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EA Exam Review

Course
Part II: Business,
Retirement Plans, and
Exempt Organizations

Mission Statement
NATP is a partner for all tax professionals in helping them achieve
business success through education, resources, and other services
pertinent to the tax preparation business.

Continuing Education Credits


Because this is a course designed to prepare you to take the IRS exam,
the IRS does not approve the course for Enrolled Agent continuing
education credit. Those individuals requiring CPE credit in compliance
with NASBA or ACAT reporting requirements can go to NATPs website
at www.natptax.com or call 800.558.3402, ext. 3 for more information.

Who We Are
Members of the National Association of Tax Professionals (NATP) work
at offices that assist over 11 million taxpayers with tax preparation and
planning. NATP is a nonprofit professional association founded in 1979
that provides professional education, tax research, and products to its
members. The national headquarters, located in Greenville, WI,
currently employs over 40 staff members and 25 instructors.
NATP exists to serve professionals who work in all areas of tax practice
and has more than 19,000 members nationwide. Members include
individual tax preparers, enrolled agents, certified public accountants,
accountants, attorneys, and financial planners. The average NATP
member has been in the tax business for over 20 years and holds a
tax/financial designation and/or a college degree. Learn more at
www.natptax.com.

2010 NATP EA Exam Review Course, Part II

Our Commitment to You


This text has been prepared with due diligence; however, the possibility
of mechanical or human error does exist. Any known corrections for this
text will be posted on NATPs website at www.natptax.com. The text is
not intended to address every situation that may arise. Consult
additional sources of information, as needed, to determine the solution
of tax questions.
This publication is designed to provide accurate and authoritative
information on the subject matter covered. It is presented with the
understanding that the National Association of Tax Professionals is not
engaged in rendering legal or accounting services.

COPYRIGHT 2010. The National Association of Tax Professionals (NATP), Appleton, WI.
Reprinting any part of this text without written permission from NATP is prohibited.

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2010 NATP EA Exam Review Course, Part II

Course Description
This text is designed to help the attendee pass Part II of the Special
Enrollment Examination (SEE), with an emphasis on business income
tax returns, estate and trust income tax returns, retirement plans, and
exempt organizations.

Objectives
Upon completion of this seminar, the tax professional will:
Comprehend the primary areas tested in Part II.
Be knowledgeable in the tax theory for sole proprietors,
partnerships, corporations, trusts, and tax-exempt organizations.
Analyze the question being asked and compare the facts of the
question to the theory being applied to select the most appropriate
answer to the question.
Distinguish various requirements and limitations as applied to a wide
variety of tax topics.
Assimilate the theory to explain such requirements and limitations to
tax clients in tax planning situations and in the completion of income
tax returns.
Evaluate the clients information to properly apply taxation principles
to that clients situation.

Introduction
Part II of the exam covers businesses income tax filing, estates and
trusts income tax filing, retirement plans, and tax-exempt
organizations. The exam consists entirely of multiple choice questions.
The format of the questions may be a direct question, an incomplete
sentence (such as wages do not include:), or items that may be all of
the following except. Each question will have four options from which
to select the most appropriate answer. Each section of the text is
followed by an exam that consists of questions from prior exams or
developed based on the theory being tested.

2010 NATP EA Exam Review Course, Part II

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Study Materials
The official answers are based on the code and regulations. Generally,
the publications reflect the code and regulations and will be sufficient
for study purposes.
The following publications will be helpful in preparing for Part II of the
exam:
Publication 15
Circular E Employers Tax Guide
Publication 15-A Employers Supplemental Tax Guide
Publication 15-B Employers Tax Guide to Fringe Benefits
Publication 17
Your Federal Income Tax
Publication 225 Farmers Tax Guide
Publication 334 Tax Guide for Small Business
Publication 463 Travel, Entertainment, Gift, and Car Expenses
Publication 510 Excise Taxes
Publication 535 Business Expenses
Publication 536 Net Operating Losses
Publication 538 Accounting Periods and Methods
Publication 541 Partnerships
Publication 542 Corporations
Publication 544 Sales and Other Dispositions of Assets
Publication 547 Casualties, Disasters, and Thefts Business and
Non-Business
Publication 550 Investment Income and Expenses
Publication 551 Basis of Assets
Publication 553 Highlights of 2009 Tax Changes
Publication 557 Tax-Exempt Status for Your Organization
Publication 560 Retirement Plans for Small Business
Publication 925 Passive Activity and At-Risk Rules
Publication 946 How to Depreciate Property
Publication 1635 Understanding Your Employer Identification Number
Form 1065 and Instructions
Form 1120 and Instructions
Form 1120S and Instructions
Form 1041 and Instructions
Form 2290 and Instructions
Form 3468 and Instructions
Form 3800 and Instructions
Form 5884 and Instructions
Form 6765 and Instructions
Form 8826 and Instructions

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2010 NATP EA Exam Review Course, Part II

The following is a breakdown of Part II examination topics as listed on


http://www.prometric.com/IRS/default.html.
Examination Topics
PART 2 - BUSINESSES
Section 1: Businesses (45 items)
Business entities
Types of business entities and their filing requirements:
Sole proprietorships
Partnerships
Corporations
S corporations
Farmers
LLCs
Tax-exempt companies and associations
Elections for type of entity
Employer identification number
Accounting periods (tax year)
Accounting methods
Partnerships
Partnership income, expenses, distributions, and flow-through (e.g, selfemployment income)
Family partnerships
Partner's dealings with partnership (e.g., exchange of property, guaranteed
payment, contribution of property to partnership)
Basis of partner's interest
Disposition of partner's interest
Corporations in general
Filing requirements and due dates
Earnings and profits
Shareholder dividends (definition and reporting requirements)
Special deductions (e.g., dividends received deductions, charitable deduction).
Reconciling books to return (e.g., Schedule M series)
Distributions and recognition requirements
Liquidations and stock redemptions
Forming a corporation
Services rendered to a corporation in return for stock
IRC section 351 exchange
Transfer of money or property; receipt of money or property in addition to the
stock of that corporation
Mortgaged property transferred
Exchange of property other than a IRC section 351 exchange
Controlled groups
Closely held corporations
Personal service corporations (e.g., 35% rate)
S corporations
Requirements to qualify including election procedure (e.g, Form 2553 election ,
attachment to return)
Tax law related to S corporation
Treatment of distributions

2010 NATP EA Exam Review Course, Part II

Shareholders basis (e.g, loan basis)


Status (e.g., terminated and reinstated)
Debt discharge
Non-cash distributions
Section 2: Business Financial Information (40 items)
Business income
Gross business income
Cost of goods sold (e.g., inventory practices, expenditures included, uniform
capitalization rule)
Net income, net operating losses, and loss limitations including passive activity
and at risk limitations
Gain or loss on disposition of depreciable property
Business expenses, deductions and credits
Employees pay (e.g., deductibility of compensation, fringe benefits, rules of
family employment, statutory employee, necessary and reasonable)
Reporting requirements for company employees (W-2, W-4, Form 1099)
Business rental deduction
Depreciation, amortization, IRC section 179, and depletion
Business bad debts
Business travel, entertainment, and gift expenses
Interest expense
Insurance expense
Taxes (e.g., deductibility of taxes, assessments, and penalties; proper
treatment of sales taxes paid)
Employment taxes
Federal excise tax
Casualties, thefts, and condemnations
IRC section 199 deduction (domestic production activities)
Eligibility and deductibility of general business credits (e.g., welfare-to-work
credit, disabled access credit, investment credit)
Business assets
Basis of assets
Disposition of depreciable property
Like kind exchange
Analysis of financial records
What type of business (e.g., service, retail, manufacturer, or farm)
Income statement
Balance sheet
Method of accounting (e.g., accrual, cash, hybrid, OCBOA)
Depreciation and amortization
Depreciation recovery (e.g., recapture, Sec 280F)
Determination of basis of assets
Shareholder/partner basis
Pass-through activity (e.g., K-1)
Proofing beginning and ending balances
Reconciliation of tax versus books (e.g., M-1, M-2)
Related party activity
Advising the business taxpayer
Filing obligations (e.g., extended returns)

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2010 NATP EA Exam Review Course, Part II

Depositing obligations (e.g., employment tax, excise tax)


Reporting obligations for businesses (e.g. IRC sections 1099 and 1031
exchanges)
Record-keeping requirements (mileage log, cell phone usage, accountable
plans)
Related party transactions
Definitions of business entities
Client habits (e.g., personal usage of business accounts, separation of business
and personal accounts)
Benefits and detriments of choosing each type of business entity
Advice on accounting methods and procedures (e.g, explanation of
requirements)
Transfer elections in or out of the business (e.g., contributed property,
distributions)
Life cycle of the business (e.g., startup, decline)
Type of industry (e.g., personal service corporation)
Section 3: Specialized Returns and Tax Payers (15 items)
Trust and estate income tax
Trust types (e.g., grantor, irrevocable, tax shelters)
Distributable net income
Exclusions and deductions
Fraudulent trusts
Income in respect of a decedent
Exempt organizations
Filing requirements (e.g., 1023, 1024, Annual 990)
Qualifications for tax-exempt status (e.g., 501(c)(3))
Retirement plans
Employer contributions
Employee contributions and reporting requirements
Plans for self-employed persons
Prohibited transactions
Qualified plans
SEP and SIMPLE
Farmers
Farm inventory
Depreciation for farmers (e.g., special use)
Various disaster-area provisions
Disposition of farm real estate
To download IRS Forms, Instructions and Publications, click on the following link:
http://www.irs.gov/taxpros/agents/article/0,,id=163346,00.html

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2010 NATP EA Exam Review Course, Part II

Table of Contents
BUSINESS ENTITIES .......................................................................... 1
GENERAL INFORMATION ................................................................... 1
Sole Proprietorship .................................................................. 1
Partnership............................................................................. 1
Corporation ............................................................................ 3
Limited Liability Company ......................................................... 4
EMPLOYER IDENTIFICATION NUMBER ..................................................... 5
EMPLOYEE OR INDEPENDENT CONTRACTOR .............................................. 7
BOOKS AND RECORDS ..................................................................... 9
ACCOUNTING PERIODS ................................................................... 10
Calendar Year ....................................................................... 10
Fiscal Year ............................................................................ 10
Short Tax Year ...................................................................... 11
ACCOUNTING METHODS ................................................................. 11
Cash Method ........................................................................ 12
Accrual Method ..................................................................... 13
Hybrid Method ...................................................................... 15
Inventories ........................................................................... 16
Change in Accounting Method ................................................. 17
CAPITAL EXPENSES ....................................................................... 19
BASIS OF ASSETS ........................................................................ 20
Cost Basis ............................................................................ 20
Basis Other Than Cost ............................................................ 21
S Corporation Stock ............................................................... 23
BASIS REFERENCE CHART ............................................................... 25
BUSINESS ENTITIES TEST .................................................................. 26
BUSINESS ENTITIES ANSWERS ............................................................ 32
INCOME, LOSS, AND EXPENSES ........................................................... 35
INCOME .................................................................................... 35
Business Income ................................................................... 35
Prepaid Income ..................................................................... 38
Items Not Considered Income ................................................. 39
EXPENSES ................................................................................. 40
Cost of Goods Sold ................................................................ 40
Inventories ........................................................................... 42
Business Expenses ................................................................ 47
Depreciation, 179 Deduction, Amortization, and Depletion ......... 79
NET OPERATING LOSSES .............................................................. 107
Determining the NOL ........................................................... 109

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When to Use an NOL ............................................................ 109


REPORTABLE TRANSACTIONS .......................................................... 112
INCOME, LOSS, AND EXPENSES TEST ................................................... 113
INCOME, LOSS, AND EXPENSES ANSWERS ............................................. 133
SALES, EXCHANGES, CREDITS, FARMING, AND SE TAX .............................. 141
SALES AND OTHER DISPOSITIONS .................................................... 141
General Information ............................................................ 141
LIKE-KIND EXCHANGE ................................................................. 142
Other Nontaxable Exchanges ................................................ 147
Other Transfers ................................................................... 148
REPORTING GAINS AND LOSSES ...................................................... 152
Depreciable Property ........................................................... 153
BUSINESS CREDITS .................................................................... 157
General Business Credit ....................................................... 157
Credits For Which Separate Limit Applies ................................ 164
SPECIAL RULES FOR FARMING ........................................................ 168
Farm Income ...................................................................... 168
Farm Income Averaging ....................................................... 174
Farm Expenses ................................................................... 175
Employment Tax Responsibilities ........................................... 177
SELF-EMPLOYMENT TAX ............................................................... 178
Self-Employment Income ..................................................... 179
SALES, EXCHANGES, CREDITS, FARMING, AND SE TAX TEST ....................... 181
SALES, EXCHANGES, CREDITS, FARMING, AND SE TAX ANSWERS .................. 195
PARTNERSHIPS ............................................................................ 203
FORMING A PARTNERSHIP ............................................................. 203
Family Partnerships ............................................................. 203
Partnership Agreement......................................................... 205
Contributions of Property ...................................................... 206
Contribution of Services ....................................................... 207
EXCLUSION FROM PARTNERSHIP RULES.............................................. 208
TAX YEAR ................................................................................ 209
Exceptions.......................................................................... 210
TERMINATING A PARTNERSHIP ........................................................ 212
Converting to LLC ................................................................ 212
PARTNERSHIP DISTRIBUTIONS ........................................................ 213
Partners Gain or Loss .......................................................... 214
Partners Basis for Distributed Property .................................. 215
Partners Dealings with Partnership ........................................ 216
Sale or Exchange of Property ................................................ 217
Guaranteed Payments .......................................................... 218
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2010 NATP EA Exam Review Course, Part II

FORM 1065 ............................................................................. 219


Penalties ............................................................................ 220
Electronic Filing ................................................................... 221
INCOME OR LOSS ....................................................................... 222
Partnership......................................................................... 222
Uniform Capitalization .......................................................... 225
Distributive Share ............................................................... 226
Reporting Distributive Share ................................................. 228
Schedules L, M-1, M-2, and M-3 ............................................ 228
PARTNER PROVISIONS ................................................................. 229
Basis of Partners Interest..................................................... 229
Limits on Losses .................................................................. 232
Partners Exclusion and Deductions ........................................ 233
DISPOSITION OF A PARTNERS INTEREST ............................................ 234
Sale, Exchange, or Other Transfer ......................................... 235
Liquidation of Partners Interest............................................. 236
PARTNERSHIP TEST ....................................................................... 239
PARTNERSHIP ANSWERS .................................................................. 257
CORPORATIONS ............................................................................ 265
GENERAL REQUIREMENTS .............................................................. 265
Personal Service Corporation ................................................ 265
Paying and Filing Income Taxes ............................................. 266
Accounting Methods and Periods ............................................ 270
TRANSFERS TO A CORPORATION ...................................................... 270
Exchange of Property for Stock ............................................. 271
Stock for Services ............................................................... 273
BASIS RULES ON PROPERTY TRANSFERS ............................................. 275
Transferor .......................................................................... 275
Corporation ........................................................................ 275
Capital Contributions ........................................................... 276
Bond Premiums ................................................................... 277
PREOPERATIONAL EXPENSES .......................................................... 278
Start-Up Costs .................................................................... 278
Organizational Costs ............................................................ 278
Amortization ....................................................................... 279
INCOME AND DEDUCTIONS ............................................................ 280
Below-Market Loans ............................................................ 280
Charitable Contributions ....................................................... 280
Dividends-Received Deduction............................................... 283
LOSSES .................................................................................. 285
Capital Losses ..................................................................... 285
Net Operating Loss .............................................................. 286

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Passive Losses .................................................................... 288


At-Risk Limits ..................................................................... 288
CORPORATE TAX ........................................................................ 289
Tax Rates ........................................................................... 289
Credits ............................................................................... 290
Alternative Minimum Tax ...................................................... 291
Accumulated Earnings Tax .................................................... 292
CORPORATE EARNINGS AND PROFITS ................................................ 293
Schedule M-3...................................................................... 295
DISTRIBUTIONS ......................................................................... 295
Money or Property Distributions............................................. 295
Distributions of Stock or Stock Rights ..................................... 296
Constructive Distributions ..................................................... 297
Reporting Dividends and Other Distributions ........................... 298
LIQUIDATIONS .......................................................................... 299
CONTROLLED GROUPS ................................................................. 301
RELATED PERSONS AND CONSTRUCTIVE OWNERSHIP .............................. 303
SHAREHOLDER BASIS .................................................................. 306
REPORTABLE TRANSACTIONS .......................................................... 306
CORPORATION TEST ...................................................................... 307
CORPORATION ANSWERS ................................................................. 331
S CORPORATIONS ......................................................................... 343
ELIGIBLE CORPORATIONS.............................................................. 343
Requirements for S Corporation Status ................................... 343
Other Shareholder Options ................................................... 345
Electing S Corporation Status ................................................ 347
BASICS OF S CORPORATIONS ......................................................... 350
Pass-Through Entity............................................................. 350
FORM 1120S ........................................................................... 351
General Instructions ............................................................ 351
Penalties ............................................................................ 352
Electronic Filing ................................................................... 353
Accounting ......................................................................... 354
Income and Expense Items ................................................... 355
S Corporation Taxes ............................................................ 358
BASIS .................................................................................... 362
Stock Basis......................................................................... 362
Loan Basis .......................................................................... 363
At-Risk Limitations .............................................................. 364
Passive Activity Limitations ................................................... 365
ACCUMULATED ADJUSTMENTS ACCOUNT (AAA) .................................... 366
DISTRIBUTIONS ......................................................................... 367

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2010 NATP EA Exam Review Course, Part II

TERMINATION ........................................................................... 369


Terminating S Corporation Status .......................................... 369
Ceasing to Qualify ............................................................... 369
Termination of a Shareholders Interest .................................. 370
S CORPORATION TEST .................................................................... 371
S CORPORATION ANSWERS .............................................................. 385
TRUSTS, RETIREMENT, AND EXEMPT .................................................... 393
FORM 1041, INCOME TAX RETURN OF A TRUST .................................... 393
General Trust Information .................................................... 393
Distributable Net Income (DNI) ............................................. 395
Income Distribution Deduction .............................................. 395
Filing ................................................................................. 396
SELF-EMPLOYED RETIREMENT PLANS ................................................ 396
Simplified Employee Pension ................................................. 396
Savings Incentive Match Plans for Employees .......................... 399
Qualified Plans .................................................................... 401
PENALTIES AND REPORTING ........................................................... 408
Penalties ............................................................................ 408
Retirement Savings Contributions Credit ................................. 410
Pension Start-Up Costs ........................................................ 411
Retirement Plan Reporting .................................................... 411
EXEMPT ORGANIZATIONS .............................................................. 413
Exemption .......................................................................... 413
Filing ................................................................................. 413
Tax ................................................................................... 414
Contributions ...................................................................... 415
TRUST, PLANS, AND EXEMPT TEST ...................................................... 419
TRUST, PLANS, AND EXEMPT ANSWERS ................................................ 429
GLOSSARY, FORMULAS, AND WORKSHEETS ............................................ 435
GLOSSARY ............................................................................... 435
FORMULAS ............................................................................... 440
WORKSHEETS ........................................................................... 444
INDEX ...................................................................................... 452

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2010 NATP EA Exam Review Course, Part II

BUSINESS ENTITIES
GENERAL INFORMATION
SOLE PROPRIETORSHIP
A sole proprietorship is an unincorporated business owned by the
taxpayer. Sole proprietorships are the simplest form of doing business.
The business does not exist apart from the owner. Its liabilities are the
personal liabilities of the owner and the ownership interest ends with
the proprietors death.
As a sole proprietor, the individual accepts the risks of business to the
extent of all of his or her assets, whether used in the business or used
personally. The income is directly attributable to the owner and is taxed
on Form 1040.
Profit or loss is reported on Schedule C, Profit or Loss from Business or
C-EZ, Net Profit from Business (Schedule F, Profit or Loss from Farming,
for farmers). A net profit of $400 or more is subject to self-employment
tax, reported on Schedule SE, Self-Employment Tax.

PARTNERSHIP
A partnership is an entity of two or more persons who join together to
carry on a trade or business with each person contributing money,
property, labor, or skill and each expecting to share in the profit or loss.
Joint undertakings for the purpose of sharing expenses are not
classified as partnerships.
Persons include an individual, a corporation, a trust, an estate, or
another partnership.
A partnership is not a taxable entity. The partnership files an
information return on Form 1065, U.S. Return of Partnership Income.
Income or loss is passed through to the partners on Schedule K- 1.

2010 NATP EA Exam Review Course, Part II

DEFINITIONS
Foreign partnership: A partnership that is not created or organized in
the United States or under the law of the United States or of any state,
including the District of Columbia.
General partner: A partner who is personally liable for partnership
debts.
General partnership: A partnership composed only of general
partners.
Limited partner: A partner in a partnership formed under a state
limited partnership law, whose personal liability for partnership debts is
limited to the amount of money or other property that the partner
contributed or is required to contribute to the partnership.
Limited partnership: A partnership formed under a state limited
partnership law and composed of at least one general partner and one
or more limited partners.
Limited liability partnership: A partnership formed under a state
limited liability partnership law. Generally, a partner in an LLP is not
personally liable for the debts of the LLP or any other partner, nor is a
partner liable for the acts or omissions of any other partner, solely by
reason of being a partner.
An organization formed after 1996 is classified as a partnership for
federal tax purposes if it has two or more members and it is none of
the following:
An organization formed under a federal or state law that refers to it
as incorporated or as a corporation, body corporate, or body politic.
An organization formed under a state law that refers to it as a jointstock company or joint-stock corporation.
An insurance company.
Certain banks.
An organization wholly owned by a state or local government.
Certain organizations, such as a publicly traded partnership, required
to be taxed as a corporation under the Internal Revenue Code.
Certain foreign organizations under Reg. 301.7701-2(b)(8).
A tax-exempt organization.
A real estate investment trust.
An organization classified as a trust under Reg. 301.7701-4.
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2010 NATP EA Exam Review Course, Part II

An organization that elects to be treated as a corporation by filing

Form 8832, Entity Classification Election.

Note: Mere co-ownership of property that is maintained and leased


or rented is not a partnership. However, if the co-owners
provide services to the tenants, a partnership exists.

CORPORATION
Corporations include associations and unincorporated organizations that
have associates. Corporations are separate entities organized to carry
on a business and divide profits.
A business formed before 1997 and taxed as a corporation continues to
be taxed as a corporation. A business formed before 1997 that had
more than two of the following characteristics was taxed as a
corporation.
Continuity of life.
Centralization of management.
Limited liability.
Free transferability of interests.
The following businesses formed after 1996 are taxed as corporations:
A business formed under a federal or state law that refers to the
business as a corporation, body corporate, or body politic.
A business formed under a state law that refers to the business as a
joint-stock company or joint-stock association.
An insurance company.
Certain banks.
A business wholly owned by a state or local government.
A business specifically required to be taxed as a corporation by the
Internal Revenue Code.
Certain foreign businesses.
Any other business formed after 1996, if an election to be taxed as a
corporation is filed for the business, using Form 8832.

2010 NATP EA Exam Review Course, Part II

LIMITED LIABILITY COMPANY


A Limited Liability Company (LLC) is an entity formed under state law
by filing articles of organization as an LLC.
A business entity that is not classified as a corporation can elect its
classification for federal tax purposes using Form 8832, Entity
Classification Election. An LLC may be taxed as a corporation, a
partnership, or an entity disregarded as an entity separate from its
owner.
Other business entities may choose how they are classified for federal
income tax purposes. Except for a business entity automatically
classified as a corporation, a business entity with at least two members
can choose to be classified as an association taxable as a corporation or
a partnership, and a business entity with a single member can choose
to be classified as either an association taxable as a corporation or
disregarded as an entity separate from its owner.
An entity wishing not to be taxed under the default rules or wishing to
change its current classification must file Form 8832 to elect a
classification.
Default rules are as follows:
A one-member entity is taxed as a sole proprietorship. A disregarded
entity is an eligible entity that is treated as an entity that is not
separate from its single owner. Its separate existence is ignored for
federal tax purposes.
An entity with two or more members is taxed as a partnership.
The election must be made at the beginning of the entitys tax year, not
with the entitys first tax return. The election must be effective no
earlier than 75 days before the date the election is filed and not more
than 12 months after the date the election is filed.
Once an eligible entity makes an election to change its classification,
the entity generally cannot change the classification by election again
during the 60-month period after the effective date of the election. This
limitation does not apply if the previous election was made by a new
entity and was effective on the date of formation.
Form 8832 cannot be used by an eligible entity that is tax-exempt
under 501(a), or a real estate investment trust as defined in 856.

2010 NATP EA Exam Review Course, Part II

A newly formed entity may be eligible for late election relief if the
following provisions apply:
The entity failed to obtain its desired classification solely because
Form 8832 was not timely filed.
The due date for the entitys desired classification tax return
(excluding extensions) for the tax year beginning with the entitys
formation date has not passed.
The entity has reasonable cause for its failure to make a timely
election.
An entity that has an EIN retains that EIN if the entitys classification
changes under Reg. 301.7701-3.
A single-owner entity classified as a disregarded entity must use that
owners identifying number (TIN), not the disregarded entitys EIN.
If the single-owner entity classification changes so that it is
recognized as a separate entity, and the entity has an EIN, that EIN
is used instead of the single-owners TIN.
An incorporated entity is exempt from the check-the-box regulations.

EMPLOYER IDENTIFICATION NUMBER


Generally, a persons social security number is his or her taxpayer
identification number. However, every partnership, corporation
(including an S corporation), and certain sole proprietorships must have
an employer identification number (EIN).
Sole proprietorships and an LLC that is a disregarded entity must have
an EIN if they do any of the following:
Pay wages to one or more employees.
Establish a qualified retirement plan.
Are required to file any pension or excise tax returns, including those
for alcohol, tobacco, or firearms.

2010 NATP EA Exam Review Course, Part II

Note: When a sole proprietorship is required to have an EIN, it is


included on Schedule C along with the social security
number. If the sole proprietorship is not required to have an
EIN, then the social security number is used as the taxpayer
identification number and the line for the EIN is left blank.

A new EIN is required for the following changes in organization:


A sole proprietorship changes to a corporation.
A sole proprietorship takes on partners and operates as a
partnership.
A sole proprietor files bankruptcy under Chapter 7 (liquidation) or
Chapter 11 (reorganization) of the Bankruptcy Code.
A partnership changes to a corporation.
A partnership is taken over by one of the partners and is operated as
a sole proprietorship (assuming the sole proprietorship would be
required to have an EIN).
A corporation changes to a partnership or sole proprietorship. A
corporation that elects to be taxed as an S corporation does not need
to get a new EIN.
A new EIN is required for the following changes in ownership:
The taxpayer purchases or inherits an existing business that will
operate as a sole proprietorship, assuming the sole proprietorship
would be required to have an EIN. (The new owner cannot use the
same EIN of the former owner even if that owner is a spouse.)
The taxpayer represents an estate that operates a business after the
death of the owner.
The taxpayer terminates a partnership and begins a new one.
However, a technical termination in which 50% or more of the total
interest in the capital and profits of the partnership changes hands
within 12 months does not require a new EIN. The old partnership is
treated as contributing the assets to the new partnership, which
continues under the same EIN [Reg. 1.708-1(b)].

2010 NATP EA Exam Review Course, Part II

EMPLOYEE OR INDEPENDENT CONTRACTOR


Employees are defined either under common law or under special
statutes. Generally, if the business can control what will be done and
how it will be done, a worker who performs services for a business is a
common law employee of that business.
This is so even if the employer gives the employee freedom of action.
What matters is that the employer has the right to control the details of
how the services are performed.
If an employer-employee relationship exists, it does not matter what it
is called, how payments are made or measured, or whether the
individual works full-time or part-time. No distinction is made between
classes of employees. Superintendents, managers, and other
supervisory personnel are all employees. An officer of a corporation is
generally an employee.
A leased employee is generally an employee of the service corporation
in the business of providing workers to other businesses.
Statutory employees are not employees under the common law rules.
The employer does not withhold federal income tax from compensation
paid to statutory employees, but the individuals are treated the same as
common law employees with regard to social security and Medicare
taxes. Employers do not pay FUTA tax for statutory employees since
they are not common law employees.
Statutory employees are identified by the following classifications:
An agent (or commission) driver who delivers food, beverages (other
than milk), laundry, or dry cleaning for someone else.
A full-time life insurance salesperson.
A homeworker who works by guidelines of the person for whom the
work is done, with materials furnished by and returned to that
person or to someone that person designates.
A traveling or city salesperson (other than an agent driver or
commission driver) who works full-time (except for sideline
activities) for one firm or person getting orders from customers. The
orders must be for items for resale or used as supplies in the
customers business. The customers must be retailers, wholesalers,
contractors, or operators of hotels, restaurants, or other businesses
dealing with food or lodging.

2010 NATP EA Exam Review Course, Part II

Corporate officers (not directors) that perform more than nominal

services and receive compensation.


A statutory employee should receive a W-2 with the Statutory Employee
box checked. The individual reports earnings as a statutory employee
on Schedule C and deducts appropriate business expenses against that
income.
Statutory nonemployees are direct sellers, qualified real estate
agents, and companion sitters who are by law considered
nonemployees. They are treated as self-employed for all federal tax
purposes, including income and employment taxes.
Independent contractors are certain individuals who follow an
independent trade, business, or profession in which they offer their
services to the public. Independent contractors are not considered
employees.
To determine if an individual is an independent contractor, the
relationship between the worker and the business needs to be
examined. All evidence of control and independence must be
considered.
Behavioral control factors include the following:
Instructions the business gives the worker.
Training the business gives the worker.
Financial control factors include the following:
The extent to which the worker has unreimbursed business
expenses.
The extent of the workers investment.
The extent to which the worker makes services available to the
relevant market.
Guarantee of regular income.
The extent to which the worker can realize a profit or loss.
Relationship factors to consider include the following:
Written contracts describing the relationship the parties intend to
create.
If the business provides the worker with employee-type benefits,
such as insurance, a pension plan, vacation pay, or sick pay.
The permanency of the relationship.

2010 NATP EA Exam Review Course, Part II

The extent to which services performed by the worker is a key

aspect of the regular business of the company.


Form SS-8, Determination of Worker Status for Purposes of Federal
Employment Taxes and Income Tax Withholding, can be filed if the
employer would like the IRS to make the determination of employment
status.

BOOKS AND RECORDS


Adequate records are needed to monitor business operations, prepare
financial statements, verify income and expenses, and to support items
reported on the tax return.
Employment tax records need to specify each employees name,
address, social security number, payments (cash and noncash),
withholding allowance certificates, amounts and dates paid, and all
items withheld. Employment tax records should be retained for at least
four years after the date the tax becomes due or is paid, whichever is
later.
Asset records are needed to adequately account for depreciation and
gain or loss on a disposition. Records for assets should be retained until
the period of limitations expires for the year in which the property is
disposed of in a taxable transaction. For assets obtained in a nontaxable
exchange, records should be kept on the old property as well as the
new property until the period of limitations expires for the year that the
new property is disposed of in a taxable transaction.
Tax returns should be retained for as long as needed in regard to one of
the preceding paragraphs or until the statute of limitations for the
return runs out. The statute of limitations is generally three years after
the date the return is due or two years after the date the tax is paid,
whichever is later.

2010 NATP EA Exam Review Course, Part II

ACCOUNTING PERIODS
Taxpayers adopt an accounting period when the first income tax return
is filed. The taxpayer must maintain his or her books and records and
report income and expenses using the tax year adopted.
Entity

Tax Year

Due Date

Sole
proprietorship

Adopts the same tax year as


the owner, generally a calendar
year

15th day of the 4th month


following the end of the tax
year

Partnership

Adopts the same tax year as


the partners owning more than
50%

15th day of the 4th month


following the end of the tax
year

C corporation

Fiscal or calendar year

15th day of the 3rd month


following the end of the tax
year

S corporation

Calendar year unless there is a


valid 444 election in effect

15th day of the 3rd month


following the end of the tax
year

CALENDAR YEAR
A calendar year is a period of 12 consecutive months ending on
December 31.
An individual taxpayer who begins a sole proprietorship during the tax
year must use the same tax year he is currently using unless he gets
permission to change to a different year. For most individuals this is a
calendar year.
An individual must adopt a calendar year if any of the following apply:
The taxpayer does not keep adequate records.
The taxpayer has no annual accounting period.
The taxpayers present tax year does not qualify as a fiscal year.

FISCAL YEAR
A fiscal year can be either 12 consecutive months ending on the last
day of any month except December, or a tax year that varies from 52
to 53 weeks.
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2010 NATP EA Exam Review Course, Part II

If the taxpayer elects a 52-53-week year, the tax year always ends on
the same day of the week, which may end on either of the following:
The date on which a specified day of the week last occurs in a
particular month.
The date that day of the week occurs nearest to the last day of a
particular calendar month.

SHORT TAX YEAR


A short tax year is a tax year that is less than 12 months. This can
occur when the entity is not in existence for the entire tax year or when
the entity changes its accounting period or form of organization.
A short tax year is considered a full tax year. The requirements for filing
the short tax year return and paying the tax are the same as for a full
tax year that ended on the same day.
Generally, IRS approval is required for a change in accounting period.
Approval can be obtained by filing Form 1128, Application to Adopt,
Change, or Retain a Tax Year, and, if not under the automatic change
procedures, submitting a user fee. This form must be filed by the due
date (including extensions) of the federal income tax return for the
short period required to effect the change.
A partnership has limits on the tax year it may use. If all the partners
are individuals, the tax year is generally a calendar year. Partnerships
are covered more in-depth later in this text.

ACCOUNTING METHODS
The accounting method is chosen when the entity files its first tax
return.
Different methods of accounting can be used for each separate and
distinct business owned by the same taxpayer, provided the method
used clearly reflects the income of each business. Special methods of
accounting are available for certain items of income and expenses such
as installment sales, long-term contracts, and bad debts.

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CASH METHOD
The cash method of accounting may be used by individuals and most
businesses without inventories.
Income is reported when actually or constructively received or when
made available without restriction. Property and services received are
included in income at fair market value (FMV).
Expenses are deducted when actually paid. This includes payments
made with a bank credit card.
The general rule is that expenses paid in advance can only be deducted
in the year to which they apply.
The 12-month rule is an exception. Under this rule, a taxpayer is not
required to capitalize amounts paid to create rights or benefits for the
taxpayer that do not extend beyond the earlier of 12 months after the
right or benefit begins, or the end of the tax year after the tax year in
which payment is made.

Example: A calendar-year taxpayer pays $3,000 in 2009 for business insurance


that is effective for three years, beginning July 1, 2009. The general rule applies to
this situation and allows $500 to be deducted in 2009, $1,000 in 2010, $1,000 in
2011, and $500 in 2012.
Assume this $3,000 is for a one-year period starting July 1, 2009. The general rule
requires $1,500 to be deducted in 2009 and $1,500 to be deducted in 2010.
However, the 12-month rule applies in this situation, and the full $3,000 can be
deducted in 2009.

The cash method cannot be used by the following:


A corporation, other than S corporations, with average annual gross
receipts exceeding $5 million.
A partnership that has a C corporation as a partner, and with the
partnership having average annual gross receipts exceeding $5
million.
Tax shelters.

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2010 NATP EA Exam Review Course, Part II

Exceptions that allow the use of the cash method:


Any corporation or partnership, other than a tax shelter, that meets
the gross receipts test for all tax years after 1985. A corporation or
partnership meets this test if, for each prior tax year beginning after
1985, its average annual gross receipts are $5 million or less.
Average annual gross receipts for a prior year is determined by
adding the gross receipts for that tax year and the two preceding tax
years and dividing the total by three.
A qualified personal service corporation (PSC).
Qualifying taxpayers who choose not to keep an inventory.
Special rules apply for farming businesses.
Generally, a taxpayer engaged in the trade or business of farming is
allowed to use the cash method for its farming business.
Corporations and partnerships that have a corporation as a partner
must use the accrual method for their farming business unless they
have gross receipts of $1 million or less for each prior tax year after
1975.
For family corporations engaged in farming, the exception applies if
gross receipts were $25 million or less for each prior tax year after
1985.

ACCRUAL METHOD

INCOME
Income is reported when all events that fix the taxpayers right to
receive the income have occurred and the taxpayer can determine the
amount with reasonable accuracy. Under this provision, income is
reported on the earliest of the following dates:
When payment is received.
When the income amount is due the taxpayer.
When the taxpayer earns the income.
When title passes.
Advance payments for services may be accrued over the period for
which the services are to be performed, provided the period does not
extend beyond the next tax year.
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Advance payments on agreements for future sales or other dispositions


of goods held primarily for sale to customers is generally included in
income when received. Under an alternative method, the taxpayer
generally includes an advance payment in income in the earliest tax
year in which:
The taxpayer includes advance payments in gross receipts under the
method of accounting used for tax purposes.
The taxpayer includes any part of advance payments in income for
financial reports under the method of accounting used for those
reports.

EXPENSES
All expenses are deducted or capitalized (if required) when both of the
following apply:
The all-events test is met. This test is met when:
All events have occurred that fix the fact of liability.
The liability can be determined with reasonable accuracy.
Economic performance has occurred.
Economic performance occurs as the property or services are provided
or as the property is used, if the expense is for the property or service
provided for the use of the property. If the expense is for property or
services provided to another, economic performance occurs when the
service or property has been provided.
An exception to the economic performance rule allows certain recurring
items to be treated as incurred during the tax year even though
economic performance has not occurred, if the following requirements
are met:
The all-events test is met.
Economic performance occurs by the earlier of 8 months after the
close of the year or the date the taxpayer files a timely return
(including extensions) for the year.
The item is recurring in nature and the taxpayer consistently treats
similar items as incurred in the tax year in which the all-events test
is met.
Either the item is not material, or accruing the item in the year in
which the all-events test is met results in a better match against
income than accruing the item in the year of economic performance.

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2010 NATP EA Exam Review Course, Part II

An expense paid in advance is deductible only in the year to which it


applies, unless the expense qualifies for the 12-month rule. Under the
12-month rule, a taxpayer is not required to capitalize amounts paid to
create certain rights or benefits for the taxpayer that do not extend
beyond the earlier of:
12 months after the right or benefit begins; or
The end of the tax year after the tax year in which payment is made.
An accrual-method taxpayer cannot deduct expenses incurred to a
related cash-basis taxpayer until actually paid and included in the
related taxpayers income. Related parties for this purpose include the
following:
Brothers and sisters (whether half or whole), spouse, ancestors, and
lineal descendants. Step siblings are not related parties.
An individual and a corporation in which the individual, directly or
indirectly, owns more than a 50% interest.
Entities in which the same person owns more than 50% interest in
each.
The fiduciary of a trust and the grantor or the beneficiary of that
trust.

HYBRID METHOD
The hybrid method is any combination of cash, accrual, or special
method of accounting that clearly reflects income and is consistently
used.
Taxpayers may use the accrual method for purchases and sales and the
cash method for all items of income and expenses with the following
restrictions:
If the cash method is used for figuring income, the cash method
must be used for reporting expenses.
If the accrual method is used for reporting expenses, the accrual
method must be used for figuring income.

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INVENTORIES
Inventories are necessary to clearly show income when the production,
purchase, or sale of merchandise is an income-producing factor. If
inventories are necessary to clearly reflect income, the accrual method
must be used for sales and purchases (unless one of the exceptions for
qualifying taxpayers applies). Inventory is discussed in more detail
later.
The following taxpayers can use the cash method of accounting even if
they produce, purchase, or sell merchandise. These taxpayers can also
account for inventoriable items, such as nonincidental materials and
supplies.
A qualifying taxpayer under Rev. Proc. 2001-10.
A qualified taxpayer must satisfy a gross receipts test for each tax
year ending on or after December 17, 1998. The average annual
gross receipts for each test year must be $1 million or less. The
average annual gross receipts is determined by the following steps:
List each of the test years. For 2009, the test years are 1999,
2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, and 2008.
Determine the average annual gross receipts for each test year.
The average annual gross receipts for a year is determined by
adding the gross receipts for that year and the two preceding
years and dividing by three.
The taxpayer meets the test if the average annual gross receipts
for each test year listed are $1 million or less.
The taxpayer is not a tax shelter.
A qualifying small business taxpayer under Rev. Proc. 2002-28.
A taxpayer is a qualified small business taxpayer under this
procedure if the following are satisfied:
The taxpayer satisfies the gross receipts test for each prior tax
year ending on or after December 31, 2000. The average annual
gross receipts for each test year must be $10 million or less.
The taxpayer is not prohibited from using the cash method under
448.
The taxpayers principle business activity is an eligible business
activity.
The taxpayer has not changed (or been required to change) from
the cash method because of becoming ineligible to use the cash
method.

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2010 NATP EA Exam Review Course, Part II

To meet the gross receipts test, the taxpayer can use the following

steps:
List each of the test years. For 2009, the test years are 2000,
2001, 2002, 2003, 2004, 2005, 2006, 2007, and 2008.
Determine the average annual gross receipts for each test year.
This is the sum of gross receipts for the current year and the two
preceding years, divided by three.
The taxpayer meets this test if average annual gross receipts for
each test year is $10 million or less.
Eligible businesses must meet the following requirements:
The principle business activity is described in a North American
Industry Classification System code other than any of the
following:
Code 211 and 212 (mining activities).
Codes 31 - 33 (manufacturing).
Code 42 (wholesale trade).
Codes 44 and 45 (retail trade).
Codes 5111 and 5122 (information industries).
The principle business activity is the provision of services,
including the provision of property incident to those services.
The principle business activity is the fabrication or modification of
tangible personal property upon demand in accordance with
customer design or specification.
This method is not available for farming. The industry is basically
allowed to use the cash method for any farming business unless
specifically identified as not being eligible.

CHANGE IN ACCOUNTING METHOD


A change in accounting method includes a change not only in the
overall system of accounting but also in the treatment of any material
item. Math errors are not considered a change in accounting.
To request a change in accounting method, the taxpayer must file Form
3115, Application for Change in Accounting Method.
For an automatic change, Form 3115 must be filed no later than the
due date, including extensions, for filing the income tax return for the
year of change.

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For a change requiring IRS consent, the application must be filed within
the first 180 days of the tax year for which the change is requested,
and a user fee must be included with Form 3115. The user fees for
2009 are as follows:
$3,800 ($625 if gross income is less than $250,000; $2,100 if gross
income is less than $1 million and more than $250,000)
Form 3115 is required to be filed regardless of whether consent is
required.
Consent from the IRS is required in the following situations:
Cash to accrual or accrual to cash (unless the change is required,
which provides approval under the automatic change request
procedure).
Change in the method or basis used to value inventories.
Change in the method of figuring depreciation (except for changes to
the straight-line method, missed depreciation, or year of sale).

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2010 NATP EA Exam Review Course, Part II

CAPITAL EXPENSES
Capital expenses are not currently deductible but are charged to a
capital asset account. The main types of costs that must be capitalized
include expenses of going into business, the cost of business assets,
and the cost of improvements.
Going into business generally requires incurring a number of expenses
before the business is operating. Start-up costs are those that are paid
or incurred prior to opening the doors for business. Organizational costs
are those that are incident to the creation of the partnership (709) or
a corporation (248). These costs are discussed later under business
expenses.
If the taxpayer fails to actually go into business, the expenses that have
already been incurred fall into one of two categories:
Costs incurred before making a decision to enter a specific business
are personal and nondeductible. They include any costs incurred in
the course of a general search for, or a preliminary investigation of,
a business or investment possibility.
A cost incurred in connection with an attempt to acquire or begin a
specific business is a capital expenditure and deducted as a capital
loss (Rev. Rul. 77-254).
Property owned by the business and used directly or indirectly to earn
its income must be capitalized. If property is produced for use in the
trade or business, all costs of producing that property should be
capitalized under the uniform capitalization rules.
The costs of making improvements to a business asset should be
capitalized if the improvement adds to the value of the asset,
appreciably lengthens the time the asset can be used, or adapts the
asset to a different use. The cost is depreciated over the life of the
asset.

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BASIS OF ASSETS
COST BASIS
Cost basis is the amount invested in the property for tax purposes.
Basis is generally the cost of the property if acquired by purchase.
For multiple assets purchased for a lump sum amount, the buyer and
the seller may agree to a specific allocation of the purchase price to
each asset. However, absent a specific allocation, both the buyer and
seller must use the residual method of allocation, which requires the
consideration paid to be allocated to all assets in proportion to (but not
more than) their FMV in the following order:
Class I assets: cash and general deposit accounts (including savings
and checking accounts) other than certificates of deposit held in
banks, savings and loan associations, and other depository
institutions.
Class II assets: actively traded personal property. This includes
certificates of deposit, foreign currency, U.S. government securities,
and publicly traded stock.
Class III assets: assets the taxpayer marks-to-market at least
annually and debt instruments, including accounts receivable.
Class IV assets: stocks in trade or other property of a kind that
would be included in inventory of the taxpayer if on hand at the close
of the taxable year, or property held by the taxpayer primarily for
sale to customers in the ordinary course of its trade or business.
Class V assets: all assets not included in the other classes. This
includes furniture and fixtures, buildings, land, vehicles, and
equipment, which constitute all or part of a trade or business.
Class VI assets: all 197 intangibles except goodwill and going
concern.
Class VII assets: goodwill and going concern value, whether or not
the goodwill or going concern value qualifies as a 197 intangible.
Adjusted basis is the original cost or other basis plus certain additions
and minus certain deductions.

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2010 NATP EA Exam Review Course, Part II

BASIS OTHER THAN COST


The FMV of property received for services is included in income and
then becomes the basis in that property.
If the property is restricted property, the basis is the propertys FMV
when the property becomes unrestricted or substantially vested.
Bargain purchases result in taxable income that is the difference
between the purchase price and the FMV, unless this difference is due
to a qualified employee discount. When included in income, the FMV of
the property acquired becomes the basis.
If the taxpayer receives property for services and the property is
subject to certain restrictions, the basis in the property is its FMV when
it becomes substantially vested. The taxpayer can make an election to
include the FMV as income at the time of the transfer as opposed to
when it becomes substantially vested.
Property received in a taxable exchange has a basis equal to the FMV
of the property at the time of the exchange.
Property received in a nontaxable or like-kind exchange generally has
the same basis as the old property given up. If the taxpayer paid
additional money to get the new property, the basis is increased by the
additional money paid.
Property received in a partially nontaxable exchange generally has
the same basis as the old property that was given up with the following
adjustments:
Decreased by:
Any money received.
Any loss recognized on the exchange.
Increased by:
Any additional costs incurred.
Any gain recognized on the exchange.
The basis of unlike property received is its FMV on the date of the
exchange. The remainder of the old propertys adjusted basis is the
basis of the new like-kind property.
If the other party assumes the taxpayers liability on the property
transferred, the amount of the liability assumed is treated as money
transferred to the taxpayer.
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The sale and purchase of similar property in two mutually dependent


transactions is treated as a nontaxable exchange.
If property is converted from personal to business or rental use, the
basis for depreciation is the lesser of the FMV or the adjusted basis on
the date of conversion. If the taxpayer later sells or disposes of the
property, the basis to use depends on whether a gain or loss is figured.
The basis for gain is the adjusted basis in the property when sold.
The basis for loss is the smaller of the adjusted basis or the FMV at
the time of the conversion plus or minus required adjustments.

Example: A taxpayer sells his house, which he had converted to rental property
after using it as his residence. When converted to rental use, it had a FMV of
$33,000 and an adjusted basis of $35,000. The original cost of the house and the
adjusted basis were the same, as there were no increases or decreases to basis
since its purchase.
His basis for depreciation is $33,000, the lesser of FMV or adjusted basis. He
claimed $3,000 depreciation, figured under the straight-line method, while renting.
His adjusted basis at the time of the sale, for figuring gain, is $32,000 ($35,000
original cost - $3,000 depreciation).
His adjusted basis at the time of the sale, for figuring loss, is $30,000 ($33,000
FMV on conversion - $3,000 depreciation). In this example, FMV must be used
because it was smaller than the adjusted basis at the time the house was
converted to rental use.
If the sales price is between $30,000 and $32,000, the taxpayer has neither gain
nor loss on the sale.

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2010 NATP EA Exam Review Course, Part II

S CORPORATION STOCK
The basis in S corporation stock is adjusted annually by various
transactions. The basis has two components: stock basis and loan basis.

STOCK BASIS
The beginning basis of stock is determined by what is transferred to the
corporation in exchange for the stock. If only money is transferred for
stock, the amount transferred is the beginning basis of the stock.
The following items increase the shareholders basis in S corporation
stock:
All income items of the S corporation, including tax-exempt income,
that are separately stated and passed through to the shareholder.
Any nonseparately stated income of the S corporation.
The amount of the deduction for depletion that is more than the
basis of the property being depleted.
The following items decrease basis in the order listed:
Property distributions (including cash) made by the corporation
(excluding dividend distributions reported on Form 1099-DIV and
distributions in excess of basis) reported on Schedule K-1, Box 16,
Code D.
Nondeductible expenses and the depletion deduction for any oil and
gas property held by the corporation, but only to the extent the
shareholders pro rata share of the propertys adjusted basis exceeds
that deduction.
Deductible losses and deductions reported on Schedule K-1.
The shareholder can make an election to reduce basis by deductible
losses and deductions before nondeductible expenses and depletion.
This election is made under Reg. 1.1367-1(g).

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LOAN BASIS
If the pass-through losses exceed the amount needed to reduce stock
basis to zero, the excess (excluding a decrease due to distributions) is
used to reduce the basis of any loans the shareholder made to the
corporation.
If a shareholders loan basis is reduced, any increase for a later year
requires that loan basis must be restored before increasing stock basis.
Distributions that exceed stock basis are taxed as capital gains and do
not reduce loan basis.
A loan from a third party to the S corporation does not provide loan
basis, even if the shareholder acts as a guarantor for that loan.

Example: John has a stock basis of $5,000 and a loan basis of $7,000. The
corporation had a loss of $6,000 and a distribution of $3,000. Johns stock basis is
first reduced by the distribution. The stock basis is reduced by the loss to the
extent that basis is reduced to zero. The remaining loss is used to reduce loan
basis.
Stock Basis Loan Basis
Beginning
$ 5,000
$ 7,000
Distribution($3,000)
- 3,000
Loss ($6,000)
- 2,000
- 4,000
Remaining Basis
$
0
$ 3,000

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2010 NATP EA Exam Review Course, Part II

BASIS REFERENCE CHART


How Acquired

Basis for Gain, Loss, and Depreciation

Purchase

Usually cost. Includes cash, FMV of other property and services,


sales tax, freight, testing and installation, closing costs, and
indebtedness assumed.

Nontaxable and partially


taxable exchanges

Basis of property acquired is the same as the basis of the


property given up, increased by additional costs and any gain
recognized, and decreased by money or unlike property
received and any loss recognized.

Gifts

If the FMV is less than the donors adjusted basis:


Basis for gain or depreciation is the donors adjusted basis
increased or decreased by adjustments to basis while the
taxpayer held the property.
The basis for loss is the FMV at the time of the gift, increased or
decreased by adjustments to basis.
If the FMV is equal to or greater than the donors adjusted
basis, the basis for gain, loss, and depreciation is the donors
adjusted basis increased by all or a portion of the gift tax paid.

Conversion from
personal use to business
use

Gain: Adjusted basis.


Loss or depreciation: Lesser of adjusted basis or FMV at the
date of conversion.

Inherited

FMV at date of death or alternate valuation date if elected.

Transfer between
spouses

Carryover of basis prior to transfer. No gain or loss recognized.

Stocks and bonds

Usually cost. First acquired, first sold.


Stock split: Divide the original basis between the old and new
stock.
Dividend reinvestment: FMV on the dividend payment date.
Reduced by nontaxable distributions.

Mutual fund shares

Cost. May use average basis if bought at different times and


prices, or specific identification.

Original issue discount

Cost, increased by OID included in income.

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BUSINESS ENTITIES TEST


1. ___

A domestic limited liability company with at least two members


that does not file Form 8832, Entity Classification Election, is
classified as:
A. An entity disregarded as an entity separate from its owner
by applying the rules in regulations section 301.7701-3.
B. A partnership.
C. A corporation.
D. A non-entity, which requires members to report the income
and related expenses on Form 1040.

2. ___

Most unincorporated businesses formed after 1996 can elect to


be taxed as a partnership or a corporation. The regulations
provide for a default rule if no election is made. If an election
is not made and the default rules apply, which of the following
is correct?
A. Any new domestic eligible entity having at least two or more
members is classified as a partnership.
B. Any new domestic eligible entity with a single member is
disregarded as an entity separate from its owner.
C. If all members of a new foreign entity have limited liability,
it is classified as an association.
D. All of the above are correct.

3. ___

XYZ, an eligible entity, made an election by filing Form 8832,


Entity Classification Election, on December 15, 2009, to be
taxed as a partnership effective for January 1, 2010. Under the
general rule, what is the earliest date XYZ can elect to be
taxed as a corporation by filing another Form 8832?
A. January 1, 2011
B. December 15, 2013
C. January 1, 2015
D. December 15, 2015

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2010 NATP EA Exam Review Course, Part II

4. ___

A new employer identification number is required if either the


form or the ownership of the business changes. A new EIN is
required for all the following changes except:
A. A sole proprietorship incorporates and retains all the same
employees.
B. A partnership incorporates and all the same partners
become shareholders in the new corporation.
C. A taxpayer inherits a business that will be operated as a
sole proprietorship.
D. A regular C corporation elects S status at the beginning of
the year and acquires three new shareholders.

5. ___

Bob works on the loading dock for the Loaden Partnership from
7:00 a.m. to 3:00 p.m., Monday Friday. Susan, the full-time
secretary, works a 4-day week. Max, the bookkeeper, is the
sole proprietor of the Books-I-Keep Accounting Service and is a
licensed accountant. Max works a different schedule each week
for Loaden Partnership but is very conscientious and reliable.
How many of these individuals are considered employees?
A. 3
B. 2
C. 1
D. None

6. ___

Abraham becomes an equal partner in the ABC Partnership in


2009. In 2008, he filed his personal tax return on the calendar
tax year basis. The partnership reports income and expenses
on the fiscal tax year basis. How should Abraham report
partnership income or loss distributed to him?
A. Abraham may choose a fiscal year to report income and
expenses.
B. Abraham must report income and expenses on the calendar
year basis.
C. Abraham may choose either a calendar tax year or fiscal tax
year to report income and expenses.
D. Abraham may choose a fiscal tax year and later obtain IRS
approval if he wishes to change to a calendar tax year for
reporting income and expenses.

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7. ___

Which of the following dates would not be considered the end


of a tax year?
A. The last Friday in June.
B. April 15, 2009.
C. September 30, 2009.
D. December 31, 2009.

8. ___

Mary is a calendar-year, accrual-basis taxpayer. She sold


merchandise on December 30, 2009. She billed the customer
in the first week of January 2010. The billing was returned for
insufficient postage and Mary sent a second bill in February
2010. When should Mary include the sale in income?
A. December 2009.
B. January 2010.
C. February 2010.
D. March 2010.

9. ___

Given the fact patterns below, which of the following entities


may not use the cash method of accounting?
A. The Acme Partnership had gross receipts of $3,500,000 in
2009. Its gross receipts for 2008 were $8,000,000 and its
gross receipts for 2007 were $3,000,000.
B. John Jones manufactures and sells fans. His average
annual gross receipts since 2000 are $975,000.
C. Dallas Partnership has two partners in 2009: Joe Dallas, an
individual, and Deer Inc., a corporation. Dallas Partnership
has average annual gross receipts of $6,500,000.
D. John Gibb files his 2009 Form 1040 with an attached
Schedule C reflecting $11,000,000 in gross receipts from
selling real estate.

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2010 NATP EA Exam Review Course, Part II

10. ___ Which of the following statements is not correct?


A. Under an accrual method of accounting, a taxpayer
generally reports income in the year earned and deducts or
capitalizes expenses in the year incurred.
B. Under an accrual method of accounting, a taxpayer
generally reports receipt of an advance payment for
services to be performed in a later tax year as income in the
year payment is received.
C. Under an accrual method of accounting, business expenses
and interest owed to a related person who uses the cash
method of accounting are deductible when the all-events
test has been met.
D. Under an accrual method of accounting, a taxpayer can take
a current deduction for taxes when economic performance
occurs.
11. ___ Which of the following individuals is not considered a related
party for deducting expenses on the accrual method?
A. Half-sister
B. Brother
C. Mother
D. Step-sister
12. ___ Eric, a cash-basis taxpayer, owned 25% of Watson, Inc. stock.
Watson, Inc. files a calendar-year U.S. Corporate Income Tax
Return Form 1120 employing the accrual method of
accounting. Eric loaned Watson, Inc. $100,000 at the
beginning of 2009. The accrued interest on this loan was
$5,000 as of December 31, 2009. Watson, Inc. paid Eric the
$5,000 in January of 2010. How should Eric report the interest
income and Watson, Inc. report the interest expense from this
transaction?
A. Watson, Inc. reports the expense in 2009 and Eric reports
the income in 2009.
B. Watson, Inc. reports the expense in 2009 and Eric reports
the income in 2010.
C. Watson, Inc. reports the expense in 2010 and Eric reports
the income in 2010.
D. None of the above.

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13. ___ Which of the following accounting changes do not require the
filing of Form 3115 to request a change in accounting method?
A. Correction of a math error.
B. Change from accrual method to cash method.
C. Change in the method inventory is valued.
D. Change from cash method to accrual method.
14. ___ Jerry, a cash-basis taxpayer, is a salesman. He sold $100,000
of merchandise in March 2009. His commission is 2% of sales.
In November 2009, he received $2,000 in commissions for
those sales and an advance of $7,000 in commissions for
future sales in 2010. What amount must Jerry include in his
income for 2009?
A. $9,000
B. $2,000
C. $3,167
D. $0
15. ___ The Smith Partnership bought a business for $1,000,000 in
January. Included in the purchase price were business assets
as follows: certificate of deposit $100,000, accounts receivable
of $200,000, and inventory of $300,000. Also purchased, but
not separately valued, were an office building, land, and goingconcern value. The real estate tax assessment was $300,000
and the buyer estimated the building was worth twice the land
value. What values should be assigned to the building, land,
and going concern?
Building
Land
Going Concern
A. $200,000
$100,000
$100,000
B. $100,000
$200,000
$100,000
C. $200,000
$200,000
$0
D. $250,000
$150,000
$0

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2010 NATP EA Exam Review Course, Part II

16. ___ Bob purchased a building and land to use in his business for a
price of $1,000,000. The land was valued at $300,000
(included in the price). He then incurred $90,000 to replace
the roof of the building. The city replaced the sewage lines to
his business and assessed Bob $20,000. Bob had been slow in
getting insurance coverage on the real property and incurred a
small fire loss of $10,000, which he plans to deduct on his
business tax return. What is Bobs basis for depreciation after
deducting the loss?
A. $1,100,000
B. $810,000
C. $800,000
D. $720,000
17. ___ Lottie traded an old video game machine that originally cost
her $8,000 for a new one. The new machine cost $12,500. She
was allowed $6,000 for the old one and paid an additional
$6,500. The adjusted basis of the old machine was $6,400.
What is Lotties basis in the new machine?
A. $12,100
B. $12,500
C. $12,600
D. $12,900
18. ___ Nelson, Inc. owned a manufacturing building with a fair market
value of $95,000 and an adjusted basis of $75,000. Nelson,
Inc. entered into an agreement to exchange the manufacturing
building for a warehouse with an adjusted basis of $80,000
and a fair market value of $90,000 with Roberts Corporation.
In addition, Nelson, Inc. would pay Roberts Corporation $5,000
in cash. Nelson, Inc. also incurred and paid attorney and deed
preparation fees of $5,000 on this exchange. What is Nelson,
Inc.s basis in the warehouse it received in this like-kind
exchange?
A. $85,000
B. $90,000
C. $95,000
D. $100,000

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BUSINESS ENTITIES ANSWERS


1.

B. A domestic LLC with at least two members that does not file
Form 8832 is classified as a partnership for federal income tax
purposes.

2.

D. Default rules provide the entity is taxed as a partnership if it has


two or more members or disregarded as an entity separate from
its owner if it has a single owner. A foreign eligible entity is a
partnership if it has two or more members and at least one
member does not have limited liability, an association if all
members have limited liability, or disregarded as an entity
separate from its owner if it has a single owner that does not
have limited liability.

3.

C. An entity cannot change its election again during the 60 months


after the effective date of the election.

4.

D. C corporations that choose to be taxed as S corporations do not


require a new employer identification number.

5.

B. The accountant conducts an independent trade or business in


which he offers his services to the public. He basically controls
what he does and how he does it for Loaden Partnership.

6.

B. If a taxpayer files his or her first tax return using the calendar
year and later begins business as a sole proprietor, becomes a
partner in a partnership, or becomes a shareholder in an S
corporation, he or she must continue to use the calendar year
unless he or she gets IRS approval to change it or meets one of
the provisions allowing the change without IRS approval.

7.

B. A calendar year ends on December 31. A fiscal year ends on the


last day of any month except December. A 52-53 week year
always ends on the same day of the week that last occurs in a
particular month or occurs nearest to the last day of a particular
calendar month.

8.

A. Using the accrual method of accounting, income is generally


included as gross income for the tax year in which all events
that fix the taxpayers right to receive the income have occurred
and he or she can determine the amount with reasonable
accuracy.

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2010 NATP EA Exam Review Course, Part II

9.

C. The following entities cannot use the cash method of


accounting, including any combination of methods that includes
the cash method: a corporation (other than an S corporation)
with average annual gross receipts exceeding $5 million; a
partnership with a corporation (other than an S corporation) as
a partner, and with a partnership having average annual gross
receipts exceeding $5 million; or a tax shelter.

10. C. Amounts are not deductible until the taxpayer makes payment
and the corresponding amount is includible in the related
persons gross income.
11. D. For deducting expenses, related persons are members of a
family, including only brothers and sisters (either whole or half),
husband and wife, ancestors, and lineal descendants.
12. B. A corporation that uses the accrual method of accounting cannot
deduct business expenses and interest owed to a related person
who uses the cash method of accounting until the corporation
makes the payment and the corresponding amount is includible
in the related persons gross income. For this purpose, related
party includes a corporation and an individual who owns,
directly or indirectly, more than 50% of the value of the
outstanding stock of the corporation. Owning only 25% does not
meet the related party rules, so each taxpayer reports the
income or expense using their own method of accounting.
13. A. The following changes do not require IRS approval: correction of
a math or posting error; correction of an error in computing tax
liability; adjustment of any item of income or deduction that
does not involve the proper time for including it in income or
deducting it; or adjustment in the useful life of a depreciable
asset (cannot change the recovery period for ACRS or MACRS
property).
14. A. Generally, a taxpayer reports an advance payment for services
to be performed in a later year as income in the year payment
is received.

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15. A. In the acquisition of a trade or business, the purchase price is


allocated to each asset class in a specific order based on FMV.
The $1,000,000 purchase price is reduced by $100,000 for the
CD, $200,000 for accounts receivable, and $300,000 for
inventory. This leaves $400,000 to be allocated to the building,
land, and finally to the going concern. The FMV of the real
estate is $300,000, with the value of the building being twice
that of the land. As such, $200,000 is allocated to the building
and $100,000 is allocated to the land. This leaves $100,000 to
be allocated to going concern.
16. C. Of the purchase price, $700,000 is allocated to the building.
This is increased by the cost of replacing the roof and the
assessment by the city for sewage lines and is subsequently
reduced by the casualty loss. The result is an $800,000 basis in
the building eligible for depreciation.
17. D. The basis in the new property is the same as the adjusted basis
in the old property ($6,400) plus additional amounts paid
($6,500) for a total basis of $12,900.
18. A. The basis of property received in a nontaxable like-kind
exchange is generally the adjusted basis of the old property,
increased by additional cash paid and expenses of the
exchange.

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2010 NATP EA Exam Review Course, Part II

INCOME, LOSS, AND EXPENSES


INCOME
BUSINESS INCOME
Business income is the income received when products and services are
sold or delivered. Business income can be in the form of cash, checks,
and credit card charges, as well as other forms such as property or
services. Business income also includes interest, dividends, rents,
royalties, payment for services (including fees, commissions, and fringe
benefits), gains from dealings in property, and the distributive share of
partnership income. A sole proprietor reports most business income on
Schedule C or Schedule C-EZ. Other forms may be required depending
on the nature of the income, such as Form 4797, Sales of Business
Property, for the sale of business assets.

BARTERING INCOME
Bartering is an exchange of property or services.
The FMV of property or services received must be included in income at
the time received. If the taxpayer exchanges services with another
person and both have agreed ahead of time on the value of the service,
that value is accepted as the FMV unless the value can be shown to be
otherwise.

RENTAL INCOME
A real estate dealer who receives income from renting real property or
an owner of a hotel, motel, etc., who provides services for guests,
reports the rental income on Schedule C. A real estate dealer is
engaged in the business of selling real estate to customers with the
purpose of making a profit from those sales. Rent received from real
estate held for sale to customers is subject to SE tax.

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Rental income from a trailer park is reported on Schedule C and is


subject to SE tax if the individual is a self-employed trailer park owner
who provides trailer lots and facilities and substantial services for the
convenience of the tenants.
If the taxpayer is not a real estate dealer, the rental income and
expenses are reported on Schedule E. The income and expenses
include:
Advance payments received under a lease that does not put any
restrictions on the use or enjoyment is income in the year received.
A bonus received for granting a lease is an addition to the rent in the
year received.
A payment from a lessee for canceling a lease is rental income in the
year received.
A payment by the lessee to a third party to pay the landlords debts
or obligations is rent when the lessee makes the payment.
Payments received in settlement of a lessees obligation to restore
leased property to its original condition is income to the extent the
payment exceeds the adjusted basis of the leasehold improvement
destroyed, damaged, removed, or disconnected by the lessee.
Rental of personal property not associated with rental real estate is
reported on Schedule C and subject to SE tax if the activity is a trade or
business. If the activity is not a trade or business, the income is
reported as other income.

INTEREST INCOME
Business income includes interest income if the taxpayer is in the
business of lending money. In any business, interest received on notes
receivable that have been accepted in the ordinary course of business is
business income.
If the taxpayer is in the business of lending money, any payment
received on a discounted loan usually includes interest and principal.
For a cash-basis taxpayer, part of the discount is interest income
when each payment is received.
For an accrual-basis taxpayer, the amount of the discount is
includable in income as it accrues over the term of the loan or it is
includable as payments are received if payments are made before
they accrue.

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2010 NATP EA Exam Review Course, Part II

If a loan becomes uncollectible during the year and the taxpayer uses
the accrual method of accounting, interest that has accrued up to the
date the loan became uncollectible is included in gross income. When
accrued interest is later determined to be uncollectible, a bad debt
deduction is taken.
When there is little or no interest charged on an installment sale,
unstated interest is considered to be included in each payment
received.

DIVIDENDS
Dividends are business income to dealers in securities.
For most sole proprietors and statutory employees, dividends are
nonbusiness income.
Dividends received from business insurance premiums deducted in an
earlier year must be reported as business income.

MISCELLANEOUS
If a debt the taxpayer owes is canceled or forgiven, other than as a gift
or bequest, the canceled amount is included in gross income. This issue
is discussed later in this section.
Amounts received that are based on productivity, use, or disposition of
a franchise, trademark, or trade name are included as ordinary income.
Promissory notes and other evidence of indebtedness are includable
in income at FMV when they are received if received as part of the sales
price, and the business uses the cash method of accounting.
Damages due to patent infringement, breach of contract or fiduciary
duty, antitrust injury, or for punitive reasons are included in gross
income.
If the taxpayer receives restricted stock or other property for services
performed, the FMV of the property in excess of cost is included in
income when the restriction is lifted.

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If the business is reduced or stopped, any payment received for lost


income of the business paid through insurance or other sources is
included in income, even if the business is inactive when the payment is
received.
Kickbacks are generally included in income. They are excluded from
income if treated as a reduction of the related expense, a capital
expenditure, or a cost of goods sold.
If a bad debt or other item deducted in a prior year is recovered, the
recovery is included in income to the extent the deduction reduced
taxes in that prior year.
A recapture of depreciation on listed property or a 179 deduction may
result when business use of the asset drops to 50% or less. This
recapture is included in income. Recapture required because of a
disposition of property is reported as ordinary income on Form 4797;
however, it does not get carried to Schedule C.

PREPAID INCOME
Prepaid income that is subject to free and unrestricted use is included in
gross income in the year received regardless of the taxpayers method
of accounting. However, there are some exceptions for accrual
accounting.
Advanced income received under an agreement for services to be
performed by the end of the next tax year may be postponed until the
next year. The election to postpone reporting does not apply:
To income under guarantee or warranty contracts.
To prepaid rent or prepaid interest.
If the agreement requires any part of the work to be performed
immediately after the close of the following year.
When the services are to be performed at any unspecified future
date.
Advanced income from sales is reported in the tax year received or
under an alternative method. Under the alternative method, income is
included in the earlier tax year in which:
The advanced payments are included in gross receipts under the
method of accounting used for tax purposes.

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2010 NATP EA Exam Review Course, Part II

Any part of the advanced payment is included in income for any

financial reports under the method of accounting used for these


reports.
Accounting for income tax purposes may differ from accounting for
financial purposes.
All income earned is taxable, even if the income is paid to a third party.
A cash discount is an amount a seller permits the buyer to deduct from
the invoice price for prompt payment. A discount can be handled in
either of two ways:
Deduct the cash discount from purchases.
Credit the cash discount to a discount income account. The credit
balance in the account at the end of the year is business income, but
the cost of goods is not reduced.
A trade discount is a reduction from the list or catalog prices and
usually is not written into the invoice or charged to customers. This is a
discount regardless of when the payment is made.
If a buyer of property places an amount in escrow, the amount is not
included in income until received from escrow.
Credit allowed to customers for returned merchandise and any other
allowances are deductions from gross sales in figuring net sales.

ITEMS NOT CONSIDERED INCOME


The following items do not qualify as income:
Issuance of stock or income from the sale of treasury stock.
Contributions to capital.
Loans.
Sales tax required to be collected and paid over to state or local
governments.
Exchange of business property for like-kind property.
Consignments.
Construction allowances received in cash or as a rent reduction from
a lease entered into after August 5, 1997. The allowance must be
received under a short-term lease of retail space and for the purpose
of constructing or improving qualified long-term real property used in

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the taxpayers trade or business. The amount excluded cannot


exceed the amount spent for construction or improvements.
A short-term lease is a lease of retail space for a period of 15
years or less.
Qualified long-term real property is nonresidential real property
that is part of or otherwise present at the retail space and that
reverts to the landlord when the lease ends.

EXPENSES
COST OF GOODS SOLD
Taxpayers who make or purchase goods for resale are entitled to a
deduction on their tax return for the cost of goods sold. Inventories
must be maintained to determine these costs. When inventories are
required to be accounted for, the accrual method of accounting must
generally be used for purchases and sales.
Inventory at the beginning of the year is identical to the closing
inventory of the previous year. Any differences must be explained in a
schedule attached to the return.
If the taxpayer donates inventory to a charitable organization, the
taxpayers deductible contribution is the smaller of the FMV of the
item on the date contributed or its basis. This item must be removed
from opening inventory. If the donated inventory is not included in
the opening inventory, the inventorys basis is zero and no charitable
contribution deduction is allowed.
Costs and expenses of the contributed property incurred in the year
of the contribution are deductible as part of the cost of goods sold for
that year if this treatment is proper under the taxpayers method of
accounting.
Any taxpayer engaged in a trade or business is eligible to claim a
deduction for a contribution of apparently wholesome food
inventory to a qualified charitable organization after August 27,
2005, and before January 1, 2010.

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2010 NATP EA Exam Review Course, Part II

The deduction is equal to the lesser of the following:

The basis of the donated food plus one-half of the gain that
would have been realized if the donated food had been sold at
FMV.
Two times the basis of the donated food.
The taxpayer must receive written confirmation from the donee.
For other than a C corporation, the deduction is limited to 10% of
the taxpayers total net income from all trades or businesses from
which the food contributions were made.

Inventory is increased by merchandise or raw materials purchased.


This is included at the price paid. If the stated price is reduced by
trade discounts, report only the actual price paid.
If the stated price is reduced by a cash discount, the taxpayer may
either credit the discount to a separate discount account, or deduct
the discount from the total purchases for the year. If reported to a
separate account, the cost of goods sold is not reduced and the
discount amount is included in business income.
Returns and allowances and all merchandise withdrawn for personal
use reduce the amount for merchandise or raw materials purchased.
Labor costs are included in cost of goods sold only in a manufacturing
or mining business. In a manufacturing business, labor costs include
both the direct and indirect labor used in fabricating the raw material
into the finished product.
Direct labor costs are the wages paid to those employees who spend
their time working directly on the product being manufactured.
Indirect labor costs are the wages paid to employees who perform a
general factory function that does not have any immediate or direct
connection with making a salable product but is nonetheless a
necessary part of the manufacturing process.
Other labor costs that are not chargeable to the cost of goods sold
are deducted as selling or administration expenses.
Materials and supplies used in manufacturing goods are included in the
cost of those goods.
Other costs incurred that are chargeable to the cost of goods sold
include the following:
Freight-in, express-in, cartage-in on raw materials and supplies that
are used in production, and merchandise that is purchased for sale.

