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6 CHAPTER DEDUCTIONS AND LOSSES: IN GENERAL Instructor: The test items in both the print Test Bank and ExamView test-creation software are numbered by question type within each chapter. Thus, users of ExamView can more easily preview their selections using the printed Test Bank in the same numbering system. Learning Objective, Level of Difficulty, Estimated Time to Completion, and the AACSBs and AICPAs Core Competencies for each test item are located within the item itself. Question/ Problem Status: Present Edition Q/P in Prior Edition Topic TRUE OR FALSE 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 Deductions for AGI and standard deduction Deductions for AGI versus from AGI Trade or business expenses and classification Employment related expenses and classification Production of income expenses and classification Moving expenses and classification Production of income expenses and classification Ordinary and necessary Ordinary business expenses: meaning of Reasonable salaries Reasonable salaries and other business expenses Closely held corporation and reasonable salaries Personal use asset losses Reporting procedures: sole proprietorship Accounting method: cash basis versus accrual basis Accounting method: cash basis Accounting method: credit cards Cash basis and one-year rule Prepaid rent and one-year rule Accrual basis and economic performance test Economic performance test and reserves Public policy limitation disallowance for bribes Fines and penalties Fines, penalties, and bribes: Foreign Corrupt Practices Act Legal tax advice: preparation of tax return Treble damages 6-1 Unchanged Unchanged Unchanged Unchanged New Unchanged New Unchanged Unchanged Modified New Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Modified Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged 1 2 3 4 6 8 9 10 12 13 14 16 17 18 19 20 21 23 24 25 26 6-2 27 28 Question/ Problem 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 2010 Comprehensive Volume/Test Bank Legal services: preparation of a will Legal expenses: rental property Topic Legal expenses: defense in criminal action Illegal business: operating expenses Illegal business: deductions Lobbying expenses Excessive executive compensation Investigation of a business Investigation of a business Hobby losses and presumption rule Hobby losses and presumption rule Hobby losses and presumption rule Hobby expenses: tax treatment of Hobby losses Hobby expenses: classification of Vacation home: less than 15-days rule on rental use Vacation home: less than 15-days rule on personal use Vacation home: primarily rental Vacation home: less than 15-days rule on rental use Vacation home: personal/rental Vacation home: primarily personal Vacation home: personal/rental Vacation home: personal/rental Vacation home: conversion to rental Payment of another taxpayers obligation Capital expenditures Capital expenditures versus deductible items Related party sale: disallowed loss and basis Sales between related parties MULTIPLE CHOICE 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Deductions for AGI: misclassification Deductions for AGI: determination of Deductions for AGI: determination of Deductions for AGI: determination of Deductions for AGI: determination of Deductions from AGI: determination of Deductions for AGI versus from AGI Deductions for AGI: determination of Deductions for AGI versus from AGI Trade or business expenses: what is not included Trade or business expenses: qualification as Reasonableness requirement: tax effect of noncompliance Trade or business expenses Cash versus accrual method: credit card charge Unchanged New Unchanged Unchanged New Modified Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged 1 3 4 6 7 8 9 10 11 12 13 14 Unchanged Unchanged Status: Present Edition Unchanged Unchanged Modified Unchanged Unchanged Unchanged Unchanged Unchanged Modified Unchanged Unchanged Modified Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Modified Unchanged Unchanged Unchanged Modified New Unchanged New 27 28 Q/P in Prior Edition 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 54 Deductions and Losses: In General Status: Present Edition New Modified Unchanged Modified Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Modified Unchanged Unchanged Unchanged Unchanged Modified Unchanged Unchanged Unchanged Modified 6-3 Q/P in Prior Edition 16 17 18 19 20 21 22 23 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 Question/ Problem 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 Topic Cash basis versus accrual method Accrual method and reserve for bad debts Trade or business expenses Illegal business expenses Public policy limitations Illegal business expenses Drug trafficking and illegal business expenses Drug trafficking expenses Excessive executive compensation Investigation of a business: deductible Investigation of a business: tax treatment of Investigation of a business: applicable tax rules Hobby losses versus trade or business Hobby losses: tax result Hobby expenses: classification of Deductible expenses Nondeductible expenses Vacation home: the 15-day rule Vacation home: IRS approach Vacation home: tax treatment Vacation home: primarily rental Other taxpayers obligations Other taxpayers obligations Legal expenses in divorce and personal expenditures Capital expenditures Capital expenditures and amortization of intangibles Stock sale to related party Stock sale to related party Constructive ownership rules applied PROBLEMS 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Question/ Problem Deductions for AGI versus from AGI Deduction for AGI: determination of Reasonable salaries: sole proprietorship Cash method versus accrual method Cash method versus accrual method Prepaid rent and one-year rule Prepaid rent and one-year rule Economic performance test and reserves Bribes and kickbacks: deduction Drug trafficking Illegal business: operating expenses Excessive executive compensation Investigation of a business Investigation of a business Hobby activity: net income determination Vacation home: less than 15-days rule Topic Modified Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged New Unchanged Unchanged Status: Present Edition 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Q/P in Prior Edition 6-4 2010 Comprehensive Volume/Test Bank Status: 17 18 19 20 21 22 23 24 Vacation home: primarily rental Vacation home: court versus IRS rule Other taxpayers obligations Legal fees and another taxpayers obligation Disallowance of personal expenditures Related party transactions: loss situation Related party transactions: attribution rules Interest expense associated with tax-exempt income ESSAY 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Reasonable salaries Reasonable salaries Cash versus accrual method One-year rule on prepayments All events and economic performance tests Public policy limitation: bribes and state law Legal expenses and deductions for versus from AGI Illegal business: deductions Investigation of a business: applicable tax rules Hobby losses: relevant factors Hobby losses: deductibility of expenses Vacation home: less than 15-days rule Other taxpayers obligations Capital expenditures Related party transactions: reason for restrictions Related party transactions: loss situation Interest expense associated with tax-exempt income Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged New Unchanged New Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged 1 2 3 4 5 6 7 9 10 11 12 13 14 15 Unchanged Unchanged Modified Unchanged New Unchanged Unchanged Unchanged Q/P 15 16 17 18 19 20 21 Deductions and Losses: In General 6-5 TRUE/FALSE 1. A taxpayer who claims the standard deduction can also deduct expenses that are classified as deductions for AGI. Register to View AnswerA taxpayer can deduct both items. PTS: 1 DIF: 1 REF: p. 6-3 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 2 min 2. A taxpayer in the 25% tax bracket may receive a different tax benefit for a $100 expenditure that is classified as a deduction from AGI than he or she will receive for a $100 expenditure that is classified as a deduction for AGI. Register to View AnswerThe value of the tax benefit for the deduction from AGI may be less than that for the deduction for AGI. The value of the deduction for AGI for a taxpayer in the 25% bracket for a $100 expenditure is $25 ($100 25%). If the taxpayer takes the standard deduction rather than itemizing deductions, then the $100 expenditure that is classified as a deduction from AGI has no tax benefit. PTS: 1 DIF: 1 REF: Example 1 NAT: AICPA FN-Measurement | AACSB Analytic 3. Expenses incurred in a trade or business are deductible for AGI. Register to View AnswerSuch expenses are deductible for AGI. PTS: 1 DIF: 1 REF: p. 6-4 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 2 min OBJ: 1 MSC: 5 min 4. Only certain employment related expenses are classified as deductions for AGI. Register to View AnswerUnreimbursed employee expenses are classified as deductions from AGI while reimbursed employee expenses are classified as deductions for AGI. PTS: 1 DIF: 1 REF: Example 1 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 2 min 5. All expenses associated with the production of income are classified as deductions from AGI. Register to View AnswerExpenses associated with the production of rental or royalty income are classified as deductions for AGI. All other expenses related to the production of income are classified as deductions from AGI. PTS: 1 OBJ: 1 MSC: 2 min DIF: 1 REF: p. 6-4 | p. 6-5 NAT: AICPA FN-Reporting | AACSB Analytic 6-6 2010 Comprehensive Volume/Test Bank 6. A moving expense that is reimbursed by the employer is a deduction for AGI, whereas an unreimbursed moving expense is classified as an itemized deduction. Register to View AnswerMoving expenses are deductible for AGI. PTS: 1 DIF: 1 REF: p. 6-5 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 2 min 7. Investment-related expenses such as those related to investments in stocks and bonds are deductions from AGI. Register to View AnswerInvestment-related expenses that are deductible are classified as itemized deductions (i.e., deductions from AGI). PTS: 1 DIF: 1 REF: p. 6-5 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 2 min 8. Some expenses that are necessary are not ordinary and, therefore, are not deductible. Register to View AnswerExample 3 and related discussion PTS: 1 DIF: 1 REF: Example 3 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 2 min 9. For an expense to be deducted as ordinary, it must be recurring in nature. Register to View AnswerAn expense is ordinary if it is normal, usual, or customary in the type of business conducted by the taxpayer and is not capital in nature. However, the expense need not be recurring to be ordinary. PTS: 1 DIF: 1 REF: p. 6-6 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 2 min 10. Rob, a shareholder-employee of Falcon, Inc., receives a $300,000 salary. The IRS classifies $100,000 of this amount as unreasonable compensation. The effect of this reclassification is to decrease Robs gross income by $100,000. Register to View AnswerWhile Robs dividend income increases by $100,000, his salary income decreases by $100,000. Thus, his gross income does not change. PTS: 1 DIF: 1 REF: Example 6 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 1 MSC: 5 min Deductions and Losses: In General 11. The concept of reasonableness applies not only to salaries but also to other business expenses. 