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Flashcards in Ch 6 Federal Taxation of Entities Deck (235)
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1

Elizabeth established a trust for her daughter, Anne (Trust A). The terms of the trust require that all the net income of the trust is to be distributed to Anne on an annual basis. What is the exemption amount for Trust A?

A.
$0

B.
$100

C.
$300

D.
$400

C.
$300

The exemption amount for a simple trust is $300. A simple trust is required to distribute all of its net income each year to the beneficiaries.

The exemption amount for a complex trust is $100. A complex trust is not required to distribute all of its net income each year to the beneficiaries.

2

What is the tax treatment for start-up expense incurred in May 2016?

A.
Not deductible

B.
Deduct up to $5,000; amortize the excess over 60 months

C.
Deduct up to $5,000; amortize the excess over 180 months

D.
Current deduction for all start-up expenses

C.
Deduct up to $5,000; amortize the excess over 180 months

For start-up expenses incurred after August 16, 2011, taxpayers may deduct up to $5,000 in the taxable year in which the business begins. The $5,000 amount is reduced by the amount by which the cumulative cost of start-up expenditures exceeds $50,000. Any remaining start-up expenditures not deducted are amortized over a 15-year period (180 months).

IRC Section 195

3

A sole proprietorship incorporated on January 1 and elected S corporation status. The owner contributed the following assets to the S corporation:
Basis Fair Market Value
Machinery $ 7,000 $ 8,000
Building 11,000 100,000
Cash 1,000 1,000
Two years later, the corporation sold the machinery for $4,000 and the building for $110,000. The machinery had accumulated depreciation of $2,000, and the building had accumulated depreciation of $1,000. What is the built-in gain recognized on the sale?

A.
$100,000

B.
$99,000

C.
$6,000

D.
$0

D. $0

The built-in gains tax applies to C corporations that change to an S corporation. Because this is a sole proprietorship changing to an S corporation, the built-in gains tax does not apply.

4

The adjusted basis of Smith’s interest in EVA partnership was $230,000 immediately before receiving the following distribution in complete liquidation of EVA:
Basis to EVA Fair Market Value
Cash $150,000 $150,000
Real estate 120,000 146,000

What is Smith’s basis in the real estate?
A.
$146,000

B.
$133,000

C.
$120,000

D.
$80,000

D. $80,000 (230-150)

The basis of property received in a liquidating distribution is the adjusted basis less the cash received. Smith will take an adjusted basis in the real estate of $80,000, computed as follows:
Smith’s adjusted basis prior to liquidating distribution $230,000
Less: Cash received is return of capital (150,000)
Adjusted basis allocated to real estate received $ 80,000

5

Bud Corp. is a calendar-year S corporation. Bud had ordinary income of $50,000 and interest income from a municipal bond of $10,000. During the year, Bud distributed $20,000 to Joe B, a 50% owner. What amount should Joe B include in gross income for the year?

A.
$20,000

B.
$25,000

C.
$30,000

D.
$40,000

B. $25,000 (50/0.5)

Shareholders of an S corporation report their share of S corporation income whether distributed or not. Because Joe B is a 50% owner, 50% of the ordinary income of $50,000 is taxable to him. Tax-exempt income flows through and is not taxable to Joe B. Because income is taxed to Joe when it is earned, the distribution is not a taxable event.

6

Garland Corp. contributed $40,000 to a qualified charitable organization. Garland's taxable income before the deduction for charitable contributions was $410,000. Included in that amount is a $20,000 dividends-received deduction. Garland also had carryover contributions of $5,000 from the prior year. What amount can Garland deduct as charitable contributions?

A.
$40,000

B.
$41,000

C.
$43,000

D.
$45,000

C.
$43,000

Taxable income before charitable contribution $410,000
Add back dividends-received deduction + 20,000
430,000
Multiplied by 10% x .10
Maximum charitable contribution allowed $ 43,000 *

7

George and Martha are equal partners in G&M Partnership. At the beginning of the current tax year, the adjusted basis of George's partnership interest was $32,500, which included his share of $40,000 of partnership liabilities. During the tax year, the following information applied to G&M:
Operating loss $30,000
Interest and dividend income 8,000
Partnership liabilities at end of year 24,000
What was the basis of George's partnership interest at year-end?
A.
$13,500

B.
$21,500

C.
$29,500

D.
$43,500

A. $13,500=(32.5+(8/2)-(30/2)-((40-24)/2))
The adjusted basis of a partnership interest includes the partner's share of partnership liabilities. The adjusted basis of a partnership interest is increased by non-separately stated income items as well as separately stated income items. The adjusted basis of a partnership interest is decreased by the partner's share of partnership losses.

To understand how the partnership liabilities work, you may need to subtract the partner's share of the beginning partnership liabilities ($20,000) and add the partner's share of the ending partnership liabilities ($12,000). This would result in the net decrease of $8,000 in George's share of the partnership liabilities:

George's adjusted basis at beginning of year $32,500
Add: George's share of interest and dividend income 4,000
Less: George's share of operating loss (15,000)
Less: Decrease in George's share of partnership
liabilities ($40,000 - $24,000 = $16,000; $16,000 / 2) (8,000)
George's adjusted basis at end of year $13,500

8

Alt Partnership, a cash-basis calendar-year entity, began business on March 1 of the current year. Alt incurred and paid the following this year, prior to March 1:

Legal fees to prepare the partnership
agreement $14,000
Accounting fees to prepare the
representations in offering materials 15,000

Alt elected to amortize costs. What was the maximum amount that Alt could deduct on the current-year partnership return?

A.
$0

B.
$3,000

C.
$5,500

D.
$6,750

C. $5,500=(5,000+((14,000-5,000)/180*10))

Alt Partnership can deduct $5,500 of organization costs, which consist of the legal fees to prepare the partnership agreement. The accounting fees of $15,000 are syndication fees, not organizational costs, and therefore not deductible.

For organizational expenditures incurred after August 16, 2011, taxpayers may deduct up to $5,000 in the taxable year in which the business begins. The $5,000 amount is reduced by the amount by which the cumulative cost of organizational expenditures exceeds $50,000. Any remaining organizational expenditures not deducted are amortized over a 15-year period (180 months) beginning with the month the active trade or business begins.

Total organization costs are less than $50,000, so the first $5,000 of costs is deductible. The remaining $9,000 is amortized over 180 months beginning with the month the business begins.

$5,000 + ($9,000 × (10 months ÷ 180 months)) = $5,500

9

A guaranteed payment by a partnership to a partner for services rendered may include an agreement to pay:

A. a salary of $5,000 monthly without regard to partnership income.
B. a 25% interest in partnership profits.
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

A.
I only

A guaranteed payment by a partnership to a partner for services rendered may include an agreement to pay a salary of $5,000 monthly without regard to partnership income. Payments that are calculated as a percent of partnership profits would not qualify as a guaranteed payment.

Guaranteed payments are payments to a partner for services or capital without regard to partnership income.


10

At the beginning of the year, Cable, a C corporation, had accumulated earnings and profits of $100,000. Cable reported the following items on its current-year tax return:

Taxable income $50,000
Federal income taxes paid 5,000
Charitable contributions carryforward 1,000
Capital loss carryforward 2,000

What is Cable’s accumulated earnings and profits at the end of the year?

A.
$145,000

B.
$146,000

C.
$148,000

D.
$150,000

C. $148,000=(100,000+50,000-5,000+1,000+2,000)

The basic idea behind the calculation of a corporation’s earnings and profits (E&P) is to determine the amount of “earnings” that is available to distribute as dividends.

Cable’s accumulated earnings and profits at year-end are $148,000, computed as follows:

Earnings and profits at beginning of year $100,000
Add: Taxable income 50,000
Less: Federal income taxes paid (5,000)
Add: Excess charitable contribution carryforward 1,000
Add: Excess capital loss carryforward 2,000
Cable’s accumulated E&P at year-end $148,000

The reason the excess charitable contribution carryforward and the excess capital loss carryforward are added back to taxable income is because both were deducted in a prior year to compute the beginning-of-the-year accumulated earnings and profits. This year, when the charitable contribution and capital loss are actually deducted on the tax return, they both must be added back to the calculation for accumulated earnings and profits.

11

Tapper Corp., an accrual-basis calendar-year corporation, was organized on January 2, 2016. During 2016, revenue was exclusively from sales proceeds and interest income. The following information pertains to Tapper:
Taxable income before charitable contributions for
the year ended December 31, 2016 $500,000
Tapper's matching contribution to employee-designated
qualified universities made during 2016 10,000
Board of Directors' authorized contribution to a qualified
charity (authorized December 1, 2016, made February 2, 2017) 30,000

What is the maximum allowable deduction that Tapper may take as a charitable contribution on its tax return for the year ended December 31, 2016?
A. $0

B. $10,000

C. $30,000

D. $40,000

D. $40,000=1. (500*10%)MAX 2. 10+30=40

A corporation's charitable contribution deduction each year cannot exceed 10% of its “taxable income” for the year. Taxable income means income before deducting the charitable contribution, the dividends-received deduction or net operating loss or capital loss carrybacks (only) to that year.

Also, an accrual method corporation whose Board of Directors has authorized a charitable contribution during the tax year may deduct the contribution in the authorization year, if paid within 2-1/2 months following the close of the year.

$500,000 × 10% = $50,000 Maximum Contribution Allowed in 2016.
$10,000 (Cash) + $30,000 (Paid 2/2/2016) = $40,000 Charitable Contribution allowed on its tax return for the year ended December 31, 2016.

12

Assume that the Brady Corporation had the following tax situation in Year 4:

Sum of AMT preference items $ 40,000
Total positive AMT adjustments 85,000
Total negative AMT adjustments 15,000
Regular taxable income 100,000

Determine the amount of AMT exemption that will apply to the Brady Corporation.

A.
$40,000

B.
$25,000

C.
$15,000

D.
$0

B. $25,000

Start with: Regular Taxable Income $100,000
Plus: AMT Preference Items 40,000
Plus/Minus: AMT Adjustments 70,000
Equals: AMTI $210,000

AMTI $210,000
Phaseout threshold amount (150,000)
Excess $ 60,000
x .25
Reduction in exemption $ 15,000

Allowable exemption: $40,000 − $15,000 = $25,000

The amount of the reduction of the maximum $40,000 exemption is $15,000. The $40,000 exemption must be reduced by 25% of the excess of AMTI over $150,000.

13

Graphite Corp. has been a calendar-year S corporation since its inception on January 2, Year 1. On January 1, Year 9, Smith and Tyler each owned 50% of the Graphite stock, in which their respective bases were $12,000 and $9,000. For the year ended December 31, Year 9, Graphite has $80,000 in ordinary business income and $6,000 in tax-exempt income. Graphite made a $53,000 cash distribution to each shareholder on December 31, Year 9. What total amount of income from Graphite is includible in Smith's Year 9 adjusted gross income?

A.
$96,000

B.
$93,000

C.
$43,000

D.
$40,000

D. $40,000

In an S corporation, income is taxed when earned, not when distributed, unless distributions exceed owners' share of earnings + basis. In this case, Smith gets 50% of ($80,000 taxable income + $6,000 nontaxable income). This yields a new basis of $55,000 ($12,000 beginning basis + $43,000 increase in basis = $55,000), which is greater than distributions. Thus, taxable income is limited to Smith's share of Graphite's taxable income, or 50% of $80,000. After the distribution, Smith's basis is $2,000 (basis of $55,000 reduced by a distribution of $53,000 = $2,000).

Basis at 01/01/Yr. 9 $12,000
Share of ordinary income 40,000
Share of tax-exempt income 3,000
New basis 55,000
Distribution (53,000)
Basis at 12/31/Yr. 9 $ 2,000

14

Which of the following statements is incorrect for limited liability companies (LLC)?

A.
LLCs have complete pass-through of tax attributes generated by operations.

B.
Every member is allowed to participate in an LLC.

C.
Every member of an LLC has liability protection.

D.
None of the members of an LLC have liability protection.

D.
None of the members of an LLC have liability protection.

The following three statements are all true for LLCs:

LLCs have complete pass-through of tax attributes generated by operations.
Every member is allowed to participate in an LLC.
Every member of an LLC has liability protection.
Therefore, the statement, “None of the members of an LLC have liability protection,” is incorrect as it directly contradicts the third item in the list.

15

All of the following statements concerning liquidation of an S corporation are true except:

A.
loss on stock redemption can be recognized prior to the complete liquidation of the corporation.

B.
gain or loss will be recognized on the distribution of property in complete liquidation as if the property were sold at its FMV.

C.
depreciable property under Section 1245 and 1250 is subject to the ordinary income recapture provisions.

D.
the shareholders' adjusted basis in the stock is subtracted from the FMV of the property received to determine the recognized gain or loss.

A.
loss on stock redemption can be recognized prior to the complete liquidation of the corporation.

Loss on stock redemption is not recognized until liquidation is complete.

16

“Hot assets” of a partnership would include which of the following?

A.
Cash

B.
Unrealized receivables

C.
Section 1231 assets

D.
Capital assets

B.
Unrealized receivables

The “hot assets” of a partnership include the unrealized receivables and inventory. These are the items that would generate ordinary income. Both Section 1231 assets and capital assets generate capital gains. Cash creates neither ordinary income nor capital gains.

17

For property contributed to a partnership after June 8, 1997, a partnership must hold contributed property how long before distributing it to avoid pre-contribution gain being taxed to the contributing partner?

A.
Three years

B.
Five years

C.
Seven years

D.
Four years

C.
Seven years

Under the Taxpayer Relief Act of 1997 (TRA '97), a partner who contributes appreciated property to a partnership generally recognizes pre-contribution gain in the event that the partnership distributes the contributed property to another partner, or distributes to the contributing partner other property whose value exceeds that partner's basis in his partnership interest, if the distribution occurs within seven years after the contribution to the partnership.

Similar rules applied under pre-TRA '97 law, except that the waiting period was only five years. The change generally applies for property contributed to a partnership after June 8, 1997.

18

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.

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

An application for exemption must be filed with the Internal Revenue Service (IRS) because exemption from taxation is not automatic. An entity may operate as a tax exempt organization while it is waiting for their application to be approved by the IRS, which may take up to 12 months.

19

If not expressly granted, which of the following implied powers would a trustee have?

I. Power to sell trust property
II. Power to borrow from the trust
III. Power to pay trust expenses
A.
I and II

B.
I and III

C.
II and III

D.
I, II, and III

B.
I and III

A trustee will have the power to sell trust property and the power to pay trust expenses if not expressly granted. A trustee has implied powers to carry out the extent of the trust. The trustee may sell property and pay expenses, but unless expressly granted, the trustee cannot borrow from the trust.

20

The adjusted basis of Smith's interest in the EVA partnership was $230,000 immediately before receiving the following distribution in complete liquidation of EVA:
Basis Fair
to EVA Market Value
Cash $150,000 $150,000
Real estate 120,000 146,000
What is Smith's basis in the real estate?

A.
$146,000

B.
$133,000

C.
$120,000

D.
$80,000

D. $80,000 (230-150)

Smith has an interest in the EVA partnership with an adjusted basis of $230,000. The receipt of $150,000 in cash reduces Smith's basis to $80,000 ($230,000 - $150,000 = $80,000).

Smith's remaining basis of $80,000 is the basis in the real estate received in the distribution and liquidation.

21

A Trust had rental income of $20,000 and taxable interest income of $10,000. The rents constituted 60% of DNI and taxable interest 40% of DNI. The trust distributed $6,000 of DNI to its sole beneficiary, Carl. What amount should Carl report as rental and interest income from the trust?

A.
Rental: $3,600; Interest: $2,400

B.
Rental: $3,000; Interest: $3,000

C.
Rental: $20,000; Interest: $10,000

D.
Rental: $4,000; Interest: $2,000

A. Rental: $3,600; Interest: $2,400

Carl is deemed to have received partly rental income and partly interest income. The allocation of the $6,000 is based on the percentage of DNI (distributable net income) from rentals and interest. Beneficiaries are taxed on their share of the trusts income distributed to them, but not more than their share of DNI of the trust.

22

Evan, a 25% partner in Vista Partnership, received a $20,000 guaranteed payment for deductible services rendered to the partnership. Guaranteed payments were not made to any other partner. Vista's partnership income consisted of:

Net business income before guaranteed payments $80,000
Net long-term capital gains 10,000

What amount of income should Evan report from Vista Partnership on her tax return?

A.
$37,500

B.
$27,500

C.
$22,500

D.
$20,000

A. $37,500 =(80-20)*25%+20+25%*10

Evan should report $37,500 from Vista Partnership, calculated as follows:

Net business income before guaranteed
payments $80,000
- Guaranteed payment - 20,000
Partnership net business income $60,000
25% × $60,000 Partnership net income $15,000
+ Guaranteed payment + 20,000
+ 25% × $10,000 Net long-term capital
gain + 2,500
Income Evan should report from Vista on
her tax return $37,500

23

Peters has a 1/3rd interest in the Spano Partnership. During Year 7, Peters received a $16,000 guaranteed payment, which was deductible by the partnership, for services rendered to Spano. Spano reported a Year 7 operating loss of $70,000 before the guaranteed payment. What are the net effects of the guaranteed payment?

I. The guaranteed payment increases Peters' tax basis in Spano by $16,000.
II. The guaranteed payment increases Peters' ordinary income by $16,000.
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

B.
II only

The guaranteed payment is treated much like self-employment income. It is declared as ordinary income, and subject to self-employment taxes. Since this income is not reinvested in the company, it does not increase the investment basis.

24

Pat created a trust, transferred property to this trust, and retained certain interests. For income tax purposes, Pat was treated as the owner of the trust. Pat has created which of the following types of trusts?

A.
Simple

B.
Grantor

C.
Complex

D.
Pre-need funeral

B.
Grantor

The trust described here is a grantor trust. The grantor retains interests in the property transferred to the trust.

A simple trust is required to distribute all its income annually. A complex trust is not required to distribute all its income annually.

25

For the current year, the AB Trust had DNI of $30,000, fiduciary accounting income of $50,000, and distributed $40,000 to beneficiaries. What amount should the sole beneficiary of the AB Trust report as taxable income from the trust?

A.
$0

B.
$30,000

C.
$40,000

D.
$50,000

B.
$30,000

Beneficiaries are taxed on their share of the trusts income distributed to them, but not more than their share of DNI of the trust.

26

Potter Corp. and Sly Corp. file consolidated tax returns. In January of Year 4, Potter sold land, with a basis of $60,000 and a fair value of $75,000, to Sly for $100,000. Sly sold the land in December of Year 5 for $125,000. In its Year 5 and Year 4 tax returns, what amount of gain should be reported for these transactions in the consolidated return?

A.
Year 5: $25,000; Year 4: $40,000

B.
Year 5: $50,000; Year 4: $0

C.
Year 5: $50,000; Year 4: $25,000

D.
Year 5: $65,000; Year 4: $0

D. Year 5: $65,000(125-60); Year 4: $0
When consolidated tax returns are filed, any sales between members of the affiliated group are eliminated (or disregarded).

Not until a sale is made to a third party (outside of the affiliated group) is the gain recognized for tax purposes. Therefore, no gain is recognized in Year 4 when the sale was made from Potter to Sly. Not until Year 5, when Sly sold the land to a third party, is the gain of $65,000 recognized.

An “affiliated group” is designated as one or more corporations connected through stock ownership with a common parent that is an includible corporation provided that (1) the common parent must directly own stock possessing at least 80% of the total voting power of at least one of the other includible corporations and having a value equal to at least 80% of the total value of the stock of the corporation, and (2) stock meeting the 80% test in each includible corporation other than the common parent must be owned directly by one or more of the other includible corporations.

27

Which of the following types of entities is entitled to the net operating loss deduction?

A.
Partnerships

B.
S corporations

C.
Trusts and estates

D.
Not-for-profit organizations

C.
Trusts and estates

As pass-through (conduit) entities, both partnerships and S corporations are denied a net operating loss deduction in determination of taxable income. Trusts and estates are allowed a net operating loss deduction under Treasury Regulations. Not-for-profit organizations are generally denied net-operating-loss deductions except in calculating any unrelated business income tax.

IRC Sections 512(b)(6), 703(a)(2)(D), and 1363(b)(2)

28

Baker acquired a 50% interest in Kode Partnership by contributing $20,000 cash and a building with an adjusted basis of $26,000 and a fair market value of $42,000. The building was subject to a $10,000 mortgage which was assumed by Kode. The other partners contributed cash only. What is the basis of Baker's interest in Kode?

A.
$36,000

B.
$41,000

C.
$52,000

D.
$62,000

B. $41,000 (20+26-(10/2))

Baker's outside basis in Kode partnership is:
Cash $20,000
Add carryover basis in the building 26,000
$46,000
Less 1/2 of the mortgage assumed by the other partners - 5,000
Bakers OUTSIDE basis $41,000

The rules followed:
No gain or loss is recognized, either by the partnership or by any of its partners, upon a contribution of property to the partnership in exchange for a partnership interest.
The basis of a partner's interest acquired in exchange for his contribution to the partnership is the amount of the money contributed plus the adjusted basis to the contributing partner of any property contributed.
If the contributed property is subject to debt or if liabilities of the partner are assumed by the partnership, the basis of the contributing partner's interest is reduced by the portion of the indebtedness assumed by the other partners.

29

On January 1, Year 3, Dix transferred certain assets into a trust. The assets consisted of Lux Corp. bonds with a face amount of $500,000 and an interest rate of 12%. The trust instrument named Dix as trustee, Dix’s child as life beneficiary, and Dix’s grandchild as remainderman. Interest on the bonds is payable semiannually on May 1 and November 1. Dix had purchased the bonds at their face amount. As of Ja­nuary 1, Year 3, the bonds had a fair market value of $600,000. The accounting period selected for the trust is a calendar year. The trust instrument is silent as to whether Dix may revoke the trust. Assuming that the trust is valid, how should the amount of interest received in Year 3 be allocated between principal and income if the trust instrument is otherwise silent?

A.
Principal: $0; Income: $60,000

B.
Principal: $0; Income: $72,000

C.
Principal: $10,000; Income $50,000

D.
Principal: $12,000; Income $60,000

C.
Principal: $10,000; Income $50,000

The initial principal placed in the trust is $500,000. The fair market value of the principal has grown to $600,000. The interest received by the trust in Year 3 is $60,000 (($500,000 × 12% × 1/2 year) × 2). The principal has grown $100,000 since the inception of the trust.

Therefore, 1/6 ($100,000 ÷ $600,000) of the interest ($10,000 = 1/6 × $60,000) would be allocated to the principal and the remainder of the interest would be allocated to the income ($50,000 = 5/6 × $60,000).

30

Jagdon Corp.'s book income was $150,000 for the current year, including interest income from municipal bonds of $5,000 and excess capital losses over capital gains of $10,000. Federal income tax expense of $50,000 was also included in Jagdon's books. What amount represents Jagdon's taxable income for the current year?

A.
$185,000

B.
$195,000

C.
$205,000

D.
$215,000

C. $205,000(150-5+10+50)

In order to reconcile Jagdon Corp.'s book income and taxable income, nontaxable and nondeductible items must be removed from the book income. Starting with $150,000 book income, the first adjustment is to subtract municipal bond interest of $5,000, which is nontaxable. The second adjustment is to add back the $10,000 of excess capital losses over capital gains. The losses can only be matched with capital gains and not against ordinary income. The third adjustment is to add back the $50,000 of federal income tax expense.

The taxable income for Jagdon Corp. is $205,000:
Book income $150,000
Less: Municipal bond interest (5,000)
Add: Nondeductible capital losses 10,000
Add: Federal income tax expense 50,000
Taxable income $205,000

31

For the current year, the Herb Company had an increase in its liabilities. Does the increase in its liabilities affect the basis of the owners if the company is a partnership or is an S corporation?

A.
Affect shareholder's basis in S corporation stock: Yes; Affect partners of partnership interest: No

B.
Affect shareholder's basis in S corporation stock: No; Affect partners of partnership interest: No

C.
Affect shareholder's basis in S corporation stock: Yes; Affect partners of partnership interest: Yes

D.
Affect shareholder's basis in S corporation stock: No; Affect partners of partnership interest: Yes

D.Affect shareholder's basis in S corporation stock: No; Affect partners of partnership interest: Yes

An S corporation shareholder does not include a proportionate share of S corporation debt in his basis. A partner's basis is increased by his share of an increase in liabilities.

