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Question 1

Who is a tax preparer? Who is not?

Answer 1

A tax preparer is one who prepares income tax returns for COMPENSATION.

Question 2

Define an “unreasonable tax position” and “reasonable basis standard.”

Answer 2

Unreasonable tax position: Tax positions that are not disclosed and lack substantial authority. Must be at least 40% probability of tax position being sustained on merits.

Question 3

Define “tax shelter.”

Answer 3

Tax shelter: Any arrangement (trust, partnership, etc) that is entered with the main purpose of avoidance or evasion of federal income tax.

Question 4

List 8 reasons that a tax preparer can be awarded a penalty.

Answer 4

1. Willful or reckless conduct (unreasonable tax position, or deliberately understating tax liability)
2. Unauthorized disclosure of client information (except to peer review panel)
3. Failure to provide copy of tax return
4. Failure to sign tax return
5. Failure to furnish identifying number
6. Failure to retain records
7. Failure to correct information returns
8. Endorsing or negotiating a refund check issued to a taxpayer

*Penalty for unauthorized disclosure is $250. Other penalties are $50 each.

Question 5

What is the penalty for deliberately understating a client’s tax liability?

Answer 5

The greater of $5,000, or 50% of the income derived from preparing the return.

Question 6

List the 3 courts and their powers.

Answer 6

1. US Tax Court (adjudicates only tax-related issues)
2. US District Court (Jury trial is available)
3. US Court of Federal Claims (Requires payment of the tax before taxpayer’s filing the tax claim. A jury trial is not allowed.)

Ninety-day letter is an IRS letter providing taxpayer with a 90-day window to file a petition in the Tax Court or satisfy any unpaid tax deficiency.

Question 7

How are standards of tax position strength quantified?

Answer 7

Frivolous position: 0% probability. Bad faith and is patently improper.
Reasonable basis: 20% chance of a tax position being sustained on merits
Substantial authority: 33% to 50% probability.
More-likely-than-not: Greater than 50% chance the tax position will be upheld if challenged by the IRS.

Question 8

What is the penalty for: (1) failure-to-pay and (2) failure-to file?

Answer 8

Base rate 5% per month of the unpaid tax, not to exceed 25% of tax due.

Question 9

What is the penalty amount for: (1) negligence, (2) substantial understatement of tax penalty, (3) substantial valuation of misstatement, (4) tax shelter abuse, and (5) accuracy-related misstatement?

Answer 9

Base penalty is 20% of the understantement of tax. Substantial understatement is defined as the amount exceeding the greater of 10% of the tax due or $5,000.

*For substantial valuation misstatement, the penalty can be 40% if valuation exceeds 200% of the correct amount.

Question 10

List the US federal tax law hierarchy.

Answer 10

1. US Constitution
2. Internal Revenue Code (IRC)
3. Treasury Regulations
4. US Supreme Court
5. US Circuit Court of Appeals
6. Federal courts of original jurisdiction

Question 11

Define a “tort”.

Answer 11

Tort refers to a negligent or intentional civil wrong not arising out of a contract or statute. Torts include ordinary negligence, actual fraud, and constructive fraud.

Demonstrating that the CPA acted with “due care” is the best defense because it establishes the absence of ordinary negligence.

Question 12

List 5 criteria that must be proven to establish fraud or gross negligence.

Answer 12

M - Misrepresentation of material facts
S - Scienter (deception) and reckless disregard of truth
R - Reasonable reliance on accountant’s work
I - Intention of CPA for client to rely on misrepresentation
D - Damages were suffered by client

Question 13

List the 4 ways agency can be established.

Answer 13

1. Agency by agreement: Formed by consent, written or oral
2. Agency by implication: Formed by implied acts, written or oral
3. Agency by ratification: Formed by an act/agreement whereby principal ratifies (consents to) conduct of a person who is not their agent.
4. Agency by estoppel (apparent authority): Formed when the principal allows third-party to believe an agency relationship exists with the alleged agent.

Question 14

Distinguish “terminination by agreement” vs “termination by operation of law”.

Answer 14

Termination by agreement of parties: Lapse of time, purpose achieved, occursence of triggering event, mutual agreement, termination by one party

Termination by operation of law: Death or insanity, impossibility (loss or destruction of subject matter), changed circumstances, bankrupcy, loss of required license, agency coupled with interest, agency terminated by principal

Question 15

List the 4 types of agent authority.

Answer 15

1. Express authority
2. Implied authority
3. Apparent authority
4. Ratification (principal accepts responsibility for agent’s unauthorized acts)

Question 16

What are the agent’s duties to the principal? Principal’s duties to agent?

Answer 16

Agent’s duties to principal: Due care, inform, accounting, loyalty, obedience
Principal’s duties to agent: Indemnification, compensation, reimbursement

Question 17

Describe the two scenarios of liability of a contract formed by an agent, depending on how the principal is classified at the time the contract is executed.

Answer 17

1. Disclosed principal: Disclosed principal is liable for contract.
2. Undisclosed principal: Principal is liable, but agent must not have apparent authority. A third-party may not exit the deal because of an undisclosed principal. If there is a breach, both principal and agent are liable.

Question 18

Describe agents’ liability vs principals’ liability in event of torts.

Answer 18

1. Agents are liable for the own tortious acts, both intentional and negligent.
2. Principals are liable for tortious acts of their agents when the principal authorizes the act during agent’s employment, when the agent acted on belief of implied authority, when there is innocent misrepresentation on part of agent.

Question 19

List the 6 required elements of a valid contract.

Answer 19

1. Offer
2. Acceptance
3. Consideration (Something of value given up by either side of the contract)
4. Proper form (Contract is in writing, if necessary)
5. Lawful object (Subject matter of contract must be legal)
6. Two or more competent parties

Question 20

Explain the mailbox rule.

Answer 20

The mailbox rule applies to acceptance of a contract. Acceptance of an offer is valid when SENT (not received).

Question 21

What is the “Statute of Frauds?”

Answer 21

“Statute of Frauds” says certain contracts must be written to be enforceable (“proper form” criteria of a valid contract). Consider GRIPE + Marriage:

G - Goods sold over $500 (Uniform Commercial Code)
R - Real estate contracts
I - Impossible to complete within one year
P - Promise to answer debt of another
E - Executor’s promise to be liable for debts of an estate
+ - Contracts for marriage

SoF also says that the contract needs only to be signed by one party.

Question 22

What are the rules if a minor wants to disaffirm a contract?

Answer 22

To disaffirm a contract, the minor needs only to return what they obtained as a result of the contract. Once they become an adult, they can subsequently ratify the contract.

However, a minor cannot disaffirm a contract for life-saving care. Also, they will still be liable in the event they commit a tort, such as lying about their age.

Question 23

Explain express vs implied contracts, and formal vs informal contracts.

Answer 23

Express contract: Formed via express written or verbal agreement of parties.
Implied contracts: Formed, at least in part, by the parties’ conduct.
Formal contracts: Require a special form of creation, like letters of credit.
Informal contracts: All contracts that are not “formal contracts.”

Question 24

Define “Parole Evidence Rule.”

Answer 24

Parole Evidence Rule: States that any pre-existing oral or written evidence that was discussed before the written contract is inadmissible in court to prove the content of a contract (Evidence “inadmissible in court” is outside evidence that may not be introduced to a jury to prove the party’s claim). Helps protect parties from having portions of a negotiation brought into a contract dispute.

Question 25

Explain “assignment” vs “delegation” of contracts as it pertains to the involvement of third-parties not explicitly stated in the contract itself.

Answer 25

1. Assignment: When original party is replaced with new party, and original party is no longer responsible for any portion of the contract.
2. Delegation: Original party substitutes another party into the contract to do some/all of the items promised by original party. BOTH the original party and new party will both be responsible for the contract.

Question 26

List the 5 types of remedies for breach of contract.

Answer 26

1. Compensatory damages
2. Specific performance (when monetary damages is insufficient to repay party for breach of contract)
3. Injunction (court order requiring one party
   to either do or refrain from doing a specific act)
4. Rescission: (restoring the parties’ conditions to their original positions pre-contract)
5. Liquidating damages

Question 27

Distinguish “implied warranties” vs “express warranties.”

Answer 27

Implied warranty: Warranties that require no words, either oral or written. For example, in implied warranty of merchantability, a merchant promises, without saying as
such, that their goods are fit and safe for normal use.

Express warranty: Warranties that a buyer receives from a seller, and typically include a material representation of a fact, or facts, regarding the goods being sold. A breach of these warranties is grounds for litigation.

Question 28

Distinguish “implied warranties of title” vs “implied warranties of fitness.”

Answer 28

Implied warranties of title: Warranties given specifically to goods to help guarantee the owner of those goods. The title the buyer of the goods acquires cannot be a “better”
title than the seller has to give.

