Unit 21 Quizzes
Most new businesses operate at a loss the first year or so. If several of your clients were forming a group to fund a start-up enterprise but wished to limit their liability and, at the same time, be able to receive favorable tax treatment for the expected losses, you would suggest forming which of the following? A. C corporation B. General partnership C. LLC D. Sole proprietorship
Answer: C. The only way to limit liability is through a corporation (C or S), LLC, or limited partnership. The LLC, choice C, allows for the flow-through of operating losses to the shareholders while the C corporation does not.
****Tricky** An investor purchases 100 shares of a stock at $100 per share on January 1. On the following July 1, the shares are sold for $120 per share. The tax consequences are A) $2,000 long-term loss B) $2,000 short-term loss C) $2,000 long-term gain D) $2,000 short-term gain
D THE FOLLOWING JULY Because the holding period did not exceed one year, the gain is considered short term for tax purposes.
*****An investor who would like to increase current income from investments and, at the same time, pay taxes on that income at *less than his marginal tax rate*, would probably find which of the following to be most suitable? A. U.S. Treasury bonds B. Public utility stock C. Growth stock D. Money market mutual fund
*******B The key to this question is that dividends paid on stock issued by American companies generally qualify for a reduced tax rate. No such benefit accrues to money market funds (their dividends are generated from interest income) and government bond interest is always taxed as ordinary income (although state income tax free). The dividends on a growth stock would also qualify, but, because the question deals with increasing current income, public utility, choice B, is a more sensible approach.
A Schedule K-1 would be received by an individual with an ownership interest in all of the following except A) a C corporation. B) an LLC. C) a partnership. D) an S corporation.
A C corporations pay tax on their earnings; the other business types listed here flow through the income to their owners. The owner's share of income (or loss) is reported to them on the Schedule K-1. A shareholder in a C corporation who receives dividends will have that reported on a Form 1099.
An investor purchases 500 shares of stock on January 10, 2020, at $50 per share and sells it on August 4 of the following year for $40 per share. As a result, the investor has realized A) a short-term capital loss B) a short-term capital gain C) a long-term capital gain D) a long-term capital loss
D Purchased on August 4 OF THE FOLLOWING YEAR the holding period was more than a year and a half, the loss is long term.
************Jean owns a $1 million life insurance policy on her mother, Clara. Jean is named as sole beneficiary, and so far she has paid $150,000 in premiums. If Clara dies, which of the following will occur? I The proceeds will be exempt from income tax. II $850,000 of the proceeds will be subject to income tax. III The proceeds will be included in Clara's estate for estate tax purposes. IV The proceeds will not be included in Clara's estate. A) II and IV B) II and III C) I and IV D) I and III
***********C Life insurance proceeds are generally free from income taxes and will be free from estate taxes, if the insured possesses no incidence of ownership. In other words, a beneficiary other than the deceased's estate has been named, and the owner is someone other than the insured.
Which of the following statements regarding grantor trusts is NOT correct? A) The grantor may be taxed on trust income only if the grantor actually received the income. B) If the grantor has the power to revoke the trust, he is treated as the owner of the trust. C) If the grantor can control the beneficial enjoyment of the trust, he is treated as the owner of the trust. D) If the grantor can receive income from the trust, he is treated as the owner of the trust.
A As long as the grantor has the power directly or indirectly to control the trust, he is treated as the owner. The grantor may be taxed on trust income if the grantor either actually or constructively receives the income.
***An individual purchased a variable life insurance policy 10 years ago with a guaranteed death benefit of $100,000. The annual premium for this policy was $2,000 per year. The individual dies and, due to outstanding performance of the separate account, leaves a death benefit to the beneficiary of $121,000. What are the income tax consequences to that beneficiary? A) There is a long-term capital gain of $1,000. B) No tax is due. C) Ordinary income tax is due on $21,000. D) Ordinary income tax is due on the $1,000 that exceeds the original cost.
