7
Overview of Deductions and Losses
Solutions to Cumulative Problems
Solutions to 7-60 through 7-61 are found on the following pages.
Cumulative Problem 7-60
[Insert UNF here]
[Insert UNF here]
[Insert UNF here]
[Insert UNF here]
7-61 The steps for determining Wendy White’s tax liability are shown below
immediately followed by her tax return.
Step 1: Calculate the amount of self-employment tax due (ignoring the temporary
reduction).
Schedule C: Wendy has net self-employment income of $9,359 [$10,000 self-
employment income — $641 ($523 transportation and lodging + $60 meals ($120
× 50%) + $58 office supplies)].
Schedule SE: Because one-half of the self-employment tax is a deductible
expense (reported on Line 29 of the Form 1040), Wendy must determine her
adjusted net self-employment income for purposes of completing the Schedule
SE. One-half of the self-employment rate is 7.65%. Therefore, her adjusted net
self-employment income is $8,643 [$9,359 × (1 – .0765)] Since her wages exceed
the social security wage base of $106,800 in 2010 she only owes the Medicare tax
on her self employment income. Therefore her self-employment tax is $251
($8,643 × 2.9%). Enter this amount on Line 56 of the 2010 Form 1040.
Step 2: Determine the amount of Wendy’s deduction for the self-employment tax.
Wendy is allowed a deduction of $126 ($251 × 50%) for one-half of the self-
employment tax. Enter this figure on Line 36 of the Form 1040.
Step 3: Calculate Wendy’s A.G.I.
Salary $150,000
Plus: Net self-employment income (Schedule C) 9,359
Less: Deduction for self-employment tax (Schedule SE) (126)
A.G.I. $159,233
Step 4: Compute Wendy’s itemized deductions.
Home mortgage interest $ 6,250
Charitable contributions 1,300
State and local income taxes 3,100
Employment-related expenses
[$920 – ($159,233 A.G.I, × 2% = $3,185)] —
Total itemized deductions $10,650
Step 5: Calculate Wendy’s personal exemption.
Wendy’s personal exemption for 2011 is $3,700.
Step 6: Calculate Wendy’s taxable income.
A.G.I. $159,233
Less: Itemized deductions (10,650)
Personal exemption (3,700)
Taxable income $144,883
Cumulative Problem 7-61
[Insert UNF here]
[Insert UNF here]
[Insert UNF here]
[Insert UNF here]
[Insert UNF here]
[Insert UNF here]
7
Overview of Deductions and Losses
Solutions to Tax Research Problems
7-62
a. Several cases have considered the tax treatment of the repayments of the
portion of compensation deemed unreasonable. Deduction of the repayment
depends on whether the taxpayer repays the amount voluntarily or pursuant to
a pre-existing arrangement requiring return of any amount that might be found
unreasonable on audit. In Berger, 37 T.C. 1026 (1962), no deduction was
allowed where repayments were made voluntarily. In contrast, in Oswald, 49
T.C. 645 (1968), (to which the IRS acquiesced in Rev. Rul. 69-115, 1969-1
C.B. 50), a deduction was granted because the taxpayer returned the
unreasonable amount pursuant to a binding legal obligation that existed at the
time the salaries were paid. The Tax Court refined the test somewhat in Pahl,
67 T.C. 286 (1976), indicating that no deduction is allowed unless the
repayment agreement is executed prior to the time when the services are
rendered. Existence of a binding legal obligation establishes the expense as
one that arises out of the taxpayer’s business needs.
b. The problem of adopting a payback arrangement is that it may be considered
evidence of the unreasonableness of the compensation. Thus, to adopt such an
agreement may be waving a “red flag” to the IRS suggesting that the
corporation is paying unreasonable compensation. See Saia Electric Inc., 33
TCM 1391, T.C. Memo 1974-290, suggesting this view.
7-63 Section 280A allows deductions related to maintaining a home office for certain
business uses. Specifically, § 280A(c)(l)(A) authorizes deductions where the
home office is exclusively used on a regular basis as the principal place of
business for any trade or business of the taxpayer. Alternatively, under §
280A(c)(l)(B), the taxpayer may deduct home office expenses if the home office
is exclusively used on a regular basis as the principal place of business for any
trade or business of the taxpayer or as a place of business that is used by patients,
clients, or customers in meeting or dealing with the taxpayer in the normal course
of business. An additional test, discussed below, must be satisfied by employees.
Each of these provisions and its application to C is examined below.
In the past, several different tests have been applied to determine the
taxpayer’s “principal place of business.” One of these tests initiated by the IRS
and the Tax Court was the “focal point” test. This test focused on where the
majority of the work was done [Baie, 74 T.C. 105 (1980)].