Implied warranty of fitness: Warranties given for a particular purpose. Buyer is relying on seller’s expert opinion and the seller must know purpose of purchase.

Question 29

List the 4 elements of negligence that must be proven.

Answer 29

1. Duty of care: The seller owes buyer the duty of due care
2. Breach: The seller failed to use reasonable care
3. Damages: The buyer suffered damages
4. Causality: Seller’s breach caused the buyer’s damages.

Question 30

List the 5 items that individuals harmed by a product must prove in order to sue the maker of the product under strict liability.

Answer 30

1. Defective product: Must show a Defective product
2. Cause: Must show the defect caused injury
3. Unreasonably dangerous: Must show the defect was unreasonably dangerous to users and consumers
4. Business: Must show seller was engaged in that Business
5. Changes: Must show it reached the user without substantial changes

Question 31

Define “surety.” List the 3 rights of a surety.

Answer 31

Surety: promises to pay a creditor the amount owed by the debtor, if debtor defaults on a debt.

1. Right of Subrogation: after surety pays debt to the creditor in full, the surety obtains all of creditor’s rights.
2. Rights of Reimbursement: surety has right to recover from debtor all money that surety paid to the creditor after debtor defaulted on the loan
3. Right of Exoneration: surety can obtain a court order that establishes that debtor is most liable for the debt amount (and not the surety)

Question 32

Define the rights of creditor after debtor defaults.

Answer 32

1. Demanding payment of the debt from the Surety (after other options have been exhausted)
2. Demanding payment of the debt from the Debtor
3. Attempting to possess any collateral that exists that was used to help secure the loan

Question 33

List the defenses of a surety from the creditor.

Answer 33

1. Lack of writing or consideration
2. Payment or performance by debtor
3. Fraud by the creditor
4. Increased risk that exceeds agreement terms

Question 34

Distinguish Chapter 7, 11, & 13 Bankruptcy.

Answer 34

Ch. 7 Bankruptcy is liquidation bankruptcy; debtor’s assets are liquidated in order to pay their debt owed to creditors. (However, excludes banks, insurance companies, railroads, savings/loan associations, credit unions, HMOs)

Ch. 11 Bankruptcy permits the reorganization of an entity’s debt. (However, excludes stockbrokers, commodities brokers, banks, savings/loan associations.)

Ch. 13 Bankruptcy permits the reorganization of debt by individuals. Requirements are less than $383,175 in unsecured debt and $1,149,525 in secured debt.

Question 35

What are the conditions necessary for creditors to file for involuntary Ch. 7 Bankruptcy?

Answer 35

If less than twelve (12) creditors exist, any single creditor who is owed more than $15,325 in unsecured debt may file a petition. Or, if more than twelve (12) creditors exist, at least three of the unsecured creditors must join in the filing to meet the $15,325 total amount needed. Also, there must be no dispute over the amount owed on the debt.

Question 36

What are the 5 criteria that must be satisfied to ensure no asset-liquidation transfers are preferential in a bankruptcy settlement?

Answer 36

T - Transfer of property that benefits a creditor
A - Antecedent, pre-existing debt
N - Ninety day window in order to make transfer
I - Debtor must be insolvent
M - Creditor received More than would have via bankruptcy

Question 37

List the 3 types of claims a creditor can make against the debtor.

Answer 37

Property claim: If a creditor has right to a piece of property held by the debtor, the property is turned over to creditor.

Trust claim: If creditor is a beneficiary for trust property, that property is not considered part of the debtor’s estate.

Secured claim: Claims that held by a creditor who has an interest in a specific piece of property.

Question 38

Distinguish “secured creditor” vs “unsecured creditor.”

Answer 38

Secured creditors have attached specific piece of property held by the debtor in exchange for something of value.

Unsecured creditors are paid in full at each level of priority before any claims at a lower level are paid.

Question 39

List the 3 ways an attachment of security interest can be perfected.

Answer 39

Attachment: Formal process of placing a claim on property owned by the Debtor, in exchange for credit

Perfection by Possession: when the Creditor takes the collateral used to secure the debt with debtor’s agreement.

Perfection by Filing: when the Creditor files a Financing Statement with the appropriate state agency.

Perfection by Attachment: form of perfecting a security interest to collateral automatically. Can only occur with PMSI Creditors in consumer goods.

Question 40

Distinguish FICA, FUTA, & WC.

Answer 40

FICA: Federal Insurance Contribution Act. FICA represents the federal payroll tax imposed on employees, employers, and independent contractors to fund Social Security and Medicare. 85% of all FICA benefits received are taxable.

FUTA: Federal Unemployment Tax Act. FUTA provides for unemployment benefits to be collected by employees who have lost their jobs through no fault of their own. Employers pay FUTA when paid $1500 in wages in a year.

WC: Workers Compensation. Provides insurance benefits to employees injured within the scope of employment.

Question 41

Define ERISA.

Answer 41

ERISA: Employee Retirement Income Security Act. Sets standards for funding and investment of pension plans to help ensure that there is no mismanagement of the investment funds contributed by both employees and employers.

Question 42

List the laws pertaining to environmental regulation.

Answer 42

1. National Environmental Policy Act (NEPA)
2. Clean Air Act (CAA)
3. Clean Water Act (CWA)
4. Comprehensive Environmental Response, Compensation and Liability Act (CERCLA)
5. Resource Conservation and Recovery Act (RCRA)

Question 43

How did Tax Cuts and Jobs Act (TCJA) affect the Patient Protection and Affordable Care Act (PPACA)’s requirement that all individuals enroll in a health insurance plan?

Answer 43

TCJA repealed the individual mandate that all persons must obtain health insurance. As of 2019, taxpayers no longer have to pay a penalty if they do not have health insurance.

Question 44

What are the filing and registration requirements for formation of the 4 major types of business entities?

Answer 44

1. Sole proprietorship: No specific filings or registrations.
2. Partnership: Partnership agreement, although not required to be in writing. Dissolution can occur by either an act of one of the partners, or by operation of law.
3. Corporation: Must file Articles of Incorporation with the state, disclosing Stock Provisions (number of authorized shares, voting stock, and a capital structure for the stock), names of the Corporation, its registered agent, and all incorporators.
4. LLC: Must file Articles of Organization within the state, disclosing name of the LLC, and where its owners have limited liability. Must file Operating Agreement as well.

Question 45

List the steps toward approval of merger/consolidation of a corporation.

Answer 45

Approval steps for merger or consolidation
1. Submit a formal plan of merger or consolidation to both boards and get majority approval.
2. Submit to all stockholders and get majority approval (give notice of time, date and place).
3. Submit a plan to the secretary of state, who issues a certificate of the merger upon approval. (Short form merger is when a parent merges with a 90%+ owned sub)

Question 46

Define the elements of a property deed, and the major types of deeds.

Answer 46

Elements of a deed: An effective real property deed must be made in writing, signed by the grantor (seller), containing a description of the property, and be delivered to the grantee (buyer).

General warranty deed: guarantees owner that they have title, including the right to convey that title, that
there are no unstated encumbrances on the property.

Special Warranty Deed: only guarantees ownership for the time in which the seller owns a piece of property.

Quitclaim Deed: deed where grantor gives whatever title or interest he has but doesn’t guarantee he has anything. This is the deed with the least protection.

Question 47

List the elements of a valid mortgage.

Answer 47

A mortgage requires four elements: must be made in a writing, signed by the mortgagor, contains a description of the property, and delivered to the mortgagee.

Question 48

Define a lease.

Answer 48

A lease is an agreement whereby the renter has the right to exclusive possession of a piece of property, but does not have ownership of that property.

Unlike mortgages, leases do not require writing unless the lease is for 1+ year. If the lease is in writing, it must include a description of the leased premises.

Question 49

List the categories of property that are eligible for their own tax treatment.

Answer 49

1. Real property: Land and anything attached to the land.
2. Personal property: Anything else that is moveable and is not real property.
   3: Conversion: From personal to real property, or vice versa.

Question 50

Define “tax basis” of property transactions, and how it is calculated.

Answer 50

Tax basis: The portion of the asset’s value from which tax liability is calculated.
Initial basis: Purchase price plus costs to ready the asset for its intended purpose.
Adjusted basis: Initial basis plus improvements, less depreciation or depletion.

Question 51

Define the formula for tax basis of assets acquired in a basket purchase.

Answer 51

Determine the Relative FMV by taking the FMV of each house divided by the total FMV of all houses. Multiply this amount by the purchase price of the land to determine the amount of the purchase price of the land allocated to each house.

Question 52

Define the formula for tax basis of sale of a gift.

Answer 52

Basis of property received as a gift, GAIN = Amount sale of gift above DONOR’s basis.

Basis of property received as a gift, LOSS = Lesser of FMV or donor’s basis.