B *One of the nice things about life insurance proceeds is that even when the death benefit is increased due to separate account performance, it is still free of income tax.*
It would be least likely for dividends paid on which of the following investments to meet the requirements to be considered qualified? A) Equity mutual funds B)Bond mutual funds C)Common stock D) Preferred stock
B Qualified dividends are those eligible for reduced income tax rates. Those rates can be as low as 0% and as high as 23.8%, with most falling within the 15% or 20% bracket. We don't expect the exam to test on the requirements for a dividend to be considered qualified or how you reach that 23.8% rate. *Dividends on bond funds and money market funds are not qualified because the majority of those dividends represent interest earned by the fund and the tax break does not apply to earnings from interest.*
*********The term "earned income" would include A) death benefit from a variable annuity policy. B) death benefit from a variable life insurance policy. C) alimony received as part of a divorce decree executed on January 15, 2019. D) a bonus paid as a result of your division exceeding its goals.
************D The IRS defines earned income as wages, salaries, tips, and other taxable employee pay, such as bonuses. *****The death benefit from a variable annuity policy is taxed as ordinary income, but is not earned. The death benefit from a variable life insurance policy is generally free of income tax so it cannot be earned income. ***** Under the TCJA of 2017, alimony received from a divorce decree dated January 1, 2019 or later is not earned income.
****Your client purchased 1,000 shares of ABC common stock on February 28, 2017. When would that purchase qualify for long-term capital gain or loss treatment? A) March 1, 2018 B) February 29, 2018 C) March 1, 2017 D) February 28, 2018
****A Only 28 days in February?!?! The best way to compute this is to add 1 day to the purchase and then that same date, 12 months in the future. Adding one day to February 28, 2017 is March 1, 2017. Twelve months later is March 1, 2018.
****Your daughter is getting married and, to celebrate, you give her fiancé a beautiful watch that you purchased for $5,575. What are the tax consequences of this gift? A) No tax B) The fiancé would have to report this as ordinary income. C) Because they are not yet married, the fiancé is not actually a family member, so a gift tax would be levied. D) Anything over the FINRA gift limit of $100 per person per year would be considered taxable.
****A This very nice gift falls well within the annual exclusion, so no gift tax would be levied.(15K exclusion) As far as FINRA or the states, first of all, there is no indication that he is a client; and, even if so, the rules do permit gifts without concern for the $100 limit in a circumstance like this.
****Which of the following offers the opportunity to realize a capital gain rather than ordinary income? A) Deferred annuities B) Stock dividends C) Cash dividends D) Section 529 plans
****B Stock dividends, unlike cash dividends, are not taxable in the year of receipt. Instead, they reduce the owner's cost basis and, when sold at a price above that cost basis, are treated as capital gain rather than ordinary income. Deferred annuities never generate anything but ordinary income, and qualified withdrawals from Section 529 plans result in no taxation on the earnings. If they are not qualified, there is ordinary income tax plus a penalty.
***One of your ultra-high net worth clients would like to give some low cost basis stock as gifts to her adult grandchildren. It would be prudent for you to tell her that A) it would be wise for her to use a TOD account to avoid probate. B) making the gift under the Uniform Transfer to Minors Act is generally the most advantageous for the child. C) for purposes of the gift tax, her cost basis will be used. D) unlike an inheritance, there is no stepped-up cost basis.
****D D The grandma client will not be the one subject to capital gains tax One of the benefits of inheriting low cost basis securities is the stepped-up basis and that does not apply to gifts. Although the donor will not be the one subject to capital gains tax, it would be the right thing to do to let her know that the donees (her grandchildren) will be receiving the stock at her cost basis. TOD would not apply to stock that is the subject of a gift; it is only when the stock remains in the grandmother's name and has been designated for the grandchildren after her death. When computing the value of a gift to determine if there is a gift tax obligation, it is the fair market value of the gift that is used. Finally, the question states these are adult grandchildren - UTMA would not apply to them.