32

PDK, LLC, had three members with equal ownership percentages. PDK elected to be treated as a partnership. For the tax year ending December 31, Year 1, PDK had the following income and expense items:

Revenues $120,000
Interest income 6,000
Gain on sale of securities 8,000
Salaries 36,000
Guaranteed payments 10,000
Rent expense 21,000
Depreciation expense 18,000
Charitable contributions 3,000
What would PDK report as nonseparately stated income for Year 1 tax purposes?

A.
$30,000

B.
$35,000

C.
$43,000

D.
$51,000

B. $35,000

PDK would report $35,000 as nonseparately stated income for Year 1, calculated as follows:

Revenues $120,000
Less: Salaries (36,000)
Less: Guaranteed payments (10,000)
Less: Rent expense (21,000)
Less: Depreciation expense (18,000)
Nonseparately stated income $ 35,000

Any income, losses, deductions, or credits that might affect the tax liability of a member in a different manner depending on any other factors in their particular tax situation must be separately stated on the tax return. In this problem, the separately stated items include gain on sale of securities and charitable contributions.

Guaranteed payments to partners are included with the nonseparately stated items.

33

On June 30, Year 14, Berk retired from his partnership. At that time, his basis was $80,000, which included his share of the partnership's liabilities of $30,000. Berk's retirement payments consisted of being relieved of his share of the partnership liabilities and receipt of cash payments of $5,000 per month for 18 months, commencing July 1, Year 14. Assuming that Berk makes no election with regard to the recognition of gain from the retirement payments, he should report income of:

A.
$13,333 in Year 14 and $26,667 in Year 15.

B.
$20,000 in Year 14 and $20,000 in Year 15.

C.
$40,000 in Year 14.

D.
$40,000 in Year 15.

D. $40,000 in Year 15.

When a partner retires from a partnership, all debt relief and cash payments are first treated as a return of capital and then capital gains.

Since the debt relief and cash payments in Year 14 total $60,000 and Berk's basis was $80,000, no gain is reported in Year 14.
Year 14: $80,000 basis - $60,000 debt relief and cash payment = $20,000 remaining basis
Year 15: $20,000 basis - $60,000 cash payment
= $40,000 gain in Year 15

Berk's capital account before retirement:
Capital account $50,000
Share of liabilities 30,000
Berk's basis $80,000

Berk's retirement payment in Year 14:
Relief of all liabilities in Year 14 - 30,000
$50,000
6 months x $5,000 in Year 14 - 30,000
Capital basis at 12/31/Yr. 14 $20,000

Beck's retirement payment in Year 15:
12 months x $5,000 in Year 15 - 60,000
Capital gain in Year 15 $40,000

34

An incorporated exempt organization subject to tax on its current-year unrelated business income:

A.
must make estimated tax payments if its tax can reasonably be expected to be $100 or more.

B.
must comply with the Code provisions regarding installment payments of estimated income tax by corporations.

C.
must pay at least 70% of the tax due as shown on the return when filed, with the balance of tax payable in the following quarter.

D.
may defer payment of the tax for up to nine months following the due date of the return.

B.
must comply with the Code provisions regarding installment payments of estimated income tax by corporations.

An unincorporated exempt organization must make quarterly estimated tax payments on any taxable unrelated business income.

35

Thompson's basis in Starlight Partnership was $60,000 at the beginning of the year. Thompson materially participates in the partnership's business. Thompson received $20,000 in cash distributions during the year. Thompson's share of Starlight's current operations was a $65,000 ordinary loss and a $15,000 net long-term capital gain. What is the amount of Thompson's deductible loss for the period?

A.
$15,000

B.
$40,000

C.
$55,000

D.
$65,000

C.
$55,000

Partnership losses are deductible by a partner up to the amount of the partner's basis in the partnership interest. To compute a partner's basis to determine deductible losses, the basis is reduced by distributions first.
Beginning of year $ 60,000
Less Distributions - 20,000
$ 40,000
Long-term capital gain 15,000
Basis for allowing deductible loss $55,000
Thus Thompson can deduct $55,000 of Starlight Partnership's ordinary loss and will have a $10,000 loss to carryforward.

IRC Section 704(d); Revenue Ruling 66-94

36

The following information pertains to Hull, Inc., a personal holding company, for the year ended Decem­ber 31, Year 0:

Undistributed personal holding company income: $100,000
Dividends paid during Year 0: $20,000
Consent dividends reported in the Year 0 individual income tax returns of the holders of Hull’s common stock, but not paid by Hull to its stockholders: $10,000
In computing its Year 0 personal holding company tax, what amount should Hull deduct for dividends paid?

A.
$0

B.
$10,000

C.
$20,000

D.
$30,000

D.
$30,000

A personal holding company is allowed a deduction for both actual paid dividends and consent dividends. Therefore, Hull, Inc., is allowed a deduction for $30,000, which is the sum of the actual dividends paid in Year 0 of $20,000 and the consent dividends reported in Year 0 of $10,000.

37

The personal service partnership of Allen, Baker & Carr had the following cash-basis balance sheet at December 31, Year 1:

Adjusted Basis Market
Assets per Books Value
Cash $102,000 $102,000
Unrealized accounts receivable -- 420,000
Totals $102,000 $522,000

Liability and Capital
Note payable $ 60,000 $ 60,000
Allen, capital 14,000 154,000
Baker, capital 14,000 154,000
Carr, capital 14,000 154,000
Totals $102,000 $522,000

Carr, an equal partner, sold his partnership interest to Dole, an outsider, for $154,000 cash on January 1, Year 2. In addition, Dole assumed Carr’s share of the partnership’s liability.

What amount of ordinary income should Carr report in his Year 2 income tax return on the sale of his part­nership interest?

A.
$0

B.
$20,000

C.
$34,000

D.
$140,000

D. $140,000

When a partner sells his interest in a partnership and he is relieved from his share of partnership liabilities, then the amount realized is the amount of cash received plus his share of liabilities. Carr’s amount realized will be $174,000. Carr’s adjusted basis of $34,000, which also includes his share of the partnership liabilities, is subtracted from the amount realized. This leaves a realized gain of $140,000.

To the extent any of the realized gain is attributable to unrealized receivables or substantially appreciated inventory, there will be gain recognized as ordinary income. In this case, there are unrealized receivables with an adjusted basis of $0 and a fair market value of $420,000. Carr’s share of the $420,000 is $140,000 ($420,000 ÷ 3). Carr will have ordinary income of $140,000.

Amount realized: Cash received $154,000
+ Liability relief ($60,000 ÷ 3) 20,000
= Total amount realized $174,000

Less: Adjusted basis: Carr, capital account $ 14,000
+ Carr’s share of partnership liabilities 20,000
= Carr’s adjusted basis in the partnership (34,000)
Realized gain $140,000

38

Strom acquired a 25% interest in Ace Partnership by contributing land having an adjusted basis of $16,000 and a fair market value of $50,000. The land was subject to a $24,000 mortgage, which was assumed by Ace. No other liabilities existed at the time of the contribution. What was Strom's basis in Ace?

A.
$0

B.
$16,000

C.
$26,000

D.
$32,000

A. $0

Strom's basis in Ace is calculated as follows:
Carryover basis $16,000
Less: 75% x $24,000
The portion of the recourse
debt assumed by the other partners - 18,000
Strom has a recognized gain of $ 2,000

and Strom has a 0 basis in Ace
Carryover Basis $16,000
Add gain on transfer 2,000
Total 18,000
Less liability assumed (18,000)
Ending Basis $ 0

Contributions from a partner to a partnership are generally tax-free (except when the liabilities assumed by the other partners exceed Strom's carryover basis).

39

Are the two items that follow used in the computation of the built-in gains tax liability for an S corporation?

A.
Flat 35% tax rate: Yes; Deduct unexpired NOLs and C corp. capital losses: Yes

B.
Flat 35% tax rate: Yes; Deduct unexpired NOLs and C corp. capital losses: No

C.
Flat 35% tax rate: No; Deduct unexpired NOLs and C corp. capital losses: Yes

D.
Flat 35% tax rate: No; Deduct unexpired NOLs and C corp. capital losses: No

A.
Flat 35% tax rate: Yes; Deduct unexpired NOLs and C corp. capital losses: Yes

Both of the items are used. The maximum corporate rate is used to prevent tax avoidance by converting C corporation income to S corporation income. Unexpired benefits of the C corporation are deducted (NOLs, capital losses, AMT credits, and business credit carryforwards).

40

The sole shareholder of an S corporation contributed equipment with a fair market value of $20,000 and a basis of $6,000 subject to $12,000 liability. What amount is the gain, if any, that the shareholder must recognize?

A.
$0

B.
$6,000

C.
$8,000

D.
$12,000

B.
$6,000


The same contribution rules apply to shareholders in a C corporation and shareholders in an S corporation. If a shareholder contributes property with a liability in excess of basis, the excess is considered a gain. It will be ordinary gain if ordinary income property was contributed, or capital gain if capital gain property was contributed.


Adjusted basis of property contributed to S corporation $ 6,000
Less: Liability transferred to S corporation (12,000)
Recognized gain $ 6,000

41

Cord’s will created a trust to take effect on Cord’s death. The will named Cord’s spouse as both the trustee and personal representative (executor) of the estate. The will provided that all of Cord’s securities were to be transferred to the trust and named Cord’s child as the beneficiary of the trust. Under the circumstances:

A.
Cord has created an inter vivos trust.

B.
Cord has created a testamentary trust.

C.
the trust is invalid because it will not become effective until Cord’s death.

D.
Cord’s spouse may not serve as both the trustee and personal representative because of the inherent conflict of interest.

B.
Cord has created a testamentary trust.

An inter vivos trust is created during the grantor’s lifetime. A testamentary trust will begin when the grantor dies and he has provided for a trust in his will. The testamentary trust becomes valid at Cord’s death. Cord’s spouse can serve as both the trustee and personal representative of the trust.

42

When a corporation has an unused net capital loss that is carried back or carried forward to another tax year:

A.
it can be used to offset ordinary income up to the amount of the carryback or carryover.

B.
it is treated as a short-term capital loss whether or not it was short-term when sustained.

C.
it is treated as a long-term capital loss whether or not it was long-term when sustained.

D.
it retains its original identity as short term or long term.

B.
it is treated as a short-term capital loss whether or not it was short-term when sustained.

Corporations are allowed to use capital losses to offset capital gains only. Any unused capital losses may be carried back 3 years and forward 5 years. When carried back or forward, all corporate capital losses become short-term capital losses.

43

The sole shareholder of an S corporation had a basis for her stock of $30,000 and a basis for a loan to the S corporation of $15,000. In Year 6, the S corporation operated at a loss of $39,000. What is the shareholder's basis in the stock and loan on December 31, Year 6?

A.
Stock: $0; Loan: $6,000

B.
Stock: $6,000; Loan: $0

C.
Stock: $3,000; Loan: $3,000

D.
Stock: $4,000; Loan: $2,000

A.
Stock: $0; Loan: $6,000

The loss reduces the shareholder's stock basis first. The remaining loss ($39,000 − $30,000) of $9,000 is deducted from the loan basis.
Stock Loan Total
Beg. Basis $30,000 $15,000 $45,000
Less: Loss ( 30,000) ( 9,000) ( 39,000)
Ending Basis: $ 0 $ 6,000 $ 6,000

44

In Year 8, Clyde formed an S corporation by contributing $5,000 in stock and $10,000 in loans. In Year 8, the corporation had a net loss of $5,000 leaving Clyde with no stock basis and $10,000 in debt basis. Clyde expects the S corporation to have a small loss in Year 9 also. Although Clyde knows he has a debt basis he still decides to take a $3,000 distribution in Year 9. Clyde will have to report:

A.
$3,000 as a dividend.

B.
$3,000 as a capital gain.

C.
$5,000 as a capital loss.

D.
$2,000 as a capital loss.

B. $3,000 as a capital gain.

Although debt provides basis for the purpose of deducting losses, it is not considered basis for purposes of distributions. The $3,000 will be treated as a capital gain because Clyde had no stock basis. Had the $3,000 been treated as a debt repayment, instead of as a distribution, Clyde would have recognized no income.

45

DB Partnership distributed land to partner Don when the fair market value (FMV) of the land was $50,000 with an adjusted basis to the partnership of $45,000. Don's basis in his partnership interest was $75,000 prior to receiving the land. After the distribution of the land, what is Don's basis in the land and his partnership interest, respectively?

A.
$45,000; $30,000

B.
$50,000; $25,000

C.
$50,000; $75,000

D.
$50,000; $30,000

A.
$45,000; $30,000

When a partnership distributes property to a partner as a nonliquidating distribution, the partner takes a carryover basis in the property received. In this case, the carryover basis is the basis the partnership had in the land, $45,000. The partner's basis in his partnership interest is then reduced by the basis of the land. Don's basis in his partnership interest becomes $30,000 ($75,000 - $45,000). The partner's basis in his partnership interest may not be reduced below zero. The partner will only have taxable income if cash received from the partnership exceeds his basis in his partnership interest.

46

An irrevocable trust that contains no provision for change or termination can be changed or terminated only by the:

A.
courts.

B.
income beneficiaries.

C.
remaindermen.

D.
grantor.

A.
courts.

An irrevocable trust is a trust that is set up and the funds or property are transferred to a trustee. Once the person signs the trust, he or she has surrendered his or her control over the funds or property. Since the trust is conclusive, it cannot be changed except by the courts.

47

Which of the following corporations are required to file Form 1120, Schedule M-3?

A.
Corporations with net income of $10 million or more

B.
Corporations with total assets of $10 million or more

C.
Corporations with taxable income of $10 million or more

D.
Corporations with retained earnings of $10 million or more

B.
Corporations with total assets of $10 million or more

Schedule M-3 of IRS Form 1120 is required to be filed when a corporation has total assets of $10 million or more.

Schedule M-1 of IRS Form 1120 is required to be filed when a corporation has both total assets and total receipts of $250,000 or more.

48

The built-in gains tax applicable to S corporations was enacted to prevent a tax avoidance plan applicable to:

A.
individual shareholders.

B.
C corporations.

C.
another S corporation.

D.
all flow-through entities.

B.
C corporations.

Built-in gains tax was enacted to prevent C corporations planning on selling or distributing property from electing S corporation status before the sale or distribution. Electing S status would otherwise avoid the double taxation associated with C corporations.

49

Beck and Nilo are equal partners in B & N Associates, a general partnership. B & N borrowed $10,000 from a bank on an unsecured note, thereby increasing each partner's share of partnership liabilities. As a result of this loan, the basis of each partner's interest in B & N was:

A.
increased.

B.
decreased.

C.
unaffected.

D.
dependent on each partner's ability to meet the obligation if called upon to do so.

A.
increased.

The basis of a partner's interest is increased by any increase in his share of partnership liabilities since the increase is treated as a contribution of money to the partnership.

In this problem, both Beck and Nilo would each increase their basis in the partnership by $5,000.

50

John Budd is the sole stockholder of Ral Corp., an accrual-basis taxpayer engaged in wholesaling operations. Ral’s retained earnings at January 1, Year 1, amounted to $1,000,000. For the year ended December 31, Year 1, Ral’s book income, before federal income tax, was $300,000. Included in the computation of this $300,000 were the following:

Keyman insurance premiums paid on Budd’s life (Ral is the beneficiary of this policy): $3,000
Group-term insurance premiums paid on $10,000 life insurance policies for each of Ral’s four employees (the employees’ spouses are the beneficiaries): $4,000
Contribution to a recognized, qualified charity (this contribution was authorized by Ral’s board of directors in December Year 1, to be paid on January 31, Year 2): $75,000

With regard to Ral’s contribution to the recognized, qualified charity, Ral:
A.
can elect to deduct in its Year 1 return any portion of the $75,000 that does not exceed the deduction ceiling for Year 1.

B.
can elect to carry forward indefinitely any portion of the $75,000 not deducted in Year 1 or Year 2.

C.
can deduct the entire $75,000 in its Year 1 return because Ral reports on the accrual basis.

D.
cannot deduct any portion of the $75,000 in Year 1 because the contribution was not paid in Year 1.

A. can elect to deduct in its Year 1 return any portion of the $75,000 that does not exceed the deduction ceiling for Year 1.

A corporation is allowed a charitable contribution deduction of 10% of taxable income computed without regard to the following:
The deduction for charitable contributions
The deduction for dividends received
Any net operating loss carryback
The deduction for domestic production activities
Any capital loss carryback
An accrual-basis corporation is allowed to take a charitable contribution deduction in the year prior to payment if the contribution was authorized by the board of directors in the prior year and paid within 2-1/2 months of the prior year-end.

The carryforward period for corporations is five years for excess charitable contributions.

51

Kari Corp., a manufacturing company, was organized on January 2, Year 0. Its Year 0 federal taxable income was $400,000 and its federal income tax was $100,000. What is the maximum amount of accu­mulated taxable income that may be subject to the accumulated earnings tax for Year 0 if Kari takes only the minimum accumulated earnings credit?

A.
$300,000

B.
$150,000

C.
$50,000

D.
$0

C. $50,000 (400-100-250)

Taxable income is reduced by the federal income tax and the accumulated earnings credit prior to determine the accumulated taxable income (ATI). The ATI is $50,000 for Kari Corp., as computed below:

Taxable income $400,000
Less: Federal income tax (100,000)
Less: Minimum accumulated earnings credit (250,000)
Equals: Accumulated taxable income $ 50,000

52

Feld, the sole stockholder of Maki Corp., paid $50,000 for Maki’s stock in Year 1. In Year 2, Feld contri­buted a parcel of land to Maki but was not given any additional stock for this contribution. Feld’s basis for the land was $10,000, and its fair market value was $18,000 on the date of the transfer of title. What is Feld’s adjusted basis for the Maki stock?

A.
$50,000

B.
$52,000

C.
$60,000

D.
$68,000

C.
$60,000

Because Feld is the only shareholder, his basis in the stock of Maki Corp. will include any future contributions of property to the corporation. Therefore, Feld’s basis in the Maki Corp. stock will become $60,000, computed as follows:

Adjusted basis of initial investment in Year 1 $50,000
+ Adjusted basis of land contribution 10,000
= Adjusted basis of Maki Corp. stock to Feld $60,000

53

Which of the following items should be included on Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, of Form 1120, U.S. Corporation Income Tax Return, to reconcile book income to taxable income?

A.
Cash distributions to shareholders

B.
Premiums paid on key-person life insurance policy

C.
Corporate bond interest

D.
Ending balance of retained earnings

B. Premiums paid on key-person life insurance policy
Premiums paid on life insurance are not deductible by any person that is directly or indirectly a beneficiary under the policy.

Key-person life insurance is life insurance purchased by a business payable to the business in the event of the death of the covered key employees to enable the business to survive the death of such key employees. Since the business, or in this case the corporation, is the beneficiary, it would not be deductible for income tax purposes and would be a reconciling item for Schedule M-1 (or Schedule M-3 required for corporations with assets over $10 million).

Corporate bond interest is part of corporate taxable income and so is not part of the Schedule M-1 reconciliation of taxable income to book income.

Cash distributions to shareholders and ending balance of retained earnings do not affect taxable income or book income and are part of Schedule M-2, reconciliation of retained earnings.

54

Which of the following investments generally will be a violation of a trustee’s fiduciary duty to the trust?

A.
Secured first mortgages on land

B.
High-interest unsecured loans

C.
Tax-exempt municipal bonds

D.
Guaranteed savings certificates

B.
High-interest unsecured loans

Generally, a trustee making any high-risk investment with trust property would be violating his fiduciary responsibility. An unsecured loan would be considered a high-risk investment. Low-risk investments would include secured mortgages, tax-exempt municipal bonds, and guaranteed savings certificates.

55

Carlt created a $300,000 trust that provided his mother with a lifetime income interest, with the remainder interest to go to his son. Carlt expressly retained the power to revoke both the income interest and the remainder interest at any time. Who will be taxed on the trust's current-year income?

A.
Carlt's mother

B.
Carlt's son

C.
Carlt

D.
The trust

C.
Carlt

While the trust will receive the income, it is then paid out to Carlt's mother currently (IRC Sections 671 and 674). Because Carlt retained the power to revoke the income interest and the remainder interest, he still controls the trust and he will be taxed on the trust income.

56

During the current year, a trust reports the following information:
Dividends $10,000
Interest from corporate bonds 12,000
Tax-exempt interest from state bonds 4,000
Capital gain (allocated to corpus) 2,000
Trustee fee (allocated to corpus) 6,000
What is the trust's accounting income?

A.
$22,000

B.
$26,000

C.
$28,000

D.
$34,000

B.
$26,000

The accounting income of a trust is the amount an income beneficiary is entitled to receive from the trust. Accounting income includes both taxable and nontaxable items of income.

Dividends $10,000
Interest from corporate bonds 12,000
Tax-exempt interest from state bonds 4,000
Capital gain allocated to corpus 0
Trustee fee allocated to corpus 0
Trust's accounting income $26,000

57

Borasco Corp. owns land with a fair market value of $200,000. Borasco purchased the land 10 years ago for $65,000 and owes a liability of $50,000 as of August 2 of the current year. Alvo Corp. owns 100% of Borasco. Borasco is completely liquidated on August 2 of the current year, according to a plan adopted on June 18 of the current year. As a result, the land is transferred to Alvo in complete cancellation of Borasco's stock. What basis does Alvo have in the land it receives?

A.
$15,000

B.
$65,000

C.
$150,000

D.
$200,000

B.
$65,000

Corporate liquidations of property generally are treated as a sale or exchange. Gain or loss generally is recognized by the corporation on a liquidating sale of its assets. Gain or loss generally is recognized also on a liquidating distribution of assets as if the corporation sold the assets to the distributee at fair market value.

In certain cases in which the distributee is a corporation in control of the distributing corporation, the distribution may not be taxable. For more information, see IRC Section 332 and the related regulations.

As a result, Alvo has a basis in the received property of $65,000 because the land was not sold and Alvo did not receive $200,000. Alvo no longer owns stock in Borasco, but has the land.

58

Stone Corp. has been an S corporation since inception. In each of Year 1, Year 2, and Year 3, Stone made distributions in excess of each shareholder's basis. Which of the following statements is correct concerning these three years?

A.
In Year 1 and Year 2 only, the excess distributions are taxed as capital gain.

B.
In Year 1 only, the excess distributions are tax-free.

C.
In Year 3 only, the excess distributions are taxed as capital gain.

D.
In all three years, the excess distributions are taxed as capital gains.

D.
In all three years, the excess distributions are taxed as capital gains.

When there is no C corporation accumulated E&P, all cash distributions are considered a return of capital until adjusted basis is reduced to zero, and then any excess is capital gain to the shareholder.

59

For the current year, Oaktree Corporation's books and records reflect the following:

Net income per books (after tax) $52,800
Tax-exempt interest 500
Excess book depreciation 7,222
Capital losses 3,000
Federal income tax 8,478
Excess contributions 1,710
Premiums on officer life insurance (payable to corp.) 1,500
Meals in excess of 50% limitation 400

What is the amount of Oaktree's taxable income as it would be shown on Schedule M-1 of its corporate income tax return?

A.
$74,610

B.
$77,110

C.
$76,610

D.
$75,110

A. $74,610

Net income per books $52,800
Add back:
Federal income tax + 8,478
Capital losses + 3,000
Depreciation + 7,222
Officer life insurance + 1,500
Meals in excess of 50% limitation + 400
Excess contributions + 1,710
Total $75,110
Deduct: Nontaxable interest 500
Taxable income $74,610

Corporations are not allowed a deduction for capital losses. Corporate capital losses are only deductible against capital gains.

Contributions are limited to 10% of taxable income.

60

Private foundations may be subject to several taxes. Which of the following taxes is a private foundation not subject to?

