Tax 8-8,9,10 Tax Traps, Penalties & Penalty Taxes

Question 1

Tax Traps, Penalties and Penalty Taxes

Name each of the following tax traps:

The substance of a transaction and not merely its form governs its tax consequences.

a. substance over form
b. assignment of income
c. reallocation of income
d. constructive ownership of stock
e. step transaction
f. hobby loss
g. discharge of indebtedness
h. sham transaction

8-8,9,10

Answer 1

substance over form

Question 2

Tax Traps, Penalties and Penalty Taxes

Name each of the following tax traps:

Income is taxed to the tree that grows the fruit, even though it may be assigned to another prior to receipt.

a. substance over form
b. assignment of income
c. reallocation of income
d. constructive ownership of stock
e. step transaction
f. hobby loss
g. discharge of indebtedness
h. sham transaction

8-8,9,10

Answer 2

assignment of income

Question 3

Tax Traps, Penalties and Penalty Taxes

Name each of the following tax traps:

The IRS may reallocate items among taxpayers to “clearly reflect income.”

a. substance over form
b. assignment of income
c. reallocation of income
d. constructive ownership of stock
e. step transaction
f. hobby loss
g. discharge of indebtedness
h. sham transaction

8-8,9,10

Answer 3

reallocation of income

Question 4

Tax Traps, Penalties and Penalty Taxes

Name each of the following tax traps:

The stock owned by one person may be attributed to another related person.

a. substance over form
b. assignment of income
c. reallocation of income
d. constructive ownership of stock
e. step transaction
f. hobby loss
g. discharge of indebtedness
h. sham transaction

8-8,9,10

Answer 4

constructive ownership of stock

Question 5

Tax Traps, Penalties and Penalty Taxes

Name each of the following tax traps:

The various steps of a multiple-step transaction may be collapsed, and the entire transaction taxed as if it took place in a single step.

a. substance over form
b. assignment of income
c. reallocation of income
d. constructive ownership of stock
e. step transaction
f. hobby loss
g. discharge of indebtedness
h. sham transaction

8-8,9,10

Answer 5

step transaction

Question 6

Tax Traps, Penalties and Penalty Taxes

Name each of the following tax traps:

A taxpayer must have a profit motive for engaging in a trade or business, or else losses will not be deductible. There is a rebuttable presumption that a profit motive exists if the activity shows net income for at least three of the past five years (two out of seven in the case of an activity which consists in major part of the breeding, training, showing, or racing of horses).

a. substance over form
b. assignment of income
c. reallocation of income
d. constructive ownership of stock
e. step transaction
f. hobby loss
g. discharge of indebtedness
h. sham transaction

8-8,9,10

Answer 6

hobby loss

Question 7

Tax Traps, Penalties and Penalty Taxes

Name each of the following tax traps:

A solvent taxpayer may have to realize income upon the forgiving of a debt by a creditor.

a. substance over form
b. assignment of income
c. reallocation of income
d. constructive ownership of stock
e. step transaction
f. hobby loss
g. discharge of indebtedness
h. sham transaction

8-8,9,10

Answer 7

discharge of indebtedness

Question 8

Tax Traps, Penalties and Penalty Taxes

Name each of the following tax traps:

Transactions that lack a business purpose and economic substance will be ignored for tax purposes.

a. substance over form
b. assignment of income
c. reallocation of income
d. constructive ownership of stock
e. step transaction
f. hobby loss
g. discharge of indebtedness
h. sham transaction

8-8,9,10

Answer 8

sham transaction

Question 9

Tax Traps, Penalties and Penalty Taxes

Name each of the following tax traps:

This may convert nontaxable receipts (such as a state tax refund) into taxable income.

a. substance over form
b. assignment of income
c. reallocation of income
d. tax benefit rule
e. step transaction
f. hobby loss
g. discharge of indebtedness
h. sham transaction

8-8,9,10

Answer 9

tax benefit rule

Question 10

Tax Traps, Penalties and Penalty Taxes

Name each of the following tax traps:

personal service corporation (Section 269A)

8-8,9,10

Answer 10

personal service corporation (Section 269A)

The IRS may reallocate income deductions and credits between a personal service corporation and its employee-owner if:

(1) the personal service corporation was formed or availed of for the principal purpose of the avoidance or evasion of federal income tax by reducing the income of—or securing the benefit of any expense, deduction, credit, exclusion, or other allowance for—any
employee-owner that would not otherwise be available; and

(2) the personal service corporation performs substantially all its services for or on behalf of one other corporation, partnership, or other entity.

