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Flashcards in REG 1 Deck (98):
1

Nare, an accrual-basis taxpayer, owns a building which was rented to Mott under a ten-year lease expiring August 31, Year 8. On January 2, Year 2, Mott paid $30,000 as consideration for cancelling the lease. On November 1, Year 2, Nare leased the building to Pine under a five-year lease. Pine paid Nare $10,000 rent for the two months of November and December, and an additional $5,000 for the last month's rent. What amount of rental income should Nare report in its Year 2 income tax return?
a. $10,000
b. $15,000
c. $40,000
d. $45,000

Choice "d" is correct. Prepaid rent is income when received even for an accrual-basis taxpayer. The $30,000 received as consideration for cancelling the lease is in substitution for rental payments and is thus rental income. The $5,000 prepaid for the last month's rent is also rental income.

2

With regard to the inclusion of social security benefits in gross income, for the Year 8 tax year, which of the following statements is correct?
a. The social security benefits in excess of modified adjusted gross income are included in gross income.
b. The social security benefits in excess of one half the modified adjusted gross income are included in gross income.
c. Eighty-five percent of the social security benefits is the maximum amount of benefits to be included in gross income.
d. The social security benefits in excess of the modified adjusted gross income over a threshold amount are included in gross income.

Choice "c" is correct. The amount of social security benefits that is taxed is dependent on whether the combined income (AGI plus interest on tax-exempt bonds and 50% of the social security benefits) is greater than a threshold amount. If the combined income is less than the threshold, the amount taxed is the lesser of 1) 50% of the benefits or 2) 50% of the excess of the combined income over the threshold. If the combined income is greater than the threshold, the amount taxed is the lesser of 1) amount calculated above plus 85% of the excess of the combined income over the threshold or 2) 85% of the benefits. Thus, 85% of the benefits is the maximum amount of benefits that may be included in gross income.

3

DAC Foundation awarded Kent $75,000 in recognition of lifelong literary achievement. Kent was not required to render future services as a condition to receive the $75,000. What condition(s) must have been met for the award to be excluded from Kent's gross income?
I. Kent was selected for the award by DAC without any action on Kent's part.
II. Pursuant to Kent's designation, DAC paid the amount of the award either to a governmental unit or to a charitable organization.
a. I only.
b. II only.
c. Both I and II.
d. Neither I nor II.

Choice "c" is correct. Generally, the fair market value of prizes and awards is taxable income. However, an exclusion from income for certain prizes and awards applies where the winner is selected for the award without entering into a contest (i.e., without any action on their part) and then assigns the award directly to a governmental unit or charitable organization. Therefore, conditions "I" and "II" must be met in order for Kent to exclude the award from his gross income.

4

Klein, a master's degree candidate at Blair University, was awarded a $12,000 scholarship from Blair in Year 8. The scholarship was used to pay Klein's Year 8 university tuition and fees. Also in Year 8, Klein received $5,000 for teaching two courses at a nearby college. What amount is includable in Klein's Year 8 gross income?
a. $0
b. $5,000
c. $12,000
d. $17,000

Choice "b" is correct. Scholarships are nontaxable for degree seeking students to the extent that the proceeds are spent on tuition, fees, books and supplies. The $5,000 for teaching courses is taxable compensation for services delivered.

5

During Year 9, Ash had the following cash receipts:
Wages $ 13,000
Interest income from U.S. Treasury bonds $350
Workers' compensation following a job-related injury $ 8,500
What is the total amount that must be included in gross income on Ash's Year 9 income tax return?
a. $13,000
b. $13,350
c. $21,500
d. $21,850

Choice "b" is correct. The total amount that must be included in gross income is $13,350 ($13,000 in wages plus $350 in interest income on U.S. Treasury bonds).
Rule: Wages and interest on U.S. Treasury bonds are includible in gross income and must be reported as part of gross income on a taxpayer's income tax return.
Rule: Damages for personal injury (i.e., workers' compensation for a job-related injury) are specifically excluded from gross income.

6

Which of the following is (are) among the requirements to enable a taxpayer to be classified as a "qualifying widow(er)"?
I. A dependent has lived with the taxpayer for six months.
II. The taxpayer has maintained the cost of the principal residence for six months.
a. Both I and II.
b. Neither I nor II.
c. II only.
d. I only.

Choice "b" is correct. The requirements that enable a taxpayer to be classified as a "qualifying widow(er)" are:
1. The taxpayer's spouse died in one of the two previous years and the taxpayer did not remarry in the current tax year,
2. The taxpayer has a child who can be claimed as a dependent,
3. This child lived in the taxpayer's home for all of the current tax year,
4. The taxpayer paid over half the cost of keeping up a home for the child,
5. The taxpayer could have filed a joint return in the year the spouse died.

7

Parker, whose spouse died during the preceding year, has not remarried. Parker maintains a home for a dependent child. What is Parker's most advantageous filing status?
a. Single.
b. Head of household.
c. Qualifying widow(er) with dependent child.
d. Married filing separately.

Choice "c" is correct. A qualifying widow(er) is a taxpayer who may use the joint tax return standard deduction and rates (but not the exemption for the deceased spouse) for each of two taxable years following the year of death of his or her spouse, unless he or she remarries. The surviving spouse must maintain a household that, for the whole entire taxable year, was the principal place of abode of a son, stepson, daughter, or stepdaughter (whether by blood or adoption). The surviving spouse must also be entitled to a dependency exemption for such individual. Parker may file as a qualifying widow(er) since her spouse died in the previous tax year, she did not remarry and she maintained a home for a dependent child. Since qualifying widow(er) is the most advantageous status and Parker qualifies, Parker would file as a qualifying widow(er).

8

In which of the following situations may taxpayers file as married filing jointly?
a. Taxpayers who were divorced during the year.
b. Taxpayers who were legally separated but lived together for the entire year.
c. Taxpayers who were married but lived apart during the year.
d. Taxpayers who were married but lived under a legal separation agreement at the end of the year.

RULE: In order to file a joint return, the parties must be MARRIED at the end of the year. Exception: If the parties are married but are LEGALLY SEPARATED under the laws of the state in which they reside, they cannot file a joint return (they will file either under the single or head of household filing status).

Choice "c" is correct. Per the above rule, taxpayers who are married but lived apart during the year are allowed to file a joint return for the year. The fact that they did not live together during the year has no bearing on the issue.

9

A couple filed a joint return in prior tax years. During the current tax year, one spouse died. The couple has no dependent children. What is the filing status available to the surviving spouse for the first subsequent tax year?
a. Head of household.
b. Married filing separately.
c. Single.
d. Surviving spouse.

Choice "c" is correct. For the first subsequent tax year (and all other subsequent tax years) after the death of a spouse with no dependent children, filing status is single.
Choice "d" is incorrect. Filing status is not "surviving spouse" because there are no dependent children.
Choice "b" is incorrect. Filing status is not "married filing separately" in the first subsequent tax year after the death of a spouse since the couple is no longer married.
Choice "a" is incorrect. Filing status is not "head of household" because there are no dependent children and no other qualifying dependents.

10

A taxpayer's spouse dies in August of the current year. Which of the following is the taxpayer's filing status for the current year?
a. Qualified widow(er).
b. Single.
c. Head of household.
d. Married filing jointly.

Choice "d" is correct. The joint return rates apply for two years following the death of a spouse, if the surviving spouse does not remarry and maintains a household for a dependent child. There is nothing in this question that says whether or not the surviving spouse maintains a household for a dependent child. However, since the question is asking about the current year, the surviving spouse is considered to be married (and thus able to file as married filing jointly) for the entire current year even if the spouse dies earlier in the year (in this case in August).

11

Thompson's spouse died in Year 1. Thompson did not remarry in Year 2 and lived alone the entire year. What is Thompson's Year 2 filing status?
a. Surviving spouse.
b. Head of household.
c. Married filing jointly.
d. Single.

Choice “d” is correct. Filing status is determined as of the last day of the year. At the end of Year 2, Thompson is not married and does not qualify for any other filing status. Therefore, his status is single.
Choice “c” is incorrect. When a spouse dies during the year, the surviving spouse can file married filing jointly for that year under an exception to the end-of-year test. But this question is about Year 2, the year after death. Thompson is single for Year 2.
Choice “a” is incorrect. Surviving spouse status, also known as qualifying widow(er), can be claimed for the two years after year of death. However, it requires the presence of a dependent child, which is not part of the facts here. Thompson is single for Year 2.
Choice “b” is incorrect. Head of household status could apply in certain circumstances where there is a dependent and surviving spouse status does not apply. That is not the case here. Thompson is single for Year 2.

