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CHAPTER 6 DEDUCTIONS AND LOSSES: IN GENERAL

Chapter 6 Deductions and Losses: In General

1. Deductions are allowed unless a specific provision in the tax law provides otherwise.a. Trueb. False

ANSWER:FalseRATIONALE: Deductions are a matter of legislative grace. The only deductions allowed are those specifically provided for by statute, rulings, etc.

2. Mitch is in the 28% tax bracket. He may receive a different tax benefit for a $2,000 expenditure that is classified as a deduction from AGI than he will receive for a $1,000 expenditure that is classified as a deduction for AGI.a. Trueb. False

ANSWER:TrueRATIONALE: The value of the tax benefit to Mitch 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 28% bracket for a $2,000 expenditure is $560 ($2,000 28%). If Mitch takes the standard deduction rather than itemizing deductions, then the $2,000 expenditure that is classified as a deduction from AGI has no tax benefit.

3. Depending on the nature of the expenditure, expenses incurred in a trade or business may be deductible for or from AGI.a. Trueb. False

ANSWER:FalseRATIONALE: Such expenses are deductible for AGI.

4. Only some employment related expenses are classified as deductions for AGI.a. Trueb. False

ANSWER:TrueRATIONALE: Unreimbursed employee expenses are classified as deductions from AGI while reimbursed employee expenses are classified as deductions for AGI.

5. Section 212 expenses that are related to rent and royalty income are deductions for AGI.a. Trueb. False

ANSWER: True

6. Alice incurs qualified moving expenses of $12,000. If she is reimbursed by her employer, the deduction is classified as a deduction for AGI. If not reimbursed, the deduction is classified as an itemized deduction.a. Trueb. False

ANSWER:FalseRATIONALE: Moving expenses are classified as deductions for AGI.

7. Expenses incurred for the production or collection of income generally are deductions from adjusted gross income.a. Trueb. False

ANSWER:TrueRATIONALE: Two exceptions are those expenses incurred in producing rent and royalty income.

8. The Code does not specifically define what constitutes a trade or business.a. Trueb. False

ANSWER: True

9. An expense need not be recurring in order to be ordinary.a. Trueb. False

ANSWER:TrueRATIONALE: An 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 deductible as ordinary.

10. Aaron, a shareholder-employee of Pigeon, 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 Aarons gross income by $100,000 and increase Pigeons gross income by $100,000.a. Trueb. False

ANSWER:FalseRATIONALE: While Aarons dividend income increases by $100,000, his salary income decreases by $100,000. Thus, his gross income does not change. Pigeons gross income does increase by $100,000.

11. The portion of a shareholderemployees salary that is classified as unreasonable has no effect on the amount of a shareholderemployees gross income, but results in an increase in the taxable income of the corporation.a. Trueb. False

ANSWER: True

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.a. Trueb. False

ANSWER:FalseRATIONALE: Only unreasonable salaries are not deductible.

13. Only under limited circumstances can a loss on the sale of a personal use asset be deducted.a. Trueb. False

ANSWER:FalseRATIONALE: Under no circumstances can such a loss be deducted.

14. The income of a sole proprietorship are reported on Schedule C (Profit or Loss from Business).a. Trueb. False

ANSWER: True

15. The cash method can be used even if inventory and cost of goods sold are an income producing factor in the business.a. Trueb. False

ANSWER:FalseRATIONALE: The accrual method must be used in these cases.

16. A taxpayers note or promise to pay satisfies the actually paid requirement for the cash basis method of accounting.a. Trueb. False

ANSWER:FalseRATIONALE: Promising to pay or issuing a note does not satisfy the actually paid requirement.

17. Isabella owns two business entities. She may be able to use the cash method for one and the accrual method for the other.a. Trueb. False

ANSWER: True

18. Under the oneyear 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.a. Trueb. False

ANSWER:TrueRATIONALE: If the one-year rule is not satisfied, the prepayment is prorated and deducted over the benefit period.

19. None of the prepaid rent paid on September 1 by a calendar year cash basis taxpayer for the next 18 months is deductible in the current period.a. Trueb. False

ANSWER:FalseRATIONALE: The 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 September through December of the current tax year may be deducted in the current tax year.

20. The period in which an accrual basis taxpayer can deduct an expense is determined by applying the economic performance and all events tests.a. Trueb. False

ANSWER: True

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, but is not allowed for a cash method taxpayer.a. Trueb. False

ANSWER:FalseRATIONALE: A reserve for estimated expenses (e.g., bad debt) is not allowed to an accrual method taxpayer for tax purposes because the economic performance test cannot be satisfied. For a cash method taxpayer, there is no addition to the reserve for bad debts because income has not been recognized that would have generated a debt.

22. All domestic bribes (i.e., to a U.S. official) are disallowed as deductions.a. Trueb. False

ANSWER:TrueRATIONALE: However, a payment to a foreign official is deductible if it is not in violation of the Foreign Corrupt Practices Act of 1977.

23. Fines and penalties paid for violations of the law (e.g., illegal dumping of hazardous waste) are deductible only if they relate to a trade or business.a. Trueb. False

ANSWER:FalseRATIONALE: Fines and penalties paid for violations of laws are never deductible.

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.a. Trueb. False

ANSWER:FalseRATIONALE: The 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.

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.a. Trueb. False

ANSWER:FalseRATIONALE: This deduction is expressly allowed under 212.

26. Two-thirds of treble damage payments under the antitrust law are not deductible.a. Trueb. False

ANSWER:TrueRATIONALE: Only one-third of such payments is deductible.

27. The legal cost of having a will prepared is not deductible.a. Trueb. False

ANSWER:TrueRATIONALE: This is a nondeductible personal expense.

28. Legal expenses incurred in connection with rental property are deductions from AGI.a. Trueb. False

ANSWER:FalseRATIONALE: This is a deduction for AGI.

29. Legal fees incurred in connection with a criminal defense are not deductible even if the crime is associated with a trade or business.a. Trueb. False

ANSWER:FalseRATIONALE: In this circumstance, the legal fees are deductible.

30. If a taxpayer operates an illegal business, no deductions are permitted.a. Trueb. False

ANSWER:FalseRATIONALE: The usual expenses for operating an illegal business are deductible. But 162 disallows a deduction for fines, bribes to public officials, illegal kickbacks, and other illegal payments. However, for illegal trafficking in drugs, 280E disallows all deductions.

31. Ordinary and necessary business expenses, other than cost of goods sold, of an illegal drug trafficking business do not reduce taxable income.a. Trueb. False

ANSWER:TrueRATIONALE: Cost 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.

32. Jacques, who is not a U.S. citizen, makes a contribution to the campaign of a candidate for governor. Cassie, a U.S. citizen, also makes a contribution to the same campaign fund. If contributions by noncitizens are illegal under state law, the contribution by Cassie is deductible, while that by Jacques is not.a. Trueb. False

ANSWER:FalseRATIONALE: Deductions are not permitted for political contributions.

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.a. Trueb. False

ANSWER:TrueRATIONALE: The $1 million limit on deducting compensation applies only to executive compensation of publicly traded companies.

