which of the following is a method in calculating total self-employment tax, where net income from self-employment is above the taxable wage base?
Calculate self-employment income; multiply by 0.9235 (1 − 0.0765); subtract the taxable wage base, and from that, multiply the excess over the taxable wage base by 2.9% (Medicare portion of the tax). Multiply the taxable wage base by 15.3%, and add the results of the previous two steps together to arrive at the total self-employment tax.
Calculate self-employment income; multiply by 0.9235 (1 − 0.0765); and multiply the result by 15.3%.
Calculate self-employment income; multiply by 14.13%.
Calculate self-employment income; multiply by 15.3%; multiply the excess over the taxable wage base by 2.9% (Medicare portion of the tax); and add the results of the previous two steps together to arrive at the total self-employment tax.
A)
II and III
B)
I and II
C)
I and IV
D)
I only
d
The steps to calculate self-employment tax for 2023 where net income from self-employment is above the taxable wage base are as follows:
Step 1: Calculate self-employment income.
Step 2: Subtract 7.65% or multiply by 0.9235 (1 − 0.0765).
Step 3: From Step 2, subtract the taxable wage base and multiply the excess over the taxable wage base by 2.9% (Medicare portion of the tax).
Step 4: Multiply the taxable wage base by 15.3%.
Step 5: Add the results of Steps 3 and 4 together to arrive at the total self-employment tax.
LO 5.3.1
Jim, a single taxpayer, sells Section 1244 stock for a $250,000 loss during the tax year. The stock had been held for two years. Which one of the following is CORRECT regarding the treatment of the loss?
A)
$50,000 is treated as an ordinary loss; $200,000 is treated as a Section 1244 carryforward.
B)
$100,000 is treated as an ordinary loss; $150,000 is treated as long-term capital loss.
C)
$50,000 is treated as an ordinary loss; $200,000 is treated as long-term capital loss.
D)
$250,000 of the loss is fully deductible as a capital loss.
c
Loss on the sale of Section 1244 stock is deductible as an ordinary loss up to $100,000 per year on a jointly filed return, or $50,000 on any other return (which applies to Jim as a single taxpayer). Any Section 1244 loss in excess of the annual limits is treated as a capital loss—long term or short term, depending on the holding period. The $100,000/$150,000 option would be correct if Jim were a married taxpayer filing jointly.
LO 5.2.1
What percentage, if any, of a taxpayer’s self-employment tax may be deductible as an adjustment to income?
A)
25%
B)
75%
C)
50%
D)
0%
c
Only half (50%) of a taxpayer’s self-employment tax liability is deductible as an adjustment to income.
LO 5.3.1
Mark operates a sole proprietorship from his apartment. His gross income for the current tax year is $61,000. Business expenses not associated with his home office total $63,000. Expenses associated with the home office total $4,200.
How much of the home office expense, if any, may Mark deduct for the current year?
A)
$2,000
B)
$275
C)
$4,200
D)
$0
d
The home office expense deduction is limited to the earned income from the business. In other words, the home office expense deduction can generally neither create nor add to a loss. In this situation, the $61,000 of gross income is reduced by the $63,000 of business expenses not associated with the home office, to leave no earned income. Thus, of the $4,200 of home office expenses, none would be deductible in the current year. Note that the entire $4,200 of home office expenses would be subject to a carryforward.
LO 5.4.1
Jena owns and operates a string of retail electronics stores with $32 million of sales annually. Approximately 20% of her sales are with extended credit terms.
What method of tax accounting is most appropriate for Jena’s business?
A)
The hybrid method, because the business involves both inventory and service
B)
The installment sale method, to spread the gain over a longer time frame
C)
The cash method, because it provides flexibility in the timing of income and expenses
D)
The accrual method, because inventory is such a large component of the business
d
The accrual method of accounting generally is mandatory when inventory constitutes a significant income-producing factor. Thus, the cash method is incorrect. The hybrid method is incorrect because there is no indication that service constitutes a significant portion of the business. Also, the installment sale method is not available for sales of inventory, or sales with revolving credit terms. With annual sales of $32 million, the accrual method exception does not apply. If she had annual sales of under $29 million (2023), she could still use the cash method, even though she has inventory.
LO 5.1.1
Kappa Corporation has the following items of income and expense:
Taxable income: $310,000
Federal income tax paid: $80,000
Dividends paid: $20,000
Accumulated earnings and profits at the end of the preceding year: $90,000
Kappa is an engineering firm with 100% of the stock owned by its three employee-shareholders. The corporation cannot establish a valid business purpose for excess accumulations. How much accumulated earnings tax is payable by Kappa?