Question 11

Tax Traps, Penalties and Penalty Taxes

Describe the procedure for calculating the dollar amount of each of the following penalties.

20% of the deficiency attributable to _____

a. negligence
b. fraud (civil)
c. failure to file
d. failure to pay
e. substantial understatement of tax liability

8-8,9,10

Answer 11

The negligence penalty is 20% of the deficiency attributable to negligence

negligence

Question 12

Tax Traps, Penalties and Penalty Taxes

Describe the procedure for calculating the dollar amount of each of the following penalties.

75%

a. negligence
b. fraud (civil)
c. failure to file
d. failure to pay
e. substantial understatement of tax liability

8-8,9,10

Answer 12

The civil fraud penalty is 75% of the deficiency attributable to fraud.

fraud (civil)

Question 13

Tax Traps, Penalties and Penalty Taxes

Describe the procedure for calculating the dollar amount of each of the following penalties.

5% of the tax due for each month the return is late, up to a maximum of 25%. The minimum penalty is the lesser of $135 or 100% of the tax, if the return is more than 60 days late.

a. negligence
b. fraud (civil)
c. failure to file
d. failure to pay
e. substantial understatement of tax liability

8-8,9,10

Answer 13

The failure to file penalty is 5% of the tax due for each month the return is late, up to a maximum of 25%. The minimum penalty is the lesser of $135 or 100% of the tax, if the return is more than 60 days late.

failure to file

Question 14

Tax Traps, Penalties and Penalty Taxes

Describe the procedure for calculating the dollar amount of each of the following penalties.

0. 5% of the tax due for each month that the tax is unpaid.
   a. negligence
   b. fraud (civil)
   c. failure to file
   d. failure to pay
   e. substantial understatement of tax liability

8-8,9,10

Answer 14

The failure to pay penalty is 0.5% of the tax due for each month that the tax is unpaid.

failure to pay

Question 15

Tax Traps, Penalties and Penalty Taxes

Describe the procedure for calculating the dollar amount of each of the following penalties.

The penalty is 20% of the _____

a. negligence
b. fraud (civil)
c. failure to file
d. failure to pay
e. substantial understatement of tax liability

8-8,9,10

Answer 15

The penalty is 20% of the understatement.

substantial understatement of tax liability

Question 16

Tax Traps, Penalties and Penalty Taxes

What amounts of estimated tax payments and withholding must be paid in order for an individual taxpayer to avoid the imposition of a penalty for underpayment of estimated tax?

8-8,9,10

Answer 16

Total withholding and estimated tax payments generally must total at least the lesser of:

90% of the taxpayer’s current year tax liability, or

100% of the individual’s tax for the prior year, as long as a return showing a tax liability was filed for the prior year and the prior year was a period of 12 months. (If the prior year AGI exceeded $150,000, the 100% is replaced by 110%.)

Question 17

Tax Traps, Penalties and Penalty Taxes

Jim Greene’s 2015 income tax return, which was for a full year, showed an AGI of $140,000 and a tax liability of $30,000. He estimates his 2016 tax to be $35,000 and his total wage withholding to be $20,000.

What minimum amount of estimated tax payments must Jim pay (in equal quarterly installments) for 2016?

8-8,9,10

Answer 17

Jim should pay $10,000 of estimated tax payments for the year— these are required to be paid in equal quarterly installments. The amount withheld ($20,000) is compared to the lesser of

(1) 90% of the 2016 tax ($31,500)

or

(2) 100% of the 2015 tax ($30,000)

Question 18

Tax Traps, Penalties and Penalty Taxes

Identify the potential tax trap involved in each of the following situations.