12

Joe and Barb are married, but Barb refuses to sign a Year 12 joint return. On Joe's separate Year 12 return, an exemption may be claimed for Barb if:
a. Barb attaches a written statement to Joe's income tax return, agreeing to be claimed as an exemption by Joe for Year 12.
b. Barb was a full-time student for the entire Year 12 school year.
c. Barb had no gross income and was not claimed as another person's dependent in Year 12.
d. Barb was under the age of 19.

Choice "c" is correct. If a married individual files a separate return, a personal exemption may be claimed for his or her spouse if the spouse has no gross income and is not claimed as a dependent of another taxpayer.

13

In Year 1, Smith, a divorced person, provided over one half the support for his widowed mother, Ruth, and his son, Clay, both of whom are U.S. citizens. During Year 1, Ruth did not live with Smith. She received $9,000 in Social Security benefits. Clay, a 25-year-old full-time graduate student, and his wife lived with Smith. Clay had no income but filed a joint return for Year 1, owing an additional $500 in taxes on his wife's income. How many exemptions was Smith entitled to claim on his Year 1 tax return?
a. 4
b. 1
c. 3
d. 2

Choice "d" is correct. Smith is entitled to an exemption for himself. He is also entitled to an exemption for his mother Ruth (qualifying relative). Ruth has $9,000 in Social Security payments during Year 1, but because that is her only income, the Social Security is not taxable, and nontaxable income does not count in calculating whether an exemption can be taken for a dependent. Clay cannot be taken as a dependent because he filed a joint return with his wife. Because the joint return was filed for a purpose other than simply claiming a refund, the joint return prevents Smith from claiming an exemption for Clay. An exemption cannot be taken for Clay's wife because she filed a joint return with Clay. Smith is entitled to two exemptions.

14

Jim and Kay Ross contributed to the support of their two children, Dale and Kim, and Jim's widowed parent, Grant. For Year 27, Dale, a 19-year-old full-time college student, earned $4,500 as a babysitter. Kim, a 23-year-old bank teller, earned $12,000. Grant received $5,000 in dividend income and $4,000 in nontaxable Social Security benefits. Grant and Kim are U.S. citizens and were over one-half supported by Jim and Kay, but neither of the two currently reside with Jim and Kay. Dale's main place of residence is with Jim and Kay, and he is currently on a temporary absence to attend school. How many exemptions can Jim and Kay claim on their Year 27 joint income tax return?
a. Three
b. Five
c. Two
d. Four

Choice "a" is correct. Taxpayers are now entitled to an exemption for each qualifying child and qualifying relative (two tests are "CARES" or "SUPORT"). For Dale, he does meet the residency requirement because there is an exception for a temporary absence while attending school. Therefore, he is a qualifying child under the CARES test. Kim does not qualify as a qualifying child (CARES test) because, although she is under age 24, she is not a full-time student. Therefore, the income limitations of the SUPORT test apply, and she does not qualify under that test either. Likewise, Grant's taxable income of $5,000 exceeds the minimum ($4,050). Thus, 3 total exemptions can be claimed (Jim, Kay, and Dale).

15

Janet and Ted have two children, Mary (age 10) and Seth (age 12). Janet's Aunt Martha resides with the family in an apartment over the garage. Martha's only income is $1,500 a month in Social Security benefits. Janet and Ted receive no rent payments from Martha and provide all remaining support for her living arrangements. How many exemptions are Janet and Ted entitled to in filing their joint tax return?
a. 3
b. 4
c. 5
d. 2

Choice "c" is correct. Janet and Ted are entitled to dependency exemptions for themselves, their two children and Aunt Martha. Aunt Martha is a "qualified relative." The qualifications to take an exemption for a qualifying relative are found in the "SUPORT" mnemonic:
S upport (over 50%) test
U nder a specific amount of (taxable) gross income test
P recludes dependent filing a joint tax return test
O nly citizens (residents of US/Canada or Mexico) test
R elative test OR
T axpayer lives with individual for whole year test

The two children meet the test for a qualifying child. In addition, Aunt Martha, a relative, qualifies because she does not have any taxable income (social security is not taxed at this low level of income), is not filing a joint tax return with another, is a citizen of the US, and is a qualifying relative. In this instance, note that Martha would not have to reside with the family. Only nonrelative members of a household must reside with the taxpayer for the entire year in order for the taxpayer to be entitled to a dependency exemption for that individual.

16

Darr, an employee of Sorce C Corporation, is not a shareholder. Which of the following would be included in a taxpayer's gross income?
a. The dividend income on shares of stock that the taxpayer received for services rendered.
b. A $10,000 gift from the taxpayer's grandparents.
c. Employer-provided medical insurance coverage under a health plan.
d. The fair market value of land that the taxpayer inherited from an uncle.

Choice "a" is correct. An individual receiving common stock for services rendered must recognize the fair market value as ordinary income. Any dividends received on that stock would also result in income recognition.

17

Adams owns a second residence that is used for both personal and rental purposes. During the current year, Adams used the second residence for 50 days and rented the residence for 200 days. Which of the following statements is correct?
a. A rental loss may be deducted if rental-related expenses exceed rental income.
b. Depreciation may not be deducted on the property under any circumstances.
c. All mortgage interest and taxes on the property will be deducted to determine the property's net income or loss.
d. Utilities and maintenance on the property must be divided between personal and rental use.

Choice "d" is correct. Because the second property was personally used more than 14 days, any net loss from the rental of the property will be disallowed.
All related expenses must be prorated between the personal use portion and the rental activity portion. Prorated depreciation is permitted for the rental activity.

18

Which of the following conditions must be present in a post-1984 divorce agreement for a payment to qualify as deductible alimony?
I. Payments must be in cash or its equivalent.
II. The payments must end at the recipient's death.
a. Neither I nor II.
b. II only.
c. I only.
d. Both I and II.

Choice "d" is correct. Among the requirements for payments to be classified as alimony are the following:
1. Payment must be in cash or its equivalent.
2. Payments cannot extend beyond the death of the payee-spouse.
3. Payments must be legally required pursuant to a written divorce (or separation) agreement.
4. Payments cannot be made to members of the same household.
5. Payments must not be designated as anything other than alimony.
6. The spouses may not file a joint tax return.
Note: The requirements for payments to be considered alimony (income) are the same as for payments to be alimony (deductions).

19

Which of the following costs is not included in inventory under the Uniform Capitalization rules for goods manufactured by the taxpayer?
a. Warehousing costs.
b. Research.
c. Quality control.
d. Taxes excluding income taxes.

Choice "b" is correct. Uniform Capitalization rules provide guidelines with respect to capitalizing or expensing certain costs. With regard to inventory, direct materials, direct labor, and factory overhead should be capitalized as part of the cost of inventory. Warehousing costs, quality control and taxes, excluding income taxes, are all considered factory overhead items. The research should be expensed.

20

During Year 9, Ash had the following cash receipts:
Wages $ 13,000
Interest income from U.S. Treasury bonds $350
Workers' compensation following a job-related injury $8,500
What is the total amount that must be included in gross income on Ash's Year 9 income tax return?
a. $13,000
b. $13,350
c. $21,850
d. $21,500

b. $13,350
Choice "b" is correct. The total amount that must be included in gross income is $13,350 ($13,000 in wages plus $350 in interest income on U.S. Treasury bonds).
Rule: Wages and interest on U.S. Treasury bonds are includible in gross income and must be reported as part of gross income on a taxpayer's income tax return.
Rule: Damages for personal injury (i.e., workers' compensation for a job-related injury) are specifically excluded from gross income.

21

Baum, an unmarried optometrist and sole proprietor of Optics, buys and maintains a supply of eyeglasses and frames to sell in the ordinary course of business. In the current year, Optics had $350,000 in gross business receipts and its year-end inventory was not subject to the uniform capitalization rules. Baum's current year adjusted gross income was $90,000 and Baum qualified to itemize deductions. During the year, Baum recorded the following information:
Business expenses: Optics cost of goods sold $ 35,000
Optics rent expense $28,000
Liability insurance premium on Optics $5,250
Other expenditures: Baum's self-employment tax $ 29,750
Baum's self-employment health insurance $8,750
Insurance premium on personal residence. In the current year, Baum's home was totally destroyed by fire. The furniture had an adjusted basis of $14,000 and a fair market value of $11,000. During the year, Baum collected $3,000 in insurance reimbursement and had no casualty gains during the year. $2,625
Qualified mortgage interest on a loan to acquire a personal residence $52,500
Annual interest on a $70,000, 5-year home equity loan. The loan was secured by Baum's home, obtained January 2 of the current year. The fair market value of the home exceeded the mortgage and the home equity loan by a substantial amount. The proceeds were used to purchase a car for personal use. $3,500
Points prepaid on January 2 of the current year to acquire the home equity loan $1,400
Real estate taxes on personal residence $2,200
Estimated payments of current year federal income taxes $13,500
Local property taxes on the car value, used exclusively for personal use $300
What amount should Baum report as current year net earnings from self-employment?
a. $273,000
b. $281,750
c. $243,250
d. $252,000

Choice "b" is correct. Baum should report $281,750 as current year net earnings from self-employment (line 12 of the Form 1040), calculated as follows:
Gross business receipts $ 350,000
Cost of goods sold (35,000)
Rent expense (28,000)
Liability insurance premium (5,250)
Net earnings on Schedule C $ 281,750
Choices "c", "d", and "a" are incorrect. Self-employment tax and self-employment health insurance expenses are adjustments from total gross income. They are not deducted from self-employment earnings (i.e., not reported net on line 12 of the Form 1040).

