PRACTICE+FINAL+EXAM+ACCT+305+Fall+07[1]

University of Wisconsin Parkside

School of Business and Technology

Dr. R. Zameeruddin

INDIVIDUAL TAXATION, ACCT 305PRACTICE FINAL EXAM

Name _______________________

MULTIPLE CHOICE

1. Jeanne had an accident while hiking on vacation. She sustained nose injuries that required cosmetic surgery. While having the surgery done to restore her appearance, she had additional surgery done to reshape her chin, which was not injured in the accident. The surgery to restore her appearance cost $15,000 and the surgery to reshape her chin cost $4,000. How much of Jeanne’s surgical fees will qualify as a deductible medical expense (before application of the 7.5% limitation)?a. $0.b. $4,000.c. $15,000.d. $19,000.e. None of the above.

ANS: CCosmetic surgery is necessary (and therefore deductible) when it ameliorates (1) a deformity arising from a congenital abnormality, (2) a personal injury, or (3) a disfiguring disease. The $15,000 cost incurred in connection with the restorative surgery (required as a result of the accident) is deductible because the surgery was necessary. Amounts paid for the unnecessary cosmetic surgery ($4,000 for reshaping the chin) are not deductible as a medical expense.

PTS: 1 REF: Example 2 | Example 3

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2. Fred and Lucy are married and together have AGI of $120,000 in 2007. They have four dependents and file a joint return. They pay $5,000 for a high deductible health insurance policy and contribute $2,600 to a qualified Health Savings Account. During the year, they paid the following amounts for medical care: $9,200 in doctor and dentist bills and hospital expenses, and $3,000 for prescribed medicine and drugs. In October 2007, they received an insurance reimbursement of $4,400 for hospitalization. They expect to receive an additional reimbursement of $1,000 in January 2008. Determine the maximum deduction allowable for medical expenses in 2007.a. $1,100.b. $3,800.c. $9,200.d. $12,800.e. None of the above.

ANS: BFred and Lucy can claim a medical expense deduction for the current year of $3,800, determined as follows:

Physician bills, dentist bills, and hospital expenses $ 9,200 Less: Reimbursement (4,400) Unreimbursed expenses $ 4,800 Health insurance premiums 5,000 Prescribed medicines and drugs 3,000Total medical expenses $12,800 Less: 7.5% of $120,000 (AGI) (9,000) Deductible medical expenses $ 3,800

The contribution of $2,600 to the HSA is a deduction for AGI, and is not included in the medical expense calculation.

PTS: 1 REF: p. 10-2 | p. 10-3 | p. 10-7 to 10-10 | Example 12 | Example 15

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3. Liz, who is single, travels frequently on business. Art, Liz’s 84-year-old dependent grandfather, lived with Liz until this year when he moved to Granite Falls Nursing Home because he needs daily medical and nursing care. During the year, Liz made the following payments to Granite Falls on behalf of Art:

Room at Granite Falls $36,300Meals for Art 7,260Doctor and nurse fees 5,610Cable TV service for Art’s room 660Total $49,830

Granite Falls has medical staff in residence. Disregarding the 7.5% floor, how much, if any, of these expenses qualifies for a medical expense deduction by Liz?a. $5,610.b. $41,910.c. $49,170.d. $49,830.e. None of the above.

ANS: CThe amount that qualifies for the medical expense deduction is $49,170 ($36,300 + $7,260 + $5,610). The room and board for Granite Falls qualifies because the move was motivated by Art’s need for medical care. The cable TV fee is a personal expense.

PTS: 1 REF: p. 10-3 | Example 4

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4. Phillip developed hip problems and was unable to climb the stairs to reach his second-floor bedroom. His physician advised him to add a first-floor bedroom to his home. The cost of constructing the room was $32,000. The increase in the value of the residence as a result of the room addition was determined to be $17,000. In addition, Phillip paid the contractor $5,500 to construct an entrance ramp to his home and $8,500 to widen the hallways to accommodate his wheelchair. Phillip’s AGI for the year was $100,000. How much of these expenditures can Phillip deduct as a medical expense?a. $14,000.b. $15,000.c. $21,500.d. $29,000.e. None of the above.

ANS: CA capital improvement that ordinarily would not have a medical purpose qualifies as a medical expense if it is directly related to prescribed medical care and is deductible to the extent that the expenditure exceeds the increase in value of the related property. Examples of such improvements include dust elimination systems, elevators, and a room built to house an iron lung. Phillip’s medical expense related to the room addition is $15,000 ($32,000 – $17,000).

The full cost of home-related capital expenditures incurred to enable a physically handicapped individual to live independently and productively qualifies as a medical expense. Qualifying costs include expenditures for constructing entrance and exit ramps to the residence, widening hallways and doorways to accommodate wheelchairs, installing support bars and railings in bathrooms and other rooms, and adjusting electrical outlets and fixtures. These expenditures are subject to the 7.5% floor only, and the increase in the home’s value is deemed to be zero. Phillip’s medical expense related to the ramp and hallways is $14,000 ($5,500 + $8,500). So Phillip’s medical expense deduction is as follows:

Qualifying medical expenses ($15,000 + $14,000) $29,000 Less: 7.5% $100,000 (7,500 ) Deductible medical expenses $21,500

PTS: 1 REF: p. 10-4 | p. 10-5 | Example 6

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5. Quinn, who is single and lives alone, is physically handicapped as a result of a diving accident. In order to live independently, he modifies his personal residence at a cost of $30,000. The modifications included widening halls and doorways for a wheelchair, installing support bars in the bathroom and kitchen, installing a stairway lift, and rewiring so he could reach electrical outlets and appliances. Quinn pays $200 for an appraisal that places the value of the residence at $129,000 before the improvements and $140,000 after. As a result of the operation of the stairway lift, Quinn experienced an increase of $680 in his utility bills for the current year. Disregarding percentage limitations, how much of the above expenditures qualify as medical expense deductions?a. $11,680.b. $30,680.c. $30,880.d. $34,880.e. None of the above.

ANS: BQuinn, who is physically handicapped, modified his residence so he could live independently. Therefore, the $30,000 cost of the improvements is not reduced by the $11,000 ($140,000 – $129,000) increase in the value of the house. The additional operating expenses of $680 are deductible as a medical expense. The $200 appraisal fee is not deductible as a medical expense, but rather as a miscellaneous itemized deduction subject to the 2% of AGI floor. So $30,680 ($30,000 + $680) qualifies as medical expenses.

PTS: 1 REF: p. 10-4 | p. 10-5

6. Marilyn, Ed’s daughter who would otherwise qualify as his dependent, filed a joint return with her husband Henry. Ed, who had AGI of $150,000, incurred the following expenses:

Laser surgery to correct Marilyn’s vision problem $ 2,900Marilyn’s prescribed medicines 500Ed’s doctor and dentist bills 6,200Prescribed drugs for Ed 1,350Contact lenses for Ed 350Cost of program for Ed to stop smoking 550Weight reduction program for Ed (related to obesity) 650Total $12,500

Ed has a medical expense deduction of:a. $0.b. $50.c. $1,250.d. $12,500.e. None of the above.

ANS: CEd may claim the medical expenses he paid on behalf of Marilyn, even though Marilyn cannot be claimed as his dependent. This exception applies if the gross income and/or joint return tests are the only reasons why a person cannot be otherwise claimed as a dependent. All of the listed expenditures qualify. Ed’s medical expense deduction is $1,250 [$12,500 – ($150,000 7.5%)].

PTS: 1 REF: p. 10-4 | p. 10-5 | Exhibit 10-1

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7. Your friend Scotty informs you that he received a “tax-free” reimbursement in 2007 of some medical expenses he paid in 2006. Which of the following statements best explains why Scotty is not required to report the reimbursement in gross income?a. Scotty itemized deductions in 2006.b. Scotty did not itemize deductions in 2006.c. Scotty itemized deductions in 2007.d. Scotty did not itemize deductions in 2007.e. Scotty itemized deductions in 2007 but not in 2006.

ANS: BIf Scotty did not itemize in 2006, he can exclude the reimbursement from gross income in 2007. If Scotty itemized deductions in 2006, he must report the reimbursement as gross income in 2007 to the extent he received a tax benefit from deducting medical expenses in 2006. Whether he itemized in 2007 will have no impact on the treatment of the reimbursement.

PTS: 1 REF: Example 12

8. In 2007, Boris pays a $4,800 premium for high-deductible medical insurance for himself and his family. In addition, he contributes $3,000 to a Health Savings Account. Which of the following statements is true?a. If Boris is self-employed, he may deduct $7,800 as a deduction for AGI.b. If Boris is self-employed, he may deduct $3,000 as a deduction for AGI and may

include the $4,800 premium when calculating his medical expense deduction.c. If Boris is an employee, he may deduct $7,800 as a deduction for AGI.d. If Boris is an employee, he may include $7,800 when calculating his medical expense

deduction.e. None of the above.

ANS: ABoris, who is self-employed, may deduct 100% of the premium ($4,800) as a deduction for AGI. He may also deduct the $3,000 HSA contribution as a deduction for AGI.


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9. During the current year, Hugh, a self-employed individual, paid the following amounts:

Real estate tax on Iowa residence $3,800State income tax 1,700Real estate taxes on land in Puerto Rico (held as an investment) 1,100Gift tax paid on gift to daughter 1,200State sales taxes 1,750State occupational license fee 300Property tax on value of his automobile (used 100% for business) 475

What is the maximum amount Hugh can claim as taxes in itemizing deductions from AGI?a. $6,600.b. $6,650.c. $7,850.d. $8,625.e. None of the above.

ANS: BState sales taxes ($1,750) are more than the state income tax ($1,700); so Hugh should choose to deduct the sales tax rather than the state income tax. The state occupational license fee ($300) and the tax on his business use auto ($475) are deductible for AGI as business expenses. The state sales tax ($1,750) and the real estate taxes ($3,800 + $1,100) are deductible as itemized deductions. The gift tax is not deductible. The total itemized deductions are $6,650 ($3,800 + $1,100 + $1,750).

PTS: 1 REF: p. 10-11 to 10-13 | Exhibit 10-2

10. Brad, who uses the cash method of accounting, lives in a state that imposes an income tax (including withholding from wages). On April 14, 2007, he files his state return for 2006, paying an additional $600 in state income taxes. During 2007, his withholdings for state income tax purposes amount to $3,550. On April 13, 2008, he files his state return for 2007 claiming a refund of $800. Brad receives the refund on August 3, 2008. If he itemizes deductions, how much may Brad claim as a deduction for state income taxes on his Federal income tax return for calendar year 2007 (filed in April 2008)?a. $3,350.b. $3,550.c. $4,150.d. $5,150.e. None of the above.

ANS: CBrad is a cash basis taxpayer. His deduction is limited to the amounts paid in 2007. The $800 refund is reported as income in 2008 under the tax benefit rule. Brad’s state income tax deduction for 2007 is determined as follows:

Paid April 14, 2007, for 2006 $ 600Withholdings for 2007 3,550Total deduction $4,150

PTS: 1 REF: p. 10-13

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11. Barry and Larry, who are brothers, are equal owners in Chickadee Corporation. On July 1, 2007, each loans the corporation $10,000 at annual interest of 10%. Both shareholders are on the cash method of accounting, while Chickadee Corporation is on the accrual method. All parties use the calendar year for tax purposes. On June 30, 2008, Chickadee repays the loans of $20,000 together with the specified interest of $2,000. How much of the interest can Chickadee Corporation deduct in 2007?a. $0.b. $500.c. $1,000.d. $2,000.e. None of the above.

ANS: AChickadee Corporation can deduct interest expense of $2,000 in 2008 and $0 in 2007. Under § 267, Barry and Larry are regarded as related to the corporation. Consequently, the deductibility must await actual payment (in 2008).

PTS: 1 REF: p. 10-18

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12. Tony is married and files a joint tax return for 2007. He has investment interest expense of $95,000 for a loan made to him in 2007 to purchase a parcel of unimproved land. His income from investments [dividends (not qualified) and interest] totaled $18,000. After reducing his miscellaneous deductions by the applicable 2% floor, the deductible portion amounted to $2,800. In addition to $1,400 of investment expenses included in miscellaneous deductions, Tony paid $3,600 of real estate taxes on the unimproved land. Tony also has a $4,500 net long-term capital gain from the sale of another parcel of unimproved land. Calculate Tony’s maximum investment interest deduction for 2007.a. $95,000.b. $18,000.c. $17,500.d. $13,000.e. None of the above.

ANS: CTony’s net investment income in 2007 is computed as follows:

Income from investments:Interest and dividends $18,000 Long-term capital gain* 4,500

Less: Investment expenses** (5,000) Net investment income $17,500

*Net capital gain generally is not included in investment income. In order to maximize his investment interest deduction, Tony may elect to treat the $4,500 net capital gain as investment income, and thereby increase the deduction for investment interest by that amount. The beneficial alternative tax on net capital gain will not apply to the $4,500 net capital gain, however.

**The amount of investment expenses is calculated as follows: The smaller of (1) $1,400, the amount of investment expenses included in the total of miscellaneous itemized deductions subject to the 2% of AGI floor, or (2) $2,800, the amount of miscellaneous expenses deductible after the 2% of AGI floor is applied.

Investment expenses $1,400 Plus: Real property taxes on unimproved land 3,600Total investment expenses $5,000

Tony’s investment interest expense deduction for 2007 is limited to $17,500, the amount of net investment income, and $77,500 would be disallowed:

Total investment interest expense $95,000 Less: Net investment income (17,500) Investment interest disallowed in 2007 $77,500

The amount of investment interest disallowed may be carried over and becomes investment interest expense in the subsequent year subject to the net investment income limitation in that later year.

PTS: 1 REF: p. 10-14 to 10-16

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13. Joseph and Sandra, married taxpayers, took out a mortgage on their home for $350,000 in 1989. In May of 2007, when the home had a fair market value of $450,000 and they owed $250,000 on the mortgage, they took out a home equity loan for $220,000. They used the funds to purchase a single engine airplane to be used for recreational travel purposes. What is the maximum amount of debt on which they can deduct home equity interest?a. $50,000.b. $100,000.c. $220,000.d. $230,000.e. None of the above.

