R1-3

Question 1

Darr, an employee of Sorce C Corporation, is not a shareholder. Which of the following would be included in a taxpayer’s gross income?

a.

The fair market value of land that the taxpayer inherited from an uncle.

b.

A $10,000 gift from the taxpayer’s grandparents.

c.

The dividend income on shares of stock that the taxpayer received for services rendered.

d.

Employer-provided medical insurance coverage under a health plan.

Answer 1

Choice “c” is correct. An individual receiving common stock for services rendered must recognize the fair market value as ordinary income. Any dividends received on that stock would also result in income recognition.

Choice “d” is incorrect. Employer-provided medical insurance is a tax-free fringe benefit.

Choices “b” and “a” are incorrect. Gifts and inheritances are both tax-free to the recipient. (Remember, tax is often paid by the person giving the gift or the estate at death.)

Question 2

Adams owns a second residence that is used for both personal and rental purposes. During the current year, Adams used the second residence for 50 days and rented the residence for 200 days. Which of the following statements is correct?

a.

Depreciation may not be deducted on the property under any circumstances.

b.

A rental loss may be deducted if rental-related expenses exceed rental income.

c.

Utilities and maintenance on the property must be divided between personal and rental use.

d.

All mortgage interest and taxes on the property will be deducted to determine the property’s net income or loss.

Answer 2

Choice “c” is correct. Because the second property was personally used more than 14 days, any net loss from the rental of the property will be disallowed.

All related expenses must be prorated between the personal use portion and the rental activity portion. Prorated depreciation is permitted for the rental activity.

Question 3

Which of the following conditions must be present in a post-1984 divorce agreement for a payment to qualify as deductible alimony?

I.

Payments must be in cash or its equivalent.

II.

The payments must end at the recipient’s death.

a.

Both I and II.

b.

II only.

c.

Neither I nor II.

d.

I only.

Answer 3

Choice “a” is correct. Among the requirements for payments to be classified as alimony are the following:

Payment must be in cash or its equivalent.

Payments cannot extend beyond the death of the payee-spouse.

Payments must be legally required pursuant to a written divorce (or separation) agreement.

Payments cannot be made to members of the same household.

Payments must not be designated as anything other than alimony.

The spouses may not file a joint tax return.

Note: The requirements for payments to be considered alimony (income) are the same as for payments to be alimony (deductions).

Question 4

Which of the following costs is not included in inventory under the Uniform Capitalization rules for goods manufactured by the taxpayer?

a.

Research.

b.

Warehousing costs.

c.

Taxes excluding income taxes.

d.

Quality control.

Answer 4

Choice “a” is correct. Uniform Capitalization rules provide guidelines with respect to capitalizing or expensing certain costs. With regard to inventory, direct materials, direct labor, and factory overhead should be capitalized as part of the cost of inventory. Warehousing costs, quality control and taxes, excluding income taxes, are all considered factory overhead items. The research should be expensed.

Question 5

During Year 9, Ash had the following cash receipts:

Wages

$ 13,000

Interest income from U.S. Treasury bonds

350

Workers’ compensation following a job-related injury

8,500

What is the total amount that must be included in gross income on Ash’s Year 9 income tax return?

a.

$21,850

b.

$21,500

c.

$13,350

d.

$13,000

Answer 5

Choice “c” is correct. The total amount that must be included in gross income is $13,350 ($13,000 in wages plus $350 in interest income on U.S. Treasury bonds).

Rule: Wages and interest on U.S. Treasury bonds are includible in gross income and must be reported as part of gross income on a taxpayer’s income tax return.

Rule: Damages for personal injury (i.e., workers’ compensation for a job-related injury) are specifically excluded from gross income.

Choices “d”, “b”, and “a” are incorrect, per the above rules.

Question 6

Baum, an unmarried optometrist and sole proprietor of Optics, buys and maintains a supply of eyeglasses and frames to sell in the ordinary course of business. In the current year, Optics had $350,000 in gross business receipts and its year-end inventory was not subject to the uniform capitalization rules. Baum’s current year adjusted gross income was $90,000 and Baum qualified to itemize deductions. During the year, Baum recorded the following information:

Business expenses:

Optics cost of goods sold

$ 35,000

Optics rent expense

28,000

Liability insurance premium on Optics

5,250

Other expenditures:

Baum’s self-employment tax

$ 29,750

Baum’s self-employment health insurance

8,750

Insurance premium on personal residence. In the current year, Baum’s home was
totally destroyed by fire. The furniture had an adjusted basis of $14,000 and a
fair market value of $11,000. During the year, Baum collected $3,000 in insurance
reimbursement and had no casualty gains during the year.

2,625

Qualified mortgage interest on a loan to acquire a personal residence

52,500

Annual interest on a $70,000, 5-year home equity loan. The loan was secured
by Baum’s home, obtained January 2 of the current year. The fair market value
of the home exceeded the mortgage and the home equity loan by a substantial
amount. The proceeds were used to purchase a car for personal use.

3,500

Points prepaid on January 2 of the current year to acquire the home equity loan

1,400

Real estate taxes on personal residence

2,200

Estimated payments of current year federal income taxes

13,500

Local property taxes on the car value, used exclusively for personal use

300

What amount should Baum report as current year net earnings from self-employment?

a.

$252,000

b.

$281,750

c.

$273,000

d.

$243,250

Answer 6

Choice “b” is correct. Baum should report $281,750 as current year net earnings from self-employment (line 12 of the Form 1040), calculated as follows:

Gross business receipts $ 350,000

Cost of goods sold (35,000)

Rent expense (28,000)

Liability insurance premium (5,250)

Net earnings on Schedule C $ 281,750

Choices “d”, “a”, and “c” are incorrect. Self-employment tax and self-employment health insurance expenses are adjustments from total gross income. They are not deducted from self-employment earnings (i.e., not reported net on line 12 of the Form 1040).

Note: There are many distracters in this question, all relating to items that are either deductible as part of itemized deductions or not deductible. Be careful to read the requirement of the question before spending unnecessary time on the question. The statement that Baum’s year-end inventory was not subject to the uniform capitalization rules is a distracter as well. There is not enough information given in the facts to apply the rules if he had been subject to them.

Question 7

Baker, a sole proprietor CPA, has several clients that do business in Spain. While on a four-week vacation in Spain, Baker took a five-day seminar on Spanish business practices that cost $700. Baker’s round-trip airfare to Spain was $600. While in Spain, Baker spent an average of $100 per day on accommodations, local travel, and other incidental expenses, for total expenses of $2,800. What amount of total expense can Baker deduct on Form 1040 Schedule C, “Profit or Loss From Business,” related to this situation?

a.

$4,100

b.

$1,200

c.

$700

d.

$1,800

Answer 7

Choice “b” is correct. Baker can deduct $1,200 in total expense on Form 1040 Schedule C, calculated as follows:

Direct educational expenses

$ 700

[cost of the course]

Daily expenses for 5-day seminar

500

[$100 per day × 5]

Total educational expenses

$ 1,200

Rule: If foreign travel is primarily for personal in nature (e.g., a vacation), none of the travel expenses (e.g., round trip airfare) incurred will be allowable business deductions, even if the taxpayer was involved in business activities while in the foreign country.

Note: It does not appear that the examiners are attempting to trick candidates on the classification of the business expenses as travel or educational. It appears that the purpose of the question is to test the candidate’s ability to recognize when expenses are deductible and when they are not deductible business expenses.

Choice “c” is incorrect, as the expenses for the 5-day period Baker attended the seminar were directly related to being in Spain for the additional period of time and are allowable business deductions.

Choices “d” and “a” are incorrect, per the above rule.

Question 8

On December 1 of the current taxable year, Krest, a self-employed cash basis taxpayer, borrowed $200,000 to use in her business. The loan was to be repaid on November 30 of the following year. Krest paid the entire interest amount of $24,000 on December 1 of the current year. What amount of interest was deductible on Krest’s current year income tax return?

a.