6-7 Register to View AnswerAlthough the Code refers to reasonableness solely with respect to salaries and other compensation for services, the courts have extended the concept. Thus, for any business expense to be deductible, it must be reasonable in amount. PTS: 1 OBJ: 1 MSC: 2 min DIF: 1 REF: p. 6-7 | Example 6 NAT: AICPA FN-Measurement | AACSB Analytic 12. Generally, a closely-held family corporation is not permitted to take a deduction for a salary paid to a family member in calculating corporate taxable income. Register to View AnswerOnly unreasonable salaries are not deductible. Example 6 and related discussion PTS: 1 DIF: 1 REF: Example 6 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 2 min 13. Bonnie sells her personal use SUV for $22,000 (adjusted basis of $38,000). Her realized loss of $16,000 ($22,000 $38,000) can be recognized for income tax purposes. Register to View AnswerA loss on the sale of a personal use asset cannot be deducted. PTS: 1 DIF: 1 REF: p. 6-8 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 5 min 14. The income of a sole proprietorship are reported on Schedule C (Profit or Loss from Business). Register to View AnswerOBJ: 1 MSC: 2 min PTS: 1 DIF: 1 REF: Figure 6.1 NAT: AICPA FN-Reporting | AACSB Analytic 15. For an expense to be deducted, the amount must be paid by the taxpayer. Register to View AnswerThe paid requirement applies only for the cash basis taxpayer. The term incurred is used in conjunction with accrual basis taxpayers. PTS: 1 OBJ: 2 MSC: 2 min DIF: 1 REF: p. 6-9 to 6-11 NAT: AICPA FN-Reporting | AACSB Analytic 16. Payment of expenses by a cash basis taxpayer does not necessarily ensure a deduction in the current year. Register to View AnswerAs an example, fixed assets that are purchased must be capitalized and depreciated. PTS: 1 DIF: 1 REF: p. 6-9 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 2 MSC: 2 min 6-8 2010 Comprehensive Volume/Test Bank 17. Using his bank credit card, Seneca, a cash method taxpayer, charged a business expense on December 5, 2009. He paid the credit card bill, which included the charge, on January 23, 2010. Seneca can deduct the expense in 2009. Register to View AnswerAt the time Seneca used the bank credit card, he is deemed to have simultaneously borrowed money from the credit card issuer and constructively paid the expense. PTS: 1 DIF: 1 REF: p. 6-9 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 2 MSC: 2 min 18. Under the one-year rule for the current period deduction of prepaid expenses of cash basis taxpayers, the asset must expire or be consumed by the end of the tax year following the year of payment. Register to View AnswerIf the one-year rule is not satisfied, the prepayment is prorated and deducted over the benefit period. PTS: 1 DIF: 1 REF: p. 6-10 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 2 MSC: 2 min 19. None of the prepaid rent paid on October 1 by a calendar year cash basis taxpayer for the next 18 months is deductible in the current period. Register to View AnswerThe amount paid for the 18-month period is not all deductible in the current tax year because the prepayment period extends substantially beyond the end of the tax year (i.e., must be capitalized). However, that portion of the prepaid rent which relates to October through December of the current tax year may be deducted in the current tax year. PTS: 1 DIF: 1 REF: Example 7 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 2 MSC: 2 min 20. The period in which an accrual basis taxpayer can deduct an expense is determined by applying the economic performance test. Register to View AnswerOBJ: 2 MSC: 2 min PTS: 1 DIF: 1 REF: p. 6-10 NAT: AICPA FN-Reporting | AACSB Analytic 21. The amount of the addition to the reserve for bad debts for an accrual method taxpayer is allowed as a deduction for tax purposes. Register to View AnswerA reserve for estimated expenses (e.g., bad debt) is not allowed for tax purposes because the economic performance test cannot be satisfied. PTS: 1 DIF: 1 REF: Example 12 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 2 MSC: 2 min Deductions and Losses: In General 6-9 22. A bribe paid to a domestic (U.S.) official is not deductible, but it may be possible to deduct a bribe paid to a foreign official. Register to View AnswerA bribe paid to a foreign official can be deducted unless it is unlawful under the Foreign Corrupt Practices Act of 1977. PTS: 1 DIF: 1 REF: p. 6-12 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 23. Fines paid in the course of carrying on a trade or business generally are deductible if there is a related business purpose. Register to View AnswerFines paid for violation of laws are not deductible. PTS: 1 DIF: 1 REF: Example 13 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 24. Susan is a sales representative for a U.S. weapons manufacturer. She makes a $100,000 grease payment to a U.S. government official associated with a weapons purchase by the U.S. Army. She makes a similar payment to a Saudi Arabian government official associated with a similar sale. Neither of these payments is deductible by Susans employer. Register to View AnswerThe payment to the U.S. official is not deductible. However, unless the payment is illegal under the Foreign Corrupt Practices Act of 1977, the payment to the Saudi official can be deducted. PTS: 1 DIF: 1 REF: p. 6-12 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 5 min 25. The cost of legal advice associated with the preparation of an individuals Federal income tax return is not deductible because it is a personal expense. Register to View AnswerThis deduction is expressly allowed under 212. PTS: 1 DIF: 1 REF: p. 6-14 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 26. Two-thirds of treble damage payments under the antitrust law are deductible. Register to View AnswerOnly one-third of such payments is deductible. PTS: 1 DIF: 1 REF: p. 6-13 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 2 min 6-10 2010 Comprehensive Volume/Test Bank 27. The legal cost of having a will prepared is deductible. Register to View AnswerThis is a nondeductible personal expense. PTS: 1 DIF: 1 REF: p. 6-13 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 28. Legal expenses incurred in connection with rental property are deductions for AGI. Register to View AnswerThis is a deduction for AGI. PTS: 1 DIF: 1 REF: p. 6-13 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 29. Legal fees incurred in connection with a criminal defense are deductible if the crime is associated with a trade or business. Register to View AnswerOBJ: 3 MSC: 2 min PTS: 1 DIF: 1 REF: Example 15 NAT: AICPA FN-Reporting | AACSB Analytic 30. Clark operates a gambling operation, which is an illegal business under the laws of Texas. Therefore, none of the expenses of the business are deductible. Register to View AnswerThe usual expenses of operating an illegal business are deductible. Section 162, however, disallows a deduction for fines, bribes to public officials, illegal kickbacks, and other illegal payments. PTS: 1 DIF: 1 REF: p. 6-14 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 31. Since the Code prohibits illegal drug dealers from deducting business expenses, they cannot reduce taxable income by cost of goods sold. Register to View AnswerCost of goods sold is part of the gross income calculation and is not considered to be an expense. Thus, the 280E prohibition on deductions does not affect cost of goods sold. PTS: 1 DIF: 1 REF: p. 6-14 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 32. Deductions for lobbying expenses incurred in attempting to influence Federal and state legislation are not allowed, but deductions for lobbying expenses incurred in attempting to influence local (e.g., a city) legislation are allowed. Register to View AnswerOBJ: 3 MSC: 2 min PTS: 1 DIF: 1 REF: p. 6-14 | p. 6-15 NAT: AICPA FN-Reporting | AACSB Analytic Deductions and Losses: In General 6-11 33. A baseball team that pays a star player an annual salary of $25 million can deduct the entire $25 million as salary expense. If the same amount is paid to the CEO of IBM, only $1 million is deductible. Register to View AnswerThe $1 million limit on deducting compensation applies only to executive compensation of publicly traded companies. PTS: 1 OBJ: 3 MSC: 2 min DIF: 1 REF: p. 6-15 | p. 6-16 NAT: AICPA FN-Measurement | AACSB Analytic 34. Hollis operates a lawn care service in southeastern Missouri. He incurs $63,000 of expenses determining the feasibility of expanding the business to southwestern Missouri. If he expands the business, the $63,000 is deductible in the current year. If he does not do so, then he must amortize the $63,000 over a 180-month period. Register to View AnswerSince Hollis already is in the lawn care service business, he can deduct the full $63,000 in the current year regardless of whether the expansion takes place. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-16 | Example 18 NAT: AICPA FN-Measurement | AACSB Analytic 35. If a taxpayer is not already engaged in the same trade or business, the cost of investigating the purchase of a business cannot be deducted in the current year even if the business is acquired. Register to View AnswerOBJ: 3 MSC: 2 min PTS: 1 DIF: 1 REF: Concept Summary 6.1 NAT: AICPA FN-Measurement | AACSB Analytic 36. If a taxpayer makes a profit in three of the five consecutive years ending with the taxable year, the burden of proof is on the IRS to prove the activity is a hobby rather than a trade or business. Register to View AnswerThe burden of proof shifts to the IRS. PTS: 1 OBJ: 3 MSC: 2 min DIF: 1 REF: p. 6-18 | p. 6-33 NAT: AICPA FN-Reporting | AACSB Analytic 37. Cynthia has been operating Cynthias Ceramics for five years. For each of the five years, her business has generated losses of between $5,000 and $10,000. Even though the business did not have profits in at least three of the five years, Cynthia may be able to deduct the losses. Register to View AnswerSince Cynthias business did not have profits in at least three of the five years, the burden of proof is on her to prove that the activity is a business rather than a hobby. If Cynthia can satisfy the burden of proof requirement, she can deduct the losses. PTS: 1 DIF: 1 REF: Example 21 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 5 min 6-12 2010 Comprehensive Volume/Test Bank 38. If an activity involves horses, a profit in at least two of seven consecutive years meets the presumptive rule of 183. Register to View AnswerOBJ: 3 MSC: 2 min PTS: 1 DIF: 1 REF: p. 6-18 NAT: AICPA FN-Reporting | AACSB Analytic 39. A hobby activity can result in all of the hobby income being included in AGI and no deductions being allowed. Register to View AnswerThe 2%-of-AGI limitation can wipe out any deductible amount. Likewise, if the taxpayer does not itemize, no deduction will be permitted. PTS: 1 DIF: 1 REF: p. 6-19 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 40. If an item such as property taxes exceeds the income from a hobby, the excess amount of this item over the hobby income can be deducted if the taxpayer itemizes deductions. Register to View AnswerThe excess in this case qualifies as an itemized deduction. PTS: 1 DIF: 1 REF: p. 6-19 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 41. Hobby activity expenses are deductible from AGI to the extent of hobby income. Such expenses not in excess of hobby income are not subject to the 2% of AGI floor. Register to View AnswerSuch expenses are an itemized deduction and are subject to the 2% floor on miscellaneous itemized deductions except for the property tax and mortgage interest. PTS: 1 DIF: 1 REF: Example 22 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 42. Susan rents part of her personal residence in the summer for 10 days for $1,000. Anne rents all of her personal residence for 3 weeks in December for $2,500. Anne must include the $2,500 in her gross income whereas Susan is not required to include the $1,000 in her gross income. Register to View AnswerThe amount received as rent for a personal residence does not need to be included in the taxpayers gross income unless the number of rental days exceeds 14. Thus, only Anne need report her rental income. PTS: 1 DIF: 1 REF: Example 24 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 5 min 43. If a vacation home is used for personal use less than 15 days and is rented for more than 14 days during a year, the property is treated as primarily rental property. Register to View AnswerOBJ: 3 MSC: 2 min PTS: 1 DIF: 1 REF: p. 6-21 NAT: AICPA FN-Reporting | AACSB Analytic Deductions and Losses: In General 44. If a vacation home is classified as primarily rental use, a deduction for all of the rental expenses is allowed. Register to View AnswerThe personal use portion must be prorated. PTS: 1 OBJ: 3 MSC: 2 min DIF: 1 REF: Concept Summary 6.2 NAT: AICPA FN-Reporting | AACSB Analytic 6-13 45. If a vacation home is rented for less than 15 days during a year, all rental income and expenses (other than mortgage interest, real estate taxes, and a personal casualty loss) are ignored. Register to View AnswerOBJ: 3 MSC: 2 min PTS: 1 DIF: 1 REF: Concept Summary 6.2 NAT: AICPA FN-Reporting | AACSB Analytic 46. Theo owns a vacation home that is classified in the personal use/rental use category. Rent income is $9,000, while property taxes and mortgage interest allocated to the rental use part are $12,000. Only $9,000 of the $12,000 expenses can be deducted. Register to View AnswerThe gross income ceiling on deducting expenses for a vacation home does not apply to expenses that are otherwise deductible (e.g., property taxes and mortgage interest). Thus, the entire $12,000 can be deducted. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: Example 28 | Example 29 NAT: AICPA FN-Measurement | AACSB Analytic 47. If a vacation home is classified as primarily personal use, part of the maintenance and utility expenses can be allocated and deducted as a rental expense. Register to View AnswerNone of these expenses can be deducted. PTS: 1 DIF: 1 REF: p. 6-21 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 48. A vacation home rented for 180 days and used personally for 16 days is classified in the personal/rental use category. Register to View AnswerThe home can have personal use of 18 days (180 days 10%) in this case and be classified as primarily rental use. Therefore, in this case, the use of the home is classified as primarily rental use. PTS: 1 OBJ: 3 MSC: 2 min DIF: 1 REF: Concept Summary 6.2 NAT: AICPA FN-Reporting | AACSB Analytic 6-14 2010 Comprehensive Volume/Test Bank 49. In allocating the utilities and maintenance expenses on a personal/rental use residence, days of non-use are considered in determining the allocation. Register to View AnswerDays of non-use are ignored. PTS: 1 DIF: 1 REF: p. 6-23 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 2 min 50. Beulahs personal residence has an adjusted basis of $250,000 and a fair market value of $230,000. Beulah converts the property to rental use on December 1, 2008. The vacation home rules that limit the amount of the deduction to the rental income will apply and the adjusted basis for depreciation is $230,000. Register to View AnswerThe adjusted basis for depreciation is $230,000, the lower of Beulahs adjusted basis of $250,000 or the fair market value of $230,000 on the date of the conversion. However, additional data is necessary to determine whether the vacation home gross income ceiling on deductions rule applies. If the qualified rental period exception applies, the gross income limit does not apply. If the qualified rental period exception does not apply, then the gross income limit does apply. PTS: 1 DIF: 1 REF: p. 6-24 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 5 min 51. Bev pays $3,000 of medical expenses for her dependent mother, Molly. Bev may include the $3,000 with her own medical expenses of $7,500 in calculating her medical expenses for itemized deduction purposes. Thus, the 7.5%-of-AGI floor would apply to the $10,500. Register to View AnswerTo the rule that a taxpayer cannot deduct another taxpayers obligation, an exception exists for medical expenses. In determining her medical expense deduction, therefore, Bev can include the $3,000 payment on behalf of Molly. The 7.5% floor applies to all of the $10,500. PTS: 1 DIF: 1 REF: p. 6-26 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 5 min 52. LD Partnership, a cash basis taxpayer, purchases land and a building for $200,000 with $150,000 of the cost being allocated to the building. The gross receipts of the partnership are less than $100,000. LD must capitalize the $50,000 paid for the land, but can deduct the $150,000 paid for the building in the current tax year. Register to View AnswerBoth the cost of the land and the building must be capitalized. The $150,000 paid for the building can be depreciated over the MACRS statutory period. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-26 | p. 6-27 NAT: AICPA FN-Measurement | AACSB Analytic Deductions and Losses: In General 6-15 53. Repairs and maintenance on a building used in a business can be deducted, while capital expenditures must be capitalized and claimed as depreciation. Register to View AnswerOBJ: 3 MSC: 2 min PTS: 1 DIF: 1 REF: p. 6-26 | p. 6-27 NAT: AICPA FN-Measurement | AACSB Analytic 54. Marge sells land to her adult son, Jason, for its $20,000 appraised value. Her adjusted basis for the land is $25,000. Marges recognized loss is $0 and Jasons adjusted basis for the land is $25,000 ($20,000 cost + $5,000 disallowed loss of Marge). Register to View AnswerAlthough Marges recognized loss is $0, Jasons adjusted basis for the land is his cost of $20,000. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: Example 35 | Example 36 NAT: AICPA FN-Measurement | AACSB Analytic 55. For purposes of the 267 loss disallowance provision, a taxpayers uncle is a related party. Register to View AnswerAn uncle is not a related party for 267 loss disallowance purposes. PTS: 1 DIF: 1 REF: p. 6-28 NAT: AICPA FN-Reporting | AACSB Analytic MULTIPLE CHOICE 1. In preparing his 2009 Federal income tax return, Sam, who is not married, incorrectly claimed alimony payments of $12,000 as an itemized deduction (rather than as a deduction for AGI). Sams AGI is $60,000 and itemized deductions (which consist of the alimony, property taxes, and mortgage interest) are $20,000. Which of the following statements is correct? a. The error will result in taxable income being overstated. b. The error will result in taxable income being understated. c. The error could result in either taxable income being overstated or understated. d. The error will have no effect on taxable income. e. None of the above. Register to View AnswerIf the correction is made, the amount of the deductions for AGI increases by $12,000 and the amount of the itemized deductions decreases by $12,000. Thus, taxable income does not change. Note that none of the itemized deductions are based on AGI (i.e., there are no medical expenses, charitable contributions, or miscellaneous itemized deductions). Even with the alimony properly classified as a deduction for AGI, Sam still itemizes because the $8,000 exceeds the amount of the standard deduction for an unmarried taxpayer. PTS: 1 OBJ: 1 MSC: 5 min DIF: 1 REF: p. 6-3 | Example 2 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 2 min 6-16 2010 Comprehensive Volume/Test Bank 2. Trade and business expenses should be treated as: a. A deduction from AGI subject to the 2%-of-AGI floor. b. A deduction from AGI not subject to the 2%-of-AGI floor. c. Deductible for AGI. d. An itemized deduction if not reimbursed. e. None of the above. Register to View AnswerOBJ: 1 MSC: 2 min PTS: 1 DIF: 1 REF: p. 6-6 NAT: AICPA FN-Reporting | AACSB Analytic 3. Saul is single, under age 65, and has gross income of $50,000. His deductible expenses are as follows: Alimony Charitable contributions Contribution to a traditional IRA Expenses paid on rental property Interest on home mortgage and property taxes on personal residence State income tax What is Sauls AGI? a. $15,800. b. $27,000. c. $32,000. d. $33,000. e. None of the above. Register to View AnswerSauls AGI is calculated as follows: Gross income Deductions for AGI: Alimony IRA Expenses on rental property AGI PTS: 1 OBJ: 1 MSC: 5 min $50,000 $12,000 5,000 6,000 $12,000 2,000 5,000 6,000 7,000 2,200 (23,000) $27,000 DIF: 1 REF: p. 6-4 | p. 6-5 NAT: AICPA FN-Measurement | AACSB Analytic Deductions and Losses: In General 4. Janice is single, had gross income of $38,000, and incurred the following expenses: Charitable contribution Taxes and interest on home Legal fees incurred in a tax dispute Medical expenses Penalty on early withdrawal of savings Her AGI is: a. $21,300. b. $28,800. c. $32,800. d. $35,500. e. $37,800. Register to View AnswerJanices AGI is calculated as follows: Gross income Deductions for AGI: Penalty on early withdrawal of savings AGI PTS: 1 DIF: 1 REF: p. 6-5 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 1 MSC: 5 min $38,000 (200) $37,800 $2,500 9,000 1,000 4,000 200 6-17 5. Which of the following expenses is classified as a deduction for AGI? a. Alimony. b. Reimbursed employee business expense. c. Safe deposit box rental fee in which investment securities are stored. d. Only a. and b. e. a., b., and c. Register to View AnswerOBJ: 1 MSC: 2 min PTS: 1 DIF: 1 REF: p. 6-3 to 6-5 NAT: AICPA FN-Reporting | AACSB Analytic 6. Which of the following is a deduction from AGI (itemized deduction)? a. Contribution to a traditional IRA. b. Roof repairs to a rental home. c. Safe deposit box rental fee in which stock certificates are stored. d. Alimony payment. e. None of the above. Register to View Answera., b., and d. are deductions for AGI. PTS: 1 OBJ: 1 MSC: 5 min DIF: 1 REF: p. 6-4 | p. 6-5 | Concept Summary 6.3 NAT: AICPA FN-Reporting | AACSB Analytic 6-18 2010 Comprehensive Volume/Test Bank 7. Which of the following is correct? a. A personal casualty loss is classified as a deduction from AGI. b. Real estate taxes on a taxpayers personal residence are classified as deductions from AGI. c. An expense associated with rental property is classified as a deduction from AGI. d. Only a. and b. are correct. e. a., b., and c., are correct. Register to View AnswerOBJ: 1 MSC: 5 min PTS: 1 DIF: 1 REF: p. 6-4 | p. 6-5 NAT: AICPA FN-Reporting | AACSB Analytic 8. Which of the following are deductions for AGI? a. Alimony payments. b. Property taxes on a personal residence. c. Charitable contributions. d. Fines and penalties incurred in a trade or business. e. None of the above. Register to View AnswerOBJ: 1 MSC: 5 min PTS: 1 DIF: 1 REF: p. 6-4 to 6-6 NAT: AICPA FN-Reporting | AACSB Analytic 9. Which of the following is incorrect? a. Alimony is a deduction for AGI. b. The expenses associated with royalty property are a deduction for AGI. c. Contributions to a traditional IRA are a deduction from AGI. d. Medical expenses are a deduction from AGI e. All of the above are correct. Register to View AnswerOBJ: 1 MSC: 5 min PTS: 1 DIF: 1 REF: p. 6-4 | p. 6-5 NAT: AICPA FN-Reporting | AACSB Analytic 10. Which of the following is not a trade or business expense? a. Interest on business indebtedness. b. Property taxes on business property. c. Parking ticket paid on business auto. d. Depreciation on business property. e. All of the above are trade or business expenses. Register to View AnswerOBJ: 1 MSC: 5 min PTS: 1 DIF: 1 REF: p. 6-6 NAT: AICPA FN-Reporting | AACSB Analytic 11. Which of the following cannot be deducted as a 162 business expense? a. Expenses of investing in stocks and bonds. b. Charitable contributions made by a sole proprietorship. c. Fines and penalties. d. Only a. and c. cannot. e. a., b., and c. cannot. Deductions and Losses: In General 6-19 Register to View AnswerNone of the listed items can be deducted as a 162 business expense. Choices a. and b. are itemized deductions and choice c. cannot be deducted. PTS: 1 DIF: 1 REF: p. 6-4 to 6-6 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 5 min 12. Agnes is the sole shareholder of Violet, Inc. For 2009, she receives from Violet a salary of $200,000 and dividends of $100,000. Violets taxable income for 2009 is $500,000. On audit, the IRS treats $50,000 of Agness salary as unreasonable. Which of the following statements is correct? a. Agness gross income will increase by $50,000 as a result of the IRS adjustment. b. Violets taxable income will not be affected by the IRS adjustment. c. Agness gross income will decrease by $50,000 as a result of the IRS adjustment. d. Violets taxable income will increase by $50,000 as a result of the IRS adjustment. e. None of the above is correct. Register to View AnswerThe $50,000 of salary is reclassified as a dividend. Thus, Violets taxable income increases by $50,000 because dividends are not deductible. Agness gross income remains the same. Her salary income decreases by $50,000, but her dividend income increases by $50,000. PTS: 1 OBJ: 1 MSC: 5 min DIF: 1 REF: p. 6-6 | p. 6-7 | Example 6 NAT: AICPA FN-Measurement | AACSB Analytic 13. Which of the following is incorrect? a. All salaries of a business are deductible. b. To be deductible, a business expense must be both ordinary and necessary. c. The income and expenses of a business are reported on Schedule C. d. The purchase of a building must be capitalized. e. All of the above are incorrect. Register to View AnswerOnly the reasonable salaries of a business are deductible. PTS: 1 OBJ: 1 MSC: 5 min DIF: 1 REF: p. 6-6 | p. 6-7 NAT: AICPA FN-Reporting | AACSB Analytic 14. Benita incurred a business expense on December 10, 2009, which she charged on her bank credit card. She paid the credit card statement which included the charge on January 5, 2010. Which of the following is correct? a. If Benita is a cash method taxpayer, she cannot deduct the expense until 2010. b. If Benita is an accrual method taxpayer, she can deduct the expense in 2009. c. If Benita uses the accrual method, she can choose to deduct the expense in either 2009 or 2010. d. Only b. and c. are correct. e. a., b., and c. are correct. 