****Bruno and Griselde have been married for 56 years. Bruno passes away in 2019 and leaves his entire estate of $10 million to his wife. During his lifetime, Bruno had used $2.2 million of his lifetime gift exclusion. Upon Griselde's death 2 years later, the estate is worth $22.2 million. The gross taxable estate is A. $0 B. $1.6million C. $2million D. $11million
***Answer: B. Because Bruno used $2.2 million, his estate tax exclusion is now $9.2 million. The portability provisions all that to be added to her exclusion making the total $9.2 million ($9.2 + $11.4 = $20.6 million). With a gross value of $22.2 million and a remaining exclusion of $20.6 million, before any deductions, the gross taxable estate is $1.6 million, choice B.
**After receiving some money from an inheritance, an individual purchases a rare gold coin for $10,000. Five years later, he gives the coin to his daughter-in-law after receiving an appraisal showing the coin is worth $15,000. The daughter-in-law's cost basis of the coin is A) $0.00. B) $15,000. C) $5,000. D) $10,000.
**D When a gift is made of an asset, whether it be a security or a collectible, the donor's cost basis passes to the donee. In this case, the original cost is $10,000 and that becomes the cost basis for the daughter-in-law and is used to determine a gain or loss when that coin is sold. Do not confuse this with the annual gift tax exclusion. Because the value of the gift did not exceed $15,000, the donor has no gift tax obligation, but that is completely different from the daughter's cost basis.
Earned income: includes salary, bonuses, tips, and income derived from active participation in a trade or business. Alimony: is payment made under a (divorce) court order to an ex-spouse. - Before December 31, 2018 person paying alimony can deduct it from from taxes and person receiving must report as income - After January 1, 2019 no deduction or declaration of income Child Support: Not deductible or reported as income Passive income and losses: come from rental property, limited partnerships, and enterprises (regardless of business structure) in which an individual does not actively participate. - Passive income is netted against passive losses....taxed at ordinary income rates. Portfolio income: includes dividends, interest, and net capital gains derived from the sale of securities. Dividend Income: If the dividend qualifies, the tax rate is generally a maximum of 15%. Otherwise, the dividend is taxed at ordinary income rates. - assume that any dividend from a U.S. corporation, including stock mutual funds, is qualified, unless the question states otherwise. Interest: on any debt security (other than tax-free municipal issues) is always taxed at ordinary income rates. - income distributions from bond funds are not qualified dividends and are taxed fully as ordinary income. Although interest income from municipal bonds is tax free, capital gains are fully taxable. -This is also true of capital gains distributions from municipal bond mutual funds. Foreign securities, including ADRs, is normally subject to withholding tax, typically about 15%, by the issuer's country of domicile. Current U.S. tax law allows many investors to reclaim the withheld tax as a credit against taxes owed on their tax returns Stocks and bonds normally pay dividends and interest in cash, (taxable in the year of receipt), and the investor only realizes a capital gain or loss when the investment is sold. Taxation on Distributions: Stocks and bonds normally pay dividends and interest in cash, (taxable in the year of receipt), and the investor only realizes a capital gain or loss when the investment is sold. - distributions are taxable to shareholders whether the distributions are taken in cash or reinvested. Dividend Reinvestment Plans (DRIPS): They are taxed in the yearof receipt as is any cash dividend. However, the amount of reinvested dividends increases the investor's cost basis, thereby reducing the amount of capital gains if the position is later sold at a profit. - Taxes have already been paid on any income reinvested, when the investor sells the asset, the cost basis is increased so that the income is not taxed again. Retirement Plan Distributions: Qualified retirement plan distributions are, with few exceptions, taxed at the investor's ordinary income tax rate when funds are withdrawn from the plan. Margin interest is a tax-deductible expense: - IRS does not allow taxpayers to deduct the margin interest expenses for municipal securities Effective Tax Rate: overall rate of tax you pay on your total taxable income. - Ex) total tax bill would be $42,449 + (35% × $50,000) or $42,449 + $17,500, which is a total tax of $59,949. That means that