$24,000

b.

$0

c.

$22,000

d.

$2,000

Answer 8

Choice “d” is correct. Cash basis taxpayers deduct interest in the year paid or the year to which the interest relates, whichever is later. Even though all of the interest on this loan was paid on December 1, of the current year, only the interest relating to December of the current year can be deducted in the current year. The question does not give an interest rate, but because the loan is to be repaid in a lump sum at maturity, 1/12 of the interest, or $2,000 applies to each month.

Choice “b” is incorrect. Because $2,000 of the interest relates to the current year, this amount is deductible in the current year.

Choice “c” is incorrect. This is the amount that cannot be deducted until the following year, the year to which the interest relates. Be sure to read questions like this very carefully, because if you had simply misread the question as seeking the amount deductible in the following year, you would get the question wrong despite understanding the rule.

Choice “a” is incorrect. Cash basis taxpayers can deduct interest in the year paid or the year to which the interest relates, whichever is later, thus 11 months of the interest will not be deductible until next year.

Question 9

Klein, a master’s degree candidate at Blair University, was awarded a $12,000 scholarship from Blair in Year 8. The scholarship was used to pay Klein’s Year 8 university tuition and fees. Also in Year 8, Klein received $5,000 for teaching two courses at a nearby college. What amount is includable in Klein’s Year 8 gross income?

a.

$17,000

b.

$5,000

c.

$12,000

d.

$0

Answer 9

Choice “b” is correct. Scholarships are nontaxable for degree seeking students to the extent that the proceeds are spent on tuition, fees, books and supplies. The $5,000 for teaching courses is taxable compensation for services delivered.

Choice “d” is incorrect. The $5,000 for teaching courses is taxable compensation for services delivered.

Choice “c” is incorrect. The scholarship is not taxable because Klein is a degree seeking student and used the proceeds for tuition and fees. Furthermore, the $5,000 for teaching courses is taxable compensation for services delivered.

Choice “a” is incorrect. The scholarship is not taxable because Klein is a degree seeking student and used the proceeds for tuition and fees.

Question 10

Which payment(s) is (are) included in a recipient’s gross income?

I.

Payment to a graduate assistant for a part-time teaching assignment at a university. Teaching is not a requirement toward obtaining the degree.

II.

A grant to a Ph.D. candidate for his participation in a university-sponsored research project for the benefit of the university.

a.

Neither I nor II.

b.

Both I and II.

c.

II only.

d.

I only.

Answer 10

Choice “b” is correct.

I.

A payment to a student for a part-time teaching assignment is taxable income just as a payment for any other campus job would be. This is not a scholarship or fellowship.

II.

There is no exclusion in the tax law for amounts paid to a degree candidate for participation in university-sponsored research.

Question 11

Under the uniform capitalization rules applicable to property acquired for resale, which of the following costs should be capitalized with respect to inventory if no exceptions are met?

~~Marketing costs
~~Off-site storage costs
a.

No

No

b.

No

Yes

c.

Yes

Yes

d.

Yes

No

Answer 11

Choice “b” is correct. Under the uniform capitalization rules, purchasers of inventory for resale may deduct their marketing costs but must capitalize their off-site storage costs.

Choices “c”, “d”, and “a” are incorrect. Marketing costs are deductible, but off-site storage must be capitalized.

Question 12

In a tax year where the taxpayer pays qualified education expenses, interest income on the redemption of qualified U.S. Series EE Bonds may be excluded from gross income. The exclusion is subject to a modified gross income limitation and a limit of aggregate bond proceeds in excess of qualified higher-education expenses. Which of the following is (are) true?

I.

The exclusion applies for education expenses incurred by the taxpayer, the taxpayer’s spouse, or any person whom the taxpayer may claim as a dependent for the year.

II.

“Otherwise qualified higher-education expenses” must be reduced by qualified scholarships not includible in gross income.

a.

Both I and II.

b.

I only.

c.

Neither I nor II.

d.

II only.

Answer 12

Choice “a” is correct. Interest earned on Series EE bonds issued after 1989 may qualify for exclusion. One requirement is that the interest is used to pay tuition and fees for the taxpayer, spouse, or dependent enrolled in higher education. The interest exclusion is reduced by qualified scholarships that are exempt from tax and other nontaxable payments received for educational expenses (other than gifts and inheritances).

Question 13

During the year Kay received interest income as follows:

On U.S. Treasury certificates

$ 4,000

On refund of prior year’s federal income tax

500

The total amount of interest subject to tax in Kay’s current year tax return is:

a.

$4,000

b.

$4,500

c.

$500

d.

$0

Answer 13

Choice “b” is correct. Interest income from U.S. obligations is generally taxable. Interest income on a federal tax refund is taxable, even though the refund itself is not taxed.

Choice “a” is incorrect. Interest income on a federal tax refund is taxable, even though the refund itself is not taxed.

Choice “c” is incorrect. Interest income from U.S. obligations is generally taxable.

Choice “d” is incorrect. Interest income from U.S. obligations is generally taxable. Interest income on a federal tax refund is taxable, even though the refund itself is not taxed.

Question 14

With regard to the inclusion of social security benefits in gross income, for the Year 8 tax year, which of the following statements is correct?

a.

The social security benefits in excess of one half the modified adjusted gross income are included in gross income.

b.

Eighty-five percent of the social security benefits is the maximum amount of benefits to be included in gross income.

c.

The social security benefits in excess of modified adjusted gross income are included in gross income.

d.

The social security benefits in excess of the modified adjusted gross income over a threshold amount are included in gross income.

Answer 14

Choice “b” is correct. The amount of social security benefits that is taxed is dependent on whether the combined income (AGI plus interest on tax-exempt bonds and 50% of the social security benefits) is greater than a threshold amount. If the combined income is less than the threshold, the amount taxed is the lesser of 1) 50% of the benefits or 2) 50% of the excess of the combined income over the threshold. If the combined income is greater than the threshold, the amount taxed is the lesser of 1) amount calculated above plus 85% of the excess of the combined income over the threshold or 2) 85% of the benefits. Thus, 85% of the benefits is the maximum amount of benefits that may be included in gross income.

Question 15

Rich is a cash basis self-employed air-conditioning repairman with current year gross business receipts of $20,000. Rich’s cash disbursements were as follows:

Air conditioning parts

$ 2,500

Yellow Pages listing

2,000

Estimated federal income taxes on self-employment income

1,000

Business long-distance telephone calls

400

Charitable contributions

200

What amount should Rich report as net self-employment income?

a.

$13,900

b.

$14,900

c.

$14,100

d.

$15,100

Answer 15

Choice “d” is correct. Deductions to arrive at net self-employed income include all necessary and ordinary expenses connected with the business. Estimated federal income tax payments are not an expense. Charitable contributions by an individual are only deductible as an itemized deduction on Schedule A. This assumes the contribution was not made with the “expectation of commensurate financial return.”

Receipts

$ 20,000

Parts

(2,500)

Listing

(2,000)

Telephone

(400)

Net self-employment income

$ 15,100

Choice “b” is incorrect. Charitable contributions are an itemized deduction unless there is an expectation of commensurate financial return.

Choice “c” is incorrect. Federal income taxes paid are not a deductible expense.

Choice “a” is incorrect. Charitable contributions are an itemized deduction unless there is an expectation of commensurate financial return. Federal income taxes paid are not a deductible expense.

Question 16

On December 1, Year 1, Michaels, a self-employed cash basis taxpayer, borrowed $100,000 to use in her business. The loan was to be repaid on November 30, Year 2. Michaels paid the entire interest of $12,000 on December 1, Year 1. What amount of interest was deductible on Michaels’ Year 2 income tax return?

a.

$0

b.

$12,000

c.

$11,000

d.

