Tax Ch 8 Flashcards by John Mussman

COMMON LOSS LIMITATIONS AND DISALLOWANCES
* Public policy limitations
* Political contributions
* Excessive compensation
* Hobby losses
* Rental of vacation homes
* Personal expenditures

How well did you know this?

Not at all

Perfectly

PUBLIC POLICY LIMITATIONS

Activities that violate public policy do not generate tax deductions
Penalties
Fines
Bribes and kickbacks
 Non-deductible even when customary
 Foreign Corrupt Practices Act

How well did you know this?

Not at all

Perfectly

ILLEGAL ACTIVITIES AND INCOME TAXATION

Illegal business expenses
Deductible as if business were legal
Fines and bribes still nondeductible
Trafficking in controlled substances (Drugs)
Only cost of goods sold is a deductible business expense
–Applies to trafficking marijuana where such activity is legal
according to state law

How well did you know this?

Not at all

Perfectly

INCOME DEDUCTIONS: ILLEGAL GAMBLING OPERATION:
EXAMPLE

Edna runs an illegal gambling operation in the back room of her meat
packing firm. Edna received $750,000 in gross receipts from the gambling operation.
The pro rata portion of rent Edna paid for the space used for the gambling operation was $40,000.
Edna paid her employees $250,000 to run the operation, and incurred $20,000 in product costs (cards, chips, dice, etc.).
Edna’s income from the gambling operation is $440,000 ($750,000 in gross receipts less $250,000 in salaries, $40,000 for rent, and $20,000 for product costs)

How well did you know this?

Not at all

Perfectly

NCOME DEDUCTIONS: ILLEGAL DRUG OPERATION:
EXAMPLE

Fred supplements his income by running an illegal drug procurement and distribution business. Fred received $750,000 in gross receipts from the illegal drug business.
Fred paid $40,000 in rent for the space used to store and package the
drugs.
Fred paid his employees and street pushers $250,000 to run the operation and incurred $150,000 in product costs (costs of drugs sold) plus incidental expenses of $20,000.
Fred’s taxable income from the drug operation is $600,000 ($750,000 in gross receipts less $150,000 cost of goods sold).

How well did you know this?

Not at all

Perfectly

POLITICAL AND LOBBYING EXPENDITURES

General Rule:
No business or personal deduction is allowed for political contributions
or lobbying
Deductions are allowed for lobbying:
To monitor legislation, and
De minimis in-house expenses (limited to $2,000)
–If greater than $2,000, none can be deducted

How well did you know this?

Not at all

Perfectly

EXCESSIVE EXECUTIVE COMPENSATION

For publicly held corporations:
CEO, principal financial officer (and anyone who holds one of these
positions at any time during the taxable year) and the three highest
compensated executives’ salaries are deductible up to $1 million each
Does not include:
Payments to qualified retirement plans
Payments excludible from gross income

How well did you know this?

Not at all

Perfectly

HOBBY ACTIVITY

Activity not entered into for profit
Personal pleasure associated with activity
Examples:
– Raising dogs
– Raising horses
– Sailboat racing
–Gardening
Sometimes difficult to determine if an activity is profit motivated or a hobby
Regulations provide nine factors to consider in making this
determination
TCJA 2017 suspends all miscellaneous itemized deductions subject to the 2% floor from 2018-2025. Consequently, hobby expenses are not deductible during this period

How well did you know this?

Not at all

Perfectly

PROFIT PURSUIT FACTORS

Manner activity is managed
Time and effort expended
Expertise of taxpayer and advisors
Taxpayer’s success in similar activities
History of profit/loss in similar activities
Amount of occasional profits generated
Expectation that assets will increase in value
Financial status of taxpayer
Whether personal pleasure dictates involvement

How well did you know this?

Not at all

Perfectly

PRESUMPTIVE RULE OF SECTION 183

If activity shows profit in 3 out of 5 years (2 out of 7 years for horses), presumption is that taxpayer has profit motive.
Rebuttable presumption
Shifts burden of proof to IRS to show that the taxpayer did not have a profit motive.
Otherwise, taxpayer has burden to prove profit motive

How well did you know this?

