Reg 1 - Problems

Question 1

A taxpayer’s Year 2 taxable income was $175,000 with a corresponding tax liability of $30,000. For Year 3, the taxpayer expects taxable income of $250,000 and a tax liability of $50,000. In order to avoid a penalty for underpayment of estimated tax, what is the minimum amount of Year 3 estimated tax payments that the taxpayer can make?

A. $30,000
B. $33,000
C. $45,000
D. $50,000

Answer 1

B. $33,000

In this scenario, the Year 2 taxable income is greater than $150,000 ($175,000); therefore, the prior year safe harbor amount is $33,000 ($30,000 × 110%). The current year safe harbor is $45,000 ($50,000 × 90%). To avoid an underpayment penalty, the taxpayer must make estimated tax payments of at least $33,000 (lesser of $33,000 or $45,000).

Question 2

Robin Corp. incurred substantial operating losses for the past three years. Unable to meet its current obligations, Robin filed a petition for reorganization under Chapter 11 of the Federal Bankruptcy Code. Which of the following statements is correct?

A. The creditors’ committee must select a trustee to manage Robin’s affairs.
B. The reorganization plan may be filed only by Robin.
C. A creditors’ committee consists exclusively of unsecured creditors.
D. Robin may continue in business only with the approval of a trustee.

Answer 2

C. A creditors’ committee consists exclusively of unsecured creditors.

Question 3

A CPA prepared a tax return that involved a tax shelter transaction that was disclosed on the return. In which of the following situations would a tax return preparer penalty not be applicable?

A. There was substantial authority for the position.
B. It is reasonable to believe that the position would more likely than not be upheld.
C. There was a reasonable possibility of success for the position.
D. There was a reasonable basis for the position.

Answer 3

B. It is reasonable to believe that the position would more likely than not be upheld.

Question 4

Which of the following is not an eligible entity type for a tax-exempt organization qualifying for 501(c)(3) exemption from federal income taxes?

A. Corporation.
B. Partnership.
C. Private foundation.
D. Social club.

Answer 4

B. Partnership.

Question 5

Soma Corp., an accrual-method calendar-year C corporation, had $600,000 in compensation expense for book purposes in Year 2. Included in this amount was a $50,000 accrual for Year 2 nonshareholder bonuses. Soma paid the actual Year 2 bonus of $60,000 on March 1, Year 3. In its Year 2 tax return, what amount should Soma deduct as compensation expense?

A. $600,000
B. $610,000
C. $550,000
D. $540,000

Answer 5

B. $610,000

In this scenario, Soma Corp.’s Year 2 $600,000 book compensation includes $550,000 of regular compensation paid for Year 2 services plus $50,000 of bonus liabilities compensating Year 2 services. The $550,000 paid is deductible in Year 2. In addition, although $50,000 was accrued for book purposes, $60,000 of bonuses are deductible in Year 2 because $60,000 was paid by March 15, Year 3 (Choice C). Therefore, Soma should deduct $610,000 ($550,000 + $60,000) in its Year 2 tax return

Question 6

Which of the following principals may normally ratify an unauthorized contract made by an agent?
I. Fully disclosed principal.
II. Partially disclosed principal.
III. Undisclosed principal.

A. I only.
B. I and II only.
C. II and III only.
D. I, II, and III.

Answer 6

B. I and II only.

Question 7

Which of the following acts by a CPA will not result in a CPA incurring an IRS penalty?

A. Failing, without reasonable cause, to provide the client with a copy of an income tax return.
B. Failing, without reasonable cause, to sign a client’s tax return as preparer.
C. Understating a client’s tax liability as a result of an error in calculation.
D. Negotiating a client’s tax refund check when the CPA prepared the tax return.

Answer 7

C. Understating a client’s tax liability as a result of an error in calculation.

Question 8

Regarding the tax treatment of a business’s domestic research and experimental (R&E) costs, which of the following statements is true?

A. Companies may elect to immediately expense R&E costs in the tax year incurred or capitalize and amortize them over fifteen years.
B. Companies must immediately expense R&E costs in the tax year incurred.
C. Companies must capitalize and amortize R&E costs over fifteen years.
D. Companies must capitalize and amortize R&E costs over five years.