A.
Tax on accumulated earnings

B.
Tax on investment income

C.
Tax on failure to distribute income for exempt purposes

D.
Tax on excess business holdings

A.
Tax on accumulated earnings

Private foundations are not subject to an accumulated earnings tax, but may be subject to the following taxes:
Tax on investment income
Tax on self-dealing
Tax on failure to distribute income for exempt purposes
Tax on excess business holdings
Tax on speculative investments that jeopardize the foundation's assets
Tax on expenditures that should not be made by private foundations

61

Brown transfers property to a trust. A local bank was named trustee. Brown retained no powers over the trust. The trust instrument provides that current income and $6,000 of principal must be distributed annually to the beneficiary. What type of trust was created?

A.
Simple

B.
Grantor

C.
Complex

D.
Revocable

C.
Complex

The trust is a complex trust. A complex trust is any trust that does not qualify as a simple trust.

The trust is not a simple trust. One of the requirements of a simple trust is that the trust not distribute principal (corpus). This trust provides that current income and $6,000 of principal be distributed annually.
The trust is not a grantor trust. A grantor trust is one in which the grantor retains beneficial enjoyment or substantial control over the trust property or income. The grantor (Brown) of this trust retains no powers over the trust and is not the trustee.
The trust is not revocable. A revocable trust is one in which the grantor retains the power to revest all or part of the trust property. Brown retained no powers over the trust.

62

Which of the following entities may not deduct fringe benefits for the owner/employee?

A.
Sole proprietorship

B.
Partnership

C.
S corporation

D.
C corporation

A.
Sole proprietorship


Sole proprietors may not deduct the cost of fringe benefits. The entity does not exist separately from the person for taxation purposes. Partnerships may deduct the benefits but the partners must include the amount in income. A more than 2% shareholder of an S corporation must include the benefits in income.

63

Ordinary and necessary administration expenses paid by the fiduciary of an estate are deductible:

A.
only on the fiduciary income tax return (Form 1041) and never on the federal estate tax return (Form 706).

B.
only on the federal estate tax return and never on the fiduciary income tax return.

C.
on the fiduciary income tax return only if the estate tax deduction is waived for these expenses.

D.
on both the fiduciary income tax return and on the estate tax return by adding a tax computed on the proportionate rates attributable to both returns.

C.
on the fiduciary income tax return only if the estate tax deduction is waived for these expenses.

Ordinary and necessary administration expenses are deductible on either the fiduciary income tax return (Form 1041) or the federal estate tax return (Form 706) but not both.

In order to deduct the expense on Form 1041, the estate must file a waiver of the death tax deduction on Form 706 and Form 1041.

While the expenses cannot be deducted twice, they can be allocated between the Form 1041 and Form 706.

64

Sam MaGee became a limited partner in the Northern Lights Partnership by contributing $20,000 in cash on the formation of the partnership. The adjusted basis of his partnership interest at the end of the year is $40,000, which includes his $30,000 share of partnership liabilities. The partnership has no unrealized receivables or substantially appreciated inventory items. Sam sells his interest in the partnership for $20,000 in cash plus $30,000 liability relief. He had been paid his share of the partnership income for the tax year. How much should he report as a capital gain?

A.
$5,000

B.
$10,000

C.
$15,000

D.
$20,000

B.
$10,000

When a partner sells his interest in a partnership, it is considered to be the sale of a capital asset. The $30,000 of liability relief is added to the cash of $20,000 for a total amount realized of $50,000.

The calculation is:

Amount realized $50,000
Basis 40,000
Capital gain $10,000

65

Beta, a C corporation, reported the following items of income and expenses for the year:


Gross income $600,000
Dividend income from a 30%-owned domestic corporation 100,000
Operating expenses 400,000
What is Beta's taxable income for the year?

A.
$200,000

B.
$220,000

C.
$230,000

D.
$300,000

B. $220,000

Beta's taxable income is calculated as follows:
Gross income $600,000
Operating expenses (400,000)
Dividend income 100,000
300,000
Dividends-received deductions (0.80 x 100,000) (80,000)
Taxable income $220,000
A corporation's dividends-received deduction (DRD) depends on the shareholder corporation's ownership in the corporation making the dividend distribution as follows:
Deduction
Ownership Percentage
Less than 20% 70%
20% or more, but less than 80% 80%
80% or more 100%
The deduction for shareholders qualifying for either the 70% or 80% deduction is further limited to 70% or 80% of taxable income computed before the deduction for dividends received. (A special rule applies if the deduction creates or increases an NOL.)

In this case, Beta qualifies for the 80% deduction percentage, and the 80% limit on taxable income does not apply since it is greater than the dividends-received deduction of $80,000 (80% of taxable income before the dividends-received deduction = 0.80 × $300,000 = $240,000).

66

Which of the following fiduciary entities are required to use the calendar year as their taxable period for income tax purposes?

A.
Estates

B.
Trusts (except those that are exempt)

C.
Both estates and trusts (except those that are exempt)

D.
Neither estates nor trusts (except those that are exempt)

B.
Trusts (except those that are exempt)

Only three entities are permitted to freely select a fiscal year: C corporations, estates, and tax-exempt entities.

Trusts, partnerships, S corporations, and personal service corporations generally must conform their tax years to the tax years of their owners or a calendar year, unless the entity can establish a business purpose for having a different tax year.

This means trusts must use a calendar year. Partnerships must use the same tax year as the partners. S corporations must use a calendar year. Generally, personal service corporations also use a calendar year

67

A trust has distributable net income of $14,000 and distributes $20,000 to the sole beneficiary. What amounts are taxable to the trust and to the beneficiary?

A.
Trust: $14,000; Beneficiary: $0

B.
Trust: $0; Beneficiary: $14,000

C.
Trust: $14,000; Beneficiary: $20,000

D.
Trust: $0; Beneficiary: $20,000

B.
Trust: $0; Beneficiary: $14,000

Distributable net income (DNI) determines the amount and character of the income to be reported by the beneficiaries. In this case, all the DNI was distributed plus an additional $6,000. The DNI is the taxable amount ($14,000). For trusts, whoever gets the money is taxed on it. In this case, the trust kept no money and the beneficiaries received all of the taxable income from the trust.

68

Which of the following expenses incurred by a C corporation are not deductible and therefore must be reported as an M-1 adjustment on the corporate income tax return?

A.
$1,000 of in-house lobbying expense

B.
$3,000 paid to a professional lobbyist to lobby Congress

C.
$500 local lobbying expenses

D.
$5,000 travel expense incurred by a professional lobbyist to lobby Congress

B. $3,000 paid to a professional lobbyist to lobby Congress

Generally, lobbying expenses are not deductible. However, there is a limited exception which allows a deduction for local lobbying expenses and up to $2,000 of in-house lobbying expenses.

Expenses incurred by a taxpayer engaged in the business of providing lobbying services are deductible by that taxpayer. Dues paid to a tax-exempt organization are generally not deductible to the extent they are used to fund lobbying activities.

IRC Section 162(e)

Corporations with over $10 million in assets must use Schedule M-3.

69

ATNOL (alternative tax net operating loss) can reduce alternative minimum taxable income (AMTI) by a maximum of 90%. In Year 5, if the AMTI was reduced by the entire 90% due to ATNOL, the AMT foreign tax credit would:

A.
reduce the remaining tax up to 100%.

B.
not be allowed in that year.

C.
reduce the remaining tax by 90%.

D.
be disallowed with no carryover provisions.

A.
reduce the remaining tax up to 100%.

For Year 5, the AMT could be eliminated by the foreign tax credit, whether or not the taxpayer used ATNOL.

70

Tech Corp. files a consolidated return with its wholly owned subsidiary, Dow Corp. During Year 1, Dow paid a cash dividend of $20,000 to Tech. What amount of this dividend is taxable on the Year 1 consoli­dated return?

A.
$20,000

B.
$14,000

C.
$6,000

D.
$0

D.
$0

When a corporation receives a dividend from its wholly owned subsidiary, the dividend is included in gross income and a 100% dividends-received deduction is allowed. This makes the dividend that was received “taxable” with an offsetting 100% dividends-received deduction allowed, and so makes the net amount equal to zero.

71

All of the following are true concerning the formation of an S corporation for tax years beginning after December 31, 2004, except:

A.
must have the consent of a majority of shareholders.

B.
election must be made at any time in the preceding year or before the 15th day of the third month of the taxable year.

C.
consent is filed by the corporation on Form 2553.

D.
it must have no more than 100 shareholders.

A.
must have the consent of a majority of shareholders.

The consent to form an S corporation must be given by all shareholders.

For tax years beginning after December 31, 2004, the maximum number of shareholders was increased from 75 to 100 by the American Jobs Creation Act of 2004.

72

Which of the following statements regarding nonliquidating distributions of a corporation is true?

A.
Nonliquidating distributions of a corporation are not taxable as dividends to the shareholder if earnings and profits exist.

B.
Nonliquidating distributions of a corporation reduce the retained earnings of the corporation.

C.
Nonliquidating distributions of a corporation are taxable as dividends to the shareholder if earnings and profits do not exist.

D.
Nonliquidating distributions of a corporation have no effect on the retained earnings of a corporation.

B.
Nonliquidating distributions of a corporation reduce the retained earnings of the corporation.

Nonliquidating distributions of a corporation will reduce the retained earnings of the corporation and are taxable as a dividend to the shareholder if earnings and profits exist. The journal entry to record the distribution is generally a debit to Retained Earnings and a credit to the asset that is distributed.

73

Under the terms of a partnership agreement, Anna is entitled to a fixed annual payment of $10,000 without regard to the income of the partnership. Her distributive share of the partnership income is 10%. The partnership has $50,000 of ordinary income after deducting the guaranteed payment. Which of the following states the amount and character of Anna's income from the partnership?

A.
$15,000 of ordinary income

B.
$10,000 capital gain and $5,000 of ordinary income

C.
$15,000 of capital gain

D.
$10,000 of ordinary income and $5,000 capital gain

A.
$15,000 of ordinary income

Guaranteed payments are included in income in the partner's tax year in which the partnership's year ends.

The calculation is:
Guaranteed payment $10,000
Distributive share 5,000 ($50,000 x 0.10)
$15,000

74

Flagg and Miles are each 50% partners in Decor Partnership. Each partner had a $200,000 tax basis in the partnership. Decor's net business income before guaranteed payments was $45,000. During the current year, Decor made a $7,500 guaranteed payment to Miles for deductible services rendered.

What total amount from Decor is includible in Flagg's current-year tax return?

A.
$15,000

B.
$18,750

C.
$22,500

\D.
$37,500

B.
$18,750

Partners are taxed on their share of partnership income earned. Partnership income is allocated as follows:

Total Flagg Miles
Partnership income before $45,000
guaranteed payments
Guaranteed payments (7,500) 7,500
Residual, 50% each partner (37,500) 18,750 18,750
Totals 0 18,750 26,250

Flagg must include $18,750 in his current-year tax return for his share of the earnings of DECOR Partnership.

75

Beech Corp., an accrual-basis, calendar-year S corporation, has been an S corporation since its inception. At the beginning of the current year, Gold owned 50% of the 100 issued shares of Beech stock, and had a $3,000 tax basis in the Beech stock. During the current year, Beech had $200,000 in net business income and $4,000 in Oak County municipal bond interest income. Beech made no distributions to its shareholders. What was Gold's tax basis in Beech stock at year-end?

A.
$102,000

B.
$103,000

C.
$104,000

D.
$105,000

D.
$105,000

A shareholder's basis can increase or decrease whether or not there is a distribution. The basis will increase for income and other separately stated items. In this case, Gold's basis increased by $100,000 (50% share of income) plus $2,000 (50% share of municipal bond interest) for an increase of $102,000. The basis was originally $3,000; adding the $102,000 increase makes Gold's total basis in Beech Corp. $105,000.

76

Turner, Reed, and Sumner are equal partners in TRS partnership. Turner contributed land with an adjusted basis of $20,000 and a fair market value (FMV) of $50,000. Reed contributed equipment with an adjusted basis of $40,000 and an FMV of $50,000. Sumner provided services worth $50,000. What amount of income is recognized as a result of the transfers?

A.
$50,000

B.
$60,000

C.
$90,000

D.
$150,000

A.
$50,000

The general rule is that when a partner contributes “property” to a partnership, no gain or loss is recognized. The exception to the general rule is that when a partner contributes “services” to a partnership, the partner will recognize ordinary compensation income on the fair market value of the services rendered.

77

Partnership JKL has decided to liquidate. Partner J's adjusted basis in the partnership is $55,000 and he received only equipment (FMV $55,000, adjusted basis to the partnership of $40,000) in complete liquidation of his share of the partnership. What is the amount of gain or loss Partner J will recognize on his personal tax return?

A.
Gain of $15,000

B.
Partner J may not recognize a loss on the liquidation of the partnership.

C.
Loss of $15,000

D.
Partner J will not recognize a gain on the liquidation of the partnership.

B.
Partner J may not recognize a loss on the liquidation of the partnership.

The rules for liquidating distributions for a partnership are as follows:

If a partner receives cash or marketable securities (cash equivalents) in excess of the partner's adjusted basis, then gain is recognized on that excess.
If no cash equivalents are distributed, no gain is recognized.
If a partner receives cash, unrealized receivables, or inventory in a liquidating distribution, a loss may be recognized by the partner equal to the difference between FMV and the partner's basis.
If only other property is received, then no loss may be recognized.

78

A will provided that an estate was to be distributed per stirpes to the deceased’s heirs. The only possi­ble heirs are two daughters, who each have three children, and two children of a predeceased son. What fraction of the estate will each child of the predeceased son receive?

A.
0

B.
1/10

C.
1/6

D.
1/4

C.
1/6

Per stirpes designates that each branch of the family receives an equal share of the estate. If used in this example, the decedent had three children, so each of the three children receive 1/3 of the estate. Where one of the children was predeceased, then the children of the predeceased receive the 1/3 share or the 1/3 is split among the two grandchildren.

1/3 share ÷ 2 = 1/6 each grandchild

79

To properly create an inter vivos trust funded with cash, the grantor must:

A.
execute a written trust instrument.

B.
transfer the cash to the trustee.

C.
provide for payment of fees to the trustee.

D.
designate an alternate trust beneficiary.

B.
transfer the cash to the trustee.

The written trust instrument would be the starting place for creating any trust. The written trust instrument would provide for payment of fees to the trustee and designate any and all beneficiaries.

Transferring the cash to the trustee would complete the creation of the trust.

80

Which of the following items is included in ordinary income of a partnership when the two partners share profits and losses equally?

A.
Misc. ordinary income split in 60/40 ratio: Yes; Tax-exempt interest income: Yes

B.
Misc. ordinary income split in 60/40 ratio: Yes; Tax-exempt interest income: No

C.
Misc. ordinary income split in 60/40 ratio: No; Tax-exempt interest income: Yes

D.
Misc. ordinary income split in 60/40 ratio: No; Tax-exempt interest income: No

D.
Misc. ordinary income split in 60/40 ratio: No; Tax-exempt interest income: No

Items allocated differently from the general profit and loss ratio must be separately stated. Tax-exempt income is not included in ordinary income because it is not taxable.

81

Clark and Hunt organized Jet Corp. with authorized voting common stock of $400,000. Clark contributed $60,000 cash. Both Clark and Hunt transferred other property in exchange for Jet stock as follows:

Other Property:
Fair Percentage
Adjusted Market of Jet Stock
Basis Value Acquired
Clark $ 50,000 $100,000 40%
Hunt 120,000 240,000 60%
What was Clark's basis on Jet stock?

A.
$0

B.
$100,000

C.
$110,000

D.
$160,000

C. $110,000

Clark's Basis in Jet Stock:
Cash $ 60,000
Adjusted basis-property 50,000
Clark's basis in Jet Stock $110,000

No gain or loss is recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange the persons are in control of the corporation. Control means 80% or more of the corporation. Since Clark and Hunt own 100% of the corporation, no gain is to be recognized. The basis of Clark's stock has to be the carryover basis, which is cash $60,000 + adjusted basis of the other property ($50,000) = $110,000.

82

Astor, a cash-basis taxpayer, died on February 3. During the year, the estate's executor made a distribution of $12,000 from estate income to Astor's sole heir and adopted a calendar year to determine the estate's taxable income. The following additional information pertains to the estate's income and disbursements for the year:

Estate income
Taxable interest $65,000
Net long-term capital gains allocable to corpus 5,000
Estate disbursements:
Administrative expenses attributable to taxable income $14,000
Charitable contributions from gross income to a public
charity made under the terms of the will 9,000

For the calendar year, what was the estate's distributable net income (DNI)?

A.
$39,000

B.
$42,000

C.
$58,000

D.
$65,000

B. $42,000

The $12,000 was distributed, not distributable. Do not include this figure in your calculations.

Taxable interest is not the only component of DNI.

The taxable interest less expenses and charitable contributions ($65,000 − $14,000 − $9,000) is distributable net income.

83

Curry’s sale of her partnership interest causes a partnership termination. The partnership’s business and financial operations are continued by the other members. What is the effect of the termination?

I. There is a deemed distribution of assets to the remaining partners and the purchaser.
II. There is a hypothetical recontribution of assets to a new partnership.
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

C.
Both I and II

When a partnership terminates yet some of the partners continue the partnership, there will have been a “deemed” distribution from the old partnership and a “deemed” recontribution of assets to the new partnership. Therefore, both statements I and II are true.

84

Which of the following entities must pay taxes for federal income tax purposes?

A.
General partnership

B.
Limited partnership

C.
Joint venture

D.
C corporation

D.
C corporation


A C corporation is a taxpaying entity. Partnerships and joint ventures are not generally taxpaying entities.

85

Smith received a 1/3rd interest of a partnership by contributing $3,000 in cash, stock with a fair market value of $5,000 and a basis of $2,000, and a new computer that cost Smith $2,500. Which of the following amounts represents Smith's basis in the partnership?

A.
$10,500

B.
$7,500

C.
$5,500

D.
$3,000

B. $7,500

The basis of a partnership interest acquired through the contribution of cash and unencumbered property to a partnership is equal to the cash and adjusted basis of the property contributed. Therefore, Smith's partnership interest basis is as follows:
Cash contributed $3,000
Basis in stock contributed 2,000
Basis in computer contributed 2,500
Basis in partnership interest $7,500

IRC Section 722

86

Which of the following entities has an unrestricted option in selecting the tax year to be used when filing the first tax return?

A.
Sole proprietor

B.
Limited liability company

C.
S corporation

D.
C corporation

D.
C corporation

Sole proprietors, partnerships, and limited liability entities are restricted to the tax year of the owner. S corporations are restricted to a calendar year unless IRS approval is obtained.

Only a C corporation can select any month for the close of the tax year.

87

Frost’s will created a testamentary trust naming Hill as life income beneficiary, with the principal to Brown when Hill dies. The trust was silent on allocation of principal and income. The trust’s sole asset was a commercial office building originally valued at $100,000 and having a current market value of $200,000. If the building was sold, which of the following statements would be correct concerning the allocation of the proceeds?

A.
The entire proceeds would be allocated to principal and retained.

B.
The entire proceeds would be allocated to income and distributed to Hill.

C.
One-half of the proceeds would be allocated to principal and one-half to income.

D.
One-half of the proceeds would be allocated to principal and one-half distributed to Brown.

A.
The entire proceeds would be allocated to principal and retained.


Since the trust’s only asset was the commercial office building and it was sold, then it is reasonable that the entire proceeds from the sale of the office building be allocated to the trust principal.

88

Pope, a C corporation, owns 15% of Arden Corporation. Arden paid a $3,000 cash dividend to Pope. What is the amount of Pope's dividend-received deduction?

A.
$3,000

B.
$2,400

C.
$2,100

D.
$0

C.
$2,100

Since the C corporation named Pope owns 15% of Arden Corporation, Pope can use a 70% dividends-received deduction to offset the dividends paid by Arden Corporation. Pope received $3,000 in taxable dividends but can offset $2,100 of that amount on its tax return (0.70 × $3,000 = $2,100).

Corporate Ownership DRD Deduction %
Less than 20% 70%
20% or more, under 80% 80%
80% or more 100%

89

The minimum total voting power that a parent corporation must have in a subsidiary's stock in order to be eligible for the filing of a consolidated return is:

A.
20%.

B.
50%.

C.
51%.

D.
80%.

D. 80%.

The minimum total voting power that a parent corporation must have in a subsidiary's stock in order to be eligible for the filing of a consolidated return is 80%. An affiliated group of corporations may file consolidated tax returns.

Once a consolidated return is filed, the group must continue to file consolidated returns.

A consolidated group is one in which the common parent directly owns at least 80% of the total voting power and 80% of the total value of the stock in at least one other “includible” corporation.

“Includible corporations” are all corporations, except the following:

Tax-exempt organizations
Life insurance companies (Exception: Affiliated groups composed only of life insurance companies can file consolidated returns.)
Foreign corporations (Exception: Certain Mexican or Canadian subsidiaries of a U.S. parent can file consolidated returns.)
Corporations that have a possessions tax credit under IRC Section 936
Regulated investment companies
Real estate investment trusts
A DISC or former DISC
An S corporation

90

Acme Corp. has two common stockholders. Acme derives all of its income from investments in stocks and securities, and it regularly distributes 51% of its taxable income as dividends to its stockholders. Acme is a:

A.
corporation subject to tax only on income not distributed to stockholders.

B.
corporation subject to the accumulated earnings tax.

C.
regulated investment company.

D.
personal holding company.

D.
personal holding company.

The key to this question is all of the income is from stocks and securities, called personal holding company income.

A “personal holding company (PHC)” is any corporation that:

derives at least 60% of its adjusted ordinary gross income for the tax year from income called “PHC income” and
more than 50% is owned directly or indirectly by not more than five individuals at any time during the last half of a tax year.

91

The standard deduction for a trust or an estate in the fiduciary income tax return is:

A.
$0.

B.
$100.

C.
$300.

D.
$600.

A.
$0.

There is no standard deduction for a trust or an estate (IRC Section 63(c)(6)(D)). Instead, the personal exemption for an estate is $600, for a simple trust is $300, and for a complex trust is $100,

92

Which of the following is allowed in the calculation of the taxable income of a simple trust?

A.
Exemption

B.
Standard deduction

C.
Brokerage commission for purchase of tax-exempt bonds

D.
Charitable contribution

A.
Exemption

Estates and trusts are separate taxable entities. A personal exemption of $300 is allowed for a trust that is required to distribute all of its income currently (simple trust). A simple trust has no beneficiaries that are charitable organizations.

93

Income in respect of a cash-basis decedent:

A.
covers income earned before the taxpayer’s death but not collected until after death.

B.
receives a stepped-up basis in the decedent’s estate.

C.
must be included in the decedent’s final income tax return.

D.
cannot receive capital gain treatment.

A.
covers income earned before the taxpayer’s death but not collected until after death.

Income in respect of a decedent (IRD) for a cash-basis taxpayer consists of taxable income that the deceased earned or otherwise was entitled to but failed to receive before their death. To avoid double taxation, the income does not receive a stepped-up basis in the decedent’s estate or is treated as capital gains. The IRD can be included on the tax return of the decedent estate, the beneficiary, or any person the estate passes the income to that had the right to receive it.

94

The personal service partnership of Allen, Baker & Carr had the following cash-basis balance sheet at December 31, Year 1:

Adjusted Basis Market
Assets per Books Value
Cash $102,000 $102,000
Unrealized accounts receivable -- 420,000
Totals $102,000 $522,000

Liability and Capital
Note payable $60,000 $ 60,000
Allen, capital 14,000 154,000
Baker, capital 14,000 154,000
Carr, capital 14,000 154,000
Totals $102,000 $522,000

Carr, an equal partner, sold his partnership interest to Dole, an outsider, for $154,000 cash on January 1, Year 2. In addition, Dole assumed Carr’s share of the partnership’s liability.

What was the total amount realized by Carr on the sale of his partnership interest?

A.
$174,000

B.
$154,000

C.
$140,000

D.
$134,000

A.
$174,000


When a partner sells his interest in a partnership and he is relieved from his share of partnership liabilities, then the amount realized is the amount of cash received plus his share of liabilities. Carr’s amount realized will be $174,000, computed as follows:

Amount realized: Cash received $154,000
+ Liability relief ($60,000 ÷ 3) 20,000
= Total amount realized $174,000

95

Carson owned 40% of the outstanding stock of a C corporation. During a tax year, the corporation reported $400,000 in taxable income and distributed a total of $70,000 in cash dividends to its shareholders. Carson accurately reported $28,000 in gross income on Carson's individual tax return. If the corporation had been an S corporation and the distributions to the owners had been proportionate, how much income would Carson have reported on Carson's individual return?