Not at all

Perfectly

HOBBY VS. FOR PROFIT ACTIVITIES

Hobby Activity
* Income is included above the line
* Expenses (after 2025)
* Allowed only to extent of income
* Deducted below the line (after 2025)
* Subject to the 2% floor
* Unless deductible without regard to profit motive (such as
mortgage interest & taxes)

Profit Activity
* Deduct expenses above the line
* At-risk and passive loss rules
may apply

How well did you know this?

Not at all

Perfectly

CLASSIFICATION OF RENTAL REAL ESTATE ACTIVITIES

Types of Rental Real Estate
Non-taxable rental use
Primarily rental use
Mixed use
Personal Use Real Estate Tax Rules Differ
Personal residences
Second homes

How well did you know this?

Not at all

Perfectly

RENTAL USE CLASSIFICATION

How well did you know this?

Not at all

Perfectly

NONTAXABLE RENTAL ACTIVITY
* Rental for less than 15 days
* Income is realized, but not recognized
* No expenses may be claimed
* Mortgage interest and property taxes (up to $10,000) treated as
personal expenses may be claimed on Schedule A (Itemized
Deductions

How well did you know this?

Not at all

Perfectly

PRIMARILY RENTAL USE ACTIVITY

Characteristics
* Rented for more than 14 days
* Personal use is less than the greater of:
–14 days
– 10% of rental days

Tax Consequences
* Income is recognized
* All allocable expenses are deductible, even if it results in a loss
* Ability to claim loss may be limited by passive activity rules

How well did you know this?

Not at all

Perfectly

MIXED-USE ACTIVITY
Characteristics
* Rented for more than 14 days
* Personal use exceeds the greater of:*
–14 days, or
– 10% of rental days

Tax Consequences
* Income is recognized
* Allocable expenses are deductible to extent of income
– Tiered deduction rules apply
–Unused expenses can be carried forward

*Days of use by family members paying less than fair rental value are
treated as personal use days.

How well did you know this?

Not at all

Perfectly

RENTAL VACATION HOME EXAMPLE (1 OF 3)

José spends relatively little time at his beach home and rents the home out for 200 days during the year. Identify if the rental activity will be classified as a rental or mixed-use activity.

How well did you know this?

Not at all

Perfectly

RENTAL VACATION HOME EXAMPLE (2 OF 3)

Erika spends relatively little time at her mountain cabin and rents it out for 100 days during the year. Identify if the rental activity will be classified as a rental or mixed-use activity.

How well did you know this?

Not at all

Perfectly

RENTAL VACATION HOME EXAMPLE (3 OF 3)

Expense Allocation (Personal v. Rental)
Mortgage interest and taxes
 IRS requires allocation based on total days used
 Courts have allowed allocation based on days in year (365)
Other expenses allocated based on total days used

How well did you know this?

Not at all

Perfectly

PERSONAL EXPENDITURES

Generally, not deductible
Some exceptions apply, usually associated with public policy concerns
Interest and taxes on personal residence and one additional home

How well did you know this?

Not at all

Perfectly

LIMITATIONS OF SPECIFIC DEDUCTIONS
* Bad debts
* Worthless securities
* Section 1244 stock
* Losses of individuals
* Research and experimental expenditures
* Net operating losses (NOLs)
* Depreciation

How well did you know this?

Not at all

Perfectly

LIMITATIONS ON BAD DEBTS

Business Bad Debts
* Only deductible if accrual method of accounting is used
* Generally required to use specific charge-off method in year the debt
becomes partially or wholly worthless
* Some businesses can use the reserve method

Nonbusiness Bad Debts
* Specific charge-off method must be used
* Allowed only when debt is wholly worthless
* Always treated as short-term capital loss, regardless of the holding
period
* Related party debts are suspect, and are usually treated as gifts

How well did you know this?

Not at all

Perfectly

CLASSIFICATIONS OF BAD DEBTS
* Determination of whether bad debt is business or nonbusiness is made
at the time debt is created.
* Individuals have nonbusiness bad debts unless:
–In the business of loaning money, or
– Bad debt is associated with the individual’s trade or business

How well did you know this?

Not at all

Perfectly

WORTHLESS SECURITIES

Loss deduction allowed for securities that become worthless during the year.
Artificial Sale Date: Last day of the year in which the securities became worthless
For individuals (cash-basis taxpayers), this is December 31st
Causes holding period to be long-term unless the security was
purchased during the year it became worthless or on the last day
of the preceding year.

