Income Tax Chapter 4
Calculator Wayne owns a 30% interest in the capital and profits of Emerald Company (a calendar year partnership). For tax year 2017, the partnership earned revenue of $900,000 and had operating expenses of $660,000. During the year, Wayne withdrew from the partnership a total of $90,000. He also invested an additional $30,000 in the partnership. For 2017, Wayne's gross income from the partnership is: a. $90,000. b. $72,000. c. $132,000. d. $162,000.
b. $72,000. Wayne must report as his gross income 30% of the partnership profits, 30% × ($900,000 - $660,000) = $72,000. The $90,000 is a return of capital. The $30,000 is a contribution to capital.
For purposes of determining gross income, which of the following is true? a. Embezzlement proceeds are not included in the embezzler's gross income because the embezzler has an obligation to repay the owner. b. A taxpayer who finds a wallet full of money is required to recognize income even though someone may eventually ask for the return of the money. c. A mechanic completed repairs on an automobile during the year and collects money from the customer. The customer was not satisfied with the repairs and sued the mechanic for a refund. The mechanic can defer recognition of the income until the suit has been settled. d. All of these choices are false. e. All of these choices are true.
b. A taxpayer who finds a wallet full of money is required to recognize income even though someone may eventually ask for the return of the money. Under the claim of right doctrine, the person who finds property, and has free and unrestricted use of the property, has realized an increase in wealth and must include the found property in his or her gross income.
Office Palace, Inc., leased an all-in-one printer to a new customer, Ashley, on December 27, 2017. The printer was to rent for $600 per month for a period of 36 months beginning January 1, 2018. Ashley was required to pay the first and last month's rent at the time the lease was signed. Ashley was also required to pay a $1,500 damage deposit. Office Palace must recognize as income for the lease: a. $1,200 in 2017, if Office Palace is an accrual basis taxpayer. b. $2,700 in 2017, if Office Palace is a cash basis taxpayer. c. $0 in 2017, if Office Palace is an accrual basis taxpayer. d. $7,800 in 2018, if Office Palace is a cash basis taxpayer. e. None of these choices are correct.
a. $1,200 in 2017, if Office Palace is an accrual basis taxpayer. The company is required to recognize the $1,200 (January 2017 and December 2020 rent) in 2017 because prepaid income from rents is ineligible for deferral. The damage deposit of $1,500 is not income.
Jim and Nora, residents of a community property state, were married in early 2016. Late in 2016 they separated, and in 2017 they were divorced. Each earned a salary, and they received income from community owned investments in all relevant years. They filed separate returns in 2016 and 2017. a. In 2017, Nora must report only her salary and one-half of the income from community property on her separate return. b. In 2017 Nora must report on her separate return one-half of the Jim and Nora salary for the period they were married as well as one-half of the community property income and her income earned after the divorce. c. In 2017, Nora must report on her separate return one-half of the Jim and Nora salary and one-half of the community property income. d. In 2017, Nora must report only her salary on her separate return. e. None of these choices are correct.
a. In 2017, Nora must report only her salary and one-half of the income from community property on her separate return. Because Jim and Nora lived apart for the entire year, she does not have to report one-half of Jim's salary on her separate return. She is required to report her share of the income from the community owned investments.
Calculator Jerry purchased a U.S. Series EE savings bond for $744. The bond has a maturity value in 10 years of $1,000 and yields 3% interest. This is the first Series EE bond that Jerry has ever owned. a. Jerry can defer the interest income until the bond matures in 10 years. b. Jerry must report ($1,000 - $744)/10 = $25.60 interest income each year he owns the bond. c. The interest on the bonds is exempt from Federal income tax. d. Jerry can report all of the $256 as a capital gain in the year it matures. e. None of these choices are correct.
a. Jerry can defer the interest income until the bond matures in 10 years. The original issue discount (OID) on the Series EE bonds is not subject to the OID rules. However, the income is interest, rather than gain from the sale of a capital asset.
