Name: ________________________ Class: ___________________ Date: __________ ID: A

1

ACCT217 - Sample Exam 2

Multiple ChoiceIdentify the choice that best completes the statement or answers the question.

____ 1. Taupe Corporation is considering deferred compensation plans for its executive employees over age 55. Oneplan is to allow the employee to make an election at the end of the year to collect his or her bonus when theemployee retires, at which time the executive would receive the deferred pay plus 6% interest.a. The interest is original issue discount and must be included in gross income before

retirement.b. The employee cannot defer the income (both the bonus and the interest) for tax purposes

because it is constructively received each year.c. The employee must recognize the bonus each year, but can defer the interest.d. The bonus and the related interest can be deferred from inclusion in gross income until

they are received.e. None of the above.

____ 2. Under the original issue discount (OID) rules as applied to a three-year certificate of deposit:a. The OID will not be included in gross income until the end of the third year.b. The OID will be amortized by the straight-line method (e.g., $75 per year.)c. All of the OID must be recognized as gross income in the first year.d. The interest income for the first year will be less than the interest income for the third

year.e. None of the above.

____ 3. Dorothy purchased a certificate of deposit for $10,000 on January 1, 2007. The certificate’s maturity value intwo years (December 31, 2008) is $10,816, yielding 4% before-tax interest.a. Dorothy must recognize $400 (.04 $10,000) gross income in 2007.b. Dorothy must recognize $816 gross income in 2008.c. Dorothy must recognize $816 gross income in 2007.d. Dorothy must recognize $408 ($816/2) gross income in 2007 and 2008.e. None of the above.

____ 4. With respect to the prepaid income from services, which of the following is true?a. The treatment of prepaid income is the same for tax and financial accounting.b. A cash basis taxpayer can spread the income over the period services are to be provided

if all of the services will be completed by the end of the tax year following the year ofreceipt.

c. An accrual basis taxpayer can spread the income over the period services are to beprovided if all of the services will be completed by the end of the tax year following theyear of receipt.

d. An accrual basis taxpayer can spread the income over the period services are to beprovided on a contract for three years or less.

e. None of the above.

Name: ________________________ ID: A

2

____ 5. As a general rule:I. Income from property is taxed to the person who owns the property.II. Income from services is taxed to the person who earns the income.III. The assignee of income from property must pay tax on the income.IV. The person who receives the benefit of the income must pay the tax on the income.

a. Only I and II are true.b. Only III and IV are true.c. I, II, and III are true, but IV is false.d. I, II, III, and IV are true.e. None of the above is true.

____ 6. Marge made a $60,000 interest-free loan to her son, Steve, who used the money to start a new business.Steve’s only sources of income were $25,000 from the business and $250 of interest on his checking account.The relevant Federal interest rate was 5%. Based on the above information:a. Steve’s business net profit will be reduced by $3,000 (.05 $60,000) of interest expense.b. Marge must recognize $3,000 (.05 $60,000) of imputed interest income on the below

market loan.c. Steve’s gross income must be increased by the $3,000 (.05 $60,000) imputed interest

income on the below market loan.d. Steve’s interest income is $250 and his interest expense is zero.e. None of the above is correct.

____ 7. Our tax laws encourage taxpayers to ____ assets that have declined in value and ____ assets that haveappreciated in value.a. sell, sellb. sell, keepc. keep, selld. keep, keepe. None of the above.

____ 8. Emily is in the 35% marginal tax bracket. She can purchase a York County school bond yielding 5% interest,but she is interested in earning a higher return for comparable risk.a. If she buys a corporate bond that pays 8% interest, her after-tax rate of return will be

greater than if she purchased the York County school bond.b. If she buys a U.S. government bond paying 6%, her after-tax rate of return will be less

than if she purchased the York County school bond.c. If she buys a common stock paying 6% dividend, her after-tax rate of return will be

higher than if she purchased the York County school bond.d. All of the above are correct.e. None of the above are correct.

Name: ________________________ ID: A

3

____ 9. In December 2007, Teal, Corp., a cash basis taxpayer, paid $1,200 fire insurance for the calendar year 2008on a building held for rental income. Teal, Corp. deducted the $1,200 insurance premiums on its 2007 taxreturn. Teal had $150,000 of taxable income that year. On June 30, 2008, the corporation sold the buildingand, as a result, received a $500 refund of the fire insurance premiums. As a result of the above:a. Teal, Corp. should amend its 2007 return and claim $500 less insurance expense.b. Teal, Corp. should add the $500 to its sales proceeds from the building.c. Teal, Corp. should include the $500 in 2008 gross income in accordance with the tax

benefit rule.d. Teal, Corp. should include the $500 in 2008 gross income in accordance with the claim

of right doctrine.e. None of the above.

____ 10. Heber, Inc. bought land from Jewel for $100,000. Heber, Inc. paid $20,000 cash and gave Jewel an 8% notefor $80,000. The note was to be paid over a five-year period. When the balance on the note was $40,000,Jewel began having financial difficulties. To accelerate its cash inflows, Jewel agreed to accept $30,000 cashfrom Heber, Inc. in final payment of the note principal.a. Heber must recognize $10,000 income.b. Heber is not required to recognize income, but must reduce its cost basis in the land to

$90,000.c. Heber is not required to recognize income, since it made a gift to Jewel when it paid the

debt before it was due.d. Jewel must recognize income from discharge of the debt.e. None of the above.

