FTax IRGTB ch07 p001-036

FTax IRGTB ch07 p001-036 - 7 Overview of Deductions and...

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Unformatted text preview: 7 Overview of Deductions and Losses Solutions to Cumulative Problems Solutions to 7-607-61 are found on the following pages. 7-1 7-2 Chapter 7 Overview of Deductions and Losses Cumulative Problem 7-60 Solutions to Cumulative Problems 7-3 Cumulative Problem 7-60 7-4 Chapter 7 Overview of Deductions and Losses Cumulative Problem 7-60 Solutions to Cumulative Problems 7-5 Cumulative Problem 7-60 7-6 Chapter 7 Overview of Deductions and Losses 7-61 The steps for determining Wendy White's tax liability are shown below immediately followed by her tax return. Step 1: Calculate the amount of self-employment tax due. Schedule C: Wendy has net self-employment income of $9,359 [$10,000 self-employment income $641 ($523 transportation and lodging $60 meals ($120 50%) $58 office supplies)]. Schedule SE: Because one-half of the self-employment tax is a deductible expense (reported on Line 29 of the Form 1040), Wendy must determine her adjusted net self-employment income for purposes of completing the Schedule SE. One-half of the self-employment rate is 7.65%. Therefore, her adjusted net selfemployment income is $8,643 [$9,359 (1 .0765)] Since her wages exceed the social security wage base of $106,800 in 2010 she only owes the Medicare tax on her self employment income. Therefore her selfemployment tax is $251 ($8,643 2.9%). Enter this amount on Line 56 of the 2010 Form 1040. Step 2: Determine the amount of Wendy's deduction for the self-employment tax. Wendy is allowed a deduction of $126 ($251 50%) for one-half of the self-employment tax. Enter this figure on Line 36 of the Form 1040. Step 3: Calculate Wendy's A.G.I. Salary Plus: Net self-employment income (Schedule C) Less: Deduction for self-employment tax (Schedule SE) A.G.I. Step 4: Compute Wendy's itemized deductions. Home mortgage interest Charitable contributions State and local income taxes Employment-related expenses [$920 ($159,233 A.G.I. 2% $3,185)] Total itemized deductions Step 5: Calculate Wendy's personal exemption. Wendy's personal exemption for 2010 is $3,650. Step 6: Calculate Wendy's taxable income. A.G.I. Less: Itemized deductions Personal exemption Taxable income $159,233 (10,650) (3,650) $144,933 $ 6,250 1,300 3,100 -- $10,650 $150,000 9,359 (126) $159,233 Solutions to Cumulative Problems 7-7 Cumulative Problem 7-61 7-8 Chapter 7 Overview of Deductions and Losses Cumulative Problem 7-61 Solutions to Cumulative Problems 7-9 Cumulative Problem 7-61 7-10 Chapter 7 Overview of Deductions and Losses Cumulative Problem 7-61 Solutions to Cumulative Problems 7-11 Cumulative Problem 7-61 7 Overview of Deductions and Losses Solutions to Tax Research Problems 7-62 a. Several cases have considered the tax treatment of the repayments of the portion of compensation deemed unreasonable. Deduction of the repayment depends on whether the taxpayer repays the amount voluntarily or pursuant to a pre-existing arrangement requiring return of any amount that might be found unreasonable on audit. In Berger, 37 T.C. 1026 (1962), no deduction was allowed where repayments were made voluntarily. In contrast, in Oswald, 49 T.C. 645 (1968), (to which the IRS acquiesced in Rev. Rul. 69-115, 1969-1 C.B. 50), a deduction was granted because the taxpayer returned the unreasonable amount pursuant to a binding legal obligation that existed at the time the salaries were paid. The Tax Court refined the test somewhat in Pahl, 67 T.C. 286 (1976), indicating that no deduction is allowed unless the repayment agreement is executed prior to the time when the services are rendered. Existence of a binding legal obligation establishes the expense as one that arises out of the taxpayer's business needs. The problem of adopting a payback arrangement is that it may be considered evidence of the unreasonableness of the compensation. Thus, to adopt such an agreement may be waving a "red flag" to the IRS suggesting that the corporation is paying unreasonable compensation. See Saia Electric Inc., 33 TCM 1391, T.C. Memo 1974-290, suggesting this view. b. 7-63 55- Section 280A allows deductions related to maintaining a home office for certain business uses. Specifically, 280A(c)(1)(A) authorizes deductions where the home office is exclusively used on a regular basis as the principal place of business for any trade or business of the taxpayer. Alternatively, under 280A(c)(1)(B), the taxpayer may deduct home office expenses if the home office is exclusively used on a regular basis as the principal place of business for any trade or business of the taxpayer or as a place of business that is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of business. An additional test, discussed below, must be satisfied by employees. Each of these provisions and its application to C is examined below. In the past, several different tests have been applied to determine the taxpayer's "principal place of business." One of these tests initiated by the IRS and the Tax Court was the "focal point" test. This test focused on where the majority of the work was done [Baie, 74 T.C. 105 (1980)]. The "focal point" test was not universally accepted by the courts. In Weissman, 85-1 USTC {9106 (CA-2, 1985), the taxpayer was employed as an associate professor of philosophy, and of the 64-75 hours he worked each week, 20 percent was spent on campus while the remaining 80 percent was spent in a tworoom office in his ten-room apartment, where he did the bulk of his research and writing. In a situation similar to that of Weissman, the taxpayer had to share an on-campus office with other professors that was inadequately equipped and was not a safe place to leave papers or equipment. The Second Circuit reversed the Tax Court's decision, indicating that a college professor's principal place of business is not any more 7-13 7-14 Chapter 7 Overview of Deductions and Losses 5- 5- 5- 5- 5- 5- the college campus than a musician's principal place of business is the concert hall where he or she performs (see Drucker, 83-2 USTC {9550). The court indicated that the focal point test improperly shifted attention from the place the dominant portion of a taxpayer's work was done to the place where his work was more visible. Thus it would appear that the Second Circuit viewed time as a major factor in determining the principal place of business. This view was also adopted by the Seventh Circuit in Meiers, 86-1 USTC {9180 (CA-7, 1986). In Drucker, Weissmann, and Meiers (noted above), the Tax Court decision was reversed. For many years, the Tax Court stuck to its Baie decision, which focused on the "focal point" of a taxpayer's activities (i.e., the place where services are performed and income is generated). However, the Tax Court departed from the "focal point" test in Soliman, 94 T.C. 3 (1990). Agreeing with the Second and Seventh Circuit courts, the Tax Court ruled that a taxpayer's principal place of business can be the location where the business is managed if the taxpayer's occupation requires essential organizational and management activities that are distinct from those that generate income. The court concluded that a taxpayer's home office can be a principal place of business when a taxpayer's home office is essential to his business, when he or she spends substantial time there, and when there is no other location available to perform the office functions of the business. The decision of the Tax Court in Soliman was upheld by the Fourth Circuit Court of Appeals (91-1 USTC {50,291). Because of the controversial decisions being reached by the various courts, the Supreme Court agreed to review the Fourth Circuit's decision in Soliman, 93-1 USTC 50,014 (USSC, 1993). The facts in this case show that Soliman was an anesthesiologist who worked at three different hospitals. He was hired by the hospitals as an independent contractor and was not given any office space in which to work. Soliman spent about 30 to 35 hours a week administering anesthesia to patients at the hospitals and spent an additional 10 to 15 hours a week in his home office performing management and administrative duties that were essential to his business. The Supreme Court decided that the previous tests used to determine the principal place of business were flawed. The