34. For a taxpayer who is engaged in a trade or business, the cost of investigating a business in the same field is deductible only if the taxpayer acquires the business.a. Trueb. False

ANSWER:FalseRATIONALE: For a taxpayer who is engaged in a trade or business, the cost of investigating a business in the same field is deductible regardless of whether or not it is acquired.

35. Investigation of a business unrelated to ones present business never results in a current period deduction of the entire amount if the amount of the investigation expenses exceeds $5,000.a. Trueb. False

ANSWER:TrueRATIONALE: Even if the business is acquired, some or all of the expenses must be capitalized and amortized over a minimum 180-month period. If the business is not acquired, no deduction results.

36. In determining whether an activity should be classified as a business or as a hobby, the satisfaction of the presumption (i.e., profit in at least 3 out of 5 years) ensures treatment as a business.a. Trueb. False

ANSWER:FalseRATIONALE: The satisfaction of the presumption merely shifts the burden of proof to the IRS. The possibility still exists that the IRS can prove the activity is a hobby.

37. If a taxpayer can satisfy the three-out-of-five year presumption test associated with hobby losses, then expenses from the activity can be deducted in excess of the gross income from the activity.a. Trueb. False

ANSWER:FalseRATIONALE: Satisfying the presumption shifts the burden of proof from the taxpayer to the IRS. Failing the presumption merely means the burden of proof remains with the taxpayer.

38. If an activity involves horses, a profit in at least two of seven consecutive years meets the presumptive rule of 183.a. Trueb. False

ANSWER: True

39. A hobby activity can result in all of the hobby income being included in AGI and no deductions being allowed.a. Trueb. False

ANSWER:TrueRATIONALE: The 2%-of-AGI limitation can wipe out any deductible amount. Likewise, if the taxpayer does not itemize, no deduction will be permitted.

40. If an item such as property taxes and home mortgage interest exceed the income from a hobby, the excess amount of this item over the hobby income can be deducted if the taxpayer itemizes deductions.a. Trueb. False

ANSWER:TrueRATIONALE: The excess in this case qualifies as an itemized deduction.

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.a. Trueb. False

ANSWER:FalseRATIONALE: Such expenses are an itemized deduction and are subject to the 2% floor on miscellaneous itemized deductions except for the property tax and mortgage interest.

42. Martha rents part of her personal residence in the summer for 3 weeks for $3,000. Anne rents all of her personal residence for one week in December for $2,500. Anne is not required to include the $2,500 in her gross income whereas Martha is required to include the $3,000 in her gross income.a. Trueb. False

ANSWER:TrueRATIONALE: The 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 Martha need report her rental income.

43. If a vacation home is rented for less than 15 days during a year, the only expenses that can be deducted are mortgage interest, property taxes, and personal casualty losses.a. Trueb. False

ANSWER: True

44. If a vacation home is classified as primarily rental use, a deduction for all of the rental expenses is allowed.a. Trueb. False

ANSWER:FalseRATIONALE: The personal use portion still must be prorated.

45. If a vacation home is classified as primarily personal use (i.e., rented for fewer than 15 days), none of the related expenses can be deducted.a. Trueb. False

ANSWER:FalseRATIONALE: Only the expenses that normally are allowed as itemized deductions (e.g., mortgage interest and property taxes) can be deducted.

46. The portion of property tax on a vacation home that is attributable to personal use is an itemized deduction.a. Trueb. False

ANSWER:TrueRATIONALE: The 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). The personal use portion of such expenses is deductible as an itemized deduction.

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.a. Trueb. False

ANSWER:FalseRATIONALE: None of these expenses can be deducted since they relate to personal use.

48. A vacation home at the beach which is rented for 200 days and used personally for 16 days is classified in the personal/rental use category.a. Trueb. False

ANSWER:FalseRATIONALE: The home can have personal use of 20 days (200 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.

49. If a vacation home is a personal/rental residence, no maintenance and utility expenses can be claimed as a deduction.a. Trueb. False

ANSWER:FalseRATIONALE: That part of the maintenance and utility expenses allocated to rental days can be deducted subject to the gross income ceiling.

50. Beulahs personal residence has an adjusted basis of $450,000 and a fair market value of $390,000. Beulah converts the property to rental use on November 1, 2014. The vacation home rules that limit the amount of the deduction to the rental income will apply and the adjusted basis for depreciation is $390,000.a. Trueb. False

ANSWER:FalseRATIONALE: The adjusted basis for depreciation is $390,000, the lower of Beulahs adjusted basis of $450,000 or the fair market value of $390,000 on the date of the conversion. However, additional data are 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.

51. Walt wants to give his daughter $1,800 for Christmas. As an alternative, she suggests that he pay the property taxes on her residence. If Ralph pays the property taxes, he can deduct them.a. Trueb. False

ANSWER:FalseRATIONALE: A taxpayer cannot deduct another taxpayers obligation. Thus, Ralph cannot deduct his daughters property taxes.

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.a. Trueb. False

ANSWER:FalseRATIONALE: Both 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.

53. Purchased goodwill must be capitalized, but can be amortized over a 60-month period.a. Trueb. False

ANSWER:FalseRATIONALE: Goodwill is a 197 intangible. Although it must be capitalized, it can be amortized over a 15-year statutory period.

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 $5,000 and Jasons adjusted basis for the land is $25,000 ($20,000 cost + $5,000 recognized gain of Marge).a. Trueb. False

ANSWER:FalseRATIONALE: Marges recognized loss is $0 Jasons adjusted basis for the land is his cost of $20,000.

55. For purposes of the 267 loss disallowance provision, a taxpayers aunt is a related party.a. Trueb. False

ANSWER:FalseRATIONALE: An aunt is not a related party for 267 loss disallowance purposes.

56. Sammy, a calendar year cash basis taxpayer who is age 66, has the following transactions:

Salary from job$90,000

Alimony received from ex-wife10,000

Medical expenses8,000

Based on this information, Sammy has:

a. AGI of $90,000.

b. AGI of $95,000.

c. AGI of $99,500.

d. Deduction for medical expenses of $0.

e. None of the above.

ANSWER:eRATIONALE: Sammys AGI is calculated as follows:

Salary from job$ 90,000

Alimony received from ex-wife 10,000

AGI$100,000

Sammys deduction for medical expenses, an itemized deduction, is $500 [$8,000 7.5%($100,000)].

57. 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.

ANSWER: c

58. Al is single, age 60, and has gross income of $140,000. His deductible expenses are as follows:

Alimony$20,000

Charitable contributions4,000

Contribution to a traditional IRA5,500

Expenses paid on rental property7,500

Interest on home mortgage and property taxes on personal residence7,200

State income tax2,200

What is Als AGI?

a. $94,100.

b. $103,000.

c. $107,000.

d. $127,000.

e. None of the above.