$1,000

Answer 16

Choice “c” is correct. Prepaid interest must be prorated over the time for which payment is made. This is true for both cash and accrual basis taxpayers. The loan is for 1 month in Year 1 and 11 months in Year 2. Therefore, 1/12 of the interest is deductible in Year 1 and 11/12, or $11,000 is deductible in Year 2.

Choices “b”, “d”, and “a” are incorrect. Prepaid interest must be prorated over the time for which payment is made. This is true for both cash and accrual basis taxpayers.

Question 17

Perle, a dentist, billed Wood $600 for dental services. Wood paid Perle $200 cash and built a bookcase for Perle’s office in full settlement of the bill. Wood sells comparable bookcases for $350. What amount should Perle include in taxable income as a result of this transaction?

a.

$0

b.

$550

c.

$200

d.

$600

Answer 17

Choice “b” is correct. The $200 cash received plus the $350 fair value of the bookcase received must be included in income by Perle, for a total of $550. The income is based on the value in money or fair value of property received by Perle, not the $600 billed.

Choice “a” is incorrect. Perle must report taxable income as a result of this transaction.

Choice “c” is incorrect. The $350 fair value of the bookcase received is also income for Perle.

Choice “d” is incorrect. The income is based on the total value received by Perle, not the $600 billed.

Question 18

Charles and Marcia are married cash-basis taxpayers. In Year 8, they had interest income as follows:

$500 interest on federal income tax refund.

$600 interest on state income tax refund.

$800 interest on federal government obligations.

$1,000 interest on state government obligations.

What amount of interest income is taxable on Charles and Marcia’s Year 8 joint income tax return?

a.

$1,900

b.

$1,100

c.

$2,900

d.

$500

Answer 18

Choice “a” is correct. The $500 interest on federal income tax refund, the $600 interest on state income tax refund, and the $800 interest on federal government obligations are taxable, for a total of $1,900. The $1,000 interest on state government obligations is normally not taxable.

Choice “d” is incorrect. The $600 interest on state income tax refund and the $800 interest on federal government obligations is also taxable.

Choice “b” is incorrect. The $800 interest on federal government obligations is also taxable.

Choice “c” is incorrect. The $1,000 interest on state government obligations is normally not taxable.

Question 19

Nare, an accrual-basis taxpayer, owns a building which was rented to Mott under a ten-year lease expiring August 31, Year 8. On January 2, Year 2, Mott paid $30,000 as consideration for cancelling the lease. On November 1, Year 2, Nare leased the building to Pine under a five-year lease. Pine paid Nare $10,000 rent for the two months of November and December, and an additional $5,000 for the last month’s rent. What amount of rental income should Nare report in its Year 2 income tax return?

a.

$15,000

b.

$40,000

c.

$10,000

d.

$45,000

Answer 19

Choice “d” is correct. Prepaid rent is income when received even for an accrual-basis taxpayer. The $30,000 received as consideration for cancelling the lease is in substitution for rental payments and is thus rental income. The $5,000 prepaid for the last month’s rent is also rental income.

Choice “c” is incorrect. The $30,000 received as consideration for cancelling the lease is in substitution for rental payments and is thus rental income. The $5,000 prepaid for the last month’s rent is also rental income.

Choice “a” is incorrect. The $30,000 is in substitution of rental payments and is thus rental income.

Choice “b” is incorrect. The $5,000 prepaid for the last month’s rent would also be rental income.

Question 20

John and Mary were divorced last year. The divorce decree provides that John pay alimony of $10,000 per year, to be reduced by 20% on their child’s 18th birthday. During the current year, John paid $7,000 directly to Mary and $3,000 to Spring College for Mary’s tuition. What amount of these payments should be reported as income in Mary’s current year income tax return?

a.

$8,600

b.

$8,000

c.

$5,600

d.

$10,000

Answer 20

Choice “b” is correct. Alimony would be income to Mary while child support would not. Funds qualify as child support only if 1) a specific amount is fixed or is contingent on the child’s status (e.g., reaching a certain age), 2) it is paid solely for the support of minor children, and 3) it is payable by decree, instrument or agreement. The actual use of the funds is irrelevant to the issue. In this case, $2,000 (20% × $10,000) qualifies as child support. The other $8,000 is alimony, which would be income to Mary.

Choice “c” is incorrect. Take 80% of the $10,000 paid, not 80% of the $7,000 received by Mary.

Choice “a” is incorrect. Only $8,000 would be alimony per the divorce decree (80% × $10,000).

Choice “d” is incorrect. The 20% reduction when the child turns 18 makes 20% of the $10,000 payment, or $2,000, child support, which is nontaxable to Mary.

Question 21

Clark filed Form 1040EZ for the Year 8 taxable year. In July, Year 9, Clark received a state income tax refund of $900 plus interest of $10, for overpayment of Year 8 state income tax. What amount of the state tax refund and interest is taxable in Clark’s Year 9 federal income tax return?

a.

$10

b.

$900

c.

$0

d.

$910

Answer 21

Choice “a” is correct. Except for interest from state and local government bonds, interest income is fully taxable, so the $10 is included in income. Filing Form 1040EZ means that Clark did not itemize in the prior year, and therefore, did not deduct any state income taxes last year. Under the tax benefit rule, the refund is not taxable this year since Clark did not deduct the tax last year.

Question 22

Freeman, a single individual, reported the following income in the current year:

Guaranteed payment from services rendered to a partnership $ 50,000

Ordinary income from an S corporation 20,000

What amount of Freeman’s income is subject to self-employment tax?

a.

$20,000

b.

$70,000

c.

$50,000

d.

$0

Answer 22

Choice “c” is correct. Guaranteed payments are reasonable compensation paid to a partner for services rendered (or use of capital) without regard to his ratio of income. Earned compensation is subject to self-employment tax. Payments not guaranteed are merely another way to distribute partnership profits. The ordinary income reported from an S corporation is taxable income to the individual or their own individual tax return but is not subject to self-employment tax. The ordinary income reported from a partnership may be subject to self-employment tax (if to a general partner).

Question 23

During the current year, Adler had the following cash receipts:

Wages

$ 18,000

Interest income from investments in municipal bonds

400

Unemployment compensation

3,900

What is the total amount that must be included in gross income on Adler’s current year income tax return?

a.

$21,900

b.

$18,000

c.

$22,300

d.

$18,400

Answer 23

Choice “a” is correct. The wages of $18,000 and unemployment compensation are both includable in gross income on Adler’s current year income tax return.

Choice “b” is incorrect. The unemployment compensation must be included in gross income.

Choice “d” is incorrect. Municipal bond interest income is excluded from gross income, and the unemployment compensation must be included in gross income.

Choice “c” is incorrect. Municipal bond interest income is excluded from gross income.

Question 24

DAC Foundation awarded Kent $75,000 in recognition of lifelong literary achievement. Kent was not required to render future services as a condition to receive the $75,000. What condition(s) must have been met for the award to be excluded from Kent’s gross income?

I.

Kent was selected for the award by DAC without any action on Kent’s part.

II.

Pursuant to Kent’s designation, DAC paid the amount of the award either to a governmental unit or to a charitable organization.

a.

Both I and II.

b.

I only.

c.

II only.

d.

Neither I nor II.

Answer 24

Choice “a” is correct. Generally, the fair market value of prizes and awards is taxable income. However, an exclusion from income for certain prizes and awards applies where the winner is selected for the award without entering into a contest (i.e., without any action on their part) and then assigns the award directly to a governmental unit or charitable organization. Therefore, conditions “I” and “II” must be met in order for Kent to exclude the award from his gross income.

Choice “b” is incorrect. “II” is a necessary condition as well. See explanation above.

Choice “c” is incorrect. “I” is a necessary condition as well. See explanation above.

Choice “d” is incorrect. “I” and “II” are both necessary conditions. See explanation above.

Question 25

Mosh, a sole proprietor, uses the cash basis of accounting. At the beginning of the current year, accounts receivable were $25,000. During the year, Mosh collected $100,000 from customers. At the end of the year, accounts receivable were $15,000. What was Mosh’s gross taxable income for the current year?

a.