out of $250,000 in income, slightly less than 24% of it ($59,949 divided by $250,000) went to pay tax. Stock Dividends: When the securities are sold, the holding period is based upon the original purchase date Effects of Reinvesting on Cost Basis for Computing Capital Gains/Losses: - distributions received, whether taken in cash or reinvested, were reported on the Form 1099 as taxable for that year. - because they have already been taxed, when a sale takes place, they are not taxed again—the amount reinvested adds to the investor's tax basis (or cost). Capital Loss Earned Income Deduction: - Capital losses that exceed capital gains are deductible against earned income up to a maximum of $3,000 per year. Any capital losses not deducted in a taxable year may be carried forward indefinitely as a deduction to offset capital gains in future years. Determine which shares to sell: first in, first out (FIFO): the cost of the shares held the longest is used to calculate the gain or loss. - In a rising market, this method normally creates adverse tax consequences. share identification: investor keeps track of the cost of each share purchased and uses this information to liquidate the shares that would provide the lowest capital gain average cost basis: when redeeming mutual fund shares (but not shares of specific stocks). Wash Sale: taxpayer sells a security at a loss and purchases the same or a substantially identical security within 30 days before or after the trade date establishing the loss. Ex) Investor buys 100 shares of ABC for $50 per share. One year later, the investor sells the shares for $40 per share. Fifteen days after the sale, 100 shares of ABC are repurchased for $42 per share. The investor's new cost basis is $52 per share because the $10 loss that was disallowed is added to the repurchase price of $42. - ADD THE LOSS FROM THE WASH SALE TO NEW COST BASIS Sale of a Primary Residence: - Needs to be primary residence for at least two of the past five years - For a couple, the first $500,000 in profit is excluded from capital gains taxation; for a single person, it is the first $250,000. - Remaining profit is taxed as a long term capital gain Income Tax Implications of Life Insurance: - proceeds from life insurance policies made to a beneficiary are exempt from federal income tax. Estate Tax to Owning Insurance: In light of the estate tax implications, it is frequently best that a party other than the insured own the life insurance policy Policy Loans: When you borrow cash value from your life insurance policy, the funds received are nontaxable. This is the same as any other borrowed money—it isn't your money and must be paid back at some time in the future. Policy Surrender: If a variable life insurance policy is surrendered, any cash value in excess of the basis in the policy (the premiums paid) is taxable as ordinary income. Withdrawal of Cash Value: If there is a partial withdrawal of cash value from a variable life insurance policy, the FIFO rules apply. This is unlike the LIFO treatment on an annuity. Therefore, there are no tax consequences until the amount withdrawn exceeds the cost basis in the policy. Trust Tax Rates: - In the case of non-distributed income, the tax consequences can be quite severe Distributable Net Income (DNI): - Because of severe tax implications described previously, most trusts and estates distribute their income. - DNI determines the amount of income that may be taxable to beneficiaries (or the grantor in the case of a revocable trust), whereas the balance may be taxed to the trust as indicated previously. If the trust is revocable, all income, whether distributed or not, is taxed to the grantor.
**DRIP (dividend reinvestment plan) An investor purchases 100 shares of DERP common stock at $50 per share and elects to have all cash dividends reinvested through the DRIP being offered by DERP. After holding the stock for 5 years, the investor has reinvested $1,200 and acquired 20 additional shares. If the market price of DERP is $55 per share and the investor liquidates the position, the tax consequence will be A. a loss of $700 B. a gain of $400 C. again of $600 D. again of$1,600 Adjusted Gross Estate Example: Caroline, who is unmarried, died in 2019, owning various property. The amountof her gross estate is $18 million. However, her estate incurred $20,000 in funeral expenses, she had made charitable gifts of $1,000,000, and she owed mortgages of $200,000 and $30,000 in credit card balances. Thus, her AGE is $16,750,000. In 2019, because of an estate tax credit that exempted the first $11,400,000 of property transferred after death, Caroline's estate will be taxed on the remaining $5,350,000 in transferred property.