The “focal point” test was not universally accepted by the courts. In
Weissman, 85-1 USTC ¶9106 (CA-2, 1985), the taxpayer was employed as an
associate professor of philosophy, and of the 64-75 hours he worked each week,
20 percent was spent on campus while the remaining 80 percent was spent in a
two-room office in his ten-room apartment, where he did the bulk of his research
and writing. In a situation similar to that of Weissman, the taxpayer had to share
an on-campus office with other professors that was inadequately equipped and
was not a safe place to leave papers or equipment. The Second Circuit reversed
the Tax Court’s decision, indicating that a college professor’s principal place of
business is not any more the college campus than a musician’s principal place of
business is the concert hall where he or she performs (see Drucker, 83-2 USTC
¶9550). The court indicated that the focal point test improperly shifted attention
from the place the dominant portion of a taxpayer’s work was done to the place
where his work was more visible. Thus it would appear that the Second Circuit
viewed time as a major factor in determining the principal place of business. This
view was also adopted by the Seventh Circuit in Meiers, 86-1 USTC ¶9180 (CA-
7, 1986).
In Drucker, Weissmann, and Meiers (noted above), the Tax Court decision
was reversed. For many years, the Tax Court stuck to its Baie decision, which
focused on the “focal point” of a taxpayer’s activities (i.e., the place where
services are performed and income is generated). However, the Tax Court
departed from the “focal point” test in Soliman, 94 T.C. 3 (1990). Agreeing with
the Second and Seventh Circuit courts, the Tax Court ruled that a taxpayer’s
principal place of business can be the location where the business is managed if
the taxpayer’s occupation requires essential organizational and management
activities that are distinct from those that generate income. The court concluded
that a taxpayer’s home office can be a principal place of business when a
taxpayer’s home office is essential to his business, when he or she spends
substantial time there, and when there is no other location available to perform the
office functions of the business. The decision of the Tax Court in Soliman was
upheld by the Fourth Circuit Court of Appeals (91-1 USTC ¶50,291).
Because of the controversial decisions being reached by the various courts, the
Supreme Court agreed to review the Fourth Circuit’s decision in Soliman, 93-1
USTC 50,014 (USSC, 1993). The facts in this case show that Soliman was an
anesthesiologist who worked at three different hospitals. He was hired by the
hospitals as an independent contractor and was not given any office space in
which to work. Soliman spent about 30 to 35 hours a week administering
anesthesia to patients at the hospitals and spent an additional 10 to 15 hours a
week in his home office performing management and administrative duties that
were essential to his business.
The Supreme Court decided that the previous tests used to determine the
principal place of business were flawed. The Court stated two primary factors that
should be weighed in making the determination: 1) The relative importance of the
function performed at each business location, and 2) the time spent at each place.
The second factor assumes greater significance when comparison of the
importance of functions performed at various places yields no definitive answer to
the question. Applying these tests to the facts in Soliman, the Court decided that
the work of Dr. Soliman performed at the hospitals was vastly more important to
his business than the administrative work performed at home and that only 25%
of his time was spent doing work in his home office. Therefore, the home office
deduction was denied.
Beginning in 1999, the tax law expands the definition of a principal place of
business to include a place that is used by the taxpayer for administrative or
management activities of a trade or business for which there is no other fixed
location where the taxpayer conducts such activities. One purpose of this
provision is to allow taxpayers like Soliman, who had no other fixed location to
perform his administrative duties, to qualify for the home office deduction.
Unfortunately, this exception is inconsistent with the client’s facts and will be of
no help.
Given the Supreme Court decision in Soliman, the taxpayer could argue that
her home office is the principal place of business, if in fact she spends more time
there than she does in the school office and the work performed in her office is
more important than her duties at the University. However, this seems unlikely. In
addition, even if the taxpayer satisfies the principal place of business test, the
deduction is not guaranteed.
For employees, the Code requires that the home office must also be
maintained for the convenience of the employer. In Chauls (T.C. Memo 1980-
471), the Tax Court indicated that the taxpayer must show that what he does at
home could not be done in the office provided at work. This appears to be the
view that has been adopted in Weissman, Drucker, and Meiers. In effect, the court
seems to be saying that where the employer has not provided suitable space, this
test is satisfied. For example, Weissman had to share an office; moreover, the
office was unsafe. Similarly, Drucker had no room in which to practice, while
Meiers had specifically not created office space at the laundromat. If C can
demonstrate that her office at school is unsuitable, she may be able to satisfy this
requirement.
7-64 The answer to this question can be found in § 121 which became effective for
sales and exchanges after May 6, 1997. The general rule under this provision
states that gross income does not include gain from the sale or exchange of
property if, during the five-year period ending on the date of the sale or exchange,
the property has been owned and used by the taxpayer as his or her principal
residence for periods aggregating two years or more. Additional rules related to
this exclusion include:
• The amount of the gain excluded cannot exceed $250,000 ($500,000 for a
married couple who file a joint return).
• The exclusion generally applies to only one sale every two years.
• A reduced exclusion is available for taxpayers who fail the ownership and use
requirement or who sell within two years. The reduced exclusion is based on
the number of months the requirements are met to 24 months.
• If a residence was acquired in a “rollover” under the prior law, the holding
period of the old home is included in the holding period of the residence being
sold.
• The exclusion does not apply to the portion of the gain that represents
depreciation taken on the home after May 6, 1997. Thus, the taxpayer must
recognize gain to the extent of any depreciation taken while the home was
rented or used for business use (i.e., office in the home).