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Overhead expenses such as rent, heat, utilities, depreciation, taxes,

insurance, and maintenance incurred as a direct and necessary


expense of the manufacturing process.
Integral parts of the product manufactured, such as containers and
packaging, are part of the cost of goods sold. If not an integral part
of the manufactured product, their costs are considered shipping or
selling expenses.
Inventory at the end of the year is then subtracted from the total of the
costs included in inventory to arrive at the cost of goods sold.

INVENTORIES
Inventories are necessary to clearly show income when the production,
purchase, or sale of merchandise is an income-producing factor in the
business.
The most common inventories include the following:
Merchandise or stock-in-trade.
Raw materials.
Work-in-process.
Finished products.
Supplies that physically become part of the item intended for sale.
The value of inventories at the beginning and end of each year is
required to determine taxable income. To accomplish this, a method of
identifying items of inventory and a method of valuing these items is
required.
Inventories include all finished or partly finished goods and the raw
materials and supplies that become part of the merchandise for sale.
Merchandise is included in inventory only if the taxpayer has title to it.
This includes goods in-transit before the taxpayer actually has physical
possession. This also includes goods under contract for sale that have
not yet been segregated and applied to the contract, goods out on
consignment, and goods held for sale in display rooms, merchandise
mart rooms, or booths located away from the place of business.
Containers are part of inventory if title to them has not passed to the
buyer of the contents. Examples include cases, bottles, drums, and
kegs.
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2010 NATP EA Exam Review Course, Part II

If merchandise is sold by mail with payment and delivery to happen at


the same time, title passes when payment is made. The merchandise
remains in closing inventory until the buyer pays for it.
There are three methods of identifying costs of items in inventory.
Specific identification method This method is used to identify the
cost of each inventoried item by matching the item with its cost of
acquisition. This includes all allocable costs such as labor and
transportation.
First-in, first-out (FIFO) This method assumes that the items the
taxpayer purchased or produced first are the first items sold or
consumed.
Last-in, first-out (LIFO) This method assumes that the items of
inventory purchased or produced last are sold or removed from
inventory first. To adopt the LIFO method, the taxpayer is required
to file Form 970, Application To Use LIFO Inventory Method. The
form or statement containing the same information must be attached
to the timely-filed return that first uses the LIFO method.
Valuing the items in inventory is a major factor in determining
taxable income. The most common methods of valuing inventory are
cost, lower of cost or market, or retail. Once a valuation method is
elected, permission is required to make a change.
Specific identification method (cost) To properly value inventory at
cost, all direct and indirect costs associated with it must be included.
For merchandise on hand at the beginning of the year, cost
means the inventory price of the goods.
For merchandise purchased during the year, cost means the
invoice price less appropriate discounts. Amounts required to be
included under the uniform capitalization rules are also included.
For merchandise produced during the year, cost means all direct
and indirect costs required to be capitalized under the uniform
capitalization rules.
Lower of cost or market method Under this method, the market
value of each item on hand at the inventory date is compared with
its cost. The lower of the two is the amount used.
This method applies to goods purchased and on hand, and the
basic elements of cost of goods being manufactured and finished
goods on hand.
The method does not apply to the following:
Goods on hand or being manufactured for delivery at a fixed
price on a firm sales contract.
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Goods accounted for under the LIFO method.


Market value under ordinary circumstances means the usual bid
price at the date of the inventory.
When goods are offered for sale at prices that are lower than
market, the sales price may be used.
If no market exists, the taxpayer may use whatever evidence
of FMV exists at the nearest date of inventory.
Under the retail method, the total retail selling price of goods on
hand at the end of the year in each department or of each class of
goods is reduced to approximate cost by using an average markup
expressed as a percent of the total retail selling price.
Unsellable goods that are in inventory are valued at selling price less
direct costs of disposition regardless of what method is used to value
the rest of the inventory. Unsellable goods may not be valued for
less than scrap value.

LOSS OF INVENTORY
The taxpayer can claim a casualty or theft loss of inventory, including
items held for sale to customers, through the increase in the cost of
goods sold by properly reporting opening and closing inventories.
Any insurance or other reimbursement received for the loss is taxable.
If a creditor forgives part of what the taxpayer owes because of the
inventory loss, this amount is treated as income and is taxable.
The taxpayer can choose to take the loss separately as a casualty or
theft loss. If the taxpayer chooses to do so, opening inventory or
purchases need to be adjusted to eliminate the loss items and avoid
counting the loss twice.
If the loss is due to a disaster in an area determined by the President to
be eligible for federal assistance, the taxpayer can choose to deduct the
loss on the return for the immediately preceding year. If elected,
opening inventory must be reduced.

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2010 NATP EA Exam Review Course, Part II

UNIFORM CAPITALIZATION
Under the uniform capitalization (UNICAP) rules for inventory,
taxpayers are required to capitalize direct costs and the allocable
portion of indirect costs that benefit or are incurred because of
production or resale activities. Include these costs in the basis of
property produced or acquired for resale, rather than claiming them as
a current deduction. These costs are recovered through depreciation,
amortization, or cost of goods sold, used, or otherwise disposed of.
These rules apply to the items used in the business such as the
construction of equipment to produce the inventory items.
Taxpayers subject to the uniform capitalization rules include the
following:
Taxpayers who produce real property or tangible personal property
for use in a trade or business or in an activity engaged in for profit.
Taxpayers who produce real property or tangible personal property
for sale to customers.
Taxpayers who acquire property for resale. This rule does not apply
to personal property if the average annual gross receipts are $10
million or less.
Tangible personal property includes films, sound recordings, video
tapes, books, artwork, photographs, or similar property containing
words, ideas, concepts, images, or sounds.
UNICAP does not apply to the following:
Resellers of personal property with average annual gross receipts of
$10 million or less (small retailers).
Property produced to use as personal or nonbusiness property or for
uses not connected with a trade or business or an activity conducted
for profit.
Research and experimental expenditures deductible under 174.
Intangible drilling and development costs of oil and gas or
geothermal wells or any amortization deduction allowable under
59(e) for intangible drilling, development, or mining exploration
expenditures.
Property produced under a long-term contract, except for certain
home construction contracts.
Timber and certain ornamental trees raised, harvested, or grown,
and the underlying land.

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Qualified creative expenses incurred as a freelance writer,

photographer, or artist that are otherwise deductible.


Costs allocable to natural gas acquired for resale to the extent these
costs would otherwise be allocable to cushion gas stored
underground.
Property produced if substantial construction occurred before March
1, 1986.
Property provided to customers in connection with providing
services. It must be de minimis in amount and not be inventory in
the hands of the service provider.
Loan origination.
The costs of certain producers who use a simplified method and
whose total indirect costs are $200,000 or less.

Direct costs that must be capitalized include:


Direct labor costs incurred for production or resale activities. This
labor cost includes basic, overtime, sick, and vacation pay, plus all
payroll taxes.
Direct labor includes payments to a supplemental unemployment
benefit plan.
Material costs that become an integral part of the asset plus material
used in the ordinary course of business.
Indirect costs include all costs other than direct labor and materials.
Such costs may include:
Repair and maintenance of equipment or facilities.
Utilities.
Rent of equipment, facilities, or land.
Indirect labor and associated costs.
Indirect material and supplies.
Tools and equipment not otherwise required to be capitalized.
Certain taxes that are not otherwise treated as part of the cost.
Depreciation, amortization, and depletion.
Administrative costs.
Insurance on equipment and facilities.
Business expenses.

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BUSINESS EXPENSES
Business expenses are the costs of carrying on a trade or business.
Such expenses are usually deductible if the business is operated to
make a profit.
The expense must be ordinary and necessary. Ordinary is one that is
common and accepted in the trade or business. Necessary is one that is
helpful and appropriate for the trade or business.
Some costs must be capitalized as opposed to deducted. These costs
are part of the investment in the business.
Costs of any assets used in the business are part of the basis in the
asset and may be depreciable.
Improvements to business assets are capital expenses if the
improvement adds to the value of the asset, appreciably lengthens
the useful life of the asset, or adapts it to a different use.
The taxpayer cannot deduct personal, living, or family expenses.
However, expenses for something used partially for business and
partially for personal are divided and the business use portion is
deductible.
If part of the taxpayers home is used exclusively and regularly for
business, a portion of applicable home expenses is deductible.
If the taxpayer uses a personal automobile partially for business, the
expenses are divided and the business portion is deductible.

EMPLOYEES PAY
Employees pay consists of salaries, wages, commissions, gifts, and
fringe benefits. Payment can be made in the form of cash or other
property.
To be deductible, employees pay must be an ordinary and necessary
expense and must be paid or incurred in the tax year. In addition, the
pay must meet the tests for reasonableness and for services performed.
Ordinary and necessary Salaries, wages, and other payments for
services employees render must be ordinary, necessary, and directly
connected to the taxpayers trade or business.

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Paid or incurred The taxpayer must have actually made the payment
or incurred the expense during the year.
Cash-basis taxpayers deduct salaries and wages in the year paid.
Accrual-basis taxpayers deduct salaries and wages when the
obligation is established and economic performance occurs.
A special rule applies to payments made by accrual-basis taxpayers
to certain related cash-basis taxpayers. The deduction for payments
to related taxpayers is not allowed until the tax year that the related
taxpayer includes the payment in income.
Additional tests that must be met for a deduction include the following:
Reasonableness Reasonable pay is determined by all the relevant
facts and circumstances. This test is based on the circumstances at
the time the taxpayer contracts for the services and not those
existing at the time payment is made.
For services performed The taxpayer must be able to prove the
payments were for services actually performed.
Bonuses and gifts are deductible if they meet certain tests.
Bonuses paid to employees are deductible if they are intended as
additional pay for services and not as gifts. When bonuses are paid,
they must be reasonable in addition to the employees regular pay.
Gifts of nominal value such as turkeys, hams, and other merchandise
distributed to employees at holidays are not taxable as salaries or
wages and remain deductible to the employer. The employer may
not deduct more than $25 per employee per year. Cash, gift
certificates, or other property that is easily converted to cash is
taxable as additional wages regardless of the amount or value.
Loans or advances made to employees that are not expected to be
repaid are deducted as wages.
Vacation pay is deductible if actually paid even though the employee
chooses not to take a vacation.
Cash-basis taxpayers deduct vacation pay when payment is made.
Accrual-basis taxpayers can deduct vacation pay in the year earned
by employees only if it is paid by either of the following:
The close of the employers tax year.
Within two and one-half months after the close of the tax year if
the amount is vested.
For tax years ending after July 22, 1998, vacation pay is not
considered paid until it is actually received by the employee.
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Unpaid salaries If there is a definite, fixed, and unconditional


agreement to pay an employee a certain salary for the year, but
payment is deferred until the following year, the deductibility depends
on the method of accounting.
Using the accrual method, the full salary can be deducted when
economic performance has occurred.
Using the cash method, only the amount actually paid each year can
be deducted.
An exception applies for an accrual-basis taxpayer making payments
to a related party. The salary is deductible for the tax year the
payment is made and the amount is included in the income of the
person paid.
If the employer pays or reimburses educational expenses for an
employee enrolled in a course not required for the job or not otherwise
job-related, the full amount of the payment is added to the employees
wages and can be deducted.
Capital assets transferred to an employee are treated as wages at the
FMV of the asset, less any amount the employee pays for the transfer.
The employer treats the deductible amount as an amount received in
exchange for the asset and recognizes any gain or loss realized on the
transfer.
Amounts paid to an employee for sickness or injury, including lumpsum amounts, are deducted as wages.
A salary paid to an employee-shareholder must meet the same
requirements for deductibility as the salary for any other employee.
The requirements for deductibility also apply to payments to a relative,
including a minor child.
Payments made to an employees beneficiary because of the employees
death are deductible if reasonable in relation to past services performed
by the employee.

FRINGE BENEFITS
A fringe benefit is a form of pay for the performance of services. Fringe
benefits can be provided to employees, independent contractors, or

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those who agree not to perform a service (covenant not to compete).


Fringe benefits are taxable and must be included in income unless
specifically excluded by law. If a taxable fringe benefit is provided to an
employee, the value of the benefit is subject to employment taxes.

Cafeteria Plans
A cafeteria plan, including a flexible spending arrangement (FSA), is a
written plan that allows employees to choose between receiving cash or
taxable benefits instead of certain qualified benefits for which the law
provides exclusion.
Qualified benefits include accident and health benefits, adoption
assistance, dependent care assistance, group-term life insurance
coverage, and health savings accounts (HSAs).
Benefits not allowed include Archer medical savings accounts (MSAs),
athletic facilities, de minimis benefits, educational assistance, employee
discounts, lodging on the employers premises, meals, moving expense
reimbursement, no-additional-cost services, scholarships, transportation
benefits, tuition reductions, or working condition fringe benefits.
The exclusion from income does not apply to certain employees.
Do not treat a 2% shareholder of an S corporation as an employee.
If the plan favors highly compensated employees as to eligibility to
participate, contributions, or benefits, the value of the taxable
benefit they could have selected is included in income. Highly
compensated employees include:
Officers.
Shareholders who own more than 5% of the voting power or
classes of stock.
Employees who are highly compensated based on the facts and
circumstances.
Spouses or dependents of any of the above.
If the plan favors key employees, the value of taxable benefits they
could have selected is included in income. Key employees include:
An officer having annual pay of more than $160,000.
An employee who is either a 5% owner of the business.
A 1% owner of the business whose annual pay is more than
$150,000.

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Accident and Health Benefits


Employer contributions to an accident or health plan for an employee
include contributions to the cost of accident or health insurance,
contributions to a separate trust or fund that provides accident or
health benefits directly or through insurance, or contributions to a
health savings account (HSA), an Archer medical savings account
(MSA), a health flexible spending arrangement (FSA), or a health
reimbursement arrangement (HRA).
The exclusion also applies to payments made directly or indirectly to an
employee, under a plan, that are either payments or reimbursements of
medical expenses, or payments for specific injuries or illnesses.
The value of accident or health benefits provided to an employee can
generally be excluded from the employees wages. The exclusion does
not apply to the cost of long-term care insurance if the coverage is
provided through a flexible spending or similar arrangement. In
addition, the exclusion does not apply to a 2% or more S corporation
shareholder or a self-insured medical reimbursement plan that favors
highly compensated employees.
For this exclusion, the following individuals are treated as employees:
A current common-law employee.
A full-time life insurance agent who is a current statutory employee.
A retired employee.
A former employee the employer maintained coverage for based on
the employment relationship.
A widow or widower of an individual who died while an employee.
A widow or widower of a retired employee.
A leased employee who has provided services to the employer on a
substantially full-time basis for at least a year if the services are
performed under the employers primary direction and control.
A health savings account is a tax-exempt trust or custodial account
set up with a qualified HSA trustee to pay or reimburse certain medical
expenses of an eligible individual.
The benefits of an HSA include the following:
Taxpayers can claim a tax deduction for contributions they make,
even if they do not itemize.
Contributions made by an employer are excluded from gross income.
Contributions remain in the account from year to year until used.
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Interest and earnings on the assets in the account are tax-free.


Distributions are tax-free if used to pay qualified medical expenses.
An HSA is portable so it stays with the taxpayer if he or she changes

employers or leaves the work force.


To be an eligible individual, the following requirements must be met:
The taxpayer has a high deductible health plan (HDHP).
The taxpayer has no other health coverage, with some exceptions.
The taxpayer is not enrolled in Medicare.
The taxpayer cannot be claimed as a dependent on someone elses
tax return.
If an individual meets the requirements, he or she is an eligible
individual even if his or her spouse has non-HDHP family coverage,
provided the spouses coverage does not cover the taxpayer. If both
spouses are eligible individuals and want an HSA, each must open a
separate HSA. They cannot have a joint HSA.
An HDHP has a higher annual deductible than typical health plans and a
maximum limit on the sum of annual deductible and out-of-pocket
medical expenses the taxpayer must pay for covered expenses. Out-ofpocket expenses include copayments and other amounts, but do not
include premiums.
For 2009, the minimum annual deductible for self-only plans is $1,150
and the maximum annual deductible and other out-of-pocket expenses
for self-only coverage is $5,800. For family coverage, the minimum is
$2,300 and the maximum is $11,600.
An eligible individual cannot have any other health coverage that is not
an HDHP. However, the individual can have additional insurance that
provides benefits for the following items:
Liabilities incurred under workers compensation laws, tort liabilities,
or liabilities related to ownership or use of property.
A specific disease or illness.
A fixed amount per day of hospitalization.
Coverage provided through insurance or otherwise for accidents,
disability, dental care, vision care, or long-term care.
A taxpayer can have a prescription drug plan, either as part of the
HDHP or a separate plan and still qualify for an HSA.
For an employees HSA, the employee and the employer may contribute
in the same year. Contributions must be made in cash. The maximum
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contribution for 2009 for a self-only plan is $3,000. This limit is $5,950
for family coverage. For an eligible individual age 55 or over, the
contribution limit is increased by $1,000.
Contributions made by an employer are excluded from the employees
income. Contributions using an amount of an employees salary
reduction through a cafeteria plan are treated as employer
contributions. Contributions by a partnership to a partners HSA for
services rendered are treated as a guaranteed payment includible in the
partners income. Contributions by an S corporation to a 2%
shareholder-employees HSA for services rendered are treated the same
as guaranteed payments, deductible by the S corporation and included
in the shareholders income. Form 8889, Health Savings Accounts
(HSAs), is used to report all contributions. Contributions in excess of
the limits are subject to a 6% excise tax on excess contributions.
An HDHP generally does not reimburse expenses until the annual
deductible is met.
An individual can receive tax-free distributions from an HSA to pay or
reimburse qualified medical expense incurred after the HSA is
established. Any other distribution is subject to a 10% early distribution
excise tax. Distributions are reported on Form 8889 and, to the extent
used for qualified medical expenses, are excluded from income.
An Archer MSA can be set up by an employer who employs on average
50 or fewer employees during either of the last two calendar years.
Employer contributions made to the individuals MSA are excluded from
wages.
An MSA is a trust or custodial account similar to an IRA that permits
individuals to set aside money to pay medical expenses that are not
reimbursed by health insurance.
Eligible employees are those who are covered by a small business high
deductible health plan. A high deductible health plan has the following
characteristics:
For 2009, an annual deductible that is not less than $2,000 and not
more than $3,000 for self-only coverage, and not less than $4,000
and not more than $6,050 for family coverage.
For 2009, an annual out-of-pocket expense limit of not more than
$4,000 for self-only coverage and $7,350 for family coverage.

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Benefits of an Archer MSA include the following:


The taxpayer can claim a tax deduction for contributions even if not
itemizing.
Interest and other earnings on the assets are tax-free.
Distributions are tax-free if used to pay qualified medical expenses.
Contributions in the Archer MSA remain from year to year until used.
The Archer MSA is portable so it stays with the taxpayer if he or she
changes employers or leaves the work force.
Contributions to an Archer MSA from both employer and employee are
limited to the applicable portion of the annual deductible amount or the
earned income from the employer for whom the individual has the
HDHP. The applicable portion for self-only coverage is 65% of the
annual deductible. For family coverage, the applicable portion is 75% of
the annual deductible. All contributions are reported on Form 8853,
Archer MSAs and Long-Term Care Insurance Contracts, and the eligible
deduction is taken as an adjustment to income on Form 1040.
Contributions in excess of the limits are subject to a 6% excise tax on
the excess contribution.
An Archer MSA may provide a tax-free distribution during the year to
meet the high deductible before the HDHP reimburses expenses.
Distributions used to pay qualified medical expenses can be excluded
from income. If not used for qualified medical expenses, the distribution
is subject to tax and may be subject to a penalty. All distributions are
reported on Form 8853.

Note: New Archer MSA plans cannot be established after 2007 (as
extended by the Tax Relief and Health Care Act of 2006).
However, individuals who have an Archer MSA before 2008
can retain those accounts and make contributions after 2007.

A health flexible spending arrangement (FSA) allows employees to


be reimbursed for medical expenses. FSAs are usually funded through
voluntary salary reduction agreements with an employer, and no
employment or federal income taxes are deducted from the
contribution.

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Benefits of an FSA include the following:


Contributions made by the employer are excluded from gross
income.
No employment or federal income taxes are deducted.
Withdrawals are tax-free if used to pay qualified medical expenses.
The funds are available for withdrawal to pay medical expenses even
if the contributions have not yet been made to the account.
There is no limit on the amount that can be contributed to the account;
however, the plan must prescribe either a maximum dollar amount or a
maximum percentage of compensation.
Distributions must be paid only to reimburse for qualified medical
expenses incurred during the period of coverage. Contributions not
spent by the end of the plan year are forfeited.
Health reimbursement arrangements (HRA) must be funded solely
by the employer, and not through a voluntary salary reduction
agreement on the part of the employee.
The benefits of an HRA include the following:
Contributions made by the employer are excluded from gross
income.
Reimbursements are tax-free if used to pay qualified medical
expenses.
Any unused amounts can be carried forward for reimbursement in
later years.
Qualified medical expenses are those specified in the plan that would
generally qualify for itemized deductions. This includes amounts paid for
health insurance, amounts paid for long-term care coverage, and
amounts that are not covered under another health plan.

Awards
Amounts paid to employees as awards, whether paid in cash or
property, are deductible. The deduction is limited for property given as
an achievement award.
An achievement award is an item of tangible personal property that
meets the following requirements:

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It is given to an employee for either length of service or safety

achievement.
It is awarded as part of a meaningful presentation.
It is awarded under circumstances that do not create a significant
likelihood of disguised pay.
An award qualifies as a length-of-service award if either of the following
applies:
The employee receives the award after five years of employment.
The employee did not receive another length-of-service award during
the same year or in any of the prior four years.
An award for safety achievement qualifies unless one of the following
applies:
It is given to a manager, administrator, clerical employee, or other
professional employee.
During the tax year, more than 10% of the employees have already
received a safety achievement award.
The deduction is limited as follows:
$400 for awards that are not qualified plan awards.
$1,600 for all awards, whether or not qualified plan awards.
The deduction is taken as a nonwage business deduction.
A qualified plan award is an achievement award given as part of an
established written plan or program that does not favor highly
compensated employees as to eligibility or benefits. Highly
compensated employees include 5% owners and employees paid at
least $110,000 for 2009 and 2010.
An employee achievement award can also be excluded from the
employees compensation up to the deductible amount. The exclusion
does not apply to awards of cash, cash equivalents, or intangible
property such as vacations, meals, tickets, or securities.

Adoption Assistance
Payments or reimbursement made under an adoption assistance
program paid for qualified adoption expenses are excludable from
wages subject to federal income tax withholding.

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Qualified expenses up to $12,150 per qualifying child can be paid or


reimbursed.
Payments are subject to social security, Medicare, and federal
unemployment taxes.
Up to $12,150 can be excluded for the adoption of a child with special
needs regardless of whether the employee has qualified adoption
expenses.

Athletic Facilities
Certain athletic facilities qualify as nontaxable fringe benefits. The
facility must be on the premises of the employer, operated by the
employer, and substantially all of the use of the facility is by the
employees, their spouses, and their dependent children.

De Minimis Benefits
The value of a de minimis benefit provided to an employee can be
excluded from wages.
A de minimis benefit is any property or service provided to an employee
that has so little value that accounting for it would be unreasonable or
administratively impracticable.
Examples of de minimis benefits include copy machine use, holiday
gifts, life insurance on a spouse or dependent if the face value is not
more than $2,000, certain meals, occasional parties or picnics,
occasional tickets for entertainment or sporting events, transportation
fare, or occasional typing of personal letters by a company secretary.

Dependent Care Assistance


This exclusion applies to household and dependent care services the
employer pays for, directly or indirectly, or provides to an employee
under a dependent care assistance program that covers only
employees. This can include providing the care facility, payments to a
third party, or reimbursing the employees directly.

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The services must be for the care of a qualifying person and must be
incurred to allow the employee to work.
Up to $5,000 of benefits can be excluded each year. This is reduced to
$2,500 if the employee is MFS.
The exclusion cannot be more than the earned income of the employee
or the employees spouse.
Dependent care assistance to highly compensated employees cannot be
excluded unless the benefits provided under the program do not favor
highly compensated employees.

Educational Assistance Program


An educational assistance program is a separate written plan of an
employer that meets all the following requirements:
It benefits employees who qualify under rules established by the
employer. The plan established must not favor highly compensated
employees or their dependents.
It does not pay more than 5% of its payments during the year for
shareholders or owners (or their spouses or dependents). For this
purpose, a shareholder or owner is someone who owns, on any day
during the year, more than 5% of the stock or capital and profits in
the business.
It does not allow employees to choose to receive cash (or other
benefits that must be included in gross income) instead of
educational assistance.
The employer must give reasonable notice of the program to eligible
employees.
Educational assistance means amounts that are paid or incurred for
tuition, books, fees, equipment, and supplies. The exclusion also applies
to graduate-level courses.
Excludable educational assistance does not include the following:
The cost of courses or other education involving sports, games, or
hobbies, unless a special exception applies.
The cost of travel, meals, or lodging.
The cost of equipment, tools, or supplies (other than textbooks) that
the individual is allowed to keep at the end of the course.

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Up to $5,250 of educational assistance provided to an employee can be


excluded under this program. If the employer does not have an
educational assistance plan or if the educational assistance program
pays more than $5,250, the excess is additional compensation to the
employee unless it qualifies to be excluded as a working condition fringe
benefit.

Employee Discounts
This exclusion applies to a price reduction given to an employee on
property or services the employer offers to customers in the ordinary
course of the line of business in which the employee performs
substantial services.
The exclusion does not apply to discounts on real property or discounts
on personal property of a kind commonly held for investment.
The exclusion is limited as follows:
For a discount of services, 20% of the price normally charged to
nonemployee customers.
For a discount of merchandise or other property, the gross profit
percentage times the price normally charged to nonemployee
customers.

Employee Stock Options


Wages for social security, Medicare, and federal unemployment taxes
do not include remuneration resulting from the exercise after October
22, 2004, of an incentive stock option (ISO) or under an employee
stock purchase plan (ESPP) option, or from the disposition of stock
acquired by exercising such an option.
Federal income tax withholding is not required on the income resulting
from a disqualifying disposition of stock acquired by the exercise of an
ISO or under an ESPP, or on income equal to the discount portion of
stock acquired by the exercise, after October 22, 2004, of an ESPP
option resulting from any disposition of the stock. The employer is not
required to withhold FICA taxes nor pay FUTA on these dispositions.
The employer must report as income in box 1 of Form W-2 both of the
following:
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The discount portion of stock acquired by the exercise of an ESPP

option on the disposition of the stock.


The spread (between the exercise price and the FMV of the stock at
the time of exercise) upon a disqualifying disposition of stock
acquired by the exercise of an ISO or an ESPP.
An employer must report the excess of the FMV of stock received upon
exercise of a non-statutory stock option over the amount paid for the
stock on Form W-2 in boxes 1, 3 (up to the social security wage base),
5, and in box 12 using code V.

Group-Term Life Insurance Coverage


Life insurance premiums paid by the employer are not included in the
employees Form W-2 income if it is a group-term policy providing a
death benefit of $50,000 or less of protection, and the employer is not
the beneficiary.
Group-term life does not include the following:
Insurance that does not provide general death benefits, such as
travel insurance.
Life insurance on the life of an employees spouse or dependent.
Insurance provided under a policy that provides permanent benefits
unless other requirements are satisfied.
If the plan favors key employees, the entire cost of the insurance is
included in the key employees wages subject to social security and
Medicare taxes. The amount is also included in box 1 of Form W-2 but
can be excluded for federal income tax withholding and federal
unemployment tax purposes.
The cost of coverage over $50,000 is included in an employees wages
subject to social security and Medicare taxes.

Lodging on Employers Business Premises


The value of lodging furnished to an employee can be excluded from
wages if it meets the following tests:
It is furnished on the employers business premises.
It is furnished for the employers convenience.
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2010 NATP EA Exam Review Course, Part II

The employee must accept it as a condition of employment.

The exclusion does not apply if the employee is given the choice of
receiving additional pay instead.

Meals
De minimis meals can be excluded from income and include such things
as coffee, doughnuts, or soft drinks; occasional meals or meal money
provided to enable the employee to work overtime; or occasional
parties or picnics for employees and guests.
The exclusion applies to meals provided at an employer-provided eating
facility for employees if the annual revenue from the facility equals or
exceeds the direct costs of the facility.
If qualified as de minimis, the 50% limit on deductions does not apply.
The employer can exclude the value of meals furnished to an employee
if they meet the following tests:
They are furnished on the employers business premises.
They are furnished for the employers convenience.
Meals furnished during working hours so an employee is available for
emergency calls during the meal period are furnished for the employers
convenience.
If the meal is provided because the nature of the work restricts an
employee to a short meal period, and the employee cannot be expected
to eat elsewhere in such a short time, the meal is provided for the
employers convenience.

Moving Expense Reimbursement


This exclusion applies to any amount given to an employee, either
directly or indirectly, as a payment for or reimbursement of qualified
moving expenses.
Eligible expenses are those the employee could deduct if paid for and
not reimbursed. Such expenses include the following:

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Moving household goods and personal effects from the former home

to the new home.


Traveling, including lodging, from the former home to the new home.

No-Additional-Cost Services
This exclusion applies to a service provided to an employee that does
not cause the employer to incur any substantial additional cost. The
service must be offered to customers in the ordinary course of the line
of business in which the employee provides substantial services.
Generally, these are excess capacity services, such as airline, bus, or
train tickets, hotel rooms, or telephone services provided free or at a
reduced price to employees working in those lines of business.
Services from an unrelated employer may also fall into this category if
provided under a reciprocal agreement and neither employer incurs any
substantial additional cost.

Retirement Planning Services


The value of any retirement planning advice or information provided to
an employee or an employees spouse can be excluded if the employer
maintains a qualified retirement plan.
The exclusion does not apply to tax preparation, accounting, legal, or
brokerage services.

Transportation Benefit
This exclusion applies to benefits provided to employees for personal
transportation, such as commuting to and from work. This benefit is
applied to de minimis transportation benefits and qualified
transportation benefits.
A de minimis transportation benefit is one provided to an employee that
has so little value that accounting for it would be unreasonable or
impractical.

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Qualified transportation benefits include provisions for commuter


highway vehicles, transit passes, and qualified parking.
The amount that can be excluded is as follows:
$120 per month through February 28, 2009, and $230 March
1-December 31, 2009, for combined commuter highway vehicle
transportation and transit passes ($230 for 2010).
$230 per month for qualified parking ($230 for 2010).
$20 per month for bicycle commuter benefits. This benefit is not
available for any month the employee is provided other transit or
parking benefits.

Tuition Reduction
An educational organization can exclude the value of a qualified tuition
reduction it provides to an employee.
The tuition reduction for undergraduate education can be for an
employee, former employee who retired or left on disability, a widow or
widower of an individual who died while employed or formerly
employed, or a dependent of any of these individuals.
Graduate education qualifies only if it is for the education of a graduate
student who performs teaching or research activities for the educational
organization.

Working Condition Benefits


Applies to property or services provided to an employee so that the
employee can perform his or her job. The employee must meet any
substantiation requirements that may apply.
The exclusion does not apply to the following items:
A service or property provided under a flexible spending account in
which the employer agrees to provide the employee with a certain
level of unspecified noncash benefits with a predetermined cash
value.
A physical examination program provided, even if mandatory.

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Any item to the extent the employee could deduct its cost as an

expense for a trade or business other than that employers trade or


business.
The exclusion may apply to the following, provided other requirements
are satisfied:
An employees use of a company car for business and job-related
education provided to an employee.
The use of a demonstrator car used by a full-time auto salesperson.
The use of a qualified nonpersonal-use vehicle, such as a clearly
marked police or fire vehicle. A pickup truck or van with a loaded
gross vehicle weight of 14,000 pounds or less is a qualified
nonpersonal-use vehicle if it has been specially modified so it is not
likely to be used more than minimally for personal purposes.
Outplacement services.

RETIREMENT PLAN CONTRIBUTIONS


The employer generally excludes qualified retirement plan contributions
it provides from the income of employees. The employer is allowed a
deduction for the contribution. Contributions to nonqualified plans are
deductible by the employer in the tax year in which the employee
includes the amount in income.

RENT EXPENSE
Rent is any amount paid for the use of property that the taxpayer does
not own. To be deductible, rent must be reasonable.
Rent paid in advance is deductible over the period to which it applies.
Lease expenses are deducible as an ordinary expense provided the
lease was not intended as a purchase from the beginning of the lease
term. If it is a lease and not a purchase, the lease payments and any
taxes paid on the leased property are deducted as rent.
Whether the transaction is a conditional sales contract or lease depends
on the intent of the parties. A conditional sales contract can be
indicated by any of the following provisions:

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The agreement applies part of each payment toward an equity

interest.
The taxpayer gets title to the property after making a stated amount
of required payments.
The amount paid to use the property for a short time is a large part
of the amount the taxpayer would pay to get title to the property.
The taxpayer pays much more than the current fair rental value of
the property.
The taxpayer has an option to buy the property at a nominal price
compared to the value of the property when the option can be
exercised.
The taxpayer has an option to buy the property at a nominal price
compared to the total amount required to be paid under the
agreement.
The agreement designates part of the payment as interest, or that
part is easy to recognize as interest.

The cost of acquiring a lease is not rent. Generally, this arises in


conjunction with acquiring an existing lease from another lessee.
If acquiring an existing lease on property or equipment to use in
business, the cost of getting the lease is amortized over the remaining
term of the lease. The term of the lease includes all renewal options if
less than 75% of the cost is for the term of the lease remaining on the
purchase date.
If an additional amount is paid to change certain provisions of the lease,
this amount is also amortized over the remaining term of the lease.
Commissions, bonuses, and fees paid to obtain a lease must be
amortized over the term of the lease.
The cost of improvements to leased property is generally
depreciated over the appropriate recovery period under the modified
accelerated cost recovery system (MACRS). The taxpayer may have a
gain or loss if the improvement is not retained when the lease expires.
The gain or loss is based on the adjusted basis of the improvement at
the time the lease expires and the sales price of the improvement, if
any.
The costs to rent equipment, facilities, or land are considered indirect
costs if the taxpayer is subject to UNICAP.

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TRAVEL, MEALS, AND ENTERTAINMENT


Travel expenses are ordinary and necessary expenses while traveling
away from home for the taxpayers profession or business. This topic is
thoroughly discussed in Part I of the EA Exam Review Course.
An advance or reimbursement of the above expenses is generally
deductible. The manner and amount depend on whether it is under an
accountable plan or a nonaccountable plan.
If the accountable plan rules are met, the expense is deductible as if
the business paid them, nothing is included in the employees Form
W-2, and the employee takes no deduction. A 50% deduction limit
applies to reimbursements made to employees for expenses incurred
for meals while traveling away from home and for entertaining business
customers.
Reimbursement under an accountable plan must meet three
requirements:
The employees expense must have a business connection.
The employee must adequately account to the employer for the
expenses within a reasonable period of time (60 days).
The employee must return any excess reimbursement or allowance
within a reasonable period of time (120 days).
An employer can reimburse employees based on travel days, miles, or
some other fixed allowance. The employee is considered to have
accounted for the amount that does not exceed the rates established by
the federal government. The federal rate can be figured using any one
of the following methods:
For per diem amounts:
The regular federal per diem rate.
The standard meal allowance.
The high-low rate.
For car expenses:
The standard mileage rate.
A fixed and variable rate (FAVR).
For 2009, the standard mileage rate is 55 cents per mile (50 cents per
mile in 2010).

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The regular federal per diem rate is the highest amount the federal
government pays to its employees while away from home on travel. It
has two components: lodging expense and meal and incidental expense
(M&IE). The employer may pay only an M&IE allowance to employees
who travel away from home if one of the following is satisfied:
The employer pays the employee for actual expenses for lodging
based on receipts submitted.
The employer provides for the lodging.
The employer pays for the actual expense of the lodging directly to
the provider.
The employer has a reasonable belief that lodging expenses were not
incurred.
The allowance is computed on a basis similar to that used in
computing the employees wages.
The standard meal allowance is an alternative to the actual cost
method. It allows the use of a set amount for daily meals and incidental
expenses (M&IE) instead of keeping actual records.
The taxpayer must still keep records to prove the time, place, and
business purpose.
Incidental expenses include fees and tips given to porters, baggage
carriers, bellhops, maids, etc.; transportation between places of
lodging or business and places where meals are taken; and mail
costs associated with filing travel vouchers and payment of
employer-sponsored charge card billings.
If using the standard meal allowance and not reimbursed, or
reimbursed under a nonaccountable plan, the taxpayer can only
deduct 50% of the allowance. If reimbursed under an accountable
plan and deducting an amount that is more than reimbursement, the
deduction is limited to 50% of the excess amount.
The standard meal allowance can be used by employees and selfemployed individuals.
The standard meal allowance can be used for business travel, travel
in connection with investment and other income-producing activities,
and travel for qualifying education. It cannot be used when travel is
for medical or charitable purposes.
The high-low method is a simplified method where the per diem
amount for travel is $256 ($58 for M&IE) for certain high-cost locations
and $158 ($45 for M&IE) for all other locations for 2009. For 2010,
these rates are $258 and $163 respectively.

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If the allowance is less than or equal to the federal rate, nothing is


reported on the employees W-2. If the allowance or reimbursement is
more than the federal rate, the excess is included in the employees
income.
If an employees expenses are more than the reimbursement, the
employee is eligible to complete Form 2106, Employee Business
Expenses, to deduct the actual expense in excess of the allowance.
For employees subject to the Department of Transportations hours
of service limits, the deduction limit is increased to 80% for 2008 and
after.
Business-related entertainment expenses for entertaining a client,
customer, or employee are deductible if they are ordinary and
necessary and meet the directly related test or the associated test.
The deduction is subject to the 50% limit.
Club dues and membership fees for clubs organized for business,
pleasure, recreation, or other social purpose are not deductible. This
includes country clubs, golf and athletic clubs, airline clubs, hotel
clubs, and clubs operated to provide meals under circumstances
generally considered to be conducive to business discussions.
Expenses for the use of an entertainment facility are not deductible.
This includes depreciation and operating expenses, rent, utilities,
maintenance, and protection. The taxpayer can deduct out-ofpocket expenses, such as for food and beverages, catering, gas, and
fishing bait that he or she provided during the entertainment at the
facility.
Entertainment meets the directly related test when:
The entertainment takes place in a clear business setting; or
The main purpose was the active conduct of business and business
was engaged in with more than a general expectation of getting
income or some other business benefit.
Entertainment meets the associated test when both of the following
apply:
The entertainment is associated with the trade or business.
Entertainment directly precedes or follows a substantial business
discussion.
An item that may be considered either a gift or entertainment generally
is considered entertainment. If the taxpayer gives a customer tickets to

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a theater performance or sporting event and does not accompany the


customer, the tickets could be treated as either a gift or entertainment,
whichever is to the taxpayers advantage. If the taxpayer accompanies
the customer, the ticket cost must be treated as an entertainment
expense.
If the accountable plan rules are not met, the reimbursement is under a
nonaccountable plan and reported as income by the employee.
An employer may reimburse under an accountable plan, but some of
the expenses may be nondeductible. Reimbursements of nondeductible
expenses are treated as paid under a nonaccountable plan.
Reimbursement under a nonaccountable plan is included in the
employees wages.
An independent contractor may receive reimbursement or an allowance
for travel, entertainment, or gift expenses incurred on behalf of a client.
If the contractor does not adequately account to the client for these
expenses, any reimbursement or allowance is included in income.

GIFTS
If the taxpayer gives gifts in the course of a trade or business, he or
she can deduct all or a part of the cost.
The taxpayer can deduct no more than $25 for business gifts given
directly or indirectly to any person during the tax year. A gift to a
company that is intended for the eventual personal use or benefit of a
particular person or limited class of people is considered an indirect gift
to that person or individuals within that class.
If the taxpayer and spouse both give gifts, both are treated as one
taxpayer for the $25 limit.
Incidental costs such as engraving, packaging, insuring, and mailing are
generally not included in the $25 limit.
Items not considered gifts for the $25 limit include the following:
An item that costs $4 or less and has the company name clearly and
permanently imprinted and is one of a number of identical items
distributed.

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Signs, display racks, or other promotional materials to be used on

the business premises of the recipient.

INTEREST
Interest paid or accrued on a debt related to a trade or business is
deductible. The taxpayer must be liable for the debt.
Allocation rules apply if money borrowed is used partially in a trade or
business and partially for personal or investment purposes, or in a
passive activity. Tracing disbursements to specific uses completes
allocation. The type of expenditure to which the debt is allocated
determines the limitation, if any, that applies to the interest expense
deduction. The allocation is not generally affected by the use of the
property that secures the debt.
If a loan is received in cash and deposited in an account, the taxpayer
can treat any payment (up to the amount of the loan) from any account
he or she owns, or from cash, as made from the loan proceeds. This
applies to any payment made within 30 days before or after the
proceeds are received and deposited. Loan proceeds deposited in an
account are treated as property held for investment. Until the proceeds
are used, interest charged on the loan is treated as investment interest.
A cash-basis taxpayer does not deduct interest until paid in cash or its
equivalent.
If any part of a loan allocated to more than one use is repaid, the
amount is treated as repaid in the following order:
Amounts allocated to personal use.
Amounts allocated to investments and passive activities.
Amounts allocated to passive activities in connection with a rental
real estate activity in which the taxpayer actively participates.
Amounts allocated to former passive activities.
Amounts allocated to trade or business use and to expenses for
certain low-income housing projects.
Interest paid or accrued on debts related to a trade or business is
generally deductible. Deductible interest includes the following:
Interest on loans with respect to life insurance policies for key
employees.

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Mortgage interest payments on business property. This includes

points paid for the use of the money, which are deducted ratably
over the term of the loan. Deductible mortgage interest also includes
a prepayment penalty charged by the lender for paying the loan off
early.
The interest portion of payments on business assets purchased using
the installment method.
Interest charged on employment taxes assessed on the business.
Nondeductible interest includes the following:
If the taxpayer uses the cash method of accounting, interest paid
with funds borrowed from the original lender through a second loan,
an advance, or any other arrangement similar to a loan.
Interest that must be capitalized.
Commitment fees or standby charges.
Interest on an income tax liability on the taxpayers individual return.
For contracts issued after June 8, 1997, the taxpayer cannot deduct
interest with respect to any life insurance, annuity or endowment
contract that covers any individual, unless that individual is a key
employee.
Interest related to tax-exempt income.
Interest on debt used to finance the production of real or tangible
personal property must generally be capitalized. The property must be
produced by the taxpayer for use in the taxpayers trade or business or
for sale to customers. Interest related to property acquired in any other
manner cannot be capitalized. Interest paid or incurred during the
production period must be capitalized if the property produced is
designated property. Designated property is any of the following:
Real property.
Personal property with a class life of 20 years or more.
Personal property with an estimated production period of more than
two years.
Personal property with an estimated production period of more than
one year if the estimated cost of production is more than $1 million.
If the taxpayer receives a below-market gift or demand loan, and uses
the proceeds in a trade or business, the forgone interest is deductible.
A below-market loan is a loan on which no interest is charged or on
which interest is charged at a rate below the applicable federal rate.

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When interest is charged at a rate below the applicable federal rate

(below market loan), the borrower is treated as having received both


of the following:
A loan in exchange for a note that requires the payment of
interest at the applicable federal rate.
An additional payment in the amount of the forgone interest. The
additional payment is treated as a gift, dividend, contribution to
capital, payment of compensation, or other payment depending
on the purpose of the transaction.
If the taxpayer receives a below-market gift loan or demand loan, he
or she is treated as receiving an additional payment equal to the
forgone interest and then treated as transferring this amount back to
the lender as interest.
For gift loans between individuals, forgone interest treated as
transferred back to the lender is limited to the borrowers net
investment income for the year. This limit applies if the outstanding
loans between the lender and borrower total $100,000 or less.
The rules for below-market loans do not apply to any day on which
the outstanding loans between the borrower and lender total
$10,000 or less.

INSURANCE
Premiums paid on cost of insurance that is for a trade, business, or
profession can generally be deducted as an ordinary and necessary
business expense. Insurance premiums are ordinarily deducted in the
tax year to which they apply, even for a cash-basis taxpayer.
Deductible premiums include:
Fire, theft, flood, or other casualty.
Merchandise or inventory insurance.
Credit insurance to cover losses from business bad debts.
Employees group hospitalization and medical plans, including longterm care insurance.
If a partnership pays accident and health insurance premiums for
its partners, it generally can deduct them as guaranteed
payments to partners.
If an S corporation pays accident and health insurance premiums
for its 2% shareholder-employees, it generally can deduct them

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as wages, but must also include them in the shareholders wages


subject to federal income tax withholding.
Employers liability.
Public liability.
Malpractice or professional liability.
Workers compensation. The same rule that applies to partnerships
and S corporations for accident and health insurance applies to
workers compensation insurance.
Contributions to state unemployment funds.
Business interruption insurance.
Car and truck insurance.
Employee performance bonds required by law.
Life insurance covering officers or employees if the business is not,
directly or indirectly, a beneficiary under the contract. The premiums
are nondeductible if the taxpayer is, directly or indirectly, the
beneficiary of the policy.

Nondeductible insurance premiums include:


Certain life insurance premiums on a policy on the taxpayers own
life.
Payments to a self-insured reserve fund.
Payments on a policy that pays for lost earnings due to sickness or
disability.
Insurance to secure a loan.
A self-employed taxpayer (including a partner and 2% S corporation
shareholder) can deduct 100% of the cost of health insurance that
covers himself or herself, a spouse, and dependents. The individual is
not allowed a deduction if he or she is eligible to be covered under a
plan subsidized by an employer or a spouses employer.
To be eligible for this deduction, the taxpayer must meet one of the
following classifications:
Self-employed with a net profit reported on Schedule C, Schedule
C-EZ, or Schedule F.
A general partner of a partnership with net earnings from selfemployment reported in box 14, Code A, of Schedule K-1 (Form
1065).
A more-than-2% shareholder of an S corporation with wages from
the corporation reported on Form W-2.
The plan must be established under the business.

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For Schedule C, Schedule C-EZ, and Schedule F filers, the policy

can be in the name of the business or the individual.


For partners, the policy can be in the name of the partner, but the
partner must substantiate the expense and be reimbursed by the
partnership. The partnership includes the reimbursement in the
partners income.
For greater than 2% shareholders, the policy can be in the name
of the shareholder, but the shareholder must substantiate the
expense and be reimbursed by the S corporation. The S
corporation includes this reimbursement in the shareholders
income.
Premiums paid on long-term care insurance also qualify but are
limited as to the amount that can be deducted.
Premiums on group-term life insurance for an amount up to $50,000
are deductible. Premiums for the cost over this amount are included in
the employees income and are deducted as a wage expense.

TAXES
Taxes paid in the course of an active trade or business are generally
deductible in the year paid, for both cash and accrual taxpayers. Taxes
are deducted in the year accrued if the exception under recurring items
is met.
Deductible taxes include the following:
Real estate taxes paid on property owned.
Assessments for local benefits that increase the value of the
property are not deductible, but can be capitalized. Local
assessments for maintenance, repairs, or interest charges for
benefits such as streets, sidewalks, and water and sewage
systems are deductible.
If real estate is sold, the real estate taxes must be divided
between the buyer and seller based on the number of days of
ownership in the real property tax year.
State and local income taxes imposed on a corporation or a
partnership are deductible by the corporation or the partnership.
Personal property tax imposed by a state or local government on
personal property used in a trade or business.

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Employment taxes include the employers payment of social security,

Medicare, and federal unemployment. This includes payments to a


state unemployment compensation fund or a state disability fund.
Sales tax, if included in gross receipts. Sales tax paid on the
purchase of property or service is part of the cost of that property or
service.
Foreign income taxes imposed on the individual can be either a
deduction or a credit.
Excise taxes that are ordinary and necessary expenses of carrying on
a trade or business.
Corporate franchise taxes.
An occupational tax charged at a flat rate by a locality for the
privilege of working or conducting a business in the locality.
Highway Use Tax.
Vehicles subject to highway use tax include highway motor
vehicles that have a taxable gross weight of 55,000 pounds or
more. The tax period is July 1 through June 30. The tax is
incurred when a highway vehicle is first used on any public
highway in the United States. If the vehicle is first used in July, a
full years tax is due. If the vehicle is first placed in service in a
month after July, tax for a partial year is due.
Trucks traded in during the year do not get credit for a partialyear usage. If the tax has not been paid, the new owner of a used
vehicle owes the tax for the entire period the vehicle was used,
even if the use was by the first owner prior to the sale or trade in.
Form 2290, Heavy Highway Vehicle Use Tax Return, is used to
figure and pay the tax due on heavy vehicles used on public
highways. Form 2290 is also used to get a suspension of tax
liability if a vehicle, otherwise subject to the tax, is used on public
highways for 5,000 miles or less (7,500 or less for agricultural
vehicles) during the period.
The due date for Form 2290 for the tax on vehicles used in July is
August 31. For newly acquired vehicles, a separate Form 2290
must be filed for each month a taxable vehicle is first used on
public highways. The due date is the last day of the month after
the month the vehicle is first used on public highways. For
example, if it was first used in November, the due date is
December 31.

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BUSINESS USE OF RESIDENCE


If part of the taxpayers home is used for business, a portion of
expenses allocable to that business use are deductible.
To qualify to claim expenses for business use of a home, the taxpayer
must use part of his or her home:
Exclusively and regularly as his or her principal place of business.
Exclusively and regularly as a place where he or she meets or deals
with patients, clients, or customers in the normal course of his or her
trade or business.
In connection with a trade or business, when there is a separate
structure, that is not attached to the home.
On a regular basis for certain storage use.
For rental use.
As a daycare facility.
If the taxpayer is an employee, he or she must qualify for the
deduction. In addition to the previously listed tests, the individual must
also meet two additional tests.
The business use must be for the convenience of the employer.
The taxpayer must not rent part of the home to his or her employer
and use the rented portion to perform services as an employee for
that employer.
Under the exclusive-use test, the taxpayer must use a specific area of
the home only for a trade or business. The area can be a room or other
separately identifiable space. The exclusive use test does not apply to
the part of the home used either for the storage of inventory or product
samples, or as a daycare facility.
To qualify under the regular-use test, the taxpayer must use a specific
area of the home for business on a regular basis. Incidental or
occasional use is not regular use.
Under the trade or business test, the use of the home for a profitseeking activity that is not a trade or business does not qualify.
The taxpayer may have more than one business location for a single
trade or business. To qualify under the principal place of business test,
the home must be the principal place of business for that trade or
business. The home office qualifies as the principal place of business if
the following requirements are met:
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The individual uses it exclusively and regularly for administrative or

management activities of the business.


The individual has no other fixed location to conduct substantial
administrative or management activities of the business.
If the home office does not qualify as a principal place of business under
the above factors, the individual can determine a principal place of
business based on the following:
The relative importance of the activities performed at each location.
The amount of time spent at each location.
The business percent can be determined by allocations based on square
feet or by allocations based on number of rooms.
Deduction of otherwise nondeductible expenses, such as insurance,
utilities, and depreciation, that are allocated to the business use are
limited to the gross income of the business after being reduced by
allocable mortgage interest and taxes, and direct business expenses.
The area of the home used for business is depreciated as nonresidential
real property over 39 years.

MISCELLANEOUS EXPENSES
Advertising that relates to the business activity. This can include

public service advertising to keep the business name before the


community.
Bank fees.
Donations to business organizations.
Education and training of employees or for the taxpayers own trade
or business education.
Energy efficient commercial buildings deduction expenses.
Environmental cleanup costs to clean up the land and treat
groundwater contaminated by the taxpayers business waste.
Interview expense allowance or reimbursement made to job
candidates.
Legal and professional fees that are ordinary and necessary to
operate the business. Fees associated with the purchase of assets
are part of the cost basis of those assets.
License and regulatory fees paid to state or local governments.

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Impairment-related expenses necessary for the taxpayer to be able

to work.
The cost of moving machinery from one city to another or from one
part of a plant to another, plus the cost of installing the machinery at
the new location.
The cost of outplacement services provided to employees.
Penalties for the late performance or nonperformance of a contract,
but not for a penalty due to a violation of a law.
Repair costs to keep business property in normal and efficient
operating condition.
Repayment of an amount included in income because the taxpayer
had an unrestricted right to the income.
Subscriptions to professional, technical, and trade journals.
Material and supplies consumed and used during the tax year.
Utilities.

NONDEDUCTIBLE EXPENSES
Anticipated liabilities or reserves for anticipated liabilities.
Bribes and kickbacks if they are payments, directly or indirectly, to

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employees of the government or payments, directly or indirectly, to


a person in violation of any federal or state law.
Charitable contributions. Corporations are allowed a deduction for
charitable contributions.
Demolition expenses or losses.
Lobbying expenses, except expenses limited to legislation of a local
council or similar governing body (Indian tribal government) or inhouse expenses, if less than $2,000 and if engaged in a trade or
business of lobbying.
Political contributions or gifts. These include indirect contributions
such as advertising in a convention program, admission to a dinner
or program benefiting a political party or candidate, or admission to
an inaugural ball, gala, parade or similar event identified with a
political party or candidate.
Dues to business, social, athletic, luncheon, sporting, airline, and
hotel clubs.
Penalties and fines paid to a government agency or instrumentality
because of breaking the law.

2010 NATP EA Exam Review Course, Part II

Repairs that add to the value of the property or significantly increase

its life.

DEPRECIATION, 179 DEDUCTION, AMORTIZATION, AND DEPLETION


Depreciation is an annual deduction that allows taxpayers to recover the
cost or other basis of certain property. Most types of tangible and
intangible property can be depreciated.
To be depreciable, the following requirements must be met:
The taxpayer must own the property.
The property must be used in the taxpayers business or incomeproducing activity.
The property must have a determinable useful life.
The property must be expected to last more than one year.
The property must not be excepted property.
Depreciation starts when property is placed in service. Property is
placed in service when it is ready and available for a specific use, even
if not currently being used. Depreciation is continued for property used
in business or for the production of income even if it is temporarily idle.
Depreciation ends when the asset is permanently withdrawn from use in
a trade or business. Any of the following events lead to a permanent
withdrawal of an asset:
The property is sold or exchanged.
The property is converted to personal use.
The property is abandoned.
The property is transferred to a supplies or scrap account.
The property is destroyed.
If intangible property is depreciable, the straight-line method must
generally be used. Intangible property that is a 197 intangible cannot
be depreciated, but may be amortized.
Depreciable basis is generally the cost of the asset plus additional
amounts paid, such as sales tax, freight charges, installation and
testing fees, and certain settlement costs. Basis is determined by a
method other than cost if the property is acquired by other means, such
as by gift, exchange, or inheritance.

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If property is converted from personal use to business use, the


depreciable basis is the lesser of the following amounts:
The FMV of the property on the date of the change in use.
Original cost or other basis increased by the cost of any
improvements or additions and other costs added to basis, and
decreased by any deductions for casualty or theft and other items
that reduced basis.
Generally, the basis of property received in a nontaxable exchange is
the same as the adjusted basis of the property given up.
Improvements to depreciable property are treated as separate
depreciable assets with the cost of the improvement as the asset basis.
Depreciation is allowed or allowable. Depreciation allowed is
depreciation actually deducted, from which the taxpayer received a tax
benefit. Allowable depreciation is the amount the taxpayer is entitled to
under the applicable method and convention. If the taxpayer does not
claim depreciation he or she is entitled to, the basis of the property
must still be reduced by the entitled amount. No depreciation deduction
is allowed for property placed in service and disposed of in the same tax
year.
If the taxpayer claimed an incorrect amount of depreciation in any
year, he or she can make a correction by filing an amended return for
that year or by filing for a change in accounting method.
An amended return can be filed if any of the following provisions apply:
The taxpayer claimed the incorrect amount because a mathematical
error was made in any year.
The taxpayer claimed the incorrect amount because of a posting
error made in any year.
The taxpayer has not adopted a method of accounting for the
property placed in service in tax years ending after December 23,
2003. The taxpayer has adopted a method of accounting if he or she
deducted an incorrect amount of depreciation for the item on two or
more consecutively filed tax returns.
The taxpayer claimed the incorrect amount on property placed in
service in tax years ending before December 30, 2003.
If the method of accounting has been adopted, the correct amount of
depreciation can only be taken by changing the method of accounting
for depreciation. Form 3115, Application for Change in Accounting

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Method, is filed to change accounting and generally requires IRS


permission to make the change. A change to account for missed
depreciation is one of the listed changes for automatic approval, but the
form must still be filed.
The change in allowable depreciation to be taken with a change of
accounting is accomplished by making a 481 adjustment. The
adjustment is the difference between the total depreciation actually
deducted and the amount allowable prior to the year of change.
A negative adjustment results in a decrease in taxable income and
can be taken into account in full for the year of change. A positive
adjustment results in an increase in taxable income and is generally
taken into account over four tax years. If the total adjustment is less
than $25,000, an election can be made to take the adjustment in the
year of change.

IRC 179 DEDUCTION.


A taxpayer can elect to recover all or a part of the cost of certain
qualifying property, up to a limit, by deducting it in the year placed in
service using the 179 expense deduction.
To qualify for the 179 deduction, property must meet the following
requirements:
It must be eligible property.
Tangible personal property.
Other tangible property (except buildings and their structural
components) used as one of the following:
An integral part of manufacturing, production, or extraction or
furnishing transportation, communications, electricity, gas,
water, or sewage disposal services.
A research facility used in one of the activities listed above.
A facility used in connection with any of the above activities for
the bulk storage of fungible commodities.
Single-purpose agricultural or horticultural structures.
Storage facilities (accept buildings and their structural
components) used in connection with distribution of petroleum or
any primary product of petroleum.
Off-the-shelf computer software.
It must be acquired for business use.

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Property acquired only for production of income, such as

investment property, rental property, and property that produces


royalties, does not qualify.
When property is used for both business and nonbusiness
purposes, 179 is available only if the property is used more than
50% for business, and then only to the extent of the basis
allocable to the business-use percent.
It must have been acquired by purchase.
Certain property does not qualify for the 179 deduction.
Land and improvements, such as buildings and other permanent
structures and their structural components, are real property and not
eligible. Land improvements include swimming pools, paved parking
areas, wharves, docks, bridges, and fences.
Excepted property.
Property leased to others.
Property used predominantly to furnish lodging or in connection
with the furnishing of lodging.
Air conditioning or heating units.
Property used predominantly outside of the United States.
Property used by certain tax-exempt organizations.
Property used by governmental units.
Property used by foreign persons or entities.
Property used for lodging is generally not eligible; however, this
restriction does not apply to the following:
Nonlodging commercial facilities that are available to those not using
the lodging facilities on the same basis as they are available to those
using the lodging facilities.
Property used by a hotel or motel in connection with a trade or
business of furnishing lodging where the predominant portion of the
accommodations is used by transients.
Any certified historic structure to the extent its basis is due to
qualified rehabilitation expenditures.
Any energy property.
The maximum allowable deduction under 179 is $250,000 (2009) and
is limited to the net income from all the taxpayers active trades or
businesses. This amount is not reduced or affected by a short tax year.

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If the cost of qualifying 179 property exceeds $800,000, the $250,000


limit is reduced dollar for dollar by the amount that is over $800,000.
For purposes of these limits, married taxpayers filing separate returns
are treated as one taxpayer.
An increased 179 deduction is available for qualified Liberty Zone
property placed in service in the New York Liberty Zone.
Qualified Liberty Zone property meets the following requirements:
Property depreciated under MACRS with a recovery period of 20
years or less.
Water utility property.
Computer software that is readily available for purchase by the
general public, is subject to a nonexclusive license, and has not
been substantially modified.
Certain nonresidential real property and residential rental
property.
It is not excepted property.
Only 50% of the cost of qualifying Liberty Zone property placed in
service during the year is taken into account in figuring the $800,000
limit.
The dollar limit of the 179 deduction is increased by the smaller of
$35,000 or the cost of 179 property that is qualified Liberty Zone
property.
The additional amount is available for qualified property placed in
service before January 1, 2007 (January 1, 2010, for certain nonresidential and residential rental properties).
An increased 179 deduction is available to enterprise zone businesses
and renewal community businesses for qualified zone property and
qualified renewal property placed in service in an empowerment zone or
renewal community.
The dollar limit on the deduction is increased by the smaller of
$35,000 or the cost of 179 property placed in service during the
year.
Only 50% of the cost of qualified zone property is considered when
figuring the reduced dollar limit for costs exceeding $800,000.
An increased 179 deduction is available for qualified 179 Disaster
Assistance property placed in service in a federally declared disaster
area.
Qualifying property is 179 property acquired after December 31,
2007, and placed into service in a federally declared disaster area.
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The dollar limit on the deduction is increased by the smaller of

$100,000 or the cost of 179 property placed in service during the


year.
The amount for which the taxpayer can make the election is reduced
if the cost of all 179 property placed in service during the year
exceeds $800,000 increased by the smaller of $600,000 or the cost
of qualified 179 Disaster Assistance property.
The taxpayer cannot elect to expense more than $25,000 of the cost of
any heavy sport utility vehicle (SUV) and certain other vehicles. This
applies to a vehicle that weighs more than 6,000 pounds and not more
than 14,000 pounds.
The 179 deduction is limited to the business taxable income for the
year.
Use net trade or business income from all businesses actively
conducted by the taxpayer during the year.
Net income also includes 1231 gains or losses, interest from
working capital in the trade or business, and wages, salaries, tips,
and other pay earned as an employee.
If the deduction is limited by the business income limit, any excess
of the elected amount over the deductible amount is carried over to
the following year.
For a partner of a partnership and shareholder of an S corporation, the
maximum deduction and business income limit apply at both the
business level and the individual level.
A 179 election for any tax year beginning before 2011 may be revoked
by the taxpayer with respect to any property. A taxpayer can revoke
the expensing election on an amended return without IRS consent.
However, once made, the revocation is irrevocable. For tax years
beginning before January 1, 2003, a 179 election could not be revoked
without IRS consent.
If, in any year during the 179 propertys recovery period, the
percentage of business use drops to 50% or less, all or a portion of the
179 deduction is recaptured. The recapture amount is included as
ordinary income in Part IV of Form 4797. The recapture amount is equal
to the amount of 179 deduction taken in excess of the MACRS
depreciation that is allowable.

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For a sale, exchange, or other disposition of property, the 179


deduction is included as depreciation and the special 179 recapture
provision for reduced business use does not apply.

SPECIAL DEPRECIATION ALLOWANCE


An additional 50% (or 30% if applicable) deduction is taken after any
179 deduction and before figuring MACRS depreciation for qualifying
property placed in service during the year.
Qualifying property includes the following:
Certain property with a long production period and certain noncommercial aircraft.
Qualified Liberty Zone property.
Qualified Gulf Opportunity Zone (GO Zone) extension property.
Qualified cellulosic biomass ethanol plant property acquired by
purchase after December 20, 2006.
Qualified Recovery Assistance property.
Qualified reuse and recycling property.
Qualified cellulosic biofuel plant property.
Qualified disaster assistance property.
Certain qualified property placed in service after December 31, 2007,
and before January 1, 2010.

Qualified Liberty Zone Property


Qualified Liberty Zone property eligible for a 30% allowance is certain
nonresidential real property and residential rental property.
It qualifies to the extent it rehabilitates real property damaged or
replaces real property destroyed or condemned as a result of the
terrorist attack of September 11, 2001.
If the property was not destroyed but the structural components of
the building were damaged or destroyed, then only the structural
components qualify.
The property must be acquired after September 10, 2001; placed in
service for use in a trade or business or for the production of income

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before January 1, 2010; the original use of the property must have
begun with the taxpayer after September 10, 2001.
This property must also meet an additional test the substantial-use
test. Substantially all (80% or more) use of the property must be in the
Liberty Zone and in the active conduct of the taxpayers trade or
business in the Liberty Zone.

Qualified Gulf Opportunity Zone Extension Property


Qualified Gulf Opportunity Zone extension property is eligible for a 50%
allowance. GO Zone extension property is:
Nonresidential real property or residential rental property placed in
service before January 1, 2011.
Any of the following types of property placed in service in a building
before January 1, 2011:
Tangible property that has a 20-year class life or less.
Water utility property.
Computer software.
Qualified leasehold improvement property.
Substantially all (80% or more) of the use of the extension property
must be in the building and placed in service no later than 90 days
after the building is placed in service.
The original use of the property in the GO Zone must have begun
with the taxpayer after August 27, 2005. Used property can be
qualified GO Zone property if it has not previously been used within
the GO Zone.
Substantially all (80% or more) of the use of the property must be in
the GO Zone and in the active conduct of the taxpayers trade or
business in the GO Zone.
Excluded property includes the following:
Property required to be depreciated using ADS.
Property any portion of which is financed with the proceeds of a taxexempt obligation under 103.
Any qualified revitalization building for which the taxpayer has
elected to claim a commercial revitalization deduction.
Any property used in connection with any private or commercial golf
course; country club; massage parlor; hot tub facility; suntan

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facility; or any store, the principal business of which is the sale of


alcoholic beverages for consumption off premises.
Any gambling or animal-racing property.
Property for which the taxpayer elected not to claim any special
depreciation allowance.
Property placed in service and disposed of in the same year.
Property converted from business use to personal use in the year
acquired.

The taxpayer can elect not to claim the special depreciation allowance.
If made, the election applies to all property in the same property
class placed in service during the year.
The election must be made on a timely-filed tax return (including
extensions) for the year the property was placed in service.
Failure to make an election treats the asset as if the 50%
depreciation was taken under the allowed or allowable provision.
If property is acquired in a like-kind exchange or involuntary
conversion, the carryover basis of the acquired property is eligible for a
special depreciation allowance.

Qualified Disaster Assistance Property


Qualified Disaster Assistance property is eligible for a 50% allowance
and must meet the following requirements:
It has a 20-year class life, water utility property, computer software,
or nonresidential real property or residential rental property as
identified under Qualified Liberty Zone property. In addition,
qualified leasehold improvement property is eligible property.
Property must be acquired by purchase on or after the applicable
disaster date, with no binding written contract for purchase in effect
prior to the applicable disaster date.
The property must rehabilitate or replace property damaged,
destroyed, or condemned as a result of the federally declared
disaster.
The property must be similar in nature to, and located in the same
county as, the rehabilitated or replaced property.
The original use of the property in the within the disaster area must
have begun with the taxpayer on or after the applicable disaster
date.
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The property is placed in service on or before the last day of the

third calendar year following the applicable disaster date (the fourth
calendar year in the case of nonresidential and residential real
property).
Substantially all (80% or more) of the use of the property must be in
the active conduct of the taxpayers trade or business in a federally
declared disaster area, occurring before January 1, 2010.
Excluded property includes the following:
Property required to be depreciated using ADS.
Property any portion of which is financed with the proceeds of a taxexempt obligation under 103.
Any qualified revitalization building for which the taxpayer has
elected to claim a commercial revitalization deduction.
Any property used in connection with any private or commercial golf
course; country club; massage parlor; hot tub facility; suntan
facility; or any store, the principal business of which is the sale of
alcoholic beverages for consumption off premises.
Property for which the taxpayer elected not to claim any special
depreciation allowance.
Property placed in service and disposed of in the same year.
Property converted from business use to personal use in the year
acquired.
The taxpayer can elect not to claim the special depreciation allowance.
If made, the election applies to all property in the same property
class placed in service during the year.
The election must be made on a timely-filed tax return (including
extensions) for the year the property was placed in service.
Failure to make an election treats the asset as if the 50%
depreciation was taken under the allowed or allowable provision.

Qualified Property Acquired After December 31, 2007


Qualified property acquired after December 31, 2007, is eligible for a
50% allowance and must meet the following requirements:
It has a 20-year class life or less, water utility property, computer
software, or is qualified leasehold improvement property.

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Property must be acquired by purchase after December 31, 2007,

with no binding written contract for purchase in effect prior to


January 1, 2008.
The original use of the property must begin with the taxpayer after
December 31, 2007.
The property is placed in service by you in your trade or business or
for the production of income on or before January 1, 2010 (before
January 1, 2011, for certain property with a long production period
and certain aircraft).

Long-Production-Period Property and Noncommercial Aircraft


To be qualifying long-production-period property, the property must
meet the following requirements:
New property of one of the following types:
Tangible MACRS property with a recovery period of 20 years or
less. Generally, every type of property except real property has a
recovery period of 20 years or less.
Certain water utility property.
Computer software that is readily available for purchase by the
general public, is subject to a nonexclusive license, and has not
been substantially modified.
Qualified leasehold improvement property.
The property has a recovery period of at least ten years or is
transportation property.
The property is subject to 263A.
The property has an estimated production period exceeding two
years or has an estimated production period exceeding one year and
an estimated production cost exceeding $1,000,000.
To be qualified noncommercial aircraft property, the property must
meet the following requirements:
The aircraft must not be tangible personal property used in a trade
or business of transporting persons or property.
The aircraft must be purchased by a purchaser, who at the time of
the contract to purchase, makes a nonrefundable deposit of the
lesser of 10% of the cost or $100,000.
The aircraft must have an estimated production period exceeding
four months and a cost exceeding $200,000.

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Long-production-period property and noncommercial aircraft property


must also satisfy the acquisition date test, the placed-in-service test,
and the original-use test.

MACRS
Modified Accelerated Cost Recovery System (MACRS) is used to recover
the basis of most business and investment property placed in service
after 1986. MACRS consists of two systems for depreciation, the
General Depreciation System (GDS) and the Alternative Depreciation
System (ADS). GDS is generally used unless the law specifically
requires the use of ADS or the taxpayer elects to use ADS.

Alternative Depreciation System


ADS must be used for certain property and may be elected for property
depreciable under GDS.
ADS must be used for the following property:
Listed property used 50% or less for business.
Tangible property used predominantly outside the United States
during the year.
Tax-exempt use property.
Tax-exempt bond-financing property.
Any property used predominantly in a farming business and placed in
service during any tax year in which an election is made not to apply
the uniform capitalization rules to certain farming costs.
Any imported property covered by an executive order of the
President of the United States.
The depreciation deduction is computed using the straight-line method
with no salvage value over the assets class life.
The recovery period for property using ADS is generally longer than the
recovery period using GDS.
The same conventions apply as in regular MACRS.
The election to use ADS is irrevocable and applies to all property of a
particular class placed in service during the tax year.

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General Depreciation System


Under GDS, assets are assigned to one of nine property classes:
3-year property: tractor units for over the road, race horses over two
years old, qualified rent-to-own property.
5-year property: automobiles, computers and peripheral equipment,
office machinery, breeding and dairy cattle, appliances, carpets,
furniture used in a residential rental real estate activity, any qualified
Liberty Zone leasehold improvement property, and gasoline pump
canopies that are not permanent structures.
7-year property: office furniture and fixtures, most machinery and
equipment, any property that does not have a class life and has not
been designated by law as being in any other class.
10-year property: vessels, single-purpose agricultural or horticultural
structures, any tree or vine bearing fruit or nuts.
15-year property: certain improvements made directly to land;, any
retail motor fuels outlet such as a convenience store; any municipal
wastewater treatment plant; any qualified leasehold improvement
property placed in service before January 1, 2008; any qualified
restaurant property placed in service before January 1, 2008; and
initial clearing and grading land improvements for gas utility
property.
20-year property: farm buildings.
25-year property: water utility property.
Residential rental property where 80% or more of its gross income is
from dwelling units is 27.5-year property.
Nonresidential real property is 39-year property.

Convention
Allowable depreciation is determined under one of three different
conventions. The convention is determined when the asset is placed in
service. The assets basis, assigned class life, and the convention and
method chosen determine the amount of depreciation allowed.
Half-year convention means that all property placed in service during
the year is considered to be placed in service during the mid-point of
the tax year. This allows the taxpayer to deduct one-half of a full years
depreciation for the first year the asset is placed in service. The half-

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year convention applies to assets with a class life of 3, 5, 7, 10, 15, and
20 years.
Mid-quarter convention applies if more than 40% of the aggregate
basis of all property is placed in service during the last three months of
the tax year (excluding nonresidential real property and residential
rental property). The aggregate basis of all property does not include
property placed in service and disposed of in the same year.
The mid-quarter convention does not apply to real property.
If an item is expensed under 179, the amount expensed is not
included for purposes of the 40% test.
Mid-month convention applies only to residential rental property in the
27.5-year class and nonresidential real property in the 39-year class.
Property is treated as if it were placed in service during the mid-point of
the month.

Method
Under MACRS, there are four methods that can be used.
200% declining balance over the GDS recovery period: nonfarm 3-,
5-, 7-, and 10-year property.
150% declining balance over GDS recovery period: all farm property
except real property, most 15- and 20-year property, and nonfarm
3-, 5-, 7-, and 10-year property.
Straight-line over GDS recovery period: Nonresidential real property,
qualified leasehold improvement property, qualified restaurant
property, residential rental property, trees or vines bearing fruit or
nuts, water utility property, and all 3-, 5-, 7-, 10-, 15- and 20-year
property.
Straight-line over ADS recovery period: listed property used less
than 50% for business, property used predominantly outside the
U.S., qualified leasehold improvement property, qualified restaurant
property, tax-exempt property, tax-exempt bond financed property,
farm property when UNICAP is not applied, imported property, and
any property for which the taxpayer elects to use this method.
Some tangible property is not depreciable such as, land, leased
property, and costs to demolish a building.