ANS: BInterest is deductible only on the portion of the $220,000 home equity loan that does not exceed the lesser of:

The fair market value of the residence, reduced by the acquisition indebtedness ($450,000 FMV – $250,000 acquisition indebtedness = $200,000).

$100,000 ($50,000 for married persons filing separate returns).

Of the $220,000 home equity loan, interest on $100,000 is deductible as home equity interest.


14. Pedro’s child attends a school operated by the church the family attends. Pedro made a donation of $1,000 to the church in lieu of the normal registration fee of $200. In addition, Pedro paid the regular tuition of $6,000 to the school. Based on this information, what is Pedro’s charitable contribution?a. $0.b. $800.c. $1,000.d. $6,800.e. $7,000.

ANS: BThe taxpayer’s donation of $1,000 in lieu of the normal $200 registration fee would be deductible to the extent of $800 [$1,000 – $200 benefit received (the registration fee)]. The tuition of $6,000 is a personal expense that cannot be deducted as a charitable contribution.

PTS: 1 REF: p. 10-20

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15. Emily, who lives in Indiana, volunteered to travel to Louisiana in March to work on a home-building project for Habitat for Humanity (a qualified charitable organization). She was in Louisiana for three weeks. She normally makes $500 per week as a carpenter’s assistant and plans to deduct $1,500 as a charitable contribution. In addition, she incurred the following costs in connection with the trip: $600 for transportation, $1,200 for lodging, and $400 for meals. What is Emily’s deduction associated with this charitable activity?a. $600.b. $1,200.c. $1,800.d. $2,200.e. $3,700.

ANS: DEmily cannot deduct the estimated value of $1,500 of her contributed services. However, she can deduct out-of-pocket costs of $2,200 ($600 for transportation, $1,200 for lodging, and $400 for meals).

PTS: 1 REF: p. 10-21

16. In 2007, Roseann makes the following donations to qualified charitable organizations:

Basis Fair Market ValueInventory held for resale in Roseann’s business (a sole proprietorship)

$3,000 $ 2,600

Stock in ABC, Inc. held as an investment (acquired two years ago)

6,000 15,000

Comic book collection held as an investment (acquired six years ago)

1,500 7,000

The ABC stock and the inventory were given to Roseann’s church, and the comic book collection was given to the United Way. Both donees promptly sold the property for the stated fair market value. Disregarding percentage limitations, Roseann’s charitable contribution deduction for 2007 is:a. $10,500.b. $19,100.c. $24,600.d. $25,000.e. None of the above.

ANS: BInventory is ordinary income property, but the fair market value ($2,600) must be used if lower than the basis ($3,000). Stock is intangible property and is not subject to the tangible personalty rules. Since a sale of the ABC stock would have yielded a long-term capital gain, the full fair market value qualifies for the deduction ($15,000). The comic book collection comes under the tangible personalty exception, and the adjusted basis ($1,500) must be used. Thus, $2,600 + $15,000 + $1,500 = $19,100.

PTS: 1 REF: p. 10-23 to 10-25

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17. Rosie owned stock in Acme Corporation that she donated to a university (a qualified charitable organization) on September 6, 2007. What is the amount of Rosie’s charitable contribution deduction assuming that she had purchased the stock for $20,100 on October 22, 2006, and the stock had a value of $28,200 when she made the donation?a. $8,100.b. $20,100.c. $24,150.d. $28,200.e. None of the above.

ANS: BIf ordinary income property is contributed to a qualified charitable organization, the deduction is equal to the fair market value of the property less the amount of ordinary income that would have been reported if the property were sold. In most instances, the deduction is limited to the adjusted basis of the property to the donor. Since she had not held the property long enough to meet the long-term capital gain requirement (October 22, 2006 - September 6, 2007), Rosie would have recognized a short-term capital gain of $8,100 if she had sold the property. Since short-term capital gain property is treated as ordinary income property for charitable contribution purposes, Rosie’s charitable contribution deduction is limited to the property’s adjusted basis of $20,100.


18. Karen, a calendar year taxpayer, made the following donations to qualified charitable organizations in 2007:

Basis Fair Market ValueCash donation to Indiana State University $30,000 $ 30,000Unimproved land to the city of Terre Haute, Indiana 70,000 210,000

The land had been held as an investment and was acquired 4 years ago. Shortly after receipt, the city of Terre Haute sold the land for $210,000. Karen’s AGI is $450,000. The allowable charitable contribution deduction is:a. $84,000 if the reduced deduction election is not made.b. $100,000 if the reduced deduction election is not made.c. $165,000 if the reduced deduction election is not made.d. $170,000 if the reduced deduction election is made.e. None of the above.

ANS: C$30,000 (cash) + $135,000 (30% $450,000 AGI) = $165,000. The long-term capital gain property is limited to 30% of $450,000 AGI, or $135,000. The carryover to the next five years is $75,000 [$210,000 (FMV of the land) – $135,000 (deduction allowed for 2007)]. If the reduced deduction election is made, the deduction becomes $100,000 [$30,000 (cash) + $70,000 (basis of land)].

PTS: 1 REF: p. 10-24 to 10-26 | Example 35 | Example 36

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19. Pat died in 2007. Before she died, Pat gave 5,000 shares of stock in Coyote Corporation (a publicly traded corporation) to her church (a qualified charitable organization). The stock was worth $180,000 and she had acquired it as an investment four years ago at a cost of $150,000. In the year of her death, Pat had AGI of $300,000. In completing her final income tax return, how much of the charitable contribution should Pat’s executor deduct?a. $90,000.b. $150,000.c. $180,000.d. $210,000.e. None of the above.

ANS: BUnder the general rule concerning long-term capital gain property, Pat’s executor could deduct $90,000 (30% of $300,000 AGI). The remaining $90,000 [$180,000 (fair market value of the Coyote Corporation stock) – $90,000 (current deduction)] would be lost because there is no five-year carryover period in Pat’s case.

Pat’s executor can, however, make the reduced deduction election, which moves the long-term capital gain property from the 30% limitation to the 50% limitation with no further carryover. To do so, the executor must forgo a deduction of the $30,000 appreciation [$180,000 (fair market value) – $150,000 (cost)] of the stock. Thus, the charitable contribution deduction on Pat’s final income tax return becomes $150,000 (50% of $300,000 AGI). By making the reduced deduction election, the charitable deduction on Pat’s final return is increased by $60,000 [$150,000 (allowed under the reduced deduction election) – $90,000 (allowed under the general rule)].


20. Roger is considering making a $3,000 investment in a venture that its promoter promises will generate immediate tax benefits for him. Roger, who does not anticipate itemizing his deductions, is in the 30% marginal income tax bracket. If the investment is of a type that produces a tax credit of 40% of the amount of the expenditure, by how much will Roger’s tax liability decline because of the investment?a. $0.b. $900.c. $1,100.d. $1,200.e. None of the above.

ANS: DThe tax credit reduces Roger’s tax liability by $1,200 ($3,000 40%).

PTS: 1 REF: p. 12-4 | Example 421. Refundable tax credits include the:

a. Foreign tax credit.b. Tax credit for rehabilitation expenses.c. Credit for certain retirement plan contributions.d. Earned income credit.e. None of the above.

ANS: D REF: Exhibit 12-1

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22. Which of the following best describes the treatment applicable to unused business credits?a. Unused amounts are carried forward indefinitely.b. Unused amounts are first carried back one year and then forward for 20 years.c. Unused amounts are first carried back one year and then forward for 15 years.d. Unused amounts are carried forward for five years.e. None of the above.

ANS: B REF: p. 12-6

23. Molly has generated general business credits over the years that have not been utilized. The amounts generated and not utilized follow:

2003 $ 5,0002004 15,0002005 10,0002006 8,000

In the current year, 2007, her business generates an additional $30,000 general business credit. In 2007, based on her tax liability before credits, she can utilize a general business credit of up to $40,000. After utilizing the carryforwards and the current year credits, how much of the general business credit generated in 2007 is available for future years?a. $0.b. $2,000.c. $23,000.d. $28,000.e. None of the above.

ANS: DTotal credit allowed in 2007 (based on tax liability) $40,000 Utilization of carryovers:

2003 $ 5,0002004 15,0002005 10,0002006 8,000 (38,000)

Remaining credit allowed: Utilization of current year credit $ 2,000

Carryover of unused current year general business creditGeneral business credit generated in 2007 $30,000 Applied against 2007 general business credit (2,000)Unused 2007 amount available for carry forward to 2008 $28,000


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24. Which of the following correctly describes the tax credit for rehabilitation expenditures?a. The cost of enlarging any existing business building is a qualifying expenditure.b. The cost of facilities related to the building (e.g., a parking lot) is a qualifying

expenditure.c. No recapture provisions apply.d. No credit is allowed for the rehabilitation of personal use property.e. None of the above.

ANS: D REF: p. 12-7 | p. 12-8

25. Several years ago, Shirley purchased a structure for $150,000 that was originally placed in service in 1929. Three and one-half years ago she incurred qualifying rehabilitation expenditures of $200,000. In the current year, Shirley sold the property in a taxable transaction. Calculate the amount of the recapture of the tax credit for rehabilitation expenditures.a. $0.b. $8,000.c. $12,000.d. $16,000.e. None of the above.

ANS: B$8,000 = 40%($200,000 10%). The structure was held for more than 3 years but less than 4 years.

PTS: 1 REF: Table 12-1 | Example 1026. Black Company paid wages of $180,000, of which $40,000 was qualified wages for the

work opportunity tax credit under the general rules. Black Company’s deduction for wages for the year is:a. $140,000.b. $164,000.c. $166,000.d. $180,000.e. None of the above.

ANS: B$164,000 = [$180,000 – ($40,000 40%)].


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27. In March 2007, Gray Corporation hired two individuals, both of whom were certified as long-term recipients of family assistance benefits. Each employee was paid $11,000 during 2007. Only one of the individuals continued to work for Gray Corporation in 2008, earning $9,000 during the year. No additional workers were hired in 2008. Gray Corporation’s work opportunity tax credit amounts for 2007 and 2008 are:a. $4,000 in 2007, $4,000 in 2008.b. $8,000 in 2007, $4,500 in 2008.c. $8,000 in 2007, $5,000 in 2008.d. $8,000 in 2007, $9,000 in 2008.e. None of the above.

ANS: BThe maximum work opportunity tax credit in this case is 40% of the first $10,000 of qualified wages per employee paid in the first year of employment, plus 50% of the first $10,000 of qualified wages per employee paid in the second year of employment. Therefore, the 2007 credit amount is $8,000 (40% $10,000 wages 2 employees), while the 2008 credit amount is $4,500 (50% $9,000 wages 1 employee).

PTS: 1 REF: p. 12-10 | Example 1328. Which, if any, of the following correctly describes the research activities credit?

a. The research activities credit is the greater of the incremental research credit, the basic research credit, or the energy research credit.

b. If the research activities credit is claimed, no deduction is allowed for research and experimentation expenditures.

c. The credit is not available for research conducted outside the United States.d. All corporations qualify for the basic research credit.e. None of the above.

ANS: CThe research activities credit is the sum of the incremental research credit, the basic research credit, and the energy research credit (option a.). Qualifying expenditures not only are eligible for the credit, they also can be expensed in the year incurred (option b.). S corporations and personal service corporations do not qualify for the basic research credit (option d.).

PTS: 1 REF: p. 12-10 to 12-12

29. Green Company, in the renovation of its building, incurs $8,000 of expenditures that qualify for the disabled access credit. The disabled access credit is:a. $7,750.b. $4,000.c. $3,875.d. $3,750.e. None of the above.

ANS: C$3,875 = ($8,000 – $250) 50%.

PTS: 1 REF: p. 12-13

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30. Rex and Dena are married and have two children, Michelle (age 7) and Nancy (age 5). During 2007, Rex earned a salary of $20,000, received interest income of $200, and filed a joint income tax return. Dena had $0 gross income. Their earned income credit for the year is:a. $0.b. $592.c. $4,124.d. $4,716.e. None of the above.

ANS: CMaximum earned income credit ($11,790 40%) $4,716 Less: Phaseout [($20,200 – $17,390) 21.06%] (592)Allowable earned income credit $4,124

PTS: 1 REF: p. 12-15 and 12-16 | Table 12-2

31. Cheryl is single, has one child (age 6), and files as head of household during 2007. Her salary for the year is $19,000. She qualifies for an earned income credit of the following amount:a. $0.b. $577.c. $2,276.d. $2,853.e. None of the above.

ANS: CMaximum earned income credit ($8,390 34%) $2,853 Less: Phaseout [($19,000 – $15,390) 15.98%] (577)Allowable earned income credit $2,276

PTS: 1 REF: p. 12-15 and 12-16 | Table 12-2

32. Barry and Susan, who are married and file a joint return, have one child, George. During 2007, Barry earned a salary of $26,000 and they received interest income of $200. Their earned income credit for the year is:a. $0.b. $1,408.c. $1,445.d. $2,853.e. None of the above.

ANS: CMaximum earned income credit ($8,390 34%) $2,853 Less: Phaseout [($26,200* – $17,390) 15.98%] (1,408)Allowable earned income credit $1,445

* The greater of earned income ($26,000) or AGI ($26,200).PTS: 1 REF: p. 12-15 and 12-16 | Table 12-2

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33. George and Jill are husband and wife, ages 67 and 65 respectively. During the year, they receive Social Security benefits of $4,000 and have adjusted gross income of $11,000. Assuming they file a joint return, their tax credit for the elderly, before considering any possible limitation due to their tax liability, is:a. $1,125.b. $750.c. $450.d. $375.e. None of the above.

ANS: C$7,500 (base amount) – $4,000 (Social Security benefits) – $500 (one-half of adjusted gross income in excess of $10,000) = $3,000 15% = $450.


34. During the year, Purple Corporation (a U.S. Corporation) has U.S.-source income of $900,000 and foreign income of $300,000. The foreign-source income generates foreign income taxes of $100,000. The U.S. income tax before the foreign tax credit is $408,000. Purple Corporation’s foreign tax credit is:a. $75,000.b. $100,000.c. $102,000.d. $136,000.e. None of the above.

ANS: BThe overall limitation is [($300,000/$1,200,000) $408,000], or $102,000. However, the foreign tax credit cannot exceed the amount of foreign taxes paid ($100,000).