Applying § 121 to the facts of this problem, it appears that R can qualify for at
least a partial exclusion of the gain. Although R has owned the home for about
two years, he has owned and used the property as a principal residence for only 12
months. Therefore, unless he acquired the home in 2011 through a rollover from a
previous owned home, R is eligible for only a partial exclusion. However, before
calculating the partial exclusion, R must recognize gain to the extent of
depreciation taken on the residence when it was rented. The gain exclusion is then
limited to the lesser of: 1) 12 months/24 months × $500,000, or 2) 12 months/ 24
months × the remaining gain on the sale of the residence after accounting for
depreciation recapture.
7-65 Code § 179 allows for the expensing of assets purchased for use in a trade or
business. Reg. § 1.179-3(d) narrows this allowance to assets used predominantly
for a qualified business use (i.e., greater than 50%). However, even if this test is
met, § 280F(d)(3)(A) provides that any employee use of “listed” property shall
not be treated as used in a trade or business for purposes of § 179 unless such use
is for the “convenience of the employer” and is “required as a condition of
employment.” Listed property includes computers.
In Rev. Rul. 86-129, 1986-2 C.B. 48, the IRS took a strict approach to the
definitions of “convenience of employer” and “required as a condition of
employment.” This same position was restated in a series of letter rulings. For
example, in Ltr. Rul. 8710009, the IRS ruled that an insurance salesman who had
purchased a computer to use exclusively in his business failed to meet the tests.
The IRS stated:
Notwithstanding the fact that the purpose of the computer will be useful and
helpful in performing your duties, you are not required to purchase the
computer in order to perform such duties. According to the facts submitted,
the computer purchase is optional rather than mandatory. While your use of
the computer may increase your productivity at work, and the benefits of such
increased productivity would inure to your employer, the purchase of the
computer is clearly not required as a condition of employment. The facts
indicate that computer use, although work-related, is not inextricably related
to the proper performance of your job. Further, there appears no evidence that
those employees who do not purchase computers are professionally
disadvantaged.
Under this definition of “condition of employment,” B would clearly not be
allowed a deduction for the personal computer. Fortunately, however, the Tax
Court does not take such a strict view. In Cadwallader, T.C. Memo 1989-356, the
Court said that for the “condition of employment” requirement to be satisfied, it is
only necessary that the computer be required to properly perform the duties of
employment. Because the taxpayer’s work was “substantially aided by computer,”
this test was passed. This is a far more liberal interpretation of the phrase
“required to properly perform the duties of employment” than that used by the
IRS. The Tax Court continued its liberal definition of the “condition of
employment” test in the case of Sherri A. Mulne (T.C. Memo 1996-320). The
court approved the cost recovery deduction for a computer because of the
taxpayer’s heavy caseload and the number of sales representatives she managed.
With respect to the second test—the computer must be acquired “for the
convenience of the employer”—the court ruled that because the purchase spared
the employer the cost of providing the taxpayer with suitable computer
equipment, this test was met.
Given the facts at hand, it is clear that the IRS would disallow the expense
deduction on audit. The fact situation is almost identical to that in Ltr. Rul.
8710009, where the deduction was denied. However, it is also clear that the Tax
Court is willing to be more lenient than the IRS in its interpretation of § 280F. If
the matter were taken to court, the taxpayer would likely win. It appears, then,
that the taxpayer is entitled to a deduction for the personal computer used
exclusively in his trade or business.
Although B may be “correct” in taking a deduction for the computer, what
should the taxpayer do if challenged by the IRS? In this case, the tax benefit of
the acquisition is quite small. With 100 percent business usage, the deduction
would be $3,000. But, because this is a miscellaneous itemized deduction, the
amount must be reduced by 2 percent of A.G.I. ($65,000 A.G.I, × 2% = $1,300).
The remaining $1,700 deduction would save B $425 in taxes ($1,700 × 25%).
This is too small a matter to pursue any further than within the IRS. If the IRS
refuses to back down on the matter, B should probably concede. Justice does not
always prevail.
7-66 To be deductible as a trade or business expense, an expenditure must be paid or
incurred in connection with a trade of business in which the taxpayer is engaged
(§ 162). Section 183 states that “if such activity is not engaged in for profit, no
deduction attributable to such activity shall be allowed.” Whether an activity is
carried on primarily for profit or as a hobby for recreation and pleasure must be
determined by an examination of all the facts and circumstances in the case [Reg.
§ 1.183-2(b)]. There need not be a reasonable expectation that the activity will
yield a profit. It is sufficient if an activity is entered into in good faith with the
purpose of making a profit [Reg. § 1.183-2(a)].
Regulation § 1.183-2(b) lists nine nonexclusive factors to consider in
determining a profit motive: (1) the manner in which the taxpayer conducts the
activity, (2) the taxpayer’s and/or taxpayer’s advisor’s level of expertise, (3) the
time and effort expended by the taxpayer on the activity, (4) the expectation that
assets used in the activity may appreciate in value, (5) the taxpayer’s success in
similar activities, (6) the taxpayer’s history of income or losses with respect to the
activity, (7) the amount of profits, (8) the taxpayer’s finances, and (9) elements of
personal pleasure or recreation connected with the activity. No one factor is
determinative in deciding if a profit motive exists.