ANSWER:c

RATIONALE: Als AGI is calculated as follows:Gross income$140,000

Deductions for AGI:

Alimony$20,000

IRA5,500

Expenses on rental property7,500 (33,000)

AGI$107,000

59. Marsha is single, had gross income of $50,000, and incurred the following expenses:

Charitable contribution$2,000

Taxes and interest on home7,000

Legal fees incurred in a tax dispute1,000

Medical expenses3,000

Penalty on early withdrawal of savings250

Her AGI is:

a. $39,750.

b. $49,750.

c. $40,000.

d. $39,750.

e. None of the above.

ANSWER:bRATIONALE: Marshas AGI is calculated as follows:Gross income$50,000Deductions for AGI:Penalty on early withdrawal of savings (250)AGI$49,750

60. Which of the following can be claimed as a deduction for AGI?a. Personal casualty losses.b. Investment interest expenses.c. Medical expenses.d. Property taxes on personal use real estate.e. None of the above.

ANSWER:eRATIONALE: All of these expenses are classified as itemized deductions.

61. Which of the following is a deduction for AGI (itemized deduction)?a. Contribution to a traditional IRA.b. Roof repairs to a personal use home.c. Safe deposit box rental fee in which stock certificates are stored.d. Property tax on personal residence.e. All of the above.

ANSWER:aRATIONALE: Choice c. and d. are deductions from AGI. Choice b. is not deductible.

62. 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 for AGI.d. Only a. and b. are correct.e. a., b., and c., are correct.

ANSWER: e

63. Which of the following are deductions for AGI?a. Mortgage interest on a personal residence.b. Property taxes on a personal residence.c. Mortgage interest on a building used in a business.d. Fines and penalties incurred in a trade or business.e. None of the above.

ANSWER: c

64. Which of the following is incorrect?a. Alimony is a deduction for AGI.b. The expenses associated with royalty property are a deduction from AGI.c. Contributions to a traditional IRA are a deduction for AGI.d. Property taxes on taxpayers personal residence are a deduction from AGIe. All of the above are correct.

ANSWER: b

65. 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.

ANSWER: c

66. Which of the following is a required test for the deduction of a business expense?a. Ordinary.b. Necessary.c. Reasonable.d. All of the above.e. None of the above.

ANSWER: d

67. Paula is the sole shareholder of Violet, Inc. For 2014, she receives from Violet a salary of $300,000 and dividends of $100,000. Violets taxable income for 2014 is $500,000. On audit, the IRS treats $100,000 of Paulas salary as unreasonable. Which of the following statements is correct?a. Paulas gross income will increase by $100,000 as a result of the IRS adjustment.b. Violets taxable income will not be affected by the IRS adjustment.c. Paulas gross income will decrease by $100,000 as a result of the IRS adjustment.d. Violets taxable income will decrease by $100,000 as a result of the IRS adjustment.e. None of the above is correct.

ANSWER:eRATIONALE: $100,000 of salary is reclassified as a dividend. Thus, Violets taxable income increases by $100,000 because dividends are not deductible. Paulas gross income remains the same. Her salary income decreases by $100,000, but her dividend income increases by $100,000.

68. During 2013, the first year of operations, Silver, Inc., pays salaries of $175,000. At the end of the year, employees have earned salaries of $20,000, which are not paid by Silver until early in 2014. What is the amount of the deduction for salary expense?a. If Silver uses the cash method, $175,000 in 2013 and $0 in 2014.b. If Silver uses the cash method, $0 in 2013 and $195,000 in 2014.c. If Silver uses the accrual method, $175,000 in 2013 and $20,000 in 2014.d. If Silver uses the accrual method, $195,000 in 2013 and $0 in 2014.e. None of the above is correct.

ANSWER: d

69. Benita incurred a business expense on December 10, 2014, which she charged on her bank credit card. She paid the credit card statement which included the charge on January 5, 2015. Which of the following is correct?a. If Benita is a cash method taxpayer, she cannot deduct the expense until 2015.b. If Benita is an accrual method taxpayer, she can deduct the expense in 2014.c. If Benita uses the accrual method, she can choose to deduct the expense in either 2014 or 2015.d. Only b. and c. are correct.e. a., b., and c. are correct.

ANSWER:bRATIONALE: Choice 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 2014. If Benita uses the accrual method, she deducts the expense in 2014. In any event, she does not merely choose the year in which to deduct the expense (choice c.).

70. 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.

ANSWER:cRATIONALE: Both 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.

71. Petal, Inc. is an accrual basis taxpayer. Petal uses the aging approach to calculate the reserve for bad debts. During 2014, the following occur associated with bad debts.

Credit sales$400,000

Collections on credit sales250,000

Amount added to the reserve10,000

Beginning balance in the reserve0

Identifiable bad debts during 201412,000

The amount of the deduction for bad debt expense for Petal for 2014 is: a. $10,000.b. $12,000. c. $22,000. d. $140,000.e. None of the above.

ANSWER: bRATIONALE: Only 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.

72. Which of the following legal expenses are deductible for AGI?a. Incurred in connection with a trade or business.b. Incurred in connection with rental or royalty property held for the production of income.c. Incurred for tax advice relative to the preparation of an individuals income tax return.d. Only a. and b. qualify.e. a., b., and c. qualify.

ANSWER:dRATIONALE: Expenses incurred for tax advice relative to the preparation of an individuals income tax return are classified as itemized deductions.

73. Rex, a cash basis calendar year taxpayer, runs a bingo operation which is illegal under state law. During 2014, a bill designated H.R. 9 is introduced into the state legislature which, if enacted, would legitimize bingo games. In 2014, Rex had the following expenses:

Operating expenses in conducting bingo games$247,000

Payoff money to state and local police24,000

Newspaper ads supporting H.R. 93,000

Political contributions to legislators who support H.R. 98,000

a. $247,000.

b. $250,000.

c. $258,000.

d. $282,000.

e. None of the above.

ANSWER:a

RATIONALE: Rex can deduct only the $247,000 of operating expenses.

74. Andrew, who operates a laundry business, incurred the following expenses during the year.

Parking ticket of $250 for one of his delivery vans that parked illegally. Parking ticket of $75 when he parked illegally while attending a rock concert in Tulsa. DUI ticket of $500 while returning from the rock concert. Attorneys fee of $600 associated with the DUI ticket.

What amount can Andrew deduct for these expenses? a. $0.b. $250. c. $600. d. $1,425.e. None of the above.

ANSWER:aRATIONALE: None of these expenses are deductible. The $75 parking ticket, the $500 DUI ticket, and the $600 attorney fee are all personal expenses. The $250 parking ticket, although related to his laundry business, is not deductible because it is a violation of public policy.

75. Which of the following may be deductible?a. Bribes that relate to a U.S. business.b. Fines paid for violations of the law.c. Interest on a loan used in a hobby.d. All of the above.e. None of the above.

ANSWER:cRATIONALE: Choices a. and b. are not deductible. Interest incurred in connection with a hobby may be deductible, depending on the amount of the gross income from the hobby and the application of the 2%-of-AGI floor.

76. 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.TerryJim

Employee salaries$200,000 $200,000

Bribes to police25,000 25,000

Rent and utilities50,000 50,000

Cost of goods sold0 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.