A.
$28,000

B.
$132,000

C.
$160,000

D.
$188,000

C.
$160,000


Shareholders in C corporation stock report as income their percentage ownership multiplied by the dividends that are distributed. It does not matter how much taxable income the C corporation reports.

Shareholders in an S corporation report as income their percentage ownership multiplied by the taxable income and separately stated items for the S corporation. There are no separately stated items, so Carson would report $160,000 ($400,000 × 0.40) as his share of the S corporation's taxable income.

96

Tan Corp. calculated the following taxes for the current year:


Regular tax liability $210,000
Tentative minimum tax 240,000
Personal holding company tax 65,000
What is Tan's total tax liability for the year?

A.
$210,000

B.
$240,000

C.
$275,000

D.
$305,000

D. $305,000
The personal holding company (PHC) tax is imposed in addition to the regular income tax and alternative minimum tax (AMT).

In computing the alternative minimum tax, the tentative minimum tax (TMT) is compared to the regular income tax. If the TMT is greater than the regular income tax, the excess is the AMT that is due for the year.

So Tan Corp will owe $305,000 computed as follows:


Regular income tax $210,000
AMT ($240,000 - $210,000) 30,000
PHC tax 65,000
Total tax $305,000

97

All of the following statements concerning a personal service corporation (PSC) are correct except:

A.
personal service corporations are taxed at a flat rate of 35%.

B.
occupations that would qualify as a PSC are lawyers, accountants, actuaries, podiatrists, and architects.

C.
a PSC is not subject to the limits on the deductibility of passive activity losses.

D.
a qualified PSC is a corporation that meets both a function test and an ownership test.

C.
a PSC is not subject to the limits on the deductibility of passive activity losses.

A PSC is subject to the limits on the deductibility of passive activity losses. The function and ownership test refers to the percentage of activity performed by the employee-owners.

IRC Sections 11(b)(2), 448(d)(2), and 469(a)(2)

98

Which of the following is a disadvantage of a revocable trust?

A.
The grantor will be subject to gift taxes on the transfer of property to the trust.

B.
The trust assets are subject to being probated upon the death of the grantor.

C.
The grantor loses power to control the trust funds for federal estate tax purposes.

D.
The trust is included in the gross estate of the grantor.

D.
The trust is included in the gross estate of the grantor.

A revocable trust is set up while the person is alive and means that the person who set up the trust can change their mind. If a revocable trust has a vehicle placed in it, the person can remove the vehicle and terminate the trust.

A trust is a grantor trust if the grantor retains certain powers or ownership benefits. In general, a grantor trust is ignored for tax purposes and all of the income, deductions, etc. are treated as belonging directly to the grantor. Thus, there are no gift taxes on the transfer of property to the trust.

The gross estate includes all property in which the decedent had an interest (including real property outside the United States). It also includes:

certain transfers made during the decedent's life without an adequate and full consideration in money or money's worth,
annuities,
the includible portion of joint estates with right of survivorship,
the includible portion of tenancies by the entirety, and
property over which the decedent possessed a general power of appointment.
As a result, a disadvantage of a revocable trust is it is included in the gross estate.

99

ABC Corporation distributes land with a fair market value (FMV) of $100,000 (adjusted basis of $75,000) to Anna when the corporation's E&P is $350,000. Anna is the sole shareholder. What basis does Anna take in the land and what amount of gain does ABC Corporation recognize, respectively, as a result of this nonliquidating property distribution?

A.
$75,000; $0

B.
$100,000; $0

C.
$25,000; $25,000

D.
$100,000; $25,000

D.
$100,000; $25,000

The shareholder's basis in property received as a result of a nonliquidating property dividend is the fair market value (FMV) on the date of the distribution. The corporation will recognize a gain for the difference between the FMV on the date of the distribution and the adjusted basis of the property at the date of the distribution. Corporations will not recognize a loss on a nonliquidating property dividend.

100

Basic Partnership, a cash-basis calendar-year entity, began business on February 1 of the current year. Basic incurred and paid the following in the current year, prior to February 1:

Filing fees incident to the creation of the
partnership $ 3,600
Accounting fees to prepare the representations
in offering materials 12,000

Basic elected to amortize costs. What was the maximum amount that Basic could deduct on the current-year partnership return?

A.
$6,943

B.
$3,600

C.
$2,860

D.
$660

B.
$3,600

The maximum deduction that the partnership can take on its current-year return is $3,600 or 100% of the organization costs up to $5,000.

Filing fees and other costs incident to the creation of the partnership are required to be capitalized as organization costs. For organizational expenditures incurred after August 16, 2011, taxpayers may deduct up to $5,000 in the taxable year in which the business begins. The $5,000 amount is reduced by the amount by which the cumulative cost of organizational expenditures exceeds $50,000. Any remaining organizational expenditures not deducted are amortized over a 15-year period (180 months) beginning with the month the active trade or business begins.

Accounting fees to prepare the representations in offering materials and other costs incurred to sell or promote the sale of the partnership are required to be capitalized as syndication costs. Syndication costs are not eligible for amortization.

101

Bank Corp. owns 80% of Shore Corp.'s outstanding capital stock. Shore's capital stock consists of 50,000 shares of common stock issued and outstanding. Shore's net income was $140,000. During the year, Shore declared and paid dividends of $60,000. In conformity with generally accepted accounting principles, Bank recorded the following entries:
Debit Credit
Investment in Shore Corp.
common stock $112,000
Equity in earnings of
subsidiary $112,000
Cash 48,000
Investment in Shore Corp.
common stock 48,000
In its consolidated tax return, Bank should report dividend revenue of:

A.
$48,000.

B.
$14,400.

C.
$9,600.

D.
$0.

D.
$0.

Because Bank filed a consolidated tax return, the dividend paid from Shore Corp. to Bank Corp. is offset. Therefore, Bank Corp. has no dividend revenue from Shore Corp.

The advantages of filing consolidated returns are:

offsetting operating losses of one company against the profits of another,
offsetting capital losses of one company against the capital gains of another, and
avoidance of tax on intercompany distributions.

102

Belson and Forman decided to terminate North partnership. On the date of termination, North's balance sheet was as follows:

Adjusted Basis
Cash $2,000
Equipment (fair market value $4,000) 6,000
Capital - Belson 4,000
Capital - Forman 4,000

Forman's outside basis is $2,000. The partnership assets were distributed equally between the partners. What is Forman's tax basis in the property received?

A.
$1,000

B.
$4,000

C.
$6,000

D.
$10,000

A.$1,000 (2000-1000)

Since the partner's basis is more than the cash received from the partnership, there would not be any gain to recognize on the liquidation. In that case, the basis in the property received would be the partner's share of the fair market value (FMV) of the distributed property less any cash received in the liquidation. Forman's distributive share of the property would be $2,000 less their share of the cash received ($1,000), which would give Forman a basis of $1,000 in the distributed property that they received from the liquidation of the partnership.

103

When a trust instrument is silent regarding a trustee’s powers, which of the following implied powers does a trustee generally have?

A. The power to make distributions of principal to income beneficiaries
B. The power to lease trust property to third parties

A.
Both A and B

B.
Only A

C.
Only B

D.
Neither A nor B


C.
Only B

When a trust instrument is silent regarding a trustee’s powers, the trustee has the implied power to lease trust property to third parties, but does not have the implied power to make distributions of principal to income beneficiaries. An implied power is the power a trustee needs to perform such acts as are necessary to achieve the objectives of the trust.

104

Max sold his 10% interest in the Ajax partnership for $60,000. Ajax had $150,000 of unrealized receivables. Max had an adjusted basis in the partnership of $40,000. As the result of the sale, Max should report:

A.
$15,000 ordinary income, $5,000 capital gain.

B.
$15,000 capital gain, $5,000 ordinary income.

C.
$20,000 ordinary income.

D.
$20,000 capital gain.

A.
$15,000 ordinary income, $5,000 capital gain.

Max must recognize $15,000 ordinary income under IRC Section 751 because Ajax had “hot assets” (unrealized receivables and inventory). Any gain in excess of that attributed to hot assets is a capital gain.

105

Commerce Corp. elects S corporation status as of the beginning of year 20X1. At the time of Commerce's election, it held a machine with a basis of $20,000 and a fair market value of $30,000. In March 20X1, Commerce sells the machine for $35,000. What would be the amount subject to the built-in gains tax?

A.
$0

B.
$5,000

C.
$10,000

D.
$15,000

C. $10,000=(30-20)

The $10,000 is subject to the built-in gains tax since the C corporation basis was $20,000, but fair market value (FMV) was $30,000 at the time of election. When a regular C corporation converts to S corporation status, a tax may be imposed on the net increase in value that took place on the assets during the time they were held by the C corporation. The tax is imposed on the S corporation when it disposes of property within five years of the S election.

106

Packer Corp., an accrual-basis, calendar-year S corporation, has been an S corporation since its inception. Starr was a 50% shareholder in Packer throughout the current year and had a $10,000 tax basis in Packer stock on January 1. During the current year, Packer had a $1,000 net business loss and made an $8,000 cash distribution to each shareholder. What amount of the distribution was includible in Starr's gross income?

A.
$8,000

B.
$7,500

C.
$4,000

D.
$0

D. $0

Since Packer Corp. has been an S corporation since its inception, it has no accumulated E&P. Distributions by S corporations with no accumulated E&P are tax-free up to the adjusted basis of the stock with any excess taxable as capital gains. In this case, the $8,000 distribution did not exceed Starr's basis and, therefore, was not taxable.

Basis on January 1 $10,000
Pro rata share of current loss
(50% x $1,000) (500)
Distribution (8,000)
Basis on December 31 $1,500
IRC Section 1368(b)

107

Edge Corp. met the stock ownership requirements of a personal holding company. What sources of income must Edge consider to determine if the income requirements for a personal holding company have been met?

I. Interest earned on tax-exempt obligations
II. Dividends received from an unrelated domestic corporation
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

B. II only
Since Edge Corp. met the stock ownership requirements of a personal holding company, of the two choices of income you had to select from, only dividends received from an unrelated domestic corporation is considered personal holding company income.

Generally, any corporation could be a personal holding company (PHC). There are specific corporations that are exempt from PHC classification.

A corporation must meet both the stock ownership test and the gross income test to be a personal holding company (PHC). These tests are:
at any time during the last half of the year more than 50% in value of its outstanding stock is owned, directly or indirectly, by five or fewer individuals, and
at least 60% of its adjusted ordinary gross income is PHC income.

A sample of some of the personal holding company income includes:
dividends, taxable interest, royalties (except copyright or software royalties), and annuities.
rents, unless they constitute 50% or more of the adjusted ordinary gross income.
mineral, oil, and gas royalties, unless they constitute 50% or more of the adjusted ordinary gross income.

108

Stone and Frazier decided to terminate the Woodwest Partnership as of December 31. On that date, Woodwest's balance sheet was as follows:
Cash $2,000
Equipment (adjusted basis) 2,000
Capital: Stone 3,000
Capital: Frazier 1,000
The fair market value of the equipment was $3,000. Frazier's outside basis in the partnership was $1,200. Upon liquidation, Frazier received $1,500 in cash. What gain should Frazier recognize?

A.
$0

B.
$250

C.
$300

D.
$500

C. $300 =(1500-1200)

Although there is generally no gain or loss recognized by a partner upon the liquidation of a partnership interest, there are exceptions:

Gain is recognized if cash distributed is in excess of the partner's basis in the partnership interest.
Loss is recognized if no property other than cash is distributed and the cash is less than the partner's basis in the partnership interest.

Frasier's cash distribution exceeded his basis in his partnership interest so he recognized gain computed as follows:

Liquidating cash distribution $1,500
Basis in partnership interest 1,200
Gain on liquidation $ 300

IRC Section 731(a)

109

Which of the following costs are organizational expenditures?

A.
Professional fees to issue the corporate stock

B.
Printing costs to issue the corporate stock

C.
Legal fees for drafting the corporate charter

D.
Commissions paid by the corporation to an underwriter

C. Legal fees for drafting the corporate charter

The only organization expenditures in this question are “legal fees for drafting the corporate charter.” All of the other expenditures relate to issuing the stock and are not organization costs.

For organizational expenditures incurred after August 16, 2011, taxpayers may elect to deduct up to $5,000 in the taxable year in which the business begins. The $5,000 amount is reduced by the amount by which the cumulative cost of organization expenditures exceeds $50,000. Any remaining organizational expenditures not deducted are amortized over a 15-year period (180 months) beginning with the month the active trade or business begins.

Organization cost included legal services, state incorporation fees, temporary directors' fees, and organizational meeting costs.

Costs of issuing stock cannot be deducted.

110

A trust in which the beneficiaries are given a future right to trust income or corpus and the $14,000 gift tax exclusion is retained is termed a:

A.
reversionary trust.

B.
Crummey trust.

C.
gift-leaseback.

D.
throwback trust.

B. Crummey trust.

A Crummey trust is a “safe harbor” rule that allows the annual gift tax exclusion on gifts to a trust. The gift of a future interest provision does not apply to gifts to a Crummey trust if trust assets go to the beneficiaries on or before age 21. Giving the right to the trust income (generally only up to $14,000 per donee, per year) meets the requirement even though the beneficiaries do not actually withdraw the funds.

111

Paul Pappas owns all of the stock of an S corporation which had previously been a C corporation. The S corporation had the following balances at the beginning of its tax year:
Accumulated adjustments account $ 8,000
Accumulated earnings and profits 10,000

Paul's stock basis was $20,000 at the beginning of the tax year. The S corporation made a distribution of $19,000 to Paul during the year. What is Paul's stock basis at the end of the year?

A.
$1,000

B.
$2,000

C.
$11,000

D.
$12,000

C. $11,000 =($20,000 - $8,000 - $1,000 = $11,000).


Paul's basis is reduced by the distribution from accumulated adjustments account, but not by the distribution from accumulated earnings and profits which is taxable income to Paul. The distribution in excess of $18,000 is a tax-free return of capital and reduces Paul's basis ($20,000 - $8,000 - $1,000 = $11,000).

112

Lincoln Corp., a calendar-year C corporation, made a nonliquidating cash distribution of $1.5 million to its shareholders with respect to its stock. At that time, Lincoln's current and accumulated earnings and profits totaled $825,000 and its total paid-in capital for tax purposes was $10 million. Lincoln had no corporate shareholders. Which of the following statements is (are) correct regarding Lincoln's cash distribution?

I. The distribution was taxable as $1.5 million in ordinary income to its shareholders.
II. The distribution reduced its shareholders' adjusted bases in Lincoln stock by $675,000.
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

B. II only

The distribution of $1.5 million is applied as follows:
(1) From current and (then) accumulated earnings
and profits (up to $825,000)
(all taxable as ordinary dividend income): $ 825,000
(2) From basis (up to $10,000,000)
(nontaxable return of capital): 675,000
(3) Capital gains, if any distribution remains
in excess of basis and earnings and profits
(taxable): 0
Total: $1,500,000
Thus, only II is correct, the distribution reduced its shareholders' adjusted bases in Lincoln Corp. stock by $675,000.

113

Cox transferred assets into a trust under which Smart is entitled to receive the income for life. After Smart’s death, the remaining assets are to be given to Mix. In Year 1, the trust received rent of $1,000, stock dividends of $6,000, interest on certificates of deposit of $3,000, municipal bond interest of $4,000, and proceeds of $7,000 from the sale of bonds. Both Smart and Mix are still alive. What amount of the Year 1 receipts should be allocated to trust principal?

A.
$7,000

B.
$8,000

C.
$13,000

D.
$15,000

C. $13,000 (60+70)

The amount of the Year 1 receipts that should be allocated to trust principal will include the following:

$6,000 of stock dividends; no cash was received, only more shares of stock to add to the principal
$7,000 proceeds from sale of bonds, which were part of the principal of the trust
The rent and interest will both be allocated to income.

114

As a general partner in Greenland Associates, an individual's share of partnership income for the current tax year is $25,000 ordinary business income and a $10,000 guaranteed payment. The individual also received $5,000 in cash distributions from the partnership. What income should the individual report from the interest in Greenland?

A.
$5,000

B.
$25,000

C.
$35,000

D.
$40,000

C. $35,000

A partner reports his distributive share of partnership income whether it is received or not. A guaranteed payment is considered income to the partner receiving it. Therefore, ordinary income and guaranteed payments are included in the individual's income.
Ordinary business income $25,000
Guaranteed payment 10,000
Interest in Greenland $35,000
Cash distributions from the partnership have no bearing on the income reported by the partner. The cash distribution will decrease the partner's basis in the partnership interest.

115

White has a 1/3rd interest in the profits and losses of Rapid Partnership. Rapid's ordinary income for the calendar year is $30,000, after a $3,000 deduction for a guaranteed payment made to White for services rendered. None of the $30,000 ordinary income was distributed to the partners. What is the total amount that White must include from Rapid as taxable income in his tax return?

A.
$3,000

B.
$10,000

C.
$11,000

D.
$13,000

D. $13,000

White must include from Rapid the following taxable income on his tax return:

$30,000 x 1/3 = $10,000
Add the guaranteed
payment 3,000
Total income: $13,000

A partner's guaranteed payment is usually given to a partner for his or her services or capital, without regard to partnership income. A guaranteed payment is treated like a salary payment to an employee and is deductible as a business expense by the partnership (IRC Section 707(c)). Each partner reports his distributive share of the partnership income (and deductions and other items such as guaranteed payments and interest payments) for a partnership tax year on his or her individual tax return (Form 1040) within or with which that partnership tax year ends.

116

Bell, a cash-basis calendar-year taxpayer, died on June 1, Year 15. In Year 15, prior to her death, Bell incurred $2,000 in medical expenses. The executor of the estate paid the medical expenses, which were a claim against the estate, on July 1, Year 15. If the executor files the appropriate waiver, the medical expenses are deductible on:

A.
the estate tax return.

B.
Bell's final income tax return.

C.
the estate income tax return.

D.
the executor's income tax return.

B. Bell's final income tax return.

The medical expense in the amount of $2,000 can reduce the taxable estate (Form 706) of Bell or they can be deducted on her final income tax return (Form 1040). Expenses for Bell's medical care ($2,000) that are paid out of her estate are treated as paid by her (and deducted on Form 1040) in the year the expenses were incurred if (1) they are paid within one year after her death, (2) they aren't deducted for federal estate tax purposes, and (3) a statement is filed with the income tax return (or amended return) showing that the expenses haven't been allowed for estate tax purposes and that an estate tax deduction for them is waived.

Since the executor filed the appropriate waiver for the medical expenses, they cannot be deducted on the estate tax return.

Medical expenses can never be deducted on the estate income tax return (Form 1041).
Medical expenses of the decedent have no connection with the executor's personal income tax return.

117

Dean is a 25% partner in Target Partnership. Dean's tax basis in Target was $20,000. Dean received a nonliquidating cash distribution of $8,000 from Target. Target's accounts recorded the following items:

Municipal bond interest income $12,000
Ordinary income 40,000

What was Dean's tax basis in Target at the end of the year?

A.
$15,000

B.
$23,000

C.
$25,000

D.
$30,000

C.
$25,000

Dean's tax basis in Target Partnership is calculated as follows:

Beginning basis $20,000
Less Distribution - 8,000
Add: 0.25 x $12,000
Municipal bond interest income + 3,000
Add: 0.25 x $40,000
Ordinary income + 10,000
Dean's tax basis in Target at year-end $25,000

118

Simon, a C corporation, had a deficit in accumulated earnings and profits of $50,000 at the beginning of the year and had current earnings and profits of $10,000. At year-end, Simon paid a dividend of $15,000 to its sole shareholder. What amount of the dividend is reported as income?

A.
$0

B.
$5,000

C.
$10,000

D.
$15,000

C.
$10,000

Corporate distributions to shareholders are considered taxable dividends to the extent of earnings and profits. When there is a deficit in accumulated earnings and profits and no deficit in current-year earnings and profits, then the distribution will be taxable to the extent of the current-year earnings and profits. Only $10,000 of the $15,000 distribution is taxable because there is only $10,000 in current-year earnings and profits.

119

On January 1, Year 0, Kane owned all 100 issued shares of Manning Corp., a calendar-year S corpora­tion. On the 41st day of Year 0, Kane sold 25 of the Manning shares to Rodgers. For the year ended December 31, Year 0 (a 366-day calendar year), Manning had $73,200 in nonseparately stated income and made no distributions to its shareholders. What amount of nonseparately stated income from Manning should be reported on Kane’s Year 0 tax return?

A.
$56,900

B.
$54,900

C.
$16,300

D.
$0

A.
$56,900

Items of income and/or loss for an S corporation are passed through to the shareholders based on their pro rata share of each separately or nonseparately stated item, whether distributed or not. Kane will report $56,900 of nonseparately stated income from Manning Corporation for Year 0, computed as follows:

Kane’s pro rata share of 100% ownership of
Manning Corp. ($73,200 × 40/366) $ 8,000
Kane’s pro rata share of 75% ownership of
Manning Corp. ($73,200 × 0.75 × 326/366) 48,900
Total $56,900

120

In April, A and B formed X Corp. A contributed $50,000 cash and B contributed land worth $70,000 (with an adjusted basis of $40,000). B also received $20,000 cash from the corporation. A and B each received 50% of the corporation's stock. What is the tax basis of the land to X Corp.?

A.
$40,000

B.
$50,000

C.
$60,000

D.
$70,000

C. $60,000 (40+20)

X Corp. received land with an adjusted basis of $40,000 from shareholder B. X Corp. paid B an additional $20,000 in cash. The tax basis of the land for X Corp. is $60,000, made up of the $40,000 in basis from B and the $20,000 paid to B.

121

Dove and Eagle formed a business entity in which they are equal owners. Dove contributed cash of $100,000, and Eagle contributed land with a basis of $40,000 and fair market value of $100,000. For its first year of operations, the entity had taxable income of $60,000 and made no distributions. At year-end it had outstanding recourse liabilities to third parties of $10,000. Eagle had a basis of $70,000 in the entity at the end of the first year of operations. What type of entity was formed?

A.
C corporation

B.
S corporation

C.
General partnership

D.
Limited liability company (LLC)

B. S corporation
In this case, Eagle’s basis at the end of the year in the S corporation is $70,000, which is the $40,000 for his basis of the contributed land plus his share of the taxable income for the first year of operations of $30,000 (50% share of the S corporation’s $60,000 income).

If the entity was a C corporation, its taxable income of $60,000 would not increase Eagle’s basis in his stock, so it cannot be a C corporation.

If the entity was a general partnership, $5,000 (50% share of the general partnership’s $10,000 of recourse liabilities) would have been added to Eagle’s basis. The partner's contributions to the partnership and the increased share of, or assumption of, partnership liabilities increase a partner’s basis. Thus, it cannot be a general partnership.

The entity choice of a limited liability company (LLC) does not provide enough information. There is uncertainty as to its tax treatment as a corporation or a partnership since there are two equal owners, Dove and Eagle, and they could choose to be either a partnership or corporation.

Thus, as first described above, the only entity that could result in an end-of-year basis for Eagle would be the S corporation.

The basis of an S corporation shareholder's stock (generally, its cost) is adjusted as follows and, except as noted, in the order listed. In addition, basis may be adjusted under other provisions of the Internal Revenue Code:
Basis is increased by (a) all income (including tax-exempt income) reported on Schedule K-1 and (b) the excess of the deduction for depletion (other than oil and gas depletion) over the basis of the property subject to depletion.
Basis is decreased by property distributions (including cash) made by the corporation (excluding dividend distributions reported on IRS Form 1099-DIV and distributions in excess of basis) reported on IRS Schedule K-1, box 16, code D, minus the amount of such distributions in excess of the basis of the shareholder's stock.
Basis is decreased by (a) nondeductible expenses and (b) the depletion deduction for any oil and gas property held by the corporation, but only to the extent the shareholder's pro rata share of the property's adjusted basis exceeds that deduction.
Basis is decreased by all deductible losses and deductions reported on Schedule K-1.
Note that the taxpayer can make an election to deduct items in (4) in the list above before nondeductible items in (3)

122

Azure, a C corporation, reports the following:

Pretax book income is $543,000.
Depreciation on the tax return is $20,000 greater than depreciation on the financial statements.
Rent income reportable on the tax return is $36,000 greater than rent income per the financial statements.
Fines for pollution appear as a $10,000 expense in the financial statements.
Interest earned on municipal bonds is $25,000.
What is Azure's taxable income?

