STUDY UNIT FOUR SELF-EMPLOYMENT, FARMING, AND ADJUSTMENTS

Question 1

Logan, an employee of Argon Industries, earned a salary of $60,000 in Year 2. In addition, the following two transactions between Logan and Argon occurred in Year 2: Logan received a bonus of 100 shares of publicly-traded stock worth $13,000 with a basis to Argon of $8,000, and Logan purchased 1,000 shares of unrestricted Argon stock pursuant to a nonqualifying stock option plan for $10 per share when stock was valued at $25 per share. What amount of compensation should Argon report in Logan’s Form W-2 for Year 2?

A. $93,000
B. $73,000
C. $60,000
D. $88,000

Answer 1

D. $88,000
Answer (D) is correct.
Income reported should include all amounts provided as compensation. First, the $60,000 is included as the base salary. Next, the bonus of publicly-traded stock is taken at the fair market value of $13,000. Finally, the nonqualified stock option will result in compensation equal to the difference between the FMV of the stock and the exercise price, or $15,000 [($25 FMV – $10 exercise price) × 1,000 shares]. This is a total of $88,000 ($60,000 + $13,000 + $15,000).
(4.3.41)

Question 2

Rich is a cash-basis, self-employed air-conditioning repair technician 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 earnings from self-employment?
A $13,945
B $14,100
C $14,900
D $15,100

Answer 2

A $13,945
This answer is correct.
The $20,000 gross receipts would be reduced by the $2,500 for parts, the $2,000 in advertising expense, and the $400 in telephone expense. This $15,100 is net income from self-employment. Net earnings from self-employment is net income from self-employment reduced by the employer’s portion of FICA taxes (.0765) times the taxpayer’s net income from self-employment. Thus, the $15,100 should be reduced by an additional $1,155 ($15,100 × .0765), resulting in net earnings from self-employment of $13,945.

Question 3

Marc Clay was unemployed for the entire year of 2013. In January 2014, Clay obtained full-time employment 60 miles away from the city where he had resided during the 10 years preceding 2014. Clay kept his new job for the entire year of 2014. In January 2014, Clay paid direct moving expenses of $300 in relocating to his new city of residence, but he received no reimbursement for these expenses. In his 2014 income tax return, Clay’s direct moving expenses are
A Fully deductible only if Clay itemizes his deductions.
B Deductible subject to a 2% threshold if Clay itemizes his deductions.
C Fully deductible from gross income in arriving at adjusted gross income.
D Not deductible.

Answer 3

C Fully deductible from gross income in arriving at adjusted gross income.
This answer is correct.
An employee may deduct as an above-the-line deduction in arriving at adjusted gross income the reasonable expenses of moving himself and his family from one location to another, provided that the move is related to the commencement of work in a new location. To be eligible for the deduction, the new place of work must be at least 50 miles farther from the taxpayer’s old residence than his old residence was from his old place of work. Also, the taxpayer must be employed full-time for at least 39 weeks during the 12-month period following the move. Clay may deduct the moving expenses as an above-the-line deduction to arrive at adjusted gross income.

Question 4

Kirk Bennett, a cash-basis taxpayer, is a self-employed accountant. During 2014, he established a qualified defined contribution retirement plan of which he will be the only beneficiary. In examining his records for 2014, the following information is available:
Earned income from self-employment $52,000
Interest income 6,000
Dividend income 4,000
Net long-term capital gains 10,000
Adjusted gross income $71,000

What is the maximum amount that Kirk can deduct as a contribution to his qualified retirement plan for 2014?
A $10,000
B $48,022
C $9,604
D $52,000

Answer 4

C $9,604
This answer is correct.
Under IRC, the maximum amount that can be deducted for a contribution on behalf of a self-employed individual is the lesser of $52,000 or 100% of the self-employed individual’s earned income from the trade or business. Kirk’s only income which qualifies as earned income is $52,000. One-half of the self-employment tax rate times the net earnings from self-employment reduces the earned income amount. The income is further reduced by the contribution deduction based on a 20% rate.
The maximum deduction allowed is calculated as follows:
Earned income

