Individual Taxation Flashcards
Under the modified accelerated cost recovery system (MACRS) the midquarter convention applies if:
Used tangible personal property is placed in service.
Real property is placed in service.
Alternate straight-line depreciation is elected by the taxpayer.
More than 40% of all personal property is placed in service during the last quarter of the taxpayer’s tax year.
D. This answer is correct. The general rule is that personal property is treated as placed in service or disposed of at the midpoint of the taxable year, resulting in a half-year of depreciation for the year in which the property is placed in service or disposed of. A midquarter convention applies if more than 40% of all personal property is placed in service during the last quarter of the taxpayer’s year. Under this convention, property is treated as placed in service (or disposed of) in the middle of the quarter in which placed in service (or disposed of).The midquarter convention only applies to personal property.
Cathy qualified to itemize deductions on her calendar year 2013 tax return. Cathy’s 2013 adjusted gross income was $25,000 and she made a $1,500 cash donation directly to a needy family. Also during 2013, Cathy donated stock, valued at $5,000, to her church. Cathy had purchased the stock ten months earlier for $2,000. What was the maximum amount of charitable contribution allowable as an itemized deduction on Cathy’s 2013 income tax return?
$1,500
$2,000
$3,500
$5,000
B. This answer is correct. The requirement is to determine the maximum amount of charitable contribution allowable as an itemized deduction. The amount of contribution for appreciated property is generally the property’s FMV if the property would result in a long-term capital gain if sold. If not, the amount of contribution for appreciated property is generally limited to the property’s basis. Here, the stock worth $5,000 was purchased for $2,000 just 10 months earlier. Since its holding period does not exceed 12 months, a sale of the stock would result in a short-term capital gain, and the amount of allowable charitable contribution deduction is limited to the stock’s basis of $2,000. Additionally, to be deductible, a contribution must be made to a qualifying organization. As a result, the $1,500 cash given to a needy family is not deductible. The amount of contribution for appreciated property held for less than one year is limited to the property’s basis.
Which of the following is correct concerning the LIFO method (as compared to the FIFO method) in a period when prices are rising?
Deferred tax and cost of goods sold are lower.
Current tax liability and ending inventory are higher.
Current tax liability is lower and ending inventory is higher.
Current tax liability is lower and cost of goods sold is higher.
D. This answer is correct. The requirement is to determine the correct statement regarding the LIFO method (as compared to the FIFO method) during a period when prices are rising. LIFO (last-in, first out) benefits a taxpayer in periods of rising prices because recently incurred high costs flow through cost of goods sold while previously incurred low costs remain in ending inventory. Compared to FIFO, LIFO increases the cost of goods sold and decreases ending inventory, thereby decreasing gross profit, taxable income, and current tax liability. Uniform capitalization rules generally require that all costs incurred (both direct and indirect) in manufacturing or constructing real or personal property, or in purchasing or holding property for sale, must be capitalized as part of the cost of the property.
(1) These costs become part of the basis of the property and are recovered through depreciation or amortization, or are included in inventory and recovered through cost of goods sold as an offset to selling price.
During 2013, Anita Simms was entirely supported by her three sons, Dudley, Carlton, and Isidore, who provided support for her in the following percentages:
Dudley 8%
Carlton 45%
Isidore 47%
Which of the brothers is entitled to claim his mother as a dependent, assuming a multiple support agreement exists? Dudley. Dudley or Carlton. Carlton or Isidore. Dudley, Carlton or Isidore.
C. This answer is correct. The support test requires an individual to furnish over one-half of a dependent’s support. In the event no one person provides more than 50% of the dependent’s support, any individual who contributed more than 10% is entitled to claim the exemption if each other person contributing more than 10% of the support signs a written consent not to claim the exemption (i.e., multiple support agreement). Therefore, only Carlton or Isidore (who each contributed more than 10%) may claim their mother as a dependent.
If an individual taxpayer’s passive losses and credits relating to rental real estate activities cannot be used in the current year, then they may be carried
Back 3 years, but they cannot be carried forward.
Forward up to a maximum period of 20 years, but they cannot be carried back.
Back 2 years or forward up to 20 years, at the taxpayer’s election.
Forward indefinitely or until the property is disposed of in a taxable transaction.
D. This answer is correct. Generally, losses and credits from passive activities can only be used to offset income from (or tax allocable to) passive activities. If there is insufficient passive-activity income (or tax) to absorb passive-activity losses and credits, the unused losses and credits are carried forward indefinitely or until the property is disposed of in a taxable transaction.Passive-activity losses and credits cannot be carried back to prior years.