A.
$528,000

B.
$543,000

C.
$544,000

D.
$559,000

C. $544,000
Azure's taxable income is $544,000, calculated as follows:
Pretax book income $543,000
Less: Additional tax depreciation (20,000)
Add: Additional rent income 36,000
Add: Nondeductible fines 10,000
Less: Nontaxable municipal bond interest (25,000)
Taxable income $544,000

Assets are generally expensed over a longer period of time for the financial statements and deducted over a shorter period of time for the tax return due to differences in book depreciation methods versus tax depreciation methods.

Prepaid rent is generally included in financial income when earned according to accrual basis accounting, and taxable when received according to the wherewithal concept.

Fines and penalties are included as expenses on the financial statements and are not deductible on the tax return.

Municipal bond interest is included as income on the financial statements but is not taxable on the tax return.

123

As of January of Year 8, Kane owned all the 100 issued shares of Manning Corp., a calendar-year S corporation. On the 41st day of Year 8, Kane sold 25 of the Manning shares to Rodgers. For the year ended December 31, Year 8 (a 365-day calendar year), Manning had $73,000 in nonseparately stated income and made no distribution to its shareholders. What amount of nonseparately stated income from Manning should be reported on Kane's Year 8 tax return?

A.
$56,750

B.
$54,750

C.
$16,250
D.
$0

A. $56,750

$73,000 Total income
- 16,250 Roger's share of the income
($73,000 x (25 / 100) x (325 days / 365 days))
$56,750 Kane's share of the income

Kane owned the stock 325 days (365 days − 40 days).

Whenever a shareholder sells S corporation stock during any year, the income or loss must be allocated on a daily basis.

There is another way to calculate Kane's share of the income:
The first 40 days of income is allocated 100% to Kane: 40 × ($73,000 ÷ 365) = $8,000.
Seventy-five percent (75%) of the remaining 325 days of income is allocated to Kane: 75% × 325 × ($73,000 ÷ 365) = $48,750.
The total income allocated to Kane is $56,750 (or $8,000 + $48,750).

124

Lind and Post organized Ace Corp., which issued voting common stock with a fair market value of $120,000. They each transferred property in exchange for stock as follows:
Adjusted Fair Market Percentage of
Property Basis Value Ace Stock Acquired
Lind Building $40,000 $82,000 60%
Post Land 5,000 48,000 40%

The building was subject to a $10,000 mortgage that was assumed by Ace.

What was Lind’s basis in Ace stock?
A.
$82,000

B.
$40,000

C.
$30,000

D.
$0

C. $30,000

This transaction qualifies as a Section 351 tax-free transaction. No gain or loss is recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange the persons are in control of the corporation. Control means 80% or more of the corporation. Since Lind and Post own 100% of the corporation, no gain is to be recognized.

The basis of the stock received by Lind will be $30,000, which is the adjusted basis of the building transferred to Ace Corp, minus the $10,000 liability Ace Corp assumed.

Adjusted basis of building $40,000
- Liability assumed by Ace Corp. (10,000)
= Adjusted basis of stock received by Lind $30,000

125

Which of the following cannot be amortized for tax purposes?

A.
Incorporation costs

B.
Temporary directors' fees

C.
Stock issuance costs

D.
Organizational meeting costs

C.
Stock issuance costs

Organizational expenses may be amortized on an entity's tax return. Organizational expenses include any costs incidental to organizing the business, such as accounting and legal fees, expenses of organizational meetings, and temporary directors' fees.

The expenses of issuing stock are not amortizable; they must be charged against paid-in capital. These expenses include printing costs, professional fees, commissions, and charges for listing the stock on an exchange.

126

Gem Trust, a simple trust, reported the following items of income and expenses:

Interest income from corporate bonds $4,000
Taxable dividend income 2,000
Trustee fees allocable to income 1,500

What is Gem's distributable net income (DNI)?
A.
$6,000

B.
$4,500

C.
$2,500

D.
$500

B. $4,500

Distributable net income (DNI) is the taxable income of a trust or estate computed without the distribution deduction, personal exemption, and certain other adjustments. The deduction that an estate or trust can take for distributions to beneficiaries is limited to DNI.

Gem's DNI is computed as follows:

Interest income $4,000
Dividend income 2,000
Less: trustee fees (1,500)
DNI $4,500

127

A corporation's capital loss carryback or carryover is:

A.
not allowable under current law.

B.
limited to $3,000.

C.
always treated as a long-term capital loss.

D.
always treated as a short-term capital loss.

D. always treated as a short-term capital loss.

A corporation may carry capital losses back three years and forward five years. The carryback and carryover is always treated as a short-term capital loss.

While an individual is allowed to offset $3,000 of capital losses against ordinary income, corporations cannot.


128

Robin, a C corporation, had revenues of $200,000 and operating expenses of $75,000. Robin also received a $20,000 dividend from a domestic corporation and is entitled to a $14,000 dividends-received deduction. Robin donated $15,000 to a qualified charitable organization in the current year. What is Robin's contribution deduction?

A.
$15,000

B.
$14,500

C.
$13,900

D.
$13,100

B. $14,500

The corporate limit for charitable contributions is 10% of taxable income (TI) computed before the deductions for contributions, dividends-received deduction, NOL carryback, and capital loss carryback. The charitable contribution deduction is $14,500 as calculated below:

Revenues $200,000
Dividend income 20,000
Less: Operating expenses (75,000)
TI applicable to the charitable
contribution limit $145,000
Multiplied by 10% x .10
Charitable contribution deduction $ 14,500

129

An S corporation had the following income and expenses:

Sales $240,000
Rent expense 25,000
Entertainment expense 5,000
Interest income 1,500
Contributions to qualifying charities 600
IRC Section 179 expense 3,000
Depreciation expense 1,800

What would be reported as ordinary income on the corporation's income tax return?

A.
$206,100

B.
$208,600

C.
$210,700

D.
$213,200

C. $210,700

Accordingly, the S corporation's ordinary income is $210,700, calculated as follows:
Business income $240,000
Rent expense (25,000)
Depreciation (1,800)
Entertainment (50% × $5,000) (2,500)
Ordinary income $210,700

All items of income, gain, deduction, loss, credit, etc. recognized at the corporate level are passed through to the shareholders. Each shareholder includes in their taxable income their pro rata share of each item of income, loss, deduction, or credit that is separately stated by the S corporation, regardless of whether or not a distribution was made to the shareholder.

The shareholders' pro rata share of deductible items reported separately on IRS Schedule K-1 includes (but is not limited to) the following items:
Expenses incurred for the production of income instead of in a trade or business
Ordinary business income (loss)
Net rental real estate income (loss)
Interest income
Dividends
Royalties
Charitable contributions
IRC Section 179 deduction
Net short-term capital gain or loss
Foreign taxes paid to the government of a foreign country
These items as well as other deductible items, credits, and foreign transactions are listed separately on Schedule K and Schedule K-1 of IRS Form 1120S.

Specific to this question, the shareholders' pro rata share items include interest income, the IRC Section 179 expense deduction, and contributions to charities. These items are listed separately on Schedule K and Schedule K-1 of Form 1120S; that is, they are not part of the ordinary income calculation on line 1 of the Schedule K-1.

130

In computing the ordinary income of a partnership, a deduction is allowed for:

A.
contributions to recognized charities.

B.
80% of dividends received from qualifying domestic corporations.

C.
short-term capital losses.

D.
guaranteed payments to partners.

D. guaranteed payments to partners.

In computing the ordinary income of a partnership, a deduction is allowed for guaranteed payments to partners.

Guaranteed payments are payments to a partner for services rendered or for the use of capital without regard to partnership income.
The guaranteed payment is deductible by the partnership as a business expense.
Charitable contributions made by the partnership and capital losses of the partnership flow through the partnership on Form 1065 K-1 to the individual partners. The partners then enter these items on their Forms 1040. The guaranteed payment will also appear as an income item on the Form K-1 of the partner receiving the payment.

The 80% dividends-received exclusion applies only to corporations.

131

Dart Corp., a calendar-year S corporation, had 60,000 shares of voting common stock and 40,000 shares of nonvoting common stock issued and outstanding. On February 23, Year 4, Dart filed a revocation statement with the consent of shareholders holding 30,000 shares of its voting common stock and 5,000 shares of its nonvoting common stock. Dart's S corporation election:

A.
did not terminate.

B.
terminated as of January 1, Year 4.

C.
terminated on February 24, Year 4.

D.
terminated as of January 1, Year 5.

A.
did not terminate.

Under IRC Section 1362(d), an S corporation terminates when the shareholders holding a majority of the total voting and nonvoting shares of stock consent. Revocation does not require more than one-half of each class of stock, only one-half of the total outstanding shares. Thus, more than 1/2 (60,000 shares + 40,000 shares), or at least 50,001 shares are needed for consent to terminate.

132

In the current year, Brown, a C corporation, has gross income (before dividends) of $900,000 and deductions of $1,100,000 (excluding the dividends-received deduction). Brown received dividends of $100,000 from a Fortune 500 corporation during the current year. What is Brown's net operating loss?

A.
$100,000

B.
$130,000

C.
$170,000

D.
$200,000

C. $170,000

Since a Fortune 500 corporation's stock is generally widely held, this indicates that Brown owns less than 20% of its stock and qualifies for the 70% dividends-received deduction. The taxable income limitation for the dividends-received deduction does not apply since Brown has a net operating loss. Brown's net operating loss is calculated as follows:
Income before dividends $ 900,000
Dividends 100,000
Gross income 1,000,000
Deductions (1,100,000)
Net operating loss before special deductions (100,000)
Dividend-received deduction ($100,000 x 70%) (70,000)
Net operating loss $ (170,000)

133

If property contributed to a partnership is distributed to a partner other than the contributing partner within seven years of its contribution to the partnership, all of the following will apply except:

A.
the contributing partner will be required to recognize the built-in gain or loss at the time of the disqualified distribution.

B.
gain or loss is calculated as if the property was sold for the lesser of its basis or FMV at the date of distribution.

C.
the contributing partner's gain recognized is limited to the gain that would be recognized by the partnership.

D.
the basis in the property and partnership interests will be adjusted for the gain or loss recognized.

B.
gain or loss is calculated as if the property was sold for the lesser of its basis or FMV at the date of distribution.

C.
Gain or loss is calculated as if the property was sold for its Fair Market Value at the date of the distribution. (For property contributed to a partnership prior to June 9, 1997, these rules had a shorter 5-year lookback.)

134

Apex, Inc., is a small calendar-year corporation with annual gross receipts as follows: Year 1 ($4 million), Year 2 ($5 million), Year 3 ($6 million), and Year 4 ($7 million). Its 3-year average annual gross receipts are $5 million in Year 3 and $6 million for Year 4. Therefore, it is exempt from alternative minimum tax for Year 5. What happens if Apex has annual gross receipts of $8 million for Year 5?

A.
It loses its small corporation exemption and is subject to AMT for Year 6.

B.
It permanently loses its small corporation exemption.

C.
It remains exempt from AMT for Year 6.

D.
It loses its small corporation exemption and must pay AMT for all the years it was exempt.

C.
It remains exempt from AMT for Year 6.


A small corporation loses the AMT exemption only if its average annual gross receipts for three consecutive years exceed $7.5 million. Although Apex gross receipts for Year 5 exceeded $7.5 million, its 3-year average gross receipts for Year 3 through Year 5 were only $7 million. Therefore, it retains its status as a small corporation that is exempt from AMT.

135

Chip and Dale each have a 50% interest in a partnership. Chip uses a calendar year while Dale has a fiscal year ending November 30. Assuming that the partnership does not make a Section 444 election and does not establish a business purpose for a different period, what tax year must the partnership use to file its tax return?

A.
November 30

B.
December 31

C.
June 30

D.
They may choose any month.

The partnership must use a tax year ending on November 30 because this results in the least aggregate deferral of income to the partners.

A partnership is required to have the same taxable year as its majority (over 50%) partners or if none, then the tax year of all its principal partners. If no taxable year can be established under these rules, then the tax year with the least aggregate deferral must be used.

The aggregate deferral is calculated based on the number of months from the partnership year-end to the partner's year-end, multiplied by the partner's ownership percentage.

A. November 30

The partnership must use a tax year ending on November 30 because this results in the least aggregate deferral of income to the partners.

A partnership is required to have the same taxable year as its majority (over 50%) partners or if none, then the tax year of all its principal partners. If no taxable year can be established under these rules, then the tax year with the least aggregate deferral must be used.

The aggregate deferral is calculated based on the number of months from the partnership year-end to the partner's year-end, multiplied by the partner's ownership percentage.

In this case, test both the November 30 year-end and the December 31 year-end. (Partnership year-end - Partner year-end) × Ownership %.
December 31 year-end
Chip 12/31 to 12/31 x 50% = 0 x 50% = 0
Dale 12/31 to 11/30 x 50% = 11 x 50% = 5.5
total deferral 5.5

November 30 year-end
Chip 11/30 to 12/31 x 50% = 1 x 50% = .5
Dale 11/30 to 11/30 x 50% = 0 x 50% = 0
total deferral .5
November 30 results in a smaller deferral and is the required year-end.

136

Baker, an individual, owned 100% of Alpha, an S corporation. At the beginning of the year, Baker's basis in Alpha Corp. was $25,000. Alpha realized ordinary income during the year in the amount of $1,000 and a long-term capital loss in the amount of $3,000 for this year. Alpha distributed $30,000 in cash to Baker during the year. What amount of the $30,000 cash distribution is taxable to Baker?

A.
$0

B.
$5,000

C.
$4,000

D.
$7,000

C. $4,000=(1+3)

Distributions to S corporation shareholders cannot reduce stock basis below zero. Distributions in excess of basis are taxable. (IRC Section 1368)

Items that increase S corporation shareholder basis include income of the corporation that is not separately computed. In this case, there is $1,000 of ordinary income. (IRC Section 1367(a)(1))

Items that decrease S corporation shareholder basis include distributions up to but not exceeding basis and loss and deduction items of the corporation that are separately stated. In this case, these are $3,000 long-term capital loss and $23,000 of the cash distribution. (IRC Section 1367(a)(2))

Stock basis is adjusted annually, as of the last day of the S corporation year, in the following order:
Increased for income items and excess depletion;
Decreased for distributions;
Decreased for non-deductible, non-capital expenses and depletion; and
Decreased for items of loss and deduction.
Therefore, $4,000 of the cash distribution is taxable to Baker. The long-term capital loss can’t be deducted in the current year as the cash distribution has already reduced the stock basis to zero.

137

When comparing liquidating distributions of different entities, which of the following statements is incorrect?

A.
If a partner receives cash in excess of the partner's adjusted basis, then gain is recognized on the excess.

B.
A C corporation will recognize a gain or loss when the corporation is liquidated.

C.
An S corporation will not recognize a gain or loss when the corporation is liquidated.

D.
In a partnership, if no cash equivalents are distributed, no gain is recognized.

C.
An S corporation will not recognize a gain or loss when the corporation is liquidated.

Both C corporations and S corporations will recognize a gain or loss when the corporation is liquidated. Gain is recognized by a partner if cash received in a liquidating distribution exceeds the partner's adjusted basis. Additionally, in a partnership, if no cash equivalents are distributed, no gain is recognized.

138

Which of the following elections are made at the partnership level?

A.
Cost or percentage depletion for oil and gas wells

B.
Cost recovery methods and assumptions

C.
Reduction of basis of depreciable property when excluding income from discharge of indebtedness

D.
Take a deduction or credit for foreign taxes paid

B.
Cost recovery methods and assumptions

There are four elections that are made at the partnership level:
Taxable year and accounting method
Cost recovery methods and assumptions
Treatment of research and development costs
Amortization of organization costs and start-up costs

139

Bridge, a C corporation, had $15,000 in accumulated earnings and profits at the beginning of the current year. During the current year, Bridge reported earnings and profits of $10,000 and paid $20,000 in cash distributions to its shareholders in both March and July. What amount of the July distribution should be classified as dividend income to Bridge's shareholders?

A.
$20,000

B.
$15,000

C.
$10,000

D.
$5,000

D. $5,000 =($5,000 dividends and $15,000 return of capital.)

Distributions to shareholders of C corporations are only considered to be dividends to the extent of earnings and profits. The ordering rules for allocating earnings and profits among distributions are as follows:

Current earnings and profits are allocated proportionately among the distributions.
Accumulated earnings and profits are allocated chronologically to the distributions.
Distributions in excess of current and accumulated earnings and profits is a return of capital.
Bridge Corporation had current earnings and profits of $10,000, which is allocated equally to the March and July distributions since they were $20,000 each. Then, the accumulated earnings and profits of $15,000 is allocated to the March distribution. There are no other earnings and profits to allocate to the July distribution, so it is $5,000 dividends and $15,000 return of capital.

140

Are start-up expenses incurred in January 2016 amortized over 60 months for sole proprietorships and partnerships?

A.
Sole proprietorships: Yes; Partnerships: Yes

B.
Sole proprietorships: Yes; Partnerships: No

C.
Sole proprietorships: No; Partnerships: No

D.
Sole proprietorships: No; Partnerships: Yes

C.
Sole proprietorships: No; Partnerships: No

For start-up expenses incurred after August 16, 2011, taxpayers may deduct up to $5,000 in the taxable year in which the business begins. The $5,000 amount is reduced by the amount by which the cumulative cost of start-up expenditures exceeds $50,000. Any remaining start-up expenditures not deducted are amortized over a 15-year period (180 months).

IRC Section 195

141

The organizational test to qualify a public service charitable entity as tax exempt requires the articles of organization to:

A. limit the purpose of the entity to the charitable purpose.
B. state that an information return should be filed annually with the Internal Revenue Service.
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

A. I only
The organizational test to qualify a public service charitable entity as tax exempt requires the articles of organization to limit the purpose of the entity to the charitable purpose.

The test does not require the articles of organization to state that an information return should be filed annually with Internal Revenue Service. In fact, certain charitable entities are not required to file annual returns with the IRS, such as organizations with less than $50,000 per year gross receipts.

Organizations with less than $50,000 gross receipts per year are required to file an annual notice with the IRS that includes the organization's legal name, address, and other basic information.

142

The CSU partnership distributed to each partner cash of $4,000, inventory with a basis of $4,000 and a fair market value (FMV) of $6,000, and land with an adjusted basis of $5,000 and an FMV of $3,000 in a liquidating distribution. Partner Chang had an outside basis in Chang's partnership interest of $12,000. In the second year after receiving the liquidating distribution, Chang sold the inventory for $5,000 and the land for $3,000. What income must Chang report upon the sale of these assets?

A.
$0 gain or loss

B.
$0 ordinary gain and $1,000 capital loss

C.
$1,000 ordinary gain and $1,000 capital loss

D.
$1,000 ordinary gain and $0 capital loss

C.
$1,000 ordinary gain and $1,000 capital loss

Assets distributed to Partner Chang:
Basis FMV
Cash $ 4,000 $ 4,000
Land 5,000 3,000
Inventory 4,000 6,000
$13,000 $13,000
Allocation of basis to assets received by Partner Chang:
Outside basis $12,000
Less: Cash received (4,000)
Remaining basis $ 8,000
Less: Basis allocated to inventory (4,000)
Basis allocated to land $ 4,000

Partner Chang's outside basis is $12,000, which is reduced to $8,000 with the distribution of the cash. Chang sells the inventory for $5,000, resulting in an ordinary gain of $1,000 ($5,000 sale - $4,000 basis). This reduces Chang's outside basis to $4,000, which becomes the basis of the land to Chang. When Chang sells the land for $3,000, the result is a $1,000 capital loss ($3,000 - $4,000). Chang's basis is now zero.

143

Which of the following statements is incorrect?

A.
All recourse debt of the partnership is allocated to the partners in calculating the tax basis of their partnership investment.

B.
A limited partner is allowed to increase partnership basis for their share of recourse debt if they share in partnership losses.

C.
A general partner is allowed to increase partnership basis by his or her share of all recourse debt.

D.
A general partner is not allowed to increase partnership basis by his or her share of all recourse debt.

D. A general partner is not allowed to increase partnership basis by his or her share of all recourse debt.

The following are considered when computing a partner's basis in a partnership:
A general partner's partnership basis is increased by his or her share of all recourse debt.
A limited partner's partnership basis is increased by their share of recourse debt if they share in partnership losses.
The partners are allocated all recourse debt of the partnership in calculating the tax basis of their partnership investment.
If a limited partner is not allocated a portion of recourse debt, then the general partner's allocation of debt must be adjusted upward to offset the limited partner's reduced allocation.

144

All private foundations must file annual information returns with the IRS. Most other tax-exempt organizations are required to file annual information returns (IRS Form 990) only if their gross receipts exceed a specified level. That level is:

A.
$100,000.

B.
$50,000.

C.
$85,000.

D.
$75,000.

B.
$50,000.

For nonprofit organizations that are not private foundations or religious organizations, an annual information report to the IRS is not required until the group's gross receipts exceed $50,000 annually.

145

Gardner, a U.S. citizen and the sole income beneficiary of a simple trust, is entitled to receive current distributions of the trust income. During the year, the trust reported:

Interest income from corporate bonds $5,000
Fiduciary fees allocable to income 750
Net long-term capital gain allocable to corpus 2,000

What amount of the trust income is includible in Gardner's gross income?

A.
$7,000

B.
$5,000

C.
$4,250

D.
$0

C.
$4,250

The full amount of a simple trust's distributable net income (DNI) is includible in the beneficiary's income for the year whether distributed or not. DNI does not include the net capital gains allocable to corpus. In this case, DNI equals the interest income less the fiduciary fees allocable to income ($5,000 − $750 = $4,250).

IRC Section 652(a)

146

On January 1, Year 3, Locke Corp., an accrual-basis, calendar-year C corporation, had $30,000 in accumulated earnings and profits. For Year 3, Locke had current earnings and profits of $20,000 and made two $40,000 cash distributions to its shareholders, one in April and one in September of Year 3. What amount of the Year 3 distributions is classified as dividend income to Locke's shareholders?

A.
$0

B.
$20,000

C.
$50,000

D.
$80,000

C. $50,000

Dividend income to shareholders is the amount of the distribution ($80,000) but is limited to the corporation's earnings and profits at the end of the year ($50,000). Distributions are considered dividends to the extent of current earnings and profits first, and then dividends to the extent of accumulated earnings and profits. The additional $30,000 distributed would be return of investment up to the total investment. Any excess would be capital gain.

147

T-TOP Corp. has a fiscal year beginning September 1 and ending August 31. T-TOP's estimated tax for the fiscal year beginning September 1, 2015, is $10,000. The first installment would be due by:

A.
December 1, 2015.

B.
December 15, 2015.

C.
January 1, 2016.

D.
January 15, 2016.

B.
December 15, 2015.

The first estimated tax payment is due by the 15th day of the 4th month following the close of the tax year. Other payments are due on the 15th day of the 6th, 9th, and 12th months of the fiscal year.

148

Which of the following can be an advantage of a limited liability company over an S corporation?

A.
Double taxation of profits is avoided.

B.
Owners receive limited liability protection.

C.
Appreciated property can be distributed tax-free to an owner.

D.
Incentive stock options can be used to compensate owners.

C.
Appreciated property can be distributed tax-free to an owner.

An S corporation recognizes a gain on the distribution of appreciated property to a shareholder. The transaction is treated as a “sale” of the property to the shareholder at fair market value (FMV).

Distributions from a limited liability company (LLC) are assigned a portion of adjusted basis of the LLC interest.