$52,000

Less: Self-employment tax adjustment

($52,000 × .1530 × 1/2)

(3,978)

Net earnings

$48,022

Contribution rate

× .20

Allowable deduction

$ 9,604

Question 5

The fringe benefit that must be included in wages and reported on Form W-2 is
A Contributions by your employer to provide long-term care services.
B Health or accident insurance coverage provided by your employer.
C Employer-provided parking near the place of business valued at less than $250 per month.
D Group-term life insurance coverage in excess of $50,000.

Answer 5

D Group-term life insurance coverage in excess of $50,000.
This answer is correct.
When group-term life insurance protection exceeds $50,000, the employee must include in income the premium attributable to the amount of coverage in excess of $50,000. The actual inclusion is dictated by the regulations rather than the actual additional premiums paid.

Question 6

All start-up costs of a business are deductible as they occur.
True.
False.

Answer 6

False.
Your answer is correct.
Although taxpayers may immediately deduct start-up costs, the immediate deduction is only for the taxable year in which the business begins (i.e., not just any year they occur), and the deduction is limited to $5,000. The $5,000 limit is reduced, but not below zero, by the cumulative cost of start-up costs that exceed $50,000.

Question 7

A self-employed taxpayer’s applicable FICA tax rate is equal to the rate paid by employers.
True.
False.

Answer 7

False.
Your answer is correct.
The FICA tax liability imposed on net earnings from self-employment is equal to the sum of the employer’s and the employee’s portion of FICA tax.

Question 8

Taxable income is derived from deducting above-the-line deductions from gross income.
True.
False.

Answer 8

False.
Your answer is correct.
Above-the-line deductions are deducted from gross income to arrive at adjusted gross income (AGI).

Question 9

Alimony is an above-the-line deduction.
True.
False.

Answer 9

True.
Your answer is correct.
Alimony is gross income to the recipient and deductible by the payor. Child support is neither gross income to the recipient nor deductible by the payor

Question 10

Sarah owns and operates a retail sporting goods business as a sole proprietor. Her store is located on the ground floor of a two-story building that she owns. Based on the following information regarding 2014, compute her net self-employment income (for SE tax purposes) to be put onto Schedule C for that year.
Gross profit from sporting goods business $100,000
Rental income from upper level (45%) of building 20,000
Building depreciation expense 10,000
Utilities for ground floor (Tenant pays own utilities.) 4,500
Depreciation on vehicles used in business 3,000
Gain on sale of van used 100% in business 2,000
Contributions to her Keogh retirement plan 5,500
Sarah’s health insurance premiums 4,000
Mortgage interest on building 10,000
Other expenses of running her sporting goods business 11,500
A $73,500
B $64,500
C $70,000
D $66,000

Answer 10

C $70,000

This answer is correct.
Net earnings from self-employment are gross income derived from a trade or business, less allowable deductions attributable to the trade or business. The rental income is not self-employment income since rental property is not Sarah’s ordinary course of business and she is not a real estate broker. Therefore, any rental expenses do not offset the self-employment income from the sporting goods business. Also, 100% of the health insurance premiums are deductible on Form 1040 as an adjustment but are not deducted against self-employment income. Capital gains and losses and contributions to retirement plans are not considered income or expenses for self-employment purposes. Sarah’s net self-employment income is computed as follows:
Gross profits from sporting goods business

$100,000
Building depreciation expense ($10,000 × 55%)

(5,500)
Utilities (ground floor only)

(4,500)
Listed property depreciation expense

(3,000)
Mortgage interest ($10,000 × 55%)

(5,500)
Other expenses

(11,500)

Net self-employment income

$ 70,000
View Subunit 4.2 Outline

Question 11

During the current year, a farmer paid $20,000 for an approved conservation plan to prevent erosion of farm land. If the farmer had gross receipts of $80,000 and $20,000 in costs of livestock sold, what is the farmer’s net farm profit?