Note: The presumption test of § 183(d) (i.e., an activity is presumed to be
engaged in for profit if it shows a profit for any three or more years in a period of
five consecutive years) is inapplicable to this problem. However, because S has
been challenged on this issue, she may wish to make the election of § 183(e) to
defer application of § 183 until after the close of the five-year presumptive period.
This will allow S a chance to meet the presumption (she will need to report profits
in the next three years). If she can manage this feat, she will shift the burden of
proof that she is not engaged in trade or business to the IRS.
A relevant court case in this area is Kimbrough, TC Memo 1988-185 (the facts
in Kimbrough are similar to those in the case problem). The Tax Court’s analysis
of the facts led to the conclusion that Kimbrough’s losses were incurred in a trade
or business activity. A comparison of the Kimbrough analysis to the facts at hand
leads to a similar conclusion. The key factors are
1. S must carry on her professional golf activities in a businesslike manner. She
already keeps separate records for her golf activities. She should continue to
keep accurate and detailed records of her potential prize money, actual
winnings, and expenses. She should also consider taking a course in managing
a golf career.
2. S has extensive golf experience and continues to play with a professional
whenever possible. Her unpaid apprenticeship is a good indicator of her
sincerity in pursuing a golf career. In the future, she might wish to formalize
her efforts (e.g., take additional courses and have a formal plan for
improvement).
3. S currently spends a great deal of time with her golf. It is not required that this
be her primary occupation as long as she devotes a substantial amount of time
and effort to the activity. If she is to begin making a profit, she may need to
devote even more time in the future.
4. Losses should generally diminish over time. In S’s case this is true, but she
needs to show even more improvement in the future. In fact, she needs to
focus on making a profit in the current year.
5. Although S receives recreational and personal pleasure from her golf, this
factor is not determinative if the other factors are strong.
Based on the results of the Kimbrough case, S has a reasonable chance of having
her golf activity deemed to be a trade or business activity if the matter is taken to
court. However, given the relatively small tax consequences of this matter, S
should probably not pursue this issue beyond the IRS. The costs of litigation will
most likely preclude her from taking the case to the Tax Court, where she would
probably win.
7
Overview of Deductions and Losses
Test Bank
True or False
________ 1. In regard to the statutory scheme for determining deductibility, a
taxpayer may deduct an expense only if it is “specifically” identified
(e.g., interest) as deductible in the Code. For example, advertising
expense of a business would not be deductible unless a code provision
specifically indicated that advertising expense is deductible.
________ 2. For tax purposes, the term “nonbusiness expense” refers to
nondeductible personal expenses, such as the costs of personal hygiene.
________ 3. J, employed as a male dancer, regularly uses a tanning salon to keep his
body looking healthy. J may deduct the cost of visiting the tanning salon.
________ 4. An “ordinary” business expense need not be recurring.
________ 5. A cash basis taxpayer may deduct all prepaid interest in the year it is
paid.
________ 6. V bought electric motors for her business from a sales representative
who said that they had a four horsepower output. V discovered while
using the motors that they only produce two horsepower after a few
weeks use. V may recognize as a loss the value of the reduction in
horsepower and currently deduct the amount as a business expense.
________ 7. Any expense that is reimbursed by the taxpayer’s employer is deductible
for A.G.I, (e.g., reimbursement of a parking ticket incurred by a
salesperson when calling on a customer).
________ 8. T’s itemized deductions for the current year are $14,000. Assuming the
standard deduction is $5,000, T may deduct no more than $9,000 of her
itemized deductions.
________ 9. Tax preparation fees incurred by an individual generally are treated as
miscellaneous itemized deductions and can be deducted only to the
extent they exceed two percent of A.G.I.
________ 10. As an employee for BBB, J earned a salary of $40,000 and incurred
unreimbursed employee business expenses of $1,000. Assuming J
itemizes his deductions, he may deduct all of his expenses.
________ 11. Fees paid for preparation of a tax return are deductible only if they are
related to a taxpayer’s trade, business, or activity engaged in for profit.
________ 12. Either W or one of his employees visits a local factory every week to
wash the windows. W may deduct the cost of all of his expenses from
washing windows.
________ 13. With respect to the deduction for hobby expenses, the taxpayer’s
expectation of profit need not be considered reasonable in order for the
expense to be deductible.
________ 14. Deductible expenses related to an activity that is considered a hobby, and
that are not otherwise allowable, are treated as miscellaneous itemized
deductions and can be deducted only to the extent they exceed two
percent of A.G.I.
________ 15. H recently purchased a residence for himself and his family for $60,000.
Shortly thereafter, property nearby was rezoned by the city council for
light commercial businesses. As a result, the value of H’s house dropped
to $50,000. H may deduct a loss of $10,000.
________ 16. Expenditures for goodwill may be recovered for tax purposes only when
there is a disposition of the asset such as a sale or exchange, and not
through amortization.
________ 17. Business expenses (other than interest) related to tax-exempt interest
income are deductible.
________ 18. Expenses incurred in the production of income, such as legal fees and
safe deposit box rentals, may be deducted even though the income
produced is wholly tax-exempt (i.e., municipal bond interest income).
________ 19. If taxpayer B pays a dependent son’s real estate taxes, B cannot deduct
the expense.