Note: There are many distracters in this question, all relating to items that are either deductible as part of itemized deductions or not deductible. Be careful to read the requirement of the question before spending unnecessary time on the question. The statement that Baum's year-end inventory was not subject to the uniform capitalization rules is a distracter as well. There is not enough information given in the facts to apply the rules if he had been subject to them.

22

Baker, a sole proprietor CPA, has several clients that do business in Spain. While on a four-week vacation in Spain, Baker took a five-day seminar on Spanish business practices that cost $700. Baker's round-trip airfare to Spain was $600. While in Spain, Baker spent an average of $100 per day on accommodations, local travel, and other incidental expenses, for total expenses of $2,800. What amount of total expense can Baker deduct on Form 1040 Schedule C, "Profit or Loss From Business," related to this situation?
a. $700
b. $4,100
c. $1,800
d. $1,200

Choice "d" is correct. Baker can deduct $1,200 in total expense on Form 1040 Schedule C, calculated as follows:
Direct educational expenses
$ 700
[cost of the course]
Daily expenses for 5-day seminar
500
[$100 per day × 5]
Total educational expenses
$ 1,200
Rule: If foreign travel is primarily for personal in nature (e.g., a vacation), none of the travel expenses (e.g., round trip airfare) incurred will be allowable business deductions, even if the taxpayer was involved in business activities while in the foreign country.
Note: It does not appear that the examiners are attempting to trick candidates on the classification of the business expenses as travel or educational. It appears that the purpose of the question is to test the candidate's ability to recognize when expenses are deductible and when they are not deductible business expenses.

23

On December 1 of the current taxable year, Krest, a self-employed cash basis taxpayer, borrowed $200,000 to use in her business. The loan was to be repaid on November 30 of the following year. Krest paid the entire interest amount of $24,000 on December 1 of the current year. What amount of interest was deductible on Krest's current year income tax return?
a. $0
b. $22,000
c. $2,000
d. $24,000

Choice "c" is correct. Cash basis taxpayers deduct interest in the year paid or the year to which the interest relates, whichever is later. Even though all of the interest on this loan was paid on December 1, of the current year, only the interest relating to December of the current year can be deducted in the current year. The question does not give an interest rate, but because the loan is to be repaid in a lump sum at maturity, 1/12 of the interest, or $2,000 applies to each month.

24

Klein, a master's degree candidate at Blair University, was awarded a $12,000 scholarship from Blair in Year 8. The scholarship was used to pay Klein's Year 8 university tuition and fees. Also in Year 8, Klein received $5,000 for teaching two courses at a nearby college. What amount is includable in Klein's Year 8 gross income?
a. $0
b. $17,000
c. $5,000
d. $12,000

Choice "c" is correct. Scholarships are nontaxable for degree seeking students to the extent that the proceeds are spent on tuition, fees, books and supplies. The $5,000 for teaching courses is taxable compensation for services delivered.

25

Which payment(s) is (are) included in a recipient's gross income?
I. Payment to a graduate assistant for a part-time teaching assignment at a university. Teaching is not a requirement toward obtaining the degree.
II. A grant to a Ph.D. candidate for his participation in a university-sponsored research project for the benefit of the university.
a. I only.
b. II only.
c. Neither I nor II.
d. Both I and II.

d. Both I and II

26

Under the uniform capitalization rules applicable to property acquired for resale, which of the following costs should be capitalized with respect to inventory if no exceptions are met?
Marketing costs..............Off-site storage costs
a. No.......................Yes
b. No.......................No
c. Yes......................No
d. Yes......................Yes

a. Marketing Costs: No, Off-site Storage costs: Yes
Choice "a" is correct. Under the uniform capitalization rules, purchasers of inventory for resale may deduct their marketing costs but must capitalize their off-site storage costs.

27

In a tax year where the taxpayer pays qualified education expenses, interest income on the redemption of qualified U.S. Series EE Bonds may be excluded from gross income. The exclusion is subject to a modified gross income limitation and a limit of aggregate bond proceeds in excess of qualified higher-education expenses. Which of the following is (are) true?
I. The exclusion applies for education expenses incurred by the taxpayer, the taxpayer's spouse, or any person whom the taxpayer may claim as a dependent for the year.
II. "Otherwise qualified higher-education expenses" must be reduced by qualified scholarships not includible in gross income.
a. Neither I nor II.
b. I only.
c. II only.
d. Both I and II.

Both I and II

Choice "d" is correct. Interest earned on Series EE bonds issued after 1989 may qualify for exclusion. One requirement is that the interest is used to pay tuition and fees for the taxpayer, spouse, or dependent enrolled in higher education. The interest exclusion is reduced by qualified scholarships that are exempt from tax and other nontaxable payments received for educational expenses (other than gifts and inheritances).

28

During the year Kay received interest income as follows:
On U.S. Treasury certificates
$ 4,000
On refund of prior year's federal income tax
500
The total amount of interest subject to tax in Kay's current year tax return is:
a. $500
b. $4,500
c. $0
d. $4,000

b. $4,500
Choice "b" is correct. Interest income from U.S. obligations is generally taxable. Interest income on a federal tax refund is taxable, even though the refund itself is not taxed.

29

With regard to the inclusion of social security benefits in gross income, for the Year 8 tax year, which of the following statements is correct?
a. Eighty-five percent of the social security benefits is the maximum amount of benefits to be included in gross income.
b. The social security benefits in excess of one half the modified adjusted gross income are included in gross income.
c. The social security benefits in excess of the modified adjusted gross income over a threshold amount are included in gross income.
d. The social security benefits in excess of modified adjusted gross income are included in gross income.

Choice "a" is correct. The amount of social security benefits that is taxed is dependent on whether the combined income (AGI plus interest on tax-exempt bonds and 50% of the social security benefits) is greater than a threshold amount. If the combined income is less than the threshold, the amount taxed is the lesser of 1) 50% of the benefits or 2) 50% of the excess of the combined income over the threshold. If the combined income is greater than the threshold, the amount taxed is the lesser of 1) amount calculated above plus 85% of the excess of the combined income over the threshold or 2) 85% of the benefits. Thus, 85% of the benefits is the maximum amount of benefits that may be included in gross income.

30

Rich is a cash basis self-employed air-conditioning repairman with current year gross business receipts of $20,000. Rich's cash disbursements were as follows:
Air conditioning parts $ 2,500
Yellow Pages listing $2,000
Estimated federal income taxes on self-employment income $1,000
Business long-distance telephone calls $400
Charitable contributions $200

What amount should Rich report as net self-employment income?
a. $15,100
b. $13,900
c. $14,900
d. $14,100

Choice "a" is correct. Deductions to arrive at net self-employed income include all necessary and ordinary expenses connected with the business. Estimated federal income tax payments are not an expense. Charitable contributions by an individual are only deductible as an itemized deduction on Schedule A. This assumes the contribution was not made with the "expectation of commensurate financial return."
Receipts$ 20,000
Parts (2,500)
Listing (2,000)
Telephone (400)
Net self-employment income $ 15,100

31

On December 1, Year 1, Michaels, a self-employed cash basis taxpayer, borrowed $100,000 to use in her business. The loan was to be repaid on November 30, Year 2. Michaels paid the entire interest of $12,000 on December 1, Year 1. What amount of interest was deductible on Michaels' Year 2 income tax return?
a. $12,000
b. $1,000
c. $0
d. $11,000

d. $11,000

Choice "d" is correct. Prepaid interest must be prorated over the time for which payment is made. This is true for both cash and accrual basis taxpayers. The loan is for 1 month in Year 1 and 11 months in Year 2. Therefore, 1/12 of the interest is deductible in Year 1 and 11/12, or $11,000 is deductible in Year 2.