Question 53

Define the formula for basis of stock dividends.

Answer 53

Tax basis of stock dividend = Number of shares distributed, times FMV per share at date of distribution. This is the taxable dividend income amount.

Question 54

What is the holding period of gifted property? What is the significance of the holding period?

Answer 54

Gifted property will have a holding period determined by whether the taxpayer is using the GAIN basis, or the LOSS basis. Holding period determines whether the sale is a long-term vs. short-term capital gain or loss.

Gift sold at GAIN = Basis is donor’s basis. Holding period of donee begins on date when the donor purchased the gift.

Gift sold at LOSS = Lesser of the donor’s basis or FMV at the date of gift. If donor’s basis, then holding period is the date of the gift. If FMV, then holding period begins on the date the donor originally purchased the item.

Question 55

Define a “like-kind exchange.”

Answer 55

Like-kind exchange: An exchange transaction limited to business-use real property that is given up in exchange for similar business-use real property.

Basis of like-kind exchange = Basis of property given up + [Gain recognized] + [Boot basis paid] - [Loss recognized] - [FMV of boot received]

Question 56

Define “boot.”

Answer 56

Boot: Any property given up or received that is not a like-kind. The most
common type of boot is cash, or liabilities assumed.

Question 57

How does boot (received or paid) influence the tax basis of new property received?

Answer 57

Boot received: Reduction in basis.
Boot paid: Plus, or addition, in basis.

Question 58

How do assumed liabilities influence the tax basis of new property received?

Answer 58

Treatment of liability (mortgage) assumed:

1) Each taxpayer nets the mortgage assumed by the other taxpayer and the
new mortgage being taken on from the other taxpayer.

2) If the netting of the mortgages results in net boot RECEIVED, add net boot received from the mortgages to cash received to arrive at total net boot received. Recognized gain = Lesser of realized gain OR total boot received (cash only).

3) If the netting of the mortgages results in net boot PAID, net boot received will
only be the cash received. Net boot paid from the netting of the mortgages will still affect calculation of basis of the new property.

Question 59

Explain the distinction between “gain realized” vs “gain recognized.”

Answer 59

Though the gain is calculated as realized one way, for tax purposes, it is more important to determine gain RECOGNIZED to the extent of: (1) lesser of the realized gain, or (2) the net boot received from netting the mortgages.

Question 60

Define calculation of gain or loss in an “involuntary conversion.”

Answer 60

Involuntary conversions cover theft, casualty or condemnation. Proceeds would typically be insurance proceeds, if any.

Gain or loss in involuntary conversion = Insurance proceeds less the property’s adjusted basis

Question 61

Define a “wash sale,” and how gain and loss are calculated.

Answer 61

Wash sale refers to when stocks or securities are sold at a loss, and identical stocks or securities are acquired within 30 days either before or after the sale date.

Loss is postponed and will increase the basis of the newly acquired stocks or securities. Gains are fully taxable.

Question 62

Explain how to determine the tax basis of sale of a principal residence.

Answer 62

An individual taxpayer is allowed to exclude $250,000 ($500,000 if married filing a joint return) of gain upon the sale of a home if certain requirements are met. Most important rule is that the home must have been owned and occupied as the primary residence for total of at least two of the prior five years.

If the gain exceeds the dollar limit for exclusion, then the full balance of the gain is recognized. Postponement is not an option. Losses upon the sale of a principal residence are not tax deductible.

Question 63

Explain the tax deductions allowed on qualified small business stock gains (or loss), according to the PATH Act of 2015.

Answer 63

The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) includes permanent tax breaks, including exclusions on small business stock gains (Section 1202). The new law makes permanent the exclusion of 100 percent of the gain on the sale or exchange of qualified small business stock (QSBS) acquired after September 27, 2010, and held for more than five years.

If the requirements are met to be a qualified small business stock, then 100% of any gain from the sale of the stock can be excluded up to the greater of $10 million or 10 times the stockholder’s basis.

Section 1244 allows a loss upon the sale of qualified small business stock to be treated as ordinary loss versus capital losses. If there is a loss, up to $50,000 of the loss is ordinary on an individual return, or $100,000 for married filing joint.

Question 64

Explain the capital gains netting process.

Answer 64

All capital asset gains and losses must follow a specified netting process. Short-term capital gains (STCG) and losses (STCL) must be netted together SEPARATE from the long-term capital gains (LTCG) and losses (LTCL) netting process.

Once a net short-term gain (NSTCG) or loss (NSTCL) and a separate net long-term capital gain (NLTCG) or loss (NLTCL) is determined, then the net short-term gain or loss and the net long-term gain or loss is netted together. The result will be the net capital gain (NCG) or net capital loss (NCL).

STCG > STCL = NSTCG
STCG < STCL = NSTCL
LTCG > LTCL = NLTCG
LTCG < LTCL = NLTCL

Question 65

Calculate the tax basis amount of a capital gain or loss.

Answer 65

1) Capital losses: For taxpayers who file a joint return or, individual taxpayers who file single or head of household, they can take a net capital loss against ordinary income, up to a maximum of $3,000. Any amount not currently used may be carryforward indefinitely, either as shortterm or long-term, based on the holding period.

2) Capital Gains: All net capital gains are included in an individual’s tax return. If the net capital gain is a net short-term capital gain, the net amount will be taxed at ordinary income rates. If an individual has a net short-term capital loss and a net long-term capital loss, when applying the $3,000 loss limit, always use up the net short-term capital loss first and then use the net long-term capital loss. Remember, no more than $3,000 of capital losses can be deducted against ordinary income in any one year. For married filing separately, the maximum capital loss that can be deducted against ordinary income is $1,500.

Question 66

Define criteria for “Section 1231 assets,” and the criteria for “Section 1245 gain.”

Answer 66

Section 1231 assets include:

1) Depreciable personal property that is used in a trade or business or,
2) Real property used in a trade or business, and
3) Property must be held for more than one year.

The gain from the sale or exchange of a Section 1231 asset will be recaptured as ordinary income to the extent of the lesser of all depreciation taken or, the recognized gain. This recaptured gain is Section 1245 gain.

Question 67

Define “Section 1250 assets,” and explain how they are different from “Section 1231 assets.”

Answer 67

Section 1250 assets are real property subject to depreciation and used in a trade or business. If categorized as 1250 property, then IRC Section 1250 will override IRC Section 1231 for tax purposes.

Section 1250 assets must calculate ADDITIONAL depreciation to determine the amount of depreciation RECAPTURE, in the case of accelerated depreciation. The additional depreciation is equal to the amount of total accelerated depreciation taken, minus depreciation as if the straight-line method had been used for real property, under the ACRS method. This additional depreciation is the amount to be RECAPTURED AS ORDINARY INCOME upon a sale.

Question 68

Define the formula to calculate gain on an “installment sale”.

Answer 68

Installment sale: A sale of property that results in a gain (not a loss) where a taxpayer receives at least one payment after the tax year of the sale.

Annual gain recognized = [Gross profit ÷ Total contract price] x Amount received for the year

Contract price = (Sales price – seller’s liabilities assumed by the buyer) + (Excess of the liabilities assumed by buyer over the seller’s basis in the property).

Question 69

Explain rules on taxable gain or loss in a sale of property between related parties.

Answer 69

Related parties generally describes transactions between: (1) family members and (2) a corporation and an individual who owns more than 50% of the entity.

If there is a sale between related parties and a loss results, then the loss is not deductible.

But, if the purchaser sells the property later at a gain, then a disallowed loss can reduce the gain at that time.

Question 70

Define “imputed interest.”

Answer 70

Imputed interest: The difference between the original interest stated in the loan and the AFR (“applicable federal rate” published by the IRS). Imputed interest is considered a gift from the lender to the borrower and may be subject to gift tax.

Question 71

Define MACRS and how it allocates per year the cost recovery of an asset’s basis over the period of time benefited.

Answer 71

Modified Accelerated Cost Recovery System (MACRS): A simplified method of financial accounting depreciation and is an accelerated method compared to straight-line depreciation. Salvage value is ignored for all assets.

Most business assets will be either a 5 or 7-year life. 5-year assets are office machines, computers, and cars. 7-year assets are office furniture and fixtures.

Real property is classified as residential or non-residential real property. Residential recovery period is 27.5 years. Non-residential recovery period is 39 years.

Question 72

Explain the significance of “IRC Section 179” in determining the allowable depreciation expense for personal property used in business.

Answer 72

IRC Section 179 allows a taxpayer to directly expense, in addition to depreciating under MACRS, tangible personal property used in business. 179 requires that the property is purchased for use in business and is purchased from an unrelated party.

In 2021, maximum deduction is the lesser of: (1) $1,050,000 minus the amount that the total purchases exceed $2,620,000, or (2) taxable income before Section 179.