$90,000

b.

$75,000

c.

$110,000

d.

$100,000

Answer 25

Choice “d” is correct. The facts state that cash collections from customers were $100,000 and as a cash basis taxpayer this is the amount of Mosh’s gross taxable income for the year. Note that according to the formula BASE - we can determine the amount of sales = $90,000, but that would give us accrual, not cash basis, income.

Beginning A/R

$ 25,000

Add―Sales

90,000

accrual basis taxable income

115,000

Subtract―Cash collections

(100,000)

cash basis taxable income

Ending A/R

$ 15,000

Choices “b” and “c” are incorrect. See explanation above.

Choice “a” is incorrect. $90,000 is the amount of sales that would be Mosh’s taxable income if Mosh were an accrual basis taxpayer.

Question 26

Porter was unemployed for part of the year. Porter received $35,000 of wages, $6,400 from a state unemployment compensation plan, and $2,000 from his former employer’s company-paid supplemental unemployment benefit plan. What is the amount of Porter’s gross income?

a.

$37,000

b.

$41,400

c.

$43,400

d.

$35,000

Answer 26

RULE: Gross income includes all income unless it is specifically excluded in the tax code.

Choice “c” is correct. Wages and all unemployment compensation are not excluded from being taxable; therefore, they are included in the taxpayer’s gross income for tax purposes.

Wages received $ 35,000

State unemployment compensation 6,400

Employer’s unemployment compensation plan 2,000

$ 43,400

Choice “d” is incorrect. All forms of unemployment compensation are included as part of gross income.

Choice “a” is incorrect. The $6,400 of state unemployment compensation received is included as part of gross income.

Choice “b” is incorrect. The $2,000 of his former employer’s company-paid supplemental unemployment benefit plan is included as part of gross income.

Question 27

Which one of the following will result in an accruable expense for an accrual-basis taxpayer?

a.

An invoice dated prior to year end but the repair completed after year end.

b.

A repair completed prior to year end but not invoiced.

c.

A signed contract for repair work to be done and the work is to be completed at a later date.

d.

A repair completed prior to year end and paid upon completion.

Answer 27

RULE: An accruable expense is one is which the services have been received/performed but have not been paid for by the end of the reporting period.

Choice “b” is correct. The facts indicate that a repair was completed prior to year end but not yet invoiced. If it has not yet been invoiced, it is assumed that it has also not yet been paid for. Therefore, this is a situation in which the repair expense would be accrued at year end. Services have been performed, but they have not been paid for, as they have not even been invoiced yet.

Choice “a” is incorrect. If the repair was completed after year end, then the expense is not accruable, as the benefit of the services hasn’t been received as of year end. The fact that the repair was invoiced prior to year end does not impact the situation.

Choice “d” is incorrect. If a repair was completed and paid for prior to year end, no accrual is appropriate. On the accrual basis, the expense is taken in the year the repair is completed and the benefit is received. In this case, the account payable was also paid in the same year, but this has no effect on the expense.

Choice “c” is incorrect. The facts indicate that the work is to be completed at a date later than year end. Therefore, the expense is not accruable at year end, as the benefit of the repair hasn’t been received as of year end. It is reasonable that a signed contract for the repair work exists, but this has no effect on the accrual.

Question 28

In the current year Jensen had the following items:

Salary

$ 50,000

Inheritance

25,000

Alimony from ex-spouse

12,000

Child support from ex-spouse

9,000

Capital loss on investment stock sale

(6,000)

What is Jensen’s AGI for the current year?

a.

$44,000

b.

$84,000

c.

$59,000

d.

$62,000

Choice “c” is correct. The question asks for AGI, but all of the items in the list are items of potential gross income. There are no adjustments included in the list; therefore, in this case, AGI is the same as gross income. The calculation is as follows:

Salary

$ 50,000

Inheritance

0

[not taxable]

Alimony from ex-spouse

12,000

Child support from ex-spouse

0

[not taxable]

Capital loss on investment stock sale

(3,000)

[maximum deductible]

AGI

$ 59,000

Choices “a”, “d”, and “b” are incorrect, per the above calculation.

Answer 28

Choice “c” is correct. The question asks for AGI, but all of the items in the list are items of potential gross income. There are no adjustments included in the list; therefore, in this case, AGI is the same as gross income. The calculation is as follows:

Salary

$ 50,000

Inheritance

0

[not taxable]

Alimony from ex-spouse

12,000

Child support from ex-spouse

0

[not taxable]

Capital loss on investment stock sale

(3,000)

[maximum deductible]

AGI

$ 59,000

Choices “a”, “d”, and “b” are incorrect, per the above calculation.

Question 29

Which of the following is subject to the Uniform Capitalization Rules of Code Sec. 263A?

a.

Research and experimental expenditures.

b.

Editorial costs incurred by a freelance writer.

c.

Warehousing costs incurred by a manufacturing company with $12 million in annual gross receipts.

d.

Mine development and exploration costs.

Answer 29

Choice “c” is correct. Uniform capitalization rules apply to the following: (1) real or tangible personal property produced by the taxpayer for use in his or her trade or business; (2) real or tangible personal property produced by the taxpayer for sale to his or her customers; and (3) real or tangible personal property acquired by the taxpayer for resale, provided the taxpayer’s annual average gross receipts for the preceding three years exceeds $10,000,000. Warehousing costs incurred by a manufacturing company (making inventory for sale to its customers) are subject to the Uniform Capitalization Rules. Further, they are the only item on the list that is real or tangible personal property. In this case, the inventory is not acquired for resale (it is produced by the taxpayer for sale to his or her customers), so the fact that the annual sales are $12,000,000 does not matter in this case. The sales could have been less than $10,000,000 annually, and the Uniform Capitalization Rules would still have applied.

Choices “b”, “a”, and “d” are incorrect, based on the above discussion.

Question 30

Under the uniform capitalization rules applicable to taxpayers with property acquired for resale, which of the following costs should be capitalized with respect to inventory if no exceptions have been met?

~~Repackaging costs
~~Off-site storage costs
a.

Yes

Yes

b.

Yes

No

c.

No

Yes

d.

No

No

Answer 30

Choice “a” is correct. Direct material, direct labor, and factory overhead (applicable indirect costs) are capitalized with respect to inventory under the uniform capitalization rules for property acquired for resale. Applicable indirect costs include depreciation and amortization, insurance, supervisory wages, utilities, spoilage and scrap, design expenses, repair and maintenance and rental of equipment and facilities (including offsite storage), some administrative costs, costs of bonus and other incentive plans, and indirect supplies and other materials (including repackaging costs).

Choices “b”, “c”, and “d” are incorrect, per the above discussion.

Question 31

Chris, age 5, has $3,000 of interest income and no earned income this year. Assume the current applicable standard deduction is $950, how much of Chris’ income will be taxed at Chris’ parents’ maximum tax rate?

a.

$2,050

b.

$3,000

c.

$1,100

d.

$0

Answer 31

Choice “c” is correct. The amount of income for a child under 18 that is taxable at the parents’ maximum tax rate is deemed the “kiddie tax.” To calculate the amount that is taxed at the parents’ highest rate, take the child’s total interest income ($3,000 in this question) and reduce it by the child’s standard deduction ($950 in this case). The next $950 is then taxed at the child’s rate, and the balance of $1,100 ($3,000 - $950 - $950 = $1,100) is taxed at the parents’ highest rate.

Choice “d” is incorrect. The $0 indicates that nothing is taxed at the parents’ maximum tax rate. Taxing something at the parent’s tax rate is the whole idea of the “kiddie tax.”

Choice “a” is incorrect. The $2,050 uses only the $950 standard deduction, but the next $950 would be taxed at the child’s rate.

Choice “b” is incorrect. The $3,000 indicates that the entire $3,000 interest income is taxed at the parents’ maximum tax rate.