Calculator Detroit Corporation sued Chicago Corporation for intentional damage to Detroit's goodwill. Detroit had created its goodwill through providing high-quality services to its customers. Thus, no basis for the goodwill appeared on Detroit's balance sheet. The suit was settled and Detroit received $1,500,000 for the damages to its goodwill. a. The $1,500,000 is taxable because Detroit has no basis in the goodwill. b. The $1,500,000 is not taxable because Detroit settled the case. c. The $1,500,000 is not taxable because Detroit did nothing to earn the money. d. The $1,500,000 is not taxable because it represents a recovery of capital. e. None of these choices are correct.
a. The $1,500,000 is taxable because Detroit has no basis in the goodwill. Detroit had no basis in the goodwill; therefore, the entire amount received is included in gross income.
Calculator Maroon Corporation expects the employees' income tax rates to increase next year. The employees use the cash method. The company presently pays on the last day of each month. The company is considering changing its policy so that the December salaries will be paid on the first day of the following year. What would be the effect on an employee of the proposed change in company policy for paying its salaries beginning December 2017? a. The employee will not be required to recognize the income until it is received, in 2018. b. The employee would be required to recognize the income in December 2017 because the employee has a claim of right to the income when it is earned. c. The employee would be required to recognize the income in December 2017 because it is constructively received at the end of the month. d. The employee can elect to either include the pay in 2017 or 2018. e. None of these choices are correct.
a. The employee will not be required to recognize the income until it is received, in 2018. The cash basis employees do not recognize the income until it is actually or constructively received. If the employer will not pay until January 2018, the employee has not constructively received the income in 2017, nor has the employee received the income under a claim of right in that year.
Under the alimony rules: a. The income is included in the gross income of the recipient of the payments. b. To determine whether a cash payment is alimony, one must consult the state laws that define alimony. c. A person who earns $90,000 and pays $20,000 in alimony is taxed on $90,000 because the $20,000 alimony is income assigned to the former spouse. d. A person who receives a property division has experienced an increase in wealth and thus should be subject to tax. e. None of these choices are correct.
a. The income is included in the gross income of the recipient of the payments.
Harry and Wanda were married in Texas, a community property state, but moved to Virginia, a common law state. The calculation of their income on a joint return: a. Will not change as a result of changing their state of residence. b. Will decrease as a result of changing their state of residence. c. Will increase as a result of changing their state of residence. d. Will not be permitted. e. None of these choices are correct.
a. Will not change as a result of changing their state of residence. All of their income, regardless of whether they live in a common law state or community property state, must be included on their joint return.
With respect to the prepaid income from services, which of the following is true? a. 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 of receipt. b. An accrual 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 of receipt. c. The treatment of prepaid income is the same for tax and financial accounting. d. An accrual basis taxpayer can spread the income over the period services are to be provided on a contract for three years or less. e. None of these choices are correct.
b. An accrual 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 of receipt "The treatment of prepaid income is the same for tax and financial accounting" is incorrect because the tax treatment is based on the income tax provisions, whereas the financial accounting treatment is based on generally accepted accounting principles. "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 of receipt" is incorrect because the cash basis taxpayer recognizes the income in the year of receipt. "An accrual 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 of receipt" is correct because under Revenue Procedure 2004-34 any unearned income at the end of the first tax year must be included in the gross income of the second tax year. "An accrual basis taxpayer can spread the income over the period services are to be provided on a contract for three years or less" is incorrect because there is no three-year provision. The deferral possibilities for services to be provided exist only in the case of accrual basis taxpayers who satisfy the requirements of Revenue Procedure 2004-34.