____ 11. Gold Company was experiencing financial difficulties, but was not bankrupt or insolvent. Pink, Inc., theholder of a mortgage on Gold’s building, agreed to accept $40,000 in full payment of the $50,000 due. Pinkhad sold the property to Gold for $150,000 five years ago. The National Bank, which held a mortgage onother real estate owned by Gold, reduced the principal from $100,000 to $85,000. The bank had made theloan to Gold when it purchased the real estate from Silver, Inc. As a result of the above, Gold must:a. Include $25,000 in gross income.b. Reduce the basis in its assets by $25,000.c. Include $10,000 in gross income and reduce its basis in its assets by $15,000.d. Include $15,000 in gross income and reduce its basis in the building by $10,000.e. None of the above.

____ 12. On January 1, 1997, Yellow corporation issued 6% 25-year bonds at par and used the $10,000,000 proceedsto finance the construction of a new plant. On January 1, 2007, the company acquired the bonds on the openmarket for $9,500,000. Assuming that Yellow Corporation is neither bankrupt nor insolvent, the acquisitionand retirement of the bonds results in which of the following:a. The company must recognize a $500,000 gain.b. The company can make an election to recognize a $500,000 gain or reduce the

company’s basis in the plant by $500,000.c. The company must recognize a $500,000 gain and increase the company’s basis in the

plant by $500,000.d. The company can amortize the $500,000 gain, recognizing income over the remaining

life of the bonds.e. None of the above.

Name: ________________________ ID: A

4

____ 13. During the year, Kim sold the following assets: business auto for a $1,000 loss, stock investment for a $1,000loss, and pleasure yacht for a $1,000 loss. Presuming adequate income, how much of these losses may Kimclaim?a. $0.b. $1,000.c. $2,000.d. $3,000.e. None of the above.

____ 14. Elk, a C corporation, has $400,000 operating income and $350,000 operating expenses during the year. Inaddition, Elk has a $30,000 long-term capital gain and a $52,000 short-term capital loss. Elk’s taxable incomeis:a. ($2,000).b. $28,000.c. $50,000.d. $80,000.e. None of the above.

____ 15. 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.

____ 16. Shady, Inc., a cash basis calendar year taxpayer, runs a bingo operation which is illegal under state law.During 2007, a bill designated H.R. 9 is introduced into the state legislature which, if enacted, wouldlegitimize bingo games. In 2007, Shady, Inc. had the following expenses:

Operating expenses in conducting bingo games $247,000Payoff money to state and local police 24,000Newspaper ads supporting H.R. 9 2,000Political contributions to legislators who support H.R. 9 8,000

Of these expenditures, Shady, Inc. may deduct:a. $247,000.b. $249,000.c. $257,000.d. $281,000.e. None of the above.

____ 17. In Lawrence County, the real property tax year is the calendar year. The real property tax becomes a liabilityof the owner of real property on January 1 in the current real property tax year, 2007 (which is not a leapyear). The tax is payable on June 1, 2007. On May 1, 2007, Jackson, Inc. sells an office building to Denver,Inc. for $250,000. On June 1, 2007, Denver, Inc. pays the entire real estate tax of $7,950 for the year endingDecember 31, 2007. How much of the property taxes may Jackson, Inc. deduct?a. $0.b. $2,614.c. $2,625.d. $7,950.e. None of the above.

Name: ________________________ ID: A

5

____ 18. Hippo, Inc., a calendar year C corporation, manufactures golf gloves. For 2007, Hippo had taxable income of$200,000, qualified domestic production activities income of $250,000, and W-2 wages related to productionactivities of $23,000. Hippo’s domestic production activities deduction for 2007 is:a. $11,500.b. $12,000.c. $15,000.d. $23,000.e. None of the above.

____ 19. Cream, Inc.’s taxable income for 2007 before any deduction for an NOL carryforward of $30,000 is $70,000.Cream’s qualified production activities income (QPAI) is $60,000. What is the amount of Cream’s domesticproduction activities deduction (DPAD) for 2007?a. $1,200.b. $1,800.c. $2,400.d. $3,600.e. None of the above.

____ 20. Jamestown, Inc. purchased a new business asset (three-year property) on July 23, 2007, at a cost of $50,000.The corporation did not elect to expense any of the asset under § 179, nor did the corporation electstraight-line cost recovery. Determine the cost recovery deduction for 2007.a. $8,333.b. $16,665.c. $26,666.d. $33,333.e. None of the above.

____ 21. Atara, Corp. purchased an office condominium on September 20, 2007, for $200,000. On October 10, thecompany purchased business assets (seven-year property) for $80,000. The company did not elect to expenseany of the assets under § 179, nor did it elect straight-line cost recovery. Determine the cost recoverydeduction for the business assets for 2007.a. $2,856.b. $25,999.c. $32,002.d. $41,428.e. None of the above.

____ 22. Paz, Inc.’s business is raising and harvesting peaches. On March 10, 2007, Paz purchased 10,000 new peachtrees at a cost of $50,000. Paz does not elect to expense assets under § 179. Determine the cost recoverydeduction for 2007.a. $0.b. $1,250.c. $2,500.d. $10,000.e. None of the above.