How well did you know this?

Not at all

Perfectly

WORTHLESS SECURITIES: EXAMPLE

On December 1, 2022, Sharna purchased stock for $10,000. The stock became worthless on June 1, 2023.
SECTION 1244 STOCK
Stock may be classified as Section 1244 stock if:
It is held by an original investor in the company.
The initial capitalization of the company was $1 million or less.
Tax Treatment
If sold at a loss:
 The first $50,000 ($100,000 for MFJ) each year is treated as an
ordinary loss.
 Excess losses for the year follow normal capital loss rules.
Section 1244 does not apply to gains.Sharna is treated as having sold the stock on December 31, 2023. The result is a long-term capital loss

How well did you know this?

Not at all

Perfectly

SECTION 1244 STOCK: EXAMPLE

In 2019, Kasey (who is single) purchased a 20% interest in a newly
organized company, Mishka Enterprises, Inc. for $100,000. Unfortunately, the company did not succeed, and Kasey’s interest became worthless in 2024. What are the tax consequences for Kasey?

The first $50,000 of loss is treated as an ordinary loss.
Not subject to limitation
The remaining $50,000 of loss is treated as a long-term capital loss.
Kasey’s holding period was greater than 1 year.
Assuming that Kasey had no other capital transactions for the year,
she can deduct $53,000 on her 2024 income tax return.

How well did you know this?

Not at all

Perfectly

LOSSES BY INDIVIDUALS
* Generally, personal losses are not deductible.

Example: Loss on sale of personal residence is not deductible.
Individuals can deduct losses:
Incurred in a trade or business, or
Incurred in a transaction entered into for profit, or
Caused by fire, storm, shipwreck, or other casualty or by theft (if the loss resulted from a presidentially declared disaster during tax years 2018- 2025).

How well did you know this?

Not at all

Perfectly

RESEARCH AND EXPERIMENTAL EXPENSES

Costs for the development of an experimental model, plant process,
product, formula, or similar property and improvement of such existing property.
Three alternatives are available for R&E expenditures (prior to 2022)

Expense in year paid or incurred,*
Defer and amortize over period of 60 months or more (180 months for research conducted outside the United States), or
Capitalize (deductible when project abandoned or worthless).
* Credit of 20% of certain research and experiment expenditures available

*No longer available after 2021

NET OPERATING LOSSES (NOL)
* Business losses are above-the-line deductions and offset future income.
* Losses from trade or business operations, casualty and theft, or
foreign government confiscations can create an NOL.

Carryforward
NOL can be carried forward indefinitely.
NOL carryovers are allowed to be claimed in a taxable year up to
the lesser of:
The carryover amount, or
80% of taxable income determined without regard to the
deduction for NOLs (in tax years beginning in 2021 or later)
Carryback
 NOLs arising in tax years beginning in 2018, 2019, or 2020 may
be carried back up to five years
 NOLs arising in a tax year beginning in 2021 or later may not be
carried back

EXCESS BUSINESS LOSS LIMITATION

General Rule: After 2017, excess business losses are not permitted to be deducted by a non-corporate taxpayer.
Excess business losses are carried forward and add to a taxpayers
NOL.
The “excess” loss is the amount over $305,000 ($610,000 for joint
return) in 2024

DEPRECIATION

Allowed for assets used in:
A trade or business
An activity for the production of income
Represents return of capital
Basis is returned to the owner over the useful life of the asset.
Personal assets and land are not depreciated.
Basis is returned to the owner when the property is sold.

RETIREMENT PLAN PENALTIES

Excess IRA Contributions Penalty (Too Much)
6% excise tax for contributing too much
If corrected by due date of return, does not apply
Early Distribution Penalty (Too Early)
10% excise tax for taking early distribution
25% for SIMPLE plan distributions within 2 years of entry
Exceptions apply
Late Distribution Penalty (Too Late)
25% excise tax for not taking enough
Must take distributions beginning at age 72, 73, or 75. depending on
select years found in SECURE 2.0 Act

EARLY DISTRIBUTION PENALTY EXCEPTIONS

Both Qualified Plans & IRAs
* Death
* Attainment of age 59½
* Disability
* Substantially equal periodic payments (Section 72(t))
* Medical expenses that exceeds 7.5% of AGI
* Tax levy
* Qualified distribution up to $5,000 for birth or adoption