A)
$42,000
B)
$46,000
C)
$34,000
D)
$30,000
d T he accumulated earnings tax applies to corporate accumulated earnings in excess of $250,000, generally, for which there is no valid business reason for accumulating the funds. For a personal service corporation (PSC), the accumulations limit is $150,000. Engineering is one of the personal services specifically listed for determining a PSC. Expenses otherwise not allowed in computing the corporate income tax are allowed in computing the accumulated earnings tax, as is summarized here. (Note that the accumulated earnings credit of $60,000 is the difference between the $150,000 safe harbor and the $90,000 of accumulations at the beginning of the year.) The accumulated earnings tax rate is 20%, the highest rate that may apply to qualified dividends.
Taxable income $310,000
Federal income tax (80,000)
Dividends paid (20,000)
$210,000
Less: accumulated earnings credit (60,000)
Excess accumulations $150,000
× 20%
$30,000
LO 5.2.1
What is Bobby’s total self-employment tax on his Schedule C net income of $50,000? Round your answer to the nearest dollar.
A)
$3,533
B)
$3,825
C)
$7,650
D)
$7,065
d
Bobby’s total self-employment tax is $7,065 ($50,000 × 0.9235 = $46,175; $46,175 × 0.1530 = $7,065).
LO 5.3.1
A small business with under $20 million in gross receipts and no inventory should most likely use which accounting method?
A)
Accrual
B)
LIFO
C)
Hybrid
D)
Cash
d A typical small business would use the cash method of accounting. Due to cost and complexity, the accrual and hybrid methods would NOT be recommended. A business is not required to use the accrual method until it has at least $29 million in gross receipts (2023). A business that has no inventory would not use LIFO.
LO 5.1.1
Ron, age 43, and Sandy, age 41, are married with two children, Michael, age 12, and Victoria, age 8, who has been blind since her birth. Ron is an architect and general partner with XYZ partnership. Sandy is self-employed as an attorney and works out of a home office. Her home office is exclusively and regularly used for business, and the home office is her principal place of business. Their information for the tax year 2023 is as follows:
AGI: $217,300
Itemized deductions (including qualified residential mortgage interest, taxes paid, and charitable contributions): $33,000
Early in the current year, Sandy’s father died. Sandy is the sole beneficiary of her father’s entire estate. The estate is presently in the probate process. Sandy’s mother, Lisa, age 68, has moved in with them but provides her own support. She was married to Sandy’s father when he died earlier this year.
This is Ron’s second marriage. He makes monthly support payments to his former spouse and his daughter.
Because both Ron and Sandy are considered to be self-employed, they make quarterly estimated tax payments each year to cover both their income tax and self-employment tax obligations.
Based on the information provided in the case scenario for Ron and Sandy, which of the following statements regarding Sandy’s home office deduction is CORRECT?
A)
Sandy may deduct her qualifying home office expenses when calculating AGI.
B)
The amount Sandy may deduct this year for qualifying home office expenses is unlimited.
C)
Sandy is not eligible to deduct her home office expenses.
D)
The net income from the business use of Sandy’s home must equal or exceed the business expenses (including depreciation).
a
Because Sandy is self-employed, she can deduct her qualifying home office expenses when calculating AGI (as a line item on Schedule C). The amount of her home office expense deduction this year is limited to the net income from her business. A profit from the business is not one of the tests for qualification of a home office for tax deduction purposes. Rather, it is one of the limitations on the deductible amount after it qualifies.
LO 5.4.1
Which of the following forms does a C corporation file?
A)
Form 1065
B)
Form 1120-C
C)
Form 1120-S
D)
Form 1120
The C corporation files a tax return with the IRS—this is the Form 1120.
LO 5.2.1
Ron has the following income for the current tax year:
Schedule C net income: $12,000
Flow-through of general partnership operating income: $15,000
Wages: $80,000
Net income from rental of real estate: $10,000
What is the amount of Ron’s self-employment tax?
A)
$9,467
B)
$1,696
C)
$5,228
D)
$3,815
d
The items included in the computation of self-employment income are the Schedule C income and the flow-through of general partnership operating income. The total of these items is $27,000. This is then reduced by 7.65% of this amount, and then multiplied by 15.3% to give us $3,815. Remember, the 7.65% subtraction always applies. Because the total of the self-employment income and the wages received are less than the wage base, no special computation is necessary.
LO 5.3.1
Mike is involved in the business of breeding show horses on a part-time basis as a sole proprietor. He has shown a significant net loss in this business every year for the last six years, and he has used these losses to reduce the tax liability on the salary he has earned from his law practice.