A. $40,000
B. $80,000
C. $60,000
D. $45,000

Answer 11

D. $45,000
Answer (D) is correct.
Net farm profit equals gross farm income less applicable expenses. Gross farm income equals total sales less the cost of livestock sold ($60,000). The conservation cost deduction is limited to 25% of gross farm income ($15,000). The net farm profit is $45,000 ($60,000 – $15,000).
(4.4.46)

Question 12

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 2015, Optics had $350,000 in gross business receipts and its year-end inventory was not subject to the uniform capitalization rules. Baum’s 2015 adjusted gross income was $90,000 and Baum qualified to itemize deductions. During 2015, 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 2015, 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 2015, Baum collected $3,000 in insurance reimbursement and had no casualty gains during the year. 2,625
Qualified 2015 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 on January 2, 2015. 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, 2015, to acquire the home equity loan 1,400
Real estate taxes on personal residence 2,200
Estimated payments of 2015 federal income taxes 13,500
Local property taxes on the car value, used exclusively for personal use 300
What amount should Baum report as 2015 net earnings from self-employment?

A. $252,000
B. $243,250
C. $260,196
D. $273,000

Answer 12

C. $260,196
Answer (C) is correct.
The net profit or (loss) from self-employment is the gross business receipts reduced by the business expenses. The net profit or (loss) therefore should be $281,750 ($350,000 gross business receipts – $35,000 cost of goods sold – $28,000 rent expense – $5,250 liability insurance premium). Line 4 on Schedule SE requires the tax preparer to multiply the net profit or (loss) by .9235 ($281,750 × .9235 = $260,196). The net earnings from self-employment should be $260,196.
(4.2.24)

Question 13

Employee Y, who is 44 years old, is provided with $120,000 of nondiscriminatory group term life insurance by his employer. Based on the IRS uniform premium cost table, the total annual cost of a policy of this type is $1.20 per $1,000 of coverage. Y’s required contribution to the cost of the policy is $4.00 per month. Y was covered for the entire year. How much of the cost must Y include in his income?

A. $96
B. $36
C. $0
D. $84

Answer 13

B. $36
Answer (B) is correct.
Under the IRC, the cost of qualified group term life insurance paid by an employer is included in the employee’s gross income to the extent that such cost exceeds the cost of $50,000 of such insurance. The includible cost is determined on the basis of uniform premiums prescribed by regulations, rather than actual cost. Therefore, we do not need to know what the employer’s actual premiums were in order to compute the answer.

The includible cost is the total cost minus the cost of the first $50,000, minus the cost paid by the employee. Computation is below:
Total ($1.20 × 120)

$144
Less excludable portion ($1.20 × 50)

(60)
Less employee cost ($4 × 12)

(48)

Amount included in Y’s income

$ 36
(4.3.35)

Question 14

Kirk Bennett, a cash-basis taxpayer, is a self-employed accountant. During 2015, he established a qualified defined contribution retirement plan of which he will be the only beneficiary. In examining his records for 2015, the following information is available:
Earned income from self-employment $53,000
Interest income 6,000
Dividend income 4,000
Net long-term capital gains 10,000
Adjusted gross income $73,000

What is the maximum amount that Kirk can deduct as a contribution to his qualified retirement plan for 2015?