Name: ________________________ ID: A

6

____ 23. White Company acquires a new machine (seven-year property) on January 10, 2007, at a cost of $204,000.White makes the election to expense the maximum amount under § 179. No election is made to use thestraight-line method. Determine the total deductions in calculating taxable income related to the machine for2007 assuming White has taxable income of $500,000.a. $46,294.b. $51,151.c. $119,147.d. $125,147.e. None of the above.

____ 24. Ace Corporation, an accrual basis taxpayer, sells widgets. Ace sold on account a deluxe widget to Alan, Inc.,for $22,000. Ace had a basis in the widget of $12,000. During the current year, after receiving $3,000 fromAlan, Ace was notified that Alan was bankrupt and no further payments would be received. What amount ofloss may Ace deduct in the current year?a. $0.b. $7,000.c. $9,000.d. $10,000.e. None of the above.

____ 25. On May 1, 2006, Mary loaned John $20,000. In 2007, John filed for bankruptcy. At that time, it was revealedthat John’s creditors could expect to receive 60 cents on the dollar. In March 2008, final settlement wasmade, and Mary received $5,000. How much loss can Mary deduct and in which year?a. 2006—$15,000.b. 2007—zero; 2008—$15,000.c. 2007—$12,000; 2008—$3,000.d. 2007—$8,000; 2008—$7,000.e. None of the above.

____ 26. Jones Corporation incurred a $10,000 bad debt in the current year. Jones Corporation also had a $6,000long-term capital gain during the current year. How should Jones report the bad debt deduction on the taxreturn?a. $0 bad debt deduction.b. $3,000 bad debt deduction.c. $4,000 bad debt deduction.d. $10,000 bad debt deduction.e. None of the above.

____ 27. Which of the following is true regarding net operating losses?a. They are carried back for 3 years.b. They are carried back for 5 years.c. They are carried back for 2 years and forward for 20 years.d. They are carried back for 1 years.e. None of the above.

Name: ________________________ ID: A

7

____ 28. In 2007, Cindy invested $100,000 for a 25% interest in a limited liability company (LLC) involved in anactivity in which she is a material participant. The LLC reported losses of $340,000 in 2007 and $180,000 in2008 with Cindy’s share being $85,000 in 2007 and $45,000 in 2008. How much of the losses can Cindydeduct?a. $0 in 2007, $0 in 2008.b. $85,000 in 2007, $0 in 2008.c. $85,000 in 2007, $15,000 in 2008.d. $85,000 in 2007, $45,000 in 2008.e. None of the above.

____ 29. Nora acquired passive activity A several years ago that until 2006 was profitable. However, the activityproduced losses of $100,000 in 2006 and $50,000 in 2007. Nora had passive income from activity B of$40,000 in 2006 and $0 in 2007. How much loss is suspended from activity A in each year?a. $60,000 in 2006 and $50,000 in 2007.b. $100,000 in 2006 and $50,000 in 2007.c. $0 in 2006 and $0 in 2007.d. None of the above.

____ 30. Samantha sells a passive activity (adjusted basis of $50,000) for $90,000. Suspended losses attributable tothis property total $30,000. The realized gain and the taxable gain are:a. $40,000 realized gain; $70,000 taxable gain.b. $10,000 realized gain; $10,000 taxable gain.c. $40,000 realized gain; $0 taxable gain.d. $40,000 realized gain; $10,000 taxable gain.e. None of the above.

____ 31. Ned, a college professor, owns a separate business (not real estate) in which he participates in the currentyear. He has one employee who works part-time in the business. Which of the following statements iscorrect?a. If Ned participates for 120 hours and the employee participates for 120 hours during the

year, Ned does not qualify as a material participant.b. If Ned participates for 95 hours and the employee participates for 5 hours during the

year, Ned probably does not qualify as material participant.c. If Ned participates for 500 hours and the employee participates for 520 hours during the

year, Ned qualifies as material participant.d. If Ned participates for 600 hours and the employee participates for 2,000 hours during

the year, Ned qualifies as a material participant.e. None of the above.

____ 32. Paula owns four separate activities. She elects not to group them together as a single activity under the“appropriate economic unit” standard. Paula participates for 130 hours in Activity A, 115 hours in ActivityB, 260 hours in Activity C, and 100 hours in Activity D. She has one employee, who works 125 hours inActivity D. Which of the following statements is correct?a. Activities A, B, C, and D are all significant participation activities.b. Paula is a material participant with respect to Activities A, B, C, and D.c. Paula is not a material participant with respect to Activities A, B, C, and D.d. Losses from all of the activities can be used to offset Paula’s active income.e. None of the above.

Name: ________________________ ID: A

8

____ 33. Dena owns interests in five businesses and has full-time employees in each business. She participates for 100hours in Activity A, 120 hours in Activity B, 130 hours in Activity C, 140 hours in Activity D, and 125 hoursin Activity E. Which of the following statements is correct?a. All five of Dena’s activities are significant participation activities.b. Dena is a material participant with respect to all five activities.c. Dena is not a material participant in any of the activities.d. Dena is a material participant with respect to Activities B, C, D, and E.e. None of the above.