Which one of the following credits in not a component of the general business credit? Work opportunity credit. Child and dependent care credit. Disabled access credit. Alcohol fuels credit.
B. This answer is correct. The general business credit is a combination of several credits that provide uniform rules for current and carryback-carryover years. The general business credit is composed of numerous credits including the investment credit, work opportunity credit, alcohol fuels credit, research credit, low-income housing credit, enhanced oil recovery credit, disabled access credit, renewable electricity production credit, empowerment zone employment credit, Indian employment credit, employer social security credit, orphan drug credit, the new markets credit, the small employer pension plan start-up costs credit, and the employer-provided child care credit. A general business credit in excess of the limitation amount is carried back 1 year and forward 20 years to offset tax liability in those years.
Lane, a single taxpayer, received $160,000 in salary, $15,000 in income from an S corporation in which Lane does not materially participate, and a $35,000 passive loss from a real estate rental activity in which Lane materially participated. Lane’s modified adjusted gross income was $165,000. What amount of the real estate rental activity loss was deductible? $0 $15,000 $25,000 $35,000
B. This answer is correct. A real estate rental activity is generally considered to be a passive activity, even though the taxpayer materially participates in the rental activity. That is important because losses from passive activities can only be used to offset income from other passive activities. Here, since Lane did not materially participate in the S corporation, the S corporation income of $15,000 is treated as passive activity income and is offset by $15,000 of the rental real estate passive loss. Although a special rule permits up to $25,000 of income that is not from passive activities to be offset by losses from a rental real estate activity, that special $25,000 allowance is reduced by 50% of a taxpayer’s modified AGI in excess of $100,000 and is fully phased out when modified AGI exceeds $150,000. Since Lane’s modified AGI is $165,000, the $25,000 allowance is not available. As a result, Lane’s rental real estate loss is deductible in the current year only to the extent that it offsets the $15,000 of passive activity income.
Terry, a taxpayer, purchased stock for $12,000. Later, Terry sold the stock to a relative for $8,000, when the stock’s fair market value was still $12,000. What amount is the relative’s gain or loss resulting from the purchase of the stock from Terry? $2,000 loss. $0 $2,000 gain. $4,000 gain.
B. This answer is correct. The requirement is to determine the relative’s gain or loss as a result of the purchase of stock from Terry. Here, Terry purchased stock for $12,000 and later sold the stock for $8,000 to a relative, when the stock’s FMV was $12,000. A sale of property to a relative for less than FMV is considered in part a sale and in part a gift. Terry is not allowed to recognize any loss resulting from the sale and is deemed to have made a gift to the relative to the extent that the selling price was less than FMV ($12,000 − $8,000 = $4,000 gift). The receipt of the gift is excluded from the relative’s gross income, and the relative’s basis for the stock would be $12,000.
Nicole Sandler, a public school teacher with adjusted gross income of $20,000, paid the following items in 2013 for which she received no reimbursement:
Initiation fee for membership in teachers’ union $300
Dues to teachers’ union 250
Voluntary unemployment benefit fund contributions to union-established fund 85
How much can Nicole claim in 2013 as allowable miscellaneous deductions on Schedule A of Form 1040? $150 $335 $550 $635
A. This answer is correct. The requirement is to determine the amount that can be claimed as miscellaneous itemized deductions. Both the initiation fee and the union dues are deductible. The voluntary benefit fund contribution is not deductible. Miscellaneous itemized deductions are generally deductible only to the extent that they exceed 2% of AGI. In this case the deductible amount is $150 [$550 - (.02 x $20,000)].