Court stated two primary factors that should be weighed in making the determination: 1) The relative importance of the function performed at each business location, and 2) the time spent at each place. The second factor assumes greater significance when comparison of the importance of functions performed at various places yields no definitive answer to the question. Applying these tests to the facts in Soliman, the Court decided that the work of Dr. Soliman performed at the hospitals was vastly more important to his business than the administrative work performed at home and that only 25% of his time was spent doing work in his home office. Therefore, the home office deduction was denied. Beginning in 1999, the tax law expands the definition of a principal place of business to include a place that is used by the taxpayer for administrative or management activities of a trade or business for which there is no other fixed location where the taxpayer conducts such activities. One purpose of this provision is to allow taxpayers like Soliman, who had no other fixed location to perform his administrative duties, to qualify for the home office deduction. Unfortunately, this exception is inconsistent with the client's facts and will be of no help. Given the Supreme Court decision in Soliman, the taxpayer could argue that her home office is the principal place of business, if in fact she spends more time there than she does in the school office and the work performed in her office is more important than her duties at the University. However, this seems unlikely. In addition, even if the taxpayer satisfies the principal place of business test, the deduction is not guaranteed. For employees, the Code requires that the home office must also be maintained for the convenience of the employer. In Chauls (T.C. Memo 1980-471), the Tax Court indicated that the taxpayer must show that what he does at home could not be done in the office provided at work. This appears to be the view that has been adopted in Weissman, Drucker, and Meiers. In effect, the court seems to be saying that where the employer has not provided suitable space, this test is satisfied. For example, Weissman had to share an office; moreover, the office was unsafe. Similarly, Drucker had no room in which to practice, while Meiers had specifically not created office space at the laundromat. If C can demonstrate that her office at school is unsuitable, she may be able to satisfy this requirement. Solutions to Tax Research Problems 7-15 7-64 The answer to this question can be found in 121 which became effective for sales and exchanges after May 6, 1997. The general rule under this provision states that gross income does not include gain from the sale or exchange of property if, during the five-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as his or her principal residence for periods aggregating two years or more. Additional rules related to this exclusion include: The amount of the gain excluded cannot exceed $250,000 ($500,000 for a married couple who file a joint return). The exclusion generally applies to only one sale every two years. A reduced exclusion is available for taxpayers who fail the ownership and use requirement or who sell within two years. The reduced exclusion is based on the number of months the requirements are met to 24 months. If a residence was acquired in a "rollover" under the prior law, the holding period of the old home is included in the holding period of the residence being sold. The exclusion does not apply to the portion of the gain that represents depreciation taken on the home after May 6, 1997. Thus, the taxpayer must recognize gain to the extent of any depreciation taken while the home was rented or used for business use (i.e., office in the home). 5- Applying 121 to the facts of this problem, it appears that R can qualify for at least a partial exclusion of the gain. Although R has owned the home for about two years, he has owned and used the property as a principal residence for only 12 months. Therefore, unless he acquired the home in 2010 through a rollover from a previous owned home, R is eligible for only a partial exclusion. However, before calculating the partial exclusion, R must recognize gain to the extent of depreciation taken on the residence when it was rented. The gain exclusion is then limited to the lesser of: 1) 12 months/24 months $500,000, or 2) 12 months/ 24 months the remaining gain on the sale of the residence after accounting for depreciation recapture. Code 179 allows for the expensing of assets purchased for use in a trade or business. Reg. 1.179-3(d) narrows this allowance to assets used predominantly for a qualified business use (i.e., greater than 50%). However, even if this test is met, 280F(d)(3)(A) provides that any employee use of "listed" property shall not be treated as used in a trade or business for purposes of 179 unless such use is for the "convenience of the employer" and is "required as a condition of employment." Listed property includes computers. In Rev. Rul. 86-129, 1986-2 C.B. 48, the IRS took a strict approach to the definitions of "convenience of employer" and "required as a condition of employment." This same position was restated in a series of letter rulings. For example, in Ltr. Rul. 8710009, the IRS ruled that an insurance salesman who had purchased a computer to use exclusively in his business failed to meet the tests. The IRS stated: 5Notwithstanding the fact that the purpose of the computer will be useful and helpful in performing your duties, you are not required to purchase the computer in order to perform such duties. According to the facts submitted, the computer purchase is optional rather than mandatory. While your use of the computer may increase your productivity at work, and the benefits of such increased productivity would inure to your employer, the purchase of the computer is clearly not required as a condition of employment. The facts indicate that computer use, although work-related, is not inextricably related to the proper performance of your job. Further, there appears no evidence that those employees who do not purchase computers are professionally disadvantaged. 7-65 5- 7-16 Chapter 7 Overview of Deductions and Losses 5- 55- 5- Under this definition of "condition of employment," B would clearly not be allowed a deduction for the personal computer. Fortunately, however, the Tax Court does not take such a strict view. In Cadwallader, T.C. Memo 1989-356, the Court said that for the "condition of employment" requirement to be satisfied, it is only necessary that the computer be required to properly perform the duties of employment. Because the taxpayer's work was "substantially aided by computer," this test was passed. This is a far more liberal interpretation of the phrase "required to properly perform the duties of employment" than that used by the IRS. The Tax Court continued its liberal definition of the "condition of employment" test in the case of Sherri A. Mulne (T.C. Memo 1996-320). The court approved the cost recovery deduction for a computer because of the taxpayer's heavy caseload and the number of sales representatives she managed. With respect to the second test--the computer must be acquired "for the convenience of the employer"--the court ruled that because the purchase spared the employer the cost of providing the taxpayer with suitable computer equipment, this test was met. Given the facts at hand, it is clear that the IRS would disallow the expense deduction on audit. The fact situation is almost identical to that in Ltr. Rul. 8710009, where the deduction was denied. However, it is also clear that the Tax Court is willing to be more lenient than the IRS in its interpretation of 280F. If the matter were taken to court, the taxpayer would likely win. It appears, then, that the taxpayer is entitled to a deduction for the personal computer used exclusively in his trade or business. Although B may be "correct" in taking a deduction for the computer, what should the taxpayer do if challenged by the IRS? In this case, the tax benefit of the acquisition is quite small. With 100 percent business usage, the deduction would be $3,000. But, because this is a miscellaneous itemized deduction, the amount must be reduced by 2 percent of A.G.I. ($65,000 A.G.I. 2% $1,300). The remaining $1,700 deduction