Answer 8

D. Companies must capitalize and amortize R&E costs over five years.

Question 9

The filing of an involuntary petition in bankruptcy

A. Allows creditors to continue their collection actions against the debtor while the bankruptcy action is pending.
B. Terminates liens associated with exempt property.
C. Stops the enforcement of a judgment lien against property in the bankruptcy estate.
D. Terminates all security interests in property in the bankruptcy estate.

Answer 9

C. Stops the enforcement of a judgment lien against property in the bankruptcy estate.

Question 10

Which of the following exempt organizations would be eligible to satisfy its annual filing requirement by filing Form 990-N (e-Postcard)?

A. Church
B. Private foundation
C. An exempt organization with $20,000 of gross receipts
D. An exempt organization with $3,500 of gross income from an unrelated business

Answer 10

C. An exempt organization with $20,000 of gross receipts

Small exempt organizations whose gross receipts are $50,000 or less are generally eligible to annually file an electronic Form 990-N (e-Postcard) listing the organization’s legal name, mailing address, and employer identification number. Exceptions apply to churches and exempt organizations that are required to file a different form. Churches do not have to file an annual information return. A private foundation must annually file Form 990-PF, Return of Private Foundation. An exempt organization having gross income of $1,000 or more from an unrelated business must file Form 990-T, Exempt Organization Business Income Tax Return.

Question 11

Filler-Up is an accrual-basis calendar-year C corporation. Filler-Up uses an allowance method for accounting for credit losses. The allowance for credit losses was $20,000 at the beginning of the year and $30,000 at the end of the year. During the year, Filler-Up wrote off $5,000 of uncollectible receivables and accrued an additional $15,000 of expenses for accounts estimated to be uncollectible. What is the Schedule M-1 adjustment on Filler-Up’s federal income tax return?

A. $10,000 subtraction from book income.
B. $10,000 addition to book income.
C. $5,000 subtraction from book income.
D. $5,000 addition to book income.

Answer 11

B. $10,000 addition to book income.

In this scenario, Filler-Up uses the allowance method for book purposes and has recorded an expense for credit losses of $15,000 (the accrual). For tax purposes, only the direct write-off method is permitted, so the tax deduction should be $5,000 (the amount written off). As a result, the expense for book purposes is $10,000 more than it is for tax purposes ($15,000 − $5,000). Because the book expense is larger, book income is lower than taxable income. To reconcile book income to taxable income, Filler-Up must add back the $10,000 that was not deducted for taxable income.

Question 12

Easy Corp. is a real estate developer and regularly engages real estate brokers to act on its behalf in acquiring parcels of land. The brokers are authorized to enter into such contracts but are instructed to do so in their own names without disclosing Easy’s identity or relationship to the transaction. If a broker enters into a contract with a seller on Easy’s behalf.

A. The broker will have the same actual authority as if Easy’s identity had been disclosed.
B. Easy will be bound by the contract because of the broker’s apparent authority.
C. Easy will not be liable for any negligent acts committed by the broker while acting on Easy’s behalf.
D. The broker will not be personally bound by the contract because the broker has express authority to act.

Answer 12

A. The broker will have the same actual authority as if Easy’s identity had been disclosed.

In this scenario, the brokers are instructed to enter the contract themselves, as if there is no principal or agency. Under these circumstances, only the brokers are bound by the contract because they entered the contract in an individual capacity (Choice D). However, as part of the agency agreement, Easy must indemnify the brokers for all contracts they make when using the actual authority granted by Easy (ie, buying parcels of land).

Question 13

A client suing a CPA for negligence must prove each of the following factors except

A. Breach of duty of care.
B. Proximate cause.
C. Reliance.
D. Injury.

Answer 13

C. Reliance.

Question 14

Village Corp., a June 30 fiscal-year-end corporation, began business in Year 1. Village made a valid S Corporation election on September 5, Year 8, with the unanimous consent of its shareholders. The eligibility requirements for S status were met throughout Year 8. On what date did Village’s S status become effective?