ANSWER:bRATIONALE: Terry and Jim should report net profit from their businesses as follows:

TerryJim

Gross revenues$500,000 $500,000

Less:Cost of goods sold (0) (125,000)

Gross income$500,000 $375,000

Less:Expenses

Employee salaries(200,000)(0)

Rent and utilities(50,000)(0)

Bribes to police (0) (0)

Net profit$250,000$375,000

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.

77. Tom operates an illegal drug-running operation and incurred the following expenses:

Salaries$ 75,000

Illegal kickbacks20,000

Bribes to border guards25,000

Cost of goods sold160,000

Rent8,000

Interest10,000

Insurance on furniture and fixtures6,000

Utilities and telephone20,000

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.

ANSWER:bRATIONALE: Cost 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.

78. For a president of a publicly held corporation, which of the following are not subject to the $1 million limit on executive compensation?a. Contribution to medical insurance plan.b. Contribution to pension plan.c. Premiums on group term life insurance of $50,000.d. Only b. and c. are not subject to the limit.e. a., b., and c., are not subject to the limit.

ANSWER: e

79. 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 180-month period.e. Not deductible.

ANSWER:eRATIONALE: Since 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.

80. Iris, a calendar year cash basis taxpayer, owns and operates several TV rental outlets in Florida, and wants to expand to other states. During 2014, 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 2014.c. Expense $9,000 for 2014 and capitalize $14,000.d. Capitalize $23,000.e. None of the above.

ANSWER:bRATIONALE: Since Iris owns and operates TV rental outlets, all of the investigation expenses can be deducted.

81. 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 regardless of whether the business being investigated is acquired.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.

ANSWER: b

82. Which of the following is not relevant in determining whether an activity is profit-seeking or a hobby?a. Whether the activity is enjoyed by the taxpayer.b. The expertise of the taxpayers or their advisers.c. The time and effort expended.d. The relationship of profits earned and losses incurred.e. All of the above are relevant factors.

ANSWER:eRATIONALE: All of these items are relevant factors in determining whether an activity is profit-seeking or a hobby.

83. For an activity classified as a hobby, the expenses are categorized as follows:

(1) Amounts that affect adjusted basis and would be deductible under other Code sections if the activity had been engaged in for profit (e.g., depreciation, amortization, and depletion).

(2) Amounts deductible under other Code sections without regard to the nature of the activity, such as property taxes and home mortgage interest.

(3) Amounts deductible under other Code sections if the activity had been engaged in for profit, but only if those amounts do not affect adjusted basis (e.g., maintenance, utilities, and supplies).

If these expenses exceed the gross income from the activity and are thus limited, the sequence in which they are deductible is:a. (1), (2), (3).b. (1), (3), (2).c. (2), (3), (1).d. (2), (1), (3).e. (3), (2), (1).

ANSWER: c

84. 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 the bedspreads for $10,000. She incurred expenses as follows:

Supplies$4,000

Interest on loan to get business started500

Advertising6,500

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 $11,000 of the expenses as itemized deductions.d. Include $10,000 in income and deduct interest of $500 for AGI.e. None of the above.

ANSWER:eRATIONALE: The potential itemized deductions of $11,000 must be reduced by 2% of $50,000 or $1,000. So the itemized deductions are $10,000.

85. Cory incurred and paid the following expenses:

Tax return preparation fee$ 600

Moving expenses2,000

Investment expenses500

Expenses associated with rental property1,500

Interest expense associated with loan to finance tax-exempt bonds400

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.

ANSWER:bRATIONALE: All 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).

86. Which of the following is not deductible?a. Moving expenses in excess of reimbursement.b. Tax return preparation fees of an individual.c. Expenses incurred associated with investments in stocks and bonds.d. Allowable hobby expenses in excess of hobby income.e. None of the above.

ANSWER:dRATIONALE: Moving 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.

87. If a residence is used primarily for personal use (rented for fewer than 15 days per year), which of the following is correct?a. No income is included in AGI.b. No expenses are deductible.c. Expenses must be allocated between rental and personal use.d. Only a. and b. are correct.e. a., b., and c. are correct.

ANSWER:aRATIONALE: Expenses that would otherwise be deductible (e.g., property taxes and interest on mortgage of personal residence) can be claimed (choice b.).

88. 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$9,000

Real estate taxes3,000

Utilities2,000

Maintenance1,000

Insurance500

Depreciation (rental part)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.

ANSWER:dRATIONALE: Since 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).

89. 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 that are deductible are classified as deductions from AGI.c. Expenses must be allocated between rental and personal use.d. Only a. and c. are correct.e. a., b., and c. are correct.

ANSWER:dRATIONALE: The allowable deductions are classified as deductions for AGI.

90. 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$4,000

Less: Mortgage interest and property taxes$3,500

Other allocated expenses 2,000 (5,500)

Net rental loss($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.

ANSWER: a

91. Because Scott is three months delinquent on the mortgage payments for his personal residence, Jeanette (his sister) is going to cover the arrearage. Based on past experience, she does not expect to be repaid by Scott. Which of the following statements is correct?a. If Scott receives the money from Jeanette and pays the mortgage company, Jeanette can deduct the interest part.b. If Jeanette pays the mortgage company directly, neither Scott nor Jeanette can deduct the interest part.c. If Jeanette pays the mortgage company directly, she cannot deduct the interest part.d. Only b. and c. are correct.e. a., b., and c. are correct.

ANSWER:dRATIONALE: The obligation is that of Scott and not of Jeanette. If Scott pays his mortgage company, he can deduct the mortgage interest part of the payment. Under no circumstances can Jeanette deduct Scotts mortgage interest.

92. Melba incurred the following expenses for her dependent daughter during the current year:

Payment of principal on daughters automobile loan$3,600

Payment of interest on above loan2,900

Payment of daughters property taxes1,800

Payment of principal on daughters personal residence loan2,800

Payment of interest on daughters personal residence loan7,000

How much may Melba deduct in computing her itemized deductions?

a. $0.

b. $8,800.

c. $11,700.

d. $18,100.

e. None of the above.

ANSWER:aRATIONALE: None of the items are incurred for the taxpayers (Melba) benefit or as a result of the taxpayers obligation.

93. Velma and Bud divorced. Velmas attorney fee of $5,000 is allocated as follows:

General representation in obtaining the divorce$1,500

Services in obtaining custody of the child900

Services in settlement of martial property600

Determining the tax consequences of: Dependency deduction for child700

Property settlement1,300

Of the $5,000 Velma pays to her attorney, the amount she may deduct as an itemized deduction is: a. $0.b. $700. c. $2,000.d. $5,000.e. None of the above.

ANSWER:cRATIONALE: Velma may deduct only the legal fees that relate solely to tax advice in the divorce proceedings. Thus, she may deduct $2,000 ($700 + $1,300).

94. 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 b. and c. must be capitalized.e. a., b., and c. can be expensed rather than capitalized.

ANSWER:cRATIONALE: All of these expenses, except for the covenant, can be deducted in the current tax year. The amortization period for the covenant is 15 years.