Mike Barton is engaged in the business of breeding racehorses on a parttime basis as a sole proprietor. He has lost a significant amount of money in this business every year for the last 10 years and has used these losses to reduce his tax liability on the $300,000 per year he earns in income from his medical practice

a. personal holding company rules
b. unreasonable compensation doctrine
c. substance over form doctrine
d. accumulated earnings tax
e. assignment of income doctrine
f. hobby loss rules

8-8,9,10

Answer 18

The hobby loss rules would likely disallow a loss in this situation.

Question 19

Tax Traps, Penalties and Penalty Taxes

Identify the potential tax trap involved in each of the following situations.

Bob Morovich owns certain income-producing property. Bob retains ownership of the property, but he directs that the income be paid to his son. The income is, in fact, paid directly to the son, who reports it as a part of his taxable income. Bob does not report the income on his tax return.

a. personal holding company rules
b. unreasonable compensation doctrine
c. substance over form doctrine
d. accumulated earnings tax
e. assignment of income doctrine
f. hobby loss rules

8-8,9,10

Answer 19

The assignment of income doctrine would cause the income to be taxable to Bob. One cannot give away the income from an asset while retaining ownership of the asset.

Question 20

Tax Traps, Penalties and Penalty Taxes

Identify the potential tax trap involved in each of the following situations.

Owen Downey is the sole shareholder, director, and president of a small but profitable corporation. Rather than taking a salary, Owen arranges to have the corporation loan him the money he needs. Owen does not intend to repay the debt. Since Owen borrowed the money, he reports no income.

a. personal holding company rules
b. unreasonable compensation doctrine
c. substance over form doctrine
d. accumulated earnings tax
e. assignment of income doctrine
f. hobby loss rules

8-8,9,10

Answer 20

The substance over form doctrine would likely cause recharacterization from a loan to a salary, which is the substance of the transaction.

Question 21

Tax Traps, Penalties and Penalty Taxes

Identify the potential tax trap involved in each of the following situations.

Richard Keller is a college professor who has a consulting business on the side that he runs as a C corporation. He lives off his teaching salary and has never withdrawn any salary or issued dividends from the consulting practice, preferring to save the money within the corporation; he intends to withdraw it upon retirement. The corporation currently has retained earnings and profits of $600,000.

a. personal holding company rules
b. unreasonable compensation doctrine
c. substance over form doctrine
d. accumulated earnings tax
e. assignment of income doctrine
f. hobby loss rules

8-8,9,10

Answer 21

The accumulated earnings tax may be imposed at a rate of 20% on the amount of unreasonable, or excess, accumulations. As a service-type business, the corporation may accumulate $150,000 of earnings and profits (E and P) without having to prove a valid
business purpose.

Question 22

Tax Traps, Penalties and Penalty Taxes

Identify the potential tax trap involved in each of the following situations.

Donald Mavis is the sole shareholder of a C corporation. The corporation is not actively engaged in a trade or business; it receives all of its income in the form of dividends, interest, and royalties from investments. The corporation reinvests all of this income and does not distribute it to Donald.

a. personal holding company rules
b. unreasonable compensation doctrine
c. substance over form doctrine
d. accumulated earnings tax
e. assignment of income doctrine
f. hobby loss rules

8-8,9,10

Answer 22

The personal holding company rules would come into play, as all of the income is investment income. This would cause a 20% penalty tax to be levied on the personal holding company income.

Question 23

Tax Traps, Penalties and Penalty Taxes

Identify the potential tax trap involved in each of the following situations.

Jack Smith owns 60% of the stock of SK Investment Corporation, and Paul Kuttner owns 40%. SK invests in raw land. Because of the nature of the business, neither Jack nor Paul is required to perform any regular services, and they only occasionally evaluate a parcel of land for acquisition. SK sells a parcel of land in a transaction that results in a $1 million taxable gain. To avoid tax at the corporate level, SK pays Jack a salary of $600,000 and pays Paul a salary of $400,000. SK thus takes a salary deduction equal to its gross income, causing its taxable income to be zero.

a. personal holding company rules
b. unreasonable compensation doctrine
c. substance over form doctrine
d. accumulated earnings tax
e. assignment of income doctrine
f. hobby loss rules

8-8,9,10

Answer 23

The unreasonable compensation doctrine likely would come into play here. The IRS may deem the salary to be unreasonable and treat the excess salary as a constructive dividend. This is more likely due to the salaries being proportionate to the ownership interests.