Question 73

Explain “bonus depreciation” in context of IRC Sec 179.

Answer 73

Under the Tax Cuts and Jobs Act, qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 for taxable years starting on or after January 1, 2019, can take bonus depreciation of 100% which remains in effect until January 1, 2024. Applies to personal property used in a trade or business with a useful life of 20 years or less.

The bonus depreciation percentage is only calculated in the year of acquisition.

The bonus depreciation decreases by 20% each year.

Question 74

Define formula to calculate first-year depreciation of a MACRS asset, according to IRC Sec 179.

Answer 74

The orders of Items to be used in the calculation of the first year’s depreciation for tangible personal property, used in a trade or business.:

i. Take the cost of tangible personal property.
ii. Apply Section 179 and deduct it from the cost.
iii. Subtotal is the basis after Section 179.
iv. Take bonus depreciation and subtract it from “iii.”
v. This equals the remaining basis, which is used to calculate the averaging convention depreciation for the first year.

First year depreciation = “ii” + “iv” + “v”

Question 75

Define the gift tax formula.

Answer 75

Tax basis of gifts is:

Gross gifts (cash + Property FMV at date of gift)
PLUS: One-half of spouse’s gifts to third parties if gift-splitting is elected
LESS: Deductions allowed:
-One-half of gifts to third parties treated as given by spouse if gift-splitting is elected
-Annual exclusion (up to $15,000 per donee, for gifts of a present interest)
-Unlimited exclusion for tuition or medical expenses paid on behalf of the
donee, and the amounts are paid directly to the provider
-Unlimited exclusion for gifts paid to political organizations
-Unlimited exclusion for gifts for amounts paid to charitable organizations
-Unlimited exclusion for gifts to your spouse

EQUALS: Taxable gifts for the current year

Question 76

Which entities can use the CASH vs ACCRUAL basis accounting method when calculating their taxable year?

Answer 76

Cash: Individuals; C Corp, S Corp, & Partnerships UNDER $26M over 3-yr avg; Sole proprietorship; Qualified personal service corporations

Accrual: C Corp, S Corp, & Partnerships ABOVE $26M over 3-yr avg; Tax shelters

Question 77

When is a business entity subject to capitalization rules?

Answer 77

If the average annual gross receipts for the past three years exceeds $26 million, the entity is subject to the uniform capitalization rules.

Capitalized direct costs include: direct materials and direct labor (as well as other indirect costs). Does not include: Marketing, selling, distribution costs; General and administrative expenses; Research and experimental costs.

Question 78

How is income tax of a farming business tax reported?

Answer 78

First, income from farming business is reported on Schedule F. After a farmer calculates net earnings from self-employment on Schedule F, they must file Schedule SE to determine self-employment tax.

Question 79

How do you compute taxable income?

Answer 79

To Compute Taxable Income:
Step 1: Compute gross income, defined as “all income from whatever source derived,” by determining what is included and what can be excluded.
Step 2: Subtract deductions (above the line) to arrive at Adjusted Gross Income (AGI)
Step 3: Subtract “itemized” deductions or the standard deduction (whichever is greater)
Result: Taxable Income

Question 80

How do you compute individual income tax liability?

Answer 80

To Compute Individual Income Tax Liability:
Step 1: Compute the annual income tax liability
Step 2: Decrease this tax liability by any available tax credits
Step 3: Add to tax liability any other applicable taxes (for example, self-employment tax or the Alternative Minimum Tax)
Step 4: Deduct payments that were made to the IRS during the tax year, including:
- Taxes that were withheld during the year by an employer
- Estimated tax payments made during the year
Result: Taxes due to IRS or tax refund due to the taxpayer

Question 81

What items are always INCLUDED in gross income?

Answer 81

1. Compensation for services
2. Gross Income from a business or profession
3. Unemployment benefits
4. Distributive share of dividend income
5. Gifts from an employer (excludes non-cash holiday gifts)
6. Gain from sale or exchange of real estate, securities, property
7. Rent and royalties
8. Gambling winnings
9. Employee death benefits paid by an employer (NOT life insurance proceeds)
10. Embezzled or illegal income
11. Litigation settlement income awarded for punitive damages
12. Scholarship funds for non-degree seeking students, and for room & board (even if degree-seeking)
13. Discharge of debt
14. Prize or award money (but excluded if transferred directly to tax-exempt charitable organization)
15. Interest income (but excluded if from state & local bonds, or mutual funds)

Question 82

What items are always EXCLUDED from gross income?

Answer 82

1. Unrealized income (stock went up in value but hasn’t been sold)
2. Return of capital (such as stock dividends on common stock)
3. Property received from your former spouse under the divorce decree, and cash alimony received from a divorce executed after December 31, 2018
4. Proceeds to a beneficiary from a life insurance policy
5. Workers compensation payments
6. Reimbursement from employer-provided accident and health plan
7. Accident and health insurance benefits paid to an employee
8. Qualified foster care payments
9. Welfare payments received from government entities
10. Payments received for support of minor children
11. Litigation settlement income awarded for non-punitive damages
12. Scholarship funds used by a degree-seeking candidate toward tuition and related expenses.

Question 83

Explain the purpose of filing Schedule K-1 (Form 1065).

Answer 83

Each pass-through entity must prepare a Schedule K-1 to report the amounts that are passed through to each partner. Parts I and II of the Schedule K-1 include information about the partnership and the partner’s portion of income. Three types of partnership income: (1) Ordinary income (loss); (2) Passive income (loss); (3) Portfolio income items.

Schedule K-1, Part III discloses the partner’s share of current year income, deductions, credits, and other items.

Question 84

What are the sub-sections of Schedule K-1 (Form 1065)?

Answer 84

1. Ordinary business income
2. Net rental real estate income
3. Other net rental income
4. Guaranteed payments
5. Interest income
6. Ordinary and qualified dividends
7. Royalties
8. Net short-term capital gain
   9a. Net long-term capital gain
   9b. Collectibles (28%) gain
   9c. Unrecaptured Section 1250 gain
9. Net Sec. 1231 gain
10. Other income (Porfolio income, involuntary conversion, cancellation of debt)
11. Sec. 179 deduction
12. Other deductions (Charitable contributions, investment interest expense, royalty income, portfolio income, medical insurance, dependent care benefits, pension & IRA payments)
13. Self-employment earnings
14. Credits
15. Foreign transactions
16. Alternative minimum tax
17. Tax-exempt income/interest, and other non-deductible expenses
18. Distributions
19. Other information

Question 85

Distinguish “above-the-line” deductions vs. “below-the-line” deductions toward AGI.

Answer 85

Above-the-line: Deductions subtracted from gross income to arrive at AGI.
Below-the-line: Deductions subtracted from AGI, after above-the-line.

The term “tax expense” refers to a liability owed to a federal, state, or local government within the tax year. Taxpayer expenses are divided into 3 categories: Trade/business, investment, personal

Question 86

List the most common above-the-line deductions toward AGI.

Answer 86

1. Business expenses associated with a trade or self-employment
2. Expenses arising from rents and royalties
3. One half of self-employment tax
4. IRA and self-employed retirement plan contributions
5. Student loan interest
6. Jury duty pay remitted to an employer
7. Contributions to Health Savings Accounts
8. Attorney’s fees and court costs for discrimination suits and whistleblower awards
9. Forfeited interest or penalties paid on premature withdrawals from a time-savings account
10. Losses from the sale or exchange of property
11. Expenses of elementary and secondary teachers
12. Health Savings Accounts
13. Up to $300.00 of qualified cash charitable contributions for taxpayers, except married filing jointly is $600 and who do not itemize their deductions

Question 87

List the most common below-the-line deductions from AGI.

Answer 87

All taxpayers can take either a standard deduction or itemized deductions.

Basic standard deduction (2021):
1. Married filing jointly or surviving spouse: $25,100
2. Head of Household: $18,800
3. Single: $12,550

Categories of itemized deductions (2021):
1. Medical expenses
2. Taxes
3. Interest
4. Charitable contributions
5. Gambling losses
6. Miscellaneous deductions not subject to 2% deduction

Question 88

Define the medical expense deduction computation.

Answer 88

Deductible Medical Expenses = Qualified Medical Expenses – Any Medical Expense Reimbursements – 7.5% of AGI

This means that only the portion of qualified medical expenses that exceed 7.5% of the taxpayer’s AGI are deductible.

Question 89

Define the QBI deduction and how it is calculated for relevant entities.

Answer 89

QBI (qualified business income) is income that passes through to the taxpayer from a sole proprietorships, partnerships, or S corporation.

The individual who receives the income flow can get a deduction of 20% for their Qualified Business Income (QBI). It is also known as a Section 199A deduction. QBI is ordinary business income less business expenses. Both itemizing and non-itemizing taxpayers are eligible
to take the deduction on their Form 1040.