95. On January 2, 2014, Fran acquires a business from Chuck. Among the assets purchased are the following intangibles: patent with a 7-year remaining life, a covenant not to compete for 10 years, and goodwill.

Of the purchase price, $140,000 was paid for the patent and $60,000 for the covenant. The amount of the excess of the purchase price over the identifiable assets was $100,000. What is the amount of the amortization deduction for 2014?a. $10,667. b. $16,000. c. $20,000. d. $32,667.e. None of the above.

ANSWER:cRATIONALE: All of these intangibles are 197 intangibles and are amortized over a 15year statutory period.

Patent$140,000 15= $9,333Covenant$ 60,000 15=4,000Goodwill$100,000 15= 6,667$20,000

96. 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.

ANSWER:dRATIONALE: Lances 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.

97. Nikeya sells land (adjusted basis of $120,000) to her adult son, Shamed, for its appraised value of $95,000. Which of the following statements is correct?a. Nikeyas recognized loss is $25,000 ($95,000 amount realized $120,000 adjusted basis).b. Shameds adjusted basis for the land is $120,000 ($95,000 cost + $25,000 disallowed loss for Nikeya).c. If Shamed subsequently sells the land for $112,000, he has no recognized gain or loss.d. Only a. and b. are correct.e. a., b., and c. are correct.

ANSWER:cRATIONALE: Nikeyas realized loss of $25,000 ($95,000 amount realized $120,000 adjusted basis) is disallowed because Shamed is a related party. Shameds adjusted basis for the land is his cost of $95,000. However, when he sells the land for $112,000, his realized gain of $17,000 ($112,000 amount realized $95,000 adjusted basis) is not recognized because he can offset it against $17,000 of Nikeyas $25,000 disallowed loss in calculating his taxable income.

98. Which of the following is not a related party for constructive ownership purposes under 267?a. The taxpayers aunt.b. The taxpayers brother.c. The taxpayers grandmother.d. A corporation owned more than 50% by the taxpayer.e. None of the above.

ANSWER:aRATIONALE: Taxpayers aunt is not a related party under 267.

99. Austin, a single individual with a salary of $100,000, incurred and paid the following expenses during the year:

Medical expenses$ 5,000

Alimony24,000

Charitable contributions2,000

Casualty loss (after $100 floor)1,000

Mortgage interest on personal residence4,500

Property taxes on personal residence4,200

Moving expenses2,500

Contribution to a traditional IRA4,000

Sales taxes (no state or local income tax is imposed)1,300

Calculate Austins deductions for AGI.

ANSWER: Only the following expenses are deductible for AGI:

Alimony$24,000

Moving expenses2,500

Contribution to IRA 4,000

Deductions for AGI$30,500

The other expenses, after applying any statutory floors, are deductions from AGI.

100. Arnold and Beth file a joint return. Use the following data to calculate their deduction for AGI.

Mortgage interest on personal residence$ 6,000

Property taxes on personal residence2,500

Alimony payments12,000

Moving expenses7,000

Charitable contributions1,500

State income taxes5,000

Investment interest ($8,000 of expenses limited to net investment income of $7,500)7,500

Unreimbursed employee expenses2,500

Sales taxes2,600

ANSWER: Arnold and Beths deduction for AGI is $19,000 and consists of the following items:

Alimony payments$12,000

Moving expenses 7,000

Deduction for AGI$19,000

All of the other items are itemized deductions. Note that the taxpayer must choose between the state income taxes and the sales taxes.

101. Robin and Jeff own an unincorporated hardware store. They determine their salaries at the end of the year by using the amount required to reduce the net income of the hardware store to $0. Based on this policy, Robin and Jeff each receive a total salary of $125,000. This is paid as follows: $8,000 per month and $29,000 on December 31. Determine the amount of the salary deduction.

ANSWER: Since the hardware store is not incorporated, the issue of the reasonableness of the salaries is not relevant. Robin and Jeff will report income of $125,000 each regardless of whether it is labeled as salary or as a distribution of the hardware stores net income. Therefore, there is nothing wrong with the hardware store (i.e., a partnership) taking a $250,000 salary deduction.

102. Sandra owns an insurance agency. The following selected data are taken from the agency balance sheet and income statement prepared using the accrual method.

Revenue$250,000

Salaries and commissions100,000

Rent10,000

Insurance5,000

Utilities6,000

Accounts receivable, 1/1/201440,000

Accounts receivable, 12/31/201438,000

Accounts payable, 1/1/201412,000

Accounts payable, 12/31/201411,000

Calculate Sandras net profit using the cash method for 2014.

ANSWER: Sandras accrual method net profit is calculated as follows:

Revenue$250,000Less:ExpensesSalaries and commissions$100,000 Rent10,000Insurance5,000Utilities6,000(121,000)Net profit$129,000

To convert to cash method net profit, the following adjustments must be made.

Net profitaccrual method$129,000

Deduct: Decrease in accounts payable ($11,000 $12,000)(1,000)

Add: Decrease in accounts receivable ($38,000 $40,000) 2,000

Net profitcash method$130,000

103. Alfreds Enterprises, an unincorporated entity, pays employee salaries of $100,000 during the year. At the end of the year, $12,000 of additional salaries have been earned but not paid until the beginning of the next year.

a. Determine the amount of the deduction for salaries if Alfred is a cash method taxpayer.

b. Determine the amount of the deduction for salaries if Alfred is an accrual method taxpayer.

ANSWER: a.The deduction for salaries is the amount paid of $100,000.

b.The deduction for salaries is calculated as follows:

Salaries$100,000

Accrued salaries 12,000

Salary deduction$112,000

104. Taylor, a cash basis architect, rents the building in which his office is located for $5,000 per month. He commenced his practice on February 1, 2014. In order to guarantee no rent increases during an 18-month period, he signed an 18-month lease and prepaid the $90,000 on February 1, 2014. How much can Taylor deduct as rent expense for 2014?

ANSWER: Taylor is a cash basis taxpayer. Thus, he is eligible to use the oneyear rule on prepayments. Since his prepayments of 18-months rent does not extend beyond the end of 2015, he can deduct the $90,000 paid in 2014.

105. In order to protect against rent increases on the building in which she operates a dance studio, Mella signs an 18-month lease for $36,000. The lease commences on October 1, 2014. How much of the $36,000 payment can she deduct in 2014 and 2015?

a. If Mella is an accrual basis taxpayer?

b. If Mella is a cash basis taxpayer?

ANSWER:

a. As an accrual basis taxpayer, Mella can deduct the 2014 amount of the rent expenses incurred in 2014 of $6,000 ($2,000 3 months) and the $24,000 ($2,000 12 months) incurred in 2015.

b. Since Mella is a cash basis taxpayer, she can deduct the entire $36,000 prepayment in 2014 if she can satisfy the one-year rule. However, since the rental period of 18 months extends beyond the end of 2015, she fails the requirement for the one-year rule. Consequently, she can deduct only $6,000 in 2014 and $24,000 in 2015.