6-20 2010 Comprehensive Volume/Test Bank Register to View AnswerChoice a. is incorrect because charging the expense on a bank credit card is treated as a constructive payment. Thus, as a cash method taxpayer, she can deduct the expense in 2009. If Benita uses the accrual method, she deducts the expense in 2009. In any event, she does not merely choose the year in which to deduct the expense (choice c.). PTS: 1 OBJ: 2 MSC: 5 min DIF: 1 REF: p. 6-9 | p. 6-10 NAT: AICPA FN-Reporting | AACSB Analytic 15. Payments by a cash basis taxpayer of capital expenditures: a. Must be expensed at the time of payment. b. Must be expensed by the end of the first year after the asset is acquired. c. Must be deducted over the actual or statutory life of the asset. d. Can be deducted in the year the taxpayer chooses. e. None of the above. Register to View AnswerBoth cash basis and accrual basis taxpayers are required to recover the cost of capital assets through amortization, depletion, or depreciation over the actual or statutory life of the asset. PTS: 1 DIF: 1 REF: p. 6-9 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 2 MSC: 5 min 16. Swan, Inc. is an accrual basis taxpayer. Swan uses the aging approach to calculate the reserve for bad debts. During 2009, the following occur associated with bad debts. Credit sales Collections on credit sales Amount added to the reserve Beginning balance in the reserve Identifiable bad debts during 2009 The amount of the deduction for bad debt expense for Swan for 2009 is: a. $10,000. b. $12,000. c. $20,000. d. $22,000. e. None of the above. Register to View AnswerOnly the specific charge-off method can be used. Reserves for estimated expenses are not allowed for tax purposes because the economic performance test cannot be satisfied. PTS: 1 DIF: 1 REF: p. 6-10 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 2 MSC: 5 min $300,000 280,000 12,000 0 10,000 17. Which of the following is deductible as a trade or business expense? a. A city coroner contributes to the mayors reelection campaign fund. b. Illegal bribes and kickbacks. c. Two-thirds of treble damage payments. d. Fines and penalties. e. None of the above. Deductions and Losses: In General Register to View AnswerOBJ: 2 MSC: 5 min PTS: 1 DIF: 1 REF: p. 6-6 | p. 6-11 to 6-13 NAT: AICPA FN-Measurement | AACSB Analytic 6-21 18. Rex, a cash basis calendar year taxpayer, runs a bingo operation which is illegal under state law. During 2009, a bill designated H.R. 9 is introduced into the state legislature which, if enacted, would legitimize bingo games. In 2009, Rex had the following expenses: Operating expenses in conducting bingo games Payoff money to state and local police Newspaper ads supporting H.R. 9 Political contributions to legislators who support H.R. 9 Of these expenditures, Rex may deduct: a. $247,000. b. $250,000. c. $258,000. d. $282,000. e. None of the above. Register to View AnswerRex can deduct only the $247,000 of operating expenses. PTS: 1 DIF: 1 REF: Example 16 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 5 min $247,000 24,000 3,000 8,000 19. Angela, a real estate broker, had the following income and expenses in her business: Commissions income Expenses: Commissions paid to non-brokers for referrals (illegal under state law and subject to criminal penalties) Commissions paid to other real estate brokers for referrals (not illegal under state law) Travel and transportation Supplies Office and phone Parking tickets How much net income must Angela report from this business? a. $48,500. b. $49,000. c. $60,000. d. $68,500. e. $69,000. $100,000 20,000 10,000 12,000 4,000 5,000 500 6-22 2010 Comprehensive Volume/Test Bank Register to View AnswerThe illegal commissions and the parking tickets are in violation of public policy and are not deductible. Income Expenses: Commissions to other brokers Travel and transportation Supplies Office and phone Net income PTS: 1 OBJ: 3 MSC: 10 min $100,000 $10,000 12,000 4,000 5,000 (31,000) $ 69,000 DIF: 1 REF: Example 14 | Example 16 NAT: AICPA FN-Measurement | AACSB Analytic 20. Melvin is engaged in an illegal drug-running operation. Which of the following expenses will reduce Melvins taxable income? a. Rent. b. Bribes paid to border guards. c. Cost of goods sold. d. Interest on business indebtedness. e. None of the expenses are deductible. Register to View AnswerOBJ: 3 MSC: 5 min PTS: 1 DIF: 1 REF: p. 6-14 NAT: AICPA FN-Reporting | AACSB Analytic 21. Terry and Jim are both involved in operating illegal businesses. Terry operates a gambling business and Jim operates a drug running business. Both businesses have gross revenues of $500,000. The businesses incur the following expenses. Employee salaries Bribes to police Rent and utilities Cost of goods sold Terry $200,000 25,000 50,000 0 Jim $200,000 25,000 50,000 125,000 Which of the following statements is correct? a. Neither Terry nor Jim can deduct any of the above items in calculating the business profit. b. Terry should report profit from his business of $250,000. c. Jim should report profit from his business of $500,000. d. Jim should report profit from his business of $250,000. e. None of the above. Deductions and Losses: In General Register to View AnswerTerry and Jim should report net profit from their businesses as follows: Gross revenues Less: Cost of goods sold Gross income Less: Expenses Employee salaries Rent and utilities Bribes to police Net profit Terry $500,000 (0) $500,000 (200,000) (50,000) 0 $250,000 Jim $500,000 (125,000) $375,000 0 0 0 $375,000 6-23 For Terry, the bribes to the police of $25,000 cannot be deducted. None of Jims expenses can be deducted. However, the cost of goods sold is viewed as a negative item in calculating gross income (i.e., gross income = gross profit) rather than as a deduction. PTS: 1 DIF: 1 REF: p. 6-14 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 10 min 22. Tom operates an illegal drug-running operation and incurred the following expenses: Salaries Illegal kickbacks Bribes to border guards Cost of goods sold Rent Interest Insurance on furniture and fixtures Utilities and telephone Which of the above amounts reduces his taxable income? a. $0. b. $160,000. c. $279,000. d. $324,000. e. None of the above. Register to View AnswerCost of goods sold of $160,000 is treated as a negative item in calculating gross income rather than as a deduction. For a drug dealer, all deductions are disallowed. PTS: 1 DIF: 1 REF: p. 6-14 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 5 min $ 75,000 20,000 25,000 160,000 8,000 10,000 6,000 20,000 23. Vera is the CEO of Brunettes, a publicly held corporation. For the year, she receives a salary of $950,000, a bonus of $600,000, and contributions to her retirement plan of $35,000. The bonus was awarded at the December board meeting based on Veras threat to accept a better paying job with a competitor. What amount may Brunettes deduct? a. $950,000. b. $985,000. c. $1,550,000. d. $1,585,000. e. None of the above. 6-24 2010 Comprehensive Volume/Test Bank Register to View AnswerSince Brunettes is a publicly held corporation and Vera is the CEO, the excessive executive compensation limitation (i.e., millionaires provision) applies. Thus, only the following may be deducted. Salary and bonus (limited to $1 million) Retirement plan contribution Note that the bonus does not meet the performance based exception. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-15 | p. 6-16 NAT: AICPA FN-Measurement | AACSB Analytic $1,000,000 35,000 $1,035,000 24. Tommy, an automobile mechanic employed by an auto dealership, is considering opening a fast food franchise. If Tommy decides not to acquire the fast food franchise, any investigation expenses are: a. A deduction for AGI. b. A deduction from AGI, subject to the 2 percent floor. c. A deduction from AGI, not subject to the 2 percent floor. d. Deductible up to $5,000 in the current year with the balance being amortized over a 180month period. e. Not deductible. Register to View AnswerSince Tommy is not in a business that is the same as or similar to the one being investigated and did not acquire the new business, his investigation expenses cannot be deducted. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-17 | Example 19 NAT: AICPA FN-Reporting | AACSB Analytic 25. Iris, a calendar year cash basis taxpayer, owns and operates several TV rental outlets in Florida, and wants to expand to other states. During 2009, she spends $14,000 to investigate TV rental stores in South Carolina and $9,000 to investigate TV rental stores in Georgia. She acquires the South Carolina operations, but not the outlets in Georgia. As to these expenses, Iris should: a. Capitalize $14,000 and not deduct $9,000. b. Expense $23,000 for 2009. c. Expense $9,000 for 2009 and capitalize $14,000. d. Capitalize $23,000. e. None of the above. Register to View AnswerSince Iris owns and operates TV rental outlets, all of the investigation expenses can be deducted. PTS: 1 DIF: 1 REF: Example 18 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 5 min Deductions and Losses: In General 26. Which of the following statements is correct in connection with the investigation of a business? a. If the taxpayer is not already engaged in the trade or business, the expenses incurred are deductible if the project is abandoned. b. If the business is acquired, the expenses may be deducted immediately by a taxpayer engaged in a similar trade or business. c. That business must be related to the taxpayers present business for any expense ever to be deductible. d. Regardless of whether the taxpayer is already engaged in the trade or business, the expenses must be capitalized and amortized. e. None of the above. Register to View AnswerOBJ: 3 MSC: 5 min PTS: 1 DIF: 1 REF: Concept Summary 6.1 NAT: AICPA FN-Reporting | AACSB Analytic 6-25 27. Which of the following is not relevant in deciding whether an activity is profit-seeking or a hobby? a. The time and effort expended. b. The expertise of the taxpayers or their advisers. c. The history of income or losses from the activity. d. The tax benefits of the activity to the taxpayer. e. All of the above factors are to be considered. Register to View AnswerThe first three choices are taken from the listing of 9 factors in the text. The fourth choice is paraphrased from the list (i.e., the financial status of the taxpayer). PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-18 | p. 6-19 NAT: AICPA FN-Reporting | AACSB Analytic 28. Which of the following is correct? a. If an activity is classified as a trade or business, the net loss can be deducted. b. If an activity is classified as a hobby, none of the expenses can be deducted. c. If an activity is classified as a hobby, part of the expenses may be deductible. d. Only a. and c. are correct. e. a., b., and c. are correct. Register to View AnswerIf the activity is classified as