35. In 2006, Juan and Juanita incur $7,200 in legal and adoption fees directly related to the adoption of an infant son born in a nearby state. Over the next year, they incur another $4,300 of adoption expenses. The adoption becomes final in 2007. Which of the following choices properly reflects the amounts and years in which the adoption expenses credit is available.

2006 2007a. $7,200 $ 4,300b. None $10,960c. None $11,500d. $7,000 $ 4,390e. None of the above.

ANS: EFor qualifying adoption expenses paid or incurred in a tax year prior to the year when the adoption is finalized, the adoption expenses credit must be claimed in the year following the year the expense is paid. Also, the total amount of the credit cannot exceed $11,390 in 2007. Thus, the adoption expenses credit is $11,390 in 2007.


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36. Which of the following statements regarding the adoption expenses credit is not true?a. The adoption expenses credit is a nonrefundable credit.b. The adoption expenses credit starts to be phased out in 2007 beginning when a

taxpayer’s modified AGI exceeds $170,820.c. No adoption expenses credit is a available in 2007 if a taxpayer’s modified AGI exceeds

$210,820.d. The adoption expenses credit is limited to no more than $10,000 per eligible child in

2007.e. All of the above statements are true.

ANS: DIn 2007, the credit is limited to no more than the indexed amount of $11,390, not $10,000.

PTS: 1 REF: p. 12-20

37. Caleb and Zoe are married and file a joint tax return claiming their two children, ages 10 and 8 as dependents. Assuming their AGI is $118,200, Caleb and Zoe’s child tax credit is:a. $0.b. $450.c. $1,550.d. $2,000.e. None of the above.

ANS: CThe maximum child tax credit is $1,000 per dependent child under age 17. The maximum credit must be reduced for higher-income taxpayers. For married taxpayers, the credit reduction is $50 for every $1,000 (or part thereof) of AGI above the threshold amount $110,000, resulting in a reduction of $450 [($118,200 – $110,000)/$1,000 (rounded to 9) $50] for Caleb and Zoe. Therefore, the child tax credit is $1,550 ($2,000 maximum credit – $450 reduction).


38. Tom, unmarried, pays Heloise (a housekeeper) $4,900 to care for his physically incapacitated mother so that he can be gainfully employed. He has AGI of $40,000 and claims his mother as a dependent. Tom may claim a credit for child and dependent care expenses of: a. $0.b. $660.c. $1,050.d. $1,078.e. None of the above.

ANS: B$660 = 22% $3,000.

PTS: 1 REF: p. 12-21 | p. 12-22

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39. Which of the following statements concerning the credit for child and dependent care expenses is not correct?a. A taxpayer is not allowed both an exclusion from income and the credit for child and

dependent care expenses on the same amount.b. A taxpayer is not allowed both a deduction as a medical expense and the credit for child

and dependent care expenses on the same amount.c. If a taxpayer’s adjusted gross income exceeds $43,000, the rate for the credit for child

and dependent care expenses is 20%.d. If a taxpayer’s adjusted gross income exceeds $15,000 but is less than $17,000, the rate

for the credit for child and dependent care expenses is 35%.e. All of the above are correct.

ANS: DIf AGI exceeds $15,000, the credit is less than 35%.

PTS: 1 REF: p. 12-22

40. Jermaine and Kesha are married, file a joint tax return, have AGI of $75,000, and have two children. Devona is beginning her freshman year at State University during Fall 2007, and Arethia is beginning her senior year at Northeast University during Fall 2007 after having completed her junior year during the spring of that year. Both Devona and Arethia are claimed as dependents on their parents’ tax return. Devona’s qualifying tuition expenses and fees total $3,500 for the fall semester, while Arethia’s qualifying tuition expenses and fees total $5,250 for each semester during 2007. Full payment is made for the tuition and related expenses for both children during each semester. The HOPE scholarship and lifetime learning credits available to Jermaine and Kesha for 2007 are:

HOPE scholarship credit Lifetime learning credita. $1,650 $1,050b. $1,650 $2,000c. $2,250 $2,625d. $2,250 $5,250e. None of the above.

ANS: BThe HOPE scholarship credit is available for Devona since she is in her first two years of postsecondary education. Arethia’s expenses are eligible for the lifetime learning credit since she is beyond the first two years of post-secondary education. Therefore, the available credit amounts are $1,650 [(100% $1,100) + (50% $1,100)] for the HOPE scholarship credit and $2,000 for the lifetime learning credit (20% $10,000). No reduction for income level is required. The credit phase-out for higher-income taxpayers begins at an AGI level of $94,000 for married taxpayers filing joint returns.


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41. Bob and Sally are married, file a joint tax return, have AGI of $110,000, and have two children. Del is beginning her freshman year at State College during Fall 2007, and Owen is beginning his senior year at Southwest University during Fall 2007. Owen completed his junior year during the Spring semester of 2006 (i.e., he took a “leave of absence” during the 2006-2007 school year). Both Del and Owen are claimed as dependents on their parents’ tax return. Del’s qualifying tuition expenses and fees total $4,500 for the Fall semester, while Owen’s qualifying tuition expenses were $4,200 for the Fall 2007 semester. Del’s room and board costs were $2,750 for the Fall semester. Owen did not incur room and board costs since he lived with his aunt and uncle during the year. Full payment is made for the tuition and related expenses for both children at the beginning of each semester. In addition to the children’s college expenses, Bob also spent $2,500 on professional education seminars during the year in order to maintain his license as a practicing dentist. Bob attended the seminars during July and August 2007. Compute the available education tax credits for Bob and Sally for 2007.a. $598.b. $2,392.c. $2,840.d. $2,990.e. None of the above.

42. Realizing that providing for a comfortable retirement is up to them, Jim and Julie commit to making regular contributions to their IRAs, beginning this year. Consequently, they each make a $2,000 contribution to their traditional IRA. If their AGI is $35,000 on their joint return, what is the amount of their credit for certain retirement plan contributions?a. $2,000.b. $800.c. $400.d. $200.e. None of the above.

ANS: CThe available credit for taxpayers reporting AGI of $35,000 on a joint return is limited to 10% times up to $2,000 for each eligible individual who makes a contribution. Therefore, the credit is equal to $400 [10% ($2,000 2)].

PTS: 1 REF: Example 3443. Recognized gains and losses must be properly classified. Proper classification depends upon

three characteristics. Which of the following is not one of those three characteristics?a. The tax status of the property.b. The manner of the property’s acquisition.c. The manner of the property’s disposition.d. The holding period of the property.e. All of the above.

ANS: BThe manner of the property’s acquisition generally has no impact on classification of the recognized gain or loss.

PTS: 1 REF: p. 14-3

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44. An individual taxpayer owns a landscape painting. The painting would not be a capital asset if it was held by the taxpayer in which of the following circumstances?a. It is used in his business and is depreciable property.b. It is personal use activity property for the taxpayer and he did not create it or receive it

by gift from someone who did create it.c. It is investment use activity property for the taxpayer and he did not create it or receive

it by gift from someone who did create it.d. It is held as inventory by the taxpayer.e. a. and d.

ANS: EIf the property is depreciable, it is used in a business and is not a capital asset (option a.). If the property is inventory, the taxpayer is in the business of buying and selling paintings and the painting is an ordinary asset (option d.). Personal use activity and investment activity assets are capital assets as long as the taxpayer’s efforts did not create the painting or the taxpayer did not receive the painting by gift from the creator of the painting (options b. and c.).

PTS: 1 REF: p. 14-4

45. Jeremiah is a dealer in securities. He would like to acquire and hold stock as a capital asset, then sell it to get a capital gain or loss. Which of the statements below is correct?a. Since he is a dealer, he cannot hold stock as a capital asset.b. Since he is a dealer, all the stock he acquires is a capital asset.c. Losses are capital losses if at any time the stock has been clearly identified by Jeremiah

as held for investment.d. If Jeremiah clearly identifies the stock as held for investment by the close of business on

the acquisition date, gain from the stock’s sale will be capital gain.e. c. and d.

ANS: EGenerally, stock acquired by a securities dealer is an ordinary asset because the stock is the dealer’s inventory. However, if the dealer designates the stock by the end of the business day of its acquisition as an investment, gain from disposition of the stock can be capital gain (option d.). Designating the stock as an investment at any time before selling it is sufficient to characterize the loss as a capital loss (option c.).

PTS: 1 REF: p. 14-7

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46. Rea is a songwriter. She wrote a song, copyrighted it, and sold it for $10,000 cash after holding the copyright for 14 months. The song had a zero tax basis. The purchaser was a national song brokerage company. Rea is not in the business of songwriting. The $10,000 received by Rea is:a. Long-term capital gain if she elects to treat the copyright as a capital asset.b. Short-term capital gain no matter what is the holding period.c. Ordinary gain because the song is treated as inventory.d. Long-term capital gain if she elects not to treat the copyright as a capital asset.e. None of the above.

ANS: ANormally, the song creator does not have a capital asset. However, under § 1221(b)(3), the creator of a song may elect to have the copyright treated as a capital asset, not elect not to have it treated as a capital asset (options a. and d.). There is no rule automatically making the gain on the song copyright short-term capital gain (option b.). Since Rea is not in the business of creating songs, the song copyright is not inventory (option c.).

PTS: 1 REF: p. 14-4 | p. 14-5

47. Sam operates a variety store as a sole proprietorship. Which of the following items are capital assets in the hands of Sam?a. The vacant lot next to his store that was purchased for use as a parking lot for his

customers.b. Sixteen bicycles that have been in his inventory for over a year.c. A note receivable that was given to him by a customer in payment of the balance due on

the customer’s account at the store.d. A corporate bond in which Sam invested some of the store’s excess cash.e. None of the above.

ANS: DSection 1221 excludes all of the listed items from being capital assets except the bond.

PTS: 1 REF: p. 14-3 | p. 14-4

48. Julia purchased vacant land in 2006 that she subdivided for resale as lots. All 10 of the lots were sold during 2007. The lots had a tax basis of $3,000 each and sold for $45,000 each. Julia made no substantial improvements to the lots. She acted as her own real estate broker; so there were no sales expenses for selling the lots. Which of the following statements is correct?a. Julia must hold the lots for at least five years before she is eligible for the special capital

gain treatment of § 1237.b. Some of the gain from the sale of the ten lots is long-term capital gain.c. All of the gain from the sale of the ten lots is long-term capital gain.d. To be eligible for the special capital gain treatment of § 1237, Julia must be a real estate

dealer.e. None of the above.

ANS: AJulia must hold the land at least five years to be eligible for § 1237 treatment and must not be a dealer in lots. Since Julia does not satisfy this requirement, all of the gain is ordinary income.

PTS: 1 REF: p. 14-7

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49. A worthless security had a holding period of 11 months when it became worthless on November 10, 2007. The investor who had owned the security had a basis of $10,000 for it. Which of the following statements is correct?a. The investor has a long-term capital loss of $10,000.b. The investor has a short-term capital loss of $10,000.c. The investor has a nondeductible loss of $10,000.d. The investor has a long-term capital gain of $10,000.e. None of the above.

ANS: ASection 165(g)(1) provides that if a security becomes worthless during the tax year, the loss is treated as if it occurred on the last day of the tax year. On the last day of the tax year, the security would have been held for more than a year.

PTS: 1 REF: p. 14-9

50. Sylvia purchased for $1,610 a $2,000 bond when it was issued two years ago. Sylvia amortized $200 of the original issue discount and then sold the bond for $1,800. Which of the following statements is correct?a. Sylvia has $10 of long-term capital loss.b. Sylvia has $190 of long-term capital gain.c. Sylvia has no capital gain or loss.d. Sylvia has $190 of long-term capital loss.e. None of the above.

ANS: ASylvia’s original basis of $1,610 is increased by the $200 of original issue discount amortization. Her basis is $1,810 when she sells the bond for $1,800; so her loss is $10 and is long term.

PTS: 1 REF: p. 14-9

51. On July 1, 2007, Brandon purchased an option to buy 1,000 shares of General, Inc. at $30 per share. He purchased the option for $2,000. It was to remain in effect for five months. The market experienced a decline during the latter part of the year, so Brandon decided to let the option lapse as of December 1, 2007. On his 2007 tax return, what should Brandon report?a. A $2,000 long-term capital loss.b. A $2,000 short-term capital loss.c. A $2,000 § 1231 loss.d. A $2,000 ordinary loss.e. None of the above.

ANS: BThe lapse of the option is treated as a sale or exchange by § 1234(a)(2). Therefore, a short-term capital loss of $2,000 is recognized.

PTS: 1 REF: Concept Summary 14-1

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52. Which of the following events causes the purchaser of an option to add the cost of the option to the basis of the property to which the option relates?a. The option is exercised.b. The option is sold.c. The option lapses.d. The option is rescinded.e. None of the above.

ANS: AIf the option is exercised, the cost of the option becomes part of the basis of the property. Otherwise, the lapse of the option is treated as a sale or exchange.

PTS: 1 REF: p. 14-10

53. Harold is a mechanical engineer and, while unemployed, invents a switching device for computer networks. He patents the device, but does not reduce it to practice. Harold has a zero tax basis for the patent. In consideration of $300,000 plus a $1 royalty per device sold, Harold assigns the patent to a computer manufacturing company. Harold assigned all substantial rights in the patent. Which of the following is correct?a. Harold automatically has long-term capital gain from the lump sum payment, but not

from the royalty payments.b. Harold automatically has long-term capital gain from the royalty payments, but not from

the lump sum payment.c. Harold automatically has long-term capital gain from both the lump sum payment and

the royalty payments.d. Harold does not have automatic long-term capital gain from either the lump sum

payment or the royalty payments.e. None of the above.

ANS: CSince Harold meets the definition of a holder, he receives automatic long-term capital gain treatment for both the lump sum payment and the royalty payments.

PTS: 1 REF: p. 14-11 | p. 14-12

54. Blue Company signs a 12-year franchise agreement with Fast Taco. Fast Taco retained significant powers, rights, and a continuing interest. Blue (the franchisee) makes noncontingent payments of $15,000 per year for the first five years of the franchise. Blue Company also pays a contingent fee of 2% of gross sales every month. Which of the following statements is correct?a. Blue Company may deduct the $15,000 per year noncontingent payments in full as they

are made.b. Blue Company may deduct the monthly contingent fee as it is paid.c. Blue Company may deduct both the noncontingent annual fee and the contingent

monthly fees as they are paid.d. Blue Company may not deduct either the noncontingent annual fee or the contingent

monthly fees as they are paid.e. None of the above.