Question 32

Barkley owns a vacation cabin that was rented to unrelated parties for 10 days during the year for $2,500. The cabin was used personally by Barkley for three months and left vacant for the rest of the year. Expenses for the cabin were as follows:

Real estate taxes $ 1,000

Maintenance and utilities 2,000

How much rental income (loss) is included in Barkley’s adjusted gross income?

a.

$500

b.

$0

c.

$(500)

d.

$(1,500)

Answer 32

RULE: If a vacation residence is rented for less than 15 days per year, it is treated as a personal residence. The rental income is excluded from income, and mortgage interest (first or second home) and real estate taxes are allowed as itemized deductions. Depreciation, utilities, and repairs are not deductible.

Choice “b” is correct. Applying the RULE above, if a vacation residence is rented for less than 15 days per year, it is treated as a personal residence. The rental income ($2,500 in this case) is excluded from income. A Schedule E is not filed for this property (i.e., no income is reported, the taxes are reported as itemized deductions, and the maintenance and utilities are not deductible), so the effect on AGI is zero.

Choice “a” is incorrect. This assumes that the property taxes are reported as itemized deductions but that the rental income ($2,500) less the maintenance and utilities ($2,000) are reported net on Schedule E. Per the above RULE, the rental income is excluded from income, and the maintenance and utilities are not deductible.

Choice “c” is incorrect. This assumes that all of the items shown are reported net on the Schedule E-$2,500 - $1,000 - $2,000 = ($500). Per the above RULE, the rental income is excluded from income, the maintenance and utilities are not deductible, and the property taxes are reported on Schedule A as an itemized deduction.

Choice “d” is incorrect, per the above RULE and discussion.

Question 33

In a tax year where the taxpayer pays qualified education expenses, interest income on the redemption of qualified U.S. Series EE Bonds may be excluded from gross income. The exclusion is subject to a modified gross income limitation and a limit of aggregate bond proceeds in excess of qualified higher-education expenses. Which of the following is (are) true?

I.

The exclusion applies for education expenses incurred by the taxpayer, the taxpayer’s spouse, or any person whom the taxpayer may claim as a dependent for the year.

II.

“Otherwise qualified higher-education expenses” must be reduced by qualified scholarships not includible in gross income.

a.

I only.

b.

II only.

c.

Both I and II.

d.

Neither I nor II.

Answer 33

Choice “c” is correct. Both I and II are true per the following rule.

Rule: Qualified higher education expenses are tuition and fees required for the enrollment or attendance of the taxpayer, the taxpayer’s spouse, or any dependent for whom the taxpayer is allowed a dependency exemption, at an eligible educational institution.

The expenses otherwise taken into account must be reduced by the total amounts received for excludable qualified scholarships, certain educational assistance allowances, and other tax-exempt payments (other than gifts, bequests, devises, or inheritances).

Question 34

Kant, a cash-basis individual, owns and operates an office building. Kant received the following payments during the current year:

Current rents

$ 30,000

Advance rents for the next year

10,000

Security deposits held in a segregated account

5,000

Lease cancellation payments

15,000

What amount is included in gross income?

a.

$60,000

b.

$30,000

c.

$55,000

d.

$40,000

Answer 34

Rule: The basic formula for determination of net rental income or loss follows:

Gross rental income

Prepaid rental income

Rent cancellation payments

Improvements in lieu of rent

(Rental expenses)

Net rental income (loss)

If security deposits are held separately and not available to be applied to last month’s rent (as in a segregated account), they are a liability of the taxpayer and not included in income in the year received.

Choice “c” is correct. The calculation of gross income for the year follows:

Current rents

$ 30,000

Advance rents for the next year

10,000

Security deposits held in a segregated account

−

Lease cancellation payments

15,000

Gross income from the rental activity

$ 55,000

Choice “b” is incorrect. This answer option incorrectly includes only the current rents as part of gross income, when advance rents and lease cancellation payments also must be included.

Choice “d” is incorrect. This answer option incorrectly includes only the current rents and the advance rents as part of gross income, when lease cancellation payments also must be included.

Choice “a” is incorrect. This answer option incorrectly includes all of the payments collected for the rental activity in the year, when the security deposits that are held in a segregated account are excluded from gross income.

Question 35

An individual received $50,000 during the current year pursuant to a divorce decree. A check for $25,000 was identified as annual alimony, checks totaling $10,000 as annual child support, and a check for $15,000 as a property settlement. What amount should be included in the individual’s gross income?

a.

$40,000

b.

$0

c.

$50,000

d.

$25,000

Answer 35

Rules: Payments for the support of a spouse are income to the spouse receiving the payments and are deductible to arrive at adjusted gross income by the contributing spouse. Child support is not taxable. Property settlements are not taxable.

Choice “d” is correct. Only the $25,000 in alimony is included in the gross income of the receiving spouse.

Choice “c” is incorrect. This answer option incorrectly includes all of the payments received in the year. The child support ($10,000) and the property settlement ($15,000) are NOT included in the gross income of the receiving spouse.

Choice “a” is incorrect. This answer option incorrectly includes the payments received in the year for alimony and property settlement for the year [$25,000 + $15,000 = $40,000]. The property settlement ($15,000) is NOT included in the gross income of the receiving spouse.

Choice “b” is incorrect. The amount received for alimony ($25,000) is included in the gross income of the receiving spouse.

Question 36

Which one of the following statements is correct with regard to an individual taxpayer who has elected to amortize the premium on a bond that yields taxable interest?

a.

The amortization is treated as an itemized deduction.

b.

The bond’s basis is reduced by the amortization.

c.

The amortization is not treated as a reduction of taxable income.

d.

The bond’s basis is increased by the amortization.

Answer 36

Choice “b” is correct. The bond’s basis is reduced by the amortization of the premium.

Choice “a” is incorrect. For bonds acquired after 12/31/87, the amortization of the premium is an offset to interest income on the bond rather than a separate interest deduction.

Choice “c” is incorrect. The amortization of the premium will reduce taxable income.

Choice “d” is incorrect. The bond’s basis will be decreased by the amortization.

Question 37

For a cash basis taxpayer, gain or loss on a year-end sale of listed stock arises on the:

a.

Date of receipt of cash proceeds.

b.

Date of delivery of stock certificate.

c.

Settlement date.

d.

Trade date.

Answer 37

Choice “d” is correct. Trade date.

Gain or loss on a year-end sale of listed stock arises on the trade date.

Rule: Whether on the cash or accrual method of accounting taxpayers who sell stock or securities on an established securities market must recognize gains and losses on the trade date, rather than on the settlement date.

Choices “c”, “a”, and “b” are incorrect, per the above rule.

Question 38

Lane, a single taxpayer, received $160,000 in salary, $15,000 in income from an S Corporation in which Lane does not materially participate, and a $35,000 passive loss from a real estate rental activity in which Lane materially participated. Lane’s modified adjusted gross income was $165,000. What amount of the real estate rental activity loss was deductible?

a.

$15,000

b.

$25,000

c.

$0

d.

$35,000

Answer 38

Rule: Passive activity is any activity in which the taxpayer does not materially participate. A net passive activity loss generally may not be deducted against other types of income (e.g., wages, other ordinary or active income, portfolio income (interest and dividends), or capital gains). In other words, passive losses may generally only offset passive income for a tax year-the remaining net loss is generally “suspended” and carried forward to a year when it may be used to offset passive income (or when the final disposition of the property occurs). However, there is an exception (the “mom and pop exception,” as we refer to it in the textbooks) to this general rule. Taxpayers who own more than 10% of the rental activity, have modified AGI under $100,000, and have active participation (managing the property qualifies), may deduct up to $25,000 annually of net passive losses attributable to real estate. There is a phase-out provision for modified AGI from $100,000 − $150,000, and the deduction is completely phased-out for modified AGI in excess of $150,000.