With which one of the following potential tax traps should Mike be most concerned?
A)
Assignment of income
B)
Substance over form
C)
Passive activity
D)
Hobby loss
d
The fact that this business has not been profitable and is merely a side business increases the likelihood it could be reclassified as a hobby loss. Mike has operated the business only part time, and he has not demonstrated that he is attempting to make it a profitable business. The fact that huge losses have occurred every year overrides the presumption that Mike is in the business to make a profit.
LO 5.4.2
Which of the following methods of accounting is mandatory for businesses that maintain inventory and have gross receipts in excess of $29 million?
A)
Accrual method of accounting
B)
IRS method of accounting
C)
Hybrid method of accounting
D)
Cash method of accounting
a
Under the cash method of accounting, a taxpayer generally reports income when any cash is collected (or the constructive receipt income tax doctrine applies) and reports expenses when any cash payment is made. The accrual method is the conceptual opposite of the cash method and requires recognition of taxable income in the same tax year it is reported on the taxpayer’s financial statements; it is mandatory for businesses maintaining inventory and have gross receipts in excess of $29 million. The hybrid method of accounting is a combination of the accrual method and the cash method of accounting. There is no IRS method of accounting.
LO 5.1.1
Which of the following is NOT an advantage of the cash basis method of accounting?
A)
Constructive receipt serves to defer income.
B)
Taxpayers can keep simple records.
C)
Income is reported when it is received.
D)
Taxpayers have more control over each year’s income and expenses.
a
Constructive receipt, which serves to accelerate income, is not considered an advantage of the cash method of accounting.
LO 5.1.1
John, an accountant, is considering forming an S corporation for his practice. He will be the sole employee of the corporation. Which of the following statements accurately describes the income tax consequences of the proposed arrangement?
A)
The corporation would be considered a PSC, subject to graduated tax rates.
B)
The corporation would not be considered a personal service corporation (PSC), and the income would be subject to John’s personal income tax rates.
C)
The corporation would be considered a PSC, subject to a flat 21% tax rate.
D)
The corporation would not be considered a PSC; therefore, the income would be subject to the graduated corporate income tax rates.
b
The personal service corporation (PSC) classification for a C corporation was effectively repealed with the Tax Cuts and Jobs Act (TCJA). S corporations do not have corporate income tax rates. As an S corporation, all income would flow through to John to be taxed at his individual rates.
LO 5.2.2
Which of the following is subject to the self-employment tax?
Distributive share of limited partnership operating income
Flow-through of S corporation income
Distributive share of general partnership operating income
Interest or dividends from investments
A)
II and IV
B)
I and III
C)
III only
D)
I, II, III, and IV
c
The general partnership operating income is self-employment income. By definition, the other items of income are not subject to the self-employment tax.
LO 5.3.1
Harriet builds remote-control cars as a hobby. Which hobby expenses must she deduct from hobby income first?
A)
Cost of goods sold
B)
Cost recovery deductions
C)
None are deductible
D)
Operating expenses
a
Most hobby expenses are not deductible with the notable exception of cost of goods sold.
LO 5.4.2
Your client, Mary, is contemplating the formation of an S corporation for her small manufacturing business. What can you accurately tell Mary about forming an S corporation?
Mary would have limited liability.
The number of shareholders is limited to 100.
Mary’s death would require reorganization of the corporation.
The corporation’s items of income, deductions, and tax credits would flow through to Mary’s income tax return.
A)
I and IV
B)
I, II, and IV
C)
III only
D)
II and III
b
The S corporation form is similar to the partnership in operating as a conduit for tax purposes. It also is similar to a C corporation, since it features limited liability for shareholders. In addition, the death of a shareholder in an S corporation does not create a need to reorganize the business. Finally, unlike a C corporation, an S corporation may have no more than 100 shareholders.
LO 5.2.2
Amanda’s share of general partnership net income is $60,000 in 2023. In addition, her distributive share of S corporation income is $10,000. What is Amanda’s self-employment tax, if any, for 2023? Round your answer to the nearest dollar.
A)
$0
B)
$9,891
C)
$10,710
D)
$8,478
Explanation
d The distributive share of income from an S corporation is not subject to the self-employment tax.
Actual earnings $60,000
Less: 7.65% – (4,590)
Net earnings from self-employment $55,410
Multiply by × 15.3%
Self-employment tax $8,478
LO 5.3.1
All of the following are examples of self-employment income for purposes of the self-employment tax except
A)
net Schedule C income.