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Capital expenditures made by a lessee on leased property are


recoverable through allowances for depreciation or amortization. The
cost is recovered by depreciating/amortizing the improvement using the
appropriate useful life.
The IRS has developed MACRS percentage tables that incorporate the
applicable convention and method.
The taxpayer must apply the rates in the percentage tables to the
propertys unadjusted basis.
The taxpayer cannot use the percentage tables for a short tax year.
A short tax year is any tax year consisting of less than 12 months.
The mid-month, half-year, or mid-quarter conventions still apply but
on the basis of the short year. The special 50% allowance and 179
still apply in full regardless of the short year.
Once the taxpayer starts using the percentage tables for any item of
property, he or she generally must continue to use the tables for the
entire recovery period.
The taxpayer must stop using the percentage tables if the basis of
the property is adjusted for any reason other than depreciation
allowed or allowable, or an addition or improvement to property that
is depreciated as a separate item of property.

Exchange
Special rules apply for property acquired in a like-kind exchange or
involuntary conversion.
To determine whether the recovery period and the method for the
replacement property are the same as the relinquished property, the
recovery period and method for the replacement property are
considered to be the period and method that would have applied had
the replacement property been placed in service at the same time as
the relinquished property.
If the period and method are the same for the replacement property
that applied to the relinquished property, the depreciable exchanged
basis of the replacement property is depreciated over the remaining
recovery period by using the depreciation method of the relinquished
property.
The excess basis, the part of the acquired propertys basis that exceeds
its carryover basis, is treated as newly placed in service property.

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If the recovery period or the depreciation method is not the same as


the relinquished property, special rules apply.
If the recovery period prescribed for the replacement property is
longer than that for the relinquished property, the depreciation
allowance for the depreciable exchanged basis beginning in the year
of replacement is determined as though the replacement property
had originally been placed in service in the same taxable year of the
relinquished property but using the longer recovery period.
If the recovery period is shorter, the depreciation allowance for the
depreciable exchange basis beginning in the year of replacement is
determined using the same recovery period as the relinquished
property.
If the method is less accelerated than the relinquished property, the
depreciation allowance for the exchanged basis is determined as
though the replacement property had originally been placed in
service at the same time as the relinquished property but using the
less accelerated method.
The depreciation allowance for the exchanged basis of the relinquished
property and the replacement property is determined under the
appropriate period and method and prorated by the number of months
each property was in service.
The depreciation allowance limitation for passenger automobiles, the
280F limit, applies to both the relinquished and replacement property,
determined in the following order:
First, the deduction allowable for the relinquished property to the
extent of the smaller of the replacement auto 280F limit and the
relinquished auto limit, if the year of disposition is also the year of
replacement.
Second, the additional first-year depreciation allowable on the
remaining exchange basis of the replacement auto, to the extent of
the excess of the replacement 280F limit over the amount allowable
in the prior step.
Third, the depreciation deduction allowable on the exchanged basis
of the replacement auto to the extent of any excess over the
amounts from the first two steps of the smaller of the replacement
auto limit and the relinquished auto limit.
Fourth, any 179 deduction allowable in the year of replacement on
the excess basis to the extent of the excess of the replacement auto
limit over the sum of the amounts allowable in the first three steps.

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Fifth, the additional first year depreciation allowable on the

remaining excess basis of the replacement auto, to the extent of the


excess of the replacement auto 280F limit over the sum of the
amounts allowable in the previous steps.
Lastly, the depreciation deduction allowable for the depreciable
excess replacement auto basis to the extent of the excess of the
replacement auto limit over the sum of the amounts previously
determined.

Example: Sandy acquired and placed in service an old auto in January 2006 for
$30,000. In December 2009, in a like-kind exchange, Sandy traded the old auto
and $15,000 cash for a new auto. Both are 100% business use, depreciated using
200% DDB, HY, over five years.
The 2009 280F limit for the old auto is $1,775. The 2009 280F limit for the new
auto is $10,960. The exchange basis carried to the new auto is $17,615, which is
the original $30,000 basis reduced by $12,385 allowable depreciation for 2006
through 2009. [$2,960 + $4,800+ $2,850 + $1,775]
Without taking the 280F limit into account, the additional first-year depreciation
on this amount is $8,808. Because this is less than $9,185 (new auto limit of
$10,960 minus the old auto allowable depreciation of $1,775), the additional firstyear depreciation deduction for the exchange basis is $8,808.
No depreciation is allowable in 2009 for the exchange basis because the
depreciation deductions taken on the old auto and the remaining exchange basis
exceed the old auto 280F limit.
An additional first-year depreciation deduction of $377 is allowable for the excess
basis of $15,000 on the new auto.
At the end of 2009, the adjusted depreciable basis of the new auto is $23,430.
This is a sum of the adjusted depreciable exchange basis of $8,807 ($17,615 $8,808) and the adjusted depreciable excess basis of $14,623 ($15,000 - $377).

Only the excess basis of the replacement property is eligible for the
179 election.
An election can be made not to apply the basis computation regulations
to the exchange. If the election is made, the exchanged basis and the
excess basis, if any, in the replacement property are treated as being
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placed in service by the taxpayer at the time of replacement and the


adjusted depreciable basis of the relinquished property is treated as
being disposed of by the taxpayer at the time of the exchange.

Listed Property
Certain limitations and reporting requirements apply to the depreciation
of a special category of property known as listed property. Property is
considered listed if it is property that lends itself to personal as well as
business use.
Listed property includes the following:
Any passenger automobile weighing 6,000 pounds or less.
Any other property used for transportation, unless it is an excepted
vehicle.
Any property of a type generally used for entertainment, recreation,
or amusement (including photographic, phonographic,
communication, and video-recording equipment).
Any computer and related peripheral equipment, unless it is used
only at a regular business establishment and owned or leased by the
person operating the establishment. A computer is a programmable,
electronically-activated device capable of accepting information,
applying prescribed processes to the information, and supplying the
results of those processes with or without human intervention.
Any cellular telephone.
A passenger automobile is any four-wheeled vehicle made primarily for
use on public streets, roads, and highways and rated at 6,000 pounds
or less of unloaded gross vehicle weight (6,000 pounds or less of gross
vehicle weight for trucks and vans when loaded).
The following vehicles are not passenger automobiles for this purpose:
An ambulance, hearse, or combination ambulance-hearse used
directly in a trade or business.
A vehicle used directly in the trade or business of transporting
persons or property for pay or hire.
A truck or van that is a qualified nonpersonal-use vehicle.
Clearly marked police and fire vehicles.
Unmarked vehicles used by law enforcement officers if the use is
officially authorized.

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Any vehicle with a loaded gross vehicle weight of over 14,000

pounds that is designed to carry cargo.


Bucket trucks, cement mixers, dump trucks, flatbed trucks, and
refrigerator trucks.
Qualified moving vans.
Qualified specialized utility repair vehicles.
School buses used to transport students and employees of schools.
Other buses with a capacity of at least 20 passengers that are used
as passenger vehicles.
Tractors and other special-purpose farm vehicles.

Business use limits apply if the listed property is not used


predominantly in business. If not used more than 50% for business, the
following limits apply:
The property does not qualify for the 179 deduction or the special
depreciation allowance.
Depreciation must be figured using straight-line over the ADS
recovery period.
Excess depreciation on property previously used predominantly in
business must be recaptured in the first year that business use drops
to 50% or less. Excess is the amount of depreciation allowable in
prior years over what would have been allowable using straight-line
over the ADS life.
The use of property to produce income in a nonbusiness activity
(investment use) is not qualified business use for determining if used
predominantly in business. However, once the determination is made,
the taxpayer can treat the investment use as business use to figure the
depreciation deduction for the property.
An employee can claim a depreciation deduction for the use of listed
property in performing services as an employee only if the use is a
business use. A business use must meet both of the following
requirements:
The use is for the employers convenience.
The use is required as a condition of employment.
The listed property depreciation limit for passenger automobiles was
previously discussed under employee transportation expenses. If the
depreciation deductions for the year are reduced due to these limits,
the taxpayer has an unrecovered basis at the end of the recovery
period. However, if business use continues for a passenger automobile,
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the taxpayer can continue to claim the depreciation deduction, subject


to the listed property limits, until the basis is recovered.

COSTS THAT CAN BE DEDUCTED OR CAPITALIZED


Certain costs can be deducted in the current year or capitalized. If
capitalized, the cost is added to the basis of the property to which it
relates. This cost can be deducted over a period of years through
periodic deductions for amortization, depletion, or depreciation.
Carrying charges include the taxes and interest paid to carry or develop
real property or to carry, transport, or install personal property.
If the taxpayer is subject to UNICAP, the taxpayer must capitalize
carrying charges.
If not subject to UNICAP, the taxpayer can choose to capitalize
carrying charges separately for each project and for each type of
carrying charge.
For unimproved and unproductive real property, the choice to
capitalize is good for only one year at a time. The taxpayer must
decide whether to capitalize carrying charges each year the property
remains unimproved and unproductive.
For other real property, the choice remains in effect until
construction or development is completed.
For personal property, the election is effective until the date the
property is installed or first used, whichever is later.
The election is made on a statement attached to the return,
indicating which charges the taxpayer elects to capitalize.
Research and experimental costs are generally capital expenses.
However, the taxpayer can deduct these costs as current expenses. The
choice to deduct is binding for the year it is made and for all later years,
unless the IRS approves a change.
Intangible drilling costs (IDCs), the costs of developing oil, gas, or
geothermal wells, are ordinarily capital expenses. Certain drilling and
development costs for wells in the United States, in which the taxpayer
holds an operating or working interest, can be deducted currently at the
choice of the taxpayer. If the expense is capitalized and the well later
becomes nonproductive, the IDCs can be deducted as an ordinary loss.

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Exploration costs of determining the existence, location, extent, or


quality of any mineral deposit are ordinarily capital expenditures if the
costs lead to the development of a mine. However, the taxpayer can
choose to deduct domestic exploration costs paid or incurred before the
beginning of the development stage of the mine.
Development costs paid or incurred during the year for developing a
mine or any other natural deposit located in the United States are
deductible. These costs must be paid or incurred after the discovery of
ores or minerals in commercially marketable quantities. A choice can be
made to treat them as deferred expenses and deduct them ratably as
the units of produced ores or minerals are sold.
A publisher can deduct as a current expense the costs of establishing,
maintaining, or increasing the circulation of a newspaper, magazine, or
other periodical. Otherwise, circulation costs can be amortized over a
three-year period starting with the tax year they were paid or incurred.
Environmental cleanup costs are generally capital expenditures. The
taxpayer can choose a current deduction for certain cleanup costs. This
option is generally available for qualified environmental cleanup costs
paid or incurred before January 1, 2010, (2011 for certain Midwestern
disaster areas) incurred to abate or control hazardous substances at a
qualified contaminated site.
Qualified disaster expenses are generally capital expenditures.
Taxpayers can elect to take a current deduction for qualified disaster
expenditures paid or incurred after 2007 on business related property
for the abatement or control of hazardous substances released as the
result of a federally declared disaster occurring before January 1, 2010.
This includes removal of debris, the demolition of structures on real
property, as well as the repair of damage to business related real
property.
Business start-up and organizational expenses are generally capital
expenditures. The taxpayer can choose to deduct up to $5,000 of
business start-up and $5,000 of organizational cost, paid or incurred
after October 22, 2004, as a current expense. The $5,000 deduction is
reduced by the amount by which total start-up or organizational costs
exceed $50,000. Any remaining costs must be amortized over a 180month period.
Reforestation costs paid or incurred must be capitalized unless an
election is made to amortize them. A taxpayer can deduct up to
$10,000 of qualifying reforestation costs paid or incurred after October

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22, 2004, for each qualified timber property. The remaining costs can
be amortized over an 84-month period.
If the taxpayer retires or removes a depreciable asset in connection
with the installation or production of a replacement asset, costs of
removing the retired asset can be currently deducted.
The cost of an improvement to a business asset is normally a capital
expense. However, a taxpayer can choose to deduct the cost of making
a facility or public transportation vehicle more accessible to and usable
by those who are disabled or elderly. The most that can be deducted as
a cost of removing barriers to the disabled and the elderly for any tax
year is $15,000.

AMORTIZATION
Amortization allows a taxpayer to recover certain capital costs in much
the same way as straight-line depreciation.
Only specific expenses can be amortized by making an election on Form
4562, Depreciation and Amortization, and attaching the required
statement to the return for the first year of the amortizable expense.
Form 4562 is not required for later years unless another amortizable
asset is started. The statement should include total costs, description,
date incurred, month business began, and the number of months in the
amortization period.
Start-up and organizational costs may be amortized at the election of
the taxpayer, starting with the month the active trade or business
begins.
Start-up costs are costs for creating an active trade or business or
investigating the creation or acquisition of an active trade or business.
Start-up costs include the following:
A survey of potential markets.
An analysis of available facilities, labor, supplies, etc.
Advertisements for opening the business.
Salaries and wages for training employees and their instructors.
Travel and other necessary expenses for securing prospective
suppliers, distributors, or customers.
Salaries/fees for executives, consultants, or other professionals.

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A start-up cost is amortized if it meets both of the following tests:


It is a cost the taxpayer could deduct if paid or incurred in operating
an existing active trade or business.
It is a cost paid or incurred before the day the active trade or
business begins.
Organizational costs are those that are incident to the creation of the
partnership (709) or a corporation (248).
Costs of organizing a corporation are the direct costs of creating the
corporation.
An amortizable organizational expense must meet the following
tests:
It is for the creation of the corporation.
It is chargeable to a capital account.
It could be amortized over the life of the corporation if the
corporation had a fixed life.
It is incurred before the end of the first tax year the corporation is
in business.
Organizational costs include the following costs:
Cost of temporary directors.
Cost of organizational meetings.
State incorporation fees.
Cost of accounting services for setting up the corporation.
Cost of legal services.
Organizational costs of a partnership are the direct costs of creating a
partnership.
Organizational costs are amortizable if the following tests are met:
It is for the creation of the partnership and not for starting or
operating the partnership trade or business.
It is chargeable to a capital account.
It could be amortized over the life of the partnership if the
partnership had a fixed life.
It is incurred by the due date of the partnership return (excluding
extensions) for the first tax year in which the partnership is in
business.
It is for a type of item normally expected to benefit the
partnership throughout its entire life.

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Organizational costs include the following fees:


Legal fees for services incident to the organization of the

partnership.
Accounting fees for services incident to the organization of the
partnership.
Filing fees.

197 Intangibles
Capitalized cost of certain intangibles acquired after August 10, 1993,
must be amortized. The amount of the deduction is the adjusted basis
amortized over 15 years (180 months) starting with the later of the
month acquired or the month the trade or business activity began.
IRC 197 intangibles include the following:
Goodwill (purchased, not created).
Going-concern value.
Workforce in place, including its components, terms, and conditions
of employment.
Business books and records, operating systems, and any other
information base, including customer lists.
A patent, copyright, formula, process, design, pattern, know-how,
format, or similar item.
A customer-based intangible.
A supplier-based intangible.
A license, permit, or other right granted by a government unit or
agency.
A covenant not to compete entered into in connection with the
acquisition of an interest in a trade or business.
A franchise, trademark, or trade name. For acquisitions after October
22, 2004, a franchise engaged in professional sports and any
intangible assets acquired in connection with acquiring the franchise
(including player contracts) is a 197 intangible
A contract for the use of, or a term interest in, any of the above.
If a taxpayer is engaged in the trade or business of film production, he
or she may amortize the creative property costs for properties not set
for production within three years of the first capitalized transaction.
Creative property costs include costs paid or incurred to acquire and

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develop screenplays, scripts, story outlines, motion picture production


rights to books and plays, and similar items for purposes of potential
future film development, production, and exploitation.
If the taxpayer did not deduct the correct amortization for a 197
intangible in any year, the corrected amount may be taken by
amending the return or filing for a change of accounting.
A 197 intangible is treated as depreciable property used in a trade or
business, qualifying for 1231 treatment. Recapture is treated as 1245
property.
Other amortization provisions include the following:
Reforestation costs for qualified timber property are amortized over a
period of 84 months.
For tax years beginning after August 8, 2005, the cost of geological
and geophysical expenses paid or incurred in connection with oil and
gas exploration or development within the United States are
amortized ratably over a 24-month period.
The cost of certified pollution control facilities is amortized over 60
months.
Research or experimental costs may be amortized over a period of
60 months, deducted as a current business expense, or written off
over a 10-year period.
A taxpayer can elect to amortize tax preference items over an
optional period beginning in the tax year in which the cost is
incurred, If this election is made, there is no AMT adjustment. The
election can be made for the following:
Circulation costs, over 3 years.
Intangible drilling and development costs over 60 months.
Mining exploration and development costs over 10 years.
Research and experimental costs over 10 years.

DEPLETION
Depletion is the using up of natural resources by mining, quarrying,
drilling, or felling. Depletion deductions are allowed on oil, gas,
geothermal wells, mineral property, and standing timber. There are two
ways of computing depletion: cost depletion and percentage depletion.

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Cost depletion per unit is figured by dividing the adjusted basis of the
property by the total number of recoverable units. The number of units
sold multiplied by this result is the current years deduction. Cost
depletion is used for timber and mineral deposits.
Percentage depletion is deducted as a certain percent of the gross
income from the property subject to the following limitations:
It cannot exceed 50% of the taxable income from the property
(100% for oil and gas properties).
It cannot be used for oil and gas wells unless:
The taxpayer is either an independent producer or royalty owner.
The well produces natural gas which is either sold under a fixed
contract or produced from geopressured brine.
It can be used for mine, geothermal, and other natural deposits.
The deduction is the greater of cost depletion or percentage
depletion.

DEBTS

Debt Forgiveness Income


A canceled or forgiven debt (other than by gift or bequest) or a debt
paid for by another is included in gross income. If the debt was incurred
in a business, report the amount on Schedule C, Schedule C-EZ, or
Schedule F (or other appropriate business form).
If the taxpayer is a stockholder in a corporation and the corporation
cancels or forgives a debt, this cancellation is dividend income.
Canceled debt is not included in income if it is excluded debt.
The debt is canceled in a bankruptcy case under Title 11 of the U.S.
Code.
The debt is canceled when the taxpayer is insolvent, to the extent of
insolvency.
The debt is qualified farm debt and is canceled by a qualified person.
The debt is qualified real property business debt.
In the case of a taxpayer other than a C corporation, forgiveness of
qualified real property business indebtedness can be excluded by
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making an election. The basis of depreciable property is then reduced


by the excluded amount using Form 982, Reduction of Tax Attributes
Due to Discharge of Indebtedness (and Section 1082 Basis
Adjustment).

Business Bad Debt


A business bad debt is the loss from the worthlessness of a debt that
was either created or acquired in the taxpayers trade or business, or
closely related to the taxpayers trade or business when it became
partially or totally worthless.
Business bad debts are mainly the result of credit sales to customers,
generally recorded as accounts or notes receivable. Accrual method
taxpayers can deduct bad debts when they are unable to collect what is
owed to them, provided the amount has been included in income. A
cash method taxpayer generally does not have a business bad debt
deduction because the amount owed has not been included in income.
If a taxpayer disposes of a business but keeps its receivables, these
debts are business debts since they arose out of a trade or business. If
any of these debts later becomes worthless, the loss is still a business
bad debt.
Business bad debts can result from any of the following situations:
The taxpayer makes a loan to a client, supplier, employee, or
distributor for a business reason.
If a political party owes the taxpayer money, a bad debt is allowed if
the debt arose from the sale of goods or services in the ordinary
course of business, more than 30% of the receivables accrued in the
year of sale were from sales to political parties, and the taxpayer
made substantial continuing efforts to collect the debt.
The taxpayer cannot take a bad debt deduction for a loan made to a
corporation if, based on the facts, the loan was actually a
contribution to capital.
A taxpayer pays any part of an insolvent partners share of
partnership debts.
If the taxpayer guaranteed a business loan, had a legal duty to pay
the debt, made the guarantee before the debt became worthless,
and received reasonable consideration for making the guarantee.

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If the taxpayer entered the guarantee transaction with a profit

motive or to protect an investment, the debt can be treated as a


nonbusiness bad debt.
If the taxpayer makes the guarantee as a favor to a friend and receives
no consideration in return, the transaction is a gift.
A debt becomes worthless when there is no longer any chance the
amount owed will be paid. It is not necessary to go to court as long as
the taxpayer can show that reasonable steps have been taken to collect
the debt.
If property is received in partial settlement, reduce the debt by the FMV
of the property. The remaining debt is deductible.
Uncollectible business bad debt options include:
Specific charge-off method, in which the taxpayer can deduct
specific business bad debts that become either partly or totally
worthless during the tax year.
Partially worthless bad debts are limited to the amount charged
off the books. This does not have to be done annually. No part of
the bad debt may be deducted in a year after the year in which
the debt becomes totally worthless.
Totally worthless bad debts are deducted only in the tax year they
become worthless.
Nonaccrual experience method, in which the taxpayer does not
accrue service-related income he or she expects to be uncollectible.
Can be used for accounts receivable for services the taxpayer
performs only if one of the following conditions are met:
The services are provided in the fields of accounting, actuarial
science, architecture, consulting, engineering, health, law, or
the performing arts.
The taxpayer meets the $5 million annual gross receipts test
for all prior years.
Is not used for amounts due for which interest or a late payment
penalty is required.
Is not used for amounts owed because the taxpayer is engaged in
the business of lending money, selling goods, or acquiring
receivables or other rights to receive payment from other
persons.
If a bad debt deduction is taken and in a later year all or part of the
debt is recovered, the recovery is included in income. The recovery is
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excludible to the extent the deduction did not reduce the tax in the year
the bad debt was deducted. A bad debt deduction may add to or
produce a net operating loss (NOL).

NET OPERATING LOSSES


A net operating loss (NOL) occurs when business losses and deductions
exceed gross income.
To have an NOL, the loss must be caused by:
Deductions from a trade or business.
Deductions taken by an employee that are work-related.
Casualty or theft losses.
Moving expenses.
Rental property.
Confiscation of a business by a foreign government.
An NOL cannot result from the deduction of:
Net capital losses.
Personal or dependent exemptions.
Nonbusiness losses.
Nonbusiness deductions.
A domestic production activity deduction.
Nonbusiness income and deductions must be separated from business
income and deductions.

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Business income includes:

Business deductions include:

Income from a trade or business.

Ordinary and necessary expenses from a


trade or business, which include moving
expenses.

Salary earned as an employee.


Gain from the disposition of assets used
in a trade or business.
Rental income on Schedule E.
Income from a general partnership or S
corporation.
S corporation income reportable on
Schedule E.

Personal casualty and theft losses reportable


on Schedule A.
Deductible employee business expenses.
State and local income tax on business
profits.
State and local income tax withheld from
Form W-2 wages.
Section 1244 losses.
Losses from an S corporation or partnership.
Unrecovered investment in an employee
annuity contract.
Interest on business indebtedness.
Losses on the sale of assets used in a trade
or business.
A deduction for one half of self-employment
tax or the deduction for self-employed
health insurance.
Educator expenses.
Domestic production activity deduction.
Rental losses.
Loss on the sale of accounts receivable.

Nonbusiness income includes:

Nonbusiness expenses include:

Interest and dividends.

Alimony paid.

Alimony.

Medical expenses after the AGI limitation.

Taxable pensions and annuities.

Charitable contributions.

Income from a limited partnership.

IRA, SEP, SIMPLE, and Keogh contributions.

Gambling and/or lottery winnings.

Gambling losses.

Gains from the sale of property held for


investment.

Standard deduction.

Taxable distributions from an IRA or


Keogh.

Safe deposit box rental.

Tax preparation fees.


Investment expenses.
IRA custodial fees.
Health savings account deduction.
Archer MSA deduction.

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DETERMINING THE NOL


Personal and dependent exemptions cannot be claimed.
NOL carryover/carryback from other years cannot be deducted.
Nonbusiness capital losses are limited to nonbusiness capital gains.
Nonbusiness deductions are limited to the total of the following:
Nonbusiness capital gains that are more than nonbusiness capital
losses.
Nonbusiness income.
Business capital losses are limited to the total of the following:
Non-business capital gains that are more than the total of
nonbusiness capital losses and excess nonbusiness deductions.
Business capital gains.
A domestic production activity deduction is not allowed.

WHEN TO USE AN NOL


Generally, an NOL for a tax year ending in 2009 must be carried back to
the two tax years before the NOL year, and then carried forward for up
to 20 years after the NOL year. Any unused portion is lost after the 20year carryforward period.
A taxpayer can choose not to carry back an NOL and only carry it
forward. This choice is made by attaching a statement to the original
return for the loss year filed by the due date (including extensions). The
statement must show the taxpayer is choosing to waive the carryback
period under 172(b)(3).
If the above election was not made on the original return, it can be
accomplished with an amended return filed within six months of the due
date of the original return (excluding extensions), and writing Filed
pursuant to 301.9100-2 on the top of the form.
An election to waive the carryback period, once made, is irrevocable.

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For tax years beginning before August 6, 1997, the NOL was carried
back three years and carried forward for up to 15 years until used. Any
unused portion is lost after the fifteenth carryforward year.
A carryback for an individual can be accomplished by either of two
methods:
Form 1045, Application for Tentative Refund, filed no later than one
year after the close of the NOL year.
Form 1040X is used within three years of the due date, including
extensions for filing the tax return for the NOL year.
A carryback for a C corporation can be accomplished by either of two
methods:
Form 1139, Corporation Application for Tentative Refund, filed no
later than one year after the close of the NOL year.
Form 1120X is used within three years of the due date, including
extensions, for filing the tax return for the NOL year.
For a carryforward, the NOL is listed as negative income on the Other
Income line on Form 1040 for individuals and Line 29a of Form 1120
for C corporations.
Special carryback periods apply to certain losses.
An eligible loss can be carried back three years.
An eligible loss is any part of an NOL that is from a casualty or
theft, or is attributable to a Presidentially declared disaster for a
qualified small business.
A qualified small business is a sole proprietorship or partnership
that has average annual gross receipts of $5 million or less during
the three-year period ending with the tax year of the NOL.
A five-year carryback period is available for an NOL created by a
farming loss.
A farming loss is the smaller of the amount that would be the NOL
for the tax year if only income and deductions attributable to the
farming businesses were taken into account, or the NOL for the
tax year.
A farming loss can be treated as if it were not a farming loss. If
this choice is made, the carryback period is two years.
A five-year carryback period applies to a qualified GO Zone loss,
federally declared disaster loss, Kansas disaster area loss, and
Midwestern disaster area loss.

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Eligible small business losses for years ended in 2009 are allowed to

be carried back three, four or five years. Only the portion of the loss
directly associated with the sole proprietorship, partnership, or S
corporation are allowed to be carried back under these rules.
A ten-year carryback period applies to a specified liability loss.
Modified taxable income is used only to determine if there is any excess
NOL to be carried to the next tax year. There are two steps in the
calculation of modified taxable income:
Step One Figure AGI as usual except deduct capital losses only to
the extent of capital gains (no deduction for any part of a net capital
loss is allowed). Do not deduct the NOL carried from the NOL year or
any later tax years. Be sure to deduct any allowable NOL carryovers
from years before the NOL year.
Step Two Take deductions from AGI that are normally allowed.
Refigure deductions and credits that are based on a percentage of
AGI using the modified AGI from step one.
Taxpayers who were not married to each other in all the years involved
in determining the NOL carryback and carryover can deduct the loss
against only the income of the spouse who had the loss. If a joint return
is filed, the NOL deduction is limited to the income of that spouse.
Separate to joint return If a joint return is filed in a carryback or
carryover year, but the taxpayers were married and filed a separate
return for any of the years involved in figuring the NOL carryback or
carryover, the separate carryback or carryover is treated as a joint
carryback or carryover.
Joint to separate returns If separate returns are filed for a
carryback or carryover year, but a joint return was filed for any or all
of the tax years involved in figuring the NOL carryover, each
carryover is figured separately.
Partnerships and S corporations are not allowed an NOL deduction. The
losses are passed through to the partners or shareholders separately
and deducted on their individual income tax returns.

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REPORTABLE TRANSACTIONS
A taxpayer must file Form 8886, Reportable Transaction Disclosure
Statement, to report certain transactions.
Reportable transactions include the following:
Transactions the same as or substantially similar to tax avoidance
transactions identified by the IRS.
Transactions offered to a taxpayer under conditions of confidentiality
for which the taxpayer paid an advisor a minimum fee.
Transactions for which the taxpayer has, or a related party has,
contractual protection against disallowance of the tax benefits.
Transactions that result in losses of at least $2 million in any single
tax year ($50,000 if from certain foreign currency transactions) or
$4 million in any combination of tax years. For corporations, other
than S corporations, this is increased to $10 million in any single
year or $20 million in any combination of tax years.
Transactions resulting in book-tax differences of more than $10
million on a gross basis.
Transactions with asset holding periods of 45 days or less and that
result in a tax credit of more than $250,000.
A taxpayer is subject to penalty if he or she is required to file Form
8886 but does not do so. The taxpayer is also subject to interest and
penalties on any reportable transaction understatements.

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INCOME, LOSS, AND EXPENSES TEST


1. ___

Peter is an auto mechanic. On November 25, 2009, he made


some major auto repairs on Harrys Mercedes. Harry is an
attorney. In exchange for the service, Harry is going to draft
Peters will and represent him when he settles on his new
house. Harry will perform all of these services in 2010. The
repair bill for the Mercedes came to $1,200. Both Peter and
Harry are cash-basis taxpayers. How do they report this
income?
A. Both report $1,200 income in 2009.
B. Both report $1,200 income in 2010.
C. Harry reports $1,200 in 2009 and Peter reports $1,200 in
2010.
D. Peter reports $1,200 in 2009 and Harry reports $1,200 in
2010.

2. ___

Which of the following amounts should be included as income


to John?
A. John owns a rental house and the rental agreement directs
the lessee to pay the $1,000 monthly rent to Michelle, his
ex-wife.
B. The lessee erects a carport on the rental property without
notifying John. Upon inspection, John estimates the value of
the carport is approximately $2,000.
C. John ships goods on consignment to a vendor. The FMV of
the goods is $10,000.
D. The consignment vendor sells $3,000 of Johns goods and
places the proceeds in an escrow account controlled by the
vendor.

3. ___

Luck and Charm Partnership provides consulting services to the


public. In 2009, the firm performed services and in exchange
received a truck with a FMV of $10,000, adjusted basis of
$7,500, and also received lawn care services with a FMV of
$5,000. Luck and Charm uses the cash-basis method for
accounting purposes. What must Luck and Charm report as
income for 2009?
A. $5,000
B. $10,000
C. $12,500
D. $15,000

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4. ___

Alayna is a voice and singing coach. She is a calendar-year


taxpayer using the accrual method of accounting. On
November 2, 2009, she received $3,200 for a two-year
contract for 64 one-hour voice and singing lessons beginning
on that date. The contract provided that Alayna gives eight
lessons in 2009, 48 lessons in 2010, with the remaining
lessons to be given in 2011. What is the amount that Alayna
should report on her 2009 return?
A. $3,200
B. $2,800
C. $2,400
D. $0

5. ___

Shawn Smith, sole proprietor, had the following transactions


during 2009:
Received rental income.
$ 7,500
Performed legal services for ATI Corporation in
return for 10 shares of stock.
24,000
Recovered accounts receivable that had been
written off and deducted in 2008 (did not reduce tax).
20,000
What amount must Mr. Smith include in gross income for
2009?
A. $51,500
B. $44,000
C. $31,500
D. $27,500

6. ___

Ellie operates a restaurant business and Joyce works as a


waitress Monday through Friday from 7 a.m. to 4 p.m. Ellie
provides Joyce with a free breakfast and lunch each day,
including Saturday and Sunday. Ellie values the breakfast at $5
a day and lunch at $7 a day. How much should Ellie add to
Joyces weekly paycheck for meals that she ate?
A. $0
B. $24
C. $60
D. $84

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7. ___

The FX Partnership manufactures garden hoses for sale. In the


month of January, its sales were $80,000. During that month,
the partnership had:
Beginning inventory, January 1
$
0
Raw materials purchased January
35,000
Raw materials shipping costs
1,585
Direct labor (production)
27,000
Factory overhead
6,000
Ending inventory, January 31
10,000
What is the cost of goods sold for the FX Partnership for the
month of January?
A. $69,585
B. $59,585
C. $58,000
D. $53,585

8. ___

The taxpayer is a merchant who has purchased inventory


items. He withdrew some of these items for personal use. He
must:
A. Increase his sales by the cost of the items withdrawn.
B. Reduce the cost of purchases by the cost of the personaluse items.
C. Reduce the cost of purchases by the FMV of the personaluse items.
D. Reduce beginning inventory by the cost of the personal-use
items.

9. ___

All of the following items should be included in inventory


except:
A. Raw materials.
B. Direct labor.
C. Freight paid for shipping completed products.
D. C.O.D. mail sales (C.O.D. payment not received).

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10. ___ Which of the following is not an acceptable inventory practice?


A. Claim a casualty or theft loss of inventory through the
increase in the cost of goods sold by properly reporting
opening and closing inventories.
B. To properly value inventory at cost, reduce the invoice price
of inventory by a trade discount.
C. Under the lower of cost or market method, compare the
market value of each item on hand on the inventory date
with its cost and use the lower of the two as its inventory
value.
D. To properly value inventory at cost, include only the direct
costs associated with each item.
11. ___ Which of the following items are generally included in
inventory?
A. Goods for sale that someone else has consigned to you.
B. Equipment used in your business to manufacture goods.
C. Goods you have sent out on consignment for someone else
to sell.
D. Goods in transit to you for which title has not yet passed to
you.
12. ___ Under the general rule, all of the following require a taxpayer
to capitalize rental expenses except:
A. The taxpayer produces real or tangible personal property for
sale to customers.
B. The taxpayer produces real or tangible personal property for
use in a trade or business or activity engaged in for profit.
C. The taxpayers rent increases during the lease.
D. The taxpayer acquires property for resale and his or her
average annual gross receipts are greater than $10 million.
13. ___ Under the lower of cost or market method, what is the value of
the following items included in closing inventory?
Item
Cost
Market
X
$450
$700
Y
$250
$100
Z
$300
$250
Total
$1,000
$1,050
A. $800
B. $1,000
C. $1,050
D. $1,250

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14. ___ Payments made to employees are normally currently


deductible as business expenses except:
A. Vacation pay paid to an employee even when the employee
chooses not to take a vacation.
B. Wages paid to employees for constructing a new building to
be used in the business.
C. Reasonable salaries paid to employee-shareholders for
services rendered.
D. Payments made to the beneficiary of a deceased employee
that is reasonable in relation to the employees past
services.
15. ___ Supplemental wages are compensation paid in addition to an
employees regular wages. They do not include payments for:
A. Accumulated sick leave.
B. Nondeductible moving expenses.
C. Vacation pay.
D. Travel reimbursements paid at the federal governments per
diem rate.
16. ___ Which of the following statements is correct in respect to
determining when fringe benefits are deductible?
A. Education expenses paid for employees are deductible as
fringe benefits whether or not job-related.
B. Cafeteria plans are written plans that allow employees to
choose among two or more benefits consisting of cash and
qualified benefits.
C. Only those fringe benefits that are includable in an
employees wages are deductible.
D. If a taxpayer transfers a capital asset to an employee, no
gain or loss is recognized by the employer or employee.
17. ___ Which of the following fringe benefits for meals is subject to
the 50% deduction limit?
A. Meals furnished to your employees at the work site when
you operate a restaurant.
B. Meals furnished to your employees as part of the expense of
a company picnic.
C. Meals furnished to your employees at your place of business
when more than half of these employees are provided the
meals for your convenience.
D. Meals furnished to a customer during a business discussion.

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18. ___ All of the following are excludable from wages except:
A. A noncash achievement award valued at $100.
B. Meals furnished during work hours for the benefit of the
employer.
C. Employer-provided vehicles when used by employees for
personal purposes.
D. De minimis fringe benefit.
19. ___ Alan is a sole proprietor of the SAFE Auto Towing Company.
Alan paid Landslide Land, Inc., (unrelated), $24,000 for the
entire year 2009 for the use of the garage where he operates
his business. On September 1, 2009, Alan signed a contract to
purchase the garage. His rent payments from September
through December are applied to his equity interest in the
business. What is the rent expense deduction that Alan may
take on his Schedule C for 2009?
A. $0
B. $8,000
C. $16,000
D. $24,000
20. ___ In 2008, Marge purchased a lease on an office for four years,
beginning January 1, 2009, to use in her tax practice. Of the
$21,600 she paid, $5,000 was for the purchase of the existing
lease with four years remaining and no options to renew. The
remaining amount was for monthly lease payments paid in
advance. How much can Marge deduct for 2009?
A. $0
B. $1,500
C. $3,800
D. $5,400
21. ___ The standard meal allowance cannot be used to figure a
deduction for:
A. Business travel if you are self-employed.
B. Travel in connection with investment property.
C. Travel for qualifying educational purposes.
D. Travel to obtain medical treatment.

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22. ___ To meet the directly related test for entertainment expenses, a
taxpayer must show which of the following:
A. He or she did engage in business with the person during the
entertainment period.
B. The main purpose of the combined business and
entertainment was the active conduct of business.
C. The taxpayer had more than a general expectation of
receiving income or some other specific business benefit at
some future time.
D. All of the above.
23. ___ Ann is a self-employed caterer. To encourage the continuation
of an existing business relationship, Ann took one of her clients
to a Broadway show. The visit to the show occurred directly
after a substantial business discussion with that client. Ann
paid a ticket broker $300 for two tickets to that show. The face
value of each ticket was $100 ($200 total). What is Anns total
deductible expense for both tickets?
A. $100
B. $150
C. $200
D. $300
24. ___ John sells products to the Sienna Company. To thank the
company for its business, John gave the company three bottles
of champagne. Each of the companys three executives took
home a bottle for their families to share. John has no business
relationship with any of the executives family members. If
John paid $40 for each bottle, the total amount John can
deduct is:
A. $25
B. $60
C. $75
D. $120

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25. ___ On June 30, 2009, Angie, who uses the cash method of
accounting, borrowed $25,000 from a bank for use in her
business. Angie was to repay the loan in one payment with
interest on December 30, 2009. On December 30, 2009, she
renewed that loan plus the interest due. The new loan was for
$27,000. What is the amount of interest expense that Angie
can deduct for 2009?
A. $0
B. $333
C. $1,000
D. $2,000
26. ___ Using borrowed funds, a taxpayer buys an interest in a
partnership for $20,000. The partnerships only assets include
machinery used in the business valued at $60,000 and stocks
valued at $15,000. In 2009, he paid $2,000 interest on the
loan. How much interest is deductible as interest attributed to
a trade or business?
A. $0
B. $400
C. $1,600
D. $2,000
27. ___ Which of the following insurance premiums are generally not
deductible by a sole proprietorship?
A. Liability insurance.
B. Workers compensation insurance.
C. Life insurance.
D. Merchandise and inventory insurance.

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28. ___ The J&M partnership paid liability insurance of $2,200 on its
building for the year 2009. This represents a premium for one
year. J&M also prepaid fire insurance premiums of $2,400. The
premium paid was for 2009 and 2010. What is the amount of
insurance that J&M may deduct for 2009?
A. $4,600
B. $3,400
C. $2,400
D. $2,200
29. ___ Pleasant Beach City, to improve downtown commercial
business, converted a downtown business area street into an
enclosed pedestrian mall. The city assessed the full cost of
construction, financed with 10-year bonds, against the affected
business properties. The city is paying the principal and
interest with the annual payments made by the property
owners. The portion that the business owners were assessed to
pay the construction costs is:
A. Deductible as taxes.
B. Deductible as a business expense.
C. A nondepreciable capital expenditure.
D. A depreciable capital expenditure.
30. ___ During 2009, Ms. Smith had the following expenditures relating
to commercial real estate that she owns:
County property tax
$1,975
State property tax
980
Assessment for sewer construction1,500
Charges for sewer and water service810
What is the amount Ms. Smith may deduct as real estate taxes
on her commercial real estate for 2009?
A. $2,955
B. $3,765
C. $4,455
D. $5,265

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31. ___ For a tax period beginning July 1, a truck with taxable gross
weight of 60,000 pounds, registered to Mason Corporation,
was first used on a public highway on July 10. On December
10, the truck was sold to Mr. Davis, who registered and used it
in the tax period. The total federal highway use tax for the
period was $210. Which of the following statements is not
correct in respect to who is liable for the tax?
A. Mason Corp. is liable for the full tax of $210 because it first
placed the truck in service.
B. Mr. Davis is liable for the full tax of $210 to the extent
Mason has not paid the tax.
C. Mr. Davis is liable only for the tax due from December
through June.
D. To the extent that either Mason or Mr. Davis pays the $210,
the other party is relieved of the liability even though the
truck changed ownership.
32. ___ Under which situation below is a deduction allowable for an
office in your home?
A. The taxpayers home is the only fixed location for his
business of selling mechanics tools at retail. He regularly
uses his walk-in closet for storage of inventory and product
samples. He also uses this area occasionally for personal
purposes.
B. A taxpayer is an attorney and uses a den in her home to
write legal briefs. Her family also uses the den for
recreation.
C. The taxpayer uses part of his home exclusively and
regularly to read financial periodicals and reports, clip bond
coupons, and carry out similar activities to monitor personal
investments.
D. The taxpayer uses her walk-in closet at home exclusively
and regularly to bill customers, clients, or patients; to set
up appointments; and to order supplies. She also rents
office space downtown where she conducts those same
activities. She uses the home office three days a week and
the rented office space two days a week.

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33. ___ Dawn meets the requirements for deducting expenses for the
business use of her home. She uses 20% of her home for her
business. She had the following income and expenses. What
amount of depreciation is allowed under the office-in-home
deduction limitation rules?
Gross income from business
$6,000
20% of the home mortgage interest expense
3,000
100% of business supplies and business phone
2,000
20% of home maintenance, insurance, and utilities 800
Depreciation (calculated on 20% of the cost of the home)
1,600
A. $0
B. $200
C. $800
D. $1,600
34. ___ Which of the following penalties paid by Castle Construction
Partnership is deductible?
A. A penalty for late performance of a contract.
B. A penalty for late filing of Form 1065 partnership return.
C. A penalty for violating the state maximum highway weight
law.
D. A penalty paid to the city for violating the citys housing
codes.
35. ___ Hahn Company, a calendar-year taxpayer operating as a sole
proprietorship, reports federal income taxes employing the
accrual method of accounting. Hahn Company shows the
following items of income and expense for 2009:
Sales
$230,000
Cost of Sales
(70,000)
Operating Expenses (excluding insurance) (40,000)
Insurance Expenses:
Self-employed health insurance premium
(4,000)
Self-insurance reserve
(2,000)
Business liability insurance premium for a
3-year policy (from 7-1-09 to 6-30-12)
(15,000)
For 2009 tax purposes, what is the amount of Hahn Companys
net income reportable on Schedule C, Profit or Loss from
Business (Sole Proprietorship)?
A. $117,500
B. $115,500
C. $111,500
D. $111,000

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36. ___ All of the following statements about the alternative


depreciation system (ADS) are correct except:
A. The election must be made by the due date, including
extensions, for the tax return of the year in which the
property was placed in service.
B. The election to use ADS can be revoked.
C. Excluding nonresidential real and residential rental property,
the election of ADS for a recovery class of property applies
to all property in that recovery class that is placed in service
during the tax year of the election.
D. ADS is figured using the straight-line method.
37. ___ John purchased a new gasoline-electric hybrid automobile on
July 2, 2006, for $20,000. He also claimed a $2,000 clean-fuel
vehicle deduction on his 2006 tax return for that vehicle. In
2006, John used this automobile only for personal purposes.
On January 1, 2009, he began using the hybrid automobile
exclusively for business purposes. The fair market value of the
automobile on that day was $17,000. What is the automobiles
depreciable basis as of January 1, 2009?
A. $15,000
B. $16,000
C. $17,000
D. $18,000
38. ___ Ms. Miller set up a computer system for Mr. Towns business.
In return, Mr. Town gave Ms. Miller a storage facility. Ms. Miller
plans to use this facility for business purposes and plans to
depreciate it. The FMV of Ms. Millers services and the storage
facility was $50,000. Mr. Towns basis in the storage facility
was $30,000. How should Ms. Miller treat the transaction and
what is her depreciable basis for the property?
A. Ms. Miller should include the $50,000 in income and use
$30,000 as the depreciable basis for the storage facility she
received.
B. Ms. Miller should include the $30,000 in her income and use
the $50,000 as the depreciable basis for the storage facility.
C. Ms. Miller should include $30,000 in income and $30,000 as
the depreciable basis for the storage facility.
D. Ms. Miller should include $50,000 in income and use
$50,000 as the basis for the storage facility.

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39. ___ James bought and placed in service computer equipment in


2009. He paid $15,000 cash and received a $3,000 trade-in
allowance for his old computer equipment. James had an
adjusted basis of $4,000 in the old computer equipment. He
used both the old and new computer equipment 90% for
business and 10% for personal purposes. His allowable 179
expense deduction is:
A. $12,600
B. $13,500
C. $15,000
D. $16,200
40. ___ Kim Smith, a calendar-year taxpayer, bought and placed in
service in 2007 an item of three-year property at a cost of
$5,000. She elected the 179 deduction of $5,000 for the
property. She used the property 100% for business in 2007
and 2008. In 2009, she used it for personal purposes only. She
must determine if she needs to recapture any of the 179
deduction, because of the change from business to personal. If
allowable depreciation for 2007 and 2008 would have been
$3,889, if 179 had not been elected, how much 179
recapture must she claim?
A. $0
B. $1,111
C. $3,889
D. $5,000
41. ___ With regard to the Modified Accelerated Cost Recovery System
(MACRS), all of the following statements are correct except:
A. Both the General Depreciation System (GDS) and the
Alternative Depreciation System (ADS) use three
conventions to compute the deduction: half-year
convention, mid-month convention, and mid-quarter
convention.
B. ADS must be used for tangible property used predominantly
outside the United States during the year.
C. One of the depreciation methods that is used under GDS is
the 200% declining balance method over the GDS recovery
period.
D. Under GDS, 20-year property includes certain depreciable
improvements to land, such as shrubbery, fences, roads,
and bridges.

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42. ___ During 2009, Nancy, a calendar-year taxpayer, acquired and


placed in service the following business assets:
January:
Delivery trucks
$ 50,000
March:
Warehouse building
150,000
September:
Automobile
30,000
November:
Office equipment
90,000
No 179 or bonus depreciation is claimed. Which convention(s)
can Nancy use to figure depreciation for 2009?
A. Mid-quarter for all assets except the warehouse building,
which uses the mid-month.
B. Half-year for all of the assets.
C. Mid-quarter for all of the assets.
D. Half-year for all assets except the warehouse building,
which uses mid-month.
43. ___ During 2009, Reba agreed to lease a building for use in her
business for five years with a five-year renewal option. She
made substantial leasehold improvements in 2009. Reba can
depreciate the cost of the improvements over:
A. The recovery class life of the building.
B. 10 years.
C. 8 years.
D. 5 years.
44. ___ Mr. Skiles purchased the following business equipment:
Pick-up truck (less than 6,000 gross weight)$15,000
Cellular phones
450
Desks
1,500
Chairs
275
Total
$17,225
How much of his purchase is considered listed property for
depreciation purposes?
A. $17,225
B. $15,450
C. $1,775
D. $0

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45. ___ Esther works as a computer programmer for a marketing firm.


She performs 40% of her computer programming on a home
computer during the weekend (her company is closed on the
weekends) so she can take off two days during the regular
work week. The home computer that Esther works on is
identical to the computer she uses at work, and she uses it
exclusively for her job-related duties. Esthers employer does
not require Esther to take work home with her on the
weekendsit is Esthers choice. Because she uses the home
computer exclusively for business purposes, she can use the
following percentage of business usage when computing her
yearly depreciation for the computer:
A. 100%.
B. 40%.
C. 25%.
D. 0%.
46. ___ An election to amortize may be made for qualifying costs of
organization for a partnership. Which of the following is not
considered a qualifying cost?
A. A cost incurred in the creation of the partnership and not for
starting or operating the partnership trade or business.
B. Accounting fees for services incident to the organization or
the partnership.
C. Legal fees for preparation of the partnership agreement.
D. The costs of acquiring assets for the partnership.
47. ___ Jeanne incurred start-up costs for her new business, which
opened October 1, 2009. The costs were for advertising of
$1,000, a market analysis survey of $2,500, employee training
costs of $6,000, and travel costs for securing prospective
distributors of $2,500. What is the maximum Jeanne can
deduct in 2009?
A. $7,000
B. $5,467
C. $5,117
D. $800

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48. ___ Michael James purchased a travel agency on July 1, 2009, and
immediately took over the business. The purchase contract
included the following items as part of the purchase price:
Goodwill valued at $60,000.
Workforce in place valued at $30,000.
Trademark valued at $60,000.
Government Permit valued at $30,000.
What is the proper amount of Michaels IRC 197 amortization
expense for 2009 assuming Michael is a calendar-year
taxpayer?
A. $6,000
B. $12,000
C. $30,000
D. $90,000
49. ___ All of the following qualify for the depletion deduction except:
A. Geothermal deposits.
B. Gas and oil.
C. Timber.
D. Land.
50. ___ With regard to the correct treatment of business bad debts, all
of the following statements are correct except:
A. Tom deducted a bad debt in a prior tax year and later
recovered part of it. He may have to include the amount
recovered in gross income in the year of recovery.
B. Bill can deduct his business bad debt as a short-term capital
loss.
C. Sally received property in a partial settlement of a debt. She
could reduce the debt by the FMV of the property received
and deduct the remaining amount as a bad debt.
D. Jane can deduct the difference between the amount owed
by a bankrupt entity and the amount received from the
distribution of its assets as a bad debt.

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51. ___ Walter is an accrual-basis taxpayer who has a business with


significant accounts receivable. In 2008, Walter had an $8,000
receivable owed to his business from Fred. Fred was unable to
pay the full amount, but did transfer a parcel of land with a fair
market value of $6,000 to Walter in partial payment. Walter
entered on his books the $2,000 difference as a business bad
debt, but was unable to take a tax benefit from this bad-debt
deduction as he had no taxable income at the end of 2008. In
2009, Walter sold the land received from Fred at a $3,000
gain. At the end of 2009, how much gain from the sale of this
land must Walter report in taxable income?
A. $3,000 the entire gain.
B. $1,000 the gain less the bad debt.
C. $0 any gain is limited to the amount of bad debt.
D. None of the above.
52. ___ In 2008, Kathy Hood, a sole proprietor of Hoods Basket Shop,
had gross income of $245,000, a bad-debt deduction of
$5,000, and other expenses of $75,940. The business reported
on the accrual method of accounting and used the specific
charge-off method for bad debts. In 2009 she recovered
$4,500 of the $5,000 deducted in 2008. How much will she
claim as income and in which year?
A. $4,500 amended 2008.
B. $5,000 in 2009.
C. $4,500 in 2009.
D. None of the above.
53. ___ Which of the following losses generally would not generate a
NOL?
A. Loss from trade or business.
B. Casualty or theft loss.
C. Loss from rental property.
D. Loss created by sale of personal residence for less than its
cost.

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54. ___ All of the following statements about forgoing the NOL
carryback period are correct except:
A. The election should be made as a written statement
attached to the tax return for the NOL year citing the
appropriate Internal Revenue Code section.
B. Once the election is made, the taxpayer cannot later revoke
it for that tax year.
C. A taxpayer may amend a prior years return to include the
election as long as the election is made before the
expiration of the statute of limitations.
D. A taxpayer who wants to forgo the carryback period for
more than one NOL must make a separate election for each
NOL year.
55. ___ In 2009, Sherri, who is single, started a leasing business. Her
2009 income tax return reflected the following income and
deductions:
Income
Wages from part-time job
$1,225
Interest income
425
Net short-term capital gain (business)
2,000
Total income
$3,650
Deductions
Net loss from business
$5,000
Net long-term capital loss on sale of stock 1,000
Personal exemption
3,650
Standard deduction
5,700
Loss on small business stock
1,000
Total deductions
$16,350
Using the above facts, what is the amount of Sherris NOL for
2009?
A. $5,000
B. $3,350
C. $2,775
D. $2,100

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56. ___ Mark and Nancy are married and file a joint return for 2009.
They have an NOL of $5,000. They carry the NOL back to
2007, a year in which Mark and Nancy filed separate returns.
Figured separately, Nancys 2009 deductions were more than
her income. Marks income was more than his deductions. How
much NOL does each have for purposes of carrying back?
A. Each may carry back $2,500.
B. Neither may carry back any NOL.
C. Mark does not have any NOL to carry back, and Nancy may
carry back $5,000.
D. Nancy does not have any NOL to carry back, and Mark may
carry back $5,000.

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INCOME, LOSS, AND EXPENSES ANSWERS


1.

C. Each individual must include in gross receipts, at the time


received, the FMV of the property or services received in
bartering.

2.

A. Items not included in income are leasehold improvements


completed by the tenant (unless the improvement replaces
rent), goods held on consignment, or amounts placed in escrow,
until actually or constructively received.

3.

D. Bartering is an exchange of property or services. The taxpayer


must include in gross receipts, at the time received, the FMV of
the property or service received in bartering.

4.

A. Postponement is not allowed if the taxpayer is to perform any


part of the service after the end of the tax year immediately
following the year the advance payment was received.
Therefore, all of the payment was includable in 2009, with
nothing remaining to report in 2010 or 2011.

5.

C. The FMV of stock received for services and the rental income is
included in income. The recovery of an item previously written
off is included in income to the extent that all or part of the
deduction reduced tax in the earlier year.

6.

B. The value of meals furnished to an employee can be excluded


from that employees pay if the meals are furnished on the
employers business premises and the meals are furnished for
the employers convenience. Meals furnished to an employee on
a day when the employee is not working cannot be excluded
from that employees income.

7.

B. The purchase and shipping of raw materials, direct labor costs,


and the factory overhead are all part of the cost of goods. The
total cost for the year was $69,585. Reduced by the amount
remaining in inventory leaves cost of goods sold at $59,585.

8.

B. If a taxpayer withdraws merchandise for personal use or family


use, he or she must exclude this cost from the total amount of
merchandise bought for sale.

9.

C. Freight paid for shipping completed products is deducted as a


current expense. The cost is not included in inventory.

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10. D. To properly value inventory at cost, include all direct and


indirect costs associated with it.
11. C. Inventory includes merchandise or stock in trade. Merchandise
does not include: goods the taxpayer has sold, but only if title
has passed to the buyer; goods consigned to the taxpayer; or
goods ordered for future delivery, if the taxpayer does not yet
have title.
12. C. UNICAP applies if the taxpayer produces real or tangible
personal property or acquires property for resale. If the rent is
subject to the UNICAP provisions, then an increase in rent would
also be subject to the UNICAP provisions.
13. A. Under the lower of cost or market method, the cost and the fair
market value of each item on hand on the inventory date is
compared, and the lower of the two is used to value inventory.
Item X is valued at cost, and items Y and Z are valued at
market, for a total inventory value of $800.
14. B. Salaries paid to an employee in connection with the construction
of a capital asset are not currently deductible. They are added
to the basis of the property and recovered through depreciation.
15. D. Travel reimbursement at the government per diem rate is
reimbursement under an accountable plan. Supplemental wages
are compensation paid in addition to the employees regular
wages. They include, but are not limited to: bonuses,
commissions, overtime pay, payments for accumulated sick
leave, severance pay, awards, prizes, back pay and retroactive
pay increases for current employees, and payments for
nondeductible moving expenses. Other payments subject to the
supplemental wage rules include taxable fringe benefits and
expense allowances paid under a nonaccountable plan.
16. B. If a cafeteria plan meets certain requirements, the benefits are
not included in income.

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17. D. Meals not subject to the 50% limit are meals or meal money
provided to an employee if it has so little value (taking into
account how frequently the employer provides meals to
employees) that accounting for it would be unreasonable or
administratively impracticable. This includes: coffee, doughnuts,
or soft drinks; occasional meals or meal money provided to
enable an employee to work overtime; and occasional parties or
picnics for employees and their guests. The exclusion also
applies to meals provided at an employer-operated eating
facility for employees if the annual revenue from the facility
equals or exceeds the direct costs of the facility.
18. C. The value of any tangible personal property given to an
employee as an award for either length of service or safety
achievement can be excluded up to $400 or $1,600 for a
qualified plan award. A de minimis benefit provided to an
employee can be excluded from the employees wages. Meals
provided by the employer on the employers premises and for
the employers convenience can be excluded from wages. For an
employer-provided vehicle, the amount that can be excluded is
the amount that would be allowable as a deductible business
expense, if the employee paid for its use. The portion
attributable to personal use cannot be excluded.
19. C. Payments under a conditional sales contract are not deductible
as rent expense. A conditional sales contract includes an
agreement that applies part of each payment toward an equity
interest the taxpayer will receive. Applicable from September 1,
payments are applied toward the purchase of the property and
cannot be deducted as rent.
20. D. The cost of purchasing an existing lease is amortized over the
remaining term of the lease, which is four years. The prepaid
rent is deductible in the year to which it applies.
21. D. A taxpayer can use the standard meal allowance whether he or
she is an employee or self-employed, and whether or not
reimbursed for traveling expenses. He or she can use the
standard meal allowance to figure meal expenses when
traveling in connection with investment and other incomeproducing property. He or she can also use it to figure a meal
expense when traveling for qualifying educational purposes. The
taxpayer cannot use the standard meal allowance to figure the
cost of meals when traveling for medical or charitable purposes.

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22. D. For the directly-related test, the main purpose must be the
active conduct of business. The taxpayer did engage in
business, and the taxpayer had more than a general expectation
of getting income or some other benefit.
23. A. Generally a taxpayer cannot deduct more than the face value of
an entertainment ticket, even if he or she paid a higher price.
Entertainment is then limited to 50% of the related expense.
24. C. A taxpayer can deduct no more than $25 for business gifts
given directly or indirectly to any person during the tax year.
The total for the three gifts is $75.
25. A. A cash-method taxpayer cannot deduct interest paid with
borrowed funds from the original lender through a second loan,
an advance, or any other arrangement similar to a loan.
26. C. A debt-financed acquisition is the use of loan proceeds to buy an
interest in, or make a contribution to the capital of a partnership
or S corporation. The loan proceeds and related interest
expense must be allocated among all assets of the entity.
$16,000 or 80% ($60,000/$75,000 x $20,000) of the interest
paid on this amount is allocated to the trade or business.
27. C. Life insurance is generally not deductible for the sole proprietor.
However, for life insurance contracts issued after June 8, 1997,
the premium may be deductible provided that the sole
proprietor is not directly or indirectly a beneficiary of the policy.
28. B. The taxpayer generally cannot deduct expenses in advance,
even if paid in advance. The $2,400 paid for fire insurance is for
two years, so half of the amount is deductible for the current
year.
29. D. A taxpayer cannot deduct taxes charged for local benefits and
improvements that tend to increase the value of the property.
The taxpayer should increase the basis of the property by the
amount of the assessment. Amounts can be deducted as taxes
only if the taxes are for maintenance, repairs, or interest
charges related to those benefits. The assessment for
construction costs are not deductible as taxes or business
expenses, but are depreciable capital expenses.
30. A. Assessments for sewer construction and charges for sewer and
water services are not deductible as taxes.

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31. C. If the highway use tax is unpaid when the vehicle is transferred
to a new owner, the new owner must pay the tax for the entire
period.
32. A. To qualify to claim expenses for the business use of a home, the
business part of the home must be used exclusively and
regularly for a trade or business; or the business part of the
home must be a place where the taxpayer meets and deals with
patients, clients or customers in the normal course of a trade or
business, or be a separate structure (not attached to the home)
used in connection with a trade or business. The exclusive use
test does not apply to the area the taxpayer regularly uses for
the storage of inventory or product samples, or as a daycare
facility.
33. B. Deductions of otherwise nondeductible expenses, such as
insurance, utilities, and depreciation (with depreciation taken
last) allocable to the business, is limited to the gross income
from the business use of the home minus the sum of: the
business part of expenses deductible even if the home was not
used for business (mortgage interest, taxes) plus the business
expenses that relate to the business activity in the home
(business phone, supplies).
34. A. Penalties and fines paid to a governmental agency or
instrumentality because of breaking the law are not deductible.
However, a penalty or fine paid for the late performance or
nonperformance of a contract is deductible.
35. A. The net income prior to the insurance is $120,000. Of the
insurance, the self-employed health insurance is an adjustment
on Form 1040, and the self-insurance reserve is nondeductible.
For the business liability insurance under the accrual method of
accounting, the taxpayer cannot deduct insurance premiums
before the tax year in which the liability is incurred. For 2009,
six months ($2,500) of insurance is deductible.
36. B. Once the election to use ADS is made, it cannot be changed.
37. C. If a deduction for a clean fuel vehicle is claimed, the basis in
that vehicle is reduced by the amount of the deduction. The
deduction reduces Johns basis in the vehicle to $18,000. On
converting the vehicle to business use, the basis for
depreciation is the lesser of the FMV on the date of change or
the adjusted basis on the date of change.

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38. D. Property received for services is included in income at its FMV.


The amount included in income becomes the basis of the
property.
39. B. If the taxpayer purchases qualifying property with cash and a
trade-in, its cost for purposes of 179 includes only the cash
paid multiplied by the business percent.
40. B. The amount to recapture is the expense deduction minus the
depreciation that would have been allowed had the item been
depreciated rather than expensed. $5,000 - $3,889 = $1,111.
41. D. The 15-year class includes improvements made directly to land
or added to it, such as shrubbery, fences, roads, and bridges.
42. A. The building is not included in determining if mid-quarter must
be used. The depreciable basis of property put in service the
last three months exceeds 40% of the depreciable basis of all
property put in service during the year.
43. A. Improvements are depreciated over the appropriate MACRS
recovery period as would apply to the property to which the
improvement was made.
44. B. Listed property includes property used for transportation or
entertainment and certain computers and cellular phones. A
passenger automobile includes any four-wheeled vehicle made
primarily for use on public streets, roads, and highways and
rated at 6,000 pounds or less of unloaded gross vehicle weight
(8,000 pounds or less of gross vehicle weight for trucks and
vans).
45. D. The use of property in performing services as an employee is a
business-use deduction only if the use is for the employers
convenience, and the use is required as a condition of
employment.
46. D. Organizational expenses that can be amortized include the
following: legal fees for services incident to the organization of
the partnership, such as negotiation and preparation of a
partnership agreement; accounting fees for services incident to
the organization of the partnership; and filing fees.

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47. C. All identified expenses, $12,000, are qualified start-up


expenses. Up to $5,000 of start-up costs can be currently
deducted with the excess amortized for a period of 180 months
beginning with the month business starts.
48. A. The goodwill, workforce-in-place, trademark, and government
permit are all eligible 197 assets. Intangible assets are
amortized over a period of 180 months, starting in the month
the business was acquired.
49. D. Depletion is available to individuals having an economic interest
in mineral property or timber, but does not apply to the land.
There is a residual value of land upon completion of the mining,
quarrying, drilling, or felling operation.
50. B. A business bad debt is deducted as an ordinary expense on the
reporting form for the business entity.
51. A. Under the specific charge-off method, a taxpayer can deduct
specific business bad debts that become either partially or
totally worthless during the year. The tax deduction is limited to
the amount charged off the books during the year. Walter wrote
off $2,000 in 2008. With no taxable income, this may create an
NOL. Walter reports the entire gain on the disposition in 2009.
52. C. A recovery of a bad debt that was deducted in an earlier year is
included in income in the year received. Only the amount
actually received is included in income.
53. D. To have an NOL, the loss must generally be caused by
deductions from: a trade or business, work as an employee,
casualty and theft loss, moving expenses, or rental property.
54. C. The statement must be filed with the tax return for the NOL
year by the due date, including extensions. If not timely filed,
the election to forego the carryback period cannot be made.
55. C. Expenses exceed income by $12,700. To determine the NOL,
this difference is reduced by non-business expenses including
the following: $3,650 (personal exemption), $5,275 (standard
deduction minus interest income), and $1,000 (capital loss on
the sale of stock). $12,700 - $3,650 - $5,275 - $1,000 =
$2,775.

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56. C. Figured separately, Mark does not have a loss. Thus, the entire
NOL is attributable to Nancy and she can carry back the entire
$5,000.

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SALES, EXCHANGES, CREDITS, FARMING, AND


SE TAX
SALES AND OTHER DISPOSITIONS
GENERAL INFORMATION
A sale is a transfer of property for money or a mortgage, note, or other
promise to pay money.
An exchange is a transfer of property for other property or services.
Gain is the excess of the amount realized over the adjusted basis of the
property. Loss is the excess of the adjusted basis over the amount
realized.
The amount realized is the total of all money received plus the fair
market value (FMV) of all property and services received. The amount
realized also includes any liabilities that were assumed by the buyer and
liabilities to which the property traded is subject (mortgage, real estate
taxes, etc.).
Realized gain or loss is the amount realized less the adjusted basis of
the property.
The amount recognized is the amount that is included or deducted in
determining gross income for tax purposes.
Recognized gain or loss is the gain or loss included in determining
gross income.
The FMV is the price at which the property would change hands
between a willing buyer and a willing seller when both have reasonable
knowledge of all the facts and neither is required to buy or sell.
Property that is used partly for business or rental and partly for
personal use is treated as a sale of two separate assets. The selling
price, selling expenses, and basis is allocated between the business

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portion and the personal portion. The basis of the business portion is
adjusted for depreciation allowed or allowable.
A loss on the sale of a home or personal use property is generally not
deductible. If that home or personal property is converted to business
use property, the loss on the sale is allowed but may be limited. The
basis to use in determining the loss is the lower of the propertys
adjusted basis or the FMV on the date of conversion. This is then
adjusted for changes and depreciation during the business use period. If
this adjusted basis is greater than the amount received on the sale, the
loss is allowed.

LIKE-KIND EXCHANGE
When an exchange qualifies as like-kind, the gain is not taxed and
losses are not deductible. To be a like-kind exchange, the property
traded and the property received must be qualifying property and likekind property.
Generally, a transaction is not an exchange when a taxpayer voluntarily
sells property for cash and immediately buys similar property to replace
it. The sale and purchase are two separate transactions. However, if the
taxpayer sells property and buys similar property in two mutually
dependent transactions, it may have to be treated as a single
nontaxable exchange.
Qualifying property must be held for business or investment use.
The like-kind exchange rules do not apply to the following property:
Property used for personal purposes, such as a home or car.
Stock in trade or other property held for sale, such as inventories,
raw materials, and real estate held by dealers.
Stocks, bonds, notes, or other securities or evidence of
indebtedness, such as accounts receivable.
Partnership interests.
Certificates of trust or beneficial interest.
Choses in action.
An exchange of assets of a business for the assets of a similar business
cannot be treated as an exchange of a single asset. The assets of each
business must be looked at separately.

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Like-kind properties are properties of the same nature or character,


even if they differ in grade or quality. For example:
Personal property for similar personal property such as a truck for a
van qualifies.
The exchange of livestock of different sexes does not qualify under
the like-kind rules (heifers for bulls).
Real property for real property. Unimproved land for improved land
qualifies as like-kind. Real property located in the United States for
real property located outside of the United States does not qualify.
Depreciable tangible personal property can be either like-kind or likeclass. Like-class properties are those within the same General Asset
Class or Product Class. Product Class is listed in a six-digit product class
in the North America Industry Classification System (NAICS).
An exchange of intangible personal property or nondepreciable personal
property for like-kind property can qualify for the nonrecognition of gain
or loss. Whether intangible personal property, such as a patent or
copyright, is of like kind to other intangible personal property generally
depends on the nature or character of the rights involved. It also
depends on the nature or character of the underlying property to which
those rights relate.
An exchange of the goodwill or going concern value of a business for
the goodwill or going concern value of another business is not a likekind exchange.
The exchange may be a deferred exchange in which business or
investment property is transferred, and at a later time, replacement
property is received.
If, before receiving replacement property, the taxpayer actually or
constructively receives money or unlike property in full payment for the
property transferred, the transaction is treated as a sale rather than a
deferred exchange.
A deferred exchange must meet certain requirements:
The property to be received in the exchange must be identified
within 45 days after the date in which the property exchanged is
transferred.

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The replacement property must be identified in a signed written

document and delivered to the other person involved in the


exchange.
Up to three properties can be identified as replacement property.
This may include property that is not yet in existence or is being
produced at the time identified.
The taxpayer must take possession of the replacement property by
the end of the receipt period.
The receipt period ends with the earliest of the following dates:
The 180th day after the date on which the taxpayer transferred
the property given up in the exchange.
The due date, including extensions, for the return for the tax
year that the transfer of the property given up occurs.
If the replacement property is personal property that is being
produced, it must be completed by the date the taxpayer receives
it to qualify as substantially the same property as that identified.
If the replacement property is real property that had to be
produced and it is not completed by the date the taxpayer
receives it, it may still qualify as substantially the same property
identified if considered real property under state law. However,
any additional production on the property after the taxpayer
receives it does not qualify as like-kind property.
An exchange can be accomplished through a qualified intermediary,
where property is transferred to the intermediary and the intermediary
acquires replacement property and transfers it to the taxpayer.
A taxpayer who transfers property given up to a qualified intermediary
in exchange for replacement property formerly owned by a related
person is not entitled to nonrecognition treatment if the related person
receives cash or unlike property for the replacement property.
A qualified intermediary cannot be an agent of the taxpayer at the time
of the transaction (employee, attorney, accountant, investment broker,
real estate agent within the two-year period before the transfer of the
property given up), or a person related to the taxpayer or the
taxpayers agent.
An acquisition of property before giving up property generally does not
qualify for like-kind exchange treatment. However, the transaction may
qualify as a like-kind exchange if completed through the use of a
qualified exchange accommodation arrangement (QEAA).

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Either the replacement property or the relinquished property is

transferred to an exchange accommodation titleholder (EAT), who is


treated as the beneficial owner of the property.
For transfers of qualified indications of ownership, the
replacement property held in a QEAA may not be treated as
property received in an exchange if the taxpayer previously
owned it within 180 days of its transfer to the EAT.
Property is held in a QEAA only if the following requirements are
met:
There is a written agreement.
The time limits for identifying and transferring the property are
met.
The qualified indications of ownership of property are transferred
to an EAT.
An EAT must meet all of the following requirements:
Hold qualified indications of ownership at all times from the date
of acquisition of the property until the property is transferred.
Be someone other than the taxpayer or a disqualified person.
Be subject to federal income tax.
A like-kind exchange may be partially taxable if money or unlike
property (boot) is received in addition to the like-kind property.
Gain recognized is the lesser of the following amounts:
Gain realized.
Money and/or the FMV of unlike property received. Liabilities
assumed by the other party are treated as money received in the
amount of the liability.
Subtract exchange expenses from the consideration received to
figure the amount realized on the exchange. Also, add these
expenses to the basis of the like-kind property received. If cash or
unlike property is also received, subtract exchange expenses from
the cash or FMV of the unlike property, then use the net amount to
figure the recognized gain.
If, in addition to like-kind property, the taxpayer gives up unlike
property, he or she must recognize gain or loss on the unlike
property given up.
A like-kind exchange is reportable in the year the property is
transferred to another party. The exchange is reportable on Form 8824,
Like-Kind Exchanges, regardless of whether gain is recognized.

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The basis of the property received in a nontaxable exchange is the basis


of the property given up plus any additional cash paid or liabilities
assumed.
The basis of all properties (other than money) received in a partially
nontaxable exchange is the total adjusted basis of the properties given
up, with certain adjustments.
Decreased by money received, any liabilities transferred, and any
loss recognized on the exchange.
Increased by any additional costs incurred, money paid, liabilities
assumed, and gain recognized on the exchange.
Allocate this basis first to unlike property, other than money, up to
its FMV on the date of the exchange.
Property acquired in an exchange or involuntary conversion must
generally be depreciated over the remaining recovery period of the
exchanged property. The part of the acquired propertys basis that
exceeds the carried-over basis is depreciated as newly acquired
property.
If multiple properties are exchanged, a property-by-property
comparison is generally completed to figure gain or loss and basis. This
property-by-property determination may be waived if the taxpayer does
either of the following:
Transfers and receives properties in two or more exchange groups.
Transfers or receives more than one property within a singleexchange group.
Exchanges between related parties are nontaxable provided certain
rules are followed.
Related parties include any of the following relationships:
Members of a family (spouse, brother, sister, parent, child, etc.).
A corporation in which the taxpayer owns more than a 50% interest,
or a partnership in which the taxpayer owns, directly or indirectly, a
more than 50% interest in the capital or profits.
If either party to the exchange disposes of the property within two
years after the exchange, the exchange is disqualified from
nonrecognition treatment. The gain or loss on the original exchange
must be recognized as of the date of the later disposition.
Exceptions to the related-party rules include the following transactions:

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Dispositions due to the death of either related person.