____ 34. Maria, who owns a 50% interest in a restaurant, has been a material participant in the restaurant activity forthe last 20 years. She retired from the restaurant at the end of last year and will not participate in therestaurant activity in the future. However, she continues to be a material participant in a retail store in whichshe is a 50% partner. The restaurant operations produce a loss for the current year, and Maria’s share of theloss is $80,000. Her share of the income from the retail store is $150,000. She does not own interests in anyother activities. Which of the following statements is correct?a. Maria cannot deduct the $80,000 loss from the restaurant because she is not a material

participant.b. Maria can offset the $80,000 loss against the $150,000 of income from the retail store.c. Maria will not be able to deduct any losses from the restaurant until she has been retired

for at least three years.d. None of the above.

____ 35. Josh has investments in two passive activities. Activity A, acquired three years ago, produces income in thecurrent year of $60,000. Activity B, acquired last year, produces a loss of $100,000 in the current year. At thebeginning of this year, Josh’s at-risk amounts in Activities A and B are $10,000 and $100,000, respectively.What is the amount of Josh’s suspended passive loss with respect to these activities at the end of the currentyear?a. $0.b. $36,000.c. $40,000.d. $100,000.e. None of the above.

____ 36. Rita earns a salary of $150,000, and invests $40,000 for a 20% interest in a passive activity. Operations of theactivity result in a loss of $250,000, of which Rita’s share is $50,000. How is her loss characterized?a. $40,000 is suspended under the passive loss rules and $10,000 is suspended under the

at-risk rules.b. $40,000 is suspended under the at-risk rules and $10,000 is suspended under the passive

loss rules.c. $50,000 is suspended under the passive loss rules.d. $50,000 is suspended under the at-risk rules.e. None of the above.

Name: ________________________ ID: A

9

____ 37. Vic’s at-risk amount in a passive activity is $200,000 at the beginning of the current year. His current lossfrom the activity is $80,000. Vic had no passive activity income during the year. At the end of the currentyear:a. Vic has an at-risk amount in the activity of $120,000 and a suspended passive loss of

$80,000.b. Vic has an at-risk amount in the activity of $200,000 and a suspended passive loss of

$80,000.c. Vic has an at-risk amount in the activity of $120,000 and no suspended passive loss.d. Vic has an at-risk amount in the activity of $200,000 and no suspended passive loss.e. None of the above.

____ 38. Jon owns an apartment building in which he is a material participant and a computer consulting business. Ofthe 2,000 hours he spends on these activities during the year, 55% of the time is spent operating theapartment building and 45% of the time is spent in the computer consulting business. Which of the followingstatements is correct?a. The computer consulting business is a passive activity but the apartment building is not.b. The apartment building is a passive activity but the computer consulting business is not.c. Both the apartment building and the computer consulting business are passive activities.d. Neither the apartment building nor the computer consulting business is a passive activity.e. None of the above.

____ 39. Carmen, a single taxpayer, has $80,000 in salary, $10,000 in income from a limited partnership, and a$30,000 passive loss from a real estate rental activity in which she actively participates. Her modifiedadjusted gross income is $80,000. Of the $30,000 loss, Carmen may deduct:a. $0.b. $10,000.c. $25,000.d. $30,000.e. Some other amount.

____ 40. Roxanne, who is single, has $125,000 of salary, $10,000 of income from a limited partnership, and a $26,000passive loss from a real estate rental activity in which she actively participates. Her modified adjusted grossincome is $125,000. Of the $26,000 loss, how much is deductible?a. $0.b. $10,000.c. $25,000.d. $26,000.e. None of the above.

Name: ________________________ ID: A

10

Problem

41. Determine the proper tax year for gross income inclusion in each of the following cases.a. An automobile dealer has several new cars in inventory, but often does not have the right

combination of body style, color, and accessories. In some cases the dealer makes anoffer to sell a car at a certain price, accepts a deposit, and then orders the car from themanufacturer. When the car is received from the manufacturer, the sale is closed, and thedealer receives the balance of the sales price. At the end of the current year, the dealerhas deposits totaling $8,200 for cars that have not been received from the manufacturer.When is the $8,200 subject to tax?

b. Purple Corporation, an exterminating company, is a calendar year taxpayer. It contracts toprovide service to homeowners once a month under a one-, two-, or three-year contract. OnApril 1 of the current year, the company sold a customer a one-year contract for $120. Howmuch of the $120 is taxable in the current year if the company is an accrual basis taxpayer.If the $120 is payment on a two-year contract, how much is taxed in the year the contract issold and in the following year? If the $120 is payment on a three-year contract, how muchis taxed in the year the contract is sold and in the following year?

c. Pink, Inc., an accrual basis taxpayer, owns an amusement park whose fiscal year endsSeptember 30. To increase business during the fall and winter months, Pink sold passesthat would allow the holder to ride “free” during the months of October through March.During the month of September, $6,000 was collected from the sale of passes for theupcoming fall and winter. When will the $6,000 be taxable to Pink?

d. The taxpayer is in the office equipment rental business and uses the accrual basis ofaccounting. In December he collected $5,000 in rents for the following January. When isthe $5,000 taxable?