Choice “a” is correct. Per the above rule, unless an exception exists (and it does not in this case, as Lane’s modified adjusted gross income is in excess of $150,000), passive losses may only offset passive income for a tax year (i.e., no “net loss” may exist). In this case, Lane has a $20,000 net loss from passive activity [$15,000 S Corporation income (passive, in this case because the facts state Lane does not materially participate) minus the $35,000 rental real estate loss]. Thus, only $15,000 of the passive loss from real estate rental activity may be used to offset the $15,000 income from the S Corporation. The remaining $20,000 passive activity loss is carried forward to be used in future years.

Choice “c” is incorrect. Per the above rule, passive losses may generally only offset passive income for a tax year. Lane has passive income of $15,000 in the year; thus, passive loss up to $15,000 may be deducted from passive income.

Choice “b” is incorrect. This answer option is an attempt to confuse the candidate into using the “mom and pop” exception, which applies when taxpayers who actively participate, own more than 10% of the rental activity, and have modified AGI under $100,000 are able to deduct up to $25,000 annually of net passive losses attributable to real estate. There is a phase-out provision for modified AGI from $100,000 − $150,000, and the deduction is completely phased-out for modified AGI in excess of $150,000. In this case, the facts state that Lane’s modified adjusted gross income is $165,000; thus, Lane does not qualify to use the exception.

Choice “d” is incorrect. This answer option assumes that the full amount of the rental real estate loss is deductible against the passive income from the S Corporation, and, thus, against Lane’s other taxable income. As indicated in the rule above, unless an exception applies (it does not in this case), a net passive activity loss may not be deducted against other types of income (e.g., wages, other ordinary or active income, portfolio income (interest and dividends), or capital gains). Thus, the full $35,000 rental real estate loss is not deductible in the year by Lane.

Question 39

A 33-year-old taxpayer withdrew $30,000 (pretax) from a traditional IRA. The taxpayer has a 33% effective tax rate and a 35% marginal tax rate. What is the total tax liability associated with the withdrawal?

a.

$13,500

b.

$10,000

c.

$13,000

d.

$10,500

Answer 39

Rule: Generally, unless an exception applies, retirement money cannot be withdrawn until the individual reaches the age of 59 ½. If retirement money (without an exception) is withdrawn before the age of 59 ½, the premature distribution is subject to a 10% penalty tax (in addition to the applicable regular income tax that applies to all distributions of traditional IRA money).

Choice “a” is correct. The taxpayer is under the age of 59 ½, and the facts do not indicate that an exception applies; therefore, the taxpayer is subject to the 10% penalty on the IRA distribution in addition to the regular income tax. The regular income tax that applies is the marginal rate (the rate for the next dollar of taxable income). The effective tax rate is simply the total tax divided by the total taxable income. In this case, the taxpayer would have to pay the regular tax on the distribution at the 35% marginal rate PLUS the 10% penalty on early distribution without an exception. The calculation to arrive at the total tax associated with the withdrawal follows:

Regular Income Tax

$ 30,000

× 35%

$ 10,500

Penalty Tax

30,000

× 10%

3,000

Total Tax

$ 13,500

Choice “b” is incorrect. This answer option assumes the effective income tax rate (rounded, assuming 33.33%) applied to the $30,000 distribution. It uses the incorrect tax rate (the marginal rate should be used) and omits the inclusion of the applicable 10% penalty tax. [$30,000 × 33.33% = $10,000]

Choice “d” is incorrect. This answer option includes the $30,000 distribution multiplied by the (proper) marginal tax rate, but it omits the inclusion of the applicable 10% penalty tax. [$30,000 × 35% = $10,500]

Choice “c” is incorrect. This answer option assumes the effective income tax rate (rounded, assuming 33.33%) applied to the $30,000 distribution plus the applicable 10% penalty tax [($30,000 × 33.33%) + ($30,000 × 10%) = $13,000]. It uses the incorrect tax rate (the marginal rate should be used).

Question 40

Which of the following should be included when determining adjusted gross income?

a.

Tuition scholarship.

b.

Rental value of parsonages.

c.

Alimony received.

d.

Compensation for injuries or sickness.

Answer 40

Rule: IRC Sections 71, 62, and 215 control the taxation of alimony. Payments for the support of a spouse (alimony) are income to the spouse receiving the payments and are deductible to arrive at adjusted gross income (AGI) by the spouse making the payments. To be alimony:

Payments must be legally required pursuant to a written divorce or separation agreement,

Payments must be in cash or its equivalent.

Payments cannot extend beyond the death of the payee-spouse,

Payments cannot be made to members of the same household.

Payments must not be designated as anything other than alimony, and

The spouses may not file a joint tax return.

Choice “c” is correct. Alimony received is definitely considered part of income and of adjusted gross income.

Choice “d” is incorrect. Compensation for injuries or sickness is excluded from income and thus adjusted gross income.

Choice “b” is incorrect. The rental value of parsonages (furnished by churches or synagogues) is excluded from the income of a minister and thus that minister’s adjusted gross income.

Choice “a” is incorrect. A scholarship for tuition is excluded from income and thus adjusted gross income. There are certainly limits or restrictions such as the student has to be a degree-seeking student and amounts must actually be spent on tuition, fees, books, and supplies, but, as a general statement, the amount is excluded.

Question 41

In the current year, a taxpayer reports the following items:

Salary $ 50,000

Income from partnership A, in which the taxpayer materially participates 20,000

Passive activity loss from partnership B (40,000)

During the year, the taxpayer disposed of the interest in partnership B, which had a suspended loss carryover of $10,000 from prior years. What is the taxpayer’s adjusted gross income for the current year?

a.

$30,000

b.

$70,000

c.

$60,000

d.

$20,000

Answer 41

Choice “d” is correct. The $50,000 salary and income from partnership activity of $20,000 are taxable. Typically, passive activity losses, whether in the current or prior years, may only be used to offset passive activity income. The exception to this is in the year the passive activity is disposed of (sold), if still unused, passive activity losses are fully deductible in the year of disposal:

Salary $ 50,000

+ Income from partnership A 20,000

• PAL from partnership B (40,000)
• Loss carryover from partnership B (10,000)

Adjusted gross income $ 20,000

Question 42

Which of the following costs are subject to the Uniform Capitalization Rules of Code Sec. 263A for manufactured tangible personal property?

a.

Off-site storage.

b.

Marketing.

c.

Research.

d.

Advertising.

Answer 42

Choice “a” is correct. Costs required to be capitalized under the uniform capitalization rules include direct materials, direct labor, and applicable indirect costs. Applicable indirect costs include utilities, warehousing costs, repairs, maintenance, indirect labor, rents, storage, depreciation and amortization, insurance, pension contributions, engineering and design, repackaging, spoilage and scrap, and administrative supplies.

Choice “d” is incorrect. Costs not required to be capitalized include selling, advertising, and marketing expenses, certain general and administrative expenses, research, and officer compensation not attributed to production services.

Choice “c” is incorrect. Costs not required to be capitalized include selling, advertising, and marketing expenses, certain general and administrative expenses, research, and officer compensation not attributed to production services.

Choice “b” is incorrect. Costs not required to be capitalized include selling, advertising, and marketing expenses, certain general and administrative expenses, research, and officer compensation not attributed to production services.

Question 43

Seth Silver had the following items of income during the taxable year:

Interest income from a checking account $ 1,000

Interest income from a money market account 2,050

Interest income from a municipal bond he purchased during the current year 250

Interest income from federal bonds he purchased 2 years ago 750

On his current year tax return, what amount is taxable income?

a.

$3,800

b.

$3,300

c.

$3,050

d.

$4,050

Answer 43

Choice “a” is correct. Taxable interest includes amounts received from general investment accounts as well as interest on federal obligations. Interest received from state and municipal bonds is not taxable.

Question 44

Tom and Sharlene had the following items of income and expense during the taxable year:

Self-Employment Activity

Gross income

$35,000

Business license fees

500

Marketing Expenses

2,000

Salary paid to Sharlene

10,000

Tom’s wages from his Job

67,000

Interest from money market

1,500

Gain from sale of securities owned for 3 months

15,000

What is Tom & Sharlene’s gross income before adjustments?

a.