Involuntary conversions.
Exchanges or dispositions if it is established to the satisfaction of the

IRS that the main purpose is not the avoidance of federal income
tax.
Property that is traded-in for other property is treated as an exchange.
The transaction is treated as an exchange regardless of how the parties
try to avoid the trade-in rules. An example of a like-kind exchange is
the trade-in of a used vehicle for a new vehicle. Selling the old property
to a dealer and then buying new property from the same dealer cannot
increase the exchange basis of property for depreciation. If the sale and
purchase are dependent on each other, it is treated as a trade-in.

OTHER NONTAXABLE EXCHANGES


Certain other exchanges may not be taxable under other provisions.
An exchange of partnership interests does not qualify as a
nontaxable exchange of like-kind property. However, under certain
circumstances, the exchange may be treated as a tax-free
contribution of property to a partnership.
Certain issues of U.S. Treasury obligations may be exchanged for
certain other issues designated by the Secretary of the Treasury with
no gain or loss recognized on the exchange.
Certain insurance policies and annuities may be exchanged for other
contracts. The insured or annuitant must be the same under both
contracts. The following exchanges are nontaxable, whereas any
other exchange not listed is taxable:
A life insurance contract for another life insurance contract or for
an endowment or annuity contract.
An endowment contract for an annuity contract or for another
endowment contract that provides regular payments beginning at
a date not later than the beginning date under the old contract.
An annuity contract, or a portion of an annuity contract, for
another annuity contract if the insured or annuitant remains the
same.
Generally, no gain or loss is recognized if the taxpayer receives stock
in exchange for his or her interest as a policyholder or an annuitant if
completed as a demutualization of a life insurance company.

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In a transfer of property to a corporation and immediately after the

transfer, the taxpayer is in control of the corporation, the exchange


is usually not taxable.
An exchange of common stock for common stock, or preferred stock
for preferred stock in the same corporation, can be completed
without having to recognize gain or loss.

OTHER TRANSFERS

ABANDONMENT
The abandonment of property is a disposition. Property is abandoned
when the taxpayer voluntarily and permanently gives up possession and
use with the intention of ending ownership but without passing it on to
anyone else.
Loss on abandonment of business or investment property is deductible
as an ordinary loss, even if the property is a capital asset. The loss is
the propertys adjusted basis when abandoned.
If the abandoned property secures a debt for which the taxpayer is
personally liable and the debt is cancelled, the taxpayer realizes
ordinary income equal to the cancelled debt. This income is separate
from the loss realized from the abandonment.

FORECLOSURE AND REPOSSESSION


A foreclosure or repossession is treated as a sale or exchange. Gain or
loss is the difference between the adjusted basis in the property and the
amount realized.
If the taxpayer is not personally liable for repaying the debt
(nonrecourse debt), the amount realized is the full debt cancelled.
The cancelled debt is included even if the FMV of the property is less
than the cancelled debt. (Selling price is the mortgage amount.)
If the taxpayer is personally liable for repaying the debt (recourse
debt), the amount realized does not include the cancelled debt. If the
FMV is less than the cancelled debt, the amount realized includes the
cancelled debt up to the FMV. The taxpayer is treated as receiving
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ordinary income from the cancelled debt for the part of the debt that
is more than the FMV. (Selling price is the lesser of the mortgage
amount or the FMV.)

INVOLUNTARY CONVERSION
An involuntary conversion occurs when property is destroyed, stolen,
condemned, or disposed of under a threat of condemnation.
Gain or loss from an involuntary conversion is reported on the tax
return for the year realized. Depending on the type of involuntary
conversion and the replacement property, gain may be eligible for
deferral.
Casualty and theft losses are reported on Form 4684, Casualties and
Thefts, in the year of the casualty. Section B of the form is used to
report the casualty or theft of business or income-producing property.
If the casualty or theft is of business or income-producing property, the
deductible loss is the adjusted basis of the property reduced by any
reimbursement received. For this property, the decrease in FMV is not
considered.
A casualty or theft loss of inventory is taken by either of two methods:
Deduct the loss through the increase in the cost of goods sold by
properly reporting opening and ending inventories. The loss is not
again claimed as a casualty or theft loss. If the loss is reported
through an increase in the cost of goods sold, any insurance or other
reimbursement is included in gross income.
Deduct the loss separately. Eliminate the affected inventory from the
cost of goods sold by making a downward adjustment to opening
inventory or purchases. Reduce the loss by insurance or other
reimbursement received.
Gain on an involuntary conversion may be postponed if the taxpayer
receives property that is similar or related in service or use to the
converted property.
A condemnation is the process by which private property is legally
taken for public use without the owners consent. The taxpayer
generally receives a condemnation award for the property taken.

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The net condemnation award is treated as the sales price in

determining gain or loss. This is the amount of the award reduced by


expenses of obtaining the award.
If interest is paid due to a delay in paying the award, the interest is
not part of the award.
Payments to relocate because of being displaced are not part of the
award.
Severance damages are not part of the award. Severance damages
are paid if part of the property is taken and the value of the part not
taken is decreased because of the condemnation. Severance
damages reduce the basis of the portion of the property kept. If the
severance amount exceeds the basis in that part, the excess is gain,
which may be postponed if replaced.
To postpone reporting all of the gain, the taxpayer must buy
replacement property costing at least as much as the amount realized
for the condemned property. If the cost of the replacement property is
less than the amount realized, the taxpayer must report the gain up to
the unspent part of the amount realized.

RELATED PARTY
If gain is recognized on a sale to a related party, the gain may be
ordinary income even if the asset is a capital asset. The gain is ordinary
if the sale or exchange is a depreciable property transaction or a
controlled partnership transaction.
If the property is depreciable property, including leasehold and
patent applications, in the hands of the person who receives it, the
gain is ordinary income if the transaction is either directly or
indirectly between related parties. For this purpose, related parties
include:
A person and a persons controlled entity.
A taxpayer and any trust which the taxpayer (or spouse) is a
beneficiary unless the beneficiarys interest in the trust is a
remote contingent interest.
An executor and a beneficiary of an estate unless the sale or
exchange is in satisfaction of a pecuniary bequest.
An employer and a welfare benefit fund that is controlled directly
or indirectly by the employer.

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A gain recognized in a controlled partnership transaction is ordinary

if it results from a sale or exchange of property that, in the hands of


the party who receives it, is a noncapital asset such as trade
accounts receivable, inventory, stock in trade, or depreciable or real
property used in a trade or business.
A partnership and a partner who, directly or indirectly, owns more
than a 50% of a capital interest or profits interest.
Two partnerships, if the same person owns, directly or indirectly,
more than 50% of a capital interest or profits interest in both
partnerships.
A loss on the sale or exchange of property between related persons is
not deductible. If the purchaser later sells or exchanges the property at
a gain, the individual recognizes gain only to the extent it is more than
the loss previously disallowed to the related person.

OTHER DISPOSITIONS
A sale of a business is generally a sale of multiple assets, with gain or
loss calculated separately for each asset.
An interest in a partnership is treated as the sale of a capital asset
when sold. Gain or loss from unrealized receivables and inventory items
is treated as ordinary gain or loss.
A sale of a corporation interest is a sale of stock resulting in capital gain
or loss.
A sale of an entire business for a lump sum is considered a sale of each
individual asset. Except for assets exchanged under the nontaxable
exchange rules, the buyer and seller must use the residual method to
allocate the price to each asset. The residual method was discussed
earlier in determining basis for multiple assets purchased for a lump
sum amount.
The buyer and seller may enter into a written agreement as to the
allocation of any consideration or the FMV of any asset. This
agreement is binding on both parties unless the IRS determines the
amounts not appropriate.
Gain or loss on the sale or exchange of amortizable or depreciable
intangible property held longer than one year is a 1231 gain or loss.

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Gain due to amortization or depreciation is recaptured as ordinary


income.
A covenant not to compete that is treated as a 197 intangible
cannot be treated as disposed of or worthless until the entire interest
in the trade or business is disposed of.
A loss on the disposition of one 197 intangible is not deductible until
disposition of all 197 intangibles acquired in the same transaction.
A transfer of a patent is treated as a sale or exchange of a capital
asset held longer than one year.
Money received on the transfer or renewal of a franchise, trademark,
or trade name for a price contingent on its productivity, use, or
disposition, is treated as an amount received from the sale of a
noncapital asset.
Gain on land that is subdivided into lots or parcels is normally
ordinary income. Capital gain treatment can apply on part of the
proceeds if the provisions of 1237 are met.
Standing timber held for investment is a capital asset. If held for sale
to customers, it results in ordinary business income.

REPORTING GAINS AND LOSSES


Property used in a trade or business or held for the production of rents
and royalties and held for more than one year is referred to as 1231
property. On disposition, the treatment as ordinary or capital depends
on whether there is a net gain or a net loss from all 1231 transactions.
The following transactions result in gain or loss subject to 1231
treatment:
Sales of exchanges of real property or depreciable personal property.
Sales or exchanges of leaseholds.
Sales or exchanges of cattle and horses held for draft, breeding,
dairy, or sporting purposes and held for two years or longer.
Sales or exchanges of other livestock, not including poultry, held for
draft, breeding, dairy, or sporting purposes and held for one year or
longer.
Sales and exchanges of unharvested crops when the crop and land
are sold, exchanged, or involuntarily converted at the same time and
to the same person.
Cutting of timber or disposal of timber, coal, or iron ore.

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Condemnation of business property or a capital asset held in

connection with a trade or business or a transaction entered into for


profit.
Casualties or thefts that affect business property, property held for
the production of income, or investment property.
In a disposition, first determine the ordinary part of the gain. Any
remaining gain is included in the 1231 computation.
Combine all 1231 gains and losses for the year. If the 1231 gains
exceed losses, there is a net 1231 gain.
If 1231 losses equal or exceed 1231 gains, then treat each item as
an ordinary gain or loss.
A net 1231 gain is treated as ordinary to the extent the taxpayer has
nonrecaptured net 1231 losses taken in the previous five years.
Nonrecaptured net 1231 losses are those 1231 losses deducted in
the taxpayers five most recent tax years that have not been applied
against any net 1231 gains in a tax year beginning after 1984.
The amount of the taxpayers net 1231 gain that is not treated as
ordinary income is long-term capital gain.

Example: Ashley Graphics is a calendar-year corporation. In 2006, it had a net


1231 loss of $8,000. For tax years 2008 and 2009, the company has net 1231
gains of $5,250 and $4,600, respectively. In figuring taxable income for 2008,
Ashley treated its net 1231 gain of $5,250 as ordinary income by recapturing
$5,250 of its $8,000 net 1231 loss from 2006. In 2009 it applies its remaining net
1231 loss, $2,750 ($8,000 - $5,250) against its net 1231 gain, $4,600. For 2009,
the company reports $2,750 as ordinary income and $1,850 ($4,600 - $2,750) as
long-term capital gain.

DEPRECIABLE PROPERTY
If depreciable or amortizable property is disposed of at a gain, part or
all of the gain may have to be treated as ordinary income.

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1245 PROPERTY
The gain on 1245 property is treated as ordinary income to the extent
of depreciation allowed or allowable. Any gain recognized that is more
than allowable depreciation is 1231 gain. Section 1245 property
includes any property that is or has been subject to an allowance for
depreciation or amortization and that is any of the following types of
property:
Personal property (either tangible or intangible).
Certain other tangible property (except building and their structural
components) used in a trade or business.
That part of real property with an adjusted basis that was reduced by
certain amortization or other deductions.
Single purpose agricultural (livestock) or horticultural structures.
Storage facilities used in distributing petroleum or any primary
product of petroleum.
Any railroad grading or tunnel bore.
The gain treated as ordinary income is the lesser of the following:
The depreciation or amortization allowed or allowable on the
property.
The gain realized on the disposition.
Depreciation or amortization includes the amount the taxpayer has
claimed on 1245 property as well as the following:
Amounts claimed on property the taxpayer exchanged for the 1245
property in a like-kind exchange or involuntary conversion.
Amounts a previous owner claimed if the taxpayers basis is
determined with reference to that persons adjusted basis (such as
by gift).
Amounts claimed as 179 expense.
Depreciation allowed or allowable is the amount used to determine
ordinary income.
If the taxpayer has consistently taken proper depreciation under one
method, the amount allowed is not increased even if a greater
amount would have been allowable under a different method.
If no deduction was taken, the basis is adjusted for depreciation
allowable by using the straight-line method.

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1250 PROPERTY
Gain on the disposition of 1250 property is ordinary income to the
extent of additional depreciation allowed or allowable on the property.
Additional depreciation is the actual depreciation taken that is more
than the depreciation figured using the straight-line method.
If 1250 property is held for one year or less, all depreciation is
additional depreciation.
Section 1250 property includes all real property that is subject to an
allowance for depreciation and that is not and never has been 1245
property.
Gain on the sale of business or rental real estate is generally
1250 property unless the property is nonresidential real property
depreciated under ACRS. Nonresidential real property for which
ACRS deductions were taken is considered 1245 property.
Gain on the sale of residential rental property is treated as
ordinary income to the extent of the excess depreciation taken
under ACRS over what would have been allowed using straightline.
Ordinary income rules do not normally apply to residential real
property or nonresidential real property placed in service after
December 31, 1986, because MACRS for this property is
determined using the straight-line method. However, if the
additional first year depreciation allowance was taken, the
recapture rules do apply.

1231 Land and depreciable property used in a business, held over one year
Sold at a gain
1245
Personal property.
Nonresidential real
property
depreciated using
ACRS.
Treated as
ordinary gain up to
the amount of
depreciation. The
remaining gain is
1231 gain.

Sold at a loss

1250
Residential rental property.
Nonresidential real property depreciated
using straight-line.
ACRS
Depreciation in
excess of straightline is recaptured
as ordinary income.
The remaining gain
is 1231 gain.

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All losses are


treated as 1231
ordinary losses.

SL or MACRS
Recapture special
30% allowance.
Remaining gain is
treated as capital
1231.

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Form 4797, Sales of Business Property, is used to report gain or loss


from the sale, exchange, or involuntary conversion of property used in a
trade or business or held for the production of rents or royalties, or
property that is depreciable or amortizable. Net 1231 gain is carried to
Schedule D as long-term capital gain. Ordinary gain or loss is carried
from Part II of Form 4797 to the return being filed (1040, 1065, 1120,
etc.).

Note: A portion of the 1231 gain may be characterized as


unrecaptured 1250 gain, taxed at the 25% capital gain rate.
The portion characterized as unrecaptured 1250 is the gain
up to the amount of all depreciation taken that has not been
recaptured as ordinary income.

If the sale is reported using the installment method, any depreciation


recapture under 1245 or 1250 is taxable as ordinary income in the
year of the sale. This applies even if no payment is received in the year
of sale. Unrecaptured 1250 gain is recognized as payments are
received and before any 1231 gain.
When a taxpayer dies, no gain is reported on depreciable personal
property or real property transferred to his or her estate or beneficiary.
If the basis of 1250 property received as a gift or in a tax-free
exchange is reduced by the depreciation that was either allowed or
allowable to the former owner, a separate statement showing the basis
determination must be attached to the return for the year the property
was acquired.

OTHER
No gain or loss is recognized on a transfer of property from an
individual to a spouse or former spouse if incident to divorce.

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BUSINESS CREDITS
GENERAL BUSINESS CREDIT
The general business credit consists of a number of credits combined on
Form 3800, General Business Credit. It is limited to the net income tax
minus the larger of the tentative minimum tax or 25% of the net
regular tax liability that is more than $25,000. The total credit for the
tax year is a combination of the following amounts:
Carryforward of business credits.
The current-year business credit.
Carryback of business credits to the current year.
The information that follows describes the credits that make up the
general business credit.

INVESTMENT CREDIT
The investment credit consists of the rehabilitation, energy, qualifying
advanced coal project, qualifying gasification project, and qualifying
advanced energy project credits.
Rehabilitation credit.
Applies to any building that is either a qualified rehabilitation
building or a certified historic structure. The credit is 10% of the
expenditures for any qualified rehabilitation building other than a
certified historic structure and 20% of the expenditures for a
certified historic structure.
The rehabilitation credit is increased by substituting 13% for 10%
and 26% for 20% with respect to qualifying expenditures paid or
incurred after August 27, 2005, and before January 1, 2010, on
qualified properties located in the Gulf Opportunity Zone, and
before January 1, 2012 for the Midwestern disaster area.
Energy credit.
Energy property must be constructed, reconstructed, or erected
by the taxpayer. If acquired by the taxpayer, the original use of
such property must begin with the taxpayer.
The depreciable basis of property is reduced by 50% of the
energy credit determined.
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Geothermal energy property is equipment that uses geothermal

energy to produce, distribute, or use energy derived from a


geothermal deposit.
Solar energy property is classified into two types.
Equipment that uses solar energy to illuminate the inside of a
structure using fiber-optic distributed sunlight.
Equipment that uses solar energy to generate electricity, heat
or cool a structure, or provide solar process heat.
Qualified fuel cell property is a fuel cell power plant that
generates at least 0.5 kilowatts of electricity using an
electrochemical process and has electricity-only generation
efficiency greater than 30%.
Qualified microturbine property is a stationary microturbine power
plant that generates less than 2,000 kilowatts and has an
electricity-only generation efficiency of not less than 26%.
Qualifying advanced coal and gasification property. Eligible property
is any property that is part of a qualifying advanced coal project
using an integrated gasification combined cycle and is necessary for
gasification of coal, including any coal-handling and gas-separation
equipment. This applies to property placed in service after August 8,
2005.
Investment credit is allowed to patrons of 1381(a) cooperatives that
have elected to pass through an unused investment credit. This is
reported to the patron on Form 1099-PATR, Box 7.

WELFARE-TO-WORK CREDIT
The welfare-to-work credit provided businesses with an incentive to hire
long-term family assistance recipients.
The credit was 35% of the qualified first-year wages and 50% of the
qualified second-year wages.
The maximum wage considered was $10,000 per qualifying individual.
This resulted in a maximum credit per employee of $8,500 ($3,500 for
the first year and $5,000 for the second year).
The credit was available for qualified wages paid or incurred to
employees who begin work before January 1, 2008.
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Work Credit, should not be used to calculate a credit for any employee
hired after December 31, 2006. Form 8861 is not reprinted for 2009,
and Form 3800 for 2009 does have a line entry for the welfare-to-work
credit, but it appears it is only for the credit from flow-through entities.

CREDIT FOR INCREASING RESEARCH ACTIVITIES


The increasing research activities credit is equal to 20% of the increase
in research expenses for the year over the base amount for the year.
The base amount is a fixed percentage times the average annual gross
receipts of the payor for the four taxable years preceding the taxable
year of the credit.
The research must be undertaken to discover information that is
technological in nature and its application must be intended for use in
developing a new or improved business component of the taxpayer. In
addition, substantially all of the activities of the research must be
elements of a process of experimentation relating to a new or improved
function, performance, reliability, or quality.

LOW-INCOME HOUSING CREDIT


The low-income housing credit is available to the owners of residential
property used for low-income housing. The credit equals the propertys
qualified basis times an applicable percentage published monthly by the
IRS. The amount cannot exceed the state agencys housing credit dollar
amount allocated to the property. The credit is taken over a ten-year
period. There is a 15-year compliance period during which the
residential rental building must continue to meet certain requirements.
If those requirements are not met, the credit is subject to recapture.

DISABLED ACCESS CREDIT


The disabled access credit was enacted to allow eligible small
businesses to claim a credit for eligible expenditures to comply with
requirements under the Americans With Disabilities Act. The credit is
equal to 50% of the expenses over $250 but not more than $10,250
incurred to provide access to persons with disabilities. The maximum
amount of the disabled access credit for any tax year is $5,000.

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RENEWABLE ELECTRICITY, REFINED COAL, AND INDIAN COAL


PRODUCTION CREDIT
The credit is allowed only for the sale of electricity, refined coal, or
Indian coal produced in the United States or U.S. possessions from
qualified energy resources at a qualified facility. The renewable
electricity production credit is available for the production of electricity
from qualified energy resources. Qualified energy resources means
wind, closed-loop biomass, poultry waste, open-looped biomass,
geothermal energy, solar energy, small irrigation power, municipal solid
waste, hydropower production, refined coal, and Indian coal. Generally,
the credit is 1.5 cents per kilowatt-hour of electricity produced and sold.
The 1.5 cents credit amount is reduced by half for open-looped
biomass, small irrigation, landfill gas, trash combustion, hydropower,
and marine and hydrokinetic renewable facilities. The credit is $4.375
per ton for the sale of refined coal produced at a qualified facility during
the credit period, $1.50 per ton for the sale of Indian coal produced at a
qualified facility during the credit period, and $2.00 per barrel-of-oil
equivalent for the sale of steel industry fuel.
The renewable electricity production from facilities placed in service
prior to October 23, 2004, is determined from Section A of Form 8835,
Renewable Electricity, Refined Coal, and Indian Coal Production Credit.
This credit is carried to Form 3800. For facilities placed in service after
this date and the coal production, the credit is determined in Section B
and carried to the appropriate business form.

INDIAN EMPLOYMENT CREDIT


The Indian employment credit allows a credit of up to $4,000 per
qualified Indian hired before January 1, 2010. The amount of the credit
is equal to 20% of the net incremental Indian employment wage. The
net incremental Indian employment wages are the excess of the
qualified wages and qualified employee health insurance costs paid or
incurred during the taxable year over these same costs for 1993. The
employee must perform substantially all of his or her services within an
Indian reservation while living on or near the reservation.

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ORPHAN DRUG CREDIT


The orphan drug credit is allowed for qualified clinical testing expenses
paid or incurred during the year. Qualified clinical testing expenses
include amounts paid or incurred that would be described as qualified
research expenses except that they specifically relate to clinical testing
of certain drugs and 100% of contract research expenses are taken into
account. The credit equals 50% of qualified human clinical testing
expenses for drugs to treat rare diseases.

NEW MARKET CREDIT


The new market credit was created to encourage equity investment in a
qualified community development entity. The investor receives a credit
of 5% for the first, second, and third years of the seven-year credit
period beginning with the year the qualified investment is made and 6%
for later years.

PENSION START-UP CREDIT


The credit for small employer pension start-up costs is to help offset the
cost an employer incurs in setting up a retirement plan. An eligible
employer is one who had no more than 100 employees during the tax
year preceding the first credit year who received at least $5,000 of
compensation. The credit is up to 50% of the first $1,000 of qualified
expenses for each of the first three years of the plan, for a maximum of
$1,500 over the three years. An eligible plan is a qualified employer
plan as defined in 4972(d). The credit is available in the year prior to
the effective date of the plan.

EMPLOYER- PROVIDED CHILDCARE FACILITIES


The credit for employer-provided childcare facilities and services is
available to an employer who provides for the care of employees
children. The credit is the sum of 25% of the qualified childcare
expenditures and 10% of the qualified childcare resource and referral
expenditures, not to exceed $150,000 for the tax year.

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BIODIESEL AND RENEWABLE DIESEL FUELS


The biodiesel and renewable diesel fuels credit consists of the biodiesel
credit, renewable diesel credit, biodiesel mixture credit, renewable
diesel mixture credit, and small agri-biodiesel producer credit. This
credit is allowed for gallons sold or used during the tax year. The credit
rate is $.10, $.50, or $1.00 per gallon depending on the type of fuel.

NONCONVENTIONAL FUELS CREDIT


The nonconventional source fuel credit is allowed for a qualified fuel
that the taxpayer produced and sold to an unrelated person. The only
qualified fuels for 2009 are coke or coke gas. The credit amount is
$3.00 per barrel-of-oil equivalent adjusted by an inflation factor for the
year.

ENERGY EFFICIENT HOME CREDIT


The energy efficient home credit is available for eligible contractors for
certain homes substantially completed after August 8, 2005 and sold for
use as a residence during the year. The credit is $2,000 or $1,000
based on the energy saving requirements of the home.

ENERGY EFFICIENT APPLIANCE CREDIT


Manufacturers of energy efficient appliances (eligible dishwashers,
clothes washers, and refrigerators) produced in 2009 can file Form
8909, Energy Efficient Appliance Credit, to claim this credit. The
maximum overall credit for all qualified appliances is the smaller of 2%
of average annual gross receipts for the three prior years or
$75,000,000 less the credit claimed in the prior two years.

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ALTERNATIVE MOTOR VEHICLE CREDIT


The alternative motor vehicle credit consists of four credits for new
vehicles placed in service during the year. The credits included are the
qualified fuel cell motor vehicle credit; the advanced lean burn
technology motor vehicle credit; the qualified hybrid motor vehicle
credit; and the qualified alternative fuel motor vehicle credit.

COMMUNITY DEVELOPMENT CORPORATIONS


The credit for contributions to selected community development
corporations (CDCs) is available for cash transfers to qualified CDCs
that are available for use by the CDC for at least ten years. The credit
amount is 5% of the contribution for each year of the ten-year period.

OTHER CREDITS REPORTED ON FORM 3800


Low sulfur diesel fuel production credit.
Distilled spirits credit.
Alternative fuel vehicle refueling property credit.
Mine rescue team training credit.
General credits from an electing large partnership.
Credits for affected Midwestern disaster area employers.
Agricultural chemicals security credit.
Credit for employer differential wage payments.
Carbon dioxide sequestration credit.
Qualified plug-in electric drive motor vehicle credit (Form 8936).
Qualified plug-in electric vehicle credit (Form 8834, Part I only).

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CREDITS FOR WHICH SEPARATE LIMIT APPLIES

EMPOWERMENT ZONE AND RENEWAL COMMUNITY EMPLOYMENT


CREDIT
This is a credit that serves as an incentive for investment in certain
geographic areas designated as empowerment zones or renewal
communities.
The credit is available for qualified zone wages paid for services
performed by an employee while a qualified zone employee. The credit
amount is 20% of the employers qualified wages (up to $15,000) paid
or incurred during the calendar year on behalf of qualified
empowerment zone employees plus 15% of the employers qualified
wages (up to $10,000) paid or incurred during the year on behalf of
qualified renewal community employees.
Each type of zone or community provides for different tax benefits,
which can include one or more of the following provisions:
An increased 179 deduction.
Additional work opportunity credit.
The rollover of gain on the sale of zone assets.
An increased exclusion for the gain of small business stock.
Tax-exempt bond financing.
A commercial revitalization deduction.
A capital gain exclusion.
A special depreciation allowance and accelerated depreciation for
qualified leasehold improvements.
An extension of the replacement period for the involuntary
conversion of property.

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WORK OPPORTUNITY CREDIT


The work opportunity credit provides an incentive to hire persons from
targeted groups that have a particularly high unemployment rate or
other employment needs.
The employer must request and be issued a certification for each
employee from the state employment security agency.

Targeted Groups
Targeted groups include the following:
Hurricane Katrina employees (certification requirement does not
apply).
Long-term family assistance recipient hired after December 31,
2006.
Qualified members of families receiving assistance under the
Temporary Assistance for Needy Families (TANF) program.
Qualified veterans.
Qualified ex-felons.
Designated community residents.
Vocational rehabilitation referrals.
Summer youth employees.
Supplemental Nutritional Assistance Program (SNAP) recipients.
Qualified Supplemental Security Income recipients.
Unemployed veteran.
Disconnected youth.
Qualifying Wages
The credit is available for employees who are members of a targeted
group that begin work for the employer during a qualified period.
The employer can claim a credit after 2005 for wages paid to Hurricane
Katrina employees. Eligible employees must have had a main home in
the core disaster area on August 28, 2005, and, within a four-year
period beginning on that date, were hired for a job whose principal
place of employment is in the core disaster area.

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Qualified first-year wages are those paid or incurred for work performed
during the one-year period beginning on the date the targeted group
member begins work.
The amount of qualified first-year wages and the amount of qualified
second-year wages that may be taken into account for any employee
certified as a long-term family assistance recipient is limited to
$10,000 per year.
The amount of qualified first-year wages that may be taken into
account for any employee certified as a qualified veteran entitled to
compensation for a service connected disability and who, during the
1-year period ending on the hiring date, was either (a) discharged or
released from active duty in the U.S. Armed Forces, or (b)
unemployed for a period of periods totaling at least six months, is
limited to $12,000.
The amount of qualified first-year wages that may be taken into
account for any employee certified as a summer youth employee is
limited to $3,000.
The amount of qualified first-year wages that may be taken into
account for an employee certified as a member of any other targeted
group is $6,000.
This credit is 40% of qualified first-year wages of qualifying individuals
working at least 400 hours, or 25% of the first-year wages if the
employee works less than 400 hours but at least 120 hours, and 50% of
second year wages of employees certified as long-term family
assistance recipient.
This credit cannot be claimed with respect to wages used to claim the
empowerment zone, enterprise community, or renewal community
employment credit, or for any employee who is included in figuring the
welfare-to-work credit.

ALCOHOL AND CELLULOSIC BIOFUEL FUELS CREDIT


The credit consist of the alcohol mixture credit, the alcohol credit, the
small ethanol producers credit, and cellulosic biofuel producer credit.

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SOCIAL SECURITY AND MEDICARE TAX ON TIPS


The credit for employer social security and Medicare taxes paid on
certain employee tips is available to employers in the food and
beverage industry. The credit is computed on the total amount of tips
received by employees reduced by the amount of tips required to meet
the federal minimum wage rate for tipped employees. The federal
minimum wage in effect on January 1, 2007, $5.15 per hour, is used to
figure the credit even if the federal minimum wages increases.

QUALIFIED RAILROAD TRACK MAINTENANCE CREDIT


The qualified railroad track maintenance credit is available to taxpayers
that are Class II or Class III railroads, as defined by the Surface
Transportation Board, any taxpayer that transports property using
facilities of a Class II or Class III railroad, or taxpayers that offer
services or property to such railroads.
The eligible expenditures include maintenance, repair and improvement
of qualified railroad structures that are owned or leased as of January 1,
2005, by a Class II or Class III railroad.

UNUSED CREDITS
In general, the unused portion of the credit is carried back one year and
then forward to the next 20 years. Credits must be used in the order in
which they are earned.
For credits arising in tax years before January 1, 1998, the time period
for carryback of unused business credits was three years and the time
period for carryforward of unused business credits was 15 years.
Unused credits after the 20-year carryover, or when the taxpayer dies
or goes out of business, may be taken as a deduction in the first tax
year following the expiration of the 20-year carryover period, or in the
year in which the taxpayers death or cessation of business occurs.

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SPECIAL RULES FOR FARMING


If at least two-thirds of the taxpayers total gross income is from
farming, special estimated tax and return due dates apply.
A taxpayer is not required to pay estimated tax if he or she expects
to owe less than $1,000, after subtracting credits and withholding.
If at least two-thirds of gross income for 2008 or 2009 was from
farming, the taxpayer is a qualified farmer and can choose either of
the following options for the 2009 tax:
Make the required annual payment by January 15, 2010, and file
Form 1040 by April 15, 2010.
File Form 1040 by March 1, 2010, and pay all the tax due at that
time. The taxpayer is not required to make the annual payment
and no penalty for failure to pay estimated tax applies.
The individual does not have to pay estimated tax if he or she
expects the 2009 income tax withholding to be at least 66-2/3%
(.6667) of the total tax to be shown on the 2009 return or 100%
of the total tax shown on the 2008 return.
If the two-thirds gross income from farming test is met, the required
annual payment is the smaller of the following amounts:
Two-thirds (.6667) of the total tax for 2009.
The total tax (100%) shown on the 2008 return.
Gross income from farming includes the following:
Farm income from Line 11, Schedule F.
Farm rental income from Line 7, Form 4835, Farm Rental Income
and Expenses.
Gross farm income from pass-through entities reported on
Schedule E.
Gains from the sale of livestock used for draft, breeding, sport, or
dairy purposes reported on Schedule D or Form 4797.

FARM INCOME
Net farm income and loss from regular farm operations is reported on
Schedule F (Form 1040).
Income from farming reported on Schedule F includes amounts received
from cultivating the soil or raising or harvesting agricultural

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commodities. This includes income from operating a stock, dairy,


poultry, fish, bee, fruit, or truck farm; income from operating a
plantation, ranch, nursery, orchard, or oyster bed; and income from the
sale of crop shares if the taxpayer materially participates in producing
the crop.
Income received from operating a nursery that specializes in growing
ornamental plants is considered to be income from farming.
Income reported on the Schedule F does not include gains from the sale
of the following assets:
Farmland or depreciable farm equipment.
Building and structures.
Livestock held for draft, breeding, sport, or dairy purposes.
The sale of livestock, produce, grains, or other products raised on the
farm for sale or bought for resale is reported on Schedule F.
Animals not held primarily for sale are considered business assets and
the sale of such animals should be reported on Form 4797.
Farmers may elect to postpone reporting the sale or exchange of more
livestock, including poultry, than would normally be sold or exchanged
in a year because of drought, flood, or other weather-related condition.
Reporting the gain from the sale of additional livestock can be
postponed until the next year. This election applies to all livestock held
for sale, draft, breeding, dairy, or sporting purposes. To qualify for this
election, the following conditions must be met:
The taxpayers principal business must be farming.
The farmer must use the cash method of accounting.
The farmer must be able to show that under normal business
practices, the sale would not have occurred except for the weatherrelated condition.
The area was designated as eligible for assistance by the federal
government. The livestock does not have to be raised in a drought
area. Sales made before the area became eligible for federal
assistance qualify if the weather-related condition that caused the
sale also caused the area to be eligible for assistance.
Rent received for the use of farmland is generally reported on Form
4835 and Schedule E.

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If the individual pastures someone elses cattle and takes care of

them for a fee, the income is from a farming business and reportable
on Schedule F.
If the taxpayer materially participates, the rental income is reported
on Schedule F. If the material participation standard is not met, the
income is reported on Form 4835, with the net income or loss carried
to Schedule E.
The taxpayer must include rent received in the form of crop shares in
the year the crop is converted to money or its equivalent.
Most government program payments are included in income on
Schedule F. This includes those for approved conservation practices,
direct payments, and counter-cyclical payments, whether received in
cash, materials, services, or commodity certificates.
If the taxpayer pledges part or all of a crop to secure a Commodity
Credit Corporation (CCC) loan, the loan may be treated as if it were a
sale of the crop.
If reported in income when received, the loan amount becomes the
basis in the crop. If the loan is later paid and the crop is sold, income
or loss is the difference between the sales proceeds and this basis.
If the crop is forfeited to the CCC in full payment and the amount of
the forfeited loan is less than the basis, the difference is a loss
reported on Schedule F. If the loan proceeds were not reported in
income when received, they must be included in income in the year
of forfeiture.
Conservation Reserve Program (CRP) payments are included in income
in the year received. The CRP payments are subject to self employment
tax regardless of the farmers activity level. However, if the farmer
receives Social Security benefits, the amount is only subject to income
tax.
Crop insurance and disaster payments are generally included in
income in the year received.
An election to postpone reporting these payments from the tax year
the crops were damaged to the following year can be made.
A statement is attached to the return making the election indicating
the crops were damaged, the cause of the damage, and the total
insurance payment received.

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One election covers all crops representing a single trade or business.

The election is binding for the year unless the IRS approves a
request to change.
The Disaster Assistance Act authorized programs to provide feed
assistance, reimbursement payments, and other benefits to qualifying
livestock producers if a livestock emergency exists. Benefits are
included in income in the year received.
Payments received under certain federal or state cost-sharing
conservation, reclamation, and restoration programs may be excluded
from income. To be excludable, the payments must satisfy three tests:
They were for a capital expense.
They do not substantially increase the annual income from the
property for which they were made.
The Secretary of Agriculture certified the payments were made
primarily to conserve soil and water resources, protecting or
restoring the environment, improving forests, or providing habitat for
wildlife.
The Farm Security and Rural Investment Act of 2002 created two new
types of payments, direct and counter-cyclical payments, and amended
some other programs.
Direct and counter-cyclical payments are included in taxable income.
For each of the crop years of certain covered commodities, the USDA
made direct payments to producers on farms who meet specified
requirements.
Counter-cyclical payments are based on a determination by the
USDA that the effective price for covered commodities is less than
the target price for the covered commodities.
If the taxpayer is a producer, landowner, or tobacco quota owner who
receives money from the National Tobacco Settlement Trust Fund,
these payments are reported as income. If the individual produces the
crop, the payments are reported as farming income on Schedule F. If a
landowner or tobacco quota owner who leases tobacco-related property
but does not produce the crop, the payments are reported as farm
rental income on Form 4835.
The Fair and Equitable Reform Act of 2004 terminated the tobacco
marketing quota program and the tobacco price support program. As
a result, the USDA offered to enter into contracts with eligible tobacco

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quota holders and growers to provide compensation for the lost value of
the quotas and related price supports.
The following applies for quota holders:
The contract entitled quota holders to total payments of $7 per
pound of quota in ten equal annual payments in fiscal years 2005
through 2014. If the taxpayer was an eligible tobacco grower, the
contract entitled the taxpayer to receive total payments of up to $3
per pound of quota in ten equal annual payments in fiscal years 2005
through 2014.
For quota holders, the payments are considered proceeds from a sale
of the tobacco quota. Taxable gain or loss is the total amount
received reduced by any amount treated as interest over the
adjusted basis. The gain or loss is capital or ordinary depending on
how the quota was used.
The payments are not self-employment income and are not
considered farm income for income averaging.
A tobacco quota is considered an interest in land, so a Form 1099-S
is issued for amounts over $600.
The following applies to growers:
For tobacco growers, contract payments are determined by reference
to the amount of quota under which the taxpayer produced (or
planted) quota tobacco during the 2002, 2003, and 2004 tobacco
marketing years and are prorated based on the number of years the
taxpayer produced quota tobacco during those years. Form 1099G or
1099 MISC is issued to the grower. If the grower actively
participated in the production of the crop during 2002-2004, the
amount is reported on Schedule F. If the grower did not actively
participate, the income is reported on Form 4835.
Payments received by growers are treated as self-employment
income and are considered farming income for farm income
averaging.
Patronage dividends received from farm cooperatives are generally
included in income.
Such dividends can be excluded if due to one of the following
provisions:
The patronage dividend is a nonqualified notice of allocation.
The patronage dividend is for purchasing or selling capital assets or
depreciable property.

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The patronage dividend is for the purchase of personal items.

Per-unit retain certificates are treated the same as patronage


dividends. These are written notices showing the stated dollar amount
of a per-unit allocation made by the cooperative and are based on the
cooperatives sale of products for the taxpayer.
Farm income does not include wages received as a farm employee. This
is also true for wages received by a farm corporation shareholder.
Cancellation or forgiveness of debt is normally included in income.
Some or all of the canceled amount may be excluded from income if it
is qualified farm debt owed to a qualified person. Qualified farm debt
must meet both of the following requirements:
The debt directly relates to the operation of a farming business.
At least 50% of the taxpayers total gross receipts for the three
years preceding the year of debt cancellation were from the farming
business.

INCOME FROM OTHER SOURCES


If the individual is paid for work in farm products, other property, or

services, report the FMV of product, property, or service as income.


If the taxpayer makes a below-market loan, the taxpayer may have
to report income from the loan in addition to any stated interest
received.
Gains and losses from commodity futures and options transactions.
Pay received for contract work or custom work performed off the
farm.
Income received for granting an easement or right-of-way on the
farm or ranch for flooding land, laying pipelines, constructing electric
or telephone lines, etc., may result in income, a reduction in the
basis of all or a part of the farmland, or both.
Prizes won on farm livestock or products at contests, exhibitions,
fairs, etc., is reportable as Other Income on Schedule F.
Recapture of 179 or listed property deductions when business use
drops below 50%.
A refund or reimbursement of a previously deducted item.

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The sale of topsoil, loam, fill dirt, sand, gravel, or other natural

deposit from the property is ordinary income.

FARM INCOME AVERAGING


Individuals, partners, and shareholders of S corporations engaged in
the business of farming are able to elect farm income averaging.
Corporations, partnerships, S corporations, estates, and trusts may not.
A taxpayer engaged in a farming business is allowed to average all or
some farm income by allocating it to the three prior tax years (base
years).
Elected farm income (EFI) is the amount of farm income a taxpayer
elects to shift to the base years. This income can be any portion of farm
income that is less than or equal to that years taxable income.
Farm income is the total revenue produced by the farm minus farm
expenses, excluding the sale of land.
Gains from the sale or other disposition of farm property other than
land can be designated as EFI if the property was used regularly for a
substantial period in a farming business. EFI includes both ordinary
income and capital gains, and must be allocated in an equal portion by
each type of income to each base year to figure the tax on EFI.
Form 1040, Schedule J, is used to calculate the income tax using this
method.
If a taxpayers income in a base year was zero as a result of expenses
in excess of income, he or she may use the negative taxable income for
that year combined with the elected farm income.
A taxpayer can choose to use income averaging to compute regular tax
liability. However, income averaging is not used to determine the
regular tax liability or tentative minimum tax when figuring AMT. Use of
income averaging may reduce regular tax liability even though the
farmer is subject to AMT.
Income averaging can be used by filing a timely return. It can also be
used on a late return or the taxpayer can use, change, or cancel it on
an amended return, if the time for filing a claim for refund has not
expired for that election year.

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FARM EXPENSES
The deductibility of farm expenses generally follows the rules previously
discussed.
Prepaid farm supplies are amounts paid for feed, fertilizer, and
similar farm supplies not used or consumed during the year, as well as
poultry bought for use in the farm business. If using the cash method of
accounting, the deduction for prepaid farm supplies in the year of
payment may be limited to 50% of other deductible farm expenses for
the year.
A prepaid livestock feed expense is not deducted by a cash-basis
taxpayer until the feed is consumed, unless the following tests are met:
The payment is for the purchase rather than a deposit.
The prepayment has a business purpose and is not merely for tax
avoidance.
Deducting the prepayment does not result in a material distortion of
income.
Breeding fees are a deductible farm business expense. However, if
using the accrual method of accounting, the fee must be capitalized to
the cost basis of the calf, foal, etc.
To deduct accelerated depreciation of farm assets under MACRS, the
150% declining balance method must be used.
The costs of maintaining houses and their furnishings for tenants or
hired help are deductible farm business expenses. The value of the
dwelling furnished to a tenant under the usual tenant-farmer
arrangement is not taxable income to the tenant.
The costs of livestock or other items purchased for resale is deductible
only in the year of sale. This includes freight charges for transporting
livestock.
If in the business of planting and cultivating Christmas trees to sell
when they are more than six years old, capitalize expenses incurred for
planting and stump culture and add them to the basis of the standing
trees.
A farmer is allowed a deduction for income attributable to domestic
production activities. The deduction can be 6% of the lesser of the
qualified production activity income or the taxable income for the year.

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However, the deduction is limited to 50% of Form W-2 wages paid by


the taxpayer for the year.
Qualified production activity income is the excess of domestic
production gross receipts over the cost of goods and other
deductions, expenses, or losses directly allocable to such receipts
plus a ratable share of other deductions, expenses and losses that
are not directly allocable.
Domestic production gross receipts include gross receipts from any
lease, rental, license, sale, exchange, or other disposition of tangible
personal property that was manufactured, produced, grown, or
extracted by the taxpayer in whole or in significant part within the
United States.
A loss from operating a farm may be limited by the at-risk limits and
the passive activity limits.
If the taxpayer operates the farm for profit, ordinary and necessary
expenses of carrying on the business are reported on Schedule F. If not
carried on to make a profit, income is reported as other income on Form
1040, Line 21 and expenses are miscellaneous itemized deductions on
Schedule A, subject to 2% of AGI, to the extent of income.
A farmer can choose to deduct certain expenses for soil or water
conservation or for the prevention of erosion of land used in farming.
Otherwise, these expenses are capital expenses and must be added to
the basis of the land.
The deduction cannot be more than 25% of the gross income from
farming.
Ordinary and necessary expenses that are otherwise deductible are
not soil and water conservation expenses. This includes interest,
taxes, periodic brush clearing, removal of sediment from a drainage
ditch, and expenses to produce an agricultural crop.
Soil and water conservation expenses are deductible only if they are
consistent with a plan approved by the Natural Resources
Conservation Service of the Department of Agriculture or comparable
state agency plan.

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EMPLOYMENT TAX RESPONSIBILITIES


Federal income tax must be withheld if the cash wages paid to a farm
employee are subject to social security and Medicare withholding.
Noncash wages are subject to income tax withholding, but only if the
employee and employer agree to do so.
Social security and Medicare taxes are required to be withheld and
deposited if the farmer has one or more employees who meet either of
the following tests:
The employee was paid $150 or more in cash wages during the year.
During the year, $2,500 or more in cash and noncash wages were
paid to all employees.
Federal unemployment tax (FUTA) is required to be paid if cash wages
are paid and either of the following tests are met:
Cash wages of $20,000 or more were paid to farm workers in any
calendar quarter during the current or preceding calendar year.
Ten or more farm workers were employed for some part of at least
one day during each of 20 different calendar weeks during the
current or preceding year.
Wages paid to aliens admitted on a temporary basis to the United
States to perform farm work [H-2(A) visa workers] are exempt from
FUTA taxes. However, the amount paid to such workers is included in
total wages to determine whether FUTA is required.
Commodity wages (payments in-kind) are not considered wages for
purposes of employment tax withholding. However, the value of these
noncash wages is reported in box 1 of the farm employees Form W-2.
The employer must use the Electronic Federal Tax Payment System
(EFTPS) to make electronic deposits of all depository tax liabilities
incurred in 2010 and thereafter if he or she deposited more than
$200,000 in federal depository taxes in 2008 or had to use EFTPS in
2009.
Wages paid to family members are subject to employment taxes.
However, exceptions may apply to wages paid to the taxpayers child,
spouse, or parent.
Payments for services of the taxpayers child age 17 or younger who
works for his or her parent are not subject to social security and
Medicare taxes. For a child age 20 or younger, whether or not in the
parents trade or business, wages are not subject to FUTA.

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Payments to the taxpayers spouse are subject to income tax

withholding and social security and Medicare taxes, but not FUTA.
These exceptions do not apply if the taxpayer operates the business
as a corporation, as a partnership (unless each partner is a parent of
the child), or an estate.
Payments made to a parent are subject to income tax withholding
and social security and Medicare taxes, but not FUTA. If the payment
is not in the taxpayers trade or business and not for household
services, withholding for employment taxes does not apply.

SELF-EMPLOYMENT TAX
Self-employment (SE) tax provides social security coverage for selfemployed individuals. Taxpayers are self-employed if they carry on a
business as a sole proprietor, an independent contractor, a member of a
partnership, or are otherwise in business for themselves.
A trade or business is generally an activity carried on for a livelihood or
in good faith to make a profit.
A statutory employee would use a separate Schedule C to report income
and expenses related to the earnings as a statutory employee;
however, this net income is not subject to SE tax.
Individuals must pay SE tax if either of the following applies:
They had net earnings from self-employment of $400 or more.
They are church employees with income of $108.28 or more.
Ministers, Christian Science practitioners, and members of religious
orders who have not taken a vow of poverty are subject to SE tax on
earnings for services performed for the religious order. An individual
may get an exemption from SE tax on certain earnings by filing Form
4361, Application for Exemption From Self-Employment Tax for Use by
Ministers, Members of Religious Orders and Christian Science
Practitioners.

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SELF-EMPLOYMENT INCOME
Resident aliens are subject to the same rules as U.S. citizens.
Nonresident aliens do not pay SE tax.
Depreciation recapture or 179 recapture due to business use dropping
to 50% or less is included in determining SE income.
If the taxpayer reduces or stops the business activity, any payments
received for lost income of the business from insurance or other sources
are SE income.
Fees received for performing services as a corporate director are SE
income. Income as an employee or officer of the corporation is not SE
income.
An S corporation shareholder is not self-employed with respect to the
corporations taxable income.
Newspaper carriers are generally not self-employed. However, if over
age 18 and paid the difference between a fixed sales price and the cost
of the newspaper to the carrier, the income is SE income.
A distributive share of partnership income or loss and guaranteed
payments from the partnership are treated as SE income. Limited
partners are generally not subject to SE tax.
Rent received by a real estate dealer is included in income subject to SE
tax.
Income, based on a percentage of commissions received prior to
retirement, paid by an insurance company to a retired insurance agent
is SE income.
Net SE income usually includes all business income less all business
deductions allowed for income tax purposes.
If the taxpayer has more than one trade or business, the net earnings
from each business are combined to determine net SE income.
A loss in one business reduces a gain in another business for
determining income subject to SE tax.
If taxpayers are filing a joint return, they cannot file a joint Schedule
SE. If both spouses have earnings subject to SE tax, each must
complete a separate Schedule SE.
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The SE tax rate is 15.3% (12.4% social security and 2.9% Medicare
tax).
No more than $106,800 (in 2009) of combined wages, tips, and net SE
earnings is subject to the 12.4% rate for social security.
All wages, tips, and SE earnings are subject to the 2.9% Medicare tax.
Nonfarm optional method can be used for SE income from nonfarm
activities.
To use this method, four tests must be met:
Net nonfarm profits from Line 31 of Schedule C and box 14 Code A
of Schedule K-1 (Form 1065) are less than $4,721.
Net nonfarm profits are less than 72.189% of gross nonfarm income.
The individual is self-employed on a regular basis.
The individual has not previously used this method for more than
four years.
If gross income is $6,540 or less, the individual can report two-thirds of
the gross income from nonfarm SE as net earnings from selfemployment.
The farm optional method has fewer restrictions than the nonfarm
optional method. There is neither a test of regular self-employment nor
a requirement that net farm profits be less than 72.189% of gross
income. There is also no limit on the number of years this method may
be used.
The farm optional method can be used if either of the following apply:
Gross farm income is $6,540 or less.
Net farm profits are less than $4,721.

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SALES, EXCHANGES, CREDITS, FARMING, AND


SE TAX TEST
1. ___

Assuming all items are held for use in a business or for


investment, which of the following does not qualify as a
nontaxable like-kind exchange?
A. The exchange of stock of one corporation held for
investment for stock of another corporation to be held for
investment.
B. The trade of an apartment house for a store building that is
subsequently rented out.
C. The exchange of a vacant city lot for unimproved farmland.
D. The exchange of real estate owned for a real estate lease
that runs 30 years.

2. ___

Which of the following statements, with respect to the


exchange of like-kind property, is correct?
A. If there is an exchange of like-kind property in which the
taxpayer also received cash and the exchange results in a
loss, the taxpayer is allowed to deduct a loss to the extent
of cash received.
B. If there is an exchange of like-kind property in which the
taxpayer also gives cash and the exchange results in a gain,
the taxpayer must report any gain to the extent of the cash
given.
C. If there is an exchange of like-kind property in which the
taxpayer also received cash and the exchange results in a
gain, the taxpayer does not have to report the gain.
D. If there is an exchange of like-kind property in which the
taxpayer also gives cash and the exchange results in a loss,
the taxpayer cannot deduct a loss.

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3. ___

Which of the following transactions qualifies as a like-kind


exchange?
A. The exchange of a copyright on a novel for a copyright on a
song.
B. An exchange of the goodwill or going concern value of a
business for the goodwill or going concern value of
another business.
C. An exchange of land improved with an apartment house for
land improved with a store building.
D. An exchange of personal property used predominantly in
the United States for personal property used predominantly
outside the United States.

4. ___

Rebecca exchanges real estate held for investment with an


adjusted basis of $400,000 and a mortgage of $100,000 for
other real estate to be held for investment. The other party
agrees to assume the mortgage. The FMV of the real estate
Rebecca receives is $500,000. She pays exchange expenses of
$10,000. What amount of gain does Rebecca realize?
A. $200,000
B. $190,000
C. $100,000
D. $90,000

5. ___

The Andee Partnership traded its panel truck with an adjusted


basis of $10,000 for a pick-up truck with a FMV of $15,000.
Andee also received $3,500 cash on the trade. What is the
recognized gain, if any, on this trade?
A. $5,000
B. $3,500
C. $1,500
D. $0

6. ___

The Post and Rail Partnership traded farm land with an


adjusted basis of $4,000 for a farm tractor that has a FMV of
$9,000 and an adjusted basis of $8,000. What is the
recognized gain or loss?
A. $5,000
B. $4,000
C. $1,000
D. None, it is a like-kind exchange.

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7. ___

Fred exchanged his rental property with an adjusted basis of


$220,000 and a FMV of $250,000 for a storefront worth
$230,000 and paid $20,000 cash. Fred paid $15,000 in
exchange costs from his personal checking account. The
property given up had a mortgage of $100,000, which the
other party in the trade assumed. Fred assumed a $90,000
liability on the new property. What is Freds recognized gain?
A. $ 0
B. $15,000
C. $20,000
D. $25,000

8. ___

Special rules apply to like-kind exchanges between related


persons. Under these rules, related persons are:
A. The taxpayer and a member of his or her family.
B. The taxpayer and a corporation in which the taxpayer has a
25% ownership.
C. The taxpayer and a partnership in which the taxpayer
directly or indirectly owns a 25% interest in the capital or
profits.
D. All of the above.

9. ___

Which of the following does not qualify as a nontaxable


exchange or transfer?
A. A life insurance contract for an annuity contract.
B. A general partnership interest for a general partnership
interest in the same partnership.
C. A transfer of property from an individual to a former
spouse, incident to divorce.
D. None of the above.

10. ___ Jeff and his brother each own a 40% interest in J & K
Partnership. Jeff also owns a 70% interest in Mega Partnership.
In 2008, J & K sold a building to Mega Partnership for
$100,000. J & Ks adjusted basis of the building at the time of
the sale was $110,000. In 2009, Mega sold the building for
$115,000. How much gain or (loss) does Mega recognize in
2009?
A. $0
B. $5,000
C. $10,000
D. $15,000

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11. ___ Mark owned 100% of the stock in Gathers Corporation. In


2009, Gathers Corporation sold a computer with an adjusted
basis of $5,000 and a fair market value of $8,000 to Marks
Uncle Seth for $4,000. What is the amount of Gathers
Corporations deductible loss on the sale of this computer in
2009?
A. $(4,000)
B. $(3,000)
C. $(1,000)
D. $(0)
12. ___ Carol owns 50% of the capital interest in ABC Partnership and
50% of the profits interest in XYZ Partnership. In 2006 for
$100,000, ABC Partnership sells land to XYZ Partnership, which
XYZ Partnership intends to use in its trade or business. The
ABC Partnerships adjusted basis in the land at the time of the
sale was $120,000. In 2009, the XYZ Partnership sells the land
to an unrelated third party for $160,000. How much gain does
XYZ Partnership recognize in 2009?
A. $20,000
B. $30,000
C. $40,000
D. $60,000
13. ___ Which of the following transactions is not a transaction that
results in a gain or loss subject to 1231 treatment?
A. Sales or exchanges of leaseholds.
B. Sales or exchanges of cattle and horses.
C. The sale of a copyright, literary, musical, or artistic
composition created by the taxpayer.
D. Sales or exchanges of unharvested crops sold together with
land to the same buyer.
14. ___ Milton spent $70,000 for a building that he used in his
business. He made improvements at a cost of $20,000 and
deducted depreciation of $10,000. He sold the building for
$100,000 cash, and received property having a FMV of
$20,000. The buyer assumed Miltons real estate taxes of
$3,000 and a mortgage of $17,000 on the building. Selling
expenses were $4,000. The gain on the sale is:
A. $10,000
B. $40,000
C. $52,000
D. $56,000

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15. ___ In 2005, Joe purchased a candy making machine for his
business. The machine cost $50,000 and he claimed a $20,000
179 deduction for that machine. In 2009, he sold the machine
for $52,000. His accumulated depreciation from 2005 through
2009 was $18,974 (not including the 179 deduction). How
much is his taxable gain and what portion of that gain must be
reported as ordinary income under Internal Revenue Code
1245?
A. Taxable gain of $40,974 and ordinary income of $40,974.
B. Taxable gain of $40,974 and ordinary income of $38,974.
C. Taxable gain of $20,974 and ordinary income of $18,974.
D. Taxable gain of $2,000 and ordinary income of $2,000.
16. ___ Sam files a calendar-year return. In February 2007, he
purchased and placed in service for 100% use in his business a
light-duty truck (five-year property) for a cost of $10,000. He
used the half-year convention and figured his MACRS
deductions for the truck were $2,000 in 2007 and $3,200 in
2008. He did not take the 179 deduction on it. He sold the
truck in May 2009 for $7,000. The MACRS deduction in 2009,
the year of sale, is $960 (1/2 of $1,920). How much of the
gain is treated as ordinary income in 2009?
A. $2,200
B. $3,160
C. $3,840
D. None of the above
17. ___ Arthur is a proprietor of Arthurs Pizza Emporium. He bought a
commercial building several years ago. He made a down
payment of $20,000 in cash and assumed a mortgage for
$100,000. After he paid off the mortgage, Arthur later sold the
building for $180,000. Straight-line depreciation taken up to
the date of sale was $18,000. What is the total gain on the
sale?
A. $160,000
B. $80,000
C. $78,000
D. $60,000

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18. ___ On December 15, 2009, Miranda, a calendar-year taxpayer,


sold two business assets on the installment method for a total
of $300,000. Her 1245 property accounted for $100,000 of
the selling price and was subject to depreciation recapture of
$65,000. Her 1250 property sold for the remaining $200,000
and was subject to a $25,000 depreciation recapture. Miranda
received $60,000 as a down payment in 2009. The remaining
payments are to be made in subsequent years. How much total
depreciation recapture is Miranda required to report on her
2009 income tax return?
A. $0
B. $18,000
C. $60,000
D. $90,000
19. ___ Martha owns a grocery store. On October 2, 2009, a tornado
caused her stores freezers to lose power. As a result of the
power outage, $5,000 of frozen food spoiled. Her insurance
company reimbursed her $4,000 on December 7, 2009. In
2009, Martha had a beginning inventory of $10,000, purchases
of $8,000, and an ending inventory of $3,000. Which of the
following is a proper method to account for this event?
A. Report the inventory as she normally would and report the
$4,000 as additional gross income for 2009.
B. Report the inventory as she normally would and exclude the
$4,000 from gross income.
C. Reduce beginning inventory by $5,000 for 2009 and deduct
a $1,000 loss on her 2009 return.
D. Reduce purchases by $5,000 for 2009 and deduct a $1,000
loss on her 2009 tax return.
20. ___ Jackies car, which she used 75% for business, was stolen in
2009. It cost $30,000 in 2007. She had properly claimed
depreciation of $5,970. The insurance company reimbursed her
$19,000, which was the FMV at the time of the theft. What is
the amount of business loss Jackie can claim?
A. $5,780
B. $4,335
C. $3,280
D. $2,280

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21. ___ Tom Thumb owned a greenhouse that was built on leased land.
He used the greenhouse one-half for business and one-half for
personal use. In 2009, the greenhouse was totally destroyed
by a fire. The greenhouse cost $500,000 to build, had a FMV of
$300,000 and accumulated depreciation of $50,000 when it
was destroyed. Tom received $250,000 from his insurance
company in 2009 to reimburse him for the loss. Toms adjusted
gross income for 2009 is $54,000. What is the amount of
Toms deductible loss on the greenhouse for 2009?
A. $150,000
B. $144,500
C. $94,500
D. $25,000
22. ___ Sallys business office was condemned to make way for an
expanded highway on May 1, 2009. Sallys adjusted basis in
her building was $20,000 ($80,000 original cost less $60,000
in depreciation). Her proceeds from condemnation were
$220,000. Sally replaces her office on November 10, 2009, at
a cost of $185,000. Sally must recognize a gain of:
A. $200,000
B. $60,000
C. $35,000
D. $0
23. ___ The general business credit is limited to the taxpayers net
income tax minus the larger of 25% of the regular tax liability
that is more than $25,000 or:
A. Alternative minimum tax.
B. Tentative minimum tax.
C. Net income tax.
D. Taxable income.
24. ___ The Barrow & Jones partnership incurred qualified
rehabilitation expenses of $50,000 on a certified historic
structure. What is the rehabilitation investment credit before
tax limitations are applied?
A. $5,000
B. $6,000
C. $7,500
D. $10,000

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25. ___ An employee who qualifies for the work opportunity credit
must be a member of a targeted group. All of the following are
considered a targeted group except:
A. Qualified veteran.
B. A qualified relative of the employer.
C. Qualified summer youth employee.
D. Qualified SNAP recipient.
26. ___ John has three employees who are certified as designated
community residents. Two of the employees worked for John
for two months in 2007 and came back to work for John on
January 1, 2009. The other employee began working for John
on January 1, 2009. Each employee makes $1,000 per month.
How much can John claim as qualified first-year wages in
computing the work opportunity credit?
A. $0
B. $6,000
C. $12,000
D. $36,000
27. ___ A company increased their research expenses by $3,600 over
the base year. What is the maximum credit they qualify for on
their tax return for tax year 2009?
A. $2,700
B. $900
C. $720
D. $360
28. ___ The F&E Partnership spent $100,000 on eligible access
expenditures that qualify for the disabled access credit. The
partnership had gross receipts of $1 million and 30 full-time
employees during the preceding tax year. What is the amount
of the disabled access credit for the year 2009?
A. $250
B. $5,000
C. $10,000
D. $50,000

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29. ___ Rob and George own an office building that was built in 1976.
They opened a tax return business in 2008 and made
numerous renovations to the building during 2009 to bring it
into compliance with the Americans with Disabilities Act of
1990. They had gross receipts of $750,000 dollars and ten fulltime employees during 2009. They spent $15,000 in eligible
access expenditures. What is the current year disabled access
credit?
A. $14,750
B. $7,500
C. $5,000
D. $1,500
30. ___ In 2009, Colleen started a SIMPLE plan for all five of her
employees and herself. It cost her $400 in fees to administer
the plan. She never had a pension plan prior to starting this
plan. Her tax credit is:
A. $400
B. $200
C. $100
D. $0
31. ___ Gary is a calendar-year eligible small employer and wishes to
take advantage of the credit for small employer pension plan
start-up costs. He incurred $2,000 in qualified start-up costs in
2009 for an eligible plan that is to become effective on January
1, 2010. What is Garys pension start-up costs credit amount
for calendar year 2009?
A. $2,000
B. $1,000
C. $500
D. $0 (he gets the credit in 2010)

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32. ___ In 2009, Santergraph, Inc. remodeled and converted a portion


of their building into a licensed child care facility open for the
care of any of their employees children. The cost of this
remodeling qualifies for which of the following:
A. An asset to be depreciated over the remaining useful life of
the building.
B. An adjustment to income of 75% of the costs, with the
balance depreciable.
C. A tax credit of 25% of the qualified expenses, maximum
credit of $150,000, with the balance depreciable.
D. 179 expensing election.
33. ___ Ryan runs a manufacturing business employing several people
with young children. These employees require daycare as both
parents work. He decided that, in order to make it easier for
his employees to come to work each day, he would allocate
some of the unused space in his manufacturing facility to a
childcare facility. In 2009, he incurred $20,000 in qualified
childcare facility expenditures. He had no qualified childcare
resource and referral expenditures and had no pass-through
credits. What is Ryans credit for 2009?
A. $5,000
B. $7,500
C. $10,000
D. $20,000
34. ___ Dan, a calendar-year taxpayer, has the following amounts of
gross income for 2009:
Wages
$ 10,000
Interest
2,000
Farm income
200,000
Dan has tax, including self-employment tax, of $20,000, and
withholding of $1,000. To avoid any filing or estimated tax
penalties, Dan must:
A. File an estimated tax payment by January 15, 2010, and
pay 60% of the tax due.
B. File his tax return and pay all tax due by March 1, 2010.
C. File an estimated tax payment by March 1, 2010, and pay
66-2/3% of the tax due.
D. File his tax return and pay all tax due by April 15, 2010.

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35. ___ If at least two-thirds of a taxpayers gross income for 2008 or


2009 was from farming, only one estimated tax payment is
due. The required annual payment is the:
A. Larger of two-thirds of the total tax for 2009 or 100% of the
total tax shown on the full-year 2008 return.
B. Smaller of two-thirds of the total tax for 2009 or 100% of
the total tax shown on the full-year 2008 return.
C. Larger of two-thirds of the total tax for 2008 or 100% of the
total tax shown on the full-year 2009 return.
D. Smaller of two-thirds of the total tax for 2008 or 100% of
the total tax shown on the full-year 2009 return.
36. ___ Sandy had the following total gross income for 2009:
Taxable interest
$45,000
Dividends
$1,000
Rental income (Schedule E)
$1,500
Farm income (Schedule F)
$75,000
Gain from sale of farm animals
$5,000
How much of Sandys gross income qualifies as gross income
from farming?
A. $75,000
B. $80,000
C. $81,500
D. $127,500
37. ___ Tom, a cash-basis farmer, operates a cow-calf breeding
operation. The breeder cows are not primarily held for sale. In
addition to the calves raised on his farm, Tom also purchases
calves for resale. During 2009, Tom had the following
acquisitions and dispositions of cattle:
Purchase of 25 calves for resale
$2,875
Sale of 25 calves purchased for resale
5,700
Sale of 40 calves raised by Tom
9,200
Sale of 10 breeder cows
6,750
Original cost of breeder cows
5,500
Accumulated depreciation on breeder cows
2,860
What amount should Tom include in gross income on his
Schedule F for 2009?
A. $17,525
B. $14,900
C. $14,665
D. $12,025

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38. ___ In November of 2009, Farmer Smith, a cash-basis taxpayer,


sells 100 additional beef feeder cattle (raised for resale) due to
severe lack of water in his area, and the area is eligible for
Federal assistance. Normally, these feeders sell in February
2010. The transaction is correctly reported:
A. In 2009 as a capital gain or loss.
B. In 2010 as a capital gain or loss.
C. Upon election, as ordinary farm income in either 2009 or
2010.
D. Not taxable due to drought conditions.
39. ___ The receipt of agricultural program payments by a farmer for
refraining from growing crops should be reported as:
A. Miscellaneous income on Form 1040.
B. Farm income, not subject to self-employment tax.
C. Rental income, not subject to self-employment tax.
D. Farm income, subject to self-employment tax.
40. ___ Farm income averaging is computed on Schedule J, which may
be filed:
A. For the current year when a taxpayer files Schedule F
showing a farm loss.
B. For the current year which includes Schedule F showing net
income from farming.
C. Only by the IRS after the taxpayers return is completed
and reviewed.
D. On a family farming corporation with less than $25 million
in gross receipts.
41. ___ With regard to the employment tax responsibilities of farmers,
all of the following statements are correct except:
A. Cash wages, but not noncash wages, paid to farm workers
may be subject to social security and Medicare taxes.
B. A farmer-employer must pay federal unemployment tax if
he paid cash wages of $20,000 or more to farm workers
during the current or preceding calendar year.
C. A farmer-employer must pay federal unemployment tax if
he employed ten or more farm workers for some part of at
least one day during any 20 different calendar weeks during
the current or preceding calendar year.
D. Social security and Medicare do not cover the services of a
child under the age of 18 who works for his or her parent in
a trade or business.

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42. ___ All of the following are subject to self-employment tax except:
A. Ted received $5,000 for serving as a director of a
corporation.
B. Paula, an attorney, received $43,000 as her distributive
share of her law firms partnership income.
C. Clint, a real estate dealer, had net rental income of
$112,000.
D. Susan, a limited partner, received $5,400 as her distributive
share of the partnership income.
43. ___ Maude has a small business that has a profit of $15,000. Her
husband, Harold, has a farm that has a loss of $7,000. They
are married. Which of the following is correct regarding their
self-employment tax computation?
A. If they file separately, Harold may not elect to use the
optional method.
B. Maude must pay self-employment tax on $15,000.
C. On a joint return, the self-employment tax is computed
based on $8,000 of income for Maude only.
D. If they file separately, they may elect to split the net profit
for self-employment tax purposes, each paying based on
$4,000.
44. ___ Which of the following is not subject to self-employment tax?
A. Gains and losses by a dealer in options or commodities from
dealing or trading in foreign currency contracts.
B. Fees earned by a professional fiduciary who administers a
deceased persons estate.
C. Fees received for services performed as a notary public.
D. All of the above.

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45. ___ Paul owns and operates a gourmet food store as a sole
proprietorship out of a building he also owns. Based on the
following information regarding 2009, compute his selfemployment income (for SE tax purposes) for 2009.
Gross receipts
$125,000
Cost of goods sold
$63,000
Utilities
$7,000
Real estate taxes
$1,500
Gain on sale of business truck
$2,000
Depreciation expense
$4,000
179 deduction
$1,500
Mortgage interest on building
$8,000
Contributions to Keogh retirement plan
$2,000
Net operating loss from 2008
$15,000
A. $25,000
B. $27,000
C. $38,000
D. $40,000

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SALES, EXCHANGES, CREDITS, FARMING, AND


SE TAX ANSWERS
1.

A. The rules for like-kind exchange do not apply to exchanges of


stocks, bonds, notes, certificates of trust or beneficial interests,
or other securities or evidences of indebtedness or interest.

2.

D. If, in addition to giving up like property, a taxpayer pays money


in a like-kind exchange, he or she still has no recognized gain or
loss. If, in addition to like property, the taxpayer receives
money or unlike property in the exchange on which he or she
realizes a gain, the taxpayer is taxed on the gain realized, but
only to the extent of the money or FMV of the unlike property
received.

3.

C. Generally, real property, whether improved or unimproved, is


like-kind to other real property, whether improved or
unimproved. Foreign property is not considered like-kind to U.S.
property. An exchange of intangible property (copyright) may
qualify depending on the nature and character of the rights
involved as well as to the nature and character of the underlying
property to which those rights relate. The exchange of the
goodwill or going concern value of a business for the goodwill or
going concern value of another business is not a like-kind
exchange.

4.

B. The mortgage assumed by the other party is treated as an


amount received in the exchange. The total amount received is
the FMV of the property, $500,000, plus the mortgage assumed,
$100,000, minus exchange expenses, $10,000, for a total of
$590,000. With an adjusted basis of $400,000, Rebecca realizes
a gain of $190,000.

5.

B. The amount realized on the exchange was $18,500 (money and


the FMV of the property). Therefore, the gain on the trade was
$8,500. In a partially nontaxable exchange, gain recognized is
limited to the money and the FMV of unlike property received,
or $3,500 in this situation.

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6.

A. The exchange of unlike property is a taxable exchange, in which


any gain is taxable and a loss is deductible. The basis of the
property received is usually its FMV at the time of the exchange.
The FMV of the property received is considered the amount of
consideration received on the sale of the property given up.

7.

A. Fred gave up property with an adjusted basis of $220,000 and


cash of $20,000. He also paid exchange expenses of $15,000.
He received property with a value of $230,000 and relief of
liability of $10,000. There is no realized or recognized gain on
the exchange.

8.

A. For related parties, a corporation requires more than 50%


ownership and a partnership requires more than a 50% interest
in capital or profits.

9.

B. Exchanges of partnership interests do not qualify as nontaxable


exchanges of like-kind property. This applies regardless of
whether they are general or limited partnership interests or are
interests in the same partnership or different partnerships.

10. B. Two partnerships are related if the same persons own, directly
or indirectly, more than 50% of the capital interest or profits
interest in both partnerships. As such, J&K Partnership does not
recognize the $10,000 loss on the sale to Mega. On Mega
Partnerships subsequent sale, Mega Partnership can use the
loss J&K could not use, resulting in a reportable gain of $5,000.
11. C. A loss on the sale of property to a related party, other than a
distribution in complete liquidation, is not allowed as a
deduction. Related party includes members of the taxpayers
family. However, family for this purpose includes only brothers
and sisters, half-bothers and half-sisters, spouse, ancestors,
and lineal descendents. An uncle is not a related party, so the
loss of $1,000 is allowed.
12. D. The related-party rules disallow a loss on the sale of assets
between related parties. For the purpose of this rule, two
partnerships are related parties if the same persons directly or
indirectly own more than 50% of the capital interest or profit
interests in both partnerships. With 50% ownership, the
partnerships are not related, allowing the loss on the first sale.
XYZ Partnership has a basis equal to the cost, $100,000,
resulting in gain of $60,000.

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13. C. The sale of a copyright, or a literary, musical, or artistic


composition, or similar property is not a 1231 transaction if the
taxpayers personal efforts created the property, or the taxpayer
acquired the property in a way that entitled him or her to the
basis of the previous owner whose personal efforts created it.
14. D. The adjusted basis in the property is the original cost, plus
improvements, reduced by depreciation taken, for a total of
$80,000. The amount realized on the sale is the cash, FMV of
other property, and any debt paid off or assumed by the buyer,
for a total of $140,000. The amount realized, reduced by
expenses of the sale ($4,000) and the adjusted basis of the
property, results in a gain of $56,000.
15. B. Total depreciation and 179 taken is $38,974, leaving an
adjusted basis of $11,026. With a selling price of $52,000, the
taxpayer realized a gain of $40,974. Gain to the extent of
depreciation taken, $38,974, is recaptured as ordinary income.
16. B. Total depreciation taken is $6,160. This gives an adjusted basis
of $3,840, which results in gain on the sale of $3,160. Gain to
the extent of depreciation taken is taxed as ordinary income.
17. C. The original basis of $120,000 ($100,000 mortgage plus
$20,000 cash) is reduced by the depreciation taken ($18,000)
for an adjusted basis of $102,000.
18. D. Gain, to the extent of depreciation recapture, is reported in the
year of sale whether or not an installment payment was
received.
19. A. The loss is reflected in proper reporting of beginning and ending
inventory. Any recapture is then included in income in the year
received.
20. D. For business property, the decrease in FMV is not considered.
The loss is the adjusted basis minus any salvage value minus
any insurance or other reimbursement. The cost for the
business portion is $22,500. The depreciation reduces only the
basis of the business portion, for an adjusted basis of $16,530.
The insurance is allocated to both personal and business,
resulting in a business loss of $2,280.