32

Perle, a dentist, billed Wood $600 for dental services. Wood paid Perle $200 cash and built a bookcase for Perle's office in full settlement of the bill. Wood sells comparable bookcases for $350. What amount should Perle include in taxable income as a result of this transaction?
a. $200
b. $550
c. $600
d. $0

b. $550
Choice "b" is correct. The $200 cash received plus the $350 fair value of the bookcase received must be included in income by Perle, for a total of $550. The income is based on the value in money or fair value of property received by Perle, not the $600 billed.

33

Charles and Marcia are married cash-basis taxpayers. In Year 8, they had interest income as follows:
*$500 interest on federal income tax refund.
*$600 interest on state income tax refund.
*$800 interest on federal government obligations.
*$1,000 interest on state government obligations.
What amount of interest income is taxable on Charles and Marcia's Year 8 joint income tax return?
a. $2,900
b. $1,100
c. $500
d. $1,900

d. $1,900

Choice "d" is correct. The $500 interest on federal income tax refund, the $600 interest on state income tax refund, and the $800 interest on federal government obligations are taxable, for a total of $1,900. The $1,000 interest on state government obligations is normally not taxable.

34

Nare, an accrual-basis taxpayer, owns a building which was rented to Mott under a ten-year lease expiring August 31, Year 8. On January 2, Year 2, Mott paid $30,000 as consideration for cancelling the lease. On November 1, Year 2, Nare leased the building to Pine under a five-year lease. Pine paid Nare $10,000 rent for the two months of November and December, and an additional $5,000 for the last month's rent. What amount of rental income should Nare report in its Year 2 income tax return?
a. $40,000
b. $15,000
c. $45,000
d. $10,000

c. $45,000

Choice "c" is correct. Prepaid rent is income when received even for an accrual-basis taxpayer. The $30,000 received as consideration for cancelling the lease is in substitution for rental payments and is thus rental income. The $5,000 prepaid for the last month's rent is also rental income.

35

John and Mary were divorced last year. The divorce decree provides that John pay alimony of $10,000 per year, to be reduced by 20% on their child's 18th birthday. During the current year, John paid $7,000 directly to Mary and $3,000 to Spring College for Mary's tuition. What amount of these payments should be reported as income in Mary's current year income tax return?
a. $10,000
b. $8,000
c. $8,600
d. $5,600

Choice "b" is correct. Alimony would be income to Mary while child support would not. Funds qualify as child support only if 1) a specific amount is fixed or is contingent on the child's status (e.g., reaching a certain age), 2) it is paid solely for the support of minor children, and 3) it is payable by decree, instrument or agreement. The actual use of the funds is irrelevant to the issue. In this case, $2,000 (20% × $10,000) qualifies as child support. The other $8,000 is alimony, which would be income to Mary.

36

Clark filed Form 1040EZ for the Year 8 taxable year. In July, Year 9, Clark received a state income tax refund of $900 plus interest of $10, for overpayment of Year 8 state income tax. What amount of the state tax refund and interest is taxable in Clark's Year 9 federal income tax return?
a. $900
b. $10
c. $910
d. $0

Choice "b" is correct. Except for interest from state and local government bonds, interest income is fully taxable, so the $10 is included in income. Filing Form 1040EZ means that Clark did not itemize in the prior year, and therefore, did not deduct any state income taxes last year. Under the tax benefit rule, the refund is not taxable this year since Clark did not deduct the tax last year.

37

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. $50,000
b. $70,000
c. $0
d. $20,000

Choice "a" is correct. Guaranteed payments are reasonable compensation paid to a partner for services rendered (or use of capital) without regard to his ratio of income. Earned compensation is subject to self-employment tax. Payments not guaranteed are merely another way to distribute partnership profits. The ordinary income reported from an S corporation is taxable income to the individual or their own individual tax return but is not subject to self-employment tax. The ordinary income reported from a partnership may be subject to self-employment tax (if to a general partner).

38

During the current year, Adler had the following cash receipts:
Wages $ 18,000
Interest income from investments in municipal bonds $400
Unemployment compensation $3,900

What is the total amount that must be included in gross income on Adler's current year income tax return?
a. $22,300
b. $18,000
c. $18,400
d. $21,900

Choice "d" is correct. The wages of $18,000 and unemployment compensation are both includable in gross income on Adler's current year income tax return.

39

DAC Foundation awarded Kent $75,000 in recognition of lifelong literary achievement. Kent was not required to render future services as a condition to receive the $75,000. What condition(s) must have been met for the award to be excluded from Kent's gross income?
I. Kent was selected for the award by DAC without any action on Kent's part.
II. Pursuant to Kent's designation, DAC paid the amount of the award either to a governmental unit or to a charitable organization.
a. Neither I nor II.
b. I only.
c. Both I and II.
d. II only.

c. Both I and II

Choice "c" is correct. Generally, the fair market value of prizes and awards is taxable income. However, an exclusion from income for certain prizes and awards applies where the winner is selected for the award without entering into a contest (i.e., without any action on their part) and then assigns the award directly to a governmental unit or charitable organization. Therefore, conditions "I" and "II" must be met in order for Kent to exclude the award from his gross income.

40

Mosh, a sole proprietor, uses the cash basis of accounting. At the beginning of the current year, accounts receivable were $25,000. During the year, Mosh collected $100,000 from customers. At the end of the year, accounts receivable were $15,000. What was Mosh's gross taxable income for the current year?
a. $100,000
b. $75,000
c. $90,000
d. $110,000

Choice "a" is correct. The facts state that cash collections from customers were $100,000 and as a cash basis taxpayer this is the amount of Mosh's gross taxable income for the year. Note that according to the formula BASE - we can determine the amount of sales = $90,000, but that would give us accrual, not cash basis, income.
Beginning A/R
$ 25,000
Add―Sales
90,000
accrual basis taxable income
115,000
Subtract―Cash collections
(100,000)
cash basis taxable income
Ending A/R
$ 15,000

41

Porter was unemployed for part of the year. Porter received $35,000 of wages, $6,400 from a state unemployment compensation plan, and $2,000 from his former employer's company-paid supplemental unemployment benefit plan. What is the amount of Porter's gross income?
a. $41,400
b. $37,000
c. $35,000
d. $43,400

RULE: Gross income includes all income unless it is specifically excluded in the tax code.
Choice "d" is correct. Wages and all unemployment compensation are not excluded from being taxable; therefore, they are included in the taxpayer's gross income for tax purposes.
Wages received $ 35,000
State unemployment compensation 6,400
Employer's unemployment compensation plan 2,000
$ 43,400

42

Which one of the following will result in an accruable expense for an accrual-basis taxpayer?
a. A repair completed prior to year end but not invoiced.
b. An invoice dated prior to year end but the repair completed after year end.
c. A repair completed prior to year end and paid upon completion.
d. A signed contract for repair work to be done and the work is to be completed at a later date.

RULE: An accruable expense is one is which the services have been received/performed but have not been paid for by the end of the reporting period.
Choice "a" is correct. The facts indicate that a repair was completed prior to year end but not yet invoiced. If it has not yet been invoiced, it is assumed that it has also not yet been paid for. Therefore, this is a situation in which the repair expense would be accrued at year end. Services have been performed, but they have not been paid for, as they have not even been invoiced yet.

43

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?
a. $59,000
b. $84,000
c. $62,000
d. $44,000

a. $59,000
Salary + Alimony - $3,000 of capital loss.


Choice "a" is correct. The question asks for AGI, but all of the items in the list are items of potential gross income. There are no adjustments included in the list; therefore, in this case, AGI is the same as gross income

44

Which of the following is subject to the Uniform Capitalization Rules of Code Sec. 263A?
a. Mine development and exploration costs.
b. Editorial costs incurred by a freelance writer.
c. Research and experimental expenditures.
d. Warehousing costs incurred by a manufacturing company with $12 million in annual gross receipts.

Choice "d" is correct. Uniform capitalization rules apply to the following: (1) real or tangible personal property produced by the taxpayer for use in his or her trade or business; (2) real or tangible personal property produced by the taxpayer for sale to his or her customers; and (3) real or tangible personal property acquired by the taxpayer for resale, provided the taxpayer's annual average gross receipts for the preceding three years exceeds $10,000,000. Warehousing costs incurred by a manufacturing company (making inventory for sale to its customers) are subject to the Uniform Capitalization Rules. Further, they are the only item on the list that is real or tangible personal property. In this case, the inventory is not acquired for resale (it is produced by the taxpayer for sale to his or her customers), so the fact that the annual sales are $12,000,000 does not matter in this case. The sales could have been less than $10,000,000 annually, and the Uniform Capitalization Rules would still have applied.