Which of the following is not included in adjusted gross income on an individual's federal income tax return? A) State income tax refunds B) Stock dividends C) Income from a sole proprietorship D) Wages and tips
B Stock dividends (dividends paid as additional shares of stock rather than in cash) adjust the investor's cost basis and don't come into play until the stock is sold.
Using industry jargon, the tax on the last dollar of income is at A) the effective rate B) the marginal rate C) the final rate D) the average rate
B The IRS defines marginal tax rate as "the highest rate that you will pay on your income." Basically, as you make more money, you pay tax at a higher rate incrementally. The effective tax rate is the average that you pay on all of your income.
Sally Sherman purchased 100 shares of Chocolate Manufacturers Corporation for $19 per share on February 12. She received a 10% stock dividend on May 18. She sold all of her CMC at $13 per share in June of the same year. What were her tax results? A) $575 short-term loss; $105 long-term gain B) $575 long-term gain, $105 short-term loss C) $470 short-term loss D) $575 long-term loss
C Sally paid $1,900 for 100 shares and sold 110 shares for $1,430 (13 at 110). Because the transactions all took place in less than a year, the transaction was a short-term loss.
You have a client who was divorced 3 years ago, maintains a home, and has custody of the children. More than likely, the most advantageous tax filing status for your client is A) single. B) joint. C) head of household. D) divorced parent.
C When qualifying for head of household status (the technical qualifications are beyond the exam), the individual has the lowest tax burden. There is no such status as "divorced parent" and one cannot file jointly unless married. Filing as a single carries the highest tax burden. (Joint would have lowest if you qualify)
One of your ultra-high net worth clients has extensive real estate holdings and is concerned about his children being forced to liquidate some of them in order to pay the estate taxes after his death. One tool that could be suggested to solve this problem would be A) registering the properties as JTWROS. B) placing the properties into a living trust. C) using a TOD account. D) purchasing a life insurance policy using an ILIT.
D Estate taxes must be paid within 9 months of death. If the client doesn't want to have to liquidate his real estate holdings, then another source for the tax payment must be found. A frequently-used tool is the irrevocable life insurance trust (ILIT) where a policy is purchased on the life of the client, but owned by the trust. When properly structured, this means that the death benefit is not included in the estate and passes tax free to the beneficiaries. Those funds can then be used to pay the estate taxes and the real estate assets pass to the beneficiaries. A living trust won't work because the only way the policy's proceeds aren't considered part of the estate is when the trust is irrevocable. TOD and JTWROS avoid probate, but do not avoid estate taxes.
Which of the following is federally tax exempt for a corporation? A) Preferred stock dividends B) Foreign corporate stock dividends C) Capital gains D) Municipal bond interest
D Municipal bonds are tax exempt for corporations, as well as for individuals. Preferred stock dividends are taxable but at a reduced rate for corporations due to the 50% dividend exclusion. That break does not apply to the dividends on foreign securities. Regardless of the security, capital gains are taxable.
One of your clients runs a small business, currently organized as a sole proprietorship. Among the primary reasons why the client might consider changing to an LLC is A) reducing paperwork B) changing the due date of his tax filing C) prestige D) limiting his personal liability
D The Ls in LLC stand for limited liability. As a sole proprietor, all your personal assets are exposed to the creditors of the business. With an LLC, there is no personal liability. As it happens, a one-member LLC (as this question indicates would be the case) is treated the same as a sole proprietorship for the tax filing due date. There would be slightly more paperwork involved with an LLC.
The gain on the sale of a security held as an investment will be treated as a long-term capital gain if the security was held for A) more than 6 months B) more than 3 months C) more than 1 month D) more than 12 months
D The sale of a capital asset will result in a long-term capital gain only if the asset was held for more than 12 months. In other words, the holding period for long-term capital gains is 12 months.