A. July 1, Year 8
B. September 5, Year 8
C. January 1, Year 9
D. July 1, Year 9

Answer 14

A. July 1, Year 8

Question 15

Which of the following increases the accumulated adjustments account of an S corporation?

A. Capital contributions by the shareholders
B. Distribution to shareholders
C. Interest and dividends
D. Charitable contributions

Answer 15

C. Interest and dividends

Question 16

Which of the following professions might well be deemed statutory employees under the proper circumstances?

A. Lumberjacks.
B. Welders.
C. Farmers.
D. Life insurance agents.

Answer 16

D. Life insurance agents.

(Choice D) Choice d: Correct! This profession is listed in the rules as potentially being a statutory employee if three conditions are met: the service contract states or implies that substantially all the services are to be performed by the worker personally, the worker does not have a substantial investment in the equipment and property used to perform the services; and the services are performed on a continuing basis for the same business.

Question 17

To qualify as an exempt organization other than a church or an employees’ qualified pension or profit-sharing trust, the applicant

A. Cannot operate under the “lodge system” under which payments are made to its members for sick benefits.
B. Need not be specifically identified as one of the classes on which exemption is conferred by the Internal Revenue Code, provided that the organization’s purposes and activities are of a nonprofit nature.
C. Is barred from incorporating and issuing capital stock.
D. Must file a written application with the Internal Revenue Service.

Answer 17

D. Must file a written application with the Internal Revenue Service.

Question 18

Which of the following taxpayers may use the cash basis as its method of accounting for tax purposes?

A. Partnership that is designated as a tax shelter.
B. Retail store with a $2 million inventory.
C. An international accounting firm.
D. Office cleaning business with average annual income of $8 million.

Answer 18

C. An international accounting firm.

The cash basis may not be used by tax shelters and may not be used to account for the purchase and sale of inventory. In addition, businesses with gross receipts in excess of $5,000,000 may not use the cash basis. An international accounting firm would be able to use the cash basis provided it did not fall into a different category for which the cash basis is not allowed.

Question 19

On March 1, Year 3, a taxpayer was bequeathed 1,000 shares of Extra Corp. common stock under their parent’s will. The parent had paid $5,000 for the stock in Year 0. The fair market value of the stock on March 1, Year 3, the date of the parent’s death, was $8,000 and had increased to $11,000 six months later. The executor of the estate elected the alternate valuation date for estate tax purposes. The taxpayer sold the stock for $9,000 on May 1, Year 3, the date that the executor distributed the stock to the taxpayer. What was the taxpayer’s recognized gain or loss on sale of the 1,000 shares in Year 3?

A. $2,000 loss
B. $0
C. $1,000 gain
D. $4,000 gain

Answer 19

B. $0

In this scenario, since the executor has made the AVD election, the earlier of the transfer date or six months after the date of death determines the stock’s basis. The stock was transferred before the six-month date, so the taxpayer’s basis is the FMV on the transfer date.

Question 20

Brown Corp., a calendar-year taxpayer, was organized and actively began operations on July 1, Year 2, and incurred the following costs:

Legal fees to obtain corporate charter $ 40,000
Commission paid to underwriter 25,000
Other stock issue costs 10,000
Brown elects to amortize its organizational costs. In Year 2, what is the maximum amount Brown may deduct from taxable income as a result of organizational expenses incurred?

A. $1,333
B. $5,000
C. $6,167
D. $6,500

Answer 20

C. $6,167

In this scenario, the $40,000 legal fees to obtain a corporate charter are organizational costs, but the $25,000 commission paid and the $10,000 stock issue costs are not. Because Brown Corp. elected to amortize its organizational expenses, $5,000 of the $40,000 is immediately deductible. The $35,000 remaining costs ($40,000 − $5,000) are amortized over 180 months. However, Brown began business on July 1, thus limiting the amortization in Year 2 to $1,167 [($35,000 / 180) × 6 months]. The total amount expensed in Year 2 is $6,167 ($5,000 + $1,167).

Question 21

Filler-Up is an accrual-basis calendar-year C corporation. Filler-Up uses an allowance method for accounting for credit losses. The allowance for credit losses was $20,000 at the beginning of the year and $30,000 at the end of the year. During the year, Filler-Up wrote off $5,000 of uncollectible receivables and accrued an additional $15,000 of expenses for accounts estimated to be uncollectible. What is the Schedule M-1 adjustment on Filler-Up’s federal income tax return?