45

Under the uniform capitalization rules applicable to taxpayers with property acquired for resale, which of the following costs should be capitalized with respect to inventory if no exceptions have been met?
Repackaging costs........Off-site storage costs
a. Yes......................No
b. Yes......................Yes
c. No......................No
d. No......................Yes

Choice "b" is correct. Direct material, direct labor, and factory overhead (applicable indirect costs) are capitalized with respect to inventory under the uniform capitalization rules for property acquired for resale. Applicable indirect costs include depreciation and amortization, insurance, supervisory wages, utilities, spoilage and scrap, design expenses, repair and maintenance and rental of equipment and facilities (including offsite storage), some administrative costs, costs of bonus and other incentive plans, and indirect supplies and other materials (including repackaging costs).

46

Chris, age 5, has $3,000 of interest income and no earned income this year. Assume the current applicable standard deduction is $950, how much of Chris' income will be taxed at Chris' parents' maximum tax rate?
a. $3,000
b. $2,050
c. $0
d. $1,100

Choice "d" is correct. The amount of income for a child under 18 that is taxable at the parents' maximum tax rate is deemed the "kiddie tax." To calculate the amount that is taxed at the parents' highest rate, take the child's total interest income ($3,000 in this question) and reduce it by the child's standard deduction ($950 in this case). The next $950 is then taxed at the child's rate, and the balance of $1,100 ($3,000 - $950 - $950 = $1,100) is taxed at the parents' highest rate. (Note that although $950 is not the current standard deduction for a dependent, the question tells us to use it.)

47

Barkley owns a vacation cabin that was rented to unrelated parties for 10 days during the year for $2,500. The cabin was used personally by Barkley for three months and left vacant for the rest of the year. Expenses for the cabin were as follows:
Real estate taxes $ 1,000
Maintenance and utilities $2,000
How much rental income (loss) is included in Barkley's adjusted gross income?
a. $(500)
b. $0
c. $(1,500)
d. $500

b. $0

RULE: If a vacation residence is rented for less than 15 days per year, it is treated as a personal residence. The rental income is excluded from income, and mortgage interest (first or second home) and real estate taxes are allowed as itemized deductions. Depreciation, utilities, and repairs are not deductible.
Choice "b" is correct. Applying the RULE above, if a vacation residence is rented for less than 15 days per year, it is treated as a personal residence. The rental income ($2,500 in this case) is excluded from income. A Schedule E is not filed for this property (i.e., no income is reported, the taxes are reported as itemized deductions, and the maintenance and utilities are not deductible), so the effect on AGI is zero.

48

In a tax year where the taxpayer pays qualified education expenses, interest income on the redemption of qualified U.S. Series EE Bonds may be excluded from gross income. The exclusion is subject to a modified gross income limitation and a limit of aggregate bond proceeds in excess of qualified higher-education expenses. Which of the following is (are) true?
I. The exclusion applies for education expenses incurred by the taxpayer, the taxpayer's spouse, or any person whom the taxpayer may claim as a dependent for the year.
II. "Otherwise qualified higher-education expenses" must be reduced by qualified scholarships not includible in gross income.
a. II only.
b. I only.
c. Neither I nor II.
d. Both I and II.

Choice "d" is correct. Both I and II are true per the following rule.
Rule: Qualified higher education expenses are tuition and fees required for the enrollment or attendance of the taxpayer, the taxpayer's spouse, or any dependent for whom the taxpayer is allowed a dependency exemption, at an eligible educational institution.
The expenses otherwise taken into account must be reduced by the total amounts received for excludable qualified scholarships, certain educational assistance allowances, and other tax-exempt payments (other than gifts, bequests, devises, or inheritances).

49

Kant, a cash-basis individual, owns and operates an office building. Kant received the following payments during the current year:
Current rents $ 30,000
Advance rents for the next year $10,000
Security deposits held in a segregated account $5,000
Lease cancellation payments $15,000
What amount is included in gross income?
a. $30,000
b. $55,000
c. $40,000
d. $60,000

b. $55,000
Rule: The basic formula for determination of net rental income or loss follows:
Gross rental income +
Prepaid rental income +
Rent cancellation payments +
Improvements in lieu of rent +
(Rental expenses) =
Net rental income (loss)
If security deposits are held separately and not available to be applied to last month's rent (as in a segregated account), they are a liability of the taxpayer and not included in income in the year received.
30,000 + 10,000 + 15,000

50

An individual received $50,000 during the current year pursuant to a divorce decree. A check for $25,000 was identified as annual alimony, checks totaling $10,000 as annual child support, and a check for $15,000 as a property settlement. What amount should be included in the individual's gross income?
a. $25,000
b. $0
c. $40,000
d. $50,000

a. $25,000

Rules: Payments for the support of a spouse are income to the spouse receiving the payments and are deductible to arrive at adjusted gross income by the contributing spouse. Child support is not taxable. Property settlements are not taxable.
Choice "a" is correct. Only the $25,000 in alimony is included in the gross income of the receiving spouse.

51

Which one of the following statements is correct with regard to an individual taxpayer who has elected to amortize the premium on a bond that yields taxable interest?
a. The amortization is not treated as a reduction of taxable income.
b. The bond's basis is reduced by the amortization.
c. The bond's basis is increased by the amortization.
d. The amortization is treated as an itemized deduction.

Choice "b" is correct. The bond's basis is reduced by the amortization of the premium.

52

For a cash basis taxpayer, gain or loss on a year-end sale of listed stock arises on the:
a. Date of delivery of stock certificate.
b. Date of receipt of cash proceeds.
c. Trade date.
d. Settlement date.

c. Trade Date.

Rule: Whether on the cash or accrual method of accounting taxpayers who sell stock or securities on an established securities market must recognize gains and losses on the trade date, rather than on the settlement date.

53

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?
a. $25,000
b. $15,000
c. $35,000
d. $0

b. $15,000

Rule: Passive activity is any activity in which the taxpayer does not materially participate. A net passive activity loss generally may not be deducted against other types of income (e.g., wages, other ordinary or active income, portfolio income (interest and dividends), or capital gains). In other words, passive losses may generally only offset passive income for a tax year-the remaining net loss is generally "suspended" and carried forward to a year when it may be used to offset passive income (or when the final disposition of the property occurs). However, there is an exception (the "mom and pop exception," as we refer to it in the textbooks) to this general rule. Taxpayers who own more than 10% of the rental activity, have modified AGI under $100,000, and have active participation (managing the property qualifies), may deduct up to $25,000 annually of net passive losses attributable to real estate. There is a phase-out provision for modified AGI from $100,000 − $150,000, and the deduction is completely phased-out for modified AGI in excess of $150,000.
Choice "b" is correct. Per the above rule, unless an exception exists (and it does not in this case, as Lane's modified adjusted gross income is in excess of $150,000), passive losses may only offset passive income for a tax year (i.e., no "net loss" may exist). In this case, Lane has a $20,000 net loss from passive activity [$15,000 S Corporation income (passive, in this case because the facts state Lane does not materially participate) minus the $35,000 rental real estate loss]. Thus, only $15,000 of the passive loss from real estate rental activity may be used to offset the $15,000 income from the S Corporation. The remaining $20,000 passive activity loss is carried forward to be used in future years.

54

A 33-year-old taxpayer withdrew $30,000 (pretax) from a traditional IRA. The taxpayer has a 33% effective tax rate and a 35% marginal tax rate. What is the total tax liability associated with the withdrawal?
a. $10,000
b. $13,000
c. $10,500
d. $13,500

d. $13,500
Rule: Generally, unless an exception applies, retirement money cannot be withdrawn until the individual reaches the age of 59 ½. If retirement money (without an exception) is withdrawn before the age of 59 ½, the premature distribution is subject to a 10% penalty tax (in addition to the applicable regular income tax that applies to all distributions of traditional IRA money).