Mr. and Mrs. Donald Curry’s real property tax year is on a calendar-year basis, with payments due annually on August 1. The realty taxes on their home amounted to $1,200 in 2013, but the Currys did not pay any portion of that amount since they sold the house on April 1, 2013, four months before payment was due. However, realty taxes were prorated on the closing statement. Assuming that they owned no other real property during the year, how much can the Currys deduct on Schedule A of Form 1040 for real estate taxes in 2013? $0 $296 $800 $1,200
B. This answer is correct. When real estate is sold, the real estate tax deduction is apportioned between the seller and the buyer according to the number of days in the real property tax year that each holds the property. Since Curry sold his home on April 1, 2012, the deduction allocated to Curry would be
90/365 × $1,200 = $296
Soma Corp. had $600,000 in compensation expense for book purposes in 2013. Included in this amount was a $50,000 accrual for 2013 nonshareholder bonuses. Soma paid the actual 2013 bonus of $60,000 on March 1, 2014. In its 2013 tax return, what amount should Soma deduct as compensation expense? $600,000 $610,000 $550,000 $540,000
B. This answer is correct. The requirement is to determine the amount that Soma Corp. can deduct as compensation expense on its 2013 tax return. An accrual-method taxpayer can deduct compensation when there is an obligation to make payment, economic performance has occurred, the amount is reasonable, and payment is made no later than 2½ months after the end of the taxable year. Economic performance generally occurs when an employee performs services. It is not required that the exact amount of compensation be determined during the taxable year, as long as the computation is known and the liability is fixed, accrual is proper even though the profits upon which the compensation is based are not determined until after the close of the year. In this case, since Soma’s $600,000 of compensation expense per books included bonuses of $50,000, while actual bonus payments totaled $60,000, its compensation expense on its 2013 tax return would be $600,000 + $10,000 = $610,000.
The Rites are married, file a joint income tax return, and qualify to itemize their deductions in the current year. Their adjusted gross income for the year was $55,000, and during the year they paid the following taxes:
Real estate tax on personal residence $2,000
Ad valorem tax on personal automobile 500
Current year state and city income taxes withheld from paycheck 1,000
What total amount of the expense should the Rites claim as an itemized deduction on their current year joint income tax return? $1,000 $2,500 $3,000 $3,500
D. This answer is correct. The requirement is to determine the amount of expense that the Rites can claim as an itemized deduction. An individual’s itemized deductions include state and local income taxes paid or withheld from paychecks, real estate taxes based on the value of real estate not used in a business, and personal property taxes based on the value of personal property if charged on a yearly basis. Here, the Rites can deduct a total of $3,500 as an itemized deduction including the $2,000 of real estate tax, $500 of ad valorem tax on personal automobile, and $1,000 of state and local income taxes withheld from paycheck. The ad valorem tax is a personal property tax. (i.e., assessed in relation to the value of property).
Cobrin, a sole proprietor with no employees, has a Keogh profit-sharing plan to which he may contribute 15% of his annual earned income. For this purpose, “earned income” is defined as net self-employment earnings reduced by the
Deductible Keogh contribution.
Self-employment tax.
Self-employment tax and one-half of the deductible Keogh contribution.
Deductible Keogh contribution and one-half of the self-employment tax.
D. This answer is correct. The requirement is to determine the definition of “earned income” for purposes of computing the annual contribution to a Keogh profit-sharing plan by Cobrin, a sole proprietor. A self-employed individual may contribute to a qualified retirement plan called a Keogh plan. The maximum contribution to a Keogh profit-sharing plan is the lesser of $51,000 (for 2013) or 100% of earned income. For this purpose, “earned income” is defined as net earnings from self-employment (i.e., business gross income minus allowable business deductions) reduced by the deduction for one-half of the self-employment tax, and the deductible Keogh contribution itself.
The maximum contribution and deduction to a defined-contribution self-employed retirement plan for 2013 is the lesser of
(1) $51,000, or 100% of earned income
(2) The definition of “earned income” includes the retirement plan and self-employment tax deductions (i.e., earnings from self-employment must be reduced by the retirement plan contribution and the self-employment tax deduction for purposes of determining the maximum deduction).
A husband and wife can file a joint return even if
The spouses have different tax years, provided that both spouses are alive at the end of the year.
The spouses have different accounting methods.
Either spouse was a nonresident alien at any time during the tax year, provided that at least one spouse makes the proper election.
They were divorced before the end of the tax year.
B. This answer is correct. The requirement is to determine the correct statement regarding the filing of a joint tax return. A husband and wife can file a joint return even if they have different accounting methods.
If either spouse was a nonresident alien at any time during the tax year, both spouses must elect to be taxed as US citizens or residents for the entire tax year. If divorced before the end of the year, taxpayers cannot file a joint return.