A. $10,000 subtraction from book income.
B. $10,000 addition to book income.
C. $5,000 subtraction from book income.
D. $5,000 addition to book income.

Answer 21

B. $10,000 addition to book income.

In this scenario, Filler-Up uses the allowance method for book purposes and has recorded an expense for credit losses of $15,000 (the accrual). For tax purposes, only the direct write-off method is permitted, so the tax deduction should be $5,000 (the amount written off). As a result, the expense for book purposes is $10,000 more than it is for tax purposes ($15,000 − $5,000). Because the book expense is larger, book income is lower than taxable income. To reconcile book income to taxable income, Filler-Up must add back the $10,000 that was not deducted for taxable income.

Question 22

Ames Construction Co. contracted to build a warehouse for White Corp. The construction specifications required Ames to use Ace lighting fixtures. Inadvertently, Ames installed Perfection lighting fixtures, which are of slightly lesser quality than Ace fixtures, but in all other respects meet White’s needs. Which of the following statements is correct?

A. White’s recovery will be limited to monetary damages because Ames’s breach of the construction contract was not material.
B. White will not be able to recover any damages from Ames because the breach was inadvertent.
C. Ames did not breach the construction contract because the Perfection fixtures were substantially as good as the Ace fixtures.
D. Ames must install Ace fixtures or White will not be obligated to accept the warehouse.

Answer 22

A. White’s recovery will be limited to monetary damages because Ames’s breach of the construction contract was not material.

In this scenario, White Corp.’s damages will equal the difference in value between the higher quality Ace fixtures that were not installed and the lower quality Perfection fixtures that were installed.

Question 23

If a CPA recklessly departs from the standards of due care when conducting an audit, the CPA will be liable to third parties who are unknown to the CPA based on

A. Negligence.
B. Statute of frauds.
C. Privity.
D. Gross negligence.

Answer 23

D. Gross negligence.

In common law, CPAs face liability as a result of three common law principles:

Contract: A CPA who does not fulfill the terms of the engagement contract (eg, audit) faces liability for breach of contract. The CPA’s liability is to the client and any intended (ie, named) third-party beneficiary.

Negligence: When performing an engagement, a CPA has a duty to exercise due professional care expected of an ordinarily prudent CPA. A CPA who fails to exercise this care faces liability for negligence. The CPA’s liability is to the client, any intended (ie, named) third-party beneficiary, and (in most states) any third party known or foreseen by the CPA (Choice A).

Gross negligence/fraud: A CPA who recklessly departs from the standard of due care when performing an engagement faces liability for gross negligence. The CPA’s liability is to the client, any intended third party, and any third party (known or unknown) who suffered financial loss.

Question 24

On July 1, Year 4, a donor gave a taxpayer a gift of stock worth $19,000. The donor purchased the stock for $20,000 in Year 1. On November 1, Year 4, the taxpayer sold the stock to an unrelated party for $18,500. What is the amount and character of the taxpayer’s gain or loss upon the sale?

A. $500 short-term capital loss.
B. $1,500 long-term capital loss.
C. $500 long-term capital loss.
D. $1,500 short-term capital loss.

Answer 24

A. $500 short-term capital loss.

When gifted, the stock’s FMV ($19,000) was less than the donor’s adjusted basis ($20,000); therefore, the taxpayer’s basis and holding period are determined by the sale. Since the stock sold ($18,500) for less than the FMV at the time of gift, the FMV at the time of gift is used as the basis to calculate the $500 loss ($18,500 sale − $19,000 basis) (Choices B and D).

Question 25

Ritz hired West for 6 months as an assistant sales manager at $4,000 a month plus 3% of sales.

Which of the following is correct?

A. The employment agreement must be in writing and signed by the party to be charged.
B. The agreement between Ritz and West formed an agency coupled with an interest.
C. West must disclose any interests he has which are adverse to Ritz in matters concerning Ritz’s business.
D. West can be dismissed by Ritz during the 6 months only for cause.