would save B $425 in taxes ($1,700 25%). This is too small a matter to pursue any further than within the IRS. If the IRS refuses to back down on the matter, B should probably concede. Justice does not always prevail. To be deductible as a trade or business expense, an expenditure must be paid or incurred in connection with a trade of business in which the taxpayer is engaged ( 162). Section 183 states that "if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed." Whether an activity is carried on primarily for profit or as a hobby for recreation and pleasure must be determined by an examination of all the facts and circumstances in the case [Reg. 1.183-2(b)]. There need not be a reasonable expectation that the activity will yield a profit. It is sufficient if an activity is entered into in good faith with the purpose of making a profit [Reg. 1.183-2(a)]. Regulation 1.183-2(b) lists nine nonexclusive factors to consider in determining a profit motive: (1) the manner in which the taxpayer conducts the activity, (2) the taxpayer's and/or taxpayer's advisor's level of expertise, (3) the time and effort expended by the taxpayer on the activity, (4) the expectation that assets used in the activity may appreciate in value, (5) the taxpayer's success in similar activities, (6) the taxpayer's history of income or losses with respect to the activity, (7) the amount of profits, (8) the taxpayer's finances, and (9) elements of personal pleasure or recreation connected with the activity. No one factor is determinative in deciding if a profit motive exists. Note: The presumption test of 183(d) (i.e., an activity is presumed to be engaged in for profit if it shows a profit for any three or more years in a period of five consecutive years) is inapplicable to this problem. However, because S has been challenged on this issue, she may wish to make the election of 183(e) to defer application of 183 until after the close of the five-year presumptive period. This will allow S a chance to meet the presumption (she will need to report profits in the next three years). If she can manage this feat, she will shift the burden of proof that she is not engaged in trade or business to the IRS. A relevant court case in this area is Kimbrough, TC Memo 1988-185 (the facts in Kimbrough are similar to those in the case problem). The Tax Court's analysis of the facts led to the conclusion that Kimbrough's losses were incurred in a trade or business activity. A comparison of the Kimbrough analysis to the facts at hand leads to a similar conclusion. The key factors are 1. S must carry on her professional golf activities in a businesslike manner. She already keeps separate records for her golf activities. She should continue to keep accurate and detailed records of her potential prize money, actual winnings, and expenses. She should also consider taking a course in managing a golf career. S has extensive golf experience and continues to play with a professional whenever possible. Her unpaid apprenticeship is a good indicator of her sincerity in pursuing a golf career. In the future, she might wish to formalize her efforts (e.g., take additional courses and have a formal plan for improvement). 7-66 5- 5- 5- 2. Solutions to Tax Research Problems 7-17 3. 4. 5. S currently spends a great deal of time with her golf. It is not required that this be her primary occupation as long as she devotes a substantial amount of time and effort to the activity. If she is to begin making a profit, she may need to devote even more time in the future. Losses should generally diminish over time. In S's case this is true, but she needs to show even more improvement in the future. In fact, she needs to focus on making a profit in the current year. Although S receives recreational and personal pleasure from her golf, this factor is not determinative if the other factors are strong. Based on the results of the Kimbrough case, S has a reasonable chance of having her golf activity deemed to be a trade or business activity if the matter is taken to court. However, given the relatively small tax consequences of this matter, S should probably not pursue this issue beyond the IRS. The costs of litigation will most likely preclude her from taking the case to the Tax Court, where she would probably win. 7 Overview of Deductions and Losses Test Bank True or False 1. In regard to the statutory scheme for determining deductibility, a taxpayer may deduct an expense only if it is "specifically" identified (e.g., interest) as deductible in the Code. For example, advertising expense of a business would not be deductible unless a code provision specifically indicated that advertising expense is deductible. For tax purposes, the term "nonbusiness expense" refers to nondeductible personal expenses, such as the costs of personal hygiene. J, employed as a male dancer, regularly uses a tanning salon to keep his body looking healthy. J may deduct the cost of visiting the tanning salon. An "ordinary" business expense need not be recurring. A cash basis taxpayer may deduct all prepaid interest in the year it is paid. V bought electric motors for her business from a sales representative who said that they had a four horsepower output. V discovered while using the motors that they only produce two horsepower after a few weeks use. V may recognize as a loss the value of the reduction in horsepower and currently deduct the amount as a business expense. Any expense that is reimbursed by the taxpayer's employer is deductible for A.G.I. (e.g., reimbursement of a parking ticket incurred by a salesperson when calling on a customer). T's itemized deductions for the current year are $14,000. Assuming the standard deduction is $5,000, T may deduct no more than $9,000 of her itemized deductions. Tax preparation fees incurred by an individual generally are treated as miscellaneous itemized deductions and can be deducted only to the extent they exceed two percent of A.G.I. As an employee for BBB, J earned a salary of $40,000 and incurred unreimbursed employee business expenses of $1,000. Assuming J itemizes his deductions, he may deduct all of his expenses. Fees paid for preparation of a tax return are deductible only if they are related to a taxpayer's trade, business, or activity engaged in for profit. 7-19 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 7-20 Chapter 7 Overview of Deductions and Losses 12. Either W or one of his employees visits a local factory every week to wash the windows. W may deduct the cost of all of his expenses from washing windows. With respect to the deduction for hobby expenses, the taxpayer's expectation of profit need not be considered reasonable in order for the expense to be deductible. Deductible expenses related to an activity that is considered a hobby, and that are not otherwise allowable, are treated as miscellaneous itemized deductions and can be deducted only to the extent they exceed two percent of A.G.I. H recently purchased a residence for himself and his family for $60,000. Shortly thereafter, property nearby was rezoned by the city council for light commercial businesses. As a result, the value of H's house dropped to $50,000. H may deduct a loss of $10,000. Expenditures for goodwill may be recovered for tax purposes only when there is a disposition of the asset such as a sale or exchange, and not through amortization. Business expenses (other than interest) related to tax-exempt interest income are deductible. Expenses incurred in the production of income, such as legal fees and safe deposit box rentals, may be deducted even though the income produced is wholly tax-exempt (i.e., municipal bond interest income). If taxpayer B pays a dependent son's real estate taxes, B cannot deduct the expense. According to the Cohan rule, taxpayers may deduct reasonable estimates of expenses where they have no evidence, such as a receipt, to substantiate the actual amount. 13. 14. 15. 16. 17. 18. 19. 20. Multiple Choice 21. The courts have determined that to qualify as a trade or business, an activity must a. b. c. d. e. Be operated with a profit motive Have a sufficient degree of taxpayer involvement Show a profit Both a. and b. are true. All three statements are true. 22. The crucial reason for determining whether an item is deductible as an expense under 162 or under 212 is that a. b. c. d. Production-of-income expenses are not deductible. 