Question 24

Tax Traps, Penalties and Penalty Taxess

Module Check

10. Which one of the following economic substance doctrines deals with determining whether or not a taxpayer retains control over the “tree” and is thus taxed or not taxed on its “fruit”?
11. the constructive receipt doctrine
12. the tax benefit rule doctrine
13. the assignment of income doctrine
14. the sham transaction doctrine

(LO 8-8)

Answer 24

3. the assignment of income doctrine

The assignment of income doctrine attributes funds to a taxpayer according to whether he or she has control over the source of the income. The assignment of income doctrine is sometimes referred to as the “fruit and the tree” doctrine.

The constructive receipt doctrine requires a taxpayer to recognize income when he or she has control over the funds, regardless of whether the funds are actually received or not.

Under the tax benefit rule doctrine, certain types of nontaxable income, typically refunds or reimbursements, may become taxable if a prior year tax deduction created a tax benefit.

The sham transaction doctrine requires that a transaction must be real and bona fide and not be lacking in actual economic substance.

Question 25

Tax Traps, Penalties and Penalty Taxes

Module Check

11. Which one of the following is not a tax trap that is likely to affect the owners of closely held businesses?
12. the personal holding company tax
13. the accumulated earnings tax
14. the hobby loss provision
15. the constructive receipt doctrine

(LO 8-8)

Answer 25

4. the constructive receipt doctrine

The constructive receipt doctrine typically affects individual taxpayers, although it may impact small businesses as well.

Question 26

Tax Traps, Penalties and Penalty Taxes

Module Check

12. Which one of the following statements correctly defines negligence as it applies to imposition of the negligence penalty?
13. Negligence is bad faith conduct by a taxpayer who has intent to evade paying income tax.
14. Negligence is intentional conduct by a taxpayer to avoid paying income tax.
15. Negligence is a failure to make a reasonable attempt to comply with provisions of the Internal Revenue Code.
16. Negligence is an intentional disregard of the provisions of the Internal Revenue Code that results in a substantial underpayment.

(LO 8-8)

Answer 26

3. Negligence is a failure to make a reasonable attempt to comply with provisions of the Internal Revenue Code.

Negligence is defined as a disregard of the tax laws and regulations, but without intent to defraud.

Fraud is defined as bad faith conduct by a taxpayer with intent to evade paying income tax.

Taxpayers who substantially underpay the income tax they owe are subject to the substantial underpayment penalty.

Question 27

Tax Traps, Penalties and Penalty Taxes

Module Check

23. Which one of the following is not an economic substance doctrine?
24. the step transaction doctrine
25. the substance over form doctrine
26. the comparative income doctrine
27. the assignment of income doctrine

(LO 8-8)

Answer 27

3. the comparative income doctrine

The comparative income doctrine (a made-up term) is not an economic substance doctrine.

Question 28

Tax Traps, Penalties and Penalty Taxes

Module Check

28. ABC Corporation has the following items of income and expense.

Taxable Income = $300,000

Federal Income Tax = $80,000

Dividends Paid (all in current year) $40,000

Accumulated Earnings and profits at end of preceding tax year $160,000

Assume that XYZ Corporation is not a personal service corporation and cannot establish a valid business purpose for the excess accumulations. What is the amount, if any, of the accumulated earnings tax payable?

$0

$6,000

$18,000

$26,000

(LO 8-9)

Answer 28

$18,000
  $300,000 Taxable Income
- $80,000 Federal Income Tax
- $40,000 Dividends Paid (all in current year) 
- $90,000 Accumulated Earnings Credit ($250,000- $160,000)
= $90,000
* 20% accumulated earnings tax rate
= $18,000 Accumulated Taxable Income

The accumulated earnings credit is the $250,000 accumulation limit minus accumulated earnings and profits at the end of the preceding tax year.