Seymour Thomas named his wife, Penelope, the beneficiary of a $100,000 (face amount) insurance policy on his life. The policy provided that upon his death, the proceeds would be paid to Penelope with interest over her present life expectancy, which was calculated at 25 years. Seymour died during 2014 and Penelope received a payment of $5,200 from the insurance company. What amount should she include in her gross income for 2014? $ 200 $1,200 $4,200 $5,200
B. This answer is correct. Life insurance proceeds paid by reason of death are excluded from income if paid in a lump sum or in installments. If the payments are received in installments, the principal amount of the policy divided by the number of payments is excluded each year. Therefore, only $1,200 of the $5,200 insurance payment is included in Penelope’s gross income.
Annual installment $ 5,200
Principal amount ($100,000/25) (4,000)
Amount included in gross income $ 1,200
Ryan and Christine Holm, filing a joint tax return for 2013, had a tax liability of $5,000 based on their tax table income and three exemptions. Ryan and Christine had earned income of $15,000 and $5,000, respectively, during 2013. In order for Christine to be gainfully employed, the Holms incurred the following employment-related expenses for their 5-year old son, Toby, in 2013:
Payee Amount
Alpine Day Care Center $ 900
Mulford Home Cleaning Service 700
Cindy Holm, babysitter (Ryan’s mother) 1,100
Assuming that the Holms do not claim any other credits against their tax, what is the amount of the child care tax credit they should report on their tax return for 2013? $400 $640 $700 $945
B. This answer is correct. The requirement is to determine the amount of the child care credit allowable to the Holms. The credit is from 20% to 35% of certain dependent care expenses limited to the lesser of (1) $3,000 for one qualifying individual, $6,000 for two or more; (2) taxpayer’s earned income or spouse’s if smaller; or (3) actual expenses. The $900 paid to the Alpine Day Care Center qualifies, as does the $1,100 paid to Cindy Holm. Payments to relatives qualify if the relative is not a dependent of the taxpayer. Since Ryan and Christine Holm only claimed three exemptions, Cindy was not their dependent. The $700 paid to Mulford Home Cleaning Service does not qualify since it is completely unrelated to the care of their child. The credit is 35% if AGI is $15,000 or less, but is reduced by 1 percentage point for each $2,000 (or portion thereof) of AGI in excess of $15,000 (but not reduced below 20%). As the Holms had AGI of $20,000, the 35% maximum credit is reduced by 3 percentage points to 32% ($20,000 - $15,000/$2,000 = 2.5). Since qualifying expenses were $2,000, the Holms’ credit is 32% x $2,000 = $640.
Child Care Credit
- The credit may vary from 20% to 35% of the amount paid for qualifying household and dependent care expenses incurred to enable taxpayer to be gainfully employed or look for work. Credit is 35% if AGI is $10,000 or less, but is reduced by 1 percentage point for each $2,000 (or portion thereof) of AGI in excess of $15,000 (but not reduced below 20%).
EXAMPLE: Able, Baker, and Charlie have AGIs of $10,000, $20,000, and $40,000 respectively, and each incurs child care expenses of $2,000. Able’s child care credit is $700 (35% x $2,000); Baker’s credit is $640 (32% x $2,000); and Charlie’s credit is $440 (22% x $2,000).
Maximum amount of expenses that qualify for credit is the least of
a. Actual expenses incurred, or
b. $3,000 for one, $6,000 for two or more qualifying individuals, or
c. Taxpayer’s earned income (or spouse’s earned income if smaller)
d. If spouse is a student or incapable of self-care and thus has little or no earned income, spouse is treated as being gainfully employed and having earnings of not less than $250 per month for one, $500 per month for two or more qualifying individuals
In 2013, Roe Corp. purchased and placed in service a used machine to be used in its manufacturing operations. This machine cost $2,200,000. What portion of the cost may Roe elect to treat as an expense rather than as a capital expenditure? $ 0 $200,000 $300,000 $500,000
C. This answer is correct. For 2013, Sec. 179 permits a taxpayer to elect to treat up to $500,000 of the cost of qualifying depreciable personal property as an expense rather than as a capital expenditure. However, the $500,000 maximum is reduced dollar-for-dollar by the cost of qualifying property placed in service during the taxable year that exceeds $2 million. Here, the maximum amount that can be expensed is [$500,000 – ($2,200,000 – $2,000,000)] = $300,000.
Sec. 179 expense election. A taxpayer (other than a trust or estate) may annually elect to treat the cost of qualifying depreciable property as an expense rather than a capital expenditure.
(1) Qualifying property is generally recovery property that is tangible personal property acquired by purchase from an unrelated party for use in the active conduct of a trade or business.