Question 90

Define “passive activity” and how passive income is reported in a tax filing.

Answer 90

Passive activity is any in which taxpayer does not “materially participate” in its management. In most cases, passive rental income (loss) will be reported on Form 1040, Schedule E.

Material participation means the taxpayer either: (1) worked more than 500 hours on the activity during the tax year, or (2) worked 100+ hours on the activity when no other individual has. Also, the taxpayer must own 10%+ of the estate. An active manager of the rental real estate can deduct a maximum loss of $25,000/year.

Question 91

Define formula for calculating deductible loss when a taxpayer disposes of trade or business property and incurs a loss.

Answer 91

Deductible loss = [Adjusted Basis of Property] – [Cash or FMV of Property/Services Received] – [Any Reimbursement or Compensation for the Loss] – [Property’s Salvage Value (if any)]

Question 92

Define formula for calculating net operating loss (NOL).

Answer 92

A net operating loss (NOL) is the excess of allowable business deductions over the gross income of the business activity for a particular tax year. NOL can be carried forward indefinitely but cannot be carried back.

To compute NOL for corporate taxpayers:
Gross Income
– Allowable Business Deductions
= Business Activity Loss
– Any deduction for dividends received that was disallowed due to
corporation’s taxable income
– Any deduction for dividends paid on certain preferred stock of public
utilities without limiting it to the year’s taxable income
– Exclusion of gain from qualified small business stock

= Corporate Net Operating Loss

Question 93

List the 5 different filing statuses.

Answer 93

1. Married Filing Jointly: Taxpayers who file jointly must have the same tax year. Married taxpayers filing jointly can have different accounting methods.
2. Married Filing Separate: Spouses divide their income and expenses according to ownership.
3. Qualifying Widower: Applicable for the two years after the year of death of spouse. When a spouse dies during the tax year, the surviving spouse may still choose MFJ status for that tax year. Taxpayer must provide more than 50% of the cost of maintaining the household for a child.
4. Head of Household: Taxpayer must be unmarried, and have a qualifying person living in the house for more than half the year.
5. Single: Everyone who does not fit the above. Includes taxpayers who were married but who then obtained a legal separation agreement at end of year.

Question 94

Define the 3 most common refundable personal credits, and the maximum deduction amount of each.

Answer 94

1. Earned income credit (EIC): For eligible low-income workers who have “earned income.” For 2021, the maximum earned credit is $6,728.
2. Child Tax Credit (CTC): Taxpayers with AGI under a certain threshold can take a credit of $3,600 for qualifying child UNDER AGE 6, $3,000 per qualifying dependent under the age of 17.
3. American Opportunity Tax Credit (AOTC): Allowed a max of $2500/year for each eligible student, as: (1) 100% of first $2,000 of qualified educational expenses, and (2) 25% of the next $2,000 of qualified educational expenses.

Question 95

Define the 5 most common non-refundable personal credits, and the maximum deduction amount of each.

Answer 95

1. Elderly credit: For taxpayers age 65+ or permanently disabled. 15% of the difference between an initial flat amount ($5,000 for single taxpayers; $7,500 for taxpayer and spouse) and income.
2. Child and dependent care credit: A child must be under 13 must live with the taxpayer for more than half the year. Income of $250/month for one qualifying individual requiring care.
3. Adoption credit: A non-refundable credit is allowed for qualified adoption expenses up to $14,440 for 2021 for each eligible child.
4. Lifetime Learning credit: The credit is computed as 20% of education expenses up to $10,000, for a maximum credit of $2,000. The AGI amount for Joint Filings totally phases out when AGI exceeds $90,000.
5. Foreign tax credit: The credit is limited to the lower of foreign taxes paid or the proportion of U.S. tax allocable to foreign sourced income

Question 96

Define the most common business tax credits, and the maximum deduction amount for each.

Answer 96

1. General Business Credit (GBC): Is actually a combination of multiple credits, including: (a) Rehabilitation Credit, (b) Business Energy Credit, (c) Work Opportunity Credit, (d) Alcohol fuels credit, (e) Research credit, (f) Employer-Provided Child Care Credit, (g) Small Employer Health Insurance Credit. But the combined limit of all of these credits is net income tax MINUS 25% of net regular tax liability over $25,000.

Question 97

List the amounts of the 7 tax brackets for individual income, effective 2020.

Answer 97

The federal income tax has 7 tax brackets for 2020: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Question 98

Define the taxable rate toward self-employment FICA & FUTA tax liability. Define the formula for self-employment income and net earnings from self-employment.

Answer 98

Social Security (FICA) is 7.65% for both employers and employees.
Federal Unemployment (FUTA) is 6.2% of the first $7,000 wages paid to each employee.

Self-Employment Income = [Gross Income from Self-Employment] – [Deductions Associated with the Activity (including director’s fees)]

Net Earnings from Self-Employment = [Self-Employment Income] * 92.35%

Question 99

Define the 3 tax rate portions that comprise self-employment tax liability.

Answer 99

The total self-employment tax is the sum the 12.4% Social Security, the 2.9% Medicare, and the .9% Additional Medicare tax portions.

1. Social Security Taxes = [Net Earnings from Self-Employment (up to $118,500)] * 12.4%
2. Medicare Taxes = [Net Earnings from Self-Employment (no ceiling)] * 2.9%
3. Additional Medicare Tax = [Ceiling Based on Filing Status] – [Net Earnings from Self-Employment] * 0.9%

Question 100

Define the 2 methods used to calculate the required annual payment of estimated taxes.

Answer 100

For taxpayers with an AGI at or below the threshold in the prior year, estimated tax payments plus withholdings must equal the lesser of:
- 90% of the current year’s tax
- 90% of the tax determined using the annualized income method
- 100% of the prior year’s tax, even if there was no tax liability in the prior year.

For taxpayers with an AGI above the threshold ($150,000 for joint returns and single filers; $75,000 for married filing separately) in the prior year, estimated tax payments plus withholdings must equal the lesser of:
- 90% of the current year’s tax
- 90% of the tax determined using the annualized income method
- 110% of the prior year’s tax

Question 101

When can a partner recognize a gain on liquidating distributions and non-liquidating distribution?

Answer 101

Partners can only recognize a gain on liquidating distributions if the cash received by the partner exceeds the partner’s basis in the partnership.

Distribution is first treated as a distribution out of the Accumulated Adjustment Account (AAA), which is non-taxable, and reduces the shareholder’s basis in stock. Any distribution in excess of the S corporation shareholder’s stock basis is treated as a capital gain.

Question 102

Describe the tax advantages/disadvantages of a general partnership.

Answer 102

Tax advantages of a general partnership are:
1. Minimal tax filings as form 1065 is not a complicated filing
2. A flow-through entity which avoids double taxation

Tax disadvantages of a general partnership are:
1. A partner’s share of ordinary income and guaranteed payments are subject to
the self- employment tax. This is the combined employer and employee rate
on social security and Medicare.

Question 103

Describe the tax advantages/disadvantages of a limited partnership (LP) & limited liability partnership (LLP).

Answer 103

Tax advantages of a limited partnership are:
1. Flow-through entity, and no double taxation
2. The ordinary income of a limited partner is passive, and is not subject to self-employment tax

Tax disadvantages of a limited partnership are:
1. Because the ordinary income (loss) of a limited partner is passive, it cannot offset non-passive income and losses of the limited partner.
2. The general partner in a limited partnership will pay self-employment taxes on the share of ordinary income, and guaranteed payments to partners.

Question 104

Describe the tax advantages/disadvantages of an LLC.

Answer 104

Tax advantages of an LLC are:
1. Flow-through entity, and no double taxation
2. Can elect to be taxed like a S Corporation. The ordinary income of the S Corporation is not self-employment income, and is not subject to self-employment tax.

Tax disadvantages of an LLC are:
1. Because it could elect to be a C Corporation, it is subject to double taxation
2. If it elects S Corporation status, now subject to requirements, such as no more than 100 members, no non-resident alien shareholders, and only one class of members.

Question 105

Describe the tax advantages/disadvantages of a S Corporation.

Answer 105

An S corporation is a hybrid of sorts in that it follows many of the C corporation rules, but is treated like a partnership for taxation purposes.

Advantages of forming an S corporation include:
1. Profits and losses flow through to the shareholders. The entity itself does not pay taxes on its income.
2. Shareholders enjoy limited liability and cannot be held liable for the debts or misconduct of the entity.
3. Shareholders can be both owners of the corporation as well as compensated employees, so long as the compensation is reasonable.
4. Ownership of S corporation shares can be freely transferred.