a hobby, expenses can be deducted to the extent of the income. PTS: 1 DIF: 1 REF: p. 6-18 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 5 min 6-26 2010 Comprehensive Volume/Test Bank 29. Priscella pursued a hobby of making bedspreads in her spare time. Her AGI before considering the hobby is $40,000. During the year she sold bedspreads the for $10,000. She incurred expenses as follows: Supplies Interest on loan to get business started Advertising $4,000 500 6,500 Assuming that the activity is deemed a hobby, how should she report these items on her tax return? a. Include $10,000 in income and deduct $11,000 for AGI. b. Ignore both income and expenses since hobby losses are disallowed. c. Include $10,000 in income, deduct nothing for AGI, and claim $10,000 of the expenses as itemized deductions. d. Include $10,000 in income and deduct interest of $500 for AGI. e. None of the above. Register to View AnswerThe itemized deductions of $10,000 must be reduced by 2% of $50,000 or $1,000. PTS: 1 DIF: 1 REF: p. 6-19 NAT: AICPA FN-Reporting | AACSB Analytic 30. Cory incurred and paid the following expenses: Tax return preparation fee Moving expenses Investment expenses Expenses associated with rental property Interest expense associated with loan to finance tax-exempt bonds Calculate the amount that Cory can deduct (before any percentage limitations). a. $5,000. b. $4,600. c. $3,000. d. $1,500. e. None of the above. Register to View AnswerAll of the expenses are deductible either as deductions for ($2,000 + $1,500) or as deductions from ($600 + $500) except for the expenses associated with the tax-exempt bonds ($400). PTS: 1 OBJ: 1 | 3 MSC: 5 min DIF: 1 REF: p. 6-29 | Concept Summary 6.3 NAT: AICPA FN-Measurement | AACSB Analytic $ 600 2,000 500 1,500 400 OBJ: 3 MSC: 5 min Deductions and Losses: In General 31. Which of the following is not deductible? a. Moving expenses. b. Tax return preparation fees. c. Expenses incurred for the production of income. d. Allowable hobby expenses in excess of hobby income. e. None of the above. 6-27 Register to View AnswerMoving expenses ( 217); tax return preparation fee ( 212); and expenses incurred for the production of income ( 212) are deductible. The hobby expenses in excess of the hobby income cannot be deducted. PTS: 1 OBJ: 1 | 3 MSC: 5 min DIF: 1 REF: p. 6-18 | Concept Summary 6.3 NAT: AICPA FN-Reporting | AACSB Analytic 32. Which of the following statements is correct? a. If a personal residence is rented for fewer than 15 days, the rent income is not included in gross income and no expenses can be deducted. b. If a personal residence is rented for more than 14 days, the rent income must be included in gross income and all the related expenses can be deducted. c. If a personal residence is rented for more than 14 days and the personal use days exceed 14 days and 10% of the rental days, the rent income must be included in gross income, but the expense deductions are limited to the amount of gross income. d. Only a. and b. e. Only a. and c. Register to View AnswerChoice a. is incorrect in that itemized deductions such as mortgage interest and property taxes can be deducted. Choice b. is incorrect since only the allocated portion of rental expenses can be deducted. PTS: 1 OBJ: 3 MSC: 10 min DIF: 2 REF: Concept Summary 6.2 NAT: AICPA FN-Reporting | AACSB Analytic 33. Robyn rents her beach house for 60 days and uses it for personal use for 30 days during the year. The rental income is $6,000 and the expenses are as follows: Mortgage interest Real estate taxes Utilities Maintenance Insurance Depreciation (rental part) $9,000 3,000 2,000 1,000 500 4,000 Using the IRS approach, total expenses that Robyn can deduct on her tax return associated with the beach house are: a. $0. b. $6,000. c. $8,000. d. $12,000. e. None of the above. 6-28 2010 Comprehensive Volume/Test Bank Register to View AnswerSince the property is classified as personal/rental use, the general rule is that the deductible expenses cannot exceed the gross income. Thus, under the general rule, the deductible expenses would be limited to $6,000. However, this ceiling does not apply to expenses that otherwise would be deductible as itemized deductions. Consequently, all of the mortgage interest and real estate taxes can be deducted ($9,000 + $3,000 = $12,000). PTS: 1 DIF: 2 REF: p. 6-22 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 10 min 34. If a vacation home is determined to be a personal/rental use residence, which of the following statements is correct? a. All rental income is included in gross income. b. All rental related expenses are a deduction from gross income. c. Expenses must be allocated between rental and personal use. d. Only a. and c. are correct. e. a., b., and c. are correct. Register to View AnswerOnly part of the rental expenses are deductible. Those that are deductible are classified as deductions for AGI. PTS: 1 DIF: 1 REF: Example 28 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 5 min 35. Bob and April own a house at the beach. The house was rented to unrelated parties for 8 weeks during the year. April and the children used the house 12 days for their vacation during the year. After properly dividing the expenses between rental and personal use, it was determined that a loss was incurred as follows: Gross rental income Less: Mortgage interest and property taxes Other allocated expenses Net rental loss $4,000 $3,500 2,000 (5,500) ($1,500) What is the correct treatment of the rental income and expenses on Bob and Aprils joint income tax return for the current year assuming the IRS approach is used if applicable? a. A $1,500 loss should be reported. b. Only the mortgage interest and property taxes should be deducted. c. Since the house was used more than 10 days personally by Bob and April, the rental expenses (other than mortgage interest and property taxes) are limited to the gross rental income in excess of deductions for interest and taxes allocated to the rental use. d. Since the house was used less than 50% personally by Bob and April, all expenses allocated to personal use may be deducted. e. Bob and April should include none of the income or expenses related to the beach house in their current year income tax return. Register to View AnswerPTS: 1 DIF: 1 REF: p. 6-22 | Concept Summary 6.2 OBJ: 3 NAT: AICPA FN-Measurement | AACSB Analytic MSC: 5 min Deductions and Losses: In General 36. Which of the following is correct? a. A taxpayer generally cannot claim a deduction for payment of an obligation of a dependent. b. Expenses paid for medical care of a dependent are deductible by the payor. c. Charitable contributions paid on behalf of a dependent are deductible by the payor. d. Only a. and b. are correct. e. a., b., and c. are correct. Register to View AnswerOBJ: 3 MSC: 5 min PTS: 1 DIF: 1 REF: p. 6-25 | p. 6-26 NAT: AICPA FN-Reporting | AACSB Analytic 6-29 37. Sarah incurred the following expenses for her dependent son during the current year: Payment of principal on sons automobile loan Interest on above loan Payment of sons property taxes Payment of principal on sons personal residence loan Payment of interest on sons personal residence loan How much may Sarah deduct in computing her itemized deductions? a. $0. b. $9,200. c. $11,200. d. $17,700. e. None of the above. Register to View AnswerNone of the items are incurred for the taxpayers (Sarah) benefit or as a result of the taxpayers obligation. PTS: 1 DIF: 1 REF: p. 6-25 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 5 min $5,000 2,000 1,200 1,500 8,000 38. Harry divorced Wanda during the year. He incurred the following legal expenses as itemized on the bill from his attorney: Fees related to property division Fees related to the determination of dependency exemption General legal fees incident to divorce How much can Harry deduct? a. $0. b. $150. c. $650. d. $1,550. e. None of the above. Register to View AnswerOnly those separately stated fees that relate solely to tax advice ($150) are deductible. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-13 | p. 6-26 NAT: AICPA FN-Measurement | AACSB Analytic $500 150 900 6-30 2010 Comprehensive Volume/Test Bank 39. Which of the following must be capitalized by a business? a. Replacement of a windshield of a business truck which was broken in an accident. b. Repair of a roof of a building used in business. c. Amount paid for a covenant not to compete. d. Only a. and c. must be capitalized. e. a., b., and c. can be expensed rather than capitalized. Register to View AnswerAll of these expenses, except for the covenant, can be deducted in the current tax year. The amortization period for the covenant is 15 years. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-26 | p. 6-27 NAT: AICPA FN-Reporting | AACSB Analytic 40. On January 2, 2009, Fran acquires a business from Chuck. Among the assets purchased are the following intangibles: patent with a 12-year remaining life, a covenant not to compete for 10 years, and goodwill. Of the purchase price, $120,000 was paid for the patent and $45,000 for the covenant. The amount of the excess of the purchase price over the identifiable assets was $90,000. What is the amount of the amortization deduction for 2009? a. $11,000. b. $17,000. c. $13,250. d. $18,500. e. None of the above. Register to View AnswerAll of these intangibles are 197 intangibles and are amortized over a 15-year statutory period. Patent Covenant Goodwill $120,000 15 $ 45,000 15 $ 90,000 15 = = = $ 8,000 3,000 6,000 $17,000 OBJ: 3 MSC: 10 min PTS: 1 DIF: 1 REF: p. 6-28 NAT: AICPA FN-Measurement | AACSB Analytic 41. In January, Lance sold stock with a cost basis of $26,000 to his brother, James, for $24,000, the fair market value of the stock on the date of sale. Five months later, James sold the same stock through his broker for $27,000. What is the tax effect of these transactions? a. Disallowed loss to James of $2,000; gain to Lance of $1,000. b. Disallowed loss to Lance of $2,000; gain to James of $3,000. c. Deductible loss to Lance of $2,000; gain to James of $3,000. d. Disallowed loss to Lance of $2,000; gain to James of $1,000. e. None of the above. Register to View AnswerLances realized loss of $2,000 ($24,000 $26,000) is disallowed. James may reduce his realized gain of $3,000 ($27,000 $24,000) by Lances disallowed loss of $2,000. So James recognized gain is $1,000. PTS: 1 DIF: 1 REF: Example 35 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 5 min Deductions and Losses: In General 6-31 42. On January 3, 2009, Hector sold stock (cost of $60,000) to his sister Florine for its fair market value of $55,000. On July 30, 2009, Florine sold the same stock to a friend for $63,000. What is the proper treatment in 2009 for these transactions? a. Neither Hector nor Florine has a recognized gain or loss. b. Hector has a recognized loss of $5,000. c. Florine has a recognized gain of $8,000. d. Florine has a recognized gain of $3,000. e. None of the above. Register to View AnswerSince this is a related-party transaction, Hectors realized loss of $5,000 ($55,000 $60,000) is disallowed. Florine can reduce her realized gain of $8,000 ($63,000 $55,000) by Hectors disallowed loss of $5,000. So her recognized gain is $3,000. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: Example 35 | Example 36 NAT: AICPA FN-Measurement | AACSB Analytic 43. For constructive ownership purposes, which of the following are related parties under 267? I. II. III. IV. a. b. c. d. e. Taxpayers nephew. Taxpayers aunt. Taxpayers 55% owned corporation. Taxpayers sister. I IV. II IV. III and IV. IV only. None of the above are related parties. Register to View AnswerTaxpayers nephew and aunt are not related parties under 267. PTS: 1 DIF: 1 REF: p. 6-28 NAT: AICPA FN-Reporting | AACSB Analytic PROBLEM 1. Amy incurs and pays the following expenses during the year: Alimony of $14,000 to her former spouse, Ted. Child support of $12,000 to Ted for the care of their son, Bobby. Medical expenses of $8,000 for herself. Charitable contributions of $3,000 to her church. Contribution to her traditional IRA of $5,000. Mortgage interest on her residence of $11,000. Property taxes on her residence of $1,200. State income taxes for herself of $4,000. OBJ: 3 MSC: 5 min Amys only income is a $100,000 salary. Calculate Amys deductions for AGI and from AGI. 6-32 2010 Comprehensive Volume/Test Bank ANS: Amys AGI is calculated as follows: Salary Less: Deductions for AGI: Alimony Traditional IRA contribution AGI Her itemized deductions (i.e., deductions from AGI) are as follows: Medical expenses [$8,000 ($81,000 7.5%)] Charitable contributions Mortgage interest on residence Property taxes on residence State income taxes Total itemized deductions The child support of $12,000 for Bobby is not deductible. PTS: 1 OBJ: 1 MSC: 10 min DIF: 2 REF: p. 6-3 to p. 6-5 NAT: AICPA FN-Measurement | AACSB Analytic $100,000 $14,000 5,000 (19,000) $ 81,000 $ 1,925 3,000 11,000 1,200 4,000 $ 21,125 2. Arnold and Beth file a joint return. Use the following data to calculate their deduction for AGI. Mortgage interest on personal residence Property taxes on personal residence Alimony payments Moving expenses Charitable contributions State income taxes Investment interest ($8,000 of expenses limited to net investment income of $6,000) Unreimbursed employee expenses Sales taxes ANS: Arnold and Beths deduction for AGI is $18,000 and consists of the following items: Alimony payments Moving expenses Deduction for AGI $12,000 6,000 $18,000 $ 4,000 2,000 12,000 6,000 1,500 5,000 6,000 2,500 2,600 All of the other items are itemized deductions. Note that the taxpayer must choose between the state income taxes and the sales taxes. PTS: 1 OBJ: 1 MSC: 10 min DIF: 2 REF: p. 6-4 | p. 6-5 NAT: AICPA FN-Measurement | AACSB Analytic Deductions and Losses: In General 6-33 3. Irene and Jim own an unincorporated bakery. They determine their salaries at the end of the year by using the amount required to reduce the net income of the bakery to $0. Based on this policy, Irene and Jim each receive a total salary of $250,000. This is paid as follows: $10,000 per month and $130,000 on December 31. Determine the amount of the salary deduction. ANS: Since the bakery is not incorporated, the issue of the reasonableness of the salaries is not relevant. Irene and Jim will report income of $250,000 each regardless of whether it is labeled as salary or as a distribution of the bakerys net income. Therefore, there is nothing wrong with the bakery (i.e., a partnership) taking a $500,000 salary deduction. PTS: 1 OBJ: 1 MSC: 5 min DIF: 1 REF: p. 6-6 | p. 6-7 NAT: AICPA FN-Measurement | AACSB Analytic 4. Sandra owns an insurance agency. The following selected data is taken from the agency balance sheet and income statement prepared using the accrual method. Revenue Salaries and commissions Rent Insurance Utilities Accounts receivable, 1/1/2009 Accounts receivable, 12/31/2009 Accounts payable, 1/1/2009 Accounts payable, 12/31/2009 Calculate Sandras net profit using the cash method for 2009. ANS: Sandras accrual method net profit is calculated as follows: Revenue Less: Expenses Salaries and commissions Rent Insurance Utilities Net profit $250,000 $100,000 10,000 5,000 6,000 $250,000 100,000 10,000 5,000 6,000 40,000 48,000 12,000 15,000 (121,000) $129,000 To convert to cash method net profit, the following adjustments must be made. Net profitaccrual method Add: Increase in accounts payable ($15,000 $12,000) Deduct: Increase in accounts receivable ($48,000 $40,000) Net profitcash method PTS: 1 OBJ: 2 MSC: 10 min DIF: 2 REF: p. 6-9 | p. 6-10 NAT: AICPA FN-Measurement | AACSB Analytic $129,000 3,000 (8,000) $124,000 6-34 2010 Comprehensive Volume/Test Bank 5. Woody owns a barber shop. The following selected data is taken from the barber shop balance sheet and income statement prepared using the cash method. Revenue Salaries and commissions Rent Insurance Utilities The following supplemental data also is provided. Accounts receivable, 1/1/2008 Accounts receivable, 12/31/2008 Accounts payable, 1/1/2008 Accounts payable, 12/31/2008 Calculate Woodys net profit using the accrual method. ANS: Woodys cash method net profit is calculated as follows: Revenue Less: Expenses Salaries and commissions Rent Insurance Utilities Net profit $242,000 $97,000 10,000 5,000 6,000 $40,000 48,000 12,000 15,000 $242,000 97,000 10,000 5,000 6,000 (118,000) $124,000 To convert to accrual method net profit, the following adjustments must be made. Net profitcash method Add: Increase in accounts receivable ($48,000 $40,000) Deduct: Increase in accounts payable ($15,000 $12,000) Net profitaccrual method PTS: 1 OBJ: 2 MSC: 10 min DIF: 2 REF: p. 6-9 | p. 6-10 NAT: AICPA FN-Measurement | AACSB Analytic $124,000 8,000 (3,000) $129,000 6. Taylor, a cash basis architect, rents the building in which his office is located for $2,000 per month. He commenced his practice on June 1, 2009. In order to guarantee no rent increases during an 18-month period, he signed an 18-month lease and prepaid the $36,000 on June 1, 2009. How much can Taylor deduct as rent expense for 2009? ANS: Taylor is a cash basis taxpayer. Thus, he is eligible to use the one-year rule on prepayments. Since his prepayments of 18-months rent does not extend beyond the end of 2010, he can deduct the $36,000 paid in 2009. PTS: 1 OBJ: 2 MSC: 5 min DIF: 1 REF: Example 7 | Example 8 NAT: AICPA FN-Measurement | AACSB Analytic Deductions and Losses: In General 6-35 7. In order to protect against rent increases on the building in which she operates a dance studio, Mella signs an 18-month lease for $18,000. The lease commences on November 1, 2009. How much of the $18,000 payment can she deduct in 2009 and 2010? a.If Mella is an accrual basis taxpayer? b.If Mella is a cash basis taxpayer? ANS: a.As an accrual basis taxpayer, Mella can deduct the amount of the rent expenses incurred in 2009 of $2,000 ($1,000 2 months) for 2009 and the $12,000 ($1,000 12 months) incurred in 2010 for 2010. b.Since Mella is a cash basis taxpayer, she can deduct the entire $18,000 prepayment in 2009 if she can satisfy the one-year rule. However, since the rental period of 18 months extends beyond the end of 2010, she fails the requirement for the one-year rule. Consequently, she can deduct only $2,000 in 2009 and $12,000 in 2010. PTS: 1 OBJ: 2 MSC: 5 min DIF: 1 REF: Example 7 | Example 8 NAT: AICPA FN-Measurement | AACSB Analytic 8. Roses business sells air conditioners which have a one-year warranty. Based on historical data, the warranty costs amount to 16% of sales. During 2009, air conditioner sales are $200,000. Actual warranty expenses paid in 2009 are $30,500. a. b. Determine the amount of the warranty expense deduction for 2009 if Roses business uses the accrual method. How would your answer change if Rose used the cash method for extended warranties and the purchasers paid $20,000 for the warranties which covered the second and third years of ownership? Register to View AnswerEven though Roses business uses the accrual method, reserves for estimated warranty expenses are not permitted. Therefore, the deduction for warranty expenses is the amount paid of $30,500. b. Rose would record gross income in 2009 of $220,000 ($200,000 + $20,000). The deduction for warranty expense would still be $30,500. OBJ: 2 MSC: 10 min PTS: 1 DIF: 1 REF: Example 12 NAT: AICPA FN-Measurement | AACSB Analytic 9. Rabbit, Inc., an airline manufacturer, is negotiating with a Middle East country for the sale of jet fighters. To complete the sale, a $1 million grease payment must be made. How much, if any, of the grease payment is deductible? ANS: 6-36 2010 Comprehensive Volume/Test Bank If the grease payment does not violate the Foreign Corrupt Practices Act of 1977, then the entire $1 million payment is deductible. However, if the grease payment does violate the Act, then none of it is deductible. PTS: 1 DIF: 1 REF: p. 6-12 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 5 min 10. Robert operates an illegal drug-running business and has the following items of income and expense. What is Roberts adjusted gross income from this operation? Income Expenses: Rent Utilities Bribes to police Medical expense Legal fees Depreciation Illegal kickbacks Cost of goods sold $500,000 8,000 2,000 10,000 5,000 20,000 14,000 15,000 200,000 ANS: He is allowed to deduct only the cost of goods sold; thus, his AGI is $300,000 ($500,000 $200,000). Note that the cost of goods sold is treated as a negative item in calculating gross income. PTS: 1 DIF: 1 REF: p. 6-14 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 5 min 11. Kitty runs a brothel (illegal under state law) and has the following items of income and expense. What is the amount that she must include in taxable income from her operation? Income Expenses: Rent Utilities Bribes to police Medical expense Legal fees Depreciation Illegal kickbacks ANS: Income Expenses: Rent Utilities Medical Legal fees Depreciation $200,000 8,000 2,000 10,000 5,000 20,000 14,000 15,000 $200,000 $ 8,000 2,000 5,000 20,000 14,000 (49,000) $151,000 Deductions and Losses: In General The bribes to police of $10,000 and illegal kickbacks of $15,000 are not deductible. PTS: 1 DIF: 1 REF: Example 16 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 10 min 6-37 12. The salaries of the top seven executives of Lime, Inc. are as follows: No. 1 No. 2 No. 3 No. 4 No. 5 No. 6 No. 7 a. b. $3.0 million 2.5 million 2.0 million 1.5 million .5 million .4 million .3 million Determine the amount Lime may deduct for the salaries if it is a publicly traded corporation. Determine the amount Lime may deduct for the salaries if it is a closely held corporation. Register to View AnswerThe salary deduction for the top five executives is limited to $1 million per executive. Thus, Limes deduction is limited to $4.5 million ($1 million + $1 million + $1 million + $1 million + $0.5 million) for these five executives. In addition, Lime can deduct the $700,000 ($400,000 + $300,000) paid to the other two executives. b. Assuming the salaries paid by Lime are reasonable, the entire $10.2 million ($3.0 million + $2.5 million + $2.0 million + $1.5 million + $0.5 million + $0.4 million + $0.3 million) paid may be deducted. DIF: 1 REF: p. 6-15 | p. 6-16 NAT: AICPA FN-Measurement | AACSB Analytic PTS: 1 OBJ: 3 MSC: 10 min 13. Gladys owns a retail hardware store in Tangipahoa. She is considering opening a business in Hammond, a community located 25 miles away. She incurs expenses of $60,000 in 2009 in investigating the feasibility and desirability of doing so. What amount can Gladys deduct in 2009 if the business is: a. b. c. d. Another retail hardware store which she opens in December 2009? Another retail hardware store which she decides against opening? A video rental store which she opens in December 2009? A video rental store which she decides against opening? 