Question 29

Tax Traps, Penalties and Penalty Taxes

Module Check

30. Which one of the following statements regarding common tax traps is not accurate?
31. A transaction is based solely on its economic form.
32. A transaction must be based on economic reality as well as economic form.
33. Tax traps may result in the unexpected recognition of income.
34. Tax traps are of particular concern to owners of closely held businesses.

8-8,9,10

(LO 8-8)

Answer 29

1. A transaction is based solely on its economic form.

A transaction cannot be based solely on form, it must also be based on “economic reality.”

Transactions must be based on substantive law, and they must have economic substance.

Unexpected recognition of income will occur if a transaction is not based on substantive law and it does not have economic substance.

Several tax traps discussed in the materials apply to businesses.

Question 30

Tax Traps, Penalties and Penalty Taxes

Step transaction doctrine

Not every transaction has a clear beginning and end, such that it falls clearly within a particular Code section. Often, a series of transactions are involved. If each transaction is viewed separately, there is one tax result. But if the transactions are viewed together, there is a different tax result. This has led to the judicial formulation of the step transaction doctrine. Under the step transaction doctrine, a court may ignore the separate, individual transactions, choosing instead to impose tax based upon the ultimate economic reality of the entire series of transactions.

Constructive Receipt Doctrine

Reallocation of Income Doctrine

Substance over Form Doctrine

Step transaction doctrine

Assignment of income doctrine

8-8,9,10

Answer 30

step transaction doctrine

Not every transaction has a clear beginning and end, such that it falls clearly within a particular Code section. Often, a series of transactions are involved. If each transaction is viewed separately, there is one tax result. But if the transactions are viewed together, there is a different tax result. This has led to the judicial formulation of the step transaction doctrine. Under the step transaction doctrine, a court may ignore the separate, individual transactions, choosing instead to impose tax based upon the ultimate economic reality of the entire series of transactions.

Question 31

Tax Traps, Penalties and Penalty Taxes

Sham Transaction Doctrine

To be given effect for tax purposes, a purported transaction must be real and bona fide—not mere paper fiction that completely lacks substance. A transaction so lacking in substance that the court considers it a sham will be disregarded for tax purposes. For example, suppose there is a sale of property by one entity to another, both of which are controlled by the same persons. There is no business purpose for the sale, and the only motive for the sale was to recognize a tax gain or loss on the sale in a particular year. This sale will be viewed as a sham transaction, and no gain or loss will be recognized.

Constructive Receipt Doctrine

Reallocation of Income Doctrine

Substance over Form Doctrine

8-8,9,10

Answer 31

To be given effect for tax purposes, a purported transaction must be real and bona fide—not mere paper fiction that completely lacks substance. A transaction so lacking in substance that the court considers it a sham will be disregarded for tax purposes. For example, suppose there is a sale of property by one entity to another, both of which are controlled by the same persons. There is no business purpose for the sale, and the only motive for the sale was to recognize a tax gain or loss on the sale in a particular year. This sale will be viewed as a sham transaction, and no gain or loss will be recognized.

Question 32

Tax Traps, Penalties and Penalty Taxes

Substance over Form Doctrine

The substance of a transaction, rather than its “mere form,” will govern the tax consequences of a transaction. If, for example, A sells an asset to B at a loss, and B sells an identical asset to A, also at a loss, the transaction will be viewed, in substance, as a like-kind exchange and the losses will be disallowed.

Constructive Receipt Doctrine

Reallocation of Income Doctrine

Substance over Form Doctrine

8-8,9,10

Answer 32

The substance of a transaction, rather than its “mere form,” will govern the tax consequences of a transaction. If, for example, A sells an asset to B at a loss, and B sells an identical asset to A, also at a loss, the transaction will be viewed, in substance, as a like-kind exchange and the losses will be disallowed.

Question 33

Tax Traps, Penalties and Penalty Taxes

Constructive Receipt Doctrine

A cash basis taxpayer must report income in the year it is constructively received, even if it is not actually received until a later year. Income is constructively received when the taxpayer could have it if he or she wanted. Taxpayers may not turn their backs on income to defer its recognition to a later year.