Name: ________________________ ID: A

11

42. On January 1, 2007, Faye gave Todd, her son, a 36-month certificate of deposit she purchased December 31,2005 for $4,319. Faye gave Todd 1,000 shares of ABC, Inc., on December 2, 2007. The certificate had amaturity value of $5,000 and the yield to maturity was 5%. On November 30, 2007, ABC, Inc., had declareda dividend of $1.00 payable to stockholders of record on December 5th. How much interest and dividendsshould Todd include in his gross income for 2007?

Name: ________________________ ID: A

12

43. Roy is considering purchasing land for $10,000. He expects the land to appreciate in value 8% each year(compounded) and he will sell it at the end of 10 years. He also is considering purchasing a bond for $10,000.The bond does not pay any annual interest, but will pay $21,589 at maturity in 10 years. The before-tax rateof return on the bond is 8%. Roy is in the 40% (combined Federal and State) marginal tax bracket. Roy hasother investments that earn a 8% before-tax rate of return. Given that the compound interest factor at 8% is2.1589, and at 4.8% the factor is 1.5981, which alternative should Roy choose?

Name: ________________________ ID: A

13

44. Ostrich Corporation has net short-term capital gains of $60,000 and net long-term capital losses of $380,000during 2007. Ostrich had taxable income from other sources of $1 million. Prior years’ transactions includedthe following:

2003 Net short-term capital gains $200,0002004 Net long-term capital gains 80,0002005 Net short-term capital gains 60,0002006 Net long-term capital gains 140,000

a. How are the capital gains and losses treated on Ostrich’s 2007 tax return?b. Determine the amount of the 2007 capital loss that is carried back to each of the

previous years.c. Compute the amount of capital loss carryover, if any, and indicate the years to which

the loss may be carried.d. If Ostrich were a proprietorship, how would Ellen, the owner, report these

transactions on her 2007 tax return?

Name: ________________________ ID: A

14

45. Alex sells land with an adjusted basis of $48,000 and a fair market value of $40,000 to his mother, Sybil, for$40,000. Sybil holds the land for one year and a day and sells it in the marketplace for $45,000.

a. Determine the tax consequences to Alex.

b. Determine the tax consequences to Sybil.

Name: ________________________ ID: A

15

46. In 2006, Robin Corporation incurred the following expenditures in connection with the development of a newproduct:

Salaries $50,000Supplies 20,000Market survey 10,000Depreciation 15,000

In 2007, Robin incurred the following additional expenditures in connection with the development of theproduct:

Salaries $75,000Supplies 15,000Depreciation 17,000Advertising 8,000

In October 2007, Robin began receiving benefits from the project. If Robin elects to expense research andexperimental expenditures, determine the amount and year of the deduction.

Name: ________________________ ID: A

16

47. Nora purchased a new automobile on July 20, 2007, for $29,000. The car was used 60% for business and40% for personal use. In 2008, the car was used 30% for business and 70% for personal use. Determine thecost recovery recapture and the cost recovery deduction for 2008.

48. Hugh has four passive activities. The following income and losses are generated in the current year.

Activity Gain (Loss)A ($60,000)B (20,000)C (10,000)D 10,000

Total ($80,000)

How much of the $80,000 net passive loss can Hugh deduct this year? Calculate the suspended losses (byactivity).

Name: ________________________ ID: A

17

49. Orange Corporation, a closely held (non-personal service) C corporation, earns active income of $300,000 inthe current year. The corporation also receives $35,000 in dividends during the year. In addition, Orangeincurs a loss of $50,000 from an investment in a passive activity. What is Orange’s income for the year afterconsidering the passive investment?

50. Faye dies owning an interest in a passive activity property (adjusted basis of $150,000, suspended losses of$52,000, and a fair market value of $180,000). What, if any, can be deducted on her final income tax return?

ID: A

1

ACCT217 - Sample Exam 2Answer Section

MULTIPLE CHOICE

1. ANS: CThe bonus is due at the end of the year and therefore an employee who elects the deferral has turned his orher back on the income.

PTS: 1 REF: p. 4-8 to 4-102. ANS: D

The OID is amortized using the effective interest rate method. Because the principal amount is increasedeach year by the amount of the OID which is amortized, the total interest income increases each year.

PTS: 1 REF: p. 4-11 | Example 133. ANS: A

The 4% interest rate is applied to the $10,000 original investment in the first year ($10,000 4% = $400).Answers b., c., and d. are incorrect because these answers assume a method of allocating the income thatdiffers from the effective interest method.

PTS: 1 REF: p. 4-114. ANS: C

Answer a. is incorrect because the tax treatment is based on the income tax provisions, whereas the financialaccounting treatment is based on generally accepted accounting principles. Answer b. is incorrect because thecash basis taxpayer recognizes the income in the year of receipt. Answer c. is correct because under RevenueProcedure 2004-34 any unearned income at the end of the first tax year must be included in the gross incomeof the second tax year. Answer d. is incorrect because there is no three-year provision. The deferralpossibilities for services to be provided exist only in the case of accrual basis taxpayers who satisfy therequirements of Revenue Procedure 2004-34.

PTS: 1 REF: p. 4-125. ANS: A

III is false because a person who has the right to income (the assignor) but assigns the rights to another mustpay the tax on the income. IV is false because, for example, the assignee of income receives the benefit, butthe assignor has the right to the income and therefore must pay the tax on that income.