6-38 2010 Comprehensive Volume/Test Bank Register to View AnswerThe $60,000 of investigation expense can be deducted by Gladys in 2009. b. c. Even though Gladys decided not to open another store, she can deduct the $60,000 of investigation expenses in 2009 since she already is in the retail hardware business. Because Gladys was not in the video rental business, the $60,000 of investigation expenses must be capitalized. The $5,000 expense allowance is completely phased out; thus, the entire $60,000 is amortized over a 180-month period beginning with the month in which the business is started (i.e., December). Thus, Gladys can deduct $333 in 2009 ($60,000 180 1 month). Since Gladys was not in the video rental business and she did not open the store, none of the $60,000 can be deducted. DIF: 2 REF: p. 6-16 | p. 6-17 | Concept Summary 6.1 NAT: AICPA FN-Measurement | AACSB Analytic d. PTS: 1 OBJ: 3 MSC: 10 min 14. While she was a college student, Juliet worked in a bookstore located near campus. She thinks a bookstore located on the other side of campus would be successful. She incurs expenses of $18,000 (accounting fees, marketing survey, etc.) in exploring its business potential. Her parents have agreed to loan her the money required to start the business. What amount of these investigation costs can Juliet deduct if: a. She opens the business in July 2009. b. She decides not to open the bookstore. ANS: a.If Juliet opens the bookstore in July 2009, she can deduct the following investigation expenses in 2009. Allowed expense deduction in first year $5,000 $5,433 Amortization ($13,000/180 months 6 months) Deductible investigation expenses $433 b. If Juliet does not open the bookstore, she cannot deduct any of the $18,000 of expenses she incurred. PTS: 1 OBJ: 3 MSC: 10 min DIF: 1 REF: p. 6-16 | p. 6-17 | Concept Summary 6.1 NAT: AICPA FN-Measurement | AACSB Analytic Deductions and Losses: In General 15. Calculate the net income includible in taxable income for the following hobby: Income Mortgage interest and property taxes allocable to hobby Depreciation Supplies and fees Telephone for hobby ANS: Income (includible in gross income) Itemized deductions: Mortgage interest and property taxes Supplies and fees Telephone Depreciation (limited to $23,000 $12,000 $7,000 $3,000) $23,000 12,000 4,000 7,000 3,000 $23,000 $12,000 7,000 3,000 1,000 6-39 (23,000) $ 0 Otherwise deductible expenses must be deducted first; only enough other expenses are allowed to offset the remaining income. Deductions affecting depreciable basis are taken last. The mortgage interest and property taxes are deductible as itemized deductions and the other hobby-related expenses are subject to the 2%-of-AGI floor. Once the taxpayers AGI is determined, the effect of the 2%-of-AGI floor on itemized deductions can be calculated. PTS: 1 DIF: 1 REF: Example 22 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 10 min 16. Emelie and Taylor are employed by the Federal government and own their home in Washington, D.C. While vacationing in the summer for three weeks, they rent their home for two weeks to an Angolian diplomat for $4,000. During the third week, they permit Taylors aunt and uncle to stay in the house. Expenses associated with the home for the year are as follows: Mortgage interest Property taxes Insurance Utilities Maintenance and repairs Depreciation $12,000 4,000 1,000 2,400 1,500 9,000 Determine the effect of these income and expense items associated with their home if they file a joint return. ANS: Since Emelie and Taylor rent their home for less than 15 days during the year, the $4,000 of rent income is excluded from their gross income. The only deductions permitted are the mortgage interest of $12,000 and the property taxes of $4,000. Note that Taylors aunt and uncles occupancy of the house for one week has no effect as no rent was involved. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-21 | Example 24 NAT: AICPA FN-Measurement | AACSB Analytic 6-40 2010 Comprehensive Volume/Test Bank 17. During the year, Larry rented his vacation home for 200 days and lived in it for 20 days. During the remaining days of the year, the vacation home was available for rental use. Income and expenses associated with the vacation home were as follows: Rent income Expenses: Property taxes Mortgage interest Utilities Maintenance and repair Depreciation Insurance a. b. $25,000 3,500 11,000 1,800 2,000 6,000 1,500 Is the vacation home subject to the limitation on the deduction of a personal/rental use vacation home? Calculate the effect of the vacation home rental on Larrys AGI. Register to View AnswerThe vacation home is not subject to the limitations on the deductions of a personal/rental vacation home. It does satisfy the rental part of the classification because it is rented for greater than 14 days. However, the personal use of 20 days does not exceed the greater of (1) 14 days or (2) 10% of the rental days, since 10% of the rental days is 20 (200 rental days 10%) days. Therefore, the appropriate classification is primarily rental use rather than personal/rental use. b. Rent income $25,000 Expenses: (3,182) Property taxes ($3,500 90.9%) (10,000) Mortgage interest ($11,000 90.9%) (1,636) Utilities ($1,800 90.9%) (1,818) Maintenance and repairs ($2,000 90.9%) (5,454) Depreciation ($6,000 90.9%) (1,364) Insurance ($1,500 90.9%) Increase in Larrys AGI $ 1,546 PTS: 1 DIF: 3 REF: p. 6-21 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 10 min 18. During the year Martin rented his vacation home for three months and spent one month there. Gross rental income from the property was $5,000. Martin incurred the following expenses: mortgage interest, $3,000; real estate taxes, $1,500; utilities, $800; maintenance, $500; and depreciation, $4,000. Compute Martins allowable deductions for the vacation home. ANS: Since the vacation home is rented for 15 or more days and is used for personal purposes for more than the greater of (1) 14 days or (2) 10% of the rental days, the deductions are scaled down, using the courts approach, as follows: Deductions and Losses: In General Gross income Deduct: Taxes and interest (3/12 $4,500) Remainder applicable to other rental expenses Deduct: Allocable share of utilities and maintenance [3/4 ($800 + $500)] Balance applicable to depreciation Deduct: Depreciation (3/4 $4,000 = $3,000) but limited to above balance Net income $5,000 (1,125) $3,875 (975) $2,900 (2,900) $ 0 6-41 Thus, Martin may deduct $1,125 taxes and interest, $975 utilities and maintenance, and $2,900 depreciation against the gross income of $5,000. The personal portion of taxes and interest ($3,375) is deductible as an itemized deduction. Example 29 Using the IRSs approach, though, the deductions are as follows: Gross income Deduct: Taxes and interest (3/4 $4,500) Remainder applicable to other rental expenses Deduct: Allocable share of utilities and maintenance [3/4 ($800 + $500)] Balance applicable to depreciation Deduct: Depreciation (3/4 $4,000 = $3,000) but limited to above balance Net income $5,000 (3,375) $1,625 (975) $ 650 (650) $ 0 Thus, Martin may deduct $3,375 taxes and interest, $975 utilities and maintenance, and $650 depreciation against the gross income of $5,000. The personal portion of taxes and interest ($1,125) is deductible as an itemized deduction. PTS: 1 DIF: 2 REF: Example 28 NAT: AICPA FN-Measurement | AACSB Analytic OBJ: 3 MSC: 15 min 19. Bridgetts son, Amos, is $4,500 in arrears on his residential mortgage payments. Of the $4,500, $3,800 represents interest and $700 represents principal. a. b. If Bridgett pays the $4,500 to the lender, how much can she deduct? How much can Amos deduct? If Bridgett pays the $3,800 of interest to the lender and loans or gives $700 to Amos, who pays the $700 of principal, how much can she deduct? How much can Amos deduct? If Bridgett gives or lends the $4,500 to Amos who pays the lender, how much can he deduct? How much can Bridgett deduct? Advise Bridgett and Amos on how the payment should be made. c. d. 6-42 2010 Comprehensive Volume/Test Bank Register to View AnswerA deduction cannot be taken for paying another taxpayers obligation. So if Bridgett pays the lender, neither Bridgett nor Amos could deduct the $3,800 of mortgage interest expense. b. Bridgett cannot deduct the $3,800 payment identified as principal since this represents the payment of another taxpayers obligation. Even though Amos has identified the $700 payment as relating to the principal of the mortgage, he probably can deduct the $700 as mortgage interest expense since Bridgett is not allowed the deduction. Amos could deduct the $3,800 of mortgage interest expense, and Bridgett would receive no deduction. Bridgett should either loan or give the funds to Amos who then makes the mortgage payments of $4,500 ($3,800 interest + $700 principal). DIF: 1 REF: p. 6-25 | p. 6-26 NAT: AICPA FN-Measurement | AACSB Analytic c. d. PTS: 1 OBJ: 3 MSC: 10 min 20. Mattie and Elmer are separated and are in the process of obtaining a divorce. They incur legal fees for their respective attorneys with the expenses being itemized as follows: For General costs of the divorce Determination of dependency exemptions Property settlement tax consequences Mattie $3,500 1,500 400 $5,400 Elmer $3,000 0 1,500 $4,500 Although there is no requirement that he do so, Elmer pays Matties lawyer as a gesture of the positive feelings he still has for her. a. b. Determine the deductions for Mattie and for Elmer. Classify the deductions as for AGI and from AGI. Register to View AnswerOnly the legal fees associated with the divorce that relate solely to tax advice are deductible. Therefore, Elmer may deduct the following: Property settlement tax consequences If Mattie had paid her attorney, she could have deducted the following: Determination of dependency exemptions Property settlement tax consequences However, since Elmer paid Matties lawyer, Mattie is ineligible to take the deduction. Likewise, Elmer is ineligible to take the deduction for this $1,900 since the obligation was that of Mattie. $1,500 400 $1,900 $1,500 Deductions and Losses: In General b. Any expenses that are deductible in this situation are classified as itemized deductions (i.e., from AGI). DIF: 2 REF: p. 6-13 | p. 6-26 NAT: AICPA FN-Measurement | AACSB Analytic 6-43 PTS: 1 OBJ: 3 MSC: 10 min 21. Marvin spends the following amounts on a house he owns: Repair to roof Carpeting for the living room Painting of the exterior Replacement of front door $ 800 1,200 5,000 900 a. How much of these expenses can Marvin deduct if the house is his principal residence? b. How much of these expenses can Marvin deduct if he rents the house to a tenant? c. Classify any deductible expenses as deductions for AGI or as deductions from AGI. Register to View AnswerSince these expenditures are personal expenditures, no deduction is allowed. b. c. Since these expenditures are for rental property, Marvin can deduct $7,900 ($800 + $1,200 + $5,000 + $900). The $7,900 deduction associated with the rental property is classified as a deduction for AGI. DIF: 1 REF: Concept Summary 6.3 NAT: AICPA FN-Measurement | AACSB Analytic PTS: 1 OBJ: 3 MSC: 10 min 22. Alex sells land with an adjusted basis of $73,000 and a fair market value of $64,000 to his mother, Sybil, for $64,000. Sybil holds the land for one year and a day and sells it in the marketplace for $72,000. a. b. Determine the tax consequences to Alex. Determine the tax consequences to Sybil. $64,000 (73,000) ($ 9,000) Register to View AnswerAmount realized Adjusted basis Realized loss Alexs realized loss of $9,000 is disallowed because Alex and Sybil are related parties. Amount realized $72,000 6-44 b. 2010 Comprehensive Volume/Test Bank Adjusted basis Realized gain Alexs disallowed loss needed to reduce Sybils gain to zero Recognized gain (64,000) $ 8,000 (8,000) $ 0 Sybil may use as much of Alexs disallowed loss as she needs to reduce her realized gain (i.e., $8,000) to $0. Thus, Sybils recognized gain is $0 and the $1,000 ($9,000 $8,000) of Alexs disallowed loss that is not used by Sybil is permanently lost. PTS: 1 DIF: 1 REF: p. 6-27 NAT: AICPA FN-Measurement | AACSB Analytic 23. The stock of Eagle, Inc. is owned as follows: Tom Toms uncle Toms daughter Toms sister Toms spouse Toms nephew Toms CPA, unrelated 23% 22% 7% 15% 15% 8% 10% OBJ: 3 MSC: 10 min Tom sells land and a building to Eagle, Inc. for $212,000. His adjusted basis for these assets is $225,000. Calculate Toms realized and recognized loss associated with the sale. ANS: Toms realized loss is $13,000. Amount realized Adjusted basis Realized loss $212,000 (225,000) ($ 13,000) However, his recognized loss is $0 because the loss is disallowed as a 267 related party transaction. A related party includes a corporation more than 50% (directly or indirectly) owned by the taxpayer. Toms total ownership (i.e., both direct and constructive) of Eagle, Inc. is 65%. Tom Toms daughter Toms sister Toms spouse Toms uncle, nephew, and the CPA are not related parties for 267 purposes. PTS: 1 OBJ: 3 MSC: 10 min DIF: 2 REF: p. 6-27 | p. 6-28 NAT: AICPA FN-Measurement | AACSB Analytic 23% 7% 15% 15% 60% Deductions and Losses: In General 24.Brenda invested in the following stocks and bonds during 2009. Green, Inc. City of Falcon bonds $20,000 80,000 6-45 To finance the investments, she borrowed $100,000 from Swan Bank. Interest expense paid on the loan during 2009 was $6,000. During 2009, Brenda received $2,400 of dividend income from Green, Inc. and $3,200 of interest income on the municipal bonds. a. Determine the amount of Brendas gross income. b. Determine the maximum amount of Brendas deductible interest expense. Register to View AnswerBrenda must include the $2,400 of dividend income in her gross income. The interest on the municipal bonds of $3,200 is tax-exempt. b. Brenda can deduct the interest paid of $1,200 ($6,000 1/5) on the portion of the loan that relates to the Green, Inc. stock. The interest paid of $4,800 on the portion of the loan that relates to the municipal bonds is disallowed because the interest income from the bonds is tax-exempt. OBJ: 3 MSC: 10 min PTS: 1 DIF: 1 REF: p. 6-29 NAT: AICPA FN-Measurement | AACSB Analytic ESSAY 1. Salaries are considered an ordinary and necessary expense of a trade or business if they meet what other requirement? What are the tax consequences if this requirement is not met? ANS: Reasonableness is an additional requirement that applies to salaries. Generally, the unreasonable expense is disallowed as a deduction to the corporation and taxable as a dividend, rather than as salary, to the shareholder. PTS: 1 DIF: 1 REF: Example 6 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 MSC: 5 min 2. If part of a shareholder/employees salary is classified as unreasonable, determine the effect on the: a. Shareholder/employees gross income. b. Corporations taxable income. Register to View AnswerThe reclassification of part of a shareholder/employees salary as unreasonable will have no effect on the shareholder/employees gross income. That is, the shareholder/employees salary income will decrease by the same amount as his dividend income increases. Note that if the dividends are qualified dividends, they are eligible for the same preferential tax rate of 15%/5% applicable to long-term capital gains. 