On November 1, 2017, Bob, a cash basis taxpayer, gave Dave common stock. On October 30, 2017, the corporation had declared the dividend payable to shareholders of record as of November 22, 2017. The dividend was paid on December 15, 2017. The corporation has paid the $1,200 dividend once each year for the past ten years, during which Bob owned the stock. When Dave collected the dividend on December 15, 2017: a. Bob must include $1,000 (10/12 x $1,200) of the dividend in his gross income. b. Bob must include all of the dividend in his gross income. c. Dave must include all of the dividend in his gross income. d. Dave should treat the $1,200 as a recovery of capital. e. None of these choices are correct.
b. Bob must include all of the dividend in his gross income. Dave received the stock as a gift. According to the Tax Court, when the donor makes the gift after the declaration but prior to the record date, the dividend is included in the gross income of the donor.
Calculator On January 5, 2017, Tim purchased a bond paying interest at 6% for $30,000. On March 31, 2017, he gave the bond to Jane. The bond pays $1,800 interest on December 31. Tim and Jane are cash basis taxpayers. When Jane collects the interest in December 2017: a. Jane reports $450 of interest income in 2017, and Tim reports $1,350 of interest income in 2017. b. Jane reports $1,350 of interest income in 2017, and Tim reports $450 of interest income in 2017. c. Tim must include all of the interest in his gross income. d. Jane must report $1,800 gross income for 2017. e. None of these choices are correct.
b. Jane reports $1,350 of interest income in 2017, and Tim reports $450 of interest income in 2017. Tim held the bond for 3 months before he gave it to Jane, who held the bond for the other 9 months that the interest accrued. Therefore, Tim must recognize $450 (3/12 × $1,800), and Jane must recognize $1,350 (9/12 × $1,800).
Mike contracted with Kram Company, Mike's controlled corporation. Mike was a medical doctor and the contract provided that he would work exclusively for the corporation. No other doctor worked for the corporation. The corporation contracted to perform an operation for Rosa for $8,000. The corporation paid Mike $6,500 to perform the operation under the terms of his employment contract. a. Mike must recognize the $8,000 gross income because he provided the service. b. Mike's gross income is $6,500. c. The Kram Company corporation's gross income is $1,500. d. Mike must recognize $8,000 gross income since the patient obviously wanted him to perform the operation. e. None of these choices are correct.
b. Mike's gross income is $6,500. Mike is an employee of Kram Company. Thus, Kram Company is taxed on the $8,000 income from the services provided by Mike to the patient. Mike is taxed on the $6,500 of compensation received from Kram.
On a particular Saturday, Tom had planned to paint a room in his house, but his employer gave him the opportunity to work that day. If Tom works, he must hire a painter for $120. For Tom to have a positive cash flow from working and hiring the painter: a. Tom must earn at least $150 if he is in the 25% marginal tax bracket. b. Tom must earn more than $160 if he is in the 25% marginal tax bracket. c. Tom must earn at least $135 if he is in the 15% marginal tax bracket. d. Tom must earn at least $160 if he is in the 33% marginal tax bracket. e. None of these choices are correct.
b. Tom must earn more than $160 if he is in the 25% marginal tax bracket. If Tom earns $160, he will have after-tax pay of $120 [(1 - .25)($160)], which is equal to what he must pay the painter.
Orange Cable TV Company, an accrual basis taxpayer, allows its customers to pay by the year in advance ($500 per year), or two years in advance ($950). In September 2017, the company collected the following amounts applicable to future services: October 2017-September 2019 services (two-year contracts) $144,000 October 2017-September 2018 services (one-year contracts) 128,000 Total $272,000 As a result of the above, Orange Cable should report as gross income: a. $272,000 in 2017. b. $128,000 in 2017. c. $222,000 in 2018. d. $168,000 in 2018. e. None of these choices are correct.
c. $222,000 in 2018. One-eighth (3/24) of the payments on the two-year contracts were earned (1/8 × $144,000 = $18,000) and one-fourth (1/4 × $128,000 = $32,000) of the payments on the one-year contracts were earned in 2017 and is included in 2017 gross income. The balance of the payments of $222,000 ($272,000 - $18,000 - $32,000) must be included in 2018 gross income.