149

Best Corp., an accrual-basis calendar-year C corporation, received $100,000 in dividend income from the common stock that it held in an unrelated domestic corporation. The stock was not debt-financed and was held for over a year. Best recorded the following information:

Loss from Best's operations $(10,000)
Dividends received 100,000
Taxable income (before dividends-received deduction) $ 90,000
Best's dividends-received deduction on its tax return was:

A.
$100,000.

B.
$80,000.

C.
$70,000.

D.
$63,000.

D. $63,000.

Loss from Best's operations ($ 10,000)
Dividends received 100,000
Taxable income (before dividends-
received deduction) $ 90,000 x .70 = $63,000

A corporation's dividends-received deduction (for dividends from unrelated domestic corporations) is 70% of the lesser of the dividend received or taxable income before the dividends-received deduction. A special rule applies if the deduction creates or increases an NOL.

150

Which of the following fiduciary duties may be violated by the trustee if the trustee, without express direc­tion in the trust instrument, invests trust assets in unsecured loans to a co-trustee?

A. Duty to invest prudently 谨慎地
B. Duty of loyalty to the trust
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

C.
Both I and II

Generally, a trustee has a fiduciary duty to the beneficiaries of a trust to make prudent decisions, including the investing of trust assets according to the instructions in the trust document. If the trust instructions are not explicitly followed, then there will be a breach of fiduciary duty, and the trustee can be held liable for any adverse results.

151

Jay Bird is a partner in Soundview Partnership. The adjusted basis of his interest is $19,000, of which $15,000 represents his share of partnership liabilities. Jay's share of the partnership's unrealized receivables is $6,000. The partnership has no substantially appreciated inventory items. Jay sold his partnership interest for $28,000 cash plus $15,000 of his liability relief. What is the amount and character of his gain?

A.
$6,000 capital gain

B.
$6,000 ordinary income; $18,000 capital gain

C.
$18,000 capital gain

D.
$18,000 ordinary income; $6,000 capital gain

B.
$6,000 ordinary income; $18,000 capital gain

The total gain on the sale of his partnership is $24,000 ($28,000 cash + $15,000 relief of his share of liabilities less basis of $19,000). Unrealized receivables of $6,000 are treated as ordinary income—the remaining $18,000 is capital gain.

152

Michael's adjusted basis in the MW Partnership was $20,000 at the time he received the following nonliquidating distribution:

Cash of $5,000
Equipment with an adjusted basis to the partnership of $8,000 and a fair market value of $10,000.
What is the gain/loss Michael will recognize on this transaction?

A.
$0

B.
$7,000

C.
$8,000

D.
$15,000

A. $0
The general rule for gain or loss recognition for nonliquidating partnership distributions is no gain or loss is recognized by the partner or the partnership in a nonliquidating distribution of cash or property.

The exception to the above general rule is that a partner will recognize a gain if the cash received in a nonliquidating partnership distribution exceeds the partner's adjusted basis in the partnership.

Because the cash received ($5,000) did not exceed Michael's adjusted basis ($20,000), there is no gain recognized by Michael.

Michael will take an adjusted basis in the equipment of $8,000, computed as follows:
Beginning adjusted basis $20,000
Less: Cash received (5,000)
Remaining basis $15,000
Less: Basis allocated to equipment (8,000)
Ending adjusted basis $ 7,000

153

Tax-exempt organizations are not taxed on investment income derived from investments that are accepted as proper sources of income for a charity or trust. Which of the following types of income would be taxable income for a nonprofit?

A.
Dividends and interest

B.
Rent from a debt-financed building

C.
Royalties and capital gains

D.
Other rents not using debt financing

B.
Rent from a debt-financed building

Income from a debt-financed property is included in the same category as the regular operation of a business that is unrelated to the organization's exempt purpose. Income from both of these activities is taxed as unrelated business income (UBI).

Nontaxable income includes dividends and interest, royalties and capital gains, and other rental income (not financed by debt).

154

All of the following would be recognized as a partnership for tax purposes except:

A.
joint ventures.

B.
three lawyers sharing office expenses.

C.
four individuals leasing out office space and providing services to tenants.

D.
a syndicate.企业联合

B.
three lawyers sharing office expenses.

Co-owners of property that provide services to the tenants are considered partners for tax purposes. Mere sharing of expenses does not constitute a partnership.

155

Gray Corp. had taxable income of $100,000 before capital gains for Year 6. Here is a history of the corporate capital gain transactions:

Year 1 $ 10,000 Year 4 $ 8,000
Year 2 $ 3,000 Year 5 $(40,000)
Year 3 $ 0 Year 6 $ 20,000

What is Gray Corp.'s Year 6 taxable income including capital gains and what M-1 adjustment, if any, will Gray Corp. report on its corporate income tax return?

A.
Taxable income: $80,000; M-1 adjustment: $40,000

B.
Taxable income: $100,000; M-1 adjustment: $20,000

C.
Taxable income: $101,000; M-1 adjustment: $19,000

D.
Taxable income: $120,000; M-1 adjustment: $0

B. Taxable income: $100,000; M-1 adjustment: $20,000

Corporations are not allowed a deduction for capital losses. They can only be used to offset capital gains. Corporations can carry capital losses back three years and forward five years. In this case, Gray Corp. incurred a capital loss in Year 5, which was carried back to offset all available capital gains in Year 2, Year 3, and Year 4, and the excess is carried forward to Year 6 as follows:
Year 5 loss $40,000
Carry back to
Year 2 ( 3,000)
Year 3 0
Year 4 ( 8,000)
Available to carryforward $29,000
Used Year 6 20,000
Available for Year 7 through Year 11 $ 9,000

So the total taxable income is $100,000 computed as follows:
Income before capital gain $100,000
Capital gain 20,000
Less capital loss carryforward (20,000)
Income after capital items $100,000

The $20,000 of capital loss carryforward used in Year 6 is also entered as a Schedule M-1 adjustment.

156

RR Trust had a long-term capital gain of $3,000 (allocated to corpus), taxable interest of $2,000 and nontaxable interest of $2,000. The trustee's fee was $400. The trust distributed $1,600 to beneficiaries. RR Trust is a simple trust. The trust's taxable income is:

A.
$0.

B.
$3,000.

C.
$4,000.

D.
$3,700.

D. $3,700.

The trust's taxable income is computed as follows:
Capital gain $ 3,000
Taxable interest 2,000
Trustee fee (1/2) - 200
Distribution (1/2) - 800
Exemption - 300
Taxable income $ 3,700

Simple trusts (1) distribute all trust income ($1,600 in this question), (2) do not deduct charitable contributions, and (3) do not distribute trust principal. In addition, a personal exemption is allowed of $300 for a trust that is required to distribute all of its income currently (i.e., simple trusts).

According to IRC Section 265, expenses that are not related to a particular type of income (indirect expenses) must be allocated proportionately between taxable and nontaxable income. The trustee fee allocation is ($2,000 ÷ $4,000) × $400 = $200. The numerator of $2,000 is the nontaxable income and the $4,000 denominator is the total income included in trust accounting income and excludes income allocated to corpus. Also, the denominator includes gross income (if the amount is given), such as gross rental income, and not net rental income.

The same allocation applies to the deduction for distributions to beneficiaries (IRC Section 662). Since the beneficiaries received $1,600, it is assumed that half ($2,000 ÷ $4,000) of the distribution or $800 is from nontaxable income. The trust gets a deduction for the amount that the beneficiaries include in income.

157

Bingo Corp. had $500,000 gross income from business operations and $625,000 of allowable business expenses for 20X6. It also received $150,000 in dividends from Blackjack Corp., a domestic corporation of which it owns 22% of its stock. It also has a net operating loss carryover from 20X5 of $85,000. What is Bingo's net operating loss for 20X6?

A.
$95,000

B.
$80,000

C.
$25,000

D.
$180,000

A. $95,000
The NOL is calculated as follows:
Income from business $500,000
Dividends 150,000
Gross income $650,000
Deductions (expenses) (625,000)
Taxable income before special deductions $ 25,000
Minus: Deductions for dividends received.
80% of $150,000 (120,000)
Net operating loss ($95,000)

The 20X5 NOL carryover does not have any effect on the 20X6 NOL computation. Since Bingo owns more than 20% of Blackjack Corp., they are allowed a dividends-received deduction of 80%. Since the deduction results in an NOL, the full amount may be deducted. Generally, the dividends-received deduction is limited to a percentage of taxable income. However, this limitation does not apply in a year in which an NOL occurs, even if the NOL is caused by the dividends-received deduction.

158

During Year 4, HAS Corp. had the following income and expenses:
Gross receipts $700,000
Salaries 300,000
Contributions to qualified charitable
organizations (paid 1/2/Yr. 4) 60,000
Capital gains 7,000
Depreciation expense 28,000
Dividend income 60,000
Dividends-received deduction 42,000

What is the amount of HAS Corp.'s charitable contribution deduction for Year 4?

A.
$33,400

B.
$43,900

C.
$46,900

D.
$60,000

B. $43,900 =(700-300+7-28+60)

Without the charitable contributions and dividends-received deduction, the taxable income is $439,000. Allowable contributions are $43,900.

A corporation cannot deduct contributions that total more than 10% of its taxable income. Capital gains are used in the computation of net income as is the full amount of dividends received. Carryover of excess contributions is limited to five years.

159

How does a noncorporate shareholder treat the gain on the redemption of stock that qualifies as a partial liquidation of the distributing corporation?

A.
Entirely as capital gain

B.
Entirely as a dividend

C.
Partly as capital gain and partly as a dividend

D.
As a tax-free transaction

A.
Entirely as capital gain

A partial liquidation of a corporation is not equivalent to a dividend and therefore is treated as an exchange of stock for cash. The exchange should be considered a capital gain and should be treated as a capital gain for tax purposes.

160

Which of the following is an advantage of forming a limited liability company (LLC) as opposed to a partnership?

A.
The entity may avoid taxation.

B.
The entity may have any number of owners.

C.
The owner may participate in management while limiting personal liability.

D.
The entity may make disproportionate allocations and distributions to members.

C.
The owner may participate in management while limiting personal liability.

An LLC with two or more members is taxed as a partnership in the absence of an election otherwise. As such, both LLCs and partnerships are pass-through entities (conduit entities) and avoid taxation. Both LLCs and partnerships allow for an unlimited number of owners. Both LLCs and partnerships allow for disproportionate allocations and distributions to members. An LLC does allow an owner to participate in management while limiting personal liability, while even a limited partnership requires managing partners to retain general liability.

161

If a tax-exempt organization is a trust, and its unrelated business income is taxed, what tax rates are used?

A.
Tax rates for C corporations

B.
Tax rates for S corporations

C.
Tax rates for trusts

D.
Tax rates for single individuals

C.
Tax rates for trusts

Unrelated business income is net income from the regular operation of business activity and from debt-financed property.

A tax-exempt organization's unrelated business income is taxed using the tax rates for a trust.

162

Dole, the sole owner of Enson Corp., transferred a building to Enson. The building had an adjusted tax basis of $35,000 and a fair market value of $100,000. In exchange for the building, Dole received $40,000 cash and Enson common stock with a fair market value of $60,000. What amount of gain did Dole recognize?

A.
$0

B.
$5,000

C.
$40,000

D.
$65,000

C. $40,000=CASH RECEIVED WHEN BUILDING APPRECIATED.

Under IRC Section 351, transfers of appreciated property to a controlled corporation (80%) are tax free to the extent they are exchanged solely in exchange for stock in the corporation. If cash or other property is received, gain is recognized equal to the cash and fair market value of other property received, limited by the amount of appreciation in the property transferred to the corporation.

Dole was the sole owner of Enson, so he meets the control test. He transferred a building with a basis of $35,000 and a fair market value of $100,000, so the building has appreciation of $65,000. Dole received cash of $40,000 and Enson stock worth $60,000 in exchange for the building. Since he received cash, the exchange is not completely tax free.

The amount taxable is the lesser of the amount of cash received ($40,000) or the appreciation ($65,000), so Dole is taxed on $40,000.

163

Manny, Moe, Matilda, and Shep are partners in a manufacturing business. The partnership is on a calendar tax year. They were so busy making money that they forgot to file their 2016 personal and partnership tax returns on a timely basis. They finally filed them on June 30, 2017. What is the correct penalty the partnership will be assessed for late filing of the partnership return?

A.
$195 per partner times three months

B.
$195 per partner times two months

C.
$195 per partner times four months

D.
Penalties are assessed against the partners, not the partnership.

C.
$195 per partner times four months

For the tax year ended 2016, a domestic partnership must file Form 1065 by the 15th day of the 3rd month following the date its tax year ended. The partnership return was due on March 15, 2017. The penalty for late filing is $195 per partner for each month, or part of a month, that the return is late, up to 12 months. The total penalty in this case would be $3,120 ($195 × 4 partners = $780; $780 × 4 months = $3,120).

164

Which of the following exempt organizations must file annual information returns?

A.
Churches

B.
Internally supported auxiliaries of churches

C.
Private foundations

D.
Those with gross receipts of less than $5,000 in each taxable year

C. Private foundations

The following exempt organizations are not required to file an annual information return:

Churches, their integrated auxiliaries, and conventions or associations of churches
Any organization (other than a private foundation) where the gross receipts each taxable year are not more than $5,000 and that supports an IRC Section 501(c)(3) religious organization
The exclusively religious activities of any religious order
Therefore, private foundations must file an annual information return. According to IRC Section 6033, churches, internally supported auxiliaries of churches, and organizations with not more than $5,000 in gross receipts do not have to file.

IRS Publication 557 states that private foundations do have to file some form of annual information return if the gross receipts of the organization exceed $50,000 for the year.

165

Brisk Corp. is an accrual-basis, calendar-year C corporation with one individual shareholder. At year-end, Brisk had $600,000 accumulated and current earnings and profits as it prepared to make its only dividend distribution for the year to its shareholder. Brisk could distribute either cash of $200,000 or land with an adjusted tax basis of $75,000 and a fair market value of $200,000. How would the taxable incomes of both Brisk and the shareholder change if land were distributed instead of cash?

A.
Brisk's taxable income: No change; Shareholder's taxable income: No change

B.
Brisk's taxable income: Increase; Shareholder's taxable income: No change

C.
Brisk's taxable income: No change; Shareholder's taxable income: Decrease

D.
Brisk's taxable income: Increase; Shareholder's taxable income: Decrease

B.
Brisk's taxable income: Increase; Shareholder's taxable income: No change

If the shareholder receives property with a fair market value (FMV) of $200,000, the taxable income to the shareholder is the same as a cash distribution of $200,000.

For Brisk Corp., the basis in the land was only $75,000. Brisk will have to report income of $125,000 on the transaction to account for the FMV of the distributed property.

166

The accumulated earnings tax can be imposed:

A.
on both partnerships and corporations.

B.
on companies that make distributions in excess of accumulated earnings.

C.
on personal holding companies.

D.
regardless of the number of stockholders in a corporation.

D. regardless of the number of stockholders in a corporation.

The accumulated earnings tax can be imposed regardless of the number of stockholders in a corporation. The accumulated earnings tax applies to every corporation (not any partnership) formed or availed of for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being divided or distributed.

The accumulated earnings tax does not apply to the following:
A personal holding company
A foreign personal holding company
A corporation exempt from tax under Subchapter F
A passive foreign investment company

167

To which of the following trusts would the rule against perpetuities not apply?

A.
Charitable

B.
Spendthrift

C.
Totten

D.
Constructive

A.
Charitable


The rule against perpetuities does not apply to charitable trusts. The rule was created to restrict the trustor’s power to perpetually control the funds or property in the trust after death plus 21 years and to ensure transferability of the funds or property.

168

At the beginning of the year, Westwind, a C corporation, had a deficit of $45,000 in accumulated earnings and profits. For the current year, Westwind reported earnings and profits of $15,000. Westwind distributed $12,000 during the year. What was the amount of Westwind's deficit in accumulated earnings and profits at year-end?

A.
$30,000

B.
$42,000

C.
$45,000

D.
$57,000

B. $42,000

Corporate distributions are considered to be paid first out of current earnings and profits, without regard to any accumulated deficit in earnings and profits.

So in this case, the year-end deficit in earnings and profits is computed as follows:

Beginning of year $(45,000)
Current earnings and profits 15,000
Less distributions - 12,000
Increase in earnings in profits 3,000
End of year $(42,000)

169

Brown Corp., a calendar-year taxpayer, was organized and actively began operations on July 1, 2016, and incurred the following costs during 2016:

Legal fees to obtain corporate charter $45,000
State incorporation fees 5,000
Temporary director expenses 2,000
Commission paid to underwriter 25,000
Other stock issue costs 10,000

Brown elects to deduct its organizational costs. In 2016, what is the maximum amount of organizational costs that Brown can deduct?

A.
$4,633

B.
$5,000

C.
$5,200

D.
$6,567

A. $4,633

The organizational expense deduction for 2016 will be:
Legal fees to obtain corporate charter $45,000
State incorporation fees 5,000
Temporary director expenses 2,000
Total $52,000

Since total costs are $2,000 greater than $50,000, the $5,000 portion of the deduction is reduced by $2,000 and the balance of the costs are capitalized and amortized over 180 months.

($5,000 − 2,000) + (($52,000 − 3,000) × (6 months ÷ 180 months)) = $4,633
Organizational expenses are those which are (1) incident to the creation of the corporation, (2) chargeable to a capital account, and (3) of a character which, if expended incident to the creation of a corporation having a limited life, would be amortizable over such life.

170

Bern Corp., an S corporation, had an ordinary loss of $36,500 for the year ended December 31, Year 0. At January 1, Year 0, Meyer owned 50% of Bern’s stock. Meyer held the stock for 40 days in Year 0 before selling the entire 50% interest to an unrelated third party. Meyer’s basis for the stock was $10,000. Meyer was a full-time employee of Bern until the stock was sold. Meyer’s share of Bern’s Year 0 loss was:

A.
$0.

B.
$2,000.

C.
$10,000.

D.
$18,250.

B. $2,000. $36,500 × 0.50 × 40/365 = $2,000

Each shareholder of an S corporation will include in his taxable income his pro rata share of corporate items of income, deduction, loss, and credit in his tax year in which the corporation’s tax year ends.

Meyer owned 50% of Bern Corp for 40 days during Year 0. Therefore, Meyer will include in his Year 0 tax return a loss of $2,000 from Bern Corporation, as computed below:

171

Mackenzie is the grantor of a trust over which Mackenzie has retained a discretionary power to receive income. Kelly, Mackenzie's child, receives all taxable income from the trust unless Mackenzie exercises the discretionary power. To whom is the income earned by the trust taxable?

A.
To the trust to the extent it remains in the trust

B.
To Mackenzie because he has retained a discretionary power

C.
To Kelly as the beneficiary of the trust

D.
To Kelly and Mackenzie in proportion to the distributions paid to them from the trust

B.
To Mackenzie because he has retained a discretionary power


The general rule is that whoever receives the income from the trust is taxed on the income. However, there is an exception for the grantor who retains a discretionary power. Then, the income from the trust is taxed to the grantor whether or not the grantor receives the income.

172

Cable Corp., a calendar-year C corporation, contributed $80,000 to a qualified charitable organization. Cable's taxable income before the deduction for charitable contributions was $820,000 after a $40,000 dividends-received deduction. Cable also had carryover contributions of $10,000 from the prior year. What amount can Cable deduct as charitable contributions?

A.
$90,000

B.
$86,000

C.
$82,000

D.
$80,000

B. $86,000

A corporation's contribution deduction is limited to 10% of its taxable income computed without regard to (1) the deduction for a charitable contribution, (2) the deductions for dividends received and for dividends paid on certain preferred stock of public utilities, (3) any net operating loss carryback to the tax year, (4) any capital loss carryback to the tax year, and (5) the domestic production deduction.
Cable taxable income before the deduction
for charitable contributions $820,000
Add back: dividends-received deduction + 40,000
$860,000
Charitable contributions limit x .10
Cable Corp. can deduct a charitable
contribution of: $ 86,000

Current contributions $80,000
Carryover from prior year + 6,000
Total deductions $86,000

173

Eastern Corp., a calendar-year corporation, was formed January 3, Year 5, and on that date placed 5-year property in service. The property was depreciated under the general MACRS system. Eastern did not elect to use the straight-line method. The following information pertains to Eastern:

Eastern's Year 5 taxable income $300,000
Adjustment for the accelerated
depreciation taken on Year 5
5-year property 1,000
Year 5 tax-exempt interest from
specified private activity bonds
issued after August 7, 1986 5,000

What was Eastern's Year 5 alternative minimum taxable income before the adjusted current earnings (ACE) adjustment?
A.
$306,000

B.
$305,000

C.
$304,000

D.
$301,000

A. $306,000

Eastern's Year 5 taxable income $300,000
(1) Adjustment for the accelerated
depreciation taken on Year 5
5-year property 1,000
(2) Year 5 tax-exempt interest from
specified private activity bonds
issued after August 7, 1986 5,000
AMTI $306,000

Alternative minimum tax rules have been devised to ensure that at least a minimum amount of income tax is paid by corporate and high-income noncorporate taxpayers (including estates and trusts).

Depreciation for AMT is usually calculated using 150% DB (or) straight-line over the same life as regular tax. This is called an “adjustment.”
“Tax-exempt interest” from private activity bonds is taxable for AMT. This add-back is called a preference.

For property placed in service in or before 1998, AMT depreciation was computed using 150% DB or straight-line over a longer life than used for regular tax.

174

The rule limiting the allowability of passive activity losses and credits applies to:

A.
partnerships.

B.
personal service corporations.

C.
widely held C corporations.

D.
S corporations.

B.
personal service corporations.

The passive activity loss rules are applicable to individuals, estates, trusts, closely held C corporations, and personal service corporations.

The passive activity loss rules are not applicable to partnerships, widely held C corporations, or S corporations. For partnerships and S corporations, the passive activity loss rules apply at the partner/shareholder level.

175

With regard to basis in an S corporation, which of the following statements is incorrect?

A.
Basis can never be reduced below zero.

B.
Debts owed by the corporation to third parties, even if personally guaranteed by the shareholder, cannot be added to the shareholder's adjusted basis.

C.
Nonseparately stated items of loss and deductions increase basis.

D.
The increase in basis in stock for corporate income is made only after any basis in loans that has been previously reduced is restored.

C.
Nonseparately stated items of loss and deductions increase basis

IRS Form 1120S, Schedule K-1 Instructions

176

Jans, an individual, owns 80% and 100% of the total value and voting power of A and B Corps., respectively, which in turn own the following (both value and voting power):
Ownership
Property A Corp. B Corp.
C Corp. 80% -
D Corp. - 100%

All companies are C corporations except B Corp., which had elected S status since inception. Which of the following statements is correct with respect to the companies' ability to file a consolidated return?

A.
A, C, and D may file as a group.

B.
A and C may not file as a group, and B and D may not file as a group.

C.
A and C may file as a group, and B and D may file as a group.

D.
A and C may file as a group, but B and D may not file as a group.

D.
A and C may file as a group, but B and D may not file as a group.


A Corp. and C Corp. are members of an affiliated group since A Corp owns at least 80% of C Corp. (parent/subsidiary relationship). As such, A Corp. and C Corp. may file a consolidated return. S corporations are prohibited from being members of an affiliated group, although they are now permitted to have C corporation subsidiaries. As such, B Corp. (an S corporation) is prohibited from filing a consolidated return with D Corp. (a C corporation).

IRC Sections 1504(b)(8) and 1563(a)(1)

177

In Year 1, Cape Co. reported book income of $140,000. Included in that amount was $50,000 for meals and entertainment expense and $40,000 for federal income tax expense. In Cape’s Schedule M-1 of Form 1120, which reconciles book income and taxable income, what amount should be reported as Year 1 taxable income?

A.
$205,000

B.
$180,000

C.
$165,000

D.
$140,000

A. $205,000

Cape’s Year 1 taxable income will be computed as follows:

Book income $140,000
+ 50% of meals 25,000
+ Federal income tax 40,000
= Taxable income $205,000

The federal income tax is not deductible on the corporate tax return. Business meals are 100% deductible for book purposes and only 50% deductible for tax purposes.

178

In Year 3, Brun Corp. properly accrued $10,000 for an income item on the basis of a reasonable estimate. In Year 4, Brun determined that the exact amount was $12,000. Which of the following statements is correct?