ANS: BThe contingent payments are deductible as they are made. The noncontingent payments must be capitalized and amortized over 15 years.

PTS: 1 REF: p. 14-12 | p. 14-13

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55. Which of the statements below concerning sports franchises (e.g., the Detroit Tigers) is correct?a. Sports franchises are subject to the franchise rules of § 1253.b. Player contracts are usually one of the major assets acquired with a sports franchise.c. Player contracts are amortizable over 15 years.d. All of the above.e. None of the above.

ANS: DSports franchises are subject to the rules of § 1253 that apply to franchises generally. Under those rules, the franchise and other intangible assets acquired along with the franchise are 15-year § 197 intangibles. Therefore, the player contracts are amortized over 15 years even though the contracts may be for a shorter period.

PTS: 1 REF: p. 14-13 | p. 14-14 | Concept Summary 14-2

56. Virgil was leasing an apartment from Mauve, Inc. Mauve paid Virgil $1,000 to cancel his lease and move out so that Mauve could demolish the building. As a result:a. Virgil has a $1,000 capital gain.b. Virgil has a $1,000 capital loss.c. Mauve has a $1,000 capital loss.d. Mauve has a $1,000 capital gain.e. None of the above.

ANS: ASince the apartment was Virgil’s personal residence, the lease on the apartment was a capital asset because all personal use assets are capital assets. Virgil has a zero basis for the lease. Therefore, the entire payment is capital gain. Whether the gain is long term or short term depends upon how long Virgil has held the lease. Mauve has an ordinary deduction of $1,000.

PTS: 1 REF: p. 14-14 | p. 14-15

57. Magenta, Inc. sold a forklift on February 12, 2007, for $3,000 (its FMV) to its 100% shareholder, Anise. Magenta’s adjusted basis for the forklift was $7,000. Anise’s holding period for the forklift:a. Includes Magenta’s holding period for the forklift.b. Begins on February 12, 2007.c. Begins on February 13, 2007.d. Does not begin until Anise sells the forklift.e. None of the above.

ANS: CWhen a loss is disallowed in a related party transaction, there is no carryover of holding period. Magenta has a $4,000 realized loss on the sale of the forklift to Anise and the loss is disallowed because Anise is a related taxpayer. Anise’s holding period begins on the day after the property is acquired.

PTS: 1 REF: p. 14-16

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58. Harry inherited a residence from his mother when she died. The mother had a tax basis of $566,000 for the residence when she died and the residence was worth $433,000 at the date of her death. Which of the statements below is correct?a. Harry’s holding period for the residence includes his mother’s holding period for the

residence.b. Harry’s holding period for the residence does not include his mother’s holding period

for the residence.c. Harry’s holding period for the residence is automatically long term.d. b and ce. None of the above.

ANS: DHarry has an automatic long-term holding period because the residence is inherited property. Therefore, his holding period does not include his mother’s holding period for the residence.

PTS: 1 REF: p. 14-16

59. Which of the following is correct concerning short sales of stock?a. At the time the short sale is made, the taxpayer does not deliver to the purchaser the

shares sold short.b. At the time the short sale is made, the taxpayer delivers to the purchaser the shares sold

short.c. At the time the short sale is made, the taxpayer may already own the shares sold short.d. At the time the short sale is made, the taxpayer always already owns the shares sold

short.e. None of the above.

ANS: BA short sale occurs when a taxpayer sells borrowed property and repays the lender with substantially identical property either held on the date of the sale or purchased after the date of the sale.

PTS: 1 REF: p. 14-16

60. In 2007, Mark has $14,000 short-term capital loss, $6,000 28% gain, and $7,000 5%/15% gain. Which of the statements below is correct?a. Mark has a $1,000 capital loss deduction.b. Mark has a $3,000 capital loss deduction.c. Mark has a $1,000 net capital gain.d. Mark has a $6,000 net capital gain.e. Mark has a $14,000 net capital loss.

ANS: AThere is a net short-term capital loss of $1,000 ($14,000 short-term capital loss – $6,000 28% gain – $7,000 5%/15% gain) which is deductible for AGI as a capital loss deduction.

PTS: 1 REF: p. 14-20

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61. In 2006, Jenny had a $14,000 net short-term capital loss and deducted $3,000 as a capital loss deduction. In 2007, Jenny has a $18,000 5%/15% long-term capital gain and no other capital gain or loss transactions. Which of the statements below is correct?a. Jenny has a 2007 $18,000 net capital gain.b. Jenny has a 2007 $7,000 net capital gain.c. Jenny has a 2007 $7,000 net capital loss.d. Jenny has a 2007 $3,000 capital loss deduction.e. Jenny has a 2007 $7,000 capital loss deduction.

ANS: BThe 2006 capital loss carryforward is $11,000 ($14,000 2006 net capital loss – 2006 $3,000 capital loss deduction). The $11,000 carries forward as a short-term capital loss and is offset against the $18,000 long-term capital gain.

PTS: 1 REF: p. 14-22

62. In 2007, Satesh has $4,000 short-term capital loss, $14,000 5%/15% long-term capital gain, and $7,000 qualified dividend income. Satesh is single and has other taxable income of $15,000. Which of the following statements is correct?a. No more than $14,000 of Satesh’s taxable income is taxed at 5%.b. No more than $7,000 of Satesh’s taxable income is taxed at 5%.c. No more than $17,000 of Satesh’s taxable income is taxed at 5%.d. None of Satesh’s taxable income is taxed at 5%.e. All of Satesh’s taxable income is taxed at 5%.

ANS: CThe net long-term capital gain is $10,000 ($14,000 5%/15% long-term capital gain – $4,000 short-term capital loss). The $7,000 qualified dividend income is added to the 5%/15% net long-term capital gain and the $17,000 total is eligible for the 5%/15% alternative tax rate.


63. Corrine is filing as head of household and has 2007 taxable income of $38,000 which includes $24,000 of 5%/15% gain. What is the tax on her taxable income using the alternative tax method?a. $1,200.b. $2,740.c. $3,300.d. $5,700.e. None of the above.

ANS: BSince Corrine’s total taxable income does not take her out of the 15% regular tax bracket, all of the $24,000 5%/15% gain is taxed at 5%. The total tax is $2,740 ($1,540 on $14,000 regular taxable income + 5% of $24,000 long-term capital gain).

PTS: 1 REF: p. 14-23 | p. 14-24

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64. Sam is filing as single and has 2007 taxable income of $48,000 which includes $23,000 of 5%/15% gain. What is the tax on his taxable income using the alternative tax method?a. $12,000.b. $6,125.c. $6,809.d. $4,386.e. None of the above.

ANS: BSam’s taxable income takes him out of the 15% regular tax bracket, but his regular taxable income does not. Therefore, a portion of the 5%/15% gain is taxed at 5% and a portion is taxed at 15%. His total tax is $6,125 {$3,359 tax on $25,000 regular taxable income ($48,000 – $23,000) + [($31,850 end of single 15% bracket – $25,000) .05] + [($48,000 – $31,850) .15]}.

PTS: 1 REF: p. 14-24

65. For 2007, Ryan (a single person) has $35,000 net capital gain (all 5%/15% gain). His taxable income is $185,000. Which of the following is correct?a. The net capital gain will be subject to special tax treatment.b. Ryan’s taxable income without the net capital gain will be taxed at greater than 25%.c. The tax rate on the net capital gain cannot exceed 15%.d. All of the above.e. None of the above.

ANS: DThe net capital gain is subject to special tax treatment. The taxable income without the net capital gain puts Ryan in the 28% bracket. The net capital gain is taxed at no greater than 15%.

PTS: 1 REF: p. 14-24

66. Which of the following comparisons is correct?a. Corporations may carryback capital losses; individuals may not.b. Both corporation and individual long-term capital losses carryover as short-term capital

losses.c. Corporations may carryforward capital losses indefinitely; individuals may only

carryforward capital losses for five years.d. Both corporations and individuals may use an alternative tax rate on net capital gains.e. None of the above.

ANS: ACorporations may carryback capital losses; individuals may not (a). Individual long-term capital losses carryover as long-term, not short-term. Corporations have a five-year carryforward limit; individuals may carryforward capital losses indefinitely. Corporations’ alternative tax rate on long-term capital gains is 35%, not 20%.

PTS: 1 REF: p. 14-26 | p. 14-28

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67. Tan, Inc., has a 2007 $50,000 long-term capital gain included in its $185,000 taxable income. Which of the following is correct?a. Tan will benefit from an alternative tax on net capital gains computation.b. Tan’s regular tax on taxable income will be the same as its tax using an alternative tax

on net capital gains approach.c. Tan’s $50,000 net capital gain is not taxable.d. Tan’s regular tax on taxable income will be greater than its tax using an alternative tax

on net capital gain approach.e. None of the above.

ANS: BAlthough there is an alternative tax on net capital gains for corporations, it yields the same tax result as the regular computation method. This unusual result is caused by the fact that the alternative tax rate and the maximum regular tax rate are both 35%.

PTS: 1 REF: p. 14-28

68. Green Company acquires a new machine for use in its manufacturing operations, places it in service, but then discovers that it is not suitable for Green’s business. Consequently, Green sells the machine 10 months after it was acquired. There is a $10,000 loss on the disposition. When the machine was disposed of, it was:a. A capital asset.b. An ordinary asset.c. An inventory asset.d. A § 1231 asset.e. None of the above.

ANS: BThe machine was depreciable property used in a business and held one year or less; so it was an ordinary asset.

PTS: 1 REF: p. 14-30

69. Which of the following assets held by a manufacturing business is not a § 1231 asset?a. Inventory.b. A machine used in the business and held more than one year.c. A factory building used in the business and held more than one year.d. Land used in the business and held more than one year.e. All of the above.

ANS: AInventory is an ordinary asset.

PTS: 1 REF: p. 14-31

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70. Which of the following assets held by a cash basis law firm is not a § 1231 asset?a. An account receivable from a client.b. A computer used in the business and held more than one year.c. An office building used in the business and held more than one year.d. A desk used in the business and held more than one year.e. All of the above.

ANS: AAn account receivable is an ordinary asset.

PTS: 1 REF: p. 14-31

71. A machine held more than one year and used in a business is destroyed in a fire. The machine was not insured. So there is a loss from its destruction. Which of the statements below is correct concerning these facts?a. The machine was a long-term nonpersonal use asset.b. The machine was a long-term personal use asset.c. The loss is not usable.d. The loss is subject to special netting rules.e. a and d

ANS: EProperty used in a business is a nonpersonal use asset and the loss due to casualty is subject to a special netting rule for nonpersonal use property casualty gains and losses.

PTS: 1 REF: p. 14-31 | p. 14-32

72. Vertigo, Inc., has a 2007 net § 1231 loss of $45,000 and had a $22,000 net § 1231 gain in 2006. For 2007, Vertigo’s net §1231 loss is treated as:a. Ordinary loss.b. Ordinary gain.c. Capital loss.d. Capital gain.e. None of the above.

ANS: ASince there is a 2007 net § 1231 loss, the loss is treated as an ordinary loss.

PTS: 1 REF: p. 14-33

73. Vertical, Inc., has a 2007 net § 1231 gain of $45,000 and had a $22,000 net § 1231 loss in 2006. For 2007, Vertical’s net § 1231 gain is treated as:a. $23,000 long-term capital gain and $22,000 ordinary loss.b. $45,000 ordinary gain.c. $23,000 long-term capital gain and $22,000 ordinary gain.d. $45,000 capital gain.e. None of the above.

ANS: CThe 2006 § 1231 loss is a lookback loss and converts $22,000 of the 2007 net § 1231 gain into ordinary gain. The $23,000 remaining of the $45,000 2007 net § 1231 gain is treated as long-term capital gain.

PTS: 1 REF: p. 14-33 | p. 14-34

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74. Verway, Inc, has a 2007 net § 1231 gain of $45,000 and had a $52,000 net § 1231 loss in 2006. For 2007, Verway’s net § 1231 gain is treated as:a. $45,000 ordinary loss.b. $45,000 ordinary gain.c. $45,000 capital loss.d. $45,000 capital gain.e. None of the above.

ANS: BSince the 2007 $45,000 net § 1231 gain is less than the $52,000 2006 § 1231 lookback loss, the entire $45,000 is treated as ordinary gain.

PTS: 1 REF: p. 14-33 | p. 14-34

75. The following assets in Jack’s business were sold in 2007:

Asset Holding Period Gain/(Loss)Office Equipment 6 years $1,100Automobile 8 months ($ 800)ABC Stock (capital asset) 2 years $1,400

The office equipment had a zero adjusted basis and was purchased for $8,000. The automobile was purchased for $2,000 and sold for $1,200. The ABC stock was purchased for $1,800 and sold for $3,200. In 2007 (the year of sale), Jack should report what amount of net capital gain and net ordinary income?a. $1,700 LTCG.b. $600 LTCG and $300 ordinary gain.c. $1,400 LTCG and $300 ordinary gain.d. $2,500 LTCG and $800 ordinary loss.e. None of the above.

ANS: CThe sale of the office equipment results in a $1,100 § 1245 gain. The sale of the auto results in an ordinary loss of $800 because the auto was not held for the long-term holding period. The § 1245 gain of $1,100 offsets the $800 ordinary loss for a net ordinary gain of $300. The sale of the stock results in a $1,400 LTCG.

PTS: 1 REF: p. 14-33 to 14-37

33

76. An individual had the following gains and losses during 2007 on property held for the long-term holding period: sale of Orange common stock ($8,000 gain); sale of real property used in the taxpayer’s business ($1,800 loss); destruction of real property used in the taxpayer’s business by fire ($1,000 loss). Which of the following is correct?a. The fire loss would reduce the real property sale loss.b. The fire loss would reduce the stock sale gain.c. The sale of real property loss would be netted against the stock sale gain.d. The sale of real property is a § 1231 loss.e. None of the above.

ANS: DThe sale of the Orange stock produces a $8,000 LTCG, which is fully includible in gross income. The real property sale results in a net §1231 loss of $1,800. The real property $1,000 fire loss is treated as an ordinary loss because there are no casualty gains against which it can be netted.