__________________________
Only IRAs
* Higher education expenses
* First time home purchase (up to $10,000)
* Health insurance for unemployed
* Distributions of earnings from corrective distributions of excess
contributions
__________________________
Only Qualified Plans
* QDRO or state order under divorce*
* Attainment of age 55 and separation from service
* Public safety employee separated from service after age 50 or 25
years of service under the plan

OTHER LOSS DISALLOWANCE

Temporarily Disallowed
–Section 1031 Exchanges
–Wash Sales
___________________________
Permanently Disallowed
Related Party Transactions
Gifts Below Fair Market Value
Loss on Sale of Personal Residence

Losses related to wash sales are temporarily disallowed.

a. True b. False

TRUE

Losses incurred in related party transactions are permanently disallowed.

a. True b. False

TRUE

All of the following expenses incurred when an individual travels from their office to a client’s place of business to discuss business matters will qualify as a business deduction, EXCEPT:

a. A $6 toll to cross the commerce bridge.
b. Mileage expense for the round trip to visit the client.
c. A $30 parking ticket for parking in a no-parking zone since no other parking spaces were available.
d. Cost of printing material for the client meeting.

correct answer is c.

Penalties and fines are never deductible business expenses, even if they are incurred in the conduct of a
trade or business. The other expenses are deductible.

Barney not only uses drugs, he also sells them to a circle of friends and associates. This year, Barney grossed $650,000 from drug sales. He paid $125,000 to his street pushers to compensate them for their services, $200,000 for the raw drugs, $30,000 for rent for the drug processing and packaging plant, and $30,000 in supplies and equipment leasing costs. How much income will be subject to tax on Barney’s income tax return?
a. $275,000.
b. $325,000.
c. $450,000.
d. $650,000.

The correct answer is c.

The salary/commission
payments to the drug pushers, rent, supplies and equipment leasing costs will not qualify as a deduction

Cobie, a single individual, is an avid coin collector. To raise some money to support her hobby, Cobie began to occasionally buy and sell coins about 10 years ago, incurring business-related expenses in those transactions. Cobie does not consider herself to be in the business of dealing in coins, and over the time she has been selling coins, she has never made a profit. This year, Cobie grossed $4,000 in sales, and had $4,500 in expenses associated with the activity. Cobie’s AGI for the year (including any inclusion due to the coin trading activity) is $50,000, and aside from the coin trading loss, her only other permissible itemized deductions are mortgage interest of $8,000 and real estate taxes of $2,500. Which of the following statements concerning this situation is correct?

a. Cobie will take the $500 loss from the coin business into her gross income.
b. Since she has never made money from the activity, she is not required to report the purchase and sale transactions on her return.
c. Cobie can offset the $4,000 in income with $4,000 of her expenses, so the coin trading activity will have no impact on her AGI.
d. The increase in Cobie’s taxable income as a result of the coin trading activity is equal to the income of $4,000

correct answer is d.

Cobie is engaging in a hobby activity.

She has never made a profit, and does not appear to have a profit motive.

Consequently, she must include all $4,000 in her gross income. She cannot deduct her hobby expenses after 2017

Ted owns a mansion built on the cliff of a large island overlooking the Atlantic ocean. Each year, an international sailing race takes place around the Island, and large corporations descend on the town, inviting clients and business associates to entertain them. Carman Corporation, a custom designer of racing sailboats, is particularly interested in this event each year, and for the week and a half of the race, they rent Ted’s mansion, paying him $200,000. At first, Ted was hesitant to rent the home, but decided that since it would only be a week and a half, he could go on vacation himself at that time. Ted incurs some costs associated with the rental, including storage charges for his valuables of $10,000, cleaning expenses before and after the rental of $8,000 and he estimates that the pro-rata portion of real estate taxes for the period of the rental is $1,000. How much income from this rental activity will be included in Ted’s AGI?

a. $0.
b. $181,000.
c. $190,000.
D $200,000

The correct answer is a.