(2) The maximum cost that can be expensed is $500,000 for 2012 and 2013, but is reduced dollar-for-dollar by the cost of qualifying property that is placed in service during the taxable year that exceeds $2 million.
(3) The amount of expense deduction is further limited to the taxable income derived from the active conduct by the taxpayer of any trade or business. Any expense deduction disallowed by this limitation is carried forward to the succeeding taxable year.
(4) If property is converted to nonbusiness use at any time, the excess of the amount expensed over the MACRS deductions that would have been allowed must be recaptured as ordinary income in the year of conversion.
Chris, age five, has $3,000 of interest income and no earned income this year. Assume the current applicable standard deduction is $1,000; how much of Chris’s income will be taxed at Chris’s parents’ maximum tax rate? $0 $1,000 $1,100 $3,000
B. This answer is correct. The requirement is to determine the amount of a 5-year old child’s income that will be taxed at the parents’ tax rate. The earned income of a child of any age and the unearned income of a child 18 years or older as of the end of the tax year is taxed at the child’s own tax rates. However, the unearned income of a child under age 18 in excess of a threshold amount is generally taxed at the rates of the child’s parents. The threshold amount is subject to change because it is indexed for inflation, but it is normally twice the amount of the applicable standard deduction for a dependent who has only unearned income. Since the multiple-choice item assumes the applicable standard deduction for the child is $1,000, the applicable threshold would be $1,000 x 2 = $2,000. As a result, $3,000 interest income - $2,000 threshold = $1,000 of the child’s interest income would be taxed using the rates of the child’s parents.
Kiddie tax on unearned income. The earned income of a child of any age and the unearned income of a child 24 years or older as of the end of the taxable year is taxed at the child’s own marginal rate. However, for 2013, the unearned income in excess of $2,000 of a child under age eighteen is generally taxed at the rates of the child’s parents.
a. This rule also applies to 18-year-old children, as well as 19-to 23-year-old children who are full-time students, if they do not provide at least half of their support with earned income.
b. Unearned income will be taxed at the parents’ rates regardless of the source of the assets creating the child’s unearned income so long as the child has at least one living parent as of the close of the tax year and does not file a joint return.
c. The amount taxed at the parents’ rates equals the child’s unearned income less the sum of (1) any penalty for early withdrawal of savings, (2) $1,000, and (3) the greater of $1,000 or the child’s itemized deductions directly connected with the production of unearned income.
(1) Directly connected itemized deductions are those expenses incurred to produce or collect income, or maintain property that produces unearned income, including custodian fees, service fees to collect interest and dividends, and investment advisory fees. These are deductible as miscellaneous itemized deductions subject to a 2% of AGI limitation.
(2) The amount taxed at the parents’ rates cannot exceed the child’s taxable income.
EXAMPLE: Janie (age 11) is claimed as a dependent on her parents’ return and in 2013 receives dividend income of $10,000, and has no itemized deductions. The amount of Janie’s income taxed at her parents’ tax rates is $8,000 [$10,000 – ($1,000 + $1,000)].
EXAMPLE: Brian (age 12) is claimed as a dependent on his parents’ return and in 2013 receives interest income of $15,000 and has itemized deductions of $1,200 that are directly connected to the production of the interest income. The amount of Brian’s income taxed at his parents’ tax rates is $12,800 [$15,000 – ($1,000 + $1,200)].
EXAMPLE: Kerry (age 10) is claimed as a dependent on her parents’ return and in 2013 receives interest income of $12,000, has an early withdrawal penalty of $350, and itemized deductions of $400 that are directly connected to the production of the interest income. The amount of Kerry’s income taxed at her parents’ tax rates is $9,650 [$12,000 – ($350 + $1,000 + $1,000)].
Robbe, a cash-basis single taxpayer, reported $50,000 of adjusted gross income last year and claimed itemized deductions of $7,250, consisting solely of $7,250 of state income taxes paid last year. Robbe’s itemized deduction amount, which exceeded the standard deduction available to single taxpayers for last year by $1,150, was fully deductible and it was not subject to any limitations or phaseouts. In the current year, Robbe received a $1,500 state tax refund relating to the prior year. What is the proper treatment of the state tax refund?
Include none of the refund in income in the current year.
Include $1,150 in income in the current year.
Include $1,500 in income in the current year.
Amend the prior year’s return and reduce the claimed itemized deductions for that year.