B)
net Schedule F income.
C)
income from a sole proprietorship.
D)
salary paid to an S corporation shareholder.
d
Wages and salary paid to an S corporation shareholder are not self-employment income.
Which of the following businesses may be considered a specified service business (SSB) for purposes of the qualified business income (QBI) deduction?
A)
An automobile repair shop
B)
An engineering firm
C)
A furniture manufacturer/wholesaler
D)
A medical practice
d
An SSB is any trade or business involving the performance of services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees; or, any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. Thus, the medical practice would be an SSB, but none of the other businesses would. Engineering and architecture are specifically excluded from the definition of SSB.
LO 5.2.2
Which of the following statements about S corporations is CORRECT?
A)
S corporations may have nonresident aliens as shareholders.
B)
S corporation status is automatic if there are fewer than 100 shareholders.
C)
S corporations are prohibited from having more than one class of stock.
D)
S corporations are prohibited from earning passive income.
c
Explanation
An S corporation may have only one class of stock, although differences in voting rights are allowed within that one class of stock. An S corporation may have no more than 100 shareholders; however, the corporation must elect S status by filing a Form 2553—the treatment is not automatic. An S corporation may have passive income, although excess passive income may trigger the sting tax if the corporation had been a C corporation with earnings & profits (E&P). Nonresident aliens may not be shareholders in an S corporation.
LO 5.2.2
Alisha, a CFP® certificant and fee-only financial planner, has assisted Roger, a self-employed physician, in income tax return preparation and investment planning during the year. On which of the following schedules may Alisha’s fee be deductible by Roger on his federal income tax return?
Schedule A—itemized deductions
Schedule C—profit or loss from business
Schedule D—capital gains and losses
A)
I only
B)
II only
C)
I, II, and III
D)
I and II
b
The investment planning fees are not deductible. This expense may not be added to the basis of securities. The tax preparation fee is partly nondeductible (the portion attributable to the individual return), and the portion of the fee for completing the Schedule C is a business expense that would be deducted on the Schedule C.
LO 5.2.3
Glen and Debbie both have significant net worth and are currently in the highest marginal income tax bracket. They have developed a process that allows them to neutralize toxic chemical waste. They want to form a business that will protect their net worth in case the business fails or it becomes involved in lawsuits. They expect the business to produce significant profits immediately, as they have agreements in the works with several large chemical companies. Also, they would like to share ownership with other family members as they get closer to retirement.
Which business form would be most appropriate for Glen and Debbie at this time?
A)
General partnership
B)
S corporation
C)
Limited partnership
D)
C corporation
d
The S corporation (and the partnership entities) are conduits, and would cause the income to be added to their other significant individual income. The use of the C corporation would allow for protection from lawsuits or business failure. Also, the general partnership and the limited partnership both would cause a flow-through of the income, and the general partnership would not provide protection from personal liability. There is no indication that either party wants to be a general partner in a limited partnership. The use of a C corporation would be appropriate since it is a separate taxable entity, and the profits would not flow through. They could receive a reasonable salary, and the qualified dividends that are paid out would be subject to long-term capital gain rates.
LO 5.2.3
Irwin, a young financial planner, operates his practice as an LLC. His LLC net income is $100,000, and the taxable income on his single return is $140,000. The LLC paid no wages, and has no depreciable property.
What is the amount of Irwin’s qualified business income (QBI) deduction?
A)
$0, because he has no depreciable property
B)
$20,000
C)
$28,000
D)
$0, because he paid no wages
b
For a specified service business (SSB), if the taxpayer’s taxable income is below the phaseout range of $182,100 to $232,100 (Single 2023), the QBI deduction is fully available. An SSB involves performance of services in the fields of health, law, accounting, actuarial science, performing arts, veterinary services, consulting, athletics, financial services, or brokerage services. For pass-through entities, the owner/taxpayer may be allowed a deduction equal to 20% of the lesser of the QBI, or 20% of the taxpayer’s taxable income (reduced by net capital gain). Thus, the available deduction is 20% of the QBI of $100,000, or $20,000.
LO 5.2.3
Which of the following forms of business would file a Schedule C to report the income or loss from the business?
A)
Limited partnership
B)
C corporation
C)
S corporation
D)
Sole proprietorship
d
The sole proprietorship is the business that files a Schedule C with the individual’s Form 1040. The limited partnership files a Form 1065, and the C corporation files a Form 1120. The S corporation files an 1120-S.
Note that a single-member LLC would also file a Schedule C, as it would be treated as a disregarded entity for income tax purposes.
LO 5.2.3