A. $53,000
B. $48,945
C. $10,000
D. $9,789

Answer 14

D. $9,789
Answer (D) is correct.
Under IRC, the maximum amount that can be deducted for a contribution on behalf of a self-employed individual is the lesser of $53,000 or 100% of the self-employed individual’s earned income from the trade or business. Kirk’s only income which qualifies as earned income is $53,000. One-half of the self-employment tax rate times the net earnings from self-employment reduces the earned income amount. The income is further reduced by the contribution deduction based on a 20% rate.
The maximum deduction allowed is calculated as follows:
Earned income

$53,000

Less: Self-employment tax adjustment

($53,000 × .1530 × 1/2)

(4,055)

Net earnings

$48,945

Contribution rate

× .20

Allowable deduction

$ 9,789
(4.5.65)

Question 15

Under a “cafeteria plan” maintained by an employer,

A. Provision may be made for deferred compensation other than 401(k) plans.
B. At least 3 years of service are required before an employee can participate in the plan.
C. Participation must be restricted to employees and their spouses and minor children.
D. Participants may select their own menu of benefits.

Answer 15

D. Participants may select their own menu of benefits.
Answer (D) is correct.
A cafeteria plan is one in which the employees may choose among their fringe benefits. Participation is restricted to the employee. There is no minimum period of employment required. Benefits that do not qualify include (1) deferred compensation plans other than Sec. 401(k) plans, (2) scholarships and fellowship grants or tuition reductions, (3) educational assistance, and (4) other fringe benefits.
(4.3.30)

Question 16

Sol and Julia Crane, both age 48, are married and filed a joint return for 2015. Sol received a distribution of $80,000 from his employer’s pension plan. In addition, Sol and Julia earned interest of $3,000 in 2015 on their joint savings account. Julia is not employed, and the couple had no other income. On January 15, 2015, Sol contributed $3,000 to an IRA for himself and $3,250 to an IRA for his spouse. The allowable IRA deduction in the Cranes’ 2015 joint return is

A. $3,000
B. $0
C. $6,250
D. $3,250

Answer 16

B. $0
Answer (B) is correct.
The allowable deduction for contributions to an IRA is limited to the lesser of $5,500 or compensation. Compensation represents earned income and does not include distributions from pension plans or interest income. Therefore, since compensation is $0, the allowable IRA deduction is limited to $0. Note that the maximum amount otherwise deductible is $5,500 for Sol and another $5,500 for the contribution for his spouse.
(4.5.50)

Question 17

Jim and Nancy Walton, both age 55, had adjusted gross income of $25,000 in 2014. During the year, they paid the following medical-related expenses:
Over-the-counter medicines $400
Prescription drugs 300
Doctor fees 830
Health club membership (recommended by
the family doctor for general health care) 800
Medical care insurance 280
How much may the Waltons use as medical expenses in calculating itemized deductions for 2014?
A $0
B $1,090
C $110
D $1,410

Answer 17

A $0
This answer is correct.
The cost of the health club membership is not included in the computation of the medical expense deduction since the cost is incurred for the purpose of improving the taxpayers’ general health, not for curing a specific ailment or disease. Only prescription drugs and insulin are deductible, so the over-the-counter medicines are not included.
Medical care insurance

$ 280
Doctor fees

830
Prescription drugs

300

Total expenses

$1,410
Less 10% of AGI

(2,500)

Allowable medical expense deduction

$ 0

Question 18

Alt Partnership, a cash-basis, calendar-year entity, began business on October 1, 2015. Alt incurred and paid the following in 2015:
Legal fees to prepare the partnership agreement

$12,000
Accounting fees to prepare the representations

in offering materials

15,000
Alt elected to amortize costs. What was the maximum amount (ignoring any immediate expensing allowed) that Alt may deduct on the 2015 partnership return?

A. $0
B. $3,000
C. $6,750
D. $200

Answer 18

D. $200
Answer (D) is correct.
Organization expenses are incurred in the formation of the partnership. The partnership may elect to amortize organization expenses over a period of not less than 180 months. The fees related to preparing the partnership agreement are organization expenses, but the expenses related to the issuance or sale of partnership interests (syndication fees) are specifically excluded. The partnership may recognize a maximum of 3 months of amortization expense this year, or $200 ($12,000 ÷ 180 × 3).
(4.1.20)