PTS: 1 REF: p. 14-33 to 14-37

77. Spencer has an investment in two parcels of vacant land. Parcel 1 is a capital asset and parcel 2 is a § 1231 asset. Spencer already has short-term capital loss for the year he would like to offset with capital gain. Spencer has § 1231 lookback loss that exceeds the gain from the disposition of either land parcel. Spencer only wants to sell one land parcel and each of them would yield the same amount of gain. The gain that would be recognized exceeds the short-term capital loss Spencer already has. Which of the statements below is correct?a. Spencer will have a net capital loss no matter which land parcel he sells.b. Spencer will have a net capital loss if he sells parcel 2.c. Spencer will have a net capital loss if he sells parcel 1.d. Spencer will have a net capital gain if he sells either parcel 1 or parcel 2.e. None of the above.

ANS: BSince parcel 2 is a § 1231 asset, its gain will be treated as ordinary income due to the § 1231 lookback and none of the gain will be treated as long-term capital gain. Thus, the existing short-term capital loss will not be offset by any gain and a net capital loss will result. Selling parcel 1 will yield a capital gain that will more than offset the existing short-term capital loss, resulting in a net capital gain.

PTS: 1 REF: p. 14-33 to 14-36

34

78. Copper Corporation sold machinery for $27,000 on December 31, 2007. The machinery had been purchased on January 2, 2004 for $30,000 and had an adjusted basis of $21,000 at the date of the sale. For 2007, what should Copper Corporation report?a. Ordinary income of $6,000.b. A § 1231 gain of $3,000 and $3,000 of ordinary income.c. A § 1231 gain of $6,000.d. A § 1231 gain of $6,000 and $3,000 of ordinary income.e. None of the above.

ANS: AThe recognized gain from the disposition of the machinery is $6,000 ($27,000 sale price – $21,000 adjusted basis). Since the recognized gain is less than the depreciation taken of $9,000 ($30,000 cost – $21,000 adjusted basis) and the asset is depreciable equipment used in a business, § 1245 depreciation recapture applies.

PTS: 1 REF: p. 14-37

79. Blue Company sold machinery for $55,000 on December 23, 2007. The machinery had been acquired on April 1, 2005 for $49,000 and its adjusted basis was $14,200. The § 1231 gain, § 1245 recapture gain, and § 1231 loss from this transaction are:a. $6,000 § 1231 gain, $34,800 § 1245 recapture gain, $0 § 1231 loss.b. $0 § 1231 gain, $40,400 § 1245 recapture gain, $0 § 1231 loss.c. $6,000 § 1231 gain, $40,400 § 1245 recapture gain, $0 § 1231 loss.d. $0 § 1231 gain, $40,400 § 1245 recapture gain, $14,200 § 1231 loss.e. None of the above.

ANS: ASince the machine was held more than 12 months and was depreciated, it was a § 1231 asset. Since it was sold at a gain and the selling price exceeded the original cost, all of the depreciation taken of $34,800 ($49,000 cost – $14,200 adjusted basis) is gain recaptured by § 1245 and the remaining $6,000 gain ($55,000 selling price – $49,000 original cost) is § 1231 gain.

PTS: 1 REF: p. 14-37

80. Red Company had an involuntary conversion on December 23, 2007. The machinery had been acquired on April 1, 2005 for $49,000 and its adjusted basis was $14,200. The machinery was completely destroyed by fire and Red received $10,000 of insurance proceeds for the machine and did not replace it. This was Red’s only casualty or theft event for the year. As a result of this event, Red initially has:a. $10,000 § 1231 loss.b. $10,000 § 1245 recapture gain.c. $4,200 casualty loss.d. $4,200 § 1231 loss.e. None of the above.

ANS: CSince the machine was held more than 12 months and was depreciated, it was a § 1231 asset. However, since it was disposed of at a $4,200 loss ($10,000 insurance proceeds – $14,200 adjusted basis), all of the loss is initially a casualty loss.

PTS: 1 REF: p. 14-39

35

81. Orange Company had machinery destroyed by a fire on December 23, 2007. The machinery had been acquired on April 1, 2005 for $49,000 and its adjusted basis was $14,200. The machinery was completely destroyed and Orange received $30,000 of insurance proceeds for the machine and did not replace it. This was Orange’s only casualty or theft event for the year. As a result of this event, Orange has:a. $4,200 ordinary loss.b. $15,800 § 1245 recapture gain.c. $14,200 § 1245 recapture gain.d. $30,000 § 1231 gain.e. None of the above.

ANS: BSince the machine was held more than 12 months and was depreciated, it was a § 1231 asset. However, since it was disposed of at a $15,800 gain ($30,000 insurance proceeds – $14,200 adjusted basis), all of the gain is initially § 1245 depreciation recapture gain and not casualty gain.

PTS: 1 REF: p. 14-38 | p. 14-39

82. Section 1250 property is:a. Depreciable real property.b. Depreciable intangible personal property.c. Depreciable tangible personal property.d. Inventory.e. None of the above.

ANS: ASection 1250 property is depreciable real property (principally buildings and their structural components).

PTS: 1 REF: p. 14-39

83. A business building owned by an individual is destroyed by fire. The building was depreciated using straight-line depreciation. The building was insured and the insurance proceeds exceeded the building’s adjusted basis. The building was not replaced. The insurance proceeds did not exceed the original cost of the building. The gain from disposition of the building is initially:a. Casualty gain.b. Casualty loss.c. Section 1231 gain.d. Section 1250 gain.e. None of the above.

ANS: AThere is no § 1250 depreciation recapture because straight-line depreciation was used. Since the disposition of the asset was by casualty and depreciation recapture does not apply, the initial characterization of the gain is casualty gain.

PTS: 1 REF: p. 14-31 | p. 14-40

36

84. Kari owns depreciable residential rental real estate which has accumulated depreciation (all from straight-line) of $45,000. If Kari sold the property, she would have a $33,000 gain. The initial characterization of the gain would be:a. Section 1245 gain.b. Section 1231 gain.c. Section 1250 gain.d. Section 1239 gain.e. None of the above.

ANS: BThe gain is § 1231 gain. Since straight-line depreciation was used, there is no § 1250 recapture. Also, since Kari is an individual, there is no “ordinary gain adjustment” under § 291. Section 1239 would not apply because there is no reason to conclude that the property would be sold to a related taxpayer.

PTS: 1 REF: p. 14-40 | p. 14-41 | p. 14-46

85. A retail building used in the business of a sole proprietor is sold on March 10, 2007, for $322,000. The building was acquired in 1997 for $400,000 and straight-line depreciation of $104,000 had been taken on the building. What is the maximum unrecaptured § 1250 gain from the disposition of this building?a. $400,000.b. $322,000.c. $104,000.d. $26,000.e. None of the above.

ANS: CThe maximum unrecaptured § 1250 gain is the $104,000 depreciation taken. That maximum is reduced to the $26,000 gain from the disposition [$322,000 sale price – ($400,000 cost – $104,000 depreciation taken)].

PTS: 1 REF: p.14-42 | p. 14-43

86. Which of the following statements is correct?a. When depreciable property is gifted to another individual taxpayer, the depreciation

recapture potential is extinguished.b. When depreciable property is inherited by a taxpayer, the depreciation recapture

potential is extinguished.c. When corporate depreciable property is distributed as a dividend, the depreciation

recapture potential is generally not recognized.d. When depreciable property is contributed to charity, the depreciation recapture potential

has no effect on the amount of the charitable contribution deduction.e. All of the above are correct.

ANS: BDepreciation recapture potential is extinguished when property is received as an inheritance, carries over when the property is received by gift, is recognized by the corporation when property is distributed by a corporation and a gain would have been recognized if the property had been sold, and reduces the charitable contribution deduction amount.

PTS: 1 REF: p. 14-44 to 14-46

37

87. Which of the following would extinguish the § 1245 recapture potential?a. An exchange of depreciable business equipment for like-kind business equipment with

gain realized, but not recognized.b. A nontaxable incorporation under § 351.c. A nontaxable contribution to a partnership under § 721.d. A nontaxable reorganization.e. None of the above.

ANS: EAll of the transactions involve a carryover of basis and do not extinguish the § 1245 depreciation recapture potential.

PTS: 1 REF: p. 14-45 | p. 14-46

88. Section 1239 (relating to the sale of certain property between related taxpayers) does not apply unless the property:a. Was depreciated by the transferor.b. Is depreciable in the hands of the transferee.c. Is a capital asset.d. Is real property.e. None of the above.

ANS: BSection 1239 produces the conversion of the transferor’s capital gain into ordinary income if the property is depreciable in the hands of the related transferee.

PTS: 1 REF: p. 14-46

89. An individual has a $10,000 § 1245 gain, a $15,000 § 1231 gain, a $13,000 § 1231 loss, a $4,000 § 1231 lookback loss, and a $15,000 long-term capital gain. The net long-term capital gain is:a. $30,000.b. $40,000.c. $17,000.d. $15,000.e. None of the above.

ANS: DNone of the § 1231 gain survives to be treated as long-term capital gain. $13,000 of the $15,000 § 1231 gain is absorbed by the $13,000 § 1231 loss and the remaining $2,000 is treated as ordinary gain because of the $4,000 § 1231 lookback loss. The $10,000 of § 1245 gain is ordinary income.

PTS: 1 REF: Concept Summary 14-8

38

90. Which of the following statements regarding a 52-53 week tax year is not correct?a. The year-end must be the same day of the week in all years.b. Some tax years will include more than 366 calendar days.c. Whether the particular tax year includes 52 weeks or 53 weeks is not elective.d. All of the above are correct.e. None of the above is correct.

ANS: DThe tax year-end must be the same day of the week in all years. Thus, a. is correct. With a 52-53 week year, 371 days (53 7) may be included in a tax year. Thus, b. is correct. Whether the tax year is 52 weeks or is 53 weeks is not elective. Thus, c. is correct.

PTS: 1 REF: p. 16-391. Gold Corporation and Silver Corporation are equal partners in the G&S Partnership, which

was formed on July 1, 2007. Gold uses a calendar tax year, and Silver’s tax year ends September 30. G&S is not a seasonal business.a. G&S must use a tax year ending June 30th.b. G&S must use a tax year ending December 31st.c. G&S must use a tax year ending September 30th.d. G&S may elect its tax year without regard to the partners’ tax years.e. None of the above.

ANS: CA tax year ending September 30th will result in the least aggregate deferral.

Year-endSeptember 30 .5 3 = 1.5December 31 .5 9 = 4.5

PTS: 1 REF: p. 16-4

92. In regard to choosing a tax year for a retail business owned by individuals, which form of business provides the greater number of options in regard to the tax year?a. The C corporation.b. The S corporation.c. The partnership.d. The limited liability company.e. All of the above have the same options.

ANS: AAnswer b. is incorrect because S corporations generally must use a calendar tax year. Answer c. and d. are incorrect because a specific sequence is provided for determining the tax year of partnerships (i.e., the limited liability company is normally taxed as a partnership): (1) majority interest partners, (2) principal partners, and (3) least aggregate deferral method.

PTS: 1 REF: p. 16-3 to 16-5

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93. In the case of a partnership whose partners all use a calendar year, a reason that is acceptable to the IRS for using a tax year ending June 30th would be:a. The accountant is already overburdened with calendar year tax returns and could not

timely file the partnership’s return.b. A December 31st inventory would be required if a calendar year was used, and the

employees do not want to work on New Year’s Eve.c. The company’s income does not fluctuate a great deal from year to year.d. The business has a natural business year that ends June 30th.e. None of the above.

ANS: DThe IRS has issued Revenue Ruling 87-57 to objectively determine the entity’s natural business year.

PTS: 1 REF: p. 16-5

94. Purple Corporation, a personal services corporation, adopted a fiscal year ending September 30th. The sole shareholder of the corporation is a calendar year taxpayer. During the fiscal year ending September 30, 2007, the shareholder-employee received $120,000 salary. The corporation paid the shareholder-employee a salary of $15,000 during the period beginning October 1, 2007 through December 31, 2007.a. The corporation salary expense for the fiscal year ending September 30, 2008 is limited

to $120,000.b. The corporation salary expense for the fiscal year ending September 30, 2008 is limited

to $135,000.c. The corporation salary expense for the fiscal year ending September 30, 2008 is limited

to $60,000.d. The corporation must switch to a calendar year.e. None of the above.

ANS: CThe corporation can deduct only the annualized amount paid in the period from October 1, 2007 through December 31, 2007 calculated as follows: $15,000 + $15,000[(12 – 3)/3] = $60,000.


40

95. In 2007, Godfrey received a $5,000 refund of his 2006 state income tax. He included the refund in his 2007 gross income in accordance with the tax benefit rule (i.e., because the state income tax had been deducted on his 2006 Federal income tax return). In 2008, Godfrey’s 2006 state income tax return was audited and he was required to pay an additional $4,000 of state income tax. Godfrey was in the 15% tax bracket in 2006 and 2007, but his marginal tax bracket in 2008 is 35%. He will itemize his deductions on his 2008 return.a. The $4,000 payment in 2008 is not deductible.b. Godfrey must amend his 2007 return.c. The $4,000 payment in 2008 will reduce his 2008 Federal income tax by $600 ($4,000

15%).d. Godfrey can reduce his 2008 Federal income tax by $1,400 ($4,000 35%).e. None of the above.

ANS: DThe tax year in which the $4,000 payment is made (2008) applies for the deduction even though the deduction is an adjustment to income taxed at a lower rate.


96. Which of the following is permitted to use the cash method of accounting?a. A retail business with average annual gross receipts of $800,000.b. A medical doctor with average annual gross receipts of $2,000,000.c. An insurance agency with average annual gross receipts of $2,000,000.d. All of the above are permitted to use the cash method.e. None of the above is permitted to use the cash method.

ANS: DGenerally, sales and cost of goods sold for the retail business must be reported by the accrual method because inventories are material. However, for a., the small business exception applies. Therefore, the retailer in a. can use the cash method. The cash method can be used in b. and c. because the medical doctor and insurance agency are service entities.

PTS: 1 REF: pp. 16-10 to 16-12

41

97. The accrual method generally must be used to report income:

I. From long-term construction contracts.II. Earned by a partnership with a corporate partner.III. Earned by an incorporated public accounting firm with gross receipts in excess of

$5,000,000.

a. All of the above are true.b. Only III is true.c. Only II and III are true.d. Only II is true.e. None of the above is true.