________ 20. According to the Cohan rule, taxpayers may deduct reasonable estimates
of expenses where they have no evidence, such as a receipt, to
substantiate the actual amount.
Multiple Choice
________ 21. The courts have determined that to qualify as a trade or business, an
activity must
a. Be operated with a profit motive
b. Have a sufficient degree of taxpayer involvement
c. Show a profit
d. Both a. and b. are true.
e. All three statements are true.
________ 22. The crucial reason for determining whether an item is deductible as an
expense under § 162 or under § 212 is that
a. Production-of-income expenses are not deductible.
b. § 162 business expenses usually are deductions for A.G.I., while §
212 production-of-income expenses usually are miscellaneous
itemized deductions.
c. § 162 business expenses are deductions from A.G.I., while § 212
production-of-income expenses are deductions for A.G.I.
d. It resolves certain ownership questions.
________ 23. Z is a ten-percent (10%) shareholder of H, Inc. H, Inc. has distributable
net income of $100,000 this year and no accumulated earnings and
profits. Z was paid $15,000 by the company for his expertise as a pilot,
but he did not fly this year. How is the IRS likely to view the $15,000?
a. $15,000 salary to Z
b. $15,000 dividend
c. $10,000 dividend, $5,000 salary or return of capital
d. $7,500 salary, $7,500 dividend
________ 24. Near year-end, P, a cash basis, calendar year taxpayer, paid for various
deductible expenses as described below.
1. The payment was dropped in the mail before year-end.
2. P gave a note evidencing her promise to pay the amount in three
months.
3. The amount was charged on her Master Card on December 28. The
charge appeared on her bill for the period December 1 through
December 31, which she received in January and which she paid on
January 20. The bank actually paid the expense in January.
4. The amount was paid using the pay-by-phone service provided by
her bank. P called in the charge on December 20. The bank sent her a
statement indicating that it had paid the charge on January 3.
P may deduct the expense in which cases?
a. 1.
b. Land2.
c. 1. and 3.
d. 1., 3. and 4.
e. 1., 2., 3. and 4.
________ 25. S is a cash basis, calendar year taxpayer (she uses the accrual-method for
inventory). She operates Cloth R Us. All of the store’s profits come from
the sale of fabric. During the year she paid the following expenses:
1. $3,000 premium for liability insurance covering her business. The
coverage runs from December 1, 2012 through November 30, 2015.
2. $10,000 for cloth, all of which is still on hand at the end of the
taxable year.
3. $2,000 for “points” related to obtaining a loan for the purchase of her
personal residence.
4. $1,200 for “points” related to obtaining a loan on rental property.
S may deduct all of the expense incurred in 2012 for which item(s)?
a. 1.
b. Land2.
c. L, 2. and 3.
d. L, 3. and 4.
e. 3.
________ 26. F, a calendar year, cash basis taxpayer, started a business on June 1. Her
lease required monthly payments of $ 1,000 beginning on June 1.
Insurance for the premises, also begun on June 1, was to be paid every
six months and cost $600 for each six-month period (she paid her
premiums due on June 1 and December 1). F’s deductions for these
expenses total
a. $7,000
b. $7,100
c. $7,600
d. $8,200
________ 27. T was looking for a house when he happened upon an old mansion. After
looking it over, he decided that although he would not want to live there
himself, it would be a good investment. As a result, he decided to buy it
to hold as rental property. T borrowed $100,000 from his bank to finance
the purchase. The loan was to be repaid over a 10-year period starting
January 5 of the following year. In addition, he paid five points for the
loan. T closed the deal in early December and paid the closing costs,
including the points, at that time. T also paid his first installment on the
loan in late December, even though it was not due until January 5 of the
following year. The installment he paid included $800 of interest. How
much can T deduct in the year of the closing? (T is a cash basis
taxpayer.)
a. $0
b. $41.67
c. $800
d. $5,000
e. $5,800
________ 28. L operates a sole proprietorship that manufactures lawn sprinklers. The
business is an accrual basis, calendar year taxpayer. During the year, the
following transactions occurred.
1. In December, L contracted for $5,000 with a distinguished products
management firm, Y Research, to help him market his product
nation-wide. Y performed the services in the following year.
2. L has a long-time agreement with M Service Company to come once
a month to service certain equipment. The Company charges L $50
per month. L accrues the fee at the end of each month and pays the
bill when it is received, usually in the following month. This year M
was extremely busy and was not able to perform its services for the
month of December until January of the following year.
3. L provides a one-year money back guarantee on his products. At the
close of the current year he estimated that the guarantees for
sprinklers sold during the year would cost him $1,500.
Indicate in which of the cases above L is entitled to accrue a deduction.
a. 1
b. 1. and 2.
c. 2.
d. 2. and 3.
e. 3.