Because the home is rented out for 14 days or less, Ted will not be required to report any income for the
rental, but he cannot deduct any expenses associated with the rental activity

Robin owns and operates an engineering consulting business as a sole proprietorship. For tax reporting, Robin uses the cash method. Last year, she provided services to a local builder, and upon completing the task she was asked to do, she sent an invoice to the builder for $5,000. The builder never paid the bill, and recently filed for bankruptcy, so Robin will not be able to collect the amount due. How should this bad debt be treated for income tax purposes?

a. No bad debt deduction is permitted.
b. Robin may deduct $5,000 from her business income.
c. Robin may deduct $5,000 as a short-term capital loss.
d. Robin may deduct $5,000 as a long-term capital loss.

The correct answer is a.

No bad debt deduction is allowed in this case because Robin is a cash basis taxpayer.

Cash basis taxpayers report and pay tax on their income when it is received, so Robin was never taxed on the $5,000 of income that she billed the builder.

If Robin’s business was accounting on an accrual basis, she would have reported and paid tax on the income last year and would be entitled to a deduction against her business income this year to reverse out the inclusion of the $5,000 of income.

Since the deduction results from a specific client failing to pay, this would have been an example of the specific charge-off method if Robin was using the accrual method of accounting.

Two years ago, Thelma purchased her dream home, paying $800,000 for the house. Unfortunately, the real estate market was at its height when she purchased the home, and has since “corrected” as interest rates began to climb. Thelma was transferred by her employer to an office across the country, and she put her home on the market, eventually selling it for $720,000. Assuming Thelma had no other capital transactions this year, which of the following statements correctly describes the income tax consequences of this transaction?

Thelma can reduce her adjusted gross income by the amount of her loss, $80,000.
Thelma can reduce her adjusted gross income by $3,000 this year.
Thelma will carry forward a $77,000 short-term capital loss.
Thelma’s AGI will not be affected in any way by the loss.

Thelma’s AGI will not be affected in any way by the loss.

Rationale

The home is a personal use asset.

It was not purchased for investment or production of income
.
While Thelma did suffer an economic loss on the home, she is not entitled to take any part of the loss as a tax deduction since the home was a personal use asset.

Which of the following statements concerning Net Operating Losses (NOL) is correct?

NOLs must be used in the current tax year to offset other income; they cannot be applied to other tax years.
NOLs can be carried back up to six years to offset income from those prior tax years.
NOLs can be carried forward indefinitely.
Prior to carrying forward NOLs, a taxpayer is required to apply the NOLs against prior-year income for at least two years.

NOLs can be carried forward indefinitely.
Rationale

NOLs can be carried forward indefinitely and cannot generally be carried back for years after 2020.

On December 1 of last year, Carla purchased 100 shares of Wooster Enterprises, Inc. (a large, publicly held company established 80 years ago that is traded on the New York Stock Exchange) common stock for $5,000. On March 1 of this year, Wooster Enterprises declared that it was bankrupt, that it will wind up operations and that all of its assets will be used to satisfy secured creditor claims so there will be no residual equity left for the stockholders.

Which of the following statements describes the tax treatment of this transaction?

Carla may deduct the $5,000 as an ordinary loss.
Carla may deduct the $5,000 investment as a short-term capital loss.
Carla may deduct the $5,000 investment as a long-term capital loss.
Carla is not permitted to take a loss deduction.

Carla may deduct the $5,000 investment as a long-term capital loss.

Rationale

Carla is not an original owner of Wooster Enterprises, so even if the company was originally capitalized with less than $1 million, Carla will not qualify for the ordinary loss deduction allowed under IRC Section 1244.

Since the company became worthless during the year, a constructive sale of the stock occurs on December 31 of this year making Carla’s holding period for the stock long-term (she purchased the stock on December 1 of the prior year).

Therefore, Carla will be able to deduct the $5,000 investment as a long-term capital loss.

No bad debt deduction is permitted.
Robin may deduct $5,000 from her business income.
Robin may deduct $5,000 as a short-term capital loss.
Robin may deduct $5,000 as a long-term capital loss.