Answer 25

C. West must disclose any interests he has which are adverse to Ritz in matters concerning Ritz’s business.

C. West must disclose any interests he has which are adverse to Ritz in matters concerning Ritz’s business.

Question 26

An unmarried taxpayer maintains a separate home for their parents but does not have a qualifying child in their household. The parents’ income consisted of $2,400 from dividends and interest and $9,600 from Social Security. Assume the current income threshold and personal exemption amount is $5,050. What filing status should the taxpayer claim for the year?

A. Single.
B. Head of household.
C. Married filing separately.
D. Qualifying surviving spouse.

Answer 26

B. Head of household.

An individual taxpayer’s filing status affects their tax rates and certain deductions, exclusions, and credits. Filing status is primarily determined by marital status on the last day of the tax year. Unmarried taxpayers must file as single, head of household, or qualifying surviving spouse (Choice C). The qualifying surviving spouse and head of household statuses are more favorable than single. Single is the only one of these filing statuses that does not require a dependent.

Filing as qualifying surviving spouse alleviates the financial hardships a taxpayer with a dependent child may face after the death of a spouse (Choice D). To qualify as a head of household, the taxpayer must have a qualifying person who is an eligible dependent and must:

Provide more than 50% of the costs of maintaining a household for the qualifying person.
Live with the qualifying person for more than 50% of the year. However, a taxpayer’s parents are not required to live with the taxpayer.
Here, the taxpayer would file as head of household because the parents are dependents, and the household maintenance requirement, income test, and residency exception are met for the parents to be considered qualifying relatives. Social security income is excluded when determining head of household status. Head of household is more advantageous than single status (Choice A).

Question 27

A taxpayer has an AGI of $135,000 without taking into consideration $40,000 of losses from rental real estate activities. The taxpayer actively participates in the rental real estate activities. What amount of the rental losses may be deducted in determining taxable income?

A. $7,500
B. $17,500
C. $25,000
D. $32,500

Answer 27

A. $7,500

The taxpayer has no passive income to offset the passive loss. Because the taxpayer actively participates in the rental activity, up to $25,000 of the loss is deductible. However, since the taxpayer’s MAGI exceeds $100,000, a portion of the $25,000 deduction is phased out. The $7,500 deductible loss is calculated as follows:

AGI - 135000
Subtract Threshold - (100000)
Equals 35000

Multiply by .50 phaseout - 17500
subtract from 25000 max deduction - 7500

Carryforward remaining loss - 32500

Question 28

Which of the following statements is true regarding the calculation of a C corporation’s taxable income and tax liability?

A. Business bad debts are allowed as an ordinary business deduction if the direct write-off method is used.
B. Charitable contributions are always fully deductible as ordinary business deductions.
C. The foreign tax credit is applied to taxable income before multiplying by the tax rate to determine gross tax liability.
D. The dividends received deduction is used to determine income before NOL and special deductions.

Answer 28

A. Business bad debts are allowed as an ordinary business deduction if the direct write-off method is used.

Question 29

A taxpayer is the sole beneficiary of two life insurance policies:

Both the taxpayer’s aunt and brother died unexpectedly this year. The taxpayer accepts his brother’s $200,000 life insurance policy proceeds as a lump sum and elects to receive aunt’s $300,000 policy in 24 installments of $15,000 each. If the taxpayer receives the $200,000 in a lump sum and only four of the 24 payments from the $300,000 in the current year, what amount, if any, is taxable this year?

A. $0
B. $10,000
C. $60,000
D. $260,000

Answer 29

B. $10,000

Section 101(a) of the IRC allows for an exclusion from gross income for life insurance proceeds received due to the death of the insured person. Life insurance proceeds are usually paid in a lump sum. However, the beneficiary may have the option to receive the payout in installments. When choosing this option, the beneficiary will receive more than the face value (amount payable at time of death) of the policy due to interest earned on the principal.

Although the insurance proceeds representing the face value of the policy are nontaxable, any interest received is taxable. An allocation between the face value of the policy and the interest component must be made for each installment received. The formula to determine the nontaxable portion of each installment is the face value of the policy divided by the number of installments.