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21. C. The cost, FMV, and insurance are divided equally between the
personal use and business use, and depreciation is attributable
to business only. The personal loss is the FMV ($150,000),
reduced by insurance ($125,000), reduced by the $100 floor
amount, and then reduced by 10% of AGI ($5,400) for a loss of
$19,500. The business loss is the adjusted basis of $200,000
($250,000 - $50,000) reduced by the insurance reimbursement
($125,000) for a loss of $75,000. The total of the two is
$94,500.
22. C. To postpone reporting all of the gain, the taxpayer must buy
replacement property costing at least as much as the amount
realized for the condemned property. If the cost of the
replacement property is less than the amount realized, gain
realized up to the amount unused for replacement property
must be reported.
23. B. The credit is limited based on tax liability and tentative
minimum tax.
24. D. For a certified historic structure, the credit is 20% of the
qualified expenses.
25. B. An employee is a member of a targeted group if he or she is a
qualified recipient of Temporary Assistance for Needy Families
(TANF), qualified veteran, qualified ex-felon, vocational
rehabilitation referral, qualified summer youth employee,
qualified SNAP recipient, qualified SSI recipient, Hurricane
Katrina employee, long-term family assistance recipient hired
after December 31, 2006, a designated community resident,
unemployed veteran, or disconnected youth.
26. B. The work opportunity credit is available for qualified first year
wages paid or incurred for targeted employees. Qualified firstyear wages are those paid or incurred for work performed
during a one-year period beginning on the date the certified
individual begins work for the employer. Wages paid to prior
employees are not qualified first-year wages. The amount of
wages that may be taken into account for any one employee is
limited to $6,000.
27. C. The credit is 20% of the increase in amount spent on research
and experimental activities.

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28. B. The maximum credit for the disabled access credit is 50% of the
eligible expenditures over $250 and less than $10,250, for a
maximum of $5,000.
29. C. An eligible small business may claim a credit in a particular tax
year for 50% of its eligible access expenditures for the year that
exceed $250, but do not exceed $10,250.
30. B. A credit for small business pension start-up costs is allowed the
taxpayer if he or she begins a new qualified defined benefit or
defined contribution plan [including a 401(k) plan], SIMPLE
plan, or simplified employee pension. The credit is 50% of the
first $1,000 of qualified start-up costs.
31. C. A taxpayer may be able to claim a tax credit for part of the
ordinary and necessary costs of starting a SEP, SIMPLE, or
qualified plan. The credit equals 50% of the cost to set up and
administer the plan and educate employees about the plan, up
to $500 per year for each of the first three years of the plan.
The credit can be taken in the tax year before the tax year in
which the plan becomes effective.
32. C. The credit for employer-provided child care facilities and
services applies to the qualified expenses the employer paid for
employee child care and qualified expenses for child care
resource and referral services. The credit is 25% of qualified
expenses paid for employee child care and 10% of qualified
expenses paid for child care resource and referral services. The
credit is limited to $150,000 each year.
33. A. The credit for employer-provided childcare facilities and services
is 25% of qualified expenses paid for employee childcare and
10% of qualified expenses paid for childcare resource and
referral services.
34. B. If at least two-thirds of gross income for 2008 or 2009 was from
farming, the taxpayer can choose either of the following options
for his or her 2009 tax: make the required annual payment by
January 15, 2010, and file Form 1040 by April 15, 2010, or file
Form 1040 by March 1, 2010, and pay all the tax due.

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35. B. If at least two-thirds of gross income for the most recently


completed tax year and for the following year (2008 and 2009)
is from farming or fishing, the required annual payment is the
smaller of 100% of the tax shown on the most recent return
(2008) or two-thirds (.6667) of the total tax to be due on the
following year for which estimates are to be made (2009).
36. B. Interest, dividends, and rental income reported on Schedule E
are not considered gross income from farming.
37. D. Schedule F is used for the sale of livestock, produce, grains, or
other products raised for sale or bought for resale on the farm.
Form 4797 is used for the sales of livestock held for draft,
breeding, dairy, or sporting purposes. The gain from the sale of
calves purchased, $2,825, and the calves raised, $9,200, are
reported on Schedule F.
38. C. If a farmer sells more livestock, including poultry, than he or
she would normally sell in a year because of a drought, flood, or
other weather-related conditions, he or she may be able to
postpone reporting the gain from selling the additional animals
until the next year.
39. D. Report agricultural program payments on the appropriate line of
Part 1 of Schedule F. Some payments can be excluded under
certain cost-sharing conservation programs. For payments made
after 2007, CRP payments are excluded from self-employment
tax for individuals receiving social security benefits for
retirement or disability.
40. B. A taxpayer can use farm income averaging by filing Schedule J
(Form 1040) with his or her timely filed (including extensions)
return for the year. Farm income averaging is used to determine
the current year tax on farm income; thus, it is not necessary
with a farm loss. Farm income averaging can still be used if one
of the base years was a loss.
41. B. Farmers paying cash wages are subject to FUTA if either: 1)
they paid cash wages of $20,000 or more to farm workers in
any calendar quarter during the current or preceding calendar
year; or 2) they employed ten or more farm workers for some
part of at least one day during any 20 different calendar weeks
during the current or preceding calendar year.

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42. D. A limited partner does not include a distributive share of


partnership income in determining self-employment tax.
Guaranteed payments, such as salary or fees paid for services
performed would be included.
43. B. If the taxpayers file a joint return, they cannot file a joint
Schedule SE. This is true whether one spouse or both spouses
have earnings subject to SE tax. If both have earnings subject
to SE tax, each must complete a separate Schedule SE.
44. C. As a dealer in options or securities, gains and losses from
dealing or trading in 1256 contracts are subject to SE tax. If
the taxpayer administers a deceased persons estate, fees are
subject to SE tax if the individual is a professional fiduciary.
Fees received for services performed as a notary public are not
subject to SE tax.
45. D. The gain on the sale of the business truck is reported on Form
4797. The Keogh contribution is reported as an adjustment to
income. The net operating loss is reported as a negative amount
on the other income line of Form 1040. These entries are not
carried to the computation of current year self-employment
income for determining self-employment tax.

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PARTNERSHIPS
FORMING A PARTNERSHIP
The general definition of a partnership and the definition of various
terms as related to a partnership were presented in the first section
under Business Organizations.

FAMILY PARTNERSHIPS
Family members can be partners, providing certain conditions are
satisfied.
Family members are recognized as partners only if one of the following
requirements is met:
If capital is a material income-producing factor, they must have
acquired their capital interest in a bona fide transaction, actually own
the partnership interest, and actually control the interest.
If capital is not a material income-producing factor, they must have
joined together in good faith to conduct a business. In addition, they
must have agreed that their contributions entitle them to a share in
the profits. Each partner must provide some capital or services.
Family members include only spouses, ancestors, and lineal
descendants, or any trust for their primary benefit.
Capital is a material income-producing factor if a substantial part of
the gross income of the business comes from the use of capital. Capital
is not a material income-producing factor if the income of the business
consists principally of fees, commissions, or other compensation for
personal services performed by members or employees of the
partnership.
A capital interest is an interest in partnership assets that is distributable
to the owner of the interest if he or she withdraws from the partnership,
or the partnership liquidates.

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If a family member receives a gift of a capital interest in which capital is


a material income-producing factor, the donees distributive share of
partnership income is limited.
The partnership income must be reduced by reasonable
compensation for services rendered to the partnership by the donor.
The donee-partners share of the remaining profits allocated to
donated capital must not be proportionately greater than the donors
share attributable to the donors capital.
An interest purchased from another family member is considered a gift.
The FMV of the purchased interest is considered donated capital.

COMMUNITY PROPERTY
A husband and wife who own a qualified entity can choose to classify
the entity as a partnership for federal tax purposes by filing the
appropriate partnership tax returns.
They can choose to classify the entity as a sole proprietorship by filing a
Schedule C listing one spouse as a sole proprietor.
A change in reporting position is treated for federal tax purposes as a
conversion of the entity.
A qualifying entity is a business that meets all of the following
requirements:
The business entity is wholly owned by a husband and wife as
community property under the laws of the state.
No person other than one or both spouses would be considered an
owner for federal tax purposes.
The business entity is not treated as a corporation.

HUSBAND-WIFE PARTNERSHIP
A business carried on by a husband and wife who share in the profits
and losses may be a partnership regardless of whether or not there is a
formal partnership agreement. They should report income and loss from
the business on Form 1065, not on a Schedule C in the name of one
spouse as a sole proprietor.

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Beginning in 2007, if a husband and wife both materially participate as


the only members of a jointly owned and operated business, and they
file a joint return for the year, they can make an election to be treated
as a qualified joint venture instead of a partnership. If the election is
made, income, gain, loss, deduction, and credit is divided between
them in accordance with their respective interest in the joint venture,
and then each files their own Schedule C, C-EZ, or F, and Schedule SE.
Once made, the election cannot be revoked without IRS consent.
For this purpose, a qualified joint venture is a joint venture involving
the conduct of a trade or business. However, if the election is made in
regards to a rental real estate business, the income and expenses from
that activity are reported on Schedule C or C-EZ and will not be subject
to self-employment tax.

Note: Based on an IRS Small Business article posted to irs.gov, only


businesses that are owned and operated by spouses as coowners (and not in the name of a state law entity such as an
LLC) qualify for the election.

PARTNERSHIP AGREEMENT
The partnership agreement includes the original agreement plus any
modifications. Modifications must be agreed to by all partners or
adopted in any other manner provided for in the partnership
agreement.
The agreement or modifications may be oral or written.
Partners can modify the agreement for a particular tax year after the
close of the year but not later than the due date, excluding extensions,
for filing the partnership return for that year.
If the partnership agreement or modification is silent on any matter, the
provisions of local law are treated as part of the agreement.

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CONTRIBUTIONS OF PROPERTY
Generally, neither the partner nor the partnership recognizes a gain or
loss when property is contributed to a partnership in exchange for a
partnership interest.
Gain or loss may be recognized on the contribution of money or
property to a partnership.
A contribution, followed by a distribution of different property from
the partnership to the partner is treated as a sale of property if the
distribution would not have been made but for the contribution and
the partners right to the distribution does not depend on the success
of partnership operations.
All facts and circumstances are considered; however, if the
contribution and distribution occur within two years of each other,
the transfers are presumed to be a sale. If more than two years has
passed, the transactions are presumed not to be a sale.
A partner must attach Form 8275, Disclosure Statement, to his or
her return if the partner contributes property and before or after the
contribution, the partnership transfers money or other consideration
to the partner within two years.
A partnership must attach Form 8275 to its return if it distributes
property to a partner, and before or after the distribution, the
partner transfers money or other consideration to the partnership
within two years.
Gain is recognized when property is contributed (in an exchange for a
partnership interest) to a partnership that would be treated as an
investment company if it were incorporated. A partnership is generally
treated as an investment company if over 80% of the value of its assets
is held for investment and consists of certain readily marketable items.
The partnerships basis of property for determining depreciation,
depletion, and gain or loss on property contributed by a partner is the
same as the partners adjusted basis for the property when it was
contributed, increased by any gain recognized by the partner at the
time of the contribution.
If the FMV of the property at the time of contribution differs from the
partners adjusted basis, the partnership must allocate among the
partners any income, deduction, gain, or loss on the property in a
manner that accounts for the difference. If the partnership sells

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contributed property and recognizes gain or loss, built-in gain or loss is


allocated to the contributing partner. If contributed property is subject
to depreciation or other cost recovery, the allocation of deductions for
these items takes into account built-in gain or loss on the property.
However, the total depreciation, depletion, gain, or loss allocated to
partners cannot be more than the depreciation or depletion allowable to
the partnership or the gain or loss realized by the partnership.
If contributed property is distributed to another partner within seven
years of the contribution, gain or loss must be recognized by the
contributing partner. The recognized gain or loss is the amount the
contributing partner would have recognized if the property had been
sold for its FMV when it was distributed. This amount is the difference
between the propertys basis and its FMV at the time of the
contribution. The character of the gain or loss is the same as the
character that would have resulted if the partnership had sold the
property to the distributee partner. If the contributed property was
unrealized receivables or inventory, any gain or loss is ordinary. If the
property was a capital asset, any loss is a capital loss.

CONTRIBUTION OF SERVICES
A partner can acquire an interest in partnership capital or profits as
compensation for services.
A capital interest is an interest that would give the holder a share of the
proceeds if the partnerships assets were sold at FMV and the proceeds
were distributed in complete liquidation of the partnership.
The FMV of a capital interest received by a partner as compensation
for services must generally be included in the partners gross income
in the first tax year in which the partner can transfer the interest or
the interest is not subject to a substantial risk of forfeiture.
The FMV of an interest in partnership capital transferred to a partner
as payment for services to the partnership is a guaranteed payment.
A profits interest is a partnership interest other than a capital interest.
If a person receives a profits interest for providing services to or for
the benefit of the partnership in a partner capacity or in anticipation
of being a partner, the interest is not a taxable event for the partner
or the partnership.
The receipt of a profits interest may be a taxable event in any of the
following situations:
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The profits interest relates to a substantially certain and

predictable stream of income from partnership assets.


Within two years of receipt, the partner disposes of the profits
interest.
The profits interest is a limited partnership interest in a publicly
traded partnership.

Interest

Basis

Contributed Interest

Basis is the amount of money contributed plus the adjusted basis


of any property contributed increased by any gain recognized on
the transfer. Any increase in a partners individual liability
because of an assumption of partnership liabilities is also treated
as a contribution of money. If the partnership assumes debt on
property contributed, the partners basis is reduced by the
liability assumed by the other partners.

Purchased Interest

Basis is the money paid for the interest.

Inherited Interest

Basis is the FMV of the interest at the date of death or alternate


valuation date increased by the estate or other successors share
of partnership liabilities and decreased to the extent such value
is attributable to income in respect of a decedent.

EXCLUSION FROM PARTNERSHIP RULES


Certain partnerships that do not actively conduct a business can choose
to be completely or partially excluded from being treated as a
partnership for federal income tax purposes.
All of the partners must agree to make the choice and the partners
must be able to compute their own taxable income without computing
the partnerships income.
The loss limitation determined by the partners basis and the required
tax year rules still apply.
This exclusion applies to unincorporated investing or operating
agreement partnerships where there is no active conduct of a trade or
business.
An investing partnership can be excluded if the participants in the joint
purchase, retention, sale, or exchange of investment property meet all
of the following requirements:
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They own the property as co-owners.


They reserve the right separately to take or dispose of their shares

of any property acquired or retained.


They do not actively conduct business or irrevocably authorize some
person acting in a representative capacity to purchase, sell, or
exchange the investment property.
An operating agreement partnership group can be excluded if the
participants in the joint production, extraction, or use of the property
meet requirements similar to an investing partnership.
An eligible organization that wishes to be excluded from the partnership
rules must make the election not later than the time for filing the
partnership return for the first tax year for which the exclusion is
desired. The election is made by attaching a statement to a Form 1065
showing only the name or other identification of the partnership and the
address of the organization.

TAX YEAR
The partnership determines the tax year as if it were the taxpayer. A
partnership has limits on the tax year it may use. If all the partners are
individuals, the tax year is generally a calendar year. However, a
partnership must use what is called a required year determined by
adapting its tax year to the partners tax years.
If one or more partners having the same tax year own an interest in
partnership profits and capital of more than 50% (a majority interest),
the partnership must use the tax year of those partners. This is a
majority-interest tax year.
If there is no majority-interest tax year, the partnership must use the
tax year of all its principal partners. A principal partner is one who has a
5% or more interest in the profits or capital of the partnership.
If there is no majority-interest tax year and the principal partners do
not have the same tax year, the partnership must generally use a tax
year that results in the least aggregate deferral of income to the
partners. The tax year that results in the least aggregate deferral of
income is determined as follows:
1) Determine the number of months of deferral for each partner using
one partners tax year. Find the months of deferral by counting the

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months from the end of that tax year forward to the end of each of
the other partners tax year.
2) Multiply each partners months of deferral by that partners share of
interest in the partnership profits for the tax year.
3) Add the amounts determined in (2) to get the total deferral for the
tax year used in (1).
4) Repeat steps (1) through (3) for each partners tax year that is
different from the other partners years.
5) The tax year that results in the lowest aggregate number is the tax
year that must be used.

EXCEPTIONS
IRC 444 provides an opportunity for a partnership, S corporation, or
personal service corporation to have a tax year that is different than the
required tax year.
A partnership may elect a tax year other than a required year under
444 if:
It is not a member of a tiered structure under Reg. 1.444-2T.
It has not previously had a 444 election in effect.
It elects a year that meets the deferral period requirement.
The deferral period is the number of months between the end of
the tax year it wants to use and the close of the required year.
The deferral period must not be longer than the shorter of:
Three months.
The deferral period of the tax year being changed.

Example: A newly formed partnership, owned by calendar year partners, began


operations on December 1, 2009. The partnership wants to make a 444 election
to adopt a September 30 tax year. The deferral period for the tax year beginning
on December 1, 2009 is three months, the number of months between September
30 and December 31.

The election is made by filing Form 8716, Election To Have a Tax Year
Other Than a Required Tax Year, by the earlier of:
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The due date of the return, without extension, resulting from the

444 election; or
The fifteenth day of the fifth month following the month that includes
the last day of the tax year for which the election is to be effective.
A partnership must make a required payment for any tax year the
444 election is in effect, and the amount is more than $500. Form
8752, Required Payment or Refund Under Section 7519, is used for this
purpose.
Another option available for tax year selection for partnerships, S
corporations, and personal service corporations is to have a natural
business year.
A natural business year may be determined under the annual business
cycle test, the seasonal business test, or the 25% gross receipts test.
A natural business year may exist if more than 25% of the gross
receipts for the year fall into the last two months of the year.
The entity must be in existence long enough to establish a
consistency over the three most recent years.
Form 1128, Application to Adopt, Change, or Retain a Tax Year, must
be filed by the fifteenth day of the second month following the close
of the year being requested if filed under the expeditious procedures.
If more than one natural business year meets the 25% test, the tax
year containing the highest percentage of gross receipts must be
selected.
The annual business cycle test can be used if the entitys gross receipts
from sales and services for the short period and the three immediate
preceding years indicate that the entity has a peak and a non-peak
period of business. The natural business year is considered to end at, or
one month after, the end of the highest peak period.
The seasonal business test applies if the entitys gross receipts from
sales and services for the short period and the three immediately
preceding years indicate that the entitys business is operational for
only part of the year. During the period it is nonoperational, it has gross
receipts equal to or less than 10% of its gross receipts for the year. The
natural business year is considered to end at, or one month after, the
end of operations for the season.
In addition, a taxpayer can establish a business purpose year based on
all the relevant facts and circumstances.

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A change due to ownership change or a natural business year is


generally automatic. Other changes, such as a business purpose year,
require IRS approval.

TERMINATING A PARTNERSHIP
A partnership terminates when either of the following events takes
place:
All of its operations are discontinued and no part of any business,
financial operations, or venture is continued by any of its partners in
a partnership or LLC classified as a partnership.
At least 50% of the total interest in partnership capital and profits is
sold or exchanged within a 12-month period, including a sale or
exchange to another partner.
The partnerships tax year ends on the date of termination.
When operations are discontinued, the date of termination is the
date the partnership completes the winding up of its affairs.
With a 50% ownership change, the date of termination is the date of
the sale or exchange of the partnership interest.
If terminated before the end of the normal tax year, a short-period
return is due by the fifteenth day of the fourth month following the date
of termination.

CONVERTING TO LLC
Converting a partnership to an LLC taxed as a partnership does not
terminate the partnership. The partnerships tax year does not close,
and the LLC continues to use the old partnerships EIN. This also applies
if an LLC classified as a partnership is converted into a partnership.
A conversion may change some of the partners bases in their
partnership interest if the partnership has recourse liabilities that
become nonrecourse liabilities. Because partners share recourse and
nonrecourse liabilities differently, their basis must be adjusted to reflect
the new sharing ratios. If the adjustment results in a decrease of

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liabilities for one partner that exceeds that partners basis, he or she
must recognize gain on the excess.

PARTNERSHIP DISTRIBUTIONS
Partnership distributions include the following:
A withdrawal by a partner in anticipation of the current years
earnings.
A distribution of the current years or prior years earnings not
needed for working capital.
A complete or partial liquidation of a partners interest.
A distribution to all partners in a complete liquidation of the
partnership.
A partnership distribution is not taken into account in determining the
partners distributive share of partnership income or loss. If gain or loss
is recognized by the partner, it must be reported on his or her return for
the year of the distribution.
Money or property withdrawn by a partner in anticipation of the current
years earnings is treated as a distribution received on the last day of
the partnerships tax year.
A partners adjusted basis in his or her partnership interest is decreased
(not below zero) by the money and adjusted basis of property
distributed to the partner.
A partnership generally does not recognize any gain or loss due to
distributions to partners.
The distribution may be treated as a sale or exchange of property,
rather than a distribution, when the partnership distributes the following
items:
Unrealized receivables or substantially appreciated inventory items
distributed in exchange for any part of the partners interest in other
partnership property, including money.
Inventory items are considered to have appreciated substantially
in value if, at the time of distribution, their total FMV is more than
120% of the partnerships adjusted basis for the property.

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If a principal purpose for acquiring inventory property is to avoid

ordinary income treatment by reducing the appreciation to less


than 120%, that property is excluded.
Other property (including money) distributed in exchange for any
part of a partners interest in unrealized receivables or substantially
appreciated inventory items.
The sale or exchange treatment does not apply to a distribution of
property to the partner who contributed the property or to payments to
a retiring partner or successor in interest to a deceased partner that are
the partners distributive share of partnership income or guaranteed
payments.

PARTNERS GAIN OR LOSS


A partner generally recognizes gain on a partnership distribution only to
the extent any money included in the distribution exceeds the adjusted
basis of the partners interest in the partnership.
The distribution of marketable securities is treated as a distribution of
money.
Any gain recognized is generally treated as a capital gain from the sale
of the partnership interest on the date of the distribution.
If property is distributed to a partner, he or she generally does not
recognize any gain until a later sale or disposition of the property. The
partners basis in the partnership interest is reduced by the
partnerships adjusted basis in the property, not to exceed the partners
adjusted basis in the partnership interest.
A partner does not recognize loss on a partnership distribution unless all
of the following requirements are met:
The adjusted basis of the partners interest in the partnership
exceeds the distribution.
The partners entire interest in the partnership is liquidated.
The distribution is in money, unrealized receivables, or inventory
items.
If a partnership acquires a partners debt and extinguishes the debt by
distributing it to that partner, the partner recognizes capital gain or loss
to the extent the FMV of the debt differs from the basis of the debt. The

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partner is treated as having satisfied the debt for its FMV. If the issue
price of the debt exceeds its FMV when distributed, the partner includes
the excess amount in income as canceled debt.
A partner generally must recognize gain on the distribution of property
(other than money) if the partner contributed appreciated property to
the partnership during the seven-year period before the distribution.

PARTNERS BASIS FOR DISTRIBUTED PROPERTY


The partners basis of property, other than money, distributed by a
partnership (other than in liquidation) is the partnerships adjusted
basis immediately before the distribution.
The basis of the property received cannot be more than the adjusted
basis of the partners interest reduced by any money received in the
same transaction.
The holding period for distributed property to the partner includes
the period the property was held by the partnership.
The basis of property received in complete liquidation of a partners
interest is the adjusted basis of the partners interest in the partnership
reduced by any money distributed to the partner in the same
transaction.
If the basis of property received is the adjusted basis of the partners
interest in the partnership, it must be divided among the properties
received, using the following rules:
Allocate the basis first to unrealized receivables and inventory items
included in the distribution by assigning a basis to each item equal to
the partnerships adjusted basis in the item immediately before the
distribution. If the total of these assigned bases exceeds the
allocable basis, decrease the assigned bases by the amount of the
excess.
Allocate any remaining basis to properties other than unrealized
receivables and inventory items by assigning a basis to each
property equal to the partnerships adjusted basis in the property
immediately before the distribution. If the allocable basis exceeds
the total of these assigned bases, increase the assigned bases by the
amount of the excess. If the total of these assigned bases exceeds
the allocable basis, decrease the assigned bases by the amount of
the excess.

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In allocating a basis increase, allocate first to properties with

unrealized appreciation to the extent of the unrealized appreciation.


Allocate any remaining basis increase among all properties in
proportion to their respective FMVs.
In allocating a basis decrease, allocate first to items with unrealized
depreciation to the extent of the unrealized depreciation, then
allocate any remaining basis decrease among all items in proportion
to their respective assigned basis amounts after the first allocation.
If the basis of a partners interest to be divided in liquidation is more
than the partnerships adjusted basis in distributed unrealized
receivables and inventory items, and if no other property was
distributed, the partner has a capital loss to the extent of the remaining
basis in the partnership interest.
Generally, a partnership may not adjust the basis of its retained
property as the result of a distribution of other property to a partner or
a transfer of an interest in the partnership. However, the partnership
may choose to make an optional adjustment to the basis of its property
upon the transfer provided the election is in writing (754 election).

PARTNERS DEALINGS WITH PARTNERSHIP


For certain transactions between a partner and the partnership, the
partner is treated as not being a partner. These transactions include the
following:
Performing services for or transferring property to a partnership if
both of the following are met:
There is a related allocation and distribution to a partner.
The entire transaction, when viewed together, is properly
characterized as occurring between the partnership and a partner
not acting in the capacity of a partner.
Transferring money or other property to the partnership if both of
the following provisions are met:
There is a related transfer of money or other property by the
partnership to the contributing partner or another partner.
The transactions together are properly characterized as a sale or
exchange of property.

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A partnership that uses an accrual method of accounting cannot deduct


any business expense owed to a cash basis partner until the amount is
paid. This rule does not apply to guaranteed payments made to a
partner.

SALE OR EXCHANGE OF PROPERTY


Special rules apply to a sale or exchange of property between a
partnership and certain persons.
Losses are not allowed from a sale or exchange of property directly
or indirectly between a partnership and a person whose direct or
indirect interest in the capital or profits of the partnership is more
than 50%.
This also applies if the sale is between two partnerships in which the
same persons directly or indirectly own more than 50% interest of
the capital or profits of both partnerships.
If sold at a loss, the basis of each partners interest in the
partnership is decreased (not below zero) by the partners share of
the disallowed loss. If the purchaser later sells the property, only the
gain realized that is greater than the loss not allowed is taxable. If
the gain is not recognized because of this rule, the basis of each
partners interest in the partnership is increased by the partners
share of that gain.
Gains are treated as ordinary income in a sale or exchange of
property directly or indirectly between a person and a partnership, or
between two partnerships, if both of the following tests are met:
More than 50% of the capital or profits interest in the
partnership(s) is directly or indirectly owned by the same
person(s).
The property in the hands of the transferee immediately after the
transfer is not a capital asset.
To determine ownership in partnership capital or profits, the following
rules apply:
Rule 1: An interest directly or indirectly owned by or for a
corporation, partnership, estate, or trust is considered to be owned
proportionately by or for its shareholders, partners, or beneficiaries.
Rule 2: An individual is considered to own the interest that is directly
or indirectly owned by or for the individuals family. Family includes

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only brothers, sisters, half-brothers, half-sisters, spouse, ancestors,


and lineal descendants.
Rule 3: If a person is considered to own an interest using Rule 1,
that person (the constructive owner) is treated as if actually owning
that interest when Rules 1 and 2 are applied. However, if a person is
considered to own an interest using Rule 2, that person is not
treated as actually owning that interest, thus making another person
the constructive owner.

GUARANTEED PAYMENTS
Guaranteed payments are those made by a partnership to a partner
that are determined without regard to the partnerships income.
Guaranteed payments are reported as ordinary income by the partner
and are generally subject to self-employment tax.
The partnership generally deducts guaranteed payments on Form 1065
as a business expense. Guaranteed payments made to partners for
organizing the partnership or syndicating interests in the partnership
are capital expenses and are not deductible by the partnership.
If a partner is to receive a minimum payment from the partnership, the
guaranteed payment is the amount by which the minimum payment is
more than the partners distributive share of the partnership income
before taking into account the guaranteed payment.
Premiums for health insurance paid by the partnership on behalf of a
partner for services as a partner are treated as guaranteed payments.
The partnership can deduct the payments as a business expense and
the partner must include them in income. A partner who qualifies can
deduct 100% of the health insurance premiums paid by the partnership
as an adjustment to income.
If the guaranteed payment creates a loss, the partner still includes the
full amount of payment in income and then reports a proportionate
share of the partnership loss.
If a partnership transfers appreciated property to a partner as a
guaranteed payment, Rev. Rul. 2007-40 requires that the transfer is
treated as a sale or exchange. As a sale or exchange, it is reported on
Schedule D by the partnership.

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FORM 1065
A partnership is not a taxable entity, but must file an annual
information return using Form 1065, U.S. Return of Partnership Income.
The partnership return must show the names and addresses of each
partner and each partners distributive share of taxable income. The
return must be signed by a general partner and filed every year of
existence if there is any gross income or deductions, even though there
is no net partnership income for the year.
An LLC that is classified as a partnership for federal income tax
purposes must file Form 1065.
Form 1065 is due by the fifteenth day of the fourth month following the
close of the tax year (April 15 for calendar year partnerships).
For partnerships that keep their records and books of account outside
the United States and Puerto Rico, an extension of time to file and pay
is granted to the fifteenth day of the sixth month following the close of
the tax year.
If the partnership is unable to file its return by the due date, a fivemonth extension can be obtained by filing Form 7004, Application for
Automatic Extension of Time To File Certain Business Income Tax,
Information, and Other Returns.
If the partnership has an automatic two-month extension for records
outside of the United States, Form 7004 is not required. However, if
unable to file within the two-month period, Form 7004 is used to
request an additional three-month extension.
A partnership is not considered to engage in a trade or business and is
not required to file a Form 1065 for any tax year in which it neither
receives income nor pays or incurs any expenses treated as deductions
or credits for federal income tax purposes.
Form 1065 is not considered to be a return unless it is signed. One
general partner or LLC member manager must sign the return.
The partners distributive share of separately reportable partnership
items is shown on Schedules K and K-1, Form 1065. A copy of Schedule
K-1 must be furnished to all partners.

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PENALTIES

LATE FILING OF RETURN


A penalty is assessed against any partnership that must file a
partnership return and fails to file on time, including extensions, or fails
to file a return with all of the information required, unless the failure is
due to reasonable cause.
For returns required to be filed in 2009, the penalty is $89 for each
month or part of a month (for a maximum of 12 months) the failure
continues, multiplied by the total number of persons who were
partners in the partnership during any part of the partnerships tax
year for which the return is due.
For tax years beginning after December 31, 2009, the penalty is
$195 for each month or part of a month (for a maximum of 12
months) the failure continues, multiplied by the total number of
persons who were partners in the partnership during any part of the
partnerships tax year for which the return is due.

FAILURE TO FURNISH INFORMATION TIMELY


For each failure to furnish Schedule K-1 to a partner when due and each
failure to include on Schedule K-1 all the information required to be
shown (or the inclusion of incorrect information), a $50 penalty may be
imposed with respect to each Schedule K-1 for which the failure occurs.
The maximum penalty is $100,000 for all such failures during a
calendar year.
If the requirement to report correct information is intentionally
disregarded, each $50 penalty is increased to $100 or, if greater, 10%
of the aggregate amount of items required to be reported, and the
$100,000 maximum does not apply.

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REASONABLE CAUSE
The penalty is not imposed if the partnership can show reasonable
cause for its failure to file a complete or timely return. A small
partnership (ten or fewer partners) meets the reasonable cause test if
the following apply:
All partners are individuals other than nonresident aliens, estates, or
C corporations.
All partners have timely filed income tax returns fully reporting their
shares of the partnerships income, deductions, and credits.
The partnership has not elected to be subject to the rules for
consolidated audit procedures.

TRUST FUND RECOVERY PENALTY


The trust fund recovery penalty may apply if certain excise, income,
social security, and Medicare taxes that must be collected or withheld
are not collected or withheld, of these taxes are not paid.
This penalty may be imposed on all persons who are determined by the
IRS to have been responsible for collecting, accounting for, and paying
over these taxes, and who acted willfully in not doing so. The penalty is
equal to the unpaid trust fund tax (100%).

ELECTRONIC FILING
Certain partnerships with more than 100 partners are required to file
Form 1065, Schedules K-1, and related forms and schedules
electronically. Other partnerships generally have the option to file
electronically.
The option to file electronically does not apply to certain returns,
including:
Bankruptcy returns.
Returns with precomputed penalty and interest.
Returns with reasonable cause for failing to file timely.

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The IRS may waive the electronic filing rules if the partnership
demonstrates that a hardship would result if it were required to file its
return electronically.

INCOME OR LOSS
PARTNERSHIP
The partnership computes its income and files its return in the same
manner as individuals. However, a partnership must state certain items
of gain, loss, income, etc., separately and certain deductions are not
allowed to the partnership.

SEPARATELY STATED
Separately stated items include the following:
The ordinary income or loss from the trade or business.
Net income or loss from rental real estate activities.
Net income or loss from other rental activities.
Gains and losses from sales or exchanges of capital assets.
Gains and losses from sales or exchanges of 1231 property.
Charitable contributions.
Dividends for which corporate partners can claim a deduction.
Taxes paid or accrued to foreign countries and U.S. possessions.
Any 179 expense deduction, which is limited at both the partnership
level and the partner level.
Depletion and intangible drilling costs.
Distributive shares of any partnership items that, if taken into
account separately by each partner, could result in a tax different
from the tax if the item had not been taken into account separately.

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PARTNERSHIP CHOICES
The partnership makes most choices about how to compute income.
These include choices for the following items:
Accounting method.
Depreciation method.
Accounting for specific items, such as depletion, amortization, or
installment sales.
The election to expense certain property under 179.
Nonrecognition of gain on involuntary conversions of property.
Amortization of certain organization fees and business start-up costs.
The manner of electing an optional adjustment to the basis of
partnership property under 754.
Each partner chooses how to report the partners share of certain items.
Foreign and U.S. possessions taxes.
Certain mining exploration expenses.
Income from cancellation of debt.
Neither the partnership nor any partner can deduct, as a current
expense, amounts paid or incurred to organize a partnership or to
promote the sale of, or to sell, an interest in the partnership.
For organizational expenses paid or incurred after October 22, 2004, up
to $5,000 of the expenses can be deducted in the current year and the
remainder of the organizational expenses are amortized over a period of
not less than 180 months.
For expenses paid or incurred after September 8, 2008, a partnership is
deemed to have made an election to deduct up to $5,000 of
organizational and start-up costs. No election statement is attached to
the return for these costs. The partnership can choose to capitalize and
amortize these costs over 180 months rather than deducting them.
Amortization applies to expenses in the following categories:
Costs incident to the creation of the partnership.
Costs chargeable to the capital account.
Costs of the type that would be amortized if they were incurred in
the creation of a partnership having a fixed life.

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Examples of amortizable expenses include the following:


Legal fees for services incident to the organization of the partnership
(preparing the partnership agreement).
Accounting fees for services incident to the organization.
Filing fees.
Expenses that cannot be amortized include expenses connected with
the following actions:
Acquiring assets for, or transferring assets to, the partnership.
Admitting or removing partners other than at the time the
partnership is first organized.
Making a contract relating to the operation of the partnership trade
or business even if the contract is between the partnership and one
of its members.
Syndicating the partnership. Syndication expenses, such as
commissions, professional fees, and printing costs connected with
the issuing and marketing of interests in the partnership are
capitalized. They can never be deducted even if the partnership is
unsuccessful.

PARTNERSHIP PASSIVE ACTIVITY


The passive activity limits apply to the individual partners, not the
partnership. Because the treatment of each partners share of
partnership income, loss, and credit attributable to a passive activity
depends on the nature of the activity that generated it, the partnership
must report income, loss, and credits separately for each activity.

PORTFOLIO INCOME
Portfolio income includes all gross income, other than income derived in
the ordinary course of a trade or business, that is attributable to
interest; dividends; royalties; income from a real estate investment
trust, a regulated investment company, a real estate mortgage
investment conduit, a common trust fund, a controlled foreign
corporation, a qualified electing fund, or a cooperative; income from the
disposition of property that produced this type of income; and income
from the disposition of property held for investment. Generally, this
income is separately stated to the partners.
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Income derived in the ordinary course of a trade or business, and


includible in business ordinary income, may include these types of
income.
Interest income on loans and investments made in the ordinary
course of a trade or business of lending money.
Interest on accounts receivable.
Income from investments made in the ordinary course of business of
furnishing insurance or annuity contracts.
Income and gain derived in the ordinary course of an activity or
trading or dealing in any property is such activity constitutes a trade
or business.
Royalties derived in the ordinary course of a trade or business of
licensing intangible property.
Amounts included in the gross income of a patron of a cooperative
by reason of any payment or allocation to the patron based on
patronage occurring with respect to a trade or business of the
patron.

UNIFORM CAPITALIZATION
The uniform capitalization rules of 263A generally require partnerships
to capitalize or include in inventory certain costs incurred in connection
with the following:
The production of real property and tangible personal property held
in inventory or held for sale in the ordinary course of a trade or
business.
Real property or personal property (tangible or intangible) acquired
for resale.
The production of real property and tangible personal property by a
partnership for use in its trade or business or in an activity engaged
in for profit.
The costs required to be capitalized are not deductible until the property
to which the costs relate is sold, used, or otherwise disposed of by the
partnership.
Exceptions to the uniform capitalization rules apply to the following:
Inventoriable items accounted for in the same manner as materials
and supplies that are not incidental.

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Personal property acquired for resale if the partnerships average

annual gross receipts for the three prior years were $10 million or
less.
Timber.
Most property produced under a long-term contract.
Certain property produced in a farming business.
Geological and geophysical costs amortized under 167.

DISTRIBUTIVE SHARE

PARTNERS INCOME OR LOSS


A partners income or loss from a partnership is that partners
distributive share of partnership items for the partnerships tax year
that ends with or within the partners tax year.
When necessary to determine the partners gross income, gross income
includes his or her share of partnership gross income.
Partners may be required to make estimated tax payments during the
year as a result of partnership income.
A partner is not an employee of the partnership. The partners
distributive share of ordinary income from a partnership is generally
included in figuring net earnings from self-employment. A limited
partner generally does not include his or her distributive share of
partnership income in computing earnings from self-employment. This
exclusion does not apply to guaranteed payments to a limited partner
for services rendered.

FIGURING DISTRIBUTIVE SHARE


A partners distributive share of partnership items is generally
determined by the partnership agreement. If the partnership agreement
does not address an allocation or if the allocation does not have
substantial economic effect, the distributive share is determined by the
partners interest in the partnership.

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An allocation has substantial economic effect if both of the following


tests are met:
There is a reasonable possibility that the allocation substantially
affects the dollar amount of the partners shares of partnership
income or loss independently of tax consequences.
The partner to whom the allocation is made actually receives the
economic benefit or bears the economic burden corresponding to the
allocation.
An allocation of a loss, deduction, or expense attributable to a
partnership nonrecourse liability does not have any economic effect
because the partner does not bear the economic burden corresponding
to that allocation.
If allocated based on a partners interest in the partnership, the
partners interest is determined by taking into account the following
items:
The partners relative contributions to the partnership.
The interest of all partners in economic profits and losses and in cash
flow and other non-liquidating distributions.
The rights of the partners to distributions of capital upon liquidation.
If any partners interest changes during the year, each partners share
of certain cash basis items of the partnership must be determined by
prorating the items on a daily basis. This rule applies to the following
items for which the partnership uses the cash method of accounting:
Interest.
Taxes.
Payments for services or for the use of property.
If a partners entire interest is disposed of, whether by sale, exchange,
liquidation, death, or otherwise, his or her distributive share of items
must be included in the partners income for the tax year in which the
interest terminates. For determining the distributive share, the
partnerships tax year is considered ended on the date the partner
disposes of his or her interest.
In the event of a partners death, the partner is allocated income and
loss up to the date of death. The partners self-employment income
includes the partners distributive share of income earned by the
partnership through the end of the month in which the partners death
occurred.

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REPORTING DISTRIBUTIVE SHARE


A partners distributive share of certain items of income, gain, loss,
deduction, or credit must be reported on the individuals tax return even
though the partnership does not actually distribute any money to the
partner.
The character of certain items of income, gain, loss, deduction, or credit
included in a partners distributive share is determined as if the partner
realized the item directly from the same source as the partnership and
incurred the item in the same manner as the partnership.
Partners must generally treat partnership items the same way on their
individual returns as they are treated on the partnership return.
If a partner treats an item differently, he or she should identify the
different treatment by filing Form 8082, Notice of Inconsistent
Treatment or Administrative Adjustment Request (AAR).

SCHEDULES L, M-1, M-2, AND M-3


Schedules L, M-1, and M-2 are not required to be completed if the
partnerships total receipts were less than $250,000, the partnerships
total assets at the end of the year were less than $1,000,000,
Schedules K-1 are filed with the return and furnished to the partners on
or before the due date (including extension) for the partnership return,
and the partnership is not required to file Schedule M-3.
A partnership must complete Schedule M-3 instead of Schedule M-1 if
any of the following is true:
The amount of total assets at the end of the tax year reported on
Schedule L is equal to $10 million or more.
The amount of adjusted total assets for the year is equal to $10
million or more.
The amount of total receipts is equal to $35 million of more.
An entity that is a reportable entity partner with respect to the
partnership owns or is deemed to own, directly or indirectly, an
interest of 50% or more in the partnerships capital, profit, or loss,
on any day during the tax year.
Partnerships required to file Schedule M-3 have additional requirements
for completing Schedule L. For partnerships required to file Schedule
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M-3, the amounts reported on Schedule L must be amounts from


financial statements used to complete Schedule M-3. If the partnership
prepares nontax basis financial statements, Schedule M-3 and Schedule
L must report nontax financial statement amounts. If the partnership
prepares tax basis financial statements, Schedule L must be based on
the partnerships books and records and may show tax basis balance
sheet amounts if the partnership books and records reflect only tax
basis amounts.
A partnership required to file Schedule M-3 must also complete
Schedule C (Form 1065), Additional Information for Schedule M-3
Filers.
The balance sheet, Schedule L, should agree with the partnerships
books and records. If not, a statement explaining the difference should
be attached to the return.
Schedule M-1 is the partnerships reconciliation of income or loss per
books with income or loss on the return. Many items of a partnership
are separately stated and passed through to the partners, and are not
included in determining the income per the tax return.
Schedule M-2 is an analysis of the partners capital accounts. The
amounts reported on all of the partners Schedules K-1, box L, should
be equal to the amounts reported on Schedule M-2.
The partners capital accounts maintained by the partnership are not
the same as the partners outside basis in his or her partnership
interest. In the very basic of formats, these two amount may be equal,
but in most real life partnership situations, they are not equal.

PARTNER PROVISIONS
BASIS OF PARTNERS INTEREST
The basis of a partnership interest is the money plus the adjusted basis
of any property the partner contributes. If gain is recognized, the gain
is also included in the basis.

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Any increase in a partners individual liabilities because of an


assumption of partnership liabilities is considered a contribution of
money to the partnership, which increases basis.
If a partner acquires an interest in a partnership by gift, inheritance, or
under any circumstances other than by a contribution of money or
property to the partnership, the partners basis is determined under the
general rules for determining basis of property.

ADJUSTED BASIS
The partners beginning basis is increased by the following items:
An increased share of, or assumption of, partnership liabilities.
A partners distributive share of taxable and nontaxable partnership
income, including capital gain income and tax-exempt income.
Depletion deductions in excess of basis.
Additional contributions to capital.
The partners beginning basis is decreased (not below zero) by the
following items:
Any money and the adjusted basis of property distributed to the
partner by the partnership.
Depletion deductions for oil and gas property.
Partnership losses including capital losses.
Partnership expenses not deducted on return.
Decrease in share of partnership liabilities.
Partners share of any 179 expense deduction, even if the partner
cannot deduct the entire amount on his or her individual tax return.
If contributed property is subject to a debt or if a partners liabilities are
assumed by the partnership, the basis of that partners interest is
reduced (but not below zero) by the liability assumed by the other
partners.
The adjusted basis of a partners interest is determined without
considering any amount shown in the partnership books as capital,
equity, or similar account.
The adjusted basis of a partners interest is normally determined at the
end of the partnerships tax year, unless there has been a sale or
exchange of all or a part of the partners interest.
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EFFECT OF PARTNERSHIP LIABILITIES


A partners basis in a partnership interest includes the partners share of
a partnership liability if and only to the extent that the liability
meets one of the following provisions:
Creates or increases the partnerships basis in any of its assets.
Gives rise to a current deduction to the partnership.
Gives rise to a nondeductible, noncapital expense of the partnership.
If a partners share of partnership liabilities increases, or a partners
individual liability increases because he or she assumes a partnership
liability, this increase is treated as a contribution of money by the
partner to the partnership. If the liability decreases, the decrease is
treated as a distribution of money to the partner by the partnership.
A partner is considered to have assumed a liability of the partnership to
the extent of the following:
The partner is personally liable for it.
The creditors know that the partner is personally liable.
The creditors can demand payment from the partner or related
person.
No other partner bears the economic risk of loss on that liability
immediately after the assumption.
When property is contributed to the partnership, the partnership is
treated as having assumed the liability attached to the property. When
property is distributed with a liability attached, the partner is treated as
having assumed the liability to the extent it does not exceed the FMV of
the property.
A partners share of partnership liabilities depends on whether the
liability is recourse or nonrecourse.
A liability is a recourse liability to the extent that any partner or
related person has an economic risk of loss for that liability. The
partners share of such liabilities equals the partners share of the
economic risk of loss. A limited partner generally has no obligation to
contribute additional capital to the partnership and therefore does not
have an economic risk of loss in partnership recourse liabilities.
A liability is a nonrecourse liability if no partner or related party has
an economic risk of loss for that liability. A partners share of such

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liability generally is determined by the partners ratio for sharing


partnership profits.

LIMITS ON LOSSES
Losses are allowed to the extent of the adjusted basis in the partners
interest in the partnership. The adjusted basis is figured as of the end
of the partnerships tax year in which the loss occurred, before taking
the loss into account. The excess can be used to reduce any restored
basis in the following years. The basis can never be less than zero.

AT-RISK
The at-risk rules limit the loss a partner can deduct to the amount the
partner is considered at-risk in the activity.
A partner is considered at-risk for the following amounts:
The amount of money and the adjusted basis of property
contributed to the activity.
The partners share of net income retained by the partnership.
Certain amounts borrowed by the partnership for use in the
activity if the partner is personally liable for repayment or the
amounts borrowed are secured by the partners property.
A partner is not considered at-risk for amounts protected against
loss through guarantees, stop-loss agreements, or similar
arrangements. Nor is the partner at-risk for amounts borrowed if the
lender has an interest in the activity or is related to a person having
an interest.

PASSIVE ACTIVITY
The passive activity rules do not apply to the partnership. They do apply
to each partners share of loss or credit from the activity.
Generally, passive activities include trade or business activities in which
the partner does not materially participate.
Passive activities also include rental activities, regardless of the
partners participation. However, a rental real estate activity in which
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the partner materially participates is not considered a passive activity


for that partner if the partner meets both of the following conditions for
the tax year:
More than half of the personal services the partner performs in any
trade or business are in real property trades or businesses in which
the partner materially participated.
The partner performed more than 750 hours of service in real
property trades or businesses in which the partner materially
participated.
Certain self-charged interest income and deductions may be treated as
passive activity gross income and passive activity deductions if the loan
proceeds are used in a passive activity. Generally, self-charged interest
and deductions result from loans between the partnership and its
partners.
Limited partners are generally not considered to materially participate.

PARTNERS EXCLUSION AND DEDUCTIONS


To determine the allowable amount of any exclusions or deductions
subject to a limit, the partner must combine any separate exclusions or
deductions in his or her income tax return with the distributive share of
partnership exclusions or deductions before applying the limit.
A partner can elect to exclude from gross income the partners
distributive share of income from cancellation of the partnerships
qualified real property business debt. A partner who elects the exclusion
must reduce the basis of his or her depreciable real property by the
amount excluded. For this purpose, a partnership interest is treated as
depreciable real property to the extent of the partners share of the
partnerships depreciable real property.
The partnership can elect to deduct all or part of the cost of certain
assets under 179. The deduction is allocated and passed through to
the partners for each partner to take into account. The amount passed
through is combined with the amount the individual elects under 179
for other trades or business and the total is subject to the limit at the
individual level. A partner who is allocated 179 expenses from the
partnership must reduce the basis of his or her interest by the total
179 expense allocated, regardless of whether the full amount can be
currently deducted. In determining if a partner has exceeded the

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$800,000 investment limit for purposes of 179, the partner does not
include any cost of 179 property placed in service by the partnership.
A partnership can elect to amortize certain reforestation costs for
qualified timber property over an 84-month period. The amortizable
costs are passed through to the partners and subject to limitations at
the individual level.
A partner cannot deduct partnership expenses paid out of personal
funds unless required to do so by the partnership agreement.
If a partnership distributes borrowed funds to a partner, the partnership
should list the partners share of interest expense for these funds as
interest expense allocated to debt-financed distributions under the
other deduction line of the partners Schedule K-1.
If a partnership terminates and one of the partners is insolvent and
cannot pay any of the partnership debts, the other partner(s) may have
to pay more than his or her share. As such, that partner can take a bad
debt deduction for any part of the insolvent partners share of debts
that he or she is required to pay.
If an individual borrows money to purchase an interest in a partnership,
the loan proceeds and interest expense are allocated among all the
assets of the partnership. If the loan proceeds are contributed to capital
of the partnership, the allocation is made based on the assets or by
tracing the proceeds to the partnerships expenditure.

DISPOSITION OF A PARTNERS INTEREST


A loss incurred from the abandonment or worthlessness of a partnership
interest is an ordinary loss if both of the following tests are met:
The transaction is not a sale or exchange.
The partner has not received an actual or deemed distribution from
the partnership. Even a de minimis actual or deemed distribution
makes the loss a capital loss.
Generally, a partnerships basis in its assets is not affected by a transfer
of an interest in the partnership. However, a partnership can elect to
make an optional adjustment to the basis in the year of transfer.

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SALE, EXCHANGE, OR OTHER TRANSFER


A sale or exchange of a partners interest usually results in capital gain
or loss to the selling partner.
Gain or loss is the difference between the amount realized and the
partners adjusted basis in his or her partnership interest.
If the selling partner is relieved of any partnership liabilities, he or she
must include the liability relief as part of the amount realized for his or
her interest.
An exchange of a partnership interest generally does not qualify as a
nontaxable exchange under the like-kind exchange rules. However,
under certain circumstances, such an exchange may be treated as a
tax-free contribution of property to a partnership.
The sale of a partnership interest at a gain can be reported on the
installment method. The gain is treated as part capital gain and part
ordinary income if the partnerships assets included unrealized
receivables and substantially appreciated inventory items. The gain
allocable to unrealized receivables and inventory items is reported in
the year of sale.
Any amount that would be recaptured if the partnership had sold its
depreciable property at the time the partner sells his interest is treated
as ordinary income. The partners share of unrealized receivables and
substantially appreciated inventory is also treated as ordinary income.
For a sale or exchange after August 5, 1997, it is no longer necessary
that inventory be substantially appreciated before it generates ordinary
income.
Unrealized receivables include any rights to payment not already
included in income for goods delivered or services rendered. It also
includes potential gain that would be ordinary income if certain
partnership property is sold at its FMV. This includes property subject to
recapture of depreciation, franchises, trademarks, and trade names.
Inventory items are not just stock-in-trade. They also include property
that would be considered inventory if on hand at the end of the year,
property that if sold by the partnership would not be a capital asset or
1231 property, and property held by the partnership that would be
considered inventory if held by the partner selling the partnership
interest or receiving the distribution.

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LIQUIDATION OF PARTNERS INTEREST


Payments made by the partnership to a retiring partner or successor in
interest of a deceased partner in return for the partners entire interest
in the partnership may have to be allocated between payments in
liquidation of the partners interest in partnership property and other
payments.
Partnership payments include an assumption of the partners share of
partnership liabilities treated as a distribution of money.
Payments made in liquidation of the interest of a retiring or deceased
partner in exchange for his or her interest in partnership property are
considered a distribution, not a distributive share or guaranteed
payment that could give rise to a deduction (or its equivalent) for the
partnership.
Payments made for the retiring or deceased partners share of the
partnerships unrealized receivables or goodwill are not treated as made
in exchange for partnership property if both of the following tests are
met:
Capital is not a material income-producing factor for the partnership.
The retiring or deceased partner was a general partner of the
partnership.
Upon the receipt of the distribution, the retiring partner or successor in
interest of a deceased partner recognizes gain only to the extent that
any money (and marketable securities treated as money) distributed is
more than the partners adjusted basis in the partnership. The partner
recognizes a loss only if the distribution is in money, unrealized
receivables, and inventory items. No loss is recognized if any other
property is received.
Payments made by the partnership to a retiring partner or successor in
interest of a deceased partner that are not made in exchange for an
interest in partnership property are treated as distributive shares of
partnership income or guaranteed payments. This applies regardless of
the time over which such payments are to be made.
If a partner receives money or property in exchange for any part of a
partnership interest, the amount due to his or her share of the
partnerships unrealized receivables or inventory items results in
ordinary gain or loss.

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If the amount is based on partnership income, the payment is

taxable as a distributive share of partnership income, retaining the


same character it would have if reported by the partnership.
If the amount is not based on partnership income, it is treated as a
guaranteed payment, reported as ordinary income.
Former partners who continue to make guaranteed periodic
payments to satisfy the partnerships liability to a retired partner
after the partnership is terminated can deduct the payment as a
business expense in the year paid.

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PARTNERSHIP TEST
1. ___

Members of a family can be partners. Family members


generally are recognized as partners if:
A. The partnership agreement states that they have a right to
share in earnings and profits of the partnership.
B. Capital is not a material income-producing factor, they
joined together in good faith for the conduct of a business,
and they agreed that contributions of each entitle them to a
share in the profits, and some capital or service has been
(or is) provided by each partner.
C. Capital is a material income-producing factor, they acquired
their capital interest in a bona fide transaction, and they
actually own the partnership interest but allow the related
partner to control the interest.
D. The partnership agreement designates who the partners
are, what degree of service they perform for the
partnership, and the extent to which they share in the
profits, losses, and other attributes of the partnership.

2. ___

Regarding family partnerships in a noncommunity property


state, if a husband and wife carry on a business together and
share in the profits and losses:
A. They must have a formal partnership agreement to be
considered a partnership.
B. They can report the income or loss on a Schedule C (Form
1040) if they are filing a joint return.
C. They should each carry his or her share of the partnership
income or loss from the Form 1065 Schedule K-1 to their
joint or separate individual income tax returns.
D. They can combine the self-employment income on a single
Schedule SE (Form 1040).

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3. ___

John sold 50% of his business to his daughter. The resulting


partnership had an $80,000 profit this year before deducting
any compensation to the partner as a guaranteed payment.
Capital is a material income-producing factor. John performed
services worth $55,000, which is reasonable compensation.
The daughter performed no services. How much income does
John claim on his individual tax return?
A. $40,000
B. $55,000
C. $67,500
D. $80,000

4. ___

Generally, no gain or loss is recognized by the partnership or a


partner when the partner contributes property to the
partnership, unless:
A. The partnership is being formed.
B. The partnership would be treated as an investment
company if the partnership were incorporated.
C. The partnership is already operating.
D. Unencumbered depreciable property is contributed.

5. ___

Mary and Jonah formed the Quaking Aspen Partnership. Mary


contributed $25,000 in cash and Jonah contributed land with
an adjusted basis of $40,000 and a FMV of $25,000. Quaking
Aspen sells the land to an unrelated party two years after start
up for $27,000. How much gain (loss) should the partnership
recognize on the sale of the contributed land?
A. $0
B. $2,000 gain
C. $15,000 loss
D. $13,000 loss

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6. ___

David and Robert form an equal partnership. David contributed


$10,000 cash to the partnership and Robert contributed
depreciable property with a FMV of $10,000 and an adjusted
basis of $4,000. What is the partnerships basis for
depreciation of the property and how is the depreciation
deduction allocated to the partners (assuming the depreciation
rate is 10% per year)?
Partnerships Basis
Annual Depreciation Deduction
Davids Share
Roberts Share
for Depreciation
A. $4,000
$200
$200
B. $4,000
$400
$0
C. $4,000
$0
$400
D. $10,000
$500
$500

7. ___

Sharon provides services to a partnership in 2009 in exchange


for a capital interest of 30% worth $25,000. Sharons basis in
the partnership is:
A. Zero since she exchanged services for her interest.
B. $25,000, which must be reported by her as income in the
year of receipt if the interest is vested.
C. The present value of $25,000, computed over the lesser of
Sharons remaining life or the average remaining life of the
other partners.
D. Considered a profits interest and has a zero basis.

8. ___

All of the following conditions must be met in choosing to


exclude a partnership from being treated as a partnership for
federal income tax purposes except:
A. Members must be able to figure their income without a
partnership return.
B. The activities involve investing or the organization is an
operating agreement partnership where no active business
is conducted.
C. The loss sharing must have substantial economic effect.
D. An initial partnership return must be filed to elect to be
excluded from the partnership provisions.

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9. ___

New ABC Partnership is organized in 2009 with three general


partners. The partners include a corporation with a tax year
ending on March 31 and a 60% interest in partnership capital
and profits, and two individuals, each having a calendar tax
year and a 20% interest in partnership capital and profits. The
partnerships required tax year ends on:
A. March 31
B. September 30
C. October 31
D. December 31

10. ___ Tri-State Partnership is required to change from a fiscal year


ending June 30. The partnerships four partners have the
following ownership percentages and fiscal years:
Boulder
40% Owner March 31
Granite
30% Owner December 31
Shale
20% Owner June 30
Slate
10% Owner June 30
Assuming the partnership does not make a 444 election and
does not establish a business purpose for a different period,
what tax year must Tri-State use to file its tax return?
A. March 31
B June 30
C. September 30
D. December 31
11. ___ A partnership, S corporation, or personal service corporation
can elect to use a tax year other than its required tax year, if
it:
A. Elects a year that meets the deferral period requirement.
B. Is not a member of a tiered structure as defined by the
regulations.
C. Has not previously had an election in effect to use a tax
year other than its required tax year.
D. All of the above.

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12. ___ Maggie and Simon each have a 50% interest in a partnership
that started business October 1. Maggie uses a calendar year
while Simon has a fiscal year ending November 30. Which of
the following is correct?
A. The partnership may use the fiscal year ending September
30 provided a 444 election and payments are made.
B. The partnership may use the fiscal year ending November
30, as that results in the least deferral.
C. The partnership may use the calendar year.
D. A and B above are both correct.
13. ___ Jens basis in her partnership interest is $9,000. Jen receives a
partnership distribution of $8,000 cash and property that has
an adjusted basis to the partnership of $2,000 and a FMV of
$3,000. Which of the following is correct?
A. Jen has a capital gain of $1,000 on the distribution, and has
an adjusted basis of $1,000 in her partnership interest.
B. Jen has a capital gain of $2,000 on the distribution, and has
an adjusted basis of $1,000 in her partnership interest.
C. Jen recognizes no gain or loss on the distribution, and has
an adjusted basis of zero.
D. Jen has a capital gain of $1,000 on the distribution, and has
an adjusted basis of zero.
14. ___ The adjusted basis in Carols partnership interest is $50,000.
She receives a distribution of $10,000 cash, and land that has
an adjusted basis of $30,000 and a FMV of $50,000. What is
Carols adjusted basis in the land?
A. $20,000
B. $30,000
C. $40,000
D. $50,000

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15. ___ Mr. Thomas is the 70% owner of A & T Partnership. On August
1, Mr. Thomas bought A & Ts computer system for $50,000 for
use in his Schedule C business. The system had an adjusted
basis to A & T of $34,000. The accumulated depreciation on
the system that was subject to recapture was $12,000. What is
the amount and character of the gain to be reported by A & T
Partnership?
Capital Gain
Ordinary Income
A. $0
$16,000
B. $16,000
$0
C. $12,000
$4,000
D. $4,000
$12,000
16. ___ Partnership A purchased a tract of land for investment for
$50,000. They immediately sold the land to Partnership B for
$70,000. The FMV of the land at the time of sale was $75,000.
Betty owns 50% of Partnership A. Betty owns 30% and her
mother, Irene, owns 30% of Partnership B. All other
partnership owners are not related to Betty, Irene, or each
other. Identify the nature and the amount of gain (loss)
Partnership A should properly report for tax for the year of the
sale.
A. Partnership A should report a short-term capital gain of
$20,000.
B. Partnership A should report an ordinary gain of $20,000,
because the sale was made to a related party.
C. Partnership A may elect to defer the $20,000 capital gain on
the sale of the property.
D. Partnership A should report $25,000 capital gain on the sale
of the property.
17. ___ All of the following are true statements describing guaranteed
payments except:
A. Guaranteed payments are payments made to a partner
without regard to the partnerships income.
B. Guaranteed payments are included in income in the
partners tax year in which the partnerships tax year ends.
C. Premiums for health insurance paid by a partnership on
behalf of a partner for services as a partner are treated as
guaranteed payments.
D. Guaranteed payments to a partner cannot create a loss on
the partnership return (Form 1065).

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18. ___ Under a partnership agreement, Sybil is to receive 40% of the


partnerships income, but not less than $15,000. Before
considering the minimum guaranteed amount, the
partnerships net income was $30,000. What amount can the
partnership deduct as a guaranteed payment, and what
amount of income is Sybil required to report on her individual
tax return?
Partnership
Sybil
A. $3,000
$15,000
B. $15,000
$15,000
C. $3,000
$27,000
D. $15,000
$27,000
19. ___ Larkspur, a calendar-year partnership, is owned equally by
Nathan, Jerry, Jon, and Marty. The partnership agreement
states that Nathan is to receive 25% of the profit (loss) of the
partnership with a minimum of $15,000 for his services to the
partnership. The other partners are each to receive 25% of the
profit (loss). The net income of the partnership, without regard
to the $15,000 minimum, is $40,000. The partnership should
deduct a guaranteed payment of:
A. $0
B. $5,000
C. $10,000
D. $15,000
20. ___ Jack sold his son a 25% share in JR and Associates. Under the
terms of the partnership agreement, Jack receives 25% of all
partnership income or loss plus a guaranteed payment of
$60,000 per year for services he performed. His son did not
perform any services. Capital is a material income-producing
factor. The partnership had a $50,000 profit before deducting
Jacks guaranteed payment. What is the amount of income or
loss Jack would report on his tax return, assuming he
materially participates in the partnership activities?
A. $12,500 guaranteed payment, $2,500 loss.
B. $15,000 guaranteed payment, $2,500 loss.
C. $60,000 guaranteed payment, $2,500 loss.
D. $60,000 guaranteed payment.

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21. ___ The Rising Moon Partnership, with a fiscal year ending March
31, terminated the partnership on January 31, 2009. If no
extension is filed by Rising Moon, by what date must they file
their final Form 1065, U. S. Return of Partnership Income?
A. March 15, 2009
B. April 15, 2009
C. May 15, 2009
D. July 15, 2009
22. ___ Simon and Maggie Partnership, a calendar year partnership
with two partners, filed its 2009 Form 1065 tax return on
December 31, 2010. An extension of time to file was not filed.
What is the amount of their failure to file penalty?
A. $810
B. $1,440
C. $1,602
D. $1,620
23. ___ F & J Partnership had the following income for the current
year:
Income from operations
$170,000
Tax-exempt interest
10,000
Dividends from foreign corporations
5,000
Net rental income
20,000
Partners Fred and Joe share the profits and losses equally.
What is Freds share of the partnership income (excluding all
partnership items which must be accounted for separately)?
A. $85,000
B. $95,000
C. $97,500
D. $170,000

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24. ___ The L&J Auto Parts Store operated as an accrual based
partnership and filed a Form 1065. In addition to receipts of
$250,000 from parts sales, they had the following other items
of income and expenses:
Salaries
($50,000)
Insurance
( 5,000)
Charitable contributions
( 5,000)
Licenses
( 5,000)
Rental income
25,000
Guaranteed payments to partners
(75,000)
What is the correct ordinary income or loss that L&J should
report on Line 22 of their Form 1065?
A. $150,000
B. $115,000
C. $100,000
D. $85,000
25. ___ All of the following items must be separately stated on the
partnerships Schedule K (Form 1065) and included as
separate items on the partners return except:
A. Ordinary gains and losses from Form 4797, Part II.
B. Gains and losses from sales or exchanges of capital assets.
C. Guaranteed payments to the partners.
D. Interest income.
26. ___ Comfy Chairs Manufacturing, Ltd. operates as a partnership
and files Form 1065. Comfy manufactures inflatable lounge
chairs. During the tax year, Comfy generated income and
expenses as stated below:
Employee wages
$15,000
Income from rental real estate
20,000
Charitable contributions
500
Cost of goods sold
10,000
Income from chair sales
75,000
What is the correct amount of ordinary income (loss) from
trade or business activities Comfy should report on Schedule
K?
A. $69,500
B. $65,000
C. $50,000
D. $30,000

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27. ___ The partnership, not the partners, makes choices about all of
the following except:
A. Depreciation methods.
B. Nonrecognition of gain on involuntary conversions of
property.
C. Amortization of certain organization fees.
D. Income from discharge of indebtedness.
28. ___ Phil and Don are equal partners in the Hilldale Company.
Hilldale has a fiscal year ending on January 31. Phil and Don
file their individual tax returns on a calendar-year basis. For
the tax year ending January 31, 2009, Hilldale had taxable
income from the active conduct of its business of $100,000 of
which $60,000 was earned in 2008. How much of their
partnership taxable income should Phil and Don each include in
computing their taxable income limit for the 2009 tax year?
A. $50,000
B. $30,000
C. $20,000
D. $0
29. ___ If the partners distributive share of a partnership item cannot
be determined under the partnership agreement, it is
determined by his or her interest in the partnership. The
partnership interest is determined by taking into account all of
the following items except:
A. The partners relative contributions to the partnership.
B. The interests of all partners in economic profits and losses
(if different from interests in taxable income or loss) and in
cash flow and other nonliquidating distributions.
C. The amount of the partnerships nonrecourse liabilities.
D. The rights of the partners to distributions of capital upon
liquidation.

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30. ___ On January 1, 2009, Ben and Jerry each own 50% of the B&J
Fudge partnership. B&J Fudge employs the cash method of
accounting and receives $1,000 in interest income each month
from an unrelated party loan receivable. On July 1, 2009, Jerry
purchased 50% of Bens partnership interest. There were no
other changes in partnership interest for the remainder of the
2009 year. How much does Ben report as his ratable share of
the interest income for 2009?
A. $7,500
B. $6,000
C. $4,500
D. $3,000
31. ___ DUG Partnerships tax year ends on December 31. A partner
dies on August 20. The deceased partners (and his or her
estates) distributive share of partnership income for the year
of death is $18,000. The partners share of self-employment
income from the partnership is:
A. $9,000
B. $11,500
C. $12,000
D. $18,000
32. ___ Alex and Arthur are equal partners in the A&R Partnership.
Alex receives a guaranteed payment of $5,000. The
partnership had distributive net income (after deducting the
guaranteed payment of $5,000) of $80,000. What amounts are
subject to self-employment tax?
Arthur
Alex
A. $37,500
$37,500
B. $40,000
$40,000
C. $42,500
$42,500
D. $45,000
$40,000
33. ___ Bill and Jimmy formed a new partnership. Bill contributes
property that has an adjusted basis of $1,400 and a fair
market value of $2,000 to the partnership. Jimmy contributes
$2,000 in cash to the partnership. Each partners capital
account as reflected on the partnerships books is $2,000.
What is the adjusted basis of each partners interest?
A. Bills at $1,400 and Jimmys at $1,400.
B. Bills at $1,400 and Jimmys at $2,000.
C. Bills at $1,700 and Jimmys at $1,700.
D. Bills at $2,000 and Jimmys at $2,000.

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34. ___ Loris outside basis in the Briar Patch Partnership at January 1,
2009, was $11,000. She is a 50% partner and shares profits
and losses in the same ratio. The partnerships ordinary
business income was $40,000; tax-exempt interest income
was $200. Lori received a cash distribution from the
partnership of $700 during the year. If the partnership were to
liquidate on December 31, what is Loris basis for determining
gain or loss?
A. $24,900
B. $30,300
C. $30,400
D. $30,750
35. ___ Marlene acquired a 30% interest in a partnership by
contributing property that had an adjusted basis to her of
$25,000, FMV of $50,000, and a $40,000 mortgage. The
partnership assumed the liability. What is Marlenes gain or
loss on the contribution of her property to the partnership?
A. $0
B. $3,000 gain
C. $12,000 gain
D. $10,000 loss
36. ___ Jacob contributes property with a FMV of $7,000, adjusted
basis of $4,000, and a mortgage of $1,000, which the
partnership assumes, to a partnership for a 40% interest in the
partnership. What is Jacobs basis in his partnership interest?
A. $6,000
B. $4,000
C. $3,400
D. $3,000
37. ___ A partners basis in a partnership interest includes the
partners share of a partnership liability in all of the following,
except:
A. A liability that creates or increases the partnerships basis in
any of its assets.
B. A partners share of accrued but unpaid expenses of a cashbasis partnership.
C. A liability that is a nondeductible, noncapital expense of the
partnership.
D. A liability that gives rise to a current deduction to the
partnership.

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38. ___ A partnership has $1,000 of nonrecourse liabilities and $500 of


recourse liabilities. The recourse liabilities are attributable to
Karen who is a 50% partner. Karen contributed property with a
FMV of $400 and an adjusted basis of $250 for her interest in
the partnership. The first year of business the partnership
incurred a $4,000 loss. How much of this loss, if any, may
Karen deduct on her tax return?
A. $250
B. $1,250
C. $1,750
D. $2,000
39. ___ Paul and Linda form a partnership with cash contributions of
$40,000 each. Paul is not a general partner. Under the
partnership agreement, Paul and Linda share all partnership
profits and losses equally. The partnership borrows $100,000
from a local bank to purchase depreciable equipment to be
used in the partnerships business. Linda is required under the
partnership agreement to pay the creditor if the partnership
defaults. The partnership had a $150,000 loss. Based upon the
facts, what are Paul and Lindas allowable losses?
Linda
Paul
A. ($75,000)
($75,000)
B. ($40,000)
($75,000)
C. ($40,000)
($40,000)
D. $0
($40,000)
40. ___ A partner is considered not at-risk for which of the following
amounts:
A. The money and adjusted basis of any property the partner
contributed to the activity.
B. The partners share of net income retained by the
partnership.
C. An allocation of a loss, deduction, or expense attributable to
a partnership nonrecourse liability.
D. Certain amounts borrowed by the partnership for use in the
activity if the partner is personally liable for repayment.

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41. ___ Bryan has a 50% interest in a partnership and he materially


participates in the partnership business. Bryans adjusted basis
in the partnership was $40,000 at the beginning of the year.
There were no distributions to Bryan during the year. During
the year, the partnership borrowed $180,000 from a local bank
for the following reasons:
Purchased business equipment
$120,000
Paid off existing liabilities in full
60,000
All of the partners are personally liable for all the partnership
debts. The partnership incurred a $300,000 loss. What amount
of the loss can Bryan claim on his individual tax return?
A. $150,000
B. $100,000
C. $40,000
D. $0
42. ___ A loss incurred from the abandonment of a partnership interest
is an ordinary loss when:
A. The partner receives a de minimis or deemed distribution.
B. The partners capital account reflects a positive balance.
C. The partner transfers the entire interest to a nonrelated
party.
D. The transaction is not a sale or exchange and the partner
has not received an actual or deemed distribution from the
partnership.
43. ___ On January 1, 2008, Brian contributed $20,000 cash to Lock
and Key Partnership for a 25% interest. The adjusted basis of
his partnership interest at the end of 2009 was $35,000, which
included his $16,000 share of partnership liabilities and the
contributed cash. The partnership had no other liabilities and
no unrealized receivables or substantially appreciated
inventory items. On December 31, 2009, Brian sold his entire
interest in Lock and Key Partnership for $19,000 cash. Brian
did not take any distributions in 2009. What is the amount of
Brians capital gain or (loss)?
A. $0
B. ($1,000)
C. $16,000
D. $19,000

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44. ___ Cynthia is a partner in CF Partnership. The adjusted basis of


her partnership interest is $19,000, of which $15,000
represents her share of partnership liabilities. Cynthias share
of the partnerships unrealized receivables is $6,000. The
partnership has no substantially appreciated inventory items.
Cynthia sold her partnership interest for $28,000 cash. What is
the amount and character of her gain?
A. $6,000 capital gain.
B. $6,000 ordinary income, $18,000 capital gain.
C. $18,000 capital gain.
D. $18,000 ordinary income, $6,000 capital gain.
45. ___ In 2009, Linda sold her partnership interest for $25,000. Her
adjusted basis at the time of the sale is $22,500, which
includes her $12,500 share of partnership liabilities. When she
initially invested in the partnership, she contributed $10,000
worth of equipment. There was no profit or loss at the
partnership level at the time she sold her interest. What is the
amount and nature of her gain or loss from the sale of her
partnership interest in 2009?
A. $7,500 ordinary loss.
B. $10,000 capital gain.
C. $12,500 ordinary gain.
D. $15,000 capital gain.
46. ___ All of the following statements with respect to a partners sale
or exchange of a partnership interest are correct except:
A. The sale or exchange of a partners interest in a partnership
usually results in a capital gain or loss.
B. Gain or loss recognized by the selling partner is the
difference between the amount realized and the adjusted
basis of the partners interest in the partnership.
C. The selling partner must include as part of the amount
realized, any partnership liability he or she is relieved of.
D. The installment method of reporting cannot be used by the
partner who sells a partnership interest at a gain.