No bad debt deduction is permitted.
Rationale

No bad debt deduction is allowed in this case because Robin is a cash basis taxpayer. Cash basis taxpayers report and pay tax on their income when it is received, so Robin was never taxed on the $5,000 of income that she billed the builder. If Robin’s business was accounting on an accrual basis, she would have reported and paid tax on the income last year and would be entitled to a deduction against her business income this year to reverse out the inclusion of the $5,000 of income. Since the deduction results from a specific client failing to pay, this would have been an example of the specific charge-off method if Robin was using the accrual method of accounting

J.J., a 45-year-old professor, was speaking with his good friend, Evan, who is 53 years old. The topic of retirement savings came up, and Evan told J.J. that individuals age 50 and over could contribute $8,000 to an IRA. J.J. did not review the laws for those younger than 50 which indicates the deduction limit to be $6,000, but, instead, contributed $8,000 also. Assuming that J.J. does not correct his error, what is the amount of the tax penalty that J.J. must pay for making the $8,000 contribution for (the current tax year) to the IRA?

$60.
Rationale

J.J. has made an excess contribution to his IRA of $1,000.

Evan was permitted to make the contribution due to the catch-up provisions for taxpayers age 50 or over.

The excess contribution penalty is 6%, so J.J. must pay a penalty tax of $60.

Ten years ago, Norm loaned his son, Cliff, $20,000 to start a business. The note required the payment of interest at a rate of nine percent for ten years, with a balloon payment of the principal at the end of the note term. Cliff has been making interest payments on the note for the past six years, but this year his business took a turn for the worse and he was not able to make the annual interest payment of $1,800. The business was closed down, and Cliff owed an amount greater than his net worth to secured creditors, so he informed his father that he would not be able to make the interest or principal payments on the note.
How should Norm treat the default for income tax purposes?

Norm may deduct $20,000 as a short-term capital loss.
Norm may deduct $21,800 as a short-term capital loss.
Norm may deduct $20,800 as a long-term capital loss.
Norm may deduct $21,800 as a long-term capital loss.

Norm may deduct $20,000 as a short-term capital loss.

Rationale

Since Norm is not in the business of making loans, the debt is classified as a non-business bad debt.
As an individual, Norm is a cash basis tax payer.
While he did lose both the principal of the loan and the current year interest payment from an economic perspective, he never included the current year interest payment in his income (because he did not receive it), and therefore cannot take a deduction for that amount.
All nonbusiness bad debts are treated as short-term capital losses regardless of the length of time the note has been outstanding, so Norm can deduct $20,000 as a short-term capital loss.

Neil runs an extortion racket in his home neighborhood. He paid Patrick $100,000 to run the street operations, and incurred $30,000 for secretarial support and $20,000 in miscellaneous expenses, such as rent for his office and supplies. Neil had gross income from the extortion ring of $400,000.

How much of the income is subject to income tax this year?

$250,000.
$270,000.
$300,000.
$400,000.

250,000.

Rationale

Even though Neil is running an illegal business, the income from the activity is subject to income tax. Neil is entitled to deduct all reasonable and necessary expenses associated with the production of the income, including salaries and costs incurred in business operation

Stella owns a beach home, which is her second home, in a national resort area. Since this home is only a vacation home, and she can generate substantial cash flow by renting the property, Stella lists the property with a real estate agent who successfully rents the property for 12 weeks a year. Stella and her family use the home for the entire month of September, for two weeks in January, and for two weeks in May each year. If Stella’s gross rental income from the property is $60,000, and she has $75,000 of expenses (mortgage interest, real estate taxes, brokerage fees, and miscellaneous expenses) associated with the rental activity,
which of the following statements is correct?

Stella will be able to take a deduction for expenses limited to $60,000.

Stella will report a $15,000 loss on the property for tax purposes this year.

The $15,000 loss on the property is suspended under the passive activity rules.

By increasing Stella’s AGI, the inclusion of the income could result in the loss of some of Stella’s otherwise allowable itemized deductions.

Stella will be able to take a deduction for expenses limited to $60,000.

Rationale

This is a mixed-use property, since the property was rented out for more than 14 days (12 weeks), and Stella used the property for more than 14 days (8 weeks) (10 percent of the rental days, in this example, would only be 8.4 days). Therefore, Stella must include the rental income, but is permitted to deduct expenses to the extent of the income generated from the activity as a production of income expense, which directly offsets gross income (is an above-the-line deduction). Therefore, there will be no increase in Stella’s AGI or taxable income for the year. The $15,000 of additional expenses that would otherwise have generated a loss are not deductible, so there is no loss that can be suspended under the passive activity rules. Since the expenses are deducted as above-the line deductions, the income will not reduce itemized deductions since it will not increase AGI.