Disadvantages of forming an S corporation include:
1. S corporation setup is more complicated. Articles of Incorporation must be filed in the corporation’s home state, and the entity must have a registered agent in the state.
2. Annual filings are also more complicated for S corporations, including annual report fees and franchise taxes imposed by most states.
3. An S corporation can only have 100 shareholders and can only issue one class of stock. A husband and wife count as one shareholder.
4. Because profit and loss allocation is based on stock ownership, S corporations do not have the flexibility that partnerships have in allocating income.

Question 106

Describe the tax advantages/disadvantages of a C Corporation.

Answer 106

Advantages of forming an C corporation include:
1. Shareholders enjoy limited liability and cannot be held liable for the debts or misconduct of the entity. Can have unlimited number of shareholders.
2. C corporation has an unlimited life, which is not tied to the life of its owner(s).
3. Shareholders can be both owners of the corporation as well as compensated employees, so long as the compensation is reasonable.
4. Capital can be raised simply by selling stock. Ownership can be easily transferred through the sale of stock.

Disadvantages of forming a C corporation include:
1. Corporate profits are subject to double taxation. The corporate entity itself is taxed on its profits, and the shareholders are also taxed on corporate income distributed as dividends.
2. C corporation set up is more complicated. Articles of Incorporation must be filed in the corporation’s home state, and the entity must have a registered agent in the state.
3. Annual filings are also more complicated for C corporations, including annual report fees and franchise taxes imposed by most states.
4. A more complicated tax return (Form 1120).

Question 107

Explain the difference between “book income” vs “taxable income.”

Answer 107

Book income: The income that is computed by applying GAAP to the corporation’s accounting records and communicated to the shareholders in the financial statements.

Taxable income: The income used to compute a taxpayer’s income tax liability.

Question 108

Explain the difference between “permanent” vs. “temporary differences.”

Answer 108

Permanent differences: These items are either on the books or the tax return but never reverse themselves. Can arise from income items that are never taxable or expense items that are never deductible. These items will cause book income to be greater than taxable income.

Temporary differences: Arise when GAAP rules dictate that income and expense to be recognized in one period, but tax accounting rules dictate that they are recognized in another period.

Question 109

Explain the difference between “Schedule M-1” vs “Schedule M-3.”

Answer 109

Both M-1 & M-3 are corporate tax return filings. But, Schedule M-1 should be completed by entities with LESS than $10 million of total assets, while Schedule M-3 should is for corporations with MORE than $10 million in total assets.

Schedule M-1 starts with book income (loss), Line 1, and then adjusts up or down based on permanent or temporary differences. Meanwhile, Schedule M-3 is divided into three parts: (1) Financial information and net income reconciliation, (2) Reconciliation of net income with taxable income, and (3) Expense and deduction items that affect Part 2.

Schedule M-2 is Analysis of Unappropriated Retained Earnings per Books.

Question 110

Reconcile the differences between book and taxable income (loss) of a business entity.

Answer 110

To calculate taxable income, these items are ADDED to book income:
1. Non-deductible expenses, including federal taxes, net capital losses, expenses that exceed deductible limits, certain fines, and penalties, etc.
2. Income that is taxable but not included in book income. For example, rents received in advance.

To calculate taxable income, these items are DEDUCTED from book income:
1. Non-taxable income that is included in book income, such as municipal interest income and life insurance proceeds, etc.
2. Deductions that are not expensed in book income, including the dividends received deduction, depreciation on tax return in excess of book depreciation.

Question 111

Explain what is meant by “double taxation.”

Answer 111

Corporations are artificial legal entities in which the owners, referred to as shareholders, typically enjoy limited liability. This “corporate veil” shields corporate shareholders from personal liability and generally limits a shareholder’s losses to the amount invested in the corporate stock.

In exchange for limited liability and unlimited lifespan, corporate earnings are subject to “double taxation.” This means that not only is the corporation itself taxed on earnings, but shareholders too are taxed on earnings (dividends) distributed by the corporation.

Question 112

Calculate taxable income and tax liability for a C corporation.

Answer 112

Gross income = [Gross profit on sales] + [Gross dividends] + [Interest income] + [Gross rents and royalties] + [Capital gains] + [Other income]

Taxable income = [Gross income] - [Deductions] - [NOL carryback]

Net tax liability = [Taxable income x Tax rate] - [Credits] - [Payments] + [Other taxes]

Remember that issuance of corporate stock, issuance of corporate debt and contributions of capital are all EXCLUDED from gross income of a corporation.

Question 113

Recall the TCJA’s guidance on how to calculate deductible amount of business interest.

Answer 113

Business interest is deductible up to 50% of adjusted taxable income plus the taxpayer’s business interest income for the year. The limitation to business interest applies to C corporations, S corporations, partnerships, and sole proprietors that meet the gross receipts threshold of $26M.

Question 114

Describe the order in which special corporate deductions must be applied.

Answer 114

1. Organization and Start-Up Expenditures: Incurred in connection with the formation and organization of a corporation, usually includes accounting and legal. Costs of issuance of stock and amortization thereof are excluded.
2. Syndication Expenses: Include costs associated with the issuance and sale of corporate stock. These costs must be capitalized and cannot be amortized.
3. Charitable contributions: 25% of the corporation’s taxable income before: Deduction for charitable contributions, dividends-received deduction, and any loss carrybacks.
4. Dividends received deduction (DRD): Deduction for a percentage of
   domestic dividends received by the corporation.
   a) Less than 20% ownership deduction = 50% of dividends received.
   b) 20% to 79% ownership deduction = 65% of dividends received.
   c) 80% ownership or more deduction = 100% of dividends received.
   (Hint: When an exam question does not specify the company’s ownership percentage, assume it is less than 20%, and so DRD percentage would be 50%.)
5. Transactions with related taxpayers (Think of indirect ownership as well).
6. Capital losses: Can offset capital gains, but corporations are not allowed to deduct any net capital losses against ordinary income.
7. Passive losses, then casualty losses.

Question 115

Define accumulated earnings tax, and explain how it is calculated.

Answer 115

Accumulated earnings tax is imposed by the IRS if it determines that the corporation is trying to avoid these taxes by accumulating income in excess of reasonable business needs.

Accumulated Earnings Tax = ([Taxable income] +/- [Adjustments]) x 20%

Adjustments include: Corporate income tax, charitable contributions over 25% limit, net capital loss, net long-term capital gains, dividends received deduction

Question 116

Define personal holding company tax, and explain how it is calculated.

Answer 116

PHC tax is a penalty tax that is triggered by relatively high levels of investment income in a corporation. It imposes a penalty on undistributed personal holding company income.

A C corporation qualifies as a PHC if 2 tests are met: An income test (If passive income and portfolio income represent 60%+ of the entity’s adjusted ordinary gross income) and a stock ownership test (if more than 50% of the value of the corporation’s stock is owned, directly or indirectly, by 5 or fewer individuals).

Adjusted Taxable Income = [Taxable income] +/- [Adjustments]
PHC tax = ([Adjusted taxable income] +/- [Dividend adjustments]) x 20%

Question 117

Calculate the current-year net operating or capital loss of a C corporation.

Answer 117

A corporation’s net operating loss is the excess of an entity’s business deductions over its gross income during a tax year. Effective for tax years beginning 2021, the CARES Act now allows for only a NOL carry forward (indefinitely), although there is a 80% limitation for all NOL carry forwards.

Capital losses are deductible only against capital gains. They are not deductible against ordinary income on a corporate return. Unused capital losses can be carried back three years and carried forward five years, to offset capital gains.

Question 118

Calculate the tax gain (loss) realized and recognized by both the shareholders and the corporation on a contribution or on a distribution in complete liquidation of a C corporation for federal income tax purposes.

Answer 118

When a taxpayer contributes property and receives boot in addition to corporate stock, and gets control, gain (but not loss) should be recognized.

If boot is received, gain recognized to the shareholder is the lower of: (1) Realized gain (FMV less property’s adjusted basis), and (2) the FMV of boot received.

Gain may be recognized in two circumstances if a corporation assumes shareholder’s debt: (1) Recognized Gain = Liability Assumed – Basis of Transferred Property, or (2) Gain = Lesser of realized gain or boot received

Question 119

Calculate an entity owner’s basis in C corporation stock for federal income tax purposes.

Answer 119

Shareholder Basis in Corporate Stock = [Basis of all property transferred to the corporation] + [Gain recognized by the shareholder] – [Boot received by the shareholder] - [Liabilities assumed by the corporation]

Corporation’s adjusted basis in property = [Transferor’s basis in property] + [Any gain recognized by the transferor]

Question 120

Calculate the tax gain (loss) recognized by both the shareholders and the corporation on a complete liquidation of a C corporation.