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47. ___ Mrs. Zee sold her 30% interest in LPM partnership for $50,000.
The partnership reports income on the accrual basis. Mrs.
Zees adjusted basis in the partnership interest was $30,000.
The partnership had no liabilities at the date of the sale. The
partnership had the following assets at the time of Mrs. Zees
sale:
Adjusted Basis
FMV
Cash
$ 10,000
$ 10,000
Accounts Receivable
9,000
9,000
Inventory
7,000
10,000
Machinery and Equipment
12,000
12,000
Accumulated Depreciation
9,000
0
Land
80,000
100,000
Total Assets
$109,000
$141,000
How much should Mrs. Zee report as capital gain and ordinary
gain?
A. Capital gain $20,000, ordinary gain $0.
B. Capital gain $16,400, ordinary gain $3,600.
C. Capital gain $13,700, ordinary gain $6,300.
D. Capital gain $0, ordinary gain $20,000.
48. ___ Archie sells his 50% interest in XYZ partnership to Hal for
$5,000 cash. His outside basis in the partnership is $3,500.
The partnership has inventory and a capital asset with respect
to basis of $6,000 and $2,000. The respective fair market
values of the inventory and capital asset are $8,000 and
$1,000. Archie should properly recognize:
A. Ordinary income of $2,000 and a capital loss of $500.
B. Capital gain of $1,500 on the sale of his partnership
interest.
C. Ordinary income of $1,500, the amount of cash he received.
D. Ordinary income of $1,000 and a capital gain of $500.
49. ___ Michael has a partnership interest with a zero basis. The
partnership has inventory valued at $250,000. Michaels share
of the ordinary income to be received from the sale of the
inventory would be $10,000. In 2009, Michael sells his
partnership interest for $30,000. Michael reports the following
gain in 2009:
A. $30,000 capital gain.
B. $20,000 ordinary gain and $10,000 capital gain.
C. $10,000 ordinary gain and $20,000 capital gain.
D. No gain or loss.

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50. ___ Generally, a partner does not recognize loss on a partnership


distribution unless all of the following requirements are met
except:
A. The adjusted basis of the partners interest in the
partnership exceeds the distribution.
B. The adjusted basis of the partners interest in the
partnership exceeds the fair market value of the property
distributed.
C. The partners entire interest in the partnership is liquidated.
D. The entire distribution is in money, unrealized receivables,
or inventory items.
51. ___ The adjusted basis of Rebeccas partnership interest is
$17,500. She received a distribution of $9,000 cash and land
with an adjusted basis of $2,500 and a FMV of $4,000. What is
the gain to be recognized at the time of these distributions?
A. $0
B. $1,500
C. $4,500
D. $6,000
52. ___ Which of the following statements about the liquidation of a
partners interest is incorrect?
A. A retiring partner is treated as a partner until his or her
interest in the partnership has been completely liquidated.
B. The retiring partner recognizes a gain on a liquidating
distribution to the extent that any money distributed is
more than the partners adjusted basis in the partnership.
C. Payments in liquidation of a partnership interest that are
not made in exchange for the interest in partnership
property are reported as capital gain by the recipient.
D. Former partners, who continue to make guaranteed periodic
payments to satisfy the partnerships liability to a retired
partner after the partnership is terminated, can deduct the
payments as business expenses in the year paid.
53. ___ Partner A received inventory items with a basis of $20,000 in
complete dissolution of a partnership. Within five years,
Partner A sells the entire inventory for $30,000. What amount
and type of gain should Partner A report?
A. $0
B. $10,000 short-term capital gain.
C. $10,000 long-term capital gain.
D. $10,000 ordinary gain.

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PARTNERSHIP ANSWERS
1.

B. Family members are recognized as partners if: capital is not an


income-producing factor, they joined together in good faith to
conduct business; they agreed that contributions of each entitle
them to a share of profits; and some capital or service have
been (or are) provided by each partner.

2.

C. If spouses carry on a business together and share in the profits


and losses, they may be partners whether or not they have a
formal partnership agreement. They should file Form 1065 and
each carry a distributive share of the partnership income or loss
from Schedule K-1 to his or her own personal return. Each
spouse calculates his or her own self-employment income on a
separate Schedule SE.

3.

C. For purposes of determining a partners distributive share, an


interest purchased by one family member from another family
member is considered a gift from the seller. The donees
distributive share is figured by reducing the partnership income
by reasonable compensation ($55,000) for services the donor
renders then allocating the remainder ($25,000) to each
partner.

4.

B. Gain is recognized when property is contributed (in exchange for


a partnership interest) to a partnership that would be treated as
an investment company if it were incorporated.

5.

D. The partnerships basis in contributed property for determining


depreciation, depletion, and gain or loss is the same as the
partners adjusted basis when it was contributed, increased by
any gain recognized by the partner at the time of contribution.
The partnerships basis in the property is Jonahs adjusted basis
at the time of the contribution, $40,000, resulting in a loss of
$13,000.

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6.

B. If a partner contributes property, the partnerships basis for


determining depreciation, depletion, gain, or loss for the
property is the same as the partners adjusted basis when
contributed, increased by any gain recognized by the partner on
the contribution. In effect, David purchased one-half interest in
the property with his cash contribution and as such should be
allowed $500 per year of depreciation. Because the adjusted
basis of $4,000 results in only $400 of depreciation, it is all
allocated to David.

7.

B. The FMV of the interest received by a partner as compensation


for services must generally be included in the partners gross
income in the first tax year in which the partner can transfer the
interest or the interest is not subject to substantial risk of
forfeiture. This then becomes that partners basis in his or her
interest.

8.

C. The exclusion from partnership treatment applies only to certain


unincorporated investing or operating agreement partnerships
where there is no active conduct of a business. Partners electing
to be partially excluded from partnership treatment are not
exempt from partnership provisions that limit a partners
distributive share of a partnership loss to the partners adjusted
basis in the partnership.

9.

A. If one or more partners having the same tax year own an


interest in partnership profits and capital of more than 50%, the
partnership must use the tax year of those partners.

10. D. The least aggregate deferral of income method must be used.


The total deferral for a March 31 year end is 3.6; for a
December 31 year end is 3.0; and for a June 30 year end is 5.4.
Therefore, the December 31 year-end must be used.
11. D. A partnership, S corporation, or PSC must use the required tax
year unless it receives IRS approval to use another permitted
tax year or makes an election under 444. The entity can make
an election under 444 if it meets all the following
requirements: it is not a member of a tiered structure; it has
not previously had a 444 election in effect; and it elects a year
that meets the deferral period requirement.
12. D. Other than a required tax year, a partnership may elect a fiscal
year based on a business purpose or make a 444 election.

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13. C. Jens basis is reduced by the cash and property distribution, but
not below zero. Jens basis is first reduced by cash, leaving
$1,000. When property is distributed, the partners basis in the
property is the partners adjusted basis in the partnership
interest to the extent of the partnerships adjusted basis in the
property. On distribution, Jen has a basis in the property of
$1,000, and will not recognize any gain or loss until she
disposes of the property.
14. B. The basis of property distributed to a partner, if not distributed
in liquidation, is the partnerships adjusted basis immediately
before the distribution. The basis to the partner cannot be more
than his or her basis in the partnership reduced by any money
received in the same transaction.
15. A. Gain is treated as ordinary income in the sale or exchange of
property between a person and a partnership if more than 50%
of the capital or profits interest in the partnership is owned by
the same person, and the property in the hands of the
transferee immediately after the transfer is not a capital asset.
16. A. Common ownership of the two partnerships is only 50%.
Related party rules apply if more than 50% is common
ownership, and then only to disallow a loss. As such, the
partnership recognizes a $20,000 short-term capital gain.
17. D. Premiums for health insurance paid by a partnership on behalf
of a partner for services as a partner are treated as guaranteed
payments. Guaranteed payments are included in income in the
partners tax year in which the partnerships tax year ends. If a
guaranteed payment to a partner results in a partnership loss in
which the partner shares, the partner must report the full
amount of the guaranteed payment as ordinary income.
18. A. If a partner is to receive a minimum payment from the
partnership, the guaranteed payment is the amount by which
the minimum payment is more than the partners distributive
share of the partnership income before taking into account the
guaranteed payment. Sybils allocable share of partnership
income is $12,000. With a minimum payment of $15,000,
$3,000 is a guaranteed payment. Sybils reportable income is
$15,000 ($12,000 + $3,000).

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19. B. Nathans share of partnership income without deducting the


guaranteed payment is $10,000 (25% x $40,000). The
guaranteed payment that can be deducted by the partnership is
$5,000 ($15,000 - $10,000). Nathans income for the year is
$15,000 and the other $25,000 is allocated to the other
partners.
20. C. Guaranteed payments are made by a partnership to a partner
without regard to the partnership income. If the guaranteed
payment results in a loss to the partnership, the partner reports
the full guaranteed payment and is allowed a loss to the extent
of the partners adjusted basis. Jack receives a guaranteed
payment of $60,000, resulting in a partnership loss of $10,000.
Jacks allocable share of that is 25% or $2,500.
21. C. The partnership return is due by the fifteenth day of the fourth
month following the close of its tax year. The partnerships tax
year ends on the date of termination.
22. C. The penalty for a partnership that fails to file on time for a tax
year starting in 2009 is $89 times the total number of partners
in the partnership during any part of the tax year for each
month (or part of a month) the return is late or incomplete, up
to 12 months. The return was due April 15, 2010, so it was nine
months late. (9 * $89 * 2 partners = $1,602)
23. A. The tax-exempt interest, dividends from foreign corporations,
and net rental income are separately stated items. The ordinary
income is allocated equally to each partner.
24. B. Separately stated items for charitable contributions and rental
income are reported on K-1 and not included in determining the
partnerships ordinary income. Salaries, insurance, licenses, and
guaranteed payments are included in determining Form 1065,
Line 22 ordinary income.
25. A. Ordinary gains and losses from Form 4797 are included in
determining the partnerships ordinary income or loss from the
trade or business.
26. C. The income from the rental real estate and the charitable
contribution are separately stated items. The ordinary income is
the income from sales minus wages and cost of goods.

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27. D. The election to reduce the basis of depreciable property for


amounts excluded from gross income due to discharge of
indebtedness is made by each partner separately.
28. A. A partner reports a distributive share of partnership income or
loss in the year that includes the partnerships year-end. For a
partnership with a year-end of January 31, 2009, the partners
report their distributive share on their 2009 tax return, due by
April 15, 2010. As equal partners, they each report $50,000.
29. C. An allocation based on a partners interest takes into
consideration the partners relative contributions, the interest of
all partners in economic profits and losses, and the rights of
partners to distributions in liquidations. A partnerships
nonrecourse liabilities are not considered in calculating a
distributive share.
30. C. For the year 2009, $12,000 of interest was received. Ben sold
one half of his interest July 1, 2009, so Ben would be allocated
50% of the interest for the first six months ($3,000) and 25%
of the interest for the last six months ($1,500) for a total of
$4,500.
31. C. When a partner dies, his or her partnership earnings subject to
SE tax are figured through the end of the month in which the
death occurs. The partnership earnings subject to SE tax for the
year are treated as though they were earned in equal amounts
each month.
32. D. A partners distributive share of ordinary income from the
partnership is included in determining self-employment
earnings. A guaranteed payment is also included for SE
purposes. As equal partners, they are each allocated $40,000 of
the partnerships distributive net income, plus Alex includes the
$5,000 guaranteed payment.
33. B. The basis in a partnership interest is the money plus the
adjusted basis of any property the partner contributed.
34. C. If the partnership were to liquidate, Loris starting basis is
increased by her share of partnership ordinary income and taxexempt income, reduced by the distribution during the year, for
a total of $30,400.

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35. B. If the portion of the liability assumed by the other partners is


greater than the partners adjusted basis in the property
transferred, the excess is treated as capital gain from the sale of
a partnership interest. The other partners assumed debt of
$28,000 on the property ($40,000 x 70%), which is $3,000
more than the adjusted basis of the property transferred.
36. C. The basis in the partnership interest is the adjusted basis of the
property transferred reduced by the portion of the liability the
other partners assume. With a 40% interest, $600 of the debt is
assumed by the other partners.
37. B. Basis includes a partners share of a partnership liability only if,
and to the extent that, the liability: creates or increases the
partnerships basis in any of its assets; gives rise to a current
deduction to the partnership; or is a nondeductible, noncapital
expense of the partnership.
38. B. The amount of the loss allocated to Karen is $2,000. Karens
basis is the adjusted basis of the property contributed ($250),
the recourse liability for which she is liable ($500), and the
partners share of nonrecourse liability ($1,000 x 50%) for a
total of $1,250. Karen can deduct $1,250 of the loss.
39. B. Paul is a limited partner, so his basis is the original contribution
of $40,000. Linda is liable for the partnerships liabilities
according to the partnership agreement, so her basis is
increased to $140,000. Each partner is entitled to 50% of the
loss or $75,000. Pauls allowable loss is limited to $40,000 and
Linda may take the full $75,000.
40. C. A partner is considered at-risk for all the following amounts: the
money and adjusted basis of any property the partner
contributed to the activity; the partners share of net income
retained by the partnership; and certain amounts borrowed by
the partnership for use in the activity if the partner is personally
liable for repayment or the amounts borrowed are secured by
the partners property.
41. B. His adjusted basis of $40,000 is increased by his 50% of the
new loan, which was not used to pay off the existing loan. His
share of the existing loan is already included in the $40,000.

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42. D. The loss is an ordinary loss if it is not a sale or exchange and


the partner has not received an actual or deemed distribution.
Even a minimal actual or deemed distribution makes the loss a
capital loss.
43. A. Gain or loss on the sale of a partnership interest is the
difference between the amount realized and the adjusted basis
of the partners interest in the partnership. If the selling partner
is relieved of any partnership liabilities, that partner must
include the liability relief as part of the amount realized for his
or her interest. Brian is considered to have received cash of
$19,000 and debt relief of $16,000 for a total of $35,000. His
basis is $35,000, resulting in no gain or loss.
44. B. If a partner receives cash or property in exchange for a
partnership interest, the amount due to the partners share of
unrealized receivables or substantially appreciated inventory is
ordinary income. Cynthia received $43,000 ($28,000 cash +
$15,000 debt relief) resulting in a gain of $24,000 ($43,000 $19,000 basis). Of the $24,000 gain, $6,000 is treated as
ordinary income and the remaining $18,000 is capital gain.
45. D. If the partnership has no unrealized receivables or inventory,
gain or loss on the sale of a partnership interest is the difference
between the amount realized and the adjusted basis of the
partners interest. If the partner is relieved of any partnership
liabilities, that partner must include the liability relief as part of
the amount realized for his or her interest.
46. D. The installment method may be used. If part of the sale is
allocated to unrealized receivables or appreciated inventory,
that portion is ordinary income and recognized in the year of the
sale.
47. B. The total gain on the disposition of the partnership interest is
$20,000. Gain from the partners share of unrealized receivables
and inventory items is treated as ordinary. Using the accrual
method of accounting, this amounts to $3,000 that would be
treated as ordinary if inventory was sold at FMV and $9,000 that
would be treated as ordinary under the recapture of
depreciation rules. Mrs. Zees 30% share is $3,600, treated as
ordinary gain. The remaining $16,400 is treated as capital gain.

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48. D. As per 731, with the partnership holding inventory, part of the
gain on the sale of a partnership interest is treated as ordinary.
Archie has total gain on the sale of $1,500. If the partnership
sold its inventory at FMV, it would have gain of $2,000. The
50% that is attributable to Archie is $1,000. Therefore, Archie
reports $1,000 ordinary income and $500 capital gain.
49. C. As per 731, with the partnership holding inventory, part of the
gain on the sale of a partnership interest is treated as ordinary.
With zero basis, Michael has $30,000 of gain realized from the
sale of his interest. Of this gain, $10,000 attributable to
inventory is treated as ordinary, with the remaining $20,000
being capital gain.
50. B. A distribution of property is measured by the partnerships
basis, not the FMV of the property distributed. The other two
requirements to recognize a loss are: 1) the entire distribution
is a liquidating distribution; and 2) the distribution is in money,
unrealized receivables, or inventory items.
51. A. A partners adjusted basis in his or her partnership interest is
decreased (but not below zero) by the money and adjusted
basis of property distributed to the partner. A partner generally
recognizes gain on a partnership distribution only to the extent
any money (and marketable securities treated as money)
included in the distribution exceeds the adjusted basis of the
partners interest in the partnership.
52. C. Payments made by the partnership to a retiring partner or
successor in interest of a deceased partner that are not made in
exchange for an interest in partnership property are treated as
distributive shares of partnership income or guaranteed
payments.
53. D. Any gain or loss on a sale or exchange of unrealized receivables
or inventory items a partner receives in a distribution is ordinary
gain or loss.

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CORPORATIONS
GENERAL REQUIREMENTS
PERSONAL SERVICE CORPORATION
Personal service corporations (PSCs) are special types of corporations.
The principal business of a PSC is the performance of personal services,
and employee-owners substantially perform these services.
To be classified as a PSC, the corporation must be organized and
operated as a corporation that is not an S corporation.
Employee-owners must own more than 10% of the FMV of the
corporations outstanding stock on the last day of a testing period.
The testing period for a tax year is generally the prior tax year.
This definition applies to the performance of personal services in the
following fields only:
Health (including veterinary services).
Law.
Engineering.
Architecture.
Accounting.
Actuarial science.
Performing arts.
Consulting.
The principal activity is considered to be the performance of personal
services if, during the testing period, the corporations compensation
costs for the performance of personal services are more than 50% of its
total compensation costs.
Personal services are substantially performed by employee-owners if,
during the testing period, more than 20% of the corporations
compensation costs for the performance of personal services are for
services performed by employee-owners.

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A person is an employee-owner of a PSC if both of the following apply:


He or she is an employee of the corporation or performs personal
services for, or on behalf of, the corporation (even if he or she is an
independent contractor for other purposes) on any day of the testing
period.
He or she owns any stock in the corporation at any time during the
testing period.
PSCs must use a calendar tax year unless it does the following: elects
to use a 52-53 week year, elects a tax year under 444, or establishes
a business purpose for a different tax year and obtains IRS approval.
A PSC is subject to the passive activity limitations, requiring the
completion of Form 8810, Corporate Passive Activity Loss and Credit
Limitations, to compute the allowable passive activity loss and credit.
A PSC is a qualified PSC if it meets both of the following tests:
Substantially all, 95% or more, of the corporations activities involve
the performance of personal services.
At least 95% of the corporations stock, by value, is directly or
indirectly owned by employees performing the service, retired
employees who had performed the service, the estate of an
employee or retired employee who performed the service, or any
person who acquired the stock as a result of the death of an
employee or retiree (but only for a two-year period).
A qualified PSC is taxed at a flat rate of 35% on taxable income and can
use the cash method of accounting.

PAYING AND FILING INCOME TAXES

ESTIMATED TAX
A corporation must make estimated tax payments if it expects to have a
tax liability for the year of $500 or more, which is lower than the
individual requirement of a tax liability of $1,000 or more.
A corporation making estimated tax payments must do so by making
required installment payments. The required installment is the smallest
installment payment under the following two methods:
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Each required installment is 25% of the income tax the corporation

will show on its return for the current year.


Each required installment is 25% of the income tax shown on the
corporations return for the previous year. The corporation is not
allowed to base the required annual payment on the prior years tax
unless the following requirements are satisfied:
The corporation must have filed a return for the preceding tax
year, showing a positive tax liability.
The preceding years return must have been for a full 12 months.
If a corporation is a large corporation, it can use the prior year tax
method for the first installment only. A corporation is a large
corporation if it had modified taxable income of $1,000,000 or more for
any of the three immediately preceding years. Modified taxable income
is taxable income figured without net operating loss or capital loss
carrybacks or carryovers.
Estimated tax payments are due four times during the year based on
the following schedule:
The fifteenth day of the fourth month.
The fifteenth day of the sixth month.
The fifteenth day of the ninth month.
The fifteenth day of the twelfth month of the tax year.
A corporation can file for a refund of overestimated taxes prior to the
filing of the corporate return for the current tax year. The claim for
refund is filed using Form 4466, Corporation Application for Quick
Refund of Overpayment of Estimated Tax.
The claim can be made if the following conditions exist:
The overpayment must be at least 10% of the expected tax liability.
The overpayment is at least $500.
Form 4466 should be filed before the sixteenth day of the third month
after the end of the tax year, but before the corporation files its income
tax return.
An extension of time to file the corporate tax return does not extend the
time to file for a quick refund.
A corporation must use the Electronic Federal Tax Payment System
(EFTPS) to make deposits of all depository tax liabilities (including
social security, Medicare, withheld income, excise, and corporate
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income taxes) incurred if the corporation deposited more than $200,000


in federal depository taxes in the second preceding year or had to make
electronic deposits in the prior tax year.
Once the $200,000 threshold is met, the corporation must continue
to use EFTPS even if subsequent deposits fall below that threshold.
Failure to use EFTPS, if required, may result in a 10% penalty.
Participation in EFTPS is voluntary if below the $200,000 threshold.

INCOME TAX RETURN


Corporations that are in existence for any part of the year, including
corporations in bankruptcy, must file unless they are specifically exempt
under 501, regardless of their gross income or taxable income. They
must continue to file even if there is no activity and only cash is
retained to pay state taxes. A corporation does not need to file after
dissolution even if the charter has not expired.
The due date for the corporations tax return is the fifteenth day of the
third month following the close of the tax year. For a calendar-year
corporation, including an S corporation, the due date is March 15.
A corporation that has dissolved must generally file by the fifteenth day
of the third month after the date it dissolved.
A taxable corporation files Form 1120, U.S. Corporation Income Tax
Return. An S corporation files Form 1120S, U.S. Income Tax Return for
an S Corporation.
A six-month extension for filing can be obtained by filing Form 7004,
Application for Automatic Extension of Time to File Certain Business
Income Tax, Information, and Other Returns. Payment of any tax due
must be made with the extension. No further extension of time to file is
available. All corporations can use this form. The IRS can terminate the
extension to file at any time by mailing a notice of termination to the
corporation.

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PENALTIES
A failure-to-file penalty of 5% of the unpaid tax is assessed for each
month or part of a month the return is late, not to exceed 25%.
The minimum penalty for a return that is over 60 days late is the
smaller of the tax due or $135.
The penalty is not imposed if the corporation can show that the
failure to file on time was due to reasonable cause. A statement
explaining the reasonable cause must be attached to the tax return.
If income, social security, and Medicare taxes are not timely withheld
and deposited, the trust fund recovery penalty may apply. This penalty
is the full amount of the unpaid trust fund tax, 100% penalty.
The trust fund recovery penalty may be imposed on all persons who
are determined by the IRS to be responsible for collecting,
accounting for, and paying these taxes, and who acted willfully in not
doing so.
A responsible person can be an officer or employee of the
corporation, an accountant, or a volunteer director/trustee.
A corporation that does not pay the tax when due may be penalized
one-half of 1% of the unpaid tax for each month or part of a month the
tax is not paid, up to a maximum of 25% of the unpaid tax. The failureto-pay penalty is waived if the corporation can show reasonable cause.

FINAL RETURN
A dissolving corporation filing its final return may wish to wind up affairs
without waiting for the three-year statute of limitations to expire. The
corporation may request a prompt assessment after filing its final
return.
This request is made by filing Form 4810, Request for Prompt
Assessment Under Internal Revenue Code 6501(d), with the IRS
center where the return is being filed. The filing of this form means that
the IRS must review the return within 18 months of the request. The
form must be filed by itself after the filing of the tax return.

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ACCOUNTING METHODS AND PERIODS


Generally, a corporation (other than a qualified personal service
corporation) must use the accrual method of accounting if its average
annual gross receipts exceed $5 million.
If inventories are required, the accrual method generally must be used
for sales and purchases of merchandise. Qualifying taxpayers and
qualifying small-business taxpayers are excepted from using the accrual
method and may account for inventoriable items as materials and
supplies that are not incidental.
Under the accrual method, income is includable when all events have
occurred that fix the right to receive income and the amount can be
determined with reasonable accuracy. Expenses are deductible in the
tax year when all events that determine the liability have occurred, the
amount can be figured with reasonable accuracy, and economic
performance takes place with respect to the expense.
A corporation can use either the calendar year or a fiscal year as its tax
year. A tax year can be adopted by the due date of its first income tax
return.
A personal service corporation must use a calendar year unless an
exception applies.

TRANSFERS TO A CORPORATION
Study Tip: Questions on transfers to a corporation have
historically been a major concept on the EA exam. Questions in
the past require that you know how to treat such transfers and
how basis is determined after the transfer, both for the
shareholder and for the corporation.

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EXCHANGE OF PROPERTY FOR STOCK


A corporation is generally formed when a person or persons transfer
money or property to the corporation in exchange for stock. A
mandatory provision under 351 enables a tax-free transfer of property
if certain conditions are met. These rules apply whether the corporation
is being formed or is already operating.
Both the corporation and any person involved in a nontaxable exchange
of property for stock must attach to their income tax returns a complete
statement of all of the facts pertinent to the exchange.
No gain or loss is recognized by the corporation upon transfer of money
or property to the corporation in exchange for stock (including treasury
stock).
No gain or loss is recognized by the person(s) transferring property if
that person(s) receives only stock of the corporation and, immediately
after the transfer, has control of the corporation.
To be in control of a corporation, the transferor or group of transferors
must own, immediately after the exchange, at least 80% of the total
combined voting power of all classes of stock entitled to vote and at
least 80% of the outstanding shares of each class of nonvoting stock of
the corporation.
This enables owners of unincorporated businesses to change their
business entity to a corporation without recognizing any gain on the
transfer (351).
If there is a single shareholder, the 80% rule is automatically
satisfied. If there are two or more shareholders, the rule applies if
the shareholders transferring property to the corporation collectively
hold 80% or more of the outstanding stock of the corporation.
The tax-free transfer provisions do not apply in the following situations:
Transfers to a corporation that is an investment company.
Transfers in bankruptcy or a similar proceeding in exchange for stock
used to pay creditors.
A transfer of stock in exchange for the corporations debt (other than
a security) or for interest on the corporations debt that accrued
while the debt was being held. A corporation that transfers stock in
satisfaction of an outstanding debt is treated as having satisfied the
debt with an amount of money equal to the FMV of the stock. Thus,
a corporation generally recognizes discharge of indebtedness income

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at the time of the exchange to the extent the FMV of the stock is less
than the issue price of the indebtedness [108(e)(8)].
The gain or loss on a transfer of property to a corporation is recognized
if the 80% ownership rule is not met after the transfer. The property
transferred is treated as sold at FMV.
If a group of transferors exchange property for stock, each transferor
does not have to receive stock in proportion to his or her interest in the
property transferred. If a disproportionate transfer takes place, it is
treated for tax purposes in accordance with its true nature. It may be
treated as if the stock were first received in proportion and then some
of it was used to make gifts, pay compensation for services, or satisfy
the transferors obligations.
It is possible to receive money and/or other property in addition to the
stock when transferring property to a corporation. This is called boot
and could result in the recognition of gain. Gain is taxable only to the
extent of the money and FMV of other property received. The rules for
figuring the recognized gain generally follow those for a partially
nontaxable exchange. If the property transferred is depreciable
property, the gain recognized may have to be reported as ordinary
income from depreciation. No loss is recognized if boot is received.
Generally, a person who transfers property to a corporation and
receives nonqualified preferred stock must treat such stock as other
property or money received. Preferred stock is stock that is limited and
preferred as to dividends and does not participate in corporate growth
to any significant extent. Preferred stock is nonqualified if it has any of
the following characteristics:
The holder of the stock can require the issuer or a related person to
redeem or purchase the stock.
The issuer or a related person is required to redeem or purchase the
stock.
The issuer or a related person has the right to redeem or repurchase
the stock and, as of the issue date, it is more likely than not that the
right will be exercised.
The dividend rate of the stock varies in whole or in part with
reference to interest rates, commodity prices, or other similar
indices.
If the corporation assumes the transferors liabilities, the exchange is
not generally treated as if money or other property was received. There
are two exceptions to this treatment.
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If the liabilities the corporation assumes are more than the adjusted

basis of the property transferred, gain is recognized up to the


amount of the difference. However, if the liabilities assumed give rise
to a deduction when paid, such as a trade accounts payable or
interest, no gain is recognized.
If there is not a good business reason for the corporation to assume
the transferors liabilities, or if the main purpose in the exchange is
to avoid federal income tax, the assumption is treated as if money,
in the amount of the liabilities, was received.
If the transferor has a loss from an exchange and owns, directly or
indirectly, more than 50% of the corporations stock, the loss is not
deductible.

Study Tip: Recognized vs. Realized Realized gains and


losses involve economically incurred gains and losses from
which recognized gains and losses are derived. Recognized
gain is that much of the realized gain taken into account for
purposes of federal income tax reporting. For example, taxfree exchanges of like-kind property frequently involve
substantial realized gains, none of which are currently
recognized.

STOCK FOR SERVICES


The term property does not include services rendered or to be rendered
to the issuing corporation. The value of stock received for services is
income to the recipient.
If the shareholder receives stock in exchange for services, the
shareholder has taxable compensation. The amount of the
compensation is the shareholders basis in the stock.
The transfer of stock as wages is transferred to the employee at FMV,
and the FMV is the wage deduction for the corporation. If the stock
transferred is not the corporations own stock, the corporation must also
recognize gain or loss realized on the transfer. The gain or loss is the
difference between the FMV of the property and its adjusted basis on
the date of transfer.

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Property does not include property of a relatively small value, when


it is compared to the value of stock or securities already owned or to be
received for services by the transferor if the main purpose of the
transfer is to qualify for the nonrecognition of gain or loss by other
transferors. Property transferred is not considered to be of relatively
small value if its FMV is at least 10% of the FMV of the stock and
securities already owned or to be received for services by the
transferor.

Formula to Determine Gain on Exchanged Stock


First determine exactly what the question is asking amount realized, gain realized,
or gain recognized.
Step 1:

FMV of stock received


+

FMV of other property received plus cash received and liabilities


transferred

Amount realized

Step 2:

Amount realized from Step 1


-

Adjusted basis of property transferred including cash paid

Gain realized (Compare to Step 3)

Step 3:

FMV of other property received including cash received


+

Debt relief only to the extent it exceeds the adjusted basis of all assets
transferred

Boot received

Step 4:

Smaller of Gain realized from Step 2 or Boot received from Step 3


=

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Gain recognized (taxed)

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BASIS RULES ON PROPERTY TRANSFERS


TRANSFEROR
The basis of the stock the transferor receives is generally the adjusted
basis of the property transferred.
The adjusted basis is increased by the following:
Any amount treated as a dividend.
Any gain recognized on the exchange.
The adjusted basis is decreased by the following:
The FMV of other property received.
Money received.
Loss recognized on the exchange.
Liabilities assumed by the corporation, unless payment of the liability
gives rise to a deduction when paid.
In a taxable transaction, the transferors basis of stock received is its
FMV.
The transferors basis in any other property received in the transfer is
that propertys FMV on the date of the trade.

CORPORATION
The basis of the property received by the corporation in an 80% control
transaction, as paid-in surplus or as a contribution to capital, is the
same as it was in the hands of the transferor prior to the transfer,
increased by any gain recognized on the exchange (351).
The basis of property transferred to a corporation, other than in an 80%
control transaction, is the FMV of the stock at the time of the exchange
(if it can be determined). The FMV of the transferred property can set
the value of the stock in the following situations:
The stock has no established value.
The corporation issues all outstanding stock in exchange for that
property.

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CAPITAL CONTRIBUTIONS
Contributions to the capital of a corporation, whether or not by
shareholders, are paid-in capital.
Capital contributions are not taxable to the corporation.
The basis of property contributed to capital by a person other than a
shareholder is zero.
If the corporation receives a cash contribution from a person other than
a shareholder, the corporation must reduce the basis of any property
acquired with the contribution during the 12-month period beginning on
the day it received the contribution by the amount of the contribution.
If the amount contributed is more than the property acquired, the
corporation must reduce, not below zero, the basis of other properties
held by the corporation on the last day of the 12-month period in the
following order:
Depreciable property.
Amortizable property.
Property subject to cost depletion but not to percentage depletion.
All other remaining properties.
The holding period of stock received in a 351 transfer includes the
transferors holding period. This also applies to the exchange of assets
where the basis of the new asset is determined in whole or in part by
the basis of the old property.

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IRC 351 TRANSFER


Assets Transferred

Basis to Corporation

Basis in Stock

Services

FMV

Transfer of services for stock


results in taxable compensation
to shareholder. Basis in stock is
the value of the services taxed
as compensation.

Cash

FMV

Amount of cash.

Property without
liability.

Adjusted basis of property


received.

Adjusted basis of property


transferred.

Property with liability


that is less than
adjusted basis.

Adjusted basis of property


received (no gain is
recognized by shareholder
on transfer).

Adjusted basis of property


transferred decreased by
liability assumed by corporation.

Property with liability


that is more than
adjusted basis.

Adjusted basis of property


received increased by gain
recognized by shareholder
(gain recognized is excess of
liability over adjusted basis
of property).

Adjusted basis of property


transferred decreased by
liability assumed by corporation
and increased by gain
recognized.

BOND PREMIUMS
A premium paid to buy a bond is considered part of the basis in the
bond.
If the bond yields taxable interest, the premium may be amortized.
Thus each year, over the life of the bond, part of the premium reduces
the amount of interest includable in income. In addition, the basis in the
bond must be reduced by the amount of amortization for each year.
When a corporation issues bonds at a premium, the corporation must
include the amount over the face value in income. The additional
amount in excess of the face value is included ratably over the term of
the bond.
To figure the amount to include each tax year, divide the number of
months the bonds are outstanding during the year by the number of
months from the date of issue to the date of maturity. Multiply this ratio
by the total bond premium, less any conversion feature.

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PREOPERATIONAL EXPENSES
START-UP COSTS
Start-up costs are costs incurred for creating an active trade or
business or for investigating the creation or acquisition of an active
trade or business. Generally start-up costs are ordinary and necessary
expenses of a business, which would be deductible if the business
activity had started.
A start-up expense is amortizable if it meets both of the following tests:
It is a cost that could be deducted if paid or incurred to operate an
existing active trade or business.
It is a cost paid or incurred before the date the active trade or
business began.
These expenses may include surveys of potential markets; advertising
for the opening of the business; training wages; travel and other
necessary costs for securing prospective distributors, suppliers, or
customers; and salaries and fees for executives and consultants, or
similar professional services. It does not include interest, taxes, and
research and experimental expenses.
Amortizable start-up costs for purchasing an active trade or business
include only investigative costs incurred in the course of a general
search for or preliminary investigation of the business.

ORGANIZATIONAL COSTS
Organizational costs are expenses directly related to the creation of the
business and not currently deductible.
The election to amortize must be made when the first return as an
active business is filed. If amortization is not elected, the expenses are
capitalized and deducted in the year of liquidation.
To be eligible for amortization, an organizational expense must meet
the following tests:
It is for the creation of the corporation.

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It is chargeable to a capital account.


It could be amortized over the life of the corporation, if the

corporation had a fixed life.


It is incurred before the end of the first tax year in which the
corporation is in business.
The expenses included in this category would be expenses of temporary
directors, organizational meetings of directors, fees paid to a state for
incorporation, and accounting and legal fees incident to the
organization.
Non-qualifying costs include costs for issuing and selling stock and costs
associated with the transfer of assets to the corporation. The costs of
transferring assets to the corporation must be capitalized.

AMORTIZATION
For start-up and organizational costs paid or incurred in 2009, the
following rules apply separately for each category of costs.
The corporation can elect to deduct up to $5,000 of such costs for
the year.
The $5,000 deduction is reduced by the amount the total costs
exceed $50,000.
If the election is made, any costs that are not deducted must be
amortized ratably over a 180-month period.
For start-up and organizational expenditures paid or incurred after
September 8, 2008, the corporation is deemed to have made an
election to deduct up to $5,000 of such costs and amortize the balance
over 180 months beginning with the month the corporation begins an
active trade or business.
If a business is disposed of before the end of the amortization period,
the remaining deferred start-up costs can be deducted.

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INCOME AND DEDUCTIONS


Rules on income and deductions that apply to individuals also apply, for
the most part, to corporations. The following special provisions only
apply to corporations.

BELOW-MARKET LOANS
A below-market loan is a loan on which no interest is charged or on
which interest is charged at a rate below the applicable federal rate.
A below-market loan generally is treated as an arms-length transaction
in which the borrower is considered as having received both of the
following:
A loan in exchange for a note that requires payment of interest at
the applicable federal rate.
An additional payment in an amount equal to the forgone interest.
The additional payment is treated as a gift, dividend, contribution to
capital, payment of compensation, or other payment, depending on the
substance of the transaction.

CHARITABLE CONTRIBUTIONS
A corporation can claim a limited deduction for charitable contributions
made in cash or other property if made to, or for the use of, a qualified
organization.
A corporation using the cash method of accounting deducts the
contribution in the tax year paid.
A corporation using the accrual method of accounting can choose to
deduct unpaid contributions for the tax year the board of directors
authorizes them if it pays them within 2 months after the close of the
tax year.
The deduction for charitable contributions is limited to 10% of the
corporations taxable income for the year.
Taxable income is computed without regard to the following:
Deduction for the charitable contributions.
Deduction for dividends received and paid.
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The domestic production activities deduction.


Deduction for any NOL carryback or capital loss carryback.

Any contribution made during the year that exceeds the 10% limit can
be carried to each of the subsequent five years. Any excess not used
within that period is lost.
Current-year contributions are deducted before any carryover
contributions.
Special rules apply if the corporation has an NOL carryover to the tax
year.
In figuring the charitable contributions deduction, the 10% limit is
applied using the taxable income after taking into account any
deduction for the NOL.
A carryover of excess contributions cannot be deducted to the extent
it increases an NOL carryover.
Substantiation is required for certain contributions.
No deduction is allowed for any contribution of $250 or more unless
the corporation gets a written acknowledgment from the donee
organization. The acknowledgment must be obtained by the due date
of the corporations return.
If a corporation (other than a closely held corporation or PSC)
contributes property other than cash and claims over a $500
deduction, it must attach a schedule to the return describing the
property and the method for determining FMV. Closely held
corporations and PSCs must attach Form 8283, Noncash Charitable
Contributions.
For contributions of certain property made after June 3, 2004, a
corporation must file Form 8283 and get a qualified appraisal if
claiming a deduction of more than $5,000.
If a corporation makes a qualified conservation contribution, the
corporation must provide information regarding the legal interest being
donated, the FMV of the underlying property before and after the
donation, and a description of the conservation purpose for which the
property will be used.
A corporation is allowed a deduction for the contribution of used motor
vehicles, boats, and airplanes. The deduction is limited to the gross
proceeds from the sale of the vehicle, if sold without any intervening
use or material improvement by the donee organization. An

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acknowledgement from the organization for deductions claimed in


excess of $500 must be attached to the return.
Generally, the eligible contribution of business property (FMV) must be
reduced by the amount of gain which would be ordinary income or
short-term capital gain had the property been sold at FMV. If the
tangible personal property is not used for the donee organizations
exempt purpose, the entire deduction is limited to the corporations
basis in the donated property.
A larger deduction is allowed for certain qualified contributions.
Inventory and other property to certain organizations for use in the
care of the ill, needy, or infants.
Books donated to a public school that provides elementary or
secondary education.
Food inventory that is apparently wholesome.
Scientific equipment constructed by the corporation (other than an S
corporation, PHC, or PSC) and donated no later than two years after
substantial completion of the construction. The property must be
donated to a qualified organization and its original use must be by
the donee for research, experimentation, or research within the
United States in the area of physical or biological science.
Computer technology and equipment acquired or constructed and
donated no later than three years after either acquisition or
substantial completion to a public library or an educational
organization for educational purposes within the United States.
Qualified gifts include contributions of computer software, computer
or peripheral equipment, and fiber optic cable related to computer
use.
Limitations for qualified contributions include:
The original use of the property must be by the donor or the
donee. The donee may not transfer the donated property for
money, services, or other property, except for shipping, transfer,
and installation costs.
The donation is equal to the lesser of the following:
The basis of the property plus one-half of the ordinary income
that would have been recognized had the property been sold;
or
Twice the basis of the property.

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For a donation of a patent or other intellectual property to a qualified


organization the deduction is limited to the basis of the property or the
FMV, whichever is less.
This includes patents, copyrights, trademarks, trade names, trade
secrets, know-how, certain software, and similar property or
applications or registrations of such property.
An additional deduction may be claimed in the year of contribution
and years following, based on income from the donated property. For
the first two years ending on or after the date of the contribution,
100% of the organizations income from the property can be
deducted. This decreases 10% each year after for years 3 through
10, and then 10% for years 11 and 12.

DIVIDENDS-RECEIVED DEDUCTION
A corporation is allowed a deduction for a percentage of certain
dividends-received (DRD). The greater the ownership in the corporation
issuing the dividends, the greater the percentage of dividends eligible
for deduction. For domestic (U.S.) corporations the deduction is as
follows:
A corporation can deduct, within certain limits, 70% of dividends
received or accrued when stock ownership in the paying corporation
is less than 20%.
A corporation can deduct, within certain limits, 80% of dividends
received or accrued if the ownership in the paying corporation is
20% or more.
A corporation can deduct, within certain limits, 100% of dividends
received if the recipient corporation is a small business investment
company.
A corporation can deduct, within certain limits, 100% of dividends
received from a member if in the same affiliated group.
Regulated investment company dividends received are subject to
certain limits. Capital gain dividends received from a regulated
investment company do not qualify for the deduction.
Dividends on deposit or withdrawable accounts in domestic building and
loan associations, mutual savings banks, cooperative banks, and similar
organizations are interest, not dividends. As such, they do not qualify
for the dividends-received deduction.

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The dividends-received deduction does not apply to dividends received


from the following sources:
A real estate investment trust.
A corporation exempt from tax either for the tax year of the
distribution or the preceding tax year.
A corporation whose stock has been held less than 46 days during
the 91-day period beginning 45 days before the stock became exdividend with respect to the dividend if the dividends received are for
a period or periods totaling more than 360 days.
A corporation whose preferred stock was held less than 91 days
during the 181-day period beginning 90 days before the stock
became ex-dividend with respect to the dividend if the dividends
received are for a period or periods totaling more than 360 days.
Any corporation, if another corporation is under an obligation
(pursuant to a short sale or otherwise) to make related payments for
positions in substantially similar or related property.
The dividends-received deduction is limited to 70% or 80% of the
taxable income of the corporation. There is an ordering rule if the
corporation has dividends subject to the 80% limit and dividends
subject to the 70% limit.
The total deduction is limited to 80% of the difference between
taxable income and the 100% deduction allowed for dividends
received from affiliated corporations, or by a small business
investment company, for dividends received or accrued from 20%owned corporations.
The total deduction is limited to 70% of the difference between
taxable income and the 100% deduction allowed for dividends
received from affiliated corporations, or by a small business
investment company, for dividends received or accrued from a lessthan-20%-owned corporation.
Taxable income for this purpose is determined without the following
items:
A net operating loss deduction.
The domestic production activities deduction.
A deduction for dividends received.
Any adjustment due to the nontaxable part of an extraordinary
dividend.
Any capital loss carryback to the tax year.

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The 80% or 70% taxable income limitation does not apply if the
corporation has an NOL for the tax year. To figure if the corporation has
an NOL, figure the dividends-received deduction without the 80% (or
70%) of taxable income limit.

Example: (From Publication 542) A corporation loses $25,000 from operations. It


receives $100,000 in dividends from a 20%-owned corporation. Its taxable income
is $75,000 before the deduction for dividends received. If it claims the full
dividends-received deduction of $80,000 ($100,000 x 80%) and combines it with
the operations loss of $25,000, it will have a net operating loss of $5,000.
Therefore, the 80% of taxable income limit does not apply. The corporation can
deduct the full $80,000.

Example: Assume the same facts as in the prior example except that the
corporation loses $15,000 from operations. Its taxable income is $85,000 before
the deduction for dividends received. After claiming the dividends-received
deduction of $80,000 ($100,000 x 80%), its taxable income is $5,000. Because the
corporation will not have a net operating loss after a full dividends-received
deduction, its allowable dividends-received deduction is limited to 80% of its
taxable income, or $68,000 ($85,000 x 80%).

Dividends received in the form of property are included in income at the


lesser of FMV or adjusted basis to the distributing corporation plus the
amount of gain recognized on the transaction.

LOSSES
CAPITAL LOSSES
Capital losses are deducted only to the extent of capital gains. The
$3,000 loss limitation does not exist for the corporation.
Any excess capital losses are carried back three years, then forward five
years.
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The character of any capital loss carryover becomes a short-term


capital loss carryover.
Capital losses cannot be carried back or forward to a year the
corporation was an S corporation.
When figuring the current years net capital loss, do not combine it with
a capital loss carried from another year.
If two or more capital losses are carried to the same year, the loss from
the earliest year is applied first, either to reduce current gain or as a
deduction.
A capital loss carried from another year cannot produce or increase a
net operating loss in the year to which it is carried back.

NET OPERATING LOSS


A corporation determines and deducts a net operating loss (NOL) in
much the same way an individual, estate, or trust does. A corporations
NOL will differ in the following ways:
A corporation can take different deductions when figuring an NOL.
A corporation must make different modifications to its taxable
income in the carryback or carryforward year when figuring how
much of the NOL is used and how much is carried over to the next
year.
A corporation figures an NOL in the same way it figures its taxable
income using the following rules for figuring the NOL:
A corporation cannot increase its current year NOL by carrybacks or
carryovers from other years.
A corporation cannot use the domestic production activities
deduction to create or increase its current year NOL, including any
carryback or carryover.
A corporation can take the deduction for dividends-received without
regard to the aggregate limits that normally apply.
A corporation can figure the deduction for dividends paid on certain
preferred stock of public utilities without limiting it to its taxable
income for the year.
The corporations deduction for dividends received is generally subject
to an aggregate limit of 70% or 80% of taxable income. However, if a
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corporation has an NOL, the corporation figures its dividends-received


deduction without regard to the 70% or 80% of taxable income limit.
If the NOL available for carryback or carryover is greater than the
taxable income for that year, the corporation must modify its taxable
income to figure how much of the NOL is used up in that year and how
much it can carry to the next carryover year. Modified taxable income is
determined with the following adjustments:
It can deduct NOLs only from years before the NOL year whose
carryover is being figured.
The corporation must figure its deduction for charitable contributions
without considering any NOL carryback.
For NOLs created in years ending after August 5, 1997, the NOL is
carried back 2 years and carried forward 20 years. NOLs carried into
years after August 5, 1997, retain the 15-year carryforward if they were
created in a year prior to that date.
A special exception exists for small businesses and farms if the loss is
attributable to a Presidentially Declared Disaster. For these small
businesses that have average annual gross receipts of $5 million or less
for a three-tax-year period and for taxpayers in the business of
farming, the carryback period is three years.
A 5-year carryback exists for certain farm losses, while a 10-year
carryback period exists in specified liability losses.
The portion of an NOL that was a qualified GO Zone loss could be
carried back to the five tax years before the NOL year. In addition, the
90% limit on the alternative tax NOL deduction did not apply to the GO
Zone portion of the alternative tax NOL. The same provisions are
extended to the Kansas Disaster Area for the period May 4, 2007, to
December 31, 2009.
For tax years beginning after 2007, a five year carryback period applies
to NOLs to the extent of a qualified disaster loss incurred before
January 1, 2009.
The American Recovery and Reinvestment Act of 2009 provided eligible
small businesses an election to carry an applicable 2008 NOL back
three, four, or five years. The Worker, Homeownership, and Business
Assistance Act of 2009 extended this provision to 2009.

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The corporation may elect to forego the carryback period and carry the
loss forward. The election is made on a year-by-year basis by the due
date of the return including extensions. The election is irrevocable.

PASSIVE LOSSES
Passive activity rules apply to personal service corporations and closely
held corporations (other than S corporations).
Personal service corporations are subject to the passive activity rules in
the same manner as individuals.
In a closely held corporation, passive losses may offset active income
from the corporation but not portfolio income.

AT-RISK LIMITS
The at-risk rules generally limit losses from most activities to the
amount at-risk in that activity. These rules apply to certain closely held
corporations. The amount at risk generally equals the following:
The money and adjusted basis of property contributed by the
taxpayer to the activity.
The money borrowed for the activity.
For this purpose, a corporation is a closely held corporation if, at any
time during the last half of the tax year, more than 50% of the value of
its outstanding stock is owned directly or indirectly by, or for, five or
fewer individuals.

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CORPORATE TAX
The corporations taxable income is determined on Form 1120 from
Lines 1 through 29. The tax is calculated on Schedule J.
A corporations taxable income may be determined by reconciling the
book income with the income for tax purposes on Schedule M-1. Begin
with net income per books, add back items that are deducted on the
books but not on the return, and then reduce this by income shown on
the books but not on the return.
The following is a list of possible modifications added to determine
taxable income:
Federal income taxes paid or accrued depending on the accounting
method used.
Excess capital losses over capital gains.
Charitable contribution carryover.
Travel and entertainment expenses in excess of the allowable limit.
Depreciation in excess of the amount allowable for tax purposes.
Income subject to tax not included on the books.
The following is a list of possible modifications subtracted to determine
taxable income:
Income recorded on the books not subject to income taxes such as
tax-exempt interest and insurance premiums.
Other deductions on the tax return not included in book income such
as depreciation or contribution carryovers.
Schedule M-3 must be completed by corporate taxpayers starting with
the first year in which they report gross assets on an accrual basis of
$10 million or more on Schedule L of Form 1120. Schedule M-3 is
completed in lieu of completing Schedule M-1 for taxpayers meeting the
minimum threshold and can be filed voluntarily if not required.

TAX RATES
Most corporations not filing a consolidated return figure their tax by
using the tax rate schedule. Corporations are subject to graduated tax
rates ranging from 15% to 34% with an additional 5% surtax for
corporations with taxable income over $100,000 up to $335,000, then

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35% over $10 million. There is an additional 3% surtax for incomes


over $15 million up to $18,333,333. Members of a controlled group
should use the worksheet in the Form 1120 Instructions to allocate the
tax bracket.

Corporate Tax Table


Taxable income
Over

But not over

$0

$50,000

50,000

75,000

75,000

Tax is

Of the amount over


15%

$0

$7,500

+ 25%

50,000

100,000

13,750

+ 34%

75,000

100,000

335,000

22,250

+ 39%

100,000

335,000

10,000,000

113,900

+ 34%

335,000

10,000,000

15,000,000

3,400,000

+ 35%

10,000,000

15,000,000

18,333,333

5,150,000

+ 38%

15,000,000

35%

18,333,333

Qualified personal service corporations are taxed at a flat 35%. If the


corporation is a qualified personal service corporation for this provision,
the box on Form 1120, Schedule J, Line 2, should be checked even if
the corporation has no tax liability.

CREDITS
A corporations tax liability may be reduced by various business credits.
Form 3800, General Business Credit, must be filed if any of the
following apply:
The corporation has more than one credit of those listed on Form
3800.
The corporation has a carryback or carryforward of any of the
general business credits.
Any of the general business credits, other than the low-income
housing credit, is from a passive activity.
In addition to the credits listed on Page 1 of Form 3800, the general
business credit includes the following, for which any carryback,
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carryover, and passive activity limitation is computed separately on


Page 3:
The Empowerment Zone and Renewal Community Employment
Credit (Form 8844).
The investment credit from Part III of the form (Form 3468)
The work opportunity credit (Form 5884)
The alcohol and biofuel credit (Form 6478, Alcohol and Cellulosic
Biofuel Fuel Credit).
The employer tip credit (Form 8846)
Qualified railroad track maintenance credit (Form 8900)
The portion of the renewable electricity, refined coal, and Indian coal
production credit figured in Part II of the form (Form 8835).

ALTERNATIVE MINIMUM TAX


The corporate alternative minimum tax (AMT) is similar to the individual
AMT. The rate for corporations is 20%. The corporation is allowed a
$40,000 exemption, which is reduced by 25% of the amount by which
the alternative minimum taxable income (AMTI) exceeds $150,000. The
tax due is the greater of the alternative minimum tax or the regular tax.
Small corporations will have a tentative minimum tax of $0. A
corporation is treated as a small corporation exempt from AMT for its
current tax year if that year is the corporations first tax year in
existence, regardless of its gross receipts for the year. For years other
than the corporations first tax year, the corporation is eligible for the
small corporation exemption if both of the following are met:
It was treated as a small corporation exempt from AMT for all prior
tax years beginning after 1997.
Its average annual gross receipts for the three-tax-year period (or
portion thereof during which the corporation was in existence)
ending before its current tax year did not exceed $7.5 million ($5
million if the corporation had only one prior tax year).
A corporation is eligible for the minimum tax credit, calculated in a
manner similar to the credit for prior year minimum tax for individuals,
estates, and trusts.
Form 8827, Credit for Prior Year Minimum Tax-Corporations, is used to
calculate the credit. The credit is the smaller of the following.

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The current years tentative minimum tax.


The sum of the prior years AMT, any minimum tax carryforward, and

any 2008 unallowed qualified electric vehicle credit.


Unlike individuals, both deferral and exclusion items are taken into
consideration for the minimum tax credit for corporations.
A minimum tax credit is carried forward indefinitely. However, for
corporations with tax years ending after March 31, 2008, the
corporation can elect to claim a refundable credit for certain unused
minimum tax credit carryovers in lieu of the special depreciation
allowance for qualified property.

ACCUMULATED EARNINGS TAX


If the corporation allows earnings to accumulate beyond the reasonable
needs of the business, it may be subject to an accumulated earnings
tax. For tax years beginning after 2002 and before 2011, the
accumulated earnings tax rate is reduced from the highest rate of tax
under 1(c) (rate for single individuals) to 15%.
An accumulation of $250,000 or less is considered to be within
reasonable limits. This limit is $150,000 for PSCs. Reasonable needs of
a business include the following:
Specific, definite, and feasible plans for use of the earnings
accumulation in the business.
The amount necessary to redeem the corporations stock included in
a deceased shareholders gross estate, if the amount does not
exceed the reasonably anticipated total estate and inheritance taxes
and funeral and administration expenses incurred by the
shareholders estate.
Special situations allow the accumulation of earnings and profits (E&P)
in excess of the amounts listed. The regulations provide guidance in
determining acceptable accumulations.
The following is a list of acceptable accumulations:
To provide for bona fide expansion of business or replacement of
plant.
To acquire a business enterprise through purchasing stock or assets.

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To provide for the retirement of bona fide indebtedness created in

connection with the trade or business.


To provide necessary working capital for the business.
To provide for investments or loans to suppliers or customers if
necessary in order to maintain the business of the corporation.
To provide for the payment of reasonably anticipated product liability
losses.
Unreasonable accumulations include the following:
Loans to shareholders, or the expenditure of funds of the corporation
for the personal benefit of the shareholders.
Loans having no reasonable relation to the conduct of the business
made to relatives or friends of shareholders, or to other persons.
Loans to another corporation, the business of which is not that of the
taxpayer corporation, if the capital stock of such other corporation is
owned, directly or indirectly, by the shareholder or shareholders of
the taxpayer corporation and such shareholders are in control of
both corporations.
Investments in properties or securities that are unrelated to the
activities of the business of the taxpayer corporation.
Retention of E&P to provide against unrealistic hazards.
Personal holding companies and tax-exempt corporations are not
subject to the accumulated earnings tax.

CORPORATE EARNINGS AND PROFITS


The calculation of E&P is necessary to determine the status of corporate
distributions. E&P differs from retained earnings since the latter is
measured on tax basis rather than book basis.
The calculation of E&P begins with taxable income and is then adjusted.
The following is a list of the most common adjustments. A complete list
can be found in the worksheet for computation of E&P attached to Form
5452, Corporate Report of Nondividend Distributions.
Subtract the actual federal tax liability.
Add back the full amount of carry-ins from other years for such items
as capital losses, charitable contributions, and NOLs deducted in the
current year.

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Adjust the insurance deduction for the amount of the premiums in

excess of the cash surrender value.


Subtract nondeductible interest expenses, nondeductible charitable
contributions, and net capital losses incurred in the current year.
Add tax-exempt interest.
Add insurance proceeds in excess of the cash surrender value.
Add the recovery of debt previously written off but not deducted on
the tax return.
Add the difference between the depreciation deducted on the tax
return and the straight-line depreciation allowed for E&P.

A distribution affects E&P in the following manner:


A cash distribution reduces E&P by the amount distributed, but not
below zero.
If appreciated property is distributed, the E&P is increased by the
excess of the FMV over the basis of the property. Then the E&P is
decreased, but not below zero, by the FMV of the appreciated
property and the FMV of any other property. The FMV is reduced by
any liability that the property is subject to and any liability assumed
by the shareholder relating to the distribution.
Distributions first reduce current E&P. Any excess reduces
accumulated E&P.
If a corporations E&P for the year (figured as of the close of the year
without reduction for any distributions made during the year) are more
than the total amount of distributions made during the year, all
distributions made during the year are treated as distributions of
current-year E&P.
If the corporations current-year E&P are less than the total distributions
made during the year, part or all of each distribution is treated as a
distribution of accumulated E&P.
If the corporation has current-year E&P that are less than the total
distributions, divide the E&P by the total distributions. This results in a
percentage that is the percentage of each distribution from current E&P.
The remainder of the distribution is from accumulated E&P. If the
accumulated E&P are reduced to zero, the remaining part of each
distribution is applied against and reduces the shareholders basis in
stock.
If the current-year E&P balance is negative, prorate the negative
balance to the date of each distribution made during the year. Figure
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the available accumulated E&P by subtracting this prorated amount and


use the adjusted accumulated E&P to determine the character of the
distribution.
If the corporations accumulated earnings account is negative at the end
of the year, but was positive at the time the distribution was made, to
the extent of the earnings, the distribution is a taxable dividend.
E&P are reduced by any distributions made in cash and by the adjusted
basis of any property distributed, but not below zero. Distributions in
excess of E&P are generally not taxable, but reduce the basis in the
shareholders stock. If the distribution exceeds the basis in stock, the
excess is treated as gain from the sale of property and generally
receives capital gain treatment.

SCHEDULE M-3
Schedule M-3, Part I, asks certain questions about the corporations
financial statements and reconciles worldwide financial statement net
income (loss) to income (loss) per books. Parts II and III reconcile
financial statement net income (loss) per Schedule M-3, Part I, Line 11,
to taxable income on Form 1120, page 1, Line 28.
Any domestic corporation required to file Form 1120 that reports on
Schedule L total consolidated assets at the end of the corporations tax
year that equal or exceed $10 million must complete and file Schedule
M-3 in lieu of Schedule M-1.
If the parent corporation of a U.S. consolidated tax group files Form
1120 and files Schedule M-3, all members of the group must file
Schedule M-3.

DISTRIBUTIONS
MONEY OR PROPERTY DISTRIBUTIONS
Most distributions are in money, but they may also be in stock or other
property. For this definition, property generally does not include stock
in the corporation or rights to acquire stock.
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The amount of the distribution is generally the amount of any money


paid to the shareholder plus the FMV of any property transferred to the
shareholder. This amount is reduced, but not below zero, by certain
liabilities.
Any liability of the corporation the shareholder assumes in
connection with the distribution.
Any liability to which the property is subject immediately before, and
immediately after, the distribution.
The FMV of any property distributed to a shareholder becomes the
shareholders basis in that property.
If property being distributed is subject to a liability that is greater
than the adjusted basis of the property, the FMV is treated as not
less than the liability assumed or acquired by the shareholder.
If the liability on the distributed property is less than the FMV, the
amount of the distribution is equal to the FMV minus the assumed
liability.
If the distributed property was depreciable or amortizable, the
corporation may have to treat all or part of the gain as ordinary income
from depreciation recapture.
The distribution of appreciated property is treated as if it were sold. The
corporation recognizes gain on the excess of the FMV over the adjusted
basis of the property. The type of property distributed determines the
character of the gain. Some of the gain may be ordinary based on the
recapture rules. For this purpose, the FMV of the property is the greater
of the actual FMV or the amount of any liabilities the shareholder
assumed in connection with the distribution of the property.

DISTRIBUTIONS OF STOCK OR STOCK RIGHTS


Distributions by a corporation of its own stock are known as stock
dividends. Stock rights, or stock options, are distributions by a
corporation of rights to acquire its stock. Distributions of stock
dividends and stock rights are generally tax-free to shareholders.
Stock or stock rights are treated as property distributions and not taxfree if any of the following apply:
Any shareholder has the choice to receive cash or other property
instead of stock or stock rights.

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The distribution gives cash or other property to some shareholders

and an increase in the percentage interest in the corporations assets


or E&P to other shareholders.
The distribution is in convertible preferred stock unless it does not
result in a disproportionate distribution.
The distribution gives preferred stock to some common stock
shareholders and gives common stock to other common stock
shareholders.
The distribution is on preferred stock.
The expenses of issuing a stock dividend must be capitalized. These
expenses include printing, postage, cost of advice sheets, fees paid to
transfer agents, and fees for listing on stock exchanges.
Distributions of stock in satisfaction of debt may be taxable to the
recipient. The FMV of the stock is considered the payment. If the value
of the stock is less than the debt satisfied, the corporation recognizes
debt forgiveness income. The corporation does not recognize income if
it is in bankruptcy and reduces tax attributes in an amount equal to the
debt forgiveness.

CONSTRUCTIVE DISTRIBUTIONS
A corporation may issue constructive dividends. These generally result
when the shareholder has received a personal benefit from the
corporation that was not included in income. These are not declared
dividends but result from the discovery of unreported income by the
preparer or the IRS in audit.
The following transactions may be treated as distributions:
If a corporation gives a shareholder a loan on which no interest is
charged or on which interest is charged at a rate below the
applicable federal rate, the interest not charged is treated as a
distribution to the shareholder.
If a corporation cancels a shareholders debt without repayment by
the shareholder, the amount canceled is treated as a distribution to
the shareholder.
A sale or exchange of property to a shareholder is treated as a
distribution. For a shareholder who is not a corporation, if the FMV of
the property on the date of the sale or exchange exceeds the price

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paid by the shareholder, the excess is treated as a distribution to the


shareholder.
If a corporation rents property from a shareholder and the rent is
unreasonably more than the shareholder would charge another, the
excessive part of the rent is treated as a distribution to the
shareholder.
If a corporation pays an employee who is also a shareholder a salary
that is unreasonably high considering the services actually
performed, the excessive part of the salary is treated as a
distribution to the shareholder-employee.

REPORTING DIVIDENDS AND OTHER DISTRIBUTIONS


A corporate distribution to a shareholder is generally treated as a
distribution of E&P. Distributions from corporate E&P are paid to
shareholders as dividends. (This does not apply to S corporations
without prior C corporation retained earnings, since all earnings pass
through to shareholders.)
Any part that is not from E&P is applied against and reduces the
adjusted basis of the stock in the hands of the shareholder.
To the extent the balance is more than the adjusted basis of the stock,
the shareholder has gain from the sale or exchange of property.
Form 1099-DIV is required to report dividends and other distributions
on stock.
Each shareholder to whom the corporation has paid dividends and
other distributions on stock of $10 or more.
For whom the corporation has withheld and paid any foreign tax on
dividends and other distributions on stock.
For whom the corporation has withheld any federal income tax under
the backup withholding rules.
To whom the corporation has paid $600 or more as part of a
liquidation.
If the corporation makes a payment that is a dividend but the
corporation is unable to determine whether any part of the payment is a
dividend by the required filing date of Form 1099-DIV, the entire
payment must be reported as a dividend.

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Form 1099-DIV is due to the shareholders by January 31. Form 1099DIV, along with Form 1096, is due to the IRS by February 28, or if the
date falls on Saturday or Sunday, the next business day.
Backup withholding of 28% is required if the shareholder does not
provide the payer with a taxpayer identification number (TIN) in the
required manner.
Other reasons backup withholding is required are as follows:
The IRS notifies the payer that the TIN given by the shareholder is
incorrect.
The shareholder is required, but fails to certify that he or she is not
subject to backup withholding.
The IRS notifies the corporation to start withholding because the
shareholder underreported interest or dividends on his or her income
tax return. This only happens after the IRS has mailed the
shareholder four notices over a 129-day period.
Withholding is required on dividends paid by U.S. corporations to
nonresident payees, to the extent treated as gross income from sources
within the United States. Nontaxable distributions payable in stock,
stock rights, or distributions are treated as part or full payment for
stock. If any of the portion is taxable, the entire distribution is subject
to withholding.
Nontaxable dividends are distributions that exceed the corporations
accumulated E&P. Form 5452 must be filed if nontaxable dividends are
paid to shareholders. The shareholders receive a Form 1099-DIV
including the amount.
A return of capital is a distribution that is not paid out of the
corporations E&P. It is a return of the shareholders investment in
the stock.
A return of capital reduces the shareholders basis in his or her stock.
A return of capital is not taxed until the shareholders basis in the
stock is reduced to zero.

LIQUIDATIONS
Liquidation is generally accomplished by the corporation redeeming
(buying back) its outstanding stock for cash, property, or a combination
of both. This redemption is treated as if the corporation sold the

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property for FMV to the shareholder for his or her stock. If property is
subject to a liability, the FMV cannot be less than the liability assumed
by the shareholder.
Liquidating distributions and liquidating dividends are distributions
received during a partial or complete liquidation of a corporation.
These distributions are, at least in part, one form of a return of
capital.
A liquidating distribution is not taxable to the shareholder until the
shareholder has recovered his or her basis in the stock.
In liquidation, distributions to shareholders are considered full payment
in exchange for the stock. They are reported on Schedule D (Form 4797
if the stock is qualified 1244 stock).

Definition: 1244 stock is the stock of a domestic small


business corporation issued after November 6, 1978, subject to
the following requirements: the stock must be original issue
stock; issued in exchange for money or property; and the
issuing corporation must have capitalization of $1 million or
less.

A distribution in redemption of stock is treated as a sale or exchange


rather than a dividend if any of the following conditions exist:
The redemption is not equivalent to a dividend.
The distribution is a substantially disproportionate redemption of
stock.
The shareholder must own less than 50% of the total combined
voting stock immediately after the redemption.
The distribution must be substantially disproportionate with
respect to all shareholders.
The distribution is considered substantially disproportionate if the
ratio of the voting stock of the shareholder to the total voting
stock of all shareholders immediately after the redemption is less
than 80% of the ratio of the voting stock of the shareholder to the
total voting stock of all shareholders immediately before the
redemption.
There is a complete redemption of all of the stock of the corporation
owned by the shareholder.
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The redemption is a distribution in partial liquidation of a

corporation.
Redemption of stock of a noncorporate shareholder is treated as a sale
or exchange of the stock in partial liquidation if any of the following
apply:
The distribution in redemption of the stock is not essentially
equivalent to a dividend (determined at the corporate rather than
the shareholder level). A distribution is not considered equivalent to
a dividend if:
The distribution is attributable to the distributing corporations
ceasing to conduct a qualifying trade or business that was actively
conducted throughout the five-year period ending on the date of
the redemption.
Immediately after the distribution, the distributing corporation
must be actively engaged in conducting another trade or business
that also had been carried on for at least five years before the
redemption.
The distribution is made pursuant to a plan of partial liquidation.
The distribution is made either in the year the plan of partial
liquidation is adopted or in the following year.
Distributions to a corporate shareholder in redemption of stock (other
than one that is in complete liquidation or is substantially
disproportionate) are treated as dividends to the extent of E&P of the
corporation.
If gain or loss is recognized, the basis of the property received in
liquidation is the FMV at the time of the distribution. If gain or loss is
not recognized, the basis in the property is the shareholders adjusted
basis in the stock given up.

CONTROLLED GROUPS
A controlled group is two or more corporations connected through stock
ownership. The types of controlled groups include parent-subsidiary,
brother-sister, and combined group. All members of a controlled group
need not use the same tax year.
A controlled group of corporations must allocate certain tax attributes.

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Tax brackets must be apportioned. One apportionable $50,000

amount, one $25,000 amount in each taxable income bracket below


34% and one $9,925,000 taxable income bracket is allowed. The
income tax bracket must be apportioned equally unless there is an
apportionment plan adopted. The statement of consent must be
attached to the return of each corporation.
The controlled group is allowed one $250,000 accumulated earnings
credit for the group. This must be divided equally among the group.
The alternative minimum tax exemption is limited to $40,000 to be
divided among the members. The exemption is phased out at the
rate of 25 cents for every dollar that AMTI exceeds $150,000.
The maximum 179 deduction ($250,000) and the general business
credit limitation ($25,000) must be allocated among the members.
A parent-subsidiary is a corporation connected through stock
ownership with a common parent corporation.
To be considered a parent-subsidiary, both of the following
requirements must be met:
One or more of the other corporations own 80% or more of the
voting stock or 80% or more of all classes of stock of each
corporation.
The common parent owns 80% or more of voting stock or 80% or
more of all classes of stock of at least one of the other companies.
A parent-subsidiary is the only controlled group allowed to file a
consolidated return.
A brother-sister is two or more corporations that are owned by the
same five or fewer persons who meet both of the following conditions:
These five or fewer persons own 80% or more of voting stock or
80% or more of the total value of all classes of stock of each
corporation.
These five or fewer persons own more than 50% of voting stock or
more than 50% of the total value of all classes of stock, if taking into
consideration the stock owned by these five or fewer shareholders to
the extent of identical ownership.

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Note: For tax years beginning after October 22, 2004, the 80%
ownership test for a brother-sister controlled group no longer
applies for the purposes of the taxable income brackets,
alternative minimum tax exemption amounts, and
accumulated earnings credit. The 80% test does continue to
apply for provisions such as 179 expensing, the 41
research credit, and the 267 related party rules.

A combined group is a group of three or more corporations.


Each corporation is a member of a parent-subsidiary or brothersister group.
At least one of the corporations is the common parent of a parentsubsidiary and is also a member of a brother-sister controlled group.
The appropriate tax return to be filed for the controlled group depends
on the members of the group.
A consolidated return may be filed by a controlled group linked by
the parent-subsidiary relationship.
The consolidated return option is not available to the members of a
brother-sister controlled group. Each corporation must file separate
returns but must allocate the tax attributes as mentioned above.

RELATED PERSONS AND CONSTRUCTIVE


OWNERSHIP
Study Tip: Attribution and related-party rules differ depending
on the situation. Under 318 attribution rules, family includes
spouse, parents, children, and grandchildren. Under 267,
regarding losses on transactions between related parties,
family includes spouse, brothers, sisters, ancestors and lineal
descendents. Determine what the question is asking before
deciding which rules apply.

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A corporation that uses the accrual method of accounting cannot deduct


business expenses and interest owed to a related person who uses the
cash method of accounting until the corporation makes payment and
the related person includes the amount in gross income.
The related person determination is made as of the end of the tax year
for which the expense or interest would otherwise be deductible. If the
deduction is denied under this rule, the rule continues to apply even if
the corporations relationship with that person ends before the expense
or interest is includable in that persons gross income.
This rule also applies to deny a deduction of losses on the sale or
exchange of property between related persons.
The following persons are considered related to a corporation:
Another corporation that is a member of the same controlled group
of corporations determined by applying a 50% ownership test.
An individual who owns, directly or indirectly, more than 50% of the
value of the outstanding stock of the corporation.
A trust fiduciary when the trust or grantor of the trust owns, directly
or indirectly, more than 50% in value of the outstanding stock of the
corporation.
An S corporation if the same persons own more than 50% in value of
the outstanding stock of each corporation.
A partnership if the same persons own more than 50% in value of
the outstanding stock of the corporation and more than 50% of the
capital interest or profits interest in the partnership.
Any employee-owner if the corporation is a personal service
corporation, regardless of the amount of stock owned by the
employee-owner.
An S corporation and another S corporation, if the same persons own
more than 50% in value of the outstanding stock of each
corporation.
Additional related persons listed under 267 regarding losses,
expenses, and interest provisions include the following:
Members of a family, including only brothers, sisters, half-brothers,
half-sisters, a spouse, ancestors, and lineal descendents. Family
members related through marriage are not considered related
persons.
A grantor and a fiduciary of any trust.

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A fiduciary of a trust and a fiduciary of another trust, if the same

person is a grantor of both trusts.