Daniel purchased a bond on July 1, 2017, at par of $10,000 plus accrued interest of $300. On December 31, 2017, Daniel collected the $600 interest for the year. On January 1, 2018, Daniel sold the bond for $10,200. a. Daniel must recognize $300 interest income for 2017 and a $100 loss on the sale of the bond in 2018. b. Daniel must recognize $600 interest income for 2017 and a $100 loss on the sale of the bond in 2018. c. Daniel must recognize $300 interest income for 2017 and a $200 gain on the sale of the bond in 2018. d. Daniel must recognize $600 interest income for 2017 and a $200 gain on the sale of the bond in 2018. e. None of these choices are correct. Feedback
c. Daniel must recognize $300 interest income for 2017 and a $200 gain on the sale of the bond in 2018. The $600 collected consists of $300 of gross income for the interest earned from July 1 through December 31 and $300 of accrued interest that was purchased. The cost of the bond was $10,000; thus Daniel has a $200 gain ($10,200 - $10,000) on the sale.
Turner, a successful executive, is negotiating a compensation plan with his potential employer. The employer has offered to pay Turner a $600,000 annual salary, payable at the rate of $50,000 per month. Turner counteroffers to receive a monthly salary of $40,000 ($480,000 annually) and a $180,000 bonus in 5 years when Turner will be age 65. a. If the employer accepts Turner's counteroffer, Turner must recognize imputed interest income on the $180,000 to be received in 5 years. b. If the employer accepts Turner's counteroffer, Turner will recognize as gross income $55,000 per month [($480,000 + $180,000)/12]. c. If the employer accepts Turner's counteroffer, Turner will recognize $40,000 income each month for the year and $180,000 in year 5. d. If the employer accepts Turner's counteroffer, Turner will recognize $660,000 at the time the offer is accepted. e. None of these choices are correct.
c. If the employer accepts Turner's counteroffer, Turner will recognize $40,000 income each month for the year and $180,000 in year 5 The constructive receipt doctrine does not apply to the negotiations. Therefore, Turner will include the salary and bonus in his gross income in the tax year received in accordance with the negotiated contract.
The annual increase in the cash surrender value of a life insurance policy: a. Must be included in gross income each year under the original issue discount rules. b. Is taxed when the individual dies and the heirs collect the insurance proceeds. c. Is not included in gross income each year because of the substantial restrictions on gaining access to the policy's value. d. Reduces the deduction for life insurance expense. e. None of these choices are correct.
c. Is not included in gross income each year because of the substantial restrictions on gaining access to the policy's value. The income has not been actually received and, because of the restrictions, is not constructively received.
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 III and IV are true. b. I, II, III, and IV are true. c. Only I and II are true. d. I, II, and III are true, but IV is false. e. None of these choices are true.
c. Only I and II are true. III is false because a person who has the right to income (the assignor) but assigns the rights to another must pay the tax on the income. IV is false because, for example, the assignee of income receives the benefit, but the assignor has the right to the income and therefore must pay the tax on that income.
The tax concept and economic concept of income are in agreement on which of the following: a. The increase in value of assets held for the entire year should be included in income for the year. b. The fair rental value of an owner-occupied home should be included in income. c. Rent income for 2018 collected in 2017 is income for 2017. d. All of these choices are correct.
c. Rent income for 2018 collected in 2017 is income for 2017. The realization requirement applies to taxable income, but does not apply to economic income. The prepaid rent income received in 2017 is included in gross income in that year and is an increase in assets in 2017.
Theresa, a cash basis taxpayer, purchased a bond on July 1, 2013, for $10,000, plus $400 of accrued interest. The bond paid $800 of interest each December 31. On March 31, 2017, she sold the bond for $9,800, which included $200 of accrued interest. a. Theresa has $200 interest income and a $200 gain from the bond in 2017. b. Theresa has a $100 loss from the sale of the bond and no interest income. c. Theresa has $200 interest income and a $400 loss from the bond in 2017. d. Theresa's loss on the sale of the bond is $600. e. None of these choices are correct.
c. Theresa has $200 interest income and a $400 loss from the bond in 2017. The cost of the bond was $10,000 and the proceeds from the sale were $9,600 ($9,800 - $200 accrued interest). Therefore, Theresa had a $400 ($9,600 - $10,000) loss from the sale, and $200 of interest income.