106. Petulas business sells heat pumps which have a one-year warranty. Based on historical data, the warranty costs amount to 11% of sales. During 2014, heat pump sales are $400,000. Actual warranty expenses paid in 2014 are $40,000.

a. Determine the amount of the warranty expense deduction for 2014 if Petulas business usesthe accrual method.

b. How would your answer change if Petula used the cash method for extended warranties and the purchasers paid $25,000 for the warranties which covered the second and third years of ownership?

ANSWER:

a. Even though Petulas business uses the accrual method, reserves for estimated warranty expenses are not permitted. Therefore, the deduction for warranty expenses is the amount paid of $40,000.

b. Petula would record gross income in 2014 of $425,000 ($400,000 + $25,000). The deduction for warranty expense would still be $40,000.

107. Beige, Inc., an airline manufacturer, is conducting negotiations for the sale of military aircraft. One negotiation is with a U.S. assistant secretary of defense. She can close the deal on the purchase of 50 attack helicopters if she is paid $750,000 under the table. Another negotiation is with the minister of defense of a third world country. To complete the sale of 20 jet fighters to his government, he demands that he be paid a $1 million grease payment. Beige makes the payments and closes the deals. How much of these payments are deductible by Beige, Inc.?

ANSWER: The $750,000 payment to the U.S. assistant secretary of defense is a bribe and is not deductible. If the grease payment of $1 million to the minister of defense of the third world country 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.

108. Albie operates an illegal drugrunning business and has the following items of income and expense. What is Albies adjusted gross income from this operation?

Income Expenses:$800,000

Rent24,000

Utilities9,000

Bribes to police55,000

Medical expense5,000

Legal fees25,000

Depreciation30,000

Illegal kickbacks30,000

Cost of goods sold300,000

ANSWER: Albie is allowed to reduce his AGI only by the cost of goods sold thus, his AGI is $500,000 ($800,000 $300,000). Note that the cost of goods sold is treated as a negative item in calculating gross income.

109. 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$200,000Expenses:Rent8,000Utilities2,000Bribes to police10,000Medical expense5,000Legal fees20,000Depreciation14,000Illegal kickbacks15,000

ANSWER:

Income$200,000Expenses:Rent$ 8,000Utilities2,000Medical5,000Legal fees20,000Depreciation 14,000 (49,000)$151,000

The bribes to police of $10,000 and illegal kickbacks of $15,000 are not deductible.

110. Janet is the CEO for Silver, Inc., a closely held corporation. Her total compensation for 2014 is $5 million. Of this amount, $2 million is a salary and $3 million is a bonus. The bonus was calculated as 5% of Silvers net income before the bonus and before taxes ($60 million X 5% = $3 million). The bonus provision has been in effect since Janet became CEO five years ago and is related to Silvers performance. It is approved annually by the entire board of directors (1 of the 5 directors is an outside director) of Silver. How much of Janets compensation can Silver deduct for 2014?

ANSWER: All of the $5 million is deductible by Silver. Since Silver is a closely held, rather than a publicly held corporation, the $1 million statutory limit on the deduction of certain executive compensation is not applicable.

111. Agnes operates a Christmas Shop in Atlantic City, NJ. She makes a weekend trip to Vero Beach, FL, for the purpose of determining the feasibility of opening another shop. Her travel expenses are $2,000 (includes $500 for meals). In addition, she pays $5,000 to a market research firm in Vero Beach to prepare a feasibility study. Determine the amount of the expenses that Agnes can deduct if:

a. She opens a new shop in Vero Beach.b. She decides not to open a new shop in Vero Beach.

ANSWER:

a. Because Agnes is already in the Christmas Shop business, all of the investigation expenses ($2,000 + $5,000 = $7,000) are deductible regardless of whether or not she opens a shop in Vero Beach. Note, however, that as discussed in Chapter 9, only 50% of the cost of the meals is deductible.

b. Same response as in a.112. While she was a college student, Angel lived by a bookstore located near campus. She thinks a bookstore located on the other side of campus would be successful. She incurs expenses of $42,800 (legal fees, 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 Angel deduct if:

a. She opens the bookstore on August 1, 2014.

b. She decides not to open the bookstore.

ANSWER:a. If Angel opens the bookstore on August 1, 2014, she can deduct the following investigation expenses in 2014.

Allowed expense deduction in first year$5,000

Amortization ($37,800/180 months 5 months) 1,050

Deductible investigation expenses$6,050

b. If Angel does not open the bookstore, she cannot deduct any of the $42,800 of expenses she incurred.

113. Calculate the net income includible in taxable income for the following hobby:

Income$23,000

Mortgage interest and property taxes allocable to hobby12,000

Depreciation4,000

Supplies and fees7,000

Telephone for hobby

ANSWER:3,000

Income (includible in gross income)$23,000

Itemized deductions:

Mortgage interest and property taxes$12,000

Supplies and fees7,000

Telephone3,000

Depreciation (limited to $23,000 $12,000 $7,000 $3,000) 1,000(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%ofAGI floor. Once the taxpayers AGI is determined, the effect of the 2%of AGI floor on itemized deductions can be calculated.

114. During the year, Rita rented her vacation home for twelve days for $2,400 and she used it personally for three months. The following expenses were incurred on the home:

Property taxes$ 2,200

Mortgage interest10,800

Utilities and maintenance1,900

Depreciation5,000

Insurance900

Calculate her rental gain or loss and itemized deductions.

ANSWER: Rita excludes the $2,400 of rental income from gross income because the home is classified as primarily personal. She can deduct the property taxes ($2,200) and mortgage interest ($10,800) as itemized deductions. No other expenses are deductible.

115. During the year, Jim rented his vacation home for 200 days and lived in it for 19 days. During the remaining days, the vacation home was available for rental use. Is the vacation home subject to the limitation on the deductions of a personal/rental vacation home?

ANSWER: The 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 19 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.

116. 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.

ANSWER: 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:

Gross income$ 5,000

Deduct: Taxes and interest (3/12 $4,500) (1,125)

Remainder applicable to other rental expenses$ 3,875

Deduct: Allocable share of utilities and maintenance [3/4 ($800 + $500)] (975)

Balance applicable to depreciation$ 2,900

Deduct: Depreciation (3/4 $4,000 = $3,000) but limited to above balance (2,900)

Net income$ 0

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

$ 5,000

Deduct: Taxes and interest (3/4 $4,500) (3,375)

Remainder applicable to other rental expenses$ 1,625

Deduct: Allocable share of utilities and maintenance [3/4 ($800 + $500)] (975)

Balance applicable to depreciation$ 650

Deduct: Depreciation (3/4 $4,000 = $3,000) but limited to above balance (650)

Net income$ 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.

117. Bridgetts son, Clyde, is $12,000 in arrears on his residential mortgage payments. Of the $12,000, $7,500 represents interest and $4,500 represents principal.

a. If Bridgett pays the $12,000 to the lender, how much can she deduct? How much can Clyde deduct?b. If Bridgett pays the $7,500 of interest to the lender and loans or gives $4,500 to Clyde, who pays the $4,500 of principal, how much can Bridgett deduct? How much can Clyde deduct?c. If Bridgett gives or lends the $12,000 to Clyde who pays the lender, how much can he deduct? How much can Bridgett deduct?d. Advise Bridgett and Clyde on how the payment should be made.