B. This answer is correct. The requirement is to determine the proper treatment of the $1,500 state income tax refund relating to the prior year. A state income tax refund must be included in gross income for the current year under the tax benefit rule to the extent that the refunded amount was deducted in a prior year and the deduction provided a benefit by reducing the taxpayer’s federal income tax for the prior year. Here, Robbe’s $7,250 itemized deduction for state income tax provided a benefit only to the extent that it exceeded the standard deduction $6,100 that was otherwise available to him. As a result, only $1,150 of the $1,500 refund must be included in gross income for the current year. (7,250-$6,100=$1,150)
Tax benefit rule . A recovery of an item deducted in an earlier year must be included in gross income to the extent that a tax benefit was derived from the prior deduction of the recovered item.
a. A tax benefit was derived if the previous deduction reduced the taxpayer’s income tax.
b. A recovery is excluded from gross income to the extent that the previous deduction did not reduce the taxpayer’s income tax.
(1) A deduction would not reduce a taxpayer’s income tax if the taxpayer was subject to the alternative minimum tax in the earlier year and the deduction was not allowed in computing AMTI (e.g., state income taxes).
(2) A recovery of state income taxes, medical expenses, or other items deductible on Schedule A (Form 1040) will be excluded from gross income if an individual did not itemize deductions for the year the item was paid.
EXAMPLE: Individual X, a single taxpayer, did not itemize deductions but instead used the standard deduction of $6,100 for 2013. In 2014, a refund of $300 of 2013 state income taxes is received. X would exclude the $300 refund from income in 2014.
EXAMPLE: Individual Y, a single taxpayer, had total itemized deductions of $6,200 for 2013, including $800 of state income taxes. In 2014, a refund of $400 of 2013 state income taxes is received. Y must include $100 ($6,200 – $6,100) of the refund in income for 2014.only to the extent that it exceeded the standard deduction $6,100
Hall, a divorced person and custodian of her 12-year-old child, filed her 2013 federal income tax return as head of a household. Hall earned a salary of $75,000 in 2013. Hall was not covered by any type of retirement plan, but contributed $5,500 to an IRA in 2013. Hall’s $5,500 contribution to an IRA should be treated as
A deduction from income in arriving at adjusted gross income.
A deduction from adjusted gross income subject to the 2% of adjusted gross income floor.
A deduction from adjusted gross income not subject to the 2% of adjusted gross income floor.
Nondeductible, with the interest income on the $5,500 to be deferred until withdrawal.
A. This answer is correct. Since Hall was not a participant in a qualified pension plan, there is no phase-out of the $5,500 maximum IRA deduction. Therefore, Hall’s maximum contribution and deduction to an IRA would be limited to the lesser of (1) $5,500, or (2) 100% of her compensation. Since Hall earned a salary of $75,000, Hall’s maximum deduction for contributions to an IRA is $5,500. If IRA contributions are deductible, they are always deductible from gross income in arriving at adjusted gross income.
In the current year Jensen had the following items:
Salary $50,000 Inheritance 25,000 Alimony from ex-spouse 12,000 Child support from ex-spouse 9,000 Capital loss on investment stock sale (6,000)
What is Jensen’s AGI for the current year? $44,000 $59,000 $62,000 $84,000
B. This answer is correct. The requirement is to determine Jensen’s AGI for the current year. Jensen’s AGI consists of the $50,000 salary plus the $12,000 alimony received, less a deduction for a net capital loss which is limited to $3,000. The inheritance and child support that Jensen received are excluded from gross income.
The rule limiting the deductability of passive activity losses and credits applies to Partnerships S corporations Personal service corporations Widely held C corporations
C. This answer is correct. The requirement is to determine the entity to which the rule limiting the deductability of passive activity losses and credits applies. The passive activity limitations apply to individuals, estates, trusts, closely held C corporations, and personal service corporations. Application of the passive activity loss limitations to personal service corporations is intended to prevent taxpayers from sheltering personal service income by creating personal service corporations and acquiring passive activity losses at the corporate level. A personal service corporation is a corporation (1) whose principal activity is the performance of personal services and (2) such services are substantially performed by owner-employees. Since passive activity income, losses, and credits from partnerships and S corporations flow through to be reported on the tax returns of the owners of such entities, the passive activity limitations are applied at the partner and shareholder level, rather than to partnerships and S corporations themselves.
(1) A closely held C corporation is one with 5 or fewer shareholders owning more than 50% of stock.
(2) Personal service corporation is an incorporated service business with more than 10% of its stock owned by shareholder-employees.