162 business expenses usually are deductions for A.G.I., while 212 production-of-income expenses usually are miscellaneous itemized deductions. 162 business expenses are deductions from A.G.I., while 212 production-of-income expenses are deductions for A.G.I. It resolves certain ownership questions. 23. Z is a ten-percent (10%) shareholder of H, Inc. H, Inc. has distributable net income of $100,000 this year and no accumulated earnings and profits. Z was paid $15,000 by the company for his expertise as a pilot, but he did not fly this year. How is the IRS likely to view the $15,000? a. b. c. d. $15,000 salary to Z $15,000 dividend $10,000 dividend, $5,000 salary or return of capital $7,500 salary, $7,500 dividend Test Bank 7-21 24. Near year-end, P, a cash basis, calendar year taxpayer, paid for various deductible expenses as described below. 1. 2. 3. 4. The payment was dropped in the mail before year-end. P gave a note evidencing her promise to pay the amount in three months. The amount was charged on her Master Card on December 28. The charge appeared on her bill for the period December 1 through December 31, which she received in January and which she paid on January 20. The bank actually paid the expense in January. The amount was paid using the pay-by-phone service provided by her bank. P called in the charge on December 20. The bank sent her a statement indicating that it had paid the charge on January 3. P may deduct the expense in which cases? a. b. c. d. e. 25. 1. 1. and 2. 1. and 3. 1., 3. and 4. 1., 2., 3. and 4. S is a cash basis, calendar year taxpayer (she uses the accrual-method for inventory). She operates Cloth R Us. All of the store's profits come from the sale of fabric. During the year she paid the following expenses: 1. 2. 3. 4. $3,000 premium for liability insurance covering her business. The coverage runs from December 1, 2011 through November 30, 2014. $10,000 for cloth, all of which is still on hand at the end of the taxable year. $2,000 for "points" related to obtaining a loan for the purchase of her personal residence. $1,200 for "points" related to obtaining a loan on rental property. S may deduct all of the expense incurred in 2011 for which item(s)? a. b. c. d. e. 26. 1. 1. and 2. 1., 2. and 3. 1., 3. and 4. 3. F, a calendar year, cash basis taxpayer, started a business on June 1. Her lease required monthly payments of $1,000 beginning on June 1. Insurance for the premises, also begun on June 1, was to be paid every six months and cost $600 for each six-month period (she paid her premiums due on June 1 and December 1). F's deductions for these expenses total a. b. c. d. $7,000 $7,100 $7,600 $8,200 7-22 Chapter 7 Overview of Deductions and Losses 27. T was looking for a house when he happened upon an old mansion. After looking it over, he decided that although he would not want to live there himself, it would be a good investment. As a result, he decided to buy it to hold as rental property. T borrowed $100,000 from his bank to finance the purchase. The loan was to be repaid over a 10-year period starting January 5 of the following year. In addition, he paid five points for the loan. T closed the deal in early December and paid the closing costs, including the points, at that time. T also paid his first installment on the loan in late December, even though it was not due until January 5 of the following year. The installment he paid included $800 of interest. How much can T deduct in the year of the closing? (T is a cash basis taxpayer.) a. b. c. d. e. $0 $41.67 $800 $5,000 $5,800 28. L operates a sole proprietorship that manufactures lawn sprinklers. The business is an accrual basis, calendar year taxpayer. During the year, the following transactions occurred. 1. 2. In December, L contracted for $5,000 with a distinguished products management firm, Y Research, to help him market his product nation-wide. Y performed the services in the following year. L has a long-time agreement with M Service Company to come once a month to service certain equipment. The Company charges L $50 per month. L accrues the fee at the end of each month and pays the bill when it is received, usually in the following month. This year M was extremely busy and was not able to perform its services for the month of December until January of the following year. L provides a one-year money back guarantee on his products. At the close of the current year he estimated that the guarantees for sprinklers sold during the year would cost him $1,500. 3. Indicate in which of the cases above L is entitled to accrue a deduction. a. b. c. d. e. 29. 1. 1. and 2. 2. 2. and 3. 3. J, an accrual basis taxpayer, deducted an estimated expense for next year that she was required by law to pay. The principle that the IRS follows in disallowing this deduction is the a. b. c. d. All events test Economic performance test Estimated expense test Legal compunction test 30. C purchased two cars in 2008, a Corvette for $40,000 and a Buick for $20,000. Both cars were used solely for personal purposes. During the year, C sold the Corvette to a car collector for $45,000 and the Buick for $17,000. Based on these two transactions he will report a. b. c. d. A gain of $2,000 A gain of $5,000 A gain of $5,000 and a loss of $3,000 No gain or loss 31. Which of the following statements is true concerning deductions "for" and "from" adjusted gross income (A.G.I.)? a. b. c. d. A deduction from A.G.I. has no effect on the taxpayer's self-employment tax liability. Corporations, like individuals, must classify their deductions as deductions for and from A.G.I. Misclassification of a deduction for A.G.I. has no effect on the taxpayer's tax liability, assuming the taxpayer itemizes her or his deductions. Misclassification of a deduction for A.G.I. never has an effect on the taxpayer's medical expense deduction. Test Bank 7-23 32. Which of the following is not a deduction for A.G.I.? a. b. c. d. Lawn-mowing expense for a rental property actively managed by the taxpayer Deductible expenses related to a physician's home office Employee transportation expense not reimbursed by the employer Employee transportation expense reimbursed by the employer and included in employee's income 33. E works as a pharmacist for D Drug Stores. Assuming E does not itemize his deductions, which of the following is not deductible? a. b. c. d. e. Maintenance expenses for a duplex that he owns and rents out Dues to the local pharmacist organization, which are reimbursed by Drug Stores and included in his income Subscriptions to professional journals for which he receives no reimbursement Alimony to his ex-wife who lives in Texas Loss on the sale of stock 34. Which of the following is considered a miscellaneous itemized deduction subject to the 2% of A.G.I. limitation? a. b. c. d. e. Moving expenses of an employee Interest expenses attributable to a mortgage on the taxpayer's principal residence Property taxes assessed on the taxpayer's residence Tax preparation fee More than one of the above are miscellaneous itemized deductions 35. K is an attorney who had to travel to Chicago for a trial. Her law firm reimbursed her for the $1,200 hotel bill and $200 for food, but only half of her $200 entertainment expense eligible for deduction under 162. If the law firm includes the $1,500 in K's compensation on her Form W-2, she may a. b. c. d. Include the $1,500 as a miscellaneous itemized deduction Deduct the $1,500 for A.G.I Include the $100 unreimbursed entertainment expense with the miscellaneous itemized deductions Both b. and c. are true. 36. The tax break afforded to qualified performing artists allows them to a. b. c. d. Deduct their business expenses for A.G.I Itemize, but escape the 2-percent-of-A.G.I. threshold for miscellaneous itemized deductions Shelter their first $5,000 of income as tax-exempt Defer tax on their performance-related income for up to 10 years 37. B, a bank president, is a weekend potter. He regularly sells his pots at crafts fairs and spends an average of 10 hours a week either making or marketing pots. Although he has netted around $200 per year for the last two years from pottery sales, he tells everyone that he would do it for free. This year he reported gross income of $300 and expenses of $1,000. The $1,000 expense is, most likely, a. b. c. d. Deductible for A.G.I. as a business loss Available only to offset the $300 income of the pottery business Miscellaneous itemized deduction Both b. and c. are true. 7-24 Chapter 7 Overview of Deductions and Losses 38. B, a bank president, is a weekend potter. He regularly sells his pots at crafts fairs and spends an average of 10 hours a week either making or marketing pots. Although he has made around $200 profit per year for the last two years from pottery sales, he tells everyone that he would do it for free. This year he had a $1,000 net loss due to increased entrance fees at the fairs. If B has been making and selling pots for only three years and he makes an election under 183 to postpone IRS challenges, which of the following is a true statement if B makes a profit next year? a. b. c. d. He can carry forward this year's $1,000 loss and deduct it for A.G.I. He is conclusively the owner of a for-profit business rather than a hobby. He may shift the burden of proof to the IRS, which must show that the pottery activity is not a business. He can postpone paying income tax on the profit until the challenge is resolved. 