A fiduciary of a trust and a beneficiary of such trust.
A fiduciary of a trust and a beneficiary of another trust, if the same
person is a grantor of both trusts.
A person and a 501 organization which is controlled, directly or
indirectly, by such person or by members of the family of such
individual.
An executor of an estate and a beneficiary of such estate.

To determine whether an individual directly or indirectly owns any of


the outstanding stock of a corporation under 318, the following rules
apply:
Stock owned, directly or indirectly, by or for a corporation,
partnership, estate, or trust is treated as being owned
proportionately by or for its shareholders, partners, or beneficiaries.
An individual is treated as owning the stock owned, directly or
indirectly, by or for his or her family. Family includes only spouse,
parents, children, and grandchildren.
An individual owning (other than by applying the prior rule) any
stock in a corporation is treated as owning the stock owned directly
or indirectly by that individuals partner.
In applying these three rules, stock constructively owned by a person
under the first rule is treated as actually owned by that person. But
stock constructively owned by an individual under rules two and three is
not treated as actually owned by the individual for applying either rule
two or three to make another person the constructive owner of the
stock.
Other related party rules include the following:
If an individual has an option to acquire stock, that stock shall be
considered owned by the individual.
If property is sold at a loss to a related party, the loss is not allowed
to the seller; however, the amount of loss increases the related
buyers basis for purposes of determining the gain on the future sale
of the property. If the property is sold at a loss, the original basis is
used.
The disallowance of losses between related parties does not apply to
the sale or exchange of property in complete liquidation.

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SHAREHOLDER BASIS
A shareholders basis in the stock is the investment in the property. This
is generally the cost.
The cost can be determined from assets transferred to a corporation or
by a cash outlay on the purchase of stock.
Basis may be other than cost.
Stock received for services is included in the recipients gross income
at the stocks FMV. This becomes the shareholders basis in the
stock.
Stock received as a gift generally has a carryover basis from the
donor, plus a portion of gift tax paid on the gift if the FMV was equal
to or greater than the donors adjusted basis. If the FMV is less than
the donors adjusted basis, basis for determining gain is the donors
adjusted basis and basis for determining loss is the FMV.
Basis is adjusted for certain events, such as a stock split, stock
dividend, expenses, and by a nontaxable return of investment.

REPORTABLE TRANSACTIONS
Certain transactions must be reported to the IRS. Reportable corporate
transactions include the following.
Transactions that are the same as or substantially similar to tax
avoidance transactions identified by the IRS.
Transactions offered under conditions of confidentiality for which the
corporation paid an advisor a fee of at least $250,000.
Transactions for which the corporation has, or a related party has,
contractual protection against disallowance of the tax benefits.
Transactions that result in losses of at least $10 million in any single
year or $20 million in any combination of years.
Transactions resulting in book-tax differences of more than $10
million in any year.
Transactions with asset holding periods of 45 days or less and that
result in a tax credit of more than $250,000.
These transactions are reported to the IRS on Form 8886, Reportable
Transaction Disclosure Statement.
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CORPORATION TEST
1. ___

Corporations generally must make estimated tax payments if


they expect their estimated tax (income tax less credits) to be
equal to or more than:
A. $1
B. $500
C. $600
D. $1,000

2. ___

WEB Corporation, a calendar-year corporation, estimated its


income tax for 2009 will be $20,000. WEB deposited the first
two estimated tax installments on April 15 and June 15, 2009,
in the amount of $5,000 each (25% of $20,000). On July 1,
WEB estimated its tax will be $40,000. How much estimated
tax should WEB Corporation pay on September 15?
A. $20,000
B. $15,000
C. $10,000
D. $5,000

3. ___

The Susan Corporation was required to use the Electronic


Federal Tax Payment System (EFTPS) in 2008 for payment of
its employment and corporate income taxes. In 2009, the total
deposits of taxes by The Susan Corporation were $190,000.
Which of the following is true?
A. The Susan Corporation is required to use EFTPS in 2009.
B. The Susan Corporation may deposit corporate income tax
payments and estimated tax payments with Form 8109,
Federal Deposit Coupon, mailed to an authorized depository
or mailed to Financial Agent, Federal Tax Deposit Processing
in St. Louis, Missouri for tax year 2009.
C. The Susan Corporation may send deposits directly to an
Internal Revenue Service Office for tax year 2009.
D. The Susan Corporation is not required to participate in
EFTPS, but may participate voluntarily for tax year 2009.

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4. ___

Hinges, Inc. has a fiscal year end of June 30, 2009. What is the
last date on which Hinges, Inc. can request an extension of
time to file its tax return for the year ended June 30, 2009?
A. August 17, 2009.
B. September 15, 2009.
C. March 15, 2010.
D. April 15, 2010.

5. ___

ABC Corporation is dissolved on July 9, 2009. What is the due


date, without extensions, for the filing of the final corporate
income tax return?
A. March 15, 2010.
B. December 31, 2009.
C. October 15, 2009.
D. October 9, 2009.

6. ___

Jonas Corporation forgot to request an extension and filed its


Form 1120 late for calendar year 2009. It paid the $100
balance due when it filed the return on June 22, 2010. The
delinquency penalty will be:
A. $15
B. $20
C. $100
D. $135

7. ___

Lantern Corporation is in the process of dissolving and has filed


a request with the Internal Revenue Service (IRS) for a prompt
assessment. Assuming all other requirements are met, if the
request is granted, the period within which the IRS may assess
a tax liability is shortened to how many months?
A. 24 months.
B. 18 months.
C. 36 months.
D. 12 months.

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8. ___

Which of the following factors is not taken into account when


determining if a gain or loss should be recognized on the
transfer of property to a corporation in exchange for a
controlling interest in stock of the corporation?
A. Receipt of money in addition to the stock.
B. FMV of the property transferred to the corporation.
C. Ownership of a least 80% of the total combined voting
power of all stock entitled to vote.
D. Ownership of at least 80% of the total number of shares of
all other classes of stock.

9. ___

Allen contributes machinery and real property to Jack Corporation, which has been in existence for several years, as
follows:
Adjusted
Asset
Basis
FMV
Machinery
$100,000
$150,000
Real Property
500,000
550,000
Jack Corporation has two classes of stock one with voting
rights and one without voting rights. In exchange for the machinery and real property, Allen receives stock with a FMV of
$700,000. Immediately after the transfer, Allen owns 75% of
the outstanding shares of corporate stock with voting power
and 80% of the outstanding shares of each class of nonvoting
stock of the corporation. Which of the following statements is
true?
A. $100,000 gain is recognized by Allen.
B. No gain is recognized by Allen.
C. $100,000 loss is recognized by the corporation.
D. $100,000 gain is recognized by Allen and the corporation
recognizes a loss in the amount of $100,000.

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10. ___ Amanda Jones and Calvin Johnson form Quail Corporation in
2009 by simultaneously making the following transfers.
Shareholder Adjusted Basis Fair Market Value Percentage of
of Property
of Property Stock Received
Amanda
$30,000
$60,000
50%
Calvin
70,000
60,000
50%
What is the amount of gain or loss to be reported on these
transfers by Amanda and Calvin on their 2009 Federal income
tax returns?
A. Amanda reports a $30,000 gain and Calvin reports a
$10,000 loss.
B. Amanda reports a $0 gain and Calvin reports a $0 loss.
C. Amanda reports a $30,000 gain and Calvin reports a $0
loss.
D. Amanda reports a $0 gain and Calvin reports a $10,000
loss.
11. ___ Bob and John make the following transfers to Builders
Corporation in return for 100% of the stock in the corporation.
Asset and Value Asset and Value
Percentage of
Transferred to
Transferred to
Stock
Builders
Shareholder
Received
Bob
$100,000 cash
$10,000 land
80%
John 30,000 property
5,000 cash
20%
(basis of $10,000)
What is the amount of gain Bob and John must recognize on
the transfers?
A. Bob must recognize $10,000 gain and John must recognize
$25,000 gain.
B. Bob recognizes no gain and John recognizes $5,000 gain.
C. Bob recognizes $10,000 gain and John recognizes $5,000
gain.
D. Bob recognizes $10,000 gain and John recognizes $20,000
gain.

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12. ___ Sky Corporation is a C corporation. Jake owns 80% of all the
outstanding shares of Sky Corporation stock. In 2007, Jake
advanced funds to Sky Corporation as a loan. The loan instrument executed between Jake and Sky Corporation is a demand
note. The principal balance due on the loan from Sky
Corporation is $300,000. After Jake demanded repayment of
the outstanding loan on March 20, 2009, Sky Corporation
transferred to Jake preferred stock with a FMV of $325,000 in
settlement of the debt. Jake has the right to require Sky
Corporation to redeem the preferred stock. Which of the
following is true?
A. The transfer of stock to Jake qualifies as a 351 transfer.
B. The transfer of stock is a nontaxable transaction because
Jake is in control of the corporation.
C. The transfer of stock to Jake is a 1244 Qualified Small
Business Stock transaction.
D. Jake must recognize income on the transaction.
13. ___ John, Mark, Steve, and Tom organize the JMS&T Corporation
by transferring the following:
Transferors
Adjusted
Consideration
Transferor Asset
Basis
FMV
Received
John
Land
$50,000 $70,000 37 shares of stock
Mark
Equipment
35,000 40,000 22 shares of stock
Steve
Tools
45,000 35,000 19 shares of stock
Tom
Cash
40,000 40,000 22 shares of stock
100 shares total
The land contributed by John is subject to a mortgage in the
amount of $30,000. JMS&T Corporation assumes Johns
mortgage on the land. The 100 shares represent all of the outstanding stock of JMS&T Corporation. Which of the following is
correct?
A. The exchange qualifies for IRC 351 nontaxable treatment.
B. The exchange does not qualify for IRC 351 nontaxable
treatment.
C. The exchange qualifies for IRC 351 nontaxable treatment,
but John must recognize $30,000 of capital gain.
D. The exchange qualifies for IRC 351 nontaxable treatment,
but John must recognize $20,000 of capital gain.

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14. ___ If a corporation transfers its stock to an employee as payment


for services, the amount the corporation can deduct is:
A. The corporations basis in the stock transferred.
B. The FMV of the stock on the date of the transfer.
C. The FMV of the stock when the corporation issues the W-2.
D. None of the above.
15. ___ The Charlie Corporation, a calendar-year, accrual-basis
taxpayer, distributed shares of David Corporation stock to
Charlies employees in lieu of salaries. The salary expense
would have been deductible as compensation if paid in cash.
On the date of the payment, Charlies adjusted basis in David
Corporations stock was $20,000 and the stocks FMV was
$100,000. What is the tax effect to Charlie Corporation?
A. $100,000 deduction.
B. $20,000 deduction.
C. $20,000 deduction and $80,000 recognized gain.
D. $100,000 deduction and $80,000 recognized gain.
16. ___ In 2009 Omega, Inc. partially compensates employee Tom
Jones with 100 shares of stock. Omega, Inc. stock is selling for
$200 per share at the time Tom receives his shares. On
December 31, 2009, Tom sells his 100 shares of Omega, Inc.
stock for $300 each. How much of an employee compensation
expense can Omega, Inc. deduct in 2009 for Toms 100
shares?
A. $0
B. $10,000
C. $20,000
D. $30,000
17. ___ Hank transfers land with an adjusted basis of $500,000 to
Handy Hanks, Inc. In exchange, he receives shares of stock
with a FMV of $300,000 and cash in the amount of $175,000.
Hank owns 51% of all the outstanding stock of Handy Hanks,
Inc. immediately after the transfer. What is Hanks deductible
loss on the transaction, if any?
A. $0
B. $25,000 loss
C. $200,000 loss
D. $325,000 loss

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18. ___ In the year 2009, Tami transferred land with an adjusted basis
of $40,000 and a FMV of $95,000 to Nadir Corporation in
exchange for 100% of Nadir Corporations only class of stock.
The land was subject to a liability of $45,000, which Nadir
Corporation assumed. The FMV of Nadir Corporations stock at
the time of the transfer was $50,000. What amount of gain
must Tami recognize and what is her basis in the Nadir
Corporation stock?
A. $0 recognized gain, $40,000 basis.
B. $55,000 recognized gain, $95,000 basis.
C. $5,000 recognized gain, $0 basis.
D. $5,000 recognized gain, $45,000 basis.
19. ___ Jenny transferred a factory building with an adjusted basis of
$70,000 and a FMV of $110,000 to the Crystal Corporation in
exchange for 100% of Crystal Corporation stock and $20,000
cash. The building was subject to a mortgage of $25,000,
which Crystal Corporation assumed. The FMV of the stock was
$75,000. Which is the amount of Jennys realized gain and
recognized gain?
Realized
Recognized
A. $25,000
$25,000
B. $50,000
$40,000
C. $50,000
$20,000
D. $35,000
$20,000
20. ___ Karen transferred property with an adjusted basis of $45,000
and FMV of $50,000 to Holiday Corporation in exchange for
65% of Holiday Corporations only class of stock. At the time of
the transfer, the stock Karen received had a FMV of $55,000.
What is Holiday Corporations basis in the property after the
exchange?
A. $0
B. $45,000
C. $55,000
D. $60,000

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21. ___ Jeff, Mark, and Maggie decided to form Mimic Corporation. Jeff
transferred property with an adjusted basis of $35,000 and a
FMV of $44,000 for 440 shares of stock. Mark exchanged
$33,000 cash for 330 shares of stock. Maggie performed
services valued at $33,000 for 330 shares of stock. The FMV of
Mimic Corporations stock is $100 per share. What is Mimics
basis in the property received from Jeff?
A. $44,000
B. $35,000
C. $9,000
D. $0
22. ___ Kim transferred property with an adjusted basis of $16,000
and a FMV of $25,000, to Corporation K in exchange for 90%
of Ks only class of stock and $3,000 cash. The stock received
by Kim had a FMV of $22,000 at the time of the exchange.
What is Corporation Ks basis in the property received from
Kim?
A. $25,000
B. $22,000
C. $19,000
D. $16,000
23. ___ Which of the following costs qualify as business start-up
costs?
A. Deductible interest.
B. State and local taxes.
C. A survey of potential markets.
D. Research and experimental costs.
24. ___ Which of the following would qualify as business
organizational costs?
A. State incorporation fees.
B. State and local taxes.
C. Deductible interest.
D. None of the above.

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25. ___ The Lucky Corporation has just been formed. It has
organizational costs that the corporation wishes to amortize.
Which of the following tests must the Lucky Corporation meet
before it can amortize the organizational costs?
A. The costs are for the creation of the corporation.
B. The costs are chargeable to a capital account.
C. The costs could be amortized over the life of the corporation
if the corporation had a fixed life.
D. All of the above.
26. ___ The Lux Corporation incurred $10,000 in start-up costs when it
opened for business in July 2009. What is the minimum period
over which these expenses can be recovered?
A. 12 months.
B. 36 months.
C. 60 months.
D. 180 months.
27. ___ As of December 31, 2008, Doyle, Inc. had incurred $6,000 in
potential market feasibility costs, $3,600 in legal fees for
setting up the corporation, $2,400 in advertising costs for the
opening of the business, and $18,000 for the purchase of
equipment. Doyle, Inc. began business operations on January
1, 2009. If Doyle, Inc. chooses to amortize all of its
organizational and start-up expenses, how much can Doyle,
Inc. deduct as an amortization expense in 2009?
A. $800
B. $1,840
C. $2,000
D. $5,800
28. ___ In 2009, Rock Corporation made contributions totaling $20,000
to qualified charitable organizations. Due to the 10% limit,
Rock could only deduct $15,000 of the contributions on its
return. Which of the following statements regarding the excess
contributions of $5,000 is correct?
A. Charitable contributions in excess of the limit are, subject to
limitations, carried back to each of the 3 prior years.
B. Charitable contributions in excess of the limit are, subject to
limitations, carried over to each of the following 10 years.
C. Charitable contributions in excess of the limit are, subject to
limitations, carried over to each of the following 15 years.
D. Charitable contributions in excess of the limit are, subject to
limitations, carried over to each of the following 5 years.

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29. ___ In tax year 2009, Roberts Corporation made a charitable


contribution to a qualified organization of $40,000 in cash plus
a vehicle with a fair market value of $15,000, which the charity
used for its exempt purpose. For tax year 2009 Roberts
Corporation had $400,000 in total income, $100,000 in total
expenses not including the above charitable contributions, and
would have a reportable dividend received deduction of
$50,000. How much of the charitable contribution can Roberts
Corporation deduct for the 2009 tax year?
A. $15,000
B. $25,000
C. $30,000
D. $40,000
30. ___ During 2009, XYZ Corporation had the following income and
expenses:
Gross receipts
$1,000,000
Salaries
350,000
Contributions to a qualified charitable organization 75,000
Operating expenses
395,000
Dividend income from 20% owned corporation
65,000
Dividends-received deduction
52,000
What is the amount of XYZs charitable contribution carryover
to 2010?
A. $32,000
B. $43,000
C. $51,000
D. $75,000
31. ___ Which of the following statements regarding the corporate
dividends-received deduction is not true?
A. Generally, a corporation can deduct 70% of the dividendsreceived from a corporation of which it owns less than 20%.
B. Generally, a corporation can deduct 80% of the dividendsreceived from a corporation of which it owns 20% or more.
C. The dividends-received deduction is unlimited.
D. No deduction is allowed for dividends from tax-exempt
corporations.

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32. ___ Croaker, Inc. is a taxable domestic corporation. Dana


Corporation, a large manufacturing corporation, owns 15% of
Croaker, Inc.'s outstanding stock. In 2009, Dana Corporation
received $100,000 in dividends from Croaker, Inc. Dana
Corporation received no other dividends in 2009. Dana
Corporation may deduct, within certain limits, what percentage
of the dividends received?
A. 15%
B. 70%
C. 80%
D. 100%
33. ___ Brady Corporation of Cleveland, Ohio is a multi-national
conglomerate. In 1995 Brady Corporation established and
owned 100% of the stock of Toms, Inc. of Dayton, Ohio. Toms,
Inc. was established for the purpose of manufacturing rubber
gaskets, which Brady Corporation uses in many of its
international operations. By the beginning of 2009, Brady
Corporation had sold 30% of the outstanding Toms, Inc. stock.
In July of 2009 Toms, Inc. declares a dividend and pays
$100,000 to Brady Corporation. In 2009 Brady Corporation,
subject to certain limits, takes what amount as a dividends
received deduction?
A. $0
B. $70,000
C. $80,000
D. $100,000
34. ___ Kappa Corporation owns 20% interest in Sigma Corporation, a
domestic corporation. For 2009, Kappa had gross receipts of
$390,000, operating expenses of $400,000, and dividend
income of $120,000 from Sigma Corporation. The dividends
were not from debt-financed portfolio stock. What is the
amount of Kappa Corporations dividends-received deduction
for 2009?
A. $96,000
B. $88,000
C. $84,000
D. $24,000

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35. ___ Carol Corporation and Brown Corporation are domestic corporations. The Carol Corporation owns 25% of the Brown Corporation. Carol Corporations income from business for tax
year 2009 is $500,000 and business expenses are $750,000.
In addition to the income from business, Carol Corporation also
received dividends from Brown Corporation in the amount of
$100,000. Carol Corporations dividend received deduction is:
A. $100,000
B. $80,000
C. $70,000
D. $20,000
36. ___ Iron Corporation incurred net short-term capital gains of
$40,000 and net long-term capital losses of $90,000 during
2009. Taxable income from other sources was $500,000. How
are the capital gains and losses treated on the 2009 tax return,
Form 1120?
A. $3,000 of the excess net long-term capital losses are
deducted currently and the $47,000 remainder is carried
forward indefinitely.
B. None of the excess net long-term capital losses are
currently deductible, but may be carried back to the three
preceding years and then forward five years as short-term
capital losses.
C. Excess net long-term capital losses are fully deductible in
2009.
D. Excess net long-term capital losses of $50,000 are carried
back two years and then carried forward 20 years as shortterm capital losses.
37. ___ Waco, Inc. reported net capital gains as follows:
Tax year 2005 at $6,000
Tax year 2007 at $8,000
Tax year 2008 at $1,000
In tax year 2009, Waco, Inc. had $40,000 in long-term capital
losses and $25,000 in short-term capital gains. How much net
capital loss is available for Waco, Inc. to carry into tax year
2010?
A. $15,000
B. $14,000
C. $6,000
D. $0

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38. ___ In 2009, Tilden, Inc. had gross income from business
operations of $500,000 and $625,000 of allowable business
expenses. Tilden also received $150,000 in dividends from
Jefferson Corporation. Tilden owns 23% of the voting power
and value of Jefferson. What is the amount of Tilden, Inc.s
2009 net operating loss?
A. ($125,000)
B. ($95,000)
C. ($14,500)
D. None of the above.
39. ___ For the tax year ending December 31, 2009, ABC Corporation
had gross income of $300,000 and operating expenses of
$450,000. Contributions of $2,500 were included in the
expenses. In addition to the expenses, ABC Corporation had a
net operating loss carryover of $8,000. What is the amount of
ABC Corporations net operating loss for 2009?
A. $147,500
B. $150,000
C. $152,500
D. $156,500
40. ___ HY-Text, Inc., a calendar-year cash-basis corporation, had the
following transactions during 2009:
Net income per books (after tax estimates)
$ 100,000
Federal income tax paid
22,250
Excess of capital losses over capital gains
5,000
Interest from municipal bonds
11,000
Expenses related to municipal bond interest
500
What is HY-Texts taxable income?
A. $139,000
B. $127,750
C. $116,750
D. $77,750

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41. ___ Richard Crepe, M.D. owns 100% of the outstanding stock of
Crepe Corporation. All of Crepe Corporations income and
expenditures are derived from the medical services provided
by Dr. Crepe. At the end of 2009 Crepe Corporation had
$10,000 in reportable taxable income. How much federal
income tax was Crepe Corporation required to pay for the 2009
year?
A. $1,500
B. $2,500
C. $3,400
D. $3,500
42. ___ Westover Health Services, Inc., a personal service corporation,
has two shareholders. Westover was incorporated in 1991 and
has made irregular and infrequent distributions to its
shareholders. The balance sheet of Westover Health Services,
Inc. reflects unappropriated retained earnings in the amount of
$800,000 and no marketable securities. Westover has no
specific, definite, and feasible plans for use of the earnings
accumulation in its business. It has been determined that the
amount needed to redeem a deceased shareholders stock is
$500,000. What is the amount of Accumulated Earnings Tax
that Westover Health Services, Inc. could be subject to for tax
year ended December 31, 2009?
A. $22,500
B. $19,300
C. $7,500
D. $0
43. ___ During the 2009 calendar year, the Baker Corporation
distributed a dividend in the form of a building to its sole
shareholder. The building has a FMV of $60,000 and an
adjusted basis of $20,000. The corporation has sufficient E&P.
Not considering any potential tax effect of any taxes on the
distribution, the net effect of the transaction on E&P is:
A. An increase of $40,000.
B. An increase of $20,000.
C. A decrease of $40,000.
D. A decrease of $20,000.

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44. ___ Walnut, Inc. is a C corporation which was started in 1998. At


the beginning of the current year, Walnut, Inc. has accumulated earnings and profits of $100,000. During the current year
Walnut, Inc. makes a $5,000 distribution to its 100% shareholder in the first month of each quarter. At the end of the current year, Walnut, Inc. had $150,000 in gross income and
$140,000 in allowable expenses from ordinary business operations. Walnut, Inc. also received $5,000 in fully tax-exempt
interest from state bonds. What part of the second-quarter distribution is treated as a distribution of accumulated earnings
and profits?
A. $1,250
B. $2,500
C. $3,750
D. $5,000
45. ___ Hampshire, Inc., a calendar-year taxpayer, had an
accumulated earnings and profits balance at the beginning of
2009 of $20,000. During the 2009 year, Hampshire, Inc.
distributed $30,000 to its sole individual shareholder. On
December 31, 2009, Hampshire, Inc. reported taxable income
of $50,000, federal income taxes of $7,500, and had taxexempt interest on municipal bonds of $2,500. What is
Hampshire, Inc.s accumulated earnings and profits balance at
the beginning of 2010?
A. $15,000
B. $25,000
C. $30,000
D. $35,000

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46. ___ Maple Corporation had a net loss per its books for 2009 as
follows:
Gross Sales
$340,000
Cost of Goods Sold
$150,000
Depreciation
60,000
Charitable Contributions
10,000
Salaries
130,000
Meals and entertainment
20,000
Net income (loss) per books (30,000)
Total per books
$340,000
$340,000
Maple Corporation uses an accelerated method of depreciation
for tax purposes, but not for book purposes. Maple
Corporations tax depreciation for 2009 is $75,000. What is the
taxable income for federal income tax purposes in 2009 for
Maple Corporation?
A. ($5,000)
B. ($20,000)
C. ($25,000)
D. ($35,000)
47. ___ Which one of the following statements is incorrect with regard
to property distributions?
A. All stock distributions are treated as property distributions.
B. Property distributions to shareholders are measured by their
FMV on the distribution date adjusted for liabilities.
C. The distributing corporation treats the property distributed
as though sold to the shareholder at FMV or the amount of
liabilities the shareholder assumes, whichever is greater.
D. The shareholders basis in the property distributed is usually
the FMV on the date of distribution.
48. ___ The Smart Corporation distributes an office building to Collin, a
shareholder of the corporation. The FMV of the building
exceeds its basis to the corporation. Which of the following
statements is true with regard to this transaction?
A. Smart Corporation realizes, but does not recognize, gain on
the distribution.
B. Smart Corporation elects not to report the gain on this
distribution.
C. Smart Corporation must recognize gain on this distribution.
D. Collin must recognize the losses on this distribution on his
return as a shareholder.

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49. ___ Olympic Corporation distributed real estate with a FMV of


$500,000 to its sole shareholder, Joshua. Olympics basis in
the real estate is $400,000. What is the tax effect of the
distribution to Olympic and what is Joshuas basis in the real
estate?
A. $0 gain/loss to Olympic; $400,000 basis to Joshua.
B. $100,000 gain to Olympic; $400,000 basis to Joshua.
C. $0 gain/loss to Olympic; $500,000 basis to Joshua.
D. $100,000 gain to Olympic; $500,000 basis to Joshua.
50. ___ Rose Corporation, a calendar-year corporation, had
accumulated E&P of $40,000 as of January 1, 2009. However,
for the first six months of 2009 Rose Corporation had an
operating loss of $36,000, and finished the year with a total
net operating loss for tax year 2009 of $55,000. Rose
Corporation distributed $15,000 to its shareholders on July 1,
2009. Which of the following is correct?
A. The entire distribution of $15,000 is taxable.
B. The entire distribution is not taxable.
C. $12,500 of the distribution is taxable.
D. $14,000 of the distribution is taxable.
51. ___ Healey, Inc. owned a parcel of undeveloped land with an
adjusted basis of $10,000, an attached liability of $4,000, and
a fair market value of $15,000. In 2009 this land was
distributed by Healey, Inc. to its sole shareholder who also
assumed the liability. Healey, Inc. recognizes how much of a
gain on this distribution?
A. $0
B. $1,000
C. $5,000
D. $10,000
52. ___ Gold Corporation distributes land with a fair market value of
$25,000 to its sole shareholder Donna Gold, who assumes the
mortgage on the land of $35,000. This land had an adjusted
basis to Gold Corporation of $20,000. Gold Corporation must
recognize how much of a gain on this distribution?
A. $5,000
B. $10,000
C. $15,000
D. $25,000

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53. ___ Which of the following statements regarding distributions of


stock is not true?
A. Distributions of stock and stock rights are never treated as
property.
B. Stock rights are distributions by a corporation of rights to
acquire its stock.
C. Distributions of stock dividends and stock rights are
generally tax-free to shareholders.
D. Expenses of issuing a stock dividend are not deductible but
must be capitalized.
54. ___ Common kinds of distributions by a corporation to shareholders
are:
A. Ordinary dividends.
B. Capital gain distribution.
C. Nontaxable distribution.
D. All of the above.
55. ___ Annual statement Form 1099-DIV must be furnished to
recipients of which of the following:
A. Liquidating distributions.
B. Patronage dividends.
C. A and B.
D. None of the above.
56. ___ A corporate payer of an individual shareholder dividend does
not have the taxpayer identification number for that
shareholder. What backup withholding percentage rate must
the corporate payer use for this shareholders dividend
payments?
A. 15%
B. 28%
C. 35%
D. 39%

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57. ___ Rose Corporation is a calendar-year filing corporation that had


accumulated earnings and profits at the end of 2008 of $5,000.
At the end of 2009 Rose Corporation had current-year earnings
and profits of $1,000. On December 31, 2009, Rose
Corporation distributed to the sole shareholder, Paul Rose, an
automobile purchased for $10,000 with a fair market value of
$8,000. Paul Rose assumed a liability on the automobile of
$1,000. What amount of dividend paid to Paul Rose must Rose
Corporation report as an ordinary dividend in box 1a of Form
1099-DIV?
A. $6,000
B. $7,000
C. $8,000
D. $10,000
58. ___ Charles Watson owns 100% of the outstanding shares of
Watson Corporation. Charles Watson acquired these shares in
2000 for $5,000. Watson Corporation had total earnings and
profits at the end of 2009 of $10,000. On December 31, 2009,
Watson Corporation distributed $8,000 in cash and property
with a fair market value of $7,000 to Charles Watson. In 2009
how much in capital gain must Charles Watson report from this
distribution?
A. $0
B. $5,000
C. $10,000
D. $15,000
59. ___ In 2003, Mark purchased 100 shares of Roman, Inc. for $10
per share. In 2009 Roman, Inc. completely liquidated and
distributed $8,000 to Mark. Mark must report income from this
distribution as:
A. Ordinary other income.
B. Dividends.
C. Capital gains.
D. Return of capital.

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60. ___ Select the answer that best describes what happens when
shareholders receive a series of distributions, not part of an
installment obligation, covering two or more consecutive tax
years in redemption of all of the stock of a corporation
pursuant to a plan intended to result in the complete
liquidation of the corporation.
A. The shareholders are allowed to recover their respective
basis in the stock before recognizing any gains.
B. The shareholders treat the distributions as dividends to the
extent of the corporations E&P.
C. The shareholders recognize a pro-rata portion of the gain in
each of the years that distributions are received.
D. No losses from the transactions are deductible.
61. ___ Rachel purchased 100 shares of Comet Corporation stock for
$500 in 2004. In 2009, Rachel received $5,000 in a distribution from the partial liquidation of Comet Corporation. On her
personal 2009 income tax return, Rachel must report income
from this transaction as:
A. Dividends.
B. Capital gains.
C. Other.
D. None of the above.
62. ___ Diana, the sole shareholder of Charles Corporation stock, owns
1,000 shares, which she purchased in 1997. Dianas basis in
the stock is $2,000,000. During 2009, Charles Corp., which
had E&P of $5,000,000, redeemed 900 shares for $4,500,000.
What is the amount and character of Dianas gain?
A. $2,700,000 ordinary income.
B. $2,700,000 capital gain.
C. $4,500,000 dividend.
D. $4,500,000 capital gain.
63. ___ In 2009, pursuant to a complete liquidation, Richards
Corporation distributes the following to a shareholder:
inventory, basis $10,000, FMV $20,000; and land held as an
investment, basis $5,000, FMV $40,000. The land is subject to
a $30,000 liability. What are the amounts and character of
income to be recognized by Richards Corporation?
A. $10,000 ordinary income; $35,000 capital gain.
B. $10,000 ordinary income; $65,000 capital gain.
C. $0 ordinary income; $0 capital gain.
D. $10,000 ordinary income; $5,000 capital gain.

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64. ___ In 2001 Adam purchased 100 shares of Call Corporation stock
for $50 per share. During 2009 Call Corporation completely
liquidated. After paying its liabilities, Call Corporation
distributed to its shareholders $10,000 in cash and appreciated
property sold for $90,000. Adams portion received a
liquidating distribution from Call Corporation of $10,000.
Adam must report what amount of capital gains income from
this distribution?
A. $4,500
B. $5,000
C. $22,500
D. $25,000
65. ___ During 2009, Corporation T distributed machinery with a FMV
of $300,000 and an adjusted basis to T of $150,000 to Kevin in
exchange for 85% of Kevins interest in Corporation T. This
distribution was under a plan of partial liquidation that resulted
in a contraction of the business. Kevins adjusted basis in the
stock exchanged with T was $180,000. T had an earnings and
profit balance of $500,000 prior to the partial liquidation. What
is the character and amount of Kevins recognized gain on the
distribution?
A. $120,000 capital gain.
B. $150,000 capital gain.
C. $150,000 capital loss.
D. $300,000 dividend income.
66. ___ Which of the following statements about a controlled group of
corporations is true?
A. Members of a controlled group are treated as one group to
figure the applicability of the additional 5% and the
additional 3% tax.
B. A parent corporation and its 80%-owned subsidiary make
up a controlled group.
C. All members of a controlled group need not use the parent
corporations tax year.
D. All of the above.

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67. ___ York, Inc. directly owns stock of Ajax Corporation. To


determine if Ajax Corporation is a member of a controlled
group with York, Inc. as the common parent, York, Inc. must
own at least what percentage of the voting and total value of
the Ajax Corporation stock?
A. 51%
B. 75%
C. 80%
D. 100%
68. ___ The Dana Corporation has two subsidiary corporations. In
order to determine that the subsidiary corporations are in a
controlled corporate group, which of the following must be
true?
A. Ten or fewer persons (individuals, estates, or trusts) own at
least 80% of the voting stock or value of shares of each of
two or more corporations.
B. Ten or fewer persons own more that 50% of the voting
power or value of shares of each corporation, considering a
particular persons stock only to the extent that it is owned
identically with regard to each corporation.
C. A persons stock ownership is not taken into account for
purposes of the 80% requirement unless that shareholder
owns stock in all of the corporations considered to be in the
group.
D. The subsidiaries must be located in the same state.
69. ___ Art, Betty, and Cora are equal partners in ABC Partnership.
ABC Partnership and Betty are the only two shareholders in
Angel, Inc. with direct ownership of 60% and 40%
respectively. Based upon the constructive ownership rules for
stock redemptions, what are ABCs and Bettys constructive
ownership of Angel?
Betty
ABC
A. 60%
60%
B. 100%
40%
C. 100%
60%
D. 100%
100%

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70. ___ Larry owned 35 shares of Flower Corporation stock for which
he had paid $3,500. He sold this stock to his sister, Karen, for
$3,000. Karen later sold this stock to her cousin, Joe, for
$10,000. What is Larrys and Karens recognized gain or loss, if
any?
A. $0 loss for Larry and $6,500 gain for Karen.
B. $0 loss for Larry and $7,000 gain for Karen.
C. $500 loss for Larry and $7,000 gain for Karen.
D. $0 for Larry and $0 for Karen.
71. ___ The basis of property you buy is usually its cost. In
determining the acquisition basis in C corporation stock, a
shareholder must know:
A. The amount paid in cash or property.
B. The amount paid in cash and debt obligations.
C. The value of provided services and debt obligations
assumed.
D. All of the above.
72. ___ Carol provides services in 2002 to Bragg Corporation. Her
service contract with Bragg Corporation listed her fee at
$50,000 receivable in cash and/or stock. At the time her fee
was due, Bragg Corporation stock was trading for $1,000 per
share. Carol elected to receive $30,000 in cash and 20 shares
of Bragg Corporation stock. In 2004, the Bragg Corporation
stock split increasing the number of Carols shares to 40. In
2009, Carol sells 20 shares of her Bragg Corporation stock for
$1,500 per share. What is Carols basis in the Bragg Corporation shares she still owns?
A. $10,000
B. $20,000
C. $30,000
D. $40,000

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73. ___ In 2002, Ralph received ten shares of White Corporation stock
as a gift from his father. Ralphs father had originally paid $10
per share for this stock. The stock was trading for $20 per
share at the time of the gift. In 2006, Ralph purchased an
additional 20 shares of White Corporation stock for a price of
$30 per share. Ralph was charged a $20 transaction fee on this
purchase. In October of 2009, Ralph sold 20 shares of his
White Corporation stock. Ralph cannot adequately identify the
shares he disposed of. What is Ralphs basis in the White
Corporation shares he still owns?
A. $100
B. $200
C. $310
D. $360
74. ___ Mr. Forest transferred a warehouse to Corporation Deer in
exchange for 82% of its stock and $5,000 cash. The
warehouse had an adjusted basis to Mr. Forest of $30,000 and
a FMV of $80,000. The warehouse was subject to a mortgage
of $60,000, which Deer assumed for a bona fide business
purpose. The FMV of Deers stock at the date of transfer was
$15,000. What is Mr. Forests realized gain, recognized gain,
and stock basis, and what is Corporation Deers basis in the
warehouse received?
Realized
Recognized
Stock
Warehouse
Gain
Gain
Basis
Basis
A. $35,000
$20,000
$60,000
$55,000
B. $50,000
$35,000
$0
$65,000
C. $35,000
$35,000
$65,000
$60,000
D. $50,000
$20,000
$65,000
$70,000

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CORPORATION ANSWERS
1.

B. Generally, a corporation must make estimated tax payments if it


expects its estimated tax for the year to be $500 or more.

2.

A. The corporation must pay 25% of the lower of: 1) 100% of the
current years tax; or 2) 100% of the prior years tax. With the
third estimated payment, 75% of the tax should be paid. With
$40,000 estimated tax, $30,000 needs to be paid in by
September 15. Since $10,000 has been paid in, the September
15 payment should be $20,000.

3.

A. Once the $200,000 threshold is met, the taxpayer must


continue to make deposits using EFTPS in later years even if
substantial deposits are less than the $200,000 threshold.

4.

B. Filing Form 7004 requests a six-month extension of time to file


a corporation income tax return. The IRS will grant an extension
if the taxpayer completes the form properly, files it, and pays
any tax due by the original due date for the return.

5.

C. A corporation that has dissolved must generally file by the


fifteenth day of the third month after the date the corporation is
dissolved.

6.

C. A corporation that does not file on time can be penalized 5% of


the unpaid tax for each month or part of a month the return is
late, up to a maximum of 25% of the unpaid tax. The minimum
penalty for a return that is over 60 days late is the smaller of
the tax due or $135.

7.

B. Ordinarily, the IRS has three years after an income tax return is
filed to assess additional tax or to begin court action to collect
the tax. The fiduciary representing a dissolving corporation or a
decedents estate may request a prompt assessment of tax. This
limits the time to 18 months from the date the fiduciary files the
request, but not beyond three years from the date the return
was filed.

8.

B. If the transferee meets the control requirements, gain is only


recognized to the extent of the money or other property
received. The FMV of the property does not enter into the
calculation.

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9.

A. If the transferor does not own at least 80% of the total


combined voting power of all classes of stock entitled to vote
and at least 80% of the outstanding shares of each class of
nonvoting stock, gain is recognized to the extent the FMV of the
property exceeds the transferors adjusted basis.

10. B. If a taxpayer transfers property or money to a corporation in


exchange for stock in that corporation, and immediately
afterward is in control of the corporation, the exchange is
usually not taxable. This rule applies both to individuals and to
groups who transfer property to a corporation. It also applies
whether the corporation is being formed or is already operating.
11. B. In an otherwise nontaxable exchange of property for corporate
stock, when the taxpayer also receives money or other property
other than stock, gain is recognized up to the amount of money
plus the fair market value of the property received. Receipt of
property when contributing cash is treated as a purchase, and
gain is not recognized.
12. D. Preferred stock is nonqualified preferred stock when the holder
can require the issuer to redeem or purchase the stock.
Nonqualified preferred stock is treated as property other than
stock and is subject to the gain recognition rules like money or
other property.
13. A. The four transferors together are in control of the corporation,
so the transfer does qualify as a 351 tax-free transfer. The
liability assumed on the land is less than Johns adjusted basis
in the land, so no gain is recognized on the transfer.
14. B. The transfer of stock for services is compensation to the
employee. The corporation can deduct as compensation the FMV
of the stock on the day it is transferred.
15. D. If a corporation transfers property to an employee as payment
for services, the corporation can generally deduct it as wages.
The amount deductible is the FMV of the property on the date of
the transfer. The corporation must also recognize any gain or
loss realized on the transfer.

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16. C. A transfer of property, including the companys stock, to an


employee as payment for services is deductible as
compensation. The amount deductible is the stocks fair market
value on the date of the transfer, less any amount the employee
pays for the stock.
17. A. If money or property other than stock is received on the
transfer to a corporation, the transferor recognizes gain up to
the extent of the money plus the FMV of the property received.
A loss may be realized on the transfer, but no loss is recognized.
18. C. The liability the corporation assumes is more than the adjusted
basis in the property, so gain is recognized up to the difference.
Tami received $55,000 ($50,000 FMV of stock and $5,000
excess on the liability transferred) and realized a gain of
$15,000. Tami also recognizes gain of $5,000 because of the
liability. The basis in stock is the adjusted basis of the property
transferred ($40,000) increased by gain recognized ($5,000)
decreased by the liability assumed by the corporation ($45,000)
for a total of $0.
19. C. The total amount received is $120,000 ($75,000 FMV of stock,
$20,000 cash, and $25,000 liability assumed). The adjusted
basis of the property is $70,000, which results in realized gain
of $50,000. The liability is not in excess of Jennys adjusted
basis, so it is not treated as money or other property, and only
the gain up to the amount of cash, $20,000, is recognized.
20. C. A corporation that receives property in exchange for its stock
generally has the same basis the transferor had in the property,
increased by any gain recognized on the exchange.
21. A. For a nontaxable transfer to a corporation, the transfer must be
money or property. Services do not qualify. In a non-80%control transaction, the basis of the transferred property is the
FMV of the stock at the time of the exchange.
22. C. The corporations basis in the property received is the adjusted
basis of the transferor plus any gain recognized. The gain
recognized is the lesser of boot or realized gain. Boot is $3,000.
Realized gain is $9,000 ($22,000 + $3,000 - $16,000).

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23. C. Costs incurred to get a business started are capital expenses.


These costs would be deductible if the business were in
operation, but prior to starting, these costs are amortized.
Start-up costs do not include deductible interest, taxes, or
research and experimental costs.
24. A. Organizational costs include: (1) costs of temporary directors,
(2) costs of organizational meetings, (3) state incorporation
fees, (4) costs of accounting services for setting up the
corporation, and (5) costs of legal services for items such as
drafting the charter, bylaws, terms of the original stock
certificates, and minutes of organizational meetings.
25. D. Organizational costs can be amortized if they are for the
creation of the corporation, chargeable to a capital account,
could be amortized over the life of the corporation if the
corporation had a fixed life, and incurred before the end of the
first tax year in which the corporation is in business.
26. D. For expenses paid or incurred before October 23, 2004, start-up
expenses could be amortized for no less than 60 months. After
October 22, 2004, up to $5,000 could be deducted and the
remainder can be amortized over a period no less than 180
months.
27. A. The $18,000 for the purchase of equipment is added to the
basis of the equipment and depreciated. The market feasibility
study, advertising prior to opening, and legal fees are
amortizable start-up and organizational expenses, for a total of
$12,000. Over a period of 180 months, this results in $66.67
per month. The business was open for a full year, allowing $800
to be deducted in 2009. The corporation could have chosen to
currently deduct $5,000 of start-up costs, $3,600 of
organizational costs, and amortize the remaining $3,400 over
180 months.
28. D. There is no provision to carryback, so any excess is carried over
for five years. Cash-method corporations can deduct
contributions only in the year paid while accrual-method
corporations can deduct contributions in the year authorized, if
they are paid within 2 months after the close of the tax year.

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29. C. A corporation cannot deduct charitable contributions that exceed


10% of its taxable income for the tax year. Figure taxable
income for this purpose without: the deduction for charitable
contributions, the deduction for dividends received; any net
operating loss carryback to the tax year; or any capital loss
carryback to the tax year. Following this procedure, Roberts
Corporation had taxable income of $300,000, allowing for a
charitable contribution of $30,000.
30. B. Charitable contributions are limited to 10% of the corporations
taxable income, computed before the dividends-received
deduction. The taxable income for charitable purposes is
computed as $1,000,000 - 350,000 - 395,000 + 65,000 =
$320,000. The expense of $75,000 - $32,000 contribution
allows a carryover of $43,000.
31. C. The dividends-received deduction is allowed up to 70% if the
recipient corporation owns less than 20% of the distributing
corporation, or 80% if owning 20% or more. The deduction is
limited to 70% or 80% of taxable income. No deduction is
allowed for certain dividends, which includes dividends from a
corporation exempt from tax under 501 or 521.
32. B. A corporation can deduct, within certain limits, 70% of the
dividends received if the corporation receiving the dividends
owns less than 20% of the corporation distributing the dividend.
If the corporation owns 20% or more of the distributing
corporations stock, it can, subject to certain limits, deduct 80%
of the dividends received.
33. C. A corporation can deduct, within certain limits, 80% of the
dividends received if the corporation receiving the dividends
owns 20% or more of the distributing corporations stock.
34. B. By owning 20% or more of Sigma, Kappa is eligible for the 80%
DRD. If the corporation does not have a net operating loss after
subtracting the maximum DRD, the actual DRD is limited to
80% of the corporations taxable income determined before the
deduction for dividends. The full dividends-received deduction is
$96,000 ($120,000 X 80%). The taxable income without the
deduction is $110,000 ($390,000 - $400,000 + $120,000). The
DRD is limited to $88,000 ($110,000 X 80%).

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35. B. The taxable income is a loss of $150,000 ($500,000 + $100,000


- $750,000). If it claims the full dividends-received deduction of
$80,000 ($100,000 x 80%) and combines it with an operating
loss of $150,000, it will have an NOL of $230,000. Therefore,
the 80% of taxable income limit does not apply.
36. B. The $90,000 long-term capital loss is applied to offset the
$40,000 short-term capital gain. The $50,000 remaining capital
loss is available to be carried back three years and then forward
five years to offset capital gain in those years.
37. C. A corporation can deduct capital losses only up to the amount of
its capital gains. If the corporation has an excess capital loss in
the current year, it carries the loss to other tax years and
deducts it from capital gains that occur in those years. The loss
is carried to other years in the following order: three years prior
to the loss; two years prior to the loss; one year prior to the
loss; and any loss remaining is carried forward for five years.
38. B. The corporation has a net loss of $125,000 from operations.
They received $150,000 of dividend income from a 23%-owned
company. Because Tilden would have a loss by taking the full
DRD, the income limitation does not apply. As such, the DRD is
$120,000. Tildens NOL is $95,000 ($125,000 loss + $150,000 $120,000).
39. A. The net operating loss of the corporation is computed without
consideration of the charitable contribution deduction and the
net operating loss carryover ($300,000 - (450,000 - 2,500) = 147,500).
40. C. Form 1120 Schedule M-1 is for reconciling income (loss) per
books with income per return. Start with income per books
($100,000) and add federal income tax paid ($22,250), excess
capital losses over capital gains ($5,000) income subject to tax
not reported on books, and expenses recorded on books not
reported on the return ($500). From this total, subtract income
reported on the books not included on the return ($11,000) and
deductions on the return but not on the books. The result is
income as shown on Line 28, page 1 of Form 1120 ($116,750).

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41. D. This is a personal service corporation because all of the


corporations activities involve the performance of personal
services and at least 95% of the corporations stock is owned by
the employee performing the personal service. As a PSC, the
income is subject to tax at a 35% rate.
42. A. The $500,000 necessary to redeem a deceased shareholders
stock is considered a reasonable business need. As a personal
service corporation, up to $150,000 can be accumulated for
other reasonable business needs. This leaves $150,000 excess
subject to tax at a rate of 15%.
43. D. The corporation will recognize a gain of $40,000 as if the
property were sold at FMV. However, the net effect on E&P, due
to the distribution, is a decrease of $20,000.
44. A. The current-year E&P (taxable income of $10,000 plus taxexempt income of $5,000) is divided by the total distributions
for the year. The result is .75, or 75% ($15,000/$20,000). This
percentage is applied to each distribution to determine the
amount from current E&P. With sufficient accumulated E&P, the
remaining 25% of each distribution is from accumulated E&P.
45. D. If the corporations earnings and profits for the year, figured as
of the close of the tax year without reduction for any
distributions made during the year, are more than the total
amount of distributions made during the year, all distributions
made during the year are treated as distributions from currentyear earnings and profits. The current-year earnings and profits
is the taxable income, plus tax-exempt interest, minus the
federal income taxes, for a total of $45,000. After the
distribution of $30,000, the remaining $15,000 is added to the
$20,000 accumulated amount to determine the accumulated
earnings and profits for the start of 2010.
46. C. For tax purposes, Maple corporation has an NOL, which
disallows the charitable contribution. In addition, meals and
entertainment is limited to 50%. With expenses of $365,000
and gross sales of $340,000, the corporations taxable income is
($25,000).

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47. A. Property generally does not include stock in the corporation or


rights to acquire this stock. The amount of the distribution is the
money paid plus the FMV of any property transferred, reduced
by liabilities, the shareholder assumes in connection with the
distribution.
48. C. A corporation will recognize a gain on the distribution of
property to a shareholder if the FMV of the property is more
than its adjusted basis. This is generally the same treatment the
corporation would receive if the property were sold.
49. D. A corporation will recognize gain on the distribution of property
with a FMV in excess of its adjusted basis ($100,000). The FMV
of the property distributed to a shareholder becomes the
shareholders basis in that property ($500,000).
50. C. The calculation for computing the taxable portion:
Accumulated E&P 1/1
$40,000
E&P deficit for the year prorated to the date of distribution
( 27,500)
E&P available 7/1
12,500
Distribution 7/1 taxable dividend
$12,500
The accumulated E&P available at the time of distribution was
$12,500. Of the $15,000 distribution, only $12,500 is a taxable
dividend.
51. C. A corporation will recognize gain on the distribution of property
to a shareholder if the fair market value of the property is more
than its adjusted basis. For this purpose, the FMV of the
property is the greater of the actual FMV, or the amount of any
liability the shareholder assumed in connection with the
distribution of the property.
52. C. A corporation will recognize gain on the distribution of property
to a shareholder if the FMV of the property is greater than its
adjusted basis. For this purpose, the FMV is the greater of the
actual FMV or the amount of any liability the shareholder
assumed in connection with the distribution of the property.
53. A. Distributions of stock dividends and stock rights are generally
tax-free to shareholders. However, stock and stock rights may
be treated as property in certain situations, such as any
shareholder has the choice to receive cash or other property
instead of stock or stock rights.

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54. D. To the extent of earnings and profits, a distribution is a


dividend. If no earnings and profits exist, a distribution is
applied against and reduces a shareholders basis. To the extent
the distribution is more than basis, the shareholder has gain
(usually capital gain) from the sale or exchange of property.
55. A. Patronage dividends are reported on Form 1099-PATR.
56. B. If the recipient does not furnish its TIN to the corporation in the
manner required, the corporation must backup withhold at a
28% rate on certain dividend payments reported.
57. A. A corporate distribution to a shareholder is generally treated as
a distribution of earnings and profits. Any part of a distribution
from either current or accumulated earnings and profits is
reported to the shareholder as a dividend. Any part of the
distribution that is not from earnings and profits is applied
against and reduces the shareholders adjusted basis in the
stock.
58. A. Any part of a distribution from either current or accumulated
earnings and profits is reported to the shareholder as a dividend
(the first $10,000 of the $15,000 distributed). Any part of the
distribution that is not from earnings and profits (the remaining
$5,000) is applied against and reduces the shareholders
adjusted basis in the stock. With an adjusted stock basis of
$5,000, there is no excess and the stock basis is reduced to
zero.
59. C. A liquidating distribution received is not taxable until the
shareholder has recovered the basis in his or her stock. After
the basis has been reduced to zero, the taxpayer must report
the liquidating distributions as a capital gain.
60. A. When a shareholder receives a liquidating distribution in
installments not part of an installment sale, the shareholder is
able to recover basis before recognizing gain.
61. B. A redemption made in partial liquidation of the corporation is
treated as a sale of the stock. This results in capital gain
treatment.

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62. C. The corporation redeemed shares of stock which do not qualify


as a partial liquidation. Therefore, the distribution is treated as a
dividend to the extent of E&P. All $4,500,000 is treated as a
dividend.
63. A. Gain or loss is recognized by a liquidating corporation on the
distribution of property in complete liquidation as if such
property were sold to the distributee at its FMV. If the property
is subject to a liability or the shareholder assumes a liability of
the liquidating corporation, the FMV of such property shall be
treated as not less than the amount of the liability. Property
held for sale to customers or property that will become part of
merchandise for sale to customers is not a capital asset, and
thus results in ordinary income when sold.
64. B. Amounts received by a shareholder in a distribution in complete
liquidation of a corporation are treated as full payment in
exchange for stock. The amount received in excess of the
shareholders basis in the stock is capital gain.
65. A. Corporation T distributed the property under the rules for partial
liquidation. Therefore, the distribution is first treated as a return
of capital, and then any gain or loss is capital. The computation
is as follows:
FMV of machinery
$300,000
Less: Basis in Kevins stock
180,000
Amount treated as capital gain
$120,000
66. D. The component members of a controlled group of corporations
are limited to one apportionable amount of each income tax
bracket; one $250,000 amount for purposes of computing the
accumulated earnings credit; one $40,000 exemption amount
for purposes of computing the amount of the minimum tax; and
one $2,000,000 amount for purposes of computing the
environmental tax. Reg. 1.1561-2 also provides for one surtax
exemption.
67. C. A parent-subsidiary group is one or more chains of corporations
connected through stock ownership with a common parent
corporation if stock possessing at least 80% of the total
combined voting power of all classes of stock entitled to vote or
at least 80% of the total value of shares of all classes of stock of
each of the corporations, except the common parent
corporation, is directly or indirectly owned by one or more of the
other corporations.
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68. C. Brother-sister controlled group means two or more corporations


if the same five or fewer persons own at least 80% of the total
stock of each corporation and more than 50% of stock of each
corporation.
69. C. ABC partnership owns directly 60% and indirectly through Betty,
the remaining 40%. Betty owns 40% directly and indirectly 20%
(one-third of 60%) of the partnerships direct interest.
70. A. Larry realized a loss of $500 on the sale of stock to a related
party. Due to the related party rules, this loss is not recognized.
When Karen sells the stock, realizing a gain of $7,000, she is
allowed to use the loss previously disallowed to Larry, resulting
in recognized gain of $6,500.
71. D. The basis of property the taxpayer buys is usually its cost. The
cost is the amount the taxpayer pays in cash, debt obligations,
or other property or services. Stock received for providing
services is income to the recipient. This amount of income also
establishes basis in that stock.
72. A. Carols basis in the stock is $20,000, the amount included in
income. When the stock split, resulting in Carol holding 40
shares, the basis was allocated to both the old and new shares,
or $500 per share. Carol has 20 shares remaining, for a total
basis of $10,000.
73. C. If the shares are not specifically identified, the disposition is
based on the rule that first ones obtained are sold first. The ten
shares received as a gift are considered sold first. The next ten
shares are from those purchased. The transaction fee is added
to the cost for an overall basis of $620, or $31 dollars per share.
With ten shares remaining, his remaining basis is $310.

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74. B.
Amount realized:

$ 5,000
60,000
15,000
80,000

Realized gain:

80,000
30,000
50,000

building basis

30,000

excess of mortgage over

5,000
35,000

cash
total

+
-

30,000
5,000
35,000
60,000
0

building basis
cash
recognized gain
mortgage liability relief
total

30,000
35,000
65,000

basis
recognized gain
total

Recognized gain:
basis

Basis in stock:

Corporations basis
in warehouse:

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cash
mortgage
stock
total

2010 NATP EA Exam Review Course, Part II

S CORPORATIONS
ELIGIBLE CORPORATIONS
REQUIREMENTS FOR S CORPORATION STATUS
An entity must be a domestic corporation or a domestic eligible entity
that is either organized in the United States or organized under federal
or state law.
The term corporation includes a joint-stock company, certain
insurance companies, or an association that has the characteristics of a
corporation.
A limited liability company (LLC) normally files the election to be taxed
as a corporation on Form 8832, Entity Classification Election, in
accordance with Reg. 301.7701-3(c). However, if an LLC that is
eligible to elect S status timely files an S corporation election, Form
2553, Election by a Small Business Corporation, the entity is considered
to have made the election to be taxed as a corporation [Reg.
301.7701-3(c)(1)(v)(C)]. This means that the Form 8832 does not
have to be filed if the entity properly elects S status.
It must have no more than 100 shareholders. When counting
shareholders, the following rules apply:
Count the persons who are considered beneficiaries if the stock is
actually held by a trust. Do not count the trust itself as a
shareholder.
Count a husband and wife and their estates as one shareholder, even
if they own stock separately.
A member of a family can elect under 1361(c)(1) to treat all
members of the family as one shareholder.
Otherwise, count everyone who owns any stock, even if the stock is
owned jointly with someone else.
S corporations must have as shareholders only individuals, estates
(including estates of individuals in bankruptcy), certain trusts, and
certain tax-exempt organizations including retirement plans and

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charitable organizations. Partnerships and corporations cannot be


shareholders in an S corporation.
S corporations must have shareholders who are
the United States. Nonresident aliens cannot be
residents married to alien spouses who have an
the stock through community property laws will
shareholders [Reg. 1.1361-1(g)].

citizens or residents of
shareholders. U.S.
ownership interest in
not be eligible

S corporations have only one class of stock (disregarding differences in


voting rights).
Generally, a corporation is treated as having only one class of stock
if all outstanding shares of the corporations stock confer identical
rights to distribution and liquidation proceeds.
Stock may have differences in voting rights and still be considered
one class of stock.
S corporations have a permitted tax year as required by 1378 or they
can make a 444 election to have a tax year other than a permitted tax
year.
A permitted tax year is a tax year ending December 31, or any other
tax year for which the corporation establishes a business purpose.
An election under 444 can be made only if the deferral period of the
taxable year elected is not longer than three months.
Each shareholder must consent to the election to be taxed as an S
corporation.

INELIGIBLE CORPORATIONS
The following corporations are not eligible to elect S status:
A financial institution such as a bank, mutual savings bank,
cooperative bank, domestic building and loan association using the
reserve method of accounting for bad debts or losses from bank
loans, or taxable mortgage pools (TMP).
An insurance company taxed under Subchapter L of the Internal
Revenue Code.
A corporation that takes the Puerto Rico and possessions tax credit
for doing business in a United States possession.
A Domestic International Sales Corporation (DISC) or former DISC.

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OTHER SHAREHOLDER OPTIONS

QUALIFIED SUBSIDIARY
A parent S corporation can elect to treat an eligible wholly-owned
subsidiary as a qualified subchapter S subsidiary (QSub) under Reg.
1.1361-3.
As a QSub, the subsidiary is not treated as a separate corporation and
all of the assets, liabilities, income, built-in gains, E&P, etc. are treated
as those of the parent.
The parent corporation makes the election by filing Form 8869,
Qualified Subchapter S Subsidiary Election.

C CORPORATION
An S corporation is allowed to own 80% or more of the stock of a C
corporation. Therefore, after December 31, 1996, an S corporation may
be a member of an affiliated group. The S corporation still may not file
a consolidated return.

TRUSTS
Only certain trusts may be S corporation shareholders.
A trustee of a trust may make an election under 1361(d)(2) to be a

qualified subchapter S trust (QSST). An eligible trust is one that is


treated as owned by an individual who is a citizen or resident of the
United States. A QSST is a trust to which an election is made and
has the following characteristics:
Owns stock in one or more S corporations.
Distributes or is required to distribute all of its income to a citizen
or resident of the United States.
Has certain trust terms, including the requirement that there be
only one income beneficiary.
Does not distribute any portion of the trust corpus to anyone
other than the current income beneficiary during the income
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beneficiarys lifetime, including the time at which the trust


terminates.
The income interest of the current income beneficiary ceases on
the earlier of such beneficiarys death or the termination of the
trust.

Note: A husband and wife who file a joint return are considered to
meet the one-income beneficiary requirement even though
they are both income beneficiaries of the trust.

A trust created prior to death of the deemed owner that continues in

existence after death, for no more than the two-year period.


A trust set up to hold stock transferred to it pursuant to the terms of
a will, for no more than the two-year period beginning with the
transfer of the stock.
A trust created to exercise the voting power of stock transferred to
it.
A trustee of a trust may make an election under 1361(e)(3) to be
an electing small business trust (ESBT).
A trust that has only beneficiaries who are individuals, estates, or
certain tax-exempt organizations qualifying to receive tax
deductible contributions.
Interests must be acquired by reason of gift, bequest, or other
nonpurchase acquisition.

Note: Charitable remainder unit trusts and annuity trusts will not
qualify as ESBTs.

Note: Foreign trusts are not eligible to be shareholders of an S


corporation.

Certain grandfathered IRAs and Roth IRAs that hold S corporation

bank stock.

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ELECTING S CORPORATION STATUS


To elect to be an S corporation, a corporation must file Form 2553,
Election By Small Business Corporation. The election permits the income
of the corporation to be taxed to the shareholders of the corporation
rather than to the corporation itself, except for specific taxes.
The election requires the consent of all shareholders of record on the
date filed. If filed after the beginning of the tax year for which it is to be
effective, the consent of any shareholder who owned stock on any day
during the period beginning on the effective date entered on Form 2553
and ending on the day the election is made is also needed. The
following special rules apply in determining who must sign the consent
statement:
If a husband and wife have a community interest in the stock or in
the income from it, both must consent.
Each tenant in common, joint tenant, and tenant by the entirety
must consent.
A minors consent is made by the minor, legal representative of the
minor, or a natural or adoptive parent of the minor if no legal
representative has been appointed.
The consent of an estate is made by the executor or administrator.
For bankruptcy estates, the court appointed fiduciary must consent.
The consent of an electing small business trust (ESBT) is made by
the trustee and, if a grantor trust, the deemed owner.
If the stock is owned by a qualified subchapter S trust (QSST) (other
than an electing small business trust), the deemed owner of the trust
must consent.
If the stock is owned by a trust (other than an ESBT or QSST), the
person treated as the shareholder must consent.
File or fax Form 2553 with the IRS center in Cincinnati or Ogden,
depending on where the corporations principal business, office, or
agency is located.
The election of S corporation status is effective for a tax year if Form
2553 is filed at any time during the previous tax year or by the fifteenth
day of the third month of the tax year to which the election is to apply.
Form 2553 must be signed by the president, treasurer, assistant
treasurer, chief accounting officer, or other corporate officer authorized
to sign.

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Once the election is made, it stays in effect until it is terminated. IRS


consent is generally required for another election by the corporation if
the corporation wants to elect S status again within five years.
The IRS has the authority to treat a late S election, an improper S
election, or no S election as if it was filed properly and timely. The IRS
must determine if there was reasonable cause for failure to file the
election on time.
If the corporation does not file a timely S election, a late election can
still be accepted. Relief is allowed under Rev. Proc. 97-48 if all of the
following conditions are met:
The corporation fails to qualify as an S corporation solely because
Form 2553 was not timely filed.
The corporation and all of its shareholders reported their income
consistent with S corporation status for the year the election
should have been made, and for any subsequent year (if any).
At least six months have elapsed since the date on which the
corporation filed its tax return for the first year the corporation
intended to be an S corporation.
Neither the corporation nor any of its shareholders was notified by
the IRS of any problems with its S election within six months of
the date the corporations first Form 1120S was timely filed.
The S corporation files a Form 2553 with the special notation at
the top of the return Filed Pursuant to Rev. Proc. 97-48.
A late election can be accepted if filed under Rev. Proc. 2003-43.
The corporation fails to qualify as an S corporation on the first day
that S corporation status was desired solely because Form 2553
was not timely filed.
No more than 24 months have passed since the original due date
of the election.
The corporation is seeking relief for late S corporation election
and either:
The corporation has reasonable cause for its failure to make
the timely election; or
The corporation inadvertently filed an invalid election.
A Form 2553 must be filed no later than 24 months after the
original due date of the election. The form must include the
statement at the top Filed Pursuant to Rev. Proc. 2003-43.
Another option is available for eligible entities that fail to file timely
corporate classification and S corporation elections. An eligible entity
that wants to be classified as a subchapter S corporation must elect

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2010 NATP EA Exam Review Course, Part II

to be classified as an association by filing Form 8832 and elect to be


an S corporation by filing Form 2553. If an entity timely files the S
corporation election but fails to file Form 8832, Temporary Reg.
301.7701-3T(c)(1)(ii)(C) applies, and the entity is deemed to have
filed Form 8832. However, the temporary regulations do not apply to
an entity that also fails to timely file Form 2553. In this situation, the
entity must request relief through the letter ruling procedures. A late
election can be accepted if filed under Rev. Proc. 2004-48. Relief is
provided under this provision if the following apply:
The corporation is an eligible entity.
The corporation intended to be classified as an S corporation.
It fails to qualify solely because Form 8832 was not timely filed or
Form 8832 was not deemed to have been filed.
The corporation fails to qualify solely because the S corporation
election was not timely filed.
The corporation has reasonable cause for its failure to file timely
the S corporation election and the entity classification election.
Within six months after the due date for the tax return, excluding
extensions, for the first year the entity intended to be an S
corporation, the entity must file a properly completed From 2553,
with the statement at the top Filed Pursuant to Rev. Proc. 200448.
In 2007, Rev. Proc. 2007-62 was introduced to simplify and
supplement Rev. Proc. 2003-43 and 2004-48. This revenue
procedure gives relief for eligible entities that filed a late S election
and late classification election. The provisions allow the entity to file
Form 2553 with the 1120S for the year the election was intended.
A late S corporation election can be accepted under Rev. Proc.
2007-62 if the following apply:
The entity fails to qualify as an S corporation solely because of
the failure to file a timely Form 2553.
The entity has reasonable cause for failing to file a timely Form
2553.
The entity has not filed a tax return for the first year the
election was intended.
The entity applies for relief under this revenue procedure no
later than six months after the due date of the tax return
(excluding extensions).
No shareholder has reported inconsistently with the
S corporation election.

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A late S corporation election and late classification election can be

accepted under Rev. Proc. 2007-62 if the following apply:


The entity is an eligible entity.
The entity intended to be classified as a corporation as of the
intended effective date of the S corporation.
The entity fails to be a corporation solely because Form 8832
was not timely filed.
The entity fails to qualify as an S corporation solely because
the S corporation election was not timely filed.
The entity has reasonable cause for its failure to file timely
forms 2553 and 8832.
The entity has not filed a tax return for its first year.
The entity applies for relief under this revenue procedure no
later than six months after the due date of the tax return
(excluding extensions).
No taxpayer has reported inconsistently with the S corporation
election.

BASICS OF S CORPORATIONS
PASS-THROUGH ENTITY
Subchapter S treats an S corporation as a pass-through entity in that
the corporation must pass through income and loss items separately to
its shareholders. In this regard, it is much like a partnership where the
ordinary business income or loss is determined and allocated to
shareholders and specific items are separately identified and passed
through to shareholders.
An S corporations taxable income is computed in much the same
manner as for an individual. Even though many corporate tax provisions
apply to an S corporation, various items like the dividends-received
deduction and other corporate credits are not available to an S
corporation.
An S corporation generally does not generate E&P, as does a C
corporation. However, an S corporation may have accumulated E&P

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carried over from prior C corporation years or through the acquisition of


a C corporation.
A net operating loss of an S corporation is passed through to its
shareholders, and thus, cannot be used as a carryback or carryover by
the corporation.
A tax year for which an S corporation election is in effect counts in
determining the years to which a net operating loss from C
corporation years can be carried.
Income in the years for which the S corporation election is in effect
cannot be offset by a loss carryback or carryover from C corporation
years, nor does this income reduce the amount that may be carried
to later years.
Elections affecting the operation of the S corporation and items derived
from the S corporation are made at the corporate level. This includes
elections regarding an accounting method, involuntary conversion
treatment, depreciation, inventory valuation, and the tax year.

FORM 1120S
GENERAL INSTRUCTIONS
Form 1120S, U.S. Income Tax Return for an S Corporation, is used to
report the income, deductions, gains, losses, etc., of the corporation.
Form 1120S is due by the fifteenth day of the third month following the
date the corporations tax year ends March 15 for calendar-year
corporations.
If the S election is terminated during the tax year, the Form 1120S for
the S corporations short year should be filed by the due date (including
extensions) of the C corporations short-year return.
An S corporation can request an automatic six-month extension of time
to file Form 1120S by filing Form 7004.
A return must be signed and dated by the president, vice president,
treasurer, assistant treasurer, chief accounting officer, or any other
corporate officer authorized to sign.

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An S corporation may check a box to authorize the IRS to discuss its tax
return with a paid preparer who signed it. This authorization also allows
the paid preparer to do the following:
Give the IRS any information that is missing from the return.
Call the IRS for information about the processing of its return or the
status of its refund or payments.
Respond to certain IRS notices that the corporation has shared with
the preparer about math errors, offsets, and return preparation.
To correct a previously filed Form 1120S, file an amended Form 1120S
and check box H(4) on page 1. Attach a statement that identifies the
line number of each amended item, the correct amount or treatment of
the item, and an explanation of the reasons for each change.

PENALTIES

LATE FILING OF RETURN


A penalty is assessed against any S corporation that must file a return
and fails to file on time, including extensions, or fails to file a return
with all of the information required, unless the failure is due to
reasonable cause.
For returns required to be filed in 2009, the penalty is $89 for each
month or part of a month (for a maximum of 12 months) the failure
continues, multiplied by the total number of persons who were
shareholders in the S corporation during any part of the
S corporations tax year for which the return is due.
For tax years beginning after December 31, 2009, the penalty is
$195 for each month or part of a month (for a maximum of 12
months) the failure continues, multiplied by the total number of
persons who were shareholders in the S corporation during any part
of the S corporations tax year for which the return is due.
If tax is due with the 1120S, the penalty is equal to the amount stated
above plus 5% of the unpaid tax for each month or part of the month
the return is late, up to a maximum of 25%. Returns late over 60 days
are assessed a minimum of $135 or, if smaller, the balance due on the
return.

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LATE PAYMENT OF TAX


An S corporation that does not pay the tax when due is subject to a
penalty of 0.5% of the unpaid tax for each month or part of the month
the return is late, up to a maximum of 25%. The penalty is not imposed
if the S corporation can show reasonable cause for its failure to pay
timely.

FAILURE TO FURNISH INFORMATION TIMELY


For each failure to furnish Schedule K-1 to a shareholder when due and
each failure to include on Schedule K-1 all the information required to
be shown (or the inclusion of incorrect information), a $50 penalty may
be imposed with respect to each Schedule K-1 for which the failure
occurs.
If the requirement to report correct information is intentionally
disregarded, each $50 penalty is increased to $100 or, if greater, 10%
of the aggregate amount of items required to be reported.
The penalty is not imposed if the S corporation can show reasonable
cause for its failure to furnish the information.

TRUST FUND RECOVERY PENALTY


The trust fund recovery penalty may apply if certain excise, income,
social security, and Medicare taxes that must be collected or withheld
are not collected or withheld, of these taxes are not paid.
This penalty may be imposed on all persons who are determined by the
IRS to have been responsible for collecting, accounting for, and paying
over these taxes, and who acted willfully in not doing so. The penalty is
equal to the unpaid trust fund tax (100%).

ELECTRONIC FILING
Certain S corporations with $10 million or more in total assets that file
at least 250 returns (including Forms W-2 and 1099) per year are
required to file Form 1120S, Schedules K-1, and related forms and
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schedules electronically. Other S corporations generally have the option


to file electronically.
The option to file electronically does not apply to certain returns,
including:
Returns with precomputed penalty and interest.
Returns with reasonable cause for failing to file or pay timely.
Returns with request for overpayment to be applied to another
account.
The IRS may waive the electronic filing rules if the S corporation
demonstrates that a hardship would result if it were required to file its
return electronically.

ACCOUNTING
An S corporation can use the cash, accrual, or any other method
authorized by the IRS.
An S corporation may not use the cash method of accounting if it is a
tax shelter.
Generally, an accrual-method taxpayer can deduct accrued expenses
the year in which all events that determine the liability have
occurred, the liability can be figured with reasonable accuracy, and
economic performance takes place with respect to expenses.
Dealers in securities must use the mark-to-market accounting
method. Dealers in commodities and traders in securities and
commodities may elect to use the mark-to-market accounting
method.
An S corporation must file Form 3115, Application for Change in
Accounting Method, to change its method of accounting.
Generally, an S corporation may not change its accounting period to a
tax year that is not a permitted year.
A permitted year is a calendar year or any other accounting period for
which the corporation can establish that there is a business purpose for
the tax year.
An S corporation may elect to have a tax year other than the permitted
year by making a 444 election, but only if the deferral period of the

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tax year is not longer than the shorter of three months or the deferral
period of the tax year being changed.