PTS: 1 REF: p. 4-136. ANS: E

The $100,000 exception would apply. Marge is not required to recognize imputed interest income becauseSteve’s investment income is less than $1,000. Steve does not recognize any imputed interest expense.

PTS: 1 REF: p. 4-19 | p. 4-207. ANS: B

Because gains and losses are not recognized until realization has occurred, the taxpayer should selldepreciated assets (i.e., basis exceeds fair market value) and deduct any loss. The taxpayer should hold theappreciated assets (i.e., basis is less than fair market value) and, thus, defer gain.

PTS: 1 REF: p. 4-5

ID: A

2

8. ANS: DSee the table below:

Tax @ YorkBefore Tax 0.35; .15* After-tax County Bond

a. 8.00% 2.800% 5.200% 5.0%b. 6.00% 2.100% 3.900% 5.0%c. 6.00% .900% 5.100% 5.0%

*The dividend is taxed at 15%.

PTS: 1 REF: p. 4-21 | p. 4-229. ANS: C

As a cash basis taxpayer, Teal can deduct the one-year prepayment for insurance in the year it was paid,2007. Because it deducted $1,200 and its net cost was only $700 ($1,200 – $500), Teal should include the$500 refund in gross income for 2008 under the tax benefit rule.

PTS: 1 REF: p. 4-2010. ANS: B

The debt reduction of $10,000 is treated as an adjustment to the basis of the land.

PTS: 1 REF: p. 4-2611. ANS: D

The $10,000 reduction in the mortgage is an adjustment to the cost of the building. The $15,000 reduction bythe bank is includible in gross income.

PTS: 1 REF: p. 4-2612. ANS: A PTS: 1 REF: p. 4-2513. ANS: C

The loss on the business auto of $1,000 is an ordinary loss, while the loss on the stock investment of $1,000is a capital loss. The loss on the yacht of $1,000 is personal and, therefore, cannot be deducted.

PTS: 1 REF: p. 4-27 | Example 45 | Example 4614. ANS: C

A corporation cannot deduct a net capital loss in the year incurred. The net loss can be carried back for threeyears and offset against capital gain in the carryback years. If the capital loss is not used in the carryback, itcan be carried forward for five years. Capital gains of corporations are included in taxable income and are notsubject to the favorable rates applicable to individuals.

$400,000 (operating income) – $350,000 (operating expenses) = $50,000 taxable income. No capital lossdeduction is allowed.

PTS: 1 REF: p. 4-2815. ANS: D PTS: 1 REF: p. 5-2 | p. 5-316. ANS: A

Shady, Inc. can deduct only the $247,000 of operating expenses.

PTS: 1 REF: Example 11

ID: A

3

17. ANS: B$2,614. Under § 164(d), 120/365 (January 1 - April 30, 2007) $7,950 = $2,614 is apportioned to Jackson,Inc..

PTS: 1 REF: p. 5-18 | p. 5-19 | Example 3118. ANS: A

Hippo’s tentative domestic production activities deduction for 2007 is 6% of the lesser of:

$200,000 taxable income $12,000

qualified production activities income of $250,000 $15,000

Although the tentative deduction is $12,000 ($200,000 6%), the wage limitation applies ($23,000 50% =$11,500). Therefore, Hippo’s production activities deduction is $11,500.

PTS: 1 REF: p. 5-2019. ANS: C

Taxable income for purposes of calculating the DPAD is reduced by any NOL carryforward. Thus, theamount of the DPAD is $2,400 [($70,000 – $30,000) 6%].

PTS: 1 REF: p. 5-19 | p. 5-2020. ANS: B

Regular MACRS ($50,000 .3333) $16,665

PTS: 1 REF: p. 5-21 to 5-25 | Table 5-121. ANS: A

The mid-quarter convention applies in this case for the personalty.

Regular MACRS ($80,000 .0357) $2,856

PTS: 1 REF: p. 5-21 to 5-26 | Table 5-222. ANS: C

.05 $50,000 = $2,500.

PTS: 1 REF: p. 5-28 | Table 5-423. ANS: D

§ 179 deduction $112,000Regular MACRS [($204,000 – $112,000) .1429] 13,147Total deduction $125,147

PTS: 1 REF: p. 5-30 | p. 5-31 | Table 5-124. ANS: B

The loss is limited to the amount Ace included in gross income ($10,000) less any recovery ($3,000). Thisresults in a $7,000 loss.

PTS: 1 REF: p. 6-3

ID: A

4

25. ANS: BThis debt was not incurred in connection with a trade or business. Therefore, Mary can claim a bad debtdeduction in the following years:

2006—zero.2007—zero.2008—$15,000 [$20,000 (loan) – $5,000 (proceeds)].

PTS: 1 REF: p. 6-2 to 6-426. ANS: D

The entire $10,000 loss on the bad debt is classified as an ordinary loss.

PTS: 1 REF: p. 6-427. ANS: C

Net operating losses are carried back for 2 years and forward for 20 years.

PTS: 1 REF: p. 6- 1328. ANS: C

Cindy’s losses are not subject to the passive activity loss rules in either year because she is a materialparticipant. However, the at-risk rules limit her losses to $100,000 over the period ($85,000 in 2007 and$15,000 in 2008).