39. F, an attorney in New York, also operates a small farm in New Jersey. During the year, he reported the following income and expenses from the farm: Gross income Depreciation Property taxes Other operating expenses Assuming the activity is considered a hobby, F may deduct a. b. c. d. Taxes $6,000, other $0, depreciation $0 Taxes $6,000, other $0, depreciation $2,000 Taxes $6,000, other $2,000, depreciation $0 Taxes $6,000, other $4,000, depreciation $3,000 $ 8,000 (3,000) (6,000) (4,000) 40. A raises vegetables as a hobby. During the year she sold the vegetables she didn't consume for $25. She also incurred the following expenses attributable to the hobby: seeds, bulbs, and plants, $15; water, $8; and property taxes on the land, $40. Assuming A itemizes her deductions, what is the amount of the above expenses that is potentially deductible? a. b. c. d. e. $15 $23 $25 $40 $63 41. N's wife divorced him and he is trying to reduce his taxable income. He sold his car for a $2,000 loss, took out a $500,000 insurance policy on his own life with a lump sum premium of $25,000 as part of the divorce agreement, and paid alimony expenses of $12,000 this year. Based on this information, how much of a deduction can N take for A.G.I.? a. b. c. d. $12,000 $32,000 $34,000 $59,000 42. Y purchases a restaurant from R for $150,000, $130,000 of which is allocated to tangible assets (the remaining $20,000 is allocated to goodwill). Y makes substantial improvements to the restaurant (i.e., he changes the decor from Hawaiian to French), which costs $30,000, and hires a handyman to make minor repairs for $1,000. How will the three expenditures listed above be treated for tax purposes? a. b. c. d. $130,000 depreciated/amortized over the tax life of the assets, $51,000 business expense $150,000 depreciated/amortized over the tax life of the assets, $31,000 business expense $160,000 depreciated/amortized over the tax life of the assets, $1,000 business expense $180,000 depreciated/amortized over the tax life of the assets, $1,000 business expense Test Bank 7-25 43. R's only profit-seeking activities involve operation of several computer stores. She currently is considering undertaking a new venture. To this end, she pays a C.P.A. $5,800 to perform a financial analysis of the venture to determine whether to enter it. With respect to the expenditure, R may a. b. c. d. Deduct the entire expense in the year incurred if the venture involves operation of a professional sports franchise, and she enters the venture Deduct the entire expense in the year incurred if the venture involves operation of a toy store, and she does not enter the venture Deduct the entire expense in the year incurred if the venture involves another computer store, and she does not enter the venture Amortize the expenditure over 60 months if the venture involves another computer store, and she does not enter the venture 44. Q operates an art gallery and knowingly sells forged Picasso prints as authentic ones. After 60 Minutes exposes him, he files a tax return claiming deductions for 162 business expenses of $10,000 for rent, $20,000 for salaries, $5,000 for the supplies necessary to produce the forgeries, and $25,000 in fines. The IRS should allow Q to deduct a. b. c. d. $10,000 $30,000 $35,000 $60,000 45. N owns and operates a grocery store in a neighborhood that may become the subject of a major renovation if the city council approves the project. With respect to lobbying expenditures, which of the following statements is true? a. b. c. d. N may deduct consulting expenses for a lobbyist who provides information to the city council regarding the economic effect of the project. N may deduct the cost of an ad in the local newspaper in support of the proposed rehabilitation project. N may deduct the cost of a political contribution to a candidate who shares his views regarding the project. N may deduct the payment to a political action committee involved in lobbying for the renovation of the neighborhood. 46. After having his best three quarters of earnings ever, and with a predicted strong fourth quarter, D, a sole proprietor who is a calendar year, cash basis taxpayer in a manufacturing business, is looking for ways to reduce his A.G.I. this year. Which of the following would probably not generate a deduction for A.G.I.? a. b. c. d. Expenses incurred in December for a big January ad campaign Selling assets below his adjusted basis in them Expenses incurred in providing information to the city council on matters of direct interest to the taxpayer Buying life insurance on his key employees' lives, with the business as beneficiary 47. X owns 20 shares of W Corp. and so do his best friend and his step-brother. Partnership XY, of which X owns 50 percent, owns 20 shares of W Corp., and A Corporation, of which X owns 50 percent, owns 20 shares. How many shares of W Corp. does X own under the constructive ownership rules of Code 267 (related party sales)? a. b. c. d. 20 shares 40 shares 50 shares 70 shares 7-26 Chapter 7 Overview of Deductions and Losses 48. T takes out a home equity loan for $25,000 at 10 percent. He immediately purchases $25,000 of taxexempt bonds earning 8 percent a year. The IRS will probably a. b. c. d. View the income from the bonds as taxable Declare that the results of the transactions cancel each other out, so that they are a "wash" for T Allow the interest deduction Deny the deduction for the interest expense 49. On January 1, 2011, H sold stock with a basis of $4,000 to his sister M for $3,500, its fair market value. On July 30, 2011, M sold the same stock for $4,100 to a friend in a bona fide transaction. In 2011, as a result of these transactions, a. b. c. d. Neither H nor M has a recognized gain or loss. H has a recognized loss of $500. M has a recognized gain of $100. M has a recognized gain of $600. 50. G plans to sell property at a loss, which he would like to recognize. In which of the following situations, if any, would a loss on the sale be recognized? a. b. c. d. e. Sale to C Corporation; G owns 30 percent of C while his wife owns 40 percent of C. Sale to W, G's wife Sale to V, G's brother Sale to H Corporation; G owns 40 percent of H Corporation, while G's 60 percent owned corporation, J, owns 11 percent. A loss will not be recognized in any of the situations above. 