ANSWER:

a. A deduction cannot be taken for paying another taxpayers obligation. So if Bridgett pays the lender, neither Bridgett nor Clyde could deduct the $7,500 of mortgage interest expense.

b. Bridgett cannot deduct the $7,500 payment identified as interest since this represents the payment of another taxpayers obligation. Even though Clyde has identified the $4,500 payment as relating to the principal of the mortgage, he probably can deduct the $4,500 as mortgage interest expense since Bridgett is not allowed the deduction. In any event, Bridgett is not allowed a deduction.

c. Clyde could deduct the $7,500 of mortgage interest expense, and Bridgett would receive no deduction.

d. Bridgett should either loan or give the funds to Clyde who then makes the mortgage payments of $12,000 ($7,500 interest + $4,500 principal).

118. 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:

ForMattieElmer

General costs of the divorce$3,500$3,000

Determination of dependency exemptions1,5000

Property settlement tax consequences 400 1,500

$5,400$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. Determine the deductions for Mattie and for Elmer.b. Classify the deductions as for AGI and from AGI.

ANSWER:a. Only 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$1,500

If Mattie had paid her attorney, she could have deducted the following:

Determination of dependency exemptions$1,500

Property settlement tax consequences 400

$1,900

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.

b. Any expenses that are deductible in this situation are classified as itemized deductions (i.e., from AGI).

119. Marvin spends the following amounts on a house he owns:

Repair to roof$1,100

Carpeting for the living room1,200

Painting of the exterior4,000

Replacement of front door800

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.

ANSWER: a.Since these expenditures are personal expenditures, no deduction is allowed.b. Since these expenditures are for rental property, Marvin can deduct $7,100 ($1,100 + $1,200 + $4,000 + $800).c. The $7,100 deduction associated with the rental property is classified as a deduction for AGI.120. Walter sells land with an adjusted basis of $175,000 and a fair market value of $160,000 to his mother, Shirley, for $160,000. Walter reinvests the proceeds in the stock market. Shirley holds the land for one year and a day and sells it in the marketplace for $169,000.

a. Determine the tax consequences to Walter.b. Determine the tax consequences to Shirley.

ANSWER: a.Amount realized$160,000Adjusted basis(175,000)Realized loss($ 15,000)

Walters realized loss of $15,000 is disallowed because Walter and Shirleyare related parties.

b.Amount realized$ 169,000

Adjusted basis (160,000)

Realized gain$ 9,000

Walters disallowed loss needed to reduce Shirleysgain to zero (9,000)

Recognized gain$ 0

Shirley may use as much of Walters disallowed loss as she needs to reduce her realized gain (i.e., $9,000) to $0. Thus, Shirleys recognized gain is $0 and the $6,000 ($15,000 $9,000) of Walters disallowed loss that is not used by Shirley is permanently lost.

121. Sandra sold 500 shares of Wren Corporation to Bob, her brother, for its fair market value. She had paid $26,000 for the stock. Calculate Sandras and Bobs gain or loss under the following circumstances:

a. Sandra sold the shares to Bob for $20,000. One year later, Bob sold them for $18,000.b. Sandra sold the shares to Bob for $30,000. One year later, Bob sold them for $27,000.c. Sandra sold the shares to Bob for $20,000. One year later, Bob sold them for $28,000.

ANSWER:a. Sandra has no deductible loss. Bobs recognized loss is $2,000.

b. Sandra has a recognized gain of $4,000. Bob has a recognized loss of $3,000. Related party transaction rules apply only to losses.

c. Sandra has no deductible loss. Bob has a recognized gain of $2,000 ($28,000 $20,000 = $8,000 less Sandras disallowed loss of $6,000).

122. The stock of Eagle, Inc. is owned as follows:

Tom23%

Toms uncle22%

Toms daughter7%

Toms sister15%

Toms spouse15%

Toms nephew8%

Toms CPA, unrelated10%

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.

ANSWER:Toms realized loss is $13,000.

Amount realized$212,000

Adjusted basis (225,000)

Realized loss($ 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 60%.

Tom23%

Toms daughter7%

Toms sister15%

Toms spouse15%

60%

Toms uncle, nephew, and the CPA are not related parties for 267 purposes.

123. Tracy invested in the following stocks and bonds during 2014.

Blue, Inc.$25,000City of Falcon bonds75,000To finance the investments, she borrowed $100,000 from Swan Bank. Interest expense paid on the loan during 2014 was $5,000. During 2014, Tracy received $1,250 of dividend income from Blue, Inc. and $3,000 of interest income on the municipal bonds.

a. Determine the amount of Tracys gross income.

b. Determine the maximum amount of Tracys deductible interest expense.

ANSWER:

a. Tracy must include the $1,250 of dividend income in her gross income. The interest on the municipal bonds of $3,000 is tax-exempt.

b. Tracy can deduct the interest paid of $1,250 ($5,000 1/4) on the portion of the loan that relates to the Blue, Inc. stock. The interest paid of $3,750 on the portion of the loan that relates to the municipal bonds is disallowed because the interest income from the bonds is tax-exempt.

124. Trade or business expenses are classified as deductions for AGI. Section 212 expenses, barring certain exceptions, are classified as deductions from AGI. What are these exceptions?

ANSWER: The normal classification for 212 expenses is as a deduction from AGI. However, expenses paid in connection with the determination, collection, or refund of taxes related to the income of sole proprietorships, rents and royalties, or farming operations are classified as deductions for AGI. In addition, other rental and royalty expenses are classified as deductions for AGI.

125. Are all personal expenses disallowed as deductions?

ANSWER: No. Selected personal expenses can be deducted as itemized deductions. The following are examples of deductible personal expenses. Contributions to qualified charitable organizations (not to exceed a specified percentage of AGI). Medical expenses (in excess of 7.5% of AGI). Certain state and local taxes (e.g., real estate taxes and state and local income or sales taxes). Personal casualty losses (in excess of an aggregate floor of 10% of AGI and a $100 floor per casualty). Certain personal interest (e.g., mortgage interest on personal residence).

126. Under what circumstance can a bribe be deducted?

ANSWER: Bribes paid to a domestic official are disallowed if the bribe is illegal under the laws of the United States. However, a bribe paid to a foreign official is disallowed only if it is unlawful under the Foreign Corrupt Practices Act of 1977.

127. Can a trade or business expense be deductible if it is necessary but not ordinary?

ANSWER: No. To be deductible as a trade or business expense, the expense must be both ordinary and necessary.128. 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?

ANSWER: 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.

129. 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.

ANSWER:

a. The 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%/0% applicable to long-term capital gains.

b. 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.

130. What losses are deductible by an individual taxpayer?

ANSWER: Generally deductible losses of individual taxpayers are limited to (1) those incurred in a trade or business or (2) in a transaction entered into for profit. However, individuals are also allowed to deduct losses that are the result of a casualty (subject to certain statutory materiality limitations).