PTS: 1 REF: p. 6-15 | p. 6-1629. ANS: A

$60,000 is suspended from 2006 ($100,000 loss – $40,000 used to offset passive income) and $50,000 issuspended from 2007 (no passive income to absorb any of the loss).

PTS: 1 REF: p. 6-18 | p. 6-1930. ANS: D

$90,000 amount realized – $50,000 adjusted basis = $40,000 realized gain – $30,000 suspended loss =$10,000 taxable gain.

PTS: 1 REF: Example 2331. ANS: D

Option a. is incorrect; Ned participates for more than 100 hours and this is not less than the participation ofany other individual (Test 3). Option b. is incorrect; Ned’s participation constitutes substantially all of theparticipation, even though Ned’s participation is less than 100 hours (Test 2). Option c. is incorrect; Nedwould have to participate for more than 500 hours for statement c. to be correct (Test 1). Option d. is correct;an individual who participates for more than 500 hours is a material participant regardless of how muchothers participate (Test 1).

PTS: 1 REF: p. 6-23 | p. 6-24

ID: A

5

32. ANS: EActivities A, B, and C are all significant participation activities, but Activity D is not. A significantparticipation activity is one in which the individual’s participation exceeds 100 hours during the year. Thematerial participation standards are met with respect to Activities A, B, and C because total participation insignificant participation activities (130 + 115 + 260) exceeds 500 hours.

PTS: 1 REF: Example 36 | Example 3733. ANS: D

Statement d. is correct. Activity A is not a significant participation activity because Dena does not participatefor more than 100 hours. She is not a material participant with respect to Activity A because this activity isnot a significant participation activity. She is a material participant in Activities B, C, D, and E under thesignificant participation test (Test 4).

PTS: 1 REF: Example 36 | Example 3734. ANS: B

Statement b. is correct. Because Maria materially participated in the restaurant activity for at least five of thelast ten taxable years before the current year (Test 5), she is still considered an active participant in theactivity. Therefore, her loss is an active loss that can be offset against her active income from the retail store.

PTS: 1 REF: Example 3935. ANS: C

The $60,000 of passive income from Activity A is offset by $60,000 of the passive loss from Activity B,leaving a net passive loss of $40,000. None of the $40,000 net passive loss is deductible in the current year.The $40,000 net passive loss is suspended.

PTS: 1 REF: p. 6-18 | p. 6-1936. ANS: A

$10,000 of Rita’s loss is suspended under the at-risk rules, leaving a potential deduction of $40,000. The$40,000 loss is suspended under the passive loss rules.

PTS: 1 REF: Example 44 to 4737. ANS: A

The $80,000 passive loss reduces the at-risk amount to $120,000. The passive loss is suspended because Vichas no passive income.

PTS: 1 REF: Example 44 to 4738. ANS: D

More than half of Jon’s personal services are spent in a real property trade or business in which he materiallyparticipates, and the time spent exceeds 750 hours. Thus, the apartment building is not a passive activity.Because Jon participates for more than 500 hours in the computer consulting business, it also is not a passiveactivity.

PTS: 1 REF: p. 6-23 | p. 6-29

ID: A

6

39. ANS: DThe entire loss may be deducted: $10,000 is deducted against the income from the limited partnership (i.e.,passive income) and the remaining $20,000 is deducted against Carmen’s salary because she activelyparticipates in the real estate activity.

PTS: 1 REF: p. 6-30 | Example 4940. ANS: E

$22,500. A loss of $10,000 is deducted against the passive income from the limited partnership interest. Ofthe remaining $16,000 real estate rental loss, $12,500 is deducted against Roxanne’s salary because sheactively participates in the activity. The special $25,000 offset for rental real estate is reduced to $12,500[$25,000 – 50%($125,000 – $100,000)]. Therefore, of the remaining $16,000 loss, only $12,500 is deductedin the current year.

PTS: 1 REF: p. 6-30 | p. 6-31

PROBLEM

41. ANS:a. Reg. § 1.451-5 specifies that accrual basis taxpayers may defer the recognition of income

from advance payments for the future sale of inventories that are not on hand the last day ofthe year and the amount collected is less than the seller’s cost of the goods. The $8,200would not be includible in the gross income of the dealer for the current year and would beincludible in gross income at the time the sale is consummated upon delivery of the car.

b. Revenue Procedure 2004-34 permits the accrual basis taxpayer to amortize the prepaidincome for the first year under the contract. However, the balance of the unearned incomemust be recognized in the tax year following the year of receipt. In the case of a contractsold on April 1 that was for services over the twelve-month period beginning on that date,the taxpayer would recognize 9/12 of the income in the year of sale, and the remainingbalance (3/12) in the following year. In the case of a contract sold on April 1 that was forservices over the 24-month period beginning on that date, the taxpayer would recognize 9/24of the income in the year of sale and the remaining balance (15/24) in the following year. Inthe case of a contract sold on April 1 that was for services over the 36-month periodbeginning on that date, the taxpayer would recognize 9/36 of the income in the year of saleand the remaining balance (27/36) in the following year.

c. Revenue Procedure 2004-34 would permit deferral of $6,000 from income until thefollowing tax year since all services will be performed by the end of the tax year followingthe year of receipt.

d. Prepaid rent is taxable in the year of receipt to both the accrual and cash basis taxpayers.Revenue Procedure 2004-34 is not applicable to prepaid rent income.