51. Section 267 provides special rules governing payments of unpaid expenses between accrual and cash basis taxpayers who are related parties. Which of the following statements most accurately describes these rules? a. b. c. d. To police the problem, the provision denies deductions for all amounts paid to related parties, because the amounts, in effect, have never left the payor's control because the parties are related. Section 267 applies a subjective test to determine whether accrual should be allowed; that is, it allows accrual where the taxpayer can demonstrate that abuse is not intended. The rules prohibit potential abuse by treating the accrual basis taxpayer as a cash basis taxpayer. Thus, deductions are allowed only when the payment is actually made. To ensure that an accrual basis taxpayer cannot accrue large deductions without ever having to make actual cash payments, the rules allow accrual as long as payments are made within a reasonable period after year's end. 52. E owns all of the stock of THR Corporation, an accrual basis, calendar year taxpayer. E is the chair of the company's board of directors while her son, D, is chief executive officer. Both E and D are cash basis, calendar year taxpayers. The company was extremely successful during 2011 and consequently the board of directors authorized the payment of a $25,000 bonus to D for a job well done. Assuming the IRS does not re-characterize the bonus as a dividend, which of the following statements most accurately describes THR's treatment of the bonus? a. b. c. d. THR may accrue and deduct the bonus payment for 2011 regardless of when it is paid because the all events and economic-performance tests have been satisfied. Although THR is an accrual basis taxpayer, it may deduct the bonus payment for 2011 only if the bonus is paid in 2011. THR may accrue and deduct the bonus payment for 2011 assuming bonuses of this type are recurring in nature and THR consistently treats bonuses as incurred in the year in which they are authorized. THR may accrue and deduct the bonus payment for 2011 as long as it is paid within a reasonable period after the close of the taxable year (e.g., two-and-one-half months). Test Bank 7-27 53. Given the following information, indicate which of the taxpayers below would obtain the greatest tax savings from making a deductible charitable contribution of $100 next year (2011) rather than this year (2010). Assume no changes in tax rates and other items (e.g., standard deduction, etc.) and ignore the time value of money. Taxpayer Filing status Tax rate this year Other itemized deductions this year Itemized deductions expected next year a. b. c. d. e. A B C D E A Joint 25% $12,000 $12,500 B Joint 15% $9,000 $12,000 C Joint 25% $8,000 $8,500 D Single 25% $4,000 $4,500 E Single 15% $6,000 $7,500 54. P incurs an $80,000 mortgage to purchase a $100,000 house. The terms of the mortgage are 30 years at 12 percent with two points. Although P made a downpayment of $20,000, the bank deducted the points from the loan. The $2,000 P paid in points a. b. c. d. Is wholly deductible in the current year Is a miscellaneous itemized deduction Must be amortized over the term of the loan May not be deducted or amortized 55. An individual taxpayer owns and operates a chain of retail shoe stores (average annual gross receipts of $12 million). The business is run as a single person LLC. Which statement reflects the business' accounting requirements for Federal income tax purposes? a. b. c. d. The taxpayer must use the cash basis for all items of revenue, cost, and expense. The taxpayer may use either the cash or accrual basis for all items of revenue, cost, and expense. The taxpayer must use the accrual basis for all items of revenue, cost, and expense. The taxpayer must use the accrual basis for all items affecting the computation of gross profit on sales but may use the cash basis in accounting for other expenses. 56. Which of the following estimated expenses are deductible? a. b. c. d. Reserve for self-insurance Reserve for warranty repairs Reserve for bad debts None of the above 57. R's only profit seeking activities involve operation of several computer stores. He currently is considering undertaking a new venture. To this end, he pays a C.P.A. $8,000 to perform a financial analysis of the venture to determine whether to enter it. With respect to the expenditure; R may: a. b. c. d. Deduct the entire expense in the year incurred if the venture involves operation of a professional sports franchise, and he enters the venture Deduct the entire expense in the year incurred if the venture involves operation of a toy store, and he does not enter the venture Deduct a portion immediately and amortize a portion of the expense over 180 months if the venture involves operation of a winery and he enters the venture Deduct a portion immediately and amortize a portion of the expense over 180 months if the venture involves another computer store, and he does not enter the venture 7-28 Chapter 7 Overview of Deductions and Losses Matching 58. State whether or not each of the following is: For--deductible for adjusted gross income; From--deductible from adjusted gross income; or Not--not deductible. a. Cost of nurse's uniform reimbursed in full by nurse's employer (reimbursement not included in gross income) b. Rental cost of taxpayer's safe deposit box which holds only personal documents (e.g. passports, marriage license) c. Accountant's fee incurred in challenging a tax deficiency related to a medical expense deduction claimed two years ago d. Loss on the sale of corporate bonds--these bonds were held for investment e. Travel expenses (away from home) incurred as an employee; not reimbursed f. Travel expenses incurred as a self-employed businessman g. Expenses related to rental real property (taxpayer actively participates in the management of the property) h. Entertainment expenses incurred by an employee, reimbursed in full by the employer and included on Form W-2 as "other income" i. j. Commuting expenses incurred by an employee, reimbursed in full by the employer and included on Form W-2 as "other income" Entertainment expenses incurred by a self-employed businesswoman 7 Overview of Deductions and Losses Solutions to Test Bank True or False 1. False. The expense is deductible if it meets the general criteria in 162 and 212 and is not disallowed by some other section of the Code. (See pp. 7-3 and 7-4.) 2. False. The term refers to expenses deductible under 212 relating to production-of-income expenses and not business expenses. (See p. 7-6.) 3. False. Before an expense is deductible under 162, it must be directly connected with or must pertain to the taxpayer's trade or business. (See pp. 7-5 and 7-6.) 4. True. The expense only needs to be one that is customarily incurred under the given set of circumstances. (See p. 7-7.) 5. False. Except for "points," interest may only be deducted over the period it accrues. (See p. 7-12.) 6. False. V's business loss for property cannot be deducted until there has been a sale of the property, or the property, becomes completely useless. (See pp. 7-18 and 7-19.) 7. False. If an expense is reimbursed by the employer, the expense will be classified as a deduction for A.G. I., but only if it is otherwise deductible under some section of the Code. (See pp. 7-20 and 7-21.) 8. False. In computing taxable income, T may deduct the higher of her itemized deductions or her standard deduction. Her itemized deductions are not reduced by the standard deduction as was the case under prior law. (See p. 7-20.) 9. True. (See p. 7-21.) Note, however, the portion of tax preparation fees allocated to business income, rental and royalty income, or farm income may be deducted "for" A.G.I. 10. 11. False. Employee business expenses are deductible only to the extent they exceed 2 percent of A.G.I. As a result, J could deduct $200 [$1,000 (2% $40,000)]. (See Example 23 and pp. 7-21 and 7-22.) False. Section 212(3) specifically allows for the deduction of expenses incurred in the determination of tax. No limitation is imposed. (See p. 7-21.) 7-29 7-30 Chapter 7 Overview of Deductions and Losses 12. 13. 14. 15. True. W is an independent contractor (i.e., self-employed) and may deduct all of the expenses he incurred to wash the factory's windows. (See pp. 7-21 and 7-22.) True. A taxpayer's expectation of profit need not be reasonable in order for hobby expenses to be deductible. [See p. 7-24 and Reg. 1.183-2(a).] True. Otherwise allowable expenses, such as taxes, are not subject to the 2 percent limitation. (See Example 27 and pp. 7-25 and 7-26.) False. Only losses incurred (realized) in connection with a business, with transactions entered into for profit, or from casualties are deductible. A mere decline in the property's value unrelated to a business, investment, or casualty is not deductible. (See pp. 7-18 and 7-19.) False. For tax purposes, goodwill may be deducted by amortization ratably over a 15-year period. (See Example 31 and pp. 7-28 and 7-29.) True. Interest expense and nonbusiness expenses related to tax-exempt income are not deductible, but other business expenses are allowed. (See p. 7-37.) False. The only allowable expenses related to tax-exempt income are business expenses, and these are allowed only if the income is tax-exempt interest. (See p. 7-37.) True. The liability must be that of the taxpayer before he or she may take a deduction. An exception to this rule is made for medical expenses. (See Examples 55 and 56 and p. 7-41.) True. A taxpayer may deduct with certain exceptions such as entertainment expenses, a reasonable estimation of an amount where the actual amount is not substantiated. (See p. 7-42.) 