Woody, a married individual who files jointly with his spouse, is one of the founders and original shareholders of Brittania Yacht Charters, Inc., a company that charters yachts for corporate events. The company was initially capitalized with $200,000, and Woody was a 50 percent owner. The company was structured as a C corporation, and all filing requirements and permissible tax elections that could benefit the taxpayers were made at the time the company was created. After several years of successful operations, Brittania Yacht Charters, Inc. lost market share to large national firms, and eventually closed down operations. Since it had no assets other than the goodwill of the business after all secured creditors were paid, there was nothing left to distribute to the shareholders. Assuming that there were no changes to Woody’s ownership interest in Brittania Yacht Charters, Inc. over his period of ownership, and that Woody had no other capital transactions in the current tax year, what portion of Woody’s loss on his investment in Brittania Yacht Charters can he deduct against ordinary income this year?

$0.
$3,000.
$50,000.
$100,000.

$100,000.
Rationale

Woody’s initial investment in the company was $100,000 and the stock was Section 1244 stock in his hands.

He is married and files a joint tax return with his spouse, so the entire loss of $100,000 is deducted against ordinary income this year.

Since the entire loss is treated as an ordinary loss for tax purposes, there is no additional capital loss on the transaction.

All of the following expenses incurred when an individual travels from his office to a client’s place of business to discuss business matters will qualify as a business deduction, except:

A $6 toll to cross the commerce bridge.
Mileage expense for the round trip to visit the client.
A $30 parking ticket for parking in a no-parking zone since no other parking spaces were available.
Cost of printing material for the client meeting.

A $30 parking ticket for parking in a no-parking zone since no other parking spaces were available.
Rationale

Penalties and fines are never deductible business expenses, even if they are incurred in the conduct of a trade or business. The other expenses are deductible.

Barney not only uses drugs, but he also sells them to a circle of friends and associates. This year, Barney grossed $650,000 from drug sales. He paid $125,000 to his street pushers to compensate them for their services, $200,000 for the raw drugs, $30,000 for rent for the drug processing and packaging plant, and $30,000 in supplies and equipment leasing costs.
How much income will be subject to tax on Barney ’s income tax return?

$275,000.
$325,000.
$450,000.
$650,000.

450,000.
Rationale

Since Barney is conducting a drug related business, he is only permitted to deduct from his gross income the cost of goods sold when determining the amount of income subject to tax. The salary/commission payments to the drug pushers, rent, supplies and equipment leasing costs will not qualify as a deduction.

One year ago, Wilona, age 55, changed jobs and now works for a company that offers a SIMPLE plan to its employees. Each year, the company makes a non-contributory contribution of two percent of an employee’s salary to the account of each participant. Wilona’s daughter is getting married this year, and she needed some extra funds to help pay the expenses associated with the wedding. Wilona took a $4,000 distribution from the SIMPLE Plan. What is the amount of the tax penalty that Wilona must pay for taking the distribution from the SIMPLE plan?

$0.
$360.
$400.
$1,000.

$1,000.
Rationale

Since Wilona took an early distribution from a SIMPLE plan within 2 years of initially participating in the plan, the penalty is 25% of the amount of the distribution. Wilona must pay a $1,000 tax penalty in addition to regular income tax on the $4,000 distribution.

Which of the following statements concerning the tax deductibility of executive compensation is correct?

Publicly traded companies may not deduct compensation payments made to any employees to the extent that the employee’s compensation exceeds $1 million.

The compensation cap applies to all compensation (cash and non-cash) received by the executive in the taxable year.

Contributions to qualified retirement plans and benefits that would not otherwise be taxable are not considered to be compensation subject to the $1 million cap.

Private companies may elect to apply the deductibility cap for compensation to only the top five officers of the company.

Contributions to qualified retirement plans and benefits that would not otherwise be taxable are not considered to be compensation subject to the $1 million cap.

Rationale

The limitation on deductibility of executive compensation only applies to the CEO, the CFO, and the three highest compensated executives (note: beginning in 2027 the limitation will also apply to the next 5 highest paid employees). It generally does not apply to private (non-publicly traded) companies. When applying the $1 million deduction cap, contributions to qualified retirement plans are not considered to be part of the executive’s compensation.