The taxpayer will include $10,000 as income.

Question 30

A taxpayer reported the following in a tax year:

Salary $122,000
Capital gain dividends 3,700
Partnership short-term capital loss (6,300)
The taxpayer acquired the partnership interest during the year in exchange for a capital contribution of $2,750, and there were no additional items affecting the taxpayer’s basis in the partnership. What is the taxpayer’s adjusted gross income for the year?

A. $119,400
B. $122,000
C. $122,700
D. $122,950

Answer 30

D. $122,950

In this scenario, the taxpayer paid $2,750 for the partnership interest, which then became the taxpayer’s basis in the partnership. The taxpayer can deduct only $2,750 of the $6,300 capital loss due to the basis limit.

Therefore, the taxpayer’s adjusted gross income is $122,950 ($122,000 salary + $3,700 capital gain dividend − $2,750 capital loss from the partnership after basis limitation).

Question 31

Which of the following acts will always result in the total release of a compensated surety?

A. The creditor extends the principal debtor’s time to pay by three weeks.
B. The creditor failed to disclose the debtor’s bad credit rating to the surety.
C. The place of payment is changed to another state.
D. The principal debtor’s obligation is partially released.

Answer 31

B. The creditor failed to disclose the debtor’s bad credit rating to the surety.

Because the obligation of the surety is to the creditor, the creditor owes the surety a fiduciary duty to act in its best interests and not increase the surety’s risk of having to pay off the debt. A surety is released from its obligation if the creditor:

fails to disclose negative information the creditor has about the principal debtor.

changes the original agreement with the debtor in a way that materially increases the surety’s risk of loss (ie, having to pay the debt).

extends the due date for repayment by the principal debtor (a compensated surety is not released unless the extension materially increases their risk) (Choice A).

releases collateral that had secured the debt. If it is a partial release, then it releases the surety for the value of the collateral and is not a total release of the surety (Choice D).

releases the principal debtor from the obligation.

performance (eg, payment) is tendered to the creditor, even if the creditor refuses a tender of payment from the principal debtor.

Question 32

A large organization specializing in preparing federal income tax returns, Heward Jacklin (HJ) advertised that for an extra fee it would give all its tax client customers a “gold guarantee” that all returns would be accurate and that HJ would bear any costs or penalties that a customer received from the IRS. When client Chapman paid for the gold guarantee but found that HJ would not live up to its promise in that it refused to pay costs and penalties that Chapman incurred because of HJ’s errors, he was unhappy. When he found that there were hundreds of HJ tax clients across the country who had similar experiences he began to suspect that the “gold guarantee” was just a marketing ploy that HJ never intended to live up to. Which of the following is true?

A. If Chapman can prove his suspicions by a preponderance of the evidence, he can win a fraud lawsuit against HJ.
B. If Chapman can prove his suspicions with clear and convincing evidence, he can win a fraud lawsuit against HJ.
C. If Chapman can prove his suspicions with the proper level of evidence, he still will not be able to recover punitive damages from HJ.
D. None of the above.

Answer 32

B. If Chapman can prove his suspicions with clear and convincing evidence, he can win a fraud lawsuit against HJ.

Choice B: Correct! This is the appropriate burden of proof for fraud claims in civil cases

Question 33

In Year 3, Edwin Ryan bought 100 shares of a listed stock for $5,000. In June, Year 7, when the stock’s fair market value was $7,000, Edwin gave this stock to his sister, Lynn. No gift tax was paid. Lynn died in October, Year 7, bequeathing this stock to Edwin, when the stock’s fair market value was $9,000. Lynn’s executor did not elect the alternate valuation. What is Edwin’s basis for this stock after he inherits it from Lynn’s estate?

A. $0
B. $5,000
C. $7,000
D. $9,000

Answer 33

B. $5,000

A special rule applies if a decedent (Lynn) acquires appreciated property as a gift within one year of death, and this property passes to the donor (Edwin) or donor’s spouse. Then the donor’s (Edwin’s) basis is the basis of the property in the hands of the decedent (Lynn) before death. Since Lynn had received the stock as a gift, Lynn’s basis before death ($5,000) becomes the basis of the stock to Edwin.