16. 17. 18. 19. 20. Multiple Choice 21. 22. d. To be recognized as a trade or business, an activity does not need to show a profit, as long as a profit is actively pursued. (But see 183 on hobby activities and pp. 7-4 and 7-24.) b. Determining the status of an expense as either a 162 or 212 deduction is important because the 162 deductions are used to compute A.G.I., whereas the 212 deductions are only available to itemizers and deductible from A.G.I. (See p. 7-5.) c. Because Z performed no services for the company,$15,000 is an excessive salary. IRS probably would view the first $10,000 ($100,000 10% interest) as the dividend Z was entitled to as owner of 10 percent of the company. The remaining $5,000 might be considered either as a reasonable retainer for his services as a pilot, and be taxable to Z as income, or as a nontaxable return of his capital. (See p. 7-8.) Items 1 and 3 are deductible in the current year. Item 1 is deductible because the payment is deemed to have been made when it is mailed. Item 2 is not deductible because a promise to pay or a note is not considered payment by a cash basis taxpayer. Item 3 is deductible because the taxpayer is deemed to have borrowed the funds and paid the expense in the year in which the charge was made. Item 4 is not deductible because the bank did not pay the expense until the following year. (See pp. 7-8 and 7-9.) Item 3 is deductible. Item 1 is not deductible because the taxpayer is contractually obligated to make the payment for the insurance coverage that extends beyond the succeeding taxable year. Item 2 may not be deducted because S uses the accrual method. Item 3 is deductible because 461(g) permits the deduction of points paid on a primary residence. In contrast, item 4 is nondeductible because points paid on property other than a primary residence must be amortized over the term of the loan. (See Examples 9 and 11 and pp. 7-11 and 7-12.) 23. 24. c. 25. e. Solutions to Test Bank 7-31 26. d. $1,000 7 months $600 premium paid 6/1 $600 premium paid 12/1 $7,000 600 600 $8,200 rent expense insurance expense insurance expense The prepaid insurance expense of $500 ($600 $100 for December) should be deductible under the "one-year" exception. (See p. 7-11.) 27. b. A cash basis taxpayer cannot deduct prepaid interest until it accrues. Such a taxpayer may not deduct points when paid on a loan for property other than a personal residence, but must capitalize the points and amortize and deduct them over the life of the loan. Thus points for one month, $41.67, are deductible ($5,000/120). [See p. 7-12 and 461(g).] This problem requires an understanding of the all events and economic-performance tests. Item 1 is not deductible because economic performance (i.e. receipt of the services) does not occur until the following year. Item 2 is deductible under the recurring expense exception. Item 3 is not deductible because estimated warranty expenses do not meet the economic performance test. (See pp. 7-13 through 7-16.) Allowing the accrual-basis taxpayer to deduct an estimated expense in the current year overstates the value of the expense incurred because the time value of money is not considered. The accrual-basis taxpayer must wait until the economic performance occurs (e.g., goods provided, service rendered, payment made, goods, and/or services received). (See pp. 7-13 and 7-14.) The loss on the Buick is not deductible because the transaction was not entered into for profit. Thus C must report and pay taxes on the income. (See pp. 7-18 and 7-19.) Net earnings from self-employment are determined without regard to itemized deductions; the computation is made on Schedule C of the return. (See p. 7-20.) Unreimbursed employee business expenses are miscellaneous itemized deductions; a., b. and d. are deductions for A.G.I. (See pp. 7-20 and 7-21.) Unreimbursed employee business expenses are not deductible by a non-itemizer. (See p. 7-22.) Tax preparation fees are miscellaneous itemized deductions. (See p. 7-21.) Under an accountable plan, the employee expense reimbursement ordinarily is not included in income and the related expense is not deductible. However, if the reimbursement does appear as income, the employee may deduct the amount for A.G.I. Unreimbursed expenses are treated as miscellaneous itemized deductions. (See Example 25 and pp. 7-22 and 7-23.) This applies to "qualifying performing artists" who earn at least $200 from each of at least two different employers, have A.G.I. no greater than $16,000 before business deductions, and claim business deductions in excess of ten percent of their gross service income. (See p. 7-23.) The facts presented in the question strongly imply that B's pottery activity is a hobby: B has substantial other income, he devotes only 10 hours a week to it, and he enjoys it. Section 183 allows expenses from hobbies to be deducted only to offset hobby income. This expense is a miscellaneous itemized deduction subject to the two percent of A.G.I. limitation. (See pp. 7-24 through 7-26.) B would have made a profit in three out of the first five years of the pottery-making activity. Although this does not conclusively establish that the activity is a business, the IRS must now prove that D's activity is not a business. (See p. 7-25.) Deductions related to a hobby are limited to the taxpayer's gross income from the hobby reduced by otherwise allowable deductions such as interest and taxes, the deductibility of which does not depend on the nature of the activity in which they were incurred. In this case, F's gross income is $8,000. Thus, he can deduct $6,000 of property tax, which reduces the amount of other expenses he may deduct to $2,000. Of the other deductible expenses, depreciation is deducted last; consequently, $2,000 of other operating expenses are deductible in addition to the tax. (See Example 28 and pp. 7-25 and 7-26.) The property taxes are deductible without limitation by the hobby loss rules of 183. (See Example 28 and pp. 7-25 and 7-26.) N may only deduct alimony expenses ($12,000). Losses on the sale of property held for personal use (N's car) and insurance premiums paid by the insured are not deductible. [See pp. 7-18, 7-20, 7-26 and 7-27, and 165(c)(3).] 28. c. 29. b. 30. 31. 32. 33. 34. 35. b. a. c. c. d. d. 36. a. 37. d. 38. c. 39. c. 40. 41. d. a. 7-32 Chapter 7 Overview of Deductions and Losses 42. d. $130,000 of the cost of acquiring the property is depreciable. The remaining $20,000 is goodwill, which may be amortized ratably over a 15-year period. The $30,000 expense for remodeling must be depreciated because it has long-term use. Therefore, the total depreciable/amortizable amount is $180,000. The $1,000 for repairs that do not lengthen the life of the assets may be deducted currently. (See pp. 7-28 and 7-29.) c. Answer a. is incorrect because the costs must be deducted/amortized under 195. Answer b. is incorrect because the cost generally is not deductible at all. Answer c. is correct because she was already in the same business and the expenditures are deductible even if she does not enter into the new venture. (See pp. 7-31 through 7-33.) Expenses related to an illegal business are deductible; fines are not. (See p. 7-36.) 43. 44. 45. c. a. A taxpayer may deduct lobbying expenses incurred in providing information to local governmental units on legislative matters of direct interest to the taxpayer's business. Political contributions are not deductible. [See Example 45, pp. 7-36 and 7-37, and 162(e).] d. Choices a., b. and c. are deductible for A.G.I. Premiums paid by the business on its key employees with itself as beneficiary are not deductible under 263, which prohibits the deduction of expenses related to tax-exempt income (i.e., the life insurance proceeds). (See pp. 7-37 and 7-38.) c. X directly owns his own 20 shares and indirectly owns all those of his partnership (he indirectly owns not only his proportionate share, but those of his partners as well) and half those of the corporation he is half owner of. He does not indirectly own those of his step-brother (i.e., someone who shares no natural parents with X and who has a parent who married one of X's parents); for purposes of the constructive relationship rules, siblings must share at least one natural parent. (See pp. 7-38 through 7-40 and 267.) 