6-46 b. 2010 Comprehensive Volume/Test Bank Salaries are deductible in calculating corporate taxable income, whereas dividends are not. So, the taxable income of the corporation will increase due to a reduced salary deduction. DIF: 1 REF: p. 6-6 | p. 6-7 NAT: AICPA FN-Reporting | AACSB Analytic PTS: 1 OBJ: 1 MSC: 10 min 3. Calvin opened his dental practice (a sole proprietorship) in May 2009. At the end of the year, he has unpaid accounts receivable of $36,000 and no unpaid accounts payable. Should Calvin use the accrual method or the cash method for his dental practice? Register to View Answerservice provider generally should use the cash method. Under the cash method, Calvin records income from his dental practice only as he collects from his patients and/or their insurance companies. Calvin has income from the uncollected accounts receivable only as he receives payment. PTS: 1 OBJ: 2 MSC: 5 min DIF: 1 REF: p. 6-9 | p. 6-10 NAT: AICPA FN-Reporting | AACSB Analytic 4. Camille, a calendar year taxpayer, rented a building from Howard for use in her business on November 1, 2009. Camille paid $30,000 for 15 months rent and a $2,500 damage deposit. a. How much can Camille deduct for 2009 if she uses the cash basis? The accrual basis? b. How much should Howard include in gross income for 2009 if he uses the cash basis? The accrual basis? Register to View AnswerCamille can deduct only $4,000 rent (2 months at $2,000) in 2009 on either the cash or accrual basis. The one-year rule on prepaid expenses is not applicable to accrual basis taxpayers. The one-year rule requirement for a cash basis taxpayer is not met by Camille (i.e., rental period extends beyond December 31, 2010). The $2,500 damage deposit is not deductible. Example 7 b. On either the cash or accrual basis, Howard must include the entire $30,000 in gross income in 2009. The one-year rule on unearned income for accrual method taxpayers is not applicable to prepaid rent. The $2,500 damage deposit is not income. PTS: 1 OBJ: 2 MSC: 10 min DIF: 1 REF: Example 7 | Chapter 4 NAT: AICPA FN-Measurement | AACSB Analytic Deductions and Losses: In General 6-47 5. Briefly discuss the two tests that an accrual basis taxpayer must apply before an expense can be deducted. ANS: The two tests that an accrual basis taxpayer must apply before an expense can be deducted are (1) the all events test and (2) the economic performance test. The all events test provides that a deduction cannot be claimed until all the events that create the taxpayers liability have occurred and that the amount of the liability can be determined with reasonable accuracy. The economic performance test provides that the service, property, or use of property giving rise to the liability must have been performed for, provided to, or used by the taxpayer. PTS: 1 DIF: 1 REF: p. 6-10 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 2 MSC: 10 min 6. Graham, a CPA, has submitted a proposal to do the annual audit for a municipality. Owen, the city treasurer, tells Graham that for a $1,000 fee, he will use his influence to have the audit awarded to Graham. What factors are relevant in determining if Graham can deduct the $1,000 payment assuming he pays the fee to Owen? ANS: The payment from Graham to Owen appears to be a bribe. To be disallowed, the bribe must be illegal under either Federal or state law and also must subject the payer to a criminal penalty or the loss of license or privilege to engage in a trade or business. For a bribe that is illegal under state law, a deduction is denied only if the state law is generally enforced. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-12 | p. 6-13 NAT: AICPA FN-Reporting | AACSB Analytic 7. How can an individuals consultation with a lawyer be classified as a deduction for AGI in some cases and a deduction from AGI in other instances? ANS: Legal expenses are deductible when they are directly related to a trade or business (for AGI); an incomeproducing activity (either for AGI or from AGI); or the determination, collection, or refund of a tax (either for AGI or from AGI). Ordinary and necessary legal expenses incurred in conjunction with a trade/ business or in conjunction with rental/royalty property are deductible for AGI. All other deductible legal expenses are deductions from AGI. PTS: 1 DIF: 1 REF: p. 6-13 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 1 | 3 MSC: 5 min 8. If a taxpayer operated an illegal business (not drug trafficking), what expenses can be deducted and what expenses are disallowed? 6-48 2010 Comprehensive Volume/Test Bank ANS: The usual expenses of operating a business are deductible. However, the following expenses are disallowed. Fines. Bribes to public officials. Illegal kickbacks. Other illegal payments. PTS: 1 DIF: 1 REF: NAT: AICPA FN-Reporting | AACSB Analytic p. 6-14 OBJ: 3 MSC: 5 min 9. Under what circumstances may a taxpayer deduct the expenses of investigating a possible business acquisition, if (1) the business is not acquired; and (2) the business is acquired? ANS: (1) The expenses of investigation may be deducted if the taxpayer is in the same or similar business to that being investigated, even if the business is not acquired. If the taxpayer is not in the same or similar trade or business to the one being investigated, the investigation expenses are nondeductible if the business is not acquired. (2) The expenses of investigation must be capitalized by a taxpayer not in a similar business when the business is acquired. Such expenses may be immediately expensed (up to $5,000) and the balance amortized over a 180-month minimum period. If the taxpayer is in the same or similar trade or business as that acquired, investigation expenses are currently deductible. DIF: 1 REF: Concept Summary 6.1 NAT: AICPA FN-Reporting | AACSB Analytic PTS: 1 OBJ: 3 MSC: 10 min 10. What are the relevant factors to be considered in determining whether an activity is profit-seeking or a hobby? ANS: The nine relevant factors detailed in Reg. 1.183-2(b) are as follows: (1)Whether the activity is conducted in a businesslike manner. (2) The expertise of the taxpayers or their advisers. (3)The time and effort expended. (4)The expectation that the assets of the activity will appreciate in value. (5)The previous success of the taxpayer in the conduct of similar activities. (6)The history of income and losses from the activity. (7)The relationship of profits earned to losses incurred. Deductions and Losses: In General 6-49 (8)The financial status of the taxpayer. (9)Elements of personal pleasure or recreation in the activity. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-16 | p. 6-17 NAT: AICPA FN-Reporting | AACSB Analytic 11. Assuming an activity is deemed to be a hobby, discuss the order and limits in which expenses must be deducted. ANS: Amounts deductible under other Code sections without regard to the nature of the activity (e.g., property taxes and mortgage interest) must be deducted first. Amounts deductible under other Code sections had the activity been profit-seeking which do not affect adjusted basis are deducted next. Deductions affecting adjusted basis (e.g., depreciation) are taken next. At any point where the expenses exceed income, the deduction is limited to the remaining income. PTS: 1 DIF: 1 REF: Example 22 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 10 min 12. Describe the circumstances under which a taxpayer can receive rent income from a personal residence, but does not have to report it as gross income. ANS: If the personal residence is rented for fewer than 15 days in a year, the rent income is excluded from gross income. Only mortgage interest and real estate taxes can be deducted. PTS: 1 DIF: 1 REF: Example 24 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 5 min 13. Briefly explain the provisions regarding the deductibility of expenditures paid for anothers benefit or obligation. ANS: Generally, a taxpayer cannot deduct expenditures paid for anothers benefit or that arise from an obligation that is not the taxpayers. An exception exists for medical expenses paid on behalf of a dependent. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-25 | p. 6-26 NAT: AICPA FN-Reporting | AACSB Analytic 6-50 2010 Comprehensive Volume/Test Bank 14. Briefly discuss the disallowance of deductions for capital expenditures. ANS: Any expenditures that add to the value or prolong the life of property or adapt the property to a new or different use are capital expenditures which must be capitalized and depreciated or amortized. PTS: 1 OBJ: 3 MSC: 5 min DIF: 1 REF: p. 6-26 | p. 6-27 NAT: AICPA FN-Reporting | AACSB Analytic 15. Why are there restrictions on the recognition of gains and losses resulting from transactions between related parties? ANS: Sham transactions can be structured between related parties such that no real economic change occurs in the status of the parties, but a tax savings results. This is an abuse of the tax law which has resulted in restrictions on the recognition of such transactions. PTS: 1 DIF: 1 REF: p. 6-27 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 5 min 16. In a related party transaction where realized loss is disallowed, when can the disallowed loss be used by the buyer on the subsequent sale of the property? ANS: The related party buyer is permitted to use as much of the disallowed loss of the seller as is needed to reduce any realized gain on the subsequent sale of the property. If the property in the hands of the buyer appreciates to at least the amount of the sellers adjusted basis at the date of the original sale, all of the disallowed loss can be used by the buyer on the subsequent sale. PTS: 1 DIF: 1 REF: p. 6-27 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 5 min 17. Briefly explain why interest on money borrowed to buy tax-exempt municipal bonds is disallowed as a deduction. ANS: Because the interest income on municipal bonds is excludible from gross income, the related expense should not be deductible. Otherwise, a taxpayer could borrow money, at say 10%, invest the funds in taxexempt securities, at say 8%, and realize a profit if the interest expense were deductible. The entire profit would be derived from the tax treatment. PTS: 1 DIF: 1 REF: p. 6-29 NAT: AICPA FN-Reporting | AACSB Analytic OBJ: 3 MSC: 10 min ... View Full Document

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