PTS: 1 REF: p. 4-12 | p. 4-13

ID: A

7

42. ANS:Todd must report $216 of interest income and no dividends. The certificate of deposit is an original issuediscount instrument. Therefore, Faye should have reported $216 (.05 $4,319) of interest income in 2006,and thus the adjusted basis of the CD is $4,535 ($4,319 + $216). Todd must report interest income for 2007calculated as follows: $227 (.05 $4,535). The dividends had been declared before Todd received the stock.According to the IRS in this case, the income belongs to Faye since she was the owner of the stock when thedividend was declared and she assigned to Todd the right to receive it.

PTS: 1 REF: p. 4-11 | p. 4-1243. ANS:

Roy should select the investment in the land. The investment in the bond earns a 4.8% after-tax rate of return.The tax on the original issue discount must be paid each year; therefore, owning the bond is equivalent toowning an investment that appreciates at an after-tax rate of 4.8%. At the end of 10 years, Roy will haveaccumulated $15,981 (1.5981 $10,000). With the land, Roy’s investment will appreciate to $21,589(2.1589 $10,000) which exceeds the $15,981 amount accumulated with the bond.

PTS: 1 REF: p. 4-6 to 4-1144. ANS:

a. Net short-term capital gain $ 60,000Net long-term capital loss (380,000)Excess net long-term loss ($320,000)

The excess capital losses of $320,000 are not deductible on the 2007 return, but mustbe carried back to the three preceding years, applying them to 2004, 2005, and 2006, inthat order. Such long-term capital losses are carried back or forward as short-termcapital losses.

b. 2007 excess loss ($320,000)Offset against—

2004 net long-term capital gains $ 80,0002005 net short-term capital gains 60,0002006 net long-term capital gains 140,000

Total carrybacks $280,000

c. $40,000 ($320,000 – $280,000) STCL carryover to 2008, 2009, 2010, 2011, and 2012,in that order.

d. Ellen would net these transactions with all other capital transactions for 2007.Assuming these were her only capital transactions in 2007, she would offset $60,000 ofcapital losses against the capital gains and deduct an additional $3,000 in capital losseson her return. The remaining $317,000 ($380,000 – $60,000 – $3,000) would be carriedforward indefinitely.

PTS: 1 REF: p. 4-27 | p. 4-28

ID: A

8

45. ANS:a. Amount realized $40,000

Adjusted basis (48,000)Realized loss ($ 8,000)

Alex’s realized loss of $8,000 is disallowed because Alex and Sybil are related parties.

b. Amount realized $45,000Adjusted basis (40,000)Realized gain $ 5,000Alex’s disallowed loss needed to reduce Sybil’s gain to zero (5,000)Recognized gain $ -0-

Sybil may use as much of Alex’s disallowed loss as she needs to reduce her realizedgain (i.e., $5,000) to $0. Thus, Sybil’s recognized gain is $0 and the $3,000 ($8,000 –$5,000) of Alex’s disallowed loss that is not used by Sybil is permanently lost.

PTS: 1 REF: p. 5-1146. ANS:

Deductibility of research and experimental expenditures is permitted in the year of incurrence.

2006Salaries $50,000Supplies 20,000Depreciation 15,000Deductible expenses $85,000

The market survey is not a research and experimental expenditure.

2007Salaries $ 75,000Supplies 15,000Depreciation 17,000Deductible expenses $107,000

The advertising is not a research and experimental expenditure

PTS: 1 REF: p. 5-16 | p. 5-17

ID: A

9

47. ANS:Cost recovery in 2007:MACRS ($29,000 .20) = $5,800 (limited to $2,960*) $2,960 60% $1,776Straight-line ($29,000 .10) = $2,900 (limited to $2,960*) $2,900 60% (1,740)Cost recovery recapture in 2008 $ 36

Cost recovery in 2008:Straight-line ($29,000 .20) = $5,800 (limited to $4,800*) $4,800 .30 $1,440

*These depreciation limits are indexed annually.

PTS: 1 REF: p. 5-31 to 5-34 | Table 5-1 | Table 5-448. ANS:

None. The suspended losses of $80,000 are allocated as follows:

Activity Suspended LossA $60,000/$90,000 $80,000 $53,333B $20,000/$90,000 $80,000 17,778C $10,000/$90,000 $80,000 8,889

Total suspended loss $80,000

PTS: 1 REF: Example 2549. ANS:

A closely held (non-personal service) C corporation can offset passive losses against active, but not portfolioincome. Therefore, Orange’s income is $285,000 [($300,000 active income – $50,000 passive loss) +$35,000 portfolio income].

PTS: 1 REF: Example 3150. ANS:

On Faye’s final income tax return, a deduction of $22,000 is allowed, determined as follows:

FMV of property at death $180,000Adjusted basis of property (150,000)Increase (step-up) in basis $ 30,000

Suspended loss ($52,000)Increase in basis 30,000Suspended loss allowable on Faye’s final income tax return ($22,000)

PTS: 1 REF: Example 53