$131,500

b.

$128,500

c.

$116,000

d.

$106,000

Answer 44

Choice “c” is correct. Tom & Sharlene’s gross income is calculated as follows:

Net self-employment income $ 32,500

Tom’s wages 67,000

Interest 1,500

Gain from sale 15,000

Total gross Income $ 116,000

Note: Sharlene’s salary is not included as income as 100% of the net self-employment activity is taxable to her. Her salary is considered a draw and is not an allowable business deduction against the gross income of the self-employment activity.

Question 45

Ben Flood, attorney at law, is a sole proprietor and files Schedule C with his federal Form 1040. Which of the following is not a deductible expense on Schedule C?

a.

Health insurance for him and his family.

b.

$30 business tax payable to the city in which he practices.

c.

Salaries paid to the paralegal who works for him.

d.

Depreciation on the computer used by his assistant.

Answer 45

Choice “a” is correct. A rule of thumb is that personal expenses are not allowed as deductions on the Schedule C. For instance, personal use of an automobile is considered a personal expense, not a deductible expense on Schedule C. Schedule C items should be only those related to the operation of the business itself. Health insurance for himself and his family is actually an adjustment to arrive at adjusted gross income.

Choice “b” is incorrect. Business tax items are deductible expenses which should be reported on Schedule C.

Choice “c” is incorrect. Salaries and commissions paid to others as part of the business are expenses allowed on Schedule C.

Choice “d” is incorrect. Depreciation on business assets is an allowable deduction.

Question 46

Merrill and Joe divorced in June of the current year. As part of the settlement, Joe received the following:

Alimony

$3,000

/per month

Child support

1,000

/per month

Lump-sum payment as the property settlement

125,000

Payments began in July; however, Merrill only paid a total of $15,000 during the year. For the current year, what amount must Joe include in income on his Form 1040?

a.

$9,000

b.

$134,000

c.

$140,000

d.

$15,000

Answer 46

Choice “a” is correct. Alimony is an item of gross income; child support is not. Joe was to receive $3,000 per month in alimony for the remaining six months of the year (July - December), for a total of $18,000. Child support is non-taxable as are lump-sum property settlements made pursuant to a divorce. When total payments received do not equal the total due, the amounts are first allocated to child support. Thus, of the $15,000 paid by Merrill, $6,000 is first allocated to child support. The remaining $9,000 would constitute alimony and would be taxable.

Choice “d” is incorrect. The $15,000 must first be allocated between the types of payments received. Any amounts are first used to satisfy any child support requirement, and the remainder would be classified as alimony.

Choice “b” is incorrect. This answer includes both the $9,000 (discussed above) and the property settlement (which is non-taxable).

Choice “c” is incorrect. This answer includes the total amount received, $15,000 payments (child support and alimony) and the property settlement. Lump-sum property settlements are not taxable to the recipient in a divorce.

Question 47

Mr. and Mrs. Williams decided during the tax year to purchase their first new home. The fair market value of the home was $275,000, and a 20% down payment was required to secure a mortgage in the amount of $220,000 at 5% for 30 years. The Williams’ decided to utilize $10,000 that was kept in an Individual Retirement Account owned by Mrs. Williams. This amount was withdrawn on June 12 and used to fund the down payment on July 1. These amounts had been previously deducted as an adjustment by her on an individual tax return in the year of contribution. The remaining $12,000 for the down payment was drawn from a savings account. How much of the distribution from the Individual Retirement Account is subject to the premature distribution penalty tax, and how much must be included in the Williams’ joint tax return in the year of distribution as gross income?

Penalty Tax
Gross Income
a.

$10,000

$0

b.

$0

$10,000

c.

$0

$0

d.

$10,000

$10,000

Answer 47

Choice “b” is correct. Generally, a premature distribution (prior to retirement or other allowable age) from an individual retirement account is subject to a 10% penalty tax. Certain exceptions to this tax are available and are contained in the mnemonic “HIM DEAD.”

Home buyer (1st time) $10,000 max if used toward first home

Insurance (medical)

Medical expenses in excess of 10% of AGI (or 7.5% if 65 or over)

Disability

Education

And

Death

The amount removed from the IRA qualifies under the “H” exception above. However, the question states that these amounts had been previously deducted on Mrs. Williams’ individual tax return, thus this is a distribution from a traditional, deductible IRA. When distributed, funds held in a traditional, previously deducted IRA are taxable to the recipient as ordinary income and thus would be included as gross income on the Williams’ joint tax return in the year of distribution.

Choice “c” is incorrect. The distribution would be included in the Williams’ gross income.

Choice “a” is incorrect. The amount qualifies for an exception to the penalty tax and would be included in the Williams’ gross income.

Choice “d” is incorrect. The amount qualifies for an exception to the premature distribution penalty tax.

Question 48

An individual taxpayer reports the following items for the current year:

Ordinary income from partnership A, operating a movie theater in which the taxpayer materially participates

$ 70,000

Net loss from partnership B, operating an equipment rental business in which the taxpayer does not materially participate

(9,000)

Rental income from building rented to a third party

7,000

Short-term capital gain from sale of stock

4,000

What is the taxpayer’s adjusted gross income for the year?

a.

$72,000

b.

$70,000

c.

$74,000

d.

$77,000

Answer 48

Choice “c” is correct. Except in the year in which an individual, estate, trust, or closely-held C corporation disposes of an entire interest in a passive activity investment, such taxpayers cannot deduct passive activity expenses and losses against income and gain attributable to non-passive activities. A passive activity is (i) any activity in which such taxpayers do not materially participate and (ii) as a general rule, such taxpayers’ rental real estate investments, regardless of the extent of such taxpayers’ involvement with the rental real estate operations. A limited exception (the “Mom and Pop Exception”) regarding rental real estate activities is available to individuals, but the facts of this question do not provide any information which would entitle the taxpayer to the benefits of this exception.

Hence, the taxpayer can deduct, against the profit from the taxpayer’s $7,000 passive activity rental income from the building rented to a third party, only $7,000 of the $9,000 net loss from partnership B which is operating an equipment rental business in which the taxpayer does not materially participate.

Computation of adjusted gross income for the year:

Ordinary income from partnership A, operating a movie theater in which the taxpayer materially participates

$ 70,000

Rental income from building rented to a third party (a passive activity)

7,000

Net loss from partnership B, operating an equipment rental business in which the taxpayer does not materially participate
(per the above rule the taxpayer can deduct only $7,000 of the $9,000 passive activity loss)

(7,000)

Short-term capital gain from sale of stock (fully taxable)

4,000

Adjusted gross income for the year

$ 74,000

Choices “b”, “a”, and “d” are incorrect per the above rule and per the above computations.

Question 49

The Uniform Capitalization Rules of Code Sec. 263A apply to retailers whose average gross receipts for the preceding three years exceed what amount?

a.

$10,000,000

b.

$1,000,000

c.

$5,000,000

d.

$2,500,000

Choice “a” is correct. The uniform capitalization rules do not apply to inventory acquired for resale if the taxpayer’s average gross receipts for the preceding three tax years do not exceed $10,000,000.

Choices “b”, “d”, and “c” are incorrect per the above rule.

Answer 49

Choice “a” is correct. The uniform capitalization rules do not apply to inventory acquired for resale if the taxpayer’s average gross receipts for the preceding three tax years do not exceed $10,000,000.

Choices “b”, “d”, and “c” are incorrect per the above rule.

Question 50

Randolph is a single individual who always claims the standard deduction. Randolph received the following in the current year:

Wages

$ 22,000

Unemployment compensation

6,000

Pension distribution (100% taxable)

4,000

A state tax refund from the previous year

425

What is Randolph’s gross income?

a.

$28,425

b.

$22,000

c.

$32,425

d.