46. 47. 48. 49. d. Section 265 prohibits the deduction for any interest expense related to tax-exempt interest income. (See p. 7-37.) c. A taxpayer may not deduct the loss from sale to a related taxpayer; however, any loss disallowed on the sale may be used to offset any gain on a subsequent sale of the property by a related taxpayer. [See Example 51, p. 7-40, and 267(d).] 50. d. Section 267 prohibits the deduction of a loss on a sale of property to a related party. This problem requires a knowledge of who is considered a related party and the constructive ownership rules. Under these rules, a taxpayer and his more-than-50-percent-owned corporation are considered related parties. Item d. is true because G is deemed to own only 46.6 percent, 40 percent directly and 6.6 percent (60% 11%) indirectly through J. Item a. is false because G is deemed to own 70 percent of C, 30 percent directly and 40 percent through his spouse. Items b. and c. are false because a wife and brother are considered family members under the related party rules. (See p. 7-39.) c. Under 267, an accrual basis taxpayer can deduct payments to a related party who uses the cash basis method of accounting only in the year in which the payment is made. Thus the provision treats the taxpayer as if the cash method was used. Item a. is false because deductions for expenses between related parties are allowed in the year the payment is actually made. Item b. is false because the test is objective and has no exceptions. Item d. which is also false, reflects the approach taken under prior law that previously allowed deductions for payments made within two-and-one-half months after the close of the taxable year. (See Examples 53 and 54 and pp. 7-40 and 7-41.) 51. 52. b. Under 267, an accrual basis taxpayer can deduct payments to a related party who uses the cash basis method of accounting only in the year in which the payment is made. In this case, D is treated as a related party because under the constructive ownership rules he is deemed to own all of the stock owned by his family, which includes his father. (See pp. 7-40 and 7-41.) b. B would benefit the most because a payment in the current year would produce no savings, as itemized deductions including the payment would not exceed the standard deduction for joint returns ($11,600 in 2011). In the following year, however, B would be able to deduct the entire payment and produce savings of $25 (25% $100). (See p. 7-42.) a. When the money charged by a bank as points is withheld from the borrower by the bank, the payment is a currently deductible prepayment of interest as long as the cash paid by the borrower is at least equal to amount deducted for points. (See pp. 7-43 and 7-44.) d. The Regulations require taxpayers to use the accrual method for computing sales and cost of goods sold if inventories are an income-producing factor. (See p. 7-10.) 53. 54. 55. Solutions to Test Bank 7-33 56. 57. d. c. Under the "all-events" test and economic performance requirement of Code 461, taxpayers may not accrue estimated expenses. (See pp. 7-13 through 7-16.) If the taxpayer enters a business which is not similar to one in which he is currently engaged, the rules for investigation and start-up expenses allow the taxpayer to expense the first $5,000 and amortize the balance over 15 years or 180 months. In this case, the taxpayer could expense $5,000 and the remaining balance of $3,000 would be amortized. (See pp. 7-31 and 7-32.) Matching 58. a. Not. Because the reimbursement was not included in income, the expenditure is not deductible by the nurse. (See p. 7-22.) b. Not. Personal living expenses are not deductible. (See pp. 7-26 and 7-27.) c. From. Tax preparation fees are deductible as a miscellaneous itemized deduction. (See p. 7-21.) d. For. Losses from the sale or exchange of property held for investment are deductible for A.G.I. (See p. 7-18.) e. From. All unreimbursed employee business expenses are miscellaneous itemized deductions. (See p. 7-21.) f. For. Trade or business expenses of a self-employed individual are deductible "above-the-line." (See p. 7-21.) g. For. Deductions attributable to rents and royalties (assuming they are deductible under the passive loss limitation rules) are deductible for A.G.I. (See p. 7-21.) h. For. Reimbursed deductible expenses (included in the employee's income) are deductible "for" A.G.I. (See Example 24 and p. 7-22.) i. Not. Commuting expense is not deductible. The fact the expenditure is reimbursed and the reimbursement is included in the employee's income is irrelevant. (See p. 7-22.) j. For. Once again, deductible expenses incurred by a self-employed person are deductible "above-theline." (See p. 7-21.) 7 Overview of Deductions and Losses Comprehensive Problems FACTS FOR COMPREHENSIVE PROBLEMS H and W, ages 42 and 45, respectively, are married taxpayers who file jointly. H is employed as a policeman and received a salary of $30,000 in 2011. W owns a hardware store and reported gross income (gross receipts less cost of goods sold) for 2011 of $100,000. In addition, they reported the following expenditures: Expenses related to hardware store: Salaries and wages of employees Rent Premiums for fire insurance (for years 2011, 2012, and 2013) Bad debts (actual) Utilities Premiums for insurance on W's life Loss on sale of General Motors bonds held for investment Cost of police officer's uniform reimbursed in full by H's employer (reimbursement not included in gross income) Miscellaneous itemized deductions Charitable contributions Taxes Interest on home mortgage $30,000 12,000 3,000 2,000 6,000 1,000 4,000 ,500 2,600 3,800 1,500 3,000 COMPREHENSIVE PROBLEMS 1. With respect to the hardware store, W a. Must use the cash basis for all items of revenue, cost, and expense b. May use either the cash or accrual basis for all items of revenue, cost, and expense c. Must use the accrual basis for all items of revenue, cost, and expense d. Must use the accrual basis for all items affecting the computation of gross income (if no election is made to use the cash method), but may use the cash basis in accounting for expenses With respect to the bad debts of the hardware store, which of the following statements is correct? a. The reserve method is permitted for business bad debts. b. The direct charge-off method is allowed for business bad debts. c. A partial loss deduction is not available for business bad debts. d. All of the above are correct. 7-35 2. 7-36 Chapter 7 Overview of Deductions and Losses 3. Showing your work, calculate H and W's adjusted gross income (A.G.I.) for 2011. a. $72,000 b. $73,000 c. $74,000 d. $76,000 Assuming H and W's A.G.I. is $70,000, calculate the total amount of allowable itemized deductions (show your work). a. $0 (i.e., H and W will elect to use the standard deduction) b. $ 8,000 c. $ 8,800 d. $ 9,400 4. Solutions to Comprehensive Problems 1. 2. 3. d. b. d. The calculations are H's wages W's gross income Less allowable business expenses: Salaries and wages Rent Fire insurance premiums for 2011 Bad debts Utilities Less capital loss deduction A.G.I. $ 30,000 100,000 (30,000) (12,000) (1,000) (2,000) (6,000) (3,000) $ 76,000 Notes: 1. 2. 3. 4. Prepaid fire insurance must be prorated over the period to which the expenditure applies (the "one-year" test is not satisfied). (See p. 7-11.) Life insurance premiums are not deductible (with the exception of insurance provided to employees as additional compensation or as a fringe benefit). (See p. 7-38.) Reimbursed expenses, when the amount of the reimbursement is not included in the taxpayer's income, are not deductible. (See p. 7-22.) a. The answer is that H and W will use the 2011 standard deduction of $11,600 because it exceeds the total of allowable itemized deductions. The calculations are Miscellaneous itemized deductions [less 2% of A.G.I. ($2,600 $1,400)] Charitable contributions Taxes Interest on home mortgage Total (See pp. 7-20 and 7-21.) $1,200 3,800 1,500 3,000 $9,500 ...
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