Answer 120

1. Distributions to shareholders are calculated as:
   Amount Distributed = Cash + [FMV at distribution date of property received] - [Liabilities assumed by the shareholder]
2. If liability on property exceeds property’s FMV, FMV is treated as liability amount:
   Amount Distributed = Cash + [Liability assumed by shareholder (when liability > FMV)]
3. Shareholder’s basis for property received in corporate distribution is:
   Shareholder’s basis = Cash + [FMV at distribution date of property received]

Hint: While the valuation of the distribution includes liabilities assumed by the shareholder, the basis calculation does not.

Question 121

Determine tax treatment of a C Corporation’s current E&P and accumulated E&P, and whether there is a capital gain.

Answer 121

1. If current E&P and accumulated E&P are negative:
   Distributions are considered a return of capital and are tax-free up to the shareholder’s adjusted basis. Any excess is treated as a capital gain.
2. If current E&P and accumulated E&P are positive:
   The distribution is taxed as a dividend that is deducted first from current E&P. Once current E&P is depleted, distributions reduce accumulated E&P.
3. If current E&P are positive and accumulated E&P are negative:
   The distribution is a dividend only to the extent of current E&P.
4. If current E&P are negative and accumulated E&P are positive: First net the current E&P if negative against the positive Accumulated E&P, if the net is positive, then that represents the portion of the distribution which is a dividend.

Question 122

Calculate the amount of the cash distributions to shareholders of a C corporation that represents a dividend, return of capital or capital gain.

Answer 122

1. If a corporation distributes stock, it is not taxable to the shareholder if there was no option to receive property in lieu of stock and there is no change in the proportionate interests of shareholders.
2. Constructive dividends are payments to shareholders not formally declared as dividends. Property distributions to shareholders are often treated as constructive dividends.
3. The total redemption of stock occurs when a corporation repurchases stock from shareholders. It is generally treated by the shareholder as a sale of stock that will trigger recognition of a capital gain or loss by the shareholder.

Question 123

Calculate basis of shareholder’s stock/property received in complete liquidation.

Answer 123

Shareholder Gain/Loss Recognition and Basis = (FMV of distribution - Any liabilities associated with the distributed property) - Stockholder’s Basis

When a controlled subsidiary is liquidated, no real disposition of assets occurred. The assets are merely transferred from one corporation to a related corporation.

Hint: If a corporation distributes appreciated property, with debt, in a complete
liquidation, the gain to the corporation is the excess of the any debt assumed by the stockholder above basis of the property transferred to the stockholder.

Question 124

Recall the requirements for filing a consolidated federal Form 1120 – U.S. Corporation Income Tax Return.

Answer 124

A parent corporation may only elect to file consolidated returns if they own at least 80%-controlled subsidiaries.

A controlled group of corporations is entitled to one $250,000 accumulated earnings tax credit. A brother-sister controlled group exists if two or more corporations are owned by five or fewer individuals/estates/trusts who own: (1) More than 50% of the total combined voting power of the corporate stock, AND (2) More than 50% of the total value of all shares of stock of each corporation (when looking at only the stock ownership of each person that is identical with respect to each corporation).

Question 125

Define “nexus” with respect to multi-jurisdictional transactions.

Answer 125

“Nexus” is the degree of the relationship that must exist between a state and a foreign corporation for the state to have the right to impose a tax. Nexus applies to the sale of tangible personal property, and is assessed yearly.

Question 126

List the factors that increase and decrease state income tax computation.

Answer 126

State Income Tax Computation is INCREASED by: Dividends received deduction, Expenses related to interest earned on US bonds, State income taxes, Municipal interest taxed for state purposes, depreciation that exceeds states’ limits

State Income Tax Computation is DECREASED by: Federal income taxes paid, Expenses related to municipal interest income, Interest on US bonds, Depreciation that is allowed by the state but not the federal government

Question 127

Calculate the apportionment percentage used in determining state taxable income.

Answer 127

Business income for State X = [Sales Factor + Payroll Factor + Property Factor] ÷ 3

Sales Factor = [Total Sales to In-State Customers] ÷ [Total Sales (net of discounts and returns)]

Property Factor = [Avg. Cost of Real & Tangible Pers. Prop Owned/Rented & Located In-State] ÷ [Total Average Cost of All Such Property]

Payroll Factor = [Compensation Paid or Accrued to In-State Employees] ÷ [Total Compensation Paid or Accrued]

Question 128

Explain how different types of foreign income are sourced in calculating the foreign tax credit for federal income tax purposes.

Answer 128

Foreign taxpayers are only taxed on income that is from a U.S. source. United States taxpayers are taxed on all worldwide income, regardless of the source.

EARNED income is sourced where it is earned, including any employee benefits that may be associated with that income. UNEARNED income is considered to be from a foreign source if it is received from a foreign resident or if it is related to property used in a foreign country.

Interest income is considered to be from a U.S. source if it received from the U.S. government, non-corporate U.S. residents, or a domestic corporation. Dividends from U.S. corporations are U.S. sourced. Dividends from a foreign corporation are foreign sourced.

Question 129

Define the formula for Foreign Tax Credit.

Answer 129

Foreign tax credit limitation = U.S. tax on worldwide income * [Foreign source taxable income ÷ Worldwide taxable income]

Any excess foreign tax credits can be carried back one year and carried forward 10 years. Foreign currency exchange gains and losses resulting from the normal course of
business operations are ordinary gains and losses.

Question 130

Identify the federal filing requirements of cross border business investments.

Answer 130

1. Form 5471: When any U.S. individual controls a foreign corporation for at least 30 consecutive days during the shareholder’s tax year.
2. Form 8865: When any U.S. partner controls a foreign partnership.
3. Form 5472: When a U.S. corporation is 25% owned by one foreign person.
4. Form 926: When a U.S. individual transfers property to a foreign corporation (including in complete liquidation).
5. Form 8938: When a taxpayer has an interest in specified foreign financial assets above certain amount.
6. FinCEN Form 114: When a taxpayer with a financial interest in or signature authority over a foreign financial account exceeds certain amounts.

These are informational returns that must be filed with the IRS when transactions take place or a relationship exists between U.S. taxpayers or entities and foreign corporations and partnerships.

Question 131

Define “separately stated items.”

Answer 131

Separately stated items are reported on any tax items that might be treated differently by any shareholder, and are reported separately to each shareholder.

Includes: Dividend income, Charitable contributions, Section 1231 gains/losses, Net short-term capital gains/losses, interest income, gain/loss sale of collectibles

Question 132

List the items that comprise a S Corporation’s ordinary income.

Answer 132

S Corp’s net ordinary income includes: Ordinary business expenses, depreciation, amortization items, Section 1245 & 1250 recapture

Question 133

Define the purpose of an “accumulated adjustment account” (AAA) and “other adjustment account” (OAA).

Answer 133

The AAA tracks the cumulative total of undistributed net income items for S corporations. Other Adjustments Account (OAA) tracks the tax-exempt income and related expenses of the corporation.
When distributions are made, they should be deducted in the following order:
1. Distributions are first made from the AAA.
2. Distributions from AAA and OAA reduceadjusted basis of shareholder stock.
3. Distributions are made from the accumulated E&P account (AEP).
4. Any additional distributions are considered to be made from the S corporation’s stock basis.
5. Any additional distributions are treated as capital gains to the shareholders.

Question 134

Calculate the shareholder’s basis in S corporation stock.

Answer 134

Contributions of capital (cash and/or property) and S corporation income (including tax-exempt income) INCREASE the shareholder’s adjusted basis. Distributions of capital (cash and/or property) and S corporation losses (including non-deductible expenses) DECREASE the shareholder’s adjusted basis in this order: Cash, Inventory & AR, Other property.

If a shareholder contributes property with an attached liability and that liability is assumed by the S corporation, the shareholder will recognize a gain equal to the excess of liability assumed by S Corp over the basis of the property contributed.

Question 135

Calculate the shareholder’s daily share of income (recognized gain or loss) when relative interests change during the tax year.

Answer 135

1. S corporation income (loss) per day = S corporation’s annual income and separately stated items ÷ 365
2. Shareholder income before change = [S corporation income(loss) per day] * [# of days before the ownership % change] * [% ownership before change]
3. Shareholder income after change = [S corporation income(loss) per day] * [# of days after the ownership % change] * [% ownership after change]
4. Total shareholder share of S corporation income = [Shareholder income before change] + [Shareholder income after change]

Hint: Contributions of property to an S corporation follow the same rules of C corporations under Section 351.

Question 136

Explain the shareholder’s impact of an S corporation’s loss in excess of the shareholder’s basis.

Answer 136

The stock basis of the shareholder in an S corporation is increased by:
1. All income items, whether taxable or not,
2. Any additional contributions of assets, including cash.

The stock basis of the shareholder in an S corporation is decreased by:
1. Distributions which are not part of gross income,
2. Nondeductible expenses that are not charged to capital.
3. All taxable losses and deductions (not to exceed basis)

Question 137

List the order in which a S corporation’s shareholder stock basis must be adjusted.