A.
Brun is required to file an amended return to report the additional $2,000 of income.

B.
Brun is required to notify the IRS within 30 days of the determination of the exact amount of the item.

C.
The $2,000 difference is includible in Brun's Year 4 income tax return.

D.
No further inclusion. The increase in income is less than 25% of the original amount reported and the estimate had been made in good faith.

C.
The $2,000 difference is includible in Brun's Year 4 income tax return.

Brun Corp. properly accrued $10,000 in Year 3 for an income item on the basis of a reasonable estimate. The $2,000 difference is includible in Brun's Year 4 income tax return. Income accrues and must be reported in the year all events have occurred that determine the taxpayer has the right to receive it and the amount can be determined with reasonable accuracy, even though some or all of it is received in a later year.

To calculate the amount to be included in income, the Rule is:
the right to receive the income is not contingent on a future event, the amount can be reasonably estimated, and there must be a reasonable expectation that it will be received in due course.

179

Haze Corp., an accrual-basis, calendar-year C corporation, began business on January 1, 2016, and incurred the following costs:

Underwriting fees to issue corporate stock $ 2,000
Legal fees to draft the corporate charter $16,000

Haze elected to amortize its organization costs. What is the maximum amount of the costs that Haze could deduct on its 2016 income tax return?

A.
$1,067

B.
$2,000

C.
$3,200

D.
$5,733

D. $5,733

Underwriting fees are not organizational expenses; rather, they are a cost of (and netted against the proceeds of) stock issued. Legal fees to draft the corporate charter are organizational expenses. Total organization expense is under $50,000, so the first $5,000 is deductible and the rest is amortized over 180 months.

$5,000 + (($16,000 − $5,000) × (12 months ÷ 180 months)) = $5,733
For organizational expenditures incurred after August 16, 2011, taxpayers may elect to deduct up to $5,000 in the taxable year in which the business begins. The $5,000 amount is reduced by the amount by which the cumulative cost of organizational expenditures exceeds $50,000. Any remaining organizational expenditures not deducted are amortized over a 15-year period (180 months) beginning with the month the active trade or business begins.

180

When corporations sell assets, a capital loss may result. Corporate tax has different rules than individual tax. Which of the following statements about corporate tax are incorrect?

A.
Corporate capital gains are taxed the same as ordinary income.

B.
Corporate capital losses can be deducted from ordinary income.

C.
Net capital losses are carried back three years and forward five years.

D.
Corporate capital losses can only be used to offset capital gains.

B.
Corporate capital losses can be deducted from ordinary income.

Corporate capital losses can never be deducted from ordinary corporate income.

Losses can only be offset against the capital gains of that year. Any excess capital losses can be carried back three years and forward five years.

It is true that corporate capital gains are taxed at the same rate as ordinary income.

181

Andi Corp. issued $1,000,000 face amount of bonds in Year 1 and established a sinking fund to pay the debt at maturity. The bondholders appointed an independent trustee to invest the sinking fund contributions and to administer the trust. In Year 6, the sinking fund earned $60,000 in interest on bank deposits and $8,000 in net long-term capital gains. All of the trust income is accumulated with Andi’s periodic con­tributions so that the aggregate amount will be sufficient to pay the bonds when they mature. What amount of trust income was taxable to Andi in Year 6?

A.
$0

B.
$8,000

C.
$60,000

D.
$68,000

D.
$68,000

The $60,000 in interest on bank deposits and $8,000 in net long-term capital gains are considered trust income to Andi in Year 6. Funds included in a sinking fund or trust are considered assets of the entity.

182

Media Corp. is an accrual-basis, calendar-year C corporation. Its reported book income included $6,000 in municipal bond interest income. Its expenses included $1,500 of interest incurred on indebtedness used to carry municipal bonds and $8,000 in advertising expense. What is Media's net M-1 adjustment on its Form 1120, U.S. Corporation Income Tax Return, to reconcile to its taxable income?

A.
$(4,500)

B.
$1,500

C.
$3,500

D.
$9,500

A. $(4,500)

The M-1 reconciles book to tax income. Of the following:
($6,000) municipal bond interest income
1,500 interest expense
8,000 advertising expense

Only the first two ($6,000 − $1,500 = $4,500) are nontaxable. Advertising would be deductible (IRC Section 162) on both sets of books, therefore it would not cause a reconciling difference. Municipal bond interest is generally tax exempt (Regulation Section 1.61-7; IRC Section 103). Interest expense is normally tax deductible; but if used to carry tax-exempt bonds, is not deductible per IRC Section 265(a)(2). Corporations with over $10,000,000 in assets must use Schedule M-3.

183

On January 2, Year 1, Shaw Corp., an accrual-basis, calendar-year C corporation, purchased all the assets of a sole proprietorship, including $300,000 in goodwill. Federal income tax expense of $110,100 and $7,500 for impairment of goodwill were deducted to arrive at Shaw’s reported book income of $239,200. What should be the amount of Shaw’s Year 1 taxable income, as reconciled on Shaw’s Schedule M-1 of Form 1120, U.S. Corporation Income Tax Return?
A.
$239,200

B.
$329,300

C.
$336,800

D.
$349,300

C. $336,800

Shaw’s Year 1 taxable income will be $336,800, as computed below:
Book income $239,200
+ Federal income tax 110,100
+ Goodwill impairment 7,500
- Amortization of goodwill
($300,000 ÷ 15) (20,000)
Taxable income $336,800

The federal income tax is not deductible on the corporate tax return. The carrying value of goodwill is only adjusted for impairment on the books, while on the tax return goodwill is amortized over 15 years, beginning in the month the goodwill is acquired.

184

Which of the following items must be separately stated on Schedule K-1 of Form 1120S, U.S. Income Tax Return for an S Corporation?

A.
Mark-to-market income

B.
Unearned revenue

C.
Section 1245 gain

D.
Gain or loss from the sale of collectibles

D.
Gain or loss from the sale of collectibles

The primary purpose of the Schedule K-1 for an S corporation is to list any income, losses, deductions, or credits that might affect the tax liability of a shareholder in a different manner depending on any other factors in their particular tax situation. Gains or losses on collectibles are generally taxed at a different rate than other items of income.

Any ordinary income items are not separately stated on the Schedule K-1 of an S corporation. Unearned revenue is the same as prepaid revenue, is taxable when received, and is generally considered ordinary income. IRC Section 1245 gain is taxed as ordinary income.

185

Kane Corp. is a calendar-year domestic personal holding company. Which deduction must Kane make from taxable income to determine undistributed personal holding company income prior to the dividends-paid deduction?

A. Federal income taxes
B. Net long-term capital gain less related federal income taxes

A.
Both I and II

B.
I only

C.
II only

D.
Neither I nor II

A.
Both I and II

Since Kane Corp. is a domestic personal holding company, it must deduct federal income taxes and net long-term capital gain (less related federal income taxes) from taxable income to determine undistributed personal holding company income prior to the dividends-paid deduction. The end result is the undistributed personal holding company income should reflect the corporation’s ability to pay dividends.

A personal holding company has a penalty tax in addition to the regular tax for generating investment-type income (i.e., dividends, interest, rents, royalties).

All capital gains are excluded.
The penalty tax only applies to undistributed income, which is the corporation's taxable income plus or minus certain adjustments and minus dividends paid by the corporation called the “dividends-paid deduction.” Two of the adjustments are deductions for federal income taxes and net long-term capital gains less related income taxes.

IRC Section 545(b)(1) allows a deduction for federal income tax (FIT) in computing undistributed personal holding company income (PHC) income. IRC Section 545(b)(5) allows a deduction for net capital gains less the taxes thereon in computing personal holding income. IRC Section 1222(11) defines a net capital gain as the excess of a net long-term capital gain over any net short-term capital loss. Thus, IRC Section 545(b)(5) allows a deduction for a net long-term capital gain less the related FIT in determining undistributed PHC income.

186

Porter, the sole shareholder of Preston Corp., transferred property to the corporation as a contribution to capital. Two years later, Corley transferred property to the corporation in exchange for a 10% interest in corporate stock. The property transferred was valued as follows:
Porter’s Transfer Corley’s Transfer
Basis $50,000 $250,000
Fair market value 200,000 500,000
What amount represents the corporation's basis in the property received?
A.
$700,000

B.
$550,000

C.
$450,000

D.
$300,000

B.
$550,000

When property is transferred to a corporation, the basis of any property received is the fair market value (FMV) at the time of the transfer. Porter's transfer two years ago had an FMV of $50,000, but the current FMV does not have an impact on the corporation's basis in the property. The basis in Corley's contribution is the current FMV, and their basis in the property does not affect the corporation's basis. The total basis in property contributed to the corporation is the $50,000 original contribution (FMV) from Porter, plus the $500,000 current contribution (FMV) for Corley, which equals a total of $550,000.

187

The individual partner rather than the partnership makes which of the following elections?

A.
Election to amortize organizational costs

B.
Nonrecognition treatment for involuntary conversion gains

C.
IRC 179 deductions for tangible personal property

D.
Whether to take a deduction or credit for taxes paid to foreign countries

D.
Whether to take a deduction or credit for taxes paid to foreign countries

There are many income and expense items where the partnership must decide on the accounting treatment, especially where there are choices in the treatment of each item. These include the amortization of organization costs, treatment of involuntary conversions, and the option of Section 179 expensing of equipment. The choice of choosing the credit or the use of a deduction for foreign taxes is left to the individual partner.

188

Which of the following statements about qualifying shareholders of an S corporation is correct?

A.
A general partnership may be a shareholder.

B.
Only individuals may be shareholders.

C.
Individuals, estates, and certain trusts may be shareholders.

D.
Nonresident aliens may be shareholders.

C.
Individuals, estates, and certain trusts may be shareholders.

S corporations are limited to 100 shareholders and only one class of stock can be issued and outstanding. The eligible shareholders can only be individuals, estates, charitable organizations, and certain trusts. It is logical that partnerships cannot be shareholders because, like S corporations, most items of income and expense flow through to the shareholders, and if you look past the partnership to the partners, it would be very easy to go beyond 100 shareholders for S corporation status. Also, nonresident aliens may not be shareholders.

189

Partnership Abel, Benz, Clark & Day is in the real estate and insurance business. Abel owns a 40% interest in the capital and profits of the partnership, while Benz, Clark, and Day each owns a 20% interest. All use a calendar year. At November 1, the real estate and insurance business is separated, and two partnerships are formed: Partnership Abel & Benz takes over the real estate business, and Partnership Clark & Day takes over the insurance business. Which one of the following statements is correct for tax purposes?

A.
Partnership Abel & Benz is considered to be a continuation of Partnership Abel, Benz, Clark & Day.

B.
In forming Partnership Clark & Day, partners Clark and Day are subject to a penalty surtax if they contribute their entire distributions from Partnership Abel, Benz, Clark & Day.

C.
Before separating the two businesses into two distinct entities, the partners must obtain approval from the IRS.

D.
Before separating the two businesses into two distinct entities, Partnership Abel, Benz, Clark & Day must file a formal dissolution with the IRS on the prescribed form.

A.
Partnership Abel & Benz is considered to be a continuation of Partnership Abel, Benz, Clark & Day.

A partnership is considered terminated only if there has been a sale or exchange of 50% or more of the total interest in partnership capital and profits.

Together Able and Benz own 60%, so the original partnership will continue with them.

There is no penalty surtax, no one must get permission from the IRS, and a formal dissolution is not necessary.

190

Freeman, a single individual, reported the following income in the current year:

Guaranteed payment from services rendered to a partnership: $50,000
Ordinary income from an S corporation: $20,000
What amount of Freeman’s income is subject to self-employment tax?

A.
$0

B.
$20,000

C.
$50,000

D.
$70,000


C.
$50,000

Only the $50,000 guaranteed payment paid to Freeman is subject to self-employment tax.

Guaranteed payments for services performed by a partner are subject to self-employment tax at the partner level.

A shareholder will report his share of the ordinary income from an S corporation whether it is distributed or not, and this income is not subject to self-employment tax at the shareholder level.

191

For the current year, Kelly Corp. had net income per books of $300,000 before the provision for federal income taxes. Included in the net income were the following items:

Dividend income from an unaffiliated domestic taxable
corporation (taxable income limitation does not apply
and there is no portfolio indebtedness) $50,000
Bad debt expense (represents the increase in the
allowance for doubtful accounts) 80,000

Assuming that no bad debt was written off, what is Kelly's taxable income for the current year?

A.
$250,000

B.
$330,000

C.
$345,000

D.
$380,000

C.
$345,000

$300,000 Net Income per Books
- 35,000 Dividends-Received Deduction (70% x $50,000)*
+ 80,000 Bad Debts Expense**
$345,000 Taxable Income
* A corporation is entitled to a special deduction from gross income for dividends received from a domestic corporation. Since this dividend was from an unaffiliated corporation (this means less than 20% of the company was owned) 70% of the dividends received are not taxable.

IRC Section 243

** For tax purposes, only business bad debts that are, in fact, incurred can be deducted. The reserve method is not allowed for tax purposes except for certain financial institutions.

IRC Section 166(a)

192

Reid, Welsh, and May are equal partners in the RWM partnership. Reid's basis in the partnership interest is $60,000. Reid receives a liquidating distribution of $61,000 cash and land with a fair market value of $14,000 and an adjusted basis of $12,000. What gain must Reid recognize upon the liquidation of his partnership interest?

A.
$0

B.
$1,000

C.
$13,000

D.
$15,000

B.
$1,000

Although generally no gain or loss is recognized by a partner upon the liquidation of a partnership interest, there are exceptions:

Gain is recognized if cash distributed is in excess of the partner's basis in the partnership interest.
Loss is recognized if no property other than cash, unrealized receivables, and inventory is distributed and the cash and basis of the unrealized receivables and inventory received are less than the partner's basis in the partnership interest.
Reid's cash distribution exceeded his basis in his partnership interest, so he recognizes gain computed as follows:

193

Jay properly created an inter vivos trust naming Kroll as trustee. The trust’s sole asset is a fully rented office building. Rental receipts exceed expenditures. The trust instrument is silent about the allocation of items between principal and income. Among the items to be allocated by Kroll during the year are insur­ance proceeds received as a result of fire damage to the building and the mortgage interest payments made during the year. Which of the following items is properly allocable to principal?

A.
Insurance proceeds on building: No; Current mortgage interest payments: No

B.
Insurance proceeds on building: No; Current mortgage interest payments: Yes

C.
Insurance proceeds on building: Yes; Current mortgage interest payments: No

D.
Insurance proceeds on building: Yes; Current mortgage interest payments: Yes

C.
Insurance proceeds on building: Yes; Current mortgage interest payments: No

Insurance proceeds on a building are allocable to principal, but current mortgage interest payments are not allocable to principal. Since trust property was damaged and money is received because of the damage, this money would go to principal. The mortgage interest payments would go to income since they are not mortgage principal payments.

194

The charitable contribution deduction on an estate’s fiduciary income tax return is allowable:

A.
if the decedent died intestate.

B.
to the extent of the same adjusted gross income limitation as that on an individual income tax return.

C.
only if the decedent’s will specifically provides for the contribution.

D.
subject to the 2% threshold on miscellaneous itemized deductions.

C.
only if the decedent’s will specifically provides for the contribution.

An unlimited charitable contribution deduction is allowed for an estate if the contribution is provided for in the will of the decedent, the charity is a qualified charity, and if the contribution is paid in the year of deduction or the year following the deduction.

There are no other limits on the charitable contribution deduction of an estate.

195

Dart Corp., a calendar-year domestic C corporation, is not a personal holding company. For purposes of the accumulated earnings tax, Dart has accumulated taxable income in the current year. Which step(s) can Dart take to eliminate or reduce any accumulated earnings tax?

I. Demonstrate that the “reasonable needs” of its business require the retention of all or part of the accumulated taxable income.
II. Pay dividends by April 15 of the following year.
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

C.
Both I and II

Dart can either demonstrate that the “reasonable needs” of its business require the retention of all or part of the current-year accumulated taxable income, or pay dividends by April 15 of the following year. If a C corporation retains earnings (does not distribute them to shareholders) above a certain amount, the corporation may be assessed a 15% accumulated earnings tax. If the earnings are being accumulated for what the IRS considers to be the reasonable needs of the business, then the accumulated earnings tax will not be imposed.

IRC Sections 531, 533, and 563(a)

196

A C corporation net operating loss in 2016 is carried back and carried forward for how many years?

A.
Back: 3; Forward: 15

B.
Back: 2; Forward: 20

C.
Back: 5; Forward: 25

D.
Back: 3; Forward: 5

B.
Back: 2; Forward: 20


For 2016, a net operating loss is carried back 2 years and forward 20 years. A corporation can elect to waive the carryback period.

197

Salud Welfare Associates is an exempt organization that operates under a corporate charter granted by the state in which Salud’s principal office is located. Salud’s tax on unrelated business taxable income is:

A.
computed at corporate income tax rates.

B.
credited against the tax on recognized capital gains.

C.
computed at rates applicable to trusts.

D.
abated.

A.
computed at corporate income tax rates.


Because Salud Welfare Associates operates under a corporate charter, then any unrelated business income will be taxed at corporate rates. If the company was organized as a trust, then the trust tax rates would apply.

198

In Year 5, Wein Corporation had a net loss from operations of $50,000, which included a deduction for charitable contributions of $2,000. In addition, Wein received dividend income of $10,000 from a 15%-owned domestic corporation. What is the amount of Wein's net operating loss for Year 5?

A.
$45,000

B.
$49,000

C.
$55,000

D.
$59,000

A. $45,000= (-50,000+10,000-2,000)*70%

Wein's charitable contribution is not deductible for tax purposes since a net loss was incurred. A dividends-received deduction (DRD) is allowed.

A dividends-received deduction reduces taxable income. In addition, there is no limit in deducting 70% of dividends received if a net operating loss is either created or increased.

According to the instructions for Form 1120, U.S. Corporation Income Tax Return,“in a year in which an NOL occurs, this 70% limitation does not apply even if the loss is created by the dividends-received deduction.” (IRC Sections 172(d) and 246(b))

Loss from operations $(50,000)
Dividends 10,000
Total income (loss) $(40,000)
Add back charitable contributions 2,000 A charitable contribution is not deductible for tax purposes since a loss occurs. According to the scenario, the $2,000 was already included in the $50,000 net loss from operations.
Loss before $(38,000)
Less: DRD deduction
(70% x $10,000) ( 7,000)
Net operating loss $(45,000)

The dividends from a less-than-20%-owned domestic corporation are allowed a 70% special deduction. The $10,000 in dividend income Wein Corporation received from a 15%-owned domestic corporation would be reported on line 1 in Schedule C of Form 1120. The totals of line 1 through 8 in Schedule C are then subject to a taxable income limitation. A corporation's percentage dividends-received-deduction (DRD) for any tax year cannot exceed a certain applicable percentage of its taxable income. There is a worksheet for Schedule C, line 9, in the Form 1120 instructions that helps a taxpayer determine the amount of the taxable income limitation. A corporation's DRD is generally limited to 70% of its taxable income. This income limitation does not apply for any tax year for which the shareholder has an NOL.

This is not saying that the corporation gets a 100% DRD when there is an NOL in that tax year. Instead this taxable income limitation is determining what amount of the 70% DRD is going to be allowed based upon the corporation's income. Due to the NOL, Wein Corporation is allowed to deduct 100% of its 70% special dividend deduction, or $7,000.

199

The following information pertains to Lamb Corp.:

Accumulated earnings and profits at January 1 $ 60,000
Earnings and profits for the year ended December 31 $80,000
Cash distributions to individual stockholders during
the current year 180,000

What is the total amount of distributions taxable as ordinary dividend income to Lamb's stockholders in the current year?

A.
$180,000

B.
$140,000

C.
$80,000

D.
$0

B. $140,000
Beginning accumulated earnings and profits (E&P) at 1/1 $ 60,000
Add current E&P during the current year 80,000
Total amount of E&P at 12/31 $140,000

This represents the maximum distribution that a corporation can make which will be taxed to the shareholders as ordinary dividend income.

It is important to note the following:
Distribution $180,000
Taxable dividend (Total E&P from above) -140,000
Distribution in excess of total E&P $ 40,000
Reduce stock basis to zero (assume that stock
basis is $10,000); tax-free return of capital - 10,000
This is called a "deemed sale" of a capital
asset and is taxed as a capital gain $ 30,000

200

What is the usual result to the corporation of a distribution in complete liquidation of the corporation?

A.
No taxable effect

B.
Ordinary gain to the extent of cash paid

C.
Losses are recognized on certain liquidating distributions to related party shareholders.

D.
The corporation recognizes a gain or loss as if the property were sold at its fair market value.

D.
The corporation recognizes a gain or loss as if the property were sold at its fair market value.

When a corporation completely liquidates, the law assumes that the assets are sold at their fair market value (FMV) and corporate gain or loss is recognized at the time of liquidation. In addition, losses may not be recognized on certain liquidating distributions to related party shareholders. There are no ordinary gains to the extent of cash paid by the liquidating corporation.

201

Kisco Corp.’s taxable income before taking the dividends-received deduction was $70,000. This includes $10,000 in dividends from an unrelated taxable domestic corporation. Given the following tax rates, what would Kisco’s income tax be before any credits?

Partial Rate Table Tax Rate
Up to $50,000 15%
Over $50,000 but not over $75,000 25%

A.
$10,000

B.
$10,750

C.
$12,500

D.
$15,750

B. $10,750

Kisco Corporation's income tax is $10,750, as calculated below:
Taxable income before taking dividends-received deduction $70,000
Less: Dividends-received deduction ($10,000 × 0.70) (7,000)
taxable income $63,000
$50,000 × 0.15 = $ 7,500
+ 13,000 × 0.25 = 3,250
$10,750

202

The private foundation status of an exempt organization will terminate if it:

A.
becomes a public charity.

B.
is a foreign corporation.

C.
does not distribute all of its net assets to one or more public charities.

D.
is governed by a charter that limits the organization’s exempt purposes.

A.
becomes a public charity.


Charitable organizations are generally either public charities or private foundations. Therefore, when an exempt organization becomes a public charity, it can no longer be a private foundation (terminates the private foundation).

203

Able, an individual, is a partner in CD Partnership with an adjusted basis of $30,000 for Able's partnership interest. Able received a nonliquidating distribution of $25,000 cash and property with an adjusted basis of $7,000, and a fair market value of $10,000. What amount of gain should Able recognize?

A.
$0

B.
$2,000

C.
$5,000

D.
$12,000

A.
$0

Generally, a partner does not recognize a gain or loss when property is distributed in something other than the liquidation of a partner’s interest. In this case, the partner would receive the property with an adjusted basis equal to their remaining basis in the partnership. If they were to subsequently sell or dispose of the property, then they would realize a gain (loss) on it at that time.

204

Alternative minimum tax preferences include:

A. tax-exempt interest from private activity bonds issued during 1994.
B. charitable contributions of appreciated capital gain property.

A.
Both A and B

B.
A Only

C.
B Only

D.
Neither A nor B

B.
A Only

Interest on specified private activity bonds that is excluded from income for regular tax calculations is added back as a preference item on IRS Form 6251 in determining alternative minimum tax. Alternative minimum tax preferences are always added back in calculating alternative minimum tax income. Other preference items include depletion, excess intangible drilling costs, accelerated depreciation on property placed in service before 1987, and exclusion of gain on qualified small business stock. Charitable contributions are not considered a preference.

205

Tank Corp., which had earnings and profits of $500,000, made a nonliquidating distribution of property to its shareholders as a dividend in kind. This property, which had an adjusted basis of $20,000 and a fair market value of $30,000 at the date of distribution, did not constitute assets used in the active conduct of Tank's business. How much gain did Tank recognize on this distribution?

A.
$30,000

B.
$20,000

C.
$10,000

D.
$0

C. $10,000

$30,000 Fair market value (FMV)
- 20,000 Basis
$10,000 Gain

Any time a corporation has earnings and profits and makes a property (not cash) nonliquidating distribution to its shareholders, the corporation must recognize a taxable gain (not a loss) equal to the difference between the FMV and its basis. (IRC Section 311(b)(1))

The shareholder then will have dividend income equal to $30,000 (fair market value) and a basis in the property of $30,000 (fair market value). (IRC Section 301(d))

206

Internal Revenue Code Section 651 defines a simple trust as one that meets three conditions during the year. Which of the following is not one of those conditions?