The Green Company, an accrual basis taxpayer, provides business-consulting services. Clients generally pay a retainer at the beginning of a 12-month period. This entitles the client to no more than 40 hours of services. Once the client has received 40 hours of services, Green charges $500 per hour. Green Company allocates the retainer to income based on the number of hours worked on the contract. At the end of the tax year, the company had $50,000 of unearned revenues from these contracts. The company also had $10,000 in unearned rent income received from excess office space leased to other companies. Based on the above, Green must include in gross income for the current year: a. $50,000. b. $0. c. $60,000. d. $10,000. e. None of these choices are correct. Feedback
d. $10,000. The prepaid income from services that will be earned in the following year by Green can be deferred under Revenue Procedure 2004-34. However, the prepaid income from rents is not eligible for deferral.
The Maroon & Orange Gym, Inc., uses the accrual method of accounting. The corporation sells memberships that entitle the member to use the facilities at any time. A one-year membership costs $480 ($480/12 = $40 per month); a two-year membership costs $720 ($720/24 = $30 per month). Cash payment is required at the beginning of the membership period. On July 1, 2017, the company sold a one-year membership and a two-year membership. The company should report as gross income from the two contracts: a. $960 in 2017. b. $180 in 2019. c. $1,200 in 2017. d. $780 in 2018. e. None of these choices are correct.
d. $780 in 2018. The accrual basis taxpayer can prorate the income from services in the first year, but must include the balance of the income on the contract in the following year. Therefore, for the 24-month contract, all of the income was reported by the end of the second tax year. This limited deferral is provided under Revenue Procedure 2004-34. {$40 x 6 + ($720-$180)} = $780.
Freddy purchased a certificate of deposit for $20,000 on July 1, 2017. The certificate's maturity value in two years (June 30, 2019) is $21,218, yielding 3% before-tax interest. a. Freddy must recognize $1,218 gross income in 2017. b. Freddy must recognize $600 (.03 × $20,000) gross income in 2019. c. Freddy must recognize $1,218 gross income in 2019. d. Freddy must recognize $300 (.03 × $20,000 × .5) gross income in 2017. e. None of these choices are correct.
d. Freddy must recognize $300 (.03 × $20,000 × .5) gross income in 2017. The 3% interest rate is applied to the $20,000 original investment in the first year $600 ($20,000 × 3%). The certificate was held for only 6 months in 2017; therefore, the interest income for 2017 is $300 ($600 × 6/12). Answers "Freddy must recognize $1,218 gross income in 2017", "Freddy must recognize $1,218 gross income in 2019", and "Freddy must recognize $600 (.03 × $20,000) gross income in 2019" are incorrect because these answers assume a method of allocating the income that differs from the effective interest method.
With respect to income from services, which of the following is true? a. A cash basis taxpayer can spread the income from a 24-month service contract over the contract period. b. The income is always amortized over the period the services will be rendered by an accrual basis taxpayer. c. If an accrual basis taxpayer sells a 24-month service contract on July 1, 2017, one-half (12/24) the income is recognized in 2018. d. If an accrual basis taxpayer sells a 36-month service contract on July 1, 2017 for $3,600, the taxpayer's 2017 gross income from the contract is $600. e. None of these choices are correct.
d. If an accrual basis taxpayer sells a 36-month service contract on July 1, 2017 for $3,600, the taxpayer's 2017 gross income from the contract is $600. "A cash basis taxpayer can spread the income from a 24-month service contract over the contract period" is incorrect because Revenue Procedure 2004-34 does not apply to cash basis taxpayers. "The income is always amortized over the period the services will be rendered by an accrual basis taxpayer" and "If an accrual basis taxpayer sells a 24-month service contract on July 1, 2017, one-half (12/24) the income is recognized in 2018" are incorrect because they are not in accordance with Revenue Procedure 2004-34.