131. Bruce owns several sole proprietorships. Must Bruce use the same accounting method for each of these businesses?

ANSWER: No. If a taxpayer owns multiple businesses, it may be possible to use the cash method for some and the accrual method for others.

132. Max opened his dental practice (a sole proprietorship) in March 2014. At the end of the year, he has unpaid accounts receivable of $62,000 and no unpaid accounts payable. Should Max use the accrual method or the cash method for his dental practice?

ANSWER: A service provider generally should use the cash method. Under the cash method, Max records income from his dental practice only as he collects from his patients and/or their insurance companies. Max has income from the uncollected accounts receivable only as he receives payment. Note that since his accounts payable can only be deducted when paid under the cash method, he should continue to minimize the accounts payable balance at the end of the tax year.

133. Discuss the application of the oneyear rule on prepayments by a cash basis taxpayer.

ANSWER: The Regulations set forth the general rule that an expenditure that creates an asset having a useful life that extends substantially beyond the end of the tax year must be capitalized. However, under the one year rule on prepayments for cash basis taxpayers, the prepayment can be expensed in the current tax year if the asset will expire or be consumed by the end of the tax year following the year of payment. Otherwise, the taxpayer must capitalize the prepayment and deduct it over the benefit period.

134. Briefly discuss the two tests that an accrual basis taxpayer must apply before an expense can be deducted.

ANSWER: 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.

135. 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?

ANSWER: 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.

136. 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?

ANSWER: Legal expenses are deductible when they are directly related to a trade or business (for AGI); an income-producing 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.

137. If a taxpayer operated an illegal business (not drug trafficking), what expenses can be deducted and what expenses are disallowed?

ANSWER: 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.

138. Bobby operates a drug trafficking business. Because he has an accounting background, he keeps detailed financial records. What expenses can Bobby deduct on his Federal income tax return?

ANSWER: Bobby cannot deduct any of the expenses associated with operating his illegal drug trafficking business. However, gross income for tax purposes is defined as sales minus cost of goods sold. So in calculating the net income of the business for tax purposes, cost of goods sold is treated as a negative income item rather than as an expense.139. Abner contributes $2,000 to the campaign of the Tea Party candidate for governor, $1,000 to the campaign of the Tea Party candidate for senator, and $500 to the campaign of the Tea Party candidate for mayor. Can Abner deduct these political contributions?

ANSWER: No. Political contributions cannot be deducted.

140. Are there any circumstances under which lobbying expenditures are deductible?

ANSWER: Yes. Lobbying expenditures are deductible under the following three circumstances. Influencing local legislation. Activities devoted solely to monitoring legislation. De minimis provision for annual in-house expenditures (lobbying expenses other than those paid to professional lobbyists) if such expenditures do not exceed $2,000.

141. In applying the $1 million limit on deducting executive compensation, what corporations are subject to the deduction limit? What executives are covered?

ANSWER: The $1 million limit on deducting the compensation of a covered executive applies to corporations that have at least one class of stock registered under the Securities Exchange Act of 1934. Covered employees include the chief (or principal) executive officer, the chief (or principal) financial officer, and the three other most highly compensated officers.

142. 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?

ANSWER:

(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 if such expenses do not exceed $50,000) 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.

143. What are the relevant factors to be considered in determining whether an activity is profit-seeking or a hobby?

ANSWER: The nine relevant factors detailed in Reg. 1.1832(b) are as follows:(1) Whether the activity is conducted in a businesslike manner.(2) The expertise of the taxpayers or their advisers.(3) he 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.(8) The financial status of the taxpayer.(9) Elements of personal pleasure or recreation in the activity.

144. In distinguishing whether an activity is a hobby or a trade or business, discuss the presumptive rule.

ANSWER: The Code provides a rebuttable presumption that an activity is profit-seeking (i.e., a trade or business) rather than a hobby if the activity shows a profit in at least three of any five (two out of seven for horses) prior consecutive years. If this test is met, the activity is presumed to be a trade or business. The burden of proof thus shifts to the IRS to show otherwise.

145. Assuming an activity is deemed to be a hobby, discuss the order and limits in which expenses must be deducted.

ANSWER: 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.

146. 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.

ANSWER: 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.

147. For a vacation home to be classified in the primarily rental use category, what attributes must be present?

ANSWER: To be classified in the primarily rental use category, the following attributes must be present. The residence is rented for 15 days or more during the year. The residence is not used for personal purposes for more than the greater of: 14 days 10 percent of the total days rented.

148. For a vacation home to be classified in the personal/rental use category, what attributes must be present?

ANSWER: To be classified in the personal/rental use category, the following attributes must be present. The residence is rented for 15 days or more in a year. The residence is used for personal purposes for more than the greater of (1) 14 days or (2) 10% of the total days rented.

149. What is the appropriate tax treatment for expenditures paid by a taxpayer for anothers benefit?

ANSWER: To be deductible, an expense must be incurred for the taxpayers benefit or arise from the taxpayers obligation. An individual cannot claim a tax deduction for the payment of the expenses of another individual. One exception to this rule is the payment of medical expenses for a dependent. Such medical expenses are deductible by the payor subject to the normal rules that govern the deductibility of medical expenses.

150. Are there any exceptions to the rule that personal expenditures cannot be deducted?

ANSWER: Generally personal expenditures cannot be deducted. However, the Code provides that for a personal expenditure to be deductible the taxpayer must be able to identify a particular section of the Code that permits the deduction (e.g., charitable contributions, medical expenses, certain taxes, certain interest).151. Briefly discuss the disallowance of deductions for capital expenditures.

ANSWER: 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.

152. Why are there restrictions on the recognition of gains and losses resulting from transactions between related parties?

ANSWER: 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.

153. 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? In the case of a related party disallowed loss transaction, can the related party sellers disallowed loss be used by a taxpayer other than the related party buyer?

ANSWER: 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. The related party sellers disallowed loss can be used only by the related party buyer.

154. Olive, Inc., an accrual method taxpayer, is a corporation that is equally owned by Maurice and Alex, who are brothers. The corporation uses the accrual method of accounting and the shareholders use the cash method. To provide Olive with funds to acquire additional working capital, the shareholders each loan Olive $100,000 with a 6% interest rate. At the end of the tax year, there is unpaid accrued interest of $3,000 due to each shareholder. From a timing perspective, when should Olive deduct this $6,000 and when should Maurice and Alex include the $3,000 in gross income? Olive pays the $3,000 to each shareholder early next year.

ANSWER: Maurice and Alex are related parties with Olive. So Olive (accrual method) must claim the deduction of $6,000 in the same tax year that the cash method shareholders include the $3,000 each in gross income (next year). Note that this matching provision applies only if the payor uses the accrual method and the payee uses the cash method.

155. Briefly explain why interest on money borrowed to buy tax-exempt municipal bonds is disallowed as a deduction.

ANSWER: 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 tax-exempt securities, at say 8%, and realize a profit if the interest expense were deductible. The entire profit would be derived from the tax treatment. 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.