Constructive Receipt Doctrine

Reallocation of Income Doctrine

Substance over Form Doctrine

Answer 33

A cash basis taxpayer must report income in the year it is constructively received, even if it is not actually received until a later year. Income is constructively received when the taxpayer could have it if he or she wanted. Taxpayers may not turn their backs on income to defer its recognition to a later year.

Question 34

Tax Traps, Penalties and Penalty Taxes

Practice Test 1

42. Assume a taxpayer is faced with a tax deficiency of $10,000, along with interest on the deficiency of $4,200; the entire deficiency is the result of negligence from the taxpayer’s 2014 return.

What is the amount of the penalty?

(LO 8-9)

Answer 34

$2,000

The negligence penalty is 20% of the amount of the deficiency attributable to negligence. 20% of $10,000 is $2,000. The interest does not enter into the computation.

Question 35

Tax Traps, Penalties and Penalty Taxes

Practice Test 1

58. ABC Corporation has the following items of income and expense:

210,000 (taxable income)
59,000 (federal income tax)
10,000 (dividends paid in current year)
190,000 (accumulated earnings and profits at the end of the preceding tax year)

Assume ABC is not a personal service corporation and cannot establish a valid business purpose for its excess accumulations.

What is the amount, if any, of accumulated earnings tax payable?

(LO 8-9)

Answer 35

$16,200

210,000 (taxable income)
- 59,000 (federal income tax)
- 10,000 (dividends paid in current year)
- 60,000 (250,000 - 190,000 accumulated earnings credit)
= 81,000
* 20% (accumulated earnings tax rate)
= 16,200

Question 36

Practice Test 2

Tax Traps, Penalties and Penalty Taxes

63. Which one of the following describes the step transaction doctrine as a potential tax trap?
    a. Items may be reallocated among taxpayers to clearly reflect income.
    b. The substance of a transaction and not merely its form governs its tax consequences.
    c. A complex transaction may be collapsed and treated as taking place in one transaction.
    d. Income is taxed to the tree that grows the fruit, even though the income is assigned to another prior to receipt.

(LO 8–8)

Answer 36

c. A complex transaction may be collapsed and treated as taking place in one transaction.

The step transaction doctrine applies in situations where the multiple steps of a typically complex transaction are reduced to one transaction that more clearly reflects the actual substance of the transaction.

Question 37

Practice Test 2

Tax Traps, Penalties and Penalty Taxes

Which of the following describes the Tax Benefit Rule?

a. Stock owned by one person may be attributed to another related person who receives the tax benefits of ownership.
b. Income is taxed to the tree that grows the fruit, even though the income is assigned to another prior to receipt.
c. A solvent taxpayer may have to realize income upon the forgiveness of a debt by a creditor.
d. Nontaxable receipts may be converted into taxable income.

(LO 8–8)

Answer 37

d. Nontaxable receipts may be converted into taxable income.

The tax benefit rule provides that a recovery or reimbursement of a previously-deducted item will cause that recovery or reimbursement to be taxable. For instance, if an insurance reimbursement is received for medical expenses, it is generally nontaxable. However, if the reimbursement was received in the year after a medical expense deduction was taken and a tax benefit was received for that deduction, then the reimbursement is converted into taxable income in that subsequent year.

Question 38

Practice Test 2

Tax Traps, Penalties and Penalty Taxes

65. Mary Griffith timely filed her 2014 income tax return, but her negligent failure to report gambling income resulted in an additional tax liability of $20,000.

What is Mary’s negligence penalty?

$1,000

$2,000

$4,000

$15,000

(LO 8–9)

Answer 38

$4,000

The negligence penalty is 20% of the deficiency due to the taxpayer’s negligence. For a $20,000 tax deficiency, 20% results in a negligence penalty of $4,000.

Question 39

Practice Test 2

Tax Traps, Penalties and Penalty Taxes

66. Gary Miller filed his current income tax return three months late. The return showed a balance due of $10,000. What is Gary’s penalty, if any, for late filing of his income tax return?

$0

$150

$1,500

$2,000

(LO 8–9)

Answer 39

$1,500

The penalty for failing to file an income tax return is 5% of the amount due for each month, or part thereof, that the return is late. Gary has filed his return three months late, which results in a 15% penalty for late filing. In this case, $10,000 × 15% (5% per month for three months) results in a penalty of $1,500.