The annual increase in the cash surrender value of a life insurance policy: a. Reduces the deduction for life insurance expense. b. Is taxed according to the original issue discount rules. c. Is exempt because it is life insurance proceeds. d. Is not included in gross income because the policy must be surrendered to receive the cash surrender value. e. None of these choices are correct.
d. Is not included in gross income because the policy must be surrendered to receive the cash surrender value. The substantial restrictions on gaining access to the policy, the fact the taxpayer must cancel the policy means that the increase in value is not actually or constructively received.
The Blue Utilities Company paid Sue $2,000 for the right to lay an underground electric cable across her property anytime in the future. a. Sue must recognize $2,000 gross income in the current year regardless of whether the company installed the cable during the year. b. Sue must recognize $2,000 gross income in the current year, and when the cable is installed, she must reduce her cost basis in the land by $2,000. c. Sue must recognize $2,000 gross income in the current year if the company did not install the cable during the year. d. Sue is not required to recognize gross income from the receipt of the funds, but she must reduce her cost basis in the land by $2,000. e. None of these choices are correct.
d. Sue is not required to recognize gross income from the receipt of the funds, but she must reduce her cost basis in the land by $2,000. The $2,000 payment results in a reduction of Sue's basis in the land but is not income recognized.
Calculator Teal company is an accrual basis taxpayer. On December 1, 2017, a customer paid for an item that was on hand, but the customer wanted the item delivered in early January 2018. Teal delivered the item on January 4, 2018. Teal included the sale in its 2017 income for financial accounting purposes. a. Teal can elect to recognize the income in either 2017 or 2018. b. Teal must recognize the income in 2018. c. Teal must recognize the income in the year title to the goods passed to the customer, as determined under the state laws in which the store is located. d. Teal must recognize the income in 2017. e. None of these choices are correct.
d. Teal must recognize the income in 2017. Teal received the income before the goods were delivered to the customer. Therefore, when Teal recognizes the income for tax purposes depends upon Teal's financial accounting method.
Calculator Darryl, a cash basis taxpayer, gave 1,000 shares of Copper Company common stock to his daughter on September 29, 2017. Copper Company is a publicly held company that has declared a $2.00 per share dividend on September 30th every year for the last 20 years. Just as Darryl had expected, Copper Company declared a $2.00 per share dividend on September 30th, payable on October 15th, to stockholders of record as of October 10th. The daughter received the $2,000 dividend on October 18, 2017. a. Darryl must recognize $1,500 of the dividend because he owned the stock for three-fourths of the year. b. Darryl must recognize the income of $2,000 because the purpose of the gift was to avoid taxes. c. Darryl must recognize the $2,000 dividend as his income because he constructively received the dividend. d. The daughter must recognize the income because she owned the stock when the dividend was declared and she received the $2,000. e. None of these choices are correct.
d. The daughter must recognize the income because she owned the stock when the dividend was declared and she received the $2,000. The gift of the stock is made prior to the declaration date.
Under the original issue discount (OID) rules as applied to a three-year certificate of deposit: a. All of the income must be recognized in the year of maturity by a cash basis taxpayer. b. The OID will be included in gross income for the year of purchase. c. The interest income will be the same each year. d. The interest income will be greater in the third year than in the first year. e. None of these choices are correct.
d. The interest income will be greater in the third year than in the first year. The OID is amortized using the effective interest rate method. Because the principal amount is increased each year by the amount of the OID which is amortized, the total interest income increases each year. Thus, answers "All of the income must be recognized in the year of maturity by a cash basis taxpayer", "The OID will be included in gross income for the year of purchase", "The interest income will be the same each year", and "None of these choices are correct" are incorrect.