ANS: DI is not true because contractors may be required to use the completed contract method or the percentage of completion method. III is not true because a public accounting firm is a personal services corporation.

PTS: 1 REF: pp. 16-12 to 16-15

98. Which of the following must use the accrual method of accounting?

I. An incorporated property management company with average annual gross receipts of $50,000,000.

II. An incorporated law firm with average annual gross receipts of $1,200,000.III. An unincorporated grocery store with average annual gross receipts of $900,000.

a. All of the above must use the accrual method.b. None of the above must use the accrual method.c. Only I and III must use the accrual method.d. Only I must use the accrual method.e. Only III must use the accrual method.

ANS: DThe incorporated property management company must use the accrual method. The incorporated law firm is not required to use the accrual method under the small business exemption (average annual gross receipts are $5,000,000 or less). The grocery store can use the cash method under the small business exception (average annual gross receipts of $1,000,000 or less).

PTS: 1 REF: p. 16-12

42

99. In the case of an accrual basis taxpayer, an item of income:a. Is not recognized until cash is received.b. From services is never recognized until the services are performed.c. Is not recognized if the customer can return the goods.d. Is recognized when all the events have occurred to fix the taxpayer’s right to receive the

income and the amount of the income can be determined with reasonable accuracy.e. None of the above.

ANS: DAnswer b. is incorrect because prepaid income may be recognized before all of the services are performed.

PTS: 1 REF: p. 16-12

100. Ivory Fast Delivery Company, an accrual basis taxpayer, frequently has claims for damages to property the company delivered. Often the claim is not filed until a month after the delivery. In the past, approximately 80% of the claims are paid by Ivory. At the end of 2007, $15,000 in claims had been filed. The company refused to pay $4,000 of the claims, and paid the other $11,000 of claims in January 2008. Also, in January 2008, claims for $12,000 were filed for deliveries made in 2007, and $10,000 was paid on these claims by March 2008. Ivory has elected to use the recurring item exception to economic performance. Under the all-events test, Ivory can accrue as an expense for 2007:a. $11,000.b. $15,000.c. $23,000.d. $27,000.e. None of the above.

ANS: AThe all-events test is not satisfied until the customer makes a claim that Ivory acknowledged as a valid claim that it will pay. However, the $11,000 for actual claims filed in 2007 and paid in January 2008 can be deducted in 2007 under the recurring item exception. The claims filed in January 2008 for 2007 services cannot be deducted in 2007 because the claims had not be filed in 2007 and therefore, the all-events test was not satisfied by the end of 2007.

PTS: 1 REF: p. 16-13 | p. 16-14

43

101. Color Inc., is an accrual basis taxpayer. In December 2007, the company received a bill of $600 for office supplies that had been purchased and used in November. The bill was not paid until January 2008. Also in December 2007, the company received a claim from a customer for $500. The merchandise was defective and Color paid the customer in January 2008. In January 2008, the company received a claim for $900 for defective merchandise purchased in 2007. Color paid the customer the $900 in February 2008. Assuming Color uses the recurring item exception to economic performance, the company’s deductions for 2007 as a result of the above are:a. $500.b. $600.c. $1,100.d. $2,000.e. None of the above.

ANS: CThe all-events test was not satisfied in 2007 for the $900 claim for defective merchandise. The economic performance test was satisfied for the office supplies when they were delivered (i.e., the other party provided the property). The all-events test was satisfied in 2007 for the $500 customer claim and the economic performance test was also satisfied when the payment was made within 8 1/2 months after year end.

PTS: 1 REF: pp. 16-12 to 16-15

102. Pink Corporation is an accrual basis taxpayer that uses the recurring item exception to the economic performance test for all relevant years. For 2007, the corporation’s income subject to state income tax was $300,000 and the state corporate tax rate was 6%. During 2007, the corporation paid $15,000 on its state income tax liability for that year. The remaining $3,000 of 2007 state income tax was paid in March 2008. In March 2007, the corporation paid $4,000 on its year 2006 state income tax liability. As a result of the above:a. Pink should deduct $22,000 as state income taxes for 2007.b. Pink should deduct $19,000 as state income taxes for 2007.c. Pink should deduct $18,000 as state income taxes for 2007.d. Pink should deduct $15,000 as state income taxes for 2007.e. None of the above.

ANS: CPink can deduct $18,000 (6% $300,000) under the recurring item exception. The taxes are recurring; allowing the deduction will result in an accurate matching of revenues and expenses, and the taxes are paid within 8 1/2 months after the close of the tax year. The $4,000 paid in 2007 on 2006 taxes is deducted in 2006 under the recurring item exception.

PTS: 1 REF: p. 16-13 | p. 16-14

44

103. Gray Company, a calendar year taxpayer, allows customers to return defective merchandise for a full refund within 30 days of the purchase. In 2007, the company refunded $400,000 for claims involving sales. The $400,000 consisted of $350,000 in refunds from 2007 sales and $50,000 in refunds from 2006 sales. All of the refunds from 2006 sales were for claims filed in 2006 and were paid in January and February 2007. At the end of 2007, the company had $12,000 in refund claims for sales in 2007 for which payment had been approved. These claims were paid in January 2008. Also in January 2008, the company received an additional $30,000 in claims for sales in 2007. This $30,000 was paid by Gray in February 2008. With respect to the above, Gray can deduct:a. $350,000 in 2007.b. $362,000 in 2007.c. $392,000 in 2007.d. $442,000 in 2007.e. None of the above.

ANS: BThe $350,000 claims paid in 2007 for 2007 sales are deductible in that year. The $50,000 in claims from 2006 sales should have been deducted in 2006 under the recurring item exception. The $12,000 paid in January 2008 for sales in 2007 can be deducted in 2007 under the recurring item exception. The all-events test was satisfied in 2007 when claims for $12,000 were approved. Economic performance (payment) occurred within 8 1/2 months after the end of 2007. The all-events test was not satisfied for the $30,000 of claims for 2007 sales that were received in January 2008 and paid in February 2008.

PTS: 1 REF: p. 16-13 | p. 16-14

104. Generally, deductions for additions to reserves (e.g., an allowance for estimated warranty costs) are not allowed for income tax purposes because allowing the deduction would:a. Result in a mismatching of revenues and expenses.b. Violate the doctrine of constructive receipt.c. Reduce the costs of companies selling defective products.d. Violate the economic performance requirement.e. None of the above.

ANS: Da. is incorrect because the reason for creating reserves is to match revenues and expenses better.

PTS: 1 REF: p. 16-15

45

105. In 2007, Swan Company discovered that it had for the past 10 years capitalized as a production cost certain expenses that are properly classified as administrative expenses. This caused the ending inventory for 2006 to be overstated by $150,000.a. The company should amend its 2006 tax return.b. The company should change its accounting method in 2007, with a $150,000 negative

§ 481 adjustment which reduces 2007 taxable income.c. The company should change its accounting method in 2007, with a $37,500 negative

§ 481 adjustment which reduces 2007-2010 taxable income.d. The company should change its accounting method in 2007 and recognize a $150,000

positive § 481 adjustment which increases 2007 taxable income.e. None of the above.

ANS: BThis is a voluntary change in accounting method with a negative § 481 adjustment.


106. The taxpayer has consistently, but incorrectly, used an allowance for bad debts. At the beginning of the year, the balance in the allowance account is $90,000.a. If the IRS examines the taxpayer’s return and requires the taxpayer to change

accounting methods, the taxpayer will be required to recognize an additional $90,000 of income (one-half in the current year and one-half in the following year) as the adjustment due to the change in accounting methods.

b. If the taxpayer voluntarily changes methods, the $90,000 adjustment can be spread over the current and three following years.

c. If the taxpayer voluntarily changes methods, the $90,000 reserve can be used to absorb bad debts until the account balance is zero.

d. If the IRS examines the taxpayer’s return, no adjustment to the reserve account will be required if the balance is consistent with prior bad debt experience.

e. None of the above.

ANS: B REF: p. 16-16 to 16-18

107. When the IRS requires a taxpayer to change accounting methods:a. The taxpayer may be subject to penalties and interest.b. The taxpayer generally is required to make the change as of the beginning of the current

tax year.c. The adjustments due to the change can be spread over subsequent years.d. All of the above are correct.e. None of the above is correct.

ANS: AAnswers b. and c. are incorrect because the IRS will require that the change be made as of the beginning of the earliest open tax year.

PTS: 1 REF: p. 16-16 | p. 16-18

46

108. The taxpayer voluntarily changed from the cash to the accrual method of accounting, because inventories were material to the taxpayer’s business. The change resulted in a positive $60,000 adjustment to income.a. The taxpayer must add the $60,000 to income for the year of the change.b. The taxpayer must amend all prior open years and compute income by the accrual

method and pay the additional tax.c. The taxpayer must add $15,000 to income for the year of the change and add $15,000 to

the incomes for each of the three preceding years.d. The taxpayer may add $15,000 to the income for the year of the change and to the

incomes for each of the three following years.e. None of the above.

ANS: DThis is a voluntary change from a correct method to another correct method. The adjustment increases income. Under these circumstances, the taxpayer may spread the adjustment over 4 years (the current tax year and the three following tax years).

PTS: 1 REF: p. 16-16 | p. 16-17

109. At the beginning of 2007, the taxpayer voluntarily changed from the cash to the accrual method of accounting. The relevant account balances as of January 1, 2007 were as follows:

Accounts receivable $ 90,000Inventory 105,000Accounts payable for merchandise 75,000

a. The company has a positive adjustment to income of $120,000 that must be recognized in 2007.

b. The company has a negative adjustment to income of $120,000 that must be taken in 2007 income.

c. The company has a positive adjustment to income that can be allocated as follows: $30,000 to 2007 income, and $30,000 each to 2008-2010 income.

d. The company has a $120,000 positive adjustment to income that must be allocated equally to 2007-2009.

e. None of the above.

ANS: CThe change is voluntary and results in a positive $120,000 ($90,000 + $105,000 – $75,000) adjustment to income. Because the change is voluntary, the taxpayer can spread the adjustment over the current year and the three following years.

PTS: 1 REF: p. 16-16 | p. 16-17

47

110. The installment method applies to which of the following sales with payments being made in the year following the year of sale?a. An automobile dealer’s sale of an SUV.b. A cash basis individual’s sale of General Electric common stock.c. A manufacturer’s sale of fully-depreciated equipment.d. All of the above.e. None of the above.

ANS: EThe inventory in a., the publicly-traded securities in b., and the § 1245 depreciation recapture in c. are not eligible for the installment method.

PTS: 1 REF: p. 16-18 | p. 16-19

111. The installment method applies where a payment will be received after the tax year of the sale:a. By an investor who sold real estate at a gain.b. By an investor who sold real estate at a loss.c. By an appliance dealer who sold inventory.d. By an investor who sold IBM Corporation common stock.e. None of the above.

ANS: AThe installment method does not apply to realized losses (answer b.) or to inventory (answer c.). Publicly-traded securities are ineligible for the installment method (answer d.).

PTS: 1 REF: p. 16-18

112. In 2007, Helen sold property and reported her gain by the installment method. Her basis in the property was $150,000 ($200,000 cost less $50,000 of depreciation). Helen sold the property for $300,000, with $75,000 due on the date of the sale and $225,000 (plus interest at the Federal rate) due in 2009. Helen’s recognized installment sale gain in 2009 is:a. $0.b. $50,000.c. $75,000.d. $150,000.e. None of the above.

ANS: CThe total gain is $150,000 ($300,000 – $150,000). This includes $50,000 of depreciation recapture that is not eligible for installment reporting. The remaining $100,000 gain will be spread over the collection of the $300,000 (the contract price). In the year of sale, $75,000 is collected. Therefore, $25,000 [$75,000 ($100,000/$300,000)] installment sale gain and $50,000 depreciation recapture must be recognized in the year of sale. The remaining gain of $75,000 ($150,000 – $50,000 – $25,000) must be recognized when the $225,000 is collected in 2009: $225,000 ($100,000/$300,000).

PTS: 1 REF: pp. 16-19 to 16-21

48

113. Hal sold land held as an investment with a fair market value of $100,000 for $36,000 cash and a note for $64,000 that was due in two years. The note bore interest of 11% when the applicable Federal rate was 7%. Hal’s cost of the land was $40,000. Because of the buyer’s good credit record and the high interest rate on the note, Hal thought the fair market value of the note was at least $74,000.a. Hal can elect to treat the $36,000 as a recovery of capital.b. Hal must recognize $70,000 gain in the year of sale.c. Hal must recognize $60,000 gain in the year of sale.d. Unless Hal elects not to use the installment method, Hal must recognize $21,600 gain in

the year of sale.e. None of the above.

ANS: DUnder the installment method, Hal’s recognized gain in the year of sale is as follows:

[($100,000 – $40,000)/$100,000] $36,000 = $21,600PTS: 1 REF: pp. 16-18 to 16-21

114. Todd, a CPA, sold land for $200,000 plus a note for $400,000. The interest rate on the note was equal to the Federal rate. The fair market value of the note was $360,000. Todd’s basis in the land was $75,000.a. If Todd uses the accrual basis to report the income from his practice, he cannot use the

installment method to report the gain on the sale of the land.b. If Todd uses the cash basis to report the income from his practice, he cannot use the

installment method to report the gain from the sale of the land.c. If Todd uses the installment method to report the gain, the contract price is $600,000.d. If Todd does not use the installment method, his gain in the year of sale is $125,000

($200,000 – $75,000).e. None of the above.

ANS: CThe contract price is $600,000, the $200,000 down payment plus the face amount of the note of $400,000. The installment method can be used to report the gain on the land regardless of the method of accounting the taxpayer uses to report the income from his trade or business; thus, answers a. and b. are incorrect. Answer d. is incorrect because the note of $400,000 would be included in the amount realized for the cash basis sale.

PTS: 1 REF: p. 16-20

49

115. Juan, not a dealer in real property, sold land that he owned with an adjusted basis of $400,000 that was encumbered by a mortgage for $200,000. The terms of the sale required the buyer to pay Juan $150,000 on the date of the sale. The buyer assumed Juan’s mortgage and gave Juan a note for $450,000 (plus interest at the Federal rate) due in the following year. What is the gross profit percentage?a. 400/800 = 50%.b. 400/600 = 66.67%. c. 600/800 = 75%.d. 400/450 = 88.89%.e. None of the above.