Answer 137

1) Increased for all income items, whether taxable or not.
2) Increased for contributions of additional assets.
3) Decrease for withdrawal of assets.
4) Decreased for all distributions which are not part of gross income.
5) Decreased for expenses and loss which are deductible or not

Question 138

Define a “built-in gains tax.”

Answer 138

The built-in gains tax applies to entities that CHANGE THEIR STATUS from a C corporation to an S corporation. Additionally, the property must be sold after 5 years from making the S election to avoid the S corporation from paying taxes on the gain on the sale of the asset at the highest corporate level (currently 21%).

The built-in gain is calculated as an asset’s FMV less its adjusted basis at the time the entity converts from C corp. to S corp. status. In the year of conversion, the S Corp pays a built-in gain equal to 21% x the lesser of the realized built-in gain or the S corp.’s taxable income.

Question 139

List the types of “corporate reorganizations.”

Answer 139

Type A reorganization: merger or consolidation under state law. In a merger, the Target Company dissolves into another corporation, the Acquiring Corporation.

Type B reorganization: Target Company stock is acquired solely in exchange for the voting stock of Acquiring Company. As a result, acquiring Company must own at least 80% of the stock of Target Company.

Type C reorganization: “substantially all” of the assets of Target Company are acquired in exchange for voting stock in Acquiring Company. “Substantially all assets” is defined by the IRS as assets having a FMV of at least 90% of the fair market value of all of Target Company’s assets less liabilities.

Type D reorganization: Division reorganization in which the Parent Company divides by transferring assets to a Subsidiary Company in exchange for shares of the Subsidiary Company.

Type E is used for recapitalizations. Type F is used for nominal changes. Type G reorganizations are related to bankruptcy proceedings.

Question 140

Define basis of an acquired target company’s basis (and their shareholders’ basis) in their new assets.

Answer 140

Target Company basis in new assets = [Basis in property to Target Company] +
[Gain recognized by Target Company]

Shareholder basis in Acquiring Company stock = [Basis in surrendered Target Company stock] + [Recognized gain] - [Boot received]

Question 141

Calculate ordinary business income (loss) and separately stated items for a partnership that would be stated on federal Form 1065 – U.S. Return of Partnership Income.

Answer 141

Profits and losses are allocated to each partner based on each partner’s profit and loss sharing ratio as defined in the partnership agreement. All items of income, gain, loss, deduction or credit that must be separately stated.

Separately stated items include: dividends, tax-exempt interest, charitable contributions, Section 179 expenses, Section 1231 gains/losses, interest income, capital gains/losses, passive gains/losses.

Finally, remember that a general partner’s distributive share of partnership income is subject to self-employment tax. Limited partner’s distributive share is generally not subject to self-employment tax.

Question 142

Calculate the partner’s basis in the partnership, as well as the partnership’s basis in assets contributed by the partner.

Answer 142

When a partner contributes services in exchange for a partnership interest, the amount of income that must be reported and the partner’s resulting partnership basis is solely based on the value of the partnership interest received by the partner in exchange for the services. Not the value of services themselves!

When a partner contributes property to a partnership, excess of the % of liability assumed by other partners, over the adjusted basis of the property contributed is treated as gain for the partner. Can be treated as ordinary income.

Built-in gain property has a FMV that exceeds its adjusted basis at the time of contribution. Built-in loss property has a FMV lower than its adjusted basis at the time of contribution. There is no time limit on the allocation of the amount of built-in gain or loss from the sale of property.

Question 143

Define “outside basis” vs “inside basis” and how each relate to the concept of “holding period.”

Answer 143

Each partner calculates his personal adjusted basis (outside basis) in the partnership, and the partnership calculates the adjusted basis of the assets held by the partnership (inside basis). The partnership takes a carryover basis for contributed property, and this property has what is called an asset holding period which is used for depreciation calculations.

The partner’s outside basis is adjusted in the following order:
Beginning Basis
Plus: Partner’s contribution of assets plus share of recourse debt
Plus: Partner’s share of income, both taxable and tax-exempt income
Less: (Partner’s distributions and withdrawals [not guaranteed payments])
Less: (Partner’s share of non-deductible losses and expenses)
Less: (Partner’s share of deductible losses)
= Ending Basis

Remember that at least 10% of the value of the partnership interests must be owned by a partner (and spouse if applicable), in order to meet the criteria for the $25,000 exception for active participation in rental real estate activity.

Question 144

Calculate the realized and recognized gains (losses) by the partnership and partners of non-liquidating distributions from the partnership.

Answer 144

A pro rata non-liquidating or current distribution is a distribution to a continuing partner (including a draw by the partner) in accordance with the partner’s ownership percentage. Partners can only recognize gain on non-liquidating distributions of cash which exceeds the partner’s basis in the partnership.

“Hot assets” are inventory and unrealized receivables as defined under IRC Section 751. These are basically ordinary income-producing assets. Arm’s length sales to partners are not considered distributions.

A partner’s basis in the partnership is increased by the partner’s proportionate share of any increases in partnership liabilities (recourse debt), which are treated like a contribution from the partner. Non-recourse liabilities are generally excluded when calculating a partner’s basis.

Question 145

Calculate the realized and recognized gains (losses) by the partnership and partners of liquidating distributions from the partnership.

Answer 145

Like non-liquidating distributions, partners can only recognize a gain on liquidating distributions if cash exceeds the partner’s basis in the partnership. If a partner is relieved of a liability, it is treated as a cash distribution. The gain is equal to the amount realized by the partner, less the partner’s adjusted basis in the partnership.

If cash and/or multiple properties are distributed in a liquidating distribution, the partner’s basis for the partnership interest is allocated in the following order:
1. First, reduce the partner’s basis in the partnership interest by any cash distributed, then the basis of the hot assets.
2. After the cash and hot assets reduce the basis, any noncash property left in the partnership takes on the remaining partner’s basis.

Question 146

Recall the tax classification options for a LLC.

Answer 146

LLCs have several tax filing options:
1. LLCs with 2+ members are taxed as partnerships and can file a Form 1065.
2. Most LLCs can elect to be treated like a corporation for tax purposes. If they elect to be taxed as a corporation, they can be a C Corp and file Form 1120.
3. Or LLCs can instead elect to be like an S Corp, and file form 1120S.
4. A single member LLC must file a Schedule C and file self-employment tax.

Question 147

Explain the differences between simple and complex trust.

Answer 147

A trust is an entity that is created to allow a third party, or trustee, to hold assets on behalf of one or more beneficiaries.

Simple trust: All trust accounting income must be distributed to its beneficiaries annually. No charitable contributions can be made from the trust. No distributions of the trust principal, the corpus, can be made during the year. A simple trust can be revocable or irrevocable.

Complex trust: Any trust that cannot be classified as a simple trust. Can retain some current income within the trust, provide for amounts to be set aside to be given as charitable gifts, or distribute monies allocated to the trust’s corpus.

Question 148

List the different types of tax-exempt organizations, and the criteria to become a tax-exempt organization.

Answer 148

There are many types of tax-exempt organizations, like 501(c)(1), which is credit unions. Goes up to 501(c)(19). Most commonly you will see Section 501(c)(3): Commonly referred to as “charitable organizations” and include religious, charitable, scientific, literary and educational organizations. Must pass 3 tests.

Organizational test: Organization’s articles of incorporation must explicitly limit the organization’s activities to its taxexempt purpose.

Operational test: Operated exclusively for its exempt purpose by engaging only in activities that further its exempt purpose.

Activities test: May not attempt to influence legislation as a part of its activities nor may it participate in any campaign activity for or against political candidates.

Question 149

Define “public charity” and “private foundation.”

Answer 149

Both public charity and private foundations are 501c(3) organizations.

Public charity: Means donors can exclude a larger amount of their donations when giving to a public charity. To qualify, more than 50% of a public charity’s board of directors must be unrelated by blood, marriage, outside business co-ownership, nor compensated as employees of the organization. Must receive a significant amount of their revenue (33% minimum) from small donors.

Private fooundation: Any other organizations that do not qualify as public charity. Has several disadvantages: Donors can deduct a smaller amount of their contributions to private foundations as compared to public charities, must file Form 990-PF, and must distribute a minimum of 5% of their assets annually.

Question 150

Define “unrelated business income” for tax-exempt organizations.

Answer 150

Income from UBI is taxed. To be considered UBI, income must:
1. Be from a business regularly carried on by the organization
2. Be unrelated to the exempt organization’s tax-exempt purpose

Examples of UBI include:
1. Income from debt-financed property that is unrelated to the organization’s exempt function
2. Income from advertising in journals or publications of the exempt organization.