30,000 X 35% = 10,500
30,000 X 10% = 3,000
total = $13,500

55

Which of the following should be included when determining adjusted gross income?
a. Alimony received.
b. Compensation for injuries or sickness.
c. Rental value of parsonages.
d. Tuition scholarship.

a. Alimony received

56

In the current year, a taxpayer reports the following items:
Salary $ 50,000
Income from partnership A, in which the taxpayer materially participates $20,000
Passive activity loss from partnership B $(40,000)
During the year, the taxpayer disposed of the interest in partnership B, which had a suspended loss carryover of $10,000 from prior years. What is the taxpayer's adjusted gross income for the current year?
a. $60,000
b. $70,000
c. $20,000
d. $30,000

c. $20,000
Choice "c" is correct. The $50,000 salary and income from partnership activity of $20,000 are taxable. Typically, passive activity losses, whether in the current or prior years, may only be used to offset passive activity income. The exception to this is in the year the passive activity is disposed of (sold), if still unused, passive activity losses are fully deductible in the year of disposal:
50,000 + 20,000 -40,000 -10,000 = 20,000

57

Which of the following costs are subject to the Uniform Capitalization Rules of Code Sec. 263A for manufactured tangible personal property?
a. Advertising.
b. Marketing.
c. Off-site storage.
d. Research.

c. Off-site storage

58

Seth Silver had the following items of income during the taxable year:
Interest income from a checking account $ 1,000
Interest income from a money market account $2,050
Interest income from a municipal bond he purchased during the current year $250
Interest income from federal bonds he purchased 2 years ago $750
On his current year tax return, what amount is taxable income?
a. $4,050
b. $3,300
c. $3,800
d. $3,050

c. $3,800

Choice "c" is correct. Taxable interest includes amounts received from general investment accounts as well as interest on federal obligations. Interest received from state and municipal bonds is not taxable.

59

Tom and Sharlene had the following items of income and expense during the taxable year:
Self-Employment Activity
Gross income $35,000
Business license fees $500
Marketing Expenses $2,000
Salary paid to Sharlene $10,000
Tom's wages from his Job $67,000
Interest from money market $1,500
Gain from sale of securities owned for 3 months $15,000
What is Tom & Sharlene's gross income before adjustments?
a. $106,000
b. $116,000
c. $131,500
d. $128,500

b. $116,000
Net Self-employment income + Tom's Wages + interest + Gain from Sale
32,500 + 67,000 + 1,500 + 15,000 = $116,000

60

Ben Flood, attorney at law, is a sole proprietor and files Schedule C with his federal Form 1040. Which of the following is not a deductible expense on Schedule C?
a. Depreciation on the computer used by his assistant.
b. $30 business tax payable to the city in which he practices.
c. Health insurance for him and his family.
d. Salaries paid to the paralegal who works for him.

Choice "c" is correct. A rule of thumb is that personal expenses are not allowed as deductions on the Schedule C. For instance, personal use of an automobile is considered a personal expense, not a deductible expense on Schedule C. Schedule C items should be only those related to the operation of the business itself. Health insurance for himself and his family is actually an adjustment to arrive at adjusted gross income.

61

Merrill and Joe divorced in June of the current year. As part of the settlement, Joe received the following:
Alimony $3,000/per month
Child support $1,000/per month
Lump-sum payment as the property settlement $125,000
Payments began in July; however, Merrill only paid a total of $15,000 during the year. For the current year, what amount must Joe include in income on his Form 1040?
a. $15,000
b. $134,000
c. $9,000
d. $140,000

c. $9,000

62

Mr. and Mrs. Williams decided during the tax year to purchase their first new home. The fair market value of the home was $275,000, and a 20% down payment was required to secure a mortgage in the amount of $220,000 at 5% for 30 years. The Williams' decided to utilize $10,000 that was kept in an Individual Retirement Account owned by Mrs. Williams. This amount was withdrawn on June 12 and used to fund the down payment on July 1. These amounts had been previously deducted as an adjustment by her on an individual tax return in the year of contribution. The remaining $12,000 for the down payment was drawn from a savings account. How much of the distribution from the Individual Retirement Account is subject to the premature distribution penalty tax, and how much must be included in the Williams' joint tax return in the year of distribution as gross income?
Penalty Tax...................Gross Income
a. $10,000......................$10,000
b. $0................................$10,000
c. $10,000......................$0
d. $0................................$0

Choice "b" is correct. Generally, a premature distribution (prior to retirement or other allowable age) from an individual retirement account is subject to a 10% penalty tax. Certain exceptions to this tax are available and are contained in the mnemonic "HIM DEAD."
Home buyer (1st time) $10,000 max if used toward first home
Insurance (medical)
Medical expenses in excess of 10% of AGI (or 7.5% if 65 or over)
Disability
Education
And
Death
The amount removed from the IRA qualifies under the "H" exception above. However, the question states that these amounts had been previously deducted on Mrs. Williams' individual tax return, thus this is a distribution from a traditional, deductible IRA. When distributed, funds held in a traditional, previously deducted IRA are taxable to the recipient as ordinary income and thus would be included as gross income on the Williams' joint tax return in the year of distribution.

63

An individual taxpayer reports the following items for the current year:
Ordinary income from partnership A, operating a movie theater in which the taxpayer materially participates
$ 70,000
Net loss from partnership B, operating an equipment rental business in which the taxpayer does not materially participate
(9,000)
Rental income from building rented to a third party
7,000
Short-term capital gain from sale of stock
4,000
What is the taxpayer's adjusted gross income for the year?
a. $74,000
b. $70,000
c. $77,000
d. $72,000

Choice "a" is correct. Except in the year in which an individual, estate, trust, or closely-held C corporation disposes of an entire interest in a passive activity investment, such taxpayers cannot deduct passive activity expenses and losses against income and gain attributable to non-passive activities. A passive activity is (i) any activity in which such taxpayers do not materially participate and (ii) as a general rule, such taxpayers' rental real estate investments, regardless of the extent of such taxpayers' involvement with the rental real estate operations. A limited exception (the "Mom and Pop Exception") regarding rental real estate activities is available to individuals, but the facts of this question do not provide any information which would entitle the taxpayer to the benefits of this exception.
Hence, the taxpayer can deduct, against the profit from the taxpayer's $7,000 passive activity rental income from the building rented to a third party, only $7,000 of the $9,000 net loss from partnership B which is operating an equipment rental business in which the taxpayer does not materially participate.
Computation of adjusted gross income for the year:
Ordinary income from partnership A, operating a movie theater in which the taxpayer materially participates
$ 70,000
Rental income from building rented to a third party (a passive activity)
7,000
Net loss from partnership B, operating an equipment rental business in which the taxpayer does not materially participate
(per the above rule the taxpayer can deduct only $7,000 of the $9,000 passive activity loss)
(7,000)
Short-term capital gain from sale of stock (fully taxable)
4,000
Adjusted gross income for the year
$ 74,000

64

The Uniform Capitalization Rules of Code Sec. 263A apply to retailers whose average gross receipts for the preceding three years exceed what amount?
a. $1,000,000
b. $5,000,000
c. $2,500,000
d. $10,000,000

d. $10,000,000

65

Randolph is a single individual who always claims the standard deduction. Randolph received the following in the current year:
Wages $ 22,000
Unemployment compensation $6,000
Pension distribution (100% taxable) $4,000
A state tax refund from the previous year $425
What is Randolph’s gross income?
a. $32,000
b. $22,000
c. $28,425
d. $32,425

a. $32,000

66

Johnson worked for ABC Co. and earned a salary of $100,000. Johnson also received, as a fringe benefit, group term-life insurance at twice Johnson's salary. Assume the annual IRS-established uniform cost of insurance is $2.76 per $1,000. What amount must Johnson include in gross income?
a. $100,000
b. $100,414
c. $100,552
d. $100,276

Choice "b" is correct. The first $50,000 of group term life insurance is a nontaxable fringe benefit. Amounts exceeding this are taxable based on IRS tables. The total group term life insurance here is $200,000 (twice the salary of $100,000). The amount exceeding $50,000 is $150,000. The cost given here is $2.76 per $1,000 of insurance. 150 × $2.76 = $414. So the total amount included in gross income is $100,414 ($100,000 + $414).

67

Which of the following statements regarding an individual's suspended passive activity losses is correct?
a. $3,000 of suspended losses can be utilized each year against portfolio income.
b. Suspended losses must be carried back three years and forward seven years.
c. Suspended losses can be carried forward, but not back, until utilized.
d. A maximum of 50% of the suspended losses can be used each year when an election is made to forgo the carry-back period.

Choice "c" is correct. Tax rules allow suspended passive losses to be carried forward, but not back, until utilized.

68

Smith has an adjusted gross income (AGI) of $120,000 without taking into consideration $40,000 of losses from rental real estate activities. Smith actively participates in the rental real estate activities. What amount of the rental losses may Smith deduct in determining taxable income?
a. $15,000
b. $40,000
c. $0
d. $20,000

Choice "a" is correct. Generally, none of the passive losses from real estate are deductible against nonpassive income. However, Smith actively participates, which means that the "mom and pop" exception of up to $25,000 will apply. This exception is phased out over AGI of $100,000 through $150,000. That is 50 cents on the dollar. Smith's AGI is $120,000. That is $20,000 into the phaseout range. So $10,000 of the $25,000 is phased out and Smith may deduct $15,000 of the $40,000 passive loss.