ANS: BThe gross profit percentage is the gain divided by the contract price. The contract price is the selling price less the seller’s obligations assumed by the buyer. The selling price is the total consideration received by the buyer, exclusive of interest. Juan’s selling price is $800,000 ($200,000 mortgage assumed plus the $150,000 cash received plus the $450,000 buyer’s note). Juan’s gross profit is $400,000 ($800,000 less $400,000 basis). The contract price is $600,000 ($800,000 selling price less $200,000 mortgage assumed by the buyer). Therefore, the gross profit percentage is $400,000/$600,000 = 66.67%.

PTS: 1 REF: p. 16-19 | p. 16-20

116. Pedro, not a dealer, sold real property that he owned with an adjusted basis of $60,000 and encumbered by a mortgage for $28,000 to Pat in 2007. The terms of the sale required Pat to pay $14,000 cash, assume the $28,000 mortgage, and give Pedro eleven notes for $6,000 each (plus interest at the Federal rate). The first note was payable two years from the date of sale and each succeeding note became due at two-year intervals. Pedro did not "elect out" of the installment method for reporting the transaction. If Pat pays the 2009 note as promised, what is the recognized gain to Pedro in 2009 (exclusive of interest)?a. $6,000.b. $3,600.c. $2,400.d. $0.e. None of the above.

ANS: BThe realized gain on the sale is $48,000 ($66,000 + $14,000 + $28,000 – $60,000). The contract price is $80,000 ($108,000 amount realized – $28,000 mortgage assumed). The recognized gain is calculated as follows for 2009:

$48,000 $6,000 = $3,600$80,000

Since the mortgage assumed of $28,000 does not exceed the adjusted basis of $60,000, there is no deemed payment problem in 2007.

PTS: 1 REF: p. 16-19 | p. 16-20

50

117. Charlotte sold her unincorporated business for $360,000 in 2007. The sales contract allocated $150,000 to equipment, $110,000 to land, and $100,000 to goodwill. Charlotte had a $0 basis in the goodwill, the land cost $60,000, and the equipment originally cost $250,000 but it was fully depreciated. What is the amount of the gain eligible for installment sales treatment?a. $0.b. $150,000.c. $145,000.d. $255,000.e. None of the above.

ANS: BThe $150,000 gain on the equipment is all § 1245 depreciation recapture and therefore is ineligible for the installment method. The gain on the land of $50,000 and the $100,000 gain from the sale of the goodwill are eligible for the installment method. Therefore, the amount of gain eligible for installment sales treatment is $150,000 ($100,000 + $50,000).

PTS: 1 REF: p. 16-19 | p. 16-20

118. In 2007, Norma sold Zinc, Inc., common stock for $100,000 cash and a note receivable for $900,000. The note was due in 2008 with accrued interest at the Federal rate. Norma’s basis in the stock was $250,000. This was Norma’s only installment sale transaction. Which of the following statements is correct?a. Norma cannot use the installment method to report her gain if the stock is listed on the

New York Stock Exchange.b. Norma must recognize $75,000 gain in 2007 and she will be liable for interest on taxes

deferred under the installment method.c. Norma must recognize $75,000 gain in 2007 and she will not be liable for interest on the

taxes deferred under the installment method if the stock is not publicly traded.d. Norma should treat the $100,000 received as a recovery of capital.e. None of the above.

ANS: AThe sale does not qualify for the installment method if the stock is listed on the New York stock exchange. The installment method is denied for reporting the gains on stocks and securities if they are traded on an established market.

PTS: 1 REF: p. 16-18 | p. 16-19

51

119. Albert is in the 35% marginal tax bracket. He sold a building in the current year for $300,000. Albert received $100,000 cash at closing, the buyer assumed Albert’s mortgage for $120,000, and the buyer gave Albert a 6% note for $80,000 due in two years. The Federal rate was 6%. Albert’s basis in the building was $180,000 ($400,000 cost – $220,000 accumulated straight-line depreciation). Assuming he did not elect out of the installment method, Albert’s gain taxed as ordinary income and at the 25% rate in the year of sale are what amounts?

Ordinary Gain Unrecaptured § 1250 Gain Taxed at 25%a. $120,000 $0b. $0 $100,000c. $33,333 $66,667d. $0 $66,667e. $100,000 $0

ANS: DThe total realized gain is $120,000 ($300,000 amount realized – $180,000 adjusted basis). The contract price is $180,000 ($300,000 – $120,000 seller’s mortgage assumed by the buyer).

The entire recognized gain of $66,670 is unrecaptured § 1250 gain because it is less than the depreciation (straight line) that was deducted ($220,000).

$120,000= 66.67% gross profit percentage

$180,000

$100,000 payments 66.67% = $66,670 recognized gain

There is no § 1250 depreciation recapture because the straight-line method was used. This unrecaptured § 1250 gain is taxed at the 25% alternative tax rate.

PTS: 1 REF: pp. 16-18 to 16-24

120. Jay sold land (a capital asset) to an unrelated party for $20,000 cash and a 9% note for $100,000 due in two years. His basis in the land was $40,000. Which of the following statements is correct?a. If the Federal rate is 6%, interest will be imputed at that rate.b. If the Federal rate is 7%, interest will not be imputed.c. If the Federal rate is 9%, interest will be imputed at 10%.d. All of the above.e. None of the above.

ANS: BAlternative b. is correct. If the principal amount is less than $2.8 million (adjusted for inflation amount for 2006 is $4,630,300), 9% interest can be charged. In b., because the stated rate (9%) is greater than the Federal rate, no interest is imputed.

PTS: 1 REF: p. 16-20 | p. 16-21 | Concept Summary 16-1

52

121. Taylor sold a capital asset on the installment basis and did not charge interest on the deferred payment due in three years.a. Interest will be imputed, thus increasing the capital gain.b. Interest will be imputed, thus creating ordinary income.c. Interest will not be imputed because the contract is for less than five years.d. Interest will be imputed, thus reducing the seller’s total income from the transactions.e. None of the above.

ANS: BWhen the interest is imputed, the selling price is reduced by the amount of the imputed interest. Therefore, the gain is reduced by the amount of the newly created interest income. The timing of the income is affected because the gain without any interest would be reported in proportion to the payments collected each year. However, with interest, the total price is reduced and the interest accrues based on the balance of the outstanding receivable. The payment is first allocated to interest and then to principal. Therefore, the interest payments will decrease as more is paid on principal.

PTS: 1 REF: p. 16-20 | p. 16-21

122. Related-party installment sales include all of the following except the first seller’s:a. Brothers and sisters.b. Controlled corporations.c. Lineal descendants.d. Partnerships in which the seller has an interest.e. All of the above would be considered related parties.

ANS: E REF: pp. 16-21 to 16-23

123. In 2007, Father sold land to Son for $75,000 cash and an installment note for $225,000. Father’s basis was $120,000. In 2008, after paying $24,000 interest but nothing on the principal, Son sold the land for $300,000 cash. As a result of the second disposition, what gain must Father recognize in 2008?a. $180,000.b. $135,000.c. $120,000.d. $60,000.e. None of the above.

ANS: BFather’s realized gain is $180,000 ($300,000 amount realized – $120,000 adjusted basis). In 2007, Father recognized gain of $45,000 as follows:

$180,000 $75,000 = $45,000$300,000

The proceeds of the sale by Son in 2008 (to the extent of $225,000) are attributed to Father. Father is deemed to have received payment of the $225,000 receivable from Son when the second sale occurred.

This results in the recognition of the remaining realized gain of $135,000 ($180,000 – $45,000) of gain in 2008.

PTS: 1 REF: p. 16-21 | p. 16-22

53

124. In 2007, Kathy sold an apartment building to her 100 percent controlled corporation, Kathy, Inc. The apartment building cost $500,000 and the balance in the accumulated depreciation account was $400,000. Kathy, Inc. paid $100,000 in the year of sale and gave Kathy a note for $900,000 plus adequate interest due in 2009.a. Kathy can use the installment method only if tax avoidance was not a principal purpose

of the transaction.b. Kathy generally cannot report the gain by the installment method.c. a and b are true.d. a and b are false.e. None of the above.

ANS: CThe related party sale of depreciable property results in a penalty. Section 453(g) provides generally that the installment method is not available. However, if the taxpayer can establish that tax avoidance was not a principal purpose of the transaction, the installment method can be used.


125. Which of the following is (are) a taxable disposition of an installment obligation?

(1) Transfer to a relative as a gift.(2) Transfer to the transferor’s 100% owned corporation.(3) Transfer to a partnership for an interest in partnership capital and profits.

a. (1) only.b. (1) and (2).c. (1), (2), and (3).d. (2) and (3).e. None of the above.

ANS: AGifts are treated as taxable dispositions of installment obligations.

PTS: 1 REF: p. 16-23

54

126. Gold Corporation sold its 40% of the Ruby Corporation common stock. Gold received $8,000,000 in the year of the sale and a note for $12,000,000, payable in three years with interest at the Federal rate. Gold’s basis in the stock was $2,000,000. Assume that Gold Corporation will report the gain by the installment method where the method is permitted.a. If the Ruby Corporation stock is traded on a national exchange, Gold must recognize

$18,000,000 gain in the year of sale.b. If the Ruby Corporation stock is not traded on an established market, Gold must

recognize a $7,200,000 gain in the year of sale.c. If the Ruby Corporation stock is not traded on a national exchange, Gold must pay

interest on a portion of the deferred taxes.d. All of the above are true.e. None of the above is true.

ANS: DAnswer a. is correct because publicly traded property is not eligible for installment reporting. Answer b. is correct because the gain is 90% of the selling price and when $8,000,000 was collected, the company was required to recognize $7,200,000 gain ($8,000,000 90%). Answer c. is correct because outstanding installment obligations at the close of the tax year exceed $5 million.

PTS: 1 REF: pp. 16-19 to 16-21

127. In the case of a small home construction company that builds under long-term contracts, generally:a. The percentage of completion method must be used.b. The percentage of completion method should be used to defer income.c. The completed contract method must be used.d. The completed contract method defers income recognition.e. None of the above is true.

ANS: DThe major tax advantage of the completed contract method is the ability to defer income.

PTS: 1 REF: p. 16-26 | p. 16-27

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128. Robin Construction Company began a long-term contract in 2007. The contract price was $750,000. The estimated cost of the contract in 2007 was $600,000. The actual cost incurred in 2007 was $300,000. The contract was completed in 2008 and the cost incurred that year was $400,000. Under the percentage of completion method:a. Robin should report $60,000 of income in 2007.b. Robin should report a $10,000 loss in 2008.c. Robin will receive interest (under the look-back method) on the overpayment of taxes in

2007.d. All of the above are true.e. None of the above is true.

ANS: DThe profit on the contract recognized in 2007 was calculated as follows:

$150,000 $300,000 = $60,000$750,000

The total profit on the contract was $50,000 ($750,000 – $300,000 – $400,000). Because Robin reported profit on the contract of $60,000 in 2007, Robin must report a $10,000 loss in 2008 and will receive interest on the overpayment of taxes.

PTS: 1 REF: pp. 16-25 to 16-28

129. Under the percentage of completion method, if the actual costs are ____ the estimated costs, the taxpayer must pay interest on the underpayment of prior years’ taxes.a. Greater than.b. Less than.c. Equal to or greater than.d. Equal to.e. None of the above.

ANS: BUnder the lookback method, the taxpayer is deemed to have underpaid prior years’ taxes, and interest must be paid.

PTS: 1 REF: p. 16-28

130. Eve transfers property (basis of $120,000 and fair market value of $400,000) to Green Corporation for 80% of its stock (worth $350,000) and a long-term note (worth $50,000), executed by Green Corporation and made payable to Eve. As a result of the transfer:a. Eve recognizes no gain.b. Eve recognizes a gain of $230,000.c. Eve recognizes a gain of $280,000.d. Eve recognizes a gain of $50,000.e. None of the above.

ANS: DA long-term note is treated as “boot.” Thus, Eve is taxed on the value of the note received.

PTS: 1 REF: p. 18-4 | p. 18-5

56

131. Ann transferred land worth $200,000, with a tax basis of $40,000, to Brown Corporation, an existing entity, for 100 shares of its stock. Brown Corporation has two other shareholders, Bill and Bob, each of whom holds 100 shares. With respect to the transfer:a. Ann has no recognized gain.b. Brown Corporation has a basis of $160,000 in the land.c. Ann has a basis of $200,000 in her 100 shares in Brown Corporation.d. Ann has a basis of $40,000 in her 100 shares in Brown Corporation.e. None of the above.

ANS: CThe transfer does not qualify under § 351 as Ann has only a 1/3 interest in Brown Corporation. The requirements of § 351 apply to transfers to an existing corporation, as well as to a newly formed corporation.


132. Tara incorporates her sole proprietorship, transferring it to newly formed Black Corporation. The assets transferred have an adjusted basis of $240,000 and a fair market value of $300,000. Also transferred was $10,000 in liabilities, $1,000 of which was personal and the balance of $9,000 being business related. In return for these transfers, Tara receives all of the stock in Black Corporation.a. Black Corporation has a basis of $241,000 in the property.b. Black Corporation has a basis of $240,000 in the property.c. Tara’s basis in the Black Corporation stock is $241,000.d. Tara’s basis in the Black Corporation stock is $249,000.e. None of the above.

ANS: ETara has a recognized gain of $10,000 that is the amount of the boot she is treated as having received. Thus, her basis in the Black Corporation stock is $240,000 [$240,000 (basis of the property given up) – $10,000 (boot received) + $10,000 (gain recognized)]. Black Corporation’s basis in the property is $250,000 [$240,000 (Tara’s basis in the property) + $10,000 (gain recognized by Tara)]. In terms of the $10,000 boot, § 357(b) taints all liabilities even though some are supported by a bona fide business purpose.

PTS: 1 REF: p. 18-9 | p. 18-10

57

133. Tim, a cash basis taxpayer, incorporates his sole proprietorship. He transfers the following items to newly created Wren Corporation.