________ 29. J, an accrual basis taxpayer, deducted an estimated expense for next year
that she was required by law to pay. The principle that the IRS follows in
disallowing this deduction is the
a. All events test
b. Economic performance test
c. Estimated expense test
d. Legal compunction test
________ 30. C purchased two cars in 2009, a Corvette for $40,000 and a Buick for
$20,000. Both cars were used solely for personal purposes. During the
year, C sold the Corvette to a car collector for $45,000 and the Buick for
$17,000. Based on these two transactions he will report
a. A gain of $2,000
b. A gain of $5,000
c. A gain of $5,000 and a loss of $3,000
d. No gain or loss
________ 31. Which of the following statements is true concerning deductions “for”
and “from” adjusted gross income (A.G.I.)?
a. A deduction from A.G.I, has no effect on the taxpayer’s self-
employment tax liability.
b. Corporations, like individuals, must classify their deductions as
deductions for and from A.G.I.
c. Misclassification of a deduction for A.G.I, has no effect on the
taxpayer’s tax liability, assuming the taxpayer itemizes her or his
deductions.
d. Misclassification of a deduction for A.G.I, never has an effect on the
taxpayer’s medical expense deduction.
________ 32. Which of the following is not a deduction for A.G.I.?
a. Lawn-mowing expense for a rental property actively managed by the
taxpayer
b. Deductible expenses related to a physician’s home office
c. Employee transportation expense not reimbursed by the employer
d. Employee transportation expense reimbursed by the employer and
included in employee’s income
________ 33. E works as a pharmacist for D Drug Stores. Assuming E does not
itemize his deductions, which of the following is not deductible?
a. Maintenance expenses for a duplex that he owns and rents out
b. Dues to the local pharmacist organization, which are reimbursed by
Drug Stores and included in his income
c. Subscriptions to professional journals for which he receives no
reimbursement
d. Alimony to his ex-wife who lives in Texas
e. Loss on the sale of stock
________ 34. Which of the following is considered a miscellaneous itemized
deduction subject to the 2% of A.G.I. limitation?
a. Moving expenses of an employee
b. Interest expenses attributable to a mortgage on the taxpayer’s
principal residence
c. Property taxes assessed on the taxpayer’s residence
d. Tax preparation fee
e. More than one of the above are miscellaneous itemized deductions
________ 35. K is an attorney who had to travel to Chicago for a trial. Her law firm
reimbursed her for the $1,200 hotel bill and $200 for food, but only half
of her $200 entertainment expense eligible for deduction under § 162. If
the law firm includes the $1,500 in K’s compensation on her Form W-2,
she may
a. Include the $1,500 as a miscellaneous itemized deduction
b. Deduct the $1,500 for A.G.I
c. Include the $100 unreimbursed entertainment expense with the
miscellaneous itemized deductions
d. Both b. and c. are true.
________ 36. The tax break afforded to qualified performing artists allows them to
a. Deduct their business expenses for A.G.I
b. Itemize, but escape the 2-percent-of-A.G.I. threshold for
miscellaneous itemized deductions
c. Shelter their first $5,000 of income as tax-exempt
d. Defer tax on their performance-related income for up to 10 years
________ 37. B, a bank president, is a weekend potter. He regularly sells his pots at
crafts fairs and spends an average of 10 hours a week either making or
marketing pots. Although he has netted around $200 per year for the last
two years from pottery sales, he tells everyone that he would do it for
free. This year he reported gross income of $300 and expenses of
$1,000. The $1,000 expense is, most likely,
a. Deductible for A.G.I, as a business loss
b. Available only to offset the $300 income of the pottery business
c. Miscellaneous itemized deduction
d. Both b. and c. are true.
________ 38. B, a bank president, is a weekend potter. He regularly sells his pots at
crafts fairs and spends an average of 10 hours a week either making or
marketing pots. Although he has made around $200 profit per year for
the last two years from pottery sales, he tells everyone that he would do
it for free. This year he had a $1,000 net loss due to increased entrance
fees at the fairs. If B has been making and selling pots for only three
years and he makes an election under § 183 to postpone IRS challenges,
which of the following is a true statement if B makes a profit next year?
a. He can carry forward this year’s $1,000 loss and deduct it for A.G.I.
b. He is conclusively the owner of a for-profit business rather than a
hobby.
c. He may shift the burden of proof to the IRS, which must show that
the pottery activity is not a business.
d. He can postpone paying income tax on the profit until the challenge
is resolved.
________ 39. F, an attorney in New York, also operates a small farm in New Jersey.
During the year, he reported the following income and expenses from the
farm:
Gross income $ 8,000
Depreciation (3,000)
Property taxes (6,000)
Other operating expenses (4,000)
Assuming the activity is considered a hobby, F may deduct
a. Taxes $6,000, other $0, depreciation $0
b. Taxes $6,000, other $0, depreciation $2,000
c. Taxes $6,000, other $2,000, depreciation $0
d. Taxes $6,000, other $4,000, depreciation $3,000
________ 40. A raises vegetables as a hobby. During the year she sold the vegetables
she didn’t consume for $25. She also incurred the following expenses
attributable to the hobby: seeds, bulbs, and plants, $15; water, $8; and
property taxes on the land, $40. Assuming A itemizes her deductions,
what is the amount of the above expenses that is potentially deductible?
a. $15
b. $23
c. $25
d. $40
e. $63
________ 41. N’s wife divorced him and he is trying to reduce his taxable income. He
sold his car for a $2,000 loss, took out a $500,000 insurance policy on
his own life with a lump sum premium of $25,000 as part of the divorce
agreement, and paid alimony expenses of $12,000 this year. Based on
this information, how much of a deduction can N take for A.G.I.?