69

A review of Bearing's Year 2 records disclosed the following tax information:
Wages $ 18,000
Taxable interest and qualifying dividends $4,000
Schedule C trucking business net income $32,000
Rental (loss) from residential property $(35,000)
Limited partnership (loss) $(5,000)
Bearing actively participated in the rental property and was a limited partner in the partnership. Bearing had sufficient amounts at risk for the rental property and the partnership. What is Bearing's Year 2 adjusted gross income?
a. $14,000
b. $54,000
c. $29,000
d. $19,000

c. $29,000

Choice "c" is correct. Passive activity losses (PALs) can only be deducted up to passive activity income. There is no passive activity income indicated. Therefore, the passive loss from the partnership is not deductible. $25,000 of the $35,000 rental real estate loss is deductible under the "mom and pop" exception because Bearing actively participates in the rental property and the AGI is below the phaseout amounts. The AGI is calculated as follows:
Wages
$ 18,000
Taxable interest and qualifying dividends
4,000
Schedule C trucking business net income
32,000
Rental loss from residential property
(25,000)
Adjusted gross income (AGI)
$ 29,000

70

Which of the following types of costs are required to be capitalized under the Uniform Capitalization Rules of Code Sec. 263A?
a. Distribution.
b. Office maintenance.
c. Warehousing.
d. Marketing.

c. Warehousing

71

Nan, a cash basis taxpayer, borrowed money from a bank and signed a 10-year interest-bearing note on business property on January 1 of the current year. The cash flow from Nan's business enabled Nan to prepay the first three years of interest attributable to the note on December 31 of the current year. How should Nan treat the prepayment of interest for tax purposes?
a. Capitalize the interest and amortize the balance over the 10-year load period.
b. Capitalize the interest as part of the basis of the business property.
c. Deduct the entire amount as a current expense.
d. Deduct the current year's interest and amortize the balance over the next two years.

Choice "d" is correct. Interest paid in advance by a cash basis taxpayer on business loans cannot be deducted until the tax period to which the interest relates. In other words, the interest must be both paid and incurred in order to be deducted.

72

Dietz is a passive investor in three activities which have been profitable in previous years. The profit and losses for the current year are as follows:

............................................ Gain/(Loss)
Activity X......................$ (30,000)
Activity Y .........................(50,000)
Activity Z ..........................20,000
Total...............................$ (60,000)
What amount of suspended loss should Dietz allocate to Activity X?
a. $20,000
b. $30,000
c. $22,500
d. $18,000

Choice "c" is correct. For the current year, there is a net passive loss of $60,000. This should be allocated to the two activities with passive losses in the ratio of their losses to total losses. Activity X will receive an allocation of $22,500 of the net loss [$60,000 × ($30,000 / $80,000)].

73

The Jacksons, who file a joint return, actively participate in a solely-owned rental real estate activity that produces a $30,000 loss during the current year. Their adjusted gross income was $120,000 before considering the rental activity. How much of the rental loss, if any, are the Jacksons entitled to deduct?
a. $30,000
b. $25,000
c. $0
d. $15,000

d. $15,000
Choice "d" is correct. Generally, passive losses are only deductible against other passive income, and there is no passive income in the facts of this question. However, the "mom and pop" exception will apply because the Jacksons actively participate in the activity. This exception allows up to $25,000 of passive losses to be deducted against other nonpassive income. There is a phase-out over an adjusted gross income (AGI) range of $100,000 to $150,000. The Jacksons' AGI is $120,000, and that is 40% into the phase-out range. Therefore, 40% of the $25,000 exception amount is phased out, and the deduction is $15,000 [$25,000 – ($25,000 × 40%)].

74

As a result of a divorce, a taxpayer received the following during the current year:
Cash from the property settlement $100,000
Child support $12,000
Alimony payments $30,000
What amount, if any, must be included in gross income for the current year?
a. $30,000
b. $130,000
c. $142,000
d. $0

a. $30,000

Choice “a” is correct. Alimony payments are included in gross income. Child support and cash from property settlements are not included in gross income.

75

IRC Section 263A requires the capitalization of certain indirect costs related to inventory when a qualifying business is manufacturing tangible personal property. Which of the following costs is not required to be capitalized as part of this adjustment?
a. Securities services.
b. Payroll.
c. Recruiting.
d. Marketing.

d. Marketing.

76

An individual client asks a CPA to determine whether the client is solvent for federal tax purposes. The client has assets consisting of cash and marketable securities with a basis of $250,000 and a fair market value of $155,000. The client has liabilities of $175,000, which include $130,000 of nondischargeable liabilities under the Bankruptcy Code. Which of the following statements is correct?
a. The CPA is unable to determine whether the client is solvent or insolvent because the CPA is not an accredited appraiser.
b. The client is solvent because the basis of the client's assets totals $250,000 and exceeds the client's liabilities by $75,000.
c. The client is solvent because the fair market value of the client's assets exceeds the client's nondischargeable debt by $25,000.
d. The client is insolvent since the client's liabilities exceed the fair market value of the client's assets by $20,000.

Choice “d” is correct. Solvency is based on the FMV of all assets less the value of all liabilities. Here that is $155,000 – $175,000 = ($20,000).

77

Flowers, a married taxpayer, purchased an annuity for $64,400 that will pay $700 per month over the life of Flowers and Flowers' spouse. At the time of purchase, the couple's joint life expectancy was 23 years. Flowers received payment beginning April 1, Year 1, amounting to $6,300 in the first year of the annuity contract. How much is includable in Flowers' gross income in the first year?
a. $2,100
b. $4,200
c. $0
d. $6,300

b. $4,200

Choice “b” is correct. The investment amount is divided over the number of months of expected recovery. $64,400 / 276 = $233.33 (23 years × 12 months = 276 months). This is the amount of each payment that is a cost recovery and not taxable. Payments began in April of this year, resulting in 9 payments this year ($233.33 × 9 = $2,100). This is the portion of the $6,300 that is not taxable. So the taxable amount is $4,200 ($6,300 – $2,100 = $4,200).

78

Robert Corp. granted an incentive stock option for 200 shares to Beverly, an employee, on March 14, Year 12. The option price and FMV on the date of grant was $150. Beverly exercised the option on August 2, Year 14, when the FMV was $180 per share. She sold the stock on September 20, Year 15, for $250 per share. How much gross income did Beverly recognize in Year 12?
a. $30,000
b. $150
c. $0
d. $20,000

c. $0

Choice "c" is correct. Due to the fact that this is a qualified stock option, there is no recognition of income in the year of grant.

79

Robert Corp. granted an incentive stock option for 200 shares to Beverly, an employee, on March 14, Year 12. The option price and FMV on the date of grant was $150. Beverly exercised the option on August 2, Year 14, when the FMV was $180 per share. She sold the stock on September 20, Year 15, for $250 per share. How much gross income did Beverly recognize in Year 15?
a. $30,000
b. $150
c. $0
d. $20,000

d. $20,000

Choice "d" is correct. This is the gain Beverly will recognize upon the sale of the stock. The purchase was 200 shares at $150 per share, or $30,000. The sale was 200 shares at $250 per share, or $50,000. This gain is not recognized until the sale occurs in Year 15.

80

Wade Inc. granted a nonqualified stock option for 100 shares at $50 per share to Mary, an employee, on May 1, Year 12. On that date, the option was selling on an established market for $4 per share. Mary exercised the option on August 2, Year 13, when the FMV was $80 per share. She sold the stock on September 2, Year 14, for $100 per share. How much gross income and what type did Mary recognize in Year 12?
a. $5,000 ordinary income
b. $5,000 capital gain
c. $400 ordinary income
d. $400 capital gain

c. $400 ordinary income

Choice "c" is correct. The employee receiving a nonqualified stock option must recognize as ordinary income the value of the option if traded on an established market. Here, that is 100 shares at $4 per share, or $400.

81

Which of the following statements is not correct?
a. Employee Stock Purchase Plans are a type of qualified stock option plan.
b. The recipient of an Incentive Stock Option will generally have to report compensation income in the year that the option is received.
c. The employer may recognize a deductible expense for a nonqualified stock option in the same year that the employee will recognize ordinary income.
d. For an Incentive Stock Option, once exercised, the stock must be held at least two years after the grant date and at least one year after the exercise date.

Choice "b" is correct. Generally there is no recognition of compensation expense with an Incentive Stock Option.

82

James Corp. issue stock options to employees under an Employee Stock Purchase Plan. Which of the following statements is correct?
I. The option exercise price may not be less than the lesser of 95% of the FMV of the stock when granted or exercised.
II. The option cannot be exercised more than 27 months after the grant date.
a. Both.
b. I only.
c. Neither.
d. II only.

d. II Only

Choice "d" is correct. I is not correct because the rule states 85%, not 95%. II is a correct statement. This is a requirement of an ESPP.