A.
Distributes all income currently

B.
Does not distribute from trust corpus

C.
Does not deduct charitable contributions

D.
Does not have tax-exempt income

D.
Does not have tax-exempt income


Simple trusts may have tax-exempt income, but the other three conditions listed must be met for the current year for a trust to be considered simple and not complex.

207

A distribution from estate income that was currently required was made to the estate's sole beneficiary during its calendar year. The maximum amount of the distribution to be included in the beneficiary's gross income is limited to the estate's:

A.
capital gain income.

B.
ordinary gross income.

C.
distributable net income.

D.
net investment income.

C. distributable net income.

A distribution from estate income that was currently required was made to the estate's sole beneficiary during its calendar year. The maximum amount of the distribution to be included in the beneficiary's gross income is limited to the estate's distributable net income (DNI).

Distributable net income is an amount that sets the limit on the deduction of a domestic estate or trust for distributions to beneficiaries. It also sets the maximum amount of the distribution taxable to the beneficiary.

208

Fox, the sole shareholder in Fall, a C corporation, has a tax basis of $60,000. Fall has $40,000 of accumulated positive earnings and profits at the beginning of the year and $10,000 of current positive earnings and profits for the current year. At year-end, Fall distributed land with an adjusted basis of $30,000 and a fair market value (FMV) of $38,000 to Fox. The land has an outstanding mortgage of $3,000 that Fox must assume. What is Fox's tax basis in the land?

A.
$38,000

B.
$35,000

C.
$30,000

D.
$27,000

A.
$38,000

Since Fox is the sole stockholder in the C corporation Fall, his basis in the land distributed to him will be equal to the fair market value of the asset ($38,000). The liability Fox assumes reduces the amount of taxable dividend. The amount of taxable dividend Fox received is $35,000 ($38,000 - $3,000).

209

All of the following can be considered personal holding company (PHC) income except:

A.
rents.

B.
gas royalties.

C.
estate and trust income.

D.
capital gains.

D.
capital gains.

Capital gains are not considered personal holding company income. Other income that qualifies as PHC income is dividends, annuities, mineral, oil, and gas royalties. There are also some exceptions and limitations pertaining to these rules.

210

Absent specific directions, which of the following parties will ordinarily receive the assets of a terminated trust?

A.
Income beneficiaries

B.
Remaindermen

C.
Grantor

D.
Trustee

B.
Remaindermen

Income beneficiaries receive the income from a trust.

The remaindermen (or principal beneficiaries) receive the assets of a terminated trust. The grantor is the person who established the trust. The trustee is responsible for the management of the trust.

211

Parent company X and subsidiary company Y file a calendar-year consolidated federal income tax return. Company X reported a $120,000 tax loss, which included a $10,000 dividend from Y. Company Y reported $140,000 of taxable income, which included $30,000 of dividends received from less than 20%-owned stock investments. Neither company took into account any applicable dividends-received deduction. What is the group's consolidated tax loss for the year?

A.
$(1,000)

B.
$(4,000)

C.
$(11,000)

D.
$(20,000)

C. $(11,000)=(-120,000+140,000+10,000)*70%=21,000-10,000

Corporations filing a consolidated return must not report as dividends any amounts received from corporations within the tax consolidation group. Such dividends are eliminated in consolidation rather than offset by the dividends-received deduction.

A corporation is permitted to deduct a percentage of certain dividends received during its tax year. A corporation can deduct, within certain limits, 70% of the dividends received if the corporation receiving the dividend owns less than 20% of the corporation distributing the dividend. If the corporation owns 20% or more of the distributing corporation's stock, it can, subject to certain limits, deduct 80% of the dividends received.

If a corporation has a net operating loss (NOL) for a tax year, the limit of 80% (or stated 70%) of taxable income does not apply. To determine whether a corporation has an NOL, figure the dividends-received deduction without the 80% (or 70%) of taxable income limit.

Thus, the consolidated taxable income before the dividends-received deduction (DRD) would be the sum of company X’s taxable loss of $120,000 plus company Y’s taxable income of $140,000 with the $10,000 dividend income eliminated in the consolidation (the dividend that company’s X subsidiary, company Y, paid to company X, and note that there is only income elimination in this case because company Y did not recognize a deduction for the payment of dividend), which equals $10,000. The DRD of $21,000 (70% × $30,000 dividends received from less than 20%-owned stock investments) is then subtracted from the $10,000 consolidated taxable income before the DRD for a taxable loss of $(11,000).

212

An S corporation has 30,000 shares of voting common stock and 20,000 shares of nonvoting common stock issued and outstanding. The S election can be revoked voluntarily with the consent of the share­holders holding, on the day of the revocation:

A.
Shares of voting stock: 0; Shares of nonvoting stock: 20,000

B.
Shares of voting stock: 7,500; Shares of nonvoting stock: 5,000

C.
Shares of voting stock: 10,000; Shares of nonvoting stock: 16,000

D.
Shares of voting stock: 20,000; Shares of nonvoting stock: 0

C. Shares of voting stock: 10,000; Shares of nonvoting stock: 16,000

An S corporation is allowed to have one class of stock that has two different voting rights.

The rule for voluntarily revoking an S election is more than 50% of the total number of shares of S corporation stock must voluntarily revoke the S election. This S corporation has a total of 50,000 shares of stock outstanding. In order to revoke the S election, a minimum of 25,001 shares must voluntarily revoke the S election. Therefore, in order for the shareholders to revoke the S election, the best answer choice would be the 26,000 total shareholders.

213

After an S corporation elects to revoke its status as an S corporation, it must:

A.
always wait five years before making a new election.

B.
wait five years, but can apply to the IRS for an earlier reelection.

C.
never reapply for S corporation status again.

D.
wait until at least 50% of stock is owned by new shareholders.

B.
wait five years, but can apply to the IRS for an earlier reelection.

When S corporation status is revoked (either voluntarily or through failing to meet the requirements), a corporation can apply to the IRS National Office for an early reelection. The IRS will usually grant the early reelection if ownership has changed by more than 50% or when the termination was not within their control, such as death of a shareholder and inheritance of the stock by someone who is not a U.S. citizen or resident.

214

Help, Inc., an exempt organization, derived income of $15,000 from conducting bingo games. Conducting bingo games is legal in Help’s locality and is confined to exempt organizations in Help’s state. Which of the following statements is true regarding this income?

A.
The entire $15,000 is subject to tax at a lower rate than the corporate income tax rate.

B.
The entire $15,000 is exempt from tax on unrelated business income.

C.
Only the first $5,000 is exempt from tax on unrelated business income.

D.
Since Help has unrelated business income, Help automatically forfeits its exempt status for the current year.

B.
The entire $15,000 is exempt from tax on unrelated business income.

A “qualified bingo game” is not considered to be unrelated business income that is taxable if:

the bingo game is legal in both the state and the locality. and commercial bingo games are not permitted in the locality.

215

Which of the following groups may elect to file a consolidated corporate return?

A.
A brother/sister–controlled group

B.
A parent corporation and all more-than-10%-controlled partnerships

C.
A parent corporation and all more-than-50%-controlled subsidiaries

D.
Members of an affiliated group

D.
Members of an affiliated group

A consolidated corporate income tax return may be filed by the members of an affiliated group. An affiliated group exists where:

a parent company owns at least 80% of the stock in at least one other corporation in the group or
at least 80% of the stock of other companies in the group is owned directly by one or more companies in the affiliated group.

216

The at-risk limitation provisions of the Internal Revenue Code (IRC) may limit:

A. a partner's deduction for his or her distributive share of partnership losses.
B. a partnership's net operating loss carryover.
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

A.
I only

at-risk rules apply to all taxpayers (including partners) and encompass all business and investment activities, with a limited exception for certain types of real estate financing. The at-risk restrictions on deducting partnership losses provide that a partner may deduct his share of a loss from a partnership activity only to the extent to which he is at risk.

A partnership is not allowed a deduction for net operating losses (NOLs). A net operating loss (and any related carryback or carryforward) is determined at the partner level, taking into account all of the partner's applicable items of income and expense.

217

Quigley, Roberk, and Storm form a corporation. Quigley exchanges $25,000 of legal fees for 30 shares of stock. Roberk exchanges land with a basis of $10,000 and a fair market value of $100,000 for 60 shares of stock. Storm exchanges $10,000 cash for 10 shares of stock. What amount of income should each shareholder recognize?

A.
Quigley $0, Roberk $0, and Storm $0

B.
Quigley $25,000, Roberk $90,000, and Storm $0

C.
Quigley $25,000, Roberk $90,000, and Storm $10,000

D.
Quigley $0, Roberk $90,000, and Storm $0

B.
Quigley $25,000, Roberk $90,000, and Storm $0

The general rule is that transfers of property to a corporation in exchange for stock will be tax-free as long as the transferors are in control of the corporation immediately after the exchange. Control is defined as 80% of both the voting power and number of shares of the stock.

Quigley contributed services, and services are not considered part of the 80% control group; therefore, he would have to include in income $25,000. Roberk and Storm are the only ones left to be included in the 80% control group; they do not add up to 80% either, so Roberk would include $90,000 in income ($100,000 - $10,000). Storm would include nothing in income as he contributed cash for the stock.

218

A corporation that has both preferred and common stock has a deficit in accumulated earnings and profits at the beginning of the year. The current earnings and profits are $25,000. The corporation makes a dividend distribution of $20,000 to the preferred shareholders and $10,000 to the common shareholders. How will the preferred and common shareholders report these distributions?

A.
Preferred, $20,000 dividend income; Common, $10,000 dividend income

B.
Preferred, $20,000 dividend income; Common, $5,000 dividend income, $5,000 return of capital

C.
Preferred, $15,000 dividend income; Common, $10,000 dividend income

D.
Preferred, $20,000 return of capital; Common, $10,000 return of capital

B.
Preferred, $20,000 dividend income; Common, $5,000 dividend income, $5,000 return of capital

Distributions are dividends to the extent of current earnings and profits first, and then to the extent of accumulated earnings and profits. Distributions in excess of both current and accumulated earnings and profits are considered to be a return of capital. When a corporation makes distributions on two or more classes of stock in a taxable year, distributions on stock having priority as to dividends under the corporate charter are deemed to be made out of the earnings and profits of the corporation before any distributions made on stock having a lesser priority. Therefore, in this question, the $20,000 paid on preferred stock is deemed paid first from current earnings and profits and will be taxable as dividends. The $10,000 paid on common stock will be deemed as made next with $5,000 taxable as dividends up to the remaining current earnings and profits and $5,000 as a return of capital since there are no accumulated earnings and profits.

219

On June 1, Kelly received a 10% interest in Rock Co., a partnership, for services contributed to the part­nership. Rock’s net assets at that date had a basis of $70,000 and a fair market value of $100,000. In Kelly’s income tax return, what amount must Kelly include as income from transfer of partnership interest?

A.
$7,000 ordinary income

B.
$7,000 capital gain

C.
$10,000 ordinary income

D.
$10,000 capital gain

C.
$10,000 ordinary income

When a partner contributes services for a partnership interest, the partner must include the fair market value (FMV) of the services rendered as ordinary income. Kelly will include $10,000 as ordinary income, which is 10% of the FMV of the partnership’s net assets ($100,000).

220

Dale was a 50% partner in D&P Partnership. Dale contributed $10,000 in cash upon the formation of the partnership. D&P borrowed $10,000 to purchase equipment. During the first year of operations, D&P had $15,000 net taxable income, $2,000 tax-exempt interest income, a $3,000 distribution to each partner, and a $4,000 reduction of debt. At the end of the first year of operation, what amount would be Dale's basis?

A.
$16,500

B.
$17,500

C.
$18,500

D.
$21,500

C.
$18,500

Dale's basis in D&P Partnership:
Cash invested $10,000
50% of D&P debt 5,000
50% of taxable income 7,500
50% of tax-exempt income 1,000
Cash distribution (3,000)
50% of reduction of debt (2,000)
$18,500

221

Which of the following elections are made at the partner level?

A.
Taxable year and accounting method

B.
Cost or percentage depletion for oil and gas wells

C.
Cost recovery methods and assumptions

D.
Treatment of research and development costs

B.
Cost or percentage depletion for oil and gas wells

There are three elections that are made at the partner level:
Cost or percentage depletion for oil and gas wells
Reduction of basis of depreciable property when excluding income from discharge of indebtedness
Take a deduction or credit for foreign taxes paid

222

Which of the following parties is necessary to create an express trust?

A.
Remainderman: Yes; Successor trustee: Yes

B.
Remainderman: Yes; Successor trustee: No

C.
Remainderman: No; Successor trustee: Yes

D.
Remainderman: No; Successor trustee: No

D.
Remainderman: No; Successor trustee: No

Neither a remainderman nor a successor trustee is needed to create an express trust. A remainderman refers to the person who gets the remainder of the items in a trust. For example, a trust states A gets the trust, and then B gets the trust. A dies, and therefore B gets the remainder. A successor trustee is the person that takes over a trust when the original trustee becomes incapacitated or dies. Therefore, the trust dies when the beneficiary is incapacitated or dies.

223

A distribution to an estate's sole beneficiary for the current calendar year equaled $15,000, the amount currently required to be distributed by the will. The estate's current-year records were as follows:

Estate income:
$40,000 Taxable interest

Estate disbursements:
$34,000 Expenses attributable to taxable interest
What amount of the distribution was taxable to the beneficiary?

A.
$40,000

B.
$15,000

C.
$6,000

D.
$0

C.
$6,000

Taxable interest $40,000
Less: Expenses attributable
to taxable interest 34,000
Taxable to the beneficiary $ 6,000

Even though there was a distribution to an estate's sole beneficiary of $15,000, only $6,000 was taxable to the beneficiary.

In this example, $6,000 is the distributable net income of the estate. Distributable net income is an amount that sets the limit on the deduction of a domestic estate or trust for distributions to beneficiaries. It also limits the amount of the distribution taxable to the beneficiary.


224

Absent an election to close the books, the allocation of nonseparately stated income or loss for an S corporation shareholder that changed his ownership interest during the year is computed based on which of the following ownership percentages?

A.
Ownership percentage at the end of the S corporation year

B.
Ownership percentage computed on a per-share, per-day basis

C.
Ownership percentage at the beginning of the S corporation year

D.
Ownership percentage determined as an average of the beginning and ending ownership percentages

B.
Ownership percentage computed on a per-share, per-day basis

Each shareholder must include on the personal tax return the share of the corporation's income or loss and special items from the corporate tax year that has ended with or within the personal tax year. Where ownership has changed during the year, each owner must recognize a pro rata share of the income or loss allocated on a daily basis.

Income is not allocated based on the ownership percentage at either the beginning or the end of the S corporation year. Income is not allocated based on the average of the beginning and ending ownership percentages.

225

What is the nonseparately stated income amount of an accrual-basis calendar-year S corporation with the following items?
Gross receipts $200,000
Rental income 25,000
Interest income 12,000
Cost of goods sold and commissions 127,000
Net long-term capital gain 17,000
Compensation paid to shareholder 10,000
A.
$63,000

B.
$73,000

C.
$117,000

D.
$127,000

A. $63,000

The nonseparately stated income amount is calculated as follows:
Gross receipts $200,000
Less: Cost of goods sold 127,000
Compensation paid to shareholder $ 10,000
Total $ 63,000

All other items are separately stated. Any item of income, loss, deduction, or credit which could affect the tax liability of a shareholder must be separately stated. These items are passed through pro rata to the shareholders with the same character.

IRS Form 1120S Instructions

226

Clip-Joint, an S corporation hair salon, distributes land with an adjusted basis of $10,000 and a fair market value of $50,000 to its sole shareholder, Louise. Louise's basis in the corporate stock before distribution is $90,000. What is Louise's basis in the land after the distribution?

A.
$90,000

B.
$40,000

C.
$10,000

D.
$50,000

D.
$50,000

Louise's basis in the land is $50,000, its FMV at the time of distribution. A property distribution is treated as if the corporation sold the property to the shareholder at its fair market value. Clip-Joint will recognize a $40,000 gain on the distributions which it will pass to Louise.

227

The “executive pay over $1 million cap” applies to:

A.
all C corporations.

B.
all S corporations.

C.
only publicly held C corporations.

D.
all corporations.

C.
only publicly held C corporations.

For purposes of the regular income tax and the alternative minimum tax, the deduction for compensation paid or accrued with respect to a covered employee of a publicly held corporation is limited to no more than $1 million per year.

The “executive pay over $1 million cap” does not apply to compensation paid or accrued to covered employees of all C or S corporations.

228

Jetson and Tomson are equal partners in JT Partnership, which has the following income and expense items:

Sales $100,000
Interest income from checking account 1,000
Charitable contributions 3,000
Employee wages 4,000
Cost of goods sold 50,000

What is the nonseparately stated partnership income?

A.
$43,000

B.
$44,000

C.
$46,000

D.
$47,000

C. $46,000
The nonseparately stated partnership income or otherwise known as ordinary income from the trade or business is $46,000, which is the difference between the sales income of $100,000 less cost of goods sold of $50,000 and less employee wages of $4,000.

A partnership computes its income and reports only trade or business activity deductions. The ordinary business income for a partnership is computed as:
gross receipts or sales less cost of goods sold plus other partnership income, less
salaries and wages,
repairs and maintenance,
bad debts,
rent,
taxes and licenses,
interest,
depreciation,
retirement plans, and
other deductions.
Certain deductions, however, are not allowed to the partnership. Items that are separately stated on the partnership return and included as separate items on the partners' returns are:

ordinary income or loss from trade or business activities,
net income or loss from rental real estate activities,
net income or loss from other rental activities,
guaranteed payments to partners,
interest income, dividends, and royalties,
gains and losses from sales or exchanges of property described in IRC Section 1231,
dividends (passed through to corporate partners) that are eligible for the dividends-received deduction,
taxes paid or accrued to foreign countries and U.S. possessions, and
other items of income, gain, loss, deduction (e.g., IRC Section 179, charitable contributions), or credit, as provided by regulations. Examples include nonbusiness expenses, intangible drilling and development costs, and soil and water conservation expenses.

229

Dahl Corp. was organized and commenced operations in Year 0. At December 31, Year 5, Dahl had accumulated earnings and profits of $9,000 before dividend declaration and distribution. On Decem­ber 31, Year 5, Dahl distributed cash of $9,000 and a vacant parcel of land to Green, Dahl’s only stockholder. At the date of distribution, the land had a basis of $5,000 and a fair market value of $40,000. What was Green’s taxable dividend income in Year 5 from these distributions?

A.
$9,000

B.
$14,000

C.
$44,000

D.
$49,000

D. $49,000 =(9+40-5)
When a corporation distributes both cash and property dividends, the corporation must recognize a gain on the appreciated property distributed as a dividend. The recognized gain comes from treating the property “as if” it were sold at fair market value. In this problem, the recognized gain will be $35,000, which is the fair market value (amount realized) of $40,000 less the adjusted basis of $5,000.

The corporation’s earnings and profits are increased by the recognized gain on the property dividend. So, now the earnings and profits for Dahl Corporation will be $44,000, which is the $9,000 plus the recognized gain of $35,000.

The shareholder, Green, will have maximum dividend income from the cash received of $9,000 plus the fair market value of the property received of $40,000. However, the dividend income that is taxable to Green cannot exceed the earnings and profits of Dahl Corporation, which is $44,000.

230

A decedent’s will provided that the estate was to be divided among the decedent’s issue, per capita and not per stirpes. If there are two surviving children and three grandchildren who are children of a predeceased child at the time the will is probated, how will the estate be divided?

A.
1/2 to each surviving child

B.
1/3 to each surviving child and 1/9 to each grandchild

C.
1/4 to each surviving child and 1/6 to each grandchild

D.
1/5 to each surviving child and grandchild

D.
1/5 to each surviving child and grandchild

Per capita is a legal term that is used in wills to indicate that each surviving relative receives an equal part of the estate. In this case, there are two children and three grandchildren, or five survivors. Each will receive 1/5 of the estate.

In contrast, per stirpes designates that each branch of the family receives an equal share of the estate. If used in this example, the decedent had three children, so each of the three children receive 1/3 of the estate. Where one of the children was predeceased, then the children of the predeceased receive the 1/3 share or the 1/3 is split among the three grandchildren.

231

For Year 2, the Sage Company, an S corporation, had ordinary income of $70,000 and tax-exempt interest income of $10,000. Sage made a total cash distribution to its shareholders of $30,000. If Sam Sage owns a 50% interest, what was the increase in his basis for Year 2?

A.
$35,000

B.
$25,000

C.
$20,000

D.
$65,000

B.
$25,000


A shareholder's basis in stock of an S corporation is increased by all pass-through items, including nontaxable income. Distributions reduce the shareholder's basis even though distributions are not taxable to the shareholder: 0.50 × ($70,000 + $10,000 − $30,000) = $25,000.

232

Magic Corp., a regular C corporation, elected S corporation status at the beginning of the Year 3 calendar year. It had an asset with a basis of $40,000 and a fair market value (FMV) of $85,000 on January 1, Year 6. The asset was sold during Year 6 for $95,000. Magic's corporate tax rate was 35%. What was Magic's tax liability as a result of the sale?

A.
$0

B.
$3,500

C.
$15,750

D.
$19,250

C. $15,750

Generally an S corporation is not subject to income tax. The company's taxable income or loss flows through to the shareholders and is reported on their individual income tax returns. One exception to this is the built-in gains tax. When a regular C corporation converts to S corporation status, a tax may be imposed on the net appreciation of the assets owned at the time of conversion if they are sold within five years. The built-in gains tax is at the highest corporate tax rate.

Magic's tax liability as a result of the sale is as follows:

Fair market value of asset at conversion $85,000
Basis (40,000)
Unrealized built-in gain $45,000

Sale price $95,000
Basis (40,000)
Realized gain $55,000

Built-in gains tax:
Lower of unrealized built-in gain or realized gain $45,000
x Tax rate x 0.35
Built-in gains tax $15,750

233

Acorn, Inc., had the following items of income and expense:

Sales $500,000
Cost of sales 250,000
Dividends received 25,000

The dividends were received from a corporation of which Acorn owns 30%. In Acorn's corporate income tax return, what amount should be reported as income before special deductions?

A.
$525,000

B.
$505,000

C.
$275,000

D.
$250,000

C. $275,000

Sales $500,000
- Cost of Sales (250,000)
$250,000
+ Dividends Received + 25,000
Total Income before
Special Deductions $275,000

The question asks for income before special deductions (dividends-received deduction), not after special deductions.

234

Which of the following statements is correct regarding the unrelated business income of exempt organizations?

A.
If an exempt organization has any unrelated business income, it may result in the loss of the organization's exempt status.

B.
Unrelated business income relates to the performance of services, but not to the sale of goods.

C.
An unrelated business does not include any activity where all the work is performed for the organization by unpaid volunteers.

D.
Unrelated business income tax will not be imposed if profits from the unrelated business are used to support the exempt organization's charitable activities.

C.
An unrelated business does not include any activity where all the work is performed for the organization by unpaid volunteers.

Unrelated business income of an exempt organization does not include an activity where all the work is performed for the organization by unpaid volunteers.

Generally, tax-exempt organizations are subject to tax on income from any unrelated business (income from sale of goods or services rendered).

If a tax-exempt organization has unrelated business income (on which it pays income tax), it will not affect its tax-exempt status.

235

To what extent is the fee paid to a trustee of a trust deductible on Form 1041?

A.
Fully deductible

B.
Not deductible

C.
Deductible to the extent of ratio of taxable income to total income

D.
50% deductible

C.
Deductible to the extent of ratio of taxable income to total income

Indirect expenses of a trust such as trustee fees are considered to apply to all income. The ratio of taxable income to total income (not including income allocated to corpus) is used to determine the deduction.

For example, if a trust had total income of $20,000, of which $15,000 was taxable and $5,000 was tax-exempt interest, then 75% of the trustee fees would be deductible ($15,000 taxable ÷ $20,000 total = 0.75).