Question 40

Practice Test 2

Tax Traps, Penalties and Penalty Taxes

67. Omega Corporation, which is not a personal service corporation, has the following items of income and expense:

$310,000 taxable income
$80,000 federal income tax
$20,000 dividends paid
$190,000 accumulated earnings and profits at the end of the prior year

Omega Corporation cannot establish a valid business purpose for excess accumulations. How much accumulated earnings tax is payable by Omega?

$30,000

$34,000

$42,000

$70,000

(LO 8–9)

Answer 40

$30,000

The accumulated earnings tax applies to corporate accumulated earnings in excess of $250,000 for which there is no valid business reason for accumulating the funds. Expenses otherwise not allowed in computing the corporate income tax are allowed in computing the accumulated earnings tax, as is summarized in the following:

  $310,000 taxable income
- $80,000 federal income tax 
- $20,000 dividends paid
= $210,000
- $60,000 accumulated earnings credit
= $150,000
* 20% accumulated earnings tax rate
= $30,000

The accumulated earnings credit is $250,000 (or in the case of a personal service company, $150,000), reduced by the accumulated earnings and profits at the end of the preceding tax year. The 20% rate is the highest tax rate for qualified dividends.

Question 41

Practice Test 2

Tax Traps, Penalties and Penalty Taxes

68. Kevin Frazier is a college professor who has an accounting business on the side that he runs as a C corporation. He lives entirely off his teaching salary and has never withdrawn any salary or dividend from the accounting practice, preferring to save the money within the corporation (from which it will be withdrawn upon retirement). The corporation currently has retained earnings and profits of $500,000.

With which one of the following should Kevin be most concerned?

unreasonable compensation

ownership attribution

assignment of income

accumulated earnings tax

(LO 8–10)

Answer 41

accumulated earnings tax

In addition to the income tax, corporations are taxed on earnings that are accumulated and not distributed to shareholders when a valid business purpose does not exist for the accumulation. An exemption of $150,000 is allowed to C corporations that are considered personal service corporations. An accumulation of $500,000 would potentially subject the corporation to an accumulated earnings tax of 20% on the $350,000 accumulated in excess of the exemption amount.

Question 42

43. Joe Jones, a successful trial attorney, also races stock cars professionally. Joe has never won a race, but because he races the professional circuit, he claims to be in the business of racing and thus has been deducting the cost of maintaining his cars and crew from his income from practicing law.

If the IRS disallows this loss, it will most likely be because of the

sham transaction doctrine.

substance over form doctrine.

hobby loss rules.

tax benefit rule.

(LO 8-10)

Answer 42

hobby loss rules.

The tax rule(s) most likely to be applied in this situation are the hobby loss rules, which state that the taxpayer must have a profit motive in the activity in order to deduct losses from the activity.

Question 43

44. What percentage of current-year estimated tax payments and withholding must be paid by a married taxpayer to avoid the imposition of a penalty for underpayment of estimated tax? (Assume that the taxpayer had AGI in the prior year of $110,000.)

80%

90%

100%

110%

(LO 8–8)

Answer 43

90%

The current-year exception for avoiding estimated tax penalties is 90% of the current year’s tax. The other exceptions, 100% of the prior year’s tax and 110% of the prior year’s tax (for taxpayers with a 2014 AGI greater than $150,000), are each based on prior liability rather than current liability. Note that the 110% requirement for 2016 estimated payments applies only if the 2015 AGI exceeds $150,000.

Question 44

50. Gil White owns a portfolio of income-producing real estate. Gil retains ownership of the real estate but directs that the rental income be paid to his son, Kevin. The income is paid directly to Kevin, who reports it as part of his taxable income. Gil does not report the income on his tax return.

With which one of the following potential tax traps should Gil be most concerned?

ownership attribution rules

substance over form

constructive receipt

assignment of income

(LO 8–10)

Answer 44

assignment of income

The fact that Gil retains ownership of the property and merely assigns the income to someone else is a potential tax trap for him. The assignment of income doctrine serves to tax the person who actually owns the property producing the income. The income cannot merely be assigned to another in order to generate tax advantages.