83

Logan, an employee of Argon Industries, earned a salary of $60,000 in Year 2. In addition, the following two transactions between Logan and Argon occurred in Year 2: Logan received a bonus of 100 shares of publicly traded stock worth $13,000 with a basis to Argon of $8,000, and Logan purchased 1,000 shares of unrestricted Argon stock pursuant to a nonqualifying stock option plan for $10 per share when stock was valued at $25 per share. What amount of compensation should Argon report in Logan's Form W-2 for Year 2?
a. $60,000
b. $88,000
c. $73,000
d. $93,000

b. $88,000

Choice “b” is correct. The salary of $60,000 is included in the Form W-2. The FMV of the bonus of $13,000 is included in the Form W-2. Because the stock option was nonqualifying, the bargain element is included in Form W-2 as well. The stock is worth $25 per share and the option price is $10 per share. That is a bargain element of $15 per share on 1,000 shares. That is $15,000. $60,000 + $13,000 + $15,000 = $88,000.

84

Under a $150,000 insurance policy on her deceased father's life, May Green is to receive $12,000 per year for 15 years. Of the $12,000 received in the current year, the amount subject to income tax is:
a. $0
b. $12,000
c. $1,000
d. $2,000

d. $2,000

85

Cobb, an unmarried individual, had an adjusted gross income of $200,000 in the current year before any IRA deduction, taxable Social Security benefits, or passive activity losses. Cobb incurred a loss of $30,000 in the current year from rental real estate in which he actively participated. What amount of loss attributable to this rental real estate can be used in the current year as an offset against income from nonpassive sources?
a. $25,000
b. $0
c. $30,000
d. $12,500

b. $0

His AGI is over $150,000 therefore he does not get any of the $25,000

86

Dale received $1,000 in the current year for jury duty. In exchange for regular compensation from her employer during the period of jury service, Dale was required to remit the entire $1,000 to her employer in this year. In Dale's current year income tax return, the $1,000 jury duty fee should be:
a. Claimed as an itemized deduction to the extent exceeding 2% of adjusted gross income.
b. Claimed in full as an itemized deduction.
c. Deducted from gross income in arriving at adjusted gross income.
d. Included in taxable income without a corresponding offset against other income.

Choice "c" is correct. The $1,000 jury duty fee that was required to be remitted to the employer may be deducted from gross income in arriving at adjusted gross income. This, in effect, washes out the $1,000 income she will have to report as part of gross income for the jury duty fees paid to her.

87

Clark bought Series EE U.S. Savings Bonds after 1989. Redemption proceeds will be used for payment of college tuition for Clark's dependent child. One of the conditions that must be met for tax exemption of accumulated interest on these bonds is that the:
a. Purchaser of the bonds must be the sole owner of the bonds (or joint owner with his or her spouse).
b. Bonds must be bought by the owner of the bonds before the owner reaches the age of 24.
c. Bonds must be transferred to the college for redemption by the college rather than by the owner of the bonds.
d. Bonds must be bought by a parent (or both parents) and put in the name of the dependent child.

Choice "a" is correct. One of the conditions that must be met for tax exemption of accumulated interest on the bonds is that the purchaser of the bonds must be the sole owner of the bonds (or joint owner with his or her spouse). Other conditions include, for post-1989 bonds, the taxpayer is over age 24 when issued and is used to pay for higher education, reduced by tax-free scholarships, of the taxpayer, spouse, or dependents.

88

The rule limiting the allowability of passive activity losses and credits applies to:
a. Widely held C corporations.
b. S corporations.
c. Partnerships.
d. Personal service corporations.

d. Personal service corporations.

The rule limiting the allowability of passive activity losses and credits applies to personal service corporations.

89

A cash basis taxpayer should report gross income:
a. Only for the year in which income is actually received in cash.
b. Only for the year in which income is actually received whether in cash or in property.
c. For the year in which income is either actually or constructively received, whether in cash or in property.
d. For the year in which income is either actually or constructively received in cash only.

Choice "c" is correct. A cash basis taxpayer should report gross income for the year in which income is either actually or constructively received, whether in cash or in property.

90

The uniform capitalization method must be used by:
I. Manufacturers of tangible personal property.
II. Retailers of personal property with $2 million in average annual gross receipts for the three preceding years.
a. Neither I nor II.
b. I only.
c. Both I and II.
d. II only.

b. I only

91

Nicole and Andrew Harris contribute to more than half of the support of their three children, Travis, Luke, and John. Travis, age 20, worked full time at the local deli and earned $20,000. Luke, 18, is a part-time college student who earned $5,000 working as a resident assistant in the student dormitory where he lived half of the year. John, age 25, is an aspiring actor who lives at home with Nicole and Andrew. John earned $2,500 for the three commercials he starred in. How many exemptions can Nicole and Andrew claim on their Year 1 joint tax return?
a. Five.
b. Two.
c. Three.
d. Four.

d. Four

because John is a qualifying relative

92

John and Theresa are in the process of obtaining a divorce. Although they are not legally separated, John moved out of the family home in October of Year 1 and moved into an apartment nearby. John and Theresa's two children, Jenna and Stella, lived with Theresa in the family home for more than half of the tax year. What filing status can Theresa use to file her Year 1 tax return?
a. Married filing jointly/separately.
b. Surviving spouse (qualifying widow).
c. Single.
d. Head of household.

Choice "a" is correct. John and Theresa are still married at year-end, not legally separated, and have not lived apart for the last six months of the taxable year. Theresa must file as married, but may choose to do so either jointly with John or separately.
Choice "d" is incorrect. Head of household status is not an option because the couple is not legally separated at year-end and John did not live apart from Theresa for the last six months of the taxable year.

93

Mort and Mindy met at a New Year's Eve party held December 31, Year 1. They instantly bonded, fell madly in love, and were married at 11:38 p.m. that night. Identify Mort's filing status for Year 1.
a. Surviving spouse.
b. Married filing jointly.
c. Single.
d. Head of household.

b. Married filing jointly

94

Mort and Mindy met at a New Year's Eve party held December 31, Year 1. They instantly bonded, fell madly in love, and were married at 11:38 p.m. that night. Sadly, Mort passed away November 15, Year 2. What filing status should Mindy use for Year 2?
a. Married filing jointly.
b. Surviving spouse.
c. Head of household.
d. Single.

a. Married filing jointly

95

Mort and Mindy met at a New Year's Eve party held December 31, Year 1. They instantly bonded, fell madly in love, and were married at 11:38 p.m. that night. Sadly, Mort passed away November 15, Year 2. In January, Year 3, Mindy gave birth to triplets Mark, Mandy, and Maureen. Assuming that Mindy has not remarried, what filing status should she use for Year 4?
a. Surviving spouse.
b. Head of household.
c. Single.
d. Married filing jointly.

a. Surviving spouse

96

Mort and Mindy met at a New Year's Eve party held December 31, Year 1. They instantly bonded, fell madly in love, and were married at 11:38 p.m. that night. Sadly, Mort passed away November 15, Year 2. In January, Year 3, Mindy gave birth to triplets Mark, Mandy, and Maureen. Assuming Mindy has not remarried, what filing status should she use for Year 5?
a. Married filing jointly.
b. Single.
c. Head of household.
d. Surviving spouse.

c. Head of household.

97

In Year 4, after Mindy's three children have grown and moved out of the house, Mindy (unmarried) moved her mother, Mary, into an assisted living facility for which Mindy pays 75% of the cost. Mindy had not previously lived with Mary, and Mary paid for her own living expenses while she lived in her own home. What filing status should Mindy use for Year 4, assuming Mary moved into the assisted living facility on January 1, Year 4?
a. Surviving spouse.
b. Single.
c. Head of household.
d. Married filing jointly.

c. Head of household.

98

In Year 4, after Mindy's three children have grown and moved out of the house, Mindy (unmarried) moved her mother, Mary, into an assisted living facility for which Mindy pays 75% of the cost. Mindy had not previously lived with Mary, and Mary paid for her own living expenses while she lived in her own home. What filing status should Mindy use for Year 4, assuming Mary moved into the assisted living facility on August 1, Year 4?
a. Married filing jointly.
b. Head of household.
c. Single.
d. Surviving spouse.

c. Single.

Mindy does not qualify for head of household status. Had Mary moved into the assisted living home for the entire year, Mindy would have been eligible for head of household status. Mindy did not provide more than half of Mary's support and for Year 4 is ineligible for head of household status.