INCOME AND EXPENSE ITEMS


Passive activity limitations do not apply to the S corporation but
instead, apply to the individual shareholders. Self-charged interest
income and expenses may be treated as passive activity gross income
and passive activity deductions if the loan proceeds are used in a
passive activity.
Total compensation of all officers paid or incurred in the trade or
business activity of the S corporation is reported separately from
salaries and wages paid or incurred to other employees.
Fringe benefits paid on behalf of officers and employees owning 2% or
less of the S corporation are reported on a separate line as a deduction
in determining the corporations ordinary income or loss.
Compensation paid to officers and employees owning more than 2% of
the S corporations stock includes fringe benefit expenditures made on
their behalf. Also include these amounts as wages on Form W-2.
Amounts paid for health insurance coverage for a more-than-2%
shareholder (including that shareholders spouse and dependents) are
reported as an information item in box 14 of that shareholders Form
W-2. A more-than-2% shareholder may be eligible to deduct this
amount as an adjustment to income on Form 1040.
An S corporation is treated much the same as a C corporation in regard
to compensation paid to nonshareholders and to employeeshareholders.
In a C corporation, compensation may tend to be set higher so that
corporate earnings and, therefore, dividend income, which is taxed
again at the shareholder level, are less.
In an S corporation, compensation may tend to be lower so that
corporate earnings and, therefore, pass-through income, that can be
withdrawn without further tax consequences, are higher. This also
saves the corporation payroll taxes.
Compensation can also be a means of shifting income from a highincome tax bracket individual to a lower-income-tax-bracket related
party.

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Under 1366(e), if an individual who is a member of the family

(within the meaning of 704(e)(3)) of one or more shareholders of


an S corporation renders services for the corporation or furnishes
capital to the corporation without receiving reasonable
compensation, the Secretary shall make such adjustments in the
items taken into account by such individual and such shareholders as
may be necessary in order to reflect the value of such services or
capital.
If the S corporation was a C corporation in a prior year, accumulated
earnings and profits as of the close of the year are now a required entry
on Schedule B, Line 7.

SEPARATELY STATED ITEMS


Items of income, loss, expense, and credit that must be separately
stated are those items that, when separately treated on the
shareholders income tax return (not as part of a lump-sum amount)
could affect the shareholders tax liability.
Separately stated items include the following:
Net income or loss from rental real estate or other rental activities.
Portfolio income or loss (interest, dividends, royalty income, capital
gains/losses) and expenses related to portfolio income or loss.
Net short-term capital gain (loss), net long-term capital gain (loss),
collectibles (28%) gain (loss), and unrecaptured 1250 gain.
Tax-exempt income.
1231 net gain or loss.
Other income (loss) which can include the following:
Other portfolio income (loss).
Net loss from an involuntary conversion.
Net gain or loss from 1256 contracts.
Mining exploration costs recapture.
Gambling gains or losses.
Gain or loss from the disposition of an interest in oil, gas,
geothermal, or other mineral deposits, the sale or exchange of
qualified small business stock, and the amount eligible for 1045
rollover treatment.
179 expense deduction.

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An S corporation may elect to expense part of the cost of certain

tangible property purchased during the tax year.


The corporation does not claim the deduction itself, but instead
passes it through to the shareholders. The maximum deduction
and the annual ceiling limitation are applied both at the S
corporation level and at the taxpayer level.
There is also a reduced dollar limit for costs exceeding $800,000.
If the cost of qualifying 179 property placed in service in a year
is over $800,000, the 179 dollar limit must be reduced by the
amount of cost over $800,000. Hence, if the cost of 179
property placed in service in a year is $1,050,000 or more, the
179 deduction is not allowed, nor can the cost in excess of
$1,050,000 be carried over.
Charitable contributions, identified by cash or noncash, 50% or 30%
limit, or capital gain property.
For contributions made in tax years beginning after December 31,
2005, and before December 31, 2009, shareholders must reduce
their stock basis using their share of the adjusted basis, instead of
the FMV, of contributed property. The AAA account is also
adjusted by the propertys adjusted basis.
The deduction for contributions of certain food inventory has been
extended through December 31, 2009.
Credits (low-income housing credit, qualified rehabilitation expenses,
etc.).
Investment interest expense.
Tax preference and adjustment items needed to figure the
shareholders alternative minimum tax.
Foreign taxes paid to the government of a foreign country.
The domestic production activity deduction is allowed to the
shareholder. The S corporation reports the domestic production
activity information necessary for the shareholder to determine the
deduction.

ALLOCATION OF INCOME, LOSS, EXPENSE, AND CREDIT


Amounts of income, loss, expense, and credit are allocated to each
shareholder on a daily basis, according to the number of shares of stock
held by the shareholder on each day during the S corporations tax
year.
Shareholders must include their share of the income on their tax
return whether or not it is distributed to them.
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The S corporation income is not self-employment income and is not

subject to self-employment tax.


If there is a change in ownership during the year, special allocations are
necessary.
A shareholder who disposes of stock is treated as the shareholder for
the day of disposition.
A shareholder who dies is treated as a shareholder for the day of the
shareholders death.
A special election is available when a shareholder terminates an interest
in the S corporation during the tax year. If the shareholder and all
affected shareholders agree, the S corporation may treat the tax year
as closing (for allocation purposes) at the termination of the
shareholders interest. The outgoing shareholders allocation is based on
the income, loss, expense, and credit up to the termination date.
If a qualifying disposition occurs, the S corporation may make an
irrevocable election to allocate income and expenses as if the
corporations tax year consisted of two tax years, the first of which ends
on the close of the day on which the qualifying disposition occurs. A
qualifying disposition occurs if during any 30-day period during the tax
year one of the following events takes place:
A disposition by a shareholder of at least 20% of the S corporations
outstanding stock in one or more transactions.
A redemption treated as an exchange under 302(a) or 303(a) of at
least 20% of the S corporations outstanding stock in one or more
transactions.
An issuance of stock that equals at least 25% of the previously
outstanding stock to one or more new shareholders.
A shareholder is allowed to reduce other income by an S corporation
loss reported on the Schedule K-1. However, the amount of the loss
allowed is subject to limitations as determined by the basis rules, the
at-risk rules, and the passive activity rules.

S CORPORATION TAXES
Generally, an S corporation does not pay tax at the corporate level.
However, an S corporation is subject to the following taxes:
The tax on excess net passive income.

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The tax on certain capital gains if the S election was made before

1987.
The tax on built-in gains.
The tax from recomputing a prior-year investment credit.
Last In, First Out (LIFO) recapture tax.
The S corporation (not the shareholders individually) must pay the tax
due in full no later than the fifteenth day of the third month after the
end of the tax year. If the tax totals $500 or more, quarterly estimated
payments are required. Tax payments and estimated payments can be
made using the Electronic Federal Tax Payment System (EFTPS) or by
making a deposit with an authorized financial institution or Federal
Reserve Bank, accompanied by a federal tax deposit coupon. Payments
are not sent to the IRS.

EXCESS NET PASSIVE INCOME TAX


If an S corporation has always been an S corporation, the excess net
passive income tax does not apply. If the S corporation has
accumulated E&P from when it was a C corporation at the close of its
tax year, has passive investment income for the tax year that is in
excess of 25% of gross receipts, and has taxable income at year-end,
the S corporation must pay a tax on the excess net passive income.
Gross receipts are the total amount an S corporation receives or
accrues under the method of accounting it uses to figure its taxable
income. This includes the total amount received or accrued from the
sale or exchange of any kind of property (except capital assets and
stock or securities), from services rendered, or from investments. Only
the capital gain from the sale or exchange of capital assets and only the
gain from the sale or exchange of stock or securities are included in
gross receipts.
Passive investment income includes gross receipts from royalties, rents,
dividends, interest, annuities, and sale or exchanges of stock or
securities.
If significant services are provided with the rental of real property,
the rental income is trade or business income as opposed to passive
investment income.
Interest includes tax-exempt interest and unstated interest.

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Net passive income is passive investment income reduced by


deductions directly connected with the production of passive investment
income.
Excess net passive income is the amount that has the same ratio to net
passive income as the amount of passive investment income that
exceeds 25% of gross receipts has to passive investment income. This
cannot be more than the S corporations taxable income for the year.
An S corporation is liable for a tax on excess net passive income at a
rate of 35%, which represents the highest corporate tax rate.
If passive investment income is more than 25% of gross receipts for
three consecutive tax years and the S corporation has pre-S corporation
E&P at the end of each of those years, the S corporations status as an
S corporation is terminated.

Formula: Excess net passive income = net passive income x


[(passive investment income - 25% of gross receipts)
passive investment income]

BUILT-IN GAINS TAX


If a C corporation elects S status, a special built-in gains tax may apply
to the S corporation in any year within the recognition period when the
built-in gains exceed built-in losses.
The tax generally applies only to a C corporation that converted to
an S corporation after 1986. A C corporation that elected S status at
its inception is not subject to the built-in gains tax.
The recognition period is the ten-year period beginning with the first
day of the first tax year the corporation was an S corporation.
Recognized built-in gain is any gain recognized on the disposition of any
asset during the recognition period, except to the extent the S
corporation shows that either of the following applies:
The asset was not held by the S corporation as of the beginning of
its first taxable year as an S corporation.
The gain exceeds the excess of the FMV of the asset as of the
beginning of the first taxable year over the adjusted basis of the
asset.
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Recognized built-in loss is any loss recognized when any asset is


disposed of during the recognition period, to the extent the S
corporation shows that both of the following apply:
The asset was held by the S corporation at the beginning of the first
tax year as an S corporation.
The loss is not more than the adjusted basis of the asset at the
beginning of its first tax year as an S corporation, minus the FMV of
the asset at the beginning of that year.
Unused net operating losses and capital loss carryforwards, created
during the C corporation years, are considered as built-in losses.
Net recognized built-in gain is the lesser of the following:
The amount that would be taxable income of the S corporation for
the taxable year if only recognized built-in gains and recognized
built-in losses were taken into account.
The amount that would be taxable income of the corporation if it
were not an S corporation.
The amount of net recognized built-in gain never exceeds net unrealized
built-in gain minus the net recognized built-in gain for all prior tax years
in the recognition period (net unrealized built-in gain limitation).
Amount of tax is figured by applying the highest corporate rate (35%)
to the net recognized built-in gain for the tax year. The tax is assessed
at the S corporation level, not at the shareholder level.
Unused general business credits and minimum tax credits arising from
the years when the C corporation existed are used to reduce the net
recognized built-in gain tax.
The American Recovery and Reinvestment Act of 2009 shortened the
recognition period for certain S corporations. If the S corporations
recognition period was in its seventh year prior to 2009 or 2010, the
built-in gains tax does not apply for those years. In other words, if an
S corporation election was effective for the 2002 tax year, the
recognition period will end in 2009.

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BASIS
STOCK BASIS
The beginning basis of stock is determined by what was transferred to
the S corporation in exchange for the stock. If money was transferred
for stock, the amount transferred is the beginning basis of the stock.
The basis rules on the transfer of property other than money follow the
rules discussed in the C corporation section.
The following items, in order, increase the shareholders basis in S
corporation stock:
All income items of the S corporation, including tax-exempt income
that is separately stated and passed through to the shareholder.
Any nonseparately stated income of the S corporation.
The amount of the deductions for depletion that is more than the
basis of the property being depleted.
The following items, in order, decrease basis:
Property distributions (including cash) made by the S corporation
(excluding dividend distributions reported on Form 1099-DIV and
distributions in excess of basis) reported on Schedule K-1, box 16,
code D.
Nondeductible expenses of the S corporation and the deduction for
depletion of oil and gas property held by the S corporation to the
extent it is less than the proportionate share of the adjusted basis of
that property allocated to the shareholder.
All deductible losses and deductions reported on Schedule K-1.
A shareholder may elect to decrease basis by the deductible losses and
deductions reported on the Schedule K-1 before reducing basis by
nondeductible losses and excess depletion. Once made, the election
applies to the year it was made and all future tax years for that S
corporation, unless the IRS agrees to revoke the election.
The basis of stock is figured at year-end. In order to deduct a loss, the
shareholder must have sufficient basis (stock and debt). Any loss
deductions not allowed for the current year because of the basis limit
are carried forward indefinitely and deducted in a later year subject to
the basis limit for that year.

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The shareholder must report the taxable income on his or her tax
return, if required to file one, for that income to increase basis.
Basis is not increased by excludable income from discharge of
indebtedness in the S corporation, nor by the amount included in
income with respect to qualified zone academy bonds, clean renewable
energy bonds (CREB), gulf tax credit bonds, Midwestern tax credit
bonds, qualified school construction, or build America bonds.
S corporations can have cancellation of debt income not excludable
under 108, which would increase basis.

LOAN BASIS
If allocable loss and deduction amounts reduce stock basis to zero, the
excess (excluding a decrease due to distributions) is used to reduce the
basis of any loans the shareholder made to the S corporation.
The reduction in basis of indebtedness must be restored before any net
increase is applied to restore the basis of the shareholders stock. Any
net increase is applied to restore the reduction. A net increase is the
shareholders share of income in excess of losses, deductions, and
expenses [Reg. 1.1367-2(c)].
Distributions that exceed stock basis are taxed as capital gains and do
not reduce loan basis.
A loan from a third party to the S corporation, for which the S
corporation is liable, does not provide loan basis to the shareholder,
even if the shareholder acts as a guarantor for that loan.

Study Tip: Basis for an S corporation fluctuates more than for


a C corporation. An S corporation is a pass-through entity
transferring the taxation of gains and losses directly to the
shareholder. Since loans to the S corporation allow a
shareholder additional basis in which losses can be deducted,
the repayment of such loans may result in income to the
shareholder.

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AT-RISK LIMITATIONS
The at-risk rules generally limit the amount of loss and other deductions
the shareholder can claim to the amount he or she could actually lose
(economic interest) in the activity. These losses and deductions include
a loss on the disposition of assets and the 179 expense deduction.
A shareholder is generally not at-risk for the following amounts:
The shareholders basis in stock or the basis of loans to the S
corporation if the cash or other property used to purchase the stock
or make the loan was from a source with one of the following
characteristics:
Covered by nonrecourse indebtedness.
Protected against loss by a guarantee, stop-loss agreement, or
other similar arrangement.
That is covered by indebtedness from a person who has an
interest in the activity or from a person related to a person having
such an interest, other than a creditor.
Any cash or other property contributed to a corporate activity, or
interest in the corporate activity, that has one of the following
characteristics:
Covered by nonrecourse indebtedness.
Protected against loss by a guarantee, stop-loss agreement, or
other similar arrangement.
That is covered by indebtedness from a person who has an
interest in the activity or from a person related to a person having
such an interest, other than a creditor.
A shareholder is at-risk for amounts borrowed for use in the activity
either that the shareholder is personally liable for the repayment of,
or for which the shareholder has pledged property not used in the
activity as security.
The at-risk limitation applies at the shareholder level.

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PASSIVE ACTIVITY LIMITATIONS


The passive activity rules under 469 limit the deduction of certain
losses and credits. These rules apply to shareholders who are
individuals, estates, or trusts, and have a passive loss or credit for the
year.
Generally, passive activities include the following:
Trade or business activities in which the shareholder did not
materially participate.
Activities that meet the definition of rental activities under 469.
Passive activities do not include rental real estate activities in which the
shareholder materially participated if the individual was a real estate
professional. An individual is a real estate professional if the following
conditions are met:
More than half of the personal services performed by the individual
in trades or businesses were performed in real property trades or
businesses in which the individual materially participated.
The individual performed more than 750 hours of services in real
property trades or businesses in which he or she materially
participated.
Any work the shareholder or spouse does in connection with an activity
held through an S corporation, where the shareholder owns stock at
any time the work is done, is counted toward material participation.
Work is not counted toward material participation if either of the
following applies:
The work is not the type of work owners of the activity would usually
do and one of the principal purposes of the work is to avoid the
passive loss and credit limitations.
The shareholder does the work in the capacity as an investor and is
not directly involved in the day-to-day operations of the activity.

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ACCUMULATED ADJUSTMENTS ACCOUNT (AAA)


The AAA is an account of the S corporation which is adjusted for
income, loss, and distributions of the S corporation in a manner similar
to the adjustment of a shareholders basis. However, no adjustment is
made for income and expenses exempt from tax, and no adjustment is
made for Federal taxes attributable to any taxable year in which the S
corporation was a C corporation.
S corporations with accumulated E&P must maintain the AAA to
determine the tax effect of distributions during the S years and the
post-termination transition period. An S corporation without
accumulated E&P does not need to maintain the AAA in order to
determine the tax effect of distributions, but it is still recommended.
AAA generally reflects the accumulated undistributed net income of the
S corporation.
AAA is increased by income and the excess of the deduction for
depletion over the basis of the property subject to depletion. Taxexempt income does not increase AAA.
AAA is decreased by deductible losses and expenses, nondeductible
expenses, and the sum of the shareholders deductions for depletion for
any oil and gas property held by the S corporation. Expenses related to
tax-exempt income do not reduce AAA.
If the decreases are greater than the increases, the excess is a net
negative adjustment. If the S corporation has a net negative
adjustment, it is not taken into account until after a decrease for
distributions.
AAA is decreased, but not below zero, by property distributions.

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DISTRIBUTIONS
Distributions from an S corporation with no accumulated E&P are
treated as a nontaxable return of capital or gain from the sale of
property. The type of gain is determined at the end of the year after the
shareholder has adjusted his or her basis for any increases but before
any decreases attributable to the current year are deducted.
Distributions up to the adjusted stock basis are a nontaxable return of
capital.
Distributions in excess of the adjusted stock basis are reported as a
capital gain on the shareholders Schedule D. As such, the gain is either
a long- or short-term capital gain depending on how long the
shareholder held the S corporation stock.
If an S corporation has E&P but has not elected to distribute E&P first,
any distribution it makes is treated as made in the following order:
First, treated as coming out of the accumulated adjustments account
(AAA). A distribution out of AAA is applied against and reduces the
shareholders adjusted basis in the stock. If distributions during the
tax year exceed the AAA at the close of the tax year, the AAA
generally is allocated to each distribution made during the year in
proportion to the sizes of the distributions.
If the shareholder has pre-1983 previously taxed income (PTI), the
PTI is the next source of distribution. This is a nontaxable
distribution, which is applied against and reduces the shareholders
basis in stock. Most S corporations do not have this category of
income.
A distribution is then treated as coming out of the prior C
corporations E&P (retained earnings). This distribution is treated as
a dividend up to the amount of the corporations E&P. This does not
change the shareholders stock basis.
A distribution is then applied against and reduces the shareholders
basis in stock.
Finally, the distribution is treated as a sale or exchange of property.

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Example: Cord, Inc., an S corporation, has accumulated E&P of $10,000. It


distributes $80,000 to its only shareholder, Don. His basis in the stock is $50,000.
Cord has $30,000 in its AAA. The order of distributions and taxation are as follows:
Distribution
$80,000
-30,000

Source
From AAA

Type of Distribution
Reduction in Basis

Taxable
No

$50,000
-10,000

From E&P

Dividend

Yes

$40,000
-20,000

Remaining Basis

Reduction in Basis

No

$20,000
-20,000
0

Excess of Basis

Sale or Exchange of
Property

Yes

If the S corporation has E&P and elects to distribute E&P first, all
shareholders receiving distributions during the year must consent to the
election. The election is binding for that year only. After all E&P have
been distributed, the S corporation treats all remaining distributions
under the rules for S corporations with no E&P.

Note: The IRS exam may call S corporation distributions


dividends. This does not necessarily mean that the S
corporation was a prior C corporation with retained earnings.

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TERMINATION
TERMINATING S CORPORATION STATUS
Once the election is made, it stays in effect until it is terminated or
revoked. If the election is terminated in a tax year beginning after
1996, IRS consent is generally required for another S election within
five years.
An S election can be revoked for any tax year. It can be revoked only if
shareholders who collectively own more than 50% of the outstanding
shares in the S corporations stock consent to the revocation. The
consenting shareholders must own their stock at the time the
revocation is made.
The effective date of the revocation is as follows:
On the first day of the tax year if the revocation is made by the
fifteenth day of the third month of the same tax year.
On the first day of the following tax year if the revocation is made
after the fifteenth day of the third month.
On the date specified if the revocation specifies a date on or after the
day the revocation is made.

CEASING TO QUALIFY
Certain events cause the S corporation to cease to qualify, in which
case, the election terminates automatically.
Terminating events include the following:
Having more than 100 shareholders.
Transferring stock in the S corporation to an ineligible shareholder
such as a corporation, a partnership, an ineligible trust, or a
nonresident alien.
Creating a second class of stock.
The termination because of such an event is effective as of the date the
terminating event took place.

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If the S corporation, for each of three consecutive years, has


accumulated E&P and derives more than 25% of its gross receipts from
passive investment income, the S election terminates.
Termination due to passive income violations is effective on the first
day of the tax year that follows the third consecutive tax year
referred to above.
The corporation must pay the tax for each year it has excess net
passive income.
In the year of termination or revocation, the S corporation files two
short-year returns. The first is as an S corporation up to the date of
termination. The second return is for the remainder of the tax year as a
C corporation.

TERMINATION OF A SHAREHOLDERS INTEREST


If a shareholder sells or liquidates his or her interest in the S
corporation, the sale is treated in the same manner as the sale of stock
in a C corporation. The shareholder reports the sale of stock on
Schedule D. The gain or loss is the difference between the shareholders
basis, after making current year adjustments, and the sales price of the
stock.
The shareholder is responsible for reporting the income or loss from the
S corporation up to the time the sale occurs. The amount reported on
Schedule K-1 is computed in one of the following ways:
The shareholder receives a pro rata share of each item. The income
is based on the ratio of the number of days of ownership to the
number of days in the year (per share, per day rule).
A special election can be made by the shareholder and all affected
shareholders to treat the shareholders year of termination as though
it were two taxable years (specific accounting rule), the first of which
ends on the date of termination of the shareholders interest. If the
election is made, one tax return is filed. Two taxable years are used
only for purposes of determining the allocation of S corporation
items. (1377)

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S CORPORATION TEST
1. ___

Which of the following conditions prevents a corporation from


qualifying as an S corporation?
A. The corporation has both common and preferred stock.
B. The corporation has 70 shareholders.
C. One shareholder is an estate.
D. All of the above.

2. ___

The Richards Corporation has a tax year ending June 30. The
corporation wishes to elect S corporation status. In order to
have the S election effective for the 2009 tax year beginning
July 1, 2009, before which of the following dates must Form
2553 be filed with the proper IRS Service Center?
A. June 15, 2009
B. September 16, 2009
C. December 31, 2009
D. May 10, 2010

3. ___

On January 1, 2009, Tom, Dick, and Harry were sole and equal
shareholders of ABC, Inc., a calendar-year C corporation. On
February 1, 2009, Tom sold all of his interest in the corporation
to Dick. On March 1, 2009, Dick decides to convert the
corporation to an S corporation, effective January 1, 2009.
Regarding the desired conversion, which of the following
statements is true?
A. Since Dick now owns over 51% of the corporation, he can
unilaterally prepare and submit the proper election
application, IRS Form 2553.
B. Since the S corporation election requires consent by 100%
of the shareholders, both Dick and Harry must sign the
application to elect to be treated as an S corporation.
C. Since Tom, Dick, and Harry were all shareholders as of
January 1, 2009, all three must consent to elect to treat the
corporation as an S corporation.
D. Since there was a change in stock ownership after the
beginning of the corporations tax year, any election to treat
the corporation as an S corporation is not effective earlier
than January 1, 2010.

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4. ___

Which of the following items are required to be separately


stated to an S corporations shareholders?
A. Net short-term capital gain or loss.
B. Charitable contributions.
C. Foreign taxes paid to the government of a foreign country.
D. All of the above.

5. ___

Which of the following items is not a separately stated item of


a qualifying S corporation?
A. Interest income.
B. Charitable contributions.
C. Interest expense on business operating loans.
D. Net long-term capital gain.

6. ___

As of December 31, 2009, John is a 50% shareholder of XYZ,


Inc., an S corporation, as well as a 75% shareholder of ABC,
Inc., also an S corporation. Both companies are calendar-year
taxpayers. Because of profitable years, each company elected
to use the maximum depreciation deduction allowable under
179 for the year. Assuming that each election was valid, what
is the maximum amount of 179 deductions which can be
passed through to John?
A. $500,000
B. $312,500
C. $250,000
D. None. Depreciation is not a pass-through item.

7. ___

XYZ Corporation is a qualified S corporation. In 2009, its books


and records reflected the following transactions:
Business Income
$ 500,000
Real estate rental loss
(20,000)
Interest income
5,000
Salaries and wages
(50,000)
Depreciation (without 179 expense) (40,000)
Section 179 expense
(10,000)
Other business deductions
(300,000)
What is XYZs ordinary income (loss) to be reported on its
2009 Form 1120S?
A. $115,000
B. $110,000
C. $105,000
D. $85,000

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8. ___

An S corporation can be subject to which of the following


taxes?
A. Built-in gains tax.
B. Excess net passive income tax.
C. Both A and B.
D. None of the above.

9. ___

An S corporation made an early disposition of an asset on


which it had claimed the investment tax credit on its corporate
tax return before it became an S corporation. What is the
effect of this early disposition?
A. The shareholders who owned the corporation at the time
the credit was claimed are liable for the recapture tax.
B. The S corporation, not its shareholders, is liable for the
recapture tax.
C. Neither the S corporation nor its shareholders are liable for
tax resulting from the early disposition.
D. The recapture tax is the liability of the existing S
corporation shareholders.

10. ___ An S corporation may owe tax if, at the end of the tax year,
the corporation had accumulated E&P, taxable income, and:
A. Its tax preference items exceed 25% of its gross receipts.
B. Its foreign source income exceeds 25% of its gross receipts.
C. Its passive investment income exceeds 25% of its gross
receipts.
D. All of the above.
11. ___ For 2009, Real, an S corporation, had gross receipts of
$100,000, including passive investment income of $75,000.
Real also had C corporation E&P at the end of the year. Real
incurred $50,000 in expenses directly related to the earning of
passive investment income. What is the tax on the excess net
passive income?
A. $2,914
B. $5,836
C. $8,750
D. $11,667

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12. ___ With regard to built-in gains, all of the following statements
are correct except:
A. Any net operating or capital loss carryover arising in a tax
year in which the S corporation was a C corporation can
offset the built-in gains for the tax year.
B. Gasoline tax credits may be used to offset the tax on builtin gains.
C. Built-in gains are used to compute the tax on excess net
passive income.
D. The tax on built-in gains is effective for tax years beginning
after 1986, but only for corporations that have made
S corporation elections after 1986.
13. ___ Which of the following would not reduce a shareholders basis
in S corporation stock?
A. A shareholders pro-rata share of an expense not deductible
in computing the corporations taxable income and not
chargeable to the capital account.
B. A shareholders share of all loss and deduction items of the
S corporation that are separately stated and passed through
to the shareholder.
C. A shareholders pro-rata share of any non-separately stated
loss of the S corporation.
D. The excess of the corporations deductions for depletion
over the basis of the property subject to depletion.
14. ___ On January 1, 2009, Acme, Inc., a calendar-year S
corporation, was owned by four individuals as follows: John:
50%; Bob: 25%; Dave: 20%; and Tom: 5%. On March 31,
2009, John sold his shares to Bob. On the same day Dave sold
his shares to Tom. For the tax year ending December 31,
2009, the company realized an operating loss of $100,000.
Assuming that all four had sufficient basis in their stock,
calculate each shareholders recognizable loss for the 2009 tax
year. To assist in the calculation, assume a 360-day calendar
year, with 30 days in each month.
A. John: $50,000, Bob: $25,000, Dave: $20,000, and Tom:
$5,000.
B. John: $0, Bob: $75,000, Dave: $0, and Tom: $20,000.
C. John: $12,500, Bob: $62,500, Dave: $5,000, and Tom:
$20,000.
D. John: $12,500; Bob: $56,200, Dave: $5,000, and Tom:
$18,750.

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15. ___ Sams basis in S corporation stock was $100,000 before


adjusting for current year activity. After consideration of each
of the items below, what is Sams basis in his S corporation
stock?
$10,000 tax-exempt income
$20,000 nonseparately stated income
$15,000 excess of depletion deduction over the basis of the
property being depleted
A. $145,000
B. $125,000
C. $110,000
D. $105,000
16. ___ Pine Street Corporation is an S corporation. The Form 1120S
for 2009 reflects a $3,500 ordinary loss. Mr. Jones, the sole
shareholder of Pine Street Corporation, has a basis in the
corporation at January 1, 2009, of $1,500. Which of following
statements is correct?
A. Mr. Jones may deduct a $3,500 loss on his 2009 return.
B. Mr. Jones may deduct a $1,500 loss on his 2009 return and
carry back a $2,000 loss to 2007.
C. Mr. Jones may deduct a $1,500 loss on his 2009 return and
carry forward a $2,000 loss indefinitely.
D. Mr. Jones may deduct a $1,500 loss on his 2009 return and
loses the remaining $2,000 loss.
17. ___ Wanda owns 100% of S corporation, Milk Enterprises. At the
beginning of 2009, she had a zero basis and an unused ordinary loss carry over from Milk Enterprises in the amount of
$5,000. During the year, Wanda secured a bank loan of
$10,000 on her personal residence and made a shareholder
loan of that amount to Milk Enterprises. At the end of 2009,
Milk Enterprises reported on its Schedule K a $1,000 ordinary
loss and a $3,000 cash distribution made to Wanda. Wanda
has $10,000 in flow-through reportable income from other S
corporations. How much of Milk Enterprises ordinary loss can
Wanda deduct on her personal return?
A. $6,000 in loss.
B. $5,000 in loss.
C. $3,000 in loss.
D. $0 in loss.

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18. ___ Bob and Sally, unmarried taxpayers, were equal sole
shareholders of an S corporation. The corporation realized a
$50,000 operating loss for the tax year ending December 31,
2009. As of December 31, 2008, Bobs basis in his stock was
$15,000 and Sallys was $5,000. During the 2009 tax year,
Sally mortgaged her home for $25,000 and lent the money to
the corporation. Although not personally liable, Bob told her
not to worry and that if anything happened, he would help pay
the mortgage debt. Calculate the amount of allowable loss
deduction each shareholder would be able to recognize on their
individual 2009 tax returns.
A. Bob $25,000; Sally $25,000.
B. Bob $15,000; Sally $5,000.
C. Bob $15,000; Sally $30,000.
D. Bob $15,000; Sally $25,000.
19. ___ Magnolia Corporation, a calendar-year S corporation, was
formed on January 1, 2008. Kathy owns 25% of Magnolias
outstanding stock, which she purchased for $20,000. In 2008,
Kathy guaranteed a corporate loan for $40,000. In 2009,
Kathy made payments on the loan totaling $10,000. Magnolia
had losses of $90,000 and $60,000 in 2008 and 2009
respectively. What is the amount of the unallowed loss that
Kathy can carry over to 2010?
A. $0
B. $7,500
C. $10,000
D. $17,500
20. ___ Kevin, the 100% owner of an S corporation, has an adjusted
basis in stock before losses and deductions at the end of 2009
in the amount of $12,000. The 2009 corporate return shows a
$20,000 ordinary loss and a $5,000 charitable contribution
expense. What are the allowable losses and deductions Kevin
may claim on his 2009 tax return?
A. $12,000 ordinary loss and $0 contribution expense.
B. $7,000 ordinary loss and $5,000 contribution expense.
C. $9,600 ordinary loss and $2,400 contribution expense.
D. $12,000 ordinary loss and $5,000 contribution expense.

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21. ___ Mary is a 50% shareholder in an S corporation, which suffered


a $100,000 loss for the tax year ending December 31, 2009.
Marys basis in her stock as of December 31, 2009 was
$25,000. What can Mary do with the disallowed loss of
$25,000?
A. Carry back the loss three years to offset any personal taxes
paid.
B. Carry forward the loss indefinitely for use if her basis in her
stock is sufficiently restored.
C. Nothing. There is no provision for using disallowed losses
from an S corporation, in any other tax year but that in
which the loss occurred.
D. Mary does not have a disallowed loss and can use the full
$50,000 loss in the 2009 tax year.
22. ___ With regard to an S corporation and its shareholders, the atrisk rules applicable to losses:
A. Take into consideration the S corporations ratio of debt to
equity.
B. Apply at the shareholder level rather than at the corporate
level.
C. Are subject to the elections made by the S corporations
shareholders.
D. Depend on the type of income reported by the S
corporation.
23. ___ At the beginning of 2009, Tim had a $2,000 stock basis in the
S corporation, World, Inc. Tim owns 25% of the outstanding
World, Inc. stock. At the end of 2009, World, Inc. reported on
its Schedule K, a $16,000 ordinary loss, $4,000 of interest income and $2,000 in nondeductible expense. Tim has $10,000
in flow-through reportable income from other S corporations.
How much of the 2009 World, Inc. ordinary loss can Tim
deduct on his personal return?
A. $0 in loss.
B. $2,500 in loss.
C. $3,000 in loss.
D. $4,000 in loss.

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24. ___ On January 1, 2009, Allen purchased 50% of the outstanding


shares of an S corporation, Ball Enterprises, for $1,000. At
year end, Ball Enterprises had $5,000 in ordinary income,
$1,000 in net income from rental real estate, and had made
$2,000 in charitable contributions. Ball Enterprises had also
paid $700 to Allens golf instructor and $300 for a titanium
driver Allen uses as a member at his country club. What is
Allens basis in Ball Enterprises at the end of 2009?
A. $2,000
B. $2,500
C. $3,500
D. $5,000
25. ___ If all the shareholders consent to the election, an S corporation
can elect its distributions as first coming from:
A. E&P.
B. Accumulated adjustments account.
C. Previously taxed income.
D. The shareholders adjusted basis in the S corporation.
26. ___ Which of the following statements regarding distributions from
an S corporation is correct?
A. Property distributions are applied in a different manner than
cash distributions.
B. Absent an election, distributions are considered to come
first from accumulated earnings and profits, if the
corporation has accumulated earnings and profits from
when it was a C corporation.
C. A shareholders right to nontaxable distributions from
previously taxed income may be transferred to another
person.
D. A distribution from the previously taxed income account is
tax free to the extent of a shareholders basis in his or her
stock in the corporation.

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27. ___ Mr. Oliver received a distribution from an S corporation that


was in excess of the basis of his stock in the corporation. The
S corporation had no E&P. Mr. Oliver should treat the
distribution in excess of his basis as:
A. A return of capital.
B. Previously taxed income.
C. A capital gain.
D. A reduction in the basis of his stock.
28. ___ Previous years cash distributions to a shareholder have
reduced his or her stock basis to zero in an S corporation. How
are any further cash distributions treated for tax purposes if
the company continues to have losses?
A. It is treated as a deemed sale of the shareholders stock.
B. It is treated as a capital contribution to the corporation.
C. It receives passive activity loss treatment, subject to any
limitations.
D. It is carried over indefinitely to be offset with future
earnings.
29. ___ On December 31, 2008, Walter had a $2,000 basis in
S corporation, Oak, Inc. Walter owns 50% of all outstanding
Oak, Inc. stock. At the beginning of 2009, Walter contributed a
patent that he had acquired for $1,000 to Oak, Inc. During
2009 Oak, Inc. received $5,000 in royalty income from that
patent. Oak, Inc. also received $2,500 in ordinary income and
had $500 in Internal Revenue Code section 179 deductions. At
the end of 2009, Oak, Inc. returned ownership of the patent,
which now had a FMV of $5,000, back to Walter. What is
Walters basis in Oak, Inc. at the end of 2009?
A. $1,000
B. $1,500
C. $2,500
D. $5,000

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30. ___ Robert owns 50% of an S corporation, Blue Sky, Inc. and has a
basis in that corporation of $5,000 at the beginning of 2009. At
the end of 2009, Blue Sky, Inc. reports ordinary income of
$10,000 and makes a distribution to Robert of a manuscript
originally purchased for $1,000 but now valued at $8,000. How
much income must Robert report on his personal 2009 return
from this distribution?
A. $0
B. $1,000
C. $5,000
D. $8,000
31. ___ If an S corporation, which has Accumulated E&P, is allowed to
treat shareholder distributions as being made from the AE&P
account, how will those distributions be taxed, if at all?
A. They will be taxed as dividend income.
B. They will be taxed as ordinary earned income.
C. They will be taxed as capital gain income.
D. They will not be taxed, as it would be deemed a return of
shareholder capital.
32. ___ At the end of 2004, Green, Inc. was a C corporation with
$50,000 in earnings and profits. Green, Inc. elected to be
treated as an S corporation beginning with the 2005 year. At
the end of 2009, Green, Inc. has a balance of $10,000 in its
Other Adjustments Account, a balance of $20,000 in its Accumulated Adjustment Account, and a balance of $50,000 in
earnings and profits. Green, Inc. made cash distributions of
$25,000 to each of its 50% shareholders. Green, Inc. makes
no elections relating to the source of distributions. What is the
remaining Green, Inc. earnings and profits balance after the
shareholder distributions?
A. $50,000
B. $40,000
C. $30,000
D. $20,000

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33. ___ The books and records of Planter, an S corporation since 1993,
reflect the following for 2009 (Planter is a calendar-year
taxpayer):
Accumulated adjustments account as of 1/1/2009
$10,000
Accumulated E&P as of 1/1/2009
20,000
Ordinary income for 2009
40,000
Planters sole shareholder has a basis in his stock of $30,000.
During 2009, Planter distributed $100,000 to the shareholder.
How should the shareholder treat this distribution for income
tax purposes?
A. Nontaxable.
B. $30,000 capital gain.
C. $20,000 dividend and $10,000 capital gain.
D. $50,000 dividend and $20,000 capital gain.
34. ___ For 2009, VBN, an S corporation, has accumulated E&P of
$50,000, and zero balance in its accumulated adjustment
account. VBN distributes $230,000 to its sole shareholder,
Raymond. His basis in the stock is $140,000. How should
Raymond handle the distribution?
A. $230,000 as a taxable distribution.
B. $50,000 as a taxable dividend, $90,000 as return of capital,
and $90,000 as capital gain.
C. $50,000 as a taxable dividend, $140,000 as return of
capital, and $40,000 as capital gain.
D. $90,000 as dividend, $50,000 as return of capital, and
$90,000 as nontaxable.
35. ___ John is the sole shareholder of Maple Corporation, a qualified S
corporation. At January 1, 2009, John has a basis in Maple
Corporation of $2,000. The corporations 2009 tax return
shows the following:
Ordinary income
$10,000
Interest income
1,000
Nondeductible expenses
2,000
Real estate rental loss
5,000
Section 179 deduction
1,500
Distributions to Mr. Maple
3,000
What is Johns basis in Maple Corporation at the end of 2009?
A. $0
B. $1,500
C. $3,500
D. $4,500

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36. ___ Which shareholders must consent to have a corporations S


election revoked?
A. Any shareholder regardless of percentage ownership.
B. Any two shareholders holding at least 10% each.
C. All shareholders regardless of percentage ownership.
D. Any shareholder or group of shareholders owning more than
50%.
37. ___ Which of the following statements regarding the termination of
an S corporation election is true?
A. The election may be revoked with the consent of
shareholders who, at the time the revocation is made, hold
more than 50% of the number of issued and outstanding
shares.
B. The election may be revoked by the board of directors of
the corporation only if they are not shareholders.
C. The election terminates automatically if the corporation
derives more than 25% of its gross receipts from passive
investment income during the year.
D. The election may be revoked by the Internal Revenue
Service if there is a history of 10 years of operating losses.
38. ___ All of the following events would cause an S corporation to
cease qualifying as an S corporation except:
A. Having more than 100 shareholders.
B. The transfer of its stock to a corporation.
C. The transfer of its stock to a resident alien.
D. The election is revoked with the consent of shareholders
who, at the time the revocation is made, hold 55% of the
stock.
39. ___ On December 1, 2009, Bob elected to terminate his
corporations S status, effective January 1, 2010. Bob owns
55% of the corporations stock. If Bob changes his mind, what
is the earliest date that Bob could have his S corporation status
reinstated without IRS consent?
A. January 1, 2012.
B. December 1, 2014.
C. January 1, 2015.
D. Since election to terminate S corporation status requires
100% of the outstanding shareholders consent, the
revocation is not valid and the S corporation qualifies until
properly terminated.

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40. ___ Maui Corporation (S corporation) reported a $72,000 ordinary


loss during 2009. At the beginning of 2009, Elvis and Frank
owned equally all Mauis stock. On July 1, 2009, Frank gives
one-fourth of his stock to his son, George. What amount of the
2009 loss is allocated to George?
A. $0
B. $4,537
C. $9,000
D. $18,000

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S CORPORATION ANSWERS
1.

A. A corporation can make the election to be treated as an S


corporation if it meets certain requirements: it is a domestic
corporation or a domestic entity eligible to elect to be a
corporation; it has no more than 100 shareholders; its only
shareholders are individuals, estates, certain exempt
organizations, or certain trusts; it has no nonresident alien
shareholders; it has only one class of stock; it is not an
ineligible corporation; it has or will change to an appropriate tax
year; and each shareholder consents.

2.

B. To make the S election, Form 2553 should be filed at any time


before the sixteenth day of the third month of the tax year, if
filed during the tax year the election is to take effect; or at any
time during the preceding tax year.

3.

C. Each shareholder who owns (or is deemed to own) stock at the


time the election is effective must consent to the election.

4.

D. The shareholder takes into account the shareholders pro rata


share of the corporations items of income (including taxexempt income), loss, deduction, or credit the separate
treatment of which could affect the liability for tax of any
shareholder; and nonseparately computed income or loss.

5.

C. Where the character of an item may affect its tax treatment in


the hands of the shareholder, it must be separately stated. An
interest expense incurred in the trade or business activity of the
corporation is not a separate pass-through item and is included
in determining the corporations ordinary trade or business
income or loss.

6.

B. An S corporation may elect to expense part of the cost of


certain tangible property. The corporation does not claim the
deduction itself, but instead passes it through to the
shareholders. The amount that can be elected for deducting
under 179 is subject to a dollar limit and a business income
limit. These limits apply to each taxpayer, not to each business.
Therefore, $250,000 x 50% = $125,000. $250,000 x 75% =
$187,500. $125,000 + $187,500 = $312,500.

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7.

B. The real estate loss, interest income, and 179 expense are
separately stated on Schedule K-1. The ordinary business
income is the business income reduced by salaries and wages,
depreciation, and other business deductions.

8.

C. An S corporation generally does not pay tax at the corporate


level. However, built-in gains tax and excess net passive income
tax are taxes paid at the corporation level.

9.

B. The tax from recomputing a prior-year investment credit applies


if the corporation claimed investment credit on a prior years
corporate income tax return before it became an S corporation.
If the S corporation makes an early disposition of the property,
the S corporation, and not its shareholders, is liable for payment
of the tax.

10. C. Passive investment income includes gross receipts from


royalties, rents, dividends, interest, annuities, and sale or
exchanges of stock or securities. Rent does not include
payments for use or occupancy if significant services are
provided. Interest includes tax-exempt interest and unstated
interest. Net passive income is passive investment income
reduced by deductions directly connected with the production of
passive investment income.
11. B. Net passive income = $75,000 - $50,000 = $25,000.
Excess net passive income = $25,000 x [($75,000 - $25,000) /
$75,000] = $25,000 x .667 = $16,675. Tax = $16,675 x tax
rate of 35% = $5,836.
12. C. The amount of passive investment income for purposes of
figuring the tax on excess net passive income is determined by
not taking into account any recognized built-in gain or loss of
the corporation.
13. D. The excess of the corporations deductions for depletion over
the basis of property subject to depletion does not reduce basis
but, rather, increases basis.

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14. C. John and Dave each held their shares for 90 days. The loss is
considered earned equally throughout the year. Johns share of
the loss is $100,000 360 x 90 x 50% = $12,500. Bobs share
of the loss is $100,000 x 25% ($25,000) plus $100,000 360 x
270 x 50% ($37,500) = $62,500. Daves share of the loss is
$100,000 360 x 90 x 20% = $5,000. Toms share of the loss
is $100,000 x 5% ($5,000) plus $100,000 360 x 270 x 20%
($15,000) = $20,000.
15. A. An S corporation shareholders stock basis is increased by all
income of the S corporation, including tax-exempt income, that
are separately stated and passed through to the shareholder;
the nonseparately stated income of the S corporation; and the
amount of the deduction for depletion that is more than the
basis of the property being depleted.
16. C. Generally, the deduction for the shareholders share of
aggregate losses and deductions reported on Schedule K-1 is
limited to the basis of that shareholders stock, determined
without regard to distributions during the year, and loans from
the shareholder to the corporation. Any losses and deductions
not allowed in the current year because of the basis limit can be
carried forward indefinitely and deducted in a later year subject
to the basis limit for that year.
17. A. The $10,000 loan to the corporation increased Wandas debt
basis to $10,000. This increase allows the use of the suspended
loss carried into the current year as well as the current-year
loss. The $3,000 distribution does not reduce debt basis.
18. D. Bob and Sally are each allocated 50% of the loss. The deduction
of the loss is limited to the adjusted basis in stock and any debt
the corporation owes the shareholder. Sallys stock basis is
$5,000 and loan basis is $25,000, for a total of $30,000. Sally is
allowed to deduct the full $25,000 loss. Bobs loss is limited to
$15,000 stock basis.
19. B. In 2008 Kathys basis was $20,000. She is able to deduct
$20,000 of the $22,500 (25% of $90,000) loss in 2008. The
remainder of the loss ($2,500) is carried to 2009. Kathys basis
of $0 was increased by the loan payment of $10,000. With this
increase in basis she is able to deduct $10,000 of the $15,000
(25% of $60,000) loss. The remaining $5,000 and the $2,500
carried from the prior year are carried to 2010.

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20. C. If the shareholders share of the aggregate amount of losses


and deductions exceeds the sum of the adjusted basis of the
shareholders stock and the adjusted basis of any indebtedness
of the corporation to the shareholder, the limitation on losses
and deductions must be allocated to any loss and deduction by
a ratio of the specific loss or deduction to the total of losses and
deductions. The total loss and deduction allocated is $25,000,
which results in 80% allocated to the ordinary loss. The
deductible amount is limited to basis, so 80% of the $12,000
basis is allocated to the ordinary loss and 20% to the charitable
contribution.
21. B. Any loss of deduction not allowed because of the limit is carried
over and treated as a loss or deduction in the next tax year.
22. B. At-risk rules may limit an S corporation shareholders deductible
loss from an activity conducted through the S corporation. The
limitations apply at the shareholder level.
23. B. Tims starting basis, $2,000, is increased by his share of interest
income, $1,000, and then reduced by his share of nondeductible
expenses, $500. The basis at this point, $2,500, determines
how much of his share of the corporation loss, $4,000, is
currently deductible.
24. A. The amounts the corporation paid to Allens golf instructor and
for the titanium driver are considered distributions to Allen.
Allens $1,000 basis is increased by his share of the ordinary
income ($2,500) and the rental income ($500) and then
decreased by the distribution ($1,000) and his share of the
charitable contribution ($1,000).
25. A. Shareholders of an S corporation may benefit by electing to
distribute E&P first to avoid the passive investment tax.
26. D. Unless the corporation makes an election, property
distributions, including cash, are applied from a specific account
in a specific order: AAA, PTI, accumulated E&P, OAA, and then
any remaining shareholder equity accounts. PTI is a nontaxable
distribution, which is applied against and reduces the
shareholders basis in stock.
27. C. If the distributions exceed basis, the excess is treated as capital
gain.

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28. A. If the amount of the distribution exceeds the adjusted basis of


the stock, such excess shall be treated as gain from the sale or
exchange of property.
29. B. Basis is increased by the contribution of the patent ($1,000) and
an allocable share of royalty income ($2,500) and ordinary
income ($1,250), then reduced by the distribution ($5,000) and
the allocable share of the 179 deduction ($250), leaving an
ending basis of $1,500.
30. A. The allocable share of the corporations ordinary income
increases Roberts basis to $10,000. The distribution of $8,000
is thus a nontaxable distribution, which also reduces basis to
$2,000.
31. A. The portion of the distribution which remains after the
application of paragraph (1) (distributions from AAA) shall be
treated as a dividend to the extent it does not exceed the
accumulated E&P of the S corporation.
32. D. Unless an election is made, distributions will first reduce AAA,
not below zero, then from the PTI account, then from
accumulated E&P, and finally from OAA. Of the $50,000
distribution, $20,000 reduces AAA to zero, and the remaining
$30,000 brings the accumulated E&P account to $20,000.
33. C. As of December 31, 2009, AAA is $50,000 ($10,000 + $40,000)
and the shareholders stock basis is $70,000 ($30,000 +
$40,000). Distributions first come from AAA and reduce the
shareholders basis. Of the $100,000 distributed, $50,000 is
from AAA, making the AAA balance zero. This reduces the
shareholders stock basis to $20,000 ($70,000 - $50,000). The
next $20,000 of the distribution is from accumulated E&P and is
treated as a dividend. The next $20,000, an amount equal to
the shareholders remaining basis, is a nontaxable return of
capital, bringing the shareholders stock basis to zero. The final
$10,000, in excess of basis, is treated as a sale of property,
taxed as long-term capital gain.

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34. C. The distribution is first treated as coming out of the


accumulated adjustments account (AAA). Then as coming out of
the prior C corporations E&P (retained earnings), which is
treated as a dividend up to the amount of the corporations E&P.
Any remaining distribution is applied against and reduces the
shareholders basis in stock and finally the excess distribution is
treated as a sale or exchange of property on the shareholders
Schedule D.
35. B. Stock basis is increased by all income (including tax-exempt
income) reported on Schedule K-1; then decreased by property
distributions (including cash) made by the corporation reported
on Schedule K-1, box 16, code D; then decreased by
nondeductible expenses; then decreased by all deductible losses
and deductions reported on Schedule K-1.
36. D. An election may be revoked only with the consent of
shareholders who, at the time the revocation is made, hold
more than 50% of the number of issued and outstanding shares
of stock (including nonvoting stock).
37. A. The S corporation election terminates automatically if the
corporation is no longer a small business corporation; for each
of three consecutive years the corporation has accumulated
earnings and profits and derives more than 25% of its gross
receipts from passive investment income; or the election is
revoked. An election may be revoked only with the consent of
shareholders who, at the time the revocation is made, hold
more than 50% of the number of issued and outstanding shares
of stock.
38. C. The transfer of its stock to a nonresident alien causes the
corporation to cease qualifying as an S corporation.
39. C. Shareholders owning more than 50% of the corporation stock
can terminate the election. Once terminated, an S corporation
election cannot be made within five years unless the IRS
consents. With the termination effective January 1, 2010, a new
election cannot be made for any year before January 1, 2015.

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40. B. Elvis portion of the loss is $72,000 x 50% or $36,000. The


remaining loss of $36,000 ($72,000-$36,000) must be allocated
between Frank and George. Frank owned 100% of his stock for
181 days and 75% of his stock for 184 days. George owned
25% for 184 days. The calculation for George (184/365) x 25%
x $36,000 = $4,537.

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TRUSTS, RETIREMENT, AND EXEMPT


FORM 1041, INCOME TAX RETURN OF A TRUST
The term trust refers to an arrangement created either by a will
(testamentary) or by an inter vivos (living) declaration by which
trustees take title to property for the purpose of protecting or
conserving it for the beneficiaries under the ordinary rules applied in
chancery or probate courts. A trust (except a grantor-type trust) is a
separate legal entity for federal tax purposes.
The accounting period for a trust is generally a calendar year. The due
date for a calendar-year trust is April 15.
A Form 1041, U.S. Income Tax Return for Estates and Trusts, must be
filed for a trust if the trust has any taxable income for the tax year, has
gross income of $600 or more, or the trust has a beneficiary who is a
nonresident alien.
The executor of the estate and the trustee of a qualified revocable trust
can elect to treat the trust as part of the estate instead of filing a
separate Form 1041 for the trust.
A qualified revocable trust for this purpose is any trust, or portion of
a trust, that is treated as having been owned by the decedent whose
estate is making the election, because of a power in the grantor of
the trust to revoke the trust.
The election is made on the estate Form 1041 by attaching Form
8855, Election to Treat a Qualified Revocable Trust as Part of an
Estate, signed and dated by both the executor of the estate and the
trustee of the trust. The Form 8855 must be filed by the due date of
the return (including extensions) for the estate for its first tax year.

GENERAL TRUST INFORMATION


A trust is a simple trust if it meets the following requirements:
The trust requires that all income must be distributed currently.
The trust does not allow amounts to be paid, permanently set aside,
or used in the tax year for charitable purposes.

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The trust does not distribute amounts allocated to the corpus of the

trust.
The beneficiary of a simple trust must include in his or her gross income
the amount of the income required to be distributed currently, whether
or not distributed, or if the income required to be distributed currently
to all beneficiaries exceeds the distributable net income (DNI), his or
her proportionate share of DNI.
A complex trust is any trust that does not qualify as a simple trust.
The beneficiary of a complex trust must include in his or her gross
income the sum of the amount of income required to be distributed (or
proportionate share of DNI), and all other amounts properly paid,
credited, or required to be distributed.
For complex trusts that have more than one beneficiary, and if different
beneficiaries have substantially separate and independent shares, their
shares are treated as separate trusts for the sole purpose of
determining the amount of DNI allocable to each.
A qualified disability trust is a specifically identified trust established
solely for the benefit of an individual under age 65 years of age who is
disabled and all of the beneficiaries of which are determined to have
been disabled for some part of the tax year.
The S portion of an electing small business trust is the portion of the
trust that consists of S corporation stock and that is not treated as
owned by the grantor or another person.
A trust whose governing instrument requires that all income be
distributed currently is allowed a $300 exemption, even if it distributed
amounts other than income during the tax year. A qualified disability
trust is allowed a $3,650 exemption if the trusts modified AGI is less
than or equal to $166,800. A trust not fitting these definitions
(complex) is allowed a $100 exemption.

Study Tip: A trust may be a simple trust one year and a


complex trust the next year. For example, a trust that does not
distribute all income in the current year becomes a complex
trust because it failed to meet the conditions of a simple trust.

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A trust computes its gross income in much the same manner as an


individual. Generally, the deductions and credits allowed to individuals
are also allowed to trusts; however, there is one major distinction. A
trust (or a decedents estate) is allowed an income distribution
deduction for distributions to beneficiaries.

DISTRIBUTABLE NET INCOME (DNI)


DNI is the trusts income available for distribution. DNI sets the
maximum limit on the amount of deduction the trust receives for
distributions to the beneficiaries. DNI also sets the maximum amount
on which a beneficiary who receives DNI is taxed. If a beneficiary
receives a distribution in excess of DNI, only the DNI is taxed.
DNI is calculated on Form 1041, Schedule B. The calculation starts with
adjusted total income from Form 1041, adds adjusted tax-exempt
interest, which is reduced by any expense allocable to that income. DNI
is not reduced by the amount of distributions to beneficiaries.
Capital gains are allocated to corpus and are excluded from DNI unless
the trust instrument or state law require inclusion in income. Capital
losses are also excluded except to the extent that they are used to
determine the amount of capital gains required to be distributed as
income.

INCOME DISTRIBUTION DEDUCTION


The income distribution deduction (IDD) allowed to trusts (or estates)
for amounts paid, credited, or required to be distributed to beneficiaries
is limited to DNI. The income distribution deduction (IDD) is also
calculated on Schedule B. The exemption is deducted after determining
DNI.
An amount distributed to a beneficiary for inclusion in gross income
retains the same character for the beneficiary that it had for the trust.

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FILING
The fiduciary is responsible for filing Schedule K-1 and attaching a copy
of each beneficiarys Schedule K-1 to Form 1041, filed with the IRS.
Each beneficiary is to be given a copy of his or her respective Schedule
K-1.
A trust can request a five-month extension of time to file Form 1041 by
filing Form 7004, Application for Automatic Extension of Time to File
Certain Business Income Tax, Information, and Other Returns.

SELF-EMPLOYED RETIREMENT PLANS


SIMPLIFIED EMPLOYEE PENSION
A Simplified Employee Pension (SEP) is a written plan that allows the
employer to make contributions toward his or her own and his or her
employees retirement into individual IRAs without getting involved in a
more complex qualified plan.
For SEP and Keogh plans, a self-employed individual is both an
employer and employee.
A SEP can be set up for a year as late as the due date (including
extensions) of the income tax return for that year. To deduct
contributions for a year, the contributions must be made by the due
date (including extensions) of the return for the tax year.
An employer who signs a SEP agreement does not have to make any
contributions to the SEP-IRAs that are set up. However, if the employer
does make contributions, the contributions must be based on a written
allocation formula and must not discriminate in favor of highly
compensated employees.
The maximum restrictions on setting up a plan would be to require an
individual to be 21 years of age, work for the employer in at least three
of the immediately preceding five years, and receive at least $550 in
compensation from that employer in 2009.
All employees who qualify must be covered except:

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Employees covered by a union agreement and whose retirement

benefits were bargained for in good faith by their union and


employer.
Nonresident alien employees who have no U.S. source earned
income from the employer.
A leased employee must be included if that leased employee is treated
as an employee of the recipient, by meeting all of the following
requirements:
Services are provided under an agreement between the recipient and
the leasing organization.
Services are performed for the recipient, or for the recipient and
related persons, on a substantially full-time basis, for a period of at
least one year.
Services are performed under primary direction and control of the
recipient.
A highly compensated employee is any employee who meets either of
the following two conditions:
The employee owns, or owned last year, more than 5% of the capital
or profits interest in the employer, if not a corporation; or more than
5% of the outstanding stock, or more than 5% of the total voting
power of all stock of the employer corporation.
The employees compensation from the employer for last year was
more than $110,000 and, if the employer elects to apply this clause
for last year, the employee was in the top 20% when ranked on the
basis of last years compensation.
Contributions made for 2009 to a common-law employees SEP-IRA
cannot exceed the smaller of 25% of the employees compensation or
$49,000.
The employers deduction for a common-law employees SEP-IRA
cannot exceed the smaller of 25% of the employees compensation or
$49,000. Compensation is limited to $245,000 for 2009, not including
the employers contribution to the SEP-IRA. The contribution must be
made by the due date, including extensions, of the employers return.
When determining the deduction for the self-employed individual,
compensation is the net earnings from self-employment, which takes
into account the deduction for one-half of the SE tax, and the deduction
for a SEP contribution on his or her own behalf. To adjust for net

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earnings taking into account the contribution, the maximum rate for the
self-employed person is 20%.

Example: Gloria, a self-employed beauty shop operator, has a Simplified


Employee Plan (SEP) whereby she contributes 10.5% of her common-law
employees compensation. For 2009, Gloria paid her employees $100,000 and
contributed $10,500 to their SEP-IRAs. Glorias net earnings from Line 31,
Schedule C, were $200,000. Glorias self-employment tax on the $200,000 net
earnings was $19,043. Glorias net earnings from self-employment, after reducing
the amount by one-half of her self-employment tax, is $190,478. Glorias
contribution rate for her SEP is .095 (.105/1.105). Her self-employment income
limit is $18,095 ($190,478 x .095). Glorias deduction is limited to $18,095.

For purposes of the deduction limits when considering multiple plans,


treat all qualified defined contribution plans as a single plan and treat all
qualified defined benefit plans as a single plan.
If the employer has both kinds of plans, the SEP is treated as a
separate profit-sharing (defined contribution) plan. If the employer
also contributed to a qualified profit-sharing plan, the employer must
reduce the 25% deductible limit for that plan by the allowable
deduction for contributions to the SEP-IRAs of those participating in
the profit-sharing plan.
If the employer contributes to a defined-contribution retirement plan,
annual additions to an account are limited to the lesser of $49,000 or
100% of the participants compensation. For purposes of these
limits, contributions by the same employer to more than one such
plan must be totaled. Since a SEP is considered a defined
contribution plan for purposes of these limits, employer contributions
to a SEP must be added to other contributions to defined
contribution plans.
A SEP can also include a salary reduction arrangement (SARSEP).
The maximum amount a participant can elect to defer is the lesser of
$16,500 or 25% of compensation based on the limit of $245,000 of
the participants compensation.
Deferred amounts are included in wages for social security,
Medicare, and FUTA purposes only.
The SARSEP catch-up contribution limit for participants age 50 or
older is $5,500 for 2009.

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Note: An employer cannot start a SARSEP after December 31,


1996. Only SEPs that allowed employees to choose elective
deferrals prior to January 1, 1997, can include salary
reduction arrangements.

Distributions from a SEP are subject to the same rules as traditional


IRAs, including additional taxes for excess contributions, early
withdrawals, and not making required distributions. A SEP can also be
disqualified if involved in a prohibited transaction. If disqualified, the
SEP no longer qualifies as an IRA and the assets of the SEP are treated
as having been distributed to the employee on the first day of the year
in which the transaction occurred.

SAVINGS INCENTIVE MATCH PLANS FOR EMPLOYEES


A savings incentive match plan for employees (SIMPLE) is an option for
certain small business employers.
A SIMPLE plan is a written salary reduction arrangement that allows
employees of a small business to make elective contributions to
retirement accounts. In addition, the employer can contribute matching
or nonelective contributions.
An employer can set up a SIMPLE IRA plan effective on any date
between January 1 and October 1 of the year, provided he or she did
not previously maintain a SIMPLE IRA.
The plan can be either an IRA or 401(k) plan.
An eligible employer is any employer who has 100 or fewer eligible
employees who received $5,000 or more in compensation for the
preceding year. In addition, the employer is eligible if he or she does
not maintain another employer-sponsored retirement plan.
An eligible employee is any employee who receives at least $5,000 in
compensation during any two years preceding the plan year. The
employee must be expected to earn at least $5,000 during the calendar
year for which the contributions are made.

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Under the qualified salary reduction arrangement, the employers


contribution on behalf of an employee is stated as a percentage of the
employees compensation and limited to $11,500.
If the participant is age 50 or older, he or she can contribute an extra
$2,500 for catch-up purposes.
The employer is required to make a matching or a nonelective
contribution.
The matching contribution is on a dollar-for-dollar basis, up to 3% of
the employees compensation, not to exceed the employees elective
deferral.
The nonelective contribution is 2% of compensation for the year.
Only $245,000 of compensation can be taken into account.
The employer is required to contribute the employees deferral within
30 days after the end of the month for which payments were deferred.
The employers matching contributions are required to be made by the
tax return due date including extensions.
Distributions from a SIMPLE IRA plan are subject to the IRA rules and
are included in income when withdrawn. To qualify for tax-free rollover
treatment, a distribution made from a SIMPLE IRA within the first two
years, beginning on the date that the individual first participated, can
only be rolled to another SIMPLE IRA. After this two-year period, a
distribution may be rolled to an IRA other than a SIMPLE IRA.
The qualification rules, discussed later under qualified plans, also apply
to a SIMPLE 401(k) plan. However, a SIMPLE 401(k) plan is not subject
to the top-heavy rules and nondiscrimination rules if the plan satisfies
the provisions listed above.

Note: Early withdrawal of funds from a SIMPLE retirement plan


made within two years of beginning participation in the plan
is subject to a 25% penalty, rather than 10%.

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QUALIFIED PLANS
A qualified plan, sometimes referred to as a Keogh or H.R. 10 plan, is a
retirement plan that can only be established by an employer (sole
proprietor or partnership), and must be for the exclusive benefit of
employees or their beneficiaries. If self-employed, it is not necessary to
have other employees to set up a plan.
There are two basic types of qualified plans:
A defined contribution plan provides an individual account for each
plan participant.
A profit-sharing plan is a plan to share business profits with
employees. However, a contribution does not need to be made
out of net profits. The plan must provide a definite formula for
allocating the contributions among participants.
Contributions to a money-purchase pension plan are fixed and not
based on business profits.
A defined benefit plan is any plan that is not a defined contribution
plan. Contributions are based on what is needed to provide definitely
determinable benefits to plan participants. Actuarial assumptions and
computations are required to determine contributions.
To set up a plan, first adopt a written plan and then invest fund assets.
The employer is responsible for setting up and maintaining the plan. To
take a deduction for the tax year, the plan must be set up by the last
day of that year.
The plan must be in writing and communicated to employees. The
employer can adopt a master or prototype plan, or set up an
individually designed plan to meet specific needs. The employer can
apply for approval of the plan with the IRS by requesting a
determination letter. No user fee is required for employers who have
100 or fewer employees who received at least $5,000 of compensation
from the employer for the preceding year. At least one of those
employees must be a non-highly compensated employee.
If the plan is a money purchase pension plan or a defined benefit plan,
enough must be paid into the plan to meet minimum funding standards
each year. A defined benefit plan requires quarterly payments to meet
minimum funding standards.
To qualify for tax benefits, a Keogh plan must meet certain qualification
rules.

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The plan must make it impossible for its assets to be used for or

diverted to purposes other than the benefit of employees or their


beneficiaries. As a general rule the assets cannot be diverted to the
employer.
The plan must benefit at least the fewer of 50 employees or the
greater of 40% of all employees or two employees. If the employer
has only one employee, the plan must benefit that employee.
Contributions or benefits must not discriminate in favor of highly
compensated employees.
The plan must satisfy vesting requirements.
Unless the participant chooses otherwise, benefit payments must
start within 60 days after the close of the latest of the following
periods:
The plan year in which the participant reaches the earlier of age
65 or the normal retirement age specified in the plan.
The plan year in which the tenth anniversary of the year the
participant began participating fell on.
The plan year in which the participant separates from service.
Defined benefit and money-purchase pension plans must provide for
automatic survivor benefits.
If merged, the participant will receive a benefit equal to or greater
than what he or she would be entitled to prior to merger.
Benefits must not be assigned or alienated.
There must be no benefit reduction for social security increases.
Elective deferrals must be limited.

An employee must be allowed to participate if he or she meets the


following minimum participation requirements:
Has reached the age of 21.
Has at least one year of service (two years if the plan provides that,
after not more than two years of service, the employee has a
nonforfeitable right to all of his or her accrued benefits).
A plan cannot exclude an employee because of his or her reaching a
specific age.
A leased employee is considered an employee of the taxpayer for
certain plan qualification rules.
A top-heavy plan is one that mainly favors partners, sole proprietors,
and other key employees. The plan is top-heavy for any year in which

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the total value of accrued benefits or account balances of key


employees is more than 60% of the total value of accrued benefits or
account balances of all employees.
For Keogh plan purposes, common-law employees are not selfemployed with respect to income from their work, even if that income is
self-employment income for social security tax purposes. Common-law
employees, such as ministers, members of religious orders, full-time
insurance salespeople, and U.S. citizens employed in the United States
by foreign governments cannot establish Keogh plans with respect to
their earnings from such employment.

CONTRIBUTIONS
The self-employed individual can make contributions on behalf of
himself or herself only if he or she has net earnings from selfemployment in the trade or business for which the plan was set up. The
net earnings must be from personal services, not from investments. If
there is a net loss for the year, the self-employed individual cannot
make contributions for himself or herself even if required to make
contributions for common-law employees based on their compensation.
Contributions are generally applied to the year made. However,
contributions can be applied to the previous year if certain requirements
are satisfied.
The contributions are made by the due date of the employers tax
return for the previous year (plus extensions).
The plan was established by the end of the previous year.
The plan treats the contributions as if received on the last day of the
previous year.
The employer specifies in writing that the contributions apply to the
previous year or the employer deducts the contributions on the
return for the previous year.
The plan must provide that contributions or benefits cannot exceed
certain limits. The limits differ depending on whether the Keogh plan is
a defined contribution plan or a defined benefit plan.
For 2009 the annual benefit for a participant under a defined benefit
plan may not be more than the smaller of $195,000, or 100% of the
participants average compensation for his or her highest three
consecutive calendar years.

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A defined contribution plans annual contributions and other

additions (excluding earnings) to the account of a participant cannot


exceed the smaller of $49,000 or 100% of the participants
compensation. Catch-up contributions are not subject to this limit.
Excess annual additions resulting from a reasonable error in estimating
a participants compensation, a reasonable error in determining the
elective deferrals permitted, or forfeitures allocated to the participants
accounts, may be corrected.
Allocate the excess to other participants to the extent of their limits.
If the limits are exceeded, hold the excess in a separate account and
allocate to the following year, or return the after-tax contributions
and elective deferrals to employees.
Participants may be permitted to make nondeductible voluntary
contributions to a plan in addition to the employer contributions. Even
though these contributions are not deductible, the earnings on them are
tax-free until distributed in later years.
The employer deduction for contributions is limited, depending on the
type of plan.
The deduction for contributions to a profit-sharing plan or moneypurchase plan cannot be more than 25% of the compensation paid or
accrued during the year. This limit is reduced to 20% for the selfemployed individuals own contribution due to the requirement to
use net-earnings, which takes into account the deduction for one half
of the SE tax and a deduction for the contribution on his or her
behalf.
The deduction for contributions to a defined benefit plan is based on
the actuarial assumptions and computations.
For contributions to both a defined contribution plan and a defined
benefit plan, the deduction cannot be more than the greater of the
following amounts:
25% of the compensation paid during the year.
The employer contribution to the defined benefit plan, but not
more than the amount needed to meet the years minimum
funding standard.
The employer takes the deduction for contributions for common-law
employees on Schedule C (Form 1040), Schedule F (Form 1040), Form
1065, Form 1120, Form 1120-A, or Form 1120S. The deduction by the
self-employed individual (Schedule C, F, or partner) for his or her own
contributions is taken on Line 28 of Form 1040.
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A qualified plan can include a cash or deferred arrangement [401(k)


plan] under which eligible employees can elect to have the employer
contribute part of their before-tax pay to the plan rather than receive
the pay in cash.
A qualified plan can include a 401(k) plan only if the plan is a profitsharing plan or a money-purchase pension plan in existence on June
27, 1974, that included a salary-reduction arrangement on that date.
A partnership can have a 401(k) plan.
The employer can also make nonelective contributions (other than
matching contributions) for participating employees without giving
them the choice to take cash instead.
The employer can also make matching contributions for employees
who make elective deferrals.
No more than $245,000 of the employees compensation can be
taken into account when figuring contributions.
If the employer had 100 or fewer employees who earned $5,000 or
more in compensation during the preceding year, the employer may
be able to set up a SIMPLE 401(k) plan. A SIMPLE 401(k) plan is not
subject to the nondiscrimination and top-heavy plan requirements.
There is a limit on the amount that an employee can defer each year
under elective deferral retirement plans. For 2009, the limit on elective
deferrals is $16,500. This limit is subject to annual increases to reflect
adjustments for inflation.
There is a catch-up allowance of $5,500 for 2009 for individuals who
are age 50 or over at the end of the plan year. Elective deferrals are not
treated as catch-up contributions until they exceed the $16,500 limit.
If the total of the employees deferrals exceeds the annual limit, the
employee can have the excess deferral paid out of the plans that permit
these distributions. The employee must notify the plan by April 15,
2010, of the amount to be paid from each plan and the plan must then
pay the employee that amount by April 15, 2010.
If the employee takes out the excess deferral by April 15, 2010, it is not
reported again by including it in the employees gross income for 2010.
However, any income earned on the excess deferral taken out is taxable
in the tax year in which it is taken out. The distribution is not subject to
the additional 10% tax on early distributions.
If the employee does not take out the excess deferral by April 15, the
excess, though taxable in 2009, is not included in the employees cost

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basis in figuring the taxable amount of any eventual benefits or


distributions under the plan. In effect, an excess deferral left in the plan
is taxed twice, once when contributed and again when distributed.

QUALIFIED ROTH CONTRIBUTION PROGRAM


An eligible employee can designate all or a portion of his or her elective
deferrals as after-tax Roth contributions. Designated Roth contributions
are not excluded from the employees gross income but qualified
distributions from a Roth account are excluded from income.
The amount that may be designated is limited to the maximum amount
of elective deferrals ($16,500) less the total amount of the employees
elective deferrals not designated as Roth contributions.
A qualified distribution is a distribution that is made after the
employees nonexclusion period and:
On or after the employee attains age 59.
On account of the employees being disabled.
On or after the employees death.
The employees nonexclusion period for a plan is the five-year period
beginning with the earlier of the following:
The first tax year in which the employee made a designated Roth
contribution to the plan.
If a rollover contribution was made to the employees designated
Roth account from a designated Roth account previously established
for the employee under another plan, then the first tax year the
employee made a designated Roth contribution to the previously
established account.

DISTRIBUTIONS
Distributions may be required distributions, periodic distributions, or
nonperiodic distributions.
A qualified plan must provide that each participant will either:
Receive his or her entire interest in the plan by the required
beginning date; or

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Begin receiving regular periodic distributions by the required

beginning date in annual amounts calculated to distribute the


participants entire interest over his or her life expectancy or over
the joint life expectancy of the participant and the designated
beneficiary.
A participant must begin receiving distributions by April 1 of the first
year after the later of the calendar year in which he or she reaches age
70, or the calendar year he or she retires from employment with the
employer maintaining the plan.
Prior to 1997, the required beginning date did not take into account
whether the participant was still working. The participant was required
to start taking distributions by April 1 of the year following the year in
which he or she turned age 70. This rule still applies if the participant
is a 5% owner or the distribution is from a traditional or SIMPLE IRA.
Generally, distributions from a 401(k) plan cannot be made until one of
the following occurs:
The employee retires, dies, becomes disabled, or otherwise
separates from service.
The plan ends and no other defined contribution plan is established
or continued.
If part of a profit-sharing plan, the employee reaches age 59 or
suffers financial hardship.
These distribution restrictions do not apply if the distribution is to an
alternate payee under the terms of a qualified domestic relations
order (QDRO).
The recipient of an eligible rollover distribution may defer the tax by
rolling it into an IRA or other eligible plan. The following distributions
are not eligible to be rolled over:
A required minimum distribution.
A series of substantially equal periodic payments made at least
yearly.
A hardship distribution.
The portion attributable to the employees nondeductible
contribution.
A corrective distribution of excess contributions or deferrals.
Loans treated as distributions.
Dividends on employer securities.
The cost