a. $12,000
b. $32,000
c. $34,000
d. $59,000
________ 42. Y purchases a restaurant from R for $150,000, $130,000 of which is
allocated to tangible assets (the remaining $20,000 is allocated to
goodwill). Y makes substantial improvements to the restaurant (i.e., he
changes the decor from Hawaiian to French), which costs $30,000, and
hires a handyman to make minor repairs for $1,000. How will the three
expenditures listed above be treated for tax purposes?
a. $130,000 depreciated/amortized over the tax life of the assets,
$51,000 business expense
b. $150,000 depreciated/amortized over the tax life of the assets,
$31,000 business expense
c. $160,000 depreciated/amortized over the tax life of the assets, $1,000
business expense
d. $180,000 depreciated/amortized over the tax life of the assets, $1,000
business expense
________ 43. R’s only profit-seeking activities involve operation of several computer
stores. She currently is considering undertaking a new venture. To this
end, she pays a C.P.A. $5,800 to perform a financial analysis of the
venture to determine whether to enter it. With respect to the expenditure,
R may
a. Deduct the entire expense in the year incurred if the venture involves
operation of a professional sports franchise, and she enters the
venture
b. Deduct the entire expense in the year incurred if the venture involves
operation of a toy store, and she does not enter the venture
c. Deduct the entire expense in the year incurred if the venture involves
another computer store, and she does not enter the venture
d. Amortize the expenditure over 60 months if the venture involves
another computer store, and she does not enter the venture
________ 44. Q operates an art gallery and knowingly sells forged Picasso prints as
authentic ones. After 60 Minutes exposes him, he files a tax return
claiming deductions for § 162 business expenses of $10,000 for rent,
$20,000 for salaries, $5,000 for the supplies necessary to produce the
forgeries, and $25,000 in fines. The IRS should allow Q to deduct
a. $10,000
b. $30,000
c. $35,000
d. $60,000
________ 45. N owns and operates a grocery store in a neighborhood that may become
the subject of a major renovation if the city council approves the project.
With respect to lobbying expenditures, which of the following
statements is true?
a. N may deduct consulting expenses for a lobbyist who provides
information to the city council regarding the economic effect of the
project.
b. N may deduct the cost of an ad in the local newspaper in support of
the proposed rehabilitation project.
c. N may deduct the cost of a political contribution to a candidate who
shares his views regarding the project.
d. N may deduct the payment to a political action committee involved
in lobbying for the renovation of the neighborhood.
________ 46. After having his best three quarters of earnings ever, and with a
predicted strong fourth quarter, D, a sole proprietor who is a calendar
year, cash basis taxpayer in a manufacturing business, is looking for
ways to reduce his A.G.I, this year. Which of the following would
probably not generate a deduction for A.G.I.?
a. Expenses incurred in December for a big January ad campaign
b. Selling assets below his adjusted basis in them
c. Expenses incurred in providing information to the city council on
matters of direct interest to the taxpayer
d. Buying life insurance on his key employees’ lives, with the business
as beneficiary
________ 47. X owns 20 shares of W Corp. and so do his best friend and his step-
brother. Partnership XY, of which X owns 50 percent, owns 20 shares of
W Corp., and A Corporation, of which X owns 50 percent, owns 20
shares. How many shares of W Corp. does X own under the constructive
ownership rules of Code § 267 (related party sales)?
a. 20 shares
b. 40 shares
c. 50 shares
d. 70 shares
________ 48. T takes out a home equity loan for $25,000 at 10 percent. He
immediately purchases $25,000 of tax-exempt bonds earning 8 percent a
year. The IRS will probably
a. View the income from the bonds as taxable
b. Declare that the results of the transactions cancel each other out, so
that they are a “wash” for T
c. Allow the interest deduction
d. Deny the deduction for the interest expense
________ 49. On January 1, 2012, H sold stock with a basis of $4,000 to his sister M
for $3,500, its fair market value. On July 30, 2012, M sold the same
stock for $4,100 to a friend in a bona fide transaction. In 2012, as a result
of these transactions,
a. Neither H nor M has a recognized gain or loss.
b. H has a recognized loss of $500.
c. M has a recognized gain of $100.
d. M has a recognized gain of $600.
________ 50. G plans to sell property at a loss, which he would like to recognize. In
which of the following situations, if any, would a loss on the sale be
recognized?
a. Sale to C Corporation; G owns 30 percent of C while his wife owns
40 percent of C.
b. Sale to W, G’s wife
c. Sale to V, G’s brother
d. Sale to H Corporation; G owns 40 percent of H Corporation, while
G’s 60 percent owned corporation, J, owns 11 percent.
e. A loss will not be recognized in any of the situations above.
________ 51. Section 267 provides special rules governing payments of unpaid
expenses between accrual and cash basis taxpayers who are related
parties. Which of the following statements most accurately describes
these rules?
a. To police the problem, the provision denies deductions for all
amounts paid to related parties, because the amounts, in effect, have
never left the payor’s control because the parties are related.
b. Section 267 applies a subjective test to determine whether accrual
should be allowed; that is, it allows accrual where the taxpayer can
demonstrate that abuse is not intended.
c. The rules prohibit potential abuse by treating the accrual basis
taxpayer as a cash basis taxpayer. Thus, deductions are allowed only
when the payment is actually made.
d. To ensure that an accrual basis taxpayer cannot accrue large
deductions without ever having to make actual cash payments, the
rules allow accrual as long as payments are made within a reasonable
period after year’s end.