$32,000

Answer 50

Choice “d” is correct. Each item listed here is included in gross income except for the state tax refund from a prior year. The taxpayer always claims the standard deduction. This means that the state tax was not deducted in the year it was paid. Under the tax benefit rule, the refund of that tax is not taxable.

Wages

$ 22,000

Unemployment compensation

6,000

Pension distribution (100% taxable)

4,000

Total

$ 32,000

Choices “b”, “a”, and “c” are incorrect per the above rule and per the above computation.

Question 51

Johnson worked for ABC Co. and earned a salary of $100,000. Johnson also received, as a fringe benefit, group term-life insurance at twice Johnson’s salary. The annual IRS-established uniform cost of insurance is $2.76 per $1,000. What amount must Johnson include in gross income?

a.

$100,552

b.

$100,000

c.

$100,276

d.

$100,414

Answer 51

Choice “d” is correct. The first $50,000 of group term life insurance is a nontaxable fringe benefit. Amounts exceeding this are taxable based on IRS tables. The total group term life insurance here is $200,000 (twice the salary of $100,000). The amount exceeding $50,000 is $150,000. The cost given here is $2.76 per $1,000 of insurance. 150 × $2.76 = $414. So the total amount included in gross income is $100,414 ($100,000 + $414).

Choice “b” is incorrect. $100,000 does not include any of the taxable amount of group term life insurance.

Choice “c” is incorrect. $100,276 only includes $100,000 of the group term life insurance instead of $150,000.

Choice “a” is incorrect. $100,552 includes the entire $200,000 of the group term life insurance instead of only $150,000.

Question 52

Which of the following statements regarding an individual’s suspended passive activity losses is correct?

a.

A maximum of 50% of the suspended losses can be used each year when an election is made to forgo the carry-back period.

b.

$3,000 of suspended losses can be utilized each year against portfolio income.

c.

Suspended losses must be carried back three years and forward seven years.

d.

Suspended losses can be carried forward, but not back, until utilized.

Answer 52

Choice “d” is correct. Tax rules allow suspended passive losses to be carried forward, but notback, until utilized.

Choice “b” is incorrect. This is the rule for capital losses. It does not apply to passive losses.

Choice “c” is incorrect. This rule is not correct. There is no carryback allowed for suspended passive losses.

Choice “a” is incorrect. This rule is not correct. There is no carryback allowed for suspended passive losses.

Question 53

Smith has an adjusted gross income (AGI) of $120,000 without taking into consideration $40,000 of losses from rental real estate activities. Smith actively participates in the rental real estate activities. What amount of the rental losses may Smith deduct in determining taxable income?

a.

$0

b.

$40,000

c.

$20,000

d.

$15,000

Answer 53

Choice “d” is correct. Generally, none of the passive losses from real estate are deductible against nonpassive income. However, Smith actively participates, which means that the “mom and pop” exception of up to $25,000 will apply. This exception is phased out over AGI of $100,000 through $150,000. That is 50 cents on the dollar. Smith’s AGI is $120,000. That is $20,000 into the phaseout range. So $10,000 of the $25,000 is phased out and Smith may deduct $15,000 of the $40,000 passive loss.

Choices “a”, “c”, and “b” are incorrect per the above explanation.

Question 54

A review of Bearing’s Year 2 records disclosed the following tax information:

Wages

$ 18,000

Taxable interest and qualifying dividends

4,000

Schedule C trucking business net income

32,000

Rental (loss) from residential property

(35,000)

Limited partnership (loss)

(5,000)

Bearing actively participated in the rental property and was a limited partner in the partnership. Bearing had sufficient amounts at risk for the rental property and the partnership. What is Bearing’s Year 2 adjusted gross income?

a.

$54,000

b.

$19,000

c.

$14,000

d.

$29,000

Answer 54

Choice “d” is correct. Passive activity losses (PALs) can only be deducted up to passive activity income. There is no passive activity income indicated. Therefore, the passive loss from the partnership is not deductible. $25,000 of the $35,000 rental real estate loss is deductible under the “mom and pop” exception because Bearing actively participates in the rental property and the AGI is below the phaseout amounts. The AGI is calculated as follows:

Wages

$ 18,000

Taxable interest and qualifying dividends

4,000

Schedule C trucking business net income

32,000

Rental loss from residential property

(25,000)

Adjusted gross income (AGI)

$ 29,000

Choices “c”, “b”, and “a” are incorrect per the above rule and per the above computation.

Question 55

Which of the following types of costs are required to be capitalized under the Uniform Capitalization Rules of Code Sec. 263A?

a.

Marketing.

b.

Office maintenance.

c.

Distribution.

d.

Warehousing.

Answer 55

Choice “d” is correct. The Uniform Capitalization Rules require the capitalization of certain costs related to inventory. They include direct materials, direct labor, and indirect overhead costs including warehousing.

Choice “a” is incorrect. Marketing is a selling expense, which is not required to be capitalized under the Uniform Capitalization Rules.

Choice “c” is incorrect. Distribution is a selling expense, which is not required to be capitalized under the Uniform Capitalization Rules.

Choice “b” is incorrect. Office maintenance is a general and administrative expense, which is not required to be capitalized under the Uniform Capitalization Rules.

Question 56

Nan, a cash basis taxpayer, borrowed money from a bank and signed a 10-year interest-bearing note on business property on January 1 of the current year. The cash flow from Nan’s business enabled Nan to prepay the first three years of interest attributable to the note on December 31 of the current year. How should Nan treat the prepayment of interest for tax purposes?

a.

Deduct the current year’s interest and amortize the balance over the next two years.

b.

Capitalize the interest as part of the basis of the business property.

c.

Capitalize the interest and amortize the balance over the 10-year load period.

d.

Deduct the entire amount as a current expense.

Answer 56

Choice “a” is correct. Interest paid in advance by a cash basis taxpayer on business loans cannot be deducted until the tax period to which the interest relates. In other words, the interest must be both paid and incurred in order to be deducted.

Choices “d”, “c”, and “b” are incorrect, per the above rule.

Question 57

Dietz is a passive investor in three activities which have been profitable in previous years. The profit and losses for the current year are as follows:

Gain/(Loss)

Activity X

$ (30,000)

Activity Y

(50,000)

Activity Z

20,000

Total

$ (60,000)

What amount of suspended loss should Dietz allocate to Activity X?

a.

$18,000

b.

$30,000

c.

$20,000

d.

$22,500

Answer 57

Choice “d” is correct. For the current year, there is a net passive loss of $60,000. This should be allocated to the two activities with passive losses in the ratio of their losses to total losses. Activity X will receive an allocation of $22,500 of the net loss [$60,000 × ($30,000 / $80,000)].

Choices “a”, “c”, and “b” are incorrect, per the above explanation.

Question 58

The Jacksons, who file a joint return, actively participate in a solely-owned rental real estate activity that produces a $30,000 loss during the current year. Their adjusted gross income was $120,000 before considering the rental activity. How much of the rental loss, if any, are the Jacksons entitled to deduct?

a.

$25,000

b.

$30,000

c.

$15,000

d.

$0

Answer 58

Choice “c” is correct. Generally, passive losses are only deductible against other passive income, and there is no passive income in the facts of this question. However, the “mom and pop” exception will apply because the Jacksons actively participate in the activity. This exception allows up to $25,000 of passive losses to be deducted against other nonpassive income. There is a phase-out over an adjusted gross income (AGI) range of $100,000 to $150,000. The Jacksons’ AGI is $120,000, and that is 40% into the phase-out range. Therefore, 40% of the $25,000 exception amount is phased out, and the deduction is $15,000 [$25,000 – ($25,000 × 40%)].

Choice “d” is incorrect. $0 would be correct if the “mom and pop” exception did not apply or was completely phased out.

Choice “a” is incorrect. $25,000 would be the correct answer if the entire “mom and pop” exception applied.

Choice “b” is incorrect. $30,000 would only be correct if at least that amount of other passive income existed.