Adjusted Fair MarketBasis Value

Cash $ 20,000 $ 20,000Building 110,000 160,000Mortgage payable (secured by the building and held for 15 years) 135,000 135,000

With respect to this transaction:a. Wren Corporation’s basis in the building is $110,000.b. Tim has no recognized gain.c. Tim has a recognized gain of $25,000.d. Tim has a recognized gain of $5,000.e. None of the above.

ANS: DUnder § 357(c) Tim recognizes gain to the extent liabilities (mortgage payable of $135,000) exceed the basis of all assets transferred [$110,000 (building) + $20,000 (cash)]. Wren Corporation’s basis in the building is $115,000 [$110,000 (Tim’s basis) + $5,000 (gain recognized by Tim)].

PTS: 1 REF: p. 18-8 to 18-11

134. Mary transfers a building (adjusted basis of $15,000 and fair market value of $90,000) to White Corporation. In return, Mary receives 80% of White Corporation’s stock (worth $65,000) and an automobile (fair market value of $5,000). In addition, there is an outstanding mortgage of $20,000 (taken out 15 years ago) on the building, which White Corporation assumes. With respect to this transaction:a. Mary’s recognized gain is $10,000.b. Mary’s recognized gain is $5,000.c. Mary has no recognized gain.d. White Corporation’s basis in the building is $15,000.e. None of the above.

ANS: AAs a result of the transfer, Mary receives boot of $5,000 (fair market value of the automobile) and has additional gain of $5,000 (excess of the mortgage over the basis of the building). Since the sum of these amounts is less than the realized gain of $75,000, $10,000 is recognized under § 351(b). White Corporation’s basis in the building is $25,000 [$15,000 (Mary’s basis in the building) + $10,000 (Mary’s recognized gain)].

PTS: 1 REF: p. 18-4 | p. 18-9 to 18-12

58

135. Kim owns 100% of the stock of Cardinal Corporation. In the current year Kim transfers an installment obligation, tax basis of $30,000 and fair market value of $200,000, for additional stock in Cardinal worth $200,000.a. Kim recognizes no taxable gain on the transfer.b. Kim has a taxable gain of $170,000.c. Kim has a taxable gain of $180,000.d. Kim has a basis of $200,000 in the additional stock she received in Cardinal

Corporation.e. None of the above.

ANS: AAn installment obligation qualifies as “property” under § 351. Thus, Kim recognizes no gain on the transfer. Cardinal has a basis of $30,000 in the installment obligation.

PTS: 1 REF: p. 18-4 | p. 18-11

59

136. Rick transferred the following assets and liabilities to Warbler Corporation.


Building $210,000 $225,000Equipment 45,000 75,000Automobile 15,000 30,000Mortgage (held for four years) on building 30,000 30,000

In return Rick received $75,000 in cash plus 90% of Warbler Corporation’s only class of stock outstanding (fair market value of $225,000).a. Rick has a recognized gain of $60,000.b. Rick has a recognized gain of $75,000.c. Rick’s basis in the stock of Warbler Corporation is $270,000.d. Warbler Corporation has the same basis in the assets received as Rick does in the stock.e. None of the above.

ANS: ARick has a realized gain of $60,000 determined as follows.

Amount realized— Fair market value of the stock in Warbler Corporation $225,000 Cash received 75,000 Liability transferred 30,000 $330,000 Less: Basis of property transferred (270,000)Realized gain $ 60,000

Because recognized gain cannot exceed the lesser of the realized gain ($60,000) or the boot received ($75,000), the recognized gain is $60,000.

Rick’s basis in the Warbler Corporation stock is $225,000 [$270,000 (basis of property transferred) – $75,000 (boot received) – $30,000 (liability transferred) + $60,000 (gain recognized)].

Warbler Corporation’s basis in the property transferred is $330,000 [$270,000 (basis in the property transferred) + $60,000 (gain recognized)].

PTS: 1 REF: p. 18-4 | p. 18-11

60

137. Sarah and Tony (mother and son) form Dove Corporation with the following investments: cash by Sarah of $55,000; land by Tony (basis of $35,000 and fair market value of $45,000). Dove Corporation issues 200 shares of stock, 100 each to Sarah and Tony. Thus, each receives stock in Dove worth $50,000.a. Section 351 cannot apply since Sarah should have received 110 shares instead of only

100.b. As a result of the transfer, Tony recognizes a gain of $10,000.c. Tony’s basis in the stock of Dove Corporation is $50,000.d. Section 351 may apply because stock need not be issued to Sarah and Tony in

proportion to the value of the property transferred.e. None of the above.

ANS: DThe fact that the stock was not in proportion to the value of the property transferred (choice a.) does not prevent § 351 from applying. Since § 351 applies and no boot was received, Tony does not recognize a gain (choice b.). His basis in the stock is $35,000 plus $5,000, the basis of the stock implicitly gifted by Sarah to Tony (not $50,000 as in choice c.).


138. Hunter and Warren form Tan Corporation. Hunter transfers equipment (basis of $210,000 and fair market value of $180,000) while Warren transfers land (basis of $15,000 and fair market value of $150,000) and $30,000 of cash. Each receives 50% of Tan’s stock. As a result of these transfers:a. Hunter has a recognized loss of $30,000, and Warren has a recognized gain of

$135,000.b. Neither Hunter nor Warren has any recognized gain or loss.c. Hunter has no recognized loss, but Warren has a recognized gain of $30,000.d. Tan Corporation will have a basis in the land of $45,000.e. None of the above.

ANS: BThis fact pattern clearly comes within the scope of § 351. As such, Hunter may not recognize the realized loss of $30,000 (choice a.). Although cash was involved, it was given and not received by Warren (choice c.). It is not, therefore, boot within the meaning of the § 351. Tan Corporation will have a basis of $180,000 in the equipment transferred by Hunter ($210,000 carryover basis reduced by the $30,000 built-in loss) and $15,000 in the land (not $45,000 as in choice d.).

PTS: 1 REF: p. 18-3 | p. 18-4 | p. 18-12 | Example 21

61

139. Dawn, a sole proprietor, was engaged in a service business and reported her income on a cash basis. Later, she incorporates her business and transfers the assets of the business to the corporation in return for all the stock in the corporation plus the corporation’s assumption of the liabilities of her proprietorship. All the receivables and the unpaid trade payables are transferred to the newly formed corporation. The assets of the proprietorship had a basis of $105,000 and fair market value of $300,000. The trade accounts payable totaled $25,000. There was a note payable to the bank in the amount of $95,000 that the corporation assumes. The note was issued for the purchase of computers and other business equipment.a. Dawn has a gain on the transfer of $15,000.b. The basis of the assets to the corporation is $300,000.c. Dawn has a basis of $10,000 in the stock she receives.d. Dawn has a zero basis in the stock she receives.e. None of the above.

ANS: CDawn has a basis of $10,000 in the stock in the newly formed corporation [$105,000 (basis in the assets transferred to the corporation) – $95,000 (liabilities assumed by the corporation)]. Because the trade accounts payable give rise to a deduction, they are not considered to be liabilities for purposes of § 357(c); thus, liabilities do not exceed basis. In addition, the cash basis payables are not considered in the computation of Dawn’s stock basis. Dawn has no gain on the transfer, and the basis of the assets to the corporation is $105,000.

PTS: 1 REF: p. 18-10 | p. 18-11

62

140. Carl transfers land to Cardinal Corporation for 90% of the stock in Cardinal Corporation worth $20,000 plus a note payable to Carl in the amount of $40,000 and the assumption by Cardinal Corporation of a mortgage on the land in the amount of $100,000. The land, which has a basis to Carl of $70,000, is worth $160,000.a. Carl will have a gain on the transfer of $70,000.b. Carl will have a gain on the transfer of $30,000.c. Cardinal Corporation will have a basis in the land transferred by Carl of $70,000.d. Cardinal Corporation will have a basis in the land transferred by Carl of $160,000.e. None of the above.

ANS: AThe mortgage on the land exceeds Carl’s basis in the land by $30,000. This amount would be gain under § 357(c). In addition, the note payable to Carl does not qualify for nonrecognition under § 351; thus, Carl would have additional gain of $40,000.

Amount realized: Stock $ 20,000 Note 40,000 Release of mortgage 100,000

$160,000 Less: Basis of land (70,000)Realized gain $ 90,000Recognized gain ($30,000 + $40,000) $ 70,000

Cardinal Corporation will have a basis of $140,000 in the land [$70,000 (Carl’s basis in the land) + $70,000 (gain recognized by Carl with respect to the transfer of the land)].

PTS: 1 REF: p. 18-4 | p. 18-10

141. Joe and Kay form Gull Corporation. Joe transfers cash of $250,000 for 200 shares in Gull Corporation. Kay transfers property with a basis of $50,000 and fair market value of $240,000. She agrees to accept 200 shares in Gull Corporation for the property and for providing bookkeeping services to the corporation in its first year of operation. The value of Kay’s services is $10,000. With respect to the transfer:a. Gull Corporation has a basis of $240,000 in the property transferred by Kay.b. Neither Joe nor Kay recognize gain on the exchanges.c. Gull Corporation has a business deduction under § 162 of $10,000.d. Gull capitalizes $10,000 as organizational costs.e. None of the above.

ANS: CGull Corporation has a basis of $50,000 in the property it received from Kay. Kay has income of $10,000 on the exchange. Gull Corporation deducts the $10,000 as a business expense.


63

142. Earl and Mary form Crow Corporation. Earl transfers property, basis of $200,000 and value of $1,600,000, for 50 shares in Crow Corporation. Mary transfers property, basis of $80,000 and value of $1,480,000, and agrees to serve as manager of Crow for one year; in return Mary receives 50 shares of Crow. The value of Mary’s services is $120,000. With respect to the transfers:a. Mary will not recognize gain.b. Earl will recognize a gain of $1,400,000.c. Crow Corporation has a basis of $1,480,000 in the property it received from Mary.d. Crow will have a business deduction of $120,000 for the value of the services Mary will

render.e. None of the above.

ANS: DEarl will not recognize gain on the transfer. Mary will have income of $120,000, the value of the services she will render to Crow. Crow will have a business deduction of $120,000.


143. Four individuals form Chickadee Corporation under § 351. Two of these individuals, Jane and Walt, made the following contributions:


From Jane— Cash $360,000 $360,000 Patent -0- 40,000

From Walt— Equipment (depreciation claimed of $100,000) 240,000 370,000

Both Jane and Walt receive stock in Chickadee Corporation equal to the value of their investments.a. Jane must recognize income of $40,000; Walt has no income.b. Neither Jane nor Walt recognize income.c. Walt must recognize income of $130,000; Jane has no income.d. Walt must recognize income of $100,000; Jane has no income.e. None of the above.

ANS: BBoth Jane and Walt are protected by § 351 and have no income to recognize (choices a., c., and d.). The depreciation recapture rules do not apply to Walt because he does not recognize income from the transaction.

PTS: 1 REF: p. 18-15 | Example 2 | Example 3

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144. Leonard transfers equipment (basis of $40,000 and fair market value of $100,000) for additional stock in Green Corporation. After the transfer, Leonard owns 90% of the stock. Leonard had claimed depreciation of $50,000 on the equipment prior to transferring it to Green Corporation. With respect to the transfer:a. Leonard has ordinary income of $50,000.b. Leonard has ordinary income of $50,000 and a § 1231 gain of $10,000.c. Green Corporation has ordinary income of $50,000.d. Green Corporation has a basis of $40,000 in the equipment and it will have no

depreciation recapture if it later disposes of the equipment in a taxable transaction.e. None of the above.

ANS: EThe transfer comes under § 351; thus, Leonard has no recognized gain and no depreciation to recapture. However, when Green Corporation later disposes of the equipment in a taxable transaction, it must take into account the § 1245 recapture potential originating with Leonard. The basis of the equipment to Green is $40,000.


145. George transfers cash of $150,000 to Grouse Corporation, a newly formed corporation, for 100% of the stock in Grouse worth $80,000 and debt in the amount of $70,000, payable in equal annual installments of $7,000 plus interest at the rate of 9% per annum. In the first year of operation, Grouse has net taxable income of $40,000. If Grouse pays George interest of $6,300 and $7,000 principal payment on the note:a. George has dividend income of $13,300.b. Grouse Corporation does not have a tax deduction with respect to the payment.c. George has dividend income of $7,000.d. Grouse Corporation has an interest expense deduction of $6,300.e. None of the above.

ANS: DThe payment will be treated as a payment on the debt. The interest will be ordinary income to George and produce a deduction to Grouse Corporation.


146. Adam transfers cash of $300,000 and land worth $200,000 to Camel Corporation for 100% of the stock in Camel. In the first year of operation, Camel has net taxable income of $70,000. If Camel distributes $50,000 to Adam:a. Adam has taxable income of $50,000.b. Camel Corporation has a tax deduction of $50,000.c. Adam has no taxable income from the distribution.d. Camel Corporation reduces its basis in the land to $150,000.e. None of the above.

ANS: AAdam will have a taxable dividend of $50,000. Camel will not be permitted a deduction for the $50,000 payment because dividends are not deductible by the distributing corporation.

PTS: 1 REF: p. 18-17

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147. When Pheasant Corporation was formed under § 351, Kristen transferred property (basis of $26,000 and fair market value of $22,500) for § 1244 stock. Kristen’s basis in the Pheasant stock is $26,000. Three years later, Pheasant Corporation goes bankrupt and its stock becomes worthless. Kristen, who is single, owned the stock as an investment. Kristen’s loss is:a. $26,000 capital.b. $22,500 ordinary and $3,500 capital.c. $3,500 ordinary and $22,500 capital.d. $26,000 ordinary.e. None of the above.

ANS: B REF: Example 31

148. Shawn transfers property (basis of $40,000 and fair market value of $35,000) to Condor Corporation in exchange for § 1244 stock. The transfer qualifies as a nontaxable exchange under § 351; therefore, Shawn’s basis in the Condor stock is $40,000. Five years later, Shawn sells the Condor stock for $25,000. With respect to the sale, Shawn has:a. An ordinary loss of $15,000.b. An ordinary loss of $10,000 and a capital loss of $5,000.c. A capital loss of $15,000.d. A capital loss of $10,000 and an ordinary loss of $5,000.e. None of the above.

ANS: BFor purposes of § 1244 treatment, the basis in the stock is $35,000. When the stock is sold for $25,000, only $10,000 qualifies as an ordinary loss; the remaining $5,000 loss is a capital loss.


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