________ 52. E owns all of the stock of THR Corporation, an accrual basis, calendar
year taxpayer. E is the chair of the company’s board of directors while
her son, D, is chief executive officer. Both E and D are cash basis,
calendar year taxpayers. The company was extremely successful during
2012 and consequently the board of directors authorized the payment of
a $25,000 bonus to D for a job well done. Assuming the IRS does not re-
characterize the bonus as a dividend, which of the following statements
most accurately describes THR’s treatment of the bonus?
a. THR may accrue and deduct the bonus payment for 2012 regardless
of when it is paid because the all events and economic-performance
tests have been satisfied.
b. Although THR is an accrual basis taxpayer, it may deduct the bonus
payment for 2012 only if the bonus is paid in 2012.
c. THR may accrue and deduct the bonus payment for 2012 assuming
bonuses of this type are recurring in nature and THR consistently
treats bonuses as incurred in the year in which they are authorized.
d. THR may accrue and deduct the bonus payment for 2012 as long as
it is paid within a reasonable period after the close of the taxable year
(e.g., two-and-one-half months).
________ 53. Given the following information, indicate which of the taxpayers below
would obtain the greatest tax savings from making a deductible
charitable contribution of $100 next year (2012) rather than this year
(2010). Assume no changes in tax rates and other items (e.g., standard
deduction, etc.) and ignore the time value of money.
Taxpayer A B C D E
Filing status Joint Joint Joint Single Single
Tax rate this year 25% 15% 25% 25% 15%
Other itemized deductions this year $12,000 $9,000 $8,000
$4,000 $6,000
Itemized deductions expected next year $12,500
$12,000 $8,500 $4,500 $7,500
a. A
b. B
c. C
d. D
e. E
________ 54. P incurs an $80,000 mortgage to purchase a $100,000 house. The terms
of the mortgage are 30 years at 12 percent with two points. Although P
made a downpayment of $20,000, the bank deducted the points from the
loan. The $2,000 P paid in points
a. Is wholly deductible in the current year
b. Is a miscellaneous itemized deduction
c. Must be amortized over the term of the loan
d. May not be deducted or amortized
________ 55. An individual taxpayer owns and operates a chain of retail shoe stores
(average annual gross receipts of $12 million). The business is run as a
single person LLC. Which statement reflects the business’ accounting
requirements for Federal income tax purposes?
a. The taxpayer must use the cash basis for all items of revenue, cost,
and expense.
b. The taxpayer may use either the cash or accrual basis for all items of
revenue, cost, and expense.
c. The taxpayer must use the accrual basis for all items of revenue, cost,
and expense.
d. The taxpayer must use the accrual basis for all items affecting the
computation of gross profit on sales but may use the cash basis in
accounting for other expenses.
________ 56. Which of the following estimated expenses are deductible?
a. Reserve for self-insurance
b. Reserve for warranty repairs
c. Reserve for bad debts
d. None of the above
________ 57. R’s only profit seeking activities involve operation of several computer
stores. He currently is considering undertaking a new venture. To this
end, he pays a C.P.A. $8,000 to perform a financial analysis of the
venture to determine whether to enter it. With respect to the expenditure;
R may:
a. Deduct the entire expense in the year incurred if the venture involves
operation of a professional sports franchise, and he enters the venture
b. Deduct the entire expense in the year incurred if the venture involves
operation of a toy store, and he does not enter the venture
c. Deduct a portion immediately and amortize a portion of the expense
over 180 months if the venture involves operation of a winery and he
enters the venture
d. Deduct a portion immediately and amortize a portion of the expense
over 180 months if the venture involves another computer store, and
he does not enter the venture
Matching
________ 58. State whether or not each of the following is:
• For—deductible for adjusted gross income;
• From—deductible from adjusted gross income; or
• Not—not deductible.
________ a. Cost of nurse’s uniform reimbursed in full by
nurse’s employer (reimbursement not included in gross
income)
________ b. Rental cost of taxpayer’s safe deposit box which
holds only personal documents (e.g. passports, marriage
license)
________ c. Accountant’s fee incurred in challenging a tax
deficiency related to a medical expense deduction claimed
two years ago
________ d. Loss on the sale of corporate bonds—these bonds
were held for investment
________ e. Travel expenses (away from home) incurred as an
employee; not reimbursed
________ f. Travel expenses incurred as a self-employed
businessman
________ g. Expenses related to rental real property (taxpayer
actively participates in the management of the property)
________ h. Entertainment expenses incurred by an employee,
reimbursed in full by the employer and included on Form
W-2 as “other income”
________ i. Commuting expenses incurred by an employee,
reimbursed in full by the employer and included on Form
W-2 as “other income”
________ j. Entertainment expenses incurred by a self-
employed businesswoman
7
Overview of Deductions and Losses
Solutions to Test Bank
True or False
