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.

Accepted Answer

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.

Accepted Answer

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.

Accepted Answer

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.

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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.

Accepted Answer

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

Accepted Answer

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.

Accepted Answer

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

Accepted Answer

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.

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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

Accepted Answer

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.

Accepted Answer

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.

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